Strategic Professional – Options
Paper AFM
Advanced Financial
Management
Mock Exam 4
Time allowed: 3 hours 15 minutes
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be
attempted
Section B – BOTH questions to be attempted
Please allow yourself the opportunity to properly assess your
knowledge.
1- Find a quiet room
2- Set aside the correct time, and stop on time
3- Answer paper are accepted either as word document or photo
of handwritten answers with each page numbered
For our feedback to be valuable, your attempt must be honest.
Section A – This question is compulsory and MUST be attempted
Question 1
Protein Co is a listed retailer, mainly selling food and small household goods. It has outperformed its
competitors over the last few years as a result of providing high quality products at reasonable prices, and
also having a stronger presence online. It has kept a control on costs, partly by avoiding operating large
stores on expensive city centre sites. Instead, it has had smaller stores on the edge of cities and towns,
and a limited number of larger stores on convenient out-of-town sites, aiming at customers who want their
journeys to shops to be quick. One of its advertising slogans has been: ‘We are where you want us to be.’
Protein Co’s share price has recently performed better than most companies in the retail sector generally.
Share prices in the retail sector have been relatively low as a result of poor results due to high competition,
large fixed cost base and high interest rates. The exception has been shares in retailers specialising in
computer and high-technology goods. These shares appear to have benefited from a boom generally in
share prices of high-technology companies. Some analysts believe share prices of many companies in
the high-technology sector are significantly higher than a rational analysis of their future prospects would
indicate.
Maverick Co
Protein Co has identified the listed retailer Maverick Co as an acquisition target, because it believes that
Maverick Co’s shares are currently undervalued and part of Maverick Co’s operations would be a good
strategic fit for Protein Co.
Maverick Co operates two types of store:
• Maverick Home mainly sells larger household items and home furnishings. These types of retailer
have performed particularly badly recently and one major competitor of Maverick Home has just
gone out of business. Maverick Home operates a number of city centre sites but has a much
higher proportion of out-of-town sites than its competitors.
• Maverick Tech sells computers and mobile phones in much smaller outlets than those of Maverick
Home.
Extracts from Maverick Co’s latest annual report are given below:
$m
Pre-tax profit 1,950
Long-term loan 6,500
Share capital ($1 shares) 5,000
The share of pre-tax profit between Maverick Home and Maverick Tech was 80:20.
The current market value of Maverick Co’s shares is $12,500m and its debt is currently trading at its book
value. Protein Co believes that it will have to pay a premium of 15% to Maverick Co’s shareholders to buy
the company.
Protein Co intends to take advantage of the current values attributed to businesses such as Maverick Tech
by selling this part of Maverick Co at the relevant sector price earnings ratio of 18, rather than a forecast
estimate of Maverick Tech’s present value of future free cash flows of $4,500m.
The company tax rate for both companies is 28% per year.
Post-acquisition cost of capital
The post-acquisition cost of capital of the combined company will be based on its cost of equity and cost
of debt. The asset beta post-acquisition can be assumed to be both companies’ asset betas weighted in
proportion to their current market value of equity.
Protein Co has 4,000 million $1 shares in issue, currently trading at $8.50. It has $26,000m debt in issue,
currently trading at $105 per $100 nominal value. Its equity beta is 1.02.
Maverick Co’s asset beta is 0.75. The current market value of Maverick Co’s shares is $12,500m and its
long-term loan is currently trading at its book value of $6,500m.
The risk-free rate of return is estimated to be 3·5% and the market risk premium is estimated to be 8%.
The pre-tax cost of debt of the combined company is expected to be 9.8%. It can be assumed that the
debt:equity ratio of the combined company will be the same as Protein Co’s current debt:equity ratio in
market values.
The company tax rate for both companies is 28% per year.
Plans for Maverick Co
The offer for Maverick Co will be a cash offer. Any funding required for this offer will be a mixture of debt
and equity. Although for the purposes of the calculation it has been assumed that the overall mix of debt
and equity will remain the same, the directors are considering various plans for funding the purchase which
could result in a change in Protein Co’s gearing.
As soon as it acquires all of Maverick Co’s share capital, Protein Co would sell Maverick Tech as it does
not fit in with Protein Co’s strategic plans and Protein Co wishes to take advantage of the large values
currently attributed to high-technology businesses. Protein Co would then close Maverick Home’s worst-
performing city centre stores. It anticipates the loss of returns from these stores would be partly
compensated by higher online sales by Maverick Co, generated by increased investment in its online
operations. The remaining city centre stores and all out-of-town stores would start selling the food and
household items currently sold in Protein Co’s stores, and Protein Co believes that this would increase
profits from those stores.
Protein Co also feels that reorganising Maverick Co’s administrative functions and using increased power
as a larger retailer can lead to synergies after the acquisition.
Post-acquisition details
Once Maverick Tech has been sold, Protein Co estimates that sales revenue from the Maverick Home
stores which remain open, together with the online sales from its home business, will be $43,260m in the
first year post-acquisition, and this figure is expected to grow by 3% per year in years 2 to 4. The profit
margin before interest and tax is expected to be 6% of sales revenue in years 1 to 4.
Tax allowable depreciation is assumed to be equivalent to the amount of investment needed to maintain
existing operations. However, an investment in assets (including working capital) will be required of $630m
in year 1. In years 2 to 4, investment in assets each year will be $0·50 of every $1 increase in sales
revenue.
After four years, the annual growth rate of free cash flows is expected to be 2% for the foreseeable future.
As well as the free cash flows from Maverick Co, Protein Co expects that post-tax synergies will arise from
its planned reorganisation of Maverick Co as follows in the next three years:
Year 1 2 3
$m $m $m
Free cash flows 700 750 780
The current market value of Maverick Co’s shares is $12,500m and its debt is currently trading at its book
value of $6,500m.
Required:
(a) Discuss the behavioural factors which may have led to businesses such as Maverick Tech
being valued highly.
(4 marks)
(b) Prepare a report for the board of directors of Protein Co which:
(i) compares the additional value which Protein Co believes can be generated from the sale of
Maverick Tech based on the P/E ratio, with that of the projected present value of its future free
cash flows;
(4 marks)
(ii) calculates the weighted average cost of capital for the combined company;
(6 marks)
(iii) estimates the total value which Protein Co’s shareholders will gain from the acquisition of
Maverick Co; and
(10 marks)
(iv) assesses the strategic and financial value to Protein Co of the acquisition, including a
discussion of the estimations and assumptions made.
(10 marks)
(c) Discuss the factors which may determine how the offer for Maverick Co will be financed and
hence the level of gearing which Protein Co will have.
(6 marks)
Professional marks will be awarded for the demonstration of skill in communication, analysis and
evaluation, professional scepticism and commercial acumen in your answer.
(10 marks)
(Total 50 marks)
Section B – BOTH questions to be attempted
Question 2
Nortan Co is based in the Eurozone and manufactures components for agricultural machinery. The
company is financed by a combination of debt and equity, having obtained a listing five years ago. In
addition to the founder’s equity stake, the shareholders consist of pension funds and other institutional
investors. Until recently, sales have been generated exclusively within the Eurozone area but the directors
are keen to expand and have identified North America as a key export market. The company recently
completed its first sale to a customer based in the United States, although payment will not be received
for another six months.
Hedging policy and key stakeholders
At a recent board meeting, Nortan Co’s finance director argued that the expansion into foreign markets
creates the need for a formal hedging policy and that shareholder value would be enhanced if this policy
was communicated to the company’s other stakeholders. However, Nortan Co’s chief executive officer
disagreed with the finance director on the following grounds. First, existing shareholders are already well
diversified and would therefore not benefit from additional risk reduction hedging strategies. Second, there
is no obvious benefit to shareholder value by communicating the hedging policy to other stakeholders such
as debt providers, employees, customers and suppliers. You have been asked to provide a rationale for
the finance director’s comments in advance of the next board meeting.
Hedging products
Assume today’s date is 1 March 2020. Nortan Co is due to receive $18,600,000 from the American
customer on 31 August 2020. The finance director is keen to minimise the company’s exposure to foreign
exchange risk and has identified forward contracts, exchange traded futures and options as a way of
achieving this objective.
The following quotations have been obtained.
Exchange rates (quoted as €/US$1)
Spot 0·8707–0·8711
Six months forward 0·8729–0·8744
Currency futures (contract size €200,000; exercise price quoted as US$ per €1)
Exercise price
March 1·1476
June 1·1449
September 1·1422
Currency options (contract size €200,000; exercise price quoted as US$ per €1, premium: US
cents per €1)
Calls Puts
Exercise price March June September March June September
1·1420 0·43 0.59 0.77 0.62 0.78 0.89
Assume futures and options contracts mature at the month end and that there is no basis risk. The number
of contracts to be used should be rounded down to the nearest whole number in calculations. If the full
amount cannot be hedged using an exact number of futures or options contracts, the balance is hedged
using the forward market.
Margin information
Once the position is open, the euro futures contract outlined above will be marked-to-market on a daily
basis. The terms of the contract require Nortan Co to deposit an initial margin of $3,500 per contract with
the clearing house. Assume the maintenance margin is equivalent to the initial margin. The tick size on
the contract is $0·0001.
Your manager is concerned about the impact of an open futures position on Nortan Co’s cash flow and
has asked you to calculate and explain the impact of the following hypothetical changes in the closing
settlement price in the first three days of the contract.
Closing settlement prices (US$ per €1)
Date Settlement price
1 March 1·1410
2 March 1·1418
3 March 1·1433
Required:
(a) Explain the rationale for the policy of hedging Nortan Co’s foreign exchange risk and the
potential benefits to shareholder value if that policy is effectively communicated to the
company’s key stakeholders
(4 marks)
(b) Recommend a hedging strategy for Nortan Co’s foreign currency receipt in six months’
time based on the hedging choices the finance director is considering. Support your
recommendation with appropriate discussion and relevant calculations.
(11 marks)
(c) Calculate and explain the impact of the open futures position on Nortan Co’s US$ cash
flow, based on the settlement prices provided
(5 marks)
Professional marks will be awarded for the demonstration of skill in analysis and evaluation, professional
scepticism and commercial acumen in your answer.
(5 marks)
(Total 25 marks)
Question 3
Arfield Co operates in the aviation industry, manufacturing safety equipment for commercial aircraft. The
company has a policy of carefully appraising new investment opportunities, including the detailed analysis
of all cost and revenue assumptions prior to their approval.
Project chi
Arfield Co’s board is reviewing a potential investment, project chi. The company’s engineers have
developed a new technology which can detect the potential for mechanical failure with a greater degree of
accuracy than has previously been the case. Early test results have been extremely encouraging.
If the board accepts the engineers’ proposal, Arfield Co would need to submit an application to the relevant
regulatory authority. It is expected regulatory approval would be granted in one year’s time. Manufacturing
and sales would commence immediately after being granted regulatory approval. Arfield Co’s chief
engineer presented an investment case for project chi to the board, including a summary of the following
cost and revenue forecasts and assumptions.
Arfield Co is expected to sell 3,000 units in the first year of production with demand increasing by 5% in
each subsequent year of its four-year life. These sales forecasts are based on a contribution of $5,000 per
unit in the first year of production and increasing at 2% per year in subsequent years. Annual fixed costs
of $8.7m are expected in the first year of production, increasing at 3% per year throughout the life of the
project.
An investment in plant and machinery of $12m will be required as soon as regulatory approval has been
granted. Tax allowable depreciation is available on the plant and machinery at an annual rate of 20% on
a straight-line basis. A balancing adjustment is expected at the end of the project when the plant and
machinery will be scrapped.
Tax is payable at 20% in the year in which profits are made. The relevant cost of capital to be used in the
appraisal is 12%.
Project chi extra information
The finance director, however, raised the following objections and consequences to the chief engineer’s
presentation.
The chief engineer’s cost and revenue assumptions ignore the possibility of a recession, which has a 20%
probability of occurring. In a recession, the total present values for the four years of production are likely
to be 40% lower. The finance director also believes there is an alternative, mutually exclusive, development
opportunity based on the new technology although this would still depend on it being granted regulatory
approval. This alternative option would incur an identical investment cost of $12m but generate annual,
inflation adjusted, post-tax cash flows of $3·43m over its seven-year life from year two onwards.
The investment case assumes regulatory approval is certain whereas historically only 70% of Arfield Co’s
applications have been approved. In one year’s time, if the regulatory application is not approved, it is
assumed that the concept can be sold to Geo Co for $1·0m at that time. If the board rejects the proposal
now, assume the concept can be sold for $4·3m immediately.
Projects lambda and kappa
A recent board meeting discussed two recent investments, projects lambda and kappa, both involving the
construction of new manufacturing plants for safety equipment. Both projects are now operational although
project lambda experienced significant time delays and cost overruns while project kappa was under
budget and within schedule.
On closer examination, the directors noticed that project lambda’s revenue far exceeded initial
expectations, whereas project kappa’s revenue was much less than originally expected. On balance,
Arfield Co’s chief executive officer suggested that each project’s successes compensated for their
respective failings and that this was to be expected when making predictions about the future in an
investment plan. However, one of the directors suggested the company could benefit from the introduction
of a capital investment monitoring system and post-completion audit. The directors agreed to discuss this
in greater depth at the next board meeting.
Required:
(a) (i) Evaluate the financial acceptability of the project chi investment proposal based on the
chief engineer’s forecasts, assuming regulatory approval is granted in one year’s time.
(5 marks)
(ii) Calculate the expected net present value of the proposal based on the finance director’s
assumptions about the likelihood of a recession and the potential impact on project chi’s
cash flows.
(2 marks)
(iii) Calculate the net present value of the finance director’s alternative option for the
technology and advise the board whether this is worth pursuing.
(2 marks)
(iv) Recommend whether the board should proceed with the application for regulatory
approval after taking into consideration Arfield Co’s 70% approval rate with its regulatory
applications or to sell the concept now to Geo Co. Include in your analysis any comments
on your findings.
(5 marks)
(b) Explain the rationale for implementing capital investment monitoring systems and post-
completion audits. Suggest ways in which Arfield Co may have benefited if these
procedures had been applied to projects lambda and kappa.
(6 marks)
Professional marks will be awarded for the demonstration of skill in analysis and evaluation, professional
scepticism and commercial acumen in your answer.
(5 marks)
(Total 25 marks)
