Professional Level Options Module

Time allowed
Reading and planning: 15 minutes
Writing: 3 hours
This paper is divided into two sections:
Section A This ONE question is compulsory and MUST be attempted
Section B TWO questions ONLY to be attempted
Formulae and tables are on pages 913.
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may
be annotated. You must NOT write in your answer booklet until
instructed by the supervisor.
This question paper must not be removed from the examination hall.
P
a
p
e
r

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4
Advanced Financial
Management
Tuesday 3 June 2014
The Association of Chartered Certified Accountants
Section A This ONE question is compulsory and MUST be attempted
1 Cocoa-Mocha-Chai (CMC) Co is a large listed company based in Switzerland and uses Swiss Francs as its currency.
It imports tea, coffee and cocoa from countries around the world, and sells its blended products to supermarkets and
large retailers worldwide. The company has production facilities located in two European ports where raw materials
are brought for processing, and from where finished products are shipped out. All raw material purchases are paid for
in US dollars (US$), while all sales are invoiced in Swiss Francs (CHF).
Until recently CMC Co had no intention of hedging its foreign currency exposures, interest rate exposures or
commodity price fluctuations, and stated this intent in its annual report. However, after consultations with senior and
middle managers, the companys new Board of Directors (BoD) has been reviewing its risk management and
operations strategies.
The following two proposals have been put forward by the BoD for further consideration:
Proposal one
Setting up a treasury function to manage the foreign currency and interest rate exposures (but not commodity price
fluctuations) using derivative products. The treasury function would be headed by the finance director. The purchasing
director, who initiated the idea of having a treasury function, was of the opinion that this would enable her
management team to make better decisions. The finance director also supported the idea as he felt this would increase
his influence on the BoD and strengthen his case for an increase in his remuneration.
In order to assist in the further consideration of this proposal, the BoD wants you to use the following upcoming foreign
currency and interest rate exposures to demonstrate how they would be managed by the treasury function:
(i) a payment of US$5,060,000 which is due in four months time; and
(ii) a four-year CHF60,000,000 loan taken out to part-fund the setting up of four branches (see proposal two below).
Interest will be payable on the loan at a fixed annual rate of 22% or a floating annual rate based on the yield
curve rate plus 040%. The loans principal amount will be repayable in full at the end of the fourth year.
Proposal two
This proposal suggested setting up four new branches in four different countries. Each branch would have its own
production facilities and sales teams. As a consequence of this, one of the two European-based production facilities
will be closed. Initial cost-benefit analysis indicated that this would reduce costs related to production, distribution
and logistics, as these branches would be closer to the sources of raw materials and also to the customers. The
operations and sales directors supported the proposal, as in addition to above, this would enable sales and marketing
teams in the branches to respond to any changes in nearby markets more quickly. The branches would be controlled
and staffed by the local population in those countries. However, some members of the BoD expressed concern that
such a move would create agency issues between CMC Cos central management and the management controlling
the branches. They suggested mitigation strategies would need to be established to minimise these issues.
Response from the non-executive directors
When the proposals were put to the non-executive directors, they indicated that they were broadly supportive of the
second proposal if the financial benefits outweigh the costs of setting up and running the four branches. However,
they felt that they could not support the first proposal, as this would reduce shareholder value because the costs
related to undertaking the proposal are likely to outweigh the benefits.
Additional information relating to proposal one
The current spot rate is US$10635 per CHF1. The current annual inflation rate in the USA is three times higher than
Switzerland.
The following derivative products are available to CMC Co to manage the exposures of the US$ payment and the
interest on the loan:
Exchange-traded currency futures
Contract size CHF125,000 price quotation: US$ per CHF1
3-month expiry 10647
6-month expiry 10659
2
Exchange-traded currency options
Contract size CHF125,000, exercise price quotation: US$ per CHF1, premium: cents per CHF1
Call Options Put Options
Exercise price 3-month expiry 6-month expiry 3-month expiry 6-month expiry
106 187 275 141 216
107 134 222 188 263
It can be assumed that futures and option contracts expire at the end of the month and transaction costs related to
these can be ignored.
Over-the-counter products
In addition to the exchange-traded products, Pecunia Bank is willing to offer the following over-the-counter derivative
products to CMC Co:
(i) A forward rate between the US$ and the CHF of US$ 10677 per CHF1.
(ii) An interest rate swap contract with a counterparty, where the counterparty can borrow at an annual floating rate
based on the yield curve rate plus 08% or an annual fixed rate of 38%. Pecunia Bank would charge a fee of
20 basis points each to act as the intermediary of the swap. Both parties will benefit equally from the swap
contract.
Required:
(a) Advise CMC Co on an appropriate hedging strategy to manage the foreign exchange exposure of the US$
payment in four months time. Show all relevant calculations, including the number of contracts bought or
sold in the exchange-traded derivative markets. (15 marks)
(b) Demonstrate how CMC Co could benefit from the swap offered by Pecunia Bank. (6 marks)
(c) As an alternative to paying the principal on the loan as one lump sum at the end of the fourth year, CMC Co
could pay off the loan in equal annual amounts over the four years similar to an annuity. In this case, an annual
interest rate of 2% would be payable, which is the same as the loans gross redemption yield (yield to maturity).
Required:
Calculate the modified duration of the loan if it is repaid in equal amounts and explain how duration can be
used to measure the sensitivity of the loan to changes in interest rates. (7 marks)
(d) Prepare a memorandum for the Board of Directors (BoD) of CMC Co which:
(i) Discusses proposal one in light of the concerns raised by the non-executive directors; and (9 marks)
(ii) Discusses the agency issues related to proposal two and how these can be mitigated. (9 marks)
Professional marks will be awarded in part (d) for the presentation, structure, logical flow and clarity of the
memorandum. (4 marks)
(50 marks)
3 [P.T.O.
Section B TWO questions ONLY to be attempted
2 You have recently commenced working for Burung Co and are reviewing a four-year project which the company is
considering for investment. The project is in a business activity which is very different from Burung Cos current line
of business.
The following net present value estimate has been made for the project:
All figures are in $ million
Year 0 1 2 3 4
Sales revenue 2303 3660 4907 2714
Direct project costs (1382) (2196) (2944) (1628)
Interest (120) (120) (120) (120)

Profit 801 1344 1843 966
Tax (20%) (160) (269) (369) (193)
Investment/sale (3800) 400

Cash flows (3800) 641 1075 1474 1173
Discount factors (7%) 1 0935 0873 0816 0763

Present values (3800) 599 938 1203 895

Net present value is negative $165 million, and therefore the recommendation is that the project should not be
accepted.
In calculating the net present value of the project, the following notes were made:
(i) Since the real cost of capital is used to discount cash flows, neither the sales revenue nor the direct project costs
have been inflated. It is estimated that the inflation rate applicable to sales revenue is 8% per year and to the
direct project costs is 4% per year.
(ii) The project will require an initial investment of $38 million. Of this, $16 million relates to plant and machinery,
which is expected to be sold for $4 million when the project ceases, after taking any taxation and inflation impact
into account.
(iii) Tax allowable depreciation is available on the plant and machinery at 50% in the first year, followed by 25% per
year thereafter on a reducing balance basis. A balancing adjustment is available in the year the plant and
machinery is sold. Burung Co pays 20% tax on its annual taxable profits. No tax allowable depreciation is
available on the remaining investment assets and they will have a nil value at the end of the project.
(iv) Burung Co uses either a nominal cost of capital of 11% or a real cost of capital of 7% to discount all projects,
given that the rate of inflation has been stable at 4% for a number of years.
(v) Interest is based on Burung Cos normal borrowing rate of 150 basis points over the 10-year government yield
rate.
(vi) At the beginning of each year, Burung Co will need to provide working capital of 20% of the anticipated sales
revenue for the year. Any remaining working capital will be released at the end of the project.
(vii) Working capital and depreciation have not been taken into account in the net present value calculation above,
since depreciation is not a cash flow and all the working capital is returned at the end of the project.
It is anticipated that the project will be financed entirely by debt, 60% of which will be obtained from a subsidised
loan scheme run by the government, which lends money at a rate of 100 basis points below the 10-year government
debt yield rate of 25%. Issue costs related to raising the finance are 2% of the gross finance required. The remaining
40% will be funded from Burung Cos normal borrowing sources. It can be assumed that the debt capacity available
to Burung Co is equal to the actual amount of debt finance raised for the project.
Burung Co has identified a company, Lintu Co, which operates in the same line of business as that of the project it
is considering. Lintu Co is financed by 40 million shares trading at $320 each and $34 million debt trading at $94
per $100. Lintu Cos equity beta is estimated at 15. The current yield on government treasury bills is 2% and it is
estimated that the market risk premium is 8%. Lintu Co pays tax at an annual rate of 20%.
4
Both Burung Co and Lintu Co pay tax in the same year as when profits are earned.
Required:
(a) Calculate the adjusted present value (APV) for the project, correcting any errors made in the net present
value estimate above, and conclude whether the project should be accepted or not. Show all relevant
calculations. (15 marks)
(b) Comment on the corrections made to the original net present value estimate and explain the APV approach
taken in part (a), including any assumptions made. (10 marks)
(25 marks)
5 [P.T.O.
3 Vogel Co, a listed engineering company, manufactures large scale plant and machinery for industrial companies. Until
ten years ago, Vogel Co pursued a strategy of organic growth. Since then, it has followed an aggressive policy of
acquiring smaller engineering companies, which it feels have developed new technologies and methods, which could
be used in its manufacturing processes. However, it is estimated that only between 30% and 40% of the acquisitions
made in the last ten years have successfully increased the companys shareholder value.
Vogel Co is currently considering acquiring Tori Co, an unlisted company, which has three departments.
Department A manufactures machinery for industrial companies, Department B produces electrical goods for the retail
market, and the smaller Department C operates in the construction industry. Upon acquisition, Department A will
become part of Vogel Co, as it contains the new technologies which Vogel Co is seeking, but Departments B and C
will be unbundled, with the assets attached to Department C sold and Department B being spun off into a new
company called Ndege Co.
Given below are extracts of financial information for the two companies for the year ended 30 April 2014.
Vogel Co Tori Co
$ million $ million
Sales revenue 7902 1246

Profit before depreciation, interest and tax (PBDIT) 2444 374
Interest 138 43
Depreciation 724 101

Pre-tax profit 1582 230

Vogel Co Tori Co
$ million $ million
Non-current assets 7239 982
Current assets 1426 465
7% unsecured bond 400
Other non-current and current liabilities 2124 202
Share capital (50c/share) 1900 200
Reserves 4641 645
Share of current and non-current assets and profit of Tori Cos three departments:
Department A Department B Department C
Share of current and non-current assets 40% 40% 20%
Share of PBDIT and pre-tax profit 50% 40% 10%
Other information
(i) It is estimated that for Department C, the realisable value of its non-current assets is 100% of their book value,
but its current assets realisable value is only 90% of their book value. The costs related to closing
Department C are estimated to be $3 million.
(ii) The funds raised from the disposal of Department C will be used to pay off Tori Cos other non-current and
current liabilities.
(iii) The 7% unsecured bond will be taken over by Ndege Co. It can be assumed that the current market value of
the bond is equal to its book value.
(iv) At present, around 10% of Department Bs PBDIT come from sales made to Department C.
(v) Ndege Cos cost of capital is estimated to be 10%. It is estimated that in the first year of operation Ndege Cos
free cash flows to firm will grow by 20%, and then by 52% annually thereafter.
(vi) The tax rate applicable to all the companies is 20%, and Ndege Co can claim 10% tax allowable depreciation
on its non-current assets. It can be assumed that the amount of tax allowable depreciation is the same as the
investment needed to maintain Ndege Cos operations.
6
(vii) Vogel Cos current share price is $3 per share and it is estimated that Tori Cos price-to-earnings (PE) ratio is
25% higher than Vogel Cos PE ratio. After the acquisition, when Department A becomes part of Vogel Co, it is
estimated that Vogel Cos PE ratio will increase by 15%.
(viii) It is estimated that the combined companys annual after-tax earnings will increase by $7 million due to the
synergy benefits resulting from combining Vogel Co and Department A.
Required:
(a) Discuss the possible reasons why Vogel Co may have switched its strategy of organic growth to one of
growing by acquiring companies. (4 marks)
(b) Discuss the possible actions Vogel Co could take to reduce the risk that the acquisition of Tori Co fails to
increase shareholder value. (7 marks)
(c) Estimate, showing all relevant calculations, the maximum premium Vogel Co could pay to acquire Tori Co,
explaining the approach taken and any assumptions made. (14 marks)
(25 marks)
7 [P.T.O.
4 The chief executive officer (CEO) of Faoilean Co has just returned from a discussion at a leading university on the
application of options to investment decisions and corporate value. She wants to understand how some of the ideas
which were discussed can be applied to decisions made at Faoilean Co. She is still a little unclear about some of the
discussion on options and their application, and wants further clarification on the following:
(i) Faoilean Co is involved in the exploration and extraction of oil and gas. Recently there have been indications that
there could be significant deposits of oil and gas just off the shores of Ireland. The government of Ireland has
invited companies to submit bids for the rights to commence the initial exploration of the area to assess the
likelihood and amount of oil and gas deposits, with further extraction rights to follow. Faoilean Co is considering
putting in a bid for the rights. The speaker leading the discussion suggested that using options as an investment
assessment tool would be particularly useful to Faoilean Co in this respect.
(ii) The speaker further suggested that options were useful in determining the value of equity and default risk, and
suggested that this was why companies facing severe financial distress could still have a positive equity value.
(iii) Towards the end of the discussion, the speaker suggested that changes in the values of options can be measured
in terms of a number of risk factors known as the greeks, such as the vega. The CEO is unclear why option
values are affected by so many different risk factors.
Required:
(a) With regard to (i) above, discuss how Faoilean Co may use the idea of options to help with the investment
decision in bidding for the exploration rights, and explain the assumptions made when using the idea of
options in making investment decisions. (11 marks)
(b) With regard to (ii) above, discuss how options could be useful in determining the value of equity and default
risk, and why companies facing severe financial distress still have positive equity values. (9 marks)
(c) With regard to (iii) above, explain why changes in option values are determined by numerous different risk
factors and what vega determines. (5 marks)
(25 marks)
8
9 [P.T.O.
Formulae
Modigliani and Miller Proposition 2 (with tax)
The Capital Asset Pricing Model
The asset beta formula
The Growth Model
Gordons growth approximation
The weighted average cost of capital
The Fisher formula
Purchasing power parity and interest rate parity
k k T)(k k
V
V
e e
i
e
i
d
d
e
= + ( ) 1
E(r R E(r R
i f i m f
) ( ) ) = +

a
e
e d
e
d
e d
V
V V T))
V T
V V
=
+

+
+ ( (
( )
( ( 1
1
1 T))
d

P
D g)
(r g)
o
o
e
=
+ (

1
g br
e
=
WACC
V
V V
k
V
V V
k
e
e d
e
d
e d
d
=
+

+
+

( 1 TT)
( ) ( 1 1 + = + i r)(1+h)
S S x
(1+h
(1+h
F S x
(1+i
(1
1 0
c
b
0 0
c
= =
)
)

)
++i
b
)
10
Modified Internal Rate of Return
The Black-Scholes option pricing model
The Put Call Parity relationship
c PN(d P N(d e
Where:
d
P P r+
a 1 e 2
rt
1
a e
=
=
+
) )
ln( / ) ( 00.5s t
s t
d d s t
2
2 1
)
=
MIRR
PV
PV
r
R
I
n
e
=

+
( )
1
1 1
p c P P e
a e
rt
= +
11 [P.T.O.
Present Value Table
Present value of 1 i.e. (1 + r)
n
Where r = discount rate
n = number of periods until payment
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0990 0980 0971 0962 0952 0943 0935 0926 0917 0909 1
2 0980 0961 0943 0925 0907 0890 0873 0857 0842 0826 2
3 0971 0942 0915 0889 0864 0840 0816 0794 0772 0751 3
4 0961 0924 0888 0855 0823 0792 0763 0735 0708 0683 4
5 0951 0906 0863 0822 0784 0747 0713 0681 0650 0621 5
6 0942 0888 0837 0790 0746 0705 0666 0630 0596 0564 6
7 0933 0871 0813 0760 0711 0665 0623 0583 0547 0513 7
8 0923 0853 0789 0731 0677 0627 0582 0540 0502 0467 8
9 0914 0837 0766 0703 0645 0592 0544 0500 0460 0424 9
10 0905 0820 0744 0676 0614 0558 0508 0463 0422 0386 10
11 0896 0804 0722 0650 0585 0527 0475 0429 0388 0350 11
12 0887 0788 0701 0625 0557 0497 0444 0397 0356 0319 12
13 0879 0773 0681 0601 0530 0469 0415 0368 0326 0290 13
14 0870 0758 0661 0577 0505 0442 0388 0340 0299 0263 14
15 0861 0743 0642 0555 0481 0417 0362 0315 0275 0239 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0901 0893 0885 0877 0870 0862 0855 0847 0840 0833 1
2 0812 0797 0783 0769 0756 0743 0731 0718 0706 0694 2
3 0731 0712 0693 0675 0658 0641 0624 0609 0593 0579 3
4 0659 0636 0613 0592 0572 0552 0534 0516 0499 0482 4
5 0593 0567 0543 0519 0497 0476 0456 0437 0419 0402 5
6 0535 0507 0480 0456 0432 0410 0390 0370 0352 0335 6
7 0482 0452 0425 0400 0376 0354 0333 0314 0296 0279 7
8 0434 0404 0376 0351 0327 0305 0285 0266 0249 0233 8
9 0391 0361 0333 0308 0284 0263 0243 0225 0209 0194 9
10 0352 0322 0295 0270 0247 0227 0208 0191 0176 0162 10
11 0317 0287 0261 0237 0215 0195 0178 0162 0148 0135 11
12 0286 0257 0231 0208 0187 0168 0152 0137 0124 0112 12
13 0258 0229 0204 0182 0163 0145 0130 0116 0104 0093 13
14 0232 0205 0181 0160 0141 0125 0111 0099 0088 0078 14
15 0209 0183 0160 0140 0123 0108 0095 0084 0074 0065 15
12

Annuity Table
Present value of an annuity of 1 i.e.
Where r = discount rate
n = number of periods
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0990 0980 0971 0962 0952 0943 0935 0926 0917 0909 1
2 1970 1942 1913 1886 1859 1833 1808 1783 1759 1736 2
3 2941 2884 2829 2775 2723 2673 2624 2577 2531 2487 3
4 3902 3808 3717 3630 3546 3465 3387 3312 3240 3170 4
5 4853 4713 4580 4452 4329 4212 4100 3993 3890 3791 5
6 5795 5601 5417 5242 5076 4917 4767 4623 4486 4355 6
7 6728 6472 6230 6002 5786 5582 5389 5206 5033 4868 7
8 7652 7325 7020 6733 6463 6210 5971 5747 5535 5335 8
9 8566 8162 7786 7435 7108 6802 6515 6247 5995 5759 9
10 9471 8983 8530 8111 7722 7360 7024 6710 6418 6145 10
11 10368 9787 9253 8760 8306 7887 7499 7139 6805 6495 11
12 11255 10575 9954 9385 8863 8384 7943 7536 7161 6814 12
13 12134 11348 10635 9986 9394 8853 8358 7904 7487 7103 13
14 13004 12106 11296 10563 9899 9295 8745 8244 7786 7367 14
15 13865 12849 11938 11118 10380 9712 9108 8559 8061 7606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0901 0893 0885 0877 0870 0862 0855 0847 0840 0833 1
2 1713 1690 1668 1647 1626 1605 1585 1566 1547 1528 2
3 2444 2402 2361 2322 2283 2246 2210 2174 2140 2106 3
4 3102 3037 2974 2914 2855 2798 2743 2690 2639 2589 4
5 3696 3605 3517 3433 3352 3274 3199 3127 3058 2991 5
6 4231 4111 3998 3889 3784 3685 3589 3498 3410 3326 6
7 4712 4564 4423 4288 4160 4039 3922 3812 3706 3605 7
8 5146 4968 4799 4639 4487 4344 4207 4078 3954 3837 8
9 5537 5328 5132 4946 4772 4607 4451 4303 4163 4031 9
10 5889 5650 5426 5216 5019 4833 4659 4494 4339 4192 10
11 6207 5938 5687 5453 5234 5029 4836 4656 4486 4327 11
12 6492 6194 5918 5660 5421 5197 4988 4793 4611 4439 12
13 6750 6424 6122 5842 5583 5342 5118 4910 4715 4533 13
14 6982 6628 6302 6002 5724 5468 5229 5008 4802 4611 14
15 7191 6811 6462 6142 5847 5575 5324 5092 4876 4675 15



1 (1 + r)
n

r
13
Standard normal distribution table
000 001 002 003 004 005 006 007 008 009
00 00000 00040 00080 00120 00160 00199 00239 00279 00319 00359
01 00398 00438 00478 00517 00557 00596 00636 00675 00714 00753
02 00793 00832 00871 00910 00948 00987 01026 01064 01103 01141
03 01179 01217 01255 01293 01331 01368 01406 01443 01480 01517
04 01554 01591 01628 01664 01700 01736 01772 01808 01844 01879
05 01915 01950 01985 02019 02054 02088 02123 02157 02190 02224
06 02257 02291 02324 02357 02389 02422 02454 02486 02517 02549
07 02580 02611 02642 02673 02704 02734 02764 02794 02823 02852
08 02881 02910 02939 02967 02995 03023 03051 03078 03106 03133
09 03159 03186 03212 03238 03264 03289 03315 03340 03365 03389
10 03413 03438 03461 03485 03508 03531 03554 03577 03599 03621
11 03643 03665 03686 03708 03729 03749 03770 03790 03810 03830
12 03849 03869 03888 03907 03925 03944 03962 03980 03997 04015
13 04032 04049 04066 04082 04099 04115 04131 04147 04162 04177
14 04192 04207 04222 04236 04251 04265 04279 04292 04306 04319
15 04332 04345 04357 04370 04382 04394 04406 04418 04429 04441
16 04452 04463 04474 04484 04495 04505 04515 04525 04535 04545
17 04554 04564 04573 04582 04591 04599 04608 04616 04625 04633
18 04641 04649 04656 04664 04671 04678 04686 04693 04699 04706
19 04713 04719 04726 04732 04738 04744 04750 04756 04761 04767
20 04772 04778 04783 04788 04793 04798 04803 04808 04812 04817
21 04821 04826 04830 04834 04838 04842 04846 04850 04854 04857
22 04861 04864 04868 04871 04875 04878 04881 04884 04887 04890
23 04893 04896 04898 04901 04904 04906 04909 04911 04913 04916
24 04918 04920 04922 04925 04927 04929 04931 04932 04934 04936
25 04938 04940 04941 04943 04945 04946 04948 04949 04951 04952
26 04953 04955 04956 04957 04959 04960 04961 04962 04963 04964
27 04965 04966 04967 04968 04969 04970 04971 04972 04973 04974
28 04974 04975 04976 04977 04977 04978 04979 04979 04980 04981
29 04981 04982 04982 04983 04984 04984 04985 04985 04986 04986
30 04987 04987 04987 04988 04988 04989 04989 04989 04990 04990
This table can be used to calculate N(d), the cumulative normal distribution functions needed for the Black-Scholes model
of option pricing. If d
i
> 0, add 05 to the relevant number above. If d
i
< 0, subtract the relevant number above from 05.
End of Question Paper