PART 3

WEDNESDAY 15 JUNE 2005

QUESTION PAPER
Time allowed 3 hours
This paper is divided into two sections
Section A

BOTH questions are compulsory and MUST be

answered

Section B

TWO questions ONLY to be answered

Formulae sheet, present value, annuity and standard normal

distribution tables are on pages 9, 10, 11 and 12

Do not open this paper until instructed by the supervisor

This question paper must not be removed from the examination
hall

The Association of Chartered Certified Accountants

Paper 3.7

Strategic Financial
Management

Section A BOTH questions are compulsory and MUST be attempted

1

Paxis plc will soon announce a takeover bid for Wragger plc, a company in the same industry. The initial bid will be
an all share bid of four Paxis shares for every five Wragger shares.
The most recent annual data relating to the two companies are shown below:
000
Sales revenue
Operating costs
Tax allowable depreciation
Earnings before interest and tax
Net interest
Taxable income
Taxation (30%)
After tax income
Dividend
Retained earnings
Other information:
Annual replacement capital expenditure (000)
Expected annual growth rate in sales, operating costs (including
depreciation), replacement investment and dividends for the next
four years
Expected annual growth rate in sales, operating costs (including
depreciation), replacement investment and dividends after four years
Gearing (long term debt/long term debt plus equity by market value)
Market price per share (pence)
Number of issued shares (million)
Current market cost of fixed interest debt
Equity beta
Risk free rate
Market return

Paxis
13,333
(8,683)
(1,450)

3,200
(715)

2,485
(746)

1,739
(870)

869

Wragger
9,400
(5,450)
(1,100)

2,850
(1,660)

1,190
(357)

833
(458)

375

Paxis
1,600

Wragger
1,240

5%

65%

4%
30%
298
7
6%
118

5%
55%
192
8
75%
138
14%
11%

The takeover is expected to result in cost savings in advertising and distribution, reducing the operating costs
(including depreciation) of Paxis from 76% of sales to 70% of sales. The growth rate of the combined company is
expected to be 6% per year for four years, and 5% per year thereafter. Wraggers debt obligations will be taken over
by Paxis. The corporate tax rate is expected to remain at 30%.
Sales and costs relevant to the decision may be assumed to be in cash terms.

Required:
(a) Using free cash flow analysis for each individual company and the potential combined company, estimate
how much synergy is expected to be created from the takeover. State clearly any assumptions that you make.
Note: The weighted average cost of capital of the combined company may be assumed to be the market weighted
average of the current costs of capital of the individual companies, weighted by the current market value of debt and
equity of the combined company, with the equity of Wragger adjusted for the effect of the bid price.
(20 marks)
(b) Discuss the limitations of the above estimates.

(6 marks)

(c) Discuss the factors that might influence whether the initial bid is likely to be accepted by the shareholders
of Wragger plc.
(4 marks)
(d) Estimate by how much the bid might be increased without the shareholders of Paxis suffering a fall in their
expected wealth, and discuss whether or not the directors of Paxis should proceed with the bid. (5 marks)
(e) Once the bid is announced, discuss what defences Wragger plc might use against the bid by Paxis plc.
(5 marks)
(40 marks)

[P.T.O.

McTee plc is a Scottish manufacturer of golf clubs. The company has decided to purchase an existing golf club
manufacturer in the State of Florida, USA. The purchase will cost an agreed $72 million for fixed assets and
equipment, and in addition $8 million of working capital will be needed. No additional external funding for the
proposed US subsidiary is expected to be needed for at least five years, and sales from the subsidiary would be
exclusively to the US market. McTee has no other foreign subsidiaries, and the companys managers are considering
how to finance the US investment. McTees bank has advised that, taking into account McTees credit rating, the
following alternatives might be possible, with finance available up to the amount shown:
(i)

A one for four rights issue, at a price of 280 pence per share. Underwriting and other costs are expected to be
5% of the gross amount raised.

(ii) Five year Sterling 7% fixed rate secured bank term loan of up to 50 million, initial arrangement fee 1%.
(iii) $15 million one year commercial paper, issued at $US LIBOR plus 15%. This could be renewed on an annual
basis. An additional 05% per year would be payable to a US bank for a back-up line of credit.
(iv) 80 million Swiss Franc five year fixed rate secured bank loan at 25%. This may be swapped into fixed rate $ at
an additional annual interest rate of 23%. An upfront fee of 30% is also payable.
(v) 42 million 10-year Sterling Eurobond issue at 685%. This may be swapped into $ at an annual interest rate
of 495%. Eurobond issue costs of 2%, and upfront swap costs of 17% would also be payable.
(vi) $40 million floating rate six year secured term loan from a US bank, at $US LIBOR plus 3%.
No currency swaps are available other than those shown. Currency swaps would involve swapping the principal at
the current spot exchange rate, with the reversal of the swap at the same rate at the swap maturity date.
$US LIBOR is currently 3%.
Exchange rates:
$/
SF/

Spot
17985 18008
2256 2298

One year forward

17726 17746
2189 2205

McTees current balance sheet is summarised below.

m
1178
81
981

Fixed assets
Investments
Current assets
Creditors: amounts falling due within one year
Loans and other borrowings
Other creditors

(380)
(486)

1374

Creditors: amounts falling due after more than one year

Medium and long-term bank loans
8% Bond 2009 (par value 100)

Capital and reserves

Ordinary shares (25 pence par value)
Reserves

300
180

480
200
694

1374

A covenant exists that prevents the book value of McTees debt finance from exceeding 50% of total assets. McTees
current dividend per share is 222 pence and dividend growth is approximately 4% per year. The companys current
share price is 302 pence.
Interest payments on debt financing may be assumed to be made annually at the end of the year. Corporate tax in
the UK, USA and Switzerland is at a rate of 30%. Issue costs and fees such as swap fees are not tax allowable.

Required:
(a) Discuss the factors that McTee should consider before deciding how to finance the proposed US subsidiary.
(10 marks)
(b) Prepare a report discussing and evaluating each of the six possible sources of finance, and provide a reasoned
recommendation of which source, or combination of sources, McTee should use. Supporting calculations,
including costs, should be provided wherever relevant.
(20 marks)
(30 marks)

[P.T.O.

Section B TWO questions ONLY to be attempted

3

Assume that it is now 1 June. Your company expects to receive 71 million from a large order in five months time.
This will then be invested in high quality commercial paper for a period of four months, after which it will be used to
pay part of the companys dividend. The companys treasurer wishes to protect the short-term investment from
adverse movements in interest rates, by using futures or forward rate agreements (FRAs).
The current yield on high quality commercial paper is LIBOR + 060%.
LIFFE 500,000 3 month Sterling futures. 1250 tick size.
September 9625
December 9660
Futures contracts mature at the month end. LIBOR is currently 4%.
FRA prices (%)
4 v 5 385 380
4 v 9 358 353
5 v 9 350 345
Required:
(a) Devise a futures hedge to protect the interest yield of the short-term investment, and estimate the expected
lock-in interest rate as a result of the hedge.
(4 marks)
(b) Ignoring transactions costs, explain whether the futures or FRA hedge would provide the higher expected
interest rate from the short-term investment.
(2 marks)
(c) If LIBOR fell by 05% during the next five months show the expected outcomes of each hedge in the cash
market, futures market and FRA market as appropriate.
(6 marks)
(d) Explain why the futures market outcome might differ from the outcome in (c) above.

(3 marks)
(15 marks)

The managers of a pension fund follow an active portfolio management strategy. They try to purchase shares and
bonds that show a positive abnormal return (positive alpha factor in the case of shares). The pension fund is required
by law to hold at least 40% of its investments in bonds. 100 million is currently available for investment.
Three shares and three bonds are being considered for purchase.
The required return on bonds may be measured using a model similar to the capital asset pricing model, where beta
is replaced by the relative duration of the individual bond (Di) and the bond market portfolio (Dm). This is shown as
Di

Dm
Shares:
Equity market
Flitter plc
Polgin plc
Scruntor plc
Bonds:
Bond market
UK Government
Supragow plc
Teffon plc

Expected return (%)

105
110
195
135

Standard deviation
of returns
15
25
18
35

Correlation coefficient of returns

with the market
1
076
054
063

Duration (years)
175
115
186
142

Coupon (%)

8
6
9

Redemption yield (%)

58
45
53
72

The risk free rate is 4%.

Required:
(a) Evaluate whether or not any of the shares or bonds are expected to offer a positive abnormal return.
(7 marks)
(b) The pension fund currently has the maximum permitted investment in shares and wishes to continue this
strategy. It has a market value of 1,000 million and a beta of 062.
Calculate the required return from the pension fund if any shares and bonds with positive abnormal returns
are purchased.
State clearly any assumptions that you make

(3 marks)

(c) Discuss possible problems with the pension funds investment strategy.

(5 marks)
(15 marks)

[P.T.O.

Boster plc is a multinational company that has investments in several developing countries. It is considering
investments in three more developing countries, Ammobia, Flassia and Hracland. All three countries have a history
of political instability, but Boster believes that the potential returns from the investments might justify the political risk.
A consultancy report has produced the following assessments of the countries.
Ammobia
Flassia
Hracland

Expected investment return (%)

21
18
28

Political Risk (%)

33
29
42

Political risk was measured by investigating key variables in the relevant countries. These were: corruption, changes
in government, social conditions, cultural issues, unfair trade and asset security.
Boster will invest in a maximum of two of the countries, with an equal amount invested in each country. The countries
are in diverse parts of the world, and the returns from the investments in the three countries are believed to be
independent.
Required:
(a) Calculate the risk, return and coefficient of variation of the possible investment combinations.

(6 marks)

(b) Discuss how useful the information calculated in (a) above might be to Boster in making its investment
decisions.
(5 marks)
(c) Briefly discuss other ways by which Boster might attempt to measure the potential political risk of the
investments.
(4 marks)
(15 marks)

Discuss the possible foreign exchange risk and economic implications of each of the following types of exchange
rate system for multinational companies with subsidiaries located in countries with these systems:
(a) a managed floating exchange rate;
(b) a fixed exchange rate linked to a basket of currencies; and
(c) a fixed exchange rate backed by a currency board system.
(15 marks)

Formulae Sheet

E( r j ) = r f + E( rm ) r f j

Ke (i)

D1
+g
(ii)
P0
WACC Keg

E
D
+ Kd (1 t )
E+D
E+D

Dt
or Keu 1

E + D
2 asset
portfolio

p = a2 x 2 + b2 (1 x ) 2 + 2 x (1 x ) p ab a b
Purchasing
power parity

a = e

i f i uk
1 + i uk

D(1 t )
E
+ d
E + D(1 t )
E + D(1 t )

Call price for a European option = Ps N( d1) Xe rT N( d 2 )

d1 =

1n ( Ps / X ) + rT

+ 0.5 T

d 2 = d1 T
Put call parity PP = PC PS +XerT

[P.T.O.

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11

[P.T.O.

Standard normal distribution table

000

001

002

003

004

005

006

007

008

009

00
01
02
03
04

00000
00398
00793
01179
01554

00040
00438
00832
01217
01591

00080
00478
00871
01255
01628

00120
00517
00910
01293
01664

00160
00557
00948
01331
01700

00199
00596
00987
01368
01736

00239
00636
01026
01406
01772

00279
00675
01064
01443
01808

00319
00714
01103
01480
01844

00359
00753
01141
01517
01879

05
06
07
08
09

01915
02257
02580
02881
03159

01950
02291
02611
02910
03186

01985
02324
02642
02939
03212

02019
02357
02673
02967
03238

02054
02389
02703
02995
03264

02088
02422
02734
03023
03289

02123
02454
02764
03051
03315

02157
02486
02794
03078
03340

02190
02517
02823
03106
03365

02224
02549
02852
03133
03389

10
11
12
13
14

03413
03643
03849
04032
04192

03438
03665
03869
04049
04207

03461
03686
03888
04066
04222

03485
03708
03907
04082
04236

03508
03729
03925
04099
04251

03531
03749
03944
04115
04265

03554
03770
03962
04131
04279

03577
03790
03980
04147
04292

03599
03810
03997
04162
04306

03621
03830
04015
04177
04319

15
16
17
18
19

04332
04452
04554
04641
04713

04345
04463
04564
04649
04719

04357
04474
04573
04656
04726

04370
04484
04582
04664
04732

04382
04495
04591
04671
04738

04394
04505
04599
04678
04744

04406
04515
04608
04686
04750

04418
04525
04616
04693
04756

04429
04535
04625
04699
04761

04441
04545
04633
04706
04767

20
21
22
23
24

04772
04821
04861
04893
04918

04778
04826
04864
04896
04920

04783
04830
04868
04898
04922

04788
04834
04871
04901
04925

04793
04838
04875
04904
04927

04798
04842
04878
04906
04929

04803
04846
04881
04909
04931

04808
04850
04884
04911
04932

04812
04854
04887
04913
04934

04817
04857
04890
04916
04936

25
26
27
28
29

04938
04953
04965
04974
04981

04940
04955
04966
04975
04982

04941
04956
04967
04976
04982

04943
04957
04968
04977
04983

04945
04959
04969
04977
04984

04946
04960
04970
04978
04984

04948
04961
04971
04979
04985

04949
04962
04972
04979
04985

04951
04963
04973
04980
04986

04952
04964
04974
04981
04986

30

04987 04987 04987 04988 04988 04989 04989 04989 04990 04990

This table can be used to calculate N(di), the cumulative normal distribution functions needed for the Black-Scholes
model of option pricing. If di > 0, add 05 to the relevant number above. If di < 0, subtract the relevant number above
from 05.

End of Question Paper

12