Professional Level – Options Module

Advanced Financial Management

Mock Examination

December 2018

Answers
Q1a:

If Kalampa Co were to set up a manufacturing operation overseas some key

benefits could include:

Potential access to cheaper labour and / or materials.

A reduction in economic risk due to the geographic diversification of

operations.

Potential tax and other benefits from a host country who are keen to attract
foreign direct investment.

Some key drawbacks could include:

Potential cultural conflicts due to the difference between the culture at home
and in the host country.

Exposure to the political risk of the host country which may be less stable than
the home country.

Exposure to regulatory risk due to the fact that Kalampa Co will not be familiar
with the regulations in the host country.
Q1b:

APPENDIX:

Project appraisal:

W1) Cost of equity ungeared:

kd = 2.4 + 1.6 = 4.0%

13.0% = kei + (1 – 0.25) x (kei – 4.0%) x 40/60

13.0% = kei + 0.5 x (kei – 4.0%)

13.0% = kei + 0.5kei – 2.0%

(13% + 2%)/1.5 = kei = 10%

W2) Annual TAD:

$44m / 4 = $11m

W3) WC:

$’m T1 T2 T3 T4 T5
WC need 20 20 x 30/20 = 30 30 x 35/30 = 35 35 x 25/35 = 25 0
WC cash flow (20) (10) (5) 10 25

Remember the project does not start for another year hence the first cash flow
is not until T1.

W4) Relevant fixed costs:

$20m x 60% = $12m in current terms

W5) Cash flow table:

$’m T1 T2 T3 T4 T5
Revenue:
Sales revenue:
20 x $3 x 1.022 62.4
30 x $3 x 1.023 etc. 95.5 113.7 82.8
Variable costs:
20 x $1 x 1.042etc. (21.6) (33.7) (40.9) (30.4)
Fixed costs:
$12 x 1.042 etc. (13.0) (13.5) (14.0) (14.6)
TAD (11) (11) (11) (11)
Taxable 16.8 37.3 47.8 26.8
Tax 25% (4.2) (9.3) (12.0) (6.7)
Addback TAD 11 11 11 11
23.6 39.0 46.8 31.1
Capital:
Land & buildings (100) 50
Plant and machinery (44) 4
Tax on residual value of P&M (1)
Working capital (20) (10) (5) 10 25
____ _____ ____ ____ ____
Net cash flows (164) 13.6 34.0 56.8 109.1
10% discount factors 0.909 0.826 0.751 0.683 0.621
Present values (149.1) 11.2 25.5 38.8 67.8

Hence the Base case NPV = $5.8 negative

W6) The PV of the financing side effects:

PV of the tax relief on interest paid on the debt capacity increase:

$100 x 4% x 25% x 3.630 x 0.962 = $3.5

The tax relief is a 4 year annuity from T2-T5 and has been discounted at 4%
which is the gross cost of debt.

W7) APV:

APV = -5.8 + 3.5 = -$2.3 million

W8) Hedge using an FRA:

The 5v12 FRA is appropriate to the situation and will fix the interest receipt at
2.92 – 0.2 = 2.72%

Hence at the end of the year 60 x 1.0272 = $61.632 million will be available.

W9) Hedge using futures:

Hedge set up:

Date? – the company will be investing on 31 May and hence June futures
should be used.

Buy/Sell? – The company will be investing and hence they should buy futures.
(go long)

How many? – 60/1 x 7/3 = 140 contracts

The company will buy 140 June futures @ 96.94

Effective rate calculation:

Now
31 Dec
Base rate (100 – 2.4) 97.60
Futures (96.94)
Basis 0.66

There is 6 months from now until the maturity date of the June futures.

There is 5 months from now until the transaction date of 31 May.

Hence on 31 May 1/6 of the basis will be remaining = 1/6 x 0.66 = 0.11

Hence the effective rate is 96.94 + 0.11 = 97.05. As an interest rate this is 100
– 97.05 = 2.95%

Hence the company will be able to invest at 2.95 – 0.2 = 2.75%

Hence at the end of the year 60 x 1.0275 = $61.65 million will be available
Leave space at the end of your appendix in case you need to do some
more workings.

Start the report etc. on a new page.

REPORT:

To: Board of directors – Kalampa Co

From: Consultant

Date: Dec 2018

SUBJECT: PROPOSED INVESTMENT

Introduction:

This report considers the proposed investment and how the interest rate risk
should be hedged. Relevant calculations are shown in the attached appendix.

The proposed investment:

The proposed investment has an APV of -$2.3 million. Hence it would not add
to shareholder wealth and should be rejected. However the result is very
marginal and the company should carry out sensitivity and other analysis prior
to rejecting the project as a positive result could easily arise were some
variables to change slightly.

The APV approach:

The APV approach relies on M&M’s theories of capital structure. Initially the
project is discounted at the cost of equity for the ungeared company which
would be the WACC assuming there was no tax. This creates the base case
NPV. The benefit of the tax relief on interest (which reduces the WACC in
M&M’s with tax theory) is then calculated in absolute ($) terms and is used to
adjust the base case NPV and calculate the APV.
Key assumptions:

Key assumptions that have been made include:

The tax rate will remain unchanged for the duration of the project.

The ungeared cost of equity will remain unchanged for the duration of the
project.

The forecast of the additional unit sales has been correctly estimated.

Hedging the interest rate risk:

The futures hedge is preferred as it creates the biggest return. However the
difference is small and the company may prefer the simplicity of a forward rate
agreement.

Debt needed to fund the project:

In total the project requires an investment of $164 million. If the futures

hedge is used the company will have $61.65 million available after 12 months
and hence will need to raise $102.35 million.

The margin and mark to market system:

When opening a position on a futures market a company must pay a deposit

into their account held by their broker to cover potential losses. This is called
the initial margin. The gain or loss made on the hedge is calculated on a daily
basis. This is the mark to market system. These gains or losses are then
credited or charged to their account with their broker. If necessary more
monies must be paid into the account as the account balance must remain at
or above the maintenance margin level. These extra payments are called
variation margins.
Conclusion:

Kampala Co should reject the project assuming further investigation does not
show that it could generate a positive NPV. The funds to be deposited should
be hedged using futures unless the simplicity of a forward rate agreement is
preferred.

Q1c:

Two external hedging methods a company could use to hedge transaction risk
are:

i) The forward market:

This would fix the exchange rate to be used and hence provide
total certainty.
The hedge is OTC and hence the exact amount required can be
hedged for the exact period required.
However the forward market does not exist for all currencies.

ii) Exchange traded options:

This would protect the company against adverse rate moves but
would allow it the flexibility to benefit if a favourable rate move
arises. However this flexibility is costly as a premium has to be
paid.
As the hedge is exchange traded it will not necessarily be possible
to hedge the exact amount required for the exact period required.
However options are not available for all currencies.

Note – explanations of other external hedging methods is also acceptable.

Marking scheme

Marks

(a) Key benefits Max 4

Key drawbacks Max 4

Max 6

(b)(i) Gross cost of debt 1

Cost of equity ungeared 2

Annual TAD and correct treatment 1

Relevant fixed costs and ignoring funds already spent 1

Working capital 2

Inflated sales, variable costs and fixed costs 3

Tax 1

Tax on RV of P&M 1

Base case NPV 1

PV of financing side effects 2

APV and decision and sensible comment 2

17

(b)(ii) APV rationale (max 1 if no link to M&M) 3

Key assumptions 3

(b)(iii) Choosing appropriate FRA 1

Appropriate rate chosen and adjusted as req’d. 2

Futures set up and basis calculation 2

Effective rate 1

Choice of best method, cash available & debt to be 2

raised calculated

8
(b)(iv) Explanation of initial margin, mark to market system, 4
variation margin and maintenance margin

Professional marks for part (b) – appendix, suitable 4

rubric, introduction & conclusion

(c) 1 mark per point on each hedge discussed. Max 3 per 5

hedge

50
Q2a:

12 month govt. spot yield:

102 = 108/(1+x) where x = the govt. spot yield.

1+x = 108/102 = 1.0588

Hence the spot yield is 5.88%

24 month govt. spot yield:

100 = 6/1.0588 + 106/(1+y)2 where y = the govt. spot yield.

100 = 5.67 + 106/(1+y)2

(1+y)2 = 106/(100 - 5.67)

1+y = √(106/(100 - 5.67))

Hence the spot yield is 6.01%

Spot yields for X Co:

12 month = 5.88 + 20/100 = 6.08%

24 month = 6.01 + 32/100 = 6.33%

Market value of the X Co bond:

4 x 1/1.0608 = 3.77

(4 + 103)/1.06332 = 94.64

98.41
Yield to maturity of the X Co bond:

This is the IRR of the cash flows to the investor. It will be just below the spot
yield for the year of maturity of the bond which is 6.33%. Hence 6% and 7%
will be used when calculating the NPV’s required.

6% AF/DF PV’s @ 6% 7% AF/DF PV’s @ 7%

T0 (98.41) 1 (98.41) 1 (98.41)
T1 4 0.943 3.77 0.935 3.74
T2 4 + 103 0.890 95.23 0.873 93.41
0.59 (1.26)

IRR = 6% + ((0.59/(0.59 + 1.26) x (7% - 6%)

Meanings:

The government spot yields show the cost of borrowing for the government.
Effectively if it is assumed that government debt is risk free these rates are the
risk free rates. In accordance with the normal yield curve these rates rise – the
two year spot rate is higher than the one year spot rate. This is due to liquidity
preference theory.

The yield to maturity shows the annual return an investor can expect on a
bond if it is held until maturity.

Q2b:

Duration of the X Co bond:

Recalculate the market value of the bond using the YTM:

4 x 1/1.0632 = 3.76

(4 + 103)/1.06322 = 94.66

98.42
Duration = ((3.76 x 1) + (94.66 x 2)) / 98.42 = 1.96 years

Duration shows the average time take for the PV of the cash inflows to arise.
Where bonds have the same maturity date the bond with the lower duration
(this is normally the bond with the higher coupon) is lower risk as more of its
return is earned sooner.

Modified duration = 1.96 / 1.0632 = 1.84%

This means that if the yield requires rises/falls by 1% the market value of the
bond will fall/rise by about 1.84%. Modified duration assumes a straight line
relationship between yield and value. In reality the relationship is convex and
hence the calculation above is only useful for small changes in the yield.
Modified duration overstates the fall in bond values as yields rise and vice
versa.

Q2c:

Pa = 412c, Pe = 400c, r = 0.06, s = 0.1, t = 0.5.

d1 = (ln(412/400) + (0.06 + 0.5 x 0.22) x 0.5) / (0.2 x √0.5)

d1 = (0.030 + 0.040) / 0.141 = 0.496 ≈ 0.50

d2 = 0.496 – 0.141 = 0.355 ≈ 0.36

N(d1) = 0.1915 + 0.5 = 0.6915

N(d2) = 0.1406 + 0.5 = 0.6406

C = (412 x 0.6915) – (400 x 0.6406 x e(-0.06 x 0.5)) = 284.9 – 248.7 = 36.2c

P = 36.2 – 412 + 400 x e(-0.06 x 0.5) = 12.4c

The number of put options to buy = 20,000 / 0.6915 = 28,923.

Q2d:

An options gamma shows how sensitive delta N(d1) is to a change in the value
of the underlying item (the share).

As delta changes the number of put options required for the hedge changes.

Hence it is useful to know how delta is likely to change as this indicates how
the hedge may need to be updated. This is measured by gamma.

Gamma is highest for at the money options.

Q2e:

As Ash Co is an unlisted family owned company it is likely that the owners are
not well diversified and have most of their wealth invested in the company. If
this is the case they will benefit from diversification by the company.
If the owners do have other investments and are well diversified as individuals
then potentially they will see no benefit in the company having a diversified
portfolio of investments. They are likely to prefer the company to either invest
the money in its trade or return it to them.
It could be argued that even if the owners are well diversified there may be
financial synergies if the company held a portfolio of investments as having
such a portfolio is likely to smooth the cash flows generated by the company
and hence may reduce the cost of finance for the company.
Tax differences may make it more or less beneficial for the company to hold
the investments compared to the shareholders holding the investments
themselves.
Marking scheme

Marks

(a) Government spot yields 1

Spot yields for X Co 1

Market value 1

YTM 2

Meanings 2

(b) Duration (no penalty if MV not recalculated) 1

Modified duration 1

Explanations 3

(c) Inputs 1

d1 & d2 2

N(d1) & N(d2) 1

Value of a call and then a put 2

No. of puts to buy 1

(d) 1 mark per point (max 2 if gamma not defined) 3

(e) 1 mark per point 3

25
Q3a:

Togiz Co

The role of the IMF is to:

- Promote international monetary co-operation.

- Provide financial support to countries with temporary balance of
payments deficits.
- To provide for the orderly growth of international liquidity.

The impact on Togiz Co of the assistance provided could include:

- An increase in taxes as this, and other austerity measures are often

required by the IMF.
- A decrease in demand due to higher taxes on consumers and lower
government spending.
- A reduction in financial instability and uncertainty which would help
business planning.

Q3b:

Financing for Felu Co:

Ve = 100m x $4.8 = $480m

Vd = $96m

Asset Beta for Felu Co:

βa = 480 / ((480 + 96(1 – 0.25)) x 1.3 = 1.130

Financing for the other activities of Felu Co:

Ve = $480m x 30% = $144m

Vd = $96m x 30% = $28.8m

Asset Beta for the other activities of Felu Co:

βa = 144 / ((144 + 28.8(1 – 0.25)) x 1.15 = 1.000

Alternatively the $480m and $96m could be used as the proportion
between debt and equity is the same for the other activities as it is for
the company as a whole.

Asset Beta for the trade of Togiz Co’s proposed project:

Let the required asset beta = x

1.13 = 0.7x + (0.3 x 1.000)

Hence x = (1.13 – 0.3) / 0.7 = 1.186

Regear – build in the financial risk of Togiz Co:

Financing of Togiz Co:

Ve = 5m x $4 = $20m

Vd = $8m

Total finance = 20 + 8 = $28m

Regear:

1.186 = 20 / ((20 + 8(1 – 0.25)) x βe

1.186 = 20/26 x βe

1.186 x 26/20 = βe =1.542

Cost of equity:

3.5% + 1.542 x 6% = 12.8%

WACC:

(12.8% x 20/28) + (3% x 8/28) = 10%

Q3c:

NPV calculations for process Bravo:

$’000

Timings T0 T1 T2 T3 T4 T5 NPV

Bravo (5,920) 615 840 2,175 5,120 1,100

after-tax
cash flows

10% DF 1 0.909 0.826 0.751 0.683 0.621

PV (5,920) 559 694 1,633 3,497 683 1,146

20% DF 1 0.833 0.694 0.579 0.482 0.402

PV (5,920) 512 583 1,259 2,468 442 (656)

IRR:

IRR = 10 + (1146/(1146 + 656)) x (20 – 10) = 16.4%

MIRR:

PVR = 1,146 + 5,920 = 7,066

MIRR = (7,066/5,920)1/5 x (1 + 0.1) – 1 = 0.140 = 14%

Recommendation - I would recommend process Bravo.

Explanation:

This is because the MIRR of Bravo exceeds that of Alpha and MIRR is a
better measure than IRR as it overcomes the two key problems
associated with IRR:

- The fact that cash flows are assumed to be re-invested at the IRR
which is often incorrect.
- The fact that multiple results can arise if there are complex cash
flows.
 As a result MIRR is more likely to be consistent with NPV.

Reservations:

A key reservation is that MIRR (like IRR) is a relative measure and hence
should not really be used to compare mutually exclusive projects such as
Alpha and Bravo. Instead the NPV of Alpha should be calculated and
compared to the NPV calculated for Bravo. The process offering the
highest NPV should be chosen as it will produce the biggest increase in
shareholder wealth. A further reservation is that analyses are based on
estimates which may prove incorrect.

Q3d:

Disposing through a management buy-out compared to a trade sale:

Advantages include:

- It can often be achieved quicker than a trade sale

- It is often less costly than looking for and negotiating with a trade
buyer
- It is less concerning to the staff within the division being disposed of,
as the existing management team are maintained, and there is likely
to be less disruption than if the division is absorbed into another
company

Disadvantages include:

- The MBO team may not be able to pay as much as a trade buyer who
could benefit from synergies
- There is less of a clean break – the current parent company is likely to
have to continue providing some services to the new company
formed from the division for some time. Payroll services for example.
- The management team may not have the skills and/or desire
necessary to carry out an MBO
Marking scheme

Marks
(a) Description of the roles of the IMF 2-3
Description of the potential impacts on the Co 2-3
Max 5
(b) Calculation of Ve & Vd for Felu Co 1
Calculation of βa for Felu Co 1
Calculation of βa for the other activities of Felu Co 1
Calculation of the βa relevant to the proposed project of Togiz Co 1
Regearing of relevant βa 1
Cost of equity 1
WACC 1
7
(c) NPV calculations 2
IRR 1
MIRR 1
Recommendation 1
Explanation 2
Key reservation 2
Other reservations 1
Max 8
(d) Advantages 2-3
Disadvantages 2-3
Max 5
25