Questions and Answers

The role and responsibility of the financial manager


Influence on objectives


Discuss, and provide examples of, the types of non-financial, ethical and environmental issues that might influence the objectives of companies. Consider the impact of these non-financial, ethical and environmental issues on the achievement of primary financial objectives such as the maximisation of shareholder wealth.


(15 marks)


2      Investment appraisal




Assume that you have been appointed finance director of Breckhall Inc. The company is considering investing in the production of an electronic security device, with an expected market life of five years.


The previous finance director has undertaken an analysis of the proposed project; the main features of his analysis are shown below.

Proposed electronic security device project:


Year Year Year Year Year Year
0 1 2 3 5 5
Investment in $000 $000 $000 $000 $000 $000
depreciable non-current 4,500
Cumulative investment
in working capital 300 400 500 600 700 700
Sales 3,500 4,900 5,320 5,740 5,320
Materials 535 750 900 1,050 900
Labour 1,070 1,500 1,800 2,100 1,800
Overhead 50 100 100 100 100
Interest 576 576 576 576 576
Depreciation 900 900 900 900 900
–––– –––– –––– –––– ––––
3,131 3,826 4,276 4,726 4,276
––––   ––––   ––––   ––––   ––––
Taxable profit 369 1,074 1,044 1,014 1,044
Taxation 129 376 365 355 365
–––– –––– –––– –––– ––––
Profit after tax 240 698 679 659 679
–––– –––– –––– –––– ––––

All of the above cash flow and profit estimates have been prepared in terms of present day costs and prices as the previous finance director assumed that the sales price could be increased to compensate for any increase in costs.

You have available the following additional information:


  • Selling prices, working capital requirements and overhead expenses are expected to increase by 5% per year.


  • Material costs and labour costs are expected to increase by 10% per year.


  • Tax allowable depreciation (tax deduction) is allowable for taxation purposes against profits at 25% per year on a reducing balance basis.


  • Taxation of profits is at a rate of 35% payable one year in arrears.


  • The non-current assets have no expected salvage value at the end of five years.


  • The company’s real after-tax discount rate (or weighted average cost of capital) is estimated to be 8% per year and nominal after-tax discount rate 15% per year.


  • Assume that all receipts and payments arose at the end of the year to which they relate except those in year 0 which occur immediately.




  • Estimate the net present value of the proposed project. State clearly any assumptions that you make.


(16 marks)


  • Calculate by how much the discount rate would have to change to result in a net present value of approximately zero.


(4 marks)


(Total: 20 marks)

International operations and international investment appraisal


Growth of multinationals


The global revenue of the largest multinational companies is greater than the gross national product of many countries.




Discuss factors that might explain the successful growth of large multinational companies.


(10 marks)





The managers of Axmine plc, a major international copper processor are considering a joint venture with Traces, a company owning significant copper reserves in a South American country. The proposed joint venture with Traces would be for an initial period of four years.


Copper would be mined using a new technique developed by Axmine. Axmine would supply machinery at an immediate cost of 800 million pesos and 10 supervisors at an annual salary of £40,000 each at current prices. Additionally Axmine would pay half of the 1,000 million pesos per year (at current prices) local labour costs and other expenses in the South American country.


The supervisors’ salaries, local labour, and other expenses will be increased in line with inflation in the United Kingdom and the South American country respectively.


Inflation in the South American country is currently 100% per year and in the UK, it is expected to remain stable at around 8% per year. The government of the South American country is attempting to control inflation and hopes to reduce it each year by 20% of the previous year’s rate.


The joint venture would give Axmine a 50% share of Traces’ copper production, with current market prices at £1,500 per 1,000 kilograms. Traces’ production is expected to be 10 million kilograms per year, and copper prices are expected to rise by 10% per year (in pounds sterling) for the foreseeable future. At the end of four years, Axmine would be given the choice to pull out of the venture or to negotiate another four-year joint venture, on different terms.


The current exchange rate is 140 pesos/£. Future exchange rates may be estimated using the purchasing power parity theory.

Axmine has no foreign operations. The cost of capital of the company’s UK mining operations is 16% per year. As this joint venture involves diversifying into foreign operations, the company considers that a 2% reduction in the cost of capital would be appropriate for this project.

Corporate tax is at the rate of 20% per year in the South American country and 35% per year in the UK. A tax treaty exists between the two countries and foreign tax paid is allowable against any UK tax liability. Taxation is payable one year in arrears and 25% straight-line tax allowable depreciation is available on the machinery in both countries.


Cash flows may be assumed to occur at the year-end, except for the immediate cost of machinery. The machinery is expected to have negligible terminal value at the end of four years.




  • Prepare a report discussing whether Axmine plc should agree to the proposed joint venture. Relevant calculations must form part of your report or an appendix to it.


State clearly any assumptions that you make.


(20 marks)


  • Explain whether you consider Axmine’s proposed discount rate for the project to be appropriate.


(5 marks)


  • If, once the investment has taken place, the government of the South American country imposed a block on the remittance of dividends to the UK, discuss how Axmine might try to avoid such a block on remittances.


(5 marks)


(Total: 30 marks)



4      The financing decision

The dividend decision




HGT Inc is a UK based multinational company with two overseas subsidiaries. The company wishes to minimise its global tax bill, and part of its tax strategy is to try to take advantage of opportunities provided by transfer pricing.


HGT has subsidiaries in Glinland and Rytora.
Taxation UK Glinland Rytora
Corporation tax on profits 30% 40% 25%
Withholding tax on dividends 10%
Import tariffs on all goods (not tax allowable) 10%


The subsidiary in Glinland produces 150,000 graphite golf club shafts per year which are then sent to Rytora for the metal heads to be added and the clubs finished off. The shafts have a variable cost in Glinland of

$6 each, and annual fixed costs are $140,000. The shafts are sold to the Rytoran subsidiary at variable cost plus 75%.


The Rytoran subsidiary incurs additional unit variable costs of $9, annual fixed costs of $166,000, and sells the finished clubs at $30 each in Rytora.


Bi-lateral tax agreements exist which allow foreign tax paid to be credited against UK tax liability.


All transactions between the companies are in pounds sterling. The Rytoran subsidiary remits all profit after tax to the UK parent company each year, and the Glinland subsidiary remits 50% of its profit after tax.




The parent company is considering instructing the Glinland subsidiary to sell the shafts to the Rytoran subsidiary at full cost. Evaluate the possible effect of this on tax and tariff payments, and discuss briefly any possible problems with this strategy.


(10 marks)


  • The weighted average cost of capital (WACC)

Risk adjusted WACC and adjusted present value


Goddard Inc


Goddard Inc a company in the educational sector is evaluating two new projects. One is in the leisure industry and the other is in the publishing industry. Goddard’s summarised statements of financial position, and those of Cottons Inc and Blackwell Inc, quoted companies in the leisure and publication industry respectively, are shown below:


Goddard Cottons Blackwell
Inc Inc Inc
$m $m $m
Non-current assets 96 42 102
Current assets 95 82 65
–––– –––– ––––
Total assets 191 124 167
–––– –––– ––––
Ordinary shares1 15 10 30
Reserves 50 27 20
Medium and long-term loans2 56 15 69
Current liabilities 70 72 48
–––– –––– –––––
Total equity and liabilities 191 124 167
–––– –––– ––––
Ordinary share price (cents) 380 180 230
Debenture price ($) 104 112
Equity beta 1.1 1.3 1.2


  • Goddard and Blackwell 50 cents par value, Cottons 25 cents par value.


  • Goddard 12% debentures 20X8-20Y0, Cotton 14% debentures 20Y2, Blackwell medium-term bank loan.


Goddard’s capital structure will remain unchanged if both or either of the projects are undertaken. Goddard’s investors currently require a return on debt of 11 %. The risk free rate of interest is estimated to be 6% per year and the market return 14% per year. Corporate tax is at a rate of 30% per year.



  • Calculate the appropriate discount rate to use for each of these projects. Explain your answer and state clearly any assumptions that you make.


(10 marks)


  • Goddard’s marketing director suggests that it is incorrect to use the same discount rate each year for the leisure project, as the early stages of the investment are more risky and should be discounted at a higher rate. Another board member disagrees saying that more distant cash flows are riskier and should be discounted at a higher rate. Discuss the validity of the views of each of the directors.


(5 marks)


(Total: 15 marks)


8      Option pricing


Option valuation


An investor holds 200,000 shares in D Inc and is considering buying some put options to hedge her investment. D’s current share price is $6. The risk free interest rate is currently 12% pa and the recent volatility of D Inc shares has been 30% pa. She requires European put options with an exercise price of $5 for exercise in two years’ time.




  • Calculate the value that the bank is likely to charge for 200,000 put options of the investor’s required specification.

(8 marks)

  • Calculate the investor’s change in wealth if she buys 200,000 put options to hedge her portfolio and the share price in two years’ time is a) $3 per share or b) $10 per share.


(4 marks)


  • A friend informs the investor that she could achieve a safer position by selling call options to construct a delta hedge. Calculate the number of call options to be sold to construct a delta hedge.

(3 marks)


(Total: 15 marks)

An introduction to risk management


Political risk


The finance department of Beela Electronics has been criticised by the company’s board of directors for not undertaking an assessment of the political risk of the company’s potential direct investments in Africa. The board has received an interim report from a consultant that provides assessment of the factors affecting political risk in three African countries. The report assess key variables on a scale of –10 to +10, with –10 the worst possible score and +10 the best.


Country 1 Country 2 Country 3
Economic growth 5 8 4
Political stability 3 –4 5
Risk of nationalism 3 0 4
Cultural compatibility 6 2 4
Inflation 7 –6 6
Currency convertibility –2 5 –4
Investment incentives –3 7 3
Labour supply 2 8 –3


The consultant suggests that economic growth and political stability are twice as important as the other factors.


The consultant states in the report that previous clients have not invested in countries with total weighted score of less than 30 out of a maximum possible 100 (with economic growth and political stability double weighted). The consultant therefore recommends that no investment in Africa should be undertaken.




  • Discuss whether or not Beela electronics should use the technique suggested by the consultant in order to decide whether or not to invest in Africa.


(8 marks)


  • Discuss briefly how Beela might manage political risk if it decides to invest in Africa.


(7 marks)


(Total: 15 marks)


10      Hedging foreign exchange risk

Hedging interest rate risk


Murwald (Interest rate hedging)

The corporate treasury team of Murwald plc are debating what strategy to adopt towards interest rate risk management. The company’s financial projections show an expected cash deficit in three months’ time of

£12 million, which will last for a period of approximately six months. Base rate is currently 6% per year, and Murwald can borrow at 1.5% over base, or invest at 1 % below base. The treasury team believe that economic pressures in the euro zone will soon force the European Central Bank (ECB) to raise interest rates on the euro by 2% per year, which could lead to a similar rise in UK interest rates. The ECB move is not certain, as there has recently been significant economic pressure on the bank from the governments of euro zone countries not to raise interest rates.


In the UK, the economy is still recovering from a recession and representatives of industry are calling for interest rates to be cut by 1%. Opposing representations are being made by pensioners, who do not wish their investment income to fall further due to an interest rate cut.


The corporate treasury team believes that interest rates are more likely to rise than to fall, and does not want interest payments during the six month period to increase by more than £10,000 from the amounts that would be paid at current interest rates. It is now 1 March.


LIFFE prices (1 March)




£500,000 three month sterling interest rate (points of 100%)

March 93.45
June 93.10




£500,000 short sterling options (points of 100%)


Exercise price June June
9200 3.33
9250 2.93
9300 2.55 0.92
9350 2.20 1.25
9400 1.74 1.84
9450 1.32 2.90
9500 0.87 3.46



  • Illustrate results of futures and options hedges if, by 1 June:


  • Interest rates rise by 2%. Futures prices move by 1.8%.


  • Interest rates fall by 1%. Futures prices move by 0.9%.


Recommend with reasons, how Murwald plc should hedge its interest rate exposure. All relevant calculations must be shown. Taxation, transactions costs and margin requirements may be ignored. State clearly any assumptions that you make.


  • Discuss the advantages and disadvantages of other derivative products that Murwald might have used to hedge the risk.


12      Strategic aspects of acquisitions


Rayswood Inc


In a recent meeting of the board of directors of Rayswood Inc the chairman proposed the acquisition of Pondhill Inc. During his presentation the chairman stated that: ‘As a result of this takeover we will diversify our operations and our earnings per share will rise by 13%, bringing great benefits to our shareholders.’


No bid has yet been made, and Rayswood currently owns only 2% of Pondhill.


A bid would be based on a share for share exchange, which would be one Rayswood share for every six Pondhill shares.


Financial data for the two companies include:


Rayswood Pondhill
$m $m
Revenue 56.0 42.0
Profit before tax 12.0 10.0
Profit available to ordinary 7.8 6.5
Dividends 3.2 3.4
––––– –––––
Retained earnings 4.6 3.1
––––– –––––
Issued ordinary shares 40m 150m
Market price per share 320 cents 45 cents


Rayswood 50 cents par value, Pondhill 10 cents par value.

A non-executive director has recently stated that he believes ‘the share price of Rayswood will rapidly increase to $3.61 following the announcement of the bid.’



Explain whether you agree with the chairman’s and the non-executive director’s assessment of the benefits of the proposed takeover.


Support your explanation with relevant calculations, including your assessment of the likely post-acquisition share price of Rayswood if the bid is successful.


State clearly any assumptions that you make.


(15 marks)


13    Business valuation




The board of directors of Predator Inc is considering making an offer to purchase Target Co, a private limited company in the same industry. If Target is purchased it is proposed to continue operating the company as a going concern in the same line of business.


Summarised details from the most recent set of financial statements for

Predator and Target are shown below:


Predator Target
SOFP as at SOFP as at
31 March 31 March
$m $m $000 $000
Freehold property 33 460
Plant & equipment 58 1,310
Inventory 29 330
Receivables 24 290
Cash 3 20
–––– 56 –––– 640
––––– –––––
Total assets 147 2,410
Equity and liabilities ––––– –––––
Ordinary shares 35 160
Reserves 43 964
––––– –––––
Shareholders’ funds 78 1,124
Medium term bank loans 38 768
Current liabilities 31 518
––––– –––––
147 2,410
––––– –––––

Predator, 50 cents ordinary shares, Target, 25 cents ordinary shares.


Predator Target
Year PAT Dividend PAT Dividend
$m $m $000 $000
T5 14.30 9.01 143 85.0
T4 15.56 9.80 162 93.5
T3 16.93 10.67 151 93.5
T2 18.42 11.60 175 102.8
T1 20.04 12.62 183 113.1


T5 is five years ago and T1 is the most recent year.


Target’s shares are owned by a small number of private individuals. Its managing director who receives an annual salary of $120,000 dominates the company. This is $40,000 more than the average salary received by managing directors of similar companies. The managing director would be replaced, if Predator purchases Target.


The freehold property has not been revalued for several years and is believed to have a market value of $800,000.


The statement of financial position (SOFP) value of plant and equipment is thought to reflect its replacement cost fairly, but its value if sold is not likely to exceed $800,000. Approximately $55,000 of inventory is obsolete and could only be sold as scrap for $5,000.


The ordinary shares of Predator are currently trading at 430 cents ex-div.

A suitable cost of equity for Target has been estimated at 15%.


Both companies are subject to corporation tax at 33%.




Estimate the value of Target Co using the different methods of valuation and advise the board of Predator as to how much it should offer for Target’s shares.

Note: There has been no increase in the share capital of Target over the last five years. Explain why this is relevant.

Corporate failure and reconstruction


Last Chance Saloon Inc


Last Chance Saloon Inc has experienced considerable losses in the last few years, leading to a debit balance on its revenue reserves and thus a deterioration of its cash position. The company has developed a wonder product to revive its fortunes. The wonder product will require a total investment of $ 7 million. The finance director has drafted a scheme of reconstruction:


  • Existing shareholders are to be offered a cash payment 25 cents per share to redeem their shares which would then be cancelled.


  • 10 million new shares 50 cents (par value) are to be issued at $1.20 each.


  • An increase of $500,000 in inventory (working capital) is required.


  • The 10% debentures would be repaid immediately.


  • The bank is willing to provide a $1 million overdraft facility at an increased cost of 9% to replace the existing overdraft. The bank would purchase a $3 million 12% debenture. Both loans will be secured.


If the new wonder product is not launched the company earnings before interest and tax will be a ridiculously low figure from which you should immediately realise that it is over for the company unless it goes ahead will the new product.


If the scheme is organised the earnings before interest and tax is estimated to be $1 million in the first year of trading.

Summarised balance sheet (statement of financial position) as at 31 December 20X4


$000 $000
Land and buildings 2,200
Plant and machinery 6,300
Inventory 2,000 8,500
Receivables 1,500
Cash 500
Total assets 12,500
Ordinary share capital (50c shares) 3,000
Share premium 2,000
Revenue reserves (1,000)
Shareholders’ funds 4,000
10% Debentures 20X5 5,000
Current liabilities
Payables 2,300
Bank overdraft 1,200
Total equity and liabilities 12,500


The realisable values of assets upon liquidation are estimated to be:


Land and buildings 1,500
Plant and machinery 3,450
Inventory 1,000
Receivables 1,000


The current market price of ordinary shares is 22 cents per share. The corporate tax rate is 30%.




Prepare a report analysing whether the proposed scheme of reconstruction will be successful. State clearly any assumptions that you make.

Influence on objectives


Non-financial issues, ethical and environmental issues in many cases overlap, and have become of increasing significance to the achievement of primary financial objectives such as the maximisation of shareholder wealth. Most companies have a series of secondary objectives that encompass many of these issues.


Traditional non-financial issues affecting companies include:


  • Measures that increase the welfare of employees such as the provision of housing, good and safe working conditions, social and recreational facilities. These might also relate to managers and encompass generous perquisites.


  • Welfare of the local community and society as a whole. This has become of increasing significance, with companies accepting that they have some responsibility beyond their normal stakeholders in that their actions may impact on the environment and the quality of life of third parties.

  • Provision of, or fulfilment of, a service. Many organisations, both in the public sector and private sector provide a service, for example to remote communities, which would not be provided on purely economic grounds.


  • Growth of an organisation, which might bring more power, prestige, and a larger market share, but might adversely affect shareholder wealth.


  • Quality. Many engineering companies have been accused of focusing upon quality rather than cost effective solutions.


  • Survival. Although to some extent linked to financial objectives, managers might place corporate survival (and hence retaining their jobs) ahead of wealth maximisation. An obvious effect might be to avoid undertaking risky investments.


Ethical issues of companies were brought into sharp focus by the actions of Enron and others.


There is a trade -off between applying a high standard of ethics and increasing cash flow or maximisation of shareholder wealth. A company might face ethical dilemmas with respect to the amount and accuracy of information it provides to its stakeholders. An ethical issue attracting much attention is the possible payment of excessive remuneration to senior directors, including very large bonuses and ‘golden parachutes’.

Key answer tips: Should bribes be paid in order to facilitate the company’s long-term aims? Are wages being paid in some countries below subsistence levels? Should they be? Are working conditions of an acceptable standard? Do the company’s activities involve experiments on animals, genetic modifications etc? Should the company deal with or operate in countries that have a poor record of human rights? What is the impact of the company’s actions on pollution or other aspects of the local environment?


Environmental issues might have very direct effects on companies. If natural resources become depleted the company may not be able to sustain its activities, weather and climatic factors can influence the achievement of corporate objectives through their impact on crops, the availability of water etc. Extreme environmental disasters such as typhoons, floods, earthquakes, and volcanic eruptions will also impact on companies’ cash flow, as will obvious environmental considerations such as the location of mountains, deserts, or communications facilities. Should companies develop new technologies that will improve the environment, such as cleaner petrol or alternative fuels? Such developments might not be the cheapest alternative.


Environmental legislation is a major influence in many countries. This includes limitations on where operations may be located and in what form, and regulations regarding waste products, noise and physical pollutants.


All of these issues have received considerable publicity and attention in recent years. Environmental pressure groups are prominent in many countries; companies are now producing social and environmental accounting reports, and/or corporate social responsibility reports. Companies increasingly have multiple objectives that address some or all of these three issues. In the short-term non-financial, ethical and environmental issues might result in a reduction in shareholder wealth; in the longer term it is argued that only companies that address these issues will succeed.



  • As there is more than one inflation rate, we must calculate the money cash flows and hence discount them by the money (nominal) rate.


Net present value calculation for Breckhall Inc


Year 0 1 2 3 4 5 6
Receipts $000 $000 $000 $000 $000 $000 $000
(5% rise p.a.) 3,675 5,402 6,159 6,977 6,790
(10% rise p.a.) (589) (908) (1,198) (1,537) (1,449)
(10% rise p.a.) (1,177) (1,815) (2,396) (3,075) (2,899)
(5% rise p.a.) (53) (110) (116) (122) (128)
TAD (1,125) (844) (633) (475) (1,423)
Taxable Profits 731 1,725 1,816 1,768 891
Corporation tax (256) (604) (636) (619) (312)
Add Capital allowances 1,125 844 633 475 1,423
Non-current (4,500)
Working (300) (120) (131) (144) (156) (42) 893
Net cash (4,800) 1,736 2,182 1,701 1,451 1,653 581
Discount rate
(15%) 1 0.870 0.756 0.658 0.572 0.497 0.432
Present (4,800) 1,510 1,650 1,119 830 822 251
Net present $1,382


A positive NPV is when the expected return on a project more than compensates the investor for the perceived level of (systematic) risk.

(W1) Tax allowable depreciation calculation
Cost 4,500 W.D.A. Year
TAD year 1 (1,125) 1,125 1
TAD year 2 ––––– X0.75
TAD year 3 844 2
TAD year 4 633 3
Scrap value 475 4
Balancing allowance Balancing figure 1,423 5
Check Line 0 4,500

Cost – Scrap = 4,500


(W2) Working capital requirements

Year 0 1 2 3 4 5 6
Total in real terms 300 400 500 600 700 700
Inflation 1 1.05 1.052 1.053 1.054 1.055
Total in money terms 300 420 551 695 851 893
Movement (300) (120) (131) (144) (156) (42) 893


(W3) Sales – $3,500,000*1.05 = $3,675,000


$4,900,000*1.052 = $5,402,000 etc.


  • Calculation of IRR


15% gave a positive NPV, therefore I will choose a higher discount rate to try and achieve a negative NPV, to enable the calculation of the IRR by linear interpolation. Under exam conditions I would simply pick the highest discount rate from the tables i.e. 20%.


Year Cash flow 20% Discount Rate Present Value
0 (4,800) 1 (4,800)
1 1,736 0.833 1,446
2 2,182 0.694 1,514
3 1,701 0.579 985
4 1,451 0.482 699
5 1,653 0.402 665
6 581 0.335 195
The estimate of the IRR by extrapolation:
15 + ((1382/1382 – 704) × (20 – 15)) = 25.20%

Growth of multinationals


Multinational companies are normally able to take more advantage of imperfections in product markets, factor markets or financial markets than companies that only operate in a domestic market. Taking advantage of market imperfections gives a competitive advantage and facilitates the organic growth of multinationals. By virtue of their size they are also well placed to grow through acquisition, often in the form of vertical or horizontal integration.


Many market imperfections result from government actions, for example through tariffs, quotas, exchange controls, and investment incentives. Multinationals often avoid government imposed barriers through foreign direct investment, and may take advantage of favourable tax and other incentives.


Multinationals may benefit from locating production in different countries in order to take full advantage of economies of scale and scope, low labour costs, and control of raw material supplies. Economies of scale and scope may be in production (operating at an optimum unit size, and specialising production in those countries where comparative advantages are greatest), purchasing (quantity discounts and use of market power), marketing (utilising an internationally known brand image, and an efficient international marketing structure), research and development (superior technology and/or differentiated products) or financing (access to international financial markets with the potential to raise finance at relatively low cost, and to earn higher yields on financial investments). Multinationals also often have the ability to reduce their global tax payments by locating activities in tax efficient countries, reducing taxable income or shifting tax liability from one country to another through devices such as transfer pricing, royalty fees and management fees, and eliminating or deferring taxation through the use of tax havens.


In many countries multinationals may be in an oligopolistic or even monopolistic situation, which may be exploited to generate abnormally good profitability and growth.

Internalisation of comparative advantages


Competitive advantage can be maintained by possession of unique information and skills which employees can use to create further advantage through research and development, marketing and other commercial skills. The multinational company is motivated to create an internal market for this information and to keep possession of their unique advantage specific to the firm.


Taking advantage of market imperfections is important, but a prerequisite for a successful multinational is high quality management, and the ability to survive against other multinationals in a competitive world.





To:The management, Axmine plc


From:    The chief accountant




Subject:  Proposed joint venture with Traces




Axmine plc is considering entering into a joint venture with Traces in order to import copper from XX country in South America.


Financial analysis


The discounting exercise reveals that the projected cash flows have a positive net present value of £4.71 m.


Once this decision has been made public the share price will increase if the market is at least semi strong efficient. Therefore as directors can you can achieve your primary duty, which is to maximise shareholders wealth.


Accuracy and completeness of cash flows Be question specific


The price of copper grows by 10% pa in sterling terms. Metals prices are notoriously volatile and the implications of this assumption should be investigated.


The justification of the discount rate is unreliable, i.e. the 16% minus 2%, as this does not appear to reflect the systematic risk of this project.


General comments


Purchasing Power Parity Theory can be used as our best predictor of future spot rates, however it is not accurate because of the following:


–    The future inflation rates are only estimates.


– The market is dominated by speculative transactions (98%) as opposed to trade transactions; therefore purchasing power theory breaks down.


Are the various revenues and costs likely to be subject to the same level of inflation?


Corporate tax rates and tax allowances may change over the project life.

Risk analysis


General risk comment


When accepting a project we also accept the risk associated with that project. Thus I would suggest we analysis the project risk in more detail before accepting the project. The level of analysis will depend on the complexity and materiality of the project. The risk can be analysed in a number of ways, i.e. sensitive analysis, scenario analysis, and simulation analysis.


International risk comment

Axmine should undertake a political risk assessment, it may adopt both macro and micro techniques to help reach its evaluation. Joint ventures have historically been more at risk of expropriation by host governments than wholly owned subsidiaries (Bradley 1977).

A review of economic exposure should also be undertaken.


Qualitative factors


The relationship with Traces


Will Traces honour its obligations under the joint venture? What will happen at the end of the four years? Will Traces have acquired all the technical knowledge to be able to go it alone? Why is the initial period only for four years? Would it benefit Axmine to have this period extended?


Communication to sophisticated shareholders


Will our shareholders believe it is a worthwhile project to be undertaken? Does the project fit into our previously communicated strategy? Our shareholders’ confidence is crucial to maintaining or increasing our share price.


Future opportunities


Axmine should undertake a review of all real options.


Effect on other stakeholders


Employees, creditors, debentures holders and the local community.


Managerial resources


Have we the in hose managerial resources to deliver this project.

What will the impact be, on our current operational capabilities?


Conclusions and recommendations


It is therefore concluded that the joint venture should be proceeded within the absence of any more lucrative proposals, subject to clarification of the above reservations.

(W1) Estimated future exchange rates: based on PPPT
Year Forecast South Forecast Forecast exchange/rate
American UK (pesos/£)
inflation % inflation %
1 80 8 140 × 1.80/1.08 = 233.3
2 64 8 233.3 × 1.64/1.08 = 354.3
3 51.2 8 354.3 × 1.512/1.08 = 496.0
4 41 8 496.0 × 1.41/1.08 = 647.6
5 32.8 8 647.6 × 1.328/1.08 = 796.3
(W2) Sales
Year Volume Unit Inflation Exchange Total m
price pesos
1 5m £1.5 1.1 233.3 1,925
2 5m £1.5 1.12 354.3 3,215
3 5m £1.5 1.13 496.0 4,951
4 5m £1.5 1.14 647.6 7,111
(W3) Labour and other expenses
Year Total Inflation Exchange Total m
rate pesos
1 500m pesos 1.8 900
2 500m pesos 1.8 × 1.64 1,476
3 500m pesos 1.8 × 1.64 × 1.512 2,232
4 500m pesos 1.8 × 1.64 × 1.512 × 1.41 3,147
(W4) Supervisors’ costs
Year Total Inflation   Exchange rate Total m pesos
1 £.4m 1.08 233.3 101
2 £.4m 1.082 354.3 165
3 £.4m 1.083 496.0 250
4 £.4m 1.084 647.6 353
(W5) UK tax on foreign taxable profits
Tax has been paid in South America at only 20%. A further 15% is
therefore payable in the UK.
Year 2 724m × 15% = £0.47m
Year 3 1,374m × 15% = £0.58m
Year 4 2,269m × 15% = £0.69m
Year 5 3,412m × 15% = £0.79m

Axmine plc


The net cash flow projections of the proposed joint venture with




Year 0 1 2 3 4 5
Pesos Pesos Pesos Pesos Pesos Pesos
m m m m m m
Sales – (W2) 1,925 3,215 4,951 7,111
Payments: ––––– –––––   –––––   –––––   –––––   –––––
Labour and other (900) (1,476) (2,232) (3,147)
expenses – (W3)
Supervisors salaries – (101) (165) (250) (352)
TAD (200) (200) (200) (200)
Taxable ––––– ––––– ––––– –––––
724 1,374 2,269 3,412
profits ––––– ––––– ––––– –––––
Foreign tax
(145) (275) (454) (682)
@ 20%
TAD 200 200 200 200
Machinery (800)
Net foreign (800) 924 1,429 2,194 3,158 (682)
cash flow ––––– –––––   –––––   –––––   –––––   –––––
140 233.3 354.3 496.0 647.6 796.3
rate – (W1)
£ Cash flow (5.71) 3.96 4.03 4.42 4.88 (.86)
UK tax on foreign (.47) (.58) (.69) (.79)
profits @15% – (W5)
Net £ cash (5.71) 3.96 3.56 3.84 4.19 (1.65)
Discount rate 1 .877 .769 .675 .592 .519
– 14%
Present value (5.71) 3.47 2.74 2.59 2.48 (.86)
––––– ––––– ––––– ––––– ––––– –––––
Net present 4.71 m
  • Is the proposed discount rate of 14% appropriate? The first point is the each discount rate must be bespoke, i.e. calculated specifically for each project and based on the perceived systematic risk of the inherent cash flows of that project. To base the discount rate of the foreign project on the rate for UK mining operations is not satisfactory as the systematic risk of the project may be significantly different.


The logic of the 2% reduction is also questionable:


One argument put forward for overseas expansion is that of risk diversification, i.e. that the income of the combined company will be less volatile as its cash flows come from a variety of markets. However, this is a reduction in total risk, but has little or no effect on the systematic risk.


Will this benefit the shareholders? Basic answer: No


Shareholders should diversify for themselves, because a shareholder can more easily and cheaply eliminate unsystematic risk by purchasing an international unit trust.


If the diversification is into foreign markets where the individuals cannot directly invest themselves this may lead to a reduction in their systematic risk.


This could be possible for a South American country, where exchange controls and other market imperfections often exist. However, as it gets easier for individuals to gain access to foreign markets the value of this argument has diminished.


  • Blocked remittances might be avoided by means of:


  • Increasing transfer prices paid by the foreign subsidiary to the parent company.


  • Lending the equivalent of the dividend to the parent company.


  • Making payments to the parent company in the form of royalties, payment for patents, or management fees.


  • Charging the subsidiary additional head office overhead.


  • Parallel loans, whereby the subsidiary in the South American country lends cash to the subsidiary of another a company requiring funds in the South American country. In return the parent company would receive the loan of an equivalent amount of cash in the UK from the other subsidiary’s parent company.


The government of the South American country might try to prevent many of these measures being used.



Key answer tips: What appears to be an amazingly complex question for 10 marks is nothing much more than a relevant cost exercise. That said, the numbers take time and it would be sensible, if short of time, to cover the discussion points with assumed numbers if necessary.


Under the current scheme:
Ginland Rytora
$000 $000
Sales (150,000 units) 1,575 4,500
––––– –––––
Variable costs 900 1,350
Costs from Glinland 1,575
Fixed costs 140 166
––––– –––––
Profit before tax 535 1,409
Local corporate tax (40% Glinland, 214 352
25% Rytora)
––––– –––––
Profit after
corporate tax 321 1,057
Withholding tax (Glinland: 16
10% of 50% of 321)
Import tariff (10% of 1,575) 157
Retained (Glinland: 50% of 321) 161
Remitted (Glinland: 144 900
UK taxation: 321 – 161 – 16)
Taxable profit 535 1,409
––––– –––––
Tax at UK tax rate (30%) 160 423
Tax credit (Rytora: Limited to
Rytora tax) 160 352
––––– –––––
Tax paid in the UK 0 71
––––– –––––
Total tax paid $000 $000
In Glinland
Corporate tax 214
Withholding tax 16
––––– 230
In Rytora
Corporate tax 352
Import taxes 157
––––– 509
In the UK 71
Total 810


If goods are sold at cost by the Glinland subsidiary (i.e. at variable cost of 900 + fixed costs of 140 = 1,040):


Glinland Rytora
$000 $000
Sales 1,040 4,500
––––– –––––
Variable costs 900 1,350
Costs from Glinland 1,040
Fixed costs 140 166
––––– –––––
Profit before tax 0 1,944
Local corporate tax (25% Rytora) 486
Profit after corporate 1,458
Withholding tax
Import tariff (10% of 1,040) 104
Remitted (1,458 – 104) 1,354
UK taxation:
Taxable profit 1,944
Tax at UK tax rate (30%) 583
Tax credit (Limited to Rytora 486
tax) –––––
Tax paid in the UK 0 97
Total tax paid $000 $000
In Glinland 0
In Rytora
Corporate tax 486
Import taxes 104
In the UK 97
Total 687


The proposed change would result in an overall saving of $123,000 per year.


The proposal might not be acceptable to:


  • The tax authorities in Glinland, where $230,000 in taxation would be lost. The tax authorities might insist on an arm’s length price for transfers between Glinland and Rytora.


  • The subsidiary in Glinland, which would no longer make a profit, or have retentions available for future investment in Glinland. Depending upon how performance in Glinland was evaluated, this might adversely affect rewards and motivation in Glinland.



Goddard Inc


  • The overview – What method should I use to calculate the discount rate for a project in a different industry (different business risk), when the capital structure of our company remains unchanged (same financial risk) post-project implementation.


The Leisure Project


I have assumed the business risk (the beta asset) of the leisure industry can be estimated by de-gearing the equity beta of Cottons plc.


Goddard’s existing gearing ratio/capital structure based on market values is:


$m %
Equity 15/0.5 × 3.80 114.00 66
Debt 56 × 1.04 58.24 34
Total 172.24 100

Cotton’s gearing ratio/capital structure based on market values is:


$m %
Equity 10/0.25 × 1.80 72.00 81
Debt 15 × 1.12 16.80 19
Total 88.8 100


  • Find the business risk asset beta ßa of the new project/industry.


ßa    =  ße × Ve/[Ve + Vd(1 – T)]


  • 3 × 81/[81 + 19 (0.70)]


  • 12


  • Calculate the equity beta of the new project.


ßa =  ße × Ve/[Ve + Vd(1 – T)]
1.12 =  ße × 66/[66 + 34(0.70)]
1.12 = 0.73 ße
ße = 1.12/0.73 = 1.53 – Reflects the systematic risk of
the project

(3)     Keg


Rf + (RM – R f) ße.


6% + (14 – 6) 1.53 = 18.24%.


  • Kdat


The investors’ required return = K d = 11 %. Therefore to find the current cost of debt adjust for the tax relief on interest.


Kd(1 – t) = 11(0.70) = 7.70.


Kd(1 – t) = 7.70%.


  • WACC


  • 24% × 0.66 + 7.70% × 0.34 = 14.66%.


The Publication Project


I have assumed the business risk (the beta asset) of the publication
industry can be estimated by de-gearing the equity beta of
Blackwell plc.
Blackwell’s gearing ratio/capital structure based on market values is:
$m %
Equity 30/0.50 × 2.30 138.00 67
Debt 69.00 33
Total 207.00 100

As the gearing ratio/financial risk of Blackwell is almost identical to that of Goddard, there is no need to take out the financial risk (degear) and then put back in the same level of financial risk

(re gear).


  • Keg


Rf + (RM – Rf) ße.


6% + (14 – 6) 1.2 = 15.60%.


  • Kdat


  • 7%.


  • WACC


  • 60 × 0.66 + 7.7 × 0.34 = 12.91.


  • The marketing director might be correct. If there is initially a high level of systematic risk in the packaging investment before it is certain whether the investment will succeed or fail, it is logical to discount cash flows for this high risk period at a rate reflecting this risk. Once it has been determined whether the project will be successful, risk may return to a ‘more normal’ level and the discount rate reduced commensurate with the lower risk. If the project fails there is no risk (the company has a certain failure!).


The other board member is incorrect. If the same discount rate is used throughout a project’s life the discount factor becomes smaller and effectively allows a greater deduction for risk for more discount cash flows. The total risk adjustment is greater the further into the future cash flows are considered. It is not necessary to discount more distant cash flows at a higher rate.

Option valuation


  • Option valuation


First use Black-Scholes to value the equivalent call.


Step 1: Calculate d1 and d2


d1 = [ln (Pa/Pe ) + (r+0.5s2)t]/s√ t


d1 = [ln (6/5) + (0.12 + 0.5 × 0.32)2]/(0.3 × √ 2) d1 = 1.21

d2 = d1 – s√ t = 1.21 – 0.3√ 2 d2 = 0.79


Step 2:   N(d1) = 0.5 + 0.3869 = 0.8869. N(d2) = 0.5 + 0.2852 = 0.7852.

Step 3:   Plug these numbers into the Black-Scholes formula


Value of a call option = Pa N(d1) – PeN(d2)e–rt


  • 00 × 0.8869 – 5.00 × 0.7852 × e–(0.12*2)


  • 32 – 3.08


  • 24


(Reasonableness check: This exceeds the intrinsic value of $1.00 so it looks ok.)


Step 4: Then use the put call parity rule to value a put option.


$2.24 $6.00
Call price Share price
+ = +
PV of the exercise price Put price
5.00e–(0.12* 2) (Balancing Figure)
  • $2.24 + $3.93 – $6.00 = value of a put


  • $0.17


200,000 puts would therefore cost = 200,000* 0.17 = $34,000


(Reasonableness check: This option is out of the money so we would expect a low value.)

Shares only: Share prices
$3 $10
Share price movement –$600,000 $800,000
Shares with Put options ––––––––– ––––––––
Adverse Favourable
Exercise* Abandon
Share price movement –$600,000 $800,000
Profit on options* $400,000
Less premium –$34,000 –$34,000
––––––––– ––––––––
Net –$234,000 $766,000
––––––––– ––––––––


The hedge would save $366,000 ($600,000 – $234,000) if the share price fell, and would lose $ 34,000 if the share price increased i.e. the cost of the options that were not exercised.


(c)    The investor purchased 200,000 shares and wishes to hedge the position, how many call options would he have to sell to construct a risk free investment?


= 200,000/0.8869 = Sell 225,505 call options



Political risk


  • The consultant’s report should not be used as the only basis for the African investment decision, for the following reasons.


  • The decision should be taken after evaluating the risk/return trade-off; financial factors (e.g. the expected NPV from the investments); strategic factors; and other issues including political risk. Political risk is only one part of the decision process (although in extremely risky countries it might be the most important one).


  • The scores for the three countries are, giving double weighting to economic growth and political stability:


Country 1 29
Country 2 24
Country 3 28

Just because previous clients have not invested in countries with scores of less than 30 does not mean that Beela should not. The previous countries may not have been comparable

with these in Africa. This decision rule also ignores return. If return is expected to be very high, a relatively low score might

be acceptable to Beela.


  • The factors considered by the consultant might not be the only relevant factors when assessing political risk. Others could include the extent of capital flight from the country, the legal infrastructure, availability of local finance and the existence of special taxes and regulations for multinational companies.


  • The weightings of the factors might not be relevant to Beela.


  • Scores such as these only focus on the macro risk of the country. The micro risk, the risk for the actual company investing in a country, is the vital factor. This differs between companies and between industries. A relatively hi-tech electronics company might be less susceptible to political actions than, for example, companies in extractive industries where the diminishing bargain concept may apply.


  • There is no evidence of how the scores have been devised and how valid they are.


  • Prior to investing Beela might negotiate an agreement with the local government covering areas of possible contention such as dividend remittance, transfer pricing, taxation, the use of local labour and capital, and exchange controls. The problem with such negotiations is that governments might change, and a new government might not honour the agreement.


The logistics of the investment may also influence political risk:


  • If a key element of the process is left outside the country it may not be viable for the government to take actions against a company as it could not produce a complete product. This particularly applies when intellectual property or know-how is kept back.


  • Financing locally might deter political action, as effectively the action will hurt the local providers of finance.


  • Local sourcing of components and raw materials might reduce risk.


  • It is sometimes argued that participating in joint ventures with a local partner reduces political risk, although evidence of this is not conclusive.


  • Control of patents and processes by the multinational might reduce risk, although patents are not recognised in all countries.


Governments or commercial agencies in multinationals’ home countries often offer insurance against political risk.

Murwald (Interest rate hedging)


  • The treasury team believe that interest rates are more likely to increase than to decrease, and any hedging strategy will be based upon this assumption. There is also a requirement that interest payments do not increase by more than £10,000 from current interest rates.


Current expectations


The current expectation is a £12m deficit in three months’ time for a six-month period. At current rates, the company could borrow at 6%

  • 5% = 7.5%. Interest costs at current borrowing rates would therefore be: £12m × 7.5% × 6/12 = £450,000.


Alternative 1: Futures hedges


Use June contracts to hedge a deficit of £12 million. To hedge against the risk of a rise in interest rates, the company should sell futures.


Tutorial note: We sell futures because if interest rates do rise, the market price of the futures will fall. The company can then close its position by buying futures, and making a gain on the futures trading to offset the ‘loss’ from higher interest rates in the loans market.


  • If interest rates rise by 2% and the futures price moves by 1.80%.


As a six months hedge is required and each future is for a three-month interest period, the number of contracts will be £12m/£500k × 6/3 = 48 contracts.


The tick value is £500,000 × 0.0001 × 3/12 = £12.50.


Cost of borrowing at current rate 450,000
Cost if rates rise 2%
(£12m × 9.5% × 6/12) 570,000
‘Loss’ from extra borrowing cost (120,000)
Sell 48 contracts at 93.10
Buy 48 contracts at (93.10 – 1.80) 91.30
Gain per contract 1.80
Value of gain 180 × 48 × £12.50 108,000
Net additional cost with hedging (12,000)
  • If interest rates fall by 1% and the futures price moves by 0.9%


Cost of borrowing at current rate 450,000
Cost if rates fall 1%
(£12m × 6.5% × 6/12) 390,000
‘Gain’ from fall in borrowing cost 60,000
Sell 48 contracts at 93.10
Buy 48 contracts at (93.10 + 0.90) 94.00
Loss per contract 0.90
Value of loss 90 × 48 × £12.50 (54,000)
Net gain with hedging 6,000


Based on these futures prices, hedging in the futures market does not allow the company to guarantee that interest costs in the case of a deficit do not increase by more than £10,000.


Alternative 2: Options hedges


The expectation is for interest rates to rise, therefore put options on futures will be purchased. This will allow the company to sell futures contracts at the exercise price for the options. The company should buy 48 options, since this is the number of futures contracts that might be required. (If interest rates rise the value of the put options will also increase.)


For example using the 9400 exercise price:


  • If interest rates rise by 2% and the futures price moves by 1.8%.
Cost of borrowing at current rate 450,000
Cost if rates rise 2% (£12m × 9.5% × 6/12) 570,000
‘Loss’ from extra borrowing cost (120,000)
Buy 48 puts at (1.84)
Exercise – sell futures at (exercise price) 94.00
Buy 48 futures contracts at
(93.10 – 1.80) (91.30)
Gain per contract 0.86
Value of gain 86 × 48 × £12.50 ––––– 51,600
Net additional cost with hedging (68,400)

In reality the options are likely to be sold rather than exercised. This is because they are June contracts, so they will still have time value that will be reflected in the option price. The gain from the options sale is therefore likely to be higher than the gain from exercising the options and selling futures. However, no data is provided on option prices on 1 June.


  • If interest rates fall by 1% and the futures price moves by 0.9%


Cost of borrowing at current rate 450,000
Cost if rates fall 1% (£12m × 6.5% × 6/12) 390,000
‘Gain’ from fall in borrowing cost 60,000
Buy 48 puts at 1.84.
Cost = 184 × 48 × £12.50 (110,400)
Net additional cost with hedging (50,400)


Different outcomes will exist for using options if different put option exercise prices are selected. The best exercise price to select if the put options are exercised will be the 9350 option.


If interest rates rise by 2% and the futures price falls by 180 to 91.30, this will give a gain from the options of:


93.50 – 91.30 – 1.25 = 0.95 or 95 ticks


95 × 48 × £12.50 = £57,000


If interest rates fall by 1 % and the futures price rises to the futures price moves to 94.00, the option will not be exercised. The loss from hedging with options will be the premium paid off:


125 × 48 × £12.5 = £75,000


Outcomes with options at 9350


2% increase: £(120,000) + £57,000 = £(63,000) 1 % decrease:

£60,000 – £75,000 = £(15,000).


Neither futures nor options hedges can satisfy, with certainty, the requirement that the interest payment should not increase by more than £10,000.



However, one way to achieve this would be to use a collar option, whereby downside risk is protected, but potential gains are also limited. A collar effectively fixes a maximum and minimum interest rate.


If a company expects to be borrowing and is worried about interest rate increases, a suitable collar can be achieved by buying put options and selling call options, to reduce the cost of protection.


For example a collar could be achieved by buying forty eight 9400 put options at 1.84 and selling 9400 call options at 1.74, a net premium cost of 0.10 (other alternatives are possible).


Murwald doesn’t want interest to move adversely by more than £10,000 for a six month period on a £12 million loan.


In annual terms this is a £10k/£12m × 2 = 0.167%.


A put option at the current interest rate (6%) and a total premium cost of less than 0.167% will satisfy the company’s requirement. In the above example the total premium cost is 0.10%, and no matter what happens to interest rates Murwald can fix its borrowing cost at 7.6% (= 100 – 94.00 + 0.10 net option premium, plus the 1.5% premium over base rate for borrowing).


This satisfies the requirement. (Interest payments would be £12m × 7.6% × 0.5 = £456,000 which is £6,000 worse than current interest rates.)


The use of a collar is the recommended hedging strategy, but the company should consider the implications of the collar if a cash surplus was to occur rather than a cash deficit.


  • Alternative interest rate hedges include:


  • Forward rate agreements (FRAs).


  • OTC interest rate options – including interest rate guarantees.


  • Interest rate swaps.


  • A forward rate agreement (FRA) is a contract to agree to pay a fixed interest rate that is effective at a future date. As such Murwald could fix now a rate of interest of 6.1% (for example) to be effective in three months’ time for a period of six months. If interest rates were to rise above 6.1% the counter-party, usually a bank, would compensate Murwald for the difference between the actual rates and 6.1%. If interest rates were to fall below 6.1 % Murwald would compensate the counter-party for the difference between 6.1% and the actual rate.
  • OTC options. Instead of market traded interest rate options such as those that are available on LIFFE, Murwald might use OTC options through a major bank. This would allow options to be tailored to the company’s exact size and maturity requirements. An OTC collar would be possible, and the cost of this should be compared with the cost of using LIFFE options. Interest rate options for periods of less than one year are sometimes known as interest rate guarantees.


  • Interest rate swaps. Murwald expects to borrow at a floating rate of interest. It might be possible for Murwald to swap its floating rate interest stream for a fixed rate stream, pegging interest rates to approximately current levels (the terms of the swap would have to be negotiated). Interest rate swaps are normally for longer periods than six months.



Rayswood Inc




  • Share price is the present value of future cash flows i.e. the economic model.


  • The stock market is weak and semi strong efficient most of the time, therefore once new information is communicated to the market it is rapidly reflected in the share price.


  • In an efficient market shares are fairly priced i.e. a zero NPV transaction. They give investors the exact return to compensate them for the perceived level of systematic risk of the shares.


  • If shares are zero NPV transactions, takeovers/mergers could only be successful due to value created as a result of the merger i.e. the synergies.


  • Therefore it is absolutely essential that one undertakes an exhaustive review to identify all the synergies. In this question no synergies have been identified, therefore before any final advice would be given to the client one would request an immediate review of all synergies.


  • The question will therefore have to be answered on the basis of the unrealistic assumption that there are no synergies.
Post-acquisition share price:
The Add Company Approach:
Market values: $m
Rayswood – 40 × 3.2 = 128.0
Pondhill – 150 × 0.45 = 67.5
Value of combined company 195.5
No of shares: 65m
Share price of the combined company 3.01


Rayswood buys Pondhill in a 1 for 6 shares for share exchange. Rayswood already has 40m shares and buys Pondhill for (150 × 1/6) = 25m shares, thus 65m shares in total.


Tutorial note:


In fact the takeover has been a wealth decreasing decision in relation to the shareholders of Rayswood. The new share price of $ 3.01 is lower than current market price of $3.20. Which reflects the fact that premium payment to Pondhill’s shareholders has reduced the wealth of Rayswood’s shareholders.


Calculation of the acquisition premium – Value per one share of



Pondhill shareholders get 1 share in Rayswood ($3.01) for every 6 shares of Pondhill.


(1 × 3.01)/6 = $0.50


(0.50 – 0.45)/0.45 = 11.11%


Therefore before an acquisition premium is paid consideration should be given to ensure that it does not exceed the synergistic effects of the acquisition.


Director’s comments:


‘As a result of this takeover we will diversify our operations and our earnings per share will rise by 13%, bringing great benefits to our shareholders.’


Risk diversification:


One of the primary reasons put forward for all mergers is that the income of the combined entity will be less volatile (less risky) as its cash flows come from a wide variety of products and markets. However this is a reduction in total risk, but has little or no effect on the systematic risk.

Will this benefit the shareholders?


Basic answer: No. Shareholders should diversify for themselves, because a shareholder can more easily and cheaply eliminate unsystematic risk by purchasing an international unit trust. As the majority of investors in quoted companies have well diversified portfolios they are only exposed to systematic risk. Thus the reduction of total risk by the more expensive company diversification option is generally not recommended. The Director’s comment is incorrect.


Earnings per share will rise by 13%:


Calculation of EPS:
Rayswood Pondhill Enlarged Rayswood
Profit available to
Ordinary shareholders 7.8m 6.5m 14.3
EPS 19.5c 4.33c 22c


% increase in the Earnings per share: (22 – 19.5)/19.5 × 100 = 13%


An increasing EPS does not automatically result in an increase share price, as the P/E ratio may fall to reflect the lower growth potential of the enlarged company.


The P/E ratios:
Rayswood Pondhill Enlarged Rayswood
Share price 320 45 301
EPS 19.5 4.33 22
16.41 10.39 13.68


In the absence of synergy from the acquisition, purchasing Pondhill, with relatively low growth expectations, will depress the growth of the enlarged Rayswood’s post-acquisition and thus the post-acquisition P/E ratio falls.


The Director’s comment is incorrect, the increasing earnings per shares does not bring great benefits to the shareholders, in fact it masks a potential decrease in the share price.


Non-executive comments:


“The share price of Rayswood will rapidly increase to $3.61 following the announcement of the bid.”




A company is able to increase its EPS by merging with a company on a lower P/E ratio than its own. The bootstrapping argument states that the


Share price of the enlarged Rayswood = Post-acq EPS × Pre-acq P/E ratio of Rayswood.


$3.61 = 22c × 16.41 times

It contends that the market may believe that when that merger is completed that the management team of Rayswood can increase growth potential of Pondhill earnings to the same level as Rayswood earnings. It may then assign the Rayswood’s higher P/E ratio to the combined earnings of both companies (i.e. the post-acquisition EPS).


There have been some well documented cases of bootstrapping occurring in the 50s and 60s in America however as the stock markets have become more and more efficient it much less likely to occur today. The investors would request a detail analysis of the synergies so they could calculate the present value of future cash flows.


If there are no synergies identified the higher post-acquisition EPS simply results in a lower post-acquisition P/E multiple as we have seen. Therefore the non-executive is also incorrect in his views.





Predator Inc


The approaches to use for valuation are:


  • Net asset valuation.


  • Dividend valuation model.


  • P/E ratio valuation.


  • Net asset valuation


Target is being purchased as a going concern, so realisable values are irrelevant.


Net assets per accounts (1,892 – 768) 1,124
Adjustment to freehold property (800 – 460) 340
Adjustment to inventory (50)
Valuation 1,414

Say $1.4m


  • Dividend Valuation Model


The average rate of growth in Target’s dividends over the last 4 years is 7.4% on a compound basis.


The estimated value of Target using the dividend valuation model is therefore:


Valuation $113,100 × 1.074/(0.15 – 0.074)=



Say $1.6m

  • P/E ratio Valuation


A suitable P/E ratio for Target will be based on the P/E ratio of Predator as both companies are in the same industry.


P/E of Predator (70m × $4.30)/$20.04m or 430/28.63 = 15.02 The adjustments: – Downwards by 20% or 0.20 i.e. multiply by 0.80.


  • Target is a private company and its shares may be less liquid.


  • Target is a private company and it may have a less detailed compliance environment and therefore maybe more risky.


A suitable P/E ratio is therefore 15.02 × 0.80 = 12.02 (Multiplying by 0.80 results in the 20% reduction).


Target’s PAT + Synergy after tax:


$183,000 + ($40,000 × 67%) = $209,800.


After adjusting for the savings in the director’s remuneration.


The estimated value is therefore $209,800 × 12.02 = $2,521,796


Say $2.5m


Advice to the board


On the basis of its tangible assets the value of Target is $1.4m, which excludes any value for intangibles.


The dividend valuation gives a value of around $1.6m.


The earnings based valuation indicates a value of around $2.5m, which is based on the assumption, that not only will the current earnings be maintained, but that they will increase by the savings in the director’s remuneration.


On the basis of these valuations an offer of around $2m would appear to be most suitable, however a review of all potential synergies is recommended. The directors should, however, be prepared to increase the offer to maximum price.


Maximum price comment


It is worth noting that the maximum price Predator should be prepared to offer is:


The maximum price Predator should pay for target is:


PVTarget Company + PVSynergy


The comment on the maximum price is particularly appropriate in this question, as this an example of horizontal acquisition where considerable synergies normally exist.

Last Chance Saloon Inc


Report on the proposed reconstruction scheme of The Last Chance Saloon


The scheme of reconstruction is likely to be successful if:


  • It raises adequate finance.


  • If the issue price of the new shares is fair.


  • It treats all parties fairly.


  • No group is worst off under the scheme.


The reason why the scheme is required


As a result of the recent considerable losses there are inadequate funds available to finance the redemption of the $5m debentures in 20X5.


Does the scheme raise adequate finance?



Cash in:


Equity (new shares to be issued)


12% Debenture issued








Total raised


Total Out


Scheme Surplus


Current cash balance


New cash balance



$m Cash out:
12.0 Scheme funding
3.0 Equity (old shares
cancelled) 6m × 0.25
10% Debentures repaid
15.0 Total Out





The Capital Repayment position
Immediate Cash Post Scheme
Liquidation Capital Risk
Land and Buildings 1,500 1,500
Plant and machinery 3,450 3,450
Inventory 1,000 500 1,500
Receivables 1,000 1,000
Cash 500 1,000 1,500
New Assets – –––––
(realisable value may
be considerably lower) 7,000 7,000
7,450 15,950
Less: Secured creditors
10% Debentures (5,000) 5,000
12% Debenture (3,000) (3,000)
Bank overdraft (1,000)
(5,000) (4,000)
Funds available to pay
unsecured creditors 2,450 11,950
Less: Unsecured
Bank overdraft (1,200)
Other creditors (2,300) (2,300)
(3,500) (2,300)
Funds available to pay
shareholders nil 9,650
Calculation of payment 2,450 70c
in the $ to unsecured creditors 3,500


An estimate of the liquidation expenses to be incurred would be necessary in practice.


Is the issue price of the new shares fair?

Profit before interest and tax $000 $000
12% Debentures – 3,000 × 0.12 = 360
9% Overdraft – 1,000 × 0.09 = 90 (450)
Earnings before tax 550
Tax (165)
PAT ––––
Interest cover (EBIT/Interest) = 2.2


The interest cover is below the minimum acceptable level of 2.5 times and is therefore cause for concern.


E.P.S = PAT/No. of Shares = 385/10,000 = 3.85c P/E ratio: Issue price/E.P.S


120c/3.85 = 31.17 times


Assume that the industry average P/E is 16 times. Therefore would investors also be willing to pay 31.17 times the estimated earnings of Last Chance for a share?


The answer is no, they would want to be able to buy the shares at a discount given the fact that earnings would be perceived to be less reliable as a result of its recent poor performance. Therefore the current issue price may be unacceptable to investors.


A discount of 25% would seem reasonable i.e. 16 times × 0.75 = 12 times. Then a more reasonable issue price would appear to be 3.85c × 12 times = 46.2c.


Conclusion: The shares could not be sold for $1.20. Thus the financial viability of the scheme is called into question. (As the 12m cash in from the issue of new shares will not occur.)


Is the scheme acceptable to all parties?


Unsecured creditors:


In the event of liquidation they would receive 70c in the pound (ignoring liquidation expenses). However under the scheme they should receive a full repayment. The scheme is clearly beneficial to them.


The Bank:
Current position (sunk) Liquidation Scheme
$000s $000s $000s
Bank overdraft 1,200 840 1,000


The reality of the situation is that the scheme will be organised (and the overdraft will be $1 m) or the company will be liquidated and the bank will only receive $840,000. The current position of an overdraft of $1.2m as denoted in the statement of financial position is a sunk position.


Thus the bank has a simple choice have $840,000 on liquidation or agree to a reduced overdraft of $1,000,000 under the scheme, which will be secured. If the bank agrees to the scheme the capital loss on the overdraft is reduced from $360,000 to $160,000 – a saving of $200,000.


Thus the bank will probably agree to the reduced overdraft (thus the reduced overdraft does not give rise to a cash flow).


However the low interest cover would be of concern to the Bank, and raises doubts about the company’s ability to repay the interest. Therefore the bank may which to scrutinise the company profit forecasts in some details to ensure that they are based on realistic assumptions.


Existing shareholders:


Per share    Current position     Liquidation     Scheme – cash repayment


Capital          22c – ?                          Nil                       25c


The current share of 22c does not represent a realistic exit strategy of all the existing shareholders, because if a sizeable proportion of shareholders try to sell, this would drive down the share price.


Thus existing shareholders will probably agree to the scheme.


The company may consider offering the existing shareholders a share for share exchange as opposed to offering them a cash repayment as this would reduce the need for financing and allow those existing shareholders who wish to remain the opportunity to do so.


Conclusion (have the reconstruction principles been adhered to?):


  • The shares appear to be overpriced at $1.20. This need to be reviewed immediately and possibly reduced to a more realistic level.


  • As the shares are overpriced – the $12m cash inflow from their issue is therefore unrealistic. Thus the scheme in its current form will not raise adequate finance.


  • The planning horizon needs to be extended beyond one year.


I recommend that the company valuation be taken using the present value of the free cash flows approach, if the information is available. Together with some evaluation of the risk inherent in the scheme. Risk analysis methods, which may be considered, are scenario planning, sensitivity analysis and simulation.


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