Strategic Financial

Management
PART 3
WEDNESDAY 11 DECEMBER 2002
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
P
a
p
e
r

3
.
7
Section A BOTH questions are compulsory and MUST be attempted
1 (a) Discuss the advantages to a company of establishing an overseas operating subsidiary by:
either (i) Organic growth;
or (ii) Acquisition. (8 marks)
(b) The Board of Directors of Intergrand plc wishes to establish an operating subsidiary in Germany through the
acquisition of an existing German company. Intergrand has undertaken research into a number of German quoted
companies, and has decided to attempt to purchase Oberberg AG. Initial discussions suggest that the directors
of Oberberg AG may be willing to recommend the sale of 100% of the companys equity to Intergrand for a total
cash price of 115 million Euro, payable in full on acquisition.
Oberberg has provided the managers of Intergrand with internal management information regarding
accounting/cash flow projections for the next four years.
The projections are in money/nominal terms.
Oberberg AG, financial projections
Euro (million)
Year 2003 2004 2005 2006
Sales 382 412 440 490
Labour 110 121 130 141
Materials 83 87 90 94
Overheads 32 32 33 34
Interest 25 30 35 38
Tax allowable depreciation 63 58 56 52

313 328 344 359
Taxable Profit 69 84 96 131
Taxation (25%) 17 21 24 33
Incremental operating working capital 07 09 10 20
Replacement investment 42 42 42 42
Investment for expansion 90
Oberberg AG, pro forma summarised P & L account for the year ending 31 December 2002
Euro (million)
Sales 358
Operating Expenses 211
Interest expense 34
Depreciation 62

307
Taxable profit 51
Taxation (25%) 13

Profit after tax 38

Oberberg AG, pro forma summarised Balance Sheet as at 31 December 2002
Euro (million)
Fixed assets 732
Current assets 581
Current liabilities (403)

910
Financed by:
Ordinary shares (100 Euro par value) 150
Reserves 280
Medium and long term bank loans 300
8% Bond 2009 (par value 1000 Euro) 180

91.0
2
Notes:
(i) The spot exchange rate between the Euro and pound is Euro 1625/.
(ii) Inflation is at 4% per year in the UK, and 2% per year in the Euro bloc. This differential is expected to
continue unless the UK joins the Euro bloc.
(iii) The market return is 11% and the risk free rate is 4%.
(iv) Oberbergs equity beta is estimated to be 14.
(v) Oberbergs 8% bond is currently priced at 1230 Euro, and its ordinary share price is 300 Euro.
(vi) Post-merger rationalisation will involve the sale of some fixed assets of Oberberg in 2003 with an expected
after tax market value of 8 million Euro.
(vii) Synergies in production and distribution are expected to yield 2 million Euro per annum before tax from
2004 onwards.
(viii) 175,000 has already been spent researching into possible acquisition targets.
(ix) The purchase of Oberberg will provide publicity and exposure in Germany for the Intergrand name and
brand. This extra publicity is believed to be the equivalent of Intergrand spending 1 million Euro per year
on advertising in Germany.
(x) The weighted average cost of capital of Intergrand is 10%.
(xi) After tax cash flows of Oberberg after 2006 are expected to grow at approximately 2% per year.
(xii) Oberberg does not plan to issue or redeem any equity or medium and long-term debt prior to 2006.
(xiii) After tax redundancy costs as a result of the acquisition are expected to be 5 million Euro, payable almost
immediately.
(xiv) Operating working capital comprises debtors and stock less creditors. It excludes short-term loans.
(xv) Current liabilities include negligible amounts of short-term loans.
(xvi) The corporate tax rate in Germany is 25%, and in the UK 30%. A bilateral tax treaty exists between the
two countries whereby tax paid in one country may be credited against any tax liability in the other country.
(xvii) If Intergrand acquires Oberberg existing exports to Germany yielding a pre-tax cash flow of 800,000 per
annum will be lost. It is hoped that about half of these exports can be diverted to the French market.
Required:
Intergrand has suggested that Oberberg should be valued based upon the expected present value (to infinity) of the
operating free cash flows of Oberberg. These would be discounted at an all-equity rate, and adjusted by the present
value of all other relevant cash flows, discounted at an appropriate rate(s).
Acting as a consultant to Intergrand plc, prepare a report evaluating whether or not Intergrand should offer the
115 million Euro required to acquire Oberberg AG. Include in your report discussion of other commercial and
business factors that Intergrand should consider prior to making a final decision.
Assume that it is now mid-December 2002.
State clearly any other assumptions that you make. (32 marks)
Approximately 22 marks are available for calculations and 10 for discussion.
(40 marks)
3 [P.T.O.
2 The CEO of Autocrat plc is reviewing the companys interest rate and currency risk strategies for the next few months.
There has recently been considerable political instability with some countries showing signs of moving towards
economic recession whilst others are still showing steady growth. Both interest rates and currency rates could become
more volatile for many major trading countries.
Autocrat is expected to need to borrow 6,500,000 for a period of six months commencing in six months time.
The company also needs to make a US$ payment of $43 million in 3 months time.
Assume that it is now 1 December. Futures and options contracts may be assumed to expire at the end of the relevant
month, and the company may be assumed to be able to borrow at the 3 month LIBOR rate.
LIFFE futures prices, 500,000 contract size
March 9556
June 9529
LIFFE options on futures prices, 500,000 contract size. Premiums are annual %
CALLS PUTS
March June March June
95250 0445 0545 0085 0185
95500 0280 0390 0170 0280
95750 0165 0265 0305 0405
Three month LIBOR is currently 45%
Foreign exchange rates
Spot $14692 14735/
3 month forward $14632 14668/
Currency option prices
Philadelphia Stock Exchange $/ options, contract size 31,250, premiums are cents per
CALLS PUTS
March April March April
1450 312 156
1460 255 295 199 251
1470 214 251
Required:
(a) Discuss the relevant considerations when deciding between futures and options to hedge the companys
interest rate risk. (6 marks)
(b) Using the above information illustrate the possible results of
(i) futures; and
(ii) options
hedges if interest rates in six months time increase by 075%. Recommend which hedge should be selected
and explain why there might be uncertainty as to the results of the hedges. (11 marks)
(c) Illustrate and discuss the possible outcomes of forward market and currency options hedges if possible
currency rates in three months time are either:
either (i) $14350 $14386/
or (ii) $14780 $14820/. (8 marks)
(d) Discuss and illustrate whether or not a currency straddle option with an exercise price of 1460 might be an
appropriate hedging strategy for Autocrat plc. Explain the circumstances in which straddle options could be
a profitable strategy. (5 marks)
(30 marks)
4
Section B TWO questions ONLY to be attempted
3 Summarised financial data for TYR plc is shown below:
TYR plc
Year Post-tax earnings Dividends Issued shares Share price
( million) ( million) (million) (pence)
1997 862 345 180 360
1998 924 362 180 410
1999 993 376 180 345
2000 1341 516 240 459
2001 1486 533 240 448
Year All-share index Inflation rate
1997 2895 6%
1998 3300 5%
1999 2845 4%
2000 2610 3%
2001 2305 3%
TYRs cost of equity is estimated to be 11%.
Required:
(a) Explain, with supporting numerical evidence, the current dividend policy of TYR plc, and briefly discuss
whether or not this appears to be successful. (6 marks)
(b) Identify and consider additional information that might assist the managers of TYR in assessing whether the
dividend policy has been successful. (4 marks)
(c) Evaluate whether or not the companys share price at the end of 2001 was what might have been expected
from the Dividend Growth Model. Briefly discuss the validity of your findings. (5 marks)
(15 marks)
5 [P.T.O.
4 (a) Briefly discuss the possible objectives of transfer pricing strategies used by multinational companies.
(4 marks)
(b) Shegdor plc, a UK based multinational company, has subsidiaries in three countries Umgaba, Mazila and
Bettuna.
The subsidiary in Umgaba manufactures specialist components, which may then be assembled and sold in
either Mazila or Bettuna.
Production and sales volume may each be assumed to be 400,000 units per year no matter where the
assembly and sales take place.
Manufacturing costs in Umgaba are $16 per unit and fixed costs (for the normal range of production)
$18 million.
Assembly costs in Mazila are $9 per unit, and in Bettuna $75 per unit. Fixed costs are $700,000 and
$900,000 respectively.
The unit sales price in Mazila is $40 and in Bettuna $37.
Corporate taxes on profits are at the rate of 40% in Umgaba, 25% in Mazila, 32% in Bettuna, and 30% in
the UK. No tax credits are available in these three countries for any losses made.
Tax allowable import duties of 10% are payable on all goods imported into Mazila.
A withholding tax of 15% is deducted from all dividends remitted from Umgaba.
Shegdor expects about 60% of profits from each subsidiary to be remitted direct to the UK each year.
Cost and price data in all countries is shown in US dollars.
Required:
Evaluate and explain:
(i) if the transfer price from Umgaba should be based upon fixed cost plus variable cost, or fixed cost plus
variable cost plus a mark up of 30%;
(ii) whether assembly should take place in Mazila or Bettuna. (8 marks)
(c) Comment upon the likely attitude of the governments of each of the four countries towards the transfer price
and assembly location selected in b (i) and b (ii) above. (3 marks)
(15 marks)
6
5 At a luncheon meeting the managing director of Gitlor plc has told two of his colleagues, who hold senior executive
positions in different companies, that he has recently obtained from his bank forecasts of exchange rates in one years
time. His two colleagues also work for companies that are heavily engaged in international trade, and both agree to
obtain their own forecasts. The following week the three again meet for lunch and compare the forecasts made by
their banks. These forecasts are shown below:
$/Euro /Euro Yen/$ $/
Bank 1 076 056 120 136
Bank 2 084 064 140 131
Bank 3 100 065 140 154
Current spot rates 088 062 125 142
USA UK Euro bloc Japan
Annual inflation rates 3% 2% 3% (1%)
Annual short-term interest rates 325% 475% 418% 001%
The three senior executives are puzzled by this information.
Required:
Prepare a report discussing and analysing the above information, and explaining why the banks forecasts might
differ. Your analysis should include calculations based upon inflation rates and interest rates.
Discuss in the report the mechanisms influencing future exchange rates and whether or not it is possible to
accurately forecast such future exchange rates, and if so under what circumstances.
(15 marks)
7 [P.T.O.
6 The following are extracts from the corporate governance guidelines issued by a UK plc:
(i) All auditors fees, including fees for services other than audit, should be fully disclosed in the annual report. In
order to ensure continuity of standards the same audit partner, wherever possible, should be responsible for a
period of at least three years.
(ii) The board shall establish a remuneration committee comprising 50% executive directors, and 50% non-
executive directors. A non-executive director shall chair the committee.
(iii) The Chairman of the company may also hold the position of Chief Executive, although this shall not normally be
for a period of more than three years.
(iv) The annual report shall fully disclose whether principles of good corporate governance have been applied.
(v) No director shall hold directorships in more than twenty companies.
(vi) Directors should regularly report on the effectiveness of the companys system of internal control.
Required:
(a) Discuss the extent to which each of points (i) (vi) is likely to comply with corporate governance systems
such as the UK Combined Code (N.B. The Combined Code results from the Cadbury, Greenbury and Hempel
reports). (9 marks)
(b) Prepare a brief report advising senior managers of your company who are going to work in subsidiaries in
Germany, Japan and the USA of the main differences in corporate governance between the UK and any TWO
of the above countries, and possible implications of the differences for the managers. (6 marks)
(15 marks)
8
9 [P.T.O.
Ke (i)
(ii)
WACC
or Ke
u
2 asset
portfolio
Purchasing
power parity
E r r E r r
D
P
g
Ke
g
E
E D
Kd t
D
E D
Dt
E D
x x x x p
i i
i
E
E
j f m f j
p a b ab a b
f uk
uk
a e
( ) ( )
( )

( ) ( )

= +
[ ]
+
+
+
+
+

= + +
+
=

1
0
2 2 2 2
1
1
1 2 1
1
++
+
+
=
=
+
+
=
D t
D t
E D t
Ps N d Xe N d
d
Ps X rT
T
T
d d T
d
rT
( )
( )
( )
( ) ( )
/
.

1
1
1
1
0 5
1 2
1
2 1

Call price for a European option

n ( )


Formulae Sheet
10
T
3UHVHQW 9DOXH 7DEOH
Present value cf 1 i.e. (1 + U)
Q
Where r ~ cisccunt rate
n ~ number cf periccs until payment
'LVFRXQW UDWH U
3HULRGV
(n) 1 2 3 4 5 6 7 8 9 10
1 0990 0980 0971 0962 0952 0943 0935 0926 0917 0909 1
2 0980 0961 0943 0925 0907 0890 0873 0857 0842 0826 2
3 0971 0942 0915 0889 0864 0840 0816 0794 0772 0751 3
4 0961 0924 0888 0855 0823 0792 0763 0735 0708 0683 4
5 0951 0906 0863 0822 0784 0747 0713 0681 0650 0621 5
6 0942 0888 0837 0790 0746 0705 0666 0630 0596 0564 6
7 0933 0871 0813 0760 0711 0665 0623 0583 0547 0513 7
8 0923 0853 0789 0731 0677 0627 0582 0540 0502 0467 8
9 0914 0837 0766 0703 0645 0592 0544 0500 0460 0424 9
10 0905 0820 0744 0676 0614 0558 0508 0463 0422 0386 10
11 0896 0804 0722 0650 0585 0527 0475 0429 0388 0350 11
12 0887 0788 0701 0625 0557 0497 0444 0397 0356 0319 12
13 0879 0773 0681 0601 0530 0469 0415 0368 0326 0290 13
14 0870 0758 0661 0577 0505 0442 0388 0340 0299 0263 14
15 0861 0743 0642 0555 0481 0417 0362 0315 0275 0239 15
(n) 11 12 13 14 15 16 17 18 19 20
1 0901 0893 0885 0877 0870 0862 0855 0847 0840 0833 1
2 0812 0797 0783 0769 0756 0743 0731 0718 0706 0694 2
3 0731 0712 0693 0675 0658 0641 0624 0609 0593 0579 3
4 0659 0636 0613 0592 0572 0552 0534 0516 0499 0482 4
5 0593 0567 0543 0519 0497 0476 0456 0437 0419 0402 5
6 0535 0507 0480 0456 0432 0410 0390 0370 0352 0335 6
7 0482 0452 0425 0400 0376 0354 0333 0314 0296 0279 7
8 0434 0404 0376 0351 0327 0305 0285 0266 0249 0233 8
9 0391 0361 0333 0308 0284 0263 0243 0225 0209 0194 9
10 0352 0322 0295 0270 0247 0227 0208 0191 0176 0162 10
11 0317 0287 0261 0237 0215 0195 0178 0162 0148 0135 11
12 0286 0257 0231 0208 0187 0168 0152 0137 0124 0112 12
13 0258 0229 0204 0182 0163 0145 0130 0116 0104 0093 13
14 0232 0205 0181 0160 0141 0125 0111 0099 0088 0078 14
15 0209 0183 0160 0140 0123 0108 0095 0084 0074 0065 15
11 [P.T.O.
TT
7
$QQXLW\ 7DEOH
Present value cf an annuity cf 1 i.e.
Where r ~ cisccunt rate
n ~ number cf periccs
'LVFRXQW UDWH U
3HULRGV
(n) 1 2 3 4 5 6 7 8 9 10
1 0990 0980 0971 0962 0952 0943 0935 0926 0917 0909 1
2 1970 1942 1913 1886 1859 1833 1808 1783 1759 1736 2
3 2941 2884 2829 2775 2723 2673 2624 2577 2531 2487 3
4 3902 3808 3717 3630 3546 3465 3387 3312 3240 3170 4
5 4853 4713 4580 4452 4329 4212 4100 3993 3890 3791 5
6 5795 5601 5417 5242 5076 4917 4767 4623 4486 4355 6
7 6728 6472 6230 6002 5786 5582 5389 5206 5033 4868 7
8 7652 7325 7020 6733 6463 6210 5971 5747 5535 5335 8
9 8566 8162 7786 7435 7108 6802 6515 6247 5995 5759 9
10 9471 8983 8530 8111 7722 7360 7024 6710 6418 6145 10
11 1037 9787 9253 8760 8306 7887 7499 7139 6805 6495 11
12 1126 1058 9954 9385 8863 8384 7943 7536 7161 6814 12
13 1213 1135 1063 9986 9394 8853 8358 7904 7487 7103 13
14 1300 1211 1130 1056 9899 9295 8745 8244 7786 7367 14
15 1387 1285 1194 1112 1038 9712 9108 8559 8061 7606 15
(n) 11 12 13 14 15 16 17 18 19 20
1 0901 0893 0885 0877 0870 0862 0855 0847 0840 0833 1
2 1713 1690 1668 1647 1626 1605 1585 1566 1547 1528 2
3 2444 2402 2361 2322 2283 2246 2210 2174 2140 2106 3
4 3102 3037 2974 2914 2855 2798 2743 2690 2639 2589 4
5 3696 3605 3517 3433 3352 3274 3199 3127 3058 2991 5
6 4231 4111 3998 3889 3784 3685 3589 3498 3410 3326 6
7 4712 4564 4423 4288 4160 4039 3922 3812 3706 3605 7
8 5146 4968 4799 4639 4487 4344 4207 4078 3954 3837 8
9 5537 5328 5132 4946 4772 4607 4451 4303 4163 4031 9
10 5889 5650 5426 5216 5019 4833 4659 4494 4339 4192 10
11 6207 5938 5687 5453 5234 5029 4836 4656 4486 4327 11
12 6492 6194 5918 5660 5421 5197 4988 4793 4611 4439 12
13 6750 6424 6122 5842 5583 5342 5118 4910 4715 4533 13
14 6982 6628 6302 6002 5724 5468 5229 5008 4802 4611 14
15 7191 6811 6462 6142 5847 5575 5324 5092 4876 4675 15
1 (1 U)
Q

U
12
Standard normal distribution table
000 001 002 003 004 005 006 007 008 009
00 00000 00040 00080 00120 00160 00199 00239 00279 00319 00359
01 00398 00438 00478 00517 00557 00596 00636 00675 00714 00753
02 00793 00832 00871 00910 00948 00987 01026 01064 01103 01141
03 01179 01217 01255 01293 01331 01368 01406 01443 01480 01517
04 01554 01591 01628 01664 01700 01736 01772 01808 01844 01879
05 01915 01950 01985 02019 02054 02088 02123 02157 02190 02224
06 02257 02291 02324 02357 02389 02422 02454 02486 02517 02549
07 02580 02611 02642 02673 02703 02734 02764 02794 02823 02852
08 02881 02910 02939 02967 02995 03023 03051 03078 03106 03133
09 03159 03186 03212 03238 03264 03289 03315 03340 03365 03389
10 03413 03438 03461 03485 03508 03531 03554 03577 03599 03621
11 03643 03665 03686 03708 03729 03749 03770 03790 03810 03830
12 03849 03869 03888 03907 03925 03944 03962 03980 03997 04015
13 04032 04049 04066 04082 04099 04115 04131 04147 04162 04177
14 04192 04207 04222 04236 04251 04265 04279 04292 04306 04319
15 04332 04345 04357 04370 04382 04394 04406 04418 04429 04441
16 04452 04463 04474 04484 04495 04505 04515 04525 04535 04545
17 04554 04564 04573 04582 04591 04599 04608 04616 04625 04633
18 04641 04649 04656 04664 04671 04678 04686 04693 04699 04706
19 04713 04719 04726 04732 04738 04744 04750 04756 04761 04767
20 04772 04778 04783 04788 04793 04798 04803 04808 04812 04817
21 04821 04826 04830 04834 04838 04842 04846 04850 04854 04857
22 04861 04864 04868 04871 04875 04878 04881 04884 04887 04890
23 04893 04896 04898 04901 04904 04906 04909 04911 04913 04916
24 04918 04920 04922 04925 04927 04929 04931 04932 04934 04936
25 04938 04940 04941 04943 04945 04946 04948 04949 04951 04952
26 04953 04955 04956 04957 04959 04960 04961 04962 04963 04964
27 04965 04966 04967 04968 04969 04970 04971 04972 04973 04974
28 04974 04975 04976 04977 04977 04978 04979 04979 04980 04981
29 04981 04982 04982 04983 04984 04984 04985 04985 04986 04986
30 04987 04987 04987 04988 04988 04989 04989 04989 04990 04990
This table can be used to calculate N(d
i
), the cumulative normal distribution functions needed for the Black-Scholes
model of option pricing. If d
i
> 0, add 05 to the relevant number above. If d
i
< 0, subtract the relevant number above
from 05.
End of Question Paper