Advanced Financial

Management
Tuesday 2 December 2014

Time allowed
Reading and planning:
Writing:

15 minutes
3 hours

This paper is divided into two sections:

Section A This ONE question is compulsory and MUST be attempted
Section B TWO questions ONLY to be attempted
Formulae and tables are on pages 812.
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may
be annotated. You must NOT write in your answer booklet until
instructed by the supervisor.
This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper P4

Professional Level Options Module

Section A This ONE question is compulsory and MUST be attempted

1

Nahara Co and Fugae Co

Nahara Co is a private holding company owned by the government of a wealthy oil-rich country to invest its sovereign
funds. Nahara Co has followed a strategy of risk diversification for a number of years by acquiring companies from
around the world in many different sectors.
One of Nahara Cos acquisition strategies is to identify and purchase undervalued companies in the airline industry
in Europe. A recent acquisition was Fugae Co, a company based in a country which is part of the European Union
(EU). Fugae Co repairs and maintains aircraft engines.
A few weeks ago, Nahara Co stated its intention to pursue the acquisition of an airline company based in the same
country as Fugae Co. The EU, concerned about this, asked Nahara Co to sell Fugae Co before pursuing any further
acquisitions in the airline industry.
Avem Cos acquisition interest in Fugae Co
Avem Co, a UK-based company specialising in producing and servicing business jets, has approached Nahara Co
with a proposal to acquire Fugae Co for $1,200 million. Nahara Co expects to receive a premium of at least 30% on
the estimated equity value of Fugae Co, if it is sold.
Given below are extracts from the most recent statements of financial position of both Avem Co and Fugae Co.
Avem Co
$ million
800
3,550
2,200
130

6,680

Share capital (50c/share)

Reserves
Non-current liabilities
Current liabilities
Total capital and liabilities

Fugae Co
$ million
100
160
380
30

670

Each Avem Co share is currently trading at $750, which is a multiple of 72 of its free cash flow to equity. Avem Co
expects that the total free cash flows to equity of the combined company will increase by $40 million due to synergy
benefits. After adding the synergy benefits of $40 million, Avem Co then expects the multiple of the total free cash
flow of the combined company to increase to 75.
Fugae Cos free cash flow to equity is currently estimated at $765 million and it is expected to generate a return on
equity of 11%. Over the past few years, Fugae Co has returned 773% of its annual free cash flow to equity back to
Nahara Co, while retaining the balance for new investments.
Fugae Cos non-current liabilities consist entirely of $100 nominal value bonds which are redeemable in four years at
the nominal value, on which the company pays a coupon of 54%. The debt is rated at B+ and the credit spread on
B+ rated debt is 80 basis points above the risk-free rate of return.
Proposed luxury transport investment project by Fugae Co
In recent years, the country in which Fugae Co is based has been expanding its tourism industry and hopes that this
industry will grow significantly in the near future. At present tourists normally travel using public transport and taxis,
but there is a growing market for luxury travel. If the tourist industry does expand, then the demand for luxury travel
is expected to grow rapidly. Fugae Co is considering entering this market through a four-year project. The project will
cease after four years because of increasing competition.
The initial cost of the project is expected to be $42,000,000 and it is expected to generate the following after-tax cash
flows over its four-year life:
Year
Cash flows ($000s)

1
3,277.6

2
16,134.3

3
36,504.7

4
35,683.6

The above figures are based on the tourism industry expanding as expected. However, it is estimated that there is a
25% probability that the tourism industry will not grow as expected in the first year. If this happens, then the present
value of the projects cash flows will be 50% of the original estimates over its four-year life.

It is also estimated that if the tourism industry grows as expected in the first year, there is still a 20% probability that
the expected growth will slow down in the second and subsequent years, and the present value of the projects cash
flows would then be 40% of the original estimates in each of these years.
Lumi Co, a leisure travel company, has offered $50 million to buy the project from Fugae Co at the start of the second
year. Fugae Co is considering whether having this choice would add to the value of the project.
If Fugae Co is bought by Avem Co after the project has begun, it is thought that the project will not result in any
additional synergy benefits and will not generate any additional value for the combined company, above any value the
project has already generated for Fugae Co.
Although there is no beta for companies offering luxury forms of travel in the tourist industry, Reka Co, a listed
company, offers passenger transportation services on coaches, trains and luxury vehicles. About 15% of its business
is in the luxury transport market and Reka Cos equity beta is 16. It is estimated that the asset beta of the non-luxury
transport industry is 080. Reka Cos shares are currently trading at $450 per share and its debt is currently trading
at $105 per $100. It has 80 million shares in issue and the book value of its debt is $340 million. The debt beta is
estimated to be zero.
General information
The corporation tax rate applicable to all companies is 20%. The risk-free rate is estimated to be 4% and the market
risk premium is estimated to be 6%.
Required:
(a) Discuss whether or not Nahara Cos acquisition strategies, of pursuing risk diversification and of purchasing
undervalued companies, can be valid.
(7 marks)
(b) Discuss why the European Union (EU) may be concerned about Nahara Cos stated intention and how selling
Fugae Co could reduce this concern.
(4 marks)
(c) Prepare a report for the Board of Directors of Avem Co, which:
(i)

Estimates the additional value created for Avem Co, if it acquires Fugae Co without considering the
luxury transport project;
(10 marks)

(ii) Estimates the additional value of the luxury transport project to Fugae Co, both with and without the
offer from Lumi Co;
(18 marks)
(iii) Evaluates the benefit attributable to Avem Co and Fugae Co from combining the two companies with
and without the project, and concludes whether or not the acquisition is beneficial. The evaluation
should include any assumptions made.
(7 marks)
Professional marks will be awarded in part (c) for the format, structure and presentation of the report.
(4 marks)
(50 marks)

[P.T.O.

Section B TWO questions ONLY to be attempted

2

Keshi Co is a large multinational company with a number of international subsidiary companies. A centralised treasury
department manages Keshi Co and its subsidiaries borrowing requirements, cash surplus investment and financial
risk management. Financial risk is normally managed using conventional derivative products such as forwards,
futures, options and swaps.
Assume it is 1 December 2014 today and Keshi Co is expecting to borrow $18,000,000 on 1 February 2015 for a
period of seven months. It can either borrow the funds at a variable rate of LIBOR plus 40 basis points or a fixed rate
of 55%. LIBOR is currently 38% but Keshi Co feels that this could increase or decrease by 05% over the coming
months due to increasing uncertainty in the markets.
The treasury department is considering whether or not to hedge the $18,000,000, using either exchange-traded
March options or over-the-counter swaps offered by Rozu Bank.
The following information and quotes for $ March options are provided from an appropriate exchange. The options
are based on three-month $ futures, $1,000,000 contract size and option premiums are in annual %.
March calls
0882
0648

Strike price
9550
9600

March puts
0662
0902

Option prices are quoted in basis points at 100 minus the annual % yield and settlement of the options contracts is
at the end of March 2015. The current basis on the March futures price is 44 points; and it is expected to be
33 points on 1 January 2015, 22 points on 1 February 2015 and 11 points on 1 March 2015.
Rozu Bank has offered Keshi Co a swap on a counterparty variable rate of LIBOR plus 30 basis points or a fixed rate
of 46%, where Keshi Co receives 70% of any benefits accruing from undertaking the swap, prior to any bank
charges. Rozu Bank will charge Keshi Co 10 basis points for the swap.
Keshi Cos chief executive officer believes that a centralised treasury department is necessary in order to increase
shareholder value, but Keshi Cos new chief financial officer (CFO) thinks that having decentralised treasury
departments operating across the subsidiary companies could be more beneficial. The CFO thinks that this is
particularly relevant to the situation which Suisen Co, a company owned by Keshi Co, is facing.
Suisen Co operates in a country where most companies conduct business activities based on Islamic finance
principles. It produces confectionery products including chocolates. It wants to use Salam contracts instead of
commodity futures contracts to hedge its exposure to price fluctuations of cocoa. Salam contracts involve a commodity
which is sold based on currently agreed prices, quantity and quality. Full payment is received by the seller
immediately, for an agreed delivery to be made in the future.
Required:
(a) Based on the two hedging choices Keshi Co is considering, recommend a hedging strategy for the
$18,000,000 borrowing. Support your answer with appropriate calculations and discussion.
(15 marks)
(b) Discuss how a centralised treasury department may increase value for Keshi Co and the possible reasons for
decentralising the treasury department.
(6 marks)
(c) Discuss the key differences between a Salam contract, under Islamic finance principles, and futures
contracts.
(4 marks)
(25 marks)

Riviere Co is a small company based in the European Union (EU). It produces high quality frozen food which it exports
to a small number of supermarket chains located within the EU as well. The EU is a free trade area for trade between
its member countries.
Riviere Co finds it difficult to obtain bank finance and relies on a long-term strategy of using internally generated funds
for new investment projects. This constraint means that it cannot accept every profitable project and often has to
choose between them.
Riviere Co is currently considering investment in one of two mutually exclusive food production projects: Privi and
Drugi. Privi will produce and sell a new range of frozen desserts exclusively within the EU. Drugi will produce and
sell a new range of frozen desserts and savoury foods to supermarket chains based in countries outside the EU. Each
project will last for five years and the following financial information refers to both projects.
Project Drugi, annual after-tax cash flows expected at the end of each year (000s)
Year
Cash flows (000s)

Current
(11,840)

Net present value

Internal rate of return
Modified internal rate of return
Value at risk (over the projects life)
95% confidence level
90% confidence level

1
1,230

2
1,680

3
4,350

4
10,240

Privi
2,054,000
176%
134%

Drugi
2,293,000
Not provided
Not provided

1,103,500
860,000

Not provided
Not provided

5
2,200

Both projects net present value has been calculated based on Riviere Cos nominal cost of capital of 10%. It can be
assumed that both projects cash flow returns are normally distributed and the annual standard deviation of project
Drugis present value of after-tax cash flows is estimated to be 400,000. It can also be assumed that all sales are
made in (Euro) and therefore the company is not exposed to any foreign exchange exposure.
Notwithstanding how profitable project Drugi may appear to be, Riviere Cos board of directors is concerned about the
possible legal risks if it invests in the project because they have never dealt with companies outside the EU before.
Required:
(a) Discuss the aims of a free trade area, such as the European Union (EU), and the possible benefits to
Riviere Co of operating within the EU.
(5 marks)
(b) Calculate the figures which have not been provided for project Drugi and recommend which project should
be accepted. Provide a justification for the recommendation and explain what the value at risk measures.
(13 marks)
(c) Discuss the possible legal risks of investing in project Drugi which Riviere Co may be concerned about and
how these may be mitigated.
(7 marks)
(25 marks)

[P.T.O.

Kamala Co, a listed company, manufactures parts and machinery for the construction industry. About five years ago,
Kamala Co started to manufacture parts and machinery for hospitals and companies engaged in biomedical research
using largely the same manufacturing and processing systems it already had in place. In 2011, a young and
ambitious chief executive officer (CEO) took over the running of the company.
With the publication of the latest financial statements for the year to 30 November 2014, the CEO made a brief
statement and it includes the following two points:

The CEO was very pleased with growth in the financial ratios provided and sales revenue from 2012 to 2014.
More pleasing was growth in the share price, which increased even faster than the growth in the market index,
suggesting that Kamala Co has been a successful company.

The CEO expressed a desire to make Kamala Co the leading manufacturer of parts and machinery for the
construction industry by acquiring a major rival manufacturer in 2015, and financing the acquisition through an
issue of a new bond and a small rights issue.

An analyst, after examining the recent financial statements and the two points above, was less positive about
Kamala Cos future prospects.
Given below are extracts from the recent financial statements, some ratios, and other financial information for
Kamala Co.
Kamala Co
Year ending 30 November (all amounts in $m)
Sales revenue
Operating profit
Finance costs
Profit before tax
Taxation
Profit for the year
Dividends

2012
3,760

714
97

617
154

463

2013
4,054

819
168

651
163

488

2014
5,230

1,098
269

829
207

622

139

137

152

Kamala Co
Year ending 30 November (all amounts in $m)
Total non-current assets
Total current assets
Total non-current and current assets
Equity
Ordinary shares ($025)
Reserves
Total equity
Non-current liabilities
Bank loans
Bonds
Total non-current liabilities
Current liabilities
Trade and other payables
Bank overdraft
Total current liabilities
Total non-current and current liabilities

2012
3,962
980

4,942

2013
5,507
1,410

6,917

2014
7,669
1,880

9,549

750
1,476

2,226

750
1,827

2,577

750
2,297

3,047

476
1,008

1,484

1,176
1,008

2,184

1,316
2,218

3,534

1,232

1,232

2,716

1,540
616

2,156

4,340

2,016
952

2,968

6,502

Kamala Co: By activity

Year ending 30 November (all amounts in $m)
Sales revenue
Construction
Hospitals and biomedical
Operating profit
Construction
Hospitals and biomedical

2012

2013

2014

2,420
1,340

2,644
1,410

3,660
1,570

460
254

489
330

693
405

2012
190%
33
154c
40%

2013
202%
36
163c
46%

2014
210%
41
207c
54%

30 November
2012
169
4,539
840
92:1

30 November
2013
201
5,447
1,092
121:1

30 November
2014
269
6,550
1,422
153:1

2013
($m)

2014
($m)

826
990
150

1,150
1,380
170

Ratios: Kamala Co
Operating profit margin
Dividend cover
Earnings per share
Gearing [(debt/debt + equity)]
Other financial information

Kamala Co share price ($)

Market index
Industry index
Industry average PE ratio

Depreciation deducted to arrive at the operating profit

(equivalent to tax allowable depreciation)
Economic depreciation
Non-cash expenses (excluding depreciation)

Kamala Cos cost of capital is estimated to be 10%. The companys corporation tax rate is 25%.
Required:
(a) Discuss the advantages and drawbacks of using the economic value added (EVATM) technique to assess a
companys performance.
(6 marks)
(b) Estimate Kamala Cos EVATM for the years ending 30 November 2013 and 30 November 2014. (5 marks)
(c) Evaluate Kamala Cos performance and conclude whether the analysts opinion or the chief executive
officers opinion has the greater validity. Include any additional ratio and activity trends, and share price
analysis, which are deemed to be relevant to the evaluation.
(14 marks)
(25 marks)

[P.T.O.

Formulae
Modigliani and Miller Proposition 2 (with tax)
k e = kie + (1 T)(kie k d )

Vd
Ve

The Capital Asset Pricing Model

E(ri ) = R f + i (E(rm ) Rf )
The asset beta formula

V (1 T)

Ve
d
a =
e +
d
(Ve + Vd (1 T)) (Ve + Vd (1 T))

The Growth Model

Po =

Do (1 + g)
(re g)

Gordons growth approximation

g = bre

The weighted average cost of capital

V

e
d
k +
k (1 T)
WACC =
Ve + Vd e Ve + Vd d

The Fisher formula

(1 + i) = (1 + r)(1+h)

Purchasing power parity and interest rate parity

S1 = S0 x

(1+hc )

F0 = S0 x

(1+hb )

(1+ic )
(1+ib )

Modified Internal Rate of Return

1

PV n
MIRR = R 1 + re 1
PVI

The Black-Scholes option pricing model

c = PaN(d1) PeN(d2 )e rt
Where:
d1 =

ln(Pa / Pe ) + (r+0.5s2 )t
s t

d2 = d1 s t
The Put Call Parity relationship
p = c Pa + Pe e rt

[P.T.O.

Present Value Table

Present value of 1 i.e. (1 + r)n
Where

r = discount rate
n = number of periods until payment
Discount rate (r)

Periods
(n)

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1
2
3
4
5

0990
0980
0971
0961
0951

0980
0961
0942
0924
0906

0971
0943
0915
0888
0863

0962
0925
0889
0855
0822

0952
0907
0864
0823
0784

0943
0890
0840
0792
0747

0935
0873
0816
0763
0713

0926
0857
0794
0735
0681

0917
0842
0772
0708
0650

0909
0826
0751
0683
0621

1
2
3
4
5

6
7
8
9
10

0942
0933
0923
0914
0905

0888
0871
0853
0837
0820

0837
0813
0789
0766
0744

0790
0760
0731
0703
0676

0746
0711
0677
0645
0614

0705
0665
0627
0592
0558

0666
0623
0582
0544
0508

0630
0583
0540
0500
0463

0596
0547
0502
0460
0422

0564
0513
0467
0424
0386

6
7
8
9
10

11
12
13
14
15

0896
0887
0879
0870
0861

0804
0788
0773
0758
0743

0722
0701
0681
0661
0642

0650
0625
0601
0577
0555

0585
0557
0530
0505
0481

0527
0497
0469
0442
0417

0475
0444
0415
0388
0362

0429
0397
0368
0340
0315

0388
0356
0326
0299
0275

0350
0319
0290
0263
0239

11
12
13
14
15

(n)

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1
2
3
4
5

0901
0812
0731
0659
0593

0893
0797
0712
0636
0567

0885
0783
0693
0613
0543

0877
0769
0675
0592
0519

0870
0756
0658
0572
0497

0862
0743
0641
0552
0476

0855
0731
0624
0534
0456

0847
0718
0609
0516
0437

0840
0706
0593
0499
0419

0833
0694
0579
0482
0402

1
2
3
4
5

6
7
8
9
10

0535
0482
0434
0391
0352

0507
0452
0404
0361
0322

0480
0425
0376
0333
0295

0456
0400
0351
0308
0270

0432
0376
0327
0284
0247

0410
0354
0305
0263
0227

0390
0333
0285
0243
0208

0370
0314
0266
0225
0191

0352
0296
0249
0209
0176

0335
0279
0233
0194
0162

6
7
8
9
10

11
12
13
14
15

0317
0286
0258
0232
0209

0287
0257
0229
0205
0183

0261
0231
0204
0181
0160

0237
0208
0182
0160
0140

0215
0187
0163
0141
0123

0195
0168
0145
0125
0108

0178
0152
0130
0111
0095

0162
0137
0116
0099
0084

0148
0124
0104
0088
0074

0135
0112
0093
0078
0065

11
12
13
14
15

10

Annuity Table

(1 + r)n
Present value of an annuity of 1 i.e. 1
r
Where

r = discount rate
n = number of periods
Discount rate (r)

Periods
(n)

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1
2
3
4
5

0990
1970
2941
3902
4853

0980
1942
2884
3808
4713

0971
1913
2829
3717
4580

0962
1886
2775
3630
4452

0952
1859
2723
3546
4329

0943
1833
2673
3465
4212

0935
1808
2624
3387
4100

0926
1783
2577
3312
3993

0917
1759
2531
3240
3890

0909
1736
2487
3170
3791

1
2
3
4
5

6
7
8
9
10

5795
6728
7652
8566
9471

5601
6472
7325
8162
8983

5417
6230
7020
7786
8530

5242
6002
6733
7435
8111

5076
5786
6463
7108
7722

4917
5582
6210
6802
7360

4767
5389
5971
6515
7024

4623
5206
5747
6247
6710

4486
5033
5535
5995
6418

4355
4868
5335
5759
6145

6
7
8
9
10

11
12
13
14
15

10368
11255
12134
13004
13865

9787
10575
11348
12106
12849

9253
9954
10635
11296
11938

8760
9385
9986
10563
11118

8306
8863
9394
9899
10380

7887
8384
8853
9295
9712

7499
7943
8358
8745
9108

7139
7536
7904
8244
8559

6805
7161
7487
7786
8061

6495
6814
7103
7367
7606

11
12
13
14
15

(n)

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1
2
3
4
5

0901
1713
2444
3102
3696

0893
1690
2402
3037
3605

0885
1668
2361
2974
3517

0877
1647
2322
2914
3433

0870
1626
2283
2855
3352

0862
1605
2246
2798
3274

0855
1585
2210
2743
3199

0847
1566
2174
2690
3127

0840
1547
2140
2639
3058

0833
1528
2106
2589
2991

1
2
3
4
5

6
7
8
9
10

4231
4712
5146
5537
5889

4111
4564
4968
5328
5650

3998
4423
4799
5132
5426

3889
4288
4639
4946
5216

3784
4160
4487
4772
5019

3685
4039
4344
4607
4833

3589
3922
4207
4451
4659

3498
3812
4078
4303
4494

3410
3706
3954
4163
4339

3326
3605
3837
4031
4192

6
7
8
9
10

11
12
13
14
15

6207
6492
6750
6982
7191

5938
6194
6424
6628
6811

5687
5918
6122
6302
6462

5453
5660
5842
6002
6142

5234
5421
5583
5724
5847

5029
5197
5342
5468
5575

4836
4988
5118
5229
5324

4656
4793
4910
5008
5092

4486
4611
4715
4802
4876

4327
4439
4533
4611
4675

11
12
13
14
15

11

[P.T.O.

Standard normal distribution table

00
01
02
03
04

000
00000
00398
00793
01179
01554

001
00040
00438
00832
01217
01591

002
00080
00478
00871
01255
01628

003
00120
00517
00910
01293
01664

004
00160
00557
00948
01331
01700

005
00199
00596
00987
01368
01736

006
00239
00636
01026
01406
01772

007
00279
00675
01064
01443
01808

008
00319
00714
01103
01480
01844

009
00359
00753
01141
01517
01879

05
06
07
08
09

01915
02257
02580
02881
03159

01950
02291
02611
02910
03186

01985
02324
02642
02939
03212

02019
02357
02673
02967
03238

02054
02389
02704
02995
03264

02088
02422
02734
03023
03289

02123
02454
02764
03051
03315

02157
02486
02794
03078
03340

02190
02517
02823
03106
03365

02224
02549
02852
03133
03389

10
11
12
13
14

03413
03643
03849
04032
04192

03438
03665
03869
04049
04207

03461
03686
03888
04066
04222

03485
03708
03907
04082
04236

03508
03729
03925
04099
04251

03531
03749
03944
04115
04265

03554
03770
03962
04131
04279

03577
03790
03980
04147
04292

03599
03810
03997
04162
04306

03621
03830
04015
04177
04319

15
16
17
18
19

04332
04452
04554
04641
04713

04345
04463
04564
04649
04719

04357
04474
04573
04656
04726

04370
04484
04582
04664
04732

04382
04495
04591
04671
04738

04394
04505
04599
04678
04744

04406
04515
04608
04686
04750

04418
04525
04616
04693
04756

04429
04535
04625
04699
04761

04441
04545
04633
04706
04767

20
21
22
23
24

04772
04821
04861
04893
04918

04778
04826
04864
04896
04920

04783
04830
04868
04898
04922

04788
04834
04871
04901
04925

04793
04838
04875
04904
04927

04798
04842
04878
04906
04929

04803
04846
04881
04909
04931

04808
04850
04884
04911
04932

04812
04854
04887
04913
04934

04817
04857
04890
04916
04936

25
26
27
28
29

04938
04953
04965
04974
04981

04940
04955
04966
04975
04982

04941
04956
04967
04976
04982

04943
04957
04968
04977
04983

04945
04959
04969
04977
04984

04946
04960
04970
04978
04984

04948
04961
04971
04979
04985

04949
04962
04972
04979
04985

04951
04963
04973
04980
04986

04952
04964
04974
04981
04986

30

04987

04987

04987

04988

04988

04989

04989

04989

04990

04990

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

End of Question Paper

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