PART 3

WEDNESDAY 14 DECEMBER 2005

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

BOTH questions are compulsory and MUST be

answered

Section B

TWO questions ONLY to be answered

Formulae sheet, present value, annuity and standard normal

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

Do not open this paper until instructed by the supervisor

This question paper must not be removed from the examination
hall

The Association of Chartered Certified Accountants

Paper 3.7

Strategic Financial
Management

Section A BOTH questions are compulsory and MUST be attempted

1

Sleepon Hotels plc owns a successful chain of hotels. The company is considering diversifying its activities through
the construction of a theme park near London. The theme park would have a mixture of family activities and adventure
rides. Sleepon has just spent 230,000 on market research into the theme park, and is encouraged by the findings.
The theme park is expected to attract an average of 15,000 visitors per day for at least four years, after which major
new investment would be required in order to maintain demand. The price of admission to the theme park is expected
to be 18 per adult and 10 per child. 60% of visitors are forecast to be children. In addition to admission revenues,
it is expected that the average visitor will spend 8 on food and drinks, (of which 30% is profit), and 5 on gifts and
souvenirs, (of which 40% is profit). The park would open for 360 days per year.
All costs and receipts (excluding maintenance and construction costs and the realisable value) are shown at current
prices; the company expects all costs and receipts to rise by 3% per year from current values.
The theme park would cost a total of 400 million and could be constructed and working in one years time. Half of
the 400 million would be payable immediately, and half in one years time. In addition working capital of 50
million will be required from the end of year one. The after tax realisable value of fixed assets is expected to be
between 250 million and 300 million after four years of operation.
Maintenance costs (excluding labour) are expected to be 15 million in the first year of operation, increasing by
4 million per year thereafter. Annual insurance costs are 2 million, and the company would apportion 25 million
per year to the theme park from existing overheads. The theme park would require 1,500 staff costing a total of
40 million per annum (at current prices). Sleepon will use the existing advertising campaigns for its hotels to also
advertise the theme park. This will save approximately 2 million per year in advertising expenses.
As Sleepon has no previous experience of theme park management, it has investigated the current risk and financial
structure of the closest UK theme park competitor, Thrillall plc. Details are summarised below.
Thrillall plc, summarised balance sheet
million
Fixed assets (net)
1,440
Current assets
570
Less current liabilities
(620)

1,390

Financed by:
1 ordinary shares
400
Reserves
530

930
Medium and long term debt
460

1,390

Other information:
(i)

Sleepon has access to a 450 million Eurosterling loan at 75% fixed rate to provide the necessary finance for
the theme park.

(ii) 250 million of the investment will attract 25% per year capital allowances on a reducing balance basis.
(iii) Corporate tax is at a rate of 30%.
(iv) The average stock market return is 10% and the risk free rate 35%.
(v) Sleepons current weighted average cost of capital is 9%.
(vi) Sleepons market weighted gearing if the theme park project is undertaken is estimated to be 614% equity,
386% debt.
(vii) Sleepons equity beta is 070.
(viii) The current share price of Sleepon is 148 pence, and of Thrillall 386 pence.
(ix) Thrillalls medium and long term debt comprises long term bonds with a par value of 100 and current market
price of 93.
(x) Thrillalls equity beta is 145.
Required:
Prepare a report analysing whether or not Sleepon should undertake the investment in the theme park. Your
report should include a discussion of what other information would be useful to Sleepon in making the investment
decision. All relevant calculations must be included in the report or as an appendix to it. State clearly any
assumptions that you make.
(Approximately 28 marks are available for calculations and 12 for discussion)
(40 marks)

[P.T.O.

A proposal has been put to the board of directors of Semer plc that the company should increase its capital gearing
to at least 50%, in order to reduce the companys cost of capital and increase its market value.
The managing director of Semer is not convinced by the logic of the proposal, or the accuracy of the calculations, but
is unable to explain the reasons for his reservations.
A summary of the proposal and its implications is shown below.
Proposal to increase the capital gearing of Semer plc
The companys current weighted average cost of capital is estimated to be 106%. If the proportion of debt is
increased to 50% of total capital, by the repurchase of ordinary shares at their current market value, the cost of capital
may be reduced to 99%. A reduced cost of capital means that the value of the company will increase which will be
welcomed by our shareholders. Calculations supporting the above proposal are shown below:
Existing cost of capital
Cost of equity using the capital asset pricing model:
4% + (105% 4%) 12 = 118%
Cost of debt: 8%
Weighted average cost of capital:
350m
169m
118% x + 8% x = 1056%
519m
519m
Estimated new cost of capital:
2595m
2595m
118% x + 8% x = 990%
519m
519m
Impact on the value of the company:
60m
Current value = 568 million
01056
60m
Expected new value = 606 million
0099
Other information:
(i) Most recent summarised balance sheet
Semer plc
Fixed assets (net)
Current assets
Less current liabilities

Issued ordinary shares (50 pence par)

Reserves
Liabilities falling due after one year:
Bank loans
8% debenture 2010 (100 par value)

million
442
345
(268)

519

180
270

119
150

519

(ii) The current price of Semers ordinary shares is 410 pence.

(iii) The market price of one 8% debenture 2010 is 112.
(iv) The market return is 105% and the risk free rate 40%.
(v) Semers equity beta is 12.
(vi) Semer currently pays 15 million in dividends.
(vii) The corporate tax rate is 30%.
(viii) The company currently generates a free cash flow of 60 million per year, which is expected to increase by
approximately 3% per year.
4

Required:
(a) What, if any, are the mistakes in the proposal? Correcting for any mistakes produce revised estimates of the
companys current cost of capital and current value. Brief explanation of the reasons for any revisions should
be included.
(15 marks)
(b) Assuming that the cost of equity and cost of debt do not alter, estimate the effect of the share repurchase
on the companys cost of capital and value.
(5 marks)
(c) Acting as an external consultant to Semer, discuss the validity of the proposed strategy to increase gearing,
and explain whether or not the estimates produced in (b) above are likely to be accurate.
(10 marks)
(30 marks)

[P.T.O.

Section B TWO questions ONLY to be attempted

3

The managers of Daylon plc are reviewing the companys investment portfolio. About 15% of the portfolio is
represented by a holding of 5,550,000 ordinary shares of Mondglobe plc. The managers are concerned about the
effect on portfolio value if the price of Mondglobes shares should fall, and are considering selling the shares. Daylons
investment bank has suggested that the risk of Mondglobes shares falling by more than 5% from their current value
could be protected against by buying an over the counter option. The investment bank is prepared to sell an
appropriate six month option to Daylon for 250,000.
Other information:
(i)

The current market price of Mondglobes ordinary shares is 360 pence.

(ii) The annual volatility (variance) of Mondglobes shares for the last year was 169%.
(iii) The risk free rate is 4% per year.
(iv) No dividend is expected to be paid by Mondglobe during the next six months.
Required:
(a) Evaluate whether or not the price at which the investment bank is willing to sell the option is a fair price.
(10 marks)
(b) Discuss what factors Daylon should consider before deciding whether or not to purchase the option.
(5 marks)
(15 marks)

A division of Reflator plc has recently experienced severe financial difficulties. The management of the division is keen
to undertake a buy-out, but in order for the buyout to succeed it needs to attract substantial finance from a venture
capital organisation. Reflator plc is willing to sell the division for 21 million, and the managers believe that an
additional 1 million of capital would need to be invested in the division to create a viable going concern.
Possible financing sources:
Equity from management 500,000, in 50 pence ordinary shares.
Funds from the venture capital organisation:
Equity 300,000, in 50 pence ordinary shares
Debt: 85% fixed rate loan 2,000,000
9% subordinated loan with warrants attached 300,000.
The warrants are exercisable any time after four years from now at the rate of 100 ordinary shares at the price of 150
pence per share for every 100 of subordinated loan.
The principal on the 85% fixed rate loan is repayable as a bullet payment at the end of eight years. The subordinated
loan is repayable by equal annual payments, comprising both interest and principal, over a period of six years.
The divisions managers propose to keep dividends to no more than 15% of profits for the first four years.
Independently produced forecasts of earnings before tax and interest after the buy-out are shown below:
000
Year
EBIT

1
320

2
410

3
500

4
540

Corporate tax is at the rate of 30% per year.

The managers involved in the buy-out have stated that the book value of equity is likely to increase by about 20%
per year during the first four years, making the investment very attractive to the venture capital organisation. The
venture capital organisation has stated that it is interested in investing, but has doubts about the forecast growth rate
of equity value, and would require warrants for 150 shares per 100 of subordinated loan stock rather than 100
shares.
Required:
(a) Briefly discuss the potential advantages of management buy-outs.

(5 marks)

(b) On the basis of the above data, estimate whether or not the book value of equity is likely to grow by 20%
per year.
(7 marks)
(c) Evaluate the possible implication of the managers agreeing to offer warrants for 150 ordinary shares per
100 of loan stock.
(3 marks)
(15 marks)

[P.T.O.

Assume that it is now 31 December. MJY plc is a UK based multinational company that has subsidiaries in
two foreign countries. Both subsidiaries trade with other group members and with four third party companies
(company 1 company 4).
Projected trade transactions for three months time are shown below. All currency amounts are in thousands.
Receipts (read across) 000
MJY
Subsidiary 1
Subsidiary 2
Company 1
Company 2
Company 3
Company 4
Foreign exchange rates
Spot
3 months forward

Co 1
$90
50
15

Payments (read down) 000

Co 2 Co 3 Co 4 MJY Subsidiary 1
60 75

40
85 $40 $20 72

52 $30 55
35

$170

$120
50

Subsidiary 2
$50
20

65

/
14492 14523
14365 14390

$/
17982 18010
17835 17861

Currency options. 62,500 contract size. Premium in cents per

Calls
Strike price
February
May
180
196
300
178
291
384

Puts
February
317
212

May
534
420

Required:
Working from the perspective of a group treasurer, devise a hedging strategy for the MJY group, and calculate the
expected outcomes of the hedges using forward markets, and, for the dollar exposure only, currency options.
(15 marks)

(a) Provide examples of how countries might impose protectionist measures to control the volume of imports.
(5 marks)
(b) Discuss the role and main objectives of the World Trade Organisation (WTO), and its potential effect on
protectionist measures.
(6 marks)
(c) Briefly discuss the possible effects of the activities of the WTO for a multinational company with foreign
direct investment in a developing country that has recently joined the WTO.
(4 marks)
(15 marks)

Formulae Sheet

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

Ke (i)

D1
+g
(ii)
P0
WACC Keg

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

Dt
or Keu 1

E + D
2 asset
portfolio

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

a = e

i f i uk
1 + i uk

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

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

d1 =

1n ( Ps / X ) + rT

+ 0.5 T

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

[P.T.O.

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11

[P.T.O.

Standard normal distribution table

000

001

002

003

004

005

006

007

008

009

00
01
02
03
04

00000
00398
00793
01179
01554

00040
00438
00832
01217
01591

00080
00478
00871
01255
01628

00120
00517
00910
01293
01664

00160
00557
00948
01331
01700

00199
00596
00987
01368
01736

00239
00636
01026
01406
01772

00279
00675
01064
01443
01808

00319
00714
01103
01480
01844

00359
00753
01141
01517
01879

05
06
07
08
09

01915
02257
02580
02881
03159

01950
02291
02611
02910
03186

01985
02324
02642
02939
03212

02019
02357
02673
02967
03238

02054
02389
02703
02995
03264

02088
02422
02734
03023
03289

02123
02454
02764
03051
03315

02157
02486
02794
03078
03340

02190
02517
02823
03106
03365

02224
02549
02852
03133
03389

10
11
12
13
14

03413
03643
03849
04032
04192

03438
03665
03869
04049
04207

03461
03686
03888
04066
04222

03485
03708
03907
04082
04236

03508
03729
03925
04099
04251

03531
03749
03944
04115
04265

03554
03770
03962
04131
04279

03577
03790
03980
04147
04292

03599
03810
03997
04162
04306

03621
03830
04015
04177
04319

15
16
17
18
19

04332
04452
04554
04641
04713

04345
04463
04564
04649
04719

04357
04474
04573
04656
04726

04370
04484
04582
04664
04732

04382
04495
04591
04671
04738

04394
04505
04599
04678
04744

04406
04515
04608
04686
04750

04418
04525
04616
04693
04756

04429
04535
04625
04699
04761

04441
04545
04633
04706
04767

20
21
22
23
24

04772
04821
04861
04893
04918

04778
04826
04864
04896
04920

04783
04830
04868
04898
04922

04788
04834
04871
04901
04925

04793
04838
04875
04904
04927

04798
04842
04878
04906
04929

04803
04846
04881
04909
04931

04808
04850
04884
04911
04932

04812
04854
04887
04913
04934

04817
04857
04890
04916
04936

25
26
27
28
29

04938
04953
04965
04974
04981

04940
04955
04966
04975
04982

04941
04956
04967
04976
04982

04943
04957
04968
04977
04983

04945
04959
04969
04977
04984

04946
04960
04970
04978
04984

04948
04961
04971
04979
04985

04949
04962
04972
04979
04985

04951
04963
04973
04980
04986

04952
04964
04974
04981
04986

30

04987 04987 04987 04988 04988 04989 04989 04989 04990 04990

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

End of Question Paper

12