Institute of Chartered Accountant Ghana (ICAG) Paper 3.3 Advanced Financial Management

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1 Institute of Chartered Accountant Ghana (ICAG) Paper 3.3 Advanced Financial Management Final Mock Exam 1 Marking scheme and suggested solutions DO NOT TURN THIS PAGE UNTIL YOU HAVE COMPLETED THE MOCK EXAM

2 ii Final Mock Exam 1: Answers Advanced Financial Management The Institute of Chartered Accountants Ghana First edition 2015 ISBN All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of BPP Learning Media Ltd. Published by BPP Learning Media Ltd BPP House, Aldine Place London W12 8AA The Institute of Chartered Accountants Ghana 2015

3 Final Mock Exam 1: Answers 1 Question 1 Marking scheme Marks (a) Calc of impact of FRA for interest rate increase and decrease 2 Decision to sell futures 1 Selection of March futures and options 1 Unexpired basis calculation 1 Impact of interest rate increase/decrease with futures 3 Decision to buy call options 1 Impact of interest rate increase/decrease with options 4 Discussion (up to 2 marks for explanation of products' features) 2 6 Max 15 (b) 1 2 marks per well explained point Max 5 20 (a) Forward rate agreements (FRAs) The investment will take place in three months' time for a period of four months so the FRA 3-7 should be used at a rate of 4.82%. Rates fall Rates rise % % Spot rate Investment rate for ABC Co FRA (loss)/gain on spot rate (1.63) 0.17 Net effective annual interest rate Futures ABC Co is a lender (putting money on deposit), therefore it wants to buy futures on 1 November, and close out by selling futures on 1 February. March contracts are required as the investment will be made on 1 February. Number of contracts = $48m/$2m 4 months/3 months = 32 contracts Basis Current (November) price futures price = total basis ( ) = 1.15 Unexpired basis = 2/ = 0.46 Rates fall Rates rise % % Spot rate Investment rate for ABC Co Closing future (spot rate plus unexpired basis) Futures (loss)/gain (1.59) 0.21 Net effective annual interest rate

4 2 Final Mock Exam 1: Answers Options on futures As before 31 March call option contracts are required. If options are used: Rates fall Rates rise % % Spot rate Investment rate for ABC Co Closing future (as for futures) Exercise option Yes Yes Premium (0.432) (0.432) Option gain/(loss) Net effective annual interest rate If options are used: Rates fall Rates rise % % Spot rate Investment rate for ABC Co Closing future (as for futures) Exercise option Yes No Premium (0.121) (0.121) Option gain/(loss) (0.45) Net effective annual interest rate Recommendation The March call option at gives a fixed return of 4.41%, whether rates increase or decrease by 0.9%. This is lower than the return on the futures market so this choice should be rejected. The March call option at gives a higher return than the FRA and the futures if interest rate rise, but a lower return if interest rates fall. Since ABC Co wants to hedge against a fall in interest rates, this choice should also be rejected. The FRA from V bank offers a slightly higher rate than the futures contracts, but there is an additional credit risk with an over-the-counter instrument such as this FRA. ABC Co should decide on the likelihood of V Bank defaulting on its obligation. If this risk is deemed to be acceptably small then the FRA should be used to hedge this amount, otherwise the futures should be used. (b) A delta value measures the change in value of a derivative instrument, such as an option, when the value of the underlying asset changes. For example, a delta value of 0.8 indicates that when the value of the underlying asset increases by $1, the value of the equivalent option will increase by $0.80. This means that a company would need to purchase 1/0.8 = 1.25 option contracts to hedge effectively against a rise in price of the underlying asset. This is also known as the hedge ratio. If the Black-Scholes Option Pricing model is accepted, then the option delta is equal to N(d 1 ) from this model. This means that the delta value will change when the volatility or the time to expiry changes. As a result, if the delta value and hedge ratio are used to determine the number of contracts needed, the number needs to be reviewed periodically to reflect the new delta.

5 Final Mock Exam 1: Answers 3 Question 2 Marking scheme (a) Existing values dividend valuation model 1 2 Existing prices P/E ratios 1 2 Comments on existing values 1 2 Valuation of takeover 1 2 Impact of news being made public up to 3 marks for scenario discussed Max 5 Other factors influencing shareholder views up to 2 marks for each factor discussed Max 4 (b) S Ltd shareholders' views 2 M Ltd's situation 2 (c) Up to 1 mark for each suggestion Marks Max 12 Max 3 Max 5 20 (a) Views of shareholders Since the terms of the bid involve a share-for-share swap, shareholders will be highly interested in the fundamentals underlying the current market value of shares in both companies, in the potential economic gains that can be made by combining the companies and the likely effect of the takeover on share prices, including the proportion in which the gains are likely to be split between the two sets of shareholders. Shareholders of S Ltd are unlikely to accept unless they receive a premium over their existing share price, whereas M Ltd shareholders will not wish to offer too high a premium because this will cause them to lose value. Other factors are also relevant in this proposed takeover, one of which is that M Ltd may be seeking to reduce its high gearing by taking over the comparatively ungeared S Ltd. Existing share prices The reasonableness of each company's existing share price can be tested against the dividend valuation model: Latest dividend per share: M Ltd: GHS24m/300m = 8 Gp S Ltd: GHS5m/40m = 12.5 Gp Share values from the dividend valuation model: D 0 (1 + g)/(ke g): M Ltd: /(14.5% 7%) = 114 Gp S Ltd: /(13% 8%) = 270 Gp If the stock market is efficient, the companies' current market share prices provide the best indicator of the 'true' value of their shares. However, on the basis of the dividend valuation model (using past growth rates as an indicator of expected future growth) M Ltd's actual share price of 232 Gp is more than twice as high as it 'should' be. Although the DVM is a simplistic model, this might signal caution to S Ltd's shareholders, whose actual price of 295 Gp seems comparatively reasonable. It is clear that future growth for both companies is expected to be better than the past. This may reflect expectations of a general upturn in the sector, or may be the effect of general market feelings that takeovers will be taking place. Earnings per share are: M Ltd: GHS50m/300m = 16.67Gp. S Ltd: GHS8m/40m = 20 Gp The P/E ratios are: M Ltd: 232/16.67 = S Ltd: 295/20 = Unfortunately, no P/E ratios or other statistics for the food retail industry are available for comparison. However, the P/E of M Ltd, which is nearly as high as that of S Ltd, seems excessive on the basis of its poorer growth record and higher cost of equity capital.

6 4 Final Mock Exam 1: Answers Potential economic gains from the takeover The present value of the proposed rationalisation transactions following the takeover is GHS7.5m. GHSm Warehouse sale 6.8 Redundancy (9.0) Wage savings for 5 years: GHS27m 3.605* *The annuity factor for five years at 12%, the WACC of M Ltd. Wage savings may last for more than five years, giving a higher present value. Assuming this gain in value from combining the companies is achievable, it indicates that the takeover is economically worthwhile. The bid has not yet been made public. The effect of the potential gains from the takeover terms is unlikely to have been reflected in the share prices of either company. However, it is just as probable that shareholders already have some expectations of takeovers in the industry, in which case synergetic gains would already have been anticipated in share prices, even under the semi-strong view of market efficiency. Effect of the takeover announcement on share prices There are a number of different ways of examining the effect of the takeover information being made public. (i) Poor market efficiency Assume first that shareholders had no previous expectations that the takeover would take place and are taken totally by surprise when the synergetic gains of GHS7.5 million are announced. They will estimate the value of the combined business as: Value of firms before takeover: GHSm M Ltd: 300m 232 Gp S Ltd: 40m 295 Gp Post takeover synergy 7.5 Estimated value after takeover M Ltd will issue 4/3 40m new shares = m new shares to the shareholders of S Ltd. The total number of shares in M Ltd will rise to m. The expected share price for M Ltd after the takeover is announced will be GHS821.5m/ m = Gp. This is only a 0.5 Gp gain to M Ltd shareholders, who will have allowed all the advantage of synergy to accrue to S Ltd. S Ltd shares will be expected to reflect the announcement by rising to 4/ c = 310 Gp, giving them a 15 Gp gain, an increase of 5%. The reconciliation of the gains is: M Ltd 300m shares 0.5 Gp = GHS1.5m and S Ltd 40m shares 15 Gp = GHS6m, giving a total of GHS7.5m. On this assumption, shareholders of S Ltd would be fairly happy with the terms of the offer and M Ltd shareholders would not lose from their existing position. Total equity earnings from the combination will be GHS50m + GHS8m = GHS58m, assuming that wage savings are offset against redundancy cost write-offs and before any expected earnings growth. This will give an expected earnings per share of GHS58/ = 16.4 Gp. This represents a drop from M Ltd's existing 16.67Gp, but S Ltd shareholders would receive the equivalent of 4/ Gp = 21.9Gp compared with their existing 20Gp.

7 Final Mock Exam 1: Answers 5 (ii) Stronger market efficiency Suppose however that shareholders had already guessed that the takeover would take place and share prices had already increased to reflect expected gains (a stronger view of market efficiency). The value of the combined business would then be GHS814m and the expected value of M Ltd's shares after the terms of the offer were announced would be GHS814/ = Gp, a drop of nearly two Gp. M Ltd shareholders would be disappointed with the terms of the offer. S Ltd shareholders would still be better off, with an expected increase in share price to 4/ Gp = 307 Gp (a premium of 4%). (iii) Over-valuation of M Ltd shares As a third possibility, M Ltd's shares may be temporarily over-valued by the market, as indicated by the high share price compared with that predicted from the DVM. Such an over-valuation might occur, for example, if investors had false hopes of M Ltd's opportunities in the takeover market. A fair price for M Ltd's shares based on its existing business might be 114Gp, giving a total value of 300m 114Gp = GHS342m. Then the value of the combined company would be GHS342m + GHS118m + GHS7.5m = GHS467.5m, giving an expected share price after the takeover announcement of GHS467.5/ = Gp. This would represent very favourable takeover terms to M Ltd, but would be unacceptable to S Ltd, whose equivalent share value would fall from 195Gp to 4/ Gp = 176.4Gp. Conclusion In summary, the takeover terms appear to be fair and acceptable, provided that M Ltd's shares are not temporarily over-valued by false expectations. S Ltd shareholders need to evaluate the stability of M Ltd's share price before accepting the offer. Other factors (i) Gearing M Ltd is very highly geared. Even if only long term debt is considered, gearing (D/E) in terms of book value is 314/222 = 141% and in terms of market value is 364/696 = 52%. By comparison, S Ltd's gearing is only 17.5/54.7 = 32% in book terms and 17.5/118 = 15% in market value terms. In addition, M Ltd has high current payables resulting in net current liabilities. While this is not unusual for a supermarket chain, it indicates that gearing in real terms is even higher. The shareholders of M Ltd will favour the share issue terms for the takeover of S Ltd which should reduce their gearing substantially, whereas S Ltd's shareholders are unlikely to see this as an advantage. (ii) Dividend policy The companies have different dividend yields and covers, which may influence the views of some shareholders. M Ltd S Ltd Dividend yield 3.4% 4.2% Dividend cover (iii) Management plans The composition of the board of directors and senior managers will be fundamental to the success of the business after the takeover. S Ltd seems to have been performing better than M Ltd recently and may be able to argue for more than proportional representation on the board. Shareholders of both companies will be interested in these plans.

8 6 Final Mock Exam 1: Answers (b) 325 Gp per share cash offer For the shareholders of S Ltd this represents a premium of 10% over the current market price of 295 Gp and is significantly better than the most optimistic estimate of the share offer's value, which was 310 Gp. The cash offer gives a risk free return compared with the risk of shares. For this reason cash offers are usually less in value than the equivalent share offers. Since this offer is more than the share offer it represents good value to S Ltd shareholders. However, they will suffer immediate capital gains tax on the disposal. From M Ltd's point of view, the cash offer is unlikely to be feasible, given its high gearing and weak liquidity position. (c) To: Board of Directors of S Ltd From: Consultant In most countries, defences made by a publicly quoted company against a takeover bid must be legal and be allowed by the codes on Takeovers and Mergers and Stock Exchange regulations. Our advice on your proposals is as follows. (i) Doubling profits If your profits are likely to double, then now is a good time to announce the fact. You will need to substantiate your claims with clear evidence that can be verified by shareholders. This is very likely to halt the bid, or at least secure better terms. (ii) Alteration of articles Many Stock Exchange regulations prohibit the alteration of articles of association to require more than a 51% majority to accept an offer for acquisition you should check on the regulations of your own stock exchange to determine whether the proposed alteration of articles will be permitted. (iii) (iv) (v) Third party investor This defence is probably illegal as it is tantamount to the company purchasing its own shares. Legal advice should be sought to clarify this position. Advertising campaign As with defence (i) this can be a very effective form of defence provided that the information is true and can be substantiated, otherwise a libel action might result. Revaluation of non-current assets Revaluation of non-current assets is a good idea, provided that it is carried out by an independent valuer and the values can be substantiated. However, the effect on share values may be less significant than might be thought as, in an efficient market, these true asset values will already have been estimated by institutional shareholders.

9 Final Mock Exam 1: Answers 7 Question 3 Marking scheme (a) Capital allowances/tax saving NPV calculations MIRR calculation APV calculations Base case NPV Marks 3 4 Financing side effects 2 3 Give credit for technique Max 13 (b) Reward sensible discussion. Bonus mark for mention of real options Max 7 20 Suggested solution (a) Expected NPV The NPV is found by discounting at the weighted average cost of capital, calculated as follows: Cost of equity Using CAPM Ke = rf + [E(rm) rf] = 4 + (10 4) 1.5 = 13 Cost of debt After tax cost of debt = 8(1 0.3) = 5.6 Weighted average cost of capital Gearing after the investment has been financed is expected to be E = 0.6, D = 0.4 E D WACC = Ke g +K d(1 t) E+D E+D = 13(0.6) + 5.6(0.4) = 10.04%, say 10% Capital allowances These are on the GHS4.4m part of the investment that is fixed assets (not working capital or issue costs). Year Value at start of year Capital allowance Tax saving 25% 30% GHS'000 GHS'000 GHS' ,400 1, , , ,

10 8 Final Mock Exam 1: Answers Year GHS'000 GHS'000 GHS'000 GHS'000 GHS'000 Pre-tax operating cash flows 1,250 1,400 1,600 1,800 30% (375) (420) (480) (540) Tax savings from capital allowances Investment cost (5,000) Issue costs (400) After tax realisable value 1,500 Net cash flows (5,400) 1,205 1,228 1,306 2,899 Discount factor 10% Present values (5,400) 1,095 1, ,980 The expected net present value is GHS(330,000) MIRR Year GHS'000 GHS'000 GHS'000 GHS'000 Net cash flows 1,205 1,228 1,306 2,899 Multiplier Reinvested amount 1,604 1,486 1,437 2,899 Total reinvested = 7,426 MIRR = (7,426/5,400) MIRR = = 8.3% Expected APV To calculate the base case NPV, the investment cash flows are discounted at the ungeared cost of equity, assuming the corporate debt is risk free (and has a beta of zero): ß a = e E E D(1 t) = (1 0.3) = The ungeared cost of equity can now be estimated using the CAPM: Ke u = rf + [E(rm) rf] = 4 + (10 4) = 9.29% (say, approximately 9%) Year GHS'000 GHS'000 GHS'000 GHS'000 GHS'000 Net cash flows (5,000) 1,205 1,228 1,306 2,899 Discount factor 9% Present values (5,000) 1,105 1,034 1,008 2,052 The expected base case net present value is GHS199,000. Financing side effects Issue costs GHS400,000, because they are treated as a side-effect they are not included in this NPV calculation. Present value of tax shield Debt capacity of project = GHS5.4m 50% = GHS2.7m Annual tax savings on debt interest = GHS2.7m 8% 30% = GHS64,800 PV of tax savings for four years, discounted at the risk-free rate 4%, is 64, = GHS235,224

11 Final Mock Exam 1: Answers 9 (b) GHS'000 Adjusted present value Base case NPV 199 Tax relief on debt interest 235 Issue costs (400) 34 The adjusted present value is GHS34,000. Validity of the views of the two managers Manager A Manager A believes that the net present value method should be used, on the basis that the NPV of a project will be reflected in an equivalent increase in the company's share price. However, even if the market is efficient, this is only likely to be true if: The financing used does not create a significant change in gearing The project is small relative to the size of the company The project risk is the same as the company's average operating risk The manager is correct that the NPV method is quicker than the MIRR (although this is only marginal) and APV methods. The main advantage of NPV over MIRR is that it gives an absolute measure of the increase in shareholder wealth. Manager B Manager B prefers the adjusted present value method, in which the cash flows are discounted at the ungeared cost of equity for the project, and the resulting NPV is then adjusted for financing side effects such as issue costs and the tax shield on debt interest. The main problem with the APV method is the estimation of the various financing side effects and the discount rates used to appraise them. For example in the calculation the risk-free rate has been used to discount the tax effect when the cost of debt of 8% could have been used instead and produced a different result. Problems with both viewpoints Both NPV and APV methods rely on the restrictive assumptions about capital markets which are made in the capital asset pricing model and in the theories of capital structure. The figures used in CAPM (risk-free rate, market rate and betas) can be difficult to determine. Business risks are assumed to be constant. None of the methods considered attempt to value the possible real options for abandonment or further investment which may be associated with the project and could generate additional shareholder wealth. It is important to factor in these options to the initial evaluation of the project to ensure the correct decision is made.

12 10 Final Mock Exam 1: Answers Question 4 Marking scheme (a) Evaluation of dividend policy 1 2 Evaluation of financing policy 1 3 Evaluation of risk management policy 1 2 Effect of dividends and share buybacks on the policies 1 2 (b) 1-2 marks per evaluation of each of the three companies 4 Discussion of which company to invest in 2 Marks Max 6 (c) Calculation of initial dividend capacity 3 Calculation of new repatriation amount 2 Comment 1 2 (d) 1 mark per relevant point Max 6 Max Suggested solution (a) Dividend policy Many high-growth companies, such as L Ltd, retain cash instead of paying dividends and use the cash to help fund the growth. Many such companies declare an intention not to pay dividends and as such the shareholders expect their wealth to increase through capital gains rather than dividend payments. Financing Capital structure theory suggests that to take advantage of the tax shield on interest payments, companies should have a capital structure which is a mixture of debt and equity. Pecking order theory suggests that companies typically use internally generated funds before seeking to raise external funds (initially debt, then equity). The two main factors in deterring companies from seeking external finance are favouring one investor group at the expense of another and the agency effect of providing additional information to the market. L Ltd is following the pecking order theory to the extent that it is using internally-generated funds first. However it is then deviating from pecking order theory in looking to raise equity finance rather than debt even though it currently has insignificant levels of debt and is therefore not making full use of the tax shield. This may be explained by the fact that L Ltd operates in a high-risk, rapidly changing industry, where business risk is high. It may not want to take on high levels of financial risk by using significant levels of debt finance. Other issues such as potentially restrictive debt covenant may also be a factor in the financing decision. Risk management Managing the volatility of cash flows enables a company to plan its investment strategy more accurately. L Ltd needs to ensure that it will have sufficient internally-generated cash available when it is needed for planned investments. More importantly, since L Ltd faces high levels of business risk, as discussed above, the company should look to manage the risks that are beyond the individual control of the company's managers. Affect on policies by returning funds to shareholders Returning funds to shareholders will affect each of these policies. The shareholder clientele could change, which may lead to share price fluctuations. However, since the change is being requested by shareholders, there is a good chance that this may not happen. The financing policy is likely to change since there will be less internally-generated funds available, so L Ltd may consider taking on additional debt finance and therefore will have to look at the balance of business and financial risk.

13 Final Mock Exam 1: Answers 11 (b) (c) (d) This could in turn change the risk management policy as interest rate risk will also have to be managed as well. T Ltd T Ltd has a fixed dividend payout ratio of 40%. As a result the increase in dividends in recent years depends on the increase in profit after tax in these years rather than increasing at a steady rate, which is often preferred by shareholders. If profit after tax was to fall, T Ltd may reduce its dividend, which could send the wrong signals to shareholders and cause significant fluctuations in the share price. To avoid this, T Ltd may keep a stable dividend in years of reduced profits. O Ltd O Ltd has a policy of increasing dividends at approximately 5% per year, but earnings are only increasing at a rate of approximately 3% per year. This means the dividend payout ratio is increasing, it was 60% in 20X3 and is 65% in 20X7. Although this cannot continue in the long term, it suggests that there are less investment opportunities currently and O Ltd is reducing its retention ratio. This investment would be attractive to an investor looking for a high level of dividend income. K Ltd K Ltd has increased its payout ratio from 20% in 20X3 to 27% in 20X7. This is a fairly low payout ratio, but it is growing. Earnings are growing rapidly overall, but not at a constant annual rate (35% growth in 20X4, but only 3% in 20X5). Overall dividend growth is at a rate of 29% per year, and the annual dividend growth rate has been fairly constant. This policy seems consistent with a growing company, which is now starting to pay more significant dividends and return more funds to shareholders. This investment would be attractive to investors seeking a lower level of dividend income and higher levels of capital growth. Due to uncertainty about whether T Ltd could decrease its future dividend payments, L Ltd is likely to prefer to invest in either O Ltd or K Ltd. The choice between these two depends on whether L Ltd would prefer higher dividends or higher capital growth. Issues such as taxation position or length of time that the funds would be invested for may influence this choice too. Current dividend capacity GHS'000 Profit before tax (23% GHS600m) 138,000 Tax (26% GHS138m) (35,880) Profit after tax 102,120 Add back depreciation (25% 220m) 55,000 Less investment in assets (67,000) Overseas remittances 15,000 Additional tax (6% 15m) (900) Dividend capacity 104,220 Increase in dividend capacity = m 0.1 = GHS10.422m Gross up to allow for extra 6% tax = GHS10.422m/0.94 = GHS11,087,234 Percentage increase in remittances needed = (11,087,234/15,000,000) 100% = 73.9% Dividend repatriations would need to increase by approximately GHS11.1 million or 73.9% in order to increase dividend capacity by 10%. L Ltd needs to consider both whether this is possible for the subsidiaries, but also the motivational and operational impact of doing so on the subsidiaries. The main benefit of a share buyback scheme to a shareholder is that they can choose whether or not to sell their shares back to the company. This means they can control the amount of cash they receive and in turn manage their own tax liability. With dividend payments, especially with large special dividends, there may be a large tax liability as a result. Further benefits include the fact that, as share capital is reduced, the earnings per share figure is likely to increase and share price may increase too. Additionally share buybacks are often viewed positively by the markets and share price may increase.

14 12 Final Mock Exam 1: Answers Question 5 Marking scheme (a) Implications of change of government 3 4 Other business factors (1 2 marks per factor) 5 7 Max 10 (b) 1 mark per relevant point 5 (c) General commentary regarding benefits of risk diversification 2 3 Relating specifically to T Ltd and the Gamalan investment 2 3 Max 5 Total 20 Marks (a) (b) Government change A change of government in Gamala may have a significant impact on the project as a result of changes threatened by the opposition party. The proposed tax increase may be significant as this would reduce the total tax shield and subsidy benefits as well as creating higher cash outflows in years 3 and 4 of the project. An even more significant change may arise, however, from the review of commercial benefits.' The new government may also review whether remittances are allowed every year. This issue may be fairly minor as the majority of the value comes from the final year of operation anyway. Other business factors T Ltd needs to also consider whether being based in Gamala will lead to any follow-on projects. The real options that are present within any such projects should be factored into the assessment of whether to relocate. T Ltd also needs to ensure that this project fits within its overall strategy. Even if the decision to cease production Ghana is made there may be other, better alternatives than the Gamalan option. These other options should also be assessed. T Ltd also needs to consider whether its systems can be adapted to the culture in Gamala. If T Ltd has experience in international ventures then its directors may be surer of this. T Ltd will need to develop strategies to combat any cultural differences. There may be further training costs as part of these strategies which have not been factored into this assessment. Another factor to consider is whether the project can be delayed as this will reduce the opportunity cost of lost contribution, which is greater in years 1 and 2. Therefore a delay could increase the overall value of the project. There are possible redundancies from the closure of production of X-IT in Ghana. Since production will probably cease in Ghana anyway the strategy should be clearly communicated to employees and other stakeholders in order to ensure its reputation is not damaged. As a result it may be even more important to consider alternatives to this plan. Triple bottom line (TBL) reporting involves providing a quantitative summary in terms of social, financial and environmental performance. The underlying principle is that in order to evaluate a company's true performance against its objectives, and assess the risk to the investor, the investor must consider all three areas. Under the TBL approach decision-making should ensure that each perspective is growing but not at the expense of the others. That is economic performance should not come at the expense of the environment or society. The idea is that an organisation which accommodates all three areas will enhance shareholder value as long as the costs of producing the report are less than the benefits that arise from it.

15 Final Mock Exam 1: Answers 13 (c) In the case of T Ltd and production of X-IT, reporting on the impact of moving production to Gamala, including the environmental impact, will show T Ltd in a good light and improve its reputation. This should in turn make it easier to attract and retain the best employees. Portfolio theory states that shareholders who hold a well-diversified portfolio will have diversified away the unsystematic or company specific risk and will be left with systematic risk. Following this a shareholder cannot reduce risk further by undertaking additional diversification in the same system or market. A company may be able to achieve further diversification for its shareholders by investing in a system or market that the individual shareholders do not invest in themselves. Some studies have shown that well-diversified investors can benefit from risk diversification when companies invest in emerging markets. In the case of T Ltd and X-IT, it is unclear whether there will be any diversification benefits from the Gamalan investment. Any benefits are dependent on the size of the investment and the nature of the business operations in Gamala. Another issue is whether the investment represents an investment in a different system or market. If the investment is large and the operations are similar to undertaking a Gamalan company then shareholders in T Ltd who do not hold similar companies' shares may gain risk diversification benefits from the investment.

16 14 Final Mock Exam 1: Answers