Paper P4 (SGP) Advanced Financial Management (Singapore) Thursday 5 June Professional Level Options Module. Time allowed

Transcription

1 Professional Level Options Moule Avance Financial Management (Singapore) Thursay 5 June 2008 Time allowe Reaing an planning: Writing: 15 minutes 3 hours This paper is ivie into two sections: Section A BOTH questions are compulsory an MUST be attempte Section B TWO questions ONLY to be attempte Formulae tables are on pages Do NOT open this paper until instructe by the supervisor. During reaing an planning time only the question paper may be annotate. You must NOT write in your answer booklet until instructe by the supervisor. This question paper must not be remove from the examination hall. Paper P4 (SGP) The Association of Chartere Certifie Accountants The Institute of Certifie Public Accountants of Singapore

2 This is a blank page. The question paper begins on page 3. 2

3 Section A BOTH questions are compulsory an MUST be attempte 1 Mercury Training was establishe in 1999 an since that time it has evelope rapily. The irectors are consiering either a flotation or an outright sale of the company. The company provies training for companies in the computer an telecommunications sectors. It offers a variety of courses ranging from short intensive courses in office software to high level risk management courses using avance moelling techniques. Mercury employs a number of in-house experts who provie technical materials an other support for the teams that service iniviual client requirements. In recent years, Mercury has iversifie into the financial services sector an now also provies computer simulation systems to companies for valuing acquisitions. This business now accounts for one thir of the company s total revenue. Mercury currently has 10 million, 50c shares in issue. Jupiter is one of the few competitors in Mercury s line of business. However, Jupiter is only involve in the training business. Jupiter is liste on a small company investment market an has an estimate beta of 1 5. Jupiter has 50 million shares in issue with a market price of 580c. The average beta for the financial services sector is 0 9. Average market gearing (ebt to total market value) in the financial services sector is estimate at 25%. Other summary statistics for both companies for the year ene 31 December 2007 are as follows: Mercury Jupiter Net assets at book value ($million) Earnings per share (c) Divien per share (c) Gearing (ebt to total market value) 30% 12% Five year historic earnings growth (annual) 12% 8% Analysts forecast revenue growth in the training sie of Mercury s business to be 6% per annum, but the financial services sector is expecte to grow at just 4%. Backgroun information: The equity risk premium is 3 5% an the rate of return on short-ate government stock is 4 5%. Both companies can raise ebt at 2 5% above the risk free rate. Tax on corporate profits is 40%. Require: (a) Estimate the cost of equity capital an the weighte average cost of capital for Mercury Training. Explain the circumstances where each of the two rates woul be use. (10 marks) (b) Avise the owners of Mercury Training on a range of likely issue prices for the company. (10 marks) (c) Discuss the avantages an isavantages, to the irectors of Mercury Training, of a public listing versus private equity finance as a means of isposing of their interest in the company. (8 marks) (28 marks) 3 [P.T.O.

4 2 Venus Systems, a publicly quote company, is a specialist manufacturer of mechanical control units for both the efence an civil aviation inustries. Its principal customers are the efence procurement agencies of a number of western governments an European Aerospace Co, an aeroplane manufacturer. Over recent years the company has suffere a collapse in profitability an has attempte to respon by reucing its efence relate business an focusing on its civil aviation business. On the civil sie, long elays at European Aerospace Co in the evelopment of a new large-boie passenger aeroplane, the European Aircoach, have severely impacte upon suppliers such as Venus Systems. As a result Venus s share price has ecline over the last three years, in line with movements in the sector inex. However, market valuations have not followe the general ecline in earnings across the sector. Market analysts attribute this to the high level of avance orers by airlines for the Aircoach an the confient expectation that full prouction will commence in mi Orers for efence components have fallen rapily over the last three years an the company has taken the ecision to scale own its efence ivision an switch prouction resources to the civil sie of the business. Wherever possible the company has reeploye an retraine its workforce. Inee, its commitment to its workforce has helpe maintain goo inustrial relations an the reeployment has been successfully matche against its natural labour turnover in the civil ivision. During 2007 the company commence the ecommissioning of its efence manufacturing site an began rationalising both efence an civil prouction to one site. The summary financial statements for the company over the last three years are as follows: Venus Systems Accounts for the year ene 30 April: $m $m $m Income statements Revenue Cost of Sales Gross Profit less other operating costs Operating profit Finance Costs Profit before tax Income tax expense (at 30%) Profit for the perio

5 Statements of financial position (Balance Sheets) $m $m $m Non-current assets Builings, plant an machinery Current Assets Inventories Receivables Cash Total Current Assets Total Assets Equity an Liabilities Pai up share capital Orinary shares (25c/) Other reserves Retaine earnings less iviens payable Total equity Current Liabilities Trae payables Deferre income an accrue expenses Tax payable Diviens payable Interest payable Total current liabilities Non-current liabilities Loans Provisions (eferre tax) Total non-current liabilities Total liabilities Total Equity an Liabilities Notes $m $m $m Non-current assets at start of year aitions less isposals Accumulate epreciation at start of the year less epreciation on isposals epreciation charge for the year Accumulate epreciation at the en of the year Net book value of non-current assets [P.T.O.

6 Summary statements of cash flows $m $m $m Operating cash flow less interest less taxation Free cash flow before reinvestment Divien pai Capital expeniture Financing Net cash flow Market value of equity ($ million) The boar believes that it can reverse the ecline in the company s profitability with the following turnaroun strategy: 1. By cost saving an other measures, it can return to its 2007 level of operating profit on its existing business. 2. By investment in new fabrication equipment at a cost of $35 million, it can increase the value of the company by $20 2 million. 3. Through the introuction of just-in-time manufacturing systems, it anticipates that it can reuce its inventories by 10 ays in each of the next three years. Its current receivables can be brought back to the 2007 level by improvements in its creit control but, because of the nature of its business, it oes not anticipate being able to improve beyon that. 4. The company is also consiering a scheme whereby 10% of the equity shares will be repurchase at the current price of 40c per share plus a premium of 10c. The non-executive irectors have questione the continuing viability of the company in the short to meium term an whether a more aggressive strategy than that propose by management is necessary. As a result, you have been appointe as a financial avisor to the boar. The boar has requeste that you provie a report evaluating the position thoroughly but not one that is full of figures. The executive irectors, whilst concerne about the company s position, are very keen to reassure the non-executive members of the boar about the continuing viability of the business an have given you full access to the company s information an its planning processes. However, the nonexecutive irectors are concerne about the company s prospect of survival in the short to meium term. As part of your review of the risk of failure, you believe that it will be necessary to calculate a current Z-score for the company. In the calculation of ratios using figures in the statement of financial position, you may use year-en figures throughout. Retail price inflation stans at 3% per annum an has been at that rate for the last three years. Note: The Altman Z-score is calculate as follows: Z = 1 2X X X X X 5 Where: X 1 = working capital/total assets X 2 = retaine earnings/total assets X 3 = earnings before interest an tax/total assets X 4 = market value of equity/book value of total ebt X 5 = sales/total assets In Altman s moel, a Z-score of 3 or more inicates a high likelihoo of non-failure, 1 8 or less inicates a high likelihoo of failure. 6

7 Require: Prepare a report for the boar of irectors containing an analysis of the company s position. Your report shoul inclue: (a) An introuction outlining the principal causes of financial istress in any business. (5 marks) (b) An appraisal of the impact of the propose turnaroun strategy on the company s performance, efficiency, risk an liquiity. Your appraisal of the company s exposure to risk shoul inclue an assessment of the risk of failure using Altman s Z-score an any other risk measures you consier appropriate. (17 marks) (c) Avice on any corporate governance an ethical issues that the company shoul consier when reviewing its turnaroun strategy. (6 marks) Appropriateness of the format an presentation of the report an the effectiveness with which its avice is communicate. (4 marks) (32 marks) 7 [P.T.O.

8 Section B TWO questions ONLY to be attempte 3 Asteroi Systems is a German-base company with a subsiiary in Switzerlan. The company s financial manager expects the Swiss business will remit the equivalent of Euros 1 5 million in two months. Her expectations of the future remittance are base upon the current SFr/Euro forwar rate. The current spot an forwar rates for Swiss francs against the Euro are extracte from the Financial Times an are shown in the table below. Closing Change Bi/offer Days mi One month Three month mi-point on ay sprea high low Rate annual Rate annual % % Switzerlan (SFr/ ) In the Euro money market the company can make fixe interest eposits at LIBOR an can borrow at LIBOR plus 20 basis points for terms of greater than one month but up to six months. The company can borrow at fixe rates in the Swiss money market. LIBOR rates, as quote in the Financial Times, are as follows: EUR CHF spot week week month month month The company s financial manager is keen to eliminate transaction risk. However, because of the margin requirements an their impact upon the firm s cash flow, she woul prefer not to use exchange trae erivatives. Swiss franc borrowing or lening rates woul nee to be negotiate with the bank. Require: (a) (b) Estimate the lowest acceptable Swiss borrowing or lening rate for a money market hege maturing in two months. (10 marks) Discuss the relative avantages an isavantages of the use of a money market hege compare with using exchange trae erivatives for heging a foreign exchange exposure. (6 marks) (c) Discuss the extent to which currency heging can reuce a firm s cost of capital. (4 marks) (20 marks) 8

9 4 Mr Moon is the CEO of Saturn Systems, a very large liste company in the telecommunications business. The company is in a very strong financial position, having evelope rapily in recent years through a strategy base upon growth by acquisition. Currently, earnings an earnings growth are at all time highs although the company s cash reserves are at a low level following a number of strategic investments in the last financial year. The previous evening Mr Moon gave a speech at a business inner an uring questions mae some remarks that Pluto Limite was an attractive company with great assets an that he woul be a fool if he i not consier the possibility like everyone else of acquiring the company. Pluto is a long establishe supplier to Saturn Systems an if acquire woul a substantially to the market capitalisation of the business. Mr Moon s comments were wiely reporte in the following morning s financial newspapers an, by 10 am, the share price of Pluto ha risen 15% in out-of-hours an early traing. The first that you, Saturn s chief financial officer, hear about the issue was when you receive an urgent call from Mr Moon s office. You have just complete a backgroun investigation of Pluto, along with three other potential targets instigate at Saturn s last boar meeting in May. Following that investigation, you have now commence a review of the steps require to raise the necessary ebt finance for a bi an the proceure you woul nee to follow in setting up a ue iligence investigation of each company. On arriving at Mr Moon s office you are surprise to see the chairman of the boar in attenance. Mr Moon has just put own the telephone an is clearly very agitate. They tell you about the remarks mae by Mr Moon the previous evening an that the call just taken was from the Office of the Regulator for Public Companies. The regulator ha wante to know if a bi was to be mae an what announcement the company intene to make. They ha been very neutral in their response pening your avice but ha promise to get back to the regulator within the hour. They knew that if they were force to amit that a bi was imminent an then withrew that they woul not be able to bi again for another six months. Looking at you they ask as one: what o we o now? After a short iscussion you returne to your office an began to raft a memoranum with a recommenation about how to procee. Require: (a) Assess the regulatory, financial an ethical issues in this case. (15 marks) (b) Propose a course of action that the company shoul now pursue, incluing a raft of any announcement that shoul be mae, given that the boar of Saturn Systems wishes to hol open the option of making a bi in the near future. (5 marks) (20 marks) 9 [P.T.O.

10 5 Neptune is a liste company in the telecommunications business. You are a senior financial management avisor employe by the company to review its capital investment appraisal proceures an to provie avice on the acceptability of a significant new capital project the Galileo. The project is a omestic project entailing immeiate capital expeniture of $800 million at 1 July 2008 an with projecte revenues over five years as follows: 30 June 30 June 30 June 30 June 30 June Year ene Revenue ($ million) Direct costs are 60% of revenues an inirect, activity base costs are $140 million for the first year of operations, growing at 5% per annum over the life of the project. In the first two years of operations, acceptance of this project will mean that other work making a net contribution before inirect costs of $150 million for each of the first two years will not be able to procee. The capital expeniture of $800 million is to be pai immeiately an the equipment will have a resiual value after five years operation of $40 million. The company epreciates plant an equipment on a straight-line basis an, in this case, the annual charge will be allocate to the project as a further inirect charge. Preconstruction esign an contracting costs incurre over the previous three years total $50 million an will be charge to the project in the first year of operation. The company pays tax at 30% on its taxable profits an can claim a 50% first year allowance on qualifying capital expeniture followe by a writing own allowance of 40% applie on a reucing balance basis. Given the timing of the company s tax payments, tax creits an charges will be pai or receive twelve months after they arise. The company has sufficient other profits to absorb any capital allowances erive from this project. The company currently has $7,500 million of equity an $2,500 million of ebt in issue quote at current market values. The current cost of its ebt finance is $LIBOR plus 180 basis points. $LIBOR is currently 5 40%, which is 40 basis points above the one month Treasury bill rate. The equity risk premium is 3 5% an the company s beta is The company wishes to raise the aitional finance for this project by a new bon issue. Its avisors o not believe that this will alter the company s bon rating. The new issue will incur transaction costs of 2% of the issue value at the ate of issue. Require: (a) (b) Estimate the ajuste present value of the project resulting from the new investment an from the refinancing proposal an justify the use of this technique. (14 marks) Estimate the moifie internal rate of return generate by the project cash flows, excluing the effects of refinancing. (6 marks) (20 marks) 10

11 Formulae Moigliani an Miller Proposition 2 (with tax) V i i k = k +( 1 T)(k k ) e e e V e Two asset portfolio s = w s + w s +2w w r s s p 2 2 a a 2 2 b b a b ab a b The Capital Asset Pricing Moel E(r ) = R +β ( E(r ) R ) i f i m f β a The asset beta formula V V T e = β e V + V T)) V V e + ( 1 ) β ( ( 1 ( + ( 1 T)) e The Growth Moel P o D ( 1+ g) o = (r g) e Goron s growth approximation g = br e The weighte average cost of capital V WACC V V k V e = + e V V k ( 1 T) + e + e The Fisher formula ( 1+ i) = ( 1+ r)(1+h) Purchasing power parity an interest rate parity S S x (1+h ) F S x (1+i ) c c = = 0 0 (1+h ) (1+i b ) 1 0 b 11 [P.T.O.

12 The Black-Scholes option pricing moel The FOREX moifie Black-Scholes option pricing moel c = PN( ) PN( ) e Where: 1 a 1 e 2 rt ln( P / P ) + ( r+ 0.5s ) t a e = s t = s t c = e F N( ) XN( ) Or rt rt p = e XN( ) F N( ) Where: 1 an n(F / X) + s T/2 0 = s T 1 = s T 2 1 The Put Call Parity relationship p = c P + Pe a e rt 12

13 Present Value Table Present value of 1 i.e. (1 + r) n Where r = iscount rate n = number of perios until payment Discount rate (r) Perios (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% [P.T.O.

14 Annuity Table Present value of an annuity of 1 i.e. 1 (1 + r) n r Where r = iscount rate n = number of perios Discount rate (r) Perios (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

15 Stanar normal istribution table This table can be use to calculate N(), the cumulative normal istribution functions neee for the Black-Scholes moel of option pricing. If i > 0, a 0 5 to the relevant number above. If i < 0, subtract the relevant number above from 0 5. En of Question Paper 15