Section A – This ONE question is compulsory and MUST be attempted

Question 1

Lime Co is a private company, based in Artland, which owns a chain of restaurants and hotels across the country.
Lime Co’s strategy of acquiring companies in different business sectors across the globe has so far diversified its risk
until a recent board of directors (BoD) meeting, which revealed that a recent acquisition of Asian Co, an event
management company in Asia, has brought major losses and has resulted in higher gearing levels in Asia. In the
meeting, the matter is of serious concern that whether Asian Co must be sold before any further acquisitions take
place, or not. A complete financial review and a comprehensive summary is presented to the BoD justifying that
appropriate measures and factors have been considered prior to acquisition of Asian Co. A final decision is to be
made as the acquisition failed to achieve its objectives and the problems have resulted in financial distress. The
credit rating of Asian Co has downgraded from A to BBB according to credit agency rating. The directors are very
concerned about this decision by the agency as this would directly impact the valuation of Asian Co’s bonds and the
future cost of debt.

Despite incurring losses, Asian Co has explored opportunities arising in Asia in the upcoming years. It has proposed
Lime Co that an investment in a different business sector would help generate surplus cash flows. Tulip Co is one of
the companies which currently provides services in that business sector.

Investment Project by Asian Co

Asian Co, however, has tried to convince the Lime Co’s BoD that Asia is currently investing massively in leisure
industry, which will create recreations and expand the tourism industry, resulting in rapid growth in the near future.
Asian Co is considering entering the tourism market through a four year project. Asian Co suggests that the
investment must be done on a now or never basis or the market will saturate and due to increased competition it
will no more be feasible to remain in the industry.

The initial cost of the project is expected to be $ 20,000,000. The expected post-tax cash flows to generate over the
four year project life are:

Year 1 2 3 4

Post-tax Cash Flows ($000s) 3,203 4,675 10,045 15,325

Currently, BoD being skeptical about further investing in Asian Co, has asked to delay and granted an option to invest
in the project after two years as immediate investment would be risky due to the project volatility of 25% attached
to its net present value.

Other Information

Asian Co market value of equity is estimated to be $22 million. Asian Co non-current liabilities of $20 million consists
solely of 8% redeemable bond which has a nominal value of $100 and a redemption premium of 4% in four years’
time. The government of Asia has issued four bonds. Since the bonds are all government bonds, it is assumed that
the bonds are of the same risk class. Taxation can be ignored on government bond. The coupon is payable on annual
basis. The annual spot interest rate of one-year redeemable bond is 88 basis points above the risk free rate.
The detail of bonds and credit spreads for a bond of the same risk class is as follows:

Bond A B C D

Redeemable Years 1 2 3 4

Coupon 7% 6% 5% 4%

Current Market Value ($) 103 102 98 92

Credit Spreads Rating (shown in basis points)

Year 1 2 3 4

A 21 30 42 56

BBB 55 71 87 100

Tulip Co, a listed company, provided hotel & tourism services for several years in Asia. Its business proportion of
about 20% relates to tourism services and equity beta is 1.5. The asset beta of hotel services is estimated to be 0.75.
Tulip Co has issued 5 million shares currently trading at $5 per share and its debt is currently trading at $108 per
$100 at a book value of $ 24 million. The debt beta is estimated to be zero.

Corporation tax applicable to all companies is 20%. The risk free rate is estimated to be 3% and the market risk
premium is estimated to be 6%.

Required

(a) Discuss the factors which Lime Co needs to consider before acquisition and possible reasons that why
acquisitions fail? (6 marks)

(b) Prepare a report for the board of directors of Lime Co which:

(i) Estimates the value of the bond, YTM under both ratings and the tourism project to Asian Co
(13 marks)
(ii) Estimates the value of an option using Black and Scholes option pricing model (8 marks)
(iii) Evaluates the project based on the estimates in b(i) and b(ii) above, and conclude whether or not it is
beneficial to delay or not. State any relevant assumptions made. (8 marks)

Professional marks will be awarded for the demonstration of skill in communication, analysis and evaluation,
skepticism, and commercial acumen in your answer. (10 marks )

(c) Behavioral finance attempts to explain how decision makers take financial decisions in real life, and why their
decisions might not appear to be rational every time and, hence, have unpredictable consequences

Discuss the behavioral factors which might influence the investor’s decision-making and therefore a
company’s financial strategies.
(5 marks)

(50 marks)
Section B – BOTH questions are compulsory and MUST be attempted

Question 2

Ghareebwal Co is a very successful entity. The company has consistently followed a business
strategy of aggressive acquisitions, looking to buy companies that it believes were poorly
managed and hence undervalued.
Its board of directors has chosen the takeover targets with care. Always looking for companies
with potential, but which were poorly managed and having a below-par market value,Ghareebwal
has maintained its price-earnings (P/E) ratio on the stock marketat 12.2.
Ghareebwal’s 2022 figures show a profit after tax of Rs 886m and it has 375m shares inissue.
Ameerwal Pvt is a well-established owner-managed business. In financial terms, it has a rather
history with its up and downs corresponding directly with the state ofthe global economy. Over
the past five years, its profits have fallen each year with the2022 values standing at:

Rs m
Revenue 1500
Operating Profit 480
Interest (137)
Profit before tax 343
Taxation @ 25% (86)
Profit after Tax 257
Number of shares m 150
EPS 1.72

However, with economists predicting an upturn in the economy, Ameerwal’s management team
feel that revenue will increase by 6% per annum up to and including 2026. The company’s
operating profit margin is not expected to change for the foreseeable future.
Operating profits are shown after deducting non-cash expenses (including tax allowable
depreciation) of Rs 125m. This is expected to increase in line with sales. However, the company
has recently spent Rs 210m on the purchase of non-current assets. Ameerwal’s management
believes this value will have to increase by 10% per annum until 2026 to enable the company to
remain competitive. Ameerwal has estimated its overall cost of capital to be approximately 12%,
but this assumes it will maintain its debt to equity ratioat 40:60.
Some of Ameerwal’s major shareholders are not so confident about the future and would like to
sell the business as a going concern. The minimum price they would consider would be the fair
value of the shares, plus a 10% premium. Ameerwal’s CFO believes the best way to find the fair
value of the shares is to discount the forecasted free cash flowsof the firm, assuming that beyond
2026 these will grow at a rate of 3% per annum indefinitely.
Acquisition proposals Co has proposed to pay for the acquisition using one of the following three
methods:
(i) Ghareebwal intends to make an offer to Ameerwal based upon a share for share swap.
Ghareebwal will exchange one of its shares for every two Ameerwal shares. Assuming that
Ghareebwal can maintain its earnings rating at 12.2
(ii) A cash offer of Rs 14 for each Ameerwal Co share; or A cash offer of Rs 5.5 for each
Ameerwal Co share plus one Ghareebwal Co share for every Three Ameerwal Co shares.
Requirements

(a) As at 1 January 2023, prepare a schedule of Ameerwal’s forecast free cash flows for
the firm. Ascertain the fair value of Ameerwal’s equity on a per share basis.
(7 marks)
(b) Calculate the percentage gain in all option’s equity value that will earn by both
groups of shareholders?
(7 marks)
(c) What factors should the Ameerwal shareholders consider before deciding whether
to accept or reject the offer made by Ghareebwal?
(6 marks)

Professional marks will be awarded for the demonstration of skill in analysis and evaluation, skepticism, and
commercial acumen in your answer.

(5 marks)

(25 marks)
Question 3

Ammar plc is a Pakistan-based company that regularly trades with companies in the USA. Several large
transactions are due in five months' time. These are shown below. The transactions are in '000' units of the
currencies shown. Assume that it is now 1 June and that futures and options contracts mature at the relevant
month end and one transaction with UAE.
Exports to Imports from
Company 1 $490 Rs150
Company 2 — $990
Company 3 AED 367 $750

AED is pegged against USD at 3.67 AED/USD

Exchange rates PKR/$
Spot 221.40 – 221/50
3 months forward 220.20 – 220.30
1 year forward 216.25 – 216.35
Annual interest rates available to Ammar plc
Borrowing Investing
UBL PKR 13.7% 12.4%
MCB PKR 13.5% 12.2%
Dollar 9.0% 8.0%

CME PKR/$ currency futures ($50,000)

September 220.05
December 218.15
CME currency options prices, PKR/$options $ 25,000 (Rs per $)
CALLS PUTS
Sept Dec Sept Dec
218 4.76 5.95 1.60 2.96
Required
(a) How the five-month currency risk should behedged by showing all relevant calculations relating to the
alternative types of hedge.
(16 marks)
Part b
Discuss the benefits and drawbacks for Ammar Co in using forward contracts compared with using
over-the-counter currency options, and explain why Ammar Co may prefer to use exchange-traded
derivatives rather than over-the-counter derivatives to hedge foreign currency risk (4
Marks)Professional marks will be awarded for the demonstration of skill in analysis and evaluation,
skepticism, and commercial acumen in your answer. (5 marks)(25 marks)