Professional Level – Options Module

Advanced Financial Management

Mock Examination

December 2018

Time allowed: 3 hours 15 minutes

This question paper is divided into two sections:

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

Section B – These TWO questions are compulsory and MUST be

attempted

The relevant formulae and tables should be used where necessary.

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

1 Kalampa Co is a medium sized listed company which manufactures components for the motor
industry and has both domestic and export customers. Due to the sales success of an innovative new
engine the directors of Kalampa Co are considering a new investment in order to expand the
manufacturing capacity of the company. The directors of Kalampa Co are anticipating that they will
carry out this expansion in their home country but are beginning to consider whether or not they
should perhaps expand their manufacturing operations overseas. It is now 31 December 2018 and it
is anticipated that the new investment will start on 1 January 2020.

Proposed subsidiary – financial and other projections

$100 million will be invested in land and buildings and $44 million will be invested in plant and
machinery at the start of the project. Additionally an initial investment in working capital of $20
million will be required at the start of the project. $5 million has so far been spent on evaluating the
proposed project. All of these amounts are in money terms.

The new investment is expected to increase the unit sales of the new engine as follows:

Year 1 Year 2 Year 3 Year 4

Additional sales 20,000 30,000 35,000 25,000

The selling price for the engine is $3,000 and variable costs are $1,000. The project will be charged
with $20 million of fixed overhead each year. However 40% of this cost relates to existing costs of
the company. These costs are in current price terms and it is expected that the selling price will
increase by just 2% per annum whilst the costs will inflate at 4% per annum. The working capital
requirement will increase or decrease at the start of each year in line with the change in unit sales.
The working capital will be released at the end of the project.

At the end of the project it is expected that the land and buildings could be sold for $50 million and
that the plant and machinery will have a residual value of $4 million. These values are in money
terms.

The project is expected to increase the debt capacity of the company by $100 million and the
company can borrow at 160 basis points above the risk free rate and can invest at 20 basis points
below the risk free rate.

The company has a cost of equity of 13% and is financed 40% by debt and 60% by equity.

The company will finance the project from the sale of a non-core subsidiary and by raising new debt.
The company expects to receive $60 million from the sale of the non-core subsidiary in five months’
time and will invest this amount until the project commences. The company is concerned that
interest rates may fluctuate and hence wants to hedge the investment.

Hedging data:

The following forward rate agreements are available:

5v12 @ 2.92 – 3.03
5v7 @ 2.85 – 2.94

Three month $ futures are currently quoted as follows:

March 97.01
June 96.94

The contract size is $1 million, the tick size is 0.01% and the tick value is $25.
You can assume that:
- Settlement on the futures contracts is at the end of the month.
- Basis diminishes to zero at a constant rate until contracts mature and time intervals can be
counted in months.
- Basis risk can be ignored.

When Kalampa Co previously used futures the CEO found the margin and mark to market system
confusing.

Other financial information:

Corporate tax is currently at a rate of 25% and is paid in the year the liability arises. Tax allowable
depreciation is allowed on the full cost of plant and machinery on the straight line basis. Any
residual value received is fully taxable.
The return on government bonds is currently 2.4%

Required:

(a) Briefly describe some of the key benefits and drawbacks were Kalampa Co to set up
manufacturing operations overseas.
(6 marks)

(b) Prepare a report which:

(i) Advises Kalampa Co on whether or not the proposed expansion project should proceed.
An APV approach should be used.
(17 marks)

(ii) Explains the rationale for the APV approach used and describes some key assumptions
that have been made in the project evaluation.
(6 marks)

(iii) Advises how the interest rate risk should be hedged and how much debt Kalampa Co
will need to raise to fund the project. You should show how the futures hedge will be set
up.
(8 marks)

(iv) Explains the margin and mark to market system that is used with futures hedges.
(4 marks)

Professional marks will be awarded in part (b) for the format, structure and presentation of the
memorandum.
(4 marks)

(c) Briefly explain two external hedging methods a company could use if it faced foreign
exchange risk on some of its transactions.
(5 marks)

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

2 Ash Co is a family owned unlisted company which operates a successful chain of car dealerships.
Over the years the company has built up a significant portfolio of investments in the shares and
bonds of listed companies. The finance director, a member of the family which controls the
company, is qualified by experience, and is concerned that he and the other directors do not have
sufficient knowledge to manage the portfolio. As a result the directors recently attended an investors
seminar but despite this they remain confused by much of the terminology used.

One particular investment comprises 4% coupon bonds in Co X which mature at a premium of 3% in

2 years. Co X has a AA credit rating.

Market information:
8% government bonds which mature in 12 months are trading at $102.
6% government bonds which mature in 24 months are trading at par.
Credit spreads for a AA rated company for 12 and 24 months are 20 and 32 basis points respectively.

The bonds in Co X and the government bonds all have a par value of $100.

Required:

(a) Calculate the government spot yields for 12 and 24 months and the market value and yield
to maturity of the bonds in Co X. Explain the meaning of the government spot yields and
the yield to maturity calculated.
(7 marks)

(b) Calculate and explain the duration and the modified duration of the bonds in Co X.
(5 marks)

Another investment in the portfolio comprises 20,000 shares in Co Y which currently trade at $4.12
each. The shares value has a standard deviation of 20%. Due to current economic uncertainty the
finance director has suggested that the company should buy 6 month put options with a strike price
of $4 per share to protect the value of this investment. You should assume a risk free rate of 6% in
this part of the question.

Required:

(c) Calculate the likely cost of a put option on one share and the number of put options the
company should buy such that any loss that arises on the shares is matched by a gain on the
put options held.
(7 marks)

(d) Explain how a knowledge of the options gamma could help Ash Co.
(3 marks)

(e) Briefly discuss whether or not Ash Co should be holding a portfolio of investments.
(3 marks)

(25 marks)
3 Togiz Co operates in a country which has recently suffered severe financial difficulties and has had
to request assistance from the International Monetary Fund (IMF). Despite this Togiz Co is
considering the launch of a new product. This would be a significant diversification for the
company. The product can be manufactured using either process Alpha or Bravo.

If process Alpha is used the internal rate of return (IRR) and the modified internal rate of return
(MIRR) have been calculated to be 17.6% and 13.4% respectively.

If process Bravo is used the annual after-tax cash flows expected at the end of each year ($’000s) are
as follows:

Year Current 1 2 3 4 5
Cash flows (5,920) 615 840 2,175 5,120 1,100

Togiz Co has 5 million shares trading at $4 each and its loans have a current value of $8 million and
an average after-tax cost of 3%. The capital structure of Togiz Co is not expected to change as a
result of the launch of the new product.

Felu Co currently operates in the trade that Togiz Co is considering diversifying into. Only 70% of
the company operates in this trade and the remaining 30% is involved in other activities. The equity
beta of Felu Co is 1.30, and it is estimated that the equity beta for its other activities alone is 1.15.
Felu Co has 100 million shares trading at $4.80 each. Its loans have a current value of $96 million
and pay interest at the base rate plus 150 basis points. It can be assumed that 30% of both the equity
and debt finance can be attributed to the other activities of Togiz Co.

Both companies pay annual corporation tax at a rate of 25%. The current base rate is 3.5% and the
market risk premium is 6%.

Required:

(a) Explain the role of the IMF and the potential impact on Togiz Co of the assistance provided by
the IMF to the country where it operates.
(5 marks)

(b) Provide an estimate of the cost of capital that Togiz Co should use to calculate the net present
values of the two processes.
(7 marks)

(c) Calculate the IRR and the MIRR for process Bravo and recommend which process, if any,
Togiz Co should proceed with. Explain your recommendation and note any reservations that
you may have.
(8 marks)

(d) Togiz Co is considering the disposal of another division. Discuss the advantages and
disadvantages of making the disposal through a management buy-out compared to a trade
sale.
(5 marks)