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QUESTION PAPER
Time allowed 3 hours
This paper is divided into two sections
Section A
Section B
Paper 3.7
Strategic Financial
Management
Partsea plc, a UK company, currently exports to a developing country, Hotternia. Hotternia has recently enjoyed a
period of sustained economic growth, and inflation has reduced from 60% per year to 10% per year during the last
three years. Partsea wishes to expand its sales in Hotternia and is considering either foreign direct investment or a
licensing deal with KBD, a large Hotternian company.
Foreign Direct Investment
Foreign direct investment would involve the purchase of an existing competitor in Hotternia, expansion of its facilities
and the introduction of new technologically advanced machinery. A purchase price of 120 million Hotternian dollars
($H) has been agreed for the Hotternian company, in addition to which $H70 million will be needed for expansion
of buildings, and $H35 million for working capital. The purchase of the Hotternian company and the working capital
outlay would take place immediately, the other cash outflows would occur at the end of year 1. The new machinery
will be supplied from the UK parent company at a cost of 4 million, has an expected working life of four years, and
will increase the parent companys pre-tax net cash flow in year 1 by 1 million. Tax allowable depreciation is
available in Hotternia on the new machinery on a straight line basis at 25% per year from the beginning of year two.
The existing Hotternian company has fully depreciated its machinery.
Production and sales is expected to be 1 million units at a price of $H150 per unit in the first year as existing
operations continue in the Hotternian company, and 25 million units per year for the remainder of Partseas five-year
planning horizon. Sales prices are expected to increase after year 1 in line with Hotternian inflation.
At the end of five years the investment, including working capital, is expected to have a total after tax realisable value
of $H150 million.
Variable costs per unit ($H) are expected to be:
Labour
Materials
Distribution
Year 1
350
330
80
Year 2
286
320
90
Variable costs after year 2 are expected to increase in line with inflation in Hotternia for the relevant year.
Fixed costs in year 1 are expected to be $H23 million, increasing to H$40 million in each of years 2-5.
Semi-finished components for the product will be imported from another of Partseas subsidiaries in Bottoniland from
year two onwards at a fixed price of 5 Bottoniland tala (Bt) per unit. 25% of this price represents a profit element to
the Bottoniland company.
Licensing
Under a licensing agreement Partsea would permit KBD to manufacture and market its product for an initial period
of four years commencing in year 2. Partsea would sell the 4 million new machinery to KBD in year 1, and would
also insist on a maintenance contract for the machinery for which it would charge a fixed rate of 500,000 per year.
This is double the expected annual cost of maintenance. Partsea would also supply two members of staff to Hotternia
to monitor quality control. The cost of these staff (salaries and other expenses) is expected to be 200,000 per year
in total at current prices.
KBD would pay Partsea a fee of $H20 per unit for the license, increasing after year 2 by the rate of inflation in
Hotternia. KBD expects to sell 2 million units per year. Partsea would not have a legal presence in Hotternia and would
not be liable for Hotternian tax.
Other information:
Exchange rates
Spot
$H/
1580
Bt/
42
UK
2%
3%
3%
3%
3%
Hotternia
10%
8%
8%
8%
8%
Bottoniland
5%
5%
5%
5%
5%
Corporate taxation is at the rate of 20% per year in Hotternia, and 30% per year in both the UK and Bottoniland.
Bilateral tax treaties exist between each pair of countries. Tax is payable in the year that the tax liability arises.
The relevant risk-free rate is 5% and market return 12%. The beta of the proposed foreign direct investment is
estimated to be 13.
Partsea expects its current exports to Hotternia from the UK to fall by 500,000 units per year, which currently yields
a pre-tax net cash flow of 700,000. This would occur with both FDI and licensing.
It is Partseas policy to remit all available annual cash flows from overseas subsidiaries to the UK.
Required:
Evaluate whether Partsea should expand its sales in Hotternia by using foreign direct investment or licensing.
Relevant calculations, and discussion of other information that would assist the investment decision, must be
included as part of your evaluation.
State clearly any assumptions that you make. Approximately 31 marks are available for calculations and 9 marks
for discussion.
(40 marks)
[P.T.O.
Greffer plc is reviewing its plans for the next three years.
Sales are forecast to increase by 5% per year from their current level of 55 million for three years and then to remain
constant. Variable operating costs have recently been steady at 65% of sales, and fixed costs at 9.8 million.
Capital allowances, for the last financial year ending March 31 were 62 million, estimated on a reducing balance
basis at 25% per year. No tax allowable capital investment is planned for the next three years.
Fixed assets
Current assets
Current liabilities1
Net assets
4460
1Includes
1050
1000
2410
4460
an overdraft of 95 million
The companys financial targets for the next three years are:
(i)
(3 marks)
(b) Produce financial planning estimates for Greffer plc that show whether or not Greffer is likely to achieve its
financial targets. State clearly any assumptions that you make. (Full pro forma balance sheets are not
required.)
(12 marks)
(c) Acting as an external consultant to Greffer plc
(i)
Suggest actions that Greffer might take if the objective of repaying the overdraft in three years is not
achieved.
(2 marks)
(ii) Prepare a brief memo for the managers of Greffer discussing how appropriate each of the companys
financial targets is.
(5 marks)
(d) Greffers current share price is 150 pence. Assume that after year 3 annual replacement investment necessary
for the company to continue its existing level of operations is 4 million, capital allowances are 35 million per
year, and working capital remains constant.
Required:
Evaluate whether or not the share price is higher or lower than might be expected by using free cash flow
analysis. Comment upon your findings.
(8 marks)
(30 marks)
[P.T.O.
Equity beta
135
126
115
082
165
The FTSE 100 index is currently 5930, and the face value of an index contract is 10 per point.
FTSE 100 Stock Index Futures
June
5936
September
5950
Options on FTSE 100 Stock Index Futures
Exercise price
September
Call
Put (pence)
5625
3310
355
5925
1400
1080
Required:
(a) Illustrate how each alternative might be used to hedge against falling share prices. The type of hedge,
number of contracts and hedge cost should be shown wherever relevant.
(9 marks)
(b) If, in September, the actual market prices had moved as shown below, calculate and comment upon the
outcomes of each of the hedges.
Investment
Fangle
Knoten
Dupple
Wraiter
Plesenn
(6 marks)
(15 marks)
Financed by:
Medium and long term borrowing
Ordinary shares (10 pence par value)
Reserves
Doubler
4800
630
(189)
441
(200)
241
Fader
3530
410
(123)
287
(110)
177
2840
2264
(1732)
3372
2650
1730
(1020)
3360
860
400
2112
3372
1140
300
1920
3360
Notes:
(i)
After tax saving in cash operating costs of 750,000 per year indefinitely are expected as a result of the
acquisition.
(2 marks)
(b) Estimate the expected post acquisition earnings per share and comment upon the importance of increasing
the earnings per share.
(4 marks)
(c) Estimate the effect on the combined market value as a result of the takeover using:
(i) PE based valuation;
(ii) Cash flow based valuation.
State clearly any assumptions that you make.
(5 marks)
(4 marks)
(15 marks)
[P.T.O.
Tertial plc has recently commenced exports to Blundonia, a developing country. A payment of 100 million pesos is
due from a customer in Blundonia in three months time. The Blundonian government sometimes restricts the
movement of funds from the country, but has indicated that payment to Tertial has a good chance of receiving
approval. No forward market or derivatives markets exist for the Blundonian peso.
The Blundonian peso is currently linked to the US dollar.
Exchange rates:
Spot rate
3 month forward rate
B peso/
1264 1282
Not available
$/
1775 1782
1781 1789
Tertial can borrow at 6% per annum or invest at 4% per annum in the UK, can borrow at 7% and invest at 45% in
the USA, and at 14% and 10% respectively in Blundonia.
Tertial currently has a 800,000 overdraft in the UK.
Inflation rates:
UK 3%
USA 4%
Blundonia 14%
Tertials Blundonian customer has indicated that it might be willing to make a lead payment in return for a 15%
discount on the sale price.
Required:
(a) Discuss the advantages and disadvantages of the alternative currency hedges (including relevant crosshedges) that are available to Tertial. Calculate the expected outcome of each hedge, and recommend which
hedge should be selected.
(9 marks)
(b) Evaluate whether or not Tertial should agree to its Blundonian customer receiving the 15% discount.
(3 marks)
(c) Suggest possible action that Tertial might take if the government decides not to allow the transfer of money
out of Blundonia.
(3 marks)
(15 marks)
Provide examples of ethical issues that might affect capital investment decisions, and discuss the importance of
such issues for strategic financial management.
(15 marks)
Formulae Sheet
E( r j ) = r f + E( rm ) r f j
Ke (i)
D1
(ii)
+g
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 )
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.
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.
12