PART 3

WEDNESDAY 10 DECEMBER 2003

QUESTION PAPER
Time allowed 3 hours
This paper is divided into two sections
Section A

BOTH questions are compulsory and MUST be

answered

Section B

TWO questions ONLY to be answered

Formulae sheet, present value, annuity and standard normal

distribution tables are on pages 9, 10, 11 and 12

Paper 3.7

Strategic Financial
Management

Section A BOTH questions are compulsory and MUST be attempted

1

Avto plc is considering an investment in Terrania, a country with a population of 60 million that has experienced
twelve changes of government in the last ten years. The investment would cost 580 million Terranian francs for
machinery and other equipment, and an additional 170 million francs would be necessary for working capital.
Terrania has a well-trained, skilled labour force and good communications infrastructure, but has suffered from a
major disease in its main crop, the banana, and the effect of cheaper labour in neighbouring countries.
Terrania is heavily indebted to the IMF and the international banking system, and it is rumoured that the IMF is
unwilling to offer further assistance to the Terranian government. The Terranian government has imposed temporary
restrictions on the remittance of funds from Terrania on three occasions during the last ten years.
The proposed investment would be in the production of recordable DVD players, which are currently manufactured in
the UK, mainly for the European Union market. If the Terranian investment project was undertaken the existing UK
factory would either be closed down or downsized. Avto plc hopes to become more competitive by shifting production
from the UK.
Additional information:
(i) UK corporate tax is at the rate of 30% per year, and Terranian corporate tax at the rate of 20% per year, both
payable in the year that the tax charge arises. Tax allowable depreciation in Terrania is 25% per year on a
reducing balance basis. A bilateral tax treaty exists between Terrania and the UK.
(ii) The after tax realisable value of the machinery and other equipment after four years is estimated to be 150 million
Terranian francs.
(iii) 140,000 has recently been spent on a feasibility study into the logistics of the proposed Terranian investment.
The study reported favourably on this issue.
(iv) The Terranian government has offered to allow Avto plc to use an existing factory rent free for a period of four
years on condition that Avto employs at least 300 local workers. Avto has estimated that the investment would
need 250 local workers. Rental of the factory would normally cost 75 million Terranian francs per year before
tax.
(v) Almost all sales from Terranian production will be to the European Union priced in Euros.
(vi) Production and sales are expected to be 50,000 units per year. The expected year 1 selling price is 480 Euros
per unit.
(vii) Unit costs throughout year 1 are expected to be:
Labour: 3,800 Terranian (T) francs based upon using 250 workers
Local components: 1,800 T francs
Component from Germany: 30 Euros
Sales and distribution: 400 T francs
(viii) Fixed costs in year 1 are 50 million T francs
(ix) Local costs and the cost of the German component are expected to increase each year in line with Terranian and
EU inflation respectively. Due to competition, the selling price (in Euros) is expected to remain constant for at
least four years.
(x) All net cash flows arising from the proposed investment in Terrania would be remitted at the end of each year
back to the UK.
(xi) If the UK factory is closed Avto will face tax allowable redundancy and other closure costs of 35 million.
Approximately 20 million after tax is expected to be raised from the disposal of land and buildings.
(xii) If Avto decides to downsize rather than close its UK operations then tax allowable closure costs will amount to
20 million, and after tax asset sales to 10 million. Pre tax net cash flows from the downsized operation are
expected to be 4 million per year, at current values. Manufacturing capacity in Terrania would not be large
enough to supply the market previously supplied from the UK if downsizing does not occur.
(xiii) The estimated beta of the Terranian investment is 15 and of the existing UK investment 11.
(xiv) The relevant risk free rate is 45% and market return 115%.

(xv)

Money market investment in Terrania is available to Avto paying a rate of interest equivalent to the Terranian
inflation rate.

(xvi)

Forecast % inflation levels:

Year
Year
Year
Year
Year

1
2
3
4
5

UK and the EU
2%
3%
3%
3%
3%

Terrania
20%
15%
10%
10%
10%

(xvii) Spot exchange rates:

Terranian francs/
3685
Terranian francs/Euros 2332
Required:
(a) Prepare a financial appraisal of whether or not Avto plc should invest in Terrania and close or downsize its
UK factory. State clearly all assumptions that you make.
(b) Discuss the wider commercial issues that the company should consider, in addition to the financial appraisal,
before making its decision on whether to invest.
(c) Estimate the possible impact of blocked remittances in Terrania for the planning horizon of four years, and
discuss how Avto might react to blocked remittances.
(28 marks in total are available for calculations, and 12 for discussion)
(40 marks)

[P.T.O.

The managing director of Snowwell plc has received an unsolicited letter from a reputable organisation specialising in
the prediction of corporate failure, which suggests that Snowwell has been identified as a probable failing company.
The organisation has offered to supply details of the full report on Snowwell for 100,000.
Given the collapse of many companies share prices during the last few years, the managing director of Snowwell is
concerned that if the contents of the report become public knowledge, Snowwells share price could also fall.
He has also read about various models which use combinations of financial ratios to attempt to predict corporate
failure, including a leading business schools SO model (developed in 2001) which produces a score based upon the
following equation:
SO = 35S1 + 18S 2 + 025S3 + 069S 4
where:
S1 = Earnings before interest and tax/market value of equity
S2 = Working capital/medium and long term capital employed
S3 = Market value of equity/market value of debt
S4 = The present value to infinity of current operating free cash flow/turnover
According to the SO system a company scoring less than 1 has a high probability of failure; a score of 12 suggests
remedial action is necessary to improve corporate financial performance; and a score of over 2 means that a company
has a high probability of survival for at least three years, which is the maximum claimed prediction period for the
model.
The latest summarised accounts of Snowwell plc are shown below:

Fixed assets
Land and buildings (net)
Other fixed assets (net)
Current assets
Stock
Debtors
Cash
Creditors: amounts falling due
within1 year
Creditors
Dividend
Taxation

Balance Sheets as at
31 March 2003
31 March 2002
million
million
211
196
247
235

458
431
156
32
5

196
12
7

Creditors: amounts falling due

after more than 1 year
14% loan stock redeemable
December 2006 (100 par)
Floating rate bank term loans
Shareholders funds
Ordinary shares (50 pence par)
Reserves

193

(215)

127
34
3

166
12
10

164

(188)

(150)
(94)

192

(150)
(64)

193

75
117

192

75
118

193

Profit and loss accounts for the years ending

31 March 2003
31 March 2002
million
million
620
580
43
52
20
18

23
34
7
10

16
24
17
17

(1)
7

Turnover
Earnings before interest and tax
Interest
Profit before tax
Taxation
Available to shareholders
Dividend
Retained earnings
Additional information:
(i)

The share price of Snowwell Plc is currently 232 pence.

(ii)

The current redemption yield on loan stock of similar risk to that of Snowwell is 8%, which is also the current
interest rate of the floating rate term loan.

(iii)

Snowwell needs to invest approximately 35 million per year to maintain operations at current levels.

(iv)

Tax allowable depreciation in 2003 was 38 million

(v)

Snowwells cost of equity is estimated to be 12%

(vi)

Corporate tax is at the rate of 30% per year

(vii) The average gearing of Snowwells industry is 50% (measured by the market value of medium and long-term
debt related to the market value of equity).
(viii) Snowwells turnover is mostly retail sales of high quality jewellery and watches.
Required:
You have been requested by the managing director of Snowwell plc to prepare a briefing document that includes:
(a) An estimate of the SO score for Snowwell plc;

(11 marks)

(b) A discussion of the significance of this score for Snowwell plc;

(4 marks)

(c) A brief discussion of alternative ways of assessing whether or not Snowwell plc is likely to experience
financial distress and/or corporate failure;
(4 marks)
(d) Recommendations as to whether or not Snowwell should take any action based upon your findings in
(a) (c) above and any other relevant information or analysis;
(7 marks)
(e) A discussion as to whether or not Snowwell should purchase the full report for 100,000.

(4 marks)
(30 marks)

[P.T.O.

Section B TWO questions ONLY to be attempted

3

You have been invited to an internal planning meeting of Megasal, a large plc, which has grown rapidly, mainly by
acquisitions.
Without further acquisitions Megasals turnover is expected to grow by 5% per year.
Megasals managing director announces, however, that the company expects to more than double its profits during
the next two years and to substantially increase its share price. During the period it anticipates acquiring the following
companies:

Turnover
Year 1 ANKO plc
Year 2 BHYR plc
Year 2 LKER plc

246
175
345

Current information
( million)
Pre-tax
Post-tax
Share price Number of
profits
profits
(pence) issued shares
34
24
210
100 million
18
13
168
150 million
42
29
182
200 million

Megasal plc current financial summary, and two-year forecasts incorporating the
proposed acquisitions:
( million)
Current
Year 1
Year 2
Turnover
892
1,183
1,762
Pre-tax profits
183
1,,121
1,187
Post-tax profits
158
11,85
1,131
Number of issued shares (m)
100
11,131
1,170
Share price (pence)
680
11,761
1,904
11 Required:
Discuss, with supporting evidence including relevant calculations, the likely validity of each element of Megasals
two-year forecasts. Explain any possible problems with the forecasts.
(15 marks)

(a) Assume that it is now 1 December. The financial manager of a large corporate pension fund is concerned about
the recent loss in value of the fund due to falling share prices. Although he believes that the equity market is
probably near to its low point, and that prices could soon start to rise, there is no certainty of this happening.
In order to protect the funds portfolio against possible further falls in share prices he is considering the use of
financial futures. The portfolio currently comprises eight major investments, as detailed below.
Share

Number of
shares held

Equity
Beta

MNSD
Ponder
Loyter
Wanlon
RDT Bank
UMFR
Teleike
Biller

3,000,000
1,000,000
2,600,000
800,000
4,200,000
1,700,000
1,900,000
2,000,000

074
115
065
132
156
082
111
143

1 December
Price
(pence)
110
443
126
598
176
480
890
267

On 1 December, the March FTSE 100 Index futures price is 3,850. The face value of a FTSE stock index
contract is 10 per index point (the tick size), which implies a current contract value of 38,500.
Required:
Illustrate what hedge should be undertaken to protect the portfolio against possible falls in the share prices.
(5 marks)
(b) Assume that on 31 March, the expiry date of the futures contract, the share prices have moved as shown below,
and the FTSE 100 Index futures price is 3,625.
(The number of shares held in the portfolio has remained unchanged)
Share
MNSD
Ponder
Loyter
Wanlon
RDT Bank
UMFR
Teleike
Biller

31 March
Price (pence)
101
420
93
520
81
390
846
250

Required:
With hindsight, calculate the outcome of the hedge that was illustrated in (a) above. Comment upon your findings.
(4 marks)
(c) Briefly discuss why the financial manager might use stock index futures to alter portfolio risk rather than buy
or sell actual shares in the stock market.
(3 marks)
(d) If the financial manager wished to halve the systematic risk of the portfolio by using long-term interest rate
futures, explain (but do not calculate) what hedge he might undertake.
(3 marks)
(15 marks)

[P.T.O.

Bioplasm plc is a UK based company that has completed the preliminary development of a new drug to combat a
major disease. Initial clinical trials of the drug have been favourable, and the drug is expected to receive approval from
the regulatory authority in the near future. Bioplasm has taken out a patent on the drug that gives it the exclusive right
to commercially develop and market the drug for a period of 15 years. Although it is difficult to produce precise
estimates, the company believes that to commercially develop and market the drug for worldwide use will cost
approximately 400 million at current prices. The expected present value from sales of the drug during the patent
period could vary between 350 million and 500 million. The current long-term government bond yield is 5%. The
annual variance (standard deviation squared) of returns on similar biotech companies is estimated to be 0185.
The finance director of Bioplasm can see from the possible NPVs that the company has a difficult decision as to
whether or not to develop the drug, and wonders if option pricing could assist the decision.
Required:
Using the Black-Scholes option pricing model for the life of the patent, estimate the call values of the option to
commercially develop and market the drug. Provide a reasoned recommendation, based upon your calculations
and any other relevant information, as to whether or not Bioplasm should develop the drug.
N.B. Because the value of the returns from the patent will fall over the period before the drug is commercially
developed, it is necessary to adjust the expected present value from sales of the drug. In all relevant parts of the BlackScholes model, the present value from sales of the drug should be multiplied by exp(0067)(15) to reflect this potential
reduction in value according to when the drug is developed.
(15 marks)

Discuss, and provide examples of, the types of non-financial, ethical and environmental issues that might
influence the objectives of companies. Consider the impact of these non-financial, ethical and environmental
issues on the achievement of primary financial objectives such as the maximisation of shareholder wealth.
(15 marks)

Formulae Sheet

E( r j ) = r f + E( rm ) r f j

Ke (i)

D1
+g
(ii)
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 )

Call price for a European option = Ps N( d1) Xe rT N( d 2 )

d1 =

1n ( Ps / X ) + rT

+ 0.5 T

d 2 = d1 T

[P.T.O.

7


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11

[P.T.O.

Standard normal distribution table

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.

End of Question Paper

12