04-20-2008, 07:23 AM
Again it is almost impossible for me to post full paper of ACCA P4 Advanced Financial Management, I am only posting Question Requirements because every scenario is having 2 to 3 pages plus lots of tabular information that canât be posted in forum because of incapability of this forum.
Section A â BOTH questions are compulsory and MUST be attempted
1 You are the chief financial officer of International Enterprises, a multinational company with interests in Europe and the Far East. You are concerned about certain aspects of the companyâs financial management. The company has enjoyed a high rate of growth over the last three years as a result of a single productâs development. This product has had a big impact in the fast moving mobile communications industry. However, the company does not have any new
products in development and is relying on expanding its market share and developing upgraded versions of the current product.
As part of your preparation for the board meeting to discuss the 2007 draft accounts, you have prepared a projected income statement and balance sheet for the year ending 31 December 2008. These projections are based upon a number of agreed assumptions taken from the companyâs strategic plan. As part of the agenda, the board will also consider its dividend target for the forthcoming year.
International Enterprises The projected figures assume
(i) $10 million of the existing loans will be repaid during the year.
(ii) Capital investment in plant and equipment of $80 million will be undertaken.
The company is quoted on an international stock exchange and its beta value (based upon three years of monthly return data) is 1·40. The current risk free rate is 3% and the equity risk premium is 5%. The current share price is $16·20 and the sector price/earnings ratio is 24. The companyâs cost of debt capital remains at its current rate of 5%. You may assume that the current cost of equity capital remains unchanged over the term of the projection.
Required
(a) Prepare a cash flow forecast for the year ended 31 December 2008.
Note the format does not need to comply with accounting standards. (6 marks)
(b) Estimate the companyâs maximum dividend capacity after the target level of capital reinvestment is undertaken and making any working capital adjustments you deem necessary. (6 marks)
<font color="purple">(c) Draft a brief report for senior management reviewing the potential performance of the business in the year ended 31 December 2008 if the expectations contained within the strategic plan are fulfilled. You should use the Economic Value Added (EVAâ¢) and any other performance measures you think appropriate.</font id="purple">
Note<font color="purple"> requirement (c) includes 2 professional marks</font id="purple">. (18 marks)
(30 marks)
2 Burcolene is a large European-based petrochemical manufacturer, with a wide range of basic bulk chemicals in its product range and with strong markets in Europe and the Pacific region. In recent years, margins have fallen as a result of competition from China and, more importantly, Eastern European countries that have favourable access to the Russian petrochemical industry. However, the company has managed to sustain a 5% growth rate in earnings through aggressive management of its cost base, the management of its risk and careful attention to its value base.
As part of its strategic development, Burcolene is considering a leveraged (debt-financed) acquisition of PetroFrancais, a large petrochemical business that has engaged in a number of high quality alliances with oil drilling and extraction companies in the newly opened Russian Arctic fields. However, the growth of the company has not been particularly strong in recent years, although Burcolene believes that an expected long term growth of 4% per annum is realistic under its current management.
Preliminary discussions with its banks have led Burcolene to the conclusion that an acquisition of 100% of the equity of PetroFrancais, financed via a bond issue, would not have a significant impact upon the companyâs existing credit rating. The key issues, according to the companyâs advisors, are the terms of the deal and the likely effect of the acquisition on the companyâs value and its financial leverage.
Both companies are quoted on an international stock exchange and below are relevant data relating to each company
Financial data as at 30 November 2007
The global equity risk premium is 4·0% and the most appropriate risk free rate derived from the returns on government stock is 3·0%.
Burcolene has a share option scheme as part of its executive remuneration package. In accordance with the accounting standards, the company has expensed its share options at fair value. The share options held by the employees of Burcolene were granted on 1 January 2004. The vesting date is 30 November 2009 and the exercise date is 30 November 2010. Currently, the company has a 5% attrition rate as members leave the company and, of those remaining at the vesting date, 20% are expected not to have achieved the standard of performance required.
Your estimate is that the options have a time value of $7·31.
PetroFrancais operates a defined benefits pension scheme which, at its current actuarial valuation, shows a deficit of $430 million.
You have been appointed to advise the senior management team of Burcolene on the validity of the free cash flow to equity model as a basis for valuing both firms and on the financial implications of this acquisition for Burcolene.
Following your initial discussions with management, you decide that the following points are relevant
1. The free cash flow to all classes of capital invested can be reliably approximated as net operating profit after tax (NOPAT) less net reinvestment.
2. Given the rumours in the market concerning a potential acquisition, the existing market valuations may not fully reflect each companyâs value.
3. The acquisition would be financed by a new debt issue by Burcolene.
Required
<font color="purple">(a) Estimate the weighted average cost of capital and the current entity value for each business, taking into account the impact of the share option scheme and the pension fund deficit on the value of each company. </font id="purple"> (16 marks)
(b)<font color="navy"> <b>Write a briefing paper for management</b></font id="navy">, advising them on
(i) The validity of the free cash flow model, given the growth rate assumptions made by management for both firms;
(ii) The most appropriate method of deriving a bid price; and
(iii) The implications of an acquisition such as this for Burcoleneâs gearing and cost of capital.
Note <font color="purple">requirement (b) includes 2 professional marks</font id="purple">. (14 marks)
(30 marks)
Section B â TWO questions ONLY to be attempted
3 Digunder, a property development company, has gained planning permission for the development of a housing complex at Newtown which will be developed over a three year period. The resulting property sales less building costs have an expected net present value of $4 million at a cost of capital of 10% per annum. Digunder has an option to acquire the land in Newtown, at an agreed price of $24 million, which must be exercised within the next two years.
Immediate building of the housing complex would be risky as the project has a volatility attaching to its net present value of 25%. One source of risk is the potential for development of Newtown as a regional commercial centre for the large number of professional firms leaving the capital, Bigcity, because of high rents and local business taxes. Within the next two years, an announcement by the government will be made about the development of transport links into Newtown from outlying districts including the area where Digunder hold the land option concerned. The risk free rate of interest is 5% per annum.
Required
<font color="navy">(a) Estimate the value of the option to delay the start of the project for two years using the Black and Scholes option pricing model and comment upon your findings. Assume that the government will make its announcement about the potential transport link at the end of the two-year period. (12 marks)</font id="navy">
(b) On the basis of your valuation of the option to delay, estimate the overall value of the project, giving a concise rationale for the valuation method you have used. (4 marks)
(c) Describe the limitations of the valuation method you used in (a) above and describe how you would value the option if the government were to make the announcement at ANY time over the next two years. (4 marks)
(20 marks)
4 The chairman of your company has become concerned about the accumulation of cash in hand and in the deposit accounts shown in the companyâs balance sheet. The company is in the manufacturing sector, supplying aerospace components to the civil aviation markets in the UK and Europe. For the last 20 years the company has grown predominantly by acquisition and has not invested significantly in research and development on its own account. The acquisitions have given the company the technology that it has required and have all tended to be small, relative to
the companyâs total market capitalisation. The company has a healthy current asset ratio of 1·3, although its working capital cycle has an average of 24 unfunded days. The company has not systematically embraced new manufacturing technologies nor has it sought to reduce costs as a way of rebuilding profitability. Managerial and structural problems within divisions have led to a number of substantial projects overrunning and losses being incurred as a result. It has also proven difficult to ensure the accountability of managers promoting projects â many of which have not subsequently earned the cash flows originally promised. At the corporate level, much of the companyâs accounting is on a contracts basis and over the years it has tended to be cautious in its revenue recognition practices. This has meant that earnings growth has lagged behind cash flow.
Over the last 12 months the company has come under strong competitive pressure on the dominant defence side of its business which, coupled with the slow-down in spending in this area across the major western economies, has slowed the rate of growth of its earnings. The companyâs gearing ratio is very low at 12% of total market capitalization and borrowing has invariably been obtained in the European fixed interest market and used to support capital
investment in its European production facility. In the current year, investment plans are at the lowest they have been in real terms since the company was founded in the 1930s.
In discussion, the chairman comments upon the poor nature of the companyâs buildings and its poor levels of pay which could, in his view, be improved to reflect standards across the industry. Directorsâ pay, he reminds you, is some 15% below industry benchmarks and there is very little equity participation by the board of directors. He also points out that the companyâs environmental performance has not been good. Last year the company was fined for an untreated discharge into a local river. There are, he says, many useful things the company could do with the money
to help improve the long-term health of the business. However, he does admit some pessimism that business opportunities will ever again be the same as in previous years and he would like a free and frank discussion at the next board meeting about the options for the company. The company has a very open culture where ideas are encouraged and freely debated.
The chairman asks if you, as the newly appointed chief financial officer, would lead the discussion at the next board.
Required
<font color="purple">(a) In preparation for a board paper entitled âAgenda for Changeâ, write brief notes which
identify the strategic financial issues the company faces and the alternatives it might pursue. (10 marks)</font id="purple">
<b><font color="navy">(b) Identify and discuss any ethical issues you believe are in the above case and how the various alternatives you have identified in (a) may lead to their resolution. (10 marks)</font id="navy"></b>
(20 marks)
5 Your company, which is in the airline business, is considering raising new capital of $400 million in the bond market for the acquisition of new aircraft. The debt would have a term to maturity of four years. The market capitalisation of the companyâs equity is $1·2 billion and it has a 25% market gearing ratio (market value of debt to total market value of the company). This new issue would be ranked for payment, in the event of default, equally with the companyâs other long-term debt and the latest credit risk assessment places the company at AA. Interest would be paid to holders annually. The companyâs current debt carries an average coupon of 4% and has three years to maturity. The companyâs effective rate of tax is 30%.
The current yield curve suggests that, at three years, government treasuries yield 3·5% and at four years they yield 5·1%. The current credit risk spread is estimated to be 50 basis points at AA. If the issue proceeds, the companyâs investment bankers suggest that a 90 basis point spread will need to be offered to guarantee take up by its institutional clients.
Required
(a) Advise on the coupon rate that should be applied to the new debt issue to ensure that it is fully subscribed. (4 marks)
(b) <font color="purple">Estimate the current and revised market valuation of the companyâs debt and the increase in the companyâs effective cost of debt capital. </font id="purple"> (8 marks)
(c) <b>Discuss the relative advantages and disadvantages of this mode of capital financing in the context of the companyâs financial objectives.</b> (8 marks)
(20 marks)
Section A â BOTH questions are compulsory and MUST be attempted
1 You are the chief financial officer of International Enterprises, a multinational company with interests in Europe and the Far East. You are concerned about certain aspects of the companyâs financial management. The company has enjoyed a high rate of growth over the last three years as a result of a single productâs development. This product has had a big impact in the fast moving mobile communications industry. However, the company does not have any new
products in development and is relying on expanding its market share and developing upgraded versions of the current product.
As part of your preparation for the board meeting to discuss the 2007 draft accounts, you have prepared a projected income statement and balance sheet for the year ending 31 December 2008. These projections are based upon a number of agreed assumptions taken from the companyâs strategic plan. As part of the agenda, the board will also consider its dividend target for the forthcoming year.
International Enterprises The projected figures assume
(i) $10 million of the existing loans will be repaid during the year.
(ii) Capital investment in plant and equipment of $80 million will be undertaken.
The company is quoted on an international stock exchange and its beta value (based upon three years of monthly return data) is 1·40. The current risk free rate is 3% and the equity risk premium is 5%. The current share price is $16·20 and the sector price/earnings ratio is 24. The companyâs cost of debt capital remains at its current rate of 5%. You may assume that the current cost of equity capital remains unchanged over the term of the projection.
Required
(a) Prepare a cash flow forecast for the year ended 31 December 2008.
Note the format does not need to comply with accounting standards. (6 marks)
(b) Estimate the companyâs maximum dividend capacity after the target level of capital reinvestment is undertaken and making any working capital adjustments you deem necessary. (6 marks)
<font color="purple">(c) Draft a brief report for senior management reviewing the potential performance of the business in the year ended 31 December 2008 if the expectations contained within the strategic plan are fulfilled. You should use the Economic Value Added (EVAâ¢) and any other performance measures you think appropriate.</font id="purple">
Note<font color="purple"> requirement (c) includes 2 professional marks</font id="purple">. (18 marks)
(30 marks)
2 Burcolene is a large European-based petrochemical manufacturer, with a wide range of basic bulk chemicals in its product range and with strong markets in Europe and the Pacific region. In recent years, margins have fallen as a result of competition from China and, more importantly, Eastern European countries that have favourable access to the Russian petrochemical industry. However, the company has managed to sustain a 5% growth rate in earnings through aggressive management of its cost base, the management of its risk and careful attention to its value base.
As part of its strategic development, Burcolene is considering a leveraged (debt-financed) acquisition of PetroFrancais, a large petrochemical business that has engaged in a number of high quality alliances with oil drilling and extraction companies in the newly opened Russian Arctic fields. However, the growth of the company has not been particularly strong in recent years, although Burcolene believes that an expected long term growth of 4% per annum is realistic under its current management.
Preliminary discussions with its banks have led Burcolene to the conclusion that an acquisition of 100% of the equity of PetroFrancais, financed via a bond issue, would not have a significant impact upon the companyâs existing credit rating. The key issues, according to the companyâs advisors, are the terms of the deal and the likely effect of the acquisition on the companyâs value and its financial leverage.
Both companies are quoted on an international stock exchange and below are relevant data relating to each company
Financial data as at 30 November 2007
The global equity risk premium is 4·0% and the most appropriate risk free rate derived from the returns on government stock is 3·0%.
Burcolene has a share option scheme as part of its executive remuneration package. In accordance with the accounting standards, the company has expensed its share options at fair value. The share options held by the employees of Burcolene were granted on 1 January 2004. The vesting date is 30 November 2009 and the exercise date is 30 November 2010. Currently, the company has a 5% attrition rate as members leave the company and, of those remaining at the vesting date, 20% are expected not to have achieved the standard of performance required.
Your estimate is that the options have a time value of $7·31.
PetroFrancais operates a defined benefits pension scheme which, at its current actuarial valuation, shows a deficit of $430 million.
You have been appointed to advise the senior management team of Burcolene on the validity of the free cash flow to equity model as a basis for valuing both firms and on the financial implications of this acquisition for Burcolene.
Following your initial discussions with management, you decide that the following points are relevant
1. The free cash flow to all classes of capital invested can be reliably approximated as net operating profit after tax (NOPAT) less net reinvestment.
2. Given the rumours in the market concerning a potential acquisition, the existing market valuations may not fully reflect each companyâs value.
3. The acquisition would be financed by a new debt issue by Burcolene.
Required
<font color="purple">(a) Estimate the weighted average cost of capital and the current entity value for each business, taking into account the impact of the share option scheme and the pension fund deficit on the value of each company. </font id="purple"> (16 marks)
(b)<font color="navy"> <b>Write a briefing paper for management</b></font id="navy">, advising them on
(i) The validity of the free cash flow model, given the growth rate assumptions made by management for both firms;
(ii) The most appropriate method of deriving a bid price; and
(iii) The implications of an acquisition such as this for Burcoleneâs gearing and cost of capital.
Note <font color="purple">requirement (b) includes 2 professional marks</font id="purple">. (14 marks)
(30 marks)
Section B â TWO questions ONLY to be attempted
3 Digunder, a property development company, has gained planning permission for the development of a housing complex at Newtown which will be developed over a three year period. The resulting property sales less building costs have an expected net present value of $4 million at a cost of capital of 10% per annum. Digunder has an option to acquire the land in Newtown, at an agreed price of $24 million, which must be exercised within the next two years.
Immediate building of the housing complex would be risky as the project has a volatility attaching to its net present value of 25%. One source of risk is the potential for development of Newtown as a regional commercial centre for the large number of professional firms leaving the capital, Bigcity, because of high rents and local business taxes. Within the next two years, an announcement by the government will be made about the development of transport links into Newtown from outlying districts including the area where Digunder hold the land option concerned. The risk free rate of interest is 5% per annum.
Required
<font color="navy">(a) Estimate the value of the option to delay the start of the project for two years using the Black and Scholes option pricing model and comment upon your findings. Assume that the government will make its announcement about the potential transport link at the end of the two-year period. (12 marks)</font id="navy">
(b) On the basis of your valuation of the option to delay, estimate the overall value of the project, giving a concise rationale for the valuation method you have used. (4 marks)
(c) Describe the limitations of the valuation method you used in (a) above and describe how you would value the option if the government were to make the announcement at ANY time over the next two years. (4 marks)
(20 marks)
4 The chairman of your company has become concerned about the accumulation of cash in hand and in the deposit accounts shown in the companyâs balance sheet. The company is in the manufacturing sector, supplying aerospace components to the civil aviation markets in the UK and Europe. For the last 20 years the company has grown predominantly by acquisition and has not invested significantly in research and development on its own account. The acquisitions have given the company the technology that it has required and have all tended to be small, relative to
the companyâs total market capitalisation. The company has a healthy current asset ratio of 1·3, although its working capital cycle has an average of 24 unfunded days. The company has not systematically embraced new manufacturing technologies nor has it sought to reduce costs as a way of rebuilding profitability. Managerial and structural problems within divisions have led to a number of substantial projects overrunning and losses being incurred as a result. It has also proven difficult to ensure the accountability of managers promoting projects â many of which have not subsequently earned the cash flows originally promised. At the corporate level, much of the companyâs accounting is on a contracts basis and over the years it has tended to be cautious in its revenue recognition practices. This has meant that earnings growth has lagged behind cash flow.
Over the last 12 months the company has come under strong competitive pressure on the dominant defence side of its business which, coupled with the slow-down in spending in this area across the major western economies, has slowed the rate of growth of its earnings. The companyâs gearing ratio is very low at 12% of total market capitalization and borrowing has invariably been obtained in the European fixed interest market and used to support capital
investment in its European production facility. In the current year, investment plans are at the lowest they have been in real terms since the company was founded in the 1930s.
In discussion, the chairman comments upon the poor nature of the companyâs buildings and its poor levels of pay which could, in his view, be improved to reflect standards across the industry. Directorsâ pay, he reminds you, is some 15% below industry benchmarks and there is very little equity participation by the board of directors. He also points out that the companyâs environmental performance has not been good. Last year the company was fined for an untreated discharge into a local river. There are, he says, many useful things the company could do with the money
to help improve the long-term health of the business. However, he does admit some pessimism that business opportunities will ever again be the same as in previous years and he would like a free and frank discussion at the next board meeting about the options for the company. The company has a very open culture where ideas are encouraged and freely debated.
The chairman asks if you, as the newly appointed chief financial officer, would lead the discussion at the next board.
Required
<font color="purple">(a) In preparation for a board paper entitled âAgenda for Changeâ, write brief notes which
identify the strategic financial issues the company faces and the alternatives it might pursue. (10 marks)</font id="purple">
<b><font color="navy">(b) Identify and discuss any ethical issues you believe are in the above case and how the various alternatives you have identified in (a) may lead to their resolution. (10 marks)</font id="navy"></b>
(20 marks)
5 Your company, which is in the airline business, is considering raising new capital of $400 million in the bond market for the acquisition of new aircraft. The debt would have a term to maturity of four years. The market capitalisation of the companyâs equity is $1·2 billion and it has a 25% market gearing ratio (market value of debt to total market value of the company). This new issue would be ranked for payment, in the event of default, equally with the companyâs other long-term debt and the latest credit risk assessment places the company at AA. Interest would be paid to holders annually. The companyâs current debt carries an average coupon of 4% and has three years to maturity. The companyâs effective rate of tax is 30%.
The current yield curve suggests that, at three years, government treasuries yield 3·5% and at four years they yield 5·1%. The current credit risk spread is estimated to be 50 basis points at AA. If the issue proceeds, the companyâs investment bankers suggest that a 90 basis point spread will need to be offered to guarantee take up by its institutional clients.
Required
(a) Advise on the coupon rate that should be applied to the new debt issue to ensure that it is fully subscribed. (4 marks)
(b) <font color="purple">Estimate the current and revised market valuation of the companyâs debt and the increase in the companyâs effective cost of debt capital. </font id="purple"> (8 marks)
(c) <b>Discuss the relative advantages and disadvantages of this mode of capital financing in the context of the companyâs financial objectives.</b> (8 marks)
(20 marks)
