Mock One

Advanced Financial
l
oManagement
o
hP4AFM-MK1-Z16-A
c
Answers & Marking Scheme
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B2016 DeVry/Becker Educational Development Corp.

1
(a)
TROSOFT CO
Report on the proposed internet auction investment
To
From
Date
Board of directors, Trosoft Co
Financial consultant
September 2016
Introduction
The investment will be assessed using both financial and non-financial indicator
s. It is also
l
important to consider the strategic fit of such an investment, and whether the i
nvestment will
move the company too far from its core competence.
oEvaluation report and of from the a investments purely financial Adjusted persp
ective Present Value this initially is provided o
appears in the to appendix be a very topoor
this
investment.
hOther financial factors
c
However, there are a number of other factors to consider. The data contains no i
nformation
about Although what the happens IT infrastructure after four will years, have or
zero inresidual the S case value of the the project revisedmay estimates, have
developed six years.
a
substantial brand value by the end of six years.
Other important factors might include:
y
How confident is d
Trosoft that the forecast sales and costs will occur?
Sensitivity the impact of analysis different u and/or assumptions Monte Carlo o
n net simulation cash flows.
would be useful to investigate
Has the t
risk of the venture been accurately assessed? The discount rate of the
operating practical S problems.

cash flows is based on CAPM, and is subject to its theoretical and

Are there new technologies involved in the investment which are not yet fully
r
developed and proven?
e auction What will listing be the costs reaction and potentially of other Inte
rnet start a price auction war?
providers? Will they cut their
k
Are there alternative investments that would provide a better strategic fit?
c
Are there existing or possible future government regulations that would affect
the
investment?
e
Non-financial factors
B Before a final decision is made the impact of the investment on a wide range o
f stakeholders,
not only the firms shareholders, should be undertaken to ensure the long term sus
tainability
of the strategy. Potential approaches for such an evaluation include:
Triple Bottom Line (TBL) reporting a TBL report focuses not only on financial
but also environmental and social impacts of performance.
Integrated Reporting <IR> which focuses on the ability to add value for all
providers of capital (including non-financial capital such as human capital) bot
h in
the short and long term.
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2
Real options
Several real options could exist at, or before, year six, including the option to
reinvest and
possibly expand operations, or perhaps to use the existing internet auction clie
ntele for other
purposes such as internet marketing. The initial investment decision should idea
lly take into
account the expected present value from embedded call options such as these, alt
hough even
if sophisticated option pricing models are used, real options are very difficult
to accurately
value. It would also be useful to investigate the effect on cash flow of the opt
ion to abandon
the project part way through its expected life (effectively a put option) or to
redeploy the IT
infrastructure into alternative uses (effectively a call option).
l
Conclusion
oWith the APV being significantly negative the investment would at first sight
appear to risk a
substantial some extent, loss neutralise of shareholder the downside wealth. ris
k However, of the potential project while o
embedded leaving real significant options may, upside
to
potential.
hfinal It is recommended decision is made, that together the Black-Scholes with
either model a TBL c

is used or <IR> to value evaluation any such of the options investments

before a
ability to generate long-term value for all stakeholders.
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3
Appendix
As the IT infrastructure will require major new investment after six years, the
period of the
financial evaluation will be six years.
The adjusted present value technique (APV) requires the estimation of the base c
ase NPV of
investing and operating cash flows, and, separately, the present value of any fi
nancing side
effects.
Internet auctions project
$000
l
Auction Year
fees
0
4,300
1
6,620
2
8,100
3
8,200
4
o 8,364
5
8,531
6
Outflows:
Telephone IT maintenance costs
costs
1,210
1,215
1,910
1,850
2,230
1,920
o
2,125
2,420
2,468
2,168
2,518
2,211
Wages and salaries
1,860
2,070
2,280
h 2,380
2,428

2,476
Incremental Marketing
head office overhead
500
420
50
c
200
55
200
60
65

66

68

Lost Royalty of technology

contribution
payments for use
680
500
80
S 300
80
200
80
200

200

200

Rental of premises
280
290
300
310
316
323
Tax-allowable depreciation

y
540
432
432
432
432

432
Total Profit outflows
before tax
d
(1,180)
1,180
(1,855) 6,155 7,187 (567) 7,702 398
7,932 268
8,078 286
8,228
303

Tax (245%)
u
289
454
139
(98)
(66)
(70)

(74)
(891)
(1,401) (428) 300
202
216
229
t
Add back depreciation
540
432
432
432
432
432
IT Other infrastructure
outflows
S (2,700)
Working capital
(400)
(24)
(24)
(25)
(26)
(10) 509
r

Net flows
(3,991) (885)
(20) 707
608
638 1,170
Discount Present e values
factors (10%)
(3,991) 0909 (804)
0826 (17) 0751 531
0683 415
0621 396
0564
660
k

c The expected base case NPV is ($2,810,000)
e
Notes:
B (i)
taking The business discount into risk account of rate the for the investment,
the business base case the risk NPV ungeared of the should investment. equity be
the beta ungeared of In the order internet cost to reflect of auction
equity,
the
sector will be used.

Assuming corporate debt to be risk free:

Ve
67
a =
Ve
Vd
1
T
e
=
67 33 ( 1
0.245)
142 = 1035
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4
(ii)
Using CAPM
Keu = Rf + (Rm Rf) asset beta
Keu = 4% + (95% 4%) 1035 = 969%
10% will be used as the discount rate to estimate the base case NPV.
The market research is a sunk cost.
(iii)
Working capital is assumed to be released at the end of year 6. Working capital
in
year 5 is assumed to increase by the 2% inflation rate in Singapore.
l
Tutorial note: The level of working capital as at the end of yearo 4 = 400 + 24
+ 24
+ 25 + 26 = 499. To protect this from inflation an incremental investment is
released required at at year year 6 5 = of 499 2% + 10 499 = 509 = 10 (cash (cas
h inflow)
outflow). o
Total working capital to be
The financing side effects of the investment are the tax relief h on interest pa
yments, the issue
costs and the benefit from the government subsidy.
c
Tax It is relief assumed on that interest the actual payments
debt raised equals S the change in the firms debt capacity due to
the investment.
Total borrowing for the investment is $3,100,000.
y
Annual tax relief on borrowing d
$3,100,000 45% (net of the subsidy) 24.5% = $34,178.
government The discount in rate Singapore.
used will u be the risk free rate as the tax relief is offered by a highly stab
le
t
The $34,178 present 5242 value S = of $179,161
tax relief for six years is:
Government subsidy
r
The e benefit from the government subsidy is an interest saving of 1% per year:
$3,100,000 1% = $31,000
k
However there is an opportunity cost of lost potential tax shield = $31,000 245%
=
c ($7.595)
e
The = $122,689
present value for six years, discounted at the risk free rate, is ($31,000 $7,5
95) 5242
B Tutorial normal pre-tax note: cost It would of debt be to acceptable reflect c
redit to discount risk.

the tax shield and subsidy at the firms

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5
Issue costs
Issues costs are $3,100,000 15% = $46,500
Tutorial note: An acceptable alternative approach is to assume that issue costs
are 15% of
the gross finance that will need to be raised. In this case the gross finance re
quired =
$3,100,000 100 985 = $3,147,208 and the issue costs $47,208. The gross finance ra
ised
would then be used to calculate the value of the tax shield and the subsidy.
The estimated present value of the financial side effects is:
$179,161 + $122,689 $46,500 = $255,350
l
The estimated APV of the investment is ($2,810,000) + $255,350 = ($2,554,650)
o(b)
Other corporate developments
o
The directors of Trosoft face a number of issues:
h(i)
value-adding The need to offer business management opportunities;
compensation c
that will provide an incentive to seek
(ii)
The investor pressure to release the value S in property assets, and
(iii)
The risks involved in using tax avoidance schemes.
In reviewing these issues it is important y
to bear in mind the overarching duty of the directors
which is to maximise the value d
of the firm and to act in the firms best interests.
Share options
The introduction of share u options can potentially align the objectives of mana
gement more
closely with those t
of shareholders. In this way there may be a reduction in the agency
suffer problem lower and agency the S firms costs).
performance may approach an optimal level (i.e. shareholders will
However the problem with share option schemes is that they tend to increase the
risk appetite
of r
managers who become exposed to unlimited upside potential (if the share prices
rises) but
face e no downside risk as, if the share price falls, the options can be lapsed.
Furthermore management know that the firms owners are themselves protected by lim
ited
k
liability status and also a possible government bailout if the firm fails. The
combination of
limited liability and equity options in the hands of directors may well create a
wholly
c unacceptable appetite for risk and a willingness to take on new projects that
they would
otherwise have rejected.
e
Even if the benefits of a share option scheme exceed the dangers any decision t
o introduce the
B scheme themselves. should The be made suggestion by independent that executive
s non-executive can award directors themselves as opposed generous to the share

executives
options
raises great ethical concerns.
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6
Divestment of property portfolio
Currently the firms value generation is both software and property driven. Divest
ment of the
property portfolio will simply skew the risk of the remaining business towards s
oftware and
given the increasing international competition in the sector this may result in
the firms value
falling even if the firm manages to maintain its current levels of profitability
and growth.
As things stand the investors (and other stakeholders) in Trosoft benefit from i
ts diversified
value generation with the added benefit that management can focus on the difficu
lt job of
software design and leave the property market to look after itself. Divestment o
f the property
portfolio could increase the risk of the business, pushing up its cost of capita
l and potentially
l
cutting the value of the remaining operations.
oEven if divestment can be justified the choice of method must be carefully con
sidered, If
would investors achieve wish Trosoft this. The to return alternative cash propos
al to them then of transferring only a sale o
the and property leaseback to to a a newly third listed
party
entity is effectively a demerger which does not in fact raise any h cash.
Tax avoidance scheme
c
It biased legal, may as manner. be opposed that the Even to reports tax if the ev
asion inreports the financial which are true is press it illegal. S must are not
be However, emphasised factually even correct that a legal tax or presented schem
e avoidance is in not
is
a
necessarily ethical and in recent years there has been a growing debate about th
e use of such
schemes.
y
In operating the context tax avoidance of corporate d
schemes. social responsibility For example, there consumers may be may reputati
onal boycott Trosoft risk due Cos
to
products refuse to and provide services, new capital. andu ethical On the investo
rs other hand, may tax dispose avoidance of their schemes shareholding are used i
n the by firm several
or
famous US-based technology giants whose brand values and share prices do not app
ear to
t
have been damaged as a result.
It may be that regulatory S risk is of more concern as the Singapore tax authori
ties may launch
an investigation into Trosoft Cos scheme and retrospectively recalculate the tax
due and add
fines and interest. To mitigate this risk it may be advisable to end the scheme

or at least
ensure r
it is based upon arms length transactions in compliance with the Organisation for
Economic e Co-operation and Development (OECD) guidelines.
k
Conclusion
c interests From an of ethical a range perspective, of different the stakeholder
s directors are as inwell the as position satisfying of attempting their own to
compensation
balance the
e
requirements. effective communication The dutiesand of directors integrity in i
n this the choices case can that be they summarised make.
as ones of transparency,
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7
2
(a)
POLYTOT CO
Currency hedges
Possible currency hedges are a forward market hedge, currency futures hedge or c
urrency
options hedge.
Forward market hedge
The forward market hedge locks into a known exchange rate at the time the paymen
t by the
customer is made. It is a legally-binding obligation.
l
A forward rate is required for four months time. This may be estimated o by inter
polating
between the three month and one year forward rates.
15398 15178 = 0022 1/9 = 00024
o
The four month rate is 15398 00024 = 15374
h0022 Tutorial represents notes: The the expected difference depreciation betwee
n the of three sterling c
month over and the nine one month year (12 intervening month) rates period.
of
and As from we the the are one three trying year month to forward imply rate. th
e An rate. four alternative As month Polytot approach forward will S be rate wou
ld selling we be deduct dollars/buying to interpolate one ninth between of sterl
ing this difference
spot it israte
the
(higher) rates on the right side of the spreads that are relevant throughout.
60% of the receipts will be in $US (i.e. y
the equivalent to 675m 60% = 405m pesos).
At the official rate
P405m
d
= $4,124,236
9820
u$4,124,236
Selling $ forward,
t
= 2,682,604
The balance of S 270m15374
pesos (675m 40%) will be converted directly into sterling at 115% of
the official rate (15630 115 = 179745)
r

P270m
179745
e = 1,502,128
k
Total expected receipts are 4,184,732. Assuming there is no risk of default by t
he
counterparty to the forward contract this is a guaranteed fixed amount.
cFutures hedge
e
Each futures contract is derived upon a standard quantity of sterling (62,500).
As Polytot
B needs (i.e. take to protect a long position).
itself against an appreciation of sterling it should initially buy sterling fut
ures
Tutorial note: An alternative approach to correctly identifying that Polytot sho
uld initially
buy sterling futures is that, in four months time, the firm will actually need to
buy sterling
(albeit on the spot market as opposed to the futures market where physical deliv
ery does not
occur)
In this case December futures will need to be bought as the September contract w
ill have
expired by the date of receiving dollars on 1 November.
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8
Basis on the December contract is 15510 15275, or 235 cents. The expected basis on
1
November is 2/6 (the remaining period of the futures contract) 235 cents, or 078 c
ents.
The expected outcome of the futures hedge, no matter what happens to actual spot
rates, is
15275 + 00078 = $15353.
Tutorial note: Basis is the difference between spot price and futures price. The
opening
basis in the hedge on 1 July is 235 cents. As at 1 July the December futures have
six months
until their delivery date but Polytot will close its futures position (by sellin
g futures) after four
months on 1 November. Linear interpolation can be used to estimate, in advance,
the
effective forward rate created by closing the futures position after four months
.
l
Expected receipt,
$4,124,236
15353
= 2,686,274
oTotal expected receipts are 2,686,274 + 1,502,128 = 4,188,402
o
This is slightly better than the forward market rate.
hThe hedge is for $4,124,236
c
This will require
$4,124,236
15353
= 2,686,274 or 4298 S 62,500 contracts.
43 contracts would be needed, a slight over hedge.
y
Tutorial note: The expected lock-in rate of the hedge (15353) has been used above i

n the
calculation was used for of the the translation.
number d
of contracts. Full credit would be given if the spot or forward rate
Futures contracts also require u the payment of initial margin, a security deposit
. Profit on
futures contracts t
through favourable currency movement may be taken daily, but any losses
Furthermore will result in daily basis S variation on 1 November margin when calls
the in futures order to contract keep the would hedge be open.
closed out (by selling
an identical contract) might not be 078 cents, due to the existence of basis risk
. A better or
worse r
outcome than expected is possible
The e futures contract seems to offer a slightly better rate than the forward co
ntract, but will
involve more risks. The company must choose whether or not the expected extra re
turn
k
would compensate for these risks.
c Currency options hedge
e
Currency protect against options downside offer an risk, advantage they also ov
er allow both the forwards buyer of and the futures option in to that take they
advantage not only
of
B favourable benefit is the currency option premium.
movements by allowing the option to lapse. The price of this extra
As Polytot wishes to exchange dollars for sterling, it will need to purchase Dec
ember call
options on sterling.
Tutorial note: The underlying currency beneath the option is sterling (31,250) an
d as
Polytot wants the right, but not the obligation to buy sterling, it should acqui
re call options.
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9
To select the most suitable strike price the premium is added to show the (appro
ximate)
overall exchange rate that would be achieved if the option is exercised.
Strike price
Premium
Overall rate
15250
00335
15585
15500
00225
15725
As Polytot will be buying sterling the overall rate of $15585 per 1 is relatively
attractive
and therefore the 15250 strike price should be used.
Strike price $ receipt
equivalent Number of contracts Number used
l
15250
4,124,236
2,704,417
8654

86 (or 87)
oTutorial note: As each option is derived upon a standard quantity of sterling
(31,250) the
dollar receipt must be translated into sterling (at the chosen o
exercise price) to establish how
many options are required. $4,124,236 15250 31,250 = 8654
To exercise 86 contracts will require Polytot to provide $4,098,438 h (15250 31,25
0 86),
leaving to yield $25,798 16,780.
surplus ($4,124,236 $4,098,438) c
which could be sold forward at $15374/
Strike price
Premium
($)
( Premium
at spot)
receipt
S surplus
Net receipt
15250
90,031
(58,179)
2,687,500
16,780
2,646,101
Tutorial note: The premium is quoted y
as cents per 1.December calls at 15250 have a
cost cost (at of 335 spot) cents = $90,031 which in d
15475 total = = 335 58,179. 31,250 The sterling 86 =receipt $90,031. from The exer
cising equivalent the sterling
options
2,646,101
= 31,250 86 = 2,687,500 u and the net receipt 2,687,500 + 16,780 58,179 =
t
Total expected receipts are:
2,646,101 + 1,502,128 S = 4,148,229
This outcome is much worse than the forward or futures hedges, but if sterling w
as to weaken
significantly, r
the options could be lapsed and sterling purchased relatively cheaply in
November e in the spot market.
k
contract For the options (at 15374) (with then a the strike spot price rate of o
n 15250) 1 November to give would a better have to outcome fall to 15374 than aforw
ard
00355
c = 1 5019 in order to recover the premium cost.
e
is The willing potential to pay use the of extra options cost could to have be
justified the benefit on of the the basis extra that flexibility.
they may be chosen if Polytot
B The risks recommended of futures) or currency hedge is either options the at f
orward a strike price market, of 15250.
(unless Polytot is happy with the extra
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10
(b)
Counter-trade
The proposed counter-trade needs to be compared with the 40% of expected receipt
s that are

at 15% less than the official rate. Three million

ves receipts of
between 15 and 18 million. This compares with
transaction. The price for the strawberries would
ce per kilo.
Other factors that would need to be considered in

kilos at 5060 pence per kilo gi

1,502,128 from the foreign exchange
need to be in excess of 50 pen
any counter-trade include:

How reliable is the supplier of the strawberries? Are they of suitable quality
and
could such a large quantity be supplied?
l
Strawberries are perishable and require specialised transportation. Who is
responsible for the costs of transportation, insurance etc?
o
What additional administrative expense will the counter-trade o
involve?
What are the tax implications of a counter-trade in strawberries?
3
SHEGDOR
h(a)
Optimal transfer price and manufacturing location
c
If the transfer price is at fixed plus variable cost:
SUmgaba
Mazila
Bettuna
Sales (400 $16) + 1,800
y
8,200
$000
16,000
$000
14,800
$000
Variable Fixed cost
cost (400 $16)
d
1,800
6,400
3,600
700
3,000
900
Transfer Import duty price (8, (400 200 $16) 10%)
u + 1,800

8,200
820
8,200

t
8,200
13,320
12,100

Taxable Tax (2, 680 profit 25%)

(16,000 S 13, 320)

2,680
(670)
2,700
(864)

Income r
after tax

2,010
1,836
Withholding tax

Remitted e (60%)

(1,206)

(1,102)
k
Retained

804

734
c Retained
Remitted
Home country
Total
e
(after all $000
local tax) (net)
$000
$000
tax
cash $000
flow
B Mazila
Umgaba
804

1,206

(134)

1,876

Umgaba plus Mazila

1,876 (i)

Umgaba

Bettuna
734
1,102

1,836

Umgaba plus Bettuna

1,836 (ii)

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11
Tutorial note: As full credit is given by the home country tax authorities for t
ax paid
overseas, home country tax liability will only exist for countries where the tax
rate is lower
than in the home country, in this case Mazila. Additional tax of 5% of the taxab
le income
will be payable (30% 25%) 2, 680,000 = 134, 000
If the transfer price = (fixed cost + variable cost) 130:
Umgaba
Mazila
Bettuna
Sales (8,200 130)
10,660
16,000
14,800
Variable cost (400 $16)
6,400
3,600
3,000
Fixed cost
1,800
700
l
900
Import Transfer duty price (10,660 (400 $16)
10%)

10,660
1,066
o 10,660

Taxable profit (10, 660 8,200)

2,460
8,200
16,026
o
(26)
14,560
240
Tax (2, 460 40%)


(984)

(77)
Withholding Income after tax tax
(1,476 60% 15%)
1,476
c
(133)
(26)

163

Remitted (1,476 60%) 133

S (753)

(98)
Retained
590
(26)
65

Retained
y
Remitted
Home country
Total
d
(after all $000
local tax) (net)
$000
$000
tax
cash $000
flow
Umgaba
Mazila
u 590
(26)
753

1,343
(26)
t

Umgaba plus Mazila

S
1,317 (iii)
Umgaba
590
753


1,343
Bettuna
65
98

163
r

Umgaba e plus Bettuna

1,506 (iv)
k
The with maximum assembly of possible the product cashin flow Mazila.
is from using the fixed plus variable cost transfer price,
c The use of the fixed plus variable cost transfer price is beneficial as it mea
ns that no taxes are
e
payable in the highest tax country, Umgaba.
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12
(b)
Government reactions
If the transfer price is at fixed plus variable cost, and assembly takes place i
n Mazila, the
likely attitudes of the governments are:
Umgaba the government of Umgaba would not receive any tax, and would probably tr
y to
ensure that any transfer price included an element of profit.
Mazila tax is maximised for Mazila, as well as jobs provided by the assembly. Th
e
government is likely to regard this favourably.
l
Bettuna no tax is received or jobs created as assembly would take place in Mazil
a. Unless
the government offers incentives to attract the assembly there is little it can
o do.
receive Home country any tax on this the income.
is the only situation in which the home o
country government would
(c)
Offshore dividend mixer
hIf no tax haven is used the UK tax liability would c
be:
Grossed dividend
up Overseas
tax
in Taxable
the UK
S liability
UK tax
credit
Tax
UK Net
tax
000
000
000
000
000

000
Blueland
Mopia
1,000
1,231
400
431
y
1,231
1,000
300
369
300
369
0
0
Saddonia
1,875
d
_____
375
_____
1,875
5625
375
_____
1875
1,206
4,106
1875
u _____
_____
_____
Total UK tax is 187,500
t
(e.g. Tutorial Mopia note: 600 S Grossed 100/60 = 1,000 up dividend and overseas r
efers tax topaid the pre-tax on this profit profit = relating 1,000 to 40% the=
dividend
400).
If dividends are channelled through a tax haven holding company the dividend is
assumed to
be r
treated as coming from one source rather than three individual sources.
e Grossed up Overseas
Taxable
UK tax
Tax
Net
k
dividend
000
000
tax
in000
the UK
000
liability
000
credit
000

UK tax
c Tax haven
4,106
1,206
4,106
1,232
1,206
26
e
saving Use of of the 161,500 tax haven (187,500 allows the overseas 26,000)
tax credit to be fully utilised, and results in a UK tax
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13
4
(a)
EWADE CO
Comparison of convertible and non-convertible debt
The yield to maturity on the convertible zero-coupon loan note may be found by s
olving:
100
$7110 =
(1
r) 7
r = approximately 5%
l
case Tutorial of zero-coupon note: Yielddebt to maturity there are is only the i
nternal two cash rate flows of return (i) todays of a market debtso cash value flo
ws. (in this In case
the
found the issue as (present price) and value/future (ii) the future value), rede
mption in this case value. 7110/100 The = o
relevant 0711 and discount then factor searching can the
be
published tables shows the related seven-year discount rate to be approximately
4%.
hThe yield to maturity on non-convertible debt is given at 6%. This yield will c
omprise the
time. semi-annual The market interest price payments, may be found and any by so
lving:
capital c
gain or loss on redemption in seven years
Market price =
4
+
4
+ . . .
4
+
S 100
1.03
( 1.03)
2
( 1.03 )
14
( 1.03 ) 14
From PV and annuity tables:
y
4 1130
d
4520
$

100 0661
u
6610
11130
t

The differ yield slightly on a according S zero-coupon to the loan preferences n

ote and of coupon investors bearing for regular debt of interest the same paymen
ts maturity (coupon
might
bearing), or a definite capital sum at the end of a period (zero-coupon). Zero-c
oupon loan
notes r
are not subject to reinvestment risk, but are subject to significant price risk
if not held to
maturity.
eBecause of the existence of the conversion option, the 5% yield to maturity on
the zerok
coupon loan note is less than would be expected for a zero-coupon loan note wit
hout the
conversion option.
cThe main reason for the $4020 difference between the market values is that the z
ero-coupon
e
loan However, note the just non-convertible repays $100 debt in seven pays both
years coupon time interest assuming during conversion the seven does years not a
nd occur.
$100
B in to seven nominal years value. time. Additionally, Therefore the the zero-cou
pon coupon-bearing loan debt note has is issued a coupon at a significant intere
st rate discount
higher
than the yield to maturity, driving its market value well above the nominal valu
e.
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14
(b)
Value of convertible debt
The market value of the zero-coupon loan note will be the greater of its value i
f converted
immediately, and its value as a loan note with four years until maturity.
100
The value as a loan note is:
= $7921
( 1.06 ) 4
If converted:
At a share price of $550, the value is 12 $550 = $6600
l
At a share price of $710, the value is 12 $710 = $8520
oWith a share price of $550 the value will be the loan note value o
of $7921
With a share price of $710 the value will be the value if converted of $8520
(c)
Warrants
hA warrant is a call option to purchase shares, at c
a specified price and time. If warrants are
held strategies.
as part of a portfolio, the delta and theta S values are useful in developing h
edging

If the underlying share price fell the price of call options would also fall, ca
using a loss for the
holder of warrants. This could be hedged y
by taking a short position in the underlying shares
(i.e. initially selling shares) so that gains on the falling share price offset
losses on the holding
of warrants.
d
price To perfectly to a change balance in the theunderlying gains/losses u share
requires price. knowledge This sensitivity of the is sensitivity measured of by
the delta. options
For
example, if 100 t
warrants are held and their delta is measured at 0.5 then it would be necessary
to The take theta a short value position S shows how in 50 the underlying price
of an shares.
option (warrant) changes over time. The value of a
holding of warrants would be eroded by the passing of time the nearer to the mat
urity date
of r
the warrant, the lower will be the remaining time value. Hence the holder of wa
rrants may
wish to exercise them early (although this would only be possible in the case of
American
style e options) or dispose of their holding in order to eliminate the time deca
y in their value.
k
ce
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15
(d)
Euromarkets
Euromarkets refer to borrowing (or investing) currency which is outside of its c
ountry of
issue. Effectively the Euromarkets are therefore the offshore markets.
Advantages of the Euromarkets include:
They are more flexible than many domestic markets and not subject to the same
degree of control.
The cost of borrowing in the Euromarkets is often slightly less than for the sa
me
l
currency in relevant domestic capital markets.
o
Interest is normally payable gross, which is attractive to some investors.
Very large sums can be quickly raised, without the queuing o
process that exists in
many domestic capital markets.
h
Issue costs are relatively low.
c
There Eurobonds, is an active in particular, secondary offer market the opportu
nity inS many types to swap of Euromarket interest payments security.
into a
more convenient form (e.g. fixed to floating rate), often at lower costs than
borrowing directly.

y
Potential problems include:
d
The company would either need to be rated highly by one of the international ra
ting
agencies for the company in order u to tooffer be able a guarantee to access fro
m the markets, its government or it would in association probably be with necess
ary
any
issue.
t
The minimum S sums involved in the Euromarkets may not be practical for the
company.
r
The cost of servicing foreign currency debt can rise dangerously if the value o
f that
e currency rises.
k
ce
B2016 DeVry/Becker Educational Development Corp. All rights reserved.
16
1
TROSOFT
Marking Scheme
(a)
Fees
2
Operating costs
3
Tax
2
CAPEX
1
Working capital
2
Cost of equity ungeared
2
Base case NPV
1
l
PV PV of of subsidy
tax shield
2
2
oIssue costs
1
APV
o

1
19
Discussion of other relevant factors
max h 7
Discussion of real options pricing theory
max 5
Conclusion
c

2
max 12
Use Professional of appendix
marks for:
S 1
Report heading and structure
1
Conclusion
Introduction
y
1
1
d

35
4
(b)
Overarching Commentaryduty on share of directors
options u schemes
max 1
5
Commentary on t
divestment
max 5
Commentary Conclusion
on S tax avoidance scheme
max
5
2
max 15

r
50

2
POLYTOT
e(a)
k
Calculation Forward contract:
of forward rate
1
c Futures:
Sterling receipt
2
e
Use Buy of contracts
December contracts
1
1
B Options:
Outcome Number of of contracts
hedge
2
1
Buy December calls
2
Number of options
2
Premium at chosen strike price
1

Outcome
2
Discussion and recommendation
4

19
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17
(b)
3
Analysis of financial viability
Other factors one mark per point
SHEGDOR
2
4

25

(a)
(b)
(c)
4
(a)
(b)(i)(ii)Analysis of fixed cost + variable cost with Mazila
3
Analysis of fixed cost + variable cost with Bettuna
3
Analysis of fixed + variable + mark up with Mazila
3
l
Analysis Explained of conclusion
fixed + variable + mark up with Bettuna
3
2
o
14
One mark per country
o
4
hTax Tax calculation calculation without with mixer
offshore mixer company
c
4
2
Conclusion
S
1
7

25
EWADE
y

Yield to maturity of convertible d

debt
2
Market Explanation price of of different non-convertible yields
u debt

2
2
Explanation of different t
prices
2

8
2 marks each
S 4
(c)
Understanding r
of warrants
Understanding of delta
Understanding Explanation e of of delta theta
hedging
k
Relevance of theta
(d)
c Advantages of Euromarkets one mark per point
e
Problems one mark per point
B1
2
1
1
1

max 5
max 4

6
max 7

25

2016 DeVry/Becker Educational Development Corp. All rights reserved.

18
Q Part
1
(a)
(b)
2016 DeVry/BeckerMOCK EXAM FEEDBACK SUMMARY PAPER P4 MOCK 1
Topic
APV
Study
Text ref
6
RQB
coverage
Strayer
Commentary
l
oIt is critical to read the requirement carefully you are asked to use APV as op
posed to NPV, the
reason risk and being potentially, that thedefault project risk. will be Infinan
ced fact, due o
by to debt diversifying and hence into disturb a new the area firms of operation
s, exposure to the financial
project
will operating also be cash of flows a different should class be discounted of b

usiness h at risk. a rate Hence, reflecting for the the base specific case busines
s NPV, risk the of investing the project
and
(i.e. the ungeared cost of equity c
of the internet auctions sector).
Then move onto the financing side effects (i.e. tax shield on debt, value of subsi
dy, issue costs).
could Note that, be argued as often that in issue this paper, costs S the would
model be 1.5/98.5 answer is not 3100 a unique = 47.2, approach and that to the t
he tax calculations shield should e.g. be
it
based upon the gross finance that would need to be raised (i.e. 3100 + 47.2). Fu
rthermore, it would be
acceptable (and arguably superior) to calculate the post-tax value of the subsid
y and to discount it at the
firms usual cost of debt y
(to measure default risk) i.e. 5.5%, as opposed to the risk-free rate.
so Most lost importantly, in d
calculations write that your you assumptions, miss the relatively show your fas
t and workings, easy marks produce for a comments.
clear answer and dont get
structure If you are u (e.g. struggling impact to find on employees, comments ab
out on society, non-financial on the factors environment then use stakeholder i.
e. a Corporate analysis as Social
your
t
Responsibility review).
S Regarding Arguably the ROPT internet consider auction the project four classic
could types have all of four real option of these (i.e. options delay, embedded
expand, redeploy, within it.
abandon).
Strategic,
1
Mucky
Good marks can be gained using common sense. Higher marks would be awarded for
comments on
financial and
r
Mining (c)
the appetite for risk that management may develop if granted share options, the
impact of divestment
ethical issues
e risks on the associated firms risk with profile tax avoidance (and hence schem
es..
cost of capital and valuation) and the reputational and regulatory
k
ce
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1
Q2
Part
(a)
(b)
3
(a)
(b)
2016 DeVry/BeckerMOCK EXAM FEEDBACK SUMMARY PAPER P4 MOCK 1
Topic
Study
RQB

Commentary
l
Text ref
coverage
oCurrency risk
14
Lammer
The four-month forward rate can be found by linear interpolation between the 3month and one-year
management
quotes.
o
A achieved futuresis contract found in is a a similar traded way forward i.e. li
near contract h interpolation and hence tothe 1 November expected between exchan
ge spot rate (1 that July) would and the
be
price of 31 December futures. As we want to protect against an appreciation in s
terling we would
establish the hedge on 1 July c
by buying sterling December futures (taking a long position makes a
gain on a rise in the underlying asset), then close out on 1 November by selling
the same contracts.
interpolated The model answer futures rate calculates for 1 S November; the numb
er acceptable of contracts alternatives by translating would be the to dollar di
vide exposure into spot at or the
the
price of December futures.
The option key is with sterling options (31,250). y
is to identify We want if we the should right, buy but not puts the or obligati
on, buy calls. The to buy underlying sterling; asset hence below we should
each
today buy d
calls.
Countertrade
17
No specific
Common loss during u sense transit should (obviously get reasonable insurance m
arks should here be taken).
e.g. the risk of physical deterioration or even total
Transfer
17
HGT
t
Common sense suggests that it would not be tax efficient to report profits in U
mgaba, due to its high
pricing
S tax that on calculations corporate prove profits the and optimal a withholdin
g transfer price tax on to dividend be at variable remittances. plus fixed Hence
cost.
it should be expected
Assembly should take place in the location which maximizes the overall post-tax
return for the group.
r
It is critical to understand how bilateral tax treaties operate; if the home co
untry tax rate is higher than
e than the overseas overseas rate then then no extra extra tax tax is is payable
payable in in the the home home country country, (but ifno the refund homeis co
untry given).
tax rate is lower
Transfer

k
17
Lamri (b)
Common sense suggests that governments may object to transfer prices being set
to manipulate taxes,
pricing
c and may insist on arms length or market prices being used (also recommended by
the OECD)
e
BEducational Development Corp. All rights reserved.
2
Q Part
3
(c)
4
(a)
2016 DeVry/BeckerMOCK EXAM FEEDBACK SUMMARY PAPER P4 MOCK 1
Topic
Study
RQB
Commentary
l
Text ref
coverage
oDividend
12
Boxless
It is not always tax efficient for overseas subsidiaries to remit dividends dir
ectly to the parent company.
mixer
40% Eventax if a has double been tax paid treaty overseas exists and there UK c
an tax o
is be 30% restrictions then, although on the no recovery further of tax oversea
s needs to tax be paid paid e.g. in the
if
UK, no refund will be given for the extra h 10% paid overseas.
Particularly if some subsidiaries are located in high tax jurisdictions and othe
r in lower tax jurisdiction, it
may be advantageous to establish c
a sub-holding company between the subsidiaries and the ultimate parent.
This dividend mixer company, established in a tax haven, collects the dividends fr
om various subsidiaries
and income then then pays the a single claim for dividend double S up tax to rel
ief the parent. can beIf maximized the parents and tax hence authorities globaltr
eat tax minimized.
this as a single source of
Obviously legal and ethical implications should be considered. Also note that in
practice, the UK tax
authorities, of mixer companies and many y
as other illegitimate countries, and have effectively general anti-tax tax the
income avoidance as legislation if it came directly and may from rule the severa
l
use
underlying d
sources.
Loan analysis
note
2
No specific
notes The redemption future u cash yield flows (yield to its to market maturity)

value. is the Ignoring discount the rate conversion that equates option, the th
e present only future value cash of a flow
loan
from the zero-coupon loan note is its redemption price.
t
S The As the market coupon price on of the debt straight is the present debt value
is paid of its every future six cash months flows, it discounted is necessary a
t its to yield use semi-annual
to maturity.
discounting to accurately value. It can be assumed that the given annual yield o
f 6% has been quoted
on a bond equivalent yield basis (i.e. double the semi-monthly rate, as opposed to
being an effective
r
rate). Hence the semi-annual discount rate is simply 3%.
e provides It is not surprising the investor that with the a straight cash flow
debt in has the a form higher of coupon market as value well than as redemption
the zero-coupon value.
loan note as it
k
Although the two debts have an identical maturity of seven years (and hence the
term structure of
interest rates cannot explain the difference in yields) the convertible loan not
e has a significantly lower
c yield than the straight debt. Possible explanations could include (i) better c
ollateral (ii) zero
reinvestment risk as no coupons are paid (iii) the existence of the conversion o
ption may boost the loan
e
notes market price and hence reduce its redemption yield.
BEducational Development Corp. All rights reserved.
3
Q4
Part
(b)
(c)
(d)
2016 DeVry/BeckerMOCK EXAM FEEDBACK SUMMARY PAPER P4 MOCK 1
Topic
Study
RQB
Commentary
l
Text ref
coverage
oValuation of
2
No specific
The market value of a convertible loan note will be the higher of the (i) prese
nt value of cash flows if
debt
convertible
held to redemption (ii) present value of cash o
flows if converted
The Greeks
13
Folter
Delta (found as N (d1) in the Black Scholes h model) gives the change in the va
lue of an option for a
(small)would havechange positivein value deltaof the (i.e. c

underlying if the share asset. price A rose warrant the is valueeffectivelyof t

heawarrantscall option wouldon a alsoshare rise).
and
0.50warrantsKnowledge and (a we longof hold delta position)100 would warrants, S al
low with we athe short would construction position need to on sell of the a (if del
taunderlyingshort hedge selling share. is - combining allowed)For example 50 the
shares.if holdingdelta This
was
of
would be a delta-neutral portfolio (i.e. any gains/losses on the value of warran
ts should be perfectly
cancelled by losses/gains y
on our short position in the share).
Theta measures time decay (i.e. the way in which expiration of time erodes the v
alue of options). Once
an option d
reaches its expiry date its time value equals zero.
Euromarkets
11
No specific
Euromarkets currency u is offshore refer to it the is borrowing/investing outsi
de of regulation of by a currency the issuing outside central of its bank, count
ry which ofgives issue. particular
Once a
t
advantages e.g. interest can be paid gross (without withholding taxes), banks o
perating offshore have
S more form rates (and flexibility (i.e. hence no register then can offer domesti
cof bondattractiveholders banks interestis and required), can rates applyto henc
eall a clients),narrower offering Eurobondsprivacy spread between to issuedinves
tors.
lendingby firmsandare bearer
deposit
So why dont all companies borrow in the Euromarkets? Firstly, an investment grade
credit rating is
r
usually required and secondly, if the debt is not denominated in the firms home
currency it may be
e exposed swaps).
to exchange rate risk (which us why many Eurobond issues are combined with curr
ency
k
ce
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