PART 3

WEDNESDAY 14 JUNE 2006

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 7, 8, 9 and 10

Do not open this paper until instructed by the supervisor

This question paper must not be removed from the examination
hall

The Association of Chartered Certified Accountants

Paper 3.7

Strategic Financial
Management

Section A BOTH questions are compulsory and MUST be attempted

1

Vadener plc has instigated a review of the groups recent performance and potential future strategy. The Board of
Directors has publicly stated that it is pleased with the groups performance and proposes to devote resources equally
to its three operating divisions. Two of the divisions are in the UK, and focus on construction and leisure respectively,
and one is in the USA and manufactures pharmaceuticals.
Recent summarised accounts for the group and data for the individual divisions are shown below:
Profit and loss accounts:
Turnover
Operating costs
Operating profit
Net interest
Profit before tax
Tax (30%)
Profit after tax
Equity dividends
Retained earnings
Balance sheets:
Fixed assets:
Tangible fixed assets
Intangible fixed assets
Current assets:
Stock
Debtors
Cash
Total assets
Less current liabilities:
Creditors
Short term loans
Taxation
Dividends

Financed by:
Long term liabilities
Shareholders equity

2003
1,210
800

410
40

370
111

259
146

113

Group data million

2004
1,410
870

540
56

484
145

339
170

169

2005
1,490
930

560
65

495
149

346
185

161

1,223
100

1,280
250

1,410
250

340
378
10

2,051

410
438
15

2,393

490
510
15

2,675

302
135
55
73

1,486

401
170
72
85

1,665

430
201
75
93

1,876

400
1,086

1,486

410
1,255

1,665

470
1,406

1,876

Note:
The 2005 amount for shareholders equity includes a 10 million loss on translation from the US division due
to the recent weakness of the $US.

Other group data at year end:

Share price (pence)
Number of issued shares (million)
Equity beta

2003
1,220
300

2004
1,417
300

2005
1,542
300
110

The companys share price has increased by an average of 12% per year over the last five years.
Other data at year end:
FT 100 index
PE ratio of similar companies
Risk free rate (%)
Market return (%)

2003
3,700
15:1

2004
4,600
14:1

2005
4,960
15:1
5
12

Divisional data 2005

Turnover (m)
Operating profit
Estimated after tax return (%)

Construction
480
160
13

Leisure
560
220
16

Pharmaceuticals
450
180
14

Data for the sector:

Average asset beta 2005

Construction
075

Leisure
110

Pharmaceuticals
140

Required:
(a) Evaluate and comment on the performance of Vadener plc and each of its divisions. Highlight performance
that appears favourable, and any areas of potential concern for the managers of Vadener. Comment upon the
likely validity of the companys strategy to devote resources equally to the operating divisions.
All relevant calculations must be shown. Approximately 19 marks are available for calculations,
and 9 for discussion
(28 marks)
(b) Discuss what additional information would be useful in order to more accurately assess the performance of
Vadener plc and its divisions.
(6 marks)
(c) Discuss the possible implications for Vadener plc of the 10 million loss on translation, and recommend what
action, if any, the company should take as a result of this loss.
(6 marks)
(40 marks)

[P.T.O.

(a) Lammer plc is a UK based company that regularly trades with companies in the USA. Several large transactions
are due in five months time. These are shown below. The transactions are in 000 units of the currencies shown.
Assume that it is now 1 June and that futures and options contracts mature at the relevant month end.
Company 1
Company 2
Company 3
Exchange rates:
Spot
3 months forward
1 year forward

Exports to:
$490

110

Imports from:
150
$890
$750

$US/
19156 19210
19066 19120
18901 18945

Annual interest rates available to Lammer plc

Borrowing
Investing
Sterling up to 6 months
55%
42%
Dollar up to 6 months
40%
20%
CME $/ Currency futures (62,500)
September 19045
December 18986
CME currency options prices, $/ options 31,250 (cents per pound)
CALLS
PUTS
Sept
Dec
Sept
Dec
18800
476
595
160
296
19000
353
470
236
434
19200
228
356
340
655
Required:
Prepare a report for the managers of Lammer plc on how the five-month currency risk should be hedged.
Include in your report all relevant calculations relating to the alternative types of hedge.
(20 marks)
(15 marks are available for calculations and 5 marks for discussion)
(b) In a typical financial year Lammer plc has net dollar imports of $42 million. This is expected to continue for five
years.
The companys cost of capital is estimated to be 11% per year. Taxation may be ignored, and cash flows may
be assumed to occur at the year end.
Required:
Assuming that there is no change in the physical volume or dollar price of imports, estimate the effect on
the expected market value of Lammer plc if the market expects the dollar to strengthen by 3% per year
against the pound.
(5 marks)
(c) Briefly discuss how Lammer plc might manage the economic exposure of any foreign subsidiaries in the USA.
(5 marks)
(30 marks)

Section B TWO question ONLY to be attempted

3

Ewade plc has recently issued 100 million par value of 100 zero coupon convertible debentures 2013 at a price
of 7110 per debenture. The debentures are redeemable at their par value of 100.
Conversion may take place at any time after three years from the issue date. The conversion terms are 12 ordinary
shares of Ewade for each debenture. The current redemption yield on Ewades 8% coupon straight debt with seven
years until maturity, and redeemable at the par value of 100, is 6%. The straight debt pays semi-annual interest.
Required:
(a) Estimate the redemption yield on the zero coupon convertible debentures, and the difference between the
market price of the seven year straight debt and the seven year zero coupon convertible debt. Explain the
reasons for the different market prices and yields.
(6 marks)
(b) Assume that in three years time the redemption yield of the zero coupon debt is 6% and the price of an ordinary
share of Ewade is:
(i) 550 pence
(ii) 710 pence
Required:
For each share price, estimate the minimum price of the zero coupon convertible debentures.

(4 marks)

(c) If Ewade held a portfolio including bonds with attached warrants and wished to protect the value of the
warrants, explain how the knowledge of the delta value and theta value might assist in this.
(5 marks)
(15 marks)

Arnbrook plc is considering a 50 million three year interest rate swap. The company wishes to have use of floating
rate funds, but because of its AA credit rating has a comparative advantage over lower rated companies when
borrowing in the domestic fixed rate market. Arnbrook can borrow fixed rate at 625% or floating rate at LIBOR plus
075%.
LIBOR is currently 525%, but parliamentary elections are due in six months time and future interest rates are
uncertain. A swap could be arranged using a bank as an intermediary. The bank would offset the swap risk with a
counterparty BBB rated company that could borrow fixed rate at 725% and floating rate at LIBOR plus 125%. The
bank would charge a fee of 120,000 per year to each party in the swap. Arnbrook would require 60% of any
arbitrage savings (before the payment of fees) from the swap because of its higher credit rating.
Any fees paid to the bank are tax allowable. The corporate tax rate is 30%.
Required:
(a) Discuss the risks that Arnbrook and a participating bank might face when undertaking an interest rate swap.
(3 marks)
(b) Evaluate whether or not the proposed swap might be beneficial to all parties.

(6 marks)

(c) If LIBOR was to increase immediately after the forthcoming election to 575% and then stay constant for
the period of the swap, estimate the present value of the savings from the swap for Arnbrook plc. Interest
payments are made semi-annually in arrears. Comment upon whether the swap would have been beneficial
to Arnbrook plc.
The money market may be assumed to be an efficient market.

(6 marks)
(15 marks)

[P.T.O.

Stafer plc, a UK company, is proposing to invest in two overseas countries. The first country, Xendia, has introduced
protectionist barriers and there are severe restrictions on the movements of funds between Xendia and other countries.
The government of Xendia wishes to encourage investment by Stafer plc and is prepared to relax these rules for the
proposed investment.
The second investment will be in Germany, where there are no restrictions on the movement of foreign exchange or
capital into or out of the country.
Risk free rate (%)
Market return (%)
Equity beta for the relevant industry
Long term borrowing rate (%)
Corporate tax rate (%)
Pre-tax cost of debt (%)
1World

UK
5
11
12
75
30
65

Germany
4
9
09
65
28
55

Xendia
7
14
14
10
35
90

World capital markets1

45
10
095
7
29
60

capital markets refers to markets where no significant barriers to the movement of foreign exchange or capital

exist.
Stafers capital structure if the two investments are undertaken is expected to be 50% equity, 50% debt by book
values, and 65% equity, 35% debt by market values. The debt would be borrowed in the relevant local capital market.
Required:
(a) Calculate and discuss what discount rates should be used in the evaluation of the investment opportunities
in Xendia and Germany.
(8 marks)
(b) Explain possible inaccuracies of the estimates in (a) above.

(3 marks)

(c) Briefly discuss whether or not the overseas subsidiaries should use the same capital structure as the group
as a whole.
(4 marks)
(15 marks)

Servealot plc has issued the following statement as part of its annual report:
This company aims at all times to serve its shareholders by paying a high level of dividends and adopting strategies
that will increase the companys share price. Satisfying our shareholders will ensure our success. The company will
reduce costs by manufacturing overseas wherever possible, and will attempt to minimise the companys global tax bill
by using tax haven facilities.
Required:
Discuss the validity and implications of each of the comments and strategies in the above statement.
(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
Put call parity PP = PC PS +XerT

[P.T.O.

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[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

10