Answers

Part 3 Examination Paper 3.7

Strategic Financial Management
1

June 2003 Answers

Report on the restructuring proposals of Evertalk plc.

Any decision should be taken in the best interests of the shareholders of the company, with due regard paid to other stakeholders
interests. The directors should not take decisions that are in their own best interests.
(i)

Corporate restructuring
For a restructuring to be successful it must treat all stakeholders fairly in accordance with their respective rights, and, if
possible, offer each group a more favourable outcome than would occur if the company were to be liquidated. The company
should also expect to be viable as a going concern as a result of the restructuring.
Estimated liquidation value:
Land and buildings
Other fixed assets
Stock
Debtors
Cash
Less redundancy and closure costs

Creditors
Bank loan
Bond
Other creditors

million
140
(including the surplus 40m)
50
100
70
5
(100)

265
40
300
209

549

If the company were liquidated, on average creditors would receive approximately 48% of cash due to them. Ordinary
shareholders would receive nothing.
Examining each of the individual stakeholders positions:
Bondholders:
The bondholders are to be offered 95 million shares in exchange for existing bonds of 300 million, effectively pricing each
share at 316 pence. They give up their rights to repayment of 300 million, of which about 145 million could be expected
if the company is liquidated (equivalent to a value of 153 pence per share). On the other hand they have to subscribe an
additional 100 million in order to allow rationalisation of the network division, and to improve the cash flow of the company.
The bondholders would gain control of the company, but this is only of value if the company is expected to survive.
The effect on the company is that interest of 300m 12% would be saved, and the 40 million bank loan would be repaid
from the disposal of surplus assets, saving a further 40m 8% = 32 million interest.
The projected free cash flow of the company is:

Current income from operations (after interest)

Add
Interest savings
Rationalisation gains
Add back depreciation
Replacement investment

(60)

Free cash flow

39
30
46
(100)

(45)

(300m 12% + 40m 8%)

(assumed to reduce pro-rata to the 40m disposal)

(Other items such as working capital are assumed to be constant)

On this basis, even without discounting, the company as a whole is not likely to be financially viable after the proposed
restructuring. In this situation the bondholders would be better not to accept the proposed reconstruction as they could
potentially lose more of their investment if the company were subsequently forced into liquidation. However, if the
bondholders accepted the offer and then closed the network division their position might be improved. The implications of
closing the network division are discussed below.
Existing shareholders
If the company fails, existing shareholders would receive nothing. The proposal gives them at least some possibility of future
value, and might be acceptable. Shareholders could of course currently sell their shares for 10 pence; however, if many of
the shareholders were to sell the price would fall from this level. The convertible offer would then need to be judged against
the revenue from the sale of shares. The initial conversion price of 200 pence per share does not look favourable; on current
evidence the share price is unlikely to reach 200 pence during the next five years.

15

Participants in the share option schemes

It is likely that currently the share options have little or no value as the current share price is so low. This offer appears to be
generous to this group who are existing managers/directors of the company, and probably unfair to other stakeholders.
Other creditors
The scheme does not offer any change in legal status to such creditors. It could, however, slightly improve the future financial
viability of the company, or, as the amount of loans outstanding is reduced, probably improve the proportion of funds repaid
in the event of liquidation. If, however, the new loans are secured, this could have an adverse effect on other creditors.
The proposed restructuring does not offer a viable financial solution to the companys current problems.
Other possible strategies: Closure of the network division
Given that the manufacturing division is performing much better than the network division, consideration should be given to
closing the network division. The subscriber base of the network division could possibly be sold. Future activities, and any
restructuring, could then be focussed on the manufacturing division that is currently profitable.
(ii)

Sale of the company to Globtalk

Globtalk would probably close the network division as it is loss making and a direct competitor to its own network. If the
network division is closed the receipts are expected to be:
million
Land and buildings
Other fixed assets
Stock
Debtors
Cash
Less:
Creditors
Bonds
Closure costs
Net liabilities

50
25
10
35
25
(1045)
(300)
(50)

(332 )

(100m 05. The other 40m is assumed to be used to repay the bank loan)
(50m 05 )
(100m 01)
(70m 05)

(209m 05)
(100m 05)

If the 300 million remaining bond liability is excluded from the closure, the outcome is an expected deficit on disposal of
only 32 million.
The projected free cash flow of the manufacturing division is:
Current income from operations (after interest)
Add back interest if bank loan is repaid

Tax (30%)
Add depreciation

Less replacement investment

Free cash flow

million
90
3

93
(28)
12

(tax would be payable in future)

(assumed to be relating to 20% of current annual
depreciation as the manufacturing division only undertakes
20% of replacement expenditure)

(20)

57

If the network division is closed and none of the lost sales (25%) are replaced, then free cash flow would reduce to
approximately 41 million. This is not an exact estimate, and in reality sales could increase rather than decrease, as Globtalk
would be likely to use the division as a supplier of phones to its own network customers. Without any sales reduction the
present value of the free cash flow to infinity at a 10% discount rate (see appendix below) is 570 million. If a shorter and
more conservative time horizon of 10 years is used the present value of a free cash flow of 57m per year for 10 years is:
57m 6145 = 350 million.
With a sales reduction the values are 410 million and 252 million.
Both of these estimates are well in excess of the 50 million price offered.
If Globtalk acquires Evertalk, there is potential also to access Evertalks existing network subscribers (or at least part of them),
and there could be vertical synergies with the manufacturing division. Even if Globtalk were to take full responsibility for
existing loans, at a total cost of 382 million (332m net liabilities plus 50m purchase cost), its offer could still be below
the expected value of Evertalk with the network division closed.
Given the above data it is recommended that any acquisition by Globtalk should be conditional upon the company accepting
liability for Evertalks existing loans.

16

(iii) Closure of the company

Closure of the entire company is not recommended. Given the poor performance of the network division it is recommended
that this division is closed. The manufacturing division is viable, and could either continue to be operated by Evertalk, or sold
to Globtalk. Closure of the network division would lead to a deficit of approximately 332 million (see above), which could
not easily be paid by the manufacturing division.
Conclusion:
Unless an alternative restructuring scheme can be agreed, which would reduce the burden of the closure of the network
division to the company, sale to Globtalk might be the best alternative, conditional upon Globtalk accepting the liability for all
existing loans.
Appendix: WACC for the manufacturing division:
Cost of equity for the manufacturing division:
Rf + (Rm - Rf) beta, or 5% + (14% 5%) 09 = 131%
The cost of debt may be estimated by using the current bank loan rate of 8%, or from the current bond price, by trial and
error.
12
12
121 = + + . . .
1 + Kd
(1 + Kd)2
At 8%

12
100
+ .
7
(1 + Kd)
(1 + Kd)7

12 5206 = 6247
100 0583 = 5830

12077

The cost of debt (before tax) is approximately 8%.

The weighted average cost of capital for the manufacturing division, using target gearing of 60% equity, 40% debt is:
131% (06) + 8% (1 03) (04) = 101%
10% will be used as the discount rate.
N.B. The after tax cost of debt is used as the manufacturing division is expected to pay tax in the future.
2

(a)

It is useful to estimate the return and risk of the two diversification alternatives before examining in detail the views of the
directors. The portfolio return is simply the weighted average of the expected returns of the two elements of the portfolio. The
portfolio risk may be estimated using the two-asset portfolio theory equation, based upon the expected risk and return of each
alternative.
Europe
Low growth
Average growth
Rapid growth

Probability
03
05
02

Return (%)
17
12
21

E (R)
21
60
42

123

Probability
03
05
02

Return (%)
12
30
15

E (R)
106
150
130

186

Probability
03
05
02

Return (%)
16
13
17

E (R)
18
65
34

117

East Asia
Low growth
Average growth
Rapid growth

UK
Low growth
Average growth
Rapid growth

Expected return UK/Europe (07) (117) + (03) (123) = 1188%

Expected return UK/East Asia (07) (117) + (03) (186) = 1377%
The two-asset portfolio equation measures the total risk of the portfolio. This will include some specific or unsystematic risk:
Portfolio risk UK/Europe
[(403)2 (07)2 + (486)2 (03)2 + 2(07) (03) (1789)]1/2
p = 420

17

Portfolio risk UK/East Asia [(403)2 (07)2 + (1226)2 (03)2 + 2(07) (03) (3198)]1/2
p = 591
Summary
UK alone
UK/Europe
UK/East Asia

Portfolio return
1170
1188
1377

Portfolio risk
403
420
591

Coefficient of variation
0344
0354
0429

It is not obvious from these results which investment is best. As risk increases, so does the expected return. The coefficient of
variation, which shows the amount of risk per pound of expected return, would suggest that continuing only in the UK is best.
However, the risk/return preferences of Hasder plc would need to be considered before a decision was made, as would strategic
and other issues discussed below.
Director A
Director As view has merit in that the company would be sticking to its core market and core competence. However, overseas
investments are not always too risky. Some overseas investments are less risky than UK investments. If total risk is considered then
international diversification can produce risk/return combinations that are not available from investing only in the UK. The benefits
of international portfolio diversification might reduce overall risk below that available in the UK, and provide better combinations
of risk and return for Hasder. This is the view of Director B who correctly states that international diversification will open up new
opportunities.
Director C produces no evidence that overseas investments are more expensive than UK investments. In many multinational
companies lower labour and materials costs have been key motives for overseas investments, hence such investments have been
cheaper than similar UK based investments.
If the company is investing overseas purely to achieve diversification it is fair to say that in most cases shareholders, by investing
in international unit trusts (mutual funds) or similar, could easily, and more cheaply, diversify for themselves. However, some
countries do not permit such portfolio investments, and their markets are largely segmented from major Western markets.
Segmented markets might include the developing markets in East Asia. Hasder might be able to offer risk/return combinations that
are valued by its shareholders if it invests in countries that they could not easily invest in themselves as part of their share portfolios.
Investing in segmented markets might also mean that the systematic risk of investments available to Hasder can be reduced,
especially if the segmented markets have a low or negative covariance with returns in the UK market.
International diversification might also result in less variability of the cash flows of Hasder, as the markets are not perfectly
correlated. This reduction in risk, if recognised by providers of finance, might result in lower financing costs, and a lower cost of
capital.
Director D
The summary table shows that investment in East Asia offers a higher potential return than in Europe, but at significantly higher
risk. If the coefficient of variation is considered then it is the least favoured alternative.
Director E suggests a much higher proportion of investment in East Asia. If 50% 70% was invested in Asia, and assuming
market values reflected these proportions:
50% Expected return UK/East Asia (05) (117) + (05) (186) = 1515%
70% Expected return UK/East Asia (03) (117) + (07) (186) = 1653%
Portfolio risk UK/East Asia
If 50%:
[(403)2 (05)2 + (1226)2 (05)2 + 2(05) (05) (3198)]1/2
p = 759
If 70%;
[(403)2 (03)2 + (1226)2 (07)2 + 2(03) (07) (3198)]1/2
p = 941
The potential returns increase significantly, as does risk. Unless Hasder is seeking very high returns and is prepared to take the
extra risk, there is no evidence to support the view that a higher proportion should be invested in East Asia. Such a move would
probably mean closing some UK operations with the resultant problems of redundancy, and would be a major strategic change
from the companys current position.
The risk and return evidence should only be part of the decision process. The data itself is likely to be subjective and inaccurate.
It is impossible to know with any degree of accuracy what future returns will be, and the assignment of probabilities to different
economic states is at best speculative.

18

Other factors that might influence the decision include:

(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(viii)
(ix)

How do the investments fit with Hasders strategic plans?

Has a full competitor/market analysis been undertaken?
Has the company any strategic reason for favouring Europe or East Asia?
Has political risk been considered, and its possible effects built into the cash flows?
Has foreign exchange risk been included?
Are there other investment alternatives?
What future options could arise from the investments?
What are the non-financial implications of the investments?
Is total risk the best measure of risk? Should systematic risk be used instead?

(b)

The correlation coefficient may be estimated by:

Covariance
.
Standard deviation A Standard deviation B
1789
= 091
403 486

(i)

UK/Europe

(ii)

3198
UK/East Asia = 065
403 1226

Although the returns between the UK and Europe and the UK and East Asia are both positively correlated, the degree of
correlation is much higher for the UK and Europe at 091. This means that relatively little risk reduction will take place
because of the strong relationship between the UK and Europe. This is evidenced by the portfolio standard deviation of 420,
which is little different from the individual standard deviations.
The lower correlation coefficient of 065 between the UK and East Asia allows much more risk reduction from international
diversification, with the standard deviation of East Asia alone (1226) reducing to a much safer 591 as part of a portfolio
with the UK.
(c)

Using CAPM
Required return = Risk free rate + (Market return Risk free rate) beta
Europe: required return is 5% + (13% 5%) 085 = 11.8%
The expected return is 123%. The European investment is expected to provide an abnormally good return for its systematic
risk, and on that basis would be recommended.
East Asia: required return is 8% + (18% 8%) 132 = 212%
The expected return is 186%. The investment is not providing sufficient return for its systematic risk and would not be
recommended.
However, strategic and non-financial factors should also play a major role in the decision process.

(a)

Interest rate caps and collars are available on the over the counter (OTC) market or may be devised using market based
interest rate options. They may be used to hedge current or expected interest receipts or payments. An interest cap places an
upper limit on the interest rate to be paid, and is useful to a potential borrower of funds at a future date. The borrower by
purchasing a cap, will limit the interest paid to the agreed cap strike price (less any premium paid). OTC caps are available
for periods of up to 10 years and can thus protect against long-term interest rate movements. As with all options, if interest
rates were to move in a favourable direction the buyer of the cap could let the option lapse and take advantage of the more
favourable rates in the spot market.
The main disadvantage of options is the premium cost. A collar option reduces the premium cost by limiting the possible
benefits of favourable movements. It involves the simultaneous purchase and sale of options, or, in the case of OTC collars
the equivalent net premium to this. The premium paid for the purchase of the options would be partly or wholly offset by the
premium received from the sale of options. Where it is wholly offset a zero cost collar exists.

(b)

For the company to earn interest of 6,750,000 it would need to earn an

annualised interest rate, after premium costs of

6,750,000

400,000,000

19

12
= 405%
5

The collar needs to produce a minimum of more than 405% including premium costs.
As Troder plc is investing, a lending collar will be required whereby the company will simultaneously buy a floor and sell a
cap. Buying a call option that will increase in value if interest rates fall will set the floor, or minimum interest rate. The cap,
achieved by selling put options, will set the maximum interest, with the company foregoing any higher interest rate than the
put option exercise price, but paying a lower overall premium. The overall cost of the collar will be the call option premium
paid less the put option premium received.
In order to achieve a return of more than 405% (6,750,000) a collar needs to be arranged with the call strike price higher
than the put strike price (in order to set the maximum interest that can be received).
Alternatives are:
Call strike price
95750
95750
95500

Interest rate
425%
425%
450%

Less call cost

0165%
0165%
0280%

Plus put receipt

0170% (95500)
0085% (95250)
0085% (95250)

Less 025%
025%
025%
025%

Total
4005%
392%0
4055%

Only the purchase of a call at 95500 and sale of a put at 95250 will result in a minimum return of 6,750,000. The actual
minimum return (ignoring any possible remaining time value that might increase the return) is:
5
400,000,000 4055% = 6,758,333
12
N.B If a collar is set with the same put and call price the return will be
Strike price
95250
95500
95750

Interest rate
475%
450%
425%

Less call cost

0445%
0280%
0165%

Plus put receipt

0085%
0170%
0305%

Less 025%
025%
025%
025%

Total
414%
414%
414%

This would achieve the required 405%, but would not allow Troder to take advantage of any favourable movement in interest
rates.
(ii)

The maximum return would occur if market interest rates are at least 475% and the call option were allowed to lapse. The
put option would be exercised by its buyer and the maximum overall return would be:
Strike price
95500

Interest rate
(call not exercised)
475%

Less call cost

Plus put receipt

Less 025%

Total

0280%

0085%

025%

4305%

This would yield:

5
400,000,000 4305% = 7,175,000
12
4

(i)

The use of trade insurance limits the effect of possible payment/default, although Discos would still have to bear some of the
risk.
The spot equivalent of 55 million pesos is:
55
= 1,672,241
3289
55
The three month forward rate is: = 1,591,896
3455
This is much less favourable than the spot rate, but has the advantage of fixing the expected cash flow from the export deal.
If payment is received in three months:
Receipts from payment
Interest cost
Insurance cost

1,591,896
(27,174)
(20,903)

1,543,819

(1,672,241 65% 3/12)

(1,672,241 125%)

20

If payment is not made in three months the forward contract will have to be fulfilled, or rolled over at an unknown cost. The
late payment/default is assumed not to be the result of government action. If exchange rates dont change during the months
46 (which is very unlikely):
In six months receive:

55 09

3590
Interest cost (six months)
Insurance cost

1,378,830
(54,348)
(20,903)

1,303,579

If the estimated 5% risk of late payment or default is accurate, the expected return is
(1,543,819 095) + (1,303,579 005) = 1,531,807
(ii)

The use of an export factor eliminates foreign exchange risk as payment will be made in sterling. As the factor is non-recourse,
the factor bears the risk if the customer pays late/defaults, except for the reduced sterling payment in six months that would
be made to Discos. The factor will also take responsibility for the debt collection process.
If the customer pays in three months:
Receipts from payment
Factor interest cost
Other interest cost
Factor fee

1,590,000
(20,034)
(6,504)
(39,750)

1,523,712

(1,590,000 08 63% 3/12 )

[(1,590,000 02 + 82241) 65% 3/12 ]
(1,590,000 25%)

If the customer pays late/defaults:

Receipts from payment
Factor interest cost
Other interest cost
Factor fee

1,530,000
(40,068)
(13,008)
(39,750)

1,437,174

(1,590,000 08 63% 6/12 )

[(1,590,000 02 + 82241) 65% 6/12 ]
(1,590,000 25%)

Expected return is (1,523,712 095) + (1,437,174 x 005) = 1,519,385

Other issues:
(1) Will the factor be prepared to undertake a one off deal, or will further business be required?
(2) Will the use of the factor improve the chance of payment? Most factors are subsidiaries of major banks, and might have
more market power to achieve payment.
(3) Will Discos save administrative/labour costs if the factoring company undertakes the debt collection process? If so such
savings would need to be included in any financial assessment.
(iii) The use of a documentary letter of credit should ensure that Discos receives the due payment. The letter of credit is confirmed
and irrevocable, which means that as long as Discos correctly presents all the agreed documents to the importers bank
(normally via the exporters bank), both banks guarantee to make payment to the exporter (or to the third party holding the
discounted bill of exchange). Thus in the case of late payment/default the guaranteeing banks will bear the risk. Letters of
credit are very useful for high value exports, and when dealing with customers whose creditworthiness is uncertain, as is the
case here.

55m (1 (025 3/12 ))

Discounted receipts from payment
1,567,726

3289
Arrangement cost
(30,000)

1,537,726
The banks guaranteeing the bill will be liable for payment on the bill. Discos plc will immediately discount the bill in Xeridia
and convert the net proceeds into sterling at the spot rate, in order to raise the necessary finance. Discos will face no further
foreign exchange risk or commercial risk.
Recommendation:
Unless Discos could make substantial administrative savings from option (ii), option (iii), the use of a confirmed letter of credit
results in the highest expected receipts and is the recommended alternative.

21

(a)

A yield curve may be upward sloping because of:

(i)

Future expectations. If future short-term interest rates are expected to increase then the yield curve will be upward
sloping.

(ii)

Liquidity preference. It is argued that investors seek extra return for giving up a degree of liquidity with longer-term
investments. Other things being equal, the longer the maturity of the investment, the higher the required return, leading
to an upward sloping yield curve.

(iii) Preferred habitat/market segmentation. Different investors are more active in different segments of the yield curve. For
example banks would tend to focus on the short-term end of the curve, whilst pension funds are likely to be more
concerned with medium and long term segments. An upward sloping curve could in part be the result of a fall in demand
in the longer term segment of the yield curve leading to lower bond prices and higher yields.
(b)

(i)

The current market prices of the two bonds may be estimated to be:
100
Zero coupon = 4173
(106)15
12% gilt with a semi-annual coupon
1 (103)30
Present value of an annuity for 30 periods at 3% is = 196004
003
Present value of interest payments
1
Present value of redemption using
(1 + 003)30

6 196004 = 11760
100 04120 = 4120

15880

If interest rates increase by 1%

100
Zero coupon = 3625, a decrease of 548 or 131%
(107)15
12% gilt
1 (1035)30
Present value of an annuity for 30 periods at 35% is = 183920
0035
Present value of interest payments

6 183920 = 11035

1
Present value of redemption using 100 03563 = 3563
(1 + 0035)30

14598
This is a decrease of 1282 or 81%
If interest rates decrease by 1%:
100
Zero coupon = 4810, an increase of 637 or 153%
(105)15
12% gilt with a semi-annual coupon
1 (1025)30
Present value of an annuity for 30 periods at 25% is = 209303
0025
Present value of interest payments

6 209303 = 12558

1
Present value of redemption using 100 04767 = 4767
(1 + 0025)30

17325
This is an increase of 1445 or 91%

22

(ii)

The price/yield relation is not linear; it has a convex shape. There is a bigger absolute movement in bond prices when
interest rates fall than when they rise. The percentage movement is also higher for low coupon bonds than high coupon
bonds. Other things being equal, a financial manager would prefer to hold high coupon bonds if interest rates are
expected to increase, and low or zero coupon bonds when interest rates are expected to decrease.

(iii) If interest rates are expected to rise, and the gap between yields on short and long dated bonds to widen, the financial
manager would not want to hold longer dated bonds as these would suffer a larger fall in price than short dated bonds.
Short dated bonds, probably with high coupons, would be preferred.
6

(a)

Bondholders are concerned that payments of interest and repayments of principal are made on time and without problems.
The willingness of bondholders to provide funds to companies depends upon the risks and returns that they face, including
the companies expected cash flows, assets (including available security on assets), and credit ratings. Shareholders, in
theory, seek to maximise the value of their shares. This is not necessarily consistent with the interests of bondholders, or the
incentive to maximise the total value of the company (the value of equity plus debt). Shareholders seeking to maximise their
wealth might take actions that are detrimental to bondholders. For example, shareholders, normally through their agents,
managers, might use the finance provide by bondholders to invest in very risky projects, which change the character of the
risk that the bondholders face. If the risky projects are successful, then the rewards flow primarily to the shareholders. If the
projects fail then much of the cost of failure will fall on the bondholders. If there are no constraints on shareholders, the
shareholders might have a natural incentive to take such risks. Management, acting on behalf of shareholders, might also
reduce the wealth, and/or increase the risk of bondholders by:
(i)

Selling off assets of the company;

(ii)

Paying large dividends;

(iii) Borrowing additional funds that rank above existing bonds in terms of prior payment upon liquidation.
The incentive for shareholders to take on risks at bondholders expense is especially strong when the company is in financial
difficulties and in danger of failing. In such circumstances the shareholders may believe that they have little to lose by
undertaking risky projects. In the case of corporate failure significant bankruptcy costs normally exist. Direct costs of
bankruptcy include receivers and lawyers fees, whilst indirect costs might include loss of cash flow prior to failure through
loss of sales, worse credit terms etc. When corporate failure occurs most of the firms value will be transferred to its debt
holders who ultimately bear most of the bankruptcy costs.
(b)

Bond covenants might include:

(i)

An asset covenant. This would govern the companys acquisition, use and disposal of assets. This could be for specified
types of assets, or assets in general.

(ii)

Financing covenant. This covenant often defines the type and amount of additional debt that the company can issue,
and its ranking and potential claim on assets in case of future default.

(iii) Dividend covenant. A dividend covenant restricts the amount of dividend that the company is able to pay. Such
covenants might also be extended to share repurchases.
(iv) Financial ratio covenants, fixing the limit of key ratios such as the gearing level, interest cover, net working capital, or a
minimum ratio of tangible assets to total debt.
(v)

Merger covenant, restricting future merger activity of the company.

(vi) Investment covenant, concerned with the companys future investment policy.
(vii) Sinking fund covenant whereby the company makes payments, typically to the bond trustees, who might gradually
repurchase bonds in the open market, or build up a fund to redeem bonds.
There will often also be a bonding covenant that describes the mechanisms by which the above covenants are to be
monitored and enforced. This often includes an independent audit and the appointment of a trustee representing the interests
of the bondholders
From the companys perspective the major disadvantage of covenants is that they restrict the freedom of action of the
managers, and could prevent viable investments, or mergers from occurring. They also necessitate monitoring and other costs.
However, covenants are also of value to companies. Without covenants the company might not be able to raise as much funds
in the form of debt, as lenders would not be prepared to take the risk. Even if lenders were to take the risk they would require
a higher default premium (higher interest rates) in order to compensate for the risk. The existence of covenants therefore
reduces the cost of borrowing for a company.

23

Part 3 Examination Paper 3.7

Strategic Financial Management
1

June 2003 Marking Scheme

This question requires the analysis of which strategy, if any, a company in financial difficulties should adopt. It tests knowledge of
the principles of corporate restructuring and the valuation of companies, and requires the ability to use financial information to
suggest alternative strategies that a company might use.
Marks
1
1

Report format
Overall principle(s) that should influence the decision
Corporate restructuring
Fair treatment
Financial viability estimates/comments
Liquidation value
Stakeholders positions:
Bondholders
Shareholders
Option holders
Other creditors

1
23
2
23
2
2
2

Max 15

Sale to Globtalk
Cost of capital
Valuation preferably using free cash flow
Conclusion

Max

5
67
12

Max 12

Closure of the company. Discussion/calcs

34

Alternative suggestions. Reward sensible suggestions, especially related

to the viability of the manufacturing division.
Allow for overlap

45

Total 35
2

This question requires understanding of the potential benefits of international diversification, and the ability to analyse risk and
return data in order to assist investment decision-making.
(a)

Estimates of risk and return

UK and other returns
Europe/UK risk and return
East Asia/UK risk and return
Views of directors
A
B
C
D
E including additional calculations

2
3
3

Overall views of directors

Marks may be credited for relevant overlap
Other factors relevant to the decision 1 mark for each good point

23
2
23
1
34

max 10
max 7

max 25

(b)

Estimates
Discussion

3
3

(c)

Estimates of required return

Discussion of implication for the diversification decision

2
2

4
Total

25

35

(a)

Advantages of caps
Advantages of collars

(b)

Required interest yield

Collar calculations

Marks
3
3

6
1
6

Give credit for technique

(c)

Maximum yield if option is not exercised

2
Total 15

Insurance plus forward market

Non-recourse factor
Documentary letter of credit plus discounting
Conclusion
Reward technique.

5
56
4
1
Total 15

(a)

For full marks three reasons are necessary

(b)

(i)

Current market prices

Increase 1%
Decrease 1%

2
2
2

(ii)

Reward awareness of different size of movement and its implication

(iii) Full marks for correct interpretation

2
Total 15

( a ) Discussion of reasons 12 for each good point

(b)

max

Examples of covenants. 1 mark for each sensible suggestion

Advantages and disadvantages to companies (not investors!)

max

8
5
23

Total 15

26