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PART 3

WEDNESDAY 11 JUNE 2003

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

BOTH questions are compulsory and MUST be


answered

Section B

TWO questions ONLY to be answered

Formulae sheet, present value, annuity and standard normal


distribution tables are on pages 8, 9, 10 and 11

Paper 3.7

Strategic Financial
Management

Section A BOTH questions are compulsory and MUST be attempted


1

Evertalk plc manufactures mobile phones and operates a mobile phone network. In order to offer the latest hand-held
videophone technology the company has borrowed extensively on the international bond market. Unfortunately the
new technology has proved to be unpopular with consumers, and sales of new handsets and network subscriptions
have been less than forecast. As a result the companys share price has fallen to only 10 pence, from a high two years
ago of 180 pence. Capital investment of approximately 100 million per year is required for the company to continue
operating at current levels 20 million for the manufacturing division and 80 million for the network division.
Approximately 25% of the sales of the manufacturing division are to the network division.
Profit and loss accounts for the years ending 31 March 2002 and 2003
million
2002
2003
Inflows:
Manufacturing division
280
320
Network division
410
470

690
790
Outflows:
Manufacturing division
190
230
Network division
490
560
Tax allowable depreciation
50
60

730
850
Pre-tax losses
(40)
(60)
Balance Sheet as at 31 March 2003
million
Land and buildings (net)
Other fixed assets (net)

120
175

295

Current assets
Stock
Debtors
Cash
Creditors:
amounts falling due within 1 year
Floating rate bank loans1
Creditors

260
85
5

350

40
209

(249)

Creditors:
amounts falling due after more than 1 year
12% unsecured bonds 2010

Shareholders funds
Ordinary shares (10 pence par)
Reserves

1Currently

8% interest

(300)

96
50
46

96

Evertalks board of directors has arranged a crisis meeting and is considering three proposals:
(i)

A corporate restructuring, in which bonds are converted to equity, and which gives control of the company to the
current bond holders.

(ii) Sale of the companys shares to Globtalk plc, which operates a successful rival mobile phone network, for the
sum of 50 million. This deal would be conditional upon Globtalk not taking over the liability for any of Evertalks
loans.
(iii) Cease trading and close the company.
The restructuring has the following proposed conditions:
(i)

Existing ordinary shares will be cancelled and replaced by 100 million new ordinary shares with a par value of
50 pence each. 95 million of these will be given to the existing bondholders in exchange for the cancellation of
all existing bonds. The bondholders will also make available 100 million of new 10% fixed rate loans.

(ii) Existing shareholders will be offered one 5% convertible debenture (100 nominal value) free of charge in
exchange for every 1,000 shares they now own. Conversion into new ordinary shares is available at any time
during the next five years at a conversion rate of 50 shares for every 100 convertible debenture held.
(iii) 5 million new shares will be given to existing participants in the companys share option scheme in exchange for
cancellation of their existing options to purchase 10 million old shares.
Other information:
(i)

All existing creditors have equal claims for repayment against the companys assets.

(ii)

No dividends have been paid on ordinary shares for the last three years.

(iii) Losses may not be carried forward for tax purposes.


(iv) Surplus land and buildings could be disposed of for 40 million in order to repay the bank loan.
(v)

The value of debtors, cash, fixed assets and creditors represented by the two divisions is approximately equal.
90% of the stock is represented by the manufacturing division.

(vi) The 300 million bond has been borrowed by the network division, and the 40 million bank loan by the
manufacturing division.
(vii) If the restructuring and new investment does not take place, earnings before tax (after interest payments) are
expected to stay at approximately the 2003 level. If new investment takes place, forecast earnings before interest
and tax are expected to increase by 30 million as a result of some rationalisation of the network division.
(viii) The current market price of ordinary shares is 10 pence, and of debentures 121. The par value and redemption
value of each debenture is 100.
(ix) Corporate tax is at the rate of 30%. The risk free rate is 5% and the market return 14%. The equity beta of the
company is 115, with the manufacturing division equity beta approximately 09, and the network division
equity beta approximately 135. The companys analysts believe that market weighted gearing of about 60%
equity, 40% debt is appropriate for the entire sector, but currently this cannot be achieved due to the low share
price.
(x)

Realisable values of assets

Land and buildings


Other fixed assets
Stock
Debtors

if not sold as part of a going concern are estimated to be:


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

(xi) Redundancy and closure costs of approximately 100 million would be payable if the company was closed, all
payable before any other creditors. These costs relate equally to the two divisions. All realisable values and
closure values are after tax.
Required:
Acting as an independent consultant prepare a report for the board of directors of Evertalk. Your report should
consider the advantages and disadvantages of each of the three proposals, from the viewpoint of each group of
existing stakeholders in the company. It should also identify any other strategy(ies) which might be possible for
Evertalk plc.
State clearly any assumptions that you make.
3

(35 marks)
[P.T.O.

Hasder plc currently operates only in the UK, but is considering diversifying its activities internationally into either
Europe or East Asia, the latter including several developing economies. Estimates have been obtained of the likely risk
and return of investments in these parts of the world, which are expected to vary during different economic states of
the UK. After either diversification approximately 30% of the market value of the company would be represented by
overseas investments.
UK economic state

Probability

Invest in Europe

Expected % IRR return


Invest in East Asia

03
05
02

7
12
21

2
30
15

Low growth
Average growth
Rapid growth

Invest in UK
6
13
17

Standard deviation of expected returns:


Europe
East Asia
UK

486
1226
403

Covariances of expected returns:


UK/Europe
UK/East Asia

1789
3198

Members of Hasders board of directors have different views about such diversification.
Director A believes that the company should focus exclusively upon the UK market as it always has, because overseas
investments are too risky.
Director B believes that overseas diversification will offer the company the opportunity to achieve a much better
combination of risk and return than purely domestic investments, and will open up new opportunities.
Director C considers that overseas investments are expensive, and overseas diversification will not be valued by
shareholders who could easily achieve such diversification themselves.
Director D is in favour of the diversification, but considers East Asia to be a much better alternative than Europe.
Director E is also in favour of East Asia, but suggests that a much higher proportion of the companys activities should
be located there, possibly between 50% and 70%.
Required:
(a) Discuss the views of each of the five directors. Include in your discussion relevant calculations regarding
portfolio risks and returns. What other factors might influence the investment decision?
State clearly any assumptions that you make.

(25 marks)

(b) Estimate and explain the implications of the correlation coefficients between:
(i)

UK/Europe; and

(ii) UK/East Asia.

(6 marks)

(c) Hasder plc has also purchased CAPM based risk and return estimates from an investment bank.

Europe
East Asia

Relevant market return

Relevant risk free rate

Relevant investment beta

13%
18%

5%
8%

085
132

Assuming this information is accurate, show how it might be used to assist the diversification decision.
(4 marks)
(35 marks)

Section B TWO questions ONLY to be attempted


3

(a) Discuss the advantages of hedging with interest rate caps and collars.

(6 marks)

(b) Current futures prices suggest that interest rates are expected to fall during the next few months. Troder plc
expects to have 400 million available for short-term investment for a period of 5 months commencing late
October. The company wishes to protect this short-term investment from a fall in interest rates, but is concerned
about the premium levels of interest rate options. It would also like to benefit if interest rates were to increase
rather than fall. The companys advisers have suggested the use of a collar option.
LIFFE short sterling options (500,000), points of 100%
Calls
Strike price
95250
95500
95750

Sept
0040
0
0

Puts
Dec
0445
0280
0165

Sept
0040
0250
0500

Dec
0085
0170
0305

LIBOR is currently 5% and the company can invest short-term at LIBOR minus 25 basis points.
Required:
(i)

Assume that it is now early September. The company wishes to receive more than 6,750,000 in
interest from its investment after paying any option premium. Illustrate how a collar hedge may be used
to achieve this. (N.B. It is not necessary to estimate the number of contracts for this illustration).
(7 marks)

(ii) Estimate the maximum interest that could be received with your selected hedge.

(2 marks)
(15 marks)

[P.T.O.

Discos plc is negotiating an export contract with a customer in a developing country, Xeridia. Discos has not exported
to the country before, and is concerned both about the risk of late or non-payment for the exports, and about the
foreign exchange risks associated with the Xeridian peso. The contract specifies that Discos should receive 55 million
Xeridian pesos in three months time. Discos will require short-term finance for the full value of the exports.
Exchange rates (peso/)
Spot
3234 3289
3 months forward
3382 3455
6 months forward
3517 3590
Current short-term UK interest rates available to Discos plc:
Borrowing
65%
Investing
53%
Discos is considering three different ways of protecting against the foreign trade risk:
(i)

Insure the deal with Protect Trade plc and undertake a forward market hedge. An insurance policy is available at
a cost of 125% of the spot Sterling equivalent of the export value. The policy gives the following protection: 95%
cover against non-payment as a result of political actions by a foreign government; 90% cover against other nonpayment. Any payment by the insurer would be after six months.

(ii) Use the services of a non-recourse export factor. The factor will guarantee that 1,590,000 is paid in three
months time if the customer pays on time, or 1,530,000 in six months time if the customer makes a late
payment or defaults. The factor is prepared to provide immediate trade finance of up to 80% of the value of the
guaranteed sum, at an interest rate of 63%. The factor charges an administration fee of 25% of the sum
guaranteed.
(iii) Use a confirmed, irrevocable, documentary letter of credit. The letter of credit would include a 90 day bank bill
of exchange that may be immediately discounted in the Xeridian money market at an annual rate of 25%, which
is the short term borrowing rate in Xeridia. The fees associated with the letter of credit are 30,000.
Discos has been advised that there is at least a 5% chance of late payment after six months or default by the client.
The Xeridian government is not expected to take any action that is detrimental to foreign trade during the next six
months.
Required:
Discuss the advantages and disadvantages of each alternative, and recommend which should be selected.
Relevant calculations should support your discussion. State clearly any assumptions that you make.
(15 marks)

(a) Briefly discuss possible reasons for an upward sloping yield curve.

(4 marks)

(b) The financial manager of Gaddes plcs pension fund is reviewing strategy regarding the fund. Over 60% of the
fund is invested in fixed rate long-term bonds. Interest rates are expected to be quite volatile for the next few
years.
Among the pension funds current investments are two AAA rated bonds:
1) Zero coupon June 2018
2) 12% Gilt June 2018 (interest is payable semi-annually)
The current annual redemption yield (yield to maturity) on both bonds is 6%. The semi-annual yield may be
assumed to be 3%. Both bonds have a par value and redemption value of 100.
Required:
(i)

Estimate the market price of each of the bonds if interest rates (yields):
(a) increase by 1%;
(b) decrease by 1%.

The changes in interest rates may be assumed to be parallel shifts in the yield curve (yield changes by an equal
amount at all points of the yield curve).
(6 marks)
(ii) Comment upon and briefly explain the size of the expected price movements from the current prices,
and how such changes in interest rates might affect the strategy of the financial manager with respect
to investing in the two bonds.
(3 marks)
(iii) How might the bond investment strategy of the financial manager be affected if the yield curve was
expected to steepen (the gap between short- and long-term interest rates to widen), and interest rates
are expected to rise?
(2 marks)
(15 marks)

(a) Discuss why conflicts of interest might exist between shareholders and bondholders.

(8 marks)

(b) Provide examples of covenants that might be attached to bonds, and briefly discuss the advantages and
disadvantages to companies of covenants.
(7 marks)
(15 marks)

[P.T.O.

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

d 2 = d1 T

+ 0.5 T

77


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10

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

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