Professional Documents
Culture Documents
Total receipts
Expenses:
Labour
Maintenance
Insurance
Capital allowances
Total expenses
Taxable
Taxation (30%)
(200)
(200)
(200)
4125
3437
1375
1146
10083
4249
3540
1416
1180
10385
4376
3647
1459
1216
10698
4507
3756
1502
1252
11017
4244
1500
212
6250
12206
(2123)
637
(1486)
6250
4370
1900
219
4688
11177
(792)
238
(554)
4688
4502
2300
225
3516
10543
155
(047)
108
3516
4637
2700
232
2637
10206
811
(243)
568
2637
(155)
4609
0812
3743
(159)
3975
0731
2906
(164)
3460
0659
2280
25000
(169)
28036
0593
16625
(200)
(515)
(25150)
0901
(22660)
5797
5797
0535
3101
=
=
=
=
4125
3437
1375
1146
million
million
million
million
Capital allowances:
It is assumed that allowances are available with a one year lag.
Year
0+1
2
3
4
Year available
2
3
4
5
No balancing allowances or charges have been estimated as the year 5 realisable value of fixed assets has been estimated
on an after tax basis.
As the hotel business is successful, it is assumed that allowances may be used as soon as they are available against other
taxable cash flows of Sleepon plc.
(iii) Interest is not a relevant cash flow. All financing costs are included in the discount rate.
(iv) The market research is a sunk cost.
(v)
15
(vi) Although the company will save money by advertising in its existing hotels, this is not a change in cash flow as a result of
the project and is not included in cash flows. (In effect the benefit from the savings is present as there is no cash outflow for
advertising).
(vii) Discount rate
The current weighted average cost of capital should not be used. The discount rate should reflect the risk of the investment
being undertaken; theme parks are likely to have very different risk to hotels. The cost of capital will be estimated using the
risk (beta) of Thrillall plc, as Thrillall operates in the theme park sector.
The market weighted capital gearing of Thrillall is:
Equity 400 x 386 = 1,544 m (783%)
Debt 460 x 093 = 428 m (217%)
As the gearing of Thrillall is much less than that of Sleepon, the beta used to estimate the relevant cost of equity will need to be
adjusted to reflect this difference in gearing.
Assuming corporate debt is virtually risk free:
Ungearing Thrillalls equity beta:
E
1,544
Beta asset = Beta equity x or 145 x = 1214
E + D (1 t)
1,544 + 428 (1 03)
Regearing to take into account the gearing of Sleepon:
E + D (1 t)
614 + 386 (1 03)
Beta equity = Beta asset x or 1214 x = 1748
E
614
The cost of equity may be estimated using the capital asset pricing model.
Ke = Rf + (Rm Rf) beta equity
Ke = 35% + (10% 35%) 1748 = 1486%
Kd is 75%, the cost of the new debt used for the project.
The weighted average cost of capital relevant to the new investment is estimated to be:
1486% (0614) + 75% (1 03) (0386) = 1115%
11% will be used as the discount rate for the investment.
Other relevant information
The financial projections used in the estimated net present value are subject of considerable inaccuracy. It would be useful to know:
(i)
The accuracy of estimates of attendance levels and spending in the theme park.
(ii)
The accuracy of the discount rate estimate. The activities of Thrillall are not likely to be of exactly the same risk as the theme
park project.
For a major investment it is unwise to rely on a single estimate of expected net present value. Sensitivity analysis or simulation
analysis should be used in order to ascertain the impact on the expected NPV of changes in attendance and other key cash flows.
It would be better to undertake simulation analysis, based upon different possible attendance levels, costs, risk, tax rates etc. in
order to estimate a range of possible net present values, rather than use a single point value.
A crucial question is what happens to cash flows beyond the companys four year planning horizon. The year five realisable values
are asset values, not the value of the theme park as a going concern. The value as a going concern could be very different from
the asset values, and have a major influence on the investment decision.
Will the theme park investment lead to future opportunities/investments (real options), for example in other theme parks or leisure
activities? If so the value of such options should be estimated, and should form part of the investment decision.
Strategic and other issues
The strategic importance of the venture to Sleepon must also be investigated, as this may heavily influence the final decision.
Sleepon currently runs a successful hotel chain. It might be better to keep to its core competence in hotels rather than diversify
into another sector. If new investments are sought are there better opportunities within the hotel sector?
Any final decision must encompass all relevant non-financial factors of which little detail has been provided. Sleepon must be
satisfied that it can recruit an appropriately skilled labour force for the theme park, and should thoroughly investigate the
competition in the theme park sector, and the likely reaction of competitors if it enters this new market.
16
(a)
At 3% interest:
PV annuity 56 x 4580
PV
100 x 0863
= 2424
= 7840
10264
= 2565
= 8630
11195
17
(c)
Report on the proposed adjustment of gearing through the repurchase of ordinary shares
The effect of capital structure on the value of a company is not fully understood.
Increasing the proportion of debt in the capital structure may reduce the overall cost of capital due to the interest on debt
being a tax allowable expense. Even if a company is in a non-tax paying position, mixing additional low cost debt with
relatively expensive equity might reduce the weighted average cost of capital. In such circumstances the proposed strategy to
increase gearing would have some validity. However, increasing gearing can also bring problems. Risk to investors, and
therefore the required returns on equity and debt, will increase as gearing increases. Very high levels of gearing might lead to
direct and indirect bankruptcy costs, with a detrimental effect on cash flow and corporate value. Any benefits from increasing
the proportion of debt in the capital structure will be to some extent offset as a result of increased risk with high gearing.
The revised estimates of the effect on the cost of capital and value of Semer are not likely to be accurate. Reasons for this
include:
(i)
The company will not be able to repurchase the necessary shares at their current market value. Approximately
240 million value of equity would need to be repurchased, or more than one third of the existing market value of equity.
As repurchases take place it is likely that the share price will significantly increase.
(ii)
The cost of debt is unlikely to remain constant. As more debt is issued lenders will demand a higher interest rate to
compensate for the extra risk resulting from higher gearing levels. The cost of equity will also increase with higher
gearing. These effects will increase the weighted average cost of capital to a higher level than that estimated.
(iii) The precise market values of debt and equity after the repurchase are unknown, and again will reflect the market attitude
to the new risk of the higher gearing.
The value of the company is likely to be much lower than that estimated, as the weighted average cost of capital is likely to
be underestimated.
(a)
The investment bank is offering to sell to Daylon plc an option to sell Mondglobe ordinary shares at a price no worse than
5% below the current market price of 360 pence. This is a put option on Mondglobe shares at a price of 342 pence. The
Black-Scholes option pricing model may be used to estimate whether or not the option price is a fair price. The value of a
put option may be found by first estimating the value of a call option and then using the put-call parity theorem.
Basic data:
Share price 360 pence
Exercise price 342 pence
Risk free rate 4% (004)
Volatility is measured by the standard deviation. The variance is 169% therefore the standard deviation, is 13% (013)
The relevant period is six months (05)
Using call price = PsN(d1) Xe rT N(d2 )
ln (360/342) + 04 (05)
d1 = + 05 (013) (05)5
13 (05)5
= 08218
d2 = d1 (T)05 = 08218 00919 = 07299
From normal distribution tables:
N(d1 ) = 05 + 02944 = 07944
N(d2 ) = 05 + 02673 = 07673
Inputting data into call price = Ps N(d1) Xe rT N(d2 )
342 (07673)
Call price = 360 (07944)
e (004)(05)
= 28598 25722 = 2876 pence
The value of a put option on a share may be estimated using the put-call parity theorem, P P = P C P S + Xe rT
The option exercise price is 342 pence, and the call option price has been estimated to be 2876 pence.
Therefore P P = 2876 360 + 342e(004)(05)
Solving, P P = 399 pence
Daylons holding of 5,550,000 shares multiplied by the put option price gives a fair option price according to the BlackScholes model of 221,445.
If the data is correct then the investment bank is charging 28,555 more than the theoretical fair value for the put option.
18
(b)
The option is for only a six month period. If Daylon wishes to protect against a price fall after that date then further
options will be necessary at additional cost.
(iii) There may be tax implications if any gains are made from the option.
(iv) There might be cheaper alternatives than the over the counter option. For example using stock index futures with the
hedge size adjusted for Mondglobes beta, or the use of a collar option which would reduce the premium costs, but
would limit any gains if Mondglobes share price was to increase.
(v)
(a)
The company might consider hedging the whole portfolio, not just the part represented by Mondglobes shares.
The advantages of a buy-out may be viewed from the perspectives of each of the parties involved.
The selling company may regard a buy-out as preferable to the liquidation of a loss making division. A buy-out might result
in a higher disposal price, and has the social effect of protecting jobs. Selling part of the organisation might allow the company
to focus on its core competence.
The current managers, with their existing expertise of the markets, relationships with clients etc may have a better chance of
successfully operating the company. They are also likely to be highly motivated through their significant equity holdings, and
by the potential for large capital gains if the company succeeds.
A venture capitalist or other type of investor normally takes a high risk, in the hope of high returns mainly through capital
gains. Most investors would seek some form of exit route for their investment after several years, possible through a listing
on the AIM or other relevant market. In some countries investing in buy-outs may offer tax advantages.
(b)
The increase in the value of equity may be estimated from the expected retained earnings over the four year period. The
maximum 15% dividend payment is assumed.
Year
Earnings before interest and tax
Interest 85%
Interest 9% loan1
1
320,000
170,000
27,000
123,000
36,900
86,100
12,915
73,185
873,185
800,000
2
410,000
170,000
23,411
216,589
64,977
151,612
22,742
128,870
1,002,055
3
500,000
170,000
19,499
310,501
93,150
217,351
32,603
184,748
1,186,803
4
540,000
170,000
15,236
354,764
106,429
248,335
37,250
211,085
1,397,888
Growth in the book value of equity from 800,000 to 1,397,888 over four years is a compound growth rate of 1497%. This
is considerably less than the 20% growth rate claimed by the managers.
It should be noted that this is a book value of equity. The market value of equity is much more relevant to a potential investor,
and is likely to be very different from this book value.
Note
1Interest
on the 9% loan
The equal annual payment comprising interest and capital that is necessary to pay off a 300,000 loan over six years is:
300,000
= 66,875 (4486 is the PV annuity factor for six years at 9%)
4486
Year
1
2
3
4
(c)
Remaining value
300,000
260,125
216,661
169,285
Interest
27,000
23,411
19,499
15,236
Repayment of capital
39,875
43,464
47,376
51,639
At the start of the buy-out, the equity holding would be 1,000,000 shares by the managers, and 600,000 by the venture
capital organisation. The initial warrant proposal would allow the venture capital organisation to purchase 300,000 new
shares after four years, a total of 900,000. The revised suggestion would allow 450,000 new shares to be purchased which
would give majority ownership and control of the company to the venture capital organisation. This is likely to be unacceptable
to the managers, unless they also will have further opportunities to increase their share ownership, for example through other
forms of option.
19
From a group perspective a sensible hedging strategy would be to net off as many offsetting currency receipts and payments as
possible, and to only hedge the relevant net amounts.
As MJY is a UK based multinational, the payments and receipts in pounds are not exposed to currency risk and should be ignored.
All $ and receipts and payments within the group and with third party companies are relevant when estimating the group
currency exposure. In the case of intragroup trade, a receipt for one company is a payment for another.
From a group view, relevant $ receipts are: 90 + 50 + 40 + 20 + 30 = 230
$ payments are: 170 + 120 + 50 = 340
$110,000 net payments need to be hedged
receipts are: 75 + 85 + 72 + 20 + 52 + 35 = 339
payments are: 72 + 35+ 50 + 20 + 65 = 242
97,000 net receipts need to be hedged
Forward market hedges:
$110,000
Buy $ 3 months forward: = 61,676
17835
97,000
Sell 3 months forward: = 67,408
14390
Currency options:
It is now 31 December. The time of the transactions is 31 March. As the February options will have expired, May options should
be used. Pounds need to be sold to purchase dollars, therefore MJY will need to purchase put options. The dollar payment is
$110,000, which is the equivalent of approximately one 62,500 option contract.
Option hedge
Strike price
$ if exercised
Premium ($)
180
178
112,500
111,250
3,338
2,625
Premium
(at spot 17982)
1,856
1,460
Overhedge ($)
2,500
1,250
Overhedge ()
(at forward 17861)
1,400
1,700
(a)
Historically, the most important protectionist measures were tariffs, a levy or effectively a tax on imports, and quotas, which
restricted either the volume or value of imports. In most recent years import barriers have tended to become more subtle,
largely in response to the actions of GATT (General Agreement on Tariffs and Trade) and the WTO, which sought to promote
free trade. Such barriers include explicit or hidden subsidies favouring local companies, and regulations/red tape that made
access to markets by importers difficult. These might include onerous environmental or health regulations, very lengthy
bureaucratic process before permission to import is given, and very slow customs procedures which delay the entry of goods
into a market. All of these measures are intended to deter overseas companies from exporting to the country.
(b)
The World Trade Organisation (WTO) in 1995 succeeded GATT (General Agreement on Tariffs and Trade) as the major world
forum for international negotiations and agreement in trade. It now encompasses almost 150 countries, which represent the
vast majority of world trade. In contrast to GATT, which focussed on the trade in goods, the WTO also covers trade in services
including banks, insurance companies, telecommunications and hotels, intellectual property and agriculture.
The WTOs overriding objectives are to promote freer trade and thereby to help trade flow smoothly, and to reduce or eliminate
protectionist barriers. It administers trade agreements, acts as a forum for negotiations and settles trade disputes. Its activities
involve:
(i)
(ii)
Encouraging lower tariffs and fairer trade around the world, including anti-dumping measures and subsidies.
20
(c)
A developing country that had recently joined the WTO would be expected to gradually reduce any barriers to trade of its
goods and services. However, because it is a developing country it would be permitted a much longer time to undertake such
measures. The effect on multinational companies could vary. If the multinational currently takes advantage of protectionist
barriers that exist in the country, such barriers would be gradually removed exposing the multinational to more competition.
However, freer trade might facilitate the expansion of the multinationals exports into more markets and stimulate demand for
its products. In either case the multinational company would normally have a considerable period of time in which to modify
its operations in response to the reduction in barriers to trade.
21
This question requires the detailed analysis of a potential capital investment in a new industry, including the identification of
relevant cash flows, and the risk of the investment. It also involves discussion of strategic and non-financial factors that might affect
the investment decision.
Marks
1
3
1
1
1
1
1
4
1
1
1
1
1
2
7
1
1
max 28
max 12
Total 40
This question requires understanding of how the cost of capital and value of a company might be estimated, and of the possible
affect on a companys market value when capital gearing is increased.
(a)
(b)
(c)
1
67
2
2
2
2
max 15
2
3
5
56
56
max 10
Total 30
23
Marks
3
(a)
(b)
6
3
1
10
12 marks for each point. Look especially for problems of Black-Scholes, alternative hedges, comments
about the total portfolio and the limited time horizon.
max 5
Total 15
(a)
1 mark for each valid point. Look for advantages to the various parties involved in the buy-out
(b)
Interest payments
Other elements in retained earnings estimate
Book value of equity and growth rate estimate
max 5
34
2
2
max 7
Bonus mark if comment is made about book value estimates not being very useful
(subject to 15 max for the question)
(c)
Total 15
1
1
$ net
net
Forward market hedges
Options hedge
Use of May put option
Option calculations including over hedge
Comment on possible benefit of not exercising the option, small hedge size
2
2
2
1
5
12
Total 15
(a)
(b)
(c)
24
Total 15