PART 3

WEDNESDAY 15 DECEMBER 2004

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

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

(a) Discuss the merits and potential problems of using each of the weighted average cost of capital and adjusted
present value to aid the evaluation of proposed capital investments.
(8 marks)
(b) Trosoft pte ltd is a Singapore based company specialising in the development of business software. The
companys managers believe that its future growth potential in the software sector is limited, and are considering
diversifying into other activities. One suggestion is Internet auctions, and a member of the management team has
produced the following draft financial proposal.

Year
Auction fees

Internet auctions project

S$000
0
1

4,300

Outflows:
IT maintenance costs
Telephone
Wages
Salaries
Allocated head office overhead
Marketing
Royalty payments for use of technology
Market Research
Rental of premises
Total outflows
Profit before tax
Tax
Other outflows:
IT infrastructure
Working capital
Net flows

2
6,620

3
8,100

4
8,200

1,210
1,215
1,460
400
85
420
500

1,850
1,910
1,520
550
90
200
300

1,920
2,230
1,680
600
95
200
200

2,125
2,420
1,730
650
100

200

1,290

280

5,570

290

6,710

300

7,225

310

7,535

(1,290)
316

(1,270)
311

(90)
22

2,700
400

(4,074)

24

(983)

24

(92)

500
680
110

875
(214)

25

636

665
(163)

26

476

Additional information:
(i) All data include the estimated effects of inflation on costs and prices wherever relevant. Inflation in Singapore
is forecast to be 2% per year for the foreseeable future.
(ii) The investment in IT infrastructure and the initial working capital will be financed by a 6 year 55% fixed
rate term loan. Other year 0 outlays will be financed from existing cash flows.
(iii) The Singapore government is expected to give a 1% per year subsidy to the cost of the loan to support the
creation of jobs associated with this project.
(iv) Highly skilled IT staff would need to be taken from other activities resulting in a loss of S$80,000 per year
pre-tax contribution for three years.
(v) Head office cash flows for overheads will increase by S$50,000 as a result of the project in year one, rising
by S$5,000 per year after year one.
(vi) Corporate tax is at a rate of 245% per year, payable in the year that the tax liability arises. The company
has other profitable projects.
(vii) Tax allowable depreciation on IT infrastructure is 20% for the first year, and straight line thereafter. The IT
infrastructure has an expected working life of six years after which major new investment would be required.
(viii) The companys current weighted average cost of capital is 78%.
(ix) The companys equity beta is 105.
(x) The average equity beta of companies in the Internet auctions sector is 142.
2

(xi) The market return is 95% per year and the risk free rate 4% per year.
(xii) Trosofts capital gearing is:
Book value 55% equity, 45% debt
Market value 70% equity, 30% debt
(xiii) The average gearing of companies in the Internet auction sector is 67% equity, 33% debt by market values.
(xiv) The market research survey was undertaken three weeks ago.
(xv) After tax operating net cash flows after year 4 are expected to stay approximately constant in real terms. The
royalty payment will remain at S$200,000 in money terms.
(xvi) Issue costs on debt are 15%. These costs are not tax allowable.
Required:
Acting as an external consultant you have been asked to prepare a report on the proposed diversification of
the company into Internet auctions. The report must include a revised financial analysis. You should use the
adjusted present value method for this purpose. Include in your report discussion of other financial and nonfinancial factors, including real options, that Trosoft might consider prior to making the investment decision.
(32 marks)
(23 marks are available for calculations of the APV and 9 marks for discussion)
(40 marks)

[P.T.O.

(a) From the perspective of a corporate financial manager, discuss the advantages and potential problems of
using currency swaps.
(8 marks)
(b) Galeplus plc has been invited to purchase and operate a new telecommunications centre in the republic of Perdia.
The purchase price is 2,000 million rubbits. The Perdian government has built the centre in order to improve the
countrys infrastructure, but has currently not got enough funds to pay money owed to the local constructors.
Galeplus would purchase the centre for a period of three years, after which it would be sold back to the Perdian
government for an agreed price of 4,000 million rubbits. Galeplus would supply three years of technical expertise
and training for local staff, for an annual fee of 40 million rubbits, after Perdian taxation. Other after tax net cash
flows from the investment in Perdia are expected to be negligible during the three year period.
Perdia has only recently become a democracy, and in the last five years has experienced inflation rates of between
25% and 500%. The managers of Galeplus are concerned about the foreign exchange risk of the investment.
Perdia has recently adopted economic stability measures suggested by the IMF, and inflation during the next three
years is expected to be between 15% per year and 50% per year. Galepluss bankers have suggested using a
currency swap for the purchase price of the factory, with a swap of principal immediately and in three years time,
both swaps at todays spot rate. The bank would charge a fee of 075% per year (in sterling) for arranging the
swap. Galeplus would take 75% of any net arbitrage benefit from the swap, after deducting bank fees. Relevant
borrowing rates are:
Galeplus
Perdian counterparty

UK
625%
83%1

Perdia
PIBOR + 20%
PIBOR + 15%

N.B. PIBOR is the Perdian interbank offered rate, which has tended to be set at approximately the current
inflation level. Inflation in the UK is expected to be negligible.
Spot
3 year forward rate

Exchange rates
854 rubbits/
Not available

Required:
(i)

Estimate the potential annual percentage interest saving that Galeplus might make from using a
currency swap relative to borrowing directly in Perdia.
(6 marks)

(ii) Assuming the swap takes place as described, provide a reasoned analysis, including relevant
calculations, as to whether or not Galeplus should purchase the communications centre. The relevant
risk adjusted discount rate may be assumed to be 15% per year.
(8 marks)
(c) As alternatives to the currency swap the bank has suggested:
(i)

A swaption with the same terms as the currency swap, and an upfront premium of 300,000.

(ii) A European style three year currency put option on the total expected net cash flow in year 3 at an exercise
price of 160 rubbits/, and an upfront premium of 17 million.
Required:
Discuss and evaluate the relative merits of these suggestions for Galeplus.

(8 marks)
(30 marks)

Section B TWO questions ONLY to be attempted

3

Assume that an important UK based client has asked you to review the performance of two overseas companies in
which he is thinking of investing. Both companies are claiming to have been successful during the last four years.
One company is located in the country of Asertia, the other in Knowland.
Company 1 in Asertia
Turnover
Profit after tax
Share price (lire)
Equity beta

Lire (million)
2000
1,432
1,155
1,058

2001
1,567
1,176
1,330

Company 2 in Knowland
Turnover
Profit after tax
Share price (francs)
Equity beta
Data for the two countries:
Asertia
Retail price (inflation) index
Stock market index
Risk free rate
Knowland
Retail price (inflation) index
Stock market index
Risk free rate

2002
1,693
1,102
1,620

2003
1,810
1,126
2,001
1155

Francs (000)
2000
12,000
11,840
11,236

2001
12,430
12,004
11,192

2002
13,100
12,320
11,204

2003
14,569
12,540
11,229
11098

2000
4503
5,005

2001
6102
6,002

2002
7731
7,450

2003
9242
9,470
1,19%

2000
11,100
10,200

2001
1043
8,896

2002
1071
9,320

2003
1108
9,457
114%

The equity betas and the risk free rate were estimated over the period 20002003.
Required:
(a) Prepare a report for the client discussing the performance of the two companies. Relevant calculations
should be included in the report.
(10 marks)
(b) Discuss what other information would be useful to assess the performance of the two companies.(5 marks)
(15 marks)

[P.T.O.

The remuneration committee of a plc is discussing the remuneration package that might to be offered to the
companys new managing director. Members of the committee have expressed different opinions. These include:
(i)

The managing director must be offered a salary at least 20% more than the average of similar sized companies
in order to attract the best candidates.

(ii) It is essential to offer a salary linked to turnover.

(iii) The managing director should be offered share options, exercisable in one years time, on at least 3,000,000
shares, at an exercise price of 25% below the current market price of 120 pence.
(iv) Remuneration should be a basic salary plus a proportion of the economic value added (EVA) of the company.
15% per year was the suggested proportion.
In the ensuing debate one committee member stated that a friend had recently bought one year European style put
options on the companys shares at a price of 35 pence. The options to be granted to the new managing director
would therefore be worth several million pounds. Such generosity would not be well received given recent newspaper
commentary about the excessive remuneration of senior managers in some companies.
Relevant company and market data is shown below:
Year ended 31 March 2004
million
Turnover
546
Cost of sales
(369)
Depreciation
(52)
Advertising
(10)
Net interest
(26)

Profit before tax

89
Taxation
(27)

Available to shareholders
62

Capital employed

million
31 March 2003 31 March 2004
420
458

Notes:
(i)

Accounting depreciation is approximately equal to economic deprecation.

(ii) Advertising has been 10 million per year for the last four years.
(iii) The companys cost of equity is 12%
(iv) The companys weighted average cost of capital is 95%
(v) The risk free rate is 4%
(vi) The corporate tax rate is 30%
Required:
(a) Discuss the relative merits of each of the four suggestions.

(6 marks)

(b) Some committee members have expressed concern about how much some of the suggestions might cost the
company.
For both the share option and EVA suggestions, estimate the potential cost to the company, and comment
on your findings. For EVA the estimate should be based upon the most recent relevant published data.
(9 marks)
(15 marks)

(a) Briefly discuss possible advantages to a multinational company from using a holding company based in a tax
haven.
(4 marks)
(b) Boxless plc has subsidiaries in three overseas countries, Annovia, Cardenda and Sporoon. Corporate taxes for the
three countries are shown below:

Annovia
Cardenda
Sporoon

Corporate income tax

rate
40%
25%
20%

Withholding tax
on dividends
10%

5%

% of after tax income

remitted to the UK
70
40
80

The UK corporate tax rate is 30%, and bilateral tax treaties exist between the UK and each of the three countries.
Under the treaties, any corporate tax paid overseas on income remitted to the UK may be credited against UK
tax liability. Boxless currently remits income from its overseas subsidiaries direct to the UK parent company.
The UK government currently only taxes income from multinational companies overseas subsidiaries when such
income is remitted to the UK. UK tax liability is based upon the grossed up dividend distributions to the UK
(grossed up at the local tax rate and before deduction of any withholding tax).
The UK government is now considering taxing the gross income earned by overseas subsidiaries. If such gross
income were to be taxed, credit against UK tax liability would be available for all corporate tax paid overseas.
Required:
(i)

Estimate the impact on the cash flows of Boxless if the UK government alters the tax rules as detailed
above.

Assume that the taxable income in each of the subsidiaries is the equivalent of 100,000.

(7 marks)

(ii) For each of the current and possible new tax rules, evaluate what benefit, if any, Boxless would
experience if it were to transfer income from its overseas subsidiaries to the parent company via a tax
haven holding company. Assume that the UK tax authorities would then treat all income from overseas
subsidiaries as coming from a single source, the tax haven holding company. Comment upon your
results.
(4 marks)
(15 marks)

Prepare a briefing document for a board of directors discussing issues that might influence a companys capital
structure strategy.
(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

+ 0.5 T

d 2 = d1 T
Put call parity PP = PC PS +XerT

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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

11