Mock 2

Advanced Financial
Management
P4AFM-MK2-X15-Q

Time allowed
Reading and planning: 15 minutes
Writing:
3 hours
This paper is divided into two sections
Section A
Section B

This ONE question is compulsory and MUST be

attempted
TWO questions only to be attempted

Formulae sheet and tables are on pages 913.

Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper
may be annotated.

2015DeVry/BeckerEducationalDevelopmentCorp.

Section A This ONE question is compulsory and MUST be attempted

1

Oakton Co, a company listed on the London Stock Exchange, has cash balances of $23
million which are currently invested in short-term money market deposits. The cash is
intended to be used primarily for strategic acquisitions, and the company has formed an
acquisition committee with an objective to identify possible acquisition targets. The
committee has suggested the purchase of Mallard Co, a company in a different industry that is
listed on the AIM (Alternative Investment Market). Although Mallard is listed, approximately
50% of its shares are still owned by three directors. These directors have stated that they
might be prepared to recommend the sale of Mallard, but they consider that its shares are
worth $22 million in total.
Recent financial data:

Revenue
Pre-tax operating cash flow
Taxation (33%)
Post-tax operating cash flow
Dividends
Non-current assets
Current assets
Current liabilities

Financed by
Ordinary shares (25 cents par)
Reserves
12% Bonds (8 years to redemption)
10% Bank loan

Oakton Co
$000
480,000
51,000
16,830
_______
34,170
11,000

3,551
842

168,000
135,000
99,680
_______

8,400
4,700
3,900
_______

203,320
_______

9,200
_______

10,000
158,320
20,000
15,000

(Mallard 10 cents par)

500
5,200

_______

Recent 11% bank loan 3,500

_______

203,320
_______

9,200
_______

Company data:
Current share price
Earnings yield
Average dividend growth
during the last five years
Equity beta
Industry data:
Average P/E ratio
Average P/E of companies
recently taken over, based
upon the offer price

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Mallard Co
$000
38,000
5,300
1,749
_______

785 cents
109%

370 cents
192%

7%
095

8%
08

10 : 1

6:1

12 : 1

7:1

The yield on Treasury bills is 6% per annum and the market return 14% per annum.
The rate of inflation is 24% per annum and is expected to remain at approximately
this level.
Expected effects of the acquisition would be:
(i)

50 employees of Mallard would immediately be made redundant at an

after-tax cost of $12 million. Pre-tax annual wage savings are expected to
be $750,000 (at current prices) for the foreseeable future.

(ii)

Some land and buildings of Mallard would be sold for $800,000 (after
tax).

(iii)

Pre-tax advertising and distribution savings of $150,000 per year (at

current prices) would be possible.

(iv)

Three of the existing directors of Mallard would each be paid $100,000

per year for three years for consultancy services. This amount would not
increase with inflation.

Oakton is also considering an investment in two overseas companies. Both companies claim
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
Revenue
Profit after tax
Share price (lire)
Equity beta

2011
432
55
1,058

Lire (million)
2012
2013
567
693
76
102
1,330
1,620

2011
12,000
1,840
236

Francs (000)
2012
2013
12,430
13,100
2,004
2,320
192
204

Company 2 in Knowland
Revenue
Profit after tax
Share price (francs)
Equity beta
Data for the two countries:
Asertia
Consumer price index
Stock market index
Yield on Treasury bills
Knowland
Consumer price index
Stock market index
Yield on Treasury bills

2011
4503
5,005
2011
100
10,200

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2014
810
126
2,001
155
2014
14,569
2,540
229
098

2012
6102
6,002

2013
7731
7,450

2014
9242
9,470
19%

2012
1043
8,896

2013
1071
9,320

2014
1108
9,457
4%

Required:
Acting as an external consultant you have been asked to prepare a report for the
acquisitions committee of Oakton. Your report should:
(a)

Explain why synergy might exist when one company merges with or takes over
another company.
(6 marks)

(b)

Estimate the value of Mallards equity based upon:

(i)
(ii)
(iii)

the use of comparative P/E ratios

the dividend valuation model
the present value of relevant operating cash flows over a 10-year
period, and

critically discuss the advantages and disadvantages of each of the three

valuation methods.
Recommend whether or not Oakton should offer $22 million for Mallards
shares.
(25 marks)
(Approximately 10 marks are available for discussion.)
(c)

Discuss the factors that might influence whether or not Oakton uses its cash
balances, rather than shares or bonds, to make payment for Mallard.
(3 marks)

(d)

Evaluate the performance of the companies in Assertia and Knowland. The

analysis should benchmark each companys performance against inflation and
share price growth against the respective market. Actual shareholder returns
should also be compared to those expected by the capital asset pricing model.
State what other information would be useful.
(12 marks)

Professional marks for the format, structure and presentation of the report.

(4 marks)
(50 marks)

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Section B TWO questions ONLY to be attempted

2

The CEO of Autocrat Co, a UK based company, is reviewing the companys interest rate and
currency risk strategies for the next few months.
There has recently been considerable political instability with some countries showing signs
of moving towards economic recession whilst others are still showing steady growth. Both
interest rates and currency rates could become more volatile for many major trading countries.
Autocrat is expected to need to borrow 6,500,000 for a period of six months commencing in
six months time. The interest rate will be set at three-month LIBOR prevailing at the date the
loan starts and will not be subsequently reset during the life of the loan.
The company also needs to make a US$ payment of $43 million in three-months time.
Assume that it is now 1 December. Futures and options contracts may be assumed to expire at
the end of the relevant month.
Three-month interest rate futures, 500,000 contract size:
March
June

9556
9529

Options on three-month interest rate futures, 500,000 contract size. Premiums are annual %
CALLS
95.25
95.50
95.75

March
0445
0280
0165

PUTS
June
0545
0390
0265

March
0085
0170
0305

June
0185
0280
0405

Three-month LIBOR is currently 45%

Foreign exchange rates:
Spot
Three-month forward

$14692 14709 per

$14632 14668 per

Currency option prices:

Philadelphia Stock Exchange $/ options, contract size 31,250, premiums are cents per
CALLS
1450
1460
1470

March
312
255
214

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PUTS
April

295

March
156
199
251

April

251

Required:
(a)

Discuss the relevant considerations when deciding between futures and options
to hedge the companys interest rate risk.
(4 marks)

(b)

Assuming that interest rates in six months time increase by 0.75% illustrate
the possible results of hedging interest rate risk using:
(i)
(ii)

futures; and
options

Explain why these results might not occur.

(c)

(13 marks)

Illustrate and discuss the possible outcomes of a forward market and a

currency option hedge if spot rates in three-months time are either:
(i)
or (ii)

$14350 $14386 per

$14780 $14820 per

(8 marks)
(25 marks)

The managers of Daylon Co are reviewing the companys investment portfolio. About 15% of
the portfolio is represented by a holding of 5,550,000 ordinary shares of Mondglobe Co. The
managers are concerned about the effect on portfolio value if the price of Mondglobes shares
should fall, and are considering selling the shares. Daylons investment bank has suggested
that the risk of Mondglobes shares falling by more than 5% from their current value could be
protected against by Daylon purchasing an Over The Counter (OTC) option. The investment
bank is prepared to sell an appropriate six-month option on 5,550,000 ordinary shares of
Mondglobe Co for a premium of $250,000.
Other information:
(i)

The current market price of Mondglobes ordinary shares is 360 cents per share.

(ii)

The annual variance of Mondglobes share price for the last year was 169%.

(iii)

The yield on Treasury bills is 4% per annum.

(iv)

No dividend is expected to be paid by Mondglobe during the next six-months.

Required:
(a)

Evaluate whether or not the price at which the investment bank is willing to
sell the option is a fair price.
(12 marks)

(b)

Discuss what factors Daylon should consider before deciding whether or not to
purchase the option.
(8 marks)

(c)

Discuss whether or not a straddle (buying puts and buying calls) with an
exercise price of 360 cents might be an appropriate hedging strategy for
Daylon. Explain the circumstances in which straddle options could be a
profitable strategy.
(5 marks)
(25 marks)

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Greffer Co is reviewing its plans for the next three years.

For the next three years revenues are forecast to increase by 5% per year from their current
level of $55 million and to remain constant thereafter. Variable operating costs have recently
been steady at 65% of revenues, and fixed costs at $9.8 million per annum.
Depreciation expense for the last financial year ending March 31 was $6.2 million and was
calculated on a reducing balance basis of 25% per year. This matches what is allowable for
tax purposes. No capital expenditure is planned for the next three years.
Statement of financial position as at 31 March:
$ million
3860
2620
(2020)

4460

Non-current assets
Current assets
Current liabilities1

Capital and reserves:

Medium and long term borrowing
Ordinary shares (25 cents par value)
Reserves

1050
1000
2410

4460

The companys financial targets for the next three years are:
(i)

Growth in pre-tax profits of 20% per year.

(ii)

To repay the overdraft within three years using retained profit.

(iii)

To satisfy a loan covenant that restricts the maximum book value of gearing
(measured by total borrowed funds to shareholders equity) to 35% in three years
time.

Other information:

(i)

The company consistently follows a 40% payout policy.

(ii)

The company pays an average interest rate of 7% per annum on each of its loans
and overdraft. Interest is paid each year on the opening balance of the overdraft.

(iii)

The companys weighted average cost of capital is 12%.

(iv)

The corporate tax rate is 30%.

(v)

Pre-tax profit in the most recent year was $2m.

Includes an overdraft of $95 million

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Required:
(a)

Prepare forecasts that show whether or not Greffer is likely to achieve its
financial targets. State clearly any assumptions that you make. (Full proforma statements of financial position are not required.)
(12 marks)

(b)

(i)

Suggest actions that Greffer might take if the objective of repaying

the overdraft in three years is not achieved.
(2 marks)

(ii)

Discuss the appropriateness of each of the companys financial

targets.
(4 marks)

(c)

Greffers current share price is 150 cents. Assume that after year three, annual
capital expenditure necessary for the company to continue its existing level of
operations will be $4 million, tax-allowable depreciation will be $35 million per
year. Working capital will remain constant.
Required:
Evaluate whether or not the share price is higher or lower than might be
expected by using free cash flow analysis. Comment upon your findings.
(7 marks)
(25 marks)

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Formulae
Modigliani and Miller Proposition 2 (with tax)

ke = kei + (1 T) (kei kd)

Vd
Ve

The Capital Asset Pricing Model

E(ri) = Rf+ i[E(rm) Rf]

The asset beta formula

Vd1 T
Ve
a =
e +
d
Ve Vd1 T Ve Vd1 T
The Growth Model

PO =

D O 1 g
re g

Gordons growth approximation

g = bre
The weighted average cost of capital

Ve
Vd
WACC =
ke +
kd1 T

Ve Vd
Ve Vd
The Fisher formula

(1+i) = (1+r) (1+h)

Purchasing power parity and interest rate parity

S1 = S0

1 h c
1 h b

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F0 = S0

1 i c
1 i b

Modified Internal Rate of Return

1

PV n
MIRR = R 1 re 1
PVI
The Black-Scholes option pricing model

c = PaN(d1) PeN(d2)e-rt
Where:

d1 =

1n (Pa /Pe ) r 0.5s 2 t

s t

d2 = d1 s t

The Put Call Parity relationship

p = c Pa + Pee-rt

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10

Present value table

Present value of 1 i.e. (1 + r)n

where

r = discount rate
n = number of periods until payment
Discount rate (r)

Periods
(n)
1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1
2
3
4
5

0.990
0.980
0.971
0.961
0.951

0.980
0.961
0.942
0.924
0.906

0.971
0.943
0.915
0.888
0.863

0.962
0.925
0.889
0.855
0.822

0.952
0.907
0.864
0.823
0.784

0.943
0.890
0.840
0.792
0.747

0.935
0.873
0.816
0.763
0.713

0.926
0.857
0.794
0.735
0.681

0.917
0.842
0.772
0.708
0.650

0.909
0.826
0.751
0.683
0.621

1
2
3
4
5

6
7
8
9
10

0.942
0.933
0.923
0.914
0.905

0.888
0.871
0.853
0.837
0.820

0.837
0.813
0.789
0.766
0.744

0.790
0.760
0.731
0.703
0.676

0.746
0.711
0.677
0.645
0.614

0.705
0.665
0.627
0.592
0.558

0.666
0.623
0.582
0.544
0.508

0.630
0.583
0.540
0.500
0.463

0.596
0.547
0.502
0.460
0.422

0.564
0.513
0.467
0.424
0.386

6
7
8
9
10

11
12
13
14
15

0.896
0.887
0.879
0.870
0.861

0.804
0.788
0.773
0.758
0.743

0.722
0.701
0.681
0.661
0.642

0.650
0.625
0.601
0.577
0.555

0.585
0.557
0.530
0.505
0.481

0.527
0.497
0.469
0.442
0.417

0.475
0.444
0.415
0.388
0.362

0.429
0.397
0.368
0.340
0.315

0.388
0.356
0.326
0.299
0.275

0.350
0.319
0.290
0.263
0.239

11
12
13
14
15

(n)

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1
2
3
4
5

0.901
0.812
0.731
0.659
0.593

0.893
0.797
0.712
0.636
0.567

0.885
0.783
0.693
0.613
0.543

0.877
0.769
0.675
0.592
0.519

0.870
0.756
0.658
0.572
0.497

0.862
0.743
0.641
0.552
0.476

0.855
0.731
0.624
0.534
0.456

0.847
0.718
0.609
0.516
0.437

0.840
0.706
0.593
0.499
0.419

0.833
0.694
0.579
0.482
0.402

1
2
3
4
5

6
7
8
9
10

0.535
0.482
0.434
0.391
0.352

0.507
0.452
0.404
0.361
0.322

0.480
0.425
0.376
0.333
0.295

0.456
0.400
0.351
0.308
0.270

0.432
0.376
0.327
0.284
0.247

0.410
0.354
0.305
0.263
0.227

0.390
0.333
0.285
0.243
0.208

0.370
0.314
0.266
0.225
0.191

0.352
0.296
0.249
0.209
0.176

0.335
0.279
0.233
0.194
0.162

6
7
8
9
10

11
12
13
14
15

0.317
0.286
0.258
0.232
0.209

0.287
0.257
0.229
0.205
0.183

0.261
0.231
0.204
0.181
0.160

0.237
0.208
0.182
0.160
0.140

0.215
0.187
0.163
0.141
0.123

0.195
0.168
0.145
0.125
0.108

0.178
0.152
0.130
0.111
0.095

0.162
0.137
0.116
0.099
0.084

0.148
0.124
0.104
0.088
0.074

0.135
0.112
0.093
0.078
0.065

11
12
13
14
15

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11

Annuity table

Present value of an annuity of 1 i.e.

where

1 (1 r ) n
r

r = discount rate
n = number of periods
Discount rate (r)

Periods
(n)
1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1
2
3
4
5

0.990
1.970
2.941
3.902
4.853

0.980
1.942
2.884
3.808
4.713

0.971
1.913
2.829
3.717
4.580

0.962
1.886
2.775
3.630
4.452

0.952
1.859
2.723
3.546
4.329

0.943
1.833
2.673
3.465
4.212

0.935
1.808
2.624
3.387
4.100

0.926
1.783
2.577
3.312
3.993

0.917
1.759
2.531
3.240
3.890

0.909
1.736
2.487
3.170
3.791

1
2
3
4
5

6
7
8
9
10

5.795
6.728
7.652
8.566
9.471

5.601
6.472
7.325
8.162
8.983

5.417
6.230
7.020
7.786
8.530

5.242
6.002
6.733
7.435
8.111

5.076
5.786
6.463
7.108
7.722

4.917
5.582
6.210
6.802
7.360

4.767
5.389
5.971
6.515
7.024

4.623
5.206
5.747
6.247
6.710

4.486
5.033
5.535
5.995
6.418

4.355
4.868
5.335
5.759
6.145

6
7
8
9
10

11
12
13
14
15

10.37
11.26
12.13
13.00
13.87

9.787
10.58
11.35
12.11
12.85

9.253
9.954
10.63
11.30
11.94

8.760
9.385
9.986
10.56
11.12

8.306
8.863
9.394
9.899
10.38

7.887
8.384
8.853
9.295
9.712

7.499
7.943
8.358
8.745
9.108

7.139
7.536
7.904
8.244
8.559

6.805
7.161
7.487
7.786
8.061

6.495
6.814
7.103
7.367
7.606

11
12
13
14
15

(n)

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1
2
3
4
5

0.901
1.713
2.444
3.102
3.696

0.893
1.690
2.402
3.037
3.605

0.885
1.668
2.361
2.974
3.517

0.877
1.647
2.322
2.914
3.433

0.870
1.626
2.283
2.855
3.352

0.862
1.605
2.246
2.798
3.274

0.855
1.585
2.210
2.743
3.199

0.847
1.566
2.174
2.690
3.127

0.840
1.547
2.140
2.639
3.058

0.833
1.528
2.106
2.589
2.991

1
2
3
4
5

6
7
8
9
10

4.231
4.712
5.146
5.537
5.889

4.111
4.564
4.968
5.328
5.650

3.998
4.423
4.799
5.132
5.426

3.889
4.288
4.639
4.946
5.216

3.784
4.160
4.487
4.772
5.019

3.685
4.039
4.344
4.607
4.833

3.589
3.922
4.207
4.451
4.659

3.498
3.812
4.078
4.303
4.494

3.410
3.706
3.954
4.163
4.339

3.326
3.605
3.837
4.031
4.192

6
7
8
9
10

11
12
13
14
15

6.207
6.492
6.750
6.982
7.191

5.938
6.194
6.424
6.628
6.811

5.687
5.918
6.122
6.302
6.462

5.453
5.660
5.842
6.002
6.142

5.234
5.421
5.583
5.724
5.847

5.029
5.197
5.342
5.468
5.575

4.836
4.988
5.118
5.229
5.324

4.656
4.793
4.910
5.008
5.092

4.586
4.611
4.715
4.802
4.876

4.327
4.439
4.533
4.611
4.675

11
12
13
14
15

2015DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved.

12

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(d), 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

2015DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved.

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