Answers

Part 3 Examination Paper 3.7 Strategic Financial Management

December 2006 Answers

Tutorial note: These model answers are considerably longer and more detailed than would be expected from any candidate in the examination. They should be used as a guide to the form, style and technical standard (but not in length) of answer that candidates should aim to achieve. However, these answers may not include all valid points mentioned by a candidate credit will be given to candidates mentioning such points. 1 (a) The valuation of private companies involves considerable subjectivity. Many alternative solutions to the one presented below are possible and equally valid. As Stanzial is considering the purchase of Besserlot, this will involve gaining ownership through the purchase of Stanzials shares, hence an equity valuation is required. Before undertaking any valuations it is advisable to recalculate the earnings for 2006 without the exceptional item. It is assumed that this is a one-off expense, which was not fully tax allowable. The revised profit and loss account is: 2006 000 22,480 1,302 280 1,022 307 200 515

Turnover Operating profit before exceptional items Interest paid (net) Profit before taxation Taxation (30%) Dividend Retained earnings

Asset based valuation An asset valuation might be regarded as the absolute minimum value of the company. Asset based valuations are most useful when the company is being liquidated and the assets disposed of. In an acquisition, where the company is a going concern, asset based values do not fully value future cash flows, or items such as the value of human capital, market position etc. Asset values may be estimated using book values, which are of little use, replacement cost values, or disposal values. The information provided does not permit a full disposal value, although some adjustments to book value are possible. In this case an asset valuation might be: Net assets Patent Stock adjustment 000 6,286 10,000 (1,020) 15,266 or 15,266,000

This value is not likely to be accurate as it assumes the economic value of fixed assets is the same as the book value, which is very unlikely. The same argument may also be related to current assets and liabilities other than stocks. PE ratios PE ratios of competitors are sometimes used in order to value unlisted companies. This is problematic as the characteristics of all companies differ, and a PE ratio valid for one company might not be relevant to another. There is also a question of whether or not the PE ratio should be adjusted downwards for an unlisted company, and how different expected growth rates should be allowed for. Expected earnings growth for Besserlot is much higher than the average for the industry, especially during this next three years. In view of this it might be reasonable to apply a PE ratio of at least the industry average when attempting to value Besserlot. The after tax earnings of Besserlot, based upon the revised P&L account, are: 1,022 307 = 715 Using a PE ratio of 30:1, this gives an estimated value of 715 x 30 = 21,450,000. This is a very subjective estimate, and it might be wise to use a range of PE ratio values, for example from 25:1 to 35:1, which would result in a range of values from 17,875,000 to 25,025,000. It could also be argued that the value should be based upon the anticipated next earnings rather than the past earnings several months ago.

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This is estimated to be: 2007 000 28,100 2,248 350 1,898 569 1,329

Turnover Operating profit before exceptional items Interest paid (net) Profit before taxation Taxation

1,329 x 30 gives a much higher estimate of 39,870,000 PE based valuation might also be criticised as it is based upon profits rather than cash flows. Dividend based valuation Dividend based valuation assumes that the value of the company may be estimated from the present value of future dividends paid. In this case the expected dividend growth rates are different during the next three years and the subsequent period. The estimated dividend valuation is: Year Expected dividend Discount factors (14%) Present values 1 250 0877 219 2 313 0769 241 3 391 0675 264 After year 3 391 (11) 014 010 0675 7258 D1 Using P = ke g

The estimated value is 7,982,000 This is a rather low estimated value and might be the result of Besserlot having a relatively low dividend payout ratio, and no value being available for a final liquidating dividend. The present value of expected future cash flows The present value of future cash flows will be estimated using the expected free cash flow to equity. In theory this is probably the best valuation method, but in reality it is impossible for an acquiring company to make accurate estimates of these cash flows. The data below relies upon many assumptions about future growth rates and relationships between variables. Turnover Operating profit Interest paid (net) Profit before taxation Taxation Add back non-cash expenses Less increase in working capital Less capital investment Free cash flow to equity Discount factors (14%) Present values 2007 28,100 2,248 350 1,898 569 1,329 1,025 (172) (1,250) 932 0877 817 2008 35,125 2,810 438 2,372 712 1,660 1,281 (214) (1,562) 1,165 0769 896 2009 43,906 3,512 547 2,965 890 2,075 1,602 (268) (1,953) 1,456 0675 983 After 2009

40,040 0675 27,027

The estimated present value of free cash flows to equity is 29,723,000 Note: 1,456 (11) Free cash flow after 2009 is estimated by = 40,040 014 010 This valuation also ignores any real options that arise as a result of the acquisition. Recommended valuation It is impossible to produce an accurate valuation. The valuation using the dividend growth model is out of line with all others and will be ignored. On the basis of this data, the minimum value should be the adjusted asset value, a little over 15,000,000, and the maximum approximately 30,000,000. All of above valuations may be criticised as they are based upon the value of Besserlot as a separate entity, not the valuation as part of Stanzial plc. There might be synergies, such as economies of scale, savings in duplicated facilities, processes etc. as a result of the purchase which would increase the above estimates.

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(b)

The success of the purchase would depend upon enticing the existing shareholders to sell their shares. The most important shareholders are the senior managers, the venture capital company, and the single shareholder holding 25% of the shares. If any two of these types of shareholder can be persuaded to sell Stanzial can gain control of Besserlot. If the shareholders of a private company do not want to sell there is little Stanzial can do. However, most shareholders will sell if the price or other conditions are attractive enough. The venture capital company will probably have invested in Besserlot with a view to making a large capital gain, possibly if Besserlot was itself to seek a listing on the AIM or other markets. Stanzial will have to offer a sum large enough to satisfy the venture capital company relative to possible alternatives such as the listing. Similarly the managers and major shareholder would need to be satisfied. In the case of the managers it might also be necessary to provide some guarantee that they would continue to have managerial positions with attractive contracts within Stanzial, and the large single shareholder might insist on continued representation on the Board of Directors. The nature of payment might also be important. The managers and single investor could be liable to immediate capital gains tax if payment was to be made in cash. They might have a preference for shares in Stanzial. The venture capital company might prefer cash rather than maintain an equity stake in a different company.

(c)

Factors that might influence the medium-term success of the acquisition include: The thoroughness of the planning of the acquisition. This would include establishing key reporting relationships and control of key factors. (ii) Corporate objectives and plans should be harmonised. Effective integration will require mutual respect for the different cultures and systems of the two companies. (iii) Human resource issues are important, such as how any redundancies are dealt with, and the role of the managers of the acquired company in the new organisation. (iv) Effective post acquisition audit. Monitoring of whether or not the post-acquisition performance is as expected, and implementation of any necessary action to remedy problems and under-performance. (v) The reaction of competitors, in particular can they produce alternative wireless links that would adversely affect Stanzials market share. (vi) Maintenance of the pension rights of existing employees post-acquisition. (i)

(a)

Short-term interest rate futures allow a company to hedge an interest rate risk by attempting to create a gain on the futures market to offset a potential loss in the underlying cash market. The futures hedge is expected to protect interest rates at the expected futures price at the time the futures contracts mature or are closed out. However, hedges will rarely be perfect because: (i) The size of the risk might not correspond to an exact number of futures contracts; the risk might need to be underhedged or overhedged. (ii) Basis risk might exist, which means that the futures price at the close out date might be different to that expected. (iii) The futures contract is based on LIBOR. The underlying risk might be based upon a short-term interest rate instrument with different characteristics to LIBOR. Futures also involve an up front margin payment, and payments of variation margin if prices move in an adverse direction. They are highly standardised and have a limited number of expiry dates. Market traded options on futures share many of the characteristics of the underlying futures contracts. The major differences are that the option contracts involve the payment of an option premium, which is payable whether or not the option is exercised. Additionally options have the advantage of allowing the buyer to take advantage of favourable movements in interest rates, whilst still protecting against adverse movements. Options also offer a wider choice of the level of interest rate that may be used to protect against adverse movements.

(b)

Futures hedge The period at risk is two months commencing in five months time, on 1 May. The June futures contract will be used as it has the first maturity date after the period of risk commences. Futures will be sold in order to make a profit if interest rates rise. As the period at risk is two months the number of contracts required is: 45,000,000 2 x = 60 500,000 3 60 June contracts will be sold. LIBOR is currently 4%, or the equivalent to a futures price of 9600 The basis is 9555 9600 = 045

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There are seven months until the futures contract matures. If there is a linear fall in basis (no basis risk) then the expected basis in five month time when the futures contracts are closed out is: 2 045 x = 013 7 The expected lock-in rate for the futures contract is 9555 + 013 = 9568 or 432%. FNDC borrows at LIBOR plus 125%, therefore the expected lock in interest rate is 557%, or 417,750, no matter what rate LIBOR moves to. Calculations of cash market and futures market profits/losses are not essential, but would be as follows: 05% increase in interest rates: Cash market: Actual borrowing cost in five months time 2 (45% + 125%) x 45,000,000 x = 431,250 12 Futures market: 1 December sell 60 June contracts at 9555 1 May buy 60 contracts at the expected futures price of 9537 (100 45% 013) Futures profit is 018 or 18 ticks. 18 x 60 x 1250 = 13,500 The net interest cost is 431,250 13,500 = 417,750 417,750 45,000,000 12 x = 557% 2

05% decrease in interest rates: Cash market: Actual borrowing cost in five months time 2 (35% + 125%) x 45,000,000 x = 356,250 12 Futures market: 1 December sell 60 June contracts at 9555 1 May buy 60 contracts at 9637 (100 35% 013) Futures loss is 082 or 82 ticks. 82 x 60 x 1250 = 61,500 The total interest cost is 356,250 + 61,500 = 417,750 or 557% Interest rate options Options to sell futures are required, hence June put options will be purchased. Only three possible exercise prices exist. Exercise price 9500 9550 9600 Option premium 45,000,000 x 0015% x 2/12 = 1,125 45,000,000 x 0165% x 2/12 = 12,375 45,000,000 x 0710% x 2/12 = 53,250

If interest rates increase by 05%, leading to an expected futures price of 9537 at the close out date of 1 May. Exercise price 9500 9550 9600 Exercise option No Yes Yes Profit from exercising options (9550 9537) 0005 x 60 x 625 = 9,750 (9600 9537) 0005 x 60 x 625 = 47,250

Overall cost if options are used: 9500 9550 9600 Market borrowing cost + Option premium Option profit 431,250 1,125 431,250 12,375 9,750 431,250 53,250 47,250 Total 432,375 433,875 437,250

As expected, all are worse than the expected cost of 417,750 using futures.

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If interest rates were to fall by 05%, the expected futures close out price is 9637 Exercise price 9500 9550 9600 Exercise option No No No

In all cases the option will be allowed to lapse, or sold for any remaining time value. Overall cost if options are used: 9500 9550 9600 Market borrowing cost + Option premium 356,250 1,125 356,250 12,375 356,250 53,250 Total 357,375 368,625 409,500

All of these outcomes are much better than the futures hedge, but would rely on interest rates falling rather than rising. This is not expected to happen by the market. The 9500 exercise price is probably the most attractive of the option contracts as it is relatively low cost and gives a very favourable outcome if interest rates fall. However, it is still 14,625 more expensive than the futures hedge if interest rates rise. (c) A maximum interest rate to the company of 575% implies a LIBOR rate of 45%, or 9550. A minimum rate of 525% implies LIBOR of 40% or 9600. The collar hedge would be to buy 60 June 9550 put option contracts and to sell 60 June 9600 call option contracts. The net premium payable would be 0165 0070 = 0095, or a cost of: 45,000,000 x 0095% x 2/12 = 7,125 If interest rates increase by 05%, the 9550 put option will be exercised. Market borrowing cost + net option premium option profit = Total 431,250 7,125 9,750 428,625 If interest falls by 05% the put option will not be exercised, but there will be a loss on the call option as it will be exercised by its buyer. Market borrowing cost (475%) = 356,250 Loss on call option is: (9600 9637) x 2 x 100 x 60 x 625 = 27,750 Total cost is 356,250 + 27,750 + 7,125 = 391,125 The collar hedge saves premium cost and might be attractive to FNDC, although the worst case outcome is still much more expensive than the futures hedge. (d) Income may be increased by writing (selling) options, as the writer of the option receives the option premium. However, unless the option is hedged, writing options exposes the writer to a theoretically unlimited loss. Uncovered writing of options is effectively speculating, involves very high risk, and is not normally recommended as a strategy to manufacturing companies such as FNDC.

(a)

The tax saving from capital allowances is: Year 1 2 3 4 NPV Year Operating cash flows Taxation (30%) Tax saving Investment cost Realisable value Net cash flows Discount factors (10%) Present values 0 1 1,250 (375) 330 1,205 0909 1,095 000 2 1,400 (420) 248 1,228 0826 1,014 3 1,600 (480) 186 1,306 0751 981 4 1,800 (540) 139 1,500 2,899 0683 1,980 Written down value 4,400 3,300 2,475 1,856 Capital allowance (25%) 1,100 825 619 464 Tax saving (30%) 330 248 186 139

(5,400) (5,400) (5,400)

The expected NPV is (330,000) The investment does not appear to be financially viable

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Note: The weighted average cost of capital is: Using CAPM Ke = 4% + (10% 4%) 15 = 13% E D WACC = Ke + kd(1 t) = 13% (06) + 8%(1 03)(04) = 1004% E+D E+D APV The relevant cash flows for APV are the same as for the NPV, except for the issue costs which are treated separately as a financing side effect. Year Net cash flows Discount factors (9%) Present values 0 (5,000) (5,000) 1 1,205 0917 1,105 000 2 1,228 0842 1,034 3 1,306 0772 1,008 4 2,899 0708 2,052

Expected base case NPV is 199,000 Note: The discount rate for the base case NPV is the ungeared cost of equity. Assuming corporate debt to be risk free (which is unlikely at 8%!) E Beta eug = Beta eg x = 15 E + D(1 t) Keug = 4% + (10% 4%) 0882 = 929% Financing side effects: Annual tax saving on interest payments on 27 million debt 2,700,000 x 8% x 03 = 64,800 The present value of tax saving over four years discounted at the cost of debt is: 64,800 x 3312 = 214,618 The estimated APV is: Base case NPV Tax savings Issue costs 199,000 214,618 (400,000) 13,618 2,700 or 0882 2,700 + 2,700(1 03)

The investment appears to be marginally viable based upon the APV method. (b) Manager A advocates the use of NPV which is used by many companies worldwide. In an efficient market a positive NPV, in theory, should lead to a commensurate increase in the value of the company and share price. However, the use of the weighted average cost of capital (WACC) in NPV is only appropriate if there is no significant change in gearing as a result of the investment, the investment is marginal in size, and the operating risk of the company does not change. If WACC is estimated using the capital asset pricing model, it also relies upon the accuracy of this model which has many unrealistic assumptions. The adjusted present value model, advocated by manager B, treats the investment as being initially all equity financed and then directly adjusts for the present value of any cash flow effects associated with financing. As gearing is expected to change as a result of the investment, APV might be better suited to the evaluation of this investment. However, it is not always easy to identify all of the relevant financing side effects, or the discount rate that used be used on each of the financing side effects. APV also relies upon unrealistic assumptions with respect to ungearing beta and the existence of perpetual risk free debt. Both NPV and APV do not consider the potential value of real options (e.g. the abandonment option and the option to undertake further investments) that might exist as a result of undertaking the initial investment.

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(a) 2001 2002 2003 2004 2005

Forthmate Payout ratio (%) Dividends/FCFE (%) 200 42 201 37 200 151 200 250 199 78 Herander Payout ratio (%) Dividends/FCFE (%) 606 82 844 118 563 50 507 119 639 167

2001 2002 2003 2004 2005

Forthmate has adopted a policy of paying dividends that are a constant percentage of after tax earnings. This is not normally recommended as it might lead to fluctuating levels of dividend per share (DPS) if earnings are volatile. If investors seek a minimum cash flow from dividend payments wide fluctuations would not be welcome. In this case, however, there are only two small reductions in DPS over the period. The payout ratio of 20% is also relatively low. This might be because investors have a preference for most of their income in the form of capital gains rather than dividends, as the tax treatment of capital gains is more favourable in some countries. Herander plc appears to maintain a constant dividend per share, possibly increasing with inflation. Its payout ratio is much higher than that of Forthmate, perhaps to satisfy its own investment clientele. Both companies act as if they believe that dividend policy is important to their investors, and potentially their share price, in contrast to the theories of Modigliani and Miller and others. Both companies appear to relate their dividend policy to earnings. It might be better to link dividend policy to available cash flow. (b) Free cash flow to equity is the funds that remain after the company has undertaken all capital investment expenditure, any changes in non-cash working capital and debt issues and redemptions. It is effectively the amount left for investors after the company has met all other needs, and could be paid to shareholders as dividends. A strategy of paying all of free cash flow as dividends might appear sensible, as the amount being paid is what the company can afford from its annual cash flow. However, there may be reasons why a company might wish to pay dividends of less than the FCFE. Payments of less than free cash flow may be because: (i) (ii) (iii) (iv) The company has a strategy of increasing cash reserves for a specific purpose, perhaps an acquisition Earnings and cash flows are volatile, and the cash is to be used to smooth out dividends There might be legal constraints such as covenants that prevent the return of cash to shareholders The company wishes to maintain a precautionary cash balance to meet unanticipated needs.

If the dividends to FCFE percentage are more than 100%, the company is paying out more than it can afford from annual cash flows and must be issuing new securities or reducing existing cash balances. It might do this to maintain an existing dividend per share, but as a result it will have to use relatively expensive external financing to meet its investment needs. (c) Herander plc has paid dividends well in excess of its FCFE in the last two years, and has had more potential positive NPV projects than it has undertaken. An implication is that the high dividend payment might be constraining Heranders ability to undertake viable investments that would increase shareholder wealth. The company is likely to be losing value because of its dividend policy.

(a)

All estimates assume no change in exchange rates. Any change would affect the profit and tax estimates. The effective total tax rate in Petronia is the corporate tax rate of 25%, plus the withholding tax rate of 15% on 75% of pre-tax income. This is effectively another 15% x 075 = 1125% tax on pre tax income, or a total of 3625%. In each case, as the total tax rates in Petronia are higher than the 30% UK tax rate, there will be full credit available against any UK tax liability on Petronian income.

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Market based transfer price UK parent Sales price Variable costs Fixed costs UK pre-tax profit Corporate tax (30%) Profit after tax Petronian subsidiary Sales price Transfer price Local variable costs Local fixed costs Petronian pre-tax profit Corporate tax (25%) Withholding tax (15%) Profit after all tax 50,000 x 250 900,000 x 78 50,000 x 82 50,000 x 18 50,000 x 13 = = 900,000 650,000 120,000 130,000 39,000 91,000 1,602,564 900,000 525,641 45,000 131,923 32,981 98,942 14,841 84,101

P$ = 12,500,000 7,020,000 = 4,100,000 351,000 1,029,000 257,250 771,750 115,763 655,987

Total UK and Petronian after tax profit 91,000 + 84,101 = 175,101 Period fixed cost plus variable cost UK parent Sales price Variable costs Fixed costs UK profit Petronian subsidiary Sales price Transfer price Local variable costs Local fixed costs Petronian pre tax profit Corporate tax (25%) Withholding tax (15%) Profit after all tax 50,000 x 250 770,000 x 7.8 50,000 x 82 770,000 650,000 120,000 0 1,602,564 770,000 525,641 45,000 261,923 65,481 196,442 29,466 166,976

50,000 x 13

P$ = 12,500,000 = 6,006,000 = 4,100,000 351,000 2,043,000 510,750 1,532,250 229,838 1,302,412

Total UK and Petronian after tax profit 0 + 166,976 = 166,976 Negotiated cost UK parent Sales price Variable costs Fixed costs UK pre-tax profit Corporate tax (30%) Profit after tax Petronian subsidiary Sales price Transfer price Local variable costs Local fixed costs Petronian profit Corporate tax (25%) Withholding tax (15%) Profit after all tax 50,000 x 250 962,500 x 7.8 50,000 x 82 962,500 650,000 120,000 192,500 57,750 134,750 1,602,564 962,500 525,641 45,000 69,423 17,356 52,067 7,810 44,257

50,000 x 13

P$ = 12,500,000 = 7,507,500 = 4,100,000 351,000 541,500 135,375 406,125 60,919 345,206

Total UK and Petronian after tax profit 134,750 + 44,257 = 179,007

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(b)

Market price Transfer at market price means that there would be no problems with the relevant tax authorities regarding the manipulation of transfer prices, and such prices would assist in the accurate evaluation of the performance of the subsidiary. However, if the parent company had spare capacity the use of the market price might not be optimal and could lead to incorrect resource allocation decisions (a price based upon the marginal cost of extra production could result in an increase in group profitability). It might not always be possible to establish a market price for a component, unless the same component is sold to other customers. Fixed cost plus variable cost per unit This method would not earn any profits for the selling company, leaving all profits in this case for the overseas subsidiary. As the total tax rate in Petronia is higher then in the UK, this would result in less overall group income than a market based price. The UK tax authorities might not accept such a transfer price as it eliminates UK tax liability. It might be better for the transfer price to be the fixed cost plus a variable charge that includes a profit element. Negotiated transfer price A negotiated price may be difficult to agree. One of the parties is likely to suffer from such a price. The negotiated price in this example has the effect of increasing the total group after tax income by reducing the tax liability in the relatively high tax environment. However, this also means that profits are reduced in Petronia, and could affect the performance measurement of the subsidiary, and the motivation of staff in the subsidiary. It is however, possible for an adjustment to be made to reflect the artificial transfer price that has been used. In practice, a negotiated price such as this might not be possible as the tax authorities in Petronia might insist on a market based transfer price being used to increase the tax take in Petronia.

A wide range of discussion on this topic is possible. Alternative emphases are acceptable. The key financial objective of a company is normally considered to be the maximisation of shareholder wealth. However, most companies now have multiple objectives, some financial and some non-financial. The objectives of Company A are out of line with those of most modern companies. Company As focus is strongly on the maximisation of global shareholder wealth, yet companies have many other important stakeholders. These include: the managers and directors of the company, other employees, customers, suppliers, banks and other providers of non-equity finance, the government and society/the local community. Shareholder wealth maximisation should be tempered by taking into account the needs of other stakeholders. The balance between financial and non-financial objectives will differ between companies. Many companies specify non-financial objectives which might include growth of sales or market share, survival, technological leadership and product quality. Increasingly companies are focussing attention on the needs of the community and the protection of the environment, both of which will tend to use cash resources and might reduce shareholder wealth. However, it is sometimes argued that if a company acts responsibly towards society and the environment this will create a good public image that ultimately leads to an increase in shareholder wealth. The impact of non-financial objectives on shareholder wealth is difficult to judge. Company A intends to use sophisticated measures to maximise cash flow in each country where the company operates. Even if other stakeholders were to be ignored maximising cash flow in each country might not lead to the maximisation of group cash flow and shareholder wealth. If company A wishes to focus on cash flow maximisation it should be from the perspective of cash flows in its home currency, not many local currencies which could change in value relative to the home currency. The companys share price will depend on the expected cash flows in the currency in which its shares are denominated. It is a difficult ethical question as to whether or not a company should outsource internationally. Many examples of this have occurred in recent years, particularly with respect to the manufacturing activities and call centres moving from developed countries to less developed countries where wage costs are much lower. When this occurs there will normally be redundancies in the developed countries. How much should a company consider this against increased profits, and possibly enhancement of the standard of living in less developed countries? If company A wishes to focus on financial objectives it might be better to relate them to cash flows rather than profits. Company B has adopted totally different objectives. There is no financial dimension to the stated objectives. It might be that the company expects financial success to result from these objectives, but that would not automatically occur. The focus on customer satisfaction is increasingly common, and if successful should enhance sales. However, reducing price might satisfy customers yet it might also lead to cash flow problems and the destruction of value rather than its creation. High quality products are fine, as long as the quality is not at the expense of any profit. Increasing market share is also desirable, but needs to be accompanied by considerations of cash flow and potential wealth creation. Outstanding levels of sales and delivery service are sensible objectives, although again these need to be achieved in the context of managing the associated costs.

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Part 3 Examination Paper 3.7 Strategic Financial Management

December 2006 Marking Scheme Marks

This question requires the use of alternative techniques to produce valuation estimates of a private limited company for potential acquisition, and discussion of factors that might influence the success of the acquisition. (a) Focus upon an equity valuation Adjustment of profit for the exceptional item Asset based valuation: Calculations Discussion PE ratios: Calculations Discussion Dividend valuation: Calculations Discussion Cash flow valuation: Calculations Discussion Recommendation and other comment, including synergy 1 2 2 23 23 23 3 2 7 23 23 Max 27 1 45 23 Max 8 Max 5 Total 40

(b)

Identification of key shareholders Possible needs of shareholders Nature of payment

(c)

12 marks for each good point. 2 for post audit discussion

This question requires understanding and application of alternative hedging techniques that may be used to manage short-term interest rate risk. It also requires knowledge of collar hedges and the implications of writing options. (a) Interest rate futures Interest rate options on futures 34 3 Max 6

(b)

Futures hedge: Correct number and time of contracts Basis Expected lock-in rate/outcomes Options hedge: June put options Outcomes if interest rates increase Outcomes if interest rate decrease Comment

2 2 3 2 34 3 12 Max 16 1 1 23 1 Max 5 3 Total 30

(c)

Correct LIBOR rates Net premium Outcomes Comment

(d)

Reward sensible discussion of the risks and rewards from writing options

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(a)

Capital allowances/tax saving NPV calculations APV calculations Base case NPV Financing side effects Give credit for technique

Marks 1 45 34 23 Max 10

(b)

Reward sensible discussion. Bonus mark for mention of real options subject to max 5 marks

5 Total 15

(a)

Calculations, including payout ratio and dividends /FCFE Forthmate discussion Herander discussion

34 23 23 Max 8 4 3 Total 15

(b) (c)

Reward sensible discussion. Look for benefits of the strategy and valid reasons not to use it Look for problems and possible effect on shareholder wealth. Do not reward waffle

(a)

Calculations: Market based Fixed plus variable cost Negotiated For 4 marks answers need to be correct. No penalty if all cash flows in

34 34 34 Max 9

(b)

Market based Fixed plus variable cost Negotiated Allow overlap if relevant

23 23 23 Max 6 Total 15

Discussion of stakeholders Financial and non-financial objectives Company A Company B Ethics Reward sensible discussion Allow for overlap between sections.

23 34 34 45 2 Maximum 15

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