Revision 1 Advanced Investment Appraisal



ACCA P4

Advanced Financial Management

Revision Class 1

Session 1 and 2

Patrick Lui

hklui2007@.hk

| |

Revision 1 Advanced Investment Appraisal

Chapter 1 Discount Cash Flows Techniques

[pic]

1. Net Present Value with Inflation and Taxation

1.1 Effect of inflation

1.1.1 It is important to adapt investment appraisal methods to cope with the phenomenon of price movement.

1.1.2 Future rates of inflation are unlikely to be precisely forecasted.

1.1.3 Two types of inflation can be distinguished.

(a) Specific inflation refers to the price changes of an individual good or service.

(b) General inflation is the reduced purchasing power of money and is measured by an overall price index which follows the price changes of a ‘basket’ of goods and services through time. => Discount rate

1.2 Real and money interest rate

1.2.1 The money (nominal or market) interest rate incorporates inflation. When the nominal rate of interest is higher than the rate of inflation, there is a positive real rate. When the rate of inflation is higher than the nominal rate of interest, the real rate of interest will be negative.

1.2.2 Fisher’s (1930) equation

(Dec 08)

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

Where h = inflation rate

r = real interest rate

i = nominal interest rate

1.3 Allowing for taxation

1.3.1 Typical assumptions about the time of payments which may be stated in questions are as follows.

(a) Half the tax is payable in the same year in which the profits are earned and half in the following year.

(b) Tax is payable in the year following (in arrears) the one in which the taxable profits are made. Thus, if a project increase taxable profits by $10,000 in year 2, there will be a tax payment, assuming tax at (say) 30%, of $3,000 in year 3.

(c) Tax is payable in the same year that the profits arise.

1.4 Capital allowances (or tax-allowable depreciation, or writing down allowances (WDAs) or depreciation allowances)

1.4.1 Capital allowance is used to reduce taxable profits, and the consequent reduction in a tax payment should be treated as a cash saving from the acceptance of a project.

1.4.2 There are two assumptions about the time when capital allowance start to be claim.

(a) It can be assumed that the first claim occurs at the start of the project (at year 0).

(b) Alternatively it can be assumed that the first claim occurs later in the first year.

1.5 Tax exhaustion

(Pilot 13)

1.5.1 There will be circumstances when the capital allowances in a particular year will equal or exceed before tax earnings. In such a case the company will pay no tax.

1.5.2 In most tax systems unused capital allowances can be carried forward indefinitely, so that the capital allowance that is set off against the tax liability in any one year includes not only the writing down allowance for the particular year but also any unused allowances from previous years.

2. Capital Rationing

2.1 Principle of capital rationing

2.1.1 In a perfect capital market, a company can raise funds as and when it needs them.

2.1.2 However, in practice, it is not the case. The capital available is always to be limited or rationed. There are two types of rationing:

2.1.3 External (hard) capital rationing:

(a) Cannot raise external finance due to too risky.

(b) Financial risk – the company’s gearing may be seen as too high.

(c) Business risk – lenders may be uncertain on the company’s future profits whether it can meet the interest and principal payments

2.1.4 Internal (soft) capital rationing:

(a) Managers impose restrictions on the funds. The reasons are as follows:

(b) Managers may not want to raise new external finance, for example

(i) Not wish to raise new debt to increase future interest payments

(ii) Not wish to issue new equity to avoid dilution of control.

(c) Managers may prefer slower organic growth in order to remain in control of the growth process and so avoid rapid growth.

(d) Managers may want to make capital investments compete for funds in order to week out weaker or marginal projects.

2.1.5 Single period capital rationing (Jun 09)

(a) Rationing occurs when limits are placed for only one year or one period.

(b) Two types of single-period rationing:

(i) Divisible projects – a proportion rather than the whole investment can be undertaken and use profitability index (PI) to rank the project for priority.

|PI = |PV of future cash flows |

| |Initial investment |

(ii) Indivisible projects – use trial and error to find the affordable combination that maximizes NPV

2.2 Multi-period capital rationing

(Dec 12)

2.2.1 Limits are placed for more than one period, in this case, linear programming should be employed. More complex linear programming problems require the use of computers.

3. Risk and Uncertainty

3.1 Meaning of risk and uncertainty

3.1.1 Since future cash flows cannot be predicted with certainty, managers must consider how much confidence can be placed in the results of the investment appraisal process. They must therefore be concerned with the risk and uncertainty of a project.

3.1.2 Risk refers to the situation where probabilities can be assigned to a range of expected outcomes, so it can be quantified.

3.1.3 Uncertainty refers to the situation where probabilities cannot be assigned to expected outcomes, so it is unquantifiable. It can only be described.

3.2 Probability and expected value (EV)

(Dec 14)

3.2.1 It refers to the assessment of the separate probabilities of a number of specified outcomes of an investment project.

3.2.2 The NPV from combinations of future economic conditions could be assessed and linked to the joint probabilities of those combinations. The expected NPV could be calculated.

3.3 Sensitivity analysis

(Jun 09, Dec 12)

3.3.1 Sensitivity analysis assesses how the NPV of an investment project is affected by changes in project variables. The purpose is to identify the key or critical variables so that management can concern more.

3.3.2 The change in one variable required to make the NPV to be zero.

3.3.3 Or alternatively, the change in NPV arising from a fixed change in the given project variable.

3.3.4 However, sensitivity analysis does not assess the probability of changes in project variables. Therefore, it cannot be described as a way of incorporating risk into investment appraisal.

3.3.5 A simple approach to deciding which variables the NPV is particularly sensitive to is to calculate the sensitivity of each variable:

|Sensitivity |= |NPV |% |

| | |PV of project variable | |

3.3.6 The lower the percentage, the more sensitive is NPV to that project variable as the variable would need to change by a smaller amount to make the project non-viable.

3.4 Duration (Macauley duration)

(Jun 09)

3.4.1 Duration measures the average time to recover the present value of the project (if cash flows are discounted at the cost of capital).

3.4.2 Projects with higher durations carry more risk than projects with lower durations.

|Duration |= |Sum of (PV × Year) |

| | |Sum of PV of return phase cash flows |

4. Monte Carlo Simulation

(Jun 10)

4.1 The main problem with sensitivity analysis is that it only allows us to assess the impact of one variable changing at a time. Simulation addresses this problem by considering how the NPV will be impacted by a number of variables changing at once.

4.2 Simulation employs random numbers to select specimen values for each variable in order to estimate a ‘trial value’ for the project NPV. This is repeated a large number of times until a distribution of NPVs emerge.

5. Value at Risk (VAR)

(Jun 12, Dec 14)

5.1 VaR can be defined as the maximum amount that it may lose at a given level of confidence.

5.2 For example, we may say that the VaR is $100,000 at 5% probability, or that it is $100,000 at 95% confidence level. The first definition implies that there is a 5% chance that the loss will exceed $100,000, or that we are 95% sure that it will not exceed $100,000.

5.3 VAR can be defined at any level of probability or confidence, but the most common probability levels are 1%, 5% or 10%.

|5.4 |Calculate of VaR |

| |When the random variable follows the normal distribution, the value at risk at specific probability levels is easily |

| |calculated as a multiple of the standard deviation. |

| | |

| |VaR for single period = K × σ |

| | |

| |Where: K is the confidence level |

| |For 10% confidence level, K = 1.282 |

| |For 5% confidence level, K = 1.645 |

| |For 1% confidence level, K = 2.33 |

| |σ is the standard deviation of a project |

| | |

| |VaR for multi-period = K × σ × [pic] |

| | |

| |Where: N is the periods over which we want to calculate the value at risk. |

6. Internal Rate of Return (IRR)

(Jun 12, Dec 14)

6.1 IRR is defined as the discount rate at which the NPV equals zero. In other words, the IRR represents the breakeven discount rate for the investment.

6.2 Decision rule:

➢ IRR > cost of capital, project accepts

➢ The higher IRR is the better

6.3 Steps in calculating the IRR using linear interpolation:

1. Calculate two NPV at two different discount rates. One must be positive and another one must be negative.

2. Using the following formula to find the IRR

IRR = L + [pic]

where:

L = Lower rate of interest

H = Higher rate of interest

NL = NPV at lower rate of interest

NH = NPV at higher rate of interest

6.4 Advantages and disadvantages of IRR

|Advantages |Disadvantages |

|Considers the time value of money |It is not a measure of absolute increase in company value. |

|Is a percentage and therefore easily understood |Interpolation only provides an estimate and an accurate |

|Uses cash flows not profits |estimate requires the use of a spreadsheet program |

|Considers the whole life of the project |It is fairly complicated to calculate |

|Means a firm selecting projects where the IRR exceeds the |Non-conventional cash flows may give rise to multiple IRRs |

|cost of capital should increase shareholders’ wealth. |Can offer conflicting advice between IRR and NPV in the |

| |evaluation of mutually exclusive projects |

| |Assume cash inflows being reinvested at the IRR rate, this is|

| |unrealistic when IRR is high. |

6.5 IRR give a conflicting result when compared to NPV

(a) Non-conventional cash flows

(i) The project has conventional cash flows, i.e. an initial cash outflow followed by a series of inflows.

(ii) When flows vary from this they are termed non-conventional.

(b) Mutually exclusive projects:

(i) This is a situation when only one project can be chosen among two or more investment choices.

(ii) NPV and IRR may give a different ranking of projects, i.e. the project with the highest IRR may not be the one with the highest NPV.

7. Modified Internal Rate of Return (MIRR)

(Jun 08, Jun 12, Dec 14)

7.1 The MIRR overcomes the problem of the reinvestment assumption and the fact that changes in the cost of capital over the life of the project cannot be incorporated in the IRR method.

|7.2 |MIRR formula |

| |MIRR = [pic] |

| | |

| |Where: |

| |PVR = the PV of the return phase (the phase of the project with cash inflows) |

| |PVI = the PV of the investment phase (the phase of the project with cash outflows) |

| |re = the cost of capital |

Question 1 – NPV, discounted payback, duration

You have been conducting a detailed review of an investment project proposed by one of the divisions of your business. Your review has two aims: first to correct the proposal for any errors of principle and second, to recommend a financial measure to replace payback as one of the criteria for acceptability when a project is presented to the company’s board of directors for approval. The company’s current weighted average cost of capital is 10% per annum.

The initial capital investment is for $150 million followed by $50 million one year later. The post tax cash flows, for this project, in $million, including the estimated tax benefit from capital allowances for tax purposes, are as follows:

|Year |0 |1 |2 |3 |4 |5 |6 |

|Capital investment (plant and machinery) | | | | | | | |

|First phase |-127.50 | | | | | | |

|Second phase | |-36.88 | | | | | |

|Project post tax cash flow ($m) | | |44.00 |68.00 |60.00 |35.00 |20.00 |

Company tax is charged at 30% and is paid/recovered in the year in which the liability is incurred. The company has sufficient profits elsewhere to recover capital allowances on this project, in full, in the year they are incurred. All the capital investment is eligible for a first year allowance for tax purposes of 50% followed by a writing down allowance of 25% per annum on a reducing balance basis.

You notice the following points when conducting your review:

1. An interest charge of 8% per annum on a proposed $50 million loan has been included in the project’s post tax cash flow before tax has been calculated.

2. Depreciation for the use of company shared assets of $4 million per annum has been charged in calculating the project post tax cash flow.

3. Activity based allocations of company indirect costs of $8 million have been included in the project’s post tax cash flow. However, additional corporate infrastructure costs of $4 million per annum have been ignored which you discover would only be incurred if the project proceeds.

4. It is expected that the capital equipment will be written off and disposed of at the end of year six. The proceeds of the sale of the capital equipment are expected to be $7 million which have been included in the forecast of the project’s post tax cash flow. You also notice that an estimate for site clearance of $5 million has not been included nor any tax saving recognised on the unclaimed writing down allowance on the disposal of the capital equipment.

Required:

(a) Prepare a corrected project evaluation using the net present value technique supported by a separate assessment of the sensitivity of the project to a $1million change in the initial capital expenditure. (14 marks)

(b) Estimate the discounted payback period and the duration for this project commenting on the relative advantages and disadvantages of each method.

(5 marks)

(c) Recommend whether this project is acceptable and also which techniques the board should consider when reviewing capital investment projects in future.

(6 marks)

(Total = 25 marks)

(Amended P4 Advanced Financial Management June 2009 Q1)

Question 2 – NPV, IRR and PI

Slow Fashions Ltd is considering the following series of investments for the current financial year 2009:

Project bid proposals ($’000) for immediate investment with the first cash return assumed to follow in 12 months and at annual intervals thereafter.

|Project |Now |2010 |

|Project |Year one |Year two |Year three |Project NPV |

| |(Immediately) | | | |

| |$ |$ |$ |$ |

|PDur01 |4,000,000 |1,100,000 |2,400,000 |464,000 |

|PDur02 |800,000 |2,800,000 |3,200,000 |244,000 |

|PDur03 |3,200,000 |3,562,000 |0 |352,000 |

|PDur04 |3,900,000 |0 |200,000 |320,000 |

|PDur05 |2,500,000 |1,200,000 |1,400,000 |Not provided |

PDur05 project’s annual operating cash flows commence at the end of year four and last for a period of 15 years. The project generates annual sales of 300,000 units at a selling price of $14 per unit and incurs total annual relevant costs of $3,230,000. Although the costs and units sold of the project can be predicted with a fair degree of certainty, there is considerable uncertainty about the unit selling price. The department uses a required rate of return of 11% for its projects, and inflation can be ignored.

The Durvo department’s managing director is of the opinion that all projects which return a positive net present value should be accepted and does not understand the reason(s) why Arbore Co imposes capital rationing on its departments. Furthermore, she is not sure why maintaining a capital investment monitoring system would be beneficial to the company.

Required:

(a) Calculate the net present value of project PDur05. Calculate and comment on what percentage fall in the selling price would need to occur before the net present value falls to zero. (6 marks)

(b) Formulate an appropriate capital rationing model, based on the above investment limits, that maximises the net present value for department Durvo. Finding a solution for the model is not required. (3 marks)

(c) Assume the following output is produced when the capital rationing model in part (b) above is solved:

Category 1: Total Final Value

$1,184,409

Category 2: Adjustable Final Values

Project PDur01: 0·958

Project PDur02: 0·407

Project PDur03: 0·732

Project PDur04: 0·000

Project PDur05: 1·000

Category 3: Adjustable Final Values

|Constraints Utilised |Slack |

|Year one: $9,000,000 |Year one: $0 |

|Year two: $6,000,000 |Year two: $0 |

|Year three: $5,000,000 |Year three: $0 |

Required:

Explain the figures produced in each of the three output categories. (5 marks)

(d) Provide a brief response to the managing director’s opinions by:

(i) Explaining why Arbore Co may want to impose capital rationing on its departments; (2 marks)

(ii) Explaining the features of a capital investment monitoring system and discussing the benefits of maintaining such a system. (4 marks)

(20 marks)

(ACCA P4 Advanced Financial Management December 2012 Q4)

Question 4 – NPV, MIRR and VAR

Tisa Co is considering an opportunity to produce an innovative component which, when fitted into motor vehicle engines, will enable them to utilise fuel more efficiently. The component can be manufactured using either process Omega or process Zeta. Although this is an entirely new line of business for Tisa Co, it is of the opinion that developing either process over a period of four years and then selling the productions rights at the end of four years to another company may prove lucrative.

The annual after-tax cash flows for each process are as follows:

Process Omega

|Year |0 |1 |2 |3 |4 |

| |$000 |$000 |$000 |$000 |$000 |

|After-tax cash flows |(3,800) |1,220 |1,153 |1,386 |3,829 |

Process Zeta

|Year |0 |1 |2 |3 |4 |

| |$000 |$000 |$000 |$000 |$000 |

|After-tax cash flows |(3,800) |643 |546 |1,055 |5,990 |

Tisa Co has 10 million 50c shares trading at 180c each. Its loans have a current value of $3·6 million and an average after-tax cost of debt of 4·50%. Tisa Co’s capital structure is unlikely to change significantly following the investment in either process.

Elfu Co manufactures electronic parts for cars including the production of a component similar to the one being considered by Tisa Co. Elfu Co’s equity beta is 1·40, and it is estimated that the equivalent equity beta for its other activities, excluding the component production, is 1·25. Elfu Co has 400 million 25c shares in issue trading at 120c each. Its debt finance consists of variable rate loans redeemable in seven years. The loans paying interest at base rate plus 120 basis points have a current value of $96 million. It can be assumed that 80% of Elfu Co’s debt finance and 75% of Elfu Co’s equity finance can be attributed to other activities excluding the component production.

Both companies pay annual corporation tax at a rate of 25%. The current base rate is 3·5% and the market risk premium is estimated at 5·8%.

Required:

(a) Provide a reasoned estimate of the cost of capital that Tisa Co should use to calculate the net present value of the two processes. Include all relevant calculations. (8 marks)

(b) Calculate the internal rate of return (IRR) and the modified internal rate of return (MIRR) for Process Omega. Given that the IRR and MIRR of Process Zeta are 26·6% and 23·3% respectively, recommend which process, if any, Tisa Co should proceed with and explain your recommendation. 8 marks)

(c) Elfu Co has estimated an annual standard deviation of $800,000 on one of its other projects, based on a normal distribution of returns. The average annual return on this project is $2,200,000.

Required:

Estimate the project’s Value at Risk (VAR) at a 99% confidence level for one year and over the project’s life of five years. Explain what is meant by the answers obtained. (4 marks)

(20 marks)

(ACCA P4 Advanced Financial Management June 2012 Q4)

Question 5 – EU, IRR, MIRR, VAR and legal risk

Riviere Co is a small company based in the European Union (EU). It produces high quality frozen food which it exports to a small number of supermarket chains located within the EU as well. The EU is a free trade area for trade between its member countries.

Riviere Co finds it difficult to obtain bank finance and relies on a long-term strategy of using internally generated funds for new investment projects. This constraint means that it cannot accept every profitable project and often has to choose between them.

Riviere Co is currently considering investment in one of two mutually exclusive food production projects: Privi and Drugi. Privi will produce and sell a new range of frozen desserts exclusively within the EU. Drugi will produce and sell a new range of frozen desserts and savoury foods to supermarket chains based in countries outside the EU. Each project will last for five years and the following financial information refers to both projects.

Project Drugi, annual after-tax cash flows expected at the end of each year (€000s)

€000

| |Current |1 |2 |3 |4 |5 |

|Cash flows (€000s) |(11,840) |1,230 |1,680 |4,350 |10,240 |2,200 |

| |Privi |Drugi |

|Net present value |€2,054,000 |€2,293,000 |

|Internal rate of return |17.6% |Not provided |

|Modified internal rate of return |13.4% |Not provided |

|Value at risk (over the project’s life) | | |

|95% confidence level |€1,103,500 |Not provided |

|90% confidence level |€860,000 |Not provided |

Both projects’ net present value has been calculated based on Riviere Co’s nominal cost of capital of 10%. It can be assumed that both projects’ cash flow returns are normally distributed and the annual standard deviation of project Drugi’s present value of after-tax cash flows is estimated to be €400,000. It can also be assumed that all sales are made in € (Euro) and therefore the company is not exposed to any foreign exchange exposure.

Notwithstanding how profitable project Drugi may appear to be, Riviere Co’s board of directors is concerned about the possible legal risks if it invests in the project because they have never dealt with companies outside the EU before.

Required:

(a) Discuss the aims of a free trade area, such as the European Union (EU), and the possible benefits to Riviere Co of operating within the EU. (5 marks)

(b) Calculate the figures which have not been provided for project Drugi and recommend which project should be accepted. Provide a justification for the recommendation and explain what the value at risk measures. (13 marks)

(c) Discuss the possible legal risks of investing in project Drugi which Riviere Co may be concerned about and how these may be mitigated. (7 marks)

(25 marks)

(ACCA P4 Advanced Financial Management December 2014 Q3)

Chapter 2 Option Pricing Theory in Investment Decisions

[pic]

1. Determinants of Option Values

(Jun 14)

1.1 The factors that affect the price of an option prior to expiration

|Factors |Explanation |

|1. The exercise price |The higher the exercise price, the lower the probability that a call will be exercised. So call |

| |prices will decrease as the exercise price increase. |

| |For the put, the effect runs in the opposite direction. A higher exercise price means that there|

| |is higher probability that the put will be exercised. So the put price increases as the exercise|

| |price increases. |

|2. The price of the underlying |As the current stock price goes up, the higher the probability that the call will be in the |

| |money. As a result, the call price will increase. |

| |As the stock price goes up, there is a lower probability that the put will be in the money. So |

| |the put price will decrease. |

|3. The volatility of the underlying |Both the call and put will increase in price as the underlying asset becomes more volatile. |

| |The buyer of the option receives full benefit of favourable outcomes but avoids the unfavourable|

| |ones (option price value has zero value). |

|4. The time to expiration |Both calls and puts will benefit from increased time to expiration. |

| |The reason is that there is more time for a big move in the stock price. |

| |But there are some effects that work in the opposite direction. |

| |As the time to expiration increase, the PV of the exercise price decreases. This will increase |

| |the value of the call and decrease the value of the put. |

| |Also, as the time to expiration increase, there is a greater amount of time for the stock price |

| |to be reduced by a cash dividend. This reduces the call value but increases the put value. |

|5. The interest rate |The higher the interest rate, the lower the present value of the exercise price. As a result, |

| |the value of the call will increase. |

| |The opposite is true for puts. The decrease in the PV of the exercise price will adversely |

| |affect the price of the put option. |

|6. The intrinsic value |The price of an option has two components – intrinsic value and time value. |

| |Intrinsic value is the value of the option if it was exercised now. |

| |Call options: Intrinsic value = Underlying stock’s current price – call strike price |

| |Put options: Intrinsic value = Put strike price – underlying stock’s current price. |

| |If the intrinsic value is positive the option is in the money. If the intrinsic value is zero, |

| |the option is at the money and if the intrinsic value is negative the option is out of the |

| |money. |

|7. The time value |The difference between the market price of an option and its intrinsic value is the time value |

| |of the option. |

| |Buyers of at the money or out of the money options are simply buying time value, which decreases|

| |as an option approaches expiration. |

| |The more time an option has until expiration, the greater the option’s chance of ending up in |

| |the money and the larger its time value. |

| |On the expiration day the time value of an option is zero and all an option is worth is its |

| |intrinsic value. It is either in the money or it is not. |

Market price of an option = Intrinsic value + time value of the option

2. The Black Scholes Pricing Model

(Dec 07, Dec 09, Jun 11, Jun 12, Dec 13)

2.1 The Black Scholes Formula

2.2.1 The formula for the value of a European call option is given by:

|Value of a call option = [pic] |

Where: Pa = the current price of the underlying asset

Pe = the exercise price

r = the continuously compounded risk-free rate

t = the time to expiration measured as a fraction of one year, for example t = 0.5 means that the time to expiration is 6 months

e = the base of the natural logarithms (= 2.71828)

|[pic] |

|[pic] |

Where: s = volatility of the share price (as measured by the standard deviation expressed as a decimal)

2.2 Value of European put options

2.2.1.1 The value of a European put option can be calculated by using the Put Call Parity relationship which is given to you in the exam formulae sheet.

|p = c – Pa + Pe e-n |

Where: p = the value of the put option

c = the value of the call option

3. Real Options

3.1 Limitations of the NPV rule

3.1.1 Dealing with uncertainty:

(a) Although the cash flows are discounted at an appropriate cost of capital, NPV does not explicitly deal with uncertainty when valuing the project.

(b) A risk-adjusted discount rate reduces the PV of the cash flows rather than giving the decision maker an indication of the range of cash flows that a project may deliver.

(c) The use of single discount rate means that risk is defined in one measure. This does not allow for the many sources of uncertainty that may surround the project and its cash flows.

3.1.2 Flexibility in responding to uncertainty:

(a) NPV fails to consider the extent of management’s flexibility to respond to uncertainties surrounding the project. Such flexibility can be an extremely valuable part of the project and by failing to account for it, NPV may significantly underestimate the project’s value.

(b) NPV will only provide an accurate estimate of the project’s value if there is not flexibility or no uncertainty, i.e. flexibility will have no value as management knows exactly what is going to happen.

3.2 Option to delay

(Dec 07, Jun 11, Jun 12)

3.2.1 A traditional investment analysis just answers the question of whether the project is a ‘good’ one if taken today. Thus, the fact that a project is not selected today either because its NPV is negative, or its IRR is less than its cost of capital, does not mean that the rights to this project are not valuable.

3.2.2 Option to delay is the same as the payoff of a call option.

3.3 Option to expand

3.3.1 The option to expand exists when firms invest in projects which allow them to make further investments in the future or to enter new markets. The initial project may be found in terms of its NPV as not worth undertaking.

3.3.2 However, when the option to expand is taken into account, the NPV may become positive and the project worthwhile. The initial investment may be seen as the premium required to acquire the option to expand.

3.4 Option to abandon/withdraw

(Dec 13)

3.4.1 Whereas traditional capital budgeting analysis assumes that a project will operate in each year of its lifetime, the firm may have the option to cease a project during its life. This option is known as an abandonment option.

3.4.2 Abandonment options, which are the right to sell the cash flows over the remainder of the project's life for some salvage value, are like American put options.

3.4.3 When the present value of the remaining cash flows (PV) falls below the liquidation value (L), the asset may be sold. Abandonment is effectively the exercising of a put option.

3.5 Option to redeploy/switch

3.5.1 The option to redeploy exists when the company can use its productive assets for activities other than the original one. The switch from one activity to another will happen if the PV of cash flows from the new activity will exceed the costs of switching.

3.5.2 The option to abandon is a special case of an option to redeploy.

3.6 Valuation of Real Options

3.6.1 To use the Black-Scholes model, we need to identify the five key input variables as follows:

|Original variables |Project variables |

|Exercise price (Pe) |For most real options (e.g. option to expand, option to delay), the capital investment |

| |required can be substituted for the exercise price. These options are examples of call |

| |options. |

| |For an option to abandon, use the salvage value (i.e. amount received) on abandonment. |

| |This is an example of a put option. |

|Value of the underlying asset (e.g. share |It is usually taken to be the PV of the future cash flows from the project (i.e. |

|price) (Pa) |excluding any initial investment). |

| |This could be the value of the project being undertaken for a call option (e.g. option to|

| |expand, option to delay), or the value of the cash flows being foregone for a put option |

| |(e.g. option to abandon). |

|Time to expiry (t) |Exercise date in years |

|Volatility (s) |The volatility is the risk attached to the project or underlying asset, measured by the |

| |standard deviation. |

|Risk-free rate (r) |Many writers continue to use the risk-free rate for real options. |

| |However, some argue that a higher rate should be used to reflect the extra risks when |

| |replacing the share price with the PV of future cash flows. |

4. Assumptions of the Black-Scholes Model

(Dec 07, Jun 14)

4.1 Assumptions:

(a) Lognormality. The model assumes that the return on the underlying asset follows a normal distribution which means the return itself follows a lognormal distribution.

(b) Perfect markets. This suggests that the direction of the market cannot be consistently predicted and thus the returns on the underlying asset can go up or down at any given moment in time.

(c) Constant interest rates. The risk-free rate is used in the Black-Scholes model and this rate is assumed to be constant and known.

(d) Constant volatility. The model assumes that the volatility of the project is known and remains constant throughout its life.

(e) Tradability of asset. The model assumes that there is a market for the underlying asset and it can therefore be traded. However, real options and their underlying assets are not traded, therefore it is very difficult to establish the volatility of the value.

(f) Style of option. The Black-Scholes model assumes that the option is a European style option – that is, it can only be exercised at the maturity date. Where the option can be exercised at any point up to the maturity date (that is, an American style option), the results of the Black-Scholes model are invalid.

Question 1 – Option to delay

Digunder, a property development company, has gained planning permission for the development of a housing complex at Newtown which will be developed over a three year period. The resulting property sales less building costs have an expected net present value of $4 million at a cost of capital of 10% per annum. Digunder has an option to acquire the land in Newtown, at an agreed price of $24 million, which must be exercised within the next two years. Immediate building of the housing complex would be risky as the project has a volatility attaching to its net present value of 25%.

One source of risk is the potential for development of Newtown as a regional commercial centre for the large number of professional firms leaving the capital, Bigcity, because of high rents and local business taxes. Within the next two years, an announcement by the government will be made about the development of transport links into Newtown from outlying districts including the area where Digunder hold the land option concerned. The risk free rate of interest is 5% per annum.

Required:

(a) Estimate the value of the option to delay the start of the project for two years using the Black and Scholes option pricing model and comment upon your findings. Assume that the government will make its announcement about the potential transport link at the end of the two-year period. (12 marks)

(b) On the basis of your valuation of the option to delay, estimate the overall value of the project, giving a concise rationale for the valuation method you have used.

(4 marks)

(c) Describe the limitations of the valuation method you used in (a) above and describe how you would value the option if the government were to make the announcement at ANY time over the next two years. (5 marks)

(d) Briefly explain TWO other types of real option that may be present, relating to the Newtown housing development. (4 marks)

(Total: 25 marks)

(Amended ACCA P4 Advanced Financial Management December 2007 Q3)

Question 2 – Option to delay

MesmerMagic Co (MMC) is considering whether to undertake the development of a new computer game based on an adventure film due to be released in 22 months. It is expected that the game will be available to buy two months after the film’s release, by which time it will be possible to judge the popularity of the film with a high degree of certainty. However, at present, there is considerable uncertainty about whether the film, and therefore the game, is likely to be successful. Although MMC would pay for the exclusive rights to develop and sell the game now, the directors are of the opinion that they should delay the decision to produce and market the game until the film has been released and the game is available for sale.

MMC has forecast the following end of year cash flows for the four-year sales period of the game.

|Year |1 |2 |3 |4 |

|Cash flows ($ million) |25 |18 |10 |5 |

MMC will spend $7 million at the start of each of the next two years to develop the game, the gaming platform, and to pay for the exclusive rights to develop and sell the game. Following this, the company will require $35 million for production, distribution and marketing costs at the start of the four-year sales period of the game.

It can be assumed that all the costs and revenues include inflation. The relevant cost of capital for this project is 11% and the risk free rate is 3.5%. MMC has estimated the likely volatility of the cash flows at a standard deviation of 30%.

Required:

(a) Estimate the financial impact of the directors’ decision to delay the production and marketing of the game. The Black-Scholes Option Pricing model may be used, where appropriate. All relevant calculations should be shown. (12 marks)

(b) Briefly discuss the implications of the answer obtained in part (a) above.

(7 marks)

(c) Discuss how a decrease in the value of each of the determinants of the option price in the Black-Scholes option-pricing model for European options is likely to change the price of a call option. (6 marks)

(Total = 25 marks)

(Amended ACCA P4 Advanced Financial Management June 2011 Q4)

Question 3 – Option pricing, estimation of coupon rate and mezzanine debt

Alaska Salvage is in discussion with potential lenders about financing an ambitious five-year project searching for lost gold in the central Atlantic. The company has had great success in the past with its various salvage operations and is now quoted on the London Alternative Investment Market. The company is currently financed by 120,000 equity shares trading at $85 per share. It needs to borrow $1·6 million and is concerned about the level of the fixed rates being suggested by the lenders. After lengthy discussions the lenders are prepared to offer finance against a mezzanine issue of fixed rate five-year notes with warrants attached. Each $10,000 note, repayable at par, would carry a warrant for 100 equity shares at an exercise price of $90 per share. The estimated volatility of the returns on the company’s equity is 20% and the risk free rate of interest is 5%. The company does not pay dividends to its equity investors.

You may assume that the issue of these loan notes will not influence the current value of the firm’s equity. The issue will be made at par.

Required:

(a) Estimate, using Black-Scholes Option Pricing Model as appropriate, the current value of each warrant to the lender noting the assumptions that you have made in your valuation. (10 marks)

(b) Estimate the coupon rate that would be required by the lenders if they wanted a 13% rate of return on their investment. (4 marks)

(c) Discuss the advantages and disadvantages of issuing mezzanine debt in the situation outlined in the case. (6 marks)

(20 marks)

(ACCA P4 Advanced Financial Management December 2009 Q3)

Chapter 3 Financing Decision

[pic]

1. Short-term Debt

1.1 It includes:

(a) Overdrafts

(b) Short-term loans

(c) Trade credit

(d) Leasing

2. Long-term debt

2.1 Reasons for seeking debt finance:

(a) Shareholders are unwilling to contribute additional capital

(b) The company does not wish to involve outside shareholders

(c) Lesser cost and easier availability

(d) Tax relief on interest payments

2.2 Factors influencing choice of debt by a company

(a) Availability

(b) Duration

(c) Fixed or floating rate

(d) Security and covenants

(e) Gearing and financial risk

(f) Target capital structure

(g) Economic expectations

2.3 Factors to be considered by providers of finance

(a) Risk and the ability to meet financial obligations

(b) Security

(c) Legal restrictions on borrowing, e.g debt contracts or articles of association

3. Valuation of Debts and Preference Shares

|3.1 |Formulae |

| |The formulae for the various types of finance are as follows: |

| | |

| |Types of finance |

| |Market value |

| | |

| |Irredeemable debt without tax |

| |[pic] |

| | |

| |Irredeemable debt with tax |

| |[pic] |

| | |

| |Redeemable debt |

| |MV = PV of future interest and redemption receipts, discounted at investors’ required returns |

| | |

| |Preference shares |

| |[pic] |

| | |

| | |

| |Where: |

| |P0 = ex-div market value of the debt or share |

| |i = annual interest starting in one year’s time |

| |Kd = company’s cost of debt, expressed as a decimal |

| |Kp = cost of the preference shares |

4. Causes of Interest Rate Fluctuations

4.1 Terms structure of interest rates

4.1.1 The term structure of interest rates refers to the way in which the yield on a security varies according to the term of the borrowing, as shown by the yield curve.

4.1.2 There are several reasons why interest rates differ in different markets and market segments.

(a) Risk

(b) Need to make a profit by financial institutions

(c) Size of the loan

(d) Types of financial asset

(e) Government policy

(f) Duration of lending

4.2 Yield curve

4.2.1 The yield curve is an analysis of the relationship between the yields on debt with different periods to maturity.

4.2.2 A yield curve can have any shape, and can fluctuate up and down for different maturities.

4.2.3 There are three main types of yield curve shapes: normal, inverted and flat (humped):

(a) Normal yield curve – longer maturity bonds have a higher yield compared with shorter-term bonds due to the risks associated with time.

(b) Inverted yield curve – the short-term yields are higher than the longer-term yields, which can be a sign of upcoming recession.

(c) Flat (or humped) yield curve – the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic transition.

4.2.4 The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.

[pic]

[pic]

4.2.5 The shape of the yield curve at any point in time is the result of the three following theories acting together:

(a) Liquidity preference theory (流動性偏好理論)

(b) Expectations theory

(c) Market segmentation theory (市場分割理論)

[pic]

4.2.6 Significance of yield curves to financial managers

Financial managers should inspect the current shape of the yield curve when deciding on the term of borrowings or deposits, since the curve encapsulates the market's expectations of future movements in interest rates.

4.3 Yield to maturity (YTM)

4.3.1 The yield to maturity (or redemption yield) is the effective yield on a redeemable bond which allows for the time value of money and is effectively the IRR of the cash flows.

5. Other Types of Financing

5.1 Equity finance

5.1.1 The issue of equity is at the bottom of the pecking order when it comes to raising funds for investments, not only because of the cost of issue but also because equity finance is more expensive in terms of required returns.

5.1.2 Equity shareholders are the ultimate bearers of risk as they are at the bottom of the creditor hierarchy in a liquidation. This means that there is a significant risk that they will receive nothing at all after all other trade payables’ claims have been met.

5.2 Venture capital

5.2.1 Venture capital is long-term capital that is available for around five years. It is normally offered by specialist institutions, and is aimed at small and medium-size businesses that have a fairly high level of risk.

5.2.2 Venture capitalists are prepared to provide capital to such businesses if the expected returns are commensurate with the level of risk taken. This means that venture capitalists will only be interested in a business with good profit and growth prospects. The amount of capital invested will vary according to need and may be provided in stages, subject to certain key objectives being met.

5.2.3 Venture capitalist may be interested in the following types of business:

(a) Business start-ups

(b) Growth capital

(c) Management acquisitions

(d) Business recoveries

5.3 Business angels

5.3.1 Business angels are wealthy individuals who invest in start-up and growth businesses in return for an equity stake. These individuals are prepared to take high risks in the hope of high returns. As a result, business angel finance can be expensive for the business.

5.3.2 Business angels are a very useful tool to fill the gap between venture capital and debt finance, particularly for start-up businesses.

5.4 Lease finance

5.4.1 There are two types of leases:

(a) A finance lease exists when the substance of the lease is that the lessee enjoys substantially all of the risks and rewards of ownership, even though legal title to the leased asset does not pass from lessor to lessee.

(b) An operating lease is a rental agreement where several lessees are expected to use the leased asset and so the lease period is much shorter than the asset’s useful economic life.

5.5 Asset securitization

(Jun 10, Jun 12, Sep/Dec 15)

5.5.1 Securitisation is the process of converting illiquid assets into marketable asset-backed securities. These securities are backed by specific assets and are normally called asset-backed securities (ABS).

5.5.2 The oldest and historically most common type of asset securitization is the mortgage-backed bond or security (MBS).

5.5.3 Very simplistically, the process is as follows:

(a) A financial entity can purchase a number of mortgage loans from banks.

(b) The entity pools the mortgage loans together.

(c) The entity issues bonds to institutional investors. The money raised from issuing bonds is used to pay for the mortgage loans.

(d) The institutional investors now have the right to receive the principal and interest payments made on the mortgage.

5.5.4 Today, virtually anything that has a cash flow (e.g. a loan, a public works project, or a receivable balance) is a candidate for securitization.

5.5.5 The tangible benefit from securitisation occurs when the pooled assets are divided into tranches and tranches are credit rated. The higher rated tranches would carry less risk and have less return, compared to lower rated tranches. If default occurs, the income of the lower tranches is reduced first, before the impact of increasing defaults move to the higher rated tranches. This allows an asset of low liquidity to be converted into securities which carry higher liquidity.

5.5.6 The main reason for securitizing a cash flow is that if allows companies with a credit rating of, for example, BB but with AAA-rated cash flows to possibly borrow at AAA rates. This will lead to greatly reduced interest payments as the difference between BB rates and AAA rates can be hundreds of basis points.

5.5.7 However, securitization is expensive due to management costs, legal fees and continuing administration fees.

[pic]

5.6 Hybrids

5.6.1 Hybrids are means of finance that combine debt and equity. Such securities pay a fixed or floating rate of return up to a certain date, after which the holder has such options as converting the securities into the underlying equity.

5.6.2 Convertible debt has a number of attractions:

(a) Self-liquidating

(b) Lower interest rate

(c) Increase in debt capacity on conversion

(d) More attractive than ordinary debt

6. Duration

(Jun 11, Pilot 13, Jun 14)

6.1 Meaning of duration

6.1.1 Duration is the weighted average length of time to the receipts of a bond’s benefits, the weights being the PV of the benefits involved.

6.1.2 Duration gives each bond an overall risk weighting that allows two bonds to be compared. In simple terms, it is a composite measure of the risk expressed in years.

6.2 Calculating duration

6.2.1 The steps of calculating duration

Step 1: Add the PV of the cash flows in each time period together.

Step 2: Multiply the PV of cash flows for each time period by the time period and add together.

Step 3: Divide the result of step 2 by the result of step 1.

6.3 Properties of duration

6.3.1 Basic features of sensitivity to interest rate risk will all be mirrored in the duration calculation.

(a) Longer-dated bonds will have longer durations. The shorter-maturity bond would have a lower duration and less price risk.

(b) Lower-coupon bonds will have longer duration. The bond with higher coupon will pay back its original cost quicker than the lower-yield bond.

(c) Lower yields will give longer durations.

6.4 Modified duration

(Jun 11, Pilot 13, Jun 14)

6.4.1 Modified duration is a measure of the sensitivity of the price of a bond to a change in interest rates.

6.4.2 Formula:

|Modified duration = |

|Macaulay duration |

| |

| |

|1 + GRY |

| |

| |

|This can be used to determine the proportionate change in bond price for a given change in yield as follows: |

| |

|ΔP = – Modified duration × ΔY × P |

| |

|Where: |

|ΔP = change in bond price |

|ΔY = change in yield |

|P = current market price of the bond |

| |

|Remember there is an inverse relationship between yield and bond price, therefore the modified duration figure is |

|expressed as a negative number. |

6.4.3 For example, if the modified duration is 2.74 and the yield increased by 0.5%, the change in price can be calculated as follows:

ΔP = –2.74 × 0.5% × $1,070.12 = –$14.66

6.5 Benefits of duration

6.5.1 Benefits:

(a) Bonds with different maturities and coupon rates can be directly compared.

(b) It is possible to determine portfolio value changes based on estimated changes in interest rates.

(c) Managers may be able to modify interest rate risk by changing the duration of the bond portfolio.

6.6 Limitations of duration

(Jun 11, Pilot 13, Jun 14)

6.6.1 The main limitation of duration is that it assumes a linear relationship between interest rates and price, i.e. it assumes that for a certain percentage change in interest rates there will be an equal percentage change in price.

[pic]

6.6.2 As you can see from the diagram above, the more convex the relationship the more inaccurate duration is for measuring interest rate sensitivity. Therefore duration should be treated with caution in your predictions of interest rate/price relationships.

6.6.3 Duration can only be applied to measure the approximate change in a bond price due to interest changes, only if changes in interest rates do not lead to a change in the shape of the yield curve.

6.6.4 If the shape of the yield curve changes, duration can no longer be used to assess the change in bond value due to interest rate change.

7. Credit Risk

7.1 Credit risk aspects

7.1.1 Credit risk, also referred to as default risk, is the risk undertaken by the lender that the borrower will default either on interest payments or on the repayment of principal on the due date, or on both.

7.1.2 Creditors to companies such as corporate bondholders and banks are also exposed to credit risk. The credit risk of an individual loan or bond is determined by the following two factors:

(a) Probability of default

(b) Recovery rate

7.2 Criteria for establishing credit ratings

(Pilot 13)

7.2.1 The criteria for rating international organizations encompasses the following.

|Criteria |Explanation |

|Country risk |No issuer’s debt will be rated higher than the country of origin of the issuer (the |

| |‘Sovereign Ceiling’ concept) |

|Universal/Country importance |The company’s standing relative to other companies in the country of domicile and globally|

| |(measured in terms of sales, profits, relationship with government, importance of the |

| |industry to the country, etc.) |

|Industry risk |The strength of the industry within the country, measured by the impact of economic |

| |forces, cyclical nature of the industry, demand factors, etc. |

|Industry position |Issuer’s position in the relevant industry compared with competitors in terms of operating|

| |efficiency. |

|Management evaluation |The company’s planning, controls, financing policies and strategies, overall quality of |

| |management and succession, merger and acquisition performance and record of achievement in|

| |financial results. |

|Accounting quality |Auditor’s qualifications of the accounts, and accounting policies for inventory, goodwill,|

| |depreciation policies and so on. |

|Earnings protection |Earnings power including return on capital, pre-tax and net profit margins, sources of |

| |future earnings growth. |

|Financial gearing |Long-term debt and total debt in relation to capital, gearing, nature of assets, |

| |off-balance commitments, working capital, management, etc. |

|Cash flow adequacy |Relationship of cash flow to gearing and ability to finance all business cash needs. |

|Financial flexibility |Evaluation of financing needs, plans and alternatives under stress (ability to attract |

| |capital), banking relationships, debt covenants. |

8. Credit Spreads and Cost of Debt Capital

(Dec 07, Dec 11)

8.1 Credit spreads

8.1.1 The credit spread is the premium required by an investor in a corporate bond to compensate for the credit risk of the bond.

8.1.2 Assuming that a government bond such as the one issued by the US or an EU government is free of credit risk, the yield on a corporate bond will be:

Yield on corporate bond = risk free rate + credit spread

8.2 The cost of debt capital

8.2.1 The cost debt capital for a company is determined by the following:

(a) its credit rating

(b) the maturity of the debt

(c) the risk-free rate at the appropriate maturity

(d) the corporate tax rate

Cost of debt capital = (1 – tax rate) × (risk free rate + credit spread)

8.3 Predicting credit ratings

8.4.1 Credit rating companies use financial ratios and other information in order to arrive at the credit score of a company.

8.4.2 The Kaplan-Urwitz model for quoted companies is as follows.

|Y = 5.67 + 0.011F + 5.13π – 2.36S – 2.85L + 0.007C – 0.87β – 2.90σ |

| |

|Where: |

|Y = the score that the model produces |

|F = the size of a firm measured in total assets |

|π = net income / total assets |

|S = debt status (subordinated debt = 1, otherwise = 0) |

|L = gearing (measured as long term debt / total assets) |

|C = interest cover (PBIT / interest payment) |

|β = beta of the company estimated using CAPM |

|σ = the variance of the residuals from the CAPM regression equation (calculated as |

|[pic], where [pic] is the variance of the market) |

8.4.3 The classification of companies into credit rating categories is done in the following way.

|Score (Y) |Rating category |

|Y > 6.76 |AAA |

|Y > 5.19 |AA |

|Y > 3.28 |A |

|Y > 1.57 |BBB |

|Y > 0 |BB |

8.4.4 The second Kaplan Urwitz model was estimated using data on unquoted companies:

|Y = 4.41 + 0.014F + 6.4π – 2.56S – 2.72L + 0.006C – 0.53σ |

You will notice that there is no beta factor in the above equation – this is because we are dealing with unquoted companies.

In this case σ is the standard deviation of earnings. All the other variables remain the same.

9. Effects of Alternative Financing Strategies on Financial Reporting

9.1 Impact of gearing on EPS, EBIT and return on equity

(Jun 12)

9.1.1 To appreciate the impact of financial gearing we shall explain and calculate the effects of changes in EBIT on EPS for a company with differing amounts of debt financing.

9.2 Degree of financial gearing

9.2.1 The degree of financial gearing measures the sensitivity of EPS to changes in EBIT.

9.2.2 The degree of financial gearing (DFG) is defined as the change in EPS over the change in EBIT or

|% change in EPS |

| |

|% change in EBIT |

| |

| |

|The degree of financial gearing can be calculated from the formula: |

| |

|EBIT |

| |

|EBIT – Interest |

| |

Question 1 – Credit spread, cost of debt and debt valuation

Your company, which is in the airline business, is considering raising new capital of $400 million in the bond market for the acquisition of new aircraft. The debt would have a term to maturity of four years. The market capitalisation of the company’s equity is $1.2 billion and it has a 25% market gearing ratio (market value of debt to total market value of the company). This new issue would be ranked for payment, in the event of default, equally with the company’s other long-term debt and the latest credit risk assessment places the company at AA. Interest would be paid to holders annually. The company’s current debt carries an average coupon of 4% and has three years to maturity. The company’s effective rate of tax is 30%.

The current yield curve suggests that, at three years, government treasuries yield 3.5% and at four years they yield 5.1%. The current credit risk spread is estimated to be 50 basis points at AA. If the issue proceeds, the company’s investment bankers suggest that a 90 basis point spread will need to be offered to guarantee take up by its institutional clients.

Required:

(a) Advise on the coupon rate that should be applied to the new debt issue to ensure that it is fully subscribed. (4 marks)

(b) Estimate the current and revised market valuation of the company’s debt and the increase in the company’s effective cost of debt capital. (8 marks)

(c) Discuss the relative advantages and disadvantages of this mode of capital financing in the context of the company’s stated financial objectives. (8 marks)

(d) Briefly consider company-specific factors that will be used in the credit rating assessment to classify the company as AA. (5 marks)

(Total = 25 marks)

(Amended ACCA P4 Advanced Financial Management December 2007 Q5)

Question 2 – Duration

GNT Co is considering an investment in one of two corporate bonds. Both bonds have a par value of $1,000 and pay coupon interest on an annual basis. The market price of the first bond is $1,079.68. Its coupon rate is 6% and it is due to be redeemed at par in five years. The second bond is about to be issued with a coupon rate of 4% and will also be redeemable at par in five years. Both bonds are expected to have the same gross redemption yields (yields to maturity). The yield to maturity of a company’s bond is determined by its credit rating.

GNT Co considers duration of the bond to be a key factor when making decisions on which bond to invest.

Required:

(a) Estimate the Macaulay duration of the two bonds GNT Co is considering for investment. (9 marks)

(b) Discuss how useful duration is as a measure of the sensitivity of a bond price to changes in interest rates. (8 marks)

(c) Among the criteria used by credit agencies for establishing a company’s credit rating are the following: industry risk, earnings protection, financial flexibility and evaluation of the company’s management.

Briefly explain each criterion and suggest factors that could be used to assess it.

(8 marks)

(Total 25 marks)

(ACCA P4 Advanced Financial Management Pilot Paper 2013 Q4)

Question 3 – Credit spread, bond price and predicting credit rating

Levante Co is a large unlisted company which has identified a new project for which it will need to increase its long term borrowings from $250 million to $400 million. This amount will cover a significant proportion of the total cost of the project and the rest of the funds will come from cash held by the company.

The current $250 million unsubordinated borrowing is in the form of a 4% bond which is trading at $98.71 per $100 and is due to be redeemed at par in three years. The issued bond has a credit rating of AA. The new borrowing will also be raised in the form of a traded bond with a par value of $100 per unit. It is anticipated that the new project will generate sufficient cash flows to be able to redeem the new bond at $100 par value per unit in five years. It can be assumed that coupons on both bonds are paid annually.

Both bonds would be ranked equally for payment in the event of default and the directors expect that as a result of the new issue, the credit rating for both bonds will fall to A. The directors are considering the following two alternative options when issuing the new bond:

(i) Issue the new bond at a fixed coupon of 5% but at a premium or discount, whichever is appropriate to ensure full take up of the bond; or

(ii) Issue the new bond at a coupon rate where the issue price of the new bond will be $100 per unit and equal to its par value.

The following extracts are provided on the current government bond yield curve and yield spreads for the sector in which Levante Co operates:

Current Government Bond Yield Curve

|Years |1 |2 |3 |4 |5 |

| |3.2% |3.7% |4.2% |4.8% |5.0% |

Yield spreads (in basis points)

|Bond rating |1 year |2 years |3 years |4 years |5 years |

|AAA |5 |9 |14 |19 |25 |

|AA |16 |22 |30 |40 |47 |

|A |65 |76 |87 |100 |112 |

|BBB |102 |121 |142 |167 |193 |

Required:

(a) Calculate the expected percentage fall in the market value of the existing bond if Levante Co’s bond credit rating falls from AA to A. (3 marks)

(b) Advise the directors on the financial implications of choosing each of the two options when issuing the new bond. Support the advice with appropriate calculations. (8 marks)

(c) Among the criteria used by credit agencies for establishing a company’s credit rating are the following: industry risk, earnings protection, financial flexibility and evaluation of the company’s management. Briefly explain each criterion and suggest factors that could be used to assess it. (8 marks)

(d) The following information is available for the expected situation after the proposed bond issue.

Total assets = $1,050m

Monthly net income = $25m

Annual profit before interest and tax = $450m

Standard deviation of earnings = 8%

Assume the new bond is issued with a 5% coupon.

Use the Kaplan-Urwitz model for unquoted companies to predict whether the credit rating will be AAA, AA or A. (6 marks)

Note: The model is Y = 4.41 + 0.014F + 6.4π – 2.56S – 2.72L + 0.006C – 0.53σ

(Amended ACCA P4 Advanced Financial Management December 2011 Q3)

Question 4 – Securitization

The finance division of GoSlo Motor Corporation has made a number of loans to customers with a current pool value of $200 million. The loans have an average term to maturity of four years. The loans generate a steady income to the business of 10·5% per annum. The company will use 95% of the loan’s pool as collateral for a collateralised loan obligation structured as follows:

– 80% of the collateral value to support a tranche of A-rated floating rate loan notes offering investors LIBOR plus 140 basis points.

– 10% of the collateral value to support a tranche of B-rated fixed rate loan notes offering investors 11%.

– 10% of the collateral value to support a tranche as subordinated certificates (unrated).

In order to minimise interest rate risk, the company has decided to enter into a fixed for variable rate swap on the A-rated floating rate notes exchanging LIBOR for 8·5%.

Service charges of $240,000 per annum will be charged for administering the income receivable from the loans.

You may ignore prepayment risk.

Required:

(a) Calculate the expected returns of the investments in each of the three tranches described above. Estimate the sensitivity of the subordinated certificates to a reduction of 1% in the returns generated by the pool. (10 marks)

(b) Explain the purpose and the methods of credit enhancement that can be employed on a securitisation such as this scheme. (4 marks)

(c) Discuss the risks inherent to the investors in a scheme such as this. (6 marks)

(d) Aside from the securitisation, GoSlo Motor Corporation has a large corporate fleet customer which owes $5 million, to be repaid in 4 years, to GoSlo. Management is worried about the possibility of default by this customer. A credit default swap, trading at 450 basis points, can be obtained. Illustrate the result of hedging using the credit default swap:

(i) In the event of no default

(ii) In the event of a default after 3 years

(5 marks)

(25 marks)

(Amended ACCA P4 Advanced Financial Management June 2010 Q3)

Question 5 – Effects of financial strategies on financial reporting and securitization

Three proposals were put forward for further consideration after a meeting of the executive directors of Ennea Co to discuss the future investment and financing strategy of the business. Ennea Co is a listed company operating in the haulage and shipping industry.

Proposal 1

To increase the company’s level of debt by borrowing a further $20 million and use the funds raised to buy back share capital.

Proposal 2

To increase the company’s level of debt by borrowing a further $20 million and use these funds to invest in additional non-current assets in the haulage strategic business unit.

Proposal 3

To sell excess non-current haulage assets with a net book value of $25 million for $27 million and focus on offering more services to the shipping strategic business unit. This business unit will require no additional investment in non-current assets. All the funds raised from the sale of the non-current assets will be used to reduce the company’s debt.

Ennea Co financial information

Extracts from the forecast financial position for the coming year

| |$m |

|Non-current assets |282 |

|Current assets |66 |

| |348 |

|Equity and liabilities | |

|Share capital (40c per share) |48 |

|Retained earnings |123 |

|Total equity |171 |

| | |

|Non-current liabilities |140 |

|Current liabilities |37 |

|Total liabilities |177 |

| | |

|Total equity and liabilities |348 |

Ennea Co’s forecast after tax profit for the coming year is expected to be $26 million and its current share price is $3.20 per share. The non-current liabilities consist solely of a 6% medium term loan redeemable within seven years. The terms of the loan contract stipulates that an increase in borrowing will result in an increase in the coupon payable of 25 basis points on the total amount borrowed, while a reduction in borrowing will lower the coupon payable by 15 basis points on the total amount borrowed.

Ennea Co’s effective tax rate is 20%. The company’s estimated after tax rate of return on investment is expected to be 15% on any new investment. It is expected that any reduction in investment would suffer the same rate of return.

Required:

(a) Estimate and discuss the impact of each of the three proposals on the forecast statement of financial position, the earnings and earnings per share, and gearing of Ennea Co. (20 marks)

(b) An alternative suggestion to proposal three was made where the non-current assets could be leased to other companies instead of being sold. The lease receipts would then be converted into an asset through securitisation. The proceeds from the sale of the securitised lease receipts asset would be used to reduce the outstanding loan borrowings.

Required:

Explain what the securitisation process would involve and what would be the key barriers to Ennea Co undertaking the process. (5 marks)

(Total = 25 marks)

(ACCA P4 Advanced Financial Management June 2012 Q2)

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ACCA June 2016 Dec 2014

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