Answers

Part 3 Examination Paper 3.7 (ENG)

Strategic Financial Management (English)
1

June 2007 Answers

The proposed FDI and licensing will be evaluated using the net present value of relevant cash flows to the UK.
Forecast exchange rates using purchasing power parity:
Spot
Year 1
Year 2
Year 3
Year 4
Year 5

$H/
1580
1704
1787
1873
1964
2060

Bt/
420
432
441
449
458
467

$H/Bt
376
394
405
417
429
441

Expected cash flows from foreign direct investment

Year
Sales
Variable costs
Fixed costs
Component
Depreciation
Total expenses
Taxable
Taxation (20%)
Add back depreciation
Initial cost
Land and buildings
New machinery
Working capital
Realisable value
Remittable cash flow

1
150
76
23

99
51
(10)

41

$H million
2
3
405
437
174
188
40
40
51
52
17
17

282
297
123
140
(25)
(28)

98
112
17
17

4
472
203
40
54
17

314
158
(32)

126
17

5
510
219
40
55
17

331
179
(36)

143
17

(4)

139

(4)
150

306

(120)

(35)

(70)
(68)
(4)

(155)

(101)

112

0
(981)

1
(593)
(030)

2
627
(069)
050

3
673
(075)
049

4
708
(080)
048

5
1485
(087)
047

(051)

557
0769
428

(053)

594
0675
401

(055)

621
0592
368

(056)

1389
0519
721

(3)

(3)

126
million

Year
Remittable from H
Extra tax (10%)
Remittable from B1
Incremental cash flow
from machinery
Tax on profit (30%)
Lost exports (after tax)2
Net cash flow
Discount factors (14%)3
Present values

(981)
(981)

100
(030)
(050)

(603)
0877
(529)

The expected net present value is 4,080,000

Notes:
The extra after tax cash flow earned by the subsidiary in Bottoniland is an incremental cash flow to the group as a result of the
investment. The data is shown in after tax for the relevant year.

Lost exports are assumed to increase with UK inflation. It might be argued that such losses would continue beyond five years
and have a more detrimental effect on cash flows.

Using CAPM, the discount rate is 5% + (12% 5%) x 13 = 141%.

14% will be used.

15

Working capital requirements in Hotternia are assumed to increase at the rate of inflation in Hotternia.
Licensing
Year
Receipts from fees $H
Receipts from fees
Incremental cash flow
from maintenance
Incremental cash flow
from machinery
Staff costs
Taxable
Tax at 30%
Lost exports (after tax)4
Net cash flows
Discount factors (14%)
Present values

2
4000
224

million
3
4
4320
4666
231
238

5
5039
245

025

025

025

025

(021)

228
(068)

160
(051)

109
0769
084

(022)

234
(070)

164
(053)

111
0675
075

(022)

241
(072)

169
(055)

114
0592
067

(023)

247
(074)

173
(056)

117
0519
061

100

100
(030)

070

070
0877
061

The expected net present value from licensing is 3,480,000.

4

With licensing, no exports are lost in year 1.

The financial analysis suggests that foreign direct investment is the better choice, as it results in a higher expected NPV.
Other information that might influence the decision includes:
(i)

Are there strategic reasons for preferring a specific method of market entry?

(ii)

What happens after five years? Would the licence be renewed? Do real options exist for each alternative and if so what is their
expected net present value?

(iii) How accurate are the cash flow projections? Simulation analysis or sensitivity analysis would be useful.
(iv) How reliable is KBD? Could quality be maintained and is there the risk of technology transfer?
(v)

What are the risks of the investments? What are the political and other non-financial risks associated with FDI and licensing?
FDI normally involves much more risk than licensing.

(vi) Does the discount rate of 14% correctly reflect the risk? Licensing should probably be discounted at a lower rate if it is less
risky.
(vii) Is the FDI realisable value estimated using an asset basis or going concern basis? A going concern valuation could be much
higher than an asset based valuation.

(a)

Gap analysis measures the difference between an organisations financial targets and what it expects to achieve given its
existing policies. It is important to estimate the potential size and nature of the gap in order to develop new strategies that
will eliminate the gap and allow the organisation to achieve its stated targets.

(b)

Financial projections for the next three years.

Year
Sales
Less
Variable costs
Fixed costs
Capital allowances
EBIT
Interest
Profit before tax
Tax
Dividends
Retained earnings

1
5775

million
2
6064

3
6367

3754
980
465

576
140

436
131

305
122

183

3942
980
349

793
127

666
200

466
186

280

4139
980
262

986
108

878
263

615
246

369

16

Achievement of financial targets:

(i)

Growth in profit before tax

53%

32%

Pre-tax profit is expected to grow by more than 20% in both years.

(ii)

Repay overdraft
Year
Overdraft at year end

1
767

2
487

3
118

The overdraft cannot be repaid within three years.

(iii) Gearing:
Year
Total borrowing
Shareholders equity
Gearing ratio

1
1817
3593
506%

2
1537
3873
397%

3
1168
4242
275%

The gearing is expected to fall to below the level required by the covenant.
Notes:
(i)

Revised interest at 7% (including loans), year 2 127, year 3 108.

Interest rates are assumed to remain at 7%.

(ii)

Fixed costs are assumed to be constant for the three years.

(iii) Working capital, other than the overdraft, is assumed to remain unchanged. In reality this is unlikely.
(c)

(i)

In order to increase retained earnings without adversely affecting any of the other targets Greffer could attempt to
increase sales, whilst maintaining its profit margin, and/or reduce costs through increased productivity, controlling wage
rises or other direct costs, or reducing fixed costs.

(ii)

Memo re financial targets

The company is advised to review its financial targets. Satisfying the loan covenant is necessary, but the other targets
make little financial sense.
Growth in profits is desirable, but, in theory, cash flow rather than profits is directly linked to the companys share price,
and the maximisation of shareholder wealth. Setting a 20% growth in profit target is arbitrary.
Repayment of the overdraft from only retained earnings is unusual. The company will be generating other cash flows,
for example linked to capital allowances. If it is desired that the overdraft is repaid within three years the company should
consider repayment from any available cash flow.

(d)

Free cash flow to the firm is cash flow before any interest payments, but after tax on operating cash flows. From the data
provided free cash flow to the firm will be defined as:
EBIT (1 tax rate)
+ Capital allowances
Investment expenditure
+/ Change in non-cash working capital (assumed to be zero in b(iii))
Free cash flow ( million)
Year
EBIT (1-t)
Capital allowances
Change in working capital
Capital Investment

1
4032
4650

2
5551
3490

3
6902
2620

Free cash flow

Discount factors (12%)
Present values

8682
0893
7753

9041
0797
7206

9522
0712
6780

Total expected present value

5973

After year 3
6902
3500
(4000 )

6402/12
0712
3799

This is the free cash flow of the firm. To find the value of equity debt must be deducted
5973 2000 debt

40 million shares

= 99 pence per share

The current share price is higher than that estimated using free cash flow analysis. However, the free cash flow projections
are subject to a number of simplifying assumptions which limit the potential accuracy of the analysis.

17

(a)

Stock index futures

In order to protect against possible falling share prices September stock index futures should be sold. If actual share prices
fall, the value of the futures contracts will also fall. The futures contracts may be closed out at a lower price than they were
sold for, resulting in a futures market gain to offset the loss from actual share price movements. If the futures contract is held
to maturity the hedge will lock into the futures price of 5950.
The number of contracts will depend upon the portfolio beta, which is estimated below.
Investment
Fangle
Knoten
Dupple
Wraiter
Plesenn

Shares held(000)
250
400
120
310
1,435

Share price (pence)

740
510
1,140
365
98

Market value()
1,850,000
2,040,000
1,368,000
1,131,500
1,406,300

7,795,800

MV x Beta
2,497,500
2,570,400
1,573,200
927,830
2,320,395

9,889,325

9,889,325
The portfolio beta is: = 1269
7,795,800
The contract size is the current index value of 5930 x 10 = 59,300. (NB In some futures markets the contract size could
be the futures price of 5,950 x 10 = 59,500. This is an acceptable answer.)
As the portfolio beta is higher than the index beta (assumed to be the market beta of 1), the hedge must be adjusted for the
additional risk of the portfolio.
Hedge:
7,795,800
Sell x 1269 = 16683 or 167 contracts
59,300
Options on stock index futures
Futures have the disadvantage of locking into an expected outcome, no matter how the associated cash market has
performed. Options on futures allow the buyer of the option to either exercise the option and fix a worst case outcome, or, if
market prices move in favour of the investor, to let the option lapse. In this case if the stock index was to rise above the
relevant exercise price the option would not be exercised.
September put options should be purchased.
If Trenter wishes to protect current share prices, the closest option to the current index price of 5930 should be selected,
which is 5925.
As with futures 167 contracts should be purchased. If the stock index value falls to below 5925 by the time of expiry of the
option, the option would be exercised and futures sold at 5925 but immediately repurchased at a lower price to close out the
deal and generate a profit. If the index value moved above 5925 the contract would not be exercised. The disadvantage of
the option is that a premium of 108, or 108 x 10 = 1,080 per contract has to be paid to purchase the option. For 167
contacts this is 180,360, or approximately 23% of the portfolio value. This is a relatively expensive form of hedge.
Synthetic short position
The cost of an option hedge may be reduced by creating a synthetic short position. This would involve buying a put option
with an exercise price of 5925 as above, but simultaneously selling a call option at the same exercise price. This would result
in net premium paid of (1080 1400) x 10 x 167 = (53,440), i.e. a net receipt.
This hedge protects against downside risk, but also takes away any potential benefit if market prices were to increase. It has
created a synthetic short future.
(b)

Outcomes of the hedges

Stock index futures
Investment Market value()
Fangle
1,700,000
Knoten
1,916,000
Dupple
1,231,200
Wraiter
1,147,000
Plesenn
1,119,300

7,113,500
The market value of the shares has fallen by 682,300

18

The futures market gain is 167 x (5950 5585) x 10 = 609,550.

Overall there is a loss of 72,750, which would mean the hedge efficiency had been

609,550
89% x 100%
682,300

Options on stock index futures

The option would be exercised to yield a futures gain of 167 x (5925 5585) x 10 = 567,800.
The net result including the cost of the option is 567,800 682,300 180,360 = 294,860, a much larger loss than
the futures hedge.
However, it must be remembered that if the FTSE 100 futures price had moved to above 5925, the option would not have
been exercised, and Trenter would have benefited from the increase in market prices.
Synthetic short position
The profit from the put option would be 567,800 as above.
The call option would expire worthless meaning that Trenter would retain the entire premium from selling the calls.
Overall the loss is 567,800 + 53,440 (net premium received) 682,300, or 61,060.
The creation of the synthetic short future provides a better outcome than the actual futures contract.

(a)

Doubler currently has 40 million ordinary shares, and Fader 30 million.

Earnings per share:
Doubler

Fader

441
= 11025 pence
40

287
= 9567 pence
30

PE ratios:

(b)

Doubler

Fader

290 pence
= 2630
11025 pence

180 pence
= 18 81
9567 pence

A 2-for-3 share exchange will result in the issue of 30 million x 2/3 new shares, or 20 million shares, giving a total of
60 million shares.
million
Current combined earnings after tax
728
Additional earnings from operating savings 075

803
Ignoring the one-off redundancy payments the expected earnings per share is:
803
= 1338 pence
60
Increasing earnings per share alone is not enough. The effect on the market value is the crucial factor. When a relatively high
PE company acquires a company with a lower PE, the expected earnings per share will increase, but not necessarily the total
market value of the companies.

(c)

(i)

The current combined value of the two companies is:

40m shares x 290 pence + 30m shares x 180 pence or 170 million.
If the market is efficient, ignoring any synergistic or other effects of the takeover, the post acquisition PE will be the
weighted average (by earnings) of the current PE ratios.
2630 x 441 + 1881 x 287
= 2335
728
The new EPS takes into account the operating savings.
Multiplying the PE by the new EPS 2335 x 1338 = 312 pence x 60 million shares gives a market value of
1872 million.
However, this ignores the impact of the redundancy costs, 700,000 after tax. When this is included the combined
value of the companies is still expected to substantially increase.

19

(ii)

Changes in expected cash flows as a result of the takeover are as follows:

750,000
Present value of operating savings (to infinity) = 6,250,000
012
Redundancy costs, after tax relief
Net effect on NPV

(700,000)

5,550,000

If the market is efficient the market value of the combined company should increase by 5,550,000 as a result of the
expected increase in NPV, much less than the estimate using PE based valuation.
(d)

Both estimates are likely to be inaccurate. Many other factors are likely to affect the post acquisition share price. For example:
(i)

The effect of the acquisition on corporate growth rates.

(ii)

There may be problems integrating the operations and workforce of the two companies.

(iii) Doublers managers may be able to apply enhanced management skills to Faders operations.
(iv) The effect of the change in risk and capital structure is not known.
With respect to the PE estimate:
(i)

PE ratios use accounting data rather than cash flow data.

(ii)

Accurate estimates of future earnings are very difficult, and earnings can rapidly change.

With respect to cash flows:

(i)

The value of all expected cash flows pre and post acquisition should be compared, not just the changes in a few cash
flows. However, post acquisition cash flows are very difficult to determine.

(ii)

Cash flows savings of 750,000 per year forever are unrealistic.

(iii) The cost of capital of Doubler is likely to change as a result of the acquisition of Fader.

(a)

Money market hedges are available, either directly in the Blundonian peso or as a cross hedge in $US. A forward market
cross hedge is also possible.
Money market hedges lock in the expected cash flow from a foreign exchange transaction by utilising both interest rates and
exchange rates. They do not however allow the hedger to benefit from favourable movements in the spot rate. The peso hedge
also runs the risk that the government will block the outflow of funds from Blundonia.
Money market hedge:
Immediately, borrow B pesos 96,618,357 at 14% per year (100m/1035)
Convert at the spot rate of P1282/ into 753,653
Use the funds to reduce the UK overdraft at 6% per annum, 753,653 x 1015 = 764,958.
This is the effective receipt in three months time.
Assuming the funds are not needed for other purposes it is better for them to be used to repay some of the overdraft rather
than invest in the UK money market.
Cross hedges via the dollar are risky. Although the peso is fixed against the $US, the much higher inflation rate in Blundonia
suggests that there will be pressure on the Blundonian government to devalue the peso from its current fixed rate. If a
devaluation was to occur during the next three months cross hedges would not be effective. Additionally funds still have to
be remitted from Blundonia to the USA in order to fulfil the hedges.
The spot cross rates between the B peso and the $ are P7093 7223/$
100m pesos
= $1,384,466
7223
Cross forward hedge:
Sell $1,384,466 3 months forward at $1789/ = 773,877
(The $1,384,466 would be bought using the 100 million pesos at the spot rate of
P7223/$, assuming the fixed rate between the peso and dollar does not change.)
Forward hedges are easy to arrange via banks, lock in the expected future cash flow, but, in common with money market
hedges, do not allow the hedger to take advantage of favourable currency movements.

20

Cross money market hedge:

Immediately borrow $1,360,655 at 7% per year ($1,384,466/10175)
Convert at the spot rate of $1782 into 763,555.
Use the to reduce the overdraft, 763,555 x 1015 = 775,008.
The cross money market hedge provides better expected receipts but is more risky than the direct money market hedge. The
cross hedge is recommended, as long as Tertial is willing to risk the devaluation of the peso against the $US.
(b)

After a 15% discount the excepted receipts are 985 million pesos
Converted at spot of P1282/ this yields 768,331
Use to repay part of the overdraft. 768,331 x 1015 = 779,856.
This is more beneficial for Tertial and should be agreed.

(c)

Tertial could use the 100m pesos to invest in Blundonia, but as the company has only just commenced exports this is unlikely
to be a favoured alternative.
A counter-trade deal is possible, where the 100m pesos are used to purchase goods in Blundonia. The goods might be sold
to a third party outside Blundonia. The third party would pay Tertial an agreed equivalent sum in sterling or another acceptable
hard currency. This form of transaction should be acceptable to the Blundonian government as it does not involve cash
leaving the country.

There are many possible answers to this question. The solution suggested below is indicative only.
Ethics impact on many aspects of investment decisions. In theory companies seek to maximise shareholder wealth, often subject
to constraining secondary objectives. Such secondary objectives include the welfare of the public. Companies are affected by
ethical standards relating to:
(i)

Health and safety. Employees and the public should be protected from danger, which includes working conditions, effective
employment law and product safety.

(ii)

Environmental issues such as controlling pollution, protecting wildlife and the countryside.
Fully satisfying these issues might be an expensive element in a capital investment.

(iii) Bribes and other payments. Investment might proceed more quickly and efficiently if bribes, incentive payments, gifts etc.
are paid to officials. This is a difficult area, as gifts are part of the business culture in some countries. Even the ethics of
political contributions is debatable.
(iv) Corporate governance. Many examples exist of companies , e.g. Enron, where the results of investments and the true financial
position have been hidden from shareholders and the public.
(v)

Taxation. Companies may try to minimise their tax liability. Tax evasion is illegal, but there is an ethical question over the use
of sophisticated tax avoidance measures, especially in developing countries.

(vi) Wage levels. Should a company pay low wages to maximise shareholder wealth, especially in countries where the standard
of living is very low?
(vii) Individual managers ethics. The ethics of individuals, including pursuing their own goals and self interest (such as job
security) rather than those of the organisation might influence the outcome of investment decisions.
There is inevitably some subjectivity as to what constitutes ethical behaviour, but there is little doubt that ethical issues are of
increasing importance to companies. Acting in an ethically responsible way often has a direct detrimental impact upon expected
cash flows and NPV. However, stakeholders, including shareholders, are increasingly expecting companies to act ethically. If they
do not, then their share price might suffer as a result of adverse publicity and investors withdrawing their support.
The concept of ethical shareholder wealth creation is likely to become increasingly important in strategic financial management.

21

Part 3 Examination Paper 3.7(ENG)

Strategic Financial Management (English)

June 2007 Marking Scheme

Marks

This question requires analysis of alternative methods of entering foreign markets, including the financial
and non-financial analysis of a potential foreign direct investment and licensing.
Criterion(a) for the decision
Exchange rate forecasts
(need all three sets for maximum marks)
FDI
Cash flows in Hotternia:
Sales
Variable costs
Component
Deprecation
Tax
Add back deprecation
Costs and realisable value
Working capital
UK cash flows:
Extra tax
Remittable from Bottoniland
Machinery plus tax
Lost exports (after tax)
Discount rate
NPV
Licensing
Receipts
Maintenance profit
Costs
Lost exports
Tax
NPV

1
4

1
1
2
1
1
2
2
2
2
1
1
2
2
1
1
1
1
1
1
1

max 31

Other information. 12 marks for each good point. 2 especially relating to strategy and risk.

23

max 9

Total 40

Marks
2

This question requires critical analysis of a companys financial planning targets, and estimates of whether
or not targets are likely to be achieved. It also requires understanding of free cash flow and how to produce
a free cash flow valuation .
(a)

Understanding of gap analysis

(b)

Financial projections:
Sales/VC/FC
Capital allowance
Interest
Dividends
Retained earnings
Target calculations:
Growth rates
Gearing/covenant
Repayment of overdraft
Relevant assumptions and comment

1
1
1
1
1
1
3
3
1

max 12

Reward technique. Do not penalise the same error twice.

(c)

(i)

Sensible suggestions of how retained earnings may be improved

(ii)

Critical analysis of targets. 1-2 marks per target.

2 marks if good critique.

(d)

Free cash flow components

Present values/link to share price
Comment

(a)

Market value of portfolio

Weighted beta
Futures hedge:
Sell September futures
Number of contracts
Options on futures:
September put
Premium cost
Synthetic short:
Correct technique
Net premium
Relevant discussion

(b)

2
max 5
2
5
1

Total 30

1
1
1
1
1
1
1
1
max 2

max 9

New portfolio value

Futures outcome
Options outcome
Synthetic position outcome

1
max 2
max 2
max 2

max 6

Total 15

Mark relatively leniently

24

(a)

EPS
PE ratios

(b)

Revised number of shares

New EPS
Comment

(c)

(i)

PE based value look for weighted PE

(ii)

Cash flow:

Marks
1
1

2
1
1
2

4
2

PV of operating savings
Overall change in cash flow
(d)

(a)

2
1

Discussion, look for general issues as well as issues relating specifically

to PE and cash flow. 1 mark for each good point

Direct money market hedge

Cross hedges:
Cross rates
Forward market
Money market

max 4

Total 15

3
1
1
2

Discussion of advantages and disadvantages of hedges

max 9

(b)

Discount calculation and comment

max 3

(c)

Reward sensible suggestions, 1 mark per point

max 3

Total 15

Examples of ethical issues 2 marks for each key issue.

Key issues might include health and safety, the environment,
bribes, corporate governance, taxation, and wage levels,
1 mark if brief and not explained.
Discussion of importance of ethical issues

25

1011
45

Maximum 15