Professional Level Options Module

The Association of Chartered Certifed Accountants

Advanced Financial
Management
Thursday 10 June 2010
Time allowed
Reading and planning: 15 minutes
Writing: 3 hours
This paper is divided into two sections:
Section A BOTH questions are compulsory and MUST be attempted
Section B TWO questions ONLY to be attempted
Formulae and tables are on pages 610.
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may
be annotated. You must NOT write in your answer booklet until
instructed by the supervisor.
This question paper must not be removed from the examination hall.
P
a
p
e
r

P
4
2
Section A BOTH questions are compulsory and MUST be attempted
1 The Seal Island Nuclear Power Company has received initial planning consent for an Advanced Boiling Water Reactor.
This project is one of a number that has been commissioned by the Government of Roseland to help solve the energy
needs of its expanding population of 60 million and meet its treaty obligations by cutting CO
2
emissions to 50% of their
2010 levels by 2030.
The project proposal is now moving to the detailed planning stage which will include a full investment appraisal within
the fnancial plan. The fnancial plan so far developed has been based upon experience of this reactor design in Japan,
the US and South Korea.
The core macro economic assumptions are that Roseland GDP will grow at an annual rate of 4% (nominal) and
infation will be maintained at the 2% target set by the Government.
The construction programme is expected to cost $1 billion over three years, with construction commencing in January
2012. These capital expenditures have been projected, including expected future cost increases, as follows:
Year end 2012 2013 2014
Construction costs ($ million) 300 600 100
Generation of electricity will commence in 2015 and the annual operating surplus in cash terms is expected to be
$100 million per annum (at 1 January 2015 price and cost levels). This value has been well validated by preliminary
studies and includes the cost of fuel reprocessing, ongoing maintenance and systems replacement as well as the
continuing operating costs of running the plant. The operating surplus is expected to rise in line with nominal GDP
growth. The plant is expected to have an operating life of 30 years.
Decommissioning costs at the end of the project have been estimated at $600 million at current (2012) costs.
Decommissioning costs are expected to rise in line with nominal GDP growth.
The companys nominal cost of capital is 10% per annum. All estimates, unless otherwise stated, are at 1 January
2012 price and cost levels.
Required:
Produce a preliminary briefng note which, on the basis of the above information, includes:
(i) An estimate of the net present value for this project as at the commencement of construction in 2012.
(11 marks)
(ii) A discussion of the principal uncertainties associated with this project. (7 marks)
(iii) A sensitivity of the projects net present value (in percentage and in $), to changes in the construction cost,
the annual operating surplus and the decommissioning cost. (Assume that the increase in construction costs
would be proportional to the initial investment for each year.) (6 marks)
(iv) An explanation of how simulations, such as the Monte Carlo simulation, could be used to assess the volatility
of the net present value of this project. (4 marks)
Note: the formula for an annuity discounted at an annual rate (i) and where cash fows are growing at an annual
rate (g) is as follows:
(28 marks)
A
g
i
i g
g
n
n

+
+
|
(
'
`
J
J

]
]
]
]
]
]
]
]
+
( )
1
1
1
1

3 [P.T.O.
2 AggroChem Co is undertaking a due diligence investigation of LeverChem Co and is reviewing the potential bid price for
an acquisition. You have been appointed as a consultant to advise the companys management on the nancial aspects
of the bid.
AggroChem is a fully listed company nanced wholly by equity. LeverChem is listed on an alternative investment
market. Both companies have been trading for over 10 years and have shown strong levels of protability recently.
However, both companies shares are thinly traded. It is thought that the current market value of LeverChems shares
at 33
1
/
3
% higher than the book value is accurate, but it is felt that AggroChem shares are not quoted accurately by the
market.
The following information is taken from the nancial statements of both companies at the start of the current year:
AggroChem LeverChem
$000 $000

Assets less current liabilities 4,400 4,200

Capital Employed
Equity 4,400 1,200
5-year oating rate loan at yield rate plus 3% 3,000

Total capital employed 4,400 4,200

Net operating prot after tax (NOPAT) 580 430
Net amount retained for reinvestment in assets 180 150
It can be assumed that the retained earnings for both companies are equal to the net reinvestment in assets.
The assets of both companies are stated at fair value. Discussions with the AtReast Bank have led to an agreement that
the oating rate loan to LeverChem can be transferred to the combined business on the same terms. The current yield
rate is 5% and the current equity risk premium is 6%. It can be assumed that the risk free rate of return is equivalent
to the yield rate. AggroChems beta has been estimated to be 126.
AggroChem Co wants to use the Black-Scholes option pricing (BSOP) model to assess the value of the combined
business and the maximum premium payable to LeverChems shareholders. AggroChem has conducted a review of the
volatility of the NOPAT values of both companies since both were formed and has estimated that the volatility of the
combined business assets, if the acquisition were to go ahead, would be 35%. The exercise price should be calculated
as the present value of a discount (zero-coupon) bond with an identical yield and term to maturity of the current
bond.
Required:
Prepare a report for the management of AggroChem on the valuation of the combined business following acquisition
and the maximum premium payable to the shareholders of LeverChem. Your report should:
(i) Using the free cash ow model, estimate the market value of equity for AggroChem Co, explaining any
assumptions made. (9 marks)
(ii) Explain the circumstances in which the Black-Scholes option pricing (BSOP) model could be used to assess
the value of a company, including the data required for the variables used in the model. (5 marks)
(iii) Using the BSOP methodology, estimate the maximum price and premium AggroChem may pay for
LeverChem. (9 marks)
(iv) Discuss the appropriateness of the method used in part (iii) above, by considering whether the BSOP model
can provide a meaningful value for a company. (5 marks)
Professional marks will be awarded in question 2 for the clarity and presentation of the report. (4 marks)
(32 marks)
4
Section B TWO questions ONLY to be attempted
3 The fnance 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 105% per annum. The company will use 95% of the loans pool as collateral for a collateralised loan
obligation structured as follows:
80% of the collateral value to support a tranche of A-rated foating rate loan notes offering investors LIBOR plus
140 basis points.
10% of the collateral value to support a tranche of B-rated fxed rate loan notes offering investors 11%.
10% of the collateral value to support a tranche as subordinated certifcates (unrated).
In order to minimise interest rate risk, the company has decided to enter into a fxed for variable rate swap on the
A-rated foating rate notes exchanging LIBOR for 85%.
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 certifcates 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)
(20 marks)
4 The MandM Company, a large listed company, has two divisions. The frst, the MoneyMint division produces coins
and notes for the national exchequer and generates 80% of the companys revenues. The second, the LunarMint
division, manufactures a brand of sweets which are very popular with traders in the fnancial markets. The company
is considering disposing of its LunarMint division. The LunarMint business is no longer viewed as part of the core
business of the MandM Company. The Chief Executive Offcer commented that he could never understand why the
company entered into sweet-making in the frst place. The LunarMint business is proftable and low risk, but has not
been a high priority for investment.
Required:
Outline the issues that should be considered when disposing of the LunarMint division noting the risks that might
be involved.
(20 marks)
5 [P.T.O.
5 You are the fnancial manager of Multidrop (Group) a European based company which has subsidiary businesses
in North America, Europe, and Singapore. It also has foreign currency balances outstanding with two non-group
companies in the UK and Malaysia. Last year the transaction costs of ad-hoc settlements both within the group and
with non-group companies were signifcant and this year you have reached agreement with the non-group companies
to enter into a netting agreement to clear indebtedness with the minimum of currency fows. It has been agreed that
Multidrop (Europe) will be the principal in the netting arrangement and that all settlements will be made in Euros at
the prevailing spot rate.
The summarised list of year end indebtedness is as follows:
Owed by: Owed to:
Multidrop (Europe) Multidrop (US) US$64 million
Multidrop (Singapore) Multidrop (Europe) S$16 million
Alposong (Malaysia) Multidrop (US) US$54 million
Multidrop (US) Multidrop (Europe) 82 million
Multidrop (Singapore) Multidrop (US) US$50 million
Multidrop (Singapore) Alposong (Malaysia) Rm25 million
Alposong (Malaysia) NewRing (UK) 22 million
NewRing (UK) Multidrop (Singapore) S$40 million
Multidrop (Europe) Alposong (Malaysia) Rm83 million
Currency cross rates (mid-market) are as follows:
Currency UK US $ Euro Sing $ Rm
1 UK = 10000 14601 10653 21956 53128
1 US $ = 06849 10000 07296 15088 36435
1 Euro = 09387 13706 10000 20649 49901
1 Sing $ = 04555 06628 04843 10000 24150
1 Rm = 01882 02745 02004 04141 10000
You may assume settlement will be at the mid-market rates quoted.
Required:
(a) Calculate the inter group and inter-company currency transfers that will be required for settlement by Multidrop
(Europe). (12 marks)
(b) Discuss the advantages and disadvantages of netting arrangements with both group and non-group
companies. (8 marks)
(20 marks)
6
Formulae
Modigliani and Miller Proposition 2 (with tax)
Two asset portfolio
The Capital Asset Pricing Model
The asset beta formula
The Growth Model
Gordons growth approximation
The weighted average cost of capital
The Fisher formula
Purchasing power parity and interest rate parity
k k T)(k k
V
V
e e
i
e
i
d
d
e
= + ( ) 1
s w s w s w w r s s
p a
2
a
2
b
2
b
2
a b ab a b
= + + 2
E(r R E(r R
i f i m f
) ( ) ) = +

a
e
e d
e
d
e d
V
V V T))
V T
V V
=
+

+
+ ( (
( )
( ( 1
1
1 T))
d

P
D g)
(r g)
o
o
e
=
+ (

1
g br
e
=
WACC
V
V V
k
V
V V
k
e
e d
e
d
e d
d
=
+

+
+

( 1 T T)
( ) ( 1 1 + = + i r)(1+h)
S S x
(1+h
(1+h
F S x
(1+i
(1
1 0
c
b
0 0
c
= =
)
)
)
++i
b
)
7 [P.T.O.
The Put Call Parity relationship
Modified Internal Rate of Return
The Black-Scholes option pricing model The FOREX modified Black-Scholes option pricing model
c PN(d P N(d e
Where:
d
P P r+
a 1 e 2
rt
1
a e
=
=
+
) )
ln( / ) ( 00.5s t
s t
d d s t
2
2 1
)
=
c e F N(d XN(d
Or
p e XN(d F N
rt
0 1 2
rt
2 0
=

=
) )
) ((d
Where:
d
n(F X) s T/2
s
T
and
d d
1
1
0
2
2 1
)
/

=
+
=
1
s
T
p c P P e
a e
rt
= +
MIRR
PV
PV
r
R
I
n
e
=

+
( )
1
1 1
8
Present Value Table
Present value of 1 i.e. (1 + r)
n
Where r = discount rate
n = number of periods until payment
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0990 0980 0971 0962 0952 0943 0935 0926 0917 0909 1
2 0980 0961 0943 0925 0907 0890 0873 0857 0842 0826 2
3 0971 0942 0915 0889 0864 0840 0816 0794 0772 0751 3
4 0961 0924 0888 0855 0823 0792 0763 0735 0708 0683 4
5 0951 0906 0863 0822 0784 0747 0713 0681 0650 0621 5
6 0942 0888 0837 0790 0746 0705 0666 0630 0596 0564 6
7 0933 0871 0813 0760 0711 0665 0623 0583 0547 0513 7
8 0923 0853 0789 0731 0677 0627 0582 0540 0502 0467 8
9 0941 0837 0766 0703 0645 0592 0544 0500 0460 0424 9
10 0905 0820 0744 0676 0614 0558 0508 0463 0422 0386 10
11 0896 0804 0722 0650 0585 0527 0475 0429 0388 0305 11
12 0887 0788 0701 0625 0557 0497 0444 0397 0356 0319 12
13 0879 0773 0681 0601 0530 0469 0415 0368 0326 0290 13
14 0870 0758 0661 0577 0505 0442 0388 0340 0299 0263 14
15 0861 0743 0642 0555 0481 0417 0362 0315 0275 0239 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0901 0893 0885 0877 0870 0862 0855 0847 0840 0833 1
2 0812 0797 0783 0769 0756 0743 0731 0718 0706 0694 2
3 0731 0712 0693 0675 0658 0641 0624 0609 0593 0579 3
4 0659 0636 0613 0592 0572 0552 0534 0516 0499 0482 4
5 0593 0567 0543 0519 0497 0476 0456 0437 0419 0402 5
6 0535 0507 0480 0456 0432 0410 0390 0370 0352 0335 6
7 0482 0452 0425 0400 0376 0354 0333 0314 0296 0279 7
8 0434 0404 0376 0351 0327 0305 0285 0266 0249 0233 8
9 0391 0361 0333 0308 0284 0263 0243 0225 0209 0194 9
10 0352 0322 0295 0270 0247 0227 0208 0191 0176 0162 10
11 0317 0287 0261 0237 0215 0195 0178 0162 0148 0135 11
12 0286 0257 0231 0208 0187 0168 0152 0137 0124 0112 12
13 0258 0229 0204 0182 0163 0145 0130 0116 0104 0093 13
14 0232 0205 0181 0160 0141 0125 0111 0099 0088 0078 14
15 0209 0183 0160 0140 0123 0108 0095 0084 0074 0065 15
9 [P.T.O.

Annuity Table
Present value of an annuity of 1 i.e.
Where r = discount rate
n = number of periods
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0990 0980 0971 0962 0952 0943 0935 0926 0917 0909 1
2 1970 1942 1913 1886 1859 1833 1808 1783 1759 1736 2
3 2941 2884 2829 2775 2723 2673 2624 2577 2531 2487 3
4 3902 3808 3717 3630 3546 3465 3387 3312 3240 3170 4
5 4853 4713 4580 4452 4329 4212 4100 3993 3890 3791 5
6 5795 5601 5417 5242 5076 4917 4767 4623 4486 4355 6
7 6728 6472 6230 6002 5786 5582 5389 5206 5033 4868 7
8 7652 7325 7020 6733 6463 6210 5971 5747 5535 5335 8
9 8566 8162 7786 7435 7108 6802 6515 6247 5995 5759 9
10 9471 8983 8530 8111 7722 7360 7024 6710 6418 6145 10
11 1037 9787 9253 8760 8306 7887 7499 7139 6805 6495 11
12 1126 1058 9954 9385 8863 8384 7943 7536 7161 6814 12
13 1213 1135 1063 9986 9394 8853 8358 7904 7487 7103 13
14 1300 1211 1130 1056 9899 9295 8745 8244 7786 7367 14
15 1387 1285 1194 1112 1038 9712 9108 8559 8061 7606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0901 0893 0885 0877 0870 0862 0855 0847 0840 0833 1
2 1713 1690 1668 1647 1626 1605 1585 1566 1547 1528 2
3 2444 2402 2361 2322 2283 2246 2210 2174 2140 2106 3
4 3102 3037 2974 2914 2855 2798 2743 2690 2639 2589 4
5 3696 3605 3517 3433 3352 3274 3199 3127 3058 2991 5
6 4231 4111 3998 3889 3784 3685 3589 3498 3410 3326 6
7 4712 4564 4423 4288 4160 4039 3922 3812 3706 3605 7
8 5146 4968 4799 4639 4487 4344 4207 4078 3954 3837 8
9 5537 5328 5132 4946 4772 4607 4451 4303 4163 4031 9
10 5889 5650 5426 5216 5019 4833 4659 4494 4339 4192 10
11 6207 5938 5687 5453 5234 5029 4836 4656 4486 4327 11
12 6492 6194 5918 5660 5421 5197 4988 4793 4611 4439 12
13 6750 6424 6122 5842 5583 5342 5118 4910 4715 4533 13
14 6982 6628 6302 6002 5724 5468 5229 5008 4802 4611 14
15 7191 6811 6462 6142 5847 5575 5324 5092 4876 4675 15



1 (1 + r)
n

r
10 13
Standard normal distribution table
000 001 002 003 004 005 006 007 008 009
00 00000 00040 00080 00120 00160 00199 00239 00279 00319 00359
01 00398 00438 00478 00517 00557 00596 00636 00675 00714 00753
02 00793 00832 00871 00910 00948 00987 01026 01064 01103 01141
03 01179 01217 01255 01293 01331 01368 01406 01443 01480 01517
04 01554 01591 01628 01664 01700 01736 01772 01808 01844 01879
05 01915 01950 01985 02019 02054 02088 02123 02157 02190 02224
06 02257 02291 02324 02357 02389 02422 02454 02486 02517 02549
07 02580 02611 02642 02673 02704 02734 02764 02794 02823 02852
08 02881 02910 02939 02967 02995 03023 03051 03078 03106 03133
09 03159 03186 03212 03238 03264 03289 03315 03340 03365 03389
10 03413 03438 03461 03485 03508 03531 03554 03577 03599 03621
11 03643 03665 03686 03708 03729 03749 03770 03790 03810 03830
12 03849 03869 03888 03907 03925 03944 03962 03980 03997 04015
13 04032 04049 04066 04082 04099 04115 04131 04147 04162 04177
14 04192 04207 04222 04236 04251 04265 04279 04292 04306 04319
15 04332 04345 04357 04370 04382 04394 04406 04418 04429 04441
16 04452 04463 04474 04484 04495 04505 04515 04525 04535 04545
17 04554 04564 04573 04582 04591 04599 04608 04616 04625 04633
18 04641 04649 04656 04664 04671 04678 04686 04693 04699 04706
19 04713 04719 04726 04732 04738 04744 04750 04756 04761 04767
20 04772 04778 04783 04788 04793 04798 04803 04808 04812 04817
21 04821 04826 04830 04834 04838 04842 04846 04850 04854 04857
22 04861 04864 04868 04871 04875 04878 04881 04884 04887 04890
23 04893 04896 04898 04901 04904 04906 04909 04911 04913 04916
24 04918 04920 04922 04925 04927 04929 04931 04932 04934 04936
25 04938 04940 04941 04943 04945 04946 04948 04949 04951 04952
26 04953 04955 04956 04957 04959 04960 04961 04962 04963 04964
27 04965 04966 04967 04968 04969 04970 04971 04972 04973 04974
28 04974 04975 04976 04977 04977 04978 04979 04979 04980 04981
29 04981 04982 04982 04983 04984 04984 04985 04985 04986 04986
30 04987 04987 04987 04988 04988 04989 04989 04989 04990 04990
This table can be used to calculate N(d), the cumulative normal distribution functions needed for the Black-Scholes model
of option pricing. If d
i
> 0, add 05 to the relevant number above. If d
i
< 0, subtract the relevant number above from 05.
End of Question Paper