Strategic Financial Management

Strategic Financial 

Management 

PART 3 

WEDNESDAY 15 JUNE 2005 

QUESTION PAPER 

Time allowed 3 hours 

This paper is divided into two sections 

Section A BOTH questions are compulsory and MUST be 

answered 

Section B TWO questions ONLY to be answered 

Formulae sheet, present value, annuity and standard normal 

distribution tables are on pages 9, 10, 11 and 12 

Do not open this paper until instructed by the supervisor 

This question paper must not be removed from the examination 

hall 

The Association of Chartered Certified Accountants 

Paper 3.7

Section A – BOTH questions are compulsory and MUST be attempted 

1 Paxis plc will soon announce a takeover bid for Wragger plc, a company in the same industry. The initial bid will be 

an all share bid of four Paxis shares for every five Wragger shares. 

The most recent annual data relating to the two companies are shown below: 

£000 

Paxis Wragger 

Sales revenue 13,333 9,400 

Operating costs (8,683) (5,450) 

Tax allowable depreciation (1,450) (1,100) 

–––––– –––––– 

Earnings before interest and tax 3,200 2,850 

Net interest (715) (1,660) 

–––––– –––––– 

Taxable income 2,485 1,190 

Taxation (30%) (746) (357) 

–––––– –––––– 

After tax income 1,739 833 

Dividend (870) (458) 

–––––– –––––– 

Retained earnings 869 375 

Other information: Paxis Wragger 

Annual replacement capital expenditure (£000) 1,600 1,240 

Expected annual growth rate in sales, operating costs (including 

depreciation), replacement investment and dividends for the next 

four years 5% 6·5% 

Expected annual growth rate in sales, operating costs (including 

depreciation), replacement investment and dividends after four years 4% 5% 

Gearing (long term debt/long term debt plus equity by market value) 30% 55% 

Market price per share (pence) 298 192 

Number of issued shares (million) 7 8 

Current market cost of fixed interest debt 6% 7·5% 

Equity beta 1·18 1·38 

Risk free rate 14% 

Market return 11% 

The takeover is expected to result in cost savings in advertising and distribution, reducing the operating costs 

(including depreciation) of Paxis from 76% of sales to 70% of sales. The growth rate of the combined company is 

expected to be 6% per year for four years, and 5% per year thereafter. Wragger’s debt obligations will be taken over 

by Paxis. The corporate tax rate is expected to remain at 30%. 

Sales and costs relevant to the decision may be assumed to be in cash terms. 

2

Required: 

(a) Using free cash flow analysis for each individual company and the potential combined company, estimate 

how much synergy is expected to be created from the takeover. State clearly any assumptions that you make. 

Note: The weighted average cost of capital of the combined company may be assumed to be the market weighted 

average of the current costs of capital of the individual companies, weighted by the current market value of debt and 

equity of the combined company, with the equity of Wragger adjusted for the effect of the bid price. (20 marks) 

(b) Discuss the limitations of the above estimates. (6 marks) 

(c) Discuss the factors that might influence whether the initial bid is likely to be accepted by the shareholders 

of Wragger plc. (4 marks) 

(d) Estimate by how much the bid might be increased without the shareholders of Paxis suffering a fall in their 

expected wealth, and discuss whether or not the directors of Paxis should proceed with the bid. (5 marks) 

(e) Once the bid is announced, discuss what defences Wragger plc might use against the bid by Paxis plc. 

(5 marks) 

(40 marks) 

3 [P.T.O.

2 McTee plc is a Scottish manufacturer of golf clubs. The company has decided to purchase an existing golf club 

manufacturer in the State of Florida, USA. The purchase will cost an agreed $72 million for fixed assets and 

equipment, and in addition $8 million of working capital will be needed. No additional external funding for the 

proposed US subsidiary is expected to be needed for at least five years, and sales from the subsidiary would be 

exclusively to the US market. McTee has no other foreign subsidiaries, and the company’s managers are considering 

how to finance the US investment. McTee’s bank has advised that, taking into account McTee’s credit rating, the 

following alternatives might be possible, with finance available up to the amount shown: 

(i) A one for four rights issue, at a price of 280 pence per share. Underwriting and other costs are expected to be 

5% of the gross amount raised. 

(ii) Five year Sterling 7% fixed rate secured bank term loan of up to £50 million, initial arrangement fee 1%. 

(iii) $15 million one year commercial paper, issued at $US LIBOR plus 1·5%. This could be renewed on an annual 

basis. An additional 0·5% per year would be payable to a US bank for a back-up line of credit. 

(iv) 80 million Swiss Franc five year fixed rate secured bank loan at 2·5%. This may be swapped into fixed rate $ at 

an additional annual interest rate of 2·3%. An upfront fee of 3·0% is also payable. 

(v) £42 million 10-year Sterling Eurobond issue at 6·85%. This may be swapped into $ at an annual interest rate 

of 4·95%. Eurobond issue costs of 2%, and upfront swap costs of 1·7% would also be payable. 

(vi) $40 million floating rate six year secured term loan from a US bank, at $US LIBOR plus 3%. 

No currency swaps are available other than those shown. Currency swaps would involve swapping the principal at 

the current spot exchange rate, with the reversal of the swap at the same rate at the swap maturity date. 

$US LIBOR is currently 3%. 

Exchange rates: 

Spot One year forward 

$/£ 1·7985 – 1·8008 1·7726 – 1·7746 

SF/£ 2·256 – 2·298 2·189 – 2·205 

McTee’s current balance sheet is summarised below. 

£m 

Fixed assets 117·8 

Investments 8·1 

Current assets 98·1 

Creditors: amounts falling due within one year 

Loans and other borrowings (38·0) 

Other creditors (48·6) 

––––– 

137·4 

––––– 

Creditors: amounts falling due after more than one year 

Medium and long-term bank loans 30·0 

8% Bond 2009 (par value £100) 18·0 

––––– 

48·0 

Capital and reserves 

Ordinary shares (25 pence par value) 20·0 

Reserves 69·4 

––––– 

137·4 

––––– 

A covenant exists that prevents the book value of McTee’s debt finance from exceeding 50% of total assets. McTee’s 

current dividend per share is 22·2 pence and dividend growth is approximately 4% per year. The company’s current 

share price is 302 pence. 

Interest payments on debt financing may be assumed to be made annually at the end of the year. Corporate tax in 

the UK, USA and Switzerland is at a rate of 30%. Issue costs and fees such as swap fees are not tax allowable. 

4

Required: 

(a) Discuss the factors that McTee should consider before deciding how to finance the proposed US subsidiary. 

(10 marks) 

(b) Prepare a report discussing and evaluating each of the six possible sources of finance, and provide a reasoned 

recommendation of which source, or combination of sources, McTee should use. Supporting calculations, 

including costs, should be provided wherever relevant. (20 marks) 

(30 marks) 

5 [P.T.O.

Section B – TWO questions ONLY to be attempted 

3 Assume that it is now 1 June. Your company expects to receive £7·1 million from a large order in five months’ time. 

This will then be invested in high quality commercial paper for a period of four months, after which it will be used to 

pay part of the company’s dividend. The company’s treasurer wishes to protect the short-term investment from 

adverse movements in interest rates, by using futures or forward rate agreements (FRAs). 

The current yield on high quality commercial paper is LIBOR + 0·60%. 

LIFFE £500,000 3 month Sterling futures. £12·50 tick size. 

September 96·25 

December 96·60 

Futures contracts mature at the month end. LIBOR is currently 4%. 

FRA prices (%) 

4 v 5 3·85 – 3·80 

4 v 9 3·58 – 3·53 

5 v 9 3·50 – 3·45 

Required: 

(a) Devise a futures hedge to protect the interest yield of the short-term investment, and estimate the expected 

lock-in interest rate as a result of the hedge. (4 marks) 

(b) Ignoring transactions costs, explain whether the futures or FRA hedge would provide the higher expected 

interest rate from the short-term investment. (2 marks) 

(c) If LIBOR fell by 0·5% during the next five months show the expected outcomes of each hedge in the cash 

market, futures market and FRA market as appropriate. (6 marks) 

(d) Explain why the futures market outcome might differ from the outcome in (c) above. (3 marks) 

6 

(15 marks)

4 The managers of a pension fund follow an active portfolio management strategy. They try to purchase shares and 

bonds that show a positive abnormal return (positive alpha factor in the case of shares). The pension fund is required 

by law to hold at least 40% of its investments in bonds. £100 million is currently available for investment. 

Three shares and three bonds are being considered for purchase. 

The required return on bonds may be measured using a model similar to the capital asset pricing model, where beta 

is replaced by the relative duration of the individual bond (Di) and the bond market portfolio (Dm). This is shown as 

Di 

––– 

Dm 

Shares: Expected return (%) Standard deviation Correlation coefficient of returns 

of returns with the market 

Equity market 10·5 15 1 

Flitter plc 11·0 25 0·76 

Polgin plc 19·5 18 0·54 

Scruntor plc 13·5 35 0·63 

Bonds: Duration (years) Coupon (%) Redemption yield (%) 

Bond market 17·5 – 5·8 

UK Government 11·5 8 4·5 

Supragow plc 18·6 6 5·3 

Teffon plc 14·2 9 7·2 

The risk free rate is 4%. 

Required: 

(a) Evaluate whether or not any of the shares or bonds are expected to offer a positive abnormal return. 

(7 marks) 

(b) The pension fund currently has the maximum permitted investment in shares and wishes to continue this 

strategy. It has a market value of £1,000 million and a beta of 0·62. 

Calculate the required return from the pension fund if any shares and bonds with positive abnormal returns 

are purchased. 

State clearly any assumptions that you make (3 marks) 

(c) Discuss possible problems with the pension fund’s investment strategy. (5 marks) 

(15 marks) 

7 [P.T.O.

5 Boster plc is a multinational company that has investments in several developing countries. It is considering 

investments in three more developing countries, Ammobia, Flassia and Hracland. All three countries have a history 

of political instability, but Boster believes that the potential returns from the investments might justify the political risk. 

A consultancy report has produced the following assessments of the countries. 

Expected investment return (%) Political Risk (%) 

Ammobia 21 33 

Flassia 18 29 

Hracland 28 42 

Political risk was measured by investigating key variables in the relevant countries. These were: corruption, changes 

in government, social conditions, cultural issues, unfair trade and asset security. 

Boster will invest in a maximum of two of the countries, with an equal amount invested in each country. The countries 

are in diverse parts of the world, and the returns from the investments in the three countries are believed to be 

independent. 

Required: 

(a) Calculate the risk, return and coefficient of variation of the possible investment combinations. (6 marks) 

(b) Discuss how useful the information calculated in (a) above might be to Boster in making its investment 

decisions. (5 marks) 

(c) Briefly discuss other ways by which Boster might attempt to measure the potential political risk of the 

investments. (4 marks) 

(15 marks) 

6 Discuss the possible foreign exchange risk and economic implications of each of the following types of exchange 

rate system for multinational companies with subsidiaries located in countries with these systems: 

(a) a managed floating exchange rate; 

(b) a fixed exchange rate linked to a basket of currencies; and 

(c) a fixed exchange rate backed by a currency board system. 

8 

(15 marks)

Ke (i) 

(ii) 

Formulae Sheet 

E 

D 

WACC Keg + Kd (– 1 t) 

E + D E + D 

⎛ Dt ⎞ 

or Keu ⎜1 

– ⎟ 

⎝ E + D⎠ 

2 asset 

portfolio 

Purchasing 

power parity 

Er ( ) 

D1 

+ g 

P 

r Er ( )– r 

0 

= +[ ] 

j f m f j 

2 2 2 2 

p a b ab a b 

σ = σ x + σ (– 1 x) + 2x(– 1 x) p σ σ 

i – i 

1+ 

i 

f uk 

uk 

E 

D(– 1 t) 

βa = βe 

+ βd 

E + D(– 1 t) 

E + D(– 1 t) 

Call price for a European option = Ps N( d1)– Xe N( d2) 

1n 

( Ps / X ) + 

d1 

= 

σ T 

rT 

+ 05 . σ T 

d = d – σ T 

2 1 

Put call parity P P = P C – P S +Xe –rT 

β 

– rT 

9 [P.T.O.

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11 [P.T.O.

Standard normal distribution table 

0·00 0·01 0·02 0·03 0·04 0·05 0·06 0·07 0·08 0·09 

0·0 0·0000 0·0040 0·0080 0·0120 0·0160 0·0199 0·0239 0·0279 0·0319 0·0359 

0·1 0·0398 0·0438 0·0478 0·0517 0·0557 0·0596 0·0636 0·0675 0·0714 0·0753 

0·2 0·0793 0·0832 0·0871 0·0910 0·0948 0·0987 0·1026 0·1064 0·1103 0·1141 

0·3 0·1179 0·1217 0·1255 0·1293 0·1331 0·1368 0·1406 0·1443 0·1480 0·1517 

0·4 0·1554 0·1591 0·1628 0·1664 0·1700 0·1736 0·1772 0·1808 0·1844 0·1879 

0·5 0·1915 0·1950 0·1985 0·2019 0·2054 0·2088 0·2123 0·2157 0·2190 0·2224 

0·6 0·2257 0·2291 0·2324 0·2357 0·2389 0·2422 0·2454 0·2486 0·2517 0·2549 

0·7 0·2580 0·2611 0·2642 0·2673 0·2703 0·2734 0·2764 0·2794 0·2823 0·2852 

0·8 0·2881 0·2910 0·2939 0·2967 0·2995 0·3023 0·3051 0·3078 0·3106 0·3133 

0·9 0·3159 0·3186 0·3212 0·3238 0·3264 0·3289 0·3315 0·3340 0·3365 0·3389 

1·0 0·3413 0·3438 0·3461 0·3485 0·3508 0·3531 0·3554 0·3577 0·3599 0·3621 

1·1 0·3643 0·3665 0·3686 0·3708 0·3729 0·3749 0·3770 0·3790 0·3810 0·3830 

1·2 0·3849 0·3869 0·3888 0·3907 0·3925 0·3944 0·3962 0·3980 0·3997 0·4015 

1·3 0·4032 0·4049 0·4066 0·4082 0·4099 0·4115 0·4131 0·4147 0·4162 0·4177 

1·4 0·4192 0·4207 0·4222 0·4236 0·4251 0·4265 0·4279 0·4292 0·4306 0·4319 

1·5 0·4332 0·4345 0·4357 0·4370 0·4382 0·4394 0·4406 0·4418 0·4429 0·4441 

1·6 0·4452 0·4463 0·4474 0·4484 0·4495 0·4505 0·4515 0·4525 0·4535 0·4545 

1·7 0·4554 0·4564 0·4573 0·4582 0·4591 0·4599 0·4608 0·4616 0·4625 0·4633 

1·8 0·4641 0·4649 0·4656 0·4664 0·4671 0·4678 0·4686 0·4693 0·4699 0·4706 

1·9 0·4713 0·4719 0·4726 0·4732 0·4738 0·4744 0·4750 0·4756 0·4761 0·4767 

2·0 0·4772 0·4778 0·4783 0·4788 0·4793 0·4798 0·4803 0·4808 0·4812 0·4817 

2·1 0·4821 0·4826 0·4830 0·4834 0·4838 0·4842 0·4846 0·4850 0·4854 0·4857 

2·2 0·4861 0·4864 0·4868 0·4871 0·4875 0·4878 0·4881 0·4884 0·4887 0·4890 

2·3 0·4893 0·4896 0·4898 0·4901 0·4904 0·4906 0·4909 0·4911 0·4913 0·4916 

2·4 0·4918 0·4920 0·4922 0·4925 0·4927 0·4929 0·4931 0·4932 0·4934 0·4936 

2·5 0·4938 0·4940 0·4941 0·4943 0·4945 0·4946 0·4948 0·4949 0·4951 0·4952 

2·6 0·4953 0·4955 0·4956 0·4957 0·4959 0·4960 0·4961 0·4962 0·4963 0·4964 

2·7 0·4965 0·4966 0·4967 0·4968 0·4969 0·4970 0·4971 0·4972 0·4973 0·4974 

2·8 0·4974 0·4975 0·4976 0·4977 0·4977 0·4978 0·4979 0·4979 0·4980 0·4981 

2·9 0·4981 0·4982 0·4982 0·4983 0·4984 0·4984 0·4985 0·4985 0·4986 0·4986 

3·0 0·4987 0·4987 0·4987 0·4988 0·4988 0·4989 0·4989 0·4989 0·4990 0·4990 

This table can be used to calculate N(d i ), the cumulative normal distribution functions needed for the Black-Scholes 

model of option pricing. If d i > 0, add 0·5 to the relevant number above. If d i < 0, subtract the relevant number above 

from 0·5. 

End of Question Paper 

12

Strategic Financial Management

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