ACCA AFM Syllabus A. Role Of The Senior Financial Adviser - Risk mitigation, hedging and diversification strategies - Past Papers ^{8 / 9}

Yilandwe
Yilandwe, whose currency is the Yilandwe Rand (YR), has faced extremely difficult economic challenges in the past 25 years because of some questionable economic policies and political decisions made by its previous governments. Although Yilandwe’s population is generally poor, its people are nevertheless well-educated and ambitious. Just over three years ago, a new government took office and since then it has imposed a number of strict monetary and fiscal controls, including an annual corporation tax rate of 40%, in an attempt to bring Yilandwe out of its difficulties. As a result, the annual rate of inflation has fallen rapidly from a high of 65% to its current level of 33%. These strict monetary and fiscal controls have made Yilandwe’s government popular in the larger cities and towns, but less popular in the rural areas which seem to have suffered disproportionately from the strict monetary and fiscal controls.

It is expected that Yilandwe’s annual inflation rate will continue to fall in the coming few years as follows:

Yilandwe’s government has decided to continue the progress made so far, by encouraging foreign direct investment into the country. Recently, government representatives held trade shows internationally and offered businesses a number of concessions, including:

(i) zero corporation tax payable in the first two years of operation; and
(ii) an opportunity to carry forward tax losses and write them off against future profits made after the first two years.

The government representatives also promised international companies investing in Yilandwe prime locations in towns and cities with good transport links.

Imoni Co
Imoni Co, a large listed company based in the USA with the US dollar ($) as its currency, manufactures high tech diagnostic components for machinery, which it exports worldwide. After attending one of the trade shows, Imoni Co is considering setting up an assembly plant in Yilandwe where parts would be sent and assembled into a specific type of component, which is currently being assembled in the USA. Once assembled, the component will be exported directly to companies based in the European Union (EU). These exports will be invoiced in Euro (€).

Assembly plant in Yilandwe: financial and other data projections
It is initially assumed that the project will last for four years. The four-year project will require investments of YR21,000 million for land and buildings, YR18,000 million for machinery and YR9,600 million for working capital to be made immediately. The working capital will need to be increased annually at the start of each of the next three years by Yilandwe’s inflation rate and it is assumed that this will be released at the end of the project’s life.

It can be assumed that the assembly plant can be built very quickly and production started almost immediately. This is because the basic facilities and infrastructure are already in place as the plant will be built on the premises and grounds of a school. The school is ideally located, near the main highway and railway lines. As a result, the school will close and the children currently studying there will be relocated to other schools in the city. The government has kindly agreed to provide free buses to take the children to these schools for a period of six months to give parents time to arrange appropriate transport in the future for their children.

The current selling price of each component is €700 and this price is likely to increase by the average EU rate of inflation from year 1 onwards.

The number of components expected to be sold every year are as follows:

The parts needed to assemble into the components in Yilandwe will be sent from the USA by Imoni Co at a cost of $200 per component unit, from which Imoni Co would currently earn a pre-tax contribution of $40 for each component unit. However, Imoni Co feels that it can negotiate with Yilandwe’s government and increase the transfer price to $280 per component unit. The variable costs related to assembling the components in Yilandwe are currently YR15,960 per component unit. The current annual fixed costs of the assembly plant are YR4,600 million. All these costs, wherever incurred, are expected to increase by that country’s annual inflation every year from year 1 onwards.

Imoni Co pays corporation tax on profits at an annual rate of 20% in the USA. The tax in both the USA and Yilandwe is payable in the year that the tax liability arises. A bilateral tax treaty exists between Yilandwe and the USA. Tax allowable depreciation is available at 25% per year on the machinery on a straight-line basis.

Imoni Co will expect annual royalties from the assembly plant to be made every year. The normal annual royalty fee is currently $20 million, but Imoni Co feels that it can negotiate this with Yilandwe’s government and increase the royalty fee by 80%. Once agreed, this fee will not be subject to any inflationary increase in the project’s four-year period.

If Imoni Co does decide to invest in an assembly plant in Yilandwe, its exports from the USA to the EU will fall and it will incur redundancy costs. As a result, Imoni Co’s after-tax cash flows will reduce by the following amounts:

Imoni Co normally uses its cost of capital of 9% to assess new projects. However, the finance director suggests that
Imoni Co should use a project specific discount rate of 12% instead.

Other financial information

Required:
(a) Discuss the possible benefits and drawbacks to Imoni Co of setting up its own assembly plant in Yilandwe, compared to licensing a company based in Yilandwe to undertake the assembly on its behalf. (5 marks)

Nahara Co and Fugae Co
Nahara Co is a private holding company owned by the government of a wealthy oil-rich country to invest its sovereign funds. Nahara Co has followed a strategy of risk diversification for a number of years by acquiring companies from around the world in many different sectors.

One of Nahara Co’s acquisition strategies is to identify and purchase undervalued companies in the airline industry in Europe. A recent acquisition was Fugae Co, a company based in a country which is part of the European Union (EU). Fugae Co repairs and maintains aircraft engines.

A few weeks ago, Nahara Co stated its intention to pursue the acquisition of an airline company based in the same country as Fugae Co. The EU, concerned about this, asked Nahara Co to sell Fugae Co before pursuing any further acquisitions in the airline industry.

Avem Co’s acquisition interest in Fugae Co
Avem Co, a UK-based company specialising in producing and servicing business jets, has approached Nahara Co with a proposal to acquire Fugae Co for $1,200 million. Nahara Co expects to receive a premium of at least 30% on the estimated equity value of Fugae Co, if it is sold.

Given below are extracts from the most recent statements of financial position of both Avem Co and Fugae Co.

Each Avem Co share is currently trading at $7·50, which is a multiple of 7·2 of its free cash flow to equity. Avem Co expects that the total free cash flows to equity of the combined company will increase by $40 million due to synergy benefits. After adding the synergy benefits of $40 million, Avem Co then expects the multiple of the total free cash flow of the combined company to increase to 7·5.

Fugae Co’s free cash flow to equity is currently estimated at $76·5 million and it is expected to generate a return on equity of 11%. Over the past few years, Fugae Co has returned 77·3% of its annual free cash flow to equity back to Nahara Co, while retaining the balance for new investments.

Fugae Co’s non-current liabilities consist entirely of $100 nominal value bonds which are redeemable in four years at the nominal value, on which the company pays a coupon of 5·4%. The debt is rated at B+ and the credit spread on B+ rated debt is 80 basis points above the risk-free rate of return.

Proposed luxury transport investment project by Fugae Co
In recent years, the country in which Fugae Co is based has been expanding its tourism industry and hopes that this industry will grow significantly in the near future. At present tourists normally travel using public transport and taxis, but there is a growing market for luxury travel. If the tourist industry does expand, then the demand for luxury travel is expected to grow rapidly. Fugae Co is considering entering this market through a four-year project. The project will cease after four years because of increasing competition.

The initial cost of the project is expected to be $42,000,000 and it is expected to generate the following after-tax cash flows over its four-year life:

The above figures are based on the tourism industry expanding as expected. However, it is estimated that there is a 25% probability that the tourism industry will not grow as expected in the first year. If this happens, then the present value of the project’s cash flows will be 50% of the original estimates over its four-year life.

It is also estimated that if the tourism industry grows as expected in the first year, there is still a 20% probability that the expected growth will slow down in the second and subsequent years, and the present value of the project’s cash flows would then be 40% of the original estimates in each of these years.

Lumi Co, a leisure travel company, has offered $50 million to buy the project from Fugae Co at the start of the second year. Fugae Co is considering whether having this choice would add to the value of the project.

If Fugae Co is bought by Avem Co after the project has begun, it is thought that the project will not result in any additional synergy benefits and will not generate any additional value for the combined company, above any value the project has already generated for Fugae Co.

Although there is no beta for companies offering luxury forms of travel in the tourist industry, Reka Co, a listed company, offers passenger transportation services on coaches, trains and luxury vehicles. About 15% of its business is in the luxury transport market and Reka Co’s equity beta is 1·6. It is estimated that the asset beta of the non-luxury transport industry is 0·80. Reka Co’s shares are currently trading at $4·50 per share and its debt is currently trading at $105 per $100. It has 80 million shares in issue and the book value of its debt is $340 million. The debt beta is estimated to be zero.

General information
The corporation tax rate applicable to all companies is 20%. The risk-free rate is estimated to be 4% and the market risk premium is estimated to be 6%.

Required:
(a) Discuss whether or not Nahara Co’s acquisition strategies, of pursuing risk diversification and of purchasing undervalued companies, can be valid. (7 marks)

1) Cocoa-Mocha-Chai (CMC) Co is a large listed company based in Switzerland and uses Swiss Francs as its currency. It imports tea, coffee and cocoa from countries around the world, and sells its blended products to supermarkets and large retailers worldwide.

The company has production facilities located in two European ports where raw materials are brought for processing, and from where finished products are shipped out. All raw material purchases are paid for in US dollars (US$), while all sales are invoiced in Swiss Francs (CHF).

Until recently CMC Co had no intention of hedging its foreign currency exposures, interest rate exposures or commodity price fluctuations, and stated this intent in its annual report. However, after consultations with senior and middle managers, the company’s new Board of Directors (BoD) has been reviewing its risk management and operations strategies.

Proposal one
Setting up a treasury function to manage the foreign currency and interest rate exposures (but not commodity price fluctuations) using derivative products. The treasury function would be headed by the finance director. The purchasing director, who initiated the idea of having a treasury function, was of the opinion that this would enable her management team to make better decisions. The finance director also supported the idea as he felt this would increase his influence on the BoD and strengthen his case for an increase in his remuneration.

In order to assist in the further consideration of this proposal, the BoD wants you to use the following upcoming foreign currency and interest rate exposures to demonstrate how they would be managed by the treasury function:
(i) a payment of US$5,060,000 which is due in four months’ time; and

Response from the non-executive directors
When the proposals were put to the non-executive directors, they indicated that they were broadly supportive of the second proposal if the financial benefits outweigh the costs of setting up and running the four branches.

However, they felt that they could not support the first proposal, as this would reduce shareholder value because the costs related to undertaking the proposal are likely to outweigh the benefits.

Additional information relating to proposal one
The current spot rate is US$1•0635 per CHF1. The current annual inflation rate in the USA is three times higher than Switzerland.

Required:

(d) Prepare a memorandum for the Board of Directors (BoD) of CMC Co which: 
(i) Discusses proposal one in light of the concerns raised by the non-executive directors; and (9 marks)