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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.<br>The annual after-tax cash flows for each process are as follows:<br>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.<br>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.<br>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%.<br>Required:<br>(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)<br>(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)<br>(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.<br>Required:<br>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)
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Section B – TWO questions ONLY to be attempted<br>Sembilan Co, a listed company, recently issued debt finance to acquire assets in order to increase its activity levels. This debt finance is in the form. of a floating rate bond, with a face value of $320 million, redeemable in four years. The bond interest, payable annually, is based on the spot yield curve plus 60 basis points. The next annual payment is due at the end of year one.<br>Sembilan Co is concerned that the expected rise in interest rates over the coming few years would make it increasingly difficult to pay the interest due. It is therefore proposing to either swap the floating rate interest payment to a fixed rate payment, or to raise new equity capital and use that to pay off the floating rate bond. The new equity capital would either be issued as rights to the existing shareholders or as shares to new shareholders.<br>Ratus Bank has offered Sembilan Co an interest rate swap, whereby Sembilan Co would pay Ratus Bank interest based on an equivalent fixed annual rate of 3·76？% in exchange for receiving a variable amount based on the current yield curve rate. Payments and receipts will be made at the end of each year, for the next four years. Ratus Bank will charge an annual fee of 20 basis points if the swap is agreed.<br>Required:<br>(a) Based on the above information, calculate the amounts Sembilan Co expects to pay or receive every year on the swap (excluding the fee of 20 basis points). Explain why the fixed annual rate of interest of 3·76？% is less than the four-year yield curve rate of 3·8%. (6 marks)<br>(b) Demonstrate that Sembilan Co’s interest payment liability does not change, after it has undertaken the swap, whether the interest rates increase or decrease. (5 marks)<br>(c) Discuss the factors that Sembilan Co should consider when deciding whether it should raise equity capital to pay off the floating rate debt. (9 marks)
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Section A – BOTH questions are compulsory and MUST be attempted<br>Nente Co, an unlisted company, designs and develops tools and parts for specialist machinery. The company was formed four years ago by three friends, who own 20% of the equity capital in total, and a consortium of five business angel organisations, who own the remaining 80%, in roughly equal proportions. Nente Co also has a large amount of debt finance in the form. of variable rate loans. Initially the amount of annual interest payable on these loans was low and allowed Nente Co to invest internally generated funds to expand its business. Recently though, due to a rapid increase in interest rates, there has been limited scope for future expansion and no new product development.<br>The Board of Directors, consisting of the three friends and a representative from each business angel organisation, met recently to discuss how to secure the company’s future prospects. Two proposals were put forward, as follows:<br>Proposal 1<br>To accept a takeover offer from Mije Co, a listed company, which develops and manufactures specialist machinery tools and parts. The takeover offer is for $2·95 cash per share or a share-for-share exchange where two Mije Co shares would be offered for three Nente Co shares. Mije Co would need to get the final approval from its shareholders if either offer is accepted;<br>Proposal 2<br>To pursue an opportunity to develop a small prototype product that just breaks even financially, but gives the company exclusive rights to produce a follow-on product within two years.<br>The meeting concluded without agreement on which proposal to pursue.<br>After the meeting, Mije Co was consulted about the exclusive rights. Mije Co’s directors indicated that they had not considered the rights in their computations and were willing to continue with the takeover offer on the same terms without them.<br>Currently, Mije Co has 10 million shares in issue and these are trading for $4·80 each. Mije Co’s price to earnings (P/E) ratio is 15. It has sufficient cash to pay for Nente Co’s equity and a substantial proportion of its debt, and believes that this will enable Nente Co to operate on a P/E level of 15 as well. In addition to this, Mije Co believes that it can find cost-based synergies of $150,000 after tax per year for the foreseeable future. Mije Co’s current profit after tax is $3,200,000.<br>The following financial information relates to Nente Co and to the development of the new product.<br>Nente Co financial information<br>Extract from the most recent income statement<br>In arriving at the profit after tax amount, Nente Co deducted tax allowable depreciation and other non-cash expenses totalling $1,206,000. It requires an annual cash investment of $1,010,000 in non-current assets and working capital to continue its operations.<br>Nente Co’s profits before interest and tax in its first year of operation were $970,000 and have been growing steadily in each of the following three years, to their current level. Nente Co’s cash flows grew at the same rate as well, but it is likely that this growth rate will reduce to 25% of the original rate for the foreseeable future.<br>Nente Co currently pays interest of 7% per year on its loans, which is 380 basis points over the government base rate, and corporation tax of 20% on profits after interest. It is estimated that an overall cost of capital of 11% is reasonable compensation for the risk undertaken on an investment of this nature.<br>New product development (Proposal 2)<br>Developing the new follow-on product will require an investment of $2,500,000 initially. The total expected cash flows and present values of the product over its five-year life, with a volatility of 42% standard deviation, are as follows:<br>Required:<br>Prepare a report for the Board of Directors of Nente Co that:<br>(i) Estimates the current value of a Nente Co share, using the free cash flow to firm methodology; (7 marks)<br>(ii) Estimates the percentage gain in value to a Nente Co share and a Mije Co share under each payment offer; (8 marks)<br>(iii) Estimates the percentage gain in the value of the follow-on product to a Nente Co share, based on its cash flows and on the assumption that the production can be delayed following acquisition of the exclusive rights of production; (8 marks)<br>(iv) Discusses the likely reaction of Nente Co and Mije Co shareholders to the takeover offer, including the assumptions made in the estimates above and how the follow-on product’s value can be utilised by Nente Co. (8 marks)<br>Professional marks will be awarded in question 1 for the presentation, structure and clarity of the answer. (4 marks)
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Alecto Co, a large listed company based in Europe, is expecting to borrow €22,000,000 in four months’ time on 1 May 2012. It expects to make a full repayment of the borrowed amount nine months from now. Currently there is some uncertainty in the markets, with higher than normal rates of inflation, but an expectation that the inflation level may soon come down. This has led some economists to predict a rise in interest rates and others suggesting an unchanged outlook or maybe even a small fall in interest rates over the next six months.<br>Although Alecto Co is of the opinion that it is equally likely that interest rates could increase or fall by 0·5% in four months, it wishes to protect itself from interest rate fluctuations by using derivatives. The company can borrow at LIBOR plus 80 basis points and LIBOR is currently 3·3%. The company is considering using interest rate futures, options on interest rate futures or interest rate collars as possible hedging choices.<br>The following information and quotes from an appropriate exchange are provided on Euro futures and options. Margin requirements may be ignored.<br>Three month Euro futures, €1,000,000 contract, tick size 0·01% and tick value €25<br>March 96·27<br>June 96·16<br>September 95·90<br>Options on three month Euro futures, €1,000,000 contract, tick size 0·01% and tick value €25. Option premiums are in annual %.<br>It can be assumed that settlement for both the futures and options contracts is at the end of the month. It can also be assumed that basis diminishes to zero at contract maturity at a constant rate and that time intervals can be counted in months.<br>Required:<br>(a) Briefly discuss the main advantage and disadvantage of hedging interest rate risk using an interest rate collar instead of options. (4 marks)<br>(b) Based on the three hedging choices Alecto Co is considering and assuming that the company does not face any basis risk, recommend a hedging strategy for the €22,000,000 loan. Support your recommendation with appropriate comments and relevant calculations in €. (17 marks)<br>(c) Explain what is meant by basis risk and how it would affect the recommendation made in part (b) above. (4 marks)
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Section A – BOTH questions are compulsory and MUST be attempted<br>Tramont Co is a listed company based in the USA and manufactures electronic devices. One of its devices, the X-IT, is produced exclusively for the American market. Tramont Co is considering ceasing the production of the X-IT gradually over a period of four years because it needs the manufacturing facilities used to make the X-IT for other products.<br>The government of Gamala, a country based in south-east Asia, is keen to develop its manufacturing industry and has offered Tramont Co first rights to produce the X-IT in Gamala and sell it to the USA market for a period of four years. At the end of the four-year period, the full production rights will be sold to a government-backed company for Gamalan Rupiahs (GR) 450 million after tax (this amount is not subject to inflationary increases). Tramont Co has to decide whether to continue production of the X-IT in the USA for the next four years or to move the production to Gamala immediately.<br>Currently each X-IT unit sold makes a unit contribution of $20. This unit contribution is not expected to be subject to any inflationary increase in the next four years. Next year’s production and sales estimated at 40,000 units will fall by 20% each year for the following three years. It is anticipated that after four years the production of the X-IT will stop. It is expected that the financial impact of the gradual closure over the four years will be cost neutral (the revenue from sale of assets will equal the closure costs). If production is stopped immediately, the excess assets would be sold for $2·3 million and the costs of closure, including redundancy costs of excess labour, would be $1·7 million.<br>The following information relates to the production of the X-IT moving to Gamala. The Gamalan project will require an initial investment of GR 230 million, to pay for the cost of land and buildings (GR 150 million) and machinery (GR 80 million). The cost of machinery is tax allowable and will be depreciated on a straight-line basis over the next four years, at the end of which it will have a negligible value.<br>Tramont Co will also need GR 40 million for working capital immediately. It is expected that the working capital requirement will increase in line with the annual inflation rate in Gamala. When the project is sold, the working capital will not form. part of the sale price and will be released back to Tramont Co.<br>Production and sales of the device are expected to be 12,000 units in the first year, rising to 22,000 units, 47,000 units and 60,000 units in the next three years respectively.<br>The following revenues and costs apply to the first year of operation: – Each unit will be sold for $70;<br>– The variable cost per unit comprising of locally sourced materials and labour will be GR 1,350, and;<br>– In addition to the variable cost above, each unit will require a component bought from Tramont Co for $7, on which Tramont Co makes $4 contribution per unit;<br>– Total fixed costs for the first year will be GR 30 million.<br>The costs are expected to increase by their countries’ respective rates of inflation, but the selling price will remain fixed at $70 per unit for the four-year period.<br>The annual corporation tax rate in Gamala is 20% and Tramont Co currently pays corporation tax at a rate of 30% per year. Both countries’ corporation taxes are payable in the year that the tax liability arises. A bi-lateral tax treaty exists between the USA and Gamala, which permits offset of overseas tax against any USA tax liability on overseas earnings. The USA and Gamalan tax authorities allow losses to be carried forward and written off against future profits for taxation purposes.<br>Tramont Co has decided to finance the project by borrowing the funds required in Gamala. The commercial borrowing rate is 13% but the Gamalan government has offered Tramont Co a 6% subsidised loan for the entire amount of the initial funds required. The Gamalan government has agreed that it will not ask for the loan to be repaid as long as Tramont Co fulfils its contract to undertake the project for the four years. Tramont Co can borrow dollar funds at an interest rate of 5%.<br>Tramont Co’s financing consists of 25 million shares currently trading at $2·40 each and $40 million 7% bonds trading at $1,428 per $1,000. Tramont Co’s quoted beta is 1·17. The current risk free rate of return is estimated at 3% and the market risk premium is 6%. Due to the nature of the project, it is estimated that the beta applicable to the project if it is all-equity financed will be 0·4 more than the current all-equity financed beta of Tramont Co. If the Gamalan project is undertaken, the cost of capital applicable to the cash flows in the USA is expected to be 7%.<br>The spot exchange rate between the dollar and the Gamalan Rupiah is GR 55 per $1. The annual inflation rates are currently 3% in the USA and 9% in Gamala. It can be assumed that these inflation rates will not change for the foreseeable future. All net cash flows arising from the project will be remitted back to Tramont Co at the end of each year.<br>There are two main political parties in Gamala: the Gamala Liberal (GL) Party and the Gamala Republican (GR) Party. Gamala is currently governed by the GL Party but general elections are due to be held soon. If the GR Party wins the election, it promises to increase taxes of international companies operating in Gamala and review any commercial benefits given to these businesses by the previous government.<br>Required:<br>Prepare a report for the Board of Directors of Tramont Co that<br>(i) Evaluates whether or not Tramont Co should undertake the project to produce the X-IT in Gamala and cease its production in the USA immediately. In the evaluation, include all relevant calculations in the form. of a financial assessment and explain any assumptions made;<br>Note: it is suggested that the financial assessment should be based on present value of the operating cash flows from the Gamalan project, discounted by an appropriate all-equity rate, and adjusted by the present value of all other relevant cash flows. (27 marks)<br>(ii) Discusses the potential change in government and other business factors that Tramont Co should consider before making a final decision. (8 marks)<br>Professional marks will be awarded in question 1 for the format, structure and presentation of the answer. (4 marks)
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Mezza Co is a large food manufacturing and wholesale company. It imports fruit and vegetables from countries in South America, Africa and Asia, and packages them in steel cans, plastic tubs and as frozen foods, for sale to supermarkets around Europe. Its suppliers range from individual farmers to Government run cooperatives, and farms run by its own subsidiary companies. In the past, Mezza Co has been very successful in its activities, and has an excellent corporate image with its customers, suppliers and employees. Indeed Mezza Co prides itself on how it has supported local farming communities around the world and has consistently highlighted these activities in its annual reports.<br>However, in spite of buoyant stock markets over the last couple of years, Mezza Co’s share price has remained static. It is thought that this is because there is little scope for future growth in its products. As a result the company’s directors are considering diversifying into new areas. One possibility is to commercialise a product developed by a recently acquired subsidiary company. The subsidiary company is engaged in researching solutions to carbon emissions and global warming, and has developed a high carbon absorbing variety of plant that can be grown in warm, shallow sea water. The plant would then be harvested into carbon-neutral bio-fuel. This fuel, if widely used, is expected to lower carbon production levels.<br>Currently there is a lot of interest among the world’s governments in finding solutions to climate change. Mezza Co’s directors feel that this venture could enhance its reputation and result in a rise in its share price. They believe that the company’s expertise would be ideally suited to commercialising the product. On a personal level, they feel that the venture’s success would enhance their generous remuneration package which includes share options. It is hoped that the resulting increase in the share price would enable the options to be exercised in the future.<br>Mezza Co has identified the coast of Maienar, a small country in Asia, as an ideal location, as it has a large area of warm, shallow waters. Mezza Co has been operating in Maienar for many years and as a result, has a well developed infrastructure to enable it to plant, monitor and harvest the crop. Mezza Co’s directors have strong ties with senior government officials in Maienar and the country’s politicians are keen to develop new industries, especially ones with a long-term future.<br>The area identified by Mezza Co is a rich fishing ground for local fishermen, who have been fishing there for many generations. However, the fishermen are poor and have little political influence. The general perception is that the fishermen contribute little to Maienar’s economic development. The coastal area, although naturally beautiful, has not been well developed for tourism. It is thought that the high carbon absorbing plant, if grown on a commercial scale, may have a negative impact on fish stocks and other wildlife in the area. The resulting decline in fish stocks may make it impossible for the fishermen to continue with their traditional way of life.<br>Required:<br>Discuss the key issues that the directors of Mezza Co should consider when making the decision about whether or not to commercialise the new product, and suggest how these issues may be mitigated or resolved.
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