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Professional Level Options Module

Paper P4
Advanced Financial
Management
March/June 2017 Sample Questions

Time allowed: 3 hours 15 minutes

This question paper is divided into two sections:

Section A This ONE question is compulsory and MUST be attempted


Section B TWO questions ONLY to be attempted

Formulae and tables are on pages 913.

Do NOT open this question paper until instructed by the supervisor.

This question paper must not be removed from the examination hall.

The Association of
Chartered Certified
Accountants
This is a blank page.
The question paper begins on page 3.

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Section A This ONE question is compulsory and MUST be attempted

1 The eight-member board of executive directors (BoD) of Chrysos Co, a large private, unlisted company, is considering
the companys long-term business and financial future. The BoD is considering whether or not to undertake a
restructuring programme. This will be followed a few years later by undertaking a reverse takeover to obtain a listing
on the stock exchange in order to raise new finance. However, a few members of the BoD have raised doubts about
the restructuring programme and the reverse takeover, not least the impact upon the companys stakeholders. Some
directors are of the opinion that an initial public offering (IPO) would be a better option when obtaining a listing
compared to a reverse takeover.
Chrysos Co was formed about 15 years ago by a team of five senior equity holders who are part of the BoD and own
40% of the equity share capital in total; 30 other equity holders own a further 40% of the equity share capital but
are not part of the BoD; and a consortium of venture capital organisations (VCOs) own the remaining 20% of the
equity share capital and have three representatives on the BoD. The VCOs have also lent Chrysos Co substantial debt
finance in the form of unsecured bonds due to be redeemed in 10 years time. In addition to the BoD, Chrysos Co
also has a non-executive supervisory board consisting of members of Chrysos Cos key stakeholder groups. Details of
the supervisory board are given below.
Chrysos Co has two business units: a mining and shipping business unit, and a machinery parts manufacturing
business unit. The mining and shipping business unit accounts for around 80% of Chrysos Cos business in terms of
sales revenue, non-current and current assets, and payables. However, it is estimated that this business unit accounts
for around 75% of the companys operating costs. The smaller machinery parts manufacturing business unit accounts
for the remaining 20% of sales revenue, non-current and current assets, and payables; and around 25% of the
companys operating costs.
The following figures have been extracted from Chrysos Cos most recent financial statements:
Profit before depreciation, interest and tax for the year to 28 February 2017
$m
Sales revenue 16,800
Operating costs (10,080)

Profit before depreciation, interest and tax 6,720

Financial position as at 28 February 2017
$m
Non-current assets
Land and buildings 7,500
Equipment 5,400
Current assets
Inventory 1,800
Receivables 900

Total assets 15,600

Equity
Share capital ($1 par value per share) 1,800
Reserves 5,400
Non-current liabilities
450% unsecured bonds 2026 (from the VCOs) 4,800
Other debt 1,050
Current liabilities
Payables 750
Bank overdraft 1,800

Total equity and liabilities 15,600

3 [P.T.O.
Corporate restructuring programme
The purpose of the restructuring programme is to simplify the companys gearing structure and to obtain extra funding
to expand the mining and shipping business in the future. At present, Chrysos Co is having difficulty obtaining
additional funding without having to pay high interest rates.
Machinery parts manufacturing business unit
The smaller machinery parts manufacturing business unit will be unbundled either by having its assets sold to a local
supplier for $3,102 million after its share of payables have been paid; or
The smaller machinery parts manufacturing business unit will be unbundled through a management buy-out by four
managers. In this case, it is estimated that its after-tax net cash flows will increase by 8% in the first year only and
then stay fixed at this level for the foreseeable future. The cost of capital related to the smaller business unit is
estimated to be 10%. The management buy-out team will pay Chrysos Co 70% of the estimated market value of the
smaller machinery parts manufacturing business unit.
Mining and shipping business unit
Following the unbundling of the smaller machinery parts manufacturing business unit, Chrysos Co will focus solely
on the mining and shipping business unit, prior to undertaking the reverse takeover some years into the future.
As part of the restructuring programme, the existing unsecured bonds lent by the VCOs will be cancelled and replaced
by an additional 600 million $1 shares for the VCOs. The VCOs will pay $400 million for these shares. The bank
overdraft will be converted into a 15-year loan on which Chrysos Co will pay a fixed annual interest of 450%. The
other debt under non-current liabilities will be repaid. In addition to this, Chrysos Co will invest $1,200 million into
equipment for its mining and shipping business unit and this will result in its profits and cash flows growing by 4%
per year in perpetuity.
Additional financial information
Chrysos Co aims to maintain a long-term capital structure of 20% debt and 80% equity in market value terms.
Chrysos Cos finance director has assessed that the 450% annual interest it will pay on its bank loan is a reasonable
estimate of its long-term cost of debt, based on the long-term capital structure above.
Although Chrysos Co does not know what its cost of capital is for the mining and shipping business unit, its finance
director has determined that the current ungeared cost of equity of Sidero Co, a large quoted mining and shipping
company, is 1246%. Chrysos Cos finance director wants to use Sidero Cos ungeared cost of equity to calculate its
cost of capital for the mining and shipping business unit.
The annual corporation tax rate on profits applicable to all companies is 18% and it can be assumed that tax is
payable in the year incurred. All the non-current assets are eligible for tax allowable depreciation of 12% annually on
the book values. The annual reinvestment needed to keep operations at their current levels is equivalent to the tax
allowable depreciation.
Details of the supervisory board
The non-executive supervisory board provides an extra layer of governance over the BoD. It consists of representatives
from the companys internal stakeholder groups including the finance providers, employees and the companys
management. It ensures that the actions taken by the BoD are for the benefit of all the stakeholder groups and to the
company as a whole. Any issues raised in board meetings are resolved through negotiation until an agreed position
is reached.

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Required:
(a) Explain what a reverse takeover involves and discuss the relative advantages and disadvantages to a
company, such as Chrysos Co, of obtaining a listing through a reverse takeover as opposed to an initial public
offering (IPO). (9 marks)

(b) Prepare a report for the board of directors of Chrysos Co which includes:
(i) An extract of the financial position and an estimate of Chrysos Cos value to the equity holders, after
undertaking the restructuring programme. (18 marks)
(ii) An explanation of the approach taken and assumptions made in estimating Chrysos Cos value to the
equity holders, after undertaking the restructuring programme. (5 marks)
(iii) A discussion of the impact of the restructuring programme on Chrysos Co and on the venture capital
organisations. (10 marks)
Professional marks will be awarded in part (b) for the format, structure and presentation of the report.
(4 marks)

(c) Discuss why the attention Chrysos Co pays to its stakeholders represented on the supervisory board may
change once it has obtained a listing. (4 marks)

(50 marks)

5 [P.T.O.
Section B TWO questions ONLY to be attempted

2 Bournelorth Co is an IT company which was established by three friends ten years ago. It was listed on a local stock
exchange for smaller companies nine months ago.
Bournelorth Co originally provided support to businesses in the financial services sector. It has been able to expand
into other sectors over time due to the excellent services it has provided and the high quality staff whom its founders
recruited. The founders have been happy with the level of profits which the IT services have generated. Over time
they have increasingly left the supervision of the IT services in the hands of experienced managers and focused on
developing diagnostic applications (apps). The founders have worked fairly independently of each other on
development work. Each has a small team of staff and all three want their teams to work in an informal environment
which they believe enhances creativity.
Two apps which Bournelorth Co developed were very successful and generated significant profits. The founders
wanted the company to invest much more in developing diagnostic apps. Previously they had preferred to use internal
funding, because they were worried that external finance providers would want a lot of information about how
Bournelorth Co is performing. However, the amount of finance required meant that funding had to be obtained from
external sources and they decided to seek a listing, as two of Bournelorth Cos principal competitors had recently been
successfully listed.
25% of Bournelorth Cos equity shares were made available on the stock exchange for external investors, which was
the minimum allowed by the rules of the exchange. The founders have continued to own the remaining 75% of
Bournelorth Cos equity share capital. Although the listing was fully subscribed, the price which new investors paid
was lower than the directors had originally hoped.
The board now consists of the three founders, who are the executive directors, and two independent non-executive
directors, who were appointed when the company was listed. The non-executive directors have expressed concerns
about the lack of frequency of formal board meetings and the limited time spent by the executive directors overseeing
the companys activities, compared with the time they spend leading development work. The non-executive directors
would also like Bournelorth Cos external auditors to carry out a thorough review of its risk management and control
systems.
The funds obtained from the listing have helped Bournelorth Co expand its development activities. Bournelorth Cos
competitors have recently launched some very successful diagnostic apps and its executive directors are now afraid
that Bournelorth Co will fall behind its competitors unless there is further investment in development. However, they
disagree about how this investment should be funded. One executive director believes that Bournelorth Co should
consider selling off its IT support and consultancy services business. The second executive director favours a rights
issue and the third executive director would prefer to seek debt finance. At present Bournelorth Co has low gearing
and the director who is in favour of debt finance believes that there is too much uncertainty associated with obtaining
further equity finance, as investors do not always act rationally.

Required:
(a) Discuss the factors which will determine whether the sources of finance suggested by the executive directors
are used to finance further investment in diagnostic applications (apps). (8 marks)

(b) (i) Identify the risks associated with investing in the development of apps and describe the controls which
Bournelorth Co should have over its investment in development. (6 marks)
(ii) Discuss the issues which determine the information Bournelorth Co communicates to external finance
providers. (3 marks)

(c) (i) Explain the insights which behavioural finance provides about investor behaviour. (3 marks)
(ii) Assess how behavioural factors may affect the share price of Bournelorth Co. (5 marks)

(25 marks)

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3 Buryecs Co is an international transport operator based in the Eurozone which has been invited to take over a rail
operating franchise in Wirtonia, where the local currency is the dollar ($). Previously this franchise was run by a local
operator in Wirtonia but its performance was unsatisfactory and the government in Wirtonia withdrew the franchise.
Buryecs Co will pay $5,000 million for the rail franchise immediately. The government has stated that Buryecs Co
should make an annual income from the franchise of $600 million in each of the next three years. At the end of the
three years the government in Wirtonia has offered to buy the franchise back for $7,500 million if no other operator
can be found to take over the franchise.
Todays spot exchange rate between the Euro and Wirtonia $ is 01430 = $1. The predicted inflation rates are as
follows:
Year 1 2 3
Eurozone 6% 4% 3%
Wirtonia 3% 8% 11%
Buryecs Cos finance director (FD) has contacted its bankers with a view to arranging a currency swap, since he
believes that this will be the best way to manage financial risks associated with the franchise. The swap would be for
the initial fee paid for the franchise, with a swap of principal immediately and in three years time, both these swaps
being at todays spot rate. Buryecs Cos bank would charge an annual fee of 05% in for arranging the swap.
Buryecs Co would take 60% of any benefit of the swap before deducting bank fees, but would then have to pay 60%
of the bank fees.
Relevant borrowing rates are:
Buryecs Co Counterparty
Eurozone 40% 58%
Wirtonia Wirtonia bank rate Wirtonia bank rate
+ 06% + 04%
In order to provide Buryecs Cos board with an alternative hedging method to consider, the FD has obtained the
following information about over-the-counter options in Wirtonia $ from the companys bank.
The exercise price quotation is in Wirtonia $ per 1, premium is % of amount hedged, translated at todays spot rate.
Exercise price Call options Put options
775 28% 16%
725 18% 27%
Assume a discount rate of 14%.

Required:
(a) Discuss the advantages and drawbacks of using the currency swap to manage financial risks associated with
the franchise in Wirtonia. (6 marks)

(b) (i) Calculate the annual percentage interest saving which Buryecs Co could make from using a currency
swap, compared with borrowing directly in Wirtonia, demonstrating how the currency swap will work.
(4 marks)
(ii) Evaluate, using net present value, the financial acceptability of Buryecs Co operating the rail franchise
under the terms suggested by the government of Wirtonia and calculate the gain or loss in from using
the swap arrangement. (8 marks)

(c) Calculate the results of hedging the receipt of $7,500 million using the currency options and discuss whether
currency options would be a better method of hedging this receipt than a currency swap. (7 marks)

(25 marks)

7 [P.T.O.
4 Toltuck Co is a listed company in the building industry which specialises in the construction of large commercial and
residential developments. Toltuck Co had been profitable for many years, but has just incurred major losses on the
last two developments which it has completed in its home country of Arumland. These developments were an
out-of-town retail centre and a major residential development. Toltuck Cos directors have blamed the poor results
primarily on the recent recession in Arumland, although demand for the residential development also appears to have
been adversely affected by it being located in an area which has suffered serious flooding over the last two years.
As a result of returns from these two major developments being much lower than expected, Toltuck Co has had to
finance current work-in-progress by a significantly greater amount of debt finance, giving it higher gearing than most
other construction companies operating in Arumland. Toltuck Cos directors have recently been alarmed by a major
credit agencys decision to downgrade Toltuck Cos credit rating from AA to BBB. The directors are very concerned
about the impact this will have on the valuation of Toltuck Cos bonds and the future cost of debt.
The following information can be used to assess the consequences of the change in Toltuck Cos credit rating.
Toltuck Co has issued an 8% bond, which has a face or nominal value of $100 and a premium of 2% on redemption
in three years time. The coupon on the bond is payable on an annual basis.
The government of Arumland has three bonds in issue. They all have a face or nominal value of $100 and are all
redeemable at par. Taxation can be ignored on government bonds. They are of the same risk class and the coupon
on each is payable on an annual basis. Details of the bonds are as follows:
Bond Redeemable Coupon Current market value
$
1 1 year 9% 104
2 2 years 7% 102
3 3 years 6% 98
Credit spreads, published by the credit agency, are as follows (shown in basis points):
Rating 1 year 2 years 3 years
AA 18 31 45
BBB 54 69 86
Toltuck Cos shareholder base can be divided broadly into two groups. The majority of shareholders are comfortable
with investing in a company where dividends in some years will be high, but there will be low or no dividends in other
years because of the cash demands facing the business. However, a minority of shareholders would like Toltuck Co
to achieve at least a minimum dividend each year and are concerned about the company undertaking investments
which they regard as very speculative. Shareholders from both groups have expressed some concerns to the board
about the impact of the fall in credit rating on their investment.

Required:
(a) Calculate the valuation and yield to maturity of Toltuck Cos $100 bond under its old and new credit ratings.
(10 marks)

(b) Discuss the factors which may have affected the credit rating of Toltuck Co published by the credit agency.
(8 marks)

(c) Discuss the impact of the fall in Toltuck Cos credit rating on its ability to raise financial capital and on its
shareholders return. (7 marks)

(25 marks)

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Formulae

Modigliani and Miller Proposition 2 (with tax)

Vd
k e = kie + (1 T)(kie k d )
Ve

The Capital Asset Pricing Model

E(ri ) = R f + i (E(rm ) Rf )

The asset beta formula

Ve V (1 T)
d
a = e + d
(Ve + Vd (1 T)) (Ve + Vd (1 T))

The Growth Model

Do (1 + g)
Po =
(re g)

Gordons growth approximation


g = bre

The weighted average cost of capital

V V
e d
WACC = k + k (1 T)
Ve + Vd e Ve + Vd d

The Fisher formula


(1 + i) = (1 + r)(1+h)

Purchasing power parity and interest rate parity

(1+hc ) (1+ic )
S1 = S0 x F0 = S0 x
(1+hb ) (1+ib )

9 [P.T.O.
Modified Internal Rate of Return

1
PV n
MIRR = R 1 + re 1
PVI
( )

The Black-Scholes option pricing model

c = PaN(d1) PeN(d2 )e rt

Where:

ln(Pa / Pe ) + (r+0.5s2 )t
d1 =
s t

d2 = d1 s t

The Put Call Parity relationship

p = c Pa + Pe e rt

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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 0914 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 0350 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

11 [P.T.O.
Annuity Table

(1 + r)n
Present value of an annuity of 1 i.e. 1
r

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 10368 9787 9253 8760 8306 7887 7499 7139 6805 6495 11
12 11255 10575 9954 9385 8863 8384 7943 7536 7161 6814 12
13 12134 11348 10635 9986 9394 8853 8358 7904 7487 7103 13
14 13004 12106 11296 10563 9899 9295 8745 8244 7786 7367 14
15 13865 12849 11938 11118 10380 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

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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 di > 0, add 05 to the relevant number above. If di < 0, subtract the relevant number above from 05.

End of Question Paper

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