Exam Prep Mock Flashcards
Describe two advantages and two disadvantages of using expected values when appraising the Supertape project.
Advantages:
The information is reduced to a single number for assessing the Supertape project rather than a range of outcomes.
Easily understood.
Disadvantages:
The probabilities of the different sales levels may not be accurate.
The expected sales of £14 million may not correspond to any of the possible expected sales levels.
The expected sales of £14 million will not be achieved unless the project is run many times.
The expected sales of £14 million are an average and it does not consider the spread of possible results. It therefore ignores risk
Describe two real options that are available to Physiotec in relation to the Supertape project.
The option to delay. Since a competitor is likely to enter into the market in one year’s time it might be prudent to start the project in one year rather than now. The product might be not as good as Supertape or it
might be better. Physiotec can make a more informed decision when it knows what the competitor is intending.
The option to abandon. Since expected values are being used to estimate sales if the worst-case scenario occurs, sales of only 1 million, Physiotec can abandon the project.
Follow on options. Producing Supertape might allow Physiotec to develop future products, which can be marketed after the initial project, even if the lower level of sales of 1 million occurs and the project initially
has a negative NPV.
Growth options. Physiotech could develop new markets for Supertape eg overseas which may turn a negative NPV project (initial sales 1 million) into a positive.
2.1 Issue 1
NAC is buying a new warehouse to store the cars and has arranged to borrow £800,000 for one year from 30 April 2024 at an interest rate of SONIA + 3%.
The board of NAC is concerned that SONIA might increase over the next five months from its current level of 1% pa. However, one member of the board is of the opinion that SONIA will fall.
A bank has offered NAC a forward rate agreement (FRA) at 4.5% pa or an interest rate option at 4% pa plus a premium of 1% of the sum borrowed.
Requirements
(a) Calculate the interest cost of the £800,000 loan using the FRA and the option assuming that SONIA on 30 April 2024 will be:
either 1.25% pa
or 0.60% pa. (6 marks)
(b) Recommend to the board of NAC whether it should hedge interest rate movements using the FRA or the interest rate option.
Two columns for each SONIA potential
SONIA = 1.25% or 0.60%
SONIA + 3 = 4.25% or 3.60%
FRA Pay to lenders = 4.25% or 3.60%
Pmt to bank = 0.25% or 0.90%
FRA rate = 4.50% or 4.50%
Interest cost for £800,000 for 12 months £36,000 or £36,000
Option – Exercise 1.25% Yes and 0.60% No
Pay interest at = 4.00% or 3.60%
Premium = 1.00% or 1.00%
Effective rate = 5.00% or 4.60%
Interest cost for £800,000 for 12 months = £40,000 or £36,800 ,
If SONIA increases to 1.25% the FRA is better than the option by £4,000.
If SONIA decrease to 0.60% the FRA is slightly better than the option by £800.
The decision on whether to hedge depends on the board’s attitude to risk as, for both the interest rates given, not hedging is cheaper.
If SONIA does fall (per one board member) the option allows upside potential and could be cheaper than the FRA but would never be cheaper than not hedging.
But, given that the overall view of the board is that SONIA will rise, it would depend on how far the board believes it would rise. SONIA would need to rise to over 1.5% before the FRA is cheaper than doing nothing and by over 2% before the option is cheaper
On 31 March 2024 NAC is due to pay $1,250,000 to its US suppliers for a shipment of 50 cars. The board of NAC would like to establish the most appropriate hedging strategy to protect the company against foreign exchange
rate (forex) risk.
The following data is available at the close of business on 30 November 2023:
Spot exchange rate ($/£) 1.3965 – 1.3970
4-month forward contract discount ($/£) 0.0052 – 0.0058
Annual borrowing and depositing interest rates:
Dollar 4.80% – 4.40%
Sterling 3.75% – 3.25%
4-month over-the-counter (OTC) currency options:
Call options to buy $ have an exercise price of $/£1.4025 and a premium of £0.006 per $ converted.
Put options to sell $ have an exercise price of $/£1.4028 and a premium of £0.002 per $ converted.
Option premiums are payable on 30 November 2023. NAC currently has an overdraft.
(a) Calculate NAC’s sterling cost of the $1,250,000 payment using:
a forward contract
a money market hedge
an OTC currency option
Assume that the spot exchange rate will be $/£1.3980 – 1.3990 on 31 March 2024.
The forward rate is: $/£ 1.4017 (1.3965 + 0.0052)
This results in a sterling payment of ($1,250,000/$1.4017) = £891,774
Using the money markets, NAC will invest in $, $ at the spot rate and borrow in £.
Invest $1,250,000/(1 + 0.044 4/12) = $1,231,932
Buy $ spot $1,231,932/$1.3965 = £882,157
Borrow in £ to give total cost £882,157 (1 + 0.0375 4/12) = £893,184
Over the counter option. Using a call option to buy $:
Exercise price $1.4025.
If spot is $1.3980 exercise the option.
The option premium is $1,250,000 x £0.006 = £7,500.
The premium with interest is £7,500 x (1 + 0.0375 x 4/12) = £7,594 1
The sterling payment will be ($1,250,000/$1.4025) + £7,594 = £898,860 «_space;borrow at the spot rate
(b) Discuss the relative advantages and disadvantages of each of the hedging techniques in 2.2(a) above and advise NAC’s board on which technique would be the most beneficial for hedging its forex risk.
Forward £891,774
Money market £893,184
Option £898,860
If no hedge the payment will cost: $1,250,000/$1.3980 = £894,134.
The forward contract and money market hedge lock NAC into an exchange rate. The options, however, protect NAC against the downside risk of the £ weakening more than expected against the $ and allow for the
upside potential of the $ weakening against the £; however, the option premium is expensive.
In addition to the above some specific advantages and disadvantages include:
Forwards:
Tailored specifically for NAC.
However, there is no secondary market.
Money market hedge:
The money market hedge is more difficult to arrange than a forward contract and might use up NAC’s credit lines.
O
TC currency options:
There is no secondary market.
It is unlikely that the $ is going to weaken enough to cover the cost of the
option premium, therefore it is not recommended that the company use
OTC foreign currency options.
The forward contract and money market hedge are both better than the spot rate, however, the forward is the
cheapest. It is recommended that NAC use a forward contract to hedge the foreign exchange risk.
The board is concerned about NAC’s exposure to economic risk as it imports cars from the USA and sells some of them to customers in the Eurozone.
Requirement
Explain how economic risk affects NAC.
NAC is an importer and exporter. It buys cars in $, exports some to the Eurozone and receives payment in €. If over a period of several years the pound weakens (although the data in the question indicates that it is
strengthening) against the dollar and appreciates against the euro the sterling value of NAC’s income will fall and its net cash flows decline. This will reduce the value of the business (PV of future cash flows).
An analyst estimated the following:
(1) If Continental were to fund the £1,000 million diversification entirely by borrowing, the market value of its existing debentures would fall by 5%.
(2) If Continental were to fund the £1,000 million diversification entirely by equity, the market value of its existing debentures would rise by 5%.
(3) The price of the company’s ordinary shares would stay the same whether the project is funded entirely by debt or entirely by equity.
- Ex-interest price of a debenture is 94
Assuming the £1,000 million finance required is raised on 1 December 2023, calculate Continental’s gearing (measured as debt/equity by market values) if it comes entirely from:
(a) debt or
(b) equity
If the diversification is financed by debt the price of the debentures
will fall to:
94 (1 – 0.05) = 89.3. 0.5
The market value of existing debt will now become: 1500 x 0.893 = £1339.5m
Total debt will be: 1339.5 + 1000 = £2339.5m
Gearing will be: 2339.5/8740 = 27%
(b) If the diversification is finance by equity the price of the debentures will rise to:
94 (1 + 0.05) = 98.7 0.5
The market value of debt will now become: 1500 x 0.987 = 1480.5 0.5
The market value of equity will be: 8740 + 1000 = £9740m
Gearing will be: 1480.5/9740 = 15%
Discuss whether the £1,000 million finance required for the diversification should be raised from debt, equity or a combination of debt and equity sources. You should make reference to:
relevant theories
From a practical viewpoint, as stated above, gearing does have implications.
However, from a theoretical point of view, it is useful to look at the views of Modigliani and Miller (M&M).
In 1958 M&M showed that in a no-tax world there is no advantage for firms to issue debt. There is therefore no optimal capital structure. However, one of the main advantages of issuing debt is that the company gets tax relief on the interest.
In 1963 M&M showed that, in the presence of corporation tax, it is advantageous for companies to issue debt.
The effect of interest being allowable against tax means that the higher the gearing the less tax a company will pay. This implies that Continental should not consider financing the diversification by equity at all and should only consider debt financing.
M&M stated that a company that has gearing is worth more than one that does not. This increase in value being due to the tax shield on debt. Since debt is cheaper than equity, this implies that WACC will fall as gearing rises, hence increasing the value of the firm.
Continental will therefore increase its value if it borrows the £1,000 million. In the extreme, M&M 1963 suggests that the optimal gearing is 100%; however, this is impractical and Continental would certainly risk bankruptcy if it were to gear up to this level.
The traditional theory (aka trade-off theory) suggests there is an optimal capital structure with a minimum WACC (and maximum firm value). If the 16% industry gearing is considered optimal by the market, then both methods of finance move the company away from the optimal, increasing the WACC and reducing the company’s value (more so in the case of debt).
