Revision Answers
Revision 1 Advanced Investment Appraisal – Case Answers
Answer 1
Briefing note to Rosa Nelson, CFO
From: Deputy CFO
Re Cost of capital
This briefing note assesses the effect of the proposed scheme to repay current debt and raise new capital through a bond issue on the firm’s cost of debt and equity and the weighted average cost of capital.
(a)
Current cost of debt, cost of equity and weighted average cost of capital
The current debt has an average term to maturity of four years. The cost of this type of debt is:
4.2% + credit risk premium of four year European government bonds
= 4.2% + 45 basis points = 4.65% [1]
Cost of equity
Using the CAPM:
[1]
Weighted average cost of capital (WACC)
In order to calculate the WACC, we must value the current debt by discounting the average coupon rate at the current cost of debt.
Market value of debt =
= $103.40 for every $100 nominal of debt
Total market value of debt = $800m × 103.4/100 = $827.2m [2]
Market value of equity = 500m shares × $1.38 = $6,900m
Gearing ratio =
WACC = [2]
(b)
Effect of redemption of existing debt and issue of new bonds
New debt is in the form of 10 year fixed interest bonds (50% in the Yen market and 50% in the Euro market). This means that cost of debt will be a weighted average of 10 year risk free rate plus the credit premium in both the Yen and Euro markets.
Cost of debt = 50% × (1.8% + 0.5%) + 50% × (4.6% + 0.85%) = 3.875% [2]
Market value of debt is $2,400m
Cost of equity
The increased gearing will impact upon the cost of equity for the company. The procedure for calculating the revised cost of equity is to ungear the current beta and revise it to the new gearing level using the market value of debt following the new issue.
Using the formula for the asset beta that the debt beta is zero
[2]
Assuming that the value of equity does not change, the revised beta will be:
[1]
The cost of equity to the new firm is:
[1]
Assuming no alteration in the market value of the firm’s equity.
WACC = [2]
(c)
Estimation of the minimum rate of return on the additional debt financing required to maintain shareholder value
The free cash flow to equity model appears to satisfactorily predict the value of the firm. The model gives a share price as follows:
Or $13.79 per share
[2]
Using 9·21% as the revised cost of equity following refinancing the free cash flow to equity required to maintain shareholder value is as follows:
g = 30% × 9.21% = 2.763%
[2]
$m / $mFree cash flow to equity / 400 / 432.5
Pre tax (divide by 0.75) / 533.33 / 567.67
Add: Interest
($800m × 4.65%) / 37.20
($2,400m × 3.875%) / 93.00
PBIT / 570.53 / 669.67
PBIT increases by $99.14m and debt increases by $1,600m. [1]
We therefore require a return of 6.2% (99.14m / 1,600m) on additional investment to maintain share price. [1]
(d)
Comparison of proposed method of raising finance with alternative methods
The use of bonds as a means of raising debt finance has considerable advantages. There is the obvious tax advantage related to interest payments. However as bonds are tradeable they may be issued at a lower cost than other forms of debt. Bonds open investment to a wider pool of subscribers who can sell the bonds to other investors if they choose.
[3]
Whilst bonds issues may appear to be an attractive means of raising large amounts of capital for investment purposes, they also carry significant risk. There are large issue costs involved and there is the risk that the issue will be undersubscribed. This risk may be mitigated somewhat by the process of underwriting (which comes at a price). Bonds issues tend to involve fairly rigid procedures due to the complex marketing procedures and regulatory requirements.
[3]
An alternative approach to raising the necessary debt finance is to use a syndicated loan. This type of loan involves a group of banks providing funds but without joint liability. There is normally a lead bank which then syndicates the loan to several other banks.
One of the main advantages of a syndicated loan is that larger loans can be arranged than through a single bank. This means that the company does not have to raise different loans from different banks. In addition, syndicated loans tend to be more flexible and can be tailored to the company’s specific needs. However the lead bank may require a higher interest rate to cover its risk of one of the syndicate banks defaulting on the loan.
[2]
I hope this information helps but I am happy to answer any queries you may have on the proposed debt financing scheme.
(e)
Maximisation of shareholder wealth
The directors have a duty to maximise shareholder wealth in the longer term. This hedging policy is seeking to achieve this objective. Arguably, therefore, directors should not take into account, when establishing policy, the impact of temporary movements in exchange rates that do not have impacts upon cash flows for the period. [2]
Impact of exchange rate changes on income statement
However, directors may be concerned about the impact on shareholders, because of the accounting requirements. This requires the euro bank balance to be translated at the exchange rate at the date of the statement of financial position, whereas the cost of inventory will be translated at the exchange rate at the date the inventory was purchased. In addition, the hedge is against future transactions as well as those reported in the accounting period. Thus the transactions and the hedge do not fully match. Also Jupiter has to disclose the exchange gains or losses arising from translating monetary assets at the accounting date. The impact of economic exposure need not be disclosed. Though it may result in a fall in profits as directors fear, shareholders will not be able to differentiate the impact of economic risk from other factors affecting the cost of sales. [2]
Impact of exchange rate changes on statement of financial position (SOFP)
The retranslation of the euro account at the accounting date will also affect its carrying value in the SOFP. If the euro significantly weakens, the account will be included at a lower value, worsening Jupiter’s asset position and gearing. This could impact on the financing of Jupiter, as finance providers require a higher cost of capital in return for higher perceived risks. [2]
Shareholder reactions
Shareholders may be most interested in the income statement impact. They may be unhappy if a fall in euro value results in an exchange loss which has been disclosed and which has resulted in lower earnings per share. If an exchange gain arises on the euro account, the higher profits may result in shareholders expecting a higher dividend, although it would not be based on cash movements. [2]
Disclosure
The company can provide more disclosure than is required by IAS 21 about exchange risks. Jupiter may be required, or it may be regarded as good practice locally, to include a report on risk management within its annual report. This would include an explanation of its hedging policy. This may help allay shareholder fears, although the fact that Jupiter will not be able to quantify precisely the economic impacts against which the hedge has been made may mean shareholders have problems judging the directors’ actions. [2]
(f)(i)
If X = 5% and standard deviation = $650,000
Then Confidence level = 1.65 deviations from the mean
VaR = $650,000 × 1.65 = $1,072,500
[3]
(f)(ii)
30-day SD = daily SD × √ 30 = 650,000 × √ 30 = $3,560,197
30-day VaR = $3,560,197 × 1.65 = $5,874,325
[2]
(f)(iii)
Usefulness as indication for directors
Risk appetite
The relevance of the decision to the directors will depend on how they relate to the decision to the risk appetite they have decided is appropriate. 5% is a widely-used measure, but it may not match Jupiter’s needs.
Maximum loss
The VaR figure is a reasonable indication of the maximum expected loss, not the maximum possible loss. The directors may wish to consider whether there are extreme factors that could mean the maximum possible loss is significantly different, and try to estimate what it might be. This will be difficult. Generally the € and $ have been fairly stable, but a big shock, for example a country dropping out of the Euro, may be unprecedented and therefore have unpredictable consequences.
Historical figures
The value at risk model is based on historical data, which may not be a fair reflection of the future economic situation. The unprecedented shocks to the global financial system over the last few years have highlighted this weakness of VaR.
Other assumptions
The VaR model assumes that possible outcomes follow a normal distribution and that factors causing volatility are independent of each other. These assumptions may not apply in practice.
Usefulness as external indicator
The VaR is an easy to understand and widely used figure that directors can use to justify their decision to investors, particularly if the loss turns out to be higher than expected.
[1 mark for each point, maximum 5 marks]
Answer 2
(a)
To: The Board of Directors of Tramont Co
From: Accountant
Date: XX/XX/XX
Subject: Evaluation of proposal to relocate production of X-IT to Gamala
The report considers the proposal to relocate production of X-IT from the USA to Gamala. The report includes an initial evaluation and then considers the key assumptions made in the evaluation, the potential effects of a change in the government of Gamala following the upcoming elections and also other business factors that should be taken into account before a decision is made.
The initial evaluation is a base case net present value calculation that assesses the impact of production in Gamala. This is then adjusted to show the impact of cash flows in the USA, including the impact of ceasing production, the impact of the subsidy and the tax shield benefits arising from the loan.
Based on the calculations, which can be found in the appendix, the move will generate a positive adjusted present value of just over $2.3 million. Based on these calculations it is recommended that production of XIT should move to Gamala.
[Initial comment: 1 – 2 marks]
Assumptions
l The borrowing rate of 5% has been used to calculate the present value of the tax shield benefits. The risk free rate of 3% could have been used instead, but it was felt more prudent to use the 5% rate.
l An adjusted present value calculation would normally use the debt capacity for the tax shield benefit calculation rather than the amount of debt finance used, but as this is not known it has been assumed that the increase in debt capacity is equal to the debt finance used.
l There are a number of variables included in the calculations. It is assumed that these will change as stated over the four year period.
l Exchange rates have been forecast using purchasing power parity, which it is assumed will hold for the four year period. In reality these variables may not alter as has been assumed and therefore it is recommended that sensitivity analysis is used to calculate the effect of changes in these key variables on the overall conclusion.
[Assumptions & sensitivity analysis: 2 – 3 marks]
Government change
l A change of government in Gamala may have a significant impact on the project as a result of changes threatened by the opposition party.
l The proposed tax increase may be significant as this would reduce the total tax shield and subsidy benefits as well as creating higher cash outflows in years 3 and 4 of the project. An even more significant change may arise, however, from the review of ‘commercial benefits.’
l Approximately 45% (1,033 / 2,317) of the adjusted present value comes from the tax shield and subsidy benefits. If these arrangements were to change then Tramont could lose a significant amount of value from the project.
l The new government may also review whether remittances are allowed every year as has been assumed in these calculations. This issue may be fairly minor as the majority of the value comes from the final year of operation anyway.
[Implication of government change: 2 – 3 marks]
Other business factors
l Tramont needs to also consider whether being based in Gamala will lead to any follow-on projects. The real options that are present within any such projects should be factored into the assessment of whether to relocate.
l Tramont also needs to ensure that this project fits within its overall strategy. Even if the decision to cease production in the USA is made there may be other, better alternatives than the Gamalan option. These other options should also be assessed.
l Tramont also needs to consider whether its systems can be adapted to the culture in Gamala. If Tramont has experience in international ventures then its directors may be surer of this. Tramont will need to develop strategies to combat any cultural differences. There may be further training costs as part of these strategies which have not been factored into this assessment.
l Another factor to consider is whether the project can be delayed as this will reduce the opportunity cost of lost contribution, which is greater in years 1 and 2. Therefore a delay could increase the overall value of the project.
l There are possible redundancies from the closure of production of X-IT in the USA. Since production will probably cease in the USA anyway the strategy should be clearly communicated to employees and other stakeholders in order to ensure its reputation is not damaged. As a result it may be even more important to consider alternatives to this plan.
[Other business factors (1 to 2 marks per factor, 5 – 6 marks)