Strategic Financial 7

Management .
3
PART 3
r
e
WEDNESDAY 11 JUNE 2003

QUESTION PAPER
p
a
Time allowed 3 hours

This paper is divided into two sections

P
Section A BOTH questions are compulsory and MUST be
answered

Section B TWO questions ONLY to be answered

Formulae sheet, present value, annuity and standard normal

distribution tables are on pages 8, 9, 10 and 11
Section A – BOTH questions are compulsory and MUST be attempted

1 Evertalk plc manufactures mobile phones and operates a mobile phone network. In order to offer the latest hand-held
videophone technology the company has borrowed extensively on the international bond market. Unfortunately the
new technology has proved to be unpopular with consumers, and sales of new handsets and network subscriptions
have been less than forecast. As a result the company’s share price has fallen to only 10 pence, from a high two years
ago of 180 pence. Capital investment of approximately £100 million per year is required for the company to continue
operating at current levels – £20 million for the manufacturing division and £80 million for the network division.
Approximately 25% of the sales of the manufacturing division are to the network division.

Profit and loss accounts for the years ending 31 March 2002 and 2003
£ million
2002 2003
Inflows:
Manufacturing division 280 320
Network division 410 470
—— ——
690 790
Outflows:
Manufacturing division 190 230
Network division 490 560
Tax allowable depreciation 50 60
—— ——
730 850
Pre-tax losses (40 ) (60)

Balance Sheet as at 31 March 2003

£ million

Land and buildings (net) 120

Other fixed assets (net) 175
——
295

Current assets
Stock 260
Debtors 85
Cash 5
—— 350

Creditors:
amounts falling due within 1 year
Floating rate bank loans 1 40
Creditors 209
—— (249)

Creditors:
amounts falling due after more than 1 year
12% unsecured bonds 2010 (300)
——
96

Shareholders’ funds
Ordinary shares (10 pence par) 50
Reserves 46
——
96
1
Currently 8% interest

2
Evertalk’s board of directors has arranged a crisis meeting and is considering three proposals:
(i) A corporate
corporate restruct
restructuring,
uring, in which
which bonds are
are converted to equity
equity,, and which gives
gives control
control of the company
company to the
current bond holders.
(ii) Sale of the company’s
company’s shares
shares to Globtalk
Globtalk plc,
plc, which operates
operates a successful
successful rival
rival mobile phone
phone network,
network, for the
sum of £50 million. This deal would be conditional upon Globtalk not taking over the liability for any of Evertalk’s
loans.
(iii) Cease trading
trading and
and close the
the company
company..

The restructuring has the following proposed conditions:

(i) Existing ordinary
Existing ordinary shares
shares will be cancelle
cancelled
d and replaced
replaced by 100
100 million
million new ordinary
ordinary shares
shares with a par value
value of
50 pence each. 95 million of these will be given to the existing bondholders in exchange for the cancellation of
all existing bonds. The bondholders will also make available £100 million of new 10% fixed rate loans.
(ii) Existing
Existing shareholde
shareholders
rs will be offered
offered one 5% convertible debenture
debenture (£100
(£100 nominal value)
value) free of charge
charge in
exchange for every 1,000 shares theythey now own. Conversion into new ordinary shares is available at any time
during the next five years at a conversion rate of 50 shares for every £100 convertible debenture held.
(iii) 5 million new shares will be given to existing participants in the company’s share option scheme in exchange
exchange for
cancellation of their existing options to purchase 10 million old shares.

Other information:
(i) All existi
existing
ng creditor
creditorss have
have equal
equal claims
claims for
for repaym
repayment
ent against
against the compan
company’s
y’s assets.
assets.
(ii) No dividends have been paid on ordinary shares for the
the last three years.
years.
(iii) Los
Losses
ses may
may not
not be carri
carried
ed forward
forward for
for tax
tax purposes
purposes..
(iv) Surpl
Surplus
us land and building
buildingss could be disposed
disposed of for
for £40 million
million in order to
to repay the
the bank loan.
loan.
(v) The value
value of debtors,
debtors, cash, fixed
fixed assets
assets and creditors
creditors represented
represented by the
the two divisions
divisions is approxima
approximately
tely equal.
equal.
90% of the stock is represented by the manufacturing division.
(vi) The £300 millio
million
n bond has been
been borrowed
borrowed by the network
network divisio
division,
n, and the
the £40 million
million bank loan
loan by the
manufacturing division.
(vii) If the restructuring and new investment does not take place,
place, earnings before tax (after interest payments) are
expected to stay at approximately the 2003 level. If new investment takes place, forecast earnings before interest
and tax are expected to increase by £30 million as a result of some rationalisation of the network division.
(viii) The current market price of ordinary shares is 10 pence, and of debentures £121. The par value and redemption
value of each debenture is £100.
(ix) Corporate
Corporate tax is
is at the rate
rate of 30%. The risk
risk free rate
rate is 5% and the
the market
market return 14%.
14%. The equity
equity beta of the
the
company is 1·15, with the manufacturing division equity beta approximately 0·9, and the network division
equity beta approximately 1·35. The company’s analysts believe that market weighted gearing of about 60%
equity,, 40% debt is appropriate for the entire sector,
equity sector, but currently this cannot be achieved due to the low share
price.
(x) Realisabl
Realisable
e values
values of aassets
ssets if not sold
sold as part of a going concer
concern
n are estimat
estimated
ed to be:
be:
£ million
Land and builild
din
ing
gs 140 (includining
g the surplus £40 million)
Other fixed assets 50
Stock 100
Debtors 70
(xi) Redundancy
Redundancy and closure
closure costs
costs of approximate
approximately
ly £100 million
million would be payable
payable if the company
company was closed,
closed, all
payable before any other creditors. These costs relate equally to the two divisions. All realisable values and
closure values are after tax.

Required:

Acting as an independent consultant prepare a report for the board of directors of Evertalk. Your report should
consider the advantages and disadvantages of each of the three proposals, from the viewpoint of each group of
existing stakeholders in the company. It should also identify any other strategy(ies) which might be possible for
Evertalk plc.

State clearly any assumptions that you make.

(35 marks)
3 [P.T.O.
2 Hasder plc currently operates only in the UK, but is considering diversifying its activities internationally into either
Europe or East Asia, the latter including several developing economies. Estimates have been obtained of the likely risk
and return of investments in these parts of the world, which are expected to vary during different economic states of
the UK. After either diversification approximately 30% of the market value of the company would be represented by
overseas investments.

Expected % IRR return

UK economic state Probability Invest in Europe Invest in East Asia Invest in UK

Low growth 0·3 7 2 6

Average growth 0·5 12 30 13
Rapid growth 0·2 21 15 17

Standard deviation of expected returns:

Europe 4·86
East Asia 12·26
UK 4·03

Covariances of expected returns:

UK/Europe 17·89
UK/East Asia 31·98

Members of Hasder’s board of directors have different views about such diversification.

Director A believes that the company should focus exclusively upon the UK market as it always has, because ‘overseas
investments are too risky’.

Director B believes that overseas diversification will offer the company the opportunity to achieve a much better
combination of risk and return than purely domestic investments, and ‘will open up new opportunities’.

Director C considers that overseas investments are expensive, and overseas diversification will not be valued by
shareholders who could easily achieve such diversification themselves.

Director D is in favour of the diversification, but considers East Asia to be a much better alternative than Europe.

Director E is also in favour of East Asia, but suggests that a much higher proportion of the company’s activities should
be located there, possibly between 50% and 70%.

Required:

(a) Discuss the views

views of each
each of the five
five directors. Include in your
your discussion
discussion relevant calculations
calculations regarding
regarding
portfolio risks and returns. What other factors might influence the investment decision?

State clearly any assumptions that you make. (25 marks)

(b) Estimate and explain

explain the implications of the correlation coefficients between:

(i))
(i UK//Eu
UK Euro
rop
pe; an
and
d

(ii)
(ii) UK
UK/E
/Eas
astt Asia
Asia.. (6 marks)

(c) Hasder plc has also purchased CAPM based risk and return estimates from an investment bank.

Relevant ma
market re
return Relevant ri
risk fr
free ra
rate Relevant in
investment be
beta
Europe 13% 5% 0·85
East Asia 18% 8% 1·32

Assuming this information is accurate, show how it might be used to assist the diversification decision.
(4 marks)

(35 marks)

4
Section B – TWO questions ONLY to be attempted

3 (a) Dis
Discus
cusss the
the adva
advanta
ntages
ges of hed
hedgin
ging
g with
with int
intere
erest
st rat
rate
e caps
caps and col
collar
lars.
s. (6 marks)

(b) Current futures prices suggest that interest rates are expected to fall during the next few months. Troder plc
expects to have £400 million available for short-term investment for a period of 5 months commencing late
October.. The company wishes to protect this short-term investment from a fall in interest rates, but is concerned
October
about the premium levels of interest rate options. It would also like to benefit if interest rates were to increase
rather than fall. The company’s advisers have suggested the use of a collar option.

LIFFE short sterling options (£500,000), points of 100%

Calls Puts
Strike price Sept Dec Sept Dec
95250 0·040 0·445 0·040 0·085
95500 0 0·280 0·250 0·170
95750 0 0·165 0·500 0·305

LIBOR is currently 5% and the company can invest short-term at LIBOR minus 25 basis points.

Required:

(i) Assume that it is now

Assume now early Septem
September
ber.. The company
company wishes
wishes to receive
receive more
more than £6,750,00
£6,750,000 0 in
interest from its investment after paying any option premium. Illustrate how a collar hedge may be used
to achieve this. (N.B. It is not necessary to estimate the number of contracts for this illustration).
(7 marks)

(ii) Estimate the maximum interest that could be

be received with
with your selected
selected hedge. (2 marks)

(15 marks)

5 [P.T.O.
4 Discos plc is negotiating an export contract with a customer in a developing coun try, Xeridia.
Xeridia. Discos has not exported
to the country before, and is concerned both about the risk of late or non-payment for the exports, and about the
foreign exchange risks associated with the Xeridian peso. The contract specifies that Discos should receive 55 million
Xeridian pesos in three months’ time. Discos will require short-term finance for the full value of the exports.

Exchange rates (peso/£)

Spot 32·34 – 32·89
3 months forward 33·82 – 34·55
6 months forward 35·17 – 35·90

Current short-term UK interest rates available to Discos plc:

Borrowing 6·5%
Investing 5·3%

Discos is considering three different ways of protecting against the foreign trade risk:

(i) Insure the deal with Protect Trade

Trade plc and undertake
under take a forward market hedge. An insurance policy is available at
a cost of 1·25% of the spot Sterling equivalent of the export value. The policy gives the following protection: 95%
cover against non-payment as a result of political actions by a foreign government; 90% cover against other non-
payment. Any payment by the insurer would be after six months.

(ii) Use the services of a non-recourse export factor. The factor will guarantee that £1,590,000 is paid in three
months’ time if the customer pays on time, or £1,530,000 in six months’ time if the customer makes a late
payment or defaults. The factor is prepared to provide immediate trade finance of up to 80% of the value of the
guaranteed sum, at an interest rate of 6·3%. The factor charges an administration fee of 2·5% of the sum
guaranteed.

(iii) Use a confirmed, irrevocable, documentary letter of credit. The letter of credit would include a 90 day bank bill
of exchange that may be immediately discounted in the Xeridian money market at an annual rate of 25%, which
is the short term borrowing rate in Xeridia. The fees associated with the letter of credit are £30,000.

Discos has been advised that there is at least a 5% chance of late payment after six months or default by the client.
The Xeridian government is not expected to take any action that is detrimental to foreign trade during the next six
months.

Required:

Discuss the advantages and disadvantages of each alternative, and recommend which should be selected.
Relevant calculations
calculations should support your discussion. State clearly any assumptions that you make.

(15 marks)

6
5 (a) Briefly discuss possible reasons for an upward sloping yield curve. (4 marks)

(b) The financial manager of Gaddes plc’s pension fund is reviewing strategy regarding the fund. Over 60% of the
fund is invested in fixed rate long-term bonds. Interest rates are expected
expected to be quite volatile for the next few
years.

Among the pension fund’s current investments are two AAA rated bonds:

1) Zer
Zero
o coup
couponon June 201
20188
2) 12% Gilt
Gilt June 2018
2018 (inter
(interest
est is payable
payable semi-a
semi-annually
nnually))

The current annual redemption yield (yield to maturity) on both bonds is 6%. The semi-annual yield may be
assumed to be 3%. Both bonds have a par value and redemption value of £100.

Required:

(i) Estimate the

Estimate the market
market price
price of each of
of the bonds
bonds if inter
interest
est rates
rates (yield
(yields):
s):
(a) increase by 1%;
(b) decrease by 1%.

The changes in interest rates may be assumed to be parallel shifts in the yield curve (yield changes by an equal
amount at all points of the yield curve). (6 marks)

(ii) Comment upon

upon and briefly
briefly explain
explain the size
size of the expected price movements
movements from the
the current prices,
prices,
and how such changes in interest rates might affect the strategy of the financial manager with respect
to investing in the two bonds. (3 marks)

(iii) How might the bond investment strategy of the financial manager be affected if the yield curve was
expected to steepen (the gap between short- and long-term interest rates to widen), and interest rates
are expected to rise? (2 marks)

(15 marks)

6 (a) Dis
Discus
cusss why con
confli
flicts
cts of
of intere
interest
st might
might exis
existt betwe
between
en share
sharehol
holder
derss and bond
bondhol
holder
ders.
s. (8 marks)

(b) Provide examples

examples of covenants that
that might be attached to bonds, and briefly discuss
discuss the advantages and
and
disadvantages to companies of covenants. (7 marks)

(15 marks)

7 [P.T.O.
 Formulae Sheet

Ke (i) E( r j ) = r f + [E(rm ) – r f ] β j
D1
(ii) +g
P0

E D
WACC Keg + Kd (1 – t )
E+D E+D

or Keu 1 –
 Dt 
 
E + D

2 asset
portfolio

σp = σ a2 x 2 + σ 2b (1 – x ) 2 + 2 x (1 – x ) p abσ aσ b

Purchasing i f – i uk
power parity 1 + i uk

E D(1 – t )
βa = βe + βd
E + D(1 – t ) E + D(1 – t )

Call
Call pric
price
e for
for a Eur
Europ
opea
ean
n opt
option = Ps N( d1) – Xe – rT N ( d 2 )
ion
1n ( Ps / X ) + rT
d1 = + 0.5σ T
σ T

d2 = d1 – σ T

8
   

       

    

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  

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          

           
           
           
           
           

           
           
           
           
           

           
           
           
           
           

9 [P.T.O.

 

    
        


    

    

  


          

           
           
           
           
           

           
           
           
           
           

           
           
           
           
           

          

           
           
           
           
           

           
           
           
           
           

           
           
           
           
           

10
 Standard normal distribution table

0·00 0·01 0·02 0·03 0·04 0·05 0·06 0·07 0·08 0·09

0·0 0·0000 0·0040 0·0080 0·0120 0·0160 0·0199 0·0239 0·0279 0·0319 0·0359
0·1 0·0398 0·0438 0·0478 0·0517 0·0557 0·0596 0·0636 0·0675 0·0714 0·0753
0·2 0·0793 0·0832 0·0871 0·0910 0·0948 0·0987 0·1026 0·1064 0·1103 0·1141
0·3 0·1179 0·1217 0·1255 0·1293 0·1331 0·1368 0·1406 0·1443 0·1480 0·1517
0·4 0·1554 0·1591 0·1628 0·1664 0·1700 0·1736 0·1772 0·1808 0·1844 0·1879

0·5 0·1915 0·1950 0·1985 0·2019 0·2054 0·2088 0·2123 0·2157 0·2190 0·2224
0·6 0·2257 0·2291 0·2324 0·2357 0·2389 0·2422 0·2454 0·2486 0·2517 0·2549
0·7 0·2580 0·2611 0·2642 0·2673 0·2703 0·2734 0·2764 0·2794 0·2823 0·2852
0·8 0·2881 0·2910 0·2939 0·2967 0·2995 0·3023 0·3051 0·3078 0·3106 0·3133
0·9 0·3159 0·3186 0·3212 0·3238 0·3264 0·3289 0·3315 0·3340 0·3365 0·3389

1·0 0·3413 0·3438 0·3461 0·3485 0·3508 0·3531 0·3554 0·3577 0·3599 0·3621
1·1 0·3643 0·3665 0·3686 0·3708 0·3729 0·3749 0·3770 0·3790 0·3810 0·3830
1·2 0·3849 0·3869 0·3888 0·3907 0·3925 0·3944 0·3962 0·3980 0·3997 0·4015
1·3 0·4032 0·4049 0·4066 0·4082 0·4099 0·4115 0·4131 0·4147 0·4162 0·4177
1·4 0·4192 0·4207 0·4222 0·4236 0·4251 0·4265 0·4279 0·4292 0·4306 0·4319

1·5 0·4332 0·4345 0·4357 0·4370 0·4382 0·4394 0·4406 0·4418 0·4429 0·4441
1·6 0·4452 0·4463 0·4474 0·4484 0·4495 0·4505 0·4515 0·4525 0·4535 0·4545
1·7 0·4554 0·4564 0·4573 0·4582 0·4591 0·4599 0·4608 0·4616 0·4625 0·4633
1·8 0·4641 0·4649 0·4656 0·4664 0·4671 0·4678 0·4686 0·4693 0·4699 0·4706
1·9 0·4713 0·4719 0·4726 0·4732 0·4738 0·4744 0·4750 0·4756 0·4761 0·4767

2·0 0·4772 0·4778 0·4783 0·4788 0·4793 0·4798 0·4803 0·4808 0·4812 0·4817
2·1 0·4821 0·4826 0·4830 0·4834 0·4838 0·4842 0·4846 0·4850 0·4854 0·4857
2·2 0·4861 0·4864 0·4868 0·4871 0·4875 0·4878 0·4881 0·4884 0·4887 0·4890
2·3 0·4893 0·4896 0·4898 0·4901 0·4904 0·4906 0·4909 0·4911 0·4913 0·4916
2·4 0·4918 0·4920 0·4922 0·4925 0·4927 0·4929 0·4931 0·4932 0·4934 0·4936

2·5 0·4938 0·4940 0·4941 0·4943 0·4945 0·4946 0·4948 0·4949 0·4951 0·4952
2·6 0·4953 0·4955 0·4956 0·4957 0·4959 0·4960 0·4961 0·4962 0·4963 0·4964
2·7 0·4965 0·4966 0·4967 0·4968 0·4969 0·4970 0·4971 0·4972 0·4973 0·4974
2·8 0·4974 0·4975 0·4976 0·4977 0·4977 0·4978 0·4979 0·4979 0·4980 0·4981
2·9 0·4981 0·4982 0·4982 0·4983 0·4984 0·4984 0·4985 0·4985 0·4986 0·4986

3·0 0·4987 0·4987 0·4987 0·4988 0·4988 0·4989 0·4989 0·4989 0·4990 0·4990

This table can be used to calculate N(di), the cumulative normal distribution
distribution functions needed for the Black-Scholes
model of option pricing. If di > 0, add 0·5 to the relevant number above. If di < 0, subtract the relevant number above
from 0·5.

End of Question Paper

11
Answers
Part 3 Examination – Paper 3.7
Strategic Financial Management June 2003 Answers

1 Report on the restructuring proposals of Evertalk plc.

Any decision should be taken in the best interests of the shareholders of the company
company,, with due regard paid to other stakeholders’
interests. The directors should not take decisions that are in their own best interests.

(i) Corporate restructuring

For a restructuring to be successful it must treat all stakeholders fairly in accordance with their respective rights, and, if
possible, offer each group a more favourable outcome than would occur if the company were to be liquidated. The company
should also expect to be viable as a going concern as a result of the restructuring.
Estimated liquidation value:
£ million
Land and buildings 140 (including the surplus £40m)
Other fixed assets 50
Stock 100
Debtors 70
Cash 5
Less re
redu
dund
ndan
anccy and
and clo
closu
sure
re cos
osts
ts (10
100)
0)
——
265

Creditors
Bank loan 40
Bond 300
Other creditors 209
——
549
If the company were liquidated, on average creditors would receive approximately 48% of cash due to them. Ordinary
shareholders would receive nothing.

Examining each of the individual stakeholder’s positions:

Bondholders:
The bondholders are to be offered 95 million shares in exchange for existing bonds of £300 million, effectively pricing each
share at 316 pence. They give up their rights to repayment of £300 million, of which about £145 million could be expected
if the company is liquidated (equivalent to a value of 153 pence per share). On the other hand they have to subscribe an
additional £100 million in order to allow rationalisation of the network division, and to improve the cash flow of the company.
The bondholders would gain control of the company, but this is only of value if the company is expected to survive.

The effect on the company is that interest of £300m × 12% would be saved, and the £40 million bank loan would be repaid
from the disposal of surplus assets, saving a further £40m × 8% = £3·2 million interest.

The
The pro
proje
ject
cted
ed fr
free
ee ca
cash
sh fl
flow
ow of th
the
e com
compa
pany
ny is
is:: £m

Curren
Curr entt in
inco
come
me fr
from
om op
oper
erat
atio
ions
ns (a
(aft
fter
er in
inte
tere
rest
st)) (60)
(60)
Add
Interest savings 39 (£300m
(£ × 12% + £40m × 8%)
Rationalisation gains 30
Add back depreciation 46 (assumed to reduce pro-rata to the £40m disposal)
Replacement investment (100)
——
Free cash flow (45)

(Other items such as working capital are assumed to be constant)

On this basis, even without discounting, the company as a whole is not likely to be financially viable after the proposed
restructuring. In this situation the bondholders would be better not to accept the proposed reconstruction as they could
potentially lose more of their investment if the company were subsequently forced into liquidation. However, if the
bondholders accepted the offer and then closed the network division their position might be improved. The implications of
closing the network division are discussed below.

Existing shareholders

If the company fails, existing shareholders would receive nothing. The proposal gives them at least some possibility of future
value, and might be acceptable. Shareholders could of course currently sell their shares for 10 pence; however, if many of
the shareholders were to sell the price would fall from this level. The convertible offer would then need to be judged against
the revenue from the sale of shares. The initial conversion price of 200 pence per share does not look favourable; on current
evidence the share price is unlikely to reach 200 pence during the next five years.

15
 Participants in the share option schemes

It is likely that currently the share options have little or no value as the current share price is so low. This offer appears to be
generous to this group who are existing managers/directors of the company, and probably unfair to other stakeholders.

Other creditors

The scheme does not offer any change in legal status to such creditors. It could, however
however,, slightly improve the future financial
viability of the company, or, as the amount of loans outstanding is reduced, probably improve the proportion of funds repaid
in the event of liquidation. If, however, the new loans are secured, this could have an adverse effect on other creditors.

The proposed restructuring does not offer a viable financial solution to the company’s current problems.

Other possible strategies: Closure of the network division

Given that the manufacturing division is performing much better than the network division, consideration should be given to
closing the network division. The subscriber base of the network division could possibly be sold. Future activities, and any
restructuring, could then be focussed on the manufacturing division that is currently profitable.
(ii) Sale of the company to Globtalk

Globtalk would probably close the network division as it is loss making and a direct competitor to its own network. If the
network division is closed the receipts are expected to be:

£ million
Land and buildings 50 (£100m × 0·5. The other £40m is assumed to be used to repay the bank loan)
Other fixed assets 25 (£50m × 0·5 )
Stock 10 (£100m × 0·1)
Debtors 35 (£70m × 0·5)
Cash 2·5

Less:
Creditors (104·5) (£209m × 0·5)
Bonds (300)
Closure costs (50) (£100m × 0·5)
–––––
Net liabilities (332 )

If the £300 million remaining bond liability is excluded from the closure, the outcome is an expected deficit on disposal of
only £32 million.

The projected free cash flow of the manufacturing division is:

£ million
Curren
Currentt inc
incom
ome
e fro
from
m op
oper
erat
atio
ions
ns (af
aftter in
inte
tere
resst) 90
Add back interest if bank loan is repaid 3
—–
93
Tax (30%) (28 ) (tax would be payable in future)
Add
Add de
depr
prec
ecia
iati
tion
on 12 (ass
(assum
umed
ed to be re
rela
lati
ting
ng to 20
20%
% of cu
curr
rren
entt an
annu
nual
al
depreciation as the manufacturing division only undertakes
20% of replacement expenditure)

Less replacement investment (20)

——
Free cash flow 57

If the network division is closed and none of the lost sales (25%) are replaced, then free cash flow would reduce to
approximately £41 million. This is not an exact estimate, and in reality sales could increase rather than decrease, as Globtalk
would be likely to use the division as a supplier of phones to its own network customers. Without any sales reduction the
present value of the free cash flow to infinity at a 10% discount rate (see appendix below) is £570 million. If a shorter and
more conservative time horizon of 10 years is used the present value of a free cash flow of £57m per year for 10 years is:
£57m × 6·145 = £350 million.

With a sales reduction the values are £410 million and £252 million.

Both of these estimates are well in excess of the £50 million price offered.

If Globtalk acquires Evertalk, there is potential also to access Evertalk’s

Evertalk’s existing network subscribers (or at least part of them),
and there could be vertical synergies with the manufacturing division. Even if Globtalk were to take full responsibility for
existing loans, at a total cost of £382 million (£332m net liabilities plus £50m purchase cost), its offer could still be below
the expected value of Evertalk with the network division closed.

Given the above data it is recommended that an y acquisition by Globtalk should be conditional upon the company accepting
liability for Evertalk’s existing loans.

16
 (iii) Closure of the company

Closure of the entire company is not recommended. Given the poor performance of the network division it is recommended
that this division is closed. The manufacturing division is viable, and could either continue to be operated by Evertalk, or sold
to Globtalk. Closure of the network division would lead to a deficit of approximately £332 million (see above), which could
not easily be paid by the manufacturing division.

Conclusion:
Unless an alternative restructuring scheme can be agreed, which would reduce the burden of the closure of the network
division to the company, sale to Globtalk might be the best alternative, conditional upon Globtalk accepting the liability for all
existing loans.

Appendix: WACC for the manufacturing division:

Cost of equity for the manufacturing division:
Rf + (Rm - Rf) beta, or 5% + (14% – 5%) 5%) 0·9 = 13·1%
The cost of debt may be estimated by using the current bank loan rate of 8%, or from the current bond price, by trial and
error.

12 12 12 100
£121 = ———– + ——–—— + . . . ——–—— + ——–—— .
1 + Kd (1 + Kd)2 (1 + Kd)7 (1 + Kd)7
£
At 8% 12 × 5·206 = 62·47
100 × 0·583 = 58·30
———
120·77
The cost of debt (before tax) is approximately 8%.
The weighted average cost of capital for the manufacturing division, using target gearing of 60% equity, 40% debt is:
13·1% (0·6) + 8% (1 – 0·3) (0·4) = 10·1%
10% will be used as the discount rate.
N.B. The after tax cost of debt is used as the manufacturing division is expected to pay tax in the future.

2 (a) It is useful to estimate the return and risk of the two diversification alternatives before examining in detail the views of the
directors. The portfolio return is simply the weighted average of the expected returns of the two elements of the portfolio. The
portfolio risk may be estimated using the two-asset portfolio theory equation, based upon the expected risk and return of each
alternative.

Europe
Probability Return (%) E (R)
Low growth 0·3 17 2·1
Average growth 0·5 12 6·0
Rapid growth 0·2 21 4·2
——
12·3

East Asia
Probability Return (%) E (R)
Low growth 0·3 12 10·6
Average growth 0·5 30 15·0
Rapid growth 0·2 15 13·0
——
18·6

UK
Probability Return (%) E (R)
Low growth 0·3 16 1·8
Average growth 0·5 13 6·5
Rapid growth 0·2 17 3·4
——
11·7

Expected return UK/Europe (0·7) (11·7) + (0·3) (12·3) = 11·88%

Expected return UK/East Asia (0·7) (11·7) + (0·3) (18·6) = 13·77%
The two-asset portfolio equation measures the total risk of the portfolio. This will include some specific or unsystematic risk:
Portfolio risk UK/Europe
1
[(4·03)2 (0·7)2 + (4·86)2 (0·3)2 + 2(0·7) (0·3) (17·89)] /2
σ = 4·20
p

17
 1
Portfolio risk UK/East Asia [(4·03) 2 (0·7)2 + (12·26)2 (0·3)2 + 2(0·7) (0·3) (31·98)] /2

σ = 5·91
p

Summar y Portfolio return Portfolio risk Coefficient of variation

UK alone 11·70 4·03 0·344
UK/Europe 11·88 4·20 0·354
UK/East Asia 13·77 5·91 0·429

It is not obvious from these results which investment is best. As risk increases, so does the expected return. The coefficient of
variation, which shows the amount of risk per pound of expected return, would suggest that continuing only in the UK is best.
However, the risk/return preferences of Hasder plc would need to be considered before a decision was made, as would strategic
and other issues discussed below.
below.

Director A
Director A’s view has merit in that the company would be sticking to its core market and core competence. However, overseas
investments are not always too risky. Some overseas investments are less risky than UK investments. If total risk is considered then
international diversification can produce risk/return combinations that are not available from investing only in the UK. The benefits
of international portfolio diversification might reduce overall risk below that available in the UK, and provide better combinations
of risk and return for Hasder. This is the view of Director B who correctly states that international diversification will open up new
opportunities.

Director C produces no evidence that overseas investments are more expensive than UK investments. In many multinational
companies lower labour and materials costs have been key motives for overseas investments, hence such investments have been
cheaper than similar UK based investments.

If the company is investing overseas purely to achieve diversification it is fair to say that in most cases shareholders, by investing
in international unit trusts (mutual funds) or similar, could easily, and more cheaply, diversify for themselves. However, some
countries do not permit such portfolio investments, and their markets are largely segmented from major Western markets.
Segmented markets might include the developing markets in East Asia. Hasder might be able to offer risk/return combinations that
are valued by its shareholders if it invests in countries that they could n ot easily invest in themselves as part of their share por tfolios.
Investing in segmented markets might also mean that the systematic risk of investments available to Hasder can be reduced,
especially if the segmented markets have a low or negative covariance with returns in the UK market.

International diversification might also result in less variability of the cash flows of Hasder, as the markets are not perfectly
correlated. This reduction in risk, if recognised by providers of finance, might result in lower financing costs, and a lower cost of
capital.

Director D
The summary table shows that investment in East Asia offers a higher potential return than in Europe, but at significantly higher
risk. If the coefficient of variation is considered then it is the least favoured alternative.

Director E suggests a much higher proportion of investment in East Asia. If 50% – 70% was invested in Asia, and assuming
market values reflected these proportions:

50% – Expected return UK/East Asia (0·5) (11·7) + (0·5) (18·6) = 15·15%

70% – Expected return UK/East Asia (0·3) (11·7) + (0·7) (18·6) = 16·53%

Portfolio risk UK/East Asia

If 50%:
1
[(4·03)2 (0·5)2 + (12·26)2 (0·5)2 + 2(0·5) (0·5) (31·98)] /2

σ
p = 7·59

If 70%;
1
[(4·03)2 (0·3)2 + (12·26)2 (0·7)2 + 2(0·3) (0·7) (31·98)] /2

σ
p
= 9·41

The potential returns increase significantly, as does risk. Unless Hasder is seeking very high returns and is prepared to take the
extra risk, there is no evidence to support the view that a higher proportion should be invested in East Asia. Such a move would
probably mean closing some UK operations with the resultant problems of redundancy, and would be a major strategic change
from the company’s current position.

The risk and return evidence should only be part of the decision process. The data itself is likely to be subjective and inaccurate.
It is impossible to know with any degree of accuracy what future returns will be, and the assignment of probabilities to different
economic states is at best speculative.

18
 Other factors that might influence the decision include:

(i) How do the investments fit with Hasder’s strategic

strategic plans?
(ii) Has a full competitor/market analysis been undertaken?
(iii) Has the company
company any strategic
strategic reason for favouring Europe or East Asia?
(iv) Has political risk
risk been considered, and itsits possible effects
effects built into the
the cash flows?
(v) Has foreign exchange risk been included?
(vi) Are there
there other
other investment
investment alternatives?
(vii) What future options could arise from the investments?
investments?
(viii) What are the non-financial implications of the investments?
(ix) Is total risk the best measure of risk?
risk? Should systematic risk be used instead?
instead?

(b) The correlation coefficient may be estimated by:

Covariance
———————————————————.
Standard deviation A × Standard deviation B

17·89
(i) UK/Europe ——–——— = 0· 0·91
4·03 × 4·86

31·98
(ii)
(ii) UK/
K/Ea
Easst As
Asia ——–—–—–—
–——— = 0·6
0·65
5
4·03 × 12·26

Although the returns between the UK and Europe and the UK and East Asia are both positively correlated, the degree of
correlation is much higher for the UK and Europe at 0·91. This means that relatively little risk reduction will take place
because of the strong relationship between the UK and Europe. This is evidenced
evidenced by the portfolio standard deviation of 4·20,
which is little different from the individual standard deviations.

The lower correlation coefficient of 0·65 between the UK and East Asia allows much more risk reduction from international
diversification, with the standard deviation of East Asia alone (12·26) reducing to a much safer 5·91 as part of a portfolio
with the UK.

(c) Using CAPM

Required return = Risk free rate + (Market return – Risk free rate) beta

Europe: required return is 5% + (13% – 5%) 0·85 = 11.8%

The expected return is 12·3%. The European investment is expected to provide an abnormally good return for its systematic
risk, and on that basis would be recommended.

East Asia: required return

return is 8% + (18% – 8%) 1·32 = 21·2%

The expected return is 18·6%. The investment is not providing sufficient return for its systematic risk and would not be
recommended.

However, strategic and non-financial factors should also play a major role in the decision process.

3 (a) Interest rate caps and collars are available on the over the counter (OTC) market or may be devised using market based
interest rate options. They may be used to hedge current or expected interest receipts or payments. An interest cap places an
upper limit on the interest rate to be paid, and is useful to a potential borrower of funds at a future date. The borrower by
purchasing a cap, will limit the interest paid to the agreed cap strike price (less any premium paid). OTC caps are available
for periods of up to 10 years and can thus protect against long-term interest rate movements. As with all options, if interest
rates were to move in a favourable direction the buyer of the cap could let the option lapse and take advantage of the more
favourable rates in the spot market.

The main disadvantage of options is the premium cost. A collar option reduces the premium cost by limiting the possible
benefits of favourable movements. It involves the simultaneous purchase and sale of options, or, in the case of OTC collars
the equivalent net premium to this. The premium paid for the purchase of the options would be partly or wholly offset by the
premium received from the sale of options. Where it is wholly offset a zero cost collar exists.

(b) For the company to earn interest of £6,750,000 it would need to earn an

£6,750,000 12
annualised
annualised intere
interest
st rate,
rate, after
after premium
premium cost
costss of —————–—
—————–— × –— = 4·0
·05%
5%
£400,000,000 5

19
 The collar needs to produce a minimum of more than 4·05% including premium costs.

As Troder plc is investing, a lending collar will be required whereby the company will simultaneously buy a floor and sell a
cap. Buying a call option that will increase in value if interest rates fall will set the floor, or minimum interest rate. The cap,
achieved by selling put options, will set the maximum interest, with the company foregoing any higher interest rate than the
put option exercise price, but paying a lower overall premium. The overall cost of the collar will be the call option premium
paid less the put option premium received.

In order to achieve a return of more than 4·05% (£6,750,000) a collar needs to be arranged with the call strike price higher
than the put strike price (in order to set the maximum interest that can be received).

Alternatives are:
Call strike price Interest rate Less call cost Plus put receipt Less 0·25% Total
95750 4·25% 0·165% 0·170% (95500) 0·25% 4·005%
95750 4·25% 0·165% 0·085% (95250) 0·25% 3·92% 0
95500 4·50% 0·280% 0·085% (95250) 0·25% 4·055%
Only the purchase of a call at 95500 and sale of a put at 95250 will result in a minimum return of £6,750,000. The actual
minimum return (ignoring any possible remaining time value that might increase the return) is:

5
£400,000,000 × — × 4·055% = £6,758,333
12

N.B If a collar is set with the same put and call price the return will be

Strike price Interest rate Less call cost Plus put receipt Less 0·25% Total
95250 4·75% 0·445% 0·085% 0·25% 4·14%
95500 4·50% 0·280% 0·170% 0·25% 4·14%
95750 4·25% 0·165% 0·305% 0·25% 4·14%
This would achieve the required 4·05%, but would not allow Troder
Troder to take advantage of any favourable movement in interest
rates.

(ii) The maximum

maximum return would
would occur if market interest
interest rates
rates are at least 4·75%
4·75% and the call option
option were allowed
allowed to lapse. The
put option would be exercised by its buyer and the maximum overall return would be:

Strike price Interest rate Less call cost Plus put receipt Less 0·25% Total
(call not exercised)
95500 4·75% 0·280% 0·085% 0·25% 4·305%

This would yield:

5
£400,000,000 × — × 4·305% = £7,175,000
12

4 (i) The use of trade insurance limits the effect of possible payment/default, although Discos would still have to bear some of the
risk.

The spot equivalent of 55 million pesos is:

55
——— = £1,672,
——— £1,672,241
241
32·89

55
The three
three month
month forward rate
rate is:
is: ——— = £1,591,896
£1,591,896
34·55

This is much less favourable than the spot rate, but has the advantage of fixing the expected cash flow from the export deal.

If payment is received in three months:

£
Receipts from payment 1,591,896
Interest cost (27,174 ) (1,672,241 × 6·5% × 3/12)
Insurance cost (20,903 ) (1,672,241 × 1·25%)
————–
1,543,819

20
 If payment is not made in three months the forward contract will have to be fulfilled, or rolled over at an unknown cost. The
late payment/default is assumed not to be the result of government action. If exchange rates don’t change during the months
4–6 (which is very unlikely):
In six months receive:

£
55 × 0·9
———— 1,378,830
35·90
Interest cost (six months) (54,348 )
Insurance cost (20,903 )
————–
1,303,579
If the estimated 5% risk of late payment or default is accurate, the expected return is

(£1,543,819 × 0·95) + (1,303,579 × 0·05) = £1,531,807

(ii) The use of an export factor eliminates foreign exchange risk as payment will be made in sterling. As the factor is non-recourse,
the factor bears the risk if the customer pays late/defaults, except for the reduced sterling payment in six months that would
be made to Discos. The factor will also take responsibility for the debt collection process.

If the customer pays in three months:

£
Receipts from payment 1,590,000
Factor interest cost (20,034 ) (1,590,000 × 0·8 × 6·3% × 3/12 )
Other interest cost (6,504 ) [(1,590,000 × 0·2 + 82241) × 6·5% ×
3
/12 ]
Factor fee (39,750 ) (1,590,000 × 2·5%)
————–
1,523,712

If the customer pays late/defaults:

£
Receipts from payment 1,530,000
Factor interest cost (40,068 ) (1,590,000 × 0·8 × 6·3% × 6/12 )
Other interest cost (13,008 ) [(1,590,000 × 0·2 + 82241) × 6·5% ×
6
/12 ]
Factor fee (39,750 ) (1,590,000 × 2·5%)
————–
1,437,174

Expected return is (£1,523,712 × 0·95) + (1,437,174 x 0·05) = £1,519,385

Other issues:

(1) Will the

the factor be prepare
prepared
d to undertake a ‘one off’
off’ deal, or will further busines
businesss be required?
required?

(2) Will the use of the factor improve the

the chance of payment? Most factors are subsidiaries
subsidiaries of major banks, and might have
more market power to achieve payment.

(3) Will Discos

Discos save administrative/labour costs if the factoring company undertakes the debt collection
collection process? If so such
savings would need to be included in any financial assessment.

(iii) The use of a documentar y letter of credit should ensure that Discos receives the due payment. The letter of credit is confirmed
and irrevocable, which means that as long as Discos correctly presents all the agreed documents to the importer’s bank
(normally via the exporter’s bank), both banks guarantee to make payment to the exporter (or to the third party holding the
discounted bill of exchange). Thus in the case of late payment/default the guaranteeing banks will bear the risk. Letters of
credit are very useful for high value exports, and when dealing with customers whose creditworthiness is uncertain, as is the
case here.
£
55m × (1 – (0·25 × 3/12 ))
Discount
nteed rec
receipts fro
from pay
payment 1,5
,5667,726 ———————————
32·89
Arrangement cost (30,000 )
—————
1,537,726

The banks guaranteeing the bill will be liable for payment on the bill. Discos plc will immediately discount the bill in Xeridia
and convert the net proceeds into sterling at the spot rate, in order to raise the necessary finance. Discos will face no further
foreign exchange risk or commercial risk.

Recommendation:
Unless Discos could make substantial administrative savings from option (ii), option (iii), the use of a confirmed letter of credit
results in the highest expected receipts and is the recommended alternative.

21
5 (a) A yield curve may be upward sloping because of:

(i) Future expectations. If future short-term interest rates are expected to increase then the yield curve will be upward
sloping.

(ii) Liquidity preference. It is argued that investors seek extra return for giving up a degree of liquidity with longer-term
investments. Other things being equal, the longer the maturity of the investment, the higher the required return, leading
to an upward sloping yield curve.

(iii) Preferred habitat/market segmentation. Different investors are more active in different segments of the yield curve. For
example banks would tend to focus on the short-term end of the curve, whilst pension funds are likely to be more
concerned with medium and long term segments. An upward sloping curve could in part be the result of a fall in demand
in the longer term segment of the yield curve leading to lower bond prices and higher yields.

(b) (i) The current market prices of the two bonds may be estimated to be:

£100
Zero
Zero co
coup
upon
on ——–—
——–—– – = £41
£41·7
·73
3
(1·06)15

12% gilt with a semi-annual coupon

1 – (1·03)–30
Present
Present value
value of an annuity
annuity for 30
30 periods
periods at 3%
3% is ——––––—–
——––––—– = 19·6004
19·6004
0·03

£
Present value of interest payments £6 × 19·6004 = 117·6
19·6004 117·60
0
1
Pre
rese
sent
nt val
value
ue of
of rede
redemp
mpti
tion
on usi
using
ng ——
——–—–———
—— £100
£100 × 0·4120
0·4120 = 41·
41·20
20
(1 + 0·03)30 ———
158·80

If interest rates increase by 1%

£100
Zero
Zero coupon
coupon —––—–
—––—– = £36·25
£36·25,, a decreas
decrease
e of £5·48
£5·48 or 13·1%
13·1%
(1·07)15

12% gilt

1 – (1·035)–30
Present
Present value of an annuity
annuity for 30 peri
periods
ods at 3·5% is —–——
—–——––—–––—– = 18·3
18·3920
920
0·035

£
Present value of interest payments £6 × 18·3920
18·3920 = 110·35
110·35
1
Pre
rese
sent
nt val
value
ue of
of rede
redemp
mpti
tion
on usi
using
ng ——–—
——–——— —— £1 £100
00 × 0·3563
0·3563 = 35·63
35·63
(1 + 0·035)30 ———
145·98

This is a decrease of £12·82 or 8·1%

If interest rates decrease by 1%:

£100
Zero coupo
coupon
n —––—–
—––—– = £48·10,
£48·10, an increase
increase of £6·37
£6·37 or 15·3%
15·3%
(1·05)15

12% gilt with a semi-annual coupon

1 – (1·025)–30
Present
Present value
value of an annuity
annuity for 30
30 periods
periods at 2·5%
2·5% is —––––––––—–
—––––––––—– = 20·9303
20·9303
0·025

£
Present value of interest payments £6 × 20·9303 = 125·5
20·9303 125·58
8
1
Pre
rese
sent
nt val
value
ue o
off rede
redemp
mpti
tion
on usi
using
ng ——
——–—
–————— £100
£100 × 0·4767
0·4767 = 47·
47·67
67
(1 + 0·025)30
———
173·25

This is an increase of £14·45 or 9·1%

22
 (ii) The price/yield relation is not linear; it has a convex shape. There is a bigger absolute movement in bond prices when
interest rates fall than when they rise. The percentage movement is also higher for low coupon bonds than high coupon
bonds. Other things being equal, a financial manager would prefer to hold high coupon bonds if interest rates are
expected to increase, and low or zero coupon bonds when interest rates are expected to decrease.

(iii) If interest rates are expected to rise, and the gap between yields on short and long dated bonds to widen, the financial
manager would not want to hold longer dated bonds as these would suffer a larger fall in price than short dated bonds.
Short dated bonds, probably with high coupons, would be preferred.

6 (a) Bondholders are concerned that payments of interest and repayments of principal are made on time and without problems.
The willingness of bondholders to provide funds to companies depends upon the risks and returns that they face, including
the companies’ expected cashcash flows, assets (including
(including available security on assets),
assets), and credit ratings. Shareholders, in
theory, seek to maximise the value of their shares. This is not necessarily consistent with the interests of bondholders, or the
incentive to maximise the total value of the company (the value of equity plus debt). Shareholders seeking to maximise their
wealth might take actions that are detrimental to bondholders. For example, shareholders, normally through their agents,
managers, might use the finance provide by bondholders to invest in very risky projects, which change the character of the
risk that the bondholders face. If the risky projects are successful, then the rewards flow primarily to the shareholders. If the
projects fail then much of the cost of failure will fall on the bondholders. If there are no constraints on shareholders, the
shareholders might have a natural incentive to take such risks. Management, acting on behalf of shareholders, might also
reduce the wealth, and/or increase the risk of bondholders by:

(i) Selling off assets of the company;

(ii) Paying large dividends;

(iii) Borrowing additional funds that rank above existing bonds in terms of prior payment upon liquidation.

The incentive for shareholders to take on risks at bondholders’ expense is especially strong when the company is in financial
difficulties and in danger of failing. In such circumstances the shareholders may believe that they have little to lose by
undertaking risky projects. In the case of corporate failure significant ‘bankruptcy costs’ normally exist. Direct costs of
bankruptcy include receivers and lawyers’ fees, whilst indirect costs might include loss of cash flow prior to failure through
loss of sales, worse credit terms etc. When corporate failure occurs most of the firm’s value will be transferred to its debt
holders who ultimately bear most of the bankruptcy costs.

(b) Bond covenants might include:

(i) An asset covenan

covenant.
t. This would
would govern the
the company’s
company’s acquisitio
acquisition,
n, use and disposal
disposal of assets.
assets. This
This could be for specifi
specified
ed
types of assets, or assets in general.

(ii) Financing covenant.

covenant. This covenant often defines the type and amount of additional debt that the company can issue,
issue,
and its ranking and potential claim on assets in case of future default.

(iii) Dividend covenant. A dividend covenant restricts

restricts the amount of dividend that the company is able to pay.
pay. Such
covenants might also be extended to share repurchases.

(iv) Financial ratio covenants, fixing the

the limit of key ratios such as the gearing
gearing level, interest cover,
cover, net working capital, or a
minimum ratio of tangible assets to total debt.

(v) Merger covenant,

covenant, restricting
restricting future merger activity
activity of the company
company..

(vi) Investment covenant, concerned with the company’s future investment policy
policy.

(vii) Sinking fund covenant whereby the company makes payments,

payments, typically to the bond trustees, who might
might gradually
repurchase bonds in the open market, or build up a fund to redeem bonds.

There will often also be a ‘bonding covenant’ that describes the mechanisms by which the above covenants are to be
monitored and enforced. This often includes an independent audit and the appointment of a trustee representing the interests
of the bondholders

From the company’s perspective the major disadvantage of covenants is that they restrict the freedom of action of the
managers, and could prevent viable investments, or mergers from occurring. They also necessitate monitoring and other costs.
However,, covenants are also of value to companies. Without covenants the company might not be able to raise as much fun ds
However
in the form of debt, as lenders would not be prepared to take the risk. Even if lenders were to take the risk they would require
a higher default premium (higher interest rates) in order to compensate for the risk. The existence of covenants therefore
reduces the cost of borrowing for a company.

23
Part 3 Examination – Paper 3.7
Strategic Financial Management June 2003 Marking Scheme

1 This question requires the analysis of which strategy, if any, a company in financial difficulties should adopt. It tests knowledge of
the principles of corporate restructuring and the valuation of companies, and requires the ability to use financial information to
suggest alternative strategies that a company might use.

Marks
Repor t format 1
Overall principle(s) that should influence the decision 1

Corporate restructuring
Fair treatment 1
Financial viability estimates/comments 2–3
Liquidation value 2
Stakeholders’ positions:
Bondholders 2–3
Shareholders 2
Option holders 2
Other creditors 2
–—
Max 15
Sale to Globtalk
Cost of capital Max 5
Valuation – preferably using free cash flow 6–7
Conclusion 1–2
—–
Max 12

Closure of the company

company.. Discussion/calcs 3–4

Alternative suggestions. Reward sensible suggestions, especially related

to the viability of the manufacturing division. 4–5
Allow for overlap

Total 35

2 This question requires understanding of the potential benefits of international diversification, and the ability to analyse risk and
return data in order to assist investment decision-making.

(a) Estimates of risk and return

UK and other returns 2
Europe/UK risk and return 3
East Asia/UK risk and return 3
Views of directors
A 2–3
B 2
C 2–3
D 1
E including additional calculations 3–4
—–
Overall views of directors max 10
Marks may be credited for relevant overlap
Other factors relevant to the decision 1 mark for each good point max 7
———
max 25

(b) Estimates 3
Discussion 3
—
6

(c) Estimates of required return 2

Discussion of implication for the diversification decision 2
—
4

Total 35
25
 Marks
3 (a) Advantages of caps 3
Advantages of collars 3
—
6

(b) Required interest yield 1

Collar calculations 6
—
Give credit for technique 7

(c) Maximum yield if option is not exercised 2

Total 15

4 Insurance plus forward market 5

Non-recourse factor 5–6
Documentary letter of credit plus discounting 4
Conclusion 1
Reward technique.
Total 15

5 (a) For full marks three reasons are necessary 4

(b) (i) Current market prices 2

Increase 1% 2
Decrease 1% 2

(ii) Reward awareness of different size of movement and its implication 3

(iii) Full marks for correct interpretation 2

Total 15

6 ( a ) Discussion of reasons 1–2 for each good point max 8

(b) Examples of covenants. 1 mark for each sensible suggestion max 5

Advantages and disadvantages to companies (not investors!) 2–3

Total 15

26