Series: NOV 2016

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FM – Nov 2016 – L3 – SC – Q7 – Mergers and Acquisitions

Advise on the benefits, drawbacks, alternatives, and target selection criteria for expansion through mergers or acquisitions.

One of the means by which companies expand is through mergers and acquisitions. However, there are other means of expansion aside from these methods.

Inkline Plc. is one of your client companies intending to expand its business by means of merger or acquisition. Your firm of management consultants has been asked to advise the management of the company on what steps to take while considering the merger and acquisition methods, and whether it should go ahead with the expansion programme or otherwise.

Required:

a. (i) FOUR benefits derivable from its proposed means of expansion. (4 Marks)
(ii) THREE probable demerits of employing its proposed method of expansion. (3 Marks)

b. TWO alternatives to merger and acquisition in your report. (2 Marks)

c. Where the company decides to go ahead with either of these methods, indicate THREE criteria the company may consider in choosing its target company. (6 Marks)

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FM – Nov 2016 – L3 – SC – Q6 – Strategic Performance Measurement

Evaluate Osamco Limited’s financial performance compared to industry benchmarks and discuss reasons for considering stock exchange listing.

Osamco Limited, manufacturer of wire and cables, was bought from its conglomerate parent company in a management buyout deal in August 2010. Six years later, the managers are considering the possibility of listing the company’s shares on the Nigerian Stock Exchange.

The following information is made available:

OSAMCO LIMITED
INCOME STATEMENT FOR THE YEAR ENDED JUNE 30, 2016

N’million Amount
Turnover 91.25
Cost of sales (79.00)
Profit before interest and taxation 12.25
Interest (3.25)
Profit before taxation 9.00
Taxation (1.25)
Profit attributable to ordinary shareholders 7.75
Dividend (0.75)
Retained profit 7.00

STATEMENT OF FINANCIAL POSITION AS AT JUNE 30, 2016

N’million Amount
Non-current assets (at cost less accumulated depreciation)
Land and buildings 9.00
Plant and machinery 24.75
Total non-current assets 33.75
Current assets
Inventories 11.00
Accounts receivable 11.75
Cash at bank 2.50
Total current assets 25.25
Total assets 59.00
Equity
Ordinary shares of N1 each 6.75
Reserves 24.25
Total equity 31.00
Non-current liabilities
Accounts payable due after more than one year: 12% Debenture 2018 5.50
Current liabilities
Trade accounts payable 17.50
Bank overdraft 5.00
Total current liabilities 22.50
Total equity and liabilities 59.00

Industry sector ratios:

Metric Industry Average
Return before interest and tax on long-term capital employed 24%
Return after tax on equity 16%
Operating profit as percentage of sales 11%
Current ratio 1.6:1
Quick (acid test) ratio 1.0:1
Total debt: equity (gearing) 24%
Dividend cover 4.0
Interest cover 4.5

Required:
a. Evaluate the financial state and performance of Osamco Limited by comparing it with that of its industry sector. (10 Marks)

b. Discuss FOUR probable reasons why the management of Osamco Limited is considering Stock Exchange listing. (5 Marks)

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FM – Nov 2016 – L3 – SC – Q5 – Portfolio Management

Assess CAPM's basic assumptions and determine overvalued securities among four companies using CAPM metrics.

a. Capital Asset Pricing Model (CAPM) is an equilibrium model of the trade-off between expected portfolio return and unavoidable risk.
What are the basic assumptions on which this model is based? (6 Marks)

b. Currently, the rate of return on the Federal Government Bond redeemable at par in the year 2018 is 5%. The securities of four companies, Akira Plc., Bombadia Plc., Courage Plc., and Divine Plc., have expected returns of 12%, 9.5%, 10.5%, and 13%, respectively. The average expected return on the market portfolio is 10%, subject to a 6% risk (standard deviation). Other relevant information relating to the four securities of the companies is as stated below:

Company Standard Deviation Correlation Coefficient
Akira Plc 0.080 0.975
Bombadia Plc 0.075 0.640
Courage Plc 0.090 0.740
Divine Plc 0.150 0.680

You are required to show which of the companies is/are overvalued. (9 Marks)

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FM – Nov 2016 – L3 – SB – Q4 – Investment Appraisal Techniques

Evaluate Gugi Plc.'s proposed investment in a foreign factory, considering costs, revenues, tax, and exchange rate impacts.

Gugi Plc. is a highly successful manufacturing company operating in Nigeria. In addition to sales within Nigeria, the company also exports to a foreign country (with currency F$) along the ECOWAS sub-region. The export sales generate annual net cash inflow of ₦50,000,000. Gugi Plc. is now considering whether to establish a factory in the foreign country and stop exporting from Nigeria to the country. The project is expected to cost F$1 billion, including F$200million for working capital.

A suitable existing factory has been located, and production could commence immediately. A payment of F$950million would be required immediately, with the remainder payable at the end of year one. The following additional information is available:

  • Annual production and sales in units: 110,000
  • Unit selling price: F$5,000
  • Unit variable cost: F$2,000
  • Unit royalty payable to Gugi Plc: ₦300
  • Incremental annual cash fixed costs: F$50million

Assume that the above cash items will remain constant throughout the expected life of the project of 4 years. At the end of year 4, it is estimated that the net realisable value of the non-current assets will be F$1.40billion.

It is the policy of the company to remit the maximum funds possible to the parent (i.e., Gugi Plc.) at the end of each year. Assume that there are no legal complications to prevent this.

If the new factory is set up and export to the foreign country is stopped, it is expected that new export markets of a similar worth in North Africa could replace the existing exports.

Production in Nigeria is at full capacity, and there are no plans for further capacity expansion.

Tax on the company’s profits is at a rate of 40% in both countries, payable one year in arrears. A double taxation agreement exists between Nigeria and the foreign country, and no double taxation is expected to arise. No withholding tax is levied on royalties payable from the foreign country to Nigeria.

Tax allowable “depreciation” is at a rate of 25% on a straight-line basis on all non-current assets.

The Directors of Gugi Plc. believe that the appropriate risk-adjusted cost of capital for the project is 13%.

Annual inflation rates in Nigeria and the foreign country are currently 5.6% and 10%, respectively. These rates are expected to remain constant in the foreseeable future. The current spot exchange rate is F$1.60 = N1. You may assume that the exchange rate reflects the purchasing power parity theorem.

Required:
a. Evaluate the proposed investment from the viewpoint of Gugi Plc.
Notes:
i. Show all workings and calculations to the nearest million.
ii. State all reasonable assumptions. (18 Marks)

b. State TWO further information and analysis that might be useful in the evaluation of this project?

(2 Marks)

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FM – Nov 2016 – L3 -SB – Q3 – Capital Gains Tax

Calculate EVA for Jack Limited and determine its market value added (MVA) based on provided assumptions.

Jack Limited is a family-owned business that has grown strongly in the last 50 years. The key objective of the company is to maximise the family’s wealth through their shareholdings. Recently, the directors introduced value-based management, using Economic Value Added (EVA) as the index for measuring performance.

You are provided with the following financial information:

Statement of Profit or Loss and Other Comprehensive Income for the year ended December 31, 2015:

₦’million 2015
Operating profit 340.0
Finance charges (115.0)
Profit before tax 225.0
Tax at 25% (56.3)
Profit after tax 168.7

Notes

Notes 2015 (₦’m) 2014 (₦’m)
(i) Capital employed – from the Statement of Financial Position 6,285 6,185
(ii) Operating costs:
Depreciation 295 285
Provision for doubtful debts 10 2.5
Research and development 60
Other non-cash expenses 35 30
Marketing expenses 50 45
(iii) Economic depreciation is assessed to be ₦415 in 2015. Economic depreciation includes any appropriate amortisation adjustments. In previous years, it can be assumed that economic and accounting depreciation were the same.
(iv) Tax is the cash paid in the current year (₦45million) and an adjustment of ₦2.5million for deferred tax provisions. There was no deferred tax balance prior to 2015.
(v) The provision for doubtful debts was ₦22.5million on the 2015 Statement of Financial Position.
(vi) Research and development cost is not capitalised in the accounts. It relates to a new project that will be developed over five years and is expected to be of long-term benefit to the company. The first year of this project is 2015.
(vii) The company has been spending heavily on marketing each year to build its brand long term.
(viii) Estimated cost of capital of the company:
Equity 16%
Debt (pre-tax) 5%
(ix) Gearing (Debt/Equity) Ratio 1.5: 1

Required:
a. Calculate, showing all relevant workings, the Economic Value Added (EVA) for the year ended December 31, 2015. Make use of the adjusted opening capital employed. Comment on your result and make appropriate recommendations. (15 Marks)

b. Irrespective of your answer in (a) above, assume the company’s current EVA is ₦120million and that this will decline annually by 2% for the next ten years and then increase by 4% per annum in perpetuity. Assume the following for this part only:

  • Cost of equity 14%
  • WACC 10%

Calculate the market value added (MVA) by the company. Show all workings. (5 Marks)

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FM – Nov 2016 – L3 – SB – Q2 – Investment Appraisal Techniques

Calculate the value of the convertible loan stock, expected growth rate in equity price, and provide recommendations on whether to hold or sell the security.

Honey Comb Plc has issued 10% convertible loan stock, which is due for redemption in 10 years’ time (i.e., December 31, 2025). The option to convert is open only for another two years. If conversion does not take place by December 31, 2017, the option will lapse. The issue was sold to the public at a price of N920 for N1000 of convertible loan stock. The conversion rate at January 1, 2016 was 250 equity shares for N1000 of stock. Non-convertible loan stock in a similar risk class is presently yielding 12%. The market price of Honey Comb Plc equity shares has been increasing steadily over time, reflecting the performance of the company. The shares currently pay a dividend of N0.30 per share. The current price of the convertible security is N960, and each share is currently valued at N3.00. A holder of the convertible loan stock is considering whether to sell his holdings or continue to hold the stock. Ignore taxation while answering the questions.

Required:
a. What is the value of the security as simple unconvertible loan stock? (5 Marks)

b. What is the expected minimum annual rate of growth in the equity share price that is required to justify the holder of convertible loan stock holding on to the security before the option expires? (12 Marks)

c. What recommendation would you make to the holder of the security and why? (3 Marks)

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FM – Nov 2016 – L3 – SA – Q1 – Cost of Capital

Analyze a potential investment project, including the valuation of the firm’s equity and bonds, calculation of the risk-adjusted cost of capital, and project valuation with and without a buyout offer.

Tinko Plc (TP) repairs and maintains heavy-duty trucks with workshops across Nigeria and parts of Africa. Below are extracts from its financial position:

Item ₦’million
Share capital (50k/share) 200
Reserves 320
Non-current liabilities 760
Current liabilities 60

The company’s Free Cash Flow to Equity (FCFE) is estimated at ₦153 million, with a perpetual growth rate of 2.5% annually. The equity shareholders require an 11% return.

The non-current liabilities consist of ₦1,000 nominal value bonds redeemable in 4 years at par with a 5.4% coupon. The credit spread is 80 basis points above the risk-free rate.

A project related to the “Graduates Back To Land (GBTL)” program is under consideration. The initial investment is ₦84 million, with estimated cash flows for four years. Details about the project include alternative scenarios for the program’s growth and a potential buyout offer of ₦100 million at the end of year one.

Required:
a. Calculate the current total market value of TP’s:
i. Equity (3 Marks)
ii. Bonds (4 Marks)

b. Calculate the risk-adjusted cost of capital required for the new project. (10 Marks)

c. Estimate the value of the project with and without the offer from FL (10 Marks)

d. State the assumptions made in your calculations. (3 Marks)

 

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AT – Nov 2016 – L3 – SC – Q7 – Tax Planning and Management

Explain tax planning and anti-avoidance legislation, summarize tax evasion and double taxation provisions, and highlight non-tax investment factors.

You were invited as the Chairman of a Tax Summit at Ikeja, Lagos State. The topics for discussion were as follows:

i. Tax Planning, an Effective Method of Tax Avoidance
ii. Tax Evasion in a Growing Economy
iii. Double Taxation – The Provisions and the Impact
iv. Jurisdiction for Investment – Non-Tax Factors

As the Chairman, you had the opportunity to summarize the papers presented by the four paper presenters in just ten minutes.

You are required to:

a. Explain briefly, Tax Planning and Anti-Avoidance Legislations put in place by the Government (3 Marks).

b. Summarize situations that may involve Tax Evasion (4 Marks).

c. Explain Double Taxation Agreement – Provisions and the Main Objectives (4 Marks).

d. Summarize Non-tax factors that attract investors in choosing a business jurisdiction (4 Marks).

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AT – Nov 2016 – L3 – SC – Q6 – Petroleum Profits Tax (PPT)

Explain associated gas and downstream activities and compute petroleum profits tax for Bivenette Petroleum Company Ltd.

a. The administration of the Petroleum Profits Tax Act is under the charge and management of the Federal Inland Revenue Service with respect to Petroleum Profits Tax Act Cap P13 LFN 2004.

You are required to explain:
i. Associated Gas (2 Marks)
ii. Downstream Activities (2 Marks)

b. Bivenette Petroleum Company Limited has been in the oil prospecting business for some years. Extracts from the financial statements for the year ended December 31, 2013, show the following information:

Details Amount (₦’000)
Value of oil exported 1,030,000
Domestic sales 842,000
Chargeable gas sales 603,000
Other income 425,000
Operating costs 1,385,000
Intangible costs 142,800
Royalty on export sales 125,000
Royalty on local sales 96,500
Non-productive rent 102,000
Exploration incentives 313,500
Rental 101,200
Interest paid 98,000
Administrative expenses 265,000

Additional Information:
(i) The Petroleum Profits Tax rate is 85%.
(ii) Interest paid included ₦12,000,000 paid to an affiliated company.
(iii) Capital allowances were agreed at ₦253,750,000.
(iv) Included in the operating cost is ₦302,000,000 paid to a company for information on oil prospect in Adamawa State.
(v) The company is entitled to Investment Allowance of ₦173,000,000.

Required:
Determine the Assessable Profit, Chargeable Profit, Assessable Tax, and Chargeable Tax of the company for the relevant Year of Assessment. (11 Marks)

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AT – Nov 2016 – L3 – SC – Q5 – Tax Incentives and Reliefs

Identify industries qualifying as Pioneer Industries and compute tax liabilities and withholding tax for Ajanaku Nigeria Limited.

a. **One of the incentives available to industries in Nigeria is contained in the Industrial Development (Income Tax Relief) Act 1971, which grants tax holidays to companies in the industries that meet the conditions for being designated “Pioneer Industries.”

Under the Industrial Development (Income Tax Relief) Act 1971, state any FOUR industries that qualify to be regarded as Pioneer Industries.** (4 Marks)

b. Ajanaku Nigeria Limited was incorporated as a pioneer company on March 15, 2011, with a focus on the manufacture of aluminum roofing sheets. It was granted a Pioneer Certificate with Production Day given as July 1, 2011. Extracts of Audited Financial Statements are as shown below:

Period 6 Months to 31/12/11 Year to 31/12/12 Year to 31/12/13 Six Months to 30/6/14
(Loss) / Profit (3,750) (4,800) 2,250 4,500
After Charging: Depreciation 2,800 2,500 1,700 1,000
Withholding Tax on Rent Included 500 250
Donations to:
Epe Traditional Dance Troupe 10
Nigerian Red Cross 100
Borno State General Hospital 120

Additional Information:

  • Ajanaku Nigeria Limited declared gross dividends of ₦600,000 and ₦1,500,000 for 2013 and 2014, respectively.
  • Withholding tax rates on dividends for the relevant years are 10%.
  • Ignore minimum tax provisions.
  • The company’s initial tax relief period was not extended.

Required:
Compute the tax liabilities for the relevant years of assessment relating to Pioneer Status only, and state the amount of Withholding Tax due from the shareholders. (11 Marks)

a. Four Industries Qualifying as Pioneer Industries:

  1. Agricultural production, including food processing and packaging.
  2. Manufacturing, such as aluminum products and roofing sheets.
  3. Mining and processing of minerals, including petroleum refining.
  4. Telecommunication and information technology.

b. Computation of Tax Liabilities and Withholding Tax for Ajanaku Nigeria Limited:

Step 1: Pioneer Period

  • Pioneer period runs from July 1, 2011, to June 30, 2014.

Step 2: Loss/Profit Exemption During Pioneer Period

  • Losses incurred during the pioneer period are disregarded for tax purposes.
  • Profits during the pioneer period are exempt from tax.

Step 3: Dividend Withholding Tax (WHT):

Year Gross Dividend (₦’000) Withholding Tax Rate (%) WHT Amount (₦’000)
2013 600 10 60
2014 1,500 10 150

Total Withholding Tax Due = ₦60,000 + ₦150,000 = ₦210,000.

Final Tax Liabilities:

  • Since Ajanaku Nigeria Limited’s profits during the pioneer period are exempt from tax, Tax Liability = ₦0.

Withholding Tax Due from Shareholders:

  • Total Withholding Tax on dividends for 2013 and 2014 is ₦210,000.

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FR – Nov 2016 – L2 – Q2c – Financial Reporting Standards and Their Applications

Calculate the carrying amount of investment property in accordance with IAS 40.

c) Tanoso owns the following properties as at 31 December 2015:

Property Fair Value (GH¢million)
Land with future use undetermined 3.2
Factory rented to Tanoso’s subsidiary under an operating lease 2.4
10-floor office building (fair value is equal per floor), 3 floors used as the subsidiary’s head office, and 7 floors rented to third parties under an operating lease 15.0
Empty building held for capital appreciation, but not leased out 4.1

Tanoso’s accounting policy is to hold its investment properties under the fair value model and its land and buildings under the revaluation model.

Required:
In accordance with IAS 40 Investment Property, calculate the carrying amount to be recognised as investment property in Tanoso’s consolidated financial statements as at 31 December 2015.

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FR – Nov 2016 – L2 – Q2b – Financial Reporting Standards and Their Applications

Identify the conditions under which it may be appropriate to change accounting policy in accordance with IAS 8.

According to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, an entity must select and apply its accounting policies consistently from one period to the next and among various items in the financial statements. However, an entity may change its accounting policies under certain conditions.

Required:
Identify the circumstances under which it may be appropriate to change accounting policy in accordance with the guidance given in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.

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FR – Nov 2016 – L2 – Q2a – Financial Reporting Standards and Their Applications

Prepare financial statement extracts showing how the lease transaction of Asokwa Ltd should be treated for the year ended 31 December 2014.

You are employed as the Financial Accountant for Asokwa Ltd. Asokwa Ltd leased a new piece of equipment from Amakom Ltd for three years commencing on 30 September 2014. The fair value of the equipment is GH¢70,000. A deposit of GH¢4,000 was payable on 30 September 2014 followed by six half-yearly payments of GH¢13,500, payable in arrears, and commencing on 31 March 2015. Asokwa Ltd allocates finance charges on a sum of the period digits basis.

Required:
Prepare financial statement extracts showing how the lease transaction of Asokwa Ltd should be treated for the year ended 31 December 2014.

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FR – Nov 2016 – L2 – Q1b – Group Financial Statements and Consolidation

Explain the elements of control an investor must have over an investee as outlined in IFRS 10 Consolidated Financial Statements.

IFRS 10 Consolidated Financial Statements outlines the requirements for the preparation and presentation of consolidated financial statements, requiring entities to consolidate entities it controls.

Required:
Explain and justify how IFRS 10 Consolidated Financial Statements determines elements of control of an investor over an investee.

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FR – Nov 2016 – L2 – Q1a – Group Financial Statements and Consolidation

Prepare the consolidated statement of financial position for Bantama Ltd Group as at 30 September 2016, with provided details of acquisition and adjustments.

Bantama Ltd acquired six million of Abrepo Ltd’s ordinary shares on 1 April 2016 for an agreed consideration of GH¢25 million. The consideration was settled by a share exchange of five new shares in Bantama Ltd for every three shares acquired in Abrepo Ltd, and a cash payment of GH¢5 million. The cash transaction has been recorded, but the share exchange has not been recorded.

The draft statements of financial position of the two companies as at 30 September 2016 are:

Additional information:

  1. The fair value of Abrepo Ltd’s land at the date of acquisition was GH¢4 million in excess of its carrying value. Abrepo Ltd’s financial statements contain a note of a contingent asset for an insurance claim of GH¢800,000 relating to some inventory that was damaged by a flood on 5 March 2016. The insurance company is disputing the claim. Bantama Ltd has taken legal advice on the claim and believes that it is highly likely that the insurance company will settle it in full in the near future.
  2. At the date of acquisition, Bantama Ltd sold an item of plant that had cost GH¢2 million to Abrepo Ltd for GH¢2.4 million. Bantama Ltd has charged depreciation of GH¢240,000 on this plant since it was acquired.
  3. Bantama Ltd’s current account debit balance of GH¢820,000 with Abrepo Ltd does not agree with the corresponding balance in Abrepo Ltd’s books. Investigations revealed that on 26 September 2016, Bantama Ltd charged Abrepo Ltd GH¢200,000 for its share of central administration costs. Abrepo Ltd has not yet recorded this invoice. Intercompany current accounts are included in accounts receivable or payable as appropriate.
  4. Abrepo Ltd paid a dividend of GH¢400,000 on 30 September 2016. The profit and dividend of Abrepo Ltd are deemed to accrue evenly throughout the year. Abrepo Ltd’s retained earnings of GH¢8.8 million for the year to 30 September 2016 as shown in its statement of financial position are after the deduction of the dividend. Bantama Ltd’s policy is to credit to income only those dividends received from post-acquisition profits. Bantama Ltd has not yet accounted for the dividend from Abrepo Ltd. The cheque has been received but not banked.
  5. At the year-end, an impairment review was carried out on the consolidated goodwill arising from the acquisition of Abrepo Ltd, and an impairment loss of GH¢595,000 was identified. No adjustment has yet been made for this. It is group policy to value non-controlling interest at acquisition at its proportionate share of the fair value of the subsidiary’s identifiable net assets.

Required:

Prepare the consolidated statement of financial position of Bantama Ltd group as at 30 September 2016.

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AFM – Nov 2016 – L3 – Q5b – Emerging issues in finance and financial management

Compare the functions of the IMF and World Bank and outline challenges faced by the IMF in West Africa.

The International Monetary Fund (IMF) and the World Bank are institutions in the United Nations system. They are twin intergovernmental pillars supporting the structure of the world’s economic and financial order.

Required:
i) Compare and contrast THREE functions of the International Monetary Fund (IMF) and the World Bank. (3 marks)
ii) Explain TWO challenges being faced by the IMF in attaining its objectives in West African Countries. (2 marks)

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AFM – Nov 2016 – L3 – Q5a – Hedging against financial risk: Non-derivative techniques

Demonstrate how YSL can hedge currency risk using futures contracts and calculate the result of the hedge.

YSL is a company located in the USA that has a contract to purchase goods from Japan in two months’ time on 1st September. The payment is to be made in yen and will total 140 million yen. The managing director of YSL wishes to protect the contract against adverse movements in foreign exchange rates and is considering the use of currency futures. The following data are available:

  • Spot foreign exchange rate: $1 = 128.15 yen
  • Yen currency futures contracts on SIMEX (Singapore Monetary Exchange)
    • Contract size: 12,500,000 yen
    • Contract prices (US$ per yen):
      • September: 0.007985
      • December: 0.008250

Assume that futures contracts mature at the end of the month.

Required:
i) Illustrate how YSL might hedge its foreign exchange risk using currency futures. (5 marks)
ii) Explain the meaning of basis risk and show what basis risk is involved in the proposed hedge. (5 marks)
iii) Assuming the spot exchange rate is 120 yen/$1 on 1 September and that basis risk decreases steadily in a linear manner, calculate what the result of the hedge is expected to be. Briefly discuss why this result might not occur. (5 marks)
(Margin requirements and taxation may be ignored.)

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AFM – Nov 2016 – L3 – Q4b – Financial strategy formulation

Discuss three advantages and three disadvantages of ABC Ltd being acquired in a leveraged buyout (LBO).

ABC Ltd is a listed company that operates in the Information Technology industry. The company has been experiencing losses for several years now, and its reserves are fast depleting. Its earnings per share have been negative for the past three years. A team of the company’s largest shareholders and some managers are considering acquiring the company in a leveraged buy-out (LBO).

Required:
Discuss THREE advantages and THREE disadvantages of ABC Ltd being acquired in an LBO.

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AFM – Nov 2016 – L3 – Q4a – Valuation of acquisitions and mergers

Calculate the NPV of Mama Ltd's acquisition of Papa Ltd and determine the value of the combined entity and an appropriate share exchange ratio.

a) The Directors of Mama Ltd (Mama), a large listed company, are considering an opportunity to
acquire all the shares of Papa Ltd (Papa), a small listed company with a highly efficient
production technology.
Mama has 10 million shares of common stock in issue that are currently trading at GH¢6.00
each. Papa Ltd has 5 million shares of common stock in issue, each of which is trading at
GH¢4.50.
If Papa is acquired and integrated into the business of Mama, the production efficiency of the
combined entity would increase and save the combined business GH¢600,000 in operating
costs each year to perpetuity.
Though Mama operates in the same industry as Papa, its financial leverage is higher than that
of Papa. Mama’s total debt stock is valued at GH¢40 million, and its after-tax cost of debt is
22%. The beta of Mama’s common stock is 1.2. The return on the risk-free asset is 20% and
the market risk premium is 5%.
Required:
Suppose Mama offers a cash consideration of GH¢25 million from its existing funds to the
shareholders of Papa for all of their shares.
i) Calculate the NPV of the acquisition, and advise the directors of Mama on whether to
proceed with the acquisition or not. (8 marks)
ii) Calculate the value of the combined entity immediately after the acquisition. (3 marks)
iii) Suppose Mama would like to acquire all the shares in Papa by offering fresh shares of its
own common stock to the shareholders of Papa. Advise the directors on the appropriate
share exchange ratio based on market price.

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AFM – Nov 2016 – L3 – Q3b – Discounted cash flow techniques

Calculate the Net Present Value (NPV) of a new product investment project considering real terms and inflation adjustments.

A company plans to invest GH¢7 million in a new product. Net contribution over the next five years is expected to be GH¢4.2 million per annum in real terms. Marketing expenditure of GH¢1.4 million per annum will also be needed. Expenditure of GH¢1.3 million per annum will be required to replace existing assets, and additional investment in working capital, equivalent to 10% of contribution, will be needed at the start of each year. Working capital will be released at the end of the project. The following inflation forecasts are made for the next five years:

  • Contribution: 8%
  • Marketing: 3%
  • Assets: 4%
  • General prices: 4.70%

The real cost of capital is 6%. All cash flows are in real terms. Ignore tax.

Required:
Calculate the Net Present Value (NPV) of the project and appraise whether it is a worthwhile project.

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