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ACCA Paper P4 Advanced Financial Management Tuition Mock Examination June 2012 Answer Guide Health Warning! How to pass Attempt the mock examination under exam conditions BEFORE looking at these suggested answers. Then constructively compare your answer, identifying the points you made well and identifying those not so well made. If you got basics wrong then re-revise by re- writing them out until you get them correct. How to fail Simply read or audit the answers congratulating yourself that you would have answered the questions as per the suggested answers.

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Page 1: Lsbf.p4 Mock Ques

ACCA

Paper P4

Advanced Financial Management Tuition Mock Examination

June 2012

Answer Guide

Health Warning!

How to pass Attempt the mock examination under exam

conditions BEFORE looking at these suggested answers. Then constructively compare your

answer, identifying the points you made well and identifying those not so well made.

If you got basics wrong then re-revise by re-writing them out until you get them correct.

How to fail Simply read or audit the answers congratulating

yourself that you would have answered the questions as per the suggested answers.

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© Interactive World Wide Ltd, April 2012

All rights reserved. No part of this publication may be reproduced, stored in a

retrieval system, or transmitted, in any form or by any means, electronic,

mechanical, photocopying, recording or otherwise, without the prior written

permission of Interactive World Wide Ltd, April 2012.

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Question 1

Tutorial help and key points

Marking scheme

Marks

(a)

Discussion

Report format 1 Selection of project based on NPV 1 2 marks each for other relevant factors discussed Up to a maximum of 8 marks 8 _______

Max 10 Calculations

Garden Tool Cost of equity 2 Cost of debt 2

WACC 1 Sales 1 Labour cost 1

Material cost 1 Tax 1 Tax savings on allowable depreciation 2 NPV 1 _______

Max 10

Jack process Cost of equity 2 WACC 1

Direct labour cost saved 1 Redundancy cost + training cost 1 Maintenance cost 1 Tax 1

Tax savings on allowable depreciation 2 Disposal of machinery 1 NPV 1 _______

Max 10

(b)

Stating the daughter statement was correct 1 Explanation of real options 2 Examples of real options 2 _______

Max 5

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(a)

To:

From:

Date:

Subject: Proposed acquisition of new jack machines or the expansion of

garden tool production.

The report is about the decision to purchase the new machines or to expand garden

tool production.

From the financial perspective the two alternatives were compared on the basis of

their respective net present values. The project with the highest net present value

would be the one that would maximise our shareholders’ wealth. The expansion of

the garden tools production produced net present value of £281.4m whilst the

purchase of the new machines for jack production produced net present value of

38.3 million. On this basis the expansion of the garden tools production produces

the highest net present value and should be the best alternative to consider.

However, before making the final decision the following factors should also be

considered:

● The cost of capital used to discount the cash flows of each alternative might

not reflect the true cost of capital. For the jack product, the cost of capital

was estimated based on the difference between the equity beta of the

company as whole and that of the garden production. The beta for the

garden production was estimated using the beta from other companies

producing tools on the assumption that the business risk is the same for all

the companies. This may not necessarily be the case.

● The new machines would make 50 employees redundant and this may have

adverse effects on the motivation of other employees.

● Future development in the markets of both the garden tools and the jack

should be considered. You should consider which of these two alternatives

have the potential future development.

● The appraisal covers a period of five years. The cash flows beyond five years

should also be considered.

● Real options

o Another important consideration should be the effect of the decision on

your competitors and market share. You were concerned that failure to

invest in the new jack manufacturing process might lead to the company

losing significant market share in the jack market if competitors were

able to reduce their prices in real terms as a result of introducing the

new process.

o Additional working capital requirement should also be considered. The

jack production will not lead increase in production and may not need

extra injection of working capital. However, the expansion of the garden

tools will require production of an additional 70,000 units and the

company may need extra working capital to finance the increase in

activity.

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o In relation to the above point, the 70,000 additional units from garden

tools would be sold at the same price. This may not be achieved as

increase in output may require you to reduce price to encourage

demand.

● From the financial perspective, both projects produce positive net present

value and would be worth to undertake all the two projects as they are not

mutually exclusive. However, this may require additional cost and is also

subject to availability of finance.

Financial and non-financial factors should be considered before taking the final

decision.

Consultant

Appendix

Net present value of new jack process

Year 0 1 2 3 4 5 6

£000 £000 £000 £000 £000 £000 £000

Dirct labour saved 271.6 287.9 305.2 323.5 342.9

Redundancy costs (354)

Training cost (15)

Maintenance cost 0 _____

46.8 _____

48.7 _____

50.6 _____

52.6 _____

54.7 _____

(369) 224.8 239.2 254.6 270.9 288.2

Tax 92.2 (56.2) (59.8) (63.6) (67.7) (72)

Tax saved on allowable depreciation

66.9 16.7 12.5 9.4 7.1 11.2

Machines cost (535)

Disposal of machine 0 _____

125 _____

0 _____

0 _____

0 _____

40 _____

0 _____

(904) 508.9 199.7 207.3 216.7 267.6 (60.8)

Discount factor 16% 1 _____

0.862 _____

0.743 _____

0.641 _____

0.552 _____

0.476 _____

0.41 _____

Present value (904) 438.9 148.4 132.9 119.6 127.4 (24.9)

Net present value 38.3

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Net present value of garden tool production

Year 0 1 2 3 4 5 6

£000 £000 £000 £000 £000 £000 £000

Sales 573.3 602 632.1 663.7 696.8

Labour cost 244.9 259.6 275.1 291.6 309.1

Material cost 178.1 _____

188.8 _____

200.1 _____

212.1 _____

224.8 _____

0 _____

150.3 153.6 156.9 160 162.9 0

Tax 37.6 38.4 39.2 40 40.7

Tax saved on

allowable depreciation

25 6.2 4.7 3.5 2.6 4.4

Equipment (200) _____

0 _____

0 _____

0 _____

0 _____

14 _____

0 _____

(200) 175.3 122.2 123.2 124.3 139.5 (36.3)

Discount factor 12% 1 _____

0.893 _____

0.797 _____

0.712 _____

0.636 _____

0.567 _____

0.507 _____

Present value (200) 156.5 97.4 87.7 79.1 79.1 (18.4)

Net present value 281.4

Workings

(1) Direct labour saved

Year 1 25% x (1.8 + 2.3) x 250 x 1.06 = 271.6

Then increase with 1.06 factor for the subsequent years.

(2) Maintenance cost

Year 1 = 45 x 1.04 = 46.8

Inflate this by 1.04 for the subsequent years.

(3) The head office and apportioned overheads as well as the interest

costs are irrelevant

(4) Tax savings on capital allowances – Jack production

Year

Capital

allowance Tax saved

1 535 267.5 66.9

2 267.5 66.9 16.7

3 200.6 50.2 12.5

4 150.5 37.6 9.4

5 112.9 28.2 7.1

Balancing allowance – assuming it is available in year 6

84.7 – 40 = 44.7 x 25% = 11.2

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(5) Tax savings on capital allowances – garden production

Year Capital

allowance Tax saved

1 200 100 25

2 100 25 6.2

3 75 18.7 4.7

4 56.2 14.1 3.5

5 42.2 10.5 2.6

Balancing allowance – assuming it is available in year 6

31.7 – 14 = 17.7 x 25% = 4.4

Assuming tax savings on capital/depreciation allowances start from year 1,

allowances are claimed at the beginning of the year.

(6) Cost of capital/discount factor

The cost of capital used should reflect the systematic risk that goes with each

investment and as such the current WACC cannot be used as the discount factor.

The specific cost of capital for each alternative can be estimated as follows:

Garden tools

● The proxy beta will be the equity beta of other tools producers. This is equal

to 1.4 (given in question).

● Ungear the proxy beta to measure the asset beta

Ba = Be (E/E + D(1-t)) as debt is assumed to be risk free

Ba = 1.4 (50/50 +50(0.75) = 0.8

● Regear to reflect the method DDP’s financing.

Market value of debt = 400 + 125/100 x 1,000 = £1,650

Market value of equity = 700/0.25 x 1.62 = £4,536

Ba = Be (E/E + D(1-t))

0.8 = Be (4,536/4,536 +1,650(0.75)

Be = 1.018

● Using CAPM calculate the cost of equity

Ke = 7% +1.018(14% - 7%) = 14.126%

● Cost of debt

The cost of debt may be estimated as the internal rate of return or can be

assumed at the risk free rate as debt is assumed to be risk free.

Using internal rate of return the cost of debt can be calculated as:

Year Item Cash DF(7%) PV DF(10%) PV flow

0 current MV (125) 1 (125) 1 (125) 1-10 interest 11.25 7.024 79.02 6.145 69.13

10 redemption value 100 0.508 50.8 0.368 36.8 ______ ______

4.82 (19.07) ______ ______

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Cost of capital 7% + 4.82 x (10%-7%)

4.82 + 19.07

= 7.61%

● Calculate WACC

WACC = 14.126% (4536/6186) + 7.6% (1650/6186) = 12.385 SAY 12%

Jack production

The overall equity beta of the DDP plc is 1.3. Given garden tools equity beta of

1.018 and 60% of the value of the company, the equity beta of jack production can

be estimated at:

1.018 x 60% + equity beta of jack x 40% = 1.3

Equity beta of jack = 1,723

Cost of equity using CAPM

Ke = 7% + 1.723(14% -7%) = 19.06%

WACC = 19.06% (4536/6186) + 7.6% (1650/6186) =16.00%

(b)

The managing director’s daughter is correct that the net present value does not

consider any future options arising from investment decisions. Such options could

lead to additional net present values and could influence the decision process. The

valuation of the options from capital investments that might occur in several years’

time is however difficult, even though the Black-scholes model could be adopted for

such valuations. For most companies it is important to have an awareness of the

nature of the possible options that might exist, and to use this qualitative

information in the decision process.

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Question 2

Tutorial help and key points

Marking scheme

Marks

(a)

Forward contract

5 months forward rate 1 Net payment 1 Money market

Amount to invest 1 Converted amount in sterling 1 Total cost of borrowing 1

Futures contract Sell December contract 1 Basis 1

Lock in rate 2 Number of contracts 1 Options

December put option 1 Number of contracts (1/2 mark for each exercise price) 1.5 Premium (1/2 mark for each exercise price) 1.5

Under/over hedge 1 Overall outcome (1 mark for each exercise price) 3 Conclusion 2 _______

Max 20

(b)

Exchange rate 1 Sterling value of $4.2 million 1 Present value 1

Relevant discussion on ways to manage economic exposure 2 _______

Max 5

(a)

Report on how the five-month currency risk should be hedged.

Asters plc is a UK based company and will have no currency exposure on sterling

payments and receipts. Therefore, only the net dollar receipts and payments

should be hedged. From the information given in the question Asters plc may

hedge the net dollar exposure using forward contract, money market hedge,

futures and options.

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Forward contract

Interpolation of the three month and one year forward rates for buying dollars will

be needed to calculate the five month forward rate. This may be estimated as:

3 month rate 1.9066

1 year rate 1.8901 Difference 0.0165

Assuming the rate decline in a linear manner;

5 month forward rate = 1.9066 - (0.0165 x 2/9) = $1.9029

Forward contact will fix the £ payment at:

9029.1

000,150,1$ = £604,341

Money market hedge

With money market hedge involving payment of dollars, the company should

borrow an appropriate amount in pounds sterling today convert it immediately at

the spot rate to dollars, place it on deposit account and repay the loan plus its

interest on the due date. How much will be borrowed depends on how much is to

be invested in order to get the amount of the exposure.

Asters plc should buy dollars now and put them into a deposit account for 5 months

in order to get $1,150,000.

= $1,150,000 / (1+ (0.02 x 5/12) = $1,140,496

Convert pounds sterling into $1,140,496 at the spot rate =1,140,496/1.9156

= £595,373

This means the company has to borrow £595,373 in the UK for 5 months at an

interest rate of 5.5%. The total amount payable in sterling is:

£595,373 x (1 + (0.055 x 5/12) == £609,017

The effective lock in rate = 1,150,000 / 609,017 = $1.8883

This is more expensive than the forward contract.

Futures

● What contract: The appropriate contract will be the contract that matures

immediately after the transaction date 1st November. This is the December

contract, which matures at the end of December.

● Sell: Asters plc should sell December sterling futures.

● Basis

Spot rate 1.9156 Future price (December) 1.8986 Basis 0.017_

Assuming the basis will decline in a linear manner over the seven months, then

the expected basis in five month =

7

2017.0 × = 0.0486

Therefore the expected lock-in futures rate may be estimated by: 1·8986 +

0·00486 = 1·9035 representing a total payment of £604,150 (1,150,000/1.9035).

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This is more favourable than the forward market. However, futures contracts are

standardized and there may over or under hedge. For example, the number of

contract is:

500,62£

150,604£ = 9·67 contracts

Also currency futures require margin payments and there exist basis risk.

Options

What date contract - The appropriate contract will be the contract that matures

at the nearest date after the transaction date: this is the December contract.

Put option. Since the contract size is denominated in pounds sterling, the

company will need to sell pounds for dollars, therefore it needs to buy a put option

to get the right to sell pounds.

No of contracts

(a) (b) c=(b/a) (d) e=(c/d) Exercise $ £ Contract size Number of Contracts

Price £ 1.8800 1,150,000 611,702 31,250 19.57 = 19 - Under hedged 1.9000 1,150,000 605,263 31,250 19.37 = 19 - Under hedged

1.9200 1,150,000 598,958 31,250 19.17 = 19 - Under hedged

Premium payment

1.8800= 31,250 x 19 contracts x 2.96cent = $17,575 at spot rate of 1.9156 =

£9,175

1.9000= 31,250 x 19 contracts x 4.34cent = $25,769 at spot rate of 1.9156 =

£13,452

1.9200= 31,250 x 19 contracts x 6.55cent = $38,891 at spot rate of 1.9156 =

£20,302

Under hedge (using forward contract)

1.8800 = 1.8800 x 31,250 x19 = $1,116,250 – $1,150,000 = $37,750 at forward

rate of 1.9029 = £17,736

1.9000 = 1.9000 x 31,250 x19 = $1,128,125 – $1,150,000 = $21,875 at forward

rate of 1.9029 = £11,496

1.9200 = 1.9200 x 31,250 x 19 = $1,140,000 – $1,150,000 = $10,000 at forward

rate of 1.9029 = £5,255

Overall outcome

Basic cost = 31250 x 19 contracts = £593,750

Exercise Basic cost (£) Premium Underhedged £ at forward Total price

1·8800 593,750 9,175 17,736 620,661 1·9000 593,750 13,452 11,496 618,698

1·9200 593,750 20,302 5,255 619,307

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The option is more expensive than the other hedging methods. However, should

the dollar weaken more than the relative strike price the company could let the

option lapse in order to take advantage of the market exchange rate.

(b)

The estimated effect on market value can be calculated as:

Exchange £ value of £ difference DF (11%) PV of Rate $/£ $4·2m difference

Spot 1·9156 2,192,525 0 1 0 1 year 1·8581 2,260,374 67,849 0·901 61,132 2 1·8024 2,330,226 137,701 0·812 111,813

3 1·7483 2,402,334 209,809 0·731 153,370 4 1·6959 2,476,561 284,036 0·659 187,180 5 1·6450 2,553,191 360,666 0·593 213,875 ________

727,370 ________

The present value of future cash flows is expected to decrease as the dollar

appreciates in value. This will therefore reduce the market value of the company

by £727,370.

Economic exposure (also called operating or competitive exposure or strategic

exposure) measures the changes in the present value of the firm resulting from any

changes in the future operating cash flows of the firm caused by an unexpected

changes in exchange rates. The change in value depends on future sale volume,

price, and costs.

Economic exposure may be managed through international diversification whereby

the company can diversify production, supply of its products and finance. For

example if it had established production plants worldwide and bought its

components worldwide it is unlikely that the currencies of all its operations would

revalue at the same time, so that a loss in some may be compensated by gain from

the others. Asters plc may also manage the economic exposure through natural

hedge by borrowing funds in the USA, and use cash flows in USA to pay interest

and principal.

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Question 3

Tutorial help and key points

Marking scheme

Marks

(a)

2 marks case for, 3 marks case against 5

(b)

(i) 2 marks for current share price (ii) 2 marks current share price, 2 marks share exchange (iii) 2 marks profit for the year, 3 marks predicted share price 11

(c)

1 mark per point (maximum 4 marks) 4 ___

20

(a)

Diversification may be used to help a business reduce its overall risk. At a point

when one particular industry is thriving, another may be in difficulties. Thus, by

operating in more than one industry, it may be possible to achieve less volatility in

overall sales and profits. Furthermore, a diversified business may be in a stronger

position to survive a downturn in one of the industries in which it has invested.

Diversification, however, may not enhance shareholder value. It can be a costly

exercise as a premium often has to be paid in order to acquire another business (as

is the case in this question). The key issue is whether diversification by a business

will provide any benefits to shareholders that the shareholders themselves cannot

achieve. It may well be cheaper and simpler for a shareholder to hold a diversified

portfolio of shares than for a business to acquire another.

(b)

(i) Earnings per share (EPS) of ASOP Co

EPS = $125/50m

= $2·50

Current market value per share of ASOP Co:

= P/E ratio x EPS

= 8 x $2·50

= $20·0

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(ii) Earnings per share (EPS) of WXP Co

EPS = $240m/80m

= $3·0

Current market value = P/E ratio x EPS

= 20 x $3·0

= $60·0

Offer price = [$20·0 + (20% x $20·0)]

= $24·0

Number of shares to be issued by WXP Co for 1 share in ASOP Co

= $24·0/$60·0

= 0·4

WXP Co will offer 2 shares for every 5 shares held in ASOP Co. This means,

(50m x 2/5)

= 20m new shares must be issued.

(iii) The profit for the year following a successful takeover will be:

$m

Profit (after tax) of WXP Co 240·0 Profit (after tax) of ASOP Co 125·0 Savings after tax 40·0 _____

405·0 _____

Number of shares in issue following takeover (80m + 20m) = 100m

EPS following takeover = $405m/100m

= $4·05

Market value per share = P/E ratio x EPS

= {[20·0 – (15% x 20·0)] x $4·05}

= $68·85

(c)

For the shareholders of ASOP Co a cash offer may have the following advantages

and disadvantages:

Advantages:

Certainty: A cash payment will mean that the amount received will be certain and

clearly understood.

Transaction costs: Cash will be received from the disposal of the shares without any

transaction costs being incurred. (Although there will be transaction costs if the

shareholders decide to re-invest the amounts received in shares.)

Disadvantages

Taxation: The receipt of cash may lead to a tax on the gains from the share

disposal.

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Investment opportunity: Shareholders will have no stake in the merged company

and so will forfeit the opportunity to benefit from any future income and capital

growth.

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Question 4

Tutorial help and key points

Marking scheme

Marks

(a)

2 or 3 marks per well discussed point related to possible impact Max 6

Contents of a code of ethics 8 ___

14

(b)

For each of the two scenarios 1 or 2 marks for explaining conflict 1 or 2 marks for discussing the resolution Max 6

(a)

An ethical code that is formally written and made available both within the

organisation and publicly could have a number of internal and external benefits.

The main external benefit would be that an ethical code made available publicly

could increase the reputation of the company. Expectations that corporations

should behave as responsible businesses are increasing. Corporate social

responsibility has been framed such that a company has responsibilities that are

wider than just going for profit maximisation. A company that behaves in an

acceptable ethical manner and does so to a set of prescribed ethical standards is

likely to enhance its image and reputation. Ethical standards should be written to

address the needs of the company’s stakeholders and this in turn would be

beneficial to shareholder value in the long term.

The second significant external benefit of an ethical code would demonstrate the

company’s intention to exercise its power responsibly. This would lessen the

burden of regulation and thus give the company more flexibility in its operations.

For this to be effective, all the major companies in the industry must buy into the

idea. A company going out on its own is unlikely to prevent or mitigate the

pressure for formal regulation.

An internal benefit of an ethical code would be to provide managers with a

framework to which they should operate. It would help managers plan their

activities to take account of what the organisation expects in terms of meeting the

expectations of the various stakeholder groups. This in turn would help managers

(and other employees) match their personal code of ethics to that of the

company’s.

Related to the above, an ethical code would also provide managers and employees

with a yardstick to measure the extent to which they are following the required

corporate social responsibility. It may provide a basis for resolving conflicts of

interest between stakeholder groups and help to provide justification for resolving

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conflicts in a prescribed manner. It may also enable managers to think in

innovative ways in order to resolve conflicts of interest.

However, Ansoft Co needs to ensure that the managers and other employees do

not just pay lip service to the ethical code. In order for the ethical code to be

accepted and become pervasive within the organisation, significant amounts of

money, time and effort must be devoted to it. It is possible that an ethical code

which is not acted upon could damage the company’s reputation much more than

having no code at all.

A code of ethics could possibly contain details on the following areas:

● Dealing with shareholders, customers, suppliers, employees and other

stakeholder groups fairly.

● How conflicts of interest may be avoided and resolved.

● Maintaining confidentiality.

● How business will be conducted to protect and preserve the environment.

● How the organisation may help develop the community.

● Compliance with regulation and the law.

● Protecting the assets of a company and using them properly.

● Encouraging the reporting of illegal and unethical behaviour.

(b)

Both the issues result in conflicts of interest between different stakeholders.

The first issue results in conflict because changing to more environmentally friendly

tyres may have a negative impact on the local manufacturer of the tyres and

possibly on its employees. On the one hand, Ansoft Co would be fulfilling its ethical

code in protecting and preserving the environment. On the other hand, it may be

responsible for curtailing the business of a supplier, and the question may be asked

whether this was treating the supplier fairly. Added to that, there is a third issue of

the environmental impact of importing the tyres from North America.

The ethical code may provide guidelines to the manager on how to prioritise if the

conflict cannot be resolved. She may consider what would impact on the loss of

reputation the least. Then there is the question as to what stance an ethical

company might take. The ethical code may also encourage the manager to think of

a new alternative. For example, would it be possible to ask the local manufacturer

to produce and supply the environmentally friendly tyres? Or could both kinds of

tyres be kept in stock and this would give the customers more choice. The

manager would need to assess the extra costs and benefits involved, and engage in

discussing the issue with the local manufacturer.

With the second issue the conflict is not immediately apparent because there is

little direct evidence to suggest that the chemical is definitely harmful.

Furthermore, the company has been complying with the health and safety

regulations. However, it needs to decide whether employees should be informed of

the potential danger and also make them aware that the evidence to date is

inconclusive or, because there is little evidence so far, to not say anything.

Compliance with the ethical code, and its guidelines that employees should be

protected, may make the Ansoft Co’s directors take the view of informing the

employees concerned. They could then explore several options, for example, are

there alternative lubricants which do not contain the chemical. Or could the

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employees be provided with protective gloves and implements to administer the

lubricants without direct contact. Such action may demonstrate the company’s

desire to be seen as a caring employer and receive positive press coverage, and the

press may recommend the company as a good place to work.

(Note: other approaches to answering both parts of this question would be

acceptable.)

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Question 5

Tutorial help and key points

Marking scheme

Marks

(a)

Benefits of interest rate swap 4-5

Problems of interest rate swap 3-4 _______

Max 8

(b)

Arbitrage savings of 0.5% 2 Arbitrage savings of £25,000 1 KFP’s after tax savings 1

BBB company’s after tax savings 1 Conclusion 1 _______

Max 6

(c)

Six month interest savings of £75,000 1 Discount factor (1/2 mark for each six month factor) 3 Present value 1 Conclusion 1 _______

Max 6

(a)

Interest rate swaps have several uses including:

(i) Long-term hedging against interest rate movements as swaps may be

arranged for periods of several years.

(ii) The ability to obtain finance at a cheaper cost than would be possible by

borrowing directly in the relevant market.

(iii) The opportunity to effectively restructure a company’s capital profile without

physically redeeming debt.

(iv) Access to capital markets in which it is impossible to borrow directly, for

example because the borrower is relatively unknown in the market or has a

relatively low credit rating.

The risks faced by KFP and the bank include:

(i) Default risk by the counterparty to the swap. If the counterparty is a bank this

risk will normally be very small. A bank would face larger counterparty

default risk, especially from counterparties such as the BBB company with a

relatively low credit rating.

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(ii) Market or position risk. This is the risk that market interest rate will change

such that the company undertaking the swap would have been better off, with

hindsight, if it had not undertaken the swap.

(iii) Banks often undertake a ‘warehousing’ function in swap transactions. The

size and/or maturity of the transactions desired by each counterparty to the

bank often do not match. In such cases the bank faces gap or mismatch risk

which it will normally hedge in the futures or other markets.

(b)

Fixed rate Floating rate

KFP 6·25% LIBOR + 0·75% BBB company 7·25% LIBOR + 1·25%

______ ______________

Difference 1·00% 0·50%

There is a potential 0·50% arbitrage saving from undertaking the swap.

On a £50 million swap this is £250,000 per year.

KFP plc would require 60% of any saving, or £150,000 annually (£105,000 after

tax). The BBB company would receive £100,000 annually (£70,000 after tax).

The bank would charge each party £120,000 per year. After tax this is a cost of

£84,000 each. This would leave a net loss of £14,000 for the BBB rated

counterparty company.

The swap is not potentially beneficial to all parties, unless the savings are shared

equally.

(c)

KFP plc will pay floating rate interest as a result of the swap. If KFP plc receives

60% of the arbitrage savings, it will save 0·5% (0·60) on its interest rates relative

to borrowing directly in the floating rate market, and effectively pay LIBOR +

0·45%,or 5·70% at current interest rates. If LIBOR moves to 5·75% in six months’

time, KFP plc will then pay 6·20% floating rate interest for the remaining period of

the swap.

Interest savings in each six month periods are £50 million x 0·30% x 0·5 =

£75,000

If the money market is efficient, the relevant discount rate will be the prevailing

interest rate paid by KFP plc.

Period: Savings £ Discount factor Present value (£) 0–6 months 75,000 0·972 (5·7%) 72,900

6 months–1 year 75,000 0·942 (6·2%) 70,650 1 year–18 months 75,000 0·913 (6·2%) 68,475 18 months–2 years 75,000 0·887 (6·2%) 66,525 2 years–30 months 75,000 0·860 (6·2%) 64,500

30 months–3 years 75,000 0·835 (6·2%) 62,625 _______

Total present values 405,675

The interest rate swap is estimated to produce interest rate savings with a present

value of £405,675 relative to borrowing floating rate directly. The swap would be

beneficial, even after deducting the fee of £120,000 per year.

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With hindsight lower interest costs would have been available by borrowing at

6·25% in the fixed rate market.