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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.
2 www.studyinteract ive.org
© 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.
www.studyinteract ive.org 3
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.