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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.