THE ASSOCIATION OF BUSINESS EXECUTIVES

ADVANCED DIPLOMA
FM

Corporate Finance

afternoon 5 June 2003

1 Time allowed: 3 hours.

2 Answer any FOUR questions.

3 All questions carry 25 marks. Marks for subdivisions of questions are

shown in brackets.

4 Calculators are allowed, providing they are not programmable and cannot
store or recall information. All workings should be shown.

5 Present value and annuity tables are included with the question paper on
pages 12–13.

6 No books, dictionaries, papers or any other written materials are

allowed in this examination.

7 Candidates who break ABE regulations, or commit any malpractice, will

be disqualified from the examinations.
 Answer any FOUR questions

Q1 (a) What are the main types of long-term finance?

In your answer you will need to distinguish between

equity and debt. (6 marks)

(b) What do you understand by the term “rights issue”? (3 marks)

(c) Before a rights issue the share price of Carlisle PLC is

£16 and the company makes a 1-for-8 issue with the
offer price per share being £12.

Calculate the theoretical ex-rights issue share price if,

before the rights issue, you held 8 shares. (7 marks)

(d) An investor requires a return of 15% on his investments

and he is considering investing £200 in 12% debentures
redeemable in exactly three years’ time. Their current
price is £80. Using NPV, determine whether or not the
investor should purchase the debentures (assume
interest is paid at the end of the year and ignore
taxation). (9 marks)
(Total 25 marks)

2
Q2 (a) The following data relates to Netherfield Ltd, a
manufacturing company:

Turnover for the year: £1,200,000

Costs as a percentage of sales: %

– direct materials 25
– direct labour 20
– variable overheads 8
– fixed overheads 12
– sales and distribution 4

On average:
– debtors take 1.5 months before payment
– raw materials are in stock for 2 months
– work in progress represents 2 months’ worth of half
produced goods
– finished goods represent 2 months’ production

Credit is taken as follows:

– direct materials 2 months
– direct labour 1 week
– variable overheads 2 months
– fixed overheads 2 months
– sales and distribution 1 month

Note that work in progress and finished goods are valued

at material, labour and variable expense costs.

Calculate the working capital requirements of Netherfield

Ltd assuming that the labour force is paid for 50 weeks a
year. (20 marks)

(b) What is overtrading? (5 marks)

(Total 25 marks)

3 P.T.O.
Q3 Easy-Rent owns a chain of video rental shops. The company
has been approached by Fill-it-up PLC, which owns a large
chain of petrol stations, with a view to a takeover of
Easy-Rent. Fill-it-up is prepared to make an offer in cash or
a share-for-share exchange.

The most recent accounts of Easy-Rent are shown below:

Profit and Loss Account for the year ended 31 December 2001

£ million
Turnover 25.0)
Profit before interest and tax* 7.5)
Interest (2.5)
–––)
Profit before taxation 5.0)
Corporation tax (1.0)
–––)
Net profit after taxation 4.0)
Dividend (2.0)
–––)
Retained profit 2.0)

*includes exceptional item (loss) of £0.5m

Balance Sheet as at 31 December 2001

Fixed assets £ million £ million

Freehold land and premises at cost 12.0)
Less accumulated depreciation (1.0) 11.0)
––––)
Equipment at cost 2.0)
Less accumulated depreciation (0.8) 1.2)
––––) ––––)
12.2)

Current assets
Stock at cost 7.0)
Debtors 1.5)
––––)
8.5)

Creditors due within one year

Trade creditors (6.0)
Dividends (2.0)
Corporation tax (1.0)
––––)
(9.0)
Net Current Liabilities (0.5)
–––––)
Total assets less current liabilities 11.7)

4
Creditors due beyond one year £ million
10% Secured Loan Stock (2.5)
––––)
Net Assets 9.2)
Share capital and reserves
Ordinary shares – par value 50p 4.0)
Reserves 5.2)
––––)
Shareholders’ Funds 9.2)
The accountant for Easy-Rent has estimated the future free
cash flows of the company as follows:
2001 2002 2003 2004 2005-2010
£’m 4.4 4.6 4.9 5.0 5.4 pa
Shareholders require a return of 10 per cent after taxes.
Easy-Rent has recently had a professional valuer estimate
the current re-sale value of its assets. His estimates are as
follows:
£’m
Freehold land and premises 20.0
Equipment 0.9
Stock 6.0
The current re-sale values of the remaining assets are
considered to be in line with their book values. A company
which is listed on the Stock Exchange and which is in the
same business as Easy-Rent has a price earnings ratio of
11 times.
Assume a rate of corporation tax of 30 per cent.

Required:

(a) Calculate the value of a share in Easy-Rent using the

following methods:

(i) Net asset value

(ii) Price earnings ratio

(iii) Discounted cash flow (15 marks)

(b) What are the main problems associated with each of

these three different methods? (10 marks)
(Total 25 marks)

5 P.T.O.
Q4 Blackpool Engineering Ltd produces and sells a computer
modem. The company has been in operation for four years
and has an issued share capital of £200,000 (par value 25p
per share). To date, the company has produced only one
product. In the year ended 31 December 2000 it sold 20,000
units.

The profit and loss account for the year to 31 December 2000
is as follows:
£000 £000
Sales 1,900)
Less:
Variable expenses (700)
Fixed expenses (400) (1,100)
Earnings before interest
and taxation 800)
Less interest payable on
100% debentures (200)
––––)
Earnings before taxation 600)
Less corporation tax (198)
––––)
Profit after taxation 402)
Dividend (160)
––––)
Retained profit for the year 242)

Recently, Blackpool has been experiencing labour problems

and, as a result, has decided to introduce a new highly
automated production process in order to improve efficiency.
The new production process is estimated to increase fixed
costs by £150,000 (including depreciation) but will reduce
variable costs by £15 per unit.

The new production process will be financed by the issue of

£1,000,000 debentures at an interest rate of 12%. If the new
production process is introduced immediately, the directors
believe that sales for the forthcoming year will not change.
Stocks will remain at the current level throughout the
coming year.

Blackpool’s shares currently sell at a P:E ratio of 13:1 and

the current corporation tax rate is 35%.

6
Required:

(a) Explain the terms “operating gearing” and “financiaI

gearing”. (5 marks)

(b) Calculate the change in earnings per share and the

change in share price if the company introduced the new
production process immediately. Explain any
assumptions which you make. (12 marks)

(c) Analyse the implications for the share price if Blackpool

makes a rights issue at an issue price of £2.50 per share
(ignore issue costs). (8 marks)
(Total 25 marks)

7 P.T.O.
Q5 The sales of London PLC for 2002 were £300,000. Sales for
2003 are expected to rise by 25%. You are to advise on the
additional financing required to support the higher level of
sales. The summary balance sheet of the company as at
31 December 2002 is as follows:

£ £
Fixed assets (net) 120,000

Current assets
Stock 42,000
Debtors 38,000
Cash 12,000
–––––––
92,000
Current liabilities
Creditors (22,000)
–––––––
Working capital 70,000
––––––––
190,000
Debentures (40,000)
––––––––
Net assets 150,000
––––––––
Financed by:
Ordinary shares 100,000
Retained earnings 50,000
––––––––
150,000
––––––––

Assume that except for fixed assets, debentures, retained

earnings and ordinary shares, the balance sheet items vary
directly with sales, and because of the rapid growth the
company will need to spend around £50,000 on new capital
investment and on replacement capital expenditure during
2003.

Earnings in 2002, before interest and tax, were 20% of sales,

and this was after deducting depreciation of £12,000. The
depreciation charge for 2003 is expected to remain the same.
The interest rate on the debentures is 10%. The corporation
tax rate is 40% and the company distributes as dividends
30% of available earnings.

8
Required:

(a) Determine the increased net working capital required to

meet the higher sales level during 2003. (5 marks)

(b) Determine the company’s total additional financial

requirements for 2003. (3 marks)

(c) Estimate how much new external finance London PLC is

likely to require during 2003. (10 marks)

(d) What are the common symptoms of over-trading? (7 marks)

(Total 25 marks)

9 P.T.O.
Q6 (a) What do you understand by the term “hedging” in
relation to managing exposure to risk? (4 marks)

(b) What is a “short hedge” and a “long hedge”? (6 marks)

(c) Penrith Co is a purchaser of oil and is due to take

delivery of 5,000,000 litres in January. In order to hedge
against the possibility of oil prices increasing over the
period up to January, the company takes a long position
in a March futures contract. At the time, the price of
March futures contracts is $14.50 per 1,000 litres, with
each contract being for delivery of 1,000,000 litres. In
January the contract is closed out, with both the spot
price of oil and the March futures being $14.75 per
1,000 litres.

Calculate the transactions involved. How effective is this

strategy in hedging the risk? Give reasons for your
answer. (10 marks)

(d) What are the costs of hedging? (5 marks)

(Total 25 marks)

10
 Present Value Table

Present value of 1 i.e. (1 + r )–n

where r = discount rate
where n = number of periods until payment

Discount Rates (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2
3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3
4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4
5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6
7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7
8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8
9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9
10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11
12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12
13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13
14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14
15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2
3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3
4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4
5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6
7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7
8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8
9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9
10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11
12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12
13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13
14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14
15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15

12
 Annuity Table

1 – (1 + r )–n
Present value of an annuity of 1 i.e. ––––––––––
r
where r = interest rate
where n = years

Interest Rates (r)

Years
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606 15

11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·748 3·685 3·589 3·498 3·410 3·326 6
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

13
 Advanced Diploma

Corporate Finance

Examiner’s Suggested Answers

Question 1

(a) For most firms the choice of different types of capital comes down to debt
versus equity, although there are many different forms of each. The follow-
ing are the main types of long-term capital available:

Equity retentions/cash flow (internal equity)

rights issues (external equity)

Debt non-market debt bank overdrafts

term loans
market debt debentures (secured loan stock)
unsecured loan stock
convertibles etc

(b) A rights issue is an issue of new shares offered initially to existing share-
holders on a pro rata basis, based on their existing shareholdings, e.g. a 1-
for-4 issue in which the company offers the right to buy one share for every
four already held. They are always offered at a discount, partly to make
them more attractive, but mainly to insure against a fall in share value
during the offer period.

(c) The discount has the effect of diluting the earnings of each existing share.

Before issue
Share price £16.00
Makes 1-for-8 offer
Offer price £12.00
Shareholder has 8 shares plus cash
Value is (8 × £16) + £12 = £140.00

After issue
Earnings diluted by additional share but company holds cash
Shareholder has 9 shares valued at £140.00/9
i.e. £15.56 = theoretical ex-rights price.
(d) First calculate the amount of stock he can purchase:

£(200 * 100/80) = £250

The yield will be (£250 * 12%) = £30 per year

To calculate the return, assume interest is paid at the end of the year
and personal taxation is ignored.

Cash Flow Discount Factor Present Value

Year £ 15% £
0 purchase 200 1.00 (200)
1 interest 30 0.87 26.10
2 interest 30 0.76 22.80
3 interest 30 0.66 19.80
3 redemption 250 0.66 165
Net Present Value +33.70

As the net present value is positive, the investor will achieve more than the
required rate of return of 15%.

Question 2

(a) Netherfield Ltd answer

1. The annual costs incurred will be as follows:

£
– direct materials 25% of £l,200,000 300,000
– direct labour 20% of £1,200,000 240,000
– variable overheads 8% of £1,200,000 96,000
– fixed overheads 12% of £1,200,000 144,000
– sales and distribution 4% of £1,200,000 48,000

2. The average value of current assets will be as follows:

£
– raw materials 2/12 * £300,000 50,000
– w-in-p
– materials (50% complete)
1/12 * £300,000 25,000
– labour 1/12 * £240,000 20,000
– variable overheads 1/12 * £96,000 8,000
– finished goods
– materials 25,000
– labour 20,000
– variable overheads 8,000
– debtors 1.5/12 * £1,200,000 150,000
306,000
3. Average value of current liabilities will be as follows:
£
– materials 2/12 * £300,000 50,000
– labour 1/50 * £240,000 4,800
– variable overheads 2/12 * £96,000 16,000
– fixed overheads 2/12 * £144,000 24,000
– sales and distribution 1/12 * £48,000 4,000
98,800

Working capital requirement is therefore:

£
306,000
less (98,800)
i.e. 207,200

(b) Overtrading is a common problem for growing companies and occurs when
a business overextends itself by having insufficient capital to match
increases in turnover. Increasing turnover will result in higher stock and
debtor levels, which will need to be funded. Another cause of overtrading is
the repayment of a loan when the business has insufficient cash to fund it.
Whilst there will be some corresponding growth in creditors, sustaining
growth on trade credit alone is unlikely to be successful in the longer term.

Question 3

Solution to Easy-Rent (numerical section)

(a) (i) Simple net asset value = £9.2 m

Adjusted net assets £’m

Freehold land etc 20.0)
Equipment 0.9)
Stock 6.0)
Debtors 1.5)
–––––
28.4)
Less current liabilities (9.0)
–––––
19.4)
Less loan stock (2.5)
–––––
16.9)
–––––
= Value of equity
No of shares – £4m * 2 = 8m
£16.9m
Value per share = ––––––
8m

= £2.11
 (ii) P/E basis
Adjusted Profits £’m
Profit before tax 7.5)
Plus exceptional item 0.5)
––––––
Profit before tax and interest 8.0)
Interest (2.5)
––––––
Taxable profit 5.5)
Tax @ 30% (1.65)
––––––
Profit after tax 3.85m = maintainable profits
––––––

Value of equity = £3.85m * 11 = £42.35m

£42.35m
Value per share = ––––––––– = £5.30
8m

(iii)

Free (£’m) cash Discount Factor

Year flow 10% P.V. (£’m)
2001 4.4 0.909 4.0
2002 4.6 0.826 3.8
2003 4.9 0.751 3.7
2004 5.0 0.683 3.4
2005–2010 5.4 2.978* 16.1
NPV 31.0

*Annuity value for years 2005 – 2010

Value of equity = £31.0m

Value per share = £31.0m/8m = £3.88

(b) Net asset value

– Based on taking at face value the figures presented in the accounts
– Fixed assets usually based on historic costless depreciation
– Values of stock may not be reliable
– Some accounts may be uncollectable
– Some liabilities are “off balance sheet”

Price Earnings Ratio

– Earnings can be distorted by different accounting policies
– The current earnings may be untypically high or low
– It is difficult in reality to find close substitutes
– You may not be comparing like with like e.g. a large company to a small
company

Discounted Cash Flow

– Can the future investment be accurately predicted?
– How can we measure the discount rate?
– Over what time period should we assess value?
Question 4

(a) Operating gearing may be defined as a measure of the impact of a change

in sales upon earnings before interest and tax (EBIT).

Financial gearing is measured by comparing a company’s use of long-term

finance relative to equity.

(b) Before the project

PAT 402 402
EPS = –––––––––––– = –––––– = ––– = 50.3 p
No of shares 200*4 800

After the project £’000

Sales 1,900)
VC (400) [(700/20 – 15) × 20,000]
FC (550) [400 + 150]
––––––)
EBIT 950)
Interest (320) [200 + 12% * £lm]
––––––)
Taxable profit 630)
Tax @ 35% (220)
––––––)
PAT 410)

EPS = 410/800 = 51.3p

1. As this is only a small change in expected EPS, the project might have
to be evaluated on other criteria.

2. The solution assumes no repayment of existing debt levels.

3. Assuming no change in P : E ratio, share price will rise

from (13 × 50.3) = £6.54
to (13 × 51.3) = £6.67

(c) Required funding = £1m

The rights price (deeply-discounted) = £2.50
Ignoring issue costs, need to sell

£1m
–––––– = 400,000 new shares
£2.50

Hence a “one-for-two” rights issue is required

New number of shares = (800,000 + 400,000) = 1.2m
 Theoretical ex-rights share price:

Before After 1-for-2 rights

2 shares @ £7.55 = £15.10

0£2.50 £17.60
Cash ––––––– ––––––– = £5.87
£17.60 3

On a forward-looking basis (including the benefits of the project):

Increase in PAT = £8,000 i.e.: 8/1200 = 0.7p per share

Valuing this at a P : E ratio of 15, share price could increase by
(15 × 0.7) = 10p
Ex rights price (cum project) £5.87 + 0.10 = £5.97

Question 5

(a) Current net working capital needs (2002) is:

(stock + debtors + cash) – creditors

= (£42,000 + £38,000 + £12,000) – £22,000

= £70,000

2003 allow for a 25% increase = £87,500

(b) Capital expenditure + additional working capital

= £50,000 + £17,500 = £67,500

(c) Additional external financing

= additional financing – cash flow

Assume: no accruals or prepayments

no tax delay
no change in dividend policy

Then cash flow = retained profits + depreciation

 Forecast P/L £’000
Sales (300 + 25%) 375)
COGS (80% of sales) (300)
–––––––––
Operating profit 75)
Less: interest (10% × £40,000) (4)
Taxable profit 71)
Corporation Tax (40%) (28.4)
–––––––––
PAT 42.6)
Dividend (20%) (12.78)
–––––––––
Retained profit £29.82)

Cash flow = £29,820 + £12,000 = £41,820

Needed for a 25% increase in sales is £67,500 less £41,820

= shortfall of £25,680

(d) • rapid sales growth

• static long-term finance
• sharp increase in trade creditors
• shortfall in cash balances/increase in overdraft
• sharp increase in gearing
• sharp change in stocks (either up/down)
• sharp fall in profit margins
• sharp increase in fixed assets to turnover ratio
• sharp increase in debtors/debtor days
Question 6

(a) Hedging a risk involves taking action now to reduce the possibility of a
future loss, usually at the cost of foregoing any possibility of a gain. It is
not possible to reduce the risk entirely but hedging does help to reduce the
risk involved.

(b) When a firm holds cash or securities, it will want to maintain their current
value. It is, though, exposed to the risk that its value will decrease due to
adverse movements in prices or interest or exchange rates. It will, therefore,
sell a derivative of equivalent value at a fixed price today (known as taking
a short position on the derivative). This position is known as a short hedge.

Conversely, a firm expecting an inflow of cash or securities at some time in

the future (for example, through payments due to the purchase of a fixed
asset) will take out a long hedge to protect the value of those future cash
flows or the asset.

(c) The transactions involved are:

buying five March futures contracts (the long position in March futures)
each at a price of $14.50 * 1,000 (1,000,000 litres per contract)

selling five March futures contracts in January (to close out the original
contracts) each at a price of $14.75 * 1,000 and

buying the 5,000,000 litres of oil on the spot market at $14.75 per 1,000
litres

The total gain on closing out the futures contracts is:

(14.75 – 14.50) * 1,000 * 5 = $1,250

The outlay for the 5,000,000 litres on the spot market is:

5,000 * $14.75 = $73,750

The net cost to Penrith Co is:

$73,750 – $1,250 = $72,500

This equates to a cost of $14.50 per 1,000 litres

The gain from closing out the futures contract offsets some or all of the
likely increase in the price of oil on the spot market over the period. The
extent of this offset depends on the spot price of oil at the time that the
futures contract was taken out. If the price of oil had fallen over the period,
there would have been a loss on closing out, but this again would have
been offset by the lower spot price paid on delivery.
(d) On the face of it, the cost of hedging essentially comprises the premiums
paid out on the derivatives transactions to the facilitating banks and or
exchanges. There is always a risk associated with trading in derivatives,
some of which are very complex, particularly if the controls are not effec-
tive. Thus any losses incurred on the derivatives transactions not offset by
gains in the underlying cash transaction must be counted as costs.

In addition to these direct costs, there is a further significant cost in the

overheads involved in the hedging operation. These are tied up with the
overheads of treasury management as a whole and include not only the
operations in respect of external hedging activities but also the operations
in respect of the application of internal hedging techniques.