Mock Exam September 2020 answer - AFM BY TAHA POPATIA

Answer # 1a

Organic growth

Advantages

 No integration issues
 Preserves organisations culture
 More control

Disadvantages

 Slow
 No new ideas
 Doesn’t kill competition

Growth by acquisition

Advantages

 Quick
 May remove actual or potential competitor
 Kills competition

Disadvantages

 Integration problems
 Incomplete information about the target may lead to payment of high consideration
 Too much managerial focus on acquisitions can be detrimental to internal development

Answer # 1b

Since Jupiter has pursued an aggressive policy of acquisitions, it needs to determine whether or not this
has been too aggressive and detailed assessments have been undertaken. Jupiter should ensure that
the valuation is based on reasonable input figures and that proper due diligence of the perceived
benefits is undertaken prior to the offer being made. Often it is difficult to get an accurate picture of the
target when looking at it from the outside. Jupiter needs to ensure that it has sufficient data and
information to enable a thorough and sufficient analysis to be undertaken.

The sources of the synergy need to be properly assessed to ensure that they are achievable and what
actions Jupiter needs to undertake to ensure their achievement.

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 Mock Exam September 2020 answer - AFM BY TAHA POPATIA
The Board of Directors of Jupiter needs to ensure that there are good reasons to undertake the
acquisition, and that the acquisition should result in an increase in value for the shareholders. The non-
executive directors should play a crucial role in ensuring that acquisitions are made to enhance the
value of the shareholders.

Procedures need to be established to ensure that the acquisition is not overpaid. Jupiter should
determine the maximum premium it is willing to pay and not go beyond that figure. Research indicates
that often too much is paid to acquire a company and the resultant synergy benefits are not sufficient
to cover the premium paid. Often this is the result of the management of the acquiring company
wanting to complete the deal at any cost, because not completing the deal may be perceived as
damaging to both their own, and their company’s, reputation.

Jupiter company needs to ensure that it has proper procedures in place to integrate the staff and
systems of the target company effectively, and also to recognise that such integration takes time.

Answer # 1c

Report to the Board of Directors, Jupiter Co.

This report evaluates whether or not it is beneficial for Jupiter Co. to acquire Mars Company. Initially
the value of Mars Company is calculated using the free cash flows model. Following this, the report
considers the assumptions made to arrive at the valuation. The report also discusses the view point of
finance director and chief financial officer. The report concludes by considering whether the acquisition
will be beneficial to Jupiter Company or not.

Estimate of the market value of Mars Company

The market value of Mars co. has been calculated using the free cash flows model. The model used
discounts the future free cash flows of the target company using an appropriate discount rate to arrive
at the market value.

Appendix 1 shows that the market value of Mars Company using the free cash flows model is $ 1,077
million. Hence if Jupiter Company wishes to acquire Mars Company they must at maximum pay the
stated amount as per free cash flows model.

Assumptions

It is assumed that all the figures relating to growth rates, discount factor, synergy benefits such as
reduction of administrative and selling expenses are accurate. There is considerable uncertainty
surrounding the accuracy of these and a small change in them could change the forecasts quite
considerably. Sensitivity analysis can be performed to aid in decision making.

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 Mock Exam September 2020 answer - AFM BY TAHA POPATIA
The basis of using a discount rate of 8% is not clear and an explanation is not provided about whether or
not this is an accurate or reasonable figure. The underpinning basis for how it is determined may need
further investigation.

Finance Director and Chief Financial Officers point of view

Both the finance director and chief financial officer have a different point of view over how to deal with
the Mars Company after a few years. Finance directors view point can be supported by the fact that
mars company may have developed new technologies and hence it will be better to keep it integrated.
The CFO is of the view that after enhancing the performance it may be sold at a premium, believing that
the company outlook will be performed after sometime.

Since the exact decision that needs to be taken is after some years it is better to wait and watch which
option will be better and it is really early to stick with one decision.

Recommendations

As per the workings, it can be concluded that Jupiter Company must acquire Mars Company provided
that the acquiring price is not more than $ 1,077 million which has been computed using the free cash
flows model. However it is recommended to use various other valuation techniques as well to get a
better idea of the valuation.

Report compiled by:

Date:

Appendices

Answer # 2 b

Manager A advocates the use of Net Present Value which is used widely by many companies worldwide.
A positive Net Present Value should lead to increase in the company’s value. However, the use of the
weighted average cost of capital (WACC) in NPV is only appropriate if there is no significant change in
the gearing as a result of the investment, the investment in marginal in size, and the operating risk of
the company does not change. One of the drawbacks of the Net Present Value approach is that it does
not highlight the financing side effects of a project separately. For example, if a project is financed using
a large chunk of debt the company may get tax advantage in terms of tax savings as interest is a tax
allowable expense.

The adjusted present value model, advocated by manager B, treats the investment as being initially all
equity financed and then directly adjusts for the present value of any cash flow effects associated with
financing. Whenever gearing is expected to change as a result of the investment, APV might be better

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 Mock Exam September 2020 answer - AFM BY TAHA POPATIA
suited to the evaluation of the investment. However it is not always easy to identify all of the relevant
financing side effects for the purpose.

Both NPV and APV do not consider the potential value of real options (e.g. the abandonment option and
the option to undertake further investments) that might exist as a result of undertaking the initial
investment.

Answer # 3 a

Forward market hedge

The forward market hedge locks into a known exchange rate at the time the payment by the customer
is made. It is a legally binding obligation.

A forward rate is required for four months’ time. This may be estimated by interpolating between the
three month and one year forward rates.

1.5362 – 1.5140 = 0.0222 x 1/9 = 0.0025

The four month rate is 1.5362 – 0.0025 = 1.5337

1.5398 – 1.5178 = 0.220 x 1/9 = 0.0024

The four month rate is 1.5398 – 0.0024 = 1.5374

60% of the receipts will be in $US, i.e. the equivalent to 405m pesos(675x60%).

At the official rate 405/98.20 = $ 4,124,236

Trading in forward, $ 4,124,236 / 1.5374 = Pounds 2,682,605

The balance of 270m pesos will be converted at 115% of the official rate

270/179.745 = Pound 1,502,128

Total expected receipts are = Pound 4,184,733

Future hedge

A future hedge locks the transaction into an expected exchange rate. In this case December futures will
need to be bought as the September contract will have expired by the date of the payment, 1
November.

Basis on the December contract is 1.5510-1.5275 = 0.0235. The expected basis on 1 November is 2/6
(the remaining period of the future contract) x 0.0235 = 0.0078. The expected lock-in futures price, no
matter what happens to actual spot rates, is 1.5275 + 0.0078 = $ 1.5353.

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 Mock Exam September 2020 answer - AFM BY TAHA POPATIA
This is slightly better than the forward market rate.

However, basis on 1 November when the futures contract would be closed out might not be 0.0078,
due to the existence of basis risk. A better or worse outcome than the expected lock-in rate is possible.
The hedge is for $ 4,124,236.

4,124,236/1.5353 = Pounds 2,686,274 or 42.98 contracts.

43 contracts would be needed, a slight over hedge.

Future contracts also require the payment of margin, a security deposit. Profit on futures contracts
through favourable currency movement may be taken daily, but any losses will result in daily variation
margin calls in order to keep the hedge open.

Currency options hedge

Currency options offer an advantage over both forwards and futures in that they not only protect
against downside risk, they also allow the buyer of the option to take advantage of favourable currency
movements by allowing the option to lapse. The price of this extra benefit is the option premium.

As Earth wishes to exchange dollars for pounds, it will need to purchase December call options.

Strike price: $1.5250

$ Receipts: 4,124,236

Pound equivalent: 2,704,417

Number of contracts: 86.54 ----- 86 or 87 contracts

86 contracts is $4,098,438 at 1.5250, leaving $ 25,798 which could be exchanged at forward rate of
$1.5374/pound yielding Pound 16,780.

Receipts in pounds: 4,098,438/1.5250 = 2,687,500 pounds

Premium in pounds (spot rate): (2,687,500 x 3.35/100)/1.5475 = Pounds 58,179

Net outcome: 2,687,500 + 16,780 – 58,179 = Pound 2,646,101

The outcome is much worse than the forward or future hedges, but if the dollar was to strengthen
further, the options could be lapsed and the pounds purchased in November in the spot market.

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 Mock Exam September 2020 answer - AFM BY TAHA POPATIA
Answer # 3b

World Trade Organisation

The World Organisation (WTO) is the global international organisation dealing with the rules of trade
between nations.

Its main aim is to reduce the barriers to international trade by seeking to prevent protectionist
measures such as tariffs, quotas and other import restrictions.

It also acts as a forum for negotiation and offering settlement processes to resolve disputes between
countries.

It promotes the view that reducing barriers to world trade will promote economic growth and
prosperity.

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