December 2019 Summary points BY TAHA POPATIA

Question # 1 – Adjusted present value and duration

(A) Why a company may prefer adjusted present value rather than the net present value method

 APV separate out a project’s cash flows and allocates a specific discount rate to each type of
cash flow, dependent on the risk attributable to that particular type of cash flow. NPV discounts
all cash flows by the average discount rate attributable to the average risk of a project.
 Using APV, company is able to determine how much value is being created by the investment
and how much by the debt financing.

(B) Report to the board of directors (BoD), Okan Co.

Introduction

Evaluation

Financing

Project return and risk

Justification

Report compiled by:

Date

Appendices

(C) Economic risk and its management

 Companies face economic exposure when their competitive position is affected due to
macroeconomic factors such as changes in currency rates, political stability, or changes in the
regulatory environment.
 In the case of Okan Co’s subsidiary company, economic risk may have occurred because interest
rates have been kept at a high level, causing the original parity conditions to break down.
 Tactics such as borrowing in international or Eurocurrency markets, sourcing input products
from overseas suppliers and ultimately shifting production facilities overseas can help manage
exposure to economic risk

(D) How each category of risk may be managed.

 Severe and frequent: immediate action needed. Avoiding certain actions or abandoning certain
projects, even if they could be profitable in the long term.

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 Not severe but frequent: Action needs to be taken so that such risks do not become severe in
future. Putting systems in place to detect these risks early and plans to deal with them if they do
occur.
 Severe but not frequent: Insure against these risks. Contingency plans could also be put in place
to mitigate the severity.
 Neither severe nor frequent: Monitored and kept under review. Monitoring such risks will
ensure that should they move out of this category into the more severe/frequent categories, the
company can start to take appropriate action.

Question # 2 – Dividend capacity and dividend policy

(A) Computational

(B) Computational and comments from analysis

(C) Theoretical answer based on scenario given

Question # 3 – Mergers and Acquisitions

(A) Possible sources of financial synergies and comment on the finance director’s concern that
synergy is often overestimated, including any steps which could be taken by Kerrin Co’ s board to
address this problem

 Possible sources of financial synergy:

o Target facing funding constraint whereas acquirer has significant cash reserves.
o Reduction in volatility of earnings, assuming cash flows of both companies are less than
perfectly correlated. This increases debt capacity.
o One company is able to utilise others unrelieved tax losses.
o Target is a privately owned company and the shareholders are therefore exposed to
diversifiable unsystematic risk. Therefore the acquisition may lead to potential
diversification and risk reduction benefits, leading to reduction in cost of capital and
increase in the value of the combined company.
 Overestimation of synergy value:
o Competition for targets increases acquisition premium.
o Deal advisers such as investment banks earn a large proportion of their fees from
mergers and acquisitions, their advice on whether an acquisition makes sense is
potentially biased if they do not look after their client’s interests.
o Management overconfidence in valuation and reluctance to admit mistakes when the
fact change, even when there is still time to back out of the deal.
o Difficulties in integrating companies due to different work cultures.
 Steps to address this problem:

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o Allocate responsibility to someone to ensure spare cash is utilised to invest in new
growth opportunities, that tax losses are offset and that the combined company avails
itself of cheaper financing.
o Effective due diligence ensures the financial documents which form basis of a valuation
are scrutinised and inspected.

(B) Computational

(C) Cash or share-for-share offer

 Cash offer:
o Provides target company shareholders with a certain and immediate return.
o However the premium is lower for target company shareholders as compared to share
for share offer.
o No dilution of control for existing shareholders of acquirer.
o Cash outflow for the acquirer.
 Share for share:
o Dilution of control for existing shareholders.
o Target company shareholders get the right to participate in the future growth of larger
company.

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