AFM -Strategic Issues in Financial

Planning at Multinationals
Contents
AREAS ADDRESSED BY FINANCIAL STRATEGIES WHICH RESULT FROM ORGANISATION’S
INTERNATIONAL ACTIVITIES: .................................................................................................. 3
Ethical and governance issues ............................................................................................... 6
Agency problems and corporate governance .................................................................... 6
AGENCY PROBLEM .............................................................................................................. 6
EXAMPLES OF CONFLICTING INTERESTS ............................................................................ 7
MANAGING CONFLICTS ...................................................................................................... 7
SETTING UP A CORPORATE GOVERNANCE FRAMEWORK.................................................. 8
CONCLUSION ...................................................................................................................... 8
Management Appraisal and Integrated Reporting ................................................................ 9
MANAGEMENT APPRAISAL: ............................................................................................... 9
The Ethical Dimension of Financial Management ............................................................ 12
ETHICS AND FINANCIAL MANAGEMENT: ......................................................................... 12
Environmental Impact of Financial Management ................................................................ 15
SUSTAINABLE DEVELOPMENT: ......................................................................................... 15
Revision ................................................................................................................................ 17
Milma (Valuation, Debt value and Ethical issues) ............................................................ 17
International Trade and Finance .......................................................................................... 21
Free Trade Theory and Practice........................................................................................ 21
THEORY OF INTERNATIONAL TRADE: ............................................................................... 21
Trade Agreements and Organisations .............................................................................. 25
INTERNATIONAL TRADE AGREEMENTS: ........................................................................... 25
INTERNATIONAL ORGANISATIONS PRESENTING FINANCING TO TROUBLED ECONOMIES:
.......................................................................................................................................... 26
Financial Markets in International Trade ............................................................................. 30
HISTORY OF THE INTERNATIONAL FINANCIAL MARKET:.................................................. 30
FINANCIAL CRISIS: ............................................................................................................. 30

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 ISSUES CONNECTED WITH THE FREE MOVEMENT OF CAPITAL: ...................................... 33
Dividends in Multinational Companies and Transfer Pricing ............................................... 35
The Dividend Policy of a Multinational Company ............................................................ 35
DIVIDENDS & INTERNATIONAL ACTIVITIES: ..................................................................... 35
MULTINATIONALS ADDRESSING DIVIDEND CAPACITY: .................................................... 35
Calculation of dividend capacity:...................................................................................... 36
REINVESTMENT STRATEGIES FOR MULTINATIONALS: ..................................................... 37
Impact of Capital Reconstruction Programmes: .............................................................. 38
Dividends in Multinational Companies and Transfer Pricing ............................................... 39
TRANSFER PRICING: .......................................................................................................... 39
General rules: ................................................................................................................... 39
Application: ....................................................................................................................... 40
Ethical considerations:...................................................................................................... 42
March/June 2018 – Sample Questions ................................................................................ 43

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AREAS ADDRESSED BY FINANCIAL STRATEGIES WHICH
RESULT FROM ORGANISATION’S INTERNATIONAL
ACTIVITIES:
1. Compliance with national governance regulations:

When a company decides to do business in a different country, it should take into account
the necessity to conform to that country’s local regulations, which may potentially be
different from the ones prevailing in its home market.

The specifics of local regulation may impact a foreign company entering the local market in
many ways. Examples of regulatory measures, which usually differ among countries, are the
admission criteria, which a company has to meet in order to be listed on the local stock
exchange, laws governing situations in which dividends may be paid out and remitted to
head office, tax regimes and other. In any case, it is essential that a company understands
the impact and implications of local regulation on its functioning in an overseas market.

The increase in the mobility of capital observed globally may help a company avoid certain
negative consequences of national restrictions, for example, thanks to the possibility of
obtaining financing and paying dividends in the most favourable locations in terms of
regulatory environment. It should be mentioned, however, that switching activities among
countries may additionally expose a company to foreign exchange risk.

2. Managing risks specific:

Aside from regulation, there are also other risk factors linked to a company’s presence in a
foreign market, the

so-called local risks.

Political risk:

Probably the most important of these, and also the most difficult to manage, is political risk,
defined as the risk

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of incurring losses arising from actions taken by the government of a host country, or its
people. The political risk may actually materialise in many ways:

– One of the most drastic cases of political risk is the risk of business confiscation,
which is the risk of the parent entity losing control over its assets in a foreign
country. Such confiscation may be caused by several factors, including a change of
government, revolution or military intervention. It is thus crucial that a company
carefully examine the political stability of a country considered as a target for
expansion, including its recent history as well its relationship with neighbouring
states.

– Another type of political risk is the so-called commercial political risk, which occurs
when a political change in the host country significantly impacts its economic and
business environment. An example of such event is the implementation of subsidies
to local producers, lowering the competitive position of foreign companies and in
severe cases, forcing multinationals to abandon their foreign operations.

– The political risk may also encompass financial restrictions imposed by the local
government on foreign businesses. These may, for example, be restrictions on the
remittance of dividends and the repatriation of capital, limitations on access to local
borrowing markets or penal taxation imposed on transactions with other group
members.

– Finally, political risk may also appear in the form of exchange controls, for example,
restrictions related to transfers in foreign currencies or a ban on foreign currency
intra-group lending.

Managing political risk:

As we have already indicated, political risks are difficult to manage, as their sources may
appear suddenly and are often difficult to predict. Potential ways of minimising the impact
of political risk include careful observation of the political situation in a host country and
being prepared for potential changes. Certain risks associated with limitations on the
remittance of funds and exchange controls may to some extent be minimised through
transfer pricing and we will be expanding on this point in further modules of the course.

3. Addressing agency issues in a multinational capital group:

Other implications of setting up foreign operations, with the potential to adversely impact a
multinational company’s performance result from agency issues. In the context of
international business, agency problems arise when local management promote their own
interest, placing it above the interest of the organisation.

Factors which increase the likelihood of agency issues are:

 Cultural differences,

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  Language barriers,

 Different time zones, in which the subsidiaries and head office operate.

Managing agency problem:

A potential solution to agency issues is stringent control over the management of

subsidiaries or the appointment of expatriates as top management. This solution, however,
may negatively impact the motivation of the local team, which, thanks to its knowledge of
the local business environment, may potentially be more effective in directing certain tasks.
Managing agency issues in a multinational company is therefore about balancing between
central control and local autonomy. Aligning the goals of a subsidiary with the strategy of
the parent organisation requires the implementation of suitable corporate governance
policies and procedures, application of appropriate management compensation packages,
as well as promoting a sound code of conduct.

NOTE: As you can see, the formulation of a business and financial strategy in a multinational
organisation requires taking into consideration specific factors and risks, associated with the
political and cultural circumstances of the host country.

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Ethical and governance issues
Agency problems and corporate governance

AGENCY PROBLEM

As you know, the main goal of any business organisation is the maximisation of shareholder
value. However, shareholders represent just one group of a company’s stakeholders.

Other groups include:

 The company’s creditors;

 Customers;
 Employees and local communities.

Their interests should also be taken into account in the company’s decision-making
processes. In many cases, the objectives of different stakeholder groups may be
contradictory and this may result in conflicts, which have to be resolved by the company’s
management.

A shareholder conflict is a conflict between the owners of the company and its
management. Typically, shareholders do not participate in the day-to-day management of
the companies which they own, as this responsibility is handed over to professional
managers, who should act in the best interests of shareholders and other important
stakeholder groups. However, as practice indicates, in certain situations, managers tend to
act in their own best interest with the goal of maximising their own wealth instead.

Agency problems exist not only in commercial organisations but also in non-profit
institutions (e.g., foundations and healthcare service providers). Although it may be
expected that the morale of managers and employees in such organisations is higher than
that found in strictly commercial entities, psychological research shows that acting in one’s
own self-interest is an immanent feature of human nature.

Remember: The agency conflict can never be entirely resolved or eliminated.

Measures which can be put in place in order to reduce its impact include:

 Performance-based compensation of managers;

 Increased shareholder participation and influence when it comes to making
strategically important decisions.

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EXAMPLES OF CONFLICTING INTERESTS

Example 1:

A conflict that arises between shareholders and providers of debt financing.

 Shareholders expect higher returns than debt holders, and may, therefore, apply
pressure on management to undertake more risky projects.

 Debt holders, on the other hand, prefer projects generating lower risk because the
return on debt financing is typically fixed or at least, not dependent on the ongoing
performance of the business.

This conflict generates increased agency costs to the company, such as those associated
with loan covenants, which may restrict further borrowing, the payment of dividends or
asset acquisitions and disposals.

Example 2:

A conflict between employees and shareholders. Employees may oppose the automation of
certain manufacturing processes for fear of losing their jobs. The costs of such opposition
may take the form of strike action initiated by employees, but also a loss of savings which
the shareholders had planned to achieve from the automation.

Example 3:

Conflicts between stakeholder groups, which are not directly associated with the firm. An
example of such conflict arises when customers apply pressure on the company to reduce
prices. The company may react by squeezing its local suppliers thus exposing itself to
negative publicity and unfavourable perception from local communities.

MANAGING CONFLICTS

Stakeholder conflicts are difficult to manage because the interests of certain groups are
often completely contradictory. A common measure involves establishing a set of rules
which define the hierarchy of decision-making, referred to as corporate governance.

Corporate governance is the way, in which a business organisation is directed and

controlled. Its primary goal is to protect the interests of stakeholders and to ensure that the
company as a whole acts in accordance with its values and ethical norms.

The basic idea is to balance the interests of a company's stakeholders by providing a

decision-making framework, which allows for the realisation of the company’s business
objectives.

Within the corporate governance framework, decision-making authority is distributed

among the management and stakeholders. In particular, certain types of decisions may be

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taken by individual executives or the full board of directors, while others require the
consent of the general meeting of shareholders. Certain decisions may be handed over to
dedicated committees within the company. In some companies, the rules of corporate
governance also require that certain key decisions are consulted with other stakeholder
groups, for example, employees.

SETTING UP A CORPORATE GOVERNANCE FRAMEWORK

Typically, operational matters are decided upon by individual executives. However,

individual executive directors are only allowed to decide within defined limits, and all
decisions exceeding those limits have to be taken at a higher level, for example by the full
board of directors, to ensure that the views of all executives are taken into account when
such strategic decisions are made.

Some matters are exempted from the decisive power of the board, and handed over to non-
executive directors, forming the organisation’s committees. Contrary to executive
managers, non-executives are independent of the company, and can more accurately
exercise their judgment in areas, where executives could potentially experience a conflict of
interest, such as management remuneration or accepting internal audit reports.

Key corporate decisions are typically reserved for the shareholders of a company, who can
vote on such matters at the annual general meeting of shareholders.

CONCLUSION

Corporate governance is all about spreading the responsibility for company management by
including various stakeholders in the decision-making process in a way which allows for the
adequate handling of conflicts of interest, which could otherwise occur between different
stakeholder groups.

However, as you may expect, even the best corporate governance systems may fail without
adequate monitoring actions taken by management and appropriate reporting, ensuring
that decisions made within the organisation are congruent with its strategy and values.

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Management Appraisal and Integrated Reporting
MANAGEMENT APPRAISAL:

As you may expect, the directors of a company tend to act in accordance with the
expectations and requirements of shareholders, providing their performance is monitored
and evaluated. Management appraisal is typically based on an assessment of whether the
targets, which they were assigned, were achieved or not. In many institutions, manager
objectives include a mix of both financial and non-financial goals.

1. Financial targets:

Financial targets used in management appraisal may refer to:

1. Accounting ratios:

 Earnings per share

 Return on capital employed

It is worth noting, however, that application of such metrics to the appraisal of managers
has been subject to criticism, because measures such as earnings are not directly linked to
shareholder wealth. Use of the dividend per share ratio eliminates this drawback, however,
it should be noted that there are situations in which dividends are not paid out, while
shareholder wealth still increases, for example, when a company reinvests its profits in
investment projects with positive NPV. In such cases linking management evaluation to
dividends is obviously inadequate. Some companies incorporate even more sophisticated
measures into management appraisal, such as Economic Value Added (EVA), which is a
more accurate measure of shareholder wealth, because it takes into account the capital
structure of the company.

2. Stock market figures:

 Price to earnings ratio

 Company’s share price

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Again, use of such measures is far from perfect, and that’s because share prices may
fluctuate in reaction to external factors, which may be independent of the decisions taken
by the company’s management.

3. A measure which is better suited to the appraisal of managers than accounting and stock
market ratios is shareholder value added, referred to as ‘SVA’, which specifically measures
the improvement in cash flows generated by a company for the benefit of its owners. It
should be noted, however, that the computation of SVA is a complex process, and this has a
negative bearing on the popularity of this approach.

2. Non-financial measure:

Majority of companies do not build their management evaluation schemes solely on

financial metrics, but incorporate non-financial measures into the process as well. For
example, management evaluation may be based on a balanced scorecard, which allows for
the assessment of a company’s performance from various angles, which include, apart from
financial results, other perspectives such as (but not limited to):

 Customer satisfaction,

 The level of innovativeness,

 Quality of business processes.

You should be aware, that management appraisal does not necessarily have to be linked to
ratios and measures which relate to the company as a whole. Many firms assign their
managers individual targets, connected strictly to their area of competence and
responsibility. These targets can either take the form of specific cost or revenue objectives,
or non-financial targets, for example, linked to employee satisfaction ratings or staff
turnover.

INTEGRATED REPORTING:

Let us now concentrate on the way companies report their results to the public. Depending
on the jurisdiction, a publicly traded firm has to periodically issue a set of information to the
market. Such a set typically comprises the financial statements, which in many countries
have to comply with International Financial Reporting Standards, as well as non-financial
reports, as required by local commercial law and stock exchange regulations.

Naturally, the main goal of financial statements is to provide information about the financial
situation and performance of the reporting entity. However, financial reporting frameworks,
such as IFRS, also require companies to disclose a great deal of qualitative information,
allowing readers to learn about other aspects of their performance, such as how they are
managed, how they approach environmental issues and social responsibility, and many
others.

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The concept of providing stakeholders with comprehensive information on the company, its
performance and operations, is referred to as ‘Integrated Reporting’ and has been
developed by the International Integrated Reporting Council. The integrated reporting
framework is a principles-based set of guidance for companies, who wish to integrate
various reports and means of communication into one, comprehensive holistic report. The
idea behind an integrated report is to provide all classes of stakeholders with concise
information on how entities create value. One of its goals is, therefore, to enable the
efficient allocation of resources by providers of capital, by giving them cohesive and
comprehensive information on the entire range of factors, which affect the way an
organisation is performing. Thanks to its holistic nature, Integrated Reporting can prove
useful to all stakeholders, including employees, suppliers, clients, local communities as well
as policy and law makers.

Information issued in accordance with integrated reporting principles has to comply with
certain requirements. Firstly, it has to contain a statement from the entity’s management,
informing that the communication is in compliance with the integrated reporting
framework. An integrated report consists of two parts:

 The first is referred to as the guiding principles, and its role is to inform readers about
how the report was prepared, what are its contents and how it is presented.

 The second part includes the content elements, which is the essential pieces of
information, which are typically presented in the form of questions and answers.

Integrated reporting is consistent with other reporting requirements, in particular, financial

reporting. The International Integrated Reporting Council expects that over time, integrated
reporting will become the universal norm for corporate reporting.

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The Ethical Dimension of Financial Management

ETHICS AND FINANCIAL MANAGEMENT:

The financial decisions of a company can impact many areas both inside the organisation,
and within its wider economic environment. As a result, unethical decisions, which may
seem beneficial from the point of view of a company’s profitability, may simultaneously
have a negative impact on certain groups of stakeholders, such as local communities,
suppliers or employees, and therefore, may ultimately have a negative impact on the
company itself, for example through adverse publicity.

So, unethical decisions can prove detrimental to the process of value creation by a business,
and it is therefore essential that companies incorporate the assessment of ethical
considerations into their decision making processes. It is important to note that all
corporate actions have to be ethical not only at the individual level, but also at the level of
the organisation and society as a whole. This means that it is not only the individuals
running the business who have to apply ethical principles to themselves and their own
behaviour, but also that the entire organisation has to exercise its legal and other
obligations with respect to all groups of stakeholders, as well as towards other parties and
social groups, not directly associated with the company. Accordingly, at a corporate level,
ethics is the way a company approaches potential stakeholder conflicts and corporate
governance.

Like all other decision makers in a firm, it is essential that a financial manager ensures that
all actions and decisions taken within the confines of their area of responsibility are ethical
and properly anchored in good governance practice.

ACCA code of Ethics:

The ACCA Code of Ethics is a set of fundamental ethical principles, which have to be
followed by any professional, holding the ACCA title. The Code may naturally be used as a
guideline to support the decision making efforts of all financial managers.

The main principles contained in the ACCA Code of CLICK Ethics are:

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 Integrity – which relates to being honest and straightforward in all business relations.

 Objectivity – that is avoiding biases, conflicts of interest and other external influences,
which could potentially take precedence over professional business norms.

 Professional competency and due care – the ACCA Code of Ethics requires members to
apply professional competence and take due care of all matters assigned to them. This
means, that finance professionals are obliged to maintain an adequate level of
professional knowledge and skill, ensuring that their decisions are properly grounded in
current finance, legal and technical developments.

 Confidentiality – the Code obliges members to respect the confidentiality of information

acquired in the course of professional relationships, implying that they may not disclose
such information to third parties, unless disclosure is required by law or regulation. In
particular, no confidential information may be used for personal benefit, such as insider
trading, or for the benefit of third parties.

Integrating ethics in financial management:

A company’s approach to ethical issues associated with financial decision-making should

be included in its financial policy, regulating the behaviour of all finance professionals
working for the company. In other words, an ethical financial policy should incorporate a
code of conduct, typically covering such points as acting in accordance with the ACCA
principles and disclosure of any possible conflicts of interest to a company officer in charge
of ethical issues.

An ethical financial policy should also ensure that the company’s financial practices,
including accounting, internal controls and auditing meet the highest standards with
respect to honesty and transparency, and that they comply with external norms and
regulations. What is more, an ethical financial policy should promote ethical behaviour
among all employees, and encourage personnel at all levels of corporate hierarchy to
constantly increase their level of knowledge and awareness of best practices. It seems
obvious, however, that even the best financial policy will not ensure a company’s ethical
behaviour, unless financial decisions are made in accordance with it.

In order to encourage employees to apply the policy and its principles to everyday decision
making, a company may put a number of measures in place:

1. First of all, employees should confirm that they actually understand the company’s
ethical principles, and commit to act in accordance with them.

2. Furthermore, a company may provide employees with additional guidance related to the
practical application of ethical norms in real business situations, and designate other
resources, such as hotlines, with the aim of helping employees make ethical decisions.

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3. Finally, a company should implement mechanisms requiring employees to immediately
report all cases of potentially unethical actions taken within the firm.

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Environmental Impact of Financial Management
SUSTAINABLE DEVELOPMENT:

The idea of environmentally responsible business is embodied by the concept of sustainable

development, which is defined by the United Nations as development that fulfils the needs
of present generations, without compromising the ability of future generations to meet
their needs.

This definition implies that when running a business, managers should focus not only on
economic performance, but also on its social and environmental impact, which ought to
become an important part of corporate policy.

As we already mentioned, one of the most significant impacts of the business activity on the
natural environment is the emission of so-called greenhouse gases, such as carbon dioxide
(CO2), which contribute to the warming of the Earth’s climate.

Kyoto Protocol:

The Kyoto Protocol, adopted in 1997 by 160 countries, which came into effect in 2005, set
targets on greenhouse gas emissions applicable to individual countries, with the aim of
reducing the global emission of carbon into the atmosphere to 5% below the level from the
year 1990 by 2012. The Kyoto Protocol introduced a market mechanism to support the
reduction of emissions, referred to as ‘carbon trading’, under which countries issue
emission permits to business entities, which can subsequently be traded in the market.

As a result, companies can decide whether they prefer to invest in new, low emission
technologies, or to spend money on the purchase of additional emission certificates.

Environmental authorities:

What is more, many countries have set up their own environmental authorities, with the
goal of regulating and controlling the impact of business and its activities on natural
resources and the environment. In particular, environmental authorities ensure that
companies comply with domestic and international environmental norms,

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with respect to the use of sustainable energy sources, recycling of waste and protection of
natural resources.

In the UK, these tasks have been assigned to DEFRA, which stands for the Department for
the Environment, Food and Rural Affairs.

Triple bottom line reporting:

In order to enable companies to inform stakeholders about their approach to the issue of
sustainable development, a system referred to as ‘triple bottom line’, or TBL, reporting was
developed. TBL is a reporting framework, which requires that companies disclose not only
how they create economic value, but also how social and environmental value is generated.

This means that in order to comply with the TBL principles, companies have to prepare
additional reports on social and environmental issues, alongside traditional financial
statements. This obviously requires setting up appropriate management reporting systems
enabling the capture and processing of relevant information, as well as ensuring that the
information disclosed is true and fair.

ISO 14,000:

A possible way to ensure that the data which companies collect and process on the
environmental impact of their activities is of satisfactory quality, is to apply a framework
provided by the ISO 14,000 international norm. ISO 14,000 is a family of standards, which
provide companies and organizations with practical tools to support the management of
their environmental responsibilities.

Among others, ISO 14,000 requires companies to periodically audit their environmental
management systems, thus ensuring that information disclosed to stakeholders is of
sufficient quality. In particular, an environmental audit performed in accordance with ISO
14,000 provides an assessment of whether the company complies with laws and regulations
related to environmental obligations, as well as whether it acts in accordance with statutory
requirements in this respect. An environmental audit additionally provides a tool for
management to effectively control the environmental practices of the company. Other
benefits of implementing an ISO 14,000 framework include increased ecological awareness
and commitment of the company’s personnel as well as an improved image of the company
in the eyes of the public.

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Revision
Milma (Valuation, Debt value and Ethical issues)

QUESTION

Mlima Co is a private company involved in aluminium mining. About eight years ago, the
company was bought out by its management and employees through a leveraged buyout
(LBO). Due to high metal prices worldwide, the company has been growing successfully
since the LBO. However, because the company has significant debt borrowings with strict
restrictive covenants and high interest levels, it has had to reject a number of profitable
projects. The company has currently two bonds in issue, as follows:

A 16% secured bond with a nominal value of $80m, which is redeemable at par in five years.
An early redemption option is available on this bond, giving Mlima Co the option to redeem
the bond at par immediately if it wants to; and

A 13% unsecured bond with a nominal value of $40m, which is redeemable at par in ten
years.

Mlima Co’s Board of Directors (BoD) has been exploring the idea of redeeming both bonds
to provide it with more flexibility when making future investment decisions. To do so, the
BoD has decided to consider a public listing of the company on a major stock exchange. It is
intended that a total of 100 million shares will be issued in the newly-listed company. From
the total shares, 20% will be sold to the public, 10% will be offered to the holders of the
unsecured bond in exchange for redeeming the bond through an equity-for-debt swap, and
the remaining 70% of the equity will remain in the hands of the current owners. The secured
bond would be paid out of the funds raised from the listing.

The details of the possible listing and the distribution of equity were published in national
newspapers recently. As a result, potential investors suggested that due to the small
proportion of shares offered to the public and for other reasons, the shares should be
offered at a substantial discount of as much as 20% below the expected share price on the
day of the listing.

Mlima Co, financial information

It is expected that after the listing, deployment of new strategies and greater financial
flexibility will boost Mlima Co’s future sales revenue and, for the next four years, the annual
growth rate will be 120% of the previous two years’ average growth rate. After the four
years, the annual growth rate of the free cash flows to the company will be 3·5%, for the
foreseeable future. Operating profit margins are expected to be maintained in the future.
Although it can be assumed that the current tax-allowable depreciation is equivalent to the
amount of investment needed to maintain the current level of operations, the company will

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require an additional investment in assets of 30c per $1 increase in sales revenue for the
next four years.

Extracts from Mlima Co’s past three years’ Statement of Profit or Loss

Year ended 31 May 2013 31 May 2012 31 May 2011

$ million $ million $ million
Sales revenue 389·1 366·3 344·7
Operating profit 58·4 54·9 51·7
Net interest costs 17·5 17·7 18·0
Profit before tax 40·9 37·2 33·7
Taxation 10·2 9·3 8·4
Profit after tax 30·7 27·9 25·3

Once listed, Mlima Co will be able to borrow future debt at an interest rate of 7%, which is
only 3% higher than the risk-free rate of return. It has no plans to raise any new debt after
listing, but any future debt will carry considerably fewer restrictive covenants. However,
these plans do not take into consideration the Bahari project (see below).

Bahari Project

Bahari is a small country with agriculture as its main economic activity. A recent geological
survey concluded that there may be a rich deposit of copper available to be mined in the
north-east of the country. This area is currently occupied by subsistence farmers, who
would have to be relocated to other parts of the country. When the results of the survey
were announced, some farmers protested that the proposed new farmland where they
would be moved to was less fertile and that their communities were being broken up.
However, the protesters were intimidated and violently put down by the government, and
the state-controlled media stopped reporting about them. Soon afterwards, their protests
were ignored and forgotten.

In a meeting between the Bahari government and Mlima Co’s BoD, the Bahari government
offered Mlima Co exclusive rights to mine the copper. It is expected that there are enough
deposits to last at least 15 years. Initial estimates 2 suggest that the project will generate
free cash flows of $4 million in the first year, rising by 100% per year in each of the next two
years, and then by 15% in each of the two years after that. The free cash flows are then
expected to stabilise at the year-five level for the remaining 10 years.

The cost of the project, payable at the start, is expected to be $150 million, comprising
machinery, working capital and the mining rights fee payable to the Bahari government.
None of these costs is expected to be recoverable at the end of the project’s 15-year life.

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The Bahari government has offered Mlima Co a subsidised loan over 15 years for the full
$150 million at an interest rate of 3% instead of Mlima Co’s normal borrowing rate of 7%.
The interest payable is allowable for taxation purposes. It can be assumed that Mlima Co’s
business risk is not expected to change as a result of undertaking the Bahari project.

At the conclusion of the meeting between the Bahari government and Mlima Co’s BoD, the
president of Bahari commented that working together would be like old times when he and
Mlima Co’s chief executive officer (CEO) used to run a business together.

Other Information

Mlima Co’s closest competitor is Ziwa Co, a listed company which mines metals worldwide.
Mlima Co’s directors are of the opinion that after listing Mlima Co’s cost of capital should be
based on Ziwa Co’s ungeared cost of equity. Ziwa Co’s cost of capital is estimated at 9·4%, its
geared cost of equity is estimated at 16·83% and its pre-tax cost of debt is estimated at
4·76%. These costs are based on a capital structure comprising of 200 million shares, trading
at $7 each, and $1,700 million 5% irredeemable bonds, trading at $105 per $100. Both Ziwa
Co and Mlima Co pay tax at an annual rate of 25% on their taxable profits.

It can be assumed that all cash flows will be in $ instead of the Bahari currency and
therefore Mlima Co does not have to take account of any foreign exchange exposure from
this venture.
Required:

(a) Prepare a report for the Board of Directors (BoD) of Mlima Co that:

(i) Explains why Mlima Co’s directors are of the opinion that Mlima Co’s cost of capital
should be based on Ziwa Co’s ungeared cost of equity and, showing relevant calculations,
estimate an appropriate cost of capital for Mlima Co;

(7 marks)

(ii) Estimates Mlima Co’s value without undertaking the Bahari project and then with the
Bahari project. The valuations should use the free cash flow methodology and the cost of
capital calculated in part (i). Include relevant calculations; (14 marks)

(iii) Advises the BoD whether or not the unsecured bond holders are likely to accept the
equity-for-debt swap offer. Include relevant calculations; (5 marks)

(iv) Advises the BoD on the listing and the possible share price range, if a total of 100
million shares are issued. The advice should also include:

 A discussion of the assumptions made in estimating the share price range;

 In addition to the reasons mentioned in the scenario above, a brief
explanation of other possible reasons for changing its status from a private
company to a listed one; and

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  An assessment of the possible reasons for issuing the share price at a
discount for the initial listing; (12 marks)

Professional marks will be awarded in part (a) for the format, structure and presentation
of the report. (4 marks)

(b) Discuss the possible impact on, and response of, Mlima Co to the following ethical
issues, with respect to the Bahari project:

(i) The relocation of the farmers; and

(ii) The relationship between the Bahari president and Mlima Co’s chief executive officer.

Note: The total marks will be split equally between each part.

(8 marks) (50 marks)

20
International Trade and Finance
Free Trade Theory and Practice

THEORY OF INTERNATIONAL TRADE:

According to a commonly used definition, a multinational company is any business, whose

revenues generated from sales to countries other than its home country exceed 25%. As you
can see, many entities may, in fact, be considered multinational in light of this definition. In
the case of all such companies, it is therefore essential to understand the global economic
environment, in which their international activities are pursued.

Let us consider why companies decide to do business internationally, or, to put it in other
words, what are the reasons for the existence of international trade? The phenomenon of
international markets may be explained using several concepts:

 The first is diversity. Not all goods may be produced in the domestic market
of a country, and without the ability to buy imported goods, consumers
would not have access to certain products.

 Another reason is competition. The fact that foreign companies can access
local markets increases the level of competition in those markets resulting in
lower prices, as well as boosting the innovativeness of local companies.

 Economies of scale and specialisation are further justifications for the

emergence of international trade. As a result of manufacturing goods for
both the domestic and foreign markets, companies can achieve economies of
scale, and, as a result, maximise their efficiency as well as offer more
attractive prices than their smaller competitors. Specialisation has a similar
effect on efficiency and prices.

Economic theory – law of comparative advantage:

Economic theory goes deeper, providing an explanation for why entities should specialise in
the production of a given product and subsequently export it to other markets. The
explanation comes from the comparative advantage theory, as developed by English
economist David Ricardo. According to his findings, individuals, companies and countries
specialise in the activity, in which they have a comparative advantage, as measured in

21
terms of endowments or technological progress.

Example:

Let us explain the law of comparative advantage using a simple example. Imagine an
individual, who has skills in producing shoes and making wooden chairs. During one working
day he can either make a pair of shoes, or one chair. His neighbour has similar skills,
however, is less endowed and it takes him three days to produce a pair of shoes, and one
and a half day to make a chair.

Is there any reason for which any of the two producers should give up production of one of
the goods and specialise in producing the other? Well, as you probably have noticed, the
first individual has an absolute advantage in the manufacturing of both shoes and chairs,
and the first impression may be that he cannot gain from specialisation and trading with the
second, less efficient individual. However, the answer changes when we consider the
opportunity cost associated with the production of the two goods by each of the individuals.

Assume that a pair of shoes costs $250 and a chair costs $200. If both individuals stick to
producing both goods, they will have to split their time between them. For example, during
a working week of six days, individual one will spend three days making shoes, thus earning
$750, and three days making chairs for a further $600.

As a result, his weekly revenue will amount to $1,350 dollars, and the production output will
be three pairs of shoes and three chairs. At the same time, his neighbour will devote 3
working days to make one pair of shoes, for which he will receive $250, and three days to
make two chairs for $400. So, his weekly revenue will come in at $650. The total production
output of both manufacturers will, therefore, comprise four pairs of shoes and five chairs,
and the total revenue of the two entrepreneurs will amount to $2,000.

You should appreciate, that by choosing to produce a mix of goods, neither of the
manufacturers are maximising their revenue. If individual one gave up making chairs and
concentrated only on shoes, he could produce 6 pairs of shoes in a week, earning $1,500
instead of the current $1,350. Similarly, individual two could earn more money if he only
produced chairs. In such a case he would spend 6 working days making 4 chairs and earning
$800 instead of $650.

The reason behind the economies of specialisation stem from differences in the opportunity
costs faced by each of the manufacturers. For the first individual, the opportunity cost of
earning $200 for one chair is losing revenue of $250 on a pair of shoes, which could also be
produced in one day. So, for individual one, the opportunity cost of making shoes amounts
to 0.80 of a chair, or $200 divided by 250.

By analogy, the opportunity cost of making a chair amounts to 1.25 of a pair of shoes, which
can be calculated as $250 divided by $200. In order to calculate the opportunity costs for
individual two, we need to calculate his daily productivity for both goods. Knowing that he

22
can make one chair in one and a half day, his daily revenue from producing chairs amounts
to $133.33 dollars. And knowing that he needs three days to make a pair of shoes, his daily
revenue from shoemaking amounts to $83.33 dollars.

So, the opportunity cost of making a chair amounts to ($83.33 ÷ $133.33 =) $0.63 of a pair of
shoes, and the opportunity cost of making a pair of shoes amounts to ($133.33 ÷ $83.33 =)
$1.60 of a chair.

As you can see, despite individual one’s absolute advantage in the production of both
goods, the opportunity costs of making the goods are different for the two producers. In
particular, individual two faces a lower opportunity cost of producing chairs, than individual
one, which means that he has a comparative advantage in making chairs over individual
one. Simultaneously, individual one faces a lower opportunity cost of making shoes than
individual two, which gives him a comparative advantage in shoemaking over individual two.

Barriers to international trade:

The theory of international trade assumes that the flow of goods and services among
countries is in fact free. The reality in this respect is, however, far different. In fact, for many
countries the import of goods from other, more efficient states, is a threat to their local
industries. Consequently, in order to protect their domestic markets, countries often impose
restrictions on imports, which form barriers to the development of international trade.

Let’s take a look at a couple of the most commonly used types of restrictions:

 The first type of trade barriers are tariffs and quotas:

- A tariff is a tax levied on imported goods, with the aim of making imported goods
less attractive to domestic customers in terms of price.

- A quota, on the other hand, is a limit on the quantity of goods that can be imported
to a country over a period of time.

The goal of its implementation is similar to that of a tariff, in other words limiting the impact
of competitive foreign products on local business.

 Probably, the most severe barrier to trade is an embargo, which is a complete ban
imposed on goods imported from a certain country. Please note, however, that an
embargo is typically used as a tool to exert pressure on the political leadership of a
country, rather than as a means of defending local markets. Nonetheless, from the
perspective of a multinational company, an embargo is a barrier to trade, which is
difficult to circumvent.

 Other types of trade barriers include exchange controls and administrative controls:

- Exchange controls are restrictions imposed on transactions in foreign currencies,

aimed at limiting the volume of imports. An example may be a ban on using a foreign

23
 currency within a country or limiting the amount of currency that can be imported to
or exported out of the country. Typically, exchange controls are used by
underdeveloped countries as well as those countries, whose economies are
undergoing transition.

- Administrative controls are aimed at deterring potential importers by implementing

extensive administrative requirements and bureaucratic paperwork in relation to
such transactions.

Bypassing trade barriers:

Multinational companies, who wish to expand to countries, in which significant trade

barriers exist, are forced to

find ways to bypass them:

 A potential way of avoiding trade barriers, which is often welcome by the government of
the target country, is locating production facilities directly in that country.

 While some countries apply trade barriers, in many areas of the world free international
trade is promoted and encouraged. This is done primarily within free trade zones,
usually set up by groups of countries located in the same part of the world.

NOTE: It is interesting to note, however, that free trade zones, whose members may do
business and transact without barriers among each other, often impose high barriers to
trade with non-member countries.

24
Trade Agreements and Organisations

INTERNATIONAL TRADE AGREEMENTS:

Trade agreements and common markets are international treaties entered into by counties
interested in fostering international trade in a given type of good or service.

NOTE: Trade agreements also act as protectionist measures against excessive imports from
countries, which didn’t sign the agreement.

Let us now take a closer look at the specific categories of such treaties which may be
encountered around the world:

1. The simplest type of such treaty is a bilateral trade agreement, in which two countries
agree to eliminate quotas and tariffs in relation to all or selected goods. Examples of such
agreements are:

– China – Australia Free Trade Agreement, also called “ChAFTA”, signed in

2015.

– Closer Economic Relations agreement between Australia and New Zealand,

referred to as ‘CER’.

2. Multilateral trade agreements are similar, but entered into by a group of more
than two countries. Example of a multilateral free trade agreement is North
American Free Trade Agreement (NAFTA) between the United States, Canada
and Mexico.

3. When a multilateral free trade agreement is entered into by a bloc of countries

located in the same geographical area, then it is typically referred to as a ‘free
trade area’. An example of such area is the Commonwealth of Independent
States Free Trade Area, signed by Russia, Ukraine, Belarus, Uzbekistan, Moldova,
Armenia, Kirgizstan and Kazakhstan.

4. A specific category of international agreement, aimed specifically at protecting

the signatories’ markets from international competition, referred to as a customs
union. Members of such a union agree to a trade freely within the union, but
simultaneously set up a common external trade policy, including tariffs and
sometimes also quotas. Consequently, a customs union represents a higher
degree of economic integration between countries than in the case of free trade
agreements, where each of the countries typically adopts its own external trade
policy. An example of a customs union is the Andean Community, comprising a
number of South American countries, Bolivia, Colombia, Ecuador and Peru.

5. Single markets, also called economic communities, represent yet a further step in the
economic integration of countries. Members of a single market remove all barriers to

25
 trade with each other in goods and services, including the freedom of movement of
production factors, which is of capital and labour. Simultaneously, the community also
adopts a common external trade policy. The MERCOSUR, including Argentina, Brazil,
Paraguay and Uruguay is an example of a single market.

6. The most advanced stage of market integration known to date is the economic and
monetary union, whose member states, in addition to a shared economic policy
regarding internal and external trade, also adopt a common currency. The so-called
Eurozone, that is a monetary union of 19 out of the 28 countries of the European Union,
is an example of an economic union with the euro being the common currency adopted.

INTERNATIONAL ORGANISATIONS PRESENTING FINANCING TO TROUBLED

ECONOMIES:

World Trade Organisation:

The liberalisation of free trade globally is promoted and supported by the World Trade
Organisation, commonly referred to as the WTO, which is an international forum, where 164
member states can negotiate rules pertaining to international trade and sort out disputes
regarding trade barriers. The current focus of the WTO is the finalisation of negotiations in
the Doha Development Round, which started in 2001, with the purpose of establishing
common rules of trade between industrialised countries and emerging economies. Since the
launch of negotiations, several meetings have already been held, however, no binding
resolutions have been achieved yet. This is primarily due to the lack of consensus regarding
protectionist measures adopted by free trade areas against other countries, particularly
with regard to trading in agricultural products. As you can see, despite the constant growth
in importance of international trade to the global economy, protectionism still remains a
significant issue, particularly in relation to less developed countries.

Protectionism – pros and cons:

Let us now consider the pros and cons of the protectionist approach to international trade.
On one hand, it seems obvious that developing economies wish to protect their local
industries from foreign competition. In such case, adopting a protectionist stance may offer
these countries time to modernise their economies in order to make them more
competitive.

There is a threat, however, that trade barriers will be used to protect obsolete technologies,
which are not expected to ever become globally competitive.

From this perspective, it may be noted that foreign competition may also act as a positive
incentive to the

26
economies of developing countries, increasing the pace of their modernisation.

Concluding, there is no simple answer to the question of whether protecting domestic

markets is right or wrong. It seems that depending on the specific circumstances and
decisions of local policymakers, the protectionist approach may either help a country
develop faster when applied responsibly, or, as in the case of countries led by populists, to
obstruct the increase of an economy’s level of competitiveness, thus hindering the
economic growth of the country.

Continuing with the theme of underdevelopment, we will devote the next part of the video
to intergovernmental organisations, which are aimed at supporting the development of
emerging economies:

1. World Bank:

The first of these is the World Bank, which was established following World War II to help
finance the reconstruction of economies damaged by the war. Currently, the World Bank
provides financing to developing countries, with the goal of eradicating poverty.

The World Bank is, in fact, made up of two institutions:

 The first of these is the International Bank for Reconstruction and Development, and
its primary function is the granting of long-term loans to underdeveloped countries,
to finance capital projects, that is projects aimed at improving infrastructure. It
should be noted that the loans are granted at commercial rates.

 The second constituent of the World Bank is the International Development

Association, which provides loans to the world’s poorest countries, aimed primarily
at financing human development projects, such as education, child vaccination as
well as construction of basic infrastructure such as paved roads or bridges. Contrary
to loans granted by the International Bank for Reconstruction and Development, the
financing provided by the International Development Association is subject to special
conditions, such as prolonged repayment terms and deferred interest payments.

2. International Monetary Fund:

Another intergovernmental organisation which provides financing to troubled economies is

the International Monetary Fund, referred to as the IMF. The primary goal of financing
granted by the IMF is to provide liquidity to countries experiencing deficits in their balance
of payments, in the transition period to recovery and the application of corrective measures.

Accordingly, contrary to the World Bank, the IMF provides its help not only to
underdeveloped economies, but to those, which are not in the position to service their
foreign obligations. The disbursement of IMF financing is conditional on the beneficiary’s
government adopting a reform action plan. Once again, the financing is granted on market
conditions.

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Central banks:

Supranational institutions like the World Bank and the IMF obviously increase the stability of
the global financial system. At the individual country level, financial stability is provided by
central banks, who are, among others, in charge of issuing the local currency and regulating
the level of interest rates. Taking into account, that a vast majority of international trade is
settled using the world’s four major currencies:

- US dollar – $

- Euro – €

- Japanese Yen – ¥

- Great Britain pound – £

Clearly, the policy and decisions of the central banks in charge of issuing these currencies
have a significant impact on international trade. A central bank, also called a reserve bank, is
responsible for issuing and managing the currency and money supply of a country or
currency zone. In other words, central banks are the implementers of monetary policy.

 The central bank of the United States is called the Federal Reserve System, a name
which is often abbreviated to the Fed. One of the primary roles of the Fed is naturally
issuing the United States dollar, which is the most frequently used currency in global
trade. You may find it interesting to know, that the US dollar is officially used as the
currency in 12 countries other than the United States, and unofficially in over 30
countries. Thus, decisions taken by the Federal Reserve regarding the supply of the
dollar, and the level of interest rates in the US dollar, have a direct impact on the
economic reality of citizens of all of these economies.

In accordance with the theory of interest rate parity, the level of interest rates is correlated
with the demand for currencies, and thus has a significant impact on exchange rates. So,
taking into account that the US dollar is the currency most often used in global trade, the
decisions of the Fed have an enormous effect on the prices of goods and services
worldwide.

– The second most traded currency in the world is the euro, issued by the European
Central Bank, or the ECB, with headquarters in Frankfurt, Germany. The euro is the
currency used in the monetary union, comprising 19 member states, all of whom belong
to the European Union. The ECB is a supranational organisation, with equity owned by
central banks of all 28 countries of the European Union. The primary objective of the
ECB is maintaining the stability of prices in the Eurozone. This goal is achieved by means
of regulating the supply of currency and using tools such as repurchase agreements,
called repo transactions, through which the amount of currency in the economy can be
reduced or increased.

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The euro is not only the currency used to settle transactions in the Eurozone and the
European Union. Eleven local currencies of countries located not only in Europe are pegged
to the euro, which means that their monetary authorities de facto follow the monetary
policy of the ECB.

 The Japanese yen is the third most important currency used for invoicing in global
trade and is issued by the Bank of Japan with headquarters in Tokyo.

 The fourth most important currency traded globally is the Great Britain pound,
called the pound sterling. It is issued by the Bank of England, which was established
in 1694, and is the second oldest central bank in the world, with first place belonging
to the Swedish National Bank.

NOTE: As you can see, the international economic environment in which multinational
companies conduct their business is complex, and includes on one hand multiple free trade
agreements and areas adopting protectionist approaches to international trade. On the
other hand, there are supranational organisations, such as the WTO, struggling to eliminate
major barriers to trade. Finally, there are also central banks issuing currencies used to settle
international transactions. This complexity of the international economic landscape gives
rise to numerous risks, faced by multinationals in their international operations.

29
Financial Markets in International Trade
HISTORY OF THE INTERNATIONAL FINANCIAL MARKET:

It would be impossible for international trade to exist without the global financial system,
which is a worldwide framework of agreements and institutions, facilitating the exchange of
financial capital among entities participating in international investment and trade. The
global financial system allows management of the world’s balance of payments, which
comprises all payments made and received by all countries. An important part of the
balance of payments is the current account, encompassing among others the balance
resulting from international trade. In the global balance of payments some countries, such
as China or Germany, have a current account surplus, meaning that they are net exporters,
while countries such as the United States record a current balance deficit, implying that they
are net importers.

Accordingly, through the global financial system countries with positive current balance, in
fact, provide financing to countries with negative current balance. Global financial markets
evolved in the nineteenth century, in reaction to an increase in international trade, mainly
triggered by the import of goods from colonies to metropolises. Since that time, global
financial markets have recorded upswings and downturns. The latter were marked with the
two world wars and the great depression of the 1920s. In more recent times, the years of
greatest economic development, that is the 1980s and 1990s, in which the globalisation of
production accelerated, followed the decisions to free float the exchange rates of the
world’s major currencies following the oil crisis of the 1970s.

Since then, a series of local financial crises took place in many regions of the world,
including South America and Asia. These crises resulted in increased financial markets
volatility. The last of the crises, which had an impact on global financial markets, was the
credit crunch of 2008 and the Eurozone crisis which started in 2009. Let us now discuss the
mechanics and implications of both of these crises.

FINANCIAL CRISIS:

1. Credit crunch:

The credit crunch resulted from excessive lending by American banks in the early 2000s. At
that time the

30
American banking industry was over-liquid, and as a result, American banks found
themselves pressured to extend loans to customers with a low level of credit worthiness,
and corresponding low credit rating, referred to as sub-prime loans.

At the same time, a new cheap way of refinancing became available to banks in the form of
securitisation transactions. In a securitisation, a portfolio of assets is sold to an entity
referred to as a special purpose vehicle (SPV), which then issues debt securities, whose risk
is connected with the risk of the assets transferred.

Such securities are known as CDOs or Collateralised Debt Obligations. A further mechanism
called the tranching of risk made it possible to achieve high external ratings of CDOs, which
were purchased by investors worldwide.

In 2007 and 2008 sub-prime loans started defaulting, as a result of which the riskiness of
CDOs, even of those tranches with high external ratings, grew dramatically. As a
consequence, institutions, who had been investing in CDOs recorded massive losses. The
direct result of plummeting CDO prices was a near complete breakdown of the inter-bank
financing market, which spread from the United States to other areas of the world, giving
rise to a global financial crisis.

The aftermath of this crisis included bankruptcies of several globally important financial
institutions, some of which were liquidated, and some saved by government intervention.
What is more, in the years following the crisis, banks in all regions of the world became
reluctant to grant loans, making it more difficult for companies to refinance their debts.

Securitisation:

In order to understand the mechanism which led to the outbreak of the crisis, let’s take a
closer look at the logic behind securitisation. As we have already noted, the SPVs, which
purchased portfolios of assets from banks, issued debt securities that were contractually
linked to the credit quality of those asset portfolios. What this meant was that the
contractual cash flows of the securities, that is their coupons and principal, would only be
paid out, if the loans backing those securities were, in fact, being repaid. In order to make
the CDOs more attractive to investors, and also to lower the refinancing cost in a
securitization, the risk of the asset portfolios was unevenly spread across the different
tranches of securities issued by an SPV.

Junior tranches were subordinated to more senior tranches, implying that the holders of
these subordinated instruments would only be paid off after the holders of more senior
tranches had received all payments due. As a result, it was possible for the issuers of such
instruments to achieve high external ratings and a relatively low credit margin on senior
tranches. In typical securitisations, the most subordinated tranche, accumulating the most
risk, was in fact retained by the SPV.

31
As one may expect, a securitisation transaction functions properly as long as the assets
purchased by the SPV generate enough cash flow to service the senior tranches of the CDO.
What happened in 2007 and 2008, was a massive increase of credit risk in the assets backing
the CDOs, as a result of which, SPVs found themselves short of cash to service even the
most senior of the tranches.

Example of securitisation:

Let us now examine a numerical example of a securitisation and tranching. Imagine a

portfolio of mortgage loans granted by a bank to its customers. The nominal amount of the
portfolio is $100 million, and the assets generate a contractual income of 10% annually. The
bank transfers the portfolio to an SPV, which will issue CDOs based on 90% of the portfolio,
and the remaining 10% will serve as an additional credit support instrument in the
transaction.

– The SPV will issue a senior tranche of $54 million in nominal value and with a coupon
rate of 8%,

– A mezzanine tranche of $27 million and a coupon rate of 9%, and

– A junior tranche of $9 million and a coupon rate of 12%.

In this transaction, the mezzanine tranche is subordinated to the senior tranche, and the
junior tranche is naturally subordinated to the mezzanine tranche. So, the flow of payments
in the transaction resembles a waterfall, where the proceeds collected from the loans fist
flow to the senior tranche, and when all payments due to holders of this tranche have been
realised, then the flow is directed further down to the mezzanine tranche. Only what is left
after servicing the mezzanine tranche, will belong to investors in the junior tranche.

Let us assume that all borrowers in the portfolio service their loans according to schedule. In
such a case, the portfolio will generate $10 million of interest proceeds, calculated as $100
million of nominal value times the contractual rate of 10%.

 The senior tranche will receive $4.32 million of interest (calculated as $54 million x
8%).

 Then the interest on the mezzanine tranche of $2.43 million ($27 million x 9%) will
be paid out.

 The remainder of the cash collected from the loan portfolio amounts to $3.25 million
($10 million – $4.32 million – $2.43 million) can be paid out to the holders of junior
debt. Please note that the $3.25 million represent the securitisation’s capacity to
absorb losses, beyond which investors in the more senior tranches become affected.

This capacity amounts to 32.5% ($3.25 million ÷ $10 million) of the total amount of
contractual interest on the securitised assets. Thus, holders of the senior and mezzanine

32
tranches are safe as long as no more than 32.5% of loan borrowers fail to repay their
obligations to the bank.

2. Eurozone crisis:

The most recent financial shock, which impacted the global financial system, began in
Europe in the year 2009 and is commonly referred to as the Eurozone crisis. The origin of
the crisis was Greece announcing that its fiscal deficit amounted to 12.7% of the country’s
GDP, compared to the 3%, allowed for counties, which adopted the euro as their currency.

In consequence, investors started selling Greek treasury bonds, whose prices plummeted.
Soon Greece stood at the verge of bankruptcy. The crisis spread to other Eurozone
countries, suspected of having problems with budget discipline, such as Portugal, Italy,
Spain, and in the later phase of the crisis, also Cyprus. In order to avoid the further
spreading of the crisis, the remaining countries of the Eurozone, together with the IMF,
decided to bail out Greece and other troubled economies, and the European Central Bank
started purchasing their treasury bonds in order to stabilise the situation in the European
banking system.

Probably the most significant consequence of the Eurozone crisis is the downgrade of many
European countries by rating agencies, and the loss of confidence in the European Union,
which also indirectly impacted a series of anti-European choices made in elections
throughout member states, including the so-called Brexit, that is Great Britain’s decision to
leave the European Union.

ISSUES CONNECTED WITH THE FREE MOVEMENT OF CAPITAL:

Let us now shift our attention to a different issue associated with international trade and
the free movement of goods, services and capital in the international economy, namely the
risk of using the reduced barriers to trade in order to remit funds for criminal purposes. On
the one hand, the elimination of restrictions, in particular, those associated with the free
movement of capital, is a cornerstone of the global economy. On the other hand, however,
it offers opportunities for criminals to pursue illegal activities such as the financing of
terrorism and money laundering. The term money laundering refers to a situation where
illicitly obtained funds or assets are entered into the financial system as a way of concealing
their link with crime.

In recent years, global leaders have been working to adopt measures that would help
identify and eliminate financial flows resulting from criminal activity. In 1989 the Financial
Action Task Force, referred to as FATF, was established, which formulated
recommendations on legal solutions aimed at the elimination of money laundering.
According to these recommendations, companies have an obligation to monitor payments
which they make and receive in order to ensure that they are not made in connection with
criminal actions, and to report all suspicious cases to the local financial investigation unit.

33
Participation in the remittance of funds coming from criminal activities, possession of and
dealing with such funds, as well as concealing knowledge regarding such transactions by a
company, are all considered a participation in the crime.

Anti-money laundering and anti-terrorism financing legislation have been implemented in

most countries. An example of such legal acts is the Anti-Money Laundering Directive of the
European Union. The ALM Directive, as it is referred to, generally fulfils the FATF
recommendations. Its provisions impose a number of requirements on accountants of
entities participating in the financial system, including, among others, identification of each
client, reporting of all suspect financial activities, adequate record keeping in relation to
transactions, and customer due diligence procedures.

34
Dividends in Multinational Companies and Transfer Pricing
The Dividend Policy of a Multinational Company

DIVIDENDS & INTERNATIONAL ACTIVITIES:

As you may remember, the primary goal of a company’s dividend policy is the maximisation
of shareholder value. Accordingly, the formulated dividend policy should address the
preferences of shareholders, who may favour current cash payments to future gains from
profits reinvested into projects with positive NPV. You should be aware that the
shareholders of many multinationals include institutional investors, for example, investment
and pension funds, which may have a strong preference for regular dividend payments. The
dividend policy of such companies will, therefore, involve paying out a stable or rising
dividend per share. Such an approach is not only in line with the expectations of
shareholders, but also helps avoid the dividend signalling effect, thus stabilising the share
price.

Apart from the need to satisfy shareholder expectations, the dividend policy of a
multinational company must also address the issue of intra-group dividends, which allow for
the repatriation of profits from subsidiaries to head office, enabling the transfer of funds
within the group.

MULTINATIONALS ADDRESSING DIVIDEND CAPACITY:

In this context, the list of factors influencing the dividend capacity of a multinational
company, must be extended to encompass so-called blocks on the remittance of dividends,
which may be enforced by the government of a host country, in which the company has a
subsidiary. Blocks on remittance are typically effected by putting in place exchange controls
or limits on the transfer of dividends to the parent company, for example through legal
restrictions on the dividend capacity of companies.

Multinational companies are obviously interested in avoiding such administrative limitations

and several ways exist for achieving this in practice:

35
1. The most widely used method to bypass blocks on remittances is referred to as transfer
pricing. Under this approach the prices for which goods and services are purchased and
sold among group entities, are set to such a level, that profits are reported at head office
or by subsidiaries located in those countries, where there are no restrictions on the
remittance of funds or where the tax regime is more favourable.

2. Other means of avoiding remittance blocks include using inter-company loans. For
example, a subsidiary may, instead of paying a dividend, grant a loan to the parent.

3. The parent may also impose additional fees and charges on its subsidiaries, such as
royalties for using trademarks, patents, or for providing consulting and management
services, which will be settled within the transfer pricing system.

4. Finally, the parent company may also charge its subsidiaries with various overhead
expenses.

You should appreciate that all of the ways to avoid remittance blocks which we have
mentioned are in fact variations of the transfer pricing approach.

Calculation of dividend capacity:

Let us now consider how a multinational company actually calculates its dividend capacity.
As you know, dividends are paid out when a company is profitable, that is when it generates
free cash flows, which are not reinvested. In the case of multinational companies, gross free
cash flow is computed as the company’s operating cash flow plus dividends received, less
interest paid on debt financing and less income tax:

Please note that gross free cash flow as we have just defined it, does not take into account
any re-investments, such as capital expenditure or funds required for the acquisition of
other entities, nor does it consider potential increases of capital. When we do incorporate
these items into the gross free cash flow formula, we come up with the so-called net free
cash flow to equity, representing the amount of money which may be paid out to
shareholders within a year, in other words, its dividend capacity. Net free cash flow to
equity is calculated as gross free cash flow, minus capital expenditure and acquisitions, plus
any proceeds from the disposal of subsidiaries and new capital issued:

36
As you can see, the formula may easily be applied using information found in a company’s
financial statements. Investors may thus use the formula to compare the net free cash flow
to equity with the level of dividends actually paid out by an entity

REINVESTMENT STRATEGIES FOR MULTINATIONALS:

Let us now discuss how multinational companies manage their free cash flows in the context
of reinvestment and capital reconstruction. A reinvestment strategy may be perceived from
two perspectives:

– Short-term reinvestment requirements stem from the need to maintain a level of

working capital, necessary to pursue the company’s business activities. For example,
a company may need to maintain a given amount of inventories in order for its
operations to function smoothly. It will, therefore, reinvest a portion of its gross free
cash flows to supplement inventory purchases. Thus, in the short-term, the
reinvestment strategy results from a company’s ordinary course of business and is
typically stable over time.

– On the contrary, long-term reinvestment strategy is associated with the pursuit of

new investment opportunities, such as capital expenditure or new acquisitions. Such
re-investments significantly reduce dividend capacity.

Accordingly, before making any reinvestment decision, management must convince

shareholders that the future gains from the reinvestment of profits will exceed the value of
cash dividends, which the shareholders will have to sacrifice. For this purpose, management
typically present shareholders with the results of an investment project appraisal, indicating
the expected NPV of the project as well as forecasts of future profitability.

Some companies decide to reward their shareholders with scrip dividends, where the
dividend pay-out is realised in equity instruments. Consequently, inventors have a choice of
either to maintain the shares received and thus realise gains from the reinvestment, or sell
the shares in the market. Irrespective of the decision made by shareholders, the free cash
flow is retained by the company.

Please note that capital expenditure investments and acquisitions sometimes require not
only that the company refrain from paying out dividends, but that it also increase its capital
by means of issuing new debt or equity instruments.

You should also be aware that there are instances of reinvestments, where the NPV of the
project is actually negative. This will often be the case, when, the company is obliged to
comply with new regulatory requirements, for example, those related to environmental
protection or waste emission.

37
Impact of Capital Reconstruction Programmes:

Let us now analyse the impact that capital reconstruction programmes have on free cash
flow and dividends. For this purpose we will define capital reconstruction as a major
change in the capital structure of a company, both relating to equity and debt:

1. Let’s start with changes resulting in the lowering of a company’s equity through a
share buyback scheme.

As you know, a share repurchase offers a practical alternative to the payment of a cash
dividend, and is performed when a business has accumulated a large amount of cash, which
it cannot effectively reinvest. When a company buys back its own shares in the market, its
free cash flow is reduced immediately. However, as a result of the repurchase, the total
number of shares decreases, and the level of free cash flows which will be generated in
future periods as measured on a per share basis may, in fact, be higher than before the
repurchase. Accordingly, a share repurchase scheme may potentially lead to a future
increase in the level of dividend per share.

2. Let us now consider the impact that an increase in capital will have on the
company’s free cash flow and its

dividend capacity. A capital increase may occur as a result of issuing new debt or equity:

 Clearly, when new debt is issued to finance working capital or new investment
projects, then free cash flows in future periods will decrease by the amount of
interest payable on the new debt. Please note, however, that the proceeds from new
debt may also be used for other purposes, for example, financing a share
repurchase. In such a case the funds will immediately be distributed to shareholders.
Nevertheless, future interest expenses will still reduce dividend capacity in
subsequent periods.

 As we indicated earlier, investment projects may be financed by issuing new shares.

In such cases, the total number of shares, to which a dividend will be paid increases,
which may lead to a fall in the level of dividend per share in future periods.

38
Dividends in Multinational Companies and Transfer Pricing
TRANSFER PRICING:

Transfer pricing is an approach used by companies to circumvent restrictions related to the

repatriation of profits from foreign subsidiaries to the parent company. In fact, transfer
pricing may serve more purposes:

1. Among the most often quoted is the avoidance of excessive charges, such as taxes,
duties and tariffs, by transferring profits to countries with more favourable fiscal
regimes.

2. Transfer pricing also enables companies to manage the final consumer price of their
goods in foreign markets thus increasing their level of competitiveness.

3. Last, but not least, transfer pricing may be used as a tool in managing foreign exchange
exposures resulting from operations located in different countries.

You should be aware that transfer pricing is not limited solely to the purchasing and selling
of goods between the parent company and its foreign subsidiaries at predetermined prices.
The term transfer pricing is typically also used to describe such practices as:

– Charging subsidiaries with royalties,

– Charging subsidiaries with overheads,

– Charging subsidiaries with other expenses,

– Invoicing subsidiaries for services rendered to them by the head office, such as:

- Human resources management.

- IT services.

 Inter-company loans to transfer funds within the group.

General rules:

Let’s now take a look at the general rules governing the practice of transfer pricing. The
most important component of a transfer pricing system is setting up the levels of prices,
which will be used to settle intra-group transactions. The unit transfer price is typically equal
to the variable cost incurred by the entity supplying a given good or service, plus the
opportunity cost incurred in association with selling that good or service internally. So, the
opportunity cost is:

– The contribution that the company lost by not selling the product externally, or

39
– The opportunity cost of using the company’s production capacity to produce goods for
internal transactions instead of using it for commercial purposes.

In light of the above observations, the transfer price will range:

 From: an amount equal to the standard variable cost of the production entity (when
there is no external market for the goods and no alternative and more profitable use for
its production facilities)

 To: the market price (when the goods or services subject to intra-group transactions are
marketable).

In order to function properly, the transfer pricing system of a multinational company should
be:

 Understood by the management of all participating entities.

 Relatively easy to operate.

 Flexible.

 Properly aligned with:

- Overall business strategy.

- Methods of performance assessment of the entities participating in the system.

Application:

There are three most commonly applied transfer pricing systems, depending on the method
used to determine transfer prices:

1. Market-based system:

The first of these is the market-based system, in which prices used for intra-group
settlements simply reflect market prices. It is important to note that market-based transfer
pricing is generally approved by tax and customs authorities in jurisdictions worldwide, as it
facilitates the fair sharing of profits between entities in a capital group. Under a market-
based system, income taxes and other burdens are also split within the group.

The main difficulty associated with the application of the market-based approach is that
prices for the same goods and services may differ across geographical locations, for
example, due to different levels of local taxes. Prices are also highly dependent on
fluctuations in foreign exchange rates. Therefore, in the case of many goods and services
there is no single market price that could be applied and approved by tax authorities across
the jurisdictions, where transfer pricing is in fact applied.

40
2. Cost-based system:

Cost-based transfer pricing exists in two variants:

1. The first is full cost pricing, where the transfer price takes into account all costs
incurred by the production division. As a result, full cost pricing ensures that the
authorities in all locations participating in the system receive their appropriate
share of taxes and duties. Accordingly, full cost transfer pricing is also accepted
by tax authorities across various jurisdictions.

2. On the opposite end of the spectrum is the variable cost approach, which is
generally not accepted by the financial authorities of supplier countries. This is
because when suppliers only receive compensation equal to the variable cost
incurred, then all profits are allocated to the receiving company, which is
typically head office. As a result, production subsidiaries avoid paying local
income taxes.

3. Negotiated prices:

Aside from market-based and cost-based pricing, there is also a third type of transfer pricing
system, which is based on negotiated prices. Under this approach, prices used in intra-
group transactions are subject to negotiations, which may make it difficult for companies to
take advantage of differences in tax and duty rates across various locations.

As we have already said, transfer pricing may help minimise the capital group’s overall tax
burden. This can be achieved by reporting high profits in countries with low income tax
rates, and avoiding reporting profits in countries with high income taxes. In terms of
transfer pricing, this means setting transfer prices in such a way, that higher costs are
generated in locations with high tax rates, or by invoicing entities located in such
jurisdictions with services provided by entities situated in countries with lower tax rates.

You should be aware, however, that tax authorities in many countries require companies to
provide evidence that the prices used in transactions with related entities are obtainable at
arm’s length, and, as a result, a simple increasing or decreasing of transfer prices seldom
allows for the effective transfer of profits within a group. Companies attempt to circumvent
local regulations by transferring goods and services, for which external market prices are
unavailable. An alternative solution involves creating distribution centres in low tax
countries, and transferring products to them using low prices. As a result, the whole margin
on the consumer price is generated in the country with lower tax rates.

Let’s now analyse how a multinational company may apply transfer pricing to circumvent
burdens resulting from regulations imposed by local governments:

1. We will start with tariffs. An import tariff is a form of duty levied on goods imported
from other countries. Tariffs are typically expressed as a percentage of the value of imports.

41
Obviously, the implementation of tariffs will impact a multinational company, whose
subsidiary is an importer.

A potential strategy to minimise that impact is to lower the transfer price for the goods
being imported. Please note, however, that a side effect of lowering the transfer price, will
be a higher level of profitability achieved by the subsidiary, which may stand in opposition
to a strategy of minimising the tax burden.

2. Other types of local regulation, which may impact transfer pricing policies are exchange
controls. A variety of measures exists, that the government of a country may adopt in
order to limit the purchasing or selling of foreign currency. Restrictions may relate both
to the country’s residents and non-residents.

From the point of view of multinationals, exchange controls represent a severe problem,
because they significantly hinder the remittance of dividends. A typical way to avoid
exchange controls involves limiting the profitability of subsidiaries which are subject to
such restrictions, for example by charging them with royalties or management fees. In
some cases, however, local authorities extend exchange controls to cover such
payments as well, for example by blocking all remittances to parent companies.

3. Governments of local countries may also implement anti-dumping regulations, under

which goods and services cannot be sold at prices lower than their cost of production.
The goal of such regulation is to eliminate unfair competition from foreign entities,
which potentially may, thanks to using low transfer prices, sell their products at prices
lower than those of competitors in order to gain market share. So, anti-dumping laws
are in fact means used by local governments to protect the local market. From the
perspective of multinational companies, anti-dumping regulations are thus a significant
restriction to adopting a fully flexible transfer pricing policy.

Ethical considerations:

The above examples of regulation indicate, that the perception of certain transfer pricing
practices by the governments of host countries may be negative. Indeed, application of
transfer pricing is subject to certain ethical issues. Among these, the most important is the
social responsibility of multinational companies, whose tax avoidance may be perceived as
contributing to poverty in underdeveloped economies. Thus, irresponsible transfer pricing
policies may be a source of bad publicity and reputational losses for the company.

The process of setting up a transfer pricing policy must, therefore, include not only an
analysis of the impact of the policy on financial performance, but also on the general wealth
of all stakeholder groups, including the societies of those foreign countries, in which the
group conducts its business.

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NOTE:

Certain countries, called tax havens, purposefully lower their taxes in order to attract foreign
investors. From the perspective of multinational companies, locating subsidiaries in tax
havens is an opportunity to reduce their overall tax liability. A tax haven may be described as
a country, where many foreign companies and financial institutions function, but there are
few or even no production operations. Accordingly, most subsidiaries of multinational
companies located in tax havens are intermediaries or entities involved in intra-group
lending operations.

Aside from low income tax rates, the typical features of a tax haven include:

– Low taxes on dividends paid to overseas entities,

– Low political risk,

– Lack of exchange controls,

– A high level of bank secrecy,

– Comprehensive tax agreements with other countries.

The most known tax havens located in Europe are:

 Luxembourg, Liechtenstein,

 The Channel Islands.

Examples of American tax havens are:

– Bahamas,

– The Cayman Islands.

43
 Professional Level – Options Module

Paper P4
P4 ACCA
Advanced Financial
Management
March/June 2018 – Sample
Questions

Time allowed: 3 hours 15 minutes

This question paper is divided into two sections:

The Association of
Section A – This ONE question is compulsory and
Chartered Certified
MUST be attempted Section B – TWO questions ONLY
Accountants
to be attempted

Formulae and tables are on pages 10–14.

Do NOT open this question paper until instructed by

the supervisor.

This question paper must not be removed from the

examination hall.

44
Section A – This question is compulsory and MUST be attempted

1 Chikepe Co is a large listed company operating in the pharmaceutical industry with a

current market value of equity

of $12,600 million and a debt to equity ratio of 30:70, in market value terms. Institutional
investors hold most of its equity shares. The company develops and manufactures
antibiotics and anti-viral medicines. Both the company and its products have an established
positive reputation among the medical profession, and its products are used widely.
However, its rate of innovation has slowed considerably in the last few years and it has
fewer new medical products coming into the market.

At a recent meeting of the board of directors (BoD), it was decided that the company
needed to change its current strategy of growing organically to one of acquiring companies,
in order to maintain the growth in its share price in the future. The members of the BoD had
different opinions on the type of acquisition strategy to pursue.

Director A was of the opinion that Chikepe Co should follow a strategy of acquiring
companies in different business sectors. She suggested that focusing on just the
pharmaceutical sector was too risky and acquiring companies in different business sectors
will reduce this risk.

Director B was of the opinion that Director A’s suggestion would not result in a reduction in
risk for shareholders. In fact, he suggested that this would result in agency related issues
with Chikepe Co’s shareholders reacting negatively and as a result, the company’s share
price would fall. Instead, Director B suggested that Chikepe Co should focus on its current
business and acquire other established pharmaceutical companies. In this way, the company
will gain synergy benefits and thereby increase value for its shareholders.

Director C agreed with Director B, but suggested that Chikepe Co should consider relatively
new pharmaceutical companies, as well as established businesses. In her opinion, newer
companies might be involved in research and development of innovative products, which
could have high potential in the future. She suggested that using real options methodology
with traditional investment appraisal methods such as net present value could help
establish a more accurate estimate of the potential value of such companies.

The company has asked its finance team to prepare a report on the value of a potential
target company, Foshoro Co, before making a final decision.

Foshoro Co

Foshoro Co is a non-listed pharmaceutical company established about 10 years ago. Initially

Foshoro Co grew rapidly, but this rate of growth slowed considerably three years ago, after
a venture capital equity backer exited the company by selling its stake back to the founding
directors. The directors had to raise substantial debt capital to buy back the equity stake.
The company’s current debt to equity ratio is 60:40. This high level of gearing means that

45
the company will find it difficult to obtain funds to develop its innovative products in the
future.

The following financial information relates to Foshoro Co: Extract from the most recent
statement of profit or loss

$ million
Sales revenue 878·1
Profit before interest and tax 192·3
Interest 78·6
Tax 22·7
Profit after tax 91·0

In arriving at the profit before interest and tax, Foshoro Co deducted tax allowable
depreciation and other non-cash expenses totalling $112·0 million. It requires a cash
investment of $98·2 million in non-current assets and working capital to continue its
operations at the current level.

Three years ago, Foshoro Co’s profit after tax was $83·3 million and this has been growing
steadily to their current level. Foshoro Co’s profit before interest and tax and its cash flows
grew at the same growth rate as well. It is likely that this growth rate will continue for the
foreseeable future if Foshoro Co is not acquired by Chikepe Co. Foshoro Co’s cost of capital
has been estimated at 10%.

Combined company: Chikepe Co and Foshoro Co

Once Chikepe Co acquires Foshoro Co, it is predicted that the combined company’s sales
revenue will be $4,200 million in the first year, and its operating profit margin on sales
revenue will be 20% for the foreseeable future.

46
After the first year, the sales revenue is expected to grow at 7% per year for the following
three years. It is anticipated that after the first four years, the growth rate of the combined
company’s free cash flows will be 5·6% per year.

The combined company’s tax allowable depreciation is expected to be equivalent to the

amount of investment needed to maintain the current level of operations. However, as the
company’s sales revenue increases over the four-year period, the combined company will
require an additional investment in assets of $200 million in the first year and then $0·64
per $1 increase in sales revenue for the next three years.

It can be assumed that the asset beta of the combined company is the weighted average of
the individual companies’ asset betas, weighted in proportion of the individual companies’
value of equity. It can also be assumed that the capital structure of the combined company
remains at Chikepe Co’s current capital structure level, a debt to equity ratio of 30:70.
Chikepe Co pays interest on borrowings at a rate of 5·3% per annum.

Chikepe Co estimates that it will be able to acquire Foshoro Co by paying a premium of 30%
above its estimated equity value to Foshoro Co’s shareholders.

Other financial information

Equity beta Asset beta

Chikepe Co 1·074 0·800

Foshoro Co 2·090 0·950

The current annual government borrowing base rate is 2% and the annual market risk
premium is estimated at 7%.

Both companies pay tax at an annual rate of 20%.

Chikepe Co estimates equity values in acquisitions using the free cash flow to firm method.

Future acquisitions

The BoD agreed that in the future it is likely that Chikepe Co will target both listed and non-
listed companies for acquisition. It is aware that when pursuing acquisitions of listed
companies, the company would need to ensure that it complied with regulations such as the
mandatory bid rule and the principle of equal treatment to protect shareholders. The BoD is
also aware that some listed companies may attempt to defend acquisitions by employing
anti-takeover measures such as poison pills and disposal of crown jewels.

Required:

(a) Compare and contrast the reasons for the opinions held by Director A and by Director
B, and discuss the types of synergy benefits which may arise from the acquisition strategy
suggested by Director B. (9 marks)

47
(b) Discuss how using real options methodology in conjunction with net present value
could help establish a more accurate estimate of the potential value of companies, as
suggested by Director C. (5 marks)

(c) Prepare a report for the board of directors of Chikepe Co which:

(i) Estimates the current equity value of Foshoro Co; (6 marks)

(ii) Estimates the equity value arising from combining Foshoro Co with Chikepe Co;
(11 marks)

(iii) Evaluates whether the acquisition of Foshoro Co would be beneficial to Chikepe

Co’s shareholders and discusses the limitations of the valuation method used in
(c)(i) and (c)(ii) above. (7 marks)

Professional marks will be awarded in part (c) for the format, structure and presentation
of the report. (4 marks)

(d) Discuss how the mandatory bid rule and the principle of equal treatment protects
shareholders in the event of their company facing a takeover bid, and discuss the
effectiveness of poison pills and disposal of crown jewels as defensive tactics against
hostile takeover bids. (8 marks) (50 marks)

48
Section B – TWO questions ONLY to be attempted

2 Tippletine Co is based in Valliland. It is listed on Valliland’s stock exchange but only

has a small number of shareholders. Its directors collectively own 45% of the equity share
capital.

Tippletine Co’s growth has been based on the manufacture of household electrical goods.
However, the directors have taken a strategic decision to diversify operations and to make a
major investment in facilities for the manufacture of office equipment.

Details of investment

The new investment is being appraised over a four-year time horizon. Revenues from the
new investment are uncertain and Tippletine Co’s finance director has prepared what she
regards as cautious forecasts. She predicts that it will generate $2 million operating cash
flows before marketing costs in Year 1 and $14·5 million operating cash flows before
marketing costs in Year 2, with operating cash flows rising by the expected levels of inflation
in Years 3 and 4.

Marketing costs are predicted to be $9 million in Year 1 and $2 million in each of Years 2 to
4.

The new investment will require immediate expenditure on facilities of $30·6 million. Tax
allowable depreciation will be available on the new investment at an annual rate of 25%
reducing balance basis. It can be assumed that there will either be a balancing allowance or
charge in the final year of the appraisal. The finance director believes the facilities will
remain viable after four years, and therefore a realisable value of $13·5 million can be
assumed at the end of the appraisal period.

The new facilities will also require an immediate initial investment in working capital of $3
million. Working capital requirements will increase by the rate of inflation for the next three
years and any working capital at the start of Year 4 will be assumed to be released at the
end of the appraisal period.

Tippletine Co pays tax at an annual rate of 30%. Tax is payable with a year’s time delay. Any
tax losses on the investment can be assumed to be carried forward and written off against
future profits from the investment.

Predicted inflation rates are as follows:

Year 1 2 3 4

8% 6% 5% 4%

49
Financing the investment

Tippletine Co has been considering two choices for financing all of the $30·6 million needed
for the initial investment in the facilities:

– A subsidised loan from a government loan scheme, with the loan repayable at the
end of the four years. Issue costs of 4% of the gross finance would be payable.
Interest would be payable at a rate of 30 basis points below the risk free rate of
2·5%. In order to obtain the benefits of the loan scheme, Tippletine Co would have to
fulfil various conditions, including locating the facilities in a remote part of Valliland
where unemployment is high.
– Convertible loan notes, with the subscribers for the notes including some of
Tippletine Co’s directors. The loan notes would have issue costs of 4% of the gross
finance. If not converted, the loan notes would be redeemed in six years’ time.
Interest would be payable at 5%, which is Tippletine Co’s normal cost of borrowing.
Conversion would take place at an effective price of $2·75 per share. However, the
loan note holders could enforce redemption at any time from the start of Year 3 if
Tippletine Co’s share price fell below $1·50 per share. Tippletine Co’s current share
price is $2·20 per share.

Issue costs for the subsidised loan and convertible loan notes would be paid out of available
cash reserves. Issue costs are not allowable as a tax-deductible expense.

In initial discussions, the majority of the board favoured using the subsidised loan. The
appraisal of the investment should be prepared on the basis that this method of finance will
be used. However, the chairman argued strongly in favour of the convertible loan notes, as,
in his view, operating costs will be lower if Tippletine Co does not have to fulfil the
conditions laid down by the government of Valliland. Tippletine Co’s finance director is
sceptical, however, about whether the other shareholders would approve the issue of
convertible loan notes on the terms suggested. The directors will decide which method of
finance to use at the next board meeting.

Other information

Humabuz Co is a large manufacturer of office equipment in Valliland. Humabuz Co’s geared

cost of equity is estimated to be 10·5% and its pre-tax cost of debt to be 5·4%. These
estimates are based on a capital structure comprising $225 million 6% irredeemable bonds,
trading at $107 per $100, and 125 million $1 equity shares, trading at $3·20 per share.
Humabuz Co also pays tax at an annual rate of 30% on its taxable profits.

Required:

(a) Calculate the adjusted present value for the investment on the basis that it is
financed by the subsidised loan and conclude whether the project should be
accepted or not. Show all relevant calculations. (17 marks)

50
 (b) Discuss the issues which Tippletine Co’s shareholders who are not directors would
consider if its directors decided that the new investment should be financed by the
issue of convertible loan notes on the terms suggested.

Note: You are not required to carry out any calculations when answering part (8 marks)

(25 marks)

51
3 Arthuro Co group

Arthuro Co is based in Hittyland and is listed on Hittyland’s stock exchange. Arthuro Co has
one wholly-owned subsidiary, Bowerscots Co, based in the neighbouring country of Owlia.
Hittyland and Owlia are in a currency union and the currency of both countries is the $.

Arthuro Co purchased 100% of Bowerscots Co’s share capital three years ago. Arthuro Co
has the power under the acquisition to determine the level of dividend paid by Bowerscots
Co. However, Arthuro Co’s board decided to let Bowerscots Co’s management team have
some discretion when making investment decisions. Arthuro Co’s board decided that it
should receive dividends of 60% of Bowerscots Co’s post-tax profits and has allowed
Bowerscots Co to use its remaining retained earnings to fund investments chosen by its
management. A bonus linked to Bowerscots Co’s after-tax profits is a significant element of
Bowerscots Co’s managers’ remuneration.

Bowerscots Co operates in a very competitive environment. Recently, a senior member of

its management team has left to join a competitor.

Arthuro Co’s dividend policy

Until three months ago, Arthuro Co had 90 million $2 equity shares in issue and $135 million
8% bonds. Three months ago it made a 1 for 3 rights issue. A number of shareholders did
not take up their rights, but sold them on, so there have been changes in its shareholder
base. Some shareholders expressed concern about dilution of their dividend income as a
result of the rights issue. Therefore, Arthuro Co’s board felt it had to promise, for the
foreseeable future, at least to maintain the dividend of $0·74 per equity share, which it paid
for the two years before the rights issue.

Arthuro Co’s board is nevertheless concerned about whether it will have sufficient funds
available to fulfil its promise about the dividend. It has asked the finance director to forecast
its dividend capacity based on assumptions about what will happen in a ‘normal’ year. The
finance director has made the following assumptions in the forecast:

1. Sales revenue can be assumed to be 4% greater than the most recent year’s of $520
million.

2. The operating profit margin can be assumed to be 20%.

3. Operating profit can be assumed to be reported after charging depreciation of $30

million and profit on disposal of non-current assets of $5·9 million. The cost of the
non-current assets sold can be assumed to be $35 million and its accumulated
depreciation to be $24·6 million. Depreciation is allowable for tax and the profit on
disposal is fully chargeable to tax.

4. The net book value of non-current assets at the year end in the most recent
accounts was $110 million. To maintain productive capacity, sufficient investment

52
 to increase this net book value figure 12 months later by 4% should be assumed, in
line with the increase in sales. The calculation of investment required for the year
should take into account the depreciation charged of $30 million, and net book
value of the non-current assets disposed of during the year.

5. A $0·15 investment in working capital can be assumed for every $1 increase in sales
revenue.

6. Bowerscots Co’s pre-tax profits can be assumed to be $45 million.

Arthuro Co’s directors have decided that if there is a shortfall of dividend capacity,
compared with the dividends required to maintain the current dividend level, the
percentage of post-tax profits of Bowerscots Co paid as dividend should increase, if
necessary up to 100%.

Taxation

Arthuro Co pays corporation tax at 30% and Bowerscots Co pays corporation tax at 20%. A
withholding tax of 5% is deducted from any dividends remitted by Bowerscots Co. There is a
bilateral tax treaty between Hittyland and Owlia. Corporation tax is payable by Arthuro Co
on profits declared by Bowerscots Co, but Hittyland gives full credit for corporation tax
already paid in Owlia. Hittyland gives no credit for withholding tax paid on dividends in
Owlia.

Required:

(a) (i) Estimate Arthuro Co’s forecast dividend capacity for a ‘normal’ year; (11 marks)

(ii) Estimate the level of dividend required from Bowerscots Co to give Arthuro Co
sufficient dividend capacity to maintain its dividend level of $0·74 per equity share.
(3 marks)

53
(b) Arthuro Co has decided to increase its level of dividend from Bowerscots Co if its
dividend capacity is insufficient.

Required:

I. From Arthuro Co’s viewpoint, discuss the financial benefits of, and problems with,
this decision; (5 marks)
II. Discuss the agency problems, and how they might be resolved, with this decision.
(6 marks)

(25 marks)

54
4 The Adverane Group is a multinational
group of companies with its headquarters in
Switzerland. The Adverane Group consists of a number of fully-owned subsidiaries and Elted
Co, an associate company based in the USA in which Adverane Group owns 30% of the
ordinary equity share capital. Balances owing between the parent, Adverane Co, and its
subsidiaries and between subsidiaries are settled by multilateral netting. Transactions
between the parent and Elted Co are settled separately.

Transactions with Elted Co

Adverane Co wishes to hedge transactions with Elted Co which are due to be settled in four
months’ time in US$. Adverane Co will owe Elted Co US$3·7 million for a major purchase of
supplies and Elted Co will owe Adverane Co US$10·15 million for non-current assets.
Adverane Group’s treasury department is considering whether to use money markets or
exchange-traded currency futures for hedging.

Annual interest rates available to Adverane Co

Investing rate Borrowing rate

Switzerland 2·7% 3·9%

USA 2·5% 3·7%

Exchange traded currency futures

Contract size CHF125,000, price quotation US$ per CHF1

Three-month expiry: 1·1213

Six-month expiry: 1·1204

Netting

The balances owed to and owed by members of Adverane Group when netting is to take
place are as follows:

55
Owed by Owed to
Local currency

Adverane (Switzerland) Bosha (Eurozone) CHF15·90

Adverane (Switzerland) Diling (Brazil) CHF4·46

Bosha (Eurozone) Cogate (USA) €24·89

Bosha (Eurozone) Diling (Brazil) €18·57

Cogate (USA) Adverane (Switzerland) US$27·08

Cogate (USA) Diling (Brazil) US$5·68

Diling (Brazil) Adverane (Switzerland) BRL38·80

Diling (Brazil) Bosha (Eurozone) BRL51·20

Spot rates are currently as follows:

CHF € US$ BRL

1 CHF = 1·0000 0·9347–0·9369 1·1196–1·1222 3·1378–3·1760

The group members will make settlement in Swiss francs. Spot mid-rates will be used in
calculations. Settlement will be made in the order that the company owing the largest net
amount in Swiss francs will first settle with the company owed the smallest net amount in
Swiss francs.

Transfer price arrangements

The Adverane Group board has been reviewing the valuation of inter-group transactions, as
it is concerned that the current system is not working well. Currently inter-group transfer
prices are mostly based on fixed cost plus a mark-up negotiated by the buying and selling
divisions. If they cannot agree a price, either the sale does not take place or the central
treasury department determines the margin. The board has the following concerns:

– Both selling and buying divisions have claimed that prices are unfair and distort the
measurement of their performance.

– Significant treasury department time is being taken up dealing with disputes and
then dealing with complaints that the price it has imposed is unfair on one or the other
division.

– Some parts of the group are choosing to buy from external suppliers rather than
from suppliers within the group.

56
As a result of the review, the Adverane Group
board has decided that transfer prices should in
future be based on market prices, where an external market exists.

Note: CHF is Swiss Franc, 3 is Euro, US$ is United States dollar and BRL is Brazilian Real.
Required:

(a) Advise Adverane Co on, and recommend, an appropriate hedging strategy for the
US$ cash flows it is due to receive from, or pay to, Elted Co. (9 marks)

(b) (i) Calculate the inter-group transfers which are forecast to take place. (7 marks)

(ii) Discuss the advantages of multilateral netting by a central treasury function within the
Adverane Group. (3 marks)

(c) Evaluate the extent to which changing to a market-price system of transfer pricing
will resolve the concerns of the Adverane Group board. (6 marks)

(25 marks)

57
58
59
 Present Value Table
Present value of an annuity of 1 i.e. 1 – (1 + r)–n
Where r = discount rate
n = number of periods
Discount rate (r)
Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
(n)
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

(n) 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 0-195 178 0-162 0-148 0-135 11
12 0-286 0-257 0-231 0-208 187 0-168 152 0-137 0-124 0-112 12
13 0-258 0-229 0-204 0-182 163 0-145 130 0-116 0-104 0-093 13
14 0-232 0-205 181 0-160 141 0-125 111 0-099 88 0-078 14
15 0-209 0-183 160 0-140 123 0-108 95 0-084 0-074 0-065 15

60
 Annuity Table
Present value of an annuity of 1 i.e. 1 – (1 + r)–n/r
Where r = discount rate
n = number of periods
Discount rate (r)
Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
(n)
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 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15

(n) 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 3·784 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

61
 Standard normal distribution table
0·00 0·01 0·02 0·03 0·04 0·05 0·06 0·07 0·08 0·09
0·0 0·0000 0·0040 0·0080 0·0120 0·0160 0·0199 0·0239 0·0279 0·0319 0·0359
0·1 0·0398 0·0438 0·0478 0·0517 0·0557 0·0596 0·0636 0·0675 0·0714 0·0753
0·2 0·0793 0·0832 0·0871 0·0910 0·0948 0·0987 0·1026 0·1064 0·1103 0·1141
0·3 0·1179 0·1217 0·1255 0·1293 0·1331 0·1368 0·1406 0·1443 0·1480 0·1517
0·4 0·1554 0·1591 0·1628 0·1664 0·1700 0·1736 0·1772 0·1808 0·1844 0·1879
0·5 0·1915 0·1950 0·1985 0·2019 0·2054 0·2088 0·2123 0·2157 0·2190 0·2224
0·6 0·2257 0·2291 0·2324 0·2357 0·2389 0·2422 0·2454 0·2486 0·2517 0·2549
0·7 0·2580 0·2611 0·2642 0·2673 0·2704 0·2734 0·2764 0·2794 0·2823 0·2852
0·8 0·2881 0·2910 0·2939 0·2967 0·2995 0·3023 0·3051 0·3078 0·3106 0·3133
0·9 0·3159 0·3186 0·3212 0·3238 0·3264 0·3289 0·3315 0·3340 0·3365 0·3389
1·0 0·3413 0·3438 0·3461 0·3485 0·3508 0·3531 0·3554 0·3577 0·3599 0·3621
1·1 0·3643 0·3665 0·3686 0·3708 0·3729 0·3749 0·3770 0·3790 0·3810 0·3830
1·2 0·3849 0·3869 0·3888 0·3907 0·3925 0·3944 0·3962 0·3980 0·3997 0·4015
1·3 0·4032 0·4049 0·4066 0·4082 0·4099 0·4115 0·4131 0·4147 0·4162 0·4177
1·4 0·4192 0·4207 0·4222 0·4236 0·4251 0·4265 0·4279 0·4292 0·4306 0·4319
1·5 0·4332 0·4345 0·4357 0·4370 0·4382 0·4394 0·4406 0·4418 0·4429 0·4441
1·6 0·4452 0·4463 0·4474 0·4484 0·4495 0·4505 0·4515 0·4525 0·4535 0·4545
1·7 0·4554 0·4564 0·4573 0·4582 0·4591 0·4599 0·4608 0·4616 0·4625 0·4633
1·8 0·4641 0·4649 0·4656 0·4664 0·4671 0·4678 0·4686 0·4693 0·4699 0·4706
1·9 0·4713 0·4719 0·4726 0·4732 0·4738 0·4744 0·4750 0·4756 0·4761 0·4767
2·0 0·4772 0·4778 0·4783 0·4788 0·4793 0·4798 0·4803 0·4808 0·4812 0·4817
2·1 0·4821 0·4826 0·4830 0·4834 0·4838 0·4842 0·4846 0·4850 0·4854 0·4857
2·2 0·4861 0·4864 0·4868 0·4871 0·4875 0·4878 0·4881 0·4884 0·4887 0·4890
2·3 0·4893 0·4896 0·4898 0·4901 0·4904 0·4906 0·4909 0·4911 0·4913 0·4916
2·4 0·4918 0·4920 0·4922 0·4925 0·4927 0·4929 0·4931 0·4932 0·4934 0·4936
2·5 0·4938 0·4940 0·4941 0·4943 0·4945 0·4946 0·4948 0·4949 0·4951 0·4952
2·6 0·4953 0·4955 0·4956 0·4957 0·4959 0·4960 0·4961 0·4962 0·4963 0·4964
2·7 0·4965 0·4966 0·4967 0·4968 0·4969 0·4970 0·4971 0·4972 0·4973 0·4974
2·8 0·4974 0·4975 0·4976 0·4977 0·4977 0·4978 0·4979 0·4979 0·4980 0·4981
2·9 0·4981 0·4982 0·4982 0·4983 0·4984 0·4984 0·4985 0·4985 0·4986 0·4986
3·0 0·4987 0·4987 0·4987 0·4988 0·4988 0·4989 0·4989 0·4989 0·4990 0·4990
This table can be used to calculate N(d), the cumulative normal distribution functions needed for the Black-Scholes
model of option pricing. If di > 0, add 0·5 to the relevant number above. If di < 0, subtract the relevant number above
from 0·5.

62