ACCA AFM — Advanced Financial Management Practice Exam 1

SECTION A - STRATEGIC CASE STUDY

This question is worth 50 marks.

AeroVentis Co is a European-based multinational manufacturer of advanced composite blades for offshore wind turbines. The board of directors is seeking to expand its technological capabilities and is considering the acquisition of GaleTech Inc, a US-based startup specializing in AI-driven predictive maintenance software for wind farms. GaleTech is currently unlisted, but its founders are considering an IPO if a suitable trade sale is not achieved.

AeroVentis plans to acquire 100% of GaleTech's equity. The acquisition will be financed entirely by a new issue of €400 million in 8% loan notes by AeroVentis, which will significantly alter AeroVentis's capital structure.

Exhibit 1: GaleTech Inc Financial Projections (in $ millions)
Year 1: Operating Profit (EBIT) = $45m
Year 2: Operating Profit (EBIT) = $58m
Year 3: Operating Profit (EBIT) = $72m
Year 4: Operating Profit (EBIT) = $85m

After Year 4, free cash flows to the firm are expected to grow at a constant rate of 3% per annum in perpetuity.
Tax depreciation is equal to the annual capital investment needed to maintain operations. However, to achieve the projected growth, GaleTech will require an additional net working capital injection of $5m in Year 1 and $8m in Year 2.
GaleTech currently has $50m of 6% debt outstanding, which will be paid off immediately upon acquisition using part of the acquisition funds.

Exhibit 2: Market and Economic Data

• Current spot exchange rate: $1.15 / €1
• Expected inflation rates: US = 2.5% p.a., Eurozone = 1.8% p.a.
• AeroVentis's current cost of equity is 11%, and its after-tax cost of debt is 4.5%.
• The risk-free rate is 3% and the equity risk premium is 6%.
• GaleTech's asset beta is estimated to be 1.40.
• Corporate tax rate in both jurisdictions is 25%.

Exhibit 3: Synergies and Financing Costs
AeroVentis expects to generate post-tax operational synergies of €12 million per year, starting in Year 2 and continuing indefinitely.
The issue costs for the new €400 million loan notes will be 2% of the gross sum raised. These issue costs are not tax-deductible.

REQUIREMENTS:

Write a report to the Board of Directors of AeroVentis Co that covers the following:

(a) Estimate the base case present value of GaleTech Inc in Euros (€) using the Free Cash Flow to Firm (FCFF) method, discounting at an appropriate risk-adjusted rate. (14 marks)

(b) Calculate the Adjusted Present Value (APV) of the acquisition of GaleTech Inc, incorporating the financial side effects of the new debt issue and the expected synergies. Conclude on whether the acquisition is financially viable if the asking price is €380 million. (16 marks)

(c) Discuss the key assumptions and limitations inherent in your APV calculation, particularly focusing on the challenges of cross-border valuations and forecasting AI-tech startup cash flows. (10 marks)

(d) Advise the board on the strategic rationale for acquiring an AI software firm rather than developing the technology in-house, and discuss two defense tactics GaleTech's founders might employ if they view AeroVentis's bid as hostile. (6 marks)

Professional marks will be awarded for the format, structure, and clarity of the report. (4 marks)

SECTION B - ADVISORY REPORT

This question is worth 25 marks.

FerrumForge PLC is a heavy steel manufacturing company. The board has recently approved the construction of a new, highly efficient blast furnace. To fund this, FerrumForge will need to borrow $50 million in exactly 6 months' time. The loan will be for a duration of 4 years.

The company's treasury team is highly concerned about the current macroeconomic environment, which suggests that interest rates will rise significantly over the next 6 months. FerrumForge can currently borrow at SOFR + 1.5%. The current SOFR is 4.2%.

The treasury team is considering two hedging strategies:
Strategy 1: An Interest Rate Swap.
Strategy 2: An Interest Rate Collar using Options on Interest Rate Futures.

Exhibit 1: Interest Rate Swap Market
FerrumForge's bank has offered a 4-year interest rate swap starting in 6 months.
The bank's swap quote is: Pay Fixed 4.8% / Receive SOFR.

Exhibit 2: Options on Interest Rate Futures
Standard contract size is $1,000,000. Tick size is 0.01% and tick value is $25.
Options expire in exactly 6 months.
Current futures price for the relevant contract is 95.50.

Strike Price | Call Premium (annualised %) | Put Premium (annualised %)
95.00 | 0.42 | 0.18
95.50 | 0.28 | 0.28
96.00 | 0.15 | 0.45

Assume that in 6 months' time, SOFR has risen to 5.5%, and the futures price has moved to 94.50.

REQUIREMENTS:

(a) Calculate the effective annual interest rate that FerrumForge will pay under BOTH Strategy 1 (Interest Rate Swap) and Strategy 2 (Interest Rate Collar, assuming the company wishes to cap its borrowing rate using the 95.00 strike and floor it using the 96.00 strike). Recommend the most appropriate strategy based on your calculations. (15 marks)

(b) Discuss the advantages and disadvantages of using Over-The-Counter (OTC) derivatives (such as the proposed interest rate swap) compared to exchange-traded derivatives (such as futures and options) for a heavy manufacturing firm like FerrumForge. (10 marks)

SECTION B - ADVISORY REPORT

This question is worth 25 marks.

AgriLogix Group is a diversified agricultural logistics and warehousing conglomerate. Over the past two years, the company has faced severe liquidity issues, primarily driven by its failing cold-storage division, which has suffered from outdated technology and loss of key contracts. The company is currently in breach of its debt covenants and faces the threat of immediate liquidation by its bondholders.

The Board of Directors has proposed a financial reconstruction scheme to save the viable parts of the business (the dry-bulk logistics division) and avoid liquidation.

Exhibit 1: Current Statement of Financial Position (Extracts, $ millions)
Assets:
Non-current assets (Dry-bulk): 120
Non-current assets (Cold-storage): 40
Current assets: 30
Total Assets: 190

Equity and Liabilities:
Ordinary Share Capital ($1 shares): 50
Retained Earnings: (20)
8% Secured Bonds: 100
Current Liabilities: 60
Total Equity and Liabilities: 190

Exhibit 2: Proposed Reconstruction Scheme

1. The cold-storage division will be spun off into a separate entity and sold to a private equity firm for $25 million in cash. This cash will be used immediately to pay down current liabilities.
2. The 8% Secured Bondholders are asked to accept a debt-for-equity swap. They will exchange $40 million of their bonds for 60 million newly issued ordinary shares in AgriLogix Group. The remaining $60 million of bonds will have their interest rate increased to 9% to compensate for the increased risk.
3. Existing shareholders will retain their 50 million shares but will suffer dilution.

Exhibit 3: Post-Reconstruction Valuation and Liquidation
If the reconstruction is successful, the remaining dry-bulk division is expected to generate a sustainable annual Free Cash Flow to Firm (FCFF) of $12 million indefinitely. The company's post-reconstruction Weighted Average Cost of Capital (WACC) is estimated to be 10%.

If the company is forced into liquidation today, the estimated realizable values are:

• Dry-bulk assets: $70 million
• Cold-storage assets: $15 million
• Current assets: $20 million
  Liquidation costs would amount to $5 million. Secured bondholders have first charge over all non-current assets.

REQUIREMENTS:

(a) Evaluate the financial impact of the proposed reconstruction scheme on both the existing shareholders and the 8% Secured Bondholders. Your evaluation must include a comparison of the value of their investments under the reconstruction scheme versus the immediate liquidation scenario. (14 marks)

(b) Discuss the strategic implications of spinning off the cold-storage division, and evaluate whether a Management Buyout (MBO) of the cold-storage division might have been a viable alternative to the private equity sale. (11 marks)