ACCA AFM — Advanced Financial Management Practice Exam 3

SECTION A: STRATEGIC CASE STUDY

This question is based on the Renewable Energy and Public Utility sector.

AuraGrid PLC is a large, publicly listed European utility company transitioning aggressively toward renewable energy. The Board of Directors is considering the acquisition of Solarix Inc, a US-based solar technology firm that holds patents for next-generation photovoltaic cells. Solarix has struggled recently due to heavy debt burdens and supply chain disruptions, making it a prime target for a turnaround acquisition.

AuraGrid's functional currency is the US Dollar ($) for its international operations.

Exhibit 1: Acquisition and Valuation Data
AuraGrid plans to acquire 100% of Solarix's equity. The initial investment required to purchase the equity and upgrade the facilities is $400 million.
The present value (PV) of the expected free cash flows from Solarix, discounted at AuraGrid's ungeared cost of equity of 10%, is estimated to be $380 million.
To fund the $400 million investment, AuraGrid will raise $200 million in new debt at a pre-tax cost of 6%. The remaining $200 million will be funded from existing cash reserves.
Issue costs for the new debt are 2% of the gross finance required and are not tax-deductible.
The corporate tax rate is 25%. AuraGrid expects to maintain this debt level in perpetuity.

Exhibit 2: Corporate Reconstruction of Solarix
Prior to the acquisition finalizing, Solarix must undergo a capital reconstruction. Solarix currently has $300 million in 8% unsecured bonds outstanding, which are trading at $70 per $100 nominal value due to default risk. AuraGrid proposes a debt-for-equity swap where bondholders will receive 40 shares in the newly reconstructed Solarix for every $100 of nominal debt. The estimated post-reconstruction share price of Solarix is expected to be $2.10.

Exhibit 3: Strategic Integration
The Board is divided on the acquisition. The CEO believes the patented technology will create immense synergy, while the CFO is concerned about the regulatory risks of a European state-backed utility acquiring a US technology firm, as well as the cultural clash between a traditional utility and an agile tech startup.

Requirements:
Write a report to the Board of Directors of AuraGrid PLC that covers the following:

(a) Calculate the Adjusted Present Value (APV) of the Solarix acquisition and advise whether it is financially viable based purely on this metric. (18 marks)

(b) Evaluate the proposed debt-for-equity swap from the perspective of Solarix's existing bondholders. Include calculations to support your evaluation. (12 marks)

(c) Discuss the strategic rationale for the acquisition, highlighting the potential synergies, regulatory risks, and post-acquisition integration challenges. (16 marks)

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

SECTION B: ADVISORY REPORT

This question is based on the Heavy Manufacturing and Aerospace sector.

AeroForge Ltd is a specialized manufacturer of aerospace components. The company has recently secured a major contract to supply landing gear for a new commercial airliner. To finance the expansion of its manufacturing plant, AeroForge will take out a $50 million loan in exactly 6 months' time. The loan will be for a period of 5 years, with interest payable annually at a floating rate of SOFR + 1.8%.

The current Secured Overnight Financing Rate (SOFR) is 4.0%. The Treasury team at AeroForge is highly concerned that interest rates will rise over the next 6 months, severely impacting the profitability of the new contract.

The company's bank has offered the following hedging instruments:

1. Interest Rate Swap:
   AeroForge can enter into a swap starting in 6 months. The bank is quoting a swap rate where AeroForge pays a fixed rate of 4.5% and receives SOFR.

2. Interest Rate Options (Collar):
   AeroForge can purchase an interest rate cap at a strike rate of 4.8% for a premium of 0.6% (payable upfront). To offset this cost, AeroForge can sell an interest rate floor at a strike rate of 3.5% for a premium of 0.4% (receivable upfront).

Assume that in 6 months' time, SOFR could either rise to 5.5% or fall to 3.0%.

Requirements:
(a) Calculate the effective annual interest rate that AeroForge will pay under BOTH the Interest Rate Swap and the Interest Rate Collar, under the two scenarios where SOFR in 6 months is 5.5% and 3.0%. (15 marks)

(b) Discuss the advantages and disadvantages of using an Interest Rate Collar compared to a Swap in this scenario. Furthermore, briefly discuss whether AeroForge's treasury department should operate as a cost center or a profit center. (10 marks)

SECTION B: ADVISORY REPORT

This question is based on the Agri-Tech and Agriculture sector.

Ceres Yields Co is a multinational agricultural technology company based in the UK (functional currency GBP). The company has developed a revolutionary drought-resistant seed and is planning a major expansion into Brazil.

The initial capital investment required to build the processing facility in Brazil is $25 million (USD). Based on traditional Net Present Value (NPV) calculations, the present value of the expected future cash flows from the Brazilian project is currently estimated at $22 million (USD), resulting in a negative NPV of -$3 million.

However, the Board of Directors has the exclusive right to delay the investment for up to 2 years. The agricultural market in South America is highly volatile. The standard deviation of the project's returns (volatility) is estimated at 35% per year. The continuous risk-free interest rate is 4% per year.

Additionally, Ceres Yields Co will eventually need to convert its GBP reserves into USD to fund the $25 million investment if it proceeds. The Treasury team is considering using Over-The-Counter (OTC) currency options or exchange-traded currency futures to hedge this future FX exposure.

Requirements:
(a) Using the Black-Scholes Option Pricing Model, calculate the value of the real option to delay the investment for 2 years. Conclude whether Ceres Yields Co should abandon the project now or hold the option to delay. (15 marks)

(b) Advise the Treasury team on the key differences between using OTC currency options versus exchange-traded currency futures to hedge the GBP/USD exchange rate risk for this specific project. (10 marks)

Note:
d1 = [ln(Pa/Pe) + (r + 0.5s^2)t] / (s * sqrt(t))
d2 = d1 - s * sqrt(t)
N(d) values can be interpolated from standard normal distribution tables.