Question 1

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.

Accepted Answer

Step 1: Identify the Black-Scholes variables from the text. Pa is the PV of cash flows, Pe is the investment cost. Step 2: Carefully calculate d1 and d2, paying attention to the order of operations and natural logs. Step 3: Look up the normal distribution values (remember to add 0.5 for positive d values, subtract from 0.5 for negative). Step 4: Plug into the final formula. Step 5: For part B, link the hedging advice directly to the fact that the project is uncertain (it's an option). Options are best for uncertain cash flows; futures are for certain cash flows.

Question 2

What mistakes do candidates make on this ACCA question?

Accepted Answer

Students often mess up the math in the d1 formula, specifically forgetting to square the volatility before multiplying by 0.5. In part B, students often list generic differences between options and futures without applying it to the specific scenario (the fact that the project might be abandoned).

How to approach this question

Full Answer

Common mistakes

Practice the full ACCA AFM — Advanced Financial Management Practice Exam 3

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