ACCA AFM — Advanced Financial Management Practice Exam 6

SECTION A: STRATEGIC CASE STUDY

This question is worth 50 marks.

Scenario:
AquaGrid PLC is a large, publicly listed utility company traditionally focused on regional water treatment and distribution. Facing stringent regulatory price caps and a mandate to achieve net-zero emissions, AquaGrid's Board has decided on a major corporate restructuring. The strategy involves acquiring 'HydroTech Innovations', an unlisted startup specializing in AI-driven smart-metering and desalination technology, while simultaneously divesting AquaGrid's legacy, carbon-intensive 'WasteCo' division.

You are a senior financial adviser reporting to the Board of Directors of AquaGrid PLC.

Exhibit 1: Acquisition of HydroTech Innovations
HydroTech is currently owned by its founders and a venture capital syndicate. AquaGrid plans to acquire 100% of HydroTech's equity.
HydroTech's projected Free Cash Flows to the Firm (FCFF) for the next four years are as follows:
Year 1: $12.0m
Year 2: $15.5m
Year 3: $22.0m
Year 4: $28.0m
After Year 4, FCFF is expected to grow at a constant rate of 3% per annum into perpetuity.

Financial data for HydroTech:

• Equity beta of a suitable proxy listed company in the smart-tech sector: 1.40
• Proxy company's debt-to-equity ratio (market value): 20:80
• HydroTech's target debt-to-equity ratio post-acquisition: 30:70
• Risk-free rate: 4.0%
• Market risk premium: 6.0%
• Corporate tax rate: 25%

AquaGrid expects post-tax operational synergies of $5m per annum, commencing in Year 2 and growing at 2% per annum into perpetuity.

Exhibit 2: Divestment of WasteCo
The Board is considering two options for divesting WasteCo:
Option 1: A Management Buy-Out (MBO). The current management team has secured private equity backing and offered a flat $150m in cash, payable immediately. The MBO would take 3 months to complete.
Option 2: A public spin-off (demerger). Investment bankers estimate WasteCo's standalone market capitalization would be $175m. However, the spin-off will incur $18m in underwriting, legal, and advisory fees. It will take 12 months to complete, during which WasteCo is expected to generate $8m in net cash flows for AquaGrid.

Exhibit 3: Financing the Restructuring
AquaGrid requires $300m to fund the HydroTech acquisition and upgrade its remaining infrastructure. The Board is debating between:

• A 10-year corporate bond issue at a fixed coupon of 6.5%.
• A 1-for-5 rights issue at a 15% discount to the current share price of $4.50.
  AquaGrid's current credit rating is A-. The Board is concerned about the impact of the bond issue on its credit rating and its Weighted Average Cost of Capital (WACC).

Requirements:
Write a report to the Board of Directors of AquaGrid PLC which:

(a) Estimates the maximum price AquaGrid should pay for the equity of HydroTech Innovations. Your analysis must include the calculation of an appropriate risk-adjusted discount rate, the valuation of HydroTech's base cash flows, and the valuation of the expected synergies. (20 marks)

(b) Evaluates the two divestment options for WasteCo (MBO vs. Spin-off), recommending the most appropriate strategy from both a financial and strategic perspective. (12 marks)

(c) Discusses the potential impact of the two financing options (bond issue vs. rights issue) on AquaGrid's WACC, gearing, and credit rating, advising the Board on the preferred method. (10 marks)

(d) Professional Skills marks will be awarded for the format, structure, tone, commercial acumen, and clarity of the report. (8 marks)

SECTION B: ADVISORY REPORT

This question is worth 25 marks.

Scenario:
Ceres Global Agri (Ceres) is a multinational agricultural cooperative based in the Eurozone, specializing in the export of high-yield crop seeds and the import of specialized farming machinery. Ceres operates a centralized treasury department.

Ceres has recently secured a major contract in Brazil and expects a receipt of BRL 50 million in exactly six months. The treasury team is concerned about the depreciation of the Brazilian Real (BRL) against the Euro (EUR).

Separately, Ceres has just drawn down a USD 20 million floating-rate loan to finance a new logistics hub in the United States. The interest is payable semi-annually at SOFR + 200 basis points (2.0%). The current SOFR is 4.0%, but the treasury team fears US interest rates will rise sharply over the next year.

Exhibit 1: Foreign Exchange Data (EUR/BRL)
Spot rate: BRL 5.2010 - 5.2550 per EUR
Six-month forward rate: BRL 5.3520 - 5.4240 per EUR

Over-the-counter (OTC) Currency Options (European style, maturity in 6 months):

• Option to sell BRL (Put BRL / Call EUR): Strike Price BRL 5.3000 / EUR. Premium: EUR 0.015 per BRL 100.
• Option to buy BRL (Call BRL / Put EUR): Strike Price BRL 5.3000 / EUR. Premium: EUR 0.018 per BRL 100.

Exhibit 2: Interest Rate Hedging Data
Ceres's bank has offered two hedging instruments for the USD 20 million loan for the next 12 months:
Instrument 1: An Interest Rate Swap where Ceres pays a fixed rate of 4.8% and receives SOFR.
Instrument 2: An Interest Rate Cap on SOFR with a strike rate of 4.5%. The premium for the cap is 0.4% of the principal amount, payable upfront.

Requirements:
(a) Evaluate the two hedging strategies for the BRL 50 million receipt (Forward Market Hedge vs. Currency Options). Calculate the net Euro receipts under both methods, assuming the spot rate in six months is BRL 5.5000 / EUR. Recommend the most appropriate strategy. (12 marks)

(b) Advise Ceres on hedging the USD 20 million floating-rate loan. Calculate the effective annual interest cost (in USD) under both the Interest Rate Swap and the Interest Rate Cap, assuming SOFR rises to 5.5% in six months and remains there for the rest of the year. (8 marks)

(c) Discuss the advantages and potential drawbacks of Ceres operating a centralized treasury department to manage these global financial risks. (5 marks)

SECTION B: ADVISORY REPORT

This question is worth 25 marks.

Scenario:
Global Health Logistics (GHL) is a UK-based specialized logistics firm contracted by international NGOs to deliver medical supplies. GHL is evaluating a major Foreign Direct Investment (FDI) to establish a regional distribution hub in 'Zamboria', a developing nation with a volatile political landscape. The local currency is the Zamborian Real (ZAR).

The initial investment required immediately (Year 0) is ZAR 500 million.

Exhibit 1: Base Case Project Data
The expected net operating cash flows in Zamboria are:
Year 1: ZAR 150 million
Year 2: ZAR 200 million
Year 3: ZAR 250 million
Year 4: ZAR 100 million
At the end of Year 4, the project will be handed over to the Zamborian government for zero terminal value.

Economic Data:

• Current spot exchange rate: ZAR 20.00 / GBP
• Annual inflation in Zamboria is expected to be 8.0%.
• Annual inflation in the UK is expected to be 3.0%.
• GHL's UK-based nominal Weighted Average Cost of Capital (WACC) is 10.0%.

Exhibit 2: Real Option to Expand
If the initial hub is successful, GHL has the exclusive right to expand operations into neighboring regions at the end of Year 3. This expansion would require a further capital outlay of ZAR 300 million at Year 3.
The present value (at Year 0) of the expected cash flows from this expansion is estimated to be ZAR 180 million.
The volatility (standard deviation) of the expansion project's returns is estimated at 30% per annum. The UK risk-free rate of interest is 5.0% per annum continuously compounded.

Requirements:
(a) Calculate the base case Net Present Value (NPV) of the Zamborian project in GBP. You must use the Purchasing Power Parity (PPP) theory to forecast the ZAR/GBP exchange rates for Years 1 to 4. (10 marks)

(b) Using the Black-Scholes Option Pricing (BSOP) model, estimate the value of the real option to expand in GBP. Calculate the overall Adjusted Present Value (Strategic NPV) of the investment.
(Note: Assume the ZAR/GBP exchange rate at Year 3 calculated in part (a) applies to the option variables). (10 marks)

(c) Discuss the specific political risks GHL faces by investing in Zamboria and recommend three strategies GHL could employ to mitigate these risks. (5 marks)