Treasury management

FM – L2 – Q122 – Business valuations

Calculate pre-acquisition market values of Clearfield Farms and Village Industries using Gordon’s growth model.

Question

Clearfield Farms Limited is considering acquiring Village Industries Limited, extracts of the financial statement of the two companies is as follows:

Statement of Financial Position

	Clearfield Farms Ltd GH¢’m	Village Industries GH¢’m
Net assets	6,300	1,892
Equity:
Ordinary share capital	2,000	1,000
Retained earnings	4,300	892
	6,300	1,892

The two companies retain the same proportion of profits each year and this is expected to continue into the future. Clearfield Farms Limited return on investment is 16%, while that of Village Industries Limited is 21%. One year after the post-acquisition period, Clearfield Farms will retain 60% of its earnings and expects to earn a return of 20% on new investment.
The dividends of both companies have been paid. The required rate of return of ordinary shareholders of Clearfield Farms Limited is 12% and Village Industries Limited 18%. After the acquisition, the required rate of return will become 16%.

Required:
(a) If the acquisition is to proceed immediately, calculate the:
(i) Pre-acquisition market values of both companies.

(ii) Maximum price Clearfield Farms Limited will pay for Village Industries Limited

(b) As a Finance Manager in your company, you have been asked to produce an explanatory memo to Senior Management on the subject Mergers and Acquisition. Your memo should clearly outline what actions a target company might take to prevent a hostile takeover bid.

Drake Limited is a Ghanaian registered multi-national company with FIVE subsidiaries in Europe, Asia and Africa. These subsidiaries have traditionally been allowed a large amount of autonomy, but Drake Limited is proposing to centralize most of the group’s treasury management operations.

Required:
(c) Acting as Group Head of Finance to Drake Limited, prepare a memo suitable for distribution to Senior Management of each of the subsidiaries explaining the potential benefits of treasury centralization.

Answer

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Tags: Centralization, Corporate finance, Financial efficiency, Risk Management, Treasury management
Level: Level 2

Topic: Treasury Management

FM – L2 – Q102 – Treasury management

PrimeCare Inc supplies medical goods to HealthBridge Ltd in Ghana, addressing credit and currency risks in a $3M contract.

Question

PrimeCare Inc, a company in the USA, has agreed a contract to supply medical supplies to HealthBridge Ltd, a large hospital group based in Ghana. The price of the contract is $3 million.
There is currently no existing relationship between the two companies and PrimeCare has no other customers in Ghana.

Required:
Explain how PrimeCare Inc can manage the credit risk and currency risk associated with this international transaction.

Answer

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Tags: Credit risk, Currency hedging, Foreign Exchange Risk, Forward Contract, International payments, Letter of credit, Treasury management
Level: Level 2

Topic: Treasury Management

FM – L2 – Q101 – Hedging with options

Calculate min net interest rate cost for a company borrowing $5m using options with a strike price of 94.50.

Question

It is May and a company intends to borrow $5m for 3 months commencing in September. Options are available on 3 month Canadian interest rate futures with a strike price of 94.50 and are quoted as follows:

Expiry month	Calls	Puts
June	0.10	0.31
September	0.46	0.67
December	0.63	0.84

The contract size of the 3-month Canadian interest rate future is $1 million.
Required
Calculate the minimum net interest rate cost for the company if it hedges using options with a strike price of 94.50.

Answer

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Tags: Borrowing, Currency Risk, Effective interest rate, Financial Risk Management, Futures, Hedging, Interest rate options, Options pricing, SOFRA, Treasury management
Level: Level 2

Topic: Hedging with options

FM – L2 – Q100 – Hedging with futures, Hedging with options

Firestone Ltd plans to borrow $5M and hedge interest rate risk using futures and options, calculating effective borrowing rates.

Question

Firestone Ltd, a Nigerian company, needs to borrow in US dollars to fund its US operations, but the chief financial officer is concerned that interest rates may be volatile given the current US political and economic environment.
It is now March and Firestone intends to borrow $5 million for a period of three months commencing in September.
Futures and options quotes for 3-month US secured overnight financing rate (SOFRA) are given below. Assume that Firestone can borrow at the three-month SOFRA rate.

3 month SOFRA futures price – contract size = $1,000,000

June	September
93.55	93.28

Traded options on 3-month SOFRA futures – contract size = $1,000,000 (premiums quoted are annual rates)

Strike	June (Calls)	September (Calls)	June (Puts)	September (Puts)
93.25	0.437	0.543	0.083	0.187
93.50	0.276	0.387	0.168	0.282
93.75	0.163	0.263	0.302	0.407

Required:
a) Discuss the relevant considerations to be considered when deciding between futures and options to hedge the company’s interest rate risk. (5 marks)
b) Assume that in September 3 month SOFRA is 7% and at that point in time September futures are quoted at 93.96.

Calculate the effective borrowing rate using a futures hedge
Calculate the effective borrowing rate when hedging with options using each of the three available strike prices

Answer

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Tags: Borrowing, Currency Risk, Effective borrowing rate, Financial Risk Management, Futures, Hedging Strategies, Interest rate hedging, Options, SOFRA, Treasury management
Level: Level 2

Topic: Futures and hedging with futures

FM – L2 – Q99 – Hedging with futures

Recommend futures/options to hedge interest rate risk for a company's loan, tender bid, and deposit scenarios.

Question

Three-month euro interest rate futures are available on a derivative exchange. Available delivery months for the future are March, June, September, and December, and the contract size for the future is €1,000,000.

Provide a justified recommendation for the most appropriate futures or options transaction in order to hedge interest rate risk in the following situations:

a) A company, Starlight Ltd, is taking out a loan of €3 million for 6 months from June to fund working capital for a new venture.

b) A company, BrightFuture Ltd, has tendered for a large government project. If it is the successful bidder, it will need to borrow €12 million for three months starting in September to cover initial costs.

c) It is June, a company, Horizon Enterprises, has €7 million on deposit with a bank for one year at 3-month money market rates. The company has become concerned about the possibility that money market interest rates may fall dramatically.

Answer

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Tags: Currency Risk, Derivative exchange, Euro interest rates, Financial Risk Management, Futures, Hedging Strategies, Interest rate hedging, Options, Risk Mitigation, Treasury management
Level: Level 2

Topic: Futures and hedging with futures

FM – L2 – Q89 – Treasury Management

Explain how NorthStar Enterprises can use an interest rate swap to hedge a variable rate loan and calculate the effective borrowing rate.

Question

A company, NorthStar Enterprises, has an outstanding 10-year variable rate loan of $15 million on which it is paying SOFRA + 2%. It wishes to eliminate its exposure to a rise in variable interest rates. Currently, 10-year US interest rate swaps are quoted at 4.458%.

Required:
Explain how the treasury function could use an interest rate swap to hedge interest rate risk and calculate the effective borrowing rate that would result.

Answer

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Tags: Hedging, Interest Rate Risk, Interest Rate Swap, SOFRA, Treasury management
Level: Level 2

Topic: Treasury Management

AAA – L3 – Q47 – Financial instruments

Discuss challenges in auditing financial instruments and matters for planning the audit of Tap Co’s forward exchange contracts.

Question

You are the manager in Dee Kay Company, a firm of Chartered Accountants. You have just attended a monthly meeting of audit partners and managers at which client-related matters were discussed. Information relating to one client which were discussed at the meeting is given below.
Tap Co
Tap Co is a clothing manufacturer, which has recently expanded its operations overseas. To manage exposure to cash flows denominated in foreign currencies, the company has set up a treasury management function, which is responsible for entering into hedge transactions such as forward exchange contracts. These transactions are likely to be material to the financial statements. The audit partner is about to commence planning the audit for the year ending 31 July 2014.
Required:
Discuss why the audit of financial instruments is particularly challenging, and explain the matters to be considered in planning the audit of Tap Co’s forward exchange contracts.

Answer

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Tags: Audit Planning, Financial instruments, Forward exchange contracts, Risk Assessment, Treasury management
Level: Level 3

Topic: Audit Evidence

Tag (SQ): Treasury management

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FM – L2 – Q122 – Business valuations

Calculate pre-acquisition market values of Clearfield Farms and Village Industries using Gordon’s growth model.

FM – L2 – Q102 – Treasury management

PrimeCare Inc supplies medical goods to HealthBridge Ltd in Ghana, addressing credit and currency risks in a $3M contract.

FM – L2 – Q101 – Hedging with options

Calculate min net interest rate cost for a company borrowing $5m using options with a strike price of 94.50.

FM – L2 – Q100 – Hedging with futures, Hedging with options

Firestone Ltd plans to borrow $5M and hedge interest rate risk using futures and options, calculating effective borrowing rates.

FM – L2 – Q99 – Hedging with futures

Recommend futures/options to hedge interest rate risk for a company's loan, tender bid, and deposit scenarios.

FM – L2 – Q89 – Treasury Management

Explain how NorthStar Enterprises can use an interest rate swap to hedge a variable rate loan and calculate the effective borrowing rate.

AAA – L3 – Q47 – Financial instruments

Discuss challenges in auditing financial instruments and matters for planning the audit of Tap Co’s forward exchange contracts.

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Tag (SQ): Treasury management

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FM – L2 – Q122 – Business valuations

Calculate pre-acquisition market values of Clearfield Farms and Village Industries using Gordon’s growth model.

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FM – L2 – Q102 – Treasury management

PrimeCare Inc supplies medical goods to HealthBridge Ltd in Ghana, addressing credit and currency risks in a $3M contract.

You're reporting an error for "FM – L2 – Q102 – Treasury management"

FM – L2 – Q101 – Hedging with options

Calculate min net interest rate cost for a company borrowing $5m using options with a strike price of 94.50.

You're reporting an error for "FM – L2 – Q101 – Hedging with options"

FM – L2 – Q100 – Hedging with futures, Hedging with options

Firestone Ltd plans to borrow $5M and hedge interest rate risk using futures and options, calculating effective borrowing rates.

You're reporting an error for "FM – L2 – Q100 – Hedging with futures, Hedging with options"

FM – L2 – Q99 – Hedging with futures

Recommend futures/options to hedge interest rate risk for a company's loan, tender bid, and deposit scenarios.

You're reporting an error for "FM – L2 – Q99 – Hedging with futures"

FM – L2 – Q89 – Treasury Management

Explain how NorthStar Enterprises can use an interest rate swap to hedge a variable rate loan and calculate the effective borrowing rate.

You're reporting an error for "FM – L2 – Q89 – Treasury Management"

AAA – L3 – Q47 – Financial instruments

Discuss challenges in auditing financial instruments and matters for planning the audit of Tap Co’s forward exchange contracts.

You're reporting an error for "AAA – L3 – Q47 – Financial instruments"

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