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1. Discuss the relative advantages and disadvantages of debt financing in the context of the company’s financial objectives.

Debt finance is a relatively low cost method of raising long term finance. Under Modigliani and Miller’s capital structure theory with tax we would expect higher gearing to generate improvements in the firm’s cost of capital given the benefit of the tax shield. However, the cost of debt capital consists of three components: the pure risk free rate, the term premium and the credit spread.

Pecking order theory suggests that debt finance should be preferred to new equity finance and is normally taken by the market as a signal that management believe that the company is undervalued. In the context of an efficient market this is doubtful but it is certainly the case that there are strong agency effects through debt.

Debt will exert a greater discipline over our action than equity finance and tends to suppress opportunistic investment and over consumption of perks. From a transactions costs perspective, debt tends to be preferred for the acquisition of general assets with high marketability and equity for intangibles and highly specific assets.

Debt is also preferable to finance non-current asset where the term of the loan matches the life of the asset. We also need to assess the second hand resale value of the asset after the useful life carefully. If there is active market for second hand assets where the asset can be disposed of for a high value, then the disposal proceeds may contribute significantly towards the out flow regarding loan repayment.


2. Discuss the advantages and disadvantages, to the directors of X limited, of a public listing versus private equity finance as a means of disposing of their majority interest in the company.


To The Directors

Company name

The two principal sources of large-scale equity finance are either through a public listing on a recognized stock exchange or through the private equity market. The former represents the traditional approach for firms who have grown beyond a certain size and where the owners wish to release, in whole or in part, their equity stake within the firm, or where they wish to gain access to new, large scale equity finance. The procedure for gaining a public listing is lengthy and invariably requires professional sponsorship from a company that specializes in this type of work. Depending upon the jurisdiction there are three stages that may have to be fulfilled before a firm can raise capital on a stock exchange:


1 Formalize the company’s status as a public limited company with rights to issue its shares to the public. In some jurisdictions this requires re-registration and in others it is implicit in the conferment of limited liability.


2 Seek regulatory approval for admission to a public list of companies who have met the basic criteria required for entry to a stock exchange (in the UK this process is under the jurisdiction of the Financial Services Authority).


3 Fulfill the requirements of the exchange concerned which may entail the publication of a prospectus which is an audited document containing, among other things, projections of future earnings and profitability.

The disadvantage of public listing is that a company will be exposed to stake building by other companies, regulatory oversight by the stock exchange and greater public scrutiny.

Stock exchanges require that quoted companies comply with company law as a matter of course but also that they adhere to various codes of practice associated with good governance and takeovers. They must also comply with stock exchange rules with respect to the provision of information and dealing with shareholders.

Private equity finance is the name given to finance raised from investors organized through the mediation of a venture capital company or a private equity business. As the name suggests these investors do not operate through the formal equity market but they operate within the context of the wider capital market for high risk finance. Because of its position, PEF does not impose the same regulatory regime as the public market. Transaction costs tend to be lower and there is evidence to suggest that private equity finance offers companies the ability to restructure and take long term decisions which have adverse short term consequences. In some jurisdictions there are favorable tax advantages to private equity investors


3. Outline the principal risks that a company should consider when assessing an acquisition of very large size.


There are many risks in acquisitions which have both a high likelihood of occurring and potentially a significant impact upon your business if they do occur. The principal risks to which the entity might be exposed in an acquisition of this type are as follows:


1. Disclosure risk: in making an acquisition of this type it is important to ensure that the information upon which the acquisition is made is reliable and fairly represents the potential earning power, financial position and cash generation of the business. As part of a due diligence exercise it would be necessary to ensure that the financial accounts have not been unduly manipulated to give a more attractive view of the business than the underlying reality would support. To this end it is important to ensure that the income statement can be supported by the reported cash flow. In addition to this all other company documents should, in due course, be scrutinized as part of a full due diligence exercise.


2. Valuation risk: a substantial acquisition has the potential to alter the risk of the acquirer either because of an alteration in the fund’s exposure to financial risk or in its exposure to market risk. Ultimately the value of the bidder to its equity investors depends upon the potential returns it offers to them and the risk of those returns. A substantial acquisition of this type can impact upon the perceived risk attaching to the equity which investors have already subscribed and hence the value they place upon the fund. As a consequence the post-acquisition value of the bidder may not be a simple sum of the fund’s current value and the existing equity valuation of the target.


3. Regulatory risk: an acquisition of the size proposed may raise concern with the government or with other regulatory agencies if it is seen to be against the public interest. As a result, the acquisition may result in adverse regulatory scrutiny and pressure. Each of these risks would need to be explicitly considered as part of your due diligence investigation to ensure that they are either mitigated or avoided.


Credit may be given for alternative, relevant risks.


4. Outline the issues that should be considered when disposing a large business unit.


1. A decision would need to be made about the nature of the assets being transferred and the process for resolving whether and how any joint assets might be sold. Fair value for all of the assets to be disposed of should then be established on the basis of an orderly sale as a going concern.


2. Checking the status of all intellectual property, that all patents are established and where necessary further valuable corporate knowledge, brand symbols and proprietary processes should be patented or protected by copyright.


3. Identification and valuation of the contribution of the business unit to be disposed to the overall performance of the whole company.  This may involve improving the business by a thorough operating and business process review, implementing any changes that might improve reported profitability and removing any impediments to a sale. It may be that the whole business is to be sold as a going concern or that only elements of the business will be disposed of. The valuation must assess the impact of the disposal upon the shareholder value both before and after a potential sale to identify a threshold value which will lead to no loss of shareholder value. Where the impact upon the firm’s exposure to systematic risk is significant the valuation process will be requiring sophisticated modelling of the potential loss of cash-flow to the group and the impact on the firm’s asset beta.


4. Any regulatory issues need to be clarified. Would sale to any of the potential purchaser’s conflict with the public interest and present problems gaining approval for the acquisition?


5. Potential buyers will need to be sought through open tender or through an intermediary. Depending upon the nature of the assets being sold a single bidder may be sought or preparations made for an auction of the business as a going concern. Members of the entity’s supply chain and distribution channels may be interested, as may be competitors in the confectionary business. High levels of discretion are required in the search process to protect the value of the business from adverse competitive action. An interested and dominant competitor may open a price war in order to force down prices, preventive measures must be carefully thought out in advance.


6. Once a potential buyer has been found, access should be given so that they can conduct their own due diligence. Up-to-date accounts should be made available and all legal documentation relating to assets to be transferred made available.


7. The company should undertake its own due diligence to check the ability of the potential purchaser to complete a transaction of this size. Before proceeding it would be necessary to establish how the purchaser intends to finance the purchase, the timescale involved in their raising the necessary finance and any other issues that may impede a clean sale.


8. If not already involved the firm’s legal team will need to assess any contractual issues on sale, the transfer of employment rights, the transfer of intellectual property and any residual rights and responsibilities to the group. Normally, a clean separation should be sought unless an agreement is required concerning the use of joint assets.


9. In the light of the above a sale price will be negotiated which will increase the shareholder value. The negotiation process should be conducted by professional negotiators who have been thoroughly briefed on the terms of the sale, the conditions attached and all of the legal requirements. The consideration for the sale, the deeds for the assignment of assets and terms for the transfer of staff and their accrued pension rights will also all be subject to agreement.


10. Once the sale has been agreed in principle it is important to address all of the employment issues which will include communicating with staff the reasons for the sale, the protection of their rights on transfer, the handling of any incentive payments including share options and the transfer of their pension rights. This step may involve discussion with unions and other employee representatives.


11. Given the size of the business being sold shareholder agreement may also be required and if so the process should be put in place to gain their approval.


12. Finally the contracts for sale and the completion documents can be exchanged and the sale completed.



5. Assess the relative advantages of loan syndication versus a bond issue.


Syndication is where a group of banks combine with one bank taking the lead in the arrangement. Syndication allows banks to offer much larger loans in combination than would be feasible singly, and given the range of banks involved can tailor loans (perhaps across different currencies) to more exactly match our requirements. The management of the syndicate lies with the arranging bank but the effective cost will be somewhat higher than with a conventional loan but usually much lower than the cost of raising the necessary finance through a bond issue.

A bond issue is where the debt is securitized and floated onto the capital market normally with a fixed interest coupon and a set redemption date. Initial set up costs can be high especially if the issue is underwritten. Some bond issues can be syndicated in that a number of borrowers of similar risk are combined by the investment bank chosen to manage the issue. The advantage of syndication is that it reduces the costs of issue.


6. Discuss the advantages and disadvantages of centralized treasury management for multinational companies.

  1. Avoids having a mix of cash surplus in one business unit and cash shortage in another business unit.  Entity may net off cash surplus and cash shortages by centralized treasury department. As a result, entity will either have a single net cash surplus or cash shortage that can be managed by obtaining a single finance or making a single investment.
  2. Subsidiaries with cash shortages may borrow from another subsidiary or the parent with cash surplus. This will result in a lower interest rate payment. The interest paid in these borrowings is just a form of transfer pricing. Overall the organization as a whole doesn’t pay interest to external lender.
  3. When cash surpluses are aggregated, entity may have a very large amount of cash surplus from its business units. Entity thus can invest in larger and more yielding projects. Often this minimizes risk of investment for a particular business unit. The risk is diversified among many business units.
  4. When cash shortages are aggregated, entity may have a large amount of cash shortage from its business units. Entity may take a single, large loan to finance all its business units with cash shortages. This will have the effect similar to a bulk purchase. Bulk borrowing will reduce interest, transaction and servicing expenses.
  5. Cash management decision made by the lower level business unit managers may lead to dysfunctional decision making. If the decision is made from centralized treasury department then there is better chance of goal congruence as the head office is more aware of long-term goal of the entity. Head office is also more concerned about the goal of the organization as a whole but lower level business units are concerned mainly about their performances that are measured and rewarded.
  6. Specialized treasury department will employ experts. The experts are expected to make better decision to maximize organizational wealth. Experts are also expected to have skills of managing risk exposures better. Investment in exotic instruments and derivative contracts to manage risk requires specialized skills which will be available within the treasury department.
  7. Foreign currency risk management is likely to be improved. Entity can arrange matching and netting within the group and with out-side companies to reduce overall exposure to risk.
  8. Transfer price can be set centrally to minimize global tax burden.


7. Discuss the points to consider when deciding whether the treasury department of a company should operate as a profit center or a cost center.

  1. Competence of staff:
    local managers may not have sufficient expertise in the area of treasury management to carry out speculative treasury operations competently. Mistakes in this specialized field may be costly. This would make a treasury department more likely to operate as a cost center.
  2. Control:
    Treasury department can be considered as a profit center where it is ensured that there is sufficient skills in a business unit to manage treasury functions profitably. Adequate control system must also be implemented to prevent costly errors and over exposure to risk.
  3. Information:
    The department must have to have up-to date market information in order to operate as a profit center. A treasury department considered as a profit center needs to compete with other specialized treasury management firms. So it must be ensured that the department must be comparable with those specialized firms in terms of skills and information availability.
  4. Non-core:
    Treasury management is not part of the core business operation of an entity. Entity should rather focus on its core activities to generate profit. A profit target given to a treasury department may lead to over exposure to risk. Managers of the department may invest in risky instruments or gamble to make quick profit.
  5. Service charge:
    In order to consider a treasury department as a profit center we must ensure that for the service provided by the department is paid for by other departments that are taking its services. Without a system of transfer pricing treasury department is hardly going to generate any profit.
  6. Performance measures:
    The main objective of designating a department as a profit center or cost center is to ensure proper performance evaluation of the department. It may become very hard to set proper KPI and target while avoiding reckless and dysfunctional decision.



8. Outline the procedural/policy considerations to be assessed in order to finalize foreign currency netting strategy. Explain key benefits and limitations of netting.

Netting inter-company transfers is a common international cash management strategy to manage foreign currency risk. The basis of netting is that, within a closed group of related companies, total payables will always equal total receivables. The advantages of netting are reduction in foreign exchange conversion fees and funds transfer fees and a quicker settlement of obligations reducing the group’s overall exposure.

In case of multilateral netting with some companies that don’t belong to a group structure some additional considerations are required. A lead company or netting manager is required to govern the arrangement. Netting manager can be a party of the netting arrangement or a 3rd party bank. If there is strong treasury department within the group, then it would be sensible to use the in-house-expertise to carry out the netting arrangement.

It is also necessary to determine a common currency in which netting needs to be effected.  The parties must also the method of establishing exchange rates to be used for netting purposes in order to agree the outstanding amounts in time, but with minimum risk of exchange rate fluctuation.

The benefits of netting are:

      1. Reduced foreign exchange cost including commission, transaction cost for conversion of currency and transaction cost of transferring fund.
      2. Less exposure to foreign exchange rate risk.
      3. Less loss in interest from having money in the transit.

However, it will be necessary to check local laws and regulations for these foreign countries to ensure multilateral netting is permitted.  Sometimes it become really difficult to enforce netting contract on a party located in overseas country because of the difference in laws. Specially there is a high chance of default by the parties that are having net payables after the netting arrangement. Further problem may arise where the receivables and payables balances are not reconciled and agreed in advance, there could be disputes between parties regarding the outstanding balances.

It should be noted that once netting has been accomplished then the residual foreign exchange rate exposure will need to be hedged in a beneficial way, ie through the use of:

  • Forward contract
  • Currency futures
  • Money market
  • Options

Netting will reduce foreign exchange exposure as balances are offset between companies. It reduces transaction risk involved with the dealings in foreign currencies. Entity needs to device hedging arrangement for fewer transactions and for lesser amount. That reduces hedging cost significantly and makes hedging more effective and efficient.

If currency exchange control is in place in a country {AKA remittance control} then netting will allow fewer amount of foreign currency exchange to and from the country and which can be within the legally acceptable limit.

There could be tax {or duty} implications on the transactions underlying. The taxation issues need to be assessed properly before entering into netting arrangement. Other costs of establishing netting arrangement must also be compared with the resulting benefit before deciding.

Netting arrangement effectively cancels existing amount of receivables and payables in favor of a net receivable or payable. Thus exiting records or invoices need to be closed in favor of new invoice or contract.



9. Discuss the relevant considerations when deciding between futures and options to hedge a company’s interest rate risk.


Interest rate futures:

A future is an agreement on the future price of a variable. Hedging with futures offers protection against adverse movements in the underlying asset; if these occur they will more or less be offset by a gain on the futures market. The person hedging may be worried about basis risk, the risk that the futures price may move by a different amount from the underlying asset being hedged.



The terms, sums involved and periods are standardized and hedge inefficiencies will be caused by either having too many contracts or too few, and having to consider what to do with the un-hedged or over-hedged amount.



Futures require the payment of a small deposit; this transaction cost is likely to be lower than the premium for a tailored forward rate agreement or any type of option. The deposited margin is refundable, so in case of a gain from the market, what entity is losing is the opportunity cost on the deposited fund.



The majority of the futures are taken out to hedge borrowing or lending for short periods.


Interest rate options:

Benefit of upside exposure:

The main advantage of options is that the buyer cannot lose on the interest rate and can take advantage of any favorable movements in interest rate. An interest rate option provides the right to borrow a specific amount at a guaranteed rate of interest. On the date of expiry of the option the buyer must decide whether or not to exercise his right to borrow and the buyer is not obliged to exercise his right if he has access to a better rate elsewhere.


Premium cost:

A premium must be paid regardless of whether or not the option is exercised, and the premium cost can be quite high. Premium is payable upfront, ie at the time of entering into the contract which may require the entity to borrow the amount and that incurs additional interest expense.

Often the premium cost is so high that the option contract may become worthless if the movement in interest rate is insignificant.


OTC options:

Over the counter options can be negotiated directly with the bank. Thus the contract can be tailor made to match with the specific requirements of a party. This removes the problem of over or under hedging exposure, which is highly likely for a futures contract. To hedge exposure relating to a long term borrowing or deposit, OTC contracts are more suitable. One main disadvantage of this is- OTC contracts cannot be traded in the market which reduces flexibility. Futures contract on this regard offers more flexibility as it can be traded on the exchange market and the holder can close out its position at any time on or before the expiry date.


Exchange traded options:

Traded options are more suitable where the holder needs the flexibility of exercising the option at any time on or before the expiry date. However, as like futures contract, the holder needs to enter into standardized contract which may lead to over/ under hedging.




10. Explain transaction and translation exposure as the finance director has heard that translation exposure risk is only a book entry and not a real cost and so can be ignored.


If a subsidiary company is established overseas, then the entity will face exposure to foreign exchange risk. The magnitude of the resulting risk can, if not properly managed, eliminate any financial benefits we expect from the subsidiary.


Transaction risk:

This is the risk of adverse exchange rate movements occurring in the course of normal trading transactions. This would typically arise as a result of exchange rate fluctuations between the date when the price is agreed and the date when the cash is paid or received.

This form of exposure can give rise to real cash flow gains and losses. It would be necessary to set up a treasury management function whose role would be to assess and manage this risk through various hedging techniques.

Translation risk:

This arises from fluctuation in the exchange rate used to convert any foreign denominated assets or liabilities, or foreign denominated income or expenses when reporting back to the head office and thereby impacting on the investment performance.

Fluctuation in exchange rate also results in variation in the value of a subsidiary on different reporting dates on the consolidated statements.

This type of risk has no direct and immediate cash flow implications as they typically arise when the results of the subsidiary denominated in a foreign currency are translated into the home currency for consolidation purposes. Although there is not direct impact on cash flows, it could influence investors’ and lenders’ attitudes to the financial worth and creditworthiness of the company. Given that translation risk is effectively an accounting measure and not reflected in actual cash flows, normal hedging techniques are not normally relevant. However, give the possible impact the translated results have on the overall group’s performance and the possible influence on any potential investment decision making process, it is imperative that such risks are reduced by balancing assets and liabilities as far as possible.



11. Discuss the relative advantages and disadvantages of the use of a money market hedge compared with using exchange traded derivatives for hedging a foreign exchange exposure. 

    1. Money market:

Money market hedge is the process of manufacturing a forward rate for future foreign currency cash flows. The rate is fixed/ manufactured based on the spot exchange rate and the borrowing and deposit rates available for 2 currencies. It requires preferential access to the short term money market in the overseas country.

Money market hedge can be considered as a substitute of forward rate agreement contract.  However, money market hedge setup is technical which will require specialized treasury management skills and it is difficult to reverse without incurring considerable loss or risk exposure.

Money market hedge is often more expensive than a simple forward contract or some other exchange traded derivatives.

If entity doesn’t have access to short term money market in a particular currency, then entity will not be able to setup a money market hedge.

    1. Exchange traded derivatives:

Exchange traded derivative such as futures and options can be entered and closed out easily. A position can be closed at any day before the expiry date of the contract under consideration. Thus exchange traded derivatives are more flexible than money market.

Futures contracts are much cheaper than money market hedge and involve fewer transactions. Transaction cost for this derivative is immaterial. The margin required to open a position can also be considered as considerably low.  However, options contracts are much more expensive comparing to futures or money market hedge. Once entered the position is not easily reversed without incurring significant cost. The premium paid on the contract will be forgone.

Options contract provide additional benefit to the holder when market moves favorably. It only limits the downside exposure of risk. But money market hedge will limit both upside exposure and downside exposure of risk thus entity can’t benefit from the favorable movement of the exchange rate.

Another disadvantage of exchange traded derivative is- these markets are available only for the major currencies of the world. So hedging against an exposure in a minor currency might not be possible using exchange traded derivative.

The contracts are standardized. Thus hedging of exact required amount is not possible using exchange traded derivative. That leads to imperfect hedge and entity has to bear some risk due to this.

In exchange traded derivatives the loss incurred by a trader must be fully covered by the margin. So whenever loss tends to be very close to the margin, entity needs to immediately deposit more money in to the market as margin. That may require an entity to do too frequent transactions or to deposit too large margin to keep its position open.

Setup a hedge using exchange traded derivatives is highly complex and requires specialized skills. Improper hedge may multiply the risk of the company instead of reducing.


12. Discuss the meaning and impact of basis risk.

Different market provides different basis of determining interest or exchange rates. It is expected by a market participant that the basis are correlated. So if one basis changes another basis is also expected to change to the same direction and by the same or close amount. i.e if LIBOR changes a market participant will expect that bank borrowing and deposit rate to change.


Often it is seen that the change in 2 markets are not 100% co-efficient. Ie. For a change in 2% interest rate in LIBOR a 2% change is expected in the futures market, in reality the change in futures market can be slightly different. This exposes the entity hedging in a market, where his exposure is related to another market in to a degree of risk.


In futures market, on the opening date exchange rate or interest rate is expected to have a slight difference with the open market rate. The difference is known as basis difference. It is expected that the difference will reduce in linear manner over the time to expiry of a futures contract and on expiry date basis difference will become zero. Practically rates on futures market may not move 100% according to the expectation of a trader. That may create a variance between the expected and actual outcome for a trader.

However, the basis risk that a trader has to bear is much negligible and it is better to accept the risk in favor of hedging a greater risk exposure.


13. Discuss the extent to which hedging exchange rate exposure can reduce a firm’s cost of capital.


Hedging is a mechanism of reducing risk exposure of an entity. Currency risk and interest rate risk both are systematic risk of an entity. For this risk investors will require premium return on their investment. As a result, beta of a company is expected to be affected by the risk in general.

Hedging will reduce or eliminate the systematic risk and thus resulting beta is expected to be lower after hedging. As a result, entity’s cost of equity and WACC are also expected to be lower.

Here we have assumed that hedging by a particular company will not affect overall market risk. If overall market risk has 100% positive correlation with the risk of an entity then hedging will not have any impact on the entity’s beta. This situation may arise if there is only one company is an industry. Or a few companies are there in the industry that is following the same strategy.

Cash flow stability:

Hedging reduces cash flow volatility, thus it will help ensuring better stability in dividend payment by a company. As the volatility in dividend payment is reduced, the level of risk faced by the equity investors also is reduced. This may result in a lower cost of equity and WACC.


Chance of default with a loan:

By ensuring stable cash flow, hedging also ensures that an entity might have lower chance of default regarding the interest and capital repayments of its borrowings. This reduction in risk is expected to be reflected in the cost of debt and overall cost of capital of the entity.


Lower borrowing rate:

Often swap is used to convert a high rate borrowing in to a low rate borrowing. The resulting reduction in cost of debt will have positive impact on the WACC.


Diversified entity:

Entity that is already highly diversified will have most of its downside risk exposures cancelled by the upside risk exposures. Resulting residual exposures to risk can be considered to be immaterial. Thus hedging might not be appropriate for this type of entities. Hedging may damage the balance between risk exposures and increase the risk rather than reducing. As a result, cost of capital might increase. For this type of entities the impact of any hedging arrangement must be carefully investigated before deciding.



14. Discuss whether a company should invoice overseas customers in home currency.

    1. Invoicing in home currency results in an elimination of foreign currency transaction of an entity. Thus the entity will have less exposure to foreign exchange rate risk. It will free up the time of the key management involved in risk management. So the entity will be able to focus better on its key trading activities.
    2. Transaction in home currency also will ensure that the record keeping will be easier. Preparation of financial and management accounts also will become much easier as the complexity of dealing with foreign currency is effectively eliminated.  As a result, the entity may achieve cost savings and its performance may improve.
    3. Price setting in home currency is much easier. Entity doesn’t need to adjust price frequently depending in exchange rate movement. Stable price may lead to better customer satisfaction.
    4. Invoicing in home currency means the overseas customers {and other business stakeholders} of the entity are receiving and paying in foreign currency. This might not be appreciated by the 3rd parties. As a result entity may lose competitive advantages over other competitor companies who are willing to accept the exchange rate risk exposure.
    5. Risk exposure may also bring benefit to an entity sometimes. If exchange rate moves favorably then entity will have a chance to make gain from the upside exposure of the risk. As return is associated with the risk, eliminating the risk will also result in an elimination of the return.
    6. A company which is highly diversified, i.e trades against many foreign currencies, will have minimum level of exchange rate risk. Down side risk exposure in one currency may be offset by the upside risk exposure in another currency. The resulting net minimum risk exposure is tolerable for the entity. Invoicing in home currency will not help the entity much rather it will create significant disadvantages for it.



15. Discuss the advantages and disadvantages of counter trading to avoid transaction in foreign currency.

    1. Some of the countries may have less convertible currencies or companies based in it may have lack of commercial credit to pay for their imports. In such cases counter trading may help as it eliminates exchange of currencies or borrowing of foreign currency to settle payables.
    2. Counter trading effectively reduces exchange rate risk as entities don’t need to exchange currencies to settle receivables or payables.
    1. Counter trading will keep remittance / exchange of currencies to or from the country within the legally acceptable limit if country imposes exchange control.
    1. By counter trading entity may obtain access to new business and new market.
    2. However, entity may incur additional transportation cost where it preferred counter trading over currency exchange. Transfer of fund may be cheaper than transferring goods from one country to another.
    3. There could be import / export tax imposed by the government of both the countries which makes counter trading an expensive option comparing to currency exchange.
    4. Entity may have poor control over the quantity or quality of goods that will be received against a receivable. The receivables can be for a very big amount that results in a delivery of huge quantity of goods for which entity may not find a good utilisation or means of disposal.
    5. For currency exchange bank guarantee is available in the form of LC. However, for exchange of goods only, such kind of guarantee might not be available. It will expose the entity into additional risk.




16. Discuss the main advantages and disadvantages of hedging using collar instead of option for interest rate exposure.


An interest rate collar involves simultaneous purchase and sales of put and call options at different exercise prices. For borrowing entity needs to buy a put option and sell a call option and for deposit put option is sold and call option is bought.


Premium expense is one of the main considerations for hedging risk exposure using an option contract. Often the premium expense is too high to make the hedging arrangement financially viable. If market rate moves only marginally then the gain from the exercise of option might not be able to cover the premium paid on the option contract.

The main advantage of a collar arrangement is that it reduces the cost of hedging. Entity pays premium on the option that it buys and at the same time it earns premium on the option that it sells. Thus the overall premium expense becomes lower.


However, option contract will not limit the benefit receivable from the upside exposure of risk. In collar arrangement this benefit is capped.



17. Given investors can diversify away all the risks by including the shares of the company in a portfolio, explain why companies would choose to hedge against risk.

The main argument for a firm to undertake hedging against risk can be summarized as follows:

      1. Hedging reduces the risks imposed on the firm’s managers, employees, suppliers and customers by reducing cost of capital. This is achieved by reducing the firm’s volatility with regards to market risk.
      2. Hedging can control the conflict of interest between bondholders and shareholders, thus reducing the agency cost. By ensuring stable cash flows hedging may secure timely appropriate return for both the investors.
      3. Hedging may increase the value of the firm, if capital market imperfections exist, since it lowers the probability of the firm encountering financial distress. A lower financial distress will result in a lower cost of capital and thus the value of the company is expected to increase.
      4. Hedging may attract equity investors to invest more in the company. In general concept lenders of the company have a degree of advantages over the equity holders. Entity is contractually bound to pay interest periodically and debt has a prior claim over company’s cash flows over equity. Thus where company’s cash flows are volatile, shareholders need to bear most of its risk. Hedging will reduce the risk of shareholders by reducing volatility in cash flows.

The main arguments against hedging:

  1. Return is correlated with the risk. Hedging will eliminate the risk thus it will also eliminate the chance of making a profit from the upside exposure of the risk. If the market is efficient then hedging will not provide any additional benefit to the shareholders; as they are receiving lower return for accepting lower risk, there position will be indifferent. Implied by the above proposition value of the firm will not be increased by hedging.
  1. In efficient market the cost of hedging is not justifiable as it doesn’t add value to the equity holders.
  2. Where equity holders are already holding widely diversified portfolio of investment, hedging would not benefit them, rather hedging may imbalance the risk profile of investors’ portfolio.
  3. Alteration of entity’s risk profile may dissatisfy investors. In efficient market an investor invests in an entity based on his risk preference and required return. Whenever entity changes the risk or the return, investors need to rebalance their portfolio.



18. Outline the benefits and dangers of a company which is using derivative agreements to manage interest rate risk.



In the climate of volatile interest rates, exposure to potential interest rate risk is more severe. Companies can use various financial derivative instruments to hedge against such risk, including futures, forward rate agreements, options and swap.


The most obvious advantage of using derivatives is that the interest rate that will be applied in the future is fixed and there is no variance between the expectation and result. This helps with financial planning as companies know how much interest they will have to pay and can budget accordingly.


OTC options and FRAs allow companies to perfectly match their hedged amounts with the amount of exposure as they can be tailored to the particular needs of the company in question. Whilst traded options and futures do not offer this benefit, they do offer flexibility as traded derivatives can be closed out or exercised at any time on or before the expiry date.


Option contract also allow an entity to benefit from the upside exposure of risk. If entity has access to better rates elsewhere comparing to the exercise rate offered by an option contract on the exercise date, then the entity may simply allow the contract to elapse. It is not forced to exercise the option.


To avoid expensive premium of option contracts entity may enter into a collar arrangement. Collar will reduce overall premium cost at the expense of the benefit receivable from upside exposure as it imposes a cap on the benefit.


Swap can be considered as another in expensive alternative of option. By entering into a swap arrangement an entity may become able to convert its floating rate loan into fixed rate to avoid the volatility. Alternatively, entity may convert a fixed rate loan in to a floating where LIBOR is expected to fall.



Traded derivatives do not allow perfect hedging. The contract size is standardized and as a result hedged amount may not match precisely with the amount that needs hedging. This will result in over or under hedging, that needs additional arrangements to smooth out. The additional arrangement not only incurs cost but also technically difficult to arrange.


Traded derivatives are not available in all the countries or for all the currencies.

Options are expensive means of hedging as their flexibility comes at a high {premium} price. Regardless of whether the option is exercised or not the premium must be paid. Premium is payable upfront which may additionally require entity to borrow fund and incur interest cost.


Swap though allows an entity to convert its loan from one type to another; often it is too difficult to predict future movement in the rates reliably. Thus entity could make a wrong choice and pay significant cost for its decision.  Moreover, in swap arrangement entity takes the risk of default by the swap partner.



19. Briefly discuss the possible benefits of disposing a subsidiary through a management buy-out.

Possible benefits of disposing the subsidiary through a management buy-out may include:

Management buy-out costs may be less for the parent compared with other forms of disposal such as selling the assets of the company or selling the company to a third party. It may be the quickest method in raising funds for the parent compared to the other methods. There would be less resistance from the managers and employees, making the process smoother and easier to accomplish. Parent may retain a better relationship and beneficial links with subsidiary and may be able to purchase or sell goods and services to it.


It may be able to get a better price for the company. The current management and employees possibly have the best knowledge of the company and are able to make it successful. Therefore, they may be willing to pay more for it. It may increase parent’s reputation among its internal stakeholders such as the management and employees. It may also increase its reputation with external stakeholders and the market if it manages the disposal successfully and efficiently.



20. When examining different currency options and their risk factors, it was noticed that a long call option had a high gamma value. Explain the possible characteristics of a long call option with a high gamma value.

Gamma measures the rate of change of the delta of an option. Deltas range from near 0 for a long call option which is deep out-of-money, where the price of the option is insensitive to changes in the price of an underlying asset, to near 1 for a long call option which is deep in-the-money, where the price of the option moves in line and largely to the same extent as the price of the underlying asset.


When the long call option is at-the-money the delta changes rapidly. Hence, the gamma is highest for a long call option which is at-the-money. The gamma is also higher when the option is closer to expiry.

It would seem, therefore, that the option is probably trading near at-the-money and has a relatively short time period before it expires.

 21. Discuss the possible reasons why a company may switch its strategy of organic growth to one of growing by acquiring companies.


A company may switch from a strategy of organic growth to one of growth by acquisition, if it was of the opinion that such a change would result in increasing the value for the shareholders.

Acquiring a company to gain access to new products, markets, technologies and expertise may be quicker and less costly.

Horizontal acquisitions may help the company eliminate key competitors and enable it to take advantage of economies of scale.

Vertical acquisitions may help the company to secure the supply chain and maximise returns from its value chain.

Organic growth may take a long time, can be expensive and may result in little competitive advantage being established due to the time taken. Also organic growth, especially into a new area, would need managers to gain knowledge and expertise of an area or function, which they not currently familiar with. Furthermore, in a saturated market, there may be little opportunity for organic growth.


22. Discuss how simulations, such as the Monte Carlo simulation, could be used to assess the volatility of the net present value of a project.                

The assessment of the volatility (or standard deviation) of the net present value of a project entails the simulation of the financial model using estimates of the distributions of the key input parameters and an assessment of the correlations between variables. Some of these variables are normally distributed but some (such as the decommissioning cost) are assumed to have limit values and a most likely value.


Given the shape of the input distributions, simulation employs random numbers to select specimen value for each variable in order to estimate a ‘trial value’ for the project NPV. This is repeated a large number of times until a distribution of net present values emerge. By the central limit theorem, the resulting distribution will approximate normality and from which project volatility can be estimated.

In its simplest form, Monte Carlo simulation assumes that the input variables are uncorrelated.


However, more sophisticated modelling can incorporate estimates of the correlation between variables. Other refinements such as the Latin Hypercube technique can reduce the likelihood of spurious results occurring through chance in the random number generation process.


The output from a simulation will give the expected net present value for the project and a range of other statistics including the standard deviation of the output distribution. In addition, the model can rank order the significance of each variable in determining the project net present value.


23. Discuss the advantages and disadvantages of swap:

Advantages of swap

Transaction costs are generally relatively low. If company arranged the swap itself, the costs would be limited to legal fees. The transaction costs may also be lower than the costs of terminating one loan and arranging another.

Entity can swap a commitment to pay a variable rate of interest which is uncertain with a guaranteed fixed rate of interest. This allows the entity to forecast finance costs on the loan with certainty.

Swaps are over-the-counter arrangements. They can be arranged in any size and for whatever time period is required, unlike traded derivatives. The period available for the swap may be longer than is offered for other interest rate derivatives.

Swaps make use of the principle of comparative advantage. Entities can borrow in the market where the best deal is available to them, and then use the swap to access the loan finance it actually wants at an overall cheaper cost.

Disadvantages of swaps

Swaps are subject to counterparty risk, the risk that the other party to the arrangement may default on the arrangement. This would apply in particular if the entity arranged the swap itself. If it is arranged through a bank, the bank can provide a guarantee that the swap will be honored.

Once a swap commitment is entered into by an entity, it cannot then change that commitment. This means it cannot take advantage of favorable interest rate changes as it could if it used options. This may be a particular problem if the swap period is more than a few months and interest rates are expected to be volatile.

As swaps are over-the-counter instruments, they cannot be easily traded or allowed to lapse if they are not needed or become no longer advantageous. It is possible that a bank may allow a re-swapping arrangement to reverse a swap which is not required, but this will incur further costs.


24. Following the MBI, the BoD of Burgut Co announced that its intention was to list the company on a recognized stock exchange within seven years. The BoD is discussing whether to obtain the listing through an initial public offering (IPO) or through a reverse takeover, but it does not currently have a strong preference for either option. Required: Distinguish between an IPO and a reverse takeover, and

Discuss whether an IPO or a reverse takeover would be an appropriate method for Burgut Co to obtain a listing.


The initial public offering (IPO) is the conventional way to obtain a listing where a company issues and offers shares to the public. When doing this, the company will follow the normal procedures and processes required by the stock exchange regarding a new issue of shares and will comply with the regulatory requirements.

Undertaking a reverse takeover enables a company to obtain a listing without going through the IPO process. The BoD of Burgut Co would initially take control of a ‘shell’ listed company by buying some shares in that company and taking over as its BoD. The ‘shell’ listed company was probably a normal listed company previously, but is no longer trading. New equity shares in the listed company would then be exchanged for Burgut Co’s shares, with the external appearance that the listed company has taken over Burgut Co. But in reality Burgut Co has now effectively got a listing, having taken control of the listed company previously. Normally, the name of the original listed company would then be changed to Burgut Co.

Compared with an IPO, the main benefits of undertaking a reverse takeover are that it is cheaper, takes less time and ensures that Burgut Co will obtain a listing on a stock exchange. An IPO can cost between 3% and 5% of the capital being raised because it involves investment banks, lawyers, and other experts. A marketing campaign and issuing a prospectus are also needed to make the offering attractive and ensure shares to the public do get sold. A reverse takeover does not need any of these and therefore avoids the related costs. The IPO process can typically take one or two years to complete due to hiring the experts, the marketing process and the need to obtain a value for the shares. Additionally, the regulatory process and procedures of the stock exchange need to be complied with. With a reverse takeover, none of these are required and therefore the process is quicker. Finally, there is no guarantee that an IPO will be successful. In times of uncertainty, economic downturn or recession, it may not attract the attention of investors and a listing may not be obtained. With reverse takeover, because the transaction is an internal one, between two parties, it will happen and Burgut Co will be listed.

However, obtaining a listing through a reverse takeover can have issues attached to it. The listed ‘shell’ company may have potential liabilities which are not transparent at the outset, such as potential litigation action. A full due diligence of the listed company should be conducted before the reverse takeover process is started. The IPO process is probably better at helping provide the senior management of Burgut Co with knowledge of the stock exchange and its regulatory environment. The involvement of experts and the time senior management need to devote to the listing process will help in this regard. Due to the marketing effort involved with an IPO launch, it will probably have an investor following, which a reverse takeover would not. Therefore, a company which has gone through an IPO would probably find it easier to raise extra funds, whilst a company which has gone through a reverse takeover may find it more difficult to raise new funding.

Overall, neither option of obtaining a listing has a clear advantage over the other. The choice of listing method depends on the company undertaking the listing and the purpose for which it is doing so.