MCR006 Financial Management Assignment 3 Sample
Assignment Task
This assessment consists of two parts. Part A, a research based topic and part B, a practical application of capital budgeting and financing.
Part A
Students will be required to research the topic relating to the concept of the definition and application of financial options.
Required
The paper should include information about how options are used in business to effectively hedge against unforeseen changes in the prices of the underlying asset. Word length 1,500 words.
Part B
Instructions
The assessment involves undertaking and completing a case study where you are required to apply concepts relating to investing in long-term assets.
Specifically, you will apply capital budgeting techniques in the case to undertake an Analysis of the data provided, interrogate the information provided by your analysis, develop a Board of Directors Report to show your recommendations and Influence the readers.
Global Testing Geneva Ltd.
Background.
The Global Testing Geneva (GTG) was established in Switzerland in 1893, by two brothers who married into a wealthy family organization. The company had developed as a global organization for inspection and testing with 40,000 employees worldwide. The core service that was provided was Inspection of International trade to ensure that governments collected the appropriate amount of customs duty and minimized and illegal profiteering by customs officers.
The company had also acquired a professional certified certification organization. That reviewed ISO 9000 standards requirement and implemented ISO 9000 standard. Systems. As the result of his inspection services the organization had increased as a global organization across a number of countries. In the 1990s the granddaughter of the founders who now was the CEO of the company introduced a strategy of corporate entrepreneurship across all international subsidiary organisations for university assignment help.
In New Zealand, the company was founded on the back of traditional inspection and testing with most of the organization focused on the testing of primary products such as wool agricultural products, coal, steel and minerals. The revenue for the group was low at $25m NZD
On one occasion the CEO of GTG New Zealand while held up in a traffic delay, noticed the signage on the back of a vehicle as. Medlab, Auckland with a tag line of. “testing for life”. Immediately recognizing an opportunity, he followed the vehicle, recognising that the word testing was core activity of the organization, only in New Zealand, but worldwide. As the result of this Inquisitive and entrepreneurial approach. GTG NZ was granted permission by head office in Geneva to actively pursue the acquisition pathology laboratories across New Zealand.
Your role.
You have just accepted the role. Is an expatriate from Australia to New Zealand as the Finance manager for GTG New Zealand Ltd. Your first task is to assist with the analysis of two potential pathology laboratory acquisitions.
There are three specific Acquisition targets as follows.
1. Auckland Pathology
2. Regional Pathology
The current ownership of each pathology business is by a few doctor- pathologists working in a partnership arrangement at each organisation. No doctors have a cross ownership or partnership in either of the other businesses.
Business Model
While the acquisition process was quite clear, the technicalities involving acquiring a professional health services organization involving pathology was quite involved. The key issue that GTG New Zealand faced was that it did not have doctors on their staff and were ill qualified to run a testing laboratory which involved decisions that could have potential high-risk effects on individual’s health.
As a result of negotiations with the government Health Department identified revealed that an alternative business model could be adopted to achieve the required involvement of qualified medical doctors.
The proposed acquisition corporate venturing model involved establishing a separate Legal entity to act as the acquisition vehicle. The owner doctors transferred their partnership share of the asset into the vehicle. And received shares amounting to 33% of the value of the acquisition vehicle.
Your Task
As the finance manager, your task is to assess which of the potential acquisition targets was the most suitable for GTG Limited. For you to accomplish this task you will be required to adhere to the specific acquisition guidelines policies of GTG Limited in Geneva.
You will be required to:
1. To determine the free cash flows from each of the potential acquisition targets (10 marks)
2. To evaluate the proposals.
a. Calculate the net present value of the acquisitions based on the cash flow information provided, using the proposed acquisition value as provided in each case.
In order to calculate the net present value in relation to each of the selected proposals the organization requires a minimum of the weighted average cost of Capital currently this is 5% plus a risk premium 2%. This will satisfy shareholders return in Geneva. (20 marks)
3. To finance the acquisitions
a. The company wishes to fund the acquisition using a Bond issue. Assuming the bonds will be issued for 5 years with a coupon rate of 6.5%, and GTG New Zealand wishes to raise $1,000,000 determine the price and number of bonds to be issued given that the market rate for similar bonds is 8%.(20 marks)
4. Prepare a board report (1 to 2 pages )the directors of GTG New Zealand and Geneva can review which highlights your recommendation based on your calculations. In addition, raise any concerns or aspects you may have other than quantitative analysis that may assist in the evaluation of the potential acquisition. Note only one of the acquisitions opportunities can be selected.
Solution
Part A
Hedging is referred as the mechanism for decreasing the financial risk confronted by the company. There are a number of techniques that can be used by businesses for minimization or elimination of risk such as future contracts, forwards contracts, options, swaps, and many more. Among all these techniques, options are one of the effective tools that are used in hedging by businesses. An organization can adjust its exposure to risks connected with rate of interest, fluctuation in the foreign exchange rate, commodity price, and equity prices through purchasing and selling of the options (Guo, Shi, and Xu, 2020). For instance, if an organization is concerned regarding the prices it will receive from selling of product that would be delivered in future can minimize risk by purchasing put option.
Overview of financial options
An option is defined as a right, but not the obligation, to purchase or sell of an asset for a particular price on or prior to a particular date. This price is known as exercise price or strike price, and the date is known as the exercise date or expiry date of the option. There are two types of option such as call option and put option. The right to purchase the asset is called as a call option (De Luca, 2022). If the value of underlying asset is less than the exercise price on expiry date then the payoff from the call option is equals to $0. Further, if the value of underlying asset is greater than the exercise price on expiry, then the pay-off from the call option is computed by deduction of value of asset from exercise price. The right to sell the asset is called as a put option. If the value of underlying asset is greater than the exercise price on expiry date then the payoff from the put option is equals to $0. Further, if the value of underlying asset is less than the exercise price on expiry, then the pay-off from the call option is computed by deduction of exercise price from value of asset.
Application in business
Options can be used by businesses to hedge numerous financial risk. Some general examples what organization can hedge with options are comprised of –
Equity risk: Option strategy can be implemented to hedge against the risk of reduction in the value of stocks.
Foreign exchange risk: For hedging against the variation in the exchange rates, options can be used. Companies that are running business across the world use options to hedge their exposure towards foreign currency risk (Hambly, Howison, and Kluge, 2022).
Commodity price risk: for hedging against the variation in the commodity prices, options can be used. This permits producers, customers, and traders to secure themselves from negative price movements.
Interest rate risk: for hedging against change in interest rate, options can be used. For example, business can use interest rate options to secure them against increasing interest rate if they have loan on variable interest rate (Fadda, 2020).
Volatility risk: For hedging against changes in market volatility, options can be used. Normally, this is done by strategies such as purchasing or selling of options to get advantage from probable changes in volatility levels.
Hedging against price change
There are numerous popular hedging strategies that utilize options for management of risk. Here are some of the main strategies of hedging by using options –
Protective Put Strategy
This strategy is comprised of buying a put option to secure a long position in the underlying asset. Protective put strategy gives downside security, because if there is reduction in the price of asset, the put option will increase in value. The maximum loss of option buyer is limited with the difference between the purchase price of asset and strike price of put option, plus amount of premium paid by buyer of option (Balakrishnan, 2020).
For implementation of a protective put strategy –
1. It is required to buy the underlying asset, if not already owned.
2. Purchase a put option at a strike price near to the current market price of the asset.
Following are some of the advantages of using a protective put strategy –
• By purchasing a protective put option, business can minimize their potential loss if there is reduction in the prices of underlying asset.
• Such strategy is flexible as the investor can select the strike price and the expiry date of put option on the basis of their risk tolerance capacity and investment goals.
• If there is increment in the price of underlying asset, the investor can still generate profits from the increment in value while having satisfaction that their downside risk is limited.
Covered Call Strategy
It is an income generating investment tool, which can support business in increase return on portfolio while decreasing overall risk. Covered call strategy involves selling of call option against current long position in the underlying asset. In this, profit is generated through getting option premium and offers restricted downside protection. The amount of maximum profit is capped at the difference between the purchase price of asset and strike price of call option, plus the amount of option premium (Yavuz, 2022).
For implementation of a covered call strategy –
1. It is required to buy the underlying asset, if not already owned
2. Selling of a call option with a strike price more than the current market price of asset.
This strategy is applied in the following situations –
3. Neutral and moderate bullish market: In these situations, the prices of stock slightly increase. Additional profits can be generated by covered calls from stock holding during these times.
4. Stocks with less volatility
5. Premium of covered call enhance with higher implied volatility. Though, high volatility can assist towards unpredictable movements in prices that may assists in exercise of call options. Stocks with less volatility minimize this risk (Hollstein, and Wese Simen, 2021).
Collar strategy
This strategy combines a protective put strategy and covered call, by which ‘collar’ is formed around the price of underlying asset. By taking put option, downside protection is availed by investor and they generate income through getting premium of call option. Collar strategy is limiting the probable loss as well as profit of investor (Chakravarty, and Sarkar, 2020).
For implementation of a collar strategy –
• It is required to buy the underlying asset, if not already owned.
• Selling of a call option with a strike price more than the current market price of asset.
• Purchase a put option at a strike price near to the current market price of the asset.
Iron Condor Strategy
This is a neutral option strategy, selling of out-of-the-money call and put options, while buying the out-of-the-money call and put options simultaneously on the similar underlying asset and with the identical expiration date. The aim of this strategy is to generate profit from the price of underlying asset remain within a particular range, while restricting probable loss (Zhan et al., 2022).
For implementation of iron condor strategy –
• Selling of out-of-the-money call option with a strike price more than the existing market price of the asset.
• Purchase a further out-of-the-money call option with a greater strike price as compared to the call option sold in step 1
• Selling of out-of-the-money put option with a strike price less than the existing market price of the asset.
• Purchase a further out-of-the-money put option with a lower strike price as compared to the put option sold in above step.
Selection of the correct hedging strategy
Selection of the correct hedging strategy is based on market outlook, investment objective, and risk tolerance capacity of an investor. It is required to consider the below prescribed elements while selecting a hedging strategy –
Market outlook
If it is expected that, market will remain stable, then an iron condor strategy might be appropriate. If investor expects that, there is probable reduction in the price of asset, then a protective put or call strategy may be preferable.
Risk tolerance capacity
It is required by investor to determine their risk tolerance capacity and select a strategy that aligns with their extent of acceptable risk. Protective puts and collar strategies provide more downside protection, while the iron condor strategy is based on price of asset staying within a particular range.
Investment objective
At the time of selection of hedging strategy, consideration of investment goal is one of the essential elements. If investor seek to earn profit, a covered call or iron condor strategy may be appropriate. If priority of investor is protection of long position, then in such as protective put or collar strategy will be preferable.
In a summarized manner, it can be said that, hedging with options offers businesses with a powerful technique for management of risk and protection of their portfolio against negative movements in market. By implementation of the appropriate option hedging strategies, organization can limit their loss, secure their income, and manage risk exposure in more effective way. Select a hedging strategy that is in accordance with market outlook, investment objective, and risk tolerance capacity to assure the best result of portfolio.
Part B
Part B
A: Free cash flows calculation
Statement showing free cash flow from Auckland Pathogy acquisition
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Statement showing free cash flow from Regional Pathology (RP) acquisition
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B: Evaluation of proposal
For the computation of WACC, risk premium will be added to average cost of capital and same will be considered for calculation of net present value.
=Average COC + risk premium
=5+2
=7%
Statement showing Calculation of net present value for Auckland Pathogy acquisition
Statement showing Calculation of net present value for Regional Pathology (RP) acquisition
C: Acquisition financing
By considering the given facts,
Coupon rate = 6.5%
Time = 5 years
Market rate = 8%
Face value (assumed) = $1000
Price of bond= ∑ (Cn / (1+YTM)n )+ P / (1+i)n
• Bond Price = 65 / (1.08) + 65 / (1.08) ^2 + 65 / (1.08) ^3 + 65 / (1.08) ^4 + 65 / (1.08) ^5 + + 1000 / (1.08) ^ 5
• Bond Price = 60.18518519 + 55.72702332 + 51.59909567 + 47.77694043+ 44.23790781+ 680.583197
• Bond Price = $940
D: Board report
To
Directors
GTG New Zealand and Geneva
Provided report contains descriptive analysis of acquisition proposals i.e. Auckland Pathogy and Regional Pathology (RP) for the company considering both financial and non-financial factors.
Financial analysis of Auckland Pathogy and Regional Pathology (RP)
Financial analysis of AP: By considering the financial analysis of AP, it has been noticed that, on the prima facie cumulative free cash flows of AP is $1532500 and NPV is - $14897. Free cash flows of company shows that, it has sufficient cash balance after deduction of expenses, which can be utilized by it for investment purpose. Further, negative NPV is not preferable as it shows that, profit cannot be generated by its project.
Financial analysis of RP: By considering the financial analysis of RP, it has been noticed that, cumulative free cash flows of all three years is $986500 and NPV is $28036.18.
Only by considering the financial aspects, RP is better because of positive NPV even if it has lesser free cash flows as compared to AP Company. Though, it is essential to consider the non-financial factors as well.
Other factors that could affect selection of proposal
Culture and values
One of the most significant elements in acquisition is the compatibility of the values and culture of two companies. if the values and culture of two companies are aligned, it can support a smooth integration, increase collaboration, and enhance innovation (Maran, and Parker, 2021). Thus, it is required by company to consider the culture and values of AP and RP and identify which is more suitable for the existing culture of GTG Limited.
Leadership and governance
Another key factor is the quality and leadership style of the two companies. If the leadership and governance of the two companies are complementary to each other, then it can increase the trust, efficiency, and alignment of the merged company.
Market and customers
Another essential element that should be considered before acquisition is the market and customers of two companies. If the consumers and market of two companies are compatible to each other, it can lead towards stronger value proposition, greater consumer base, and higher market share for the merged entity (Attah?Boakye et al., 2021).
Thus, before taking decision, all the above factors should also be considered.
Final remark
By considering the overall aspects, it could be said that, Regional Pathology (RP) is comparatively beneficial due to higher net present value.
References
Attah?Boakye, R., Guney, Y., Hernandez?Perdomo, E. and Mun, J., 2021. Why do some merger and acquisitions deals fail? A global perspective. International Journal of Finance & Economics, 26(3), pp.4734-4776.
Balakrishnan, J., 2020. Hedging Strategies Used in Selection of “Options” and “Forward” Contracts in Derivative Market. Journal of Commerce, 8(1), pp.1-12.
Chakravarty, S.R. and Sarkar, P., 2020. Option Pricing Using Finite Difference Method. In An Introduction to Algorithmic Finance, Algorithmic Trading and Blockchain (pp. 49-56). Emerald Publishing Limited.
De Luca, P., 2022. Financial Options. In Corporate Finance: Fundamentals of Value and Price (pp. 535-547). Cham: Springer International Publishing.
Fadda, S., 2020. Pricing options with dual volatility input to modular neural networks. Borsa Istanbul Review, 20(3), pp.269-278.
Guo, B., Shi, Y. and Xu, Y., 2020. Volatility information difference between CDS, options, and the cross section of options returns. Quantitative Finance, 20(12), pp.2025-2036.
Hambly, B., Howison, S. and Kluge, T., 2022. Modelling spikes and pricing swing options in electricity markets. In Commodities (pp. 573-594). Chapman and Hall/CRC.
Hollstein, F. and Wese Simen, C., 2021. The index effect: Evidence from the option market. The Index Effect: Evidence from the Option Market (January 7, 2021).
Maran, L. and Parker, L., 2021. Non-financial motivations in mergers and acquisitions: The Fiat–Ferrari case. Business History, 63(4), pp.606-667.
Yavuz, M., 2022. European option pricing models described by fractional operators with classical and generalized Mittag?Leffler kernels. Numerical Methods for Partial Differential Equations, 38(3), pp.434-456.
Zhan, X., Han, B., Cao, J. and Tong, Q., 2022. Option return predictability. The Review of Financial Studies, 35(3), pp.1394-1442.
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