The government will pay Penn Co, €55,000 per metre at the end of 2014, increasing by 3% pa. Material and local labour costs are expected to be €23,000 per metre at the end of 2014, with expected increases at a rate of 5% pa thereafter. Fixed operating costs will increase by €40m at the end of 2014 and this amount will rise by 6% pa.
Penn Co has a standard policy that all its foreign subsidiaries must make a fixed annual royalty payment of $15,000 per metre back to the holding company at the end of each respective year. This is a fair arms length value to cover the investment made by Penn Co to develop the train track technology.
Working capital funds will be needed from 1 January 2014. The initial amount can be estimated to be 10% of the revenue earned at the end of year 2014. Each year, this will need to be adjusted by €10 for each €100 change in annual sales revenue. Working capital will be recovered in full on 31 December 2018. On the same day, the Nurukian government has guaranteed to purchase from Penn Co the specialist machinery for a nominal value of €500m.
Economic forecasters believe that the mid-point spot exchange rate on 1 January 2014 will be €0.7810/$. The Ayjain Central Bank expects the dollar to devalue at a rate of 5% pa. The current risk free rate is 4.5% pa. The estimated standard deviation of the future free cash flows is 30%.
A bilateral tax treaty exists between the countries of Ayjai and Nuruk – hence, taxable profits earned in Nuruk will be liable to the differential income tax rate on company profits that applies between the two countries. The Ayjain government expects this to be paid in the same year as the taxable profits are earned.
Offer from Elders Inc
Elders Inc is the largest construction company based in Nuruk. Since 2009, it has laid and tested a substantial amount of the new SPF2 train line in Nuruk. It has worked closely with Penn Co as it supplied this train track.
The board of directors (BoD) were bemused that the Nurukian government did not offer them the SPF2 contract for the final phase. They believe that they have gone through the learning curve and could do the work on an efficient basis.
The BoD decided to approach Penn Co with an offer of $1,200m to purchase the contract from them in two years time (31 December 2015). Penn Co’s lawyers have advised them that the Nurukian government has not expressly precluded Penn Co from exiting the contract early, but advise Penn Co to consider their ethical stance should they decide to do so.
Alternative Sources of Finance
The chief financial officer (CFO) of Penn Co has concerns about the substantial initial investment required to start the project, relative to Penn Co’s market value. The company’s financial advisers agree with the CFO and are suggesting two alternative methods of raising the funds.
- €1,000m five-year 6.25% syndicated bank loan – Penn Co’s advisers believe that a number of Nurukian banks would be willing to participate in such a transaction. They also believe that they may be able to persuade the Nuruk government to provide a subsidised interest rate of 4% pa on an element of this loan.
- To raise the required funds using Islamic finance in the form of sukuk bonds. The advisers feel that the project’s characteristics are within the Sharia law regulations and this would give Penn Co access to low cost finance.
Requirement
Prepare a report to the Board of Directors (BoD) of Penn Co that:
a) Provides a financial assessment of the final phase of the Nuruk train line project as at 1 January 2014. All cash flows are to be presented in nominal terms and the project’s dollar free cash flows are to be discounted at the appropriate nominal cost of capital. Ignore the offer from Elders Inc and the alternative finance options. (22 marks)
b) A discussion of the assumptions made in arriving at the financial assessment.
(5 marks)
c) An assessment of the offer made by Elders Inc to purchase the contract from Penn Co in two years time. This should include an estimate of the financial value of the real option. (9 marks)
d) A discussion of the two alternative finance options specifically addressing:
(i) If Penn Co raised the funds from the banks based in Nuruk, how this would affect the financial assessment of the project.
No further calculations are required.
(4 marks)
(ii) The key differences that Penn Co should be aware of between raising money via the Islamic finance option as opposed to traditional forms of debt capital. (6 marks)
Professional marks awarded for format, structure and presentation of the report.
(4 marks)
(50 Marks)
Students will not be surprised to see a scenario-based question 1 containing a vast amount of information. Several areas of the syllabus will be tested, including international project appraisal. Before focusing on the primary topic, I wish to demonstrate my step-by-step approach to answering question 1.
Understand The Requirements and Allocate Your Time
This question represents 50% of the exam – therefore, the answer should be completed in 90 minutes. However, the requirements of the question should be understood. ‘Topic recognition’ as I call it entails identifying which part of the syllabus is being targeted by each requirement. Simultaneously, I will allocate my time based upon the standard approach of 1.8 minutes per mark.
a) Keywords ‘financial assessment’, ‘project’s dollar nominal cash flows’ and ‘discounted’ would trigger my thoughts. I have to prepare a schedule of free cash flows and compute the net present value (NPV). 22 marks would indicate a time allotment of 40 minutes. However, there are four professional marks for structure and presentation, which I can spread across the requirements. Revised time allocation – 45 minutes.
b) ‘Assumptions’ relating to the financial assessment – lots of scope to score marks here within nine minutes.
c) ‘Real option’ takes my thought process directly to the Black-Scholes Option Pricing model (BSOP). I have to compute the value of this PUT option and add the relevant discussion points. Allocate 17 minutes.
d) The topic under scrutiny here appears to be two different forms of debt finance. However, the requirements need to be interpreted very carefully.
(i) How raising loan finance will affect the project appraisal. My initial thoughts are to explain the Adjusted Present Value (APV) appraisal method. (8 minutes)
(ii) Islamic finance – I need to apply my knowledge of Islamic finance (sukuk bonds) to answer this final requirement. (11 minutes)
Answer Format
The question has clearly stated that the answer should be presented in a report format. The best way to do this is have appendices showing the computational elements, followed by the discussion parts in the main body of the headed report. In this case, I would layout my answer:
- Appendix 1 – NPV and relevant workings
- Appendix 2 – Real option valuation using BSOP model
- Headed report – With four subheadings matching the requirements.
From reading the examiner’s report published after each exam, there appear to be a worrying number of candidates who don’t format their answer as requested, and then missing out on the ‘easy-to-earn’ marks.
The Read Through
I understand the requirements. Now, I need to digest the details of the question. My approach is a simple one.
Let me now return and concentrate on preparing an answer on the international project appraisal aspects of this question.
Appendix 1 – NPV and Workings