Advanced Financial Management (AFM) Flashcards

A UK company expects to receive EUR 2 million in 3 months. The current spot rate is £1 = EUR 1.15. The 3-month forward rate is £1 = EUR 1.18. If the company uses the forward contract, what GBP amount will it receive?

Answer: £1,694,915

Using the forward contract at £1 = EUR 1.18, the company will receive: EUR 2,000,000 ÷ 1.18 = £1,694,915. The forward rate of 1.18 is less favourable than the spot rate of 1.15 (the company receives fewer pounds per euro). This reflects the interest rate differential between GBP and EUR, with GBP interest rates likely being lower.

In the context of real options theory, a company that invests in a pilot project before committing to full-scale production is exercising which type of real option?

Answer: Option to expand (staging option)

A pilot project represents an option to expand (also called a staging or growth option). By investing a small amount initially, the company gains the right (but not obligation) to invest further if the pilot is successful. This staged approach limits downside risk while preserving upside potential. The option to delay would mean waiting without any investment; the option to abandon means exiting after full commitment.

When using the Black-Scholes option pricing model, which of the following inputs has an INVERSE relationship with the value of a European call option?

Answer: Exercise price

The exercise price has an inverse relationship with call option value — a higher exercise price means the holder must pay more to acquire the shares, making the option less valuable. All other listed inputs have a positive relationship with call value: higher share price increases intrinsic value, more time allows more price movement, and greater volatility increases the chance of the option being in-the-money.

A company is considering an acquisition and identifies potential synergies of £5 million per year in perpetuity. The acquiring company's WACC is 10%. The maximum premium the acquirer should pay above the target's standalone value is:

Answer: £50 million

The maximum premium equals the present value of all synergies. If synergies of £5m per year continue in perpetuity and the discount rate is 10%, the PV = £5m ÷ 0.10 = £50m. Paying any more than £50m would mean the acquisition destroys value for the acquirer's shareholders, as the premium exceeds the value created by the synergies.

A company has an asset beta of 0.8 and is considering changing its capital structure to 40% debt and 60% equity (by market value). The corporate tax rate is 25%. Using the Modigliani-Miller formula to regear, what is the approximate new equity beta?

Answer: 1.20

Using the MM regearing formula: βe = βa × [1 + (1-T)(D/E)]. With debt 40% and equity 60% of total capital, D/E = 40/60 = 0.667. Therefore βe = 0.8 × [1 + (1-0.25)(0.667)] = 0.8 × [1 + 0.75 × 0.667] = 0.8 × [1 + 0.50] = 0.8 × 1.50 = 1.20. The equity beta increases from the asset beta of 0.8 to 1.20 because financial gearing amplifies the systematic risk borne by equity holders.

In the context of international investment appraisal, which of the following is a reason for using the 'foreign currency' approach rather than converting cash flows to the home currency?

Answer: It avoids the need to forecast future exchange rates

The foreign currency approach discounts foreign currency cash flows at a foreign currency discount rate (reflecting local risk and returns), avoiding the need to forecast future exchange rates. The NPV in foreign currency is then converted to the home currency at the current spot rate. This is advantageous because exchange rate forecasting is inherently uncertain and prone to significant error.