P4 Questions and Answers for Revision Kit – March/June 2017

December 2014 Questions

1. Nahara Co and Fugae Co

Nahara Co is a private holding company owned by the government of a wealthy oil-rich country to
invest its sovereign funds. Nahara Co has followed a strategy of risk diversification for a number of
years by acquiring companies from around the world in many different sectors.
One of Nahara Co’s acquisition strategies is to identify and purchase undervalued companies in the
airline industry in Europe. A recent acquisition was Fugae Co, a company based in a country which is
part of the European Union (EU). Fugae Co repairs and maintains aircraft engines.
A few weeks ago, Nahara Co stated its intention to pursue the acquisition of an airline company
based in the same country as Fugae Co. The EU, concerned about this, asked Nahara Co to sell Fugae
Co before pursuing any further acquisitions in the airline industry.
Avem Co’s acquisition interest in Fugae Co
Avem Co, a UK-based company specialising in producing and servicing business jets, has approached
Nahara Co with a proposal to acquire Fugae Co for $1,200 million. Nahara Co expects to receive a
premium of at least 30% on the estimated equity value of Fugae Co, if it is sold.
Given below are extracts from the most recent statements of financial position of both Avem Co and
Fugae Co.

Avem Co Fugae Co
$ million $ million
Share capital (50c/share) 800 100
Reserves 3,550 160
Non-current liabilities 2,200 380
Current liabilities 130 30
Total capital and liabilities 6,680 670

Each Avem Co share is currently trading at $7·50, which is a multiple of 7·2 of its free cash flow to
equity. Avem Co expects that the total free cash flows to equity of the combined company will
increase by $40 million due to synergy benefits. After adding the synergy benefits of $40 million,
Avem Co then expects the multiple of the total free cash flow of the combined company to increase
to 7·5.
Fugae Co’s free cash flow to equity is currently estimated at $76·5 million and it is expected to
generate a return on equity of 11%. Over the past few years, Fugae Co has returned 77·3% of its
annual free cash flow to equity back to Nahara Co, while retaining the balance for new investments.
Fugae Co’s non-current liabilities consist entirely of $100 nominal value bonds which are
redeemable in four years at the nominal value, on which the company pays a coupon of 5·4%. The
debt is rated at B+ and the credit spread on B+ rated debt is 80 basis points above the risk-free rate
of return.
Proposed luxury transport investment project by Fugae Co
In recent years, the country in which Fugae Co is based has been expanding its tourism industry and
hopes that this industry will grow significantly in the near future. At present tourists normally travel
using public transport and taxis, but there is a growing market for luxury travel. If the tourist
industry does expand, then the demand for luxury travel is expected to grow rapidly. Fugae Co is
considering entering this market through a four-year project. The project will cease after four years
because of increasing competition.
The initial cost of the project is expected to be $42,000,000 and it is expected to generate the
following after-tax cash flows over its four-year life:

Year 1 2 3 4
Cash flows ($000s) 3,277.6 16,134.3 36,504.7 35,683.6

The above figures are based on the tourism industry expanding as expected. However, it is
estimated that there is a 25% probability that the tourism industry will not grow as expected in the
first year. If this happens, then the present value of the project’s cash flows will be 50% of the
original estimates over its four-year life.
It is also estimated that if the tourism industry grows as expected in the first year, there is still a 20%
probability that the expected growth will slow down in the second and subsequent years, and the
present value of the project’s cash flows would then be 40% of the original estimates in each of
these years.
Lumi Co, a leisure travel company, has offered $50 million to buy the project from Fugae Co at the
start of the second year. Fugae Co is considering whether having this choice would add to the value
of the project.
If Fugae Co is bought by Avem Co after the project has begun, it is thought that the project will not
result in any additional synergy benefits and will not generate any additional value for the combined
company, above any value the project has already generated for Fugae Co.
Although there is no beta for companies offering luxury forms of travel in the tourist industry, Reka
Co, a listed company, offers passenger transportation services on coaches, trains and luxury
vehicles. About 15% of its business is in the luxury transport market and Reka Co’s equity beta is 1·6.
It is estimated that the asset beta of the non-luxury transport industry is 0·80. Reka Co’s shares are
currently trading at $4·50 per share and its debt is currently trading at $105 per $100. It has 80
million shares in issue and the book value of its debt is $340 million. The debt beta is estimated to
be zero.
 General information
The corporation tax rate applicable to all companies is 20%. The risk-free rate is estimated to be 4%
and the market risk premium is estimated to be 6%.
Required:
(a) Discuss whether or not Nahara Co’s acquisition strategies, of pursuing risk diversification and
of purchasing undervalued companies, can be valid. (7 marks)
(b) Discuss why the European Union (EU) may be concerned about Nahara Co’s stated intention
and how selling Fugae Co could reduce this concern. (4 marks)
(c) Prepare a report for the Board of Directors of Avem Co, which:
(i) Estimates the additional value created for Avem Co, if it acquires Fugae Co without
considering the luxury transport project; (10 marks)
(ii) Estimates the additional value of the luxury transport project to Fugae Co, both with and
without the offer from Lumi Co; (18 marks)
(iii) Evaluates the benefit attributable to Avem Co and Fugae Co from combining the two
companies with and without the project, and concludes whether or not the acquisition is
beneficial. The evaluation should include any assumptions made. (7 marks)
Professional marks will be awarded in part (c) for the format, structure and presentation
of the report.
(4 marks)

(50 marks)

2. Keshi Co

Keshi Co is a large multinational company with a number of international subsidiary companies. A

centralised treasury department manages Keshi Co and its subsidiaries’ borrowing requirements,
cash surplus investment and financial risk management. Financial risk is normally managed using
conventional derivative products such as forwards, futures, options and swaps.
Assume it is 1 December 2014 today and Keshi Co is expecting to borrow $18,000,000 on 1 February
2015 for a period of seven months. It can either borrow the funds at a variable rate of LIBOR plus 40
basis points or a fixed rate of 5·5%. LIBOR is currently 3·8% but Keshi Co feels that this could
increase or decrease by 0·5% over the coming months due to increasing uncertainty in the markets.
The treasury department is considering whether or not to hedge the $18,000,000, using either
exchange-traded March options or over-the-counter swaps offered by Rozu Bank.
The following information and quotes for $ March options are provided from an appropriate
exchange. The options are based on three-month $ futures, $1,000,000 contract size and option
premiums are in annual %.
 March calls Strike price March puts
0·882 95·50 0·662
0·648 96·00 0·902

Option prices are quoted in basis points at 100 minus the annual % yield and settlement of the
options contracts is at the end of March 2015. The current basis on the March futures price is 44
points; and it is expected to be 33 points on 1 January 2015, 22 points on 1 February 2015 and 11
points on 1 March 2015.
Rozu Bank has offered Keshi Co a swap on a counterparty variable rate of LIBOR plus 30 basis points
or a fixed rate of 4·6%, where Keshi Co receives 70% of any benefits accruing from undertaking the
swap, prior to any bank charges. Rozu Bank will charge Keshi Co 10 basis points for the swap.
Keshi Co’s chief executive officer believes that a centralised treasury department is necessary in
order to increase shareholder value, but Keshi Co’s new chief financial officer (CFO) thinks that
having decentralised treasury departments operating across the subsidiary companies could be
more beneficial. The CFO thinks that this is particularly relevant to the situation which Suisen Co, a
company owned by Keshi Co, is facing.
Suisen Co operates in a country where most companies conduct business activities based on Islamic
finance principles. It produces confectionery products including chocolates. It wants to use Salam
contracts instead of commodity futures contracts to hedge its exposure to price fluctuations of
cocoa. Salam contracts involve a commodity which is sold based on currently agreed prices, quantity
and quality. Full payment is received by the seller immediately, for an agreed delivery to be made in
the future.
Required:
(a) Based on the two hedging choices Keshi Co is considering, recommend a hedging strategy for
the $18,000,000 borrowing. Support your answer with appropriate calculations and
discussion. (15 marks)
(b) Discuss how a centralised treasury department may increase value for Keshi Co and the
possible reasons for decentralising the treasury department. (6 marks)
(c) Discuss the key differences between a Salam contract, under Islamic finance principles, and
futures contracts. (4 marks)

(25 marks)

3. Riviere Co

Riviere Co is a small company based in the European Union (EU). It produces high quality frozen food
which it exports to a small number of supermarket chains located within the EU as well. The EU is a
free trade area for trade between its member countries.
Riviere Co finds it difficult to obtain bank finance and relies on a long-term strategy of using
internally generated funds for new investment projects. This constraint means that it cannot accept
every profitable project and often has to choose between them.
Riviere Co is currently considering investment in one of two mutually exclusive food production
projects: Privi and Drugi. Privi will produce and sell a new range of frozen desserts exclusively within
the EU. Drugi will produce and sell a new range of frozen desserts and savoury foods to supermarket
chains based in countries outside the EU. Each project will last for five years and the following
financial information refers to both projects.
Project Drugi, annual after-tax cash flows expected at the end of each year (€000s)

Year Current 1 2 3 4 5
Cash flows (€000s) (11,840) 1,230 1,680 4,350 10,240 2,200

Privi Drugi
Net present value €2,054,000 €2,293,000
Internal rate of return 17·6% Not provided
Modified internal rate of return 13·4% Not provided
Value at risk (over the project’s life)
95% confidence level €1,103,500 Not provided
90% confidence level €860,000 Not provided

Both projects’ net present value has been calculated based on Riviere Co’s nominal cost of capital of
10%. It can be assumed that both projects’ cash flow returns are normally distributed and the
annual standard deviation of project Drugi’s present value of after-tax cash flows is estimated to be
€400,000. It can also be assumed that all sales are made in € (Euro) and therefore the company is
not exposed to any foreign exchange exposure.
Notwithstanding how profitable project Drugi may appear to be, Riviere Co’s board of directors is
concerned about the possible legal risks if it invests in the project because they have never dealt
with companies outside the EU before.
Required:
(a) Discuss the aims of a free trade area, such as the European Union (EU), and the possible
benefits to Riviere Co of operating within the EU. (5 marks)
(b) Calculate the figures which have not been provided for project Drugi and recommend which
project should be accepted. Provide a justification for the recommendation and explain what
the value at risk measures. (13 marks)
(c) Discuss the possible legal risks of investing in project Drugi which Riviere Co may be concerned
about and how these may be mitigated. (7 marks)

(25 marks)
Answers

1. Nahara Co and Fugae Co

Tutor Tips

• This is a very time pressured question. The key to picking up marks is to try to make sure that
you are answering every part of the question, even if you don’t have time to go into depth or
you have to take some shortcuts.
• The ACCA examiner’s answer mentioned Black-Scholes but you don’t need to think of detail like
this to pass!
• In part (a) you need to discuss both aspects of the strategy: targeting under-valued companies
and diversification
• In part (b) you can pick up some easy marks by knowing the basics of competition regulations
• In part (c) you need to try to get through the calculations as quickly as possible. Even if you don’t
manage to get all the calculations done, make sure that you are making and justifying
recommendations in your report.
• You will get some quick marks for identifying the assumptions and limitations in the calculations.
(a) Acquisition
Nahara can benefit from advantages in pursuing a policy of growth by acquisition. The key
advantages of this approach usually include:

○ A reduction in competition. The company may be buying a competitor who will no longer be
competing against it and its competitive position should be improved.

○ Barriers to entry into an industry or country may be avoided.

○ Growth, market penetration, access to new markets or productive capacity may be achieved
at a quicker rate by buying existing operations than by organic growth.

○ Acquisition brings possible synergies, use of skilled managers, labour, brands, patents and
trademarks.

However, there are some arguments against growth by acquisition:

○ Organic growth avoids the payment of a considerable purchase premium over the existing
market price that would often be required with growth by acquisition.

○ Organic growth tends to be in a related area of business, thus overcoming the risks arising
from diversification into non-core areas.

○ With organic growth, any investment can be planned exactly to the needs of the
organisation, that is, in line with the company’s objectives.
 ○ There are sometimes integration problems following an acquisition.

Identifying undervalued companies

If Nahara can successfully underpay for companies and subsequently increase their value by
improving performance then the effect on shareholder wealth will be positive. In order to make
this strategy work, Nahara must be able to identify these companies, successfully acquire them,
possibly dealing with competitor acquirers, and then increase the value of the acquired
companies.
There are a number of conditions needed for this to be a successful strategy.
Nahara would need to have access to the finance necessary to ensure a quick transaction: the
longer the transaction is delayed, the greater the risk that Nahara will be forced to pay more as
other firms will look at acquiring obviously undervalued companies and the shareholders of the
target company may become reluctant to sell.
Nahara will need to be able to unlock the value in target companies by using its own expertise
and resources.
Nahara will need access to better quality information than the market (implying at least some
level of market inefficiency).
Risk diversification
Diversification can reduce specific risk and as Nahara’s portfolio of investments becomes more
diversified then the variability of returns would be expected to decrease, assuming that its
investments in different companies are negatively correlated (for example, investments in
different countries or sectors). Another possible benefit of diversification is an overall reduction
in the volatility of cash flows, leading, potentially, to a lower cost of capital.
However, while the diversification argument is often made as an argument in favour of
expansion by merger and acquisition, there is a counter argument which states that individual
investors can gain the same benefit from constructing a diversified portfolio of equities and/or
bonds and so the companies that they invest in do not deliver any additional benefits from
diversifying.
Nevertheless, in the case of Nahara, there may well be some benefits from expansion by
acquisition, if the sovereign fund has its entire investment in the holding company and is not
well-diversified itself.
(b) The competition authorities will assess the benefits and risks, to stakeholders, of proposed
significant mergers and acquisitions. In particular, they will consider the impact on competition
of any reduction in the number of firms offering a product or service and/or any significant
increase in market share and market power.
The EU can block a merger or acquisition that carries a significant risk of abuse of dominant
market position that may result in, for example, less consumer choice or higher prices.
 Rather than block a transaction outright, the EU may impose conditions, such as price controls
or part-disposals as part of the approval process.
(c) Report
To: Board of Directors, Avem Co
From: X
Subject: Proposed acquisition of Fugae Co
Date: XX/XX/XXXX
Introduction
This report evaluates the benefits to Avem of acquiring Fugae.
The report first determines the value of the two individual companies compared with the
theoretical value of the new combined entity in order to assess the additional value created
from the business combination. Secondly, the report sets out possible ways of increasing value
after the combination, together with some working assumptions and limitations.
The report concludes by demonstrating the overall financial position as a result of the proposed
acquisition.
Value created for Avem (without luxury transport project)
As shown in Appendix I, the additional value created as a result of the acquisition is approx.
$452 billion. The shareholders of Nahara will gain approximately $277 billion of this
(approximately 61% of the total). This represents a premium of about 30% which is the
minimum acceptable to Nahara. The remaining $175 billion will benefit Avem, and this
represents an increase of 1.5% in the company’s value.
Value created for Avem (with luxury transport project)
As shown in Appendix II, accepting the luxury transport project would increase Fugae’s value as
the expected net present value is positive. Lumi’s offer increases the expected net present
value.
Therefore, it would be worthwhile for Fugae to take on the project and accept Lumi’s offer.
Assumptions and limitations
The following assumptions have been made in preparing this analysis, and these simplifying
assumptions may limit the reliability of the calculations.

○ All figures relating to synergies, growth rates and multipliers, as well as those relating to risk
(eg cost of capital) are accurate.

○ Growth continues in perpetuity.

○ The probability analysis is reliable.

○ There is no significant change in capital structure. (The project is small.)

Due to the uncertainty surrounding some of these figures, caution should be exercised in
interpreting any conclusion and you may wish to undertake additional analysis eg sensitivity
analysis.
There may be additional options and outcomes that have not been considered and a more
sophisticated valuation model (such as Black-Scholes) may be needed to determine the value of
these alternatives.
Overall recommendation
Both Nahara and Avem gain from the proposed acquisition; Nahara stands to gain more (in
absolute and relative terms).
If Fugae takes on the project, although it does not affect the benefits from the acquisition,
Nahara could ask for an additional 30% ie $3.7m of the $12·3m value to be transferred.
In conclusion, therefore, it is recommended that the acquisition should go ahead.
Appendix I: Additional value created from combining Avem and Fugae
Avem current value = $7·50 × 1,600m = $12,000m
Avem free cash flow to equity = $12,000 million/7·2 = $1,667m
Fugae growth rate estimate (using the g=rb model) = 0·227 × 0·11 = 0·025 ie 2·5%
Fugae valuation = $76·5 m × (1·025/(0·11 – 0·025)) = $923m
New combined entity, additional value created = (($1,667m + $77m + $40m) × 7·5) − ($12,000m
+ $923m) = $452m
Gain to Nahara from selling Fugae = 30% × $923m = $277m
Gain to Avem = $452m – $277m = $175m
Appendix II: Value of project to Fugae
Project cost of capital
Reka asset beta
Reka equity value = $4·50 × 80m = $360m
Reka debt value = 1·05 × $340 m = $357m
Reka Asset beta = 1·6 × 360m/(360m + 357m × 0·8) = 0·89
Project asset beta (X)
0·89 = X × 0·15 + 0·80 × 0·85
Therefore X = 1·4
Fugae Co
MVe = $923m
MVd = 388m (W1)
(W1)
Kd = Rf + spread = 4% + 0.8% = 4.8%
MVd (per $100) = (5·40 × (1·048–1 + 1·048–2 + 1·048–3 + 1·048–4) + 100) = 102·14
MVd = (102.14 / 100) × $380m = $388m
Project risk adjusted equity beta
1·4 × ($923m + $388m × 0·8)/$923m = 1·87
Project risk adjusted cost of equity
4% + (1·87 × 6%) = 15·2%
Project risk adjusted cost of capital
(15·2% × $923m + 4·8% × 0·8 × $388m)/($923m + $388m) = 11·84%, approx 12%
Estimate of expected value of the project without the offer from Lumi

Time Cash DF 12% PV

1 3,277.6 1.12-1 2,926.9
2 16,134.3 1.12-2 12,859.0
3 36,504.7 1.12-3 25,991.3
4 35,683.6 1.12-4 22,694.8

For expected net present value calculations, probabilities have been assigned to possible
outcomes based on whether or not the tourism market will grow.

PV year 1: 2,926,900
50% of PV years 1 to 4: 32,236,000
PV years 2 - 4: 61,545,100
40% PV years 2 to 4: 24,618,040

Expected present value of cash flows = (0·75 × (2,926,900 + (0·8 × 61,545,100 + 0·2 ×
24,618,040))) + (0·25 × 32,236,000) = 50,873,941
Expected NPV of project = 50,873,941 – 42,000,000 = 8,873,941
Estimate of expected value of the project with the offer from Lumi
Value of Lumi offer is $50,000,000 × 1.12-1 = $44,650,000
 Value of PV of years 2-4 cashflows = $30,800,000 approx
Therefore if the tourism industry does not grow as expected in the first year, Fugae should
accept the offer made by Lumi.
50% of year 1 PV = 1,463,450
Expected present value of cash flows = (0·75 × (2,926,900 + 54,159,688)) + (0·25 × (1,463,450 +
44,650,000)) = 54,343,304
Expected NPV of project = 54,343,304 – 42,000,000 = 12,343,304

2. Keshi Co

Tutor Tips

• This question focuses on interest rate risk management, specifically swaps and options.
• To maximise your marks, lay out your calculations clearly in part (a) and deal with options and
swaps one at a time.
• Both parts (b) and (c) offer the chance to pick up some marks for good background knowledge
and sensible suggestions.
• You might not remember what a Salam contract is so don’t worry too much about trying to pick
up every mark in every question. If you make some sensible points about futures you will still
get at least one mark!
(a)
(i) Traded options
Keshi needs to hedge against a rise in interest rates, therefore needs to buy put options.
Requirement is for 42 March put option contracts. ((18,000,000/1,000,000 × 7/3) = 42)
Expected futures price on 1 February if interest rates increase by 0·5% is 100 – (3·8 + 0·5) –
0·22 = 95·48
Expected futures price on 1 February if interest rates decrease by 0·5% is 100 – (3·8 – 0·5) –
0·22 = 96·48

If interest rates increase by 0·5%:

Exercise price 95·50 96·00
Futures price 95·48 95·48
Exercise? Yes Yes
Gain in basis points 2 52
Underlying cost of borrowing:
4·7% × 7/12 × 18m 493,500 493,500
Gain on options:
0·0002 × 1m × 3/12 × 42 2,100
0·0052 × 1m × 3/12 × 42 54,600
Premium:
0·00662 × $1,000,000 × 3/12 × 42 69,510
0·00902 × $1,000,000 × 3/12 × 42 94,710
Net cost: 560,910 533,610
Effective interest rate 5·34% 5·08%

If interest rates decrease by 0·5%:

Exercise price 95·50 96·00
Futures price 96·48 96·48
Exercise? No No
Gain in basis points 0 0
Underlying cost of borrowing:
3·7% × 7/12 × 18m 388,500 388,500
Gain on options 0 0
Premium 69,510 94,710
Net cost 458,010 483,210
Effective interest rate 4·36% 4·60%

(ii) Swaps
The fixed and floating rate costs are as follows:

Keshi Rozu Difference

Fixed rate borrowing 5·50 4·60 0·90
Floating rate borrowing L + 0·40 L + 0·30 0·10
Net benefit before charges 0.80
Floating rate loan (L + 0.40)
Fixed rate paid (4.60)
Floating rate received L + 0.30
Net cost (4.70)
Total gain (5.5 – 4.7) 0.80
Keshi gain (70% × 0.8) 0.56
Net outcome: 5.50
(0.56)
0.10

5.04

(iii) Recommendations
The interest cost under two alternative scenarios of interest rates rising and falling is as
follows:

Interest rates Interest rates

increase by 0.5% decrease by 0.5%
Do nothing – variable 4.70 3.70
Do nothing – fixed 5.50 5.50
Option at 95.50 5.34 4.36
Option at 96.00 5.08 4.60
Swap 5.04 5.04

The best choice would appear to be to borrow at variable rates, without using futures or
swaps. However, if interest rates rise significantly then Keshi is exposed to the risk of
significantly higher costs.
The second choice would be to undertake a swap, which increases the cost to only 5.04%
(significantly below the market fixed rate) while eliminating risk.
This illustrates the trade-off between minimising overall forecast cost and reducing risk.
(b) The key advantage of centralising the treasury function is eliminating duplication of resource
and effort.
This has become increasingly important as globalisation has led to a more complex international
business environment. According to Bloomberg, a number of individual areas can be identified
as offering advantages from treasury centralisation.
For example, centralising hedging and trading operations eliminates the need for each business
line to have their own traders and trade lifecycle management resources. Agreements with
 counterparties are streamlined, reducing the operational burden of managing different external
agreements and associated requirements.
Centralised cash management can provide similar efficiencies. (International trade requires that
cash is managed across various currencies with diverse banking partners.) Banking relationships
can be optimised across the regions and partners with which a firm transacts. Central
management of bank-to-bank payments increases the controllership over these transactions,
reducing interest and other claims against the firm.
Regulatory burdens have also increased, requiring cross-border management of the varying
regulatory regimes.
A centralised treasury department will normally be in a good position to evaluate the financing
requirements of Keshi and may allow Keshi to benefit from better rates for borrowing, for
example. A centralised treasury function may also be able to better match surplus cash in one
subsidiary with a financing need in another, thus reducing the eternal finance needed and
potentially increasing the return on surplus funds invested. Multilateral hedging (eg on currency
risk) across the group may also generate savings.
There are, however, some barriers to and disadvantages of centralisation.
The largest impediments to centralisation are often technology limitations. Although treasury
activities are linked with each other, few systems offer the capability of connecting cash
management with hedge management, requiring manual touch points or interfaces and
manipulation of data. Many treasuries manage forecasted cash exposures within spreadsheets,
for example, making the aggregation of exposures at the consolidated level a time-consuming
and error-prone manual process. Those systems that do offer this functionality are expensive,
with implementation taking months or years.
Some companies or groups may find that a “hybrid” approach works better for their business –
for example, subsidiaries are tasked with identifying exposures related to their line of business
and then request head office operations to execute hedges.
It may be that individual subsidiaries are better placed to deal with local regulations and
markets: for example Suisen uses Salam contracts rather than conventional futures.
Allowing a degree of autonomy within subsidiaries may also increase staff motivation among
local managers.
(c) The main principles contained within Islamic finance are summarised by the Financial Times as
follows:

○ adherence to interest- (riba-) free financial transactions

○ prohibition of fixed return

○ profit-and-loss sharing and hence risk sharing

○ participatory financing
 ○ prohibition of uncertainty (gharar)

○ prohibition on speculation and gambling

○ money not having any inherent value in itself

○ equity-based financing

Futures contracts can be used to hedge exposure but the hedge may not be 100% effective and
futures can also be used deliberately speculatively. Because futures are traded actively they are
subject to constant readjustments in market value. This creates uncertainty in terms of the cash
amounts to be received or paid.
By contrast, Salam contracts are forward financing transactions, where one party pays in
advance for buying specified assets, which the seller will supply on a pre-agreed date at a
pre-agreed price. The object of the contract is that the goods are a recompense for the price
paid in advance.
Because Salam contracts deal with the delivery of assets not in existence, strict rules must be
followed in defining the details of the contract and Salam contracts can only exist for those
commodities where quality and quantity, as well as price and date of delivery, can be exactly
specified in advance.

3. Riviere Co

Tutor Tips

• This question is based on an investment appraisal but also requires some discussion on free
trade and the risks associated with international trade.
• The calculations in part (b) are quite complex but should be familiar to you. Work through them
methodically and you will pick up method marks even if you make some minor mistakes.
• Read the requirements in parts (a) and (c) carefully, there are several answers that you need to
mention.
• Try where you can to make points that are relevant to this company in parts (a) and (c) – you are
asked to discuss benefits to Riviere in particular, not to companies in general.
(a) Free trade is the unrestricted movement of goods and services throughout international
markets, without tariffs, barriers, quotas etc. The European Union is a free-trade area in the
sense that member countries agree to the free movement of goods, services, capital and people.
However, the EU also shares legal frameworks and common external barriers such as import
tariffs, product safety standards and industrial and commercial standards.
According to the World Trade Organisation, the aim of a free-trade area is to reduce barriers to
exchange so that trade can grow as a result of specialisation, division of labour, and use of
comparative advantage. The theory of comparative advantage states that in an unrestricted
 market each country will tend to specialise in that activity where it has comparative advantage,
resulting in an overall increase in aggregate income and wealth.
Riviere can gain benefits from operating within the EU:

○ privileged access to the EU market and protection from non-EU competition

○ common standards of food production and packaging will reduce administration and
compliance costs

○ access to labour resource

○ easy to set up local offices in other EU countries

○ access to government support

(b) Project Drugi calculations

(i) Internal rate of return
At 10% NPV = 2,293,000 (given in question, some rounding)
At 15% NPV = 309,000 (W1)
At 20% NPV = −1,310,000 (W1)
Interpolating between 10% and 20%, IRR = 10 + (10 × (2,293 / (2293 + 1,309))) = 16.4
(W1) IRR calculations

r = 0.10 r = 0.15 r = 0.20

0 (11,840) (11,840) (11,840) (11,840)
1 1,230 1,118 1,070 1,025
2 1,680 1,388 1,270 1,167
3 4,350 3,268 2,860 2,517
4 10,240 6,994 5,855 4,938
5 2,200 1,366 1,094 884

2,295 309 (1,309)

(ii) Modified internal rate of return

At 10% total PV years 1–5 = 11,840,000 + 2,293,000 = 14,133,000
MIRR = (((14,133 / 11,840)(1/5)) × 1.10) – 1 = 0.14 ie 14%
(iii) Value at risk
A 95% confidence level requires the annual present value VAR to be within approximately
1·645 standard deviations from the mean.
 A 90% confidence level requires annual present value VAR to be within approximately 1·282
standard deviations from the mean.
95% 5 year PV VAR = 400,000 × 1·645 × 51/2 = 1,471,000
90% 5 year PV VAR = 400,000 × 1·282 × 51/2 = 1,147,000
(iv) Summary of analysis

Privi Drugi
NPV at 10% 2,054,000 2,293,000
IRR 17·6% 16·4%
MIRR 13·4% 14·0%
VAR (95% confidence level) 1,103,500 1,471,000
VAR (90% confidence level) 860,000 1,147,000

(v) Recommendations
The net present value indicates that project Drugi is preferable.
The modified internal rate of return calculations also support this decision.
The internal rate of return for project Privi is higher. However, this method should not be
used to choose between two mutually exclusive projects of different sizes because it may
produce give an answer which is inconsistent with shareholder wealth maximisation.
Therefore, based on discounted cash flows, project Drugi should be accepted due to the
higher net present value and modified IRR.
However, there is one area where the calculations could be improved. Although the
investments appear to involve different risk levels (see VAR calculations) the cash flows have
been discounted at the same rate, which is incorrect: the discount rate applied to the cash
flows should be risk-adjusted.
The VAR provides an indication of the potential riskiness of the projects. The calculations
show that if Riviere invests in project Drugi then it can be 95% confident that the present
value will not fall by more than €1,471,000 over its life. Even in this case the net present
value would still be positive. There is a 5% chance that the loss could be greater than
€1,471,000. With project Privi, the potential loss in value is smaller and therefore it is in this
sense less risky.
Therefore, when risk is also taken into account, the choice between the projects is not
obvious and involves Riviere’s directors making a decision which takes into account the
trade-off between risk and return. Project Drugi gives the higher potential net present value
but at a higher level of risk.
(c) Possible legal risks include:

○ Differing legal regulations on food preparation and quality

○ Different regulations relating to food packaging and marketing (for example, statutory
information which must be displayed on food packaging)

○ Protection for brand names, trademarks etc

○ Restrictions on and costs of distribution

○ Legal risks (eg product liability, consumer protection)

○ Barriers to trade such as tariffs and quotas and effect on Riviere’s ability to compete

Possible actions that Riviere may take to mitigate risk include:

○ Extensive market research.

○ Legal advice and specialist industry legal advice on areas such as food regulations, product
liability and consumer law

○ Contractual arrangements with partners eg local distributors, retailers