Question 1

SECTION B: ADVISORY REPORT

This question is worth 25 marks.

Scenario:
Global Health Logistics (GHL) is a UK-based specialized logistics firm contracted by international NGOs to deliver medical supplies. GHL is evaluating a major Foreign Direct Investment (FDI) to establish a regional distribution hub in 'Zamboria', a developing nation with a volatile political landscape. The local currency is the Zamborian Real (ZAR).

The initial investment required immediately (Year 0) is ZAR 500 million.

Exhibit 1: Base Case Project Data
The expected net operating cash flows in Zamboria are:
Year 1: ZAR 150 million
Year 2: ZAR 200 million
Year 3: ZAR 250 million
Year 4: ZAR 100 million
At the end of Year 4, the project will be handed over to the Zamborian government for zero terminal value.

Economic Data:
- Current spot exchange rate: ZAR 20.00 / GBP
- Annual inflation in Zamboria is expected to be 8.0%.
- Annual inflation in the UK is expected to be 3.0%.
- GHL's UK-based nominal Weighted Average Cost of Capital (WACC) is 10.0%.

Exhibit 2: Real Option to Expand
If the initial hub is successful, GHL has the exclusive right to expand operations into neighboring regions at the end of Year 3. This expansion would require a further capital outlay of ZAR 300 million at Year 3. 
The present value (at Year 0) of the expected cash flows from this expansion is estimated to be ZAR 180 million. 
The volatility (standard deviation) of the expansion project's returns is estimated at 30% per annum. The UK risk-free rate of interest is 5.0% per annum continuously compounded.

Requirements:
(a) Calculate the base case Net Present Value (NPV) of the Zamborian project in GBP. You must use the Purchasing Power Parity (PPP) theory to forecast the ZAR/GBP exchange rates for Years 1 to 4. (10 marks)

(b) Using the Black-Scholes Option Pricing (BSOP) model, estimate the value of the real option to expand in GBP. Calculate the overall Adjusted Present Value (Strategic NPV) of the investment. 
(Note: Assume the ZAR/GBP exchange rate at Year 3 calculated in part (a) applies to the option variables). (10 marks)

(c) Discuss the specific political risks GHL faces by investing in Zamboria and recommend three strategies GHL could employ to mitigate these risks. (5 marks)

Accepted Answer

For part (a), use the formula Spot * ((1+Foreign Inflation)/(1+Home Inflation))^n to find the exchange rates. Divide the ZAR cash flows by these rates to get GBP. Discount at 10%. For part (b), identify the 5 BSOP variables. Pa is the PV of inflows (convert at spot). Pe is the capital outlay (convert at Year 3 rate). Plug into d1 and d2 formulas, find the normal distribution values, and calculate the call option. Add this to the base NPV. For part (c), define political risk in the context of FDI and list practical ways a multinational can protect itself.

Question 2

What mistakes do candidates make on this ACCA question?

Accepted Answer

1. Using the interest rate parity formula instead of purchasing power parity for long-term cash flow forecasting. 2. Converting the BSOP variables (Pa and Pe) using the wrong exchange rates. 3. Calculating d1 incorrectly due to order-of-operations errors in the calculator. 4. Forgetting to calculate the final Strategic NPV by adding the option value to the base NPV.

How to approach this question

Full Answer

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Practice the full ACCA AFM — Advanced Financial Management Practice Exam 6

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