AFM Course notes

Syllabus A: Role of The Senior Financial Adviser ........................................2

Syllabus A1. The role and responsibility of senior financial executive/advisor. ...............2
Syllabus A2. Financial strategy formulation .............................................................10
Syllabus A3. Ethical and governance issues ..........................................................38
Syllabus A4. Management of international trade and finance ...................................52
Syllabus A5. Strategic business and financial planning for multinationals ...................73
Syllabus A6. Dividend policy in multinationals and transfer pricing .............................82
Syllabus B: Advanced Investment Appraisal ..........................................102
Syllabus B1. Discounted cash flow techniques ....................................................102
Syllabus B2. Application of option pricing theory in investment decisions ................ 144
Syllabus B3. Impact of financing on investment decisions and APV .......................169
Syllabus B4. Valuation and the use of free cash flows ..........................................236
Syllabus B5. International investment and financing decisions ................................258
Syllabus C: Acquisitions And Mergers ...................................................269
Syllabus C1. Acquisitions and mergers versus other growth strategies ...................269
Syllabus C2. Valuation for acquisitions and mergers .............................................281
Syllabus C3. Regulatory framework and processes .............................................285
Syllabus C4. Financing acquisitions and mergers .................................................290
Syllabus D: Corporate Reconstruction And Re- Organisation ................303
Syllabus D1. Financial reconstruction ..................................................................303
Syllabus D2. Business re-organisation ................................................................307
Syllabus E: Treasury And Advanced Risk Management Techniques .......320
Syllabus E1. The role of the treasury function in multinationals ...............................320
Syllabus E2. The use of financial derivatives to hedge against forex risk ..................329
Syllabus E3. The use of financial derivatives to hedge against interest rate risk ........ 365

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Syllabus A: Role of The Senior Financial Adviser

Syllabus A1. The role and responsibility of senior financial

executive/advisor.

Syllabus A1a. Develop strategies for the achievement of the organisational goals

Financial management is getting and using financial

resources well to meet objectives

Financial objectives

Profit maximisation is often assumed, incorrectly, to be the main objective of a

business.

Reasons why profit is not a sufficient objective:

1. Investors care about the future

2. Investors care about the dividend
3. Investors care about financing plans
4. Investors care about risk management

For a profit-making company, a better objective is the maximisation of shareholder

wealth.

This can be measured as total shareholder return (dividend yield + capital gain or the
dividend per share plus capital gain divided by initial share price)

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Key decisions:

1. Investment
(in projects or takeovers or working capital) need to be analysed to ensure that they
are beneficial to the investor.

Investments can help a firm maintain strong future cash flows by the achievement of
key corporate objectives

e.g. market share, quality.

2. Finance
mainly focus on how much debt a firm is planning to use.

The level of gearing that is appropriate for a business depends on a number of

practical issues:

Life cycle - A new, growing business will find it difficult to forecast cash flows with
any certainty so high levels of gearing are unwise.

Operating gearing - If fixed costs are a high proportion of total costs then cash
flows will be volatile; so high gearing is not sensible.

Stability of revenue - If operating in a highly dynamic business environment then

high gearing is not sensible.

Security - If unable to offer security then debt will be difficult and expensive to
obtain.

3. Dividends
how returns should be given to shareholders

4. Risk management
mainly involve management of exchange rate and interest rate risk and project
management issues.

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Key Objectives of Financial Management

Taking a commercial business as the most common organisational structure, the key
objectives of financial management would be to:

• Create wealth for the business

• Generate cash, and

• Provide an adequate return on investment bearing in mind the risks that the
business is taking and the resources invested

3 key elements to the process of financial management

1. Financial Planning
Management need to ensure that enough funding is available at the right time to
meet the needs of the business.

In the short term, funding may be needed to invest in equipment and stocks, pay
employees and fund sales made on credit.

In the medium and long term, funding may be required for significant additions to the
productive capacity of the business or to make acquisitions.

2. Financial Control
Financial control is a critically important activity to help the business ensure that the
business is meeting its objectives.

Financial control addresses questions such as:

• Are assets being used efficiently?


• Are the businesses assets secure?

• Do management act in the best interest of shareholders and in accordance with
business rules?

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3. Financial Decision-making
The key aspects of financial decision-making relate to investment, financing and
dividends:

Investments must be financed in some way – however there are always financing
alternatives that can be considered.

For example it is possible to raise finance from selling new shares, borrowing from
banks or taking credit from suppliers



A key financing decision is whether profits earned by the business should be
retained rather than distributed to shareholders via dividends.

If dividends are too high, the business may be starved of funding to reinvest in
growing revenues and profits further

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Syllabus A1bc & A2c. Recommend strategies for the management of the financial resources
of the organisation such that they are utilised in an efficient, effective and transparent way.

c) Advise the board of directors or management of the organisation in setting the financial
goals of the business and in its financial policy development with particular reference to:

i) Investment selection and capital resource allocation

ii) Minimising the cost of capital
iii) Distribution and retention policy
iv) Communicating financial policy and corporate goals to internal and external stakeholders
v) Financial planning and control
vi) The management of risk.

A2c) Recommend appropriate distribution and retention policy

The main roles and responsibilities of the financial

manager are varied:

They can include:

1. investment selection and capital resource allocation

2. raising finance and minimising the cost of capital

3. distribution and retentions

4. communication with stakeholders

5. financial planning and control

6. risk management

7. efficient and effective use of resources.

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Let's look at these in a bit more detail, hot pants, below..

1. Investment selection and capital resource allocation

Profit maximising may not be the only goal for a company, its stakeholders may want
other things..

Therefore, other considerations are as follows:

• Ethical considerations when deciding on what to invest in

• What method of investment appraisal should be used?

NPV?

IRR?

• What our stakeholders will think of the investments effects on:

 –ROCE

– EPS

2. Raising finance and minimising the cost of capital

All investments needs financing

Where should we get this financing from?

The following issues thus need to be considered:

• Are the current gearing levels minimising the cost of capital for the company?

• What gearing level is required?

• What sources of finance are available?

• Tax implications

• The risk appetite of investors and management

• Restrictions such as debt covenants

• Implications for key ratios

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3. Distribution and retention policy
Retained earnings is a great source of finance.. so should we give dividends away?

It depends on...

• Will our investments (funded by retained earnings) increase the share price and
thus shareholder wealth?

• Will paying high dividends mean we need alternative finance for capital
expenditure or working capital requirements?

Will paying low dividends fail to give shareholders their required income levels

• What are the investor preferences for cash dividends now or capital gains in
future from enhanced share value?

4. Communication with stakeholders

We need to keep stakeholders informed..

• Shareholders will need information about:

– dividends

– gearing levels

– risk

Suppliers and customers will need information about:

– credit policies

– pricing policies.

• Internal stakeholders

Mission statements and current goals and strategies is important for employees
at all levels

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5. Financial planning and control
The senior financial executive will need to develop policies on:

• Planning processes

• Business plans

• Budgets

• Evaluating performance

6. The management of risk

Risk management is key and so the following needs understanding:

• Risk appetite

• How are risks identified, Analysed, Planned for and Monitored?

7. Use of resources
It will be important to develop a framework to ensure all resources (inventory, labour
and noncurrent assets as well as cash) are used to provide value for money.

Spending must be:

• economic

• efficient

• effective

• transparent.

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 Syllabus A2. Financial strategy formulation

Syllabus A2a. Assess organisational performance using methods such as ratios and trends

Accounting Ratios

In your exam, you may be required to calculate some ratios in order to support your
strategic analysis of the case.  

This section shall only present a summary and list of ratios that could potential be
used in your exam for such purpose.

Ratios may be divided into the following categories:

• PROFITABILITY RATIOS

These are measures of value added being generated by an organisation and include
the following:

ROCE Operating Profit (PBIT)/Capital Employed

Capital Equity + LT liabilities

Employed

Capital Non current assets + net current assets

Employed

Capital Total assets - current liabilities

Employed

Gross margin Gross Profit/Sales

Net Margin Net Profit/Sales

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ROE Profit After Tax - Preference dividends/Shareholders’ Funds
(Ordinary shares + Reserves)

RI Profit After Tax - (Operating Assets x Cost of Capital)

• EFFICIENCY RATIOS

These are measures of utilisation of Current & Non-current Assets of an

organisation.  Efficiency Ratios consist of the following:

Asset Turnover Sales/Capital Employed

ROCE Margin X Asset Turnover

Receivables Days (Receivables Balance / Credit Sales) x 365

Payables Days (Payable Balance / Credit Purchases) x 365

Inventory Days (Inventory / Cost of Sales) x 365

• LIQUIDITY & GEARING RATIOS

Liquidity Ratios measure the extent to which an organisation is capable of

converting assets into cash and cash equivalents.  

On the other hand, Gearing Ratios measure the dependence of an organisation

on external financing as against shareholder funds.  

Liquidity and Gearing Ratios are outlined below:

Liquidity
Current Ratio Current Assets / Current Liabilities
Quick Ratio (Current Assets – Inventory) / Current Liabilities
Gearing
Financial Gearing Debt/Equity
Financial Gearing Debt/Debt + Equity
Operational gearing Contribution / PBIT

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• INVESTOR'S RATIOS

These ratios measures return on investment generated by stakeholders.  Such

ratios include:

Dividend Cover Profit After Tax / Total Dividend

Dividend Yield Dividends per share / Share price
Interest Cover PBIT / Interest
Interest yield (coupon rate / market price) x 100%
Earnings Per Share Profit After Tax and preference dividends / Number of Shares
PE Ratio Share Price / EPS

• In the exam you have to act like a detective.

You have to sift through evidence and extract meaningful messages for effective
business decisions.

The starting point is often the basic accounting documents that record the
progress of any business, the Income statement & SFP

These are closely related  and so need reading together.

The balance sheet is a snapshot of a business at one point in time.

The income statement is dynamic and describes the flow of money through the
business over a period of time.

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 Syllabus A2a. Assess organisational performance using methods such as ratios and trends

Ratios aren't always comparable

Factors affecting comaparability

1. Different accounting policies

Eg One company may revalue its property; this will increase its capital employed and
(probably) lower its ROCE

Others may carry their property at historical cost

2. Different accounting dates

Eg One company has a year ended 30 June, whereas another has 30 September

If the sector is exposed to seasonal trading, this could have a significant impact on
many ratios.

3. Different ratio definitions

Eg This may be a particular problem with ratios like ROCE as there is no universally
accepted definition

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4. Comparing to averages

Sector averages are just that: averages

Many of the companies included in the sector may not be a good match to the type
of business being compared

Some companies go for high mark-ups, but usually lower inventory turnover,
whereas others go for selling more with lower margins

5. Possible deliberate manipulation (creative accounting)

6. Different managerial policies

e.g. different companies offer customers different payment terms

Compare ratios with

1. Industry averages

2. Other businesses in the same business

3. With prior year information

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Syllabus A2b. Recommend the optimum capital mix and structure within a specified business
context and capital asset structure.

High Gearing problems

The higher a company’s gearing, the more the company is considered risky.

An acceptable level is determined by comparison to companies in the same industry.

A company with high gearing is more vulnerable to downturns in the business cycle
because the company must continue to service its debt regardless of how bad sales
are.

A greater proportion of equity provides a cushion and is seen as a measure of

financial strength.

The best known examples of gearing ratios include

1. debt-to-equity ratio (total debt / total equity),

2. interest cover (EBIT / total interest),

3. equity ratio (equity / assets), and

4. debt ratio (total debt / total assets).

Dangers associated with high gearing:

1. Need to cover high fixed costs, may tempt companies to increase sales prices
and so lose sales to competition

2. Risk of non payment of a fixed cost and litigation

3. Risk of unsettling shareholders by having no spare funds for dividends

4. Risk of lower credit rating

5. Risk of unsettling key creditors

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How finance can affect financial position and risk

Financial Position Gearing

Gearing can be a financially sound part of a business’s capital structure particularly if

the business has strong, predictable cash flows.

Operational gearing

Operating gearing is a measure which seeks to investigate the relationship between

the fixed operating costs and the total operating costs.

• In cases where a business has high fixed costs as a proportion of its total costs,
the business is deemed to have a high level of operational gearing.

Potentially this could cause the business problems in as it relies on continuing

demand to stay afloat.

• If there is a fall in demand, the proportion of fixed costs to revenue becomes even
greater. It may turn profits into serious losses.

Normally, businesses cannot themselves do a great deal about the operational

gearing, as it may be typical and necessary in the industry, such as the airline
business.

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The normal equation used is:

• Fixed operating costs / Total operating costs

In this sense total operating costs include both fixed and variable operating costs.

Interest cover

Interest cover is a measure of the adequacy of a company’s profits relative to

interest payments on its debt.

The lower the interest cover, the greater the risk that profit (before interest) will
become insufficient to cover interest payments.

It is:

It is a better measure of the gearing effect of debt on profits than gearing itself.

A value of more than 2 is normally considered reasonably safe, but companies with
very volatile earnings may require an even higher level, whereas companies that
have very stable earnings, such as utilities, may well be very safe at a lower level.

Similarly, cyclical companies at the bottom of their cycle may well have a low interest
cover but investors who are confident of recovery may not be overly concerned by
the apparent risk.

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Syllabus A2b. Recommend the optimum capital mix and structure within a specified business
context and capital asset structure.

Sources of Finance

Operating Leases

This is a useful source of finance for the following reasons:

1. Protection against obsolescence

Since it can be cancelled at short notice without financial penalty.

The lessor will replace the leased asset with a more up-to-date model in
exchange for continuing leasing business.

This flexibility is seen as valuable in the current era of rapid technological

change, and can also extend to contract terms and servicing cover

2. Less commitment than a loan

There is no need to arrange a loan in order to acquire an asset and so the

commitment to interest payments can be avoided, existing assets need not be
tied up as security and negative effects on return on capital employed can be
avoided

 

Operating leasing can therefore be attractive to small companies or to companies
who may find it difficult to raise debt.

3. Cheaper than a loan

By taking advantage of bulk buying, tax benefits etc the lessor can pass on some
of these to the lessee in the form of lower lease rentals, making operating leasing
a more attractive proposition that borrowing.

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4. Off balance sheet finance

Operating leases also have the attraction of being off-balance sheet financing, in
that the finance used to acquire use of the leased asset does not appear in the
balance sheet.

Debt v Equity
These are the things you need to think about when asked about raising finance - so
just put all these in your answer and link them to the scenario. Job done.

• Gearing and financial risk

Equity finance will decrease gearing and financial risk, while debt finance will
increase them

• Target capital structure

The aim is to minimise weighted average cost of capital (WACC).

In practical terms this can be achieved by having some debt in capital structure,
since debt is relatively cheaper than equity, while avoiding the extremes of too
little gearing (WACC can be decreased further) or too much gearing (the
company suffers from the costs of financial distress)

• Availability of security
Debt will usually need to be secured on assets by either a fixed charge (on
specific assets) or a floating charge (on a specified class of assets).

• Economic expectations

If buoyant economic conditions and increasing profitability expected in the future,

fixed interest debt commitments are more attractive than when difficult trading
conditions lie ahead.

• Control issues

A rights issue will not dilute existing patterns of ownership and control, unlike an
issue of shares to new investors.

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Rights Issues

A 1 for 2 at $4 (MV $6) right issue means….

The current shareholders are being offered 1 share for $4, for every 2 they already
own.

(The market value of those they already own are currently $6)

• Calculation of TERP (Theoretical ex- rights price)

The current shareholders will, after the rights issue, hold:

1 @ $4 = $4

2 @ $6 =$12
So, they now own a total of 3 for a total of $16. So the TERP is $16/3 = $5.33

• Effect on EPS

Obviously this will fall as there are now more shares in issue than before, and the
company has not received full MV for them
To calculate the exact effect simply multiply the current EPS by the TERP /
Market value before the rights issue
Eg Using the above illustration

EPS x 5.33 / 6

• Effect on shareholders wealth

There is no effect on shareholders wealth after a rights issue.

This is because, although the share price has fallen, they have proportionately
more shares

Equity issues such as a rights issue do not require security and involve no loss of
control for the shareholders who take up the right

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The factors considered when reducing the amount of debt by issuing
equity :
As the proportion of debt increases in a company’s financial structure, the level of
financial distress increases and with it the associated costs.
Companies with high levels of financial distress would find it more costly to contract
with their stakeholders.
For example, they may have to pay higher wages to attract the right calibre of
employees, give customers longer credit periods or larger discounts, and may have
to accept supplies on more onerous terms.

1. Less financial distress may therefore reduce the costs of contracting with
stakeholders.

2. Having greater equity would also increase the company’s debt capacity.
This may enable the company to raise additional finance

3. On the other hand, because interest is payable before tax, larger amounts of debt
will give companies greater taxation benefits, known as the tax shield.

4. Reducing the amount of debt would result in a higher credit rating for the
company and reduce the scale of restrictive covenants.

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 Syllabus A2d. Explain the theoretical and practical rationale for the management of risk.

Risk and the risk management process

5 step process:

1. Identify Risk

Make list of potential risks continually.

Identify risks facing the company - through consultation with stakeholders

2. Decide on acceptable risk

Decide on acceptable risk - and the loss of return/ extra costs associated
with reduced risks

3. Analyse Risk

Prioritise according to threat/likelihood.

Assess the likelihood of the risk occurring - management attention obviously on
the higher probability risks

4. Plan for Risk

Look at how impact of these risks can be minimised - through consultation with
affected parties.  
Avoid or make contingency plans (TARA)

5. Monitor Risk
Assess risks continually.
Understand the costs involved in the internal controls set up to manage these
risks - and weighed against the benefits

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Why do all this?

To ensure best use is made of opportunities



Risks are opportunities to be siezed


Can help enhance shareholder value

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 Syllabus A2e. Assess the organisation’s exposure to business and financial risk including
operational, reputational, political, economic, regulatory and fiscal risk.

Identifying Risks

Management must be aware of potential risks

They change as the business changes

So this stage is particularly important for those in turbulent environments

Uncertainty can come from any of the political, economic, natural, socio-
demographic or technological contexts in which the organisation operates.

Categories of risk

• Strategic risks

Refers to the positioning of the company in its environment.

Typically affect the whole of an organisation and so are managed at board level

• Operational risks

Refers to potential losses arising from the normal business operations.

Are managed at risk management level and can be managed and mitigated by
internal controls.

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• Financial risks

= are those arising from a range of financial measures.

The most common financial risks are those arising from financial structure
(gearing), interest rate risk, liquidity

• Business risks

The risk that the business won't meet its objectives.

If the company operates in a rapidly changing industry, it probably faces

significant business risk.

• Reputation risk

Any kind of deterioration in the way in which the organisation is perceived

When the disappointed stakeholder has contractual power over the organisation,
the cost of the reputation risk may be material.

• Market risk

Those arising from any of the markets that a company operates in, such as
where the business gets its inputs, where it sells its products and where it gets its
finance/capital

Market risk reflects interest rate risk, currency risk, and other price risks

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• Entrepreneurial risk

The risk associated with any new business venture 


In Ansoff terms, it is expressed the unknowns of the market reception

It also refers to the skills of the entrepreneurs themselves.

Entrepreneurial risk is necessary because it is from taking these risks that

business opportunities arise.

• Credit risk

Credit risk is the possibility of losses due to non-payment by creditors.

• Legal, or litigation risk

arises from the possibility of legal action being taken against an organization

• Technology risk

arises from the possibility that technological change will occur

• Environmental risk

arises from changes to the environment over which an  organisation has no direct
control,

e.g. global warming, or occurrences for which the organisation might be

responsible,

 e.g. oil spillages and other pollution.

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• Business probity risk

related to the governance and ethics of the organisation.

• Derivatives risk

due to the use of underperforming financial instruments

• Fiscal risks

risk that the new taxes and limits on expenses allowable for taxation purposes
will change.

• Health and safety risk

Health and safety risks include loss of employees' time because of injury and the
risks of having to pay compensation or legal costs because of breaches.

Health and safety risks can arise from:  


Lack of health and safety policy

Lack of emergency procedures

• Liquidity risk

If a business suddenly finds that it is unable to cover or renew its short-term

liabilities, there will be a danger of insolvency if it cannot pay its debts

However current liabilities are often a cheap method of finance (trade payables
do not usually carry an interest cost).

Businesses may therefore consider that, in the interest of higher profits, it is worth
accepting some risk of insolvency by increasing current liabilities, taking the
maximum credit possible from suppliers.

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 Syllabus A2e. Assess the organisation’s exposure to business and financial risk.

Business Risk

The risk that the business won't meet its objectives

The objective is normally profit maximisation

So we are looking for problems which may impact on the business

To look for Risks..

You could use PESTEL

Business risk identification is literally putting yourself in the shoes of the

management..

• Political risks

e.g. The current government may be unstable and if there is a change of

government, the new government may impose restrictions.

The Company will need to assess the likelihood of such restrictions.

• Economic risks

• Social and taste changes

• Technological changes

• Environmental issues

• Legal issues

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Financial Statement Risk

Simply the risk that the FS are materially misstated (before any audit procedures)

The risk comes from potential errors or deliberate misstatements

Business v Financial Risk

• Business risks will affect the FS if not addressed by management

• Business risks can lead to errors on specific areas of the FS (eg. Technological
change leading to obsolete stock)

• Business risk can have a more general effect on FS (eg. Poor controls leading to
errors)

• Business risks can lead to going concern problems. This too would be a FS risk
(wrong basis of accounting)

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 Syllabus A2fg. f) Develop a framework for risk management, comparing and contrasting risk
mitigation, hedging and diversification strategies.
g) Establish capital investment monitoring and risk management systems..

The risk framework

All projects are risky.

When a capital investment programme commences, a framework for dealing with

this risk must be in place.

This framework must cover:

1. risk awareness

2. risk assessment and monitoring

3. risk management (i.e.strategies for dealing with risk and planned responses
should unprotected risks materialise)

1. Risk awareness

In appraising most investment projects, reliance will be placed on a large number of

estimates.

For all material estimates, a formal risk assessment should be carried out to identify:

• potential risks that could affect the forecast

• the probability that such a risk would occur.

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Risks may be:

1. strategic

2. tactical

3. operational

Once the potential risks have been identified, a monitoring process will be needed to
alert management if they arise.

2. Risk assessment and monitoring

A useful way to manage risk is to identify potential risks (usually done in either
brainstorming meetings or by using external consultants) and then categorise them
according to the likelihood of occurrence and the significance of their potential
impact.

Decisions about how to manage the risk are then based on the assessment made.

These assessments may be time consuming and the executive will need to decide:

• how they should be carried out

• what criteria to apply to the categorisation process and

• how often the assessments should be updated.

The essence of risk is that the returns are uncertain.

As time passes, so the various uncertain events on which the forecasts are based
will occur.

Management must monitor the events as they unfold, reforecast predicted results
and take action as necessary.

The degree and frequency of the monitoring process will depend on the significance
of the risk to the project’s outcome.

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3. Risk management

Strategies for dealing with risk

Risk can be either accepted or dealt with.

Possible solutions for dealing with risk include:

1. mitigating the risk

– reducing it by setting in place control procedures

2. hedging the risk

– taking action to ensure a certain outcome

3. diversification

– reducing the impact of one outcome by having a portfolio of different ongoing

projects.

Well-diversified portfolios

Shareholders holding well-diversified portfolios will have diversified away

unsystematic or company specific risk, and will only face systematic risk,

ie risk that can not be diversified away.

Therefore a company can not reduce risk further by undertaking diversification within
the same system or market.

However, further risk reduction may occur if the diversification is undertaken by the
company, on behalf of the shareholders, into a system or market where they
themselves do not invest.

Some studies indicate that even shareholders holding well-diversified portfolios may
benefit from risk diversification where companies invest in emerging markets.

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 Syllabus A2h. Advise on the impact of behavioural finance on financial strategies / securities
prices and why they may not follow the conventional financial theories.

Behavioural Finance

Behavioural finance looks at why people make irrational decisions

Much of conventional finance is based on rational and logical theories, such as the
CAPM and EMH

These theories assume that people, for the most part, behave rationally and
predictably

But the real world is a very messy place people behave very unpredictably.

Contrary to convention we are not always "wealth maximisers".

Buying a lottery tickets is financially irrational for example.

Behavioral finance seeks to explain why we buy them

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The "Anomalies" that behavioural finance seeks to explain:

1. January Effect

Average monthly return for small firms is consistently higher in January than any
other month of the year.

Conversely, EMH suggests a "random walk”

2. The Winner's Curse

The winning bid in an auction often exceeds the intrinsic value of the item
purchased - maybe due to increased bid aggressiveness as more bidders enter
the market

3. Equity Premium Puzzle

CAPM says investors with riskier investments should get higher returns - but not
so much!

Shares historically return 10% and government (risk free) bonds 3% - yet shares
are not over 3 times more risky - so why is the return premium so high?

Behavioural finance shows people have a loss aversion tendency- so are more
worried by losses in comparison to potential gains - so in fact a very short-term
view on an investment.

So shareholders overreact to the downside changes.

Therefore, it is believed that equities must yield a high-enough premium to

compensate for the investor's considerable aversion to loss.

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Key concepts of Behavioural Finance

1. Anchoring

We tend to "anchor" our thoughts to a reference point - especially in new

situations

Large Coffee - £5


Medium Coffee - £3.50

Small Coffee - £3

The large is the anchor - get you used to a price (with no logic behind it) thus now
making the medium seem cheap. Especially as small (another anchor) is £3.

A share falls in value from £80 to £30 - it now seems a bargain - but thats just not
rational - you need to see the fundamentals of WHY the price fell not just look at
the £80 anchor

2. Mental Accounting

Individuals assign different functions to each of their assets, often irrationally

So a fund set aside for a vacation or a new home, while still carrying substantial
credit card debt is crazy (if the debt is costing more than the deposit account)

Some investors divide their investments between a safe and a speculative

portfolio - all this work and money spent separating the portfolios, yet his net
wealth will be no different than if he had held one larger portfolio.

3. Confirmation Bias

We all have a preconceived opinion.

So we selectively filter and pay more attention to information that supports our
opinions, while ignoring the rest

An investor "sees" information that supports her original idea and not the
contradictory info


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4. Gambler's Fallacy

You've flicked a coin 10 times - its always been heads amazingly.

Whats the chances of it being Tails on the next throw?

A gambler MAY incorrectly use the past info to try and predict the future. This is
crazy. The chance is still 50%

Some investors sell after a share has risen many times in the recent past - surely
it can't continue going up? Of course it can - the past has no effect on the future
in these situations

5. Herd Behaviour

We mimic the actions (rational or irrational) of a larger group.

Why else would anyone choose BPP or Kaplan over us?? :)

Individually, however, most people would not necessarily make the same choice.

The common rationale that it's unlikely that such a large group could be wrong.
After all, even if you are convinced that a particular idea or course or action is
irrational or incorrect, you might still follow the herd, believing they know
something that you don't. This is especially prevalent in situations in which an
individual has very little experience.

Think about investors in many dot.com companies in the past - all following each
other when fundamentally the businesses were not strong

6. Overconfidence

74% of professional fund managers believe they deliver above-average job

performance! :)

Overconfident investors generally conduct more trades than their less-confident

counterparts.

36
 Overconfident investors/traders tend to believe they are better than others at
choosing the best stocks and best times to enter/exit a position.

Unfortunately, traders that conduct the most trades tended, on average, to

receive significantly lower yields than the market.

7. Overreaction Bias

One consequence of having emotion in the stock market is the overreaction

toward new information.

According to EMH semi strong markets, new information should more or less be
reflected instantly in a security's price.

For example, good news should raise a business' share price accordingly, and
that gain in share price should not decline if no new information has been
released since.

Reality, however, tends to contradict this theory.

Often, participants in the stock market predictably overreact to new information,

creating a larger-than-appropriate effect on a security's price.

Furthermore, it also appears that this price surge is not a permanent trend -
although the price change is usually sudden and sizable, the surge erodes over
time.

37
 Syllabus A3. Ethical and governance issues

Syllabus A3ab. a) Assess the ethical dimension within business issues and decisions and
advise on best practice in the financial management of the organisation.
b) Demonstrate an understanding of the interconnectedness of the ethics of good business
practice between all of the functional areas of the organisation.

Fundamental Principles

The 5 fundamental principles of the ACCA Code of Ethics must be

followed

The 5 Fundamental principles and what they mean

1. Integrity

Be straightforward and honest in all professional relationships

2. Objectivity

No bias or conflict of interest influencing your business judgements

3. Professional Competence & Due Care

Keep up your professional knowledge and skill so as to give a competent

professional service, using current developments and techniques

Act diligently and within appropriate standards when providing professional

services

38
4. Confidentiality

Don't disclose any confidential information to third parties without proper and
specific authority

You can, however, if there is a legal or professional right or duty to disclose

Obviously never use it for personal advantage of yourself or third parties

5. Professional behaviour

A professional accountant should act in a manner consistent with the good

reputation of the profession

Refrain from any conduct which might bring discredit to the profession

In the exam question you may have to apply these to a case study - groovy baby..

39
 Syllabus A3cd. c) Recommend, within specified problem domains, appropriate strategies for
the resolution of stakeholder conflict and advise on alternative approaches that may be
adopted.
d) Recommend an ethical framework for the development of an organisation’s financial policies
and a system for the assessment of its ethical impact upon the financial management of the
organisation.

Ethical issues in financial management

The ACCA has developed a five-step framework to help you make

ethical decisions.

These are:

Step 1 - establishing the issues

A business needs to be aware of the ethical issues that it faces.

Step 2 - are there threats to compliance with fundamental principles?

A company’s fundamental ethical principles need to be clearly understood.

Step 3 - are the threats significant?

If an employee is unsure about this, they should use the mirror test.

If felt to be significant, it needs to be reported to the ethics department to deal with it.


40
Step 4 - are there safeguards to reduce threats to an acceptable level?

Safeguards in place in the work environment such as policies and procedures to

monitor the quality of work, or to encourage communication of ethical concerns.

Step 5 – can you face yourself in the mirror?

Sometimes called the mirror test.

Whether or not you choose to perform the action, it's useful to look in the mirror and
ask yourself:

Is it legal?

What will others think? – How would you feel explaining what you did to a friend, a
parent, a spouse, a child, a manager, or the media?

Is it right? – What does your conscience or your instinct tell you?

41
Syllabus A3e. Explore the areas within the ethical framework of the organisation which may be
undermined by agency effects and/or stakeholder conflicts and establish strategies for dealing
with them.

Agency Relationship

Agency is defined in relation to a principal. What?! Well all this means is an owner
(principal) lets somebody run her business (manager).

The agent is doing this job on behalf of someone else.

Footballers, film stars etc all have agents. They work on behalf of the star. The star
hopes that the agent is working in their best interest and not just for their own
commission…

Principals and Agents

A principal appoints an agent to act on his or her behalf.

In the case of corporate governance, the principal is a shareholder and the agents
are the directors.

The directors are accountable to the principals

Agency Costs

• A cost to the shareholder through having to monitor the directors

• Over and above normal analysis costs

• A result of comprised trust in directors

42
Syllabus A3e. Explore the areas within the ethical framework of the organisation which may be
undermined by agency effects and/or stakeholder conflicts and establish strategies for dealing
with them.

Transaction cost theory

General

Transaction costs occur when dealing with another party.

If items are made within the company itself, therefore, there are no transaction costs

• Analysing these costs can be difficult because of:

o Bounded rationality - our limited capacity to understand business situations

o Opportunism - actions taken in an individual’s best interests

• Company will try to keep as many transaction as possible in-house in order to:

o reduce uncertainties about dealing with suppliers

o avoid high purchase prices

o manage quality

43
Are the transaction costs (of dealing with others and not doing the thing

yourself) worth it?

The 3 factors to take into account as to whether the transaction costs are worthwhile
are:

1. Uncertainty

Do we trust the other party enough?

o The more certain we are, the lower the transaction / agency cost

2. Frequency

how often will this be needed

o The less often, the lower the transaction/agency cost

3. Asset specificity

How unique is the item

o The more unique the item, the more worthwhile the transaction / agency cost
is

Applied to Agency theory

This can be applied to directors who may take decisions in their own interests also:

1. Uncertainty - Will they get away with it?

2. Frequency - how often will they try it?

3. Asset specificity - How much is to gain?

44
 Syllabus A3f. Establish an ethical financial policy for the financial management of the
organisation which is grounded in good governance, the highest standards of probity and is
fully aligned with the ethical principles of the Association.

UK corporate governance

In the UK there are 3 main reports recommending best practice in Corporate

Governance

1. The Cadbury report

2. The Greenbury report
3. Hampel report

The reports recommend:

• Separate MD & chairman

• Minimum 50% non executive directors


(NEDs)

• Independent chairperson

• Maximum one-year notice period

• Independent NEDs (three-year contract, no share options)

• Executive remuneration should be subject to the recommendations of a

remuneration committee (entirely or mainly NEDs).

• An Audit committee, comprising of at least 3 NEDs.

• Governance should be viewed as an opportunity to enhance long term

shareholder value.

• The Board is responsible for maintaining a sound system of internal control.

45
US corporate governance

In the US, statutory requirements for publicly-traded companies are set out in the
Sarbanes-Oxley Act.

These requirements include:

1. The certification of published financial statements by the CEO and the chief
financial officer (CFO)

2. Faster public disclosures by companies

3. Legal protection for whistleblowers

4. A requirement for an annual report on internal controls

5. Requirements relating to the audit committee, auditor conduct and avoiding

‘improper’ influence of auditors.

The Act also requires the Securities and Exchange Commission (SEC) and the main

stock exchanges to introduce further rules relating to matters such as

1. the disclosure of critical accounting policies,

2. the composition of the Board and

3. the number of independent directors.

European corporate governance

In Europe most large companies are not listed on a Stock Market, and are often

dominated by a single shareholder with more than 25% of the shares (often a

corporate investor or the founding family).

46
Banks are powerful shareholders and generally have a seat on the boards of large

companies.

A major difference that exists in the board structure for companies is that the UK has

a unitary board (consisting of both executive and non-executive directors).

It is common in Europe to have a two-tier board structure consisting of a supervisory

board (elected by shareholders normally) and an executive board.

In Germany, the supervisory board has to consist of 50% trade union

representatives.

The Supervisory Board does not have full access to financial information, is meant to

take an unbiased overview of the company, and is the main body responsible for

safeguarding the external stakeholders’ interests.

The presence on the Supervisory Board of representatives from banks and

employees (trade unions) may introduce perspectives that are not present in some

UK boards.

In particular, many members of the Supervisory Board would not meet the criteria

under UK Corporate Governance Code for their independence.

47
 Syllabus A3g. Assess the impact on sustainability and environmental issues arising from
alternative organisational business and financial decisions.

Social and Environmental Issues

Social and environmental issues in the conduct of business and of ethical behaviour

• Economic activity is only sustainable where its impact on society and the
environment is also sustainable.
Sustainability can be measured empirically or subjectively

Environmental Footprint

Measures a company’s resource consumption of inputs such as energy, feedstock,

water, land use, etc.

Measures any harm to the environment brought about by pollution emissions.

Measures resource consumption and pollution emissions in either qualitative,

quantitative or replacement terms.

Together, these comprise the organisation’s environmental footprint.

A target may be set to reduce the footprint and a variance shown.

Not all do this and so this makes voluntary adoption controversial

Sustainable development

The development that meets the needs of the present without compromising the
ability of future generations to meet their own needs.

Energy, land use, natural resources and waste emissions etc should be consumed at
the same rate they can be renewed.

48
Sustainability affects every level of organisation, from the local neighborhood to the
entire planet.

It is the long term maintenance of systems according to environmental, economic

and social considerations.

Full cost accounting

This means calculating the total cost of company activities, including environmental,
economic and social costs

TBL (Triple bottom line) accounting

TBL accounting means expanding the normal financial reporting framework of a

company to include environmental and social performance.

The concept is also explained using the triple ‘P’  headings of ‘People, Planet and
Profit’

The principle of TBL reporting is that true performance should be measured in terms
of a balance between economic (profits), environmental (planet) and social (people)
factors; with no one factor growing at the expense of the others.

The contention is that a corporation that accommodates the pressures of all the
three factors in its strategic investment decisions will enhance shareholder value, as
long as the benefits that accrue from producing such a report exceeds the costs of
producing it.

Learn more list

Lauren Laverne on Ethical trade

Nice article


49
 Syllabus A3h. Assess and advise on the impact of investment and financing strategies and
decisions on the organisation’s stakeholders, from an integrated reporting and governance
perspective

Purpose and content of an integrated report

To explain to providers of financial capital how an organisation creates value over

time

The ‘building blocks’ of an integrated report are:

• Guiding principles
These underpin the integrated report
They guide the content of the report and how it is presented
• Content elements
These are the key categories of information
They are a series of questions rather than a prescriptive list

Guiding Principles
1. Are you showing an insight into the future strategy..?
2. Are you showing a holistic picture of the the organisation's ability to create value
over time?
Look at the combination, inter-relatedness and dependencies between the factors
that affect this
3. Are you showing the quality of your stakeholder relationships?
4. Are you disclosing information about matters that materially affect your ability to
create value over the short, medium and long term?
5. Are you being concise?
Not being burdened by less relevant information
6. Are you showing Reliability, completeness, consistency and comparability when
showing your own ability to create value.

50
Content Elements

1. Organisational overview and external environment


What does the organisation do and what are the circumstances under which it
operates?

2. Governance
How does an organisation’s governance structure support its ability to create
value in the short, medium and long term?

3. Business model
What is the organisation’s business model?

4. Risks and opportunities

What are the specific risk and opportunities that affect the organisation’s ability to
create value over the short, medium and long term, and how is the organisation
dealing with them?

5. Strategy and resource allocation

Where does the organisation want to go and how does it intend to get there?

6. Performance
To what extent has the organisation achieved its strategic objectives for the
period and what are its outcomes in terms of effects on the capitals?

7. Outlook
What challenges and uncertainties is the organisation likely to encounter in
pursuing its strategy, and what are the potential implications for its business
model and future performance?

51
 Syllabus A4. Management of international trade and finance

Syllabus A4ab. a) Advise on the theory and practice of free trade and the management of
barriers to trade.
b) Demonstrate an up to date understanding of the major trade agreements and common
markets and, on the basis of contemporary circumstances, advise on their policies and
strategic implications for a given business.

Free trade and the management of barriers to trade

Free trade

Practical reasons for overseas trade

1. Choice
The diversity of goods available in a domestic economy is increased through the
import of goods that could be uneconomic or impossible to produce at home.

2. Competition
International trade will increase competition in domestic markets, which is likely to
lead to both a reduction in price, together with increasing pressure for new
products and innovation.

3. Economies of scale
By producing both for the home and international markets companies can
produce at a larger scale and therefore take advantage of economies of scale.

4. Specialisation
If a country specialises in producing the goods and services at which it is most
efficient, it can maximise its economic output.

52
Trade barriers
There are a number of ways that a country can seek to restrict imports.
Trade barriers include:

• Quotas

– imposition of a maximum number of units that can be imported e.g. quotas on

the number of cars manufactured outside of Europe that can be imported into the
EU.

• Tariffs

– imposition of an import tax on goods being imported into the country to make
them uncompetitive on price.

• Exchange controls

 – domestic companies wishing to buy foreign goods will have to pay in the
currency of the exporter’s country.
To do this they will need to buy the currency involved by selling sterling.
If the government controls the sale of sterling it can control the level of imports
purchased.

• Administrative controls

 – a domestic government can subject imports to excessive levels of

administration, paperwork and red tape to slow down and increase the cost of
importing goods into the home economy.

• Embargoes

– the prohibition of commerce and trade with a certain country.

Multinational companies have to find ways of overcoming these barriers, for
example by investing directly and manufacturing within a country rather than
importing into it.

53
Trade agreements and common markets

In many parts of the world, governments have created trade agreements and
common markets to encourage free trade.

However, the World Trade Organisation (WTO) is opposed to these trading blocs
and customs unions (e.g. the European Union) because they encourage trade
between members but often have high trade barriers for nonmembers.

Specific strategic issues for multinational organisations – national governance

requirements

• A multinational company (MNC) is defined as one which generates at least 25%

of its sales from activities in countries other than its own.

This rules out returns from portfolio investment and eliminates unit and
investment trusts.

• Different countries have different governance requirements.

These national governance requirements will impact on the behaviour of

multinational organisations.

54
 Syllabus A4c. Discuss how the actions of the World Trade Organisation can affect a
multinational organisation.

The World Trade Organisation (WTO)

Aims are:

1. to reduce the barriers to international trade

It does this by seeking to prevent protectionist measures such as tariffs, quotas

and other import restrictions.

2. resolving trade disputes

it acts as a forum for negotiation and offering settlement processes to resolve

disputes between countries.

The WTO will impose fines, if members are in breach of their rules.

Members of the WTO cannot offer selective free trade deals with another country
without offering it to all other members of the WTO (the most favoured nation
principle).

The benefits of reducing protectionist measures are:

1. increased trade and economic growth

2. allow to specialise and gain competitive advantage in certain products and

services, and compete more effectively globally

3. gain political capital and more influence worldwide

55
The drawbacks of reducing protectionist measures are:

1. the need to protect certain industries.

It may be that these industries are developing and in time would be competitive
on a global scale.

They may fail too quickly due to international competition, and would create large
scale unemployment

2. dumping’ of goods at a very cheap price, which hurt local producers.

56
Syllabus A4c. Discuss how the actions of the International Monetary Fund and Central Banks
can affect a multinational organisation.

The management of international finance

Central banks

Central banks normally have control over interest rates and support the stability of
the financial system.

Collaboration between central banks is supported by the Bank of International

Settlements (BICS).

In the context of international trade, a key role of the central bank is to guarantee the
convertibility of a currency (eg from £s to $s).

The International Monetary Fund (IMF)

The IMF's main purpose is to support the stability of the international monetary
system by providing support to countries with balance of payments problems; most
countries are members.

Where a member is having difficulties overcoming balance of payments problems

the IMF will:

1. offer advice on economic policy

2. lend money, at subsidised rates to finance short-term exchange rate intervention

IMF loans are conditional on action being taken to reduce domestic demand, and are
normally repayable over a five-year period.

The IMF has been criticised as being controlled by those who don’t need funds, for
failing to control its own costs and for holding on to its substantial gold reserves.

57
The World Bank

The World Bank, partially funded by the IMF, exists to fund reconstruction and
redevelopment.

Loans are normally made directly to governments, for periods of 10-20 years and
tied to specific projects.

The International Bank for Reconstruction and Development (IBRD)

Popularly known as the World Bank, it was also created at Bretton Woods in 1944,
with the aim of financing the reconstruction of Europe after the Second World War.

The World Bank is now an important source of long-term low interest funds for
developing countries.

The Bank for International Settlements (BIS)

Established in Basle, Switzerland in 1930, it acts as a supervisory body for central

banks assisting them in the investment of monetary assets.

 It acts as a trustee for the IMF in loans to developing countries and provides
bridging finance for members pending their securing longer term finance for balance
of payments deficits.

58
 Syllabus A4d. d) Discuss the role of international financial institutions within the context of a
globalised economy, with particular attention to (the Fed, Bank of England, European Central
Bank and the Bank of Japan).

The role of international financial institutions

US Federal Reserve System (the FED)

is the central banking system of the United States.

Created in 1913.

Its roles

1. conducting the US monetary policy

2. maintaining stability of the financial system
3. supervising and regulating banking institutions.

Bank of England
The Bank of England is the central bank of the UK.

 


Its roles and aims:

• The maintenance of price stability and support of British economic policies
• Stable prices and market confidence in sterling are the two main criteria for
monetary stability.
• The Bank aims to meet inflation targets set by the Government by adjusting
interest rates.
• The Bank can also operate as a ‘lender of last resort’ – that is, it will extend credit
when no other institution will.

59
European Central Bank (ECB)
was established in 1998 and is based in Frankfurt.
• It is responsible for administering the monetary policy of the EU Eurozone
member states.
• The main objective of the ECB is to maintain price stability within the Eurozone
(keep inflation low).

Bank of Japan
is Japan’s central bank and is based in Tokyo.

In 1997, the Bank was given greater independence from the government.

The bank has ignored government requests to stimulate the Japanese economy.

As a result the Japanese economy remains in a critical state.

However in August 2011, the Bank of Japan announced a scheme to offer 3 trillion
yen (approximately $35 billion) in low- interest loans in an attempt to stimulate the
economy.

60
 Syllabus A4d. Discuss the role of international financial institutions within the context of a
globalised economy, with particular attention to (the Fed, Bank of England, European Central
Bank and the Bank of Japan).

The Euromarkets

The Euromarkets refer to transactions between banks and depositors/borrowers of

Eurocurrency.

Eurocurrency

refers to a currency held on deposit outside the country of its origin eg Eurodollars
are $US held in a bank account outside the USA.

Eurobonds

are bonds issued (for 3 to 20 years) simultaneously in more than one country.

They usually involve a syndicate of international banks and are denominated in a

currency other than the national currency of the issuer. Interest is paid gross.

Eurocurrency loans

are bank loans made to a company, denominated in a currency of a country other

than that in which they are based.

The term of these loans can vary from overnight to the medium term.

61
Euronotes

are issued by companies on the Eurobond market.

Companies issue short-term unsecured notes promising to pay the holder of the
Euronote a fixed sum of money on a specified date or range of dates in the future.

Euroequity market

refers to the international equity market where shares in US or Japanese companies

are placed on as overseas stock exchange (eg London or Paris).

These have had only limited success, probably due to the absence of a effective
secondary market reducing their liquidity.

62
 Syllabus A4e. Discuss the role of the international financial markets with respect to the
management of global debt, the financial development of the emerging economies and the
maintenance of global financial stability.

Multinationals need to consider three main issues

These are:

1. Minimisation of global taxes

Parent company financing of its overseas subsidiaries in the form of debt brings
the benefits of:
(a) reducing the corporation tax bill overseas

(b) avoiding withholding taxes on dividend payments

2. Financial market distortions

Local governments may directly or indirectly offer subsidised finance:

Direct

- Low cost loans may be offered to encourage multinational investment
- Other incentives may include exchange control guarantees, grants, tax holidays
etc
Indirect

- Local governments may reduce the interest rates to stimulate the local economy

3. Managing risk

Overseas debt finance is a useful means of managing risk:

63
Risk types Impact of overseas debt finance

Political Reduces exposure to overseas tax increases

If assets are seized, allows the firm to default on the loan (if raised
from the host government) or to use international development
agencies (with influence over the local government)
Economic The risk of a local devaluation offset by the benefit of lower
repayments on a loan

Obtaining a listing on one or more exchanges

Where overseas equity is preferred a listing on an overseas exchange may be

considered; this can have a number of advantages.

It will be important to conform to local regulations. Taking when the London Stock

Exchange is used as an overseas exchange, the relevant regulations are:

1. At least three years of audited published accounts

2. At least 25% of the company’s shares must be in public hands when trading
begins

3. Minimum market capitalisation of £700,000

4. A prospectus must be published containing a forecast of expected performance

5. In addition the company will have to be introduced by a sponsoring firm and to

comply with the local corporate governance requirements.

64
Syllabus A4f. Discuss the significance to the organisation, of latest developments in the world
financial markets such as the causes and impact of the recent financial crisis; growth and
impact of dark pool trading systems; the removal of barriers to the free movement of capital;
and the international regulations on money laundering.

The European Sovereign what??

EU countries could borrow at a cheap rate - because it was assumed they were
following the economic rules of the single currency.

This effectively meant that the good credit rating of Germany was improving the
credit rating of countries such as Greece, Portugal and Italy.

Some countries used this cheap finance and built up large balance of payments
deficits, hoping to stimulate growth - which the financial crisis prevented

This European Sovereign Debt crisis has been getting worse - see Greece as an
obvious example

The effect is an increase in the cost of borrowing for governments worldwide

In May 2010 the EU created the European Financial Stability Facility (EFSF) which
provides bailout loans to these countries

65
What's all this I hear about "Austerity"?

Many countries are now spending less to decrease their debt - this is what austerity is

Austerity was needed even more when many countries paid to save their banks from

bankruptcy meaning they had to borrow even more

The obvious problem here is people are paid less, less investment is made and ALL

countries suffer - particularly in the EU where these countries trade heavily with each

other (this is referred to as 'financial contagion'

One final problem is that the Euro then loses value. This means that buying goods

from abroad becomes even more expensive

66
 Syllabus A4e. Discuss the role of the international financial markets with respect to the
management of global debt

The global debt problem

This problem arose following the oil price increases in the 1970s, when the OPEC

countries invested their large surpluses with banks in the western world.

The banks then lent substantial sums to the less developed countries (LDCs)

believing the default risk to be low.

The oil price rises fuelled inflation and interest rates increased, forcing most of the

world’s economies into recession.

High interest rates and reduced exports placed LDCs in a situation where they could

no longer pay interest or repay loans.

These problems made economic conditions in many LDCs extremely difficult,

affecting the position of multinationals and making international banks less willing to

lend.

67
Methods of dealing with such excessive debt burdens have been:

1. A programme of debt write-offs by banks and other lenders.

2. Rescheduling existing debt repayments.

3. Re-selling debt at a discount to recoup capital.

4. Provision of additional loans where the debt problem is regarded as temporary.

5. Drastic changes in the economic policies of the LDC imposed and monitored by

the IMF.

68
Syllabus A4f. Discuss the significance to the organisation, of latest developments in the world
financial markets such as the growth and impact of dark pool trading systems

Dark Pool Trading

What is it?

The word 'trading' refers to an alternative way of trading in shares

The word 'pool' refers to LARGE BLOCKS of shares

The word 'dark' refers to the fact that the share purchase isn't made public until after

the transaction (thus not influencing the share price before)

Why do this?

Well nowadays there lots of small purchases of shares as individuals can buy and

sell easily online

Therefore a LARGE BLOCK purchase coming up would influence the share price

and possibly against the buyer

Therefore they would rather keep the purchase quiet until after the transaction

69
Any problems with this?

Well it needs an alternative exchange - thus making the regulated exchanges less

efficient (the share price is not showing the up-coming transaction)

They also reduce the fairness of a regulated exchange - thus many regulators are

now asking for dark pools to report their volumes of transactions weekly

70
Syllabus A4f. Discuss the significance to the organisation, of latest developments in the world
financial markets such as the removal of barriers to the free movement of capital

Free movement of Capital

Financial institutions joining together

e.g. banks, insurance companies etc all becoming a "one-stop" shop

This results in...

• Economies of scale for the companies

• Cost savings for customers

• Less volatility of earnings for companies as they become more diversified

Globalisation of Financial Reporting Standards

particularly IFRS

• Common FR means more efficient markets

• Easier access to capital - greater cross-border investment

71
 Syllabus A4g. Demonstrate an awareness of new developments in the macroeconomic
environment, assessing their impact upon the organisation, and advising on the appropriate
response to those developments both internally and externally.capital

Developments

Less Restrictions on trade

These improve efficiencies and investment opportunities worldwide

• Less import quotas

• Less exchange controls

• More free trade areas

More international finance available

from..

• International Lending agencies

• Discounting of trade invoices (for short term finance)

• Development banks and Eurodollar accounts

72
 Syllabus A5. Strategic business and financial planning for
multinationals

Syllabus A5a. a) Advise on the development of a financial planning framework for a

multinational organisation taking into account:
i) Compliance with national regulatory requirements (for example the London Stock Exchange
admission requirements)

Stock exchanges

Shares are bought and sold through stock exchanges.

Each keeps an index of the value of shares on that exchange; In London, for
example, the FTSE All Share (Financial Times Stock Exchange) index is a measure
of all of the shares listed in London.

In New York, it is the Dow Jones index and in Hong Kong, it is the Hang Seng index.

Role in Corporate Governance

Listing rules are sometimes imposed on listed companies often concerning

governance arrangements not covered elsewhere by company law.

In the UK, for example, it is a stock exchange requirement that listed companies
comply with the Combined Code on Corporate Governance

73
Procedure for obtaining a listing on an international stock exchange

Normally, obtaining a listing consists of three steps:

1. legal

2. regulatory

3. compliance

Steps:

1. In the UK a firm seeking listing must register as a public limited company.

This entails a change in its memorandum and articles agreed by the existing
members at a special meeting of the company.

2. The company must then meet the regulatory requirements of the Listing Agency
which, in the UK, is part of the Financial Services Authority (FSA).

These requirements impose a minimum size restriction on the company and

other conditions concerning length of time trading.

3. Once these requirements are satisfied the company is then placed on an official
list and is allowed to make a public offering of its shares.

4. Once the company is on the official list it must then seek the approval of the
Stock Exchange for its shares to be traded.

In principal it is open to any company to seek a listing on any exchange where

shares are traded.

5. The London Exchange imposes strict requirements and invariably the applicant
company will need the services of a sponsoring firm that specialises in this type
of work.

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The advantages of seeking a public listing

1. It opens the capital market to the firm

2. It offers the company access to equity capital from both institutional and private
investors and the sums that can be raised are usually much greater than can be
obtained through private equity sources.

3. Enhances its credibility as investors and the general public are aware that by
doing so it has opened itself to a much higher degree of public scrutiny than is
the case for a firm that is privately financed.

The disadvantages of seeking a public listing

1. A distributed shareholding does place the firm in the market for corporate control
increasing the likelihood that the firm will be subject to a takeover bid.

2. There is also a much more public level of scrutiny with a range of disclosure
requirements.

3. Financial accounts must be prepared in accordance with IFRS or FASB and with
the relevant GAAP as well as the Companies Acts.

4. Under the rules of the London Stock Exchange companies must also comply with
the governance requirements of the Combined Code

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Syllabus A5aii. i) Advise on the development of a financial planning framework for a multinational
organisation taking into account:
ii) The mobility of capital across borders and national limitations on remittances and transfer
pricing

The mobility of capital across borders

One of the drivers of globalisation has been the increased level of mobility of capital
across borders.

Implications of an increased mobility of capital:

1. Lower costs of capital.

2. Ability of MNCs to switch activities between countries.

3. Ability of MNCs to circumnavigate national restrictions.

4. Potentially increased exposure to foreign currency risk.

Specific strategic issues for multinational organisations – local risk

Local risk for multinationals includes the following:

1. Economic risk

is the possibility of loss arising to a firm from changes in the economy of a

country.

2. Political risk

is the possibility of loss arising to a firm from actions taken by the government or
people of a country.

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Political risk

Examples of political risk:

• Confiscation political risk

This is the risk of loss of control over the foreign entity through intervention of the
local government or other force.

• Commercial political risk

• Financial political risk

This risk takes many forms:

• Restricted access to local borrowings.

• Restrictions on repatriating capital, dividends or other remittances. These can

take the form of prohibition or penal taxation.

• Financial penalties on imports from the rest of the group such as heavy
interestfree import deposits.

• Exchange control risk

One form of exchange control risk is that the group may accumulate surplus cash
in the country where the subsidiary operates, either as profits or as amounts
owed for imports to the subsidiary, which cannot be remitted out of the country.

This can be mitigated by using FOREX hedging.

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Specific strategic issues for multinational organisations – control

• Within the hierarchy of firms (in a group) goal incongruence may arise when
divisional managers in overseas operations promote their own selfinterest over
those of other divisions and of the organisation generally.

• In order to motivate local management and to obtain the benefit of their local
knowledge, decision making powers should be delegated to them.

However, given the wide geographical spread of divisions, it is difficult for group
management to control the behaviour of the local managers.

• This gives rise to agency costs, and a difficult balance between local autonomy
and effective central control.

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 Syllabus A5a. a) Advise on the development of a financial planning framework for a
multinational organisation taking into account:
iii) The pattern of economic and other risk exposures in the different national markets
iv) Agency issues in the central coordination of overseas operations and the balancing of local
financial autonomy with effective central control.

Sources of finance for foreign trade

Bank overdrafts

either in sterling or in the overseas currency.

Bills of exchange

a negotiable instrument drafted by the exporter (the drawer), accepted by the

importer (the drawee) who thereby agrees to pay for the goods/services either
immediately or more commonly after a specified period of credit.

If the importer accepts the bill it is known as a “trade bill”, whereas if the importer
arranges for its bank to accept the bill, it becomes a less risky “bank bill”.

Where payment will be made after the specified period of credit, the exporter can sell
the bill at a discount to its face value and receive the cash immediately.

If the bill is dishonoured the exporter can seek legal remedies in the country of the
importer.

Promissory notes

similar, but less common than bills of exchange, since they cannot usually be
discounted prior to maturity.

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Documentary letters of credit

the importer obtains a Letter of Credit from its bank, which guarantees payment to
the exporter via a trade bill. Though slow to arrange, this method is virtually risk free
provided the exporter presents specified error free documents (eg shipping
documents, certificates of origin and a fully detailed invoice) within a specified time
period.

The high bank fees for this procedure are normally borne by the importer, and the
DLC is normally reserved for expensive goods only.

Factoring

the factoring company (often the subsidiary of a bank) assumes the responsibility for
collecting the trade debts of another – in this case an exporter.

The factor may provide a range of services (eg providing advances, administering
the sales ledger, credit insurance etc) for an additional fee. Widely regarded as a
useful means of obtaining trade finance and collecting of debts for small or medium
sized exporters.

However the exporter must always bear in mind the eventual consequences of
dispensing with the services of the factor and undertaking the running of the sales
ledger and cash collection activities itself.

Forfaiting

a medium term source of finance whereby a domestic bank will discount a series of
medium term bills of exchange, which have normally been guaranteed by the
importers bank. The forfaiting bank normally forgoes the right of recourse to the
exporter if the bill is dishonoured.

The exporter obtains the benefit of immediate funds, but the bank charges are
expensive. Forfaiting is normally used for the export of capital goods, where the
importer pays in a series of instalments over a period of years.

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Leasing and hire purchase

the exporter sells capital goods to a lessor, which in turn enters into a leasing
agreement with the exporter’s overseas customer.

Alternatively the equipment can be sold to a hire purchase company which resells to
the importer under a HP agreement.

Acceptance credits

a large reputable exporter can arrange for its bank to accept bills of exchange (which
are related to its export activities) on a continuing basis.

These bills can then be discounted at an effective cost, which is lower than the bank
overdraft interest rate.

Produce loans

where an importer acquires commodities for the purpose of immediate resale, it can
raise a loan from its bank, which takes custody of the goods until the importer is able
to sell them.

Thereafter the principal sum, interest and storage costs are repaid to the bank out of
the proceeds of the sale.

Requesting payment in advance from the importer

if this were possible it would avoid all of the above complications.

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 Syllabus A6. Dividend policy in multinationals and transfer
pricing

Syllabus A6a. Determine a corporation’s dividend capacity and its policy

Dividends policy

Dividend policy is mainly a reflection of the investment decision and the

financing decision

Investment decision

eg. Think about a young company (such as acowtancy.com)

All our cash will be used for investments, so our shareholders expect low or zero
dividend

They are happy with that because they think we are fab and cool :) and will grow and
their shares will go up hugely in value as we grow

Financing decision

• However, if a company can borrow to finance its investments, it can still pay
dividends.

This is sometimes called borrowing to pay a dividend. There are legal constraints
over a company’s ability to do this;

it is only legal if a company has accumulated realised profits.

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• Dividend policy tends to change during the course of a business’s lifecycle.

Young company

Zero / Low dividend

High growth / investment needs 

Wants to minimise debt

Mature company

High stable dividend

Lower growth

Able & willing to take on debt 

Possibly share buybacks too

A Residual dividend policy

is a dividend policy company management uses to fund capital expenditures with

available earnings before paying dividends to shareholders.

It is appropriate for a small company listed on a small stock exchange and owned by
investors seeking maximum capital growth on their investment

A special dividend

is a payment made by a company to its shareholders that the company declares to

be separate from the typical recurring dividend cycle

 

Usually when a company raises its normal dividend, the investor expectation is that
this marks a sustained increase.

• The disadvantage can be that the company could not respond quickly to new
business opportunities.

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What to look for when considering investing in other company:

1. Are dividends growing at a stable rate?

2. What is the company’s dividend payout ratio ( Divs / PAT)?

A reduction in dividends paid is looked poorly upon by investors.

3. What is the company’s dividend cover (PAT / dividends)?

4. Are the company’s earnings growing steadily?

5. What happen if profits will fall? Will the dividends be reduced?

If so, it may cause unnecessary fluctuations of the share price or result in a

depressed share price.

6. You should take into account factor such as taxation implications.

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 Syllabus A6ai. a) Determine a corporation’s dividend capacity and its policy given:
i) The corporation’s short- and long-term reinvestment strategy

How much of your money should you Reinvest?

There's a lot to consider when you're deciding on your reinvestment strategy.

Smart reinvesting can grow your business quickly, but a poor decision at the wrong
time can harm your long-term growth.

So, how much should you keep?

• aCOWtancy, for example, needs to be able to:

1. keep a website alive

2. keep employees paid

3. keep student service active

4. invest in development, marketing and more

• A larger physical business

has more commitments, from product shipping to leases on warehousing and

office space.

• You can't reinvest money if

that money is needed to pay your employees or ship your products

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Reinvesting is Risky

1. Less risk - Small profit

The safest reinvesting options safeguard your money and bring in a small profit.

Add a little risk and you'll take away a greater reward.

2. More risk - bigger profit

Smart investing relies on the ability to manage risk for the greatest reward.

3. High risk - No profit?

Push the risk too high and you may very well end up with nothing.

A Reinvestment Hierarchy

1. Pay your commitments

You need to have the cash flow on hand to cover your current commitments and
the commitments over the next six months

2. A reinvestment in yourself

Training and experiences for yourself and your employees will be a long-term
investment that pays off every time some of that knowledge or some of those
skills are used.

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3. Reinvesting in your business

Improving infrastructure and customer support, increasing and refining marketing.

These all directly benefit your business.

They increase your profits and decrease your expenses, potentially giving you
more capital to work with.

4. External investments

Look at Facebook. FB has purchased many different companies, the most

famous of which were Instagram in 2012 and WhatsApp in 2014.

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 Syllabus A6a. Determine a corporation’s dividend capacity and its policy given:
ii) The impact of capital reconstruction programmes such as share repurchase agreements
and new capital issues on free cash flow to equity.

Alternatives to a cash dividend

These methods include:

Shareholder perks

Some companies (e.g. hotels) offer discounts to shareholders on room bookings and
restaurant meals.

A number of transport companies offer reductions in fares.

Some retailers provide discount vouchers, which are sent to shareholders at the
same time as the annual report and accounts.

Scrip dividends

When the directors of a company consider that they must pay a certain level of
dividend, but would really prefer to retain funds within the business, they can
introduce a scrip dividend scheme.

A scrip dividend enables the shareholders to choose whether to receive a cash

dividend or shares.

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Share repurchases

Companies with cash surpluses may choose to introduce a share buy-back scheme,
whereby the company’s shares are purchased at the company’s instructions on the
open market.

Benefit of a share buyback scheme

1. It helps to control transaction costs and manage tax liabilities

2. With the share buyback scheme, the shareholders can choose whether or not to

sell their shares back to the company.

3. Share buybacks are normally viewed as positive signals by markets and may

result in an even higher share price.

4. Increasing future EPS (because of the reduction in the number of shares in issue)

5. Changing the gearing level of the company

6. Reducing the likelihood of a takeover

Timing of dividend payments

a subsidiary may pay dividends to a parent company in a way that they benefit from
expected movements in exchange rates

• A company would like to collect early (lead) payments from currencies vulnerable
to depreciation

• A company would like to collect late (lag) from currencies which are expected to
appreciate

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 Syllabus A6a. Determine a corporation’s dividend capacity and its policy given:
iv) The corporate tax regime within the host jurisdiction.

Tax considerations influence the dividend policies

Dividend income is taxed differently from Profit and therefore the tax position of the
investors can influence their preference.

e.g There is a different tax rate paid on dividends in different countries (somewhere
0% or 5% or 15%)

The parent company can reduce its tax liability by receiving larger amounts of
dividends from subsidiaries in countries where undistributed earnings are taxed.

For subsidiaries of UK companies, all foreign profits are liable to UK corporation tax,
with a credit for the tax that has already been paid abroad.

The US government does not distinguish between income earned abroad and
income earned at home.

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Illustration

The corporate tax rate in the home country is 35% and in the overseas country
where a subsidiary is located is 20%.

Both the parent company and the subsidiary have pre-tax profits of $1000.

• Taxes to foreign government = 1000 x 20% = 200 


Profit after foreign tax = 1,000 – 200 = 800

Home tax = 1000 x 35% = 350


Foreign tax credit = 200

Net tax = 350 – 200 = 150

Total taxes = 200 + 150 = 350.

Notice that they have effectively paid 35% (which is the rate in the home
country)

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 Syllabus A6c. Develop organisational policy on the transfer pricing of goods and services
across international borders and be able to determine the most appropriate transfer pricing
strategy in a given situation reflecting local regulations and tax regimes.

Transfer Pricing

Transfer pricing is used when divisions of an organisation need to charge other

divisions of the same organisation for goods and services they provide to them.

Usually, each division will report its performance separately.  Hence, some monetary

value must be allocated to record the transfer of these goods or services.   

For example, division A might make a component that is used as part of a product

made by division B of the same company, but that can also be sold to the external

market, including makers of rival products to division B's product.

There will therefore be two sources of revenue for A.

1. External sales revenue from sales made to other organisations, valued at the

selling price.

2. Internal sales revenue from sales made to other responsibility centres within the

same organisation, valued at the transfer price.

Multinational transfer pricing is the process of deciding on appropriate prices for the

goods and services sold intragroup across national borders.

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When considering a multinational firm, additional objectives are to:

1. Pay lower taxes, duties, and tariffs

Be aware that multinational firms will be keen to transfer profits if possible from
high tax countries to low tax ones.

2. Repatriate funds from foreign subsidiary companies to head office

3. Be less exposed to foreign exchange risks

4. Build and maintain a better international competitive position

5. Enable foreign subsidiaries to match or undercut local competitors’ prices

6. have good relations with governments in the countries in which the multinational
firm operates

Transfer pricing is not simply buying and selling products between divisions.

The term is also used to cover:

1. head office general management charges to subsidiaries for various services

2. specific charges made to subsidiaries by, for example, head office human
resource or information technology functions

3. royalty payments

– between parent company and subsidiaries


– among subsidiaries.

4. interest rate on borrowings between group companies.

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Ethical issues in transfer pricing

There are a number of potential ethical issues for the multinational company to
consider when formulating its transfer pricing strategy:

• Social responsibility, reducing amounts paid in customs duties and tax.

• Bypassing a country’s financial regulation via remittance of dividends.

• Not operating as a ‘responsible citizen’ in foreign country.

• Reputational loss.

• Bad publicity.

• Tax evasion.

Good transfer price

A good transfer price should have the following characteristics (objectives):

1. Preserve divisional autonomy:

almost inevitably, divisionalisation is accompanied by a degree of decentralization

in decision making so that specific managers and teams are put in charge of
each division and must run it to the best of their ability.

Divisional managers are therefore likely to resent being told by head office which
products they should make and sell.

Ideally, divisions should be given a simple, understandable objective such as

maximizing divisional profit.

2. Maintain motivation for managers

Be perceived as being fair for the purposes of performance evaluation and

investment decisions.

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3. Assess divisional performance objectively

Permit each division to make a profit:

profits are motivating and allow divisional performance to be measured using

positive ROI or positive RI

4. Ensure goal congruence

Encourage divisions to make decisions which maximize group profits:

 the transfer price will achieve this if the decisions which maximize divisional
profit also happen to maximize group profit

– this is known as goal congruence. Furthermore, all divisions must want to do

the same thing.

There’s no point transferring out if the next division doesn’t want to transfer in.

In practice it is difficult to achieve all four aims.

Potential benefits of operating a transfer pricing system within a

divisionalised company include the following:

1. Leads to goal congruence - motivates divisional managers to make decisions,

which improve divisional profit and improve profit of the organisation as a whole.

2. Hence it prevents dysfunctional decision making.

3. Transfer prices set at a level that enables divisional performance to be

measured 'commercially'.

4. Divisional autonomy - A good transfer pricing system helps to ensure that a

balance is kept between divisional autonomy to provide incentives and
motivation, and centralised authority to ensure that the divisions are all working
towards the same goals of the organisation.


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Practical Transfer Pricing

Transfer prices are set using the following techniques:

• Market prices

• Production cost – this can be based on variable or full cost including a mark-up

• Negotiation

The Use of Market Prices as a basis of Transfer Pricing

If an external market price exists for transferred goods, profit centre managers will be

aware of the price they could obtain or the price they would have to pay for their

goods on the external market, and they would inevitably compare this price with the

transfer price.

The Merits of Market Value Transfer Prices

1. Divisional autonomy

A transferor division should be given the freedom to sell output on the open

market, rather than to transfer it within the company.

'Arm's length' transfer prices, which give profit centre managers the freedom to

negotiate prices with other profit centres as though they were independent

companies, will tend to result in a market-based transfer price.

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2. Corporate profit maximisation

In most cases where the transfer price is at market price, internal transfers should

be expected, because the buying division is likely to benefit from a better quality

of service, greater flexibility, and dependability of supply.

Both divisions may benefit from cheaper costs of administration, selling and

transport.

 A market price as the transfer price would therefore result in decisions which

would be in the best interests of the company or group as a whole.

3. Divisional performance measurement

Where a market price exists, but the transfer price is a different amount (say, at
standard cost plus), divisional managers will argue about the volume of internal
transfers.

For example, if division X is expected to sell output to division Y at a transfer

price of $8 per unit when the open market price is $10, its manager will decide to
sell all output on the open market.

The manager of division Y would resent the loss of his cheap supply from X, and
would be reluctant to buy on the open market.

A wasteful situation would arise where X sells on the open market at $10, where
Y buys at $10, so that administration, selling and distribution costs would have
been saved if X had sold directly to Y at $10, the market price.

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The disadvantages of market value transfer prices

1. The market price may be a temporary one, induced by adverse economic

conditions, or dumping, or the market price might depend on the volume of output
supplied to the external market by the profit centre.

2. A transfer price at market value might, under some circumstances, act as a

disincentive to use up any spare capacity in the divisions.

A price based on incremental cost, in contrast, might provide an incentive to use

up the spare resources in order to provide a marginal contribution to profit.

3. Many products do not have an equivalent market price so that the price of a
similar, but not identical, product might have to be chosen.

In such circumstances, the option to sell or buy on the open market does not
really exist.

4. There might be an imperfect external market for the transferred item, so that if the
transferring division tried to sell more externally, it would have to reduce its selling
price.

Cost-Based Transfer Prices

Transfer prices based on variable/marginal cost

A variable cost approach entails charging the variable cost (equal to marginal cost)

that has been incurred by the supplying division to the receiving division.

The problem is that with a transfer price at marginal cost, the supplying division does

not cover its fixed costs.

Drawbacks when transfer prices are based on variable/marginal cost


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Although good economic decisions are likely to result, a transfer price equal to
marginal cost has certain drawbacks:

• Selling division will make a loss as its fixed costs cannot be covered.

This is demotivating.

• Performance measurement is distorted. Selling division is condemned to making

losses while buying division gets an easy ride as it is not charged enough to
cover all costs of manufacture.

This effect can also distort investment decisions made in each division. For
example, buying division will enjoy inflated cash inflows.

• There is little incentive for selling division to be efficient if all marginal costs are
covered by the transfer price.

Inefficiencies in selling division will be passed up to buying division.

Therefore, if marginal cost is going to be used as a transfer price, at least make it

standard marginal cost, so that efficiencies and inefficiencies stay within the
divisions responsible for them.

Approaches to transfer pricing

There are two approaches to transfer pricing which try to preserve the economic
information inherent in variable costs while permitting the transferring division to
make profits, and allowing better performance valuation .

• Variable cost plus lump sum: transfers are made at variable cost but, periodically,
a transfer is made between the two divisions to account for fixed costs and profit.

• Dual pricing: In this approach, the supplying division transfers out at cost plus a
mark up and the receiving division transfers in at variable cost.  

Obviously, the divisional current accounts won’t agree, and some period-end
adjustments will be needed to reconcile those and eliminate fictitious
interdivisional profits.

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Transfer prices based on full cost

Under this approach, the full cost (including fixed overheads absorbed) incurred by
the supplying division in making the 'intermediate' product is charged to the receiving
division.

The drawback to this is that the division supplying the product makes no profit on its
work so is not motivated to supply internally.

If a full cost plus approach is used, a profit margin is also included in this transfer
price.

The supplying division will therefore gain some profit at the expense of the buying
division.

Actual cost versus standard cost

When a transfer price is based on cost, standard cost should be used, not actual
cost.

A transfer at actual cost would give the supplying division no incentive to control
costs because all of the costs could be passed on to the receiving division.

Actual cost-plus transfer prices might even encourage the manager of the supplying
division to overspend, because this would increase divisional profit, even though the
organisation as a whole suffers.

Standard cost-based transfer prices should encourage the supplying division to

become more efficient.  

The problem with this approach is that it penalizes the supplying division if the
standard cost is unattainable, while it penalizes the receiving division if it is too easily
attainable.

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Negotiated Transfer Prices

In some cases, the divisions of a company are free to negotiate the transfer price
between themselves and then to decide whether to buy and sell internally or deal
with outside parties.  

Negotiated transfer prices are often employed when market prices are volatile and
change occurs constantly.

The negotiated transfer price is the outcome of a bargaining process between the
supplying and receiving division.

Which is the optimal transfer price?

Minimum (fixed by the supplying division):

Transfer price   ≥   variable cost of supplying division + any lost contribution

Maximum (fixed by receiving division):

Transfer price   ≤    the lower of net marginal revenue of the receiving division and
the external purchase price

When unit variable costs and/or unit selling prices are not constant, there will be a
profit-maximising level of output and the ideal transfer price will only be found by
negotiation and careful analysis: -

1. Establish the output and sales quantities that will optimise the profits of the
company or group as a whole.

2. Establish the transfer price at which both profit centres would maximise their
profits at this company-optimising output level.

There may be a range of prices within which both profit centres can agree on the
output level that would maximise their individual profits and the profits of the
company as a whole.

Any price within the range would then be 'ideal'.

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 Syllabus B: Advanced Investment Appraisal
Syllabus B1. Discounted cash flow techniques

Syllabus B1a. Evaluate the potential value added to an organisation arising from a specified
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
i) Inflation and specific price variation
ii) Taxation including tax allowable depreciation and tax exhaustion

Net Present Value method

This method is examined regularly

What it does is looks at all the projected future CASH inflows and outflows.

Obviously we hope the inflows are more than the outflows. If they are this is called a
positive NPV

However, it also introduces the concept of the “time value” of money.

The idea that money coming in today is worth more than the same amount of money
coming in in 5 years time. To do this we “discount down” all future cash flows.

This “discounting” takes into account not only the time value of money but also the
required return of our share and debt holders.

This means that if we have a positive NPV (even after discounting the future cash
flows) then the return beats not only the time value of money but it also beats what
the shareholders and debt holders require.

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So they will be happy and the company value (and hence share price) will rise by the
+NPV amount (divided by the number of shares)

So, let’s look at how we calculate NPVs in an exam..

NPV Proforma

  0 1 2 3 4
Sales   x x x x
Costs   (x) (x) (x) (x)
Profit   x x x x

Tax   (x) (x) (x) (x)

Capital Expense (x)        
Scrap         x
WDA   x x x x
Working capital (x) (x) (x) x x
Total Cashflows (x) x x x x
Discount Factors 1 0.9 0.8 0.7 0.6
Total Cashflows (x) x x x x

The Tax Effect

Tax on operating profits

• Simply calculate the net profit figure (sales less costs in table) and multiply by the
tax rate.
This is normally 30%.
Remember it is normally payable one year later. For example tax on year 1 profits
is paid in year 2 (and so goes in the NPV in yr 2)

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WDAs
• These REDUCE your tax bill!
They are the tax relief on your capital purchases.
These are normally 25% writing down allowances on plant & machinery

Calculation technique for WDA

Calculate the amount of capital allowance claimed in each year

Make a balancing adjustment in the year the asset is sold

by calculating the total tax relief that should have been given ((Cost - RV) x 30%)
less tax benefits already allowed in step 1

• Illustration

Year 0 Buy plant 100


Year 4 Sell plant 20

25% Reducing balance; Tax 30%;

• Answer

Year 1 WDA 100 x 25% = 25 Tax benefit 7.5


Year 2 WDA 75 x 25% = 18.75 Tax benefit 5.625

Year 3 WDA 56.25 x 25% = 14 Tax benefit 4.2

• Year 4 Total tax relief should be (100-20) x 30% = 24. Less benefits relieved so
far (7.5 + 5.625 + 4.2) = 6.675
Balancing Allowance = Tax benefit 6.675

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Working Capital
Think of this as like float in a restaurant. Each night in the restaurant represents a
year.

So, lets say a float of 100 is needed at the start of the night (T0).
Then the following night an extra 20 is required, the following night 30 more & the
final night 10 less
At the end of the project it all comes back to the owner

  T0 T1 T2 T3 T4
Working capital -100 -20 -30 10 140

So the technique is for WC is….:

Always start at T0
Just account for increase or decrease
Final year it all comes back as income
The working capital line should always total zero

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 Syllabus B1a iii. Evaluate the potential value added to an organisation arising from a specified
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
iii) Single period capital rationing.

Capital rationing - Single period- Types

Shareholder wealth is maximised by taking on positive NPV projects. However,

capital is not always available to allow this to happen.

In a perfect capital market there is always finance available - in reality there is not,
there are 2 reasons for this:

HARD CAPITAL RATIONING

This is due to external factors such as banks won’t lend any more - why?

Reasons for Hard Capital Rationing

1. Industry wide factor (recession?)

2. Company has no/poor track record

3. Company has too low credit rating

4. Company has no assets to secure the loan

5. Capital in short supply (crowded out by government borrowing)

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SOFT CAPITAL RATIONING

Company imposes it’s own spending restriction. (This goes against the concept of
shareholder maximisation - which occurs by always investing in positive NVP
projects ) - why?

Reasons for Soft Capital Rationing

1. Limited management skills in new area

2. Want to limit exposure and focus on profitability of small number of projects

3. The costs of raising the finance relatively high

4. No wish to lose control or reduce EPS by issuing shares

5. Wish to maintain s high interest cover ratio

6. “Internal Capital market” - deliberately restricting funds so competing projects

become more efficient

107
 Syllabus B1a iii. Evaluate the potential value added to an organisation arising from a specified
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
iii) Single period capital rationing.

Capital rationing & Divisible projects

Here, divisible investment projects can be ranked in order of desirability using the
profitability index

Steps for the exam with divisible projects

1. It's assumed that part rather than the whole investment can be undertaken
If 70% of a project is performed, for example, its NPV is assumed to be 70% of
the whole project NPV.
2. Then its profitability index is calculated

3. The profitability index is then used to rank the investment projects.

108
Illustration
A Company has 100,000 to invest and has identified the following 5 projects. They
are DIVISIBLE.

Project Investment NPV

A 40 20

B 100 35

C 50 24

D 60 18

E 50 10

Solution

Project Working Profitability Index Ranking

A 20/40 0.5 1

B 35/100 0.35 3

C 24/50 0.48 2

D 18/60 0.3 4

E who cares!   5

Plan

Funds Project NPV

100,000    
(40,000) A 20,000
(50,000) C 24,000
(10,000) 10% of B 3,500

109
 Syllabus B1a iii. Evaluate the potential value added to an organisation arising from a specified
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
iii) Single period capital rationing.

Capital rationing & INdivisible projects

In this case ranking by profitability index will not necessarily indicate the optimum
investment schedule, since it will not be possible to invest in part of a project.

In this situation, the NPV of possible combinations of projects must be calculated.

Unfortunately with indivisible projects there is no model to help us! We simply have
to look at all the possible combinations by trial and error work out which would be the
most profitable. (Highest NPV)

Surplus funds may be left over, but since the highest-NPV combination has been
selected, the amount of surplus funds is irrelevant to the selection of the optimal
investment schedule

110
Illustration

A company has 100,000 to invest and has identified the following 5 projects. They
are NOT DIVISIBLE.

Project Investment NPV

A 40 20

B 100 35

C 50 24

D 60 18

Solution

• A+C is the best mix

Project Investment required NPV

A&C 90 44

A&D 100 38

B 100 35

111
 Syllabus B1a iii. Evaluate the potential value added to an organisation arising from a specified
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
iii) Single period and multi-period capital rationing. Multi-period capital rationing to include the
formulation of programming methods and the interpretation of their output

Capital rationing - Multi-period

You have limited cash in Year 0 AND other years..

Projects may be:

1. Divisible

So here, there's a little scary cheeky monkey to deal with, called linear
programming!

But relax - it's easy :)

Basically the idea is we program a computer to tell us which different projects we

should take on - when we don't have enough cash to do them all (capital
rationing)

The problem is we don't have enough cash in year 0 or in another year (often
year 1)

2. Indivisible

Here, integer programming would be required to determine the optimal

combination of investments.

112
Good news!

In the exam you will not be expected to produce the solution to the linear
programming problem. Yay!

bad news :(

You will have to formulate a linear programming model and understand its outputs.
Booo!

So, to recap..

When capital is rationed for MORE than a single period - profitability index won't

help.. we have to use linear programming

Check these projects - all look good but you only have $150 to spend in Year 0 and
$10 to spend in Year 1 :(

Project Yr 0 Yr 1 Yr 2 Yr 3 NPV
A (100) (30) 90 60 20
B (90) (10) 50 60 10
C (80) 20 80 10 30

113
The steps to answer these questions are:

1. Do the Objective Function

(Posh way of saying write down all the projects NPVs and their names next to
them)

2. Do the Constraints Function

(Posh way of saying write down all the costs of each project and say they should
be less than the cash available)

3. Do the non-negativitity Function

(Posh way of saying you can only do a project up to once and never less than
none (the computer's a bit silly that way))

So here goes with the objective function

NPV maximised = 20a + 10b + 30c

Next the Constraints Functions

Year 0 100a + 90b + 80c < 150


Year 1 30a + 10b - 20c < 10

Finally the silly non-negative function

1 > a,b,c > 0

114
 Syllabus B1a iv. Evaluate the potential value added to an organisation arising from a specified
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
iv) Probability analysis and sensitivity analysis when adjusting for risk and uncertainty in
investment appraisal

Risk & Uncertainty basics

Risk

This is present when future events occur with measurable probability

Uncertainty

This is present when the likelihood of future events is incalculable

Risk & Uncertainty

• Risk refers to the situation where probabilities can be assigned to a range of

expected outcomes arising from an investment project and the likelihood of each
outcome occurring can therefore be quantified

• Uncertainty refers to the situation where probabilities cannot be assigned to

expected outcomes. Investment project risk therefore increases with increasing
variability of returns, while uncertainty increases with increasing project life

The analysis so far has assumed that all of the future cash flows are known with
certainty. However, future cash flows are often uncertain or difficult to estimate.

115
A number of techniques are available for handling this complication. Some of these
techniques are quite technical involving computer simulations or advanced
mathematical skills and are beyond the scope of F9.

However, we can provide some very useful information to managers without getting
too technical.

So there are 4 techniques we are going to look at:

1. Sensitivity Analysis

2. Probability Analysis

3. Simulation

4. Adjusted Payback

116
 Syllabus B1a iv. Evaluate the potential value added to an organisation arising from a specified
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
iv) Probability analysis and sensitivity analysis when adjusting for risk and uncertainty in
investment appraisal

Sensitivity Analysis

Change required to make NPV=0

Sensitivity analysis shows us which item is critical to the success of the project

The one which has to change the least to make the net present value no longer
positive

Only one variable is considered at a time

Managers should then look at the assumptions behind this key item

Also focus on it in order to increase the likelihood that the project will deliver positive
NPV

117
The calculation boyeeeeeeee

• The smaller the percentage, the more sensitive the decision to go ahead is to the
change in the variable

Illustration

ACCA colleges are considering a project which will cost them an initial 10,000

The cashflows expected for the 2 year duration are 10,000pa.

The variable costs are 1,000pa

Cost of capital 10%

Calculate the sensitivity analysis of all variables

• Solution

PV of project as a whole:

Year 0 1 2

Investment (10,000)    

Costs   (1,000) (1,000)

Sales   10,000 10,000

Discount Factor 1 0.909 0.826

Discounted Cashflows (10,000) 8,181 7,434

118
So the NPV as a whole is 5,615

Sensitivity of Initial Investment 


5,615 / 10,000 = 56%

Sensitivity of Costs 

5,615 / (909 + 826) = 323%

Sensitivity of Sales 

5,615 / (9,090 + 8,260) = 32%

Weakness of Sensitivity Analysis

• Each variable must change in isolation

Yet they are often interdependent upon each other

• It does not take into account probabilities of change occurring

• Some factors management may not control

119
 Syllabus B1a iv. Evaluate the potential value added to an organisation arising from a specified
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
iv) Probability analysis and sensitivity analysis when adjusting for risk and uncertainty in
investment appraisal

Probability analysis

This is the assessment of the separate probabilities of a number of specified

outcomes of an investment project.

For example, a range of expected market conditions could be formulated and the
probability of each market condition arising in each of several future years could be
assessed.



The NPVs arising from these combinations could then be assessed and linked to
their joint probabilities.

The expected net present value (ENPV) could be calculated, together with the
probability of the worst-case scenario and the probability of a negative net present
value.

In this way, the downside risk of the investment could be determined and
incorporated into the investment decision.

The term ‘probability’ refers to the likelihood or chance that a certain event will occur,
with potential values ranging from 0 (the event will not occur) to

1 (the event will definitely occur).

For example, the probability of a tail occurring when tossing a coin is 0.5, and the
probability when rolling a dice that it will show a four is 1/6 (0.166).

120
The total of all the probabilities from all the possible outcomes must equal 1, ie some
outcome must occur

Calculating an EV

Formula

• ∑px

P = probability and X = Value of outcome

It finds the the long run average outcome rather than the most likely outcome

Illustration

A new product cashflows will depend on whether a substitute comes onto the market
or not

• Chance of substitute coming in 30%

NPV if substitute comes along (10,000)

NPV with no substitute 20,000

• Solution

0.3 x (10,000) = (3,000)


0.7 x 20,000 = 14,000

EV = 11,000

121
Limitations of Probability Analysis

Expected values are more useful for repeat decisions rather than one-off activities,
as they are based on averages.

They illustrate what the average outcome would be if an activity was repeated a
large number of times.

A long term rather than short term average

• For example the EV of throwing a dice is 3.5!

And the average family in the UK has 2.4 children, now Ive never thrown a 3.5
nor met anyone with 2.4 children.

These are just long term averages, whereas in reality outcomes only occure once

122
 Syllabus B1a v, vi. Evaluate the potential value added to an organisation arising from a
specified capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
v) Risk adjusted discount rates
vi) Project duration as a measure of risk.

Payback method

This method focuses on liquidity rather than the profitability of a product. It is good
for screening and for fast moving environments

The payback period is the length of time that it takes for a project to recoup its initial
cost out of the cash receipts that it generates.

This period is some times referred to as “the time that it takes for an investment to
pay for itself.”

The basic premise of the payback method is that the more quickly the cost of an
investment can be recovered, the more desirable is the investment.

The payback period is expressed in years. When the net annual cash inflow is the
same every year, the following formula can be used to calculate the payback
period….

123
Formula / Equation:

• Payback period = Investment required / Net annual cash inflow*

*If new equipment is replacing old equipment, this becomes incremental net
annual cash inflow.

It simply measures how long it takes the project to recover the initial cost.
Obviously, the quicker the better.

Illustration

Constant cashflow scenario

Initial cost $3.6 million


Cash in annually $700,000

What is the payback period?

• Solution

3,600,000 / 700,000 = 5.1429

Take the decimal (0.1429) and multiply it by 12 to get the months - in this case
1.7 months

So the answer is 5 years and 1.7 months

124
So how useful is this method?

The payback method is not a true measure of the profitability of an investment.

Rather, it simply tells the manager how many years will be required to recover the
original investment.

1. Whole life of Project?

Unfortunately, a shorter payback period does not always mean that one
investment is more desirable than another.

For example it doesn’t look at the whole life of the project

2. Time value of money

Another criticism of payback method is that it does not consider the time value of
money. A cash inflow to be received several years in the future is weighed equally
with a cash inflow to be received right now.

3. Screening

On the other hand, under certain conditions the payback method can be very
useful. It can help identify which investment proposals are in the “ballpark.”

That is, it can be used as a screening tool to help answer the question, “Should I
consider this proposal further?” If a proposal does not provide a payback within
some specified period, then there may be no need to consider it further.

4. Cash poor companies

When a firm is cash poor, a project with a short payback period but a low rate of
return might be preferred over another project with a high rate of return but a long
payback period.

The reason is that the company may simply need a faster return of its cash
investment.

125
5. Quick changing environments

And finally, the payback method is sometimes used in industries where products
become obsolete very rapidly - such as consumer electronics.

Since products may last only a year or two, the payback period on investments
must be very short.

In summary, the benefits are:

1. Simple

2. Good when the project is subject to quick change like technology.

This is because cashflows in the future become harder and harder to predict so
recovering the money as soon as possible is vital.

3. It minimises risk (short term projects favoured)

4. It maximises liquidity

5. Uses cashflows not false profits

Drawbacks

1. the item with the quickest payback is simply that. What about afterwards, does it
still do well or does it then become obsolete?

2. It ignores the whole profitability. Also the time value of money is ignored (more of
that later).

126
Irregular Cashflows

When the cash flows associated with an investment project changes from year to
year, the simple payback formula that we outlined earlier cannot be used.

• To understand this point consider the following data:

Cumulative

Capital out 800 -800

Cash in 100 -700

Cash in 240 -460

Cash in 200 -260

Cash in 250 -10

Cash in 120 110

When the cumulative cashflow becomes positive then this is when the initial payment
has been repaid and so is the payback period

So in the final year we need to make 10 more to recoup the initial 800. So, that’s 10
out of 120. 10/120 x 12 (number of months) = 1.

So the answer is 4 years 1 month

Extension of Payback Method:

• The payback period is calculated by dividing the investment in a project by the

net annual cash constant inflows that the project will generate.

• If equipment is replacing old equipment then any scrap value to be received on

disposal of the old equipment should be deducted from the cost of the new
equipment, and only the incremental investment should be used in payback
computation.

127
 Syllabus B1a v, vi. Evaluate the potential value added to an organisation arising from a
specified capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
v) Risk adjusted discount rates
vi) Project duration as a measure of risk.

Adjusted Payback

This incorporates risk into the payback method we looked at earlier in

the course

2 Methods

• Add payback to NPV - Only projects with +ve NPV and payback within specified
time chosen

• Discount cashflows used in payback with a risk adjusted discount rate

Illustration of method 2

Year Cashflow
0 (1,700)
1 500
2 500
3 600
4 900
5 500

128
Calculate discounted payback at a rate of 12%

Solution

Year Cashflow 12% Cashflow Cumulative

0 (1,700) 1 (1,700) (1,700)
1 500 0.893 446.5 (1,253)
2 500 0.797 398.5 (855)
3 600 0.712 427.2 (427.8)
4 900 0.636 572.4 144.6
5 500 0.567 283.5 428.1



Discounted payback = 3 years 9 months

NPV = 428,100

Risk Adjusted Discount Rates

The discount rate should reflect:

1. Cost of debt

2. Cost of equity

The mix of the 2 above adjusted for riskiness

If a project gives additional risks then the discount factor should be altered
accordingly. This is called the risk premium

129
 Syllabus B1b i. Outline the application of Monte Carlo simulation to investment appraisal.
Candidates will not be expected to undertake simulations in an examination context but will be
expected to demonstrate an understanding of:
i. The significance of the simulation output and the assessment of the likelihood of project
success

Monte Carlo simulation

Monte Carlo simulation is a model which will include all combinations of

the potential variables associated with the project.

It results in the creation of a distribution curve of all possible cash flows which could

arise from the investment and allows for the probability of the different outcomes to

be calculated.

The steps involved are as follows:

1. Specify all major variables

2. Specify the relationship between those variables

3. Using a probability distribution, simulate each environment.

130
Illustration: Monte Carlo simulation

A business is choosing between two projects, project A and project B. It uses

simulation to generate a distribution of profits for each project.

Required:

Which project should the business invest in?

Solution

• Project A has a lower average profit but is also less risky (less variability of
possible profits).
• Project B has a higher average profit but is also more risky (more variability of
possible profits).
• There is no correct answer. All simulation will do is give the business the above
results. It will not tell the business which is the better project.
• If the business is willing to take on risk, they may prefer project B since it has the
higher average return.
• However, if the business would prefer to minimise its exposure to risk, it would
take on project A. This has a lower risk but also a lower average return.

131
 Syllabus B1b ii. b) Outline the application of Monte Carlo simulation to investment appraisal.
Candidates will not be expected to undertake simulations in an examination context but will be
expected to demonstrate an understanding of:
ii) The measurement and interpretation of project value at risk.

Project value at risk

Value at risk (VaR) is a measure of how the market value of an asset is

likely to decrease over a certain time

VaR is measured by using normal distribution theory.

VaR = amount at risk to be lost from an investment under usual conditions over a

given holding period, at a particular "confidence level".

Confidence levels are often set at either 95% (in which case the VaR will provide the

amount that has only a 5% chance of decline) or at 99% (when the VaR considers a

1% chance of loss of value).

132
Illustration
Cow plc estimates the expected NPV of a project to be £100 million, with a standard
deviation of £9.7 million.

Required:
Establish the value at risk using both a 95% and also a 99% confidence level.

Solution
• Using Z = (X - μ) / σ
where
X = result we are considering

μ = mean

σ = standard deviation

• Establishing Z from the normal distribution tables

ie at a 95% (0.95) confidence level, 1.65 is the value for a one tailed 5%
probability of decline (i.e. 0.95 - 0.50 = 0.45 = 0.4505 from the normal distribution
table)
and at a 99% (0.99) confidence level, 2.33 is the value for a one tailed 1%
probability of loss of NPV (i.e. 0.99 - 0.50 = 0.49 = 0.4901 from the normal
distribution table).

• At 95% confidence level, Z = (X-100) / 9.7 = –1.65;

therefore X = (9.7x–1.65)+100 = 84

• At 99% confidence level,  Z = (X-100) / 9.7 = –2.33;

therefore X = (9.7x–2.33)+100 = 77.4

• There is a 5% chance of the expected NPV falling to £84 million or less and a 1%
probability of it falling to £77.4 million or below.


133
Value at risk can be quantified for a project using simulation to calculate the project’s

standard deviation.
In this context, the standard deviation needs to be adjusted by multiplying by the
square root of the time period ie
• 95% value at risk = 1.645 x standard deviation of project x √time period of the
project

Illustration
A four-year project has an NPV of $2m and a standard deviation of $1m per annum.

Required
Analyse the project’s value at risk at a 95% confidence level.
• The VAR at 95% is 1.645 x 1,000,000 x √4 = $3,290,000
ie worst case NPV (only 5% chance of being worse) = $2m – $3.29m = – $1.29m

Illustration
A simulation has been used to calculate the expected value of a project and is
deemed to be normally distributed with the following results:
Mean = $40,000 (positive)

Standard deviation = $21,000
Calculate the following:
a) The probability that the NPV of the project will be greater than 0.
b) The probability that the NPV will be greater than $45,000.

• a)
Using Z = (X - μ) / σ
μ = $40,000

σ = $21,000

X=0
Z = (0 - 40,000) / 21,000

Z = 1.90

134
• From normal distribution table
1.90 = 0.4713 + 0.50 = 0.9713 = 97% probability that NPV >0

• b)
Using Z = (X - μ) / σ
Z = (45,000 - 40,000) / 21,000

Z = 0.24

• From normal distribution table

0.24 = 0.0948
then
0.50 - 0.0948 = 0.4052 = 41% probability that the project's NPV > $45,000

135
 Syllabus B1c. Establish the potential economic return (using internal rate of return (IRR) and
modified internal rate of return) and advise on a project’s return margin. Discuss the relative
merits of NPV and IRR.

Internal Rate of Return

The IRR is essentially the discount rate where the initial cash out (the investment) is
equal to the PV of the cash in.

So, it is the discount rate where the NPV = 0

It is actual return on the investment (%).

Consequently, to work out the IRR we need to do trial and error NPV calculations,
using different discount rates, to try and find the discount rate where the NPV = 0.

The good news is you only need to do 2 NPV calculations and then apply this
formula:

Where..
• L = Lower discount rate

H = Higher discount rate

NPV L = NPV @ lower rate

NPV H = NPV @ higher rate

136
If the IRR is higher than the cost of capital, the project should be accepted.
Illustration
If a project had an NPV of 50,000 when discounted at 10%, and -10,000 when
discounted at 15% - what is the IRR?

• Answer
10 + (50,000/60,000) x 5% = 14.17%

If you have a positive NPV, increase the discount rate to get a smaller NPV.
If you have a negative NPV, decrease the discount rate to get a bigger NPV.

Little Tricks
• If all the cashflows are the same
This is an annuity - simply take the Initial Cost / annual inflow - this gives you the
cumulative discount factor (annuity factor).
• Then go to the annuity table and look for this figure (in the row for the number of
years the project is for) - the column in which the figure is found is the IRR!
• If the cashflows are the same and go on forever
• This is a perpetuity - simply take the Annual inflow / Initial cost and turn it into a
percentage. That’s the IRR! Done.

Advantages of IRR
1. Considers the time value of money
2. Easily understood percentage
3. Uses cash not profits
4. Considers whole life of project
5. Increases shareholders wealth

Disadvantages of IRR
1. Does not produce an absolute figure (percentage only)
2. Interpolation of the formula means it is only an estimate
3. Fairly complicated to calculate
4. Non conventional cashflows can produce multiple IRRs

137
Interpreting the IRR

• The IRR provides a decision rule for investment appraisal, but also provides
information about the riskiness of a project – i.e. the sensitivity of its returns.

• The project will only continue to have a positive NPV whilst the firm’s cost of
capital is lower than the IRR.

• A project with a positive NPV at 14% but an IRR of 15% for example, is clearly
sensitive to:
- an increase in the cost of finance

- an increase in investors’ perception of the potential risks

- any alteration to the estimates used in the NPV appraisal.

138
 Syllabus B1c. Establish the potential economic return (using internal rate of return (IRR) and
modified internal rate of return) and advise on a project’s return margin. Discuss the relative
merits of NPV and IRR.

MIRR

Modified internal rate of return gives a measure of the return from a

project
MIRR = Project's return
MIRR gives a measure of the maximum cost of finance that the firm could sustain
and allow the project to remain worthwhile.
If Project return > company cost of finance ⇒ Accept project

Calculation of MIRR
There are several ways of calculating the MIRR, but the simplest is to use the
following formula which is provided on the formula sheet in the exam:

139
Where
• PVr= the present value of the "return phase" of the project

PVi = the present value of the "investment phase" of the project

re = the firm's cost of capital.

The MIRR assumes a single outflow at time 0 and a single inflow at the end of the

final year of the project.

The procedures are as follows:

Step 1
Convert all investment phase outlays as a single equivalent payment at time 0.
Basically bring all investment costs to year 0.
Where necessary, any investment costs arising after time 0 must be discounted back
to time 0 using the company’s cost of capital.

Step 2
All net cash flows generated by the project after the initial investment (ie the return
phase cash flows) are converted to a single net equivalent terminal receipt at the end
of the project’s life, assuming a reinvestment rate equal to the company’s cost of
capital.

Step 3
The MIRR can then be calculated employing one of a number of methods, as
illustrated in the following example.

140
Example
Cow plc is considering an investment in a project, which requires an immediate
payment of $20,000, followed by a further investment of $5,000 at the end of the first
year.
The subsequent return phase net cash inflows are expected to arise at the end of the
following years:

Year  Net cash inflows ($)

1 6,500 
2 7,000
3 5,700
4 4,000
5 3,000

Required:
Calculate the modified internal rate of return of this project assuming a reinvestment
rate equal to the company’s cost of capital of 8%.

Solution

Step 1:
Single equivalent payment discounted to year 0 at an 8% discount rate:

Year  $
0 20,000
1                     ($ 5,000 x 0.926 DF@8%) 4,630
Present Value (PV) of investment phase cash flows  24,630

141
Step 2:
Single net equivalent receipt at the end of year 5, using an 8% compound rate:

Year  $ 8% compound factors  $

1 6,500 1.3605  8,843
2 7,000 1.2597  8,818
3 5,700 1.1664  6,648
4 4,000 1.08 4,320
5 3,000 1 3,000
Terminal Value (TV) of return phase
31,629
cash flows

Step 3:
A five year PV factor can now be established i.e. ($ 24,630 ÷ $ 31,629) = 0.779
Using present value tables, this 5 year factor falls between the factors for 5% and
6% ie 0·784 and 0·747.
Using linear interpolation:
MIRR = 5% +  ((0·784 - 0.779) / (0·784 - 0·747)) x (6% - 5%)  = 5.13%
Alternatively, the MIRR may be calculated as follows:
MIRR = (5√ ($ 31,629/ $ 24,630)) − 1 = 5.13%


Furthermore, in examples where the PV of return phase net cash flows has already
been calculated, there is yet another formula for computing MIRR (which is given on
the ACCA formulae sheet).
This formula avoids having to establish the Terminal Value of those return phase net
cash flows.


PV of return phase net cash flows
(6,500 x 0.926) + (7,000 x 0.857) + (5,700 x 0.794) + (4,000 x 0.735) + (3,000 x
0.681) = $21,527
MIRR = ((5√ (($21,527/ 24,630) )× 1.08) - 1 = 5.13%

142
Advantages of MIRR

1. Eliminates the possibility of multiple internal rates of return.

2. Addresses the reinvestment rate issue ie it does not make the assumption that
the company’s reinvestment rate is equal to whatever the project IRR happens to
be.
3. Provides rankings which are consistent with the NPV rule (which is not always
the case with IRR).
4. Provides a % rate of return for project evaluation.
It is claimed that non- financial managers prefer a % result to a monetary NPV
amount, since a % helps measure the “headroom” when negotiating with
suppliers of funds.

143
Syllabus B2. Application of option pricing theory in investment
decisions

Syllabus B2a. Apply the Black-Scholes Option Pricing (BSOP) model to financial product
valuation and to asset valuation:
i) Determine and discuss, using published data, the five principal drivers of option value (value
of the underlying, exercise price, time to expiry, volatility and the risk- free rate)
ii) Discuss the underlying assumptions, structure, application and limitations of the BSOP
model.

Pricing of options

The pricing model for call options are based on the Black-Scholes

model.
Writers of options need to establish a way of pricing them.
This is important because there has to be a method of deciding what premium to
charge to the buyers.

Factors determining the value(price) of option

The major factors determining the price of options are as follows:

1. The price of the underlying item

For a call option, the greater the price for the underlying item the greater the
value of the option to the holder.
For a put option the lower the share price the greater the value of the option to
the holder.

144
 The price of the underlying item is the market prices for buying and selling the
underlying item.
However, mid-price is usually used for option pricing, for example, if price is
quoted as 200–202, then a mid-price of 201 should be used.

2. The exercise price

For a call option the lower the exercise price the greater the value of the option.
For a put option the greater the exercise price, the greater the value of the option.

3. Time to expiry of the option

The longer the remaining period to expiry, the greater the probability that the
underlying item will rise in value.
Call options are worth more the longer the time to expiry (time value) because
there is more time for the price of the underlying item to rise.
Put options are worth more if the price of the underlying item falls over time.

4. Prevailing interest rate

The seller of a call option will receive initially a premium and if the option is
exercised the exercise price at the exercised date.
If interest rate rises the present value of the exercise price will diminish and he
will therefore ask for a higher premium to compensate for his risk.
The risk free rate such as treasury bills is usually used as the interest rate.

5. Volatility of underlying item

The greater the volatility of the price of the underlying item the greater the
probability of the option yielding profits.
The volatility represents the standard deviation of day-to-day price changes in the
underlying item, expressed as an annualized percentage.

145
The following steps can be used to calculate volatility of underlying item, using

historical information:

1. Calculate daily return = Pi/Po,

where 

Pi = current price and 

Po = previous day’s price

2. Take the ‘In’ of the daily return using the calculator

3. Square the result above to get, say, X

4. Calculate the standard deviation as

=√ ((∑X² /n)−(∑X/n)²)

5. Then annualise the result using the number of trading days in a year.
The formula = daily volatility x √trading days

Illustration

Day  Price  Pi/Po  In(Pi/Po) = x  X²

Monday 100 -
Tuesday 104 = 104/100 = 1.04 ln 1.04 = 0.0392 0.0392² = 0,001538

Wednesday 110 = 110/104 = ln 1.0577 =  0.0561² = 0.003146

1.0577 0.0561
Thursday 106 = 106/110 = ln 0.9636 = -0.0370²  = 0.001372
0.9636 -0.0370
Friday 109 = 109/106 = ln 1.0283 = 0.0279²  = 0.000779
1.0283 0.0279
Total  0.0862 0.006835
n 4 4
Average  0.0862/4 = 0.006835 /4 =
0.02155 0.00170875

146
Solution
Standard deviation = Daily volatility 

= √( 0.00170875 − (0.02155)²)

= 0.035

= 4%
Since there are five trading days in a week and 52 weeks in a year, we assume the
trading days in a year is 52 x 5 = 260 days.
Annualised volatility = 4% x √260= 64.5%.

147
 Syllabus B2a. Apply the Black-Scholes Option Pricing (BSOP) model to financial product
valuation and to asset valuation:
i) Determine and discuss, using published data, the five principal drivers of option value (value
of the underlying, exercise price, time to expiry, volatility and the risk- free rate)
ii) Discuss the underlying assumptions, structure, application and limitations of the BSOP
model.

Black-Scholes Option Pricing (BSOP) model

Black-Scholes model is a model for determining the price of a call option

The market value of a call option can be calculated as:

Note:
The formula will be given in the examination paper.
You need to be aware only of the variables which it includes, to be able to plug in the
numbers.

148
The key:
• Pa = current price of underlying asset (e.g. share price)
Pe = exercise price
r = risk free rate of interest
t = time until expiry of option in years
s = volatility of the share price (as measured by the standard deviation expressed
as a decimal)
N(d) = equals the area under the normal curve up to d (see normal distribution
tables)
e = 2.71828, the exponential constant
In = the natural log (log to be base e)

Illustration
The current share price of AA plc is £2.90.

Estimate the value of a call option on the share of the company, with an exercise
price of £2.60, and 6 months to run before it expires.
The risk free rate of interest is 6% and the variance of the rate of return on the
shares has been 15%.

Solution
• d1 = (ln(2.9 / 2.6) + (0.06 × 0.5 × 0.15)) / (√0.15 × √0.5)

d1 = 0.6452, approximate to two decimal places = 0.65

d1 = 0.65 – (√0.15 x√0.5)

d1 = 0.3713 rounded to 0.37
• Using the normal distribution table:
Nd1 = N( 0.65) = 0.5 + 0.24 = 0.74

Nd2 = N(0.37) = 0.5 + 0.14 = 0.64
• Using calculator
e^(-rt) = e^(-0.03)

e^(-rt) = 0.97
• Call option price = (2.90 x 0.74) – (2.60 x 0.97 x 0.64) = £0.53
Using the Black-Scholes model to value put options
The put call parity equation is on the examination formula sheet:

149
Steps:
1. Step 1: Value the corresponding call option using the Black-Scholes model.
2. Step 2: Then calculate the value the put option using the put call parity equation.

Illustration (continue)
• P = 0.53 – 2.9 + 2.60 (0.97)

P = £0.15

Underlying assumptions and limitations

The model assumes that:

• The options are European calls.

• There are no transaction costs or taxes.

• The investor can borrow at the risk free rate.

• The risk free rate of interest and the share’s volatility is constant over the life of

the option.

• The future share price volatility can be estimated by observing past share price

volatility.

• The share price follows a random walk and that the possible share prices are

based on a normal distribution.

• No dividends are payable before the option expiry date.

150
Application to American call options

• One of the limitations of the Black-Scholes formula is that it assumes that the

shares will not pay dividends before the option expires.

If this holds true then the model can also be used to value American call options.

• In fact, if no dividends are payable before the option expiry date, the American

call option will be worth the same as a European call option.

• You will not be asked to value American call options on shares that do pay

dividends or American put options using the BlackScholes model.

Application to shares where dividends are payable before the expiry date

The BlackScholes formula can be adapted to call options with dividends being paid

before expiry by calculating a ‘dividend adjusted share price’:

• Simply deduct the present value of dividends to be paid (before the expiry of the

option) from the current share price.

• Pa, becomes Pa – PV (dividends) in the Black-Scholes formula.

PV of dividend = De-rt

Where D = dividend

151
Illustration
The following information relates to a call option:

Current share price £60

Exercise price £70

Dividend to be paid in 3 month time £1.5

Risk free rate 5%

Expiry date is 5 months.
• The dividend-adjusted share price for Black-Scholes option pricing model can be
calculated as:

PV of dividend = De-rt



r = 0.05

t = 3/12 = 0.25 of a year



PV of dividend =1.5 e-(0.05 x 0.25)

PV of dividend = £1.48
Dividend-adjusted price = 60 –1.48 = £58.52 and this will replace the price of the
underlying item in the formula.

152
Syllabus B2b. Evaluate embedded real options within a project, classifying them into one of the
real option archetypes.

Real options in decision making

Real options are those related to investment decisions

These are:

1. Timing options
– options to embark on an investment, to defer it or abandon it.

2. Scale options
– options to expand or contract an investment.

3. Staging options
– option to undertake an investment in stages.

4. Growth options
– options to make investments now that may lead to greater opportunities later,
sometimes called ‘toe-in-the-door’ option.

5. Switching option
– options to switch input or output in a production process.

153
Valuation of real options

The Black-Scholes model can be used to value real options, but the following should

be noted:

• The exercise price will be replaced by the capital investment (initial investment).

• The price of the underlying item will be replaced by the present value of future

cash flows from the project.

• Time to expiry is replaced by the life of the project.

• Interest rate is still the risk free rate.

• Volatility of cash flows can be measured using typical industry sector risk.

Option to redeploy or switch

The option to redeploy or switch exist when the company can use it productive

assets for activities other than the original one.

The switching from one activity to another will be exercised only when the present

value of cash flows from the new activity will exceed the cost of switching.

This could result to a put option if there is a salvage value for the work already

performed, together with a call option arising on the right to commence the new

investment at a later stage.

154
Syllabus B2b. Evaluate embedded real options within a project, classifying them into one of the
real option archetypes.

NPV and Real Options

NPV presumes decisions are now or never..

NPV doesn't accept that decisions are flexible and managers have a choice of
actions

The Real options method estimates a value for this choice

Real options build on NPV where there's uncertainty and..

1. when the decision isn't now or never
2. when a decision can be changed
3. when there are opportunities depending on an initial project being undertaken

So NPV tries to put risks into the cost of capital

Real options puts a value on this uncertainty - sees it as an opportunity

Ok - so how do you value these Real Options??

Well you need to estimate of the value attributable to three types of real options:
1. The option to delay a decision (a type of call option)
2. The option to abandon a project once started (which is a type of put option), and
3. The option to exploit follow-on opportunities (which is a type of call option).

155
Real options value will use BSOP and put-call parity and has 5 variables…

1. The underlying asset value (Pa), (the PV of future project cash flows)
2. The exercise price (Pe), (the amount paid / RECEIVED when the call/ PUT option
is exercised)
3. The risk-free (r), which is normally given or taken from the return offered by a
short-dated government bill
4. The volatility (s), which is the project risk  (measured by the standard deviation)
5. The time (t), in years, left before the opportunity to exercise ends.

Example 1: Delaying the decision

A company is considering bidding for the exclusive rights to undertake a project,

which will initially cost $35m.

Year 1 2 3 4
Cashflows 20 15 10 5

The relevant cost of capital for this project is 11% and the risk free rate is 4.5%. The
likely volatility (standard deviation) of the cash flows is estimated to be 50%.

Solution to Example 1
NPV without any option to delay the decision:

Year Today 1 2 3 4
Cashflows -35 20 15 10 5
Discounted at 11% -35 18 12.2 7.3 3.3

156
NPV = $5.8m
Now let's suppose the company doesn't have to make the decision right now but can
wait for two years...

Year 3 4 5 6
Cashflows 20 15 10 5
Discounted at 11% 14.6 9.9 5.9 2.7

Variables to be used in the BSOP model


Asset value (Pa) = $14.6m + $9.9m + $5.9m + $2.7m = $33.1m

Exercise price (Pe) = $35m

Exercise date (t) = Two years

Risk free rate (r) = 4.5%

Volatility (s) = 50%

Using the BSOP model:

d1 = 0.401899

d2 =-0.30521

N(d1) =0.656121

N(d2) =0.380103

Call value =$9.6m

So the company can delay its decision by two years and can bid as much as $9.6m
instead of $5.8m for the exclusive rights to undertake the project.

The increase in value reflects the time before the decision has to be made and the
volatility of the cash flows

157
Example 2: Exploiting a follow-on project

A company is considering a project with a small positive NPV of $3m but there is a

possibility of further expansion using the technologies developed for the initial

project.

The expansion would involve a second project in four years’ time.

Currently, the present values of the cash flows of the second project are estimated to

be $90m and its estimated cost in four years is expected to be $140m.

The standard deviation of the project’s cash flows is likely to be 40% and the risk

free rate of return is currently 5%

Solution to Example 2

The variables to be used in the BSOP model for the second (follow-on) project are
as follows:
Asset Value (Pa) = $90m

Exercise price (Pe) = $140m

Exercise date (t) = Four years

Risk free rate (r) = 5%

Volatility (s) = 40%
Using the BSOP model
d1 = 0.097709

d2 = -0.70229

N(d1 )= 0.538918

N(d2 )= 0.241249

Call value =$20.85m
The overall value to the company is $23.85m, when both the projects are considered

together.

158
At present the cost of $140m seems substantial compared to the present value of

the cash flows arising from the second project.

Conventional NPV would probably return a negative NPV for the second project and

therefore the company would most likely not undertake the first project either.

However, there are four years to go before a decision on whether or not to undertake

the second project needs to be made.

A lot could happen to the cash flows given the high volatility rate, in that time. The

company can use the value of $23.85m to decide whether or not to invest in the first

project or whether it should invest its funds in other activities. It could even consider

the possibility that it may be able to sell the combined rights to both projects for

$23.85m.

Example 3: The option to abandon a project

Duck Co is considering a five-year project with an initial cost of $37,500,000 and has

estimated the present values of the project’s cash flows as follows:

Year 1 2 3 4 5
Cashflows 1,496.9 4,938.8 9,946.5 7,064.2 13,602.9

Swan Co has approached Duck Co and offered to buy the entire project for $28m at

the start of year three.

The risk free rate of return is 4%.

159
Duck Co’s finance director is of the opinion that there are many uncertainties

surrounding the project and has assessed that the cash flows can vary by a standard

deviation of as much as 35% because of these uncertainties.

Solution to example 3

Since it is an offer to sell the project as an abandonment option, a put option value is

calculated based on the finance director’s assessment of the standard deviation and

using the Black-Scholes option pricing (BSOP) model, together with the put-call

parity formula.

Although Duck Co will not actually obtain any immediate cash flow from Swan Co’s

offer, the real option computation below, indicates that the project is worth pursuing

because the volatility may result in increases in future cash flows.

Without the real option:

Present value of cash flows approx. = $37,049,300


Cost of initial investment = $37,500,000


NPV of project = $37,049,300 – $37,500,000 = $(450,700)

With the real option

The asset value of the real option is the sum of the PV of cash flows foregone in

years three, four and five, if the option is exercised ($9.9m + $7.1m + $13.6m =

$30.6m)

Asset value (Pa) $30.6m


Exercise Price (Pe) $28m


160
Risk-free rate (r) 4%


Time to exercise (t) - Two years


Volatility (s) 35%


 


d1 = 0.588506


d2 = 0.093531


N(d1) = 0.721904


N(d2) = 0.537259


Call Value = 8.20


Put Value         = $3.45m

Net present value of the project with the put option is approximately $3m ($3.45m –

$0.45m).

If Swan Co’s offer is not considered, then the project gives a marginal negative net

present value, although the results of any sensitivity analysis need to be considered

as well. It could be recommended that, if only these results are taken into

consideration, the company should not proceed with the project. However, after

taking account of Swan Co’s offer and the finance director’s assessment, the net

present value of the project is positive. This would suggest that Duck Co should

undertake the project.

161
Syllabus B2c. Assess, calculate and advise on the value of options to delay, expand, redeploy
and withdraw using the BSOP model.

Option to delay or defer

The key here is to be able to delay investment without losing the opportunity,
creating a call option on the future investment.

Illustration
MMC is considering whether to undertake the development of a new computer game
based on an adventure film due to be released in 24 months.
However, at present, there is considerable uncertainty about whether the film, and
therefore the game, is likely to be successful.

MMC has forecast the following PV of cash flows:

Year Current 1 2 3 4 5 6

PV (11%)($) -7m -6.31m -28.42m 18.28m 11.86m 5.93m 2.68m

The company will require $35 million for production, distribution and marketing costs
at the start.
The relevant cost of capital for this project is 11% and the risk free rate is 3•5%.
MMC has estimated the likely volatility of the cash flows at a standard deviation of
30%.

Required:
Estimate the financial impact of the directors’ decision to delay the production and
marketing of the game.

162
Solution
1. Calculate NPV
Net Present Value = $(2•98 million)
On this basis the project would be rejected.
2. Present value of project’s positive cash flows discounted to current day:
$18•28m + $11•86m + $5•93m + $2•68m = $38•75m
3. Identify variables:
Current price (Pa) = $38•75m

Exercise price (Pe) = $35m

Exercise date = 2 years

Risk free rate = 3•5%

Volatility = 30%
4. Calculate d1 = (ln (Pa/Pe) + r + 0.5xs^2) t) / s√t
d1 = [ln(38•75/35) + (0•035 + 0•5 x 0•30^2) x 2]/(0•30 x √2) =
d1 = (0.10178 + 0.16) / 0.42426 =
d1 = 0•6170
5. Calculate d2 = d1 - s√t
d2 = 0•6170 – (0•30 x √2) = 0•1927
6. Using the Normal Distribution Table provided
N(d1) = 0•5 + 0•2291 + 0•7 x (0•2324 – 0•2291) = 0•7314

N(d2) = 0•5 + 0•0753 + 0•3 x (0•0793 – 0•0753) = 0•5765
7. Value of option to delay the decision
= Pa N(d1) - Pe N(d2) e^(-rt)
= 38•75 x 0•7314 – 35 x 0•5765 x e^(–0•035 x 2) 

= 28•34 – 18•81 = $9•53m
8. Overall value of the project = $9•53m – $2•98m = $6•55m
Since the project yields a positive net present value it would be accepted.

163
Syllabus B2c. Assess, calculate and advise on the value of options to delay, expand, redeploy
and withdraw using the BSOP model.

Option to abandon

An abandonment options is the ability to abandon the project at a certain stage in the
life of the project.

Whereas traditional investment appraisal assumes that a project will operate in each
year of its lifetime, the firm may have the option to cease a project during its life.

Abandon options gives the company the right to sell the cash flows over the
remaining life of the project for a salvage/scrape value therefore like American put
options.

Where the salvage value is more than the present value of future cash flows over the
remaining life, the option will be exercised.

Illustration

Bulud Co offered Chmura Co the option to sell the entire project to Bulud Co for $28
million at the start of year three. Chmura Co will make the decision of whether or not
to sell the project at the end of year two.

A standard deviation is 35% 


The return on short-dated $ treasury bills of 4%.

164
PV of the cash flow:

(all amounts in $, 000s)

year 1 2 3 4 5
present values ($ 000s) 1496.9 4938.8 9946.5 7064.2 3543.9

NPV of project = $(451,000)

Required
An estimate of the value of the project taking into account Bulud Co’s offer.

Solution
1. Calculate NPV
NPV of project = $(451,000)
On this basis the project would be rejected.

2. Present value of underlying asset (Pa) = $30,613,600 (approximately)

(This is the sum of the present values of the cash flows foregone in years 3, 4
and 5)

3. Identify variables:
Current price (Pa) = $38•75m

Exercise price (Pe) = $28,000,000
Exercise date = 2 years

Risk free rate = 4%

Volatility = 35%

4. Calculate d1 = (ln (Pa/Pe) + r + 0.5^2) t) / s√t

d1 = [ln(30,613•6/28,000) + (0•04 + 0•5 x 0•35^2) x 2]/[0•35 x 21/2] = 0•589

5. Calculate d2 = d1 - s√t
d2 = 0•589 – 0•35 x √2 = 0•094

165
6. Using the Normal Distribution Table provided
N(d1) = 0•5 + 0•2220 = 0•7220

N(d2) = 0•5 + 0•0375 = 0•5375

7. Call value
= Pa N(d1) - Pe N(d2) e^(-rt)
= $30,613,600 x 0•7220 – $28,000,000 x 0•5375 x e^(–0•04 x 2) = approx.
$8,210,000

8. Put value = c - Pa + Pe e^(-rt)

= $8,210,000 – $30,613,600 + $28,000,000 x e^(–0•04 x 2) = approx. $3,444,000

9. Net present value of the project with put option = $3,444,000 – $451,000 =
approx. $2,993,000

Since the project yields a positive net present value it would be accepted.

166
Syllabus B2c. Assess, calculate and advise on the value of options to delay, expand, redeploy
and withdraw using the BSOP model.

Option to expand

The option to expand exists when firms invest in projects which allow them to make
further investments in the future or to enter new market.

The initial project may be found in terms of its NPV as not worth undertaking.

However, when the option to expand is taken account, the NPV may become
positive and the project worthwhile.

Expansion will normally require additional investment creating a call option.

The option will be exercised only when the present value from the expansion is
higher than the extra investment.

Illustration
Cow plc has investigated the opening of a new restaurant in UK.
The initial capital expenditure is estimated at £16 million, whilst the present value of
the net cash inflows is expected to be £16.005 million.

If this first restaurant is opened, Cow plc would gain the right, but not the obligation
to open a second restaurant in four years time at a capital cost of £22 million.
The present value of the associated future net cash inflows is estimated at £18
million, with a standard deviation of 30%.

If the risk free rate of interest is 3%, determine whether to proceed with the
restaurant projects.

167
Solution

1. Calculate NPV
Net Present Value = £16.005 - £16 = £0.005
Since the resulting NPV of £0.005 million is a very small positive amount, this
appraisal suggests that the project is extremely marginal.

2. Identify variables:
Current price (Pa) = $18m

Exercise price (Pe) = $22m

Exercise date = 4 years

Risk free rate = 3%

Volatility = 30%

3. Calculate d1 = (ln (Pa/Pe) + r + 0.5 x s^2) t) / s√t

d1 = [ln(18/22) + (0•3+ 0•5 x 0•30^2) x 4]/(0•30 x √4) =
d1 = (- 0.20067 + 1.38) / 0.6 =
d1 = 1.965

4. Calculate d2 = d1 - s√t
d2 = 1.965 – (0•30 x √4) = 1.365

5. Using the Normal Distribution Table provided

N(d1) = 0•5 + 0.4750 + 0.5 x (0.4756 - 0.4750) = 0.9753

N(d2) = 0•5 + 0•4131 + 0•5 x (0.4147 – 0.4131) = 0.9139

6. Value of option to expand the decision

= Pa N(d1) - Pe N(d2) e^(-rt)
= 18 x 0.9753 – 22 x 0.9139 x e^(–0•03 x 4) 

= 17.56 – 17.83 = - $0.27m

7. Overall value of the project = $0.05m  - $0.27m = - $0.22m

Since the project yields a negative net present value it would be rejected.


168
 Syllabus B3. Impact of financing on investment decisions and
APV

Syllabus B3a. Identify and assess the appropriateness of the range of sources of finance
available to an organisation including equity, debt, hybrids, lease finance, venture capital.
Including assessment on the financial position, financial risk and the value of an organisation.

Debt v Equity

These are the things you need to think about when asked about raising finance - so
just put all these in your answer and link them to the scenario. Job done.

Gearing and financial risk

• Equity finance will decrease gearing and financial risk, while debt finance will
increase them

Target capital structure

• The aim is to minimise weighted average cost of capital (WACC).
In practical terms this can be achieved by having some debt in capital structure,
since debt is relatively cheaper than equity, while avoiding the extremes of too
little gearing (WACC can be decreased further) or too much gearing (the
company suffers from the costs of financial distress)

Availability of security
• Debt will usually need to be secured on assets by either:
a fixed charge (on specific assets) or 

a floating charge (on a specified class of assets).

169
Economic expectations
• If buoyant economic conditions and increasing profitability expected in the future,
fixed interest debt commitments are more attractive than when difficult trading
conditions lie ahead.

Control issues
• A rights issue will not dilute existing patterns of ownership and control, unlike an
issue of shares to new investors.

170
 Syllabus B3a. Identify and assess the appropriateness of the range of sources of finance
available to an organisation including equity, debt, hybrids, lease finance, venture capital.
Including assessment on the financial position, financial risk and the value of an organisation.

Long term finance

These are:

1. Finance Lease
You will notice we have included both operating and finance leases as potential
sources of finance - don’t forget too to mention the possibility of selling your
assets and leasing them back as a way of getting cash.
Be careful though - make sure there are enough assets on the SFP to actually do
this - or your recommendation may look a little silly ;)

2. Bank loans and bonds/debentures

Bonds securities which can be traded in the capital markets.
Bond holders are lenders of debt finance.
Bond holders will be paid a fixed return known as the coupon.
Traded bonds raise cash which must be repaid usually between 5 and 15 years
after issue.
Bonds are usually secured on non-current assets thus reducing risk to the lender.
Interest paid on the bonds is tax-deductible, thus reducing the cost of debt to the
issuing company

171
3. Equity
via a placing - does not need to be redeemed, since ordinary shares are truly
permanent finance.
The return to shareholders in the form of dividends depends on the dividend
decision made by the directors of a company, and so these returns can increase,
decrease or be passed.
Dividends are not tax-deductible like interest payments, and so equity finance is
not tax-efficient like debt finance.

4. Preference Share
These are seen as a form of debt

5. Venture Capital
For companies with high growth and returns potential
This is provided to early/start up companies with high-potential.
The venture capitalist makes money by taking an equity share and then realising
this in an IPO (Initial Public Offering) or trade sale of the company

6. Business angels
are wealthy individuals who invest in start-up and growth businesses in return for
an equity stake.
These individuals are prepared to take high risks in the hope of high returns.

7. Private equity
consists of equity securities in companies that are not publicly traded on a stock
exchange.
Private equity funds might require a 20 – 30% shareholding or/and Rights to
appoint directors

172
Equity as finance

Rights Issue For existing shareholders initially No dilution of control

Placing Fixed price to institutional investors Low cost - good for small
issues
Public Underwritten & advertised Expensive - good for large
issue

Rights Issue
For existing shareholders initially - means no dilution of control
• A 1 for 2 at $4 (MV $6) right issue means….
The current shareholders are being offered 1 share for $4, for every 2 they
already own.
(The market value of those they already own are currently $6)

Calculation of TERP (Theoretical ex- rights price)

• Calculation of TERP (Theoretical ex- rights price)
The current shareholders will, after the rights issue, hold:

1 @ $4 = $4

2 @ $6 =$12
So, they now own a total of 3 for a total of $16. So the TERP is $16/3 = $5.33

Effect on EPS
Obviously this will fall as there are now more shares in issue than before, and the
company has not received full MV for them
• To calculate the exact effect simply multiply the current EPS by the TERP /
Market value before the rights issue
Eg Using the above illustration

EPS x 5.33 / 6

173
Effect on shareholders wealth
• There is no effect on shareholders wealth after a rights issue.
This is because, although the share price has fallen, they have proportionately
more shares
Equity issues such as a rights issue do not require security and involve no loss of
control for the shareholders who take up the right

Methods of obtaining a listing

An unquoted company can obtain a listing on the stock market by means of a:

1. Initial public offer (IPO)

When a company issues shares to the public for the first time.
They are often issued by smaller, younger companies looking to expand, or large
private companies wanting to become public.
For the individual investor it is tough to predict share prices on the initial day of
trading as there’s little past data about the company often, so it’s a risky purchase.
Also expansion brings uncertainty in any case

2. Placing
Is an arrangement whereby the shares are not all offered to the public.
Instead, the shares are bought by a small number of investors, usually institutional
investors (such as pension funds and insurance companies).
This means low cost - so good for small issues
Placings are likely to be quick.

3. Public Issues
These are underwritten & advertised.
This means they are expensive - so good for large issue

174
 Syllabus B3a. Identify and assess the appropriateness of the range of sources of finance
available to an organisation including asset securitisation.

Asset securitisation

Asset securitisation involves the aggregation of assets into a pool then issuing new

securities backed by these assets and their cash flows.

The securities are then sold to investors who share the risk and reward from these

assets.

Securitisation is similar to ‘spinning off’ part of a business, whereby the holding

company ‘sells’ its right to future profits in that part of the business for immediate

cash.

The new investors receive a premium (usually in the form of interest) for investing in

the success or failure of the segment.

The main reason for securitising a cash flow is

• that it allows companies with a credit rating of (for example) BB but with AAA-

rated cash flows to possibly borrow at AAA rates.

This will lead to greatly reduced interest payments as the difference between BB

rates and AAA rates can be hundreds of basis points.

175
Tranches

Most securitisation pools consist of ‘tranches’.

Higher tranches carry less risk of default (and therefore lower returns) whereas junior

tranches offer higher returns but greater risk.

Drawbacks

Securitisation is expensive due to:

1. management costs

2. legal fees

3. administration fees

176
 Syllabus B3a. a) Identify and assess the appropriateness of the range of sources of finance
available to an organisation including Islamic finance.

Islamic Finance - Introduction

Is it moral or ethical to wish wealth into existence without any underlying productive
activity happening?

Islamic Finance is based on the principle that money must never spontaneously
generate money. Instead capital must be made fruitful or “fecundated” by labour,
material or intellectual activity or be invested in a wealth creating activity.

Islam therefore prohibits the payment of interest on loans, so observant Muslims

require specialised alternative arrangements from their banks.

Many of the largest global financial companies, including Deutsche Bank and
JPMorgan Chase, have established thriving subsidiaries that strive to meet these
requirements

Consequently Islamic Finance frowns upon speculation and applauds risk sharing.

The major difference between Islamic finance and the other finance
Equity Financing not Lending
• Under Islamic finance laws, interest cannot be charged or received due to the
lack of underlying activity
Therefore, Joint ventures under which the lender and the borrower share profits
and risks are common because of the strict prohibition of the giving and taking of
interest.

177
• Due to a ban on speculation, Islamic transactions must be based on tangible
assets such as commodities, buildings or land.
Islamic banking has its emphasis on equity financing rather than lending
Investing in businesses that provide goods or services considered contrary to the
principles of Islam is haraam (forbidden) while those that are permitted are
halaal.

The concept of interest (riba) and how returns are made

• Interest is called riba and an instrument that complies with the dictates of Fiqh al-
Muamalat (Islamic rules on transactions) is described as sharia-compliant.
Instead of charging interest (deemed to be money making money), the lender
agrees to buy the asset or part of the asset themselves (asset making money)

• Shariah-compliant mortgages, for instance, are typically structured so that the

lender buys the property and leases it out to the borrower at a price that
combines a rental income and a capital payment.
At the end of the mortgage term, when the price of the property has been fully
repaid, the house is transferred to the borrower.
NB no calculations are required for this part of the exam

• Riba is absolutely forbidden in Islamic finance. Riba can be seen as unfair from
the perspective of the borrower, the lender and the economy.
For the borrower, riba can turn a profit into a loss when profitability is low.
For the lender, riba can provide an inadequate return when unanticipated inflation
arises. In the economy, riba can lead to allocational inefficiency, directing
economic resources to sub-optimal investments

178
 Syllabus B3a. a) Identify and assess the appropriateness of the range of sources of finance
available to an organisation including Islamic finance.

Mudaraba (equity), Sukuk (debt) & Musharaka (JV)

Equity finance (mudaraba)

eg. Profit sharing

A type of partnership in which one partner provides the capital (the provider of the

finance) while the other provides expertise and management.

Each gets a prearranged percentage of the profits, but the partner providing the

capital bears any losses.

Although provisions can be made where losses can be written off against future

profits.

Mudaraba is a concept to provide capital to somebody undertaking the work.

It could be understood as being similar to the function of an employed manager of a

company.

The provider of the finance is not involved in the executive decision-making process.

As the profits are shared with the manager and the capital provider but the losses

are beared only by the capital provider this mode is also named profit sharing – loss

bearing.

Before the manager gets his share, the losses, however, if any, needs to be

recovered. A wage could be negotiated.

179
Debt finance (sukuk) eg. Bond issue

• Sukuk is an Arabic term in plural (singular Sakk) meaning certificates.

It is the root of the English word for cheque.


Sukuk are securitised assets or business.

• The company sells the certificate to the investor, who then rents it back to the

company for a predetermined rental fee.

The company promises to buy back the bonds at a future date at par value.

• Sukuks must be able to link the returns and cash flows of the financing to the

assets purchased, or the returns generated from an asset purchased.

This is because trading in debt is prohibited under Sharia.

As such, financing must only be raised for identifiable assets.

Venture capital (musharaka) eg Joint venture

Musharaka is the Islamic contract for establishing a joint venture partnership.

In musharaka, two or more parties contribute capital to a business and participate

with the related profits and losses.

• Simple Musharaka
The profit and the losses needs to be shared.
This method is recommended by Muslim economists as being the most fair and
just method.
In a Musharaka contract all parties may take part in the management or some
parties may not take part in the management (silent partnership).

• Losses need to be born proportionately to the capital provided by each party (pro
rata).
Regarding the profits there is a disagreement between the schools whether other
than pro rata distribution is permissible.

180
 Syllabus B3a. Identify and assess the appropriateness of the range of sources of finance
available to an organisation including Islamic finance.

Ijara (leasing) and Murabaha (credit)

Trade credit (murabaha)

Let’s say that you, a small businessperson, wish to go into business selling cars.

A conventional bank would examine your credit history and, if all was acceptable,

grant you a cash loan.

You would have to pay back funds on a specific maturity date, paying interest each

month along the way.

You would use the proceeds to buy the car—and meet other expenses—yourself.

Murabaha

• But in a murabaha transaction, instead of just giving you the cash, the bank itself

would buy the cars.

You promise to buy them from the bank at a higher price on a future date.

The markup is justified by the fact that, for a period, the bank owns the property,

thus assuming liability.

At no point in the transaction is money treated as a commodity, as it is in a

normal loan.

181
• A murabaha must be asset-based however, so it can’t help a small businessman

who needs a working-capital loan to meet payroll and other expenses.

To get such capital from an Islamic financial institution, an entrepreneur would

have to sell the bank an equity interest in his business.

This is far riskier for the bank and thus much harder to obtain.

Lease finance (ijara)

• A transaction where a benefit arising from an asset is transferred in return for a

payment, but the ownership of the asset itself is not transferred.

Most often the lessee returns the asset (and its benefits) to the lessor.

Basically an operating lease.

• An alternative is for the lessee to buy the asset at the end.

However some jurists do not permit this latter arrangement on the basis that it

represents more or less a guaranteed financial return at the outset to the lessor,

in much the same way as a modern interest-based finance lease.

• The terms of ijara are flexible enough to be applied to the hiring of an employee

by an employer in return for a rent that is actually a fixed wage.

182
Some generally agreed conditions for ijara are as follows:

1. The leased asset must continue to exist throughout the term of the lease.

Items which are consumed in the process of usage, ammunition for instance,

cannot be leased

2. In contrast with most conventional finance leases, the responsibility for

maintenance and insurance of the leased item under ijara remains that of the

lessor throughout

3. A price cannot be pre-determined for the sale of the asset at the expiry of the

lease.

However, lessor and lessee may agree the continuation of the lease or the sale of

the leased asset to the lessee under a new agreement at the end of the initial

lease period.

183
Syllabus B3b. Discuss the role of, and developments in, Islamic financing as a growing source
of finance for organisations; explaining the rationale for its use, and identifying its benefits and
deficiencies.

Basic Idea - IF

Islamic finance has obvious religious reasons for use but also

commercially

Commercial Reasons for using Islamic Finance

• May be available when other sources of finance aren't

• More conservative and less risky

Islamic finance does not allow "interest" instead returns come from the risks of

ownership

So the Islamic bank faces similar risks to its client and so is more involved in the

investment decision making

184
Syllabus B3b. Discuss the role of, and developments in, Islamic financing as a growing source
of finance for organisations; explaining the rationale for its use, and identifying its benefits and
deficiencies.

Advantages of Islamic finance

Remember there should always be a link between the economic activity and the

financing of that economic activity

1. Access to Islamic finance is not restricted to Muslim communities, which may

make it appealing to companies that are focused on investing ethically

2. Speculation is not allowed, reducing the risk of losses

3. Excessive profits not allowed, only reasonable mark-ups

4. Banks cannot use excessive leverage and are therefore less likely to collapse

5. The rules encourage all parties to take a longer-term view leading  to a more

stable financial environment

6. Co-operation and profit creation through ethical and fair activity benefits the

community as a whole

185
Syllabus B3b. Discuss the role of, and developments in, Islamic financing as a growing source
of finance for organisations; explaining the rationale for its use, and identifying its benefits and
deficiencies.

Disadvantages of Islamic Finance

Not all commercial risk is removed obviously...

1. Sharia interpretations of innovative financial products is not always agreed upon

Some Murabaha are based on prevailing interest rates rather than economic or

profit conditions

2. Documentation is often tailor-made for the transaction, so high transaction/issue

costs

3. Islamic finance institutions have extra compliance increasing issue / transaction

costs.

Banks need to know more than usual so more due diligence work is required.

4. Islamic banks cannot minimise their risks as hedging is prohibited

5. Some Islamic products may not be compatible with international financial

regulation.

6. Trading in Sukuk products has been limited, especially since the financial crisis

7. With no interest - it is hard to claim some Islamic instruments as debt - therefore

losing the tax benefit and increasing the WACC

8. Can be difficult to balance the interests of the financial institution with those of

other stakeholders.

186
 Syllabus B3a. Identify and assess the appropriateness of the range of sources of finance
available to an organisation including equity, debt, hybrids, lease finance, venture capital,
business angel finance, private equity, asset securitisation and sale, Islamic finance and initial
coin offerings.
Including assessment on the financial position, financial risk and the value of an organisation
.

Initial Coin Offerings

ICOs are a type of crowdfunding or crowd investing tool conducted entirely on the

blockchain.

Originally, new projects were funded by pre-selling coins to investors.

Entrepreneurs present a whitepaper of the business model and the technical

specifications of a project before the ICO.

They lay out a timeline for the project and set a target budget where they describe

the future funds spending (marketing, R&D, etc.) as well as coin distribution (how

many coins are they going to keep for themselves, token supply, etc.).

During the crowdfunding campaign, investors purchase coins/tokens with already

established cryptocurrencies like Bitcoin and Ethereum.

As opposed to traditional crowdfunding where the investment is considered to be a

donation or a pre-buy of a product, ICOs give the supporters the possibility of a

return of investment when selling their coin later at a possibly higher price.

ICOs are similar to IPOs only if the token represents a stake in the project.

ICOs could be seen as a mix between a donation, investment or risk capital.

187
 Syllabus B3cd. c) Calculate the cost of capital of an organisation, including the cost of equity
and cost of debt, based on the range of equity and debt sources of finance. Discuss the
appropriateness of using the cost of capital to establish project and organisational value, and
discuss its relationship to such value.

d) Calculate and evaluate project specific cost of equity and cost of capital, including their
impact on the overall cost of capital of an organisation. Demonstrate detailed knowledge of
business and financial risk, the capital asset pricing model and the relationship between equity
and asset betas.

Cost of Capital - Basics

The cost of capital represents the return required by the investors (such
as equity holders, preference holders or banks)

Basically the more risk you take, the more return you expect.

This risk is the likelihood of actual returns varying from forecast.

The return for the investors needs to be at least as much as what they can get from
government gilts (these are seen as being risk free). On top of this they would like a
return to cover the extra risk of giving the firm their investment.

The investors could be debt or share holders (debt and equity).

The cost of capital is made up of the cost of debt + cost of equity.

The cost of normal debt is cheaper than the cost of equity to the company. This is
because interest on debt is paid out before dividends on shares are paid. Therefore
the debt holders are taking less risk than equity holders and so expect less return.

Also debt is normally secured so again less risk is taken.

188
Creditor hierarchy

When a company cannot pay its debts and goes into liquidation, it must pay its
creditors in the following order:
1. Creditors with a fixed charge
2. Creditors with a floating charge
3. Unsecured creditors
4. Preference shareholders
5. Ordinary shareholders

Each of the above will cost the company more as it heads down the list. This is
because each is taking more risk itself

189
 Calculating the WACC

Marginal Cost of Capital

• If a company gets a specific loan or equity to finance a specific project then this
loan/equity cost is the MARGINAL cost of capital.

Average Cost of Capital

• If a company is continuously raising funds for many projects then the combined
cost of all of these is the AVERAGE cost of capital.
Always use the AVERAGE cost of capital in exam questions, unless stated that
the finance is specific

Calculating the WACC

Consider a company funded as follows:

Type Amount Cost of Capital

Equity 80% 10%

Debt 20% 8%

What is the weighted average cost of capital?

Equity 80% x 10% = 8%


Debt 20% x 8% = 1.6%
WACC 9.6%
What we have ignored here is how did we get to calculate how the ‘amount’ of equity
and debt was calculated - using book or market values?
Use MV where possible

190
Illustration

Statement of Financial Position

Ordinary Shares 2,000

Reserves 3,000

Loan 10% 1,000

Ordinary shares MV = 3.75; Loan note MV 80;


Equity cost of capital = 20%; Debt cost of capital = 7.5% (after tax)
Calculate WACC using:

1) Book Values

2) Market Values

Solution

Using Book Values:

Equity  

Ordinary Shares 2,000

Reserves 3,000

  5,000

Debt  

Loan 1,000

  6,000

Equity 5,000/6,000 x 20% = 16.67%

Debt 1,000/6,000 x 7.5% = 1.25%
WACC 17.92%

191
Solution

Using Market Values:

Equity    

Shares 2,000 x 3.75 7,500

    7,500

Debt    

Loan 1,000 80/100 800

    8,300

Equity 7,500/8,300 x 20% = 18.07%

Debt 800/8,300 x 7.5% = 0.72%
WACC 18.79%

SUMMARY

To Calculate WACC
1. Calculate weighting of each source of capital (as above)
2. Calculate each individual cost of capital
3. Multiply through and add up (as above)

192
 Dividend Valuation Model

The cost of equity – the dividend growth model

DVM can be with or without growth.

What this means is that the share price can be calculated assuming a growth in
dividends or not
Essentially this model presumes that a share price is the PV of all future dividends.
Calculate this (with or without growth) and multiply it by the total number of shares

It is similar to market capitalisation except it doesn’t use the market share price,
rather one worked out using DVM

1. DVM (without growth)

The share price is calculated like this:

o Constant Dividend / Cost of Equity (decimal)
Cost of Equity will be given, or calculated via CAPM

Take this share price and multiply it by the number of shares

2. DVM with growth

o Dividend in year 1 / Cost of Equity - growth (decimal)
Or
o Dividend just paid (1+g) / Cost of Equity - growth (decimal)

193
Illustration
• Share Capital (50c) $2 million

Dividend per share (just paid) 24c

Dividend paid four years ago 15.25c

Current market return = 15%

Risk free rate = 8%

Equity beta 0.8

Solution

Dividend is growing so use DVM with growth model:

• Calculating Growth

Growth not given so have to calculate by extrapolating past dividends as before:

24/15.25 sq root to power of 4 = 1.12 = 12%

So Dividend at end of year 1 = 24 x 1.12

• Calculate Cost of Equity (using CAPM)

8 + 0.8 (15-8) = 13.6%

Share price = 24x1.12 / 0.136 - 0.12 = 1,680c

Market cap = $16.8 x (2m / 0.5) = $67.2

194
 CAPM

This method also calculates the cost of equity (like dvm) but looks more closely at
the shareholder’s rate of return, in terms of risk.

The more risk a shareholder takes, the more return he will want, so the cost of equity
will increase.

For example, a shareholder looking at a new investment in a different business area

may have a different risk.

The model assumes a well diversified (see later) investor.

It suggests that any investor would at least want the same return return that they
could get from a “risk free” investment such as government bonds (Greece?!!).

This is called the risk free return

On top of the risk free return, they would also want a return to reflect the extra risk
they are taking by investing in a market share.

They may want a return higher or lower than the average market return depending
on whether the share they are investing in has a higher or lower risk than the
average market risk

The average market premium is Market return - Risk free return

The higher or lower requirement compared to the average market premium is called
the beta (β)

Required Return = Rf + β(Rm - Rf)

• Rm = Average return for the whole market

Rm - Rf = Average market risk premium

Beta (β )= How much of the average market risk premium (Rm - Rf) is needed

195
Systematic and non-systematic risk

More technically Beta (β ) = Systematic risk of the investment compared to the

market

1. Systematic risk

Market wide risk - such as state of the economy

All companies, though, do not have the same systematic risk as some are
affected more or less than others by external economic factors

2. Non Systematic Risk

Risk that is unique to a certain asset or company.

An example of nonsystematic risk is the possibility of poor earnings or a strike
amongst a company’s employees.

Non-systematic risk can be diversified away

• One may mitigate nonsystematic risk by buying different securities in the same
industry or different industries.

For example, a particular oil company has the diversifiable risk that it may drill
little or no oil in a given year.

An investor may mitigate this risk by investing in several different oil companies
as well as in companies having nothing to do with oil.

Nonsystematic risk is also called diversifiable risk.

196
An explanation of the graph
• If you have 1 share and this share does badly, then you DO BADLY.
• If you have 10 shares and 1 share does badly, you are sad about 1 share, but
you are still HAPPY about the other 9.
• Therefore with 1 share you are taking more risk than if you have more shares.
This risk is called UNSYSTEMATIC RISK
• So, we can buy more shares and therefore the UNSYSTEMATIC RISK should
GET SMALLER
• You will be always left with some risk that can't be diversified away.
This risk is called SYSTEMATIC RISK.
It is BETA (β) in the CAPM formulae

197
 CAPM continue

How risky is the specific investment compared to the market as a whole?

1. This is the ‘beta’ of the investment If beta is 1, the investment has the same risk
as the market overall.

2. If beta > 1, the investment is riskier (more volatile) than the market and investors
should demand a higher return than the market return to compensate for the
additional risk.

3. If beta < 1, the investment is less risky than the market and investors would be
satisfied with a lower return than the market return.

Illustration

Risk free rate = 5%

Market return + 14%

What returns should be required from investments whose beta values are: 

(i) 1 

(ii) 2 

(iii) 0.5

• Cost of Equity = Rf +beta(Rm - Rf)

(i)  = 5 + 1(14 - 5) = 14%    
The return required from an investment with the same risk as the market, which is
simply the market return.

• (ii) = 5 + 2(14 - 5) = 23%

The return required from an investment with twice the risk as the market.
A higher return than that given by the market is therefore required.

198
• (iii) = 5 + 0.5(14 - 5) = 9.5%

 

The return required from an investment with half the risk as the market.

A lower return than that given by the market is therefore required.

CAPM assumptions

1. Diversified investors
2. Perfect market (in fact they are semi strong at best)
3. Risk free return always available somewhere
4. All investors expectations are the same

Advantages of CAPM

1. The relationship between risk and return is market based

2. Correctly looks at systematic risk only
3. Good for appraising specific projects and works well in practice

Disadvantages of CAPM

1. It presumes a well diversified investor .

Others, including managers and employees may well want to know about the
unsystematic risk also

2. The return level is only seen as important not the way in which it is given.
For example dividends and capital gains have different tax treatments which may
be more or less beneficial to individuals.

3. It focuses on one period only.

Some inputs are very difficult to get hold of.
For example beta needs a subjective analysis

4. Generally CAPM overstates the required return for high beta shares and visa
versa

199
 DVM or CAPM?

CAPM is generally preferred out of the 2 methods

The dividend growth model allows the cost of equity to be calculated using empirical
values readily available for listed companies.

Measure the dividends, estimate their growth (usually based on historical growth),
and measure the market value of the share (though some care is needed as share
values are often very volatile).
Put these amounts into the formula and you have an estimate of the cost of equity.

DVM
The current share price and dividend is easily known but..
• it is very difficult to find an accurate value for the future dividend growth rate
• using a historic growth rate as a predictor of the future isn't based on fact

The equation:
• (Dividend next year / Share Price) + Growth

might suggest that the rate of return would be lowered if the company reduced its
dividends or the growth rate.
That is not so. All that would happen is that a cut in dividends or dividend growth
rate would cause the market value of the company to fall to a level where
investors obtain the return they require.

CAPM

has a sound theoretical basis, relating the required return of well-diversified

shareholders to the systematic risk they face through owning the shares of a
company. However...
• finding suitable values for the risk-free rate of return & equity beta can be difficult

200
DVM difficulties
• The dividend growth model has several difficulties.
For example, it impractically assumes that the future dividend growth rate is
constant.
The dividend decision depends on past trends but also current conditions.
The historic dividend growth rate is used as a substitute for the future dividend
growth rate.

• The model also assumes that business risk, and the cost of equity, are constant
in future periods, but reality shows us that companies are subject to constant
change.

The dividend growth model does not consider risk explicitly in the same way as
the CAPM.
Here, all investors are assumed to hold diversified portfolios and as a result only
seek return for the systematic risk of an investment.

• The individual components of the CAPM are found by empirical research and so
the CAPM gives rise to a much smaller degree of uncertainty than that attached
to the future dividend growth rate in the dividend growth model.
For this reason, it is usually suggested that the CAPM offers a better estimate of
the cost of equity than the dividend growth model.

201
 Ungearing & Regearing

When to use WACC to appraise investments

The WACC calculations we made earlier were all based on CURRENT costs and
amounts of debt and equity.

So use this as a cost for other future projects where:

1. Debt/equity amounts remain unchanged
2. Operating risk of firm stays same
3. Finance is not project specific (so the average is applicable)
4. Project is relatively small so any changes to the company are insignificant.

If any if the above do not apply - then we cannot use WACC. We then have to use
CAPM.. adapted…

Ungearing & Regearing

The betas we have been looking at so far are called Equity Betas
These represent :
• Business Risk
• Our Financial Risk (Our gearing)

If we are looking to invest into a different industry we need to use a different beta,
one which represents:
• Business Risk (of new industry)
• Financial Risk (Ours still as we are using our debt and/or equity)

202
To do this - follow these 2 simple steps

1. Ungearing

Take the equity beta of a business in the target industry.

Remember, this will represent their business risk and their financial risk (gearing).

We only want their business risk.

So we need to take out the financial risk - this is called ungearing

Business equity beta x Equity / Equity + Debt

This will leave us with business risk only (asset beta)

2. Re-Gearing

Take this asset beta and regear it using our gearing ratio as follows:

Asset Beta x Equity + Debt / Equity

*Remember Debt is tax deductible

Illustration

Tax = 30%

  Main company Proxy company

Equity beta 1⋅1 1⋅4

Gearing 2⋅5 1⋅4

203
Find the appropriate beta for the main company to use in its CAPM for investing in
an industry different to its own but the same as the proxy company

STEP 1
Ungear the ß of the proxy company:
ßu = ßg [Ve/(Ve + Vd (1 - t))]

= 1⋅4 x 4/4⋅7 =  1⋅1915

STEP 2

Regear the ß:
ßg = 1⋅1915 x (5 + 2 (1 - 0⋅3))/5

= 1⋅525

THEN APPLY THIS TO THE CAPM FORMULA

204
 Redeemable debt

The company pays the interest and the original amount (capital) back.

So the MV is the interest and capital discounted at the investor’s required rate of
return.

Remember the cost of debt to the company is the debtholder’s required rate of
return. (Tax plays a part here as we shall see later)

To calculate the cost of debt in an exam an IRR calculation is required as follows:

1. Guess the cost of debt is 10 or 15% and calculate the present value of the capital
and interest.
2. Compare this to the correct MV
3. Now do the same but guess at 5%

4. Use the IRR formula to calculate the actual cost of capital

IRR = L + (NPV L / (NPV L - NPV H)) x (H - L)

Illustration
5 years 12% redeemable debt. MV is 107.59

Time Cash 5% PV 15% PV

1-5 Interest 12 4.329 51.95 3.352 40.22
5 Capital 100 0.784 78.40 0.497 49.7
  MV   -107.59   -107.59
      22.76   -17.67

IRR = L + (NPV L / (NPV L - NPV H)) x (H - L)

IRR = 5 + (22.76 / (22.76+17.67)) x (15-5) = 10.63

205
The Tax Effect
• Tax reduces the cost of capital to a company because interest payments are tax
deductible.
It was ignored in the last example, but let’s say that that tax was 30%, then the
actual interest cost was not 12 but 12x70% = 8.40
Simply take the interest figure and multiply it by 1 - tax rate%.

Illustration
20% Redeemable debt.

Tax 30%.

What is the interest charge to be used in a cost of capital calculation for a company?

20% x 70% = 14%

Now let’s rework that last example but this time use 10% as a guess and let’s
assume tax of 30%

Time Cash 5% PV 10% PV

1-5 Interest 8.4 4.329 36.36 3.791 31.84
5 Capital 100 0.784 78.40 0.621 62.1
  MV   -107.59   -107.59
      7.17   -13.65



IRR = L + (NPV L / (NPV L - NPV H)) x (H - L)

IRR = 5 + (7.17 / (7.17 + 13.65)) x  (10-5) = 6.72

The cost of capital is lower than the original example as tax effectively reduces the
cost to the company as interest is a tax deductible expense.

206
 Irredeemable debt

The company just pays back the interest (NOT the capital)

So the MV should just be all the expected interest discounted at the investor’s
required rate of return.

Therefore, the cost of debt (the debtholder’s required return) can be calculated as
follows:
• Annual Interest / Market Value

Preference Shares

Treat the same as irredeemable debt except that the dividend payments are never
tax deductible
• Annual Dividend / Market Value

Illustration

50,000 8% preference shares. 


MV 1.20.

What is the cost of capital for these?

(8% x 50,000) / (50,000 x 1.2) = 6.67%

Bank Debt

The cost of debt is simply the interest charged. Do not forget to adjust for tax though
if applicable.

207
Illustration

$1,000,000 10% Loan. Tax 30%.

What is the cost of debt? 




7%

208
 Convertible Debt

Here the investor has the choice to either be paid in cash or take shares from the
company.

Hence, the debt is convertible into shares.

To calculate the cost of capital here, simply follow the same rules as for redeemable
debt (an IRR calculation).

The only difference is that the ‘capital’ figure is the higher of:

1. Cash payable
2. Future share payable

Illustration

8% Convertible debt. Redeemable in 5 years at:


Cash 5% premium or


209
20 shares per loan note (current MV 4 and expected to grow at 7%)

The MV is currently 85.

Tax 30%.

Time Cash 5% PV 10% PV

1-5 Interest 5.6 4.329 24.24 3.791 21.23
5 Capital 112.2 0.784 87.96 0.621 69.68
  MV   -85   -85
      27.2   5.91

IRR = L + (NPV L / (NPV L - NPV H)) x (H - L)

IRR = 5 + (27.2 / (27.2 - 5.91)) x  (10-5) = 11.4%

Note :
Interest = 100 x 8% x 70% (tax adj) = 5.6
Capital = higher of 100 x 1.05% (premium) = 105 and 20 x 4 x 1.07 power 5 = 112.2

Terminology
• Floor Value MV without conversion option (basically the above calculation using
cash as capital)
• Conversion Premium MV of loan - convertible shares @ today’s price

210
 WACC - Putting it all Together

So, you have studied all the bits in isolation, here’s where we get sexy and bring it all
together..

So, this is kind of the proforma you need to set up, when you get a “Calculate the
WACC..” question

DEBT/EQUITY COST Market Value “Interest”

Equity 10% 1,000 100
Loan 6% 800 48
Total 1,800 148

So we have paid “interest’ of 148 on capital of 1,800…

So the WACC is 148/1,800 = 8.2%

211
 WACC calculated using Asset Beta

Use when the business risks change

Steps:

1. Calculate competitor's Market Value of equity and Market Value of debt

2. Use competitor’s information to estimate the project’s asset beta (includes

business risk of the competitor only)

3. Calculate your MVe and MVd

4. Then based on your capital structure, estimate the project’s equity beta (includes
business risk of the competitor and your financial risk).

5. Calculate Ke using CAPM

6. Calculate WACC

Exam standard example (extract)

Tisa Co is considering an opportunity to produce an innovative component.

This is an entirely new line of business for Tisa Co. (New business risk)

Tisa Co has 10 million 50c shares trading at 180c each.



Its loans have a current value of $3•6 million and an average after-tax cost of debt of
4•50%.

212
Tisa Co’s capital structure is unlikely to change significantly following the investment.
(No change in Financial risk)

Elfu Co manufactures electronic parts for cars including the production of a

component similar to the one being considered by Tisa Co.

Elfu Co’s equity beta is 1•40, and it is estimated that the equivalent equity beta for its
other activities, excluding the component production, is 1•25.

Elfu Co has 400 million 25c shares in issue trading at 120c each.
The loans have a current value of $96 million.

It can be assumed that 80% of Elfu Co’s debt finance and 75% of Elfu Co’s equity
finance can be attributed to other activities excluding the component production.

Tax 25%. 

Risk free rate 3•5% 

Market risk premium 5•8%.

Required

Calculate the cost of capital that Tisa Co should use to calculate the net present
value of the project.

Solution

1. Calculate competitor's Market Value of equity and Market Value of debt

Elfu Co MVe = $1•20 x 400m shares = $480m


Elfu Co MVd = $96m

2. Use competitor’s information to estimate the project’s asset beta (includes

business risk of the competitor only)
Asset Beta = Equity Beta x (E / (E + D(1-tax))

Elfu Co portfolio asset beta for ALL activities = 


1•40 x $480m/($480m + $96m x (1 – 0•25)) = 1•217

213
 Other activities:

MVe = 75% x $480m = $360

MVd = 80% x $96 = $76.8

Elfu Co asset beta of other activities = 


1•25 x $360m/($360m + $76•8m x (1 – 0•25)) = 1•078


Assuming that:

25% can be attributed to component activities and

75% can be attributed to other activities:
1•217 = component asset beta x 0•25 + 1•078 x 0•75
Component asset beta = [1•217 – (1•078 x 0•75)]/0•25 = 1•634

3. Calculate your MVe and Mvd

MVe of Tisa Co = 10 million shares x 180c = $18m


Mvd of Tisa Co = $3.6m

4. Then based on your capital structure, estimate the project’s equity beta (includes
business risk of the competitor and your financial risk).

Equity Beta = Asset Beta x ((E + D(1-tax) / E)

Component equity beta based on Tisa Co capital structure = 

1•634 x [($18m + $3•6m x 0•75)/$18m] = 1•879

5. Calculate Ke using CAPM

Component Ke = 3•5% + 1•879 x 5•8% = 14•40%

6. Calculate WACC

Ke = 14.40%

Kd = 4.5% (after tax)
Component WACC = (14•40% x $18m + 4•5% x $3•6m)/($18m + $3•6m) =
12•75%

214
 WACC calculated using ungeared Ke

Use when the company is financed entirely by equity

Illustration 1

Cow Co is an unlisted company producing milk and wants to be  listed on a stock

exchange and be financed entirely by equity.
Cow Co’s closest competitor is Milk Co, a listed company which produces milk
worldwide.



Milk Co:

MV debt = $500

MV equity = $200

Milk Co’s geared cost of equity is estimated at 12% and its pre-tax cost of debt is
estimated at 5%.
Tax is 25%

Required

Calculate Cow Co's WACC.

• Solution:
As Cow Co. wants to be financed entirely by equity, we will use Milk Co's
Ungeared Ke (includes only equity, NO debts) as WACC.



Milk Co, ungeared Ke:

Keg = Keu + (1 – t) (Keu – Kd) D/E

12% = Keu + 0.75 x (Keu – 5%) x 500/200

12% = Keu + 1.875Keu - 9.375%

12% + 9.375% = Keu + 1.875Keu

21.375% = 2.875Keu

Keu = 7.43% (say 7%)

215
Exam standard example (extract)

Mlima Co is a private company involved in aluminium mining.

Mlima Co is an unlisted company and wants to be listed on a stock exchange and be

financed entirely by equity.

Mlima Co’s closest competitor is Ziwa Co, a listed company which mines metals
worldwide.

Mlima Co’s directors are of the opinion that after listing Mlima Co’s cost of capital
should be based on Ziwa Co’s ungeared cost of equity.

Ziwa Co’s geared cost of equity is estimated at 16•83% and its pre-tax cost of debt is
estimated at 4•76%.

These costs are based on a capital structure comprising of 200 million shares,
trading at $7 each, and $1,700 million 5% irredeemable bonds, trading at $105 per
$100.

Both Ziwa Co and Mlima Co pay tax at an annual rate of 25% on their taxable profits.

Required

Calculate Mlima Co's WACC.

Solution

Ziwa Co

MV debt = $1,700m x 1•05 = $1,785m


MV equity = 200m x $7 = $1,400m

Ziwa Co, ungeared Ke

Keg = Keu + (1 – t) (Keu – Kd) D/E

16.83% = Keu + 0.75 x (Keu – 4.76%) x 1,785/1,400


16.83% = Keu + 0.9563Keu - 4.55%

16.83% + 4.55% = Keu + 0.9563Keu

21.38% = 1.9563Keu

Keu = 10.93% (say 11%)

216
 Syllabus B3e. Assess an organisation’s debt exposure to interest rate changes using the
simple Macaulay duration and modified duration methods.

Duration (Macauley duration)

Duration is the average time taken to recover the cash flows on an

investment.

Duration measures the average time to recover the present value of the project (if

cash flows are discounted at the cost of capital).

Duration captures both the time value of money and the whole of the cash flows of a

project.

Projects with higher durations carry more risk than projects with lower durations.

Exam standard example (extract)

GNT Co is considering an investment in a corporate bond. The bond has a par value

of $1,000 and pay coupon interest on an annual basis.

The market price of the first bond is $1,079•68. 


Its coupon rate is 6% and it is due to be redeemed at par in five years.

Gross Redemption Yield is 4.2%.

Required

Estimate the Macaulay duration of the bond.

Solution: Step by step

217
1. Determine Gross Redemption Yield

= 4.2%

2. Calculate PV of the annual cash flows (interest + redemption value in the year 5)

Interest (6% x 1000=) 60 x 1•042^–1 + 60 x 1•042^–2 + 60 x 1•042^–3 + 60 x

1•042^–4 + 1,060 x 1•042^–5

PV of cash flows (years 1 to 5) = 57•58 + 55•26 + 53•03 + 50•90 + 862•91 =

1,079•68

3. Determine market price

Market price = $1,079•68

4. Calculate duration using PV calculated earlier and multiply them by number of

year and then divided by market price

Duration = [57•58 x 1 + 55•26 x 2 + 53•03 x 3 + 50•90 x 4 + 862•91 x 5]/1,079•68

= 4•49 years

218
 Syllabus B3g. Assess the organisation’s exposure to credit risk, including:
i) Explain the role of, and the risk assessment models used by the principal rating agencies
ii) Estimate the likely credit spread over risk free
iii) Estimate the organisation’s current cost of debt capital using the appropriate term structure
of interest rates and the credit spread.

Credit spread

The credit spread is a measure of the credit risk associated with a company.

Credit spreads are generally calculated by a credit rating agency and presented in a

table like the one below.

The credit spread is in basis point, which means for example 5 = 0.05%.

An alternative technique used for deriving cost of debt is based on an awareness of

credit spread (sometimes referred to as the "default risk premium"), and the formula:

kd (1–T) = (Risk free rate + Credit spread) (1–T)

219
The criteria used by credit agencies for establishing a company’s credit rating are the

following:

1. Industry risk

measures the how the company’s industrial sector reacts to changes in the

economy.

How cyclical the industry is and how large the peaks and troughs are.

2. Earnings protection

measures how well the company will be able to maintain or protect its earnings in

changing circumstances.

3. Financial flexibility

measures how easily the company is able to raise the finance.

4. Evaluation of the company’s management

considers how well the managers are managing and planning for the future of the

company.

220
 Syllabus B3g. Assess the organisation’s exposure to credit risk, including:
i) Explain the role of, and the risk assessment models used by the principal rating agencies
ii) Estimate the likely credit spread over risk free
iii) Estimate the organisation’s current cost of debt capital using the appropriate term structure
of interest rates and the credit spread.

Gearing drift

Dealing with 'gearing drift'

Profitable companies will tend to find that their gearing level gradually reduces over
time as accumulated profits help to increase the value of equity. This is known as
"gearing drift".

Gearing drift can cause a firm to move away from its optimal gearing position.
The firm might have to occasionally increase gearing (by issuing debt, or paying a
large dividend or buying back shares) to return to its optimal gearing position.

Signalling to investors
In a perfect capital market, investors fully understand the reasons why a firm
chooses a particular source of finance.
However, in the real world it is important that the firm considers the signalling effect
of raising new finance.

Generally, it is thought that raising new finance gives a positive signal to the market:
the firm is showing that it is confident that it has identified attractive new projects and
that it will be able to afford to service the new finance in the future.
Investors and analysts may well assess the impact of the new finance on a firm's
statement of profit or loss and balance sheet (statement of financial position) in order
to help them assess the likely success of the firm after the new finance has been
raised.

221
Syllabus B3h. Assess the impact of financing and capital structure upon the organisation with
respect to:
i) Modigliani and Miller propositions, before
and after tax
iii) Pecking order propositions

Capital structure theories

These are 3 theories (& pecking order) to see if there is a perfect capital structure

This simply means - is there a perfect Debt to Equity ratio?

For example, 40% Debt and 60% Equity?
Well there are 3 theories here we go..

The Traditional Theory

suggests that using some debt will lower the WACC, but if gearing rises above an
acceptable level then the cost of equity will rise dramatically causing the WACC to
rise.

222
The cheap cost of debt (as it is ranked before equity in terms of distribution of
earnings and on liquidation), combined with its tax advantage, will cause the WACC
to fall as borrowing increases.

However, as gearing increases past a certain point, shareholders increase their

required return (i.e., the cost of equity rises).
This is because there is much more interest to be paid before they get their
dividends.

At high gearing the cost of debt also rises because the chance of the company
defaulting on the debt is higher (i.e., bankruptcy risk).

So at higher gearing, the WACC will increase.

The main problem with the traditional view is that there is no underlying theory to
show by how much the cost of equity should increase because of gearing worries or
the cost of debt should increase because of default risk.

In the traditional view of capital structure, ordinary shareholders are relatively

indifferent to the addition of small amounts of debt in terms of increasing financial
risk and so the WACC falls as a company gears up.

As gearing up continues, the cost of equity increases to include a financial risk

premium and the WACC reaches a minimum value.

Beyond this minimum point, the WACC increases due to the effect of increasing
financial risk on the cost of equity and, at higher levels of gearing, due to the effect of
increasing bankruptcy risk on both the cost of equity and the cost of debt.
Although it is more or less realistic, the traditional view remains a purely descriptive
theory.

223
This view can be represented by a U shaped graph, where the vertical axis is the
WACC and the horizontal the amount of debt finance.
Next, Modigliani and Miller (MM)
the use of debt transfers more risk to shareholders, and this makes equity more
expensive so that the use of debt does not reduce finance costs ie does not reduce
the WACC.

Modigliani and Miller views

In order to demonstrate a workable theory, MMs 1958 paper made a number of
simplifying assumptions:
The capital market is perfect;
There are therefore no transactions costs and the borrowing rate is the same as the
lending rate and equal to the so-called risk free rate of borrowing;

224
Taxation is ignored
Risk is measured entirely by volatility of cash flows.
• Main idea
Debt or Equity - it doesn’t matter
The WACC remains the same throughout
• As a company takes on more debt, the equity holders take on a little more risk
The more debt brings the WACC down but the extra risk for equity holders,
increases Cost of Equity and so the WACC comes back up again

M&M (with tax)

If debt also saves corporation tax then it does reduce finance costs, which benefits
shareholders ie it reduces the WACC.
This suggests that a company should use as much debt finance as it can.

225
Main idea
• Taxation
If Debt gets tax relief and equity doesn't then the straight line graph is wrong
The tax will make debt cheaper than equity and so more debt is advantageous at
all levels
However, this still presumes a perfect market where people don't worry about
bankruptcy risk - they do!
Therefore at higher levels of debt, WACC would actually rise in the real, imperfect
market

Pecking Order Theory

This simply suggests that firms do not look for an optimum capital structure rather
they raise funds as follows:
1. Internally generated funds
2. Debt
3. New share issue

This is because internally generated funds have no issue costs and needs no time
and effort in persuading others.

Debt is better accepted by the markets than looking for cash via a share issue which
can seem desperate. Issue costs moderate.

Debt finance may also be preferred when a company has not yet reached its optimal
capital structure and it is mainly financed by equity, which is expensive compared to
debt.

Issuing debt here will lead to a reduction in the WACC and hence an increase in the
market value of the company.

One reason why debt is cheaper than equity is that debt is higher in the creditor
hierarchy than equity, since ordinary shareholders are paid out last in the event of
liquidation.

226
Debt is even cheaper if it is secured on assets of the company.

The cost of debt is reduced even further by the tax efficiency of debt, since interest
payments are an allowable deduction in arriving at taxable profit.

Debt finance may be preferred where the maturity of the debt can be matched to the
expected life of the investment project.

Equity finance is permanent finance and so may be preferred for investment projects
with long lives.

227
Syllabus B3h. Assess the impact of financing and capital structure upon the organisation with
respect to:
i) Modigliani and Miller propositions, before and after tax

Modigliani and Miller propositions

MODIGLIANI AND MILLER – TAX IGNORED (1958)

Formulae

1. Proposition 1: value of company

Vg = Vu
2. Proposition 2: cost of equity
Keg = Keu+(Keu−Kd) Vd/Ve
3. Proposition 3: WACC
WACCg = WACCu (Keu)

MODIGLIANI AND MILLER – INCLUDING CORPORATION TAX (1963)

Formulae

1. Proposition 1: value of company

Vg = Vu+Dt
Dt = Tax on debt

228
2. Proposition 2: cost of equity
Ke =  Keu + (1-T) x (Keu-Kd) x Vd/Ve
Ke = cost of equity of a geared company, 

Keu = cost of equity in an ungeared company

Kd = cost of debt (pre-tax)

Vd Ve = market value of debt & equity
NB The formula is provided on the Formulae sheet.

3. Proposition 3: WACC
WACCg = Keu (1 − (Vdt/( Ve + Vd))

Illustration
An ungeared company with a cost of equity of 15% is considering adjusting its
gearing by taking out a loan at 10% and using it to buy back equity.
After the buyback the ratio of the market value of debt to the market value of equity
will be 1:1. Corporation tax is 20%.

Required
(a) Calculate the new Ke, after the buyback.

(b) Calculate and comment on the WACC after the buyback
• (a) Ke=15+(1-0.2)(15-10)x1=15+4=20%
• (b) WACC=(0.5x20)+(0.5x10x0.8)=10+4=14%
The use of debt will bring benefit to the company because the lower WACC will
enable future investments to bring greater wealth to the company's shareholders.

Example
Cow plc (an all equity company) has on issue 10,000,000 $1 ordinary shares at
market value of $2.00 each.
Milk plc (a geared company) has on issue:

15,000,000 25p ordinary shares; and 

$5,000,000 10% debentures (quoted at 120)
Taking corporation tax at 30%, and assuming that:

229
1. The companies are in all other respects identical; and

2. The market value of Cow’s equity and the market value of Milk’s debt are “in
equilibrium”.

Calculate the equilibrium price per share of Milk’s equity.

Solution
Vg = Vu+Dt
D = $5,000,000 x 120/100 = $6m
Vu = $10,000,000 x $2.00 = $20m
Dt = $6m x 30% = $1.8m
Vg = $20m + $1.8m = $21.8m
E = balancing figure ($21.8m - $6m) = $15.8m
Price per share = $15.8m / 15m = $1.05

Why do companies not attempt a 99.9% debt structure?

1. Bankruptcy costs
The higher the level of gearing the greater the risk of bankruptcy with the
associated “COSTS OF FINANCIAL DISTRESS”.
Vg = Vu + Dt − Present value of costs of financial distress

2. Agency costs
Costs of restrictive covenants to protect the interests of debt holders at high
levels of gearing.

3. Tax exhaustion
The value of the company will be reduced if advantage cannot be taken of the tax
relief associated with debt interest.

230
4. Debt capacity
Generally loans must be secured against a company’s assets and clearly some
assets (eg property) provide better security for loans than other assets (eg high-
tech equipment which may become obsolescent overnight).
The depth of the asset’s second hand market and its rate of depreciation are
important characteristics.

231
 Syllabus B3h. h) Assess the impact of financing and capital structure upon the organisation
with respect to:
ii) Static trade-off theory

Static tradeoff theory

Incorporate bankruptcy risk to M and M’s theory and you will arrive at the same
conclusion as the traditional theory of gearing – i.e. that an optimal gearing level
exists.
Firms can reach the optimum level by means of a trade off.

This is achieved by striking a balance between the benefits and the

costs of raising debt.

Provided a company is in a static position ie not in a period of extreme growth, it is

likely to have a gearing policy that is stable over time.

1. Benefits of debt
The benefits of debt relate to the tax relief that is enjoyed when interest payments
are made – the cheaper debt finance will reduce the weighted average cost of
capital and increase corporate value.

2. Costs of debt
The costs of debt relate to the increases in the costs of financial distress (eg
bankruptcy costs) and increases in agency costs that arise when the company
exceeds its optimum gearing levels.
The resultant increase in required returns demanded by investors cause the
weighted average cost of capital of the company to increase and hence corporate
value to fall.


232
 Syllabus B3h. h) Assess the impact of financing and capital structure upon the organisation
with respect to:
iv) Agency effects.

Agency effects

Agency costs have a further impact on a firm’s practical financing decisions.

Where gearing is high, the interests of management and shareholders may conflict
with those of creditors.

Management may for example:

1. gamble on highrisk projects to solve problems
2. pay large dividends to secure company value for themselves
3. hide problems and cut back on discretionary spending
4. invest in higher risk business areas than the loan was designated to fund.
In order to safeguard their investments lenders/debentures holders often impose
restrictive conditions in the loan agreements that constrains management’s freedom
of action.

These may include restrictions:

1. on the level of dividends
2. on the level of additional debt that can be raised
3. on acceptable working capital and other ratios
4. on management from disposing of any major asset without the debenture
holders’ agreement.

These effects may:

1. encourage use of retained earnings
2. restrict further borrowing
3. make new issues less attractive to investors.

233
 Syllabus B3i. Apply the adjusted present value technique to the appraisal of investment
decisions that entail significant alterations in the financial structure of the organisation, including
their fiscal and transactions cost implications.

Adjusted present value

M&Ms theory on gearing tells us that the impact of debt finance is to save tax

This can be quantified and added as an adjustment to the PV of a project.

If a question shows an investment has been funded entirely by debt or asks for
project appraisal using ‘the adjusted present value method’, you must

Step 1
Calculate the NPV as if ungeared i.e. Kei

Step 2
Add the PV of the tax saved as a result of the debt used in the project

Step 3

Subtract the cost of issuing new finance

Illustration 1
Cow plc is considering a project that would involve investment of $8 million now and
would yield $2m per annum (after tax) for each of the next five years.
The project will raise Cow’s debt capacity by $25 million for the duration of the
project at an interest rate of 8%.

 

The costs of raising this loan are estimated at $100,000 (net of tax).

The company’s existing Ke is 16% and corporation tax is 20%.

Cow currently has a ratio of 1:2 for market value of debt to market value of equity.

234
Required

By calculating the APV, recommend whether Cow should accept this project with the
proposed financing.

Solution
Ke =  Kei + (1-T)(Kei-Kd)xVd/Ve
16 = x + (1-0.20)(x-8)x1/2

16 = x + 0.4 (x-8) 

16 = x + 0.4x – 3.2 so 

19.2 = 1.4x

X = 19.2 / 1.4 = 13.7% this is the cost of equity ungeared.
Round this up to 14% to use the discount tables.

Step 1 Base case NPV ($m)

Time 0 1-5
-8 2
DF@14% 1 3.517 
PV -8 7.034
NPV = -8 + 7.034 = -0.966

Step 2
Interest payable = $25,000,000 x 8% = $2,000,000 and tax saved = $2,000,000 x
20% = 400,000 or 0.4m
Discount at cost of debt 8% over 5 years = 3.993
PV of tax shield (3.993 x 0.4) = $1.5972

Step 3

Issue costs = $0.1m

APV ($m) = -0.966 + 1.5972 – 0.1 = +$0.5312m  
Therefore  - Accept

235
 Syllabus B4. Valuation and the use of free cash flows

Syllabus B4a. Apply asset based, income based and cash flow based models to value equity.
Apply appropriate models, including term structure of interest rates, the yield curve and credit
spreads, to value corporate debt.

Valuations - Introduction

When are Valuations needed?

1. Takeovers (Price paid would be MV + a takeover premium)

2. When setting a price for an I.P.O (Initial Public Offer)

3. Selling ‘private’ shares

4. When using shares as loan security

5. When negotiating a sale of a private company

6. For liquidation purposes

What information helps Valuation?

• Financial statements

• Non current asset summaries

• Investments held

• Working capital listing (debtors, creditors and stock)

• Lease agreements

• Budgets

• Current industry environment

236
What are the limitations of the information provided?

• Does the PPE need a costly revaluation?

• Are there any contingent liabilities not taken into account?

• Has deferred tax been calculated appropriately?

• How has stock been valued?

• Are all debtors receivable?

• Are there any redundancy costs?

• Any prior charges on assets?

• What shareholding is being sold? Does it mean the business carries on?

237
Syllabus B4a. Apply asset based, income based and cash flow based models to value equity.
Apply appropriate models, including term structure of interest rates, the yield curve and credit
spreads, to value corporate debt.

Market Capitalisation

This is very straightforward and is often referred to as “Market Cap”

It is calculated as follows:

Share Price x Number of shares

Illustration

Share Price 96c


Share Capital (nominal value 50c)  $60million

Solution

96 x (60/.5) = $115.2 million

238
Syllabus B4a and C2ci. B4a) Apply asset based, income based and cash flow based models
to value equity. Apply appropriate models, including term structure of interest rates, the yield
curve and credit spreads, to value corporate debt.
c) Discuss, assess and advise on the value created from an acquisition or merger of both
quoted and unquoted entities using models such as:
i) ’Book value-plus’ models

Asset Based Valuations

Valuing a business by looking at its assets only is a troublesome affair..

When is it a good technique then - cow face?

oooh cheeky, anywhere here goes..

1. When looking to asset strip the company

2. As a minimum price

3. When valuing Investment companies

NB. If a company is quoted on a market AND is a going concern then the minimum
valuation is..
Market price + Acquisition premium

239
There are different ways of measuring assets:

1. Book Values

This is poor as it uses Historic costs and not up to date values.

It can give a ball park figure though

2. Net Realisable Value

This would represent the minimum value of a private company - as it is what the

assets alone could be sold for.

However, even here there is the problem of needing to sell quickly may mean the

NRV might be difficult to value


Another weakness of this is that this gives a value for the assets when SOLD not

when IN USE.

Therefore, not good for a situation of partial disposal where business and hence

assets will carry on

3. Replacement Cost

Here the valuation difficult - need similar aged assets value.

It also ignores goodwill

240
If assets are to be sold on an ongoing basis

Illustration

NCA 450
Current Assets 150
Current Liabilities (50)
   
Share capital ($1) 200
Reserves 250
6% Loan 100



Loan is redeemable at 2% premium

MV of property is $30,000 more than carrying value

What is the value of an 80% holding using assets basis?

Solution

NCA 450+30 = 480

Current Assets 150
Current Liabilities (50)
   
6% Loan (100 x 1.02) = (102)
6% 478



X 80% = 382,400

241
Syllabus B4a and C2c. B4a) Apply asset based, income based and cash flow based models
to value equity. Apply appropriate models, including term structure of interest rates, the yield
curve and credit spreads, to value corporate debt.
C2c) Discuss, assess and advise on the value created from an acquisition or merger of both
quoted and unquoted entities using models such as:
ii) Market based models

Using PE ratio

Take the earnings of the company you are trying to value and multiply it

by the average P/E ratio of their industry

Income based methods like this are best used when

• When taking control of a company
• When more interested in earnings than dividend policy

Price Earnings Ratio

It essentially tells us is how long it would take the earnings to repay the share price
Ok so this is how it is calculated...

242
But what we are more concerned with here is how to use this to calculate the value
of a business, again here is the formula to use to calculate the value of ONE share..

How to calculate the value of ONE share

How to calculate the value of the WHOLE business

Or...

Both of these give the value of the company as a whole..

HOWEVER, to value a target company you need to use THEIR earnings and our
own P/E ratio or at least a P/E ratio from their industry
Also note: The PE can be adjusted down by 10 - 20%
If private company (as less liquid shares)

If risky company (fewer controls etc)

243
Share Capital (25c) $100,000

Profit before tax $260,000

Tax (120,000)

Preference Dividend ($20,000)

Ordinary Dividend ($36,000)

Retained $84,000
PE (for similar company) =  12.5

What is the value of 200,000 shares?



Solution

Value of Company = PE x Earnings (PAT - Pref divs)
Total Earnings (of 200,000 shares)

140,000 - 20,000 = 120,000 x 200/400 = 60,000
PE 12.5
60,000 x 12.5 = $750,000

Use of predator's P/E ratios

A predator company may use their higher P/E ratio to value a target company.
This use of a higher P/E ratio is known as bootstrapping
• An illustration:
Cow Co. (Predator) is valuing a potential acquisition target, Calf Co. (Target),
using a bootstrapping approach.
The following items will be used in a valuation calculation:
Calf's Earning

Cow's P/E

Drawbacks of PE model
1. Finding a quoted company that is similar in activity (most have a wide range)

2. A single year’s PE ratio may not be representative

3. The quoted company used to get the PE ratio from may have a totally different
capital structure

244
Syllabus B4a. Apply asset based, income based and cash flow based models to value equity.
Apply appropriate models, including term structure of interest rates, the yield curve and credit
spreads, to value corporate debt.

Earnings Yield

This is the inverse of the PE ratio

Basically this is how much your earnings are as a % of your share price

Value of Company using Earnings Yield = Total Earnings x 1/Earnings yield

PAT 300,000; Earnings yield 12.5%

What is the value of this company?

Solution

300,000 x 1/0.125 = $2,400,000

245
Syllabus B4a. Apply asset based, income based and cash flow based models to value equity.
Apply appropriate models, including term structure of interest rates, the yield curve and credit
spreads, to value corporate debt.

Dividend Valuation

Essentially this model presumes that a share price is the PV of all future

dividends

Calculate this (with or without growth) and multiply it by the total number of shares

It is similar to market capitalisation except it doesn’t use the market share price,
rather one worked out using DVM
DVM can be with or without growth.

DVM without Growth

Note:
• Cost of Equity will be given, or calculated via CAPM
• Take this share price and multiply it by the number of shares

246
DVM with growth

Note:
• Dividend + growth = Dividend end of year 1

Share Capital (50c) $2 million


Dividend per share (just paid) 24c

Dividend paid four years ago 15.25c

Current market return = 15%

Risk free rate = 8%

Equity beta 0.8

Solution 

Dividend is growing so use DVM with growth model:
Calculating Growth 

Growth not given so have to calculate by extrapolating past dividends as before:
24/15.25 sq root to power of 4 = 1.12 = 12%
So Dividend at end of year 1 = 24 x 1.12

Calculate Cost of Equity (using CAPM) 


8 + 0.8 (15-8) = 13.6%

So using DVM with Growth model


Dividend + growth / Cost of Equity - growth (decimal)

Share price = 24x1.12 / 0.136 - 0.12 = 1,680c

Market cap = $16.8 x (2m / 0.5) = $67.2

247
Sylllabus B4a and C2c. B4a) Apply asset based, income based and cash flow based models
to value equity. Apply appropriate models, including term structure of interest rates, the yield
curve and credit spreads, to value corporate debt.
C2c) Discuss, assess and advise on the value created from an acquisition or merger of both
quoted and unquoted entities using models such as:
iii) Cash flow models, including free cash flows.

Discounted Cashflows

This is the PV of future cashflows - value of debt

Ok so this example is difficult but let's take it one step at a time..

PBT 80 (all cash)

Capital Investment each year 48

Debt 10 ($120)

Tax = 30%

WACC = 10%
The profits are expected to continue for foreseeable future (perpetuity)

What is the value of equity?

First of all you need to know how to calculate the value of something that lasts
forever (like the profits here)
Well this is called a perpetuity

And calculating its PV is easy! Just Divide it by the discount factor!

So say it's a perpetuity of 60 at a discount rate of 4% = 60 / 0.04 = 1,500
In this question the income needs taxing remember!

Solution

Cash inflow 80 x 70% = 56 - 48 = 8 (in perpetuity)
Value of business = 8 / 0.1 = 80m
So the Equity is the value of all the cashflows less value of debt remember
Equity = 80m - (10 x 1.2) = 68m

248
Advantages of DCF Method

1. Theoretically best method

2. Can value part of a company

Disadvantages of DCF Method

1. Need to estimate cashflows and discount rate

2. How long is PV analysis for?
3. Assumes constant tax, inflation and discount rate

249
Syllabus B4a and C2b. B4a) Apply asset based, income based and cash flow based models
to value equity. Apply appropriate models, including term structure of interest rates, the yield
curve and credit spreads, to value corporate debt.
C2b) Estimate the potential near-term and continuing growth levels of a corporation’s earnings
using both internal and external measures.

Discounted Free cash flow basis

This method is based upon the PV of the free cash flow to equity of an
enterprise.

Free cash flow to equity is the cash flow available to a company from operations
after:

1. interest expenses
2. tax
3. repayment of debt and lease obligations

4. any changes in working capital

5. capital spending on assets needed to continue existing operations (ie
replacement capital expenditure equivalent to economic depreciation)

Remember!

Discounted FCF is used for the calculation of the Value of Company attributable to
equity holders.
Value of Company = PV of Free cash flows (FCF)

250
How to calculate the PV of FCF using a CONSTANT annual growth rate

e.g. After four years, the annual growth rate of the FCF to the company will be 3%,
for the foreseeable future.
FCF in Y4 = 100

g = 3%

k = 11%

PV of FCF (first 4 years) 500
• PV of FCF, year 5 onwards 

= [FCF (in Y4) x (1 + growth rate (g))  /  (cost of capital (k) – g) ] x (1+k) (to
the  negative power of the number of years before the g is consistent each year)
= (100 x 1.03) / (0.11 - 0.03)] x 1.11 ^ - 4

= 1,287.5 x 0.6587

= 848

Value of Company
• = PV of FCF (first 4 years) + PV of FCF, year 5 onwards
= 500 + 848

= 1,348

Example

COW Co’s future sales revenue will increase by 7.5% for the next four years.
After the four years, the annual growth rate of the free cash flows to the company will
be 3.5%, for the foreseeable future.
Operating profit margins are expected to be 15% in the future.
Although it can be assumed that the current tax-allowable depreciation is equivalent
to the amount of investment needed to maintain the current level of operations, the
company will require an additional investment in assets of 30c per $1 increase in
sales revenue for the next four years.
Tax rate is 25%.
Cost of capital is 11%.
Extract from COW Co's Statement of profit or loss:

251
Solution

Sales revenue in Y1 = $389.1 x 1.075 = $418.3


Operating profit in Y1 = $418.3 x 15% = $62.7

Additional capital investment in Y1 = ($418.3 - $389.1) x $0.30 = $8.8

252
Syllabus B4bc. b) Forecast an organisation’s free cash flow and its free cash flow to equity (pre
and post capital reinvestment).
c) Advise on the value of an organisation using its free cash flow and free cash flow to equity
under alternative horizon and growth assumptions.

Free cash flows

Cash that is not retained and reinvested in the business is called free
cash flow.
It represents cash flow available:
• to all the providers of capital of a company
• to pay dividends or finance additional capital projects.

Uses of free cash flows

Free cash flows are used frequently in financial management:
• as a basis for evaluating potential investment projects
• as an indicator of company performance
• to calculate the value of a firm and thus a potential share price

Calculating free cash flows for investment appraisal

Free cash flows can be calculated simply as:
• Free cash flow = Revenue - Costs - Investments
• The free cash flows used to evaluate investment projects are therefore
essentially the net relevant cash flows.

Example

Cow plc has earnings before interest and tax of $200,000 for the current year.

253
Depreciation charges for the year have been $5,000 and working capital has
increased by $2,000.

The company needs to invest $20,000 to acquire non-current assets.

Profits are subject to taxation @ 30% p.a.
• Required:

Calculate free cash flow.

Solution

$
EBIT 200,000
Less: Corporation tax @ 30%  (60,000)
Add back: Depreciation (non-cash amount)  5,000
Deduct: Capital expenditure  (20,000)
Working capital increases  (2,000)

Free cash flow  $123,000

254
Syllabus B4bc. b) Forecast an organisation’s free cash flow and its free cash flow to equity (pre
and post capital reinvestment).
c) Advise on the value of an organisation using its free cash flow and free cash flow to equity
under alternative horizon and growth assumptions.

Free cash flow to equity

Free CF to equity is the amount of cash available to pay out dividends

The dividend capacity of a company is measured by its free cash flow to equity.

Free cash flow to equity is equal to the Free CF after:

1. Deducting any interest payments and any loan repayments; and

2. Adding any cash inflows arising from the issue of debt.

The Dividend cover can be calculated as follows:

• Dividend cover
= Free cash flow to equity/ Dividends paid

255
Illustration
Operating profit = $168

NCA = $1345

Income tax expense = $15

Interest on loan = $74
During the current year:
(1) Depreciation is charged at 10% per annum on the year end non-current asset
balance and is included in other operating costs in the income statement.
(2) The investment in net working capital in Y0 was $220 and in Y1 increased to
$240.

Required

Prepare a cash flow forecast for the business highlighting the free cash flow to equity
(the dividend capacity).

Solution

Projected cash flows Year 1

Operating profit 168
Add depreciation ($1340 x 10%) 134
Less incremental working capital ($240 -$220) (20)
Less taxation (15)
Less interest (74)
––––––
Free cash flow to equity 193

256
 Syllabus B4de. d) Explain the use of the BSOP model to estimate the value of equity of an
organisation and discuss the implications of the model for a change in the value of equity.
e) Explain the role of BSOP model in the assessment of default risk, the value of debt and its
potential recoverability.

BSOP and default risk

The equity of a company can be seen as a call option on the assets of the company
with an exercise price equal to the outstanding debt.
The role of BSOP model in the assessment of default risk is based on the limited
liability property of equity investments.
The value of the firm’s equity can therefore be estimated using a variation of the
Black-Scholes model for the valuation of a European call option.
• The value of N(d1) shows how the value of equity changes when the value of the
assets change.
This is the delta of the call option (delta is covered in more detail in Topic:
Risks).

The value of N(d2) is the probability that a call option will be in the money at
expiration.
In this case it is the probability that the value of the asset will exceed the
outstanding debt,
The probability of default is therefore given by 1 – N(d2).

257
 Syllabus B5. International investment and financing decisions

Syllabus B5a. a) Assess the impact upon the value of a project of alternative exchange rate
assumptions.

International investment and financing decisions

Investment appraisal for overseas investments is similar to domestic

investment appraisal.

It includes the following steps:

1. Identification of relevant cash flows.

2. Dealing with inflation to assess real or nominal cash flows.

3. Dealing with tax, including the tax savings on capital allowances.

4. Dealing with inter-company transactions, such as management charges and

royalties and cash flow remittance restrictions.

5. Estimating future exchange rates (spot rates).

6. Dealing with double taxation arrangements.

7. Estimating the appropriate cost of capital (discount factor).

Parent or project viewpoint?

As the objective of financial management is to maximise shareholder wealth, and the

vast majority of the shareholders are likely to be located in the parent country, it is
essential that projects are evaluated from a parent currency viewpoint.

258
Accordingly, the following four-step procedure is recommended for calculating
project cash flows:

1. Compute local currency cash flows from a subsidiary viewpoint as if it were an

independent entity;
2. Calculate the amount and timing of transfers to the parent company in parent's
currency;
3. Translate the PV of cash flows to parent's currency
4. Calculate NPV in parent's currency

Project discount rates

In the same way as for domestic capital budgeting, project cash flows should be
discounted at a rate that reflects their systematic risk.
Many firms assume that overseas investment must carry more risk than comparable
domestic investment and therefore increase discount rates accordingly.
This assumption, however, is not necessarily valid. Although the total risk of an
overseas investment may be high, in the context of a well-diversified parent
company portfolio much of the risk may be diversified away.
Because of the lack of correlation between the performance of some national
economies, the systematic risk of overseas investment projects may in fact be lower
than that of comparable domestic projects.
It must therefore be realised that the automatic addition of a risk premium simply
because a project is located overseas does not always make sense, and any
increase in the discount rates used for foreign projects should be viewed with
caution.

Value of a project and exchange rate

An appraisal of an international project requires estimates of the exchange rate.

• Exchange rate risk
- is the risk that arises from the fact that the cash flows are denominated in a
foreign currency.

259
 Syllabus B5b. Forecast project or organisation free cash flows in any specified currency and
determine the project’s net present value or organisation value under differing exchange rate,
fiscal and transaction cost assumptions.

Forecasting project cash flows

When a multinational company sets up a subsidiary in another country, to which it

already exports, the relevant cash flows for the evaluation of the project should take
into account the loss of export earnings in the particular country.

The NPV of the project should be:


Sum of discounted (net cash flows – exports) + discounted terminal value – initial
investment

The appropriate discount rate will be WACC.

Taxation and international investment appraisal

The following procedure can be applied:

1. Allow for host country investment incentives (capital allowance) before applying
the local tax rate to local taxable cash flows.

2. Apply the relevant parent company rate of tax to the taxable/remitted cash flows.

3. Adjust point 2 above for any double taxation agreement.

260
Consider the following:

Spain tax  UK tax 

(1) 20%  20% 
(2) 20%  30% 
(3) 20%  18% 

In (1) no further tax will be paid in the UK as profit is taxed in Spain at 20%.

In (2) profit would be taxed at 30%, 20% in Spain and a further 10% in the UK.
In (3) no further tax will be paid in the UK. The 20% is charged in Spain.

Illustration 1
Suppose that the tax rate on profits in Country 1 is 10% and the UK corporation tax
is 20%, and there is a double taxation agreement between the two countries.
A subsidiary of a UK firm operating in Country 1 earns the equivalent of £1 million in
profit, and therefore pays £100,000 in tax on profits.
When the profits are remitted to the UK, the UK parent can claim a credit of
£100,000 against the full UK tax charge of £200,000, and hence will only pay
£100,000.

Illustration 2
Cow Co. is considering whether to establish a subsidiary in Slovakia at a cost of
€15,000,000.
The subsidiary will run for 4 years and the net cash flows from the project are:

Net Cash Flow €

Year 1  3,000,000 
Year 2 4,500,000 
Year 3 7,000,000
Year 4  8,000,000

261
There is a withholding tax of 10 percent on remitted profits and the exchange rate is
expected to remain constant at €1.50 = $1.

If the required rate of return is 15% what is the present value of the project?

Discount
€ € after WHT Remittance $ Discounted $
factor (15%) 
3,000,000 x
Year 2,700,000 / 1.5
3,000,000  0.9 = 0.870  1,566,000
1  = 1,800,000
2,700,000
4,500,000 x
Year 4,050,000 / 1.5
4,500,000  0.9 = 0.756  2,041,200
2 = 2,700,000
4,050,000
7,000,000 x
Year 6,300,000 / 1.5
7,000,000 0.9 = 0.658  2,763,600
3 = 4,200,000
6,300,000
8,000,000 x
Year 7,200,000 / 1.5
8,000,000 0.9 = 0.572  2,745,600
4  = 4,800,000
7,200,000
Total 9,116,400

The NPV is $9,116,400 - EUR 15,000,000/1.5 = - $ 883,600

262
 Syllabus B5ce. c) Evaluate the significance of exchange controls for a given investment
decision and strategies for dealing with restricted remittance.
e) Assess and advise on the costs and benefits of alternative sources of finance available
within the international equity and bond markets.

Remission of funds

Certain costs to the subsidiary may in reality be revenues to the parent company.

For example, royalties, supervisory fees and purchases of components from the
parent company are costs to the project, but result in revenues to the parent.

The normal methods of returning funds to the parent company are:

1. Dividends
2. Royalties
3. Transfer prices; and
4. Loan interest and principal

It is important to note that some of these items may be locally tax-deductible for the
subsidiary but taxable in the hands of the parent.

Overcoming exchange controls – block remittances

Block funds are funds in overseas bank accounts subject to exchange controls, such
that restrictions are placed on remitting the funds out of the country.
They mainly aim to circumvent restrictions on dividends payments out of the account
by reclassifying the payment as something else:

1. Management Charges

The parent company can impose a charge on subsidiary for the general
management services provided each year.
The fees would normally be based on the number of management hours
committed by the parent on the subsidiary’s activities.

263
2. Royalties

The parent company can charge the subsidiary royalties for patent, trade names
or know-how.
Royalties may be paid as a fixed amount per year or varying with the volume of
output.

3. Transfer Pricing
The parent can charge artificially higher prices for goods or services supplied to
the subsidiary as a means of drawing cash out.

This method is often prohibited by the foreign tax authorities.

Exchange rate risk

Changes in exchange rates can cause considerable variation in the amount of funds
received by the parent company.
In theory this risk could be taken into account in calculating the project’s NPV, either
by altering the discount rate or by altering the cash flows in line with forecast
exchange rates.
Virtually all authorities recommend the latter course, as no reliable method is
available for adjusting discount rates to allow for exchange risk.

Political risk
This relates to the possibility that the NPV of the project may be affected by host
country government actions.
These actions can include:
1. Expropriation of assets (with or without compensation!);
2. Blockage of the repatriation of profits;
3. Suspension of local currency convertibility;
4. Requirements to employ minimum levels of local workers or gradually to pass
ownership to local investors.
The effect of these actions is almost impossible to quantify in NPV terms, but their
possible occurrence must be considered when evaluating new investments.
High levels of political risk will usually discourage investment altogether, but in the
past certain multinational enterprises have used various techniques to limit their risk
exposure and proceed to invest.

264
These techniques include the following:
• Structuring the investment in such a way that it becomes an unattractive target
for government action.

For example, overseas investors might ensure that manufacturing plants in risk-
prone countries are reliant on imports of components from other parts of the
group, or that the majority of the technical “know-how” is retained by the parent
company.

These actions would make expropriation of the plant far less attractive.
• Borrowing locally so that in the event of expropriation without compensation, the
enterprise can offset its losses by defaulting on local loans.
• Prior negotiations with host governments over details of profit repatriation,
taxation, etc, to ensure no problems will arise. Changes in government, however,
can invalidate these agreements.
• Attempting to be “good citizens” of the host country so as to reduce the benefits
of expropriation for the host government.

These actions might include employing large numbers of local workers, using
local suppliers, and reinvesting profits earned in the host country.

Economic risk

Economic risk is the risk that arises from changes in economic policies or conditions
in the host country that affect the macroeconomic environment in which a
multinational company operates.

Examples of economic risk include:

• Government spending policy.

• Economic growth or recession.
• International trading conditions.
• Unemployment levels.
• Currency inconvertibility for a limited time.

265
Fiscal risk
Fiscal risk is the risk that the host country may increase taxes or changes the tax
policies after the investment in the host country is undertaken.

Examples of fiscal risk include:

• An increase in corporate tax rate.

• Cancellation of capital allowances for new investment.

• Changes in tax law relating to allowable and disallowable tax expenses.

• Imposition of excise duties on imported goods or services.

• Imposition of indirect taxes.

Regulatory risk

Regulatory risk is a risk that arises from changes in the legal and regulatory
environment which determines the operation of a company.

Examples are:

• Anti-monopoly laws.

• Health and safety laws.

• Copyright laws.

• Employment legislation.

266
Financing overseas projects

The chief sources of long-term finance are the following:

• Equity

The subsidiary is likely to be 100% owned by the parent company.

However, in some countries it is necessary for nationals to hold a stake,
sometimes even a majority of the ordinary shares on issue.

• Eurocurrency Loan

Eurocurrency loan is a loan by a bank to a company denominated in a currency

of a country other than that in which they are based.
For example, a UK company may require a loan in dollars which it can acquire
from a UK bank operating in the Eurocurrency market. This is called Eurodollar
loan.
The usual approach taken is to match the assets of the subsidiary as far as
possible with a loan in the local currency.
This has the advantage of reducing exposure to currency risk.
However, this reduced risk must be weighed against the interest rate paid on the
loan.
A loan in the local currency may carry a higher interest rate, and it may be
preferable, for example, to arrange a Eurocurrency loan in a major currency
which is highly correlated with the currency of the overseas operations.

• Government grants
Finance may be available from the UK, the overseas government, or an
international body, such as the World Bank.

• Intercompany accounts

Financing by intercompany account is useful in a situation where it is difficult to

get funds out of the foreign country by way of dividends. This is further discussed
below.

267
• Syndicated Loan Market

Syndicated loan market developed from the short-term eurocurrency market. A

syndicate of banks is brought together by a lead bank to provide medium-to long-
term currency loans to large multinational companies.
These loans may run to the equivalent of hundreds of millions of pounds. By
arranging a syndicate of banks to provide the loan, the lead bank reduces its risk
exposure.

• Eurobond

Eurobond are bonds sold outside the jurisdiction of the country in whose currency
the bond is denominated.
Eurobond is a bond issued in more than one country simultaneously, usually
through a syndicate of international banks, denominated in a currency other than
the national currency of the issuer.
They are long-term loans, usually between 3 to 20 years and may be fixed or
floating interest rate bonds
An investor subscribing to such a bond issue will be concerned about the
following factors:

0 security;

0 marketability;

0 return on the investment.

• Euroequity

These are equity sold simultaneously in a number of stock markets. They are
designed to appeal to institutional investors in a number of countries. The shares
will be listed and so can be traded in each of these countries.

The reasons why a company might make such an issue rather than an issue in just
its own domestic markets include:
• larger issues will be possible than if the issue is limited to just one market;
wider distribution of shareholders;
to become better known internationally;
queuing procedures which exist in some national markets may be avoided.

268
 Syllabus C: Acquisitions And Mergers
Syllabus C1. Acquisitions and mergers versus other growth
strategies

Syllabus C1a. Discuss the arguments for and against the use of acquisitions and mergers as
a method of corporate expansion.

Reasons for mergers and takeovers

The main reasons

why one company may wish to acquire the shares or the business of another may be
categorised as follows.

• Operating economies
Elimination of duplicate facilities and many other ways.

• Management acquisition
Acquisition of competent and go-ahead team to compensate for lack of internal
management abilities.

• Diversification
Securing long-term future by spreading risk through diversification.

• Asset backing
Company with high earnings: assets ratios reducing risk through acquiring
company with substantial assets.

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• Quality of earnings
Reducing risk by acquiring company with less risky earnings.

• Finance and liquidity


Improve liquidity/ability to raise finance through the acquisition of a more stable
company.

• Growth
Cheaper way of growing than internal expansion.

• Tax factors
Tax efficient way of transferring cash out of the corporate sector. In some
jurisdictions, it is a means of utilising tax losses by setting them against profits of
acquired companies.

• Defensive merger

Stop competitors obtaining advantage.

• Strategic opportunities
Acquiring a company that provides a strategic fit.

• Asset stripping
Acquiring an undervalued company in order to sell off the assets to make a profit.

• Big data access

Big data refers to a collection of data sets too large and complex to analyse using
traditional database management tools.
A technology company may want to acquire a company for the data it holds on
users which can be of great value to that company.

270
FB and Instagram

Facebook acquired the photo-sharing app company lnstagram tor $1billion.

Although lnstagram was not profitable, it had 30 million worldwide users before the
acquisition.
Acquiring the data of lnstagram users is valuable to Facebook, for example, it could
allow Facebook to track the movements of users who upload a photo on a mobile
device, and place targeted advertisements to the user.

271
 Syllabus C1b. Evaluate the corporate and competitive nature of a given acquisition proposal.

Strategy Development

This can be done INTERNALLY, through ACQUISITIONS or via an

ALLIANCE

Internal Development

Often called 'Organic growth'

1. Build on company's core competencies
2. Suits a Risk-averse culture
3. Easier to Control & Manage
4. Slow
5. Growth restricted by own competencies
6. Better for growth at home rather than abroad

Acquisition & Mergers

1. Fast to new markets

2. Gains new competencies

3. High risk due to initial costs
4. Funding problems of initial costs
5. Problems with cultural fit

Strategic Alliances
2+ businesses share resources to pursue a strategy
1. No large initial costs
2. No cultural fit problems

3. Specialise on each businesses own competencies

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Types of STRATEGIC ALLIANCE

• Joint Venture

A new organisation is set up

Both venturers put in resources
Formal & slow

• Licence agreement

Allow others to use your resources in a new market

Less Control
If successful the other venturer may then develop their own and thus not need
the licence
Needs little initial costs
Needs trust and cope ration

273
 Syllabus C1b. Evaluate the corporate and competitive nature of a given acquisition proposal.

Merger or acquisition

A merger
is the combining of two or more companies

Generally by offering the stockholders of one company securities in the acquiring

company in exchange for the surrender of their stock.

An acquisition

normally involves a larger company (a predator) acquiring a smaller company (a

target).

A demerger

A demerger involves splitting a company into two separate companies which would
then operate independently of each other.

The equity holders in the company would continue to have an equity stake in both
companies.

274
An alternative approach

is that a company may simply purchase the assets of another company rather than
acquiring its business, goodwill, etc.

Identifying possible acquisition targets

Suppose a company decides to expand.

1. Its directors will produce criteria (size, location, finances, products, expertise,
management) against which targets can be judged.

2. Directors and/or advisors then seek out prospective targets in the business
sectors it is interested in.

3. The team then examines each prospect closely from both a commercial and
financial viewpoint against criteria.

In general businesses are acquired as going concerns rather than the purchase
of specific assets.

275
 Syllabus C1d. Compare the various explanations for the high failure rate of acquisitions in
enhancing shareholder value.

High failure rate of acquisitions

What is the reason for the failure?

There should be some evidence of synergies in the acquiring firm to produce an

acquisition that would enhance shareholder value.

In practice, the shareholders of predator companies seldom enjoy synergistic gains,

whereas the shareholders of victim companies benefit from a takeover.

The acquiring company often pays a significant premium over and above the market
value of the target company prior to acquisition.

Agency theory
suggests that takeovers are motivated by the self-interest of the acquirer's
management.

Poor man-management

can be detrimental to successful integration.

Lack of communication of goals and future prospects of employees can lead to

employees being unclear of what is expected of them.

Window dressing
can be also a reason for the high failure rate.

It is where companies are not acquired because of the synergies that they may
create, but in order to present a better financial picture in the short term.

276
Syllabus C1e. e) Evaluate, from a given context, the potential for synergy separately classified
as:
i) Revenue synergy
ii) Cost synergy
iii) Financial synergy.

Synergy

The combinations should be pursued if they increase the shareholder wealth

Synergies can be separated into three types:

1. Revenue synergy:

- which result in higher revenues for the combined entity, 


- higher return on equity and 

- a longer period when the company is able to maintain competitive advantage;

2. Cost synergy:

- which result mainly from reducing duplication of functions and related costs, and
from taking advantage of economies of scale;

Sources of which include:

o Economies of scale (arising from eg larger production volumes and bulk

buying);

o Economies of scope (which may arise from reduced advertising and distribution
costs where combining companies have duplicated activities);

o Elimination of inefficiency;

o More effective use of existing managerial talent.

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3. Financial synergy:

- which result from financing aspects such as the transfer of funds between group
companies to where it can be utilised best, or from increasing debt capacity.

Sources of which include:

o Elimination of inefficient management practices;

o Use of the accumulated tax losses of one company that may be made available
to the other party in the business combination;

o Use of surplus cash to achieve rapid expansion;

o Diversification reduces the variance of operating cash flows giving less

bankruptcy risk and therefore cheaper borrowing;

o Diversification reduces risk (however this is a suspect argument, since it only

reduces total risk not systematic risk for well diversified shareholders);

o High PE ratio companies can impose their multiples on low PE ratio companies
(however this argument, known as “bootstrapping”, is rather suspect).

278
 Syllabus C1f. Evaluate the use of the reverse takeover as a method of acquisition and as a
way of obtaining a stock market listing.

Reverse Takeovers

A reverse merger (also known as a reverse takeover or reverse IPO)

is a way for private companies to go public, typically through a simpler, shorter, and
less expensive process

A conventional IPO needs an investment bank, regulatory paperwork and

appropriate initial pricing

Reverse mergers allow a private company to become public without raising capital,
which considerably simplifies the process.

It saves time from many months to just a few weeks

The reverse merger only converts a private company into a PLC, so is less
dependent on market conditions (because the company is not proposing to raise
capital).

Benefits as a Public Company

1. Greater Liquidity of shares

2. Greater access to the capital markets (finance)

3. PLCs often trade at higher multiples than private companies

4. Can use company stock as the currency with which to acquire target companies

5. Use stock incentive plans in order to attract and retain employee

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Disadvantages of a Reverse Merger

1. Due diligence needed on shell of the PLC company - no pending liabilities etc

2. Risk of current shareholders selling / dumping their shares on the market and the
price falling

3. Will there be demand for the shares once public?

4. Inexperienced managers in regulatory and compliance requirements of a publicly-

traded company.

280
 Syllabus C2. Valuation for acquisitions and mergers

Syllabus C2a. Discuss the problem of overvaluation.

The problem of overvaluation

The problem of overvaluation

When a company acquires another company, it always pays above its current market
value.

Mergers enhance shareholders' value if there are:

• Synergies

• Significant improvements in the management of the assets of the target company

that could be realised by an acquisition

The larger the agency problem within the acquiring company, the larger the premium
the acquiring company will be willing to pay.

During an acquisition, there is normally a fall in the price of the bidder and an
increase in the price of the target.

The overvaluation problem may arise as a miscalculation of the potential synergies

or the overestimation of the ability of the acquiring firm's management to improve
performance.

Both errors will lead to a higher price being paid as compared to the current market
price.

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282
Syllabus C2d. Apply appropriate methods, such as: risk- adjusted cost of capital, adjusted net
present values and changing price-earnings multipliers resulting from the acquisition or merger,
to the valuation process where appropriate.

The three acquisition types

Type I acquisitions
These are acquisitions that do not disturb the acquirer’s exposure to either business
risk or financial risk.

In theory, the value of the acquired company, and hence the maximum amount that
should be paid for it, is the Present Value of the future cash flows of the target
business discounted at the WACC of the acquirer.

Type II acquisitions
These are acquisitions which do not disturb the exposure to business risk, but do
impact upon the acquirer’s exposure to financial risk, eg through changing the
gearing levels of the acquirer.

Such acquisitions may be valued using the Adjusted Present Value (APV) technique
by discounting the Free Cash Flows of the acquiree using an ungeared cost of equity
and then adjusting for the tax shield.

Type III acquisitions

These are acquisitions that impact upon the acquirer’s exposure to both business
risk and financial risk.

In order to estimate WACC there is a need to establish the cost of capital of the
combined businesses.

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 Syllabus C2e. Demonstrate an understanding of the procedure for valuing high growth start-
ups.

High growth start-ups

The valuation of Start-ups create additional problems to that of well

established businesses.

This may be due to:

1. their lack of a proven track record,

2. initial on-going losses,

3. untested products with little market acceptance,

4. little market presence,

5. unknown competition,

6. high development costs, and

7. inexperienced managers with over-ambitious expectations of the future.

284
 Syllabus C3. Regulatory framework and processes

Syllabus C3a. Demonstrate an understanding of the principal factors influencing the

development of the regulatory framework for mergers and acquisitions globally and, in
particular, be able to compare and contrast the shareholder versus the stakeholder models of
regulation.

Regulation of takeovers

The regulation of takeovers concentrates on controlling directors in order

to ensure that all shareholders are treated fairly.

Typically, the rules will require the target company to:

• notify its shareholders of the identity of the bidder and the terms and conditions of
the bid;

• seek independent advice;

• not issue new shares or purchase or dispose of major assets of the company,
unless agreed prior to the bid, without the agreement of a general meeting;

• not influence or support the market price of its shares by providing finance or
financial guarantees for the purchase of its own shares;

• the company may not provide information to some shareholders which is not
made available to all shareholders;

• shareholders must be given sufficient information and time to reach a decision.

No relevant information should be withheld;

• the directors of the company should not prevent a bid succeeding without giving
shareholders the opportunity to decide on the merits of the bid themselves.

Directors and managers should disregard their own personal interest when advising
shareholders.


285
 Syllabus C3b. Identify the main regulatory issues which are likely to arise in the context of a
given offer and
i) assess whether the offer is likely to be in the shareholders’ best interests
ii) advise the directors of a target entity on the most appropriate defence if a specific offer is to
be treated as hostile.

The conduct of a takeover

The conduct of a takeover

The target company may resist the takeover

Will the bidding company's shareholders approve of a takeover?

When a company is planning a takeover bid for another company, its board of
directors should think about how its own shareholders might react to the bid.

A company does not have to ask its shareholders for their approval of every
takeover.

• When a large takeover is planned by a listed company involving the issue of a

substantial number of new shares by the predator company (to pay for the
takeover), Stock Exchange rules may require the company to obtain the formal
approval of its shareholders to the takeover bid at a general meeting (probably an
extraordinary general meeting, called specifically to approve the takeover bid).

• If shareholders, and the stock market in general, think the takeover is not a good
one the market value of the company's shares is likely to fall.

The company's directors have a responsibility to protect their shareholders' interests,

and are accountable to them at the annual general meeting of the company.

286
A takeover bid might seem unattractive to shareholders of the bidding company

because:

• It might reduce the EPS of their company.

• The target company is in a risky industry, or is in danger of going into liquidation.

• It might reduce the net asset backing per share of the company, because the
target company will probably be bought at a price which is well in excess of its
net asset value.

Will a takeover bid be resisted by the target company?

Resistance comes from the target company's board of directors, who adopt
defensive tactics, and ultimately the target company's shareholders, who can refuse
to sell their shares to the bidding company.

Resistance can be overcome by offering a higher price.

• In cases where an unquoted company is the target company, if resistance to a

takeover cannot be overcome, the takeover will not take place, and negotiations
would simply break down.

• Where the target company is a quoted company, the situation is different.

The target company will have many shareholders, some of whom will want to accept
the offer for their shares, and some of whom will not.

In addition, the target company's board of directors might resist a takeover even
though their shareholders might want to accept the offer.

Because there are likely to be major differences of opinion about whether to accept a
takeover bid or not, companies in most jurisdictions are subject to formal rules for the
conduct of takeover bids.

287
Contesting an offer

The directors of a target company must act in the interests of their shareholders,

employees and creditors.

They may decide to contest an offer on several grounds:

• The offer may be unacceptable because the terms are poor.

Rejection of the offer may lead to an improved bid.

• The merger or takeover may have no obvious advantage.

• Employees may be strongly opposed to the bid.

• The founder members of the business may oppose the bid, and appeal to the
loyalty of other shareholders.

When a company receives a takeover bid which the board of directors considers
unwelcome, the directors must act quickly to fight off the bid.

288
Defensive tactics

The steps that might be taken to thwart a bid or make it seem less attractive include:

• Revaluing assets or issuing a forecast of attractive future profits and

dividends to persuade shareholders that to sell their shares would be unwise,
that the offer price is too low, and that it would be better for them to retain their
shares.

• Lobbying to have the offer referred to the competition authorities

• Launching an advertising campaign against the takeover bid

• Finding a 'white knight', a company which will make a welcome takeover bid

• Making a counter-bid for the predator company (this can only be done if the
companies are of reasonably similar size)

• Arranging a management buyout

• Introducing a 'poison-pill' anti-takeover device

• Introducing a 'shark repellent' - changing the company's constitution to require a

large majority to approve the takeover

289
 Syllabus C4. Financing acquisitions and mergers

Syllabus C4 ac. a) Compare the various sources of financing available for a proposed cash-
based acquisition.
c) Assess the impact of a given financial offer on the reported financial position and
performance of the acquirer.

Forms of consideration

Payment methods - how an acquisition can be financed

Methods of payment

The takeover will involve a purchase of the shares of the target company for

1. cash

If the purchase consideration is in cash, the shareholders of the target company

will simply be bought out.

2. 'paper' (shares, or possibly convertible bonds)

A purchase of a target company's shares with shares of the predator company is

referred to as a share exchange.

3. Those choice will depend on:

- available cash, 

- desired level of gearing, 

- shareholders' taxation position and 

- change in control.

290
An Illustration: Cash purchases

Suppose that there are two companies

Cow Calf
Net assets (book value) $2,000 $300
Number of shares 100 10
Earnings $3,000 $90

Cow negotiates a takeover of Calf for $600 in cash.

As a result, Cow will end up with:

• Net assets (book value) of:


$2,000 + $300- $600 cash = $1,700

• 100 shares (no change)

• Expected earnings of $3,090 minus the loss of interest (net of tax) which would
have been obtained from the investment of the $600 in cash which was given up
to acquire Calf

A cash offer can be financed from:

• Cash retained from earnings

This is a common way when the firm to be acquired is small compared to the
acquiring firm, but not very common if the target firm is large relative to the
acquiring firm.

291
• The proceeds of a debt issue

That is the company may raise money by issuing bonds.

This is not an approach that is normally taken, because the act of issuing bonds
will alert the markets to the intentions of the company to bid for another company
and it may lead investors to buy the shares of potential targets, raising their
prices.

• A loan facility from a bank

This can be done as a short term funding strategy, until the bid is accepted and
then the company is free to make a bond issue.

• Mezzanine finance

This may be the only route for companies that do not have access to the bond
markets in order to issue bonds.

Mezzanine financing is a hybrid of debt and equity financing that gives the lender
the rights to convert to an equity interest in the company in case of default, after
venture capital companies and other senior lenders are paid.

292
Purchases by share exchange

One company can acquire another company by issuing shares to pay for the
acquisition.

The new shares might be issued:

• In exchange for shares in the target company.

Thus, if A acquires B, A might issue shares which it gives to B's shareholders in

exchange for their shares.

The B shareholders therefore become new shareholders of A.

This is a takeover for a paper consideration.

Paper offers will often be accompanied by a cash alternative.

• To raise cash on the stock market, which will then be used to buy the target
company's shares.

To the target company shareholders, this is a cash bid.

Sometimes, a company might acquire another in a share exchange, but the shares
are then sold immediately on a stock market to raise cash for the seller.

An Illustration: Share consideration

Cow has agreed to acquire all the ordinary shares in Calf and has also agreed a
share-for-share exchange as the form of consideration.

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The following information is available.

Cow - $m Calf -$m

Net profit after taxation 100 30
Share capital - $0.50 ordinary shares £25m £5m
Price/earnings ratio 11 14

The agreed share price for Calf will result in its shareholders receiving a premium of
25% on the current share price.

How many new shares must Cow issue to purchase the shares in Calf?

Solution

Market value Cow (11 x $100m) = $1,100m


Value per share ($1,100m/50m) = $22 per share

Market value Calf (14 x $30m) = $420m

Value of bid ($420m x 1.25) = $525m

Number of shares issued ($525m/$22) = 24 million shares

Use of bonds

Alternative forms of paper consideration, including debentures, loan notes and

preference shares, are not so commonly used, due to:

• Difficulties in establishing a rate of return that is attractive to target

shareholders

• The effects on the gearing levels of the acquiring company

• The change in the structure of the target shareholders' portfolios

• The securities being potentially less marketable, and lacking voting rights

Issuing convertible bonds will overcome some of these drawbacks, by offering the
target shareholders the option of partaking in the future profits of the company if they
wish.

294
An Illustration: Loan consideration

Cow offers to buy 100% of the equity shares of Calf.

The purchase price will be  $3 million in 10% bonds.

The annual profits before tax of Calf have been $2 millions.

Assuming no synergy as the result of the acquisition, by how much will the earnings
of Cow be expected to increase next year when the profits of Calf are taken into
account?

Company tax is 30%.

Solution

$'000 $'000
Calf profit before tax 2,000
Less: tax (30%) (600)
1,400
Interest on bonds 300
Less: tax reduction (90)
Net increase in interest 210
Increase in profit after tax for Cow 1,190

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 Syllabus C4 ab. a) Compare the various sources of financing available for a proposed cash-
based acquisition.
b) Evaluate the advantages and disadvantages of a financial offer for a given acquisition
proposal using pure or mixed mode financing and recommend the most appropriate offer to
be made.

Methods of raising cash

The predator company can raise cash from many sources to finance the
acquisition, some of the sources are:

Borrowing to obtain cash

The predator company may not have enough cash immediately available to finance
the acquisition and may have to raise the necessary cash through bank loans and
issuing of debt instruments.

Mezzanine finance

Mezzanine finance is a form of finance that combines features of both debt and
equity.

 

It is usually used when the company has used all bank borrowing capacity and
cannot also raise equity capital.

It is a form of borrowing which enables a company to move above what is

considered as acceptable levels of gearing.

It is therefore of higher risk than normal forms of borrowing.

Mezzanine finance is often unsecured.

It offers equity participation in the company either through warrants or share options.

If the venture being financed is successful the lender can obtain an equity stake in
the company.

296
Retained earnings

This method is used when the predator company has accumulated profits over time
and is appropriate when the acquisition involves a small company and the
consideration is reasonably low.

This method may be the cheapest option of finance.

Vendor placing

In a vendor placing the predator company issues its shares by placing the shares
with institutional investors to raise the cash required to pay the target shareholders.

Leveraged buy-outs (LBO)

is a takeover of a company by an investor (often private equity) using significant

debt.

Typically the debt used to fund the takeover is secured on the assets of the target
company.

The cashflow generated by the target company is then used to service and repay the
debt.

The target company would normally need to have low existing debt, stable cashflows
and good asset backing.

This approach allows a private equity investor to acquire a large company with
minimal cash or risk, since they are borrowing against the acquired company's
assets and earnings.

A range of different debt is usually used and any short-term debt instruments may
need re-financing soon after the deal.

The overall aim is to improve the running of the target over a 3-5 year period,
generate additional profits, repay the debt and sell the company for a profit.

297
 Syllabus C4b. Evaluate the advantages and disadvantages of a financial offer for a given
acquisition proposal using pure or mixed mode financing and recommend the most
appropriate offer to be made.

Cash consideration

The offer is made to purchase the shares of the target company for
cash.
The advantages of cash offer to the target entity’s shareholders are that:

1. The price that they will receive is obvious.

It is not like share exchange where the movements in the market price may
change their wealth.

2. The cash purchase increases the liquidity of the target shareholders.

A disadvantage to target shareholders’ for receiving cash is that if the price that they
receive is more than the price paid when purchasing the shares, they may be liable
to capital gains tax.

The advantages to the predator company are that:

1. The value of the bid is known and target company shareholders’ are encouraged
to sell their shares.

2. It represents a quick and easily understood approach when resistance is

expected.

The main disadvantages to the predator company are that it may deplete the
company’s liquidity position and may increase gearing.

298
Example

Cow Co. accepted a takeover offer from Milk Co, a listed company. 

The takeover offer is for $2•95 cash per share.

Cow's number of shares = 2,400,000


Cow's price per share = $2.90

Cow's Profit after tax = $620,000

Synergy gained = $150,000

Milk Co has 10 million shares in issue and these are trading for $4•80 each.

Milk Co’s price to earnings (P/E) ratio is 15 and believes that this will enable Cow Co
to operate on a P/E level of 15 as well.

Required:

Estimates the percentage gain in value to a Cow Co share and a Milk Co share
under payment offer.

Solution
• Gain in value to a Cow Co share

= ($2·95 takeover offer – $2·90 current share price)/$2·90 = 1·7%

• Gain in value to a Milk Co share

Additional earnings after acquisition = $620,000 PAT + $150,000 synergy

benefit= $770,000

Increase in market capitalisation based on P/E of 15 = 700,000 x 15 =

$10,500,000



Less: paid for Cow Co acquisition = ($2·95 x 2,400,000 shares) = $(7,080,000)

Value added for Milk shareholders ($10,500,000 - $7,080,000)  = $3,420,000

Gain in value to a Milk Co share = $3,420,000/10,000,000 shs = 34.2c


or 34.2c/480c = 7.1%

299
 Syllabus C4b. Evaluate the advantages and disadvantages of a financial offer for a given
acquisition proposal using pure or mixed mode financing and recommend the most
appropriate offer to be made.

Share exchange

The predator company issues its own shares in exchange for the shares of the target
company and the

The advantages of a share exchange to target shareholders include:

1. Capital gains tax is delayed.

2. The shareholders of the target company will participate in the control and profits
of the combined entity.

The advantages to the predator company are that:

1. It preserves the liquidity position of the company as there are no outflows of cash.

2. Share exchange reduces gearing and financial risk. However, this may depend
on the gearing of the target company.

3. The predator company can bootstrap earnings per share if its price earnings ratio
is higher than that of the target company.

300
The main disadvantages of a share exchange are that:

1. It causes dilution in control.

2. It may cause dilution in earnings per share.

3. As equity shares are issued this comparatively more expensive than debt capital.

4. The company may not have enough authorized share capital to issue the
additional shares required.

5. There is uncertainty with a share exchange where the movements in the market
price may change their wealth.

Debentures, loan stock and preference shares

Very few companies use debentures, loan stock and preference shares as a means
of paying a purchase consideration on acquisitions.

The main problems of using debentures and loan stock to the predator company are
that:

1. It affects gearing and financial risk.

2. Difficulty in determining appropriate interest rate to attract the shareholders of the

target company.

3. Availability of collateral security against repayment.

The main advantages of using debentures and loan stock are that:

1. Interest payments are a tax allowable expense.

2. Cost of debt is cheaper than equity.

3. Does not dilute control.

The main problems of using preference shares are that:

1. Dividends on preference shares are fixed and not tax allowable.

2. May not be attractive to target shareholders as preference shares carry no voting

power.

3. Preference shares are less marketable.

301
 Syllabus C4b. Evaluate the advantages and disadvantages of a financial offer for a given
acquisition proposal using pure or mixed mode financing and recommend the most
appropriate offer to be made..

Earn-out arrangements

An earn-out arrangement is where the purchase consideration is structured such that

an initial payment is made at the date of acquisition and the balance is paid
depending upon the financial performance of the target company over a specified
period of time.

The main advantages of earn-out arrangements are that:

1. Initial payment is reduced.

2. The risk to the predator company is reduced as it is less likely to pay more than
the target is worth.

The price is limited to future performance.

3. It encourages the management of the target company to work hard as the overall
consideration depends on future performance.

302
Syllabus D: Corporate Reconstruction And Re-
Organisation
Syllabus D1. Financial reconstruction

Syllabus D1. a) Assess an organisational situation and determine whether a financial

reconstruction is an appropriate strategy for a given business situation.
b) Assess the likely response of the capital market and/or individual suppliers of capital to any
reconstruction scheme and the impact their response is likely to have upon the value of the
organisation.

Capital reconstruction schemes

Is a scheme whereby a company reorganises its capital structure by changing the

rights of its shareholders and possibly the creditors

This can occur in a number of circumstances, the most common being when a
company is in financial difficulties, but also when a company is seeking floatation or
being acquired.

Financial difficulties

If a company is in financial difficulties it may have no recourse but to accept

liquidation as the final outcome.

Typical financial difficulties:

1. Large accumulated losses.

2. Large arrears of dividends on cumulative preference shares.

3. Large arrears of debenture interest.

4. No payment of ordinary dividend.

5. Market share price below nominal value.

303
However, it may be in position to survive, and indeed flourish, by taking up some
future contract or opening in the market.

The only major problem is the cash needed to finance such operations because the
present structure of the company will not be attractive to outside investors.

To get cash the company will need to reorganise or reconstruct.

Possible reconstruction

The changing or reconstruction of the company’s capital could solve these problems.

The company can take any or all of the following steps:

1. write off the accumulated losses.

2. write of the debenture interest and preference share dividend arrears.

3. write down the nominal value of the shares.

To do this the company must ask all or some of its existing stakeholders to surrender
existing rights and amount owing in exchange for new rights under a new or
reformed company.

The question is ‘why would the stakeholder be willing to do this? The answer to this

is that it may be preferable to the alternatives which are:

• to accept whatever return they could be given in a liquidation;

• to remain as they are with the prospect of no return from their investment and no
growth in their investment.

Generally, stakeholders may be willing to give up their existing rights and amounts
owing (which are unlikely to be met) for the opportunity to share in the growth in
profits which may arise from the extra cash which can be generated as a
consequence of their actions.

304
 Syllabus D1a. Assess an organisational situation and determine whether a financial
reconstruction is an appropriate strategy for a given business situation.

General guidelines in reconstruction

For a reconstruction to be successful the following principles are to be

followed:

1. Creditors must be better off under reconstruction than under liquidation.

If this is not the case they will not accept the reconstruction as their agreement is
a requirement for the scheme to take place.

2. The company must have a good chance of being financially viable and profitable
after the reconstruction.

3. The reconstruction scheme must be fair to all the parties involved, for example
preference shareholders should have preferential treatment over ordinary
shareholders.

4. Adequate finance is provided for the company’s needs.

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In solving reconstruction questions the following steps can be followed:

1. State the above principles of reconstruction.

2. Check what each party will get if the company were to go on liquidation.

This can be done by adding up the break-up values of the assets.

Note the sequence of creditor priorities as followings:

- taxes and unpaid wages


- secured debts, including unpaid interest – fixed charge

- secured debt – floating charge

- unsecured creditors

- preference shareholders including unpaid dividend

- ordinary shareholders.

3. Check the sufficiency of the amount of finance that will be raised from the
scheme.

This includes proceeds from the sale of investment, existing assets when new
assets are to be bought to replace them, and reduction in working capital.

4. Check if the parties will be better off under the proposed scheme than under
liquidation.

Assess the fairness of the scheme.

5. Assess the post-reconstruction financial viability and profitability of the company

by calculating post-reconstruction EPS and P/E ratio.

6. Come to a conclusion.

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 Syllabus D2. Business re-organisation

Syllabus D2a. Recommend, with reasons, strategies for unbundling parts of a quoted
company.

Unbundling

Unbundling is the process of selling off non-core businesses

Why do companies decide to Unbundle their business?

• to release funds

• to reduce gearing

• to allow management to concentrate on their chosen core business

The main forms of Unbundling are:

1. Divestment

2. Demergers

3. Sell-offs

4. Spin-offs

5. Management buy-outs.

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 Syllabus D2 ab.a) Recommend, with reasons, strategies for unbundling parts of a quoted
company.
b) Evaluate the likely financial and other benefits of unbundling.

Divestment

Divestment is the process of selling an asset (business)

This can be achieved either by:

• selling the whole business to a third party

• selling the assets piecemeal

Reasons for divestment

1. The principal motive for divestment will be if they either do not conform to group
or business unit strategy.

2. A company may decide to abandon a particular product/activity because it fails to

yield an adequate return.

3. Allowing management to concentrate on core business.

4. To raise more cash possibly to fund new acquisitions or to pay debts in order to
reduce gearing and financial risk.

5. The management lack the necessary skills for this business sector

6. Protection from takeover possibly by disposing of the reasons for the takeover or
producing sufficient cash to fight it effectively.

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 Syllabus D2 ab. a) Recommend, with reasons, strategies for unbundling parts of a quoted
company.
b) Evaluate the likely financial and other benefits of unbundling.

Spin-offs/demergers

This is where a new company is created and the shares in the new company are

owned by the shareholders of the original company

There is no change in ownership of assets but the assets are transferred to the new

company.

The result is to create two or more companies whereas previously there was only

one company.

Each company now owns some of the assets of the original company and the

shareholders own the same proportion of shares in the new company as in the

original company.

An extreme form of spin-off is where the original company is split up into a number of

separate companies and the original company broken up and it ceases to exist.

This is commonly called demerger.

Demerger involves splitting a company into two or more separate parts of roughly

comparable size which are large enough to carry on independently after the split.

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The main disadvantages of de-merger are:

1. Economies of scale may be lost, where the de-merged parts of the business had

operations in common to which economies of scale applied.

2. The ability to raise extra finance, especially debt finance, to support new

investments and expansion may be reduced.

3. Vulnerability to takeovers may be increased.

4. There will be lower revenue, profits and status than the group before the de-

merger.

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 Syllabus D2 ab. a) Recommend, with reasons, strategies for unbundling parts of a quoted
company.
b) Evaluate the likely financial and other benefits of unbundling.

Sell-offs

A Sell-off

is a form of unbundling involve disposing the non-core parts of the company

• involves selling part of a company to a third party for an agreed amount of funds
or value

• This value may comprise of cash and non-cash based assets.

The most common reasons for a sell-off are:

1. To divest of less profitable and/or non-core business units.

2. To offset cash shortages.

The extreme form of sell-off is liquidation, where the owners of the company
voluntarily dissolve the business, sell-off the assets piecemeal, and distribute the
proceeds amongst themselves.

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 Syllabus D2c. Advise on the financial issues relating to a management buy-out and buy-in.

Management buy-out (MBO) and buy-in

Management buy-out (MBO)

A management buy-out is the purchase of a business from its owners by its

managers.

For example, the directors of a company in a subsidiary company in a group might

buy the company from the holding company, with the intention of running it as
proprietors of a separate business entity.

Reasons for MBOs

1. A parent company wishes to divest itself of a business that no longer fits in with
its corporate objectives and strategy.

2. A company/group may need to improve its liquidity. In such circumstances a buy-

out might be particularly attractive as it would normally be for cash.

3. A company may decide to abandon a particular product/activity because it fails to

yield an adequate return.

4. In administration a buy-out may be the management’s only best alternative to

redundancy.

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Advantages of MBOs to disposing company

1. To raise cash to improve liquidity.

2. If the subsidiary is loss-making, sale to the management will often be better

financially than liquidation and closure costs.

3. There is a known buyer.

4. Better publicity can be earned by preserving employer’s jobs rather than closing
the business down.

5. It is better for the existing management to acquire the company rather than it
possibly falling into enemy hands.

Advantages of buy-out to acquiring management

1. It preserves their jobs.

2. It offers them the prospects of significant equity participation in their company.

3. It is quicker than starting a similar business from scratch.

4. They can carry out their own strategies, no longer having to seek approval from
the head office.

Problems of MBOs

1. Management may have little or no experience financial management and

financial accounting.

2. Difficulty in determining a fair price to be paid.

3. Maintaining continuity of relationships with suppliers and customers.

4. Accepting the board representation requirement that many sources of funding

may insist on.

5. Inadequate cash flow to finance the maintenance and replacement of assets.

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Sources of finance for MBOs

Several institutions specialise in providing funds for MBOs.

These include:

• The clearing banks.

• Pension funds and insurance companies.

• Venture capital.

• Government agencies and local authorities, for example Scottish Development

Agency.

Factors a supplier of finance will consider before lending

• The purchase consideration. Is the purchase price right or high?

• The level of financial commitment of the buy-out team.

• The management experience and expertise of the buy-out team.

• The stability of the business’s cash flows and the prospects for future growth.

• The rate of technological change in the industry and the costs associated with the
changing technologies.

• The level of actual and potential competition.

• The likely time required for the business to achieve a stock market flotation, (so
as to provide an exit route for the venture capitalist).

• Availability of security.

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Conditions attached to provision of finance

• Board representation for the venture capitalist.

• Equity options.

• A right to take a controlling equity stake and so replace the existing management
if the company fails to achieve specified performance targets.

Management buy-in

- a company to an external management team

• - is a type of sell-off which involves selling a division or part of a company to an

external management team, who will take up the running of the new business
and have an equity stake in the business.

• - is normally undertaken when it is thought that the division or part of the

company can probably be run better by a different management team compared
to the current one.

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 Syllabus D2 ab. a) Recommend, with reasons, strategies for unbundling parts of a quoted
company.
b) Evaluate the likely financial and other benefits of unbundling.

Share repurchase

Companies may purchase their own shares back

Therefore if a company has surplus cash and cannot think of any profitable use of
that cash, it can use that cash to purchase its own shares.

Share repurchase is an alternative to dividend policy where the company returns

cash to its shareholders by buying shares from the shareholders in order to reduce
the number of shares in issue.

So what will actually happen?

1. The company's CASH will go DOWN.

Becasue the company is buying the shares back.

2. The number of SHARES will go DOWN.

The effect on EPS

EPS = Earnings / Shares

• Earnings will stay as they are

• But you will have less shares

• Therefore EPS will INCREASE

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Shares may be purchased either by:

1. Open market purchase – the company buys the shares from the open market at

the current market price.

2. Individual arrangement with institutional investors.

3. Tender offer to all shareholders.

Reasons for share repurchase

• Readjustment of the company's equity base

• Purchase of own shares may be used to take a company out of the public market

and back into private ownership.

• Purchase of own shares provide an efficient means of returning surplus cash to

the shareholders.

• Purchase of own shares increases earning per share (EPS) and return on capital

employed (ROCE).

• To increase the share price by creating artificial demand.

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Problems of share repurchase

1. Lack of new ideas

Shares repurchase may be interpreted as a sign that the company has no new

ideas for future investment strategy.

This may cause the share price to fall.

2. Costs


Compared with a one-off dividend payment, share repurchase will require more

time and transaction costs to arrange.

3. Resolution

Shareholders have to pass a resolution and it may be difficult to obtain their

consent.

4. Gearing

If the equity base is reduced because of share repurchase, gearing may increase

and financial risk may increase.

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 Syllabus D2 ab. a) Recommend, with reasons, strategies for unbundling parts of a quoted
company.
b) Evaluate the likely financial and other benefits of unbundling.

Going private

A public company may occasionally give up its stock market quotation and return
itself to the status of a private company.

The reasons for such move are varied, but are generally linked to the disadvantages
of being in the stock market and the inability of the company to obtain the supposed
benefits of a stock market quotation.

Other reasons are:

• To avoid the possibility of takeover by another company.

• Savings of annual listing costs.

• To avoid detailed regulations associated with being a listed company.

• Where the stock market undervalues the company’s shares.

• Protection from volatility in share price with its financial problems.

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 Syllabus E: Treasury And Advanced Risk
Management Techniques
Syllabus E1. The role of the treasury function in multinationals

Syllabus E1a. a) Discuss the role of the treasury management function within:
i) The short term management of the organisation’s financial resources
ii) The longer term maximisation of corporate value

The role of the treasury management function

The functions of the treasury

Treasury management is the corporate handling of all financial matters, the

generation of external and internal funds for business, the management of
currencies and cash flows, and the complex strategies, policies and procedures of
corporate finance.

Roles of the Treasury management

1. Cash management

2. Managing financial risks

3. Raising finance

4. Sourcing finance

5. Currency management

6. Effective taxation administration

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The Association of Corporate Treasurers

cash management the treasury section will monitor the company's

cash balance and decide if it is advantageous

to give/take settlement discounts to/from

customers/suppliers even if that means the bank

account will be overdrawn.

financing the treasury section will monitor the company's

investment/borrowings to ensure they gain as

much interest income as possible and incur as

little interest expense as possible.

foreign currency the treasury section will monitor foreign exchange

rates and try to manage the company's affairs so

that it reduces losses due to changes in foreign

exchange rates.

tax the treasury section will try to manage the

company's affairs to legally avoid as much tax as

possible.

The role of the finance function in determining business tax liabilities

One of the roles of the finance function is to calculate the business tax liability and to
mitigate that liability as far as possible within the law.

1. Tax avoidance

is the legal use of the rules of the tax regime to one’s own advantage, in order to
reduce the amount of tax payable by means that are within the law.

321
2. Tax evasion

is the use of illegal means to reduce one’s tax liability, for example by deliberately
misrepresenting the true state of your affairs to the tax authorities.

The directors of a company have a duty to their shareholders to maximise the post
tax profits that are available for distribution as dividends to the shareholders, thus
they have a duty to arrange the company’s affairs to avoid taxes as far as possible.

However, dishonest reporting to the tax authorities (e.g. declaring less income than
actually earned) would be tax evasion and a criminal offense.

While the traditional distinction between tax avoidance and tax evasion is fairly clear,
recent authorities have introduced the idea of tax mitigation to mean conduct that
reduces tax liabilities without frustrating the intentions of Parliament, while tax
avoidance is used to describe schemes which, while they are legal, are designed
to defeat (nullify) the intentions of Parliament.

Thus, once a tax avoidance scheme becomes public knowledge, Parliament will
nearly always step in to change the law in order to stop the scheme from working.

Responsibilities of the finance function

The finance function of any company is responsible by law for:

1. maintaining proper accounting records that contain an accurate account of the

income and expenses incurred, and the assets and liabilities pertaining to the
company.

2. calculating the tax liability arising from the profits earned each year, and paying
amounts due to the tax authorities on a timely basis.

In practice, most companies (particularly small companies) will seek the advice of
external tax specialists to help them calculate their annual tax liability.

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Investment appraisal and financing viable investments

Investment appraisal is concerned with long term investment decisions, such as

whether to build a new factory, buy a new machine for the factory, buy a rival
company, etc.

Typically money is paid out now, with an expectation of receiving cash inflows over a
number of years in the future.

There are two questions to be addressed:

1. Is the possible investment opportunity worthwhile?

2. If so, then how is it to be financed?

For example, if a company is offered an investment opportunity that requires paying

out €1m now, and will lead to cash inflows of €2m in one year’s time and €2m in
two years’ time, during a period when interest rates are 5%, you can see that this
investment is worthwhile in real terms.

If the €1m was invested to earn interest, it would be worth €1.05m in one year’s
time.

However the investment will give you €2m in one year’s time and another €2m in
two years’ time.

So the investment is worthwhile.

The second question is how this €1m required now should be financed.

Perhaps there is a surplus €1m sitting unused in a bank account.

It is more likely that fresh funds will be required, possibly by issuing new shares, or
possibly by raising a loan (e.g. from the bank).

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There are advantages and disadvantages of each possibility.

Advantages of issuing new ordinary shares:

• Dividends can be suspended if profits are low, whereas interest payments have
to be paid each year.

• The bank will typically require security on the company’s assets before it will
advance a loan.

Perhaps there are no suitable assets available.

Advantages of raising loan finance:

• Interest payments are allowable against tax, whereas dividend payments are not
an allowable deduction against tax

• No change is required in the ownership of the company, which is governed by

who owns the shares of the company.

Generally the finance function and the treasury function will work together in
appraising possible investment opportunities and deciding on how they should be
financed.

Management of working capital

A company must also decide on the appropriate level of investment in short term net
assets, i.e. the levels of:

• inventory

• trade receivables (amounts due from debtors for sales on credit)

• cash balances

• trade payables (amounts due to creditors for purchases on credit).

324
There are advantages in holding large balances of each component of working
capital, and advantages in holding small balances, as below.

advantage of large balance advantage of small balance

inventory customers are happy since low holding costs. less risk of
they
obsolescence costs.
can be immediately provided

with goods

trade receivables customers are happy since less risk of bad debts, good
they
for cash flow.
like credit.

cash creditors are happy since bills more can be invested

elsewhere
can be paid promptly
to earn profits.

trade payables preserves your own cash suppliers are happy and may

offer discounts

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 Syllabus E1a. a) Discuss the role of the treasury management function within:
iii) The management of risk exposure.

Protection against transaction risks

Factors to consider before deciding to protect transaction exposure

The factors may include the following:

• Future exchange rate movement.

The future movements in exchange rate may depend on a number of factors

including interest rate, inflation, central bank actions and economic growth.

• The cost involved in the hedging, eg commission.

• The ability of the company to absorb foreign exchange losses.

• Expertise within the company.

• The company’s attitude towards foreign currency transactions and the importance

of overseas trading.

326
 Syllabus E1b. b) Discuss the operations of the derivatives market, including:
i) The relative advantages and disadvantages of exchange traded versus OTC agreements

Exchange and OTC

Exchange and over the counter (OTC) markets

Secondary markets can be organised as exchanges or (OTC) markets

Exchanges - where buyers and sellers of securities buy and sell securities in one

location

Examples of exchanges include:

1. the london Stock Exchange and the New York Stock Exchange for the trading of

shares

2. the Chicago Board of Trade for the trading of commodities

3. the London International Financial Futures and Options Exchange (LIFFE) for the

trading of derivatives.

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Over the counter (OTC) markets

-  where buyers and sellers transact with each other not through an exchange but by
individual negotiation.

The prices at which securities are bought over the counter may be the same as the
corresponding transactions in an exchange, because the buyers and sellers agree
the most competitive price based on constant contact through computers with other
market participants.

Securities that are issued in an over the counter market can be negotiable or non-
negotiable.

• Negotiable securities can be resold.

• Non-negotiable securities cannot be resold.

328
 Syllabus E2. The use of financial derivatives to hedge against
forex risk

Syllabus E2b. b) Discuss the operations of the derivatives market, including:

i) The relative advantages and disadvantages of exchange traded versus OTC agreements
ii) Key features, such as standard contracts, tick sizes, margin requirements and margin
trading
iii) The source of basis risk and how it can be minimised.

Futures

Ticks

A tick is the minimum price movement permitted by the exchange on which the future
contract is traded.

Ticks are used to determine the profit or loss on the futures contract.

The significance of the tick is that every one tick movement in price has the same
money value.

Example 1

If the price of a sterling futures contract changes from $1.3523 to $1.3555, then price
has risen by $0.0032 or 32 ticks.

If you entered/bought into 50 contracts the profit on the futures contract will be
calculated as:

Number of contracts x ticks x tick value


50 x 32 x $6.25 = $10,000

Ticks are used to calculate the value of a change in price to someone with a long or
a short position in futures.

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If someone has a long position, a rise in the price of the future represents a profit,
and a fall in price represents a loss.

If someone has a short position, a rise in the price of the future represents a loss,
and a fall represents a profit.

Margins

When a deal has been made both buyer and seller are required to pay margin to the
clearing house.

This sum of money must be deposited and maintained in order to provide protection
to both parties.

• Initial margin

Initial margin is the sum deposited when the contract is first made.

This is to protect against any possible losses on the first day of trading.

The value of the initial margin depends on the future market, risk of default and
volatility of interest rates and exchange rates.

• Variation margin

Variation margin is payable or receivable to reflect the day-to-day profits or losses

made on the futures contract.

If the future price moves adversely a payment must be made to the clearing
house, whilst if the future price moves favourably variation margin will be
received from the clearing house.

This process of realising profits or loss on a daily basis is known as “marking to

market”.

This implies that margin account is maintained at the initial margin as any daily
profit or loss will be received or paid the following morning.

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 Default in variation margins will result in the closure of the futures contract in
order to protect the clearing house from the possibility of the party providing cash
to cover accumulating losses.

Example 2

Contract size  £62,500 

3 months future price  $1. 3545 
Number of contract entered  50 contracts 
Tick value  $6.25 
Tick size  0.0001 

Required:

Calculate the cash flow if the future price moves to in day one $1.3700 and 1.3450
day two (variation margin). Assume a short position.

Solution 2

1. Day One

Selling price 1.3545


Buying price 1.3700

Loss 0.0155 = 155 ticks

Variation margin = payment of the loss 


= 155 x 50 x $6.25 = $48,437

2. Day 2

Selling price 1.3700 


Buying price 1.3450 

Profit 0.025  = 250 ticks

Variation margin = receipt of the profit


= 250 x 50 x $6.25 = $78,125


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Basis and basis risk

Basis is the difference between the futures price and the current cash market price of
the underlying security.

In the case of exchange rates, basis is the difference between the current market
price of a future and the current spot rate of the currency.

At final settlement date itself, the futures price and the market price of the underlying
item ought to be the same otherwise speculators would be able to make an instant
profit by trading between the futures market and spot cash market.

Most futures positions are closed out before the contract reaches final settlement,
hence a difference between the close out future price and the current market price of
the underlying item.

Basis risk may arise from the fact that the price of the futures contract may not move
as expected in relation to the value of the underlying item which is being hedged.

Futures hedge

Hedging with a future contract means that any profit or loss on the underlying item
will be offset by any loss or profit made on the future contract.

A perfect hedge is unlikely because of:

• Basis risk.

• The “round sum” nature of futures contracts, which can only be bought or sold in
whole number.

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 Syllabus E1b iv. b) Discuss the operations of the derivatives market, including:
iv) Risks such as delta, gamma, vega, rho and
theta, and how these can be managed.

Risks

In order to manage a portfolio of options, the dealer must know how the value of the
options will vary with changes in the various factors affecting their price.

Such assessments of sensitivity are measured by:

Delta

Delta = Change in option price / Change in price of underlying security

Delta is a measure of how much an option premium changes in response to a

change in the security price.

For instance, if a change in share price of 5p results in a change in the option

premium of 1p, then the delta has a value of (1p/5p) 0.2.

Therefore, the writer of options needs to hold five times the number of options than
shares to achieve a delta hedge.

A delta value ranges between 0 and +1 for call options, and between 0 and -1 for put
options.

333
The actual delta value depends on how far it is in-the-money or out- of-the-money.

The absolute value of the delta moves towards 1 (or -1) as the option goes further in-
the-money (where the price of the option moves in line as the price of the underlying
asset) and shifts towards 0 as the option goes out-of-the-money (where the price of
the option is insensitive to changes in the price of an underlying asset)

At-the- money calls have a delta value of 0.5, and at-the-money puts have a delta
value of -0.5.

Gamma

Gamma  = Change in the delta value / Change in the price of the underlying security

Gamma measures the amount by which the delta value changes as underlying
security prices change.

Vega

Vega measures the sensitivity of the option premium to a change in volatility.

As indicated above higher volatility increases the price of an option. Therefore any
change in volatility can affect the option premium.

Thus:

Vega  = Change in the option price/ Change in volatility

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Theta

Theta measures how much the option premium changes with the passage of time.

The passage of time affects the price of any derivative instrument because
derivatives eventually expire. An option will have a lower value as it approaches
maturity.

Thus:

Theta  = Change in the option price (due to changes in value) / Change in time to

expiry

Rho

Rho measures how much the option premium responds to changes in interest rates.

Interest rates affect the price of an option because today’s price will be a discounted
value of future cash flows with interest rates determining the rate at which this
discounting takes place.

Thus:

Rho = Change in the option price / Change in the rate of interest

335
 Syllabus E1a), E2a) and B5d.
E1a) Discuss the role of the treasury management function within:
iii) The management of risk exposure.
E2a) Assess the impact on an organisation to exposure in translation, transaction and
economic risks and how these can be managed.
B5d) Assess the impact of a project upon an organisation’s exposure to translation,
transaction and economic risk.

Types of foreign currency risk

Translation

• Risk that there will be losses when a subsidiary is translated into the parent
company currency when doing consolidated accounts

Transaction

• Risk of exchange rates moving against you when buying and selling on credit,
between the transaction date and actual payment date

Economic

• Long term cashflow risk caused by exchange rate movements.

For example a UK exporter will struggle if sterling appreciated against the euro.

It is like a long term transaction risk

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Options to manage these risks

1. Only deal in home currency ! (commercially acceptable?)

2. Do nothing ! (Saves transaction costs but is risky)

3. Leading - Receive early (offer discount) - expecting rate to depreciate

4. Lagging - Pay later if currency is depreciating

5. Matching - Use foreign currency bank account - so matching receipts with

payments then risk is against the net balance

6. Another way of managing the risk is using:

Hedging, options, futures, swaps and forward rates - more of these later!

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 Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
i) The use of the forward exchange market and the creation of a money market hedge

Predicting Exchange Rates

Purchasing Power Parity (PPP theory)

Why do exchange rates fluctuate?

“The law of one price”

Illustration

Item costs $1,000


$2:€ (base)

However inflation in US is 5% and Europe is 3%

According to law of one price what is the predicted exchange rate in 1 year?

• Solution

So next year - Item in US costs $1,050 and in Europe €515


“The law of one price” = $1,050 = €515

So, forward exchange rate = 1,050 / 515 = $2.039:€1

PPPT “High inflation leads to depreciation of currency”

• Another way of calculating this is as follows:

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 Exchange rate now (counter) x (1+ Inf (counter) / 1 + inf (base))

2 x 1.05 / 1.03 = 2.039

Limitations

1. Future inflation is an estimate

2. Market is ruled by speculative not trade transactions

3. Governments often intervene

Interest Rate Parity (IRP theory)

Why do exchange rates fluctuate? 


An investor will get the same amount of money back no matter where he deposits his
money

Illustration

US Interest rate = 10%


European Interest rate = 8%

Exchange rate = $2:€

Investor has $1,000 to invest for 1 year

339
What is the future exchange rate as predicted by IRPT?

• Solution

In US he will receive $1,100 in one years time


In Europe he will receive €540

Forward rate will therefore be 1,100 / 540 = $2.037:€

IRPT “High interest rates leads to depreciation of currency”

• Another way of calculating this is as follows:

Exchange rate now x (1+ Int (counter) / 1 + int (base))

2 x 1.10 / 1.08 = 2.037

Limitations

1. Government intervention

2. Controls on currency trading

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 Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
i) The use of the forward exchange market and the creation of a money market hedge

Understanding Exchange Rates

Understanding Exchange Rates

£ : $1.5

Here £ = Base Currency; $ = Counter Currency

£0.67:$

Here $ = Base Currency; £ = Counter currency

Normally the “foreign” currency is the counter currency

Banks BUY HIGH and SELL LOW

Here we are referring to the foreign / counter currency

If a company needs to make a foreign currency payment

• Banks SELL the foreign currency at the LOWER rate

If a company needs to make a foreign currency receipt

• Banks will BUY that foreign currency from them at the HIGHER rate

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Translating Currencies

1. If you are given the counter currency:

DIVIDE the amount by the exchange rate

Eg A UK company has to pay $1,500.


£ : $1.5

Solution = $1,500 / 1.5 = £1,000

2. If you are given the Base currency:

MULTIPLY the amount by the exchange rate

Eg A UK company has to pay £1,000 in $.


£ : $1.5

Solution = £1,000 x 1.5 = $1,500

If £ is strong (strengthening, appreciate)

• UK exporters suffers because the $ is weak and their revenues is in $s.
• If the £ appreciates relative to the $, the exchange rate falls:

it takes fewer £ to purchase $1.

($1 = £1.5  → $1= £1.4).

If £ is weak (weakening, depreciate, devalue)

• UK importers suffer because the $ is strong and their costs are in $s.

Translation risk 

- NCA and CA value - decrease

- NCL and CL value - increase.

• For instance, if the £ depreciates relative to the $, the exchange rate rises:

it takes more £ to purchase $1.

($1= £1.5 → $1= £1.7).

342
 Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
i) The use of the forward exchange market and the creation of a money market hedge

Forward Rates

So, remember what we are looking at here are ways to negate the risk that, in the
future, the exchange rates may move against us

So we have bought or agreed a sale now in a foreign currency, but the cash won’t be
paid (or received) until a future date

With a forward rate we are simply agreeing a future rate now.

Therefore fixing yourself in against any possible future losses caused by movements
in the real exchange rate

However - you also lose out if the actual exchange rate moves in your favour as you
have fixed yourself in at a forward rate already

Illustration

UK importer has to pay $1,000 in a months time


He takes the forward rate of $1.8-1.9:£

The bank then has agreed to SELL the dollars (counter currency) to the importer.

Remember the bank SELLS LOW

The exchange rate would therefore be $1.8:£

So, the bank will give the exporter $1,000 in return for £555.

The importer must pay £555

343
• NOTE

If importer cannot fulfill the forward contract agreed (maybe because he didnt
receive the goods) the bank will sell the importer the currency and then buy it
back again at the current spot rate.

This closes out the forward contract

Advantages of forward rate

1. Flexible

2. Straightforward

Disadvantages of forward rate

1. Contracted commitment (even if you haven’t received money)

2. Cannot benefit from favourable movements

344
 Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
i) The use of the forward exchange market and the creation of a money market hedge

Money Market Hedges - payment

The whole idea of a money market hedge is to take the exchange rate NOW even
though the payment is in the future.

By doing this we eliminate the future exchange risk (and possible benefits too of
course)

So. the foreign payment is in the future, but we are going to get some foreign
currency NOW to pay for it.

We do not need the full amount though, as we can put the foreign money into a
foreign deposit account to earn just enough interest to make the full payment when
ready

We, therefore, calculate how much is needed now by taking the full amount and
discounting it down at the foreign deposit rate

Now we know how much foreign currency we need NOW, we can convert that into
home currency using the spot rate

We now know how much home currency we need. This needs to be borrowed. So,

the cost to us will eventually be:

• Amount of home currency borrowed + interest on that until payment is made.

(Obviously here we use the home borrowing rate)

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Steps:

1. Calculate how much foreign currency needed (discount @ foreign deposit rate)

2. Convert that to home currency

3. Borrow that amount of home currency

4. The cost will be the amount borrowed plus interest on that (home currency
borrowing rate)

Illustration

Let’s say we are a UK company and need to pay $100 in 1 year.

UK borrowing rate is 8% and US deposit rate is 10%.

Exchange rate now $2 - 2.2 :£

• Need to pay $100 in 1 year so we borrow 100 x 1/ 1.10 = 91

• Borrow just $91 as we then put it on deposit and it attracts 10% interest - to pay
off the whole $100 at the end

• Convert $91 dollars now. We need dollars, so bank SELLS us them. They always
SELL LOW. So 91 / 2 = £45.5

• £45.5 is borrowed now. We will then have to pay interest on this in the UK for a
year.

So £45.5 x 1.08 = 49.14

£49.14 is the total cost to us

346
 Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
i) The use of the forward exchange market and the creation of a money market hedge

Money Market Hedge - Receipt

The whole idea of a money market hedge is to take the exchange rate NOW even
though the receipt is in the future.

By doing this we eliminate the future exchange risk (and possible benefits too of
course)

The foreign receipt is in the future, we are going to get eliminate rate risk by getting
that foreign currency NOW.

To do this we need to borrow it abroad.

We do not borrow the full amount though, as the receipt will pay off this loan plus
interest.

We, therefore, calculate how much is needed now by taking the full amount and
discounting it down at the foreign borrowing rate

Now we know how much foreign currency we need NOW, we can convert that into
home currency using the spot rate.

Here the bank are buying foreign currency off us and so will BUY HIGH

We then take this home currency and put it on deposit at home

The eventual receipt is the amount converted plus the interest earned at home

347
Steps:

1. Calculate how much foreign currency needed (discount @ foreign borrowing rate)

2. Convert that to home currency

3. Deposit that amount of home currency

4. The receipt will be the amount converted plus interest on that (home currency
deposit rate)

Illustration

Will receive $400,000 in 3 months


Exchange rate now: $1.8250 - 1.8361:£

Forward rates $1.8338 - 1.8452:£

Deposit rates (3 months) UK 4.5% annual US 4.2% annual

Borrowing rates (3 months) UK 5.75% US 5.1% annual

1. Calculate how much foreign currency needed (discount @ foreign borrowing rate)

Interest = 5.1% x 3/12 = 1.275%


$400,000 x 1/ 1.01275 = $394,964

2. Convert that to home currency


The UK company now needs to sell $394,964 from the bank. The bank will BUY
HIGH

394,964 / 1.8361 = £215,110

3. Deposit that amount of home currency

This amount will be deposited at home at 4.5% for 3/12 = 1.125% = 215,110 x
1.125% = £217,530

348
 Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
iii) Exchange-traded currency futures contracts

Currency Futures

What is this little baby all about then?

• It’s a standard contract for set amount of currency at a set date

• It is a market traded forward rate basically



*Calculations of how these work are required only for P4 exam (not F9)

Explanation

When a currency futures contract is bought or sold, the buyer or seller is required to
deposit a sum of money with the exchange, called initial margin.

If losses are incurred as exchange rates and hence the prices of currency futures
contracts change, the buyer or seller may be called on to deposit additional funds
(variation margin) with the exchange

Equally, profits are credited to the margin account on a daily basis as the contract is
‘marked to market’.

Most currency futures contracts are closed out before their settlement dates by
undertaking the opposite transaction to the initial futures transaction, ie if buying
currency futures was the initial transaction, it is closed out by selling currency
futures. A gain made on the futures transactions will offset a loss made on the
currency markets and vice versa.

349
Advantages

1. Lower transaction costs than money market

2. They are tradeable and so do not need to always be closed out

Disadvantages

1. Cannot be tailored as they are standard contracts

2. Only available in a limited number of currencies

3. Still cannot take advantage of favourable movements in actual exchange

rates (unlike in options…next!)

350
Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
iii) Exchange-traded currency futures contracts

Currency Futures - calculation

Typical available futures contracts are as follows:

Example - Extract from the exam June 11

Casasophia Co, based in a European country that uses the Euro (€) is due to
receive the payment of US$20 million in four months.

Spot rate $ per €1:


US$1·3585–US$1·3618

Currency Futures (Contract size €125,000, Quotation: US$ per €1)

2-month expiry 1•3633


5-month expiry 1•3698

Required:

Advise Casasophia Co on an appropriate hedging strategy for the US$ income it is

due to receive in four months.

351
• Solution

For a US$ receipt, the five-month futures contracts (two-month is too short for the
required hedge period) need be bought.

The contract will be closed out in 4 months.

Predicted futures rate = 1•3698 – (1/3 x (1•3698 – 1•3633)) = 1•3676 (when the
five-month contract is closed out in four months’ time)

Why did I use 1/3?


Because the change between 2-month expiry and 5-month expiry is 3 months.
Therefore 1 month represents 1/3, and therefore we have deducted 1 month from
5-month expiry  option to get the predicted rate in 4th month.

Expected receipt = US$20,000,000/1•3676 = €14,624,159

Number of contracts to be bought = €14,624,159/€125,000 = 117 contracts

• [OR: Futures lock-in rate may be estimated from the spot and five-month futures
rate:

1•3698 – (1/5 x (1•3698 – 1•3618)) = 1•3682

Note:

Casasophia Co will have $20m and the bank will buy them from it. Therefore the
bank BUYS HIGH and therefore the spot rate $1.3618 per €1 is used.

US$20,000,000/1•3682 = €14,617,746

€14,617,746/€125,000 = 116•9 or 117 contracts (a slight over-hedge)]

352
 Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
iv) Currency swaps

Currency Swaps

What are they?

• The exchange of debt from one currency to another

• 2 companies agree to exchange payments on different terms (eg different

currency)

Advantages

1. Easy

2. Low transaction costs

3. Spread debt across different currencies

How to use them

Currency swaps are better for managing risk over a longer term (than currency
futures or currency options)

A currency swap is an interest rate swap (between 2 companies) where the loans
are in different currencies.

It begins with an exchange of principal, although this may be a notional exchange

rather than a physical exchange.

353
During the life of the swap agreement, the companies pay each others’ foreign
currency interest payments. At the end of the swap, the initial exchange of principal
is reversed.

Example

Consider a US company X with a subsidiary Y in France which owns vineyards.

Assume a spot rate of $1 = €0.7062. Suppose the parent company X wishes to raise
a loan of €1.6 million for the purpose of buying another French wine company.

At the same time, the French subsidiary Y wishes to raise $1 million to pay for new
up-to-date capital equipment imported from the US.

The US parent company X could borrow the $1 million and the French subsidiary Y
could borrow the € 1.6 million, each effectively borrowing on the other's behalf. They
would then swap currencies.

354
Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
vi) Currency options

Currency Options

Features of currency options

A currency option gives its holder the right to buy (call option) or sell (put option) a
quantity of one currency in exchange for another, on or before a specified date, at a
fixed rate of exchange (the strike rate for the option).

Currency options can be purchased over-the-counter or on an exchange. In practice,

companies buying call or put currency options do so in over-the- counter deals with a
bank.

They protect against adverse movements in the actual exchange rate but allow
favourable ones!

Clearly, because of this, the option involves buying at a premium.

Disadvantages

1. The premium

2. Must be paid up immediately

3. Not available in every currency

Advantages

1. Currency options do not need to be exercised if it is disadvantageous for the

holder to do so.

2. Holders of currency options can take advantage of favourable exchange rate

movements in the cash market and allow their options to lapse. The initial fee
paid for the options will still have been incurred, however.

355
 Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
vi) Currency options

Options - calculations

A right to sell (put options) or buy (call options) a currency at the exercise price in the

future

Rules:

• If the movement in the exchange rate is favourable

- don't exercise the option


- let it lapse

• If the movement is adverse

- exercise the option

Steps:

1. Do I want call or put options?

Will I buy (call options) or sell (put options) the BASE currency?

2. Choose expiry

3. Choose strike (exercise) price

4. How many contracts?

5. How much BASE currency do I receive (call options)/pay (put options)?

6. Calculate Premium

7. Amount not hedged

8. Choose whether to exercise

356
Example - Put options- Extract from the June 13 exam

Kenduri Co is based in the UK. It will have to pay $2,400,000 in 3 months.

Spot rate US$/£1:


1.5938-1.5962

Hedging using Forward: £1,500,375 payment

Required

Advise Kenduri Co on, and recommend, an appropriate hedging strategy for the US$
cash flows it is due to pay in three month.

Currency options available to Kenduri Co

Contract size £62,500, Exercise price quotation: US$/£1, Premium: cents per £1

Exercise Call options
 Call options
 Put options
 Put options


3-month expiry 6-month expiry 3-month expiry 6-month expiry

1.60 1.55 2.25 2.08 2.23

Solution

1. Do I want call or put options?

BASE currency is £.

Kenduri Co will pay $2.4m in 3 months, therefore have to sell £ to buy $2.4m,
therefore Kenduri Co would purchase Sterling three-month put options to protect
itself against a strengthening US$ to £.

2. Choose expiry

Kenduri Co will choose Put 3-month expiry options, because it will pay $2.4m in 3
months.

357
3. Choose strike (exercise) price

Exercise price: $1•60/£1

£ payment = 2,400,000/1•60 = £1,500,000

4. How many contracts?

£1,500,000 / £62,500 = 24 contracts

24 put options purchased

5. How much BASE currency do I pay (put options)?

£ payment = 2,400,000/1•60 = 1,500,000

6. Calculate Premium

Premium payable = 24 x 0•0208 x 62,500 = US$31,200

Premium in £ = 31,200/1•5938 = £19,576

Note:

Kenduri Co will pay the premium in US$31,200. Kenduri Co have to buy $ from
the bank (the bank will "sell LOW" $, therefore the Spot rate US$1.5938  is used.

7. Amount not hedged

All amount is hedged (refer to step 4)

8. Choose whether to exercise

Total payments = £1,500,000 + £19,576 = £1,519,576

£1,519,576 > £1,500,375 FWD, therefore use the Forward rate hedge.

358
Example- Call options - Extract from the June 11 exam

Casasophia Co, based in a European country that uses the Euro (€) is due to
receive the final payment of US$20 million in four months.

Spot rate $ Per €1:


US$1·3585–US$1·3618

4-month forward $ Per €1:


US$1·3588–US$1·3623

Hedging using Forward contracts is €14,681,054.

Required

Advise Casasophia Co on, and recommend, an appropriate hedging strategy.

 Exercise Calls 2- Calls  5-month Puts 2-month Puts 5-month

price     month expiry expiry expiry expiry

1.36 2.35 2.80 2.47 2.98

Solution

1. Do I want call or put options?

BASE currency is EUR.

Casasophia Co will receive $20m in 4 months and then will convert them to EUR
(buy EUR), therefore Casasophia Co would purchase Euro call options to protect
itself against a weakening Dollar to the Euro.

2. Choose expiry

Casasophia Co will choose Call 5-month expiry options, because it will receive
$20m in 4 months. The 2-month expiry is too short.

359
3. Choose strike (exercise) price

Exercise Price: $1•36/€1

€ receipts =$ 20,000,000/($1•36/€1) = €14,705,882

4. How many contracts?

€14,705,882 / €125,000 =  117•6 contracts

117 call options purchased

5. How much BASE currency do I receive?

€ receipts = 117 x €125,000 = €14,625,000

6. Calculate Premium

Premium payable = 117 x 0•0280 x 125,000 = US$409,500


Premium in € = 409,500/1•3585 = €301,435

Note:

Casasophia Co will pay the premium in US$409,500. Casasophia Co have to buy
$ from the bank (the bank will "sell LOW" $, therefore the Spot rate US$1·3585 is
used.

7. Amount not hedged

Amount not hedged = US$20,000,000 – (117 x €125,000 x 1•36) = US$110,000

Use forwards to hedge amount not hedged = US$110,000/1•3623 (the banks

"buy high")= €80,746

8. Choose whether to exercise

Total receipts = 14,625,000 Receipt– 301,435 Premium + 80,746 FWD =

€14,404,311

€14,404,311 < €14,681,054 FWD contract, therefore choose badge using the
forward contract.


360
Syllabus E2c. c) Advise on the use of bilateral and multilateral netting and matching as tools for
minimising FOREX transactions costs and the management of market barriers to the free
movement of capital and other remittances.

Netting

Netting is setting the debtors and creditors in the group resulting in the

net amount either paid or received.

There are two types of netting:

1. Bilateral Netting

In the case of bilateral netting, only two companies are involved.

The lower balance is netted against the higher balance and the difference is the
amount remaining to be paid.

2. Multilateral Netting

Multilateral netting is a more complex procedure in which the debts of more than
two group companies are netted off against each other.

Example - June 2013 extract

Kenduri Co is considering whether or not to manage the foreign exchange exposure

using multilateral netting from the UK, with the Sterling Pound (£) as the base
currency.

If multilateral netting is undertaken, spot mid-rates would be used.

361
The following cash flows are due in three months between Kenduri Co and three of
its subsidiary companies.

The subsidiary companies are Lakama Co, based in the United States (currency
US$), Jaia Co, based in Canada (currency CAD) and Gochiso Co, based in Japan
(currency JPY).

Owed by Owed to Amount

Kenduri Co Lakama Co US$ 4.5 million

Kenduri Co Jaia Co CAD 1.1 million

Gochiso Co Jaia Co CAD 3.2 million

Gochiso Co Lakama Co US$ 1.4 million

Jaia Co Lakama Co US$ 1.5 million

Jaia Co Kenduri Co CAD 3.4 million

Lakama Co Gochiso Co JPY 320 million

Lakama Co Kenduri Co US$ 2.1 million

Exchange rates available to Kenduri Co

US$/£1 CAD/£1 JPY/£1

spot 1.5938-1.5962 1.5690-1.5710 131.91-133.59

Required:

Calculate the impact of undertaking multilateral netting by Kenduri Co and its three
subsidiary companies for the cash flows due in three months.

362
Solution

Based on spot mid-rates: US$1·5950/£1; CAD1·5700/£1; JPY132·75/£1

Multilateral netting involves minimising the number of transactions taking place

through each country’s banks.

This would limit the fees that these banks would receive for undertaking the
transactions.

It disadvantages may include:

• The central treasury may have difficulties in exercising control that the procedure
demands.

• Subsidiary company’s result may be distorted if the base currency is weaken in

the sustained period.

363
Syllabus E2c. c) Advise on the use of bilateral and multilateral netting and matching as tools for
minimising FOREX transactions costs and the management of market barriers to the free
movement of capital and other remittances.

Matching

This is the use of receipts in a particular currency to match payment in that same
currency.

Wherever possible, a company that expects to make payments and have receipts in
the same foreign currency should plan to of set it payments against its receipts in
that currency.

Since the company is offsetting foreign payment and receipt in the same currency, it
does not matter whether that currency strengthens or weakens against the
company’s domestic currency because there will be no purchase or sale of the
currency.

The process of matching is made simply by having a foreign currency account,

whereby receipts and payments in the currency are credited and debited to the
account respectively.

Probably, the only exchange risk will be limited to conversion of the net account
balance into the domestic currency.

This account can be opened in the domestic country or as a deposit account in

oversees country.

364
 Syllabus E3. The use of financial derivatives to hedge against
interest rate risk

Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure
i) Forward Rate Agreements (FRAs)
ii) Interest rate futures
iii) Interest rate swaps
iv) Interest rate options.

Interest Rate Risk

Fixed rate borrowing - risk that variable rates drop

Variable rate borrowing - risk that variable rates rise

Yield Curves (Return to debtholder)

Normal

Long term loans - higher yields (more risk)

Inverted

Longer term loans - Less yield (upcoming recession)

Flat

Yields are same for short and long term loans

365
The shape of the curve depends on:

In a bit more detail, the shape of the yield curve and thus the expectations of what
the interest rates will be depends on…

1. Liquidity preference

Investors want their cash back quickly therefore charge more for long term loans
which tie up their cash for longer and thus expose it to more risk

2. Expectations

Interest rates rise (like inflation) - so longer term more charged

NB. Recession expected means less inflation and less interest rates so producing
an inverted curve

3. Market segmentation

If demand for long-term loans is greater than the supply, interest rates in the long-
term loan market will increase

Differing interest rates between markets for loans of different maturity can also
explain why the yield curve may not be smooth, but kinked

4. Fiscal policy

Governments may act to increase short-term interest rates in order to reduce

inflation

This can result in short-term interest rates being higher than long-term interest
rates,

366
Why is yield curve important?

It predicts interest rates.

Normal curves are upward sloping.

Therefore, in these circumstances, use short term variable rate borrowing and long
term fixed rate.

• Gap Exposure?

The risk of an adverse movement in the interest rates reducing a company’s

cashflow

367
 Syllabus E3a.
a) Evaluate, for a given hedging requirement, which of the following is the most appropriate
given the nature of the underlying position and the risk exposure:
i) Forward Rate Agreements (FRAs)
ii) Interest rate futures
iii) Interest rate swaps
iv) Interest rate options.

Interest Rate - Forwards & Futures

Forward rate

This locks the company into one rate (no adverse or favourable movement) for a
future loan

If actual borrowing rate is higher than the forward rate then the bank pays the
company the difference and vice versa

They are usually only available on loans of at least £500,000

Procedure

1. Get loan as normal

2. Get forward rate agreement

3. Difference between 2 rates is paid/received from the bank

368
Illustration

Company gets 6% 600,000 FRA


Actual rate was 10%

• Solution

FRA receipt from bank (10%-6%) x 600k 24,000

Payment made (10% x 600,000) (60,000)
Net payment 36,000

Interest Futures

Standard contract for set interest rate at a set date

It is a market traded forward rate basically

Calculations of how these work are NOT required in the F9 exam. (ONLY
REQUIRED IN THE P4 EXAM)

As interest rates rise - bond prices fall

• Let’s say you are expecting interest rates to rise.

You would sell a bond futures contract, and when the interest rate rises, the value
of the bond futures contract will fall.

You would then buy the return of the contract at a normal price, making a profit.

369
As interest rates fall - bond prices increase

• Let’s say you are expecting interest rates to decline in the near future.

You would buy a futures contract for bonds.

When interest rates fall, the price of bonds increase, and so does the bonds
futures contract.

You then sell the bond futures contract at a higher price.

Borrowers sell futures to hedge against rises

Lenders buy futures to hedge against falls

370
 Syllabus E3a.
a) Evaluate, for a given hedging requirement, which of the following is the most appropriate
given the nature of the underlying position and the risk exposure:
ii) Interest rate futures

Interest rate futures

Interest rate futures

Are standardised exchange-traded contract agreement for settlement at a future

date, normally in March, June, September and December.

Pricing futures contracts

The pricing of an interest rate futures contract is determined by the three months
interest rate (r %) contracted for and is calculated as (100 – r).

For example if three months Eurodollar time deposit interest rate is 9%, a three
months Eurodollar futures contract will be priced at (100-9) = 91; and if interest rate
is 10%, the future price = 90= (100-10).

The decrease in price or value of the contract reflects the reduced attractiveness of a
fixed rate deposit in times of rising interest rates.

371
Ticks and tick values

Examples of ticks and tick values are:

• For 3 months Eurodollar futures, the amount of the underlying instrument is a

deposit of $1,000,000.

With a tick of 0.01%, the value of the tick is:

0.01% x $1m x 3/12 = $25

• For 3 months sterling, the underlying instrument is a 3 months deposit of

£500,000.

With a tick of 0.01%, the value of tick is:


500,000 x 0.01% x 3/12 = £12.5

Basis and basis risk

Example

If three months LIBOR is 7% and the September price of three months sterling future
is 92.70 now, at the end of March (let’s say), the basis is:

LIBOR (100 - 7) 93.00 


Futures 92.70

0.30% = 30 basis points

Maturity mismatch

Maturity mismatch occurs if the actual period of lending or borrowing does not match
the notional period of the futures contract (three months).

The number of futures contract used has to be adjusted accordingly.

Since fixed interest is involved, the number of contracts is adjusted in proportion to

the time period of the actual loan or deposit compared with three months.

372
Example

The company will need £18m in two months time for a period of four months.

The finance director fears that short term interest rates could rise by as much as 150
ticks (ie 1.5%).

LIBOR is currently 6.5% and AA plc can borrow at LIBOR plus 0.75%.

LIFFE £500,000 3 months futures prices are as follows:

December 93.40

March       93.10

Required:

Assume that it is now 1st December and that exchange traded futures contract
expires at the end of the month, estimate the result of undertaking an interest rate
futures hedge on LIFFE if LIBOR increases by 150 ticks (1.5%).


Solution

• What contract = 3 months contract = March futures contract.

• What type = sell as interest rates are expected to rise.

• Number of contracts

= (18m × 4) / (0.5m × 3) = 48 contracts.

• Tick size = 0.01% x 500,000 x 3/12 = 12.5

• Calculate the closing future price using basis and basis risk.

373
 Calculate opening basis as

Current LIBOR    6.5% = (100 –6.5) = 93.50

Future price                                    = 93.10

Basis                                               = 0.40

This will fall to zero when the contract expires, and it is assumed that it will fall at
an even or linear manner.

There are four months until expiry and the funds are needed in two month time,
therefore the expected basis at the time of borrowing is:

0.4 x 2/4 = 0.2

Closing future price:

LIBOR = 6.5% + 1.5% = 8% = (100 –8) = 92.0


Basis                                                         0.2

Future price                        92.0 - 0.2 = 91.8

• Calculate profit or loss

Selling price                                         93.10

Buying price                                         91.80

Gain per contract         93.10 - 91.80 = 1.3 = 130 ticks

Total profit 130 x 0.01% x 500,000 x 3/12 x 48 = £78,000


=OR

130 x 12.5 x 48 = £78,000

• Overall outcome (total cost)

Interest cost (8 +0.75) = 8.75% x 4/12 x 18m = 525,000


Profit on future position                                      (78,000)

Net cost                                                             447,000

Effective rate of interest

= (447,000/18m) x 12/4 x 100% 


= 7.45%

374
 Syllabus E3a.
a) Evaluate, for a given hedging requirement, which of the following is the most appropriate
given the nature of the underlying position and the risk exposure:
ii) Interest rate futures

LIBOR and LIBID

LIBOR

means the London inter-bank offered rate.

It is the rate of interest at which a top-level bank in London can borrow wholesale

short-term funds from another bank in London money markets.

LIBID

means the London inter-bank bid rate.

It is the rate of interest that a top- level bank in London could obtain short-term

deposits with another bank in London money markets.

The LIBID is always lower than the LIBOR

375
 Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
i) Forward Rate Agreements (FRAs)

Forward rate agreements (FRA)

FRA quotations or prices

FRAs are over-the counter transaction between a bank and a company.

The bank quotes two-way prices for each FRA period for each borrowing (loan) or
lending (deposit).

An example of bank quotations for FRA:

• 3 v 6     5.25 - 7.00



Means forward rate agreement that start in 3 months and last for 3 months at a
borrowing rate of 7% and lending rate of 5.25%.

Example

A bank has quoted the following FRA rates:

Assume that now is 1st October 2013.

2v7 5.25 - 6.25

3 v 5  6.00 - 7.00
4v6 5.85 - 6.35

Required:

Determine the FRA interest applicable to the following situations:

376
1. A company wants to borrow on 1st February 2014 and repay the loan on 1st of
April 2014.

2. A company wants to deposit money on 1st December 2013 and expect to

withdraw the amount for an investment on 1st of May 2014.

3. A company wants to borrow on 1st January 2014 and repay the loan on 1st of
March 2014


Solution

1. 4 v 6 at a borrowing rate of 6.35%

2. 2 v 7 at lending rate of 5.25%

3. 3 v 5 at a borrowing rate of 7.00%

377
Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
i) Forward Rate Agreements (FRAs)

Compensation payment

Compensation period is calculated as the difference between the FRA rate fixed and
the LIBOR rate at the fixing date (actual LIBOR) multiplied by the amount of the
notional loan/deposit and the period of the loan/deposit.

The FRA therefore protects against the LIBOR but not the risk premium attached to
the customer.

The settlement of FRA is made at the start of the loan period and not at the end and
therefore compensation payment occurs at start of the loan period.

As a result the compensation payment should be discount to it present value using

the LIBOR rate at the fixing date over the period of the loan.

Example

A company will have to borrow an amount of £100 million in four month time for a
period of six months.

The company borrow at LIBOR plus 50 basis points. 


LIBOR is currently 3.4%.

FRA prices (%)


4v10    3.63   3.68

378
Required:

Show the expected outcome of FRA:

(a) If LIBOR increases by 0.6%.

(b) If LIBOR decreases by 0.6%.

Solution

The FRA will be 4 v 10 as the money will be needed in four months time and will last
for six months.

The applicable interest rate will be 3.68%.

• (a) If LIBOR increases by 0.6%

LIBOR (Actual) at fixing date = 3.4 + 0.6 = 4.0%

Actual interest paid on the loan = 4.5% x 100m x 6/12 = £2.25m


(4 + 50/100)

Compensation received from the bank (4 – 3.68) = 0.32% x100m x 6/12 =

(£0.16m)

Net interest payment = £2.09m

Effective rate = (2.09/100) x (12/6) x 100% = 4.18%

Same as FRA rate + spread= 3.68 + 50/100 = 4.18%

• (b) If LIBOR decreases by 0.6%

LIBOR (Actual) at fixing date = 3.4 - 0.6 = 2.8%

Actual interest paid on the loan = 3.3% x 100m x 6/12 = £1.65m


(2.8 + 50/100)

Compensation received from the bank (2.8 – 3.68) = -0.88% x100m x 6/12 =
£0.44m

Net interest payment = £2.09m

Effective rate = (2.09/100) x (12/6) x 100% = 4.18%

Same as FRA rate + spread= 3.68 + 50/100 = 4.18%

379
 Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
iii) Interest rate swaps
iv) Interest rate options.

Interest Options and Swaps

Interest Rate Options

Grants the buyer the right (no obligation) to deal at a specific interest rate at a future
date.

At that date the buyer decides whether to go ahead or not

These protect against adverse movements in the actual interest rate but allow
favourable ones!

Clearly, because of this, the option involves buying at a premium.

Interest rate Swaps

2 companies agree to exchange interest rate payments on different terms (eg fixed
and variable).

For example one interest rate payment as a fixed rate and the other at a floating
rate.

Interest rate swaps can act as a means of switching from paying one type of interest
to another, allowing an organisation to obtain less expensive loans and securing
better deposit rates.

380
Advantages

1. Easy

2. Low transaction costs (compared to getting a different loan)

In the simplest form of interest rate swap

Party A agrees to pay the interest on party B's loan, while party B reciprocates by
paying the interest on A's loan.

If the swap is to make sense, the two parties must swap interest which has different
characteristics.

Assuming that the interest swapped is in the same currency, the most common
motivation for the swap is to switch from paying floating rate interest to fixed interest
or vice versa.

This type of swap is known as a 'plain vanilla' or generic swap.

Illustration 1

Company A 

- has a loan at FLOATING rate (LIBOR + 0.8%) from Bank A

- thinks that the interest rates go up so wants FIXED rate

Company B

- has a loan at FIXED rate (8%) from Bank B

- thinks that the interest rates go down so wants FLOATING rate

381
Solution

• Company A can use a swap to change from paying interest at a floating rate of
LIBOR + 0.8% to one of paying fixed interest of 8%.

So the Company A will pay:


8% to Company B

Libor + 0.8% to Bank A

And will receive LIBOR + 0.8% form Company B.

Therefore will effectively pay (8% FIXED + (LIBOR + 0.8%) - (LIBOR + 0.8%)) =
8% (FIXED).

• Company B will pay:


8% to Bank B

Libor + 0.8% to Company A

And will receive 8% form Company A.

Therefore will effectively pay (8% FIXED + (LIBOR + 0.8%) - 8% FIXED)  =

LIBOR + 0.8% (FLOATING)

LIBOR or the London Inter-Bank Offered Rate is the rate of interest at which banks
borrow from each other in the London inter-bank market.

A swap may be arranged with a bank, or a counterparty may be found through a

bank or other financial intermediary.

Fees will be payable if a bank is used.

However a bank may be able to find a counterparty more easily, and may have
access to more counterparties in more markets than if the company seeking the
swap tried to find the counterparty itself.

Swaps are generally terminated by agreeing a settlement interest rate, generally the
current market rate.

382
 Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
iv) Interest rate options.

Options on interest rate futures - calculation

Interest rate options calculations are very similar to Interest rate futures calculation

Call options = right to buy

Here we deposit some money - so we want to hedge against a fall in interest rates

To do this we want the option to buy futures (a call option)

Put options = right to sell

Here we borrow money so we need to hedge against an increase in interest rates

To do this we want the option to sell the futures (a put option)

Exam standard example (extract)

MooFace Co is expecting to receive $48,000,000 on 1 February 2014, which will be

invested until it is required for a large project on 1 June 2014 (meaning it will have 4
months to deposit money)

MooFace can invest funds at the relevant inter-bank rate less 20 basis points.

The current inter-bank rate is 4.09%.

Assume that it is 1 November 2013 now.

Expected futures price is $94·55 (If interest rates increase by 0·9%)

383
Expected futures price is $96·35 (If interest rates decrease by 0·9%)

The return on the futures market is 4.58%.

Options on three-month $ futures, $2,000,000 contract size, option premiums are in

annual %

calls calls calls strike puts puts puts

december march june december march june

0.342 0.432 0.523 94.50 0.090 0.119 0.271
0.097 0.121 0.289 95.00 0.312 0.417 0.520

Required

Recommend a hedging strategy for the $48,000,000 investment, if interest rates

increase or decrease by 0.9%.

Solution

Assume that MooFace will deposit $48,000,000 and therefore need to hedge against
a fall in interest rates and buy call options.

MooFace needs 32 March call option contracts ($48,000,000/$2,000,000 x 4

months/3 months).

Note:

Time period required for deposit = 4 months (1 February - 1 June).

Period of the call option = 3 months (it is always 3 months)

Contract size $2,000,000 (given in the question)

If interest rates increase by 0·9% to 4·99% (= 4.09% +

0.9%)

Exercise price  94.50 95.00

Futures price  94.55 94.55

384
Exercise ?  Yes No
Gain in basis points  5 0
Underlying investment return ( 4.99% - 20 basis point) = $766,400  $766,400
4·79% x 4/12 x $48,000,000

Gain on options (0·0005 x 2,000,000 contract size x 3/12 $8,000 $0

x 32 contracts, 0)  

Premium
0·00432 x $2,000,000 x 3/12 x 32  $(69,120)
0·00121 x $2,000,000 x 3/12 x 32  $(19,360)
Net return   $705,280 $747,040
Effective interest rate ($705,280 ($747,040) / $48m x 4·41% 4·67%
12/4months)

If interest rates increase by 0·9% to 3.19% (= 4.09% -

0.9%)
Exercise price  94.50 95.00
Futures price  96.35 96.35
Exercise ?  Yes Yes
Gain in basis points  185 135
Underlying investment return (3.19% - 20 basis point=) $478,400 $478,400
2·99% x 4/12 x $48,000,000 =
Gain on options 
(0·0185 x 2,000,000 x 3/12 x 32)  $296,000
(0·0135 x 2,000,000 x 3/12 x 32)  $216,000
Premium
As above $(69,120)
As above $(19,360)
Net return   $705,280 $675,040
Effective interest rate ($705,280 ($675,040) / $48m x 4·41% 4.22%
12/4months)

385
Discussion

The March call option at the exercise price of 94.50 seems to fix the rate of return at
4.41%, which is lower than the return on the futures market and should therefore be
rejected.

The March call option at the exercise price of 95.00 gives a higher return compared
to the FRA and the futures if interest rates increase, but does not perform as well if
the interest rates fall.

If MooFace takes the view that it is more important to be protected against a likely
fall in interest rates, then that option should also be rejected.

386
Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
iii) Interest rate swaps

Interest rate swaps - examples

Interest rate swap allows a company to exchange either:

Fixed rate interest payments into floating rate payment, or

Floating rate interest payment into fixed rate payments.

Example 1

aCOW plc has a loan of £20m repayable in one year.

aCOW plc pays interest at LIBOR plus 1.5% and could borrow fixed at 13% per
annum.

Milk plc also has a £20m loan and pays fixed interest at 12% per annum. 

It could borrow at a variable rate of LIBOR plus 2.5%.

The companies agree to swap their interest commitments with:

aCOW plc paying Milk plc fixed rate plus 0.5% and 

Milk plc paying aCOW plc LIBOR plus 2%.

An arrangement fee of £10,000 is charged on each company.

Required:

Calculate the total interest payments of the two companies over the year if LIBOR is
10% per annum

387
Solution

LIBOR at 10%

aCOW plc
£ 
Interest on own loan (10% + 1.5%) x 20m  (2,300,000)  (11.5%) 
Interest received from Milk (10%+2%) x 20m  2,400,000  12% 
Interest paid to Milk (12%+0.5%) x 20m  (2,500,000)  (12.5%) 
Total interest payment  (2,400,000)  (12%) 

Milk plc
£ 
Interest on own loan (12% x 20m) (2,400,000)  (12%) 
Interest received from aCOW (12% + 0.5%) x 20  2,400,000  12.5% 
Interest paid to aCOW (10% +2%) x 20m  (2,400,000)  (12%) 
Total interest payment  (2,300,000)  11.5% 

Calculation of arbitrage gains from the swap

Fixed rate  Floating rate 

aCOW 13%  LIBOR + 1.5 
Milk 12%  LIBOR + 2.5 
Difference  1% -1% 
Arbitrage gains =  1% - (-1%) = 2% 

Example 2

A company wants to borrow £6 million at a fixed rate of interest for four years, but
can only obtain a bank loan at LIBOR plus 80 basis points.

A bank quotes bid and ask prices for a four year swap of 6.45% - 6.50%.

388
Required:

(a) Show what the overall interest cost will become for the company, if it arranges a
swap to switch from floating to fixed rate commitments.

(b) What will be the cash flows as a percentage of the loan principal for an interest
period if the rate of LIBOR is set at 7%?

Solution 2

(a)
% 
Actual interest floating rate (LIBOR + 0.8) 
Swap
Receive floating rate interest from bank  LIBOR 
Pay fixed rate (higher-ask price)  (6.50) 
Overall cost  (7.3) 

(b)
% 
Actual interest floating rate (7 + 0.8)  (7.8) 
Swap
Receive floating rate interest from bank  7 
Pay fixed rate (higher-ask price)  (6.50)  0.5 
Overall cost  (7.3) 

389
Reasons for interest rate swaps

Interest rate swaps have several uses including:

1. Long-term hedging against interest rate movements as swaps may be arranged

for periods of several years.

2. The ability to obtain finance at a cheaper cost than would be possible by

borrowing directly in the relevant market.

3. The opportunity to effectively restructure a company’s capital profile without

physically redeeming debt.

4. Access to capital markets in which it is impossible to borrow directly, for example

because the borrower is relatively unknown in the market or has a relatively low
credit rating.

390
 Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
iv) Interest rate options.

Interest rate collar

A collar involves the simultaneous purchase and sale of both call and put options at

different exercise prices

The main advantage of using a collar instead of options to hedge interest rate risk is

lower cost.

However, the main disadvantage is that, whereas with a hedge using options the

buyer can get full benefit of any upside movement in the price of the underlying

asset, with a collar hedge the benefit of the upside movement is limited or capped as

well.

391
Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
iv) Interest rate options.

Market Value of Bonds

Have a think (or even better) a look at when we calculated the cost of debt for

Irredeemable debts (bonds)

You will see that we took the capital and interest and discounted it (at a guessed

rate) then compared it to the MV of the bond..and so on

This is because you calculate the MV of a loan or a bond by taking its Capital and

Interest and discounting it down by the cost of debt

Therefore the MV of Bonds is affected by:

1. Amount of interest payment

The market value of a traded bond will increase as the interest paid on the bond
increases, since the reward offered for owning the bond becomes more
attractive.

2. Frequency of interest payments

If interest payments are more frequent, say every six months rather than every
year, then the present value of the interest payments increases and hence so
does the market value.

3. Redemption value

392
 If a higher value than par is offered on redemption, the reward offered for owning
the bond increases and hence so does the market value.

4. Period to redemption

The market value of traded bonds is affected by the period to redemption, either
because the capital payment becomes more distant in time or because the
number of interest payments increases.

5. Cost of debt

The present value of future interest payments and the future redemption value
are heavily influenced by the cost of debt, i.e. the rate of return required by bond
investors.

This rate of return is influenced by the perceived risk of a company, for example
as evidenced by its credit rating.

As the cost of debt increases, the market value of traded bonds decreases, and
vice versa.

6. Convertibility 


If traded bonds are convertible into ordinary shares, the market price will be
influenced by the likelihood of the future conversion and the expected conversion
value, which is dependent on the current share price, the future share price
growth rate and the conversion ratio.

393
 Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
iv) Interest rate options.

Market value of bonds - calculation

Valuation of bonds

A ‘plain vanilla’ bond will make regular interest payments to the investors and pay the

capital to buy back the bond on the redemption date when it reaches maturity.

Therefore the value of a redeemable bond is the present value of the future income

stream discounted at the required rate of return (or yield or the internal rate of return)

Example

A company has issued 11% bonds, which are redeemable at par in 3 years’ time.

Investors require an interest yield of 10%.

Required

What will be the current market value of £100 of bond?

394
Solution

Year  Cash flow  10% discount factor  PV 

1-3  NET Interest 11 2.487  27.357
3  redemption value  100  0.751  75.10
Market value  102.457

This means that £100 of bonds will have a market value of £102.457.

Remember that there is an inverse relationship between the yield of a bond and its

price or value.

The higher rate of return (or yield) required, the lower the price of the bond, and vice

versa.

Gross redemption yield or yield to maturity or required rate of return

The cost of redeemable bond is the internal rate of return or required rate of return or

redemption yield or yield to maturity of the cash flows of the bond.

Example

A 5.6% bond is currently quoted at £95 ex-int. It is redeemable at the end of 5 years

at par. Corporation tax is 30%.

Required

Calculate gross cost of the bond.

395
Solution

Year  Cash 10% discount PV  DF5%  PV 

flow  factor 
0 MP (95)  1  (95)  1  (95) 
1-5 gross interest 5.6  3.791  21.23  4.329  24.24 
5 redemption 100  0.621 62.1 0.784  78.4 
value 
NPV  (11.67)  7.64 

IRR = 5% + (7.64 / 7.64 + 11.67) X(10% - 5%) = 7%

Standard exam question (extract)

The current $250 million borrowing is in the form of a 4% bond which is trading at

$98•71 per $100 and is due to be redeemed at par in three years. The issued bond

has a credit rating of AA.

Year 1 2 3
3.2% 3.7% 4.2%

396
Yield spreads (in basis points)

Bond Rating   1 year 2 years 3 years 4 years 5 years

AAA 5 9 14 19 25
AA 16 22 30 40 47
A 65 76 87 100 112

Required

Calculate the expected percentage fall in the market value of the existing bond if

Levante Co’s bond credit rating falls from AA to A.

Solution

Spot yield rates applicable to Levante Co (based on A credit rating)

1 year (3.2 + 0.65) = 3·85%


2 year (3.7 + 0.76) = 4·46%


3 year (4.2 + 0.87) = 5·07%

Bond value based on A rating =


Interest $((4% x $100) = 4) x 1·0385^–1 + $4 x 1·0446^–2 + $104 x 1·0507^–3 =

$97·18 per $100

Current price based on AA rating = $98·71

Fall in value = (97·18 – 98·71)/98·71 x 100% = 1·55%

397
 Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
iv) Interest rate options (including
collars).

Valuing bonds based on the yield curve

The spot yield curve can be used to estimate the price or value of a bond

Example

A company wants to issue a bond that is redeemable in four years for its par value or

face value of $100, and wants to pay an annual coupon of 5% on the par value.

Estimate the price at which the bond should be issued and the gross redemption

yield.

The annual spot yield curve for a bond of this risk class is as follows:

Year  Rate 
1 3.5% 
2 4.0% 
3 4.7% 
4 5.5% 

Solution

The market price of the bond should be the present value of the cash flows from the

bond (interest and redemption value) using the relevant year’s yield curve spot rate

as the discount factor.

398
Year  1 2 3 4

Cash flows  5 5 5 105

Df  1.035^-1  1.04^-2  1.047^-3  1.055^-4 

Present value  4.83  4.62  4.36  84.76 

The market price = $98.57

Given a market price of $98.57, the gross yield to maturity is calculated as follows:

Year CF   DF10%  PV  DF5%  PV 

0 MP (98.57)  1 (98.57) 1 (98.57) 

1-4 gross interest 5  3.170   15.85  3.546  17.73

4 Redemption value  100 0.683  68.3  0.823  82.3

NPV (14.42) 1.46

IRR or to maturity = 5% + (1.46 / 1.46 + 14.42) X(10% - 5%) = 5.46%

Note that the yield to maturity of 5.46% is not the same as the four year spot yield

curve rate of 5.5%.

The reasons for the difference are as follows:

1. The yield to maturity is a weighted average of the term structure of interest rates.

2. The returns from the bond come in earlier years, when the interest rates on the

yield curve are lower, but the largest proportion comes in Year 4.

399