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Advanced Financial
Management
Class Notes
March 2017
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2 w w w . s t ud yi nt e r a c t i ve . o r g
Contents
PAGE
w w w . s t ud y i nt e r a c t i v e . o r g 3
4 w w w . s t ud yi nt e r a c t i ve . o r g
Introduction to the
paper
w w w . s t ud y i nt e r a c t i v e . o r g 5
IN T R O D U C T I O N T O T H E P A P E R
Section A:
Section B:
6 w w w . s t ud yi nt e r a c t i ve . o r g
Formulae & tables
provided in the
examination paper
w w w . s t ud y i nt e r a c t i v e . o r g 7
F O R M U L A E & T A B L E S P R O V ID E D IN T H E E X A M I N A T IO N P A P ER
Vd
ke = kie + (1 – T)(kie – kd)
Ve
Ve Vd (1 - T)
βa = e + d
(Ve Vd (1- T )) (Ve Vd (1 - T))
D0 (1 + g)
P0 =
(re - g)
Ve Vd
WACC = ke +
V V kd(1–T)
Ve Vd e d
(1 hc ) (1 ic )
S1 = S0 Fo = So
(1 hb ) (1 ib )
1
PVR n
MIRR = (1 + re) – 1
PVI
8 w w w . s t ud yi nt e r a c t i ve . o r g
F O R M U L A E & T A BL ES P R O V ID ED IN T H E E X A M I N A T IO N P A P ER
Where:
ln(Pa /Pe ) + (r + 0.5s2 )t
d1 =
s t
and
d2 = d1 – s t
w w w . s t ud y i nt e r a c t i v e . o r g 9
F O R M U L A E & T A B L E S P R O V ID E D IN T H E E X A M I N A T IO N P A P ER
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15
________________________________________________________________________________
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
________________________________________________________________________________
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15
10 w w w . s t ud yi nt e r a c t i ve . o r g
F O R M U L A E & T A BL ES P R O V ID ED IN T H E E X A M I N A T IO N P A P ER
Annuity table
1 - (1 + r)-n
Present value of an annuity of 1 ie
r
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10
11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11
12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12
13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15
________________________________________________________________________________
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
________________________________________________________________________________
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 11
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15
w w w . s t ud y i nt e r a c t i v e . o r g 11
F O R M U L A E & T A B L E S P R O V ID E D IN T H E E X A M I N A T IO N P A P ER
0.5 0.1915 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224
0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549
0.7 0.2580 0.2611 0.2642 0.2673 0.2703 0.2734 0.2764 0.2794 0.2823 0.2852
0.8 0.2881 0.2910 0.2939 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133
0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389
1.0 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621
1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830
1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015
1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177
1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319
1.5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441
1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545
1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4616 0.4625 0.4633
1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706
1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767
2.0 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817
2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4842 0.4846 0.4850 0.4854 0.4857
2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890
2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916
2.4 0.4918 0.4920 0.4922 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936
2.5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952
2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964
2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974
2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981
2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986
3.0 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990
This table can be used to calculate N(di), the cumulative normal distribution functions
needed for the Black-Scholes model of option pricing.
If di > 0, add 0.5 to the relevant number above.
If di < 0, subtract the relevant number above from 0.5
12 w w w . s t ud yi nt e r a c t i ve . o r g
Chapter 1
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C H A P T E R 1 - C F O A N D F IN A N C I A L S T R A T E G Y F O R M U L A T I O N
14 w w w . s t ud yi nt e r a c t i ve . o r g
C H A P T E R 1 - C F O A N D F IN A N C I A L S T R A T E G Y F O R M U L A T I O N
1. Risk Management
All elements of risk need be identified and mitigated including;
1. Operational
2. Reputational
3. Political
4. Economic
5. Regulatory
6. Fiscal
Risk management will be evident across the entire syllabus, with specific coverage of
interest rate and foreign exchange risk covered in chapter 14 and 15.
w w w . s t ud y i nt e r a c t i v e . o r g 15
C H A P T E R 1 - C F O A N D F IN A N C I A L S T R A T E G Y F O R M U L A T I O N
Ordinary shares
1. Owning a share confers part ownership.
2. High risk investments offering higher returns.
3. Permanent financing.
4. Post-tax appropriation of profit, not tax efficient.
5. Marketable if listed.
Advantages
1. No fixed charges (e.g. interest payments).
2. No repayment required.
3. Carries a higher return than loan finance.
4. Shares in listed companies can be easily disposed of at a fair value.
Disadvantages
1. Issuing equity finance can be expensive in the case of a public issue (see later).
2. Problem of dilution of ownership if new shares issued.
3. Dividends are not tax-deductible.
4. A high proportion of equity can increase the overall cost of capital for the
company.
5. Shares in unlisted companies are difficult to value and sell.
Preference shares
1. Fixed dividend
2. Paid in preference to (before) ordinary shares.
3. Not very popular, it is the worst of both worlds, ie
● not tax efficient
● no opportunity for capital gain (fixed return).
16 w w w . s t ud yi nt e r a c t i ve . o r g
C H A P T E R 1 - C F O A N D F IN A N C I A L S T R A T E G Y F O R M U L A T I O N
DEBT
The loan of funds to a business without any ownership rights.
1. Paid out as an expense of the business (pre-tax).
2. Risk of default if interest and principal payments are not met.
Security
Charges
The debtholder will normally require some form of security against which the funds
are advanced. This means that in the event of default the lender will be able to take
assets in exchange of the amounts owing.
Covenants
A further means of limiting the risk to the lender is to restrict the actions of the
directors through the means of covenants. These are specific requirements or
limitations laid down as a condition of taking on debt financing. They may include:
1. Dividend restrictions
2. Financial ratios
3. Financial reports
Types of debt
Debt may be raised from two general sources, banks or investors.
Bank finance
For companies that are unlisted and for many listed companies the first port of call
for borrowing money would be the banks. These could be the high street banks or
more likely for larger companies the large number of merchant banks concentrating
on ‘securitised lending’.
This is a confidential agreement that is by negotiation between both parties.
Traded investments
Debt instruments sold by the company, through a broker, to investors. Typical
features may include:
1. The debt is denominated in units of $100, this is called the nominal or par value
and is the value at which the debt is subsequently redeemed.
2. Interest is paid at a fixed rate on the nominal or par value.
3. The debt has a lower risk than ordinary shares. It is protected by the charges
and covenants.
w w w . s t ud y i nt e r a c t i v e . o r g 17
C H A P T E R 1 - C F O A N D F IN A N C I A L S T R A T E G Y F O R M U L A T I O N
OTHER SOURCES
Venture Capital
Capital provided by an organisation for a high risk enterprises which demonstrate
high growth potential. Funds will usually be provided in return for an equity stake in
the business, with a pre-determined exit strategy.
Grants
1. Often related to regional assistance, job creation or for high tech companies.
2. Important to small and medium sized businesses (ie unlisted).
3. They do not need to be paid back.
4. Remember the EU is a major provider of loans.
Retained earnings
The single most important source of finance, for most businesses the use of retained
earnings is the core basis of their funding.
Warrants
1. An option to buy shares at a specified point in the future for a specified
(exercise) price.
2. The warrant offers a potential capital gain where the share price may rise above
the exercise price.
3. The holder has the option to buy the share. On a future date at a pre-
determined date.
4. The warrant has many uses including:
● additional consideration when issuing debt.
● incentives to staff.
18 w w w . s t ud yi nt e r a c t i ve . o r g
C H A P T E R 1 - C F O A N D F IN A N C I A L S T R A T E G Y F O R M U L A T I O N
BEHAVIOURAL FINANCE
Financial management theory assumes that decisions will always be made in a
rational manner, however this make not be the case and as such irrational decisions
and systematic errors will occur.
This theory undermines the efficient market hypothesis which suggests that no
excessive gains can be made, as information is effectively absorbed in to the share
price. However examples of such irrationality which creates opportunity for arbitrage
include;
Overconfidence
Where investors overestimate the forecasted financial performance, and as a
consequence make inaccurate decisions.
Confirmation Bias
Where investors pay consideration only to information which supports their view and
overlook anything that suggests an error has been made
Conservatism
Where investors are immune to positive information and do not believe that the
outcome is likely to be repeated, as such the information is not absorbed into the
share price.
DIVIDEND POLICY
Dividend decisions relate to the determination of how much and how frequently cash
can be paid out of the profits of an entity as income for its owners. The owners of
profit-making organisations look for reward from their investment in two ways: the
growth of the capital invested (capital gains), and the cash paid out as income
(dividend).
The dividend decision thus has two elements: the amount to be paid out and the
amount to be retained to support the growth of the entity, the latter being a financing
decision; the level and regular growth of dividends represent a significant factor in
determining a profit-making company’s market value, that is the value placed on its
shares by the stock market.
w w w . s t ud y i nt e r a c t i v e . o r g 19
C H A P T E R 1 - C F O A N D F IN A N C I A L S T R A T E G Y F O R M U L A T I O N
1. Profitability
Dividends are paid out of distributable profit and a company cannot pay dividends
which is higher than its distributable profit. For all other things being equal, a
company with stable profits is more likely to be able to pay out a higher percentage
of earnings than a company with fluctuating profits.
2. Liquidity
To pay dividends sufficient liquid funds should be available. Even very profitable
companies might sometimes find it difficult to pay dividends if resources are tied up
in other forms of asset, especially if bank overdraft facilities are not available.
3. Repayment of debt
Dividend pay-out may be made difficult if debt is scheduled for repayment and this
is not financed by a further issue of funds.
4. Restrictive covenants
The articles of association may contain agreed restrictions on dividends. In addition,
some form of debt may have restrictive covenants limiting the amount of dividend
payments or the rate of growth that applies to them.
5. Rate of expansion
Growth companies faced with many investment opportunities may prefer to finance
their expansion by retaining a large proportion of their profit instead of distributing
the profit by way of dividend and asking the existing shareholders to provide extra
money for expansion through rights issue which will incur issue cost.
6. Control
The use of retained earnings to finance new projects preserves the company’s
ownership and control.
7. Policy of competitors
Dividend policies of competitors may influence corporate dividend policy. It may be
difficult, for example, to reduce a dividend for the sake of further investment, when
competitors follow a policy of higher distribution.
8. Signalling effect
This is the information content of dividend. Dividends are seen as signals from the
company to the financial markets and shareholders. Investors perceive dividend
announcements as signals of future prospects for the company. A company should
therefore consider the likely effect on share prices of the announcement of a proposed
dividend.
20 w w w . s t ud yi nt e r a c t i ve . o r g
C H A P T E R 1 - C F O A N D F IN A N C I A L S T R A T E G Y F O R M U L A T I O N
11. Taxation
In some countries dividends and capital gains are subject to different marginal rates
of taxation, usually with capital gains being subject to lower level of taxation than
dividend. This distortion in the personal tax system can have an impact on investors’
preference. The preference would very much depend on the tax position of investors.
This is the clientele effect.
4. Zero Payout
The company chooses not to pay a dividend as they wish to retain the funds for
reinvestment. This would usually occur in fast growing companies, or those in
financial distress.
w w w . s t ud y i nt e r a c t i v e . o r g 21
C H A P T E R 1 - C F O A N D F IN A N C I A L S T R A T E G Y F O R M U L A T I O N
1. Signalling effect
In a semi-strong form efficient market, information available to directors is more
substantial than that available to shareholders, so that information asymmetry exists.
Investors perceive dividend announcements as signals of future prospects for the
company. The signalling effect also depends on the dividend expectations in the
market. The size and direction of the share price change will depend on the difference
between the dividend announcement and the expectations of shareholders.
2. Clientele effect
The clientele effect states that shareholders are attracted to particular companies as
a result of being satisfied by their dividend policies. A company with an established
dividend policy is therefore likely to have an established dividend clientele. The
existence of this dividend clientele implies that the share price may change if there
is a change in the dividend policy of the company, as shareholders sell their shares
in order to reinvest in another company with a more satisfactory dividend policy.
22 w w w . s t ud yi nt e r a c t i ve . o r g
C H A P T E R 1 - C F O A N D F IN A N C I A L S T R A T E G Y F O R M U L A T I O N
w w w . s t ud y i nt e r a c t i v e . o r g 23
C H A P T E R 1 - C F O A N D F IN A N C I A L S T R A T E G Y F O R M U L A T I O N
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.
This involves giving ordinary shareholders the choice of receiving dividend in the form
of shares instead of in the form of cash.
Scrip dividend if accepted by shareholders has the advantage of preserving the
liquidity position of the company because it will reduce the cash outflow and enables
the company to use internally generated funds to finance new investments.
Scrip dividend will also lead to a decrease in gearing because of the increase in issued
shares and may help to increase the company’s debt capacity.
A disadvantage of scrip dividend is that it may lead to increase in future dividend
payments as a result of increase in the number of shares (assuming constant dividend
per share).
Another issue is that it is optional and shareholders may not accept the proposal.
In addition, scrip dividend may give wrong signal to the market as to why the
company is making such proposal and may have adverse effect on the share price.
Share repurchases
Companies with cash surpluses, but having no positive NPV projects, 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.
This will have the effect of using up the surplus cash, increasing future EPS (because
of the reduction in the number of shares in issue), changing the gearing level of the
company and (hopefully) reducing the likelihood of a takeover. However share
repurchases are often seen as an admission that the company cannot make better
use of shareholders’ funds.
24 w w w . s t ud yi nt e r a c t i ve . o r g
C H A P T E R 1 - C F O A N D F IN A N C I A L S T R A T E G Y F O R M U L A T I O N
Required:
Discuss:
(a) The apparent dividend policy followed by each company over the past six years
and comment on the possible relationship of those policies to the companies’
market values and current share prices; and
(b) Whether there is an optimal dividend policy for Cedi plc that might increase
shareholders’ value.
w w w . s t ud y i nt e r a c t i v e . o r g 25
Chapter 2
Governance &
Ethics
Financial objectives
Financial objectives of commercial companies may include:
1. Maximising shareholders’ wealth
2. Maximising profits
3. Satisficing.
Stakeholders
We tend to focus on the shareholder as the owner and key stakeholder in a business.
A more comprehensive view would be to consider a wider range of interested parties
or stakeholders.
Stakeholders are any party that has both an interest in and relationship with the
company. The basic argument is that the responsibility of an organisation is to
balance the requirements of all stakeholder groups in relation to the relative
economic power of each group.
26 w w w . s t ud yi nt e r a c t i ve . o r g
C H A P T ER 2 – G O V ER N A N C E & ET H IC S
Agency theory
Principal
Agent
Agency relationships occur when one or more people employ one or more persons as
agent. The persons who employ others are the principals and those who work for
them are called the agent
In an agency situation, the principal delegate some decision-making powers to the
agent whose decisions affect both parties. This type of relationship is common in
business life. For example shareholders of a company delegate stewardship function
to the directors of that company. The reasons why an agents are employed will vary
but the generally an agent may be employed because of the special skills offered, or
information the agent possess or to release the principal from the time committed to
the business.
w w w . s t ud y i nt e r a c t i v e . o r g 27
C H A P T E R 2 - G O V E R N A N C E & E T H IC S
Goal Congruence
Goal congruence is defined as the state which leads individuals or groups to take
actions which are in their self-interest and also in the best interest of the entity.
For an organisation to function properly, it is essential to achieve goal congruence at
all level. All the components of the organisation should have the same overall
objectives, and act cohesively in pursuit of those objectives.
In order to achieve goal congruence, there should be introduction of a careful
designed remuneration packages for managers and the workforce which would
motivate them to take decisions which will be consistent with the objectives of the
shareholders.
Ethics
Consideration of ethical implications which may impede shareholder wealth
maximisation as consideration must be given to other stakeholder groups
Modern thinking recognises the link between an ethical approach and enhanced
revenue, by contrast unethical behaviour may have consequences such as customer
and supplier boycotts which impact upon financial and business performance.
Ethical framework for decision making
Integrity
Objectivity
Professional competence
Confidentiality
Professional behaviour
28 w w w . s t ud yi nt e r a c t i ve . o r g
C H A P T ER 2 – G O V ER N A N C E & ET H IC S
Environmental Issues
Exam questions may require you to consider environmental issues and their impact
upon corporate objectives.
Ensure that you consider a decision with the potential conflict and damage to the
business reputation
Governance
Corporate governance
Clearly the executive directors of a listed company are both decision-makers and
major stakeholders. They are therefore open to the accusation of making key
decisions for their own benefit. Following a number of notable financial scandals in
the UK during the late 20th century (eg the Maxwell affair and the collapse of the
BCCI) the Cadbury Committee was set up to investigate procedures for appropriate
corporate governance.
The Cadbury Code (1992) defined corporate governance as “the system by which
companies are directed and controlled”. This initial document has been subject to
subsequent amendments by the Greenbury, Hampel and Higgs Reports. The
Financial Conduct Authority requires listed companies to confirm that they have
complied with the Code’s provisions or – in the event of non-compliance – to provide
an explanation of their reasons for departure.
International Comparisons
The broad principles of corporate governance are similar in the UK, the USA and
Germany, but there are significant differences in how they are applied. Whereas the
UK and Germany have voluntary corporate governance codes, the US system is based
upon legislation within the Sarbanes-Oxley Act.
w w w . s t ud y i nt e r a c t i v e . o r g 29
C H A P T E R 2 - G O V E R N A N C E & E T H IC S
Germany
As both the UK and Germany are members of the EU, they must both follow EU
directives on company law. 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), whereas German companies have a two-tier board of directors.
The Supervisory Board typically includes representatives from major banks that have
historically been large providers of long-term finance to German companies (and are
often major shareholders).
Japan
Although there are signs of change in Japanese corporate governance, much of the
system is based upon negotiation or consensual management rather than upon a
legal or even a self-regulatory framework. Banks as well as representatives of other
companies (in their capacity as shareholders) also sit on the Boards of Directors of
Japanese companies.
It is not uncommon for Japanese companies to have cross holdings of shares with
their suppliers, customers and banks etc., all being represented on each other’s Board
of Directors.
30 w w w . s t ud yi nt e r a c t i ve . o r g
Chapter 3
Economic
Environment for
Multinationals
INTERNATIONAL TRADE
International trade occurs to allow companies to enjoy economies of scale, increase
their turnover and profits, use up spare capacity and to promote division of labour.
In economics, theoretical justifications of the benefits of international trade were put
forward by:
● Adam Smith – the theory of absolute advantage.
● David Ricardo – the theory of comparative advantage.
Sources of advantage may include close proximity to raw materials or markets,
access to capital or an available labour force with the necessary skills.
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C H A P T E R 3 - E C O N O M I C E N V I R O N M EN T F O R M U L T IN A T IO N A L S
Trade blocks
Trade blocs arise where a group of countries conspire to promote trade between
themselves. Trade blocs include:
● Free trade area – free movement of goods and services (no internal tariffs)
between member countries, with external tariffs set individually, eg North
American Free Trade Area (NAFTA).
● Customs union – no internal tariffs between member countries and with
common external tariffs against non-member countries, eg the former
European Economic Community.
● Common market – no internal tariffs, common external tariffs, as well as the
free movement of labour and capital between member countries, eg European
Union.
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N.B. The statistics that are gathered are not wholly perfect and some transactions
will be omitted. Thus the balancing item is unavoidable.
Temporary deficits can be financed by short term borrowing, but persistent balance
of payments deficits usually require government intervention, such as:
● Devaluation of the currency or government intervention on the foreign
exchange markets.
● Raising interest rates.
● Restricting the money supply.
● Imposing tariffs or import quotas.
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C H A P T E R 3 - E C O N O M I C E N V I R O N M EN T F O R M U L T IN A T IO N A L S
the IMF in loans to developing countries and provides bridging finance for members
pending their securing longer term finance for balance of payments deficits.
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.
● 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.
● 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.
● 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.
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Countertrade
This is an agreement in which the export of goods to a country is matched by a
commitment to import goods from that country. This usually occurs because the
foreign importing country either lacks foreign currency, has exchange controls in
place or where there are barriers to imports which can be circumvented by means of
countertrade.
The volume of countertrade is now reported at about 30% of total international
trade. In the case of some Eastern European and Third World countries it is the
only way of organizing international trade because of their shortage of foreign
currency. Many countertrade deals can be highly complex involving many parties.
36 w w w . s t ud yi nt e r a c t i ve . o r g
Chapter 4
Discounted Cash
Flow techniques
Discounting cash flow techniques are investment appraisal techniques which take into
account both the time value of money and also total profitability over the project life.
It is therefore superior to both the ARR and the payback as methods of investment
appraisal.
The discounting methods include:
● Net present value,
● Internal rate of return,
● Modified internal rate of return,
● Discounted payback period,
● Duration,
● Profitability index,
● Adjusted present value.
The assumed objective is to maximise the shareholders’ wealth.
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C H A P T E R 4 – D IS C O U N T E D C A S H F L O W T E C H N IQ U E S
Decision rule
1. If he NPV is positive, then the cash inflows from the investment will yield a
return in excess of the cost of capital and so the project should be undertaken.
2. If the NPV is negative, the cash inflows from the investment will yield a return
below the cost of capital, and the project should not be undertaken.
3. If the NPV is exactly zero, then the cash inflows from the investment will yield
a return which is exactly the same as the cost of capital, so the company should
be indifferent between undertaking and not undertaking the project.
Internal rate of return is that discount rate which gives a net present value of zero.
Alternatively, the IRR can be described as the maximum cost of capital that can be
applied to finance a project without causing harm to the shareholders.
It is sometimes called the yield, or DCF yield, or internal yield, or discounted rate of
return.
The IRR is found approximately using interpolation. This is given as:
NPVL
IRR = L% H% L%
NPVL NPVH
Where:
L = lower discount rate (say 10%)
H = higher discount rate (say 15%)
NPVL = net present value of L% = 190
NPVH = net present value of H% = 65
IRR = 10% + (190/ 190-65) x (15% -10%)
= 10% + 7.6% = 17.6%
Decision rule
If the expected (calculated) IRR exceeds the cost of capital, the project should be
undertaken.
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C H A P T ER 4 – D IS C O U N T ED C A S H F L O W T E C H N IQ U E S
Working capital
Some capital investment involves an investment in working capital as well as fixed
assets. Working capital should be considered to consist of investments in stocks and
debtors, minus trade creditors.
An increase in working capital reduces cash flows and a reduction in working capital
improves the cash flow in the year that it happens
By convention, in DCF analysis, if a project will require an investment in working
capital, the investment is treated as a cash outflow at the beginning of the year in
which it occurs. The working capital is eventually released or recouped at the end of
the project, when it becomes a cash inflow.
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C H A P T E R 4 – D IS C O U N T E D C A S H F L O W T E C H N IQ U E S
Capital allowance
The capital allowances are used to reduce the taxable profits and the consequence
reduction in a tax payment should be treated as a cash savings arising from the
acceptance of a project.
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C H A P T ER 4 – D IS C O U N T ED C A S H F L O W T E C H N IQ U E S
Example Jato Co
Jato Co is considering a project – whether or not to commercialise an innovative
muscle toning device (MTD) that will be used in the treatment of sporting injuries.
It is expected that the commercial life of MTD will be four years after which
technological advances will bring more sophisticated devices to the market and the
sales of MTD will fall to virtually zero. $8,000,000 has been spent in developing and
testing the device over the past year. Initial market research has been conducted
at a cost of $2,500,000 and is due to be paid shortly.
Information on future returns from the investment has been forecast to be as
follows:
Year 1 2 3 4
Units demand 20,000 70,000 125,000 20,000
Selling Price in current price terms ($/unit) 2,000 2,200 1,600 1,500
Variable cost in current price terms ($/unit) 900 1,000 1,020 1,020
Fixed costs in current price terms
10 10 10 10
($million/year)
Selling price inflation and fixed costs inflation are expected to be 5% per year and
variable cost inflation is expected to be 4% per year. Fixed costs represent
incremental fixed production overheads which are wholly attributable to the project.
The production equipment for the new device would cost $120 million and an
additional initial investment of $20 million would be needed for working capital. The
equipment is expected to be sold at the end of four years for $10 million when the
production and sales cease. The average general level of inflation is expected to be
3% per year and working capital would experience inflation of this level.
Capital allowances (tax-allowable depreciation) on a 25% reducing balance basis
could be claimed on the cost of equipment. Profit tax of 30% per year will be
payable one year in arrears. A balancing allowance would be claimed in the fourth
year of operation.
Jato Co has a real cost of capital of 7.8%.
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Decision rule
Where there is conflict between IRR and NPV, accept the project with the larger NPV.
Example 2
Project A Project B
NPV 610 1,026
IRR 20% 18%
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C H A P T ER 4 – D IS C O U N T ED C A S H F L O W T E C H N IQ U E S
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%.
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C H A P T E R 4 – D IS C O U N T E D C A S H F L O W T E C H N IQ U E S
Duration
Duration is the average time taken to recover the cash flows on an investment. The
average is taken as the value weighted average of the number of the year (1 to n)
in which the cash flows arise. In capital investment, the duration can be calculated
using either the firm’s original outlay, or the present value of its future cash flows as
the basis for the annual weighting.
If duration is based upon the average time to recover the initial capital investment:
1. Calculate the value of each future net cash flow, discounted at the IRR of the
project;
2. Calculate each year’s discounted cash flow as a proportion of the original capital
outlay;
3. Take the time from investment to each discounted cash flow and multiply by
the respective proportion. Finally, sum the weighted year values.
If duration is based upon the average time taken to recover the present value of the
project:
1. Calculate the value of each future net cash flow, discounted at the chosen
hurdle rate;
2. Calculate each year’s discounted cash flow as a proportion of the PV of total
cash inflows;
3. Take the time from investment to each discounted cash flow and multiply by
the respective proportion. Finally, sum the weighted year values.
Year 0 1 2 3 4
Incremental cash (£34,000) £7,600 £16,500 £13,000 £6,600
flows
Required:
Establish both the duration to recover the original investment (using the
IRR of this project of 11.13%) and the duration to recover the present value
of the project (at an 8% hurdle rate).
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C H A P T ER 4 – D IS C O U N T ED C A S H F L O W T E C H N IQ U E S
CAPITAL RATIONING
Capital rationing occurs whenever there is a budget ceiling or a market constraint on
the amount of funds which can be invested during a specific period of time. It is a
situation where there are insufficient funds to finance all profitable projects.
w w w . s t ud y i nt e r a c t i v e . o r g 45
C H A P T E R 4 – D IS C O U N T E D C A S H F L O W T E C H N IQ U E S
1. Divisible
An entire project or any fraction of that project may be undertaken. In this event
projects may be ranked by means of a profitability index, which can be calculated
by dividing the present value (or NPV) of each project by the capital outlay required
during the period of restriction.
Projects displaying the highest profitability indices will be preferred. Use of the
profitability index assumes that project returns increase in direct proportion to the
amount invested in each project.
2. Indivisible
An entire project must be undertaken, since it is impossible to accept part of a project
only. In this event the NPV of all available projects must be calculated. These
projects must then be combined on a trial and error basis in order to select that
combination which provides the highest total NPV within the constraints of the capital
available. This approach will sometimes result in some funds being unused.
1. Divisible
In this event, linear programming is used to determine the optimal combination of
projects.
Two techniques, which both result in identical project selections can be used,
ie the objective is to either:
● Maximise the total NPV from the investment in available projects, or
● Maximise the present value (PV) of cash flows available for dividends.
2. Indivisible
In this event, integer programming would be required to determine the optimal
combination of investments.
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C H A P T ER 4 – D IS C O U N T ED C A S H F L O W T E C H N IQ U E S
Initial
Project Year 1 2 3 4 5 outlay
£ £ £ £ £ £
A 70,000 70,000 70,000 70,000 70,000 246,000
B 75,000 87,000 64,000 180,000
C 48,000 48,000 63,000 73,000 175,000
D 62,000 62,000 62,000 62,000 180,000
E 40,000 50,000 60,000 70,000 40,000 180,000
F 35,000 82,000 82,000 150,000
Projects A and E are mutually exclusive. All projects are believed to be of similar
risk to the company’s existing capital investments.
Any surplus funds may be invested in the money market to earn a return of 9% per
year. The money market may be assumed to be an efficient market. Banden’s cost
of capital is 12% per year.
Required:
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C H A P T E R 4 – D IS C O U N T E D C A S H F L O W T E C H N IQ U E S
The capital available at Year 0 is only £50,000 and only £12,500 is available at Year
1, together with any cash inflows from the projects undertaken at Year 0. From Year
2 onwards there is no restriction on the access to capital. The appropriate cost of
capital is 10%.
Required:
Formulate both:
1. The NPV linear programme, and
2. The PV of dividends linear programme.
48 w w w . s t ud yi nt e r a c t i ve . o r g
C H A P T ER 4 – D IS C O U N T ED C A S H F L O W T E C H N IQ U E S
Dual Values
Dual values (also referred to as “shadow prices”) reflect the change in the objective
function as a result of having one more or one less unit of scarce resource. In the
context of capital rationing the scarce resource is available cash, so that the dual
price states the change in the objective function if one more unit of currency (eg £1)
becomes available or if one less GB pound is invested.
Shadow prices can therefore be used to calculate the impact of raising additional
finance for further investment or the effect of diverting capital away from current
projects into newly discovered investments.
The dual price depends upon which method is used to formulate the linear
programme ie
● Under the NPV formulation, it reflects the change in the NPV if £1 more or £1
less is available
● Under the PV of dividends formulation, it reflects the change in the PV of
cash available for dividend payments if £1 more or £1 less capital is available.
Dual prices relate only to marginal changes in the availability of capital. Thus,
suppose that a dual value of £1.25 arises under the PV of dividends method, this
means that if an additional £1 of funds became available, the total value of the
objective function would rise by £1.25. It does not necessarily mean that if an
additional £10,000 became available, that the value of the objective function would
increase by (£10,000 x 1.25) £12,500.
Shadow prices can therefore be used to test the validity of new investments which
emerge. The cash flows generated by the new project can be compared with the
cash flows lost by diverting funds from existing investments, thereby calculating the
effect of diversion of that finance.
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C H A P T E R 4 – D IS C O U N T E D C A S H F L O W T E C H N IQ U E S
A new investment opportunity has emerged with the following cash flows:
Cash flow
£’000
Year 0 (75)
Year 1 50
Year 2 50
Required:
Appraise the new project using both the NPV dual prices and the PV of
dividend shadow prices.
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C H A P T ER 4 – D IS C O U N T ED C A S H F L O W T E C H N IQ U E S
The board of directors of that company has approved the following capital
expenditure programme for those same accounting periods:
£
Year 0 40,000
Year 1 35,000
Year 2 42,500
The four projects are expected to produce the following positive net present values:
Required:
Discuss the approach for calculating the optimum mix of projects.
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Risk
Future events might not be certain, because there are several possible outcomes.
However, it might be possible to predict the likelihood that each possible outcome
will occur. The predictions of risk in the future might be based on statistical
assessment of what has occurred in the past.
With risk analysis, the probabilities might be obtained from analysing what has
happened in the past.
Uncertainty
Uncertainty exist where there are several possible outcomes, but there is little
previous statistical evidence to enable the possible outcomes to be predicted.
Sensitivity analysis
Sensitivity analysis is one method of analysing the risk surrounding a capital
expenditure project and enables an assessment to be made of how responsive the
project’s NPV is to changes in the variables that are used to calculate that NPV.
It is applied by varying the expected cash flows of a project to measure what would
happen if the investment were to work out somewhat worse than expected.
The NPV could depend on a number of variables such as
● initial cost or investment
● estimated selling price
● estimated sales volume or quantity
● estimated cost of capital
● estimated operating cost, both fixed and variable
● The number of years of the project.
The basic approach to sensitivity analysis is to calculate the net present value of the
project under alternative assumptions to determine how sensitive it is to changing
conditions.
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NPV of project
% change = 100
PV of cash flows affected by the variable
Example 9 CC plc
An expected NPV has already been calculated for the following project of CC plc:
Year Cash flow 10% discount factor Present value
£000 £000
0 Initial investment (100) 1 (100.00)
1-3 Revenues 40 2.487 99.48
3 Scrap value 10 0.751 7.51
NPV +6.99
Required:
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Example 10
Andrews 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.
54 w w w . s t ud yi nt e r a c t i ve . o r g
Chapter 5
Application of
Option Pricing in
Investment
Decisions
Terminology of Options
Call option
A call option is the option that gives its holder the right, but not an obligation to buy
the underlying item at the specific price on or before the specific expiry date of the
option. For example, a call option on shares of central college, gives its holder the
right to buy that number of shares in central college at the fixed price on or before
the expiry date of the option.
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Put option
A put option is the option that gives its holder the right to sell the underlying item
at the specific price on or before the specific expiry date of the option. For example,
a put option in central college shares, gives its holder the right to sell that number of
shares at the specific price on or before the specific expiry date of the option.
Intrinsic value
Intrinsic value is the difference between the strike price for the option and the current
market price of the underlying item. However, an in-the-money option has an
intrinsic value; but because intrinsic value cannot be negative, an out of the money
option has an intrinsic value of zero.
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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.
ln Pa / Pe r 0.5s2 t
d1 =
s t
d2 = d1 – st
ln = natural log
Nd1 and Nd2 are the normal distribution function of d1 and d2 respectively.
Where:
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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.
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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.
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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.
The pricing model for call options are based on the Black-Scholes model.
Example 3
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%.
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THE GREEKS
In principle, an option writer could sell options without hedging his position. If the
premiums received accurately reflect the expected pay-outs at expiry, there is
theoretically no profit or loss on average. This is analogous to an insurance company
not reinsuring its business. In practice, however, the risk that any one option may
move sharply in-the-money makes this too dangerous. In order to manage a
portfolio of options, the dealer must know how the value of the options he has sold
and bought will vary with changes in the various factors affecting their price. Such
assessments of sensitivity are measured by the “Greeks”, which can be used by
options traders in evaluating their hedge positions.
1. Delta
For each option held, the delta value can be established i.e.
2. Gamma
Gamma measures the amount by which the delta value changes as underlying
security prices change. This is calculated as the:
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3. 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:
4. 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:
5. 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:
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Chapter 6
Impact of financing
on investment
decisions
Cost of Capital
The cost of capital is the return that investors expect to be paid for putting funds into
the company. In order words, it is the cost incurred by a company for raising money
to finance its activities.
The elements of cost of capital are:
● The risk-free rate of return – return required from an investment which is
completely free from risk, example return on government securities.
● The risk premium – return to compensate for financial risk (having debts in
capital structure) and business risk (return to compensate for uncertainty about
the future and about a firm’s business prospects).
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C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M E N T D E C I S IO N S
D
Ke =
P0 (ex-div)
D0 (1 g)
Ke = g
P0
D1
= g
P0
Where
Ke = cost of equity g = constant growth rate
D0 = current dividend P0 = ex-div market price
Example 1
A company is expected to pay a constant dividend of 40 pence per share. The current
ex-div market price is £3 per share.
Example 2
A share is quoted cum div at £4.50. The dividend has been declared at £0.50.
w w w . s t ud y i nt e r a c t i v e . o r g 65
C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M EN T D E C I S I O N S
Historic pattern
A growth rate may be estimated from historic dividend pattern, as follows:
1/n
d0
1 = g
dn
Where:
dn = dividend in the past. That is the base dividend.
d0 = the current dividend. That is last dividend paid.
n = number of years of growth.
Example 3
A company currently pays a dividend of 32p. Five years ago the dividend was 20p.
Example 4
The dividends of Paulto plc over the last five years are given below:
Year Dividends
£
1 180,000
2 210,000
3 220,000
4 245,000
5 280,000
Paulto plc’s current ex-div market price is £4 and it has in issue 1,000,000 ordinary
shares.
Earnings
= 100%
Book value of equity capital employed
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C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M E N T D E C I S IO N S
Earnings-dividend
= 100%
Earnings
Example 5
Consider the following:
Current cum-div market price £2.5
Current dividend 40 pence
Dividend pay-out ratio 60%
Average return on investment 10%
Example 6
A company has in issue 100,000 6% Preference shares of £1 each with a market
price of 40p.
Example 7
A company has 8% bank loan with a book value of £3,000,000.
w w w . s t ud y i nt e r a c t i v e . o r g 67
C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M EN T D E C I S I O N S
Interest (l t )
Kb =
Market Value of debt (ex-int)
Where:
t = rate of corporation tax.
I = annual interest
P0 = ex-interest market price of debt
Example 8
A company has in issue 5% irredeemable loan notes currently quoted at £105.5 cum-
interest per £100 nominal. Assume a corporation tax of 30%.
Example 9
A 5% loan notes is currently quoted at £95.84 (ex-int). It is redeemable at the end
of 3 years at £100.
Taking corporation tax at 50%, and ignoring the timing lag for tax savings,
calculate Kd.
Cost of convertible
The cost of convertible debt is calculated in a similar manner to the calculation of the
cost of redeemable debt, EXCEPT that in the final year, one must include the:
- redemption value of the debt, or
- conversion value of the debt
whichever is the GREATER
Example 10
Some 8% convertible debentures have a current market value of £106 per cent. The
debenture will be converted into equity shares in 3 years’ time at the rate of 40
shares per £100 of debentures. The market price is expected to be £3.5 on the date
of conversion.
What is the cost of capital to the company for the convertible debentures?
Assume a corporation tax of 33%.
68 w w w . s t ud yi nt e r a c t i ve . o r g
C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M E N T D E C I S IO N S
£
Ordinary shares of £1 500,000
6% £1 Preference shares 100,000
Debentures 200,000
Reserves 380,000
1,180,000
Required: Calculate the WACC. Assume corporation tax at 50% per annum,
payable one year in arrears.
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C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M EN T D E C I S I O N S
Required:
Using the Macaulay duration method, calculate the bond duration.
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C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M E N T D E C I S IO N S
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C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M EN T D E C I S I O N S
Modified Duration
Modified duration looks at how sensitive the value of a security is in relation to the
changes in interest rates, measuring the percent change in a bond’s price for a 1%
change in its yield to maturity.
The formula is - Macauley Duration / (1+ Yield to Maturity /N)
This recognises the inverse relationship that occurs between bond price and interest
rates. This is effectively the price sensitivity.
B Speculative
CC Highly speculative
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C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M E N T D E C I S IO N S
AAA 8 16 24 32
A 32 52 72 92
Thus a four year A rated bond will cost 7 + 0.92 = 7.92% whereas a 3 year B rated
bond will cost 6.0 + 2.74 = 8.74%
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C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M EN T D E C I S I O N S
Cost of equity
At relatively low levels of gearing the increase in gearing will have relatively low
impact on Ke. As gearing rises the impact will increase Ke at an increasing rate.
Cost of debt
There is no impact on the cost of debt until the level of gearing is prohibitively high.
When this level is reached the cost of debt rises.
Cost of
capital
Ke
WACC
Kd
Gearing (D/E)
Key point
There is an optimal level of gearing at which the WACC is minimized and the value of
the company is maximised
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C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M E N T D E C I S IO N S
Cost of equity
Ke rises at a constant rate to reflect the level of increase in risk associated with
gearing.
Cost of debt
There is no impact on the cost of debt until the level of gearing is prohibitively high.
The assumptions
M&M in 1958 was based on the premise of a perfect capital market in which:
1. Perfect capital market exist where individuals and companies can borrow
unlimited amounts at the same rate of interest.
2. There are no taxes or transaction costs.
3. Personal borrowing is a perfect substitute for corporate borrowing.
4. Firms exist with the same business or systematic risk but different level of
gearing.
5. All projects and cash flows relating thereto are perpetual and any debt
borrowing is also perpetual.
6. All earnings are paid out as dividend.
7. Debt is risk free.
Big idea
The increase in Ke directly compensates for the substitution of expensive equity with
cheaper debt. Therefore the WACC is constant regardless of the level of gearing.
Ke
Cost
of
capital
WACC
Kd
Gearing (D/E)
If the weighted average cost of capital is to remain constant at all levels of gearing
it follows that any benefit from the use of cheaper debt finance must be exactly offset
by the increase in the cost of equity.
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C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M EN T D E C I S I O N S
Implication
As the level of gearing rises the overall WACC falls. The company benefits from
having the highest level of debt possible.
Ke
Cost
of
capital
WACC
Kd(1-t)
Gearing (D/E)
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C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M E N T D E C I S IO N S
D(1 t ) Vd
Keg = Keu (Keu Kb*) or kie +(1-T)(k ie -k d )
E Ve
*Kb or kd is the PRE-TAX COST OF DEBT for this formula.
NB The formula on the right-hand side is provided on the ACCA P4 Formulae sheet.
Proposition 3: WACC
Dt
WACCg = Keu 1
E D
Example 14 - MM
MM Plc is currently wholly equity funded, with an ungeared cost of equity is 9%. They
have 30 million shares in issue, with a current price of F$11 per share, though they
have yet to announce a proposed investment opportunity.
The proposed project requires an initial capital investment of F$80 million, and will
generate an NPV of F$30 million. It is expected that the entity value will increase by
F$110m as soon as the project is announced.
There has been some discussion amongst the directors of FF about how the F$80
million capital investment should be funded. Any new equity would be raised through
a rights issue and any borrowings would be at a pre-tax cost of 7%. Three alternative
financing structures are being considered as follows: FF pays corporate income tax
at 25%.
Required:
(a) Calculate the following, based on Modigliani and Miller’s (MM’s) capital theory
with tax and assuming the project goes ahead for each financing option:
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C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M EN T D E C I S I O N S
Required:
Using the assumptions of Modigliani and Miller, explain and demonstrate how this
change in capital structure will affect:
The total value of FF
The geared cost of equity
The WACC
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C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M E N T D E C I S IO N S
SYSTEMATIC RISK
11 5 9 13 17 21 25
Number
Number of
of different
different companies
companies in
in which
which shares
shares are
are held
held
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C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M EN T D E C I S I O N S
Ke Ke
%
SYSTEMATIC
FINANCIAL RISK
Gearing % D
E
Now that the issue of leverage has been introduced, there becomes a need to
distinguish:
● β asset (βa), which reflects systematic business risk only, and
● β equity (βe), which reflects both systematic business risk TOGETHER WITH
ANY systematic financial risk which MAY exist.
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C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M E N T D E C I S IO N S
Therefore:
● In the case of an all equity company, βe = βa, since no systematic financial
risk can possibly exist.
● In the case of a geared company, βe > βa, since βe contains both systematic
business risk and systematic financial risk, whereas βa reflects systematic
business risk only.
Ve Vd 1 T
βa = V V 1 T β e V V 1 T β d
e d e d
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C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M EN T D E C I S I O N S
Financed by:
Bank loans 5,300 12,600 18,200 4,000 17,400
Ordinary shares* 4,000 9,000 3,500 5,300 4,000
Reserves 15,100 10,200 17,500 12,800 11,900
24,400 31,800 39,200 22,100 33,300
*The par value per ordinary share is 25p for Freezeup and Shiverall, 50p for Topice
and £1 for Glowcold and Hotalot.
Corporate debt may be assumed to be almost risk-free, and is available to Hotalot
at 0.5% above the Treasury Bill rate, which is currently 9% per year. Corporate
taxes are payable at a rate of 35%. The market return is estimated to be 16% per
year. Hotalot does not expect its financial gearing to change significantly if the
company diversifies into the production of freezers.
Required:
(a) Estimate what discount rate Hotalot should use in the appraisal of its proposed
diversification into freezer production.
(b) Discuss whether systematic risk is the only risk that Hotalot’s shareholders
should be concerned with.
82 w w w . s t ud yi nt e r a c t i ve . o r g
C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M E N T D E C I S IO N S
Example 18 - BIGUNDER
Bigunder plc provides training and financial services. The training service accounts
for two-thirds of the value of the company. The company has a debt to total market
value ratio of 30%.
The average beta and debt to total market value for the financial service sector are
0.9 and 25%.
The average beta and debt to total market value for the training service sector are
1.5 and 12%.
Other information:
1. The equity risk premium is 3.5% and the rate of return on short-dated
government stock is 4.5%.
2. Bigunder plc can borrow at 2.5% above the risk free rate.
3. Tax on corporate profit is 40%.
4. Assume that debt is risk free.
Required:
Estimate the cost of equity capital and the weighted average cost of capital for
Bigunder plc.
w w w . s t ud y i nt e r a c t i v e . o r g 83
C H A P T E R 6 – I M P A C T O F F IN A N C IN G O N IN V E S T M EN T D E C I S I O N S
Edwards plc is considering the acquisition of a 100% stake in Colman Ltd in order to
achieve backward vertical integration. Considerable savings are anticipated due to
the combination of both the marketing operations and distribution networks of the
two companies. Therefore synergies will arise to create cash flows which are in
excess of the current estimated cash flows of the two separate companies. Upon the
acquisition of Colman Ltd, Edwards plc will immediately sell one of the warehouses
of the target company, providing instant cash inflows of £5 million. The forecast cash
inflows of the merged businesses are as follows:
Year £ millions
2016 5.00
2017 110.00
2018 115.40
2019 121.29
2020 127.70
The cash flows are expected to grow by 1.5% per annum into perpetuity after 2020.
The forecast rate of corporation tax is expected to remain at 30%. The risk free rate
of interest is to be taken at 5% and the expected return on a market portfolio is 9%.
Information currently relating to the two companies is as follows:
Cost of debt 7% 7%
Edwards plc plans to make a cash offer of £380 million for the purchase of the entire
share capital of Colman Ltd. This cash offer will be funded by additional borrowings
undertaken by Edwards plc.
Advise the directors of Edwards plc whether to proceed with the acquisition.
84 w w w . s t ud yi nt e r a c t i ve . o r g
Chapter 7
Adjusted present
value
85 w w w . s t ud yi nt e r a c t i ve . o r g
CHAPTER 7 – ADJUSTED PRESENT VAL UE
86 w w w . s t ud yi nt e r a c t i ve . o r g
C H A P T ER 7 – A D J U S T ED P R E S EN T V A L U E
Project value if all equity financed + present value of tax + Present value of
(the base case NPV) shield on the loan other side effects
The APV method involves two stages:
1. Evaluate the project first of all as if it were all equity financed, and so as if the
company were an all equity company to find the ‘based case NPV’.
2. Make adjustment to the based case NPV to allow for the side effects of the
method of financing that has been used. The financing effects may consist of:
(i) Present value of tax savings on interest paid
(ii) Present value of issue costs incurred
(iii) Present value of subsidies/cheap loans.
Issue Cost
The issue cost is the cost associated with raising funds needed to finance the project.
The issue cost is a cash outflow and that its present value should be deducted from
the base case NPV in the calculation of APV. Risk free rate is usually used as the
discount factor in calculating the present value of issue cost.
Example 1
w w w . s t ud y i nt e r a c t i v e . o r g 87
CHAPTER 7 – ADJUSTED PRESENT VAL UE
The calculation of the tax shield depends on whether the interest is payable on a
fixed amount every year or there is equal repayment.
Example 2
A project requires immediate capital expenditure of £20m. The amount will be raised
through a 10% bank loan over a period of 5 years. Tax is paid one year in arrears at
a rate of 30%.
Calculate the present value of tax shields assuming:
(a) 10% interest on the £20m per annum;
(b) the amount will be paid in equal instalments over 5 years
Example 3
Required: Calculate the present value of tax shields and present value of subsidy.
88 w w w . s t ud yi nt e r a c t i ve . o r g
C H A P T ER 7 – A D J U S T ED P R E S EN T V A L U E
Example 4 - Strayer
The managers of Strayer Inc are investigating a potential $25 million investment.
The investment would be a diversification away from existing mainstream activities
and into the printing industry. $6 million of the investment would be financed by
internal funds, $10 million by a rights issue and $9 million by long term loans. The
investment is expected to generate pre-tax net cash flows of approximately $5 million
per year, for a period of ten years. The residual value at the end of year ten is
forecast to be $5 million after tax. As the investment is in an area that the
government wishes to develop, a subsidised loan of $4 million out of the total $9
million is available. This will cost 2% below the company's normal cost of long-term
debt finance, which is 8%.
Strayer's equity beta is 0.85, and its financial gearing is 60% equity, 40% debt by
market value. The average equity beta in the printing industry is 1.2, and average
gearing 50% equity, 50% debt by market value.
The risk free rate is 5.5% per annum and the market return 12% per annum. Issue
costs are estimated to be 1% for debt financing (excluding the subsidised loan), and
4% for equity financing. The corporate tax rate is 30%.
Required:
(a) Estimate the Adjusted Present Value (APV) of the proposed
investment. (15 marks)
(b) Comment upon the circumstances under which APV might be a better
method of evaluating a capital investment than Net Present Value
(NPV). (5 marks)
(20 marks)
w w w . s t ud y i nt e r a c t i v e . o r g 89
Chapter 8
International
investment
appraisal
Introduction
w w w . s t ud y i nt e r a c t i v e . o r g 90
C H A P T E R 8 – I N T E R N A T IO N A L I N V E S T M E N T A P P R A I S A L
Example 1 - Stella
Stella plc expects to generate pre-tax net operating cash flows for 3 years from its
US subsidiary as follows:
Year 1 Year 2 Year 3
$100m $120m $130m
The corporation tax rate in the US is 25%, and is 30% in the UK. There is a double
taxation treaty in place between the two countries and all tax is paid in the year after
the liability arises.
The current $/£ spot rate is $2/£, and the US dollar is expected to weaken by 10%
per annum against sterling.
Stella uses a sterling cost of capital of 10% for all projects.
Required: Calculate the present value of the cash flows from the US
subsidiary.
w w w . s t ud y i nt e r a c t i v e . o r g 91
C H A P T E R 8 – I N T E R N A T IO N A L I N V E S T M E N T A P P R A I S A L
UK USA Bargonia
Year 1 5% 5% 20%
2 5% 5% 30%
3 5% 7% 30%
4 5% 7% 30%
5 5% 7% 30%
Required:
If current spot rates are US$1.60 = £1 and Bargonian Dowl 250 = £1, using the
PPPT, what are the predicted spot rates for the currencies concerned at the end of
each of the next five years?
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C H A P T E R 8 – I N T E R N A T IO N A L I N V E S T M E N T A P P R A I S A L
A number of ways have been devised to try and avoid such restrictions. 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.
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.
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:
● Expropriation of assets (with or without compensation!);
● Blockage of the repatriation of profits;
● Suspension of local currency convertibility;
● 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. These techniques include the following:
(a) 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.
(b) Borrowing locally so that in the event of expropriation without compensation,
the enterprise can offset its losses by defaulting on local loans.
w w w . s t ud y i nt e r a c t i v e . o r g 93
C H A P T E R 8 – I N T E R N A T IO N A L I N V E S T M E N T A P P R A I S A L
(c) 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.
(d) 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.
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.
94 w w w . s t ud yi nt e r a c t i ve . o r g
C H A P T E R 8 – I N T E R N A T IO N A L I N V E S T M E N T A P P R A I S A L
1. 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.
2. 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.
4. 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
5 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;
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C H A P T E R 8 – I N T E R N A T IO N A L I N V E S T M E N T A P P R A I S A L
Required:
(a) Evaluate the proposed investment from the viewpoint of Brookday plc. State
clearly any assumptions that you make.
(b) What further information and analysis might be useful in the evaluation of this
project?
96 w w w . s t ud yi nt e r a c t i ve . o r g
Chapter 9
Acquisitions and
Mergers
Merger v Acquisition
There are distinct differences which you must be aware of;
● Merger – the joining of two separate entities
● Acquisition – where one entity uses its resources to buy a controlling interest
in another entity.
Synergy
● An expansion policy based on merger or takeover can be justified on the basis
of synergy. (Sometimes stated as 2 + 2 = 5) ie
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C H A P T E R 9 – A C Q U I S I T I O N S A N D M ER G ER S
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C H A P T ER 9 – A C Q U I S I T I O N S A N D M ER G ER S
● Agency theory suggests that takeover bids are primarily motivated by the self-
interest of the managers of bidding companies, who are in pusuit of status and
job security.
● Over-optimistic assessment of the economies of scale or economies of scope
that may be achieved as a result of the business combination;
● Inadequate investigation of the victim company prior to the bid being made, or
insufficient appreciation of the problems that may arise after the acquisition
takes place.
● Insufficient efforts to integrate and yield the anticipated synergy post
acquisition, often the directors become fixated with their next acquisition.
● Directors of the predator company become so obsessed with the success of
their bid that they often over pay thus transferring all the benefit t investors in
the acquired company.
Reverse Takeover
A reverse takeover is where a smaller listed company acquires a larger unlisted
company. However the shares used to acquire the larger company effectively give
control to the company that has been acquired.
The driving force for the acquisition is to enable the larger unlisted company to gain
the benefits of being a larger organisation, though avoiding the long complicated
process to gain such a listing.
Benefits
1.Easier access to capital markets
2.Higher company valuation
3.Ability to undertake further acquisitions
Problems
1.Lack of expertise
2.Reputation
3.Enhanced Risk
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Chapter 10
Business Valuations
Example 2 Thorsvedt
Thorsvedt is expected to pay a dividend of 30p per share next year. The market
expects dividends to grow at the rate of 5% per annum and has a required return of
20%.
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Example 3 - Lineker
Wright plc has just paid a dividend of 15p per share. The market is in general
agreement with directors’ forecasts of 30% growth in earnings and dividends for the
next 2 years. Thereafter, a reasonable estimate is 15% growth in year 3 followed by
6% growth to perpetuity.
The market’s required return on investments of this risk level is 25% per annum.
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Dividend cover
Free cash flow to equity provides a more meaningful figure than the earnings in the
calculation of dividend cover and dividend cover in cash terms can be calculated as:
£m
Revenue 1,950.00
Cost of sales (1,314.00)
Gross profit 636.00
Operating expenses (322.50)
Earnings before interest and tax 313.50
Interest charges (24.00)
Profit before tax 289.50
Corporation tax (@ 35%) (101.32)
Profit after tax 188.18
During the year loan repayments are expected to amount to £69 million,
depreciation charges to £30 million, and capital expenditure to £60 million. The
dividend payable is £30 million.
Required:
Calculate:
(a) Free cash flow;
(b) Free cash flow to equity;
(c) Dividend cover based on free cash flows to equity.
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Required:
Calculate the value of the company if:
(a) Cash flows are expected to remain at X4 level into infinity.
(b) Cash flows are expected to remain at X4 level until the end of year 10.
(c) Cash flows are expected to grow by 4% per annum into infinity.
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on 1st January 2009 for £500 million. From the perspective of the directors of Heincarl
plc, the projections of the performance of Newscot Ltd are as follows:
Current
Projections during planning horizon (years)
year
2008 2009 2010 2011 2012 2013 2014
£m £m £m £m £m £m £m
EBITDA 117.00 138.70 162.57 188.83 217.71 249.48 251.48
Depreciation
&
amortisation (40.00) (42.00) (44.00) (46.00) (48.00) (50.00) (52.00)
EBIT 77.00 96.70 118.57 142.83 169.71 199.48 199.48
Interest
charges _ -_ (32.00) (26.88) (20.19) (11.73) (1.28) _ -__
Profit before
tax 77.00 64.70 91.69 122.64 157.98 198.20 199.48
The assumed rate of corporation tax is 35% p.a. The terminal value of the
investment is treated as a constant perpetuity equal to the free cash flows for the
year 2014. The risk free rate of interest is assumed to be 6% p.a., the return on a
market portfolio is taken to be 13.5%, whilst an asset beta of 1.1 is used for purposes
of the appraisal.
Annual capital expenditure from 2008 onwards is estimated at £20 million each year
indefinitely. Newscot Ltd currently has on issue £400 million of 8% debt and it is
intended that all available cash flows should be applied to repaying this debt at the
earliest opportunity.
Advise the directors of Heincarl plc whether to proceed with the acquisition.
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For a given EPS, a higher P/E ratio will result in a higher price. A higher P/E ratio may
indicate;
(a) Expectations that the earnings will grow rapidly in the future, so that a high
price is being paid for future profit prospects.
(b) That the company is a low risk company than a company with a lower P/E
ratio.
Example 7
ABC is a private company operating in the pharmaceutical industry. The current
average PE ratio of the pharmaceutical industry is 16·4 times and it has been
estimated that ABC’s PE ratio is 10% higher than this.
VATA Co, a publicly listed company involved in the production of highly technical and
sophisticated electronic components for complex machinery has decided to acquire
ABC.
The following information is available:
VATA Co ABC
(£000) (£000)
Earnings before tax 1,980 397
Share capital (25p/share) 600 300
The current share price of VATA Co is $9·24 per share. The annual after tax earnings
will increase by $140 million due to synergy benefits resulting from combining the
two companies. However, it is thought that the PE ratio of the combined company
would fall to 14·5 times after the acquisition.
Both companies pay tax at 20% per annum
Required
Calculate the maximum acquisition premium payable using the price-earnings ratio
method.
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Market-to-book values
Compare the market value of the company to the book value of the assets. The
difference between the two should be equivalent to the value of the intangibles.
However, this method values the assets based on accounting policies and therefore
may no longer represent their ‘true worth’. A better alternative would be to value
the assets based on realisable value.
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Additional information:
(1) The average pre-tax return on total assets for the industry over three years
has been 15%.
(2) The estimated cost of equity capital for the industry is 10% after tax.
(3) The market price of Emboss plc share is £12 per share at 31 March 2011.
Required:
Calculate the value of the intellectual capital/intangible asset.
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Valuation of the underlying The fair value of the assets of the company
Where the assets of the company are actively traded and easily liquidated, their
current market value would be appropriate. In the case of most companies, fair
value will normally be based upon the present value of the future cash flows that the
company’s assets are expected to generate over their useful lives.
The volatility of the underlying assets is likely to be the most difficult measure to
estimate accurately. One approach is to estimate the probabilities of the likely future
cash flows of the company and generate a distribution of their present values from
which a standard deviation could be established.
A possible approach to the determination of an exercise price is to assume that the
company’s liabilities consist entirely of debt in the form of a zero coupon bond. If
the company’s debt includes other types of bond, adjustments are necessary as
shown in the following illustration.
Example 9
In March 2007, Northern Rock (a UK bank) reported assets and liabilities at fair values
of £113.2 billion and £110.7 billion respectively. The average term to maturity on
the liabilities of the bank (which consisted of short-term money market borrowing
and deposits) was 100 trading days, whilst the annual number of trading days was
250 approximately. At that time the risk-free rate of interest was 3.5% and the
company had 495.6 million equity shares in issue.
Required:
Using the BSOP (sometimes referred to as the Black Scholes Merton) model,
estimate the share price of Northern Rock in each of the following situations
assuming that the standard deviation of the bank’s assets was 5%.
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Preference shares
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.
Irredeemable debt
Redeemable
Example 12
A company has issued some 9% bonds, which are redeemable at par in three years’
time. Investors require an interest yield of 10%.
Convertible
The value of a convertible cannot fall below its value as debt, but upside potential
exists due to the possibility of an increase in the share price prior to expiry of the
conversion period.
Therefore the theoretical value of a convertible (known as its “formula value”) is
the greater of its value as debt and its value as shares ie its conversion value. In
practice the actual price of convertibles will tend to trade at a value in excess of
formula value, reflecting so called “time value” ie the possibility that the share price
could rise prior to expiry of the conversion period.
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Example 14
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 1 2 3 4
Rate 3.5% 4.0% 4.7% 5.5%
Example 15
A government has three bonds in issue that all have a face or par value of $100 and
are redeemable in one year, two years and three years respectively. Since the bonds
are all government bonds, let’s assume that they are of the same risk class. Let’s
also assume that coupons are payable on an annual basis.
Bond A, which is redeemable in a year’s time, has a coupon rate of 7% and is trading
at $103.
Bond B, which is redeemable in two years, has a coupon rate of 6% and is trading
at $102.
Bond C, which is redeemable in three years, has a coupon rate of 5% and is trading
at $98.
Determine the yield curve.
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Chapter 11
Framework
Mode of Offer
Cash consideration
The offer is made to purchase the shares of the target company for cash. This method
is very appropriate for relatively small acquisitions, unless the acquirer has
accumulation of cash from operations or divestments.
The advantages of cash offer to the target entity’s shareholders are that:
● 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.
● The cash purchase increases the liquidity of the target shareholders who are in
position to alter their investment portfolio to meet any changing opportunities.
A disadvantage to target shareholders’ for receiving cash is that if the price that they
receive is on sale 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:
● The value of the bid is known and target company shareholders’ are encouraged
to sell their shares.
● It represents a quick and easily understood approach when resistance is
expected.
● The shareholders of the target company are bought out and have no further
participation in the control and profits of the combined entity.
The main disadvantages to the predator company are that it may deplete the
company’s liquidity position and may increase gearing.
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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.
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.
Share exchange
The predator company issues its own shares in exchange for the shares of the target
company and the shareholders of the target company become shareholders of the
predator company.
The advantages of a share exchange to target shareholders include:
● Capital gains tax is delayed.
● The shareholders of the target company will participate in the control and profits
of the combined entity.
The main disadvantage is that there is uncertainty with a share exchange where the
movements in the market price may change their wealth.
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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.
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Post-bid
A target company can use the following to defend itself against a possible takeover:
● Try to convince the shareholders that the terms of the offer are
unacceptable. This can be done using the following:
o Attempt to show that the current share price of the company is
unrealistically low relative to the future potential. Assets revaluation, new
profit forecasts, dividends and promises of rationalisation are commonly
employed here.
o If it is for share for share exchange, the target company can attempt to
convince the shareholders that the offer’s equity is currently overvalued.
The suitability of the bidding company to run the merged business can
also be questioned.
● Lobbying the office of fair trading and or the department of trade and
industry to have the offer referred to the competition commission. This will at
least delay the takeover and may prevent it completely.
● Launching an advertising campaign against the takeover bid. One technique
is to attack the account of the predator company.
● A reverse takeover (Pac Mac), that is make a counter offer for the predator
company. This can be done if the companies are of reasonably similar size.
● Finding a ‘white knight’, a company which will make a welcome takeover bid.
This involves finding a more suitable acquirer and promoting it to compete with
the predator company.
Pre-bid
● Selling crown jewels – the tactic of selling off certain highly valued assets of
the company subject to a bid is called selling the crown jewels. The intention
is that, without the crown jewels, the company will be less attractive.
● Golden parachutes – this is a policy of introducing attractive termination
packages for the senior executives of the victim company. This makes it more
expensive for the predator company.
● Shark repellent – super-majority. The articles of association are changed to
require a very high percentage of shares to approve an acquisition or merger,
say 80%.
● Poison pill
The most commonly used and seeming most effective takeover defence is the
so called poison pill.
An example is the Flip-in pill. This involves the granting of rights to
shareholders, other than the potential acquirer, to purchase the shares of the
target company at a deep discount. This dilutes the ownership interest of the
potential acquirer.
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CHAPTER 11 – FRAMEWORK
Regulation of takeovers
The regulation of takeovers varies from country to country and mainly 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.
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Chapter 12
Corporate
reconstruction and
reorganisation
BUSINESS REORGANISATION
Unbundling
Unbundling is the process of selling off incidental non-core businesses to release
funds, reduce gearing, and allow management to concentrate on their chosen core
business.
The main forms of Unbundling are:
● Divestment.
● Demergers.
● Sell-offs.
● Spin-offs.
● Management buy-outs.
Divestment
Divestment is a proportional or complete reduction in ownership stake in an
organisation. It is the withdrawal of investment in a business. This can be achieved
either by selling the whole business to a third party or by selling the assets piecemeal.
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Sell-offs
A sell-off is a form of divestment involving the sale of part of an entity to a third
party, usually in return for cash. The most common reasons for a sell-off are:
● To divest of less profitable and/or non-core business units.
● 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.
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 which is making the distribution
of assets. 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.
The main disadvantages of de-merger are:
● Economies of scale may be lost, where the de-merged parts of the business had
operations in common to which economies of scale applied.
● The ability to raise extra finance, especially debt finance, to support new
investments and expansion may be reduced.
● Vulnerability to takeovers may be increased.
● There will be lower revenue, profits and status than the group before the de-
merger.
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Problems of MBOs
● Management may have little or no experience financial management and
financial accounting.
● Difficulty in determining a fair price to be paid.
● Maintaining continuity of relationships with suppliers and customers.
● Accepting the board representation requirement that many sources of funding
may insist on.
● Inadequate cash flow to finance the maintenance and replacement of assets.
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Management buy-in
A management buy-ins occurs when a group of outside managers buys a controlling
stake in a business.
Share repurchase
Any limited company may, if authorised by it articles, purchase its own shares. The
Companies Act permits any company to purchase its own shares. 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.
Shares may be purchased either by:
● Open market purchase – the company buys the shares from the open market
at the current market price.
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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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Financial difficulties
If a company is in financial difficulties it may have no recourse but to accept
liquidation as the final outcome.
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:
● write off the accumulated losses.
● write of the debenture interest and preference share dividend arrears.
● 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.
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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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Chapter 13
Hedging foreign
exchange risk
EXCHANGE RATES
An exchange rate is the rate at which one country’s currency can be traded in
exchange for another country’s currency.
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C H A P T ER 1 3 – H ED G I N G F O R E IG N E X C H A N G E R I S K
Example
Consider the following exchange rate quotation:
$/£
1.500
This means $1.500 dollars is equal to £1. The dollar is the variable currency and the
pound is the base currency.
Spread
The spread is the difference between the bid price and the offer price. The offer price
is slightly higher than the bid price and the difference (spread) exist to compensate
the dealer for holding the risky foreign currency and for providing the services of
converting currencies.
Outright quotation
Outright quotation means that the full price to all of its decimal point is given.
Example
Bid Offer
Spot rate 1.6878 1.7694
One month forward rate 1.6078 1.7574
Here both the spot and forward bid/offer are given in the full decimal places.
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Point quotation
A point quotation is the number of points away from the outright spot rate with the
first number referring to points away from the spot bid and second number to points
away from the spot offer price.
Whether the point quotation is subtracted or added to the spot rate is explained by
premium or discount on the exchange rate movements.
Subtract premium from the spot rate and add discount to the spot rate.
Example 1
Bid Offer
Spot rate 1.4432 1.4442
One month forward rate (premium) 58 56
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Transaction exposure
Transaction exposure relates to the gains and losses to be made when settlement
takes place at some future date of a foreign currency denominated contract that has
already been entered into. These contracts may include import or export of goods
on credit terms, borrowing or investing funds denominated in a foreign currency,
receipt of dividends from over-seas, or unfulfilled foreign exchange contract.
Transaction exposure can be protected against by adopting a hedged position: that
is, entering into a counter balancing contract to offset the exposure.
Translation exposure
This arises from the need to consolidate worldwide operations according to
predetermined accounting rules. This is the risk that the organisation will make
exchange losses or gains when the accounting results of its foreign subsidiaries are
translated into the presentation currency of the parent company. Assets, liabilities,
revenue and expenses must be restated into presentation currency of the parent
company in order to be consolidated into the group accounts.
Translation exposure can result from restating the book value of a foreign subsidiary’s
assets at the exchange rate on the balance sheet date. Such exposure will not affect
the firm’s cash flows unless the asset is sold.
Economic exposure
Economic exposure also called operating or competitive exposure or strategic
exposure measures the changes in the present value of the firm resulting from any
changes in the future operating cash flows of the firm caused by an unexpected
changes in exchange rates. The change in value depends on future sale volume,
price and costs.
For example, a UK company might use raw materials which are priced in US dollars,
but export its product mainly within the EU. A depreciation of the pound against the
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dollar or appreciation of pound against the Euro will both erode the competitiveness
of this UK company.
The magnitude of economic exposure is difficult to measure as it considers
unexpected changes in exchange rates and also because such changes can affect
firms in many ways.
Diversification of financing
If a firm borrows in a foreign currency it must pay back in that same currency. If
that currency should appreciate against the home currency, this can make interest
and principal repayments far more expensive. However, if borrowing is spread across
many currencies it is unlikely they will all appreciate at the same time and therefore
risk can be reduced. Borrowing in foreign currency is only truly justified if returns
will then be earned in that currency to finance repayment and interest.
Currency swaps
Please see later in the chapter for currency swaps
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Netting
Netting is setting the debtors and creditors of all the companies in the group resulting
from transactions between them so that only net amount is 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. There are different ways of
arranging for multilateral netting. The arrangement might be co-ordinated by the
company’s own central treasury or alternatively by the company’s bankers. The
common currency in which netting is to be affected needs to be decided on.
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Example 2
A group of companies controlled from the USA has subsidiaries in the UK, South
Africa and France. At 31/12/X3, inter-company indebtedness were as follows
Owed by Owed to Amount
UK SA 1,200,000 SA Rand ®
UK FR 480,000 Euro
FR SA 800,000 SA rand
SA UK 74,000 Sterling
SA FR 375,000 Euro
It is the company’s policy to net off inter-company balances to the greatest extent
possible. The central treasury department is to use the following exchange rates for
these purposes:
US $ = R 6.126 / £0.6800 / Euro €0.880
Required:
Calculate the net payment to be made between the subsidiaries after netting of inter-
company balances.
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.
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Forward contract
The foreign-exchange forward market is an inter-bank market, where one party
agrees to deliver a specified amount of one currency for another at a specified
exchange rate at a designated date in the future. The designated exchange rate and
date are called the forward rate and settlement (delivery) date respectively. Where
an investor takes a position in the market by buying a forward contract, the investor
is said to be in a long- position, and where he takes a position to sell a forward
contract we say the investor is in a short-position.
A forward contract is a binding contract on both parties. This means that having
made the contract, a company must carry out the agreement, and buy or sell the
foreign currency on the agreed date and at the rate of exchange fixed by the
agreement. If the spot rate moves in the company’s favour, that will be bad for the
company and vice versa.
Example 3
FRT is a company in the UK that trades frequently with companies in the USA.
Transactions to be completed within the next six months are as follows:
Receipts Payments
Three months $350,000 $250,000
Six months £100,000 $1,000,000
Foreign exchange rates ($/£)
Spot 1.4960 – 1.4990
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Required:
Using the forward contract and money market hedge, devise a foreign exchange
hedging strategy that is expected to maximise the cash flows of FRT.
In order to reduce the volatility of their exchange rates, some countries (e.g. China,
Russia, India, Brazil, Philippines and Korea) have attempted to ban forward foreign
exchange trading. In these markets, non-deliverable forwards (NDF’s) have been
developed. Although they resemble forward contracts, no physical currency delivery
actually takes place. Instead, the difference between the actual spot rate and the
NDF rate is calculated. This will result in a profit or loss on the transaction between
the two counterparties, who merely settle with each other for this net amount.
When this profit or loss is combined with the actual currency exchanged at the
prevailing spot rate, this will effectively fix the ultimate exchange rate in a manner
which resembles a forward exchange contract.
The underlying principles of a SAFE are similar to the procedures employed for a
forward rate agreement (FRA), which is offered by banks for clients who wish to
hedge their interest rate risk.
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FUTURES
A futures is a legal binding contract between two parties to buy or to sell a
standardised quantity of an underlying item at a future date, but at a price agreed
today, through the medium of an organised exchange.
Future contracts are forward contracts traded on a future and options exchange.
Underlying item
Underlying item is the quantity of the item which is to be bought or sold under the
futures contract. Each futures contract has a standardised quantity of this underlying
items and the futures contract cannot be undertaken in fractions.
The underlying item may include agricultural products, like meat, cocoa, maize,
energy products, like crude oil gas, financial products, like currency and interest rate,
and stock index futures on shares.
Delivery dates
Financial futures are normally traded on a cycle of three months, March, June,
September and December of each year.
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.
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.
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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. 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 4
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.
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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.
Currency Futures
A currency futures is an exchange traded agreement between two parties to buy/sell
a particular quantity of one currency in exchange of another currency at a particular
rate on a particular future date.
Typical available futures contracts are as follows:
quantity of currency price value of one
Futures tick size
per contract quotation tick
£/ $ £62,500 $ per £1 $0.0001 $6.25
€/ $ €125,000 $ per €1 $0.0001 $12.50
€/£ €100,000 £ per €1 £0.0001 £10
Required:
Calculate what the result of the hedge is expected to be. Briefly discuss why this
result may not occur.
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Currency Options
A currency option is the right, but not an obligation, to buy (a call option) or sell (put
option) a particular currency at a specified exchange rate on a particular date or at
any time up to a particular date.
Required:
Show the outcome of using both forward contract and currency options to hedge
foreign currency risk and recommend the best action.
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CURRENCY SWAPS
Currency swaps are similar to interest rate swaps, but the underlying obligations are
in different currencies.
Currency swaps are characterised by the following mechanism:
● Initial exchange of principal currencies at the commencement of the swap.
● Exchange of regular interest payment during the life of the swap.
● Final exchange of principal currencies at maturity of the swap.
When currencies are exchanged at the commencement and maturity of the swap, the
same exchange rate is used. In other words, the amounts exchanged at the start of
the swap and at the end are exactly the same.
Example 7 DD plc
DD plc needs to borrow $50m to finance it US subsidiary. DD plc is not well known
in US and can only borrow in US at US basic rate + 3%. DD plc contacts a US
company it has known for many years, FFK plc. FFK plc is in a similar position to DD
plc in that it requires a sterling loan to finance its UK operations. FFK plc can borrow
sterling at 11% per annum fixed and floating rate in US at US base rate + 1%.
The two companies come into a swap arrangement where:
● DD plc will borrow sterling at 9% per annum fixed and FFK plc will borrow dollars
at US base rate + 1%
● DD plc will pay FFK plc US base rate + 1.5% per annum and FFK plc will pay
DD plc sterling 9.5% per annum
● There will be an exchange of principal now and in five years time at the current
spot rate of $8 = £1
● UK base rate is currently 7% and US base rate is 5% per annum.
Required:
Show whether the suggested swap would benefit the two companies.
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5. Swaps can be arranged for any sum typically $5m to $50m over varying time
periods, and may be reversed by re-swapping with other counter parties. Hence
it is flexible.
6. There may be low transaction cost, as cost may be limited to the legal fees in
agreeing the documentations and arrangement fees.
Forex Swaps
A forex swap is an agreement between two parties to exchange equivalent amount
of currency for a period and then re-exchange them at the end of the period at a
predetermined agreed rate.
Forex swaps are characterised by the following mechanism:
● Initial exchange of principal currencies at the commencement of the swap.
● Final exchange of principal currencies at maturity of the swap normally at a
different rate.
The purpose of forex swap are to hedge against foreign exchange risk for longer
period, say more than one year, and where it is difficult to raise money directly.
Swaptions
Swaption may also be referred as swap option, options on swap or option swap.
Swaptions are combination of swap and option.
In return for the payment of premium by the holder, a swaption gives the right, but
not an obligation, to enter into swap on or before a particular date.
Swaptions are available on an over-the-counter market and are therefore tailored to
the exact specifications of the holder. They may be American or European style.
Swaptions are example of financial engineering. Financial engineering is the
construction of a financial product from a combination of existing derivative products.
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Chapter 14
Hedging interest
rate risk
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Gross
Redemption
Yield Bond
% Yield Curve
0 5 10 15 20 25
Term to maturity (years)
A normal yield curve slopes upwards because the yield on longer dated bonds is
normally higher than the yield on shorter dated bonds. If you are confused by this
point, remember that your mortgage is only cheaper than your overdraft because the
mortgage is secured on the property, whereas the overdraft is unsecured. The reason
for the upward sloping shape of the yield curve is thought to be based on the following
theories:
● liquidity preference theory
● expectations theory
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Expectations theory
This theory states that the shape of the yield curve will vary dependent upon a
lender’s expectations of future interest rates (and therefore inflation levels). A curve
that rises from left to right indicates that rates of interest are expected to increase
in the future to reflect the investors fear of rising inflation rates.
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An inverse yield curve is downwards sloping and its general shape is as follows:
Gross
Redemption
Yield
%
Bond
Yield Curve
0 5 10 15 20 25
Term to maturity (years)
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Example 1
A bank has quoted the following FRA rates:
2v6 5.75 - 6.00
3v5 5.78 - 6.13
4v7 5.95 - 6.45
Assume that now is 1st November 2008.
Required:
Determine the FRA interest applicable to the following situations:
1. A company wants to borrow on 1st February 2009 and repay the loan on 1 st of
April 2009.
2. A company wants to deposit money on 1st January 2009 and expect to with
draw the amount for an investment on 1st of May 2009.
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 2
A company will have to borrow an amount of £100 million in three month time for a
period of six months. The company borrow at LIBOR plus 50 basis points. LIBOR is
currently 3.5%. The treasurer wishes to protect the short-term investment from
adverse movements in interest rates, by using forward rate agreement (FRAs).
FRA prices (%)
3v9 3.85 – 3.80
4v9 3.58 3.53
5v9 3.55 3.45
Required:
Show the expected outcome of FRA:
(a) If LIBOR increases by 0.5%.
(b) If LIBOR decreases by 0.5%.
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Example 3
Assume that it is now 1 June. Your company expects to receive £7.1 million from a
large order in five months’ time. This will then be invested in high-quality commercial
paper for a period of four months, after that it will be used to pay part of the
company’s dividend. The treasurer wishes to protect the short-term investment from
adverse movements in interest rates, by using forward rate agreement (FRAs).
FRA prices (%)
4v5 3.85 – 3.80
4v9 3.58 3.53
5v9 3.50 3.45
The current yield on the high-quality commercial paper is LIBOR + 0.60%. LIBOR is
currently 4%.
Required:
If LIBOR falls or increase by 0.5% during the next five months, show the expected
outcome of FRA.
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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.
Number of contracts =
Example 4 - AA plc
The monthly cash budget of AA plc shows that the company is likely to need £18m
in two months time for a period of four months. Financial markets have recently
been volatile, and 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
June 92.75
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%).
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10% CAP
5% floor
0 time
The open market rate will be applied to the loan as long as it remains between 5%
and 10%. If the open market interest rate goes outside these parameters (say 12%
or 4%) the bank will activate the ‘cap’ or ‘floor’ as appropriate to keep the loan
interest cost between the agreed limits.
The advantage of the collar compared to a normal cap is that the collar has a lower
overall premium cost, due to the potential benefit of floor to the bank.
Interest rate option is a right, but not obligation, to either borrow or lend a notional
amount of principal for a given interest period, starting on or before a date in the
future (expiry date for the option), at a specified rate of interest (exercise price of
the option).
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Example 5
Assume that it is now mid-December.
The finance director of APB plc has recently reviewed the company’s monthly cash
budgets for the next year. As a result of buying new machinery in three months’
time, the company is expected to require short-term finance of £30 million for a
period of two months until the proceeds from a factory disposal become available.
The finance director is concerned that, as a result of increasing wage settlements,
the Central Bank will increase interest rates in the near future.
LIBOR is currently 6% per annum and APB can borrow at LIBOR + 0.9%.
Derivative contracts may be assumed to mature at the end of the month.
The company is considering using interest rate futures, options on interest rate
futures or interest rate collars.
Three months sterling Future (£500,000 contract size, £12.50 tick size)
December 93.870
March 93.790
June 93.680
Required:
Illustrate how the short-term interest risk might be hedged, and the possible results
of the alternative hedges if interest rate increase or decrease by 0.5%.
SWAPS
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Required:
Calculate the total interest payments of the two companies over the year if LIBOR is
10% per annum
Example 7
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%.
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%?
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Chapter 15
Issues for
Multinationals
Fund Remittance
Transfer pricing can be used in international investments as a way to circumvent any
restrictions relating to blocked funds. The parent company will charge the foreign
subsidiary an inflated amount to ensure a cash flow that might have otherwise not
been possible to obtain.
Tax Implications
Transfer pricing can also be used to minimise the global tax payable, by adjusting
the transfer price to ensure that a low profit is declared in nations of high tax rates
and a larger profit is declared in nations where the rate is more favourable.
This may need the approval of the respective governments who may not take kindly
to such blatant attempts to avoid paying tax. They may enforce that the transaction
is carried out at “arm’s length” using a price that would be applied to an external
customer to ensure that the transaction is fair and tax is collected as it should be.
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ISLAMIC FINANCE
A form of finance that specifically follows the teachings of the Qu’ran.
The teachings of the Qu’ran are the basis of Islamic Law or Sharia. Sharia Law is,
however, not codified and as such the application of both Sharia Law and, by
implication, Islamic Finance is open to more than one interpretation.
Prohibited activities
In Shariah Law there are some activities that are not allowed and as such must not
be provided by an Islamic financial institution, these include:
1. Gambling (Maisir)
2. Uncertainty in contracts (Gharar)
3. Prohibited activities (Haram)
Riba
Interest in normal financing relates to the monetary unit and is based on the principle
of time value of money. Sharia Law does not allow for the earning of interest on
money. It considers the charging of interest to be usury or the ‘compensation without
due consideration’. This is called Riba and underpins all aspects of Islamic financing.
Instead of interest a return may be charged against the underlying asset or
investment to which the finance is related. This is in the form of a premium being
paid for a deferred payment when compared to the existing value.
There is a specific link between the charging of interest and the risk and earnings of
the underlying assets. Another way of describing it is as the sharing of profits
arising from an asset between lender and user of the asset.
Gharar
The prohibition on gharar means that forward contracts and derivatives are not
allowed. Short selling is prohibited because the seller needs to own the asset.
Constructive ownership is acceptable where the goods are under the direct control of
the owner even if the owner does not have physical possession.
Due to the above prohibitions, majority of the conventional financial instruments are
not suitable to Islamic finance.
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The partner contributing capital is liable to the extent of the capital provided. The
contract can be terminated at any time with reasonable notice.
Mudaraba transactions are appropriate for private equity investments. In the case
of financial institutions and banks, the mudaraba method become applicable as the
bank is a lender to a business it can share in the profits that the business makes
instead of charging an interest on the loan.
The result is that risk is shared equally between lender and borrower. Similarly, if
the bank is a borrower, the lender’s deposit is treated as an equity investment, and
he or she shares in the profit that the bank makes through its investments.
Conventional banks make a profit on the spread between the interest rate charged
to borrowers and paid to depositors – Islamic banks make a profit on the investments
that they make or their borrowers make.
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“Six big investment banks published trading volumes for their “dark pools” for the
first time yesterday, showing them as a tiny fraction of the market and not the major
hidden rivals to stock exchanges that some argue.
Citi, Credit Suisse, Deutsche Bank, J P Morgan Cazenove, Morgan Stanley and UBS
together executed €596 million (£513 million) of equity trades from 15 countries on
their automated crossing systems on Friday, according to Markit data.
That accounted for about 0.4 per cent of all types of cash equity trades in Europe and
1.6 per cent of all over-the-counter (OTC) trades reported on the Markit BOAT service
that day, according to Thomson Reuters data.
Dark pools are electronic platforms that allow would-be buyers and sellers of large
orders of shares to avoid revealing pre-trade information and signalling their
intentions to the rest of the market.
Bankers argue that for the bulk of OTC trades they act purely as dealers, using their
own money or share inventories to take one or another side, or they act in a non-
automated way to match buyers and sellers for big blocks of stock.”
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