1.4advanced Financial Management

Study Notes Advanced Financial Management - AFM
ACCA – AFM
ADVANCED FINANCIAL MANAGEMENT
STUDY NOTES
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Contents
Sr. # TOPIC Page #
1. TIPS TO PASS THE EXAM 3
Syllabus A: Role of the senior financial advisor in the

2. multinational organization (*Students are requested 4
to read this after finishing all the other syllabus
modules)
3. Syllabus B: Advanced investment appraisal: 34
Discounted Cash Flow Techniques
4. Syllabus B: Application of option pricing theory in 59
investment decisions
Syllabus B: Advanced investment appraisal:
5. Financing/APV/Valuation/International Appraisal 64
6. Syllabus C: Mergers and Acquisitions 111
7. Syllabus D: Corporate reconstruction and re- 143

organisation
8. Syllabus E: Treasury and advanced risk management 152
techniques
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TIPS TO PASS THE EXAM

 Start the preparation early. Ideally plan to spend 2 hours daily on reading the notes and study text
.Otherwise you will be really frustrated and exhausted during exam days.
 Try to understand the concepts and understand how they are applied
 There is no substitute for practice. Need to be able to solve at least 5 past papers so that you are able to
comprehend the exam easily.
 Try to solve the questions in exam room condition and record the time you are taking to solve each
question. Time Management is the key.
 Any concept you don’t understand ,just GOOGLE it. Investopedia is your best friend
 Never try to study on the last day before exam. This is your day to relax your brain before the BIG DAY.
 DO NOT WORRY, ALWAYS BE HAPPY! YOU HAVE THE POTENTIAL TO PASS THE EXAM
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SYLLABUS A: ROLE OF THE SENIOR FINANCIAL ADVISOR

IN THE MULTINATIONAL ORGANIZATION
Learning objectives
 Develop strategies for the achievement of the organisational goals in line with its agreed policy
framework.
 Recommend strategies for the management of the financial resources of the organisation such that
they are utilised in an efficient, effective and transparent way.
 Advise the board of directors or management of the organisation in setting the financial goals of the
business and in its financial policy development with particular reference to:i) Investment selection
and capital resource allocation ii) Minimising the cost of capital iii) Distribution and retention policy iv)
Communicating financial policy and corporate goals to internal and external stakeholders v) Financial
planning and control vi) The management of risk.
 Recommend the optimum capital mix and structure within a specified business context and capital
asset structure.
 Recommend appropriate distribution and retention policy.
 Explain the theoretical and practical rationale for the management of risk.
 Assess the organisation’s exposure to business and financial risk including operational, reputational,
political, economic, regulatory and fiscal risk.
 Develop a framework for risk management, comparing and contrasting risk mitigation, hedging and
diversification strategies.
 Establish capital investment monitoring and risk management systems.
 Advise on the impact of behavioural finance on financial strategies / securities prices and why they
may not follow the conventional financial theories.
 Assess the ethical dimension within business issues and decisions and advise on best practice in the
financial management of the organisation.
 Demonstrate an understanding of the interconnectedness of the ethics of good business practice
between all of the functional areas of the organisation.
 Recommend, within specified problem domains, appropriate strategies for the resolution of
stakeholder conflict and advise on alternative approaches that may be adopted.
 Recommend an ethical framework for the development of an organisation’s financial policies and a
system for the assessment of its ethical impact upon the financial management of the organisation.
 Explore the areas within the ethical framework of the organisation which may be undermined by
agency effects and/or stakeholder conflicts and establish strategies for dealing with them.
 Establish an ethical financial policy for the financial management of the organisation which is
grounded in good governance, the highest standards of probity and is fully aligned with the ethical
principles of the Association.
 Assess the impact on sustainability and environmental issues arising from alternative organisational
business and financial decisions.
 Assess and advise on the impact of investment and financing strategies and decisions on the
organisation’s stakeholders, from an integrated reporting and governance perspective.
 Advise on the theory and practice of free trade and the management of barriers to trade.
 Demonstrate an up to date understanding of the major trade agreements and common markets and,
on the basis of contemporary circumstances, advise on their policies and strategic implications for a
given business
 Discuss how the actions of the World Trade Organisation, the International Monetary Fund, The World
Bank and Central Banks can affect a multinational organisation.
 Discuss the role of international financial institutions within the context of a globalised economy, with
particular attention to (the Fed, Bank of England, European Central Bank and the Bank of Japan).
 Discuss the role of the international financial markets with respect to the management of global debt,
the financial development of the emerging economies and the maintenance of global financial
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stability.
 Discuss the significance to the organisation, of latest developments in the world financial markets
such as the causes and impact of the recent financial crisis; growth and impact of dark pool trading
systems; the removal of barriers to the free movement of capital; and the international regulations on
money laundering.
 Demonstrate an awareness of new developments in the macroeconomic environment, assessing their
impact upon the organisation, and advising on the appropriate response to those developments both
internally and externally.
 Advise on the development of a financial planning framework for a multinational organisation taking
into account: i) Compliance with national regulatory requirements (for
 example the London Stock Exchange admission requirements) ii) The mobility of capital across borders
and national limitations on remittances and transfer pricing iii) The pattern of economic and other risk
exposures in the different national markets iv) Agency issues in the central coordination of overseas
operations and the balancing of local financial autonomy with effective central control.
 Determine a corporation’s dividend capacity and its policy given: i) The corporation’s short- and long-
term reinvestment strategy ii) The impact of capital reconstruction programmes such as share
repurchase agreements and new capital issues on free cash flow to equity. iii) The availability and
timing of central remittances iv) The corporate tax regime within the host jurisdiction.
 Advise, in the context of a specified capital investment programme, on an organisation’s current and
projected dividend capacity.
 Develop organisational policy on the transfer pricing of goods and services across international borders
and be able to determine the most appropriate transfer pricing strategy in a given situation reflecting
local regulations and tax regimes.
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Policy Framework of Financial Managers
Key roles and responsibilities of the financial manager
Primarily the financial manager is responsible to make decision such that it maximizes the wealth of the
shareholders.
The financial managers tend to develop a policy framework that help in decision making and specifies the criteria
for the evaluation of the strategy.
Definition
A policy framework is document that sets out a set of procedures or goals, which might be used in
negotiation or decision-making to guide a more detailed set of policies, or to guide ongoing
maintenance of an organization's policies.
Major issues in which we require the assistance of the framework is
 Ethics and Social Responsibilty

What should be the behavior of the firm and its individuals towards the society as whole
 Stakeholder Protection
How to ensure that the rights of each individual stakeholder are met
 Corporate Governance
What kind of system should be in place in organization to deal with different issues of risk management
 Sustainable Development
To make decisions that will meet the needs of the present as well as not compromise the ability of future
generations.
Key Areas of Financial Policy
The areas of our financial policy as well as the role of financial manager revolve around the following
areas:
All of these topics will be covered in detail in the following chapters
 Investment Selection
How to appraise our investment?
How to evaluate competing projects?
 Cost of Capital minimization and finance raising
What is the optimal level of gearing?
What kind of finances are available?
How to analyse the restrictions of our investments such as debt covenants
 Distribution and Retention Policy
How cash to distribute to the existing shareholders?
At what levels to maintain our retained earnings?
Should we focus on cash dividends or capital gains?
 Communication with stakeholders
What kind of information is important to stakeholders ? e.g expected returns ,gearing levels etc
 Financial Planning and Control
 Risk Management ( To incorporate the risk appetite of the stakeholders into decision making process of
the organization
Optimal Capital Structure
Optimal capital structure will be discussed in detail in B3 but for introductory purposes one needs to know that
we are referring to allocation of capital raising between debt and equity instruments. The purpose to obtain an
optimal capital structure of debt and equity is to maximise its value. Primarily it all depends upon the stability of
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the cash flows. If the cash inflows are stable, this would enable a corporation to take more debt finance in its
capital structure. Stable cash flows indicate less risk and therefore debt holders would become more willing to
lend to the corporation. Since debt is cheaper to finance than equity because of lower required rates of return
and the tax shield, taking on more debt should increase the value of the corporation.
However academics have also observed that managers would prefer to use internally generated funds rather than
going to the external markets for funds because it is cheaper and less intrusive on the corporation.
Risk Management
Risk, in this context, refers to the volatility of returns (both positive and negative) that can be quantified through
statistical measures such as probabilities, standard deviations and correlations between different returns.
Its management is about decisions made to change the volatility of returns a corporation is exposed to, for
example changing a company’s exposure to floating interest rates by swapping them to fixed rates for a fee.
The volatility of returns of a project should be managed if it results in increasing the value to a corporation. Given
that the market value of a corporation is the net present value (NPV) of its future cash flows discounted by the
return required by its investors, then higher market value can either be generated by increasing the future cash
flows or by reducing investors’ required rate of return (or both). A risk management strategy that increases the
NPV at a lower comparative cost would benefit the corporation.
The return required by investors is the sum of the risk free rate and a premium for the risk they undertake. If
investors hold well-diversified portfolios of investments then they are only exposed to systematic risk as their
exposure to firm-specific risk has been diversified away. Therefore, the risk premium of their required return is
based on the capital asset pricing model (CAPM). Research suggests companies with diverse equity holdings do
not increase value by diversifying company specific risk, as their equity holders have already achieved this level of
risk diversification. Moreover, risk management activity designed to transfer systematic risk would not provide
additional benefits to a corporation because, in perfect markets, the benefits achieved from risk management
activity would at least equal the costs of undertaking such activity.
Such an argument would not apply to smaller companies which have concentrated, non-diversified equity
holdings. In this case the equity holders, because they are exposed to both specific and systematic risk, would
benefit from risk diversification by the company. Therefore smaller companies can and should undertake risk
management.
However, empirical research studies have found that risk management is undertaken mostly by larger companies
with diverse equity holdings and not by the smaller companies. The accepted reason for this is that the costs
related to risk management are large and mostly fixed
In addition to the ability of larger companies to undertake risk management, market imperfections may provide
the motivation for them to do so.
The following discussion considers the circumstances which may result in providing such opportunities.
Taxation
Risk management may help in reducing the amount of tax that a corporation pays by reducing the volatility of the
corporation’s earnings. Where a corporation faces taxation schedules that are progressive (that is the corporation
pays proportionally higher amounts of tax as its profits increase), by reducing the variability of that corporation’s
earnings and thereby staying in the same low tax bracket will reduce the tax payable.
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Insolvency and financial distress

A corporation may find itself in a situation of being insolvent when it cannot meet its financial obligations as they
fall due. Financial distress is a situation that is less severe than insolvency in that a corporation can operate on a
day-to-day basis, but it finds that these operations are difficult to conduct because the parties dealing with it are
concerned that it may become insolvent in the future. When facing financial distress a corporation will incur
additional costs, both direct and indirect, due to the situation it is facing.
Academics exploring this area postulate that because stakeholders are subject to the corporation’s full risk, as
opposed to only systematic risk, which is faced by the corporation’s equity holders, the stakeholders would
demand greater compensation for their participation. Where an organisation actively manages its risk and
prevents (or reduces the possibility of) situations of financial distress, it will find it easier to contract with its
stakeholders and at a lower cost. Hence, the more volatile the cash flows of a corporation, the more likely the
need to manage its risk in order to reduce the costs related to financial distress.
External funding and agency costs

Another consequence of financial distress is the impact this may have on the corporation’s ability to undertake
profitable future investment. Financial distress may make the cost of external debt and equity funding so
expensive that a corporation and its management may be forced reject profitable projects. Academics refer to
this as the under investment problem.
Equity holders in effect hold a call option on a corporation’s assets and debt holders can be considered to have
written the option. In cases of low financial distress the company may be considered to be similar to an at-the-
money option for its equity holders, and, therefore, they would be more willing to undertake risky projects as
they would benefit from any increase in profitability, but the impact of any loss is limited. In the case of
substantial financial distress, the option could be considered to be well out-of-money. In this situation there is
little (or no) benefit to equity holders of undertaking new projects, as the benefits of these will pass to the debt
holders initially. However, debt holders would be reluctant to lend to a severely distressed company in any case.
Therefore, when raising debt capital, a corporation that is subject to low levels of financial distress would face
higher agency costs, with lenders imposing higher borrowing costs and more restrictive covenants. Whereas debt
holders get a fixed return on their investment, any additional benefit due to higher profits would go to the equity
holders. This would make the debt holders reluctant to allow the corporation to undertake risky projects or to
lend more finance to the corporation because they would not gain any benefit from the risky projects.
A corporation that faces high levels of financial distress would find it difficult to raise equity capital in order to
undertake new investments. If corporations try to raise equity finance for relatively less risky projects then the
profits earned from such projects would initially go to the debt holders and the equity holders will gain only
residual profits. Therefore equity holders would put pressure on the corporation and its management to reject
good, low risk projects, which may have been acceptable to the bondholders. Therefore, risk management in
reducing financial distress by reducing the volatility of the corporation’s cash inflows may help the management
to obtain an optimal mix of debt and equity, and to undertake profitable projects.
Capital structure and information asymmetry

Risk management can help a corporation obtain an optimal capital structure of debt and equity to maximise its
value. Since risk management stabilises the variability of cash inflows, this would enable a corporation to take
more debt finance in its capital structure. Stable cash flows indicate less risk and therefore debt holders would
become more willing to lend to the corporation. Since debt is cheaper to finance than equity because of lower
required rates of return and the tax shield, taking on more debt should increase the value of the corporation. Risk
management can help achieve this.
Academics have observed that managers would prefer to use internally generated funds rather than going to the
external markets for funds because it is cheaper and less intrusive on the corporation. They suggest that
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borrowing money from the external markets, whether equity or debt, would involve parties who do not have the
complete information about the corporation. This information asymmetry would make the external sources of
funds more expensive. If risk management stabilises the cash flows that the corporation receives from year to
year, then this would enable managers to plan when the necessary internal funds will become available for future
investments with greater accuracy. They will then be able to align their investment policies with the availability of
funding.
Manager behaviour towards risk management

In his seminal paper, Rene Stulz suggests that managers, whose performance reward structure includes large
equity stakes in a corporation, are more likely to reduce the corporation’s risk, as opposed to managers whose
performance reward structure is based primarily on equity options. Managers who hold concentrated equity
stakes in a corporation face increased levels of risk when compared to other equity holders. As discussed
previously, investors hold well-diversified portfolios and face exposure to systematic risk only. But managers with
concentrated equity stakes would face both systematic and unsystematic risk. Therefore, they have a greater
propensity to reduce the unsystematic risk.
However, if investors do not reward corporations that are reducing unsystematic risk, because they have
diversified this risk away themselves. And if a corporation’s managers use the corporation’s resources to reduce
unsystematic risk, thereby reducing the corporation’s value. Then it is worth exploring under what circumstances
would equity investors allow managers to act to reduce unsystematic risk and whether such actions could actually
result in the value of the corporation increasing.
Stulz argues that encouraging managers to hold concentrated equity positions but allowing them to reduce
unsystematic risk at the same time, may enable them to act in the best interests of the corporation and the result
may be an increase in the corporate value. He explains that managers, who do not have to worry about risks that
are not under their control (because they have hedged them away), would be able to focus their time, expertise
and experience on the strategies and operations that they can control. This focus may result in the increase in the
value of the corporation, although the impact of this increase in value is not easily measurable or directly
attributable to risk management activity.
As an aside, one could pose the question, why don’t managers, who are rewarded by equity, diversify the risk of
concentrated equity investments themselves? They could sell equity in their own corporation and replace it by
buying equity in other corporations. In this way they do not have to hold concentrated equity positions and then
would be like the normal equity holders facing only systematic risk. A research study on wealth management,
which looked at concentrated equity positions and risk management, found that senior managers are reluctant to
reduce their concentrated equity positions because any attempt to sell the equity would send negative signals to
the markets, and cause their corporation’s value to decrease unnecessarily.
Contrary to the behaviour of managers who hold concentrated equity stakes, managers who own equity options,
which will be converted into equity at a future date, will actively seek to increase the risk of a corporation rather
than reduce it. Managers who hold equity options are interested in maximising the future price of the equity.
Therefore in order to maximise future profits and the price of the equity, they will be more inclined to undertake
risky projects (and less inclined to manage risk). Equity options, as a form of reward, have been often criticised
because they do not necessarily make managers behave in the best interests of the corporation or its equity
investors, but encourage them to act in an overly risky manner.
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Behavioral Finance
Behavioral finance considers the impact of psychological factors on financial decision-making. This challenges the
idea that share prices and investor returns are determined by rational economic criteria.
1. Psychological factors affecting decision making

Behavioral finance examines the psychological factors that lie behind financial decision making; some of the
main factors are listed below.
 Overconfidence
Investors and managers have a tendency to overestimate their own abilities.
 Search for patterns, herding and cognitive dissonance

Investors look for patterns which can be used to justify investment decisions. This might involve
analyzing a company’s past returns and using this to extrapolate future Proformance. It might also
involve comparing peaks or troughs in the stock market to historic peaks and troughs in previous
decades. This type of behavior can lead to herding, where people buy (or sell) shares because share
prices are rising (or falling) and can help to explain stock market bubbles (or crashes). Herding is also
based on the psychological comfort of following the crowd.
A stock market bubble can emerge because investors buy shares simply because share prices have been
rising in the past, this then creates a stronger rise in share prices which in turn creates a stronger
demand for shares. Share prices can therefore be driven up to a level that is not justified given the future
profit potential due investors following the crowd and continuing to buy shares.
This is compounded by a reluctance of investors to admit that they are wrong (sometimes referred to as
cognitive dissonance).
Narrow framing
Many investors fail to see the bigger picture, and focus too much on short-term fluctuations in share
price movements.
Availability bias People will often focus more on information that is prominent (available). Prominent
information is often the most recent information about a company, and this may help to explain why
share prices move significantly shortly after financial results are published.
Conservatism
Investors and managers are resistant to changing their opinion so, for example, if a company’s profits are
better than expected the share price may not react significantly because investors under react to this
news
Share valuation
Behavioral finance suggests that managers are over-confident in their own abilities. This helps to explain why
most boards believe that the market undervalues their shares. This can lead to managers taking actions that
may not be in their shareholders best interests, such as delisting from the stock market or defending against
a takeover bid that they believe undervalues their company.
Acquisitions
Behavioral finance can also explain why many acquisitions are over-valued, this aspect of behavioral finance
is covered in chapter 10.
CAPM
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Behavioral finance conflicts with theories (such as the capital asset pricing model) that suggest that asset
prices and investor returns are determined in a rational manner, based on the anticipated risk and future
cash flows of a share.
For example, narrow framing can mean that if a single share in a large portfolio performs badly in a particular
week then logically this should not matter greatly to an investor who is investing in shares over say a twenty
year period. However in reality it does seem to matter, so investors are showing a greater aversion to risk
than the capital asset pricing model (which argues that diversified investors should only care about
systematic risk) suggests they should.
Financial strategy
Behavioral factors such as overconfidence and cognitive dissonance can also explain why managers persist
with investment strategies that are unlikely to succeed. For example, in the face of economic logic managers
will often delay decisions to terminate projects for behavioral reasons.
Patterns of behavior
Are all financial decisions rational? The assumption that they are underpins theories of economic behaviour and
stock market models, such as the efficient market hypothesis.
Why then do stock market booms and busts occur if investors are acting rationally? Rational behaviour surely
implies no shocks, with stock markets showing steady movements in share prices, but not sudden spurts.
However, unexpected and significant news could still result in sudden shocks.
Also, why are some mergers and acquisitions considered to be poor deals? If a listed company is being acquired,
surely the acquisition price should be based on the market value of its shares, if the markets are valuing it fairly.
Why then is there uncertainty about the true value of many acquired companies? Why also do many acquisitions
run into difficulties?
If proper due diligence has been done and decisions are made rationally, surely the directors of the acquiring
company will only go ahead if the combination stands a very good chance of success.
Behavioural finance attempts to explain how decision makers take financial decisions in real life, and why their
decisions might not appear to be rational every time and, hence, have unpredictable consequences. Behavioural
finance has been described as ‘the influence of psychology on the behaviour of financial practitioners’ (Sewell,
2005). Behavioural finance seeks to examine the following assumptions of rational decision making by investors
and financial managers:
1. Financial decision makers seek to maximise their utility and do so by trying to maximise portfolio or company
value.
2. They take financial decisions based on analysis of relevant information.
3. The analysis of financial information that they undertake is rational, objective and risk-neutral.
Let’s look at how behavioural factors may influence decision making and, therefore, stock markets’ and
companies’ financial strategies.
Investors
Maximisation of utility
Rational decision making by investors implies that their decisions about their investment portfolios will aim to
maximise their long-term wealth and, hence, their utility. However, behavioural factors may influence investors
to take decisions that are not the best ones for achieving maximum value from their portfolios. Investors may
have preferences for particular stocks on non-financial grounds – for example, companies that they consider are
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acting with social responsibility. They may also avoid ’sin stocks’ – companies operating in sectors that they
regard as unethical.
Investor utility may also be linked to the process of decision making. Some investors hold on to shares with prices
that have fallen over time and are unlikely to recover. They may do this because it will cause them psychological
hurt to admit, even only to themselves, that their decision to invest was wrong. This is known as cognitive
dissonance.
Analysis of relevant information

Behavioural finance next looks at the basis that investors use to take decisions. It suggests that decisions may not
be based on an assessment of relevant financial information, but on other grounds. Investors may use
information that is not relevant but is readily available, possibly to simplify the decision making process (known as
anchoring). For example, investors may buy shares that in the past have had high values, on the grounds that
these represent their true potential values, even though rational analysis suggests that the prices of these shares
will remain low in the future Investors may also believe that the probability of a future outcome will be influenced
by how often the same outcome has occurred in the past. A non-financial example of this idea would be the
situation when a coin is flipped eight times, comes up as tails every time and it is said that heads is more likely the
ninth time as, by the ‘law of averages’, heads must come up soon.
If the value of a company’s shares has risen for some time, investors will be using similar logic to the coin example
if they sell those shares on the grounds that the shares have gained in value for ‘long enough’ and their price
must therefore soon start to fall, even if rational analysis suggest that the rise in price will continue. This is known
as the gambler’s fallacy.
Another deviation from rational analysis is the herd instinct, where investors buy or sell shares in a company or
sector because many other investors have already done so. Explanations for investors following a herd instinct
include social conformity, the desire not to act differently from others. Following a herd instinct may also be due
to individual investors lacking the confidence to make their own judgements, believing that a large group of other
investors cannot be wrong. If many investors follow a herd instinct to buy shares in a certain sector, for example
the IT sector, this can result in significant price rises for shares in that sector and lead to a stock market bubble.
Investors may not therefore base their decisions on rational analysis, but there is also evidence to suggest that
stock market ‘professionals’ often don’t do so either. Studies have shown that there are traders in stock markets
who do not base their decisions on fundamental analysis of company performance and prospects. They are
known as noise traders.
Characteristics associated with noise traders include making poorly timed decisions and following trends.
Chartism, using analysis of past share prices as a basis for predicting the future, is an example of noise trading.
Fund managers may also be subject to behavioural influences. Fund managers who wish to give the impression
that they are actively managing their investment portfolios, may periodically reposition their portfolios into new
sectors, even though the old sectors continue to have good prospects. Some fund managers also ignore
companies with low market capitalisation, with the result that their shares are not purchased and their value
remains low (known as small capitalisation discount).
Rational, objective and risk-neutral analysis

Investors may base their decision on an analysis of available information, but behavioural finance has highlighted
that this analysis can be subjective. One aspect is confirmation bias,taking an approach or paying attention to
evidence that confirms investors’ current beliefs about their investments and ignoring evidence that casts doubt
on their beliefs. In the dotcom boom, some investors used a variety of methods to value high-tech companies at a
large premium, but ignored models such as cash flow valuation models that indicated the worth of those
companies was much lower.
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Another aspect of investor bias is attitudes towards risks. Rational theory suggests that risk-neutral investors will
adopt a long-term approach based on expected values. However, behavioural finance has highlighted various
attitudes towards the risks of making profits or losses. Some investors may be attracted by a company that offers
the possibility of making very high returns, even if the possibility is not very great (again, the dotcom boom
provides evidence of this).
Other investors may have regret aversion, avoiding investments that have the risk of making losses, even though
expected value analysis suggests that, in the long-term, they will make significant capital gains. Investors with
regret aversion may also prefer to invest in companies that look likely to make stable, but low, profits, rather than
companies that may make higher profits in some years but possibly losses in others.
There is also evidence that many investors pay most attention to the last set of financial results and other recent
information about a company, and take less notice of data that has been available for a while. Explanations for
this have included recent information being more readily accessible and more immediate in investors’ minds than
older information. A consequence of this may be over-reaction when companies release information, with share
prices rising or falling quickly after information is released and then going back in the opposite direction to an
equilibrium value over time.
Behavioural finance also suggests that there may be a momentum effect in stock markets. A period of rising share
prices may result in a general feeling of optimism that price rises will continue and an increased willingness to
invest in companies that show prospects for growth. If a momentum effect exists, then it is likely to lengthen
periods of stock market boom or bust.
Finance managers
Behavioural finance studies have also looked at decision making by managers of companies. They have identified
factors that affect investment decisions of all types, but particularly focused on mergers and acquisitions, since
many do not appear to fulfil the expectations of the acquiring company.
Maximisation of utility
Companies can be regarded as maximising their utility by long-term maximisation of their shareholders’ wealth.
However, it is not just behavioural finance that casts doubt on whether company managers are seeking this
objective for their shareholders. Agency theory also highlights that managers may have different objectives from
shareholders, such as maximising their own short-term rewards and expanding the company by acquisition or
other means in order to enhance their own reputation.
However, behavioural finance has highlighted that managers’ objectives may not be explainable rationally.
Studies have looked at contested takeovers, where different companies bidding against each other has forced the
acquisition price up to a level that was significantly greater than many outside the companies involved thought
was reasonable. One theory for this is that once managers enter into competition, it makes acquiring a company
that others have sought to buy as well, a source of satisfaction in itself. The acquirer’s managers are unwilling to
let someone else have what they have been trying to acquire (known as loss aversion bias).
Analysis of relevant information

There is also evidence that when managers choose to bid for another company, the factor is sometimes not a
rational assessment of the target’s potential, but their belief in their own abilities. Some managers of acquiring
companies seem to believe that, however poor the outlook for the target seems, their own considerable
management skills will improve its prospects after the merger takes place. A symptom of this belief could be
managers arguing that the target should be valued not using its own price-earnings ratio, but using the (higher)
price-earnings ratio of the acquirer.
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Once an acquisition or any other strategy has been implemented, what influences managers may be the need to
show that they have made the right decisions. Managers may feel that a failing strategy would damage their
reputation, and possibly their future prospects. Therefore, they may decide to commit more funds trying to
ensure that the strategy is successful, rather than admitting defeat and taking steps to mitigate losses (known as
entrapment).
Rational, objective and risk-neutral analysis

Managers may also be subjective when they analyse information. Also, they may have confirmation bias, paying
attention to information that suggests that an acquisition will enhance value and ignoring evidence that indicates
that the target will not be a good buy. They may also seek information that provides a simple yardstick for their
own decision making, however flawed that information may be. The value put on the target company by its own
directors may be subject to considerable bias, but the acquirer’s directors may regard it as a good indication of
what the target’s fair value is.
Limitations of behavioural finance

Critics of the behavioural finance approach have argued that even if individuals make irrational decisions when
left by themselves, participating in finance markets helps discipline them to act rationally by giving them
opportunities to learn from their experiences. The consequences of irrational decisions are shortterm anomalies.
In the longer-term general theories, such as the efficient market hypothesis, will apply.
Conclusion
Behavioural finance has identified a number of factors that may take individuals away from a process of taking
decisions to maximise economic utility on the basis of rational analysis of all the information supplied. If these
factors apply in practice, they can lead to movements from what would be considered a fair price for an individual
company’s shares, and the market as a whole to a period where share prices are collectively very high or low. For
an acquisition, it can lead to a purchase price that differs significantly from what appears to be a rational
valuation.
Ethics and Financial Manager
The actions of a financial manager have an impact at 3 levels
1. Society level (to take into account wishes of all stakeholders)

2. Company level (how to approach corporate governance and resolve stakeholder conflict)
3. Individual level (actions and behavior of the self)
At all levels the financial manager should try to be ethical at the highest level
ACCA code of ethics mandates that the financial managers should have intergrity, objectivity, due diligence ,
confidentiality in matters and conducts work in professional manner.
One should always remember there is interconnectedness of the ethics of good business practice. Unethical
practices conducted in one department will have an impact on other departments as well. For example unethical
procurement practices will causes cost of production to increase which in turn will result in lower profits and thus
result in reduction in staffing and budget cuts.
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Sustainability and Environment Issues
Corporation need to make sure that they meet the needs of present without compromising the ability of future
generation. It is extremely important that attention is paid to sustainability and environment risk.
To address this issue triple bottom line reporting is used. It is an accounting framework covering three aspects:
social, environmental and financial. Triple bottom line reporting gives the idea that organization can not only
earn profits but also positively influence the society and environment.
Thus the organizations activities are assessed with reference to activities such as
 Implementing Environment Management System (EMS)

 Ensuring staff commitment to good environmental practices.
 Compliance with environment laws of the respective area of operations.
Stakeholder Conflict
Stakeholders:
Group or individuals whose interests are directly affected by activities of an organisation. e.g.
Internal:Interacts daily with the organisation

Connected: Frequent interaction with the company
External: Occasional interaction with organisation
Mendelow’s stakeholder’smodel:
To identify and manage stakeholders according to their expectations.
Power: In an influential position?

Interest: Is a stakeholder affected by the decision made in the organisation?
The Detailis:
Key Stakeholders who have high power and high interest are known as key
players: players.
Management really needs to keep those people happy. They have the
power and they have the willingness to do something about it if they are
upset. These stakeholders can stop any strategy in its tracks.
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Keep Some stakeholders have high power but they are unlikely to take action
satisfied: even if management does something which they dislike. They may be
unwilling to take because of professional or ethical reasons. For example,
medical staﬀ in hospitals are very unlikely to take industrial action.
Management doesn‘t have to be quite as careful with these people as with

the key players. However, they have to be kept satisfied otherwise they
could be provoked to take action and turn into key players.
Keep People with low power but high interest have to be kept informed. They
informed: can‘t do much about it themselves but they might be able to influence key
players to take action on their behalf.
Minimal These stakeholders have low power and low interest. Management can
eﬀort: almost ignore these people. After all, what are they going to do if they
don‘t like what‘s happening?
Integrated Reporting
This following paragraphs have been taken from the blog written by Dr Carol A Adams in ACCA global
Integrated reporting requires thinking about ‘value’ beyond financial terms – a long overdue development given
that around 80% of the value of company is typically in intangible assets.
Building strong relationships with stakeholders, building a loyal customer base, developing intellectual capital
and managing environmental risks, etc, tend to fall off the radar when corporate execs think short-term. But
they are critical to long-term success. Integrated reporting keeps the focus on long-term strategy and integrated
reports are forward-looking documents covering strategy, the context in which it will be delivered and how the
company has, and will, create value for providers of capital and others in the short, medium and long-term. The
International <IR> Framework recognises that long-term success depends, amongst other things, on sound
management, relationships, a satisfied workforce and the availability of natural resources.
Much of the information companies are providing to investors is not in their annual review or financial
statements – further evidence of the need for change. An integrated report fills some of the gap and allows an
organisation to tell providers of capital, and others, how it creates value for them.
If you asked your colleagues how they would describe your business model would they have the same view as
you? Probably not. Many corporate execs think about their business model in narrow financial terms or from the
perspective about the bit of the business they are responsible for. But if the senior exec work together in
conceptualising the business model and start to think about inputs and outcomes in broader terms, a different
picture about what needs to be managed and what adds value emerges.
The six capitals concept is intended to facilitate this broader thinking about value and the business model. ACCA
has been at the forefront of its development coordinating the work of the IIRC’s Technical Collaboration Group
on the capitals and funding my involvement.
Some companies are taking a first step towards integrated reporting by getting their financial and sustainability
people working together. This is advantageous in that accountants could better understand social and
environmental risks and their impact on reputation and the bottom line whilst sustainability teams need to
develop skills in making a business case for their work. But the integrated thinking that goes behind integrated
reporting needs to involve all the senior execs and the Board.
Multinational
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A multinational is one which own or control production facilities or subsidiaries or services facilities outside
the country in which it is based. There are many strategic reasons for engaging in foreign investment which
include following:
 New market
• New source of raw material
• Production efficiency
• Expertise
• Political safety
• Economies of scale
• Managerial and marketing expertise
• Technology
• Financial economies
• Commonly used means to establish an interest abroad include:
• Joint venture
• Licensing agreements
• Management contracts
• Branches
• Subsidiaries
• Joint
JV/Licensing /Subsidiaries
Joint Ventures
The two distinct types of joint venture are industrial co-operation (contractual) and joint-equity. A contractual
joint venture is for a fixed period and the duties and responsibility of the parties are contractually defined. A
joint-equity venture involves investment, is of no fixed duration and continually evolves.
The main advantages and disadvantages of joint ventures
Advantages
• Relatively low-cost access to new markets.
• Easier access to local capital markets, possibly with accompanying tax incentives or grants.
• Use of joint venture partner's existing management expertise, local knowledge, distribution network,
technology, brands, patents and marketing or other skills Sharing of risks.
• Sharing of risks.
• Sharing of costs, providing economies of scale.
Disadvantages
• Managerial freedom may be restricted by the need to take account of the views of all the joint venture
partners.
• There may be problems in agreeing on partners' percentage ownership, transfer prices, reinvestment
decisions, nationality of key personnel, remuneration and sourcing of raw materials and components.
• Finding a reliable joint venture partner may take a long time.
• Joint ventures are difficult to value, particularly where one or more partners have made intangible
contributions.
Exporting
Exporting may be direct selling by the firm's own export division into the overseas markets, or it may be indirect
through agents, distributors, trading. Exporting may be unattractive because of tariffs, quotas or other import
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restrictions in overseas markets, and local production may be the only feasible option in the case of bulky
products, such as cement and flat glass.
Licensing
Licensing involves conferring rights to make use of the licensor company's production process on producers
located in the overseas market. Licensing is an alternative to FDI by which overseas producers are given rights to
use the licensor's production process in return for royalty payments. The main advantages and disadvantages of
licensing
Advantages
• It can allow fairly rapid penetration of overseas markets.
• It does not require substantial financial resources.
• Political risks are reduced since the licensee is likely to be a local company.
• Licensing may be a possibility where direct investment is restricted or prevented by a country.
• For a multinational company, licensing agreements provide a way for funds to be remitted to the parent
company in the form of license fees.
Disadvantages
• The arrangement may give the licensee know-how and technology which it can use in competing with the
licensor after the license agreement has expired.
• It may be more difficult to maintain quality standards, and lower quality might affect the standing of a brand
name in international markets.
• It might be possible for the licensee to compete with the licensor by exporting the produce to markets
outside the licensee's area.
• Although relatively insubstantial financial resources are required, on the other hand relatively small cash
inflows will be generated.
Management contracts
Management contracts whereby a firm agrees to sell management skills are sometimes used in combination
with licensing. Such contracts can serve as a means of obtaining funds from subsidiaries, and may be a useful
way of maintaining cash flows where other remittance restrictions apply.
Overseas subsidiaries
The subsidiaries may be wholly owned or just partly owned, and some may be owned through other
subsidiaries. Whatever the reason for setting up subsidiaries abroad, the aim is to increase the profits of the
multinational's parent company. However, there are different approaches to increasing profits that the
multinational might take. At one extreme, the parent company might choose to get as much money as it can
from the subsidiary, and as quickly as it can. This would involve the transfer of all or most of the subsidiary's
profits to the parent company.
At the other extreme, the parent company might encourage a foreign subsidiary to develop its business
gradually, to achieve long-term growth in sales and profits. To encourage growth, the subsidiary would be
allowed to retain a large proportion of its profits, instead of remitting the profits to the parent company.
Branches
Firms that want to establish a definite presence in an overseas country may choose to establish a branch rather
than a subsidiary. Key elements in this choice are as follows:
Taxation
In many countries the remitted profits of a subsidiary will be taxed at a higher rate than those of a branch, as
profits paid in the form of dividends are likely to be subject to a withholding tax
Formalities
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• As a separate entity, a subsidiary may be subject to more legal and accounting formalities than a branch.
• However a separate legal entity, a subsidiary may be able to claim more reliefs and grants than a branch.
Marketing
A local subsidiary may have a greater profile for sales and marketing purposes than a branch.
International Trade
Theory and practice of international trade

Business enterprises are now also becoming increasingly “internationalized” by the development of
multinational activities beyond pure import and export trade.
Theory of international trade

In the modern economy, production is based on a high degree of specialization. Specialization increases
productivity and raises the standard of living. International trade extends the principle of the division of labor
and specialization to countries.
International trade arises for a number of reasons;

Different goods require different proportions of factor inputs in their production.
• Economic resources are unevenly distributed throughout the world.
• The international mobility of resources is extremely limited.
The law of comparative advantage

The significance of the law of comparative advantage is that it provides a justification for the following beliefs:
• Countries should specialize in what they produce, even when they are less efficient (in absolute terms) in
producing every type of good. They should specialize in the goods where they have a comparative
advantage (they are relatively more efficient in producing).
• International trade should be allowed to take place without restrictions on imports or exports i.e. there
should be free trade.
Does the law apply in practice?

The law of comparative advantage does apply in practice, and countries do specialize in the production of
certain goods. However, there are certain limitations or restrictions on how it operates.
• Free trade does not always exist. Some countries take action to protect domestic industries and discourage
imports. This means that a country might produce goods in which it does not have a comparative
advantage.
• Transport costs (assumed to be nil in the examples above) can be very high in international trade so that it is
cheaper to produce goods in the home country rather than to import them.
The advantages of international trade

• Some countries have a surplus of raw materials to their needs, and others have a deficit. A country with a
surplus (e.g. of oil) can take advantage of its resources to export them. A country with a deficit of a raw
material must either import it.
• International trade increases competition among suppliers in the world's markets. Greater competition
reduces the likelihood of a market for a good in a country being dominated by a monopolist. The greater
competition will force firms to be competitive and so will increase the pressures on them to be efficient, and
also perhaps to produce goods of a high quality.
• International trade creates larger markets for a firm's output, and so some firms can benefit from
economies of scale by engaging in export activities.
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• There may be political advantages to international trade, because the development of trading links provides
a foundation for closer political links. An example of the development of political links based on trade is the
European Union.
Barriers to entry
Barriers to entry are factors which make it difficult for suppliers to enter a market. Multinationals may face
various entry barriers. All these barriers may be more difficult to overcome if a multinational is investing abroad
because of such factors as unfamiliarity with local consumers and government favoring local firms. Strategies of
expansion and diversification imply some logic in carrying on operations. It might be a better decision, although
a much harder one, to cease operations or to pull out of a market completely. There are likely to be exit barriers
making it difficult to pull out of a market.
Product differentiation barriers

An existing major supplier would be able to exploit its position as supplier of an established product that the
consumer/customer can be persuaded to believe is better. A new entrant to the market would have to design a
better product, or convince customers of the product's qualities, and this might involve spending substantial
sums of money on R&D, advertising and sales promotion.
Absolute cost barriers

These exist where an existing supplier has access to cheaper raw material sources or know-how that the new
entrant would not have. This gives the existing supplier an advantage because its input costs would be cheaper
in absolute terms than those of a new entrant.
Economy of scale barriers

These exist where the minimum level of production needed to achieve the greatest economies of scale is at a
high level. New entrants to the market would have to be able to achieve a substantial market share before they
could gain full advantage of potential scale economies, and so the existing firms would be able to produce their
output more cheaply.
Fixed costs
The amount of fixed costs that a firm would have to sustain, regardless of its market share, could be a significant
entry barrier.
Legal barriers
These are barriers where a supplier is fully or partially protected by law. For example, there are some legal
monopolies (nationalized industries perhaps) and a company's products might be protected by patent (for
example, computer hardware and software).
Trade Agreements/Free trade
Free Trade
Free trade exists where there is no restriction on imports from other countries or exports to other countries. The
European Union (EU) is a free trade area for trade between its member countries. In practice, however, there
are many barriers to free trade because governments wish to protect home industries against foreign
competition.
Protectionist measures
Protectionist measures may be implemented by a government, but commonly exceeds what governments are
prepared to allow.
Protection can be applied in several ways, including the following:

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• Tariffs or customs duties

• Import quotas
• Hidden export subsidies and import restrictions
• Government action to devalue the currency
Tariffs or customs duties

Tariffs or customs duties are taxes on imported goods. The effect of a tariff is to raise the price paid for the
imported goods by domestic consumers, while leaving the price paid to foreign producers the same, or even
lower. The difference is transferred to the government sector.
An ad valorem tariff is one which is applied as a percentage of the value of goods imported. A specific tariff is a
fixed tax per unit of good.
Import quotas
Import quotas are restrictions on the quantity of a product that is allowed to be imported into the country. The
quota has a similar effect on consumer welfare to that of import tariffs, but the overall effects are more
complicated.
• Both domestic and foreign suppliers enjoy a higher price, while consumers buy less.
• Domestic producers supply more.
• There are fewer imports (in volume).
• The Government collects no revenue
Hidden export subsidies and import restrictions

An enormous range of government subsidies and assistance for exports and deterrents against imports have
been practiced, such as:
• For exports – export credit guarantees (government-backed insurance against bad debts for overseas
sales), financial help (such as government grants to the aircraft or shipbuilding industry) and State
assistance via the Foreign Office.
• For imports – complex import regulations and documentation, or special safety standards demanded
from imported goods and so on.
Government action to devalue the currency

If a government allows its currency to fall in value, imports will become more expensive to buy. This will reduce
imports by means of the price mechanism, especially if the demand and supply curves for the products are
elastic.
Arguments against protection

Arguments against protection are as follows:
Reduced international trade

Because protectionist measures taken by one country will almost inevitably provoke retaliation by others,
protection will reduce the volume of international trade. This means that the following benefits of international
trade will be reduced.
Specialization.
Greater competition and so greater efficiency among producers.
The advantages of economies of scale among producers who need world markets to achieve their economies
and so produce at lower costs.
Retaliation
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Obviously it is to a nation's advantage if it can apply protectionist measures while other nations do not. But
because of retaliation by other countries, protectionist measures to reverse a balance of trade deficit are
unlikely to succeed. Imports might be reduced, but so too would exports.
Effect on economic growth

It is generally argued that widespread protection will damage the prospects for economic growth among the
countries of the world, and protectionist measures ought to be restricted to 'special cases' which might be
discussed and negotiated with other countries.
Political consequences
Although from a nation's own point of view protection may improve its position, protectionism leads to a worse
outcome for all. Protection also creates political ill-will among countries of the world and so there are political
disadvantages in a policy of protection.
Arguments in favour of protection

• Imports of cheap goods
• Dumping
• Retaliation
• Infant industries
• Declining industries
• Reduction in balance of trade deficit
Imports of cheap goods

Measures can be taken against imports of cheap goods that compete with higher priced domestically produced
goods, and so preserve output and employment in domestic industries. The advantages of more employment at
a reasonably high wage for domestic labor are greater than the disadvantages that protectionist measures
would bring.
Dumping
Measures might be necessary to counter 'dumping' of surplus production by other countries at an
uneconomically low price. Although dumping has short-term benefits for the countries receiving the cheap
goods, the longer-term consequences would be a reduction in domestic output and employment, even when
domestic industries in the longer term might be more efficient.
Retaliation
Any country that does not take protectionist measures when other countries are doing so is likely to find that it
suffers all of the disadvantages and none of the advantages of protection.
Infant industries
Protectionism can protect a country's 'infant industries' that have not yet developed to the size where they can
compete in international markets. Less developed countries in particular might need to protect industries
against competition from advanced or developing countries.
Declining industries
Without protection, the industries might collapse and there would be severe problems of sudden mass
unemployment among workers in the industry.
Reduction in balance of trade deficit

However, because of retaliation by other countries, the success of such measures by one country would depend
on the demand by other countries for its exports being inelastic with regard to price and its demand for imports
being fairly elastic.
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European Union
The EU is one of several international economic associations. It dates back to 1957 (the Treaty of Rome) and now
consists of 27 countries, including formerly communist Eastern European countries.
The EU incorporates a common market combining different aspects.
A free trade area exists when there is no restriction on the movement of goods and services between countries.
This has been extended into a customs union.
A common market encompasses the idea of a customs union but has a number of additional features. In
addition to free trade among member countries there is also complete mobility of the factors of production. A
British citizen has the freedom to work in any other country of the EU, for example. A common market will also
aim to achieve stronger links between member countries, for example by harmonizing government economic
policies and by establishing a closer political confederation.
The single European currency, the euro, was adopted by 11 countries of the EU from the inception of the
currency at the beginning of 1999.
The single European market

The EU set the end of 1992 as the target date for the removal of all existing physical, technical and fiscal barriers
among member states, thus creating a large multinational European Single Market.
The elimination of these trade barriers will directly benefit multinational companies, making it easier for them to
engage in business across the European Union without having to deal with differing regulations (and other trade
barriers) within each country of the EU.
Elimination of trade restrictions

• Physical barriers (e.g. customs inspection) on goods and services have been removed for most products.
Companies have had to adjust to a new VAT regime as a consequence.
• Technical standards (e.g. for quality and safety) should be harmonized.
• Governments should not discriminate between EU companies in awarding public works contracts.
• Telecommunications should be subject to greater competition.
• It should be possible to provide financial services in any country.
• There should be free movement of capital within the community.
• Professional qualifications awarded in one member state should be recognized in the others.
• The EU is taking a co-ordinated stand on matters related to consumer protection.
Remaining barriers
There are many areas where harmonization is a long way from being achieved. Here are some examples:
• Company tax rates, which can affect the viability of investment plans, vary from country to country within
the EU.
• While there have been moves to harmonization, there are still differences between indirect tax rates
imposed by member states.
• There are considerable differences in prosperity between the wealthiest EU economies (e.g. Germany) and
the poorest (e.g. Greece). This has meant that grants are sometimes available to depressed regions, which
might affect investment decisions; and that different marketing strategies are appropriate for different
markets
• Differences in workforce skills can have a significant effect on investment decisions. The workforce in
Germany is perhaps the most highly trained, but also the most highly paid, and so might be suitable for
products of a high added value.
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• Some countries are better provided with road and rail infrastructure than others. Where accessibility to a
market is an important issue, infrastructure can mean significant variations in distribution costs.
North American Free Trade Agreement (NAFTA)
Canada, the US and Mexico formed the North American Free Trade Agreement (NAFTA) which came into force in
1994. This free trade area covering a population of 360 million and accounting for economic Output of US$6,000
billion annually is almost as large as the European Economic Area (EEA), and is thus the second largest free trade
area after the EEA.
Under NAFTA, virtually all tariff and other (non-tariff) barriers to trade and investment between the NAFTA
members are to be eliminated over a 15-year period. In the case of trade with non-NAFTA members, each
NAFTA member will continue to set its own external tariffs, subject to obligations under GATT.
The World Trade Organization (WTO)
The World Trade Organization (WTO) is a global international organization dealing with the rules of trade
between nations.
The World Trade Organization (WTO) was formed in 1995 to continue to implement the GATT. The WTO has well
over 100 members, including the entire EU. Its aims include:
 To reduce existing barriers to free trade.
 To eliminate discrimination in international trade such as tariffs and subsidies.
 To prevent the growth of protection by getting member countries to consult with others before taking any
protectionist measures.
 To act as a forum for assisting free trade, by for example administering agreements, helping countries
negotiate and offering a disputes settlement process.
 Establishing rules and guidelines to make world trade more predictable.
The most favored nation principle

Most favored nation: a principle in the GATT international trade agreement binding the parties to grant each
other treatment which is as favorable as that offered to any other GATT member in respect of tariffs and other
trading conditions.
The WTO encourages free trade by applying the 'most favored nation' principle where one country that offers a
reduction in tariffs to another country must offer the same reduction to all other member countries of GATT.
Impact on protectionist measures
Although the WTO has helped reduce the level of protection, some problems still remain.
 Special circumstances (for example economic crises, the protection of an infant industry, and the rules of
the EU) have to be admitted when protection or special low tariffs between a groups of countries are
allowed.
 A country in the WTO may prefer not to offer a tariff reduction to another country because it would have to
offer the same reduction to all other GATT members.
 In spite of much success in reducing tariffs, the WTO has had less effect in dealing with many non-tariff
barriers to trade that countries may set up. Some such barriers, for example those in the guise of health and
safety requirements, can be very difficult to identify.
 New agreements are not always accepted initially by all members.
Nevertheless, the WTO exists to help business, and ultimately businesses should be able to benefit from the
expanded opportunities a freer global market brings, even if in certain countries some businesses may suffer
through losing the benefits of protection.
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International monetary institutions
The International Monetary Fund (IMF) and the World Bank are closely related. Both were set up in 1944 as
United Nation’s agencies to establish a stable global economic framework.
The IMF was set up partly with the role of providing finance for any countries with temporary balance of
payments deficits.
The World Bank aims to reduce poverty and to support economic development.
The International Monetary Fund

The main importance of the IMF to multinational organizations is that the IMF will step in to provide advice and
to provide financial support to countries with temporary balance of payments deficits.
The IMF and financial support for countries with balance of payment difficulties
If a country has a balance of payments deficit on current account, it must either borrow capital or use up official
reserves to offset this deficit. Since a country's official reserves will be insufficient to support a balance of
payments deficit on current account for very long, it must borrow to offset the deficit.
The IMF can provide financial support to member countries. Most IMF loans are repayable in three to five years.
Of course, to lend money, the IMF must also have funds. Funds are made available from subscriptions or 'quotas'
of member countries. The IMF uses these subscriptions to lend foreign currencies to countries which apply to
the IMF for help.
IMF loan conditions

The preconditions that the IMF places on its loans to debtor countries vary according to the individual situation
of each country, but the general position is as follows:
• The IMF wants countries which borrow from the IMF to get into a position to start repaying the loans fairly
quickly. To do this, the countries must take effective action to improve their balance of payments position.
• To make this improvement, the IMF generally believes that a country should take action to reduce the
demand for goods and services in the economy (e.g. by increasing taxes and cutting government spending).
This will reduce imports and help to put a brake on any price rises. The country's industries should then also
be able to divert more resources into export markets and hence exports should improve in the longer term.
With 'deflationary' measures along these lines, standards of living will fall (at least in the short term) and
unemployment may rise. The IMF regards these short-term hardships to be necessary if a country is to succeed
in sorting out its balance of payments and international debt problems.
The existence of the IMF affects multinational companies by bringing a measure of financial stability by:
• Ensuring that national currencies are always convertible into other foreign currencies.
• Stabilizing the position of countries that are having difficulties repaying international loans. However it has
been suggested that the strict terms attached to IMF loans can lead to economic stagnation as countries
struggle to repay these loans. Deflationary policies imposed by the IMF may damage the profitability of
multinationals' subsidiaries by reducing their sales in the local market. Higher interest rates are likely to be
introduced to suppress domestic consumers' demand for imports . However, higher interest rates will tend
to dampen domestic investment and could result in increased unemployment and loss of business
confidence.
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The World Bank

The World Bank lends to creditworthy governments of developing nations to finance projects and policies that
will stimulate economic development and alleviate poverty.
The World Bank consists of two institutions:

The IBRD focuses on middle-income and creditworthy poorer countries, while the IDA focuses exclusively on the
world’s poorest countries. Both the IBRD and the IDA aim to provide finance for projects concerned with the
development of agriculture, electricity, transport (which are likely to have an impact on the poorest people) on
attractive terms. IBRD loans must normally be repaid within 15 years, and IDA loans are interest free and have a
maturity of up to 40 years.
The existence of the World Bank affects multinational companies by bringing a measure of financial stability by
helping to finance infrastructure projects in developing economies. This allows multinational companies
participate directly in infrastructure projects. It also creates a platform for multinational companies to invest in
such countries. A pre-condition for such investment is normally that there is a reliable electricity and transport
infrastructure and the World Bank helps to provide this.
European Central Bank

The European Central Bank (ECB) is based in Frankfurt. It is responsible for administering the monetary policy of
the EU Eurozone member states and is thus one of the world's most powerful central banks. The main objective
of the ECB is to maintain price stability within the Eurozone (keep inflation low). Its key tasks are to define and
implement monetary policy for the Eurozone member states and to conduct foreign exchange operations.
The main relevance of the ECB to a multinational organization is that by keeping inflation low, the ECB can help
to create long-term financial stability.
Bank of England
The Bank of England is the central bank of UK that performs all the functions of a central bank. The most
important of these functions is the maintenance of price stability and support of British economic policies (thus
promoting economic growth).
Stable prices and market confidence in sterling are the two main criteria for monetary stability. The bank aims to
meet inflation targets set by the Government by adjusting interest rates (determined by the Monetary Policy
Committee which meets on a monthly basis).
The bank can also operate as a 'lender of last resort' – that is, it will extend credit when no other institution will.
US Federal Reserve System

The Federal Reserve System (known as the Fed) is the central banking system of the US. Its responsibilities and
powers have evolved significantly over time. Its current main duties include conducting the US monetary policy,
maintaining stability of the financial system and supervising and regulating banking institutions.
The Fed also acts as the 'lender of last resort' to those institutions that cannot obtain credit elsewhere and the
collapse of which would have serious repercussions for the economy. However, the Fed's role as lender of last
resort has been criticized, as it shifts risk and responsibility from the lenders and borrowers to the general public
in the form of inflation.
Bank of Japan
The Bank of Japan is Japan's central bank and is based in Tokyo. Following several restructures in the 1940s, the
bank's operating environment evolved during the 1970s whereby the closed economy and fixed foreign currency
exchange rate was replaced with a large open economy and variable exchange rate. In 1997, a major revision of
the Bank of Japan Act was intended to give the bank greater independence from the Government, although the
bank had already been criticized for having excessive independence and lack of accountability before these
Page 26
revisions were introduced. However, the Act has tried to ensure a certain degree of dependence by stating that
the bank should always maintain in close contact with the Government to ensure harmony between its currency
and monetary policies and those of the Government.
Eurocurrency Markets
 Eurocurrency is currency which is held by individuals and institutions outside the country of issue of that
currency.
 Eurodollars are US dollars deposited with, or borrowed from, a bank outside the US.
 Euro credits are medium- to long-term international bank loans which may be arranged by individual banks
or by syndicates of banks. Syndication of loans increases the amounts available to hundreds of millions,
while reducing the exposure of individual banks.
Eurobonds:
A Eurobond is a bond sold outside the jurisdiction of the country in whose currency the bond is denominated.
Eurobonds are long-term loans raised by international companies or other institutions and sold to investors in
several countries at the same time.
How are Eurobonds issued?

Step 1 A lead manager is appointed from a major merchant bank; the lead manager liaises with the credit rating
agencies and organizes a credit rating of the Eurobond.
Step 2 the lead manager organizes an underwriting syndicate (of other merchant banks) who agrees the terms of
the bond (e.g. interest rate, maturity date) and buy the bond.
Step 3 the underwriting syndicate then organizes the sale of the bond; this normally involves placing the bond
with institutional investors.
Advantages of Eurobonds:
 Eurobonds are 'bearer instruments', which means that the owner does not have to declare their identity.
 Interest is paid gross and this has meant that Eurobonds have been used by investors to avoid tax.
 Eurobonds create a liability in a foreign currency to match against a foreign currency asset.
 They are often cheaper than a foreign currency bank loan because they can be sold on by the investor, who
will therefore accept a lower yield in return for this greater liquidity.
 They are also extremely flexible. Most Eurobonds are fixed rate but they can be floating rate or linked to the
financial success of the company.
 They are typically issued by companies with excellent credit ratings and are normally unsecured, which
makes it easier for companies to raise debt finance in the future.
Disadvantages of eurobonds:
 Like any form of debt finance, there will be issue costs to consider and there may also be problems if
gearing levels are too high.
– A borrower contemplating a Eurobond issue must consider the foreign exchange risk of a long-term
foreign currency loan. If the money is to be used to purchase assets which will earn revenue in a
currency different to that of the bond issue, the borrower will run the risk of exchange losses if the
currency of the loan strengthens against the currency of the revenues out of which the bond (and
interest) must be repaid.
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Listing Requirements
Compliance with listing requirements

When a company decides to raise funds from the local equity markets, the company must comply with the
requirements of the local exchanges for listing.
Listing requirements for the London Stock Exchange:

The listing requirements for the London Stock Exchange are:
– Track record requirements
– Market capitalization
– Future prospects
– Audited historical financial information
– Corporate governance
– Acceptable jurisdiction and accounting standards
– Other considerations
Track record requirements:

The track record requirements are:
– At least 75% of the entity's business must be supported by a revenue earnings record for the three-year
period. The UK listing authority has the discretion to allow a shorter period in certain circumstances.
– The company must report significant acquisitions in the three years running up to the flotation.
Market capitalization:
Market capitalization and share in public hands:
– At least £700,000 for shares at the time of listing.
– At least 25% of shares should be in public hands.
Future prospects:
The company must show that it has enough working capital for its current needs and for at least the next 12
months.
 The company must be able to carry on its business independently and at arm's length from any shareholders
with economic interest.
 A general description of the future plans and prospects must be given.
 If the company gives an optional profit forecast in the document or has already given one publicly, a report
will be required from the sponsor and the Reporting Accountant.
 This must cover the latest three full years and any published later interim period.
 If latest audited financial data is more than six months old, interim audited financial information is required.
Corporate governance:
UK companies are expected to:
• Split the roles of chairman and CEO.
• Except for smaller companies (below FTSE 350), at least half of the board, excluding the chairman, should
comprise independent non-executive directors; smaller companies should have at least two independent
non-executive directors
• Have an independent audit committee, a remuneration committee and a nomination committee
• Provide evidence of a high standard of financial controls and accounting systems
Acceptable jurisdiction and accounting standards:

The company must be properly incorporated.
International Financial Reporting Standards and equivalent accounting standards are acceptable.
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Capital mobility and blocked funds
Blocked funds:
Exchange controls block the flow of foreign exchange into and out of a country, usually to defend the local
currency or to protect reserves of foreign currencies.
Dealing with blocked funds:

Ways of overcoming blocked funds include the following:
 The parent company could sell goods or services to the subsidiary and obtain payment. The amount of this
payment will depend on the volume of sales and also on the transfer price for the sales.
 A parent company which grants a subsidiary the right to make goods protected by patents can charge a
royalty on any goods that the subsidiary sells. The size of any royalty can be adjusted to suit the wishes of
the parent company's management.
 If the parent company makes a loan to a subsidiary, it can set the interest rate high or low, thereby affecting
the profits of both companies. A high rate of interest on a loan, for example, would improve the parent
company's profits to the detriment of the subsidiary's profits.
 Management charges may be levied by the parent company for costs incurred in the management of
international operations.
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Risk Exposure of Corporations
Political risks for multinationals:

Political risk is the risk that political action will affect the position and value of a company.
When a multinational company invests in another country by setting up a subsidiary, it may face a political risk
of action by that country's government which restricts the multinational's freedom.
If a government tries to prevent the exploitation of its country by multinationals, it may take various measures:
• Import quotas could be used to limit the quantities of goods that a subsidiary can buy from its parent
company.
• Import tariffs could make imports (such as from parent companies) more expensive and domestically
produced goods therefore more competitive.
• Legal standards of safety or quality (non-tariff barriers) could be imposed on imported goods to prevent
multinationals from selling goods through a subsidiary which have been banned as dangerous in other
countries.
• Exchange control regulations could be applied .
• A government could restrict the ability of foreign companies to buy domestic companies.
• A government could nationalize foreign-owned companies and their assets (with or without compensation
to the parent company).
• A government could insist on a minimum shareholding in companies by residents. This would force a
multinational to offer some of the equity in a subsidiary to investors in the country where the subsidiary
operates.
 Dealing with political risks :

These are various strategies that multinational companies can adopt to limit the effects of political risk:
 Negotiations with host government:

The aim of these negotiations is generally to obtain a concession agreement. This would cover matters such
as the transfer of capital, remittances and products, access to local finance, government intervention and
taxation, and transfer pricing.
 Insurance:
In the UK, the Export Credits Guarantee Department provides protection against various threats, including
nationalization, currency conversion problems, war and revolution.
 Production strategies:
It may be necessary to strike a balance between contracting out to local sources and producing directly.
 Financial management:
A multinational obtains funds in local investment markets, these may be on terms that are less favorable
than on markets abroad, but would mean that local institutions suffered if the local Government intervened.
Litigation Risks Legal impacts:

Companies may face government legislation or action in any jurisdiction that extends over its whole range of
activities. Important areas may include:
 Export and import controls for political, environmental, or health and safety reasons.
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 Favorable trade status for particular countries, e.g. EU membership, former Commonwealth countries. ▪Law
of ownership. Especially in developing countries, there may be legislation requiring local majority ownership
of a firm or its subsidiary in that country, for example.
 Acceptance of international trademark, copyright and patent conventions.
 Determination of minimum technical standards that the goods must meet e.g. noise levels and contents.
Standardization measures, such as packaging sizes.
 Pricing regulations.
 Dealing with legal risks:

One aspect of minimizing problems from governmental intervention is social and commercial good
citizenship, complying with best practice and being responsive to ethical concerns.
 Other steps:
Companies may wish to take all possible steps to avoid the bad publicity resulting from a court action. This
includes implementing systems to make sure that the company keeps abreast of changes in the law, and
staff are kept fully informed.
 Internal procedures may be designed to minimize the risks from legal action. Contracts may be drawn up
requiring binding arbitration in the case of disputes.
 Of course, compliance with legislation may involve extra costs, However, these costs may also act as a
significant barrier to entry, benefiting companies that are already in the industry.
Cultural risks
Cultural risks affect the products and services produced and the way organizations are managed and staffed.
Businesses should take cultural issues into account when deciding where to sell abroad, and how much to
centralize activities.
Challenges of different cultures:

Where a business trades with, or invests in, a foreign country additional uncertainty is introduced by the
existence of different customs, laws and language. The following areas may be particularly important.
 The cultures and practices of customers and consumers in individual markets
 The media and distribution systems in overseas markets
 The different ways of doing business in overseas markets
 The degree to which national cultural differences matter for the product concerned (e.g. washing machines
where some countries prefer front-loading machines and others prefer top-loading machines) ▪The degree
to which a firm can use its own 'national culture' as a selling point
Dealing with cultural risk:
 Deciding which markets to enter:

Making the right choices about which markets to enter are a key element in dealing with cultural risk. When
deciding what types of country it should enter the major criteria for this decision should be as follows:
 Market attractiveness. This concerns such indicators as GNP/head and forecast demand.
 Competitive advantage. This is principally dependent on prior experience in similar markets, language and
cultural understanding.
 Risk. This involves an analysis of political stability, the possibility of government intervention and similar
external influences.
 Management of human resources:
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The balance between local and expatriate staff must be managed. There are a number of influences.
Expatriate staff is sometimes favored over local staff.

 Poor educational opportunities in the market may require the import of skilled technicians and
managers. For example, expatriates have been needed in many Western firms' operations in Russia and
Eastern Europe, simply because they understand the importance of profit.
 Expatriates might be better able than locals to communicate with the corporate center.
 The expatriate may know more about the firm overall, which is especially important if they are fronting
a sales office
The use of expatriates in overseas markets has certain disadvantages.
They cost more (e.g. subsidized housing, school fees).
 Culture shock. The expatriate may fail to adjust to the culture this is likely to lead to poor management
effectiveness, especially if the business requires personal contact.
 A substantial training programed might be needed.
Dividend Policy in Multinationals
Dividend capacity
The dividend capacity of a multinational company depends on its after-tax profits, investment plans and foreign
dividends. The potential dividend that can be paid, i.e the dividend capacity of the firm, can be estimated as
follows.
Dividend Capacity
$
PBIT XX
Tax @ 30% (X)
Depreciation X
Working Capital Change (X)
Interest ( 1 – 1) (X)
CAPEX (X)
Net borrowings X
Dividends from subsidiaries X
Additional tax on dividends X
Dividend Capacity xxx
$
Free Cash flow to equity XX
Net borrowings X
Dividends from subsidiaries X
Additional tax on dividends (X)
Dividend Capacity Xxx
Dividend Policies
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Stable Dividend
Some companies follow a policy of paying fixed dividend per share irrespective of the level of earning year after
year. Such firm creates reserves i.e dividend equalization reserves to enable them to pay the fixed dividend even
in case of insufficient earnings.it more suits to those companies having stable earnings.
• Dividend level (growth) should be related to profit levels (Growth).
• Retain profit should be linked with the investments of new projects.
Constant payout ratio

It means payment of fixed percentage of net earnings as dividends every year. The amount of dividend in such a
policy fluctuates in direct proportion to earnings of company. The policy of constant payout is preferred by the
firms because it is related to their ability to pay dividends.
Stable Dividend plus extra dividend: Some companies follow a policy of paying constant low dividend per share
plus an extra dividend in the years of high profit. Such a policy is most suitable to the firm having fluctuating
earnings from year to year.
Advantages of Stable Dividend Policy: A Stable dividend policy is advantageous to both investors and company
on account of the following:
(a) It is sign of continued normal operations of company.
(b) It stabilizes market value of shares.
(c) It creates confidence among investors.
(d) It improves credit standing and making financing easier.
(e) It meets requirements of institutional investors who prefer companies with stable dividends.
Dangers of Stable dividend policy

In spite of many advantages, the stable dividend policy suffers from certain limitations. Once a stable dividend
policy is followed by a company, it is not easier to change it. If stable dividends are not paid to shareholders on
any account including insufficient profits, the financial standing of company in minds of investors is damaged
and they may like to dispose of their holdings. It adversely affects the market price of shares of the company.
And if companies pay stable dividends in spite of its incapacity it will be suicidal in long run.
Residual dividend
Companies using the residual dividend policy choose to rely on internally generated equity to finance any new
projects. As a result, dividend payments can come out of the residual or leftover equity only after all project
capital requirements are met. These companies usually attempt to maintain balance in their debt/equity ratios
before making any dividend distributions, deciding on dividends only if there is enough money left over after all
operating and expansion expenses are met.
A primary advantage of the dividend-residual model is that with capital-projects budgeting, the residualdividend
model is useful in setting longer-term dividend policy. A significant disadvantage is that dividends may be
unstable.
Irregular Dividend Policy: Some companies follow irregular dividend payments on account of following:
(a) Uncertainty of Business.
(b) Unsuccessful Business operations
(c) Lack of liquid resources.
(d) Fear of adverse effects of regular dividend on financial standing of company.
No Dividend Policy: A company may follow a policy of paying no dividends presently because of its unfavorable
working capital position or on account of requirements of funds for future expansion and growth.
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Transfer Pricing in Multinationals
A transfer price may be defined as the price at which goods or services are transferred from one process or
department to another or from one member of a group to another.
The arm's length standard:

The arm's length standard states that intra-firm trade of multinationals should be priced as if they took place
between unrelated parties acting at arm's length in competitive markets.
The main methods of establishing 'arm's length' transfer prices of tangible goods include:
 Comparable uncontrolled price (CUP)
 Resale price (RP)
 Cost plus (C+)
 Profit split (PS)
The CUP method:

The CUP method looks for a comparable product to the transaction in question, either in terms of the same
product being bought or sold by the MNC in a comparable transaction with an unrelated party, or the same or
similar product being traded between two unrelated parties under the same or similar circumstances. The
product so identified is called a product comparable. All the facts and circumstances that could materially affect
the price must be considered.
Tax authorities prefer the CUP method over all other pricing methods for at least two reasons.
 It incorporates more information about the specific transaction than does any other method; i.e. it is
transaction and product specific.
 CUP takes the interests of both the buyer and seller into account since it looks at the price as determined by
the intersection of demand and supply.
The RP method:
Where a product comparable is not available, and the CUP method cannot be used, an alternative method is to
focus on one side of the transaction, either the manufacturer or the distributor, and to estimate the transfer
price using a functional approach.
Under the RP method, the tax auditor looks for firms at similar trade levels that perform similar distribution
functions (ie a functional comparable). The RP method is best used when the distributor adds relatively little
value to the product so that the value of its functions is easier to estimate. The assumption behind the RP
method is that competition among distributors means that similar margins (returns) on sales are earned for
similar functions. The RP method backs into the transfer price by subtracting a profit margin, derived from
margins earned by comparable distributors engaged in comparable functions, from the known retail price to
determine the transfer price. As a result, the RP method evaluates the transaction only in terms of the buyer.
The method ensures that the buyer receives an arm's length return consistent with returns earned by similar
firms engaged in similar transactions.
Since the resale margin is determined in an arm's length manner, but nothing is done to ensure that the
manufacturer's profit margin is consistent with margins earned by other manufacturers, the adjustment is one-
sided.
Under the RP method, having determined the buyer's arm's length margin, all excess profit on the transaction is
assigned to the seller. Thus the RP method tends to overestimate the transfer price since it gives all unallocated
profits on the transaction to the upstream manufacturer. We call this contract distributor case, since the
manufacturer is contracting out the distribution stage to the lowest bidder.
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The C+ method:
The C+ method starts with the costs of production, measured using recognized accounting principles, and then
adds an appropriate mark-up over costs. The appropriate mark-up is estimated from those earned by similar
manufacturers.
The assumption is that in a competitive market the percentage mark-ups over cost that could be earned by
other arm's length manufacturers would be roughly the same. The C+ method works best when the producer is a
simple manufacturer without complicated activities so that its costs and returns can be more easily estimated.
In order to use the C+ method, the tax authority or the MNC must know the accounting approach adopted by
the unrelated parties, such as: what costs are included in the cost base before the mark-up over costs is
calculated. Is it actual cost or standard cost?
Are only manufacturing costs included or is the cost base the sum of manufacturing costs plus some portion of
operating costs? The larger the cost base, the smaller should be the profit mark-up, or gross margin, over costs.
The PS method:
When there are no suitable product comparable (the CUP method) or functional comparable (the RP and C+
methods), the most common alternative method is the PS method, whereby the profits on a transaction earned
by two related parties are split between the parties. The PS method allocates the consolidated profit from a
transaction, or group of transactions, between the related parties. Where there are no comparable that can be
used to estimate the transfer price, this method provides an alternative way to calculate or 'back into' the
transfer price. The most commonly recommended ratio to split the profits on the transaction between the
related parties is return on operating assets (the ratio of operating profits to operating assets). The PS method
ensures that both related parties earn the same ROA
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SYLLABUS B: ADVANCE INVESTMENT APPRAISAL

:DISCOUNTED CASH FLOW TECHNIQUES
Learning objectives
 Evaluate the potential value added to an organisation arising from a specified capital investment
project or portfolio using the net present value (NPV) model.
 Project modelling should include explicit treatment and discussion of: i) Inflation and specific
price variation ii) Taxation including tax allowable depreciation and tax exhaustion iii) Single
period and multi-period capital rationing.
 Multi-period capital rationing to include the formulation of programming methods and the
interpretation of their output iv) Probability analysis and sensitivity analysis when adjusting for
risk and uncertainty in investment appraisal v) Risk adjusted discount rates vi) Project duration as
a measure of risk.
 Outline the application of Monte Carlo simulation to investment appraisal.Candidates will not be
expected to undertake simulations in an examination context but will be expected to demonstrate
an understanding of: i) The significance of the simulation output and the assessment of the
likelihood of project success ii) The measurement and interpretation of project value at risk.
 Establish the potential economic return (using internal rate of return (IRR) and modified internal
rate of return) and advise on a project’s return margin.
 Discuss the relative merits of NPV and IRR.
INVESTMENT APPRAISAL
A detailed evaluation of projects or investments viability and its effects on shareholders wealth is called
investment
appraisal.
Decision Making
Short term Long term
Capital expenditure:
Capital expenditure is expenditure which results in the acquisition of non-current assets or an improvement in
their earning capacity. It is not charged as an expense in the income statement; the expenditure appears as a
non-current asset in the Statement of financial position.
Revenue expenditure:
Charged to the income statement and is expenditure which is incurred.
(i) For the purpose of the trade of the business this includes expenditure classified as selling and
distribution, administration expenses and finance charges.
(ii) To maintain the existing earning capacity of non-current asset.
Relevant Cash flows in Investment Appraisal

Relevant cash flows are those cash flows which are:
• Directly related with the project.
Page 36
• Incremental
• Future cash flows
Any cash flows or cost incurred in the past, or any committed cost which will be incurred regardless of whether
the investment is undertaken or not is a non-relevant cash flows e.g. sunk cost, Allocated/General fixed
overheads etc.
The other cash flows, which should be considered as Relevant Cash flows, are as follow:
• Opportunity Cost:
• Tax:
• Residual value:
• Infra-structure Costs:
• Marketing Costs:
• Human resource costs:
Assumptions of Timing of Cashflows

 If Cash flows arise during the period, then it is assumed as it arises at the end of that period.
 If cash flow arises at the start of the period then it is assumed as if it arises at the end of the preceding period
 Period ‘0’ is not a period, instead it represents start of period ‘1’.
TIME VALUE OF MONEY
Sum of money received today has more worth than same sum of money received in future because of these
reasons.
• Inflation
• Opportunity to reinvest
• Risk and uncertainty
Simple interest
1. 1000 x 10% = $100
2. 1000 x 10% = $100
3. 1000 x 10% = $100
Cash flows are not reinvested each year
Compound interest
1. 1000 x 10% = 100 + 1000 = 1100
2. 1100 x 10% = 110 + 1100 = 1210
3. 1210 x 10% = 121 + 1210 = 1331
Cash flows are reinvested each year resulting in higher principal that increases the interest amount.
We can also calculate the future amounts using this formula
n
FV = PV (1+r)
FV= future value= 1331
PV= Present Value= 1000
3
1331 = 1000 x (1+10%)
Discounting
Where r = cost of capital = WACC = required rate of return
PV = FV (1+r)-n
Page 37
Assumption:
All cash flows are reinvested in the same project or any other at a given rate of return (cost of capital).
Year Cash flows Df@12% PV

1 1000 0.893
892.9
2 2000 0.797
1594.39
3 3000 0.712
2135
Consistent Cashflows
If Cashflows arises in a series of equal cashflows then it is called Consistent Cashflows. These are of two Types:
Annuity: If Consistent cash flow for a certain Period. e.g Y1-5 or Y3-7
Perpetuity: If Consistent cash flow for infinite period e.g. Y1-∞ or Y3-∞
Present Values of Consistent Cash flows

-n
𝟏− 1 + r
The Annuity Factor =
𝒓
𝟏
The Perpetuity Factor = 𝒓
Annuity Perpetuity
If Cash flows Start from Period 1.
Annual Cash flow X Annuity Factor Annual Cash flow X Perpetuity Factor
e.g. Y1-5 $10,000 at Disc. Rate of 10% e.g. Y1-∞ $10,000 at Disc. Rate of 10%
$10,000 X 3.791(from annuity table) $10,000 X (1/10%) = $100,000
=$37,910
If Cash flows Start from Period 0.
Annual Cash flow X (Annuity Factor + 1) Annual Cash flow X (Perpetuity Factor +
e.g. Y0-5 $10,000 at Disc. Rate of 10% 1)
$10,000 X (3.791+1) =$47,910 e.g. Y0-∞ $10,000 at Disc. Rate of 10%
$10,000 X ((1/10%)+1) = $110,000
If Cash flows Start from Subsequent Period e.g. Year 3.
Annual Cash flow X Annuity Factor of Annual Cash flow X Perpetuity Factor X
No. of periods X Discount factor of Discount factor of preceding period from
preceding period from Start Start
e.g. Y4-8 $10,000 at Disc. Rate of 10%
$10,000 X 3.791 X 0.751 =$28,470 e.g. Y4-∞ $10,000 at Disc. Rate of 10%
$10,000 X (1/10%) X 0.751 = $75,100
Perpetuities with growth:

• Cash flow with constant growth.
• Unlimited time period.
• Growth starts from year 1
1. Single growth model:

PV = Cash flow (1+ g)
COC – g
2. Multi growth model:

1 2 3 4 5-∞
Cash flow CF1 CF2 CF3 CF4CF4 x (1+g)
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COC -g
D.F @ 10% 0.909 0.826 0.751 0.683 x 0.683
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Example:
Cash flow in Year 1 is 1000 it will increase with a growth of 5% for next 4 years then at a constant growth of 2%
for foreseeable future COC 10% .Calculate PV?
1 2 3 4 5 5-∞
Cash flow 1000 1080 1166 1260 1360 1360 x (1+0.02)
0.10 -0.02
D.F @ 10% 0.909 0.826 0.751 0.683 0.621 x 0.621
PV 909 892 875.67 860.58 844.56 10768.14
PV = 15154
Annuity with growth:

You will receive $100 Cash flows for 5 years and cash flows will grow at a rate of 5% starting from year 1 and
discount factor of 10%. Calculate PV.
Years 1 2 3 4 5
Cash flows@ 5 % growth 105 110.25 115.76 121.55 127.63
Df@10% 0.909 0.826 0.751 0.683 0.621
PV 95.45 90.86 86.94 83.02 79.26 435.53
OR 1 +𝑔
1− (1 −𝑟 )^𝑛
PV [ ] =constant CF x (1+g)
𝑟−𝑔
PV =100 x [ 1 +0 . 05 (1+0.05) = 435
1− ( 1 −0 .1 )^5
]
0.1−0.05
Investment Appraisal Techniques
 Payback Period
 Net Present Value NPV
 Internal Rate of Return (IRR)
 Discounted Payback Period
 Modified Internal Rate of Return
(MIRR)
 Duration
 Adjusted Present Value (APV)
Payback period method:
Definition:-
The time period, in which initial investment is recovered, known as payback period. The number of years for the
cash out lay to be matched by cash inflows.
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Formula:-
For constant (Even) cash flows:
Payback period = Initial investment
Annual inflows
For Uneven cash flows:

Draw a cumulative cash flow column, then calculate project payback period. Answer should be compared with
the target payback period of the business.
Decision rule:-Feasibility Decision:

If payback period is less than target payback period then ACCEPT the project.
If payback period is more than target payback period then REJECT the project.
Comparison Decision:
Project with minimum payback period should be preferred.
Advantages of payback period:-

• It is simple to calculate and easy to understand.
• Payback period method can also be used as a basic screening device at the first stage for short list projects.
• It considers cash flows rather than accounting profits, that’s why chances of manipulation are very low.
• Payback period method indirectly avoids risk as it gives favor to those investments which have short payback
periods. This method helps the company to grow, minimize risk and maximize liquidity.
• In the situation of capital rationing, it can be used to identify the projects which generate additional cash for
investment quickly.
Disadvantages of payback period:-

• It does not consider the time value of money.
• It does not consider the whole life of project cash flows. It might be possible that it will favor the projects,
giving high cash inflows in the starting years only and giving very low cash inflows in the remaining years.
• There is no specific criteria or rule which can justify that company’s target payback period is measured
accurately that why it is difficult to measure target payback period.
• It may lead to excessive investment in short term projects.
• It does not consider the risk and uncertainty in the projects. Uncertainty of cash inflows can deteriorate the
results.
• It does not focus on shareholders wealth maximization.
Discounted Payback period

Definition:
 The time period in which initial investment is recovered in terms of present value is known as discounted
payback period
 It is same as simple payback period. The only difference is that the discounted cash flows are used instead of
simple cash flows for calculation.
Decision Rule
 Feasibility Decision:
If payback period is less than target payback period then ACCEPT the project.
If payback period is more than target payback period then REJECT the project.
 Comparison Decision :
Project with minimum payback period should be preferred.
YearsCash flows D.F @ 10%Present Values Cumulative Values
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0 (500000) 1.000 (500000) (500000)

1 300,000 0.909 272,700 (227300)
2 200,000 0.826 165,200 (62100)
3 200,000 0.751 150,200
4 600,000 0.683 409,800
Discounted Payback = 2 years + (62.100/ 150,200 x 12)

= 2 years and 5 months
 It takes into account the time value of money and timings of cash flows.
Net Present Value (NPV)
Formula to calculate NPV:-

NPV=PV of cash inflows -PV of cash outflows.
Decision Rule:-
If NPV of the project is positive, accept the project If NPV of the project is negative, reject the project.
Advantages of Net Present Value:

Net Present Value method takes into account the time value of money and this is giving a better picture of the
projects viability.
• It considers the whole life of the project because all cash flows relating to the project life is incorporated in its
calculations.
• It gives an indication about the increase or decrease in the wealth of shareholders. Its decisions rule is
consistent with the objective of maximization of shareholders wealth.
• It focuses on cash flows rather than accounting profit, so it takes into account the relevancy and irrelevancy
of cash flows.
• It can also be used for projects with non-conventional cash flows.
• It gives a better ranking of mutually exclusive projects.
• It assumes that cash flows are reinvested at the company’s cost of capital.
• NPV is technically more superior method to IRR because of its less rigid assumptions.
Disadvantages’ of Net Present Value:

• It involves complex calculations as compared to other techniques.
• Managers feel it difficult to explain the calculations of Net Present Value method.
• It does not take into account the risk and uncertainty of estimates and scarcity of resources.
• Cost of capital used in NPV calculation is difficult to calculate and gets subjective when we incorporate risk
and uncertainty within companies cost of capital.
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Years 0 1 2 3 4
Sales X X X X
Variable (X) (X) (X) (X)
Cost
Incremental (X) (X) (X) (X)
Fixed Cost
Operating X X X X
Cash flows
Tax (X) (X) (X) (X)
Expense
Tax Savings X X X X
on Capital
Allowances
Change in (X) (X) (X) (X) X
Working
Capital
Initial (X)
Investment
Scrap Value X
Net Cash (X) X X X X
flows
Discount X X X X X
Factor
Present (X) X X X X
Values
Net Present X
Value
Capital Allowances
• Straight line basis
• Reducing balance basis
Straight Line Basis
 Formula 1
Capital Allowance= Investment Cost – Scrap Value
Useful Life
 Formula 2
(Investment Cost – Scrap Value) x %age of allowance
 Tax Savings on Capital Allowances Capital Allowance x Tax rate
Reducing Balance basis
Example
Initial Investment = 2000
Capital Allowances = 25% reducing balance
Useful life = 4 years, Tax rate = 30% (payable in same year), Scrap Value = 500
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Page 44
Years Written Down Capital Tax Timing

Value Allowances Savings
@ 25% @ 30%
1 2000 500 150 1
2 1500 375 113 2
3 1125 281 84 3
4 844-500 344 103 4
In the last year:

• If the written down value > the scrap value we calculate balancing allowance.
• If the written down value < the scrap value we calculate balancing charge.
• If the scrap value is after tax, we calculate capital allowance rather than balancing allowance or balancing
charge.
INFLATION
Real rate of return/cost of capital

Real rate of interest reflects the rate of return that would be required in the absence of inflation.
Money rate of return/cost of capital

Money or nominal rate of return is rate that will be required in presence of inflation.
Relationship between real and nominal rates of interest (Fisher formula)

(1 + m) = (1 + r) (1 + i)
Where i= rate of inflation/RPI r = real rate of interest m = nominal (money rate of

interest)
Money cash flows are those cash flows in which the effect of specific inflation has been adjusted.
Real cash flows are those cash flows which have not been adjusted for inflation.
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Methods to be used in Investment Appraisal
If General inflation rate is given If Specific inflation rate is given
Money Method Real Method Money Method
Inflate all Cash flows Do not inflate Cash Inflate each variable cash flow
with general inflation flows. with its specific inflation rate.
rate. Discount all Cash flows Discount with money cost of
Discount these cash with real discount rate. capital (calculated through real
flows with money rate and general inflation rate.
discount rate.
preferred
method
Nominal Cashflow = Real cashflows ( 1+ i)n

Sometimes Examiners gives the value in year 1 terms instead of current prices terms then
Nominal Cashflow = Real cashflows ( 1+ i)n-1

Working capital change
Step 1
Calculate working capital requirement one year in advance e.g. working capital is 10% of sales at the
start of each year
Step 2
Calculate incremental working capital by taking change of each year working capital and in last year of
project (not in ongoing business) there will be an assumption that all working capital will be recovered.
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Sensitivity Analysis
 It assess how responsive is the project’s Net Present Value to the changes in a given variable.
 It considers each variable in isolation.
 Formula to calculate sensitivity of a particular variable:-
Sensitivity = Net present value %

After-tax Present value of particular variable
• It indicates which variables may impact most upon the net present value (critical variables) and the extent to which
those variables may change before the investment results in a negative NPV.
• It assesses how responsive is the project’s Net Present Value to the changes in a given variable.
• It indicates which variables may impact most upon the net present value (critical variables) and the extent to which
those variables may change before the investment results in a negative NPV.
Sensitivity analysis
Selling price sensitivity
Variable cost sensitivity
Fixed cost sensitivity
Contribution/Sales volume sensitivity
Scarp value sensitivity
Initial investment sensitivity (without tax)
Initial investment sensitivity (with tax)
Cost of capital sensitivity:

• Calculate IRR of the project and compare it with the cost of capital.
• If cost of capital increases to IRR, NPV will be zero.
Project life sensitivity:

• Calculate discounted payback period and compare it with the total project life.
• If total life reduces to the level of discounted payback period, NPV will be zero.
Advantages
• This is not a complicated theory to understand.
• Information will be presented to management in a form, which facilitates subjective judgment to decide the
likelihood of the various possible outcomes considered.
• Indicates just how critical are some of the forecast which are considered to be uncertain, those areas then can be
carefully monitored.
Disadvantages
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• It assumes that changes to variables can be made independently or in isolation. However it’s unrealistic as they are
often interdependent.
• It only identifies how far a variable needs to change; it does not look at the probability of such a change.
• It is not an optimizing technique. It provides information on the basis of which decision can be made.
• Critical factors may be those over which managers have no control.
Simulation
Sensitivity analysis considered the effect of changing one variable at a time.
Monte Carlo simulation improves on this by looking at the impact of many variables changing at the same time.Using
mathematical modeling it produce a distribution of the possible outcomes from the project.
Steps in Simulation
 Specify major variable.
Market size.
Selling price.
Market growth rate.
Market share.
Investment required.
Residual value of investment.
 Specify the relationship b/w variables to calculate an NPV Sales revenue = market size x market share x selling price.
Net cash flow = sales revenue (variable cost + fixed cost = taxation) etc.
 Simulate the environment and computerized model will generate a range of NPV across all probability levels
 Merits of simulation
• It includes all possible outcomes in the decision making process.
• It is relatively easily understood technique.
• It has a wide variety of applications (inventory control, component replacement, corporate models, etc.)
 Demerits of simulation
• Models can become extremely complex and the time and cost involved in their construction can be more than is
gained from the improved decisions.
• Probability distributions may be difficult to formulate
• Accuracy of data output depends upon the accuracy of data input.
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Capital Rationing
Capital rationing:
Where the finance available for capital expenditure is limited to an amount which prevents acceptance of all new projects
with a positive NPV, the company is said to experience “capital rationing”. There are two types of capital rationing.
Hard capital rationing:

• It is due to external factors.
• Company cannot raise funds by issuing new shares because of stock prices are depressed in stock market.
• There may restrictions on bank lending due to government control.
• Your company may be too risky for further loan from banking institution.
• Cost of new funds may be too high.
Soft capital rationing:

• It is due to internal factors.
• Management may be reluctant to issue further shares because of dilution in control of company.
• Management may be unwilling to issue further shares because of dilution in EPS.
• Company has a policy to finance the new project only from retained earnings.
• Management may not raise further debt because of fixed commitment of interest payments.
Single period capital rationing

I.e. available finance is only in short supply during the current period, but will become freely available in subsequent periods.
 Assumptions of Single Period Capital Rationing

• All projects are divisible
• Projects will be lost if not undertaken in current year( cannot be postponed)
• The risk & uncertainty and strategic importance of all projects is same
 Divisible – An entire project or any fraction of that project may be undertaken. Projects displaying the highest
profitability indices will be preferred.
Problems of Profitability index – other than assumptions stated above

• It can only be used in divisible projects.
• This method doesn’t consider the variation in cash flows.
• It doesn’t consider the absolute size of the project.
 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.
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Multi -period capital rationing

Discuss in detail below.
If Projects are Divisible:
Project Investment NPV Profitability Index Ranking
A 1,000 500 0.5 3rd
B 1,200 700 0.58 2ND
C 800 300 0.375 4TH
D 700 450 0.642 1ST
Funds Available 2500
Project Investment NPV

D 700 450
B 1,200 700
A 600 300
Total 2500 1450
Investment schedule
We will do project B and D complete and 60% of project A.
If Projects are Non-Divisible:
Project Investment NPV

A 1,000 500
B 1,200 700
C 800 300
D 700 450
Funds available $2500
Projects Combination Total Investment Total NPV

A,B 2,200 1,200
A,C,D 2,500 1,250
B,C 2,000 1,000
B,D 1,900 1,150
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Investment schedule
We will do combination of project A, C &D because it gives the best NPV of $1250.
Multi-Period Capital Rationing

Capital rationing is the situation when the company has several projects that they wish to invest it, but only have a limited
amount of capital available for investment.
You will remember that when there is limited capital in only one year (single-period capital rationing) then we rank the
projects based on the NPV per $ invested (the profitability index).
However, it is more likely in practice that investment is needed in more than one year and that capital is rationed also in more
than one year. This situation is known as multi-period capital rationing and the solution requires using linear programming
techniques. As you will see in the example that follows, you will not be required to solve the problem, but you may be
required to formulate the problem.
Linear programming
 Define objective function (maximize NPV)
 Define constrains (funds are limited)
 Final Values
Indivisible 0 or 1
Divisible 0 to 1
Example
Four indivisible projects are available.
Funds are required for two years and resulting NPVs are:
Project A Project B Project C Project D

Year 0 17500 22500 12500
Year 1 25000 15000 15000
Year 2 10000 30000 20000 17500

Npv 20000 27500 15000 10000
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Funds are available

Year 0 40,000
Year 1 35,000
Year 2 42,500
Calculate the optimum mix of projects.
Answer
Maximize = 20,000A+27,500B+15,000C+10,000D
Constraints
Year 0 17,500A+22,500B+12,500D≤40,000
Year 1 25,000A+15,000C+15,000D≤35,000
Year 2 10,000A+30,000B+20,000C17,500≤425,00
Final Values
If projects are indivisible then
A, B, C, D = 0 or 1
If projects are divisible then
A, B, C, D = 0 to 1
Linear programming
The board of Bazza Inc. has approved the following investment expenditure over the next three years.
Year 1 Year 2 Year 3

$16,000 $14,000 $17,000
You have identified four investment opportunities which require different amounts of investment.
Year1 Year2 Year3 NPV

Project 1 7,000 10,000 4,000 8,000
Project 2 9,000 0 12,000 11,000
Project 3 0 6,000 8,000 6,000
Project 4 5,000 6,000 7,000 4,000
Which combination of projects will result in the highest overall NPV while remaining within the annual investment
constraints?
The problem can be formulated as a linear programming problem as follows.
Let
Y1 be investment in project 1
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 Objective function
Maximize Y1 x 8,000 + Y2 x 11,000 + Y3 x 6,000 + Y4 x 4,000
 Subject to the three annual investment constraints:
Y1 x 7,000 + Y2 x 9,000 + Y3 x 0 + Y4 x 5,000 ≤16,000 (Year 1 constraint)

Y1 x 10,000 + Y2 x 0 + Y3 x 6,000 + Y4 x 6,000 ≤ 14,000 (Year 2 constraint)
Y1 x 4,000 + Y2 x 12,000 + Y3 x 8,000 + Y4 x 7,000 ≤ 17,000 (Year3 constraint)
When the objective function and constraints are fed into a computer program, the results are:
Y1 = 1, Y2 = 1, Y3 = 0, Y4 = 0
This means that project 1 and project 2 will be selected and project 3 and project 4 will not. The NPV of the investment
scheme will be equal to $19,000.
Note that the following solution also satisfies the constraints.
Y1 = 0, Y2 = 0, Y3 = 1, Y4 = 1
However, this is not the optimal solution since the combined NPV of projects 3 and 4 is $10,000, which is lower than the
value derived above.
Expected Values, Decision Trees and Combined Probabilities
It is a commonly used way of evaluating decisions is via the use of expected values.
An expected value summarises all the different possible outcomes by weighting the possible outcomes by their probabilities
and then summing the result.
A decision tree is a diagrammatic representation of a problem, where the decision maker needs to consider the logical
sequence of events.
Since one event may depend upon another, we may get situations where event one has a certain probability of occurring and
event two, which depends on event one occurring, has another probability of occurring. In such circumstances, we have a
situation of combined probabilities Eg if event one has a 0.6 chance of occurring and subsequent event two a 0.75 chance of
occurring, then overall the probability of both events occurring is:
0.6 x 0.75 = 0.45 ie a 45% chance of occurring.
Scenario
Brisport Master Motor Co (Brisport) designs, manufactures and sells a range of components for the motor car industry. The
design team has recently designed a new component for inclusion into hybrid cars. The component greatly enhances the
battery ‘road time’ and therefore reduces the frequency with which the battery has to be recharged.
The company can either sell the design now, for its initial market value of $400,000, or attempt to develop the design into a
marketable product, which can be supplied to the motor industry. This development would have an initial outlay of $300,000
now and the component would take one year to be developed. In such a fast moving market, the component is likely to have a
market life as a saleable product of just five years after development.
If the company decides to develop the component, the chances of succeeding in developing the design into the marketable
product are 80%. If the attempt to develop fails, the design can only be sold, in one year’s time, for half of its earlier market
value.
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If the attempt to develop the design succeeds the company has a choice of either selling both the design and the rights to sell
the developed component, or marketing the component themselves.
Selling the design would yield $300,000 in one year’s time and $160,000 in royalty payments for each of the five years
thereafter (years 2 to 6).
If the component is marketed by Brisport then there is a 75% probability that the product will be popular and will generate
cash inflows of $440,000 per annum but there is a 25% probability that it will be unpopular and it will generate cash outflows
of $55,000 per annum. Both cash flow figures are also for each of years 2 to 6.
Brisport uses a weighted average cost of capital of 7% to discount its future cash flows. The management of Brisport Master
Motor Co seeks your advice as to their best course of action.
Solution
There are two decisions which need to be taken by the company:

1. sell the design or develop it
2. if it is developed, then whether to sell the design and the rights to sell the developed component, or market it
themselves
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In order to evaluate decision 1, decision 2 needs to be evaluated first. In other words, the values we use in decision 1 need to
be determined by the decision we take in decision 2.
Decision 2
The net present value ($000s) on the 75% path is 1,686 – 300 = 1,386.
Taken together with the net present value ($000s) on the 25% path of
(211) – 300 = (511)
there is an expected net present value of choosing to market the component of ($000s): [0.75 x 1,386] + [0.25 x (511)] =
1,040 – 128 = 912
This is a higher value than the option of selling the design and the rights to sell the developed component for a net present
value of $594,000 ($894,000 – $300,000). Therefore, if the development goes ahead, it will be more beneficial to market the
product.
Of course, we still need to evaluate decision 1, whether to develop at all. The ‘success’ of the expected present value of
$912,000 in decision 2 has an 80% chance of arising, but there is a 20% chance of the development not succeeding and
recouping just half of the initial market value, that being $187,000 in present value terms, resulting in the company being
worse off by $113,000 in present value terms after taking the development costs into account.
Hence, the expected net present value of the development option of decision 1 can be calculated ($000s): = [0.80 x 912] +
[0.20 x (113)] = 730 – 23 = 707
Since this is higher than the option to sell the design at time 0, $400,000, on an expected value basis, the component should
be developed and marketed.
Attitude to risk
The expected value approach assumes risk neutrality, but not all management decision makers are risk neutral. A risk averse
management would, in this scenario, be concerned with the 20% probability of being $113,000 worse off in present value
terms should the development decision go on to fail.
Furthermore, having taken the decision (at node 2) that marketing the component is preferred to selling both the design and
developed component there is a further risk of losses, since there is a 25% chance of the component being unpopular leaving
the company worse off by $511,000 in present value terms.
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Combined with the 80% probability of the development being successful, there is an overall 20% chance of this $511,000 loss.
This 20% is known as a conditional probability since it depends upon the 80%
(0.80) success rate firstly and then depends on the 25% (0.25) unpopularity chance. Hence,
0.80 x 0.25 = 0.20 ie 20%

For completeness, there is of course a 75% chance of the component being popular if marketed, and hence the overall
combined probability of a successful development together with a marketing campaign which results in popularity is: 0.80 x
0.75 = 0.60 i.e. 60%
Summary
Net present
Outcome Probability
value ($000s)
Development succeeds and component is popular 60% 1,386
Development succeeds but component is unpopular 20% (511)
Development fails 20% (113)
Therefore, be aware that expected values can lead to a false sense of security. The expected NPV of $707,000 is an average. In
other words, it is the average NPV if the decision is repeated over and over again. But is that useful in this situation? This is a
one-off development of a product and therefore only one of the outcomes listed in the table above will actually occur. (This is
analogous to tossing a coin once. We know that the outcome will either be a head or a tail, not the expected value of ‘half a
head’ or ‘half a tail’). As can be seen above, there is a 40% chance that the NPV will be negative, and that is maybe a risk that
the company is not prepared to take.
Furthermore, be aware that the analysis largely depends upon the values of the probabilities prescribed. Often these are
subjective estimates made by the decision makers and it would only take relatively small changes in these to alter one of the
decisions.
For example, in decision 2, if the probability of successful marketing falls to 55%, then the expected NPV of ‘marketing’ falls to:
[0.55 x 1,386] + [0.45 x (511)] = 762 – 230 = 532
This is now a lower value than the option of selling the design and the rights to sell the developed component for a net
present value of $594,000.
Such sensitivity analysis can be performed on other variables within the model.
Of course, decision models such as this are only as good as the information used. In reality there would probably be a much
wider range of possible outcomes than the discrete outcomes described above.
Internal Rate of Return
The minimum return that projects can generate. Or. The cost of capital at which NPV is ZERO.
It’s the maximum cost of capital that should be acceptable for evaluating investment projects. As any increased in the cost
above IRR will result in negative NPV.
𝐴
𝐼𝑅𝑅 = 𝑎% + 𝑋 𝑏−𝑎 %
𝐴−𝐵
Where:
a%- Small Disc. Rate at which NPV is Preferably positive
A- NPV at a%
Page 56
b%- Bigger Disc. Rate at which NPV is Preferably negative

B- NPV at b%
Year 0 1 2 3 4 5 6
Cash flows (400) (600) 400 500 400 200 100
Dis. Factor @ 10% 1.000 0.909 0.826 0.751 0.683 0.621 0.564
Present Values
NPV 214
Year 0 1 2 3 4 5 6
Cash flows (400) (600) 400 500 400 200 100
Dis. Factor @ 20% 1.000 0.833 0.694 0.579 0.482 0.402 0.335
Present Values
NPV (25)
= 19%
19% is the maximum cost of capital that should be acceptable as it’s the rate where NPV of the project will be zero.
Decision Rule:-
Feasibility Decision:
• If IRR of the project > Benchmark Cost of Capital, then Accept the project because the project is adding value to the
owners wealth resulting in positive NPV.
• If IRR of the project < Benchmark Cost of Capital, then Reject the project because the project is destroying value in shape
of negative NPV.
Comparison Decision:
Project with higher IRR shall be preferred.
Advantages of IRR:
• IRR takes into account the time value of money and thus giving a better picture of the projects viability.
• It considers the timing and life of the project.
• IRR is easier to understand as compared to NPV.
• Risk can be incorporated into decision making by adjusting the company’s target discount rate.
PROBLEMS WITH IRR

• IRR assumes that all the cash flows are reinvested in the project at calculated IRR which may be invalid in case of high IRR.
• IRR produces multiple answers in case of non-conventional cash flows.
• IRR is not helpful in choosing the best answer in case of mutually exclusive projects because IRR is a relative measure and
it does not consider the size of the project.
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Modified Internal Rate of Return

Modified internal rate of return (MIRR) provides the same result as IRR but it assumes that positive cash flows are reinvested
at the firm's cost of capital.
For example, suppose that a project has an NPV of +$300,000 when discounted at a cost of capital of 8%, and the IRR of the
project is 24%. In calculating the IRR, an assumption would be that all cash flows from the project are reinvested as soon as
they are received to earn a return of 24% even though the company’s cost of capital is 8%.To reinvest cash flows at such a high
rate is unrealistic .
NPV method implicitly assumes that project cash flows can be reinvested at the discount rate used to calculate NPV. This is a
realistic assumption, because it is reasonable to assume that project cash flows could be used to reduce the firm's capital
requirements. Any funds that are used to reduce the firm's capital requirements allow the firm to avoid the cost of capital on
those funds. Just by reducing its equity capital and debt, the firm could "earn" its cost of capital on funds used to reduce its
capital requirements. If we were to rank projects by their IRRs, we would be implicitly assuming that project cash flows could
be reinvested at the project's IRR.
MIRR would be calculated on the assumption that project cash flows are reinvested, when received, to earn a return equal to
8% per year. MIRR is more realistic because it’s based on the cost of capital as the reinvestment rate.
MIRR 1st FORMULA
1
𝑃𝑉 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑃𝑕𝑎𝑠𝑒 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 𝑃𝑕𝑎𝑠𝑒
Year 0 1 2 3 4 5 6
Cash flows (400) (600) 400 500 400 200 100
Dis. Factor @ 10% 1.000 0.909 0.826 0.751 0.683 0.621 0.564
Present Values (400) (545) 330 376 273 124 56
NPV 214
1
1159 6
𝑀𝐼𝑅𝑅 = 945
1 + 10% − 1
=13.8%
WHY USE MIRR INSTEAD OF IRR

 MIRR assumes reinvestment of cash flows at cost of capital which is more realistic in case of having a very high IRR.
 In case of non-conventional cash flows MIRR produces a single answer.
 It is easier to calculate than IRR.
 MIRR decision is in line with NPV decision so there are lesser chances of conflict.
Problems of MIRR
 It is not an industry preferred method.
 MIRR is also a relative measure so it still does not consider size of the project
Duration
It is the weighted average time required to obtain cash flows from the return phase of project. Another way of saying this is
that the duration of the project is the time required to cover one half of the value of investment returns.
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Steps to calculate duration

• Find discounted cash flows of return phase
• Find total present value of return phase by adding all discounted cash flows calculated above
• Find proportion of all present values by dividing each present value with total
• Find weighted average years by multiplying relevant years to above proportion
• Add all weighted years as duration
Duration can be used in capital investment appraisal to assess the payback on the project. Unlike payback and discounted
payback, however, it takes into consideration the total expected returns from the entire project (at their projected value), not
just returns up to the payback time.
If duration of the project is short relative to the life of the project- for example, if the duration is less than half the expected
total life of the project-this means the most of the returns from the project will be recovered in the early years.
If duration of the project is large portion of the total life of the project – for example if duration is 75% or more of the total life
of the project – this means the most of the returns from the project will be recovered in later years.
It could therefore be argued that duration is the best available method of assessing the time for an investment to provide its
return on capital invested.
To calculate duration for a project, the negative cash flows at the beginning of the project are ignored. Duration is calculated
using cash flows from the year that the cash flows start to turn positive.
However, if there are any negative cash flows in any year after the cash flow turn positive, such as in the final year of the
project, these negative cash flows are included in the calculation of duration (as negative cash flows).
Advantages
• Duration captures both the time value of money and the whole of the cash flows of a project.
• It is also a measure which can be used across projects to indicate when the bulk of the project value will be captured.
• This measure captures both the full value and time value of the project it is recommended as a superior measure to either
payback or discounted payback when comparing the time taken by different projects to recover the investment involved.
Disadvantages
• Its disadvantage is that it is more difficult to conceptualize than payback and may not be employed for that reason.
• It is not an industry preferred Method.
Example
Duration 0 1 2 3 4 5 6 Total
D.F.10% P.V of return phase 43.31 57.40 46.72 26.95 16.14 190.52
Proportion of present value 0.2273 0.3013 0.2452 0.1415 0.0847
Weighted years 0.4546 0.9039 0.9809 0.7073 0.5082
Duration(=sum of weighted years) 3.55
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Duration of 3.55 reflects the project will recover its return phase cash flows in weighted average time of 3.55 years compare
to total life of 6 years of the project.
Example 2
The project duration is calculated by first calculating the discounted cash flow for each future year, and then weighting each
discounted cash flow according to its time of receipt, as follows:
Years 0 1 2 3 4 5 6 7 8
Cash flows (500) (600) 700 600 500 100 50 (20) 20
D.F @ 10% 1 0.909 0.826 0.751 0.683 0.621 0.564 0.531 0.467
PV (500) (545) 578 451 342 62 28 (10) 9 1460
Proportion of 0.40 0.31 0.23 0.04 0.02 (0.007) 0.006
each year
Weighted 0.80 0.93 0.94 0.2 0.12 (0.049) 0.048
average years
Duration 3
MODIFIED DURATION
Modified duration measures the sensitivity of the price of a bond to a change in the interest rates.
Using the example on duration, the modified duration of the bond is

2.84/(1 + 0.035) = 2.74
This can be used to determine the proportionate change in bond price for a given change in yield as follows.
Where:
ΔP = change in bond price
ΔY = change in yield
P = current market price of the bond
PROPERTIES OF MODIFIED DURATION

As the modified duration is derived from the Macaulay duration, it shares the same properties.
• Longer dated bonds will have higher modified durations – that is, bonds which are due to be redeemed at a later are more
price-sensitive to changes in interest rates and are therefore more risky.
• Lower coupon bonds will have higher modified durations
• Lower yields will give higher modified durations
• The higher the modified duration, then the greater the sensitivity of that bond to a change in the yield.
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THE BENEFITS AND LIMITATIONS OF DURATION

• Benefits
o It allows bonds of different maturities and coupon rates to be directly compared.
o If a bond portfolio is constructed based on weighted average duration, it is possible to determine portfolio values
changes based on interest rate changes.
o Managers may be able to modify interest rate risk by changing the duration of bond portfolio.
• Limitations
o The main limitation of duration is that it assumes a linear relationship between interest rates and price that is, it
assumes that for a certain percentage change in interest rates will be an equal percentage change in price. However
as interest rates change the bond price is unlikely to change in a linear fashion.
o Convexity is another method which take into account the non-linear relation.
EXAMPLE
AFC Co has taken a four-year £80,000,000 loan out to part-fund the setting up of four branches. As an alternative to paying
the principal on the loan as one lump sum at the end of the fourth year, BFC Co could pay off the loan in equal annual
amounts over the four years similar to an annuity. In this case, an annual interest rate of 2% would be payable, which is the
same as the loan’s gross redemption yield (yield to maturity).
Calculate the modified duration of the loan if it is repaid in equal amounts.
Solution:
Annuity factor, 4 years, 2% = 3·808
Equal annual amounts repayable per year = 80,000,000/3·808 = 21008403
Macaulay duration
(21008403x 0·980 x 1 year +
21008403x 0·961 x 2 years +
21008403x 0·942 x 3 years +
21008403x 0·924 x 4 years)/80,000,000 =2.47years
Modified duration = 2·47/1·02 = 2·42 years
The equation linking modified duration (D), and the relationship between the change in interest rates (∆i) and change in price
or value of a bond or loan (∆P) is given as follows:
∆P = [–D x ∆i x P+
(P is the current value of a loan or bond and is a constant)
The size of the modified duration will determine how much the value of a bond or loan will change when there is a change in
interest rates. A higher modified duration means that the fluctuations in the value of a bond or loan will be greater, hence the
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value of 2·42 means that the value of the loan or bond will change by 2·42 times the change in interest rates multiplied by the
original value of the bond or loan.
The relationship is only an approximation because duration assumes that the relationship between the change in interest
rates and the corresponding change in the value of the bond or loan is linear. In fact, the relationship between interest rates
and bond price is in the form of a curve which is convex to the origin (i.e. non-linear). Therefore duration can only provide a
reasonable estimation of the change in the value of a bond or loan due to changes in interest rates, when those interest rate
changes are small.
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SYLLABUS B2:APPLICATION OF OPTION PRICING THEORY IN

INVESTMENT DECISIONS
Learning objectives
 Apply the Black-Scholes Option Pricing (BSOP) model to financial product valuation and to asset
valuation:i) Determine and discuss, using published data, the five principal drivers of option value
(value of the underlying, exercise price, time to expiry, volatility and the risk-free rate) ii) Discuss
the underlying assumptions, structure, application and limitations of the BSOP model.
 Evaluate embedded real options within a project, classifying them into one of the real option
archetypes.
 Assess, calculate and advise on the value of options to delay, expand, redeploy and withdraw
using the BSOP model.
NET PRESENT VALUE (NPV) AND REAL OPTIONS
Real options’ valuation methodology adds to the conventional net present value (NPV) estimations by taking account of real
life flexibility and choice.
The conventional NPV method assumes that a project commences immediately and proceeds until it finishes, as originally
predicted. Therefore it assumes that a decision has to be made on a now or never basis, and once made, it cannot be changed.
It does not recognize that most investment appraisal decisions are flexible and give managers a choice of what actions to
undertake.
The real options method estimates a value for this flexibility and choice, which is present when managers are making a
decision on whether or not to undertake a project. Real options build on net present value in situations where uncertainty
exists and, for example: (i) when the decision does not have to be made on a now or never basis, but can be delayed, (ii) when
a decision can be changed once it has been made, or (iii) when there are opportunities to exploit in the future contingent on
an initial project being undertaken. Therefore, where an organization has some flexibility in the decision that has been, or is
going to be made, an option exists for the organization to alter its decision at a future date and this choice has a value.
ESTIMATING THE VALUE OF REAL OPTIONS

Although there are numerous types of real options, in the AFM paper, candidates are only expected to explain and compute
an estimate of the value attributable to three types of real options:
• The option to delay a decision to a future date (which is a type of call option.
• The option to abandon a project once it has commenced if circumstances no longer justify the continuation of the project
(which is a type of put option), and
• The option to exploit follow-on opportunities which may arise from taking on an initial project (which is a type of call
option).
It can be assumed that real options are European-style options, which can be exercised at a particular time in the future and
their value will be estimated using the Black-Scholes Option Pricing (BSOP) model and the put-call parity to estimate the
option values. However, assuming that the option is a Europeanstyle option and using the BSOP model may not provide the
best estimate of the option’s value (see the section on limitations and assumptions below).
Five variables are used in calculating the value of real options using the BSOP model as follows:
1. The underlying asset value (Pa), which is the present value of future cash flows arising from the project after option
expiry.
2. The exercise price (Pe), which is the amount paid when the call option is exercised (future expenditure) or amount
received if the put option is exercised (sale proceeds).
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3. The risk-free (r), which is normally given or taken from the return offered by a short-dated government bill. Although this
is normally the discrete annualized rate and the BSOP model uses the continuously compounded rate, for AFM purposes
the continuous and discrete rates can be assumed to be the same when estimating the value of real options.
4. The volatility (s), which is the risk attached to the project or underlying asset, measured by the standard deviation.
5. The time (t), which is the time, in years, that is left before the opportunity to exercise ends.
The following three examples demonstrate how the BSOP model can be used to estimate the value of each of the three
types of options. Example 1: Delaying the decision to undertake a project
A company is considering bidding for the exclusive rights to undertake a project, which will initially cost $35m.
The company has forecast the following end of year cash flows for the four-year project.
Year 1 2 3 4
Cash flows ($m) 20 15 10 5
The relevant cost of capital for this project is 11% and the risk free rate is 4.5%. The likely volatility (standard deviation) of the
cash flows is estimated to be 50%.
Solution:
NPV without any option to delay the decision
Year Today 1 2 3 4
Cash flows ($) -35m 20m 15m 10m 5m
PV (11%) ($) -35m 18.0m 12.2m 7.3m 3.3m
NPV = $5.8m
Example 1: Delaying the decision to undertake a project - Continued
Supposing the company does not have to make the decision right now but can wait for two years before it needs to make the
decision.
NPV with the option to delay the decision for two years
Year 3 4 5 6
Cash flows ($) 20m 15m 10m 5m
PV (11%) ($) 14.6m 9.9m 5.9m 2.7m
Variables to be used in the BSOP model:

Asset value (Pa) = $14.6m + $9.9m + $5.9m + $2.7m = $33.1m
Exercise price (Pe) = $35m
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Exercise date (t) = Two years
Risk free rate (r) = 4.5%
Volatility (s) = 50%
Using the BSOP model
d1 0.401899
d2 -0.30521
N(d1) 0.656121
N(d2) 0.380103
Call value $9.6m
Based on the facts that the company can delay its decision by two years and a high volatility, it can bid as much as $9.6m
instead of $5.8m for the exclusive rights to undertake the project. The increase in value reflects the time before the decision
has to be made and the volatility of the cash flows.
Example 2: Exploiting a follow-on project

A company is considering a project with a small positive NPV of $3m but there is a possibility of further expansion using the
technologies developed for the initial project. The expansion would involve undertaking a second project in four years’ time.
Currently, the present values of the cash flows of the second project are estimated to be $90m and its estimated cost in four
years is expected to be $140m. The standard deviation of the project’s cash flows is likely to be 40% and the risk free rate of
return is currently 5%.
Solution:
The variables to be used in the BSOP model for the second (follow-on) project are as follows: Asset Value (Pa) = $90m
Exercise price (Pe) = $140m
Exercise date (t) = Four years
Risk free rate (r) = 5%
Volatility (s) = 40%

Using the BSOP model
d1 0.097709
d2 -0.70229
N(d1) 0.538918
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N(d2) 0.241249
Call value $20.85m
The overall value to the company is $23.85m, when both the projects are considered together. At present the cost of $140m
seems substantial compared to the present value of the cash flows arising from the second project. Conventional NPV would
probably return a negative NPV for the second project and therefore the company would most likely not undertake the first
project either. However, there are four years to go before a decision on whether or not to undertake the second project needs
to be made. A lot could happen to the cash flows given the high volatility rate, in that time. The company can use the value of
$23.85m to decide whether or not to invest in the first project or whether it should invest its funds in other activities. It could
even consider the possibility that it may be able to sell the combined rights to both projects for $23.85m.
Example 3: The option to abandon a project

Duck Co is considering a five-year project with an initial cost of $37,500,000 and has estimated the present values of the
project’s cash flows as follows:
Year 1 2 3 4 5
Present values
($ 000s) 1,496.9 4,938.8 9,946.5 7,064.2 13,602.9
Swan Co has approached Duck Co and offered to buy the entire project for $28m at the start of year three. The risk free rate
of return is 4%. Duck Co’s finance director is of the opinion that there are many uncertainties surrounding the project and has
assessed that the cash flows can vary by a standard deviation of as much as 35% because of these uncertainties.
Solution:
Swan Co’s offer can be considered to be a real option for Duck Co. Since it is an offer to sell the project as an abandonment
option, a put option value is calculated based on the finance director’s assessment of the standard deviation and using the
Black-Scholes option pricing (BSOP) model, together with the put-call parity formula.
Although Duck Co will not actually obtain any immediate cash flow from Swan Co’s offer, the real option computation below,
indicates that the project is worth pursuing because the volatility may result in increases in future cash flows.
Without the real option
Year 1 2 3 4 5
Present values ($
000s) 1,496.9
4,938.8 9,946.5 7,064.2 13,602.9
Present value of cash flows approx. = $37,049,300
Cost of initial investment = $37,500,000

NPV of project = $37,049,300 – $37,500,000 = $(450,700)
Example 3: The option to abandon a project - Continued
With the real option

The asset value of the real option is the sum of the PV of cash flows foregone in years three, four and five, if the option is
exercised ($9.9m + $7.1m + $13.6m = $30.6m)
Asset value (Pa) $30.6m
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Exercise Price (Pe) $28m

Risk-free rate (r) 4%
Time to exercise (t) Two years
Volatility (s) 35%
d1 0.588506
d2 0.093531
N(d1) 0.721904
N(d2) 0.537259
Call Value 8.20
Put Value $3.45m
Net present value of the project with the put option is approximately $3m ($3.45m – $0.45m).
If Swan Co’s offer is not considered, then the project gives a marginal negative net present value, although the results of any
sensitivity analysis need to be considered as well. It could be recommended that, if only these results are taken into
consideration, the company should not proceed with the project. However, after taking account of Swan Co’s offer and the
finance director’s assessment, the net present value of the project is positive. This would suggest that Duck Co should
undertake the project.
LIMITATIONS AND ASSUMPTIONS
EUROPEAN-STYLE OPTIONS OR AMERICAN-STYLE OPTIONS

The BSOP model is a simplification of the binomial model and it assumes that the real option is a European-style option, which
can only be exercised on the date that the option expires. An American-style option can be exercised at any time up to the
expiry date. Most options, real or financial, would, in reality, be American-style options.
If the underlying asset on which the option is based is due to receive some income before the option’s expiry; say for example,
a dividend payment for an equity share, then an early exercise for an option on that share may be beneficial. With real
options, a similar situation may occur when the possible actions of competitors may make an exercise of an option before
expiry the better decision. In these situations the American-style option will have a value greater than the equivalent
European-style option.
Because of these reasons, the BSOP model will either underestimate the value of an option or give a value close to its true
value. Nevertheless, estimating and adding the value of real options embedded within a project, to a net present value
computation will give a more accurate assessment of the true value of the project and reduce the propensity of organizations
to under-invest.
OTHER LIMITATIONS OF REAL OPTIONS

The BSOP model requires further assumptions to be made involving the variables used in the model, the primary ones being:
• The BSOP model assumes that the underlying project or asset is traded within a situation of perfect markets where
information on the asset is available freely and is reflected in the asset value correctly. Further it assumes that a market
exists to trade the underlying project or asset without restrictions (that is, that the market is frictionless)
• The BSOP model assumes that interest rates and the underlying asset volatility remain constant until the expiry time ends.
Further, it assumes that the time to expiry can be estimated accurately
• The BSOP model assumes that the project and the asset’s cash flows follow a lognormal distribution, similar to equity
markets on which the model is based
• The BSOP model does not take account of behavioral anomalies which may be displayed by managers when making
decisions, such as over- or under-optimism
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• The BSOP model assumes that any contractual obligations involving future commitments made between parties, which
are then used in constructing the option, will be binding and will be fulfilled. For example, in example three above, it is
assumed that Swan Co will fulfil its commitment to purchase the project from Duck Co in two years’ time for $28m and
there is therefore no risk of non-fulfillment of that commitment.
SYLLABUS B3:FINANCING/APV/VALUATION/INTERNATIONAL
APPRAISAL
Learning objectives
 Identify and assess the appropriateness of the range of sources of finance available to an
organisation including equity, debt, hybrids, lease finance, venture capital, business angel
finance, private equity, asset securitisation and sale, Islamic finance and initial coin offerings.
Including assessment on the financial position, financial risk and the value of an organisation.
 Discuss the role of, and developments in, Islamic financing as a growing source of finance for
organisations; explaining the rationale for its use, and identifying its benefits and deficiencies.
 Calculate the cost of capital of an organisation, including the cost of equity and cost of debt,
based on the range of equity and debt sources of finance. Discuss the appropriateness of using
the cost of capital to establish project and organisational value, and discuss its relationship to
such value.
 Calculate and evaluate project specific cost of equity and cost of capital, including their impact on
the overall cost of capital of an organisation. Demonstrate detailed knowledge of business and
financial risk, the capital asset pricing model and the relationship between equity and asset
betas.
 Assess an organisation’s debt exposure to interest rate changes using the simple Macaulay
duration and modified duration methods.
 Discuss the benefits and limitations of duration including the impact of convexity.
 Assess the organisation’s exposure to credit risk, including: i) Explain the role of, and the risk
assessment models used by the principal rating agencies ii) Estimate the likely credit spread over
risk free
 Estimate the organisation’s current cost of debt capital using the appropriate term structure of
interest rates and the credit spread. Assess the impact of financing and capital structure upon
the organisation with respect to:
 Modigliani and Miller propositions, before and after tax ii) Static trade-off theory iii) Pecking
order propositions iv) Agency effects.
 Apply the adjusted present value technique to the appraisal of investment decisions that entail
significant alterations in the financial structure of the organisation, including their fiscal and
transactions cost implications.
 Assess the impact of a significant capital investment project upon the reported financial position
and performance of the organisation taking into account alternative financing strategies
Sources of Finance
Hybrid Securities
A hybrid security is a security that combines two or more different financial instruments. Generally they combine both debt
and equity characteristics. The most common type of hybrid security is a convertible bond that has the function of a normal
bond but can be converted into stock. Moreover it is heavily influenced by the price movements of the stock in which it can
convert.
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Another type of hybrid securities is convertible preference shares. It is just like normal preference shares where you receive
dividends before common equity but the shares can be exchanged for equity shares. Each of these hybrid securities have
unique risk and reward characteristics.
Lease Finance
These excerpts have been taken from the technical article published on ACCA GLOBAL website.
Leases are classified currently under IAS 17, Leases, as finance or operating leases at inception, depending on whether
substantially all the risks and rewards of ownership transfer to the lessee. Under a finance lease, the lessee has substantially
all of the risks and reward of ownership. Situations that would normally lead to a lease being classified as a finance lease
include the following:
 the lease transfers ownership of the asset to the lessee by the end of the lease term
 the lease term is for the major part of the economic life of the asset, even if title is not transferred
 at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all
of the fair value of the leased asset
 the leased assets are of a specialised nature such that only the lessee can use them without major modifications
being
 if the lessee is entitled to cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee
 gains or losses from fluctuations in the fair value of the residual fall to the lessee
 the lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market
rent
All other leases are operating leases.
Venture Capital
An investment made by private organization into firms which have prospects for long term growth. They have similar pros and
cons like private equity.
Business Angel Finance
Excerpt taken from the articles published in ACCA GLOBAL website
Business angels commonly finance start-ups and established small and medium-sized enterprises (SMEs), providing a quick
and straightforward way to secure the funding needed.
Advantages
 raising finance in the form of equity strengthens your balance sheet

 it can lead to additional finance being made available from other sources such as banks
 business angels bring wisdom as well as money, such as how to run a successful business or an intimate knowledge of
your industry.
Disadvantages
 the high risk taken by business angels can mean a high annual return: 20% or 30% is common
 there must be an exit plan in place, allowing the angel to leave the business
 if a large amount of equity is taken by the angel it can lead to control issues, and the greater the equity taken, the
greater the exit costs.
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Private Equity
Advantages
 Access to greater amounts of funding
 Private investor tend to be actively involved in the investment and provide great insights which are beneficial for the
business
 If the project is successful private investors provide incentive by bringing additional investment from other investors.
Disadvantage
 Loss of Ownership stake for the original owners.
 Loss of Management Control (you might lose the control if the private investor has a dominant and charismatic
personality)
 Private investors are focused heavily on making the company public and selling the shares at a higher value. Not
really concerned with the long term sustainability of the company.
Asset Securitisation And Sale
Pooling of assets to create a large asset and selling their respective cash flows to investors as securities.A typical example of
securitization is a mortgage-backed security (MBS), a type of asset-backed security that is secured by a collection of
mortgages.
Advantages
 Creates Liquidity for illquid assets
 Provides different forms of risk-based securities from the same pool of assets.
Disadvantages
 Extreme complexities in executing asset securitization
 Can lead to financial disaster e.g US housing credit bubble especially when government get involved in the process.
Initial Coin Offerings(ICO)
It is similar to IPO but it is for cryptocurrency like bitcoins. Companies tends to launch a new cryptocurrency which they expect
will perform exceptionally well in the future.
Benefits
 Companies don’t have to give their equity share and they just have to give token which has no inherent value.
 Tokens are easier to produce
 Growth of ICO have been phenomenal
Disadvantages
 Investors are cautious to buy in ICO since they are have been some fradualent distributions of cryptocurrency
 In recent times international banks have refused to provide services related to ICO which caused cryptocurrency like
bitcoin to fall.
 Organization like google and facebook refuse to market ICO on their platforms which has caused negative publicity.
ISLAMIC FINANCE
Islamic finance is finance that is compliant with Sharia'a law.
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Islamic finance transactions are based on the concept of sharing risk and reward between the investor and the user of funds.
The object of an Islamic finance undertaking is not simply the pursuit of profit, but that the economic benefits of the
enterprise should extend to goals such as social welfare and full employment. Making profits by lending alone and the
charging of interest is for bid den under Sharia'a law. The business of trading goods and investment in Sharia'a acceptable
enterprises form the core of Islamic finance.
Riba
Riba(interest) is for bid den in Islamic finance.
Ribais generally interpreted as the predetermined interest collected by a lender, which the lender receives over and above the
principal amount it has lent out. The Quranic ban on ribais absolute. Riba can be viewed as unacceptable from three different
perspectives, as outlined below.
 For the borrower

Riba creates unfairness for the borrower when the enterprise makes a profit which is less than the interest payment,
turning their profit in to a loss.
 For the lender

Riba creates unfairness for the lender in high inflation environments when the returns are likely to be below the rate of
inflation.
 For the economy

Riba can result in inefficient allocation available resources in the economy and may contribute to instability of the system.
In an interest-based economy, capitalis directed to the borrower with the highest credit worthiness rather than the
borrower who would make the most efficient use of the capital.
Islamic finance contracts

Musharaka – a partnership contract
Mudaraba– a form of equity where a partnership exists and profits and losses are shared
Murabaha – a form of credit sale
Ijara – a form of lease
Sukuk– similar to a bond
Mudaraba Contract
A mudaraba transaction is a partnership transaction in which only one of the partners (the rab al mal) contributes capital, and
the other (the mudarib) contributes skill and expertise. The contributor of capital has no right to interfere in the day to day
operations of the business. Due to the fact that one of the partners is running the business and the other is solely providing
capital, the investor has to rely heavily on the mudarib, their ability to manage the business and their honesty when it comes
to profit share payments.
Mudaraba transactions are particularly suited to private equity investments or for clients depositing money with a bank.
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Profit & loss Capital Expertise Profit & loss
Investing Pa r tner BusinessPartner
(RabalMal) (Mudarib)
BusinessPartner
(Mudarib)
The roles of and the returns received by the rab-al-mal and mudarib under a mudaraba contract
 Capital injection
The investor provides capital for the project or company. Generally, an investor will not provide any capital unless a
clearly defined business plan is presented to them. In this structure, the investor provides 100% of the capital.
 Skill and expertise

The business manager's contribution to the partnership is their skill and expertise in the chosen industry or area.
 Profit and loss

Any profits will be shared between the partners according to the ratios agreed in the original contract. Any losses are
solely attributable to the investor due to the fact that they are the sole provider of all capital to the project. In the event
of a loss, the business manager does not receive any compensation (mudarib share) for their efforts. The only exception
to this is when the business manager has been negligent, in which case they become liable for the total loss.
The investor in a mudaraba transaction is only liable to the extent of the capital they have provided. As a result, the
business manager cannot commit the business for any sum which is over and above the capital provided.
The mudaraba contract can usually be terminated at any time by either of the parties giving a reasonable notice. Typically,
conditions governing termination are included in the contract so that any damage to the business or project is eliminated
in the event that the investor would like to take their equity out of the venture.
The rab al mal has no right to interfere with the operations of the business, meaning this situation is similar to an equity
investment on a stock exchange.
Musharaka partnership contract

Musharaka transactions are typically suitable for investments in business ventures or specific business projects, and need to
consist of at least two parties, each of which is known as musharik. It is widely used in equity financing.
Once the contract has been agreed between the partners, the process can be broken down into the following two main
components.
• All partners bring a share of the capital as well as expertise to the business or project. The partners do not have to
provide equal amounts of capital or equal amounts of expertise.
• Any profits will be shared between the partners according to the ratios agreed in the original contract. To the
contrary, any losses that the project might incur are distributed to the partners strictly in proportion to capital
contributions. Although profits can be distributed in any proportion by mutual consent, it is not permissible to fix a
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lump sum profit for any single partner. This transaction is similar to venture capital, for example a management
buyout, where both parties contribute both capital and expertise. The venture capitalist will want board
representation and therefore provides expertise and they will also want management to provide capital to
demonstrate their commitment.
Murabaha contract
Instruments with predictable returns are typically favoured by banks and their regulators since the reliance on third-party
profit calculations is eliminated.
A murabaha transaction is a deferred payment sale or an instalment credit sale and is mostly used for the purchase of goods
for immediate delivery on deferred payment terms. In its most basic form, this transaction involves the seller and buyer of a
good, as can be seen below.
Simple murabaha structure
Seller Buyer
1. Deliver goods today

2. Pay for goods later
As part of the contract between the buyer and the seller, the price of the goods, the mark-up, the delivery date and payment
date are agreed. The sale of the goods is immediate, against future payment. The buyer has full knowledge of the price and
quality of goods they buy. In addition, the buyer is also aware of the exact amount of mark-up they pay for the convenience of
paying later. In the context of trading, the advantage to the buyer is that they can use the goods to generate a profit in their
business and subsequently use the profit to repay the original seller.
The underlying asset can vary, and can include raw materials and goods for resale.
Sharia'a prescribes that certain conditions are required for a sales contract (which include murabaha contracts) to exist.
• The object in the contract must actually exist and be owned by the seller.
• The object is offered for a price and both object and price are accepted (the price should be within fair market range).
• The object must have a value.
• The object in question and its exchange may not be prohibited by Sharia'a.
• The buyer in the contract has the right to demand that the object is of suitable quality and is not defective.
• A bank can provide finance to a business in a murabaha transaction as follows.
• The manager of the business identifies an asset that the business wants to buy.
• The bank agrees to buy the asset, and to resell it to the business at an agreed (fixed) price, higher than the original
purchase price of the asset.
• The bank will pay for the asset immediately but agrees to payment from the business under a deferred payment
arrangement (murabaha).
• The business therefore obtains the asset 'now' and pays for it later. This is similar in effect to arranging a bank loan to
purchase the asset, but it is compliant with Sharia'a law.
Ijara contract
An ijara transaction is the Islamic equivalent of a lease where one party (lessor) allows another party (lessee) to use their
asset against the payment of a rental fee. Two types of leasing transactions exist: operating and finance leases. The only
distinction between the two is the presence or absence ofa purchase undertaking from the lessee to buy the asset at the end
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of the lease term. In a finance lease, this purchase undertaking is provided at the start of the contract. The lessor cannot
stipulate that they will only lease the asset if the lessee signs a purchase undertaking.
Not every asset is suitable for leasing. The asset needs to be tangible, non-perishable, valuable, identifiable and quantifiable.
In an operating lease, depicted in Figure1, the lessor leases the asset to the lessee for a pre-agreed period and the lessee pays
pre-agreed periodic rentals. The rental or lease payments can either be fixed for the period or floating with periodical refixing.
Figure1: Operating lease
At the end of the period, the lessee can either request to extend the lease or hand the asset back to the lessor. When the
asset is returned to the lessor at the end of the period, they can either lease it to another counter party or sell the asset in the
open market. If the lessor decides to sell the asset, they may offer it to the lessee.
In a finance lease, as depicted in Figure 2, the process is the same as for an operating lease, with the exception that the lessor
amortises the asset over the term of the lease and at the end of the period the asset will be sold to the lessee.
Figure2:Finance lease
As with an operating lease, rentals can be fixed for the period or floating. As part of the lease agreement, the amount at which
the lessee will purchase the asset upon expiry of the lease is specified.
In both forms of ijara the lessor is the owner of the asset and incurs all risk associated with ownership. While the lessee bears
the responsibility for wear and tear, day to day maintenance and damage, the lessor is responsible for major maintenance and
insurance. Due to the fact that the lessee is using the asset on a daily basis, they are often in a better position to determine
maintenance requirements, and are generally appointed by the lessor as an agent to ensure all maintenance is carried out. In
addition, the lessee is, in some cases, similarly appointed as agent for the lessor to insure the asset.
In the event of a total loss of the asset, the lessee is no longer obliged to pay the future periodic rentals. However, the lessor
has full recourse to any insurance payments.
Sukuk is about the finance provider having ownership of real assets and earning a return sourced from those assets. This
contrasts with conventional bonds where the investor has a debt instrument earning the return predominately via the
payment of interest (riba). Riba or excess is not allowed under Sharia law. There has been considerable debate as to whether
sukuk instruments are akin to conventional debt or equity finance. This is because there are two types of sukuk:
Asset based – raising finance where the principal is covered by the capital value of the asset but the returns and repayments
to sukuk holders are not directly financed by these assets.
Asset backed – raising finance where the principal is covered by the capital value of the asset but the returns and repayments
to sukuk holders are directly financed by these assets.
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There are fundamental differences between these. The diagrams set out below explain the mechanics of how each sukuk
operates.
ASSET-BASED SUKUK
Sukuk Al-ijarah: financing acquisition of asserts or raising capital through sale and lease back.
1. Sukuk holders subscribe by paying an issue price to a special purpose vehicle (SPV) company.
2. In return, the SPV issues certificates indicating the percentage they own in the SPV.
3. The SPV uses the funds raised and purchases the asset from the obligor (seller).
4. In return, legal ownership is passed to the SPV.
5. The SPV then, acting as a lessor, leases the asset back to the obligor under an Ijarah agreement.
6. The obligor or lessee pays rentals to the SPV, as the SPV is the owner and lessor of the asset.
7. The SPV then make periodic distributions (rental and capital) to the sukuk holders.
ASSET-BACKED SUKUK
Sukuk: Securitisation of Leasing Portfolio
1. Sukuk holders subscribe by paying an issue price to a SPV company.
2. In return, the SPV issues certificates indicating the percentage they own in the SPV.
3. The SPV will then purchase a portfolio of assets, which are already generating an income stream.
4. In return, the SPV obtains the title deeds to the leasing portfolio.
5. The leased assets will be earning positive returns, which are now paid to the SPV Company.
6. The SPV then makes periodic distributions (rental and capital) to the sukuk holders.
7. With an asset-based sukuk, ownership of the asset lies with the sukuk holders via the SPV. Hence, they would have to
maintain and insure the asset. The payment of rentals provides the return and the final redemption of the sukuk is at a
pre-agreed value. As the obligor is the lessee, the sukuk holders have recourse to him if default occurs. This makes this
type of sukuk more akin to debt or bonds.
Asset-backed sukuk certainly have the attributes of equity finance – the asset is owned by the SPV. All of the risks and rewards
of ownership passes to the SPV. Hence, should the returns fail to arise the sukuk holders suffer the losses. In addition,
redemption for the sukuk holders is at open market value, which could be nil
Salam means a contract in which advance payment is made for goods to be delivered at a future date. The seller undertakes
to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract.
It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to
dispute. Bai Salam covers almost everything which is capable of being definitely described as to quantity, quality and
workmanship. For Islamic banks, this product is ideal for agriculture financing, however, this can also be used to finance the
working capital needs of the customers.
The permissibility of Salam is an exception to the general rule that prohibits forward sale.
The Salam transaction is subject to the strict conditions as follows:

1. It is necessary for the validity of Salam that the buyer pays the price in full to the seller at the time of affecting
the sale.
2. Only those goods can be sold through a Salam contract in which the quantity and quality can be exactly specified
e.g. precious stones cannot be sold on the basis of Salam because each stone differ in quality, size, weight and their exact
specification is not possible.
3. Salam cannot be affected on a particular commodity or on a product of a particular field or farm e.g. Supply of
wheat of a particular field or the fruit of a particular tree 4. All quality, quantity and date is specified.
ISTISNA
It is a specific kind of a Bai (sale) where the sale of the commodity is transacted before the commodity comes into existence.
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Istisna is an agreement culminating in a sale at an agreed price whereby the purchaser places an order to manufacture,
assemble or construct (or cause so to do) anything to be delivered at a future date. It becomes an obligation of the
manufacturer or the builder (as the case may be) to deliver the asset of agreed specifications at the agreed period of time. As
the sale is executed at the time of entering into the Istisna contract, the contracting parties need not renew an exchange of
offer and acceptance after the subject matter is prepared. Istisna can be used for providing the facility of financing the
manufacture or construction ofhouses, plants, projects and building of bridges, roads and highways etc. After giving prior
notice, either party can cancel the contract before the manufacturing party has begun its work. Once the work starts, the
contract cannot be cancelled unilaterally.
Weighted Average Cost of Capital
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its providers of
capital to finance its assets. WACC commonly include cost of Equity, Preference and Debt sources
WACC
Weighted Average Cost of

Capital
Cost of equity: Cost of debt: Cost of preference

the rate of return that is this is the after-tax return - shares:the return
expected by the equity expected by the debt expected by the
holders of the company. holders of the company. preference shareholders
The symbol used to The symbol used to of the company. The
represent cost of equity is represent after-tax cost of symbol used to represent
Ke debt is Kd(1 – t) cost of preference shares
is Kp
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Cost of Equity
It can be calculated using one for the following method.

• Dividend Valuation model
• Capital asset pricing model
Cost of Equity:
Cost of equity: the dividend growth model method

If it is assumed that the annual dividend will grow at a constant percentage rate into the foreseeable future, the
cost of equity can be calculated as follows:
Where:
KEis the cost of equity
Do = the annual dividend for the year that has just ended g is the annual growth rate in dividends, expressed as a
proportion (8% = 0.08, etc.) MV is the share price ex dividend d (1 + g) is therefore the expected dividend next
year=D1
Example:
A company's share price is $11.70. The company has just paid an annual dividend of $1.40 per share, and
the dividend is expected to grow by 3% into the foreseeable future. The cost of equity in the company can be
estimated as follows:
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Two methods to calculate growth
1. Historic Estimate
Example
Year End Dividend per share
$
2007 0.24
2008 0.27
2009 0.29 2010 0.32
g= 3√(0.32/0.24) -1 g=10%
2. Gordon's growth approximation

Gordon's growth approximation is an estimate of future dividend growth, expressed by the formula:
g = b re
Where:
g = the annual rate of dividend growth
b = the proportion of earnings (or free cash flow) reinvested for growth, and re = the rate of return on those
reinvested earnings
Always use Ke as ROE because over the longer term it will sustain and attainable.
Example:
A company reported profits after interest and tax of $6 million and paid dividends of $4 million. This ratio of
dividend payments to earnings is fairly typical of the company's dividend policy. The company's cost of equity is
12%.
The proportion of profits reinvested for growth is 0.33 (2/6).
An estimate of the future growth rate in annual dividends, using Gordon's growth Approximation is:
0.33x0.12 = 0.04 or 4.0%.
CAPITAL ASSET PRICING MODEL

The capital asset pricing model (CAPM) is used to calculate the required rate of return (ke). It assumes investor’s hold a
diversified portfolio so it’s require return based only on systematic risk.
Systematic risk is how market factors effect that investment. Market factors are:-• Macroeconomic variables
• Political factors
The measure is relative to the benchmark of the market portfolio which has a βeta factor of 1.
TOTAL RISK
Unsystematic risk Systematic risk

Company specific factors General economic factors
Can be eliminated by cannot be eliminated
Diversification
By holding a portfolio, the unsystematic risk is diversified away but the systematic risk is not and will be present in all
portfolios. If we were to enlarge our portfolio to include approximately 25 shares we would expect the unsystematic risk to be
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reduced to close to zero, the implication being that we may eliminate the Unsystematic portion of overall risk by spreading
investment over a sufficiently diversified portfolio.
Advantages of CAPM;
• It generates a theoretically derived relationship between required return and systematic risk, which has been subject to
frequent empirical research and testing.
• It explicitly takes into Account Company’s level of systematic risk relative to stock market as a whole.
• Clearly superior to wacc in providing discount rate for investment appraisal. Criticisms of CAPM
CAPM is a single period model. This means that the values calculated are only valid for a finite period of time and will
need to be recalculated or updated at regular intervals.
• CAPM assumes no transaction costs associated with trading securities.
• Any beta value calculated will be based on historic data which may be not appropriate currently. This is particularly so if
the company has changed the capital structure of the business or the type of business it is trading in.
• The market return may change considerably over short periods of time.
• CAPM assumes an efficient investment market where it is possible to diversify away risk. This is not necessarily the case,
meaning that some unsystematic risk may remain.
• Additionally, the idea that all unsystematic risk is diversified away will not hold true if stocks change in terms of volatility.
As stocks change over time it is very likely that the portfolio becomes less than optimal.
• CAPM assumes all stocks relate to going concerns, this may not be the case.
Assumptions of CAPM
• It is assumed that investors are rational & will hold a well-diversified portfolio (unsystematic risk will be reduced to
minimum level).
• Transaction cost is low or nil.
• Investors have homogeneous expectations about the market.
• Market is perfect and all investors have same level of information & no individual can dominate the market.
• Debt beta is zero.
• There is no cost of acquiring information.
• No individual can dominate the market.
Beta: It is a relative systematic risk of company’s earnings with the market systematic risk.As market risk =1
Beta can be > 1 more risky compare to market
Beta can be < 1 less risky compare to market
Cost of Equity = Rf + β (Risk Premium)
Cost of Equity = Rf + β (Rm-Rf)
Where:
KE = THE cost of equity in the company
RF= the risk-free rate of return
Return on govt stock, treasury yield, gilt edged security
RM = the return on the market portfolio of securities that are not risk-free
(Rm-Rf) = Market risk premium or equity risk premium
The CAPM method of estimating the cost of equity is an alternative to a dividend-based estimate using the dividend growth
model. The two methods will normally produce differing estimates.
Example: A company's shares have a current market value of $25.00. The most recent annual dividend has just been paid. This
was $2.00 per share.
Required: Calculate the cost of equity in this company in each of the following circumstances:
(a) The annual dividend is expected to remain $2.00 into the foreseeable future.
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(b) The annual dividend is expected to grow by 2% each year into the foreseeable future.
(c) The CAPM is used, the equity beta is 1.20, the risk-free cost of capital is 5% and the expected market return is 9%.
Answer:
Cost of Debt
Each item of debt finance for a company has a different cost. This is because debt capital has differing risk, according to
whether the debt is secured, whether it is senior or subordinated debt, and the amount of time remaining to maturity. Cost of
debt is adjusted for taxation because of the tax savings available on annual interest. The different types of debt are:
 Irredeemable debt
 Redeemable debt (redeemable fixed rate bonds)
 Variable rate debt (floating rate debt)
 Non-tradable debt
 Convertible debt
 Corporate debt
Irredeemable debt
 As we know that MV is the P.V of the future Cash flows.
 MV of irredeemable bond
 Required return of debt holders =
 Kd =
 Never deduct tax in calculation of market value and required rate of return.
 Always take after-tax interest in calculation of cost of debt because interest is a tax allowable expense.
 Redeemable debt (redeemable fixed rate bonds)

Market value is the present value of all future interest and principal amount.
Year Cash Flow D.F @ yield P.Values
1-5 Interest Annuity factor ××
5 Redemption Value Discountfactor ××
×××
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Required rate of return of debt holders

The required return on redeemable bonds is their redemption yield. This is calculated as the rate of return that equates the
present value of the future cash flows payable on the bond (to maturity) with the current market value of the bond. In other
words, it is the IRR of the cash flows on the bond to maturity, assuming that the current market price is a cash outflow.
Other names of required returns are yield till maturity (YTM) or gross redemption yield (GRY).
Cost of debt
Same method of IRR will be used here but in case of Kd but we have to take after tax value of interest.
Example
The current market value of a company’s 7% loan stock is 96.25. Annual interest has just been paid. The bonds will be
redeemed at par after four years. The rate of taxation on company profits is 30%.
Required:
Calculate the after-tax cost of the bonds for the company
Year Cash Flow D.F @ 5% P.Values D.F @ 10% P.Values

0 (96.25) 1.000 (96.25) 1.000 (96.25)
1–4 4.90 3.546 17.38 3.170 15.53
4 100 0.823 82.30 0.683 68.30

3.43 (12.42)
Kd (1 – t) =
= 6.08%
➢ Variable or Floating Rate Debt

Company will pay what you demand. If Interest rate and required rate are same then market value will be same as
redemption.
Kd=Interest % x (1-t)
 Non-tradable Debt
An example of non-tradable debt is bank loan.
Kd=Interest % x (1-t)
Convertible Loan
• Here bond holders have choice to either redeem the debt or convert the debt into predetermined number of shares.
• The method of calculating cost of debt for convertible is same as calculating the cost of debt of redeemable debt.
• The problem here is that we do not know whether the bond holder would exercise the conversion option or not.
Therefore we take higher value of redemption value or conversion value.
• Conversion Value is calculated as:
• Conversion Value = M.V per share at time of conversion x No. of Shares
M.V at the time of conversion = Current M.v × (1+g) ^n Where,

g = Share price growth
n = no. of years in conversion
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Market value of convertible Debt

Year Cash Flow D.F @ ytm P.Values
1– 5 Interest A.F ××
5 Higher off Redemption OR D.F ××
Conversion value
M.V ×××
Cost of debt :Example

The current market value of a company’s 7% loan stock is 96.25. Annual interest has just been paid. The bonds will be
redeemed at par after four years or convertible into 20 ordinary shares. Current share price is $4.44 and it is expected that it
will grow with a growth of 5% per year. The rate of taxation on company profits is 30%.
Required:
Calculate the after-tax cost of the bonds for the company.
Answer:
Conversion Value = 20× 4.44 × 1.05^4=$108
Redemption Value=$100
Investors are rational and will choose the higher Value
Year Cash Flow D.F @ 10% P.Values D.F @ 5% P.Values
0 (96.25) 1.000 (96.25) 1.000 (96.25)

1– 4 4.90 3.170 15.53 3.546 17.38
4 108 0.683 73.76 0.823 88.88
(7) 10
Kd (1 – t) =
=7.94 %
The Yield Curve (Term Structure of Interest Rates)
The yield is the return on an investment, such as the interest or dividends received from holding a particular security. Whereas
a yield curve on a graph in which the yield of fixed-interest debt is plotted against the length of time they have to run to
maturity.
The cost of new debt can be estimated by reference to a yield curve.

The cost of fixed-rate debtis commonly referred to as the Interest yield'.
The interest yield on debt capital varies with the remaining term to maturity of the debt.
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 As a general rule, the interest yield on debt increases with the remaining term to maturity. For example, it should
normally be expected that the interest yield on a fixed-rate bond with one year to maturity/redemption will be lower than
the yield on a similar bond with ten years remaining to redemption. Interest rates are normally higher for longer
maturities to compensate the lender for tying up his funds for a longer time.
 When interest rates are expected to fall in the future, interest yields might vary inversely with the remaining time to
maturity. For example, the yield on a one-year bond might be higher than the yield on a ten-year bond when rates are
expected to fall in the next few months.
 When interest rates are expected to rise in the future, the opposite might happen, and yields on longer-dated bonds
might be much higher than on shorter-dated bonds as investors will get higher yields when interest rates rise.
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Yield curves are widely used in the financial services industry. Two points that should be noted about a yield curve are that:
 Yields are gross yields, ignoring taxation (pre-tax yields).
 A yield curve is constructed for 'risk-free' debt securities, such as government bonds. A yield curve therefore shows 'risk-
free yields'.
As the name implies, risk-free debt is debt where the investor has no credit risk whatsoever, because it is certain that the
borrower will repay the debt at maturity. Debt securities issued in their domestic currency by the government should always
be risk-free: yield curves are therefore constructed for government bonds.
The yield curve and non-risk-free debt: spreads

The interest yield on other debt, such as corporate bonds and loans, is higher than the yield on risk-free debt with the same
maturity. For example, the interest rate on a sterling bond of ABC Company with two years to maturity will be higher than the
interest yield on a two-year UK government bond. The higher yield is to compensate investors in corporate bonds for the fact
that the debt is not risk-free. The company might default.
'Spread' is the difference between the risk-free rate of return (the yield curve) and the cost of debt for the same maturity that
is not risk-free. For example, if the risk-free return on five-year government bonds is 5.4% and the spread for a company's five-
year bonds is 80 basis points, the yield on the company bonds is:
 Yield curve + Spread ➢=5.40%+ 0.80% = 6.20%.
KD (1-t) = (Yield on similar Government debt + Credit Risk Premium) x (1-t)
Credit Ratings
The size of spreads

The size of the spread allows for the additional risk in the debt that is not risk-free. The spread is therefore higher for debt that
has a higher risk for investors or lenders. Many large companies are given a credit rating by a credit rating agency, such as
Moody's, Standard & Poor's and Fitch. (Strictly, the company's debt is given a credit rating, but it is common to speak of
companies having a credit rating rather than the debt having a credit rating.)
 The top credit rating is a 'triple-A' credit rating.
 Spreads are lowest for the top Credit ratings, and higher for lower credit ratings.
Credit Ratings
Each credit rating agency uses its own credit rating system. The most well-known are the rating systems of Standard & Poor's
and Moody's. Their ratings for bonds are set out in the table below.
Moody's credit
Standard & Poor's
credit ratings RatingsInvestment
grade
AAA Highest rating Aaa
AA Still high quality debt Aa
A A
BBB Baa
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Sub-Investment grade (*junk*)

BB Major uncertainties about the Ba
CCC ability of the borrower to pay B
CC interest Caa
C and repay principal on Time Ca
D C
D
In Default
Standard & Poor's credit ratings are also modified by ‘+’and '-' signs. A ‘+’ sign indicates a better credit rating and a'-' indicates
a lower credit rating.
 Credit ratings are therefore AAA, AA+, AA, AA-, A+, A, A-, BBB+,
BBB,
BBB-, BB+, BB, BB- and so on.
 The lowest investment grade credit rating is BBB-.
Moody's credit ratings are modified in a similar way, but using the numbers 1, 2 and 3.
 Credit ratings are therefore Aaa, Aa1, Aa2, Aa3, Al, A2, A3, Baal,
Baa2, Baa3,
Ba1, Ba2, Ba3 and so on.
 The lowest investment grade rating is Baa3.
Sub-investment grade debt, also called 'junk bonds', is a speculative investment for the lender or bondholder, and yields
required by investors are normally much higher than on investment grade debt.
Spreads and credit ratings:

Spreads vary according to:
 The risk characteristics of the industry
 The time remaining to maturity for the debt, and
 The credit rating.
Example:
Yield spreads on US bonds for companies in the construction industry are as follows:
Spreads: Years to maturity

Rating: 1 2 3 5 7 10
AAA / Aaa 2 4 10 15 20 25
AA+ / Aa1 6 10 16 24 30 38
AA / Aa2 9 15 24 34 44 55
AA- / Aa3 15 24 30 40 52 64
A+ / A1 24 35 45 60 75 88
A / A2 32 45 58 78 95 112
A- / A3 45 60 75 100 120 142
This table would show, for example, that if a company wants to issue seven year bonds, and the credit rating for the bonds is
expected to be AA-, the company will expect to pay a yield on the bonds that is 52 basis points above the risk-free rate. If the
yield curve shows the risk-free rate on US government bonds (Treasuries’) to be 6.6%, the yield on the company’s bonds will
be 6.6% + 0.52% = 7.12%.
Methods of Calculating WACC
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The WACC is a weighted average of the (after-tax) cost of all the sources of capital for the company. Steps for Calculating
WACC
 Calculate cost of each source of finance. e.g. Ke , Kd
 Calculate market value of each source of finance
• M.v of Equity = × M.v per share
• M.v of Debt = × M.v per bond

• Bank loan market value = book value
 Calculate WACC using this formula:
Source Proportion (in Market Values) X Cost WACC

Equity Proportion of Equity X Ke X%
Debt Proportion of Debt X Kd(net) X%
Preference Share Proportion of Preference X Kp X%
WACC X%
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Capital Asset Pricing Model (CAPM)
Systematic
Risk
Risk
Systematic
Business Risk
Risk
Unsystematic
Financial Risk
Risk
Systematic Risk
From the shareholder perspective, systematic risk is the sum of business risk and financial risk, Systematic risk is the risk that
remains after a shareholder has diversified investments in a portfolio, so that the risk specific to individual companies has
been diversified away and the shareholder is faced with risk relating to the market as a whole. Market risk and diversifiable
risk are therefore other names for systematic risk. From a shareholder perspective, the systematic risk of a company can be
assessed by equity beta of the company. If the company has debt in its capital structure, the systematic risk reflected by the
equity beta will include both business risk and financial risk. If company is financial entirely by equity, the systematic risk
reflected by the equity beta will be business risk alone, in which case the equity beta will be the same as the asset beta.
Business risk arises due to the nature of a company’s business operations, which determines the business sector into which it
is classified, and to the way in which a company conducts its business operations. Business risk is the variability in shareholder
returns that arises as a result of business operations. It can therefore be related to the way in which profit before interest and
tax (PBIT or operating profit) changes as revenue or turnover changes. This can be assessed from a shareholder perspective by
calculating operational gearing, which essentially looks at the relative proportions of fixed operating costs to variable
operating costs. One measure of operational gearing that can be used is (100 ×contribution/ PBIT), although other measures
are also used.
Financial Risk
Financial risk arises due to the use of debt as a source of finance, and hence is related to the capital structure of a company.
Financial risk is the variability in shareholder returns that arises due to the need to pay interest on debt. Financial risk can be
assessed rom a shareholder perspective in two ways. Firstly, balance sheet gearing can be calculated. Secondly, the interest
coverage ratio can be calculated
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Business Risk
Beta
Equity=geared
beta
Relative Financial Risk
systematic
Risk=Beta
Beta Asset=
Business Risk
ungeared beta
However, it is not simply a case that the βasset equals the sum of the βequity and the βdebt. What also need to be taken into
account is the proportions of equity and debt:
βAsset =βequity
Finally, we need to take into account tax relief on interest payments, (as it will affect the financial risk exposure of
shareholders). This now gives rise to a very important equation for the exam:
We assume βDebt is zero.
Where:
βEquity’s known as the equity Beta. It measures the systematic business risk and the systematic financial risk of the company’s
shares. βAsset is known as the asset beta. It measures the systematic business risk only. β Debt is known as the debt beta. It
measures the systematic risk of the company’s debt securities.
Example # 1:
B plc has a gearing ratio (D: E) of 1: 2 and its shares have a beta value (βEquity) of 1.45. The corporation tax rate is 30%, debt is
assumed to be risk free. Calculate beta asset ?
Solution:
Four Implications
This analysis gives rise to four important implications:
A company’s equity beta will always be greater than is asset beta. This is because the equity beta measures both business and
financial risk, while the asset beta measures business risk only.
βe>βa
The one exception to this is where the company is all equity financed, and so only has systematic business risk, and has no
financial risk. In those circumstances its equity beta and its asset beta will be the same. Then β e = β a
Companies in the same area of business, (i.e. they have the same business risk), will have the same asset beta.
Companies in the same area of business will not have the same equity beta, unless they also happen to have the same gearing
ratios. (Means financial risk same).
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IF Company is operating in more than one division

If the company operates on a divisional basis and each division is in a different business area. Then:-
1) Find suitable proxy company for each division and find βa’s of each proxy for each division field.
2) Combine βa of both divisions to calculate weighted average βa.
st nd
Weighted average βa = βa 1 division x % + βa 2 division x %
% proportion will be given in exam according to revenue share, asset share or any other basis
3) Re gear the calculated weighted average βa using company’s own gearing level.
4) Calculate Ke using CAPM
5) Calculate WACC
Example:
ABC is made up of two divisions
Division Asset βeta Proportion of the Business
Food 0.75 40%
Clothes 1.80 60%
The company gearing level is 32%.

Tax =25%
βa= (0.75 x 40%)+(1.80 x 60%)

= 1.38
1.38 = 68 x βe
68+32(1-0.25)
1.38= 68 x βe
92
Βe =1.87
Example:
ABC Ltd is operating in power sector and has a beta of 1.2 • Gearing level is at 40%.
• After tax cost Kd = 6%
• Equity risk premium = 7%
• Rf = 5 %
• Tax rate = 30%
ABC Ltd wants to diversify into cement business.

XYZ co is in Cement business it has a beta of 1.60.It does not pay tax and D/E = 2:3
Calculate WACC of ABC Ltd .After investing in Cement business .(cement will 30% of total business and gearing will remain
same) Solution:
• XYZ co: ungear the beta of proxy co for cement division
βa=βe
βa = 1.60 * 3/3+2+ βa = 0.96
• ABC Ltd: un gear the beat of Abc company for power business
βa = βe
βa = 1.2 *60/60+40(1-0.3)+ βa = o.82
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• Calculate Weighted Average beta Asset of both power and cement business
βa AVg = 0.82 x 70% + 0.96 x 30%
= 0.86
Regear it with current gearing of ABC Ltd.

0.86 = βe *60/60+40(1-0.3)]
Βe = 1.26
• Calculate Ke using CAPM Ke = 5% + 1.26 x 7%
Ke = 13.8%
• WACC = Ke + Kd (after tax)
= 13.8% [60/60+40] +6%[40/60+40]
WACC = 10.7%
Example:
ABC Ltd is operating in power sector and textile sector and has a beta of 1.45.
• Gearing level is at 40%
• Kd after tax = 6%
• Equity risk premium = 7%
• Rf = 5%
• TAX = 30%
It wants to dispose of its power business.

XYZ co is in power business. It has a beta of 1.16.
MV/ share = $3/ share
Shares = 400 m
Debt MV 108 per 100 Book value = $576m
Calculate WACC of ABC Ltd after disposal of power business. (Power business is 40% of total and gearing will remain same.
Solution:
• XYZ Ltd
Ungear beta equity of power proxy XYZ co :
βa = βe
βa = 1.16 *1200/1200+622(1-0.3)+ βa = 0.85
• ABC Ltd the total equity beta of ABC company to calculate total weighted average beta Ungear βa of ABC Ltd βa =
βe
βa = 1.45 *60/60+40(1-0.3)+ βa = 0.99
• Calculate βa of textile
Βa of total business= βa of power x 40% + βa of textile x 60%
0.99 = 0.85 x 40% + βa of textile x 60% βa of textile = 1.08
• Calculate βe by regearing the calculated beta asset of textile division
1.08 = βe
Βe = 1.58
• Calculate Ke by using CAPM
Ke = 5% + 1.58 (7%)
Ke = 16%
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• WACC = Ke + Kd (after tax)

= 16%[60/60+40] +6%[40/60+40]
WACC = 12%
EXAMPLE
A company is planning to invest in a new project that is significantly different from its existing business operations. This
company is financed 30% by debt and 70% by equity. It has located three companies with business operations similar to
the proposed investment, and details of these companies are as follows:
Company A has an equity beta of 0.81 and is financed 25% by debt and 75% by equity.
Company B has an equity beta of 0.98 and is financed 40% by debt and 60% by equity. Company C has an equity beta of
1.16 and is financed 50% by debt and 50% by equity.
Assume that the risk-free rate of return is 4% per year, and that the equity risk premium is 6% per year. Assume also that
all the companies pay tax at a rate of 30% per year. Calculate a project-specific discount rate for the proposed investment.
Solution
Ungearing the proxy equity betas: Asset beta for Company A
Asset beta for Company B =
Asset beta for Company C =

Averaging the asset betas:
Re gearing the average asset beta: 0.669 = βe x 70/(70 + 30(1 – 0.30)) = βe x 0.769. Hence βe = 0.669/0.769 = 0.870
If the re gearing equation were used:
βe = 0.669 x (1 + (1 – 0.30)30/70) = 0.870
Calculating the project-specific discount rate:
E(ri) = Rf + βi (E(rm) – Rf) = 4 + (0.870 x 6) = 4 + 5.22 = 9.2%
Example
Henry Training provides training for companies in the computer and telecommunications sectors. In recent years, Henry
has diversified into the financial services sector. This business nowaccounts for one third of the company’s total revenue.
Jupiter is one of the few competitors in Henry’s line of business. However, Jupiter is only involved in the training business.
Jupiter has an estimated beta of 1·5. The average beta for the financial services sector is 0·9. Average market gearing (debt
to total market value) in the financial services sector is estimated at 25%.
Other summary statistics for both companies for the year ended 31 December 2007 are as follows:
Henry Jupiter
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Gearing (debt to total market value) 30% 12%
The equity risk premium is 3·5% and the rate of return on short-dated government stock is 4·5%. Both companies can raise
debt at 2·5% above the risk free rate.
Tax on corporate profits is 40%.
Required:
Estimate the cost of equity capital and the weighted average cost of capital for Henry Training
WACC and market value

Solution:
Jupiter is a suitable proxy co
Ba = 1.5 x 88 = 1.39
88 + 12(0.6)
Financial sector
Ba = 0.9 x 75 = 0.75
75 + 25(0.6)
Calculate Avg Ba
0.75 x 1/3 + 1.38 x 2/3 = 1.18
Now Regear with the own co gearing
1.18 = Be x 70 = 1.48
70 + 30(0.6)
Now calculate ke by using CAPM
Ke = Rf + Be ( Rm- Rf)
=4.5% + 1.48(3.5%) = 9.7%
Kd=( 4.5% + 2.5% ) x 0.6 = 4.2%
WACC = 9.7 % x 0.7 + 4.2% x 0.3 = 8%
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For a company with constant annual 'cash profits', there is an important connection between WACC and market value.
(Note: 'Cash profits' are cash flows generated from operations, before deducting interest costs.)
If we assume that annual cash profits are a constant amount in perpetuity, the total value of a company, equity plus debt
capital, is calculated as follows:
From this formula, the following conclusions can be made:

 The lower the WACC, the higher the total value of the company will be (equity + debt capital), for any given
amount of annual profits.
 Similarly, the higher the WACC, the lower the total value of the company.
The aim should therefore be to achieve a level of financial gearing that minimizes the WACC, in order to maximize the
value of the company.
CAPITAL STRUCTURE THEORIES
These theories explain the impact on the cost of capital of the company due to change in the capital structure of the company.
It includes the following theories:
 The Traditional View
 Modigliani-Miller (MM) Theory (without tax)
 Modigliani-Miller (MM) Theory (with tax)
The traditional view of gearing and WACC

The traditional view of gearing is that there is an optimum level of gearing for a company. This is the level of gearing at
which the WACC is minimized.
The traditional view of gearing and WACC - Continued

 The traditional View towards cost of capital is that there is an optimal capital structure at which
Optimum gearing % = minimum WACC
The company’s weighted average cost of capital is at its minimum.

 Under the traditional view, the cost of equity increases as the level of gearing increases because of higher financial
risk but the relationship between cost of equity and WACC is non-linear. As a result, WACC decreases initially due
to increased borrowing until it reaches its minimum and then it starts to increase. This lowest point represents the
optimal capital structure at which WACC is at its minimum AND MV is maximum.
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The Modigliani-Miller propositions: ignoring corporate Taxation
Modigliani-Miller stated that, in the absence of tax, a company’s capital structure would have no impact on its WACC.
Assumptions
 A perfect capital market exists.
 Debt is risk-free and freely available at the same cost to investors and companies alike.
 All the assumptions of Traditional View Apply as well. Explanation
 Kd will remain constant at all level of gearing because there is no financial distress cost.
 Ke will increase as gearing level increase because it will increase the financial risk and beta equity
 The cheaper effect of Kd will exactly cancel off the increasing effect of Ke and wacc will remain constant at
every level of gearing.
 As wacc is not changing so there will be no change in market value.
Modigliani and Miller therefore reached the conclusion that the level of gearing is irrelevant for the value of a company.
There is no optimum level of gearing that a company should be trying to achieve.
The Modigliani-Miler view: allowing for corporate taxation
Modigliani-Miller stated that, with tax, a company’s capital structure is maximum debt.
 Assumptions
• A perfect capital market exists.
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• Debt is risk-free and is lower because of tax savings and freely available at the same cost to investors and
companies alike.
Explanation
• Kd(1-T) will remain constant at all level of gearing because there is no financial distress cost.
• Ke will increase as gearing level increase because it will increase the financial risk and beta equity
• The cheaper effect of Kd will dominate the increasing effect of Ke and wacc will be declining at at every level of gearing.
• As wacc is is declining at every level of gearing so market value is increasing with gearing.
• The total value of the company is therefore higher for a geared company than for an identical allequity company/The
value of a company will rise, for a given level of annual cash profits before interest, as its gearing increases.
Modigliani and Miller therefore reached the conclusion that because of tax relief on interest, there is an optimum level of
gearing that a company should be trying to achieve. A company should be trying to make its gearing as high as possible, to the
maximum practicable level, in order to maximize its value.
Modigliani-Miller formulae: allowing for taxation

Cost of equity
The cost of equity in a geared company is higher than the cost of equity in an ungeared company, by a factor equal to:
 The difference between the cost of equity in the ungeared company and the cost of debt, (KEU-KD)
 Multiplied by the ratio
Example: 1
An ABC co is currently in trading business and wants to diversify into new business.
Haizum Co, a listed company is in same business in which abc co wants to diversify Haizum Co’s cost of equity is estimated to
be 14% and it pays tax at 28%. Haizum Co has 15 million shares in issue trading at $2·53 each and $40 million bonds trading at
$94·88 per $100. The five-year government debt yield is currently estimated at 4·5% and the market risk premium at 4%
Abc co has market value of equity of $60 million. It borrows $20 million of debt finance, costing 5%.The rate of taxation on
company profits is 25%.
According to Modigliani and Miller:
(a)Identify the suitable proxy co and ungear its cost of equity
KEU= 10%
b)Regear it with Abc co gearing
KEG=11.25%
Example
Page 95
Mlima Co’s closest competitor is Ziwa Co, a listed company which mines metals worldwide. Mlima Co’s directors are of the
opinion that after listing Mlima Co’s cost of capital should be based on Ziwa Co’s ungeared cost of equity. Ziwa Co’s cost of
capital is estimated at 9·4%, its geared cost of equity is estimated at 16·83% and its pre-tax cost of debt is estimated at
4·76%. These costs are based on a capital structure comprising of 200 million shares, trading at $7 each, and $1,700 million
5% irredeemable bonds, trading at $105 per $100. Both Ziwa Co and Mlima Co pay tax at an annual rate of 25% on their
taxable profits.
Calculate ungear cost of equity of Ziwa co.
Solution:
Ziwa Co
MV Debt= $1700m x 1.05 = $1785 m
MV Equity= $ 200 m x $ 7= $1400 m
Ziwa Co ungeared Ke
Ke(g) =Ke (u) + (1-t)(Ke(u) – Ke(d)) x D/E
16.83% = Ke (u) + 0.75 x (Ke(u) – 4.76%) x 1785/1400
16.83% + 4.55% =1.9563 x Ke (u)
Ke(u) = 10.93% (approx 11%)
Relevance for capital investment appraisal

The Modigliani and Miler formulae can be used to re-calculate the cost of equity and the WACC in a company where the level
of gearing changes, provided there is no change in the overall business risk and the company is therefore similar in all respects
except for its gearing.
When a company plans a new capital investment that will alter its gearing, without affecting its business risk profile, the MM
formulae can be used to calculate the cost of equity and WACC at the new level of gearing. The new WACC can then be used
as the discount rate for calculating the NPV of the proposed project.
Assumptions of WACC
• Existing WACC can only be used as a cost of capital for new investment appraisal project if the following conditions are
met:
• Business risk of the project should be same as the existing business risk of the company and by business risk we mean the
nature of the business or the type of industry should remain same.
• Financial risk of the project should be same as the existing financial risk of the company, where financial risk is the level of
gearing.(gearing should remain same)
• Size of the project should be smaller or comparable to the existing size of the company.
• Required return of investors should remain same.
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Determination of Discount Rate for Appraisal of Project
Undertaking the project will alter the

company's capital structure
NO
Yes
Regardless of Whether the project
have same or different systematic
bussiness risk Use APV method
If new project is in same line of
existing business
NO=project is in a
YES=The project in same area
different area of
ofbussiness
bussiness
Co's existing WACC is

Risk adjusted WACC
suitable
STEPS FOR THE DETERMINATION RISK ADJUSTED WACC

• Find a suitable proxy company having same level of operations.
• Ungear βe to find the asset βeta.
• Re-gear βa to find the project equity βeta. Use either:-
o The company’s existing gearing level or
o The specified gearing level post project
• Use the calculated beta equity , calculate Ke CAPM .
• Find the relevant Kd(1-t)
• Use WACC Formula, project Ke, Kd(1-t) and gearing level stated in (c) i) or ii) above to find the Risk Adjusted WACC-a
nominal cost of capital.:
Example # 1:
SKANS is an education services provider with a debt: equity ratio of 1:3. It wishes to diversify into the professional publications
of ACCA & CA students, using an NPV analysis. The company does not intend to change its capital structure.
Suppose that BPP is a typical professional book publisher. It has an equity beta of 1.25 and a debt: equity ratio of 1: 2. Because
BPP is in the same area of business as the project, it is known as the pure-play company.
If Rf = 6%, Rm = 14% and Tc = 30% - and it is assumed that the debt is risk free.
Required:
Calculate risk adjusted WACC for the project.
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Solution
Stage One - The asset beta of BPP – the pure-play comparison company – is calculated and then used as an estimate of the
asset beta of SKANS publishing project.Using
This asset beta reflects the systematic business risk of publishing books
Stage Two - Having estimated an asset beta for the publishing project, we can now estimate an equity beta for the project; to
reflect both the systematic business risk of professional publication and the systematic financial risk of SKANS capital
structure.
Stage Three: - Using CAPM calculate Ke

Ke Publication Project = Rf + [Rm - Rf] βEquity
Ke Publication Project = 6% + [14% - 6%] X 1.142 = 15.14%
Therefore the cost of equity capital for the project is 15.14%
Stage # Four: - Using the following formula

E E
If a cost of debt capital is needed but no cost of debt is given, we can make use of the fact that the question allows use to
assume the debt beta is zero. In these circumstances;
Kd = R f
And KdAT = Rf X (1 – TC)
Therefore, KdAt = 6 X (1 – 0.30) = 4.2%
Example:
Fruit and Veg plc both grow strawberries and potatoes; by both turnover and profit, 70% of the company’s business is
strawberries and 30% is involved with producing potatoes. The company’s equity beta is 1.64 and its debt: equity ratio is 2:5.
Strawberry plc is a competitor company which specializes in strawberry production. Its equity beta is 1.25 and its debt: equity
ratio is 1:3.
The risk free interest rate is 7% and the market return is 15%. The corporate tax rate is 30%. Corporate debt can be assumed
to be risk free.
Required:
Fruit and Veg plc wish to evaluate a potato investment (which will not change the company’s existing capitals structure) and
so need a suitable discount rate to apply to their NPV analysis.
The approach to be taken here is as follows.

1. The asset beta of Strawberry plc can be Identified
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2. The asset beta of Fruit and Vet plc can also be identified.
5
3. Fruit and Veg’s asset beta measures the systematic business risk of the company. If fact it represents a weighted
average of the risk of both the strawberry business and the potato business, as follows:
βFrunit and Veg Asset =0.70 X βStrawberry Asset + 0.30 βPotato Asset
Therefore, using our knowledge of both Strawberry plc’s asset beta and Fruit and Veg plc’s asset beta, we can identify
the asset beta for potato production.
1.281=(0.70 X 1.013) + (0.30 X βPotato Asset) And so:
4. This is effectively the end of Stage One of the risk-adjusted WACC analysis, and the remainder of analysis follow as
normal:
5. Stage Two:
1.
Stage Three:
Ke Potato = 7% + *15% − 7%+ − 2.441 = 26.5%
Stage Four:
Therefore, 20.3% would be an appropriate NPV discount rate for Fruit and Veg plc to use in order to evaluate potato
projects.
Example
Louis Co’s non-current liabilities consist entirely of $100 nominal value bonds which are redeemable in four years at the
nominal value, on which the company pays a coupon of 5·4%. The debt is rated at B+ and the credit spread on B+ rated debt is
80 basis points above the risk-free rate of return.
Book value of debt is $340 million and market value of equity is $979 million
Proposed luxury transport investment project by Louis Co
Louis Co wants to invest in luxury transport business.
Although there is no beta for companies offering luxury forms of travel in the tourist industry, Reka Co, a listed company,
offers passenger transportation services on coaches, trains and luxury vehicles. About 15% of its business is in the luxury
transport market and Reka Co’s equity beta is 1·6. It is estimated that the asset beta of the non-luxury transport industry is
0·80. Reka Co’s shares are currently trading at $4·50 per share and its debt is currently trading at $105 per $100. It has 80
million shares in issue and the book value of its debt is $340 million. The debt beta is estimated to be zero.
General information
Page 99
The corporation tax rate applicable to all companies is 20%. The risk-free rate is estimated to be 4% and the market risk
premium is estimated to be 6%
Calculate Project specific discount rate of Luxury transport for Louis co?
Solution
Use RekaCo’s information to estimate the component project’s asset beta. Then based on Louis Co’s capital structure,
estimate the component project’s equity beta and weighted average cost of capital. Assume that the beta of debt is zero.
Reka Co MVe = $4.50 x 80m shares = $360m

Reka Co MVd = $105/100 x 340 = $357m
Reka Co portfolio asset beta =
βa = βe x E
E + D ( 1-T)
βa = 1.6 x 360/ 360 + 357 ( 1 – 0.2 )
βa = 0.892
βa of non luxury transport = 0.80
Calculate βa of luxury transport
0.892= luxury transport asset beta x 0•15 + 0.80 x 0•85

luxury transport asset beta = [0.892 – (0.80 x 0•85)+/0•15 = 1•413
ADJUSTED PRESENT VALUE
The APV method shows how the NPV of a project can be increased or decreased by project financing effects.
When to Use Adjusted Present Value (APVs):
Business Risk
Unchanged Change
Financial Risk Unchanged Existing WACC Risk Adjusted WACC

Change APV APV
** When financial risk changes due to new project, always use APV The APV method described as a 'DIVIDE AND CONQUER'
approach.
Broadly speaking, APV consist of two different decisions which are as follows:
Conditions:
• Same or different Business Risk
• Different Financial Risk
Adjusted Present Value = Base Case NPV + Present Value of tax shield
Page 100
Base case NPV

The base case NPV is calculated assuming the project is financed entirely by equity, so that the method of financing is ignored.
It is therefore necessary to calculate the cost of equity in an all-equity company in the same industry or the market in which
the capital investment will be made. Calculate Cost of Equity (Ungeared)Rf+ Asset Beta (Rm- Rf)
Present value of the tax shield (PV of the tax relief on interest costs)
When a new project is financed wholly or partly with new debt finance, there will be tax relief on the interest. The PV of these
tax benefits should be included in the APV of the project.
The PV of the tax relief on interest is calculated by:

- Calculating the interest costs in each year
- Calculating the savings in taxation arising as a consequence, for each year of the project
- Discounting these savings in taxation to a present value, using the pre-tax (before-tax) rate of interest on the debt as the
discount rate.
It is also important to include post tax cost or savings resulting in using debt. These are generally issue cost on debt and
government subsidy
The decision rule for the APV method

If, Adjust Present Value is positive = Accept the project
If, Adjust Present Value is Negative = Reject the project
Performa of Adjusted Present Value (APV):

Investment Decision
Base Case NPV
XXX
Financing Decisions
Present value of issue cost
Debt (x)
Present value of Tax Shield
Simple X
Subsidized Loan X
Present value of interest savings on subsidized loan X
Present value of tax loss on interest savings X
Present value of tax savings due to Debt capacity X
Adjusted Present Value XXXX
Present value of Issuance cost:

Issue costs might be an allowable expense for the tax purposes.
When they are tax- allowable, the PV of issue costs must allow for the reduction in tax payments that will occur. The PV of the
issue costs is therefore net of the present value of any tax relief on the costs. As always calculation involving debt must take
account of the tax effects. Normally, situation is as follows:
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Issuance Cost
Equity Issue Debt issue

cost cost
Not tax allowable Tax allowable

expense expense
Issuance Cost xxx
Tax Relief on issuance cost (Tax rate x Issue cost) xxx

Present Value of Tax Relief (Tax relief x discount factor)( if tax one year arrear) xxx
PV of the Issue cost xxx
Present value of Tax Shield on interest payment:
The Present value of the tax relief on interest payment is also known as the present value of the tax shield.
The method adopted depends on the information given:

Debentures:
Tax savings on Interest payments
(Gross loan x interest rate x Tax rate) XXX
Annuity {Simple or deferred (if one year in delay)} XXX
Present value of TAX shield XXXX
EXAMPLE:
A company is considering a project that would cost $100,000 and it will be financed 60% by equity and 40% by debt (pre-tax
cost 4%). Tax is at 30%. Issuance cost of equity is 4% and issuance cost of debt is 2 %. Debt is raised for 5 years
Issuance Cost
Funds required: $100,000
Equity Required: $60,000
Debt Required: $40,000
Equity Raised: 60,000/96% = 62,500
Equity Issuance Cost=62,500-60,000= 2,500

Debt Raised = 40,000/98%= 40,816
Debt issuance cost = 40,816-40,000= 816

Tax savings @ 30% = (245)
Net Debt issuance cost = 571
P.V of tax shield

P.V of tax savings on interest payment.
Gross loan × interest rate × Tax rate =
40816 x 4% x 30% 490
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Annuity factor @ before tax KD = 4.452

P.V of tax shield =
Amortizing loan:
The repayment will be made up of both interest and capital
Step 1: Find the amount of the repayment
Annual amount = Amount of the loan / Annuity Factor
Step 2: Calculate the annual interest charge using amortizing table
Subsidized or cheap loan:
First step is same to calculate tax shield on interest payment.
1) Tax savings on Interest payments

(Gross loan x interest rate x Tax rate) XXX
Annuity {Simple or deferred (if one year in delay)} XXX
Present value of TAX shield XXXX
2) P.V of Interest savings on subsidized loan.

Gross subsidized loan × interest rate saving XXX
Annuity factor @ (decided above) = XP.V of interest savings shield = XXX
3) P.V of tax loss on Interest savings.

Gross subsidized loan × interest rate saving × tax rate = XXX
Annuity factor @ (decided above) =X
P.V of tax loss = XXX
Note: step 2 and 3 will be solved separately, if tax is payable in arrears but if tax is payable in the same year then use this
single step.
P.V of after tax Interest savings on subsidized loan.

Gross subsidized loan × interest rate saving (1-T) = XXX
Annuity factor @ (decided above) =X
P.V of after tax interest savings shield = XXX
EXAMPLE: 2 (iftax is payable in the same year)

A company is considering a project that would cost $100,000 and it will be financed 60% by subsidized debt (interest cost 4%)
and 40% by normal debt (pre-tax cost 7%). Tax is at 30%. Normal loan issuance cost of debt is 2 %.Debt is raised for 5 years. It
is assumed in this example only that there is no issuance cost on subsidized debt. Risk free rate is 5%.
Issuance Cost
Subsidized debt required: $60,000
Normal Debt Required: $40,000
Subsidized debt Raised = 60,000
Normal Debt Raised = 40,000/98%= 40,816
Debt issuance cost = 816
Tax savings @ 30% = (245)
Net Debt issuance Cost = 571
Tax Shield
Normal Loan
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40,816 × 7% × 30% = $ 857

Annuity factor @ 5 % = 4.329
Present Value of Tax shield $3710
Subsidized loan
60,000 × 4% × 30% = $720
Annuity factor @ 5 % = 4.329
Present Value of Tax shield 3117
P.V of after tax Interest savings on subsidized loan.

60,000 × 3% x ( 1-0.30 ) = 1260
Annuity factor @ 5% = 4.329
P.V of interest savings = 5455
EXAMPLE: 2 Continued
When Tax is payable in arrears
Issuance Cost
Subsidized debt required: $60,000
Normal Debt Required: $40,000
Subsidized debt Raised = 60,000
Normal Debt Raised = 40,000/98%= 40,816
Debt issuance cost = 816
Tax savings @ 30% x 1.05^-1 = (233)
Net Debt issuance Cost = 583
Tax Shield
Normal Loan
40,816 × 7% × 30% = $ 857
Annuity factor @ 5 % x 1.05^-1 =4.12
Present Value of Tax shield $3533
Subsidized loan
60,000 × 4% × 30% = $720
Annuity factor @ 5 % x 1.05^-1 =4.12
Present Value of Tax shield 2966
P.V of Interest savings on subsidized loan.

60,000 × 3% = 1800
Annuity factor @ 5% = 4.329
P.V of interest savings = 7792
P.V of tax loss on Interest savings.

60,000 × 3% × 30% = 540
Normal Annuity factor × Discount factor of 1st year = 4.123
P.V of tax loss = 2226
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Debt Capacity:
Debt finances a project because of the associated tax shield. If a project brings about an increase in the borrowing capacity of
the firm, it will increase the potential tax shield available.
Note
An Exam trick is to give both the amount of debt actually raised and the increase in debt capacity brought by the project. It is
the theoretical debt capacity which the tax shield should be based.
In simple words, tax shield will be calculated on total amount of debt capacity of the company. No matter how much company
actually used the amount of debt from that debt capacity.
For example, if a question told that actual debt rose is $200,000 but you are also told in the question that the investment is
believed to add $500,000 to the company's debt capacity. Then present value of tax shield will be calculated on the $500,000
(this is theoretical amount).
DEBT CAPACITY
For example in previous example because of new project debt capacity rises to $ 120,000.
Answers:
Deb capacity = $120,000
Debt Raised = $ 100,000
Unutilized capacity = $ 20,000
Why we use APV method?

Conceptually, the APV is relatively easy to understand. The method separates the investment decision from the financing
decision by breaking the traditional DF into two parts. The first part (the investment decision) discounts cash flows at an
equity rate of return/ cost of equity (Key) to calculate base case npv. The second part (the financing decision) discounts the
interest tax shield to the present value at a rate of return that reflect the risk in actually achieving these tax benefits. The two
parts are then summed to derive the value of the entire enterprise.
The traditional discounted cash flow method where in debt free cash flows are discounted to the present at the WACC may
not be appropriate in every circumstance. The WACC assumes a static debt to equity ratio presumably at an optimal capital
structure.
However, many companies do not expect to have static level of debt to equity, particularly in situations involving highly
leveraged transactions. Under these types of situations, the Adjusted Present Value Method may be a better method. The APV
separates the value of operations from value created or destroyed by how the company is financed. The APV maybe a better
tool to analyze the value of entities with unique financing. As such, the APV can also be used as a management tool to break
out the value created from specific managerial decisions.
The APV is based upon a principle of value addition that analysts can use with valuations.
Difference of WACC & APV Approach

The APV method is a powerful tool. APV’s approach is to analyze financial maneuvers separately and then at their value to
that of the business. WACC approach is to adjust the discount rate to reflect the financial enhancement.
Analysts apply the adjusted discount rate directly to the business cash flows. WACC is supposed to handle financial side effects
automatically, without requiring any addition after the fact.
APV is used instead of NPV for appraising the project. When the capital structure and the financial risk of the new project are
different from the existing structure of the company.
The benefit of APV is that it breaks the problem down into the value of project itself (if equity financed) and the value of
financing (whereas as the effect of financing is taken account of and the WACC when calculating regular NPV). This makes APV
flexible enough to cover many different types of real world financing arrangements such as
Page 105
• Change in gearing level over the project life

• Issuance cost of equity and debt properly
• The proper impact of subsidized loan
Using debt for financing has the tax advantage and interest payment is deductible. This tax deduction has a source of value for
the firm. In the normal NPV calculation, this additional value is accounted for in the WACC.
Unlike APV, the normal assumption in NPV is that all cash flows are financed using the same WACC and remain constant each
year. Therefore, when dealing with changing financial risk and more complicated financial situation, APV is preferable
appraisal method over NPV.
Bond Valuation
Example
How much would an investor pay to purchase a bond today, which is redeemable in four years for its par value or face value of
$100 and pays an annual coupon of 5% on the par value? The required rate of return (or yield) for a bond in this risk class is
4%.
As with any asset valuation, the investor would be willing to pay, at the most, the present value of the future income stream
discounted at the required rate of return (or yield). Thus, the value of the bond can be determined as follows:
If the required rate of return (or yield) was 6%, then using the same calculation method, the price of the bond would be
$96.53. And where the required rate of return (or yield) is equal to the coupon – 5% in this case – the current price of the
bond will be equal to the par value of $100.
Thus, there is an inverse relationship between the yield of a bond and its price or value. The higher rate of return (or yield)
required, the lower the price of the bond, and vice versa. However, it should be noted that this relationship is not linear, but
convex to the origin.
Yield to maturity (YTM) (also known as the [Gross] Redemption Yield (GRY)) If the current price of a bond is given, together
with details of coupons and redemption date, then this information can be used to compute the required rate of return or
yield to maturity of the bond.
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Example 2
A bond paying a coupon of 7% is redeemable in five years at par ($100) and is currently trading at $106.62. Estimate its yield
(required rate of return).
Years Cash flows 5% PV 6%

0 (106.62) 1 (106.62) 1 (106.62)
1-5 7 4.329 30.31 4.2124 29.49
5 100 0.7835 78.35 0.7473 74.73
2.04 (2.4)
Yield = 5% + (2.04 / 2.04 + 2.4) x 1% = 5.46%
5.46% is the yield to maturity (YTM) (or redemption yield) of the bond. The YTM is the rate of return at which the sum of the
present values of all future income streams of the bond (interest coupons and redemption amount) is equal to the current
bond price. It is the average annual rate of return the bond investors expect to receive from the bond till its redemption.
Term structure of interest rates and the yield curve

The yield to maturity is calculated implicitly based on the current market price, the term to maturity of the bond and amount
(and frequency) of coupon payments. However, if a corporate bond is being issued for the first time, its price and/or coupon
payments need to be determined based on the required yield. The required yield is based on the term structure of interest
rates and this needs to be discussed before considering how the price of a bond may be determined.
It is incorrect to assume that bonds of the same risk class, which are redeemed on different dates, would have the same
required rate of return or yield. In fact, it is evident that the markets demand different annual returns or yields on bonds with
differing lengths of time before their redemption (or maturity), even where the bonds are of the same risk class. This is known
as the term structure of interest rates and is represented by the spot yield curve or simply the yield curve.
For example, a company may find that if it wants to issue a one - year bond, it may need to pay interest at 3% for the year, if it
wants to issue a two - year bond, the markets may demand an annual interest rate of 3. 5%, and for a three-year bond the
annual yield required may be 4.2%. Hence, the company would need to pay interest at 3% for one year; 3.5% each year, for
two years, if it wants to borrow funds for two years; and 4.2% each year, for three years, if it wants to borrow funds for three
years. In this case, the term structure of interest rates is represented by an upward sloping yield curve.
The normal expectation would be of an upward sloping yield curve on the basis that bonds with a longer period of maturity
would require a higher interest rate as compensation for risk. Note here that the bonds considered may be of the same risk
class but the longer time period to maturity still adds to higher uncertainty.
Valuing bonds based on the yield curve

Annual spot yield curves are often published by the financial press or by central banks (for example, the Bank of England
regularly publishes UK government bond yield curves on its website). The spot yield curve can be used to estimate the price or
value of a bond.
Example 3
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.
The annual spot yield curve for a bond of this risk class is as follows:
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One-year 3.5%
Two-year 4.0%
Three-year 4.7%
Four-year 5.5%
The four-year bond pays the following stream of income:
Year 1 2 3 4
Payments $5 $5 $5 $105
This can be simplified into four separate bonds with the following payment structure:
Year 1 2 3 4
Bond 1 $5
Bond 2 $5
Bond 3 $5
Bond 4 $105
Each annual payment is a single payment in that particular year, much like a zero-coupon bond, and its present value can be
determined by discounting each cash flow by the relevant yield curve rate, as follows:
The sum of these flows is the price at which the bond can be issued, $98.57.
The yield to maturity of the bond is estimated at 5.41% using the same methodology as example 2.
Some important points can be noted from the above calculation; firstly, the 5.41% is lower than 5.5% because some of the ret
urns from the bond come in earlier years, when the interest rates on the yield curve are lower, but the largest proportion
comes in Year 4. Secondly, the yield to maturity is a weighted average of the term structure of interest rates. Thirdly, the yield
to maturity is calculated after the price of the bond has been calculated or observed in the markets, but theoretically it is term
structure of interest rates that determines the price or value of the bond. Mathematically:
How to calculate spot yield

There are different methods used to estimate a spot yield curve, and the iterative process based on bootstrapping coupon
paying bonds is perhaps the simplest to understand. The following example demonstrates how the process works.
Example 4
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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 a t $102. Bond C,
which is redeemable in three years, has a coupon rate of 5% and is trading at $98.
To determine the yield curve, each bond’s cash flows are discounted in turn to determine the annual spot rates for the three
years, as follows:
The annual spot yield curve is therefore:
Year
1 88%
2 4.96%
3 5.80%
Exam Level examples
A company wants to issue AA rated 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.
One-year 3.5%
Two-year 4.0%
Three-year 4.7% Four-year 5.5%

Rating Year 1 Year 2 Year 3 Year 4
AAA 14 25 38 52
AA 29 41 55 70
A 46 60 76 90
BBB 61 75 91 105
Answer:
Years 1 2 3 4
Cash flows 5 5 5 105
Discount =1.0379^-1 =1.0441^-2 =1.0525^-3 =1.062^-4
factors
4.82 4.59 4.29 82.55
MV 96.25
Example:
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A company wants to issue AA rated bond that is redeemable in four years for its par value or face value of $100, and wants to
issue bond at par value. Estimate the coupon at which the bond will be fully subscribed.
One-
year 3.5%
Two- 4.0%
year
Three- 4.7%
year
Four- 5.5%
year
Rating Year Year Year Year

1 2 3 4
AAA 14 25 38 52
AA 29 41 55 70
A 46 60 76 90
BBB 61 75 91 105
Answer:
Years 0 1 2 3 4 4
Cash flows (100) X X X X 100
Discount =1.0379^-1 =1.0441^-2 =1.0525^-3 =1.062^-4 =1.062^-4
factors
1 0.9635X 0.9173X 0.8577X 0.7861X 78.61
100=0.9635X+0.9173X+0.8577X+0.7861X+78.61
100-78.61=3.5264X
X=6.07=6.07 %
Example
The directors are considering the following two alternative options when issuing the new bond:
(i) Issue the new bond at a fixed coupon of 5% but at a premium or discount, whichever is appropriate to ensure full
take up of the bond; or
(ii) Issue the new bond at a coupon rate where the issue price of the new bond will be $100 per unit and equal to its
par value.
The following extracts are provided on the current government bond yield curve and yield spreads for the sector in which
Cooperates: Current Government Bond yield curve
Years 1 2 3 4 5
3·2% 3·7% 4·2% 4·8% 5·0%
Bond Yield Spread
Bond Rating 1 year 2 years 3 years 4 years 5 years

AAA 5 9 14 19 25
AA 16 22 30 40 47
A 65 76 87 100 112
BBB 102 121 142 167 193
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Calculate Market value of the first option and identify it is issued on discount or premium
Calculate Coupon of second option.
Solution:
(i) Value of 5% coupon bond
$5 x 1•0385^–1 + $5 x 1•0446^–2 + $5 x 1•0507^–3 + $5 x 1•0580^–4 + $105 x 1•0612^–5 = $95•72

Hence the bond will need to be issued at a discount if only a 5% coupon is offered.
(ii) New coupon rate for bond valued at $100 by the markets
Since the 5% coupon bond is only valued at $95•72, a higher coupon needs to be offered. This coupon amount can be
calculated by finding the yield to maturity of the 5% coupon bond discounted at the above yield curve. This yield to maturity
will be the coupon amount for the new bond such that its face value will be $100.
Therefore, if the yield to maturity is denoted by YTM then

$5 x (1 + YTM)^–1 + $5 x (1 + YTM)^–2 + $5 x (1 + YTM)^–3 + $5 x (1 + YTM)^–4 + $105 x (1 + YTM)^–5 = $95•72
Solve by trial and error, assume YTM is 5•5%. This gives the bond value as $97•86.
Assume YTM is 6%; this gives the bond value as $95•78, which is close enough to $95•72
$5 x (1•06)^–1 + $5 x (1•06)^–2 + $5 x (1•06)^–3 + $5 x (1•06)^–4 + $105 x (1•06)^–5 = $95•78
Hence if the coupon payment is 6% or $6 per $100 bond unit then the bond market value will equal the par value at $100.
$6 x (1•06)^–1 + $6 x (1•06)^–2 + $6 x (1•06)^–3 + $6 x (1•06)^–4 + $106 x (1•06)^–5 = $100
Alternatively:
Take R as the coupon rate, such that:
(R x 1•0385^–1) + (R x 1•0446^–2) + (R x 1•0507^–3) + (R x 1•0580^–4) + (R x 1•0612^–5) + (100 x 1•0612^–5) = $100
4•2826R + 74•30 = $100

R = 6% or $6 per $100
Advice:
If only a 5% coupon is offered, the bonds will have to be issued at just under a 4•3% discount. To raise the full $150 million, if
the bonds are issued at a 4•3% discount, then 1,567,398 $100 bond units need to be issued, as opposed to 1,500,000. This is
an extra 67,398 bond units for which Co will need to pay an extra $6,739,800 when the bonds are redeemed in five years.
On the other hand, paying a higher coupon every year of 6% instead of 5% will mean that an extra $1,500,000 is needed for
each of the next five years.
If the directors feel that the drain in resources of $1,500,000 every year is substantial and that the project’s profits will cover
the extra $6,739,800 in five years’ time, then they should issue the bond at a discount and at a lower coupon rate.
On the other hand, if the directors feel that they would like to spread the amount payable then they should opt for the higher
coupon alternative
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INTERNATIONAL INVESTMENT APPRAISAL
There are four adjustments in international investment appraisal.

1. Exchange Rate prediction:
EXAMPLE:
The Current Dollar Sterling exchange rate is given $/£ 1.7050 Expected Inflation Rates are:
Year USA UK
1 5% 2%
2 3% 4%
3 4% 4%
Find the expected spot rate for next three years.
SOLUTION:
Year Calculation Future Expected Spot
Year 1 1.7050 x (1.05/1.02) 1.7551
Year 2 1.7551 x (1.03/1.04) 1.7382
Year 3 1.7382 x (1.04/1.04) 1.7382
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2. Taxation
 The level of taxation on a project’s profits will depend on the relationship between the tax rates in the home
and overseas country.
 The question will always assume a double-tax treaty project always taxed at higher rate.
EXAMPLE:
What will be the rate of tax on a project carried out in the US by a UK company in each of the following
scenarios?
Scenarios UK TAX US TAX

A 33% < 40%
B 33% = 33%
C 33% > 25%
Scenario A – No further UK tax to pay on the project’s $ profits. Profits taxed at 40% in US.
Scenario B – No further UK tax to pay on the project’s $ profits. Profits taxed at 33% in US.
Scenario C – Project’s profits would be taxed at 33%. 25% in US and further 8% tax payable in the
UK.
3. Inter-Company Cash flows

Inter-company cash flows, such as transfer prices (intercompany transactions), royalties and management charges,
can also affect the tax computations.
Example: A project carried out by a US subsidiary of a UK company is due to earn revenues of $100m in the US in
Year 2 with associated costs of $30m. Royalty payments of $10m will be made by US subsidiary to UK. Assume tax
is paid at 25% in the US and 33%; and assume a forecast $/£ spot rate of $1.50/£.
What are the cash flows associated with the project?
Year 2 $m
Revenues 100
Costs (30)
Royalties (10)
Pre-Tax profit 60
25% US Tax (15)
Remit to Parent 45*
£ Cash Flow 30 - *45/1.50
Royalties 6.7 $10m/1.50
UK Tax (5.4)**
After Tax Cash flow £31.3m
4. Remittance
Remittance occurs where an overseas government places a limit on the funds the can repatriated back to the holding
company.
This restriction will change the cash flows that are received by the holding company.
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Example:
A project’s after US-tax $ cash flow is as follows ($m):
YEAR 0 1 2 3
(10) 3 4 6
In any one year, only 50% of cash flows generated can be remitted back to the parent. The blocked funds can be
released back to parent in the year after the end of project Q. Identify the cash flows to be evaluated?
YEAR 1 2 3 4
Net Cash Flow 3 4 6

Blocked Funds (1.5) (2) (3)
Remit to Parent (Final Cash flows) 1.5 2 3 6.5
INTERNATIONAL INVESTMENT APPRAISALPROFORMA:
Year 0 1 2 3 4 5
FC FC FC FC FC FC
Sales/receipts x x x X
payments:
Variable costs (x) (x) (x) (x)
Wages/materials (x) (x) (x) (x)
Incremental fixed (x) (x) (x) (x)
Costs
Untaxed royalties / (x) (x) (x) (x)
mgt charges etc
Tax allowable depreciation (x) (x) (x) (x)
Taxable profits x x x X
Foreign tax @ say (x) (x) (x) (x)
20%
Add: Tax allowable x x x X
Depreciation
Initial outlay (x)
Realizable value X
Working capital (x) (x) (x) (x) (x) x
Net foreign CF (x) x x x X x
0 1 2 3 4 5
FC FC FC FC FC FC
Exchange rate x x x x X x
(based on PPPT)
Home currency CF (x) x x x X x
Domestic tax on (x) (x) (x) (x)
foreign taxable
profits @30% -
20% = 10%
Untaxed royalties / x x x X
mgt charges etc
Domestic tax on (x) (x) (x) (x)
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royalties etc. @30%

x x x x x
Net home (x)
currency CF
DF (say 16%) 1 0.862 0.743 0.641 0.552 0.476
Home currency (x) x x x x x
PV
Home currency NPV
INTERNATIONAL APV
INVESTMENT SIDE
• Same Performa as in Investment Appraisal
• Discount with Un-gear cost of equity.
Parent Co home currency cash flows

• Additional Tax
• Incremental contribution or royalty income
• Contribution Loss
• Discount with parent co Cost of capital
Financing Side
• Issuance Cost of Equity and Debt
• Present Value of Tax saving on Interest
• Subsidized Loan
• Debt Capacity
First convert each year data into parent company currency using exchange rates then discount with before Tax Kd or Rf of
parent company.
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SYLLABUS C: MERGERS AND ACQUISITIONS

Learning objectives
 Discuss the arguments for and against the use of acquisitions and mergers as a method of corporate
expansion.
 Evaluate the corporate and competitive nature of a given acquisition proposal.
 Advise upon the criteria for choosing an appropriate target for acquisition.
 Compare the various explanations for the high failure rate of acquisitions in enhancing shareholder
value.
 Evaluate, from a given context, the potential for synergy separately classified as:
i)Revenue synergy ii) Cost synergy iii) Financial synergy.
 Evaluate the use of the reverse takeover as a method of acquisition and as a way of obtaining a stock
market listing
 Discuss the problem of overvaluation.
 Estimate the potential near-term and continuing growth levels of a corporation’s earnings using both
internal and external measures.
 Discuss, assess and advise on the value created from an acquisition or merger of both quoted and
unquoted entities using models such as: i) ’Book value-plus’ models ii) Market based models iii) Cash
flow models, including free cash flows. Taking into account the changes in the risk profile and risk
exposure of the acquirer and the target entities
 Apply appropriate methods, such as: risk-adjusted cost of capital, adjusted net present values and
changing price-earnings multipliers resulting from the acquisition or merger, to the valuation process
where appropriate.
 Demonstrate an understanding of the procedure for valuing high growth start-ups.
 Demonstrate an understanding of the principal factors influencing the development of the regulatory
framework for mergers and acquisitions globally and, in particular, be able to compare and contrast
the shareholder versus the stakeholder models of regulation.
 Identify the main regulatory issues which are likely to arise in the context of a given offer and i) assess
whether the offer is likely to be in the shareholders’ best interests ii) advise the directors of a target
entity on the most appropriate defence if a specific offer is to be treated as hostile.
 Compare the various sources of financing available for a proposed cash-based acquisition.
 Evaluate the advantages and disadvantages of a financial offer for a given acquisition proposal using
pure or mixed mode financing and recommend the most appropriate offer to be made.
 Assess the impact of a given financial offer on the reported financial position and performance of the
acquirer
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Merger and Acquisitions (Introduction)
Mergers
A merger is in essence the pooling of interests by two business entities which results in common Ownership.
Acquisitions
An acquisition normally involves a larger company (a predator) acquiring smaller company (a target).
• Generally both referred to as mergers for PR reasons:
i. It portrays a better message to the customers of the target company.
ii. To appease the employees of the target company.
• An alternative approach is that a company may simply purchase the assets of another company rather than
acquiring its business, goodwill,
Types of merger
There are 3 main types of mergers
1. Horizontal integration.
2. Vertical integration.
3. Conglomerate integration.
1. Horizontal integration
When two companies in the same industry, whose operations are very closely related& are combined, integrate .This
is known as horizontal integration/merger.
Main Benefits of horizontal integration includes economies of scale, increased market power& improved product
mix.
Disadvantages of such type of integration are that it can be referred to relevant competition authorities.
2. Vertical integration
When two companies in the same industry, but from different stages of the production chain are merged. This is
known as vertical integration.
For example
1. A company combines with its supplier
2. Major players in the oil industry tend to be highly vertically integrated.
Main benefits of such type of integration include increased certainty of supply or demand and just-intime inventory
systems leading to major savings in inventory holding costs.
3. Conglomerate integration
When two or more companies which are completely unrelated businesses combine/merged & there is no common
thread, such type of merger is known as conglomerate. The main synergy lies with the management skills and brand
name.
Main benefits of conglomerate integration are 1) risk reduction through diversification, 2) cost reduction
(management) &3) improved revenues (brand).
Growth Strategies
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The companies can grow in 2 ways i.e. either organically or by acquisition/merger. Whatever will be the growth strategy,
assuming a standard profit maximizing company, the primary purpose of any growth strategy should be to increase
shareholder wealth?
Comparison of Organic growth & growth by acquisition
1. Organic Growth
Organic growth is internally generated growth within the firm.
No external growth should be considered unless the organic alternative has been dismissed as inferior.
Advantages of organic growth

• Organic growth allows planning of strategic growth in line with stated objectives of company.
• It is less risky because it is done over time i.e. more understanding of business
• The Cost in organic growth is lower
• Organic Growth Avoids problems of integrating new acquired companies i.e. the integration process is often a
difficult process due to cultural differences between the two companies.
• By organic Growth, an immediate pressure on current management resources to learn to manage the new business
will be avoided
Disadvantages of organic growth

• It requires time to enter a new product or geographical market.
• It increases the risk of over-supply and excessive competition.
• It increased the competition as more competitor are in market.
• Organic growth Might result in low market power as compared to acquisition strategy &by increased market power
companies are able to exercise some control over the price of the product, e.g. monopoly or by collusion with other
producers.
• Organic growth may give lesser competitive edge as compared to acquisition i.e. Acquisition results in the
Acquisition of the target company's staff & highly trained staff may give a competitive edge
2. Growth by Acquisition
It is the growth achieved by merger/acquisition of Target Company.
Advantages of growth by acquisition

• It is the quickest way to enter a new product or geographical market.
• It reduces the risk of over-supply and excessive competition.
• Acquisition results in decrease competition as fewer competitors are available in market.
• Acquisition results in Increase market power& by increased market power companies are able to exercise some
control over the price of the product, e.g. monopoly or by collusion with other producers.
• Acquisition results in the Acquisition of the target company's staff & highly trained staff may give a competitive edge
Disadvantages of growth by acquisition

As compared to Organic growth, growth by acquisition does not allow the planning of strategic growth in line with stated
objectives.
It is more risky than organic growth because it is not done over time & might have lesser understanding of business of
Target Company
The cost is often much higher in an acquisition due to significant acquisition premiums.
It increases the problems of integrating new acquired companies i.e. the integration process is often a difficult process
due to cultural differences between the two companies.
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An acquisition places an immediate pressure on current management resources to learn to manage the new business.
Reasons for Acquisition:

• Synergy is a key reason given for growth by acquisitions
• Entry to new markets and industries.
• To acquire the target company's staff and know-how.
• Managerial motives /Arrogance factor/Hubris hypothesis.
• Diversification.
• A defense mechanism to prevent being taken over.
• A means of improving liquidity.
• Improved ability to raise finance.
• A reduction of risk by acquiring substantial assets (if the predator has a high earnings to net asset ratio and is in a
risky business).
• To obtain a growth company (especially if the predator's growth is declining).
Synergies
The existence of synergies increases shareholder`s value in an acquisition growth strategy. TYPES OF SYNERGIES
1. Revenue Synergy
Revenue synergy exists when the acquisition of the target company will result in higher revenues for the acquiring company,
higher return on equity or a longer period of growth. Revenue synergies arise from:
• Increased market power
• Marketing synergies
• Strategic synergies
Revenue synergies are more difficult to quantify relative to financial and cost synergies.
When companies merge, cost synergies are relatively easy to assess pre-deal and to implement post-deal. But revenue
synergies are more difficult. It is hard to be sure how customers will react to the new market/product(In financial services
mergers, massive customer defection is quite common)& whether customers will actually buy the new products & how it react
to new expanded total systems capabilities.
2. Cost Synergy
A cost synergy results primarily from the existence of economies of scale. As the level of operation increases, the marginal
cost falls and this will be manifested in greater operating margins for the combined entity. The resulting costs from
economies of scale are normally estimated to be substantial.
3. Financial Synergy
Sources of Financial Synergy

There are many factors which results in financial synergy. These include:
 Diversification
▪ Diversification is the process of acquiring another firm/co. as a way of reducing risk. It cannot create wealth
for two publicly traded firms, with diversified stockholders, but it could create wealth for private firms or
closely held publicly traded firms. A takeover, motivated only by diversification considerations, has no effect
on the combined value of the two firms involved in the takeover. The value of the combined firms will always
be the sum of the values of the independent firms.
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▪ In the case of private firms or closely held firms, where the owners may not be diversified personally, there
might be a potential value gain from diversification.
 Cash Slack
▪ When a firm with significant excess cash acquires a firm, with great projects but insufficient capital, the
combination can create value. Managers may reject profitable investment opportunities to take over a cash-
poor firm with good investment opportunities, or vice versa. The additional value of combining these two
firms lies in the present value of the projects that would not have been taken if they had stayed apart, but
can now be taken because of the availability of cash.
 Tax Benefits
▪ The tax paid by two firms combined together may be lower than the taxes paid by them as individual firms. If
one of the firms has tax deductions that it cannot use because it is losing money, while the other firm has
income on which it pays significant taxes, the combining of the two firms can lead to tax benefits that can be
shared by the two firms. The value of this synergy is the present value of the tax savings that accrue because
of this merger. The assets of the firm being taken over can be written up to reflect new market value, in some
forms of mergers, leading to higher tax savings from depreciation in future years.
 Debt Capacity:
▪ By combining the two firms, each of which has little or no capacity to carry debt, it is possible to create a firm
that may have the capacity to borrow money and create value. Diversification will lead to an increase in debt
capacity and an increase in the value of the firm, has to be weighed against the immediate transfer of wealth
that occurs to existing bondholders in both firms from
▪ The stockholders. When two firms in different businesses merge, the combined firm will have less variable
earnings, and may be able to borrow more (have a higher debt ratio) than the individual firms.
Reverse Takeovers (RTO)
An RTO involves a smaller quoted company taking over a larger unquoted company by a share-for-share exchange. In order to
acquire the larger unquoted company, a large number of shares in the quoted company will have to be issued to the
shareholders of the larger unquoted company. Hence, after the takeover the current shareholders in the larger unquoted
company will hold the majority of the shares in the quoted company and will therefore have control of the quoted company.
REVERSE TAKEOVERS – THE POTENTIAL BENEFITS

As previously stated, an RTO is effectively a way that a currently unquoted company can achieve a listing. Hence, just as with
an IPO, the company obtains the benefits of the public trading of its securities. These benefits include:
• Easier access to capital markets

As a listed company, more finance is likely to be available and the cost of that finance is likely to be lower than if the
company was still unquoted.
• Higher company valuation

As the shares in the company will be listed, potential investors will deem the shares to be less risky as the company will
have to abide by the relevant rules and regulations. Additionally, they will know that the shares are liquid and that
whenever they wish to sell there will be a willing buyer. As a result of this, investors are likely to attribute a higher value
to the shares.
• Enhanced ability to carry out further takeovers

Once the shares in a company are listed, the company is able to acquire other companies through further share-for-share
exchanges.
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Enhanced ability to use share based incentive plans

Once the shares of a company are listed, share based incentive plans can be used as a key tool to attract and retain good
quality employees.
In addition to the above, an RTO has a number of other potential benefits when compared to a normal IPO.
These include the following:

Speed
An IPO can often take between one and two years to complete whereas an RTO can be completed in as little as 30 days.
Furthermore, the work required to complete an IPO can mean that the managers of a company have less time to run the
company, which may prove detrimental to the growth prospects of the company.
The variability of market conditions can also make the speed of an RTO attractive, as in the time taken to prepare for an IPO,
the market may deteriorate such that the IPO is not finally worth completing. Furthermore, particular circumstances in a
market may make RTOs attractive. For instance, in China the IPO process is notoriously slow and there is usually a significant
queue of companies waiting to carry out an IPO. An RTO allows a company to jump this queue.
Cost
Just as an IPO is a time-consuming process, it is also an expensive one due to the volume of work required by investment
banks, sponsors, accountants and other advisers. An RTO will usually, but not always, cost less.
Availability
In a market downturn it is not easy to convince investors to support an IPO, whereas this does not seem to be the case with
RTOs. Studies have shown that the volume of RTO transactions is far more resilient to market downturns. During the market
correction that followed the bursting of the dotcom bubble, the number of RTOs actually increased while the number of IPOs
fell very significantly.
Similarly, the fall in the number of RTOs was less than the fall in the number of IPOs following the more recent financial crisis.
This is probably because, with an RTO, the deal is fundamentally between the shareholders of the quoted and unquoted
companies involved and, hence, market sentiment has much less import.
Furthermore, while an RTO is often accompanied by a concurrent secondary offering to raise new finance, the amount of new
finance being raised in both $ and % terms is usually less than that which is raised during an IPO. Hence, even in a downturn,
investors are often more willing to support an RTO rather than an IPO.
Existing analyst coverage

A listed company subject to an RTO is likely to have existing analyst coverage and, after the RTO, this analyst coverage usually
continues. However, companies that use an IPO may struggle to get significant analyst coverage especially if they are smaller.
Without reasonable analyst coverage, potential investors may not have much awareness of the company and, hence, are
unlikely to want to invest in the company.
REVERSE TAKEOVERS – THE POTENTIAL DRAWBACKS

RTOs do, however, have a number of potential drawbacks when compared to an IPO and any company considering an RTO
should be aware of these.
Lack of expertise
A company achieving a listing through an RTO may find that it does not have the expertise to understand and deal with all the
regulations and procedures that listed companies must comply with. The long process of listing through an IPO can be viewed
as a valuable training period and any company that has been through the process is in a better position to deal with the
requirements of the exchange than a company catapulted onto the market through an RTO. Hence, any company considering
an RTO must consider the need to hire and/or retain staff from the existing listed company who are able to keep the company
compliant with all the relevant regulations.
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Reputation
As previously discussed, an RTO has often been viewed as a poor man’s IPO. Hence, companies that achieve their listing in this
way may be viewed less favorably by investors than companies that have completed an IPO.
Risk
As a result of the lower level of scrutiny that is applied to an RTO compared to an IPO, investors must be aware of the higher
level of risk that is attached to companies achieving a listing in this way. In particular, the unquoted company carrying out an
RTO must ensure that there is a thorough investigation of the listed company which they are taking over so that all potential
problems and liabilities are revealed.
Regulation
Although RTOs can generally be completed more quickly than an IPO as there is less regulation and scrutiny involved, it must
be recognized that there are still a significant amount of regulatory hurdles to overcome.
Regulation
It should be understood that RTOs are, to some extent, combinations of acquisitions and IPOs and, as such, are potentially
complex and difficult deals to manage. By way of example, two regulatory issues that may arise are now discussed:
 Suspension
The Financial Conduct Authority’s (FCA) standard view is that when an RTO is announced or leaked, there will generally be
insufficient information publicly available on the proposed transaction. In particular, information on the unquoted
company contemplating the takeover could well be limited compared to the information that is available on listed
companies. As a result of this, the listed company will not be able to accurately assess its financial position and inform the
market. Hence, the FCA will often consider that a suspension of trading in the shares is appropriate. This standard view
can be rebutted, but there is significant work required to achieve this. However, this work is essential as the listed
company will not want to contemplate a scenario where its listing is suspended and is quite likely to walk away from the
proposed transaction were this to occur.
 Mandatory offer
If, individually or with their closely connected persons or friends, any shareholder in the unquoted company carrying out
an RTO will on completion of the transaction hold shares that carry 30% or more of the voting rights of the listed
company, then that shareholder will be required to make a general cash offer for the remaining shares in the listed
company under the mandatory bid rule. This would obviously undermine the reason for doing the RTO in the first place.
While the takeover panel will usually consent to a waiver of this requirement as long as certain conditions are satisfied, it
is another regulatory obstacle which must be navigated around carefully.
Share price decrease

Many listed companies which could make potential RTO targets are in that position because of past problems. Hence, they
may have shareholders who are keen to exit from the company as soon as a suitable opportunity arises and, hence, they may
‘dump’ their shares shortly after the RTO has completed. To safeguard against the risk of a ‘dump’ occurring, the shareholders
may need to guarantee that they will not sell their shares until a certain period of time has elapsed since the deal is
completed. This is called a lock-up and/or a lock-up period.
Cost
While a reverse takeover is usually cheaper than an IPO, there are still significant direct and indirect costs involved and, hence,
the total cost can easily be far more than was originally anticipated. A number of these costs are now considered:
Regulatory costs
As mentioned previously, an RTO is a complex transaction and to ensure that the regulatory hurdles are successfully overcome
will incur significant cost.
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Acquisition cost
As a result of an RTO being seen as an easier and quicker option than an IPO, especially in the Chinese market, the value of
potential listed company targets are often at a significant premium to their true value.
Acquisition cost - continued

Furthermore, the pressure to find a target has resulted in some unusual combinations such as a mobile computer game
developer getting listed through the acquisition of a shoe company! It is hard to imagine there were any synergy gains
available here and, indeed, resolving cultural and other issues that may well have arisen would have further added to the
indirect cost of achieving the listing.
Investor relations
Although an RTO may benefit from existing analyst coverage, RTO transactions only really introduce liquidity to a previously
private company if there is real investor interest in the company. In many cases, in order to generate this interest, a
comprehensive investor relations and investor marketing programme will be required. This is another potential indirect cost of
an RTO.
Appropriate Target for Acquisitions
• Following factors should be considered to choose an appropriateTarget

• Benefits for acquiring undervalued company
• Diversification
• Operating synergy
• Tax savings:
• Increase the debt capacity
• Disposal of cash slack
• Access to cash resources
• Control of the company:
In this case the objective is to find a target firm which is badly managed and whose stock has underperformed the market.
The management of an existing company is not able to fully utilize the potential of the assets of the company and the
bidding company feels that it has greater expertise or better management methods.
• Access to key technology
Reasons for Failures in Acquisition
• Over-optimistic assessment of economies of scale.

• Once a company has been bought, management moves on to identify the next target rather than ensuring that the
predicted synergy is realized.
• Inadequate preliminary investigation combined with an inability to implement the amalgamation efficiently.
• Winner’s curse – where two or more predators bid to buy a target & the winner often had to pay an excessive premium
to secure the deal.
• Dominance of subjective factors such as the status of the respective board of directors.
• Difficulty of valuation i.e. correct value of target company/firm\Culture differences
• Loss of key personnel from target company
• Capital structure
• Integration difficulties - e.g. systems, operations
Factors effecting the likely success of the bid for Acquisition

(1) Level of consideration
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The acquirer should offer an initial bid price, keeping in mind a satisfactory premium over and above the actual
market value of the acquire company. A generous offer would incline the target company to consider the offer
positively.
(2) Expectations of future profits
In order to encourage the shareholders of Target Company to retain their shares in the combined company, a
potential estimate of future earnings and synergies would be required by them.
(3) Future dividend policy
Shareholders of Target Company may be sensitive to the dividend policy possibly being less generous than they have
been used to before the acquisition.
(4) Tax position
The shareholders may prefer a future capital gain on sale of shares in acquirer company to cash consideration, or
instant sale of any shares they are given.
(5) Changes in shares prices
Shareholders will also take account of any changes in share prices that occur during the bid price.
Defenses to Takeover/Merger/Acquisition
When a target company is faced with a hostile tender offer (takeover) ,the target managers and board use defensive measure
to delay, negotiate a batter deal for shareholders ,or attempt to keep the company independent.
Defensive measure can be implemented either before or after a takeover attempt has begun. Strategic Defenses can be split
into pre-bid and post-bid defenses.
Pre Offer Defense

• Poison Pill
This is an attempt to make a company unattractive normally by giving the right to existing shareholders to buy shares
at a very low price. Poison pills have many variants.
• Poison Put
Whereas poison pills grant common shareholders certain rights in a hostile takeover attempt, poison puts give rights
to the target company's bondholders. In the event of a takeover, poison puts allow bondholders have the right to
sell their bonds back to the target at a redemption price that is pre-specified in the bond Agreement, typically above
par value.
• Staggered Board of Directors

Instead of electing the entire board of directors each year at the company's annual meeting, a company may arrange
to stagger the terms for board members so that only a portion of the board seats are due for election each year.
• Golden Parachutes
Golden parachutes are compensation agreements between the target company and its senior managers. These
employment contracts allow the executives to receive lucrative payouts, usually several years’ worth of salary, if they
leave the target company following a change in corporate control. Golden parachutes may encourage key executives
to stay with the target as the takeover progresses and the target explores all options to generate shareholder value.
Without a golden parachute, some contend that target company executives might be quicker to seek employment
offers from other companies to secure their financial future.
• Eternal vigilance
Maintain a high share price by being an effective management team and educate shareholders.
• Cross shareholdings
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Your company buys a substantial proportion of the shares in a friendly company, and it has a substantial holding of
your shares.
• Strong dividend Policy

The level of cash dividend is often held to influence share price.
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Post offer defenses

• Litigation
The target company can challenge the acquisition by inviting an investigation by the regulatory authorities or through
the courts. The target may be able to sue for a temporary order to stop the predator from buying any more of its
shares.
• Green Mail
This technique involves an agreement allowing the target to repurchase its own shares back from the acquiring
company, usually at a premium to the market price. Greenmail is usually accompanied by an agreement that the
acquirer will not pursue another hostile takeover attempt of the target for a set period.
• "Crown Jewel" Defense

The firm's most valuable assets may be the main reason that the firm became a takeover target in the first place. By
selling these or entering into arrangements such as sale and leaseback, the firm is making itself less attractive as a
target.
"Pac-Man" Defense
The target can defend itself by making a counteroffer to acquire the hostile bidder. This technique is rarely used because, in
most cases, it means that a smaller company (the target) is making a bid for a larger entity. Additionally, once a target uses a
Pac-Man defense, it forgoes the ability to use a number of other defensive strategies. For instance, after making a
counteroffer, a target cannot very well take the acquirer to court claiming an antitrust violation.
• White Knight Defense

This would involve inviting a firm that would rescue the target from the unwanted bidder. The white knight would act
as a friendly counter-bidder.
Issues of Overvaluation
Overvaluation is basically the acquisition of companies at overpriced rates. This happens primarily because firms tend to
overestimate the synergies and potential benefit from acquisitions or mergers. Problem with such acquisition is that it can
cause serious financial damage to the buying organization if things don’t work out as expected. Plus firms due to reputational
risk may not be able to sell it back because it will provide a negative vibe to the market that they do not have competent
management executives. This may even dent the success of products which are profitable in the market.
Methods of Financing Mergers
Type of Consideration
The means of transferring the financial value of the shares or assets of the business, the consideration, can be satisfied in a
combination of several alternatives:
1. Cash
2. Debt
3. Preference shares.
4. Ordinary shares.
5. Debt and preference share consideration that can be convertible into ordinary shares.
6. Share and loan stock used as consideration are known as 'paper issues'.
7. If a share exchange is used the target company's shares are purchased using shares of the predator.
Cash
It is the most popular method (especially after stock market declines in early years.)
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For the Acquirer
Advantages Disadvantages
When the bidder has sufficient cash the merger can be Cash flow strain - usually either must borrow
achieved quickly. (increased gearing) or issue new shares in order
to raise the cash.
Cheaper: the consideration is likely to be less than a
share exchange, as there is less risk to the
shareholders.
Retains control of their company.
For the Target Shareholders
Certainty about bids value Liable to CGT
Freedom to invest in a wide ranging portfolio. Do not participate in new group synergy benefits
The cash to fund the purchase may have been raised by a rights issue before the takeover bid.
Shares
It is the second most popular method.
For the Acquirer
No cash outflow Dilution of control
Bootstrapping – when high P/E ratio Co acquires low

P/E co, acquirer will have to issue less number of
shares so EPS rises.
For the Target Shareholders
Postponement of CGT liability Uncertain value
Participate in new group synergy benefits
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Choice of payment type

a) Sometimes investors are given a choice in the method of payment, with the logic that different forms of
payment might be attractive to different types of investor.
b) Could influence the success or failure of a bid.
c) Problematic for the bidder in that the cash needs and the number of shares to be issued is not known.
d) Capital structure may alter in an unplanned manner.
e) Ideally a bidder would like to tailor the form of the bid to that favored by major investors in the targeted
company.
Factors used to decide payment type
Predator and its shareholders Target company shareholders

Control
if a large number of shares are issued then control  Share price shareholders want shares that will at
of the company may alter least retain their value
Increases in authorized capital may be needed  Future investments some shareholders may
Increases in borrowing limits may be required The prefer shares to maintain an investment in the
cost to the company will vary with debt, equity and company
convertible loan stocks  Taxation Liability may be deferred if the
There may be a dilution of earnings per share The consideration was in shares
level of gearing resultant on an issue of debt to  Income Shareholders will want a minimum
finance a cash acquisition may be unacceptable income stream.
The Global Regulatory Framework
Introduction
Takeover regulation is an important corporate governance device that seeks to protect the interest of minority shareholder
and other types of stakeholders and ensure a well-functioning market for corporate control.
Potential conflict of interests

Takeover regulation seeks to regulate the conflicts of interest between the management and shareholders of both target and
bidder
There are two main agency problems that emerge in the context of a takeover that regulation seeks to address:
 The first is the possibility that management of the target company may implement the measure to prevent the takeovers
even if these are against the stakeholder’s interest.
 The second is the protection of minority shareholders. In addition to existing minority shareholders, transfers of control
may turn existing majority shareholders of the target into minority shareholders.
Key aspects of Takeover Regulation

The following seven regulatory devices are available to traitors and aim at the protection of shareholders.
1. Mandatory Bid- Rule:

The aim of this rule is to protect the minority shareholders by providing them with the opportunity to exit the company at
the fair price once the bidder as cumulated a certain percentage of the shares. National thresholds vary between
countries what the trend has been for these to decrease over the years. In UK these thresholds is specified by the city
code for takeovers and mergers and is at 30%. This rule is based on the grounds once the bidder obtains the control he
may exploit his position at the expense of minority shareholders.
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This why the mandatory bid rule normally also specifies the price that is to paid for the shares. The bidder normally
required to offer the remaining the shareholders the price not lower than the highest price for the shares already
acquired during the periods specified prior to the bid.
2. The principle of equal treatment:

The principle of treating all the shareholders equally is fundamental in all western, European countries in general terms.
The principle of equal treatment requires the bidder to offer to minority shareholders as same term as those offered to
earlier shareholders from whom the controlling block was acquired.
3. Transparency of ownership and control:

The disclosure of information about major shareholding is an important element of investor protection in a well-
functioning corporate market. The transparency enables the regulators to monitor the large shareholders, minimize
agency problems and investigate insider dealing. It also enables that minority shareholder and the market to monitor the
large shareholders who may able to exercise undue influence exact at the expense of the other shareholdings.
4. The squeeze-out and sell-out rights:

Squeeze out rights gives the bidder who has acquired a specific percentage of the equity (90%) the right to force minority
shareholders to sell their shares.
Sell-out rights enable minority shareholders to require the majority shareholder to purchase their shares.
5. The one-share-one vote:

Where the one share-one vote principle is upheld, arrangements restricting voting rights are forbidden. Differentiated
voting rights, such as non-voting shares and dual-clan shares with the multiple voting rights, enable some shareholders to
accumulate control at the expense of other shareholders and could provide a significant barrier to potential takeovers.
6. The break-through rule

The effect of the break-through rule where this is allowed by corporate law, is to enable a bidder with a specified
proportion of the company’s equity to break-through the company’s multiple voting rights and exercise control as if one
share-one vote existed.
7. Board neutrality and anti-takeover measures

Seeking to address the agency issue where management may be tempered to act in their own interests at the expense of
the interest of the shareholders, several regulatory devices propose board neutrality. For instance the board would not be
permitted to carry out post-bid aggressive defensive tactic (such as selling the company’s main assets, known as crown
jewels defense, or entering into special arrangements giving rights to existing shareholders to buy shares at a low price,
known as poison pill defense), without prior authority of the shareholders.
General Principles:
• All the shareholders of the target company must be treated similarly.
• All information disclosed to one or more shareholders of the target company must be disclosed to all.
• An offer should only be made if it can be implemented in full individuals or firms should not make an offer unless they
have reason to believe that they will be able to implement this in full.
• Sufficient information, advice and time to be given for a properly informed decision ‘Shareholders must be given sufficient
information and advice to enable them to reach a properly informed decision and mist have sufficient time to do so. No
relevant information should be withheld from them.
• All documentation should be of the highest standards of accuracy A “documentation produced by the bidding company or
the directors of the target should be produced to the highest standards of accuracy.
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• All parties must do everything t0 ensure that a false market is not created in the shares of the target company. A false
market is created when a deliberate attempt is made to distort the market in the offeror’s or target shares. An example
would be where false information is either given or withheld in such a way as to prevent the free negotiation of prices.
• Directors of a target company are not permitted to frustrate a takeover bid, nor to prevent the shareholders from having
a chance to decide for themselves.
• The directors of both target and bidder must act in the interest of their respective companies.
The Competition Commission

• A UK company might have to consider whether its proposed takeover would be drawn to the attention of the Competition
Commission (formerly called the Monopolies and Mergers Commission). Under the terms of the Monopolies and Mergers
Act, the Office of Fair Trading (OFT) is entitled to scrutinize and possibly reject all major mergers and takeovers. If the OFT
thinks that a merger or takeover might be against the public interest, it can refer it to the Competition Commission.
• If a transaction is referred to the Competition Commission and the commission finds that it results in a substantial
lessening of competition in the defined market, it will specify action to remedy or prevent the adverse effects identified,
or it may decide that the merger does not take place (or, in the case of a completed merger, is reversed).
• Any person aggrieved by a decision of the OFT, the Secretary of State or the Competition Commission in connection with
a reference or possible reference, may apply to the Competition Appeal Tribunal (CAT) for a review if that decision.
BUSINESS VALUATION
Method of Valuation
Cash flow Net Asset Market Relative

based
model method based model
Dividend Free cash Combine Net asset P/E ratio

Valuation Free Cash flow to Company Valuation Price/cas
model flow to Value Value Or
Equity Based on Earning h flow
Firm FCFF FCFE APV Yield
Calculated
Intangible
Value (CIV )
CASH FLOW BASED METHOD
DIVIDEND VALUATION MODEL

The dividend valuation model (or growth model) suggests that the market value of a share is supported by the present value
of future dividends Formula
MV =
Where:
MV = share price g = future annual growth rate
D0 = dividend at Time 0
Ke = rate of return required by the equity shareholders
Three inputs have to be estimated if this approach is to be used: D0, g and Ke.
D0 This is the dividend that has either just been paid or is just about to be paid: it is the current dividend. g = this is estimate
by looking directly at the historical dividend growth rate and assuming this will continue in the future. OR Gordon’s growth
approximation:
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G=b x r g = b x Cost of equity

Where: b =( 1-dividend payout ratio).
r= Cost of equity
Ke can be estimated using the capital asset pricing model: Required rate of return, Ke = Rf + β( Rm – Rf )
DIVIDEND VALUATION MODEL ( TWO METHODS)

Single Growth model:
MV =
Multiple Growth model:
Year 1 2 3 4-∞
Dividends D1 D2 D3 D3 ( 1 + g)
Ke − g
Discount factor @ Discount factor of
Ke last year
Market Capitalization= Mv/share × number of shares
ASSUMPTIONS
 It is assumed that current dividend payout ratio reflects the normal dividend capacity of business.
 It is assumed that dividend will increase with constant growth for the foreseeable future.
 Required return of investors (Ke) will remain constant for the foreseeable future.
 Dividend Growth model estimates market value according to the non-controlling shareholders. In order to get control of
the company acquirer will have to pay some extra amount as control premium.
Example
Now end of 2016.

Dividend history, expected dividends and cost of capital, Lirio Co
Year 2013 2014 2015 2016
Number of $1 60,000 60,000 80,000 80,000
equity shares in
issue (000)
Total dividends 12,832 13,602 19,224 20,377
paid ($ 000)
It is expected that dividends will grow at the historic rate in current policy.
Expected dividends and dividend growth rates in new policy.

Year to end of February 2017 $4,760,000 will be paid as dividends.
Year to end of February 2018 Dividends paid will be the same amount as the previous year.
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Year to end of February 2019 Dividends paid will be $0·31 per share.
In future years from February 2019 Dividends will grow at an annual rate of 7%.
Lirio Co’s cost of equity capital is estimated to be 12%.
Decide shareholders will choose which policy?
Solution:
If the large project is not undertaken and dividend growth rate is maintained at the historic level
Dividend history
Year to end 2013 2014 2015 2016
No of $1 equity 60000 60000 80000 80000
shares
Total dividend paid 12823 13602 19224 20377
($000)
Dividend per share $0.214 $0.227 $0.240 $0.377
Average dividend growth rate = (0·255/0·214)1/3– 1 = 1·0602 (or say 6%)
Expected dividend in February 2017 = $0·255 x 1·06 = $0·270
Lirio Co, estimate of value if large project is not undertaken =

$0·270/(0·12 – 0·06) = $4·50 per share or $360 million market capitalization
Dividend capacity funds left after transfer$4,760,000
Annual dividend per share after transfer$0·0595

Annual dividend paid (end of February 2017 and February 2018)$0·0595
Dividend paid (end of February 2019)$0·3100
New growth rate7%
Lirio Co, estimate of value if large project is undertaken
=$0·0595 x 1·12–^1+ $0·0595 x 1·12–^2+ $0·3100 x 1·12–^3
+ [$0·3100 x 1·07/(0·12 – 0·07)] x 1·12–^3
= $5·04 pershare or $403 million market capitalisation
FREE CASH FLOWS

Free Cash Flow from Firm
PBIT XX
Tax (X)
Depreciation X
CAPEX (X)
FCFF
Discount this using weighted average cost of capital.

Scenario 1: Single Growth Model.
𝐹𝐶𝐹𝐹(1 + 𝑔)
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝐴𝑙𝑢𝑒 𝑜𝑓 𝐵𝑢𝑠𝑖𝑛𝑒𝑠𝑠 =
𝑊𝐴𝐶𝐶 − 𝑔
Scenario 2: Multiple Growth Model
Year 1 2 3 4 5 - inf
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Free cash
FCFF1 FCFF2 FCFF3 FCFF4
flows to firm
Discount
Discount factor of
factor @
Preceding year
WACC
P.V= Market Value of Business

Market Value of Equity = Market Value of Business – Market Value of Debt
Historic Growth
Historic cost based on sales or operating profits.
FCFE
Free Cash Flow To Equity
PBIT XX
Tax @ 30% (X)
Depreciation X
Interest ( 1 – 1) (X)
CAPEX (X)
FCFE
Discount using cost of equity
Scenario 1 Single Growth Model
Market Value of Equity =
Scenario 2 Multiple Growth Model

Year 1 2 3 4
Free FCFE ( 1 + g)
cashflows to FCFE FCFE FCFE FCFE
equity Ke − g
Discount Discount factor of
factor @ Ke last year
P.V= Market Value of Equity
How to Calculate Growth in FCFE model

Historical Growth
Based on Sales or Operating profits
Gordon Growth
g=bxr
r = Cost of Equity
b=
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Return on equity is not suitable therefore use cost of equity.
Other formulas to calculate FCFE
Free Cash Flows to Equity

PBIT XX
Interest (X)
PBT X
Tax @ 30% (X)
Depreciation X
W. Cap change (X)
CAPEX (X)
FCFE
Free Cash Flows to Equity

Free Cash flow to firm XX
Interest (1 – t) (X)
FCFE
Assumptions of Free Cash Flows

 It is assumed that level of free cash flows reflect the normal capacity of business.
 It is assumed that free cash flows will grow with constant growth rate for the foreseeable future.
 Required return of investors will remain constant.
 It is company policy to have consistent re-investments in CAPEX.
 Interest rate or Interest amount will remain constant (loan amount will be constant)
 It is assumed that replacements CAPEX are equivalent to the annual depreciation (only when mentioned in question).
Example
Rayn Co’s annual sales growth rate is expected to be 5% and the profit margin before interest and tax is expected to be
17·25% of sales revenue, for the next four years. It can be assumed that the current tax allowable depreciation will remain
equivalent to the amount of investment needed to maintain the current level of operations, but that the company will require
an additional investment in assets of 40c for every $1 increase in sales revenue. After the four years, the annual growth rate of
the company’s free cash flows is expected to be 3% for the foreseeable future.
Cost of capital is 9%.The corporation tax rate applicable to all companies is 22%.
Financial information: Rayn Co

Given below are extracts from Rayn Co’s latest statement of profit or loss and statement of financial position for the year
ended 30 November 2015.
2015
$ million
Sales revenue 14,980
Profit before interest and tax (PBIT) 2,584
Interest 720
Pre-tax profit 1,864
Calculate Market value of Rayn Co (Firm Value).
Solution:
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Years 1 2 3 4 5
Sales 15729 16515 17341 18208

Revenue @
5%
PBIT @ 2713 2849 2991 3141

17.25%
Tax @22% (597) (627) (658) (691)
CAPEX (299.6) (314.4) (330.4) (346.8)0
FCFF 1816 1907.6 2002.6 2103.2 2103.2 X

(1.03)/(0.09-
0.03)
DISC @ 9% 0.917 0.842 0.772 0.708 0.708
P.V 1665 1606 1546 1489 25562
Total PV = 31868
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Example
Frank is a fully listed company financed wholly by equity.
The following information is taken from the financial statements of company at the start of the current year:
$‘’000’’
Assets less current liabilities 4400
Capital Employed
Equity 4400
Net operating profit after tax (NOPAT) 580

Net amount retained for reinvestment in assets 180
It can be assumed that the retained earnings forcompany is equal to the net reinvestment in assets.
The current yield rate is 5% and the current equity risk premium is 6%. It can be assumed that the risk free rate of return is
equivalent to the yield rate. Frank’s beta has been estimated to be 1·26.
Required:
(i) Using the free cash flow model, estimate the market value of equity for Frank Co.
Co is financed entirely by equity therefore we can assume that its cost of capital is the same as its cost of equity.
Estimated market value = Free Cash Flow (FCF) x (1 + g) / (ke– g)
Where g = growth rate

ke= cost of capital
Free Cash Flow = NOPAT – net investment in assets
= $580,000 = $180,000 = $400,000
Cost of equity (ke) = RI + β (Rm – RI) = 5 + (6 x 1.26) = 12.56%
Growth rate = retention rate x cost of capital
= (180 / 580) x 12.56 = 3.90%
Estimated market value = 400,000 x (1.039) / (0.1256 – 0.039) = $4,799,076
Example
The following financial information relates to Rayn Co and to the development of the new product.
Rayn Co financial information
$’000
Sales revenue 8,780

PBIT 1,230
Interest (455)
Tax (155)
PAT 620
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Balance sheet Extract

$000
Net non-current assets 10,060
Current assets 690
Total Assets 10,750
Share capital (40c per share par value 960
Reserves 1,400
Non-current liabilities: Variable rate loans 6,500
Current liabilities 1,890
Total liabilities and capital 10,750
In arriving at the profit after tax amount, Rayn Co deducted tax allowable depreciation and other non-cash expense totaling
$1,206,000. It requires an annual cash investment of $1,010,000 in non-current assets and working capital to continue its
operations.
Rayn Co’s profits before interest and tax in its first year of operation were $970,000 and have been growing steadily in each of
the following three years, to their current level. Rayn Co’s cash flows grew at the same rate as well, but it is likely that this
growth rate will reduce to 25% of the original rate for the foreseeable future.
It is estimated that an overall cost of capital of 11% is reasonable compensation for the risk undertaken on an investment
of this nature.
Required:
Estimates the current value of a Rayn Co share, using the free cash flow to firm methodology.
Estimate of current value of RaynCo’s equity based on free cash flows
Total value = Free cash flows × (1 + growth rate (g))/(Cost of capital (k) – g)
k = 11%
Past growth rate = (latest profit before interest and tax (PBIT) / Earliest PBIT) 1/no of periods of growth - 1
Past g = (1,230/970) 1/3 - 1 = 0.0824
Future g = 0.25 × 0.0824 = 0.0206
Free cash flow calculation
Free cash flow (FCF) = PBIT + non-cash flows – cash investment – tax
FCF = 1,230,000 + 1,206,000 – 1,010,000 – (1,230,000 × 20%) = $1,180,000
Total value = $1,180,000 × 1.0206/(0.11 – 0.0206) = $13,471,007
Equity value = $13,471,007 - $6,500,000 = $6,971,007
Number of shares = $960,000/$0.40 = 2.4 million
Equity value per share = $6,971,007/2.4 million shares = $2.90
ASSET BASED APPROACH/NET ASSET METHOD
The business is estimated as being worth the value of its Net Assets.
Net Assets = Total Assets – Total Liabilities – Preference Share Value
Adjustments:
Monetary assets: book value
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Tangible assets:
• Replacement value( if purpose is going concern)
• Realizable Value( if purpose is of disposal)
• Book value( if above values are not available)
Intangible Assets: consider if market value is available

Inventory: at NRV
Receivable: less any allowance for doubtful debt
Liabilities: redemption value
PROBLEMS & ADVANTAGES OF NET ASSETS METHOD

Problems of Net Assets Method
 It does not consider future prospects of a company.
 It does not consider all intangibles of a company.
 It cannot be used in service based industry.
 Replacement cost is difficult to estimate.
Advantages of Net Asset Method

 It can be used as floor value (minimum value) in mergers and acquisitions.
 It is the only method used in case of liquidation.
 It can be used as valuation method in asset intensive firm. e.g. real estate business.
CALCULATED INTANGIBLE VALUE (CIV) MODEL
Step 1: Identify suitable proxy company or industry ‘return on capital employed.’
Step 2
PBIT of Target Company XX
Capital Employed of target. x Industry ROCE (XX)
Excess earnings or value surplus XX
Tax (XX)
After-tax Excess Earnings or value surplus XX
P.V of all intangibles = Excess Earnings (1-T)
WACC
Total Value = Capital Employed + P.V of Intangibles
MARKET RELATIVE BASED APPROACH
Price/Earning Method / Earnings Multiple

This method relies on finding listed companies in similar businesses to the company being valued (the target company), and
then looking at the relationship they show between share price and earnings.
P/E ratio = Market Value of Share / Earnings per Share
Market Value of Target Company = Earnings per Share of Target Company X P/E Ratio of Proxy or (Industry Average)
Adjustments:
 Adjust earnings for one off exceptional items (After-tax).
 If target company is a private company then downwards adjust the calculated market value because:
 Public company has better image over private company
 Public company shares are more marketable and liquid
 Public company is less risky as compared to private company.
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 If private company has better growth prospects then upwards adjust the calculated market value.
 For better analysis use forecasted earnings.
 MV of Target co=Forecasted Earnings x P/E Ratio of Industry
 In exam we will calculate both values (using historic earnings and forecasted earnings) and suggest that market value of
the company should be in between.
INCOME BASED APPROACH
Earning Yield Method:

Earnings yield = Earnings per share/ Market value per share.
For example, if EPS was £1 per share and the market price per share was £10, then the earnings yield would be 10%. Earnings
yield is the mirror image of the PRICE-EARNINGS RATIO.
MARKET VALUE OF TARGET COMPANY/ SHARE = EPS OF TARGET COMPANY X 1/

EARNING YIELD (PROXY)
Problems of P/E ratio method

 Historical values used in calculations
 Single year data is being considered
 Difficult to find suitable proxy company
Example
Zayn Co’s has medical equipment manufacturing business and directors want to sell the company to Sino co.The value of the
sell-off will be based on the medical and dental equipment manufacturing industry. Sino Co has estimated that Rayn Co’s
manufacturing business should be valued at a factor of 1·2 times higher than the industry’s average price-to-earnings ratio.
Currently the industry’s average earnings-pershare is 30c and the average share price is $ 2.4.The corporation tax rate
applicable to all companies is 22%.
Financial information: Zayn Co

Given below are extracts from Zayn Co’s latest statement of profit or loss and statement of financial position for the year
ended 30 November 2015.
2015
$ million
Sales revenue 6420
Profit before interest and tax (PBIT) 963
Interest 216
Pre-tax profit 747
Calculate Market value of Zayn Co.
Solution:
OTHER MEASURES
Price to Cash Flow Ratio/ Cash flow multiple

M.V of target = Free cash flow of target x price to CF ratio of proxy
Price to Book Value/ Book Value Multiple

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M.V of target = Book value of target x price to book value of proxy
Valuation Using Apv Method

Same Business Risk and Different Financial Risk:
Use Adjusted Present Value
Investment Side
Calculate free cash flows of target Company and discount these free cash flows at un-geared cost of equity.
FINANCING SIDE
 Issue costs
 Present value of tax shield
 Present value of interest savings on subsidized loan.
 Discount all of these using risk-free rate or cost of debt
Market value of business = Base case NPV + Present Value of tax shield
Market value of equity = Market value of business – market value of debt Benefit = Market value of equity – cost of acquisition
Valuation Techniques
Point of view of Acquirer (Buyer)

Acquirer will want to know about the maximum price that should be paid for acquisition. Hence the value of Target Company
will be
Value of the combined company

Less: Value of the parent company before Acquisition
Value of the Target Company (The Maximum Value)
Point of view of Acquiree (Seller)

Acquiree will want to know about the minimum price that it should be accepted for acquisition. Hence the value of Target
Company will be
PV of the Target Company.
Gain and Losses on Acquisition
Acquirer Target
Value in view of Acquirer Price Agreed
Less: Price agreed Less: Value in view of Acquiree
Gain/(Loss) Gain/(Loss)
Market Value of Combine Business Using Cashflows
Different Business Risk and Different Financial Risk:

Market value of combined company
 Step 1: Un-gear βe of both acquirer and Target Company to calculate βa.
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 Step 2: Calculated weighted average βa using above calculated βa weighting them according to their current market
values.
 Step 3: Re-gear the calculated βa (w.avg) using post acquisition gearing and calculate βe.
 Step 4: Calculate cost of equity using CAPM and WACC using post-acquisition gearing.
 Step 5: Calculate combined free cash flows to the firm and using combined WACC, calculate combined market value of
business.
M.V of Equity = M.V of Business – Total Debt

Synergy Benefit = Combined M.V – M.V of Acquirer. – M.V of Target
Synergy benefit= Maximum premium to be paid
Example
Sino co wants to acquire Hank Co.Sino Co is of the opinion that as a result of acquiring Hank Co, the cost of capital will be
based on the equity beta and the cost of debt of the combined company.
The asset beta of the combined company is the individual companies ‘asset betas weighted in proportion of the individual
companies’ market value of equity.
Sino Co has a market debt to equity ratio of 40:60 and an equity beta of 1·10.
It can be assumed that the proportion of market value of debt to market value of equity will be maintained after the two
companies combine.
Currently, Sino Co’s total firm value (market values of debt and equity combined) is $60,000 million and Hank Co’s asset beta
is 0·68.
Additional information
– The estimate of the risk free rate of return is 4·3% and of the market risk premium is 7%.
– The corporation tax rate applicable to all companies is 22%.
– Hank Co’s current share price is $3 per share, and it can be assumed that the book value and the market value of its
debt are equivalent. Number of shares are 7 million.
– The pre-tax cost of debt of the combined company is expected to be 6.0%.
Calculate combine Cost of capital?

Solution:
Sin co Be = 1.10
Mv of E = 60
Mv of D = 40
Ba = 1.10 x 60/ 60+40(1-0.22)
Ba = 0.72
Hank co Ba = 0.68
Ba(avg) = 0.72 x 60 + 0.68 x 21 = 0.709
60+21 60+21
0.709= Be x 60/(60+40(1-0.2)
Be= 1.078
Ke= 4.3 + 1.078(7) = 11.85
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WACC = 11.85 x 0.6 + 6 (1-0.22) x0.4 = 8.9 ≈ 9%
Example
Nemar Co, a listed company which manufactures electronic components, is interested in acquiring Roney Co.
Information on Nemar Co and Roney Co
Nemar Co
Nemar Co has a market debt to equity ratio of 50:50 and an equity beta of 1·18. Currently Nemar Co has a total firm value
(market value of debt and equity combined) of $140 million.
Roney Co has a market debt to equity ratio of 10:90 and an estimated equity beta of 1·53. Roney Co has a total firm value
(market value of debt and equity combined) of $40 million.
Information about combine Company

Following the acquisition, it is expected that the combined company’s sales revenue will be $51,952,000 in the first year, and
its profit margin on sales will be 30% for the foreseeable future. After the first year the growth rate in sales revenue will be
5·8% per year for the following three years. Following the acquisition, it is expected that the combined company will pay
annual interest at 6·4% on future borrowings.
The combined company will require additional investment in assets of $513,000 in the first year and then 18c per $1 increase
in sales revenue for the next three years. It is anticipated that after the forecasted four-year period, its free cash flow growth
rate will be half the sales revenue growth rate.
It can be assumed that the asset beta of the combined company is the weighted average of the individual companies’ asset
betas, weighted in proportion of the individual companies’ market value.
The current annual government base rate is 4·5% and the market risk premium isestimated at 6% per year. The Tax rate is
28%.
Required:
Evaluates whether the acquisition of Roney Co would be beneficial to Nemar Co and its shareholders. The free cash flow to
firm method should be used to estimate the values of Roney Co and the combined company assuming that the combined
company’s capital structure stays the same as that of NemarCo’s current capital structure. Include all relevant calculation.
Solution:
Value of combined company

Year 1 2 3 4
$000 $000 $000 $000
Sales revenue – growth rate 5.8% 51,952 54,965 58,153 61,526
Operating profit (30% of sales) 15,586 16,490 17,446 18,458
Tax at 28% (4,364) (4,617) (4,885) (5,168)
Less additional investment (W1) (513) (542) (574) (607)
Free cash flow 10,709 11,331 11,987 12,683
Discount factor 9% (W2) 0.917 0.842 0.772 0.708
Discounted cash flow 9,825 9,541 9,256 8,985
Total discounted cash flows (years 1 – 4) 37,607

Terminal value (W3) 151,566
Total value of combined company 189,173

Synergy benefits = Total value of combined company – total value of individual companies
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= $189,173,000 – ($140,000,000 + $40,104,000)

= $9,069,000
Premium required to purchase Fodder Co = 25% of equity
Equity = 90% of $40,104,000 = $36,093,600
Premium = $9,023,400
Net benefits to Pursuit’s shareholders = $9,069,000 – $9,023,400 = $45,600
Workings
(1) Additional investment

Year Sales revenue increase ($000) 18% of increase
1 See note below
2 54,965 – 51,952 = 3,013 542
3 58,153 – 54,965 = 3,188 574
4 61,526 – 58,153 = 3,373 607
Note – the additional investment for Year 1 is given in the question
(2) Combined company cost of capital

Asset beta is calculated using the formula:
Asset beta (nemar ) = 1.18 (0.5/*0.5 + 0.5 (1

– 0.28)]) = 0.686 (assume debt beta = 0)
Asset beta (roney ) = 1.53 (0.9/*0.9 + 0.1 (1
– 0.28)]) = 1.417 (assume debt beta = 0)
Asset beta (combined company)

= [(0.686 $140m) + (1.417 $40.095m)+/(140m + 40.095m) = 0.849
Equity beta (combined company) = 0.849 *0.5 + (0.5 0.72)+/0.5 = 1.46
Cost of equity (ke) = 4.5% + 1.46 6% = 13.26%
WACC = [13.26% 0.5+ + *6.4% (0.5 0.72)+ = 8.93% (say 9%)
(3) Terminal value

Growth rate is halved to 2.9% pa.
PV of cash flows in perpetuity = 12,683 *1.029/(0.09
– 0.029)] = $213,948
Discounted back to year 0 = $213,948 0.708 = $151,566
METHODS OF FINANCING MERGERS CALCULATIONS
 Share for Share

 Cash Offer
 Bond Offer
 Mix Offer (Cash + Share offer, cash + bond offer)
Example
Market value of target company $5 per share, market value of acquirer $4 per share. Acquirer has offered its 3 shares for
every 2 shares of Target Company.
Calculate %age benefits for Target Company.

Solution:
$
Value Offered =3x4 = $12.00
Value of Target = 2 x 5 = $10.00
Gain $2.00
Gain %age= 2/10 x 100 20%
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In share for share exchange as soon as acquirer company transfer its shares to target company, both company’s
shareholders will become the owner of group so combine value of group is more relevant here rather than the existing
value of acquirer.
Share for Share Exchange
Example
Market value of Target Company is $2.50, market value of acquirer $3.00, combined market value $4.00.
Acquirer has offered its 2 shares for every 3 shares of target company.
Requirement: Calculate %age gain to both the acquirer and target shareholders.
Solution:
Gain to Target Co
Value offer (Based on combine value) $8

2x4
Value of target co 3 x 2.5 7.5
Gain 0.5
= 0.5/7.5 6.67%
Gain to Acquirer
Post-acquisition value ( combine value) 4
Pre-acquisition value 3
Gain 1
=1/3 33.33 %
Combined Market Value

o Earning Based (P/E will be given, synergy/year given)
o Based on total synergy
o Based on combine free cash flow and combined WACC
Earning Based:
 Combine Earnings = Acquirer Earnings + Target Earnings + Synergy/year ➢Combine Market Value = Combined Earnings x
P/E of Group
Combine market value
 Combine M.V/Share =
Combine Market Value
Combine market value based on total synergy

M.V of Acquirer + M.V of target Co + Total Synergy = Combine M.V of Equity

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Combine market value based on free cash flows
Step 1:
Calculate Combine M.V by discounting FCFF with combined WACC.
Step 2:
Combined M.V of Equity = M.V of Business – Total Debt M.V (consolidated Debt)
CASH OFFER
Example:
Market value of target co. is $4/share. Acquirer has offered $5 each for every share of target company. Calculate %age gain to
the target company shareholders.
Gain to Target Co
Cash Offer 5
Value of target co 4
Gain 1
25 %
Combined Market Value

Calculate combine M.V using any method given. Combine
market value−cash paid
Existing aquirer shares
BOND OFFER
Example:
M.V of target co is $4/Share. Acquirer has offered $110 worth Bond for every 20 shares of target co. Calculate %age gain for
target company shareholders.
Gain to Target Co
Value of bond/ shares offered=110/20 $5.5
Value of target co $4
Gain 1.5
37 %
STEPS
Combine Market Value (In-order to calculate acquirers gain)
Calculate combined market value using given method
Combine market value−value of debt
Combine M.V/Share =
Existing aquirer shares
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MIX OFFER
• Cash + share offer
• Cash + bond offer
• Bond + share offer
Combine value can be calculated using combine the individual formula of calculating combine market value
E.g. In case of Cash + share offer
➢Combine M.V/Share =
Example: Market value of target company $5 per share. Company has offered $107 worth bond for 25 shares of Target
Company plus $1.50 cash for every share of Target Company. Requirement: Calculate %age gain to the target company.
Value of Offer
Shares 107/25 4.28
Cash 1.50
5.78
Value of target (5.00)
Gain 0.78
Gain percentage 15.60%
Example: Market value of target company $5 per share. Acquirer has offered $0.25 cash and its 3 shares for every 2 shares of
Target Company. Market value of acquirer is $3 per share and market value of Combine Company is $ 3.5 per share.
Requirement: Calculate %age gain to the target company.
Value of Offer
Shares offer =3.5 x 3 10.5
Cash = 2X 0.25 0.5
11
Value of target = 2 x 5 (10)
Gain 1
Gain percentage 10%
Example
Rayn Co, an unlisted company, designs and develops tools and parts for specialist machinery. The Board of Directors,
consisting of the three friends and a representative fromeach business angelorganisation, met recently to discuss how to
secure the company’s future prospects. Proposal was put forward, as follows:
To accept a takeover offer from Meon Co, a listed company, which develops and manufactures specialist machinery tools and
parts. The takeover offer is for $2·95 cash per share or a share-forshare exchange where two Meon Co shares would be
offered for three Rayn Co shares. Meon Co would need to get the final approval from its shareholders if either offer is
accepted;
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Currently, Meon Co has 10 millionshares in issue and these are trading for $4·80 each. MeonCo’s price to earnings (P/E) ratio
is 15. It has sufficientcash to pay for RaynCo’s equity and a substantial proportion of its debt, and believes that this will
enable Rayn Co to operate on a P/E level of 15 as well. In addition to this, Meon Co believes that it can find cost-based
synergies of $150,000 after tax per year for the foreseeable future. MeonCo’s current profit after tax is $3,200,000. Rayn Co
share price is 2.90$ / share.
Rayn Co PAT is $ 620,000. Number of shares are 2.4 million.

Required:
(ii) Estimates the percentage gain in value to a Rayn Co share and a Meon Co share under each payment offer;
Solution:
Cash offer
Gain in value to a Rayn Co shareholder = ($2.95 – $2.90)/$2.90 = 1.7%

Additional earnings post-acquisition = $620,000 + $150,000 = $770,000
Additional earnings per share = $770,000/10m = 7.7c per share
Using the P/E ratio to calculate the increase in share price = 15 × 7.7c = $1.16
Additional value created = $1.16 × 10 million = $11.6 million
Less cost of acquisition = ($2.95 × 2.4 million) = $7.08 million
Value added for Meon Co shareholders = 11.6 million – 7.08 million = $4.52 million
Gain in value to a shareholder of Meon = $4.52m/10m = 45.2c
45.2c/480c = 9.4%
Share-for-share offer
Earnings of combined company = $770,000 (from above) + $3,200,000 = $3,970,000

Total number of shares in combined number = 10 million + (2.4million × 2/3) = 11,600,000
EPS of combined company = $3.97m/11.6m = 34.2c
Expected share price using P/E ratio = 34.2 × 15 = 513c = $5.13
Gain in value to a shareholder of Meon Co = ($5.13 – $4.80)/$4.80 = 6.9%
Current value of three shares in Rayn Co = $2.90 × 3 = $8.70
Gain in value to a shareholder of Rayn Co = ((2 × $5.13) – $8.70) /$8.70 = 17.9%
Example
Abel Co, a listed engineering company, manufactures large scale plant and machinery for industrial companies.
Abel Co is currently considering acquiring Adam Co, an unlisted company. Given below are extracts of financial information
for the two companies for the year ended 30 April 2014.
Abel Adam
Million Million
Sales Revenue 790.2 124.6
PBDIT 244.4 37.4
Interest 13.8 4.30
Depreciation 72.4 10.1
Pre- tax profit 158.2 23
Non-current assets 723.9 98.2

Current assets 142.6 46.5
7% unsecured bond 40
Other non-current 212.4 20.2
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and current liabilities
Share capital 190 20

(50c/share)
Reserves 464.1 64.5
Abel Co’s current share price is $3.2 pershare and it is estimated that Adam Co’s price-to-earnings (PE) ratio is 30 % higher
than Abel Co’s PE ratio. After the acquisition, when Adam becomes part of Abel Co, it is estimated that Abel Co’s PE ratio will
increase by 17%.
It is estimated that the combined company’sannual after-tax earnings willincrease by $7.5 million due to the synergy benefits
resulting from combining Abel Co and Adam.
Required:
Estimate, showing all relevant calculations, the maximum premium Abel Co could pay to acquire Adam
Solution
Abel Co’s current value = $3.2 x 380m = $1,216m

Abel Co, profit after tax = $158·2m x 0·8 = $126·56m
Abel Co, PE ratio before acquisition = $1,216m/$126·56m = 9·61
Abel Co, PE ratio after acquisition = 9.61 x 1·17 = 11.24
Adam Co, PE ratio before acquisition = 9.61 x 1·3 = 12.49
Adam Co’s current value = 12.49 x ($23·0 x 0·8) = $230.6m
Value created from combined company

($126·56m + 0·5 x $23·0m x 0·8 + $7.5m) x 11.24 = $1,610·24
Maximum premium = ($1,610·24m) – ($1,216m + $230·6m) = $163.64m
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Syllabus D: Corporate Restructuring

Learning objectives
 Assess an organisational situation and determine whether a financial reconstruction is an
appropriate strategy for a given business situation.
 Assess the likely response of the capital market and/or individual suppliers of capital to any
reconstruction scheme and the impact their response is likely to have upon the value of the
organisation.
 Recommend, with reasons, strategies for unbundling parts of a quoted company.
 Evaluate the likely financial and other benefits of unbundling.
 Advise on the financial issues relating to a management buy-out and buy-in.
Types of Reconstruction
Financial Reconstruction
• It involves changing the capital structure of the firm.
• It also includes Leveraged Recapitalization, Leveraged Buy-Outs and Debt for Equity swap.
Portfolio Reconstruction
• It involves making additions to or disposals from companies businesses.
• It includes Divestments, Demergers, spin-offs or management buy-outs.
Organizational Reconstruction
• It involves changing the organizational structure of the firm.
Financial Restructuring Reasons:

• Company going towards Default
• Reconstruction for Value Creation
• Facing Downfall so restructure to improve Performance
• No innovation in products
• Statutory and Legal Compliance
Steps: - It is assumed that company is no longer operational.

Prepare a Liquidation Statement and calculate what each party gets if the company were to go in Liquidation.
Liquidation Statement
Realizable value of Assets XX
Liquidation Fees (xx)
Redundancy Cost (xx)
Secure Creditors (xx)
Unsecured Creditors
Trade Payable (xx)
Overdraft (xx)
Preference shares Ordinary Shares XX
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Steps: - Bond Holders/Banks is risk averse in nature therefore will not be ready to take uprisk.
Evaluate the effects of Restructuring Proposals on the following, (you may have to calculate in exam)
• Fund Flow Forecasts (Cash Inflow & Cash Outflow) from additional resources and investments
• Forecasted Earning per Share
• Market value on the basis of forecasted Cash Flows and P/E Ratios.
Analyze the Restructuring Proposal and check whether the parties will be better off under the proposed scheme compare to
liquidation.
• Increase in interest rate from existing level
• Offer higher nominal value to existing bondholders
• Offer majority shares to debt holders.
• Offer security to unsecured to debt holders
• Fixed Charge offered to existing floating charge debt holders.
Leveraged Recapitalization
• In leveraged Recapitalization a firm replaces the majority of its equity with a package of debt securities.
• The high level of debt in the company discourages other companies to make take-over bids.
• Companies should be
Relatively debt free
Consistent cash flows
Debt/Equity Swaps
• The value of the swap is determined usually at current market rates.
• Management may offer higher exchange values to share- and debt holders to force them participate in the swap.
Leveraged buy-outs (LBOs)

• It refers to the takeover of a company that utilizes mainly debt to finance the buyout and company is de-listed.
• A small group of individuals, possibly including existing shareholders and/or management buys all the company's
shares.
Advantages
• Protection from Share price movement
• No hostile bids
• Focus on Long-term Performance
• Minimized agency costs
Disadvantages
• Shares don’t trade publicly anymore.
• Bankrupt if the cash flow risk is too high.
•
Business Reorganisation
Unbundling is a process by which a large company with several different lines of business retains one or more core businesses
and sells off the remaining assets, product/service lines, divisions or subsidiaries.
Unbundling is a Portfolio Restructuring Strategy.
It includes the following:
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Divestment Demergers Sell - Offs
Spin - Off Carve Outs
Management Buy Out
Divestments
Divestment is the partial or complete sale or disposal of physical and organizational assets, the shutdown of facilities and
reduction in workforce in order to free funds for investment in other areas of strategic interest.
Divestments are undertaken for a variety of reasons. They may take place as a
 Corrective action in order to reverse unsuccessful previous acquisitions.

 Divestments may also be take place as a response to a cyclical downturn in the activities of a particular unit or line of
business. normally to reduce costs or to increase return on assets
Demergers
A demerger is the splitting up of corporate bodies into two or more separate bodies, to ensure share prices reflect the true
value of underlying operations.
A demerger is the opposite of a merger. It is the splitting up of a corporate body into two or more separate and independent
bodies.
Advantages of demergers
• The main advantage of a demerger is its greater operational efficiency and the greater opportunity to realize value. A two-
division company with one loss making division and one profit making, fast growing division may be better off by splitting
the two divisions. The profitable division may acquire a valuation well in excess of its contribution to the merged
company.
Disadvantages of demergers •Economies of scale may be lost.
• The smaller companies which result from the demerger will have lower turnover, profits and status than the group
before the demerger.
• There may be higher overhead costs as a percentage of turnovers.
• The ability to raise extra finance, especially debt finance, to support new investments and expansion may be reduced.
• Vulnerability to takeover may be increased.
Sell-offs
A sell-off is the sale of part of a company to a third party, generally for cash.
A sell-off is a form of divestment involving the sale of part of a company to a third party, usually another company. Generally,
cash will be received in exchange.
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Reasons for Sell-Off

• As part of its strategic planning, it has decided to restructure, concentrating management effort on particular parts of the
business. Control problems may be reduced if peripheral activities are sold off.
• It wishes to sell off a part of its business which makes losses, and so to improve the company's future reported
consolidated profit Performance.
• In order to protect the rest of the business from takeover, it may choose to sell a part of the business which is
particularly attractive to a buyer.
• The company may be short of cash.
• A subsidiary with high risk in its operating cash flows could be sold.
• A subsidiary could be sold at a profit.
Liquidations
The extreme form of a sell-off is where the entire business is sold off in liquidation. In a voluntary dissolution, the shareholders
might decide to close the whole business, sell off all the assets and distribute net funds raised to shareholders.
Spin-offs
In a spin-off, a new company is created whose shares are owned by the shareholders of the original company which is making
the distribution of assets.
In a spin-off, there is no change in the ownership of assets, as the shareholders own the same proportion of shares in the new
company as they did in the old company.
Reasons:
a) The change may make a merger or takeover of some part of the business easier in the future, or may protect parts of the
business from predators.
b) There may be improved efficiency and more streamlined management within the new structure.
c) It may be easier to see the value of the separated parts of the business now that they are no longer hidden within a
conglomerate.
d) The requirements of regulatory agencies might be met more easily within the new structure.
Carve-Out
• A carve-out is the creation of a new company, by detaching parts of the company and selling the shares of the new
company to the public.
• In a carve-out, a new company is created whose shares are owned by the public with the parent company retaining a
substantial fraction of the shares.
• Parent companies undertake carve-outs in order to raise funds in the capital markets. These funds can be used for the
repayment of debt or creditors or it can be retained within the firm to fund expansion. Carved out units tend to be highly
valued.
Management buy-outs (MBOs)
A management buy-out is the purchase of all or part of the business by its managers.
The main complication with management buy-outs is obtaining the consent of all parties involved.
Venture capital may be an important source of financial backing.
A management buy-out is the purchase of all or part of a business from its owners by its managers.
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Reasons for a management Buy-out

• The subsidiary may be peripheral to the group's mainstream activities, and no longer fit in with the group's overall
strategy.
• The group may wish to sell off a loss-making subsidiary, and a management team may think that it can restore the
subsidiary's fortunes.
• The parent company may need to raise cash quickly.
• The best offer price might come from a small management group wanting to arrange a buy-out.
• When a group has taken the decision to sell a subsidiary, it will probably get better co-operation from the management
and employees.
• The sale can be arranged more quickly than a sale to an external party.
• The selling organization is more likely to be able to maintain beneficial links with a segment sold to management rather
than to an external party.
Problems with buy-outs

• Managers may have little or no experience of entrepreneur skills.
• Difficulties in deciding on a fair price to be paid
• Convincing employees of the need to change working practices
• Inadequate cash flow to finance the maintenance and replacement of tangible fixed assets
• The maintenance of previous employees' pension rights
• Accepting the board representation requirement that many sources of funds will insist upon
• The loss of key employees.
• Maintaining continuity of relationships with suppliers and customers
Advantages of MBOs to disposing company

• To raise cash quickly to improve liquidity.
• Known buyer
• If subsidiary is loss making then sale to management will be better financially than liquidation
• Better publicity
Advantages of MBOs to management

• It preserves their jobs.
• It offers a chance to become owner of the company
• It is quicker than starting a similar business from scratch
• They can carry out their own strategies, no longer required approval from head office.
• They have detail knowledge and relevant skills.
Buy-ins
'Buy-in' is when a team of outside managers, as opposed to managers who are already running the business, mount a
takeover bid and then run the business themselves.
A management buy-in might occur when a business venture is running into trouble, and a group of outside managers see an
opportunity to take over the business and restore its profitability. They may bring fresh ideas and experience and raise better
finances for company.
PAST PAPER ACCA EXAMPLE

Doric Co, a listed company, has two manufacturing divisions: parts and fridges. It has been manufacturing parts for
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domestic refrigeration and air conditioning systems for a number of years, which it sells to producers of fridges and
air conditioners worldwide. It also sells around 30% of the parts it manufactures to its fridge production division. It
started producing and selling its own brand of fridges a few years ago. After limited initial success, competition in the
fridge market became very tough and revenue and profits have been declining. Without further investment there are
currently few growth prospects in either the parts or the fridge divisions. Doric Co borrowed heavily to finance the
development and launch of its fridges, and has now reached its maximum overdraft limit. The markets have taken a
pessimistic view of the company and its share price has declined to 50c per share from a high of $2·83 per share
around three years ago.
Extracts from the most recent financial statements:

Financial position as at 30 November 2010 $m Assets
Non-Current Assets
Land and buildings 70
Machinery and equipment 50
––––
120
––––
Current Assets
Inventory 180
Receivables 40
––––
220
––––
Total Assets 340
––––
Equity and Liabilities
Share capital (40c per share par value) 40
Reserves 20
––––
60
––––
Non-Current Liabilities
7% Unsecured bonds 2020 120
Other unsecured loans (currently 51/3% interest) 30
––––
150
––––
Current Liabilities
Payables 70
Bank overdraft (currently 10% interest) 60
––––
130
––––
Total Liabilities and capital 340
––––
Income for the year ended 30 November 2010
$m
Sales revenue: Parts division 170

Fridge division 340
Costs prior to depreciation, interest payments and tax: Parts division (120)
Fridge division (370)
Tax allowable depreciation (18)
Finance cost (interest) (16)
Tax Nil
––––
Loss (14)
––––
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A survey from the refrigeration and air conditioning parts market has indicated that there is potential for Doric
Co to manufacture parts for mobile refrigeration units used in cargo planes and containers. If this venture goes
ahead then the parts division before-tax profits are expected to grow by 5% per year. The proposed venture
would need an initial one-off investment of $50 million.
Suggested proposals
The Board of Directors has arranged for a meeting to discuss how to proceed and is considering each of the
following proposals:
1. To cease trading and close down the company entirely.
2. To undertake corporate restructuring in order to reduce the level of debt and obtain the additional
capital investment required to continue current operations.
3. To close the fridge division and continue the parts division through a leveraged management buy-out,
involving some executive directors and managers from the parts division. The new company will then
pursue its original parts business as well as the development of the parts for mobile refrigeration
business, described above. All the current and long-term liabilities will be initially repaid using the
proceeds from the sale of the fridge division. The finance raised from the management buy-out will
pay for any remaining liabilities, the additional capital investment required to continue operations
and re-purchase the shares at a premium of 20%.
The following information has been provided for each proposal:
Cease trading
Estimated realisable values of assets not sold as going concern are:
Land and buildings 60

Machinery and equipment 40
Inventory 90
Receivables 20
Corporate restructuring
The existing ordinary shares will be cancelled and ordinary shareholders will be issued with 40 million
new $1 ordinary shares in exchange for a cash payment at par. The existing unsecured bonds will be
cancelled and replaced with 270 million of $1 ordinary shares. The bond holders will contribute $90 million
in cash. All the shares will be listed and traded. The bank overdraft will be converted into a secured ten-
year loan with a fixed annual interest rate of 7%. The other unsecured loans will be repaid. In addition to
this, the directors of the restructured company will get 4 million $1 share options for an exercise price
of $1·10, which will expire in four years.
An additional one-off capital investment of $80 million in machinery and equipment is necessary to
increase sales revenue for both divisions by 7%, with no change to the costs. After the one-off 7% growth,
sales will continue at the new level for the foreseeable future.
It is expected that the Doric’s cost of capital rate will reduce by 550 basis points following the restructuring
from the current rate.
Management buy-out
The parts division is half the size of the fridge division in terms of the assets and liabilities attributable to it.
If the management buy-out proposal is chosen, a pro rata additional capital investment will be made to
machinery and equipment on a one-off basis to increase sales revenue of the parts division by 7%. Sales
revenue will then continue at the new level for the foreseeable future.
All liabilities categories have equal claim for repayment against the company’s assets.
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It is expected that Doric’s cost of capital rate will decrease by 100 basis points following the management
buy-out from the current rate.
The following additional information has been provided:
Redundancy and other costs will be approximately $54 million if the whole company is closed, and pro rata
for individual divisions that are closed. These costs have priority for payment before any other liabilities in
case of closure. The taxation effects relating to this may be ignored.
Corporation tax on profits is 20% and losses cannot be carried forward for tax purposes. Assume that tax is
payable in the year incurred.
All the non-current assets, including land and buildings, are eligible for tax allowable depreciation of 15%
annually on the book values. The annual reinvestment needed to keep operations at their current levels is
roughly equivalent to the tax allowable depreciation. The $50 million investment in the mobile
refrigeration business is not eligible for any tax allowable depreciation.
Doric’s current cost of capital is 12%.
Prepare a report for the Board of Directors, evaluating the financial and non-financial impact of all the
three proposals to Doric Co’s main stakeholder groups, that includes:
a) A discussion of the impact of each proposal on the existing shareholders, the unsecured bond
holders, and the executive directors and managers involved in the management buy-out. Suggest
which proposal is likely to be selected.
Answer:
Corporate Restructuring and Management Buy-Out Shareholders
The shareholders would benefit from either proposal two or three, as opposed to the first proposal, as
they stand to gain some funds. The restructuring proposal requires them to pay $40m cash for new shares
but lose their control of the company (the shareholding falls to just under 13%). On the other hand the
statement of financial position looks robust with a $20m cash float and bank overdraft facilities probably
available at previous levels . This may make the company more successful in the future, as directors are
less restricted by covenants. The value at $256·3m currently only gives existing shareholders a share (or
stake) of about $33·3m (13% x $256·3m), which is less than the amount they would inject. The
shareholders would benefit immediately if the management buy-out option is taken because they will
receive a premium on the share price, although this may still be lower than when the company’s share
price was at its height. Therefore the shareholders need to weigh up whether they would like to possibly
benefit from future company prospects (not evident at the moment) or whether they would like to sell
their shares for 60c per share. They would probably opt for the management buy-out.
Unsecured Bond Holders
The unsecured bond holders’ position is not dissimilar to the shareholders’ position in that with the
restructuring, their financial position depends on the future success of the company, but with the
management buy-out they benefit from receiving the full repayment of their initial investment. However,
their preferred proposal is probably more difficult to judge. With the restructuring option they would
become the majority shareholder with just over 87% of the company for a total investment of $210m. They
would be able to play a major part in influencing the management’s decision possibly with representation
on the Board. However, they would be exposed to additional risk as equity holders, as opposed to being
debt holders. The value attributable to them based on perpetuity cash flows is $223m ($256·3 x 87%)
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approximately, which is more than their investment. Like the shareholders they would benefit from any
future projects that the re-structured business undertakes. They would also receive the shares at a
significant discount, 270m shares for $210m which is 77·7c per $1 par value. The ability to influence the
Board and the possibility of obtaining a higher return than their investment from almost the start may
sway them to accept the restructuring option. On the other hand, the management buy-out pays them
what is due immediately, but they cannot participate in future benefits. Bond holders may therefore be
more tempted to opt for the restructuring when compared to shareholders.
Directors and Management Participating in the Management Buy-Out
If the restructuring is considered as opposed to liquidation then clearly a significant benefit to the
management and directors is that they would retain their employment, unless the new shareholder
owners decide to terminate some of their contracts. The possibility of the offer of the share options is
interesting. At first the $1·10 exercise price may seem generous as the directors would be able to exercise
when the price of shares increase by just 10%. However, it is unlikely that the share price will start at $1
per share. If the estimate of the value to perpetuity of $256·3m is taken against the total number of shares
of 310m, this gives a theoretical share price of 82·7c per share. This means that the share price needs to
increase by over 33% before the option will become in-the-money. The option is currently well out-of-
money and would have a low value. Given the asymmetric payoff of the option and the need to increase
the price dramatically, directors and managers may be tempted to act in an excessively risky manner, to
the detriment of the shareholders and other stakeholders. Indeed research has shown that the presence of
share options in individual pay structure do make option holders behave in a more risky manner compared
to pay structures which do not contain options. The management buy-out may influence different classes
of managers and directors very differently. For those who participate in the management buy-out, the
calculations seem to indicate a clear benefit of a gain net of the cost of the buy-out. It would seem that by
having a 5% growth, the value has increased to more than 50% of the initial cost 17 of the buy-out,
although some unreasonable assumptions have been made. For managers and directors not participating
in the buy-out, it is likely that they will lose their employment once the fridge division is sold.
Conclusion Given that the shareholders will probably prefer the management buy-out, and as it appears to
have a significant advantage for the participating managers, it is likely that this will be the option that is
preferred. Although some parties may not approve of the option, it is unlikely that their ‘voice’ will be
strong enough to alter the decision.
*For further clarity please see the entire question to understand it in its entirety
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SYLLABUS E: TREASURY AND ADVANCE RISK

MANAGEMENT
Learning objectives
 Discuss the role of the treasury management function within: i) The short term management of
the organisation’s financial resources ii) The longer term maximisation of corporate value iii) The
management of risk exposure.
 Discuss the operations of the derivatives market, including: i) The relative advantages and
disadvantages of exchange traded versus OTC agreements ii) Key features, such as standard
contracts, tick sizes, margin requirements and margin trading iii) The source of basis risk and how
it can be minimised. iv) Risks such as delta, gamma, vega, rho and theta, and how these can be
managed.
 Assess the impact on an organisation to exposure in translation, transaction and economic risks
and how these can be managed.
 Evaluate, for a given hedging requirement, which of the following is the most appropriate
strategy, given the nature of the underlying position and the risk exposure: i) The use of the
forward exchange market and the creation of a money market hedge ii) Synthetic foreign
exchange agreements (SAFEs) iii) Exchange-traded currency futures contracts iv) Currency swaps
v) FOREX swaps vi) Currency options.
 Advise on the use of bilateral and multilateral netting and matching as tools for minimising
FOREX transactions costs and the management of market barriers to the free movement of
capital and other remittances.
 The use of financial derivatives to hedge against interest rate risk a) Evaluate, for a given hedging
requirement, which of the following is the most appropriate given the nature of the underlying
position and the risk exposure: i) Forward Rate Agreements (FRAs) ii) Interest rate futures iii)
Interest rate swaps iv) Interest rate options (including collars).
Role of Treasury
1. Working Capital Management

2. Cash Forecasting
3. Cash Management
4. Investment Management
5. Treasury Risk Management
6. Credit Rating Agency Relations
7. Bank Relation
8. Fund Raising
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Centralised VS Nationalised VS Global Treasury System
Organising treasury activities on a regional basis would be consistent with what is happening in the group overall.
Other functions will be organised regionally. A regional treasury function may be able to achieve synergies with
them and also benefit from information flows being organised based on the regional structure. If, as part of a re-
organisation, some treasury activities were to be devolved outside to a bank or other third party, it would be
simpler to arrange for a single provider on a regional basis than arrange for separate providers in each country. A
regional function will avoid duplication of responsibilities over all the countries within a region. A regional
function will have more work to do, with maybe a greater range of activities, whereas staff based nationally may
be more likely to be under-employed. There may be enough complex work on a regional basis to justify
employing specialists in particular treasury areas which will enhance the performance of the function. It may be
easier to recruit these specialists if recruitment is done regionally rather than in each country. Regional centres
can carry out some activities on a regional basis which will simplify how funds are managed and mean less cost
than managing funds on a national basis. These include pooling cash, borrowing and investing in bulk, and netting
of foreign currency income and expenditure. Regional centres could in theory be located anywhere in the region,
rather than having one treasury function based in each country. This means that they could be located in the
most important financial centres in each region or in countries which offered significant tax advantages.
From the point of view of directors and senior managers, it will be easier to enforce common standards and risk
management policies on a few regional functions than on many national functions with differing cultures in
individual countries. As discussed above, reorganising treasury functions regionally will be consistent with the
way other functions are organised. Reorganising the treasury function regionally will be one way of dealing with
the problem of having a single, overstretched, global function. A regional function could employ experts with
knowledge of the regulations, practices and culture of the major countries within the region.
It may be more difficult for a global function to recruit staff with local expertise. There may be practical issues
why individual countries prefer to deal with regional functions rather than a global function, for example, a
regional function will be based in the same, or similar, time zone as the countries in its region. A regional function
may have better ideas of local finance and investment opportunities. There may, for example, be better
alternatives for investment of the surplus funds than the centralised function has been able to identify
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FOREIGN CURRENCY RISK MANAGEMENT
FOREX
How to Convert How Currency Types of Foreign Hedging Methods

Currency Fluctuates Risk
Quotes Quoted Example (Pakistan) Converting foreign currency to local

Direct Local/foreign Rs. 100/1$ Multiply eg. $10= (100 X 10) = Rs. 1,000
Indirect Foreign/local $0.01/1Re. Divide eg. $10 = (10/0.01) = Rs. 1,000
QUOTES
EXCHANGE RATE CONVERSION
Bid Offer/ask
Bank Buy Bank Sell
1.2320 $/£ 1.2324 $/£
When dealing with converting foreign currency, it is important to consider the following points ➢Always consider
yourself at Adverse Position
In case of Receipt (Lower Receipt) In case of Payments (Higher Payment)
➢ In Currency Division
Divide with Higher

Currency Rate
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Divide with Lower

In case of Receipt, Sell Currency, Exports, Gain or Income
Currency Rate
In case of Payment, Buy Currency, Import, Loss or Expense
HOW CURRENCY FLUCTUATES

Supply & Demand
• Speculation
• Export and Import
• Foreign Direct Investment (FDI)
• Foreign Currency Loans
PURCHASING POWER PARITY (PPP)
It follows ‘’ law of one price’’. Commodities price between two economies should have the same value, if price
changes because of inflation, exchange rate will absorb this impact and will change.
According to PPP the exchange rate between two currencies can be explained by the difference between inflation
rated in respective countries.
PPP says country with HIGH inflation rate normally faces the decrease in its currencies value and a country with a
LOW inflation rate has an expectation of increase in its currencies value.
The businesses normally use PPP for calculation of expected spot rate against the forward rate offered by banks.
𝟏 + 𝒊𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝒊𝒏 𝟏𝒔𝒕 𝒄𝒐𝒖𝒏𝒕𝒓𝒚

𝑭𝒖𝒕𝒖𝒓𝒆 𝑺𝒑𝒐𝒕 𝑹𝒂𝒕𝒆 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑺𝒑𝒐𝒕 𝒓𝒂𝒕𝒆 𝑿
𝟏 + 𝒊𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝒊𝒏 𝟐𝒏𝒅 𝒄𝒐𝒖𝒏𝒕𝒓𝒚
INTEREST RATE PARITY
This concept says that the difference between 2 currencies worth can be explained by interest rate structure in
the countries of these 2 currencies.
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According to IRP a country with a high interest rate structure normally has a currency at discount in relation to
another currency whose country has a low interest rate structure & vice versa.
HIGH INTEREST in country LOWER will be the value of currency
LOWER INTEREST in country HIGHER will be the value of currency
We can predict forward rate between two currencies by using interest rate parity concept as follows;
𝟏 + 𝒊𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝒊𝒏 𝟏𝒔𝒕 𝒄𝒐𝒖𝒏𝒕𝒓𝒚

𝑭𝒖𝒕𝒖𝒓𝒆 𝑺𝒑𝒐𝒕 𝑹𝒂𝒕𝒆 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑺𝒑𝒐𝒕 𝒓𝒂𝒕𝒆 𝑿
𝟏 + 𝒊𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝒊𝒏 𝟐𝒏𝒅 𝒄𝒐𝒖𝒏𝒕𝒓𝒚
FISHER EFFECT
This concept tells us the relation between interest rate and inflation.
It assumes that real interest rate between two economies is same and nominal interest rates are different
because of inflation.
 Countries with relatively high rate of inflation will generally have high nominal rates of interest, partly
because high interest rates are a mechanism for reducing inflation.
 USA 1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate]
 UK 1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate]
FOREIGN EXCHANGE RISK
TRANSLATION RISK
• Translation risk refers to the possibility of accounting loss that could occur because of foreign subsidiary, as a
result of the conversion of the value of assets and liabilities which are denominated in foreign currency, due
to movements in exchange rate. Parent company will face this risk if subsidiary is in depreciating currency
environment.
• This risk is involved where a parent company has foreign subsidiaries in a depreciating currency environment.
TRANSLATION RISK HEDGING

• Arrange Maximum Borrowing in Subsidiary Co. currency.
• Maintain Surplus Assets in Parent Co. currency which will reduce the overall exposure of Translation risk.
ECONOMIC RISK
• Long-term movement in the rate of exchange which puts the company at some competitive disadvantage is
known as economic risk. E.g. if competitor currency starts depreciating or our company currency starts
appreciating.
• It may affect a company’s Performance even if the company does not have any foreign currency transactions.
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ECONOMIC RISK HEDGING

• Shift manufacturing to cheaper labor areas
• Create innovative and differentiate units to create brand loyalty
• Diversify into new products and into new markets
TRANSACTION RISK - INTERNAL HEDGING METHOD
TRANSACTION RISK
• Transaction risk refers to adverse changes in the exchange rate before the transaction is finally settled.
Hedging Methods
Internal Hedging Methods
• Invoice in Home Currency
• Matching Foreign Currency (Receipts and Payments)
• Netting
Invoice in Home Currency

Suitability: Monopoly power & customer has no option. Supplier agrees to invoice in your currency.
Matching Foreign Currency (Receipts and Payments)

Match the balances of receipts and payments. Timing and currencies should be same
Netting
Netting is a process in which all transaction of group companies are converted into the same currency and then
credit balances are netted off against the debit balances, so that only reduced net amounts remain due to be paid
or received.
Step 1:
Convert all transactions of group companies or in case of multilateral netting the other non-group companies in
to the same currency (normally the parent Co currency) using mid spot rates.
Step 2:
Prepare the Transaction matrix (Netting Table)
USA UK Europe Total Receipts

Receipts USA X x x Xx
Read Across UK X x x Xx
Europe X x x Xx
Total Payments (xx) (xx) (xx)
Total Receipts Xx xx xx
Net Amounts (xx) (xx) xx
Step 3:
Companies with negative balance will pay the amounts to companies having positive balance.
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Netting is a process whereby the debt between group member companies or between group members and other
parties can be reduced.
Advantages:
 The number of currency transactions can be minimized, saving transaction costs and focusing the transaction
risk onto a smaller set of transactions that can be more effectively hedged.
 It may also be the case, if exchange controls are in place limiting currency flows across borders, that balances
can be offset, minimizing overall exposure. Where group transactions occur with other companies the benefit
of netting is that the exposure is limited to the net amount reducing hedging costs and counterparty risk.
Disadvantages:
 Some jurisdictions do not allow netting arrangements, and there may be taxation and other cross border
issues to resolve. It also relies upon all liabilities being accepted – and this is particularly important where
external parties are involved.
 There will be costs in establishing the netting agreement and where third parties are involved this may lead
to re-invoicing or, in some cases, re-contracting.
Example
The following cash flows are due in three months between KRish Co and three of its subsidiary companies. The
subsidiary companies are LALA Co, based in the United States (currency US$), Trudeau Co, based in Canada
(currency CAD) and Shinzo Co, based in Japan (currency JPY).Amounts are in million.
Owed by Owed to Amount

KRish Co LALA Co US$ 4·5 million
KRish Co Trudeau Co CAD 1·1 million
Shinzo Co Trudeau Co CAD 3·2 million
Shinzo Co LALA Co US$ 1·4 million
Trudeau Co LALA Co US$ 1·5 million
Trudeau Co KRish Co CAD 3·4 million
LALA Co Shinzo Co JPY 320 million
LALA Co KRish Co US$ 2 . 1
Exchange rates available to KRish Co

US$/£1 CAD/£1 JPY/£1
Spot 1·2938–1·2962 1·6690–1·6710 131·91–133·59
Calculate net amount owed by or to each part using netting approach
SOLUTION:
Based on spot mid-rates: US$1·295/£1; CAD1·67/£1; JPY132·75/£1
In £000
UK USA CANADA JAPAN TOTAL

UK - 1621.6 2035.9 - 3657.5
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USA 3474.9 - 1158.2 1081.08 5714.3

CANADA 658.7 - - 1916.2 2574.9
JAPAN - 2410.5 - - 2410.5
TOTAL PAYMENT 4133.6 4032.1 3194.2 2997.3
TOTAL RECEIPTS 3667.5 5714.3 2574.9 2410.5
NET (476.1) 1682.2 (619.3) (586.8)
RECEIPTS/(PAYMENT)
Each of Krish Co, Trudeau Co and Shinzo Co will make payments of £ equivalent to the amount given above to
Lala Co. Multilateral netting involves minimising the number of transactions taking place through each country’s
banks. This would limit the fees that these banks would receive for undertaking the transactions and therefore
governments who do not allow multilateral netting want to maximise the fees their local banks receive. On the
other hand, some countries allow multilateral netting in the belief that this would make companies more willing
to operate from those countries and any banking fees lost would be more than compensated by the extra
business these companies and their subsidiaries bring into the country
TRANSACTION RISK-EXTERNAL HEDGING METHOD
Forward Contract:
A forward contract is an agreement made today between a buyer and seller to exchange a specified quantity of
an underlying asset at a predetermined future date, at a price agreed upon today. It is a legally binding contract
between two parties to buy or sell in future at a pre-determined rate and a pre-specified date.
Example
Home Currency is British Pound £ , Exports receipts = $ 500,000 after six months
Spot Rate = 1.30 – 1.31 $/£
Six month forward rate = 1.32 – 1.33 $/£
Expected Net Receipt if Forward Contract is taken = $500,000/1.33 = £ 375,940
Advantages
• Eliminate currency risk, as foreign exchange costs are determined upfront.
• They are tailor made and can be matched against the time period of exposure as well as for the cash size of
the exposure, therefore they are referred to as a complete hedge.
• They are easy to understand.
Disadvantages
• It is subject to default risk.
• There may be difficult to find counter-party.
• They are legally binding so difficult to cancel.
Money Market Hedging:

Use of the short-term money markets to borrow or deposit funds. This gives the company the opportunity to
exchange currency today at the prevailing spot rate.
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Steps of Setting-up Money Market Hedge

1. Borrow – borrow funds in the currency in which you need the money.
2. Translate – exchange the funds today avoiding exposure to fluctuations in the rate.
3. Deposit – deposit the funds in the currency in which you eventually want the funds until such time as you
will need them.
Foreign Currency Receipts / Exports Steps:

a) Calculate present value of foreign currency using borrowing rate of foreign currency and take loan of this
amount.
Present Value = Foreign Currency amount
(1+ borrowing rate of FCY)
a) Convert that present value into home currency using spot exchange rate.
b) Deposit the home currency at the deposit rate of home currency. Total receipts= Home currency × (1 +
lending rate of HCY)
c)
FOREIGN CURRENCY PAYMENTS/EXPORTS
Steps:
a) Calculate present value of foreign currency using lending rate of foreign currency and deposit that amount.
Present Value = Foreign Currency amount
(1+ lending rate of FCY)
a) Convert that present value into home currency using spot exchange rate.
b) Borrow the home currency at the borrowing rate of home currency.
Total payment= Home currency × (1 + borrowing rate of HCY )
 A money market hedge is a mechanism for the delivery of foreign currency, at a future date, at a specified
rate without recourse to the forward FOREX market. If a company is able to achieve preferential access to the
short term money markets in the base and counter currency zones then it can be a cost effective substitute
for a forward agreement. However, it is difficult to reverse quickly and is cumbersome to establish as it
requires borrowing/lending agreements to be established denominated in the two currencies.
 With relatively small amounts, the OTC market represents the most convenient means of locking in exchange
rates. Where cross border flows are common and business is well diversified across different currency areas
then currency hedging is of questionable benefit. Where, as in this case, relatively infrequent flows occur
then the simplest solution is to engage in the forward market for hedging risk. The use of a money market
hedge as described may generate a more favorable forward rate than direct recourse to the forex market.
However the administrative and management costs in setting up the necessary loans and deposits are a
significant consideration.
DERIVATIVES
• Future Settlement
• Initial amount to be paid is nil or low
• Drive their value from some underlying
• Traded in two types of market
• (Over the counter Market & Exchange Traded)
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Over-the-Counter Derivatives Exchange-Traded Derivatives

Customized Contracts Standardized Contracts
Any Amount Standardized Contract Size (e.g. $ 62,500)
Available in any Currency Major Currencies
Settlement on any date Settlement Date – Mar/Jun/Sept/Dec
No Initial margin requirement Initial Margin Requirement
Gain or Loss settled on daily basis using ‘Mark
Gain or Loss settled at maturity
to Market”
High Risk of Default
Counter Party is another Investor Counter Party is clearing house.
E.G FORWARD CONTRACTS E.G FUTURE CONTACTS
FUTURE CONTRACT
• Futures are standardized contracts traded on a regulated exchange to make or take delivery of a specified
quantity of a foreign currency, or a financial instrument at a specified price, with delivery or settlement at a
specified future date.
• They are Exchange Traded derivatives contracts.
• Standardized contract sizes and are available in only major currencies
• There are four settlement dates MAR/JUNE/SEPT/DEC.
• Minimum movement is in ticks
• Tick = Contract size x 0.01%
• For Japanese ¥ = Contract size x 0.0001%
• If you want to buy any currency in Future Buy future contracts
• If you want to sell any currency in Future Sell future contracts
• Think according to contract size currency
Example 1
Country USA, Currency $
Export £300,000
Contract size £62,500
Solution
Sell £ future contracts
Example 2
Country UK, Currency £

Export $600,000
Contract Size £62,500
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Solution
Buy £ Future Contracts
Example 3
Currency €
Export £600,000
Contract size £62,500
Solution
Sell £ Future Contracts
Example 4
Currency ¥
Imports $1,000,000
Contract size ¥1.5million
Solution
Sell ¥ Future Contracts
Steps in future contract hedging

1) Identify the amount of currency to be hedged
2) Decide whether to buy or sell future
3) Identify the settlement date expiring immediately after the payment is due to be paid or received
Transaction Amount
4) Calculate no of contracts 
Contract Size
If transaction currency is different from the contract size currency then using future rate convert that
transaction amount currency into the same currency of contract size.
.
5) Close the future contract by taking opposite position:
Buy £ Future 1.50 $/£
Sell £ Future 1.60 $/£
Gain 0.10 $/£ x No.of Contracts x Contract size
Gain or loss will be in $ amount if $ amount is not home currency, then using transaction date spot rate,
convert this into home currency.
6) Actual buying or selling of currency in market xxx
Gain or loss in future contract xx
Net Receipt or payment xx
Example:
st
Home Currency £ 1 Jan
Exports $400,000 at 1st May
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Spot 1.40-1.41 $/£

June Future 1.45 $/£
March Future 1.44 $/£
Contract Size £ 25,000
st
On 1 May
Spot 1.466-1.467 $/£
June Future 1.47 $/£
Answer:
Exports $400,000
Buy £ Future
June Contract @ 1.45 $/£
Calculate no of contracts 
= 11
Close the Future by
Buy Future @ 1.45 Sell Future @ 1.47
0.02 $/£ x 11 x £25000 = $5500
Gain £ = $5500/ 1.4670$/£ = £ 3749
Sell 400,000 at actual market rate
400000/1.4670$/£ = £272665
Gain = £3749
Total Receipt £276414
Types of Future
TYPE: 1
1. Opening Future rate is given
2. Closing Future rate is given
3. Closing Spot rate is given
TYPE: 2
1. Opening Future rate is given
2. Closing Future rate is not given
3. Closing Spot rate is given
BASIS = Current Spot rate – Opening Future Rate
Difference
Remaining Basis = x remaining months
Closing Future = Closing Spot +/- Remaining Basis
EXAMPLE:
Home Currency € Now 1st June
st
Import $600,000 1 Nov
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Spot rate - 1.2020 – 1.2022 $/ €

Sept Future - 1.2420 $/ €
Dec Future - 1.2520 $/ €
• Contract size € 25,000
st
• 1 Nov Spot rate - 1.2710 – 1.2720 $/ €
Solution:
Imports $ 600,000
Sell € future
Dec contract @ 1.2520 $/ €
No of Contract = (600,000 / 1.2520) / 25,000 = 19 Contracts
Basis = 1.2020 -1.2520 = (0.05/7) x 2 = 0.0143
Closing Future = Closing Spot +/- Remaining Basis
= 1.2710 + 0.0143
= 1.2853
Close the future contract

Sell € Future - 1.2520 $/ €
Buy € Future - 1.2853 $/ €
LOSS 0.0333 x 19 x 25,000 = $15,818

LOSS in € = $ 15,818/1.2710 $/ €= 12,445
BUY $ 600,000 in Actual Market

• 600,000 / 1.2710 = € 472,069
LOSS = €12,445
Total Payment = € 484,514
Type 3
1) Opening Future Rate is Given
2) Closing Future Rate is not Given
3) Closing Spot Rate is not Given
It is assumed that all parity theories hold true & forward rate will be equal to the Future Spot Rate.
FUTURE CONTRACT
Step 1:
Identify the amount of currency to be hedged Step 2:
Decide whether to buy or sell future
If you want to buy currency buy that currency future
If you want to sell currency sell that currency future
Think according to the contract size currency
Step 3:
Identify the settlement date expiring immediately after the payment is due to be paid or received
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Step 4:
If transaction currency is different from the contract size currency then using future rate convert that transaction
amount currency into the same currency of contract size.
Step 5:
BASIS = Current Spot rate – Opening Future Rate
Basis Risk – It’s the risk that current spot will not reduce over the time to exactly match the opening future rate.
Lock in Rate= opening future rate ± Remaining Basis (opposite to normal rule)
Convert the foreign currency into home currency using Lock in rate.
It is a legally binding contract between two parties to buy or sell in future at a pre-determined rate and a pre-
specified date.
Advantages
 The commission charges for futures trading are relatively small as compared to other type of investments.
 Futures contracts are highly leveraged financial instruments which permit achieving greater gains using a
limited amount of invested funds.
 It is possible to open short as well as long positions. Position can be reversed easily.
 Lead to high liquidity.
Disadvantages
 Leverage can make trading in futures contracts highly risky for a particular strategy.
 Futures contract is standardized product and written for fixed amounts and terms.
 Lower commission costs can encourage a trader to take additional trades and lead to over-trading.
It offers only a partial hedge.
 It is subject to basis risk which is associated with imperfect hedging using futures.
Imagine it is 10 July 2017. A UK company has a US$6.65m invoice to pay on 26 August 2014. They are concerned
that exchange rate fluctuations could increase the £ cost and, hence, seek to effectively fix the £ cost using
exchange traded futures. The current spot rate is $/£1.7111.
Research shows that $/£ futures, where the contract size is denominated in £, are available on the CME Europe
exchange at the following prices:
September expiry – 1.7103
December expiry – 1.7086
The contract size is £100,000 and the futures are quoted in US$ per £1.
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SETTING UP THE HEDGE

1. US$6.65m payment
2. Settlement Date – September:
3. Sell £ future
4. Contracts 39
($6.65m ÷ 1.7103)/£100,000 ≈ 39.

Outcome on 26 August:
On 26 August the following was true:
Spot rate – $/£ 1.6577
September futures price – $/£1.6575 Gain/loss on futures:
As the exchange rate has moved adversely for the UK company a gain should be expected on the futures hedge.
$/£
Sell – on 10 July 1.7103
Buy back – on 26 August (1.6575)

Gain 0.0528
This gain is in terms of $ per £ hedged. Hence, the total gain is:
0.0528 x 39 contracts x £100,000 = $205,920
Alternatively, the contract specification for the futures states that the tick size is 0.0001$ and that the tick value is
$10. Hence, the total gain could be calculated in the following way:
0.0528/0.0001 = 528 ticks
528 ticks x $10 x 39 contracts = $205,920

This gain is converted at the spot rate to give a £ gain of:
$205,920/1.6577 = £124,220
All of the above is essential basic knowledge. As the exam is set at a particular point in time you are unlikely to be
given the futures price and spot rate on the future transaction date. Hence, an effective rate would need to be
calculated using basis. Alternatively, the future spot rate can be assumed to equal the forward rate and then an
estimate of the futures price on the transaction date can be calculated using basis. The calculations can then be
completed as above.
INITIAL MARGIN
When a futures hedge is set up the market is concerned that the party opening a position by buying or selling
futures will not be able to cover any losses that may arise. Hence, the market demands that a deposit is placed
into a margin account with the broker being used – this deposit is called the ‘initial
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Margin’.
These funds still belong to the party setting up the hedge but are controlled by the broker and can be used if a
loss arises. Indeed, the party setting up the hedge will earn interest on the amount held in their account with
their broker. The broker in turn keeps a margin account with the exchange so that the exchange is holding
sufficient deposits for all the positions held by brokers’ clients.
In the scenario above the CME contract specification for the $/£ futures states that an initial margin of $1,375 per
contract is required.( assumption)
Hence, when setting up the hedge on 10 July the company would have to pay an initial margin of $1,375 x 39
contracts = $53,625 into their margin account. At the current spot rate the £ cost of this would be $53,625/1.7111
= £31,339.
MARKING TO MARKET
In the scenario given above, the gain was worked out in total on the transaction date. In reality, the gain or loss is
calculated on a daily basis and credited or debited to the margin account as appropriate. This process is called
‘marking to market’.
Hence, having set up the hedge on 10 July a gain or loss will be calculated based on the futures
Settlement price of $/£1.7092 on 11 July. This can be calculated in the same way as the total gain was calculated:
$/£
Sell – on 10 July 1.7103
Settlement price – 11 July (1.7092)
Gain 0.0011
Gain in ticks – 0.00110/0.0001 = 11
Total gain – 11 ticks x $10 x 39 contracts = $4,290
This gain would be credited to the margin account taking the balance on this account to $53,625 + $4,290 =
$57,915.
At the end of the next trading day (Monday 14 July), a similar calculation would be performed:
$/£
Settlement price – 11 July 1.7092
Gain 0.0012
Gain in ticks – 0.0012/0.0001 = 12
Total gain – 12 ticks x $10 x 39 contracts = $4,680.
This gain would also be credited to the margin account taking the balance on this account to $57,915 + $4,680 =
$62,595.
Similarly, at the end of the next trading day (15 July), the calculation would be performed again:
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$/£
Settlement price – 14 July 1.7080
$/£
Loss 0.0055
Loss in ticks – 0.0055/0.0001 = 55

Total loss – 55 ticks x $10 x 39 contracts = $21,450.
This loss would be debited to the margin account, reducing the balance on this account to $62,595 – $21,450 =
$41,145.
This process would continue at the end of each trading day until the company chose to close out their position by
buying back 39 September futures.
MAINTENANCE MARGIN, VARIATION MARGIN AND MARGIN CALLS

Having set up the hedge and paid the initial margin into their margin account with their broker, the company may
be required to pay in extra amounts to maintain a suitably large deposit to protect the market from losses the
company may incur. The balance on the margin account must not fall below what is called the ‘maintenance
margin’. In our scenario, the CME contract specification for the $/£ futures states that a maintenance margin of
$1,250 per contract is required. Given that the company is using 39 contracts, this means that the balance on the
margin account must not fall below 39 x $1,250 = $48,750. As you can see, this does not present a problem on 11
July or 14 July as gains have been made and the balance on the margin account has risen. However, on 15 July a
significant loss is made and the balance on the margin account has been reduced to $41,340, which is below the
required minimum level of $48,750.
Hence, the company must pay an extra $7,410 ($48,750 – $41,340) into their margin account in order to maintain
the hedge. This would have to be paid for at the spot rate prevailing at the time of payment unless the company
has sufficient $ available to fund it. When these extra funds are demanded it is called a ‘margin call’.The
necessary payment is called a ‘variation margin’.
If the company fails to make this payment, then the company no longer has sufficient deposit to maintain the
hedge and action will be taken to start closing down the hedge. In this scenario, if the company failed to pay the
variation margin the balance on the margin account would remain at $41,340, and given the maintenance margin
of $1,250 this is only sufficient to support a hedge of $41,340/$1,250 ≈ 33 contracts. As 39 futures contracts were
initially sold, six contracts would be automatically bought back so that the markets exposure to the losses the
company could make is reduced to just 33 contracts. Equally, the company will now only have a hedge based on
33 contracts and, given the underlying transaction’s need for 39 contracts, will now be under hedged.
Conversely, a company can draw funds from their margin account so long as the balance on the account remains
at, or above, the maintenance margin level, which, in this case, is the $48,750 calculated.
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SAFE (Synthetic Foreign Exchange Agreements)
These resemble forward contracts, except no currency is delivered. Instead the profit or loss on the agreed
amount of currency is settled between the two counter parties.
Combined with an actual currency exchange at the prevailing spot rate, this effectively fixes the future rate in a
similar manner to futures. One other feature is that the settlement is in US dollars.
OPTION CONTRACT
• Currency options give the buyer the right but not the obligation to buy or sell a specific amount of foreign
currency at a specific exchange rate (the strike price) on or before a predetermined future date.
• For this protection, the buyer has to pay a premium.
• A currency option may be either a call option or a put option
• Currency option contracts limit the maximum loss to the premium paid up-front and provide the buyer with
the opportunity to take advantage of favorable exchange rate movements.
TYPES:
CALL OPTION Right to buy at a specified rate
PUT OPTION Right to sell at a specified rate
OPTION BUYER – OPTION HOLDER LONG POSITION
OPTION SELLER – OPTION WRITER SHORT POISTIONAmerican Option – can be exercised at any time before
maturityEuropean Option – can be exercised at maturity only.
OPTION CONTRACT
Step 1:
Identify the amount of currency to be hedged
Step 2:
Decide whether to buy Call or Put
If you want to buy any currency in future call
If you want to sell any currency in future put
Think according to the contract size currency
Step 3:
Identify the settlement date expiring immediately after the payment is due to be paid or received
Step 4:
Identify the exercise price
Solve with two exercise prices at least with highest premium (it is expensive because it is best) and second highest
premium so you can justify in exam which exercise price is best
Step 5:
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Step 6:
Calculate the premium cost = No of contract x Contract size x Premium
If premium answer is not in your home currency then using current spot rate convert it into home currency.
Step 7:
NOTE: It is assumed that option will be exercised.
Exercise the option ×××
Over or under hedge amount × ××
Premium ×××
Net Amount ×××
• A currency option is an agreement involving a right, but not an obligation, to buy or sell a certain amount of
currency at a stated rate of exchange (the exercise price) at some time in the future.
• Currency options protect against adverse exchange rate movements while allowing the investor to take
advantage of favorable exchange rate movements. They are particularly useful in situations where the cash
flow is not certain to occur (eg when tendering for overseas contracts).
Options are of two types, traded and over the counter, and both have different kinds of benefits.
• Traded options are standard sizes and are thus 'tradable' which means they can be sold on to other parties if
not required. OTC options are designed for a specific purpose and are therefore unlikely to be suitable for
another party.
• Traded options are more flexible in that they cover a period of time (American options, whereas OTC options
are fixed date (European options).
• OTC options can be agreed for a longer period than the standard two-year maximum offered by traded
options. This gives greater flexibility and protection from currency movements in the longer term should the
transaction require it.
• OTC options are tailored specifically for a particular transaction, ensuring maximum protection from currency
movements. As traded options are of a standard size, the full amount of the transaction may not be hedged,
as fractions of options are not available.
Example
IEM Co is a large listed company based in Ireland and uses UK sterling as its currency. A payment of
US$1,060,000 which is due in four months time The current spot rate is US$1·0530 per £1.
The following derivative products are available to IEM Co to manage the exposures of the US$ payment and
the interest on the loan:
Exchange-traded currency futures
Contract size £125,000 price quotation: US$ per £1
3-month expiry 1·0542
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Exchange-traded currency options

Contract size £125,000, exercise price quotation: US$ per £1, premium: cents per £1
Call Options Put Options

Exercise price 3-month expiry 6-month expiry 3-month expiry 6-month expiry
1·05 1·87 2·75 1·41 2·16
1·06 1·34 2·22 1·88 2·63
Required:
Advise IEM Co on an appropriate hedging strategy to manage the foreign exchange exposure of the US$
payment in four months’ time. Show all relevant calculations, including the number of contracts bought or sold
in the exchange-traded derivative markets
Solution:
The foreign exchange exposure of the dollar payment due in four months can be hedged using the following
derivative products:
Forward rate ;
Exchange-traded futures contracts; and
Exchange-traded options contracts
Using the forward rate
Forward rate = 1·0542 + [(1·0545 – 1·0542) x 1/3] = 1.0543
Payment = US$1,060,000/1·0543 = £1005406
Using futures contract
Since a dollar payment needs to be made in four months’ time, Co needs to hedge. Hence, the company should
go short and the six-month futures contract is undertaken. It is assumed that the basis differential will narrow in
proportion to time.
[ predict futures rate based on spot rate: 1·0530 + [(1·0545 – 1·0530) x 4/6] = 1·054]
Expected payment = US$1,060,000/1·054 = £1005693
No. of contracts sold = £1005693/£125,000 = 8 contracts
Using options contracts
Exercise price US$1·06/CHF1
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Payment = US$1,060,000/1·05 = £1009523
Buy £1009523/£125,000 =8 contracts
payment = £1009523
Premium payable = 8 x £125,000 x 0·0216 = $21600
In £ = $21600/1·0530 = £20513
Amount not hedged = US$1,060,000 – (38 x £125,000 x 1·05) = US$10,000
Use forward contracts to hedge this = US$10,000/1·0543 = £9485
Total payment = £1009523 + £20513 + £9485 = £1039521
Exercise price US$1·07/CHF1
Payment = US$1,060,000/1·06 = £1000000
Buy 1000000/125,000 = 8 contracts
payment =£1000000
Premium payable = 8 x£125,000 x 0·0263 = US$26300
In £ = 26300/1·0530 = £24976
Amount over- under hedged = US$1,060,000 – (8 x 125,000 x 1·06) = 0
Total payment = £1000000 + £24976= £1024976
Example
Pearson Co, based in a European countrythat uses the Euro (€). It has justcompleted a major project in the USA
and isdue to receive the final payment of US$30 million in four months. Exchange Rates available to Pearson
Spot US$1·3585–US$1·3618
Currency Futures (Contract size €125,000, Quotation: US$ per €1)

Currency Options (Contract size €125,000, Exercise price quotation: US$ per €1, cents per Euro)
Calls Puts
Exercise price 2-month expiry 5-month expiry 2-month expiry 5-month
1·36 2·35 2·80 2·47 2·98
1·38 1·88 2·23 4·23 4·64
Advise Pearson Co on, and recommend, an appropriate hedging strategy for the US$ income it is due to receive
in four months. Include all relevant calculations.
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Solution
(a) Hedging strategy

Forward contract
Receipt in € = US$30m/1.3676 = €21936239
Futures contract
A 2 month contract is too short for the required hedge period therefore we must use a 5 month contract.
The contract will be closed out in four months’ time.
Predicted futures rate = 1.3698 – [1/3 x (1.3698 – 1.3633)] = 1.3676
Using the predicted futures rate, expected receipt = US$30m/1.3676 = €21936239
Number of contracts = €21936239/€125,000 = 175 contracts
Options
With options the holder has the right but not the obligation to exercise the option (that is, the option will be
exercised if it is beneficial to the holder). However there is a premium to be paid for this flexibility, making
options more expensive than futures and forward contracts.
To protect itself against a weakening US$, co will purchase Euro call options.
Exercise price = $1.36
Receipts = $30m/1.36 = €22058824

Number of contracts = €22058824/€125,000 = 176 contracts
With 176 contracts, receipts = €125,000 x176 = €22000000
Premium payable = $0.0280 x176x125,000 = $616000 (or $616000/1.3585 = €453441)
Amount not hedged = US$30m – (176 x €125,000 x 1.36) = US$80,000
This amount can be hedged using a 4 month forward contract as follows:
US$80,000/1.3676= €58497
Total receipts = €22000000 - €453441 + €58497 = €21605056
Exercise price $1.38
Receipts = $30m/1.38 = €21739130

Number of contracts = €21739130/€125,000 = 173.8 contracts (purchase 174 contracts)
With 115 contracts, receipts = €125,000 x174 = €21750000
Premium payable = $0.0223 x174 x125,000 = US$485025 (or $485025/1.3585 = €357030)
Amount over hedged = US$30m – (174 x €125,000 x 1.38) = US$15000
This amount can be hedged using a 4 month forward contract as follows:
US$15000/1.3623 = €11011
Total receipts = €21750000 – €357030 - €11011 = €21381959
Example OTC option

Lignum Co ( home currency euro ) regularly trades with companies based in Zuhait, a small country in South
America whose currency is the Zupesos (ZP). It recently sold machinery for ZP140 million, which it is about to
deliver to a company based there. It is expecting full payment for the machinery in four months. Although there
are no exchange traded derivative products available for the Zupesos, Medes Bank has offered Lignum Co a
choice of over-the-counter derivative products.
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Lignum Co can purchase either Euro call or put options from Medes Bank at an exercise price equivalent to the
current spot exchange rate of ZP142 per €1. The option premiums offered are: ZP7 per €1 for the call option or
ZP5 per €1 for the put option.
The premium cost is payable in full at the commencement of the option contract. Lignum Co can borrow money
at the base rate plus 150 basis points and invest money at the base rate minus 100 basis points in France.
What is the net receipt in euros ?
Solution:
Lignum co
Transactions exposure, as faced by Lignum Co in situation one, lasts for a short while and is easier to manage by
means of derivative products or more conventional means. Here Lignum Co has access to two derivative
products: an OTC forward rate and OTC option. Using the forward rate gives a higher return of €963,988,
compared to options where the return is €936,715 (see appendix I). However, with the forward rate, Lignum Co is
locked into a fixed rate (ZP145·23 per €1) whether the foreign exchange rates move in its favour or against it.
With the options, the company has a choice and if the rate moves in its favour, that is if the Zupeso appreciates
against the Euro, then the option can be allowed to lapse. Lignum Co needs to decide whether it is happy
receiving €963,988, no matter what happens to the exchange rate over the four months or whether it is happy to
receive at least €936,715 if the ZP weakens against the €, but with a possibility of higher gains if the Zupeso
strengthens
Lignum Co should also explore alternative strategies to derivative hedging. For example, money markets, leading
and lagging, and maintaining a Zupeso account may be possibilities. If information on the investment rate in
Zupesos could be obtained, then a money market hedge could be considered. Maintaining a Zupeso account may
enable Lignum Co to offset any natural hedges and only convert currency periodically to minimise transaction
costs.
INTEREST RATE RISK MANAGEMENT
Interest rate risk (IRR) can be explained as the impact on an institution’s financial condition if it is exposed to
negative movements in interest rates.
This risk can either be translated as an increase of interest payments that it has to make against borrowed funds
or a reduction in income that it receives from invested funds.
METHODS OF HEDGING INTEREST RATE RISK
• Forward rate Agreement (FRA)
• Interest Rate Future
• Options
• Interest Rate Swaps
• CAP, FLOOR & COLLAR
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FORWARD RATE AGREEMENT (FRA)
• FRA is a contract in which two parties agree on interest rate to be paid on a notional amount at a specified
future time.
• The “buyer” of FRA is partly wishing to protect itself against a rise in rates while the “seller” is a party
protecting itself against an interest rate decline.
• FRAs can be used to hedge transactions of any size or maturity and offer an alternative ta interest rate
futures for hedging purpose.
• FRAs do not involve any margin requirements.
Forward Rate Agreement (FRA)

A co, can enter into a FRA with a bank that fixes the rate of interest for borrowing at a certain time in the futures.
If the actual interest rate proves to be
Higher than the rate agreed lower than the rate agreed
The bank pays the co, the Co, pays the bank the
Difference difference
FORWARD RATE AGREEMENT

It is 30 June. Lynn plc will need a £10 million 6 month fixed rate after 3 months. Company is expecting that
interest rate will rise in future and wants to hedge using an FRA.
The following FRA are available

3-6 FRA 5%- 5.5%
3-9 FRA 5.5% - 6%
Lynn can borrow in market at Libor + 50 basis points.
a) What is the result of the FRA and the effective loan rate if the 6 month Libor rates has moved to
1. 5%
2. 9%
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Solution
Company will select 3-9 FRA at 6% and it will lock its position at
FRA+spread=6%+0.5%=6.5%
Whether interest rate rises or falls lynn cost is locked at 6.5%
a) The forward rate agreement required is 3-9.

(i) At 5% because interest rates have fallen, Lynn plc will pay the bank:
£
FRA payment £10 million x (6% - 5%) x 6/12 (50,000)
Payment on underlying loan (5% +0.5%)x £10 million x 6/12 (275,000)
Net payment on loan (325,000)
Effective interest rate on loan 6.50%
(ii) At 9% because interest rates have risen, the bank will pay Lynn plc
£
FRA receipt £10 million x (9% - 6%) x 6/12 150,000
Payment on underlying loan at market rate 9.5% x £10 million
(475,000)
x 6/12
Net payment on loan (325,000)
Effective interest rate on loan 6.50%
INTEREST RATE FUTURE
IMPORTANT TERMS
a) BUY FUTURE RIGHT TO RECEIVE INTEREST (DEPOSIT) SELL FUTURE RIGHT TO PAY INTEREST (BORROW)
b) PRICE OF THE CONTRACT IS DETERMINED AS (100 – r)

r = Libor interest rate
If Libor 11% = (100-11) =89
If Libor 5% = (100-5) =95
c) TICK VALUE=CONTRACT SIZE X 0.01 % x 3/12

d) Settlement date = March, June, September & December
e) Contract size= standardized normally in £500000, £1000000.
f) Basis = Current spot rate( current Libor) – opening future rate
Closing future = Closing Spot (closing Libor) ± Remaining Basis (based on Trend)
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Basis Risk – It’s the risk that current spot will not reduce over the time to exactly match the opening future
rate.
g) No. of contracts
= amount of loan /deposit x time period of loan
Contract size 3
STEPS:
• Identify the borrowing or lending amount.
• Decide whether to buy or sell future
If you want to receive interest = buy future=Lender
If you want to pay interest = sell future=Borrower
• Identify the settlement date expiring immediately after the loan is taken
• No of Contracts = amount of loan /deposit x time period of loan
Contract size 3
• Basis = Current spot rate( current Libor) – opening future rate
Difference
Total months
Closing future = Closing Spot (closing Libor) ± Remaining Basis (based on Trend)
• Close the future contract by comparing opening future with the closing future and calculate gain or loss.
Opening future rate xx
Closing future rate xx
Gain/Loss xx
Gain/Loss = (no of ticks) x tick value x number of contracts

0.01%= tick size
• Actual lending or Borrowing from market
Loan amount x (Actual Interest + Spread) x months/12 xxx
Gain/Loss on Future contract = xx/(xx)
Effective Cost or income xx
Advantages of futures
• An important advantage of futures as a hedging instrument is the flexibility of closing a position at any time
before delivery date, so that the hedge can be timed to match exactly the underlying borrowing, lending or
investment transaction. In contrast, the settlement date or exercise date for FRAs and European-style
interest rate options is set for an exact date when the transaction is arranged; giving the user no timing
flexibility should the loan or investment date be slightly delayed or brought forward.
• The user of futures also has the opportunity to benefit from current market prices, should these seem
particularly favorable, by closing a position before the loan or investment takes place.
Disadvantages of futures
• Initial margins and variation margins tie up cash in deposits for the sale or purchase transaction until the
futures position is closed.
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• There can be a considerable amount of administrative work to manage futures positions efficiently.
• Futures are a short-term hedging method, and most contracts traded on an exchange are for the next one or
two delivery dates. The range of available interest rate contracts is fairly limited and restricted to the major
currencies.
INTEREST RATE OPTION
An interest rate option is an option on a notional borrowing or a deposit which guarantees a minimum or a
maximum rate of interest (called strike price) for the option holder. The option is settled in cash. This product is
available on payment of an upfront fee called a premium.
STEPS:
• Identify the amount of borrowing/lending
• Decide whether to Buy Call or Put Option
Call option=Right to buy= Buy future=If you want to receive interest=Lender
Put option= Right to Sell= Sell future=If you want to pay interest =Borrower
• Identify the settlement date expiring immediately after the loan is taken
• Identify the best Exercise Price
Select lower Put Option Exercise Price interest rate + Premium Cost
Select higher Call Option Exercise Price interest rate - Premium Cost
• No of Contracts = amount of loan /deposit x time period of loan
Contract size 3
• Calculate Premium Cost = ticks x tick value x number of contracts
• Decide whether to exercise the option or not by comparing strike price with basis adjusted closing future
price.
• Actual lending or Borrowing from market
Loan amount x (Actual Interest + Spread) x months/12 xxx
Gain/Loss on Future contract = xx/ (xx)
Premium Cost xx
Effective Cost or income xx

Interest Rate CAPS
• An interest rate cap is a series of borrower’s option which sets the limit on maximum interest rate.
• A CAP fixed the interest rate to be paid on the borrowing.
JAN MAR JUN
CAP @ 6% 6% 6%
Interest Rate (Market) 8% 9% 4%*
2% (Gain) 3% (Gain) 4%
*Interest rate will be paid at 4% as Cap will not be exercised
High upfront premium Cost
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Interest Rate FLOOR

• An interest rate floor is a series of Lenders options that protects the lender against a decline in the floating
interest rates. A floor guarantees that the interest rate received on a deposit will not be less than a specified
level.
• High upfront premium Cost

JAN MAR JUN
Floor @ 6% 6% 6%
Interest Rate 4% 5% 9%
2% (Gain) 1% (Gain) 9%
COLLAR
An interest rate collar is a combination of a cap and a floor transacted simultaneously.
BORROWER COLLAR
 E.g. put option is bought at 95.00(5% exercise price).

Buy Cap
 Whenever interest rate rises above this level it will be
Buy Put options /Lock the
exercised and company will pay maximum cost of 5%.
maximum interest cost
 PREMIUM PAID
 E.g. Call option is Sold at 96.00(4% exercise price).
Sell Floor  Whenever interest rate falls below this level it will be
Sell Call option /Lock the minimum exercised by lenders and company will have to pay minimum
interest cost cost of 4%.
 PREMIUM RECEIVED
Advantage: Reduced Premium
Cost
Disadvantage: Borrower will have to pay
minimum interest
cost in any case
Lender’s Collar
• E.g. put option is sold at 95.00(5% exercise price).

Sell Cap
Sell Put options /Lock the maximum • Whenever interest rate rises above this level it will be exercised
by borrower and Lender will receive maximum Income of 5%.
interest Income
• PREMIUM Received
Buy Floor • E.g. Call option is bought at 96.00(4% exercise price). Whenever
Buy Call option /Lock the minimum • interest rate falls below this level it will be exercised by lenders
interest Income and will receive minimum income of 4%.
• PREMIUM Paid
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Advantage: Reduced Premium Cost

Disadvantage: Lender has set limit to
its maximum interest income.
Methods of Hedging Interest Rate Risk
Interest Rate COLLAR

An interest rate collar is a combination of a cap and a floor transacted simultaneously. The buyer of an interest
rate cap, purchases an interest rate cap while selling a floor indexed to the same interest rate, for the same
amount and covering the same period.
BORROWER COLLAR
• Set a collar contract by buying Put option at higher rate and selling call option at lower rate and also
calculate net premium cost
• Compare call or put strike prices with closing future rates to calculate gain and losses
1. Actual Borrowing from Market xx

2. Gain or loss on Collar xx
3. Net premium cost xx
4. Effective Cost X
LENDER COLLAR
• Set a collar contract by selling Put option at higher rate and buying call option at lower rate and also calculate
net premium cost
• Compare call or put strike prices with closing future rates to calculate gain and losses
1. Actual Deposit from Market xx

2. Gain or loss on Collar xx
3. Net premium cost xx
4. Effective Income X
INTEREST RATE SWAP
It’s instrument in which two parties agree to exchange interest rate cash flows based on a specified notional
amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another called plain vanilla
swap.
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Borrow from bank • (Floating interest rate)
Receive from swap agent • (Floating interest rate)
Pay to swap agent • (Fixed interest rate)
After swap cost • Fixed interest cost
Over the counter Interest Rate SWAP

It’s instrument in which two parties agree to exchange interest rate cash flows based on a specified notional
amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another
Example
Firm A has a credit rating of BBB and is about to arrange a loan' of UK10 million.. It can obtain this loan at either a
fixed rate of 9.25% or a floating rate of LIBOR +1.5%. Firm A has approached a Swap dealer with the request to
arrange an interest rate swap that could potentially lower its interest cost.
Firm B, another client of the Swap dealer, is about to raise the same amount priced at a floating rate of LIBOR
+0.5%. It shall be provided a price of 7.5% if it wishes to raise this amount on a fixed rate. Firm B has a credit
rating of AA and has made it clear that it would be willing to enter into a swap agreement if two-thirds of the
potential swap benefits are passed on to it.
Illustrate how the Swap dealer can proceed with the arrangement, with the Swap fee being 0.10% from each
party?
Solution:
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ARRANGEMENT FOR AN INTEREST RATE SWAP
• Make two possible swaps by combining fixed rate of Part A with floating rate of party B and then combine
fixed rate of party B and floating rate of party A, select the cheaper combination.
• Difference between these two combinations will be savings and Firm A and B should borrow now in the
chosen structure.
Firm b should borrow at fixed rate 7.5% and company A should borrow at floating rate of Libor + 1.5%
• Distribute the savings between both parties as per the arrangement provided otherwise divide equally.
• Deduct the swap dealer's fee from the savings to compute the Net savings.
Swap Fees Net Savings

Share of A (1/3) 0.25% 0.10% 0.15%
Share of B (2/3) 0.50% 0.10% 0.40%
Deduct the Net savings from the interest rate that each party would have paid, had it not arranged for a swap and
taken loan directly in its desire exposure. This shall become the final interest cost to be borne by each parry.
Preferred Price Net Savings Final Cost

Firm A 9.25% 0.15% 9.10%
Firm B Libor + 0.5% 0.40% LIBOR + 0.10%
Given that the interest rate to be paid to the bank and the final cost is now available, the interest rate for the cash
flows to be exchanged between the parties shall be computed. The simplest way to compute these rates is to
make the party that has borrowed a floating rate, receive the same floating rate from the other party. The
equation should than be solved for the fourth variable which is the fixed rate that is to be paid to the other party
by the floating rate payer.
Arrange for Swap

Firm A Firm B
Borrow Floating (LABOR + 1.5%) Borrows Fixed (7.5%)
Pays to B (9.00%) Receives from A 9.00%
Receives from B LIBOR + 1.5% Pays to A (LIBOR+1.5%)
Net Cost (9.00%) (LIBOR)
Swap Fee (0.10%) (0.10%)
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Final Cost (9.10%) (LIBOR+ 0.10%)
Advantages of swaps
• Swaps are flexible instruments for managing interest rates for longer- term funding (and investments), as a
separate measure from managing the debt (or investment portfolio) itself.
• As a hedging instrument, swaps give management the opportunity to:
• manage the fixed/floating rate balance of debts or investments, and
• Take action in anticipation of future interest rate changes, without having to repay existing loans, take out
new loans or alter an investment portfolio.
• Fixing the cost of debt for an extended period can improve the credit perception of a company, particularly in
an environment of rising interest rates, as it reduces a company's financial risk exposures.
• There is an active swaps market and positions can be changed over time as required. It is also relatively easy,
when necessary, to close a swaps position by termination, reversal or buyout.
EXAMPLE
AFC Co has taken a four-year £80,000,000 loan out to part-fund the setting up of four branches. Interest will be
payable on the loan at a fixed annual rate of 2·2% or a floating annual rate based on the yield curve rate plus
0·40%. The loan’s principal amount will be repayable in full at the end of the fourth year.
An interest rate swap contract with a counterparty, where the counterparty can borrow at an annual floating rate
based on the yield curve rate plus 0·8% or an annual fixed rate of 3·8%. Bank would charge a fee of 20 basis points
each to act as the intermediary of the swap. Both parties will benefit equally from the swap contract.
(b) Demonstrate how AFC Co could benefit from the swap offered by Bank
Solution:
Annuity factor, 4 years, 2% = 3·808
Equal annual amounts repayable per year = CHF80,000,000/3·808 = CHF21008403
Macaulay duration
(21008403x 0·980 x 1 year +
21008403x 0·961 x 2 years +
21008403x 0·942 x 3 years +
21008403x 0·924 x 4 years)/80,000,000 =2.47years
Modified duration = 2·47/1·02 = 2·42 years
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The equation linking modified duration (D), and the relationship between the change in interest rates (∆i) and
change in price or value of a bond or loan (∆P) is given as follows:
∆P = [–D x ∆i x P+
(P is the current value of a loan or bond and is a constant)
The size of the modified duration will determine how much the value of a bond or loan will change when there is
a change in interest rates. A higher modified duration means that the fluctuations in the value of a bond or loan
will be greater, hence the value of 2·42 means that the value of the loan or bond will change by 2·42 times the
change in interest rates multiplied by the original value of the bond or loan.
The relationship is only an approximation because duration assumes that the relationship between the change in
interest rates and the corresponding change in the value of the bond or loan is linear. In fact, the relationship
between interest rates and bond price is in the form of a curve which is convex to the origin (i.e. non-linear).
Therefore duration can only provide a reasonable estimation of the change in the value of a bond or loan due to
changes in interest rates, when those interest rate changes are small.
SWAPTION
An interest rate swaption is an option on a swap where one counter party (buyer) has paid a premium to the
other counter party(seller) for an option to choose whether the swap will actually go into effect on some future
Date.
There are two types of swaption.
Payer swaption: a payer swaption gives the buyer the right to be the fixed-rate payer(and floating rate receiver)in
a pre-specified swap at a pre-specified date .the payer swaption is almost like a protective put in that it allows the
holder to pay a set fixed rate, even if rates have increased.
Receiver swaption: a receiver swaption gives the buyer the right to be the fixed rate receiver (and floating rate
payer) at some future date. The receiver swaption is the reverse of the payer swaption.in this case, the holder
must expect rates to fall, and the swap ensures receipt of a higher fixed rate while paying a lower floating rate.
Payer swaption
If market interest rates are high at the expiration of the swaption,the holder of the payer swaption will exercise
the option to pay a lower rate through the swap than the holder of the swaption would pay with a regular swap
purchased in the market. If interest rates are low, the holder would let the swaption expire worthless and only
lose the premium paid.
Receiver swaption
If interest rates are high, the holder of the swaption would let it expire worthless and only lose the premium paid.
If market interest rates are low, the swaption would be exercised in order to receive cash flows based on an
interest rate higher than the market rate.
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CURRENCY SWAP
A currency swap is an agreement in which two parties exchange the principal amount of a loan and the interest in
one currency for the principal and interest in another currency.
At the inception of the swap, the equivalent principal amounts are exchanged at the spot rate.
During the length of the swap each party pays the interest on the swapped principal loan amount. At the end of
the swap the principal amounts are swapped back at either the prevailing spot rate, or at a pre-agreed rate such
as the rate of the original exchange of principals. Using the original rate would remove transaction risk on the
swap.
FIXED FOR FIXED SWAP

An American company may be able to borrow in the United States at a rate of 6%, but requires a loan in rand for
an investment in South Africa, where the relevant borrowing rate is 9%. At the same time, a South African
company wishes to finance a project in the United States, where its direct borrowing rate is 11%, compared to a
borrowing rate of 8% in South Africa.
Each party can benefit from the other's interest rate through a fixed-for-fixed currency swap. In this case, the
American company can borrow U.S. dollars for 6%, and then it can lend the funds to the South African company
at 6%. The South African company can borrow South African rand at 8%, and then lend the funds to the U.S.
Company for the same amount.
CROSS CURRENCY PLAIN VANILLA SWAP/FIXED FOR FLOATING SWAP

Barrow Co, a company based in the USA, wants to borrow €500m over five years to finance an investment in the
Eurozone.
Today’s spot exchange rate between the Euro and US $ is €1·1200 = $1.
Barrow Co’s bank can arrange a currency swap with Greening Co. The swap would be for the principal amount of
€500m, with a swap of principal immediately and in five years’ time, with both these exchanges being at today’s
spot rate.
Barrow Co’s bank would charge an annual fee of 0.4% in € for arranging the swap.
The benefit of the swap will be split equally between the two parties. The relevant borrowing rates for each party
are as follows:
Barrow Co Greening Co
USA 3.6% 4.5%
Eurozone EURIBOR + 1.5% EURIBOR + 0.8%
Barrow Co Greening Co Swap Combinations

USA 3.6% 4.5% EURIBOR+6%
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Eurozone EURIBOR + 1.5% EURIBOR + 0.8% EURIBOR+4.4%

Gain on swap 1.6%
Bank fee (0.2%) (0.2%) (0.4%)
Final gain 0.6% 0.6% 1.2%
Barrow Co Greening Co
Barrow Co borrows 3.6%
Greening Co borrows EURIBOR + 0.8%
Swap
Greening Co receives (EURIBOR)
Barrow Co pays EURIBOR
Barrow Co receives (2.9%)
Greening Co pays 2.9%
Net result EURIBOR + 0.7% 3.7%
Bank fee 0.2% 0.2%
Overall result EURIBOR + 0.9% 3.9%
OPTION PRICING
Call Option The right but not the obligation to buy a particular asset at an exercise price
Put Option The right but not an obligation to sell a particular asset at an exercise price
VALUE OF an OPTION= Intrinsic value + time Value
Call option Value= (Market value – exercise price) + time Value

Put option Value = (Exercise price- market value) + time Value
DETERMINANTS OF CALL OPTION PRICES
Increase In Value of a Call Value of a Put
Pa= price of underlying Share Price Increase Decrease
Pe = Exercise price Exercise Price Decrease Increase
Time= t ( in years) Time to Expiry Increase increase
S=standard deviation ( in
Volatility Increase increase
decimal )
Risk free rate = Rf ( in decimal Interest Rate Increase Decrease
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VALUE AT RISK (VAR)
• Value at risk (VAR) is the minimum amount by which the value of an investment portfolio will fall over a
given period of time at a given level of probability.
• Alternatively, it is defined as the maximum amount that it may lose at a given level ofconfidence Level.
Example:
• Assume VAR is $100,000 at 5% probability, or that it is $100,000 at 95% confidence level.
• The first definition implies that there is a 5% chance that the loss will exceed $100,000, or that we are 95%
sure that it will not exceed $100,000.
• VAR can be defined at any level of probability or confidence, but the most common probability levels are 1, 5
and 10%.
In general the VAR will be given by:
VAR = k x σ x fund value

VAR = k x σ*
Where - k is determined by the probability level, σ is the standard deviation and
σ* is the standard deviation in dollar amount( there is no need to multiply with fund value)
VAR is calculated for some specific time perio , if it is calculated for different period than a year then we have to
convert annual standard deviation into that period standard deviation.
. σ annual= σ quarter x √4
. σ annual= σ six monthly x √2
. σ 3 year= σ annual x √3
Having defined the VAR, we can define the project value at risk (PVAR),
PVAR - As the loss that may occur at a given level of probability over the life of the project.
Example
The annual cash flows from a project are expected to follow the normal distribution with a mean of $50,000 and
standard deviation of $10,000. The project has a 10 year life. What is the PVAR if probability is 5%? The PVAR for
a year is:
PVAR = 1.645 x $10,000 = $16,450
The PVAR that takes into account the entire project life is:
PVAR = 1.645 x $10,000 x √10 = $52,019; this is the maximum amount by which the value of the project will fall at
a confidence level of 95%.
So far we have used the normal distribution to calculate the VAR. The assumption that project cash flows or
values follow the normal distribution may not be plausible.
Example
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A simulation model has been used to calculate the expected value of the NPV of a project. This is $282,000. The
project has an expected life of ten years, and the volatility of the PV of the annual cash flows is $30,000.
Normal distribution tables can also be used to calculate the following probabilities:
 At the 95% confidence level, the project value at risk is:
N(0.95) 30,000 √10 = 1.645 × $94,868 = $156,058.
At the 95% confidence level, the NPV will not be worse than $282,000 – $156,058 = $125,942.
 At the 99% confidence level, the project value at risk:
N(0.99) 30,000 √10 = 2.327 × $94,868 = $220,758.
At the 99% confidence level, the NPV will not be worse than $282,000 - $220,758 = $61,242.
ADVANTAGES
• It’s easy to understand
• Comparing VAR of different assets and portfolios
• The VAR provides an indication of the potential riskiness of a project
•
THE BLACK SCHOLES MODEL
THE Black-Scholes model values options before the expiry date and takes account of all the determinants that
effect the value of option
Value of a Call Option = Pa N (d1) – Pe N (d2) e ^-rt
2
Where d1=
d2 = d1 – S √T
Pa = Current Price of a underlying asset

Pe = Exercise Price R= Risk Free Rate
t = time until expiry of options in years
S = Volatility of the share price
Example:
The current share price of TYZ Co = $120
The exercise price = $100
The risk free interest rate = 12%
Standard deviation of return on the shares = 40%
Time to Expiry = 3 months
Calculate the value of call option
Solution:
d1 = In (120/100) + (0.12 + 0.5 x 0.4^2)0.25 / 0.4 √0.25 = 1.16 d2 = 1.16 - 0.4 √0.25 = 0.96 N (d1) = 0.5 + 0.3770
= 0.8770
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N (d2) = 0.5 + 0.3315 = 0.8315
Value of Call Option = 120 x 0.8770 – 100 x 0.8315 x 2.71828 ^ (- 0.12 x 0.25)
THE Black-Scholes model values options before the expiry date and takes account of all the determinants that
effect the value of option
Value of a PUT option = c – Pa + Pe x e^-rt

Step 1 : Value the corresponding call option using Black Scholes Model Step 2 : Calculate the value of a put option
using the above formula
Assumptions and Limitations

• No Transaction Costs or taxes
• Options are European calls
• Investor can borrow at the risk-free rate
• Risk free rate and share price volatility is constant over the period
• No dividends before expiration
AMERICAN CALL OPTIONS
If no dividends are payable before the option expiry date, the American call option will be worth the same as
European Call Option
Calculate the ‘Dividend adjusted share price ‘

Deduct the present value of dividends to be paid from current Share Price
Pa, becomes Pa – PV (dividends) in Black Scholes Model.
Pa adjusted = Pa – Dividend × e-(rt)
DISADVANTAGES
• Value At Risk can be misleading: false sense of security
• VAR does not measure worst case loss
• The resulting VAR is only as good as the inputs and assumptions
• Different Value At Risk methods lead to different results
GREEKS
DELTA
In Black-Scholes model, the value of N(d1) can be used to indicate the amount of the underlying shares (or other
instruments) which the writer of an option should hold in order to hedge the option position.
Delta = change in call option price ÷ change in the price of the shares
Nd1 = Delta
The appropriate ‘hedge ratio’ N(d1) is referred to as the delta value; hence the term delta hedge. The delta value
is valid if the price changes are small.
For long call options (and/or short put options), delta has a value between 0 and 1.
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For long put options (and/or short call options), delta has a value between 0 and -1.
DELTA HEDGING CALL OPTION

Delta hedging allows us to determine the number of shares that we must buy to create the equivalent portfolio to
an option and hedge it.
Investing at risk free rate = buying share portfolio + selling call options • Delta hedge is only valid for small
share price movement.
Delta value is likely to change during the period of hedge so continuous rebalancing is required that is why it is an
expensive hedge
Example
What is the number of call options that you would have to sell in order to hedge a holding of 200,000 shares, if
the delta value (N(d1)) of options is 0.8?
Assume that option contracts are for the purchase or sale of units of 1,000 shares.
Answer
The delta hedge can be calculated by the following formula.
Number of Contracts = Number of Shares
Delta of Option x size of contract

= 200000
0.8 x 1000
= 250
If in this example the price of shares increased by $1, the value of the call options would increase by $800 per
contract. Since however we were selling these contracts the increase in the value of our holding of shares,
200,000 x $1, would be matched by the decrease in our holding of option contracts 250 x $800.
DELTA HEDGING PUT OPTION

Investing at risk free rate = buying share portfolio + Buy Put options
Put option delta= N(-d1)
If D1 is positive then N(-d1) = 0.5 - Table value
If D1 is negative then N(-d1) = 0.5 + Table value
OTHER POINTS ABOUT DELTA VALUES

The table below shows approximate values of delta for different types of options and the position of the exercise
In the Money At the Money Out of the Money
Call Approaching 1 Approx. 0.5 Approaching 0
Put Approaching -1 Approx. -0.5 Approaching 0
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OTHER POINTS ABOUT DELTA VALUES

The factors influencing delta are:
The exercise price
The time to expiration
The risk-free rate of return
The volatility in the returns on the share
GAMMA
Gamma = Change in Delta Value/ Change in price of the underlying share
 It measures the extent to which delta changes when the share price changes.
 The higher the gamma value, the more difficult it is for the option writer to maintain a delta hedge because
the delta value increases more for a given change in share price.
 Gamma values will be highest for a share which is close to expiry and is 'at the money‘
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THETA
• Theta is the change in an option's price (specifically its time premium) over time
• An option's price has two components, its intrinsic value and its time premium. When it expires, an option
has no time premium.
• Thus the time premium of an option diminishes over time towards zero and theta measures how much value
is lost over time, and therefore how much the option holder will lose through retaining their options.
• Theta is usually expressed as an amount lost per day.
• At the money options have the greatest time premium and thus the greatest theta.
RHO:
• Rho measures the sensitivity of option prices to interest rate changes
• An option's rho is the amount of change in value for a 1% change in the risk-free interest rate.
• Rho is positive for calls and negative for puts
• Interest rate is the least significant influence on change in price and interest rate tends to change slowly and
in small times.
• Long-term options have larger RHO than short-term options. The more time there is until expiration, the
greater the effect of a change in interest rates.
VEGA:
• Vega measures the sensitivity of an option's price to a change in its implied volatility
• Vega is the change in value of an option that results from a 1% point change in its volatility. If a dollar option
has a vega of 0.4, its price will increase by 40 cents for a 1% point increase in its volatility.
• Vega is the same for both calls and puts.
• Long-term options have larger vega than short-term options. The longer the time period until the option
expires, the more uncertainty there is about the expiry price.
SUMMARY OF GREEKS
Change in With
Delta Option Value Underlying Asset Value
Gamma Delta Underlying Asset Value
Theta Time Premium Time
Rho Option Value Interest rates
TRENCHING/SECURITIZATION
A tranche is a slice of a security (typically a bond or other credit-linked security) which is funded by investors who
assume different risk levels within the liability structure of that security.
SECURITIZATION THROUGH COLLATERALIZED DEBT OBLIGATIONS (CDOS)
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One common use of securitization occurs when banks lend through mortgages, credit cards, car loans or other
forms of credit, they invariably move to ‘lay off’ their risk by a process of securitization. Such loans are an asset on
the statement of financial position, representing cash flow to the bank in future years through interest payments
and eventual repayment of the principal sum involved. By securitizing the loans, the bank removes the risk
attached to its future cash receipts and converts the loan back into cash, which it can lend again, and so on, in an
expanding cycle of credit formation.
Securitization is achieved by transferring the lending to specifically created companies called ‘special purpose
vehicles’ (SPVs). In the case of conventional mortgages, the SPV effectively purchases a bank’s mortgage book for
cash, which is raised through the issue of bonds backed by the income stream flowing from the mortgage holder.
In the case of sub-prime mortgages, the high levels of risk called for a different type of securitization, achieved by
the creation of derivative-style instruments known as ‘collateralized debt obligations’ or CDOs.
Securitization may be also appropriate for an organization which wants to enhance its credit rating by using low-
risk cash flows, such as rental income from commercial property, which will be diverted into a "ring-fenced" SPV.
SECURITIZATION THROUGH COLLATERALIZED DEBT OBLIGATIONS (CDOS)

(Continued)
CDOs are a way of repackaging the risk of a large number of risky assets such as sub-prime mortgages. Unlike a
bond issue, where the risk is spread thinly between all the bond holders, CDOs concentrate the risk into
investment layers or ‘tranches’, so that some investors take proportionately more of the risk for a bigger return
and others take little or no risk for a much lower return.
Each tranche of CDOs is securitized and ‘priced’ on issue to give the appropriate yield to the investors. The
investment grade tranche of CDOs will be the most highly priced, giving a low yield but with low risk attached. At
the other end, the ‘equity’ tranche carries the bulk of the risk – it will be very lowly priced but with a high
potential, but very risky, yield. There is more detail on this in the next section.
CDOs are, therefore, a mechanism whereby losses are transferred to investors with the highest appetite for risk
(such as hedge funds), leaving the bulk of CDOs’ investors (mainly other banks) with a low risk source of cash
flow.'
THE STRUCTURE OF CDOS

An example of a possible structure for a CDO is as follows. For a pool of mortgages taken over by the SPV, three
tranches of CDOs are created:
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Tranche 1 (highest risk) known as the ‘equity’ tranche and normally comprising about 10% of the value of the
mortgages in the pool. Throughout the CDOs’ life, the equity tranche will absorb any losses brought about by
default on the part of mortgage holders, up to the point that the principal underpinning the tranche is exhausted.
At this point the investment is worthless.
Tranche 2 (intermediate risk or ‘mezzanine’ tranche) consists of around 10% of the principal and will absorb any
losses not absorbed by the equity tranche until the point at which its principal is also exhausted.
Tranche 3 (AAA or ‘senior’ tranche) consists of the balance of the pool value and will absorb any residual losses.
THE STRUCTURE OF CDOS (Continued)

When cash flows are received from borrowers in the form of interest payments and loan repayments, these
payments are paid to tranche 3 first until their obligation is fulfilled, then tranche 2, and anything left over is paid
to the equity tranche. Any defaults hit tranche 1 first, then tranche 2 and so on. The repayments represent a
‘waterfall’ of cash with the investors holding the tranches like buckets. The senior tranches get filled first, the
mezzanine holders get filled next and anything left falls into the equity pools at the bottom.
Example
A bank has made a number of mortgage loans to customers with a current total value of $350 million. The
mortgages have an average term to maturity of ten years. The net income from the loans is 7% per year.
The bank will use 85% of the mortgage pool as collateral for a securitization with the following structure:
75% of the collateral value to support a tranche of A-rated loan notes offering investors 6% per year.
15% of the collateral value to support a tranche of B-rated loan notes offering investors 11% per year.
10% of the collateral value to support a tranche of subordinated certified which are unrated.
EXAMPLE (Continued)
The estimated cash flows for this arrangement would be as follows:
Cash inflows
In flows from mortgages $350m x 7% = $24.5m
Cash outflows
A-rated loan notes
$350m x 85% x 75% x 6% = $13.4m
B-rated loan notes
$350m x 85% x 15% x 11% = $4.9m
Total outflows = $13.4m + $4.9m = $18.3m
The difference between the inflows and the outflows is returned to the high-risk unrated certificates.
Difference in cash flows = $24.5m – $18.3m = $6.2m
The subordinated certificates have a value of $350m x 85% x 10% = $29.75m.
The return on this high-risk investment is $6.2m/$29.75m = 20.8%
Benefits of Tranching
• Trenching is a good way of dividing risk. Anyone who invests in risky loans is taking a chance, but trenching
lets you divide the chances up, so that people who want safety can buy the top (senior) tranches, get less of a
profit, but know that they're not going to lose out unless things go seriously wrong.
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• People who are willing to take their chances in the lower (junior) tranches know that they're taking a
significant risk, but they can potentially make a lot more money.
• Securitization can offer issuers higher credit ratings and lower borrowing costs
• One of the major allures of securitization for issuers is off-balance-sheet treatment, meaning that the assets
included in the reference portfolio are wiped off the originator's financial statements.
Risks of Tranching
• Tranches are very complex; most investors do not really understand the risks associated with each tranche.
• Tranches may not be divided properly and the bundling process may be misleading. Investors are obviously
anxious to obtain the most senior tranche – the more junior tranches are more difficult to 'get rid of'. Default
risk will be there, success of tranching depends upon the quality of underlying loan portfolio.
• It is assumed here that default in asset side is uncorrelated with liability side.
• Timing risk may be there of matching of interest receipts on receivables and payments on Asset backed
securities.
DARK POOL TRADING
• A dark pool network allows shares to be traded anonymously, away from public scrutiny.
• No information on the trade order is revealed prior to it taking place. The price and size of the order are only
revealed once the trade has taken place.
MAIN REASONS:
• It prevent the risk of other traders moving the share price up or down;
• It result in reduced costs because trades normally take place at the mid-price between the bid and offer; and
because broker-dealers try and use their own private pools, and thereby saving exchange fees.
• Dark pools are an 'alternative' trading system that allows participants to trade without displaying quotes
publically. The transactions are only made public after the trades have been completed.
PROBLEMS WITH DARK POOL TRADING SYSTEM:

 Prices at which these trades are executed remain unknown until after the event.
 Lack of information on significant trades makes the regulated exchanges less efficient
 Resulting in reduced transparency as fewer trades are publicly exposed
 Reduce liquidity in the regulated exchanges and hinder efficient price-setting.
Dark Pool Trading defeats the purpose of fair and regulated markets with large numbers of participants and
threatens the healthy and transparent development of these markets.
CREDIT DEFAULT SWAPS
A credit default swap is a specific type of counterparty agreement which allows the transfer of third-party credit
risk from one party to the other.
• It is similar to insurance because – in the event of a fire, the buyer of the policy will receive whatever the
damaged or destroyed goods are worth in monetary terms.
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• It provides the buyer of the contract, who often owns the underlying credit, with protection against default,
a credit rating downgrade, or another negative credit event.
• The buyer of CDS agrees to pay a fixed spread to the seller of the CDS. The more likely the risk of default, the
larger the spread.
For example,
If the CDS spread is 200 basis points (or 2.0%) then a party buying $10 million worth of CDS from a bank must
pay the bank $200,000 per year. These payments continue until either the CDS contract expires or party
defaults.
• CDSs are unregulated. This means that contracts can be traded – or swapped – from investor to investor
without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the
security defaults.
USES OF CREDIT DEFAULT SWAPS:

Speculative investors bought and sold the instruments without having any direct relationship with the underlying
investment. Speculators to "place their bets" about the credit quality of a particular reference entity:
EXAMPLE:
A hedge fund believes that a company (ABC Co) will shortly default on its debt of $20 million. The hedge fund may
therefore buy $20 million worth of CDS protection for, say, 2 years, with (ABC Co) as the reference entity, at a
spread of 1000 basis points (10%) per annum.
If (ABC Co) does default after, say, one year, then the hedge fund will have paid $2000,000 to the bank but will
then receive $20 million (assuming zero recovery rate). The bank will incur a $1.8 million loss unless it has
managed to offset the position before the default.
If (ABC Co) does not default, then the CDS contract will run for two years and the hedge fund will have paid out $4
million to the bank with no return. The bank makes a profit of $4 million; the hedge fund makes a loss of the
same amount.
 What would happen if the hedge fund decided to liquidate its position after a certain period of time in an
attempt to lock in its gains or losses? Say after one year the market considers ABC Co to be at greater risk
of default, and the spread widens from 1000 basis points to 2,500.
 The hedge fund may decide to sell $20 million protection to the bank for one year at this higher rate. Over
the two years, the hedge fund will pay the bank $4 million (2 x 10% x $20 million) but will receive $5
million (1 x 25% x $20 million) – a net profit of $1million (as long as (ABC Co) does not default in the
second year)
 A CDS contract can be used as a hedge or insurance policy against the default of a bond or loan. An individual
or company that is exposed to a lot of credit risk can shift some of that risk by buying protection in a CDS
contract.
Example
A pension fund owns $20 million of a 5-year bond issued by XYZ Co. In order to manage the risk of losses in the
event of a default by XYZ Co, CDS of a notional amount of $20 million were bought by the pension funds to hedge
the risk. Assume the CDS trades at 500 basis points (5%) which means that the pension fund will pay the bank an
annual premium of $1 million.
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If XYZ Co does not default on the bond, the pension fund will pay a total premium of 5 x $1000,000 = $5 million to
the bank and will receive the $20 million back at the end of the 5 years. Although it has lost $5 million, the
pension fund has hedged away the default risk.
If XYZ Co defaults on the bond after, say, 2 years, the pension fund will stop paying the premiums and the bank
will refund the $20 million to compensate for the loss. The pension fund's loss is limited to the premiums it had
paid to the bank (2 x $1000,000 = $2000,000) – if it had not hedged the risk, it would have lost the full $20
million.
THE ROLE OF CDS IN GLOBAL FINANCIAL CRISIS
 Once an obscure financial instrument for banks and bondholders, CDSs are now at the heart of the recent
credit crisis.
 American International Group (AIG) – the world's largest insurer – could issue CDSs without putting up any
real collateral as long as it maintained a triple-A credit rating. There was no real capital cost to selling these
swaps; there was no limit. Thanks to fair value accounting, AIG could book the profit from, say, a five-year
credit default swap as soon as the contract was sold, based on the expected default rate. In many cases, the
profits it booked never materialized.
 On 15 September 2007 the bubble burst when all the major credit-rating agencies downgraded AIG. At issue
were the soaring losses in its CDSs. The first big write-off came in the fourth quarter of 2007, when AIG
reported an $11 billion charge. It was able to raise capital once, to repair the damage. But the losses kept
growing. The moment the downgrade came, AIG was forced to come up with tens of billions of additional
collateral immediately. This was on top of the billions it owed to its trading partners. It didn't have the
money. The world's largest insurance company was bankrupt.
 As soon as AIG went bankrupt, all those institutions which had hedged debt positions using AIG CDSs had to
mark down the value of their assets, which at once reduced their ability to lend. The investment banks had
no ability to borrow, as the collapse of the CDS market meant that no one was willing to insure their debt.
The credit crunch had started in earnest
DETERMINATION OF INTEREST RATE FORWARDS
Supposing that a bank assesses and quotes the following rates to a company, based on the annual spot yield
curve for that company’s risk class:
One-year: 3.50%
Two-year: 4.60%
Three-year: 5.40%
Four-year: 6.10%
Five-year: 6.30%
This indicates that the company would have to: pay interest at 3.50% if it wants to borrow a sum of money for
one year; pay interest at 4.60% per year if it wants to borrow a sum of money for two years; pay interest at 5.40%
per year if it wants borrow a sum of money for three years; and so on.
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Alternatively, for a two-year loan, the company could opt to borrow a sum of money for only one year, at an
interest rate of 3.50%, and then again for another year, commencing in one year’s time, instead of borrowing the
money for a total of two years.
Although the company would be uncertain about the interest rate in one year’s time, it could request a
forward rate from the bank that is fixed today – for example, through a 12v24 forward rate agreement (FRA).
The question then arises: how may the value of the 12v24 FRA be determined?
Difference between these two is the duration of loan.
12V24 Total months
Period of hedging (after 12 months company wants to borrow)
A forward rate commencing in one year for a borrowed sum lasting a year can be calculated as follows:
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In summary:
Supposing the company wants to borrow a sum of money for three years on the basis of the above rates:
i it could pay annual interest at a rate of 5.40% in each
of the three years, or
ii it could pay interest at a rate 3.50% in the first year, 5.71% in the second year and 7.02% in the third
year, or iii. it could pay annual interest at a rate of 4.60% in each of the first two years and 7.02% in the third
year.
USING INTEREST RATE FORWARDS TO VALUE A SIMPLE INTEREST RATE SWAP CONTRACT
Supposing the above company has $100m borrowings in the form of variable interest rate loans repayable in five
years and pays interest annually equivalent to annual forward rates. It expects interest rates to increase in the
future and is therefore keen to fix its interest rate payments.
The bank offers to swap the variable interest rate payments for a fixed rate, such that the company pays a fixed
rate of interest to the bank in exchange for receiving a variable rate of return from the bank based on the above
yield rates less 50 basis points. The variable rate receipts from the bank will then be used to pay the interest on
the loan.
The fixed equivalent rate of interest the company will pay the bank for the swap can be calculated as follows:
The current expected amounts of interest the company expects to receive from the bank, based on year 1
forward rate and years 2, 3, 4 and 5 forward rates are:
Year 1 0.0300 x $100m = $3.00m

Year 2 0.0521 x $100m = $5.21m
Year 3 0.0652 x $100m = $6.52m
Year 4 0.0773 x $100m = $7.73m
Year 5 0.0660 x $100m = $6.60m
Note: The rates used to calculate the annual amounts are reduced by 50 basis points or 0.5%.
At the start of the swap, the net present value of the swap receipts based on the variable rates from the bank will
be the same as the costs based on the fixed amount paid to the bank.
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Let’s say R is the fixed amount of interest the company will pay the bank, then
Removing the brackets, the above expands to:

2.90m – 0.966R + 4.76m – 0.914R + 5.57m – 0.854R +
6.10m – 0.789R + 4.86m – 0.737R= 0
Simplifying this, adding all the $ flows together and R-flows together, gives:
24.19m – 4.26R = 0
$5.68m = R
In percentage = $5.68m/$100m = 5.68%
In practice the receipts and payments of the swap would be netted off such that the company will expect to pay
$2.68m ($5.68m – $3.00m) to the bank in year one, and expect to receive $0.84m ($6.52m – $5.68m) from the
bank in year three, and so on for the other years. The present values of these n et annual flows, discounted at the
yield curve rates, will be zero. The fixed rate of 5.68% is lower than the five-year spot rate of 6.30% because some
of the receipts and payments related to the swap contract occur in earlier years when the spot yield curve rate is
lower.
Although at the commencement of the contract, the present value of the swap is zero, as interest rates
fluctuate, the value of the swap will change. For example, if interest rates increase and the company pay interest
at a fixed rate, then the swap’s value to the company will increase. The value of the swap contract will also
change as the swap approaches maturity, and the number of receipts and payments reduce.
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Study Notes Advanced Financial Management - AFM

ADVANCED FINANCIAL MANAGEMENT

1. TIPS TO PASS THE EXAM 3

Syllabus A: Role of the senior financial advisor in the

6. Syllabus C: Mergers and Acquisitions 111

7. Syllabus D: Corporate reconstruction and re- 143

TIPS TO PASS THE EXAM

SYLLABUS A: ROLE OF THE SENIOR FINANCIAL ADVISOR

Policy Framework of Financial Managers

Key roles and responsibilities of the financial manager

Major issues in which we require the assistance of the framework is

 Ethics and Social Responsibilty

Key Areas of Financial Policy

Optimal Capital Structure

Insolvency and financial distress

External funding and agency costs

Capital structure and information asymmetry

Manager behaviour towards risk management

1. Psychological factors affecting decision making

 Search for patterns, herding and cognitive dissonance

Analysis of relevant information

Rational, objective and risk-neutral analysis

Analysis of relevant information

Rational, objective and risk-neutral analysis

Limitations of behavioural finance

Ethics and Financial Manager

The actions of a financial manager have an impact at 3 levels

1. Society level (to take into account wishes of all stakeholders)

Sustainability and Environment Issues

 Implementing Environment Management System (EMS)

Internal:Interacts daily with the organisation

Power: In an influential position?

Management doesn‘t have to be quite as careful with these people as with

The main advantages and disadvantages of joint ventures

Theory and practice of international trade

Theory of international trade

International trade arises for a number of reasons;

The law of comparative advantage

Does the law apply in practice?

The advantages of international trade

Product differentiation barriers

Absolute cost barriers

Economy of scale barriers

Trade Agreements/Free trade

Protection can be applied in several ways, including the following:

• Tariffs or customs duties

Tariffs or customs duties

Hidden export subsidies and import restrictions

Government action to devalue the currency

Arguments against protection

Reduced international trade

Effect on economic growth

Arguments in favour of protection

Imports of cheap goods

Reduction in balance of trade deficit

The EU incorporates a common market combining different aspects.

The single European market

Elimination of trade restrictions

North American Free Trade Agreement (NAFTA)

The World Trade Organization (WTO)

The most favored nation principle

International monetary institutions

The International Monetary Fund