acca p4 becker.pdf

ACCAADVANCED FINANCIAL MANAGEMENT P4

STUDY SYSTEMDecember 2014–June 2015 Edition

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Contents

Paper P4

© 2014 DeVry/Becker Educational Development Corp. All rights reserved. iii

Page

introduction ...............................................................................................v

About this Study System ............................................................................v

Syllabus .....................................................................................................vi

ACCA Study Guide .......................................................................................x

Formulae and tables .............................................................................. xvii

Examination technique ........................................................................... xxi

Sessions

1 Role of Financial Strategy ..................................................... 1-1

2 Security Valuation and the Cost of Capital ............................ 2-1

3 Weighted Average Cost of Capital and Gearing ..................... 3-1

4 Portfolio theory and CAPM ................................................... 4-1

5 Basic investment Appraisal .................................................. 5-1

6 Advanced investment Appraisal ........................................... 6-1

7 Business Valuation ............................................................... 7-1

8 Mergers and Acquisitions ...................................................... 8-1

9 Corporate Reconstruction and Re-organisation ..................... 9-1

10 Equity issues .......................................................................10-1

11 Debt issues .........................................................................11-1

12 Dividend Policy ....................................................................12-1



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Contents

iv © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

PageSessions

13 Options ................................................................................13-1

14 Foreign Exchange Risk Management ....................................14-1

15 interest Rate Risk Managemen t ...........................................15-1

16 the Economic Environment for Multinationals .....................16-1

17 international Operations .....................................................17-1

18 Financial Statement Analysis ..............................................18-1

19 Glossary ..............................................................................19-1

20 index ..................................................................................20-1



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Introduction

© 2014 DeVry/Becker Educational Development Corp. All rights reserved. v

ABOut thiS StuDy SyStEMThis Study System has been specifically written for the Association of Chartered Certified Accountants professional level examination, Paper P4 Advanced Financial Management

It provides comprehensive coverage of the core syllabus areas and is designed to be used both as a reference text and as an integral part of your studies to provide you with the knowledge, skill and confidence to succeed in your ACCA examinations

About the author: Mike Ashworth is ATC International's lead tutor in financial management and has more than 15 years' experience in delivering ACCA exam-based training.

How to Use This Study SystemYou should start by reading through the syllabus, study guide and approach to examining the syllabus provided in this introduction to familiarise yourself with the content of this paper.

The sessions which follow include the following features:

Focus These are the learning outcomes relevant to the session,as published in the ACCA Study Guide.

Session Guidance Tutor advice and strategies for approaching each session.

Visual Overview A diagram of the concepts and the relationships addressedin each session.

Definitions Terms are defi ned as they are introduced and larger groupings of terms will be set forth in a Terminology section.

illustrations These are to be read as part of the text. Any solutions to numerical Illustrations are provided.

Exhibits These extracts of external content are presented to reinforce concepts and should be read as part of the text.

Examples These should be attempted using the pro forma solution provided (where applicable).

Key Points Attention is drawn to fundamental rules, underlying concepts and principles.

Exam Advice These tutor comments relate the content to relevance in the examination.

Commentaries These provide additional information to reinforce content.

Session Summary A summary of the main points of each session.

Session quiz These quick questions are designed to test your knowledge of the technical content. A reference to the answer is provided.

Study question Bank

A link to recommended practice questions contained in the Study Question Bank. At a minimum, you should work through the priority questions after studying each session. For additional practice, you can attempt the remaining questions (where provided).

Example Solutions Answers to the Examples are presented at the end of each session.



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P4 Advanced Financial Management

vi © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Syllabus

Main CapabilitiesOn successful completion of this paper, candidates should be able to:

A. Explain and evaluate the role and responsibility of the senior financial executive or advisor in meeting conflicting needs of stakeholders

B. Evaluate the impact of macro economics and recognise the role of international financial institutions in the financial management of multinationals

C. Evaluate potential investment decisions and assess their financial and strategic consequences, both domestically and internationally

D. Assess and plan acquisitions and mergers as an alternative growth strategyE. Evaluate and advise on alternative corporate re-organisation strategies F. Apply and evaluate alternative advanced treasury and risk management techniquesG. Identify and assess the potential impact of emerging issues in finance and financial

management.

PA (P1) AFM (P4)

MA (F2)

FM (F9)

Advanced Financial Management

Financial Management

Management Accounting

SyllABuS

AimTo apply relevant knowledge, skills and exercise professional judgement as expected of a senior financial executive or advisor, in taking or recommending decisions relating to the financial management of an organisation in private and public sectors.

Relationship to Other Papers

ProfessionalAccountant



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© 2014 DeVry/Becker Educational Development Corp. All rights reserved. vii

Syllabus

Relational Diagram of Main Capabilities

Rationale This syllabus develops upon the core financial management knowledge and skills covered in the F9 Financial Management syllabus at the Fundamentals level and prepares candidates to advise management and/or clients on complex strategic financial management issues facing an organisation.

The syllabus starts by exploring the role and responsibility of a senior executive or advisor in meeting competing needs of stakeholders within the business environment of multinationals. The syllabus then re-examines investment and financing decisions, with the emphasis moving towards the strategic consequences of making such decisions in a domestic, as well as international, context. Candidates are then expected to develop further advisory skills in planning strategic acquisitions and mergers and corporate re-organisations.

The next part of the syllabus re-examines, in the broadest sense, the existence of risk in business and the sophisticated strategies which are employed in order to manage such risks. It builds on what candidates would have covered in the F9 Financial Management syllabus and the P1 Professional Accountant syllabus.

The syllabus finishes by examining the impact of emerging issues in finance.



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viii © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Syllabus

Detailed Syllabus

A. Role and Responsibility Towards Stakeholders

1. The role and responsibility of senior financial executive/advisor

2. Financial strategy formulation 3. Conflicting stakeholder interests 4. Ethical issues in financial management 5. Environmental issues and integrated

reportingB. Economic Environment for

Multinational Organisations

1. Management of international trade and finance

2. Strategic business and financial planning for multinational organisations

C. Advanced Investment Appraisal

1. Discounted cash flow techniques 2. Application of option pricing theory in

investment decisions 3. Impact of financing on investment

decisions and adjusted present values 4. Valuation and the use of free cash flows 5. International investment and financing

decisions D. Acquisitions and Mergers

1. Acquisitions and mergers versus other growth strategies

2. Valuation for acquisitions and mergers 3. Regulatory framework and processes 4. Financing acquisitions and mergers

E. Corporate Reconstruction and Re‑Organisation

1. Financial reconstruction 2. Business re-organisation F. Treasury and Advanced Risk

Management Techniques

1. The role of the treasury function in multinationals

2. The use of financial derivatives to hedge against forex risk

3. The use of financial derivatives to hedge against interest rate risk

4. Dividend policy in multinationals and transfer pricing

G. Emerging Issues in Finance and Financial Management

1. Developments in world financial markets

2. Developments in international trade and finance

3. Developments in Islamic financing



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© 2014 DeVry/Becker Educational Development Corp. All rights reserved. ix

Syllabus

Approach to Examining the SyllabusThe P4 Advanced Financial Management paper builds upon the skills and knowledge examined in the F9 Financial Management paper. At this stage candidates will be expected to demonstrate an integrated knowledge of the subject and an ability to relate their technical understanding of the subject to issues of strategic importance to the organisation. The study guide specifies the wide range of contextual understanding that is required to achieve a satisfactory standard at this level.

Examination StructureThe examination will be a three-hour paper in two sections:

Section A:

One compulsory question of 50 marks

Section B:

Answer two from three questions of 25 marks each

Total 100 Marks

15 minutes for reading and planning is given at the start if the examination. During this time candidates may make notes on the question paper but may not write in the answer booklet.

Candidates will be provided with a formulae sheet as well as present value, annuity and standard normal distribution tables.

Section A will contain a compulsory question comprising 50 marks. This section will normally cover significant issues relevant to the senior financial manager or advisor and will be set in the form of a case study or scenario. The requirements of the section A question are such that candidates will be expected to show a comprehensive understanding of issues from across the syllabus.

The question in section A will contain a mix of computational and discursive elements. Within this question candidates will be expected to provide answers in a specified form such as a short report or board memorandum commensurate with the professional level of the paper in part of whole of the question.

In section B candidates will be asked to answer two from three questions, each comprising 25 marks.

Section B questions are designed to provide a more focused test of the syllabus. Questions will normally contain a mix of discursive and computational elements but may also be wholly discursive or evaluative where computations are already provided.

ACCA SupportFor examiner's reports, guidance and technical articles relevant to this paper see

www.accaglobal.com/en/student/acca-qual-student-journey/qual-resource/ acca-qualification/p4.html

The ACCA's Study Guide which follows is referenced to the Sessions in this Study System.



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x © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

ACCA Study Guide

ACCA StuDy GuiDE

A. Role and Responsibility towards Stakeholders Ref.

1. the role and responsibility of senior financial executive/advisor 1a) Develop strategies for the achievement of the organisational goals in line with its

agreed policy framework.b) Recommend strategies for the management of the financial resources of the

organisation such that they are utilised in an efficient, effective and transparent way.

c) Advise the board of directors or management of the organisation in setting the financial goals of the business and in its financial policy development with particular reference to: i) Investment selection and capital resource allocation ii) Minimising the cost of capital iii) Distribution and retention policy iv) Communicating financial policy and corporate goals to internal and external

stakeholders v) Financial planning and control vi) The management of risk.

2. Financial strategy formulationa) Assess organisational performance using methods such as ratios, trends, EVATM

and MVA. 18

b) Recommend the optimum capital mix and structure within a specified business context and capital asset structure. 3

c) Recommend appropriate distribution and retention policy. 12d) Explain the theoretical and practical rationale for the management of risk. 1e) Assess the organisation's exposure to business and financial risk including

operational, reputational, political, economic, regulatory and fiscal risk. 1

f) Develop a framework for risk management, comparing and contrasting risk mitigation, hedging and diversification strategies. 1

g) Establish capital investment monitoring and risk management systems. 63. Conflicting stakeholder interests 1a) Assess the potential sources of the conflict within a given corporate governance/

stakeholder framework informed by an understanding of the alternative theories of managerial behaviour. Relevant underpinning theory for this assessment would be: i) The separation of ownership and control ii) Transaction cost economics and comparative governance structures iii) Agency Theory.

b) Recommend, within specified problem domains, appropriate strategies for the resolution of stakeholder conflict and advise on alternative approaches that may be adopted.

c) Compare the different governance structures and policies (with particular emphasis upon the European stakeholder and the US/UK shareholder model) and with respect to the role of the financial manager.

4. Ethical issues in financial management 1a) Assess the ethical dimension within business issues and decisions and advise on

best practice in the financial management of the organisation.b) Demonstrate an understanding of the interconnectedness of the ethics of good

business practice between all of the functional areas of the organisation.c) 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.

(continued on next page)



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© 2014 DeVry/Becker Educational Development Corp. All rights reserved. xi

ACCA Study Guide

Ref.d) Recommend an ethical framework for the development of an organisation's financial

policies and a system for the assessment of its ethical impact upon the financial management of the organisation.

e) 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.

5. Environmental issues and integrated reporting 1a) Assess the issues which may impact upon organisational objectives and governance

from: i) Sustainability and environmental risk ii) The carbon-trading economy and emissions iii) The role of the environment agency iv) Environmental audits and the triple bottom line approach.

b) Assess and advise on the impact of investment and financing strategies and decisions on the organisations' stakeholders, from an integrated reporting and governance perspective.

B. Economic Environment for Multinationals Ref.

1. Management of international trade and finance 16a) Advise on the theory and practice of free trade and the management of barriers to

trade.b) Demonstrate an up-to-date understanding of the major trade agreements and

common markets and, on the basis of contemporary circumstances, advise on their policies and strategic implications for a given business.

c) Discuss the objectives of the World Trade Organisation.d) Discuss the role of international financial institutions within the context of a

globalised economy, with particular attention to the International Monetary Fund, the Bank of International Settlements, The World Bank and the principal Central Banks (the Fed, Bank of England, European Central Bank and the Bank of Japan).

e) Assess the role of the international financial markets with respect to the management of global debt, the financial development of the emerging economies and the maintenance of global financial stability.

2. Strategic business and financial planning for multinationalsa) 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) 10

ii) The mobility of capital across borders and national limitations on remittances and transfer pricing 16

iii) The pattern of economic and other risk exposures in the different national markets 17

iv) Agency issues in the central coordination of overseas operations and the balancing of local financial autonomy with effective central control. 17

C . Advanced investment Appraisal Ref.

1. Discounted cash flow techniquesa) 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 5ii) Taxation including capital allowances and tax exhaustion 5iii) Single period and multi-period capital rationing. Multi-period capital rationing

to include the formulation of programming methods and the interpretation of their output

6




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xii © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

ACCA Study Guide

Ref.iv) Probability analysis and sensitivity analysis when adjusting for risk and

uncertainty in investment appraisal 6

v) Risk adjusted discount rates. 4b) 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:

6

i) Simple model design ii) The different types of distribution controlling the key variables within the

simulation iii) The significance of the simulation output and the assessment of the likelihood

of project success iv) The measurement and interpretation of project value at risk.

c) 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.

5, 6

2. Application of option pricing theory in investment decisions 13a) 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.

b) Evaluate embedded real options within a project, classifying them into one of the real option archetypes.

c) Assess, calculate and advise on the value of options to delay, expand, redeploy and withdraw using the BSOP model.

3. impact of financing on investment decisions and adjusted present valuesa) 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 and Islamic finance. Including assessment on the financial position, financial risk and the value of an organisation.

10, 11

b) 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.

2, 3

c) 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.

4

d) Assess an organisation's debt exposure to interest rate changes using the simple Macaulay duration method. 2

e) Discuss the benefits and limitations of duration including the impact of convexity. 2f) Assess the organisation's exposure to credit risk, including: 9

i) Explain the role of, and the risk assessment models used by the principal rating agencies

ii) Estimate the likely credit spread over risk free iii) Estimate the organisation's current cost of debt capital using the appropriate

term structure of interest rates and the credit spread.




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© 2014 DeVry/Becker Educational Development Corp. All rights reserved. xiii

ACCA Study Guide

Ref.g) Assess the impact of financing and capital structure upon the organisation with

respect to: 3

i) Modigliani and Miller propositions, before and after tax ii) Static trade-off theory iii) Pecking order propositions iv) Agency effects.

h) 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.

6

i) 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.

5, 18

4. Valuation and the use of free cash flowsa) Apply asset based, income based and cash flow based models to value equity. Apply

appropriate models, including term structure of interest rates, the yield curve and credit spreads, to value corporate debt.

2, 7

b) Forecast an organisation's free cash flow and its free cash flow to equity (pre- and post-capital reinvestment). 7

c) Advise on the value of an organisation using its free cash flow and free cash flow to equity under alternative horizon and growth assumptions. 13

d) Explain the use of the BSOP model to estimate the value of equity of an organisation and discuss the implications of the model for a change in the value of equity.

13

e) Explain the role of BSOP model in the assessment of default risk, the value of debt and its potential recoverability. 13

5. international investment and financing decisionsa) Assess the impact upon the value of a project of alternative exchange rate

assumptions. 17

b) Forecast project or organisation free cash flows in any specified currency and determine the project's net present value or organisation value under differing exchange rate, fiscal and transaction cost assumptions.

17

c) Evaluate the significance of exchange controls for a given investment decision and strategies for dealing with restricted remittance. 16

d) Assess the impact of a project upon an organisation's exposure to translation, transaction and economic risk. 14

e) Assess and advise on the costs and benefits of alternative sources of finance available within the international equity and bond markets. 10, 11

D. Acquisitions and Mergers Ref.

1. Acquisitions and mergers versus other growth strategies 8a) Discuss the arguments for and against the use of acquisitions and mergers as a

method of corporate expansion.b) Evaluate the corporate and competitive nature of a given acquisition proposal.c) Advise upon the criteria for choosing an appropriate target for acquisition.d) Compare the various explanations for the high failure rate of acquisitions in

enhancing shareholder value.e) Evaluate, from a given context, the potential for synergy separately classified as:

i) Revenue synergy ii) Cost synergy iii) Financial synergy.




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xiv © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

ACCA Study Guide

Ref.2. Valuation for acquisitions and mergersa) Discuss the problem of overvaluation. 8b) Estimate the potential near-term and continuing growth levels of a corporation's

earnings using both internal and external measures. 7

c) Assess the impact of an acquisition or merger upon the risk profile of the acquirer distinguishing: 8

i) Type 1 acquisitions that do not alter the acquirer's exposure to financial or business risk

ii) Type 2 acquisitions that impact upon the acquirer's exposure to financial risk iii) Type 3 acquisitions that impact upon the acquirer's exposure to both financial

and business risk.d) Advise on the valuation of a type 1 acquisition of both quoted and unquoted entities

using: 7

i) "Book value-plus" models ii) Market based models iii) Cash flow models, including EVA™, MVA.

e) Advise on the valuation of type 2 acquisitions using the adjusted net present value model. 8

f) Advise on the valuation of type 3 acquisitions using iterative revaluation procedures. 8

g) Demonstrate an understanding of the procedure for valuing high growth start-ups. 73. Regulatory framework and processes 8a) 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.

b) 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.4. Financing acquisitions and mergers 8a) Compare the various sources of financing available for a proposed cash-based

acquisition. b) Evaluate the advantages and disadvantages of a financial offer for a given

acquisition proposal using pure or mixed mode financing and recommend the most appropriate offer to be made.

c) Assess the impact of a given financial offer on the reported financial position and performance of the acquirer.

E. Corporate Reconstruction and Re-Organisation Ref.

1. Financial reconstruction 9a) Assess an organisational situation and determine whether a financial reconstruction

is the most appropriate strategy for dealing with the problem as presented.b) Assess the likely response of the capital market and/or individual suppliers of

capital to any reconstruction scheme and the impact their response is likely to have upon the value of the organisation.

c) Recommend a reconstruction scheme from a given business situation, justifying the proposal in terms of its impact upon the reported performance and financial position of the organisation.




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© 2014 DeVry/Becker Educational Development Corp. All rights reserved. xv

ACCA Study Guide

Ref.2. Business re-organisation 9a) Recommend, with reasons, strategies for unbundling parts of a quoted company.b) Evaluate the likely financial and other benefits of unbundling.c) Advise on the financial issues relating to a management buy-out and buy-in.

F. treasury and Advanced Risk Management techniques Ref.

1. the role of the treasury function in multinationalsa) Discuss the role of the treasury management function within:

i) The short term management of the organisation's financial resources 17ii) The longer term maximisation of corporate value 17iii) The management of risk exposure. 14, 15

b) Discuss the operations of the derivatives market, including: i) The relative advantages and disadvantages of exchange traded versus OTC

agreements 15

ii) Key features, such as standard contracts, tick sizes, margin requirements and margin trading 14

iii) The source of basis risk and how it can be minimised. 14, 15iv) Risks such as delta, gamma, vega, rho and theta, and how these can be

managed. 13

2. the use of financial derivatives to hedge against forex riska) Assess the impact on an organisation to exposure in translation, transaction and

economic risks and how these can be managed. 14

b) Evaluate, for a given hedging requirement, which of the following is the most appropriate strategy, given the nature of the underlying position and the risk exposure:

14

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.

c) Advise on the use of bilateral and multilateral netting and matching as tools for minimising FOREX transactions costs and the management of market barriers to the free movement of capital and other remittances.

17

3. the use of financial derivatives to hedge against interest rate risk 15a) 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) Options on FRAs (caps and collars), Interest rate futures and interest rate

swaps.




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xvi © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

ACCA Study Guide

Ref.4. Dividend policy in multinationals and transfer pricinga) Determine a corporation's dividend capacity and its policy given: 12

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.

b) Advise, in the context of a specified capital investment programme, on an organisation's current and projected dividend capacity. 12

c) 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.

17

G. Emerging issues in Finance and Financial Management Ref.

1. Developments in world financial marketsa) 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.

1, 2, 16

2. Developments in international trade and finance 16a) 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.

3. Developments in islamic financing 16a) Demonstrate an understanding of 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.



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© 2014 DeVry/Becker Educational Development Corp. All rights reserved. xvii

Formulae and Tables

FORMulAE AND tABlES

Formula Sheet

Modigliani and Miller Proposition 2 (with tax)

ke = kei + (1 – T) (ke

i – kd) VV

d

e

The Capital Asset Pricing Model

E(ri) = Rf+ βi[E(rm) – Rf]

The Asset Beta Formula

βa = V

V V Te

e de+ −( )( )

1

β + V T

V V Td

e dd

11−( )

+ −( )( )

β

The Growth Model

PO = D

rO

e

1 +( )−( )

gg

Gordon's growth approximation

g = bre

The Weighted Average Cost Of Capital

WACC = V

V Vke

e de+

+

VV V

k Td

e dd+

−( )1

The Fisher Formula

(1 + i) = (1 + r)(1 + h)

Purchasing Power Parity And Interest Rate Parity

S1 = S0 × 1 +( )+( )

h1 h

c

b F0 = S0 ×

1 +( )+( )

i1 i

c

b

Modified Internal Rate of Return

MIRR = PVPV

rR

I

ne

+( ) −1

1 1

The Black‑Scholes Option Pricing Model

C = PaN(d1) – PeN(d2)e-rt

Where:

d1 = ln (P /P ) r 0.5s t

s ta e

2+ +( )

d2 = d1 – s t

The Put Call Parity Relationship

p = c – Pa + Pee−rt



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xviii © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Formulae and Tables

TablesPresent Value Table

Present value of 1, i.e. (1 + r)−n

where r = discount raten = number of periods until payment

Discount rate (r)Periods

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 12 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 23 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 34 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 45 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 56 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 67 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 78 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 89 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9

10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 1011 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 1112 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 1213 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 1314 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 1415 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15

11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 12 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 23 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 34 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 45 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 56 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 67 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 78 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 89 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9

10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 1011 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 1112 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 1213 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 1314 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 1415 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15



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© 2014 DeVry/Becker Educational Development Corp. All rights reserved. xix

Formulae and Tables

Annuity Table

Present value of an annuity of 1, i.e. 1 1− + −( )rr

n

where r = interest raten = number of periods

Discount rate (r)Periods

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 12 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 23 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 34 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 45 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 56 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 67 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 78 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 89 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9

10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 1011 10.370 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 1112 11.260 10.580 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 1213 12.130 11.350 10.630 9.986 9.394 8.853 8.358 7.904 7.487 7.103 1314 13.000 12.110 11.300 10.560 9.899 9.295 8.745 8.244 7.786 7.367 1415 13.870 12.850 11.940 11.120 10.380 9.712 9.108 8.559 8.061 7.606 15

11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 12 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 23 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 34 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 45 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 56 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 67 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 78 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 89 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9

10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 1011 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.586 4.327 1112 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 1213 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 1314 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 1415 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15



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xx © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Formulae and Tables

Standard Normal Distribution Table

0·00 0·01 0·02 0·03 0·04 0·05 0·06 0·07 0·08 0·09

0·0 0·0000 0·0040 0·0080 0·0120 0·0160 0·0199 0·0239 0·0279 0·0319 0·03590·1 0·0398 0·0438 0·0478 0·0517 0·0557 0·0596 0·0636 0·0675 0·0714 0·07530·2 0·0793 0·0832 0·0871 0·0910 0·0948 0·0987 0·1026 0·1064 0·1103 0·11410·3 0·1179 0·1217 0·1255 0·1293 0·1331 0·1368 0·1406 0·1443 0·1480 0·15170·4 0·1554 0·1591 0·1628 0·1664 0·1700 0·1736 0·1772 0·1808 0·1844 0·1879

0·5 0·1915 0·1950 0·1985 0·2019 0·2054 0·2088 0·2123 0·2157 0·2190 0·22240·6 0·2257 0·2291 0·2324 0·2357 0·2389 0·2422 0·2454 0·2486 0·2517 0·25490·7 0·2580 0·2611 0·2642 0·2673 0·2703 0·2734 0·2764 0·2794 0·2823 0·28520·8 0·2881 0·2910 0·2939 0·2967 0·2995 0·3023 0·3051 0·3078 0·3106 0·31330·9 0·3159 0·3186 0·3212 0·3238 0·3264 0·3289 0·3315 0·3340 0·3365 0·3389

1·0 0·3413 0·3438 0·3461 0·3485 0·3508 0·3531 0·3554 0·3577 0·3599 0·36211·1 0·3643 0·3665 0·3686 0·3708 0·3729 0·3749 0·3770 0·3790 0·3810 0·38301·2 0·3849 0·3869 0·3888 0·3907 0·3925 0·3944 0·3962 0·3980 0·3997 0·40151·3 0·4032 0·4049 0·4066 0·4082 0·4099 0·4115 0·4131 0·4147 0·4162 0·41771·4 0·4192 0·4207 0·4222 0·4236 0·4251 0·4265 0·4279 0·4292 0·4306 0·4319

1·5 0·4332 0·4345 0·4357 0·4370 0·4382 0·4394 0·4406 0·4418 0·4429 0·44411·6 0·4452 0·4463 0·4474 0·4484 0·4495 0·4505 0·4515 0·4525 0·4535 0·45451·7 0·4554 0·4564 0·4573 0·4582 0·4591 0·4599 0·4608 0·4616 0·4625 0·46331·8 0·4641 0·4649 0·4656 0·4664 0·4671 0·4678 0·4686 0·4693 0·4699 0·47061·9 0·4713 0·4719 0·4726 0·4732 0·4738 0·4744 0·4750 0·4756 0·4761 0·4767

2·0 0·4772 0·4778 0·4783 0·4788 0·4793 0·4798 0·4803 0·4808 0·4812 0·48172·1 0·4821 0·4826 0·4830 0·4834 0·4838 0·4842 0·4846 0·4850 0·4854 0·48572·2 0·4861 0·4864 0·4868 0·4871 0·4875 0·4878 0·4881 0·4884 0·4887 0·48902·3 0·4893 0·4896 0·4898 0·4901 0·4904 0·4906 0·4909 0·4911 0·4913 0·49162·4 0·4918 0·4920 0·4922 0·4925 0·4927 0·4929 0·4931 0·4932 0·4934 0·4936

2·5 0·4938 0·4940 0·4941 0·4943 0·4945 0·4946 0·4948 0·4949 0·4951 0·49522·6 0·4953 0·4955 0·4956 0·4957 0·4959 0·4960 0·4961 0·4962 0·4963 0·49642·7 0·4965 0·4966 0·4967 0·4968 0·4969 0·4970 0·4971 0·4972 0·4973 0·49742·8 0·4974 0·4975 0·4976 0·4977 0·4977 0·4978 0·4979 0·4979 0·4980 0·49812·9 0·4981 0·4982 0·4982 0·4983 0·4984 0·4984 0·4985 0·4985 0·4986 0·4986

3·0 0·4987 0·4987 0·4987 0·4988 0·4988 0·4989 0·4989 0·4989 0·4990 0·4990

This table can be used to calculate N(d), the cumulative normal distribution functions needed for the Black-Scholes model of option pricing. If di> 0, add 0·5 to the relevant number above. If di< 0, subtract the relevant number above from 0·5.



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© 2014 DeVry/Becker Educational Development Corp. All rights reserved. xxi

Examination Technique

ExAMiNAtiON tEChNiquE

OverallIn an exam at this level there will rarely be a unique "correct" answer, particularly in subjective areas such as valuation or ethics. The marking team is flexible—just show those on the team that you can make a reasonable attempt and they will reward you.

Generous marks are often available for performing relatively straightforward calculations (e.g. estimating WACC) or basic discussion (e.g. suggesting various sources of debt finance). Other requirements may ask for something very complex—but only for relatively few marks. If you pick up the easier marks, where available, and at least make an attempt at the more complex parts then you should be awarded a pass.

Excellent attempts at the Paper P4 exam demonstrate the following elements:

< Knowledge and understanding of the entire P4 syllabus, including current issues. Therefore, last minute study, "question spotting" and reliance on exam "tips" is a strategy that is unlikely to be successful.

< Application of knowledge to the scenario given in each question. Weaker answers make general comments rather than being specific to the scenario.

< A balanced answer for all the parts of each question, whether the part required discussion or calculations or both. Make sure, through question practice, that you are going to be able to answer all requirements of a section B question before selecting it.

< Effective time management. Weaker candidates spend too long on section A and then rush through section B. For example, in June 2013 some candidates had difficulty obtaining a relevant discount rate in Question 1 (a)(i). Making a sensible guess and moving on to the next part will help you manage your time effectively.

< Legible, well-presented and well-structured answers. Not only in Section A, where professional marks are available, but throughout your script.

Reading and Planning TimeDuring the 15 minutes reading and planning time you may write on the question paper but not in your answer booklet.

Try to rank the optional questions in section B by their level of difficulty—plan to attempt the easiest question first and then the second easiest. This should help keep your confidence high during the exam.

Although you may use your calculator during the reading and planning time it would be more effective to jot down ideas for the written elements of the questions.

Any calculations done in the reading and planning time should be restricted to those that you should be able to do in your head (as you must show workings in your script for more involved calculations).

Time AllocationTo allocate your time multiply the marks for each question by 1.8 minutes.

e.g. the 50 mark scenario based question in section A should take you 50 × 1.8 = 90 minutes.

You should also apportion your time carefully between the parts of each question.

Do not be tempted to go over the time allocation—remember the "law of diminishing returns" the longer you spend the lower your efficiency in gaining marks. It is more effective to move on.

Attempt all parts of the required number of questions and ensure you pick up relatively easy marks where available (e.g. for routine cost of capital calculations).



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xxii © 2014 DeVry/Becker Educational Development Corp. All rights reserved.


Numerical Elements< Before starting a computation, picture your route. Do this by noting down the steps you

are going to take and imagining the layout of your answer.< Write your assumptions—if you are not sure how to interpret something in the question

then state your assumed interpretation.< Use a columnar (tabular) layout when appropriate (e.g. for PV calculations). This helps

to avoid mistakes and is easier for the marker to follow.< Use plenty of space; include all your workings and cross-reference them to the face of

your answer.< A clear approach and workings will help earn marks even if you make an arithmetic

mistake.< If you cannot perform a particular calculation but need the result to continue to the next

step (e.g. cost of equity to input into WACC) make a sensible guess and move on.< "Sanity check" the results of your calculations for reasonableness. Do they make sense?

For example, if your calculated cost of equity is below the cost of debt you have made a mistake. If you cannot find the source of it at least state that you realise an error has been made.

< If you later notice a mistake made earlier in your answer, it is not worthwhile spending time amending the consequent effects of it. The marker of your script will not penalise you for consequential errors (under the "own error" and "method mark" rules).

< Do not produce a long chain of calculations without inserting brief comments between your steps.

< Make sure you practice for Black Scholes calculations. Make sure you bring a scientific calculator to the exam.

Written ElementsPlanning

< Read the requirements carefully at least twice to identify exactly how many points you are being asked to address.

< Note down relevant thoughts on your plan.< Give your plan a structure which you will follow when you write up the answer.Presentation

< Use headings and sub-headings to give your answer structure and to make it easier to read for the marker.

< Use short paragraphs for each point that you are making.< Use bullet points where this seems appropriate (e.g. for a list of advantages/

disadvantages). However each bullet point must be followed by a full sentence. < Separate paragraphs by leaving at least one line of space between each.Style

< Long philosophical debate does not impress markers. Concise, easily understood language scores good marks and requires less writing.

< Lots of points briefly explained tend to score higher marks than one or two points elaborately explained.

< Give real life examples and be aware of what is happening in the world economy and finance. In the months prior to the exam you should be reading quality financial press (e.g. www.ft.com, www.economist.com, www.cfo.com).

< As you write refer back to the requirement to ensure that you are specifically addressing it with relevant comments.

< If you write appropriate comments based on previous calculations which contained errors, you can still be awarded all the marks for the comments.



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© 2014 DeVry/Becker Educational Development Corp. All rights reserved. xxiii


< If you could not complete the calculations required for comment then assume an answer. As long as your comments are consistent with your assumed answer you can still be awarded marks for the comments.

< Make sure your handwriting is clear— use black ink only and consider using block capitals.

Professional Marks< The section A question will require candidates to produce their answers in a specified

format (e.g. report or memorandum).< Four professional marks will be available, partly for using the specified format, as well as

for the general clarity and structure of your answers.< You cannot afford to throw away these professional marks—for many candidates they

make the difference between passing and failing the exam.



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P4 Advanced Financial Management Becker Professional Education | ACCA Study System

Session 1

FOCUS This session covers the following content from the ACCA Study Guide.


1. The role and responsibility of senior financial executive/advisora) Develop strategies for the achievement of the company's goals in line with its agreed

policy framework.b) Recommend strategies for the management of the financial resources of the company

such that they are utilised in an efficient, effective and transparent way.c) Advise the board of directors of the company in setting the financial goals of the business

and in its financial policy development.2. Financial strategy formulationd) Explain the theoretical and practical rationale for the management of risk.e) Assess the organisation's exposure to business and financial risk including operational,

reputational, political, economic, regulatory and fiscal risk.f) Develop a framework for risk management comparing and contrasting risk mitigation,

hedging and diversification strategies.3. Conflicting stakeholder interestsa) Assess the potential sources of the conflict within a given corporate governance/

stakeholder framework informed by an understanding of the alternative theories of managerial behaviour.

b) Recommend, within specified problem domains, appropriate strategies for the resolution of stakeholder conflict and advise on alternative approaches that may be adopted.

c) Compare the emerging governance structures and policies with respect to the roles of the financial manager.

4. Ethical issues in financial managementa) Assess the ethical dimension within business issues and decisions and advise on best

practice in the financial management of the organisation.b) Demonstrate an understanding of the interconnectedness of the ethics of good business

practice between all of the functional areas of the organisation.c) Establish an ethical financial policy for the financial management of the company

which is grounded in good governance, the highest standards of probity and is fully aligned with the ethical principles of the Association.

d) Recommend an ethical framework for the development of a company's financial policies and a system for the assessment of their ethical impact upon the financial management of the organisation.

e) Explore the areas within the ethical framework of the company which may be undermined by agency effects and/or stakeholder conflicts.

5. Environmental issues and integrated reportinga) Assess the issues which may impact upon corporate objectives and governance. b) Assess and advise on the impact of investment and financing strategies and decisions on

the organisations' stakeholders, from an integrated reporting and governance perspective.


1. Developments in world financial marketsa) Discuss the significance to the organisation of the international regulations on money

laundering.

Role of Financial Strategy

(see ACCA Study Guide for expanded learning objectives)



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© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 1- 1

Session 1 Guidance

CORPORATE OBJECTIVES

• In Practice• Shareholders'

Wealth• Integrated

Reporting

VISUAL OVERVIEWObjective: To introduce the role and operating environment of the senior financial executive.

Recognise the role of an organisation's chief financial executive (s.1). Understand a company's objectives (s.2) and how these objectives may conflict within a principal-agent relationship (s.3).

Recognise the different approaches to corporate governance around the world—and the main legislation (e.g. US Sarbanes-Oxley Act, UK Corporate Governance Code) (s.4).

Appreciate the relevance of integrated reporting (s.6) and risk management (s.7) to corporate governance in an ethical environment (s.5).

Read the technical article "Risk Management".

ROLE OF SENIOR FINANCIAL EXECUTIVE

CORPORATE GOVERNANCE

• Definition• Around the

World• Sarbanes-

Oxley Act• Cadbury

Report• Greenbury

Code• Combined

Code• Turnbull

Report

ETHICS• Ethical

Contexts• Ethical

Decision-Making

• Decision-Making Models

• Stakeholder Conflicts

RISK MANAGEMENT

• Should Risk Be Managed?

• Equity-Debt Investors' Conflicts

• Types of Risk• Managing

Exposure• Framework

CONFLICTS OF INTEREST

• Agency Theory• Stakeholders• Directors and

Shareholders• Transaction

Cost Theory• Goal

Congruence

ENVIRONMENTAL ISSUES AND INTEGRATED

REPORTING• Sustainability• TBL Reporting• Carbon Trading

Economy• Government

Environment Agencies• Integrated Reporting



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Session 1 • Role of Financial Strategy P4 Advanced Financial Management

1- 2 © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

1 Role of the Senior Financial Executive

The role of the senior financial executive or adviser encompasses the following:

< Advising the board of directors in setting the financial goals of the business and in its financial policy development. Specific areas include: Investment selection and capital resource allocation

(Sessions 5, 6 and 17); Minimising the firm's cost of capital (Session 3); Distribution and retention policy (Session 12); Communicating financial policy and corporate goals

to internal and external stakeholders (see later in this session);

Financial planning and control (Sessions 8, 9 and 18); The management of risk (Sessions 13–15).

< Developing strategies for the achievement of the firm's goals in line with its agreed policy framework.*

< Recommending strategies to manage the financial resources of the firm such that they are utilised in an efficient, effective and transparent way.

< Establishing an ethical financial policy for the financial management of the firm which is grounded in good governance, the highest standards of probity and is fully aligned with the ethical principles of the ACCA.

< Exploring the areas within the ethical framework of the firm which may be undermined by agency effects and/or stakeholder conflicts and establishing strategies to deal with them.

< Preparing advice on personal finance to individual as well as groups of investors, covering areas such as investment and financing.

2 Corporate Objectives

2.1 Corporate Objectives in PracticeIn practice, companies are likely to have a variety of different objectives which may include a number of the following:

< profit targets;< market share targets;< share price growth;< local and environmental concerns;< contented workforce;< meeting short-term targets; and< long-term plans.

*Clearly, before any strategies can be developed for the firm its objectives must be identified.



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P4 Advanced Financial Management Session 1 • Role of Financial Strategy

These objectives can be classified as follows:

< Profit goals—objectives which lead directly to increased profits (e.g. cost reduction measures);

< Surrogate profit goals—objectives which lead indirectly to increased profits (e.g. maintaining a contented workforce);

< Constraints on profit—objectives which actually restrict profit (e.g. ensuring that the company's operations do no harm to the environment);

< Dysfunctional goals—objectives which do not provide a benefit even in the long run (e.g. the pursuit of market leadership at all costs).

A company may aim at either maximising or satisficing these objectives:

< Maximising involves seeking the best possible outcome;< Satisficing involves finding an adequate outcome.

2.2 Maximisation of Shareholders' WealthIn theoretical terms a single corporate objective is assumed and this is "the maximisation of shareholder wealth".

Shareholder wealth is the combination of dividend and share price growth—together referred to as Total Shareholder Returns ("TSR").

The objective of maximising shareholder wealth can be justified in the following ways:

The company which provides the highest returns for its investors will find it easiest to raise new finance and grow in the future. If a company does not provide competitive returns it will inevitably decline.

The directors of a company have a legal duty to run the company on behalf of the shareholders. It is generally considered a reasonable assumption that the shareholders of listed companies (mainly institutional investors) seek to maximise wealth.

Criticisms of the above include the following:

Maximising TSR ignores the interests of other stakeholders such as employees, customers and arguably, society as a whole.

In the case of unlisted companies even the shareholders may not require maximised returns (e.g. some closely held companies are run as "life-style firms" whose main objective is to create prestige for the owners).



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2.3 Integrated Reporting< The International Integrated Reporting Council (IIRC) is a

global coalition of regulators, investors, companies, standard setters, the accounting profession and non-government organisations. It has a vision of a business environment in which integrated thinking is ingrained in mainstream business practice, in both public and private sectors. This would be facilitated by integrated reporting.*

< The goals of integrated reporting are: to improve the quality of information available to providers

of financial capital; to promote a more cohesive and efficient approach to

corporate reporting; to enhance accountability and stewardship for all forms of

capital; to promote the understanding of the interdependencies

among the various capitals; and to support integrated thinking in decision-making and

actions which create value.< Capitals include—Definition

Financial—The pool of funds that is:— available for use in the production of goods or provision

of services; or— obtained through financing.

Manufactured—Manufactured physical objects that are distinct from natural physical objects (e.g. buildings, equipment and infrastructure).

Intellectual—Organisational, knowledge-based intangibles. Human—People's competencies, capabilities and experience

and their motivations to innovate. Social and Relationship—The institutions and the

relationship within and between communities, groups of stakeholders and other networks, and the ability to share information to enhance individual and collective well-being.

Natural—All renewable and non-renewable environmental resources and processes that provide goods or services that support the past, current or future prosperity of an organisation.

< The purpose of the <IR> Framework is to provide principles and content elements that help: to shape the information provided; and to explain why the inclusion of the information provided is

important.< The <IR> Framework challenges an organisation to recognise

the needs of multiple stakeholders when making financial and investment decisions. In particular, an integrated report should enhance the transparency of an organisation.

*The IIRC launched a new <IR> Framework in December 2013.

Integrated report— a concise communication about how an organisation's strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value over the short, medium and long term.

Capitals— the resources and relationships used and affected by an organisation.



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3 Conflicts of Interest

3.1 Agency Theory Agency theory examines the duties and conflicts that occur between the parties in a company that have an agency relationship.

PRINCIPAL Shareholders Directors Loan creditors

AGENT Directors Employees Shareholders

AGENT'S RESPONSIBILITY Generate maximum return for

shareholders

Work to maximum efficiency

Minimum risk from uses of

borrowed funds

A company can be viewed as a set of contracts between each of these various interest groups. The company will not succeed unless all of the groups are working towards the same objectives.



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3.2 StakeholdersCompanies are made up of a variety of different interest groups or "stakeholders", all of whom are likely to have different interests in and objectives for the company:

CompanyCompanyCompanyCompanyCompanyCompany

LOAN CREDITORS• Security• Cash Flow• Long-Term

prospects

EMPLOYEES• Pay and Conditions• Job Security

DIRECTORS• Remuneration• Power• Esteem

EQUITY SHAREHOLDERS

• Maximum Wealth

TRADE CREDITORS

• Short-Term Cash Flow

COMMUNITY• Environmental

Issues

While shareholders are clearly the key stakeholder, modern corporate governance suggests that directors should take into account the objectives of a wider range of interested parties. Directors are therefore expected to show responsibility:

< to creditors (e.g. reasonable payment terms);< to employees (e.g. health and safety); and ultimately < to society as a whole (e.g. minimising pollution, investing in

social projects).*Therefore the overall corporate objective may become "satisficing" (i.e. producing satisfactory rather than maximum returns for shareholders). With the rise of the "ethical investor" on world stock markets, it appears that many shareholders are in fact willing to accept slightly lower returns in exchange for their companies following a wide range of both financial and non-financial objectives.

*This is encompassed by corporate social responsibility (CSR).



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3.3 Directors and Shareholders In larger companies the shareholders entrust the management of the company to the directors—referred to as the separation of ownership and control. The directors are managing the company on behalf of the shareholders and should therefore always act in the best interests of the shareholders, while taking into account the objectives of other stakeholder groups.

This may not always be the case, as the directors may have other personal objectives such as:

< increasing personal remuneration levels;< maximising bonus payments;< empire building;< job security. In addition to the personal aspects shown above, a small number of directors have been guilty of not fulfilling their fiduciary duties by:

< creative accounting; by choosing creative accounting policies the directors can flatter the accounts —known as "window dressing".

< off balance sheet finance (e.g. via the use of "special purpose vehicles").

< takeovers; in defending the company from takeovers some directors have been accused of trying to protect their own jobs rather than acting in the interests of their shareholders.

< disregard for environmental issues; directors may allow processes which emit pollution or test products on animals.

If directors follow personal objectives which conflict with those of their shareholders this leads to "agency costs" (i.e. lost potential returns for shareholders). This can be referred to as "the agency problem".

Good corporate governance procedures should be implemented to minimise the effect of agency costs. Unfortunately, the implementation of corporate governance brings its own costs (particularly in the case of the Sarbanes-Oxley Act) and hence a cost-benefit approach should be followed to determine an appropriate level of control over directors.

It can be argued that:

Actual return to shareholders = maximum potential return – agency costs – costs of CSR

To some degree shareholders themselves should be more active in monitoring the behaviour of directors. Most shares in listed companies are held by institutional investors (e.g. pension funds). Fund managers have often been guilty of operating in a very passive way, for example not even using the proxy voting rights given to them by the fund's investors. Until there is a rise in shareholder activism it remains likely that some directors will continue to work in their own best interest.



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3.4 Transaction Cost Theory < Initially considered by Ronald Coase (1937), transaction

costs were first defined in purely economic terms as the costs incurred in making an "economic exchange with an external third party". These include: search and information costs (e.g. determining who has

the goods and services available, terms and conditions and prices charged by different suppliers);

bargaining costs (e.g. negotiating prices, terms and conditions, reaching an acceptable agreement, drawing up contracts); and

policing and enforcement costs (e.g. ensuring that there is no breach of contract and seeking redress if there is).

< Coase argued that these market-based transactions (and costs) can be eliminated in a firm. Firms should therefore tend towards vertical integration (i.e. acquire suppliers and distributors) as this would remove such costs and the risks and uncertainties of dealing with external sources. Ultimately, the market would be replaced by one firm.

< The underlying assumption made by Coase was that managers make rational decisions for the primary aim of profit maximisation. Further work by Cyert and March (1963), Williamson (1966) and others considered that a firm consists of people with differing views and objectives. They also extended the concept of transactions from merely buying and selling to include intangible elements (e.g. promises made and favours owed).

< They also considered managers to behave rationally, but only up to a certain point, as like all human beings they are also opportunistic. As agents they take advantage of opportunities to further their own self-interest and privileges.

< Although managers would organise transactions for the firm's benefit, there would come a point (e.g. when it is worth the risk and they do not expect to be caught) when certain transactions and opportunities would be organised to the manager's benefit.

< Consequently, principals (shareholders) need to ensure that transactions maximise the benefit to the company while minimising the potential for opportunism by agents.



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3.5 Goal Congruence Goal congruence is when each of the parties in an organisation is seeking to achieve personal objectives which are also in the best interests of the company as a whole.

For example, managers should be encouraged to aim for long-term growth and prosperity rather than short-term reported profitability.

Methods of encouraging goal congruence between directors and shareholders:

< Executive Share Option Plans (ESOPs)—although the evidence is mixed regarding the success of such schemes in motivating directors to improve performance (e.g. a company's share price may rise due to a general rise in the stock market rather than the quality of its management).

< Long-Term Incentive Plans (LTIPs)—paying a bonus to directors if over several years the company's performance is good when benchmarked against that of competitors.

< Transparency in corporate reporting.< Improved corporate governance (e.g. through the

appointment of truly independent non-executive directors).< Increased shareholder activism (e.g. using voting rights).

4 Corporate Governance

4.1

Corporate governance—the system by which companies are directed and controlled.The objective of corporate governance may be considered as the reduction of agency costs to a level acceptable to shareholders.

4.2 Corporate Governance Around the World

4.2.1 UK*

< Cadbury Report (see s.4.4)< Greenbury Code (see s.4.5)< Combined Code (see s.4.6)< Turnbull Report (see s.4.7)

4.2.2 US

< SEC imposes quarterly reporting requirements.< Audit committees required for all listed companies. < Sarbanes-Oxley Act introduced in 2002 as a response to

a series of high-profile corporate scandals (e.g. Enron, WorldCom, Global Crossing and Tyco International).

*Since 2010 the provisions of these have been incorporated in the UK Corporate Governance Code ("the Code").



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4.2.3 Germany

< Two-tier board system—separate management and supervisory board.

< Banks providing credit often have long-term equity holding.

4.2.4 Japan

< Traditionally, companies doing business together would hold shares in each other although this system is now reducing.

< Three-tier board system—policy, functional and monocratic.

4.3 Sarbanes-Oxley Act Introduced in 2002, the Sarbanes-Oxley Act ("SOX") represents the most significant review of US corporate governance since the Securities Exchange Act of 1934.

SOX imposes new responsibilities on chief executive officers (CEOs) and chief financial officers (CFOs) and exposes them to much greater potential liability.

It applies to all companies listed on a US stock market—including their foreign subsidiaries. Compliance is mandatory.

One of the main provisions is that the CEO and CFO should sign off personally on company accounts. Fraudulent certification (i.e. signing accounts known to be inaccurate) leads to criminal penalties—fines of up to $5 million and up to 20 years in prison.

However, some CEOs and CFOs have tried to avoid their responsibilities under SOX by asking divisional heads to certify their division's accounts before they are sent to the head office.

Furthermore, the level of detail required in reporting compliance with SOX is very high. Such high compliance costs have discouraged many companies from listing their shares in New York—often choosing London, where corporate governance codes are based more upon principles than detail.

4.4 Cadbury ReportThe Cadbury Committee was set up in 1991 to review aspects of corporate governance—specifically related to financial reporting and accountability.

The Cadbury Report was published in 1992 and the boards of all UK listed companies had to comply with the Code of Best Practice contained in the report.

Main provisions of the Code include:

< Board of directors: meet regularly; monitor executive management; division of responsibility at head of company; include non-executive directors ("NEDs").

< Non-executive directors: bring independent judgement to matters of strategy,

performance, resources; should sit on remuneration committee.



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< Executive directors: service contracts not exceeding three years; pay subject to recommendations of remuneration

committee; total emoluments disclosed fully and clearly.

< Audit committee: made up of at least three NEDs; liaise with external auditors; recommend appointment and fees of external auditor; review company statement on internal controls.

< Directors statements: must report on effectiveness of company's system of

internal control; should report that company is a going concern.

4.5 Greenbury CodeThe Greenbury Committee (formally known as The Study Group on Directors' Remuneration) issued its report in 1995 covering best practice recommendations in the realm of executive and director compensation. Its principles have drawn far more criticism than those drafted by Cadbury, but institutional investors in Britain accept the main points as valuable. The Greenbury Code includes the following key recommendations:

The compensation committee should be composed exclusively of independent outsiders.

Companies should annually outline their compliance with the Greenbury Code, including explanations if they do not comply.

The annual compensation committee report should disclose pay details for all executive directors, including pension provisions, incentive pay, option plans, performance measurements, severance agreements and comparisons with similar companies.

Executive pay should not be "excessive". Employment contracts should extend for no longer than one

year so as to rule out multiyear golden handshake payouts in the event an executive is dismissed or the company is taken over.

New long-term incentive plans should replace, not supplement, existing stock option plans.

Performance-related pay should "align the interest of directors and shareholders", while performance criteria should be "relevant, stretching and designed to enhance the business. Upper limits should always be considered".

Executive stock option awards should be phased rather than given all at once, and options should never be awarded at a discount.



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4.6 Combined CodeThe Combined Code of the Committee on Corporate Governance was first issued in June 1998 and revised in July 2003. In many ways it is derived from the Cadbury and Greenbury Codes.

The Combined Code is included in the Listing Rules of the London Stock Exchange. Although compliance is not obligatory, any listed company which does not comply with the Combined Code must explain its reasons for non-compliance.

It sets out the following UK Principles of Good Governance:

Every listed company should be headed by an effective board which should lead and control the company.

Chairman and CEO—there should be a clear division of responsibilities at the head of the company between running the board and running the business; no single individual should dominate.

The board should have a balance of executive and independent non-executive directors.

All directors should be required to submit themselves for re-election at least every three years.

Remuneration committees should be 100% independent non-executive directors.

Remuneration committees should provide the packages needed to attract, retain and motivate executive directors and avoid paying more.

Executive service contracts should be for one year or less. No director should be involved in setting his own

remuneration.

4.7 Turnbull ReportIssued in 1999 to give implementation guidance on aspects of the Combined Code dealing with internal control, internal audit and risk management.

It states that "the board should maintain a sound system of internal control to safeguard shareholders' investment and the company's assets".

The key objective of the Turnbull report was to reflect best business practice by adopting a risk-based approach to designing, operating and maintaining a sound system of internal control. The guidance it offers is based on a framework of principles rather than checklists. It also encourages making meaningful disclosure.

Instead of specifying particular controls for all companies, the report requires the board of directors of listed companies to identify those risks that are significant to the fulfilment of their particular corporate business objectives and to implement a sound internal control system to manage these effectively. This requires the board to have a clear understanding of the company's long-term strategic aims.



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Illustration 1 Corporate Governance

Briefly explain what is meant by corporate governance and discuss the major differences that exist between corporate governance practice in the UK, US and Japan.

SolutionCorporate governance is the system by which companies are controlled. In the UK this is the responsibility of the directors. The function of the director is the high-level management of the company, strategy, etc and reporting the performance of the company to the owners. The auditors provide a check on the accuracy of financial statements and help to satisfy the owners that a system of corporate governance exists.The actions of the directors of course affect all interest groups not just the business owners. Their general behaviour is governed by the articles of association but there exists also a body of civil and criminal law which can restrict their actions. This body of law is much larger in the US than in the UK; UK directors are more subject to voluntary codes of conduct; and the Cadbury Report in the UK has suggested that this may be the most effective way of introducing controls. In addition to conventional laws and codes of conduct, the behaviour of directors is also "controlled" by the stock exchanges; again the rules of the New York exchange (SEC) are much more comprehensive than in London.As one would expect, the culture of Japan is reflected in its approach to corporate governance. No detailed framework or system of laws exists. Everybody is expected to work together for the good of the company and not for the shareholders alone. The system is therefore, in principle, more flexible and responsive.Boards are often split into different levels, each with its own remit, for example:(i) Policy boards responsible for strategy.(ii) Functional boards where senior management discusses the main

functional responsibilities.(iii) Monocratic boards, which tend to be symbolic and have few

actual functions.In Japan, a close relationship exists between the banks and their clients; banks usually have board representation and take an active role in decision-making. The US is more of a middle ground where creditors or other corporations may be represented. The UK companies tend to be the most insular.



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5 Ethics

5.1 Ethical Contexts for the Financial Executive or Adviser

5.1.1 Main Components

< Act with integrity.< Be a credit to the profession.< Use independent professional judgement.< Be competent.

5.1.2 Fundamental Responsibilities

< Know and comply with laws, regulations, ethical codes and professional standards.

< Do not knowingly participate or assist others in any violation of applicable regulations or ethical codes.

5.1.3 Relationship With the Profession

< Use ACCA designation with dignity.< Do not engage in any act which adversely reflects on one's

honesty, trustworthiness or professional competence.< Do not plagiarise.

5.1.4 Relationship With the Employer

Members must inform employers of their obligation to comply with the ACCA Code of Ethics and Standards of Professional Conduct. They must:

< Not undertake any independent practice in competition with their employer without their employer's consent and the consent of the client.

< Disclose to their employer all matters that could be reasonably expected to impair their ability to render an unbiased and objective opinion.

< Disclose to their employer all monetary and other benefits received for services other than the usual compensation paid by their primary employer.

5.1.5 Interaction With Clients

Members must:*< place their client's interest before their own;< have a reasonable and adequate basis for stating opinions;< use reasonable judgement to include relevant facts,

distinguish between fact and opinion and use independence and objectivity in making opinions.

*This is particularly relevant to financial advisers.



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5.1.6 Compliance With Anti– Money-Laundering Legislation

In many countries professionals, such as accountants, are required by law to report any suspicion of money laundering. For reference, the basic provisions of UK law are given below.

The Proceeds of Crime Act 2002 contains the UK anti-money-laundering legislation, including provisions requiring businesses in the "regulated sector" (banking, investment, money transmission and professions such as accountancy) to report to the authorities suspicions of money laundering by customers or others. Money laundering is defined in the UK as any handling of the proceeds of any crime, including any process by which proceeds of crime are concealed or disguised so that they may be made to appear to be of legitimate origin. Unlike certain other jurisdictions (notably the US and much of Europe), UK money-laundering offences are not limited to the proceeds of serious crimes, nor are there any monetary limits. A money-laundering offence under UK legislation need not involve money, since the legislation covers assets of any description. Therefore any person who commits an acquisitive crime (i.e. one from which he obtains some benefit in the form of money or an asset of any description) in the UK will inevitably also commit a money-laundering offence under UK legislation.This applies also to a person who, by criminal conduct, evades a liability (e.g. a taxation liability) as he is deemed thereby to obtain a sum of money equal in value to the liability evaded. The consequence of the act is that accountants who suspect that their clients (or others) have engaged in tax evasion or other criminal conduct are required to report their suspicions to the authorities.

5.1.7 International Aspects

Specific ethical issues may arise for businesses operating overseas. The following questions may have to be faced:

< Should "facilitation payments" be made to local officials to overcome problems with "red tape" (e.g. for customs clearance)?

< Is it acceptable to use transfer pricing internationally to minimise tax liabilities?

< Should assets be transferred into offshore companies to shield them from capital gains tax on disposal?

< If laws overseas are more relaxed than at home (e.g. regarding the employment of child labour) should the company follow the more relaxed local laws or apply the business practices of its home country?

< Sensitivity to local business practices (e.g. in the Islamic world Shariah law prohibits the payment/receipt of interest and investing in "immoral" activities, such as alcohol and gambling. Raising debt finance may still be possible through the issue of sukuk Islamic bonds which claim Shariah compliance through paying returns based on a profit share of the underlying project, as opposed to a market-based interest rate.)

There may be no right or wrong answer to such questions but the examiner expects an opinion to be expressed in the exam.



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5.2 Ethical Decision-MakingThere are many models and approaches for the classification and description of moral and ethical decision-making. For example:

< Rest's four-component model;< Albrecht's Ethical Development Model (EDM); and< IAESB Ethics Education Framework.

5.2.1 Rest's Model

< This four-component model is as follows:

Step 1 It must be recognised that there is a moral issue involved. The decision-maker must be able to appreciate that the selection of a particular course of action will affect the welfare of other interested parties.

Step 2 The decision-maker must be able to select an appropriate action.

Step 3 The decision-maker must attach priority to moral values, rather than, for example, acting out of self-interest.

Step 4 The decision-maker must have sufficient moral strength to implement the resolution identified in the previous steps.

Based on Rest, 1986

Illustration 2 Charitable Contributions

The decision of a company not to make a donation to a charity could be based on prejudice or self-interest. This is not then a moral decision.Alternatively, it could be based on an ethical position that supporting the charity may help the plight of those who are disadvantaged and/or prevent others suffering similarly.Whether a donation is made does not give insight into the motive. A donor may give without much thought through embarrassment or a belief that it is wrong to rebut a call for help. The decision could be motivated by a considered ethical stance or by self-interest or some other non-ethical position.

5.2.2 Albrecht's Ethical Development Model (EDM)

< The Ethical Development Model (EDM) is another progressive model which sets out the life development of an ethical perspective. Developed by Albrecht et al. it has four levels:

(1) Personal ethical understanding

A foundation level. Appreciates the difference between right and wrong and understands the basic principles of integrity and empathy.

(2) Application of ethics to business situations

This is the first of two levels in which professional education has a role to play in translating and applying ethics to the business context.



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(3) Ethical courage This requires individuals to develop ethical strength and moral conviction to act appropriately in "questionable" situations.

(4) Ethical leadership Building on (3) this calls for "ethical leadership" and the capacity to inspire others to develop their own ethical awareness.

5.2.3 IAESB Ethics Education Framework

< The International Accounting Education Standards Board (IAESB) is an independent standard-setting board of the IFAC.

< The Ethics Education Framework as developed by the IAESB is a four-stage learning continuum to be applied by all professional accountants throughout their careers.

• Ethical knowledge—obtaining an understanding of the fundamental theories and principles of ethics, virtues and individual moral development.

• Ethical sensitivity—applying the knowledge to the work environment, to enable ethical threats to be recognised.

• Ethical judgement—applying knowledge and sensitivity to form reasoned and well-informed decisions.

• Ethical behaviour—continuous believing in, applying and acting on ethical principles.

Review

Review

3Improving Ethical Judgement

1Enhancing Ethics Knowledge

2Developing Ethical Sensitivity

Revise

Revise

4Maintaining an Ongoing Commitment to Ethical Behavior



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< Ethical sensitivity and ethical judgement require professional accountants to develop: the ability to recognise an ethical threat or issue; an awareness of alternative courses of action leading to an

ethical solution; and an understanding of the effects of each alternative course of

action on stakeholders.< Doing so improves professional judgement by sharpening

ethical decision-making skills through the application of ethical theories, social responsibilities, codes of professional conduct and ethical decision-making models (EDMM).

5.3 Ethical Decision-Making Models (EDMM)

5.3.1 Issues Addressed

< The two basic issues in ethics are determining: the right motive; and the right action.

< EDMMs have been developed from conceptual approaches, to provide a method of practically applying a framework to resolve ethical dilemmas.

< The role of EDMMs is to provide a more systematic analysis enabling comprehensible judgement, clearer reasons and a justifiable and more defensible action than would have otherwise been the case.

5.3.2 American Accounting Association (AAA)

< The AAA model frames the ethical decision as a series of answers to questions and requires the user to explicitly outline their norms, principles and values. The model is appropriate for use when considering professional or individual ethical conflicts.

< The questions to be answered are: (1) What are the facts of the case?

(2) What are the ethical issues in the case?

(3) What are the norms, principles and values related to the case?

(4) What are the alternative courses of action?

(5) What is the best course of action that is consistent with the norms, principles and values identified in (3) above?

(6) What are the consequences of each possible course of action?

(7) What is the decision?



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Example 1 AAA Model

You are the chief executive of a company which depends heavily on government contracts. You have been approached by the fundraiser for a political party candidate. He asks you for a large contribution, strongly implying that if this candidate wins the election it will increase your ability to win government contracts. You do not prefer the candidate, either personally or from a business perspective.Required:Use the AAA model to determine whether the contribution should be made.1. What are the facts of the case? 2. What are the ethical issues in the case?3. What are the norms, principles and values related to the case?4. What are the alternative courses of action?5. What is the best course of action that is consistent with the norms,

principles and values identified in No. 3. above?6. What are the consequences of each possible course of action?7. What is the decision?Solution



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5.3.3 Tucker's 5-Question Model

< Five questions about a business decision must be answered in the affirmative to confirm that it is ethical. Is the decision:(1) Profitable (But compared to what?)

(2) Legal (What framework was used?)

(3) Fair (From whose perspective? Consider stakeholders.)

(4) Right (Based on what ethical position?)

(5) Sustainable (Or environmentally sound?)

< Tucker's model actually creates more questions than it asks. It encourages debate over conflicting ethical approaches, the stakeholders involved and sustainability and is therefore more appropriate to use when considering organisational problems rather than professional or individual situations.

Example 2 Tucker's Model

Your company owns a number of large properties in various major cities. The real estate assessor in one city offers, for a fee, to underestimate the value of your building and so you will save substantial annual taxes assessed on property value. This is common practice in the region.Required:Use Tucker's model to determine whether you ought to pay the fee.

Solution



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5.3.4 ACCA Ethical Conflict Resolution

< Under the ACCA's Code of Ethics and Conduct, professional accountants should consider: the relevant facts; the ethical issues involved; related fundamental principles; established procedures of the firm; the action that can be followed and the probable outcome; alternative courses of action and their consequences; and internal and external sources of consultation available (e.g.

ethics partner, audit committee).< If a significant conflict cannot be resolved, consulting

legal advisers and/or ACCA should be considered. Such consultation can be taken without breaching confidentiality.

< If, after exhausting all possibilities, the ethical conflict remains unresolved, members should, where possible, refuse to remain associated with the matter creating the conflict.

5.3.5 Institute of Business Ethics (IBE)

< The IBE, a UK charity registered in 1986, promotes three simple ethical tests for a business decision: Transparency: Do I mind others knowing what I have

decided? Effect: Who does my decision affect or hurt? Fairness: Would my decision be considered fair?

5.4 Agency Issues and Stakeholder ConflictsThe ability of an organisation's management to implement its ethical framework can potentially be undermined by agency issues and conflicts between stakeholder groups. Management needs to identify and resolve conflicts quickly so as to avoid a potentially damaging public debate about the organisation's ethics.

5.4.1 Agency Issues

Agency issues are particularly likely in the case of a quoted company where there is significant divorce of ownership and control. The directors (as agents) are in a quite different ethical position compared with their shareholders (the principal) as:

< the directors' ethical performance is scrutinised by the public and potentially by investigative journalists. Any alleged wrongdoing can lead to serious damage to a director's personal reputation;

< the shareholders, being separate from the running of the business, cannot be easily held responsible for any ethical lapses in the company. Furthermore, most shares in quoted companies are held by institutional investors who will have their portfolios diversified across many companies.



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Therefore, company directors (and indeed the entire workforce) may tend to take a very cautious approach towards ethics, even verging on paranoia, as their own reputation is very closely linked to that of their firm. Institutional investors, on the other hand, may take a more relaxed view of ethics as they are shielded from personal scrutiny and, in any case, would only hold a small percentage of their fund's wealth in the shares of one particular company.

If the directors come under pressure from shareholders to relax the firm's ethical guidelines then appropriate responses could include:

< quoting relevant legislation (e.g. if the firm is US-based, the Foreign Corrupt Practices Act prohibits the payment of bribes anywhere in the world);*

< encouraging "ethical investment funds" to take shareholdings in the firm, whose ethical stance is more likely to be aligned with that of the directors.

5.4.2 Stakeholder Conflicts

Although shareholders are a firm's key stakeholder, there are also potential conflicts with other groups:

< Consumers may boycott the firm's products if it is discovered that the products were made in exploitative working conditions. A strategy to mitigate this risk could be to arrange manufacturing through a subcontractor.*

< Governments may "attack" firms that use aggressive tax avoidance schemes. For example, the UK government has strongly criticised Google, Amazon and Starbucks for complex schemes, such as the "double Irish with a Dutch sandwich", that avoid taxable profits being recorded in the UK. A possible defence is to highlight the amount of sales tax and payroll tax that the firm collects on behalf of the government.*

6 Environmental Issues and Integrated Reporting

6.1 Sustainability

Sustainability—"… not a fixed state of harmony, but rather a process of change in which the exploitation of resources, the direction of investments, the orientation of technological development and institutional change are made consistent with future as well as present needs." Sustainable development—"a business approach that creates long-term shareholder value by embracing opportunities and managing risks from economic, environmental and social developments." Sustainable development—"development that meets the needs of the present without compromising the ability of future generations to meet their own needs."

*Large fines can be imposed for contravening.

*However, this is no guarantee of isolating the firm from reputational risk.*Or, as in the case of Starbucks, making a voluntary payment of profit tax.



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Examples of sustainable development:

< Using or adapting existing facilities, rather than building "from scratch".

< Environmentally friendly building and design.< Minimisation of adverse effects on nearby residents.< Protection of native vegetation (e.g. forests, wetlands, fauna).< Minimisation of waste with recycling encouraged.< Minimisation of energy use (e.g. solar power).< Minimisation of pollution (or cleaning up if it exists).< Construction on "brownfield sites" (i.e. those previously used

as industrial/commercial sites)—leaving "greenfield" (i.e. undeveloped) land untouched.

< Integrated reporting emphasises the importance of financial ability and sustainability for an organisation's success.

6.2 Triple Bottom Line Reporting ("TBL" or "3BL")< The phrase was coined by John Elkington, co-founder of

the business consultancy SustainAbility. It is an expanded baseline for measuring performance.

< Triple bottom line accounting attempts to measure and report corporate performance against economic, social and environmental benchmarks in order to show improvement or to make more in-depth evaluation.*

< It can be viewed as: a reporting device (e.g. information presented in annual

reports); and/or an approach to improving decision-making and the activities

of organisations (e.g. by providing tools and frameworks for considering the economic, environmental and social implications of decisions, products, operations, future plans).

Advantages

Makes transparent the organisation's decisions that explicitly consider effects on the environment and people, as well as on financial capital. More informed decision-making as

decision-makers can quantify trade-offs between different aspects of sustainability. Improved relationships with key

stakeholders and improved risk-management through consultation. Specific commercial advantages (e.g.

competitive advantage with customers suppliers and providers of finance). Enhancement of reputation and brand.

May result in attracting and retaining employees with sustainable values.

Disadvantages

There are currently few standards for measuring these effects. Usefulness and comparability, as there

is a significant range of disclosure (content and quality). The difference between the economic

bottom line and the financial bottom line is often blurred. Increase in annual reporting costs

with disproportionate costs for smaller entities. Potential exposure to risk and liability

relating to the reliability of the report's content (unless audit is mandatory). Potential bias in voluntary presentation

(e.g. including only favourable information).

*There is also a move to add governance to the bottom line, making "Quadruple Bottom Line reporting".



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< Such indicators can distil complex information into a form which is accessible to stakeholders. (Organisations report on indicators that reflect their objectives and are relevant to stakeholders.)

< One difficulty in identifying and using indicators is consistency in an organisation, over time and between organisations at any point in time (important for benchmarking).



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Example 3 TBL Reporting

The board of directors of Triple Tipple plc are discussing whether to adopt a triple bottom line (TBL) reporting system, increasingly used by the firm's competitors. The board would like to demonstrate the firm's commitment to sustainable development but is concerned that the costs of TBL reporting would exceed the benefits, particularly as TBL reporting is not mandatory for external reporting purposes.Required:(a) Explain what TBL reporting involves and how it would help demonstrate Triple

Tipple's sustainable development. Include examples of measures that can be used in a TBL report. (8 marks)

(b) Discuss how producing a TBL report may help management improve the financial performance of the firm, providing examples where appropriate. (10 marks)

Solution

(a)

(b)



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6.3 The Carbon Trading Economy< The carbon trading economy has emerged in which

governments allocate each polluting firm a quota of the number of tonnes of greenhouse gasses that it can emit. If a firm then switches to "greener" production techniques it may find it has a surplus of carbon credits which can then be sold to a firm that is exceeding its quota (i.e. carbon trading).

< Economist Craig Mellow wrote in May 2008: "The combination of global warming and growing environmental consciousness is creating a potentially huge market in the trading of pollution-emission credits."

< 23 multinational corporations came together in the G8 Climate Change Roundtable at the 2005 World Economic Forum. The group included Ford, Toyota, British Airways, BP and Unilever. The group published a statement stating that there was a need to act on climate change and stressing the importance of market-based solutions.

< The Kyoto Protocol created mandatory trading of carbon dioxide emissions and London has established itself as the centre of a market valued at $60 billion in 2007.

6.4 Government Environment Agencies< The UK Environment Agency's stated purpose is "to protect or

enhance the environment, taken as a whole" so as to promote "the objective of achieving sustainable development".

< The Agency is the main regulator of discharges to air, water and land—under the provisions of a series of acts of Parliament. It does this through the issue of formal consents to discharge or, in the case of large, complex or potentially damaging industries, by means of a permit.

< Failure to comply with such a consent or permit or making a discharge without consent can lead to criminal prosecution. If prosecuted in the Crown Court, there is no limit on the amount of the fine and sentences of up to five years' imprisonment may be imposed on those responsible for the pollution or on directors of companies causing pollution.

6.5 Integrated Reporting and the Environment< The "environment" to be addressed in integrated reporting

includes factors affecting the external environment: the legal, commercial, social, environmental and political contexts that affect the organisation directly or indirectly.

< The environmental factors to be included in the integrated report are: those that influence the particular organisation, the industry

or region of the organisation; and those affecting the global economy.

< Integrated reporting: presents the link between a company's financial

management and its social and environmental capital, and demonstrates to investors and other stakeholders that

business interests can only be enhanced by embracing a sustainable future.



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6.5.1 Guiding Principles

The guiding principles provide the foundation for how an organisation should consider information to be included in the report and how information should be presented. These include:

< Strategic focus and future orientation—insight into the organisation's strategy and how it relates to the organisation's ability to create value over time;

< Materiality—information about items that significantly affect the organisation's ability to create value over time should be disclosed.

6.5.2 Content Elements

The content elements are fundamentally linked to each other and not mutually exclusive. These include:

< Organisational overview and external environment: What does the organisation do and under what circumstances does it operate?

< Governance: How does the governance or leadership structure support the organisation's ability to create value over time?

< Business model: What is the organisation's business model?< Risks and opportunities: What are the specific risks and

opportunities that affect the organisation's ability to create value over time and how are these dealt with?

< Strategy and resource allocation: Where does the organisation want to go, and how does it intend to get there?

< Outlook: What challenges and uncertainties are likely to be encountered in pursuing the organisation's strategy and what are the implications for the business model and future performance?

Exhibit 1 CHIEF EXECUTIVE OFFICER'S REVIEW

Extracts from the Chief Executive Officer's Review in Village Main Reef Integrated Annual Report 2013. The review discusses challenge, change, curbing costs and strategic progress.

Question: In last year's report you were at pains to indicate what Village was not. Can you tell us a bit more about what Village is, and how its strategy is evolving?

Answer: We remain about value rather than size; we aim to make smart investments, unlock value and return it to shareholders; and to develop a diversified portfolio of assets.

But, our strategy has evolved in that we are no longer a buyer of marginal or, if you will, "throw-away" gold mining assets. We continue to convert Village from an operator of diversified small mines into a resources investment company. Particularly given the state of the markets, we will rather be targeting smaller companies that can generate their development financing needs internally.

Question: What are your views on the share price performance?

Answer: The share price fell by 70%—from 150c to 45c—over the year. The share price performance has been disappointing, particularly as we had made special strategic distributions to shareholders by means of a share buy-back and a 30c special dividend. Our stated policy has been to create new value from assets that may not be attractive to others and to distribute that value to shareholders.

That said, the travails of the platinum and gold sectors as a whole affected us too. Some platinum juniors fell by as much as 80% to 90%, while even some of the gold majors shed 50%.



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7 Risk Management

Risk— "the variability of returns" (e.g. due to exchange rate changes).

7.1 Should Risk Be Managed?At first glance, it may appear logical for a firm's management to attempt to reduce the firm's risk exposures. However, implementing a default policy of hedging all risks may not be effective for the following reasons:

< Hedging may give short-run but not long-run protection. For example, the exchange rate in derivatives contracts (e.g. forwards, futures and swaps) will follow the same long-term trend as the exchange rate in the spot market. In the end, if an exporter faces an appreciating home currency it will find its margins under pressure either with or without hedging the exchange rate.

< Hedging incurs costs—both the transactions costs of using derivatives, for example, and the higher salary costs of employing specialist risk managers.

< The firm's shareholders may have already hedged many risks—in the case of a listed company the majority of shares are likely to be held by institutional investors who will hold well-diversified equity portfolios (e.g. including shares in both exporters and importers). Hence, shareholders may have natural protection against some forms of risk, in which case, corporate risk management will only add costs and not benefits.

So why, in practice, do many firms engage in significant amounts of risk management? There may be various explanations:

< In the case of privately held firms, the shareholders may have significant amounts of their personal wealth invested in an individual firm (i.e. the shareholders are exposed to total risk as opposed to only systematic risk). In this case, risk management at the corporate level may indeed reduce the risk of the shareholders.

< In the case of listed firms, although shareholders may be well diversified and only exposed to systematic risk, the company's management work only for that specific firm and not for a portfolio of firms (i.e. their bonuses or share option plans are exposed to total risk). Management may therefore become highly risk-averse and attempt to hedge their personal risk—incurring agency costs for their shareholders.

< Progressive corporate tax systems—in many countries, the tax rate on large profits is significantly higher than the tax rate on lower profits. In this case, there could be a valid argument for using risk management to "smooth" the firm's profits in order to reduce the long-run tax burden. Care must be taken to avoid cosmetic smoothing of reported profits (i.e. accounting manipulation).



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< Reduction in cost of capital—corporate diversification may lead to financial synergy as smoother group cash flows may lead to an improved credit rating and a lower cost of debt. Care must be taken to ensure that the control premium paid on acquisitions does not exceed the value of synergy.

< Financial distress costs—where a firm experiences cash flow problems it can find that its costs of doing business rise (e.g. suppliers may refuse to give credit; customers may lose faith in any warranties given on the firm's products). Risk management may be justified in reducing the risk of financial distress.

7.2 Conflicts Between Equity and Debt InvestorsEquity investors are, of course, participating investors in that their returns are linked to the underlying volatility of profits (i.e. they absorb the firm's level of business risk). However, the equity investors' downside risk is restricted to some degree by their limited liability status (i.e. if the firm cannot pay its debts the shareholders cannot be forced to inject more capital).

Debt investors, on the other hand, receive fixed contractual payments of interest and principal (i.e. they are not exposed to business risk). The main risk faced by debt investors is that the firm cannot service the debt (i.e. default risk/credit risk).

The different positions of equity and debt investors can lead to differing attitudes towards the level of risk-taking by the firm. This is particularly the case where the value of the firm's assets is close to the level of its liabilities:

< Shareholders may develop an "appetite for risk" and encourage the management to take high risks. If the firm's high-risk strategies succeed, the value of assets would "spike up" above the level of liabilities and the equity rises in value. If the gamble fails and the value of assets collapses then shareholders can walk away under the protection of limited liability. Overall, shareholders have high upside potential and limited downside risk.

< Debt investors would be highly risk averse as any fall in asset value would reduce the recoverability of their debt, whereas any rise in asset value would not lead to any extra return on the debt (i.e. debt investors have high downside risk and no upside potential).

7.3 Types of Risk and Risk Mitigation < Business risk—volatility of operating cash flows. This is

driven by (i) sales volatility (ii) level of operational gearing (i.e. proportion of fixed to variable operating costs). Hence the key strategies for reducing exposure to business risk are: reposition the firm's product lines into "defensive industries"

(i.e. those sectors relatively unaffected by the economic cycle such as food, clothes and pharmaceuticals);

convert fixed costs into variable costs (e.g. via outsourcing).< Financial risk—the increased volatility of returns to equity due

to fixed interest payments first being paid on debt. Obviously, this can be reduced through lowering the firm's level of financial gearing, although this should be balanced against the loss in tax shield.



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< Credit risk/ default risk—becomes significant at high perceived levels of debt. Obviously, this can be reduced by a reduction in financial gearing but alternative methods include: diversifying operations to smooth cash flows; diverting low-risk cash streams into a ring-fenced special

purpose vehicle (SPV), (protected should the firm itself becomes bankrupt). The SPV then "securitises" its future cash stream (i.e. issues bonds backed by the stream). These asset-backed securities should attract an investment-grade credit rating.

< Reputational risk—damage to the brand value due to poor corporate behaviour (e.g. environmental damage or use of child labour). Mitigation strategies could include implementing Corporate Social Responsibility or using a public relations agency.

< Operational risk—the risk of loss resulting from inadequate or failed internal processes, people and systems (e.g. for an investment bank the risk of a "rogue trader"). Mitigation could include implementation of the Turnbull Report.

< Fiscal risk—impact of unexpected events adversely affecting the government's fiscal strength and hence the business climate (e.g. commodity exporting nations are highly exposed to volatile commodity prices). The fiscal risk of different countries can be assessed using reports from the IMF or the EIU (Economist Intelligence Unit).

< Regulatory risk—risk of government regulation adversely affecting the firm (e.g. price caps on privatised natural monopolies, compulsory compliance with corporate governance codes, blocks or restrictions placed on mergers and acquisitions). Regulatory risk may be managed through political lobbying.

< Project risk—the risk that project cash flows are not in line with expectations. Project risk can be managed by: appointing an experienced project manager; carefully selecting contractors; appointing a steering committee to monitor deadlines and

cost levels; and PCA (Post Completion Audit) to review and improve the

process in the future.< Currency risk (see Session 14).< Interest rate risk (see Session 15). < Political risk (see Session 17).

7.4 Risk Mitigation, Hedging and Diversification*

Risk mitigation, hedging and diversification are all strategies designed to manage an organisation's exposure to various risks. The nature of each of these strategies can be distinguished as follows:

< Risk mitigation—involves the use of pre-emptive strategies to prevent a particular risk from materialising. For example, prior to setting up an overseas subsidiary political risk may be mitigated by contacting overseas officials and seeking agreements on matters such as repatriation of funds and the level of transfer prices or management charges.

*See Sessions 14 and 15 for details on currency and interest rate hedging.



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< Risk hedging—refers to managing a risk which has already materialised (e.g. foreign currency risk on an overseas export).

< Risk diversification—refers to corporate diversification either domestically into other industries ("conglomerate diversification") or other countries ("international diversification"). As previously explained, if the firm's shareholders are institutional investors (e.g. fund managers) they will have already used personal portfolio diversification to remove almost all industry-specific unsystematic risk and, in the case of global fund managers, country-specific unsystematic risk. There is, therefore, an argument that if its shareholders are diversified then the firm should specialise.

This does not, however, mean that corporate diversification is never justified. For example:

< significant synergy may be obtained through buying competitors, suppliers or distributors;

< diversified groups have lower financial distress risk, may achieve an enhanced credit rating and may pay less tax in a progressive tax system due to reporting "smoother" profits.

7.5 Developing a Framework for Risk Management

7.5.1 Elements

There are many examples of risk management systems and processes that have been developed by various organisations. In general, a risk management process should, at the very least, incorporate the following elements:

THREATS TO ACHIEVING CORPORATE OBJECTIVES

MONITOR ANALYSE

PLAN APPROACH

AND ACTION

IDENTIFY

?



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7.5.2 Stages in Risk Cycle Management

The IIA's Professional Briefing Note 13, Managing Risk, identifies the following stages in risk cycle management:

Develop risk mitigation/control strategies

Evaluate and model risk

Obtain resources and assign responsibilities

Monitor and review

Establish the context and set perspectives Identify and document risk

Assess, quantify and classify risk

Reduce, offset and/or optimise the risk



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7.5.3 Risk Management Standard

The Institute of Risk Managers (IRM), the Association of Insurance and Risk Managers (AIRMIC) and the National Forum for Risk Management in the Public Sector (ALARM) jointly published a Risk Management Standard in 2002, within which the risk management process was diagrammatically shown as:

Risk ReportingThreats and Opportunities

Risk Treatment

Decision

Monitoring

Residual Risk Reporting

The Organisation's Strategic Objectives

Risk AnalysisRisk IdentificationRisk DescriptionRisk Estimation

Risk Assessment

Risk Evaluation

FormalAudit



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7.5.4 COSO Framework

In September 2004, COSO expanded its internal control framework to develop the Enterprise Risk Management Integrated Framework.

Internal EnvironmentObjective SettingEvent Identifi cationRisk AssessmentRisk ResponseControl ActivitiesInformation & CommunicationMonitoring

ENTITY

LEVEL

DIV

ISIO

N

BU

SIN

ESS

UN

IT

SU

BS

IDIA

RY

OPERATIONS

COMPLIANCE

REPORTING

STRATEGIC



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Session 1

< The first step in developing the objectives of financial management is to identify the relevant stakeholders in the organisation.

< In the corporate sector the key stakeholders are clearly the shareholders. Most traditional finance theory is therefore built on the assumption that a company's objective is to maximise the wealth of its shareholders.

< However, modern CSR suggests that directors should also take into account other stakeholders and therefore also follow a range of non-financial objectives (e.g. employee satisfaction, reducing environmental impacts).

< Such non-financial objectives may be in conflict with maximising shareholder wealth. Therefore, the overall objective may be to produce satisfactory returns for shareholders, while attempting to meet the demands of other interest groups.

< In practice, managers may also have personal objectives which conflict with their responsibilities as agents of the shareholders. Some managers may try to maximise personal wealth (e.g. through manipulating bonus schemes or even theft of company assets).

< This creates agency costs for the shareholders. Well-designed remuneration systems and good corporate governance should reduce these costs to an acceptable level.

< One aspect of CSR involves ethical corporate behaviour—the "good corporate citizen".

< CSR also involves the creation of a sustainable business model which balances not only financial but also social and environmental performance. Reporting these three areas of performance can be achieved using the TBL approach.

< More recently the IIRC has formulated an IR Framework that reflects developments in financial governance, management commentary and sustainability reporting. It requires organisations to publish material information about their strategy, governance, performance and prospects in a clear, concise and comparable format.

Summary



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Study Question BankEstimated time: 60 minutes

Priority Estimated Time Completed

Q1 Agency Relationships 60 minutes

Additional

Q2 Ethics (ACCA D03)

Session 1 QuizEstimated time: 20 minutes

1. State TWO arguments for and TWO arguments against the maximisation of shareholder wealth as a corporate objective. (2.2)

2. Define "integrated report". (2.3)

3. Define "agency costs". (3.3)

4. Suggest methods of improving goal congruence between directors and shareholders. (3.5)

5. State the board structure common in German companies. (4.2.3)

6. State which area of corporate governance the UK Greenbury Code focussed on. (4.5)

7. State whether compliance with the Combined Code is obligatory for companies listed in the UK. (4.6)

8. List the "principles of good governance" as per the Combined Code. (4.6)

9. State which area of corporate governance the UK Turnbull Report focussed on. (4.7)

10. List ethical issues specific to multinational companies. (5.1.7)

11. State the THREE areas of evaluation in the Triple Bottom Line (TBL) approach to reporting. (6.2)

12. List FOUR examples of content elements in an integrated report. (6.5.2)

13. Provide examples of regulatory risk. (7.3)



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EXAMPLE SOLUTIONSSolution 1—AAA Model

(1) Facts—in exchange for a significant payment you may secure government contracts in the future.

(2) Ethical issues—should you provide a contribution in what would be in the best case an inducement and in the worst case considered a bribe? As the CEO, you may be in breach of your fiduciary duties and probably in breach of campaign contribution laws. As a professional accountant, you would be in breach of your ethical codes. However, not to do so may mean a lack of government orders should the candidate win the election.

(3) Norms, principles, and values—government contracts should not be awarded on the basis of favours, inducements or bribes—value for money (VFM) would be an expected driver. CEOs, as leaders of their companies, are expected to set the moral and ethical tone of the organisation. Professional accountants are expected to have integrity and objectivity.

(4) Alternative courses of action—(i) make the contribution, (ii) make a lower contribution, or (iii) make no contribution.

(5) Best course of action—decline to make a contribution and report the incident to an appropriate elections committee.

(6) Consequences of each possible course of action:(i) Making the payment will incur cash flow now for which there

may be future awards of contracts if the candidate wins. The political contribution would need to be disclosed in the financial statements and the candidate would also need to disclose it, as it is material. If the candidate wins and additional contracts are awarded, there may be possible media speculation why the company appears to be winning more contracts than normal, which may lead to an investigation and negative consequences for the firm and its directors.

(ii) Not making the payment (or lower than requested) and the candidate wins, may result in future contracts not being awarded. This would have a detrimental impact on the business with possible going concern consequences.

(iii) The broad assumptions are that the candidate will win and that they have control over the tendering process (i.e. awards are not made by a separate committee).

(7) Decision—the ethical approach would be to decline making the requested contribution.

Solution 2—Tucker's ModelThis is a case of bribery. Since all five questions in this model must be answered in the affirmative, the payment is not defensible as the evasion of tax is illegal. It is not fair to the wider society that the burden of evaded tax should be borne by others in order to provide the services and facilities for which the tax is raised. Nor can it be right (just) that others should suffer a deterioration in, or lack of, services as a result of under-funding. That it is considered common practice does not make it acceptable. It is not sustainable in that a "vicious circle" is created of increasing levies which are increasingly evaded. The environment may be harmed. For example, vital services (e.g. the provision of clean water) may be compromised. If charges then have to be made for services such as waste-disposal (because there are not taxes to fund the service), environmentally damaging practices (e.g. illegal dumping) are likely to increase.



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Solution 3—TBL Reporting(a) Sustainable developmentThe principle of TBL reporting is that a corporation's true performance must be measured in terms of a balance between economic (profits), environmental (planet) and social (people) factors; with no one factor growing at the expense of the others.A corporation's sustainable development is about how these three factors can be combined so that the firm builds a reputation as being a good corporate citizen. A corporation that balances the pressures of all three factors should enhance shareholder value by addressing the needs of its stakeholders.However, whereas TBL reporting is a quantitative summary of the corporation's historical performance, sustainable development tends to be forward-looking and qualitative. Economic impact can be measured by considering operating profits, dependence on imports and the extent to which the local economy is supported by purchasing locally produced goods and services. Social impact can be measured by considering working conditions, fair pay, using an appropriate labour force (not child labour), and the level of ethical investments. Environmental impact can be measured by considering the firm's ecological footprint, emissions to air, water and soil, use of energy and water and investments in renewable resources.Ideally the firm's economic, social and environmental performance should be benchmarked against that of its competitors or against the industry, national or global leader in sustainable development.

(b) Financial performanceFor TBL reporting to improve the firm's financial performance the benefits that accrue from the assessment and production of a TBL report must exceed the costs of undertaking the report. The costs of producing the report should be relatively easy to measure but the financial benefits may be more difficult to measure and may take place over a longer time period. Examples of the ways in which the firm may benefit financially:

Focusing on and reporting the company's environmental and social impact may build and enhance reputation and long-term revenues.

Reducing the firm's environmental impact may reduce the risk of paying fines for environmental damage.

Consideration and improvement of working standards and consulting employees as part of this process may help in retaining and attracting high calibre employees.

Better communication with stakeholders may result in improvements in governance procedures. This in turn should lead to a reduction in agency costs.

Reducing the carbon footprint may be achieved by switching from importing materials to using local suppliers. This may reduce the risk of stockouts and also boost the firm's reputation through supporting the local economy.

Monitoring and reporting on the performance of employees and managers as part of the assessment of economic and social factors may help identify areas where work can be done more effectively and efficiently.



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NOTES



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Session 2

Session 2 Guidance

Understand that the theoretical market price of a security is the present value of its future cash flows discounted at the investor's required return (s.1).

Understand the Dividend Valuation Model; i.e. the theoretical share price is the present value of future dividends discounted at the shareholder's required return (s.2).

Learn how to reconfigure the DVM to infer the required return of shareholders and hence the firm's cost of equity finance (s.3).


3. Impact of financing on investment decisions and adjusted present values

b) 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.

d) Assess an organisation's debt exposure to interest rate changes using the simple Macaulay duration method.

e) Discuss the benefits and limitations of duration including the impact of convexity.

4. Valuation and the application of free cash flowsa) Apply appropriate models, including term structure of interest rates, the

yield curve and credit spreads, to value corporate debt.

Security Valuation and the Cost of Capital



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Session 2 Guidance

VISUAL OVERVIEWObjective: To develop a valuation model for shares and bonds that facilitates estimation of equity and debt costs, and to consider the relationship between short- and long-term interest rates.

Understand application of discounted cash flow to bond valuation, recognise the difference between bondholders' required return v firm cost of debt and learn the calculations to assess how interest rate changes affect bond price (s.4).

Learn how to derive the spot yield curve using "bootstrapping" (s.5).

CAPITAL MARKET EFFICIENCY• Introduction• Efficient Market Hypothesis• Implications for Financial

Managers

DIVIDEND VALUATION MODEL• General Model• Constant Dividend• Constant Dividend Growth• Assumptions• Uses• Practical Factors

COST OF EQUITY• Required Rate of Return• Dividend With Constant

Growth• Growth From Past Dividends• Gordon's Growth Model• Project Appraisal• Preference Shares

BOND VALUATION AND COST OF DEBT

• Terminology• Irredeemable Bonds• Redeemable Bonds• Semi-annual Interest• Convertible Bonds• Bond Duration

TERM STRUCTURE OF INTEREST RATES

• Yield Curve Theory• Spot Yield Cure• Corporate Bonds Valuation



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Session 2 • Security Valuation and the Cost of Capital P4 Advanced Financial Management


1 Capital Market Efficiency

1.1 Introduction An efficient market is one in which the market price of all securities traded on it reflects all the available information. A perfect market is one which responds immediately to the information made available to it.

An efficient and perfect market will ensure that quoted share prices are as fair as possible, in that they accurately and quickly reflect a company's financial position with respect to both current and future profitability.

Efficiency can be looked at in four ways:

1. Allocative efficiency: Does the market attract funds to the best companies?

2. Operational efficiency: Does the market have low transaction costs and a convenient trading platform? These promote a "deep" market with high liquidity (i.e. a high volume of transactions).

3. Informational efficiency: Is all relevant information available to all investors at low cost?

4. Pricing efficiency: Do share prices quickly and accurately reflect all known information about the company? This is also referred to as information-processing efficiency.

Most research on market efficiency has focused on pricing efficiency. The most well-known model is the Efficient Market Hypothesis.

1.2 Efficient Market HypothesisThe value of a share is based on expectations of future cash flows from that share in the form of dividends or share buybacks (see Session 12).

The strength of the link between the performance of the company and the share price will depend upon the pricing efficiency of the capital markets.

The Efficient Market Hypothesis (EMH) considers three potential levels of efficiency:

1. Weak-form efficiency:

Share prices reflect all the information contained in the record of past prices. Share prices therefore follow a "random walk" and will move up or down depending on what information next reaches the market.

If this level of efficiency has been achieved it should not be possible to forecast price movements by reference to past trends (i.e. "chartists" (also known as technical analysts) should not be able to consistently out-perform the market).

The way to consistently "beat" a weak-from efficient market is by analysis of publicly available information such as financial statements (i.e. fundamental analysis).



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P4 Advanced Financial Management Session 2 • Security Valuation and the Cost of Capital

2. Semi-strong form efficiency:

Share prices reflect all information currently publicly available. Therefore the price will alter only when new information is published.

If this level of efficiency has been reached, price movements can only be forecast by using "inside" information (i.e. significant non-public information). This is known as insider trading which is illegal in most markets and is unethical in any market.

3. Strong-form efficiency:

Share prices reflect all information, published and unpublished, that is relevant to the company.

If this level of efficiency has been reached, share prices cannot be predicted and gains through insider dealing are not possible as the market already knows everything!

In major markets (e.g. the London or New York Stock Exchanges) there are strict rules outlawing insider dealing. Therefore such markets are regarded as semi-strong efficient.

1.3 Implications for Financial ManagersThe level of efficiency of the stock market has implications for financial managers:

The timing of new issues:

Unless the market is fully efficient the timing of new issues remains important. This is because the market does not reflect all the relevant information, and hence advantage could be obtained by making an issue at a particular point in time just before or after additional information becomes available to the market.

Project evaluation:

If the market is not fully efficient, the price of a share is not fair, and therefore the rate of return required from that company by the market cannot be accurately known. If this is the case, it is not easy to decide what rate of return to use to evaluate new projects.

Creative accounting:

Unless a market is fully efficient creative accounting can still be used to mislead investors.

Mergers and takeovers:

Where a market is fully efficient, the price of all shares is fair. Hence, if a company is taken over at its current share value the purchaser cannot hope to make any gain unless economies can be made through scale or rationalisation when operations are merged. Unless these economies are very significant an acquirer should not be willing to pay a significant premium over the current share price.

Validity of current market price:

If the market is fully efficient, the share price is fair. In other words, an investor receives a fair risk/return combination for his investment and the company can raise funds at a fair cost. If this is the case, there should be no need to discount new issues to attract investors.



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2 Dividend Valuation Model

2.1 General Model

The dividend valuation model implies that the market value of a share or other security is equal to the present value of the future expected cash flows from the security discounted at the investor's required rate of return.

A security is any traded investment (e.g. shares and bonds).

2.2 Constant Dividend The formula for share valuation can be developed as follows:

Ex-div market value at time 0 = Present value of the future dividends discounted at the shareholders' required rate of return

Ex-div market value is the market value assuming that a dividend has just been paid.

Let:

P0 = Current ex-div market value Dn = Dividend at time n ke = Shareholders' required rate of return/company's cost

of equity The model then becomes:

P0 =D1 +

D2 +D3 .....

Dn

(1 + ke) (1 + ke)2 (1 + ke)3 (1 + ke)n

If the dividend is assumed to be constant to infinity, this becomes the present value of a perpetuity, which simplifies to:

P0 =D

ke

This version of the model can be used to determine the theoretical value of a share which pays a constant dividend (e.g. a preference share or an ordinary share in a zero growth company).



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2.3 Constant Dividend Growth If dividends are forecast to grow at a constant rate in

perpetuity, where g = growth rate:

P0 =Do(1 + g)

= D1

ke – g ke – g

where Do = most recent dividend D1 = dividend in one year

The formula is published in the exam in the following format:

P0 =Do(1 + g)

(re – g)

Where re = required return of equity investors (i.e. ke)

2.4 Assumptions Behind the Dividend Valuation Model

Rational investors. All investors have the same expectations and therefore the

same required rate of return. Perfect capital market assumptions including:

no transactions costs; large number of buyers and sellers of shares; no individual can affect the share price; and all investors have all available information.

Dividends are paid just once a year and one year apart. Dividends are either constant or are growing at a constant rate.

2.5 Uses of the Dividend Valuation Model The model can be used to estimate the theoretical fair value of

shares in unlisted companies where a quoted market price is not known.

However if the company is listed, and the share price is therefore known, the model can be used to estimate the required return of shareholders (i.e. the company's cost of equity finance).



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Illustration 1 Dividend Valuation Model

A share has a current ex-div market value of 80 cents, and investors expect a dividend of 10 cents per share to be paid each year, as has been the case for the past few years. Using the dividend valuation model, the investors' required return can be determined:

P0 =Dke

80c =10c

ke

ke =10c

80c

ke = 12.5%

Investors will all require this return from the share, as the model assumes they all have the same information about the risk of this share and they are all rational.If investors think that the dividend is due to increase to 15 cents each year, then at a price of 80 cents the share is giving a higher return than 12.5%. Investors will therefore buy the share and the price will increase until, according to the model, the value will be:

P0 =15c = 120 cents

0.125

Alternatively, suppose that the investors' perception is that the dividend will remain at 10 cents per share but that the risk of the share has increased and so requires a 15% return. If the share only gives a return of 12.5% (on an 80 cents share price), then investors will sell and the price will fall. The fair value of the share according to the model will be:

P0 =10c = 66.7 cents0.15

2.6 Practical Factors Affecting Share Prices The dividend valuation model gives a theoretical value, under

the assumptions of the model, for any security.* In practice there will be many factors other than the present

value of cash flows from a security that play a part in its valuation. These are likely to include: interest rates; market sentiment; expectation of future events; inflation; press comment; speculation and rumour; currency movements; takeover and merger activity; Political issues.

The dividend valuation model helps us to understand how a change in these variables should affect the market value of the security.

*Share prices change, often dramatically, on a daily basis. The dividend valuation model will not predict this, but will give an estimate of the underlying fair value of the shares.



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3 Cost of Equity

3.1 Shareholders' Required Rate of Return The basic dividend valuation model is:

P0 =D

ke

This can be rearranged to find ke:

ke =D

p0

If ke is the return required by the shareholders in order for the share value to remain constant, then ke is also the return that the company must pay to its shareholders. Therefore, ke also equates to the cost of equity of the company.

Therefore, the cost of equity for a company with a constant annual dividend can be estimated as the dividend divided into the ex-div share price (i.e. the dividend yield).

The ex-div market value is the market value of the share, assuming that the current dividend has just been paid. A cum-div market value is one which includes the value of the dividend just about to be paid. If a cum-div market value is given, then this must be adjusted to an ex-div market value by taking out the current dividend.

Example 1 Cost of Equity

A company's shares have a market value of $2.20 each. The company is just about to pay a dividend of 20 cents per share as it has every year for the last 10 years.

Required:Calculate the company's cost of equity.

Solution

Many relatively easy marks are often available in the Paper P4 exam for performing cost of capital calculations.



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3.2 Dividend With Constant Growth The model can also deal with a dividend that is growing at a

constant annual rate of g. The formula for valuing the share is as seen earlier:

P0 =D0(1 + g)

= D1

ke – g ke – g

where D0 = most recent dividend D1 = dividend in one year

Rearranged, this becomes:

ke =D0(1 + g)

+ g P0

where g = growth rate (assumed constant in perpetuity) P0 = ex-div market value

Therefore, the cost of equity = dividend yield + estimated growth rate.

Illustration 2 Dividend With Constant Growth

D0 = 12c, P0 (ex-div) = $1.75, g = 5%. What is ke?

ke =0.12(1.05)

+ 0.05 = 12.2%1.75

Constant Growth

The growth rate of dividends can be estimated using either of two methods.

Extrapolation of past dividends

Gordon's growth model

Two MethodsTwo MethodsTwo Methods



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3.3 Growth From Past Dividends Look at historical growth and use this to predict future growth.

If specific information about future growth is given, use it. If dividends have grown at 5% in each of the last 20 years,

predicted future growth = 5%. Uneven but steady growth—take an average overall growth

rate. Discontinuity in growth rate—take the most recent evidence. New company with very high growth rates—take care! It is

unlikely to produce such high growth in perpetuity. No pattern—do not use this method (i.e. dividends up one

year, down the next).

Example 2 Growth Using Extrapolation

A company has paid the following dividends over the last five years:

Cents per share20X0 10020X1 11020X2 12520X3 13620X4 145

Required:Estimate the growth rate and the cost of equity if the current (20X4) ex-div market value is $10.50 per share.

Solution

g = %

ke = %



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3.4 Gordon's Growth Model Gordon's growth model states that growth is achieved by

retention and reinvestment of funds.

g = bre

b = proportion of profits retained re = return on equity

Take an average of r and b over the preceding years to estimate future growth.

re =Profit after tax

=Profit after tax

Shareholders' funds Net assets

b =Retained profit

Profit after tax

These figures can be obtained from the statement of financial position (balance sheet) and statement of profit or loss (income statement).

Example 3 Gordon's Growth Model

A company has 300,000 ordinary shares in issue with an ex-div market value of $2.70 per share. A dividend of $40,000 has just been paid out of Post-tax profits of $100,000.Net assets at the year end were $1.06m.

Required:Estimate the cost of equity.

Solution

b = %

re = %

g = %

ke = %



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3.5 Cost of Equity and Project Appraisal

Illustration 3 Impact of Project on Value

Apple is all equity financed and has 1m shares quoted at $2 each (ex-div). It pays constant annual dividends of 30 cents per share.It is considering a project which will cost $500,000 and which is of the same risk as its existing activities. The cost will be met by a rights issue. The project will produce inflows of $90,000 per annum in perpetuity. All inflows will be distributed as dividends. What is the new value of the equity in Apple and what is the gain to the shareholders? Ignore tax.

ke =0.30 = 15%2.00

New dividend$

Existing total dividend 300,000Dividends from the project 90,000New total dividend 390,000

Value of equity = 390,0000.15

= $2,600,000

Shareholders' gain = $(2,600,000 – 2,000,000) – $500,000 = $100,000

Project NPV = ($500,000) + 90,000 = $100,0000.15

Therefore, new value of equity = Existing value + Equity outlay + NPV = Existing value + PV of additional dividends

Impact of Project on Value

Therefore the NPV of a project increases the value of the company's shares (i.e. the NPV of a project shows the increase in shareholders' wealth).

This proves that NPV is the correct method of project appraisal —it is the only method consistent with the assumed objective of maximising shareholders' wealth.

3.6 Cost of Preference Shares By definition, preference shares have a constant dividend:

ke =D

p0

where D = constant annual dividend

Preference dividends are normally quoted as a percentage (e.g. 10% preference shares). This means that the annual dividend will be 10% of the nominal value.



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Example 4 Cost of Preference Shares

A company has 100,000 12% preference shares in issue (nominal value $1).The current ex-div market value is $1.15 per share.

Required:Calculate the cost of the preference shares.

Solution

4 Bond Valuation and Cost of Debt

4.1 TerminologyA bond is a written acknowledgement of a company's debt. A bond usually pays a fixed rate of interest and it may be secured or unsecured. It may be traded on the bond market and will reach a market price. The terms bond, debenture and loan stock all basically refer to the same thing (i.e. traded corporate debt). They are unlike bank loans which are not traded.

The coupon rate is the interest rate printed on the bond certificate.

Annual interest = coupon rate × nominal value

Nominal value is also known as par or face value. Market value (MV) is normally quoted as the MV of a block of

$100 nominal value.

In the exam the nominal value of one bond is usually $100.



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Illustration 4 Bond Terminology

10% bonds quoted at $95 means that a $100 block is selling for $95 and annual interest is $10 per $100 block.

Bond Terminology

Market value (ex-int) is where interest has just been paid. Market value (cum-int) includes the value of accrued interest

which is just about to be paid.

4.2 Irredeemable Bonds

4.2.1 Valuation of Irredeemable Bonds

The market value of any bond should equal the present value of the future payments to investors discounted at their required return.

In the case of irredeemable (undated) bonds there will be a fixed annual payment of "coupon" interest into perpetuity, with no repayment of principal.

P0 =

Ire

Where:

P0 = Ex-interest market price

I = Annual interest payment

re = Bondholders' required return

Note that the required return = IP0

= current yield, which could

also be described as the interest yield, running yield or the firm's pre-tax cost of irredeemable bonds.

Example 5 Valuation of Irredeemable Bonds

A firm has in issue 7% undated bonds each with $100 nominal value.

The current yield is quoted as 7.42%.

Required:Calculate the market price of each bond.

Solution

Annual coupon =

Required return =

P0 =

4.2.2 Cost of Irredeemable Bonds

Although the interest yield is the firm's pre-tax cost of irredeemable debt, the post-tax cost will be lower due to "tax shield" on the coupon payments.



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Illustration 5 Tax Shield of Debt Interest

Consider two companies with the same earnings before interest and tax (EBIT). The first company uses some debt finance, the second uses no debt.

$ $EBIT 100 100Debt interest (10) Profits before tax 90 100Tax @ 33% 29.70 33

$3.30 difference

ThereforeEffective cost of debt $Debt interest 10.00Less: tax shield (3.30)Effective cost of debt 6.70

Because of tax relief, the cost to the company is less than the required return of the bondholders.

Unless told otherwise, tax relief is assumed to be instant (in practice, there will be a minimum time lag of nine months under the UK tax system).

If the debt is irredeemable, then:

Cost of debt to the company (also known as the post-tax cost of debt)

=Return required by the bondholders × (1 – Tc)

= Interest yield × (1 – Tc)

Where Tc = corporate tax rate as a decimal

Kd can be used to denote the cost of debt—but care is needed as to whether it is stated pre-tax or post-tax.



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Example 6 Cost of Irredeemable Debt

12% undated bonds with a nominal value of $100 are quoted at $92 cum- interest. The rate of corration tax is 33%

Required:Calculate(a) the return required by the bondholders; and(b) the cost to the company.

Solution:(a) Return required by bondholders

Required return by bondholders = %

(b) Cost to the company

4.3 Redeemable Bonds*

4.3.1 Valuation of Redeemable Bonds

The market value of a redeemable bond should equal the present value of the coupon interest (paid each year until maturity) and the redemption price (paid at maturity), discounted at the investors' required rate of return.

The required return on a redeemable bond is referred to as its Yield to Maturity, Gross Redemption Yield or the firm’s pre-tax cost of the redeemable bond.

*Also called dated bonds.



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Example 7 Valuation of Redeemable Bonds

A company has in issue 8% $100 nominal value bonds redeemable at a 5% premium in 10 years' time. 4% $100 treasury notes are trading at $98 and are redeemable at face value after one year; the yield curve is flat and the corporate credit spread is 388 basis points.

Required:Calculate the market price of each bond.

Solution:Yield to maturity on risk-free treasuries =

Yield to maturity on corporate bond =

Annual coupon =

Present value of the coupon =

Redemption price =

Present value of redemption price =

Market price of bond =

4.3.2 Cost of Redeemable Bonds

The cash flows are not a perpetuity because the principal will be repaid. However, the following general rule can be applied:

The cost of any source of funds is the IRR of the cash flows associated with that source.

Looking at the return from an investor's point of view, interest payments are included gross.

Looking at the cost to the company, interest payments are included net of corporation tax. (Assume instant tax relief.)

Assume that the final redemption payment does not have any tax effects.

To find the cost of debt for a company, find the IRR of the following cash flows:

Time $0 Market value (ex-interest) x

1–n Post-tax coupon interest (x)n Redemption value (x)

The IRR is found as usual using linear interpolation.



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Example 8 Cost of Redeemable Debt

A company has in issue $200,000 7% bonds redeemable at a premium of 5% on 31 December 20X6. Interest is paid annually on 31 December. It is currently 1 January 20X3 and the bonds are trading at $98 ex-interest. Corporation tax is 33%. Required:Calculate the cost of debt for this company.Solution:

Time Cash flow$

PV @ 10% PV @ 5%$

0

1–4

4

IRR =

kd = %

Care should be taken not to confuse the required return of the bondholders with the cost of debt of the company.

Required return of the redeemable bondholder = IRR of pre-tax cash flows

from the bond = Gross redemption yield

Gross Redemption Yield is also referred to as the Yield to Maturity (YTM)



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4.4 Semi-annual Interest Payments

In practice, bond interest is usually paid every six months rather than annually. This practical aspect can be built into calculations for the cost of debt.

If interest payments are being made every six months, the IRR of the bond's cash flows should be calculated on the basis of each time period being six months.

The IRR, or cost of debt, will then be a six-month cost of debt and must be adjusted to determine the annual cost of debt.

Effective annual cost = (1 + semi-annual cost)2 – 1

Example 9 Effective Annual Cost

A company has in issue 6% bonds, the interest on which is paid on 30 June and 31 December each year. The bonds are redeemable at par on 31 December 20X9. It is now 1 January 20X7 and the bonds are quoted at $96 per $100 nominal value. Required:Calculate the effective annual cost of debt for the company. Ignore corporation tax.Solution:

TimeCash flow

$PV @ 3%

$PV @ 5%

$

0

1–6

6

IRR =

Effective annual cost of debt = %



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4.5 Convertible Bonds

4.5.1 Valuation of Convertible Bonds

Convertible bonds allow the investor to choose between redeeming them at some future date or converting them into a predetermined number of ordinary shares in the company.

To estimate the market value, it is first necessary to predict whether the investor will choose redemption or conversion. The redemption value will be known with certainty, but the future share price can only be estimated.

Other amounts that may be calculated for convertibles: Floor value = the value assuming redemption; Conversion premium = market value – current

conversion value.

Example 10 Valuation of Convertible Debt

A company has in issue 9% bonds which are redeemable at their par value of $100 in five years' time. Alternatively, each bond may be converted on that date into 20 ordinary shares. The current ordinary share price is $4.45, and this is expected to grow at a rate of 6.5% per year for the foreseeable future. Bondholders' required return is 7% per year.

Required:Calculate the following values for each $100 convertible bond:(i) market value;(ii) floor value; and(iii) conversion premium.

Solution(i) Market value

(ii) Floor value

(iii) Conversion premium

MV (ex-interest) = present value of future interest payments and the higher of:(i) redemption value:

or (ii) forecast conversion

value, discounted at the bondholder's required rate of return.



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4.5.2 Cost of Convertible Bonds

To find the post-tax cost of convertible debt for a company, find the IRR of the following cash flows:

Time $

0 Market value (ex-interest) x

1–n Post-tax interest (x)

n Higher of redemption value/forecast conversion value (x)

Example 11 Post-Tax Cost of Convertible Debt

A company has in issue some 8% convertible loan stock currently quoted at $85 ex-interest. The loan stock is redeemable at a 5% premium in five years' time, or can be converted into 40 ordinary shares at that date. The current ex-div market value of the shares is $2 per share and dividend growth is expected at 7% per annum. Corporation tax is 33%.

Required:Calculate the cost to the company of the convertible loan stock.Solution

DF @ 5% PV $

DF @ 10% PV $

t0

t1–5

t5

IRR =

Therefore, cost to the company = %



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4.6 Bond Duration When market interest rates (yields) fall the market price of

bonds rises (because the present value of the bonds' fixed future cash flows rises). When yields rise the price of bonds falls.

The change in bond price is approximately the same in either direction for a small rise/fall in yield. For larger changes in yield the change in price is greater for falls in yield than for rises in yield. Therefore the relationship between yields and bond prices is not linear, but convex.

Duration measures the average time it takes for a bond to pay its coupons and principal. It recognises that bonds which pay higher coupons effectively mature earlier compared to bonds which pay lower coupons, even if the redemption dates of the bonds are the same.

This is because a higher proportion of the higher coupon bonds' income is received sooner. Therefore these bonds are less sensitive to interest rate changes and will have a lower duration.

Duration is often expressed in years – known as Macaulay's duration.

Macaulay's duration = the weighted average of the number of years in the bond's life, with the weighting factor being the present value of the flows in each year (discounted at the yield to maturity).

Higher Macaulay's duration indicates higher bond price volatility.

Modified duration – gives the approximate percentage price change in a bond for a 1% change in yield.

Modified duration = Macaulay's duration

1 + YTM

� where YTM = bond's yield to maturity.

However modified duration is not totally accurate as it assumes a linear relationship between yield and price (i.e. ignores convexity).

Therefore duration will predict a lower price than the actual price and for large changes in interest rates this difference can be significant.

If interest rates fall duration will understate the rise in bond prices, whereas if interest rates rise duration will over-state the fall in bond prices.



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Bond ValueActual relationship

Relationship predicted by duration

Interest Rates

Therefore the price change predicted by modified duration needs to be adjusted by the convexity measure to make the calculation more accurate.

Total % price change = ± change due to duration + change due to convexity

Even after correcting for convexity duration can only measure the change in bond price if the change in interest rates does not lead to a change in the shape of the yield curve. This is because duration is an average measure based on the bond's gross redemption yield (yield to maturity).

If there is a non-parallel shift in the yield curve (i.e. the shape of the yield curve changes) duration can no longer be used to assess the change in bond value.

Factors affecting duration: Term to maturity—longer dated bonds have longer durations

and hence higher price volatility. Coupon—lower coupon bonds have longer durations and

hence higher price volatility (the duration of a zero-coupon bond equals its term to redemption).

Yield—bonds with low yields have longer durations and hence higher price volatility.



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Example 12 Duration

6% coupon bond (paid annually) with three years to maturity. Yield to maturity is 10%, $1,000 par value.

Calculate:(a) Macaulay's duration;(b) Modified duration;(c) The actual % change in bond price for a 1% rise/fall in yield.

Solution

(a) Macaulay's duration

Year $ DF PV Year x PV

1

2

3

Macaulay duration = years

(b) Modified duration

Modified duration =

(c) Actual % change in bond price for a 1% rise/fall in yield

Recalculate bond price if yield rises to 11%:

Year $ DF PV

1

2

3

% fall in bond price = % ≈ modified duration

Recalculate bond price if yield falls to 9%:

Year $ DF PV

1

2

3

rise in bond price = % ≈ modified duration



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5 Term Structure of Interest Rates

5.1 Yield Curve TheoryThe return provided by a security will alter according to the length of time before the security matures.

If, for example, a graph is drawn showing the yield to maturity/redemption yield of various government securities against the number of years to maturity, a "yield curve" such as the one below might result.

Years to maturity

Yield

It is important for financial managers to be aware of the shape of the yield curve, as it indicates to them the likely future movements in interest rates and hence assists in the choice of finance for the company.The shape of the curve can be explained by the following: Expectations theory:

If interest rates are expected to increase in the future, a curve such as that above may result. The curve may invert if interest rates are expected to decline.

Liquidity preference theory:Yields will need to rise as the term to maturity increases, as by investing for a longer period the investor is deferring his consumption and needs higher compensation.

Segmentation theory:Different investors are interested in different segments of the yield curve. Short-term yields, for example, are of interest to financial intermediaries (e.g. banks). Hence the shape of the yield curve in that segment is a reflection of the attitudes of the investors active in that sector. Where two sectors meet there is often a disturbance or apparent discontinuity in the yield curve as shown in the above diagram.



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This can also be referred to as "preferred habitat theory" (i.e. different investors have a preference for being in different segments of the yield curve). Pension fund managers often have a preference for investing in long-dated bonds—to match against the long-term liabilities of the fund. This can drive up the price of long-dated bonds which brings down their yield, possibly resulting on an "inversed" (falling) yield curve.

Risk: On high-quality government/sovereign debt (e.g. UK Gilt-Edged Securities ("Gilts")) the risk of default is not significant even for long-dated bonds.

However, default risk may be more significant on corporate debt, therefore the corporate yield curve may rise more steeply than the government yield curve.

5.2 Deriving the Spot Yield Curve A "spot interest rate" is the rate for borrowing a sum of money today to be repaid by a single sum on a specific future date.

For example, the one-year spot rate is the rate for borrowing money today to be repaid with a single "bullet" after one year; the two-year spot rate is the rate for borrowing money today to be repaid with a single sum after two years (i.e. with zero coupon paid during the loan's life).

Ideally, spot interest rates could be found directly as the quoted yield to maturity (gross redemption yield) of zero-coupon bonds of various maturities.

However, in practice most government (and corporate) bonds pay coupon (i.e. are not repaid as a single sum). In this case spot rates cannot be directly observed and have to be implied using a process known as "bootstrapping":

First find the YTM on a one-year government bond. Assuming coupon is paid annually (as opposed to semi-annually) this one-year bond is in fact repaid by a single sum (i.e. its YTM is by definition the one-year spot rate).

Then find the market price of a two-year government bond. The market price should theoretically equal the present value (PV) of the first-year coupon (discounted at the one-year spot rate) plus the PV of the second-year coupon and redemption value (discounted at the two-year spot rate). As the one-year spot is known the two-year spot can be implied.

Then find the market price of a three-year government bond. This should equal: the PV of the first-year coupon (discounted at the one-year

spot rate) plus the PV of the second-year coupon (discounted at the two-

year spot rate) plus the PV of the third-year coupon and redemption value

(discounted at the three-year spot rate, which can now be implied).

The process continues for as long as required.



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Example 13 Spot Rates

The following data has been collected on government treasury notes (annual coupon, $100 face and redemption value):

Years to redemption Coupon Market PriceOne 7% $103Two 6% $102Three 5% $98

Required:Calculate the one-year, two-year and three-year treasury spot rates.

Solution

One-year spot rate: S1 =

Two-year spot rate: S2 =

Three-year spot rate: S3 =

5.3 Valuing Corporate Bonds Using Spot RatesAn accurate approach to bond valuation is to "strip" a bond into its constituent cash flows and discount each cash flow separately at its related spot rate.

Once the theoretical market value of the bond has been found then its YTM can be estimated (i.e. the equal annual rate that would discount the bond's cash flows to the market price).

It can then be observed that a bond's YTM is a weighted average of the underlying spot rates, the weighting being the proportion of returns generated in each year.



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Example 14 Spot Curve Valuation

A three-year, 5% coupon corporate bond ($100 face and redemption value) has the following spread above the treasury spot rates from example 12 (bps = basis points):

Year Spread (bps) One 29 Two 41 Three 55

Required:(a) Value the bond based on the corporate spot curve.(b) Estimate the bond's yield to maturity.

Solution

(a) Corporate Spot Curve

YearSpread (bps)

Treasury spot

Corporate spot $

Present value

1

2

3

(b) YTM

Time $ 6% DF PV $ 7% DF PV $0

1-3

3

YTM = IRR = %



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�The Efficient Markets Hypothesis deals with the pricing efficiency of the capital markets (i.e. what information is included in the price of securities).

�The rise of "dark pool trading" (i.e. off-market private trading) may be a challenge to the pricing efficiency of public markets.

�If capital markets are perfect the sale/purchase of any security must be a zero NPV transaction (i.e. market price = present value of future cash flows discounted at investors' required return).

�This general rule can be specifically applied to shares to develop the Dividend Valuation Model (DVM) and also applied to bond valuation.

�If the market price of a security is already known then the model can be rearranged to find the required return of investors' (i.e. the company's cost of equity and debt finance).

�Care must be taken with the cost of debt as interest, unlike dividends, is a tax allowable expense for the company.

�Bond duration measures the sensitivity of a bond's price to a change in yield.

�The term structure of interest rates deals with the relationship between short- and long-term interest rates. Everything else being equal, long-term rates should be higher to compensate investors for locking their money away and deferring consumption. However, other factors (e.g. expectations or preferred habitat) can produce an inverted yield curve.

�A spot interest rate refers to the rate that would apply if money borrowed today is to be repaid by a single sum.

�As spot interest rates cannot usually be directly observed they have to be implied through the process of bootstrapping.

Summary



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Session 2


1. Distinguish between the following types of financial market efficiency: allocative, operational, informational, pricing. (1.1)

2. State what information is reflected in share prices under each of the three levels of the Efficient Markets Hypothesis. (1.2)

3. State how the theoretical value of a share is calculated. (2.1)

4. State what future growth in dividends is a function of under Gordon's growth model. (3.4)

5. State the ratio that measures the required return of investors in irredeemable bonds. (4.2)

6. Explain why a company's cost of debt is lower than the required return of its debt investors. (4.2)

7. State which cash flows should be used to find IRR as an estimate of the post-tax cost of redeemable debt. (4.3)

8. State how the cost of convertible debt can be estimated. (4.5)

9. State why duration only gives the approximate price change for a bond for a change in interest rates (4.6)

10. State the theories or factors that can be used to explain the shape of the interest rate yield curve. (5.1)

11. Name the technique used to infer spot interest rates. (5.2)



Q3 Cost of capital 30 minutes

Additional

Q4 Gaddes

Q5 Stock market efficiency



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EXAMPLE SOLUTIONSSolution 1—Cost of Equity

P0 (cum-div) = $2.20

P0 (ex-div) = $2.00

ke = D/P0(ex-div) = 20/200 × 100%

ke = 10%

Solution 2—Growth Using Extrapolation

20X0–20X4—four changes in dividend.

100 (1 + g)4 = 145

(1 + g)4 = 145/100

1 + g = 145100

4 = 1.097

g = 9.7%

ke = D1/P0 + g

= 145(1.097)/1,050 + 0.097

ke = 24.8%

Solution 3—Gordon's Growth Model

Growth rate g = bre

b = % profit retained

= 60,000/100,000 = 60%

re = Return on equity*

= Profit after tax/Opening net assets

= 100,000/1,060,000 – 60,000 × 100%

re = 10%

g = 0.6 × 0.1 = 0.06

g = 6%

k = D1/P0 + g

ke = 40,000(1.06)/300,000 x 2.70 + 0.06

ke = 11.2%

Solution 4—Cost of Preference Shares

12% preference shares: dividend is 12% × nominal value

ke = D/P0

= 12/115 × 100%

ke = 10.4%

*Return on average equity could be used rather than return on opening equity.



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Solution 5—Valuation of Irredeemable Bonds

Annual coupon = 7% × $100 = $7

Required return = 7.42% = 0.0742

P0 =$7

0.0742 = $94.34

Solution 6—Cost of Irredeemable Debt

(a) Return required by debt holders

r = Int/MV ex int

= 12/92 – 12 × 100% = 15%

Return required by bondholders = 15%.

(b) Cost to the company:

kd = Int(1 – T)/MV ex int

= 12(1 –0.33)/92 – 12

kd = 10.05%

Solution 7—Valuation of Redeemable Bonds

Yield to maturity on risk-free treasuries = (104/98) − 1 = 6.12%

Yield to maturity on corporate bond = 6.12% + 3.88% = 10%

Annual coupon = 8% × $100 = $8

Present value of the coupon(applying a 10-year annuity factor at 10% discount rate)

= $8 × 6.145 = $49.16

Redemption price = $105

Present value of redemption price(applying a 10-year discount factor at 10% discount rate)

= $105 × 0.386 = $40.53

Market price of bond = $49.16 + $40.53 = $89.69

Solution 8—Cost of Redeemable Debt

Time Cash flow PV @ 10% PV @ 5%

0 (98) (98) (98)

1–4 (7) × 0.67 = (4.69) 14.87 16.63

4 (105) 71.72 86.42

(11.41) 5.05

IRR = 5 + 5.01/5.01 + 11.41 × (10 – 5) = 6.5%

kd = 6.5%



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Solution 9—Effective Annual Cost

Time 0 is 1 January 20X7. Interest payments are due:

30 June X7 Time 131 Dec X7 Time 230 June X8 Time 331 Dec X8 Time 430 June X9 Time 531 Dec X9 Time 6

Each interest payment will be just half of the coupon rate, $3 each 6 months.

Time Cash flow PV @ 3% PV @ 5%

0 (96) (96) (96)

1–6 3 16.25 15.23

6 100 83.75 74.62

4.00 (6.15)

IRR = 3 + 4.00/4.00 + 6.17 x (5 – 3) = 3.79%

This is the semi-annual cost of debt.

Effective annual cost of debt = 1.03792 – 1 = 7.7%

Solution 10—Valuation of Convertible Debt

(i) Market value

Expected share price in five years' time = 4.45 x 1.0655 = $6.10

Forecast conversion value = 6.10 x 20 = $122

Compared with redemption at par value of $100, conversion will be preferred.

Today's market value is the PV of future interest payments, plus the PV of the forecast conversion value:

MV0 = (9 x 4.100) + (122 x 0.713) = $123.89

(ii) Floor value

Floor value is the PV of future interest payments, plus the PV of the redemption value:

FV0 = (9 x 4.100) + (100 x 0.713) = $108.20

(iii) Conversion premium

Current conversion value = 4.45 x 20 = $89.00

Conversion premium = $123.89 – 89.00 = $34.89

This is often expressed on a per share basis (i.e. 34.89/20 = $1.75 per share).



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Solution 11—Post-Tax Cost of Convertible Debt

First decide whether the loan stock will be converted or not in five years. To do this compare the expected value of 40 shares in five years' time with the cash alternative.

Assuming that the MV of shares will grow at the same rate as the dividends:

MV/share in five years = 2(1.07)5 = $2.81

MV of 40 shares × $2.81 = $112.40

Cash alternative = $105

Therefore all loan stockholders will choose the share conversion.

To find the cost to the company, find the IRR of the Post-tax flows.

DF @ 5% PV$

DF @ 10% PV$

t0 (85) 1 (85.00) 1 (85.00)

t1–5 8(1 – 0.33) 4.329 23.20 3.791 20.32

t5 112.4 0.784 88.12 0.621 69.80

26.32 5.12

IRR = 5 + 26.32/26.32 – 5.12 × (10 – 5) = 11.2%

Therefore, cost to the company = 11.2%.



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Solution 12—Duration


Year $ DF PV Year x PV

1 60 0.909 54.54 54.54

2 60 0.826 49.56 99.12

3 1,060 0.751 796.06 2,388.18

900.16 2,541.84

Macaulay duration =2,541.84

= 2.82 years900.16


Modified duration = 2.82/1.10 = 2.56

(c) Actual % change in bond price for a 1% rise/fall in yield

Recalculate bond price if yield rises to 11%:

Year $ DF PV

1 60 0.901 54.06

2 60 0.812 48.72

3 1,060 0.731 774.86

877.64

% fall in bond price = (900.16 – 877.64)/900.16 = 2.5% ≈ modified duration

Recalculate bond price if yield falls to 9%:

Year $ DF PV

1 60 0.917 55.02

2 60 0.842 50.52

3 1,060 0.772 818.32

923.86

rise in bond price = (923.86 – 900.16)/900.16 = 2.63% ≈ modified duration*

*Note how duration overstates falls in bond prices when interest rates rise but understates rises in bond prices when interest rates fall. This is because duration assumes a linear relationship between yields and bond prices, whereas the true relationship is convex.



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Solution 13—Spot Rates

S1 = (107/103) – 1 = 3.88%

The two-year spot rate can be implied by "stripping" the two-year treasury note into its constituent cash flows and discounting each at the relevant spot rate (where s = two-year spot rate):

102 = (6/1.0388) + ((106/(1 + s2)2)

96.22 = ((106/(1 + s2)2)

S2 = √(106/96.22) – 1 = 4.96%

98 = (5/1.0388) + (5/1.04962) + ((105/(1 + s3)3)

88.65 = ((105/(1 + s3)3)

S3 = (105/88.65)1/3 – 1 = 5.8%

Solution 14—Spot Curve Valuation

(a) Corporate Spot Curve

YearSpread (bps)

Treasury spot

Corporate spot $

Present value

1 29 388 4.17% 5 5/1.0417 = 4.80

2 41 496 5.37% 5 5/1.05372 = 4.50

3 55 580 6.35% 105 105/1.06353 = 87.29

96.59

(b) YTM

Time $ 6% DF PV $ 7% DF PV $0 (96.59) 1 (96.59) 1 (96.59)

1-3 5 2.673 13.36 2.624 13.12

3 100 0.84 84 0.816 81.60

0.77 (1.87)

YTM = IRR = 6% + 0.77/(0.77 + 1.87) = 6.29%



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Session 3

Session 3 Guidance

Recognise that WACC is simply a mix of the cost of equity and post-tax cost of debt and understand why the weightings should be market values in preference to book values (s.1).

Understand that as an average cost of long-term finance, WACC is an appropriate discount rate for projects that do not disturb the firm's business risk or financial risk profile (s.2).


2. Financial strategy formulationb) Recommend the optimum capital mix and structure within a specified

business context and capital asset structure.



b) Discuss the appropriateness of using the cost of capital to establish project and organisational value, and discuss its relationship to such value.

g) Assess the impact of financing and capital structure upon the organisation with respect to:i) Modigliani and Miller propositions, before and after taxii) Static trade-off theoryiii) Pecking order theoryiv) Agency effects.

Weighted Average Cost of Capital and Gearing



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Session 3 Guidance

WEIGHTED AVERAGE COST OF CAPITAL

• Calculation• Limitations

EFFECTS OF GEARING

TRADITIONALVIEW

• Reasoning• Conclusions

PECKING ORDER THEORY• Retained

Earnings• Preference

MODIGLIANI AND MILLER'S

THEORIES• Mathematical

Model• Theory Without

Tax• Theory With Tax• Impact of

Default Risk• Practical

Considerations

Learn Modigliani and Miller's models and work carefully through Illustration 1 (s.4). Understand and be prepared to discuss the impact of agency theory on capital structure; debt can reduce agency costs through encouraging discipline but too much debt leads to restrictions on the firm's flexibility (s.6).

VISUAL OVERVIEWObjective: To evaluate and apply various capital structure theories to estimate an organisation's weighted average cost of capital (WACC) and discuss practical influences on gearing.

AGENCY THEORY AND CAPITAL STRUCTURE

• Agency Costs• Impact of

Gearing

STATIC TRADE-OFF THEORY

• Debt Finance• Comparison• Conclusion



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Session 3 • Weighted Average Cost of Capital and Gearing P4 Advanced Financial Management


1 Weighted Average Cost of Capital

1.1 Calculation of WACC < A firm's long-term finance is often a mixture of both equity

and debt (i.e. using some degree of financial gearing/leverage). The average cost of long-term finance is known as the WACC – the weighted average cost of capital.

< Calculating the cost of equity and the cost of various types of corporate debt have already been covered (Session 2).

< The various costs of long-term finance now need to be weighted using their respective market values:

WACC = keg E

E D++ kd

DE D+

Where:

E = Total market value of equity D = Total market value of debt keg = Cost of equity of a geared company kd = Cost of debt to the company (i.e. the post-tax cost of debt)

In the exam the formula is given as follows:

WACC = V

V Vke

e de+

+

VV V

k 1 td

e dd+

−( )

Where:

Ve = Total market value of equity

Vd = Total market value of debt

ke = Cost of equity geared

kd = Pre-tax cost of debt

T = corporation tax rate

The post-tax cost of debt only = kd (1 – T) for irredeemable debentures or bank loans.For a redeemable bond calculate the IRR of its post-tax cash flows which directly gives post-tax cost of debt.

< At any moment in time a firm can estimate its existing WACC.< The existing WACC may be a suitable discount rate for

estimating the NPV of potential projects – but is not automatically the appropriate rate.



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P4 Advanced Financial Management Session 3 • Weighted Average Cost of Capital and Gearing

A company's existing WACC should only be used A company's existing WACC should only be used A company's existing WACC should only be used as the discount rate for a potential project ifas the discount rate for a potential project ifas the discount rate for a potential project if

Proportion of debt to equity

does not change

Project is financed by existing pool

of funds

Project has same business risk as

existing operations

i.e. a company's existing WACC can only be used as the discount rate for a potential project if that project does not change the company's:

< Gearing level (i.e. financial risk);< Operational risk (i.e. business risk).*

Example 1 Estimating WACC

A company has in issue:45 million $1 ordinary shares10% irredeemable loan stock with a book value of $55millionThe loan stock is trading at par.Share price $1.50Dividend 15c (just paid)Dividend growth 5% paCorporation tax 33%

Required:Estimate the WACC.

Solutionke =

kd =

WACC =

*Important concepts of business and financial risk are dealt with in the next section.



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LIMITATIONS

THEORETICAL• Assumes perfect capital market• Assumes

─ market value of shares = PV of dividend stream

─ market value of debt= PV of interest/principal

• Current WACC can only be used to assess projects which─ have similar business risk to

that of existing operations─ do not change the company's

gearing level i.e. financial risk.

CALCULATION OF • Estimation of "g"

─ lack of historical data─ Gordon's model only applies

to all equity financed companies

• Assumes constant growth

ke

CALCULATION OF • Assumes constant tax rates• Complexities e.g.

kd

CONVERTIBLE LOAN STOCK• Investor has option of

(i) taking the redemption value, or

(ii) converting into shares• Assume it will be

redeemed unless data is available to suggest conversion

BANK OVERDRAFT• Current liability but often

has a permanent core• Must be split between

permanent and fluctuating element

• Include permanent element in calculation of WACC

FOREIGN LOANS• Exchange rates will

affect the value of the loans to be included and the effective cost

PRACTICAL

< These problems are particularly acute for unquoted companies which have no share price available and often make irregular dividend payments.

< In this case it may be advisable to estimate the WACC of a quoted company in the same industry and with similar gearing and then add a (subjective) premium to reflect the higher return required by investors in unquoted companies due to the perceived higher risk.



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2 Effects of Gearing

< The existing WACC reflects the current risk profile of the company:

Business risk — the volatility of operating profit due to the nature of the industry, country and level of operational gearing (i.e. proportion of fixed to variable operating costs).Financial risk — The additional variability in the return to equity as a result of introducing debt (i.e. using financial gearing). Interest on debt is also a fixed cost which leads to even more volatile profits for shareholders.

< As a company introduces debt into its capital structure two things happen.

• ke increases due to the increased financial risk.

• All else equal, this pushes up the value of WACC.

• The proportion of debt relative to equity in the capital structure increases.

• Since kd < ke this pushes the value of WACC down, all else equal.

ke E + kd DE + D

WACC =

< The effect of increased financial gearing on the WACC depends on the relative sizes of these two opposing effects.

< There are two main schools of thought:= Traditional view of capital structure;= Modigliani and Miller's theories.



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3 Traditional View of Capital Structure

3.1 ReasoningThe traditional view has no theoretical foundation; it is often described as the "intuitive approach". This view assumes that the following occurs:

< ke rises slowly at low levels of gearing and, therefore, the benefit of using lower-cost debt finance outweighs the cost of the rising ke.

< At higher levels of gearing, the increased financial risk outweighs this benefit and WACC rises.

< At very high levels of gearing, the cost of debt rises. This is due to the risk of default on debt payments (i.e. credit risk). This is referred to as financial distress risk; it should not be confused with financial risk, which occurs even at relatively safe levels of debt.

These relationships are shown in the graph below:

Cost of capital

%

WACC

ke

kd

D/EOptimal gearing

Valueof firm

$

D/EOptimal gearing

Vu = value of ungeared firm, Vg = value of geared firm*

Vu

Vg

*Value of geared firm = Value of equity + Value of debt



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3.2 ConclusionsAs the graph shows, there is an optimal gearing level (an optimal capital structure) at which WACC is minimised and hence the NPV of all projects is maximised (i.e. the value of the firm is maximised).

< However, there is no straightforward method of calculating ke or WACC, much less the optimal capital structure.

< The optimal capital structure can only be found by trial and error.

4 Modigliani And Miller's Theories

4.1 Mathematical Model < Modigliani and Miller (MM) constructed a mathematical model

to attempt to provide a basis for financial managers to make finance decisions.

< Mathematical models predict outcomes that would occur based on simplifying assumptions.

< Comparison of the model's conclusions to the real world observations then allows researchers to understand the impact of the simplifying assumptions. By relaxing these assumptions in turn the model can be moved towards real life.

< MM's assumptions include:= Rational investors.= Perfect capital markets.= No tax (either corporate or personal) – although they later

relaxed the assumption of no corporate tax.= Investors are indifferent between personal and corporate

borrowing.= There is a single risk-free rate of borrowing.= No financial distress risk (i.e. no risk of default) even at

very high levels of debt – although they later relaxed this assumption.

= Corporate debt is irredeemable.= No agency costs (i.e. directors continue to put shareholders'

interests first even at high levels of debt).

Don't panic—you will not be asked to prove MM, just to apply it. Their formula for adjusting the cost of equity for a change in financial gearing is published in the exam.



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4.2 Theory Without Tax< MM expressed their theory as two propositions.< MM considered two companies – both with the same size and

in the same line of business therefore both having the same level of business risk.= One company was ungeared - Co U= One company was geared - Co G

< MM's basic theory was that because each firm would have the same operating profit it would have the same total market value (V) and the same WACC (proposition 1)Vg = Vu

WACCg = WACCu

< MM argued that the individual costs of capital would change as gearing changed in the following manner:= kd would remain constant whatever the level of gearing;= ke would increase at a constant rate as gearing increased

due to the increased financial risk (proposition 2);= the rising ke would exactly offset the benefit of the cheaper

debt in order for the WACC to remain constant.This can be shown as a graph:

Cost of capital

WACC

ke

kd

D/E

Valueof firm

VgVu

D/E

$



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< Conclusions= There is no optimal gearing level;= The value of the company is independent of the

finance decisions= Only investment decisions affect the value of the company.

< This is not true in practice because the assumptions are too simplistic. There are differences between the real world and the model.

< Note that MM never claimed that gearing does not matter in the real world. They said that it would not matter in a world where their assumptions were correct. They were then in a position to relax the assumptions to see how the model predictions would change.

< The first assumption they relaxed was the no corporate tax assumption.



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4.3 Theory With Tax

Illustration 1 Gearing

Consider two companies, one ungeared, Co U, and one geared, Co G, both of the same size and level of business risk.

Co U Co G$m $m

EBIT 100 100Interest – 20

PBT 100 80Tax @ 35% 35 28

Dividends 65 52

Returns to the investors:Equity 65 52Debt – 20

Total return 65 72

The investors in G receive $7m more than the investors in U. This is due to the tax relief on debt interest and is known as the tax shield.

Tax shield = Kd × D × t

where kd = required return of debt holders

D = current market value of the debt

t = tax rate

MM assume that the tax shield will be in place each year to perpetuity and therefore has a present value, which can be found by discounting at the rate applicable to the debt, kd.

PV of tax shield =K D t

kd

d

× ×

= D × t

The difference in market value between G and U should therefore be that G has a higher market value due to the tax shield and this extra value is made up of the present value of the tax shield.

MM expressed this as:

MVg = MVu + Dt



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< When corporation tax is introduced MM argue that the individual costs of capital change as follows:= kd (the required return of the debt holders) remains

constant at all levels of gearing;= ke increases as gearing levels increase to reflect additional

financial risk;= WACC falls as gearing increases due to the additional tax

relief on the debt interest.

Cost of capital

WACC

ke

kd

D/E

Value of firm

Vg

Vu

D/E

$

< The relationship between the WACC of a geared company and the WACC of an ungeared company is:

WACC = keu 1 DtE D

−+

where keu = cost of equity in an ungeared company D = market value of debt in the geared company E = market value of equity in the geared company t = corporate tax rate

< The formula for the cost of equity is:

keg = keu + (1 – T) (keu – kd) DE

< This is provided on the formulae sheet in the following format:

ke = kei + (1 – T) (ke

i – kd) VV

d

e

Where kd = pre-tax cost of debt

This formula is not provided in the exam.



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Illustration 1 Gearing (continued)

Returning to the previous illustration these MM formulae can now be illustrated.

Suppose that the business risk of the two companies requires a return of 10% and the return required by the debt holders in Co G is 5%.

Co UMarket value of Co U will be the market value of the equity. This will be the dividend capitalised at the equity holders' required rate of return.

MVu =650 1. = $650m

Keu = 10% (required rate of return for business risk)

Co GMarket value of the equity of Co G is determined by the equity shareholders' analysis of their net operating income into its constituent parts and the capitalisation of those elements at appropriate rates:

MVe =EBIT0.1 −

Tax @ 35%0.1 −

Interest0.05

−

tax relief @ 35%0.05

= 1000 1

350 1. .

− −

200 05

70 05. .

−

= 1,000 − 350 − (400 + 140) = $390m

Market value of debt is determined by the debt holders capitalising their interest at their required rate of return:

MVd =20

0 05.= $400m

Therefore, total market value of Co G = MVg = $390m + $400m = $790m

The MM formula that describes the relationship between the market values of equivalent companies at various gearing levels can be illustrated here:

MVg = MVu + tD

$790m = $650m + (35% × $400m)



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Illustration 1 Gearing (continued)

MM's WACC relationship can also be illustrated

Firstly, WACC by the usual approach:

Keg =Dividend

Market value =

52390

= 13.33%

(assumes no growth in dividends)

Kd = 5% × (1 − 35%) = 3.25%

WACC = 13.33% ×

390790

+ 3.25% × 400790

= 8.23%

Then by using MM/s formula: WACC = Keu (1 − DtE D+

)

= 10% (1 − 400 35390 400

×+

%)

= 8.23%

MM's equation for the cost of equity can also be checked

Keg = Keu + (1 – T) (Keu – kd)

DE

= 10 + (1 – 0.35)(10 – 5) 400390

= 13.33% (as per the dividend valuation model above).

< Conclusion= MM's theory with tax implies that there is an optimal

gearing level and that this is at 99.9% debt in the capital structure.

= This implies that the financing decision for a company is vital to its overall market value and that companies should gear up as far as possible.

< This is not true in practice; companies do not gear up to 99.9% as there are obviously other factors to consider, the most important being default risk.



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4.4 Impact of Default Risk < MM were criticised for their assumption of zero default

risk even at very high levels of gearing. In practice higher gearing leads to higher risk of business failure and a lower credit rating.

< In response MM introduced default risk to their model and produced the rather surprising graph below (based on their theory without corporate tax).

Cost of capital

WACC

ke

kd

D/E

< MM argued that default risk increases the cost of debt but decreases the cost of equity. This is based on their view that the business risk of a firm is shared between its groups of investors. Hence if debt holders are taking more risk this reduces the risk faced by equity investors.

< The problem with this argument is that default risk is not a segment of business risk – it is a separate class of risk. Debt holders have legally binding contracts with the firm and are not exposed to business risk, the major risk they face is default. Furthermore the factors which increase the risk of default are also likely to affect the equity investors, increasing the cost of equity rather than decreasing it as MM claimed.

< However there may be another way to justify the falling cost of equity. When gearing is high the firm's liabilities are close to its assets and hence net assets (i.e. equity is low). In this situation equity investors have little to lose – if the firm follows a high risk strategy which succeeds then assets rise above liabilities and equity investors take a gain, but if the gamble fails then equity investors can walk away using the protection of limited liability. Hence equity investors may develop a relaxed attitude to risk – an appetite for risk as opposed to the usual assumption of aversion to risk.

< There is no unique answer as to how high gearing affects equity investors but, on balance, it would seem unlikely that the cost of equity falls as suggested by MM.



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4.5 Practical Considerations in Choosing a Gearing Level

< These will include:= business risk of the firm;= the risk of financial distress;= type and quality of assets for debt security;= personal tax position of the shareholders and debt holders;= tax exhaustion (not enough profit to fully utilise

the tax shield); = issue costs;= market sentiment.

5 Pecking Order Theory

5.1 Using Retained Earnings As an alternative to issuing new shares (or debts) a company can finance its investment projects using retained earnings (i.e. using internal finance rather than external finance).

< The potential amount of internal finance available = operating cash flow – interest – tax.

< The actual amount of internal finance used then depends on the dividend decision.*

5.2 Preference for Internal Finance< Company managers may prefer to use internal finance rather

than external finance for the following reasons: = A belief that using internal finance costs nothing—in

fact this is not true as retained earnings belong to the shareholders who expect significant returns.

= "Asymmetry of information"—external investors do not have as much knowledge of the business as the management and are therefore often reluctant to provide finance or will only provide it at high cost. This is particularly significant for SMEs which often have problems attracting new investors due to little public knowledge of the business. Using internal finance avoids the problem.

= No issue costs on internal finance. = Internal finance avoids possible change in control due to

issue of new shares.= Taxation position of shareholders who may prefer to make a

capital gain than receive current income via dividends.< This preference for internal finance has been referred to as

"Pecking Order Theory".< Once internal sources of finance have been exhausted then

the firm obviously has little choice but to consider an external issue. Research suggests that managers will then favour a debt issue over a new equity issue – as debt is easier and faster to raise than equity, has lower issue costs and interest is tax deductible.

*Microsoft did not pay any dividends for many years – it reinvested all cash to produce growth of the company and its share price. Any shareholder that required a dividend could simply sell some shares to take a capital gain and create a "home- made dividend".



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6 Agency Theory and Capital Structure

6.1 Agency Costs< In many firms there is a "divorce of ownership from control";

shareholders (the principals) delegate the running of the firm to the directors (their agents).

< This inevitably leads to the risk that the directors will fail to maximise shareholders' wealth. This is known as the "agency problem" and the resulting loss of wealth "agency costs".

< Agency costs can be categorised into two main types:= Lost returns due to directors following objectives that fail to

align with those of shareholders (e.g. personal objectives such as empire building, or prioritising the objectives of other stakeholders, in particular debt investors).

= The costs of monitoring the directors and management (e.g. the costs of internal audit departments and of implementing corporate governance procedures).

6.2 Impact of Gearing on Agency Costs< Research has found that moderate levels of debt can actually

reduce the level of agency costs for the following reasons:= the existence of debt encourages company directors to

practice sound financial discipline (e.g. careful cost control);= debt investors, especially banks, implement their own

monitoring systems (e.g. requiring regular cash flow forecasts). This reduces the level of monitoring required by the equity investors.

< However at high levels of gearing these benefits may become out-weighted by other problems for the equity investors:= increasingly onerous debt covenants restrict the directors'

ability to undertake any projects except those of very low risk. This limits potential gains for equity investors.

= potential costs of financial distress – if the firm is perceived as being at risk of default then suppliers may refuse credit, key employees might leave, customers may lose faith in any warranties given on the products, etc. If the firm actually does default it may go through a capital reconstruction (the costs of which would also be borne by the shareholders) or be forced into liquidation (in which case equity investors rank last for repayment of capital).

< Therefore there may be an optimal capital structure in terms of minimising agency costs, although research is mixed as to where this optimal point may lie.



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7 Static Trade-Off Theory

7.1 Use of Debt FinanceThe trade-off theory of capital structure refers to the idea that a company chooses how much debt finance to use by balancing the relative costs and benefits of debt.

The relevant benefit of debt is the tax shield on interest payments.

The relative costs of using debt include:= Agency costs—as financial gearing rises, debt contracts

include increasingly restrictive covenants (e.g. forcing the firm to stay in low-risk projects or limiting dividend payments). The resulting loss in potential shareholder wealth is referred to as agency costs.

= Financial distress costs—when stakeholders perceive the level of gearing to be dangerous the firm's cost of operating the business may rise as suppliers refuse credit, staff leave, potential customers lose faith in products sold under warranty or guarantee, etc.

= Bankruptcy costs—if a firm defaults on its debt it will either incur the costs of going through a capital reconstruction scheme or the costs of being liquidated.

7.2 Comparison With MM and Pecking Order Theory

< MM only considered the benefit of using debt (and hence concluded that the firm's value would continuously rise with financial gearing). The static trade-off theory also considers the costs and attempts to explain why, in practice, firms use less debt than expected by MM.

< The pecking order theory does not suggest that there is an optimal debt-to-equity ratio. However, static trade-off theory suggests that there is an optimal point at which the marginal cost of taking on more debt equals the marginal benefit.

7.3 ConclusionThe conclusion of static trade-off theory is, therefore, that an optimal capital structure does exist and the related cost of capital and valuation graphs would be similar to that of the traditional view. However, the optimal debt-to-equity ratio suggested by static trade-off theory would not necessarily be exactly the same as that of the traditional view of capital structure.



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< WACC estimates the company's average cost of long-term finance.

< It is therefore a potential discount rate to use for the calculation of the NPV of possible projects. However the existing WACC should only be used if the project would not change the company's business risk or level of gearing (i.e. financial risk).

< There are various, and conflicting, models of how financial gearing affects the WACC—traditional trade-off theory, Modigliani and Miller with and without tax and static trade-off theory. Each model has useful elements even if the conclusions of such models lack practical relevance.

< Pecking Order Theory is a practical model as opposed to theoretical. It is based on real world evidence that company managers have a preference for using internal finance rather than face the complications of dealing with external investors.

Summary



Q6 Redskins 40 minutes

Additional

Q7 Berland

Q8 Kulpar Co


1. State whether market or book values should be used in the estimate of WACC. (1.1)

2. State the conditions when a company's existing WACC can be used as the discount rate for a potential project. (1.1)

3. Define "business risk" and "financial risk". (2)

4. Explain the impact of financial gearing on WACC according to the traditional view of capital structure. (3.1)

5. Explain the impact of financial gearing upon WACC according to the Modigliani and Miller's model without tax. (4.2)

6. Explain the impact of financial gearing upon WACC according to Modigliani and Miller's model with tax. (4.3)

7. State what happens to the cost of equity if the cost of debt rises, according to Modigliani and Miller. (4.4)

8. State the hierarchy of finance according to Pecking Order Theory. (5)

9. Define agency costs and state their two main sources. (6.1)



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Session 3

EXAMPLE SOLUTION Solution 1—Estimating WACC

ke = Do(1 g)Po

g+

+

= 0 15 1 051 50

0 05. ..

.×+

= 15.5%

kd = 10% (1 − 0.333) = 6.67%

WACC = 15.5% ××

× ++ ×

× +45 1 50

45 1 50 556 67 55

45 1 50 55.

( . ). %

( . ) = 11.54%



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Session 4

Session 4 Guidance

Understand that diversification of risk is possible by building a portfolio with returns from assets that are not perfectly correlated (s.1).

Recognise the type of risk that can be reduced using diversification (i.e. unsystematic risk) and the nature of a portfolio that contains every share on the market (the market portfolio), as well as the type of risk that cannot be diversified away (i.e. unsystematic risk) (s.2).


1. Discounted cash flow techniquesa) Evaluate a specified capital investment project or portfolio including

specific treatment and discussion of risk adjusted discount rates.3. Impact of financing on investment decisions and adjusted

present valuesc) 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.

Portfolio Theory and CAPM



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Session 4 Guidance

VISUAL OVERVIEWObjective: To apply CAPM in calculating project-specific discount rates and in investment analysis, and to discuss Arbitrage Pricing Theory (APT) to address limitations of CAPM.

Learn the uses and limitations of the Capital Asset Pricing Model (CAPM) (s.3).

WHAT IS RISK?• Definition• Measurement• Investors and Risk

PORTFOLIO THEORY• Risk Reduction• Two Asset Portfolios—Mathematics• Markowitz Efficient Frontier• Capital Market Line• Systematic v Unsystematic Risk• Implications for Financial Management

CAPITAL ASSET PRICING MODEL• Measurement of Systematic Risk• Calculation of Beta• Interpretation of Beta• CAPM Formula• Security Market Line• Asset v Equity Betas• Asset Beta Formula• Project Appraisal in a New Industry• Assumptions and Limitations

ARBITRAGE PRICING THEORY



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Session 4 • Portfolio Theory and CAPM P4 Advanced Financial Management


1 What Is Risk?

1.1 Definition Investment risk— Uncertainty or variability of an investment's returns. The amount of risk an investment has will depend upon the variability of the returns of the investment around the average return (variance or standard deviation).

1.2 Measurement Risk is measured by the standard deviation of the returns

around the average return.

Example 1 Expected Return and Standard Deviation

Two investments have the following possible returns and associated probabilities:

Investment 1

Probability Return

0.1 10%

0.4 30%

0.2 40%

0.3 −20%

Investment 2

Probability Return

0.3 10%

0.3 20%

0.2 30%

0.2 0

What are the expected return and the standard deviation of these investments?



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P4 Advanced Financial Management Session 4 • Portfolio Theory and CAPM

Example 1 Expected Return and Standard Deviation (continued)

SolutionInvestment 1

Probabilityp

Returnx px x − x p(x − x)2

Expected return x

Standard deviation =

Investment 2

Probabilityp


Expected return x

Standard deviation =

(continued)

1.3 Investors and Risk Investors are assumed to be risk averse. Investors in general will seek to maximise return in relation to

risk—this is referred to as " mean–variance efficiency" and is the basis of portfolio theory.

Example 2 Risk Averse Investor

Explain which of the two investments in Example 1 a risk averse investor is likely to prefer.

Solution



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2 Portfolio Theory

2.1 Risk Reduction Risk averse investors will accept more risk provided that they

are compensated for it by an adequate return. However if they could reduce their risk without a reduction in return this would be even better.

This is possible by the process of diversification. When an investment (a) is added to an existing portfolio (b) the

risk of the new portfolio formed will usually be less than a simple weighted average of the individual risks of a and b alone.*

Furthermore, some investments can be added to an existing portfolio to give a new portfolio of lower risk than the existing portfolio.*

Whether such investments are acceptable will depend on the effect that they have on the return of the existing portfolio.

Portfolio theory appraises investments by looking at the effect that they have on the risk/return characteristics of the total investments held. The approach involves: a comparison of the return of the existing portfolio to the

return of the existing portfolio + the new investment:AND

a comparison of the risk of the existing portfolio to the risk of the existing portfolio + the new investment.

Possible outcomes

Return Risk Conclusion

Accept the investment

Stays the same Accept the investment

Stays the same Accept the investment

Reject the investment

Stays the same Reject the investment

Stays the same Reject the investment

Unable to decide. It depends on whether the fall in return is compensated by the fall in risk

Unable to decide. It depends on whether the increase in return is thought to be adequate compensation for the increase in risk

It is theoretically possible to apply this approach to any number of combinations of investments. In practical terms the appraisal will look at two assets only. These two assets are the existing portfolio (which may of course be made up of lots of investments) and a new investment.

For an individual investor portfolio theory can be used to make decisions about including a new share in a portfolio of shares.

For a firm it can be used to make decisions about including a new project in the existing portfolio of projects.

*This diversification benefit results from the way investment returns interact with each other in different sets of economic conditions—"states of the world".

*This will almost always be the case.



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2.2 Two Asset Portfolios—Mathematics

Investment Return Risk Weight in portfolio

A ra sa wa

B rb sb wb

Risk is measured by standard deviation(s).

Weighting of investments should be by market values.

What will be the return and risk of the portfolio? The return will be a simple weighted average of the return on

each investment, but the risk will depend on how much the fluctuations in A and B counteract each other.

amplify fluctuations

counteract each other

Time

% Return

rb

raA

B

The extent to which this happens will depend on the correlation between the two investments' returns.

Correlation coefficients can have a value between –1 and +1: +1 means the two investments are perfectly positively

correlated (i.e. they move in the same direction and in the same proportion). In this (rare) situation the risk of the portfolio will be a simple weighted average of the risks of the two investments (i.e. no risk reduction is available).

–1 means the two investments are perfectly negatively correlated (i.e. they move in the opposite direction but in the same proportion). Although this is also rare in practice it would be perfect for risk reduction.

0 means that there is no correlation between the returns Formulae for risk and return of a two asset portfolio:

Return = wara + wbrb

Risk = sp = w s w s 2w w r s sa2

a2

b2

b2

a b ab a b+ +



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The final element of the two asset portfolio risk equation is the vital part:

rabsasb = the covariance of returns between a and b

rab = the correlation coefficient between the returns of a and b

It is the correlation coefficient which determines how much risk reduction is possible.

Calculating the risk of a two asset portfolio will not be required in the exam. The calculations are presented in this study system for illustrative purposes only.

Illustration 1 Covariance

If rab = +1 then the covariance becomes:

+1 sa sb or sa sb

Then w s w s 2w w r s sa2

a2

b2

b2

a b ab a b+ +

simplifies to wasa + wbsb

This means that if rab = +1 the risk of the portfolio is a simple weighted average of the individual risks.In practice it is almost always the case that the correlation coefficient between two investments is less than +1. In this case the risk of the portfolio is less than a simple weighted average of the individual risks.



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Example 3 Portfolio Risk and Return

The following information is given about securities A and B:

Risk Return

A 4% 8%

B 8% 16%

A portfolio is to be constructed with 60% of the available funds invested in A and 40% in B.RequiredDetermine the return and risk of the portfolio if the correlation coefficient between the returns of A and B is:(a) 0.9(b) 0.5(c) -0.2

Solution

Return on portfolio =

Risk of portfolio:

(a) =

(b) =

(c) =



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2.3 Markowitz Efficient Frontier With many risky assets available, the risk and return

combinations become an area:

Efficient frontierReturn

Risk

all possible risk and return combinations from all available risky assets: known as "Opportunity Set"

Only those portfolios lying along the "north west frontier" are mean-variance efficient.

A portfolio is mean-variance efficient if it offers: maximum return for a given level of risk OR minimum risk for a given level of return

The frontier is known as the Markowitz efficient frontier.

2.4 Capital Market Line If an investor constructs a portfolio of shares then obviously

these are all risky assets. However an investor may also consider buying risk-free

securities (e.g. treasury bills). An individual investor may decide on one of the following

courses of action: to invest only in risky shares; to withdraw some of his investment in shares and invest in

risk-free securities; to increase his investment in shares by borrowing at the

risk-free rate (Rf) i.e. using leverage.



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Mean-variance efficient portfolios now become a mix of risky shares and risk-free securities. This new efficient frontier is known as the Capital Market Line.

Capital Market Line (CML)

Most efficient portfolios

M

Risk

Return

Rf

Point M is where the frontier of equity portfolios touches the Capital Market Line.

The Capital Market Line represents various combinations of equity portfolio M and a risk free investment.

These most efficient portfolios lie along the line from Rf to M and beyond (i.e. these portfolios maximise return for a given level of risk).

Assuming that all investors are rational and risk averse and have access to the same information, they will all choose portfolios lying on the Capital Market Line.

M is therefore the only efficient portfolio of shares and is known as the Market Portfolio—an equity portfolio that contains every share on the market.

2.5 Systematic v Unsystematic Risk It is possible for an investor to diversify away a certain type

of risk by investing in more shares. The type of risk that can be removed by diversification is known as unsystematic risk or unique risk.

A rational risk-averse investor will diversify away as much risk as is possible and will therefore hold the market portfolio of shares (i.e. a portfolio containing every share on the market). This portfolio contains zero unsystematic risk.

The investor may then choose to combine the market portfolio with the risk-free asset by either borrowing or investing at the risk free interest rate.

However the market portfolio itself cannot be risk-free; its returns rise and fall due to factors (e.g. macro-economic changes). Therefore some risk remains even in a perfectly diversified equity portfolio.

This remaining risk is known as systematic risk or market risk. Systematic risk cannot be removed from equity investments.



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2.6 Implications for Financial Management Financial managers should also appreciate the concepts of

portfolio diversification. This is perhaps particularly important in unquoted companies

where the shareholders themselves may not be holding diversified portfolios (e.g. in a family-owned company a large proportion of the shareholders' wealth may be invested in this single company). In such circumstances it may benefit the shareholders if the company diversifies its investments with the aim of risk reduction.

However in larger quoted companies financial managers should not be aiming at diversification of the operations to reduce risk. This is because the shareholders in such companies can easily become personally diversified by building a balanced portfolio of shares. Therefore they do not need the company to diversify for risk reduction purposes.

Most shares in quoted companies are held by institutional investors (e.g. fund managers). All professional investors will hold something that approximates to the market portfolio (i.e. they have already removed unsystematic risk via the fund's diversification).

For the financial manager of a quoted company the implications of portfolio theory are: The company should specialise, not diversify; The company needs to compensate shareholders for the

systematic risk they face. Therefore a measure of systematic risk is needed to derive

the required return of shareholders on potential investments projects.

The measure of systematic risk is known as a beta factor. Beta factors are input into the Capital Asset Pricing Model

to estimate the return required to compensate for an investment's level of systematic risk.

3 Capital Asset Pricing Model

3.1 Measurement of Systematic Risk Even a well-diversified equity portfolio still has some degree

of risk or variability. This is due to the fact that all shares are exposed to some degree of systematic risk/market risk (i.e. to macro-economic changes).

Systematic risk will affect the shares of all companies although some will be affected to a greater or lesser degree than others.

The sensitivity to systematic risk is measured by a beta factor. Beta factors for quoted shares are measured using historic

data and published in "beta books". They are determined by comparing changes in a share's returns to changes in the equity market's returns over a period of many years (60 months data should be used at least)

This can be illustrated by the Security Characteristic Line which gives an indication of the share's sensitivity to market changes.



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The beta factor is estimated from these observations by determining the gradient of the "line of best fit" using linear regression. The steeper the gradient the more volatile the share and the higher the beta factor.

Security characteristic line

Slope=β

Intercept=α

(Rm− R )

(Ri−R )f

f

Where: (Ri−Rf) is the excess return of the share over

the risk-free return (Rm−Rf) is the excess return of the equity market

over the risk-free return Rf is the return on a risk-free investment

The Security Characteristic Line should in the long run pass through the point where the two axes meet.

However in the short run this may not always be the case and any short term difference, or abnormal return, is known as the alpha factor.

3.2 Calculation of Beta A beta factor for a share "i" can also be calculated using the

formula:

Bi =

Covariance of i with the marketVariance of the market's returns

Or

Correlation of the share with the market × standard deviation of the share's returns

Standard deviation of the market portfolio's returns



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Example 4 Beta Factor

A share has a standard deviation of 15% and a correlation coefficient with the market returns of 0.72. The standard deviation of the market is 21%.

RequiredCalculate the share's beta factor.

Solution

Beta factor =

3.3 Interpretation of Beta A beta factor therefore simply describes a share's degree of

sensitivity to general changes in the market's returns, caused by systematic risk.

Beta factor of 1— this indicates that the share is as sensitive as the market to systematic risk

Beta factor > 1— this means that the share is more sensitive than the market. Therefore if the market in general rises by 10% then the returns from this share are likely to be more than 10%.

Beta factor < 1— the share is less sensitive than the market and is likely to rise and fall in value less than the market in general.

3.4 CAPM Formula If the shareholders of a company hold well-diversified

portfolios then they are concerned only with systematic risk. The return these shareholders require is therefore a return to

cover the systematic risk of an investment. Systematic risk is measured by a beta factor and therefore

the required return from an investment must be related to the beta factor of that investment.

This is brought together in the Capital Asset Pricing Model which is a formula that relates required returns to beta factors as measures of systematic risk.

The CAPM formula is:

E(ri) = Rf + βi(E(rm)–Rf)

E(ri) = expected/required return from an investment Rf = risk free return E(rm) = expected return from the "market portfolio" βi = beta of the investment The market portfolio is a portfolio containing every share on the equity market.

CAPM is the equation of the Security Market Line.



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3.5 Security Market Line The Security Market Line is a graph that indicates the required

return from any investment given its beta factor. Forecast returns from investments can be compared to the figure from the security market line to indicate whether that investment is under or over-valued.

Security market line

Return

Rm

Rf

×Ra

×Rb

BbBa0 1Beta

Where Ra = the forecast return from investment A

The required return of an investment with a beta of zero (risk free) will be the risk free return.

The required return of an investment with a beta of 1 will be the market return.

Consider investment A—it is forecast to earn higher returns than the CAPM would predict given its beta. It is therefore temporarily under-priced. This is referred to as a "positive alpha" investment.

Consider investment B—it would appear to be temporarily overpriced—a "negative alpha" investment.

In the long run market forces should ensure that all investments do give the returns predicted by the Security Market Line.

3.6 Asset v Equity Betas Any company is made up of its assets or activities. These

assets will have a certain amount of risk depending upon their nature and a beta factor that recognises the sensitivity of such assets to systematic risk. This beta factor is the asset beta and measures the systematic business risk of the company. It can also be referred to as an ungeared beta factor.

If an asset beta is used in the CAPM formula it gives the cost of equity ungeared (Keu)

The equity beta measures the sensitivity to systematic risk of the returns to the equity shareholders in a company. In a geared company the equity shareholders face not only business risk but also a degree of financial risk. Equity betas measure systematic business and financial risk.

Equity betas can also be called geared betas. If the equity beta is used in the CAPM formula it gives the cost of equity geared (Keg)

The CAPM can therefore be used as an alternative method to the Dividend Valuation Model for estimating the cost of equity of a company.

*A comparison of returns predicted by CAPM and returns received in the real world shows that they are markedly different.



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Example 5 Cost of Equity

The equity beta of a company is estimated to be 1.2. The risk free return is 7% and the return from the market is 15%.

RequiredEstimate the cost of equity of the company.

Solution

ke =

3.7 Asset Beta Formula Robert Hamada applied Modigliani and Miller's theory to

produce the following formula (published in the exam):

βa = Ve

Ve Vd Tβe

+ −( )( )

1 +

+ −( )Vd T

Ve Vd Tβd

11−

( )

where βa = asset beta

βe = equity beta

βd = beta of corporate debt

Ve = market value of equity

Vd = market value of debt

T = corporation tax rate

MM viewed the business risk of a firm as being shared between equity and debt investors—hence the asset beta is a weighted average of the equity beta and debt beta.

However debt is a legally binding contract and its holders are not significantly exposed to business risk—the main risk faced by debt is default which is a separate class of risk. Therefore in practice (and in the exam) the beta of debt is usually assumed to be zero—otherwise it would imply that the cost of equity falls as the cost of debt rises.



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3.8 Risk-Adjusted Discount Rates A company's existing WACC is only a relevant discount rate for a

project with the same level of business risk as existing activities. If the project is in a different industry (or country) then a

discount rate to reflect the business risk of that industry is required.

A "proxy" company in a similar industry should be found and its beta discovered. If that company is geared then its equity beta will contain both business risk and financial risk. However that company will probably have a different level of gearing compared to our company.

This requires us to use the asset beta formula to first "degear" the proxy beta to find the asset beta, and then "regear" to reflect our company's level of financial risk.

Example 6 Risk-Adjusted Cost of Equity

Acorn produces electronic components but is considering venturing into the manufacture of computers. Acorn is ungeared with an equity beta of 0.8. The average equity beta of computer manufacturers is 1.4 and the average gearing ratio is 1:4. The risk free return is 5%, the market return 12% and the rate of Corporation Tax 33%.

RequiredCalculate the discount rate Acorn should use to appraise a computer manufacturing project assuming that it is to remain an all equity financed company.

Solution



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Example 7 Risk-Adjusted WACC

Suppose that Acorn from the previous example has a gearing ratio of 1:2. It still wishes to enter into the same computer manufacturing project.

RequiredCalculate the discount rate that Acorn should use for a computer manufacturing project.

Solution



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3.9 Assumptions and Limitations of CAPM

Assumptions

Total risk can be split between systematic risk and unsystematic risk.

Unsystematic risk can be completely diversified away. All of a company's shareholders hold well-diversified portfolios. A risk-free security exists. Beta values remain stable over time. Perfect capital markets. Returns from shares follow the normal distribution.

Limitations

It is a single period model. It is a single index model—beta being the only variable to

explain different required returns on different investments. Lack of data for the model—particularly in developing markets. CAPM tends to over-state the required return on very high

risk companies and under-state the returns on very low risk companies.

Many of the assumptions do not hold in real life.Therefore CAPM does not provide an accurate estimate of required returns.*

4 Arbitrage Pricing Theory

It might be argued that the main limitation of the CAPM is that it is a single index model in that the expected return is based solely upon the beta factor.

An alternative theory is the Arbitrage Pricing Theory (APT). This is a multi-index model where the required return is determined by a variety of factors (e.g. return on the market, industrial growth rates, etc).

APT also has less restrictive assumptions than CAPM (e.g. it does not require perfect capital markets or that returns are normally distributed).

However APT is not commonly used in practice due to its complexity (e.g. different key factors drive the returns on different shares).

*A comparison of returns predicted by CAPM and returns received in the real world shows that they are markedly different.



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The risk of a portfolio is almost always less than the weighted average risk of its underlying investments. This is because the returns on different investments are rarely perfectly correlated.

The type of risk that can be removed by building a portfolio is referred to as unsystematic risk.

A rational investor will continue to add investments to the portfolio to diversify away all unsystematic risk. Regarding investment in ordinary shares this means holding the Market Portfolio—a portfolio which contains every share on the market.

Of course the market portfolio is not risk-free; the market itself rises and falls with economic factors. This element of risk cannot be removed from equities and is known as systematic risk.

Although systematic risk cannot be removed it can be measured using beta factors.

Beta factors can be input into the CAPM formula to estimate the required return on a particular company.

CAPM is an alternative to the Dividend Valuation Model (DVM) for estimating a company's cost of equity.

More importantly CAPM can also be used to estimate how the cost of equity will change if the company changes its level of business risk or financial risk.

Hence CAPM is useful for calculating project-specific discount rates.

Like all models CAPM has weaknesses and limitations, some of which are addressed by Arbitrage Pricing Theory.

Summary



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Session 4


1. State the range of values that a correlation coefficient can take. (2.2)

2. State the relationship between correlation coefficient and covariance. (2.2)

3. Define the Market Portfolio. (2.4)

4. State the type of risk that can be removed via diversification. (2.5)

5. State the type of risk measured by beta factors. (3.1)

6. State from what gradient beta can be estimated. (3.1)

7. State the implication of a positive alpha factor. (3.5)

8. Explain the difference between an asset beta and an equity beta. (3.6)

9. Justify the usual assumption that the beta of debt is zero. (3.7)

10. List the assumptions of CAPM. (3.9)

11. State the limitations of CAPM. (3.9)

12. Name the multi-factor model that has been developed to more accurately calculate required returns. (4)



Q9 Maltec 10 minutes

Q10 Wemere 50 minutes

Additional

Q11 Crestlee

Q12 Hotalot



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EXAMPLE SOLUTIONS

Solution 1—Expected Return and Standard Deviation

Investment 1

Probabilityp


0.1 10% 1 −5 2.5

0.4 30% 12 15 90.0

0.2 40% 8 25 125.0

0.3 −20% −6 −35 367.5

Expected return x 15 585.0

Standard deviation = 585 = 24.2

Investment 1 has an expected return of 15% and a standard deviation (risk) of 24.2%

Investment 2

Probabilityp


0.3 10% 3 −5 7.5

0.3 20% 6 5 7.5

0.2 30% 6 15 45.0

0.2 0% 0 −15 45.0

Expected return x 15 105.0

Standard deviation = 105 = 10.2

Investment 2 has an expected return of 15% with a risk of 10.2%

Solution 2—Risk Averse Investor

It is likely that investors would prefer investment 2 as they can achieve the same expected return as with investment 1 but with a lower level of risk.



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Solution 3—Portfolio Risk and Return

Return on portfolio = (0.6 × 8%) + (0.4 × 16%) = 11.2%

Risk of portfolio

(a) = 0 6 4 0 4 8 2 0 6 0 4 0 9 4 82 2 2 2. . . . .× + × + × × × × × = 5.46%

(b) = 0.6 4 + 0.4 8 + 2 0.6 0.4 0.5 4 8 2 2 2 2× × × × × × × = 4.87%

(c) = 0.6 4 + 0.4 8 + 2 0.6 0.4 0.2 4 8 2 2 2 2× × × × × − × × = 3.60%

Solution 4—Beta Factor

Beta factor =0 72 15

21. ×

= 0.51

Solution 5—Cost of Equity

ke = 7 + 1.2 × (15 − 7) = 16.6%

Solution 6—Risk-Adjusted Cost of Equity

Using published formula find the asset beta of the computer industry:

Ba =1 4 44 1 0 67

..

×+ ×

= 1.2

As Acorn is ungeared then this asset beta is the appropriate beta for use in the CAPM to determine the discount rate that it should use for a computer manufacturing project:

Required return = 5 + 1.2 × (12 − 5) = 13.4%

Solution 7—Risk-Adjusted WACC

Using published formula find the asset beta of the computer industry:

Ba = 1 4 44 1 0 67

..

×+ ×

= 1.2

To find the discount rate for Acorn this asset beta must be converted into an equity beta appropriate to Acorn:

1.2 = Be2

2 1 0.67+ ×

1.2 = Be × 0.749Be = 1.6Ke of Acorn if in computer manufacture= 5 + 1.6 × (12 − 5) = 16.2%The discount rate that Acorn must use is the WACC that it would have if its Ke were 16.2%. In the absence of any other information assume the pre-tax cost of debt is 5% (risk free rate). Discount rate = (16.2% × 2⁄3) + (5 (1 − 0.33) × 1⁄3) = 11.92%



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Session 5

Session 5 Guidance

Understand non-discounted methods of project appraisal including payback period and Accounting Rate of Return (ARR) (s.1).

Learn DCF techniques (s.2) and the interpretation of NPV—the absolute dollar change in the value of equity (and hence shareholders' wealth) due to a project (s.3).


1. Discounted cash flow techniquesa) Evaluate the potential value added to an organisation arising from a

specified capital investment project or portfolio using the net present value (NPV) model.i) Inflation and specific price variationii) Taxation including capital allowances and tax exhaustion

c) Establish the potential economic return using internal rate of return (IRR) and advise on a project's return margin. Discuss the relative merits of NPV and IRR.


i) Assess the impact of a significant capital investment project upon the reported financial position and performance of the company taking into account alternative financing strategies.

Basic Investment Appraisal



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Session 5 Guidance

Understand Internal Rate of Return (IRR) as the discount rate that results in NPV of zero and "linear interpolation"—the most common method of estimating IRR (s.4).

Recognise future incremental operating cash flows as relevant to project appraisal (s.5). Learn to integrate taxes, inflation and working capital into the DCF analysis (s.5).

VISUAL OVERVIEWObjective: To revise profit and payback based measures of investment appraisal and discounted cash flow (DCF) methods.

INTERNAL RATE OF RETURN (IRR)

• Definition and Decision Rule

• Method• Unconventional Cash

Flows

NET PRESENT VALUE (NPV)• Procedure• Meaning• Cash Budget Pro Forma• Tabular Layout

RELEVANT CASH FLOWS

• General Rule• UK Tax System• Inflation• Cash Flow

Forecasts• Discounting With

Inflation• Working Capital

INVESTMENT APPRAISAL

NON-DCF METHODS• Purpose• Payback Period• Accounting Rate of Return

DISCOUNTED CASH FLOW TECHNIQUES

• Time Value of Money• Discount Factors

FINANCIAL POSITION AND PERFORMANCE

• Relevance• Impact of the Project• Financing



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Session 5 • Basic Investment Appraisal P4 Advanced Financial Management


1 Non-DCF Methods of Investment Appraisal

1.1 Purpose of Investment AppraisalThe purpose of investment appraisal is to determine whether an investment project gives an adequate financial return. This return can be measured in a variety of ways but the most common are either by measuring the profitability of the investment or the cash flows from the investment.

Profits can be distorted by selection of different accounting policies and therefore methods based on cash flows are preferable.

1.2 Payback Period

Payback period— the time it takes for the operating cash flows from a project to pay back the initial investment.

Decision RuleIf payback period < target ACCEPT

If payback period > target REJECT

Illustration 1 Payback Period

Investment $1.4mAnnual operating cash flow $0.3mProject life 10 yrs

Payback period =1.4

= 4.7 years0.3

(or five years if cash flows are assumed to arise at year ends.)

Payback Period

Advantages Simple to calculate. Easy to understand. Concentrates on earlier flows: more certain; more important if firm has

liquidity concerns.

Disadvantages Ignores cash flows after

payback period; Target period is

subjective; Gives little information

about change in shareholder wealth;

Ignores the time value of money (although using discounted payback deals with this).



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P4 Advanced Financial Management Session 5 • Basic Investment Appraisal

1.3 Accounting Rate of Return (ARR)

Accounting rate of return (ARR)— The earnings of a project expressed as a percentage of the capital outlay or average investment.

Also referred to as Return on Capital Employed (ROCE) or Return on Investment (ROI).

This is a financial accounting measure based on the statement of profit or loss and statement of financial position.

It includes: Sunk costs (money already spent); Net book values of assets; Depreciation and amortisation; Allocated fixed overheads.

Calculated as:

Average annual operating profit × 100

Initial investment

ORAverage annual operating profit

× 100Average investment

Decision RuleIf ARR < target ACCEPT

If ARR > target REJECT



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Example 1 Accounting Rate of Return

Initial investment $200mScrap value at end $20m

Cash flows Year 1 $100mYear 2 $50mYear 3 $50mYear 4 $50m

Required: Calculate ARR on:

(i) Initial investment;(ii) Average investment.

Solution

Average annual profit =

Average investment =

(i) ARR on initial investment =

(ii) ARR on average investment =

Advantages Uses readily available accounting

information; Simple to calculate and understand; Often used by financial analysts to appraise

performance.

Disadvantages Different methods of calculation may

cause confusion; Based on profits rather than cash.

Profits are easily manipulated by accounting policy.

Ignores time value of money; Target rate is subjective; A relative measure (%)—gives little

information about the absolute change in shareholders' wealth.

Accounting Rate of Return



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2 Discounted Cash Flow Techniques

2.1 Time Value of Money Investors prefer to receive $1 today rather than $1 in one year. This concept is referred to as the "time value of money"(or

"time preference"). There are several reasons for this preference:

Liquidity preference—if money is received today it can either be spent or reinvested to earn more in future. Hence investors have a preference for having cash/liquidity today.

Risk—cash received today is safe, future cash receipts may be uncertain.

Inflation—cash today can be spent at today's prices but the value of future cash flows may be eroded by inflation.

DCF techniques take account of the time value of money by restating each future cash flow in terms of its equivalent value today.

Two traditional DCF methods are used in project appraisal:

NET PRESENT VALUE

INTERNAL RATE OF RETURN

DCF TECHNIQUESDCF TECHNIQUESDCF TECHNIQUESDCF TECHNIQUESDCF TECHNIQUESDCF TECHNIQUESDCF TECHNIQUESDCF TECHNIQUESDCF TECHNIQUES



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Discount factors are provided in the exam for discount rates from 1% to 20% for up to 15 years.

2.2 Discount Factors

2.2.1 Single Cash Flow

Discount factor is 1

n(1 r)+

or (1 + r)–n

2.2.2 Annuities

Annuities are equal annual cash flows each year for a number of years.

The first cash flow is assumed to start at T1

The present value of $1 received each year from T1 to Tn discounted at interest rate r

=$1 × 1(1 + r)

+ 1(1 + r)

+ 1(1 + r)

+ ... ... ... 1(12 3 + r)

n

=$1 × 1 1− + −( )r

r

n

In some instances the annuity will not start until some period after time 1. The tables cannot be used directly (as they assume the first cash

flow is at time 1). Two methods can be used to deal with this.

Illustration 2 Unusual Annuity Cash Flows

An equal annual amount is to be received for each of 10 years starting at time 3 with a discount rate of 10% per annum.

Method 1

10 year 10% annuity factor × 2 year 10% discount factor6.145 × 0.826

= 5.076

Method 2

12 year 10% annuity factor − 2 year 10% annuity factor6.814 − 1.736

= 5.078 (difference is due to rounding)

Unusual Annuity

A further "complication" is that an annuity may begin at Time 0 (i.e. today). This simply means that there is an additional cash flow at Time 0 which will always have a discount factor of 1. Therefore 1 should be added to the annuity factor taken from the tables.



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The formula for the present value of an annuity and annuity factors calculated for discount rates of 1% to 20% for up to 15 years are provided in the exam.

2.2.3 Perpetuities

A perpetuity is an equal annual cash flow to infinity.

1r

perpetuity factor=

2.2.4 Change of Discount Rates

Normally for discounting purposes the annual discount rate is assumed to be constant each year. However, it is possible for rates to change in which case discount factors must be calculated from first principles.

Illustration 3 Multiple DiscountRates

Interest rates for year 1 are anticipated to be 10% and to be 11% in year 2.

Discount factor for Time 1 cash flow =1

= 0.9091.10

Discount factor for Time 2 cash flow =1

= 0.8191.10 x 1.11

Multiple Discount

2.2.5 Non-annual Cash Flows

DCF questions normally assume that cash flows occur at each year end; however, this may not always be the case. If cash flows occur at anything other than annual time periods then a matching non-annual discount rate must be calculated using the following formula:

1 + r = 1 Rn + where r = periodic discount rate R = annual discount rate n = number of periods per annum

Example 2 Non-annual Cash Flows

A cash flow is to occur in three months' time and the annual interest rate is 10%.Required: Calculate the discount factor that should be applied to this cash flow.Solution

Non-annual Cash Flows



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3 Net Present Value (NPV)

3.1 Procedure Forecast the relevant cash flows from the project. Estimate the required return of investors (i.e. the discount

rate). The required return of investors represents the company's cost of finance, also referred to as its cost of capital.

Discount each cash flow (receipt or payment) to its present value (PV).

Sum present values to give the NPV of the project. If NPV is positive then accept the project as it provides a

higher return than required by investors.

3.2 Meaning NPV shows the theoretical change in the $ value of the

company due to the project. It therefore shows the change in shareholders' wealth due to

the project. The assumed key objective of financial management is to

maximise shareholder wealth. Therefore NPV must be considered the key technique in

business decision making.

3.3 Cash Budget Pro Forma

Time 0 1 2 3

$000 $000 $000 $000

Capital expenditure (x) – – x

Cash from sales – x x x

Materials (x) (x) (x) (x)

Labour – (x) (x) (x)

Overheads – (x) (x) (x)

Advertising (x) – (x) –

Grant – x – –

Net cash flow (x) x x x

r% discount factor 1 1

1+r

1

(1+r)2

1

(1+r)3

Present value (x) x x x

NPV = x



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3.4 Tabular Layout

Time Cash Flow Discount Factor

Present Value

$000 @r% $000

0 CAPEX (x) 1 (x)

1–10 Cash from sales x x x

0–9 Materials (x) x (x)

1–10 Labour and overheads (x) x (x)

0 Advertising (x) x (x)

2 Advertising (x) x (x)

1 Grant x x x

10 Scrap value x x x

Net present value x

4 Internal Rate of Return (IRR)

4.1 Definition IRR is the discount rate where NPV = 0. IRR represents the average annual percentage return from

a project. It therefore shows the highest finance cost that be accepted

for the project.

Decision Rule

If IRR > cost of capital, ACCEPT project.

If IRR < cost of capital, REJECT project.



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This is not an exam formula, so must be learnt.

*The answer should always be rounded, appropriately, due to the inherent inaccuracy of this method. The IRR thus calculated is only approximate, based on the simplifying assumption that there is a linear relationship between NPV of a project and discount rate. However, this is not so and the diagram illustrates the true situation.

4.2 Method Calculate the NPV of the project at a chosen discount rate. If NPV is positive, recalculate NPV at a higher discount rate

(i.e. to get closer to IRR). If NPV is negative, recalculate at a lower discount rate. By "linear interpolation"

IRR ~ A +NA (B – A)

NA – NB

Where A = Lower discount rate B = Higher discount rate NA = NPV at rate A NB = NPV at rate B

Illustration 4 Estimating IRR

The NPVs of a project with uneven cash flows are as follows:

Discount rate NPV$

10% 64,23720% (5,213)

Required:Estimate the IRR of the investment using interpolation.

Solution

IRR ~ A +NA

(B – A)NA – NB

IRR ~ 10% +$64,237

(20% – 10%)$64,237 – (–$5,213)

IRR ~ 19%*

NPV

IRR using formula (interpolated)

Discount rate

NA

A

Actual IRR

B

Actual NPV asdiscount rate varies

NB

Estimating IRR



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Example 3 Estimating IRR

An investment opportunity with uneven cash flows has the following net present values:

NPV$

At 10% 71,530At 15% 4,370

Required: Estimate the IRR of the investment.

Solution

IRR ~



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4.3 Unconventional Cash Flows If there are cash outflows, followed by inflows and then more

outflows the situation of "multiple IRR" may arise:

Discount rate

Actual IRR

IRR 1 IRR 2

NPV

Actual NPV asdiscount rate varies

The project appears to have two different IRRs—in this case IRR is not a reliable method of decision making.

4.4 NPV v IRR

NPV IRR

An absolute measure ($) A relative measure (%)

If NPV ≥ 0, accept If IRR ≥ target %, accept

If NPV ≤ 0, reject If IRR ≤ target %, reject

Shows $ change in value of company/wealth of shareholders

Does not show absolute change in wealth

A unique solution (i.e. a project has only one NPV)

May be multiple solutions

Always reliable for decision-making

Assumes that project cash flows can be reinvested at the IRR

Not always reliable



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5 Relevant Cash Flows for Discounting

5.1 General RuleInclude only those costs and revenues which are affected by the decision. This means using only future, incremental, operating cash flows.

Operating cash flows means the cash flows generated from operating the project (e.g. cash from sales and operating costs such as materials and labour).

Do not include financing cash flows because the cost of finance is measured in the cost of capital/discount rate—finance costs are taken into account by the discounting process itself.

Specifically, exclude:

sunk costs (i.e. money already spent); historic costs (e.g. of acquiring an asset); non-cash flows (e.g. depreciation); book values (e.g. FIFO/LIFO inventory values); unavoidable costs (e.g. money already committed and

apportioned fixed costs); finance costs (e.g. interest) as discounting the operating cash

flows already deals with this. The cost of capital is the finance cost—never include interest payments in a DCF calculation or the finance cost will be double counted.

Specifically, include:

all opportunity costs and revenues. For example, where there is "cannibalisation" (i.e. where the launch of a new product will reduce the sales of an existing product) the lost contribution is an opportunity cost and should be shown as a cash outflow.

5.2 UK Tax System

Do not panic—exam questions will tell you the tax rates/policies to use. All you really need to know is that depreciation expense is not a tax allowable deduction in the UK—instead companies are allowed to deduct a Writing Down Allowance (WDA), also called a Capital Allowance (CA). In the year of disposal of the asset there may be a tax loss (known as a Balancing Allowance) or a taxable gain (Balancing Charge).



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5.2.1 Effect on Investment Appraisal

Taxation has two effects in investment appraisal

NEGATIVE EFFECTTax charged on

operating results

POSITIVE EFFECTTax relief given on

non-current assets via

Investment Appraisal Investment Appraisal Investment Appraisal Taxation EffectsTaxation EffectsTaxation Effects

WRITING DOWN ALLOWANCES

Operating results = revenues – operating costs

Depreciation expense from the financial statements is not a tax allowable deduction in the UK

Any tax relief on finance costs is taken into account in the discount rate/cost of capital.

Instead businesses can claim Writing Down Allowances (WDAs)

Details: Often given at 25%

reducing balance – but exam question will specify the policy.

no WDA in year of sale; a balancing allowance/charge is given instead (representing a tax loss/gain on disposal).



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5.2.2 Timing of Tax Cash Flows

The timing of tax cash flows is complex. Some exam questions will specify that tax is paid in the year of taxable profits, others will indicated that tax is paid "one year in arrears" (i.e. in the following year):

T0 T1 T2Year 1

Assume net revenues (revenues – operating costs) are received at the end of year 1 (T1)

Tax assessed at T1 Tax paid T2 (assuming tax is paid one year in arrears)

If asset bought at start of year 1 First WDA received at T1 (date of next tax assessment) Reduces tax payment at T2

However if the asset is bought on the last day of the previous year (i.e. on the date of a tax assessment) the first WDA would be received immediately (i.e. at T0) which reduces the tax payment at T1.

Illustration 5 Tax Savings

An asset is bought for $5,000 at the start of an accounting period. It is sold at the end of the third accounting period for $1,000.Corporation tax is 30% and paid one year in arrears. Writing down allowances are available at 25% reducing balance.Determine the tax savings available and when they arise.

Solution

Tax saving Timing

@ 30%

$ $ $

Cost 5,000

Year 1 WDA 25% (1,250) 375 T2

WDV c/f 3,750Year 2 WDA 25% (938) 281 T3

WDV c/f 2,812Year 3 Disposal (1,000)

Balancing allowance 1,812 544 T4



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5.2.3 Other Assumptions

Tax rate is constant. Sufficient taxable profits are available to use all tax

deductions in full. Working capital flows have no tax effects. For example, if

accounts receivable increase this does not change the tax situation as tax is charged when revenues are recorded rather than when the cash is received.

5.2.4 Tax Exhaustion

Tax exhaustion refers to the situation where a firm does not have sufficient profits to fully utilise available capital allowances (i.e. where deducting capital allowances leads to a tax loss).

Although the usual assumption in examination questions is that the firm has sufficient profits elsewhere in its business to fully utilise capital allowances on a new project, in practice this may not always be the case. The impact of tax exhaustion would then depend on the tax code of the relevant jurisdiction. There are three main possibilities for unused capital allowances:

(1) they are simply lost;

(2) they can be carried back against profits inprevious years;

(3) they can be carried forward to potentially use against future profits.

5.3 Inflation

5.3.1 Real and Money (or Nominal) Interest Rates

Real rate of interest reflects the rate of interest that would be required in the absence of inflation.

Money (or nominal) rate of interest reflects the real rate of interest adjusted for the effect of general inflation (measured by the CPI, the Consumer Price Index).

Illustration 6 Nominal (Money) Return Required

Suppose you invest $100 today for one year and, in the absence of inflation, you require a return of 5%. The CPI is expected to rise by 10% over the coming year.

In one year, in the absence of inflation, you require:

$100 × 1.05 = $105

To maintain the purchasing power of your investment (i.e. to cover inflation) you require:

$105 × 1.1 = $115.50

You therefore require a money return of 15.50

100 = 15.5% over the year.



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Money rates, real rates and general inflation (CPI) are linked by the Fisher formula:

(1 + money rate) = (1 + real rate)(1 + general inflation rate)(1 + i) = (1 + r)(1 + h)

i = nominal/money interest rate r = real interest rate h = general inflation rate

In the above illustration: (1 + i) = (1.05) (1.1) = 1.155

i = 15.5%

5.3.2 General and Specific Inflation Rates

A specific inflation rate is the rate of inflation on an individual item (e.g. wage inflation, materials price inflation).

The general inflation rate is a weighted average of many specific inflation rates (e.g. CPI).

5.4 Cash Flow ForecastsIf there is inflation in the economy there are three ways in which the cash flow forecast for project appraisal can be performed:

5.4.1 Current Cash Flows

Cash flows expressed at today's prices (i.e. before the effects of inflation).

5.4.2 Money (or Nominal) Cash Flows

Cash flows are inflated to future price levels using the specific inflation rate for each type of revenue/cost.

This produces a forecast of the physical amount of money that will move in/out of the company.

5.4.3 Real Cash Flows

Money cash flows with the effect of general inflation removed.

5.5 DiscountingThere are three methods of discounting if there is inflation. Each method results in the same NPV.

5.5.1 Money Method

Adjust individual cash flows for specific inflation to convert to money cash flows.

Discount using money discount rate.

5.5.2 Real Method

Remove the effects of general inflation from money cash flows to generate real cash flows.

Discount using real discount rate.

5.5.3 Effective Method

Express each type of cash flow in current terms (i.e. at t0 prices).

Discount at the effective rate for that cash flow:

(1 + money rate) = (1 + effective rate)(1 + specific inflation rate)



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Illustration 7 Nominal and Real

One year projectOutlay at T0 = $5mSales for the year are expected to be $10m in current terms, with an expected specific inflation rate of 5%Costs for the year are expected to be $3m in current terms, with an expected specific inflation rate of 3%CPI expected to rise by 4%Nominal cost of capital = 6%

Solution(1) Money method

T0 T1

Outlay (5)

Sales 10 x 1.05 = 10.5

Costs (3) x 1.03 = (3.09)

Money flows (5) 7.41

NPV = (5) +7.41

= $1.99m1.06

(2) Real method*

T0 T1

Money cash flow (5) 7.41

CPI 4%7.41

1.04

Real cash flow (5) 7.125

(1 + i) = (1 + r) (1 + h)(1.06) = (1 + r) (1.04) r = 1.92307%

NPV = (5) + = 7.125

= $1.99m1.0192307

As money flows are needed to calculate real cash flows, the money method might just as well be used—it gives the same result.

Net cash flow expressed in current terms ($7m) is not the same as real cash flow ($7.125m) because sales and costs are not changing at CPI.




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Illustration 7 Nominal and Real (continued)

Solution(3) Effective Method Effective discount rates:

for sales (1.06) = (1 + e) (1.05) e = 0.95238%for costs (1.06) = (1 + e) (1.03)

e = 2.91262%

TechniqueDiscount cash flows expressed in current terms at effective rates

NPV = (5) + 10

+(3)

= $1.99m1.0095238 1.0921262

as before

Effective method can be useful where an annuity is given in today's prices.

5.6 Working CapitalMovements in working capital need to be incorporated into investment appraisals. Cash flows are derived as follows:

Increase in net working capital = cash outflow; Decrease in net working capital = cash inflow.

Unless the question states otherwise assume that working capital is "released" at the end of a project (i.e. the investment in working capital falls to zero) creating a cash inflow.

Assume that changes in the level of working capital have no tax effects. This is a realistic assumption because tax will be charged when net revenues accrue rather than when the cash is received.

(continued)



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6 Impact of Projects on Reported Financial Position and Performance

6.1 RelevanceParticularly in the case of a listed company, it is essential for the board of directors to evaluate the potential impact of significant capital expenditure (and related financing) on the firm's published financial statements. With most stock markets operating at the semi-strong level of pricing efficiency, the firm's share price would already have adjusted upon the initial public announcement of the project but the market will subsequently adjust its expectations once the actual effects on the financial statements are reported.

Of specific relevance is the impact of the project and its financing on key ratios used by the financial analysts who advise major institutional investors whether to buy, sell or hold the firm's shares:* earnings per share (EPS); return on equity (ROE) and/or return on capital employed

(ROCE); financial gearing and interest coverage.In the case of closely held private firms, the effects on financial statements may be less critical. In such firms, the shareholders may also be the managers and would have full information about the firm's current underlying position and performance, irrespective of what is recorded in the historical financial statements.

6.2 Impact of the ProjectThe capital expenditure will initially be recorded, at cost, in the statement of financial position as a non-current asset (or assets) according to its nature (i.e. tangible and/or intangible).

Over time, the carrying value of the non-current asset will be affected by:

depreciation (or amortisation) policy; revaluation policy (particularly in the case of property); results of impairment reviews (i.e. impairment losses).Most projects would also require an investment in working capital, which also increases the net current assets in the statement of financial position.

Use of the asset(s) in operations should lead to an increase in revenues, cash operating costs and depreciation (or amortisation) expense, but overall operating profit (earnings before interest and tax) would be expected to rise.

*See Session 18 for detailed consideration of ratios relevant to P4.



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6.3 Mode of FinancingThe overall reported impact of a project is highly dependent on the mode of financing and, assuming the directors follow pecking order theory, the relative effects would be as follows:

6.3.1 Internal Equity Finance

Internal equity would already be reflected in retained earnings in the statement of financial position. However, to finance a project, the retained earnings would have to be represented by cash (or cash equivalents), which would then fall to the extent of the capital expenditure and required investment in working capital.

Although the project itself should produce an overall increase in EBIT, this may, to some extent, be offset by lost income on cash equivalents.

6.3.2 Debt Finance

Initially, non-current liabilities would increase to the extent of the capital expenditure and required investment in working capital. This will lead to a potentially large rise in financial gearing. However, over the life of the project the reported financial gearing may fall from its initial level due to:

additional retained earnings leading to a rise in equity; repayments of debt (e.g. under a finance lease).Interest on debt will to some extent offset the increase in EBIT due to the project. However, the additional interest will lead to additional tax shield.

6.3.3 External Equity Finance

If new shares are issued (e.g. in a rights issue), the value of equity in the statement of financial position will increase to the extent of the required finance for the project. Hence reported financial gearing will initially fall. Gearing may continue to fall over the project's life due to additional retained earnings.

The additional EBIT created by the project will not be offset by additional interest expense, or by lost interest on deposits, and hence total earnings would be maximised under this mode of finance.*

*However, ROE and EPS would not be maximised due to the higher level of equity and additional shares in issue.



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Payback and ARR are commonly used in practice. However, neither method informs management of the absolute change in shareholders' wealth due to a particular project.

As well as being able to calculate payback and ARR, it is therefore vital that you can also explain why they are not acceptable methods of project appraisal.

Discounted cash flow techniques are arguably the most important methods used in financial management.

DCF techniques have two major advantages: (i) they focus on cash flow, which is more relevant than the accounting concept of profit, and (ii) they take into account the time value of money.

NPV must be considered a superior decision-making technique to IRR as it is an absolute measure which tells management the change in shareholders' wealth expected from a project.

The golden rule—only discount future, incremental, operating cash flows. Never discount depreciation—it is not a cash flow. Do not discount finance costs—the cost of finance is measured in the discount rate

and is therefore already taken into account. Exam questions may be in the environment of the UK tax system. Depreciation

expense is not a tax allowable deduction in the UK—instead companies can claim WDAs/CAs.

Discounting with inflation is a difficult area. The key here is consistency (i.e. if inflation is included in the cash flow forecast then it must be included in the discount rate).

Adjusting for changes in working capital is relevant if you are given accrual-based accounting information which needs to be converted to a cash flow basis.

Summary



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Session 5


1. Define payback period. (1.2)

2. List advantages and disadvantages of payback period. (1.2)

3. Give alternative names for "Accounting Rate of Return". (1.3)

4. State the alternative methods of calculating ARR. (1.3)

5. List advantages and disadvantages of ARR. (1.3)

6. Explain why it is necessary to discount future cash flows to present value. (2.1)

7. State the name of an equal annual cash flow for several years. (2.2.2)

8. State the meaning of NPV. (3.2)

9. Define IRR. (4.1)

10. Describe how IRR can be estimated. (4.2)

11. State the characteristics of costs and revenues which are relevant for discounting topresent value. (5.1)

12. Give examples of costs/revenues which are not relevant for discounting. (5.1)

13. State the two effects of the UK tax system on project appraisal. (5.1)

14. List three methods of dealing with inflation in DCF. (5.3)

15. State what happens to the cash position if working capital rises. (5.4)



Q13 Amble 50 minutes

Additional

Q14 Progrow



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EXAMPLE SOLUTIONSSolution 1—Accounting Rate of Return

Average annual profit

Total cash flows − Total depreciation =

250-180

No. of project years 4

= 17.5

Average investment

Initial investment + Scrap value =

200+20

2 2

= 110

(i) ARR on initial investment = 17.5

x 100 = 8.75%200

(ii) ARR on initial investment = 17.5

x 100 = 15.91%110

Solution 2—Non-annual Cash Flows

1 + r = 1 Rn +

R = 10%

n = 4

1 + r = 1 104 . =1.0241

Therefore, 3-month interest rate is 2.41%

Discount factor for a cash flow in 3 months' time:

PVIF =1

1 0241. = 0.976



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Solution 3—Estimating IRR

Formula

IRR ~ A +NA

(B – A)NA – NB

IRR ~ 10% + 71 53071 530 4 370

,, ,−

(15 – 10)

IRR ~ 10 + 5.325 say 15.4% (rounded up)

NPV

ActualNPV

Discount rate(%)

71,530–

│

ActualIRR

IRR usingformula

(extrapolated)

$

4,370–

10 15│

*The formula for estimating IRR provides a reasonable estimate, but take care with + and – signs.



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Session 6

Session 6 Guidance

Understand the relationship between Modigliani-Miller theories and the Adjusted Present Value (APV) technique as well as its shortcomings (s.1).

Understand application of linear programming to multi-period capital rationing (s.2.3). Recognise the problems with IRR overcome by MIRR (s.3).


Advanced Investment Appraisal


2. Financial strategy formulationg) Establish capital investment monitoring and risk management systems.


1. Discounted cash flow techniquesa) Evaluate the potential value added to an organisation arising from a specified capital

investment project or portfolio using the net present value (NPV) model. Project modelling should include explicit treatment and discussion of:iii) Single-period and multi-period capital rationing. Multi-period capital rationing

to include the formulation of programming methods and the interpretation of their output

iv) Probability analysis and sensitivity analysis when adjusting for risk and uncertainty in investment appraisal

b) Outline the application of Monte Carlo simulation to investment appraisal. Candidates will not be expected to undertake simulations in an examination context, but will be expected to demonstrate an understanding of:

c) Establish the potential economic return using modified internal rate of return and advise on a project's return margin.

3. Impact of financing on investment decisions and adjusted present valuesh) Apply the adjusted present value technique to the appraisal of investment decisions that

entail significant alterations in the financial structure of the company, including their fiscal and transactions cost implications.

(see ACCA Study Guide for expanded learning objectives)



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Session 6 Guidance

VISUAL OVERVIEWObjective: To recognise and understand advanced capital budgeting techniques.

Learn calculations for Macaulay's duration and modified duration and their application to analysing project liquidity (s.4).

Recognise and understand various methods of analysing and quantifying project risk (s.5).

ADJUSTED PRESENT VALUE• Use• Approach• Comparison With NPV • Critique

ADVANCED INVESTMENT APPRAISAL

MODIFIED IRR• Limitations of Traditional IRR• Alternative Calculation

Methods

ANALYSING PROJECT RISK• Expected Values• Standard Deviation• Sensitivity Analysis• Monte Carlo Simulation• Value at Risk (VaR)• Stress Testing• Reducing Risk• Monitoring and Control• Post-Completion Audits

ANALYSING PROJECT LIQUIDITY

• Traditional Measures• Project Duration

CAPITAL RATIONING• Types• Single-period • Multi-period



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Session 6 • Advanced Investment Appraisal P4 Advanced Financial Management


1 Adjusted Present Value (APV)

1.1 Use APV is used to appraise investments whose financing package

disturbs the firm's existing capital structure (i.e. financial risk). It can also deal with a change in business risk.

It is often described as the "divide and conquer" approach in that it separates the "base" benefits of the project from its "side-effects".

APV is based on Modigliani and Miller's assertion that the value of a geared firm = value of an ungeared firm + present value of tax shield. Applied at a project level:

APV = Project value if all equity financed

+ Present value of the tax shield from any debt

± Present value of other side effects

1.2 Approach(a) Calculate the operational value of the project as if it were

being financed only by equity—"Base Case NPV".

Operating cash flows are discounted at a cost of equity ungeared representing the project's level of business risk.

(b) Calculate the present value of the "side-effects". For example: — value of the tax shield on interest on debt finance for the

project;

— issue costs from raising external finance;

— value of government subsidies (e.g. loans received below commercial interest rates).

The amount of debt should be grossed up to cover its issue costs (unless otherwise stated).

The tax shield and value of subsidies should be discounted at the firm’s commercial pre-tax cost of debt (unless the scenario suggests the debt is risk-free).



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P4 Advanced Financial Management Session 6 • Advanced Investment Appraisal

Example 1 Adjusted Present Value

Blades is considering diversifying its operations away from its main area of business (food manufacturing) into the plastics business. It wishes to evaluate an investment project which involves the purchase of a moulding machine costing $450,000. The project is expected to produce net annual operating cash flows of $220,000 for each of the three years of its life. At the end of this time its scrap value will be zero.The assets of the project will support debt finance of 40% of its initial cost (including issue costs). The loan is to be repaid in three equal annual instalments. The balance of finance will be provided by a placing of new equity. Issue costs will be 5% of funds raised for the equity placing and 2% for the loan. Issue costs are tax allowable.The plastics industry has an average equity beta of 1.356 and an average debt: equity ratio of 1:5 at market values. Blades' current equity beta is 1.8 and 20% of its long-term capital is represented by debt which is generally regarded to be risk-free.The risk-free rate is 10% pa and the expected return on the market portfolio is 15%. Profits are taxed at 35%, payable one year in arrears. The machine will attract a 70% capital allowance; the balance is to be written off over the three years and is tax allowable. The firm is certain that it will earn sufficient profits against which to offset these allowances.

Required:Appraise the investment project using:(a) the current WACC;(b) a WACC adjusted for business and financial risk;(c) Adjusted Present Value (APV).

Solution

Operating Cash Flows Year 0$000

Year 1$000

Year 2$000

Year 3$000

Year 4$000

Equipment

Capital allowances (W)

Operating cash flows

Tax on operating cash flows

Working



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Example 1 Adjusted Present Value (continued)

Working(a) Current WACC

(b) WACC adjusted for business and financial risk

(c) Adjusted Present Value (APV)



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Example 2 APV With Subsidised Finance

Gilmore Co has a potential $25 million investment that would represent a diversification away from its existing activities and into the printing industry. Of the investment, $6 million would be financed by internal funds, $10 million by a rights issue and $9 million by long-term loans. The investment is expected to generate pre-tax operating cash inflows of $5 million per year, for a period of 10 years. The residual value at the end of year 10 is forecast to be $7 million after tax.As the investment is in an area that the government wishes to develop, a 10-year subsidised loan of $4 million at 6% interest is available. Another $5 million of debt would be raised with a 10-year bank loan at 8% which is Gilmore's usual borrowing rate.Gilmore's equity beta is 0.85 and its financial gearing is 60% equity, 40% debt by market value. The average equity beta in the printing industry is 1.2, and average gearing is 50% equity, 50% debt by market value. The risk-free rate is 5.5% per year and the market return is 12% per year.Issue costs are estimated to be 1% for the bank loan and 4% for the rights issue. There are no issue costs on the subsidised loan. Issue costs are not tax allowable. The corporate tax rate is 30%. Tax is paid in the year of returns and capital allowances may be ignored.Required:(a) Estimate the APV of the proposed investment. (b) State three circumstances in which APV may be a better method of evaluating a

capital investment than NPV.



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Example 2 APV With Subsidised Finance (continued)

Solution(a) Adjusted Present Value (APV)

βa =

Ke ungeared =

Annual after-tax operating cash flows =

$Present value of annual cash flows

Present value of the residual value

Less: Initial investment

Base case NPV

Issue costs

Debt

Equity

Tax shield on interest

8% bank loan

Subsidised loan

Annual tax relief

Present value of tax savings =

Value of subsidy

Net saving =

Present value =

APV =

(b) When APV may be a better technique to use than NPV

1.

2.

3.



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1.3 Comparison of NPV and APV

NPV APV*

Firstly, prepare cash flow. Firstly, prepare cash flow.

Stage 1 Base Case NPV

Take βe of company in target industry and degear. Gives βa.

Take βe of company in target industry and degear. This gives βa.

Regear βa to take account of project gearing. Put βa into CAPM, gives Ke ungeared.

This gives βe which reflects project finance and project risk. Discount operating cash flows at Ke ungeared.

Use βe in CAPM to calculate Ke geared. Total of discounted cash flow is "base case" NPV.

Calculate post-tax cost of debt.

Calculate WACC. Stage 2 PV of tax shield

Discount cash flows. Discount tax savings on debt interest at the pre-tax cost of debt.

Accept project if positive NPV.

Stage 3 PV of issue costs

Discount issue costs at the pre-tax cost of debt.APV is the sum of Stages 1, 2 and 3. If positive accept project.

*APV is based on Modigliani and Miller (MM). Stage 1 uses MM's original model without tax. Ignoring tax, there is no reason to regear the asset beta because WACC = Ke ungeared.Stages 2 & 3 simply correct imperfections in MM's original model. Stage 2 brings in MM's model with tax and adds the value of the tax shield. MM assumed that issue costs do not exist. They do in practice, so this is taken into account in stage 3.Stages 2 & 3 are not necessary when using NPV as all financing side effects are measured in the WACC.

1.4 Critique of APV Critics of APV point out that by valuing a project as a stand-alone entity it ignores the impact of a change in capital structure upon the value of the firm's existing operations.

The correct procedure would therefore be as follows:1. Value the firm pre-project at its existing WACC.

2. Revalue the firm with the new project included, at the firm's post-project WACC.

3. NPV of project = 2 − 1 − cost of investment.

This type of stepped approach to valuation is particularly important is the case of large strategic investments (e.g. mergers and acquisitions).



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2 Capital Rationing

2.1 Types of Capital RationingCapital rationing: a situation in which there is not enough finance (capital) available to undertake all available positive NPV projects. Therefore, capital has to be rationed.

Hard capital rationing: the capital markets impose limits on the amount of finance available (e.g. due to high perceived risk of the company).

Soft capital rationing: the company sets internal limits on finance availability (e.g. to encourage divisions to compete for funds).

Single-period capital rationing: capital is in short supply in only one period.

Multi-period capital rationing: capital is rationed in two or more periods.

2.2 Single-period Capital Rationing If projects are divisible (i.e. any portion of a project may be

undertaken) the correct method is to calculate a profitability index for each project and then to rank them according to this measure.

Profitability index = Net Present ValueCapital Invested

Example 3 Divisible Projects

Projects A$000

B$000

C$000

D$000

NPV 100 (50) 84 45

Cash flow at t0 (50) (10) (10) (15)

Cash is rationed to $50,000 at t0. Projects are divisible.Required:(a) Determine the optimal investment plan.



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Example 3 Divisible Projects (continued)

Solution

Projects A$000

B$000

C$000

D$000

NPV 100 (50) 84 45

Cash flow at t0

NPVInvestment

Profitability Index

Rank

Plan Capital NPV

If projects are non-divisible there is no need to calculate the index above—the optimal investment plan can only be found using trial and error (i.e. trying different combinations of projects until the maximum possible NPV is found).

Example 4 Non-divisible Projects

Detail as for Example 3, but assume that projects are non-divisible.Solution



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Mutually exclusive projects—where two or more particular projects cannot be undertaken at the same time (e.g. because they use the same land). In this case, use the following method: Divide projects into groups; with one of the mutually-

exclusive projects in each group. Calculate the highest NPV available from each group

(assume projects are divisible unless told otherwise). Choose the group with the highest NPV.

Example 5 Mutually Exclusive Projects

As for Example 3, but C and D are mutually exclusive.

Solution

Group 1$000

Group 2$000

A B C A B D

NPV

Investment

Index

Rank

Plan:NPV Capital NPV Capital

Accept Accept

Accept Accept

Therefore, accept:



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2.3 Multi-period Capital Rationing If investment funds are expected to be restricted in more

than one period, then neither the profitability index nor trial-and-error approaches can be used, as they do not take into account the restriction on finance in future periods.

If projects are divisible, then a linear programming model must be formulated and solved. If there are only two projects, the solution can be found graphically. Three or more variables require a computer solution.

Multi-period Capital RationingMulti-period Capital RationingMulti-period Capital RationingMulti-period Capital RationingMulti-period Capital RationingMulti-period Capital Rationing

NPV formulation PV of dividends

Linear programming approach

AimTo maximise NPVs of projects To maximise present value of dividendsMethodLet a, b, etc be the proportions of projects A, B undertaken

Let a, b, c be the proportions of projects A, B, C undertaken, and d0, d1, d2 be the dividend paid at t0, t1, t2, etc.

Objective function

Maximise (a × NPVA) + (b × NPVB) Maximise dd

(1 r)d

(1 r)01 2

2+

++

+ where

r = cost of capitalConstraints(a × outflow A) + (b × outflow B) ≤ Period 1 capital constraint and inflows.

(a × outflow A) + (b × outflow B) ≤ Period 2 capital constraints and inflows, etc.

a, b .................... ≤ 1a, b .................... ≥ 0

(a × outflow A) + (b × outflow B) + d1 ≤ Period 1 constraint and inflows.

(a × outflow A) + (b × outflow B) + d2 ≤ Period 2 constraints and inflows, etc.

a, b .............................. ≤1a, b.......... d0, d1, d2..... ≥0AssumesAll surplus cash is distributed as dividends

If projects are non-divisible the mathematics become even more complex and would not be required in the examination.



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Example 6 Linear Programming

A company is considering investment in two projects both of which are divisible. However, neither project can be deferred.The cash flows of the two projects are:

Year Project A Project B0 (20,000) (40,000)1 (40,000) (20,000)2 (60,000) –3 200,000 120,000

The company's cost of capital is 10%. The funds available to the company are restricted as follows:

Year Project A0 $40,0001 $50,0002 $40,000

Required: Determine the company's optimum investment policy to maximise NPV.



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Example 6 Linear Programming (continued)

Solution

Exam questions are likely to focus on interpreting the output from a linear programming model, rather than requiring the model to be solved manually.



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Illustration 1 Linear Programming

The following linear programming model has been formulated to find the optimal proportions (X) of projects A, B and C where capital is limited to $40,000 at the start of the first year and $35,500 at the start of the second year.

Maximise 23,245XA + 28,414XB + 37,939XC

Subject to 15,000XA + 25,000XB + 35,000XC ≤ 40,000

25,000XA + 15,000XB + 15,000XC ≤ 35,500

XA, XB, XC ≤ 1

XA, XB, XC ≥ 0

A computer provides the solution of the above problem as follows:

Project ProportionA 0.988B 0C 0.719

Shadow prices: 1st constraint (the $40,000 first year budget) = 0.922 2nd constraint (the $35,000 second year budget) = 0.3755

Interpretation of solutionThe solution indicates that 0.988 of Project A and 0.719 of Project C should be initiated. This investment plan uses all the funds available in the first year and the second year.The resulting value of objective function, NPV = $50,244 The shadow prices indicate the amount by which the NPV could be increased if the budgetary constraints could be relaxed. For every $1 increase in finance in the first year, $0.922 extra NPV would be obtained. For every $1 relaxation of the constraint in the second year, $0.3755 extra NPV would be obtained.The shadow prices indicate that extra funds in the first year are worth approximately three times those in the second year. This fact may give management some guidance in their considerations of various alternative sources of capital.It is assumed that each project is divisible and that there is a linear relationship between the proportion of each project undertaken and the NPV generated.

Linear Programming



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3 Modified Internal Rate of Return

3.1 Limitations of Traditional IRR Traditional Internal Rate of Return (IRR) has a major limitation

as it implies that the cash flows from a project can be reinvested at the IRR itself. This may be an over-optimistic assumption, particularly when the IRR is significantly higher than the firm's hurdle rate (i.e. cost of capital).

Furthermore, traditional IRR can be a multiple solution. A project may have two IRRs, particularly if there are cash outflows at the end of the project's life (e.g. decommissioning costs).

Modified Internal Rate of Return (MIRR) overcomes these problems and assumes that the cash flows arising from a project (excluding the initial investment) are reinvested at the firm's hurdle rate.*

3.2 Alternative Methods of Calculation Each annual cash flow is projected forward at the firm's hurdle

rate to obtain a terminal value at the end of the project:

MIRR = Terminal Value of project returnsPresent Value of investmeent outlay

n −1

where n = number of years

Use the published formula:

MIRR = PVPV

rR

I

ne

+( ) −1

1 1

where: PVR = present value of project returns PVI = present value of investment outlay re = reinvestment rate which will be the firm's cost of capital.

*However, MIRR shares a weakness with traditional IRR in that it gives no indication of the absolute change in shareholder's wealth.



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Example 7 MIRR

A project has the following forecast cash flows:

T0 T1 T2 T3 T4

(34,000) 7600 16,500 13,000 6,600

The firm's cost of capital is 8%.Required: Estimate the MIRR.Solution



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4 Analysing Project Liquidity

4.1 Traditional Measures Traditional measures of project liquidity have significant

weaknesses: Payback period—ignores the time value of money and

ignores cash flows beyond the payback date Discounted payback—takes into account the time value of

money, but still ignores post-payback cash flows Clearly, there is a need for measures which take into account

cash flows over the whole life of the project.

4.2 Project Duration The " Macaulay's duration" of a project is the weighted average

period of its returns, the weighting being the proportion of returns generated in each year.

The method involves the following steps: Calculate the present value of each future cash flow. Express each year's discounted cash flow as a proportion of

the total present value of the project's returns. Multiply each proportion by the relevant year. Sum the weighted years.

Even Macaulay's duration is not a perfect measure of liquidity as it does not indicate the time taken to recover the initial investment.

However, Macaulay's duration can be modified to a % measure to estimate the approximate rise/fall in the present value of project returns for a 1% fall/rise in the discount rate (i.e. modified duration can be used to model the project's sensitivity to changes in the cost of capital).

Modified duration = Macaulay's duration1 + WACC

Example 8 Duration

A project has the following forecast cash flows:

T0 T1 T2 T3 T4

(34,000) 7600 16,500 13,000 6,600

The firm's cost of capital is 8%.Required: (a) Macaulay's duration.(b) Modified duration.Solution



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5 Analysing Project Risk

5.1 Probability Analysis

5.1.1 Terminology

Independent events—If the occurrence of one event in no way affects the occurrence of any other event.

Conditional (dependent) events—If the occurrence of one event affects the occurrence of subsequent events.

Mutually exclusive events—If the occurrence of one event precludes the occurrence of any other events.

5.1.2 Rules

Addition rule—If a test has several mutually exclusive outcomes (A, B, C, etc), then the probability of alternative outcomes in a single test is the sum of their individual probabilities.

Prob (A or B or C) = Prob (A) + Prob (B) + Prob (C)

Multiplication rule—The probability of two independent events occurring is equal to the product of their individual probabilities.

Prob (A and B) = Prob (A) x Prob (B)

Example 9 Customer Complaints

The number of customer complaints received in a day by a customer service manager is given by the following table:

Number of complaints 0 1 2 3 4 5

Probability 0.05 0.15 0.20 0.30 0.20 0.10

Required:Calculate the probability that:(i) on any one day, there will be more than three complaints;(ii) there will be no complaints over a two-day weekend;(iii) there will be at least nine complaints over a weekend.Solution

(i) P(> 3) =

(ii) P(0 & 0) =

(iii) P(≥ 9) =



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Conditional events—The multiplicative rule also holds true for conditional events.If B depends on A then the probability that A and B occur simultaneously is :

P(A and B) = P(A) × P(B|A)

"the probability of B if (or given) A"

Illustration 2 Conditional Probability

Employees of an accountancy firm can be analysed by workplace and professional qualification as follows:

Office X Office Y Office Z TotalQualified 18 29 32 79Not qualified 7 9 16 32

25 38 48 111

The probability that an employee selected at random is not qualified and comes from office Y can be calculated: From the analysis: P(not qualified and from office Y) = 9⁄111

Using the rule P(A and B) = P(A) × P(B|A): P(not qualified and from office Y) = P(not qualified) × P(office Y|not

qualified) = 32⁄111 × 9⁄32 = 9⁄111



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5.2 Expected Values

Expected value—the quantitative result of weighting uncertain events by the probability of their occurrence.

Expected value = weighted arithmetic mean of possible outcomes

= x p(x)Σ

Example 10 Expected Values

State of Market Diminishing Static Expanding

Probability 0.4 0.3 0.3

Project 1 $100 $200 $1,000

Project 2 $0 $500 $600

Project 3 $180 $190 $200

Payoffs represent net present value.

Required:Determine which is the best project, based on expected values.

Solution

Project 1 Expected value =



Therefore, based on expected values, Project should be adopted.

5.2.1 Advantages

It reduces the information to one value for each choice. The idea of an average is readily understood

5.2.2 Limitations

The probabilities of the different possible outcomes may be difficult to estimate.

The average may not correspond to any of the possible outcomes.

Unless the same decision has to be made many times, the average will not be achieved; therefore, it is not a valid way of making a decision in "one-off" situations.

The average gives no indication of the spread of possible results (i.e. it ignores risk).



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Example 11 Different Probabilitiesin Different Periods

Zombie Co is worried about breaching its overdraft limit of $5 million.The company has produced the following forecasts of net cash flows for the next two periods, together with their associated probabilities.

Period 1 Cash Flow Probability Period 2 Cash Flow Probability$000 $0006,000 20% 8,000 35%3,000 50% 4,000 40%

(2,500) 30% (8,000) 25%

Zombie Co expects to be overdrawn at the start of period 1 by $1.5 million.Required:Calculate the following for the end of period 2:(i) the expected value (EV) of the closing balance;(ii) the probability of a negative cash balance;(iii) the probability of exceeding the overdraft limit.Discuss whether the above analysis can assist the company in managing its cash flows.Solution(i) EV of Closing Balance

Period 1 Period 2 Combined Probability

Closing Balance EV

1

(ii) Probability of negative cash balance =

(iii) Probability of exceeding the overdraft limit =

Discussion



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5.3 Standard Deviation

Standard deviation— a measure of variation of numerical values from a mean value.

It is a measure of spread (i.e. it indicates the likely level of variation from an expected value.

σ = standard deviation = ( )x x−∑ 2 prob ( )x

x = each observation

x = mean of observations

Prob (x) = probability of each observation

Note that variance = σ2

Example 12 Standard Deviation

Using the information from Example 10, calculate the standard deviation for each project.

Solution

Project 1

Project 2

Project 3

5.3.1 Advantages

It gives an idea of the spread of possible results around the average.

It can be used in further mathematical analysis. For example, estimating Value at Risk (VaR) on an investment (i.e. the potential loss in value at a given level of confidence).

5.3.2 Limitations

The calculation of standard deviation can be time-consuming. The exact meaning is not widely understood by non-financial

managers.

Exam questions are more likely to provide standard deviation for interpretation, rather than to require its calculation.



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5.4 Sensitivity Analysis

Sensitivity analysis—the analysis of changes made to significant variables in order to determine their effect on a planned course of action.*

The cash flows, probabilities or cost of capital are varied until the decision changes (i.e. NPV becomes zero). This will show the sensitivity of the decision to changes in those elements.

Therefore, the estimation of IRR is an example of sensitivity analysis, in this case on the cost of capital.

Sensitivity analysis can also be referred to as "what if?" analysis.

5.4.1 Method

Step 1 Calculate the NPV of the project on the basis of best estimates.

Step 2 For each element of the decision (cash flows, cost of capital), calculate the change necessary for the NPV to fall to zero.

The sensitivity can be expressed as a percentage change.

For an individual cash flow in the computation:*

Sensitivity =NPV

× 100%PV of flow considered

*In project investment, sensitivity analysis is used to analyse the risk of the various elements.

*For a change in sales volume, the factor to consider is contribution. This may involve combining a number of cash flows.



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Example 13 Sensitivity Analysis

Mr Williams has just set up a company, JPR Manufacturing Company, and estimates its cost of capital to be 15%. His first project involves investing $150,000 in equipment which has a life of 15 years and a final scrap value of $15,000.The equipment will be used to produce 15,000 deluxe pairs of rugby boots per annum, generating a contribution of $2.75 per pair. He estimates that annual fixed costs will be $15,000 per annum. Ignore taxation.

Required:(a) Determine, on the basis of the above figures, whether the project is worthwhile.(b) Calculate what percentage changes in the following factors would cause your

decision in (a) to change and comment on your results: (i) initial investment; (ii) sales volume; (iii) fixed costs; (iv) scrap value; (v) cost of capital.

Solution

(a) Time Cash Flow$

DF @ 15% PV$

0 Initial cost

1–15 Contribution

1–15 Fixed costs

15 Scrap value

The project is as NPV is .

(b) (i) Initial investment

Sensitivity =

(ii) Sales volume

Sensitivity =

(iii) Fixed costs

Sensitivity =

(iv) Scrap value

Sensitivity =

Comments:




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Example 13 Sensitivity Analysis (continued)

Solution

(v) Sensitivity to cost of capital

Year Cash Flow$

Factor Present Value$

0 (150,000) 1.000

1–15 26,250

15 15,000

NPV

IRR =

If the cost of capital rises above the project would be rejected.

5.4.2 Advantages of Sensitivity Analysis

It gives an idea of how sensitive the project is to changes in any of the original estimates.

It directs management attention to checking the quality of data for the most sensitive variables.

It identifies the critical success factors for the project and directs project management.

It can be easily adapted for use in spreadsheet packages.

5.4.3 Limitations of Sensitivity Analysis

Although it can be adapted to deal with multi-variable changes, sensitivity analysis is normally used to examine what happens when one variable changes and others remain constant.

Assumes data for all other variables is accurate. Without a computer, it can be time-consuming. Probability of changes is not considered.



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5.5 Monte Carlo Simulation Traditional sensitivity analysis can be used if one project

variable changes independently of all others. However, some project variables may be interdependent (e.g. production volume and unit costs).

Simulation is a technique which allows more than one variable to change at the same time. The classic example of simulation is the "Monte Carlo" method which can be used to estimate not only a project's NPV but also its volatility.

5.5.1 Designing a Monte Carlo Simulation

An assessment of the volatility (or standard deviation) of the net present value of a project requires estimates of the distributions of the key input parameters and an assessment of the correlations between variables. Some of variables may be normally distributed (e.g. demand), but others may be assumed to have limit values and a most likely value (e.g. redundancy costs).

In its simplest form, Monte Carlo simulation assumes that the input variables are uncorrelated. More sophisticated modelling can, however, incorporate estimates of the correlation between variables.

Monte Carlo simulation then employs random numbers to select a specimen value for each variable in order to estimate a "trial value" for the project NPV. This is repeated a large number of times until a distribution of net present values emerges. This distribution will approximate a normal distribution.

Refinements such as the Latin Hypercube technique can reduce the likelihood of spurious results occurring through chance in the random number generation process.

5.5.2 Outputs From Monte Carlo Simulation

The output from the simulation will give the expected NPV for the project and a range of other statistics including the standard deviation of the output distribution.

In addition, the model can rank the significance of each variable in determining the project NPV.

5.5.3 Summary of Monte Carlo Simulation

1. Specify the major variables.

2. Specify the relationship between the variables.

3. Attach probability distributions (e.g. the normal distribution) to each variable and assign random numbers to reflect the distribution.

4. Simulate the environment by generating random numbers.

5. Record the outcome of each simulation.

6. Repeat simulation many times to obtain a frequency distribution of the NPV.

7. Determine the expected NPV and its standard deviation.



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5.5.4 Advantages of Monte Carlo

It gives more information about the possible outcomes and their relative probabilities.

It can be used to estimate the probability that the actual NPV will be negative.

It can be used to calculate project Value at Risk (VaR).

5.5.5 Limitations of Monte Carlo

It is not a technique for making a decision, but only for obtaining more information about the possible outcomes.

It can be very time-consuming without a computer. It could prove expensive in designing and running the

simulation, even on a computer. Simulations are only as good as the probabilities, assumptions

and estimates made.

Example 14 Monte Carlo Simulation

Monte Carlo simulation has produced the following outputs for a potential project:• Expected NPV $1.964m• Standard deviation of NPV $1.02m

Required: Calculate the probability that the project will reduce shareholder wealth.

Solution



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5.6 Value at Risk (VaR)Project VaR = N(confidence level) × s × √T

Where: N (confidence level) is the number of standard deviations

from the mean for the given confidence level (extracted from the normal distribution tables)

s is the annual standard deviation of the project's returns T is the number of years of the project.

For reference, 95% confidence represents 1.645 standard deviations below the mean, and 99% confidence represents 2.33 standard deviations below the mean. For exam purposes, it is recommended that these figures are memorised to avoid errors in using the normal distribution tables.

Example 15 Value at Risk

Monte Carlo simulation has produced the following output for a potential 10-year project:

• Expected NPV $1.964m• NPV volatility $1.02m (annual standard deviation)

Required: Calculate Value at Risk at the 95% and 99% confidence levels.

Solution

Value at Risk (VaR)— an indication of the potential monetary loss likely to occur at a given level of confidence.



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5.7 Stress Testing Stress testing is designed to test the sensitivity of a project's

value at risk under the worst set of outcomes that can reasonably be expected to occur

This requires a careful evaluation of the worst possible outcomes—possibly by looking at the response of the model to extreme external events (e.g. major currency or interest rate changes).

5.8 Reducing Risk Methods of keeping project risk within acceptable levels:

Setting a maximum (discounted) payback period in the initial screening process of potential projects.

Use of risk adjusted discount rates for both NPV and discounted payback—a higher discount rate should be applied to projects of higher risk, therefore reducing the influence of more distant cash flows. Project-specific discount rates can be found using CAPM.

Use conservative forecasts—reduce the forecast returns downwards to reflect the guaranteed minimum inflows from a project—known as "certainty equivalents". These should then be discounted at the risk-free interest rate (i.e. risk is removed from the cash flows rather than adjusted for in the discount rate). Calculations using this method will not be required in the exam.

Select projects with a combination of acceptable expected NPV and relatively low standard deviation of NPV.

Focus attention on the critical success factors indicated by sensitivity analysis.

5.9 Project Monitoring and Control A project "steering committee" should be set up to help control

the project and ensure efficient use of time and resources. The steering committee should include a project leader and

representatives from different areas of the project. A project manager should be appointed to oversee the project

and be held accountable for any time or cost over runs. The project manager should report to the steering committee

Actual expenditure should be compared with budgets on a regular basis. This should ensure effective management of resources through increased scrutiny.



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5.10 Post-completion Audits A post-completion audit (PCA) can be defined as "an

objective and independent appraisal of all phases of the capital expenditure process regarding a specific project". The main purposes include project control, improving the investment process and assisting the assessment of performance of future projects.

A major requirement of a PCA is that the objectives of the investment project must be clear and an adequate investment proposal should have been prepared. The objectives should also be stated, wherever possible, in terms that are measurable.

The PCA should include an assessment of the reasons for any variance from the expected performance, cost and time outcomes. This should improve project control and governance and enable changes to be introduced to put the project back on track in a timely manner.

The PCA should also provide a source of information that will help future management decision making.

Limitations of PCAs include:

Time consuming and costly to complete. Sufficient resources are often not allocated to the task of

completing PCAs. Sometimes seen as tools for apportioning blame. Managers may claim credit for all that went well in the project

and blame external factors for everything that did not.



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Session 6

Traditional NPV calculated using WACC does not deal well with a project whose finance significantly changes the firm's capital structure.

In this situation, it is preferable to use APV which splits the operational side of a project from its financing implications and values each separately before finding the overall impact of the project with the proposed financing.

Multi-period capital is where cash for investment is a limiting factor for several years. In this case, it is necessary to formulate a linear programming model and solve graphically.

Traditional IRR assumes that project cash flows can be reinvested at the IRR itself—often an optimistic assumption. Modified IRR makes the more realistic assumption that cash flows can be reinvested at the cost of capital.

Various measures of project liquidity can be calculated—listed in order of increased usefulness—payback, discounted payback and duration.

Project risk can be modelled using Monte Carlo simulation, the results of which can then be used for VaR analysis.

Summary



Q15 Tampen 30 minutes

Additional

Q16 Project review


1. State what discount rate should be used to discount operating cash flows for APV. (1)

2. State what discount rate should be used to value the tax shield for APV. (1)

3. State the technique used to deal with multi-period capital rationing. (2.3)

4. State the criticism of traditional IRR which MIRR attempts to deal with. (3.1)

5. State THREE measures of project liquidity. (4)

6. List stages in Monte Carlo simulation (5.5)

7. Define Value at Risk. (5.6)



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These weights are based on the mix of funds for the project.

Solution 1—Adjusted Present Value

Firstly identify the operating cash flows:

Operating Cash Flows Year 0$000

Year 1$000

Year 2$000

Year 3$000

Year 4$000

Equipment (450)

Capital allowances (W) 110.25 15.75 15.75 15.75

Operating cash flows 220.00 220.00 220.00

Tax on operating cash flows (77.00) (77.00) (77.00)

(450) 330.25 158.75 158.75 (61.25)

WORKING

$ $ Tax @ 35%Cost of machine 450,000First year allowance (70%) (315,000) 110,250

135,000Writing down allowances—straight line for the next 3 years 45,000 15,750

(a) Current WACC

ke = 10% + (15% – 10%) 1.8 = 19%kd = 10% (1 − 0.35) = 6.5%

Therefore, WACC = (0.8 × 19%) + (0.2 × 6.5%) = 16.5%

and NPV = − 450 +330 251 165

..

+158 751 1652

..

+158 751 1653

..

−61 251 1654

..

= 17.59

(b) WACC adjusted for business and finance riskTo adjust for the business risk of the project, use the cost of equity of a firm engaged in a similar line of business to the new project. In this case, use the equity beta of the plastics industry.However, as the plastics industry is at a different level of gearing to the project, adjustment should also be made for financial risk by finding beta of the asset (βa).

Therefore, ßa =

ße xE

E D(1 t)+ − = 1.356 ×

55 1 1 0 35+ −( . ) = 1.2

So the equity beta for an ungeared firm in the plastics industry = 1.2As Blades' plastics operation will be 40% debt:60% equity, this must be "regeared" using the same equation:

1.2 = ße ×0 6

0 6 0 4 1 0 35.

. . ( . )+ −

ß equity geared = 1.72Re = 10% + 1.72 (15% − 10%) = 18.6% and a WACC for the plastics project of

WACC = E

E D+× 18.6% +

DE D+ × 10% (1 – t) =

60100

× 18.6% +40

100 × 6.5%

= 13.76%

Therefore NPV = – 450 +330 251 1376

..

+158 751 13762

..

+158 751 13763

..

−61 25

1 13764.

. = 34.23

EXAMPLE SOLUTIONS



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(c) Adjusted Present Value Approach (APV)

Step 1 Calculate "base case" NPV

Asset beta = 1.2 (see (b) above) Required return = 10% + (15% – 10%) 1.2 = 16%

"Base" NPV = − 450 + 330 251 16

..

+ 158 751 162

..

+ 158 751 163

..

– 61 251 164

..

= $20,552

Step 2 Financing side-effects

$Capital requirements

Equity (60%) 270,000Debt (40%) 180,000Total capital requirement 450,000

Issue costsEquity 5/95 × $270,000 14,210Debt 2/98 × $180,000 3,673

17,883Less: tax saving(1) (5,690)Post-tax issue costs 12,193

(1) Tax rate amount $×=

×=

DF35 17 883

1 15 690% ,

.$ ,

Tax relief on loan interest Gross value of loan = $180,000 + 3,673 = $183,673

Annual repayments =Gross loan value

yr a.f @ 10%3 .= $183,673

2 487.= $73,853

Loan schedule:

Opening balance

Interest Repayment Closing balance

$ $ $ $Year 1 183,673 18,367 73,853 128,187Year 2 128,187 12,819 73,853 67,153Year 3 67,153 6,715 73,853 15

(difference due to rounding)

Tax relief at 35% on interest (one year's delay)

Cash$

10% factor

PV$

Year 2 6,428 0.826 5,309Year 3 4,487 0.751 3,370Year 4 2,350 0.683 1,605

10,284Adjusted Present Value

$Base NPV 20,552Issue costs (12,193)Tax shield 10,284Project APV 18,643



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Solution 2—APV With Subsidised Finance

(a) Adjusted Present Value (APV)A project–specific asset beta is required to find the ungeared cost of equity for the "base case NPV".Therefore, ungear the equity beta of the printing industry, assuming the beta of debt is zero:

βa = V

V V Te

e de+ −( )( )

1

β

βa = 1.2 × 5050 50 (1 - 0.30)+

= 0.706

Then use CAPM:Ke ungeared = 5.5% + 0.706 (12% – 5.5%) = 10.09% or approximately 10%Annual after-tax operating cash flows = $5 million (1 – 0.3) = $3,500,000

$From annuity tables with a 10% discount rate:

Present value of annual cash flows (3,500,000 × 6.145) 21,507,500

Present value of the residual value (7,000,000 × 0.386) 2,702,000

24,209,500

Less: Initial investment 25,000,000

Base case NPV (790,500)

Issue costs $

Debt ($5 million × 1⁄99) 50,505

Equity ($10 million × 4⁄96) 416,667

467,172

Tax shield

$5,050,505 8% bank loan:Annual interest $404,040, tax relief at 30%

$121,212

$4 million subsidised loan:Annual interest $240,000, tax relief at 30% 72,000

Total annual tax relief 193,212

The present value of this tax saving, discounted at the firm's commercial pre-tax cost of debt of 8% is:

$193,212 × 6.71 = $1,296,452Value of subsidyThe company saves 2% per year on $4,000,000 = $80,000 but loses potential tax shield of $24,000. Net savings = $56,000 Discounted at the firm's commercial pre-tax cost of debt, 8%:

$56,000 × 6.71 = $375,760APVThe adjusted present value is estimated to be:

($790,500) – $467,172 + $1,296,452 + $375,760 = $414,540Based on these estimates the project should be accepted.



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Solution 2—APV With Subsidised Finance (continued)

(b) When APV may be a better technique to use than NPV 1. There is a significant change in the firm's capital structure due to

the project's financing package. 2. Subsidised loans, grants or issue costs exist. 3. Financing side effects exist (e.g. the subsidised loan) that require

discounting at a rate different from that applied to the project's operating cash flows.

Solution 3—Divisible Projects

Projects A$000

B$000

C$000

D$000

NPV 100 (50) 84 45Cash flow at t0 (50) (10) (10) (15)

NPVInvestment

10050

( )5010

8410

4515

Profitability Index 2 Reject 8.4 3

Rank 3 1 2

Plan: Capital NPV

Available 50

C (10) 84

40

D (15) 45

25

50% A (25) 50

0 $179

Solution 4—Non-divisible Projects

Combinations NPV$000

A only 100C + D 129

Therefore, choose C + D.



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Solution 5—Mutually Exclusive Projects

Group 1$000

Group 2$000

A B C A B DNPV 100 (50) 84 100 (50) 45Investment 50 10 10 50 10 15Index 2 (5) 8.4 2 (5) 3Rank 2 Reject 1 2 Reject 1Plan:

NPV Capital NPV Capital50 50

Accept C 84 (10) Accept D 45 (15)Accept 0.8A 80 (40) Accept 0.7A 70 (35)

164 115

Therefore, accept: C and 0.8A

Solution 6—Linear Programming

Let a be the proportion invested in project A.

b be the proportion invested in project B.

Subject to the constraints:

Year 0 20,000a + 40,000b ≤ 40,000

Year 1 40,000a + 20,000b ≤ 50,000

Year 2 60,000a ≤ 40,000

0 ≤ a ≤ 1

0 ≤ b ≤ 1

The objective function:

Maximise NPV = 44,280a + 31,940b (W)

WORKINGNPV of projects

Time DF @ 10% Project A Project BCash flow PV Cash flow PV

$ $ $ $ 0 1.00 (20,000) (20,000) (40,000) (40,000)1 0.909 (40,000) (36,360) (20,000) (18,180)2 0.826 (60,000) (49,560) − −3 0.751 200,000 150,200 120,000 90,120

44,280 31,940



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Solution 6—Linear Programming (continued)

Graph

0.5

0.5

0.67 1 a

x

b

objective

b = 140,000a + 20,000b ≤ 50,000

20,000a + 40,000b = 40,000

a = 1

x

x

x x

O

60,000a = 40,000

To plot the objective function set it equal to (say) $44,280 44,280a + 31,940b = 44,280

when a = 0 b = 1.386when b = 0 a = 1

Optimal solutionFrom the graph the objective function would appear to be maximised at point O. Reading off from the graph, this would comprise 2/3 of project A and 2/3 of project B.

Solution 7—MIRR

T0 T1 T2 T3 T4

CF (34,000) 7600 16,500 13,000 6,600

Future value of first year cash flow = 7,600 × 1.083 = 9,574Future value of second year cash flow = 16,500 × 1.082 = 19,245Future value of third year cash flow = 13,000 × 1.08 = 14,040Total future value = 9,574 + 19,245 + 14,040 + 6,600 = 49,459

MIRR = 49 45934 000

4,,

−1 = 9.82%

Alternative method:

T0 T1 T2 T3 T4

(34,000) 7600 16,500 13,000 6,600

Present value 7,037 14,146 10,320 4,851 Total = 36,354

MIRR =36 35434 000

1 08 1

14,

,.

( ) − = 9.82%



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Solution 8—Duration


T1 T2 T3 T4 TotalCash flows 7,600 16,500 13,000 6,600PV Cash flows 7,037 14,146 10,320 4,851 36,354

PVCF / Total 0.194 0.389 0.284 0.133 1

Macaulay's duration = (0.194) + (0.389 × 2) + (0.284 × 3) + (0.133 × 4) = 2.356 years


Modified duration = 2.356/1.08 = 2.18%

Solution 9—Customer Complaints(i) P(>3) = P(4 or 5) = P(4) + P(5) = 0.2 + 0.1 = 0.3(ii) P(0 & 0) = P(0) × P(0) = 0.05 × 0.05 = 0.0025 (= 1⁄4 % chance!)(iii) P(≥ 9)

= P(9 or 10) = P(9) + P(10) = P(4) × P(5) + P(5)× P(4) + P(5) × P(5)= (2 × 0.2 × 0.1) + (0.1 × 0.1) = 0.04 + 0.01 = 0.05

Solution 10—Expected Values

Project 1 Expected value = 100 × 0.4 + 200 × 0.3 + 1,000 × 0.3 = 400

Project 2 Expected value = 0 × 0.4 + 500 × 0.3 + 600 × 0.3 = 330

Project 3 Expected value = 180 × 0.4 + 190 × 0.3 + 200 × 0.3 = 189

Therefore, based on expected values, Project 1 should be adopted.



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Solution 11— Different Probabilitiesin Different Periods

(i) EV of Closing Balance

Period 1 Period 2 Combined Probability Closing Balance EV

6,000 8,000 0.2 × 0.35 = 0.07 (1,500) + 6,000 + 8,000 = 12,500 0.07 × 12,500 = 875

6,000 4,000 0.08 8,500 6806,000 (8,000) 0.05 (3,500) (175)3,000 8,000 0.175 9,500 1,662.53,000 4,000 0.2 5,500 1,1003,000 (8,000) 0.125 (6,500) (812.5)

(2,500) 8,000 0.105 4,000 420(2,500) 4,000 0.12 0 0(2,500) (8,000) 0.075 (12,000) (900)

1 2,850

EV of the period 2 closing balance is $2.85 million.(ii) Probability of a negative cash balanceProbability of negative cash balance at the end of period 2 = 0.05 + 0.125 + 0.075 = 0.25 = 25%(iii) Probability of exceeding the overdraft limitProbability of exceeding the overdraft limit at the end of period 2 = 0.125 + 0.075 = 0.2 = 20%Discussion

The EV analysis has shown that, on an average basis, Zombie will have a positive cash balance at the end of period 2 of $2.85 million. However, the actual cash balances that could occur are any of the specific closing balances shown above, rather than the average of these balances.There could be serious consequences for the firm if it exceeds its overdraft limit (e.g. the overdraft facility could be withdrawn). There isa 20% chance that the overdraft limit will be exceeded at the end of period 2. To guard against exceeding its overdraft limit the firm must find additional finance of up to $7 million ($12m – $5m).The EV analysis is useful in illustrating the cash flow risks faced by Zombie. However, the assumptions used in the simulation model must be reviewed before decisions are made based on the forecast cash flows and their associated probabilities.Furthermore EVs are more useful for repeat decisions rather than one-off activities, as they are based on averages. They illustrate what the average outcome would be if an activity was repeated a large number of times.In fact, each period and its cash flows will occur only once and the EVs of the closing balances are not values that are forecast to arise in practice. For example, the EV closing balance of $2.85 million is not forecast to actually occur, and a closing balance of $1.1 million has a 20% chance of occurring.



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Solution 12—Standard Deviation

Project 1 Expected value = ( ) .100 400 02− × − × − × 0.4 + (200 400) 0.3 + (1,000 400) 32 2

156,000 = 395

Project 2 Expected value =( )0 330 2− × − × − ×0.4 + (500 330) 0.3 + (600 330) 0.32 2

74 100, = 272

Project 3 Expected value = ( )180 189 2− × − × − ×0.4 + (190 189) 0.3 + (200 189) 0.32 2

69 = 8.3

Solution 13—Sensitivity Analysis

(a) Time Cash Flow$

DF @ 15% PV$

0 Initial cost (150,000) 1 (150,000)

1–15 Contribution 41,250 5.847 241,189

1–15 Fixed costs (15,000) 5.847 (87,705)

15 Scrap value 15,000 0.123 1,845

5,329

The project is worthwhile as NPV is positive.

(b) The sensitivity of the decision in (a) can be calculated by expressing the NPV as a percentage of the various factors:

(i) Initial investment If the initial investment rises by more than $5,329, the project would

be rejected.

Sensitivity = 5 329150 000

,,

× 100=3.6%

(ii) Sales volume The PV figure of contribution $241,189 is directly proportional to

volume. If this PV is reduced by more than $5,329, the project would be rejected.

Sensitivity =5 329

241 189,, × 100=2.2%

(iii) Fixed costs

Sensitivity = 5 32987 705

,,

× 100=6.1%

(iv) Scrap value

Sensitivity = 5 3291 845,,

× 100=289%

Comments: From the above calculations, the decision to accept the project is

extremely sensitive to most of the figures given in the question. The project will be rejected in the event of small rises in the initial investment or fixed cost figures or falls in contribution or volume. It could be seen, for instance, that the project just breaks even if fixed costs become $15,000 × 1.06 = $15,900.

The scrap value is relatively irrelevant to the investment decision. The project would only be rejected if it would be necessary to pay to have the plant taken away.



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Solution 13—Sensitivity Analysis (continued)

(v) Sensitivity to Cost of Capital This can be found by calculating the project’s IRR, which is probably

only marginally above 15%.

Year Cash Flow$

16% Factor Present Value$

0 (150,000) 1.000 (150,000)

1–15 26,250 5.575 146,344

15 15,000 0.108 1,620

NPV at 16% (2,036)

IRR = r1 +NPV1

(r2 − r1)NPV1 − NPV2

= 15% +5,329

(16% − 15%)5,329 − 2,036

= 15.7%

If the cost of capital rises above 15.7% the project would be rejected.

Solution 14—Monte Carlo SimulationThe requirement is to find the probability that the project's NPV could fall to zero from its expected level of $1.964m. This fall represents 1.964/1.02 = 1.92 standard deviations below the mean. Using the normal distribution tables (1.9 on the left row and 0.02 (the second decimal) on the top column) gives 0.4726. Adding 0.5 (the other half of the normal distribution) gives 0.9726 i.e. 97.3%. This means that there is a 97.3% chance that the actual NPV will not fall below zero i.e. there is a 2.7% chance that it will fall below zero.

0.473 0.500.027

−1.92



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Solution 15—Value at Risk

First, search the published normal distribution tables for the probability of 0.45 (the tables are given for half of the distribution i.e. 0.45 + 0.5 = 0.95 = 95% confidence). Exactly 0.45 does not appear, but only 0.4495 (at 1.64 standard deviations) and 0.4505 (at 1.65 standard deviations). As 0.45 is midway between these values, the "z-score" is 1.645.

0.45 0.500.05

−1.645

N (95% confidence level) = 1.645 standard deviations below the meanVaR = 1.645 × 1.02 × √10 = $5.3m There is 95% confidence that the value of the investment will not fall more than $5.3m below its mean.There is a 5% chance that the actual NPV will be 1.964 − 5.3 = $(3.336)m or less.VaR (99% confidence) = 2.33 × 1.02 × √10 = $7.51m



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NOTES



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Session 7

Session 7 Guidance

Learn the reasons for valuing a business (s.1) and understand the reasons for differing asset-based valuation methods, specifically the relationship between book and market values (s.2).

Recognise the purpose of relative valuation models and the market metric on which they are based (s.3).

Learn the free cash flow valuation methods, the definitions of Free Cash Flow to Equity and Free Cash Flow to the Firm and the appropriate discount rate for each method (s.5).

Learn the EVA™ and MVA methods of estimating a firm's value (s.6).


4. Valuation and the use of free cash flowsa) Apply asset based, income based and cash flow based models to value

equity.b) Forecast an organisation's free cash flow and its free cash flow to equity

(pre- and post-capital reinvestment).c) Advise on the value of an organisation using its free cash flow and free

cash flow to equity under alternative horizon and growth assumptions.

D. Acquisitions and Mergers

2. Valuation for acquisitions and mergersa) Discuss the problem of overvaluation.b) Estimate the potential near-term and continuing growth levels of a

corporation's earnings using both internal and external measures.d) Advise on the valuation of a type 1 acquisition of both quoted and

unquoted entities using:i) "Book value-plus" modelsii) Market based modelsiii) Cash flow models, including EVA™, MVA.

g) Demonstrate an understanding of the procedure for valuing high-growth start-ups.

Business Valuation



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VISUAL OVERVIEWObjective: To estimate a company's total value or equity value in total, or the equity value of a single share.

BUSINESS VALUATION• Reasons For• Nature

DIVIDEND VALUATION

MODEL• Ordinary Shares• Preference Shares

ASSET-BASED METHODS

• Net Book Value• Net Realisable

Value• Replacement

Cost• "Book Value-

Plus"

VALUE ADDED METHODS

• Economic Value Added

• Market Value Added

• Shareholder Value Added

HIGH GROWTH START-UPS

• "Seed" Firms• Chepakovich

Model• Forecast

Performance • Other Features

RELATIVE VALUATION

MODELS• P/E Multiples• Earnings Yield• Dividend Yield• Tobin's Q• Market to Book

Ratio

FREE CASH FLOW MODELS

• Introduction• Free Cash

Flow to Equity (FCFE)

• Forecasting Growth of FCFE

• Free Cash Flow to the Firm



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Session 7 • Business Valuation P4 Advanced Financial Management


1 Business Valuation

1.1 Reasons For*< To determine the value of a private company (e.g. for a

Management Buy Out (MBO) team).< To determine the maximum price to pay when acquiring a

listed company (e.g. in a merger or takeover).< To place a value on companies joining the stock market (i.e.

Initial Public Offerings—IPOs).< To value shares in a private company for tax/legal purposes.< To value subsidiaries/divisions for possible disposal or spin off.

1.2 Nature

You need to enter the exam with a range of methods at your disposal and choose the most relevant depending what data is available and whether you are required to value a minority stake or total equity.

< When a business is valued it is not a precise exercise and there is often no unique answer to the question of what it is worth (e.g. the value to the existing owner may be significantly different from its value to a potential buyer).

< There are a variety of different methods of valuing businesses which may produce very different results. These can be used to determine a range of prices.

< The relevant range of values is:= the minimum price the current owner is likely to accept;= the maximum price the bidder should be prepared to pay.

< The final price will result from negotiations between the parties.< The following methods of valuation may be considered:

= Asset valuation—where a summary of the assets less the liabilities of the firm are valued upon some agreed basis.

= Relative valuation—this involves valuing an attribute of the firm (e.g. its current level of earnings or book value) in terms of the price the market is prepared to pay per dollar of that attribute.

= Flow valuations—this identifies a future flow (dividends, free cash flow, or earnings) and converts to a present value. There are three flow-based models:

− Dividend Valuation Model − Free Cash Flow − Economic Value Added (EVA™)

*Quoted share prices are only relevant for minority shareholdings.



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P4 Advanced Financial Management Session 7 • Business Valuation

2 Asset-Based Valuation Methods

2.1 Net Book Value (NBV)< Simply uses the "balance sheet" equation:

Equity = assets − liabilities

< Problems and weaknesses of this method include:* Statement of financial position (balance sheet) values are

often based on historical cost rather than market values. Net book value (also called carrying amount) of assets

depends on depreciation/ amortisation policies. Many key assets are not recorded on the balance sheet

(e.g. internally generated goodwill).

2.2 Net Realisable Value (NRV) < This estimates the liquidation value of the business:

Equity = estimated net realisable value of assets − liabilities

< This may represent the minimum price that might be acceptable to the present owner of the business.

< Problems and weaknesses of this method include: Estimating the NRV of assets for which there is no active

market (e.g. a specialist item of equipment). It ignores unrecorded assets (e.g. internally-generated

goodwill).

2.3 Replacement Cost < This can be viewed as the cost of setting up an identical

business from nothing

Equity = estimated depreciated replacement cost of net assets

< This may represent the maximum price a buyer might be prepared to pay.

< Problems and weaknesses of this method include: Technological change means it is often difficult to find

comparable assets for the purposes of valuation; It ignores unrecorded assets.

*For these reasons a valuation based on balance sheet net assets is not likely to be reliable.



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2.4 " Book Value-Plus" < Even using replacement cost suffers the problem of ignoring

unrecorded assets (e.g. goodwill).< A possible solution is to use one the of formulae below:

Equity value = replacement cost of net assets + (m × annual profits)

Equity value = replacement cost of net assets + (m × annual revenue)

< The factor m is agreed by negotiation and is designed to compensate the seller for the value of the business goodwill.

< This method of valuation is often used in practice to place a value on a small business.

3 Relative Valuation Models

3.1 Price/Earnings RatiosThe published P/E ratio of a quoted company takes into account the expected growth rate of that company (i.e. it reflects the market's expectations for the business).

< Using published P/E ratios as a basis for valuing unquoted companies may indicate an acceptable price to the seller of the shares.

Price/earnings (P/E) ratio = Market price per ordinary shareEarnings Per Share

Earnings per share (EPS) = Profit after tax and preference dividends

Number of issued oordinary shares

Therefore:

Ordinary share price = P/E ratio × EPS

< This can be used for valuing the shares in an unquoted company. The steps required are:

Step 1 Select the P/E ratio of a similar quoted company. Step 2 Adjust downwards to reflect the additional risk of

an unquoted company and the non-marketability of unquoted shares.

Step 3 Determine the maintainable earnings to use for the unquoted company's EPS.

Step 4 Multiply the earnings determined in Step 3 by the adjusted P/E from Step 2 to find the value of the unquoted company.

ACCA exams generally now use the term revenue (or income) in preference to turnover.



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3.2 Earnings Yield< Earnings yield is simply the reciprocal of the P/E ratio.

Earnings yield = EPS

Market price per share × 100

Therefore:

Ordinary share price = EPS

Earnings Yield

Example 1 Income-Based Valuation

You are given the following information regarding Accrington Co, an unquoted company.• Issued ordinary share capital is 400,000 25c shares.• Extract from statement of profit or loss for the year ended 31 July

20X4:

$ $Profit before taxation 260,000Less: Taxation (120,000)

Profit after taxation 140,000Less: Preference dividend 20,000

Ordinary dividend 36,000

(56,000)Retained profit for year 84,000

• P/E ratio applicable to a similar type of business (suitable for an unquoted company) is 12.5.

Required:Value 200,000 ordinary shares in Accrington Co. on an earning basis.

Solution

Income-Based Valuation



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3.3 Dividend YieldThe dividend yield approach is based on the following:

Dividend yield = Dividend per share

Market price per share× 100

Therefore:

Share price = Dividend per share

Dividend yield

< This model can be used for valuing the shares in an unquoted company. The steps required are:Step 1 Determine the dividend for the unquoted company.

Step 2 Choose a published dividend yield for a similar quoted company.

Step 3 Adjust this dividend yield upwards to reflect the greater risk of an unquoted company and the non-marketability of unquoted company shares.

Step 4 The value of the unquoted company is then found by multiplying its dividend by the adjusted dividend yield from Step 3.

< Weaknesses of this method include: This method fails to take growth into account, and

therefore can lead to an undervaluation. It also has little relevance for valuing a majority

shareholding as such an investor has the ability to change the dividend policy.

Example 2 Dividend Yield Model

An individual is considering the purchase of 2,000 shares in G Co. G Co has 50,000 shares in issue and the latest dividend payment was 12 cents per share. G Co is similar in type of business, size and gearing to H Co, a company listed on a stock exchange. H Co has a published dividend yield of 10%. Because G Co shares are unquoted and not marketable, the individual believes that the G Co shares are 30% riskier than H Co shares and the dividend yield should be higher by that level. Required:Suggest a price that the individual might pay for the 2,000 shares in G Co.Solution



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3.4 Tobin's Q < This ratio was proposed by the Nobel Prize winning economist

James Tobin in 1969. < The ratio can be presented in various formats:

Q = Total market capitalisation of the firmReplacement cost of the firm's assets

= Total market capitalisation of the firm - market value of ddebtReplacement cost of the firm's assets - debt

= Market value of equityNet worth of the firm

< The long-run equilibrium for this ratio = 1.< Although Tobin's Q may be a useful measure to determine

whether an entire stock market is over or undervalued its use at an individual company level is more questionable for the following reasons:= assets in firms acquire value not because they are held in

isolation but because they are held together in a network (i.e. the replacement cost of the firm is not the sum of its parts).

= many of a firm's assets do not trade in liquid markets and it is difficult to establish their replacement cost (e.g. non-current assets in use).

< Therefore in practice the application of Tobin's Q often relies upon the use of accounting information as a proxy for replacement cost. This leads to the more measurable Market to Book ratio.

3.5 Market to Book Ratio < This is a pragmatic interpretation of Tobin's Q.

< Market to Book ratio =

market value of equitynet book value of the firm

< This can also be referred to as the Price to Book ratio.< The ratio assumes that there is a consistent relationship

between market and book values (i.e. the market prices one dollar of book value in one firm the same as in another).

< Therefore the ratio would appear to be useful in the relative valuation of companies and it is indeed popular with market analysts.

< However there can be problems in identifying an appropriate benchmark for a specific company.



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4 Dividend Valuation Model

4.1 Ordinary SharesIf dividends are forecast to grow at a constant annual rate to perpetuity, then use the published valuation formula*:

P0 = ( )

D0

re

1 +( )−

gg

where: P0 = today's ex-div share price

D0 = most recent dividend

g = growth rate

re = required return of equity investors

< This model can be used for valuing a company's shares. The steps required are:

Step 1 Identify current dividend. Step 2 Estimate the growth rate of dividends. Three methods

may be available: (i) economic forecasting (i.e. the exam question

may give a growth rate); (ii) using the historic dividend growth rate and

assuming it will apply into the future; (iii) Gordon's growth approximation (i.e. growth is a

function of reinvestment and return on equity). Use the given formula, g = bre where:

b = Retained profitProfit after tax

=

Profit after tax - dividendProfit after tax

re* = Profit after tax

Shareholders' funds =

Profit after taxNet assets

Step 3 Determine the required return (e.g. using CAPM).*

*The abbreviation re is used both in the valuation formula (where it refers to the required return of shareholders) and in Gordon's formula (where it refers to the actual return on reinvested profits). It can be argued that, in competitive markets, the actual return on equity will, in the long run, equal the required return. In this case the CAPM-based return can also be used in Gordon's formula.

Step 4 Use the inputs determined above in the model to find the value per share.

< Weaknesses of this method include : Determining growth rate of dividends. Determining the required return for an unquoted company. It is of little relevance for valuing a majority shareholding,

as such an investor has the ability to change the dividend policy.

*See Session 2 for an introduction to the dividend valuation model.



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Example 3 Growth's Effect on Valuation

Claygrow Co is a company which manufactures flower pots. The following information is available:

Current dividend 25c per shareRequired return on equities in this risk class 20%

Required:Value one share in Claygrow Co under the following circumstances:(i) No growth in dividends.(ii) Constant dividend growth of 5% per annum.(iii) Constant dividends for five years and then growth of 5% per annum to

perpetuity.(iv) Constant dividends for five years and then sale of the share for $2.00.Solution

(i) Constant dividend

(ii) Constant dividend growth

(iii) Constant dividend followed by growth

(iv) Constant dividend followed by sale



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Example 4 Value Using Dividend Growth Model

Current EPS = 30 centsPayout ratio = 40%Number of shares in issue = 5 millionNet assets per statement of financial position = $12 millionRisk-free rate = 4%Market premium = 5%Equity beta = 1.4Required:Value the firm's equity using the dividend growth model.Solution



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4.2 Preference SharesThe market value of any share should equal the present value of the future dividend stream discounted at the investors' required return.

As preference dividends are a fixed percentage of the share's face value there will be zero growth of the future cash flow and the share price becomes the present value of a perpetuity:

P0 = Dre

Where:

P0 = Ex-div share price

D = Annual dividend per share

re = Required return*

Example 5 Valuation of Preference Shares

A company has 5% preference shares in issue which have $1 nominal value.

The financial press quotes the yield on these shares as 4.7%.

Required:Calculate the market price of each preference share.

Solution

Annual fixed dividend =

Required return =

P0 =

*The required return,DP0

= dividend yield,

may also be referred to as the firm's cost of preference share capital.



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5 Free Cash Flow Models

5.1 Introduction*< The value of company is the present value of its estimated

future cash flows < In theory this is the best method of valuation and is

sometimes known as "fundamental valuation". < Problems and weaknesses of this method include:

Estimating the future cash flows—particularly complex in mergers and acquisitions due to synergy.

Determining an appropriate discount rate taking into account the level of business risk and financial gearing.

Determining an appropriate time horizon for cash flows.

5.2 Free Cash Flow to Equity (FCFE)Net profit x

Add: depreciation, amortisation and other non-cash charges x

Deduct: capital expenditure (x)

Increase/decrease in working capital (x)/x

Deduct: debt principal repayments (x)

Add: new debt raised x

FCFE x

< FCFE represents the surplus cash flow generated for shareholders (i.e. the potential dividend). More specifically this is known as the post reinvestment FCFE as capital expenditure is deducted.

< Theoretically FCFE should be forecast from year one to year infinity. In practice a detailed forecast may be performed for several years and then an assumption made about a sustainable growth rate to perpetuity.

< FCFE should be discounted to present value at the required return of shareholders (i.e. the cost of equity geared).

< Present value of FCFE discounted at keg = theoretical total value of equity.

5.3 Forecasting Growth of FCFE< Gordon's growth approximation states that growth is achieved

by retention and reinvestment of profit.

g = bre

b = proportion of profits retained

re = return on equity

< Take an average of re and b over the preceding years to estimate future growth.

re = Profit after taxShareholders' funds

= Profit after taxNet assets

b = Retained profitProfit after tax

= Profit after tax - dividend Profit after tax

*There are two versions of the model, derived from two alternative definitions of Free Cash Flow.



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< However the use of the accounting ratio for return on equity can be challenged as:= It often overstates the return on new investments. This is

because the book value of equity does not include many of the true reserves of companies (e.g. the value of human capital). This will be particularly relevant in the service sector.

= Even in the industrial sector the ratio is distorted by accounting policy. For example, if property is revalued to market value (as in IFRS) or left at historic cost (as in US GAAP).

= In the long-run in competitive markets the actual return on new investment should equal the minimum required return (i.e. cost of equity). The Free Cash Flow model needs to forecast a sustainable growth rate to infinity.

< Furthermore it is more relevant to analyse the proportion of cash generated by the firm that is reinvested, rather than the proportion of accounting profits. This is found by comparing:= net reinvestment = capital expenditure−new finance raised= FCFE (pre-reinvestment) = operating cash flow−interest−tax

< An improved model is therefore:

b = Net reinvestment

FCFE (pre-reinvestment)

re = cost of equity geared (e.g. from CAPM).

FCFE (post-reinvestment) = FCFE (pre-reinvestment) − net reinvestment

Example 6 Valuation Based on FCFE

The following data has been extracted from the Statement of Cash Flows:Operating cash flow = $150.42mNet interest paid = $7.64mTax paid = $19.49mCapital expenditure = $105.75Finance raised = $10.5mThe firm's cost of equity geared is estimated at 7.2%Required:Value the firm's equity.Solution



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Example 7 Ongoing and AdditionalReinvestment

Corona Co's latest free cash flow to equity of $2.6 million was stated after deducting sufficient reinvestment to continue the current level of business. It can be assumed that the level of reinvestment to continue with the current level of business is equivalent to the annual amount of depreciation.

Over the past few years, Corona has consistently used 40% of its free cash flow to equity to finance additional investment, and this trend is expected to continue.

Corona's equity beta is 1.1, the risk-free rate is estimated to be 4% and the market risk premium is estimated to be 6%.

Required:Estimate the market value of Corona's equity.

Solution

Cost of equity =

Forecast growth =

Value of equity =

5.4 Free Cash Flow to the Firm (FCFF)Earnings before interest and tax (EBIT) x

Tax on EBIT (x)

Net operating profit x

Add: depreciation, amortisation and other non-cash charges x

Deduct: capital expenditure (x)

Increase/decrease in working capital (x)/x

FCFF x

FCFF represents the cash flows available to all of the company's investors, both equity investors and debt investors. Therefore FCFF is pre interest.

< Theoretically FCFF should be forecast from year one to year infinity. In practice a detailed forecast may be performed for several years and then an assumption made about a sustainable growth rate to perpetuity

< As FCFF represents the cash flow available for distribution to all providers of finance (as interest or dividend) it should be discounted at the average return required by all providers of finance (i.e. WACC). The tax shield on interest is implied by using the post-tax cost of debt in the WACC.

< Discounting FCFF at WACC gives the total theoretical value of the firm (also referred to as the entity value.)

< Value of the firm = value of equity + value of debt



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< Most situations are only interested in the value of the equity. For example in an acquisition the predator company buys the shares of the target company, not its debts—it does however take over responsibility for the debts, reducing the equity value.

Value of the firm x

Market value of debt (x)

Value of equity x

The equity valuation should reconcile to that from the FCFE model.

Example 8 Valuation Based on FCFF

Arrow is considering purchasing the entire share capital of Target.Arrow operates on a five-year planning horizon and believes that Target will be able to generate operating cash flows of $1 million per annum after deducting funds for necessary reinvestment. The following information is also relevant but has not been included in the above estimates.1. Target's head office premises can be disposed of, and its staff can be relocated in

Arrow's head office. This will have no effect on the operating cash flows of either business but will generate an immediate net revenue of $2m.

2. Synergistic benefits of $200,000 per annum should be generated by the acquisition.3. Target has loan stock with a current market value of $1.5m in issue. It has no

other debt.4. Arrow estimates that in five years' time it could, if necessary, dispose of Target for

an amount equal to five times its annual operating cash flow.5. Arrow believes that a WACC of 20% per annum reflects the risk of the cash flows

associated with the acquisition.Required:Calculate the maximum price to be paid for Target. Ignore taxation.Solution

Year 0 1 2 3 4 5$m $m $m $m $m $m



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Example 9 Two-Stage FCFF Model

Layman Co has forecast revenue of $51,952,000 for next year and its operating profit margin will be 30% for the foreseeable future. After the first year, the growth rate in revenue will be 5.8% per year for the following three years. It can be assumed that tax-allowable depreciation is equivalent to the amount of investment needed to maintain current operational levels. However, Layman will require additional investment in assets of $513,000 in the first year and then 18 cents per $1 increase in sales revenue for the next three years. It is anticipated that after the forecast four-year period, its free cash flow growth rate will be 2.9% to perpetuity.Layman has issued share capital of $15 million with each share having 25 cents par value. It also has debt outstanding with a book value of $35 million and market value of $40 million. The tax rate is 28% and Layman's weighted average cost of capital has been estimated at 9%.Required:Estimate the market value of each share in Layman.Solution

Year 1 2 3 4$000 $000 $000 $000

Sales revenue

Operating profit

Tax on operating profit

Additional investment

FCFF

PV

$000

Value of the firm

Market value of equity =

Number of shares in issue =

Share price =



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6 Value Added Methods

6.1 Economic Value Added (EVA™)< EVA™ is a refinement on the concept of residual income as

introduced in paper F5 Performance Management. < EVA™ tries to measure "economic" profit as opposed to the

financial accounting profit shown in the accounts. Economic profit represents the surplus profit being generated above the minimum level required by the company's investors:

Adjusted earnings before interest and tax (see note) x

Tax on EBIT (x)

Net operating profit x

Less: capital invested × WACC (x)

EVA™ x

< Note—EVA™ is a registered trademark of the US consultants Stern Stewart and Co who suggest a large number of possible adjustments to EBIT. The main adjustments include:= Capitalisation and amortisation of all research and

development expenditure;= Capitalisation and amortisation of assets under operating

leases;= Capitalise but do not amortise goodwill;= Use of economic depreciation which tries to measure the

amount of cash that must be set aside for the replacement of non-current assets.

< Capital invested = "economic" capital employed (i.e. book value of equity + debt) with possible adjustments (e.g. to capitalise operating leases).

< Capital invested × WACC = minimum return required by investors = "normal" profit.

6.2 Market Value Added (MVA)< For valuation purposes EVA™ should be forecast from next

year to infinity. In practice a detailed forecast may be performed for several years and then an assumption made about a sustainable growth rate to infinity.

< The forecast stream of EVA™ can then be discounted to present value using the WACC.

< Discounted EVA™ is known as Market Value Added (MVA).< MVA™ represents the theoretical excess value of the firm

above book value.

Capital invested x

MVA x

Market value of equity + debt x



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6.3 Shareholder Value Added (SVA)SVA measures the change in equity valuation over a period (e.g. using the FCFE model) and deducts any additional share capital injected during the period:

Theoretical equity valuation at end of year x

Theoretical equity valuation at start of year (x)

Increase in equity value x

Additional equity finance introduced (x)

SVA during the year x

Example 10 Economic Value Added

Extracts from the statement of profit or loss for the most recent financial year show the following:

$ millionOperating profits 25Interest on loans 1Profit before tax 24 Tax at 25% 6Profit after tax 18

Included in the calculation of the profit was a write off of $4 million relating to development costs which did not meet the requirements of IAS38 for capitalisation. The development was not complete until the final day of the financial period.Accounting depreciation is considered to be the same as economic depreciation. In the previous financial year, development expenditure of $10 million on another product was written off. Sales of this product began during the current financial year, and are expected to continue for another three financial years.The weighted average cost of capital of the company is 12%. Capital employed (long-term debt plus equity) per the Statement of Financial Position was $89 million at the end of the previous financial period.Required:Calculate the Economic Value Added during the current financial year.Solution



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7 High Growth Start-Ups

7.1 Difficulty in Valuing "Seed" Firms Valuing a firm still in the "seed" stage of its life is notoriously difficult as, to date, it will probably have made losses and generated negative cash flows. Obviously the valuation should be based on the future but, due to the uncertainty associated with high growth start-ups, forecasting the cash flows is very subjective.

To avoid forecasting there may be the temptation to use multiples and, in practice, high growth start-ups are often valued as a multiple of revenues, taking the multiple from a listed proxy firm. However this methodology is weak as:

< the proxy itself may be under-valued or, more likely, over-valued—note the speculative bubble that occurred in high tech shares on the NASDAQ exchange in the 1990s. Many commentators believe there is a current second wave of dot.com over-valuations.

< a suitable proxy may not exist as start-ups tend to be unique in nature (e.g. involved in a new technology).

Therefore a cash-flow based valuation should be attempted. A possible methodology was developed in 2000 by Alexander Chepakovich.

7.2 Chepakovich Model The Chepakovich valuation model uses the discounted cash flow valuation approach. The model was designed for valuation of "growth stocks" (ordinary/common shares of companies experiencing high revenue growth rates) and has been successfully applied to the valuation of high-tech companies, even those that do not generate profit yet.

The key feature of the Chepakovich model is separate forecasting of fixed and variable costs. The model assumes that:

< fixed costs will rise in total at a predetermined rate (e.g. the inflation rate);

< variable costs are set at a fixed percentage of revenues (subject to efficiency improvements in the future—when this can be foreseen).

This feature allows the valuation of start-ups and other high-growth companies on a fundamental basis. Such companies initially have high fixed costs (relative to revenues) and small or negative net profits. However, high rates of revenue growth ensure that contribution (revenues minus variable costs) will grow rapidly in proportion to fixed costs. This process will eventually lead the company to predictable and measurable future profitability and cash generation.

Unlike other methods of valuation of loss-making companies, which rely primarily on use of multiples and therefore provide only relative valuation, the Chepakovich model estimates intrinsic (i.e. fundamental) value.



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7.3 Forecast Performance of A Loss-Making But Fast-Growing Company

years

200

151

100

50

0

-50

Revenues

Fixed expenses

Variable expenses

EBIT

7.4 Other Features of the Chepakovich Model< Incremental investment in tangible and intangible assets is set

as a function of revenue growth. < Forecast revenues are driven by the company's organic growth

rate—this means that historical revenue growth rates must be adjusted for effects of acquisitions/divestments.

< Long-term convergence of company's revenue growth rate to that of GDP—based on the assumption that over or underperformance by individual companies will be eliminated in the long run).

< The actual cost of share-based remuneration of employees is subtracted from cash flows—the cost is determined as the difference between the market price of the shares and the amount received from selling them to employees.

< It is assumed that over time the firm's capital structure will converge to the optimal level of financial gearing (i.e. the WACC will fall to its minimum).

< A different discount rate is applied to each future cash flow—representing the required return of investors at that specific point in time.



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8 Practical Points

< When valuing any business it is important not only to provide a range of theoretical values (using any of the methods discussed above) but also to take into account any other practical information available.

< Points worth considering:= are all of the assets of the business recorded? Particularly

in the service sector there are likely to be many human resource assets.

= will key employees leave after the acquisition and what effect would this have on the value?

= do key staff have long service contracts?= do surplus staff have long service contracts with early

termination penalties? = when forecasting future figures can these be based on

past figures or does the acquirer plan to make significant changes to the business?

= who is the value being estimated for, the buyer or the seller?= are there any restrictive covenants in the target company's

debt agreements regarding takeovers—or even "poison pills"?= are there other bidders who are likely to push up the price?



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< Business valuation is not a science—different analysts use different techniques.

< There are many problems with asset-based methods (e.g. unrecorded assets).

< Relative valuation models include P/E multiples (must be adjusted downwards for an unquoted company) and earnings yield and dividend yield (must be adjusted upwards for an unquoted company).

< The market to book ratio is an interpretation of Tobin's Q ratio.

< Cash flow-based methods are considered to be the superior approach for valuing the firm's equity in total. The Chepakovich model is a model adapted for "seed" firms.

< EVA™ is based on the concept of residual income.

Summary



Q18 Mercury Training 60 minutes

Additional

Q17 Daron


1. State the asset-based valuation methods which may indicate a minimum and maximum range of values. (2.2, 2.3)

2. Define Tobin's Q. (3.4)

3. State the limitations of the DVM. (4.1)

4. Define Free Cash Flow to Equity both pre-reinvestment and post-reinvestment. (5.2, 5.3)

5. State which discount rate should be used to value Free Cash Flow to the Firm. (5.4)

6. Define the value of the firm/entity value. (5.4)

7. State the relationship between Market Value Added and EVA™. (6.2)

8. State the type of business the Chepakovich model is designed to value. (7.2)



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Session 7

EXAMPLE SOLUTIONS

Solution 1—Income-Based Valuation

Valuation of 200,000 shares = 200,000 shares × P/E ratio × EPS

= 200,000 shares × 12.5 × (140,000 20,000)400,000

−

= $750,000

Solution 2—Dividend Yield Model

Dividend yield to be adjusted upwards to reflect greater risk and non-marketability of unquoted company—say 13% (subjective).

Share price for = Dividend

Adj Dividend yield=

0 120 13..

Estimated value of 2,000 shares = $1,840

Solution 3—Growth's Effect on Valuation

(i) Constant dividend

Po = 0.250.2

= $1.25

(ii) Constant growth in dividend

Po = 0.25 (1.05)(0.2 0.05)

−

= $1.75

(iii) Constant dividend followed by growthPV of five years' dividend of $0.25 pa ($0.25 × 2.991) $0.748PV of growing dividend from year 6 onwards

0.25 (1.05)(0.20 0.05)

− × 1

1.2

5 = $0.703

$1.451(iv) Constant dividend followed by sale

Present value of five years' dividend of $0.25 pa ($0.25 × 2.991) $0.748

Present value of $2.00 in five years' time ($2.00 × 11.2

5 ) $0.804

$1.552



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Solution 4—Value Using Dividend Growth Model

Current dividend per share (D0) = $0.30 × 0.4 = $0.12

Retention ratio = 60%

Profit after tax = $0.30 × 5m = $1.5m

Return on equity = 1 512

100.× = 12.5%

Growth = RR x ROE = 0.6 × 0.125 = 0.075 (i.e. 7.5%)

Required return = 4 + (1.4 × 5) = 11%

P0 = ( )D g

r ge

0 1 0 12 1 0750 11 0 075

+( )−

=( )−( )

. .

. .= $3.69

Total value of equity = $3.69 × 5m = $18.45m

Alternative approach (assuming actual return on reinvested profit will equal the minimum required return as per CAPM):

Growth = 0.6 × 0.11 = 0.066 (i.e. 6.6%)

CAPM required return (re) = rF + b(rM-rF) = 0.04 + 1.4(0.05) = 0.11

P0 = ( )

D gr ge

0 1 0 12 1 0660 11 0 066

+( )−

=( )−( )

. .

. . = $2.91

Total value of equity = $2.91 × 5m = $14.55m

Solution 5—Valuation of Preference Shares

Annual fixed dividend =5% × $1 = $0.05Required return = 4.7% = 0.047

P0 = Dre

= 0.050.047

= $1.06

Solution 6—Valuation Based on FCFE

FCFE (pre-reinvestment) = 150.42 − 7.64 − 19.49 = 123.29

Net reinvestment = 105.75 − 10.5 = 95.25

FCFE (post-reinvestment) = 123.29 − 95.25 = 28.04

Reinvestment ratio = 95.25/123.29 = 0.7726

g = 0.7726 ×0.072 = 0.0556

Value = 28.04 (1.0556)(0.072 0.0556)

−

= $1,805m



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Solution 7—Ongoing and Additional Reinvestment

Growth of FCFE can be forecast using Gordon's growth approximation as a function of the reinvestment ratio and the expected return on equity. The minimum expected return on equity can be taken as the CAPM-based cost of equity i.e.:

Cost of equity = 4% + (1.1 × 6%) = 10.6%

Forecast growth = 40% × 10.6% = 4.24%

Market value of equity can then be estimated by using the growth model formula, with dividend capacity being that part of FCFE which is not reinvested:

Value of equity = (2,600 × 60% × 1.0424) ÷ (0.106 – 0.0424) = $25.6 million

Solution 8—Valuation Based on FCFF

Year 0 1 2 3 4 5$m $m $m $m $m $m

Operating cash flow 1.000 1.000 1.000 1.000 1.000

Sale of head office 2.000

Synergistic benefits 0.200 0.200 0.200 0.200 0.200

Disposal* 5.000

Net cash flow 2.000 1.200 1.200 1.200 1.200 6.200

Discount factor @ 20% 1.000 0.833 0.694 0.579 0.482 0.402

Present value 2.000 1.000 0.833 0.695 0.578 2.492

Total Present value $7.598m

Less: Value of loan stock ($1.500m)

Maximum value of target $6.098m

1. The estimated disposal value of the target is included to compensate for Arrow's short planning horizon. It is assumed that the estimated disposal value is an approximation of the present value of cash flows from year 6 onward.

2. The market value of loan stock has to be deducted from the total value of the business to arrive at an equity value.



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Solution 9—Two-Stage FCFF Model

Year 1 2 3 4

Sales revenue 51,952 54,965 58,153 61,526

Operating profit (30%) 15,586 16,490 17,446 18,458

Tax on operating profit (28%) (4,364) (4,617) (4,885) (5,168)

Additional investment (18c/$1 of sales revenue increase)

(513) (542) (574) (607)

FCFF 10,709 11,331 11,987 12,683

PV (9%) 9,825 9,537 9,256 8,985

$000

PV (first 4 years) 37,603

PV (after 4 years) (8,985 × 1.029/(0.09 − 0.029)) 151,566

Value of the firm 189,169

Market value of equity = Value of firm − Market value of debt= $189m − $40m = $149 million

Number of shares in issue (15m/0.25) = 60 million

Share price ($149m/60m) = $2.48

Solution 10—Economic Value Added

$000

Net operating profit after tax (W1)Finance charge (W2) 99,000 × 12%EVA™

20,25011,8808,370

Workings (1) Net operating profit after tax

$000Profit after tax per statement of profit or loss 18,000Add: Interest net of tax (1 million × (1 − 25%)) 750Add: Development costs 4,000Less: Amortisation of prior year development (2,500)Net operating profit after tax 20,250

(2) Capital employed$000

Capital employed at start of period per SOFP 89,000Add: Development costs written off in prior periods 10,000Adjusted capital employed at start of period 99,000



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NOTES



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Session 8

Session 8 Guidance

D. Acquisitions and Mergers

1. Acquisitions and mergers versus other growth strategiesa) Discuss the arguments for and against the use of acquisitions and mergers as a method

of corporate expansion.b) Evaluate the corporate and competitive nature of a given acquisition proposal.c) Advise upon the criteria for choosing an appropriate target for acquisition.d) Compare the various explanations for the high failure rate of acquisitions in enhancing

shareholder value.e) Evaluate, from a given context, the potential for synergy separately classified as:

i) Revenue synergy ii) Cost synergy iii) Financial synergy.

2. Valuation for Acquisitions and Mergersc) Assess the impact of an acquisition or merger upon the risk profile of the acquirer

distinguishing:i) Type 1 acquisitions that do not alter the acquirer's exposure to financial or

business riskii) Type 2 acquisitions that impact upon the acquirer's exposure to financial riskiii) Type 3 acquisitions that impact upon the acquirer's exposure to both financial and

business risk.e) Advise on the valuation of type 2 acquisitions using the adjusted net present value

model.f) Advise on the valuation of type 3 acquisitions using iterative revaluation procedures.3. Regulatory framework and processesa) 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.

b) Identify the main regulatory issues which are likely to arise in the context of a given offer and

4. Financing acquisitions and mergersa) Compare the various sources of financing available for a proposed cash-based

acquisition.b) Evaluate the advantages and disadvantages of a financial offer for a given acquisition

proposal using pure or mixed mode financing and recommend the most appropriate offer to be made.

c) Assess the impact of a given financial offer on the reported financial position and performance of the acquirer.

Mergers and Acquisitions



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Session 8 Guidance

VISUAL OVERVIEWObjective: To understand mergers and acquisitions as alternatives to organic growth and the various methods of analysing, financing and preventing their implementation

Understand the rationale for acquisitions or mergers and how the success of such transactions may be affected by inability to realise synergies or by changes to the firm's risk profile (s.1).

Recognise the complications inherent in Type II and Type III mergers that require an iterative process for valuation (s.2).

Learn the "pecking order theory" of funding acquisitions and the advantages and disadvantages of each financing source (s.3).

Recognise which strategies for defending a company from hostile takeover are appropriate before a bid has been announced (e.g. poison pills) versus after a bid (e.g. white knight) (s.5).

VALUATION OF ACQUISITIONS

• General Principles

• Types of Acquisition

• Type I• Type II• Type III

POST-MERGER MONITORING

• Reasons for Failure

METHODS OF FINANCING• Options Available• Advantages and

Disadvantages• Case Study• Impact on Financial

Statements

STRATEGY AND TACTICS• Strategy• Dawn Raid• City Code• Competition Law• Activity in Different

Countries

DEFENCES AGAINST A BID• Hostile Bids• Before a Bid is Made• After a Bid is Made

NATURE OF MERGERS AND ACQUISITIONS

• Organic v External Growth• Criteria for Selecting Targets• Evaluating a Proposed

Acquisition• Acquisitions• Acquisition v Merger• Synergy• Sources of Synergy• Impact on Shareholders• Risk of Over-valuation• High Failure Rate



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Session 8 • Mergers and Acquisitions P4 Advanced Financial Management


1 Nature of Mergers and Acquisitions

1.1 Organic Growth v External Growth< If the strategy of a company is for long-term growth then this

can come from:= organic growth—development of new projects by the firm

financed by retentions or new debt/equity; or= external growth—buying existing projects by acquiring

another business.

1.2 Criteria for Selecting TargetThe key factors to consider when choosing an appropriate target for an acquisition include:

< Price—if the target firm is listed on the stock market does it currently appear to be undervalued or overvalued?

< Expected control premium—quoted share prices reflect the price for a minority shareholding. When majority control is sought the shareholders of the target company may expect a significant premium above the quoted price.

< Potential synergy benefits—discussed later in more detail.< Transaction costs—legal fees, due diligence costs etc.< Potential intervention by regulators—the combined firm

may be viewed as against the public interest (e.g. if it has significant market share).

1.3 Evaluating a Proposed AcquisitionThe corporate and competitive nature of a proposed acquisition can be evaluated by reference to the following classifications:

< Horizontal integration—where the proposed strategy is to acquire a competitor, presumably in an attempt to gain pricing power and potentially restrict the range of products.

< Vertical integration backward—acquiring a key supplier in order to cut out its profit margin and potentially to gain exclusivity of supply.

< Vertical integration forward—acquiring a key distributor, potentially to prevent it from selling competitors' products.

< Conglomerate—acquisition of a company in an unrelated business sector. This strategy may be justified if the parent company is "closely held" in that its shareholders have invested a large proportion of their personal wealth. In this case, shareholders face total risk (as opposed to only systematic risk) that can be reduced through their company becoming a conglomerate.*

*This argument would not be valid, however, for a listed company in which most shares are held by institutional investors who have already diversified all unsystematic risk exposures.



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P4 Advanced Financial Management Session 8 • Mergers and Acquisitions

A proposed acquisition can also be evaluated in terms of the potential risks that may be attached to the transaction itself:*< Disclosure risk: It is important to ensure that the

information on which the acquisition is made is reliable and fairly represents the potential earning power, financial position and cash generation of the target company. As part of a due diligence exercise, it would be necessary to ensure that the financial accounts have not been unduly manipulated to give a more attractive view of the business than the underlying reality would support.

< Valuation risk: A substantial acquisition has the potential to alter the acquirer's exposure to financial risk or its exposure to business risk. This in turn can affect the value its equity investors place on its existing operations. In this case, it is important to value the target company "embedded" with the acquirer as opposed to being a stand-alone entity. This is developed further in the next section of these notes.

< Regulatory risk: An acquisition may raise concern with the government or with other regulatory agencies if it is seen to be against the public interest. This is particularly likely in the case of horizontal integration where the combined market share may be perceived as being unfair. This is developed further in the next section of these notes.

Other relevant aspects may include:

< Combined market power of the entities—this may allow selling price increases and rationalisation of the product range.*

< Skills transfer—each firm may have particular strengths that can be transferred into the other as part of an internal benchmarking process leading to best practice throughout the group.

< Disposal of surplus assets— if there is overlap or even duplication of activities (e.g. research and development) then there is potential for rationalisation.

< Security of supply chain— vertical integration backwards may not only reduce input costs but lead to guaranteed security of the supply of key components.

< Utilisation of brought forward tax losses—the parent firm's tax system may allow brought forward losses in the acquired firm to be offset against future group profits.

1.4 Acquisitions

1.4.1 Advantages of Acquisitions

Speed—often quicker than organic growth.Entry costs—if the cost of entering a new market is high it may

be better to acquire a business already operating in that market.Barriers to entry—acquisition may be the only method of entry

into a new market.Risk—organic growth may be riskier than acquiring an

existing business.Undervaluation—"asset stripping" may be possible in an

acquisition.

*Each of these risks would need to be explicitly considered as part of a due diligence investigation to ensure that they are either mitigated or avoided.

*However, these potential benefits also carry regulatory risk, and a strategic partnership may be advisable as opposed to a formal combining of the firms.



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1.4.2 Disadvantages of Acquisitions

Cost—the control premiums paid over the existing market price are considerable, typically over 40%;Shareholder wealth—if the bidder pays too high a price for

the target company this will reduce the bidding company shareholders' wealth.May attract the attention of regulatory authorities if there are

concerns about damage to the public interest.

1.5 Difference Between an Acquisitionand a Merger

< An acquisition is where one company (the predator) buys the share capital of another company (the target or victim); creating a parent and subsidiary in a group. Both companies continue to exist as legal entities.

< A merger is where two companies of similar size cancel their share capital and pool their net assets together into a new entity. The new entity then issues shares to the previous shareholders in an agreed ratio.

< For financial management whether the transaction is classified as an acquisition or as a merger is not usually critical. It is often a more important distinction for financial reporting where merger accounting tends to report better results than acquisition accounting—although International Financial Reporting Standards no longer permit merger accounting due to past abuses.

1.6 Synergy< The motive for many mergers and acquisitions is to create

incremental value through the existence of synergy when two entities are combined. Synergy means that the value of the new whole is greater than the sum of the previous values of the component parts.

< Evidence suggests that many mergers and acquisitions do not achieve the forecast synergies, and that shareholders in the target firm take most of the benefits from any additional value created. Reasons for not achieving expected synergy include:= The acquisition decision was based on incomplete or

incorrect information;= Unexpected costs and problems exist when combining

two organisations with different organisational structures, cultures and managerial styles;

= Managers are not given suitable incentives to achieve maximum synergies.

*For the purposes of the Paper P4 exam the terms "merger" and "acquisition" are equivalent.



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< Furthermore, two arguments about creation of synergy are simply not valid:= Risk reduction—diversification by a company can only

reduce unsystematic risk. However if its shareholders have balanced portfolios they have already removed all unsystematic risk and are only concerned with systematic risk (which cannot be removed either by shareholder or company diversification.)

= Bootstrapping—sometimes it is argued that if a company with a high P/E ratio buys a company with a low P/E ratio then the higher ratio will be applied to the combined entity creating an immediate share price gain. However in an efficient market a weighted average P/E ratio would be applied.

1.7 Sources of Synergy

1.7.1 Cost Synergies

< Economies of scale—for example bulk buying discounts.< Economies of vertical integration—purchasing distributors and/

or suppliers to remove "middlemen".< Economies of investment—use of common research and

development, plant, etc.< Economies of management—eradicating duplication by

creating combined departments for finance, marketing, etc.< Skills transfer—sharing best practice to achieve productivity

gains.

1.7.2 Revenue Synergies

< Monopoly power—leading to possible price increases, although this may attract the attention of regulators.

< Cross-selling opportunities (i.e. referring customers to products or services provided by other group companies).

< Surplus assets—can be sold off and proceeds invested in new projects.

< Cash cows—buying a company with surplus cash to reinvest profitably.

1.7.3 Financial Synergies

< Reduction in variability of cash flows—more stable cash flows might reduce borrowing costs and through achieving a better credit rating. Furthermore the improved stability reduces the risk and related costs of financial distress.

< Tax losses—reduced tax by acquiring a company with tax losses, although many tax jurisdictions restrict the use of brought forward losses.

< Tax shield—acquiring a company with low-gearing in order to gear up and gain the benefit of the tax shield on debt interest.

< Internal hedging of interest rate and foreign exchange risk—the firms may, to some degree, have opposite positions regarding fixed/variable rate debt and asset/liabilities in foreign currencies. This leads to natural internal hedges.



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1.8 Impact on ShareholdersFor a proposed acquisition to be approved by both sets of shareholders (i.e. the acquirer and the target), the bid price being offered and the form of payment must allow for a reasonable return to both groups.

From the viewpoint of the bidding company's shareholders it is essential that the expected post-acquisition value of each share is above the current share price, leading to a reasonable capital gain. (Forecasting the post-acquisition share price is the focus of the next section of this session.)

From the viewpoint of the target company's shareholders the form of payment becomes particularly relevant:

< If cash is being offered for their shares then a simple comparison to the current share price of their firm would reveal their instant capital gain or loss. However, if the target firm is not listed then the bid price would have to be compared to its estimated equity value, thereby introducing a large degree of uncertainty.

< If the proposed form of payment is a "share-for-share exchange" then, taking into account the proposed terms of the share swap, a comparison would be required of the current value of shares in the target with the expected post-acquisition value of shares in the acquirer.

1.9 Risk of OvervaluationResearch suggests that in many cases the directors of the acquiring company overvalue the target firm's equity and hence offer a final bid price above fair value.

Various explanations for the overvaluation problem have been suggested:

< Merger and acquisition (M&A) activity tends to go through cycles, often driven by the relative availability of cheap credit. At the peak of a wave of M&A activity there may be several potential bidders for a target company, thereby bidding up the price.

< Investment banks earn a large proportion of their fees from M&As and may encourage their clients to engage in potentially expensive acquisitions.

< Insights from behavioural finance theory show that directors of the acquiring company tend to suffer from:= over confidence in the potential for synergy benefits; and= confirmation bias (i.e. choosing the valuation model that

appears to confirm the value they think the target company is worth).



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1.10 High Failure RateResearch has shown that, in many cases, the post-acquisition share price performance of the acquiring company tends to be disappointing. If cash was paid to acquire the target then, looking back, wealth has effectively been transferred from the acquirer's shareholders to the target's shareholders.

Indeed, when potential acquisitions are initially announced (or rumoured) the acquirer's share price often falls and the target's share price often rises in anticipation of the subsequent wealth transfer.

If an acquisition was made through a share-for-share exchange and the acquirer's performance subsequently disappoints, then wealth is destroyed for both groups of shareholders.

Possible explanations for this high failure rate include:

Overvaluation of the target company leading to excessive bid premiums being paid.

High transaction costs. High costs of integrating the companies' systems. Actual synergy benefits being less than expected. Negative synergy effects (e.g. due to cultural conflict). Agency problems, where the directors of the acquiring firm are

more interested in "empire building" than in generating added value for their shareholders.

Badly designed executive remuneration contracts. Such bonuses tend to be paid in advance, with no requirement for them to be repaid if the acquisition is subsequently shown to be a failure (e.g. awarding a bonus for "successfully" negotiating an acquisition).



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2 Valuation of Acquisitions

2.1 General Principles< In practice, the directors of a bidding company often appear to

offer too high a price to acquire a target company (i.e. control premium exceeds synergy benefits).

< It is obviously critical to make an accurate estimate of the value of the target company (i.e. the maximum price that should be offered).

< What is relevant here is not the value of the target company as a separate entity but the increase in value of the acquiring firm after the acquisition has taken place.

< Significant transactions (e.g. mergers and acquisitions) are likely to disturb the acquiring firm's exposure to various types of risk (e.g. business, financial, default) and hence change its cost of capital and its own value.

< Therefore, the maximum price the acquirer should pay is the increase in its own value following the acquisition. Only in very simple cases will this be the stand-alone value of the target firm.

< From a valuation perspective, acquisitions can be categorised into three types.

2.2 Types of AcquisitionThe approach that should be taken to valuing a target company critically depends on whether the transaction will disturb the acquirer's existing exposure to business, financial and credit risk, as only in the most simple cases will the value of the group be a simple sum of the value of the component entities.

Any disturbance to the acquirer's risk exposures may have unintended consequences in that the change in its cost of capital will alter the present value of its existing cash flows, thereby distorting its existing valuation. Note that this is even before potential synergy effects, which are an additional influence on valuation.



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2.2.1 Potential Risk Disturbances to Be Evaluated

< Business risk—Does the target company have higher⁄lower volatility of operating cash flows compared to the acquirer? A simple comparison of each firm's respective business in terms of cyclical (high volatility) or defensive (low volatility) will give guidance here (and respective political risk in the case of international M&As). However, bona fide evidence of different underlying business risks would come from a comparison of each firm's asset beta, which would first require degearing each firm's published equity beta (if known).

< Financial risk—The crucial issue here is will the mode of financing the acquisition disturb the acquirer's existing capital structure? A comparison would be required of the acquirer's existing debt-to-equity ratio (using market values) to the post-acquisition debt-to-equity ratio. However, the post-acquisition gearing level cannot be known in advance of the valuation exercise being completed, but the valuation cannot be done until the discount rate is calculated, which itself requires knowledge of the final gearing level. Hence a circular (or recursive) problem of "chicken and egg" emerges between cost of capital and valuation.

Furthermore, the amount of debt that may have to be raised to (partly) finance the bid is not known until the target company has been valued, which again requires a discount rate reflecting the post-acquisition gearing level—another recursive loop. Solutions to such circular problems come from iterative valuation methods, discussed later.

< Credit risk—An evaluation is required of whether the acquisition will disturb the acquirer's credit rating and, hence, cost of debt. If the acquirer and target firm are countercyclical with respect to each other (i.e. one firm's cash flows tend to rise when the other's fall, and vice versa) then there could be financial synergy available in the form of smoothing of group cash flows, leading to an enhanced credit rating.

2.2.2 Classification

Following a review of the proposed acquisition's effect on the above risks, the acquisition can be classified into one of the following three categories:

< Type I—acquisitions that neither disturb the business risk of the acquiring firm nor require additional external financing, hence, no change to the acquiring firm's existing cost of capital. This could be the case in the proposed acquisition of a relatively small competitor (horizontal integration).

< Type II—acquisitions that do not disturb business risk but do disturb the financial risk of the acquirer through a change in the debt-to-equity ratio, or through altering exposure to credit risk.

< Type III—acquisitions that alter the firm's exposure to business risk (and possibly its exposure to financial risk and default risk).

The type of acquisition in turn determines the most appropriate method of valuation.



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2.3 Valuation of Type I Acquisitions < For valuing small unquoted companies, it may be acceptable

to use simple asset-based models (e.g. replacement cost, "book value-plus") or relative models (e.g. P/E multiples, price to book ratios).

< Theoretically, it is superior to use flow-based models. For example, dividend valuation model (DVM), Free Cash Flow to Equity, Free Cash Flow to the Firm or EVA™ (extended to find MVA).

< Discount rates should be the acquiring firm's WACC (if using Free Cash Flow to the Firm or EVA) or its cost of equity geared if using DVM or Free Cash Flow to Equity.

< If using Free Cash Flow to the Firm or EVA, remember that the resulting valuation will be that of the target firm in total (i.e. its equity plus its debt). Usually, in acquisitions, it is the shares that are bought, not the debts.

< Equity valuation = total value of the firm − market value of debt.

2.4 Valuation of Type II Acquisitions < Adjusted Present Value (see Session 6) is the technique which

appears to deal well with a change in the level of debt. Steps would be:1. Use the asset beta to find the cost of equity ungeared. Use

this to discount the forecast operating cash flows of the target company (including any synergy benefits).

2. Calculate the present value of the tax shield on the target company’s debt plus any debt raised to finance the bid, discounted at the pre-tax cost of debt.

3. 1 + 2 = APV = total value of the target firm (i.e. value of equity + value of debt).

4. Deduct market value of the target's debt to arrive at equity valuation (i.e. the maximum price to offer for the target's equity).

< Whilst APV may be an acceptable approach under exam conditions, it is unfortunately not an accurate method. With the new company "embedded" the acquiring firm's WACC will change due to the change in debt—this in turn changes the value of the acquiring firm. Therefore the target company cannot be viewed as a stand-alone entity.

< A superior method is a stepped approach:1. Estimate the acquiring firm's existing equity value.

2. Estimate the combined firms' operating cash flows (i.e. the acquirer's cash flows, the target's cash flows and any synergy benefits).

3. Estimate the post-acquisition WACC.

4. Discount the combined cash flows at the post-acquisition WACC.

5. Deduct the combined value of existing debt to arrive at the combined equity value.

6. 5 − 1 = value of target's equity.



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< Unfortunately, this method encounters a problem known as "recursion": = Step 3 uses "seed values" to estimate the post-acquisition

WACC (i.e. based on the existing equity and debt values of the acquiring and target firms).

= The values that are derived from discounting in step 4 are likely to be different from the seed values input into the WACC, due to the disturbance of financial risk (and possibly default risk).

= Therefore, the model is not internally consistent due the circularity (i.e. recursion between Steps 3 and 4).

= The way to quickly resolve this is using a spreadsheet (e.g. Excel) which has an "iteration" function (i.e. recalculates the WACC using the derived values, then re-values the cash flows, etc until the model settles to an equilibrium).

< An acquisition can only be justified if the final price paid for the target's shares is below their value to the acquiring company. In this case the surplus value (i.e. positive NPV) will increase the wealth of the acquiring company's shareholders.

< If, as is regrettably common in practice, the price paid is too high there will be an increase in the wealth of the target company's shareholders and a destruction in wealth for the acquiring company shareholders. This suggests that an agency problem exists with the acquiring company's directors.

2.5 Valuation of Type III Acquisitions < As per type II, the superior approach is to value the acquiring

company prior to the transaction, re-value with the target company embedded, and find the difference.

< However, there are even more complications due to the change in business risk:= Before the post-acquisition WACC can be found, an estimate

is required of the post-acquisition level of business risk (i.e. asset beta).

= This is a weighted average of the business risk of three cash flow streams 1) the acquiring firm 2) the target firm 3) synergy effects.

= The asset beta of each of these streams should be weighted according to the relative value of the streams. This gives a "combined" asset beta, also referred to as a "bottom up" beta factor.

= The streams cannot be valued until the WACC is known; the WACC is not known until the streams are valued!

< Hence, use seed values to estimate the post-acquisition asset beta, regear to the equity beta, estimate the post-acquisition WACC and use it to value the cash flow streams. If the derived values are significantly different from the seed values, then use a spreadsheet's iteration function to resolve the inconsistency.



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Example 1 Valuation of Type III Acquisition

Loopy Juice, a brewing company, is considering the acquisition of Boozy Bars which operates a chain of pubs.Loopy Juice's existing value of equity = $2300m, value of debt = $400m, equity beta = 1.45Boozy Bar's existing value of equity = $700m, value of debt = $150m, equity beta = 1.20Loopy Juice will make a cash offer of $800m for the entire equity of Boozy Bars, financed by a new debt issue. Risk-free rate = 6%, market premium = 5%, corporate tax rate = 25%Both companies have a credit spread of 1% and this is not expected to change.

Required:(a) Estimate the combined WACC(b) Your colleagues then use the estimated WACC to discount the

combined firms' operating cash flows (less required reinvestment) including synergy benefits. The resulting valuation = $3680m. Determine whether the acquisition appears to increase the wealth of the shareholders of Loopy Juice.

(c) One of your colleagues then claims there may be an inconsistency between your estimate of the WACC in (a) and the resulting valuation given in (b).Identify this inconsistency and suggest how it could be resolved.



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Example 1 Valuation of Type III Acquisition (continued)

Solution(a) Estimate the Combined WACC

(b) Effect on wealth of shareholders

(c) Inconsistency



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3 Methods of Financing an Acquisition

3.1 Options AvailableThe main options available to a bidding company for buying the victims' shares are:

< cash;< ordinary shares;< loan stock;< "hybrids" (e.g. convertible loan stock).Commonly a mixture of these is offered.

3.2 Advantages and Disadvantages3.2.1 Cash

To bidder To victim

Price is certain.Liquidity problems

Price is certain. Capital gains tax implications.

3.2.2 Ordinary Shares

To bidder To victim

Saves cash.Value is uncertain.Dilution of EPS

No capital gains tax (until shares sold).

Maintains ownership stake. Value is uncertain.

3.2.3 Loan Stock

To bidder To victim

Saves cash. Reasonably certain value.Increases gearing.

No capital gains tax (initially). Reasonably certain value.Changes character of investment

(i.e. no longer owners).

3.2.4 Convertible Loan Stock

To bidder To victim

Saves cash.Increases gearing.Uncertain eventual outcome.

No capital gains tax (initially).Changes character of investment

(but option to convert back to equity).



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3.3 Case Study—Acquisition FinanceThe acquisition committee of Imperial Co, a listed company, is considering making takeover bids for two competitors, Astral Co (listed) and Zandra Co (unlisted). Summarised financial data is given below for the three companies:

Statement of Financial Position as at 31 March 20X4

Imperial Astral Zandra$m $m $m $m $m $m

Non-current assets 50 8.6 6.4Current assets 431 6.7 9.5Less: Current liabilities 27 3.0 3.9

16 3.7 5.666 12.3 12.0

Financed by Ordinary shares2 17 5.0 2.8 Reserves 30 1.3 3.7

47 6.3 6.5Long term debt 193 6.04 5.55

66 12.3 12.0Notes:

1. Including $5 million cash

2. Par values: Imperial 50 cents, Astral and Zandra $1

3. 8% bonds currently trading at $80 per $100 nominal

4. 11% bonds currently trading at $110 per $100 nominal

5. 7-year 10% bank loan

Imperial Astral ZandraP⁄E ratio at 31 March 20X4 18.4:1 18.7:1 –Earnings before interest and tax for year ended 31 March 20X4 $10 million $1.5 million $1.4 million

The bid price for Astral will be based on its market capitalisation and it is believed that Zandra can be fairly valued using a price-to-book ratio of 2. In addition, a 12% control premium will be offered for each firm.

The corporation tax rate is 35%.

Required:Discuss and analyse alternative payment terms that might be offered to the shareholders of Astral and Zandra and the implications of these terms for the shareholders of Imperial.



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Solution—Alternative Payment TermsPayment may be made in cash, preference shares, some form of debt, often with a conversion or warrant option attached, ordinary shares or some combination of these.

From the target shareholders' perspective, cash provides a known, precise sum, and might be favoured for this reason. However, in some countries payment in cash might lead to an immediate capital gains tax liability for the investor. Furthermore, as Imperial currently has only $5 million in cash, neither of the potential bids could be made in cash without significant new external finance being raised. If this took the form of additional borrowing this could lead to an unacceptable rise in Imperial's level of financial risk, and potentially credit risk. If a rights issue is used this would be costly in terms of issue costs and also potentially too time consuming if the acquisitions need to be made quickly.

Payment using preference shares or debt is not always acceptable to a target's shareholders, as these modes of payment fundamentally alter the characteristic and risk of their investment, moving them from being participating investors with voting rights to a fixed return with little upside potential. From Imperial's viewpoint, preference shares would be particularly unattractive as they carry no tax shield. If fixed return finance is proposed then, for tax purposes, it should take the form of loan stock as the interest expense would be tax allowable.

Payment with ordinary shares, in the form of a share-for-share exchange, offers a target's shareholders continuation in ownership, albeit in the parent company. This defers capital gains tax for the target's investors until they ultimately dispose of their new shares. The terms of the share swap will be in the form of a fixed ratio of acquirer's shares for the target's shares. However, relative share prices will change during the period of the bid and the owner of shares in the target company will not know the precise post-acquisition value of the bid.

Ideally a bidder would like to tailor the form of the bid to that favoured by major investors in the potential target company. "Mixed mode" payment could be offered; for example, a combination of cash and shares.

Alternatively, the target's investors may be given a choice in the method of payment, with the logic that different forms of payment might be attractive to different types of investors. This could influence the success or failure of both bids, but is problematic for the bidder in that the cash needs and number of shares to be issued are not known in advance, and the company's capital structure may change in an unplanned manner.



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Detailed Analysis

Proposed bid price

Astral's profit after tax = $1.5m − ($6m × 11%) × 0.65 = $0.546m

Market capitalisation = $0.546 × 18.7 = $10.2m

Zandra's market value is estimated at $6.5m × 2 = $13m

Total bid price (including control premium) = ($10.2m + $13m) + 12% = $26m

Cash offer

This has the advantage that all parties are assured of the sum received. However, Imperial has only $5 million in cash, and additional borrowing or an equity issue would be required to raise at least $21 million. Furthermore, the $5 million cash on Imperial's most recent statement of financial position may no longer exist, and even if it does it would be unwise to use it all to finance the bids.

Loan stock-for-share exchange

Imperial could offer to exchange new loan stock in return for the shares of the target companies. This would give the victim shareholders a fairly safe income stream and not expose them to immediate capital gains tax. It would, however, prevent them from participating in future profit growth and this might not be popular.

From the viewpoint of Imperial it would cause a significant increase in financial gearing which might be of concern to both to its shareholders and debt investors. Existing gearing (using book value of debt⁄equity) = 19⁄47 = 40% and forecast gearing, assuming additional debt of $26m = 45⁄47 = 96%. This represents a large rise in financial risk and potentially the introduction of significant default risk.

A share-for-share exchange

Imperial could offer to exchange new shares for the existing shares in Astral and Zandra:

Imperial's current share price = earnings per share × P⁄E ratio

Profit after tax = $10m − ($19m × 8%) × 0.65 = $5.512m

Number of shares in issue = 17m⁄05 = 34m

EPS = $5.512m⁄34m = 16.21 cents

Market price = 16.21c × 18.4 = $2.98

At a current market price of $2.98 and a total bid of $26 million, this would require the issue of approximately 8.7 million additional shares. The current EPS of Imperial is 16.21c, whereas the incremental EPS on the new shares is only

Current profit after tax of Astral and Zandra8.7m shares =

$ . $ ..

0 546 0 5538 7m m

m+

= 12.6 cents

This would result in a dilution of Imperial's EPS and possibly a reduction in its share price.



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Conclusion

Overall, each of the potential modes of payment presents problems. Imperial's shareholders might not be happy with a cash offer as it would require significant external financing, which they may have to provide in the form of a rights issue. The use of loan stock, either to finance a cash offer or to make a debt-for-equity exchange could drive financial risk to an unacceptable level. A share-for-share offer could result in a reduction in EPS although much would depend on the combined earnings of the three companies, including synergy. A compromise solution would be to use a mixture of the above packages, for example a cash and equity offer.

3.4 Forecast Impact on Acquirer's Financial Statements

The directors of the acquiring company will wish to know the impact the target company and the proposed bid finance will have on the group financial statements. In particular, the following areas will be critical:

< Impact of bid financing on reported financial gearing—leveraged acquisitions are likely to increase financial gearing, whereas equity finance (either raising cash through a rights issue or acquiring the target company through a "share for share exchange") is likely to reduce financial gearing.

< Impact of acquired company on group profit, cash flow and capital expenditure requirements.

< Impact of the acquired company and bid finance on group interest cover, return on capital employed, return on equity and earnings per share.

< An acquisition near the year end will mean that capital employed will include all the assets acquired but profits from the acquisition will only be included in the statement of profit or loss for a small part of the year, thus tending to depress ROCE.



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Example 2 Acquisition Financing

Pink is listed on the New York Stock Exchange. The directors have made a bid for its main US competitor, Floyd whose directors have rejected the bid. If the bid eventually succeeds, the new company will become the largest in its industry in the US. However, it will still be smaller than some of its Chinese competitors. The directors of Pink are aware that the company must continue to expand if it is to remain competitive in a global market, and avoid being taken over by a larger Chinese company.

Pink FloydShare price as at today 671 cents 565 centsShares in issue 820 million 513 millionP/E ratios as at today 14 16

Debt outstanding (market value) $2.2 billion $1.8 billion

Other information:● The average P/E for the industry is currently estimated at 13.● The average debt ratio for the industry (long-term debt as proportion of total

funding) is 30% based on market values.● 40% of Pink's debt is repayable in three years; 30% of Floyd's in four years.● Pink's cost of equity is 13%.● Pink has cash available of $460 million following the recent disposal of some

subsidiary companies. Floyd's cash balances at its last year end were $120 million.Terms of the bid: Pink's directors made an opening bid one week ago of 10 Pink shares for 13 Floyd shares. They are aware that they might have to raise the bid in order to succeed and also may need to offer a cash alternative. Their advisers have told them that, typically, 50% of shareholders might be expected to accept the share exchange and 50% the cash alternative. Required:Advise the directors of Pink on the following: (a) The implications that the current share prices of the two companies

have for the bid. Recommend terms of a revised share exchange.(b) The advantages and disadvantages of offering a cash alternative and

how the cash alternative might be financed, based on your revised bid terms recommended in answer to (a) above. Your discussion should include an evaluation of the impact of the proposed finance on the merged group's financial standing. Assume a rights issue is not appropriate at the present time.



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Example 2 Acquisition Financing (continued)

Solution(a) Implications for the bid.

(b) Advantages and disadvantages.



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4 Strategy And Tactics

4.1 Strategy< Identify potential target.< Approach board of directors in confidence to judge reaction.< Determine price to offer.< Determine terms of the offer.< Determine tactics of acquisition. Possible tactics are:

= dawn raid;= offer via the City Code.

4.2 Dawn Raid< Bidder buys shares on the open market.< Once 30% of shares are obtained a formal offer must be made

to the other shareholders.

4.3 City Code on Takeovers and MergersThe City Code is an attempt to regulate the process of mergers and acquisitions and in 2006 was made into law. The Code requires that all shareholders in a company should be treated equally, regulates when and what information companies must and cannot release publicly in relation to the bid, sets timetables for certain aspects of the bid, and sets minimum bid levels following a previous purchase of shares.

The general approach to an offer under the City Code is:

< bidder puts offer to the board of the victim;< as soon as a firm offer is made shareholders must be informed

by press notice;< an announced offer cannot be withdrawn;< directors must act in the interests of the shareholders;< all documentation must be prepared with the same care as if

they were a prospectus being prepared under the Companies Act;

< shareholders must be informed of all relevant facts; and< once 30% of shares have been acquired an offer must be

made to the remaining shareholders. This offer must include a cash alternative.

< Under UK law, once 90% of the shares in the target company have been acquired the predator can force the remaining 10% of victim shareholders to sell their minority stake.

4.4 Competition LawRegulators may have wider concerns than the fair treatment of shareholders. The impact on other stakeholders may need to be considered, in particular the impact on the public if the combined firms could dominate the market and cut consumer choice and/or raise prices.

UK competition law on mergers and acquisitions follows European Union Law. The authority to deal with issues that only affect the UK market falls under the Competition and Markets Authority (CMA).*

*The CMA brings together the functions of the Competition Commission (abolished from 1 April 2014) and the competition and certain consumer functions of the Office of Fair Trading (OFT).



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The law is founded on "the need to avoid the establishment of market structures which may create or strengthen a dominant position". The market shares of the merging companies can be assessed and added; a combined market share above 25% is used as an indicator that there may be a reduction in competition.

The firms involved could challenge the regulator's definition of the market. For example, if the world's two major cola producers were to merge their share of the global cola market would be very large—but their share of the total soft drinks market would be relatively small.

4.5 Merger and Acquisition Activity in Different Countries

< Merger activity is much more prevalent in the UK and US than Germany or Japan. This is because in Germany and Japan a large proportion of a company's shares are often held by banks who would not consider selling to a predator.

< Shares in the UK are usually held by institutional investors who will realise a profit if the price is right.

< Some argue that the UK situation is better as it leads to market efficiency. Others argue that it leads to short-termism.

5 Defences Against a Bid

5.1 Hostile Bids< In some instances, a merger will be agreed by both boards

and the victim company directors will recommend the shareholders to accept the offer.

< However, in many instances the bid will not be initially accepted either because the directors fear for their own futures or because they are holding out for a higher price.

5.2 Defences Before a Bid Is Made< If a company wishes to avoid the attention of a bidder, there

are a number of actions that it can take to make it appear less attractive:= Minimise cash holdings;= Hold strategic cross-shareholdings with other-companies

(common in Japan);= "Poison pills" (e.g. debentures that become instantly

redeemable upon takeover);= "Golden parachutes"—where the directors have the right to

leave with substantial pay-outs if the business is taken over;= "Crown jewels"—sell off assets that might make the

company attractive to predators;= "Fat man"—grow the company to such a size that it would

not be practical for anybody to buy.



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5.3 Defences After a Bid Is Made< If a bid is initially rejected, the following defences are common:

= the terms of the offer are unacceptable;= there is no logic/synergy to the merger;= victim's shares are undervalued and bidder's overvalued;= appealing to the loyalty of the shareholders;= seeking a bid from a friendly third party—a "white knight";= claiming that the bid is contrary to the City Code;= appealing to the Competition and Markets Authority that the

bid is against public interest. = "Pac-Man defence"—bid for the predator.

6 Post-Merger Monitoring

Many mergers and acquisitions fail, and therefore if a deal is agreed, it must be carefully monitored by management.

6.1 Reasons for FailureThe most common reasons for failure of mergers and acquisitions include:

Over-optimistic assessment of potential economies of scale.Inefficient amalgamation of the two parties.Insufficient appreciation of the problems of the merger, in

particular personnel problems.Excessive concern with matters such as dominance of the

boards of directors.Problems of determining value and terms of the offer.Inaccurate assessment of future resource needs.Incompatibility of systems/processes.



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< Many company directors view mergers and acquisitions as the key to maintaining a high level of growth for the business.

< However, there is significant empirical evidence to suggest that many real-life mergers and acquisitions actually destroy wealth for the bidding company's shareholders.

< Either the premium paid for control is too high and/or the magical "synergy" benefits of combining the companies never become a reality.

< Therefore, it is critical that a target company is accurately valued. However, this tends to be complicated, partly due to problems in forecasting synergy benefits, but also because adding another company to the group is likely to disturb the group's WACC and hence the value of existing operations.

< Hence, a target company cannot be valued as a separate entity—it must be valued as if it becomes embedded into the existing group.

< Mergers and acquisitions can be financed like any other project (internal equity, raising external debt or equity), but with the additional option of using a share-for-share exchange.

< Which methods of defence against hostile takeover can be legally used depends on whether the bid has already been announced.

Summary



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Session 8

Study Question Bank Estimated time: 60 minutes


Q22 Miniprice & Savealot 60 minutes

Additional

Q19 Bigun

Q20 Demast

Q21 Laceto

Session 8 Quiz Estimated time: 30 minutes

1. State the advantages of growth by acquisition as opposed to organic growth. (1.4)

2. State why conglomerate-style diversification does not necessarily reduce the risk faced by shareholders. (1.7)

3. List potential sources of synergy in M&As. (1.7)

4. Distinguish between type I/II/III acquisitions. (2.2)

5. State why APV may not be accurate for valuing type II acquisitions. (2.4)

6. State how an appropriate beta factor can be derived for type III valuations. (2.5)

7. State the advantages and disadvantages of offering cash for the shares of a targetcompany. (3.1)

8. State the advantages and disadvantages of a share-for-share exchange as a method of acquiring a target company. (3.2.2)

9. Define a "dawn raid". (4.2)

10. List defences against hostile takeover that can be used before a bid has been made. (5.2)

11. List defences against hostile takeover that can be used after a bid has been made. (5.3)



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Solution 1—Valuation of Type III Acquisition

(a) Estimate the Combined WACC

First step is to de-gear each firm's equity beta to find its asset beta. Assuming the beta of debt to be zero:

βa = + −( )

Ve

Ve Vd Tβe( )

1

For Loopy Juice:

βa = 2,300 1.45

2 300 400 1 0 25, ( . )+ −

= 1.28

For Boozy Bars: βa =

700 1.20700 150 1 0 25+ −

( . ) = 1.03

Next is to estimate the combined asset beta (i.e. a weighted average of the business risks of brewing and of operating pubs). The relative value of assets (i.e. equity + debt of each firm) should be used for the weightings.Loopy Juice value of assets = 2,300 + 400 = 2,700Boozy Bars value of assets = 700 +150 = 850Combined value of assets = 2,700 + 850 = 3,550

Combined asset beta = 2,7003,550

1.28

+

8503,550

1 03. = 1.22

This should be regeared to the post-acquisition capital structure:Combined equity value = 2,300 + 700 = 3,000 Combined debt = 400 + 150 + 800 (new debt raised) = 1,350

1.22 = 3,000

3,000βe+ −( )( )

1 350 1 0 25, .

βe = 1.63

Cost of equity geared = 6 + (1.63 × 5) = 14.15%

WACC = 3,000

3,000 1,35014.15

+

+

1,3504,350

−7 1 0 25( . ) = 11.39%

(b) Effect on wealth of shareholders

$mCombined value of operating cash flows 3,680

Existing debt (400+150) (550)

Combined equity value 3,130

Bid price (800)

Loopy Juice's post-bid equity value 2,330

Loopy Juice's post-bid equity value (2300)

Shareholder Value Added (SVA) 30

The proposed acquisition of Boozy Bars would appear to increase the wealth of Loopy Juice's shareholders by $30m.

EXAMPLE SOLUTIONS



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(c) Inconsistency

The inconsistency arises due a difference between the "seed values" used for weighting the asset betas, regearing to the equity beta and weighting the WACC, and the derived values from the discounting process.Assuming that the seed values for debt are accurate then the problem relates to the equity values (i.e. seed value for combined equity = 2,300 + 700 = 3,000 but the derived value = 3,130).To resolve the problem the "iteration" function on Excel can be used to recalculate the combined asset beta, equity beta and WACC based on the derived values, revalue the cash flows, etc until an equilibrium is reached between the WACC and the valuation.

Solution—2 Acquisition Financing

(a) Implications for the bid

The current total market capitalisation of Floyd is $5.65 × 513m = $2,898m The bid from Pink values Floyd at (513m/13) × 10 × $6.71 = $2,648m The bid is taking place in a market that has imperfect information with many factors impacting on the share prices. It is possible that the current share price of Floyd reflects an expectation of a higher bid. The share prices of both companies will also reflect the market's view of the merger and the potential benefits to the shareholders in both companies. From the information available it is difficult to produce any independent verification of the value of Floyd. However the latest earnings for Floyd can be estimated as: ($5.65 × 513m)/16 = $181.15m Using Pink's cost of equity (13%) this gives a present value in perpetuity (with zero growth) of: $181.15/0.13 = $1,393m With the actual market capitalisation of Floyd being $2898m this indicates that the market is assuming a growth rate of at least 6% per annum ($181.15 × 1.06/0.13 − 0.06) = $2743). This would seem optimistic, particularly as the valuation assumes that all earnings can be distributed as dividends (i.e. it ignores reinvestment required to produce the growth).More information is required and before a revised bid is submitted, a full analysis and assessment of the value of Floyd to Pink is required.On the assumption that Floyd is valued fairly, a revised bid is clearly required to gain acceptance. Various alternatives exist but one possibility would be to offer 17 Pink shares for every 20 Floyd shares (i.e. $114 versus $113).



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(b) Advantages and disadvantages

The advantage to Pink of a cash alternative is that because no new shares are issued (or at least fewer shares issued if it is taken up by a proportion of Floyd's shareholders) there is no dilution of earnings or change in the balance of control. There is also a greater chance that, if the return expected on the assets exceeds the cost of borrowing (which it should do), Pink's EPS will increase. The main problem for Pink is raising the cash. It has insufficient liquid resources and a substantial repayment of existing debt is due to be made in three years' time. The most likely source of finance is new long-term debt. Assuming that the total purchase consideration is $2,900m (Floyd's current market capitalisation) and 50% of shareholders take up the cash alternative, Pink would need to find $1,450m. The combined cash balance of Pink and Floyd is $580m, so the minimum new debt required to be raised would be $870m. This would significantly increase the financial gearing ratio and could, therefore, adversely affect the value of the combined entity, depending on how the weighted average cost of capital behaved. It is difficult without further information to make these estimates. To help overcome the problem of increased gearing, it would be worthwhile considering raising convertible debt. The rate of interest on this debt is likely to be lower than conventional debt due to the advantages accruing to the debt holders.



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NOTES



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Session 9

Session 9 Guidance

Learn methods of estimating credit risk and the relative merits of each method, especially the potential conflicts inherent to rating agency estimates (s.1).

Understand capital reconstruction plans and the necessity for fair treatment to ensure all stakeholders agree to the plan (s.2).

Corporate Reconstruction and Re-organisation



f) Assess the organisation's exposure to credit risk including:i) Explain the role of, and the risk assessment models used by the

principal rating agenciesii) Estimate the likely credit spread over risk freeiii) Estimate the company's current cost of debt capital using the

appropriate term structure of interest rates and the credit spread.

E. Corporate Reconstruction and Re-organisation

1. Financial reconstructiona) Assess an organisational situation and determine whether a financial

reconstruction is the most appropriate strategy for dealing with the problem as presented.

b) Assess the likely response of the capital market and/or individual suppliers of capital to any reconstruction scheme and the impact their response is likely to have upon the value of the organisation.

c) Recommend a reconstruction scheme from a given business situation, justifying the proposal in terms of its impact upon the reported performance and financial position of the organisation.

2. Business re-organisationa) Recommend, with reasons, strategies for unbundling parts of a quoted

company.b) Evaluate the likely financial and other benefits of unbundling.c) Advise on the financial issues relating to a management buy-out and buy-in.



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Session 9 Guidance

VISUAL OVERVIEWObjective: To estimate credit risk and formulate plans for rescuing a firm from financial distress, including methods of divestment.

Recognise that even a healthy company may undergo significant restructuring in order toboost future performance, e.g. "unbundling" peripheral operations to create more focus oncore activities (s.3).

Understand the management buyout (MBO) process, particularly with regard to financing requirements (s.4).

RECONSTRUCTION AND RE-ORGANISATION

ESTIMATING CREDIT RISK• Introduction• Ratings Agencies• Structural Models

DIVESTMENT• Reasons for• Strategies

CAPITAL RECONSTRUCTIONS• Background• Types• Formulating a Scheme• Factors Affecting Success

MANAGEMENT BUYOUTS• Introduction• Reasons for• Ideal MBO Candidate• Commercial Aspects• Financial Aspects• Exit Routes



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Session 9 • Corporate Reconstruction and Re-organisation P4 Advanced Financial Management


1 Estimating Credit Risk

1.1 Introduction< For financial managers, it is just as important to understand

how the debt market works as it is to understand the operation of the equity market.

< With equity, CAPM tells us that a firm's exposure to market risk is the principal determinant of a firm's equity cost of capital. With debt, market risk is not so relevant—what is important is whether a borrower will default on a loan. This is referred to as "credit risk".

< Default occurs when the value of a borrower's assets falls below the value of their outstanding debt. Two variables influence the potential loss to the lender: the chance of default occurring, and the proportion of the debt that can then be recovered upon default. Recoverability is influenced by the nature of the firm's assets and their saleability, any covenants which impose restrictions on their disposal, the priority of the lender, and any directors' guarantees that may be in place.

< If the probability of a company defaulting is 5%, and only 80% of the debt can be recovered by the lender (that is, 20% will be lost), then at least an extra 1% (20% × 5%) will be charged to cover the potential loss.

< For the largest loans, or where the borrower is considering a bond issue, then the borrower itself will need to obtain a credit risk assessment from a rating agency (e.g. Moody's, Standard and Poor's, or Fitch).

< There are three main approaches to credit risk analysis:= Ratio analysis—in 1966 William Beaver showed that

operating cash flow divided by total outstanding debt successfully predicted default within five years with over 70% accuracy. Edward Altman later developed the more sophisticated "Z score" multivariate model (calculations would not be required in the exam). A common criticism of all these models is that they have weak theoretical support.

= The ratings agencies approach—agencies such as Fitch, Moody's and Standard & Poor's use their own criteria to assess a company's credit rating.

= "Structural models"—these rely on an assessment of the underlying volatility of a firm's assets or its cash generation, and hence the likelihood the firm will not be able to pay interest or repay principal on the due date.



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P4 Advanced Financial Management Session 9 • Corporate Reconstruction and Re-organisation

1.2 Ratings Agencies< Among the criteria used by agencies to establish a company's

credit rating are the following: industry risk, country risk, earnings protection, financial flexibility and evaluation of the company's management.

< Industry risk—measures the resilience of the company's industrial sector to changes in the economy. The following factors could be used in measuring this risk:= Impact of economic changes on the industry in terms of

how successfully the firms in the industry operate under differing economic outcomes;

= How cyclical the industry is and how large the peaks and troughs are;

= How the demand shifts in the industry as the economy changes.

< Country risk—measures the exposure of the firm to negative aspects of the countries it which it operates. To assess this the following factors could be used:= Risk of appropriation of assets, blocked remittances or

currency controls;= Level of transparency in business dealings and financial

reporting;= Level of political stability.

< Earnings protection—measures how well the company will be able to maintain or protect its earnings in changing circumstances. The following factors could be used to assess this:= Differing range of sources of earnings growth;= Diversity of customer base;= Profit margins and return on capital;= Level of operational gearing i.e. the proportion of fixed to

variable operating costs. Firms with heavy fixed costs will find their profits highly exposed to falling revenues.

< Financial flexibility—measures how easily the company is able to raise the finance it needs to pursue its investment goals. To assess this, the following factors could be used:= Evaluation of plans for financing needs and range of

alternatives available;= Relationships with finance providers (e.g. banks);= Operating restrictions that currently exist as debt covenants.

< Evaluation of the company's management—considers how well the managers are planning for the future of the company. To assess this, the following factors could be used:= The company's planning and control policies;= Management succession planning;= The qualifications and experience of the managers;= Performance in achieving financial and non-financial targets.



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1.3 Structural Models< This approach takes the following steps:1. Identify the current value and volatility of the firm's assets, the

level of its outstanding debt and the proportion that could be recovered upon default.*

2. Calculate the "distance to default" (i.e. the amount by which the value of assets must fall to trigger default).

3. Compare the distance to default to the annual standard deviation of asset value. This shows us by how many standard deviations below the mean the value of assets must fall to trigger default—known in statistics as a "Z score".

The Z-Score and Zeta models can be used to estimate credit risk—both are basically an application of ratio analysis and lack theoretical foundation. Detailed knowledge of, or calculations using such models will not be required.

4. Input the Z score to the normal distribution tables to find the probability of default.

5. Draw a decision tree to show the two possible outcomes for the bank at the end of the year; a (relatively small) probability of default and a (high) probability that the full principal and interest will be received. The interest rate on the debt is not yet known so set this as "i". Assume the debt has one year to repayment.

6. Form an equation where the expected present value of these outcomes discounted at the bank's finance cost (e.g. the London Interbank Offered Rate (LIBOR)) equals the principal of the debt.*

7. Solve the equation to find the interest rate that should be charged on the debt.

8. Deduct LIBOR to show the "credit/default spread" on the debt.

< One problem is how to estimate the firm's asset value and the volatility of that asset value. A possible solution comes from Robert Merton who developed the Black-Scholes model into a format for valuing equity as a call option over the firm's assets. Key inputs for Merton's model are the value and volatility of assets, which in practice cannot be directly observed. However, for a quoted company, the output of Merton's model can be observed (i.e. the share price). By analysing the share price (and its volatility) it is possible to use Merton's model "in reverse" to imply the value and volatility of assets.*

*An alternative approach would be, in step 1, to use the current level and volatility of the firm's cash position. In this case "distance to default" would be a fall in the level of cash to zero.

*If the bank is assumed to be risk averse as opposed to risk neutral then a higher discount rate should be used to reflect this.*More detail on Merton's structural debt model can be found in Session 13.



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Example 1 Structural Debt Model

A firm's assets have a value of $1m and its outstanding debt is $0.4m. The volatility of assets (as given by the standard deviation of monthly asset values) is 10.23%. Its bank assesses the recoverability of the debt as 80% and it, in turn, pays LIBOR 5% to raise finance.

Required:Estimate the interest rate that the bank should charge on the firm's debt and state the credit spread.Solution



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2 Capital Reconstructions

2.1 Background< A capital reconstruction may be required when a company

has experienced financial difficulties which have weakened its statement of financial position/balance sheet and drained its resources.

< The company may have good prospects in the future but is currently unable to exploit the opportunities available because of lack of cash.

< Often the firm's balance sheet will be characterised by:= a debit balance on retained earnings due to accumulated

losses;= low NAPS (net assets per share);= expensive and risky use of overdraft facilities which are

technically repayable on demand.< Existing shareholders may at present be unwilling to inject

more cash due to the debit balance on retained earnings preventing the payment of dividends.

< A reconstruction scheme is therefore suggested by the directors (or another stakeholder).

2.2 Types of Capital Reconstruction< Under UK company law (Companies Act 2006) a broad

distinction can be made between capital reconstructions:= Simple reconstruction (sometimes called a quasi-

reorganisation) which involves the elimination of a debit balance on retained earnings (i.e. accumulated trading losses) against share capital and non-distributable reserves. This allows dividends to be paid in the near future and helps to attract new equity finance.

= Complex reconstruction arrangements that affect the rights of creditors and other stakeholders (e.g. cancellation of debt in exchange for shares). This requires court approval.*

*US law has similar legislation known as " Chapter 11" bankruptcy protection.



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2.3 Formulating a Scheme< Elements may include:

= write-off retained earnings debit balance;= write off any "fictitious" assets (e.g. goodwill, development

expenditure);= revalue other assets;= reorganise capital structure (e.g. write off debt in exchange

for equity); = raise new capital.

< In formulating a scheme, consider the interests of the various existing suppliers of capital:= Secured creditors have power to apply for the company to be

liquidated. Therefore, they should be given incentives not to do so (e.g. an offer of free equity or increased coupon rate).

= Preference shareholders may have to forego arrears of preference dividend in return for a promise of higher coupon rate in future.

= Ordinary shareholders would rank last upon liquidation, therefore it will not normally be necessary to be too generous to them in reorganisation.

2.4 Factors Affecting Success of Scheme

Exam questions may present you with a draft scheme and ask you to evaluate its chance of success.

The steps to take are:

< Identify the position of each class of investor if the company goes into liquidation.

< Identify the position of each class of investor post-reconstruction (i.e. if the company is saved).

< Is each investor no worse off under reconstruction than under liquidation (i.e. will investors vote to accept the scheme)?*

< Is the refinancing package sufficient (i.e. do the cash inflows upon reconstruction at least equal the outflows)?

< Does the scheme treat all investors fairly?

*75% agreement is needed from creditors for a complex reconstruction to receive court approval.



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3 Divestment

Divestment— the withdrawal of investment in an activity. Unbundling— the process of selling off incidental businesses in order to concentrate resources on the core business.A demerger/spin off— splitting a group into two or more independent units.

3.1 Reasons for Divestment< To raise significant cash—to improve liquidity or to pay off

debts and reduce gearing.< To focus on core activities—which can then be expanded to

generate economies of scale.< To dispose of operations giving poor returns/unacceptable

level of risk.< In the case of demerger/spin-off, it may be possible that

shareholder wealth can be enhanced by splitting the group (e.g. by appointing specialist managers for each business segment).

< "Crown Jewels" defence against hostile takeover—selling assets which predators are interested in.

3.2 Divestment Strategies< Sell-offs—where a company sells part of its operations to a

third party, normally for a cash settlement. This is a common strategy for a multi-product company that wishes to raise cash by selling a division peripheral from the main business. The decision should be made on the basis of NPV appraisal.

< Spin-offs—a pro rata distribution of subsidiary shares to the shareholders of the parent. Effectively, this is another name for a demerger (i.e. one company becomes two or more companies, perhaps with new management but the same shareholders). No cash is raised but possible benefits include:

Clearer management structure and more efficient use of assets;

Removing the "conglomerate discount". Previously investors may have under-valued certain assets which were not clearly visible as part of a large group. Once spun-off these assets stand alone and may become fully valued by the market.

< Management Buyout (MBO)—the purchase of part or all of a business from its parent company, by the existing management.

< Management Buy-In (MBI)—an external management team purchases the business together with a financier. Alternatively, a financier may purchase a company and then find a suitable management team. Riskier than the management buyout, since the incoming team have far less knowledge of the company.



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< Institutional Buyout (IBO)—where an institution identifies a target company, arranges the finance and then approaches a potential management team. This approach has become far more common in recent years with the rise of private equity funds.

Example 2 Divestment

General Eclectic is a diversified conglomerate. It is proposing to dispose of its aircraft engines division, which at present accounts for 15% of total revenues. The disposal proceeds are estimated at $1,200m and this will be used to repay debt.General Eclectic's current value of equity = $6,000m, debt = $3,500m and equity beta = 1.15 The average equity beta of aircraft engine manufacturers is 1.40 and their average gearing is 20:80 debt to equity.Risk-free rate = 6%Equity risk premium = 4%Tax rate = 25%Corporate debt may be assumed to be risk-free.

Required:Estimate General Eclectic's weighted average cost of capital following the disposal. Assume that the disposal will not affect the value of equity.Solution



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4 Management Buyouts

4.1 Introduction< An MBO is the purchase of part or all of a business by the

existing management. As the management team usually have limited resources, a substantial amount of external capital will be required.

4.2 Reasons for the Development of the MBO< The MBO developed in the UK as an accepted form of

transaction in the early 1980s. At the time, a number of companies were severely affected by economic recession. When faced with an unprofitable subsidiary, the options were to put it into receivership or sell to the only available purchaser (i.e. the management). Often the sales were made at distress prices and existence of security in the form of land and buildings made borrowing to finance the transaction very easy.

< Although these advantages largely disappeared for subsequent deals, the early transactions gave an impetus to the market and ensured familiarity with the concepts involved.

Other reasons which led to growth of the MBO market include:

< US banks: The arrival of US banks in the UK with their familiarity with highly leveraged transactions in their home market meant that many deals which would not have been possible in the past could now be accepted.

< Legislation permitting financial assistance for purchase of own shares: Changes in legislation in the UK made it easier in the 1980s for companies to assist in the purchase of their own shares. For example, loans in MBOs are often secured on the assets of the company. Previously such assistance by the company would have been illegal.

< Repayment of national debt by the UK government in the late 1980s: The government's reduction in borrowing requirements led to a surplus of institutional funds in the UK, which partly found a home in MBOs.

< Government policy: Government policy has been to encourage private share ownership and privatisations have often favoured MBOs (e.g. privatisation of regional bus companies).

< Disposal of non-core subsidiaries: The tendency of groups to focus on core activities and dispose of non-core subsidiaries has led to a supply of companies for MBOs.

< Management desire: The desire of management teams to be liberated from the chains of a large organisation (and to get rich) has meant that there is no shortage of aspiring risk takers.



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4.3 Ideal MBO Candidate< The ideal MBO candidate is a company in a relatively low

risk environment. This will enable the providers of finance (e.g. venture capitalists) to realise a satisfactory return without substantial risk that the company will fail. Desirable characteristics for a company to have are:= a stable or growing market;= stable cash flows;= large asset backing as security for loans;= the ability to restrict capital expenditure over the years

subsequent to the buyout to minimise cash outflow;= the ability to squeeze working capital in the early years to

generate additional cash to pay back loan finance;= the existence of surplus assets which can be sold to pay

down debt;= a strong well balanced management team; = an "exit route" (e.g. the company should be of sufficient

size for an IPO or should be an attractive purchase for other acquisitive companies).

4.4 Commercial Aspects of Buyouts< It is important to ensure that a deal is feasible from the very

start. This means that all parties must be serious about making the deal work. The vendor must be willing to sell, the management willing to buy and there must a good prospect that the finance will be available.

< To make the deal easy to negotiate the management team should preferably be fairly small. This will make decisions easier and minimise the risk of members backing out at a late stage to move on to more attractive positions.

4.4.1 Financiers and Advisers

< Before making an offer and negotiating with the vendor, the management team should meet with the potential financiers who can inspect the business plan and establish whether finance is likely to be available or not.

< It may be useful to use professional advisers at this stage (e.g. accountants or lawyers). The risk is that heavy fees will be incurred which will need to be met by the management personally if the bid does not succeed. Accountants may make their fee contingent on a successful deal being completed, but in such instances the fee will be higher.



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4.4.2 Offer to the Vendors

< After meeting with the potential financiers, an offer can be made to the vendors. This will include details of the following:= the assets or shares to be purchased;= trademarks or other brand names to be included in the deal;= the employees and attached obligations (e.g. redundancy

payments) to be included in the deal;= pre-conditions for the sale (e.g. an investigation or tax

clearances);= the purchase price and payment terms.

< When setting the price, the management will have to value the company using various valuation techniques. This however will only give a base guide and the final price will be determined by a range of factors. The negotiating strength of each party will be paramount.

< The problem for the management team is that they have only one potential target. However, the financiers will be looking at a range of options and the vendor will possibly have a number of potential purchasers. The management team will therefore need to strengthen their own position by stressing the benefits of having a MBO and by having alternative courses of action (e.g. walking out and setting up a new business).

4.5 Financial Aspects of Buyouts

4.5.1 Gearing Levels

< An MBO is usually financed by a mixture of debt and equity with the MBO team putting their own money in.

< Relatively high levels of debt finance may be required. The gearing (ratio of debt to equity) can easily be 5:1, though 10:1 is not rare and 20:1 has been known. For this reason such deals are often referred to a highly-levered MBOs.

< High gearing requires a strong cash-flow to enable interest payments to be met.

< The equity investment of the buy-out team, together with debt secured on the assets of the business and/or individual team members may not be enough, resulting in applications to banks or venture capital providers.

< They will usually take an equity stake in the business, have a non-executive director on the board, and require a say in its medium and long term plans.



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4.5.2 Equity Finance

< The equity finance will typically be split between the management team and the venture capitalist, although it may be the case that the vendor wishes to retain an interest in the company. The venture capitalists will be concerned to earn a satisfactory rate of return on an IRR basis taking into account the risk being incurred.

< Key elements in the equity package may be:= Share options or convertible loan stock: These will enable

the financiers to increase their percentage holding of the company at low cost. The terms can be altered depending on whether the company achieves agreed performance targets.

= Redeemable preference shares: These enable the venture capitalists to obtain repayment of their investment if equity returns are inadequate. They will give a running yield which will increase overall returns. They may include a conversion option.

= Mezzanine finance: This is essentially a form of high risk unsecured debt bordering on equity, with its exact nature depending on how it is structured. It is useful when there is no way of raising additional straight debt and the issue of more equity would unsatisfactorily dilute the interests of the management team and other equity investors.

4.6 Exit Routes

4.6.1 Possibilities

< The two main exit routes whereby investors can realise their capital gain are:

(i) flotation (IPO); or

(ii) trade sale to another company.

< The attractiveness of each depends to an extent on market conditions. The use of each has varied in the past but, in general, trade sales have been more common than floatation.

4.6.2 Exit—Flotation or Trade Sale?

Factor Flotation Trade sale

Size of company Large Any size

Timing of exit Market determined Flexible

Business weaknesses Unacceptable Can be accommodated

Management quality Essential Not essential, but will be reflected in the price



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< The "big 3" credit ratings agencies of Fitch, Moody's and Standard & Poor's assess credit risk using factors such as industry risk, country risk, earnings protection, financial flexibility and quality of management.

< "Structural debt models" assess credit risk through analysing the level and volatility of assets compared to the level of liabilities, or more accurately, the level and volatility of cash.

< If management or stakeholders identify a significant risk of bankruptcy then steps should obviously be taken to avoid this. Company law in many countries allows some form of capital reconstruction (e.g. debt to equity swaps).

< Even a healthy company may wish to restructure its operations, perhaps to focus on core activities or to separately quote potentially undervalued segments of the business.

< Divestment of non-core activities can take various forms such as MBO, sale to another firm or to private equity investors.

Summary



Q23 Dricom 60 minutes

Additional

Q24 Aster

Q25 MBO


1. State what factors the principal ratings agencies use to determine credit risk. (1.2)

2. Define "distance to default". (1.3)

3. Define "credit spread". (1.3)

4. State the variant of the Black-Scholes model which can be used to imply the value and volatility of a firm's assets. (1.3)

5. State the characteristics of a complex capital reconstruction. (2.2)

6. Define "unbundling". (3)

7. Define "spin off". (3.2)

8. Define "management buy in". (3.2)

9. Define "mezzanine finance". (4.5.2)

10. State two possible "exit routes" for an MBO team. (4.6.1)



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Session 9

Solution 1—Structural Debt Model

A 10.23% monthly (σm) volatility can be converted to an annual volatility (σa) as follows:σa = σm × √Twhere T is the number of time periods (months) in a year. Therefore:σa = 10.23% × √12 = 35.44%which, when applied to an average asset value of $1m, gives a standard deviation of $354,400.The "distance to default" in value terms is $1m – $0.4m = $0.6m. Dividing this by the standard deviation tells us the number of standard deviations (z) below the average asset value.

Z = fall in value to default

standard deviation = $600,000$354,400 = 1.693

From the normal distribution tables the proportion represented by 1.69 standard deviations is 0.4545 and the proportion represented by 1.70 standard deviations is 0.4554. By interpolation the probability represented by the Z-score of 1.693 = 0.4545 + 0.3(0.4554 − 0.4545) = 0.4548. Adding this to the probability of an asset value being above the mean (0.5) gives a total probability of not defaulting of 0.9548 (i.e. a probability of defaulting of 0.0452). On a loan of $400,000, the bank would expect to receive LIBOR plus the premium it wishes to charge at the end of the year, giving an overall rate of i%. A simple decision tree shows how the bank equates the present value of a certain sum $400,000 to the uncertain future outcomes on the loan:

$400,000 x (1 + i%)1 + LIBOR

Prob. = 0.9548

Non-default

$400,000

Default

Prob. = 0.0452

80% x $400,000 x (1 + i%)1 + LIBOR

This decision tree can be expressed as a simple equation:

$400,000 = 0.9548 × $400,000 x (1 + i)

1.05 + 0.0452 × 0.8 x $400,000 x (1 + i)

1.05

Rearranging:

i = 1 + LIBOR

P(non-default) + [P(default) x Potential recovery] = 1.05

0.9548 + 0.0452 x 0.8 = 0.0596

i.e. the interest rate on the loan is 5.96%, which is a spread of 96 basis points over LIBOR.

EXAMPLE SOLUTIONS



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Solution 2—Divestment

First de-gear the equity betas of General Eclectic and the aircraft engine manufacturers:

βa = Ve

(Ve + Vd(1 − T)) βe

General Eclectic

βa = 6,000

(6,000 + 3,500(1 − 0.25))1.15 = 0.80

Aircraft engine manufacturers

βa = 80

(80 + 20(1 − 0.25))1.4 = 1.18

Unbundled asset betasNow "unbundle" General Eclectic's existing asset beta into the individual asset betas of aircraft engines and its other activities (β0):0.80 = (0.15 × 1.18) + (0.85 × β0)*β0 = 0.73Regeared equity betaThis is now regeared to General Eclectic's new capital structure:

0.73 = 6,000

(6,000 + 2,300(1 − 0.25)) βe

βe = 0.94Ke = 6% + (0.94 × 4%) = 9.76%

WACC = 6,000

6,000 + 2,300 9.76 + 2,3008,300 6(1 − 0.25) = 8.30%

*The weights used above are the relative revenues generated from aircraft engines and other activities. This is an approximation; if data were available it would be better to use the relative value of assets (i.e. present value of pre-interest cash flows from each segment discounted at the WACC).



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NOTES



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Session 10

Session 10 Guidance

Learn the advantages and disadvantages of publicly listing a company's securities, as well as the parties involved in the listing process (s.1).

Differentiate between share issuance methods for companies with an existing listing versus companies applying for a new listing (s.2).

Equity Issues

B. Economic Environment for Multinationals

2. Strategic business and financial planning for multinationalsa) Advise on the development of a financial planning framework for a

multinational taking into account compliance with national regulatory requirements (for example the London Stock Exchange admission requirements).



a) Identify and assess the appropriateness of the range of sources of finance available to a company including equity, hybrids, venture capital, business angel finance and private equity. Including assessment on the financial position, financial risk and the value of an organisation.

5. International investment and financing decisionse) Assess and advise on the costs and benefits of alternative sources of

finance available within the international equity markets.



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Session 10 Guidance

VISUAL OVERVIEWObjective: To understand domestic and international capital markets and how companies issue equity in them.

Understand the methods of setting the offer price in an IPO (s.3). Learn the advantages and disadvantages of being listed on the "main market" of the LSE and the AIM (s.4).

STOCK EXCHANGE ADMISSION• The Stock Exchange• Reasons for Applying• London Stock Exchange• Regulatory Requirements• Role of Sponsor• Summary Timetable

METHODS OF ISSUING SHARES• Existing Listing• New Applicants

ALTERNATIVES TO MAIN MARKET

• AIM Listing• Trade Sale• Unquoted Equity Finance• Debt Finance

DETAIL ON METHODS• Offer for Subscription• Offer for Sale• Fixed Price or Dutch Auction• Book Building



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Session 10 • Equity Issues P4 Advanced Financial Management


1 Stock Exchange Admission

1.1 The Stock Exchange< The Stock Exchange is responsible by law for controlling

companies that are listed and those who are applying for a listing. The Exchange's rules serve to ensure that:= Applicants are suitable for a listing;= Securities are brought to the market in a way that ensures

open and fair trading;= There is a balance between providing issuers with capital

and protecting investors;= Relevant information is provided by companies.

1.2 Reasons for Wanting a Listing< Whenever a new company is formed, particularly with the

assistance of venture capitalists, one of the aspirations of the directors and/or shareholders will be for the company to seek a listing in the future. In reality, very few companies ever actually come to the market and it is important to consider the reasons why a listing may be appropriate or not.

1.2.1 Advantages of a Listing

Exit route Flotation of the company will enable investors to realise

their investment. This may be a major factor where the company has venture capital or private equity investors who need to realise their gains within a set time scale. One of the first questions a venture capitalist will ask when assessing a business is the feasibility of various exit routes, including flotation.

Immediate source of long term capital for the business The company will be able to issue new shares and obtain

long term capital. This will enable the business to expand its markets, make acquisitions and reduce gearing levels.

On-going source of capital The ability to issue new shares in the future, subject to

investor sentiment, or to issue listed debt will give the company more flexibility in its financing options. This will translate into lower costs and will assist the company in its expansion plans.

Share for share acquisitions The ability to issue shares as consideration when making

an acquisition will give the company more options when implementing a strategy of growth.

Raised profile The listing will give the company more credibility with

potential customers and suppliers and will also be a source of publicity, leading to lower costs and higher revenues.



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P4 Advanced Financial Management Session 10 • Equity Issues

Share incentive schemes It will be easier to introduce share option schemes (for

employees and/or directors), since there is a readily ascertainable market price and a liquid market in which to dispose of a holding.

Personal factors The directors of the company may feel attracted by the

prestige of being the directors of a listed company.

1.2.2 Disadvantages of a Listing

Time and cost spent preparing for flotation Planning a flotation is a lengthy procedure (typically at least

six months). Throughout this time, a significant amount of management effort will need to be diverted into the flotation process.

In addition, advisers will be spending time and charging fees. These may be rolled up and only be payable if the flotation goes ahead, but at some time the cost will come through.

The cost of the flotation itself The flotation process itself is very expensive, involving fees

to advisers, the Stock Exchange and the underwriters and various other expenses.

The on-going costs of maintaining a listing These include the on-going fees to be paid to the Stock

Exchange and higher compliance costs. For example, to satisfy the UK Combined Code on Corporate Governance or (even more expensive) the US Sarbanes-Oxley Act. Furthermore, significant management time will be spent communicating with investors and ensuring that the company is being marketed properly.

Satisfying the needs of external shareholders The needs of external shareholders will depend on the nature

of those investors—whether they want income or capital growth, whether they are pension funds, insurance companies, unit trusts/mutual funds or private investors. The company will need to identify their needs and tailor the strategy of the company to meet those requirements.

However, the pressure to achieve short term results may damage the long term development of the business—a problem often referred to as "myopia".

Accountability The requirement to have non-executive directors on the board

and to justify performance, executive pay and other decisions to outside shareholders may be an interference to directors used to running the company their own way.

Lack of privacy The disclosure requirements set by the Stock Exchange,

and the fact that the company is subject to the attention of analysts and the public in general, means that the company will not have the benefits of secrecy and discretion available to a private company.



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The risk of takeover If the directors do not perform satisfactorily, the company may

be taken from them and sold to a (possibly hostile) predator. They may feel a great sense of loss if they had built up the company from start-up—although the pain may be cushioned by "golden parachutes".

Different culture The culture of the business is likely to change since the

directors will be answerable to outside shareholders. Previously, the business may have been run as a "lifestyle" company, with generous benefits to the directors and their families. Such advantages may disappear on listing.

Tax planning for investors The scope for tax planning is much wider in an unquoted

company with a small group of shareholders and an uncertain market value.

1.3 Stock Exchange Regulations< The conditions for a listing on the London Stock Exchange are

published by the UK Listing Authority (UKLA)—a department of the Financial Services Authority.

< The conditions below are for the Main Market—less strict conditions apply to the AIM (Alternative Investment Market):

Public limited company

A private limited company ("Ltd") is not permitted to issue shares to the public. Therefore, a private company will need to re-register as a public limited company ("plc") before it can apply for a listing. This means that it must have an issued share capital of a least £50,000, of which at least one quarter must be paid up.

Company history

It is important that there is evidence of a company's stability and likely future success. The company must have published accounts for the three years prior to the application for a listing, except in exceptional circumstances (e.g. Eurotunnel). The accounts must have been audited, usually have an unqualified audit report and comply in all material respects with International Financial Reporting Standards (IFRSs).

The main business activity of the company should also have been carried on for the previous three years. In addition, there should have been continuity of management over the period.

Directors

The directors must collectively have appropriate experience to run the business. They must be free of conflicts of interest unless it can be demonstrated that these will be managed to avoid detriment to the company.

Working capital

The directors must confirm in writing that the company has sufficient working capital for its needs and will not become insolvent in the near future.



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Controlling shareholder

A controlling shareholder is a person who owns 30% or more of the voting rights in the company or who controls the board of directors. Such a person would have great influence over the company and this could lead to conflicts of interest between them and other shareholders.

The company must demonstrate that all significant decisions are taken by directors independent of a controlling shareholder and that there are arrangements in place to avoid detriment to other shareholders.

Transferability of securities

The shares must be freely transferable. This may mean that the company will have to change its articles of association. Many private companies will have a condition that shares may only be transferred with the approval of the board of directors.

Market value of securities to be listed

To ensure that securities to be listed for the first time are readily marketable, the minimum market value of shares to be listed is £700,000. The minimum value of any debt securities to be listed is £200,000.

These limits may be ignored if the Stock Exchange is satisfied that securities of a lower market value would be adequately marketable. However, given the problems that small company shares have in being traded anyway, it is unlikely that this will often be the case.

Public shareholders

A sufficient number of the shares must be in the hands of the public, to ensure that the secondary market for the shares is sufficiently liquid and the shares are marketable. This requirement will be satisfied where 25% of the shares are in public hands. A lower percentage than 25% may be permitted if the shares will nevertheless be sufficiently marketable.

1.4 Regulatory Requirements of Major Stock Exchanges

NYSE NASDAQ Tokyo LSE EuronextMinimum free float $40m 1.25m shares 30% 25% 25%Minimum market capitalisation $150m $160m ¥2bn £700,000 none

Minimum years of audited accounts 1 year 1 year 3 years 3 years 3 years

Key:

NYSE = New York Stock ExchangeNASDAQ = New York based market for technology firms LSE = London Stock Exchange (main market)Euronext = a pan-European stock exchange based in Amsterdam with subsidiaries in Belgium, France, Portugal and the United Kingdom. Euronext is part of the NYSE group."Free float" refers to the value, number or proportion of shares available to the general public.



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1.5 Role of the Sponsor< The Sponsor is usually a member firm of the Stock Exchange,

though not always.< The Sponsor's responsibilities include ensuring that:

= the company complies with the Stock Exchange rules; and= the directors understand their responsibilities.

< Also, if the sponsor is a member firm, it will provide a market for the shares on the first day of trading.

1.5.1 Written Submissions to the Stock Exchange

< The sponsor must make the following written confirmations to the Stock Exchange:

Written declaration

On application for listing, a declaration to confirm that in all cases the directors are aware of their responsibilities under the UKLA rules and that adequate financial reporting procedures are in place.

Working capital report

A confirmation that the sponsor has received a working capital report from the company directors and that in the sponsor's view it has been prepared with due care.

Profit forecast report

A confirmation that a profit forecast (if presented) has been prepared with due care.

Declaration of sponsor's interests

A declaration of interests should be submitted at an early stage (i.e. if the sponsor holds shares in the company).



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1.5.2 Other Factors

< In addition to the specific requirements highlighted by the UKLA, a sponsor will need to consider a number of other factors. These will include the following:

Product range and customer base

The company should not be over reliant on one product or one customer.

State of the market

The markets in which the company is operating should preferably be growing, but certainly not in steep decline.

Management quality

This will need to be of the highest quality and should not have any weaknesses in one particular area (e.g. finance or marketing).

Accounting and financial information

The company should have good financial records giving a well-documented history of its performance. Accounting policies should be conservative and consistently applied.

Background of the directors

The directors' backgrounds should show financial integrity and adequate experience to run a large company.

Litigation and other contingent liabilities

The company should not have any unresolved litigation or other factors which may result in a significant liability to the business.



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1.6 Summary TimetableThe following table summarises the build-up to a listing for a company:

Time before listing Action

24 weeks Appoint advisersCommence the Long Form ReportConsult Stock ExchangePlanning

8 to 12 weeks Draft documents preparedDrafts submitted to Stock ExchangePublic relations campaign starts

1 to 6 weeks Draft Listing Particulars (detailed documents about the securities to be listed and the company)Formal submission of documents to Stock Exchange

Final week Approval of documents by Stock ExchangeCompletion meetingUnderwriting agreement signedInvestment presentationsAllocation lists open and basis of share allocation is announcedApplication for listingDealings commence

It is not necessary to know all details but knowledge of the main steps in a listing, the parties involved and the types of share issue (see next page) is essential.



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2 Methods of Issuing Shares

2.1 Companies With an Existing Listing< In the case of a company which already has a listing, the

Stock Exchange is concerned to protect the interests of existing shareholders. It therefore requires that the company gives existing shareholders pre-emption rights (i.e. the right to purchase new shares in the company in preference to other investors).

< This means that the usual method of issuing shares for a company which already has a listing is the rights issue. However, the Stock Exchange permits other methods to be used in certain circumstances.

2.2 New Applicants for a Listing< The objective of the Stock Exchange is to ensure the

marketability of the shares when listed. The major methods which may be used are:= Offer for Subscription—the company sells new shares

directly to the public.= Offer for Sale—new shares are sold to an intermediary

who then sells to the general public.= Placing—new shares are sold to specific individuals (to

obtain a listing there must be more than five individuals.)= Introduction—no new shares are issued, two market

makers simply agree to trade existing shares. This method is often used when a company de-merges.

< Whichever method is used, there must be a least two market makers willing to make a market in the securities, of which at least one must be independent of the sponsor or other advisers.

< If the sponsor or any other adviser becomes interested in 3% or more of the shares, this must be notified to the Stock Exchange before dealings in the securities commence.



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3 Detail on Methods

3.1 Offer for Subscription< Offer for subscription—when a firm issues new shares to new

shareholders directly.< The problem in making an offer for subscription for most

companies is that they lack the expertise to sell their shares to the public directly. This means that it is typically only used by experts in this field (e.g. investment trusts).

< Most trading companies will use a similar method, the offer for sale.

< Stock Exchange rules concerning offers for sale and subscription are the same.

3.2 Offer for Sale< In an offer for sale, the company issues shares to an issuing

house (usually an investment bank) which then sells the shares to the public.

< In addition to selling shares newly issued by the company, the issuing house can also sell shares to the public which were previously owned by the original shareholders—thus enabling them to realise their investment.

3.3 Fixed Price or Dutch Auction< Fixed price tender offer—where the price per share is fixed by

the company in advance of the offer and the public are invited to subscribe at that price.

< "Dutch auction"—where the public are invited to tender for shares, offering whatever price they think is appropriate subject to a minimum tender price set by the company. The company will set a strike price for the offer based on tenders received. Investors who tendered at higher prices will receive preference.

Illustration 1 Dutch Auction

XYZ wishes to issue 1,000 shares by way of tender and sets a minimum tender price of $2.00 per share. The following tenders are received:

Investor Number of shares Price per share ($)A 500 4.00B 700 3.00C 700 3.00D 600 2.00

XYZ could theoretically set the strike price at $3.00 per share, issue 500 shares to A and 250 shares to B and C at this price, with no shares being issued to D.In practice, the price may be set at below $3.00 to stimulate trading in the secondary market.



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< The two approaches may be compared as follows:

Fixed price Dutch auction

Total finance to be raised is known in advance

Not known until strike price set

Easy for investors to understand Complex for the private investor but not for institutions

Difficult to set price Price is set by the market

Makes "stagging" possible (a stag is an investor who buys new issues of shares in the hope of selling them quickly for a higher price).

Less scope for stagging.

< Overall, if the wish of the company and its existing investors is to achieve wide share ownership and to appeal to the public in general, the fixed price offer is likely to be the better alternative.

< The Dutch auction approach is likely to be superior if the company wishes to target its investor base more carefully and ensure that the share issue provides the best value to existing shareholders.



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3.4 " Book Building"< The "book building" approach is to some extent a merging

of the two above methods, the fixed price tender offer and Dutch auction.

< The idea of book building is that the issuing house gauges demand for the issue prior to setting a fixed price for the offer. Institutional and individual investors are asked to indicate, either on a firm or uncommitted basis, the best price which they are willing to pay and the maximum number of shares that they will buy at particular prices.*

The advantage of using book building is that it can build up market tension and increase demand for the shares and the final issue price.

It is highly suitable for large issues where underwriting would not be possible due to the size of the risk to which the underwriters would be exposed. It is well established as a technique in the UK and US markets.

The technique does have potential problems, however. While creating tension may drive the issue price up for a popular share, there is the possibility that investors will all wait to see what others do, particularly in uncertain markets. If no one is prepared to take a lead, then the issue may never get started.

In addition, it is possible for investors to sell the stock short prior to the issue in an attempt to drive the price down upon issue (i.e. first sell the shares, wait for the price to fall upon their issue, buy them at the lower price and take a quick gain).

< To combat these problems the issuing house will need to:= Establish an anchoring market place to get the issue off

the ground.= Establish a sophisticated computer system to enable global

demand to be accurately tracked on an instantaneous basis.= Establish detection techniques to identify sellers of the stock

prior to the issue. This requires good relations with market participants so that all sellers can be identified.

= Have the power to punish institutions who sell short in the above fashion.

= Have the ability to stabilise the market after issue.

*This information will enable the issuing house to build up a demand curve and establish the most appropriate offer price for the issue.



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4 Alternatives to the Main Market

4.1 Listing on the Alternative Investment Market (AIM)

AIM is a subsidiary of the London Stock Exchange. Specifically tailored to growing businesses, AIM combines the benefits of a public quotation with a flexible regulatory approach.

AIM gives companies from all countries and industry sectors access to the market at an earlier stage of their development, allowing them to experience life as a public company. Since its launch in 1995, more than 3,000 companies have been admitted to AIM and more than £60 billion has been raised in new and further capital fundraisings.

Differences in the admission criteria for the Main Market and AIM:

Main Market AIM

Minimum 25% shares in public hands No minimum shares to be in public hands

Normally 3 year trading record required No trading history requirement

Prior shareholder approval required for substantial acquisitions and disposals

No prior shareholder approval

Pre-vetting of admission documents by the UKLA and the Exchange

Admission documents not pre-vetted by the UKLA or the Exchange

Sponsors needed for certain transactions Nominated adviser required at all times

Minimum market capitalisation (£700,000) No minimum

4.2 Trade Sale to Another Company< The trade sale is an alternative means of realising the

investment and is, in fact, the more common occurrence in practice for a successful company.

< The decision about exit route depends on a number of factors:

Flotation Trade sale

Size of company Relatively large Any size

Timing of exit Market determined Flexible

Business weakness Unacceptable Can be accommodated

Management quality Essential Not essential but will be reflected in the price

Realisation Can be partial Full

Price Depends on market sentiment

Possibly at a control premium



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4.3 Unquoted Equity Finance< Alternatives to listing on either the Main Market or AIM are

to use:= Private equity finance: private equity investors buy

out private companies, actively manage them to improve performance, then list the firm on the market or sell to another private investor.

= Venture capital: venture capital funds may be prepared to provide "seed" finance to start ups or second stage growth finance. Unlike private equity investors venture capitalists do not always expect to take full control of the firm.

= Business angels: individual venture capitalists who are often wealthy, retired entrepreneurs.

4.3.1 Possible Advantages and Disadvantages

An equity investor can be selected whose vision for the business matches that of the existing shareholders/directors.

The investor may have existing business interests in connected fields, creating possibilities of shared research and development, transfer of management skills (i.e. "synergy").

A private investor may be prepared to take a more long-term view than institutional investors on the stock market; reducing the risk of myopia.

Dilutes the interests of existing shareholders.

New investors may demand a seat on the board.

The level of funds which can be raised in this way is probably less than available from a public listing.

4.4 Debt Finance

4.4.1 Advantages and Disadvantages Compared To Equity

Lower issue costs. Providers of debt take less risk than

shareholders and hence require lower returns.

Interest is tax allowable—the "tax shield".

Leaves control of the company with existing shareholders.

Ensures that all the benefits of success stay with the existing shareholders.

Only available in limited quantities up to acceptable gearing levels.

Leads to financial risk for shareholders (i.e. more volatile profits due to the presence of committed interest costs).

Exposes the company to the risk of insolvency should operating profits and cash flows fall—financial distress risk.

Restrictive debt covenants may limit the firm's flexibility-leading to "agency costs" for shareholders (i.e. sub-optimisation of returns).*

*Issues relating to debt finance are detailed in the next session.



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Session 10

< The main advantages of a listing include sources of capital, raised profile for the company and exit route for the investors. The main disadvantages include costs, additional accountabilities and scrutiny and increased risk of takeover.

< The rules for listing shares on a major market (e.g. LSE) are inevitably detailed and strict to give potential investors sufficient protection and maintain confidence in the market.

< A sponsor must make written confirmations concerning the directors' responsibilities and reports presented (e.g. working capital and profit forecast).

< Offer for sale and offer for subscription are two methods of bringing a company to the market in which the public can apply for shares.

< Potential investors may be canvassed for their interest in a new issue ("book building").

< AIM is a market suitable for smaller growing companies operating in any business sector throughout the world.

< Sources of unquoted equity finance include private equity, venture capital and business angels.

Summary



Q26 Equity and debt issues 35 minutes


1. State the parties involved when a firm plans to list its shares on the stock market. (1)

2. List advantages of becoming quoted. (1.2.1)

3. List disadvantages of becoming quoted. (1.2.2)

4. State the conditions that must be met before listing on the Main Market of the London Stock Exchange. (1.3)

5. State the criteria new applicants for an LSE listing must satisfy. (2.2)

6. Discuss the difference between fixed price and Dutch auction pricing. (3.3)

7. State how the pricing methods develop the demand curve for issued shares. (3.4)

8. Name the subsidiary of the LSE that was set up as a market for smaller companies to list their shares. (4.1)

9. List FIVE differences in the admission criteria for the Main Market and AIM. (4.1)



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Session 11

Session 11 Guidance

Learn the types of financial intermediaries and their functions (s.1). Recognise the various types of short-term finance (s.2) and medium-term finance (s.3), as well as the advantages and disadvantages of each. Attempt Example 1.



a) Identify and assess the appropriateness and price of the range of sources of finance available to an organisation including debt, lease finance and asset securitisation.

5. International investment and financing decisionse) Assess and advise upon the costs and benefits of alternative sources of

finance available within the international bond markets.


Debt Issues



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Session 11 Guidance

Understand the details of each type of long-term finance (s.4). Learn the different components of the Euromarkets (s.5).

VISUAL OVERVIEWObjective: To understand domestic and Euro debt markets and how companies issue debt in them.

DEBT ISSUES

DOMESTIC DEBT MARKETS• Financial Intermediaries• Roles• The Money Market

EUROMARKETS• Components• Eurocurrency• Eurocredit• Euronote• Eurobond

SHORT-TERM FINANCE

• Bank Overdraft• Trade Credit• Bills of Exchange• Commercial Paper

MEDIUM-TERM FINANCE

• Bank Loans• Leasing• Sale and Leaseback• Mortgage Loan

LONG-TERM FINANCE• Preference Shares• Debentures• Deep Discount

Bonds• Zero Coupon Bonds• Convertibles• Warrants• Securitisation



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Session 11 • Debt Issues P4 Advanced Financial Management


1 Domestic Debt Markets

1.1 Financial Intermediaries

Financial intermediaries— Organisations in the debt market which bring together potential lenders and potential borrowers.

The following financial institutions act as financial intermediaries:

< Commercial banks and building societies (i.e. deposit takers).

< Investment banks—which provide banking services to corporate clients, including advice on areas such as share issues and acquisitions.

< Insurance companies—which can invest much of their premium income in long-term assets, as their outgoings are reasonably easy to predict.

< Investment trusts and unit trusts/mutual funds—which attract investors and then reinvest the funds raised into other companies.

< Pension funds—which have predictable cash outflows and can invest in the long term.

< Finance companies—which provide business and domestic credit, lease finance and factoring/invoice discounting services. These companies are often a subsidiary of another financial institution.

< Discount houses—which trade in investments such as bills of exchange.

1.2 Role of Financial IntermediariesFinancial intermediaries are important as they carry out the following roles:

< Aggregation—small deposits are combined and lent to large borrowers.

< Maturity transformation—a continuing stream of short-term deposits can be used to lend monies in the long term.

< The risk of each particular borrower is effectively spread across many lenders.

< Providing a liquid market with flexibility and choice for both lenders and borrowers.

< Providing instruments to business for hedging risk (e.g. forward contracts, options and swaps).

1.3 The Money MarketThe money market is not actually a physical market but is the term used to describe the trading between financial institutions. The main areas of trading include:

The discount market—where Bills of Exchange are traded.

< The inter-bank market—where banks lend each other short-term funds.



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P4 Advanced Financial Management Session 11 • Debt Issues

< The Certificate of Deposit market—a CD is a savings certificate entitling the holder to receive interest. A CD states a maturity date, a specified fixed interest rate and can be issued in any denomination.

< The Eurocurrency market—where banks trade in foreign currencies, usually in the form of Certificates of Deposit.

< The inter-company market—where companies lend directly between themselves.

< The commercial paper market.These markets are for short-term lending and borrowing where the maximum term is normally one year.

2 Short-Term Finance

2.1 Bank Overdraft*Advantages

Flexible. Provides instant finance.

Disadvantages

Repayable on call, unless the bank offers a "revolving line of credit".

The interest rate charged is often both high and variable.

2.2 Trade credit*Advantages

Generally cheap.

Flexible.

Disadvantages May lose settlement (quick

payment) discounts. May lose suppliers'

goodwill.

2.3 Bills of Exchange

Bill of exchange*—an acknowledgement of a debt to be paid at some time in the future (e.g. by a customer). Such a bill may then be "discounted" (i.e. sold to a third party for a percentage of face value).

Advantages Improves cash flow. Flexible.

Disadvantages Fees.

*As bills of exchange primarily are used in international trade they could be an appropriate method of financing exports where relatively long periods of credit are often involved.

*It is appropriate for every firm to have an agreed overdraft facility as lack of prior agreement may lead to significant fees and very high interest rates. Once agreed, a facility should only be used from time to time to cover short-term cash deficits.*If a supplier offers a period of interest-free credit then, unless early payment discounts are sacrificed, it would be appropriate to use this source of finance.



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Illustration 1 Bill of Exchange

X sells $2 million worth of goods to Y. X writes out ("draws") a bill of exchange for $2 million payable in two months (for example) which it sends to Y. Y signs the bill to acknowledge the debt and returns it to X.

X can either hold the bill for two months until Y pays the debt or sell it at a discount (e.g. at 98% of face value). If Y then pays, the buyer of the bill receives the $2 million and makes a gain.

Bill of Exchange

2.4 Commercial Paper

Commercial paper*—short-term (usually less than 270 days), unsecured debt issued by high-quality companies. The paper can then be traded by investors on the secondary market.

Advantages Large sums can be raised relatively cheaply. No security is required.

Disadvantages Only available to large companies with very good credit

ratings.

*Commercial paper may be appropriate for the financing of accounts receivable, inventories and meeting short-term liabilities. However, the commercial paper market can only be accessed by firms with investment-grade credit ratings (i.e. BBB– or higher).



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3 Medium-Term Finance

3.1 Bank Loans*Advantages

The loan will be for a fixed term: no risk of early recall (unlike overdrafts that can be called).

The interest rate may be fixed.Disadvantages Inflexible. May require security. May require covenants, which are restrictions on the

company (e.g. limits on dividend payments, limits on further borrowing).

3.2 Leasing*Advantages

There are many willing providers. Remains off balance sheet if an operating lease. Matches finance to the asset. Very flexible packages available, some of which include

maintenance.Disadvantage Can be quite costly.

Effect on Financial StatementsWhen management makes a final decision on whether to borrow to buy an asset, or whether to acquire it under a lease, the respective financial accounting implications may be an important factor.

This is certainly relevant for the managers of a listed company (i.e. whose shares are traded on the stock market) as key ratios may be influenced—particularly financial risk indicators (e.g. debt-to-equity ratio and interest cover).

*It may be appropriate to convert a significant and permanent overdraft into a medium-term bank loan to reduce the cost and remove the call risk.

*Leasing may be appropriate where the lessor achieves significant volume discounts and passes these on to the lessee. In this case, leasing can be potentially cheaper than an outright purchase.



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The implications of each financing option can be summarised as follows:

< Borrow to buy—The bank loan (or bond) will be recorded in non-current liabilities and will hence increase the firm's reported level of financial gearing (debt-to-equity ratio). Interest on the debt will reduce the firm's interest cover (earnings before interest and tax⁄interest expense). However, the overall effect also depends on the profits generated by the asset as these will increase the EBIT figure, and any retained profit would increase the level of equity.

< Operating lease—Neither the asset nor any related liability would be shown in the statement of financial position. Operating leases are a form of "off balance sheet" finance (although commitments under operating leases would be disclosed in the notes to the accounts). Therefore, reported financial gearing would not rise. Although rental expense would be charged against EBIT this should be outweighed by the returns generated by operating the asset.

< Finance lease—Both the asset, and a related liability, would be recognised on the statement of financial position (as per the borrow-to-buy option). Hence reported financial gearing would initially rise. However lease payments would be split between interest expense and repayment of principal (similar to a mortgage-style loan) and hence the liability would amortise over time and ultimately fall to zero. Interest expense in early years would be relatively high, tending to reduce interest cover, but lower in later years.

Financial analysts often manually adjust published accounts to treat all leases as finance leases (for comparability). A joint project of the IASB and FASB proposed that assets and liabilities should be recognised for all leases (over 12 months).

3.3 Sale and Leaseback*Property is sold to an institution (e.g. a pension fund) and then leased back to the company.

Advantages Funds are raised from the sale. May improve ratios such as Return On Capital

Employed (ROCE).Disadvantages No longer own the property and hence cannot participate in

any future increase in value. Risk of lease payments increasing.

*Sale and leaseback may be appropriate when a firm wishes to reduce its level of financial risk by using the sale proceeds to pay off debt. However there can be unintended consequences (e.g. the firm's asset beta is likely to rise as a result of the property disposal, potentially pushing up its cost of capital and damaging its value).



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Example 1 Sale and Leaseback

Ocean Island Co is considering a sale and leaseback on part of its property portfolio. The most recent statements of financial position are as follows:

At year end At year end20X4 20X3$m $m

ASSETSNon-current assetsIntangible assets 190 160Property, plant and equipment 4,050 3,600Other assets 500 530

4,740 4,290Current assets 840 1,160Total assets 5,580 5,450LIABILITIESCurrent liabilities 1,600 2,020Non-current liabilitiesMedium-term loan notes 1,130 1,130Other non-financial liabilities 890 900

2,020 2,030Total liabilities 3,620 4,050Net assets 1,960 1,400EQUITYIssued share capital 425 420Retained earnings 1,535 980Total equity 1,960 1,400

The company's profitability has improved significantly in recent years and earnings for 20X4 were $670 million (20X3: $540 million).The property portfolio was revalued at the 20X4 year end. It is proposed that property valued at $1,231 million would be sold to a newly established property holding company that would issue bonds backed by the assured rental income stream from Ocean Island. Ocean Island would not hold any equity interest in the newly formed company nor take any part in its management.The rental yield on this type of property is estimated to be 8%.Ocean Island is currently financed by equity in the form of 25c par ordinary shares with a current market value of 400c per share. The debt for the company consists of medium-term loan notes of which $360 million are repayable at the end of two years and $770 million are repayable at the end of six years. Both issues of medium-term notes carry a floating rate of LIBOR plus 70 basis points. LIBOR is currently at 5.5%. If the firm's financial gearing (measured as the book value of debt⁄(book value of debt + equity)) falls below 30% then the credit spread on its existing debt would fall by 30 basis points.The company's current accounting rate of return on new investment is 13% before tax. The effective rate of company tax is 35%.Required:(a) Prepare a comparative statement to show the effects on the statement of financial

position and on EPS assuming that the cash proceeds of the property sale are used:

(i) To repay the debt, repayable in two years, with reinvestment of the balance into new non-current assets.

(ii) To repay the debt, repayable in two years, with the balance used to finance a share buyback at the current market price.

(b) Evaluate the potential effect of each alternative on the firm's share price.



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Example 1 Sale and Leaseback (continued)

Solution

(a) Statements of financial position

20X4 Option (i) Option (ii)$m $m $m

ASSETSNon-current assetsIntangible assets 190

Property, plant and equipment 4,050

Other assets 500

4,740

Current assets 840

Total assets 5,580

LIABILITIESCurrent liabilities 1,600

Non-current liabilities

Medium-term loan notes 1,130

Other non-financial liabilities 890

2,020

Total liabilities 3,620

Net assets 1,960 EQUITYIssued share capital 425

Retained earnings 1,535

Total equity 1,960 Earnings per share

Current Option (i) Option (ii)$m $m $m

Earnings for the year 670.00 670.00 670.00

Revised earnings 670.00 696.00 620.50

Number of shares in issue

Revised EPS (cents per share)

(b) Potential effect on share price



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3.4 Mortgage Loan—a Loan Secured on Property*Advantages

Given the security, the loan will have a lower rate of interest than other debt.

Institutions will be willing to lend over a longer term. Still participate in the growth of the property's value.

Disadvantages Default may result in a key asset being liquidated.

*Although a mortgage may be appropriate for financing commercial real estate there are likely to be restrictive covenants concerning the use of the property and its potential disposal.



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4 Long-Term Debt Finance

4.1 Preference Shares

Preference shares —shares with a fixed rate of dividend which have a prior claim on profits available for distribution.

Preference shares, which are also called "preferred shares", are legally equity. They are often treated as debt (e.g. under International Financial Reporting Standards) as they are similar in nature to debt.

Some of the common features found for preference shares include:

< The shares have a fixed percentage dividend payable before ordinary dividends. This preference share dividend is expressed as a percentage of par value.

< The dividend is only payable if there are sufficient distributable profits. If the shares are cumulative preference shares, however, the right to receive dividends which were not paid is carried forward (this is known as cumulative preference dividends). Any arrears of dividend are then payable before ordinary dividends.

< As with ordinary dividends, preference dividends are not deductible for corporate tax purposes. The preference dividends are considered a distribution of profit rather than an expense.*

< On liquidation of the company, preference shareholders rank before ordinary shareholders and after debt holders.

Advantages No voting rights; therefore no dilution of control. Compared to the issue of debt: preferred dividends do not have to be paid in any specific

year, especially if profits are poor; preferred shares are not secured on company assets; and non-payment of dividend does not give holders the right to

appoint a liquidator.Disadvantages Preferred dividends are not tax deductible (unlike interest on

debt). To attract investors to buy preferred shares, the company

needs to pay a higher return to compensate for the additional risk compared to debt.

*For a tax-paying firm, preference shares are unlikely to be an appropriate source of finance as the lack of tax shield seriously damages the potential value of the firm. Less than 5% of companies listed on the London Stock Exchange have preference shares in issue.



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4.2 Bonds

Bond—a written acknowledgement of a debt, usually given under the company's seal, containing provisions for payment of interest and repayment of principal. The debt may be secured on some or all of the company's assets.

Type Secured Bonds Unsecured Bonds

Security and voting rights

Can be secured by one or more specific asset (e.g. over property), this is known as a fixed charge.

No security.

Holders have the same rights as ordinary creditors

Secured by a class of assets (e.g. net current assets or working capital), this is known as a floating charge.

No voting rights.

On default, the assets used as security are sold and the proceeds applied towards repaying the debt.

No voting rights.

Income A fixed annual amount (interest), usually expressed as a percentage of nominal value.

A fixed annual amount (interest), usually expressed as a percentage of nominal value.

< In the UK bonds are usually issued with a face value of £100. They can then be traded on the bond market and reach a market price. Hence, if a bond is "selling at a premium" of £15%, this means that a bond with a face value of £100 is currently selling for £115. This indicates that the rate of interest on this bond is attractive when compared with current market rates, creating demand for the bond and a rise in price.

< In the US the face value of a bond is usually $1,000.< The terms "debenture", "loan stock" and "bond" all basically

refer to the same thing (i.e. a written acknowledgement of a company's debt which can then be traded). Also, "face value" can also be referred to as "par value" or "nominal value".

< The most common process of issuing bonds is through underwriting—one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors.

*Bonds are an appropriate source of long-term debt for a tax-paying listed company as: (i) unlike preference dividends the coupon interest on bonds creates a tax shield for the issuer; (ii) as a form of financial disintermediation the interest rate on a bond is likely to be lower than on an equivalent bank loan.



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4.3 Deep Discount Bonds

Deep discount bonds—bonds issued at a large discount to nominal value (i.e. issued well below face value) and redeemable at par on maturity.

With deep discount bonds, investors receive a large capital gain on redemption, but are paid a low rate of interest, if any, during the term of the loan.*

Illustration 2 Deep Discount Bonds

A five-year, $1,000, 3% annual-pay bond issued at $800 would generate the following cash inflows/(outflows) for the issuing company:

t0 t1 t2 t3 t4 t5

Issue price 800Interest (30) (30) (30) (30) (30)Redemption (1000)

4.4 Zero Coupon Bonds

Zero-coupon bonds*—bonds issued at a discount to face value and which pay zero annual interest.

< No interest is paid (hence "zero").< Investors gain from the difference between issue and

redemption price (a capital gain).< Advantages to borrowers:

No cash payout until maturity; Cost of redemption known at time of issue.

*Deep discount bonds may be an appropriate type for a project that is not expected to generate significant net cash inflows in its early years. However, the issuer must be confident on meeting the promised redemption value.

*Whether zero-coupon bonds are appropriate critically depends on the corporate tax treatment of the issuer's jurisdiction. In the UK and the US, the difference between the discounted issue price and the redemption price is written off as a tax-allowable expense over the life of the bond and hence zero-coupon bonds effectively produce a tax shield.



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4.5 Convertibles

Convertibles*—bonds or preference shares which can be converted into ordinary shares. An example of hybrid or mezzanine finance (i.e. that has characteristics of both debt and equity).

Convertible bonds, which are usually unsecured, and convertible preference shares:

< Pay fixed interest or dividend until converted.< May be converted into ordinary shares:

on a pre-determined date; at a pre-determined rate; and at the option of the holder.

< Conversion ratio may change during the period of convertibility—to stimulate early conversion.

< Advantages to investors—a relatively low risk investment with the opportunity to make high returns upon converting to ordinary shares.

< Advantages to issuing company—lower rate of interest than on "straight" debt.

4.6 WarrantsWarrants have the following features:

< They are sometimes attached to loan stock, to make the bond more attractive. In this case, the loan stock becomes hybrid or mezzanine finance.

< They are basically options on shares. < The holder of the warrants may sell them rather than keep

them.

Warrants are share options attached to debt. The debt itself is not convertible. A warrant "sweetens" a new debt issue and makes it more attractive to investors.

Warrants offer several advantages for the issuing company:

The warrants do not involve the payment of any interest or dividends.

When they are initially attached to the bond, the interest rate on the bond will be lower than for comparable straight debt. This is due to the investor gaining the additional benefit of potentially being able to purchase equity shares at an attractive price.

They may make an issue of unsecured debt possible when the company's assets are inadequate to secure the debt.

*Issuing convertible debt may be appropriate if management wishes to raise debt but without increasing reported financial gearing to perceived dangerous levels. IFRS splits convertible debt between liability (the present value of the debt's future cash flows) and equity (the difference between the issue price and the value of the liability).

Warrants— rights given to investors which allow the investors to purchase new shares at a future date at a fixed price. This fixed price is also called the exercise or subscription price.



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4.7 Securitisation

Securitisation—the creation and issuance of tradable securities (e.g. bonds) that are backed by the income generated by an asset, a loan, a public works project or other revenue source.

< The classic example of securitisation is where a bank packages a pool of the loans given to homeowners into "Mortgage Backed Securities". The MBS is then issued via a ring-fenced Special Purpose Entity (SPE) that is protected if the firm collapses.*

< The SPE achieves a high credit rating as in future it will collect the cash from the underlying mortgages, and it cannot be touched if the bank gets into financial distress.

< The finance raised by selling the MBS is then transferred back to the bank which can then use it to grant more loans to customers.

Advantages Converts an illiquid asset (e.g. loans granted to homeowners)

into a liquid asset (i.e. cash). Credit enhancement—achieving a high credit rating through

the use of SPEs.*Disadvantages Creates a cycle of credit creation which may lead to an asset

bubble followed by collapse (e.g. US property prices pre and post the 2008 financial crisis).

The SPE may be opaque, particularly if set up in a lightly regulated offshore regime—therefore difficult for investors in an MBS to interpedently analyse the credit risk.

*Securitisation may be appropriate for a firm that wants to enhance its credit rating as low-risk cash flows (e.g. rental income from commercial property) are diverted into a "ring-fenced" SPV. The SPV then issues bonds backed by the future cash flow stream. Such bonds typically achieve an investment-grade credit rating.

*Also called Special Purpose Vehicle (SPV).



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5 Euromarkets

Euromarkets—banking and financial markets which are located outside the country which issued the currency.

5.1 ComponentsInternational bank borrowing/lending:

< Eurocurrency market;< Eurocredit market.< International securitised (traded) debt instruments:Euronote market;

< Eurobond market.*

5.2 Eurocurrency Market

Eurocurrency—currency deposited outside of its country of issue.

5.2.1 Characteristics

< Short to medium-term deposits (overnight up to 5 years). < Investors and borrowers are blue-chip companies and

governments—an international bank is the intermediary.< As the currency is offshore, the bank is outside of government

regulation and has more flexibility than domestic banks (e.g. is able to lend 100% of its deposits and therefore applies a relatively narrow spread between investing and borrowing rates).

< Borrowing possible up to several years (most is under one year).< Floating rates quoted as "LIBOR +".

5.2.2 Advantages (to both investors and borrowers)

Higher interest rates for investors than in domestic markets. Lower interest rates to borrowers than in domestic markets. Interest is paid gross to investors (i.e. no withholding tax). Very large loans can be arranged more quickly than in

domestic markets.

5.3 Eurocredit Market


< Major borrowers are multinationals, governments and other banks.

< Average maturity is 8 years.< Floating rates. < Large sums are syndicated (i.e. made by a group of banks).

Eurocredit—Eurobonds—long-term debt securities denominated in a currency outside of the control of its country of origin.

*The word "Euro" in this context does not refer to the European single currency. It relates to funds which are outside their home country (i.e. offshore) and hence beyond the regulation of the central bank that issued them.



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5.4 Euronote Market

Euronote— a variety of short to medium-term debt instruments issued in the Euromarkets.

5.4.1 Instruments Available

< Eurocommercial Paper—securitised borrowing where a company writes a short-term promissory note (less than 12 months). Only companies with very high credit ratings can issue commercial paper. Banks create a secondary market by buying the paper before its maturity date.

< Euro Medium Term Notes—maturities from nine months up to 10 years; filling the gap between commercial paper and long-term bonds.

< Note Issuance Facilities—medium-term commercial paper written by companies but underwritten by banks.

< Revolving Underwriting Facilities—a series of short-term paper issues designed to raise medium-term finance at short-term rates.

5.5 Eurobond Market


< Underwritten by an international syndicate of banks.< The main issuers are large multinationals, governments and

banks.< Usually unsecured but high credit rating is required. < Fixed or floating rate notes.< Many Eurobond issues are combined with swaps (either

interest rate swaps or currency swaps)

5.5.2 Advantages of Eurobonds

< Relatively low issue costs (2–2.5%).< Interest can be paid gross to investors.< "Bearer form"—there is no register of investors; possession of

the certificate is proof of ownership. This provides privacy to investors.

< Very large sums can be raised relatively quickly at attractive interest rates.

< Existence of secondary market.

Eurocredit—Medium to long-term international bank loans given by banks located outside the country which issued the currency.



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5.5.3 History of the Market

< In the 1950s, the US, unlike most countries, had no currency controls. As a result, large amounts of dollars were held outside the US.

< As a result of the lack of currency controls, the US dollar became the currency of international trade leading to a demand for US dollars outside of the US. This led to the birth of the Eurobond market in London.

< Regulation was introduced in the 1980s by the formation of the International Primary Markets Association.

5.5.4 Eurobond Primary Market

< The Primary market refers to new issues of Eurobonds. < Bonds are marketed by a lead manager who sells the bonds to

a syndicate of banks. The banks then sell on to their clients. < Historically, the clients then held the bonds to maturity,

though this pattern has changed to some degree over recent years.

5.5.5 Eurobond Secondary Market

< The secondary market is the process by which Eurobonds are traded once they have been issued.

< The market is small with very few issues being traded. < When trading takes place, it is done on an "Over the Counter"

basis, based on information provided by such companies as Reuters. Deals are agreed directly between investors rather than via a formal market.



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< Financial intermediaries bring together potential lenders and potential borrowers (e.g. banks).

< The maximum term for lending and borrowing on the money market is normally one year.

< Bills of exchange may be discounted; commercial paper is issued at a discount.

< Sources of medium-term finance include loans and leasing arrangements.

< Long-term debt finance includes bonds. Preference shares may also be regarded as debt rather than as equity.

< Although bonds can also be listed, companies with good credit ratings may prefer to use the Euromarkets to achieve lower interest rates and access large sums relatively quickly.

< The Euromarket is the money market for currency and bonds denominated in currencies other than that of the country issuing them.

Summary


1. State the usual maximum time period for finance to be considered money market. (1.3)

2. List FOUR types of short-term finance. (2)

3. State the advantages and disadvantages of leasing. (3.2)

4. Describe the difference between discount bonds and other bonds. (4.3)

5. List the characteristics of the Eurocurrency market. (5.2)

6. Define the "Eurocredit market". (5.3)

7. Give examples of instruments that firms can issue into the Euronote market. (5.4)

8. List the characteristics of Eurobonds. (5.5)



Q27 IXT 50 minutes

Additional

Q28 New debt issue



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Session 11

EXAMPLE SOLUTIONSSolution 1—Sale and Leaseback(a) Effect of sale and leaseback on statement of financial position

and EPSSale proceeds = $1,231 million. $360 million would be used to repay medium-term loan notes.(i) The balance of $871 million is reinvested in the business. (ii) The balance is used to buy back $871 m⁄$4 = 217.75 million

shares. Share capital is reduced by the par value of 217.75 m × $0.25 = $54 million and reserves by $817 million ($871m - $54m).*

The comparative statements of financial position under each option are as follows:

As atYears end

20X4Sale

ProceedsReinvestment

Option (i)Share Buyback

Option (ii)$m $m $m $m $m $m

ASSETSNon-current assetsIntangible assets 190 190 190

Property, plant and equipment 4,050 −1,231 871 3,690 −1,231 2,819

Other assets 500 500 500

4,740 4,380 3,509

Current assets 840 1,231 −1,231 840 840

Total assets 5,580 5,220 4,349

LIABILITIES

Current liabilities 1,600 1,600 1,600

Non-current liabilitiesMedium-term loan notes 1,130 −360 770 −360 770

Other non-financial liabilities 890 890 890

2,020 1,660 1,660

Total liabilities 3,620 3,260 3,260

Net assets 1,960 1,960 1,089EQUITYIssued share capital 425 425 −54 371

Retained earnings 1,535 1,535 −817 718

Total equity 1,960 1,960 1,089

If financial gearing is measured as book value of debt⁄(book value of debt + equity):

• Existing gearing = 1,130⁄(1,130 + 1,960) = 36.6%• Under option (i) gearing would fall to

770⁄(770 +1,960) = 28.2%• Under option (ii) gearing would increase to

770⁄(770 + 1,089) = 41.4%

*Note that 217.75 million is rounded to 218 million for the EPS calculation.



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Solution 1—Sale and Leaseback (continued)

The effects on EPS are less straightforward: Under both options the company would benefit from a reduction in

interest expense but would be required to pay an open market rent at 8% per year on the property released.

Under option (i) the reduction in gearing would also lead to a 30-basis-points saving in interest on the remaining debt and the company would earn a rate of return of 13% on the funds reinvested.

The existing number of shares in issue ($425m⁄0.25c) = 1,700 million would not change under option (i) but would fall to 1,700m – 218m = 1,482 million under (ii).

The adjustment to the current earnings to show these effects is as follows:

Current Option (i) Option (ii)$m $m $m

Earnings for the year 670.00 670.00 670.00Add interest saved (net of tax)

$360 million × 6.2% × 0.65 14.51 14.51Add reduction in credit spread on six-year debt

$770 million × 0.003 × 0.65 1.50Less additional property rent (net of tax)

$1,231 × 8% × 0.65 (64.01) (64.01)Add additional return on equity

$871 million × 13% × 0.65 74.00

Revised earnings 670.00 696.00 620.50

Number of shares in issue 1,700 1,700 1,482

Revised EPS (cents per share) 39.41 40.94 41.87



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Solution 1—Sale and Leaseback (continued)

(b) Potential effect on share priceCurrent P⁄E ratio = 400⁄39.41 = 10.15 timesThe P⁄E ratio reflects the equity market's view of a firm's growth potential. It may be reasonable to assume that a sale and leaseback scheme does not significantly distort the nature of the firm's underlying business and hence, assuming a constant P⁄E ratio, the forecast share price under each option would be: (i) 40.94 × 10.15 = 416 cents(ii) 41.87 × 10.15 = 425 centsHowever, this is a simplified view as:• moving from being the owner of property to being the tenant

may affect the firm's overall business risk, albeit in a subtle way; • under (i) there will be significant reinvestment in new non-

current assets, the business risk of which is not known; and• each option disturbs the firm's level of gearing and hence

financial risk. Option (i) leads to a fall in financial risk, which could potentially lead to an increase in the P⁄E ratio, and vice versa for (ii).

A discounted cash flow approach (i.e. FCFE or FCFF) would be needed to more accurately forecast the final share price under each option. This approach also has difficulties, however, as:• the geared cost of equity requires an estimate of the equity

beta;• the equity beta requires an estimate of the final market values

of the firm's equity and debt; and• the final value of equity is not known until the discounted cash

flow has been performed, which of course requires the estimate of the cost of equity.

Hence a circular or recursive problem emerges. This can be solved by: initially inputting a "seed value" for equity into the cost of capital

model (e.g. assuming no change in the share price); using this first estimate of the cost of cost to value the cash

flows and hence find the "output" value for equity; "reseed" the cost of capital estimate based on the output value

for equity, then revalue the cash flows to find an updated value for equity; and

continue this process until the input and output values for equity agree, at which point there is equilibrium between the cost of capital and valuation. The most efficient method is to use the "iterative" function on EXCEL.



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Session 12

Session 12 Guidance

Understand the various dividend policies a firm may adopt (s.1). Learn alternatives to cash dividends (s.1).

Dividend Policy


2. Financial strategy formulationc) Recommend appropriate distribution and retention policy.

F. Treasury and Advanced Risk Management Techniques

4. Dividend policy in multinationals and transfer pricinga) 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.

b) Advise, in the context of a specified capital investment programme, on a company's current and projected dividend capacity.



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Session 12 Guidance

DIVIDEND POLICY

DIVIDEND CAPACITY

• Estimating• Preventing

Overtrading• Legal Restrictions • Multinational

Corporations

DOMESTIC DIVIDEND POLICY

• Stable Dividend• Constant Payout Ratio• Residual Dividend Policy• Clientele Theory• Bird-in-the-Hand Theory• Dividend Irrelevance Theory• Dividend Valuation Model• Share Buyback Programmes• Special Dividends• Scrip Dividends• Zero Dividend• Practical Considerations

INTERNATIONAL DIVIDEND POLICY• Tax Planning• Blocked

Remittances

VISUAL OVERVIEWObjective: To understand theories and practical approaches to dividend policy, including dividends for a multinational organisation.

Learn how to estimate a firm's dividend capacity (i.e. maximum sustainable dividend) based on Free Cash Flow to Equity (post-reinvestment) (s.2).

Recognise that the key to international dividend policy will likely be minimisation of withholding tax and/or the maximisation of double tax relief—either may be achieved by placing an offshore "mixer company" between overseas subsidiaries and the ultimate parent (s.3).



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Session 12 • Dividend Policy P4 Advanced Financial Management


1 Domestic Dividend Policy

A parent company must decide whether group profits should be returned to investors as a dividend or retained in the business for reinvestment into new projects. Many different policies and theories are available:

1.1 Stable Dividend< Stable level of dividends or constant level of growth to avoid

sharp movements in share price.< Maintains the level of dividends in the face of fluctuating

earnings.< A common approach for quoted companies (as the financial

markets like a stable dividend profile).

1.2 Constant Payout Ratio < Constant proportion of earnings paid out as dividend.< This is not particularly suitable for quoted companies as

dividends will fluctuate (which can cause a volatile share price).

1.3 Residual Dividend Policy< Remaining earnings, after funding all attractive projects, are

paid out as dividend:< dividend = operating cash flow – interest – tax – capital

expenditure< This links to Pecking Order Theory (i.e. a dividend is only paid

if more cash is available than required for reinvestment back into the business).

< However, it is likely to lead to fluctuating dividends and may not be particularly suitable for quoted companies. Shareholders must fully understand the policy and have confidence in the investment criteria adopted by the company.

1.4 Clientele Theory< The company's historical dividend policy may have attracted

particular investors to whom the policy is suited in terms of tax, need for current income, etc.

< The company should then maintain a stable dividend policy or risk losing key investors.

< Management should view shareholders as their "clientele".

1.5 Bird-in-the-Hand Theory< Shareholders may prefer higher dividends (and therefore

lower potential capital gains) as a cash dividend today is without risk whereas future share price growth is uncertain.

< This theory can be challenged, as when a share moves from cum-div to ex-div its price falls by a certain amount (i.e. the amount of dividend).



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P4 Advanced Financial Management Session 12 • Dividend Policy

1.6 Dividend Irrelevance Theory< A firm requiring funds for investment has two choices: 1. Retain earnings (i.e. reduce dividends); or 2. Maintain dividends and raise external finance.< According to Modigliani and Miller, the choice of dividend

policy is irrelevant to the value of the company and shareholders' wealth.

< Shareholders either receive the dividend in the form of cash (if paid) or in the form of a capital gain (if retained).

< MM argue that if no dividend is paid in a particular year due to investment opportunities then the shareholders can manufacture their own "home-made" dividend either by:= selling some shares (which will now have a higher price)

while keeping the total value of their holding the same or,= borrowing by using the value of the shares as security.

< It is not dividends themselves that are irrelevant but the timing of dividends.

< The theory is based on the following perfect capital market assumptions:= Rational investors= Investors are indifferent between corporate and

personal debt= No transaction costs= No personal tax distortions

< In practice, there are likely to be distortions due to the personal tax system which may tax dividends differently than capital gains. Also, there are usually transaction costs on "manufactured" dividends.

1.7 Dividend Valuation Model

Po = D0(1 + g)

re – g =

D1re – g

where P0 = current share price D0 = most recent dividend D1 = dividend in one year g = growth rate re = required return of equity investors

< The growth rate of future dividends is a function of the retention ratio (i.e. proportion of profits reinvested) and the return on reinvested profits.

< Therefore higher dividends today will reduce the long-term growth rate, and vice versa.

< The firm should set its payout ratio in order to maximise the share price.



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1.8 Share Buyback Programmes< In recent years there has been a trend for traditional dividend

payments to be replaced by share repurchase schemes.< With approval from shareholders the company uses surplus

cash to buy back part of its share capital, on the assumption that shareholders can reinvest this cash more effectively than the company.

< The buyback can be performed either by writing directly to all shareholders with an offer to buy shares at a fixed price (a "tender offer") or by purchasing shares via the stock market at the prevailing price.

< The shares are either cancelled or held by the company as treasury shares for possible future reissue. If held by the company the shares carry no voting rights or dividend.

< The result of a buyback programme is that there will be fewer shares in issue hence ratios such as Earnings per Share (EPS) and Return on Equity (ROE) should rise.

< Share buyback programmes tend to be viewed favourably by investors for two reasons:= "Signalling" not only of company strength in generating

surplus cash but also that the directors are not prepared to gamble it in marginal projects or to waste it on extravagant executive perks.

= Buy backs are usually classified as capital gains rather than income and, in many countries, investors are taxed at a lower rate on capital gains.

1.9 Special Dividends< If a quoted company announces a larger than expected

dividend this may raise market expectations of at least the same in future.

< To avoid raising expectations to an unsustainable level the dividend may be announced as a "special" dividend—basically a bonus dividend.

< The company is telling the markets that, from time to time, any exceptional cash surplus will be returned in this way, but that this should not be built into dividend per share forecasts.

1.10 Scrip Dividends< A scrip dividend is where the company gives its shareholders a

choice of:= cash dividend; or= shares in lieu of cash.

< If shareholders choose to receive their dividend in the form of additional shares this allows the company to retain more cash in the business for reinvestment—the preferred source of finance under "pecking order theory".

< Shareholders may opt for the additional shares as a method of building their holding without incurring trading commissions.



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1.11 Zero Dividend< High growth firms may find that, in early years, all surplus

cash can be profitably reinvested back into the business—particularly if the firm lacks access to external finance.

< At some point, however, margins will fall and the firm will find fewer positive NPV projects available and hence should return cash to investors—either as a dividend or through a share buyback.

1.12 Practical Considerations< Company law—a dividend can only be legally paid if there is a

credit balance on retained earnings in the balance sheet.< Level of inflation (i.e. the need to at least maintain the

dividend in real terms).< Liquidity position (i.e. cash, rather than profits, is required to

pay a dividend).< The company must retain sufficient funds for reinvestment

purposes.< Stability of earnings—if earnings are stable, a larger dividend

can be more easily maintained.< Information content/"signalling"—capital markets tend not to

be perfect markets and in the absence of perfect information a company's dividend declaration is seen as an important signal of the future prosperity of the company.*

< Personal taxation—some shareholders prefer dividends and others capital gains.

< Transaction costs—reduce the "manufacturing" of dividends expected by MM.

*Investors can panic if dividends are cut, even if this is to fund good projects.



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Example 1 Dividends and Share Buybacks

Cloak and Dagger both operate department stores in Europe. They operate in similar markets and are generally considered to be direct competitors. Both companies have had similar earnings records over the past 10 years and have similar capital structures. The earnings and dividend record of the two companies over the past six years is as follows:

Year to 31 MarchCloak Dagger

EPS DPS Average Share Price EPS DPS Average Share Price

2006 230 60 2,100 240 96 2,200

2007 150 60 1,500 160 64 1,700

2008 100 60 1,000 90 36 1,400

2009 –125 60 800 –110 0 908

2010 100 60 1,000 90 36 1,250

2011 150 60 1,400 145 58 1,700

EPS = Earnings per share and DPS = Dividends per share. All data is stated in cents.Cloak has had 25 million shares in issue for the past six years. Dagger currently has 25 million shares in issue. At the beginning of 2010 Dagger had a 1 for 4 rights issue.The Chairman of Cloak is concerned that the share price of Dagger is higher than his company's despite the fact that Cloak has recently earned more per share than Dagger and frequently during the past six years has paid a higher dividend.

Required:(a) Discuss: (i) the apparent dividend policy followed by each company over the past six years

and comment on the possible relationship of these policies to the companies' market values and current share prices, and

(ii) whether there is an optimal dividend policy for Cloak that might increase shareholder value.

(b) Forecast earnings for Cloak for the year to 31 March 2012 are $40 million. At present, it has excess cash of $2.5 million and is considering a share repurchase in addition to maintaining last year's dividend. The Chairman thinks this will have a number of benefits for the company, including a positive effect on the share price.

Advise the Chairman of Cloak: (i) how a share repurchase may be arranged; (ii) the main reasons for a share repurchase; (iii) the potential problems of such an action, compared with a one-off special

dividend payment, and any possible effect on Cloak's share price.



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Example 1 Dividends and Share Buybacks (continued)

Solution

(a) (i) Apparent dividend policy

(ii) Optimal dividend policy



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Example 1 Dividends and Share Buybacks (continued)

Solution

(b) (i) Share repurchase arrangements

(ii) Main reasons for repurchase

(iii) Potential problems



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2 Dividend Capacity

2.1 Estimating Dividend Capacity

2.1.1 From Cash Flow Data

< Dividend capacity is determined by the Free Cash Flow to Equity (FCFE) after net reinvestment.

< Reinvestment is required to maintain the operating capacity of the business at the rate of growth necessary to achieve the firm's strategic goals.

< External finance raised during the year is deducted from the capital expenditure figure to show the amount of investment financed from the free cash flow.

< From the statement of cash flows the following can be identified:

FCFE (pre-reinvestment) = operating cash flow – interest paid – tax paid

Net reinvestment = capital expenditure – new finance raised

FCFE (post-reinvestment) = FCFE (pre-reinvestment) – net reinvestment

= dividend capacity

2.1.2 From Net Income

< If cash flow data is not directly available then FCFE (post-reinvestment)/dividend capacity can be found by starting with the firm's net income figure and making the following adjustments:Net income

– (capital expenditure – depreciation)

– (change in non-cash working capital)

+ (new debt issued – debt repayments)

= FCFE (post-reinvestment)



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Illustration 1 From Net Income to Dividend Capacity

The following table shows the year-by-year calculation of Home Depot's (a large US retailer) dividend capacity (all figures in $m).

YearNet

Income Depreciation CAPEX

Changein non-cash

WCNet

debt issued FCFE 1 $111.95 $21.12 $190.24 $6.20 $181.88 $118.51

2 $163.43 $34.36 $398.11 $10.41 $228.43 $17.70

3 $249.15 $52.28 $431.66 $47.14 –$1.94 ($179.31)

4 $362.86 $69.54 $432.51 $93.08 $802.87 $709.68

5 $457.40 $89.84 $864.16 $153.19 –$2.01 ($472.12)

6 $604.50 $129.61 $1,100.65 $205.29 $97.83 ($474.00)

7 $731.52 $181.21 $1,278.10 $247.38 $497.18 ($115.57)

8 $937.74 $232.34 $1,194.42 $124.25 $470.24 $321.65

9 $1,160.00 $283.00 $1,481.00 $391.00 –$25.00 ($454.00)

10 $1,615.00 $373.00 $2,059.00 $131.00 $238.00 $36.00

Average $639.36 $146.63 $942.99 $140.89 $248.75 ($49.15)

Home Depot had negative free cash flows to equity in 5 of the 10 years, largely as a consequence of significant capital expenditures. The average net debt issued during the period was $248.75 million and the average net capital expenditure and working capital requirements amounted to $937.25 million ($942.99 – 146.63 +140.89) resulting in a debt ratio of 26.54% ($248.75/$937.25).

From Net Income to Dividend Capacity

2.2 Restricting Dividends to Prevent Overtrading< If a business is expanding rapidly and at risk of overtrading it

may be wise to restrict the dividend to ensure the growth can be financed.

< Reduction in dividend = unfunded days/365 × cash cost of sales= Unfunded days = receivables days + inventory days −

payables days= Cash cost of sales = cost of sales − depreciation expense

Ratio analysis is not mentioned in the syllabus as a separate topic but the examiner will assume that candidates are able to calculate and interpret all commonly used ratios.



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Example 2 Dividend Capacity

Statement of profit or loss

For the year ended 31 December 20X8(projected) 20X7

$m $m

Revenue 288 262

Cost of sales 143 133

Gross profit 145 129

less other operating costs 36 27

Operating profit 109 102

Finance costs 2 2

Profit before tax 107 100

Income tax expense (at 30%) 32 30

Profit for the period 75 70

Statement of financial position

As at 31 December 20X8(projected) 20X7

$m $m

Non-current assets (see note)

Buildings, plant and machinery 168 116

Current assets

Inventories 3 4

Receivables 26 29

Cash 152 156

Total current assets 181 189

Total assets 349 305



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Example 2 Dividend Capacity (continued)

As at 31 December 20X8(projected) 20X7

$m $mEquity and liabilitiesPaid up share capital Ordinary shares (25c) 25 25 Other reserves 12 12 Retained earnings 217 170 less dividends payable 0 –28

217 142Total equity 254 179Current liabilities Trade payables 9 8 Tax payable 28 26 Dividends payable 0 28 Interest payable 2 2Total current liabilities 39 64Non-current liabilities Loans 35 45 Provisions (deferred tax) 21 17Total non-current liabilities 56 62Total liabilities 95 126Total equity and liabilities 349 305

Note 20X8 20X7

$m $mNon-current assets 280 200less accumulated depreciation 112 84Net book value of non-current assets 168 116

The projected figures assume:(i) $10 million of the existing loans will be repaid during the year.(ii) Capital investment in plant and equipment of $80 million will be undertaken.

Required:(a) Prepare a cash flow forecast for the year ended 31 December 20X8.(b) Estimate the company’s maximum dividend capacity after the target

level of capital reinvestment is undertaken and making any working capital adjustments you deem necessary.



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Example 2 Dividend Capacity (continued)

Solution(a) Cash flow forecast

Operating profit

Add depreciation

Add change in:

trade payables

trade receivables

inventories

Operating cash flow

less interest

less taxation

Free cash flow before reinvestment

CAPEX

Dividend paid

Repayment of loan

Net cash change

(b) Maximum dividend capacity

(i) FCF before reinvestment

(ii) CAPEX

(iii) Repayment of loan

Dividend capacity (before expansion of working capital requirements)



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2.3 Legal Restrictions on Use of Dividend Capacity

A dividend may only be paid out of "profits available for distribution" as determined by local legislation.

Typically companies may only distribute accumulated realised profits. This means that a company may pay a dividend in periods in which it has made a loss as long as it has made sufficient profit in earlier periods to absorb this loss and leave a credit balance of retained earnings.

There is no single definition of realised profit. Usually a transaction is deemed to be realised when it results in a transfer of economic benefit (usually cash) or is reasonably certain to result in such a transfer. If IFRS allows profit to be taken to profit or loss it is usually realised.

Depending on local legislation it may, in specific circumstances, be permitted to write-off a brought-forward debit balance on retained earnings. For example, as part of a capital reconstruction scheme (the write off would go to a reconstruction reserve in equity). This would allow a firm with brought forward losses to quickly resume the payment of dividends once it moves back into profitability. The ability to resume dividends may be essential in attracting new equity finance.

An alternative use of dividend capacity is to finance the purchase of the firm's own shares (i.e. a buyback programme). Local legislation will apply but, like a dividend, it is usually only permitted if sufficient realised profits exist.

Furthermore, in the case of a share buyback, there may also be a legal requirement to make a transfer from distributable reserves to a non-distributable reserve known as a "capital redemption reserve". This is to protect creditors from the firm making excessive dividend payments following a share buyback (i.e. it maintains the "creditors' buffer").



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2.4 Multinational CorporationsIn additional to its domestic dividend capacity a company with overseas operations would expect to have additional dividend capacity generated by its foreign subsidiaries.

This raises various specific issues:

< What proportion of profits should overseas subsidiaries remit to the parent company?

< Do host governments place any restrictions on remittances out of their countries?

< If the local currency is not a "hard" currency are there any restrictions on its convertibility?

< Does the parent company's government tax only dividends received from overseas subsidiaries or the underlying profits of the subsidiaries?

< Do bilateral tax treaties exist to allow relief from double taxation?

Due to these issues the parent company may consider various strategies to maximise the dividend capacity generated by its overseas subsidiaries:*< methods of dealing with blocked remittances (e.g.

management fees, licence fees, royalty payments);< political lobbying to obtain rights to convert overseas earnings

into hard currency;< use of transfer pricing to move profits from subsidiaries in high

tax jurisdictions to those in low tax jurisdictions;< use of a "dividend mixer company" to first collect dividends

from overseas subsidiaries before paying them as a single dividend to the parent. If done legally this can increase claims for double tax relief;

< transfer of overseas assets into offshore entities in tax havens. If done legally this can shelter overseas assets from capital gains tax on disposal.

*The ethical implications of each of the strategies should be thoroughly considered.



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Example 3 Transfer Pricing and Global Dividend Capacity

Jalfrezi Inc is expecting revenues to grow to $80 million next year, which is an increase of 20% from the current year. The operating margin for next year is forecast to be the same as this year at 30%. In addition to these profits, Jalfrezi Inc receives 75% of the post-tax profits from one of its overseas subsidiaries, Pathia Co, as dividends. However, its second overseas subsidiary, Korai Co, does not pay dividends.For the coming year it is expected that Jalfrezi will require the following reinvestment:(1) An investment equivalent to the amount of depreciation to keep its non-

current asset base at the present productive capacity. Depreciation is 25% straight-line on its non-current assets of $15 million.

(2) A 25% investment in additional non-current assets for every $1 increase in sales revenue.

(3) $4.5 million additional investment in non-current assets for a special project.(4) 15% investment in working capital for every $1 increase in sales revenue.Korai produces components for Pathia to assemble into finished goods. Korai will produce 300,000 specialist components at $12 variable cost per unit and incur fixed costs of $2·1 million for the coming year. It will then transfer the components at full cost to Pathia, where they will be assembled at a cost of $8 per unit and sold for $50 per unit. Pathia will incur additional fixed costs of $1.5 million in the assembly process.

Other information(1) Jalfrezi has outstanding non-current liabilities of $35 million, on which it pays

interest of 8% per year. (2) Jalfrezi's, Korai's and Pathia's profits are taxed at 28%, 42% and 22%

respectively. The tax authorities where Jalfrezi is based charge tax on profits made by subsidiary companies but give full credit for tax already paid by overseas subsidiaries.

Required:Forecast Jalfrezi Inc's dividend capacity for the coming year.



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Example 3 Transfer Pricing and Global Dividend Capacity (continued)

Solution

$000

Workings



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Example 4 Dividend Capacity With Debt Redemption

Following on from Example 3. In subsequent years Jalfrezi Inc's revenues will grow at 5% per annum. All other data as before except no further special projects are planned and half of the firm's debt will be redeemed at the end of the second subsequent year.Required:Forecast Jalfrezi Inc's dividend capacity for the following three years.

Solution

Year 1 Year 2 Year 3

$000 $000 $000

Dividend capacity

3 International Dividend Policy

3.1 Tax Planning< If the parent company has a subsidiary located overseas then

it must consider the tax cost of repatriating profits in the form of a dividend.

< Assuming that the subsidiary has not been established in a "tax haven" its profits will be subject to local corporate tax. In addition, on payment of a dividend, it may also have to deduct withholding tax.

< Under double tax treaties the parent receiving the dividend will usually be entitled to offset the tax paid overseas against its eventual tax liability on the dividend.

< However there may be limited or even no liability in the hands of the parent, either because the dividend is not treated as taxable income in the parent's country, or because the parent has tax allowable deductions which reduce the taxable amount.



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< Therefore the group may suffer overseas tax that cannot be recovered.

< A possible solution to this problem is to establish an offshore sub-holding company between overseas subsidiaries and the ultimate parent. This can in fact lead to three potential tax benefits:

Increased double tax relief—the use of an offshore "mixer" company can increase credits for double tax relief by combining dividends from high and low taxed subsidiaries before they are paid up to the parent.

Capital gains tax protection—if the holding company is established in an appropriate jurisdiction any gains on the sale of the subsidiary may avoid tax.

Withholding tax minimisation—in certain cases the careful use of an offshore holding company can reduce the withholding tax burden compared to direct repatriation of income from the subsidiary to parent.

3.2 Management of Blocked RemittancesIf a multinational company finds that remittances are blocked, it may have to consider other methods of transferring profit from the overseas subsidiary to the parent company.

< Manipulation of transfer prices for goods or services supplied by the parent to the subsidiary. However, either the host country and⁄or the parent's jurisdiction may require the transfer price to be set at "arm's length" which may limit the amount of profit that can be extracted using this method.*

< Charging management fees from the parent company to the subsidiary. This may be easier to justify in the early years of investment but more difficult in later years if local managers have replaced expatriates.

< Royalty payments or licence fees for the use of patents or intellectual capital owned by the parent. This method can be particularly flexible in the "new economy" where fees for human capital are more subjective than for physical goods.

< Financing the overseas subsidiary with loans from the parent company and hence extracting profits in the form of interest as opposed to dividends.

However, each of the above methods must be carefully reviewed before implementation for their potential to expose the firm to:

< Reputational risk: Ethical investors may dump the parent company's shares if it is suspected of circumventing overseas regulations. Furthermore, consumers may boycott its products.

< Political risk: The host government may react aggressively to schemes and potentially appropriate its assets.

*Members of the OECD require transfer prices to be set at arm's length.



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< Dividend policy is of course closely linked to financing and investing strategy. If company managers follow Pecking Order Theory they are likely to view the dividend as the residual cash available after financing all positive NPV projects. However, this may lead to a volatile dividend which can cause practical problems for a listed company. It may be better to use the surplus for a share buyback programme.

< International groups also have to make decisions about the level of dividends paid by subsidiaries to the parent. This may be affected by overseas government policy which may restrict the payment of dividends to a foreign parent or impose high withholding taxes.

Summary



Q29 Pavlon 40 minutes

Additional

Q30 TYR


1. Define "residual dividend policy". (1.3)

2. Explain how Modigliani and Miller argue that the pattern of dividends is irrelevant. (1.6)

3. State why share buyback programmes tend to be viewed positively by investors. (1.8)

4. Define a "special dividend". (1.9)

5. State why a zero dividend company is not likely to continue such a policy to perpetuity. (1.11)

6. Define dividend capacity. (2.1)

7. State the potential tax benefits of establishing an offshore entity between overseas subsidiaries and the ultimate parent. (3.1)

8. State methods of circumventing a government block on the payment of dividends to an overseas parent. (3.2)



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Session 12

(a) (i) Apparent dividend policyCloak has followed a policy of paying a fixed dividend per share each year, of 60 cents per share, regardless of the profits earned that year. Thus the dividend was paid, even in a year when the company reported losses.Dagger has followed a policy of varying the size of the dividend per share each year, depending on the level of profits earned in that year. No dividend is paid in a year when losses are reported.Draw up a table of the companies' payout percentages and P/E ratios at each year-end:

Cloak DaggerPayout % P/E ratio Payout % P/E ratio

2006 26 9.1 40 9.22007 40 10.0 40 10.62008 60 10.0 40 15.62009 N/A N/A N/A N/A2010 60 10.0 40 13.92011 40 9.3 40 11.7

It can be seen that Dagger is following a consistent policy of paying out 40% of each year's profits as dividend and retaining the balance of 60%.Cloak's policy of paying a fixed dividend, even if losses are being made, will mean that fewer profits are retained in the business in a poor period, leading to less investment for the future. It is this lack of investment that has probably worried the stock market and led to the lower P/E ratio being placed on Cloak's shares.However the extreme volatility in dividend levels resulting from Dagger's chosen policy will also upset the stock market, unless the market is totally informed about what is going on.The Chairman of Cloak is right to be concerned that the share price of Dagger is higher than the share price of Cloak, though wrong if he explains this as due to the two companies' dividend policies. It is more likely that Dagger has a better business strategy that the market believes will produce higher future profits than Cloak.

(ii) Optimal dividend policyAcademic theory suggests that there is no such thing as an "optimal" dividend policy. Modigliani and Miller proposed a dividend irrelevance theory, asserting that the share price was independent of dividend policy. The share price constituted the present value of future cash earnings of the company, which is not dependent on the pattern in which the earnings are distributed to shareholders.However Modigliani and Miller's theory depends on certain unrealistic assumptions:• perfectly efficient markets, with no transaction costs;• no personal tax difference between income and capital gains;• perfectly rational investors.Given the ideal nature of these assumptions, the theory can be challenged as to its validity in the real world. In practice it is best if the "signalling" nature of dividends is recognised (i.e. the directors can signal their opinion on the company's prospects by reducing or increasing the dividend level). Neither Cloak nor Dagger is able to give signalling information to the market, by the very nature of their dividend policy.Each company can state that they have chosen a policy and are sticking with it, so that they should attract a particular "clientele" of shareholders who like the sort of policy that the company has chosen, but it lacks signalling information about the future.In practice, most quoted company boards of directors try to pay a slightly larger dividend per share each year, regardless of the profits earned. The annual dividend will be higher if the directors wish to signal increased confidence. If prospects are poorer the directors try to avoid cutting the dividend per share.Cloak should adopt such a "ratchet" system in the attempt to increase its value. The directors should announce to the market that they will increase the dividend per share by at least the inflation rate.

Solution 1—Dividends and Share Buybacks

EXAMPLE SOLUTIONS



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Solution 1—Dividends and Share Buybacks (continued)

(b) (i) Share repurchase arrangementsA share repurchase may be arranged by any of the following methods:• purchase of the company's own shares on the stock market;• by arrangement with large shareholders;• by an offer to all shareholders.It is not stated whether or not Cloak is quoted on a stock market, though this seems likely. Cloak can purchase its own shares (an "on-market" transaction) and then cancel the shares.Alternatively Cloak can carry out an "off-market" transaction and buy its shares directly from large shareholders (normally investment institutions such as pension funds). This is often the quickest and most convenient way of buying one's own shares.The final possibility is to make a tender offer to all shareholders. This enables all shareholders to participate in the transaction, but will be complicated and expensive to carry out.(ii) Main reasons for repurchaseThere are a variety of reasons why a share repurchase may be carried out:• reducing the number of shares in issue should increase the earnings per share, thus

hopefully increasing the share price and shareholders' wealth• reducing the number of shares in issue will increase the gearing ratio, possibly reducing the

weighted average cost of capital since there is less equity to have to service• to return surplus cash to shareholders • to reduce the cash cost of future dividends. Since there will be fewer shares in issue,

future dividends per share can perhaps be increased, which again should please the remaining shareholders.

(iii) Potential problems• In practice, a share repurchase can be thought of by the market as signifying a lack of

imagination on the part of management. Ambitious managements should be seeking out positive-NPV investments and investing in those.

• There may also be tax disadvantages to the shareholders giving up their shares, who may have to pay capital gains tax on this disposal.

• It may be difficult to decide on an appropriate price to pay. Continuing shareholders will want the lowest possible price paid, while those shareholders giving up their shares will want the highest possible price paid.

Share repurchase compared with a one-off extra dividend:Cloak has excess cash of $2.5m which it is considering returning to shareholders. There are 25m shares in issue, so the company could pay a one-off special dividend of 10c to each shareholder, on top of the 60c due to be paid.Alternatively $2.5m market value of shares could be repurchased. The forecast earnings of $40m equate to $1.60 per share. At the latest P/E ratio of 9.3 a share price of $14.88 per share is expected. Since shareholders must be given some incentive to sell, suppose the company offers to buy shares at $15.Therefore 2.5m ÷ 15 = 166,667 shares will be repurchased and cancelledThis leaves 25m – 166,667 = 24,833,333 shares still in issueNew EPS = 40m ÷ 24.833m = $1.61 per shareNew share price = 9.3 × $1.61 = $14.98These calculations show how, in an efficient market, a shareholder should be indifferent between a one-off dividend and a share repurchase. Either a special dividend of 10c per share is paid by Cloak, or else a share repurchase is carried out and the share price will increase by 10c per share.In a world of no tax differentials and efficient pricing the results are valid. In practice there is no guarantee that the P/E ratio will remain unchanged after the share repurchase is announced. There is therefore less risk to shareholders associated with the one-off dividend than with the share repurchase.



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*The format of a cash flow forecast as opposed to a cash flow statement does not need to comply with accounting standards.

*See Session 19 for revision of ratio analysis.

Solution 2—Dividend Capacity*

(a) Cash flow forecast

$000Operating profit 109Add depreciation 28

137Add change in: trade payables 1 trade receivables 3 inventories 1Operating cash flow 142less interest (2)less taxation (26)Free cash flow before reinvestment 114CAPEX (80)Dividend paid (28)Repayment of loan (10)Net cash change (4)

(b) Maximum dividend capacity

Free cash flow before reinvestment 114CAPEX (80)Repayment of loan (10)Dividend capacity (before expansion of working capital requirements) 24.00

Inventory days = 3

143 x 365 = 8 days

Receivables days = 26288 x 365 = 33 days

Payables days = 9

143 x 365 = 23 days

Working capital cycle = 8 + 33 – 23 = 18 days

Cash cost of sales = 143 – 28 = 115

18 days of cost of sales is unfunded which implies that (18/365 × 115) = $5·67 million of extra capital would be required to finance the working capital cycle.This reduces the dividend capacity to $24m – $5.67m = $18.33 million.Given the actual dividend is $28 million this implies that the firm has over-distributed given its free cash generation during the year and its necessary reinvestment.



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$000Revenues 80,000Operating profit* (30% × $80,000,000 revenues) 24,000Less: Interest (8% × $35,000,000) (2,800) Taxation (28% × (24,000 – 2,800)) (5,936) Investment in working capital

(15% × (80,000 – 66, 667(W1))) (2,000) Investment in additional non-current assets

(25% × (80,000 – 66, 667)) (3,333) Investment in special project (4,500)Cash flows from domestic operations 5,431Cash flows from overseas dividend remittances (W2) 3,159Additional tax payable on Pathia's profits (6% × 5,400) (324)Dividend capacity 8,266

Workings

(1) Prior year revenues 80,000/1.2 = 66,667(2) Overseas dividend remittance

Korai Pathia$000 $000

Sales revenue 5,700 15,000CostVariable (3,600) (2,400)Fixed (2,100) (1,500)Transfer (5,700)Profit before tax Nil 5,400Tax Nil 1,188Profit after tax Nil 4,212Remitted Nil 3,159Retained Nil 1,053

*The impact of depreciation is neutral, as this amount will be spent to retain assets at their current productive capability.

Solution 3—Transfer Pricing and Global Dividend Capacity



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Solution 4—Dividend Capacity With Debt Redemption

Year 1 Year 2 Year 3$000 $000 $000

Revenues (80,000 × 1.05) 84,000 88,200 92,610Operating profit (30% × 84,000) 25,200 26,460 27,783Less: Interest (8% × 35,000) (2,800) (2,800) (1,400) Taxation (28% × (25,200 – 2,800)) (6,272) (6,625) (7,387) Investment in working capital

(15% × (84,000 – 80,000)) (600) (630) (662) Investment in additional non-current assets

(25% × (84,000 – 80,000)) (1,000) (1,050) (1,103)Redemption of debt (50% × 35,000) (17,500)Cash flows from: Domestic operations 14,528 (2,128) 17,231 Overseas dividend remittances 3,159 3,159 3,159Additional tax payable on Pathia's profits (324) (324) (324)Dividend capacity 17,363 707 20,066



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Session 13

Session 13 Guidance

Learn options terminology: puts, calls, expiry date, exercise price, etc (s.1). Recognise the factors which drive option value; intrinsic value and time value (s.2). Understand the "basic" Black-Scholes model designed for valuing European style call options (e.g. a firm's employee share option plan) including the adjustments required when the underlying security pays a dividend (s.3).


2. Application of option pricing theory in investment decisionsa) 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

b) Evaluate embedded real options within a project, classifying them into one of the real option archetypes.

c) Assess, calculate and advise on the value of options to delay, expand, redeploy and withdraw using the BSOP model.

4. Valuation and the use of free cash flowsd) Explain the use of the BSOP model to estimate the value of equity of an

organisation and discuss the implications of the model for a change in value of equity.

e) Explain the role of BSOP model in the assessment of default risk, the value of debt and its potential recoverability.


1. The role of the treasury function in multinationalsb) Discuss the operations of the derivatives market, including:

iv) Risks such as delta, gamma, vega, rho and theta, and how these can be managed.

Options



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Session 13 Guidance

VISUAL OVERVIEWObjective: To understand and value options, and discuss how various factors influence option value.

Understand application of the model to valuing "real options" that may be embedded within company projects (s.5).

Learn to use the Black-Scholes model to value a firm's equity and its debt (s.5, s.6). Read the article "Application of option pricing to valuation of firms".

NATURE AND USES OF OPTIONS• Terminology• Exchange Traded Options• OTC Options• Uses• Protective Put• Options Collar

ELEMENTS OF OPTION VALUE• Definitions• Intrinsic Value• Time Value• Summary

BLACK-SCHOLES MODEL• Formulae• Assumptions and Limitations• Put-Call Parity• Dividend-Paying Shares

SENSITIVITY OF OPTION PRICES

• Delta• Delta Hedging• Gamma• Theta• Vega• Rho• Summary of the

Greeks

REAL OPTIONS• Approach• Archetypes• Limitations• Application to

Intangible Assets

MERTON'S MODELS• Valuing Equity as

an Option• Structural Debt

Model• Credit Derivatives



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Session 13 • Options P4 Advanced Financial Management


1 Nature and Uses of Options

1.1 TerminologyOption: a contract giving one party the right, but not the obligation, to buy or sell an underlying asset at an agreed price, on or before a specified date (expiry date). The purchaser/holder of the option can either exercise their right or let it lapse (i.e. not exercise).

Call option: option which gives its holder the right to buy the underlying asset.

Put option: option which gives its holder the right to sell the underlying asset.

Exercise price/strike price: the price at which the underlying asset can be bought or sold when exercising the option.

Premium: the amount the purchaser of the option must pay to buy the option. It is also referred to as the price of the option—not to be confused with the exercise price. In a perfect market, it should represent the value of the option.

Writer: the seller of an option who receives the premium.

European-style options: options which can only be exercised on the expiry date.

American/US-style options: options which can be exercised at any time up to and on the expiry date.

Mid-Atlantic/Bermuda options: options which can be exercised on any one of a pre-set series of dates.

1.2 Exchange Traded Options< In London, options are traded on the London International

Financial Futures and Options Exchange (LIFFE). The basic features are: bought and sold on a recognised exchange; price transparency (i.e. quoted premium should represent fair value); can be easily resold during their lifetime before expiry. only available in standardised contract sizes; available on a limited number of underlying assets; limited number of exercise prices and expiry dates; only available with expiry dates of up to one year ahead; obtained via a broker who will charge a commission.

1.3 Over the Counter (OTC) Options< These are available from banks via individual negotiation. The

basic features are: option can be tailored to the purchaser's specific requirements; option can be for any size, exercise price, expiry date etc; expiry date can be any time up to five years ahead. usually not transferable/non-negotiable (i.e. cannot be resold).



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P4 Advanced Financial Management Session 13 • Options

1.4 Uses of Options< An option gives the purchaser the right to buy or sell an

underlying asset. Once the option has been purchased and the premium paid, there are then two possible outcomes:= the option is later exercised if it is "in the money" and a

gain is made (minus the cost of the premium); or= the option is allowed to lapse because it would not be

profitable to exercise it ("out of the money"). The only loss incurred by the option holder is the premium paid.

< Options can be used for either speculation or hedging.< Consider a portfolio manager who holds shares in a particular

company and fears a price fall in the near future but does not wish to dispose of the holding due to the voting rights. Possible hedges include:

1.5 Protective Put< A simple hedge would be to buy puts with a strike price at

today's share price ("at the money"). < If the share price falls:

= there will be a loss on the shareholding;= the puts will move "into the money" and can be exercised to

take a gain;= the gain on exercising the puts should equal the loss on

the share, but there will still be an overall loss due to the premium paid to set up the hedge.

< If the share price rises:= there will be a gain on the shareholding;= the puts will move "out of the money" and will lapse;= the premium paid will not be refunded and hence reduces

the gain on the shareholding.< The hedge above is known as a "protective put". However, the

manager may consider the cost of the hedge to be too high in terms of the premium paid. To reduce the cost of the hedge, a more complex strategy could be used (e.g. a "collar").

1.6 Options Collar< This would involve simultaneously buying puts and selling

calls. To some degree, the premium received from selling calls will offset the premium paid from buying puts, hence reducing the cost of establishing the hedge.

< If the share price falls:= a loss is made on the shareholding;= a gain is made by exercising the puts;= there will still be an overall loss equal to the net premium

paid.< If the share price rises:

= a gain is made on the shareholding;= the person who bought the calls from the portfolio manager

will exercise them against him—creating a loss on the calls;= there will still be an overall loss equal to the net premium paid.

The focus in the exam is likely to be on hedging (i.e. managing risk) rather than on taking risk.



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2 Elements of Option Value

2.1 Definitions

In the money—< a call option is in the money if the current market price of the

underlying asset is above the exercise price< a put option is in the money if the current market price of the

underlying asset is below the exercise price Out of the money—< a call option is out of the money if the current market price of the

underlying asset is below the exercise price< a put option is out of the money if the current market of the

underlying asset is above the exercise priceAt the money—< a call or a put option is described as at the money if the current

market price of the underlying asset is the same as the exercise price.

Illustration 1 Marks & Spencer

Extract from LIFFE equity options prices on 4 February

Calls Puts

Apr Jul Oct Apr Jul Oct

M&S 460 40 45½ 52½ 6 10½ 13½

(490) 500 15½ 22 31½ 21 28½ 31½

Each option contract is to buy (call) or sell (put) 1,000 Marks & Spencer's shares at an exercise price of either 460 pence per share or 500 pence per share. The option can be exercised before the end of April, July or October depending on which expiry date is selected (traded options are usually American style).The figures below the month columns are the premiums (i.e. the cost of buying each option).The price in brackets, 490 pence, is the market price of a M&S share on 4 February.

Marks & Spencer



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Example 1 In or Out of the Money

Using the information from the illustration above, answer the following:(a) Is a July call option at an exercise price of 500 pence in or out of the money?(b) Is an April put option at an exercise price of 460 pence in or out of the money?(c) Is an October call option at an exercise price of 460 pence in or out of the money?

Solution(a) July call option @ 500 pence

(b) April put option @ 460 pence

(c) October call option @ 460 pence

2.2 Intrinsic Value of an Option

Intrinsic value—an option's basic or fundamental price or value. It is the profit that a purchaser could make if the option were exercised immediately.

< An option will only have an intrinsic value if it is in the money. If it is out of the money, the intrinsic value is zero as it would not be exercised (i.e. the intrinsic value cannot be negative).

Example 2 Intrinsic Value

Using the Marks & Spencer traded option prices from Illustration 1, what is the intrinsic value of the following options:(a) A July call option at an exercise price of: (i) 460 pence; (ii) 500 pence.(b) An October put option at an exercise price of: (i) 460 pence; (ii) 500 pence.Solution(a) (i) July call option @ 460 pence. Intrinsic value =

(ii) July call option @ 500 pence. Intrinsic value =

(b) (i) October put option @ 460 pence. Intrinsic value =

(ii) October call option @ 500 pence. Intrinsic value =



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2.3 Time Value of an Option

Total value of an option (i.e. premium = intrinsic value + time value)The time value of an option is therefore the difference between the premium and the intrinsic value.

< The intrinsic value of the option was based on the assumption that the option would be exercised or lapse today. However, if there is still time until the expiry of the option then it will have a higher total value than its intrinsic value because:= value is placed upon the possibility that the option will

become worth exercising, or more worthwhile, between now and the expiry date; and

= the purchase of a call option is effectively a form of borrowing for which there is an interest cost which is part of the cost of the option.

Example 3 Time Value

Using the information from Illustration 1, determine the time value of a Marks & Spencer call option at a price of 460 pence for April, July and October

Solution

April call =

July call =

October call =

2.3.1 Components of Time Value

There are three components of the time value:

1. time to expiry;

2. expected volatility of the underlying asset; and

3. the level of interest rates.

2.3.2 Time to Expiry

< The longer the period to expiry of the option the higher the time value of the option.

< The longer the period to expiry, the greater the chance of the option moving into the money and therefore profitable to exercise.

2.3.3 Volatility of Underlying Asset

< If the price of the underlying asset (e.g. share price) is expected to be highly volatile then the value of the option rises.

< This is because there is a greater chance of a "price spike" in the underlying asset, which could move the option deep into the money and lead to a large profit upon exercise.



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2.3.4 Level of Interest Rates

< If a call option is purchased, then only a small proportion of the total price of the underlying asset needs be paid immediately in the form of the premium. The remainder (i.e. the exercise price) will be paid if and when the option is exercised. This is similar to buying the underlying asset on credit.

< Therefore the higher the level of interest rates the higher will be the value of the call option.

< The opposite applies to put options—the owner of a put has to wait until the expiry date (if European style) before receiving the exercise price. If interest rates rise then the present value of the exercise price falls and with it the value of the put option.

< N(d2) represents the probability that the shareholders' call option will be "in the money" on its expiry date, in which case the value of assets would exceed the redemption price of debt. Therefore 1 − N(d2) measures the probability that the value of assets will not cover the repayment of debt in which case there would be default. Hence 1 − N(d2) estimates the probability of default.

2.4 Summary of Factors Affecting Option Prices

Increase in Price of Call Price of Put

Exercise price Decreases Increases

Price of underlying asset Increases Decreases

Volatility Increases Increases

Time to expiry Increases Increases

Interest rate Increases Decreases



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3 Black-Scholes Options Pricing Model

3.1 Formulae< In 1973, Fischer Black and Myron Scholes took the elements

of options value (intrinsic value and time value) and formed them into an equation to find the theoretical price of an option.

< The formula for the value of a European call option is:c = PaN(d1) – PeN(d2)e-rt

Where: d1 = ln (P /P ) r 0.5s t

s ta e

2+ +( )

d2 = d1 – s t c = price of call option Pa = current price of the underlying asset N(d1) = probability that a normal distribution is less than

d1 standard deviations above the mean N(d2) = the probability that the option will be exercised Pe = exercise price/strike price r = annual risk free interest rate t = time to expiry (in years) s = annual standard deviation of the underlying

asset's returns e = the exponential constant ln = the natural log (log to the base e)

3.2 Assumptions and Limitations of the Model

3.2.1 Assumptions

< No dividend is payable on the share during the life of the option (although the model can be easily adjusted to deal with dividends).*

< The option is a European call option (i.e. can be exercised on expiry date but not before).

< Returns from the underlying asset follow the normal distribution.

< A risk-free asset exists.< Perfect markets (e.g. no transactions costs , freely available

information, rational investors).

The formulae and normal distribution tables are given in the exam. However, you must still learn the definitions of the terms and remember to bring a scientific calculator.

*The share price would fall when it moves from cum-div to ex-div.



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3.2.2 Limitations of Black-Scholes Model

< Theoretically, the forecast volatility of returns should be input but, in practice, the historical standard deviation of returns may have to be used. History may repeat itself.*

< Research has shown that returns from major stock markets do not approximate the standard normal distribution. In practice it appears that the true distribution exhibits "fat tails" (i.e. extreme events—large market falls⁄rises—occur more often than predicted by the normal distribution).

< A true risk-free asset does not exist in any economy. Even Treasury bills carry some risk in terms of reinvestment risk (after 90 days the principal must be reinvested at uncertain future yields).

< In practice many options, particularly OTC options, are American-style (i.e. can be exercised at any time until expiry). However the holder of an American option would not usually choose to exercise it early as the time value would be sacrificed (it would be better to resell the option) and hence American options actually tend to behave like European options, in which case Black-Scholes is still reasonably accurate.

Example 4 Black-Scholes

The current share price of Cesar is $14. A European at-the-money call option on the share has one year to run before it expires. The risk-free rate is 10%, and the standard deviation of the rate of return on the share has been 20%.Required:(a) Calculate the price of the call option.Solution

d1 =

d2 =

N(d1) =

N(d2) =

Option price =

*From 2000 to 2007, market volatility had been relatively low and many investors expected this to continue. Actual volatility from 2008 onward has been much higher.



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3.3 Put-Call ParityThe basic Black-Scholes model gives the price of a call option. To find the price of a put option a formula known as "put-call parity" (which will be also provided in the exam) is needed:

p = c – Pa + Pee-rt

Price of a put (p) = price of a call – price of the underlying asset + present value of the exercise price (Pee-rt).*

*The present value of the exercise price is calculated using a technical method of discounting known as "continuous discounting".

Example 5 Put-Call Parity

Using the data from Example 4, estimate the value of a European at-the-money put option with one year to run before it expires.SolutionP =

3.4 Options on Dividend-Paying Shares< If a dividend will be paid between today and the exercise date

of the option then, everything else being equal, the underlying share price will fall. This is because when a dividend is paid the firm's net assets falls and with it the market value of each share.

< Before inputting Pa into the Black-Scholes model, the current price of the share must be adjusted to reflect the expected fall upon payment of the dividend:

Pa = current share price – present value of dividend (dividend × e-rt)

< Another way to conceptualise this adjustment is to compare buying an option with simply buying the underlying share and holding it until the option's expiry date; the share price is paid today, but "cash back" is received later in the form of a dividend. Hence the net price paid for the share is the current price less the present value of the next dividend.

< Note that the present value of the dividend is calculated using a continuous discount factor (e-rt) rather than the discrete discount factors published in the tables. This is to be consistent with the way in which the Black-Scholes model discounts the strike price of the option and is based on the assumption that the returns from the underlying asset are generated in a continuous manner.



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Example 6 Option On Dividend-Paying Share

Stern Bear is proposing the introduction of an ESOP (Employee Share Option Plan). Employees will be offered options to purchase shares in Stern Bear at a price of 500 cents per share after the options have been held for one year. The company's shares have just become ex-div and have a current market price of 610 cents. The dividend paid was 25 cents per share, a level that has remained constant for the last three years. The company's share price has experienced a standard deviation of 38% during the last year.The short-term risk free interest rate is 6% per annum.Required:(a) Calculate the value of one call option on Stern Bear's share.Solution

Pa is estimated as

d1=

d2=

N(d1)=

N(d2)=

Option price=

Option On Dividend-Paying Share



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4 Sensitivity of Option Prices

Both speculators and risk managers need to know how much an option's price will change if there is a change in a key factor (e.g. in the price of the underlying asset).

Sensitivity of option values to such factors is measured by "the Greeks". The discussion below assumes that the underlying asset is a share.

4.1 Delta

Delta — the change in price of an option for a one cent change in the share price. It is calculated as N(d1) from the Black-Scholes model.

Delta = N(d1) = Change in the option priceChange in share price

Call price

Out of themoney

Share price

At the money

In the money

Slope = Delta = 0 Slope = Delta = 0.5

Slope = Delta = 1

Change of Call Price With Change in Share Price

< A put option has a negative delta (i.e. the price of a put moves in the opposite direction to the movement in the share price). The delta for put options is calculated as N(d1) – 1 and lies between 0 and –1.



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4.2 Delta Hedging< Delta is also known as the "hedge ratio" and can be used by

risk managers to construct a "delta neutral portfolio"< An investor who holds shares (a "long" position) and sells call

options (a "short" position) in the proportion dictated by delta ensures a perfectly hedged portfolio (i.e. where the gains and losses exactly cancel each other out).

< A delta neutral portfolio is risk-free and will only earn the risk-free rate.

< Assume an investor holds shares and that the delta of call options on this share = 0.5

= Number of call options to sell = Number of shares bought

N(d )1= For a holding of 100 shares (100/0.5) = 200 calls need to

be sold to construct a delta hedge. = If the share price falls by 10c, there will be a $10 loss on

the shareholding. However, the price of each option will have fallen by 5c. Each option can then be bought back at 5c lower price than they were previously sold. This gives a gain on options of 0.05 × 200 = $10.

= A "covered call" (long share/short call) in the hedge ratio therefore ensures a delta neutral portfolio where gains and losses cancel each other out.

< However, the problem with delta hedging is that delta is not a constant. It changes as the share price changes. Note from the graph above that there is not a linear relationship between share prices and option prices. The portfolio will therefore need to be rebalanced as delta changes.

< The frequency of rebalancing depends on the rate of change of delta—measured by gamma.

4.3 Gamma

Gamma—the rate of change of delta (the sensitivity of delta) as the share price changes.

Gamma (G) =

Change in deltaChange in share price

< If an option is deep "out of the money," then its delta will be low and will stay low—hence gamma will also be low.

< If an option is deep "in the money," its delta will be high and will stay high—hence gamma will be low.

< If an option is near to or "at the money," then delta changes rapidly—and gamma will be high (i.e. a delta hedge would need constant rebalancing).



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4.4 Theta

Theta—the measure of value lost over time, usually expressed as the amount of loss per day.

Optionvalue

Passing of time

< Time decay reduces the value of both call options and put options.

4.5 Vega

Vega—the measure of option price change given changes in share price volatility. Vega can also be referred to as Kappa or Lambda.

< Vega is always positive and therefore as price volatility increases the option premium (for puts or calls) will also increase.



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4.6 Rho

Rho—The measure of option price change given changes in the risk-free interest rate.

< If interest rates rise the price of call options will also rise< If interest rates rise the price of put options will fall.

4.7 Summary of the Greeks

Change in Regarding

Delta Option value Share Price

Gamma Delta Share Price

Theta Option Value Time

Vega Option Value Volatility

Rho Option Value Interest Rate



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5 Real Options

5.1 ApproachReal Options Pricing Theory (ROPT) tries to measure the value of managerial flexibility to adapt decisions in response to unexpected market developments.

Companies create shareholder value by identifying, managing and exercising real options that may be "embedded" in their investment portfolio.

Traditional methods of project appraisal (e.g. NPV) fail to accurately capture the economic value of investments in an environment of widespread uncertainty and rapid change.

ROPT extends the valuation techniques for financial options (e.g. the Black Scholes model) to the valuation of non-financial assets (i.e. physical projects).

True NPV = traditional NPV + value of embedded options

This may explain why, in practice, managers sometimes appear to accept projects whose traditional NPV is negative—they are mentally valuing the embedded options.

5.2 Real Option ArchetypesA company project or strategy may potentially have one or more of the following types of embedded real option:

< Delay option—for example a construction company may have a "call" option to buy a piece of land for potential development. The option gives value in that the firm can "wait and see" what happens to market conditions before deciding whether to "strike" the option and buy the land, or "lapse" the option and walk away.

< Expansion option*—where a firm has the ability to expand its production or service in the future (e.g. a cable TV provider may have spare capacity that could be used to launch new services such as Internet, phone, etc). Hence the initial project provides the firm with the option to "call" future projects.

< Redeployment option*—where the project assets can be switched into an alternative activity (e.g. Flexible Manufacturing Systems (FMS)) which can be easily re-tooled to make alternative products. Hence the assets in the project can be "called" to perform alternative functions.

< Abandonment option*—the option to sell the project to a third party for a pre-agreed price. This therefore has the characteristics of a "put".

*Also called a "withdrawal" or "exit" option.

*Can also be referred to as a "growth" or "learning" option.

*Also called a "flexibility" option.



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Example 7 Option to Abandon

A company has developed a new process with the following data:Conventional NPV $10mCapital expenditure $90m10 year lifeVolatility of the project's future cash flows = 45% Risk free rate = 5%The company has the option to abandon the project at any time and sell the technology for an estimated $40m.Required:(a) Use the Black-Scholes model to estimate the value of the

abandonment option and the total value of the project.Solution

d1=

d2=

N(d1)=

N(d2)=

Value of call

P=

Total value of project=



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5.3 Limitations of ROPTSupporters of ROPT argue that a focus on the value of flexibility provides a better measure of projects that may otherwise appear uneconomical using traditional NPV.

However critics of ROPT make the following points:

< The Black-Scholes model was designed for valuing financial options (e.g. share options) as opposed to real options in physical company projects. In the real economy, the assumptions of the Black-Scholes model may not hold, in particular:= The returns from company projects are unlikely to follow the

normal distribution.= Real options may be "American" style (i.e. available for

exercise at any time until their expiry date) whereas the Black-Scholes model assumes that the option can only be exercised on expiry (European style). In this case, Black-Scholes would tend to undervalue real options.*

< When applying ROPT, great care must be taken not to double-count the project's NPV. In many cases, the embedded option will not be "detachable" from the project (i.e. the firm could not simultaneously sell the option and undertake the project).

< This is a particular issue in the case of a " delay" or "wait and see option"—part of the value of this option to "call" the project may be its positive intrinsic value (i.e. the NPV of the project if it started today). Adding the total value of the option to the project NPV may therefore double-count the NPV.

< In this case, it would be more reasonable to suggest that the total value of the project =

Traditional NPV + Time value of the option to delay

It must be stated that the above argument is debatable. Furthermore, it does depend on the specific circumstances in the scenario. In the exam, you will have to use judgement as to whether to add the total value or just the time value of an embedded option. There may be no unique "correct" answer—so explain your thought process and write any assumptions you make.

< If the Efficient Markets Hypothesis (EMH) holds then:= investors will be aware of which firms are dynamic and have

the flexibility granted by real options;= investors will be attracted to such firms, bidding up the

price of their shares and bonds;= dynamic firms will therefore achieve a relatively low WACC;

and= lower WACC increases project NPV (i.e. traditional NPV will

already take into account the value of real options).

*Binomial models (complex decision trees) are more accurate for valuing American options but calculations involving binomial models will not be examined.



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Example 8 Option to Delay

Paradise Villas, an Indian property development company, has gained planning permission for the development of a complex of holiday apartments in a southern state of India. The project has an expected net present value of $4 million at a cost of capital of 10% per annum.Paradise Villas has an option to acquire the necessary land at an agreed price of $24 million, which must be exercised within the next two years. Immediate building of the complex would be risky as the main purchasers of the apartments would be foreigners and, at present, there are uncertainties over the legality of property sales to foreigners. As a result, the project has a volatility attached to its future cash flows of 25%.Within the next two years, an announcement by the state government will be made about the rights of foreigners to purchase property.The risk free rate of interest is 5% per annum.Required:(a) Use the Black-Scholes model to estimate the value of the option to

delay commencement of the project and state the total value of the project

Solution

Pa=

Pe=

t=

r=

s=

d1=

d2=

N(d1)=

N(d2)=

c=

Total value of project=



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Example 9 Option to Expand

Bevvy Inc. is considering introducing a new beer to the US market. The beer would initially be introduced only in the major cities with an investment costing $500 million, but the present value of the cash flows from this investment would be only $400 million. However, if the initial introduction of the beer works out well, Bevvy could go ahead with a full-scale introduction to the entire market with an additional investment of $1 billion any time over the next five years. Although the current expectation is that the present value of cash flows from making this additional investment is only $750 million, there is considerable uncertainty about the potential for the beer.The annualised standard deviation in firm value of listed companies in the brewing industry is 34.25%.The yield to maturity on five-year treasury notes is 6%Required:(a) Value the option to expand production of the beer and advise Bevvy

Inc whether to proceed with the project.Solution

P=

Pe=

t=

r=

s=

d1=

d2=

N(d1)=

N(d2)=

c=

Recommendation=



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Example 10 Option to Redeploy

Caffeine Queen Inc. operates a chain of coffee shops in a country where the use of bank cards is still relatively low. It is considering introducing pre-paid swipe cards that would allow customers to pay their bill quickly without using cash. The cards would also operate a loyalty system, awarding points to be redeemed for free food and drinks, as well as various promotions such as a monthly prize for one lucky customer picked at random.Although the cards themselves are relatively cheap to produce, major investment in new IT infrastructure would be required at a cost of $20m. The present value of net cash flows generated by the swipe cards would be only $15m.However, the IT involved in the project is very flexible in that, with minimal reprogramming and upgrades, it could be easily switched into alternative uses.Caffeine Queen has entered into preliminary discussions with a local bank with a view to launching a joint branded card that would operate both as a loyalty card and bank card. Any launch would occur after two years. The cost to Caffeine Queen of reprogramming and upgrading its IT would be $3m and the present value of additional net cash flows $10m.However, the success of the joint card is highly uncertain as it depends, amongst other things, on whether the government passes a new law which would force employers to pay their staff into bank accounts as opposed to paying them in cash. Monte Carlo simulation has estimated the standard deviation of returns from the joint card at 35%.The risk-free interest rate is 5%Required:(a) Value the option to redeploy the IT infrastructure and advise Caffeine

Queen whether to proceed with the initial investment.Solution

Pa=

Pe=

t=

r=

s=

d1=

d2=

N(d1)=

N(d2)=

c=

Recommendation=



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5.4 Applying ROPT to Value Intangible Assets< It may be possible in some circumstances to apply the Black-

Scholes model to the valuation of intangible assets (e.g. patents).

< In many ways, holding a patent on a new product or technology provides the option to "wait and see" what happens to market conditions before commencing commercial development. As a delay option, it would be a call option albeit American style as opposed to European style.

< However using Black-Scholes to value a patent introduces a further complication. Due to the finite life of patents, the longer the firm waits to start commercial exploitation, the shorter the remaining useful life. Therefore, the present value of project returns will be eroded while the decision is delayed.

< The way to deal with this is to picture the project's returns as a share whose value falls each year as it pays a dividend, with the dividend yield (r) being 1/t where t = life of the patent. To set Pa the present value of the project's returns is adjusted as follows: Pa = PV of returns × e-rt

= PV of returns × e-1



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Example 11 Valuing Intangible Assets as an Option

Stem Cell Solutions is a medical research company that has completed the preliminary development of a breakthrough treatment for eye disease. Initial clinical trials of the drug have been favourable and the drug is expected to receive approval from the regulatory authority in the near future.Stem Cell Solutions has taken out a patent on the drug that gives it the exclusive right to develop the drug commercially and market it for a period of 15 years. Although it is difficult to produce precise estimates, the company believes that to commercially develop and market the drug for worldwide use will cost approximately $400 million. The expected present value from sales of the drug during the patent period could vary between $350 million and $500 million.*

*Because the value of the returns from the patent will fall over the period before the drug is commercially developed, it is necessary to adjust the expected present value from sales of the drug. In all relevant parts of the Black-Scholes model, the present value from sales of the drug should be multiplied by e(–0.067)(15) to reflect this potential reduction in value according to when the drug is developed.

The risk-free rate is 5%. The annual variance (standard deviation squared) of returns on similar medical research firms is estimated to be 0.185.The finance director can see from the possible NPVs that the company has a difficult decision, whether or not to develop the drug, and wonders if option pricing could assist the decision.Required:(a) Using the Black-Scholes option pricing model for the life of the

patent, estimate the call values of the option to commercially develop and market the drug. Provide a reasoned recommendation, based on your calculations and any other relevant information, as to whether or not Stem Cell Solutions should develop the drug.



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Example 11 Valuing Intangible Assets as an Option (continued)

Solution



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6 Merton's Models (1974)

6.1 Valuing Equity as an Option< Robert Merton (who worked with Black and Scholes on their

original model) viewed equity investors as having a European call option over a firm's underlying assets, with the exercise price being the amount required to pay off debt.

< If the value of assets rises above the level of outstanding debt, the call option moves into the money and equity investors can exercise their right to pay off the debt and take a gain (i.e. the net assets). If, however, the value of assets falls below the level of debt, shareholders can allow their option to lapse and walk away under the protection of limited liability.

< Merton values equity using the Black-Scholes model with the following inputs:= market value of assets;= volatility of asset value;= redemption value of debt;= time to redemption of debt; and= risk free rate.

< Assuming that the firm's debt is long term in nature, then any short-term liabilities (e.g. trade payables) should be deducted from the market value of assets (i.e. the value of assets is usually input as total assets less current liabilities).

< For simplicity, Merton assumed that the firm's debt is a single discounted bond with zero coupon and redemption at face value, the time to redemption sets the period to expiry of the shareholders' call option.

< However, in the real world, a firm's debt is unlikely to be a single discounted bond. Firms may issue coupon-paying debts with various maturities. There are two main methods of recalibrating a firm's actual debt before it is input into the Merton model:= Estimate the redemption value of a hypothetical zero-

coupon bond with the same fair value, yield and average time to maturity as the firm's actual debt.

= Estimate the "Macaulay duration" of the firm's actual debt by multiplying the year of each payment of coupon or principal by the proportion of total present value received in that year and then summing. Duration is then used as the time to expiry of the call option, and the exercise price is set as the face value of the firm's actual debt plus the cumulative coupons to be paid.



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Example 12 Equity as an Option

Wobbly Bob has $100m face value of debt in issue carrying 5% coupon and with five years to maturity. The company's current cost of debt is 8%.The fair value of the firm's total assets less current liabilities is $90m and has a monthly volatility of 8% Risk free rate 6%

Required:Value Wobbly Bob's equity using the Black-Scholes model, under each of the following methods for recalibrating the firm's debt:(a) using the redemption value of an equivalent zero-coupon bond; (b) using the Macaulay duration of the firm's actual debt.

Solution(a) Using redemption value of an equivalent zero-coupon bond

(b) Using Macaulay duration of the firm's actual debt



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6.2 Merton's Structural Debt Model< Having valued the equity, Merton then uses Modigliani and

Miller's assertion that the market value of equity plus the market value of debt equals the total value of the firm's assets:

Value of debt = value of assets – value of equity

< By comparing the theoretical market value of the debt to its face value, the yield can be easily implied and then compared to the risk-free rate to estimate the credit spread on the bond and hence the firm's default risk/credit risk. Hence Merton provides us with a "structural debt model" built on stronger foundations than ratio-based models such as Altman's Z-score.

< As the yield is not known in advance (it is the output of the model), a variation on Macaulay duration must be used when calibrating the firm's debt to set the strike price of the call option. In this case, find the "nominal duration" of the firm's debt by multiplying the year of each payment of coupon or principal by the proportion of total payment and then summing (i.e. as per Macaulay duration but calculated using undiscounted cash flows).

< Unfortunately, two of the inputs to Merton's model are not easily observed in practice—the value and volatility of assets. However, for a quoted company, the output of the model is known (i.e. the equity value). Via some complex maths (which would not be required in the exam), the value and volatility of assets can be implied and hence the value and risk of debt.



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Example 13 Structural Debt Model

Rottweiler has the following data:< market value of assets $1816m;< volatility of assets 11.64%;< nominal value of debt $267m, average coupon rate 5.73% and average term to

maturity 5 years; < risk free rate 4.364%.Required:(a) Estimate the nominal duration of the firm's debt.(b) Use the Black-Scholes model to value the firm's equity.(c) Estimate the spread on the firm's debt.(d) Estimate the probability of default on the firm’s debt.

Solution

(a) Nominal duration of the firm's debt

(b) Black-Scholes model to value equity

(c) Estimated spread on the firm's debt

(d) Estimated probability of default on the firm’s debt.



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Example 14 Debt Analysis in a Distressed Firm

Bloated Inc. has borrowed extensively by issuing zero-coupon bonds. The debt has been used to finance acquisitions. Unfortunately, the synergies that were predicted by Bloated's chief executive have not materialised and, in some cases, have even been negative due to cultural clashes and lack of strategic fit. Subsequently, the value of Bloated's assets has fallen and cash flows have been weak.Current fair value of asset = $50mFace value of outstanding debt = $80mMaturity of debt = 10 yearsVariance of asset value = 0.16 Yield to maturity on 10 year treasury bonds = 10%

Required:(a) Apply the Black-Scholes model to estimate: (i) the fair value of the firm's debt; and (ii) the probability of default.(b) Estimate the debt's yield to maturity and credit spread over

benchmark treasuries.(c) Estimate the expected recoverability of the debt.

Debt Analysis in a Distressed Firm



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Example 14 Debt Analysis in a Distressed Firm (continued)

Solution(a) Black-Scholes Model(i) Fair value of debt

Pa =

Pe =

t =

r =

s =

d1 =

d2 =

N(d1) =

N(d2) =

Value of the option =

Fair value of debt =

(ii) Probability of default

(b) Yield to maturity and credit spread

Yield to maturity=

Credit spread=

(c) Expected recoverability

Debt Analysis in a Distressed Firm



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6.3 Credit DerivativesThe Merton Model may reveal significant default risk on a bond, or risk of the spread increasing. An investor in bonds can hedge against such risks using various credit derivatives:

< Credit forward contracts—the holder of a credit forward can use it to lock a particular credit spread on an underlying bond. If the actual spread becomes wider than the contracted spread, the buyer of the contract receives compensation from the seller and vice versa. No premium is paid, but the holder does not benefit from falling spreads.

< Credit default swaps—the buyer of the swap pays a series of premiums to the seller, which basically represent credit risk insurance. If a "default event" occurs on the underlying bond, then the seller of the swap is obliged to buy the bond at face value, or to compensate the difference between face and market value.

< Credit options—common types include:= Credit spread options—the buyer of the option receives a

payout if the actual spread on a bond exceeds the strike spread of the option.

= Predetermined payout option—which pays the holder a fixed sum if a specified event occurs (e.g. default or downgrade in credit rating).



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< The holder/buyer of an option has the right, but not the obligation, to buy (if calls) or sell (if puts) the underlying asset at a fixed price (the strike/exercise price) on (if European style) or before (if American style) an agreed date (the expiry date).

< The value of an option is reflected in its premium (i.e. price) and has two main components —intrinsic value and time value.

< Black and Scholes produced the most famous model for valuing options—designed for European call options but easily converted to puts using put-call parity. The value of American options is usually close to their European equivalent.

< "The Greeks" analyse how the price of an option varies with key factors. The most famous Greek is delta—popular with fund managers for setting up perfectly hedged portfolios to protect against short-term volatility.

< A project may be undervalued by failing to capture the potential benefits of embedded strategic options. Real Options Pricing Theory (ROPT) attempts to put a monetary value on options to delay, abandon, expand or redeploy a project. The Black-Scholes model can also be used to value options embedded in company projects.

< Merton later applied the Black-Scholes model to valuing corporate debt.

Summary



Q31 Uniglow 30 minutes

Additional

Q32 Bioplasm


1. Distinguish between a "European option" and an "American option". (1.1)

2. State the characteristic of an "OTC" option. (1.3)

3. State what is meant by the phrase "at the money". (2.1)

4. Define the "intrinsic value" of an option. (2.2)

5. State the drivers of the time value of an option. (2.3.1)

6. List the assumptions of the Black-Scholes model. (3.2)

7. State which statistic from the Black-Scholes model is also referred to as "delta". (4.1)

8. State which of "the Greeks" measures the impact of time decay on the value of anoption. (4.4)

9. Give examples of the types of real option that may be embedded within a project. (5.2)

10. State how Merton viewed the position of shareholders in terms of an option. (6.1)

11. Explain the operation of a credit default swap. (6.3)



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Session 13

EXAMPLE SOLUTIONSSolution 1—In or Out of the Money

(a) July call option @ 500 pence- out of the money as the exercise price is higher than the current market price

(b) April put option @ 460 pence- out of the money as the exercise price is below the current market price

(c) October call option @ 460 pence- in the money as the exercise price is below the current market price

Solution 2—Intrinsic Value

(a)

(i) July call option @ 460 pence This would be exercised as the shares would be bought @ 460 pence, and they have a current market value of 490 pence Intrinsic value = 490 - 460 = 30 pence(ii) July call option @ 500 pence Currently, this would not be exercised as you would not buy shares for 500 pence that are only currently worth 490 penceIntrinsic value = zero

(b)(i) October put option @ 460 pence This would not be exercised as this gives the right to sell shares worth 490 pence currently for just 460 pence. Intrinsic value = zero(ii) October put option @ 500 pence This would be exercised as it gives a right to sell share worth 490 pence for 500 pence. Intrinsic value = 500 – 490 = 10 pence

Solution 3—Time Value

Time value = Option price – intrinsic valueIntrinsic value of call option @ 460 pence = 490 - 460 = 30 penceApril call price - time value = 40 - 30 pence = 10 penceJuly call price - time value = 45 ½ - 30 pence = 15 ½ penceOctober call price - time value = 52 ½ - 30 pence = 22 ½ penceThe longer the time to expiry, the greater will be the time value of the option.



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*The intrinsic value of the option is zero and therefore all of the premium must represent time value.

Solution—4 Black-Scholes

d1 = ln (P /P ) r 0.5s t

s ta e

2+ +( )=

ln (14/14) 0.1 0.5 0.2 1

0.2 1

2+ + ×( )( )= 0.6

d2 = d1 – s t = 0.6 – 0.2 = 0.4Now use the normal distribution tables—read the note given at the bottom of the tables.N(d1) = probability that a normally distributed variable will be less than 0.6 standard deviations above the meanN(d1) = 0.5+0.2257 = 0.7257N(d2) = 0.6554Option price = PaN(d1) – PeN(d2)e-rt

= 14×0.7257 – 14×0.6554e-0.1 = $1.8574$1.8574 is the theoretical premium of this option.*

Solution 5—Put-Call Parity

The price of a call option has been calculated as $1.8574.P = c – Pa + Pee-rt = 1.8574 – 14 + 14e-0.1

= 1.8574 – 14 + 12.6677 = $0.5251

Solution 6—Option On Dividend-Paying Share

As there is dividend payment due during the option period the share price, Pa, should be reduced by the present value of the expected dividend.Dividend per share has remained constant for three years. It is assumed that it will be constant in the next year. The present value of the dividend (discounted at the risk free rate) is 25× e-0.06 = 23.54 centsPa is estimated to be 610 – 23.54 = 586.46 cents

d1 = ln (P /P ) r 0.5s t

s ta e

2+ +( )

= ln (586.46/500) 0.06 0.5x0.38 1

0.38 1

2+ +( )( )= 0.77

d2 = d1 – s t = 0.77 – 0.38 = 0.39Now use the normal distribution tables—read the note given at the bottom of the tables.N(d1) = probability that a normally distributed variable will be less than 0.77 standard deviations above the meanN(d1) = 0.5 + 0.2794 = 0.7794N(d2) = 0.6517Option price = PaN(d1) – PeN(d2)e-rt

= (586.46 × 0.7794) – (500 × 0.6517e-0.06) = 150 cents



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Solution 7—Option to Abandon

d1 = ln (P /P ) r 0.5s t

s ta e

2+ +( ) =

ln (100/40) 0.05 0.5 0.45 10

0.45 10

2+ + ×( )

= 1.707 = 1.71 (approx)

d2 = d1 – s t = 1.707 – 1.423 = 0.28 (approx)N(d1) = 0.4564 + 0.5 = 0.9564N(d2) = 0.1103 + 0.5 = 0.6103Value of call = PaN(d1) – PeN(d2)e-rt

= (100× 0.9564) – (40×0.6103 e-0.5) = 80.83P = c – Pa + Pee-rt = 80.83 – 100 + 24.26 = $5.09mTotal value of project = 10 + 5.09 = $15.09m*

Solution 8—Option to Delay

Pa = today's value of the underlying asset = present value of the project = $28 millionPe = exercise price = capital expenditure = $24 milliont = exercise date = 2 yearsr = risk free rate = 5% = 0.05s = volatility = 25% = 0.25

d1 = ln . . .

...

2824

0 05 0 5 0 25 2

0 25 20 316650680 35355339

2

+ + ×( ) ×

×= = 0.8956

d2 = 0.8956 – 0.25 × √2 = 0.5421The areas under the normal curves for these two values are:N (d1) = 0.8147N (d2) = 0.7061.The value of the call option on the project is:c = 0.8147 × 28 – 0.7061 × 24 × e–.05 × 2 = $7.48 millionThe total value of the option represents intrinsic value of $4m (expected project NPV) and time value of $7.48m – $4m = $3.48m. The time value represents the additional value of being able to "wait and see" what decision the government makes. This flexibility allows Paradise Villas to neutralise much of the downside risk of the project (if the law goes against the firm it can walk away from the acquisition of land) whilst having almost unlimited upside potential (if the government allows foreigners to buy holiday homes in India the project returns could be very high).Total value of project = expected NPV + time value of option to delay = $4m + $3.48m = $7.48m

*This is still conservative as the option is American style in nature, but has been valued as European style.



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Solution 9—Option to Expand

Pa = today's value of the underlying asset = PV of cash flows from expansion into entire US market = $750mPe = exercise price = cost of expansion into entire US market =$1,000mt = exercise date = 5 yearsr = risk free rate = 6% = 0.06s = volatility = 34.25% = 0.3425

d1 = ln / . . .

.

750 1000 0 06 0 5 0 3425 5

0 3425 5

2( ) + + ×( ) ××

= 0.39

d2 = 0.39 – 0.3425 × √5 = –0.38The areas under the normal curves for these two values are:N (d1) = 0.1517 + 0.5 = 0.6517 N (d2) = 0.5 – 0.148 = 0.352The value of the call option on the expansion is:c = 0.6517 × 750 – 0.352 × 1,000 × e–.06 × 5 = $228mNPV of limited introduction = $400m − $500m = − $100mNPV of project with option to expand = − $100m+ $ 228 million = $128mRecommendation: Bevvy Inc. should invest in the project.

Solution 10—Option to Redeploy

Pa = PV of cash flows from redeploying the IT infrastructure = $10mPe = exercise price = cost of redeploying the IT infrastructure = $3mt = exercise date = 2 years r = risk free rate = 5% = 0.05s = volatility = 35% = 0.35

d1 = ln / . . .

.

10 3 0 05 0 5 0 35 2

0 35 2

2( ) + + ×( ) ××

= 2.88

d2 = 2.88 – 0.35 × √2 = 2.39The areas under the normal curves for these two values are:N (d1) = 0.498 + 0.5 = 0.998 N (d2) = 0.4916 + 0.5) = 0.9916The value of the call option on the expansion is:c = 0.998 × 10 – 0.9916 × 3 × e–.05 × 2 = $7.3mNPV of initial project = $15m – $20m = − $5mNPV of project with option to redeploy = − $5m+ $7.3 million = $2.3mRecommendation: Caffeine Queen Inc. should invest in the project.



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Solution 11— Valuing Intangible Assets as an Option

Sales of $350mPa is estimated to be either 350e (-0.067)(15) or 500e(-0.067)(15) = 128.11 or 183.02The exercise price, Pe = 400The interest rate, r = 0.05Time, t = 15Volatility, s =√ 0.185 = 0.430Using call price =. c = PaN(d1) – PeN(d2)e-rt

Where:

d1 = ln ( P /P ) r 0.5s t

s ta e

2+ +( )

If Pa is 128.11

d1 = ln (128.11/400) 0.05 (0.50 0.43 ) 15

0.43 15

2+ + ×( ) = 0.600

d2 = d1 – s t = 0.600 – 1.665 = –1.065From normal distribution tables:N(d1) = 0.5 + 0.226 = 0.726N(d2) = 0.5 – 0.357 = 0.143Inputting data into call price = PaN(d1) – PeN(d2)e-rt

Call price = (128.11× 0.726) – (400 × 0.143 × e-0.75) = 93.01 – 27.02 = $65.99 millionIf Pa is 183.02d1 = 0.814d2 = –0.851From normal distribution tables:N(d1) = 0.5 + 0.292 = 0.792N(d2) = 0.5 – 0.303 = 0.197Call price = $107.73 millionRecommendationIf the data are correct, then the option pricing model would suggest that the company should develop the patent no matter which present value occurs.Under both scenarios, the call option has a value in excess of the static NPV estimates. With a $350 million present value from sales, the expected NPV is -$50 million, but the value of the call option is $66 million. With a $500 million present value from sales, the expected NPV is $100 million, whilst the call option value is $108 million. Assuming there is equal probability of the present value being $350m or $500m, the expected value of the patent = (0.5 × $66m) + (0.5 × $108m = $87m.



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However, valuing a long-term option such as this is subject to restrictive assumptions and will be subject to a considerable margin of error. Possible problems include:■ The accuracy of the present value forecasts, and the use of the

correct discount rate to assess their risk.■ The accuracy of the estimated development cost of the drug for

commercial use. This estimate could be subject to substantial error as it relates to a new product and probably to new technology.

■ Accuracy of the estimated variance. As this is a new drug, the variance of returns from other medical research companies might not be relevant, and the Black-Scholes model is quite sensitive to this variable. The model also assumes that this volatility will be constant for the 15 year period which is very unlikely.

■ The Black-Scholes model was developed for European options. As development of the drug could take place at any time during the 15 year period, the option is an American option rather than a European option. The use of a binomial valuation model would be more accurate.

■ What will happen after 15 years? Although competition will probably eliminate most abnormal returns, the company is likely to have built up a strong brand image and could still generate positive NPVs—which have not been included in the above calculations—after this time.

■ How likely is it that a competitor might develop a superior drug? If this occurs, the projections will be very adversely affected.

Because of the potential margin of error, the firm should be cautious about accepting the values produced by the option pricing model, although they might be used as part of the overall decision process. This should also include the NPV estimates and strategic considerations. The company would also be advised to investigate possible cash flows after the patent period has expired



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Solution 12—Equity as an Option

(a) Using redemption value of an equivalent zero-coupon bondThe market value of debt is estimated as follows:

Year 1 2 3 4 5 TotalCash flow 5 5 5 5 1058% DF 0.926 0.857 0.794 0.735 0.681Present value 4.63 4.29 3.97 3.68 71.51 88

The redemption value of an equivalent zero coupon bond is calculated by finding the future value which, when discounted at 8% over five years, gives a present value of $88.

Pe FV PV

FVIF= =

$.88

0 681 = $129

Hence the exercise price would be set at $129 and the time to expiry as 5 years Pa = 90Pe = 129r = 0.06s = 0.08 × = 0.28 12t = 5

d1 = ln (P /P ) r 0.5s t

s ta e

2+ +( ) =

0 129 0 06 0 5 0 28 5

0 28 5

2 ( / ) . . .

.

+ + ×( )9ln = 0.22

N(d1) = 0.0871 + 0.5 = 0.5871

d2 = d1 – s t = 0.22 – 0.63 = (0.41)N(d2) = 0.5 – 0.1554 = 0.3446Vequity: c = PaN(d1) – PeN(d2)e-rt = (90× 0.5871) – (129×0.3446× e-0.3) = $20m(b) Using Macaulay duration of the firm's actual debtMacaulay duration is the average term to maturity of the debt's cash flows, the weighting being the relative present value paid in each time period:

Year 1 2 3 4 5 TotalCash flow 5 5 5 5 105 1258% DF 0.926 0.857 0.794 0.735 0.681Present value 4.63 4.29 3.97 3.68 71.51 88Proportion (4.63/88) 0.05 0.05 0.05 0.04 0.81 1Year × proportion 0.05 0.1 0.15 0.16 4.05 4.5

Duration = 4.5 yearsAn alternative presentation is possible:

Year 1 2 3 4 5 TotalCash flow 5 5 5 5 105 1258% DF 0.926 0.857 0.794 0.735 0.681Present value 4.63 4.29 3.97 3.68 71.51 88Year × PV 4.63 8.58 11.91 14.72 357.55 397

Duration = 39788

= 4.5 years



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In this case, the time to expiry would be set at 4.5 years and the exercise price as the total payment on the debt (i.e. $125). The exercise price is set slightly lower than in the zero-coupon method, but the time to expiry is set slightly shorter—these two effects should (approximately) cancel each other out.Pa = 90Pe = 125r = 0.06s = 0.08 × 12 = 0.28t = 4.5

d1 = ln (P /P ) r 0.5s t

s ta e

2+ +( ) =

8 4. .

0 125 0 06 0 5 0 28 4 5

0 2 5

2n ( / ) . . . .+ + ×( )l 9 = 0.20

N(d1) = 0.0793 + 0.5 = 0.5793d2 = (0.39)N(d2) = 0.5 – 0.1517 = 0.3483Vequity: c = PaN(d1) – PeN(d2)e-rt = (90× 0.5793) – (125×0.3483× e-0.27) = $19m



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Solution 13—Structural Debt Model

(a) Nominal duration of the firm's debtAnnual coupon payment = $267 × 0.0573 = $15.3m

Year 1 2 3 4 5 TotalCash flow 15.3 15.3 15.3 15.3 282.3 343.5Proportion of total 15.3/343.5

0.045 0.045 0.045 0.045 0.82 1

Year × proportion

0.045 0.09 0.135 0.18 4.1 4.55

Duration = 4.55 years (i.e. the firm's actual debt is equivalent to paying a single sum of $343.5m after 4.55 years).

(b) Black-Scholes model to value equity

d1 = ln (P /P ) r 0.5s t

s ta e

2+ +( ) =

1816 343 5 0 04364 0 5 0 1164 4 55

0 1164 4 55

2n ( / . ) . . . .

. .

+ + ×( )l

= 7.64N(d1) = 0.5 + 0.5 = 1

d2 = d1 – s t = 7.64 – 0.248 = 7.39N(d2) = 1Value of call = PaN(d1) – PeN(d2)e-rt

= (1816× 1) – (343.5×1× e-0.2) = $1535 = value of equity

(c) Estimated spread on the firm's debtMVdebt = MVassets – MVequity = 1816 – 1535 = $281mThe 4.55 year factor which discounts the future value of the cash flows to market value of the debt: PV Factor = MVdebt/cash flows = 281/343.5 = 0.818Technically speaking, the risk-free rate used in Black-Scholes is a continuously compounded rate and hence this should be compared to the continuously compounded return on the firm's debt: PV Factor = e-rt = 0.818

ln ln .

. .

..

.e

r

r

r−( ) = ( )

− = −

=−−

4 55 0 818

4 55 0 2009

0 20094 55

= 0.0442Spread = 4.42% – 4.36% = 0.06% (i.e. the firm's debt is almost risk-free).

(d) Estimated probability of default

N(d2) = 1 = 100% probability that assets will exceed liabilities on the date of debt repayment. Hence probability of default is zero.



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Solution 14—Debt Analysis in a Distressed Firm

(a) Black-Scholes model(i) Fair value of debtPa = today's fair value of underlying assets = $50mPe = amount required to pay off the firm's debt on redemption date = $80mt = time to redemption of debt = 10 yearsr = risk free rate = 10% = 0.16s = standard deviation of asset value= √ 0.16 = 0.40

d1 = ln / . . .

.

50 80 0 10 0 5 0 40 10

0 40 10

2( ) + + ×( ) ××

= 1.05

d2 = 1.05 – 0.40 × √10 = -0.21The areas under the normal curves for these two values are:N (d1) = 0.3531 + 0.5 = 0.8531 N (d2) = 0.5 – 0.0832 = 0.4168The value of the call option on the assets is:c = 0.8531 × 50 – 0.4168 × 80 × e–.10 × 10 = $30.4m = fair value of equityFair value of debt = fair value of assets – fair value of equity = 50 – 30.4 = $19.6m(ii) Probability of defaultN(d2) gives the probability of non-default. Hence the probability of default = 1 – 0.4168 = 0.58 = 58%(b) Yield to maturity and credit spreadYield to maturity = (80/19.6)1/10 – 1 = 15.1%Credit spread = 15.1% – 10% = 5.1%(c) Expected recoverabilityThe fair value of debt should represent the minimum expected recoverable amount on its maturity, discounted at the risk-free rate:Recoverable amount × (1.10)-10 = $19.6mRecoverable amount = 19.6 × (1.10)10 = $50.8mExpected recovery of face value = 50.8/80 = 63.5% i.e. "63 1/2 cents in the dollar".This represents a "haircut" of 100 – 63.5 = 36.5% of face value.



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NOTES



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Session 14

Session 14 Guidance

Understand the most common models for forecasting future exchange rates, and that PPP forecasts future spot exchange rates and IRP is used to determine forward exchange rates (s.1).

Recognise the three types of currency risk—translation, economic and transaction risk (s.2). Learn internal methods of hedging exposure to transaction risk and economic risk (s.2.4). Learn external methods of managing transaction risk—forward contracts, money market hedging, options, futures and currency swaps (s.3).


5. International investment and financing decisionsd) Assess the impact of a project upon an organisation's exposure to

translation, transaction and economic risk.


1. The role of the treasury function in multinationalsa) Discuss the role of the treasury management function within

iii) the management of risk exposure.b) Discuss the operations of the derivatives market, including:

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.2. The use of financial derivatives to hedge against forex riska) Assess the impact on an organisation to exposure in translation,

transaction and economic risks and how these can be managed.b) Evaluate, for a given hedging requirement, which of the following is the

most appropriate strategy, given the nature of the underlying position and the risk exposure:i) The use of the forward exchange market and the creation of a money

market hedge ii) Synthetic foreign exchange agreements (SAFEs) iii) Exchange-traded currency futures contractsiv) Currency swapsv) FOREX swaps vi) Currency options.

Foreign Exchange Risk Management



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FOREIGN EXCHANGE RISK MANAGEMENT

TYPES OF EXCHANGE RATE RISK

• Translation• Economic• Transaction• Internal Management • External Hedging

Techniques

FORECASTING EXCHANGE RATES

• Four-Way Equivalence Model

• Purchasing Power Parity

• Interest Rate Parity• Fisher Effect• International Fisher

Effect• Expectations Theory• Other Factors

EXTERNAL HEDGING STRATEGIES

• Forward Exchange Contract

• Money Market Hedges• Currency Options• Currency Futures

Contracts• Currency Swaps

VISUAL OVERVIEWObjective: To understand exchange rate forecasting in the context of managing a company's currency risk.



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Session 14 • Foreign Exchange Risk Management P4 Advanced Financial Management


1 Forecasting Exchange Rates

Spot exchange rate— the market exchange rate for buying/selling the currency for immediate delivery. Forward exchange rate— the exchange rate for buying or selling the currency at a specific date in the future.

1.1 Four-Way Equivalence Model< The key models for forecasting future exchange rates focus

either on inflation rate differences or interest rate differences.< The relationships between these macro-economic variables

can be summarised in the "four-way equivalence model" shown below:

Expectations theory

International Fisher effect

Interest rate parity

Purchasing power party

Fisher effect

1.2 Purchasing Power Parity (PPP)Absolute PPP states that the exchange rate simply reflects the different cost of living in two countries.

< For example, if a representative basket of goods and services costs $1,700 in the US and £1,000 in the UK, the exchange rate should be $1.70 to £1.

< While absolute PPP exchange rates may represent the long-run equilibrium rate between two currencies, they are of limited practical use in financial management.

< Financial managers are more interested in market exchange rates than theoretical rates. This is where relative PPP is useful.



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P4 Advanced Financial Management Session 14 • Foreign Exchange Risk Management

Relative PPP claims that changes in market exchange rates are caused by differences in the rate of inflation in different countries.

< For example, if the rate of inflation is higher in the US than in the UK, relative PPP predicts that the value of the dollar will fall.

< The formula for relative PPP:

S1 = S0 ×

1 +( )+( )

h1 h

c

b

where:

S1 = expected spot exchange rate after one year

S0 = today's spot exchange rate

hc = foreign inflation rate (as a decimal)

hb = domestic inflation rate (as a decimal)

< Spot rates should be put into the formula in the format:

Units of foreign currency/units of domestic currency

Example 1 Relative PPP

Spot rate 1 January 20X6 = $1.90 per £1Predicted inflation rates for 20X6:

US 2%UK 3%

Required:Calculate the predicted exchange rate at 31 December 20X6.

Solution

The relative PPP formula is provided on the exam's Formulae Sheet.



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1.3 Interest Rate Parity (IRP)IRP states that the forward exchange rate is based on the spot rate and the interest rate differential between the two currencies:

< Forward rate = spot rate × [(1 + foreign interest rate)/(1 + domestic interest rate)]

F0 =S0 × 1 +( )+( )

i1 i

c

b

where:

F0 = forward exchange rate

S0 = spot exchange rate

ic = foreign interest rate

ib = domestic interest rate

Example 2 Interest Rate Parity

If spot is $1.78 per £, and the dollar and sterling interest rates are 3.25% and 4.5% respectively, what is the one-year forward exchange rate?Required:Calculate the one-year forward exchange rate. Solution

Interest Rate Parity

< If this theory did not hold it would be possible for investors to make a risk-free profit using covered interest rate arbitrage as follows: = borrow domestic currency;= convert it into foreign currency at the spot exchange rate;= deposit the foreign currency;= sign a forward exchange contract to repatriate the foreign

currency into domestic currency.

The interest rate parity formula is provided on the exam's Formulae Sheet.



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1.4 Fisher Effect< Countries with a higher rate of inflation have higher nominal

interest rates in order to offer the same real return as countries with low inflation:

(1 + i) = (1 + r) (1 + h)

Where i = nominal interest rate

r = real interest rate

h = inflation rate

1.5 International Fisher Effect< States that the spot exchange rate will change to offset

interest rate differences between countries.< The calculations are basically as per Interest Rate Parity theory.

1.6 Expectations Theory< Differences between forward and spot rates reflect the

expected change in spot rates.

1.7 Other Factors Influencing Exchange Rates < Current and prospective government policies.< Balance of payments surpluses/deficits.< Actions of speculators.< "Financial contagion"—the extent to which a currency depends

on another currency,

2 Types of Exchange Rate Risk

There are three types of exchange rate (foreign currency) risk to consider:

1. Translation risk

2. Economic risk

3. Transaction risk.

2.1 Translation RiskTranslation risk occurs where a parent company has an overseas subsidiary.

< In order to consolidate the subsidiary's financial statements into the group accounts, they must first be translated into the reporting currency of the parent company. The exact method for doing this depends on the relevant financial reporting standards.



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< In particular, translating the statement of financial position of overseas subsidiaries can lead to significant translation gains/losses.= If the home currency has appreciated against the foreign

currency, it is likely to produce a translation loss when converting the value of overseas net assets.

= If the home currency has depreciated against the foreign currency, it is likely to produce a translation gain when converting the value of overseas net assets.

< Although such gains/losses can be significant in size, they do not represent actual cash gains/losses for the group; they are simply caused by financial accounting methods for consolidating overseas subsidiaries.= As long as users of financial statements understand that

translation differences do not represent cash flows, they should not affect the value of the group.

= Therefore, the financial manager should ensure that the nature of translation gains/losses is clearly explained (e.g. in the annual report, at shareholder meetings).

= However, the financial manager does not need to hedge translation risk, because it is not a cash flow.

2.2 Economic Risk< Economic risk is the risk that cash flows will be affected by

long-term exchange rate movements. < As the value of a firm is the present value of its future cash

flows, economic risk is a significant issue for the financial manager. Unfortunately it is difficult to hedge against.

Illustration 1 Economic Risk*

A UK company exports to the US and, therefore, it has dollar export earnings. Over time, sterling becomes stronger against the dollar. The sterling value of the export earnings will fall, damaging the cash flow and the value of the company. What can the company do to reduce this risk?

< Increase the dollar price of the exports. However, this may not be practical, particularly when exporting to a competitive market.

< Diversify exports into other markets in the hope that sterling will fall against some currencies while rising against the dollar.

< Use hedging techniques such as forward contracts. Unfortunately, in the long run this will not give effective protection. As sterling rises over time in the spot markets, it also rises in the forward markets. Thus, the hedged value of the company's exports still falls.

< Attempt to convert the cost base into dollars by importing materials from the US or setting up operations in the US. However, these may not be practical options for many companies.

Economic Risk*

*Economic risk can affect a company even if it does not export or import. Domestic producers may face tougher competition from overseas firms if the home currency appreciates. Again, there is no easy method of protecting against this.



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2.3 Transaction RiskTransaction risk is the short-term version of economic risk. It is the risk that the exchange rate changes between the date of a specific export/import and the related receipt/payment of foreign currency.

< Like economic risk, this affects cash flows and hence affects the value of the firm. It is therefore a significant issue for financial management.

< Transaction risk can be effectively managed using both internal and external hedging techniques.

2.4 Internal Management of Exchange Rate Risk< Invoicing in the domestic currency—an exporter could

denominate sales invoices in its domestic currency, effectively transferring the transaction risk to the customer. However this may lead to lost sales.

< "Leading and lagging—paying overseas suppliers earlier ("leading") if the home currency is expected to fall, or later ("lagging") if the home currency is expected to rise.

< Netting—where there are both sales and purchases in a foreign currency offset the receivables and payables and only consider an external hedge on the net difference.

< Matching—consider using foreign currency loans to finance overseas subsidiaries. Overseas earnings can be used to pay the loan interest and repay principal, reducing the net foreign currency cash flow exposed to risk upon repatriation to the parent company. This may be effective as a longer-term hedge against economic risk.

< Asset and liability management—if overseas subsidiaries borrow locally rather than receiving additional equity finance from the pfarent company this reduces the exposed net assets of the subsidiary. This "balance sheet hedge" reduces exposure to translation risk upon consolidation of the subsidiaries' net assets into the group accounts (although, as mentioned above, translation risk should not affect the value of the group).

2.5 External Hedging Techniques Transaction risk can be managed using a variety of external hedges. The syllabus mentions the following:

< Forward exchange contracts;< Money market hedges;< Currency options;< Currency futures contracts;< Currency swaps.



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Before each of these is considered in detail some thought should be given as to whether a firm should use external hedging methods. Factors to take into account include:

< the costs of hedging (as a type of insurance policy hedging cannot be free). There may also be higher payroll costs to employ risk management experts.

< the benefits of hedging. In the long run the exchange rate in forward contracts (for example) will follow the same trend as the spot market (i.e. in the end hedging is not effective).

It would therefore seem appropriate to undertake hedging techniques on a selective basis (e.g. if the firm's liquidity position is at present poor and could not survive an adverse exchange rate movement).

In practice it appears that some firms use hedging techniques more than would be expected. This may be because the managers, working for one firm, are more risk averse than shareholders who have used portfolio theory to balance their risks across many industries and countries (and hence currencies). Excessive hedging therefore leads to agency costs for shareholders.

3 External Hedging Strategies

3.1 Forward Exchange Contracts

3.1.1 With Physical Delivery

< Forward contract—a legally binding agreement to buy or sell:= a specified quantity;= of a specified currency;= on an agreed future date ("delivery date");= at an exchange rate fixed today.

< Forward contracts are not traded but agreed between a company and a counterparty (e.g. a bank). This means they are customised agreements which can match the exact requirements of the company regarding quantity and delivery date.

< Forward contracts are not bought, they are entered into. Therefore, no premium needs to be paid to set up a forward hedge (unlike options).

< Forward contracts do not require any margin to be posted (i.e. no deposit of cash is required when setting up a forward hedge, unlike futures contracts). However, there will usually be a small arrangement fee to set up a forward contract.

< The major disadvantage of forward contracts is that physical delivery must occur (i.e. if a company signs a forward contract to buy/sell foreign currency, then it must physically exchange currency on the agreed date at the agreed rate, even if that rate has become unattractive compared to the spot rate).

< Therefore, forward contracts are not a flexible method of hedging.



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Example 3 Hedging With a Forward

Today is 1 January 20X1. A UK-based company is expecting dividend income of $200,000 to be received from its US subsidiary on 31 March 20X1.

Spot rate 1 January 20X1 ($ per £) = 1.5123–1.5245Three month forward = 2.00–2.14 cents discount (c dis)

Required:(a) Calculate how much sterling will be received if forward cover is taken out. (b) Calculate how much sterling would be received if no forward cover is taken out

and the actual spot rate on 31 March 20X1 = 1.5247 − 1.5361.Solution(a) Sterling received if forward cover is taken out = £

(b) Sterling received if no forward cover is taken out = £

3.1.2 Non-deliverable Forwards (NDFs)

Non-deliverable forward (NDF)— a short-term, cash-settled currency forward contract between two counterparties.

< On the settlement date, the gain/loss is transferred between the two counterparties based on the difference between the contracted forward rate and the prevailing spot rate, multiplied by an agreed notional amount.

< The notional amount is the "face value" of the NDF. There is no exchange of the notional amount; the only exchange of cash flows is the difference between the forward rate and the prevailing spot market rate on the settlement date—multiplied by the notional amount. Such contracts are therefore cash settled rather than requiring physical delivery of the underlying currency.

< Both the counter-parties are obliged to honour the deal and hence like all forward contracts there is little flexibility. However counterparty risk in cash settled forwards is lower than in physically delivered contracts as the cash flows at settlement are smaller.

< Banks quote NDFs from between one month to one year, although some quote up to two years upon request.

< They can also be referred to as Synthetic Agreements for Foreign Exchange (SAFEs).



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3.2 Money Market Hedges

Money market hedge— attempting to eliminate currency risk by locking in the value of a foreign currency transaction in terms of the organisation's domestic currency.

< Suppose a UK company has dollar export earnings. A money market hedge could be set up as follows:1. Today borrow dollars at the foreign risk-free rate.

2. Exchange these dollars into sterling, which can then be invested at the organisation's domestic risk-free rate.

3. Use the dollar export earnings to repay the dollar loan.

< A money market hedge effectively produces a "home-made" forward exchange rate. The resulting exchange rate depends on the interest rate differential between the two currencies (i.e. Interest Rate Parity theory holds).

Example 4 Money Market Hedge

A UK-based company expects to receive $300,000 in 3 months.Spot rate ($ per £): 1.7820 ± 0.0002One year sterling interest rates: 4.9%(borrowing), 4.6% (investing)One year dollar interest rate: 5.4% (borrowing), 5.1% (investing)Required:Set up a money market hedge. Solution

3.3 Currency Options

3.3.1 Terminology

< If a company wants a more flexible hedge it may consider buying a currency option.

< Options are an example of derivatives—a financial instrument based on an underlying asset. In the case of currency options the underlying asset is a currency.



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< The purchaser of a currency option has the right, but not the obligation, to buy (if calls) or sell (if puts): = a specified quantity;= of a specified currency;= on or before a specified date (expiry date);= at an exchange rate agreed today (exercise price/strike price).

< The owner of the option can either: = exercise their right or = allow it to lapse (i.e. not exercise it).

< However the owner of an option must pay for this flexibility. The cost of an option is known as its premium.

< Premiums are paid at the date the option is bought and are non-refundable.

< A company may buy options on:= a derivatives market; or= directly from a bank—known as OTC (Over The Counter).

< European style options can only be exercised on the expiry date. OTC options are usually European style.

< American style options can be exercised at any time until the expiry date. Traded options are usually American style.

3.3.2 Hedging With Options

< A currency option may be useful, for example, where a company is tendering for a contract overseas and hence will only exercise the option if the tender is successful.

Illustration 2 Hedging With Options

Johnson is UK-based and considering the take-over of a US company for $3m. It has set itself a three month deadline to complete the transaction or then pull out. The current spot rate is $1.45 to £1. The company has been offered a three month OTC call option on US dollars at $1.42 to £1, costing 1.5 cents per £.What is the maximum sterling amount Johnson will require if the take-over proceeds?The maximum sterling amount will be paid if the option is exercised, requiring Johnson to pay:

$3m$1.42

= £2,112,676

In addition, there is the cost of the option:

$0.015 × £2,112,676 = $31,690 (payable immediately)

This is payable regardless of whether the option itself is exercised.Hence the total maximum sterling amount.

£To purchase $3m 2,112,676

Cost of option (at spot) $31,690$1.45

21,855

2,134,531

Hedging With Options

LIFFE (London International Financial Futures and Options Exchange) no longer deals in foreign currency options. However they are still available on other exchanges and are examinable.



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< To set up a hedge using traded options it is necessary to answer the following: 1. Should we buy or sell options? The default answer is to

buy options as this represents buying an insurance policy (i.e. risk management); selling options represents writing an insurance policy (i.e. risk taking).

2. Should we buy puts or buy calls? There is no default answer here—it depends on whether we need the right to sell the currency represented by the option, or to buy it.

3. Which expiry date? Use the first practical expiry date to cover the period of exposure.

4. Which strike price? If the examiner does not specify a strike price then one has to be chosen. A reasonable approach would be to use options which are "close to the money" (i.e. strike price close to spot). It cannot be claimed that any strike price is "better" than another as:

(i) changing the strike price changes the premium (i.e. you pay for what you get):

(ii) what will happen to the spot is not known in advance.

5. How many options? Divide the amount of exposure into the standardised size of each option.

Example 5 Hedging WithOptions

Philadelphia SE £/$ options £31,250 (cents per pound). Data on 4 February:

Strike CALLS PUTSprice Feb Mar Apr Feb Mar Apr1.600 1.88 2.77 3.30 0.69 1.64 2.241.610 1.38 2.27 2.77 1.11 2.08 2.751.620 0.92 1.81 2.36 1.61 2.58 3.20

On 4 February a UK exporter sells to a US customer for $300,000 receivable towards the end of April. Current spot rate $1.6119 to £1.Required:(a) Show how this receipt could be hedged using currency

options(b) Illustrate the outcomes if the spot exchange rate on the

date of receipt is: (i) 1.625; (ii) 1.605.



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Example 5 Hedging With Options (continued)

Solution(a) Currency options

(b) (i) Exchange rate 1.625

(ii) Exchange rate 1.605

(continued)

3.3.3 Delta Hedging With Currency Options

< Delta is the change in price of an option for a (small) change in the price of the underlying asset (i.e. the spot exchange rate).

< Delta is calculated as N(d1) in the Grabbe variant of the Black-Scholes options pricing model.

< Delta is also known as the "hedge ratio" and can be used to construct delta-neutral portfolios that eliminate FOREX risk by producing gains/losses on options which cancel losses/gains on an underlying currency exposure.



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Example 6 Delta Hedge

A UK-based company needs to buy 150m Euro in three months' time. Euro/Sterling spot rate 0.69 (indirect quote i.e. €1 = £0.69) Euro/Sterling "at the money" call options are available with a contract size of 100,000 Euro and 3 months to expiry. The price of each contract is £3158 and N(d1) = 0.5386Required:(a) Construct a delta hedge to eliminate the FOREX risk;

and(b) Demonstrate how the hedge would operate if Euro/

Sterling strengthens to 0.7.Solution(a) Construct a delta hedge

Number of options required = options

(b) EUR/GBP strengthens to 0.7

3.3.4 Compound Options

< A compound option is an option on an option. There are four main types:= call on a call;= call on a put; = put on a call; = put on a put.

< Compound options are specified with two strike prices and two expiration dates—one of each for the compound option and one of each for the underlying option. There are also two option premiums—the first is paid up front for the compound option, the second is paid for the underlying option in the event that the compound option is exercised.

< Generally, the premium for the compound option is relatively small. However, if the compound option is exercised, the combined premiums will exceed what would have been the paid for just buying the underlying option at the start.



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< Hedging using compound options could be appropriate to protect a "contingent exposure". For example, for a company that has tendered for an overseas contract which, if successful, would provide a receipt of foreign currency at some point in the future.

< Simply buying a put option on the foreign currency could be regretted later if the tender fails—a large premium has been paid to hedge an exposure that has not materialised.

< Therefore it may be better to buy a call on the put option. If the contract is won then exercise the right to buy the underlying put option. If the tender is unsuccessful then the compound option lapses and only a relatively small premium was paid.

3.4 Currency Futures Contracts

3.4.1 The Nature of Futures

Futures contract— a standardised contract between buyer and seller, in which the buyer has a binding obligation to buy a fixed amount (the contract size), at a fixed price (the futures price), on a fixed date (the delivery date), of some underlying asset via a recognised exchange.

< Futures are simply standardised forward contracts that can be traded on an exchange.

< The futures market is a market for risk. Speculators use the market to take risk and companies use the market to hedge risk.

< Currency futures contracts are standardised contracts for the buying or selling of a specified quantity of a specified currency. They are traded on a futures exchange and have various "delivery dates" (e.g. March, June, September and December). The exact day during the month is set in the specification of the contract but is usually toward the end of the month.

< The price of a currency futures contract represents the forward exchange rate for the currencies specified in the contract.

< Daily price data may show the opening price at the start of the day's trading, the intra-day high and low prices and the closing/settlement price at the end of the day. In most exam situations it is the settlement price which is relevant.

< When a futures contract is bought or sold, the buyer or seller is required to deposit a sum of money with the exchange, called initial margin. The exchange also sets a maintenance margin—if losses are made and the margin falls to the maintenance level there is a "margin call" and the margin must be restored to its initial level.

< Any gains are credited to the margin account on a daily basis as the contract is "marked to market".

The focus for futures in the exam is likely to be risk management—not speculation.



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3.4.2 Hedging With Futures

< Although the definition of a futures contract is basically the same as a forward contact, there is a significant practical difference between hedging with forwards and futures:= With forward contracts there is (usually) physical delivery

(i.e. a company that signs a forward contract will physically buy or sell the underlying currency when the contract reaches its delivery date). NDFs are an exception.

= However most currency futures contracts are "closed out" before their delivery date. The company simply executes the opposite transaction to the initial futures position (e.g. if buying currency futures was the initial transaction, it is later closed out by selling currency futures). This technique is referred to as "offset".

= By using offset the participant in the futures market does not physically buy or sell the underlying currency but simply takes gains or losses on the price movement of the contract.

= Even if a futures contract is held until its "delivery date" physically delivery may still not occur—many currency futures are "cash settled" (i.e. any gains/losses are taken on delivery date rather than exchanging the underlying currency).

= In practice it is rare that the company would wish to hold the contract until its delivery date—there are usually only four such dates per year and hence not very likely to perfectly match with the company's underlying exposure.

= Therefore the company will usually use offset before the delivery date and not physically exchange currency using the futures contract. If and when the company needs to exchange currency it will have to use the spot market.

< When setting up a position on futures the company must answer the following three questions:1. Should the company today buy or sell futures contracts

(i.e. take a "long" or a "short" position)? There is no default answer to this—a long position will create a gain on futures upon a rise in the underlying asset, a short position creates a gain upon a fall in the underlying asset.

2. Which delivery date should be used? Take the first practical delivery date (i.e. that falls on or after the period of exposure).

3. How many contracts should be used? Divide the size of exposure into the standardised size of each futures contract.

< When the company later wishes to close out its position it simply reverses the answer to the buy/sell question.

< If a futures hedge is correctly performed any gain made on the futures market will balance a loss on the spot market. However the gains/losses are not likely to perfectly cancel each other out as futures prices rarely move the same amount as spot prices.



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Illustration 3 Currency Futures

In August a UK company sells a machine to a US customer for an agreed price of $1,216,250 receivable in November. The UK supplier is exposed to exchange risk on $1,216,250. Current spot rate is $1.40 to £1 and December sterling futures are trading at $1.39 (contract size £62,500). The company fears that sterling may appreciate against the dollar, leading to a transaction loss when the dollars are sold in November on the spot market.The December sterling futures are currently priced at $1.39 (slightly different to the spot rate—the difference is known as basis). If sterling rises on the spot market than the price of sterling futures will also rise—although not by the same amount as basis must fall over the life of the futures contract. The company needs to set up a position on futures that will produce a gain if sterling rises. The company should therefore buy sterling futures—a long position gives a gain upon a rising price.December contacts can be used as they allow the company to hedge at least its period of exposure (September contracts could only hedge until the end of September).Sterling value of the hedge = 1,216, 250/1.39= £875,000Number of contracts required = 875,000/62,500 = 14Therefore in August the company buys 14 December sterling futures at 1.39In November the company will receive $1, 216, 250 and change into sterling at the prevailing spot rate.It will also close out the sterling futures by selling the contracts.

Solution(i) Suppose that the spot rate in November is $1.45 and the December

futures price has moved to $1.445

Spot market:$1,216,250 @ $1.45 £838,793Compare to original target @$1.40 £868,750Loss on spot market £29,957

Futures market:$

Buy 14 contracts × £62,500 @ $1.39 1,216,250Sell 14 contracts × £62,500 @ $1.445 1,264,375Gain on futures contracts 48,125$48,125 @ spot $1.45 = £33,190

Summary: £Loss on spot market (29,957)Gain on futures contract 33,190Net sterling gain 3,233

The gain and loss do not perfectly match; this is due to the fact that the futures price did not move directly in line with the spot rate. In fact the futures price moved by more than the spot rate—creating an overall gain. This occurred due to the fall in the level of basis in the futures contract between August when it was bought and November when it was sold. Basis always falls over the life of a futures contract because as the contract approaches its delivery date its price must converge to the spot price. Sometimes this creates a net gain from the hedge, sometimes a net loss.If basis changes unexpectedly this is known as basis risk.



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Illustration 3 Currency Futures (continued)

Solution(ii) Suppose that the spot rate in November is $1.38 and the December

futures price is $1.375.

Spot market:$1,216,250 @ $1.38 £881,341Compare to original target £868,750Gain on spot market £12,591

Futures contract:Buy 14 contracts × £62,500 @ $1.39 $1,216,250Sell 14 contracts × £62,500 @ $1.375 $1,203,125Loss on futures contract $13,125$13,125 @ spot rate $1.38 = £9,511

Summary: £Gain on spot market 12,591Loss on futures contract (9,511)Net gain 3,080

Without the hedge the gain would be much larger. However default on futures contracts is not possible—they are legally binding.

3.4.3 The Tick System

< The minimum price movement for a futures contract is known as a tick size. The exchange specifies the size of this minimum price movement for each type of futures contract.

< For £/$ futures with a contract size of £62,500 the tick size is 0.01c per £. This means that the tick value, expressed in $, is:

£62,500 × 0.0001 = $6.25

< Therefore, for each 0.01 cent movement in the price of the futures contract the company's account with the market is credited/debited with $6.25 per contract. This would accrue daily using the mark to market system.

Illustration 3 Currency Futures (continued)

Solution(i) Suppose that the spot rate in November is $1.45 and the December

futures price has moved to $1.445 The gain on the futures contract can be expressed in ticks:Buy 14 contracts @ 1.39Sell 14 contracts @ 1.445This is a 5.5 cent increase in futures price which is equivalent to 550 ticks. Therefore the margin to be credited to the account over the period is:550 ticks × 14 contracts × $6.25 = $48,125 (as before)



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Example 7 Currency Futures

Assume that it is now 30 June. Boozy is a company located in the US that has a contract to purchase goods from Japan in two months' time on 1 September. The payment is to be made in yen and will total 280 million yen.The CEO wishes to protect the contract against adverse movements in foreign exchange rates and is considering the use of currency futures. The following data is available:Spot foreign exchange rate Yen/$ (indirect) 128.15Yen currency futures contracts on SIMEX (Singapore Monetary Exchange)Contract size 12,500,000 yen, contract prices are in $ per yen. Contract prices: September 0.007985 December 0.008250Assume that futures contracts mature at the end of the month.Required:(a) Illustrate how Boozy might hedge its foreign exchange risk using currency

futures.(b) Show what basis is involved in the proposed hedge. (c) (i) Assuming the spot exchange rate is $/Yen 120 on 1 September and that

basis decreases steadily in a linear manner, calculate what the result of the hedge is expected to be.

(ii) Briefly discuss why this result might not occur. Ignore margin requirements and taxation.

Solution(a) Currency futures

(b) Basis involved

(c) Expected result



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3.4.4 Comparison of Futures With Forward Contracts

Forward contract Futures contract

Credit risk Users have to be wary of the credit risk of the other party in every deal

Credit risk is virtually eliminated as the clearing house guarantees deals through the margin system

Credit lines Credit lines with bank are used Credit lines with banks can be kept free

Size A deal is for whatever size and date the parties agree

Standard contracts are traded for fixed amounts and delivery periods

Margin No margin generally required Users have to deposit initial margin

Settlement Usually physical delivery Usually via offset

Basis risk Not applicable Exists

Cash flow On delivery date Gains/losses accrue daily

3.5 Currency Swaps

Currency swap— an agreement between two parties to exchange principal and/or interest payments in different currencies over a stated time period.

3.5.1 Uses and Structure

< Currency swaps can be used:= to obtain foreign currency loans at lower interest rates than

via direct borrowing in overseas markets;= to hedge transaction risk on existing foreign currency loans

(e.g. Eurobonds). < In a standard currency swap, there is an exchange of both

principal and coupon interest, using the following steps:= On commencement of the swap—an exchange of agreed

principal amounts, usually at the prevailing spot exchange rate.

= Over the life of the swap—an exchange of interest payments. In the case of a "plain vanilla" currency swap, the interest rate on each currency is fixed.

= At the end of the swap—a re-exchange of principals, usually at the original spot exchange rate (thereby removing foreign currency risk).



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Illustration 4 Currency Swap

Consider a UK company wishing to borrow dollars to finance an investment project in the US. If the UK firm is not well known in the US money markets it might have to pay higher interest rates on the dollar than a similar US company. To mitigate this problem, the UK company could (via an international bank) locate a US company facing the opposite situation on borrowing sterling. The two parties could then arrange the following swap:

(a) The US company borrows dollars and the UK firm borrows an equivalent amount of sterling. The two parties then swap funds at the current spot rate (i.e. there is a swap of principals).

(b) The US company agrees to pay the UK company the annual interest on the sterling loan. In return the UK company pays interest on the dollar loan.

(c) At the end of the period, the two parties then swap back the principal amounts. This could be at prevailing spot rates or at a predetermined rate (e.g. the original spot rate) in order to eliminate foreign exchange transaction exposure.

By following the above procedure each party has taken advantage of the other's credit rating in its local capital markets and therefore reduced its financing costs.

Currency Swap

3.5.2 Valuation of Plain Vanilla Currency Swaps

< Over the life of a plain vanilla currency swap, a fixed amount of one currency is exchanged for a fixed amount of the counter-currency.

< This can be viewed as a series or "strip" of forward exchange contracts. However, the effective forward rate in the swap will be the same for each exchange of coupon, whereas the actual forward rates quoted in the market would vary according to the delivery date.

< In perfect markets, the swap should have zero NPV at inception (i.e. the present value of payments in the swap should reconcile to the present value using a strip of forward contracts). If this was not the case, speculators would see an arbitrage opportunity between the markets.

< To calculate the fixed equivalent of a series of variable payments, use the following formula:

Fixed payment = Present value of variable payments/ Sum of discount factors



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Example 8 Currency Swaps

A UK company has signed a large contract to import materials from the US. The contract is for a fixed price of $100,000 per month for each of the next 6 months. Forward contracts are available at the following rates:

Month 1 2 3 4 5 6$ per £ 1.64 1.65 1.66 1.67 1.68 1.69

Short-term sterling interest rates are as follows:

4.34% 4.38% 4.47% 4.54% 4.62% 4.69%

An advisor has suggested that, rather than incur the transaction costs of using a series of forward contracts, the UK firm should use a 6-month plain vanilla currency swap (with no exchange of principals).Required:Estimate the forward exchange rate that would be fixed for a six-month currency swap with monthly deliveries of $100,000. Solution

3.5.3 FX Swaps

< An FX swap is where there is a swap of currencies between counterparties but no swap of interest. The key advantage is avoiding the transaction costs of exchanging currency on the market. Two variations are common:= " spot against forward"—where the counterparties swap

principals today at spot rate and then re-exchange on a set date at forward rate;

= "forward against forward"—where both legs of the deal are performed at the forward rate.

< FX swaps can also be referred to as "foreign exchange swaps".



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Session 14

< The four-way equivalence model summarises the relationships between the macro-economic variables of interest rates, exchange rates and inflation rates.

< The favoured method of forecasting long-term exchange rate changes is relative purchasing power parity theory. Short-term fluctuations may have a closer connection with interest rate parity; this is used to set forward rates.

< Although three types of exchange rate risk may affect a firm (translation, economic and transaction) only two of them need to be hedged (economic and transaction) and from these only one can be easily hedged (transaction).

< Practical internal management techniques should be considered before considering external hedging techniques derivatives.

< Forward exchange contracts may require physical delivery (a major disadvantage) or be non-deliverable.

< A money market hedge produces a "home-made" forward exchange rate.

< Currency options are an example of a derivative. Over the Counter options are usually exercised on expiry (European style); traded options are usually exercisable at any time (American style).

< The most "mysterious" of derivatives, the futures contract as physical delivery, is very rare; most participants close out their positions before the delivery date and therefore do not actually exchange currency using the contract but take a gain/loss on the change in contract's price.

< Currency hedging is just one use of currency swaps. A currency swap may involve an exchange of both principal and interest or only currency.

Summary



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1. Name the exchange rate forecasting model that is based upon the difference in inflation rates between two countries. (1.2)

2. State which model is used to set forward exchange rates. (1.3)

3. State whether translation exposure needs to be hedged. (2.1)

4. Suggest methods a firm may use to protect the value of its cash flows against long-term exchange rate trends. (2.2)

5. State which type of foreign exchange risk can be effectively hedged using derivatives. (2.5)

6. Define a forward contract. (3.1)

7. Define a Non-Deliverable Forward/Synthetic Agreement for Foreign Exchange. (3.1.2)

8. State whether an exporter would today borrow or invest foreign currency in order to establish a money market hedge. (3.2)

9. State whether a company should buy options or sell options in order to hedge risk. (3.3)

10. Name the statistic that gives the "hedge ratio" for establishing a currency delta hedge. (3.3.3)

11. Define a futures contract. (3.4)

12. State whether to initially buy or sell currency futures to protect against a fall in the value of the underlying currency. (3.4.2)

13. Define tick size and tick value. (3.4.3)

14. State what happens on the commencement, over the life of, and at end of a currency swap on an underlying loan. (3.5)

15. Define a foreign exchange/FX swap. (3.5.3)



Q33 Forun 80 minutes

Additional

Q34 Storace

Q35 Participating Option

Q36 MJY Co



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EXAMPLE SOLUTIONS

Solution 1—Relative PPP

S1 = S0 × 1 +( )+( )

h1 h

c

b

S1 = 1.90 × 1 0 02

0 03+( )+( )

.

.1 = $1.88 per £1

This is a predicted fall in the value of sterling.

Solution 2—Interest Rate Parity

F0 = S0 × 1 +( )+( )

i1 i

c

b

F0 = 1.78 ×1 0 0325

0 045+( )+( )

..1

= $1.76 per £

Sterling is weaker in the forward market than in the spot market.

Solution 3—Hedging With a Forward

(a) Forward rate = 1.5245 + 0.0214 = 1.5459

Sterling received if forward cover is taken out

= $ ,.

200 0001 5459

= £129,374

(b) Sterling received if no forward cover is taken out

= $ ,.

200 0001 5361

= £130,200

Solution 4—Money Market Hedge

Expected receipt after 3 months = $300,000

Dollar interest rate over 3 months = 5.4% x 3/12 = 1.35%

Dollars to borrow now to have $300,000 liability after 3 months = $300,000/1.0135 = $296,004

Spot rate for selling dollars = 1.7820 + 0.0002 = $1.7822 per £

Sterling deposit from borrowed dollars = $296,004/$1.7822 per £ = £166,089

Sterling interest rate over 3 months = 4.6% x 3/12 = 1.15%

Value in 3 months of sterling deposit = £166,089 x 1.0115 = £167,999



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Solution 5—Hedging With Options

(a) Currency options

The exporter will receive US$, so US$ will be sold and pounds purchased.Receipt is in April therefore April call options. Any exercise price can be chosen—this hedge will be illustrated using 1.610 exercise price.Number of option contracts required:

Sterling size of hedge $ ,.

300 0001 610

= £186,335

Number of contracts £186 33531 250

,£ ,

= 6 contracts required

Premium cost (6 × £31,250 × 2.77 cents) $5,194$5.194 @ current spot rate of 1.6119 £3,222

(b)(i) Outcome—Exchange rate 1.625

At spot $ ,.

,300 0001 625

184 615= £

Exercising the option to buy 6 contracts of $£31,250 @ 1.610 301,875Only receive $300,000 therefore buy $1,875 £on spot market @ 1.625 (1,154)Under option—receive 6 × £31,250 187,500Less: cost of additional $

186,346

Therefore exercise option.

(ii) Outcome—Exchange rate 1.605

At spot $ ,.

,300 0001 605

186 916= £

Exercising the option to buy 6 contracts of $£31,250 @ 1.610 301,875Only receive $300,000 therefore buy $1,875 £on spot market @ 1.605 (1,168)Under option − receive 187,500Less: cost of additional $

186,332

Therefore do not exercise option (i.e. sell $ at spot).



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Solution 6—Delta Hedge

(a) Construct a delta hedgeThe company needs to protect itself against a rise in the price of the Euro. Therefore it should set up an options position that produces a gain upon a rising Euro (i.e. buy calls on the Euro).Exposure is on €150 million and each option is on €100,000. Therefore a "static" hedge would require €150 million/€100,000 = 1,500 options. However a "dynamic" hedge requires that the static hedge be divided by the "hedge ratio" of delta. Therefore 1,500/0.5386 = 2,785 call options should be purchased.

(b) EUR/GBP strengthens to 0.7

Spot Exposure Cost Call option premium

Number of contracts

Market value of option

€:£ €000 £000 £ £0.6900 150,000 103,500 3158 2,785 Buy 8,795,0300.7000 150,000 105,000 3696.6 2,785 Sell 10,295,031

Rounding (1)(1,500,000) 1,500,000

Loss Gain

Explanation: If the euro rises by one pence the value of each call option would rise by 0.5386 pence and the total value of the options held would rise by 0.5386 pence × 100,000 × 2, 785 = £1,500,000 (perfectly balancing the loss on the underlying exposure).

Solution 7—Currency Futures

(a) Currency futuresBoozy needs to purchase yen on the spot market in two months' time. To protect against the risk of the yen strengthening against the $US, Boozy should buy yen futures contracts, hoping to sell them at a higher price if the yen strengthens. This is intended to offset any loss relative to the current spot rate when the yen are purchased in the spot market in two months' time.Use contracts that mature at the nearest date after 1 September, the September contract. To protect 280 million yen, 22 contracts will need to be bought.Boozy needs to buy yen futures contracts.The number of contracts required is 22.

(b) Basis involvedBasis is the difference between the current spot price and the futures price, in this case Y128.15 − Y125.23 or 2.92 yen. (September futures in terms of yen per $1 = 1/0.007985 = 125.23)

¥Current spot price 128.15Futures price (1/0.007985) 125.23Basis to appropriate contract 2.92



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(c) Expected resultBasis will be zero at the maturity date of the futures contract, 30 September. If it reduces in a linear manner, the expected basis on:

1 September is 2 923. = 0.973 yen

The expected futures price is 0.973 yen below the spot price of 120 = 119.027 or 0.008401 yen per $1Expected result of the hedge:

Spot market Futures market30 June 30 JuneYen 280m = $2,184,939 Buy 22 September yen contracts at 0.007985

(Contracts are for a total of 275,000,000 yen)1 September 1 SeptemberYen 280m = $2,333,333 Sell 22 September yen contracts at 0.008401

Futures gain is 275,000,000 (0.008401 – 0.007985) = $114,400

Loss on the spot market = $148,394

Hedge efficiency is 114 400148 394

,,

= 77%

This result may not occur as basis is unlikely to decrease in a linear manner. Depending on the movement in basis the hedge efficiency might be higher or lower than 77%.

Solution 8—Currency Swaps

Month 1 2 3 4 5 6$ per £ 1.64 1.65 1.66 1.67 1.68 1.69£ payment 60,976 60,606 60,241 59,880 59,524 59,172£ DF 0.996 0.993 0.989 0.985 0.981 0.977£ PV 60,732 60,182 59,578 58,982 58,393 57,811

Total PV = 355,678

Total DF = 5.921

PV/DF = 355,678/5.921 = 60,071

Fixed swap rate = 100,000/60,071 = 1.665 $ per £*

Working

Calculation of discount factors (e.g. for two months)

4.38% × 2⁄12 = 0.73% = 0.0073

1/1.0073 = 0.993

*Although the methodology above is the technically correct approach to finding the swap rate, the final answer can be found more quickly as a simple average of the forward rates: (1.64 + 1.65 + 1.66 + 1.67 + 1.68 + 1.69)/6 = 1.665



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NOTES



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Session 15

Session 15 Guidance

Recognise the nature of interest rate risk for the firm, the classic scenario being a firm concerned about rising interest rates leading to an increased cost of borrowing (s.1).

Learn internal methods of managing interest rate risk (s.1.4).


1. The role of the treasury function in multinationalsa) Explain the role of the treasury management function within:

iii) The management of risk exposure.b) Discuss the operations of the derivatives market, including:

i) The relative advantages and disadvantages of exchange traded versus OTC agreements.

iii) The source of basis risk and how it can be minimised3. The use of financial derivatives to hedge against interest rate riska) 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) Options on FRAs (caps and collars), interest rate futures and interest

rate swaps.

Interest Rate Risk Management



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Session 15 Guidance

NATURE OF INTEREST RATE RISK

• Rising Interest Rates• Falling Interest Rates• Other Types of Interest

Rate Risk• Risk Management

EXTERNAL HEDGING STRATEGIES

• Forward Rate Agreements• OTC Options• Interest Rate Futures• Options on Futures Contracts• Interest Rate Swaps• Relative Advantages of OTC

v Traded Derivatives

VISUAL OVERVIEWObjective: To appreciate the nature of interest rate risk and to recognise, understand and implement strategies to hedge interest rate exposure.

Learn the range of external hedging techniques—forward rate agreements, interest rate futures, options on interest rate futures, interest rate swaps (s.2).

Recognise how forward interest rates can be used to imply the theoretical fixed rate in a plain vanilla interest rate swap (s.2.5).



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Session 15 • Interest Rate Risk Management P4 Advanced Financial Management


1 Nature of Interest Rate Risk

1.1 Exposure to Rising Interest Rates There are two main situations in which a company may fear

rising interest rates:1. A company which has a significant proportion of floating

interest rate debt will fear a rise in interest rates as this obviously leads to lower profits. However, higher interest expense also leads to higher financial risk (i.e. more volatile future profits due to a larger block of committed interest expense to be covered). An extreme interest rate rise could even cause financial distress risk (i.e. bankruptcy).

2. A company which has a significant amount of surplus cash invested in fixed interest rate securities (e.g. government bonds). If market interest rates rise then bond prices fall.

1.2 Exposure to Falling Interest Rates There are two main situations in which a company may fear

falling interest rates:1. A company which has a significant proportion of fixed interest

rate debt and therefore does not participate in the benefits of falling rates.

2. A company with significant floating rate investments (e.g. money market investments).

1.3 Other Types of Interest Rate Risk Basis risk—even if a company has floating rate assets and

floating rate liabilities of similar size, they may be linked to different reference rates which may change at different times and/or by different amounts. This can be referred to as basis risk (which is also used to describe the risk of an unexpected change in the level of basis in a futures contract).

Gap exposure—if a company has floating rate assets and floating rate liabilities of similar size that are all linked to the same reference rate (e.g. LIBOR) it can still face risk. It is possible that the interest rate is re-set at different intervals on assets and liabilities (e.g. every six months on assets but every three months on liabilities).

1.4 Management of Interest Rate Risk For some companies, it may be practical to use internal

methods of hedging against interest rate risk. For example: Smoothing—maintaining a balance between fixed rate and

floating rate borrowing. Matching—attempting to have a common interest rate

for both assets and liabilities. This is more practical for financial institutions than for trading companies.

However, it may be necessary to also consider external hedging techniques. The following are mentioned in the syllabus and will be considered in detail: Forward rate agreements (FRAs); OTC options—caps, floors and collars; Interest rate futures contracts; Options on interest rate futures; Interest rate swaps and swaptions.



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P4 Advanced Financial Management Session 15 • Interest Rate Risk Management

*A company cannot actually borrow or invest money using an FRA—but can use it to hedge the interest rate on underlying physical positions.

2 External Hedging Strategies

2.1 Forward Rate Agreements

Forward rate agreement (FRA)— an agreement by a bank to enter into a notional loan or accept a notional deposit from a customer for a specified period of time. The contract is settled based on the difference between the interest rate agreed when the contract is signed and the rate prevailing when the notional loan/deposit is deemed to start.

FRAs allow companies to fix, in advance, either a future borrowing rate or a future deposit rate, based on a notional principal amount, over a given period.*

FRAs are settled in advance (i.e. when the notional loan/deposit is deemed to start). The settlement is based on the difference on settlement date between: the rate fixed in the contract; and the reference interest rate (e.g. LIBOR).

FRAs are therefore cash settled rather than requiring physical delivery.

The maximum maturity period for an FRA is usually about two years.

FRAs are customised agreements with a bank (i.e. OTC). No premium is paid for an FRA and no margin needs to

be posted. Although no money changes hands when an FRA is signed, the

words "buy" and "sell" are still used: Buying an FRA—represents taking a notional loan from the

bank at a fixed borrowing rate. Hence a company would buy an FRA to hedge against rising interest rates.

Selling an FRA—represents making a notional deposit at the bank at a fixed rate. A company would sell an FRA to hedge against falling rates.

If the company buys an FRA it will be offered a higher rate than if it sells an FRA. The bank makes its profit by applying a spread to the rates; this is where the cost of hedging for the company is "hidden".



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Illustration 1 Forward Rate Agreement

A company plans to borrow $20 million in 3 months' time for a period of 6 months. The interest rate on the loan will be set at LIBOR + 0.5%. The company fears that LIBOR may rise above 5% during the next 3 months. It can buy an FRA from a bank at an agreed rate of 5% on a notional principal of $20 million, starting in 3 months from today, ending 9 months from today and referenced to LIBOR. This is known as a 3v9 FRA. If LIBOR is higher than 5% in 3 months' time, then the bank pays the

company the difference between 5% and LIBOR (i.e. cash settlement is made at the start of the FRA period). The compensation would be calculated as the present value of the interest rate difference on a $20m 6-month loan (discounted at LIBOR).

If actual interest rates are lower than 5% then the company pays the bank the difference.

Therefore, whatever happens to LIBOR during the next 3 months the company will pay interest at a rate of 5.5% (5% LIBOR plus 0.5% spread) on the underlying $20 million loan.No premium is paid for the FRA. There also is no reason why the company must use the same bank for the FRA and the underlying loan

2.2 OTC OptionsVarious OTC interest rate options can be purchased from financial institutions and tailor-made to meet company requirements. The three major types are described below:

2.2.1 Cap

Interest rate cap— an agreement by the seller of the cap to pay the buyer the excess of the reference interest rate over the agreed cap rate, based on a notional principal amount.

Caps are usually written/sold by financial institutions and purchased by companies.

If the reference interest rate rises above a predetermined level, the financial institution pays the difference to the company, based on an agreed notional principal and time period. This puts a cap or ceiling on the interest rate paid by the company. If the reference rate stays below the pre-determined rate the cap will not be exercised.

An interest rate cap is an option which allows the buyer, for the cost of the premium, to limit the interest that it pays to a maximum amount while being able to take advantage of possible falls in interest rates.

Forward Rate Agreement



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Illustration 2 Interest Rate Cap

Co A has $1 million of debt in issue and it pays interest on this debt at the rate of LIBOR + 0.5%. Interest is due every 3 months and Co A's treasury manager is concerned about a possible rise in interest rates during the next 6 months above the current LIBOR of 5%. Co A buys a 6-month interest rate cap based on a notional principal of $1 million with a cap rate of 7%. The cap is re-set every 3 months.LIBOR at the end of the first three month period is 8%. This means that under the cap agreement the seller of the cap must pay Co A:

1% × $1,000,000 × 3/12 = $2,500being the difference between the reference interest rate (8%) and the cap rate (7%) based on the notional principal amount for a 3-month period.LIBOR at the end of the next 3-month period is 4%Co A simply pays 4.5% interest on its debt and the cap option is not exercised.

2.2.2 Floor

Interest rate floor— an agreement by the seller of the floor to pay the buyer the excess of the agreed floor rate over the reference interest rate based on a notional principal amount.

Floors are usually written by financial institutions and purchased by companies.

If the reference interest rate falls below a predetermined level, the financial institution pays the difference to the company. This would be relevant for a company with floating rate investment income that wishes to guarantee a minimum return.

Illustration 3 Interest Rate Floor

Co B has investments of $2m producing income of LIBOR which is currently 5%. Interest is received every 3 months. The company does not wish to see this income decline during the next 6 months.Co B therefore purchases a 6-month floor at 5% based on a notional principal of $2 million and referenced to LIBOR every 3 months. LIBOR at the end of the first 3-month period is 4%

Seller of floor pays Co B 1% × $2,000,000 × 3/12 = $5,000LIBOR at the end of the next 3-month period is 7%Co B receives 7% on its investments and the floor option is not exercised.



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2.2.3 Collar

Interest rate collar (low-cost cap)— a combination of a purchased cap and a written/sold floor agreement. It protects against rising interest rates but limits participation in falling rates.

Buying an interest rate cap can be expensive in terms of the premium cost. Therefore by simultaneously selling a floor a premium can also be received to reduce the net cost of the hedge.

The effect of the collar is to create both a maximum and a minimum interest rate. The benefit is the reduced cost of establishing the hedge but the disadvantage is that it restricts the possible gains from drops in interest rates compared to simply buying a cap.

Building a collar is also known as a constructing a "low-cost cap".

Illustration 4 Interest Rate Collar

Co A has floating rate debt. The treasury manager believes that LIBOR might rise above 7% but he is fairly confident that it will not fall below 5%. Therefore Co A — buys a cap from a bank at 7% — sells a floor at 5% If LIBOR rises to 8% — bank pays 1% difference to Co AIf LIBOR falls to 3% — Co A pays 2% difference to the buyer of the floorCo A has created an interest band of 5% – 7%.

Another variation on the collar is the " low-cost floor" (i.e. buy a floor/sell a cap). This may be considered by a company with floating rate investments that wants to protect against falling interest rates but is discouraged by the cost of just buying a floor. By also selling a cap the cost of the hedge falls but so does the participation in rising interest income.

2.3 Interest Rate Futures

Interest rate futures (IRFs)— are traded forward interest rate agreements.

2.3.1 Characteristics of IRFs

The nature and terminology of interest rate futures is very similar to that of currency futures, as are the principles of hedging.

The most common futures contract to use for interest rate hedging is a three-month contract. This contract is referenced to short-term interest rates (e.g. three month LIBOR). In London these are traded on LIFFE (now part of NYSE Euronext) and are also referred to as "short sterling futures".

The key to hedging with these contracts is familiarity with the pricing convention:

Contract price = 100 – implied forward interest rate



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Illustration 5 Interest Rate Futures

3-month sterling interest rate futures £500,000 contract sizeLIFFE prices on 4 February: Mar 93.65June 93.42Sep 93.21Dec 93.03Assume the delivery date is the end of the relevant month (in practice it is the third Wednesday)Consider the March futures:On 4 February the forward interest rate for the end of March = 100-93.65 = 6.35%. If LIBOR on 4 February is 6% then the basis in March futures = 0.35%. Between 4 Feb and the end of March the level of basis in the contract must fall to zero. If, by chance, LIBOR is still 6% on the delivery date the contract price would be 100 – 6 = 94.00

In effect, the "seller" of the contract agrees to issue, at a price agreed today, a three-month sterling discount bill on the delivery date with a face value of £500,000. The "buyer" agrees to buy this bill on the delivery date and to pay the agreed price.

The implied interest rate in a futures contract is therefore a forward interest rate (i.e. the interest rate that applies on the delivery date of the contract).

Physical delivery will not occur as most participants will use "offset" before the delivery date. Even if the contracts are held until their delivery date they are cash settled rather than settled by physical delivery (i.e. the seller does not actually issue a discount bill to the buyer; each party simply takes an equal and opposite gain or loss depending on the price change of the contracts). Gains/losses accrue daily using the mark to market system.

Therefore a company cannot physically borrow or invest money using three-month interest rate futures. However, the contracts can be used to hedge interest rate risk on an underlying physical loan or deposit.

2.3.2 Hedging With IRFs

As with currency futures there are three questions to answer when setting up the hedge:

1. Should we buy or sell futures contracts?

2. Which delivery date to use?

3. How many contracts?

The first question is the most critical. If a company wishes to hedge against rising interest rates it should use futures as follows: Today sell interest rate futures. Wait until the period of exposure ends.



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If interest rates have risen, the price of futures will have fallen. "Close out" the futures position by buying the same

contracts that were originally sold.* There should be a gain on futures (as we sold high and

bought low) to cover higher interest expense on company debt. The gain can be calculated using the tick system: − tick size = 0.01%− tick value = 0.0001 × £500,000 × 3/12 (3 months'

notional interest) = £12.50 However, the hedge is not likely to be perfectly efficient as

futures prices rarely move the same amount as LIBOR due to the fall in basis over the life of the contract.

Delivery date—use a contract with a delivery date that falls on or after the date you expect to close the hedge. To minimize exposure to basis risk it is recommended to choose the first practical contract.

Number of contracts—compare both the principal and duration of the company's debt to the notional principal (£500,000) and notional duration (three months) of the discount bill represented by the futures contract.

2.4 Options on Futures Contracts

2.4.1 LIFFE Short Sterling Options

LIFFE short sterling option contracts involve an option on interest rate futures contracts.

It is convenient for both speculators and risk managers that the options are on futures rather than on actual discount bills as futures do not require physical delivery.

Illustration 6 Options on Interest Rate Futures

LIFFE short sterling options £500,000 contract size (4 February) CALLS PUTS

Strike price: Mar Jun Sep Mar Jun Sep9350 0.18 0.13 0.13 0.03 0.21 0.429375 0.03 0.05 0.06 0.13 0.38 0.609400 0 0.01 0.02 0.35 0.59 0.81

Strike price represents the price at which the underlying interest rate futures contract can be bought or sold. There is a convention that the decimal point is removed (i.e. 9350 = 93.50).The holder of calls has the right to buy futures contracts at the chosen strike price on or before the chosen expiry date (traded options are US style) The numbers below the month columns represent the price of each option (i.e. the premium). The premium is expressed as a percentage cost on £500,000 for 3 months (the specification of the notional bill in the futures contract) but can be easily calculated in total using the tick system.

*In this hedge, futures were first sold and later bought. This is called taking a "short position" and is possible in all futures markets because of the ability to close out positions before contracts reach their delivery date.



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2.4.2 Hedging With Options on Futures Contracts

As usual with traded options there are five questions to answer when establishing the hedge:

1. Should we buy or sell options? The default answer is to buy options as this represents buying an insurance policy (i.e. risk management).

2. Should we buy puts or buy calls? There is no default answer here—it depends on whether we need the right to sell interest rate futures or to buy interest rate futures.

3. Which expiry date? Use the first practical expiry date to cover the period of exposure.

4. Which strike price? If the examiner does not specify a strike price then choose for yourself but it cannot be claimed that any strike price is "better" than another as (i) changing the strike price changes the premium (i.e. you pay for what you get) (ii) what will happen to interest rates is not known in advance.

5. How many options? As per the number of futures contracts.

The principle hedging strategies include the following:

Interest rate cap—to protect against rising interest rates the company should buy puts on interest rate futures. If interest rates rise the price of futures will fall. The company can then buy futures at the lower market price, exercise the puts to sell the futures at the strike price and take a gain.

Interest rate floor—to protect against falling interest rates the company should buy calls. If rates fall then futures prices will rise. The company can then exercise the calls to buy futures at the strike price, sell them at the higher market price and take a gain.

Low cost cap/collar—a combination of a purchased cap and a written floor (i.e. buy puts and simultaneously sell calls).

Low cost floor/collar—buy calls and simultaneously sell puts.



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Example 1 Futures/Options Hedging

The corporate treasurer of Theakston has received the company's financial projections for the next year. The figures show a deficit of £12.2m from 1 March and lasting for 6 months. Today is 1 November. Theakston can borrow at base rate, currently 6%, plus 1.5%.The treasurer believes that the Bank of England is likely to raise interest rates during the next 3 months in order to cool the economy. LIFFE prices (1 November)FuturesLIFFE £500,000 three month sterling interest rate (points of 100%): December 93.75 March 93.45 June 93.10Tick size = 0.01% OptionsLIFFE £500,000 short sterling options (points of 100%) Exercise price Calls - March Puts - March

9200 3.33 –9250 2.93 –9300 2.55 0.929350 2.20 1.259400 1.74 1.849450 1.32 2.909500 0.87 3.46

Required:(a) Illustrate the results of a futures hedge if interest rates rise by 2%

and futures prices move by 1.8%. (b) Illustrate the results of an options hedge using the same

assumptions.(c) Explain what the company can do to reduce the cost if the hedge in

(b) is too expensive for Theakston.



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Example 1 Futures/Options Hedging (continued)

Solution(a) Results of futures hedge

(b) Options hedge

(c) Cost reduction



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2.5 Interest Rate Swaps

Interest rate swaps— an exchange between two parties of interest obligations or receipts in the same currency on an agreed amount of notional principal for an agreed period of time.

2.5.1 Plain Vanilla Swaps

This most common interest rate swap is a plain vanilla swap where fixed interest payments based on a notional principal are swapped for floating interest payments based on the same notional principal.

This is a flexible method for companies to change the interest rate profile of their underlying loans or investments.

It can also lead to cheaper finance for both parties.



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Illustration 7 Plain Vanilla Swaps

(a) A wishes to raise $1m fixed interest debt finance. Because of a poor credit rating a debenture issue is not possible and the best fixed interest rate loan it can obtain is at 12.5%. It can, however, borrow at a variable rate of LIBOR + 0.5%.

(b) B can issue fixed-rate debentures at 11% or alternatively borrow at a variable rate equivalent to LIBOR. B wants $1m in floating rate finance.

If A and B arrange to swap, the following steps might be taken: (1) A borrows $1 million at the variable rate of LIBOR + 0.5%.(2) B borrows $1 million at the fixed rate of 11%.(3) In the swap agreement A agrees to pay B interest of 11.75% (fixed) on $1 million, while B

agrees to pay A an interest rate of LIBOR (variable) on the same sum. Note that there is a swap of interest streams, not a swap of principals.

LIBOR + 0.5%

LIBOR11.75% 11%

The net cost of financing to each party is thus as follows:AInterest payable on variable rate loan LIBOR + 0.50%Less: Received from B (LIBOR) 0.50%Add: Interest payment to B 11.75%Net cost 12.25% (fixed)BInterest payable on fixed rate debenture 11.00%Less Received from A (11.75%) (0.75%)Add: Interest payment to A LIBORNet cost LIBOR – 0.75% (variable)Overall both parties have received the type of financing they require and each has made a saving—A paying 0.25% less for fixed interest funds than if it borrowed fixed rate directly; B paying 0.75% less for variable rate funds.Swaps use the principle of "comparative advantage". B can borrow more cheaply than A at both fixed and variable rate—however, there is a differential of 1.5% on their fixed-rate borrowings but only 0.5% on their variable-rate borrowings, i.e. A B DifferenceFixed rate 12.5% 11% 1.5%Variable rate LIBOR + 0.5% LIBOR (0.5)%

Saving that can be achieved via a swap 1.0%

Although B has an absolute advantage in both fixed- and variable-rate markets, it has a comparative advantage in the fixed-rate market. Therefore it is better for B to borrow fixed rate and use a swap to get the floating rate position it desires. Under the above swap agreement this saving is split as follows:A 0.25%B 0.75% 1.00%This simple swap from fixed-floating rate (and vice versa) is known as a plain vanilla interest rate swap. More complex swaps exist but all follow the principle of comparative advantage.



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2.5.2 Advantages of Swaps

Interest rate hedging—over longer periods than available using FRAs, futures or options.

Cheaper finance—by borrowing the opposite of the desired type of finance and then swapping into what is required, a company can pay less interest compared to directly borrowing what it wants.

Access to types of finance not directly available—for example, some companies are not offered fixed rates by their banks. In this case they can borrow floating rate and use a plain vanilla swap to indirectly obtain fixed rate.

Flexibility—swaps can be arranged for any sum and over varying time periods and may be reversed by re-swapping with other counter-parties.

Low transaction costs—these are limited to the legal fees in agreeing the documentation and arrangement fees.

Financial engineering—swaps are a fast and convenient method of changing a company's debt profile. Imagine that the company has issued fixed-rate debts and now wishes to move towards floating rate. Without a swap it would be necessary to redeem the exiting debts (possibly triggering large early redemption penalties) and then issue new debts with the related issue costs. However, with a swap the company does not need to touch the existing debts and thereby avoids redemption penalties and new issue costs.

2.5.3 Disadvantages of Swaps

Risk of default—to date there have been few publicised defaults on swap contracts. As a result all market participants have been "winners". Swaps are usually arranged via an international bank which acts as the counterparty for each company and hence minimises default risk.

Position risk—for example, if a company has fixed interest debt and swaps into floating rate debt it faces the risk of an unexpected rise in interest rates.

Transparency risk—historically swaps were off-balance sheet transactions and not dealt with by accounting standards which tend to lag developments in finance. Therefore there was a risk that a company's finances were not transparent to users of the accounts. Such transparency risk should be falling with the introduction of IAS 39, although how many users of accounts understand that the financial reporting for derivatives is questionable.

Warehousing risk—if the bank does not have a counterparty available it may personally enter into a swap with a client, and then later attempt to re-swap out of the position. During this period this time the bank has changed its own interest rate position, which may have adverse consequences. This is known as warehousing risk.



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Example 2 Plain Vanilla Swap

Real wishes to raise $15 million of fl oating rate fi nance. It has an AAB rating and can issue fi xed-rate fi nance at 6.35%, or fl oating rate at LIBOR plus 60 basis points. Ale has only a BBC credit rating and can raise fi xed-rate fi nance at 7.8%, or fl oating rate at LIBOR + 1.35%.A fi ve-year interest rate swap on a $15 million loan could be arranged with Golden Sacks Bank acting as an intermediary for a fee of 0.25% per annum, half payable by each party.

Required:(a) Prove that the swap can benefit both companies. (b) Design the swap so as to benefit both companies equally.

Solution

(a) Swap agreement

Fixed rate Floating rateReal

Ale

Differential

Explanation:

(b) Designing the swap to split benefit equally



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2.5.4 Quotation of Plain Vanilla Swaps

In practice most swaps are arranged through financial institutions, with the bank operating as the counterparty to each firm involved in the swap.

The institution organising the swap quotes two interest rates for the fixed leg:

the rate at which it is prepared to receive a fixed interest cash flow (the " ask rate");

the rate at which it is prepared to pay a fixed interest cash flow (the " bid rate");

In either case the floating rate leg of the swap will be LIBOR.

Illustration 8 Bank as Counterparty

Happy has a one-year, $15m loan at a variable rate of LIBOR plus 60 basis points. Its treasurer fears that interest rates may rise and wishes to use a swap to convert to fixed interest. Happy would be able to raise a $15m fixed rate loan for 5.5%. Larry pays 5.05% fixed rate on a one year $15m loan. Its treasurer believes that rates may fall and wishes to swap to a variable rate. Larry could raise a variable interest rate loan at LIBOR plus 75 basis points.A bank is quoting a 12 month swap rate of 4.61% (bid) and 4.62% (ask). The diagram below shows how the bank will operate as an intermediary for the swaps:

The overall interest rate position of each counterparty is as follows:

Happy LarryExisting interest liability LIBOR + 60 5.05%Receipt from bank (LIBOR) (4.61%)Paid to bank 4.62% LIBORInterest flow after swap 5.22% LIBOR + 44Open market cost 5.50% LIBOR + 75Saving from swap 0.28% 0.31%



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2.5.5 Using Forward Rates to Value Swaps

A plain vanilla interest rate swap effectively represents a series of FRAs (forward rate agreements). For example, a three-year swap represents:

initially borrowing the notional principal for a period of one year; refinancing the borrowing after one year (i.e. paying the first

year's interest and "rolling over" the notional principal from year one to year two);

rolling over again from year two to year three.

The fixed rate in the swap should, under perfect market assumptions, be equivalent in overall cost to using an actual series of FRAs. Hence to find the theoretical fixed rate in the swap it is first necessary to find the relevant "forward" interest rates.

Forward interest rates are the rates that apply to borrowing money between two points in time. For example, the forward rate from year two to year three is the interest rate that can be agreed today for borrowing money in two years' time for a period of one year.

Forward rates can be implied from spot rates as follows:

The one-year spot rate is the interest rate that applies for borrowing money today for one year. By definition this is also the forward rate from year zero to year one.

The forward rate from year one to year two is the interest rate that geometrically "links" the one-year spot rate to the two-year spot rate:(1 + one year spot) × (1 + forward rate) = (1 + two year spot)2

The forward rate from year two to year three can be found as:(1 + two year spot2) × (1 + forward rate) = (1 + three year spot)3*

*See Session 2 for the derivation of spot rates.



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Example 3 Swap Valuation

The process of "bootstrapping" has revealed the following treasury spot rates: Year Treasury spot 1 3.88% 2 4.96% 3 5.8%

Required:(a) Calculate the forward interest rates from year one to year two, and from

year two to year three. (b) Calculate the theoretical fixed rate in a three-year plain vanilla swap

(assume the floating rate leg would be set at LIBOR).

Solution

(a) Forward interest rates

(b) Theoretical fixed rate



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2.5.6 Other Types of Swap

The most common type of interest rate swap is the plain vanilla. However various " flavoured" swaps are also possible:

Amortising swap—the notional principal falls over the life of the swap;

Accreting swap—he notional principal rises; Seasonal swap—the notional principal varies over the year; Roller Coaster swap—the notional principal initially rises then

amortizes to zero; Off market swap—has a NPV an inception (usually swaps start

with zero NPV). For example, the fixed rate in the swap is above market rate, creating negative NPV at inception for the fixed rate payer;

Forward swap—starts at a future date; Extension swap—extends an existing swap; Basis swap—based on two floating rates; Yield curve swap—two floating rates referenced to instruments

with different maturities; Differential swap—referenced to interest rates in different

currencies but settled in one currency.

2.5.7 Swaptions

Swaption— an option that provides the holder with the right but not the obligation to execute an interest rate (or a currency swap) during a limited period of time and at a specified rate.

Swaptions integrate the benefits of swaps and flexibility of options and are known as "hybrid derivatives".

There are three main types: American swaptions—can be exercised on any day within

the exercise period. European swaptions—can only be exercised on the expiry

date. Extendable swaptions—allows the company to extend the

period of an existing swap.



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2.6 Relative Advantages of OTC vs. Exchange Traded Derivatives

2.6.1 Advantages of OTC Agreements

Advantages of hedging interest rate (or currency) risk using OTC agreements such as forwards, OTC options and swaps include the following:

Arranged face-to-face between a bank and its client and therefore can be customised to the client's specific circumstances.

No requirement to post initial margin (i.e. no security deposit is needed to set up the hedge).

Available on a wide range of underlying positions (i.e. a wide range of currencies and interest rates). This is useful if a firm has currency exposure on a relatively exotic currency or if its interest rate is referenced to an unusual benchmark.

Can be used to hedge for relatively long periods (e.g. FRAs have settlement dates up to two years).

2.6.2 Disadvantages of OTC Agreements

Counterparty risk—OTC agreements are not guaranteed by a clearing house and therefore are exposed to default risk.

Price opacity—as OTC agreements are not traded in a liquid market they are less likely to be fairly priced than exchange traded instruments.

Governments find it difficult to regulate and monitor the OTC markets as they are "off-exchange".

2.6.3 Advantages of Exchange Traded Derivatives

No counterparty risk—the clearing house effectively operates to eliminate counterparty risk by demanding that participants post initial margin.

Price transparency—derivatives markets are very liquid (i.e. with a huge number of transactions). Such a "deep" market quickly discovers fair prices.

Physical delivery is not required; futures contracts can be settled by offset (i.e. reversing positions rather than holding to delivery date). This can be convenient for risk managers (e.g. an oil company would not be able to physically delivery its own oil on the futures market if it does not match the exact grade specified in the contract).

2.6.4 Disadvantages of Exchange Traded Derivatives

Standardisation—futures and traded options are only available on a limited range of underlying assets, have standard contract sizes and maturity dates.

Initial margin is (usually) required—when hedging with futures a deposit of cash or cash equivalents must be made to cover potential losses.

Risk of market collapse—the companies that operate the derivatives markets themselves maintain relatively low levels of liquid reserves. There is concern that a major shock to the market could cause its collapse.



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Session 15

Depending on the nature of its assets and liabilities, a firm may be concerned with either rising or falling interest rates.

Practical internal hedges are available such as keeping a balance of exposures between floating and fixed rates on both investments (if practical) and liabilities.

However, any residual exposure can be hedged externally using various financial instruments.

When using interest rate derivatives physical delivery is very unusual—contracts are either cash settled (FRAs, OTC options, swaps) or closed out using offset (futures).

Summary



Q37 Omnitown 50 minutes

Additional

Q38 Manling

Q39 Murwald

Q40 Turkey


1. State TWO internal methods of interest rate hedging. (1.4)

2. Name the interest rate equivalent of a forward contract. (2.1)

3. Define a low-cost cap/interest rate collar. (2.3)

4. State whether 3-month sterling interest rate futures contracts can be physically delivered. (2.3)

5. State whether a firm should initially buy or sell interest rate futures in order to protect itself from rising interest rates. (2.3.2)

6. Explain why futures prices rarely move by the same amount as spot market prices. (2.4.2)

7. State how options on interest rate futures can be used to create a cap. (2.4.2)

8. Define a "plain vanilla" interest rate swap. (2.5.1)

9. List advantages of swaps. (2.5.2)

10. List disadvantages of swaps. (2.5.3)

11. Give examples of "flavoured" swaps. (2.5.6)

12. Define a "swaption". (2.5.7)



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EXAMPLE SOLUTIONSSolution 1—Futures/Options Hedging

(a) Results of futures hedgeThe company fears that interest rates will rise, causing extra interest on its forecast borrowing. Therefore it should set up a position on futures that will produce a gain if interest rates rise. If interest rates rise then futures prices fall. Therefore Theakston should first sell interest rate futures in the expectation that their price will fall. Assume that the forecast loan will be fixed rate (i.e. the interest rate on the loan will be set according to base rate on 1 March and then not reset during its six month' life). Therefore the risk for Theakston is that rates rise between 1 November and 1 March.Hence the hedge needs to be open until 1 March. March or June futures contracts can be used although it is better to use March futures as this reduces the basis risk in the hedge (the March futures will be closed out relatively close to their delivery date which would be towards the end of March) The notional bill underlying each futures contract has a face value of £500,000 and duration of three months. If Theakston was borrowing £12.2m for three months it would need 12.2/0.5 = 24.4 futures contracts to protect the loan. However the bank loan is for six months and the number of contracts must be doubled to account for the futures duration. Therefore, 48.8 futures contracts are required to fully hedge it – round to 49 contracts.

# contracts = amountFace value of futures contract

Loan Loa×

nn

round

termFutures duration

££5

= ×

=

12 200 00000 000

63

48 8

, ,,

. tto contracts 49

On 1 November Theakston sells 49 March futures at 93.45On 1 March the company simultaneously takes out the loan and closes the futures positionThe additional interest on the loan at 2% for 6 months costs:

Cost of additional interest = £12.2m × 6/12× 2% = £122,000If interest rates rise futures prices fall so the market price of March futures is now 93.45-1.80 = 91.65.On 1 March Theakston buys 49 March futures at 91.65 Sell 93.45 Buy (91.65) Gain 1.80Tick size 0.01% and therefore tick value = 0.01% × 3/12 × 500,000 = £12.50Change in value of futures = 180 ticks×£12.50×49 = £110.250.

Summary Evaluation £Change in value of futures (49 contracts x 180 x £12.50) 110,250Cost of additional interest (£12.2m × 6/12× 2%) (122,000)Net gain/(loss) (11,750)Explanation: The hedge was not perfectly efficient because the futures price changed by less than the interest rate in the economy. This was due to the fall in the level of basis in the contracts.



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(b) Options hedge Selling futures today produces a gain on futures if interest rates rise but would lead to loss on futures if rates fall—futures are legally binding contracts and therefore not a flexible method of hedging. Therefore the company might prefer to have the right, but not the obligation, to sell futures (i.e. on 1 November buy puts on futures).Assume that Theakston wants a cap at today's base rate (i.e. 6%). It therefore buys puts at an exercise price of 100 – 6 = 94.00. Only March options are available but these can be used to hedge until 1 March—although they would expire at the end of March they are American style and can be exercised at any time until expiry. The company needs the right to sell 49 futures and therefore buys 49 put options.

March puts at 94.00 cost 1.84. This is a percentage cost based on the standard contract, i.e. 1.84% × £500,000 × 3/12 × 49 = £112,700.On 1 November the company buys 49 March puts at 94.00 strike price and pays a premium of £112,7001st March:Additional interest at 2% is calculated as before £122,000The price of a March future is now 91.65 (93.45 – 1.8) which is less than the exercise price of the option so Theakston should exercise the options:

Sell futures (by exercising puts) 94.00 Buy futures (at the market price) (91.65) Gain on futures 2.35 Total gain on futures 235 ticks × £12.50 × 49 = £143.938 Overall loss therefore is 143.938 – 122.000 – 112.700 = £90.762

Buying puts on interest rate futures creates an interest rate cap.

SummaryChange in value of futures (49 x 235 ticks × £12.50) 143,938Cost of additional interest (£12.2m × 6/12× 2%) (122,000)Cost of puts (49 x 1.84% × × 3/12 £500,000) (112,700)Net gain/(loss) (90,762)



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(c) Cost reduction

To reduce the cost of the hedge the company can build a "low cost cap". This involves buying puts on 1 November (as above) and simultaneously selling calls. The premium paid when buying puts is offset to some degree by premium received from selling calls.

Further ExplanationAssume Theakston decides to set a floor at 5%. It will sell calls at 95.00. If interest rates fall to 4% futures prices will be 96.00 (ignoring basis). The purchaser of the calls will exercise them against Theakston and demand to buy futures from Theakston at 95.00. So Theakston must sell futures at 95.00 after first buying at market price of 96.00, creating a loss of 1%. Interest on the loan is 4% plus 1% loss on futures—bringing Theakston up to the floor at 5%.If Theakston sells calls at 95.00 the premium income will be 0.87% × £500,000 × 3/12 × 49 = £53.288If Theakston decides to set a cap at 6% it buys 49 March puts at 94.00, paying a premium of £112,700 as per (b). Hence Theakston has created an interest rate band between 5 and 6% (i.e. a collar). Theakston will not suffer if base rises above 6% but will not benefit from falls below 5%.The net premium cost is £112,700 – £53,288 = £59,412

Solution 2—Plain Vanilla Swap

(a) Swap agreement

Fixed rate Floating rateReal 6.35 LIBOR + 0.6Ale 7.8 LIBOR + 1.35Differential 1.45 0.75

Explanation:The overall possible arbitrage saving is 1.45 – 0.75 = 0.70% (Real borrows fixed and swaps to floating; Ale borrows floating and swaps to fixed). The bank requires 0.25% leaving an arbitrage gain of 0.45% to be shared between Real and Ale.

(b) Designing the swap to split benefit equally Real will pay its bank fixed rate 6.35%. Ale will pay its bank LIBOR + 1.35%. Under the swap Real will pay Ale variable rate interest and Ale will pay Real fixed interest.Each company requires 0.7%/2 = 0.35% benefit from the swap (pre fees).Real could pay Ale LIBOR + 1.35%, bringing Ale's net interest expense to zero. Ale can borrow fixed rate itself at 7.8%. With the swap it will pay 7.8% – 0.35% = 7.45%. Hence Ale should pay Real 7.45% fixed.*The following table summarises the position of both parties:

Real AlePayment on own debt 6.35% LIBOR + 1.35%Payments/ (receipts) under swap (7.45%) 7.45%

LIBOR + 1.35% (LIBOR + 1.35%)Net interest LIBOR + 0.25% 7.45%Interest if borrowed directly LIBOR + 0.6% 7.8%Saving from swap (pre fees) 0.35% 0.35%

*There are numerous combinations of cash flows that will split the benefit equally. The answer here is just one possibility.



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Solution 3—Swap Valuation(a) Forward interest rates(1.0388) × (1 + forward rate) = 1.04962

Forward rate (year one to two) = 6.05%(1.04962) × (1 + forward rate) = 1.0583

Forward rate (year two to three) = 7.50%

(b) Theoretical fixed rateThe fixed-rate leg in the swap would be set to be equivalent in cost to taking a loan today for one year, rolling it over from year one to year two and then refinancing it again from year two to year three. Taking $100 as notional principal and forward interest rates developed in (a), the cash flows from such a series of loans would be expected to be:

Time $ 0 100.00 1 (3.88) 2 (6.05) 3 (107.50)

For the fixed rate in the swap to be equivalent in cost it would be set as the IRR of the above cash flows:

Time $ 5%DF PV 6%DF PV0 100.00 1.000 100.00 1.000 100.001 (3.88) 0.952 (3.69) 0.943 (3.66)2 (6.05) 0.907 (5.49) 0.890 (5.38)3 (107.50) 0.864 (92.88) 0.840 (90.30)

(2.06) 0.66

Swap fixed rate: IRR = 5% + [2.06/(2.06+0.66)] = 5.76%



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Session 16


1. Management of international trade and financea) Advise on the theory and practice of free trade and the management of

barriers to trade.b) Demonstrate an up to date understanding of the major trade agreements

and common markets and, on the basis of contemporary circumstances, advise on their policies and strategic implications for a given business.

c) Discuss the objectives of the World Trade Organisation.d) Discuss the role of international financial institutions within the context

of a globalised economy, with particular attention to the International Monetary Fund, the Bank of International Settlements, The World Bank and the principal Central Banks (the Fed, Bank of England, European Central Bank and the Bank of Japan).

e) Assess the role of the international financial markets with respect to the management of global debt, the financial development of the emerging economies and the maintenance of global financial stability.


5. International investment and financing decisionsc) Evaluate the significance of exchange controls for a given investment

decision and strategies for dealing with restricted remittance.


1. Developments in world financial marketsa) 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 and the removal of barriers to the free movement of capital.

2. Developments in international trade and financea) 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.

3. Developments in Islamic financinga) Demonstrate an understanding of 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.

The Economic Environmentfor Multinationals



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Session 16 Guidance

Recognise the ability of multinational corporations to generate competitive advantages (s.1, s.2).

Learn the roles of international financial institutions such as the IMF, World Bank and the World Trade Organisation (s.3).

Appreciate the growing prominence of Islamic finance and understand the related issues (s.3.5).

Understand the ever-increasing problem of "financial contagion", the risk to the world economy due to rising interdependence between countries brought about by "globalisation" (s.4.3).

Read the technical article "Toxic Assets".

VISUAL OVERVIEWObjective: To describe the international financial system and economic influences on management decisions in that context.

MULTINATIONAL CORPORATIONS

• Background• Competitive Advantage• Effect of Globalisation

EMERGING ISSUES • Global Financial Crisis• "Dark Pools"• Financial Contagion• Developments in Derivatives• SPVs• Tax Havens

INTERNATIONAL TRADE• International Trade

v Protectionism • Free Trade Areas• Mobility of Capital

INTERNATIONAL FINANCE• Exchange Rate Systems• International Financial

Institutions • Role of Central Banks• Global Debt• Islamic Finance• Sukuk Finance



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Session 16 • The Economic Environment for Multinationals P4 Advanced Financial Management


1 Multinational Corporations

1.1 Background

Multinational corporation—a corporation that has operations in at least one country other than its home country. Such companies have offices and/or factories in different countries and usually have a centralised head office where they coordinate global management. Sometimes referred to as a "transnational corporation".

< Very large multinationals have budgets which exceed those of some small countries.

< Advocates of multinationals say they create jobs and wealth and improve technology in countries that are in need of such development.

< On the other hand, critics say multinationals can have undue political influence over governments, can exploit developing nations and create job losses in their own home countries.

1.2 Competitive AdvantageThe success of multinationals may be attributed to various sources of competitive advantage:

< High investment in research and development.< Ability to attract and retain top personnel.< Economies of scale (e.g. buying power).< Flexibility to switch production to lowest-cost locations.< Vertical integration (control of suppliers and distributors).< Horizontal integration (buying competitors).< Power to negotiate favourable terms with host governments

(e.g. lower tax rates, grants). < Brand recognised worldwide.< Use of international transfer pricing to reduce tax costs.

1.3 Effect of Globalisation on Strategy Factors which affect international trade and international finance will also affect the strategy of multinationals. The overall strategy is to maximise after-tax funds received while minimising risk; this can be done in the following ways:

< Using international sources of finance suitably hedged against interest rate, currency and political risks.

< Diversifying type and source of funds.< Taking advantage of market imperfections which lead to cheap

borrowings in some countries.< Taking advantage of government subsidised finance.< Using derivative products (e.g. swaps) to modify obligations as

circumstances change.< Using tax havens to reduce the tax burden or to raise funds

cheaply.



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P4 Advanced Financial Management Session 16 • The Economic Environment for Multinationals

2 International Trade

2.1 International Trade v Protectionism

2.1.1 Potential Advantages From Trade

< Increased competition for domestic producers:= Greater pressure to keep costs and prices down.= Dilution of monopoly power in domestic markets.= Reduction in price discrimination.

< Exploitation of the principle of comparative advantage: = Comparative advantage is where a country has a lower cost

of producing one particular good or service than another.= The country should specialise in the production of that good

and then trade with other countries which may have lower production costs for other goods.

< Dynamic efficiency gains:= Trade tends to speed up the pace of technological progress

and innovation across many different industries.= Greater choice for consumers.

< Economies of scale (lower long-run average costs) and higher profits.

< Trade is seen as a stimulant to short-term and long-run economic growth:= Exports are an injection of aggregate demand.= Boost to exports will have a multiplier effect on GDP. = Supply-side improvements from investment and greater

factor mobility between countries.

2.1.2 Arguments for Protectionism

< The "infant industry" argument: = Protecting young domestic firms which do not have access

to the same economies of scale as multinationals.< The balance of payments argument:

= Balance of payments—a summary of economic transactions between a country and other countries over a specific time period.

= Desire to control the growth of imports to improve the trade balance

< Response to "dumping": = Dumping is predatory pricing by overseas suppliers.= Overseas suppliers offload excess capacity at below cost-

price.< Employment protection:

= Fear of structural unemployment in declining sectors. = Social costs of unemployment resulting from increased

import penetration in particular industries.< Desire to increase government revenue via import tariffs.< The "national interest" argument—protecting industries of

strategic importance (e.g. energy, defence).



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2.1.3 Arguments Against Protectionism

< Welfare losses for consumers (higher prices).< Threat to global growth from reduction in trade.< Threat of retaliation.< Import controls do not encourage domestic producers to

improve efficiency and act as a barrier to entry.< Bureaucracy of administering import controls.

2.1.4 Forms of Protectionism

< "Red tape"—excessive complexity for foreign companies wishing to set up a local subsidiary.

< Refusing licences to foreign companies (e.g. banking licence).< Appropriation of assets of foreign companies.< Block on remittances to overseas parent.< Payment of subsidies to domestic producers.< Tariffs (import duties)—import taxes lead to lower imports,

higher prices for consumers and revenue for the government.< Quotas—quantitative limits on the level of imports allowed.< Embargoes—a total ban on imported goods.< Exchange controls—limiting the amount of foreign exchange

that can move between countries.

2.2 Free Trade Areas and Customs Unions

2.2.1 Grouping of Nations

Free trade area Customs unionCharacteristics Grouping of nations which have

< removed all trade restrictions between themselves

< remain free to impose whatever restrictions they wish on non-member states

Grouping of nations which have< removed all trade restrictions

between themselves< impose a common external tariff

on imports from non-member states

Examples European Free Trade Area European Union

2.2.2 European Union

< Single market created from 1 January 1993.< Maastricht treaty dealt with single currency, common foreign

and social policy, economic and currency union.

2.2.3 European Free Trade Area (EFTA)

< Established in 1960 by non-EU countries.< Linked with the EU in 1993 to create the European Economic

Area (EEA).< As new members join the EU, the EFTA may be left with no

role.

2.2.4 North American Free Trade Area (NAFTA)

< Canada, US, Mexico.< Established in 1993 as a free trading block.



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2.2.5 ASEAN

< Association of South East Asian Nations.< Formed as a defence against the growing economic power of

Japan.

2.2.6 GATT

< General Agreement on Tariffs and Trade.< International agreement to progressively remove measures

which distort free trade.< Countries cannot discriminate between trading partners.< Average tariffs fell from 40% in 1947 to 5% in the mid-1990s.< However, this led to increased use of non-tariff barriers.

2.2.7 World Trade Organisation (WTO)

< The World Trade Organisation (WTO) in 1995 succeeded GATT as the major world forum for international negotiations and agreement in trade.

< It now includes almost 157 members which represent the majority of world trade. The most significant new member, the Russian Federation, joined on 22 August 2012. In contrast to GATT, which focussed on the trade in goods, the WTO also covers trade in services.

< The WTO's overriding objectives are to promote freer trade and to reduce or eliminate protectionist barriers.

< WTO activities involve:= Extending trade concessions equally to all members of

the WTO.= Encouraging lower tariffs and fairer trade around the world,

including anti-dumping measures.= Introducing rules that make trade more predictable.= Stimulating competition through cutting subsidies.

2.3 Mobility of Capital 2.3.1 Perfect Capital Mobility

Perfect mobility of capital is when capital is able to move without cost or restriction between countries. If this occurred the interest rate, adjusted for inflation and risk, would be equal in all countries.

Many barriers to the international movement of capital across national boundaries have indeed been removed over recent decades.

Financial integration has been greatly enhanced by:

< the removal of capital controls by the US, Germany, Canada, Switzerland, the Netherlands, the UK and Japan in the 1970s;

< the subsequent reinvestment of surpluses to developing countries through the Euromarkets;

< financial integration among EU countries from the 1990s onward, combined with expansion of the EU;

< the steady process of technical and institutional innovation that has reduced transaction costs both for exchanging currencies and for international cash transfers.



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Despite these developments, research shows that significant differences in returns between currencies still exist. Perfect capital mobility is prevented partly by some countries still imposing controls on capital movements, and partly by lack of information about foreign countries, which makes the risks of investment or lending abroad appear greater than those for home country activities.

2.3.2 Barriers to Free Movement of Capital

Barriers to capital mobility tend to be more prevalent in developing countries, which are concerned with protecting domestic companies and⁄or the value of the currency.*Common measures include:

< Restrictions on foreign direct investment (FDI), especially into "strategically important" segments of the economy such as defence, natural resources and the banking system.

< Currency controls—restrictions on converting the domestic currency into "hard currency".

< Restrictions on the use of multilateral netting (i.e. preventing multinationals from settling inter-company balances on a net basis). Governments sometimes impose this restriction in order to increase fees for their domestic banks.

< Blocks, or at least restrictions, on dividends being paid to overseas shareholders.

Although such policies may reduce capital flight they also tend to reduce foreign direct investment and, hence, access to technology and knowledge.

2.3.3 Management of Restrictions

< If FDI is restricted then the potential investor may consider other methods of entering the overseas market, such as licensing production or entering into a joint venture with a local firm. However, each of these carries the risk of "industrial espionage" in the form of technology or trade secrets being stolen.

< If there are restrictions on the conversion of currency this could potentially be mitigated in advance with political lobbying. If currency restrictions are subsequently imposed then counter-trade may be a solution (i.e. exchanging overseas production for a globally traded commodity).

*For the management of blocked remittances, see section 3.2 in Session 12.



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3 International Finance

3.1 Exchange-Rate Systems

3.1.1 Floating Exchange Rates

< A floating exchange rate is where the value of the currency is allowed to move freely with supply and demand.

< The main sources of demand are:= exports of goods;= exports of services;= inflows of foreign investment;= speculative demand; and= official buying of currency by the central bank.

< The main sources of supply are: = imports of goods;= imports of services;= outflows of foreign investment;= speculative selling; and= official selling by the central bank.< Managed float—rates allowed to float but the Government

intervenes if fluctuations are likely to be very large.

3.1.2 Fixed Peg

< A fixed exchange-rate regime where the rate is kept fixed against that of another currency.

< No fluctuations are permitted; the central bank intervenes to maintain the currency.

< Occasional revaluation or devaluation may be required when economic fundamentals demand it.

3.1.3 Crawling Peg

< An exchange-rate system in which a currency is allowed to fluctuate within a band of rates. The target rate also is adjusted frequently due to factors such as inflation. This gradual shift of the currency's value is done as an alternative to a sudden and significant devaluation.

< For example, in the 1990s, Mexico had fixed its peso with the US dollar. However, due to the significant inflation in Mexico, as compared with the US, it was evident that the peso would need to be severely devalued. Because a rapid devaluation would create instability, Mexico put into place a crawling peg exchange-rate adjustment system, and the peso was slowly devalued towards a more appropriate exchange rate.

< A similar policy of gradual devaluation was followed by the Russian government in 2008 and 2009.



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3.2 International Financial Institutions3.2.1 Bretton Woods

IMF WORLD BANK

< Promotes stable exchange rates;< Provides credit for countries with

balance of payments difficulties;< Attaches conditions to loans (e.g.

reduce money supply, public expenditure cuts, tax increases);

< Makes finance available to cover unexpected problems (e.g. financial crisis following 2007 US sub-prime meltdown);

< Enhances international liquidity through use of Special Drawing Rights (SDRs) for inter-government settlements.

< The Bank's aims are reduction of global poverty and the implementation of sustainable development.

< Its "arms" are:● the International Bank for Reconstruction

and Development (IBRD);● the International Development

Association (IDA); and ● the International Finance Corporation

(IFC).< The Bank achieves its aims through the

provision of low- or no-interest loans and grants to countries with little or no access to international credit markets.

3.2.2 International Banking

< Cross-border lending.< Cross-currency lending.< Large expansion due to:

= deregulation offering new profit opportunities;= lower transaction costs arising from technological advances;

and= diversification to reduce risk.

< Syndication—a group of bankers in which each agrees a portion of the funding.

< Multi-option facilities—allows companies to choose how to raise funds from a variety of funding instruments on the Euromarkets (e.g. note issuance facilities, revolving underwriting facilities).

3.2.3 The Bank for International Settlement (BIS)

< Based in Basle, Switzerland, and responsible for monitoring the international banking system.

< Effectively a supervisory body for central banks and aims to improve the capital adequacy of commercial banks.



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3.3 Role of Central BanksA central bank is an institution that manages a state's currency, money supply and interest rates. Central banks also usually oversee the commercial banking system of their respective countries. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the amount of money in the nation, and usually also prints the national currency, which usually serves as the nation's legal tender.

The primary function of a central bank is to manage the nation's money supply (monetary policy) through active duties such as:

< managing interest rates;< setting the reserve requirement; and < acting as a lender of last resort to the banking sector during

times of commercial bank insolvency or financial crisis.

Central banks usually also have supervisory powers, intended to prevent bank runs and to reduce the risk that commercial banks and other financial institutions engage in reckless or fraudulent behaviour. Central banks in most developed nations are institutionally designed to be independent from political interference

The most influential national banks are the US Federal Reserve, Bank of England, the European Central Bank and the Bank of Japan. The specific roles of each are set out below.

3.3.1 US Federal Reserve ("the Fed")

The Fed's mandate is "to promote sustainable growth, high levels of employment, stability of prices to help preserve the purchasing power of the dollar and moderate long-term interest rates".

To accomplish its mission, the Fed implements monetary policy, serves as the banker's bank, the government's bank and the regulator of financial institutions.

< Monetary policy—The primary responsibility of the Fed is devising and implementing monetary policy: setting key interest rates and controlling the money supply.

< Banker's bank—Each of the 12 regional Federal Reserve banks provide services to financial institutions. This helps to assure the safety and efficiency of the nation's payments system.

< The Government's bank—The biggest customer of the Federal Reserve is the US government. The US Treasury has an account with the Federal Reserve; all revenue generated by taxes and all outgoing government payments are handled through this account. The Fed also:= sells and redeems government securities such Treasury bills,

notes and bonds;= issues all coin and paper currency.

< Regulator and supervisor—This includes monitoring domestic US banks, the US activities of international banks and the overseas activities of US banks. The Fed also helps to ensure that banks act in the public's interest by helping to develop federal laws governing consumer credit.



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3.3.2 Bank of England (BoE)

The Bank of England exists to ensure the UK's monetary stability and to protect and enhance the stability of the financial system.

Monetary stability means stable prices and confidence in the currency. Stable prices are defined by the Government's inflation target, which the Bank seeks to meet through the decisions of its Monetary Policy Committee, explaining those decisions transparently and implementing them effectively in the money markets.

Financial stability means maintaining an efficient flow of funds within the economy and confidence in financial intermediaries. This is achieved through:

< the Bank's financial operations, including those as the "lender of last resort";

< the prudential regulation of financial institutions; and < Bank oversight and regulation of key payment, clearing and

settlement infrastructure.

3.3.3 European Central Bank (ECB)

The ECB is one of the EU institutions. Based in Frankfurt, Germany, it manages the euro (the EU's single currency) and safeguards price stability in the EU. The ECB is also responsible for devising and implementing the EU's economic and monetary policy.

Its main purposes are to:

< keep prices stable (keep inflation under control) especially in countries that use the euro; and

< keep the financial system stable by making sure financial markets and institutions are properly supervised.

The Bank works with the central banks in all 28 EU countries. Together they form the European System of Central Banks (ESCB).

It also leads the close cooperation between central banks in the euro area—the 17 EU countries that have adopted the euro, also known as the Eurozone. The cooperation between this smaller, tighter group of banks is referred to as the "Eurosystem".

The ECB's role includes:

< setting key interest rates for the Eurozone and controlling the money supply;

< managing the Eurozone's foreign-currency reserves and buying or selling currencies when necessary to keep exchange rates in balance;

< helping to ensure that financial markets and institutions are adequately supervised by national authorities, and that payment systems function smoothly;

< authorising central banks in Eurozone countries to issue euro banknotes; and

< monitoring price trends and assessing the risk that they pose to price stability.



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3.3.4 Bank of Japan (BoJ)

The Bank of Japan is the central bank of Japan. It is a legal entity established based on the Bank of Japan Act and is not a government agency or a private corporation.

The Act sets the Bank's objectives as:

< to issue banknotes and to carry out currency and monetary control; and

< to ensure smooth settlement of funds among banks and other financial institutions, thereby contributing to the maintenance of stability of the financial system.

The Act also stipulates the Bank's principle of currency and monetary control as "currency and monetary control by the Bank of Japan shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy".

3.4 Global Debt 3.4.1 International Debt Problem

< The origin of the problem is the huge balance-of-payments problems of developing countries in the 1970s due to:= oil price rises;= recessions in developed countries reducing exports by

developing nations; and= the growth of non-tariff barriers.

< Deficits financed not by deflation but by borrowing. Eurocurrency markets channelled surpluses of oil-exporting countries to developing countries, which thus accumulated huge international debts.

< The burden of debt repayment grew during the 1980s (e.g. servicing Brazil's debt in 1980 absorbed 63.1% of that country's export earnings).

3.4.2 Efforts to Decrease the Problem

Measures include:

< Capping of interest rates by banks.< Accepting payment of debt in local currencies.< Debit for equity swaps allowing multinationals to acquire

shares in local companies.< Restructuring of economies.< Restructuring of loans allowing countries longer to repay.< Removal of tariff barriers and quotas by the developed world.< 1985 Baker Plan:

= increased commercial lending to developing countries;= economic reform by indebted countries.

< 1989 Brady package: = some debt cancellation by international banks;= economic reform by indebted countries.



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3.4.3 The Blair-Brown Deal

< Agreement was reached at the 2005 G8 summit to write off the entire US$40-billion debt owed by 18 Highly Indebted Poor Countries to the World Bank, the International Monetary Fund and the African Development Fund. The annual saving in debt payments amounts to just over US$1 billion.

< The G8 ministers stated that 20 more countries, with an additional US$15 billion in debt, would be eligible for debt relief if they met targets on fighting corruption and to privatise industries, liberalise their economies, eliminate subsidies and reduce budgetary expenditures.

< Many criticised the Blair-Brown plan as inadequate and argued that the continuation of structural reform policies outweighed the benefits of debt cancellation, also pointing out that only a small proportion of the developing world's debt would be affected.

< Structural reforms have been criticised in the past for devastating poor countries. For example, in Zambia, structural reforms of the 1980s and early 1990s included massive cuts to health and education budgets, the introduction of user fees for many basic health services and for primary education, and the cutting of crucial programs such as child immunisation initiatives.

< Although the G8 ministers made efforts to reduce the debt crisis in developing nations, they unfortunately did not see the "toxic mix" that was brewing in the developed world:= house price bubbles fuelled by cheap credit for homeowners

and speculators;= securitisation of mortgage debt into mortgage-backed

securities (MBS) and re-securitisation into collateralised debt obligations (CDOs). That is, putting more and more distance between the owner of the debt and the borrower;

= use of credit default swaps (CDS) to transfer the risk yet another step.

< The result of this toxic mix was the global financial crisis of 2007–2010.

3.5 Islamic Finance3.5.1 Principles

Islamic principles demand that business should be conducted with honesty and integrity and profit creation should only be the result of activity that benefits society as a whole. For example, higher prices should not be charged to an individual because the person lacks knowledge and information about the fair price of the product.

The Islamic finance framework is based on certain prohibitions:

Money (and money substitute products such as gold and silver) should not be viewed as commodities, but rather as means of exchange. Therefore, interest (or riba) cannot be paid or received on loans.

The definition of riba in classical Islamic law was "to ensure equivalency in real value". During this period, gold and silver currencies were the benchmark metals that defined the value of all other materials being traded. Applying interest to the benchmark itself made no sense as its value remained constant relative to all other materials.



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Investment in companies that have too much borrowing (debt totalling more than 33% of the firm's stock market value).

Dealing in alcohol, pork-related products, weapons, gambling and other socially detrimental activities is not acceptable. Transactions which involve speculation or extreme risk—this

is seen as gambling. This prohibits speculating on the futures and options markets.Uncertainty about the subject matter and terms of contracts—

this includes a prohibition on selling something that one does not own. Therefore, complex derivative instruments and short selling are prohibited under Islamic finance.

Islamic finance currently accounts for only about 1% of global assets, but this is growing every year. In 2013, the value of Sharia-compliant assets worldwide stood at $1.8 trillion, up from $1.3 trillion in 2011. Non-Muslim investors also have an appetite for Islamic instruments because of the security they offer (e.g. in Malaysia, 80% of Sharia-compliant assets are held by non-Muslims).

Furthermore, non-Muslim countries are increasingly involved in Islamic finance, particularly the UK. The London Stock Exchange is preparing to launch an Islamic Market Index to help the managers of Sharia-compliant funds identify new investment opportunities and the UK Treasury is planning to issue a £200 million sukuk (Islamic-compliant bond).

3.5.2 Islamic Business Structures

The main business structure in the Western world is the limited liability company. However, the use of such a corporate structure in the Islamic world raises serious issues:

< The concept of a business being a separate legal entity from its owners is not recognised in Sharia law.

< The concept of limited liability is in contradiction to Sharia law. In Islam, a creditor has full recourse to a debtor and a debtor has to meet his obligation to a creditor. Issuing debts in the name of a corporate entity and later refusing to use personal assets to repay those debts is therefore prohibited.

< Company share certificates are not compliant with Islamic finance principles as they only represent the right to receive a dividend and vote at meetings. In Islam, investors should have direct ownership of the underlying business assets. For this reason, some Islamic scholars also state that buying and selling shares on the stock market is unacceptable.

For the reasons listed, a partnership is the preferred business vehicle in Islamic finance. However, local law in some countries may restrict the maximum number of partners (e.g. South African law puts the limit at 20). If more partners are involved than local law allows then the only option would be to form a company but write its articles of association in such a way as to comply with Sharia rulings as far as possible.



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3.5.3 Islamic Banks

How can finance flow between investors and borrowers without involving interest? The answer is through profit-sharing arrangements or partnerships.

Islamic financial institutions (IFIs), including banks, can raise finance via Mudaraba and Musharaka equity-type contracts (see below).

< Investors deposit funds with the IFI, which acts as their investment manager.

< The funds are then pooled and used in profit-making projects that comply with Islamic principles.

< Profits earned are shared between the corporation running the project, the IFI and the investors.*

However, with corporations requiring different modes of finance and IFIs keen on providing these, different types of Islamic financial products have been developed. The challenge for IFIs is to ensure that the products comply with Sharia law, as well as local financial regulations and laws.

IFIs offer two broad categories of financial products: equity-based and fixed-income-based.

3.5.4 Equity-Based Financial Products

Equity-based financial products consist of Mudaraba and Musharaka contracts. With these contracts, the IFI and the corporation share the profits from the business venture in a pre-arranged ratio. The key differences between the two contracts are as follows:Mudaraba Contract Musharaka Contract< The IFI provides 100% of the capital for

the project.< Both parties invest funds in the project.

< All losses are borne solely by the IFI (although provisions can be set up to carry them forward against future profits).

< Losses are shared between the two parties in proportion to their relative investments.

< The corporation, as the expert in the business venture, takes the sole responsibility for running the project.

< Both parties participate in managing and running the project.

< Similar in nature to venture capital. < Similar in nature to a joint venture.

A more recent innovation is the "diminishing Musharaka contract" in which, over time, one party's ownership in the underlying asset falls. This is similar in nature to a mortgage.

3.5.5 Fixed-Income-Based Financial Products

< Murabaha contracts—where the IFI purchases an asset and then sells it to the business or individual at cost plus a fair profit. The business or individual pays for the asset in pre-agreed instalments and over a pre-agreed time period.

< Ijara contracts—similar to operating leases where the IFI purchases an asset for the business or individual to use. The lease payments, the lease period and payment terms are agreed at the start of the contract. The lessor is responsible for the maintenance and insurance of the asset. Provisions can be made to allow the lessee to purchase the asset for a nominal fee at the end of the contract.

*All three parties may share losses if the business venture is not successful.



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< Salam contracts—where a business sells a commodity to the IFI today but for future delivery. Cash is received immediately by the business and the quantity, quality, the future date and the time of delivery are determined immediately. The sales price would usually be at a discount. In turn, the IFI would probably resell the salam contract to receive immediate cash and profit. Salam contracts are prohibited for commodities such as gold, silver and other money-type assets.

< Istisna contracts—often used for long-term, large construction projects of property and machinery. Here, the IFI funds the construction project for a client that is delivered on completion to that client. The client pays an initial deposit, followed by instalments to the IFI, the amount and frequency of which are determined at the start of the contract.

< Hibah (gift): where Islamic banks voluntarily pay their customers a "gift" on savings account balances, representing a portion of the profit made by using those balances in other activities.

< Qard hassan/Qardul hassan (good loan/benevolent loan): a loan extended on a goodwill basis, and the debtor is only required to repay the amount borrowed. However, the debtor may, at his discretion, pay an extra amount to the creditor.

< Sukuk bonds—see section 3.6.

3.5.6 Sharia Boards

Sharia boards ensure that all products and services offered by IFIs are compliant with the principles of Islamic finance. Additionally, they often oversee Sharia-compliant training programmes for an IFI's employees and participate in the preparation and approval of the IFI's annual reports.

Sharia boards are normally made up of a mixture of Islamic scholars and finance experts. The Islamic scholars often sit on several Sharia boards of a number of different IFIs. These boards are, in turn, supervised by the International Association of Islamic Bankers (IAIB).

Sharia boards face several challenges when making judgements:

< Sharia rules can be open to different interpretations.< Precedents set by Sharia boards are not binding.< Changes in a board's personnel over time may shift the

balance of opinion.< They need considerable resources to operate effectively,

especially where sukuk finance is concerned. IFIs need to ensure that their Sharia board members are well informed about the developments and trends in global financial markets.



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3.5.7 Benefits of Islamic Finance

No uncertainty about the subject matter and terms of the contract (in contrast to the intangible and complex nature of derivatives).States that debt should be serviced by specific physical

projects and discourages excessive use of debt.Vetting of any new investment products by the Sharia board

provides a level of independent oversight.Islamic investment vehicles are based on shared business risk.

Investors will, therefore, scrutinise proposed investments with great care, thereby promoting good entrepreneurship, which in turn promotes a more stable economy.Islamic mortgages cannot be aggressively sold by banks.

Furthermore if customers are unable to keep up with their payments, banks are encouraged to show sympathy and are allowed to count such losses as part of their mandatory annual zakat payment (the Islamic equivalent of a charitable tax); Sub-prime home loans, their securitisation and credit default

swaps (i.e. the causes of the 2007 financial crisis) are all prohibited in Islamic banking.

Corporations, individuals and IFIs belong to stakeholder partnerships that are engaged in deriving benefits from ethical, fair business activity that benefits society as a whole. The nature of these partnerships is one of mutual interest, trust and cooperation.

The prohibition on speculation and short-term opportunism encourages all parties to take a longer-term view of success from the partnership and should result in a more stable financial environment. It could be argued that if the Western world had followed Islamic finance principles the banking and sovereign debt crises that began in 2007 may have been greatly reduced.

IFIs (or conventional financial institutions with products based on Islamic finance principles) gain access to Muslim funds across the world and provide finance for organisations and individuals who need them.

Access to Islamic finance is not restricted to Muslim communities—the wider business community could have access to new sources of finance. This may be particularly attractive to corporations focused on ethical investing.



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3.5.8 Drawbacks

Due to the prohibition on riba, IFIs may be slower to react to market changes and may lack flexibility in their product offering compared with conventional financial institutions.

Due to the prohibition on speculation, IFIs may be less able to take advantage of short-term opportunities.

Informational asymmetry between the IFI and the borrower of funds potentially leads to principal-agent problems. Therefore, agency costs related to due diligence and monitoring are probably higher for IFIs than for traditional banks (i.e. an IFI is engaged in a series of partnerships whereas a traditional bank simply makes loans).

Costs related to developing new financial products may also be higher for IFIs because not only will the products have to comply with normal financial laws and regulations but also with Sharia rules. These costs are ultimately passed on to the borrowers of funds.

The approval process for new financial products can be time consuming, slowing down innovation.

Some Islamic finance products may not be compatible with international financial regulation (e.g. diminishing Musharaka contract may not be an acceptable mortgage instrument in law).

The interpretation of Sharia rulings may allow certain Islamic finance products to be acceptable in some markets, but not in others.*

*Sukuk bonds with repayments based on prevailing interest rates, and that have been credit-rated and have a redemption value based on a nominal value, are extremely similar to conventional bonds.

Conflicts between partners, particularly in joint-venture Musharaka contracts where the IFI and the entrepreneur are both involved in the management of a project.

Corporations issuing Islamic instruments that resemble debt may have difficulty persuading tax authorities to grant a tax shield, whereas conventional loans or bonds would certainly qualify. Islamic bank loans are confined to financing the purchase of

physical assets to which they have recourse in case of default (e.g. finance would not be available for a medical research project). Although Islamic finance is based on the principle of sharing

business risk, the total risk remains the same.Islamic finance cannot dictate in which assets people invest

(i.e. property price bubbles can develop even in the Islamic world).Lack of independent auditing of Islamic institutions. Although

standards are set by external bodies (the Islamic Financial Services Board and the Accounting and Auditing Organisation for Islamic Financial Institutions), it is the bank-employed Sharia advisers who decide whether a financial institution is compliant with those standards.



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3.6 Sukuk Finance

Sukuk finance— certificates of equal value representing shares in the ownership of tangible assets or the assets of particular projects.

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 interest (riba). *There is debate as to whether sukuk instruments are closer to conventional debt or equity finance. This is because there are two types of sukuk:

1. Asset based—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.

2. Asset backed—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.

3.6.1 Asset-Based Sukuk

Financing the acquisition of an asset through sale and leaseback is shown as follows:

Periodic rental and capital distributionsIssue certificates

(Sukuk)

Pay asset price

Title to assets

Pay issue price

Rentals

*Riba is not allowed under Sharia law.



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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 Ijara 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 makes periodic distributions (rental and capital) to the sukuk holders.

The final redemption of the sukuk is at a pre-agreed value and, hence, asset-based sukuk is closer to debt finance.

3.6.2 Asset-Backed Sukuk

Securitisation of a leasing portfolio is shown as follows:

Periodic rental and capital distributions

Issue certificates

Sukuk proceeds

Sale of portfolio

Pay issue price

1. Sukuk holders subscribe by paying an issue price to an SPV company.

2. In return, the SPV issues certificates indicating the percentage the sukuk holders 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.

Should the returns fail to materialise, the sukuk holders suffer the losses. In addition, redemption for the sukuk holders is at open-market value, which could be nil.

Hence, asset-backed sukuk is closer to equity finance.



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3.6.3 Case Studies

For Emirates airline, the use of sukuk finance has been a huge success.

< The company issued its first sukuk, with a seven-year term, in 2005, which was listed on the Luxembourg Stock Exchange. The $550 million was repaid in full in June 2012.

< For financing new aircraft, the use of sukuk is complicated (as the cash would have to pass from investors through an SPV to the manufacturer before a leaseback arrangement is put in place). Hence, using existing assets to obtain sukuk finance is far easier and Emirates currently has two sukuk instruments issued globally, backed by existing aircraft.

< The sukuk market has been relatively strong during the instability in global financial markets. That is partly because Islamic investors in the Persian Gulf region remain cash-rich, partly due to the limited supply of sukuk, and partly because sukuk investors tend to hold the bonds until maturity.

However, the story of Dubai World, the sovereign investment fund of the Dubai royal family, presents another side of the story.

< On 25 November 2009, the financial world was shocked when Dubai World requested a restructuring of $26 billion in debts.

< The main concern was the delay in the repayment of the $4bn sukuk, or Islamic bond, of Dubai World's developer Nakheel, which was especially known for construction of the Dubai Palm Islands.

< Ultimately Abu Dhabi had to come to the rescue with a bailout.



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4 Emerging Issues

4.1 The Global Financial Crisis

4.1.1 Roots of the Banking Crisis

< We need to look back at the attempts made by successive US administrations to enhance the availability of credit for home loans.

< Since the 1970s, the Community Reinvestment Act (CRA) attempted to stop what were believed to be the discriminatory lending practices of US banks. Banks and other "depository institutions" came under close scrutiny to ensure that they made credit available to all sectors of society.

< The two great US mortgage providers, the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association (nicknamed "Freddie Mac" and "Fannie Mae", respectively), and other banks started to grant mortgages to people who, under normal banking criteria, presented a very high risk of default. These were the so called "sub-prime mortgages".

< Since the 1990s, there was a wave of aggressive selling of sub-prime mortgages, often to individuals who had no realistic prospect of ever repaying the debt.

4.1.2 Securitisation

Securitisation—the process of converting illiquid assets into marketable securities.*

< When banks lend through mortgages, credit cards, car loans or other forms of credit, such loans are an asset on the balance sheet, representing cash flow to the bank in future years through interest payments and eventual repayment of the principal.

< By securitising 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.

< Securitisation is achieved by transferring the lending to specifically created companies called " special purpose vehicles" (SPV). 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—these bonds are known as mortgage-backed securities (MBS).*

The examiner expects students to know what is happening in the world economy and wider reading is recommended, e.g.www.economist.comwww.cfo.com

*Tradable instruments known generally as Asset Backed Securities (ABS).

*Selling blocks of home loans to raise cash to lend again (MBS) is the classic example of an ABS.



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< In the case of sub-prime mortgages, the high levels of risk called for a different type of securitisation, achieved by the creation of complex, derivative-style instruments known as "collateralised debt obligations", or CDOs. This is the world of "structured finance".

< 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 evenly between all the bond holders, CDOs "chop up" the risk into 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.

4.1.3 Structure of CDOs

< For each pool of mortgages taken over by the SPV, three tranches of CDOs are created:= Tranche 1—highest risk and known as the "equity"

tranche. Normally comprising 5%–10% of the value of the mortgages in the pool. Throughout the CDO's life, the equity tranche will absorb any losses brought about by default on the part of mortgage holders, up to the point at which the principal of the tranche is exhausted. At this point, the investment is worthless.

= Tranche 2—intermediate risk, or "mezzanine" tranche. This consists of about 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.

< Each tranche of CDO is priced on issue to give the appropriate yield to the investors. The investment-grade tranche will be the most highly priced, giving a low yield. At the other end, the "equity" tranche carries the bulk of the risk—it will be priced low but with a high potential, but very risky, yield.

< The proportion of the principal held in each tranche is known as the CDO "structure", and if there is perceived to be little risk of default then the percentage of value in the mortgage pool forming the equity and mezzanine tranches will be quite small.

< When cash flows are received from borrowers in the form of interest payments and principal 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.

< By repackaging home loans into MBS, then chopping them up into CDOs, the final holder of the risk is far removed from the original homeowner. Hence, the holder of a CDO is at the mercy of the ratings agencies and, in the event of default or late payment, has no mechanism for enforcing the underlying loan.

< Hence, the holder of the CDO often would use a credit default swap (CDS) to transfer the risk yet another step further.

< High-quality journals (e.g. The Economist) had been warning for many years that this was a dangerous game of "pass the parcel", particularly with a housing bubble ready to burst in the US and the UK. Risk can be repackaged, chopped up, transferred—but it does not disappear.



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4.1.4 What Went Wrong?

< When the sub-prime mortgages were issued, the perception was that with high employment in the US, and rising property prices, most of the CDO's principal could be safely located in the senior tranche.

< The rating agencies had a critical role to play, in that they validated the construction of the sub-prime CDOs and graded the tranches. Up until 2005, many CDOs were constructed with very optimistic structures so that when the defaults started to occur, it was not just the equity tranches that were left unfulfilled, but also the mezzanine and then progressively the previously AAA-rated senior grade tranches.

< Under US Securities and Exchange Commission rules, CDOs could be traded only between financial institutions. At the start of the credit crisis, $1 trillion of sub-prime debt was held by banks in the form of what they believed to be very low-risk, investment-grade securities.

< With falling property values, many sub-prime borrowers found themselves in negative equity; rising unemployment resulted in a significant increase in the number of defaults and a "drying up" of the liquidity that the CDOs required to satisfy their investors.

< The banks also faced another problem—how to value CDOs. There were models of varying degrees of complexity, but there was no effective market from which a price could be taken. The CDOs could not be "marked to market" but had to be "marked to model" in the banks' balance sheets. Suspicion grew across the financial markets that some bank balance sheets were carrying large amounts of CDOs which were not worth what they appeared to be.

< Unlike most other commercial enterprises, banks are very highly geared, with typically less than 10% of their asset value covered by equity. A loss of asset value can soon wipe out a bank's equity account and it was this risk which led some banks to start unloading their asset-backed securities (e.g. CDOs). But the sellers in this restricted market could not find buyers; as a result, the values at which these assets could be sold went into free fall and the banking system entered into what many considered to be a death spiral.

< Furthermore, the sub-prime debt issued in the US had become distributed across the global markets. In addition, other countries' own banks (e.g. Northern Rock in the UK) had issued asset-backed securities to refinance the issue of further sub-prime mortgages in booming property markets.

< Banks that had stayed free of the problem began to suspect the creditworthiness of other banks and, as a result, became reluctant to lend on the interbank market. LIBOR, the rate at which banks lend short-term, began to rise, thereby threatening the liquidity of banking operations and so a credit squeeze became a crunch.



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< The vulnerability of banks to risk soon fed through into the real economy, as credit began to dry up and borrowing rates rose. Homebuyers could not raise mortgages and, as a result, property prices fell, further exacerbating the crisis.

< A recession in the real economy, with job losses and insolvencies, meant that more people defaulted on their home loans. Consumer confidence began to deteriorate and, as a result, previously strong economies began to slow down.

4.1.5 Is There a Solution?

< The US solution is for the federal government to buy up the so-called toxic assets from banks, and up to $850 billion has been set aside for that purpose

< The UK solution is for the government to inject new capital into banks through preference shares, and to support the operation of the money markets by offering loan guarantees and by lending to troubled banks.

< There is a serious risk that no amount of government intervention will restore confidence and the investment will incur significant losses. However if the banking system recovers the governments will make large capital gains.

< Only one problem remains: what to do about the toxic assets? There is no market for securities of this type apart from the financial institutions. The market value of CDOs and similar instruments is far lower than the intrinsic value of the underlying pool of mortgages (the present value of their associated income stream and repayments).

< Ultimately, if held long enough, at least some of the underlying mortgages will be redeemed. However, that is beyond the time horizon of any government, so they will need to create a new market for CDOs. The creation of such a market could be the missing piece of the puzzle required to restore confidence and get the financial world working again.

4.2 Dark Pools< A "dark pool" (or dark pool of liquidity) is a private electronic

transaction network, typically maintained by major banks, where shares are bought and sold by clients of the bank.

< Because the matching of buyer and seller is done entirely within the walls of the bank, the bid, offer and sale prices are not (immediately) published to exchanges (e.g. the London Stock Exchange).

< Dark pools range from completely opaque to semi-transparent. The more transparent the liquidity pool, the easier it is to be manipulated by outsiders. More transparent networks (e.g. Liquidnet) solve this problem by not letting brokers or very active traders onto the platform and by Policing their community and evicting Poachers.

< The majority of dark pools, however, tend to be completely dark/opaque. Markets such as Nasdaq Cross fit this description.

< The banks who provide dark pools gain a double benefit of collecting fees from clients, whilst not paying exchange transaction costs.



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< Clients of the dark pool prefer execution out of the public eye, whether to protect their trading strategies, or simply to complete their transaction without having their volume create a major price change in the public market.

< The traditional public exchanges are beginning to lose substantial trading volume to dark pools. However the dark pool operators are still in many cases major clients of the exchange, routing a large volume of non-dark orders to the traditional system.

< Some believe that dark pools take away the opportunity to play on a fully level field, as transactions are hidden from public view. Hence dark pools may damage the pricing efficiency of the stock market and challenge the EMH.

4.3 Financial Contagion< Financial contagion refers to the spread of economic and

financial problems from one country to another. < As barriers to trade, investment and capital flows are reduced

or eliminated, the resultant more "global" economy is more susceptible to contagion.

< As can be seen from the problems of the Thai baht in 1997, the problems of even a relatively small economy can easily have severe economic effects on neighbouring countries and even on larger countries, such as Brazil and Russia.

< More recently, what started as defaults on US sub-prime mortgages in 2007 led to a global financial crisis. Some countries had hoped that they were sufficiently "decoupled" from the US economy to be immune from financial contagion—but, regrettably, they were not.

4.4 Developments in DerivativesMany argue that the exponential growth in the market for credit default swaps (CDSs) was one of the contributory factors to the global financial crisis.

< A credit default swap is basically an insurance policy against default on an underlying bond. A gigantic notional principal of CDSs had been written against default on US sub-prime mortgage-backed securities. Risk can be transferred but it does not disappear, as the financial crisis has shown.

< CDSs are part of the OTC (over the counter) derivatives market (i.e. they are traded face-to-face as opposed to via an exchange). This creates a problem for regulators as the OTC market is "opaque". Many governments, particularly the US government, therefore want to move the OTC markets onto formal exchanges.*

*Some advocate a unified global exchange for all derivatives, although this could bring its own dangers—what would happen if the global exchange collapsed?



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4.5 Special Purpose Vehicles (SPVs)Also referred to as a "bankruptcy-remote entity", an SPV's operations are limited to the acquisition and financing of specific assets.

< The SPV is usually a subsidiary company with an asset⁄liability structure and legal status that makes its obligations secure even if the parent company goes bankrupt.

< SPVs legitimately can be used to achieve an enhanced credit rating by diverting relatively high-quality cash flows into the SPV, which is ring-fenced should the parent become distressed. The SPV (often established offshore) then uses its enhanced credit rating to issue asset-backed securities (ABS) at a low interest rate.

Unfortunately SPVs have also been abused, most famously by Enron, which used hundreds of such entities (which were not consolidated into its group accounts) to hide its liabilities.

4.6 Increasing Transparency of Tax Havens< The Organisation for Economic Co-operation and Development

(OECD) is putting increasing pressure on tax havens to become more transparent.

< US authorities are particularly unhappy about the use of the Cayman Islands for both tax avoidance and the hiding of "toxic assets". US parent companies are only taxed on overseas profits that are remitted back to the US—hence many keep the cash offshore.*

< The UK government considers the level of banking secrecy in Lichtenstein to be of particular concern.

< International anti-money-laundering laws are also pressuring offshore regimes to increase their disclosure requirements.

*This may explain why Apple Inc had to make a record bond issue in 2013 to finance its share buyback programme. Despite generating huge cash flows from global operations, Apple is not inclined to remit the cash back to the US where it would be taxed at 35%.



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Session 16

< The rise of the multinational appears to be unstoppable, particularly with the continuing consolidation in many sectors via mergers and acquisitions.

< Arguably there is a connected global trend for the removal of trade barriers, with increasing number of countries joining organisations such as the WTO. The banking and financial services sectors are certainly very much global in nature due the falling incidence of exchange controls and technological advances.

< While "globalisation" may bring dynamic economic gains, it may also be bringing unexpected risks due to the increasing interdependence of economies—financial contagion.

< There are also concerns about the huge use of increasingly complex derivatives and asset-backed securities (where banks sell parts of their loan books) to transfer risks until they almost seem to have disappeared. Unfortunately, although risk can be transferred it does not disappear—as the US sub-prime mortgage crisis revealed.

< Be aware of the rise in the importance of Islamic banking, its prohibition on riba (interest) and the many loopholes to circumvent this prohibition.

Summary



Q41 Global Debt 30 minutes

Additional

Q42 Beela Electronics

Q43 IMF


1. Suggest sources of competitive advantage enjoyed by multinational companies. (1.2)

2. List forms of protectionism a government may use to defend domestic companies from global competition. (2.1.4)

3. State the main objectives of the WTO. (2.2.7)

4. Distinguish between fixed peg and crawling peg exchange-rate systems. (3.1)

5. List the functions of the IMF. (3.2)

6. Name the THREE arms of the World Bank. (3.2)

7. List efforts that have been made to reduce developing country debt. (3.4.2)

8. Distinguish between Mudaraba and Musharaka contracts. (3.5.4)

9. State what is meant by "securitisation". (4.1.2)

10. Describe the structure of CDOs. (4.1.3)

11. State what is meant by "dark pools trading". (4.2)

12. Define "financial contagion". (4.3)



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Session 17



2. Strategic business and financial planning for multinationalsa) Advise on the development of a financial planning framework for a

multinational organisation taking into account:ii) The mobility of capital across borders and national limitations on

remittances and transfer pricingiii) The pattern of economic and other risk exposures in the different

national marketsiv) Agency issues in the central coordination of overseas operations

and the balancing of local financial autonomy with effective central control.


5. International investment and financing decisionsa) Assess the impact upon the value of a project of alternative exchange rate

assumptions.b) Forecast project or organisation free cash flows in any specified currency

and determine the project's net present value or organisation value under differing exchange rate, fiscal and transaction cost assumptions.


1. The role of the treasury function in multinationalsa) Explain the role of the treasury management function within:

i) The short-term management of the organisation's financial resourcesii) The longer term maximisation of corporate value

2. The use of financial derivatives to hedge against forex riskc) 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.

4. Dividend policy in multinationals and transfer pricingc) 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.

International Operations



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Session 17 Guidance

VISUAL OVERVIEWObjective: To consider further aspects of financial management relating to the international operations of companies.

Understand the risks of international trade and how various payment methods can help reduce or eliminate such risks (s.1).

Learn the methods for expanding overseas (s.2). Recognise that an overseas project's cash flows will be in foreign currency but the final NPV must be found in terms of the group's home currency (s.4).

Understand transfer pricing methodologies, especially as to how such policies can reduce tax liability (s.6).

INTERNATIONAL OPERATIONS

INTERNATIONAL TRADE RISKS• Foreign Exchange • Commercial • Physical • Political • Cultural • Default Risk• Payment Methods

INTERNATIONAL CAPITAL STRUCTURE

INTERNATIONAL CAPITAL BUDGETING

• Net Present Value• Adjusted Present

Value

TRANSFER PRICING• When Required?• Objectives • Optimal Price• Other Methods• Tax Planning

OVERSEAS EXPANSION• Methods• Political Risk

INTERNATIONAL TREASURY FUNCTION

• Role • Cost Centre v Profit Centre• Centralized v Decentralized• Agency Issues• Cash Transfer Mechanisms• Short-Term Investments• Maximisation of Shareholder

Value



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Session 17 • International Operations P4 Advanced Financial Management


1 International Trade Risks

Apart from foreign exchange issues, many of the risks of engaging in foreign trade are shared with those domestic operations. However, the management of such risks in an international context may require particular approaches.

1.1 Foreign Exchange Risks*< Short-term transaction risk and longer term economic risk.< Translation risk on the consolidation of overseas subsidiaries'

financial statements into the group accounts.

1.2 Commercial Risk< The risk that the overseas customer will not pay or pay late. < The level of credit risk can be evaluated by using agencies

such as Dun and Bradstreet.< The risk can be managed by:

= Buying credit insurance from a commercial bank (UK exporters can also obtain insurance from NCM Holding);

= Using export factoring (without recourse);= Requesting a letter of credit from the customer's bank.

1.3 Physical Risk< Loss or damage to goods in transit.< Managed using insurance.

1.4 Political Risk< Examples include quotas and tariffs, exchange controls,

bureaucratic delays and excessive documentation. Appropriation of assets may be a risk in some countries.

< The level of political risk can be evaluated using the Department of Trade, Embassy or commercial reports (e.g. from the Economist Intelligence Unit).

1.5 Cultural Risk< Different business customs overseas can hinder foreign trade.< The problem may be reduced by using local agents.

1.6 Default Risk< Risk of default on exports may be higher than on domestic

sales. Ideally cash in advance should be requested, or at least a percentage deposit—however, such terms may not be acceptable to the customer.

< In fact, credit periods on exports are often longer than for those on domestic sales. Therefore, the firm needs to carefully consider the method of payment both with a view to minimising default risk and of financing the export.

*Management of these risks is dealt with in Session 14.



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P4 Advanced Financial Management Session 17 • International Operations

1.7 Payment Methods*

1.7.1 Open Account Trading

< This means simply trusting the customer to pay within the stated credit period with no additional collateral or security.

1.7.2 Cash Against Documents

< Documents of title to the goods are not released to the customer until payment is made.

1.7.3 Bills of Exchange

< A bill of exchange is a document drawn by the exporter and sent to the customer who signs to accept responsibility to pay the amount specified on the stated date.

< Often the documents of title to the goods will not be released to the customer until he has accepted a bill of exchange.

< The exporter may choose to hold the bill until maturity and then receive payment from the customer or to discount the bill with a bank in order to receive the cash earlier. However, if the customer does not eventually pay up on the bill the bank will have recourse to the exporter for payment.

1.7.4 Forfaiting

< This is where a bank discounts a series of bills of exchange but forgoes the right of recourse to the exporter if the customer does not pay.

1.7.5 Letters of Credit

< A letter of credit is issued by the customer's bank in favour of the exporter. If this letter of credit is then expressed as irrevocable and then confirmed, the exporter has absolute assurance of payment.

1.7.6 Export Credit Houses

< These give credit to the overseas customer and guarantee payment to the exporter.

1.7.7 Export Merchants

< Operate as intermediaries between the exporter and the overseas customer.

< The merchant buys the goods (at a discount) from the exporter, sells them to the final customer and pays the exporter (usually within 7 days).

1.7.8 Export Factors

< Factors buy the trade receivables from the exporter and charge commission on the transaction. Other services may also be offered (e.g. operating the receivables ledger and credit insurance).

1.7.9 Export Credits Guarantee Department (ECGD)

< UK exporters can obtain guarantees from the ECGD on bank loans taken to finance exports.

*Shocks to credit availability is a primary economic risk exposure.



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1.7.10 Counter-trade

Counter-trade is an agreement where goods exported are matched by a commitment to import. There are several types:

< Barter, where goods are exchanged.< Counter-purchase, goods are purchased and an agreement

signed that the seller will itself purchase different goods at some time in the future.

< Switch trading, involves using trade agreements between countries. Country A wishes to export to country B but cannot because of restrictions. Country C has capacity in its agreement with B so A's goods go via C. In return A will have to import goods from C.

2 Overseas Expansion

2.1 Methods< Exporting—relatively low risk but no local presence and high

travel cost of sales force.< Licensing agreement—relatively low risk but limited period

of time.< Joint venture—pools expertise, gives access to local

knowledge but can lead to arguments over profit sharing or strategy. In some developing markets (e.g. China) this may be the only permitted route to local presence.

< Overseas branch—establishes local presence and can be tax efficient if branch losses in early years can be offset against head office profits in the home country.

< Overseas subsidiary—gives evidence of long-term commitment and may attract government grants. However, it may not be tax efficient if payment of dividends to the parent company incurs withholding tax.

< Economic Interest Groups—facilitate cooperation between firms based in different countries.

2.2 Political Risk< Possible government actions that give rise to political risk are:

= appropriation of assets (e.g. nationalisation)—with or without compensation;

= limits on local currency convertibility;= laws regarding local ownership;= laws regarding employment of local staff; = blocks or high withholding tax on the payment of dividends

to a foreign parent.



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< Ways of limiting exposure to political risk include:= structuring the investment so that it is unattractive as a

target for government action (e.g. retention of technical knowledge in the parent company);

= borrowing locally so that if there is uncompensated appropriation of assets the company could default on local loans;

= prior negotiation with host governments;= being "good corporate citizens" of the host country (e.g.

high levels of local employment, use of local suppliers, etc). = using a variety of methods to repatriate funds, not only

dividends, such as:— transfer pricing;

— management fees;

— royalty payments;

— interest payments.

3 International Treasury Function

3.1 Role of International Treasury< Cash flow forecasting.< Cash management.< Foreign exchange risk management.< Interest rate risk management.< Financing decisions.< Investment decisions.< Global tax planning.

3.2 Cost Centre v Profit Centre< Cost centre—the cost of the treasury department is

recharged throughout the group on some equitable basis.< Profit centre—creates an incentive for the treasury

department to be an income generator. However, this may lead to speculation and hence there is a need for strong internal controls to avoid disasters such as:= In 1990 Allied Lyons' treasury took a speculative high-risk

position on the level of volatility of the £/$ exchange rate. Unfortunately this lead to £150 million of losses.

= In 1993 the German oils and metals company Metallgesellschaft lost $1 billion after becoming over-exposed to oil derivative contracts.

= In 1994 the US consumer products group Procter & Gamble lost $102 million on two swap contracts from fixed rate loans into floating rate—gambling that US and German interest rates would stay low. Unfortunately both interest rates rose sharply.



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3.3 Centralised v Decentralised

3.3.1 Advantages of Centralised Treasury Management

Economies of scale—lower staff costs, increased power with financial institutions, lower transaction costs. Bilateral and Multilateral netting*—finding the net position

for group companies regarding inter-company payments. This can reduce the number of transactions and hence cash transmission costs. Control over subsidiaries—for example regarding gearing levels. "Pooling" of short-term cash surpluses and deficits—to reduce

interest expense. Netting of currency exposures to reduce the amount of

external hedging required. Identification of the best investments available within the group. Transfer of cash from subsidiaries producing surpluses to those

requiring project finance. Effective global tax planning—via transfer pricing and offshore

"dividend mixer" companies. Minimising finance costs—perhaps through the use of Special

Purpose Vehicles; diverting low risk cash flows into a separate entity which gains a high credit rating and can issue bonds at low interest rates.

3.3.2 Disadvantages of Centralised Treasury Management

Reduced autonomy of subsidiaries—may lead to demotivation. Lack of understanding of local conditions. Slow to react to opportunities at local level. Potentially dangerous to concentrate power in the hands of a

few personnel. Some governments restrict the use of multilateral netting in

order to protect the fees generated by their banking system.

Bilateral means only two companies are involved; multilateral means several are involved.



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Example 1 Multilateral Netting

InterBevvie Co is a UK-based multinational which has a number of intra-group transactions with its four foreign subsidiaries in six months' time. These are summarised below. Intra-group transactions are denominated in US dollars.

Paying Company

UK Co 1 Co 2 Co 3 Co 4Receiving company US $000UK – 300 450 210 270

1 700 – 420 – 180

2 140 340 – 410 700

3 300 140 230 – 350

4 560 300 110 510

Required:Explain and demonstrate how multilateral netting might be of benefit to InterBevvie Co.Solution

Payments

Receipts

UK 1 2 3 4 Total Receivable

Net Receipts/

(Payments)

UK

1

2

3

4 Total payments

3.4 Agency Issues in the Central Coordination of Overseas Operations

< An agency relationship exists between, for example, a head office and local subsidiaries. This may result in a potential conflict between the subsidiaries' desire for financial autonomy and the parent's need for effective central control.The senior financial executive (or advisor) must manage this conflict through finding a balance between autonomy and control which is acceptable to both the principal (head office) and agent (overseas subsidiary).



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Illustration 1 Agency Issues

Blackheath PLC is a UK-based multinational with subsidiaries in 14 countries in Europe, Asia and Africa. The subsidiaries have traditionally been allowed a large amount of autonomy, but Blackheath is now proposing to centralise most of group treasury management operations.You are required, as a consultant to Blackheath, to prepare a memo from the group finance director suitable for distribution to the senior management of each of the subsidiaries explaining:(i) the potential benefits of treasury centralisation; and(ii) how the company proposes to minimise any potential problems for the subsidiaries that might

arise as a result of treasury centralisation.

MemoTo: All directors of foreign subsidiaries From: Group Finance DirectorIt is proposed that the group will centralise its treasury functions. Centralisation of group treasury management functions means that decisions regarding currency management, short-term investment and borrowing and financial risk management will be taken centrally rather than at subsidiary level. This will permit significant efficiency improvements and cost savings. The major effects will be that:— Decisions will be taken in line with the tactical and strategic objectives of the group as a

whole, rather than by individual subsidiaries, which might from time to time have different objectives.

— A central treasury can better appreciate the total foreign exchange exposure position of the group. Netting of receivables and payables in foreign currencies will be possible, only the net amounts need be hedged.

— Better knowledge will exist of total debts and cleared bank balances. Surplus cash from one subsidiary will be lent to other subsidiaries, eliminating a bank lending-borrowing spread. Cash may be aggregated together and invested at better rates, and borrowing may be possible at favourable rates, including from international markets to which individual subsidiaries would not have direct access.

— It is expensive to establish a high quality specialist treasury management team and supporting technical infrastructure. It is not financially prudent to set up high cost expert teams for each subsidiary.

— A centralised treasury will collect and analyse relevant economic and financial information, and supply such information to subsidiaries to aid in their decision-making.

— Transfer prices will be centrally set to try to minimise the group global tax bill.— A centralised treasury function, with effective internal controls, will be able to prevent the

possibility of major financial losses.

The main effect of any form of centralisation is that some decision-making will be removed from senior managers of the subsidiaries. The centralisation is intended to increase the efficiency of subsidiaries. I would be pleased to receive any comments and suggestions that you have on the implementation process, and can assure you that at all times you will be fully consulted.

From time to time centralised treasury decisions, taken in the interests of the group, might distort reported profitability of subsidiaries. Any such distortions will be removed from data used for the performance evaluation of the subsidiaries, and managers of subsidiaries will only be evaluated on the results of actions over which they have full control.

It is important that information flows to the central treasury from subsidiaries are quick and accurate. Full computer support and links will be provided. If you have specialist knowledge of any local conditions that you feel the central team needs to be aware of, or if you have any specific questions regarding this new policy, please contact me at your earliest convenience.



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3.5 International Cash Transfer Mechanisms< Cheque—slow and risk of loss in the postal system.< Banker's draft—a cheque drawn by a bank against funds

held in another bank (e.g. an overseas customer's bank may draw a banker's draft against a bank in the exporter's country). The draft is posted to the exporter who presents it and arranges payment into their own account. Slow and risk of loss in the postal system.

< SWIFT (Society for Worldwide Inter-bank Financial Telecommunications)—electronic funds transfer; fast and reliable but high fees.

3.6 Short-Term Investments Short-term cash surpluses should be invested in low-risk, high liquidity investments such as:

< Short-term bank deposits;< Eurocurrency deposits;< Certificates of Deposit (issued by banks)—pay specified rate of

interest and have a fixed maturity date. They are negotiable instruments (i.e. they can be resold);

< Treasury bills; < Bills of exchange;< Commercial paper (i.e. unsecured short-term promissory

notes issued by banks and creditworthy corporate borrowers).

3.7 Long-Term Maximisation of Corporate ValueThe treasury department of a multinational firm can contribute to the long-term generation of shareholder wealth in various ways:

< designing the transfer prices between group companies in order to minimise global tax liabilities;

< optimising the timing and structure of dividend remittances from overseas subsidiaries (e.g. channelling dividends via a "dividend mixer company" to maximise claims for double tax relief);

< sheltering the group from tax on the disposal of overseas assets by transferring them into offshore entities established in tax havens;

< designing schemes to remit overseas profits if host governments block dividends (e.g. management fees, royalty payments);

< designing credit enhancement schemes (e.g. diverting high quality cash flows into a special purpose vehicle which then issues asset-backed securities to raise debt at low interest rates);

< accessing favourable interest rates for both investing and borrowing in the Euromarkets (i.e. the offshore banking markets).



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4 International Capital Budgeting

4.1 Net Present Value< The key issue here is to find the value of an overseas project

in the hands of the parent company's shareholders (i.e. if the parent is UK based then it is necessary to find the sterling NPV of the project). However, there may be various complications: = Differences between the cash flows generated by the

project and the amount that can actually be remitted to the parent—the remittable cash flow may be significantly less than the project cash flow due to exchange controls. As the project in the hands of the ultimate shareholders needs to be valued, it is the remittable cash flow which is relevant.

= Taxation policies—the project's returns will often be taxable both in the overseas country and, on a remittance basis, in the home country. However, bilateral tax treaties may offer some relief from double taxation.

= Exchange rates—as the remittable cash flows need to be valued in terms of the home currency it is necessary to forecast future exchange rates.

< The conventional approach to deal with these complications is as follows:(1) forecast the relevant cash flows in the foreign country,

taking into account any foreign tax effects;(2) estimate remittable cash flows to the parent company;(3) forecast future spot exchange rates (e.g. using purchasing

power parity);(4) translate the remittable cash flows into the parent

company's currency;(5) incorporate any other cash flows for the parent that arise

due to the project (e.g. lost contribution from exporting, additional tax in the home country);

(6) estimate the parent's WACC that reflects the risk of the project and find the NPV.

< If the home currency is expected to appreciate/depreciate by the same amount each year, this can be reflected in the discount rate and all overseas cash flows can then be translated at today's spot rate. To calculate the "adjusted discount rate" use the following formula:

(1 + adjusted= (1 + conventional discount rate)(1 + annual appreciation)

discount rate)



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Example 2 Overseas Project Evaluation

Albion, a UK-based company, is evaluating a project in the US. The relevant cash flows have been estimated as follows:

t0 t1 t2 t3

$m $m $m $mCash flow (100) 60 80 90Sterling cost of capital = 10%.Spot rate $1.38 per £1UK interest rate 4% and US interest rate 6%.

Required:Calculate the sterling NPV using:(a) the conventional approach (sterling cash flows discounted at sterling

discount rate);(b) the alternative approach (dollar cash flows discounted at adjusted discount rate).

SolutionConventional approach




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Example 2 Overseas Project Evaluation (continued)

Alternative approach

4.2 Adjusted Present Value< APV may be a suitable method for appraising an overseas

investment where the project finance significantly disturbs the existing capital structure

< The first step would be to calculate the "base case" NPV—the present value of the post-tax remittable operating cash flow discounted at the cost of equity ungeared.

< The base case NPV would then be adjusted for any financing side effects which in an international context might be:= subsidies from foreign governments;= tax shields on local and/or home country loan finance.



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5 International Capital Structure

There are a variety of ways in which a holding company can finance its overseas subsidiary:

Method CommentsEquity < Either 100% from the holding company or partly raised locally.

< Sometimes a requirement for locals to own some equity. < Remittance of funds via dividend can be problematic due to blocks or

withholding tax.

Debt < Either in parent's currency or local currency.< Foreign currency debt could be accessed either by

(i) directly borrowing in the local market (ii) using the Euromarkets (iii) using currency swaps.

< Loans are often taken in local currency in order to match the assets of subsidiary and reduce foreign exchange economic risk and translation risk.

< Borrowing locally also gives some protection against political risk.

Government grants < Possibly available from the overseas government or international bodies such as the World Bank.

6 Transfer Pricing

6.1 When Required A transfer pricing policy is needed when:

< a business has been decentralised into divisions or subsidiaries; and

< inter-divisional/company trading of goods or services occurs.Transfers between divisions must be recorded in monetary terms as revenue for supplying divisions and costs for receiving divisions.

Transfer pricing is more than just a bookkeeping exercise. It can have a large effect on the behaviour of divisional managers.

6.2 Objectives of Transfer Pricing

6.2.1 Goal Congruence

< Transfer prices should encourage divisional managers to make decisions which are in the best interests of the parent company's shareholders.

< In any divisionalised organisation there is a risk of dysfunctional decision-making. Where inter-divisional trading occurs, this risk is particularly high.

< Achievement of goal congruence must be the primary objective of a transfer pricing system.



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6.2.2 Divisional Autonomy

< Divisional managers should be free to make their own decisions. A transfer pricing system should eliminate the need for the head office to tell divisions what to do—instead it gives information to divisional managers which allows them to make the correct decisions.

< Autonomy should improve motivation of divisional managers.

6.2.3 Divisional Performance Evaluation

< Transfer prices should be "fair" and allow an objective assessment of divisional performance.

< If there is conflict between these objectives, then goal congruence must take priority.

6.3 Optimal Transfer Price for Goal Congruence

Optimal transfer price = Marginal cost to selling division + Opportunity cost

to the company

The classic example of opportunity cost is where an internal sale will be at the expense of an external sale (i.e. the opportunity cost is the lost contribution from the missed external sale).

6.4 Other Transfer Pricing Methods< Market price—suitable if an external market exists and the

supplying division is at full capacity. However, the market price might need to be adjusted downwards if internal sales incur lower costs than external sales (e.g. due to lower delivery costs).

< Cost plus—the supplying division charges cost plus a mark-up. However, the mark-up is arbitrary and the resulting transfer price may not be optimal for decision-making.

< Two-part transfer prices—the supplying division charges the receiving division a fixed charge per period and a variable cost per unit. May not be optimal for decision making.

< Negotiated transfer prices—bargained between divisional managers. May lead to conflict.

< Dual pricing—one price is used for crediting the supplying division and another (usually lower) price used for debiting the receiving division. Allows both divisions to record profits—improves motivation.

6.5 Tax Planning < In multinational organisations the issues relating to taxation

may take precedence over other transfer pricing issues and significant amounts of management time are spent attempting to determine the transfer prices that will minimise tax paid on a global basis.

< Within legal and ethical limits transfer pricing can be used to transfer profits to subsidiaries located in lower tax countries.

< Management should be aware of the fact that anti-avoidance legislation may exist to prevent companies from using transfer pricing to divert profits to overseas subsidiaries.



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Multinationals may use two transfer pricing systems:= one for internal decision-making (based on marginal cost +

opportunity cost);= another for tax purposes.

< Import duties/tariffs—it is desirable that transfer prices be kept as low as possible in order to minimise the payment of duty in countries that impose import tariffs based on the "value" of incoming goods. Governments are aware of such practices and may invoke similar policies to that of anti-avoidance legislation.

< Repatriation of funds—some developing countries place restrictions on the payment of dividends to a foreign parent, or imposes high withholding taxes on dividends. In this situation transfer pricing may be an alternative method of remitting profits back to the parent.

Example 3 Transfer Pricing

Supplying division A manufactures components in a country whose tax regime is 12% and transfers to receiving division B suffering a tax rate of 40%.Required:(a) State whether the transfer price should be maximised or minimised.(b) State any other factors which should be taken into account.

Solution(a)

(b)



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< The risk of exporting is not confined to exchange rate risk; it includes more fundamental risks such as loss of goods in transit. However, for each risk there is a method of management or at least evaluation before entering a particular market.

< A key risk when exporting, as with domestic sales, is of bad debts. Carefully structuring the deal can minimise this risk (e.g. requesting a letter of credit from the overseas customer's bank).

< The firm may move from exporting to establishing operations overseas. This brings in a whole range of issues:

• how to structure the investment;

• how to fi nance it;

• how to evaluate projects overseas; and

• how to repatriate the profi ts.

< Goal congruence is a primary objective of transfer pricing. The optimal transfer price to achieve this is:

Marginal cost to selling division + Opportunity cost

to the company

< Tax issues are a major consideration in establishing transfer prices.

Summary



Q44 Polycale 35 minutes

Additional

Q45 Avto

Q46 Servealot

Q47 Kandover


1. State SIX potential risks for a company when engaging in international trade. (1)

2. List methods of reducing bad debt risk on exports. (1.7)

3. List methods of expanding overseas. (2.1)

4. Suggest methods of managing political risk on overseas investments. (2.2)

5. State advantages for a multinational company of centralising treasury management. (3.3)

6. State advantages of financing an overseas subsidiary on its local debt markets. (5)

7. List THREE objectives of an international transfer pricing system. (6.2)



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Session 17

Solution 1—Multilateral NettingMultilateral netting is an effective means of reducing the transactions costs associated with foreign currency exchange and international money transfers. The netting of InterBevvie's intra-company US dollar exposures gives the following transactions matrix:

Payments

Receipts

UK 1 2 3 4 Total Receivable

Net Receipts/

(Payments)

UK — 300 450 210 270 1,230 (470)

1 700 — 420 – 180 1,300 220

2 140 340 — 410 700 1,590 380

3 300 140 230 — 350 1,020 (110)

4 560 300 110 510 — 1,480 (20)

Total payments 1,700 1,080 1,210 1,130 1,500 6,620 –

Some dollar payments will still need to be made from the UK, country 3 and country 4 to countries 1 and 2. However, such payments will total a maximum of $600,000 against the total trade value of $6,620,000, saving transactions and other costs on more than $6 million.

Solution 2—Overseas Project Evaluation(a) Conventional approach t0 t1 t2 t3

$m $m $m $mCash flow (100) 60 80 90

Exchange rate (W) $1.38 $1.407 $1.434 $1.462

£m £m £m £mCash flow (72) 43 56 62

10% discount factor 1 0.909 0.826 0.751

PV (72) 39 46 47

NPV = £60m

WORKING

The International Fisher Effect can be used to forecast future spot rates

t1, exchange rate = $1.38 × 1.061.04

= $1.407

t2, exchange rate = $1.407 × 1.061.04 = $1.434

t3, exchange rate = $1.434 × 1.061.04

= $1.462



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Solution 2—Overseas Project Evaluation (continued)

(b) Alternative approach t0 t1 t2 t3

$m $m $m $mCash flow (100) 60 80 90

12.1% discount factor (W1) 1 0.892 0.796 0.71

PV (100) 54 64 64

NPV = $82m

Current spot $1.38 per £

Translation to sterling = 82/1.38 = £59m

(£1m rounding difference with conventional approach)

WorkingsSterling is expected to appreciate against the dollar by 1.92% each year (1.06/1.04 – 1). This reduces the sterling value of overseas cash flows and hence a higher discount rate should be applied to dollar cash flows.

(1 + adjusted discount rate) = (1 + conventional discount rate)(1 + annual appreciation)

(1 + adjusted discount rate) = 1.10 × 1.0192

Adjusted discount rate = 12.1%

t1, present value factor = 11.121

= 0.892

t2, present value factor = 1(1.121)2

= 0.796

t3, present value factor = 1(1.121)3

= 0.71

Solution 3—Transfer Pricing

(a) It is in the company's best interest to maximise the transfer price and hence the profits of the supplying division where tax rates are much lower. This simultaneously lowers the profits of the receiving division where tax rates are higher.

(b) Some taxation authorities are aware of these policies and may attempt to impose additional tax. OECD guidance on arm's length transactions recommends a price based on one that would have been negotiated between unrelated parties.



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NOTES



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Financial StatementAnalysis


Session 18



2. Financial strategy formulationa) Assess organisational performance using methods such as ratios, trends,

EVATM and MVA.



i) Assess the impact of a significant capital investment project upon the reported financial position and performance of the company taking into account alternative financing strategies.



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The only specific reference to ratios in the P4 syllabus relates to the assessment of corporate performance in the context of financial strategy formulation. However, many areas of financial management require a sound understanding of ratio analysis (e.g. the impact of a major investment decision on financial position and performance). This session revises assumed knowledge of interpretation of financial statements relevant to financial managers.

VISUAL OVERVIEWObjective: To calculate commonly used ratios.

ANALYSIS OF FINANCIAL STATEMENTS

• By Management• By Equity Investors• By Lenders• Influences on Ratios• Limitations of Ratios • Other Indicators

PERFORMANCE RATIOS

• Significance • Key Ratios

LIQUIDITY RATIOS

• Short Term • Long Term

EFFICIENCY RATIOS

• Significance • Key Ratios• Working

Capital Cycle

INVESTOR RATIOS

• Significance • Key Ratios

ECONOMIC VALUE ADDED• Uses• Calculation and Interpretation• Advantages• Disadvantages



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Session 18 • Financial Statement Analysis P4 Advanced Financial Management


1 Analysis of Financial Statements

1.1 By Management

1.1.1 Major Capital Expenditure

< Aspect of financial position and performance of concern the impact of:= project financing on reported levels of financial gearing;= the project on operating profit and operating cash flows;= the project and its financing on interest cover, return on

capital employed, return on equity and earnings per share.

1.1.2 Potential Acquisitions

Aspect of target firm of concern:

< Value of target company on basis of earnings, assets and free cash flow;

< Disposable value of surplus assets;< Financial and dividend policy.

Analysis of target will focus on:

< several years' accounts with particular reference to;< profits including any exceptional items;< return on capital employed on a divisional basis;< indications of true asset values;< liquid assets.

Forecast impact on acquirer's financial statements:

< Impact of bid financing on reported financial gearing—leveraged acquisitions are likely to increase financial gearing, whereas equity finance (either raising cash through a rights issue or acquiring the target company through a "share for share exchange") is likely to reduce financial gearing.

< Impact of acquired company on group profit, cash flow and capital expenditure requirements.

< Impact of the acquired company and bid finance on group interest cover, return on capital employed, return on equity and earnings per share.

< An acquisition near the year-end will mean that capital employed will include all the assets acquired but profits of the new acquisition will only be included in the statement of profit or loss for a small part of the year, thus tending to depress ROCE.

1.2 By Equity Investors

1.2.1 Aspect of Business Performance of Concern

< Potential for the business to grow;< Cash generation and dividend capacity;< Financial stability.



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P4 Advanced Financial Management Session 18 • Financial Statement Analysis

1.2.2 Focus of Analysis

< Analysis of several years' accounts, paying particular attention to trends exhibited in:= sales, costs and profits;= dividend record;= dividend cover.

< Attention will also be paid to:= maintenance of adequate liquid funds;= control over net current assets;= financial and operational gearing;= quality of corporate governance.

< This analysis may be carried out by experienced investment analysts.

1.3 By Lenders

1.3.1 Aspect of Concern

< Level and volatility of cash flows available to service interest and repay principal;

< Level and quality of assets available as collateral;< Potential recoverability of amounts owed if company defaults.

1.3.2 Focus of Analysis

< Level of financial gearing, interest cover and cash coverage;< Priority of claims upon default (i.e. senior debt versus

subordinated debt).

1.3.3 Sources of Information

< Although published financial statements will be of some use they by definition will be out of date.

< Banks providing loans may demand access to management accounts, in particular cash flow forecasts.

< Bond investors may turn to the commercial credit rating agencies (Fitch, Moody's, Standard and Poor) although the reputation of such agencies has been damaged by the high ratings they attached to sub-prime US mortgage-backed debt (collateralised debt obligations).



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1.4 Influences on Ratios< Ratios may change over time or differ between companies

because of the nature of the business, or management actions in running the business. For example:= Type of business (e.g. retailer versus manufacturer) This affects the nature of the assets employed and the

returns earned (e.g. a retailer may have higher asset turnover but lower margins than a manufacturer).

= Quality of management Better managed businesses are likely to be more profitable

and have better working capital management than businesses where management is weak.

= State of economy and market conditions If a market or the economy in general is depressed, this is

likely to adversely affect companies and make most or all of their ratios appear worse.

= Management actions These will be reflected in changes in ratios. For example,

price discounting to increase market share is likely to reduce margins but increase asset turnover; withdrawing from unprofitable market sectors is likely to reduce income but increase profit margins.

= Changes in the business If the business diversifies into wholly new areas, this is

likely to change the resource structure and thus impact on key ratios.

< Choice of accounting policies can significantly affect the view presented by the accounts, and the ratios computed, without affecting the business's core ability to generate profits and cash. For example:= Revaluations versus historic cost If a business revalues its assets rather than carrying them

at historic cost, this will usually increase capital employed and reduce profit before tax (due to higher depreciation). Thus, ROCE, profit margins and gearing are all likely to be lower if a business revalues its assets.

< The choice of policies in order for the accounts to show a particular picture is known as creative accounting.

1.5 Limitations of Ratios < Ratios use historic data which may not be predictive as

this ignores future actions by management and changes in the business environment. When calculating historic ratios consideration must be made of the entity's future plans and the impact that these plans will have upon the historic data.

< Ratios may be distorted by differences in accounting policies.< Comparisons between different types of businesses are

difficult because of differing resource structures and market characteristics.

< Many ratios use figures from the statement of financial position, these figures only apply at that one point in time. If an entity has seasonal or cyclical trading cycles then the ratios drawn down from the statement of financial position may not be representative of how that business works during its busy periods.



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1.6 Other Indicators< Ratios are a key tool of analysis but other sources of

information are also available:= absolute comparisons can provide information without

computing ratios (e.g. comparing statements of financial position between this year and last may show that new shares have been issued to repay borrowings or finance new investment, which may in turn impact on gearing and ROE);

= background information supplied about the nature of the business may help to explain changes or trends (e.g. if the business has made an acquisition);

= the statement of cash flows provides information as to how a business has generated and used cash so that users can obtain a fuller picture of liquidity and financial adaptability.

< Not all indicators of performance need to be financial in nature. There are many other factors that affect how the performance of an entity should be assessed. For example:= staff turnover;= interaction of the entity with the local community;= environmental and green accounting issues—many

companies now include an environmental report in their annual financial statements;

= customer care policy.

2 Performance Ratios

2.1 Significance< Performance ratios measure rate of return earned on capital

employed, and analyse this into profit margins and use of assets. These ratios are frequently used as the basis for assessing management effectiveness in utilising the resources under their control.

2.2 Key Ratios

2.2.1 Return on (Total) Capital Employed (ROCE)

< Profit before interest and tax

× 100Share capital + reserves + debt

< Measures overall efficiency of company in employing resources available to it.

2.2.2 Return on Shareholders' Funds (ROSF)

< Profit before tax

Share capital reserves+

< Measures how efficiently the funds provided by shareholders have been employed.

< Also called Return on Equity (ROE) and can also be calculated using profit after tax.



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Considerations 1—ROCE/ROSF < When drawing conclusions from ROCE/ROSF consider:

= target return on capital (company or shareholder);= real interest rates;= age of plant and equipment;= leased v owned assets;= revaluation of assets;= research and development policy.

2.2.3 Gross Profit Percentage

< Gross profit × 100

Sales< Measures margin earned by company on sales.

Considerations 2—GP %

< Variations between years may be attributable to:= change in sales prices;= change in sales mix;= change in purchase/production costs;= inventory obsolescence.

2.2.4 Overheads/Sales Percentage

< Overheads

× 100Sales

< Measuresmarginofoverheads(fixedandvariable−usually=distribution costs + administrative expenses) to sales.

< Ideally should be broken into variable overheads (expected to change with sales) and fixed overheads (likely to move in more "lumpy" fashion).

Considerations 3—Overheads/Sales

< May change because of:= change in the value of sales—investigate whether due to

price or volume changes;= company relocation to new premises.

2.2.5 Operational Gearing

If an exam question does not define a calculation then state your definition, show your workings and be consistent between companies/years.

< Fixed operating costs

× 100Variable operating costs

< Operating gearing measures the sensitivity of operating profits to changes in revenue. Firms with high operating gearing will have high volatility of profits, contributing to business risk.



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2.2.6 Analysis

< ROCE measures return achieved by management from assets which they control, before payments to providers of financing for those assets (i.e. lenders and shareholders). Usually year-end capital employed is used to compute this ratio.

< Consideration needs to be made in respect of the age of an entity's assets; old assets with low carrying values will lead to a high ROCE, whereas an entity that has just made a major acquisition of new assets will find that their ROCE will be fairly low as the asset will not have reached its optimum performance levels.

< ROCE can be further sub-divided into operating profit margin and asset turnover:

Operating margin × Asset turnover = ROCE

PBIT

Revenue ×

Revenue

Capital employed =

PBITCapital employed

= Profit margin is often seen as a measure of quality of profits. A high profit margin indicates a high profit on each unit sold.

= Asset turnover is often seen as a quantitative measure, indicating how intensively the management is using the assets.

< A trade-off often exists between margin and asset turnover. Low margin businesses (e.g. food retailers) usually have high asset turnover. Conversely, capital-intensive manufacturing industries usually have relatively low asset turnover but higher margins (e.g. electrical equipment manufacturers).

3 Liquidity Ratios

3.1 Short Term

3.1.1 Significance

< Short-term liquidity ratios are used to assess a company's ability to raise cash to meet payments when due. In practice, information contained in the statement of cash flows is often more useful when analysing liquidity.

3.1.2 Key Ratios

< Current ratio

= Current assetsCurrent liabilities

= Measures adequacy of current assets to cover current liabilities.

< Quick ratio (acid test)

= Debtors investments cashCurrent liabilities+ +

(usually expressed as X:1)= Eliminates the slower moving item—inventory—from the

calculation, thus measuring real short-term liquidity.



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Considerations 4—Current and Quick Ratios

< Indicators:= Low ratio may indicate—liquidity problems;= High ratio may indicate—poor use of shareholder/company

funds;= Consider constituent components of ratio—inventory

obsolescence (in case of current ratio), recoverability of receivables (in case of both ratios);

= Consider manipulation—if company has positive cash balances and a ratio greater than 1:1, payment of payables just prior to the year end will improve ratio.

3.1.3 Analysis

< The current ratio is of limited use as some current assets (e.g. inventory) may not be readily convertible into cash, other than at a large discount. Hence, this ratio may not indicate whether or not the company can pay its debts as they fall due.

< As the quick ratio omits inventory, this is a better indicator of liquidity but is subject to distortions. For example, retailers have few receivables and utilise cash from sales quickly, but finance their inventory from trade payables. Hence, their quick ratios are usually low.

3.1.4 Window Dressing

< The illustration below shows how easy it is for an entity to manipulate the ratios simply by writing a cheque to clear some of the payable balance.

Illustration 1 Financial Shenanigans

Statement of financial position extracts$000

Receivables 900Cash 500Payables 1,000

Required:(a) Calculate the quick ratio.(b) Recalculate the ratio if cheques amounting to $400,000

are written out of the cash book and posted to suppliers' accounts.

Solution

(a) Quickratio=1 4001 000,,

=1.4:1

(b) Quickratio=1 400 4001 000 400,,

−−

=1.7:1



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3.2 Long Term

3.2.1 Significance

< Gearing ratios examine the financing structure of a business. They indicate to shareholders the degree of risk attached to the company and the sensitivity of profits and dividends to changes in profitability and activity level.

< Key ratios are:= Financial gearing ratio; and= Interest cover

3.2.2 Financial Gearing Ratio

< Formulae:

= Fixed return capital, preference shares, debentures, loan sstockEquity capital and reserves

= Debt

Equity

= Debt

Debt Equity+

< Measures relationship between company's borrowings and its share capital and reserves. Use market values of equity and debt if available.*

< A company is highly geared if it has a substantial proportion of its capital in the form of preference shares, debentures or loan stock.*

*Preference share capital is usually included as part of debt rather than equity since it carries the right to a fixed rate of dividend which is payable before the ordinary shareholders have any right to a dividend.

< Interest on fixed return capital (and dividends on preference shares) generally have to be paid irrespective of whether profits are earned—this may cause a liquidity crisis if a company is unable to meet its fixed return capital obligations. High gearing should therefore be accompanied by stable profits.= If a business is highly geared, this usually indicates

increased risk for shareholders as, if profits fall, debts will still need to be financed, leaving much smaller profits available to shareholders.

= Highly geared businesses are usually more exposed to insolvency if there is an economic downturn. However, returns to shareholders will grow proportionately more in highly geared businesses where profits are growing.

< Asset backing—generally loan capital is secured on assets—these should be suitable for the purpose (not fast depreciating or subject to rapid changes in demand and price).

*As many measures of gearing are used in practice, it is especially important with gearing ratios that the ratios calculated are defined.



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3.2.3 Interest Cover

< Profit before interestInterest

Considerations 5—Gearing

< When drawing conclusions from gearing ratios consider:= assets in the statement of financial position at historic cost

or revalued amount—revaluation of non-current assets increases shareholders' funds and thus decreases gearing;

= use of off balance sheet finance to reduce gearing.

Illustration 2 Impact of Gearing on Earnings

Consider three situations for the same geared company, ignoring tax.

(1) (2) (3)$ $ $

Profit before interest 200 100 300Interest on fixed debt (100) (100) (100)Profit available to shareholders (earnings) 100 — 200

Compared to situation (1) Change in profits before interest – 50% + 50% Change in earnings – 100% + 100%

Solution< Low gearing provides scope to increase borrowings when potentially

profitable projects are available. Companies with low gearing are likely to find it easier to borrow and should be able to borrow more cheaply than if gearing is already high.

< Gearing is also significant to lenders as they are likely to charge higher interest, and be less willing to lend, to companies which are already highly geared as such companies are more likely to default on the interest or debt repayments

< Interest cover indicates the company's ability to pay interest out of profits generated. Less than two is usually considered unsatisfactory. This indicates that the company may have difficulty financing its debts if profits fall and also indicates to shareholders that their dividends are at risk as interest must be paid first, even if profits fall.



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4 Efficiency Ratios

4.1 Significance < Working capital ratios are an important indicator of

management's effectiveness in running the business efficiently, as for a given level of activity, it is most profitable to minimise the level of working capital employed in the business.

4.2 Key Ratios

4.2.1 Inventory Turnover

< Cost of sales

Average inventory

(=numberoftimesinventoryisturnedovereachyear—thehigher the better)

< Average inventory

× 365Cost of sales

(=numberofdaysittakestoturninventoryoveronce—thelower the better)

< Ideally consider three components of inventory:= Raw material to volume of purchases;= WIP to cost of production;= Finished goods to cost of sales.

Considerations 6—Inventory Turnover

< High inventory turnover rate—may be efficient but risk of stock-outs increased

< Low inventory turnover rate—inefficient use of resources and potential obsolescence problems

< Accurate reflection?< Does position represent real inventory turnover rate for the

year or does year-end inventory holding distort the true picture?

4.2.2 Receivable Days

< Average trade receivables × 365

Credit sales< Measures period of credit taken by company's customers.< Ideal approximately 30—40 days, depending on the industry.



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Considerations 7—Receivables Days

< A change in the ratio may indicate:= bad debt/collection problems;= change in nature of customer base (big new receivable—

slow payer);= change in settlement terms.

< Accurate reflection?< Do year-end receivables give reasonable indication of

receivable profile for the year as a whole?

4.2.3 Payable Days

< Average trade payables × 365

Credit purchases< Measures number of days of credit taken by company

from suppliers.< Should be broadly consistent with debtor days.

Considerations 8—Payables Days

< A change in the ratio may indicate:= High figure may indicate liquidity problems with company;= Potential appointment of receiver by aggrieved suppliers.

< Accurate reflection?< Do year end payables give reasonable indication of creditor

profile for year as a whole?



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4.3 Working Capital Cycle < Combining the three efficiency ratios will give the number of

days' worth of working capital that an entity needs before it starts to receive cash. The number of days could be negative, common in the retail sector, meaning that cash will be received before the entity has to pay its suppliers.

Illustration 3 Working Capital Cycle

Manufacturing RetailInventory days 120 15Receivable days 50 nilPayable days (45) (30)Working capital cycle 125 (15)

The manufacturing company will have raw materials, WIP and finished goods whereas the retail company will only have low levels of finished goods.The manufacturer will probably sell their product on credit whereas the retail outlet will sell their goods only for cash.Both companies will probably buy their supplies on credit.In this example the manufacturing company needs 125 days' worth of working capital before it receives any cash but the retail outlet receives 15 days' worth of free credit from its supplier.

Working Capital

< Inventory turnover, receivable days and payable days give an indication of whether a business is able to generate cash as fast as it uses it. They also provide useful comparisons between businesses (e.g. on effectiveness in collecting debts and controlling inventory levels). The average of opening and closing inventories, receivables and payables is often used to compute these ratios.



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5 Investor Ratios

5.1 Significance < Investors' ratios help to establish characteristics of ordinary

shares in different companies. For example:= Earnings per share will be important to those investors

looking for capital growth;= Dividend yield, dividend cover and dividends per share will

be important to those investors seeking income.

5.2 Key RatiosEarnings per ordinaryshare(EPS)=

Profit after tax – Preference dividendsWeighted average number of ordinary shares in issue

Diluted EPS should also be calculated where a company has a complex capital structure that includes Potentially Dilutive Securities (PDSs). These are securities in issue which involve an obligation to issue shares in the future (e.g. convertible debt, warrants).

DilutedEPS= Profit after tax – Preference dividends + PDS adjustmentsWeighted average ordinary shares + PDS's outstanding

Dividendcover = Profit after tax – Preference dividendOrdinary dividend

Dividendpayoutratio = Ordinary dividendProfit after tax – Preference dividend

Dividendyield = Dividend per ordinary shareOrdinary share price

× 100

Priceearningsratio(P/Eratio)= Ordinary share priceEPS

Earningsyield = EPSOrdinary share price

× 100

Totalshareholderreturn(TSR) = Year-end share price + dividendsShare price at start of year

× 100

Analysis

< Ideally investors should use forecast information when making investment decisions. In practice only historic figures are usually available.

< Dividend yield measures dividend policy rather than performance. A high yield based on recent dividends and current share price may arise because the share price has fallen in anticipation of a future dividend cut.

< Rapidly growing companies may exhibit low yields based on historic dividends, especially if the current share price reflects anticipated future growth.

< The dividend cover ratio shows how many times a company could have paid its current dividend from available earnings (i.e. an indication of how secure dividends are).

< The PE ratio is used to indicate whether shares appear expensive or cheap in terms of how many years of current earnings investors are prepared to pay for.



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Example 1 Gearing and EPS

Darbar needs to raise $5 million to finance project VZ, and other new projects. The proposed investment of the $5 million is expected to yield earnings before interest and tax of $2 million per annum. Earnings on existing investments are expected to remain at their current level. From the data supplied below:

Statement of financial position (extract from last year) $000Authorised share capital Ordinary shares of 50c each 20,000Issued ordinary share capital, Shares of 50c each 2,500Reserves 4,00010% Debentures (4 years to redemption) 2,000Bank Overdraft (secured) 2,000

10,500

Other information: $000Revenue 55,000Net profit after interest and tax 3,000Interest paid 200Dividends paid and proposed 800

The 50c ordinary shares are currently quoted at $2.25 per share: The company's tax rate is 33%. The average gearing percentage for the industry in which the company operates is 35% (computed as debt as a percentage of debt plus equity, based on book values, and excluding bank overdrafts).Required:(a) Calculate and comment briefly on the company's current

capital gearing.



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Example 1 Gearing and EPS (continued)

(b) Calculate and briefly discuss the effect on gearing and EPS at the end of the first full year following the new investment if the $5 million new finance is raised in each of the following ways:

(i) By issuing ordinary shares at $2 each.

(ii) By issuing 5% convertible loan stock, convertible after four years. The conversion ratio is 40 shares per $100 of loan stock.

(iii) By issuing 7.5% undated debentures.



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6 Economic Value Added

6.1 Uses The use of Economic Value Added (EVA™) for business valuation was covered in Session 7. However many firms also use EVA for:

< Internal performance evaluation of divisions or subsidiaries as financial accounting profit does not deal well with finance costs. Managers may wrongly believe that financial accounting profit indicates satisfactory performance.*EVA attempts to convert financial accounting profit to "economic profit" to show any surplus returns above the minimum required by providers of finance (i.e. a measure of residual income).

< External performance reporting; showing the firm's overall EVA in the annual report. This is done on a voluntary basis in an attempt to improve communication with stakeholders about the true performance of the firm.*

6.2 Calculation and Interpretation

Cash earnings1 before interest but after tax x

Imputed finance charge2 (x)

Economic Value Added x

1 After "economic depreciation", which measures the true fall in the value of assets each year through wear and tear and obsolescence (i.e. the amount of cash the firm would need to put aside to maintain its existing capacity). Other potential adjustments include capitalising and amortising:< all research and development costs;< long-term assets held under operating leases.*

2 Imputedfinancecharge=Capitalemployed×WACC

< Although capital employed is based on the book value of equity plus debt (alternatively, total assets less current liabilities), adjustments may be required for the items mentioned above (economic depreciation, etc).

< The imputed finance charge measures the minimum profit required to compensate the providers of long-term capital for the risk they take.

< EVA can also be expressed in relative terms as the difference between the actual return on capital employed and the weighted average cost of capital:

EVA%=ROCE–WACC Where ROCE is measured as net operating profit after tax

(NOPAT) divided by total capital employed. Any surplus return above the WACC can be referred to as the

"value spread".

*In fact equity costs are totally ignored.

* Disclosure is not a mandatory requirement.

*IASB and FASB have jointly proposed this treatment for financial reporting.



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6.3 Advantages It makes the cost of capital explicit in performance reports. It is closely aligned to the NPV approach to decision-making.

6.4 Disadvantages Projects with strong NPV may report poor EVA in early years

(due to high initial capital employed) and thus be rejected by "myopic" managers working under short-term pressures.

Possible manipulation of subjective EVA adjustments. (Stern, Stewart & Co suggest up to 164 potential adjustments to financial accounting profits to arrive at economic profit.)

Difficulties in estimating the true or "economic" capital employed in the service sector where the main asset may be human capital which is not measured on the statement of financial position.



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7 Interpretation Technique

7.1



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< If asked to interpret accounts:• makecommentspertinenttotheusersofaccounts(thereforeidentifytheaudience

from requirement);• onlycomputeratiosifyoucanmakeuseofthem(andalwaysdefineratioscalculated)

make comparisons and suggest reasons;• alsocompareabsolutenumbersintheaccountstoidentifydifferences(e.g.changes

year-on-year);• lookforinfluenceofbusinessfactorsandaccountingpolicies;• beabletolinkdifferentpiecesofinformationandseewhattheypointtowards;• indicateneedforfurtherinformationifnecessary;and• beawareoflimitationsofratios.

< Most marks in the exam are likely to be for specific, relevant comments rather than solely for computations.

< If asked to write a report, put a table of ratios in an appendix and refer to them in the text as appropriate.



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Example 2 Stock Market Ratios

Cathcart—Statement of financial position as at 31 December 200X$000 $000

Non–current assetsCost less depreciation 2,200

Current assets Inventory 400Receivables 500Cash 100

1,0003,200

Equity Ordinary shares ($1 par) 1,000Retained earnings 800

Non-current liabilities10% bond 600Preferred shares (10%) ($1 par) 200

Current liabilitiesPayables 400Income tax 200

6003,200

Cathcart—Statement of profit or loss for the year ended 31 December 200X$000 $000

Revenue 3,000Cost of sales (2,400)Gross profit 600Operating expenses (200)Profit before interest and tax 400Interest (60)Profit before tax 340Income tax (180)Profit after tax 160Dividends: Ordinary 125

Preference 20Current quoted price of $1 ordinary shares in Cathcart $1.40



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Example 2 Stock Market Ratios (continued)

SolutionCalculate each of the following ratios for Cathcart:

(a) Grossprofitmargin=

(b) Operatingprofitmargin=

(c) Returnoncapitalemployed=

(d) Returnonequity=

(e) Currentratio=

(f) Acidtestratio=

(g) Receivablesdays=

(h) Totalassetturnover=



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Example 2 Stock Market Ratios (continued)

(i) Fixedassetturnover=

(j) Proportionofdebtfinance=

(k) Interestcover=

(l) Earningsperordinaryshare=

(m) Dividendcover=

(n) Dividendyield=

(o) Priceearningsratio=



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Ratio analysis is a subjective area—different analysts calculate ratios in slightly different ways. Often a change in a ratio is more relevant than its absolute level.



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Session 18

Study Question Bank Estimated time: 1 hour 20 minutes


Q50 Sparks 30 minutes

Q51 Wurrall 50 minutes

Additional

Q48 Noifa Leisure

Q49 Twello



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EXAMPLE SOLUTIONSSolution 1—Gearing and EPS

(a) Current gearing

Gearing(excludingoverdraft)= debtdebt equity+

= ×2,0008,500

100 =23.53%

Gearing(includingoverdraft)= 4 00010 500

,,

=38.08%

The current gearing position is on the low side, particularly when compared with the industry average of 35%. This provides an indication that the company still has the scope and capacity to attract more debt.

There is however, a large secured bank overdraft, and it is quite likely that quite a high proportion of it represents hard-core debt. It is also most unlikely that the bankers would call in such a large overdraft at short notice. If the overdraft were included in the gearing calculation, and treated as debt, the gearing ratio 38.1% is a little above the industry average.

Currentearningpershare($000)= 3,0005,000

=60cpershare

(b) Effect on gearing(i) Issue of ordinary shares

Numberofnewshares= $5,000,000$2.00

=2,500,000shares

Earnings $000 $000Current net profit after interest and tax 3,000Additional earnings 2,000Less tax at 33% 660 Additional net profit after tax 1,340New net profit after tax 4,340

EPS= 4,3407,500

=58cpershare

Gearing= 2 00013 500

,,

×100=14.81%

More equity would reduce the gearing further. The gearing in the future would also tend to fall due to increases in reserves via retained earnings.

The scheme would reduce the EPS by 2c per share when compared with current earnings. Another consideration is the control factor (i.e. those shareholders who currently control the company could lose control unless they buy some of the shares being offered).



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(ii) 5% convertible loan stock

$000 $000Current net profit after interest and tax 3,000Plus Additional earnings 2,000Less Loan stock interest at 5% 250Additional net profit after interest 1,750Less tax at 33% 578Additional net profit after tax 1,172New net profit after tax 4,172

UndilutedEPS= 4,1725,000

=83cpershare

Gearingatthetimeofissuingtheconvertibleloanstock= 7,00013,500

×100=51.85%

This figure would be expected to decrease in future years as a result of "ploughing back" profits by way of retained earnings (i.e. increasing the equity). On conversion the gearing percentage should fall quite significantly. This would be affected by the retained earnings, new loans taken out and old loans paid off.

The fully diluted earnings per share (i.e. where all the holders convert) would be:

Earnings $4,340 as per scheme (i)

EPS 4 3407,000 shares

=62cpershare

For the period in which the holders cannot or do not convert the undiluted EPS (provided earnings remain at this level and tax rates do not change) is much greater, at 83c per share as indicated above. If and when the holders convert a dilution of earnings will take place and the control of the company may be affected. If the interest rate is fixed, the company would appear to have locked in to quite alowratecomparedwiththe7½%debentures(i.e.theconvertibleshavealowservicecost).Thegearing would be well above the current industry average, but on conversion would fall well below it.

(iii) 7½% debentures

Earnings $000 $000Current net profit 3,000Add Additional 2,000Less Interestat7½% 375

1,625Less tax at 33% 536Additional net profit after tax 1,089New net profit after tax 4,089

EPS= 4,0895,000

=82cpershare

Explanation:

The EPS again illustrates that using more debt (i.e. becoming more highly geared) can increase the earnings of the ordinary shareholders (i.e. EPS 82c per share compared with current earnings of 60c per share). However, the increase in gearing; which would be higher than the industry average, does place the increased risk of insolvency on the company. If trading conditions are bad, the company still has to pay the interest on the debentures.



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Solution 2—Stock Market Ratios

(a) Gross profit margin =600

3 000100

,× = 20%

(b) Operating profit margin =400

3 000100

,× = 13.3%

(c) Return on capital employed =400

1 000 200 800 600100

, + + +× =15.4%

(d) Return on equity160-201800

100× = 7.8%

(e) Current ratio =1,000600

= 1.67:1

(f) Acid test ratio =600600

= 1: 1

(g) Receivables days =500

3,000× 365 = 61 days

(h) Total asset turnover =3,0003,200

= 0.94

(i) Fixed asset turnover =3,0002,200

= 1.4

(j) Proportion of debt finance

=8001800

×100 = 44.4%

OR

= 800

800 1800+×100 =30.8%

(k) Interest cover =Profit before interest and tax

Interest charge

=40060

= 6.67

(l) Earnings per ordinary share =160 20

1,000−

= 14 cents

(m)Dividend cover =160 20

125−

= 1.1

(n) Dividend yield =Dividend per ordinary share

Ordinary share price×100

=12.5 cents

$1.40×100 = 8.9%

(o) Price earnings ratio =Share price

EPS

=14014

= 10



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NOTES



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Index


A

AAA, See American Accounting AssociationAbandonment option ....................... 13-16ACCA Code of Ethics and Conduct .......1-21Accounting rate of return (ARR) ............5-3Acid-test ratio .................................. 18-7Acquisitions ............................... 8-2, 18-2Addition rule ....................................6-18Adjusted present value (APV) ..... 6-2, 17-12Agencies

environment .................................1-26ratings ...........................................9-3

Agency theory ....................................1-5AIM, See Alternative Investment MarketAlbrecht's EDM .................................1-16Alpha ..............................................4-11Alternative Investment Market (AIM) . 10-13American Accounting Association

(AAA) ........................................1-18American swaptions ........................ 15-19Annuity .............................................5-6APV, See Adjusted present valueArbitrage pricing theory .....................4-17ARR, See Accounting rate of returnAsk rate ........................................ 15-16Asset-based valuation methods ............7-3Asset betas ......................................4-13Autonomy ....................................... 17-6

B

Baker plan ..................................... 16-11Bank

loans ............................................ 11-5overdraft ................................ 3-4, 11-3

Bank for International Settlements ..... 16-8Bank of England ............................. 16-10Bank of Japan ................................ 16-11Banker's draft .................................. 17-9Banking crisis ................................ 16-21Basis risk ........................................ 15-2Beta factor ......................................4-10Bid rate ......................................... 15-16Bills of exchange .......................11-3, 17-3Bird-in-the-hand theory ..................... 12-2Black-Scholes model ......................... 13-8Blair-Brown deal ............................. 16-12Blocked remittances ........................ 12-19Bonds

deep discount ................................ 11-9duration .......................................2-21valuation ......................................2-12zero coupon .................................. 11-9

Bonus dividend ................................ 12-4Book building ................................. 10-12Book value-plus .................................7-4

Bootstrapping ............................2-25, 8-5Brady package ............................... 16-11Business

angels ........................................ 10-14ethics ...........................................1-21risk ..................................1-29, 3-5, 8-9valuation ........................................7-2

C

Cadbury Report ................................1-10Cap ................................................ 15-4Capital

budgeting ................................... 17-10expenditure .................................. 18-2market effi ciency .............................2-2market line .....................................4-8mobility ........................................ 16-5rationing .........................................6-8reconstructions ................................9-6structure .............................3-16, 17-13

Carbon trading economy ....................1-26Cash against documents .................... 17-3Cash budget pro forma ........................5-8Cash fl ow forecast ............................5-17Cash fl ows, See Discounted cash fl ow;

See Free cash fl owCash transfer mechanisms ................. 17-9CDOs, See Collateralised debt obligationsCentral banks .................................. 16-9Chapter 11 ........................................9-6Chepakovich model ...........................7-19Cheques .......................................... 17-9Chief fi nancial executive ......................1-2City Code ........................................8-21Clientele theory ................................ 12-2Coase, Ronald (1937) .........................1-8Code of Ethics and Conduct................1-21Collar .......................................13-3, 15-6Collateralised debt obligations

(CDOs) .................................... 16-22Combined Code ................................1-12Commercial

paper ........................................... 11-4risk .............................................. 17-2

Community Reinvestment Act (CRA) . 16-21Competition law ...............................8-21Complex reconstruction .......................9-6Compound options .......................... 14-14Conditional events ............................6-19Confi rmation bias ...............................8-6Confl icts of interest .............................1-5Constant dividend ...............................2-4Contract futures ............................. 14-15Controlling shareholder ..................... 10-5Conversion premium .........................2-19



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P4 Advanced Financial Management Session 20 • Index

Debtanalysis ...................................... 13-29domestic markets .......................... 11-2fi nance ....................................... 10-14interest ........................................2-14long-term ..................................... 11-7redemption ................................. 12-18

Deep discount bonds ......................... 11-9Default risk ............................. 15-14, 17-2

methods for reducing .....................1-30MM theory ....................................3-14yield curve ....................................2-25

Default swaps ....................... 13-31, 16-12Delay option ......................... 13-16, 13-18Delivery date ................................... 15-8Delta ............................................ 13-12Delta hedging ....................... 13-13, 14-13Derivatives

credit ......................................... 13-31exchange-traded ......................... 15-20

Diluted EPS ................................... 18-14Directors ...........................................1-7Disclosure risk ...................................8-3Discounted cash fl ow (DCF) .................5-5Discount factors .................................5-6Discounting

FCFF ............................................7-14relevant cash fl ows ........................5-13

Diversifi cation strategies ...................1-30Portfolio theory ..............................4-10

Divestment ........................................9-8Dividend

bonus .......................................... 12-4capacity ....................................... 12-9domestic policy ............................. 12-2growth .................................... 2-8, 7-8international policy ...................... 12-18irrelevance theory .......................... 12-3payout ratio ................................ 18-14valuation model (DVM) .............. 2-4, 7-8yield ..............................................7-6

Divisible project .................................6-8Divisional autonomy ....................... 17-14Dual pricing ................................... 17-14Dutch auction ................................ 10-10DVM, See Dividend valuation modelDysfunctional goals .............................1-3

E

Earnings yield ....................................7-5ECGD, See Export Credits Guarantee

DepartmentEconomic risk .................................. 14-6Economic value added (EVA) .....7-17, 18-17EDM, See Ethical development model

Convertiblebonds......................................... 11-10debentures ...................................2-19loan stock .......................................3-4

Corporatebonds...........................................2-26governance .....................................1-9objectives .......................................1-2social responsibility (CSR) .................1-6

COSO Framework .............................1-34Cost of debt

bond valuation ..............................2-12irredeemable debentures ................2-13redeemable debentures ..................2-15

Cost of equity ............................2-7, 4-13Cost plus ....................................... 17-14Costs

agency .........................................3-16bargaining ......................................1-8convertibles post-tax ......................2-20fl otation ....................................... 10-3preference shares ..........................2-11replacement ....................................7-3

Cost synergies ...................................8-5Counter-trade .................................. 17-4Coupon rate ...............................2-12, 9-7CRA, See Community Reinvestment ActCrawling peg .................................... 16-7Credit default swaps .............. 13-31, 16-12Credit derivatives ........................... 13-31Credit forward contracts .................. 13-31Credit options ................................ 13-31Credit risk ...........................1-30, 8-9, 9-2Cross-selling ......................................8-5Crown jewels ...................................8-22CSR, See Corporate social responsibilityCultural risk ..................................... 17-2Cumulative preference dividends ........ 11-7Currency

futures ....................................... 14-15options ....................................... 14-10risk ..................................... 14-5, 15-20swaps ........................................ 14-20

Currency controls ............................. 16-6Current ratio .................................... 18-8Customs unions ................................ 16-4Cyert and March (1963) ......................1-8

D

Dark pools ..................................... 16-24Dawn raid ........................................8-21DCF, See Discounted cash fl owDebentures ...................................... 11-8



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Session 20 • Index P4 Advanced Financial Management


Financial distress risk ..........................3-7Financial risk......................................3-5Financiers ........................................9-11Fiscal risk ........................................1-30Fisher

effect ........................................... 14-2formula ........................................5-17

Fixed peg ........................................ 16-7Fixed price auction .......................... 10-10Flavoured swaps ............................. 15-19Floating exchange rates ..................... 16-7Floor

interest rate .................................. 15-5value ...........................................2-19

Flotation .................................. 9-13, 10-2Foreign direct investment .................. 16-6Foreign exchange risk ....................... 14-5Forfaiting......................................... 17-3Forward

contracts ........................... 13-31, 14-20exchange contracts ........................ 14-8exchange rate ............................... 14-2non-deliverable ............................. 14-9rates .......................................... 15-17

Forward rate agreement (FRA) ........... 15-3Four-way equivalence model .............. 14-2FRA, See Forward rate agreementFree cash flow to equity (FCFE) .. 7-12, 12-9Free cash flow to the firm (FCFF) ........7-14Free trade ....................................... 16-4Futures

currency ..................................... 14-15hedging ........................................ 15-9interest rate .................................. 15-6options ......................................... 15-8

FX swaps ....................................... 14-22

G

Gamma ......................................... 13-13Gap exposure .................................. 15-2GATT, See General Agreement on Tariffs

and TradeGearing ............................. 3-5, 9-12, 18-9General Agreement on Tariffs and Trade

(GATT) ...................................... 16-5Global debt .................................... 16-11Goal congruence ...................... 1-9, 17-13Golden parachute .............................8-22Gordon's growth model ...............2-10, 7-8Greeks .......................................... 13-12Greenbury Code ...............................1-11Gross profit percentage ..................... 18-6Gross redemption yield .....................2-17

EDMM, See Ethical decision-making modelsEfficient market hypothesis (EMH) ........2-2Environment agencies .......................1-26Equal annual cash flows ......................5-6Equity, See also Cost of equity

beta .............................................4-13discount rate for all ........................4-15finance .........................................9-13investors ......................................1-29unquoted .................................... 10-14valuation .................................... 13-25

ESOPs, See Executive share option plansEthical conflict resolution ...................1-21Ethical decision-making .....................1-16Ethical decision-making models

(EDMM) .....................................1-18Ethical development model (EDM) ......1-16Eurobond market ............................ 11-15Eurocredit market ........................... 11-14Eurocurrency market ...................... 11-14Euromarkets .................................. 11-14Euronote market ............................ 11-15European call option ......................... 13-8European Central Bank .................... 16-10European swaptions ........................ 15-19European Union (EU) ........................ 16-4EVA, See Economic value addedExchange rates

forecasting.................................... 14-2systems ....................................... 16-7

Exchange-tradedderivatives .................................. 15-20options ......................................... 13-2

Executive share option plans (ESOPs)....1-9Exit routes ............................... 9-13, 10-2Expansion option ................... 13-16, 13-20Expectations theory ..........................2-24Expected values ...............................6-20Export

factors ......................................... 17-3Export Credits Guarantee Department

(ECGD) ...................................... 17-3Exposure ......................................... 15-2Extendable swaptions ...................... 15-19External hedging .......................14-7, 15-3

F

FCFE, See Free cash flow to equityFCFF, See Free cash flow to the firmFinancial

contagion ................................... 16-25distress cost ..................................1-29distress risk ....................................3-6gearing ................................ 1-29, 18-9intermediaries ............................... 11-2risk ..................................1-29, 3-6, 8-9synergies ........................................8-5



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J

Joint venture ................................... 17-4

K

Kappa ........................................... 13-14

L

Lagging ........................................... 14-7Lambda ......................................... 13-14Leading ........................................... 14-7Leasing ........................................... 11-5Letters of credit ................................ 17-3LIFFE, See London International Financial

Futures and Options ExchangeLinear programming .........................6-12Liquidity

preference theory ....................2-24, 5-5project .........................................6-17ratios ........................................... 18-7

Listing............................................. 10-9London International Financial Futures and

Options Exchange (LIFFE) .......... 14-11Long-term debt finance ..................... 11-7Long-term incentive plans (LTIPs) .........1-9

M

Macaulay's duration .........2-21, 6-17, 13-25Managed float .................................. 16-7Management buy-in (MBI) ...................9-8Management buyout (MBO) .................9-8Manufactured dividends ..................... 12-3Market

portfolio .................................. 4-9, 6-3price .......................................... 17-14to book ratio ...................................7-7value ...........................................2-12value added ..................................7-17

Markowitz efficient frontier ..................4-8Matching ......................................... 14-7MBI, See Management buy-inMBO, See Management buyoutMean-variance efficiency .....................4-3Medium-term finance ........................ 11-5Merger ..............................................8-2Merton's models ............................. 13-25Mezzanine finance ............................9-13Modified internal rate of return

(MIRR) ......................................6-15Modigliani and

Miller ............3-7, 4-14, 6-2, 12-3, 13-27Money

laundering ....................................1-15market hedges ............................ 14-10markets........................................ 11-2rates ............................................5-16

H

Hamada, Robert ...............................4-14Hard capital rationing ..........................6-8Hedging

compound options ....................... 14-15delta ................................. 13-13, 14-13external ....................................... 14-8futures ....................................... 14-16internal ..........................................8-5IRFs ............................................. 15-7options ......................................... 15-9

High-growth start-ups .......................7-19Hostile bids ......................................8-22

I

IAESB Ethics Education Framework .....1-17IBE, See Institute of Business EthicsIBO, See Institutional buyoutIMF, See International Monetary FundImport duties ................................. 17-15Inflation ..........................................5-16Initial public offering (IPO) ...........7-2, 9-13Institute of Business Ethics (IBE) ........1-21Institutional buyout (IBO) ....................9-9Intangible assets ............................ 13-22Integrated reporting ...................1-4, 1-26Interest

cover ..................................8-18, 18-10floor cap ....................................... 15-6rate ............................. 2-24, 5-16, 13-7

Interest ratefutures (IRFs) ............................... 15-6parity (IRP) ................................... 14-4risk .............................................. 15-2swaps ........................................ 15-12

Internalfinance .........................................3-15hedging ..........................................8-5

Internal rate of return (IRR) .2-16, 5-9, 6-15International

dividend policy ............................ 12-18Fisher effect .................................. 14-5trade .....................................16-3, 17-2

International Monetary Fund (IMF) ...... 16-8In the money ................................... 13-4Intrinsic value .................................. 13-5Inventory turnover ......................... 18-11Investment

appraisal ................................. 5-2, 6-2risk ................................................4-2

IPO, See Initial public offeringIRFs, See Interest rate futuresIRP, See Interest rate parityIRR, See Internal rate of return



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redeployment ..................... 13-16, 13-21traded .......................................... 13-2value ........................................... 13-4

Organic growth ..................................8-2Out of the money ............................. 13-4Overseas expansion .......................... 17-4

P

Par value .........................................2-12Payables days ................................ 18-12Payback period ...................................5-2Payment methods ............................. 17-3Payout ratio ..................................... 12-3P/E, See Price/earnings ratioPecking order theory .........................3-15Perpetuities .......................................5-7Physical risk ..................................... 17-2Plain vanilla swap .................. 14-21, 15-12Poison pill ........................................8-22Political risk ............................ 12-19, 17-2Portfolio theory ..................................4-4Position risk ................................... 15-14Post-completion audit........................6-30PPP, See Purchasing power parityPreference shares ..................... 7-11, 11-7

cost .............................................2-11redeemable ...................................9-13

Price/earnings ratio (P/E) ....................7-4Private equity ....................................9-9Probability analysis ...........................6-18Proceeds of Crime Act 2002 ...............1-15Profitability index ...............................6-8Project appraisal

cost of equity ................................2-11duration .......................................6-17risk ..............................................1-30WACC ..........................................4-15

Protectionism ................................... 16-4Protective put .................................. 13-3Purchasing power parity (PPP) ............ 14-2Put-call parity ................................ 13-10

Q

Quick ratio ....................................... 18-7

R

Ratings agencies ................................9-3Ratio analysis................................... 18-2Real interest rates ............................5-16Receivables days ............................ 18-11Redeemable

debentures ...................................2-15preference shares ..........................9-13

Redeployment option ............. 13-16, 13-21Regulatory risk ...........................1-30, 8-3Relative based valuation ......................7-4

Monitoringpost-merger ..................................8-23project .........................................6-29

Monopoly power ............................... 16-3Monte Carlo method .........................6-26Mortgage loan .................................. 11-6Mudaraba contract .......................... 16-14Multilateral netting............................ 16-6Multinational corporations ......... 12-15, 16-2Multiperiod capital rationing ...............6-11Multiplication rule .............................6-18Musharaka contract ........................ 16-14Mutually exclusive projects ................6-10Myopia ............................................ 10-3

N

NDFs, See Non-deliverable forwardsNegotiated transfer prices ................ 17-14Net book value (NBV)..........................7-3Net present value (NPV)

capital budgeting ......................... 17-10investment appraisal ........................5-8

Net realisable value (NRV) ...................7-3Netting ........................................... 14-7New applicants ................................. 10-9Nominal

interest rates ................................5-16value ...........................................2-12

Non-deliverable forwards (NDFs) ........ 14-9Note-issuance facilities ...................... 16-8NPV, See Net present valueNRV, See Net realisable value

O

Objectives, corporate ..........................1-2Offer

initial public ....................................7-2share ......................................... 10-10

Open account trading ........................ 17-3Operational

gearing .......................... 1-29, 9-3, 18-6risk ..............................................1-30

Operational gearing ............................3-5Options ........................................... 13-2

abandonment .............................. 13-16collar ........................................... 13-3compound .................................. 14-14credit ......................................... 13-31currency ..................................... 14-10delay ................................ 13-16, 13-18expansion .......................... 13-16, 13-20futures ......................................... 15-8hedging ...................................... 14-11over-the-counter (OTC) ...........13-2, 15-4real ............................................ 13-16



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Sharesdividend-paying ........................... 13-10issuing ......................................... 10-9preference ............................ 2-11, 11-7redeemable ...................................9-13

Sharia boards ................................ 16-15Short-term finance ........................... 11-3Short-term

investments .................................. 17-9Simulation .......................................6-26Single-period capital rationing ..............6-8Soft capital rationing ...........................6-8SOX, See Sarbanes-Oxley Act (2002)Special purpose vehicles (SPV) ......... 16-21Spin-offs ...........................................9-8Sponsor .......................................... 10-6Spot against forward ....................... 14-22Spot yield curve ...............................2-25SPV, See Special purpose vehiclesStagging ....................................... 10-11Stakeholders ......................................1-6Standard deviation .....................4-2, 6-22Stock exchange ................................ 10-3Stress testing ..................................6-29Strong-form efficiency .........................2-3Structural models ...............................9-4Sukuk finance ................................ 16-18Surrogate profit goals .........................1-3Sustainability ...................................1-22SVA, See Shareholder value addedSwaps ........................................... 15-12

credit default .............................. 13-31currency ..................................... 14-20FX ............................................. 14-22interest rate ................................ 15-12plain vanilla ....................... 14-21, 15-17

Swaptions ..................................... 15-19SWIFT ............................................ 17-9Syndication...................................... 16-8Synergy ............................................8-4Synthetic Agreements for Foreign

Exchange (SAFEs) ....................... 14-9Systematic risk ..................................4-9

T

Takeovers .......................... 2-3, 8-21, 10-4Tax

cash flows ....................................5-15investment appraisal ......................5-14planning ............................ 12-18, 17-14post-tax cost of debt ......................2-20shield ...........................................2-14

TBL, See Triple bottom lineTender offer ............................ 10-10, 12-4Term structure .................................2-24Theta ............................................ 13-14Tick system ................................... 14-18Time to expiry .................................. 13-6

Relevant cash flows ..........................5-13Repatriation of funds ....................... 17-15Replacement cost ...............................7-3Reputational risk .....................1-30, 12-19Residual dividend policy .................... 12-2Rest's model ....................................1-16Return on capital employed

(ROCE) ................................ 5-3, 18-5Return on investment (ROI) .................5-3Revolving underwriting facilities ........ 11-15Rho .............................................. 13-15Risk, See also Foreign exchange risk;

Interest rate riskappetite........................................1-29averse ............................................4-4commercial ................................... 17-2credit .....................................1-29, 9-2currency ....................................... 14-5default ................................ 15-14, 17-2diversification ................................1-31hedging ........................................1-31investment .....................................4-2management .................................1-28mitigation .....................................1-30position ...................................... 15-14project ................................. 1-30, 6-18reduction ..........................4-4, 6-29, 8-5regulatory .....................................1-30systematic ......................................4-9transparency ............................... 15-14unsystematic ..................................4-9

ROCE, See Return on capital employedROI, See Return on investment

S

SAFEs, See Synthetic Agreements for Foreign Exchange

Sale and leaseback ........................... 11-6Sarbanes-Oxley Act (SOX) (2002) ......1-10Scrip dividends................................. 12-4Securitisation ........................ 11-11, 16-21Security characteristic line .................4-10Security market line ..........................4-13Seed firms .......................................7-19Segmentation theory ........................2-24Selecting a target ...............................8-2Sell-offs ............................................9-8Semi-strong form efficiency .................2-3Sensitivity analysis ...........................6-23Share

buyback ....................................... 12-4incentive schemes ......................... 10-3options .........................................9-13

Shareholdersagency theory .................................1-5cost of equity ..................................2-7wealth ............................................1-3

Shareholder value added (SVA) ..........7-18



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W

WACC, See Weighted average cost of capital

Warehousing risk ............................ 15-14Warrants ....................................... 11-10Weak-form efficiency...........................2-2Wealth maximisation ...........................1-3Weighted average cost of capital

(WACC) .......................................3-2Williamson (1966) ..............................1-8Window dressing .............................. 18-8Working capital ................................5-19Working capital cycle ...................... 18-13World Bank ...................................... 16-8World Trade Organisation (WTO) ......... 16-5Writing down allowance .....................5-14Written submissions .......................... 10-6WTO, See World Trade Organisation

Y

Yielddividend .........................................7-6earnings .........................................7-5gross redemption ...........................2-17

Yield curve theory .............................2-24

Z

Zero coupon bonds ........................... 11-9Zero dividend ................................... 12-5

Time valuemoney ...........................................5-5option .......................................... 13-6

Tobin's Q ...........................................7-7Total shareholder returns (TSR) ............1-3Total shareholder return (TSR) ......... 18-14Trade

credit ........................................... 11-3creditors .........................................1-6sale ........................................... 10-13

Transactioncost theory .....................................1-8exposure .................................... 14-21risk .............................................. 14-7

Transfer pricing .............................. 17-13Translation risk ................................. 14-5Transparency risk ........................... 15-14Treasury function .............................. 17-5Triple bottom line (TBL) .....................1-23TSR, See Total shareholder returnTucker's five-question model ..............1-20Turnbull Report ................................1-12Two-asset portfolios ............................4-5Two-part transfer prices .................. 17-14

U

UK tax system .................................5-13Unbundling ........................................9-8Unconventional cash flows .................5-12Undated debentures, See Irredeemable

debtUnquoted equity ............................. 10-14Unsystematic risk ...............................4-9US Federal Reserve ........................... 16-9

V

Valuation risk .....................................8-3Valuations ........................................ 7-2

See also Dividend valuation modelequity ........................................ 13-25swaps ............................... 14-21, 15-17

Value-added methods .......................7-17Value at risk (VaR) ............................6-28Vega ............................................. 13-14Venture capital ................................. 10-2Volatility .......................................... 13-6



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Glossary

Words highlighted by italics within an entry indicate other entries under which further explanation or information can be found.

AAccounting Rate of Return (ARR)— the average annual operating profi t generated by a project expressed as a percentage of initial or average investment.

Adjusted Present Value (APV)— an approach to appraising a project whose fi nancing would change the fi rm's capital structure (i.e. fi nancial risk).

Agency costs— the reduction in shareholders' returns below the maximum possible level due to company managers following personal objectives not in the best interests of shareholders.

Alpha— a measure of abnormal return from a security (i.e. where the forecast return is higher or lower than expected by CAPM).

American/US style options— can be exercised by the holder at any time until the expiry date.

Arbitrage pricing theory— a multi-index model where the required return on an investment is determined by a variety of factors such as return on the market, industrial growth rates, etc.

Asymmetry of information— the fact that potential investors know less about a company than its managers and may therefore over-estimate the risk of providing fi nance. This can be a particular problem for SMEs.

BBasis— the diff erence between the price of a futures contract and the spot price of the underlying asset.

Basis risk— (i) the risk that interest rates on assets and liabilities are referenced to a diff erent benchmark (ii) the risk of an unexpected change in the level of basis in a futures contract.

Beta factors— a measure of the sensitivity of a security's returns to systematic risk.

Bermuda option— can be exercised by the holder on one of a series of dates.

Bird in the Hand theory— suggest that shareholders may prefer the certainty of a cash dividend today rather than reinvestment of profi ts to create an uncertain capital gain in the future.

Black-Scholes Model— Fischer Black and Mryon Scholes' 1973 model for calculating the theoretical price of a European call option.

Bonus issue— issue of new shares to existing shareholders, without any subscription of new funds. Also referred to as a scrip issue.

Business risk— the volatility of operating profi ts, caused by the volatility of revenues and the level of operational gearing.

CCall option— gives the holder the right to buy the underlying asset.

Cap— an agreement that fi xes a maximum rate of interest. An interest rate cap is an agreement by the seller of the cap to pay the buyer the excess of the reference interest rate over the agreed cap rate, based on a notional principal amount.

Capital Market Line— shows diff erent possible combinations of holding a risk-free asset and the Market Portfolio.

Capital Rationing— where insuffi cient fi nance is available to undertake all available positive NPV projects.

CAPM— Capital Asset Pricing Model. A model that relates the systematic risk of an investment to the required return.

CDO— Collateralised Debt Obligation— a structured fi nance product that repackages individual loans into "tranches" that can be sold on the secondary market.

CDS— Credit Default Swap— an insurance policy against default on an underlying loan. The buyer pays a series of premiums; the seller pays compensation should there be a default on the underlying loan.

Certificate of deposit— a tradable security issued by banks to investors who deposit a fi xed amount for a fi xed period.

Clientele Theory— suggest that a company's historical dividend pattern may have attracted particular investors. Changing the pattern in future may cause this "clientele" to sell their holdings and lead to a fall in share price.

Collar— an agreement that keeps either a borrowing or lending rate between specifi ed upper and lower limits. A low-cost cap is a combination of a purchased cap and a written/sold fl oor agreement. It protects against rising interest rates but limits participation in falling rates.



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P4 Advanced Financial Management Session 19 • Glossary

EEconomic risk— the risk that long-term changes in exchange rates aff ects a company's cash fl ows.

Economic Value Added (EVA)— measures the surplus profi t being generated by a fi rm above the minimum level required by its providers of long-term fi nance.

Efficient Markets Hypothesis (EHM)— a theory which asks what information is refl ected in share prices.

Eurobond market— Eurobonds are long term debt securities denominated in a currency outside of its country of origin.

Eurocredit market— medium to long-term international bank loans given by banks located outside the country which issued the currency.

Eurocurrency market— Eurocurrency is currency deposited outside of its country of issue.

Euromarkets— banking and fi nancial markets which are located outside the country which issued the currency.

Euronote market— variety of short to medium-term debt instruments issued in the Euromarkets.

European option— can be exercised on its expiry date, but not before.

FFinancial gearing/leverage— the proportion of debt in the capital structure.

Financial risk— the increased volatility of returns to ordinary shareholders due to interest on debt being a fi xed committed cost.

Financial distress risk— the risk of bankruptcy caused by dangerously high levels of fi nancial gearing.

Floor— an agreement that fi xes a minimum rate of interest. An interest rate fl oor is an agreement by the seller of the fl oor to pay the buyer the excess of the agreed fl oor rate over the reference interest rate based on a notional principal amount.

Forward contract— a legally binding contract between a company and a bank to buy or sell a fi xed amount of foreign currency at a fi xed exchange rate on a fi xed date in the future.

Forward Rate Agreements— contracts which allow companies in advance to fi x future borrowing or lending rates, based on a notional principal over a given period.

Corporate governance— controls and procedures implemented to reduce agency costs to an acceptable level. Corporate governance is defi ned as "the system by which companies are directed and controlled".

Corporate Social Responsibility (CSR)— a model which suggests that company managers should take into account the objectives of a wide range of stakeholders and not just the shareholders.

Currency futures contracts— a standard contract between buyer and seller, in which the buyer has a binding obligation to buy a fi xed amount (the contract size), at a fi xed exchange rate (the futures price), on a fi xed date (the delivery date), of an underlying currency via a recognised exchange.

Currency swaps— A currency swap is a formal agreement between two parties to exchange principal and interest payments in diff erent currencies over a stated time period.

DDark pools— share dealing networks set up by investment banks to allow their clients to execute transactions away from the public exchanges.

Delta— Delta is the change in price of an option for a small change in the price of the underlying asset. It is calculated as N(d1) from the Black Scholes Model. Also referred to as "the hedge ratio".

Delta hedging— setting up an options position as dictated by the hedge ratio to create a delta-neutral (i.e. risk-free portfolio).

Divestment— the withdrawal of investment in an activity.

Dividend Valuation Model— states that the value of a share is the present value of future expected dividends, discounted at the investors' required return.

Duration— the weighted average period of a bond's returns, the weighted being the proportion of returns generated in each period. Also known as Macaulay's duration.



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Session 19 • Glossary P4 Advanced Financial Management


Market Value Added— present value of EVA forecast to infinity.

Merton Model— Robert Merton's model for estimating credit spreads and the probability of default on corporate debt. Based upon the Black Scholes Model.

Mezzanine finance— a form of high risk unsecured debt bordering on equity, with its exact nature depending on how it is structured. Also known as hybrid finance.

Modified Internal Rate of Return (MIRR)— the average annual % return on a project under the assumption that its cash flows are reinvested at the firm's minimum required return.

Monte Carlo analysis— a simulation model that can estimate both the expected NPV of a project and its standard deviation.

NNon-deliverable forwards (NDFs)— A NDF is a short-term, cash-settled currency forward contract between two counterparties. Also known as SAFEs— Synthetic Agreements on Foreign Exchange.

NPV— Net Present Value; the change in shareholders' wealth due to an investment project.

OOperational gearing— the proportion of fixed operating costs to variable operating costs.

Option— a contract giving one party the right, but not the obligation, to buy or sell an underlying asset at a given price, on or before a specified date (expiry date).

OTC— Over The Counter— any derivative that is not exchange traded.

PPayback— the period of time required for the operating cash flows from a project to equal the cost of investment.

Pecking Order theory— a theory which suggests that company managers have a preference for using internal finance (i.e. retained earnings) rather than external finance. A key cause may be asymmetry of information.

Pre-emptive rights— the right of existing shareholders to be offered new shares before they can be offered to new investors. Also known as pre-emption rights.

Put option— gives the holder the right to sell the underlying asset.

Free Cash Flow to Equity— the surplus cash flow generated for shareholders (i.e. the potential dividend).

Free Cash Flow to the Firm— the cash flow available to all of the company's investors, both equity investors and debt investors.

Futures contract— a traded forward contract.

FX swaps— where there is a swap of currencies between counterparties but no swap of interest.

GGamma— measures the rate of change of delta as the price of the underlying asset changes.

Gap exposure— the risk that interest rates on assets and liabilities are reset at different intervals.

Gordon's growth model— states that the forecast growth rate of a company's dividend = proportion of profits retained × return on equity.

Gross Redemption Yield— see Yield to Maturity.

HHybrid finance— a form of high risk unsecured debt bordering on equity, with its exact nature depending on how it is structured.

IInterest rate futures— interest rate futures (IRFs) are traded forward interest rate agreements.

Interest Rate Swaps— an exchange between two parties of interest obligations or receipts in the same currency on an agreed amount of notional principal for an agreed period of time.

Intrinsic value of an option— intrinsic value of an option is its basic or fundamental price or value. It is the profit that a purchaser could make if the option were exercised immediately.

IRR— Internal Rate of Return; the discount rate where NPV equals zero.

MMacaulay's duration— the weighted average period of a bond's returns, the weighted being the proportion of returns generated in each period.

Market Portfolio— an equity portfolio containing every share listed on the stock market and hence contains zero unsystematic risk.



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P4 Advanced Financial Management Session 19 • Glossary

Swaptions— A swaption is an option that provides the holder with the right but not the obligation to execute an interest rate (or a currency swap) during a limited period of time and at a specified rate.

Synthetic Agreements on Foreign Exchange (SAFE)— a short-term, cash-settled currency forward contract between two counterparties. Also known as Non-deliverable forwards (NDFs).

Systematic risk— the relative effect on the returns of an individual security of changes in the market as a whole. Also known as market risk. It cannot be removed by diversification but can be measured using beta factors.

TTax shield— interest on debt is a tax allowable expense for a company and leads to lower corporate tax payments.

Term structure of interest rates— the relationship between short and long term interest rates.

Tick size— the minimum price movement recognised by the futures market.

Tick value— the gain or loss on one futures contract for a one tick price change.

Time value of an option— the difference between the premium and the intrinsic value.

Theta— measures how much value an option loses over time. The theta is usually expressed as the amount of loss per day.

Tobin's Q = Total market capitalisation of the firm/Replacement cost of the firm's assets

Total Shareholder Returns (TSR)— the total return to shareholders via dividend and capital gain, usually measured over a one year period.

Transaction risk— the risk that exchange rates change between the date of an import/export and the related payment/receipt of foreign currency.

Translation risk— gains/losses caused by translating the financial statements of overseas subsidiaries into the reporting currency of the parent upon consolidation.

Treasury bills— virtually risk-free short-dated debt securities issued by governments.

RRecovery period— the number of years required to recover a project's initial investment, taking into account the time value of money.

Rho— measures how much option prices change with changes in interest rates.

Riba— the Islamic prohibition on the payment of interest.

Rights Issue— an offer of new shares to existing shareholders who hold pre-emptive rights.

Risk— An investment is defined as having a degree of risk if its returns are uncertain or variable. The amount of risk an investment has will depend upon the variability of the returns of the investment around the average return.

SScrip dividend— issue of new shares to existing shareholders in lieu of a cash dividend.

Scrip issue— see bonus issue.

Securities— financial instruments that can be traded (e.g. shares, bonds and derivatives).

Securitisation— a structured finance process that distributes risk by aggregating debt instruments into a pool, then issues new securities backed by the pool. CDOs are an example of securitisation.

Security Characteristic Line— a graph of the excess returns from a particular share (above the risk-free rate) against the excess returns from the market portfolio. The gradient of the line measures the share's beta factor.

Security Market Line— a graph of the CAPM formula.

SMEs— Small and Medium-sized Enterprises. No official definition exists but generally these are unlisted companies.

Special dividend— a substantial dividend payment that is not expected to be repeated in the near future.

Spin off— splitting a group into two or more independent units. Another name for a demerger.

Stakeholders— groups of people who have some type of interest in an organisation. Shareholders are the key stakeholder but other groups include employees, customers, suppliers and, arguably, even society as a whole.



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Session 19 • Glossary P4 Advanced Financial Management


WWACC— Weighted Average Cost of Capital; the average cost of long-term finance.

Warrants— share options attached to debt to make the debt more attractive to investors.

YYield to Maturity (YTM)— the average annualised return on a debt security, taking into account both income and capital gains.

ZZero coupon bond— a bond issued at a discount to face value, pays no annual coupon and is redeemed at par.

UUnbundling— the process of selling off incidental businesses in order to concentrate resources on the core business.

Unsystematic risk— the risk that is specific to a company and hence can be diversified away by building a portfolio of investments.

VValue At Risk (VAR)— gives an indication of the potential loss which is likely to occur from a project at a given level of confidence.

Vega— measures how much option prices change with changes in volatility of the underlying asset.



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