p4 lsbf by acca reloaded

ACCA Paper P4

Advanced Financial Management

Class Notes

June 2013

2 www.studyinteract ive.org

Original version prepared by Ken Preece.

Interactive World Wide Ltd. January 2013.

All rights reserved. No part of this publication may be reproduced, stored in a

retrieval system, or transmitted, in any form or by any means, electronic,

mechanical, photocopying, recording or otherwise, without the prior written

permission of Interactive World Wide Ltd.

www.studyinteract ive.org 3

Contents PAGE

INTRODUCTION TO THE PAPER 5

FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER 7

CHAPTER 1: ISSUES IN CORPORATE GOVERNANCE 13

CHAPTER 2: ADVANCED INVESTMENT APPRAISAL SECTION 1 25

CHAPTER 3: ADVANCED INVESTMENT APPRAISAL SECTION 2 51

CHAPTER 4: COST OF CAPITAL 69

CHAPTER 5: THEORIES OF GEARING 85

CHAPTER 6: CAPITAL ASSET PRICING MODEL 103

CHAPTER 7: ADJUSTED PRESENT VALUE 117

CHAPTER 8: INTERNATIONAL INVESTMENT APPRAISAL 129

CHAPTER 9: VALUATIONS, ACQUISITIONS AND MERGERS SECTION 1 145



CHAPTER 12: CORPORATE RECONSTRUCTION AND REORGANISATION 197

CHAPTER 13: CORPORATE DIVIDEND POLICY 211

CHAPTER 14: MANAGEMENT OF INTERNATIONAL TRADE AND FINANCE 221

CHAPTER 15: HEDGING FOREIGN EXCHANGE RISK 237

CHAPTER 16: HEDGING INTEREST RATE RISK 255

CHAPTER 17: FUTURES 269

CHAPTER 18: OPTIONS 283

CHAPTER 19: SWAPS 317

CHAPTER 20: PRINCIPLES OF ISLAMIC FINANCE 329

ACCA STUDY GUIDE 341


Introduction to the

paper

INTRODUCTION TO THE PAPER


Aim of the paper

The aim of the paper is to 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.

Outline of the syllabus

A. Role and responsibility towards stakeholders

B. Economic environment for multinationals

C. Advanced investment appraisal

D. Acquisitions and mergers

E. Corporate reconstruction and re-organisation

F. Treasury and advanced risk management techniques

G. Emerging issues in finance and financial management

Format of the exam paper

The examination will be a three-hour paper (with the additional 15 minutes reading

and planning time) of 100 marks in total, divided into two sections:

Section A:

Section A will contain a compulsory question, comprising of 50 marks.

Section A 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 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 or whole of the question.

Section B:

In section B candidates will be asked to answer two from three questions,

comprising of 25 marks each.

Section B questions are designed to provide a more focused test of the syllabus.

Questions will normally contain a mix of computational and discursive elements, but

may also be wholly discursive or evaluative where computations are already

provided.

Candidates will be provided (within the examination paper) with a

formulae sheet as well as present value, annuity and standard normal

distribution tables.


Formulae & tables

provided in the examination paper

FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER


Formulae

Modigliani and Miller Proposition 2 (with tax)

ke = kie + (1 T)(k

ie kd)

e

d

V

V

The Capital Asset Pricing Model

E(rj) = Rf + j (E(rm) Rf)

The asset beta formula

a =

+

ede

e

))T-1(VV(

V +

+

dde

d

))T-1(VV(

)T-1(V

The Growth Model

P0 = g) - (r

g) + (1 D

e

0

Gordons growth approximation

g = bre

The weighted average cost of capital

WACC =

+ de

e

VV

V ke +

+ de

d

VV

V kd(1T)

The Fisher formula

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

Purchasing power parity and interest rate parity

S1 = S0 )h(1

)h(1

b

c

+

+ Fo = So

)i(1

)i(1

b

c

+

+



Modified Internal Rate of Return

MIRR = n

1

I

R

PV

PV

(1 + re) 1

The Black Scholes Option

Pricing Model

c = Pa N(d1) Pe N(d2) e-rt

Where:

d1 = ts

)t0.5s +(r + )/Pln(P 2ea

and

d2 = d1 ts

The Put Call Parity relationship

p = c Pa + Pe e -rt



Present value table

Present value of 1 ie (1 + r)-n

Where r = discount rate

n = 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 1 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5

6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10

11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15 ________________________________________________________________________________

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% ________________________________________________________________________________

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5

6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9 10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10

11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15



Annuity table

Present value of an annuity of 1 ie r

r) + (1 - 1 -n

Where r = discount rate

n = 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 1 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5

6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10

11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11 12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12 13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13 14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14 15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15 ________________________________________________________________________________

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% ________________________________________________________________________________

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5

6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10

11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 11 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15



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 0.1 0.2 0.3 0.4

0.5 0.6 0.7 0.8 0.9

1.0 1.1 1.2 1.3 1.4

1.5 1.6 1.7 1.8 1.9

2.0 2.1 2.2 2.3 2.4

2.5 2.6 2.7 2.8 2.9

3.0

0.0000 0.0398 0.0793 0.1179 0.1554

0.1915 0.2257 0.2580 0.2881 0.3159

0.3413 0.3643 0.3849 0.4032 0.4192

0.4332 0.4452 0.4554 0.4641 0.4713

0.4772 0.4821 0.4861 0.4893 0.4918

0.4938 0.4953 0.4965 0.4974 0.4981

0.4987

0.0040 0.0438 0.0832 0.1217 0.1591

0.1950 0.2291 0.2611 0.2910 0.3186

0.3438 0.3665 0.3869 0.4049 0.4207

0.4345 0.4463 0.4564 0.4649 0.4719

0.4778 0.4826 0.4864 0.4896 0.4920

0.4940 0.4955 0.4966 0.4975 0.4982

0.4987

0.0080 0.0478 0.0871 0.1255 0.1628

0.1985 0.2324 0.2642 0.2939 0.3212

0.3461 0.3686 0.3888 0.4066 0.4222

0.4357 0.4474 0.4573 0.4656 0.4726

0.4783 0.4830 0.4868 0.4898 0.4922

0.4941 0.4956 0.4967 0.4976 0.4982

0.4987

0.0120 0.0517 0.0910 0.1293 0.1664

0.2019 0.2357 0.2673 0.2967 0.3238

0.3485 0.3708 0.3907 0.4082 0.4236

0.4370 0.4484 0.4582 0.4664 0.4732

0.4788 0.4834 0.4871 0.4901 0.4925

0.4943 0.4957 0.4968 0.4977 0.4983

0.4988

0.0160 0.0557 0.0948 0.1331 0.1700

0.2054 0.2389 0.2703 0.2995 0.3264

0.3508 0.3729 0.3925 0.4099 0.4251

0.4382 0.4495 0.4591 0.4671 0.4738

0.4793 0.4838 0.4875 0.4904 0.4927

0.4945 0.4959 0.4969 0.4977 0.4984

0.4988

0.0199 0.0596 0.0987 0.1368 0.1736

0.2088 0.2422 0.2734 0.3023 0.3289

0.3531 0.3749 0.3944 0.4115 0.4265

0.4394 0.4505 0.4599 0.4678 0.4744

0.4798 0.4842 0.4878 0.4906 0.4929

0.4946 0.4960 0.4970 0.4978 0.4984

0.4989

0.0239 0.0636 0.1026 0.1406 0.1772

0.2123 0.2454 0.2764 0.3051 0.3315

0.3554 0.3770 0.3962 0.4131 0.4279

0.4406 0.4515 0.4608 0.4686 0.4750

0.4803 0.4846 0.4881 0.4909 0.4931

0.4948 0.4961 0.4971 0.4979 0.4985

0.4989

0.0279 0.0675 0.1064 0.1443 0.1808

0.2157 0.2486 0.2794 0.3078 0.3340

0.3577 0.3790 0.3980 0.4147 0.4292

0.4418 0.4525 0.4616 0.4693 0.4756

0.4808 0.4850 0.4884 0.4911 0.4932

0.4949 0.4962 0.4972 0.4979 0.4985

0.4989

0.0319 0.0714 0.1103 0.1480 0.1844

0.2190 0.2517 0.2823 0.3106 0.3365

0.3599 0.3810 0.3997 0.4162 0.4306

0.4429 0.4535 0.4625 0.4699 0.4761

0.4812 0.4854 0.4887 0.4913 0.4934

0.4951 0.4963 0.4973 0.4980 0.4986

0.4990

0.0359 0.0753 0.1141 0.1517 0.1879

0.2224 0.2549 0.2852 0.3133 0.3389

0.3621 0.3830 0.4015 0.4177 0.4319

0.4441 0.4545 0.4633 0.4706 0.4767

0.4817 0.4857 0.4890 0.4916 0.4936

0.4952 0.4964 0.4974 0.4981 0.4986

0.4990

This table can be used to calculate N(di), the cumulative normal distribution

functions needed for the Black-Scholes model of option pricing.

If di > 0, add 0.5 to the relevant number above.

If di < 0, subtract the relevant number above from 0.5


Chapter 1

Issues in corporate governance

CHAPTER 1 ISSUES IN CORPORATE GOVERNANCE


CHAPTER CONTENTS

FINANCIAL OBJECTIVES ------------------------------------------------ 15

THE UK CORPORATE GOVERNANCE CODE ----------------------------- 16

CODE OF BEST PRACTICE 16

INTERNATIONAL COMPARISONS OF CORPORATE GOVERNANCE -- 22

UNITED STATES OF AMERICA 22

GERMANY 22

JAPAN 23



FINANCIAL OBJECTIVES

Advanced Financial Management is concerned with the following key decisions:

- What to invest in (INVESTMENT DECISIONS)

- How to finance the investment (FINANCING DECISIONS)

- The level of dividend distributions (DIVIDEND DECISIONS).

Objectives

Primary objective: to maximise the wealth of shareholders. A positive NPV equates

(in theory) to an increase in shareholder wealth.

Secondary objectives may be e.g. meeting financial targets (say satisfactory

ROCE), meeting productivity targets, establishing brands and quality standards and

effective communication with customers, suppliers, employees.

As an alternative to maximising the wealth of shareholders a company must in

reality consider satisficing objectives for each of the major stakeholders.

Stakeholders (user groups) and their goals

These include:

Shareholders

Directors

Management and employees

Loan creditors

Customers

Suppliers

The government

Environmental pressure groups

The general public

Many of these groups may have conflicting objectives, which need to be reconciled.

Corporate governance

Clearly the executive directors of a listed company are both decision-makers and

major stakeholders. They are therefore open to the accusation of making key

decisions for their own benefit. Following a number of notable financial scandals in

the UK during the late 20th century (e.g the Maxwell affair and the collapse of the

BCCI) the Cadbury Committee was set up to investigate procedures for appropriate

corporate governance.

The Cadbury Code (1992) defined corporate governance as the system by which

companies are directed and controlled. This initial document has been subject to

subsequent amendments by the Greenbury, Hampel and Higgs Reports. The

Financial Services Authority requires listed companies to confirm that they have

complied with the Code provisions or in the event of non-compliance to provide

an explanation of their reasons for departure.



THE UK CORPORATE GOVERNANCE CODE

Code of best practice

Section A: Leadership

A.1 The Role of the Board

Main Principle: Every company should be headed by an effective board

which is collectively responsible for the long-term success of the company.

The annual report should identify the chairman, the deputy chairman (where there

is one), the chief executive, the senior independent director and the chairmen and

members of the board committees. It should also set out the number of meetings

of the board and its committees and individual attendance by directors.

A.2 Division of Responsibilities

Main Principle: There should be a clear division of responsibilities at the

head of the company between the running of the board and the executive

responsibility for the running of the companys business. No one individual

should have unfettered powers of decision.

The roles of chairman and chief executive should not be exercised by the same

individual. The division of responsibilities between the chairman and chief

executive should be clearly established, set out in writing and agreed by the board.

A.3 The Chairman

Main Principle: The chairman is responsible for leadership of the board and

ensuring its effectiveness on all aspects of its role.

The chairman should on appointment meet the independence criteria set out in B.1

below. A chief executive should not go on to be chairman of the same company.

If, exceptionally, a board decides that a chief executive should become chairman,

the board should consult major shareholders in advance and should set out its

reasons to shareholders at the time of the appointment and in the next annual

report. (Compliance or otherwise with this provision need only be reported for the

year in which the appointment is made).

A.4 Non-executive Directors

Main Principle: As part of their role as members of a unitary board, non-

executive directors should constructively challenge and help develop

proposals on strategy.

The board should appoint one of the independent non-executive directors to be the

senior independent director to provide a sounding board for the chairman and to

serve as an intermediary for the other directors when necessary. The senior

independent director should be available to shareholders if they have concerns

which contact through the normal channels of chairman, chief executive or other

executive directors has failed to resolve or for which such contact is inappropriate.

The chairman should hold meetings with the non-executive directors without the

executives present. Led by the senior independent director, the non-executive



directors should meet without the chairman present at least annually to appraise

the chairmans performance and on such other occasions as are deemed

appropriate.

Section B: Effectiveness

B.1 The Composition of the Board

Main Principle: The board and its committees should have the appropriate

balance of skills, experience, independence and knowledge of the company

to enable them to discharge their respective duties and responsibilities

effectively.

The board should identify in the annual report each non-executive director it

considers to be independent. The board should determine whether the director is

independent in character and judgement and whether there are relationships or

circumstances which are likely to affect, or could appear to affect, the directors

judgement. The board should state its reasons if it determines that a director is

independent notwithstanding the existence of relationships or circumstances which

may appear relevant to its determination, including if the director:

has been an employee of the company or group within the last five

years;

has, or has had within the last three years, a material business

relationship with the company either directly, or as a partner,

shareholder, director or senior employee of a body that has such a

relationship with the company;

has received or receives additional remuneration from the company

apart from a directors fee, participates in the companys share option or

a performance-related pay scheme, or is a member of the companys

pension scheme;

has close family ties with any of the companys advisers, directors or

senior employees;

holds cross-directorships or has significant links with other directors

through involvement in other companies or bodies;

represents a significant shareholder; or

has served on the board for more than nine years from the date of their

first election.

Except for smaller companies (i.e. those below the FTSE 350 throughout the year

immediately prior to the reporting year), at least half the board, excluding the

chairman, should comprise non-executive directors determined by the board to be

independent. A smaller company should have at least two independent non-

executive directors.

B.2 Appointments to the Board

Main Principle: There should be a formal, rigorous and transparent

procedure for the appointment of new directors to the board.

There should be a nomination committee which should lead the process for board

appointments and make recommendations to the board. A majority of members of

the nomination committee should be independent non-executive directors. The

chairman or an independent non-executive director should chair the committee, but



the chairman should not chair the nomination committee when it is dealing with the

appointment of a successor to the chairmanship. The nomination committee should

make available its terms of reference, explaining its role and the authority

delegated to it by the board. (This requirement would be met by including the

information on the company website).

B.3 Commitment

Main Principle: All directors should be able to allocate sufficient time to the

company to discharge their responsibilities effectively.

For the appointment of a chairman, the nomination committee should prepare a job

specification, including an assessment of the time commitment expected,

recognising the need for availability in the event of crises. A chairmans other

significant commitments should be disclosed to the board before appointment and

included in the annual report. Changes to such commitments should be reported to

the board as they arise, and their impact explained in the next annual report.

The board should not agree to a full time executive director taking on more than

one non-executive directorship in a FTSE 100 company nor the chairmanship of

such a company.

B.4 Development

Main Principle: All directors should receive induction on joining the board

and should regularly update and refresh their skills and knowledge.

The chairman should ensure that the directors continually update their skills and

the knowledge and familiarity with the company required to fulfil their role both on

the board and on board committees. The company should provide the necessary

resources for developing and updating its directors knowledge and capabilities.

To function effectively, all directors need appropriate knowledge of the company

and access to its operations and staff.

The chairman should ensure that new directors receive a full, formal and tailored

induction on joining the board. As part of this, directors should avail themselves of

opportunities to meet major shareholders.

The chairman should regularly review and agree with each director their training

and development needs.

B.5 Information and Support

Main Principle: The board should be supplied in a timely manner with

information in a form and of a quality appropriate to enable it to discharge

its duties.

B.6 Evaluation

Main Principle: The board should undertake a formal and rigorous annual

evaluation of its own performance and that of its committees and

individual directors.

The board should state in the annual report how performance evaluation of the

board, its committees and its individual directors has been conducted.

Evaluation of the board of FTSE 350 companies should be externally facilitated at

least every three years. A statement should be made available of whether an



external facilitator has any other connection with the company. (This requirement

would be met by including the information on the company website).

The non-executive directors, led by the senior independent director, should be

responsible for performance evaluation of the chairman, taking into account the

views of executive directors.

B.7 Re-election

Main Principle: All directors should be submitted for re-election at regular

intervals, subject to continued satisfactory performance.

All directors of FTSE 350 companies should be subject to annual election by

shareholders. All other directors should be subject to election by shareholders at

the first annual general meeting (AGM) after their appointment, and to re-election

thereafter at intervals of no more than three years. Non-executive directors who

have served longer than nine years should be subject to annual re-election. The

names of directors submitted for election or re-election should be accompanied by

sufficient biographical details and any other relevant information to enable

shareholders to take an informed decision on their election.

Section C: Accountability

C.1 Financial and Business Reporting

Main Principle: The board should present a balanced and understandable

assessment of the companys position and prospects.

C.2 Risk Management and Internal Control

(The Turnbull Guidance, last updated in October 2005, suggests means of

applying this part of the Code)

Main Principle: The board is responsible for determining the nature and

extent of the significant risks it is willing to take in achieving its strategic

objectives. The board should maintain sound risk management and

internal control systems.

The board should, at least annually, conduct a review of the effectiveness of the

companys risk management and internal control systems and should report to

shareholders that they have done so. The review should cover all material controls,

including financial, operational and compliance controls.

C.3 Audit Committee and Auditors

(The FRC Guidance on Audit Committees - formerly referred to as the Smith

Guidance - suggests means of applying this part of the Code)

Main Principle: The board should establish formal and transparent

arrangements for considering how they should apply the corporate

reporting and risk management and internal control principles and for

maintaining an appropriate relationship with the companys auditor.

The board should establish an audit committee of at least three, or in the case of

smaller companies (i.e. those below the FTSE 350 throughout the year immediately

prior to the reporting year) two, independent non-executive directors. In smaller

companies the company chairman may be a member of, but not chair, the

committee in addition to the independent non-executive directors, provided he or



she was considered independent on appointment as chairman. The board should

satisfy itself that at least one member of the audit committee has recent and

relevant financial experience.

Section D: Remuneration

D.1 The Level and Components of Remuneration

Main Principle: Levels of remuneration should be sufficient to attract,

retain and motivate directors of the quality required to run the company

successfully, but a company should avoid paying more than is necessary

for this purpose. A significant proportion of executive directors

remuneration should be structured so as to link rewards to corporate and

individual performance.

The performance-related elements of executive directors remuneration should be

stretching and designed to promote the long-term success of the company.

The remuneration committee should judge where to position their company relative

to other companies. But they should use such comparisons with caution, in view of

the risk of an upward ratchet of remuneration levels with no corresponding

improvement in performance.

They should also be sensitive to pay and employment conditions elsewhere in the

group, especially when determining annual salary increases.

In designing schemes of performance-related remuneration for executive directors,

the remuneration committee should follow the provisions of this Code.

Where a company releases an executive director to serve as a non-executive

director elsewhere, the remuneration report (required by UK legislation) should

include a statement as to whether or not the director will retain such earnings and,

if so, what the remuneration is.

D.2 Procedure

Main Principle: There should be a formal and transparent procedure for

developing policy on executive remuneration and for fixing the

remuneration packages of individual directors. No director should be

involved in deciding his or her own remuneration.

The board should establish a remuneration committee of at least three, or in the

case of smaller companies two, independent non-executive directors. In addition

the company chairman may also be a member of, but not chair, the committee if he

or she was considered independent on appointment as chairman. The

remuneration committee should make available its terms of reference, explaining

its role and the authority delegated to it by the board. Where remuneration

consultants are appointed, a statement should be made available of whether they

have any other connection with the company (This requirement would be met by

including the information on the company website).



Section E: Relations with shareholders

E.1 Dialogue with Shareholders

Main Principle: There should be a dialogue with shareholders based on the

mutual understanding of objectives. The board as a whole has

responsibility for ensuring that a satisfactory dialogue with shareholders

takes place.

The chairman should ensure that the views of shareholders are communicated to

the board as a whole. The chairman should discuss governance and strategy with

major shareholders. Non-executive directors should be offered the opportunity to

attend scheduled meetings with major shareholders and should expect to attend

meetings if requested by major shareholders. The senior independent director

should attend sufficient meetings with a range of major shareholders to listen to

their views in order to help develop a balanced understanding of the issues and

concerns of major shareholders.

E.2 Constructive Use of the AGM

Main Principle: The board should use the AGM to communicate with

investors and to encourage their participation.

At any general meeting, the company should propose a separate resolution on each

substantially separate issue, and should, in particular, propose a resolution at the

AGM relating to the report and accounts. For each resolution, proxy appointment

forms should provide shareholders with the option to direct their proxy to vote

either for or against the resolution or to withhold their vote. The proxy form and

any announcement of the results of a vote should make it clear that a vote

withheld is not a vote in law and will not be counted in the calculation of the

proportion of the votes for and against the resolution.

The company should ensure that all valid proxy appointments received for general

meetings are properly recorded and counted. For each resolution, where a vote has

been taken on a show of hands, the company should ensure that the following

information is given at the meeting and made available as soon as reasonably

practicable on a website which is maintained by or on behalf of the company:

the number of shares in respect of which proxy appointments have been

validly made;

the number of votes for the resolution;

the number of votes against the resolution; and

the number of shares in respect of which the vote was directed to be

withheld.

The chairman should arrange for the chairmen of the audit, remuneration and

nomination committees to be available to answer questions at the AGM and for all

directors to attend.

The company should arrange for the Notice of the AGM and related papers to be

sent to shareholders at least 20 working days before the meeting.



INTERNATIONAL COMPARISONS OF CORPORATE

GOVERNANCE

The broad principles of corporate governance are similar in the UK, the USA and

Germany, but there are significant differences in how they are applied. Whereas

the UK and Germany have voluntary corporate governance codes, the US system is

based upon legislation within the Sarbanes-Oxley Act.

United States of America

Whereas the UK has historically relied upon a system of self-regulation and

voluntary codes of best practice, the USA corporate governance structure is more

formalised, with legally enforceable controls.

In the US, statutory requirements for publicly-traded companies are set out in the

Sarbanes-Oxley Act. These requirements include the certification of published

financial statements by the CEO and the chief financial officer (CFO), faster public

disclosures by companies, legal protection for whistleblowers, a requirement for an

annual report on internal controls, and requirements relating to the audit

committee, auditor conduct and avoiding improper influence of auditors.

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

stock exchanges to introduce further rules, relating to matters such as the

disclosure of critical accounting policies, the composition of the Board and the

number of independent directors. The Act has also established an independent

body to oversee the accounting profession, which is known as the Public Company

Accounting Oversight Board. Managers must be careful to comply with regulations

to avoid possible legal action against the company or themselves individually.

Germany

As both the UK and Germany are members of the EU, they must both follow EU

directives on company law. A major difference that exists in the board structure for

companies is that the UK has a unitary board (consisting of both executive and

non-executive directors), whereas German companies have a two-tier board of

directors. The Supervisory Board of non-executives (Aufsichtsrat) has

responsibility for corporate policy and strategy and the Management Board of

executive directors (Vorstand) has responsibility primarily for the day-to-day

operations of the company.

The Supervisory Board typically includes representatives from major banks that

have historically been large providers of long-term finance to German companies

(and are often major shareholders). The Supervisory Board does not have full

access to financial information, is meant to take an unbiased overview of the

company, and is the main body responsible for safeguarding the external

stakeholders interests. The presence on the Supervisory Board of representatives

from banks and employees (trade unions) may introduce perspectives that are not

present in some UK boards. In particular, many members of the Supervisory Board

would not meet the criteria under UK Corporate Governance Code for their

independence.



Japan

Although there are signs of change in Japanese corporate governance, much of the

system is based upon negotiation or consensual management rather than upon a

legal or even a self-regulatory framework. Banks as well as representatives of

other companies (in their capacity as shareholders) also sit on the Boards of

Directors of Japanese companies.

It is not uncommon for Japanese companies to have cross holdings of shares with

their suppliers, customers and banks etc., all being represented on each others

Board of Directors. There are often three boards of directors: Policy Boards,

responsible for strategy and comprised of directors with no functional responsibility;

Functional Boards, responsible for day to day operations; and largely symbolic

Monocratic Boards. The interests of the company as a whole should dictate the

actions of these boards. This is in contrast to the UK or USA systems where, at

least in theory, the board should act primarily in the best interests of the

shareholders, being the owners of the company.


Chapter 2

Advanced investment

appraisal section 1

CHAPTER 2 ADVANCED INVESTMENT APPRAISAL: SECTION 1


CHAPTER CONTENTS

INVESTMENT APPRAISAL TECHNIQUES ------------------------------- 27

1. ACCOUNTING RATE OF RETURN 27

2. PAYBACK PERIOD 28

3. DISCOUNTED CASH FLOW 28

INFLATION AND DISCOUNTED CASH FLOW -------------------------- 34

MONEY CASH FLOWS 34

REAL CASH FLOWS 34

RELATIONSHIP BETWEEN MONEY INTEREST RATES AND REAL INTEREST RATES 34

TAXATION AND INVESTMENT APPRAISAL ---------------------------- 36

CAPITAL RATIONING ---------------------------------------------------- 38

WHAT ARE THE 2 TYPES OF CAPITAL RATIONING? 38

CAPITAL RATIONING AND TIME 38

SINGLE PERIOD CAPITAL RATIONING 40

MULTI-PERIOD CAPITAL RATIONING 43



INVESTMENT APPRAISAL TECHNIQUES

Assumed objective is

Selection of those projects which will maximise the wealth of the owners (or

shareholders) of the enterprise. Involves a consideration of FUTURE events, not

PAST performance.

Accepted techniques are

1. Accounting Rate of Return (alternatively called Return on Investment)

2. Payback Period

3. Discounted Cash Flow, of which there are two major variants:

(a) Net Present Value

(b) Internal Rate of Return (alternatively called Yield).

1. Accounting rate of return

The ARR (or ROI) is a measure of relative project profitability, which expresses:

1. the expected average annual profit (after allowing for depreciation, but

before taxation) emerging from a project

as a percentage of

2. the investment involved. Normally the average investment over the life

of the project is used, but initial investment is sometimes employed.

Advantages

It is relatively easy to understand

The required figures are readily available from accounting data.

The ROI technique is frequently used as an assessment of managements

actual (hindsight) performance.

It gives an indication as to whether available projects are meeting target

returns on capital employed.

Disadvantages

Based on accounting profits not cash flows - the success of an enterprise

depends on its ability to generate cash. The ability to invest depends on

availability of cash.

Ignores the time value of money

It is relative rate of return, thus ignores the size of the project

No set rules (theoretical or practical) for determining the cut-off rate of

return.



2. Payback period

The Payback Period demonstrates how long an enterprise must expect to wait

before the after-tax cash flows generated by the project allow it to recoup the initial

amount invested. Thus it gives an investor an idea of how long their money will

be at risk; a short payback period is taken to reveal low risk, and a long payback -

high risk.

Advantages

The most tried and tested of all methods

Easy to calculate and understand

An enterprise with limited cash resources is obviously concerned with speed of

return.

Some companies combine DCF techniques with the payback method.

Disadvantages

Does not measure profitability nor increases in shareholders wealth, since it

ignores cash flows expected to arise beyond the payback period.

Ignores the time value of money (but discounted payback sometimes used).

No set rules (theoretical or practical) for determining the minimum acceptable

payback period.

May be difficult to measure the initial amount invested when eg net outlays

arise in both the initial and final years of a project.

3. Discounted cash flow

DCF is a method of capital investment appraisal which takes account of:

1. The overall cash flows arising from projects, and

2. The timing of those cash flows.

Only relevant cash flows are considered (ie those future cash flows which arise as a

result of those projects) and the timing effect is incorporated by means of the

discounting technique.

Both the Accounting Rate of Return and the Payback approaches are surpassed by

the DCF methods. The basic arguments are:

it is better to consider cash rather than profits because cash is how investors

will eventually see their rewards (ie dividends, interest, or the proceeds from

the sale of the shares or debentures).

the timing of the cash flows is important because early cash receipts can be

reinvested to earn interest.

it is important to consider the cash flows arising over the entire life of a

project.

The technique of discounting reduces all future cash flows to current equivalent

values (present values) by allowing for the interest which could have been earned if

the cash had been received immediately.

There are two common techniques, net present value and internal rate of return,

but net terminal value can be used.



DCF Net present value

The NPV of a project is the net value of a projects cash flows after discounting (ie

allowing for reinvestment) at the companys cost of capital. Projects with a negative

NPV should be rejected.

N.B. Cost of capital is the average required return which is set by the market for

the company in view of the risk associated with its operations.

Provided that:

1. The project under consideration is of average risk for the company, and

2. There is no restriction on access to capital,

a positive NPV provides the best theoretical estimate of the total absolute increase

in wealth which accrues to an enterprise as a result of accepting that project.

However in the short run the use of the NPV rule may not lead to good profits being

reported in the published accounts of the enterprise although in the long term

cash flows and reported profits should move in tandem.

The NPV rule has a sound theoretical basis and is likely to produce investment

decision advice of consistently good quality.

DCF Internal rate of return (economic return/yield)

The IRR (or Economic return) of a project is that discount rate which when applied

to a projects cash flows provides an NPV of zero. The IRR is therefore the expected

earning rate of an investment. If the IRR of a project exceeds the cost of capital

of that enterprise, that project is acceptable.

When considering a single project in isolation IRR will give the same decision as

NPV (ie if the NPV of a project is positive, its IRR will exceed the cost of capital).

However, when choosing between mutually exclusive projects, the two techniques

may conflict and (subject to the provisos set out above) NPV always provides the

correct solution.

Disadvantages of IRR

1. IRR provides a relative (as opposed to an absolute) result, and may give

incorrect decision advice if mutually exclusive projects:

o Are of different size, or

o Have unequal lives.

2. May be multiple IRRs or no IRR

3. Cannot adapt to expected changes in cost of capital during the life of a

project.

4. Makes an inconsistent assumption about the rate at which cash surpluses can

be reinvested; it assumes they are reinvested at whatever the IRR happens to

be. The companys cost of capital is a more appropriate reinvestment rate ie

the assumption underlying NPV.

5. More difficult to calculate than the theoretically more sound NPV approach.



Example Congo Ltd

Congo Ltd is considering the selection of one of a pair of mutually exclusive

investment projects. Both would involve purchase of machinery with a life of five

years

Project 1 would generate annual cash flows (receipts less payments) of 200,000;

the machinery would cost 556,000 and have a scrap value of 56,000.

Project 2 would generate annual cash flows of 500,000; the machinery would cost

1,616,000 and have a scrap value of 301,000.

Congo uses the straight-line method for providing depreciation.

Its cost of capital is 15 per cent per annum. Assume that annual cash flows arise

on the anniversaries of the initial outlay, that there will be no price changes over

the project lives and that acceptance of one of the projects will not alter the

required amount of working capital.

Requirements:

(i) Calculate for each project

(a) the accounting rate of return (ie the percentage of the average

accounting profit to the average book value of investment) to the nearest 1%.

(b) the net present value

(c) the internal rate of return (Yield or Economic return) to the nearest 1%,

and

(d) the payback period to one decimal place.

Ignore taxation.

(ii) WITHOUT ANY REFERENCE TO THE INCREMENTAL YIELD METHOD, briefly

explain which one of the discounted cash flow techniques used in part (i) of

this question should be used by the management of Congo Ltd, in deciding

whether Project 1 or Project 2 should be undertaken.

Suggested solution to Congo Ltd

(i) Summary of results

Project 1 2

a) Accounting rate of return 33% 25%

b) Net present value (000) 142 210

c) Internal rate of return (Economic return) 25% 20%

d) Payback period (years) 2.8 or 3 3.2 or 4



Summary of rankings

Better project

a) Accounting rate of return 1

b) Net present value 2

c) Internal rate of return 1

d) Payback period 1

WORKINGS

Project 1 Project 2

(a) Accounting rate of return 000 000

Initial investment 556 1,616

Scrap value (56) (301)

Total depreciation 500 1,315

Annual depreciation 100 263

Cash flows 200 500

Depreciation (see above) (100) (263)

Average accounting profit 100 237

Project 1 Project 2

000 000

Average book value of investment (000)

(556 + 56) 306

(1,616 + 301) 958

Accounting rate of return 33% 25%

(b) Net present value

000 000

Year

0 Initial outlay (556) (1,616)

1 5 Cash flows

200 x 3.352 670

500 x 3.352 1,676

5 Residual value

56 x 0.497 28

301 x 0.497 ___ 150

Net present value (000) 142 210

(c) Internal rate of return (Economic return)

000 000

By trial and error

Try 20%

Initial outlays (556) (1,616)

Cash flows 598 1,495

Residual values _22 _121

NPV (000) 64 NIL



Try 25%

Initial outlays (556) (1,616)

Cash flows 538 1,345

Residual values __18 __99

NPV (000) NIL (172)

IRR 25% 20%

(d) Payback period

000 000

Annual cash flows 200 500

Initial investment 556 1,616

Payback period in years

If cash flows arose during each year 2.8 3.2

If cash flows arose at year end (as in this

question)

3 4

(ii) Investment Decision

This example illustrates the conflict which will often be found between the two

discounted cash flow appraisal techniques in a ranking decision.

Under the net present value criterion, project 2 is preferred because it has a

higher net present value when the project cash flows are discounted at the

cost of capital. On the other hand project 1 has the higher internal rate of

return.

To decide which method of ranking is correct it is necessary to consider the

assumed objective of the firm, which is to maximise the wealth of the

providers of finance. Both projects earn more than the required rate of return

but project 2 generates larger cash surpluses in excess of the required

amounts than project 1, as can be seen from the net present value

calculations. It is these cash surpluses which improve the wealth of the

owners of the firm.

IRR provides a relative (as opposed to an absolute) result, and may give

incorrect decision advice if mutually exclusive projects are of different size (as

in this instance) or have unequal lives.

IRR makes an inconsistent assumption about the rate at which cash surpluses

can be reinvested; it assumes they are reinvested at whatever the IRR

happens to be. The companys cost of capital is a more appropriate

reinvestment rate i.e. the assumption underlying NPV.

Accordingly PROJECT 2 IS PREFERRED TO PROJECT 1 and this can be justified

by the following argument:

Project 1 is relatively more profitable than project 2, but it is smaller. The

two projects are mutually exclusive, which means that only one of them can

be accepted. It is better for the owners of the company to receive the large

cash surpluses from a large adequately profitable project than to receive the

smaller cash surpluses from a small very profitable project. Taken to

extremes, a return of ten per cent on 1,000 is better than a return of one

thousand per cent on a penny.



Tutorial Note

This question examines the conflicting rankings sometimes given by the NPV

and IRR technique. You may wish to add a graph to amplify your solution to

part (c).



INFLATION AND DISCOUNTED CASH FLOW

The mechanics of allowing for inflation are basically easy to handle in DCF

calculations. The real difficulty is one of predicting what the rate will be. At this

point we will discuss the mechanics.

There are two possible techniques:

1. discount money (nominal) cash flows at the money (nominal) discount rate.

2. discount real cash flows at the real discount rate.

Money cash flows

These are the predictions of the actual sums of money which will be received and

paid taking into account predicted inflation levels. The money rate of interest is

the interest rate which is normally quoted and contains an allowance for inflation

(for example, a 20% discount rate may contain an allowance for expected inflation

of 5%).

Real cash flows

These are cash flows expressed in todays prices. A real discount rate is the real

required rate of return after adjusting the money discount rate for the inflation

allowance.

Relationship between money interest rates and real

interest rates

Suppose we can invest money in a bank to earn 7% per annum interest. However,

we expect inflation to be 4% per annum next year. If I invest 1 this must grow to

1.04 to keep pace with inflation. So, if I have 1.07 cash in the bank after one

year, the real interest I have received is 1.07 - 1.04 = 3p. When compared with

the capital required to keep pace with inflation (1.04), this shows a return of

0.03/1.04 = 2.9%.

The formula which relates real and money interest rates is as follows:

1 + r = i1

m1

+

+

or, according to the ACCA Formula Sheet, (1 + i) = (1 + r)(1 + h)

Where r is the real interest rate, m is the money interest rate and i is the rate of

inflation.

Thus 1 + r = 1.07/1.04 in the above example, giving r = 0.029 or 2.9%.



Suggested solution to AP

Method 1: Compute the real discount rate and discount the real cash flows

1 + r = 1+ m = 1.155 = 1.1

1 + i 1.05

Thus r = 0.1 or 10%

Real cash flow 10% factor Present value

Year

0 (1,500) 1 (1,500)

1 670 1/1.1 609.1

2 500 1/1.12 413.2

3 1,200 1/1.13 901.6

NPV 423.9

Method 2: Compute the money cash flows, using the rate of inflation and discount

at the money discount rate.

Money cash flow 15.5% factor Present value

Year

0 (1,500) 1 (1,500)

1 670 x 1.05 = 703.5 1/1.155 609.1

2 500 x 1.052 = 551.25 1/1.1552 413.2

3 1,200 x 1.053 =1,389.15 1/1.1553 901.6

NPV 423.9

Please note that discount rates have been computed as opposed to looked up in

tables, to ensure that accuracy is obtained for the reconciliation.

Example AP

A project requires an outlay of 1.5m in year 0 and will repay cash flows in real

terms (todays prices) as follows:

Year 000 1 670 2 500 3 1,200

The companys money cost of capital is 15%. Appraise the project if inflation is

estimated to remain at 5% per annum.



TAXATION AND INVESTMENT APPRAISAL

Example AA plc

AA plc buys a fixed asset for 10,000 at the beginning of an accounting period (1

January 2001) to undertake a two year project.

Net trading revenues at t1 and t2 are 5,000 per annum.

The company sells the fixed asset on the last day of the second year for 6,000.

Corporation tax = 33%. Writing down allowance = 25% reducing balance.

Required:

Calculate the net cashflows for the project.

Suggested solution to AA plc

t0 t1 t2 t3

Net trading revenue 5,000 5,000

Tax at 33% (1,650) (1,650)

Fixed asset (10,000)

Scrap proceeds 6,000

Tax savings on WDAs _____ ____ 825 495

Net cashflow (10,000) 5,000 10,175 (1,155)

WORKING

Tax savings on writing down allowances

Tax relief

at 33%

Timing

t0 Investment in fixed asset 10,000

t1 WDA @ 25% (2,500) 825 t2

7,500

t2 Proceeds (6,000)

Balancing allowance (1,500) 495 t3

Example BB plc

BB plc buys a fixed asset for 10,000 at the end of the previous accounting period

(31 December 2000) to undertake a two year project.

Net trading revenues at t1 and t2 are 5,000 per annum.

The fixed asset has zero scrap value when it is disposed of at the end of year 2.

Corporation tax = 33%. Writing down allowance = 25% reducing balance.

Required:

Calculate the net cashflows for the project.



Suggested solution to BB plc

t0 t1 t2 t3

Net trading revenue 5,000 5,000

Tax at 33% (1,650) (1,650)

Fixed asset (10,000)

Tax savings on

WDAs

_____ 825 619 1,856

Net cashflow (10,000) 5,825 3,969 206

WORKING

Tax savings on writing down allowances

Tax relief at 3% Timing

t0 Investment in fixed asset 10,000

t0 WDA @ 25% (2,500) 825 t1

7,500

t1 WDA @25% (1,875) 619 t2

5,625

t2 Proceeds ____

Balancing allowance (5,625) 1,856 t3



CAPITAL RATIONING

Where the finance available for capital expenditure is limited to an amount which

prevents acceptance of all new projects with a positive NPV, the company is said to

experience capital rationing.

What are the 2 types of capital rationing?

They are:

1. Hard capital rationing

This applies when a company is restricted from undertaking all worthwhile

investment opportunities due to external factors over which it has no control.

These factors may include government monetary restrictions and the general

economic and financial climate (eg, a depressed stock market, which precludes a

rights issue of ordinary shares).

2. Soft capital rationing

This applies when a company decides to limit the amount of capital expenditure

which it is prepared to authorise. Segments of divisionalised companies often have

their capital budgets imposed by the main board of directors. A company may

purposely curtail its capital expenditure for a number of reasons eg, it may consider

that it has insufficient depth of management expertise to exploit all available

opportunities without jeopardising the success of both new and ongoing operations.

Capital rationing and time

Capital rationing may exist in a:

1. Single period

This is where available finance is only in short supply during the current period, but

will become freely available in subsequent periods.

Projects may be:

(i) Divisible An entire project or any fraction of that project may be

undertaken. In this event projects may be ranked by means of a

profitability index, which can be calculated by dividing the present value (or

NPV) of each project by the capital outlay required during the period of

restriction.

Projects displaying the highest profitability indices will be preferred. Use of

the profitability index assumes that project returns increase in direct

proportion to the amount invested in each project.

(ii) Indivisible An entire project must be undertaken, since it is impossible to

accept part of a project only. In this event the NPV of all available projects

must be calculated. These projects must then be combined on a trial and

error basis in order to select that combination which provides the highest total

NPV within the constraints of the capital available. This approach will

sometimes result in some funds being unused.



2. Multi-period

This is where available finance is limited not only during the current period, but also

during subsequent periods.

Projects may be:

(i) Divisible - In this event, linear programming is used to determine the

optimal combination of projects. Two techniques, which both result in

identical project selections can be used ie the objective is to either:

Maximise the total NPV from the investment in available projects, or

Maximise the present value (PV) of cash flows available for dividends.

(ii) Indivisible - In this event, integer programming would be required to

determine the optimal combination of investments.



Single period capital rationing

Example of single period capital rationing Banden Ltd

Banden Ltd is a highly geared company that wishes to expand its operations. Six

possible capital investments have been identified, but the company only has access

to a total of 620,000. The projects are not divisible and may not be postponed

until a future period. After the projects end, it is unlikely that similar investment

opportunities will occur.

Expected net cash inflows (including salvage value)

Initial Project Year 1 2 3 4 5 outlay

A 70,000 70,000 70,000 70,000 70,000 246,000 B 75,000 87,000 64,000 180,000

C 48,000 48,000 63,000 73,000 175,000 D 62,000 62,000 62,000 62,000 180,000 E 40,000 50,000 60,000 70,000 40,000 180,000 F 35,000 82,000 82,000 150,000

Projects A and E are mutually exclusive. All projects are believed to be of similar

risk to the companys existing capital investments.

Any surplus funds may be invested in the money market to earn a return of 9%

per year. The money market may be assumed to be an efficient market. Bandens

cost of capital is 12% per year.

Required:

(a) Calculate:

(i) The expected net present value;

(ii) The expected profitability index associated with each of the six

projects.

Rank the projects according to both of these investment appraisal

methods and explain briefly why these rankings differ.

(b) Give reasoned advice to Banden Ltd recommending which projects

should be selected.



Solution to single period capital rationing example Banden Ltd

(a) (i) Calculation of expected Net Present value

Project NPV

A. 70,000 x 3.605 - 246,000 = 6,350

B. 75,000 x 0.893 + 87,000 x 0.797 + 64,000

x 0.712 - 180,000 = 1,882

C. 48,000 x 0.893 + 48,000 x 0.797 + 63,000

x 0.712 + 73,000 x 0.636 - 175,000 = (2,596)

D. 62,000 x 3.037 - 180,000 = 8,294

E. 40,000 x 0.893 + 50,000 x 0.797 + 60,000

x 0.712 + 70,000 x 0.636 + 40,000 x 0.567

- 180,000 = 5,490

F. 35,000 x 0.893 + 82,000 x 0.797 + 82,000

x 0.712 - 150,000 = 4,993

(ii) Calculation of Profitability Index

Present value of cash inflows initial outlay:

Project PI

A. 252,350/246,000 = 1.026

B. 181,882/180,000 = 1.010

C. 172,404/175,000 = 0.985

D. 188,294/180,000 = 1.046

E. 185,490/180,000 = 1.031

F. 154,993/150,000 = 1.033



Ranking NPV P.I

1 D D

2 A F

3 E E

4 F A

5 B B

6 C C

The rankings differ because NPV is an absolute measure of the benefit from a

project, whilst profitability index is a relative measure, and shows the benefit

per of outlay. Where the initial outlays vary in size the two methods may

give different rankings.

(b) In a capital rationing situation, the projects should be selected which give the

greatest total NPV from the limited outlay available.

A and E are mutually exclusive.

C is not considered as it has a negative NPV.

Total outlay is limited to 620,000.

Possible selections are:

Projects Expected NPV Total NPV Outlay in 000

A, B, D (6,350 + 1,882 + 8,294) 16,526 (246 + 180 + 180) 606

A, B, F (6,350 + 1,882 + 4,993) 13,225 (246 + 180 + 150) 576

A, D, F (6,350 + 8,294 + 4,993) 19,637 (246 + 180 + 150) 576

B, D, E (1,882 + 8,294 + 5,490) 15,666 (180 + 180 + 180) 540

B, D, F (1,882 + 8,294 + 4,993) 15,169 (180 + 180 + 150) 510

B, E, F (1,882 + 5,490 + 4,993) 12,365 (180 + 180 + 150) 510

D, E, F (8,294 + 5,490 + 4,993) 18,777 (180 + 180 + 150) 510

The recommended selection is projects A, D and F

Tutorial note: Neither the NPV nor PI rankings will necessarily be appropriate

because of the sheer size of these indivisible investments. In this particular

instance, because of the similarity in size of the projects, only three can be

undertaken, and the NPV ranking clearly leads to A, D and E. Profitability

index will not work if projects are indivisible or where multiple limiting factors

exist. The PI might lead to the incorrect solution of D, E and F.



Multi-period capital rationing

Please remember that you are only likely to be asked to set up the

equations for both the linear programming and integer programming

formulations and then to interpret the output. The actual solving of these

equations are computer-based calculations.

Example of multi-period capital rationing using linear

programming Barney Ltd

The management team of Barney Ltd has identified the following independent

investment projects, all of which are divisible.

No project can be delayed or performed on more than one occasion. The projected

cash flows during the life of each project are as follows:

Year 0 Year 1 Year 2 Year 3 Year 4

000 000 000 000 000

Project A (25) (50) 25 50 50 Project B (25) (25) 75 - -

Project C (12.5) 5 5 5 5 Project D - (37.5) (37.5) 50 50 Project E (50) 25 (50) 50 50 Project F (20) (10) 37.5 25 -

The capital available at Year 0 is only 50,000 and only 12,500 is available at

Year 1, together with any cash inflows from the projects undertaken at Year 0.

From Year 2 onwards there is no restriction on the access to capital. The

appropriate cost of capital is 10%.

Required:

Formulate both:

1. The NPV linear programme, and

2. The PV of dividends linear programme.



Suggested solution to Barney Ltd

NPV formulation

Since the objective is to maximise the total NPV from these projects, it is initially

necessary to calculate the NPV of each project at a discount rate of 10%:

Year 0 Year 1 Year 2 Year 3 Year 4 Total

NPV

Discount factor

(10%) 1.000 0.909 0.826 0.751 0.683

000 000 000 000 000 000

Project A (25) (45.45) 20.65 37.55 34.15 +21.90

Project B (25) (22.73) 61.95 - - +14.22

Project C (12.5) 4.55 4.13 3.75 3.42 +3.35

Project D - (34.09) (30.97) 37.55 34.15 +6.64

Project E (50) 22.73 (41.30) 37.55 34.15 +3.13

Project F (20) (9.09) 30.98 18.77 - +20.66

The combination of projects, which will maximise the total NPV can now be

specified, where:

a = the proportion of Project A to be undertaken

b = the proportion of Project B to be undertaken

c = the proportion of Project C to be undertaken

d = the proportion of Project D to be undertaken

e = the proportion of Project E to be undertaken

f = the proportion of Project F to be undertaken

The objective function, which represents the maximum NPV that can be earned, is:

z = 21.90a + 14.22b + 3.35c + 6.64d + 3.13e + 20.66f

This is subject to the following constraints:

Year 0 : 25a + 25b + 12.5c + 50e + 20f 50

Year 1 : 50a + 25b + 37.5d + 10f 12.5 + 5c + 25e

Furthermore : 0 a, b, c, d, e, f 1

When solved, the linear programme will provide the proportions of each project

which should be undertaken in order to establish the value of z, which represents

the maximum NPV achievable in view of the limitation of available capital.

Notice that the first constraint relates to the limited capital available at Year 0. The

second constraint concerns the capital limitation at Year 1, which is of course eased

by the Project C and E cash inflows, which can also be used to fund investment

needs at that time.

The third constraint shows that each project can only be undertaken once and that

it is impossible to undertake a negative quantity of any project. This non-negative

rule is essential, since if it were excluded a computer model may well establish that

negative quantities of a project could make cash inflows available that would be

included within the solution!!



PV of dividends formulation

The combination of projects, which will maximise the PV of cash flows available for

dividends must be specified, where:

a = the proportion of Project A to be undertaken

b = the proportion of Project B to be undertaken

c = the proportion of Project C to be undertaken

d = the proportion of Project D to be undertaken

e = the proportion of Project E to be undertaken

f = the proportion of Project F to be undertaken

The objective function will be based upon the premise that:

z = the PV of dividends.

The dividend flows need to be defined for each year up to the point where the

investment with the longest life ceases in this case up to the end of Year 4 ie

d0 = the dividend flow generated at Year 0 by the projects selected





Therefore the objective function, which represents the present value of the

maximum dividends, discounted at the cost of capital of 10% is:

z = d0 + 1.1

d1 + 2

2

1.1

d +

3

3

1.1

d +

4

4

1.1

d

alternatively

z = d0 + 0.909 d1 + 0.826 d2 + 0.751 d3 + 0.683 d4

This is subject to the following constraints:

Year 0 : 25a + 25b + 12.5c + 50e + 20f + d0 50

Year 1 : 50a + 25b + 37.5d + 10f + d1 12.5 + 5c + 25e

Year 2 : 37.5d + 50e + d2 25a + 75b + 5c + 37.5f

Year 3 : d3 50a + 5c + 50d + 50e + 25f

Year 4 : d4 50a + 5c + 50d + 50e

Furthermore : 0 a, b, c, d, e, f 1

Additionally : d0, d1, d2, d3, d4 0

When solved, the linear programme will provide the proportions of each project

which should be undertaken in order to establish the value of z, which represents

the maximum PV of dividends earned in view of the capital constraints.

With an NPV formulation, we only have constraints for the periods during which

capital rationing exists (in this instance, Years 0 and 1), whereas under the

dividend formulation we have a constraint for every year of potential project cash

flows (in this case, Years 0 to 4).

The available funds are the same as in the NPV formulation (ie available capital

together with cash inflows from the projects); however the dividend flow for each

period must also be included. Furthermore an additional non-negative constraint is

used, since the dividends must be greater than or equal to zero. If this constraint

were excluded, a computer model may specify negative dividend payments, which

make cash inflows available that could be used to finance more projects!!

One advantage of the PV of dividends formulation is that it removes the need to

even calculate the NPV of each investment opportunity, since the discounting



process is carried out by the linear programme as part of the calculation of the

solution.

Notice the only difference in the value of z in these formulations is as follows:

Under the NPV formulation, z provides the NPV of the project returns,

whereas

Under the PV of dividends formulation, z provides the PV of the project

returns.

Dual values

Dual values (also referred to as shadow prices) reflect the change in the objective

function as a result of having one more or one less unit of scarce resource. In the

context of capital rationing the scarce resource is available cash, so that the dual

price states the change in the objective function if one more unit of currency (eg

1) becomes available or if one less GB pound is invested.

Shadow prices can therefore be used to calculate the impact of raising additional

finance for further investment or the effect of diverting capital away from current

projects into newly discovered investments.

The dual price depends upon which method is used to formulate the linear

programme ie

Under the NPV formulation, it reflects the change in the NPV if 1 more or

1 less is available

Under the PV of dividends formulation, it reflects the change in the PV of

cash available for dividend payments if 1 more or 1 less capital is available.

Dual prices relate only to marginal changes in the availability of capital. Thus,

suppose that a dual value of 1.25 arises under the PV of dividends method, this

means that if an additional 1 of funds became available, the total value of the

objective function would rise by 1.25. It does not necessarily mean that if an

additional 10,000 became available, that the value of the objective function would

increase by (10,000 x 1.25) 12,500.

Shadow prices can therefore be used to test the validity of new investments which

emerge. The cash flows generated by the new project can be compared with the

cash flows lost by diverting funds from existing investments, thereby calculating the

effect of diversion of that finance.



Example of the use of dual values in linear programming

Bruno Ltd

Bruno Ltd is experiencing capital rationing during both Year 0 and Year 1 in

relation to a number of divisible projects. It has used linear programming to

develop an investment strategy over its three year planning horizon for dividend

payments, using a cost of capital of 10%.

Shadow prices have been calculated under the NPV formulation for the two years

of capital constraints and under the PV of dividends formulation for the three year

planning horizon. The dual prices per 1 of capital available are as follows:

NPV method PV of dividends method

Year 0 0.1 (1 + 0.1) = 1.1

Year 1 0.08 (0.909 + 0.08) = 0.989 Year 2 0 (0.826 + 0) = 0.826

A new investment opportunity has emerged with the following cash flows:

Cash flow

000 Year 0 (75) Year 1 50

Year 2 50

Required:

Appraise the new project using both the NPV dual prices and the PV of

dividend shadow prices.



Solution to Bruno Ltd

Appraisal using NPV dual values

The NPV of the new investment project is:

Year Cash flow Discount

factor Present value

000 @ 10% 000

0 (75) 1 (75)

1 50 0.909 45.45

2 50 0.826 41.3

NPV 11.75

The net dual value of the new investment project (ie the impact of diverting funds

from the current investment strategy) is:

Year Cash flow Shadow price Opportunity cost

000 000

0 (75) 0.1 (7.5)

1 50 0.08 4

2 50 0 - _

Net dual value (3.5)

Accordingly, the NPV of the current investment strategy would fall by 3,500 if the

new project were accepted. However, Bruno Ltd would benefit from the positive

NPV of that new investment opportunity. Therefore:

000

NPV of new project 11.75

Net dual value (3.5)

Net benefit of undertaking new project 8.25

This indicates that this project is worth further consideration, since if it were

accepted in full (and in doing so does not violate the marginality assumption of dual

values) it would result in the value of the objective function increasing by 8,250.

Appraisal using PV of dividends dual values

The net dual value of the new investment project (ie the impact of diverting funds

from the current investment strategy) is:

Year Cash flow Shadow price Opportunity cost

000 000

0 (75) 1.1 (82.5)

1 50 0.989 49.45

2 50 0.826 41.3

Net dual value (ie net benefit of undertaking new

project) 8.25

The two techniques will always provide the same result, but as can be seen the PV

of dividends dual prices technique is far quicker and simpler to solve.

Again, the project is worth considering; the linear programme should therefore be

reformulated (by including the new project) and then re-solved.



Solution to Toby Ltd

The problem is to identify that combination of investment projects which will

produce the highest possible total NPV (within the annual funding limitations).

For instance, if Projects C and D were undertaken, they would satisfy the annual

capital constraints, because the combined investment for Year 0 is 12,500, for

Year 1 is 30,000 and for Year 2 is 37,500, whilst achieving a total positive NPV of

25,000.

On the other hand, if Projects A and B were selected, they would also remain within

the annual capital limitations. The combined investment for Year 0 is 40,000, for

Year 1 is 25,000 and for Year 2 is 40,000, whilst achieving a total positive NPV of

47,500. This amount exceeds the NPV earned by the combination of Projects C

and D.

This problem can be solved by an integer programming formulation. The

procedures would be to establish the value of variables YA, YB, YC and YD for each of

the four projects, which maximise the total net present value ie

Maximise: 20,000 YA + 27,500 YB + 15,000 YC + 10,000 YD

Example of multi-period capital rationing using integer

programming Toby Ltd

The management team of Toby Ltd has identified four indivisible projects, which

require funds to be invested over the next few years, as set out below:

Project A Project B Project C Project D

Year 0 17,500 22,500 - 12,500 Year 1 25,000 - 15,000 15,000 Year 2 10,000 30,000 20,000 17,500

The board of directors of that company has approved the following capital

expenditure programme for those same accounting periods:

Year 0 40,000

Year 1 35,000 Year 2 42,500

The four projects are expected to produce the following positive net present

values:

Project A Project B Project C Project D

Project NPV +20,000 +27,500 +15,000 +10,000

Required:

Discuss the approach for calculating the optimum mix of projects.



Subject to three annual capital investment constraints:

Year 0 : 17,500 YA + 22,500 YB + 0 YC + 12,500 YD 40,000

Year 1 : 25,000 YA + 0 YB + 15,000 YC + 15,000 YD 35,000

Year 2 : 10,000 YA + 30,000 YB + 20,000 YC + 17,500 YD 42,500

The solution to the above problem would result in YA = 1, YB = 1, YC = 0, YD = 0.

In other words, both Project A and Project B would be selected, whilst the other two

projects would be rejected and the positive NPV of the entire investment strategy

would be 47,500.

Notice that the above solution is superior to the combination of YA = 0, YB = 0, YC

= 1, YD = 1, since the combined positive NPV of Project C and Project D is only

25,000, as already stated.


Chapter 3

Advanced investment

appraisal section 2



CHAPTER CONTENTS

MODIFIED INTERNAL RATE OF RETURN ------------------------------ 53

CALCULATING THE MIRR 53

FREE CASH FLOW -------------------------------------------------------- 56

DEFINITION OF FREE CASH FLOW 56

FREE CASH FLOW TO EQUITY 57

RISK AND UNCERTAINTY ----------------------------------------------- 61

SENSITIVITY ANALYSIS 61

PROBABILITY AND EXPECTED VALUES 62

MONTE CARLO SIMULATION 62

PROJECT VALUE AT RISK 63

DURATION ---------------------------------------------------------------- 64

THE MACAULAY DURATION METHOD ---------------------------------- 66



MODIFIED INTERNAL RATE OF RETURN

To assist in remedying some of the deficiencies of IRR, a technique called Modified

Internal Rate of Return (MIRR) has been developed. MIRR has certain advantages

in that it:

Eliminates the possibility of multiple internal rates of return.

Addresses the reinvestment rate issue ie it does not make the assumption

that the companys reinvestment rate is equal to whatever the project IRR

happens to be.

Provides rankings which are consistent with the NPV rule (which is not always

the case with IRR).

Provides a % rate of return for project evaluation. It is claimed that non-

financial managers prefer a % result to a monetary NPV amount, since a %

helps measure the headroom when negotiating with suppliers of funds.

Calculating the MIRR

The MIRR assumes a single outflow at time 0 and a single inflow at the end of the

final year of the project. The procedures are as follows:

Convert all investment phase outlays as a single equivalent payment at time

0. Where necessary, any investment phase outlays arising after time 0 must

be discounted back to time 0 using the companys cost of capital.

All net cash flows generated by the project after the initial investment (ie the

return phase cash flows) are converted to a single net equivalent terminal

receipt at the end of the projects life, assuming a reinvestment rate equal to

the companys cost of capital.

The MIRR can then be calculated employing one of a number of methods, as

illustrated in the following example.

Example Carter plc

Carter plc is considering an investment in a project, which requires an immediate

payment of 15,000, followed by a further investment of 5,400 at the end of the

first year. The subsequent return phase net cash inflows are expected to arise at

the end of the following years:

Net cash inflows

Year

1 6,500 2 7,750 3 5,750 4 4,750

5 3,750

Required:

Calculate the modified internal rate of return of this project assuming a

reinvestment rate equal to the companys cost of capital of 8%.



Solution to Carter plc

Single equivalent payment discounted to year 0 at an 8% discount rate:

Year

0 15,000

1 (5,400 x 0.926) _5,000

Present Value (PV) of investment phase cash flows 20,000

Single net equivalent receipt at the end of year 5, using an 8% compound rate:

Year 8% compound factors

1 6,500 1.3605 8,843

2 7,750 1.2597 9,763

3 5,750 1.1664 6,707

4 4,750 1.08 5,130

5 3,750 1 3,750

Terminal Value (TV) of return phase cash flows 34,193

The above compound factors are produced with a calculator.

A five year PV factor can now be established ie (20,000 34,193) = 0.585

Using present value tables, this 5 year factor falls between the factors for 11% and

12% ie 0.593 and 0.567. Using linear interpolation:

MIRR = 11% + 0.567) - (0.593

0.585) - 0.593( x (12% - 11%) = 11.3%

Alternatively, the MIRR may be calculated as follows;

MIRR = 000,20

193,34

5 1 = 11.3%

Furthermore, in examples where the PV of return phase net cash flows has already

been calculated, there is yet another formula for computing MIRR (which is given

on the ACCA formulae sheet). This for

p4 lsbf by acca reloaded

Documents