Professional Documents
Culture Documents
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ACCA
P4
Advanced Financial Management
Prepared By:
Sunil Bhandari
Tutor Contact Details
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Contents
Chapter
Number
Chapter Name
Chapter One
Chapter Two
Preliminaries
Financial Objectives-Review of F9 Knowledge
Cost of Capital
Chapter Three
Chapter Four
Chapter Five
Dividend Policy
Chapter Six
Chapter Seven
Chapter Eight
Chapter Nine
Risk Management
Chapter Ten
Chapter Eleven
Chapter Twelve
Chapter Thirteen
Chapter Fourteen
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My Summary
Strong Link To F9
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Chapter One
Financial ObjectivesReview of F9 Knowledge
1
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Indicators
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3.2.2
3.2.3
3.2.4
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Directors pay
Taking high risk business decisions
Non-payment of dividends
Using debt finance (against the wishes of the
S/H)
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4.4 Dividends
4.4.1 The Board needs to establish a dividend policy
see Chapter 5
4.5 The three decisions are interlinked.
Example: New projects need new finance but must
generate cash to service the finance providers
including paying dividends to the shareholders.
5
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Chapter Two
Cost of Capital
1 Weighted Average Cost of Capital (WACC)
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1.3 Some past P4 answers used the following symbols:WACC= Were + Wdrd(1-t)
We=
Ve
or (1-Wd)
Ve+Vd
W d = Vd
or (1-We)
Ve+Vd
re=Ke=Cost Of Equity
rd(1-t)=Kd(1-t)=Cost of Debt
Therefore, its the same Formula!!
2 Cost of Equity (Ke, re)
2.1 Formulae are given in the exam as:a)
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c)
2007
2008
2009
2010
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g= 3(0.32/0.24) -1
g=10%
ii) Gordon Growth Model
g=bre
b= the proportion of profits retained by the
business.
re= the accounting rate of return (ARR)
Example
A company has an ARR of 12% and pays out 30% of
its profits as a dividend.
g=0.70 x 0.12=0.084
2.4
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Vd:Ve 1:4
d=NIL
Find a
a =
4
x 1.95
4+1(1-0.30)
=
4
x 1.95
4.7
= 1.66
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Example
ABC is made up of two divisions
Division
Asset eta
Food
Clothes
0.75
1.80
Proportion of the
Business
40%
60%
68
x e
68+32(1-0.25)
1.38= 68 x e
92
e =1.87
3 Post Tax Cost of Debt (Kd(1-t) or rd(1-t))
3.1 Kd or rd is the yield or minimum return for the debt
holder pre tax cost of debt.
Kd(1-t) or rd(1-t) is the post tax cost of debt for the
company.
3.2 To find the cost of debt we need to look at the type of
debt finance skills taught at F9.
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$
(X)
X
X
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3.6 The main method used in the P4 exam is:Kd(1-t)=(Yield on similar Government debt + Credit Risk
Premium) x (1-t)
Example
Table of credit spreads for industrial company bonds in Basis
Points (BP=0.01%).
Rating
1 yr
2 yr
3 yr
5 yr
7 yr
10 yr
30 yr
10
15
22
27
30
55
AA
15
25
30
37
44
50
65
40
50
57
65
71
75
90
BBB
65
80
88
95
126
149
175
BB
210
235
240
250
265
275
290
B+
375
402
415
425
425
440
450
AAA
(i)
(ii)
(i)
(ii)
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1
(1+r)n
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4 Use of WACC
4.1 The WACC is the nominal cost of capital to be used in
advanced project appraisal involving DCF methods.
i.e. NPV
IRR
MIRR
4.2 The nominal cost of capital has the symbol i at P4 and
can be found via:-
4.3 The WACC is only useable providing: The project under consideration is a core activity of the
company.
The project finance will not significantly change the
current gearing ratio of the entity.
4.4 If the new project is a NON CORE Activity but the project
will have no significant effect upon the companys
gearing ratio then the nominal cost of capital to use is
the RISK ADJUSTED WACC.
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Chapter Three
Risk Adjusted WACC
1 When do we use this?
As stated in Chapter Two above if the:a) Project is a non-core one
b) Will have no effect upon the companys gearing ratio
2 Approach
a) Find an equity eta for the industry relating to the
project.
b) Degear e to find the asset eta.
c) Re-gear a to find the project equity eta . Use either:i.
ii.
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ii.
iii.
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Chapter Four
Capital Structure and
Raising Finance
1 Introduction
How should the company decide the mix of
equity and debt capital?
2 Practical Issues
If the company uses Debt capital funding it should
consider:Credit Rating of the company
Rate of interest it will pay
Market conditions- access to Debt capital
Forecast Cash Flows-to service and repay the debt.
Level of Tangible Assets on which secure the loans.
Interest will lead to tax savings i.e Tax Shield
Constraints on the level of debt from
a) Articles Of Association
b) Loan Agreements.
Effect upon the company gearing ratio
Debt/Equity+Debt OR Debt/Equity
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3.1
3.2
Traditional View
%
Cost
Of
capital
Ke
WACC
Kd
Gearing
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Ke
WACC
Kd
Gearing
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Vd=Vu+VDT
WACC=Keu{1-T x Vd}
(Ve+Vd)
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Debt
The degree of questioning and publicity associated with
debt is usually significantly less than that associated
with a share issue.
Moderate issue costs.
New issue of equity
Perception by stock markets that it is possible sign of
problems. Extensive questioning and publicity
associated with a share issue.
Expensive issue costs.
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Chapter Five
Dividend Policy
1 Introduction
To maximise S/H wealth the Board should establish a
dividend policy-the payment pattern to the equity investors.
2 Theories
Several theories have been put forward to assist:2.1 Residual If spare cash exists at the end of the year pay
dividend.
2.2 Pattern Be consistent with dividend payments. Either
a) Pay the same dividend per share (DPS) each year.
b) Maintain the payout ratio (DPS/EPS)
c) Maintain the same year-on-year growth rate in
dividends. The latter links into the Po via the
dividend valuation model (DVM)
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3 Practical Considerations
There are many to consider:
Availability of cash
What dividends do S/H want (clientele effect)?
Signalling effect payment of dividends indicates a
healthy company
Retaining cash is a key source of finance.
Dividend growth should be greater than inflation
Tax impact upon S/H
Effect
the
dividend
will
have
on
dividend
cover(EPS/DPS)
Number of investment opportunities will restrict
dividend payments.
Risk-paying now is safer than promising to pay next
year
Is the dividend within the company law regulations?
4 Alternatives to Cash Dividends
4.1 Scrip Dividends
4.1.1 The S/H will receive extra shares instead of cash on a
pro rata basis.
4.1.2 This will allow the S/H to sell extra shares for cash and
the gain will be subject to CGT.
4.1.3 The effect will:a) Increase the issued equity capital
b) Dilute EPS and Po values
c) Create pressure for the board to pay more total
dividends in the future as more shares are in issue
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Chapter Six
Advanced Investment
Appraisal I
1 NET PRESENT VALUE OF FREE CASH FLOWS (FCF)
1.1 Free Cash Flows (FCF)
The cash is available after expenditure and
reinvestment into the business.
Computed two ways:1) Incremental cash flow approach
Revenue Costs Tax -Capex + Scrap Value - Asset
Replacement Spending Working Capital Injection + Tax
saved on Tax Allowable Depreciation.
2) Adjusting Accounting Profit
Net operating profit (before
interest and tax)
Plus Depreciation
Less Taxation
Operating cash flow
Less Investment:
Replacement non-current
asset investment(RAI)
X
X
(X)
X
(X)
Incremental non-current
asset investment(IAI)
(X)
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(X)
X used in NPV comps
(X)
(X)
X
X used to value equity in
certain business valuation
models.
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1.4 Inflation
(Symbol h)
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XXX
Incremental Costs
(XXX)
(XXX)
Taxable Profit
XXX
Netted are
operating
Cash flows
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T0
(100)
T1
100
(70)
T2
170
(130)
T3
300
300
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= 8.928
0.112
d) Annuity Factor starting at time 4 stopping at time 9 at
8%
AF4-9 = AF1-9 AF1-3
= 6.247-2.577=3.67
e) The present value of a cash flow starting at T5 at $200
then growing in perpetuity at 2% at 12% cost of capital.
1
r-g
x DF3
1
X .712
0.12-0.02
= 7.12
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2 Layouts
Two options depending upon the nature and style of the
FCFS
Format A (Assuming One Line Tax)
$000
Revenue
Materials
Labour
VOH
Incremental
FOH
Operating
CF
Tax(w1)
T0
-
T1
X
(X)
(X)
(X)
(X)
Capex &
Scrap
W Capital
FCF
i%
PV
(X)
(X)
(X)
1.0
(X)
NPV
Time
T2
X
(X)
(X)
(X)
(X)
T3
X
(X)
(X)
(X)
(X)
T4
X
(X)
(X)
(X)
(X)
(X)
(X)
(X)
(X)
X
X
X
$ XXX
(X)
X
X
X
(X)
X
X
X
X
X
X
X
T5
(X)
(X)
X
X
Format B
Time
T0
T1-T30
T2-T31
T32
$000
(X)
X
(X)
X
%
1.0
X
X
X
NPV
PV$000
(X)
X
X
X
$XXX
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Chapter Seven
Advanced Investment
Appraisal II
1 IRR
1.1 Internal Rate of Return is the cost of capital that gives
an NPV of NIL
1.2 Example
NPV @ 10% = $30K
NPV @ 20% = ($160K)
IRR=10 + ( 30 ) x (20-10) =11.6%
30-(-160)
1.3 IRR has weaknesses:a) Cannot be used to compare mutually exclusive projects.
b) Multiple IRRs exist
when the cash flow pattern is not standard
ie Standard Pattern -,+,+,+,+
Non-Standard Pattern -, +, +, +,1.4 MIRR is a measure that gives an NPV of nil but will lead
to a project decision rule consistent with NPV.
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2 Computing MIRR
2.1 Class Illustration
Time
T0
T1
T2
T3
$000
(1000)
400
600
300
Return phase
of the project
Cost of Capital=10%
2.2 Using The Formula
NPV had been computed at 10%.
Time
T0
T1
T2
T3
$
(1000)
400
600
300
10%
1.0
0.909
0.826
0.751
PV
(1000)
363.6
495.6
225.3
84.5
* PV of Return Phase=$1084.50
Formula given
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$000
400 X 1.102=
600 X 1.10 =
300 X 1.0 =
484
660
300
1444
(1000)
1444
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T0
-
T1
X
(X)
(X)
X
(X)
T2
X
(X)
(X)
X
(X)
T3
X
(X)
(X)
X
(X)
T4
X
(X)
(X)
X
(X)
(X)
(X)
X
(X)
X
(X)
X
(X)
X
X
X
(X)
X
(X)
X
X
X
X
X
X
X
X
X
X
X
X
(X)
(X)
X
(X)
X
(X)
X
(X)
X
4.1.1 APV is a NPV method to be used when: Project is core or non-core activity
Specific debt finance is being use on a project.
Subsidised interest exists on the project debt finance.
4.1.2 APV is still the change in shareholder wealth arising
from the project.
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4.2 Method
Establish the asset for the project.
Using the asset in CAPM find Keu (all equity Kei)
Discount the relevant project cash flows using Keu to
find the base case NPV
Establish the yield on the debt
Find PV of the issue costs (possibly post tax) using
yield as a discount rate.
Find PV of the tax savings on the interest paid on the
loan finance raised using the yield as a discount rate
4.3 Subsidised Loans
4.3.1 If any part of the loan Finance is at a subsidised rate,
then the APV must include an extra benefit.
4.3.2 PV of the post tax subsidy discounted at the pretax cost
of debt.
APV
$m
Base case NPV
PV of issue costs
PV of tax savings on interest
PV of net of tax subsidised interest
APV
X
(X)
X
X
X
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5 Capital Rationing
5.1 When there is a lack of sufficient cash to invest in all
projects with a positive NPV
5.2 Cash can be restricted due
a. Hard Reasons external constraint eg Credit Crunch.
b. Soft Reasons internal restrictions eg Capex Budget
Single Period-Divisible Projects
5.3 Compute the Profitability Index (PI) for each project.
PI=
NPV
Cash outlay in critical period
Spend-Today
$m
22
17
40
18
NPV
$m
67
25
65
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c. 65/40=1.63
d. 26/18=2.00
Multi-period-Divisible Projects
5.5 This is when cash is restricted in more than one period.
You must understand that the aim will be to maximise the
wealth of the shareholders but stay within the cash limits
each year. Also, some projects can cross fertilise meaning
that they generate positive cash flows which can fund those
with deficits. Deposit accounts can be used to carry cash
forward into future periods.
5.6 A optimum solution can be found using linear
programming (divisible projects) and integer programming
(non divisible projects).
6 Dealing with Risk within Investment Appraisal
6.1 Sensitivity Analysis
6.1.1 Remember from ACCA F9 that this is defined as change
one variable within the project and cause the NPV to go from
positive to nil.
6.1.2 A quick way to compute the sensitivity margin%:For any Cash Flow
NPV
x 100
PV Of Cash Flow
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x 100
Example
Time
T0 Capex
T1-T5
Revenue
T1-T5 Cost
T5 Scrap
$000
(1000)
400
10%
1.0
3.791
PV $000
(1000)
1516
(20)
200
3.791
0.621
(76)
124
564
NPV
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Chapter Eight
Valuation of Options
+Value at Risk
1
Valuation of Options
1.1 An option gives the holder the right, but not the
obligation to buy or sell a share at a fixed price on a
specified future date.
Details and terminology: (a)
(b)
(c)
(d)
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(b)
(ii)
(ii)
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All three formulae are given in the tables but you must
know what the symbols stand for.
Symbols:
Pa=share price
Pe=exercise price option
r =annual (continuously compounded) risk free rate of
return
t =time to expiry of option in years
s =share price volatility, the standard deviation of the
rate of return on shares
e =the exponential constant 2.7183
In =natural logarithm
On Your calculator!!
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3) C
C = (100 x .6664) - (95 x 57.14 x .975)
= $ 13.71
1.3 Put-call parity
Black Scholes model will only calculate the value of a
call option. The value of a call option, a put option, the
exercise price and the share price are related (where
the put and call have the same strike and exercise
date):
Example
p = 13.71-100 + (95 x .975)
= $6.34
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3.2 Use the normal BSOP equations but:Pa= PV of future Cash Flows
Pe= Given or CAPEX
R= Risk Free Rate
t= time to expiry (in years)
s= standard deviation
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45%
50%
$50m
s=$4.85m
$ 50m-(1.65 X $4.85m) =$42m
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Chapter Nine
Risk Management
1 Introduction
1.1 I expect Shish may well write an article on this topic as
guidance. I would guess that it will cover how he
expects students to deal with this topic at P4 level. This
chapter has been written in anticipation of that article.
1.2 Risk Management is a substantial part of ACCA P1. A lot
of that knowledge will be required here but with some
emphasis on particular areas.
2
Summary of P1
market
credit
liquidity
technological
legal
health and safety
reputation
business probity
derivatives
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Identify
Assess
Measure
Avoid
Accept
Hedge/Reduce Effect
Business Risk
Financial Risk (Chapter 4)
Foreign Currency Risk (Chapter 10)
Interest Rate Risk (Chapter 11)
Business Risk
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Portfolio Theory(PT)
Perfect
Negative
Correlation
+1
No Correlation
Perfect
Positive
Correlation
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Unsystematic
Risk
Systematic Risk
20
No of investments
6.3 PT removes one part of Sp unsystematic risk. This is the
specific risk caused by factors relating to the company or
industry.
6.4 The risk remaining is systematic risk-that caused by
general economic and political factors. This can be
measured via Beta factor.
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7 CAPM
7.1 Once the market portfolio fully diversified position has
been reached ,the company and shareholders should use
CAPM.
Risk =e
Return= RF + (Rm-RF)e
OR
RF + (ERP)e
7.2 Remember from Chapter Two Cost Of Capital how a e
can be analysed.
8 WHY DO DIRECTORS LIKE TO HAVE A DIVERSIFIED
BUSINESS?
Several Reasons:
Stabilise profits
Lead to move predictable cash flows
Larger or safer business
Conglomerate theory-some directors feel they can run
any type of business (Virgin, Tata)
Foreign acquisitions will reduce economic risk.
Risk of the investment failing a more of a problem for
the shareholder than the director
May be the only expansion option.
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Chapter Ten
Foreign Currency Risk
Management
1. Translation Exposure
1.1 Risk caused by change in the value of a Forex asset or
liability over the long term.
1.2 Example: ABC plc has a US subsidiary worth $10m.
2009
at $1.50
6.67m
2010
at $1.75
5.71m
Loss to equity
(0.96m)
at $1.50
6.67m
2010 -
at $1.75
5.71m
Gain to equity
0.96m
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2 Transaction Exposure
2.1 Change in the value of the spot rate over the short term
causing a cash gain or loss.
2.2
Must hedge!!
3 SPOT Rates
3.1 Rate of exchange at a point in time.
(Bid)
(Offer)
$1.5000 - $1.5555 /
Reciprocal and
cross over!!!!!
0.6429 - 0.6667 / $
(Bid)
(Offer)
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30 Sep
200K = Expected Receipt
( 120K)=Expected Payment
80K)
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External Hedges
2.
3.
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Technique
Home
Abroad
Todays Spot
Today
Answer
FX
1 + ints foreign
1+ints home
Future Date
Answer
FX
FX
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1.
2.
Setup Today
Ascertain the downside(d/s) risk
Bet on the d/s risk via the futures market.
No. of contracts =
Net FX Transaction
Futures Rate
Standard Contract Size (in currency of the
contract)
Work out tick / contract value
Deposit the returnable margin
3.
XXX
XXX
XXX
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5.4 Options
Right to buy (call) or sell (put) FX at a fixed rate over a
set period (American) or on a set date (European).
Technique: 1. Timeline-As for futures
2. Set up today
Ascertain if we need a put or a call option
Pick a strike rate from: 1. Cheapest premium or
2. Nearest to spot or
3. Best possible rate
No. of contracts
Transaction
Number
Strike Rate
Standard Contract Size
Summary
Number of contracts x size x rate.
Compute the premium and convert at spot
3.
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Cons
Forward Market
Fixed Rate, certainty
Inflexible/contract
Easy
Lose out on the upside
Cheap
Must ensure FX receipts
Tailored
arrive
MMH
Convert today
Complicated
Cheap
May not apply for FX
Tailored
receipt
Flexible
Futures
Effectively fix rate
Complicated
No cost
Small loss
Small gain
Need cash for margin
No tailoring
Options
Best hedge cover
Complicated
d/s risk only
No tailoring
Flexibility
Expensive
Lots of choice
7. SWAPS
7.1 In forex swap, the parties agree to swap equivalent
amounts of currency for a period and then re-swap them
at the end of the period at an agreed swap rate.
The swap rate and amount of currency is agreed
between the parties in advance. Thus it is called a
fixed rate/fixed rate swap.
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(5.0)
5.0
(0.5)
(5.0)
4.5
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m
With forex swap
Buy 100m pesos @20
Swap 100m pesos back
@20
Sell 100m pesos @40
Interest on sterling loan (5
x 10%)
(5.0)
5.0
2.5
(0.5)
(5.0)
7.0
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Chapter Eleven
Interest Rate Risk
Management
Interest Rate Risk
1 ISSUE
There are two issues / type of F9 questions: Term Structure of Interest rates
Risk Management.
2 Term Structure of Interest Rates
2.1 Interest rates on the market generally follow this
relationship:
Return on
Govt Bonds
(RF)
<
LIBOR
(Interbank
Rate)
<
Lenders
Rates
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%
The standard of the
yield curve
The curve is upward due to:a) Liquidity Preference Theory- the longer there is to
maturity the greater the return wanted by the lender.
b) Expectations theory-the yield reflects the expectation of
higher future inflation rates
2.4 Some research has indicated it may not be a curve but a
kinked function.
%
5 years
Years to
Maturity
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No of years of maturity
3 Risk Management
3.1 Normally, this occurs when a company has produced a
short term budget and believe that in the near future
they will run up a cash deficit (possibly a surplus). They
want to hedge against interest change that could damage
their profits.
3.2 For example
1 Jan
Now
31 Mar
(Deficit)
Pay o/d interest
for 2 months
31 May
Return to
surplus
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3.3 To hedge this risk a company has two basic choices: Lock the Rate
Ceiling/ cap the rate
4 Lock the Rate
4.1 Forward Rate Agreements
Companies can lock the future interest rate by
purchasing a FRA from the markets. There is no fee
payable but the market likes to deal with minimum loan
size of $1m.
On the day the company pays the interest to the loan
provider a settlement/cash transaction takes place
between the company and the seller of the FRA.
4.2 Futures
The aim here is to lock the interest rate to a value
approximately the same as the current value of
interest.
The Futures market is similar to spread bettingtaking a bet that the interest rate will change from
current position.
The hedge is complicated due to:
i.
ii.
iii.
Margins/deposits
iv.
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CEILING/CAPPED RATE
5.1 IRG
All aspects are the same as a FRA except
1) Rate is capped /maximum is created
2) Fee is payable up front.
5.2 Options
All the aspects same as a Futures hedge except
1) Create a ceiling by buying a put option
2) Pay a Fee
3) No margins/deposits
6 SWAPS
6.1 Longterm method of hedging where companies swap
their interest commitments but no their loans.
6.2 Class Illustration
Company A wishes to raise $10m and to pay interest at
a floating rate, as it would like to be able to take
advantage of any fall in interest rates. It can borrow for
one year at a fixed rate of 10% or at a floating rate of
1% above LIBOR.
Company B also wishes to raise $10m.They would prefer
to issue fixed rate debt because they want certainty
about their future interest payments, but can only
borrow for one year at 13% fixed or LIBOR+2%floating
as it has a lower credit rating than company A.
Calculate the effective swap rate for each company
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Fixed
10%
13%
Float
LIBOR +1%
LIBOR +2%
Want
FLOAT
FIXED
=LIBOR +12
=LIBOR+14
2%
B
12(w1)
Net = LIBOR
Rate
LIBOR+2
Net Rate=12
(w1) B-(0.5 x 2) = 12
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Chapter Twelve
Business Valuation &
Acquisitions
1 Valuation Methods
1.1 The aim is to find a range of values for a
company. The answer can be presented:a) Ve
b) Po
1.2 Net Asset Valuation
1.2.1 Business is worth just the value of its Net Assets.
To establish the net assets:Total Assets-(Total Liabilities +Preference Shares)
1.2.2 The Net Asset value equals the Ve and can be based
on:a) Book Values
b) Net Realisable Value(NRV)
c) Replacement cost
1.2.3 Useful For:a) Seller to set minimum value of the company
(NRV)
b) Companies with lots of tangible high value
assets.Eg: Property Investment company
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DPS
$0.45
$0.49
$0.52
$0.54
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g= 3 (0.54)-1
(0.45)
g=0.063
b) Gordon Growth Model
g=bre
where b=Profit retention ratio
re= ARR or Cost of equity
eg A company has a retained profit ratio of 0.45.It has
an ARR of 12% and re of 14%.
Short term g=0.45 X 0.12=0.054
Long term g=0.45 X 0.14=0.063
1.4 Price Earnings Model
1.4.1 A business is worth a multiple of its profits.
1.4.2 Ve=Sustainable PAT X Suitable P/E
Po=Sustainable EPS X Suitable P/E
1.4.3 Sustainable PAT-have to adjust the latest reported
reports for non-reoccurring items (post tax)
1.4.4 Suitable P/E:a) Take a proxy Company P/E
b) Adjust to suit the company we are valuing.
c) Simple rules
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1.5.4 Example
A company has FCF for equity currently at $400m. It
has a re of 8.5% and returns 30% of its profits. If
growth is expected in perpetuity what is the Ve?
g =b X re =0.30 X 0.085 = 0.0255
Ve= FCF0(1+g)
(re-g)
= $400m (1.0255) = $6,894m
(0.085-0.0255)
1.5.5 Another Example
A company has projected its FCF to equity at:T1
T2
T3
$420m
$490m
$510m
T1
420
1/1.0792
389
T2
490
1/1.07922
421
T3
510
1/1.07923
406
T4-F.Ever
510(1.03)
16.171*
8,495
Ve=$9,711m
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1
X
1
= 16.171
3
(0.0792-0.03)
(1.0792)
X
(X)
Value Spread
Tax @X%
(X)
1/r
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r =Cost of Capital
4) Value of Equity is
Value of IC + Book value of the Assets
Option Valuation Method
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year
year
year
year
75
95
120
135
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Answer
The approach to answering this question is as per Bob Ryans
article in Novembers Student Accountant. The basic process
is to recognise that the equity represents a call option to
purchase the company from the debenture holders in three
years time.
Firstly, calculate the exercise price. This is the redemption
value of the debt BUT including the interest element also.
This requires calculating the fair value of the debt and then
converting it to a zero coupon bond with the same fair value
and time to maturity to obtain a redemption value
incorporating interest as well.
Required yield=risk free rate + credit premium = 4.25+1.20
=5.45%
Fair value calculation:
Year
1
2
3
4
C. Flow
4
4
4
125
DCF (5.45%)
0.9483
0.8993
0.8528
0.8528
Fair Value per 100
PV
3.79
3.60
3.41
106.60
117.40
For a 3 year zero coupon bond to have the same fair value,
the redemption premium would need to be:
Premium in 3 years =117.40 * (1+5.45%) 3 = 137.66
Therefore, theoretical exercise price=137.66/100*900m=
1,238.94m
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1,238.94
1,450.00
0.0425
3
1
(1,450-1,238.94)
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X
X
X
X
XX
X
X
X
X
XX
XX
(XX)
XX
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Cash offers
Advantages:
When the bidder gas sufficient cash the takeover can
be achieved quickly and at low cost.
Target company shareholders have certainty about the
bids value i.e. there is les risk compared to accepting
shares in the bidding company.
Increased liquidity to target company shareholders,
i.e. accepting cash in takeover, is a good way of
realising an investment.
The acceptable consideration is likely to be less than
share exchange as there is less risk to target company
shareholders. This reduces the overall cost of the bid
to the bidding company.
Disadvantages:
With the larger acquisitions the bidder must often
borrow in the capital markets or issue new shares in
order to raise the cash.
Target company shareholders liable to CGT.
Target company shareholders do not participate in new
group.
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Loan Stock
Advantages:
Low cost when interest rates low.
Interest payments tax deductible
Less dilution of EPS than in a share for share
exchange.
Disadvantages:
Increases gearing hence shareholders risk.
Share Exchange
Advantages:
Shareholders of the acquired company will be
shareholders in the post acquisition company.
Can finance very large acquisitions.
Disadvantages:
Price risk- there is a risk that the market price of the
bidding companys shares will fall during the bidding
process, which may result in the bid failing.
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Chapter Thirteen
Company Performmance
Analysis
Ratios
1. Ratios-You must Learn!!!!
1.1 Investor
EPS = PAT less Preference Dividends
No of ordinary shares in issue
P/E = Po
EPS
Dividend Cover= EPS
DPS
Payout Ratio = DPS
EPS
Dividend Yield = DPS
Po
Total Shareholder = Dividend for + Capital Gain
Return(TSR)
the year
for the year
Share Price at start of the
year
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1.2 Gearing
Capital Gearing= Debt or Debt
X 100
Equity
Debt+Equity
NB Preference shares are generally treated as debt.
Interest Cover = Operating Profit
Interest
1.3 Profitability
ROCE = Operating Profit X 100
Equity +Debt
ROE = PAT X 100
Equity
Margin = Operating Profit X 100
Turnover
1.4 Liquidity
Current Ratio= C.Assets
C.Liabilities
Quick/Acid Test = (C.Assets-Inventory)
Ratio
C.Liabilities
Inventory Days=
Inventory
x 365
COS or purchases
------------------------------------------------------------------------------------------------------------
Operating Profit
Add: Depreciation
$000
xxx
xxx
Change in Inventory
Change in Receivables
Change in payables
xxx
xxx
xxx
xxx
Sale of NCA
Issue of Shares
New Loans
xxx
xxx
xxx
Tax paid
Interest paid
Dividends paid
Purchase of NCA
Loans repaid
(xxx)
(xxx)
(xxx)
(xxx)
(xxx)
Share buyback
(xxx)
xxx
xxx
$xxx
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f. Example
The directors of Old Nick plc wish to establish whether
they have increased shareholder value in the year to
September 20X2. They use the EVA model.
Profit and loss account for year ended 30 September
20X2
m
Turnover
150
PBT
50
Tax
18
PAT
32
Dividends
10
Retained earnings
22
Additional information:
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
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Required
Calculate the EVA in the year to September 20X2 and
the value of the equity.
g. Solution
WACC
NOPAT:-
m
32
15
47
3.25
PAT
Add: Non cash Expenses
Add: Post tax ints
(5m X 0.65)
50.25
EVA = 50.25m (10.75% X 108m)
= 38.64m
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Chapter Fourteen
Corporate Reconstruction
and Reorganisation
1 Causes of Corporate Failure
Corporate failure when a company cannot achieve a
satisfactory return on capital over the longer term:
If unchecked, the situation is likely to lead to an ability
of the company to pay its obligations as they become
due.
The company may still have an excess of assets over
liabilities, but if it is unable to convert those assets into
cash it will be insolvent.
The issue is more problematic in sectors, or economies,
where profitability is not an issue. For example, in the
former Soviet Bloc, the economy simply does not
identify poorly performing companies
For not-for-profit organisations, the issue is usually one
of funding, and failures indicated by the inability to raise
sufficient funds to carry out activities effectively.
Although stated in financial terms, the reasons behind
such failure are rarely financial, but seem to have more
to do with a firms ability to adapt to changes in its
environment.
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X1
X2
X3
X4
X5
Ratio
Working capital to total
assets
Retained earnings to
total assets
Earnings before
interest and tax to
total assets
Market value of
equity(including
preference shares)to
total liabilities
Sales to total assets
Included to measure
Liquidity
Gearing
Productivity of the
companys assets.
The extent to which
the equity can decline
before the liabilities
exceed the assets and
the company becomes
insolvent
The ability of the
companys assets to
generate revenue.
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