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P4 Advanced Financial Management

CH 1: Financial Strategy Formulation and the role and responsibilities of senior financial executive
Financial Involve (planning): 1. Establish and identify objectives 2. identify alternative courses of action 3. evaluate 4. select 5. Implement ->
Planning and (Control): 6. monitor actual results to ensure that actual performance is proceeding according to the plan 7. Respond to divergences
Control from plan
Investment Investment Appraisal + Financing Decision + Dividend Decisions
Decision
Factors to Cost, risk, flexibility, matching/purposes, amount involved, security
consider for
Capital Structure
Methods of 1. Prospectus 2. Placing (with issuing house/institutional investor) 3. Stock exchange introduction 4.Offer for Sale (To issuing house
obtaining Stock and issuing house then to public) 5. Offer for sale by tender (Offered to public but not at fixed price)
market listing
Problems facing Risk, Security, Marketability of ordinary shares, Tax considerations, Cost, Lack of information, Funding gap, maturity gap
small businesses
in financing
Dividend Traditional theory Dividend payout influence the market value bc 1. Information content (Dividend signaling) 2. Transaction cost of
Relevance raising new finance avoided 3. Preference for current income 4. Distorting taxes
Theory
Dividend Modigliani and Miller (M&M) value of the firm is determined by its future earning stream and thus dividends and retention has no
Irrelevance impact. Assumptions: 1. $H knows everything 2. No transaction cost 3. No distorting taxes 4. Share price move in the manner
Theory predicted by the model

CH 2: Conflicting Stakeholders Interest


Stewardship Mgtment as steward who prioritizes company's strategy
Theory
Agency Theory Mgtment as agent who prioritize own interest and will only watch out for company performance when both goals coincide.
Stakeholder Mgtment ahas duty of care that extend beyond shareholder to the wider public
Theory
Cadbury Code Corporate Governance = System by which companies are directed and controlled
1992

CH 3: Cost of Capital
Cost of Equity P0 = D0(1+g)/(Ke-g)
Share Capital
Gordon's Growth G = rb. Assumption: 1. Entity is entirely equity financed 2. Retained profit is the only source of finance 3. Constant proportion of
model earnings is retained (b) 4. projected earns constant rate of return (r)
Cost of Kps = D(net)/P0(ex-div)
Preference Share
Cost of debt Irredeemable: Kb = Interest (1-T)/MVd(Ex-div); Redeemable: Kb = yield to maturity = internal rate of return
WACC Basic Principles: Cost of capital required for investment appraisal = cost of raising more capital (historical cost of capital = irrelevant),
Assume that co. Maintain same mix of capital; Uncertainties and assumptions: (1) g = historical avg (2) assume that current share
price is a reflection on logical investor behavior- Perfect market condition (3) Corporate Tax is constant (4) Risk class= assumed same
as existing project

CH 4: Portfolio Theory and Capital Asset Pricing Model (CAPM)


CAPM assess the investment from the viewpoint of well-diversified shareholders using beta factor (Systematic risk), Ke = Rf+B(Rm-Rf), if B =
0=> risk free, if B = 1 => neutral (risk same as market), if B > 1, aggressive (riskier), If B < 1, defensive (less risky)
Assumptions (1) All $H hold the market portfolio (2) Perfect Capital market (3) Investor can borrow and lend at risk free interest rate (4) Single
period (5) Investors have same expectation
Advantages 1. Demonstrate unsystematic risk can be diversified away 2. best practical mtd for Ke of public company 3. Highlight relationship of
risk and returns 4. Provide a risk adjusted discount rate for investment appraisal
Limitations 1. Concentrate purely on systematic risk/diversified portfolio 2. Treats dividend and Capital gains as equally desirable to investors
and ignore tax position 3. Single period model 4. Requires data hard to obtain such as Rf, Rm, Beta 5. Not suitable for small
companies

CH 5: Theories of Capital Structure


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Traditional Debt => Increase financial risk and gearing, but is cheaper than equity
Theory
M & M 1958 (No Tax) => All companies with the same earnings in the same risk class have the same future income stream and should therefore
have the same value, independent of capital structure: Vg = Vu, Keg = Keu+(Keu-Kb)D/E, WACCg = WACCu(Keu), but it assumes
investors r rational and info is everywhere, no tax/transaction/cost, debt is risk free
M & M 1963 (With Tax) => Companies with higher gearing ratio have greater net future income stream purely due to tax shield: Vg = Vu + DT, Keg
= Keu+(Keu-Kb)D(1-T)/E, WACCg = WACCu-DT/(E+D)
Risk of Debt 1. Bankruptcy cost, 2. Agency cost (restrictive covenant), 3. Tax exhaustion, 4. Debt capacity
Beta Asset (Ba) Reflects systematic business risk only
Beta Equity (Be) Reflects systematic business risk and financial risk. If all-equity co, Ba = Be; If geared co, Be>Ba => Ba = Be(E/E+D(1-T))
Project Specific Suitable for company diversifying into another industry/new investment (Affect both business and financial risk). Steps: 1. Identify
Cost of Capital proxy beta = avg equity beta of the industry, 2. Ungear Be to Ba, 3. Regear Ba to Be that reflects the mtd of financing, 4. CAPM: Ke =
Rf+Be(Rm-Rf), 5. WACC= KeMVe+KdMVd
Pecking Order Firms have a preferred hierarchy of financing decisions based on convenience: RE, Straight debt, Convertible Securities, Preference
Theory shares, and equity shares

CH 6: Reporting financial Performance, Investment Appraisal techniques and the use of FCF
Investment Accounting Rate of Return (ARR = Annual profit post depreciation/Average investment), Payback period, Discounted CF:NPV and IRR
Appraisal (Yield = a%+NPVa/(NPVa-NPVb)*(b5-a%))
Techniques
Modified Internal Adv: 1. eliminate multiple IRR 2. address the reinvestment issue facing IRR 3. Provides ranking which is consistent with NPV 4.
Rate of Return Provide % instead of value; Steps to calculate: (1) Convert all investment phase output into a single equivalent payment at time 0 (2)
(MIRR) All net cash inflow convert to single terminal receipt at the end of the project's life, reinvestment rate using company's cost of capital
(3) MIRR =(Outflow/inflow)^1/t 1
Discounted Length of time the DCF required to recover the original cash outlay
Payback
Duration Avg time taken to recover the CF on an investment. Steps: 1. Calculate value of each fcf and discounted at DF, 2. Calculate each
year's DCF as a proportion of the original outlay, 3. Take the time from the investment and multiply with the proportion in (2), 4.
Sum the weighted year values Duration. If duration is based upon the avg time to recover the initial capital investment, DF = IRR; IF
the duration is based upon the avg time taken to recover the PV of the project, DF = Chosen hurdle rate.
Capital Rationing Hard vs Soft; Single period vs Multi-Period; Divisible (Profitability index/linear programming) vs Indivisible (Trial and error, integer
programming)
Dual Values Shadow prices which reflects the change in the objective function as a result of having one more or less unit of the scarce resource.
Free Cash Flow Cash that is not retained and reinvested in the business, available to be distributed to providers of capital = EBIT Tax + Depreciation
(FCF) WC CAPEX
Free Cash Flow Represents the funds available for distribution only to ordinary $H, measures the dividend capacity of the company = FCF Interest
to equity (FCFE) payments loan repayments + CF from issuance of debt
Dividend cover FCFE/Dividend paid
Risk Mtds of treating = sensitivity analysis, probability estimate of CF, certainty equivalent, adjusting Discount rate, simulation modeling

CH 7: Impact of financing on investment decisions and Adjusted Present Values (APV)


APV Suitable when (1) New investment and thus operating risk changes (2) significant change in capital structure and financial risk (3)
Investment has complex tax payment and allowance (4) Subsidized loans and benefits involved. Steps: (1) Calculate base case NPV
using ungeared Ke as DF as if it were all equity financed (2) Calculate PV of side effects of financing the project (Tax shield, issue cost
of debt, subsidies) and add to Base case NPV = APV
Monte Carlo Maths model which include all combinations of potential variables associated with a project, resulting in the creation of a
Simulation distribution curve of all possible cashflow and probabilities of different outcomes to be calculated.
Value at Risk Value attached to the downside of a price distribution (Stad deviation) and within a confidence level. At 95% confidence, X-100/s = -
(VaR) 1.65; At 99% confidence, X-100/s = -2.33

CH 8: Application of Option Pricing Theory in Investment Decisions


Option Right to buy (CALL) or sell (PUT) a fixed amt of financial asset at a specific exercise price fixed today (Exercise or strike price) on or
before the maturity date. (In-the-Money) happens when mkt price > exercise price (Call) or market price < exercise price (PUT). Out-
of-the-money = opposite. At-the-money happens when market price = exercise price
Intrinsic value of Profit that the buyer of an ITM option could make id the option were to be exercised immediately.
option
Factors Price of Underlying instrument, exercise price, prevailing interest rate, time to expiry of option, volatility of underlying item => Black
determining Scholes Option Pricing model (European style option pricing model). American style will be higher than European pricing
Pricing of Option
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Black Scholes Assumption and Limitations: 1. Returns on the stock is normally distributed, 2. std deviation (is difficult to determine) and it's
Option Pricing assumed to be constant over the life of option, 3. transaction cost and tax = 0, 4. share pays no dividend (If dividend is paid before
model the date of expiry, simply reduce the share price by the PV of dividend, PV = De-rt), 5. European exercise term, 6. mkt is efficient and
operate continuously, 7. Rf is known and constant. (Impact of changes in s and t have large impact on the values of pricing).
Formulas given.
Put-call parity Price of put P = Price of call C Current value of underlying security Pa + PV of the exercise price Pee-rt
The Greeks Assessment of sensitivity of factors influencing the value of the options: 1. Delta = Changes in Option premium/ Change in Value of
underlying security (Range from o to +1 for call options, 0 to -1 for put option, ITM = 1/-1, OTM = 0, ATM = .5/-.5) => Determine how
much should the option writer hedge; 2. Gamma = change in delta/change in price of the security, 3. Vega = change in option
price/change in volatility, 4. Theta = change in option price/change in time to expiry, 5. RHO = Change in option price/change in
interest rate
Real Options Apply BS model in the evaluation of financial options of capital investment appraisal: Option to delay/expand/new investment = Call
option, Option to abandon/redeploy = Put option. Valuation: Pa = PV of FCF of project, Pe = CAPEX or receipts from the option, s =
volatility of project, r = risk free rate, t = time to expiry (European Style)
BS Model to Pa = FV of assets of the company (PV of FCF), Pe = settlement values of outstanding liabilities (Assumes all company's liabilities =
estimate value of zero coupon bond then adjust by getting the redemption value/Future value of the zero coupon bond), s = std dev of underlying
equity assets, r = current yield on company debt, t = avg period to settlement of co liabilities => Findings: 1. Value of the option increases as
the level of risk (r) increases, 2. Even Pa fall to the same as Pe, the value of option is not 0. Only if t = 0, then price = 0. 3. When near
At-the-money position, companies become risk aggressive as time value will become significant

CH 9: International Investment and Financing Decisions


Steps of 1. Identity relevant CF in local currency, 2. Deal with inflation, 3. Deal with local tax, 4. Deal with inter co transaction such as
calculation management charge, dividend, transfer pricing, loan interest and royalties, 5. Estimate FOREX (Spot rates) 6. Deal with double
Overseas Project taxation 7. Apply Cost of capital for PV.
NPV
FOREX rate 1. Purchasing Power Parity Theory (PPPT), S1 = So*(1+ho/I+h1), 2. International Fisher Effect, Fo = So*(1+i0/1+i1)
forecast
Cross Rate Computation of exchange rate for a currency from the exchange rate of 2 other currencies
Exchange rate 1. Transaction risk = gains/losses made when settlement takes place at some future date of a foreign currency denominated contract
risk entered. 2. Translation risk = result from restating the BV of Foreign asset in the consolidation report, does not affect co's CF, 3.
Economic risk = Operating and competitive exposure caused by the unexpected foreign economic situations
Overseas Short-term: 1. Eurocurrency loan = loan given by a bank denominated in foreign currency, 2. Syndicated loan Market = 2 or more
Projects Funding banks brought tgt by a lead bank to provide a large sum of money to borrower and therefore reduce the risk exposure; Long term
funding: 1. Equity, 2. Loan, 3. Govt grants, 4. Eurobond = bond issued in >1 country simultaneously, 5. Euroequity = equity sold
simultaneously in >1 stock markets to ensure larger issues, wider distribution, international recognition and avoid queuing
procedures in some national markets
Factors 1. Acceptable level of gearing, 2. availability, 3. size, 4. availability of collateral security, 5. cost, 6. tax relief available, 7. currency
determining type risk, 8. political risk
of finance

CH 10: Impact of capital investment on financial Reporting

Effects of 1. Financial Risk: Gearing ratio, 2. interest cover, 3. EPS


financing options
Double Taxation Occurs when the same income is taxed twice. DT relief ensure that tax payer finally suffer tax at no more than the higher of the two
tax rate using 1. Exemption method, 2. Credit method

CH 11: Acquisitions and Merger


Synergy Occurs when >= 2 activities/processes complement each other to provide combined effect greater than individual parts: 1. Revenue
synergy (Vertical integration, eliminate competition, and complementary resource), 2. cost synergy (Economies of scale, scope,
elimination of inefficiency, effective use of managers), 3. Financial Synergy (Elimination of inefficient pactices, utilize tax losses and
surplus cash, diversification)
Failure of 1. Agency theory, 2. Integration failure, 3. Over-optimistic, 4. Paying too high premium, 5. Inadequate investigation, 6. Never spend
acquisition enough time in newly acquired business
Organic Growth Adv: 1. Avoid paying premium 2. Minimal risk, 3. careful planning, 4. No integration Prob
Acquisition Adv: 1. Eliminate competition, 2. Avoid barriers to entry, 3. quicker rate of growth, 4. Synergy
Post-acquisition A) Druker's Golden 5 Rules: 1. share common core of unity, 2. ask what can we offer them?, 3. treat target co's pdt and ppl with
Integration respect, 4. provide skilled mgtment to target co, 5. make cross entity promotion of staff; B) CS Jones' 5: 1. Reduce uncertainty in
initial relationship 2. Rapid control 3. Resource audit 4. Corporate objective redefined 5. Organizational structure revised

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Earn-out Purchase consideration = initial payment + balance depending upon the financial performance of the target co. Adv: 1. Reduce initial
arrangement payment, 2. reduce risk, 3. encourages managers to work hard
Methods of For Predator, Depends on 1. Control, 2. Earnings per share, 3. Authorized shares 4. cost to the co, 5. gearing; For target co, depends
Payment on 1. Taxation, 2. share price, 3. further investment
Accounting for Goodwill: (Acquisition) recognized (Merger) no; Value of shares exchanged: (Acquisition) recorded at market value (Merger)
merger and recorded at nominal value; Pre-post profit: (Acquisition) only post (Merger) Both pre and post based on conditions: 1. No party is
acquisition acquirer, 2. both party jointly manage the co, 3. Relative size of co is similar, 4. Equity holder receives consideration from the
combined business
Regulations of The city code of takeover and mergers- regulates acquisitions of quoted co in UK. Main obj: all Shareholders are treated fairly where
takeover $H should be informed of the identity of bidder, info and time to reach decision etc.
Office of free Responsible for ensuring acquisition will not result into monopoly. Competition commission has <= 6 months to conduct investigation
trade before reporting to the Secretary of State on whether the acquisition is agst public interest. Shareholder Model (Market-based
model) is designed to protect the rights of shareholders. Stakeholder regulations (Block-holder model regulation) is designed to
protect a wider group of stakeholders
Takeover 1. Appeal to shareholders on undervaluation 2. Appeal to Competition Commission 3. White knight defence- find more acquirers to
Defense compete, 4. Pac-mac defence reverse takeover, 5. Selling Crown jewels- selling off highly valued assets, 6. Golden parachute
Introducing attractive termination packages to senior executives and make it expensive, 7. Share-repellent/super majority Change
MA&AA to require very high % of shares to approve, 8. Poison Pill Give $H rights to buy future loan and preference share and
automatically convert into ordinary shares- make it expensive to buy

CH 12: Valuation for Acquisitions and Mergers


Types of 1. Acquisition that do not disturb the acquirer's exposure to financial and business risk (Valuation model: 1. Asset Valuation Model,
Acquisition 2. Market relative model, 3. Cashflow model), 2. Acquisition that do not disturb business risk but affect financial risk (APV method),
3. Acquisition that disturb both business and financial risk (Modified WACC method)
Asset Valuation MV = Asset-liabilities using 1. NBV, 2. Net realisable value, 3. Net replacement cost Adv: Info available, reliable, simple and easy.
Model Disadv: Key assets such as skillful workforce are ignored, Historical cost, can be manipulated, future profitability expectation is
ignored.
Intellectual The value platform- IC = human capital, organisational capital and customer capital. Method of valuation: 1. Market-to-book
Capital Valuation values (ICV = MV NBV), 2. Tobin's q = ratio of the market value of enterprise to the replacement cost of its assets (Q = Market Cap /
Replacement cost or book value) and IC = q*NBV, 3. Calculated Intangible value (CIV) 7 steps to determine the proportion of return
attributable to intangible assets: 1. Calculate PBT, 2. YE tangible assets, 3. Return on assets (ROA) = PBT/Asset, 4. Find industry avg
ROA, 5. Excess return = Industry ROA*Co's Tangible assets PBT 6. Excess Return (1-T) = After-tax premium allocated to intangible
assets, 7. NPV of the premium = CIV.
Market relative Price Earnings (P/E) Ratio => Share Price = EPS*PE. Adv: easy, convenient, and applicable to co without dividend, Disadv: Easily
Valuation Model manipulated, historical, not useful for loss-making co, difficult to obtain similar quoted co
Earnings Yield EY = 1/PE
Mtd
Dividend Suitable for minority shareholder with no influence, P0 = D1/(Ke-g) Problems: Uncertainty of Ke, Difficult to forecast g, difficult to
valuation model udstand, and impossible to use if Ke<g. Or Share value = Dividend of Co being valued/Dividend yield of similar listed co.
Free Cash Flow Free cash flow to Equity (FCFE) = cashflow available to a co from operations aft interest expense, tax, repayment of debt and lease,
WC, and CAPEX => The best method to value a co in theory
Economic Value EVA = NOPAT (Net operating PAT = PBIT+dep+write-off GW + Provision increase+capital cost replacement cost dep amortisation
added (EVA) tax paid) Capital Charge (Investor required ROC = WACC*adjusted capital employed: Capital employed = NCA+CA+GW+Provision
+NBV of capitalised cost Non-interest bearing liabilities eg Trade and ax payables) => Corporate Value = PV of EVA (Discounted by
WACC) + Adjusted Capital employed.
Market Value Value added to business since it's formed = Market Cap NBV => Evaluation of management performance
Added (MVA)
Valuation of high Gordon's Growth Model where Revenue/Ke-g Cost/Ke-g = MV
growth start-up

CH 13: Corporate Reconstruction and Reorganisation


Capital Confirmation by court is not necessary for pte co id directors make a Solvency statement. Scheme: 1. reduce liability of shares,
Reduction cancel any paid up shares and repay any paid up shares. Objective: write off debit balances, write off asset values, revalue all assets,
Scheme and reorganize capital structure of a co.
Reconstruction Principles: 1. Creditors must be better off than liquidation, 2. Co must have good chance of financially viable, 3. Must be fair to all
parties involved (Creditors Priorities: Taxes and unpaid wages> Secured debts (Fixed charge) > Secured debts (Floating charge) >
unsecured debts > preference shareholders > ordinary shareholders), 4. Adequate finance is provided for co's needs. Assessment
steps: 1. Calculate Position under liquidation (And % each party will get), 2. Calculate the sufficiency of the amount of finance under
reconstruction, 3. Calculate position under reconstruction (And check if % each party gets improved and fairness), 4. Assess post-
reconstruction financial viability/profitability EPS/PE ratio 5. Conclusion
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Business Unbundling = disposal of assets / non-core biz such as sell-offs, liquidation, spin-off/demerger, and management Buy-out
Reorganization
Buy-out finance VC/ mezzanine finance, clearing banks, pension etc. Depending on the factors: 1. financial performance, 2. Market of pdt 3. Team
commitment 4. Management quality 5. Risk 6. Business operations 7. Exit route
Models of 1. z-score model (less than 1.8 = potential failure, more than 2.7 = success), 2. Zeta model (7 ratios for commercial confidentiality), 3.
predicting Beaver failure ratio (Operating cashflow/total debt must be bigger than survival threshold of +0.15), 4. Argenti Score = suggest that
corporate failure failure process follows a predictable sequence of firstly defects, then mistakes, then failure

CH 14: The Role of the Treasury function in multinationals


Capital Market Trading long term finance (Equity and debentures) Primary market = raise new finance + secondary function = existing investors to
buy sell securities
Floating in stock Adv: 1. Easier to raise cap 2. realise assets 3. reduction of risk 4. facilitate growth by acquisition 5. enhance co images 6. Employee's
market reward and retention stock option; Disadvantages: 1. Expensive to get listing 2. Admin burden for tight regulation 3. Stringent
corporate control 4. Dilution of control 5. Transparency trade off 6. vulnerable to take over
Money Market Market where ppl lend and borrow money for short period of time <1 year. Instruments: 1. coupon bearing instruments (Certificate
of deposits, repurchase agreement), 2. Discount Instruments (Treasury bills, banker's acceptance/banker's guarantee, Commercial
paper) 3. Derivatives (Forward contract, forward rate agreements (FRA), Futures, Options)
Role of treasury 1. Liquidity management, 2. Funding management, 3. Currency management, 4. corporate finance
management
function

CH 15: The use of financial derivatives to hedge against FOREX risk


Direct Quote No. of units of home currency to deal in one unit of foreign currency. If home = USD = variable currency, => ($1.725 / Euro 1), where
foreign = euro = base currency
Indirect Quote No. of units of foreign currency to deal in one unit of home currency. If home = USD, => (Euro 0.5797/$ 1)
Spot rate Price at which FOREX can be bought or sold today
Forward rate Rate quoted today for delivery at a fixed future date of specified amt of one currency agst another currency
Outright Full price to all of it's decimal point is given
Quotation
Point Quotation No. of point away from the outright quotation. Premium = subtract, Discount = added to spot rate
FOREX risk Currency risk = Transaction, Translation, and Economic risk
Internal Hedging Invoicing in domestic currency, Matching, Netting (setting the debtors and creditors of all companies in the group resulting from
Techniques transaction between them so that only net amt is paid/received and reduce transaction fee Bilateral netting, Multilateral netting),
Leading and Lagging
External Hedging Non-Derivative: 1. Forward Exchange contract, 2. Money Market Hedge, 3. Synthetic foreign exchange agreements (SAFE);
Techniques Derivates: 4. Currency future, 5. Currency Option, 6. Swaps
Forward Binding contract btw co and bank to purchase or sell a specified quantity of Foreign currency at a rate of exchange fixed when the
Exchange contract is made
Contract
Money Market Co borrow funds in one currency and exchange the proceeds for another currency. Steps: (Receipt of Foreign currency): 1. borrow
Hedge from foreign currency today, 2. convert to home currency immediately, 3. place it in deposit, 4. Repay the loan plus interest;
(Payment) 1. Borrow in home currency today, 2. Convert immediately to foreign currency, 3. Place it on deposit in foreign currency,
4. Repay the loan plus interest
SAFE No physical delivery of currency, difference between the non-deliverable forward (NDF) and spot rate is calculated and settled.
Similar to forward rate agreement, Use in countries that ban Forward exchange trading
Futures Legally binding agreement btw 2 parties to buy or sell a standardised quantity of a specific financial instrument at a future date, but
at the price agreed today, thru medium of exchange. Delivery date = 3 months, ticks = min. Price movement permitted by the
exchange, initial margin = sum deposited when contract is made, variation margin payable/receivable by marking to market,
basis = diff btw current market price and the futures price, Basis risk arises when the price of the future contact may not move as
expected in relation to the value of the underlying item which is being hedged. Perfect hedge = unlikely due to basis risk and the
round sum nature of the future contracts. Steps for calculation: 1. Determine what contract (Which month, buy or sell?), 2. No. Of
contracts = (Amt involved/contract size), 3. Calculate the closing price = spot + basis = tick and net gain/loss = no. Of
contract*contract size*tick, 4. Net cash flow = spot + Profit/(Loss)
Options Right to buy (CALL) or sell (PUT) a particular currency at a specified exchange rate on a particular date or up to that date. Steps: 1.
What contract (Contract maturing at the nearest date to transaction date, call or put= if buy the denominated currency = call, if sell
the denominated currency = put), 2. Calculate the no of contract for each exercise price given, 4. Calculate premium for each exercise
price, 5. calculate the over or under hedged amt, 6. Overall NCF
Pricing of Adapted version of BS model = Grabbe variant, where Pa = Forward rate, Pe = Spot rate using direct quote, r = home risk free interest
Currency Option rate, s = volatility, t = period

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Currency Swap Agreement btw 2 parties to exchange equivalent amt of currency at a predetermined agreed rate for a period and then re-
exchanged them at the end of the period. Benefits = Access to debt finance in another country less known, flexible and give co
exchange control. Risk: Market risk, credit risk, sovereign risk, liquidity risk

CH 16: The use of financial derivatives to hedge against Interest Rate risk
Forward rate Pre-agreed fixed interest rate for a specific level of borrowing for a given future period btw co and bank
agreement (FRA)
Interest rate Binding contract btw buyer and seller for delivery of agreed interest rate commitment on an agreed date at agreed price. Future
futures price = 100 r %, the higher the interest rate, the lower the future price. Borrower =SELL futures, Investor = BUY futures. Steps: 1.
What contract? (Months, buy or sell) 2. No. Of contract = (amt of loan/futures contract size)*(time period required for loan/3
months), tick size, 3. Calculate closing future price= future spot-basis, 4. Calculate profit/(loss) = contract price-closing price = gain
per contract = tick*contract size*no. Of contracts = total profit or loss, 5. Overall NCF
Options on Right to buy or sell the related interest rate futures contract. Borrower = PUT, Investor = CALL. Steps: 1. What contract? (Months, buy
Interest Rate or sell) 2. No. Of contract = (amt of loan/futures contract size)*(time period required for loan/3 months), tick size, 3. Calculate
Futures Premium and Calculate profit/(loss) = contract price-closing price = gain per contract = tick*contract size*no. Of contracts = total
profit or loss, 4. Overall NCF = borrowing cost + premium + Profit/(Loss)
Interest Rate Agreement to exchange their interest rate commitment. Benefits: 1. Lower than bank 2. Easy to organize 3. Flexible, reversible upon
Swaps agreement
Interest Rate Right to borrow or lend a notional amount for a given period at a specified interest rate on a specified future date. Borrower's
Options Option = CALL, Seller's Option = PUT
Interest Rate Right to a series of compensation if interest rates increase above the exercise price at each interest fixing date = borrower's option.
Caps
Interest Rate Right to a series of compensation if interest rates decrease below the exercise price at each interest fixing date = Lender's option.
Floors
Interest Rate Combination of purchasing interest rate cap and sell floors or vice versa to specify the range in which interest rate fluctuate. Adv:
Collars Lower overall premium. Borrower = buy cap sell floor, Investor = sell cap buy floor
Swaption Option to enter into an interest rate swap or currency swap = protection with flexibility. But once exercised irreversible
Macaulay's Total weighted avg time for recovery of a payment and principal in relation to the current market price of bond. Steps: 1. FCF, 2. PV
Duration of FCF @IRR, 3. Each year's FCF/MV of bond, 4. FCF/MV*time from investment, 5. Sum = weighted year values = measurement of
interest rate sensitivity. Bonds with higher durations have greater price volatility. Conclusion: Maturity increases, MV more sensitive
to interest rate; Coupon rate increase, duration decrease, less sensitive; Interest rate increase, duration decrease, less sensitive

CH 17: Dividend Policy in Multinationals and Transfer Pricing


Dividend Measured by Dividend cover, depending on: 1. Liquidity, 2. Control (Using RE to fund new investment can retain co control), 3. Debt
Capacity repayment obligations, 4. Growth/reinvestment opportunities, 5. Companies Act Restriction (Can't pay dividend out of capital), 6.
Information content of dividend, 7. Taxation, 8. Volatility of profit, 9. Other restrictions such as debt covenant / exchange control
Transfer pricing Objective: 1. fair, 2. motivate division manager, 3. retain divisional autonomy, 4. ensure overall group profit 5. Goal congruence.
Basis of setting TP: 1. Market-based (Appropriate where there is external market), 2. Cost-based (Appropriate when there is no
external market=> Full cost, full cost-plus, marginal cost, marginal cost-plus)=> If there's external market but there's spare capacity
in the producing division, TP should be based on cost rather than market price, 3. Negotiated transfer price
TP in Based on 1. Fund positioning effect, 2. Income tax effect (Min, but must reflect an arm's length price 1. Comparable uncontrolled
multinationals prices to unrelated customers, 2. Resale price, 3. Cost-plus), 3. Managerial incentives and evaluation, 4. Tariff and quota effect
(Import duties effect)

CH 18: Other forms of Risk


Political Risk Impossible to quantify, manage by investment structuring, local borrowing, negotiation with govt, and being good citizen
Economic risk Govt spending policy, recession, unemployment, international trading condition, currency
Regulatory Risk Anti-monopoly law, Health and Safety law, Copy right law, employment legislations
Fiscal risk Increase of tax, import duty, WHT etc
Credit Factors: Credit policy of organization, Credit limit and term, Credit assessment procedures, debt collection procedures
Risk/Default Risk
Kaplan- Urwitz Determine the credit score of a co. S > 6.76 = AAA, S >0 = BB
model
Credit Spread Premium over an equivalent return on risk free bond to compensate the investor for credit risk = Rf+S (Rf = risk free rate, S = credit
risk)

CH 19: Economic Environment for Multinationals


Adam Smith Absolute Advantage
David Ricardo Comparative Advantage
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Trade Bloc Free trade area, Customs Unions, Common Market
WTO, MNC, Free Trade vs Protectionism, Balance of payment, IMF, EMS, Currency crisis, Counter trade
Source of finance Bank Overdraft, Bill of exchange, Promissory note, documentary letters of credit, factoring, forfaiting (Banker's guarantee), leasing
for foreign trade and hire purchase, acceptance credits (To accept bill of exchange on continuing basis), produce loans (Immediate resale goods being
taken into custody of bank for the proceeds of the sale and interest), Payment in advance by importer

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