This action might not be possible to undo. Are you sure you want to continue?
June 2010

ACCA
P4
Advanced Financial Management
Key Point
Notes
June 2010
These notes are not intended to cover the whole syllabus, but target key examinable areas.
Tutor:
Sunil Bhandari
Tutor Contact Details
Mobile: 07833 096979
Email: via
www.IntelligentAccountancyTutorsLtd.co.uk
Copyright to Intelligent Accountancy Tutors Ltd
________________________________________________________________________
Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk
1
ACCA P4 Advanced Financial Management Key Point Notes
June 2010

Use of these Key Point Notes
These notes have been written as an aid to assist students
preparing for the ACCA P4 June 2010. They accrue for the
topics tested in the past exams.
It is of paramount importance that they are used with an up
to date Revision Kit (KAPLAN or BPP). A combination of
using the notes and question practice is the best way to
prepare for the forthcoming exams.
________________________________________________________________________
Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk
2
ACCA P4 Advanced Financial Management Key Point Notes
June 2010

Index
Chapter Number Chapter Name
Page Numbers
Preliminaries
516
Chapter One
Cost of Capital
1726
Chapter Two
Capital Structure &
Raising Finance
Dividend policy
2735
How lenders set their
Interest Rates
Advanced Investment
Appraisal
Adjusted Present Value
4146
6570
Chapter Eight
Modified Internal Rate of
Return (MIRR)
Capital Rationing
Chapter Nine
Foreign Currency Risk
7584
Chapter Ten
Interest Rate Risk
8596
Chapter Eleven
Valuaton of
Options+Value at Risk
97112
Chapter Twelve
Business Valuations &
115134
Mergers &
Acquisitions
Modern Valuation
135139
Methods
Corporate Reconstruction 141145
& Reorganisation
Chapter Three
Chapter Four
Chapter Five
Chapter Six
Chapter Seven
Chapter Thirteen
Chapter Fourteen
Chapter Fifteen
Question 4 & Emerging
Issues
3739
4757
5964
7174
147148
________________________________________________________________________
Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk
3
uk 4 .IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.co.
ACCA P4 Advanced Financial Management Key Point Notes June 2010  Exam Formulae and Tables ________________________________________________________________________ Sunil Bhandari – www.uk 5 .IntelligentAccountancyTutorsLtd.co.
co.uk 6 .ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.
ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.uk 7 .IntelligentAccountancyTutorsLtd.co.
ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.uk 8 .IntelligentAccountancyTutorsLtd.co.
ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 9 .
uk 10 .co.IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.
Try to attempt all parts to all the questions.co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Exam Technique First 15 minutes Read the questions carefully Recognise the topic being tested I would recommend that Section B questions are done first and then Section A Next 180 minutes Attempt the questions in your ranked order. If in doubt about how to compute a valuemake a reasonable estimate and move on.IntelligentAccountancyTutorsLtd. If the written elements are unrelated to the computationstry front load as they represent ‘easier’ marks.uk 11 . Stay within your time allocation both on each part of the question and on the question itself. ________________________________________________________________________ Sunil Bhandari – www.
uk 12 . ________________________________________________________________________ Sunil Bhandari – www.co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  General Numerical Questions State formula Show method Explain as you go Make assumptions if in doubt Written Questions Check format – report / essay/ listed points Headings / subheadings / columnar Simple short paragraphsessays and reports Use ‘numbered’ points for most questionssimple sentence approach.IntelligentAccountancyTutorsLtd.
co. ________________________________________________________________________ Sunil Bhandari – www.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Tips These will be posted on my website sometime in late May 2010.uk 13 .IntelligentAccountancyTutorsLtd.
IntelligentAccountancyTutorsLtd.uk 14 .co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.
on the NYBOT website). the Financial Times.g.uk 15 . He expects students to demonstrate expertise. when questioned about the Futures question (Q5 D08) he said that students should be familiar with Open and Settlement quotes since this is how prices are quoted in the real world (e. For example. There’s no point question spotting. Main problems in the last 3 papers Weak knowledge of basic F9 topics Weak integration with other Professional Level papers.co. The Examiner expects the students to have a good knowledge of (for example) P1 and P2 topics.ACCA P4 Advanced Financial Management Key Point Notes June 2010  'What the Current Examiner (Bob Ryan) Has Said Recently' Key facts The Examiner sees this as a “Masters Level” paper. Lack of contextual understanding. and real world knowledge / awareness.g.IntelligentAccountancyTutorsLtd. It is more important to have worked through past exam questions. his own text book “Corporate Finance and Valuation”. He has suggested the students should read widely around the subject e. ________________________________________________________________________ Sunil Bhandari – www.
Bob Ryan explained that there are lots of easy marks.uk 16 .IntelligentAccountancyTutorsLtd. so only good candidates pick up the higher level marks. He says this helps to differentiate between candidates.ACCA P4 Advanced Financial Management Key Point Notes June 2010  The “essay question” (Q4) and written areas in general were badly done. Positives Good standards of English Good attention to presentation Good understanding of options and their role ________________________________________________________________________ Sunil Bhandari – www. but then his “mark ramp” is quite steep. Students missing easy marks.co.
Vd= Market Value of the Debt Capital t= Corporation tax rate ________________________________________________________________________ Sunil Bhandari – www. 1.2 Remember that: Ke= Cost Of Equity Kd(1t) = Cost of Debt Kd= Yield to maturity on debt Ve=Market value of the Equity Capital.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Chapter One Cost of Capital 1 Weighted Average Cost of Capital (WACC) 1.co.uk 17 .IntelligentAccountancyTutorsLtd.1 This is the formula given on your formula sheet.
it’s the same Formula!! 2 Cost of Equity (Ke. re) 2.ACCA P4 Advanced Financial Management Key Point Notes June 2010  1.co.IntelligentAccountancyTutorsLtd.1 Formulae are given in the exam as: This can be simply presented as:Ke or re =Rf +βe(RmRf) This you have to rearrange to:re=Do(1+g) +g Po ________________________________________________________________________ Sunil Bhandari – www.3 The examiner often represents the above formula as:WACC= Were + Wdrd(1t) We= Ve or (1Wd) Ve+Vd Wd= Vd or (1We) Ve+Vd re=Ke=Cost Of Equity rd(1t)=Kd(1t)=Cost of Debt Therefore.uk 18 .
ACCA P4 Advanced Financial Management Key Point Notes June 2010  This latter formula applies under M&M assumptions with tax. 2. g = Constant annual growth rate in dividends.3 A common issue is finding the g value. 2.29 $0.27 $0.32 g= n√ (Do) 1 Dn n=Increments of growth Dn=Oldest DPS given ________________________________________________________________________ Sunil Bhandari – www.uk 19 . Po =Share price currently Kei= Cost of equity assuming all equity position.IntelligentAccountancyTutorsLtd.co. Do=The dividend per share (DPS) today or last paid. There are several ways that this can be found.2 Lets clear up the additional symbols to those listed under 1.2 above:Rf=Risk Free Return Rm= Return on the Market Portfolio βe=Systematic Risk being faced by the shareholders. (RmRf)= Equity Risk Premium. Example Today is 31st December 2008 31st December 2005 2006 2007 2008 DPS $0.24 $0. a) Past growth rate is assumed to be future growth rate.
70=0.24 g= 0.ACCA P4 Advanced Financial Management Key Point Notes June 2010  g= 3√(0.084 This is a short term growth measure.re =14% g= 0.IntelligentAccountancyTutorsLtd. g= 0.co.70=0.098 This is a long term measure ________________________________________________________________________ Sunil Bhandari – www.10 b) Gordon’s Growth Model b=the proportion of profits retained by the business re= can be the accounting rate of return(ARR) or cost of equity Example If a company has an ARR of 12% and pays out 30% of profits as a dividend.14 x 0.uk 20 .12 x 0.32) 1 0.
30)=7.2 To find the cost of debt we need to look at the type of debt finance. 3.1% $89 ________________________________________________________________________ Sunil Bhandari – www. Example 9% Bonds trading at $89 t=30% Kd(1t)=$9 x(1030) = 7. Kd(1t) or rd(1t) is the cost of debt for the company.1 Kd or rd is the yield or minimum return for the debt holder.ACCA P4 Advanced Financial Management Key Point Notes June 2010  3 Cost of Debt (Kd(1t) or rd(1t)) 3.uk 21 .3 Bank Loans Kd(1t)=Interest % x (1t) Example A company has a 11% Bank Loan .Tax =30% Kd(1t)=11x(10.IntelligentAccountancyTutorsLtd.7% 3. 3.4 Traded BondsPerpetual Kd(1t)=Ints x (1t) Po Remember Po is the market value per block of $100.co.
5 Traded BondsRedeemable Kd(1t) is an IRR computation based upon Time To Po T1Tn Ints X(1t) Tn Capital Repayment $ (X) X X Take two guesses like 10% and 1% and do an IRR Example 7.uk 22 .ACCA P4 Advanced Financial Management Key Point Notes June 2010  3.90 1% 1.co.IntelligentAccountancyTutorsLtd.791 19. t=30% Time $ To Po T1Tn Ints X(1t) T5 CR (105) 7.63% (15.10 15. Trading at $105.951 95.50 X(10.58 Kd(1t)=1 + 15.621 62.0 (105) 3.0 4.58+23) 3.10 (23) 0.48 0.853 PV (105) 25.5% Bond redeemable at par ($100)in 5 years time.30) 100 10% PV 1.58 X (101)=4.6 Quick assumption that the examiner might indicate is that Kd(1t)=RF X (1t) OR Kd(1t)=Yield X (1t) OR Kd(1t)=(Yield or Rf + Credit Risk Premium) x 1t ________________________________________________________________________ Sunil Bhandari – www.
ACCA P4 Advanced Financial Management Key Point Notes
June 2010

3.7 As can be seen above the market value of debt (Po) is
given per block of $100.This may have to be computed using
the Dividend Valuation Model (DVM).
i.e Po=Present Value of all future cash flows discounted at
the yield to maturity.
Example:
$20 m 7% Bond will be redeemed in 3 years at par ($100).
Yield to maturity is 5.25%.
NB: Don’t forget that discount factor tables also show
formulae at the top of each table.
On the PV Table the formula is
(1+r)n =
1
(1+r)n
Hence the Po=
$7
+
$7
+ $107
1
2
(1+0.0525) (1+0.0525) (1+0.0525)3
=$6.65+$6.32+£91.77
= $104.74
The Vd is
$20m X $104.74= $20.948m
$100
i.e Book value of Debt X Po
$100
________________________________________________________________________
Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk
23
ACCA P4 Advanced Financial Management Key Point Notes
June 2010

4 Degearing/Regearing βeta
4.1 βe must reflect the combination of the systematic
business and financial risk being faced by a shareholder.
4.2 We can remove the financial risk element via
βa = Asset Beta, measure of systematic business risk
βd= Debt Beta (Often nil)
Example
βe is 1.95
t= 30%
βa =
=
Vd:Ve 1:4
βd=NIL
4
4+1(10.30)
X 1.95
4 X 1.95
4.7
= 1.66
________________________________________________________________________
Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk
24
ACCA P4 Advanced Financial Management Key Point Notes
June 2010

Now, if the gearing went Vd: Ve 1:2
1.66 =
2
X βe
2+1(10.30)
1.66 =
2 X βe
2.7
1.66 X 2.7 = 2.24
2
4.3 βasset values may have to be combined before gearing
up to find βe
Example
ABC is made up of two divisions.
Division
Asset βeta
Food
Clothes
0.75
1.80
Proportion of the
Business
40%
60%
The company has Wd=0.32 and t=30%.Rf=5% and the
equity risk premium is 9%
Hence,
Combined Asset βeta = (0.75 x40%) + (1.80 X 60%)
= 1.38
β a=
Ve
X βe
Ve+Vd(1t)
(Note: Wd =Debt Proportion of the company’s finance)
________________________________________________________________________
Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk
25
68+0.IntelligentAccountancyTutorsLtd.68 X βe 0.83 0.32 (10.38 X 0.904 1.68 X βe 0.uk 26 .38= 0.38= 1.83 = 21.68 Take Ke for the company via CAPM Ke=Rf+(RmRf) βe (Note (RmRf) is equity risk premium) Ke =5+ (9)1.ACCA P4 Advanced Financial Management Key Point Notes June 2010  1.co.47% ________________________________________________________________________ Sunil Bhandari – www.904 =1.30) 0.
Interest will lead to tax savings i.e Tax Shield Constraints on the level of debt from a) Articles Of Association b) Loan Agreements.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Chapter Two 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.uk 27 .co.access to debt capital Forecast Cash Flowsto service and repay the debt. Level of Tangible Assets on which secure the loans. Effect upon the company gearing ratio(Wd) Vd:Ve Will the debt providers exercise influence over the company? The chance of bankruptcy.IntelligentAccountancyTutorsLtd. ________________________________________________________________________ Sunil Bhandari – www.
1 Theories of Optimal Capital Structure Common Groundboth major views accept two facts:a) Yield<Ke b) Gearing causes Ke to rise –Financial Risk 3. 2) Kd is initially uneffected by gearing but rises at “high” gearing levels due to the perception of the possibility of bankruptcy.co.uk 28 . ________________________________________________________________________ Sunil Bhandari – www.2 Traditional View (NB Ko=WACC) Key Points:1) Ke rises due to financial risk caused by gearing. Point X is the optimum gearing level where WACC is lowest. 3) Kotrade off of Ke and Kd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  3 3.IntelligentAccountancyTutorsLtd.
IntelligentAccountancyTutorsLtd. companies should maximise the use of debt finance. 3) Specific Equations can be used under MM +Tax theory. the risk free rate Full distribution of profits Perfect Capital Market 2) MM concluded that due to the benefit of the tax shield. 3.uk 29 .co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  4) Once point X is reached via trial and error it must be maintained. Vg=Vu+VDT ________________________________________________________________________ Sunil Bhandari – www.3 MM and Tax Ve+Vd Key points:1) Assumptions behind the model: All debt is risk free Only corporation tax exists Debt is issued to replace Equity All types of debt carry one yield.
30 X 150}) 545 = 11.IntelligentAccountancyTutorsLtd. If it raises $150m of Debt Finance and tax is 30%.co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  WACC= Keu {1T x Vd} (Ve+Vd) Only the latter is given on the formulae sheet. Example ABC is all equity financed.30) (125) 150 395 = 12+1.01% Ke = 12+ (10. Vg=Vu+VDT Vg=$500m+ ($150m X 30%) = $545m Split Vd=$150m Ve=$395m WACC = 12(1{0.Yield is 5%.uk 30 .86 = 13.86% ________________________________________________________________________ Sunil Bhandari – www.It has a Ke=12%. Its Ve is $500m.
1) Internal Generated Fund 2) Debt 3) New Issue of Equity 5 Recent Exam Questions on Raising Debt Finance.1 Static Trade off Theory MM +TAX view can be reviewed in the light of the practical issue that too much gearing leads a company towards bankruptcy.co.uk 31 .2 Pecking Order Theory Funds are raised in a practical orderease of accessing funds.IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  4 Practical Approached /Views 4.. fixed interest bonds with half being in the Yen and half in the Euro market” ________________________________________________________________________ Sunil Bhandari – www.(Probability of Financial Distress X Costs of Finance Distress) Hence an optimum point exists for gearing where Vg is maximised. “ ….. Order :. would be in the form of 10 year. A revised equation is:Vg=Vu+VDt . raise new capital through a bond issue of $2400 million…. 4.
ACCA P4 Advanced Financial Management Key Point Notes June 2010  Key Point Answer:Bond issue attractive way of raising $2400 million.IntelligentAccountancyTutorsLtd. Disadvantages Forex Risk of foreign loans.co. Alternative could be via a syndicated loan Syndicated entails: Led by arranging bank. Bring banks together who will provide the loan. Syndication advantages are: Loan sizes are larger than one bank can take on its own. Risk of a Bank default Rates may be greater than that on Bond market ________________________________________________________________________ Sunil Bhandari – www.uk 32 . Low transaction costs. Banks may be based in different countries –mixed lending package. Issue costs will be incurred May not be fully subscribed May need to be underwritten –mitigate some of the risk.
Underwriting agreement would be sensible but costly.1% +0. issued at an attractive premium but costly for the company. debt will not be taken. b) Current Vd WD=0.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Solution:a) Key Point answer Coupon Rate=5.90%=6% 0.co.90% is credit risk premium is key.uk 33 .IntelligentAccountancyTutorsLtd.25 W D = Vd Ve+Vd Ve=$1. If too low. If too high.2billion ________________________________________________________________________ Sunil Bhandari – www.
90 =$395. existing debt’s new Vd= $400million x $98.2+Vd)=Vd 0.0442 $104 1.0443 =$3.co.4billion Revised Vd The existing debt of $0.67+$91. ________________________________________________________________________ Sunil Bhandari – www. Therefore.Hence yield now be 3.25(1. the new credit rating is 90bp’s above the RF%.90=4.30=0.uk 34 .5+0.2+Vd 0.30+0.83+$3.75 Vd Vd=0.044 $4 + 1. value of the existing debt (via DVM) will now be:$4 + 1.75 =$0.25= Vd 1.25 Vd=Vd 0.30 0.90 Therefore.IntelligentAccountancyTutorsLtd.60+$400=$795.4% Therefore.ACCA P4 Advanced Financial Management Key Point Notes June 2010  0. Vd=$395. However.4 billion ($400 million) carries a coupon and assumed yield of 4%.40=$98.This is 50bp’s above RF%.60million.60 $100 The new debt will be issued at its market value.
60 X 6) +( 395. {( 400 795. c) Advantages and Disadvantages of this mode of financing Pros Cons Tax Shield benefit Cost Lower Co’s WACC Damage to credit rating of the company Secure on the tangible asset(plane) WACC could rise therefore lowering Ve ________________________________________________________________________ Sunil Bhandari – www.uk 35 .IntelligentAccountancyTutorsLtd.60 X 4.4)} x (10.30) 795.co.8% New rd(1t)would be based on a weighted average approach.60 =3.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Current Cost of Debt rd(1t) =4% X (10.30) = 2.64% Hence increase of 84 bp’s.
ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.uk 36 .co.IntelligentAccountancyTutorsLtd.
ACCA P4 Advanced Financial Management Key Point Notes June 2010  Chapter Three Dividend Policy 1 Introduction To maximise S/H wealth the Board should establish a dividend policythe payment pattern to the equity investors.The latter links into the Po via the dividend valuation model (DVM) 2.3 Irrelevancy (M&M) In a perfect capital market providing the directors can invest in projects with a positive NPV no dividends are required. Either a) Pay the same dividend per share (DPS) each year. b) Maintain the payout ratio (DPS/EPS) c) Maintain the same yearonyear growth rate in dividends. ________________________________________________________________________ Sunil Bhandari – www.2 Pattern – Be consistent with dividend payments.co.uk 37 .IntelligentAccountancyTutorsLtd. The Ve will rise and the S/H can sell shares to create the cash the need(Manufacture Dividends). 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.
IntelligentAccountancyTutorsLtd.1 Scrip Dividends 4. 4.2 This will allow the S/H to sell extra shares for cash and the gain will be subject to CGT.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 ________________________________________________________________________ Sunil Bhandari – www.co. 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.uk 38 .1. 4. Riskpaying now is safer than promising to pay next year Is the dividend within the company law regulations? 4 Alternatives to Cash Dividends 4.1 The S/H will receive extra shares instead of cash on a pro rata basis.ACCA P4 Advanced Financial Management Key Point Notes June 2010  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.1.
________________________________________________________________________ Sunil Bhandari – www.1 If the board has “one off” period of excess cash.e.2 Share Buy Back 4. 4. e) Less dividend pressure on the board in future.uk 39 .IntelligentAccountancyTutorsLtd.2. they could consider a share buy back. Buy back shares at Po and cancel them. f) Criticismis this the best use of company cash. b) Increase gearing as Ve may fall.2. c) Tax implications for the S/H(CGT) d) Reduced number of shares will cut supply for trading purposes.2 Considerations:a) Allowable under company law.ACCA P4 Advanced Financial Management Key Point Notes June 2010  4. i.co.
IntelligentAccountancyTutorsLtd.co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.uk 40 .
Part of the debt recovered from the sale of the assets.3 Lenders action re credit risk Assess via credit assessment agencies (the chance the company is unable to pay the interest or principal) Set credit risk premiums to the borrower.8m. Occurs when the secured asset value falls below the value of the loan 1.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Chapter Four How lenders set their interest rates? 1 Credit Risk 1.1 Risk Neutral Lender –Example A company has an asset worth $2m and secured debt of $0. σa = σm x √ T σa = 10% x √12months = 34. Therefore.co.64% annually Therefore. 2 Credit Risk Premium 2. 1. Asset can vary in value by ________________________________________________________________________ Sunil Bhandari – www.The asset can vary in value by 10%monthly.1 This is the risk of default by the borrower.uk 41 .IntelligentAccountancyTutorsLtd.2 Loss to the lender depends upon: Probability of default occurring.
$0.200.8m is 0.4582. The ‘chance ‘of the asset not falling below $0.9582 If the company defaults then the bank need to recover the debt.8m $2m Lies 1.800 annually Hence using the “Z” value concept (how many standard deviations) from normal distribution table.732 σ σ =$692.ACCA P4 Advanced Financial Management Key Point Notes June 2010  34.4582+0.000 = 1.uk 42 . $1.732 $692.732 (or 1. This depends upon:________________________________________________________________________ Sunil Bhandari – www.732 standard deviations below the $2m asset value.800 Away from $2m Checking the normal distribution tables for 1.50=0. Value of the asset $0.IntelligentAccountancyTutorsLtd.64% X $2m = $692.800 Therefore.8m lies 1.co.73)=0.
06 “Note: 0.e 7.0712 746. i.000723.2 Risk Adverse Lender If the bank were more risk adverse the discount rate above can be adjusted to value greater than LIBOR.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Type of Asset Covenants on disposing the asset If (say) only 75% of the debt can be recovered and LIBOR is 6%.830 i (800.660(1+i) 800.000 X (1+i) X0.000 X (1+i) X 0.170+23.12% which is 112 basis points above LIBOR OF 6%.9582} + {75% X $800.000=723.17023.IntelligentAccountancyTutorsLtd.830 i.000= {$800.What premium above LIBOR should the bank set? Based on a 1 year period and a discount rate equal to LIBOR.e $800.06 1+0.0418} 1+0.000= (PV of the cash recd in 1year not defaulting) + (PV of the cash recd in 1year if default occurs) i= Interest rate the bank sets (inc the risk premium) $800.co.660) = 0.9582” 800. 2.uk 43 . the bank needs a present value to equal $800.000=723.170(1+i) +23.0418=10. ________________________________________________________________________ Sunil Bhandari – www.660+746.000 – value of the loan today.
ACCA P4 Advanced Financial Management Key Point Notes June 2010  In other words the “i” would increase accordingly.e = 7.000(1+i) X 0.000= {$800.LIBOR is still 6%.549+743.5% and not 6%.co.775+23.0418} 1.065 800. $800.000 = 719. (Say) in the above example the bank set a discount rate of 6.324i i = 0.9582}+ {$800.uk 44 .62% 162 Basis points above LIBOR 3 Problems Finding asset values Assessing the recoverable amounts on default σ assessment ________________________________________________________________________ Sunil Bhandari – www.000 X 75%X(1+i) X 0.0762 i.IntelligentAccountancyTutorsLtd.065 1.
IntelligentAccountancyTutorsLtd.co.uk 45 .ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.
co.IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.uk 46 .
uk 47 .IntelligentAccountancyTutorsLtd. 2) Adjusting Accounting Profit Net operating profit (before interest and tax) Plus Depreciation Less Taxation Operating cash flow Less Investment: Replacement noncurrent asset investment(RAI) Incremental noncurrent asset investment(IAI) X X (X) X (X) (X) ________________________________________________________________________ Sunil Bhandari – www.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Chapter Five Advanced Investment Appraisal 1 Net Present Value of Free Cash Flows (FCF) 1.co.1 Free Cash Flows(FCF) The cash is available after expenditure and reinvestment into the business.Asset Replacement Spending – Working Capital Injection + Tax saved on Tax Allowable Depreciation. Computed two ways:1) Incremental cash flow approach Revenue – Costs – Tax Capex + Scrap Value .
1.IntelligentAccountancyTutorsLtd.0 (X) (X) X X X $XXX (X) X X X X X X X (X) (X) (X) ________________________________________________________________________ Sunil Bhandari – www.co.uk 48 .ACCA P4 Advanced Financial Management Key Point Notes June 2010  Incremental working capital investment(IWCI) Free cash flow for the company Debt Interest Debt Repayments Debt Issues FCF to equity (X) X used in NPV comps (X) (X) X X used to value equity in certain business valuation models.2 Proforma Time $’000 Revenue(inc Inflation) Costs(inc Inflation) Operating Cash flows Tax @ (1year delay) Capex&Scrap Value Tax savings on TAD Asset replacement spending Working Capital Free Cash Flows Cost of Capital% PV NPV T0  T1 X T2 X T3 X T4   (X) (X) (X)   X X X    (X) (X) (X) (X)   X   X X X  (X) (X) (X)  (X) (X) 1.
IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  1.07)3 = $735 Include in the cost of capital 3 possibles:Chapter 1 a) Company WACC is inflation inclusive b) Risk adjusted WACC is inflation inclusive.co. c) Use the Formula given.uk 49 .4 Inflation Include in the cash flows Money/Nominal CFn=Real CFn X (1+h)n eg Real CF3=$600 = 7%pa Money CF = $600 X (1+0. (1+i) = (1+r) (1+h) h = inflation r = real cost of capital i = money cost of capital eg r = 10% h=5% ________________________________________________________________________ Sunil Bhandari – www.3 Relevant Cash Flows Incremental –caused by the project Future –still to occur Exclude:1) Sunk Costs 2) Finance Charges 3) Dividends 4) NonCash flows 5) Nonincremental fixed overheads 1.
co. Timings –could be no delay or 1 year delay Tax on operating cash flows. the examiner showed taxation as a “2 line approach”.5 Taxation Using the December 08 paper as benchmark.2m X 30%=$310. Tax is 30 %( no time delay).2m.000 3 years ________________________________________________________________________ Sunil Bhandari – www.000 T2T4 Tax saving=50% X $6.155 or 15. eg Extract from the NPV:$’000 Operating Cash Flows Tax 30%(say 1year delay) T1 200 T2 300 T3   (60) (90) Tax saved on Tax allowable depreciation /Capital Allowances.155 i =0. eg Capex will take place over the first year and be finished by the end of the year.TAD is 50%.ACCA P4 Advanced Financial Management Key Point Notes June 2010  (1+i) = (1+0.5% 1.10) (1+0.uk 50 .First year allowance followed by straight line allowances for a further three years. Cost $6. T1 Tax saving =50% X $6.2m X 30%=$930.IntelligentAccountancyTutorsLtd.05) 1+i = 1.
92 (w1) Timing and Tax Saving T2 1000 X 25% X 30% T3 75 X (100%25%) T4 56. ________________________________________________________________________ Sunil Bhandari – www.92 240 NB: Other assumptions are possible –so read the question carefully.19 X 75% T6 Balance figure 30%(1000200)= $’000 75 56.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Another Example T0=1/Jan/09 T0 CAPEX $1000K T5 Scrap $200K TAD is 25% reducing balance and tax is 30% with a one year delay.D(w1)  T1  T2   75 T3  T4  T5 200 T6  56.25 X 75% T5 42.uk 51 .25 42.IntelligentAccountancyTutorsLtd.19 31.co. Extract from the NPV: Time $’000 T0 Capex & (1000) Scrap T.64 34.64 34.19 31.25 42.A.
10 * 1 =discount rate for perpetuity 0.751 1 X 0. Invest.IntelligentAccountancyTutorsLtd.uk 52 .ACCA P4 Advanced Financial Management Key Point Notes June 2010  1. Close!!! eg $’000 WC needed Relevant Cash Flows T0 (100) T1 100 (70) T2 170 (130) T3 300 300 These go into the NPV 1.co. Eg Project has following cash flows and a cost of capital of 10%.751 0.826 .0 0. Time $’000 Cash Flows 10% * T0 (1000) T1 200 T2 400 T3 300 T4Tperp 350pa 1.10 If applied to a cash flow starting at T4 it discounts back to T3 ________________________________________________________________________ Sunil Bhandari – www.7 Cash flows into Perpetuity. Adjust.909 .6 Working Capital Think as it is a project bank account.
e 1 (rg) computes the discount factor for a cash flow with a constant growth rate pa 2 IRR 2.co.751 rg 1 X 0. 0.IntelligentAccountancyTutorsLtd.2 Example NPV @10%=$300K NPV @20%=($160K) ________________________________________________________________________ Sunil Bhandari – www. $’000 Cash Flows 10% * T0 (1000) T1 200 T2 400 T3 300 T4Tperp 350 1.909 0.751 9.10 Take the same example as above and now bring in constant growth of 2% from T5 each year in perpetuity.751 =7.751=9.02) i.51 is the effective discount rate.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Therefore.0 0.uk 53 .388 (0.826 0.100. 1 X 0.388 * 1 X 0.1 The Internal Rate of Return is the cost of the capital that gives an NPV of NIL 2.
1 Predicting future spot rates via formulae provided: S1= F0= Future Spot Rate S0= Spot Rate Today hc = Inflation Rate abroad hb= Inflation Rate home ic = Interest Rate abroad ib = Interest Rate Home 3. ________________________________________________________________________ Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.2 Double Taxationthe golden rule is you must pay the higher of the two rates.ACCA P4 Advanced Financial Management Key Point Notes June 2010  IRR= 10+ { 300 } X (2010) (300(160) = 16.uk 54 .52% 2.3 Decision rule with IRR is if IRR>Cost of Capital –Accept However IRR has many weaknesses which are overcome by MIRR (see a later chapter) 3 Foreign Investment Appraisal 3.co.
Cash flows have been computed already as:Time T0 T3 scrap T1 operating flows T2 operating flows T3 operating flows £’000 1.uk 55 .50/£ and inflation is expected to be USA=5%pa UK=3%pa What are the free cash flows ready for discounting? Solution Notes:USA=Home.co.3 Formatmay need to change from earlier in this chapter to accrue for double tax. Example Jon inc (USA company) has a project in the UK.000 100 500 600 400 TAD in the UK is straight line and tax rates are UK 20% USA 30% with a one year delay S0=$1.67/$ Spot Rates via PPP: ________________________________________________________________________ Sunil Bhandari – www.50/£ or £0. UK=Foreign S0=$1.IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  3.
63 698 (46) 652 (20) (20) £0.co.66 X 1.05 £’000 Operating Flows TAD (1000100) 3 Taxable “Profit” Tax@20% Add back TAD(not cash flow) 0.62 T1 500 T2 600 T3 400   (300) (300) (300)   200 300 100   300 (40) 300 (60) 300 (20)  500 500 £0.05 S3 0.uk 56 .IntelligentAccountancyTutorsLtd.03 = 1.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Time £/$ 0.63 X 1.05 S4 0.66 758 758 560 560 £0.62 (32) (16) (48)  T0 Capex&Scrap (1000) £’000 (1000) Spot Rates £0.67 $’000 (1493) USA Tax(w1) FCF (1493) T4 ________________________________________________________________________ Sunil Bhandari – www.03 = 1.66 S0 S1 0.65 862 (30) 832 340 100 440 £0.67 0.03 = 1.03 = 1.67 X 1.65 0.05 S2 0.65 X 1.63 0.
IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  (w1) Example working T1 Taxable Profit=£200 Additional Tax=10% X £200=£20 Converted @ T1 spot =£20/£0.66 =$30 Paid at T2!!! ________________________________________________________________________ Sunil Bhandari – www.co.uk 57 .
co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.uk 58 .
ACCA P4 Advanced Financial Management Key Point Notes June 2010  Chapter Six Adjusted Present Value 1 When to use it 1.1 APV is a NPV method to be used when: Project is core or noncore activity Specific debt Finance is being use on a project. Find PV of the tax savings on the interest paid on the loan finance raised using the yield as a discount rate. Find PV of the issue costs (possibly post tax) using yield as a discount rate. 1.uk 59 . 2 Method Establish the βasset for the project. Using the βasset 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.2 APV is still the change in shareholder wealth arising from the project.IntelligentAccountancyTutorsLtd.co. ________________________________________________________________________ Sunil Bhandari – www. Subsidised interest exists on the project debt finance.
ACCA P4 Advanced Financial Management Key Point Notes June 2010  APV $m Base case NPV PV of issue costs PV of tax savings on interest APV X (X) X X Recent Exam Question ________________________________________________________________________ Sunil Bhandari – www.uk 60 .co.IntelligentAccountancyTutorsLtd.
ACCA P4 Advanced Financial Management Key Point Notes June 2010  Following steps above:a) βa = = Ve X βe Ve+Vd(1t) 7500 7500+2500(10.co.5 ________________________________________________________________________ Sunil Bhandari – www.400.0+ (3.40=5 (RmRF)=Equity Risk =Premium =3.uk 61 .14 b) Keu=RF+ (RmRF)βa Keu=5.IntelligentAccountancyTutorsLtd.40 = 1.5)1.30) X 1.14 Note: = 9% RF=Gilt Yield =5.
uk 62 .ACCA P4 Advanced Financial Management Key Point Notes June 2010  c) Base Case NPV $m Revenue Direct Costs Lost Cont’n Operating Cashfows Tax at 30 % T0  Capex&Scrap (800) Tax Saved on Capital Allowances (w) FCF (800) 9% 1.708 156 95 .842 247 345 .co.0 PV (800) T1 T2 T3 T4 T5 680 900 900 750 320 (408) (540) (540) (450) (192) (150) (150) 122 210 360 300 128 T6   (37) (63) (108) (90) (38)  120 48 29 40 17 14 122 .650 62 (24) .917 112 293 .IntelligentAccountancyTutorsLtd. (w) Timing and Tax Saving T2 800 x 50% x 30% T3 400 x 40% x 30% T4 48 x (10040)% T5 29 X 60% T6 Balance figure 30%(80040)= $m 120 48 29 17 14 228 ________________________________________________________________________ Sunil Bhandari – www.596 (14) Base Case NPV = $29m Assumptions: Indirect costs are not incremental Design costs are sunk therefore ignored.772 266 221 .
80=7.62 = $67.e $800 m X 2%=$16.06 $79.73m ________________________________________________________________________ Sunil Bhandari – www.63m + $ 17.ACCA P4 Advanced Financial Management Key Point Notes June 2010  d) Yield on new debt= 5.63m pa $17.63m + $17.31+ 13.40+1.2% $816.0725 1.0723 1.33m $58.0722 1.45+ 11.63m + $17.0726 15.e LIBOR + 180BP’s e) Issue costs payable to has to be 2% of loan +Issue costs i.2% pa Tax saved @30%T2T6 Discounted at 7.33m 0.2% i.0724 1.34+ 14.06m Base Case NPV Issue Costs PV of Tax Savings $m 29 (16.IntelligentAccountancyTutorsLtd.34+ 12.63m + $17.77m pa $17.33) 67.co.63m 1.uk 63 .98 f) PV of tax savings on interest paid:Loan inc Issue Costs Ints Paid in T1T5 @ 7.
uk 64 . i. 3.ACCA P4 Advanced Financial Management Key Point Notes June 2010  3 Subsidised Loans 3.e Ints pa not paid less tax not saved all discounted at the yield.IntelligentAccountancyTutorsLtd. ________________________________________________________________________ Sunil Bhandari – www.1 If any part of the loan Finance is at a subsidised rate.co. then the APV must include an extra benefit.2 PV of the post tax subsidy discounted at the yield.
b) Multiple IRR’s exist when the cash flow pattern is not standard ie Standard Pattern .4 MIRR is a measure that gives an NPV of nil but will lead to a project decision rule consistent with NPV. However.3 IRR has weaknesses:a) Cannot be used to compare mutually exclusive projects.IntelligentAccountancyTutorsLtd. +.+.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Chapter Seven Modified Internal Rate of Return (MIRR) 1 NPV vs IRR vs MIRR 1.1.2 IRR is the cost of capital that causes the NPV to be nil. It’s decision rule IRR > Project Cost of Capital Accept 1.+ NonStandard Pattern .1 NPV represents the increase in Ve arising from the project. it can be hard to explain the “layman”. 1. +.+.+. ________________________________________________________________________ Sunil Bhandari – www. +.co.uk 65 .
Time T0 T1 T2 T3 $ (1000) 400 600 300 10% 1.909 0.50 Formula given PVR=PV of Return Phase Cash Flows PVI=PV of Investment Cash flows re=Cost of Capital n= Year of the final cash flow ________________________________________________________________________ Sunil Bhandari – www.co.751 PV (1000) 363.2 Using The Formula NPV had been computed at 10%.6 225.0 0.5 * PV of Return Phase=$1084.826 0.IntelligentAccountancyTutorsLtd.uk 66 * .6 495.3 84.1 Simple Example Time T0 T1 T2 T3 $’000 (1000) 400 600 300 Return phase of the project Cost of Capital=10% 2.ACCA P4 Advanced Financial Management Key Point Notes June 2010  2 Computing MIRR 2.
1301.co.10)1 1000 = 0. Therefore 1444 .10 = 300 X 1.1303 OR 13.03% ________________________________________________________________________ Sunil Bhandari – www.ACCA P4 Advanced Financial Management Key Point Notes June 2010  (1/3) MIRR= {1084. we now have a revised set of cash flows T0 T3 (1000) 1444 MIRR is the discount rate that causes an NPV of nil.1000 =NIL 3 (1+MIRR) 1444 =1000 3 (1+MIRR) MIRR = 3√(1444) 1 1000 0. Time T1 T2 T3 $’000 400 X 1.102= 600 X 1.01% Alternative Method: a) Terminal value of Return Phase cash flows.IntelligentAccountancyTutorsLtd.e 13.uk 67 .0 = 484 660 300 1444 Therefore.50} (1+0. i.
3.0 0.3 More complex Example Time T0 T1 T2 T3 T4 $. ________________________________________________________________________ Sunil Bhandari – www.7 PVR =985.826 0.2 (972.1 Both NPV and MIRR assume cash flows from a project are reinvested at re.uk 68 .3 Defining the “Investment Phase”.4 450. 3 Problems with MIRR 3.683 NPV PV (700) (272. Per Q1 Dec 08 two definitions were possible giving slightly different answers.909 0.7 = 10.IntelligentAccountancyTutorsLtd.751 0. MIRR= {985.37% Both NPV rule and MIRR rule indicate project is worthwhile.9}¼ (1. 3.7) 985.000 (700) (300) 400 600 300 10% 1.ACCA P4 Advanced Financial Management Key Point Notes June 2010  2.9 PVI=972.7) 330.2 MIRR may itself have to be “modified” to accrue of variable reinvestment rates.co.10)1 972.9 Therefore.This may not be the case.6 204.9 13.
uk 69 .co.IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.
ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 70 .
ACCA P4 Advanced Financial Management Key Point Notes June 2010  Chapter Eight Capital Rationing 1 The Problem 1. PI= NPV Cash outlay in critical period 2.co.IntelligentAccountancyTutorsLtd. b.uk 71 .2 Rank the projects based upon the PI 3 MultiperiodDivisible Projects 3. “Soft” Reasons –internal restrictions eg Capex Budget 2 Single PeriodDivisible Projects 2.1 Compute the Profitability Index (PI) for each project. ________________________________________________________________________ Sunil Bhandari – www.1 Can only be solved by linear programming 3. “Hard” Reasons –external constraint eg Credit Crunch.2 Cash can be restricted due a.1 When there is a lack of sufficient cash to invest in all projects with a positive NPV 1.2 The examiner has indicated the formulation may be tested but not arriving at a solution.
c. plus the cash inflows from the projects undertaken at T0. capital is freely available.b. The appropriate discount rate is 10%.103 ________________________________________________________________________ Sunil Bhandari – www.10 D2 + D3 1.uk 72 . 2) Objective Maximise the PV of dividends. all of which are divisible and exhibit constant returns to scale.000 of capital available at T0 and only $5000 at T1.102 1. No project can be done more than once.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Example A company has identified the following independent investment projects.IntelligentAccountancyTutorsLtd.In each time period thereafter. Z= Objective.co.d = Proportions invested in each project. Project Cash Flows at time: A B C 0 1 2 3 $000 10 10 5 $000 20 10 +2 $000 +10 +30 +2 $000 +20 +6 +2 There is only $20. Z= D0+ D1 + 1. (Assuming A Full Distribution Policy) 1) Symbols Dn=Dividends paid at time n. a. Solution Using the Dividend Formulation Model.
co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  3) Constraints 10a +10b+5c+D0=20. ≤1 ________________________________________________________________________ Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.uk 73 . b. c.000 20a+10b+D1=5000+2c D2=10a+30b+2c D3=20a+6b+2c Dn≥0 0≤ a.
co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.uk 74 .
67m 2008  at $1. 1.75 £5.67m 2008  at $1.96m 1.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Chapter Nine Foreign Currency Risk 1.1 Risk caused by change in the value of a Forex asset or liability over the longterm.IntelligentAccountancyTutorsLtd.71m Loss to equity (£0.50 £6.2 Example: ABC plc has a US subsidiary worth $10m.96m) Funded by a $10m loan.75 £5. Translation Exposure 1.71m Gain to equity £0.co. 2007  at $1.1 Change in the value of the spot rate over the short term causing a cash gain or loss.3 Not a cash risk.50 £6.2 Must hedge!! ________________________________________________________________________ Sunil Bhandari – www. 2. 2007  at $1. only due to financial reporting!!!! 2 Transaction Exposure 2.uk 75 .
uk 76 .6667 / $ (Bid) (Offer) 3.5000 . Euro) Pool all transactions in same FX ________________________________________________________________________ Sunil Bhandari – www.co.6429 .2 Picking the correct rateQuick Method If the SPOT Rates are FX/Home Currency We are RECEIVING FX then Use the right hand rate 4 Internal Hedges 4.IntelligentAccountancyTutorsLtd.£0.5555 / £ Reciprocal and cross over!!!!! £0.1 Invoice in home currency All transactions in home currency Transfer risk to the other party Monopoly powerover our customers or suppliers 4.2 Foreign currency bank account Held in the main currencies ($. (Bid) (Offer) $1.ACCA P4 Advanced Financial Management Key Point Notes June 2010  3 SPOT Rates 3.$1.1 Rate of exchange at a point in time.
________________________________________________________________________ Sunil Bhandari – www. Ascertain if “buying” or “selling” the £.IntelligentAccountancyTutorsLtd.co. 2. Forward contract.ACCA P4 Advanced Financial Management Key Point Notes June 2010  4.uk 77 . X months.3 Leading and Lagging Watcher / predictor of spot rate changes in short term(say 3 months) Leading – accelerate exchange(early) Lagging – delay the exchange(late as possible) Used a lot by Importers who have to sell their home currency 4. Net the future transactions in same FX and same date. Exchange FX at the forward rate on the future date. at Forward Rate “may” have to computed as :SPOT + Discount (.4 Netting Match all FX transactions in the same FX occurring on the same day 5 External Hedges 5.1 Forward Market(Lock into a Fixed Rate) “Fix the rate today that will apply on a set future date” Technique: 1.Premium) 3.
________________________________________________________________________ Sunil Bhandari – www.ACCA P4 Advanced Financial Management Key Point Notes June 2010  5.uk 78 .co.3 Futures(Lock into a rate that will approximately equal Today’s Spot Rate) The hedge is ‘effectively’ like a spread bet. then the hedge is to ‘effectively bet’ that this event will occur on the Futures Market. Technique Home Abroad Today’s Spot Today £ Answer FX X 1 + ints foreign 1+ints home Future Date £ Answer FX FX 5.2 Money Market Hedge(Rate used is Today’s Spot Rate) “The exchange will take place today at the known spot rate”. Hence the loss on the Spot Market is offset by the profit on the Futures Market.IntelligentAccountancyTutorsLtd. Hence it is trying to lock the rate at approx today’s Spot Rate. If a gain is made on the Spot Market then a loss will be made on the Futures Market. If the company will make a transaction loss by the spot rate rising.
IntelligentAccountancyTutorsLtd. Draw the timeline showing all rates.0001/currency) Deposit the returnable margin 3.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Technique: 1.uk 79 . Close out – future date (a)Transaction – at spot (b) £ XXX Futures Profit / Loss (No of contracts x Tick value x Tick Movement) @ SPOT XXX XXX NB: Loss on transaction. ________________________________________________________________________ Sunil Bhandari – www. of contracts = Net FX Transaction Futures Rate Standard Contract Size (in currency of the contract) Work out ticks / contract(normally 0. Best if rates are presented as value of the currency of the contracts. 2.loss on the futures.co. No. Setup – Today Ascertain the downside(d/s) risk ‘Bet’ on the d/s risk via the futures market. gain on the future or gain on transaction .
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. Set up today Ascertain if we need a put or a call option Pick a strike rate from: 1. Best possible rate No.ACCA P4 Advanced Financial Management Key Point Notes June 2010  5. Close out – Future date All situations cost = premium paid ________________________________________________________________________ Sunil Bhandari – www. Technique: 1. Nearest to spot or 3.uk 80 . TimelineAs for futures 2.4 Options (Bet possible Hedge) “Right to buy (call) or sell (put) FX at a fixed rate over a set period (American) or on a set date (European)”.co.IntelligentAccountancyTutorsLtd. Cheapest premium or 2.
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 ________________________________________________________________________ Sunil Bhandari – www. Pros & Cons Pros Cons Forward Market Fixed Rate.co.uk 81 .ACCA P4 Advanced Financial Management Key Point Notes June 2010  No receipt or payment in FX – options lapse Compare spot with strike rate – choose the best rate for the business 6.IntelligentAccountancyTutorsLtd.
the parties agree to swap equivalent amounts of currency for a period and then reswap them at the end of the period at an agreed swap rate. A plc cannot borrow pesos directly and there is no forward market available.uk 82 .The current UK borrowing rate is 10%. The currency spot rate is 20 pesos/£. Forex swaps are especially useful when dealing with countries that have exchange controls and /or volatile exchange rates.ACCA P4 Advanced Financial Management Key Point Notes June 2010  7. and the government has offered a forex swap at 20 pesos/£.Say the bridge will require an initial investment of 100m pesos and is will be sold for 200m pesos in one year’s time.co.IntelligentAccountancyTutorsLtd. Thus it is called a ‘fixed rate/fixed rate’ swap. Determine whether A plc should do nothing or hedge its exposure using the forex swap. 7. The main objectives of a forex swap are: To hedge against forex risk. Access to capital markets. possibly for a longer period than is possible on the forward market. SWAPS 7.2 Example. The estimated spot rate in one year is 40 pesos/£. in which it may be impossible to borrow directly.1 In forex swap. The swap rate and amount of currency is agreed between the parties in advance. ________________________________________________________________________ Sunil Bhandari – www.
0 A plc should use a forex swap.) ________________________________________________________________________ Sunil Bhandari – www.5) (5.0) 5. whilst in the spot market pesos have depreciated from a rate of 20 to 40 pesos per pound.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Solution £m Without swap Buy 100m pesos @20 Sell 200m pesos @40 Interest on sterling loan (5 x 10%) £m With forex swap Buy 100m pesos @20 Swap 100m pesos back @20 Sell 100m pesos @40 Interest on sterling loan (5 x 10%) 0 1 (5.0) 7. as it is swapped at both the start and end of the year at the swap rate of 20.5) (5.0 2.co.0) 4.0 (0. We can see that in this basic exercise that the swap amount of 100m pesos is protected from any depreciation. (Key idea: The forex swap is used to hedge foreign exchange risk.uk 83 .0) 5.5 0 1 (5.IntelligentAccountancyTutorsLtd.5 (0.
uk 84 .ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.
co.uk 85 .IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Chapter Ten Interest Rate Risk 1 What are the issues? We have loan finance interest rates are set at a variable rate on a regular basis Cover an interest rate rise We have deposits and earning a variable interest rate Cover an interest rate fall ________________________________________________________________________ Sunil Bhandari – www.
cheap Cons .IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  2 “FIXING” INSTRUMENTS (Lock in to Fixed Rate) Forward rate agreements (FRA) Purchased from a merchant the money markets Pros .easy flexible .uk 86 .co.contract size (≥ $1m) Contract that fixes future interest rates for a set period FRA 39 Fix start 3months from now @ 4% pa Fix stops 9 months from now Fixed Rate ________________________________________________________________________ Sunil Bhandari – www.
ACCA P4 Advanced Financial Management Key Point Notes
June 2010

Interest rate future
Fixing the interest rate can be achieved by using futures.
One of the main markets that is used is the UK LIFFE
(London International Financial Futures Exchange).
The hedge is achieved by effectively ‘betting’ on the futures
market that its interest rate will change. The bet is always
on the downside (ie those with loans are betting that rates
will increase). Also, the futures interest rate is derived from
the market interest rates (LIBOR)
If the downside occurs, the company will have to pay more
on its loans as the market rate has risen, but would have
made a profit on the futures market. If rates go down, loan
interest will fall but a loss will be made on the futures
market. In both cases, the effective interest rate is fixed.
Futures are complicated by a number of factors.
Contract sizes
Margins / deposits payable at the start of the
hedge
Not perfect hedge .May not look in at the current
rate.
________________________________________________________________________
Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk
87
ACCA P4 Advanced Financial Management Key Point Notes
June 2010

3 “CAPPING” METHODS (Setting a ceiling for the loan
interest rate)
Interest rate guarantee
(IRG)
Purchased from
a merchant bank for
a fee
Covers the adverse
of interest rate
changes but at a
cost!!!
Contract that caps
the future interest
rate for a set
period
IRG
39
@ 4% pa
Cap starts in
3 months time
Cap stops 9
months from now
Capped rate
________________________________________________________________________
Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk
88
ACCA P4 Advanced Financial Management Key Point Notes
June 2010

Interest Rate Option
The future and options market provides a product that can
cap interest rates for borrowers like an IRG. The hedge is to
effectively have the ‘right to bet’ on an interest rate increase
as shown on the futures market.
As an example, suppose that today is 30 June and the
following data is available on September LIFFE options.
Strike price
(SP)
%
93.75
94.25
94.75
Interest rate
cap
(100 – SP)
%
6.25
5.75
5.25
Call options
premium
%
Put options
premium
%
1.29
0.69
0.16
0.23
0.77
1.33
If a company wished to protect itself against an interest rate
increase above, say, 5.75%, it would purchase a put option.
A premium of 0.77% would be payable now. If the market
interest rates started to rise, the company would have to
pay more interest on its loans. However, interest rates on
the futures market will also rise and should this exceed
5.75%, the business will exercise its put option. The cash
received from this should cover most of the extra interest
paid on the loan.
Contract sizes and a standard length of three months
complicate interest rate options.
________________________________________________________________________
Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk
89
uk 90 . 4.3 Exam Technique (1) Table of Interest Rates. 4.ACCA P4 Advanced Financial Management Key Point Notes June 2010  NB Collars Create a cap & floor simultaneously Save premium Lose benefit of interest rate drops below the floor 4 SWAPS 4. Company B also wishes to raise $10m.They would prefer to issue fixed rate debt because they want certainty about their future interest payments. as it would like to be able to take advantage of any fall in interest rates.co. Calculate the effective swap rate for each company – assume savings are split equally.2 Example Company A wishes to raise $10m and to pay interest at a floating rate.IntelligentAccountancyTutorsLtd.1 Longterm method of hedging where companies “swap” their interest commitments but no their loans. It can borrow for one year at a fixed rate of 10% or at a floating rate of 1% above LIBOR. but can only borrow for one year at 13% fixed or LIBOR+2%floating as it has a lower credit rating than company A. Company A B Fixed 10% 13% Float LIBOR +1% LIBOR +2% Want FLOAT FIXED ________________________________________________________________________ Sunil Bhandari – www.
% A (Fixed)+B (Float) 10+LIBOR+2 A(Float)+B (Fixed) LIBOR+1+B Difference =LIBOR +12 =LIBOR+14 2% (3) SWAP Diagram LIBOR+2 A B 12 (w1) 10 LIBOR+2 (w1) 13(0.5 x2) =12 (4) Effective Rates A PAY LIBOR B PAY 12 Both save 1% and get what they want.IntelligentAccountancyTutorsLtd.4 Problems Fees payable to intermediaries Default risk by one party.co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  (2) Interest Difference. 4. ________________________________________________________________________ Sunil Bhandari – www.uk 91 .
ACCA P4 Advanced Financial Management Key Point Notes June 2010  Recent Exam Question: ________________________________________________________________________ Sunil Bhandari – www.uk 92 .co.IntelligentAccountancyTutorsLtd.
04 (w1) 0. ________________________________________________________________________ Sunil Bhandari – www.04 * Use settlement values if given (10093.12=0.12 [12 Basis points] will fall to nil by 31st March.00 or 7.00 Mar Futures=6.00 5.12 * Basis =0. 1/3 x 0. Hence.co. On the 1st March one month from three is still remaining.00] it is assumed to stay higher until expiry.IntelligentAccountancyTutorsLtd.04 0.04 (w2) As the Mar Futures at 1 Jan was higher than LIBOR [6.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Solution a) (i) Interest Rate Futures Use a simple 3 step approach 1) Timeline 1 Jan (Now) LIBOR = 6.880) 31 March NIL Basis falls to nil at the end of the quarter (w1) Basis of 0.12 1 March 5.12 vs 6.04 (w2)7.uk 93 .
50 X80 0.00% 7.000) (6.125.04) X £12.000) (750.04 6.co.58% 6.000) As a % of £30m 6.000 X 4 months = 80 contracts 3 months 3) 1st MarClose Out Hedge LIBOR Falls LIBOR Rises 5.12) X £12.ACCA P4 Advanced Financial Management Key Point Notes June 2010  2) 1st JanSet up the Hedge The company will be exposed to movements on the LIBOR for a period of 4 months from 1st March Buying futures (or effectively betting on a rise in interest rates) Number of contacts:£30m £500.000 X 12 X 100% £30m 4 ________________________________________________________________________ Sunil Bhandari – www.01 Effective Cost of Loan (658.50% LIBOR £ £ Payment of 4 months Interest (550.000 (7.01 Profit on Futures 92.50% 7.000) (658.IntelligentAccountancyTutorsLtd.00% Company will pay 50 BP’s above 5.e £658.58% i.50 X80 0.000) £30m X 4/12 X Interest Rate Loss on Futures (108.uk 94 .
00) to cap it’s interest rate.000) 104. the company will buy March put options at 94000(1006.168 X 80c X £500.04% Therefore.67% (662.800) 6.01 Total Cost Effective Annual% LIBOR 5.00% vs 5. No of contracts – as above 80 Premium Payable 0.800 3) 1st March –Close out Hedge Premium Paid Interest paidsee Futures above Compare Cap vs Mar Futures Interest Rate 6.50 0.00% £ (16.IntelligentAccountancyTutorsLtd.800) (550.800) (750.000 (566.63% ________________________________________________________________________ Sunil Bhandari – www.00%.00) X 80 X £12.uk 95 . Use the option and receive (7.co.046.ACCA P4 Advanced Financial Management Key Point Notes June 2010  (ii) Options 1) Timelineas for futures above 2) 1st Jan –Set up the Hedge As the current LIBOR is at 6.800) 5.000) LIBOR 7.04% 6.00% vs 7.00% £ (16.000 X 3/12 100 = £16.
67% X 0.60% However the options are preferred at 6.co.50) + (6.15% b) What did the examiner write to answer this: ________________________________________________________________________ Sunil Bhandari – www.65% X 0.IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  As both are equally as likely (5.50) = 6.uk 96 .15% Both methods keep the APR below the treasures target of 6.
(d) Expiry Date – date on which the option can be exercised (European type option). but not the obligation to buy or sell a share at a fixed price on a specified future date. Our aim is to find the value of the options on the open market.1 An option gives the holder the right.co.IntelligentAccountancyTutorsLtd. (b) Call – right to buy.uk 97 . Details and terminology: (a) Put – right to sell.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Chapter Eleven Valuation of Options +Value at Risk 1 Valuation of Options 1. (c) Exercise price / strike price – price at which shares can be bought or sold. ________________________________________________________________________ Sunil Bhandari – www.
co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  1. reflecting the uncertainty surrounding the intrinsic value between now and the exercise date.uk 98 .2 Components of Option Value Intrinsic value and time value There are 5 main components to the value of an option (a) (b) Intrinsic value.IntelligentAccountancyTutorsLtd. Relevant factors: (i) Variability in the daily value of the asset (currency. interest etc)(s) (ii) Time until expiry of the option (a later expiry date having greater risk)(t) (iii) Interest rates (since cash flows occur at two different times)(r) ________________________________________________________________________ Sunil Bhandari – www. the difference between (i) The current price of the asset(Pa) (ii) The exercise price of the option(Pe) The time value of the premium.
co.1 The above five factors have been built into the BlackScholes formula to find the value at time 0 of a European call option.ACCA P4 Advanced Financial Management Key Point Notes June 2010  The Black Scholes Option Pricing Model 1.7183 On Your calculator!! In =natural logarithm ________________________________________________________________________ Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.uk 99 . (c). the standard deviation of the rate of return on shares e =the exponential constant 2. 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.
43 d2=0. N(d1)& N(d2)=the cumulative value from the normal distribution tables for the value d1 or d2.50+0.50+0.25 1) Find d1 and d2 d1=In (100/95)+(0.IntelligentAccountancyTutorsLtd.1664=0.6664 N (d2) =0.uk 100 .975 ________________________________________________________________________ Sunil Bhandari – www.18 2) N (d1) =0.056 0.5X0.5714 3) Find ert rt =0.co.1 X0.25 d1=0.Read the bottom of the tables very carefully.52)0.ACCA P4 Advanced Financial Management Key Point Notes June 2010  d1 &d2= Compute to two decimal places.25 =0.0714=0.25=0.25 d1=0.5√0.10+0.025 e0.025=0.430.5 return on the shares The time to expiry =3 months=0.25 0.051+0. Example The current share price of B plc shares=$100 The exercise price =$95 The risk free rate of interest = 10%pa =0.1 The standard deviation of =50% =0.
co.IntelligentAccountancyTutorsLtd.975 = $6. c= (100 x 0.71 1. the exercise price and the share price are related (where the put and call have the same strike and exercise date): Find the value of the put option p =$13.uk 101 . a put option.6664)(95 x 0. The value of a call option.71$100+$95 X 0.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Hence.3 Putcall parity Black Scholes’ model will only calculate the value of a call option.34 ________________________________________________________________________ Sunil Bhandari – www.5714 x 0.975) =$13.
The delta also measures how many shares one option will ‘cover’ if used to hedge a holding of shares.7 they will need to hold 0.IntelligentAccountancyTutorsLtd. If the delta is 0.co. 2. ________________________________________________________________________ Sunil Bhandari – www.7 shares for every option written.uk 102 .2 The Delta Hedge Delta hedging is used by options traders who have written options and wish to calculate how many shares they need to hold to hedge their position.1 Change In Varying With Delta δ Option value Underlying asset value Gamma Υ Delta Underlying asset value Theta θ Time Vega no symbol Time premium Option value Volatility Rho ρ Option value Interest rates 2.ACCA P4 Advanced Financial Management Key Point Notes June 2010  2 ‘The Greeks’ There are five indicators of how the option price changes according to the different factors in the Black Scholes equation.
1 Formulae where FO=Forward Rate X=Exercise Rate R=Domestic interest rate.ACCA P4 Advanced Financial Management Key Point Notes June 2010  3 FOREX modified BlackScholes option pricing model. ________________________________________________________________________ Sunil Bhandari – www. (Grabbe variant) 3.IntelligentAccountancyTutorsLtd. 3.2 Used for the valuation of Forex options.uk 103 .co.
IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  3.co.3 Example ________________________________________________________________________ Sunil Bhandari – www.uk 104 .
IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.uk 105 .co.
co.uk 106 .ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.
ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.co.uk 107 .IntelligentAccountancyTutorsLtd.
IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.co.uk 108 .
ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.uk 109 .co.IntelligentAccountancyTutorsLtd.
1 Real options on projects Delay/Defer the project Switch /redeploy resources Expand/contract the project Option to abandon. 4.ACCA P4 Advanced Financial Management Key Point Notes June 2010  4 Black and Scholes applied to Investment Appraisal.2 Recent Exam Questions ________________________________________________________________________ Sunil Bhandari – www.uk 110 .co.IntelligentAccountancyTutorsLtd. 4.
35=0.45m Hence “value “of the project is NPV +value to delay $4m+$7.900.10=0.25) 1) Find d1&d2 2 d1=ln (28/24)+(0.10 e0.05 x 2=0.5x0.2088=0.8159) – (24 X 0.45m ________________________________________________________________________ Sunil Bhandari – www.50+0.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Solution Pa=PV of the project = ($4m+$24m) =$28m Pe=Capex=$24m t=2 years r=5% (0.7088 3) ert rt=0.154+0.IntelligentAccountancyTutorsLtd.uk 111 .50+0.9048 X 0.90 d2= 0.25)2 0.7088) =$7.55 2) N(d1)=0.35 = 0.co.9048 Hence c= (28 X 0.25 X √2 = 0.8159 N(d2)=0.45m =$11.05+0.1625 0.0159=0.05) s=25 %( 0.
what is VaR? 45% 50% $50m s=$4.65 X $4.ACCA P4 Advanced Financial Management Key Point Notes June 2010  5. Value at Risk (VaR) 5.85m $ 50m(1.3 Confidence levels are normally set at 95% or 99%.85m. under normal conditions.2 Used by Investment banks to measure the market risk of their portfolios.1 VaR is a measure of how the market value of asset or a portfolio of assets is likely to decrease over certain time. the holding period (usually 1 to 10 days).co. ________________________________________________________________________ Sunil Bhandari – www. 5.85m) =$42m There is a 5% chance that the portfolio will fall below $42m.uk 112 . 5. At 95%.with standard deviation of $4. Example A bank has estimated the expected value of its portfolio in 2 week time will be $50m.IntelligentAccountancyTutorsLtd.
IntelligentAccountancyTutorsLtd.co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.uk 113 .
IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.co.uk 114 .
2.IntelligentAccountancyTutorsLtd. The answer can be presented:a) Ve b)Po 1.Eg: Property Investment company ________________________________________________________________________ Sunil Bhandari – www.3 Useful For:a) “Seller “ to set minimum value of the company (NRV) b) Companies with lots of tangible high value assets.co.2 Net Asset Valuation 1.1 Business is worth just the value of it’s Net Assets.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Chapter Twelve Business Valuations & Mergers &Acquisitions 1 PreAcquisition Values 1.uk 115 .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 1.1 The aim is to find a range of values for a company.2. To establish the net assets:Total Assets(Total Liabilities +Preference Shares) 1.
2.co.3.3 Major Weaknesses are:a) Not include nontangible assets b) Excludes what all assets generate future:i.49 $0.IntelligentAccountancyTutorsLtd.1 The company is worth the present value of it’s future dividends discounted at the cost of equity 1.3.4 Finding g a) Past Growth model eg: Year 2006 2007 2008 2009 DPS $0.uk 116 .3.54 ________________________________________________________________________ Sunil Bhandari – www.3.ACCA P4 Advanced Financial Management Key Point Notes June 2010  1.3 Take Care:Growth may not be constant forever Where to we get “g” from? CAPM may be needed to find Ke Often better for valuing a small shareholding 1.45 $0.2 Ve = Total Do(1+g) (Keg) OR Po = Do(1+g) (Keg) 1.4 Dividend Valuation Model 1.2. Profits iii. Cash Flows 1.52 $0. Dividends ii.
45) g=0. c) Simple rules i.uk 117 . Short term g=0.054 Long term 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 0.45.4 Price –Earnings Model 1.2 Ve=Sustainable PAT X Suitable P/E Po=Sustainable EPS X Suitable P/E 1.ACCA P4 Advanced Financial Management Key Point Notes June 2010  g= 3√ (0.54)1 (0.It has an ARR of 12% and re of 14%.4. 1.4.4 Suitable P/E:a) Take a proxy Company P/E b) Adjust to suit the company we are valuing.co.45 X 0.063 1.4. Ltd Co’s – deduct 30%off proxy Co P/E ________________________________________________________________________ Sunil Bhandari – www.3 Sustainable PAThave to adjust the latest reported reports for nonreoccurring items (post tax) 1.45 X 0.14=0.12=0.4.IntelligentAccountancyTutorsLtd.1 A business is worth a multiple of it’s profits.
4.co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ii.5. 1.5% and returns 30% of its profits.5.uk 118 .5.3 Weaknesses are: 1. It has a re of 8. If growth is expected in perpetuity what is the Ve? g =b X re =0.4 Example A company has FCF for equity currently at $400m.5.0255 ________________________________________________________________________ Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.085 = 0. 1.30 X 0. Nonlisted PLC’sdeduct 10% to proxy Co P/E 1.2 Establish:a) Future Cash flows and timescales b) Cost of capital (WACC or Risk adjusted WACC) 1.5 Concerns are: Finding a proxy Co P/E Adjustments are arbitrary Sustainable profits needs forecasting adjustments.1 A business is worth the discounted value of the future cash flows.5 Present value of Free Cash Flows 1.
ACCA P4 Advanced Financial Management Key Point Notes
June 2010

Ve= FCF0(1+g)
(reg)
= $400m (1.0255) = $6,894m
(0.0850.0255)
1.5.5 Another Example
A company has projected its FCF to equity at:T1
T2
T3
$420m
$490m
$510m
From T4 onwards growth will be at 3 %pa.re=7.92%.
Find Ve
Time
$m
FCF
PV
T1
420
1/1.0792
389
T2
490
1/1.07922
421
T3
510
1/1.07923
406
T4F.Ever
510(1.03)
16.171*
8,495
Ve=$9,711m
*
1
X
1
= 16.171
3
(0.07920.03)
(1.0792)
________________________________________________________________________
Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk
119
ACCA P4 Advanced Financial Management Key Point Notes
June 2010

1.6 Intellectual Capital(IC)
1.6.1 There are several methods of valuing IC and /or other
nontangible assets.
1.6.2 Simple estimate
Ve under DVM or P/E
Or PV of CF’s method

Book value of Net
Assets
1.6.3 Computed Intangible value (CIV) to compute this
an industry /proxy return on total assets % must be
given in the question.
Approach:
$ ‘000
1) Last reported profit before tax
Less: Industry of Proxy x Co’s total
Return on assets
assets
X
(X)
Value Spread
X
2) Take value spread
X
Tax @X%
(X)
Post tax value spread
X
3) Assume post tax value spread will stay constant
From time 1 to perpetuity.
Value of IC=Post tax value Spread
x
1/r
r =Cost of Capital
________________________________________________________________________
Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk
120
ACCA P4 Advanced Financial Management Key Point Notes
June 2010

4) Value of Equity is
Value of IC + Book value of the Assets
1.6.4 Lev’s knowledge earning method
An alternative method of valuing intangible assets
involves isolating the earnings deemed to be related to
intangible assets, and capitalising them. However its is
more complex than the CIV model in how it
determines the return to intangibles and the future
growth assumptions made.
In practice, this model does produce results that are
close to the actual traded share price, suggesting that
is a good valuation technique.
However, it is often criticised as over complex given
that valuations are in the end dependent on
negotiation between the parties.
Method
1) Calculate normalised earnings.
These are taken as a weighted average of:
35 years of past earnings (adjusted for any
oneoff items)
35 years of forecast earnings (based on analyst
predictions or sales patterns)
with the forecast earnings being given heavier
weight.
Note: In the exam you may simply have to use
current earnings as an approximation.
________________________________________________________________________
Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk
121
IntelligentAccountancyTutorsLtd. ________________________________________________________________________ Sunil Bhandari – www.He assumes they will grow as follows: Five years at the current rate of growth. and receivalbles. 3) Capitalise the intangible earnings Rather than simply assume these earnings will grow in perpetuity as under the CIV model.ACCA P4 Advanced Financial Management Key Point Notes June 2010  2) Isolate the earnings driven by intangible assets. Normalised earnings Less Return on financial/monetary assets(Rf X monetary assets employed) Less Return on physical /tangible assets(Average industry return on tangibles X tangible assets employed) Earnings driven by intangible assets $ X (X) (X) X Lev identified the expected returns on assets as the: financial /monetary assetsrisk free rate tangible assetsaverage market return in industries primarily driven by their investment in tangible assets intangible assets6% premium on the risk free rate. Lev’s model is more sophisticated .They are essentially current assets.uk 122 . Note: Financial assets are cash and other assets that convert directly into known amounts of cash. marketable securities. The three basic categories are cash.co.
IntelligentAccountancyTutorsLtd. 2 Post Acquisitions Values Follow a 3 step approach 2.co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Declining growth year on year for the next five years.1 PreAcquisition Data Predator Target No of Equity shares in Issue X X PAT X X EPS X X Pre acquisition Po X X P/E Ratio X X If the P/E ratio of Predator is greater than target then a bootstrap method is possible ________________________________________________________________________ Sunil Bhandari – www. Year eleven onwardsgrowing at the long term predicted growth rate.uk 123 .
IntelligentAccountancyTutorsLtd.uk 124 .ACCA P4 Advanced Financial Management Key Point Notes June 2010  2.2 Post Acquisition value of Predator a) Using Bootstrap $000 Predator PAT X Target PAT X Total PAT X Total PAT X PREDATOR P/E = Ve* b) Using Add Together $000 Predator Preacquisition Ve X Target Preacquisition Ve X X PV of Synergy Cash flows X Ve * *Divide this by the new number of total issued shares in Predator to find Post Acquisition Po ________________________________________________________________________ Sunil Bhandari – www.co.
________________________________________________________________________ Sunil Bhandari – www.e. cut out the middle man.3 Assess the Takeover Predator Check the KPI’s post acquisition against pre acquisition:a) Po risen? b) EPS risen? Target Compute the Bid Premium:Per Share $ Value received post acquisition Per target share Preacquisition price X (X) X 3 Factors to consider in Mergers and Takeovers 3.1 Assets of sharesmost companies buy the victim company’s shares rather than transferring their assets.2 Synergiesconcept of “2+2=5”.IntelligentAccountancyTutorsLtd.uk 125 . 3. Both are feasible.ACCA P4 Advanced Financial Management Key Point Notes June 2010  2. b) Buying suppliers can reduce profit charged on purchases i.Many sources exist: a) Economies of scale from horizontal combinations reduces costs and increase profits.co.
IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  c) Improve badly managed /inefficient businesses. 3. d) Diversify to stabilise profits and cash flows.uk 126 .3 Financeto fund the takeover the predator company Could use:a) Cash b) Shares c) Loan Stock ________________________________________________________________________ Sunil Bhandari – www. e) Access companies that generate cash (Cash Cow) f) Use the managerial talent of the victim in a more productive way.co. g) Market power may allow consumer price increases and more profits.
uk 127 .co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.
co. b)Find an alternative/Friendly buyer (White Knight) ________________________________________________________________________ Sunil Bhandari – www.5 DefencesThe victim company could defend a takeover in several ways:a)Appeal to the Competition Commission indicating the takeover is anticompetitive.4 Regulation of Takeovers 3.ACCA P4 Advanced Financial Management Key Point Notes June 2010  3.IntelligentAccountancyTutorsLtd.uk 128 .
uk 129 .ACCA P4 Advanced Financial Management Key Point Notes June 2010  c) Appeal to the shareholders and manage a defence showing that the takeover will not benefit them. d)Super majorityset up in the Articles requiring a high proportion of S/H to agree on takeovers. ________________________________________________________________________ Sunil Bhandari – www. e)Poison pill strategy –creation of “tripwires” invoked on a takeover causing the acquirer to spend more money.co.IntelligentAccountancyTutorsLtd.
IntelligentAccountancyTutorsLtd.co.uk 130 .ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.
uk 131 .IntelligentAccountancyTutorsLtd.co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.
IntelligentAccountancyTutorsLtd.co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.uk 132 .
uk 133 .IntelligentAccountancyTutorsLtd.co.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.
co.IntelligentAccountancyTutorsLtd.uk 134 .ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.
co. It is accepted that companies exits to maximise shareholder value. The three terms to be familiar with are: (a) Economic value added (EVA) (b) Market value added (MVA) (c) Shareholder value added (SVA) Economic Value Added 1.3 EVA = Net operating profit after tax (NOPAT) – imputed interest charge EVA shows whether a company is making sufficient profit to cover its cost of capital. It is a similar approach to residual income.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Chapter Thirteen Modern Valuation Methods 1 VALUE BASED MEASURES 1.IntelligentAccountancyTutorsLtd. adding back interest and taking off the tax paid.2 More recent approaches to valuations and performance measures have focused on shareholder value. yet managers continue to be rewarded based on traditional accounting measures.uk 135 . It is sometimes referred to as cash earnings before interest but after tax.4 NOPAT is calculated by taking the operating profit from published accounts. 1. ________________________________________________________________________ Sunil Bhandari – www.
the interests of managers and shareholders should be aligned. They use the EVA model. This represents the return on capital required to keep the investors happy.uk 136 . if managers’ remuneration is linked to EVA.6 A positive EVA indicates that a company is adding value for its shareholders.7 Disadvantages of EVA include: Calculations can be complicated and involve many adjustments to accounting information EVA is a historic measure EVA cannot be used to directly compare companies as it requires an adjustment for their relative sizes The calculation relies on CAPM for the WACC.IntelligentAccountancyTutorsLtd.5 The imputed interest charge is calculated as the capital employed multiplied by the WACC. Profit and loss account for year ended 30 September 20X2 £m Turnover 150 PBT 50 Tax 18 PAT 32 Dividends 10 ________________________________________________________________________ Sunil Bhandari – www. Therefore. 1. 1.co.8 Example The directors of Old Nick plc wish to establish whether they have increased shareholder value in the year to September 20X2. which itself is subject to many restrictive assumptions 1.ACCA P4 Advanced Financial Management Key Point Notes June 2010  1.
ACCA P4 Advanced Financial Management Key Point Notes June 2010  Retained earnings Additional information: 22 (a) Included in cost of sales and expenses is £10 million of economic depreciation. Required Calculate the EVA in the year to September 20X2. (h) The gearing ratio is 50:50 debt to equity by market value. (b) Noncash expenses amounted to £15 million. This is the same as the depreciation used for tax purposes.co. (d) The pretax cost of debt is 10%. (e) The cost of equity is 15%. (c) The opening capital employed on the balance sheet was £108 million. (f) Old Nick plc has an effective tax rate of 35%.IntelligentAccountancyTutorsLtd. (g) The interest expense in 20X2 was £5 million. ________________________________________________________________________ Sunil Bhandari – www.uk 137 .
10 MVA is the value added to a business since it was formed.9 Solution WACC NOPAT: = (50% X 15%) + (50% X 10% X 0.25m – (10.IntelligentAccountancyTutorsLtd.£25m .64m Market Value Added 1.75% £m 32 15 47 3.£5m = £10m ________________________________________________________________________ Sunil Bhandari – www.25 PAT Add: Non – cash Expenses Add: Post tax ints (5m X 0.uk 138 .75% X £108m) = £38.ACCA P4 Advanced Financial Management Key Point Notes June 2010  1.co. Quick Example BB Plc 2003 Ve = £25m 2004 Ve = £40m Rights issue in 2004 = £5m MVA = £40m .65) = 10. over and above the money invested in the company by shareholders and long term debt holders.65) £50.25 EVA = £50.
a.5m SVA = £1. WACC = 14% Vd = £2.5m = £8.5m p.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Shareholder Value Added 1.IntelligentAccountancyTutorsLtd. The discount rate will be the company’s WACC.21m ________________________________________________________________________ Sunil Bhandari – www.5m x 1 0.14 .uk 139 .£2.11 SVA represents the discounted future free cash flows less the value of the company’s debt. Quick Example CC Plc Free cash flows for T1 on in perpetuity of £1.co.
IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.uk 140 .co.
the situation is likely to lead to an ability of the company to pay its obligations as they become due.ACCA P4 Advanced Financial Management Key Point Notes June 2010  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 reasons behind such failure are rarely financial. or economies.IntelligentAccountancyTutorsLtd. the economy simply does not identify poorly performing companies For notforprofit organisations. in the former Soviet Bloc. The issue is more problematic in sectors. but if it is unable to convert those assets into cash it will be insolvent. Although stated in financial terms. and failures indicated by the inability to raise sufficient funds to carry out activities effectively. For example.co. but seem to have more to do with a firm’s ability to adapt to changes in its environment. The company may still have an excess of assets over liabilities. where profitability is not an issue.uk 141 . ________________________________________________________________________ Sunil Bhandari – www. the issue is usually one of funding.
4X2 +3.once combined . are: 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 company’s assets.co.2 X1 +1.uk 142 . which . The five ratios.were considered to be the best predictors of failure.0X5 ________________________________________________________________________ Sunil Bhandari – www.1 Altman ZScore Model The Z score model was first developed by Altman in 1968 based on research in the USA into bankrupt manufacturing companies: Z scores are an attempt to anticipate strategic and financial failures by examining company financial statements. which are then multiplied by a predetermined weighting factor and added together to produce the Z score. The extent to which the equity can decline before the liabilities exceed the assets and the company becomes insolvent The ability of the company’s assets to generate revenue. Z score=1.3X3 +0.ACCA P4 Advanced Financial Management Key Point Notes June 2010  2 Predicting Corporate Failure 2.IntelligentAccountancyTutorsLtd.6X4 +1. The Z score is generated by calculating five ratios.
2 Assessing the risk of failure The accuracy of prediction of the model. The Z score model was found to be an accurate predictor of failure for up to two years prior to bankruptcy. but that the accuracy decreases over longer periods. Some scoring systems tend to rate companies lowthat is they are likely to classify distressed firms as actually failing. ________________________________________________________________________ Sunil Bhandari – www.81 indicates that the Company is in danger and possibly heading towards bankruptcy.uk 143 .IntelligentAccountancyTutorsLtd.81 and 2.co. Scores are only good predictors in the short term. Z score of 3 or above indicates financially sound. Further analysis is needed to fully understand the situation. Companies with scores between 1. Care needs to be taken when applying it to other types of companies.3 Limitations of corporate failure prediction models There are number of limitations of the Z score and other similar failure prediction models: The score estimated is a snapshotit gives an indication of the situation at a given point in time but does not determine whether the situation is improving or deteriorating. What level of Z score indicates different levels of likelihood of failure? It was found that: Z score<1.ACCA P4 Advanced Financial Management Key Point Notes June 2010  2. The Z score was estimated based on manufacturing companies.99 need further investigation 2.
for example: very large increases in intangible fixed assets a worsening cash and cash equivalents position shown by the cash flow statement very large contingent liabilities important post balance sheet events Information in the chairman’s report and the director’s report (include warnings. changes in the composition of the board since last year.2 General principles in devising a scheme In most cases the company is ailing: Losses have been incurred with the result that capital and long term abilities are out of line with the current value of the company’s assets and their earning potential.ACCA P4 Advanced Financial Management Key Point Notes June 2010  3 Other signs of Corporate Failure Information in the published accounts.co. ________________________________________________________________________ Sunil Bhandari – www. 4 Financial Reconstructions 4. New capital is normally desperately required to regenerate the business. Information in the press (about the industry and the company or its competitors). evasions.uk 144 . You should have a good idea as to the type of environmental or competitive factors that affect firms.1 Options open to failing companies a company Voluntary Arrangement (CVA) an administration order 4. but this will not be forthcoming without a restructuring of the existing capital and liabilities. Information about environmental or external matter.IntelligentAccountancyTutorsLtd.
________________________________________________________________________ Sunil Bhandari – www. Agree the scheme with the various parties involved.in what form(shares. if further finance is required. determine the amount required .uk 145 . determine a reasonable manner in spreading the write off(the capital loss) between the various parties that have financed the company(shareholders and creditors). Given the size of the write off required and the amount of further finance require. Determine whether the company can continue to trade without further finance or. loan stock) and from which persons it is obtainable (typically existing shareholders and financial institutions).IntelligentAccountancyTutorsLtd.ACCA P4 Advanced Financial Management Key Point Notes June 2010  The general procedure to follow would be: Write off fictitious assets and the debit balance on profit and loss account.co. Revalue assets to determine their current value to the business.
IntelligentAccountancyTutorsLtd.uk 146 .ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.co.
________________________________________________________________________ Sunil Bhandari – www. 2 Preparation In my view.IntelligentAccountancyTutorsLtd. Go on to the ACCA Global website and read and review the past answers to ‘Q4’ set by Bob Ryan. There is no indication that this is likely to change in the near future. Common points in past question have been: Either a two part question of at least two themes within the requirements Ethical Issues Providing a solution to a Financial or Strategic problem.ACCA P4 Advanced Financial Management Key Point Notes June 2010  Chapter Fifteen Question 4 and Emerging Issues 1 The Written Question The Examiner has been consistent on all papers he has set so far. one way to prepare for this question is to look back and review what the examiner has set so far and how he has answered the question. Q4 has been a full written question.co.uk 147 .
IntelligentAccountancyTutorsLtd.uk 148 .ACCA P4 Advanced Financial Management Key Point Notes June 2010  ________________________________________________________________________ Sunil Bhandari – www.co.
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue reading from where you left off, or restart the preview.