December 2010 Examinations Paper P4 87

Predicting and Preventing Corporate Failure Chapter 16

5 Avoiding failure
Ross and Kami listed ‘Ten Commandments’ that should be followed by a company to avoid failure:
• You must have a strategy
• You must have controls
• The Board must participate
n
• You must avoid one-man rule
si o
• There must be management in depth
e r
•
•
Keep informed of, and react to, change

a l V
•
The customer is king
Do not misuse computers
T ri n
•
•
Do not manipulate your accounts
it h si o
W
Organise to meet employees needs

d e r
t e a l V
re a T ri
C it h o n
W e r si
t e d l V
re a ri a
C h T o n
W it r si
e d V e
a t a l
C re T ri
i t h
d W
at e
C r e

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88 December 2010 Examinations Paper P4
Predicting and Preventing Corporate Failure Chapter 16

o n
e r si
a l V
T ri n
it h si o
d W e r
t e a l V
re a T ri
C it h o n
W e r si
t e d l V
re a ri a
C h T o n
W it r si
e d V e
a t a l
C re T ri
i t h
d W
at e
C r e

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December 2010 Examinations
Predicting and Preventing Corporate Failure
technical
page 54
BUSINESS FAILURE e r
V
PREDICTION AND PREVENTION
RELEVANT TO ACCA QUALIFICATION PAPERS P4 AND P5
Students are required to be familiar with failure prediction models based on both quantitative and
d W
qualitative information, and also to comprehend the underlying factors leading to the decline
and eventual demise of a company. In this article, the various failure prediction models are critically
e l
discussed and an attempt is made to identify the most significant reasons for eventual company failure.
t a
re a
C it
According to recent statistics from the UK’s
Ministry of Justice, almost 12,000 companies
W
filed for insolvency in 2007 in England and Wales.
This number is forecast to increase significantly
d
(to around 13,500 companies) in 2008 (Financial
t e
Times, 2 January 2008) as the financial crisis
hits businesses in the wider economy. Smaller
a a l
companies are likely to suffer most because of
re
a slowing economy and the increasing costs of
borrowing in a deteriorating business environment.
C h T
THE MODELS
Corporate failure models can be broadly divided
W
into two groups: quantitative models, which are
based largely on published financial information;
d
and qualitative models, which are based on an
a t e
internal assessment of the company concerned.
Both types attempt to identify characteristics,
whether financial or non-financial, which can
re
then be used to distinguish between surviving and
failing companies.
C
Quantitative models
Quantitative models identify financial ratios
i t 0.2
W
with values which differ markedly between
surviving and failing companies, and which can
e d
subsequently be used to identify companies which
exhibit the features of previously failing companies.
at
Commonly-accepted financial indicators of
impending failure include:
C r e
low profitability related to assets and
commitments
low equity returns, both dividend and capital
poor liquidity
high gearing
high variability of income.
The pioneer of corporate failure prediction models
which used financial ratios was William Beaver
(1966). He applied a univariate model in which
a classification model was carried out separately
for each ratio, and (also for each ratio), an optimal
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Paper P4 89
Chapter 16
student accountant
JUNe/JULY 2008
o n
si
a l
T ri n
it h
si o
e r
V
T ri
h o n
si
cut-off point was identified where the percentage The optimal cut-off point is chosen on an
of misclassifications (failing or non-failing) was ex-post basis, ie when the actual failure status
minimised. The misclassification could be either
classifying a failing firm as non-failing (a Type I
e r
of each company is known. As a result, the
cut-off points may be sample-specific and the
V
error), or classifying a non-failing firm as failing classification accuracy may be much lower
(a Type II error). Beaver selected a sample of
79 failed firms and 79 non-failing firms and
when applied on a predictive basis.
ri
investigated the predictive power of 30 ratios The logical solution is to select a combination
when applied five years prior to failure. Of the of ratios, a multivariate approach, in an attempt
ratios examined, he found that the ‘cash flow to
total debt’ ratio (Figure 1) was most significant in
to provide a more comprehensive picture of
n
the financial status of a company. Following
o
it si
predicting failure, with a success rate of 78% for Beaver, Altman (1968) proposed ‘multiple
five years before bankruptcy. discriminant analysis’ (MDA). This provided
FIGURE 1: CASH FLOW TO TOTAL DEBT RATIO
e r
a linear combination of ratios which best
distinguished between groups of failing and
V
non-failing companies. This technique dominated
Cash flow/Total debt
a l
the literature on corporate failure models until the
1980s and is commonly used as the baseline for
ri
0.6 comparative studies.
0.5 In the MDA model, the ratios are combined
0.4
0.3
h T into a single discriminant score, termed a ‘Z score’,
with a low score usually indicating poor financial
0.1
health. Altman’s study involved 66 manufacturing
companies with equal numbers of failures and
0 survivors, and a total of 22 ratios from five
5 4 3 2 1 categories, namely liquidity, profitability, leverage,
-0.1
-0.2 solvency, and activity. From this set of ratios, five
were finally chosen on the basis of their predictive
Years before failure ability. Altman’s original Z score equation was:
Key: Non-failed Failed
Although the simplicity of the univariate approach
is appealing, there are a number of potential
problems:
Z = 0.012X1 + 0.014X2 + 0.33X3 + 0.006X4
+ X5
Where:
X1 = working capital/total assets
Company classification is based on one ratio X2 = retained earnings/total assets
at a time, which may give inconsistent and X3 = profit before interest and tax/total assets
confusing classification results for different X4 = market value of equity/book value of debt
ratios used on the same company. X5 = sales/total assets
It contradicts reality, in that the financial
status of a company is complex and cannot be The pass mark for Altman’s Z score was three,
captured by one single ratio. above which companies would be considered
90 December 2010 Examinations Paper P4
Predicting and Preventing Corporate Failure Chapter 16

technical linked performance objectives

page 55 performaNce obJectives 15 aNd 16 are reLevaNt to paper p4
stUdYiNg paper p5? check oUt performaNce obJectives 12, 13, aNd 14

o n
relatively safe. Companies with Z scores below 1.8
would be classified as potential failures; scores
between 1.8 and three were in a grey area. He
capital intensiveness
profitability expressed as earnings, or cash
flows as related to assets or funds si
The threshold identified by Company Watch

r
is a score of 25, below which companies are

e
described as being in the ‘Warning Area’. The
found a misclassification rate of 5% one year prior
to failure and 17% two years prior to failure.
working capital position
liquidity position
asset turnover.

a l V
H score distinguishes between different types
of company by using a suite of sub-models –
these are associated with a particular category

ri
FIGURE 2: LINEAR DISCRIMINATE ANALYSIS of company with broadly similar balance
They concluded that these patterns were not sheet structures.
Failing
companies
Surviving
companies
T
stable during the period of their study, even A company’s valuation is based on seven key

n
Distribution density

h
when considering the same group of companies. discriminating factors which are grouped into three

it
However, their general conclusions were that it
was possible to identify distinct financial patterns

si o
key management areas, each on a percentile basis:
1 Profit management, as measured by changes

‘Zone of ignorance’

W
and that these could be used to reduce the number
of ratios being studied, but that the long-term

d e r
in profitability.
2 Asset management, as measured by liquidity,

V
instability of the patterns made their application to working capital, and current asset cover.
1.81

a t e Z 2.67 different periods or countries difficult.

a l
The last in the category of quantitative models
3 Funding management, as measured by
adequacy of the capital base, dependency on

ri
In the UK, a similar methodology was employed is the H score, devised by Company Watch (www. debt, and dependency on current liabilities.

re
by Taffler and Tishaw (1977) based on a sample companywatch.net). As with the Z score, the
of 92 manufacturing companies. The resulting Z

C
score equation was based on a combination of four

h T
H score is based on discriminant analysis, in which
characteristics of companies are used to optimally
In conclusion, the statistical evidence supporting

n
both univariate and multivariate techniques of

ratios, albeit with undisclosed coefficients:
Z = co + c1X1 + c2X2 + c3X3 + c4X4
o
it si
discriminate between those which subsequently predicting failure is generally impressive and often
failed within a specified time period and those reveals considerable predictive power. Certain

W
which survived. Similar to Taffler’s PAS, it is a
ranked percentile score taking a value between 0

d r
caveats should, however, be borne in mind:

e
The precise specification of a model will be

V
Where: and 100. The interpretation of a particular H score, sample specific, and decision makers should

a t e
X1 = profit before tax/current assets (53%)
X2 = current assets/current liabilities (13%)
for example 20, is that only 20% of companies

l
have characteristics even more indicative of failed

a
exercise care when using previous models.
The value of a model is difficult to assess

ri
X3 = current liabilities/total assets (18%) companies, and therefore the company’s health without a realistic costing of Type I

re
X4 = no credit interval (16%) would be judged as relatively weak. and II errors.

C
The percentages reveal a guide to the relative

h T o n
it si
weightings of the ratios. Taffler and Tishaw
claimed a 99% successful classification based on
the original 92 companies from which the model
was derived. However, when the model was tested
by Taffler (1983) on a sample of 825 companies,

d W e r
t e
the results were less convincing. The equation then
classified 115 out of the 825 quoted industrial

a l V
were still at risk.
re a
companies as being at risk. In the following four
years, 35% went bankrupt and a further 27%

T ri
C
Both Altman and Taffler’s original models
were then developed further. Altman et al (1977)
addressed the problem of the assumption
regarding the normal distribution of ratios in their
i t h
ZETA model. Taffler then adapted the Z score
technique to develop the Performance Analysis

d W
e
Score (PAS).

at
This forms a ranking of all company Z
scores in percentile terms, measuring relative

C r e
performance on a scale of 0 to 100. A score
of X means that 100 - X% of companies have
higher Z scores (eg a score of 80 means 20%
have higher scores). As the PAS score over
time shows the relative performance trend of
a company, any downward trend should be
investigated immediately.
Ezzamel, Brodie and Mar-Molinero (1987)
briefly reviewed the earlier research and reported
their UK study of financial ratios using factor
analysis. Using 53 ratios, they described five
broad patterns:

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December 2010 Examinations Paper P4 91
Predicting and Preventing Corporate Failure Chapter 16

technical student accountant

page 56 JUNe/JULY 2008

o n
Qualitative models
This category of model rests on the premise that
the use of financial measures as sole indicators

e r si
of organisational performance is limited. For
this reason, qualitative models are based on
non-accounting or qualitative variables. One of

a l V
ri
the most notable of these is the A score model
attributed to Argenti (1976), which suggests that
the failure process follows a predictable sequence:

h T o n
it si
Defects
â
Mistakes made
â

d W e r
V
Symptoms of failure

t e
Defects can be divided into management

a a l
ri
weaknesses and accounting deficiencies as follows:

re
Management weaknesses:

C
autocratic chief executive (8)
failure to separate role of chairman and chief

h T o n
it si
executive (4)
passive board of directors (2)

W
lack of balance of skills in management team
– financial, legal, marketing, etc (4)

d e r
V
weak finance director (2)

a t e
lack of ‘management in depth’ (1)
poor response to change (15).

a l
ri
1 Financial signs – in the A score context, these is perhaps the most notable, a large number of

re
Accounting deficiencies: appear only towards the end of the failure non-accounting or qualitative variables have been

C
no budgetary control (3)
no cash flow plans (3) 2
T
process, in the last two years (4).
Creative accounting – optimistic statements

h
included in other studies. These include:

n
company-specific variables – such as

o
it si
no costing system (3). are made to the public and figures are altered management experience, customer
(inventory valued higher, depreciation lower, concentration, dependence on one or a few

W
Each weakness/deficiency is given a mark (as
shown) or given zero if the problem is not present.

d
The total mark for defects is 45, and Argenti
etc). Because of this, the outsider may not
recognise any change, and failure, when it
arrives, is therefore very rapid (4).
e rsuppliers, level of diversification, qualified
audit opinions, etc
general characteristics – such as industry type

t e
suggests that a mark of 10 or less is satisfactory.
If a company’s management is weak, then
3 Non-financial signs – various signs include

l
frozen management salaries, delayed capital

a V factors in the external environment – such

as the macroeconomic situation, including

re a
Argenti suggests that it will inevitably make
mistakes which may not become evident in the
form of symptoms for a long period of time. The 4
staff turnover (3).

T ri
expenditure, falling market share, rising

Terminal signs – at the end of the failure

interest rates, the business cycle, and the
availability of credit.

C
failure sequence is assumed to take many years,
possibly five or more. The three main mistakes
likely to occur (and attached scores) are:
1 high gearing – a company allows gearing to
i t
process, the financial and non-financial signs

h
become so obvious that even the casual
observer recognises them (1).
OTHER SYMPTONS OF FAILURE
Many other lists of symptoms of failure exist. For
example, there is a list of 65 reasons on the UK
Insolvency website which include:

d
can have disastrous consequences (15)
W
rise to such a level that one unfortunate event The overall pass mark is 25. Companies scoring
above this show many of the signs preceding
1 Failure to focus on a specific market because
of poor research.

e
2 overtrading – this occurs when a company failure and should therefore cause concern. 2 Failure to control cash by carrying too much

at
expands faster than its financing is capable of Even if the score is less than 25, the sub-score stock, paying suppliers too promptly, and
supporting. The capital base can become too can still be of interest. If, for example, a score allowing customers too long to pay.

C r esmall and unbalanced (15)

3 the big project – any external/internal project,
the failure of which would bring the company
down (15).
The suggested pass mark for mistakes is a
maximum of 15.
The final stage of the process occurs when the
symptoms of failure become visible. Argenti
classifies such symptoms of failure using the
following categories:
over 10 is recorded in the defects section, this
may be a cause for concern, or a high score in
the mistakes section may suggest an incapable
management. Usually, companies not at risk
have fairly low scores (0–18 being common),
whereas those at risk usually score well above
25 (often 35–70).
The A score has therefore attempted to
quantify the causes and symptoms associated
with failure. Its predictive value has not been
adequately tested, but a misclassification rate of
5% has been suggested. While Argenti’s model
3 Failure to control costs ruthlessly.
4 Failure to adapt your product to meet
customer needs.
5 Failure to carry out decent market research.
6 Failure to build a team that is compatible
and has the skills to finance, produce, sell,
and market.
7 Failure to pay taxes (insurances and VAT).
8 Failure of businesses’ need to grow. Merely
attempting stability or having even less
ambitious objectives, businesses which did not
try to grow didn’t survive.

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92 December 2010 Examinations
Predicting and Preventing Corporate Failure
technical
page 57
9
10
11
Failure to gain new markets.
Under-capitalisation.
Cash flow problems.
12
13
14
Tougher market conditions.
Poor management.
Companies diversifying into new, unknown
areas without a clue about costs.
15 Company directors spending too much money
on frivolous purposes thus using up all
available capital.
ULTIMATE REASON FOR FAILURE
It has been suggested that the ultimate reason for
business failure is poor leadership. According to
d W
business guru, Brian Tracy, ‘Leadership is the most
t e
important single factor in determining business
success or failure in our competitive, turbulent,
re a
fast-moving economy.’ Based on a study by the
US Bank, the main reasons why businesses fail are:
poor business planning
C
poor financial planning
poor marketing
poor management.
W
Proper application of these key factors is a function
d
of good leadership. According to the study, in the
a t e
business planning category, 78% of businesses fail
due to the lack of a well-developed business plan.
Remember the old saying: ‘If you fail to plan, you
re
plan to fail.’
Leadership is about planning for success
C
before it happens. Sun Tzu, the 6th century
Chinese philosopher, in his epic work The Art of
War, gave some sound advice that still applies
to business today: ‘When your strategy is deep
and far-reaching, then what you gain by your
d W
calculations is much, so you can win before
a t e
you even fight. When your strategic thinking is
shallow and near-sighted, then what you gain by
your calculations is little, so you lose before you
re
do battle.’
In the financial planning category, 82%
C
of businesses failed due to poor cash flow
management skills, followed closely by starting
out with too little money. Business leadership is
about taking financial responsibility, conducting
sound financial planning and research, and
d
understanding the unique financial dynamics of
at e
one’s business. Half of the UK’s small businesses
fail within the first three years because of cash
flow problems. They either run out of money
C r e
or run out of time. Consumer debt, personal
bankruptcies, and company insolvencies are all
now on the increase.
The third business failure factor profiled in
the study, and a critical one, was marketing.
Over 64% of the businesses surveyed in
the marketing category failed because their
owners ignored the importance of properly
promoting their business, and then ignored their
competition. Again, as a business leader, you
must be able to effectively communicate your
idea to the right people and understand their
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Paper P4
Chapter 16
useful Websites
www.companywatch.net
www.briantracy.com
o n
unique needs and wants. Leadership is all about
taking initiative, taking action, getting things
done, and making decisions. If you are not doing si
to become frogs because of over-optimism, a
r
failure to make contingency plans and a lack
e
of interest in overall success as a result of too
anything of significance to market and promote
your business, you are most likely headed for
business failure.
a l V
much focus on the product.
AVOIDING FAILURE
ri
You must also know your competition. Perhaps the best way to avoid failure is to examine
Leadership is about providing value to customers; the myriad explanations for business failure. Many
h T
if your main competitors are all providing a better
quality and lower priced product, how can you
books and articles have focused on identifying
n
reasons for failure as a remedy for prevention. One
o
it si
possibly create any value? Either you harness of the more significant earlier works was by Ross
your strengths to provide different benefits (such and Kami (1973); they gave ‘Ten Commandments’
as speed, convenience, or better service), lower
your price and improve quality, create a different
e r
which, if broken, could lead to failure:
1 You must have a strategy.
product for an unmet demand, or get out of
the game.
a l
Finally, one of the most important reasons why V
2 You must have controls.
3 The Board must participate.
4 You must avoid one-man-rule.
ri
businesses fail is due to poor management. In the
management category, 70% of businesses failed
T
due to owners not recognising their failings and
5 There must be management in depth.
6 Keep informed of, and react to, change.
7 The customer is king.
h
not seeking help, followed by insufficient relevant
it
8 Do not misuse computers.
o n
si
business experience. Not delegating properly 9 Do not manipulate your accounts.
and hiring the wrong people were additional 10 Organise to meet employees’ needs.
major contributing factors to business failure in
this category.
e r
FURTHER REFERENCES
V
An interesting, alternative method of Altman, E, 1968. Financial ratios,
classifying reasons for failure is provided by
a
Richardson et al (1994), who use the analogy of
l
discriminant analysis and the prediction of
corporate bankruptcy. Journal of Finance.
ri
frogs and tadpoles: Altman, E, Haldeman, R G, Narayanan, P,
1 Boiled frog failures 1977. ZETA analysis: a new model to identify
T
These are long-established organisations which
exhibit the often observed organisational
h
bankruptcy risk of corporations. Journal of
Banking & Finance.
o n
it si
characteristics of introversion and inertia in Argenti, J, 1976. Corporate Collapse: The
the presence of organisational change. This Causes and Symptoms. McGraw Hill.
category can be illustrated by the problems
faced by ICI.
2 Drowned frog failures
e r
Beaver, W, 1966. Financial ratios as
predictors of failure. Journal of Accounting
V
Research, Supplement 4.
Less to do with management complacency
l
and more to do with managerial ambition and
a
Ezzamel, M, Brodie, T, Mar-Molinero,
C, 1987. Financial Patterns of UK
ri
hyperactivity. In the smaller company context, Manufacturing companies. Journal of
this is the failed ambitious entrepreneur, Business Finance & Accounting.
T
whereas in the bigger context this is the failed
conglomerate kingmaker, perhaps typified by
h
Richardson, F M et al, 1994. Understanding
the Causes of Business Failure Crises.
t
Robert Maxwell.
i
3 Bullfrogs
Expensive show-offs who need to adorn
Management Decision.
Ross, J E and Kani, M J, 1973. Corporate
Management In Crisis: Why the Mighty Fail.
Wthemselves with the trappings of success.
The bullfrog exists on a continuum from
Prentice Hall.
Taffler, R J and Tishaw, H, 1977. Going,
the ‘small firm flash’ to the ‘money messing
megalomaniac’. The behaviour of bullfrogs
often raises ethical issues due to a failure to
Going, Gone: Four Factors Which Predict.
Accountancy, 88.
Taffler, R J, 1983. The assessment of
separate business expenditure from personal
expenditure (for example, Conrad Black).
4 Tadpoles
Tadpoles never develop into frogs and
represent the failed business start-up in the
company solvency and performance using a
statistical model: a comparative UK-based
study. Accounting & Business Research, 15.
Tzu, S, Zi, S, Giles, L, 2006. The Art of War.
Filiquarian Press.
small business setting. In the large business www.companywatch.net
context, the tadpole is typified by the business www.insolvencyhelpline.co.uk
which is dragged down by a big new project www.briantracy.com
which turns out to be such an expensive www.nationalbusiness.org/NBAWEB/
failure that it destroys its parent. New products Newsletter2005/2029.htm
and services often fail, such as the Sinclair
home computer. Small tadpoles usually fail Michael Pogue is assessor for Paper P5
December 2010 Examinations Paper P4 93

Chapter 17
Corporate Reorganisation and
Capital Reconstruction Schemes
o n
e r si
a l V
1  Introduction
T ri n
it h
This chapter examines the financial restructuring possibilities open to UK companies. These
include divestments, MBOs (which became increasingly popular in the 1980’s) and more general
si o
schemes of reconstruction.

d W e r
t e
2  Demergers, sell-offs, unbundling and asset stripping
a l V
re a T ri
C All of these involve splitting a company into two or more businesses. With a demerger existing

it h
shareholders are given shares in each of the two separate businesses – control is maintained.
o n
W r si
Under a ‘sell-off ’, at least part of the business will be sold to a third party. Control is lost, but funds
are raised.
e
t e d l V
‘Unbundling’ means to take apart the components of a company with the intention of disposing of

a ri a
part or all of the parts separately at a higher price than the whole. This would usually be done via

re
C Why demerge or sell?
h T
a ‘sell-off ’. When done following a takeovers it is termed ‘asset stripping’.

o n
(a) to focus on core competence

W it r si
(b) to react to changes in strategic focus

e d V e
(c)

a tto sell off unwanted asswets

a l
C re T
(e) to remove ‘co-insurance benefits’ from debtholders ri
(d) to capture ‘revers synergy’ resulting from an existing ‘conglomerate discount’

(f ) to meet regulatory requirements

i t h
d W
at e
C r e

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94 December 2010 Examinations Paper P4
Corporate Reorganisation and Capital Reconstruction Schemes Chapter 17
3  Management buyouts
A management buyout is the purchase of all or part of a business from its owners by one or more
of its executive managers
A management buy-in is where a team (usually assembled by a venture capitalist) identify a target
company to take-over.

o n
si
A buy-in / buy-out is where a team is drawn from a combination of the existing management and
experts appointed via the venture capitalist.
Parties to a buyout
e r
(a) the management team
a l V
(b) the directors of the company
(c) T ri
the financial backers of the management team (often including a venture capitalist)
n
Reasons for a buyout
it h si o
W
(a) from the buyout teams’ point of view:

d e r
i.

t e
to obtain ownership of the business rather than remin as employee
ii. to avoid redundancy when the business is threatened with closure
a l V
re a
(b) from the seller’s point of view

T ri
C i.
n
to dispose of part of the company that does not fit in with the overall strategy of the company

it h o
si
ii. to dispose of a loss-making segment of the business which the directors do not have time or
inclination to turn around
iii. in order to raise cash

d W e r
t
in the open market
a l V
iv. it is often easier to arrange a management buyout than to try and sell off parts of a business
e
re a ri
v. it may well avoid redundancy costs, strike action, etiii. if closure if the only alternative

T
C it h o n
si
Why may buyouts generate shareholder value?

W
(a) personal motivation of the buyout team

d e r
(b) a more hands-on approach to management
(c)
t e a l
keener decision making on such areas as pricing, debt collection etiii. V
re a
(d) savings in head office overheads
T ri
C
Possible problems
i t h
(a) the main problem is likely to be the lack of experience of the management team in actually running
all aspects of the business

d W
Obviously the more experience they have the better, and the more likely they are to be able

at e
to find financial backing.

C e
(b) other problems include:
ri. tax and legal complications
ii. motivation of other employees not party to the buyout
iii. the lack of additional finance once the buyout has taken place
iv. the maintenance of previous commitments made by the company to the workforce or other
parties
v. the loss of key employees

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December 2010 Examinations Paper P4 95
Corporate Reorganisation and Capital Reconstruction Schemes Chapter 17
Providers of capital
(a) the clearing banks (usually ‘senior debt’)
(b) merchant banks
(c) pension funds
(d) venture capital (who require a high return!)

o n
si
(e) government agencies
Post acquisition
e r
financing / dividend decisions.

a l V
Company problems post-acquisition can be related back to the three key decisions: investment /

4 Capital reconstruction schemes T ri n

it h si o
go into liquidation.

d e r
Restructuring a company is corporate surgery to enable a company to continue in business or to
W
t e
Legal framework

a l V
re a ri
(a) the company must receive the court’s permission to launch a scheme
(b) compromises must be agreed by all parties – classes of creditors should meet separately so that
T
C substantial minorities are not voted down. Every class must vote in favour for the scheme to

it h o n
si
succeed.

e r
(c) Under the Insolvency Act a reconstruction can be achieved by transferring assets of the company
W
to a new company in exchange for shares, these new shared being distributed to the existing
d
t e
shareholders. Creditors do not lose their rights in this arrangement.

a l V
re a
Why restructure?
T ri
C it h o n
(a) to write off large debit balances in the profit and loss accounts, so allowing the company to pay

si
dividends in the future, and therefore encouraging the injection of new finance.
(b) To rearrange the capital structure. Ordinary shares may be worth very little so that small monetary

W
changes in value represent significant relative movements.

d e r
t e
Approach to reconstructions
a l V
re a ri
(a) evaluate the position of each party if liquidation were to go ahead. This will represent the minimum
acceptable payment for each group.
T
C t h
(b) Assess sources of finance e.g. selling assets, issuing shares, raising loans.

i
(c) Design the reconstruction (often given in the question)

d W
(d) Calculate and assess new position / marginal costs and returns to each group separately, and
compare with (a). Do not forget the non-financial stakeholders.

at e
(e) Check the company is financially viable after the reconstruction.

r e
5 Going private
C All the listed shares of a company are bought by a small group of investors, and the company is
de-listed.
(a) both direct and indirect listing costs are saved
(b) a hostile takeover bid is impossible
(c) a small number of shareholders reduces the agency problem

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 Free resources for accountancy students

o n
e r si
a l V
T ri n
it h si o
d W e r
t e a l V
re a T ri
C it h o n
W e r si
t ed l V
re a ri a
C h T o n
W it r si
ed V e
a t a l
C re T ri
i t h
d W
at e
C r e

CHAT WITH
ACCA STUDENTS
December 2010 Examinations Paper P4 97

Chapter 18
Foreign Exchange Risk Management (1)

o n
1  Introduction e r si
a l V
T ri
Globalisation has served to increase the amount of foreign trade which has in turn increased the
amount of foreign currency transactions that companies have. Any dealing in foreign currency

n
it h
presents the problem of the risk of changes in exchange rates. The adoption in most of Europe of
the single currency – the euro – has removed the problem for companies trading within Europe,
si o
W
look for ways of removing or reducing this risk.
d e r
but for trading with companies in other countries an important role of the financial manager is to

t e l V
This chapter and the next chapter look in detail at the different ways available for the removal or

a
a
reduction of the risk of changes in exchange rates.

re T ri
C
2 Types of risk
it h o n
(a) Transaction risk W e r si
e d l V
This is the risk that a transaction in a foreign currency at one exchange rate is settled at
t
re a ri a
another rate (because the rate has changed). It is this risk that the financial manager may
attempt to manage and forms most of the work in the rest of this chapter.

C (b) Translation (or accounting) risk

h T o n
W it
balances for the purposes of preparing the accounts.
r si
This relates to the exchange profits or losses that result from converting foreign currency

e d V e
These are of less relevance to the financial manager, because they are book entries as opposed

a t
to actual cash flows.
a l
C re
(c) Economic risk
T ri
i t h
This refers to the change in the present value of future cash flows due to unexpected
movements in foreign exchange rates. E.g. raw material imports increasing in cost.

d
3  The foreign exchange market
W
at e
C r eThe foreign exchange market is known as FOREX. The biggest centre is the London FOREX
market, although since the market is very competitive virtually no differences exist between one
FOREX market and another.

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98 December 2010 Examinations Paper P4
Foreign Exchange Risk Management (1) Chapter 18
4  Exchange rates
The exchange rate on a given day is known as the spot rate and two prices are quoted, depending
on whether we are buying or selling the currency – the difference is known as the spread.
In the examination, the way exchange rates are quoted is always the amount of the first mentioned
currency that is equal to one of the second mentioned currency.

o n
si
For example, suppose we are given an exchange rate as follows:
$/£ 1.6250 – 1.6310

e r
l V
In this quote, the first number (1.6250) is the exchange rate if we are buying the first mentioned
currency ($’s), and (1.6310) is the rate if we are selling the first mentioned currency ($’s).
a
T ri
(Alternatively, if you prefer, the first number is the rate at which the bank will sell us $’s and the
second number the rate at which the bank will buy $’s from us. It is up to you how you choose to
n
it h
remember it, but it is vital that you get the arithmetic correct!)

si o
Example 1
d W e r
t e
A plc receives $100,000 from a customer in the US.
a l V
re a
The exchange rate is $/£ 1.6250 – 1.6310.

T ri
C
How many £’s will A plc receive?

it h o n
W e r si
t e d l V
re a ri a
C h T o n
W it r si
d V e
Usually the questions in the examination relate to real currencies (such as dollars and euros).
e
t l
However, occasionally the examiner invents currencies which makes the answer a little less

a a
obvious – it becomes even more important that you know the rules.

C re T ri
Example 2
i t h
d W
Jimjam is a company based in India, where the currency is the Indian Rupee (IR). They owe money to a
supplier in Ruritania, where the currency is Ruritanian Dollars (R$). The amount owing is R$ 240,000.

at e
The current exchange rate is IR/R$ 8.6380 – 9.2530

r e
How many Indian Rupees will Jimjam have to pay?

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December 2010 Examinations Paper P4 99
Foreign Exchange Risk Management (1) Chapter 18
5  Methods of hedging transaction exposure
In the above examples, our answers are (hopefully!) correct provided that we convert the money
at the spot rate. The problem is that if the transaction is not going to take place until some time in
the future, the exchange rate stands to change. We obviously have no idea what the rate will be – it
may change to our advantage or to our disadvantage – and therefore there is risk.
The following methods of removing or reducing this risk are the methods of which you must be
o n
aware for the examination:
(a) Invoicing in home currency
e r si
a l V
(b) Leading and lagging
T ri n
it h si o
d W e r
t e a l V
re a
(c) Netting

T ri
C it h o n
W e r si
(d) Matching

t e d l V
re a ri a
C T
The above methods do not require any special techniques, but in addition you must have knowledge
h o n
(e) forward contracts
W it
(and be able to perform detailed calculations) of the following:

r si
e d V e
a t
(f) money market hedges
a l
C re T ri
(g) currency futures

i t h
(h) currency options
d W
at e
C r e(i) currency swaps

It is these last five methods that we will go through in this and the following chapters.

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100 December 2010 Examinations Paper P4
Foreign Exchange Risk Management (1) Chapter 18
6  Forward contracts
If a company wishes to buy or sell foreign currency at some date in the future, then they can obtain
a quote from the bank today which will apply on a fixed date in the future. Once the quote has
been accepted, that rate is then fixed (on the date, and on the amount specified) and what happens
to the actual (or spot) rate on the date of the transaction is then irrelevant.
An alternative way in which you might see forward rates quoted is as follows:
o n
$/£ 1.2845 ± 0.0015
This means that the forward rates are: $/£ 1.2830 – 1.2860
e r si
a l V
Example 3

X is due to pay $200,000 in 1 months time. T ri n

Spot $/£ 1.4820 – 1.4905
it h si o
1 month forward $/£ 1.4910 – 1.4970

d W e r
If X contracts 1 month forward, how much will he have to pay in 1 months time (in £’s)?

t e a l V
re a T ri
C it h o n
W e r si
t e d l V
More often, forward rates are quoted as difference from spot. The difference is expressed in the

a ri a
smaller units of currency (e.g. cents, in the case of the US), and is expressed as a premium or a

re
discount depending on whether we should deduct or add the discount to the spot rate.

C h T o n
Example 4

W it r si
Y is due to receive $150,000 in 3 months time.
Spot
e d
$/£ 1.5326 – 1.5385
V e
3m forward
a t 0.62 – 0.51 c pm
a l
re
How much will Y receive?
C T ri
i t h
d W
at e
C r e
Example 5

Z is due to pay $200,000 in 2 months time.

Spot $/£ 1.6582 – 1.6623
2m forward 0.83 – 0.92 dis
How much will Z pay?

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December 2010 Examinations Paper P4 101
Foreign Exchange Risk Management (1) Chapter 18
Advantages and disadvantages of using forward contracts:

o n
e r si
7  Money market hedging
a l V
T ri
This approach involves converting the foreign currency at the current spot, which therefore makes
n
it h
future changes in the exchange rate irrelevant. However, if we are (for example) not going to

si
receive the foreign currency for 3 months, then how can we convert the money today? The answer o
W r
is that we borrow foreign currency now at fixed interest, on the strength of the future receipt.

d e
Example 6
t e a l V
re a
P is due to receive $5M in 3 months time.
T ri
C
Spot:
h
$/£ 1.5384 – 1.5426

it o n
si
Current 3 month interest rates: US prime 5.2% – 5.8%

d WUK LIBOR 3.6% – 3.9%

e r
t e
Show how P can use the money markets to hedge the risk.

a l V
re a T ri
C it h o n
W e r si
t e d l V
re a ri a
C h T
i t
d W
at e
C r e

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102 December 2010 Examinations Paper P4
Foreign Exchange Risk Management (1) Chapter 18

o n
e r si
a l V
T ri n
it h si o
d W e r
t e a l V
re a T ri
C it h o n
si
Example 7

Q is due to pay $8M in 3 months time.

d W e r
Spot:

t e
$/£ 1.6201 – 1.6283
Current 3 month interest rates: US prime 6.4% – 6.9%

a l V

re a UK LIBOR 9.2% – 9.9%

Show how Q can use the money markets to hedge the risk.
T ri
C it h o n
W e r si
t e d l V
re a ri a
C h T
i t
d W
at e
C r e

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December 2010 Examinations Paper P4 103
Foreign Exchange Risk Management (1) Chapter 18

o n
e r si
a l V
T ri n
it h si o
d W e r
t e a l V
re a T ri
C it h o n
si
Advantages and disadvantages of using the money markets:

d W e r
t e a l V
re a T ri
C it h o n
W e r si
e
8  Currency futures
t d l V
re a ri a
C T
If we buy a sterling futures contact it is a binding contract to buy pounds at a fixed rate on a fixed
date. This is similar to a forward rate, but there are two major differences:
h
i t
(a) delivery dates for futures contracts occur only on 4 dates a year – the ends of March, June,
September and December.
W
(b) futures contracts are traded and can be bought and sold from / to others during the period up to
d
at e
the delivery date.
For these two reasons, most futures contracts are sold before the delivery date – speculators use

C r ethem as a way of gambling on exchange rates. They buy at one price and sell later – hopefully at a
higher price. To buy futures does not involve paying the full price – the speculator gives a deposit
(called the margin) and later when the future is sold the margin is returned plus any profit on the
deal or less and loss. The deal must be completed by the delivery date at the latest. In this way it
is possible to gamble on an increase in the exchange rate. However, it is also possible to make a
profit if the exchange rate falls! To do this the speculator will sell a future at today’s price (even
though he has nothing to sell) and then buy back later at a (hopefully) lower price. Again, at the
start of the deal he has to put forward a margin which is returned at the end of the deal plus any
profit and less any loss.
The role of the financial manager is not to speculate with the company’s cash, but he can make use
of a futures deal in order to ‘cancel’ (or hedge against) the risk of a commercial transaction.
Here is a simple example (note that there are more limitations that are ignored in this example but
will be explained later – this example is just to illustrate the basic principle.).

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104 December 2010 Examinations Paper P4
Foreign Exchange Risk Management (1) Chapter 18
Example 8

R is in the US and needs £800,000 on 10 August.

Spot today (12 June) is: $/£ 1.5526 – 1.5631
September $/£ futures are available. The price today (12 June) is 1.5580.

Show the outcome of using a futures hedge (assuming that the spot and the futures prices both increase
by 0.02).
o n
e r si
a l V
T ri n
it h si o
d W e r
t e a l V
re a T ri
C it h o n
W e r si
t e d l V
re a ri a
C h T o n
W it r si
e d V e
a t a l
C re T ri
i t h
d W
at e
C r e
Note:
(a) the futures price on any day is not the same as the spot exchange rate on that date. They are two
different things and the futures prices are quoted on the futures exchanges – in London this is
known as LIFFE (the London International Financial Futures Exchange). More importantly, the
movement in the futures price over a period is unlikely to be exactly the same as the movement in
the actual exchange rate. The futures market is efficient and prices do move very much in line with
exchange rates, but the movements are not the same (unlike in the simple example above). We will
illustrate the effect of this shortly.
(b) In practice any deal in futures must be in units of a fixed size (you will be given the size in the
examination). It is therefore not always possible to enter into a deal of precisely the same amount
as the underlying transaction whose risk we are trying to hedge against.
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