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ACCA P4 Study Text PDF
ACCA P4 Study Text PDF
Advanced Financial
Management
Class Notes
June 2013
Original version prepared by Ken Preece.
© Interactive World Wide Ltd. January 2013.
All rights reserved. No part of this publication may be reproduced, stored in a
retrieval system, or transmitted, in any form or by any means, electronic,
mechanical, photocopying, recording or otherwise, without the prior written
permission of Interactive World Wide Ltd.
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Contents
PAGE
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Introduction to the
paper
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IN T R O D U C T I O N T O T H E P A P E R
Section A:
Section B:
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Formulae & tables
provided in the
examination paper
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F O R M U L A E & T A B L E S P R O V ID E D IN T H E E X A M I N A T IO N P A P E R
Formulae
Ve Vd (1 - T)
βa = βe + βd
(Ve + Vd (1 - T)) (Ve + Vd (1 - T ))
Ve Vd
WACC = ke +
V + V kd(1–T)
V
e + Vd e d
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F O R M U L A E & T A B L E S P R O V ID E D IN T H E E X A M I N A T IO N P A P E R
Where:
ln(Pa /Pe ) + (r + 0.5s 2 )t
d1 =
s t
and
d 2 = d1 – s t
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F O R M U L A E & T A B L E S P R O V ID E D IN T H E E X A M I N A T IO N P A P E R
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15
________________________________________________________________________________
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
________________________________________________________________________________
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15
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F O R M U L A E & T A B L E S P R O V ID E D IN T H E E X A M I N A T IO N P A P E R
Annuity table
1 - (1 + r) -n
Present value of an annuity of 1 ie
r
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10
11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11
12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12
13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15
________________________________________________________________________________
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
________________________________________________________________________________
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 11
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15
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F O R M U L A E & T A B L E S P R O V ID E D IN T H E E X A M I N A T IO N P A P E R
0.5 0.1915 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224
0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549
0.7 0.2580 0.2611 0.2642 0.2673 0.2703 0.2734 0.2764 0.2794 0.2823 0.2852
0.8 0.2881 0.2910 0.2939 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133
0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389
1.0 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621
1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830
1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015
1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177
1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319
1.5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441
1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545
1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4616 0.4625 0.4633
1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706
1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767
2.0 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817
2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4842 0.4846 0.4850 0.4854 0.4857
2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890
2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916
2.4 0.4918 0.4920 0.4922 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936
2.5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952
2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964
2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974
2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981
2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986
3.0 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990
This table can be used to calculate N(di), the cumulative normal distribution
functions needed for the Black-Scholes model of option pricing.
If di > 0, add 0.5 to the relevant number above.
If di < 0, subtract the relevant number above from 0.5
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Chapter 1
Issues in corporate
governance
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C H A P T E R 1 – I S S U E S IN C O R P O R A T E G O V E R N A N C E
CHAPTER CONTENTS
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C H A P T E R 1 – I S S U E S IN C O R P O R A T E G O V E R N A N C E
FINANCIAL OBJECTIVES
Advanced Financial Management is concerned with the following key decisions:
- What to invest in (INVESTMENT DECISIONS)
- How to finance the investment (FINANCING DECISIONS)
- The level of dividend distributions (DIVIDEND DECISIONS).
Objectives
Primary objective: to maximise the wealth of shareholders. A positive NPV equates
(in theory) to an increase in shareholder wealth.
Secondary objectives may be e.g. meeting financial targets (say satisfactory
ROCE), meeting productivity targets, establishing brands and quality standards and
effective communication with customers, suppliers, employees.
As an alternative to maximising the wealth of shareholders a company must in
reality consider satisficing objectives for each of the major stakeholders.
Corporate governance
Clearly the executive directors of a listed company are both decision-makers and
major stakeholders. They are therefore open to the accusation of making key
decisions for their own benefit. Following a number of notable financial scandals in
the UK during the late 20th century (e.g the Maxwell affair and the collapse of the
BCCI) the Cadbury Committee was set up to investigate procedures for appropriate
corporate governance.
The Cadbury Code (1992) defined corporate governance as “the system by which
companies are directed and controlled”. This initial document has been subject to
subsequent amendments by the Greenbury, Hampel and Higgs Reports. The
Financial Services Authority requires listed companies to confirm that they have
complied with the Code provisions or – in the event of non-compliance – to provide
an explanation of their reasons for departure.
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C H A P T E R 1 – I S S U E S IN C O R P O R A T E G O V E R N A N C E
Section A: Leadership
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C H A P T E R 1 – I S S U E S IN C O R P O R A T E G O V E R N A N C E
directors should meet without the chairman present at least annually to appraise
the chairman’s performance and on such other occasions as are deemed
appropriate.
Section B: Effectiveness
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C H A P T E R 1 – I S S U E S IN C O R P O R A T E G O V E R N A N C E
the chairman should not chair the nomination committee when it is dealing with the
appointment of a successor to the chairmanship. The nomination committee should
make available its terms of reference, explaining its role and the authority
delegated to it by the board. (This requirement would be met by including the
information on the company website).
B.3 Commitment
Main Principle: All directors should be able to allocate sufficient time to the
company to discharge their responsibilities effectively.
For the appointment of a chairman, the nomination committee should prepare a job
specification, including an assessment of the time commitment expected,
recognising the need for availability in the event of crises. A chairman’s other
significant commitments should be disclosed to the board before appointment and
included in the annual report. Changes to such commitments should be reported to
the board as they arise, and their impact explained in the next annual report.
The board should not agree to a full time executive director taking on more than
one non-executive directorship in a FTSE 100 company nor the chairmanship of
such a company.
B.4 Development
Main Principle: All directors should receive induction on joining the board
and should regularly update and refresh their skills and knowledge.
The chairman should ensure that the directors continually update their skills and
the knowledge and familiarity with the company required to fulfil their role both on
the board and on board committees. The company should provide the necessary
resources for developing and updating its directors’ knowledge and capabilities.
To function effectively, all directors need appropriate knowledge of the company
and access to its operations and staff.
The chairman should ensure that new directors receive a full, formal and tailored
induction on joining the board. As part of this, directors should avail themselves of
opportunities to meet major shareholders.
The chairman should regularly review and agree with each director their training
and development needs.
B.6 Evaluation
Main Principle: The board should undertake a formal and rigorous annual
evaluation of its own performance and that of its committees and
individual directors.
The board should state in the annual report how performance evaluation of the
board, its committees and its individual directors has been conducted.
Evaluation of the board of FTSE 350 companies should be externally facilitated at
least every three years. A statement should be made available of whether an
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external facilitator has any other connection with the company. (This requirement
would be met by including the information on the company website).
The non-executive directors, led by the senior independent director, should be
responsible for performance evaluation of the chairman, taking into account the
views of executive directors.
B.7 Re-election
Main Principle: All directors should be submitted for re-election at regular
intervals, subject to continued satisfactory performance.
All directors of FTSE 350 companies should be subject to annual election by
shareholders. All other directors should be subject to election by shareholders at
the first annual general meeting (AGM) after their appointment, and to re-election
thereafter at intervals of no more than three years. Non-executive directors who
have served longer than nine years should be subject to annual re-election. The
names of directors submitted for election or re-election should be accompanied by
sufficient biographical details and any other relevant information to enable
shareholders to take an informed decision on their election.
Section C: Accountability
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C H A P T E R 1 – I S S U E S IN C O R P O R A T E G O V E R N A N C E
Section D: Remuneration
D.2 Procedure
Main Principle: There should be a formal and transparent procedure for
developing policy on executive remuneration and for fixing the
remuneration packages of individual directors. No director should be
involved in deciding his or her own remuneration.
The board should establish a remuneration committee of at least three, or in the
case of smaller companies two, independent non-executive directors. In addition
the company chairman may also be a member of, but not chair, the committee if he
or she was considered independent on appointment as chairman. The
remuneration committee should make available its terms of reference, explaining
its role and the authority delegated to it by the board. Where remuneration
consultants are appointed, a statement should be made available of whether they
have any other connection with the company (This requirement would be met by
including the information on the company website).
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C H A P T E R 1 – I S S U E S IN C O R P O R A T E G O V E R N A N C E
The company should ensure that all valid proxy appointments received for general
meetings are properly recorded and counted. For each resolution, where a vote has
been taken on a show of hands, the company should ensure that the following
information is given at the meeting and made available as soon as reasonably
practicable on a website which is maintained by or on behalf of the company:
● the number of shares in respect of which proxy appointments have been
validly made;
● the number of votes for the resolution;
● the number of votes against the resolution; and
● the number of shares in respect of which the vote was directed to be
withheld.
The chairman should arrange for the chairmen of the audit, remuneration and
nomination committees to be available to answer questions at the AGM and for all
directors to attend.
The company should arrange for the Notice of the AGM and related papers to be
sent to shareholders at least 20 working days before the meeting.
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C H A P T E R 1 – I S S U E S IN C O R P O R A T E G O V E R N A N C E
Germany
As both the UK and Germany are members of the EU, they must both follow EU
directives on company law. A major difference that exists in the board structure for
companies is that the UK has a unitary board (consisting of both executive and
non-executive directors), whereas German companies have a two-tier board of
directors. The Supervisory Board of non-executives (Aufsichtsrat) has
responsibility for corporate policy and strategy and the Management Board of
executive directors (Vorstand) has responsibility primarily for the day-to-day
operations of the company.
The Supervisory Board typically includes representatives from major banks that
have historically been large providers of long-term finance to German companies
(and are often major shareholders). The Supervisory Board does not have full
access to financial information, is meant to take an unbiased overview of the
company, and is the main body responsible for safeguarding the external
stakeholders’ interests. The presence on the Supervisory Board of representatives
from banks and employees (trade unions) may introduce perspectives that are not
present in some UK boards. In particular, many members of the Supervisory Board
would not meet the criteria under UK Corporate Governance Code for their
independence.
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C H A P T E R 1 – I S S U E S IN C O R P O R A T E G O V E R N A N C E
Japan
Although there are signs of change in Japanese corporate governance, much of the
system is based upon negotiation or consensual management rather than upon a
legal or even a self-regulatory framework. Banks as well as representatives of
other companies (in their capacity as shareholders) also sit on the Boards of
Directors of Japanese companies.
It is not uncommon for Japanese companies to have cross holdings of shares with
their suppliers, customers and banks etc., all being represented on each others
Board of Directors. There are often three boards of directors: Policy Boards,
responsible for strategy and comprised of directors with no functional responsibility;
Functional Boards, responsible for day to day operations; and largely symbolic
Monocratic Boards. The interests of the company as a whole should dictate the
actions of these boards. This is in contrast to the UK or USA systems where, at
least in theory, the board should act primarily in the best interests of the
shareholders, being the owners of the company.
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C H A P T E R 1 – I S S U E S IN C O R P O R A T E G O V E R N A N C E
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Chapter 2
Advanced
investment
appraisal – section
1
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
CHAPTER CONTENTS
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
Assumed objective is –
Selection of those projects which will maximise the wealth of the owners (or
shareholders) of the enterprise. Involves a consideration of FUTURE events, not
PAST performance.
Accepted techniques are –
1. Accounting Rate of Return (alternatively called Return on Investment)
2. Payback Period
3. Discounted Cash Flow, of which there are two major variants:
(a) Net Present Value
(b) Internal Rate of Return (alternatively called Yield).
Advantages
● It is relatively easy to understand
● The required figures are readily available from accounting data.
● The ROI technique is frequently used as an assessment of management’s
actual (hindsight) performance.
● It gives an indication as to whether available projects are meeting target
returns on capital employed.
Disadvantages
● Based on accounting profits not cash flows - the success of an enterprise
depends on its ability to generate cash. The ability to invest depends on
availability of cash.
● Ignores the time value of money
● It is relative rate of return, thus ignores the size of the project
● No set rules (theoretical or practical) for determining the cut-off rate of
return.
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
2. Payback period
The Payback Period demonstrates how long an enterprise must expect to wait
before the after-tax cash flows generated by the project allow it to recoup the initial
amount invested. Thus it gives an investor an idea of “how long their money will
be at risk”; a short payback period is taken to reveal low risk, and a long payback -
high risk.
Advantages
● The most tried and tested of all methods
● Easy to calculate and understand
● An enterprise with limited cash resources is obviously concerned with speed of
return.
● Some companies combine DCF techniques with the payback method.
Disadvantages
● Does not measure profitability nor increases in shareholders wealth, since it
ignores cash flows expected to arise beyond the payback period.
● Ignores the time value of money (but discounted payback sometimes used).
● No set rules (theoretical or practical) for determining the minimum acceptable
payback period.
● May be difficult to measure the initial amount invested when eg net outlays
arise in both the initial and final years of a project.
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
1. The project under consideration is of average risk for the company, and
2. There is no restriction on access to capital,
a positive NPV provides the best theoretical estimate of the total absolute increase
in wealth which accrues to an enterprise as a result of accepting that project.
However in the short run the use of the NPV rule may not lead to good profits being
reported in the published accounts of the enterprise – although in the long term
cash flows and reported profits should move in tandem.
The NPV rule has a sound theoretical basis and is likely to produce investment
decision advice of consistently good quality.
Disadvantages of IRR
1. IRR provides a relative (as opposed to an absolute) result, and may give
incorrect decision advice if mutually exclusive projects:
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
Requirements:
(i) Calculate for each project
(a) the accounting rate of return (ie the percentage of the average
accounting profit to the average book value of investment) to the nearest 1%.
(b) the net present value
(c) the internal rate of return (Yield or Economic return) to the nearest 1%,
and
(d) the payback period to one decimal place.
Ignore taxation.
(ii) WITHOUT ANY REFERENCE TO THE INCREMENTAL YIELD METHOD, briefly
explain which one of the discounted cash flow techniques used in part (i) of
this question should be used by the management of Congo Ltd, in deciding
whether Project 1 or Project 2 should be undertaken.
Project 1 2
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
Summary of rankings
Better project
d) Payback period 1
WORKINGS
Project 1 Project 2
Project 1 Project 2
£000 £000
Average book value of investment (£000)
½ (556 + 56) 306
½ (1,616 + 301) 958
Accounting rate of return 33% 25%
(b) Net present value
£000 £000
Year
0 Initial outlay (556) (1,616)
1–5 Cash flows
200 x 3.352 670
500 x 3.352 1,676
5 Residual value
56 x 0.497 28
301 x 0.497 ___ 150
Net present value (£000) 142 210
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
Try 25%
Initial outlays (556) (1,616)
Cash flows 538 1,345
Residual values __18 __99
NPV (£000) NIL £(172)
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
Tutorial Note
This question examines the conflicting rankings sometimes given by the NPV
and IRR technique. You may wish to “add a graph” to amplify your solution to
part (c).
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
The formula which relates real and money interest rates is as follows:
1+m
1+r =
1+i
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
Example AP
A project requires an outlay of £1.5m in year 0 and will repay cash flows in real
terms (today’s prices) as follows:
Year £’000
1 670
2 500
3 1,200
The company’s money cost of capital is 15½%. Appraise the project if inflation is
estimated to remain at 5% per annum.
Suggested solution to AP
Method 1: Compute the real discount rate and discount the real cash flows
1+r = 1+ m = 1.155 = 1.1
1+i 1.05
Thus r = 0.1 or 10%
Year
0 (1,500) 1 (1,500)
1 670 1/1.1 609.1
2 500 1/1.12 413.2
3 1,200 1/1.13 901.6
NPV 423.9
Method 2: Compute the money cash flows, using the rate of inflation and discount
at the money discount rate.
Year
0 (1,500) 1 (1,500)
1 670 x 1.05 = 703.5 1/1.155 609.1
2 500 x 1.052 = 551.25 1/1.1552 413.2
3 1,200 x 1.053 =1,389.15 1/1.1553 901.6
NPV 423.9
Please note that discount rates have been computed as opposed to looked up in
tables, to ensure that accuracy is obtained for the reconciliation.
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
Example AA plc
AA plc buys a fixed asset for £10,000 at the beginning of an accounting period (1
January 2001) to undertake a two year project.
Net trading revenues at t1 and t2 are £5,000 per annum.
The company sells the fixed asset on the last day of the second year for £6,000.
Corporation tax = 33%. Writing down allowance = 25% reducing balance.
Required:
Calculate the net cashflows for the project.
t0 t1 t2 t3
£ £ £ £
Net trading revenue 5,000 5,000
Tax at 33% (1,650) (1,650)
Fixed asset (10,000)
Scrap proceeds 6,000
Tax savings on WDAs _____ ____ 825 495
Net cashflow (10,000) 5,000 10,175 (1,155)
WORKING
Tax savings on writing down allowances
Tax relief Timing
at 33%
£ £
t0 Investment in fixed asset 10,000
t1 WDA @ 25% (2,500) 825 t2
7,500
t2 Proceeds (6,000)
Balancing allowance (1,500) 495 t3
Example BB plc
BB plc buys a fixed asset for £10,000 at the end of the previous accounting period
(31 December 2000) to undertake a two year project.
Net trading revenues at t1 and t2 are £5,000 per annum.
The fixed asset has zero scrap value when it is disposed of at the end of year 2.
Corporation tax = 33%. Writing down allowance = 25% reducing balance.
Required:
Calculate the net cashflows for the project.
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
t0 t1 t2 t3
£ £ £ £
Net trading revenue 5,000 5,000
Tax at 33% (1,650) (1,650)
Fixed asset (10,000)
Tax savings on _____ 825 619 1,856
WDAs
Net cashflow (10,000) 5,825 3,969 206
WORKING
Tax savings on writing down allowances
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
CAPITAL RATIONING
Where the finance available for capital expenditure is limited to an amount which
prevents acceptance of all new projects with a positive NPV, the company is said to
experience “capital rationing”.
1. Single period
This is where available finance is only in short supply during the current period, but
will become freely available in subsequent periods.
Projects may be:
(i) Divisible – An entire project or any fraction of that project may be
undertaken. In this event projects may be ranked by means of a
profitability index, which can be calculated by dividing the present value (or
NPV) of each project by the capital outlay required during the period of
restriction.
Projects displaying the highest profitability indices will be preferred. Use of
the profitability index assumes that project returns increase in direct
proportion to the amount invested in each project.
(ii) Indivisible – An entire project must be undertaken, since it is impossible to
accept part of a project only. In this event the NPV of all available projects
must be calculated. These projects must then be combined on a trial and
error basis in order to select that combination which provides the highest total
NPV within the constraints of the capital available. This approach will
sometimes result in some funds being unused.
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
2. Multi-period
This is where available finance is limited not only during the current period, but also
during subsequent periods.
Projects may be:
(i) Divisible - In this event, linear programming is used to determine the
optimal combination of projects. Two techniques, which both result in
identical project selections can be used ie the objective is to either:
● Maximise the total NPV from the investment in available projects, or
● Maximise the present value (PV) of cash flows available for dividends.
(ii) Indivisible - In this event, integer programming would be required to
determine the optimal combination of investments.
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
Initial
Project Year 1 2 3 4 5 outlay
£ £ £ £ £ £
A 70,000 70,000 70,000 70,000 70,000 246,000
B 75,000 87,000 64,000 180,000
C 48,000 48,000 63,000 73,000 175,000
D 62,000 62,000 62,000 62,000 180,000
E 40,000 50,000 60,000 70,000 40,000 180,000
F 35,000 82,000 82,000 150,000
Projects A and E are mutually exclusive. All projects are believed to be of similar
risk to the company’s existing capital investments.
Any surplus funds may be invested in the money market to earn a return of 9%
per year. The money market may be assumed to be an efficient market. Banden’s
cost of capital is 12% per year.
Required:
(a) Calculate:
(i) The expected net present value;
(ii) The expected profitability index associated with each of the six
projects.
Rank the projects according to both of these investment appraisal
methods and explain briefly why these rankings differ.
(b) Give reasoned advice to Banden Ltd recommending which projects
should be selected.
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
Project NPV
Project PI
A. £252,350/£246,000 = 1.026
B. £181,882/£180,000 = 1.010
C. £172,404/£175,000 = 0.985
D. £188,294/£180,000 = 1.046
E. £185,490/£180,000 = 1.031
F. £154,993/£150,000 = 1.033
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
1 D D
2 A F
3 E E
4 F A
5 B B
6 C C
The rankings differ because NPV is an absolute measure of the benefit from a
project, whilst profitability index is a relative measure, and shows the benefit
per £ of outlay. Where the initial outlays vary in size the two methods may
give different rankings.
(b) In a capital rationing situation, the projects should be selected which give the
greatest total NPV from the limited outlay available.
A and E are mutually exclusive.
C is not considered as it has a negative NPV.
Total outlay is limited to £620,000.
Possible selections are:
Tutorial note: Neither the NPV nor PI rankings will necessarily be appropriate
because of the sheer size of these indivisible investments. In this particular
instance, because of the similarity in size of the projects, only three can be
undertaken, and the NPV ranking clearly leads to A, D and E. Profitability
index will not work if projects are indivisible or where multiple limiting factors
exist. The PI might lead to the incorrect solution of D, E and F.
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
The capital available at Year 0 is only £50,000 and only £12,500 is available at
Year 1, together with any cash inflows from the projects undertaken at Year 0.
From Year 2 onwards there is no restriction on the access to capital. The
appropriate cost of capital is 10%.
Required:
Formulate both:
1. The NPV linear programme, and
2. The PV of dividends linear programme.
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
NPV formulation
Since the objective is to maximise the total NPV from these projects, it is initially
necessary to calculate the NPV of each project at a discount rate of 10%:
Year 0 Year 1 Year 2 Year 3 Year 4 Total
NPV
Discount factor
1.000 0.909 0.826 0.751 0.683
(10%)
£’000 £’000 £’000 £’000 £’000 £’000
Project A (25) (45.45) 20.65 37.55 34.15 +21.90
Project B (25) (22.73) 61.95 - - +14.22
Project C (12.5) 4.55 4.13 3.75 3.42 +3.35
Project D - (34.09) (30.97) 37.55 34.15 +6.64
Project E (50) 22.73 (41.30) 37.55 34.15 +3.13
Project F (20) (9.09) 30.98 18.77 - +20.66
The combination of projects, which will maximise the total NPV can now be
specified, where:
a = the proportion of Project A to be undertaken
b = the proportion of Project B to be undertaken
c = the proportion of Project C to be undertaken
d = the proportion of Project D to be undertaken
e = the proportion of Project E to be undertaken
f = the proportion of Project F to be undertaken
The objective function, which represents the maximum NPV that can be earned, is:
z = 21.90a + 14.22b + 3.35c + 6.64d + 3.13e + 20.66f
This is subject to the following constraints:
Year 0 : 25a + 25b + 12.5c + 50e + 20f ≤ 50
Year 1 : 50a + 25b + 37.5d + 10f ≤ 12.5 + 5c + 25e
Furthermore : 0 ≤ a, b, c, d, e, f ≤ 1
When solved, the linear programme will provide the proportions of each project
which should be undertaken in order to establish the value of z, which represents
the maximum NPV achievable in view of the limitation of available capital.
Notice that the first constraint relates to the limited capital available at Year 0. The
second constraint concerns the capital limitation at Year 1, which is of course eased
by the Project C and E cash inflows, which can also be used to fund investment
needs at that time.
The third constraint shows that each project can only be undertaken once and that
it is impossible to undertake a negative quantity of any project. This non-negative
rule is essential, since if it were excluded a computer model may well establish that
negative quantities of a project could make cash inflows available that would be
included within the solution!!
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
PV of dividends formulation
The combination of projects, which will maximise the PV of cash flows available for
dividends must be specified, where:
a = the proportion of Project A to be undertaken
b = the proportion of Project B to be undertaken
c = the proportion of Project C to be undertaken
d = the proportion of Project D to be undertaken
e = the proportion of Project E to be undertaken
f = the proportion of Project F to be undertaken
The objective function will be based upon the premise that:
z = the PV of dividends.
The dividend flows need to be defined for each year up to the point where the
investment with the longest life ceases – in this case up to the end of Year 4 ie
d0 = the dividend flow generated at Year 0 by the projects selected
d1 = the dividend flow generated at Year 1 by the projects selected
d2 = the dividend flow generated at Year 2 by the projects selected
d3 = the dividend flow generated at Year 3 by the projects selected
d4 = the dividend flow generated at Year 4 by the projects selected
Therefore the objective function, which represents the present value of the
maximum dividends, discounted at the cost of capital of 10% is:
d1 d2 d3 d4
z = d0 + + 2
+ 3
+
1.1 1.1 1.1 1.14
alternatively
z = d0 + 0.909 d1 + 0.826 d2 + 0.751 d3 + 0.683 d4
This is subject to the following constraints:
Year 0 : 25a + 25b + 12.5c + 50e + 20f + d0 ≤ 50
Year 1 : 50a + 25b + 37.5d + 10f + d1 ≤ 12.5 + 5c + 25e
Year 2 : 37.5d + 50e + d2 ≤ 25a + 75b + 5c + 37.5f
Year 3 : d3 ≤ 50a + 5c + 50d + 50e + 25f
Year 4 : d4 ≤ 50a + 5c + 50d + 50e
Furthermore : 0 ≤ a, b, c, d, e, f ≤ 1
Additionally : d0, d1, d2, d3, d4 ≥ 0
When solved, the linear programme will provide the proportions of each project
which should be undertaken in order to establish the value of z, which represents
the maximum PV of dividends earned in view of the capital constraints.
With an NPV formulation, we only have constraints for the periods during which
capital rationing exists (in this instance, Years 0 and 1), whereas under the
dividend formulation we have a constraint for every year of potential project cash
flows (in this case, Years 0 to 4).
The available funds are the same as in the NPV formulation (ie available capital
together with cash inflows from the projects); however the dividend flow for each
period must also be included. Furthermore an additional non-negative constraint is
used, since the dividends must be greater than or equal to zero. If this constraint
were excluded, a computer model may specify negative dividend payments, which
make cash inflows available that could be used to finance more projects!!
One advantage of the PV of dividends formulation is that it removes the need to
even calculate the NPV of each investment opportunity, since the discounting
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
process is carried out by the linear programme as part of the calculation of the
solution.
Notice the only difference in the value of z in these formulations is as follows:
● Under the NPV formulation, z provides the NPV of the project returns,
whereas
● Under the PV of dividends formulation, z provides the PV of the project
returns.
Dual values
Dual values (also referred to as “shadow prices”) reflect the change in the objective
function as a result of having one more or one less unit of scarce resource. In the
context of capital rationing the scarce resource is available cash, so that the dual
price states the change in the objective function if one more unit of currency (eg
£1) becomes available or if one less GB pound is invested.
Shadow prices can therefore be used to calculate the impact of raising additional
finance for further investment or the effect of diverting capital away from current
projects into newly discovered investments.
The dual price depends upon which method is used to formulate the linear
programme ie
● Under the NPV formulation, it reflects the change in the NPV if £1 more or
£1 less is available
● Under the PV of dividends formulation, it reflects the change in the PV of
cash available for dividend payments if £1 more or £1 less capital is available.
Dual prices relate only to marginal changes in the availability of capital. Thus,
suppose that a dual value of £1.25 arises under the PV of dividends method, this
means that if an additional £1 of funds became available, the total value of the
objective function would rise by £1.25. It does not necessarily mean that if an
additional £10,000 became available, that the value of the objective function would
increase by (£10,000 x 1.25) £12,500.
Shadow prices can therefore be used to test the validity of new investments which
emerge. The cash flows generated by the new project can be compared with the
cash flows lost by diverting funds from existing investments, thereby calculating the
effect of diversion of that finance.
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
A new investment opportunity has emerged with the following cash flows:
Cash flow
£’000
Year 0 (75)
Year 1 50
Year 2 50
Required:
Appraise the new project using both the NPV dual prices and the PV of
dividend shadow prices.
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
The net dual value of the new investment project (ie the impact of diverting funds
from the current investment strategy) is:
Year Cash flow Shadow price Opportunity cost
£000 £000
0 (75) 0.1 (7.5)
1 50 0.08 4
2 50 0 -_
Net dual value (3.5)
Accordingly, the NPV of the current investment strategy would fall by £3,500 if the
new project were accepted. However, Bruno Ltd would benefit from the positive
NPV of that new investment opportunity. Therefore:
£’000
NPV of new project 11.75
Net dual value (3.5)
Net benefit of undertaking new project 8.25
This indicates that this project is worth further consideration, since if it were
accepted in full (and in doing so does not violate the marginality assumption of dual
values) it would result in the value of the objective function increasing by £8,250.
The two techniques will always provide the same result, but as can be seen the PV
of dividends dual prices technique is far quicker and simpler to solve.
Again, the project is worth considering; the linear programme should therefore be
reformulated (by including the new project) and then re-solved.
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
The board of directors of that company has approved the following capital
expenditure programme for those same accounting periods:
£
Year 0 40,000
Year 1 35,000
Year 2 42,500
The four projects are expected to produce the following positive net present
values:
Required:
Discuss the approach for calculating the optimum mix of projects.
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C H A P T E R 2 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
50 www.studyinteractive.org
Chapter 3
Advanced
investment
appraisal – section
2
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C H A P T E R 3 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 2
CHAPTER CONTENTS
DURATION ---------------------------------------------------------------- 64
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C H A P T E R 3 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 2
Required:
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C H A P T E R 3 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 2
Year £
0 15,000
1 (£5,400 x 0.926) _5,000
Present Value (PV) of investment phase cash flows 20,000
Single net equivalent receipt at the end of year 5, using an 8% compound rate:
£34,193
MIRR = − 1 = 11.3%
5 20,000
Furthermore, in examples where the PV of return phase net cash flows has already
been calculated, there is yet another formula for computing MIRR (which is given
on the ACCA formulae sheet). This formula avoids having to establish the Terminal
Value of those return phase net cash flows ie
PV of return phase net cash flows
(6,500 x 0.926) + (7,750 x 0.857) + (5,750 x 0.794) + (4,750 x 0.735) + (3,750 x
0.681) = £23,271
£23,271
MIRR = × 1.08 - 1 = 11.3%
5 20,000
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C H A P T E R 3 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 2
The reservations which are often cited concerning the MIRR technique include:
● In what are claimed to be the very exceptional circumstances where the
reinvestment rate exceeds the company’s cost of capital, the MIRR will
underestimate the project’s true rate of return.
● The determination of the life of a project can have a significant effect on the
actual MIRR, if the difference between the project’s IRR and the company’s
cost of capital is large.
● Like IRR, the MIRR is biased towards projects with short payback periods and
large initial cash inflows.
● The extent to which this method is being used in industry is unclear and only
time will tell whether it eventually becomes popular.
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C H A P T E R 3 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 2
Required:
Calculate free cash flow.
£
EBIT 225,000
Less: Corporation tax @ 30% (67,500)
157,500
Add back: Depreciation (non-cash amount) 15,000
Deduct: Capital expenditure (22,500)
Working capital increases (2,500)
Free cash flow £147,500
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C H A P T E R 3 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 2
£m
Revenue 1,950.00
Cost of sales (1,314.00)
Gross profit 636.00
Operating expenses (322.50)
Earnings before interest and tax 313.50
Interest charges (24.00)
Profit before tax 289.50
Corporation tax(@ 35%) (101.32)
Profit after tax 188.18
During the year loan repayments are expected to amount to £69 million,
depreciation charges to £30 million and capital expenditure to £60 million.
Required:
Calculate:
(a) Free cash flow;
(b) Free cash flow to equity.
£m
EBIT 313.50
Less: Corporation tax (@ 35% thereon) (109.72)
203.78
Add back: Depreciation (non-cash amount) 30.00
Deduct: Capital expenditure (60.00)
Free cash flow 173.78
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C H A P T E R 3 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 2
£m
Free cash flow (as above) 173.78
Deduct: Loan repayments (69.00)
Interest charges, net of tax [£24m x (1 – 0.35)] (15.60)
Free cash flow to equity 89.18
Method Two
£m
Profit after tax 188.18
Add back: Depreciation (non-cash amount) 30.00
Deduct: Capital expenditure (60.00)
Loan repayments (69.00)
Free cash flow to equity 89.18
£000
Capital expenditure for expansion 100
Capital expenditure to replace existing non-current assets 240
Depreciation charges 300
Amounts raised from fresh bond issue 120
Increase in working capital 220
Interest paid 40
Repayment of loans 60
Profit from operations 1,880
Corporation tax paid (@ 30%) 552
Ordinary share capital (@ 25p par value) 1,840
Dividend paid for the year is expected to be 5p per share
Required:
Calculate:
(a) Free cash flow;
(b) Free cash flow to equity;
(c) Dividend cover based upon free cash flow to equity.
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C H A P T E R 3 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 2
£000
Profit from operations (EBIT) 1,880
Deduct: Corporation tax (@ 30% thereon) (564)
1,316
Add back: Depreciation (non-cash amount) 300
Deduct: Capital expenditure to replace existing non-current assets (240)
Capital expenditure for expansion (ARGUABLY, THIS SHOULD NOT (100)
BE DEDUCTED IN ARRIVING AT FREE CASH FLOW)
Increase in working capital (220)
Free cash flow 1,056
£000
Free cash flow (as above) 1,056
Deduct: Loan repayments (60)
Interest charges, net of tax [£40,000 x (1 – 0.3)] (28)
Add: Proceeds of bond issue 120
Free cash flow to equity 1,088
Method Two
£000
EBIT 1,880
Interest charges (40)
Corporation tax (552)
Profit after tax (ie Earnings after interest and tax) 1,288
Add back: Depreciation (non-cash amount) 300
Deduct: Increase in working capital (220)
Capital expenditure [£240,000 + £100,000] (340)
Loan repayments (60)
Add: Amounts raised from bond issue 120
Free cash flow to equity 1,088
£1,288,000
ie, = = 3.5 times
£368,000
WORKING:
Dividends for the year:
£1,840,000
Number of shares in issue = = 7,360,000
£0.25
Dividends for the year = 7,360,000 x £0.05 = £368,000
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C H A P T E R 3 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 2
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C H A P T E R 3 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 2
Sensitivity analysis
A technique which assesses the effect on an overall decision if a single constituent
variable were to change ie how sensitive is the investment decision to a change in a
single aspect (eg sales revenue, material price, project life, etc). This allows for the
consideration of a range of possible outcomes. Sadly the technique does not take
into account the interdependence of the variables ie the technique ignores the
interaction of the constituent variables.
Procedure
Firstly, calculate the expected NPV, using the best estimates available.
Then, calculate for each input factor (eg initial investment, sales price, wage rate,
discount rate, residual value, etc) the necessary percentage change which would
cause the NPV to become zero.
To find the percentage change required to achieve an NPV of zero, the calculation is
as follows:
NPV of project
% change = × 100
PV of cash flows affected by the variable
Illustration
An expected NPV has already been calculated for the following project of CC plc:
Year Cash flow 10% discount factor Present value
£000 £000
0 Initial investment (100) 1 (100.00)
1-3 Revenues 40 2.487 99.48
3 Scrap value 10 0.751 7.51
NPV +6.99
From these results, the sensitivity to each variable, which would create an NPV of 0
is:
6.99
Initial investment: x 100 = an increase of 7%
100
6.99
Annual revenues: x 100 = a decrease of 7%
99.48
6.99
Scrap value: x 100 = a decrease of 93%
7.51
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C H A P T E R 3 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 2
Discount factor: (this requires the calculation of the IRR, since this would cause the
NPV to be 0. The IRR is, of course, established by trial and error),
ie:
Year Cash flow Try 13% Try 14%
£000 DF £000 DF £000
0 (100) 1 (100) 1 (100)
1-3 40 2.361 94.44 2.322 92.88
3 10 0.693 6.93 0.675 6.75
NPV +1.37 -0.37
1.37
IRR = 13% + × (14% − 13%) = 13.79%
1.37 + 0.37
Cost of capital will have to increase by 37.9% (ie from 10% to 13.79%) for an NPV
of 0 to arise.
Project life: Clearly if the project life were for a shorter period than 3 years an NPV
of 0 would at some point arise. Accurate calculations are in this case not possible,
since at a life of less than 3 years, the scrap value would be greater, but the precise
amount is unknown.
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Required:
Establish the value at risk using both a 95% and also a 99% confidence
level.
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DURATION
Duration is the average time taken to recover the cash flows on an investment.
The average is taken as the value weighted average of the number of the year (1 to
n) in which the cash flows arise. In capital investment, the duration can be
calculated using either the firm’s original outlay, or the present value of its future
cash flows as the basis for the annual weighting.
If duration is based upon the average time to recover the initial capital investment:
1. Calculate the value of each future net cash flow, discounted at the IRR of the
project;
2. Calculate each year’s discounted cash flow as a proportion of the original
capital outlay;
3. Take the time from investment to each discounted cash flow and multiply by
the respective proportion. Finally, sum the weighted year values.
If duration is based upon the average time taken to recover the present value of
the project:
1. Calculate the value of each future net cash flow, discounted at the chosen
hurdle rate;
2. Calculate each year’s discounted cash flow as a proportion of the PV of total
cash inflows;
3. Take the time from investment to each discounted cash flow and multiply by
the respective proportion. Finally, sum the weighted year values.
Year 0 1 2 3 4
Incremental cash (£34,000) £7,600 £16,500 £13,000 £6,600
flows
Required:
Establish both the duration to recover the original investment (using the
IRR of this project of 11.13%) and the duration to recover the present
value of the project (at an 8% hurdle rate).
Year 1 2 3 4
1. Discount cash inflows @ 11.13% £6,839 £13,361 £9,473 £4,327
2. Proportion of initial outlay (£34,000) 0.201 0.393 0.279 0.127
3. Proportion multiplied by year number 0.201 0.786 0.837 0.508
Finally, sum these to provide the duration ie on average the company will take
2.332 years to recover the initial investment ie an indication of project uncertainty
(see below).
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Year 1 2 3 4
1. Discount cash inflows @ 8% £7,037 £14,146 £10,320 £4,851
2. Proportion of project PV (£36,354) 0.194 0.389 0.284 0.133
3. Proportion multiplied by year number 0.194 0.778 0.852 0.532
Finally, sum these to provide the duration ie on average the company will take
2.356 years to recover half the present value of the project ie a different
indication of project uncertainty. The longer the duration, the greater the
uncertainty attaching to future returns!!
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C H A P T E R 3 – A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 2
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Furthermore, the above calculation is almost identical to the approach used for
calculating the duration taken to recover an original investment in project appraisal
(as described earlier on page 64).
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(a)
Year 1 2 3 4 5
1 Annual cash flows (£) 8.00 8.00 8.00 8.00 108.00
2 Discounted @ 10% (£) 7.27 6.61 6.01 5.46 67.06
3 Proportion of bond value
0.079 0.072 0.065 0.059 0.726
(£92.41)
4 Proportion multiplied by year
0.079 0.144 0.195 0.236 3.630
number
Finally, establish the totals of row 4, since these provide the bond duration of 4.284
years, ie the weighted average time to full recovery of an investment in this bond.
(b)
Year 1 2 3 4
1 Annual cash flows (£) 5.50 5.50 5.50 105.50
2 Discounted @ 2.75% (£) 5.35 5.21 5.07 94.65
Proportion of bond value
3 0.049 0.047 0.046 0.858
(£110.28)
Proportion multiplied by year
4 0.049 0.094 0.138 3.432
number
Finally, establish the totals of row 4, since these provide the bond duration of 3.713
years, ie the weighted average time to full recovery of an investment in this bond.
(c)
Period ½ 1 1½ 2 2½ 3
1 Half-yearly cash flows (£) 3 3 3 3 3 103
2 Discounted @ 5% per
2.86 2.72 2.59 2.47 2.35 76.86
half year (£)
3 Proportion of bond value
0.032 0.030 0.029 0.028 0.026 0.855
(£89.85)
4 Proportion multiplied by
0.016 0.030 0.044 0.056 0.065 2.565
period number
Finally, establish the totals of row 4, since these provide the bond duration of 2.776
years, ie the weighted average time to full recovery of an investment in this bond.
General observations
Note that Macaulay duration will always be lower than the term to maturity
(assuming that the coupon rate exceeds zero - you may think that this is a stupid
comment, but the world of finance is going through some amazing times!!).
Nowadays, the value of Macaulay duration is less evident, due to wide availability of
computer programs with Monte Carlo simulation. Obviously, bonds are subject to
risk, but duration is not intended to reflect risk; it measures interest rate
sensitivity.
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Chapter 4
Cost of capital
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CHAPTER 4 – COST OF CAPITAL
CHAPTER CONTENTS
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CHAPTER 4 – COST OF CAPITAL
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CHAPTER 4 – COST OF CAPITAL
What is Ke?
What is Ke?
(ii) Carsberg recommends that share issue costs are treated as a year 0 cash
outflow of the project for which the share capital is raised. Thus share issue
costs do not affect Ke. In Example 2, Ke would be calculated as follows:
32.2p
Ke = = 12.9%
£2.50
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(c) Growth
The Dividend Growth model is:
D 0 (1 + g)
Ke = +g
P0
D1
= +g
P0
Calculate Ke
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CHAPTER 4 – COST OF CAPITAL
Dividend in 2008
(1 + g)4 =
Dividend in 2004
£262,350
= = 1.749
£150,000
4
(1 + g) = 1.749 = 1.15
g = 15%
Example V plc
Solution to V plc
g = 40% x 10% = 4%
12.48p
Ke = + 4% = 17%
96p
3. Cost of debt
(a) Irredeemable
Interest (l − t)
Kb =
Market Value of debt (ex - int)
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(b) Redeemable
IRR exercise
Example VI plc
A 5% debenture is currently quoted at £95.84 (ex-int). It is redeemable at the end
of 3 years at £100.
Taking corporation tax at 50%, and ignoring the timing lag for tax savings,
calculate Kd.
Solution to VI plc
Year £ Try DF @ 4% £
0 Cost (95.84) 1.00 (95.84)
1 Interest £5(0.5) 0.962 2.41
2 Interest £2.50 0.925 2.31
3 Interest & Redemption £102.50 0.889 91.12
NPV NIL
Therefore, Kb = IRR = 4%
NB Try 3% (NPV + £2.74) and 5% (NPV - £2.63), then by linear interpolation
£2.74
Kb = 3% + x 2% = 4.02%
£5.37
ie linear interpolation tends to overstate the IRR of “normal” cash flows
(c) Convertible
The cost of convertible debt is calculated in a similar manner to the calculation of
the cost of redeemable debt, EXCEPT that in the final year, one must include the:
- redemption value of the debt, or
- conversion value of the debt
whichever is the GREATER.
Example
Some 8% convertible debentures have a current market value of £106 per cent.
The debenture will be converted into equity shares in 3 years time at the rate of 40
shares per £100 of debentures. The market price is expected to be £3.5 on the
date of conversion.
What is the cost of capital to the company for the convertible debentures? Assume
a corporation tax of 33%.
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CHAPTER 4 – COST OF CAPITAL
Solution
Net interest = 8% x 100 (1 - 0.33) = £5.36
Conversion value = 40 x 3.5 = £140 higher
Redemption value = £100
Year Item cashflow DF(12%) PV DF(15%) PV
0 current MV (106) 1 (106) 1 (106)
1-3 interest 5.36 2.402 12.87 2.283 12.24
3 conversion value 140 0.712 99.68 0.658 92.12
6.55 (1.64)
6.55
Cost of capial = 12% + × (15% − 12%) = 14.4%
6 .55 + 1 .64
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£270,000
K0 = = 13.5%
£2,000,000
£10 (1 − 0.4)
*Kb = = 8%
£75
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£
Ordinary shares of £1 500,000
6% £1 Preference shares 100,000
Debentures 200,000
Reserves 380,000
1,180,000
Required:
Calculate the WACC. Assume corporation tax at 50% per annum, payable
one year in arrears.
6p
Kps = = 15%
40p
Kb
Therefore, Kb = IRR = 8%
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WACC
£110,498
Ko = = 14.6%
£755,600
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CHAPTER 4 – COST OF CAPITAL
SOURCES OF FINANCE
Bank overdrafts
If cash outflows from a bank current account exceed inflows for a temporary period,
a clearing bank may provide an overdraft. Overdrafts may be arranged speedily,
but are subject to review by the bank, may be renewable and offer a level of
flexibility, whilst interest is only paid on the overdrawn amount.
Overdrafts are technically repayable on demand and may require some form of
security or guarantee. Interest is often payable at a variable rate (ie benchmark
rate plus a premium) and an arrangement fee is normally payable upon the initial
grant of the facility.
Short-term loans
Bank loans are an agreement for the provision of a specific fixed sum for a
predetermined period at an agreed interest rate. A term loan is provided in full at
the start of the loan period and is repaid at a specified time or in instalments over a
period of agreed dates.
Bank loans are only repayable on the agreed dates, but are more expensive and
less flexible than overdrafts. The terms of the loan must be adhered to and the
bank may impose loan covenants with which the borrower must comply.
Trade credit
Raw materials are normally purchased on credit and this effectively represents an
interest free short-term loan. It is important to remember that payment delays
would worsen the credit rating of the company and that additional credit may then
be difficult to obtain. The loss of settlement discounts that suppliers may offer for
early payment must be considered.
Lease finance
Instead of the outright purchase of a non-current asset, a company may choose to
obtain the temporary use of that asset by means of an operating lease, whereby
the risks and rewards of ownership are retained by the lessor (ie the legal owner).
An operating lease contract between a lessor and lessee is for the hire of a specific
asset, whereby the lessee has possession and use of equipment for a period which
is shorter than the economic useful life of the asset, but the lessee is committed to
pay specified rentals during the period of the lease. The lessor is normally
responsible for repairs and maintenance and the lease can sometimes be cancelled
at short notice.
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CHAPTER 4 – COST OF CAPITAL
1. Lease finance
A long-term leasing arrangement is likely to be finance lease, ie a lease that
transfers substantially all the risks and rewards incidental to the ownership of an
asset to the lessee. Legal title may or may not eventually be transferred.
The lessor is likely to be a bank or other financial institution, which does not
normally trade in the type of asset concerned. The lessee normally becomes
responsible for the cost of repairs and maintenance.
The substance of a finance lease arrangement is that the lessee is effectively
borrowing in order to have use of a non-current asset for substantially the whole of
its useful economic life and thereby becomes liable for all lease payments. In
contrast, an operating lease is equivalent to the short-term rental of an asset from
an organisation which normally trades in that type of asset.
2. Venture capital
Venture capital is the provision of risk bearing capital, normally provided in return
for an equity stake in companies with high growth potential.
The 3i Group is one of the world’s oldest venture capital organisations and is
involved in schemes in Europe, the USA and the Far East. The 3i Group is prepared
to invest in companies with a highly motivated management team, having a well
defined strategy and target market, which are committed to innovation and a
proven ability to outperform competitors.
Venture capitalists may provide finance for business start-ups, the development of
existing businesses, management buyouts and the realisation of the investments of
existing owners who wish to exit their companies.
Where company directors seek assistance from a venture capitalist they must
expect that the institution will require an equity stake in the company, need
convincing that the business will be successful, seek representation on the
company’s board of directors, demand exceptional returns on their investment and
expect an obvious ultimate exit route.
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CHAPTER 4 – COST OF CAPITAL
Risk
Investors are less willing to offer finance to small companies as they are seen as
inherently more risky than large companies.
Security
Since small companies are likely to possess little by way of assets to offer as
security, banks usually require a personal guarantee instead, and this limits the
amount of finance available.
Tax considerations
Individuals with cash to invest may be encouraged by the tax system to invest in
large institutional investors rather than small companies, for example by tax
incentives offered on contributions to pension funds. These institutional investors
themselves usually invest in larger companies, such as stock-exchange listed
companies, in order to maintain what they see as an acceptable risk profile, and in
order to ensure a steady stream of income to meet ongoing liabilities. This tax
effect reduces the potential flow of funds to small companies.
Cost
Since small companies are seen as riskier than large companies, the cost of the
finance they are offered is proportionately higher. Overdrafts and bank loans will
be offered to them on less favourable terms and at more demanding interest rates
than debt offered to larger companies. Equity investors will expect higher returns,
if not in the form of dividends then in the form of capital appreciation over the life
of their investment.
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CHAPTER 4 – COST OF CAPITAL
Lack of information
Potential lenders may refuse to provide finance to a small business because of lack
of financial information about the small business to asses it creditworthiness.
Funding gap
Funding gap is the difference between the amount available for lending and the
amount required to finance investment. Small businesses often need more funds
than are available for them to finance growth.
Business angel
Business Angels refer to wealthy individuals who are prepared to help smaller
companies by purchasing shares in that company. A Business Angel may have
expertise and experience to offer that could be useful in a small company situation.
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Chapter 5
Theories of gearing
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C H A P T E R 5 – T H E O R I E S O F G E A R IN G
CHAPTER CONTENTS
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C H A P T E R 5 – T H E O R I E S O F G E A R IN G
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C H A P T E R 5 – T H E O R I E S O F G E A R IN G
Graph
Formulae
Preposition 1: value of company
Vg = Vu
Preposition 2: cost of equity
D
Keg = Keu + (Keu − Kb)
E
Preposition 3: WACC
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C H A P T E R 5 – T H E O R I E S O F G E A R IN G
Assumptions
● Investors are rational
● Investors have the same view of the future
● Personal and corporate gearing are perfect substitutes
● Information is freely available
● No transaction costs
● No tax
● Firms can be grouped into similar risk classes.
The arbitrage “proof”, which incorporates these assumptions, can be used to
support this M & M proposition.
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C H A P T E R 5 – T H E O R I E S O F G E A R IN G
Graph
Formulae
Proposition 1: value of company
Vg = Vu + Dt
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C H A P T E R 5 – T H E O R I E S O F G E A R IN G
Proposition 3: WACC
Dt
WACCg = Keu 1 −
E + D
£m
Vu = 6,000,000 @ £2.50 = 15
Dt = £10,000,000 x 35% = 3.5
Vg = £18.5m
£m
E = (balancing figure) 8.5
D (as above) 10_
Vg (as above) £18.5m
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C H A P T E R 5 – T H E O R I E S O F G E A R IN G
1. Bankruptcy costs
The higher the level of gearing the greater the risk of bankruptcy with the
associated “COSTS OF FINANCIAL DISTRESS”.
Vg = Vu + Dt − Present value of costs of financial distress
2. Agency costs
Costs of restrictive covenants to protect the interests of debt holders at high levels
of gearing.
3. Tax exhaustion
The value of the company will be reduced if advantage cannot be taken of the tax
relief associated with debt interest.
4. Debt capacity
Generally loans must be secured against a company’s assets and clearly some
assets (eg property) provide better security for loans than other assets (eg high-
tech equipment which may become obsolescent overnight). The depth of the
asset’s second hand market and its rate of depreciation are important
characteristics.
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C H A P T E R 5 – T H E O R I E S O F G E A R IN G
SOLVENCY RATIOS
1. Gearing ratio
This indicates the relationship between:
Equity : Fixed return securities (or Debt) on issue
It may be based upon balance sheet values (in which case “Equity” will comprise
ordinary share capital and reserves) or upon stock exchange values (in which event
the shares and debentures on issue are valued at mid market price).
Required:
Calculate the Capital Gearing Ratio, based upon
(a) Book values
(b) Market values.
Debt may include long-term borrowings only or both short and long-term debt.
A further problem is the classification of hybrid securities e.g preference shares. In
the above illustration they have been classified as debt, but this is open to debate
when the ratio is calculated for the benefit of lenders.
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C H A P T E R 5 – T H E O R I E S O F G E A R IN G
2. Interest cover
Earnings before Interest and Tax
ie
Gross Interest
Berlan plc
Berlan plc has annual earnings before interest and tax of £15m. These earnings
are expected to remain constant. The market price of the company’s ordinary
shares is 86 pence per share cum div and of debentures £105.50 per debenture
ex-interest. An interim dividend of six pence per share has been declared.
Corporate tax is at the rate of 35% and all available earnings are distributed as
dividends.
Berlan’s long-term capital structure is shown below:
£’000
Ordinary shares (25 pence par value) 12,500
Reserves 24,300
36,800
16% debentures 31.12.2007 (£100 par value) 23,697
60,497
Required:
Calculate the cost of capital of Berlan plc according to the traditional theory of
capital structure. Assume that it is now 31 December 2004.
Canalot plc
Canalot plc is an all-equity company with an equilibrium market value of £32.5
million and a cost of capital of 18% per year.
The company proposes to repurchase £5 million of equity and to replace it with
13% irredeemable loan stock.
Canalot’s earnings before interest and tax are expected to be constant for the
foreseeable future. Corporate tax is at the rate of 35%. All profits are paid out as
dividends.
Required:
(a) Using the assumptions of Modigliani and Miller, explain and demonstrate how
this change in capital structure will affect:
(i) the market value
(ii) the cost of equity
(iii) the cost of capital
of Canalot plc.
(b) Explain any weakness of both the traditional and Modigliani and Miller
theories and discuss how useful they might be in the determination of the
capital structure for a company.
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C H A P T E R 5 – T H E O R I E S O F G E A R IN G
Cost of equity
£’000
Earnings before interest and tax 15,000
Interest (16% x 23,697) 3,792
11,208
Tax (35% x 11,208) 3,923
Earnings 7,285
Dividend (full distribution) 7,285
NIL
Pence
Market price per share: cum div 86
Less interim dividend declared _6
Ex div 80p
Cost of equity capital, using the dividend valuation model and assuming constant
dividends
7285
= = 18.21%
40,000
Cost of debt
A market value higher than redemption value implies that the cost (pre-tax) is less
than the nominal rate of 16%.
Using 8% and 9% as discount rates.
8% 9%
Year £ PV PV
factors factors
0 Market value (105.50) 1 (105.50) 1 (105.50)
1-3 Interest (net of tax) 10.40 2.577 26.80 2.531 26.32
3 Redemption 100.00 0.794 79.40 0.772 77.20
+0.70 −1.98
0.7
Cost of debt = 8% + X 1% = 8.26%
0.7 + 1.98
105 .50
Market value of debt = £23.697million x = £25 million
100
Value of debt plus equity = £(25 + 40) million = £65 million
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C H A P T E R 5 – T H E O R I E S O F G E A R IN G
£’000
Earnings before interest and tax 9,000
Less interest: £5m x 13% _650
8,350
Tax (35% x 8,350) 2,922
Equity earnings (= dividend) 5,428
5,428
Cost of equity = = 18.56%
29,250
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C H A P T E R 5 – T H E O R I E S O F G E A R IN G
Dt
WACCg = Keu 1 −
E + D
5 x 0.35
= 18% 1 − = 17.08%
34.25
The WACC has declined from 18%, reflecting the benefits of tax relief on
interest.
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Chapter 6
Capital asset
pricing model
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CHAPTER 6 – CAPITAL ASSET PRICING MODEL
CHAPTER CONTENTS
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CHAPTER 6 – CAPITAL ASSET PRICING MODEL
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CHAPTER 6 – CAPITAL ASSET PRICING MODEL
return the investor demands as compensation for the systematic risk borne.
Obviously unsystematic risk (which is diversified away by holding the shares of a
sufficient number of companies) can be ignored.
SYSTEMATIC RISK
11 5 9 13 17 21 25
Number
Number of
of different
different companies
companies in
in which
which shares
shares are
are held
held
CAPM formulae
CAPM provides the return that would be required by a well-diversified, risk-averse
investor. The formula can be expressed in a variety of ways, eg:
E(ri) = Rf + βi (E(rm) – Rf)
Ke = Rf + [Rm – Rf] β
Required return = rf + (Erm – rf) βj
where:
Rf = the risk free rate of interest (eg the return on 90 day Treasury bills)
Rm = the average return on a market portfolio (eg the return on FTSE 100
constituents)
[Rm – Rf] = the market risk premium or excess market return
β (beta) = an index which compares the systematic risk of the investment with
the systematic risk of the market portfolio
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The above CAPM formula appears in one form or another on formulae sheets
provided by the accountancy bodies. However the following formulae for
calculating β are not provided in the examination and must therefore be committed
to memory:
Example
Details of a portfolio, which consistent of shares in 3 UK companies, are as follows:
Company Beta(equity) Average Return
A 1.16 19.5%
B 1.28 24.0%
C 0.90 17.5%
The current market return is 19% and the treasury bill yield is 11%
Required:
Asses the best composition of the portfolio.
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CHAPTER 6 – CAPITAL ASSET PRICING MODEL
Solution
The alpha values of each share is:
Company expected return CAPM return Alpha
A 19.5% 11% + 1.16(19 - 11) = 20.8% -0.78%
B 24% 11% + 1.28(19 - 11) = 21.24% 2.76%
C 17.5% 11% + 0.90(19 – 11) = 18.20% -0.70%
These figures suggest that shares in A and B are to be sold because they are
overpriced and buy more shares in B because they are underpriced.
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Following the M & M with corporation tax theory of 1963, as gearing levels increase,
Ke behaves as follows:
Ke Ke
%
SYSTEMATIC
FINANCIAL RISK
Gearing % D
E
Now that the issue of leverage has been introduced, there becomes a need to
distinguish:
● β asset (βa), which reflects systematic business risk only, and
● β equity (βe), which reflects both systematic business risk TOGETHER
WITH ANY systematic financial risk which MAY exist.
Therefore:
● In the case of an all equity company, βe = βa, since no systematic financial
risk can possibly exist.
● In the case of a geared company, βe > βa, since βe contains both
systematic business risk and systematic financial risk, whereas βa reflects
systematic business risk only.
Ve Vd (1 − T )
βa = (V + V (1 − T )) β e + (V + V (1 − T )) β d
e d e d
E D(1 − t )
βa = βe + βd
E + D(1 − t ) E + D(1 − t )
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The debentures of Stiles plc are virtually risk-free and the corporation tax rate is
40%.
Therefore since Giles plc is an all equity company within the same industry as Stiles
plc, the βe of Stiles plc can be calculated as follows:
E + D(1 − t )
βe = βa
E
15 + 6(1 − 0.4 )
= 0.95 x
15
= 1.178
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Financed by:
Bank loans 5,300 12,600 18,200 4,000 17,400
Ordinary shares* 4,000 9,000 3,500 5,300 4,000
Reserves 15,100 10,200 17,500 12,800 11,900
24,400 31,800 39,200 22,100 33,300
*The par value per ordinary share is 25p for Freezeup and Shiverall, 50p for Topice
and £1 for Glowcold and Hotalot.
Corporate debt may be assumed to be almost risk-free, and is available to Hotalot
at 0.5% above the Treasury Bill rate, which is currently 9% per year. Corporate
taxes are payable at a rate of 35%. The market return is estimated to be 16% per
year. Hotalot does not expect its financial gearing to change significantly if the
company diversifies into the production of freezers.
Required:
(a) Estimate what discount rate Hotalot should use in the appraisal of its
proposed diversification into freezer production.
(b) Corporate debt is often assumed to be risk-free. Explain whether this is a
realistic assumption and calculate how important this assumption is likely to
be to Hotalot’s estimate of a discount rate in (b) above. For this purpose
assume that Hotalot and the four freezer companies all have a debt beta of
0.3.
(c) Discuss whether systematic risk is the only risk that Hotalot’s shareholders
should be concerned with.
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(a) Discount rate for the appraisal of the proposed diversification into
freezers
First, estimate the average equity beta in the freezer industry, then degear this
figure. Regear it up to Hotalot’s debt/equity ratio and apply the CAPM to find
Hotalot’s cost of equity. A WACC can then be calculated for Hotalot.
Average equity beta in the freezer industry
£’million
F: 5.3
G: 12.6
S: 18.2
T: 4.0
£40.1 million
192
= 1.175 × = 1.035
192 + 40.1(1 − 0.35)
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1.07 = βe x
33.92
+ 0.3 x
(17.4x0.65)
33.92 + (17.4 x 0.65) 33.92 + (17.4 x 0.65)
βe = 1.327
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Advantages
● It demonstrates that unsystematic risk can be diversified away, therefore the
only risk premium required is for systematic risk only;
● Probably the best practical method for establishing the Ke of a publicly traded
company;
● It highlights the relationship between risk and return, based upon stock
market performance and provides a measure of the risk of shares held within
a well-diversified portfolio and measures the required rate of return in view of
that level of risk;
● Helps to provide a risk adjusted discount rate for use in investment appraisal.
Limitations
● It concentrates purely upon systematic risk and is therefore of limited use for
investors who do not hold a well-diversified portfolio;
● Since CAPM only considers the level of return to investors, it ignores the
manner in which that return is received. Therefore, it treats dividends and
capital gains as equally desirable to investors, thus totally ignoring the tax
position of individual investors;
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● It is purely a single period model, therefore not ideal for use in projects which
extend for multiple periods;
● The model requires the use of data which can be difficult to obtain ie
(i) The risk free rate of interest: It is necessary to take the best proxy
measure of a short-term default free rate eg UK 90 day Treasury bills;
(ii) The return on the market portfolio: Should the FT all-share index be
used, or the FTSE 100, or the FTSE 350, or a world composite share
price index?;
(iii) Beta: Clearly this should strictly be based on subjective probabilities of
future events, but since this is impracticable in practice, regression
analysis is often used to compare the historical behaviour of individual
securities with the behaviour of a suitable market index within the same
time period.
● CAPM tends to overstate the required return of high beta securities and to
understate the required return of low beta securities. The returns of small
companies, returns on certain days of the week or months of the year have in
practice been observed to differ from those expected from CAPM.
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Chapter 7
Adjusted present
value
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CHAPTER CONTENTS
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CALCULATION OF APV
The APV method therefore sees the value of the project to shareholders as being:
Project value if all equity financed + present value of tax + Present value of
(the base case NPV) shield on the loan other side effects
The APV method involves two stages:
1. Evaluate the project first of all as if it were all equity financed, and so as if the
company were an all equity company to find the ‘based case NPV’.
2. Make adjustment to the based case NPV to allow for the side effects of the
method of financing that has been used. The financing effects may consist of:
(i) Present value of tax savings on interest paid on debt raised to finance
the investment.
(ii) Present value of issue costs incurred in raising both debts and equity
capital.
(iii) Present value of subsidies/cheap loans. This is technically an
opportunity benefit.
Example
A project with an initial cost of £80,000 is expected to yield an annual return of
£10,000 in perpetuity. The £80,000 will be financed by £30,000 debts and £50,000
equity.
Required:
Calculate APV, assuming 10% ungeared cost of equity and corporation tax
of 30%.
Solution
Based case NPV (NPV if all equity financed) = (£10,000/ 0.10) – 80,000 =£20,000
PV of tax shield 30,000 x 30% = 9,000
APV = 29,000
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Issue cost
The issue cost is the cost associated with raising funds needed to finance the
project. The issue cost is a cash outflow and that its present value should be
deducted from the base case NPV in the calculation of APV. Risk free rate is usually
used as the discount factor in calculating the present value of issue cost.
Example
Required:
Calculate the issue cost that should be included in the APV calculations
assuming:
(a) the issue cost is not a tax allowable expense;
(b) the issue cost is a tax allowable expense and tax is paid one year in
arrears. Corporation tax rate is 30%.
Solution
(b) Issue cost is a tax allowable expense and tax is paid one year in
arrears.
Issue cost = £20m x (5 / 95) = £1.05m
Tax saving on issue cost = £1.05m x 30% = £0.315m
PV of issue cost:
Year Item cash flow (£) Discount factor Present value
(10%)
0 issue cost (1.05) 1.000 (1.05)
1 tax saved 0.315 0.909 0.286
Present value
0.764
of issue cost
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The calculation of the tax shield depends on whether the interest is payable on a
fixed amount every year or there is equal repayment.
Example
Required:
Calculate the present value of tax shields assuming:
(a) 10% interest on the £20m per annum;
(b) the amount will be paid in equal instalments over 5 years.
Solution
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Subsidy
It may be possible for a company to raise a subsidised loan to finance a project. In
this case the company will save interest cost which is the difference between the
normal interest and the subsidised interest. However, by paying less interest the
company forfeits the tax benefit on the amount of interest not paid.
The present value of the net interest saved represents an addition to the base case
NPV in APV calculation.
Example
Required:
Calculate the present value of tax shields and present value of subsidy.
Solution
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Example Strayer
The managers of Strayer Inc are investigating a potential $25 million investment.
The investment would be a diversification away from existing mainstream activities
and into the printing industry. $6 million of the investment would be financed by
internal funds, $10 million by a rights issue and $9 million by long term loans. The
investment is expected to generate pre-tax net cash flows of approximately $5
million per year, for a period of ten years. The residual value at the end of year ten
is forecast to be $5 million after tax. As the investment is in an area that the
government wishes to develop, a subsidised loan of $4 million out of the total $9
million is available. This will cost 2% below the company's normal cost of long-
term debt finance, which is 8%.
Strayer's equity beta is 0.85, and its financial gearing is 60% equity, 40% debt by
market value. The average equity beta in the printing industry is 1.2, and average
gearing 50% equity, 50% debt by market value.
The risk free rate is 5.5% per annum and the market return 12% per annum.
Issue costs are estimated to be 1% for debt financing (excluding the subsidised
loan), and 4% for equity financing. These costs are not tax allowable. The
corporate tax rate is 30%.
Required:
(a) Estimate the Adjusted Present Value (APV) of the proposed
investment. (15 marks)
(b) Comment upon the circumstances under which APV might be a better
method of evaluating a capital investment than Net Present Value
(NPV). (5 marks)
(20 marks)
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Solution to Strayer
(a)
APV = Base case NPV ± Present value of financing effects
50
Βa = 1.2 × =0.71
50 + 50(1 − 0.3)
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(b)
The APV method may be better than NPV in situations where:
● The operating risk of the company changes as a result of the new investment.
● There is a significant change in the capital structure and hence financial risk of
the company as a result of the investment.
● The investment has complex tax payments and tax allowances, and/or periods
when tax is not paid.
● There are subsidised loans or other benefits associated explicitly with an
individual project.
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Chapter 8
International
investment
appraisal
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CHAPTER CONTENTS
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Introduction
In essence capital budgeting for overseas investments is similar to domestic
investment appraisal. It includes the following steps:
● Identification of relevant cash flows.
● Dealing with inflation to assess real or nominal cash flows.
● Dealing with tax, including the tax savings on capital allowances.
● Dealing with inter-company transactions, such as management charges and
royalties and cash flow remittance restrictions.
● Estimating future exchange rates (spot rates).
● Dealing with double taxation arrangements.
● Estimating the appropriate cost of capital (discount factor).
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UK USA Bargonia
Year 1 5% 5% 20%
2 5% 5% 30%
3 5% 7% 30%
4 5% 7% 30%
5 5% 7% 30%
Required:
If current spot rates are US$1.60 = £1 and Bargonian Dowl 250 = £1, using the
PPPT, what are the predicted spot rates for the currencies concerned at the end of
each of the next five years?
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Year 0 1 2 3 4 5
Remission of funds
Certain costs to the subsidiary may in reality be revenues to the parent company.
For example, royalties, supervisory fees and purchases of components from the
parent company are costs to the project, but result in revenues to the parent. Care
should be exercised in identifying exactly how and when funds are repatriated. The
normal methods of returning funds to the parent company are:
● Dividends
● Royalties
● Transfer prices; and
● Loan interest and principal
It is important to note that some of these items may be locally tax-deductible for
the subsidiary but taxable in the hands of the parent.
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Political risk
This relates to the possibility that the NPV of the project may be affected by host
country government actions. These actions can include:
● Expropriation of assets (with or without compensation!);
● Blockage of the repatriation of profits;
● Suspension of local currency convertibility;
● Requirements to employ minimum levels of local workers or gradually to
pass ownership to local investors.
The effect of these actions is almost impossible to quantify in NPV terms, but their
possible occurrence must be considered when evaluating new investments. High
levels of political risk will usually discourage investment altogether, but in the past
certain multinational enterprises have used various techniques to limit their risk
exposure and proceed to invest. These techniques include the following:
(a) Structuring the investment in such a way that it becomes an unattractive
target for government action. For example, overseas investors might ensure
that manufacturing plants in risk-prone countries are reliant on imports of
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components from other parts of the group, or that the majority of the
technical “know-how” is retained by the parent company. These actions
would make expropriation of the plant far less attractive.
(b) Borrowing locally so that in the event of expropriation without compensation,
the enterprise can offset its losses by defaulting on local loans.
(c) Prior negotiations with host governments over details of profit repatriation,
taxation, etc, to ensure no problems will arise. Changes in government,
however, can invalidate these agreements.
(d) Attempting to be “good citizens” of the host country so as to reduce the
benefits of expropriation for the host government. These actions might
include employing large numbers of local workers, using local suppliers, and
reinvesting profits earned in the host country.
Economic risk
Economic risk is the risk that arises from changes in economic policies or conditions
in the host country that affect the macroeconomic environment in which a
multinational company operates. Examples of economic risk include:
● Government spending policy.
● Economic growth or recession.
● International trading conditions.
● Unemployment levels.
● Currency inconvertibility for a limited time.
Fiscal risk
Fiscal risk is the risk that the host country may increase taxes or changes the tax
policies after the investment in the host country is undertaken. Examples of fiscal
risk include:
● An increase in corporate tax rate.
● Cancellation of capital allowances for new investment.
● Changes in tax law relating to allowable and disallowable tax expenses.
● Imposition of excise duties on imported goods or services.
● Imposition of indirect taxes.
Regulatory risk
Regulatory risk is a risk that arises from changes in the legal and regulatory
environment which determines the operation of a company. Examples are:
● Anti-monopoly laws.
● Health and safety laws.
● Copyright laws.
● Employment legislation.
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1. Equity
The subsidiary is likely to be 100% owned by the parent company. However,
in some countries it is necessary for nationals to hold a stake, sometimes
even a majority of the ordinary shares on issue.
2. Eurocurrency Loan
Eurocurrency loan is a loan by a bank to a company denominated in a
currency of a country other than that in which they are based. For example, a
UK company may require a loan in dollars which it can acquire from a UK
bank operating in the Eurocurrency market. This is called Eurodollar loan.
The usual approach taken is to match the assets of the subsidiary as far as
possible with a loan in the local currency. This has the advantage of reducing
exposure to currency risk. However, this reduced risk must be weighed
against the interest rate paid on the loan. A loan in the local currency may
carry a higher interest rate, and it may be preferable, for example, to arrange
a Eurocurrency loan in a major currency which is highly correlated with the
currency of the overseas operations.
3. Government grants
Finance may be available from the UK, the overseas government, or an
international body, such as the World Bank.
4. Intercompany accounts
Financing by intercompany account is useful in a situation where it is difficult
to get funds out of the foreign country by way of dividends. This is further
discussed below.
6. Eurobond
Eurobond are bonds sold outside the jurisdiction of the country in whose
currency the bond is denominated.
Eurobond is a bond issued in more than one country simultaneously, usually
through a syndicate of international banks, denominated in a currency other
than the national currency of the issuer. They are long-term loans, usually
between 3 to 20 years and may be fixed or floating interest rate bonds
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7. Euroequity
These are equity sold simultaneously in a number of stock markets. They are
designed to appeal to institutional investors in a number of countries. The
shares will be listed and so can be traded in each of these countries.
The reasons why a company might make such an issue rather than an issue in
just its own domestic markets include:
● larger issues will be possible than if the issue is limited to just one
market;
● wider distribution of shareholders;
● to become better known internationally;
● queuing procedures which exist in some national markets may be
avoided.
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Required:
(a) Evaluate the proposed investment from the viewpoint of Brookday plc. State
clearly any assumptions that you make.
(b) What further information and analysis might be useful in the evaluation of this
project?
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Discount
factors @ 13%
(note 6) 1 0.885 0.783 0.693 0.613 0.543
Present values (14,615) 716 3,407 3,254 17,092 (5,688)
Notes:
1. Sales price increases by 5% per year
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6. Using the capital asset pricing model to determine the discount rate:
ke = rf + (Erm – rf) β project
ke = 7% + (12% − 7%) 1.2 = 13%
(b) Further information and analysis might include:
(i) How accurate are the cash flow forecasts? How have they been
established?
(ii) Why has a four year planning horizon been chosen? The valuation of the
fixed assets at year 4 is highly significant to the NPV solution. How has
this valuation been established? Is this valuation based upon future
earnings as a going concern? It would be more desirable to evaluate the
project over the whole of its projected life.
(iii) Risk is taken into account by using a CAPM derived discount rate. How
has this rate been derived for a situation involving two countries? Does
this fully reflect the risk of the project? Is the use of CAPM appropriate
as it is a single period model? Other, theoretically weaker, measures of
risk might be useful as an aid to decision-making eg, sensitivity analysis
of the key variables or simulation.
(iv) Cash flow is usually assumed to occur at the end of each year. Greater
accuracy would result if consideration were given to when during the
year cash flow arises and these cash flows discounted at the appropriate
rate.
(v) Political and economic factors should be considered. How stable is the
US government policy? Will a change in government lead to changes in
taxation policy, exchange controls, restrictions on the remittance of
funds or attitudes towards foreign investment?
(vi) Are there any intangible benefits of establishing a manufacturing plant in
the USA eg making the American public more aware of Brookday’s
product?
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Required:
Using the Adjusted Present Value technique, advise the management of Polycalc on
the project’s desirability.
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Solution to Polycalc
PV of tax shield
Based upon debt capacity created ie
A$15m 2
x = £5m (which happens to be equal to the loan raised)
2 3
Annual tax relief on interest = £5m x 0.10 x 0.35 = £175,000
PV of tax relief for 4 years: £175,000 x 3.170 = £554,750
PV of issue costs
£5m x 0.025 x (1 − 0.35) = £81,250
£m
Base case NPV (0.404)
PV of tax shield 0.555
PV of issue costs (0.081)
Adjusted present value £0.07m or +£70,000 approx
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Chapter 9
Valuations,
acquisitions and
mergers – section 1
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CHAPTER CONTENTS
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= £2.63
Then compute the dividend for year 4 and ‘plug’ this into the growth formula with g
= 0.06
Year 4 dividend = 29.15p x 1.06 = 30.90p
30 .90p
Using the growth formula P3 = = 162.63p
0.25 − 0.06
The growth formula for P is based on dividends from year 1 to perpetuity. Since
the dividends in the above calculation go from year 4 to perpetuity, the value for P
above must be at year 3. But we want its present value at year 0. Therefore we
must discount back three further years, using the 3 year factor at 25%, which is
0.512.
Present value at year 0 of dividends from year 4 to perpetuity = 162.63p x 0.512
= 83.27p
Adding the present value of dividends from years 1 to 3 gives:
Share value = 46.75p + 83.27p = £1.30
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A cost of capital of 12% is assumed to represent the systematic risk of the cash
flows of Miller Ltd.
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£000
Turnover 525,000
Cost of goods sold (315,000)
Distribution costs and administrative expenses (36,000)
174,000
Tax on operating profits (30% x 174,000) (52,200)
Tax saved on writing down allowances (30% x 46,500) 13,950
Non-current assets purchased (72,000)
Annual net cash flows 63,750
r =
(1 + m) − 1 = 1.133
−1 = 10%
(1 + i) 1.03
Since the annual net cash flows are perpetuities expressed in terms of real cash
flows, it has been necessary to establish a real discount rate.
£000
63,750
Corporate value 637,500
10%
Less market value of irredeemable bonds (21,000 x 1.3) (27,300)
Equity market capitalisation 610,200
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The average P/E ratio of listed companies in the industry in which Mayfly Ltd
operates is 10. Listed companies which are similar in many respects to Mayfly Ltd
are:
Bumblebee plc, which has a P/E ratio of 15, but is a company with very
good growth prospects;
Wasp plc, which has had a poor profit record for several years, and has a
P/E ratio of 7.
What would be a suitable range of valuations for the shares of Mayfly Ltd?
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P/E ratio. A P/E ratio of 15 (Bumblebee’s) would be much too high for Mayfly Ltd,
because the growth of Mayfly Ltd earnings is not as certain, and Mayfly Ltd is an
unlisted company.
On the other hand, Mayfly Ltd’s expectations of earnings are probably better than
those of Wasp plc.
A suitable P/E ratio might be based on the industry’s average, 10; but since Mayfly
is an unlisted company and therefore more risky, a lower P/E ratio might be more
appropriate: perhaps (60% to 70% of 10) = 6 or 7, or conceivably even as low as
(50% of 10) = 5.
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£ £
Fixed assets
Land and buildings 160,000
Plant and machinery 80,000
Motor vehicles 20,000
Goodwill 20,000
280,000
Current assets
Stocks 80,000
Debtors 60,000
Short-term investments 15,000
Cash 5,000
160,000
440,000
£ £
Capital and reserves
Ordinary shares of 50p 80,000
Reserves 140,000
220,000
4.9% preference shares of £1 50,000
270,000
12% debentures 60,000
Deferred taxation 10,000
70,000
Creditors: amounts falling due within one year
Creditors 60,000
Taxation 20,000
Proposed ordinary dividend 20,000
100,000
440,000
What is the value of an ordinary share using the net assets basis?
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Since Taylor Ltd is a private company the calculated share price of £4.00 could be
reduced by between 30% to 50%, ie around £2.80 to £2.00, due to lack of
marketability.
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Irredeemable debt
Since there are 10,000 bonds on issue each with a £100 par value, an individual
bond has a market value of:
£1,239,000
= £123.90
10,000
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Preference shares
Convertible debt
The value of a convertible cannot fall below its value as debt, but upside potential
exists due to the possibility of an increase in the share price prior to expiry of the
conversion period.
Therefore the theoretical value of a convertible (known as its “formula value”) is
the greater of its value as debt and its value as shares ie its conversion value. In
practice the actual price of convertibles will tend to trade at a value in excess of
formula value, reflecting so called “time value” ie the possibility that the share price
could rise prior to expiry of the conversion period.
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Discount Present
End of year
factor value
£ 9% £
1-7 Gross annual interest 11 5.033 55.36
7 Redemption value 120 0.547 65.64
Notice that there is no need to calculate the present value of the share price, since
under the fundamental theory of share valuation a current share price reflects the
PV of the future cash flow streams associated with holding the share.
The conversion price where the investor would be indifferent between redemption
and conversion is (£121 ÷ 15 shares) ie £8.07. The value of the convertible will
never fall below its value as debt (£121). However if the share price rises above
£8.07, the convertible loan notes will then reflect the value of the equity receivable
on conversion.
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Type I acquisitions
These are acquisitions that do not disturb the acquirer’s exposure to either business
risk or financial risk. In theory, the value of the acquired company, and hence the
maximum amount that should be paid for it, is the Present Value of the future cash
flows of the target business discounted at the WACC of the acquirer. The valuation
techniques already considered would deal adequately with this type of business
combination.
Type II acquisitions
These are acquisitions which do not disturb the exposure to business risk, but do
impact upon the acquirer’s exposure to financial risk, eg through changing the
gearing levels of the acquirer. Such acquisitions may be valued using the Adjusted
Present Value (APV) technique by discounting the Free Cash Flows of the acquiree
using an ungeared cost of equity and then adjusting for the tax shield.
The assumed rate of corporation tax is 35% p.a. The terminal value of the
investment is treated as a constant perpetuity equal to the free cash flows for the
year 2014. The risk free rate of interest is assumed to be 6% p.a., the return on a
market portfolio is taken to be 13.5%, whilst an asset beta of 1.1 is used for
purposes of the appraisal.
Annual capital expenditure from 2008 onwards is estimated at £20 million each
year indefinitely. Newscot Ltd currently has on issue £400 million of 8% debt and
it is intended that all available cash flows should be applied to repaying this debt at
the earliest opportunity.
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Total
£m
Discount
factor
(14.25%) - 0.875 0.766 0.671 0.587 0.514
PV (£m) - 74.25 77.42 79.74 81.19 82.07 394.67
161 .66
From 2014 to infinity: × 0.514 = 583.11
0.1425
PV to infinity of Company Free Cash Flow 977.78
APV £m
Corporate value (977.78 + 27.37) 1005.15
Less Value of debt (400.00)
Value of equity 605.15
Less Purchase consideration (500.00)
APV 105.15
Therefore, the directors of Heincarl plc should proceed with the acquisition of
Newscot Ltd.
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The forecast rate of corporation tax is expected to remain at 30%. The risk free
rate of interest is to be taken at 5% and the expected return on a market portfolio
is 9%.
Information currently relating to the two companies is as follows:
Cost of debt 7% 7%
Edwards plc plans to make a cash offer of £380 million for the purchase of the
entire share capital of Colman Ltd. This cash offer will be funded by additional
borrowings undertaken by Edwards plc.
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1,000 300
βa = × 0.9 + × 2.4 = 1.25
1,000 + 300 1,000 + 300
Cost of equity
Ke = 5% + (9% − 5%) 1.62 = 11.48%
1,180 500
WACC = × 11.48% + × 7% × (1 − 0.3) = 9.52%
1,680 1,680
£m £m
2008 5.00 1 5.00
2009 60.00 1÷1.0952 54.78
2010 65.40 1÷1.09522 54.52
2011 71.29 1÷1.09523 54.27
2012 77.70 1÷1.09524 54.01
2013 84.69 1÷1.09525 53.75
2014 92.32 1÷1.09526 53.50
2015 100.63 1÷1.09527 53.24
2016 109.68 1÷1.09528 52.99
2017 119.55 1÷1.09529 52.74
2018 130.29 1÷1.095210 52.48
Terminal value 2,396.84 1÷1.095211 881.48
1,422.76
Value of equity
£m
PV of combined entity 1,422.76
Less combined value of debt (500.00)
Value of equity 922.76
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£m
PV of combined entity 1,395.45
Less combined value of debt (500.00)
Value of equity 895.45
The increased proportion of debt (500 ÷ 1,395.45) ie about 36% of corporate value
has caused both βe and Ke to increase, whilst there has been a slight reduction in
WACC due to the larger weighting applied to debt.
Since the value of equity has now fallen to £895.45 million, which is below the
current value of the equity shares in Edwards plc (ie £900 million), the acquisition
would cause a reduction in shareholder wealth of £4.55 million. The business
combination should thus be abandoned.
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Using a cost of equity of 20% p.a., produce a valuation for Bednar plc
based upon both the maximum and the minimum growth rate predictions,
using the Growth Model combined with Gordon’s growth approximation.
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Maximum valuation
Growth prediction: (g = br) g = 1 x 0.18 = 18%
Valuation using the Growth Model:
320 1,200
− = 16,000 – 7,500 = £8,500 million
20% − 18% 20% − 4%
Minimum valuation
Growth prediction: (g = br) g = 1 x 0.16 = 16%
Valuation using the Growth Model:
320 1,200
− = 8,000 – 7,500 = £500 million
20% − 16% 20% − 4%
Growth rates are affected by changes in technology, management competence,
demand and inflation levels, and are therefore extremely difficult to predict. Notice
the dramatic change in the business valuation that has been caused by a slight
change in the predicted rate of growth.
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Chapter 10
Valuations,
acquisitions and
mergers – section 2
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CHAPTER CONTENTS
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1. Synergy
● An expansion policy based on merger or takeover can be justified on the basis
of synergy. (Sometimes stated as 2 + 2 = 5) ie
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● Conclusions on Synergy
o Synergy is not automatic
o When bid premiums are considered, the consistent winners in mergers
and takeovers are victim company shareholders.
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3. Mode of offer
Cash consideration
The offer is made to purchase the shares of the target company for cash. This
method is very appropriate for relatively small acquisitions, unless the acquirer has
accumulation of cash from operations or divestments.
The advantages of cash offer to the target entity’s shareholders are that:
● The price that they will receive is obvious. It is not like share exchange where
the movements in the market price may change their wealth.
● The cash purchase increases the liquidity of the target shareholders who are
in position to alter their investment portfolio to meet any changing
opportunities.
A disadvantage to target shareholders’ for receiving cash is that if the price that
they receive is on sale is more than the price paid when purchasing the shares,
they may be liable to capital gains tax.
The advantages to the predator company are that:
● The value of the bid is known and target company shareholders’ are
encouraged to sell their shares.
● It represents a quick and easily understood approach when resistance is
expected.
● The shareholders of the target company are bought out and have no further
participation in the control and profits of the combined entity.
The main disadvantages to the predator company are that it may deplete the
company’s liquidity position and may increase gearing.
Mezzanine finance
Mezzanine finance is a form of finance that combines features of both debt and
equity. It is usually used when the company has used all bank borrowing capacity
and cannot also raise equity capital.
It is a form of borrowing which enables a company to move above what is
considered as acceptable levels of gearing. It is therefore of higher risk than
normal forms of borrowing.
Mezzanine finance is often unsecured.
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Retained earnings
This method is used when the predator company has accumulated profits over time
and is appropriate when the acquisition involves a small company and the
consideration is reasonably low. This method may be the cheapest option of
finance.
Vendor placing
In a vendor placing the predator company issues its shares by placing the shares
with institutional investors to raise the cash required to pay the target
shareholders.
Share exchange
The predator company issues its own shares in exchange for the shares of the
target company and the shareholders of the target company become shareholders
of the predator company.
The advantages of a share exchange to target shareholders include:
● Capital gains tax is delayed.
● The shareholders of the target company will participate in the control and
profits of the combined entity.
The main disadvantage is that there is uncertainty with a share exchange where the
movements in the market price may change their wealth.
The advantages to the predator company are that:
● It preserves the liquidity position of the company as there are no outflows of
cash.
● Share exchange reduces gearing and financial risk. However, this may
depend on the gearing of the target company.
● The predator company can bootstrap earnings per share if its price earnings
ratio is higher than that of the target company.
The main disadvantages of a share exchange are that:
● It causes dilution in control.
● It may cause dilution in earnings per share.
● As equity shares are issued this comparatively more expensive than debt
capital.
● The company may not have enough authorized share capital to issue the
additional shares required.
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Earn-out arrangements
An earn-out arrangement is where the purchase consideration is structured such
that an initial payment is made at the date of acquisition and the balance is paid
depending upon the financial performance of the target company over a specified
period of time.
The main advantages of earn-out arrangements are that:
● Initial payment is reduced.
● The risk to the predator company is reduced as it is less likely to pay more
than the target is worth. The price is limited to future performance.
● It encourages the management of the target company to work hard as the
overall consideration depends on future performance.
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4. Strategic defences
Post-bid
A target company can use the following to defend itself against a possible takeover:
● Try to convince the shareholders that the terms of the offer are
unacceptable. This can be done using the following:
o Attempt to show that the current share price of the company is
unrealistically low relative to the future potential. Assets revaluation,
new profit forecasts, dividends and promises of rationalisation are
commonly employed here.
o If it is for share for share exchange, the target company can attempt to
convince the shareholders that the offer’s equity is currently overvalued.
The suitability of the bidding company to run the merged business can
also be questioned.
● Lobbying the office of fair trading and or the department of trade and
industry to have the offer referred to the competition commission. This will at
least delay the takeover and may prevent it completely.
● Launching an advertising campaign against the takeover bid. One
technique is to attack the account of the predator company.
● A reverse takeover (Pac Mac), that is make a counter offer for the predator
company. This can be done if the companies are of reasonably similar size.
● Finding a ‘white knight’, a company which will make a welcome takeover
bid. This involves finding a more suitable acquirer and promoting it to
compete with the predator company.
● Crown jewels (or scorched earth) policy, with the approval of shareholders
in general meeting.
Pre-bid
● Selling crown jewels – the tactic of selling off certain highly valued assets
of the company subject to a bid is called selling the crown jewels. The
intention is that, without the crown jewels, the company will be less
attractive.
● Golden parachutes – this is a policy of introducing attractive termination
packages for the senior executives of the victim company. This makes it
more expensive for the predator company.
● Shark repellent – super-majority. The articles of association are changed to
require a very high percentage of shares to approve an acquisition or merger,
say 80%.
● Poison pill
The most commonly used and seeming most effective takeover defence is the
so called poison pill.
An example is the Flip-in pill. This involves the granting of rights to
shareholders, other than the potential acquirer, to purchase the shares of the
target company at a deep discount. This dilutes the ownership interest of the
potential acquirer.
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5. Regulation of takeovers
The regulation of takeovers varies from country to country and mainly concentrates
on controlling directors in order to ensure that all shareholders are treated fairly.
Typically, the rules will require the target company to:
● notify its shareholders of the identity of the bidder and the terms and
conditions of the bid;
● seek independent advice;
● not issue new shares or purchase or dispose of major assets of the company,
unless agreed prior to the bid, without the agreement of a general meeting;
● not influence or support the market price of its shares by providing finance or
financial guarantees for the purchase of its own shares;
● the company may not provide information to some shareholders which is not
made available to all shareholders;
● shareholders must be given sufficient information and time to reach a
decision. No relevant information should be withheld;
● the directors of the company should not prevent a bid succeeding without
giving shareholders the opportunity to decide on the merits of the bid
themselves.
Directors and managers should disregard their own personal interest when advising
shareholders.
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“Six big investment banks published trading volumes for their “dark pools” for the
first time yesterday, showing them as a tiny fraction of the market and not the
major hidden rivals to stock exchanges that some argue.
Citi, Credit Suisse, Deutsche Bank, J P Morgan Cazenove, Morgan Stanley and UBS
together executed €596 million (£513 million) of equity trades from 15 countries on
their automated crossing systems on Friday, according to Markit data.
That accounted for about 0.4 per cent of all types of cash equity trades in Europe
and 1.6 per cent of all over-the-counter (OTC) trades reported on the Markit BOAT
service that day, according to Thomson Reuters data.
Dark pools are electronic platforms that allow would-be buyers and sellers of large
orders of shares to avoid revealing pre-trade information and signalling their
intentions to the rest of the market.
Bankers argue that for the bulk of OTC trades they act purely as dealers, using
their own money or share inventories to take one or another side, or they act in a
non-automated way to match buyers and sellers for big blocks of stock.”
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Chapter 11
Valuations,
acquisitions and
mergers – section 3
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CHAPTER CONTENTS
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Value drivers
Seven key factors, called value drivers, are identified as being fundamental to the
determination of value:
● sales growth rate;
● operating profit margin;
● tax rate;
● incremental fixed capital investment;
● incremental working capital investment;
● the planning horizon;
● the required rate of return.
The model assumes a constant percentage rate of sale growth and a constant
operating profit margin. Tax is assumed to be a constant percentage of operating
profit. Finally, fixed and working capital investments are assumed to be a constant
percentage of change in sale.
Corporate value
Using the free cash flows, corporate value is then computed using the company’s
WACC as a discounting factor:
Corporate value = PV of free cash flows + current value of marketable securities
and other non operating investment.
Share value
The share value may then be calculated as:
SV = Corporate value – Debt
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Required:
Compute Zoozo’s corporate value and share value.
Strengths of SVA
● Simple approach.
● It is consistent with the concept of share valuation by DCF.
● It creates management awareness of the key value variables (drivers).
● Sensitivity analysis can be applied to each of the value drivers.
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Problems
● The constant percentage assumptions may be unrealistic.
● The input data may not be easily available from current system.
● There are subjective judgments necessary to determine the value drivers.
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Calculating EVA
To calculate EVA the following steps can be followed:
● Calculate the net operating profit after tax (NOPAT).
● Calculate the adjusted/economic capital employed.
● Find the weighted average cost of capital (WACC) of the company.
● Calculate capital charge as the WACC multiplied by the adjusted/economic
capital employed.
● Calculate the EVA as difference between NOPAT and capital charge.
Add
- accounting depreciation xx
- any goodwill written off for the year xx
- any increase ( less any decrease) in provision for doubtful debts xxx
- any increase in net capitalised development cost xxx
- any increase in net capitalised lease expenditure xxx
Less
- replacement cost depreciation (economic depreciation) (xx)
- amortisation of development cost and leases (xx)
- cash payment for tax on operating profit (xx)
NOPAT xxxx
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Add
- cumulative amortised goodwill xxx
- provision for doubtful debts xxx
- economic value = (net book value) of capitalised development cost xxx
- economic value = (net book value) of leased expenditure xxx
Less
- non-interest bearing liabilities such as trade payables and tax payable (xxx)
- economic capital employed xxxxx
Example
A company has reported annual operating profits for the year of £89·2m after
charging £9·6m for the full development costs of a new product that is expected to
last for the current year and two further years. The cost of capital is 13% per
annum. The balance sheet for the company shows fixed assets with a historical
cost of £120m. A note to statement of financial position estimates that the
replacement cost of these fixed assets at the beginning of the year is £168m. The
assets have been depreciated at 20% per year.
The company has a working capital of £27·2m.
Ignore the effects of taxation.
Required:
Calculate EVA.
Solution
£m
Profit 89·20
Add
Current depreciation (120 x 20%) 24·00
Development costs (9·60 x 2/3) 6·40
Less
Replacement depreciation (168 x 20%) 33·60
Adjusted profit 86·00
Less cost of capital charge (Working 1) 21·84
EVA 64·16
Working 1
Cost of capital charge
Fixed assets (168 – 33·6) 134·4
Working capital 27·2
Development costs 6·4
Adjusted capital employed 168.0
x 13% = 21·84
The value of a company using EVA technique can be seen as the adjusted
capital employed plus the present value of future EVA discounted at the
WACC.
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Strengths of EVA
● It measures the value added to the organisation after deducting a charge for
the use of capital made by that organisation.
● It is based on economic profit and economic value of capital employed, not
accounting profit and assets values which can be manipulated.
● EVA may be consistent with the objective of maximising shareholder wealth.
● It can easy be communicated to, and understood by, managers and
employees.
● EVA can be used to assess performance by managers, and linked to
remuneration schemes that reward the creation of value to the organization
Problems of EVA
● EVA is complicated and requires many adjustments to accounting information.
● It does not capture all the value drivers, especially non-purchase goodwill.
● EVA is normally historic. It does not help to decide future investments and
strategy. It is based on historical accounts which may be of limited use as a
guide to the future.
● It usually relies on CAPM for the estimation of the weighted average cost of
capital. CAPM is based on restrictive assumptions and may not accurately
determine cost of capital.
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INTELLECTUAL CAPITAL
Market-to-book values
Compare the market value of the company to the book value of the assets. The
difference between the two should be equivalent to the value of the intangibles.
However, this method values the assets based on accounting policies and therefore
may no longer represent their ‘true worth’. A better alternative would be to value
the assets based on realisable value.
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Additional information:
(1) The average pre-tax return on total assets for the industry over three years
has been 15%.
(2) The estimated cost of equity capital for the industry is 10% after tax.
(3) The market price of Emboss plc share is £12 per share at 31 March 2011.
(4) The current replacement cost of a plant with a book value of £60 million is
estimated at £80 million.
Required:
Calculate the value of the company using the asset valuation method including
estimate of intellectual capital.
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An analyst working for a stockbroker has taken these published results, made the
adjustments shown below, and has reported his conclusion that ‘the management
of V plc is destroying value’.
£m
Required return (12% x £146.0m) 17.5 (weighted average cost of capital = 12%)
Adjusted profit 16.1
Value destroyed 1.4
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Required:
(a) Explain, as management accountant of V plc, in a report to your chairman, the
principles of the approach taken by the analyst. Comment on the treatment of
the specific adjustments to R & D, advertising, interest and borrowings and
goodwill.
(b) Having read your report, the chairman wishes to know which division or divisions
are ‘destroying value’, when the current internal statements show satisfactory
returns on investment (ROIs). The following summary statement is available.
Divisional performance, 20XX
Division A Division B Division C Head
Total
(Retail) (Manufacturing) (Services) Office
£m £m £m £m £m
Turnover 81.7 63.2 231.8 - 376.7
Profit before
5.7 5.6 5.8 (1.9) 15.2
interest and tax
Total assets less
27.1 23.9 23.2 3.2 77.4
current liabilities
ROI 21.0% 23.4% 25.0%
Some of the adjustments made by the analyst can be related to specific divisions:
● Advertising relates entirely to Division A (retail)
● R & D relates entirely to Division B (manufacturing)
● Goodwill write-offs relate to
Division B (Manufacturing) £10.3m
Division C (Services) £30.4m
● The deferred tax relates to
Division B (Manufacturing) £1.4m
Division C (Services) £6.2m
● Borrowings and interest, per divisional accounts, are as follows:
Division A Division B Division C Head
Total
(Retail) (Manufacturing) (Services) Office
£m £m £m £m £m
Borrowings - 6.6 6.9 1.5 15.0
Interest
(0.4) 0.7 0.9 0.4 1.6
paid/(received)
Required:
Explain, with appropriate comment, in a report to the chairman, where ‘value is
being destroyed’. Your report should include:
● A statement of divisional performance
● An explanation of any adjustments you make
● A statement and explanation of the assumptions made
● Comment on the limitations of the answers reached.
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2. Advertising
The analyst has added back advertising expenditure of £2.3 million
to the 20XX profit figure on the assumption that the expenditure
has supported sales, raised customer awareness and/or increased
brand image/loyalty, all of which could produce significant
cashflows in the future and hence are for the long-term benefit of
the organisation. The advertising expenditure over the last five
years of £10.5 million has been added back to the capital
employed figure (in much the same way as the research and
development expenditure) to reflect the fact that the costs will
provide for future growth. Again, an amortisation charge should
be made if brand values are being eroded, possibly by competition.
4. Goodwill
The analyst has added back goodwill amortisation of £1.3 million to
the 20XX profit figure. Goodwill is the difference between the price
paid for a business acquisition and the current cost valuation of
that acquisition’s net assets. On the assumption that a realistic
price was paid, the goodwill purchased should provide benefits in
the future, not just in the year of purchase. And the goodwill of
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(b)
REPORT
To: Chairman
From: Management accountant Date: XX.XX.XX
Subject: Where is value being destroyed?
An analyst working for X Stockbrokers has recently commented that ‘the
management of V plc is destroying value’. In an attempt to establish where
value is being destroyed in our organisation, a revised statement of divisional
performance has been prepared, adopting an approach similar to that used by
the analyst. The statement, plus supporting explanations, is set out in
Appendix 1.
The analysis shows that value of £0.1 million was destroyed in Division B,
while value of £2.3 million was destroyed in Division C. Division A, on the
other hand, created value of £1 million.
This is in marked contrast to the performance indicated in the conventional
divisional performance report prepared for 20XX. This shows all three
divisions earning a return on investment in excess of 20%, with Divisions B
and C, the destroyers of value, making higher returns on investment than
Division A, the creator of value.
The analyst’s approach is similar to performance evaluation using residual
income in that a charge is made for the capital employed within the division.
Further adjustments are also made to both profit and capital employed to
provide more realistic measures for performance analysis (as explained in my
earlier report and in Appendix 1). The results of the analysis are dependent
upon the following factors:
1. Head office expenses are assumed to have been incurred in relation to
divisional turnover. Any one of a number of other bases might be
equally valid.
2. Tax paid is assumed to be related to divisional profit after interest and
head office expenses. Deferred tax liabilities have not been incorporated
into the analysis.
3. Each division’s share of head office assets has been assumed to be in
proportion to the division’s share of total turnover. Other bases could be
equally valid.
4. It has been assumed that each division has the same cost of capital.
This takes no account of the individual characteristics of each division,
its risk profile and its mix of financing.
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Despite the limitations set out above, the analyst’s approach provides an
alternative insight into how our divisions are performing and could well prove
useful in enabling us to create value for our shareholders in the future.
Signed: Management Accountant
APPENDIX 1
Statement of profitability
Divisions
A B C Head office Total
£m £m £m £m £m
20XX PBIT 5.7 5.6 5.8 (1.9) 15.2
Add back
Advertising 2.3 - - - 2.3
R&D - 2.1 - - 2.1
Goodwill (1) - 0.3 1.0 - 1.3
Head office expenses (2) (0.4) (0.3) (1.2) 1.9 -
Less: tax paid (2.0) (1.6) (1.2) - (4.8)
Revised profit 5.6 6.1 4.4 - 16.1
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1. Goodwill
Goodwill amortised has been apportioned to Divisions B and C in
proportion to the value of goodwill written off to capital and reserves.
Goodwill
Division Goodwill amortised
write-off
£m % £m
B 10.3 25.3 x £1.3m 0.3289
C 30.4 74.7 x £1.3m 0.9711
40.7 100.0 1.3000
3. Tax paid
The tax liability of £4.8 million for V plc has to be apportioned over the
three trading divisions. Given that the divisions’ taxable profits will be
affected by the allocation of head office expenses and the interest paid,
the overall tax liability has been apportioned on the basis of divisional
profit after interest paid and allocated head office costs.
Interest Head office Apportionme
Division PBIT Charge
paid expenses nt figures
£m £m £m % £m
A 5.7 − (0.4) − 0.4 = 5.7 41 2.0
B 5.6 − 0.7 − 0.3 = 4.6 33 1.6
C 5.8 − 0.9 − 1.2 = 3.7 26 1.2
14.0 100 4.8
5. Required return
The required return is based on a weighted average cost of capital of
12%.
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Chapter 12
Corporate
reconstruction and
reorganisation
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CHAPTER CONTENTS
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BUSINESS REORGANISATION
Unbundling
Unbundling is the process of selling off incidental non-core businesses to release
funds, reduce gearing, and allow management to concentrate on their chosen core
business.
The main forms of Unbundling are:
● Divestment.
● Demergers.
● Sell-offs.
● Spin-offs.
● Management buy-outs.
Divestment
Divestment is a proportional or complete reduction in ownership stake in an
organisation. It is the withdrawal of investment in a business. This can be
achieved either by selling the whole business to a third party or by selling the
assets piecemeal.
Sell-offs
A sell-off is a form of divestment involving the sale of part of an entity to a third
party, usually in return for cash. The most common reasons for a sell-off are:
● To divest of less profitable and/or non-core business units.
● To offset cash shortages.
The extreme form of sell-off is liquidation, where the owners of the company
voluntarily dissolve the business, sell-off the assets piecemeal, and distribute the
proceeds amongst themselves.
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Spin-offs/demergers
This is where a new company is created and the shares in the new company are
owned by the shareholders of the original company which is making the distribution
of assets. There is no change in ownership of assets but the assets are transferred
to the new company. The result is to create two or more companies whereas
previously there was only one company. Each company now owns some of the
assets of the original company and the shareholders own the same proportion of
shares in the new company as in the original company.
An extreme form of spin-off is where the original company is split up into a number
of separate companies and the original company broken up and it ceases to exist.
This is commonly called demerger.
Demerger involves splitting a company into two or more separate parts of roughly
comparable size which are large enough to carry on independently after the split.
The main disadvantages of de-merger are:
● Economies of scale may be lost, where the de-merged parts of the business
had operations in common to which economies of scale applied.
● The ability to raise extra finance, especially debt finance, to support new
investments and expansion may be reduced.
● Vulnerability to takeovers may be increased.
● There will be lower revenue, profits and status than the group before the de-
merger.
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Problems of MBOs
● Management may have little or no experience financial management and
financial accounting.
● Difficulty in determining a fair price to be paid.
● Maintaining continuity of relationships with suppliers and customers.
● Accepting the board representation requirement that many sources of funding
may insist on.
● Inadequate cash flow to finance the maintenance and replacement of assets.
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Management buy-in
A management buy-ins occurs when a group of outside managers buys a controlling
stake in a business.
Share repurchase
Any limited company may, if authorised by it articles, purchase its own shares. The
Companies Act permits any company to purchase its own shares. Therefore if a
company has surplus cash and cannot think of any profitable use of that cash, it
can use that cash to purchase its own shares.
Share repurchase is an alternative to dividend policy where the company returns
cash to its shareholders by buying shares from the shareholders in order to reduce
the number of shares in issue.
Shares may be purchased either by:
● Open market purchase – the company buys the shares from the open market
at the current market price.
● Individual arrangement with institutional investors.
● Tender offer to all shareholders.
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Going private
A public company may occasionally give up its stock market quotation and return
itself to the status of a private company.
The reasons for such move are varied, but are generally linked to the
disadvantages of being in the stock market and the inability of the company to
obtain the supposed benefits of a stock market quotation.
Other reasons are:
● To avoid the possibility of takeover by another company.
● Savings of annual listing costs.
● To avoid detailed regulations associated with being a listed company.
● Where the stock market undervalues the company’s shares.
● Protection from volatility in share price with its financial problems.
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Financial difficulties
If a company is in financial difficulties it may have no recourse but to accept
liquidation as the final outcome.
Possible reconstruction
The changing or reconstruction of the company’s capital could solve these
problems. The company can take any or all of the following steps:
● write off the accumulated losses.
● write of the debenture interest and preference share dividend arrears.
● write down the nominal value of the shares.
To do this the company must ask all or some of its existing stakeholders to
surrender existing rights and amount owing in exchange for new rights under a new
or reformed company.
The question is ‘why would the stakeholder be willing to do this? The answer to
this is that it may be preferable to the alternatives which are:
● to accept whatever return they could be given in a liquidation;
● to remain as they are with the prospect of no return from their investment
and no growth in their investment.
Generally, stakeholders may be willing to give up their existing rights and amounts
owing (which are unlikely to be met) for the opportunity to share in the growth in
profits which may arise from the extra cash which can be generated as a
consequence of their actions.
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Required:
(a) Suggest a scheme of capital reduction and write up the capital reduction
account.
(b) Outline your suggestions as to the action that should be taken by the
directors.
(c) Show the balance sheet after implementing your suggestions.
Ignore taxation.
This leaves £8,000 for the shareholders. This will go to the preference
shareholders in priority to the ordinary shareholders. Therefore, the loss suffered
by the preference shareholders is £(50,000 – 8,000), ie £42,000. The loss
allocated to them under the scheme must be less than this.
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Explanation
Use notes c) to e) in the question; list total costs, compare to money coming in
(always sell any non-trade investments). Issue enough new shares to leave a
positive cash balance. Complete double entries as you work. Finally complete the
balance sheet.
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£
Produced by
Sale of investments (ignoring costs) 14,000
Bank loan 50,000
Issue of shares to directors and existing shareholders
(10 x 400,000 x 1p) _40,000
£104,000
Leaving a balance at bank of £14,200
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Explanation
It could be argued that Jenkins plc is still not in a sufficiently strong liquidity
position.
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Chapter 13
Corporate dividend
policy
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CHAPTER CONTENTS
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C H A P T E R 1 3 – C O R P O R A T E D I V ID E N D P O L I C Y
Theory
The proponents of the dividend irrelevance hypothesis (Miller & Modigliani) claim
that the value of a firm is determined by its future earnings stream. The way this
stream is split between dividends and retentions has no impact upon shareholder
wealth.
Given a set investment policy, a dividend cut now to finance new projects will be
compensated by higher dividends at a later stage.
The shareholder will be indifferent to the dividend policy provided the PRESENT
VALUE of dividend payments remains unchanged.
Assumptions
● A set investment policy so that shareholders know the reason for withholding
dividends.
● No transactions costs.
● No distorting taxes.
● Share prices move in the manner predicted by the model.
In the case of a withheld dividend, the shareholder can maintain his level of income
by selling shares to generate ‘home made’ dividends, with no consequent decrease
in wealth.
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Transactions costs
● Shareholder can no longer replace a withheld dividend by selling shares
without incurring dealing commissions.
● Company will benefit by financing investments from retained earnings to
avoid the high costs associated with raising new finance.
Distorting taxes
Individuals will generally prefer dividends to capital gains whether a basic-rate or
higher-rate tax payer, subject to certain complications:
● exemption limit for capital gains tax;
● non-tax-paying individuals;
● tax-exempt institutions.
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Clientele theory
● Consistent dividend policy is maintained which will attract a group of
shareholders to whom the policy is suited in terms of tax, need for current
income, etc.
Other considerations
● Legality, re distributable profits.
● Existence of inflation and consideration of real profitability.
● Growth and requirements for retained earnings.
● Liquidity position.
● Limited sources of funds (particularly for small companies).
● Stability of earnings.
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Shareholder perks
Several UK companies (notably hotel operators) offer discounts to shareholders on
room bookings and restaurant meals. A number of transport companies offer
reductions in fares. Some retailers provide discount vouchers, which are sent to
shareholders at the same time as the annual report and accounts.
Scrip dividends
When the directors of a company consider that they must pay a certain level of
dividend, but would really prefer to retain funds within the business, they can
introduce a scrip dividend scheme.
This involves giving ordinary shareholders the choice of a cash dividend or newly
created shares in the company of a similar monetary value. Scrip dividend plans
were very popular in the 1990s since they enabled companies to use share
premium accounts to create the new shares (instead of reducing retained profits)
and there were certain tax advantages for the company.
However a change in the accounting regulations subsequently forced companies to
charge the profit and loss account with the scrip dividend, and a later change in UK
legislation removed the tax advantages, which companies had enjoyed. Therefore
UK companies abandoned scrip dividend schemes at the turn of the century,
although there is now evidence of a few companies re-introducing this method (eg
Millennium and Copthorne Hotels plc and Whitbread plc).
Share repurchases
Companies with cash surpluses, but having no positive NPV projects, may choose to
introduce a share buy-back scheme, whereby the company’s shares are purchased
at the company’s instructions on the open market.
This will have the effect of using up the surplus cash, increasing future EPS
(because of the reduction in the number of shares in issue), changing the gearing
level of the company and (hopefully) reducing the likelihood of a takeover.
However share repurchases are often seen as an admission that the company
cannot make better use of shareholders’ funds.
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Required:
(a) Estimate the price ex div of Parabat’s ordinary shares, following acceptance of
the new project, if finance is obtained from (i) retained earnings or (ii) a
rights issue.
(b) Calculate the price at which the new shares should be issued under option (iii)
assuming the objective of maximising the gain of existing shareholders.
(c) Calculate the gain made by present shareholders under each of the three
finance options.
Ignore taxation and issue costs of new shares.
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70p 70p
Ke = = = 20%
(420p − 70p) 350p
£120,000
Future increase per share = = 6p
2,000,000
70p + 6p
Hence new price = = £3.80
0.20
69p
New price = = £3.45
0.20
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* This represents 1.1 shares @ £3.45 each (ie allowing for the 1 for 10
rights issue).
Hence the gain to the original shareholders is 5p per share in each case,
whatever the method of financing. The NPV of the project (ie £100,000) has
been allocated over the 2,000,000 shares already on issue, irrespective of
whether the project has been financed by retentions, a rights issue or a
correctly priced issue of shares to the general public.
Hence the dividend decision was “irrelevant”.
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Chapter 14
Management of
international trade
and finance
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CHAPTER CONTENTS
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INTERNATIONAL TRADE
International trade occurs to allow companies to enjoy economies of scale, increase
their turnover and profits, use up spare capacity and to promote division of labour.
In economics, theoretical justifications of the benefits of international trade were
put forward by:
● Adam Smith – the theory of absolute advantage.
● David Ricardo – the theory of comparative advantage.
Sources of advantage may include close proximity to raw materials or markets,
access to capital or an available labour force with the necessary skills.
Trade blocks
Trade blocs arise where a group of countries conspire to promote trade between
themselves. Trade blocs include:
● Free trade area – free movement of goods and services (no internal tariffs)
between member countries, with external tariffs set individually, eg North
American Free Trade Area (NAFTA).
● Customs union – no internal tariffs between member countries and with
common external tariffs against non-member countries, eg the former
European Economic Community.
● Common market – no internal tariffs, common external tariffs, as well as the
free movement of labour and capital between member countries, eg European
Union.
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N.B. The statistics that are gathered are not wholly perfect and some transactions
will be omitted. Thus the balancing item is unavoidable.
Temporary deficits can be financed by short term borrowing, but persistent balance
of payments deficits usually require government intervention, such as:
● Devaluation of the currency or government intervention on the foreign
exchange markets.
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The Euromarkets
The Euromarkets refer to transactions between banks and depositors/borrowers of
Eurocurrency.
● Eurocurrency refers to a currency held on deposit outside the country of its
origin eg Eurodollars are $US held in a bank account outside the USA.
● Eurocurrency loans are bank loans made to a company, denominated in a
currency of a country other than that in which they are based. The term of
these loans can vary from overnight to the medium term.
● Eurobonds are bonds issued (for 3 to 20 years) simultaneously in more than
one country. They usually involve a syndicate of international banks and are
denominated in a currency other than the national currency of the issuer.
Interest is paid gross.
● Euronotes are issued by companies on the Eurobond market. Companies
issue short-term unsecured notes promising to pay the holder of the Euronote
a fixed sum of money on a specified date or range of dates in the future.
● Euroequity market refers to the international equity market where shares in
US or Japanese companies are placed on as overseas stock exchange (eg
London or Paris). These have had only limited success, probably due to the
absence of a effective secondary market reducing their liquidity.
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NCM UK; for longer periods the ECGD may provide this service. Private sector
companies such as Trade Indemnity plc provide similar services.
● Trade risk – the overseas customer may refuse to accept the goods and be
uncooperative in returning them, thus taking advantage of the long physical
distances involved.
● Liquidity risk – this is caused by the duration of the delivery period and the
lengthy periods of credit expected by some overseas customers.
● Cultural risk – there may be misunderstandings caused by differences in trade
practice, religious and moral attitudes, legal systems and language barriers.
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● Leasing and hire purchase – the exporter sells capital goods to a lessor, which
in turn enters into a leasing agreement with the exporter’s overseas
customer. Alternatively the equipment can be sold to a hire purchase
company which resells to the importer under a HP agreement.
● Acceptance credits – a large reputable exporter can arrange for its bank to
accept bills of exchange (which are related to its export activities) on a
continuing basis. These bills can then be discounted at an effective cost,
which is lower than the bank overdraft interest rate.
● Produce loans – where an importer acquires commodities for the purpose of
immediate resale, it can raise a loan from its bank, which takes custody of the
goods until the importer is able to sell them. Thereafter the principal sum,
interest and storage costs are repaid to the bank out of the proceeds of the
sale.
● Requesting payment in advance from the importer – if this were possible it
would avoid all of the above complications.
Countertrade
This is an agreement in which the export of goods to a country is matched by a
commitment to import goods from that country. This usually occurs because the
foreign importing country either lacks foreign currency, has exchange controls in
place or where there are barriers to imports which can be circumvented by means
of countertrade.
The volume of countertrade is now reported at about 30% of total international
trade. In the case of some Eastern European and Third World countries it is the
only way of organising international trade because of their shortage of foreign
currency. Many countertrade deals can be highly complex involving many parties.
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monetary union. The Single Market programme of the late 1980s gave fresh
impetus to it.
In April 1978 at a meeting of the European Heads of State the German Chancellor
Schmidt and the French President, Giscard d’Estaing, proposed the creation of a
European Monetary System (EMS) with the purpose of creating a zone of monetary
stability in Europe. In March 1979 the EMS commenced operations in the hope that
closer monetary co-operation between member states would lead to monetary
stability and economic growth. The EMS utilised a system of quasi-fixed exchange
rates, known as the Exchange Rate Mechanism (ERM), and had as its unit of
account the European Currency Unit (ECU). The value of the ECU was the weighted
average of a basket of national currencies with the weight allocated to each
currency being determined by that country’s GNP and intra-EC trade.
Those countries which were members of the ERM declared a central exchange value
for their currency and the majority of currencies agreed to fluctuate within a band ±
2.25% of this central value. This meant that the Central Bank of each participating
currency was committed to intervening, when necessary, in order to maintain their
exchange rate within the specified band. This was done by buying their own
currency when it was weak and selling their currency when it was strong. The UK,
although a member of the EMS since its inception, did not join the ERM until
October 1990.
The rules of the EMS allowed governments to realign the central value of their
exchange rate if changing circumstances showed it to be no longer appropriate. In
the early part of the EMS from 1979 to 1983 there were a number of realignments.
However, from 1987 the system became very rigid and there was only one
realignment from 1987 – the lira was realigned in January 1990 – until the currency
crisis in 1992.
The currency crisis
Speculators interpreted a number of developments in the world economy during
1992 as being attributable to fundamental weaknesses within currency markets.
This perception stimulated a period of intense speculative pressure which caused a
currency crisis.
German unification was a principal cause of the currency crisis. It is difficult to
imagine a bigger shock to the fixed parities of the ERM than the absorption of the
then East Germany into the European economy. Demand for consumer goods
soared, pushing up inflation. The government’s budget expanded adding to the
Bundesbank’s (German Central Bank) alarm. Very low, short-term American
interest rates caused huge surges of money from the US into Germany, further
fuelling German inflation rates. The Bundesbank reacted by pushing up German
interest rates. These high German interest rates occurred just when the rest of
Europe needed the rates to be low. The German mark was the anchor currency of
the ERM, so no European country could hold its interest rates below those in
Germany. When interest rates in Germany were increased all other EMS countries
followed suit.
Other causes of the currency crisis were the lack of realignments with the EMS, so
that its exchange rates had become increasingly rigid and out of touch with
international developments. Furthermore, the necessary behind the scenes macro-
economic co-ordination was not taking place as EU Member States publicly bickered
over interest rate policy. The existence of widespread unemployment as economic
recession threw millions out of work intensified these tensions.
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The straw that broke the camel’s back was 2 June 1992 when the Danish people
rejected the Maastricht Treaty in a referendum. The Danish rejection by 50.7% to
49.3% cast immediate doubt over the whole process of economic and monetary
union. Under EU law, the Danish failure to ratify the Maastricht Treaty made the
treaty null and void. As there had been no realignments within the ERM since
January 1987, the money markets had assumed that the European Union’s political
commitment to EMU meant that the parties were virtually fixed. Doubts over
Maastricht destroyed this assumption. Almost immediately the weaker currencies
came under selling pressure.
The pressure resulted in the devaluation of the Finnish mark, the Spanish peseta,
the Irish punt, the Portuguese escudo and the Swedish krona, in addition to forcing
the UK and Italy to leave the ERM in September 1992. In August 1993, further
speculative pressure against the French franc and the Danish krone led to a
decision to widen fluctuation bands within the ERM to ± 15%. This action
effectively ended the currency crisis.
These events strengthened the political resolve in Europe to introduce Economic
and Monetary Union and the single currency.
The Maastricht Treaty
The Treaty on European Union was signed at the Dutch town of Maastricht in
February 1992. This Treaty became known as the Maastricht Treaty. The
centrepiece of the Maastricht Treaty was the decision to set up a single European
currency.
A single European currency meant that all the participating countries would use the
same currency. The new currency was called the “euro”. It is divided into one
hundred cents.
An essential aspect of a single European currency is the close co-ordination of
economic policies between Member States of the European Union. Economic and
Monetary Union means that the currencies of the member states are locked
irrevocably to one another at the same exchange rate. (Irrevocably means that
these exchange rates cannot be changed afterwards). The EMU depends on a
similar level of development of the economies of the countries which are members.
In order to ensure that the economies of the countries concerned are at similar
levels of development five convergence criteria were developed. These
convergence criteria are economic indicators of the strength of each economy.
Economic and Monetary Union involves:
● an internal market with free movement of persons, goods, services and
capital;
● the irreversible locking of exchange rates;
● a single currency among participating Member States;
● EU management of macro-economic policy with intensified co-ordination of
the economic and budgetary policies of participating countries;
● EU management of market-regulating policies, for example, competition
policy, to ensure every country plays by the same rules;
● a European Central Bank in Frankfurt deciding European monetary policy.
The Stability and Growth Pact is part of the arrangements agreed by those
countries which are part of the EMU. The pact requires Member States in the EMU
to commit themselves to aim for a medium-term budgetary position of close to
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balance or in surplus. As part of the process of ensuring that the euro is as stable
as possible, the Stability and Growth Pact is aimed at minimising internal fiscal
imbalances in the short term. The rationale underlying the pact is that in
favourable economic times, Member States should so manage their budgets as to
ensure that they can, over the course of a normal economic cycle, reliably keep
under the 3% ceiling on budget deficits set out in the Treaty. The pact allows for
exceptional circumstances when deficits can exceed 3% of GDP. It provides for
penalties and fines of up to 0.5% of GDP if deficits persist.
The five Maastricht criteria
These criteria are measures of the economy of each country across a number of
headings:
Inflation
The level of inflation must be within 1.5% of the average of the three lowest
inflation countries in the system.
Government borrowing
The amount of Government borrowing is an important measure of the strength of
the economy. The amount of this borrowing as a percentage of the Gross Domestic
Product must be below 60% or making progress towards 60%.
Interest rates
States are permitted a maximum of 2% points above the average of the three
lowest inflation countries.
Budget deficit
This is the toughest and politically most sensitive criterion involving tax policy and
overall debt. Member states must keep their government budget deficit within 3%
of Gross Domestic Product.
Exchange rates
The fifth and final criterion for joining the EMU covers exchange rates. Countries
must carefully manage their exchange rate and must not have unilaterally devalued
their currency within two years.
The timetable to EMU
The timetable to Economic and Monetary Union was decided by European leaders.
On 1 January 1999 the new European currency, the euro, came into being. From
this date there was be no change in the exchange rates of the member countries.
Euro notes and coins were introduced into circulation on 1 January 2002. Dual
circulation of the euro and the legacy currencies of each country continued for a
short period of time. Thereafter participating countries have only used euro notes
and coins.
The arguments in favour of EMU
Transparency
The strongest argument in favour of a single European currency is transparency –
prices of goods in the shops will be in the same currency and this will allow people
to compare prices between euro countries.
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monetary policies the countries with weaker economies were able to devalue their
currencies. With the EMU, devaluation will not be possible for any reason.
European monetary policy will now be decided by the European Central Bank in
Frankfurt, Germany.
Less flexibility
A disadvantage of joining the EMU would be that countries would have less
flexibility in their economic policies. Under the Stability and Growth Pact countries
will have less economic flexibility.
Loss of national pride
Many countries, like Britain, are proud of their currencies as a symbol of economic
success and national cohesion.
Price increases
Some firms might use the transition to the euro to disguise price increases.
The weak currencies
Those in favour of the EMU make much of the benefits of being tied to Europe’s
stronger currencies. There would be powerful pressures on members to bail out
economies that borrow too much. This could be very costly.
Regional disparities
Another disadvantage of the EMU is that it may contribute to greater regional
disparities, especially for more peripheral regions. There may be a tendency for
economic activity to move towards the core of Europe, the golden triangle between
Paris, Hamburg and Rome.
Loss of foreign exchange earnings
A disadvantage of the EMU is the loss of money to the banks for the purchase and
sale of foreign exchange.
One way Street
The EMU sets EU member states on an inevitable track to a federal Europe.
Effectively, once a country signs up it loses control of economic policy. As a result,
national parliaments would be no more than regional town halls within Europe, with
effectively little more power than local government.
Changeover costs
The changeover to the euro involves transition costs for business, public
administrations and financial institutions.
The position of the UK
In a speech in July 1997, the UK Chancellor of the Exchequer specified five
economic tests of the UK’s suitability for EMU membership. The five economic tests
are:
1 Are business cycles and economic structures compatible, so that the UK and
others could live comfortably with euro interest rates on a permanent basis?
2 If problems emerge, is there sufficient flexibility to deal with them?
3 Would joining the EMU create better conditions for firms making long-term
decisions to invest in Britain?
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4 What impact would entry into the EMU have on the competitive position of the
UK’s financial services industry, particularly the City’s wholesale markets?
5 Will joining the EMU promote higher growth, stability and a lasting increase in
jobs?
In his statement on the EMU to the House of Commons on 27 October 1997, the
Chancellor assessed these five economic tests. His analysis was based on a UK
Treasury paper published on that date. This concluded that a successful EMU would
bring benefits for the UK economy by securing macro-economic stability and
underpinning a well-functioning single market. This in turn would be good for
investment, growth and employment in the UK economy.
However, reflecting the cyclical divergences between the UK and continental
European economies at this time, the Chancellor concluded it would not be right for
the UK to join the EMU from the outset.
On 23 February 1999 the UK Prime Minister, in a statement to the House of
Commons, launched an Outline National Changeover Plan. In his statement he
indicated that Britain’s intention is that it should join a successful single currency
provided that the five conditions are met. The plan indicated that making a
decision to join the single currency at that time was not realistic but that, should
the economic tests be met, this could be decided at some future time.
Conclusion
The global economic environment is changing fast. This process will continue, and
would continue if the EMU had never been thought of. It involves greater
globalisation of activity, increasing intensification of competition among all the
countries of the world and increasing technological change.
The formation of the EMU marked a substantial change in the economic
environment of the European Union as a whole. This is true for all Member States,
and it is true whether or not they have joined the EMU. Continuation of the status
quo is not an option for any Member State, whether it has joined the EMU or not.
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Chapter 15
Hedging foreign
exchange risk
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CHAPTER CONTENTS
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EXCHANGE RATES
An exchange rate is the rate at which one country’s currency can be traded in
exchange for another country’s currency.
Example 1
Consider the following exchange rate quotation:
$/£
1.500
This means $1.500 dollars is equal to £1. The dollar is the variable currency and
the pound is the base currency.
Spread
The spread is the difference between the bid price and the offer price. The offer
price is slightly higher than the bid price and the difference (spread) exist to
compensate the dealer for holding the risky foreign currency and for providing the
services of converting currencies.
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Outright quotation
Outright quotation means that the full price to all of its decimal point is given.
Example 2
Bid Offer
Spot rate 1.6878 1.7694
One month forward rate 1.6078 1.7574
Here both the spot and forward bid/offer are given in the full decimal places.
Point quotation
A point quotation is the number of points away from the outright spot rate with the
first number referring to points away from the spot bid and second number to
points away from the spot offer price.
Whether the point quotation is subtracted or added to the spot rate is explained by
premium or discount on the exchange rate movements.
Subtract premium from the spot rate and add discount to the spot rate.
Example 3
Bid Offer
Spot rate 1.4432 1.4442
One month forward rate (premium) 58 56
Solution 3
58 – 56 is the point quotation, hence the forward rate is
Spot rate 1.4432 1.4442
Point -0.0058 -0.0056
Cross rates
A cross rate is the computation of an exchange rate for a currency from the
exchange rates of two other currencies. In other words it is the exchange rate
between two currencies determined by their common relationships to a third
currency.
Example 4
If
Y1 = $0.55
£1 = $1.60
Required:
What is the price of the pound in Yen?
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Solution
If $0.55 = Y1
$1.60 = x
X = (1.6 x 1) / 0.55 = Y2.91
Hence Y2.91 = £1.
Example 5
Consider the following exchange rates:
Bid Offer
Dollar/sterling ($/£) 1.4580 1.4980
Sterling/Euro (£/€) 0.4570 0.4890
Required:
(a) What would be received in pounds sterling by a UK company expecting to
receive $400,000?
(b) What would be paid in pound sterling by a UK company expecting to pay
$500,000?
(c) What would be received in pounds sterling by a UK company expecting to
receive €400,000?
(d) What would be paid in pound sterling by a UK company expecting to pay
€500,000?
Solution 5
(a) 400,000/1.4980 = £267,023
(b) 500,000/1.4580 = £342,936
(c) 400,000 x 0.4570 = £182,800
(d) 500,000 x 0.4890 = £244,500
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Transaction exposure
Transaction exposure relates to the gains and losses to be made when settlement
takes place at some future date of a foreign currency denominated contract that
has already been entered into. These contracts may include import or export of
goods on credit terms, borrowing or investing funds denominated in a foreign
currency, receipt of dividends from over-seas, or unfulfilled foreign exchange
contract. Transaction exposure can be protected against by adopting a hedged
position: that is, entering into a counter balancing contract to offset the exposure.
Translation exposure
This arises from the need to consolidate worldwide operations according to
predetermined accounting rules. This is the risk that the organisation will make
exchange losses or gains when the accounting results of its foreign subsidiaries are
translated into the presentation currency of the parent company. Assets, liabilities,
revenue and expenses must be restated into presentation currency of the parent
company in order to be consolidated into the group accounts.
Translation exposure can result from restating the book value of a foreign
subsidiary’s assets at the exchange rate on the balance sheet date. Such exposure
will not affect the firm’s cash flows unless the asset is sold.
Economic exposure
Economic exposure also called operating or competitive exposure or strategic
exposure measures the changes in the present value of the firm resulting from any
changes in the future operating cash flows of the firm caused by an unexpected
changes in exchange rates. The change in value depends on future sale volume,
price and costs.
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For example, a UK company might use raw materials which are priced in US dollars,
but export its product mainly within the EU. A depreciation of the pound against
the dollar or appreciation of pound against the Euro will both erode the
competitiveness of this UK company.
The magnitude of economic exposure is difficult to measure as it considers
unexpected changes in exchange rates and also because such changes can affect
firms in many ways.
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Diversification of financing
If a firm borrows in a foreign currency it must pay back in that same currency. If
that currency should appreciate against the home currency, this can make interest
and principal repayments far more expensive. However, if borrowing is spread
across many currencies it is unlikely they will all appreciate at the same time and
therefore risk can be reduced. Borrowing in foreign currency is only truly justified if
returns will then be earned in that currency to finance repayment and interest.
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Netting
Netting is setting the debtors and creditors of all the companies in the group
resulting from transactions between them so that only net amount is either paid or
received.
There are two types of netting:
1. Bilateral Netting
In the case of bilateral netting, only two companies are involved. The lower
balance is netted against the higher balance and the difference is the amount
remaining to be paid.
2. Multilateral Netting
Multilateral netting is a more complex procedure in which the debts of more than
two group companies are netted off against each other. There are different ways of
arranging for multilateral netting. The arrangement might be co-ordinated by the
company’s own central treasury or alternatively by the company’s bankers. The
common currency in which netting is to be affected needs to be decided on.
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Example 7
A group of companies controlled from the USA has subsidiaries in the UK, South
Africa and France. At 31/12/X3, inter-company indebtedness were as follows
Debtors Creditors Amount
UK SA 1,200,000 SA Rand ®
UK FR 480,000 Euro
FR SA 800,000 SA rand
SA UK 74,000 Sterling
SA FR 375,000 Euro
It is the company’s policy to net off inter-company balances to the greatest extent
possible. The central treasury department is to use the following exchange rates
for these purposes:
US $ = R 6.126 / £0.6800 / Euro 5.880
Required:
Calculate the net payment to be made between the subsidiaries after netting of
inter-company balances.
Solution 7
Step 1: convert the balance into a common currency, the US dollar.
Debtors creditors amount
UK SA 1,200,000/6.126 = 195,886
UK FR 480,000/5.880 = 81,633
FR SA 800,000/6.126 = 130,591
SA UK 74,000/0.6800 = 108,824
SA FR 375,000/5.880 = 63,776
Paying subsidiaries
TOTAL
UK SA FR
Receipts
$ $ $ $
Receiving subsidiary
UK - 108,824 - 108,824
SA 195,886 - 130,591 326,477
FR 81,633 63,776 - 145,409
Total payments (277,519) (172,600) (130,591) (580,710)
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Matching
This is the use of receipts in a particular currency to match payment in that same
currency. Wherever possible, a company that expects to make payments and have
receipts in the same foreign currency should plan to of set it payments against its
receipts in that currency.
Since the company is offsetting foreign payment and receipt in the same currency,
it does not matter whether that currency strengthens or weakens against the
company’s domestic currency because there will be no purchase or sale of the
currency.
The process of matching is made simply by having a foreign currency account,
whereby receipts and payments in the currency are credited and debited to the
account respectively. Probably, the only exchange risk will be limited to conversion
of the net account balance into the domestic currency. This account can be opened
in the domestic country or as a deposit account in oversees country.
Forward contract
The foreign-exchange forward market is an inter-bank market, where one party
agrees to deliver a specified amount of one currency for another at a specified
exchange rate at a designated date in the future. The designated exchange rate
and date are called the forward rate and settlement (delivery) date respectively.
Where an investor takes a position in the market by buying a forward contract, the
investor is said to be in a long- position, and where he takes a position to sell a
forward contract we say the investor is in a short-position.
A forward contract is a binding contract on both parties. This means that having
made the contract, a company must carry out the agreement, and buy or sell the
foreign currency on the agreed date and at the rate of exchange fixed by the
agreement. If the spot rate moves in the company’s favour, that will be bad for the
company and vice versa.
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Example 8
Consider the following exchange rate:
$/£
Bid Offer
Spot rate 1.5090 1.5600
2months forward 1.5060 1.5590
3 month forward 1.5000 1.5500
A UK company is expecting to receive $100,000 in three months time from the
goods supplied to a USA company.
Required:
What is the sterling receipt if the company decides to hedge using a forward
exchange contract?
Solution 8
Guaranteed sterling receipts is = $100,000/1.5500 = £64,516.13
This is the guaranteed right from the outset when the contract was made, and it is
irrelevant what the exchange rate will be in three months.
Example 9
A company expects to receive $10m in two month time. Exchange rates are as
follows:
Spot $1.6100 – 1.6400
1 month dis 200 - 300
2 months dis 400 - 600
3 months dis 800 - 120
Required:
Show how forward contract can be used to hedge the exposure.
Solution 9
Three month forward rate will be: $/£
Spot 1.6100 - 1.6400
2 month points (add) 0.0400 - 0.0600
2 months forward rate 1.6500 – 1.7000
The guaranteed sterling receipt is $10m / 1.7000 = £5,882,353
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Example 10
The exchange rate for dollar and sterling: $/£
Spot 1.5100 – 1.5150
3 months forward (premium) 45 – 42
A UK company is expected to pay $1,000,000 in three months time and wish to fix
a rate for the transaction.
Required:
Use forward market contract to hedge this exposure.
Solution 10
Spot rate 1.5100 -- 1.5150
Points (less) 0.0045 -- 0.0042
3 months forward rate 1.5055 1.5108
Guaranteed payment = 1,0 00,000/ 1.5055 = £ 664231.2
Example 11
A UK company export goods to a number of companies in the USA and Europe. It
is due to receive $100,000 in three month time from the goods supplied to a USA
company. The three months forward rate is 1.4550 – 1.4600. The spot rate is
1.4960-1.4990
The interest rates available in the money market are:
UK US
Annual interest 6% - 9% 11% - 14%
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Solution 11
Normally two interest rates will be given. Note that the lower rate is the rate for
depositing or investing your money in the bank and the higher rate is the
borrowing/taking money from the bank.
Following the steps!
1. Borrow from a bank an appropriate amount
● this means that we will borrow in the US bank at an interest rate of 14%
● the appropriate amount to be borrowed now at 14% to get $100,000 in
three month time is:
$100,000/ 1.035 = $96618.4
14/4 = 3.5% = three months interest rate
The amount borrowed of $96618.4 will compound up to $100,000 in three
month at the rate of 14% per annum or 3.5% for three months.
2. Convert the amount borrowed into sterling at the spot rate
$96618.4/ 1.4990 = £64455.2
3. Invest the £64455.2 in UK at an interest rate of 6% for three months
64455.2 x (1.015) = £65422.028
This amount is less than the amount given by the forward contract hence the
company can hedge the exposure by using the forward contract.
Example 12
Assume the same facts as example one above except that the UK company is
making payment of $1,000,000.
Solution 12
Step 1
The UK company should buy dollars now and put them into a deposit account for
three months in order to get $1,000,000.
= $1,000,000 / (1+ (0.11/4) = $973,236.01
Step 2
Convert this amount to sterling at the spot rate, = 973,236.01/ 1.4960
= £650,558.83
Step 3
This means the company has to borrow £650558.83 in the UK for three months at
an interest rate of 9%. The total amount payable in sterling is:
650,558.83 x (1 + (0.09/4) = £665,196.40
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Required:
(i) Identify the bank’s buying and selling rates.
(ii) Calculate the three months rates for the US dollar and the Swiss franc.
Required:
Ignoring transaction costs calculate the best rate (for the customer) at which
a bank will sell the US $ twelve months forward.
Required:
(i) An American customer will pay $3m in three months’ time. Show how
foreign exchange risk can be eliminated using:
(1) forward market cover, and
(2) money market cover.
(ii) You must pay an American supplier $3m in three months’ time. Show
how foreign exchange risk can be eliminated using:
(1) forward market cover, and
(2) money market cover.
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(b) This exchange rate can be calculated from first principles as follows:
Therefore the bank cannot sell $ forward for more than $1.7389 (ie $1,982.4
÷ £1,140).
However the interest rate parity theory can alternatively be used.
1.12
Forward rate = $1.77 × = $1.7389
1.14
In this instance the current spot rate is $1.77 = £1, whereas the one year forward
rate is $1.7389 = £1. Thus there is a premium of $0.0311!!
Accordingly, provided this theory holds, where:
Foreign interest rates < UK interest rates, the forward rate is quoted at a
premium,
and where:
Foreign interest rates > UK interest rates, the forward rate is quoted at a
discount.
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* 10.5%
= 2.625%
4
# 13%
= 3.25%
4
It is more effective to hedge in the forward market.
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Chapter 16
Hedging interest
rate risk
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CHAPTER CONTENTS
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Gross
Redemption
Yield Bond
% Yield Curve
0 5 10 15 20 25
Term to maturity (years)
A normal yield curve slopes upwards because the yield on longer dated bonds is
normally higher than the yield on shorter dated bonds. If you are confused by this
point, remember that your mortgage is only cheaper than your overdraft because
the mortgage is secured on the property, whereas the overdraft is unsecured. The
reason for the upward sloping shape of the yield curve is thought to be based on
the following theories:
● liquidity preference theory
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● expectations theory
● market segmentation theory.
Expectations theory
This theory states that the shape of the yield curve will vary dependent upon a
lender’s expectations of future interest rates (and therefore inflation levels). A
curve that rises from left to right indicates that rates of interest are expected to
increase in the future to reflect the investors fear of rising inflation rates.
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An inverse yield curve is downwards sloping and its general shape is as follows:
Gross
Redemption
Yield
%
Bond
Yield Curve
0 5 10 15 20 25
Term to maturity (years)
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Valuation of bonds
A ‘plain vanilla’ bond will make regular interest payments to the investors and pay
the capital to buy back the bond on the redemption date when it reaches maturity.
Therefore the value of a redeemable bond is the present value of the future income
stream discounted at the required rate of return (or yield or the internal rate of
return) as seen in chapter 9.
Example
A company has issued some 9% bonds, which are redeemable at par in three years’
time. Investors require an interest yield of 10%.
Solution
10%
Year Cash flow discount factor PV
1-3 net interest 9.0 2.487 22.38
3 redemption value 100 0.751 75.10
Market value 97.48
This means that £100 of bonds will have a market value of £97.48
Remember that there is an inverse relationship between the yield of a bond and its
price or value. The higher rate of return (or yield) required, the lower the price of
the bond, and vice versa.
Example
A 5.6% bond is currently quoted at £95 ex-int. It is redeemable at the end of 5
years at par. Corporation tax is 30%.
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Solution
Year CF DF10% PV DF5% PV
0 MP (95) 1 (95) 1 (95)
1-5 gross interest 5.6 3.791 21.23 4.329 24.24
5 Redemption value 100 0.621 62.1 0.784 78.4
NPV (11.67) 7.64
IRR = 5% + (7.64 / 7.64 + 11.67) X(10% - 5%) = 7%
Example
A company wants to issue a bond that is redeemable in four years for its par value
or face value of $100, and wants to pay an annual coupon of 5% on the par value.
Estimate the price at which the bond should be issued and the gross
redemption yield.
The annual spot yield curve for a bond of this risk class is as follows:
Year Rate
1 3.5%
2 4.0%
3 4.7%
4 5.5%
Solution
The market price of the bond should be the present value of the cash flows from
the bond (interest and redemption value) using the relevant year’s yield curve spot
rate as the discount factor.
Year 1 2 3 4
Cash flows 5 5 5 105
Df 1.035-1 1.04-2 1.047-3 1.055-4
Present value 4.83 4.62 4.36 84.76
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Example
A government has three bonds in issue that all have a face or par value of $100
and are redeemable in one year, two years and three years respectively. Since the
bonds are all government bonds, let’s assume that they are of the same risk class.
Let’s also assume that coupons are payable on an annual basis.
Bond A, which is redeemable in a year’s time, has a coupon rate of 7% and is
trading at $103.
Bond B, which is redeemable in two years, has a coupon rate of 6% and is trading
at $102.
Bond C, which is redeemable in three years, has a coupon rate of 5% and is
trading at $98.
Solution
To determine the yield curve, each bond’s cash flows are discounted in turn to
determine the annual spot rates for the three years, as follows:
Bond A: $103 = $107 x (1+r1)-1
r1 = 107/103 – 1 = 0.0388 or 3.88%
Bond B: $102 = $6 x 1.0388-1 + 106 x (1+r2)-2
r2 = [106 / (102 – 5.78)]1/2 - 1= 0.0496 or 4.96%
Bond C: $98 = $5 x 1.0388-1 + $5 x 1.0496-2 + 105 x (1+r3)-3
r3 = [105 / (98 – 4.81 – 4.54)]1/3 – 1 = 0.0580 or 5.80%
The annual spot yield curve is therefore:
Year
1 3.88%
2 4.96%
3 5.80%
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Example
A bank has quoted the following FRA rates:
2v6 5.75 - 6.00
3v5 5.78 - 6.13
4v7 5.95 - 6.45
Assume that now is 1st November 2008.
Required:
Determine the FRA interest applicable to the following situations:
1. A company wants to borrow on 1st February 2009 and repay the loan on 1st of
April 2009.
2. A company wants to deposit money on 1st January 2009 and expect to with
draw the amount for an investment on 1st of May 2009.
3. A company wants to borrow on 1st March 2009 and repay the loan on 1st of
June 2009.
Solution
1. 3 v 5 at a borrowing rate of 6.13%
2. 2 v 6 at lending rate of 5.75%
3. 4 v 7 at a borrowing rate of 6.45%
Compensation payment
Compensation period is calculated as the difference between the FRA rate fixed and
the LIBOR rate at the fixing date (actual LIBOR) multiplied by the amount of the
notional loan/deposit and the period of the loan/deposit.
The FRA therefore protects against the LIBOR but not the risk premium attached to
the customer.
The settlement of FRA is made at the start of the loan period and not at the end
and therefore compensation payment occurs at start of the loan period. As a result
the compensation payment should be discount to it present value using the LIBOR
rate at the fixing date over the period of the loan.
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Example
A company will have to borrow an amount of £100 million in three month time for a
period of six months. The company borrow at LIBOR plus 50 basis points. LIBOR is
currently 3.5%. The treasurer wishes to protect the short-term investment from
adverse movements in interest rates, by using forward rate agreement (FRAs).
FRA prices (%)
3v9 3.85 – 3.80
4v9 3.58 3.53
5v9 3.55 3.45
Required:
Show the expected outcome of FRA:
(a) If LIBOR increases by 0.5%.
(b) If LIBOR decreases by 0.5%.
Solution
The FRA will be 3 v 9 as the money will be needed in three months time and will
last for six months. The applicable interest rate will be 3.85%.
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Example
Assume that it is now 1 June. Your company expects to receive £7.1 million from a
large order in five months’ time. This will then be invested in high-quality
commercial paper for a period of four months, after that it will be used to pay part
of the company’s dividend. The treasurer wishes to protect the short-term
investment from adverse movements in interest rates, by using forward rate
agreement (FRAs).
FRA prices (%)
4v5 3.85 – 3.80
4v9 3.58 3.53
5v9 3.50 3.45
The current yield on the high-quality commercial paper is LIBOR + 0.60%. LIBOR
is currently 4%.
Required:
If LIBOR falls or increase by 0.5% during the next five months, show the expected
outcome of FRA.
Solution
The FRA will be 5 v 9 as the money will be invested in five month time and will last
for four months. The applicable interest rate will be 3.45%.
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Chapter 17
Futures
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CHAPTER CONTENTS
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DERIVATIVES
A derivative is a financial instrument that derives its value from the price or rate of
an underlying item. A company can enter into Derivative position for one of two
reasons:
● To hedge against exposure to a particular risk, or
● To speculate, and hope to make a profit from favourable movements in rate
or price.
Examples of derivatives are forward contracts, futures contracts, options and
swaps.
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FUTURES
A futures is a legal binding contract between two parties to buy or to sell a
standardised quantity of an underlying item at a future date, but at a price agreed
today, through the medium of an organised exchange.
Future contracts are forward contracts traded on a future and options exchange.
Underlying item
Underlying item is the quantity of the item which is to be bought or sold under the
futures contract. Each futures contract has a standardised quantity of this
underlying items and the futures contract cannot be undertaken in fractions.
The underlying item may include agricultural products, like meat, cocoa, maize,
energy products, like crude oil gas, financial products, like currency and interest
rate, and stock index futures on shares.
Delivery dates
Financial futures are normally traded on a cycle of three months, March, June,
September and December of each year.
Ticks
A tick is the minimum price movement permitted by the exchange on which the
future contract is traded. Ticks are used to determine the profit or loss on the
futures contract. The significance of the tick is that every one tick movement in
price has the same money value.
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Example 1
If the price of a sterling futures contract changes from $1.4523 to $1.4555, then
price has risen by $0.0032 or 32 ticks.
If you entered/bought into 50 contracts the profit on the futures contract will be
calculated as:
Number of contracts x ticks x tick value
50 x 32 x $6.25 = $10,000
Ticks are used to calculate the value of a change in price to someone with a long or
a short position in futures.
If someone has a long position, a rise in the price of the future represents a profit,
and a fall in price represents a loss.
If someone has a short position, a rise in the price of the future represents a loss,
and a fall represents a profit.
Margins
When a deal has been made both buyer and seller are required to pay margin to
the clearing house. This sum of money must be deposited and maintained in order
to provide protection to both parties.
Initial margin
Initial margin is the sum deposited when the contract is first made. This is to
protect against any possible losses on the first day of trading. The value of the
initial margin depends on the future market, risk of default and volatility of interest
rates and exchange rates.
Variation margin
Variation margin is payable or receivable to reflect the day-to-day profits or losses
made on the futures contract. If the future price moves adversely a payment must
be made to the clearing house, whilst if the future price moves favourably variation
margin will be received from the clearing house. This process of realising profits or
loss on a daily basis is known as “marking to market”.
This implies that margin account is maintained at the initial margin as any daily
profit or loss will be received or paid the following morning. Default in variation
margins will result in the closure of the futures contract in order to protect the
clearing house from the possibility of the party providing cash to cover
accumulating losses.
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Example 2
Contract size £62,500
3 months future price $1. 3545
Number of contract entered 50 contracts
Tick value $6.25
Tick size 0.0001
Required:
Calculate the cash flow if the future price moves to in day one $1.3700 and 1.3450
day two (variation margin). Assume a short position.
Solution 2
Day One
Selling price 1.3545
Buying price 1.3700
Loss 0.0155 = 155 ticks
Variation margin = payment of the loss
= 155 x 50 x $6.25 = $48,437
Day 2
Selling price 1.3700
Buying price 1.3450
Profit 0.025 = 250 ticks
Variation margin = receipt of the profit
= 250 x 50 x $6.25 = $78,125
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Futures hedge
Hedging with a future contract means that any profit or loss on the underlying item
will be offset by any loss or profit made on the future contract. A perfect hedge is
unlikely because of:
● Basis risk.
● The “round sum” nature of futures contracts, which can only be bought or sold
in whole number.
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CURRENCY FUTURES
A currency futures is an exchange traded agreement between two parties to
buy/sell a particular quantity of one currency in exchange of another currency at a
particular rate on a particular future date.
Typical available futures contracts are as follows:
quantity of currency value of one
Futures price quotation tick size
per contract tick
£/ $ £62,500 $ per £1 $0.0001 $6.25
€/ $ €125,000 $ per €1 $0.0001 $12.50
€/£ €100,000 £ per €1 £0.0001 £10
Required:
Calculate what the result of the hedge is expected to be. Briefly discuss why this
result may not occur.
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contracts. This means 0.2 x 12.5 = 2.5 million yen is left unhedged under the
futures contract. The company can either hedge this 2.5m yen by using
forward contract or leave it unhedged.
● Calculation of closing price. This can be done, by using the basis and basis
risk. Basis is the difference between current spot rate and the future price.
Yen
Spot rate 128.15
Future price (September) = $ 0.007985 to yen = 1/ 0.007985 125.23
Basis 2.92 yen
Basis will be zero at maturity date of the future contract, 30th September. If
it reduces in a linear manner over the three months period (30/6 to 30/9), the
expected basis on 1st September, when there is still one month to maturity =
(2.92 x1)/3 = 0.973 yen.
The expected futures price on 1st September is therefore 0.973 yen below the
spot price of 120 yen/$1
Closing price
Yen
Spot rate = 120
Basis 0.973
Future price 1 Sept = 119.027 or $0.008401 (1/119.027)
● Calculation of profit or loss:
$
Entered by buying 11 future contract each at 0.007985
Will close by selling the 11 contracts each at 0.008401
Profit on futures position for each contract 0.000416
Total profit on future position = 0.000416 x 11 x 12.5m
= $57,200
● Expected result of the hedge or outcome
$
st
1 September- spot market (140/120) 1,166,667
Profit from the future position 57,200
Net payment 1,109,467
● Hedge efficiency. This is to check whether the hedge is a perfect hedge.
Spot market
30th June – spot market (140/128.15) 1,092,470
1st September – spot market (140/120) 1,166,667
Loss in the spot market 74,197
Hedge efficiency = 57,200/74,197 = 77%
● This result may not occur as basis is not likely to decrease in a linear manner.
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Maturity mismatch
Maturity mismatch occurs if the actual period of lending or borrowing does not
match the notional period of the futures contract (three months). The number of
futures contract used has to be adjusted accordingly. Since fixed interest is
involved, the number of contracts is adjusted in proportion to the time period of the
actual loan or deposit compared with three months.
Number of contracts =
amount of actual loan/depos it time period required for loan/depos it
×
futures contrat size 3 months
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Example AA plc
The monthly cash budget of AA plc shows that the company is likely to need £18m
in two months time for a period of four months. Financial markets have recently
been volatile, and the finance director fears that short term interest rates could rise
by as much as 150 ticks (ie 1.5%). LIBOR is currently 6.5% and AA plc can borrow
at LIBOR plus 0.75%.
LIFFE £500,000 3 months futures prices are as follows:
December 93.40
March 93.10
June 92.75
Required:
Assume that it is now 1st December and that exchange traded futures contract
expires at the end of the month, estimate the result of undertaking an interest rate
futures hedge on LIFFE if LIBOR increases by 150 ticks (1.5%).
Solution to AA plc
● What contract = 3 months contract = March futures contract.
● What type = sell as interest rates are expected to rise.
● Number of contracts
18m × 4
= = 48 contracts.
0.5m × 3
● Tick size = 0.01% x 500,000 x 3/12 = 12.5
● Calculate the closing future price using basis and basis risk.
Calculate opening basis as
Current LIBOR 6.5% = (100 –6.5) 93.50
Future price 93.10
Basis 0.40
This will fall to zero when the contract expires, and it is assumed that it will
fall at an even or linear manner.
There are four months until expiry and the funds are needed in two month
time, therefore the expected basis at the time of borrowing is:
0.4 x 2/4 = 0.2
Closing future price:
LIBOR = 6.5% + 1.5% = 8% = (100 –8) 92.0
Basis 0.2
Future price 91.8
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Chapter 18
Options
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CHAPTER CONTENTS
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OPTIONS
An option is a contract giving it holder the right, but not an obligation to buy or sell
a specific quantity of a specific asset at a fixed price on or before a specific future
date.
Options can be bought and sold over a wide range of assets from coffee beans to
pork bellies and financial assets such as amount of currency, an interest bearing
security or bank deposit, and company’s shares.
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TERMINOLOGIES OF OPTIONS
Call option
A call option is the option that gives its holder the right, but not an obligation to
buy the underlying item at the specific price on or before the specific expiry date of
the option. For example, a call option on shares of central college, gives its holder
the right to buy that number of shares in central college at the fixed price on or
before the expiry date of the option.
Put option
A put option is the option that gives its holder the right to sell the underlying item
at the specific price on or before the specific expiry date of the option. For
example, a put option in central college shares, gives its holder the right to sell that
number of shares at the specific price on or before the specific expiry date of the
option.
Note that options are contractual agreements, so when the holder of the option
exercises the option, the seller or writer of the option must fulfil his side of the
contract by selling (call option) or buying (put option) the underlying item at the
specified price.
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If the exercise price is less than the market price of the underlying item, a call
option will be in the money and a put option will be out of the money.
If the exercise price is equal to the market price of the underlying item both call
and put options will be at the money.
Intrinsic value
Intrinsic value is the difference between the strike price for the option and the
current market price of the underlying item. However, an in-the-money option has
an intrinsic value; but because intrinsic value cannot be negative, an out of the
money option has an intrinsic value of zero.
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PRICING OF OPTIONS
Writers of options need to establish a way of pricing them. This is important
because there has to be a method of deciding what premium to charge to the
buyers.
The pricing model for call options are based on the Black-Scholes model.
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= (∑ X 2
)
/ n − (∑ X / n)
2
● Then annualise the result using the number of trading days in a year.
The formula = daily volatility x √trading days
Example
Day Price Pi/Po In(Pi/Po) X2
X
Monday 100 - - -
Tuesday 103 1.03 0.0296 0.000874
Wednesday 106 1.0291 0.0287 0.000823
Thursday 105 0.9906 -0.0094 0.000089
Friday 108 1.0282 0.0282 0.000795
Total 0.0771 0.00251
n 4 4
Average 0.019275 0.0006275
Solution
0.0006275 − (0.019275)
2
Standard deviation = Daily volatility =
= 0.016
= 2%
Since there are five trading days in a week and 52 weeks in a year, we assume the
trading days in a year is 52 x 5 = 260 days.
Annualised volatility = 2% x √260 = 32.2%.
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d1 =
( )
ln(Pa / Pe) + r + 0.5s 2 t
s t
d2 = d1 – s√t
ln = natural log
Nd1 and Nd2 are the normal distribution function of d1 and d2 respectively.
Where:
Pa = current market price of the underlying item
Pe = the exercise price
R = the annual risk free rate in decimals
T = time to expiry of option in years, so six months will be 0.5
years.
S = the standard deviation of the underlying instrument returns.
This measures the volatility of underlying item.
Example
The current share price of AA plc is £2.90.
Estimate the value of a call option on the share of the company, with an exercise
price of £2.60, and 6 months to run before it expires.
The risk free rate of interest is 6% and the variance of the rate of return on the
shares has been 15%.
Solution
ln(2.9 / 2.6 ) + (0.06 × 0.5 × 0.15)
d1 =
0.15 × 0.5
d1 = 0.6452, approximate to two decimal places = 0.65
d2 = 0.65 – (√0.15 x√0.5)
= 0.3713 rounded to 0.37
Using the normal distribution table:
Nd1 = N( 0.65) = 0.5 + 0.24 = 0.74
Nd2 = N(0.37) = 0.5 + 0.14 = 0.64
Using calculator e-rt = e-0.03
= 0.97
Call option price = (2.90 x 0.74) – (2.60 x 0.97 x 0.64)
= £0.53
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Example
The following information relates to a call option:
Current share price £60
Exercise price £70
Dividend to be paid in 3 month time £1.5
Risk free rate 5%
Expiry date is 5 months.
The dividend-adjusted share price for Black-Scholes option pricing model can be
calculated as:
PV of dividend = De-rt
r = 0.05
t = 3/12 = 0.25 of a year.
-(0.05 x 0.25)
PV of dividend = 1.5 e
= £1.48
Dividend-adjusted price = 60 –1.48 = £58.52 and this will replace the price of the
underlying item in the formula.
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REAL OPTIONS
Real options are concerned with options related to operational and strategic
decisions, in particular those concerned with investment in projects.
Conventional DCF analysis looks at whether a project is going to add value for
shareholders. In practice, managers of a business are unlikely to consider net
present values of projects alone. Investing in a particular project might lead to
other opportunities that may have been ignored in a DCF analysis. Managers could
take action to help boost a project’s NPV if it falls behind forecast. They can create
and take advantage of options in managing projects.
The flexibility provided by real options in investments appears in many guises.
Busby and Pitts identify the following types:
● Timing options – options to embark on an investment, to defer it or abandon
it.
● Scale options – options to expand or contract an investment.
● Staging options – option to undertake an investment in stages.
● Growth options – options to make investments now that may lead to greater
opportunities later, sometimes called ‘toe-in-the-door’ option.
● Switching option – options to switch input or output in a production process.
Based on the P4 syllabus, we have to consider option to delay, expand, redeploy
and withdraw.
Option to expand
The option to expand exists when firms invest in projects which allow them to make
further investments in the future or to enter new market. The initial project may
be found in terms of its NPV as not worth undertaking. However, when the option
to expand is taken account, the NPV may become positive and the project
worthwhile.
Expansion will normally require additional investment creating a call option.
The option will be exercised only when the present value from the expansion is
higher than the extra investment.
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Option to abandon
An abandonment options is the ability to abandon the project at a certain stage in
the life of the project. Whereas traditional investment appraisal assumes that a
project will operate in each year of its lifetime, the firm may have the option to
cease a project during its life.
Abandon options gives the company the right to sell the cash flows over the
remaining life of the project for a salvage/scrape value therefore like American put
options. Where the salvage value is more than the present value of future cash
flows over the remaining life, the option will be exercised.
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Solution to illustration
d1 =
(
ln(15 ÷ 20) + 0.06 + 0.5 × 0.2832 5 )
0.283 5
−0.2877 + 0.3 + 0.2002 0.2125
= = = 0.3358
0.6328 0.6328
d2 = 0.3358 − 0.283 × 5 = –0.297
Conclusion:
£m
NPV of first restaurant 0.005
Value of call option (to expand) on second restaurant 3.8352
Value of combined projects +3.8402
Therefore the project should be accepted, since the additional value (which
incorporates the option to expand), allows Winter plc to avoid the downside
element of risk.
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Solution to illustration
Secondly, using the put call parity relationship, calculate the value of the put option
p = c - Pa + Pe e-rt
= 153.017 – 254 + (150 x 2.7183-0.07 x 5)
= 153.017 – 254 + 105.703
= £4.72m
Alternatively, it is possible to directly calculate the value of the put option using the
following modified Black-Scholes formula, but this is not provided on the ACCA
formula sheet:
p = Pe N(−d2)e-rt – Pa N(−d1)
where:
−d1)
N(− = 0.5 – 0.4495 = 0.0505
−d2)
N(− = 0.5 − 0.3340 = 0.166
p = (150 x 0.166 x 2.7183-0.35) – (254 x 0.0505)
= (150 x 0.166 x 0.7047) – 12.827
= 17.547 – 12.827
= £4.72m
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Conclusion:
£m
NPV of joint venture project 4
Value of put option (to abandon joint 4.72
venture)
Total NPV with the abandonment option +8.72
Therefore Summer plc should go ahead with the joint venture, since the additional
value, which incorporates the option to abandon allows Summer plc to avoid the
downside element of risk.
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Valuation of the underlying The fair value of the assets of the company
Where the assets of the company are actively traded and easily liquidated, their
current market value would be appropriate. In the case of most companies, fair
value will normally be based upon the present value of the future cash flows that
the company’s assets are expected to generate over their useful lives.
The volatility of the underlying assets is likely to be the most difficult measure to
estimate accurately. One approach is to estimate the probabilities of the likely
future cash flows of the company and generate a distribution of their present values
from which a standard deviation could be established.
A possible approach to the determination of an exercise price is to assume that the
company’s liabilities consist entirely of debt in the form of a zero coupon bond. If
the company’s debt includes other types of bond, adjustments are necessary as
shown in the following illustration.
Illustration 1
A company has on issue a 5% bond with five years to redemption with a gross yield
to maturity of 8%.
Required:
Estimate the market value of that bond and that of an equivalent zero coupon
bond.
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Solution 1
The market value of the debt is estimated as follows:
Year 1 2 3 4 5
Annual interest and redemption payments (£) 5 5 5 5 105
Discount factors @ 8% 0.926 0.857 0.794 0.735 0.681
Present values (£) 4.63 4.29 3.97 3.67 71.50
Present value of debt = £88.06
The redemption value of a zero coupon bond of the same market value is calculated
by establishing the unknown future value which (when discounted at 8% p.a. for a
five year period) provides a present value of £88.06, ie:
Future value = £88.06 x 1.085 = £129.39
Therefore £129.39 is treated as the exercise price (ie the redemption value of a
zero coupon bond with the same features as the debt currently in issue, which has
a yield to maturity of 8%).
Assuming that acceptable estimates of the input variables have been established,
the next step is to incorporate them into the BSOP model. The model does have a
number of restricting assumptions, but it can be used to produce an acceptable
valuation of a company.
Illustration 2
In March 2007, Northern Rock (a UK bank) reported assets and liabilities at fair
values of £113.2 billion and £110.7 billion respectively. The average term to
maturity on the liabilities of the bank (which consisted of short-term money market
borrowing and deposits) was 100 trading days, whilst the annual number of trading
days was 250 approximately. At that time the risk-free rate of interest was 3.5%
and the company had 495.6 million equity shares in issue.
Required:
(a) Using the BSOP (sometimes referred to as the Black Scholes Merton) model,
estimate the share price of Northern Rock in each of the following situations:
(i) Assuming that the standard deviation of the bank’s assets was 5%; and
(ii) Assuming that the volatility of the bank’s assets was 10%.
(b) Using the Black Scholes Merton model, recalculate an estimate of the share
price of Northern Rock if the fair value of the company’s assets fell to £110.7
billion and their volatility was 5%.
(c) Comment upon the results and consequences of the calculations performed in
parts (a) and (b) above.
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Solution 2
This entire procedure is based on the notion that if equity shareholders pay off the
liabilities at “expiry date”, they are effectively paying the “exercise price” of a call
option and thus “exercising their right to buy” the underlying assets of the company
at their fair value.
Taking the data provided and converting to the ACCA symbols:
(a)
Pa = 113.20; Pe = 110.70; r = 0.035; t = (100 ÷ 250) = 0.4 (since
the annual number of trading days is 250); s is initially taken as 0.05 and,
subsequently as 0.1
d1 =
(
ln(113.20 ÷ 110.70) + 0.035 + 0.5 × 0.052 0.4 )
0.05 0.4
0.0223323 + 0.014 + 0.0005
=
0.0316227
0.0368323
= = 1.16474
0.0316227
d2 = 1.16474 - 0.0316227 = 1.13312
-0.035 x 0.4
c = (113.20 x 0.87795) – (110.70 x 0.87145 x e )
= 99.384 – (110.70 x 0.87145 x 0.98610)
= 99.384 – 95.128 = £4.258bn
Price = (£4.258 bn ÷ 495.6 m shares) = £8.59 per share
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d1 =
(
ln(113.20 ÷ 110.70) + 0.035 + 0.5 × 0.12 0.4 )
0.1 0.4
0.0223323 + 0.014 + 0.002
=
0.0632455
0.0383323
= = 0.60609
0.0632455
d2 = 0.60609 – 0.0632455 = 0.54284
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(b)
In this instance, the asset value (Pa) falls and is now equal to the liability value (at
a volatility of 0.05), so that both Pa and Pe become 110.70. All other facts are
unchanged.
The calculations are:
d1 =
( )
ln(110.70 ÷ 110.70) + 0.035 + 0.5 × 0.052 0.4
0.05 0.4
0 + 0.014 + 0.0005
=
0.0316227
0.0145
= = 0.45853
0.0316227
d2 = 0.45853 – 0.0316227 = 0.42691
(c) Comments
As can be seen from the calculations in part (a), the value of an option increases as
the level of risk rises. At a standard deviation of 5%, the share price is £8.59,
whilst at a volatility of 10%, the share price rises to £10.64. The actual share price
of Northern Rock in March 2007 fluctuated around £9.50 per share.
In part (b) of this illustration, the fair value of the bank’s assets fell to £110.7
billion to be equal to the fair value of its liabilities. Accordingly, the Statement of
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financial position would show an equity value of zero. However, the BSOP model
shows a quite different result, at a volatility of 5% the total value of the equity is
still worth £2.29 billion, that is £4.62 per share – almost precisely its value in
September 2007!
At this date, the information being released from the company suggested that its
assets had fallen in value as the bank’s mortgage receivables were written down in
line with falling house prices and potential defaults.
It was only when the threat of nationalisation became a real possibility (during the
final months of 2007) that the equity value began to collapse - and this can be
explained within the framework of the BSOP model. Nationalisation eliminates the
possibility of asset recovery for the shareholders. This deprives them of the “time
value” on their call option on the underlying assets of the business.
The rationale for this rather strange result is that the equity of a business can still
have a substantial positive value (despite the Statement of financial position
showing a zero equity value) because of the presence of limited liability!
Limited liability protects shareholders from a loss - and in fact they have everything
to gain if the fair value of the assets should recover! When the equity of a
company is “at or near the money”, ie when its gearing levels approach 100%, the
equity investors will become increasingly risk aggressive (i.e. risk-seeking). Agency
theory suggests they will provide management with incentives to increase risk,
rather than reduce it. Hence, the very high levels of reward offered to bank
employees, particularly those employed in the risk-taking departments of the
business.
The work of Black, Scholes and Merton provides a framework to value those
companies that are financed, in part, by borrowing. Where shareholders are
protected by limited liability, they have a call option on the underlying business
assets. Employing the BSOP model, an estimate can be made of the value of a
company’s equity on the basis of the value of its assets and their volatility.
For companies that are deep “in-the-money”, time value is small and the intrinsic
value of the business (i.e. the present value of the net assets) will dominate the
value of the equity. In this case, normal risk aversion can be expected to apply as
that intrinsic value will be exposed to equal positive and negative movements in the
value of the company’s assets.
This situation dramatically changes when companies are “near-the-money”. This
occurs with high growth start-ups financed by debt, leveraged buyouts and
companies that are in risk of default.
One class of company (banks) always operate “near-the-money”, and in valuing
such businesses, time value would be more significant than intrinsic value in equity
valuation.
When time value dominates, shareholders become risk-seekers and they will grant
management incentives to take greater risk, which will cause the company to be
pushed closer and closer “to-the-money”, by expanding assets and liabilities
without increasing the equity capital.
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THE GREEKS
In principle, an option writer could sell options without hedging his position. If the
premiums received accurately reflect the expected pay-outs at expiry, there is
theoretically no profit or loss on average. This is analogous to an insurance
company not reinsuring its business. In practice, however, the risk that any one
option may move sharply in-the-money makes this too dangerous. In order to
manage a portfolio of options, the dealer must know how the value of the options
he has sold and bought will vary with changes in the various factors affecting their
price. Such assessments of sensitivity are measured by the “Greeks”, which can be
used by options traders in evaluating their hedge positions.
1. Delta
For each option held, the delta value can be established i.e.
Change in option price
Delta =
Change in price of underlying security
A delta value ranges between 0 and +1 for call options, and between 0 and -1 for
put options. The actual delta value depends on how far it is in-the-money or out-
of-the-money.
The absolute value of the delta moves towards 1 (or -1) as the option goes further
in-the-money and shifts towards 0 as the option goes out-of-the-money. At-the-
money calls have a delta value of 0.5, and at-the-money puts have a delta value of
-0.5.
2. Gamma
Gamma measures the amount by which the delta value changes as underlying
security prices change. This is calculated as the:
Change in the delta value
Change in the price of the underlying security
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3. Vega
Vega measures the sensitivity of the option premium to a change in volatility. As
indicated above higher volatility increases the price of an option. Therefore any
change in volatility can affect the option premium. Thus:
Change in the option price
Vega =
Change in volatility
N.B. Vega is the name of a star, not a letter of the Greek alphabet!!
4. Theta
Theta measures how much the option premium changes with the passage of time.
The passage of time affects the price of any derivative instrument because
derivatives eventually expire. An option will have a lower value as it approaches
maturity. Thus:
Change in the option price (due to changes in value)
Theta =
Change in time to expiry
5. Rho
Rho measures how much the option premium responds to changes in interest rates.
Interest rates affect the price of an option because today’s price will be a
discounted value of future cash flows with interest rates determining the rate at
which this discounting takes place. Thus:
Change in the option price
Rho =
Change in the rate of interest
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CURRENCY OPTIONS
A currency option is the right, but not an obligation, to buy (a call option) or sell
(put option) a particular currency at a specified exchange rate on a particular date
or at any time up to a particular date.
Required:
Show the outcome of using both forward contract and currency options to hedge
foreign currency risk and recommend the best action.
Forward contract
Guaranteed payment = 2.8 x 5.6190 = GHC 15,733,200
Currency options
What date contract - The most suitable contract will be the contract that matures
at the nearest date after the transaction date 1st September. This is the September
contract, which matures at the on 15th September.
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Call or put option. Select call option to give right to buy or put option to give the
right to sell the contract size currency. In this case, since the contract size is
denominated in Ghana Cedi, the company will need to sell GHC for Sterling,
therefore it needs to buy a put option to get the right to sell GHC, hence
September put option should be selected.
Calculate the number of contracts
a b c = b/a d e = c/d
Exercise Contract Number of
£ GHC
price size contracts
Amount
Number
Exercise Contract hedged Amount Exposure (Over)/ Forward Outcome
of
price size GHC hedged £ £ under rate GHC
contracts
=bxc
0.18 125 125,000 15,625,000 2,812,500 2,800,000 (12,500) 5.5880 (69,850)
0.185 121 125,000 15,125,000 2,798,125 2,800,000 1,875 5.5880 10,535
a b c d e f g h i
Overall outcome if the option is exercised
(a) (b) (c) (d) e = b+c+d
Exercise Basic cost Premium (Over)/under hedge Total cost
Price (GHC) cost (GHC) outcome (GHC) (GHC)
0.175 16,000,000 130,161 0 16,130,161
0.180 15,625,000 279,111 (69,850) 15,834,261
0.185 15,125,000 594,564 10,536 15,730,100
It is recommended that Diano plc should use 0.185 currency option to hedge
against the sterling exposure as it is the cheapest.
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Required:
Calculate the value of the call option.
d1 =
[
ln(0.5484 / 0.54) + 0.0579 − 0.0483 + 0.5 × 0.12 0.4167 ]
0.1 × 0.4167
= 0.02152/0.06455
d1 = 0.3334 = 0.33
d2 = 0.3334 - 0.1 x√0.4167 = 0.2688 = 0.27
Reading from normal distribution table:
N(d1) = 0.5 + 0.1293 = 0.6293
N(d2) = 0.5 + 0.1064 = 0.6064
-rf x T
Value of call option = e S N(d1) – e-rT XN(d2)
= e-(0.0483 x 0.4167) x 0.5484 x 0.6293 – e-(0.0579 x 0.4167) x 0.54 X0.6064
= £0.0185799 = 1.858 pence
1.0201
F5 months = 1.8234 × 5/12 x 4.83% = 2.01%
1.0241
1.0201
F5 months = 1.8234 × 5/12 x 5.79% = 2.41%
1.0241
= $1.8163
Direct quote = 1/1.8163 = £0.5506/$1
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ln(F / X ) + 0.5s 2 T
d1 =
s T
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Example A plc
A plc needs to borrow £100m in four months time, 1/4/2003, but is worried about
interest rate changes in the intervening period. Its bankers are prepared to enter
into a IRG with it. The terms of the IRG are that it will last for six months and
include an interest rate of 8% per annum. Initial premium payment is £1,000,000
Required:
Show how IRG could be used, if on 1/4/2003 interest rate is 11%.
Solution
The interest rate in the IRG is 8% and this is lower than the open market rate of
11%, hence the bank will operate the IRG on the company’s behalf at 8% per
annum.
Interest payment £100m x 8% x 6/12 4,000,000
Premium payment 1,000,000
Total payment £5,000,000
If the IRG has not been bought the total interest would have been
11% x £100m x 6/12 = £5,500,000
Therefore the premium of £1m has saved interest of 5,500,000- 4,000,000 =
1,500,000, with a net savings of £500,000.
The IRG allows the company to participate in favourable interest rate movements,
but this flexibility is paid for through the premium.
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IRG like FRA cannot normally be arranged for periods of longer than one year but
successive IRG can be arranged so the maximum interest cost is always known one
period in advance.
IRG and FRA are all over the counter hedging techniques.
Example Shawter
Assume that it is now mid-December.
The finance director of Shawter plc has recently reviewed the company’s monthly
cash budgets for the next year. As a result of buying new machinery in three
months’ time, the company is expected to require short-term finance of £30 million
for a period of two months until the proceeds from a factory disposal become
available. The finance director is concerned that, as a result of increasing wage
settlements, the Central Bank will increase interest rates in the near future.
LIBOR is currently 6% per annum and Shawter can borrow at LIBOR + 0.9%.
Derivative contracts may be assumed to mature at the end of the month.
Three types of hedge are available:
Three months sterling Future (£500,000 contract size, £12.50 tick size)
December 93.870
March 93.790
June 93.680
FRA prices
3v6 7.01 – 6.91
3v5 7.08 – 7.00
3v8 7.28 – 7.20
Required:
Illustrate how the short-term interest risk might be hedged, and the possible
results of the alternative hedges if interest rates increase by 0.5%.
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Solution Shawter
Futures
● What contract = 3 months contract = March futures contract
● What type = sell interest rate futures as interest rates are expected
to rise. If interest rate rises, future price will fall, and we can close the
position by buying futures.
● Number of contracts
30m × 2
= = 40 contracts
0.5m × 3
● Tick size = 0.01% x 500,000 x 3/12 = 12.5
● Calculate the closing future price using basis and basis risk.
Calculate opening basis as:
Current LIBOR = 6% = (100 –6) = 94.00
Future price 93.790
Basis 0.21
This will fall to zero when the contract expires, and it is assumed that it will
fall at an even or linear manner
There are three and half months until expiry and the funds are needed in
three months time, therefore the expected basis at the time of borrowing is:
0.21 x 1/7 = 0.03
Closing future price
LIBOR = 6.5% (100 –6.5) 93.5
Basis 0.03
Future price 93.47
● Calculate profit or loss
Selling price 93.79
Buying price 93.47
Gain per contract 0.32 = 32 ticks
Total profit 32 x 0.01% x 500,000 x 3/12 x 40 = £16,000
OR
32 x 12.5 x 40 = £16,000
● Overall outcome (total cost)
£
Interest cost (6.5 +0.9) = 7.4% x 2/12 x 30m = 370,000
Profit on future position (16,000)
Net cost 354,000
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Option
● What date contract = March contract
● Call or put = buy put option to have the right to sell sterling futures
● Calculate premium
Exercise price Premium cost
93750 30,000,000 x 0.085% x 2/12 = £4,250
94000 30,000,000 x 0.225% x 2/12 = £12,750
94250 30,000,000 x 0.480% x 2/12 = £24,000
The premium cost is annual % so it should be expressed to 2/12, to reflect
period of borrowing.
● Calculate profit or loss
If interest rate increases, the option will be exercised and the futures contract
sold at the exercise price.
Exercise price Profit
93750 (93.75 – 93.47) x 100 x 40 x12.5 = £14,000
94000 (94.00 – 93.47) x 100 x 40 x 12.5 = £26,500
94250 (94.25 – 93.47) x 100 x 40 x 12.5 = £39,000
Conclusion
The future and FRA have the same expected total cost. However, future contract
require margin payments and the associated basis risk makes the future cost
uncertain, therefore the FRA would be preferable. However, if there is any belief of
a chance of interest rate falling, then the best alternative would be the option with
exercise price of 94,250.
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10% CAP
5% floor
0 time
The open market rate will be applied to the loan as long as it remains between 5%
and 10%. If the open market interest rate goes outside these parameters (say
12% or 4%) the bank will activate the ‘cap’ or ‘floor’ as appropriate to keep the
loan interest cost between the agreed limits.
The advantage of the collar compared to a normal cap is that the collar has a lower
overall premium cost, due to the potential benefit of floor to the bank.
Interest rate option is a right, but not obligation, to either borrow or lend a notional
amount of principal for a given interest period, starting on or before a date in the
future (expiry date for the option), at a specified rate of interest (exercise price of
the option).
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Chapter 19
Swaps
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SWAPS
A swap is an agreement between two parties to exchange cash flows related to
specific underlying obligations for an agreed period of time. It is the exchange of
one stream of future cash flows for another stream of future cash flows with
different characteristics.
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Required:
Calculate the total interest payments of the two companies over the year if LIBOR
is 10% per annum
Solution
LIBOR at 10%
Fred plc
£
Interest on own loan (10% + 1.5%) x 20m (2,300,000) (11.5%)
Interest received from Martin (10%+2%) x 20m 2,400,000 12%
Interest paid to Martin (12%+0.5%) x 20m (2,500,000) (12.5%)
Martin plc
£
Interest on own loan (12% x 20m) (2,400,000 12%)
Interest received from Fred (12% + 0.5%) x 20 2,500,000 12.5%
Interest paid to Fred (10% +2%) x 20m (2,400,000) (12%)
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Example 2
A company wants to borrow £6 million at a fixed rate of interest for four years, but
can only obtain a bank loan at LIBOR plus 80 basis points. A bank quotes bid and
ask prices for a four year swap of 6.45% - 6.50%.
Required:
(a) Show what the overall interest cost will become for the company, if it
arranges a swap to switch from floating to fixed rate commitments.
(b) What will be the cash flows as a percentage of the loan principal for an
interest period if the rate of LIBOR is set at 7%?
Solution 2
(a)
%
Actual interest floating rate (LIBOR + 0.8)
Swap
Receive floating rate interest from bank LIBOR
Pay fixed rate (higher-ask price) (6.50)
Overall cost (7.3)
(b)
%
Actual interest floating rate (7 + 0.8) (7.8)
Swap
Receive floating rate interest from bank 7
Pay fixed rate (higher-ask price) (6.50) 0.5
Overall cost (7.3)
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CURRENCY SWAPS
Currency swaps are similar to interest rate swaps, but the underlying obligations
are in different currencies.
Currency swaps are characterised by the following mechanism:
● Initial exchange of principal currencies at the commencement of the swap.
● Exchange of regular interest payment during the life of the swap.
● Final exchange of principal currencies at maturity of the swap.
When currencies are exchanged at the commencement and maturity of the swap,
the same exchange rate is used. In other words, the amounts exchanged at the
start of the swap and at the end are exactly the same.
Example 3 DD plc
DD plc needs to borrow $50m to finance it US subsidiary. DD plc is not well known
in US and can only borrow in US at US basic rate + 3%. DD plc contacts a US
company it has known for many years, FFK plc. FFK plc is in a similar position to
DD plc in that it requires a sterling loan to finance its UK operations. FFK plc can
borrow sterling at 11% per annum fixed and floating rate in US at US base rate +
1%.
The two companies come into a swap arrangement where:
● DD plc will borrow sterling at 9% per annum fixed and FFK plc will borrow
dollars at US base rate + 1%
● DD plc will pay FFK plc US base rate + 1.5% per annum and FFK plc will pay
DD plc sterling 9.5% per annum
● There will be an exchange of principal now and in five years time at the
current spot rate of $8 = £1
● UK base rate is currently 7% and US base rate is 5% per annum.
Required:
Show whether the suggested swap would benefit the two companies.
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Solution 3
DD plc borrows = $50/ 8 = £6.25m at 9%
FFK plc borrows = $50 at base rate + 1% = 6%
The currencies borrowed will then be swapped so that each company obtains the
currency they require.
The swap arrangement results in the following interest rates:
DD plc FFK plc
% %
Actual cost of loan (9) (6)
Swap arrangement:
FFK to DD 9.5 (9.5)
DD to FFK (6.5) 6.5
Overall cost of foreign currency finance 6% 9%
Cost without swap 8% 11%
Savings 2% 2%
At the end of the swap arrangement both companies have benefited considerably,
not only they have managed to get the currencies they wanted, but also have
obtained them at a lower interest rate than they could have achieved by borrowing
overseas directly.
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2. Market Risk
This is the risk that interest rates or exchange rates will move unfavourably against
the company after it has committed itself into the swap.
3. Sovereign Risk
This is the risk associated with the country in whose currency a swap is being
considered. It covers political instability or the possibility of exchange controls
being introduced.
4. Liquidity Risk
Liquidity risk is the risk that the entity will not have access to sufficient cash to
meet its payment obligations when these are due.
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SWAPTIONS
Swaption may also be referred as swap option, options on swap or option swap.
Swaptions are combination of swap and option.
In return for the payment of premium by the holder, a swaption gives the right, but
not an obligation, to enter into swap on or before a particular date.
Swaptions are available on an over-the-counter market and are therefore tailored
to the exact specifications of the holder. They may be American or European style.
Swaptions are example of financial engineering. Financial engineering is the
construction of a financial product from a combination of existing derivative
products.
Illustration 3 Swaptions
Noswis plc borrowed two million Euros (€) in four year floating rate notes funds
nine months ago at an interest rate EURIBOR plus 1%, in an attempt to reduce the
level of interest paid on its loans. At that time EURIBOR was 6%. Unfortunately
EURIBOR interest rates have increased since that time to 7.2%. The company
wishes to protect itself from further interest rate volatility, but does not wish to lose
the benefit of possible interest rate reductions that might occur in a few months
time. An adviser has suggested the use of a six month American style Euro
swaption at 8.5% with a premium of €50,000, commencing in three months time
and with a maturity date the same as the floating rate Euro loan.
Required:
Briefly explain what is meant by a swaption, and illustrate under what
circumstances this proposed swaption would benefit Noswis. The time value of
money may be ignored.
Solution 3
Swaptions are hybrid derivative products that integrate the benefits of swaps and
options. The buyer of a swaption has the right, but not the obligation, to enter into
an interest rate or currency swap during a limited period of time and at a specified
rate.
Swaptions are available on the over-the-counter market and involve the payment of
a premium, normally in advance. They may be ‘European style’, exercisable only
on the maturity date, or ‘American style’, exercisable on any business day during
the exercise period.
Noswis is interested in protection against interest rate volatility, but wishes to
maintain the flexibility to benefit from falls in interest rates. A swaption would offer
the opportunity to do this.
Noswis is currently paying 8.2% on its Euro loan. The swaption offers a swap from
floating rate to fixed rate finance for the remaining three year period of the Euro
loan. (N.B. the four year loan was raised nine months ago and the swaption will
not commence until another three months have elapsed).
The fixed rate is 0.3% per annum above the current floating rate payable by
Noswis.
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The premium payable of €50,000 is 2.5% of the total value of the loan, or, ignoring
the time value of money, 0.833% per year over the remaining three year period of
the loan.
If Euro interest rates rise during the next nine months by more than 0.3% the
swaption is likely to be exercised. For the swaption to be beneficial to Noswis, the
average floating rate payable by Noswis without the swap over the three year
period would have to exceed:
8.2% + 0.3% + 0.833% = 9.333%
This is a 13.8% increase on the current EURIBOR payable rate (ie over 8.2%)
If interest rates fall then the swaption would not be exercised and Noswis would
benefit from borrowing at the lower floating rates. If the swaption is not exercised
the premium is still payable, and Noswis would be worse off by the amount of the
premium than if no swaption had been agreed.
However, this premium is the price that must be paid for the flexibility of being able
to take advantage of any lower interest rates in the future.
Furthermore it should be noted that once the swaption is exercised this action
cannot be reversed. Therefore if interest rates subsequently fall, Noswis will
continue to pay the fixed rate of interest set out in the agreement.
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Chapter 20
Principles of islamic
finance
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1. It is interest-free
The Western concept of the transaction between individuals and institutions rests
on the basis of time value of money, whereby someone borrowing money has to
repay the lender a higher amount in return for the satisfaction of using that money
today. Western societies reward capitalism and private enterprise through interest.
Islamic societies are founded on the concept of welfare and equitable distribution of
income, whereby growth will be collective, and societal welfare will be prioritized
over individual enterprise. Interest is, hence, considered illegal, and all the tools
and mechanisms for growth will have a profit sharing component instead of an
interest component where one segment in society gains at the expense of the
other.
Thus, in an Islamic society, everyone will share in the profits of an enterprise, and
everyone will bear a loss equally.
3. It is equity-oriented
Lending and investing are separate functions as loans are interest-free but carry a
service charge, while investing is on a profit-and-loss-sharing (mudaraba) basis.
Commercial banks only grant loans and do not engage in investment-financing.
Investment-financing is conducted through investment banks and investment
companies. Value erosion of capital due to inflation is compensated.
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Overall
Therefore, the difference between Islamic banking and finance and conventional
banking lies in the social concept of sharing responsibility, risk, and property.
Consequently, fixed interest transactions where risk is entirely assigned to the
borrower are avoided.
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the bank makes through its investments. Conventional banks make a profit on the
spread between the interest rate charged to borrowers and paid to depositors –
Islamic banks make a profit on the investments that they make or their borrowers
make.
There are various limitations on the use of mudaraba as a viable basis of financial
intermediation in an interest-free framework. The legal system operating in the
country should provide legal safeguards to the provider of capital so that he can
finance projects on the basis of mudaraba. As a result, the number of banks
providing finance on the basis of mudaraba is not very large. Even among those
banks that use mudaraba as a financing technique, the frequency of its use is not
very high. An Islamic financial institution (IFI) will perform the functions of
financial intermediation through appraising profitable projects and monitoring the
performance of projects on behalf of the investors who deposit their funds with the
IFI. Therefore, the mudaraba contract becomes the cornerstone of financial
intermediation and thus banking.
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Salam contract
Salam contract is a short term production contract or a purchase contract in which
payment is made today against future delivery of an asset. (Sale with deferred
delivery).
Salam contracts are exempted from criteria of existence and ownership.
In istisna and salam contracts, the buyer takes a business risk and is therefore not
subject to the prohibitions of gambling and uncertainty.
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Direct investment
In direct investment, the Islamic bank performs the role of an investment company.
The option of direct investment gives Islamic banks an opportunity to invest in
priority projects in chosen sectors. In this way, banks can channel their funds in
the direction they think most desirable.
There are several ways in which Islamic banks undertake direct investment. A
number of Islamic banks have taken the initiative in establishing and managing
subsidiary companies.
The general method of undertaking direct investment includes establishing a company
dealing with investment, insurance and reinsurance, trade, construction and real
estate. Another method of undertaking direct investment is participation in the equity
capital of other companies. The companies are established by the Islamic banks
themselves and the public subscription of shares are invited or banks participate in
the equity capital of companies established by others.
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ACCA STUDY
GUIDE
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A C C A S T U D Y G U ID E
Below I have set out ACCA’s Study Guide in detail for you.
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b) Assess a company’s debt exposure to interest rate changes using the simple
Macaulay duration method.
c) Discuss the benefits and limitations of duration including the impact of
convexity.
d) Assess the company’s exposure to credit risk, including:
i) Explain the role of, and the risk assessment models used by the
principal rating agencies.
ii) Estimate the likely credit spread over risk free.
iii) Estimate the company’s current cost of debt capital using the
appropriate term structure of interest rates and the credit spread.
e) Explain the role of BSOP model in the assessment of default risk, the value of
debt and its potential recoverability.
f) Assess the impact of financing and capital structure upon the company with
respect to:
i) Pecking order theory.
ii) Static trade-off theory.
iii) Agency effects.
g) Apply the adjusted present value technique to the appraisal of investment
decisions that entail significant alterations in the financial structure of the
company, including their fiscal and transactions cost implications.
h) Assess the impact of a significant capital investment project upon the reported
financial position and performance of the company taking into account
alternative financing strategies.
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c) Advise upon the criteria for choosing an appropriate target for acquisition.
d) Compare the various explanations for the high failure rate of acquisitions in
enhancing shareholder value.
e) Evaluate, from a given context, the potential for synergy separately classified
as:
i) Revenue synergy.
ii) Cost synergy.
iii) Financial synergy.
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1. Financial reconstruction
a) Assess a company situation and determine whether a financial reconstruction
is the most appropriate strategy for dealing with the problem as presented.
b) Assess the likely response of the capital market and/or individual suppliers of
capital to any reconstruction scheme and the impact their response is likely to
have upon the value of the company.
c) Recommend a reconstruction scheme from a given business situation,
justifying the proposal in terms of its impact upon the reported performance
and financial position of the company.
2. Business reorganisation
a) Recommend, with reasons, strategies for unbundling parts of a quoted
company.
b) Evaluate the likely financial and other benefits of unbundling.
c) Advise on the financial issues relating to a management buy-out and buy-in.
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G Emerging issues
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