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ACCA- Advanced Financial Management (AFM) -Revision Content

CONTENT

Part Advanced Investment Appraisal ........................................................................................................ 2

1. Formula of WACC .................................................................................................................................... 2
2. Risk adjusted WACC ................................................................................................................................ 2
3. NPV format.............................................................................................................................................. 3
4. APV Format ............................................................................................................................................. 4
5. NPV vs APV vs Oversee NPV.................................................................................................................... 5
6. Internal rate of return (IRR) approach .................................................................................................... 6
7. MIRR and MGR ........................................................................................................................................ 6
8. Recovery and duration ............................................................................................................................ 6
9. Value at Risk vs Sensitivity analysis ......................................................................................................... 6
10. Capital rationing .................................................................................................................................... 7
11. Basic options ......................................................................................................................................... 7
Part Acquisitions and Mergers.................................................................................................................. 8
1. Nature of acquisitions and mergers ........................................................................................................ 8
2. Valuation ................................................................................................................................................. 8
3. Payment and financing in M&A .............................................................................................................. 9
Part Corporate Reconstruction and Reorganisation ................................................................................. 10
1. What factors will rating agencies consider? ......................................................................................... 10
2. Structural models .................................................................................................................................. 10
Part Treasury and Advanced Risk Management ...................................................................................... 11
1. Hedging derivatives............................................................................................................................... 11
Word..................................................................................................................................................... 12
1. Risk mitigation....................................................................................................................................... 12
2. Hedging ................................................................................................................................................. 12
3. Diversification strategies....................................................................................................................... 12
4. Capital investment monitoring system (CIMS) ..................................................................................... 12
5. Behavioural finance .............................................................................................................................. 13
6. Ethical and governance issues .............................................................................................................. 14
7. Management of international trade and finance ................................................................................. 17
8. Strategic business and financial planning for multinationals ............................................................... 25
Other important study guide .................................................................................................................. 29
1. Bound .................................................................................................................................................... 29
2. Dividend policy ...................................................................................................................................... 29
3. Performance Evaluating ........................................................................................................................ 33

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ACCA- Advanced Financial Management (AFM) -Revision Part Advanced Investment Appraisal

Part Advanced Investment Appraisal

1. Formula of WACC
𝐄 𝐃
WACC = k e × 𝐄+𝐃
A+ k d (1 - t)×𝐄+𝐃

⚫ Market value of equity and debt

 MV of Equity = No. of ordinary share × Share price
 MV of Debt
Bond/Debenture = Book value of debenture × Debenture price/100 Loan: Market value = Book value
Preference share: No. of preference share × share price

⚫ ke and kdat

WACC

Cost of equity-ke Cost of debt-kdat

DVM CAPM Non-traded traded

No growth With growth K =R +(Rm-R ) ×β kdat=int. rate (1-t)

e f f
Irredeemable Redeemable
Ke=PD Ke=
DO×(1+g)
+g
O PO
i(1−t) IRR
kdat=
PO

2. Risk adjusted WACC

risk adjusted WACC'
CAPM MM
1. Degearing Beta asset' 1. Degearing kei 公式 经营风险
2. Regearing Beta equity' 2. Regearing ke公式 总风险
3. ke' CAPM
4. Kd' Yield + risk premium kd'
5. Risk adjustment WACC' WACC'

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ACCA- Advanced Financial Management (AFM) -Revision Part Advanced Investment Appraisal

3. NPV format

Year 0 1 2 3 4 5

£000 £000 £000 £000 £000 £000

Receipts - (or cost savings) X X X X

Payments:

Wages (X) (X) (X) (X)

Materials (X) (X) (X) (X)

Variable / Fixed overheads (X) (X) (X) (X)

Administration / Distribution expenses (X) (X) (X) (X)

Capital Allowances/Tax allowable depreciation (X) (X) (X) (X)

Taxable Profits = EBIT X X X X

Tax: (X) (X) (X) (X)

Add back: Capital Allowances/ Tax allowable depr. X X X X

Initial outlay (X)

Net Realisable Value X

Working capital - (net current assets) (X) X

Net Cash Flows = Free Cash Flows (X) X X X X (X)

Discount rate (10%) 1 0.909 0.826 0.751 0.683 0.621

Present value (X) X X X X (X)

Net Present Value X/(X)

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ACCA- Advanced Financial Management (AFM) -Revision Part Advanced Investment Appraisal

1 2 3 4
PBIT
扣过
sales 100 Sales 100 (taxable
CA
(cost saving) profit) PBIT
Relevant CF: CF; incremental;
-30 -Cost -30 -TAX
-Cost 123 future -Tax
Irrelevant cost: R&D, study,
design-sunk; depreciation; +CA Inv = CA
allocative fix cost…int. cost +CA
Relevant cost: opportunity cost, -Inv on
-inv. On NCA
cost saving … NCA
-CA -10 +S.V + S.V
=Taxable - Inv. on
60 =Taxable CF 70 - inv. On WC
profit WC
-Tax -18 -Tax -21 =NET CF = net CF
+Tax saving
10 3
+CA from CA
52 52
-Inv. on NCA -Inv on NCA
+S.V +S.V
-Inv. on net
-Inv on WC
CA
=Net CF Net CF
Fisher: (1+ money/nominal r)
=(1+real r)*(1+inflation) ;
dr: nominal r=real r+ inflation
cost of CF with growth rate -- nominal r
capital CF no growth rate --- real r
PV
NPV

4. APV Format

Net CF of investment effect

kei
Base case NPV X/(X)
Present value of financing effect
PV of the issue costs (x)
PV of the Tax Shield:
- Normal Loan X
- Cheap Loan X
PV of the cheap loan: - Interest saved X
Adjusted Present Value X/(X)

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ACCA- Advanced Financial Management (AFM) -Revision Part Advanced Investment Appraisal

Year 0 1 2 3 4 5
FC FC FC FC FC FC
Sales/Receipts x x x x
Payments:
Variable costs (x) (x) (x) (x)
Wages / Materials (x) (x) (x) (x)
Incremental fixed costs (x) (x) (x) (x)
Capital allowances (x) (x) (x) (x)
Royalties (x) (x) (x) (x)
Foreign Taxable profits x x x x
Foreign Tax (x) (x) (x) (x)
Capital allowances x x x x
Initial outlay (x)
Realisable value x
Working capital (x) (x) (x) (x) (x) x
Net Foreign cash flow (x) x x x x (x)
Exchange rate (based on PPPT) x x x x x x
Net domestic Cash Flow (x) x x x x (x)
Royalties x x x x
Opportunity cost
Taxable profit
Tax (x) (x) (x) (x)
Additional tax on taxable profits (x) (x) (x) (x)
Total cash flows (x) x x x x (x)
Discount rate
Present value (x) x x x x (x)
Net £ Present Value x/(x)

5. NPV vs APV vs Oversee NPV

NPV: APV Oversee NPV

Net CF Net CF--investment CF foreign net CF
WACC kei Exchange rate
PV PV of investment CF domestic net CF
Financing CF Domestic relevant CF+
kd/ normal int. rate CF-
PV of financing CF Taxable CF
-tax
Domestic net CF
Total net CF
WACC
PV

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ACCA- Advanced Financial Management (AFM) -Revision Part Advanced Investment Appraisal

6. Internal rate of return (IRR) approach

IRR is used in project appraisal to calculate the % return given by a project.

Year CF DF @ L% PV DF @ H% PV
0 (MV) (X) (X)
1-n interest*(1-t) X X
n redemption X X
NPV = NL NPV = NH

NL
IRR=L%+ ×（H% -L%）
NL -NH

7. MIRR and MGR

n Terminal value of return phase

MIRR= √ -1
Present value of investment phase
1
PV of return
1 + MGR = [ ]n 1 + MIRR = (1 + MGR)(1 + i)
PV of investment

Where:

i = Discount rate used to calculate the NPV in the first place

8. Recovery and duration

⚫ Recovery = (PV of investment / PV of return) ×project life
⚫ Duration

Year 1 2 3 4
CF x x x x
dr x x x x
PV x x x x
Value
Recovery% x x x x
Weighted
x x x x
Ave. years
Duration x

9. Value at Risk vs Sensitivity analysis

9.1 Value at Risk

X−μ
Z= σ
VaR = Zσ

Time adjusted: VaR = Zσ × √T

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ACCA- Advanced Financial Management (AFM) -Revision Part Advanced Investment Appraisal

9.2 Sensitivity analysis

sensitivity margin of x = NPV / PV of x

sensitivity margin of price = NPV / PV of revenue
sensitivity margin of volume = NPV / PV of contribution
sensitivity margin of discounting rate = ( IRR - dr) / dr

10. Capital rationing

Single period capital rationing

Capital rationing

Multi-period capital rationing

11. Basic options

(此处为视频资源，详情请见视频)

⚫ Total value of option = intrinsic value + time value

11.1 The Black Scholes Modes -BSOP

⚫ Plugging the number to the Black Scholes Formula
Value of a call option =Ps N(d1)-Xe-rT N(d2)
In (Ps/X) + rT
Where d1 = σ√T
+ 0.5σ√T
d2 = d1 − σ√T Calculate d1+ d2 to two decimal places.

Put Call Parity PP = Pc - Ps + Xe–rT

11.2 Sensitivity of options

⚫ Delta hedging
 Model 1: Holding share and sell call option
Number of shares bought
No. of option calls to sell =
N(d1 )
 Model 2: holding share and buy puts options
No. of shares
No. of put option to buy =
N(−d1 )
11.3 Greeks

Change in Regarding
Delta Option value Share Price
Gamma Delta Share Price
Theta Option value Time
Vega Option value Volatility
Rho Option value Interest Rate

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ACCA- Advanced Financial Management (AFM) -Revision Part Acquisitions and Mergers

Part Acquisitions and Mergers

1. Nature of acquisitions and mergers

Organic growth Vs growth by acquisition

Types of merger

Factors needs to be consider when M&A

Nature of acquisitions
Synergy
and mergers

Reasons for high failure rate when M&A

Regulation of takeovers

Defences against a bid

2. Valuation
PVA+B POST ACQ = PVA + PVB + synergy - consideration (cash)
Max consideration = value of combine - value of acquiring company Max premium = max consideration - value
of target company

Intrinsic valuation of equity (E)

Ask: whether stock market is efficient

Efficient Not efficient

E= Market value 4 approaches

Asset valuation Relative valuation Flow valuation BSOP

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ACCA- Advanced Financial Management (AFM) -Revision Part Acquisitions and Mergers

Asset valuation model

Valuing intangible
Valuation

Relative valuation models

Flow valuation model

BSOP method for valuation

3. Payment and financing in M&A

Cash purchase – 发债

Payment and financing

in M&A

Shares for share exchange — 发股

Q: impact on EPS, gearing, financial statement gains of acquiring and target company?

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ACCA- Advanced Financial Management (AFM) -Revision Part Corporate Reconstruction and Reorganisation

Part Corporate Reconstruction and Reorganisation

Q: impact on EPS, gearing, financial statement MBO and MBI difference?

1. What factors will rating agencies consider?

⚫ industry risk
⚫ country risk
⚫ earnings protection
⚫ financial flexibility
⚫ evaluation of the company's management

2. Structural models

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ACCA- Advanced Financial Management (AFM) -Revision Part Treasury and Advanced Risk Management

Part Treasury and Advanced Risk Management

1. Hedging derivatives

'Over the Counter' Market Exchange Traded Instruments

Forward Agreement futures
option options on futures
cap; floor; collar
Swaps

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ACCA- Advanced Financial Management (AFM) -Revision Word

Word
(此处为网课资源，详情请见视频)
1. Risk mitigation
Risk mitigation is the process of minimising the probability of a risk's occurrence or the impact of the risk should
it occur.
Severity/frequency matrix

Severity
Low High

Accept Transfer
Frequency Low
 Risks are not significant  Insure risk or implement contingency plan

Control or reduce Abandon or avoid

High
 Take some action  Take immediate action

2. Hedging
2.1 Financial hedging
It involves the use of financial instruments, mainly derivatives to reduce or eliminate exposure to risks.

2.2 Operating hedging

It hedges a firm’s risk exposure through operational activities using non-financial instruments, such as real
option. Real options give the possibility of delaying, abandoning, enhancing or switching activities.

3. Diversification strategies
Diversification strategies seek to reduce the volatility of earnings of a company. This can be achieved through
product or geographical diversification.

4. Capital investment monitoring system (CIMS)

A capital investment monitoring system (CIMS) monitors how an investment project is progressing once it has
been implemented.
⚫ Initially, the CIMS will set a plan and budget for how the project is to proceed. It sets milestones for what
needs to be achieved and by when. It also considers the possible risks, both internal and external, which may
affect the project.
⚫ CIMS then ensures that the project is progressing according to the plan and budget. It also sets up
contingency plans for dealing with the identified risks.
⚫ Benefits of CIMS
 It tries to ensure that the project meets what is expected of it in terms of revenues and expenses.
 It tries to ensure that the project is completed on time and risk factors that are identified remain valid.
 A critical path of linked activities which make up the project will be identified. The departments
undertaking the projects will be proactive, rather than reactive, towards the management of risk, and
therefore possibly be able to reduce costs by having a better plan.
 CIMS can also be used as a communication device between managers charged with managing the
 project and the monitoring team.
 CIMS would be able to re-assess and change the assumptions made of the project if changes in the
external environment warrant it.

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5. Behavioural finance
Behavioural finance is the influence of psychology on the behaviour of financial practitioners.

5.1 Behavioural finance studies on investors

⚫ Own preference
Investors may prefer to invest in the companies acting with social responsibility and avoid the unethical
companies.

⚫ Cognitive dissonance
Investors may be reluctant to admit that their decision to investment was wrong. It explains that why some
investors hold on to shares with prices that have fallen over time and are unlikely to recover.

⚫ Anchoring
Investors may use information that is not relevant but is readily available, possible to simplify the decision
making process. For example, investors may buy shares that in the past have had high values, on the grounds
that these represent their true potential values, even though rational analysis suggests that the prices of
these of shares will remain low in the future.

⚫ Gambler’s fallacy
Investors may believe that the probability of a future outcome will be influenced by how often the same
outcome has occurred in the past. For example, if the value of a company’s shares has risen for some time,
investors may sell those shares on the grounds that the shares have gained in value for ‘long enough’ and
their price must therefore soon start to fall, even if rational analysis suggests that the rise in price will
continue.

⚫ Herd instinct
Investors may buy or sell shares in a company because many other investors have already done so. These
investors believe that a large group of other investors cannot be wrong.

⚫ Search for patterns

Investors may use analysis of past share price as a basis for predicting the future.

⚫ Small capitalisation discount

Some fund managers may ignore companies with low market capitalisation, with the result that their shares
are not purchased and their value remains low.

⚫ Confirmation bias
Investors may pay attention to evidence that confirms their current beliefs about their investments and
ignores evidence that casts doubt on their beliefs.

⚫ Attitude to risk
Some investors may be attracted by a company that offers the possibility of making very high returns, even
if the possibility is not very great. While investors with regret aversion tend to avoid investments that have
the risk of making losses, even though expected value analysis suggests that, in the long-term, they will make
significant capital gain.

⚫ Availability bias
Many investors pay most attention to the last set of financial results and other recent information about a
company and take less notice of data that has been available for a while. A consequence of this may be over-
reaction when companies release information, with share prices rising or falling quickly after information is
released and then going back in the opposite direction to an equilibrium value over time.

⚫ Momentum effect
A period of rising share prices may result in a general feeling of optimism that price rise will continue and
increased willingness to invest in companies that show prospects for growth.

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ACCA- Advanced Financial Management (AFM) -Revision Word

5.2 Behavioural finance studies on finance managers

Behavioural finance particularly identified factors that affect investment decision on mergers and acquisitions.
⚫ Agency problem
Managers may maximise their own short-term rewards and expand the company by acquisition in order to
enhance their own reputation.

⚫ Loss aversion bias

The acquirer’s manager is unwilling to let someone else have what they have been trying to acquire.

⚫ Overconfidence
Some acquirer’s managers seem to believe that, however poor the outlook for the target seems, their own
considerable management skills will improve its prospects after the merger takes place.

⚫ Entrapment
Where a strategy is failing, managers may become unwilling to move away from it because of their personal
commitment to it.
In the AFM exam, you’ll need to read the question scenario very carefully. Look out for information about
how investors or managers may be making decisions, or factors in the situation that may trigger biases that
the decision makers have. You may not be about to come to a firm conclusion about what decision maker
will do and why, but you should be looking to discuss various possibilities. Bringing real life into your answer
has to mean questioning the assumption that all financial decisions are taken rationally, and at least
admitting behavioural factors may influence decision makers.

6. Ethical and governance issues

The ethical dimension in business

Ethical aspects and functional areas of the

organisation
Ethical and
Ethical framework for developing financial policies
governance issues

Stakeholder conflict

Triple bottom line reporting and integrated

reporting
6.1 The ethical dimension in business
The prime financial objective of a company is to maximise the wealth of its ordinary shareholders. Ethical
considerations are part of the non-financial objectives of a company and influence the decisions of management.
Non-financial objectives
Ethical considerations Actions and strategies
Competitive wage and salaries, comfortable and safe working
Welfare of employee
conditions, good training and career development
Welfare of management High salaries, company cars, perks
Welfare of society Concern for environment
Responsibilities to customers Providing quality products or service, fair dealing
Responsibilities to suppliers Not exploiting power as buyer
Business ethics are developed to deal with the behaviour of firms and the norms they should follow.

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ACCA- Advanced Financial Management (AFM) -Revision Word

6.2 Ethical aspects and functional areas of the organization

Business ethics should govern the conduct of corporate policy in all functional areas of a company.
⚫ Human resources management
There is a conflict between the financial objectives of the firm and the right of the employees. The ethical
problems arise in relation to minimum wages and discrimination.
Companies are obliged to pay their employees at least the minimum wage. However, when multinational
companies operate in countries where there are no minimum wage requirements, then the companies may
try to take advantage of the lack of protection and offer low wages. Business ethics would require that
companies should not exploit workers and pay lower than the warranted wages.
Discrimination on the basis of race, gender, age, marital status, disability or nationality is prohibited
in most advanced economies, through equal opportunity legislation. However, companies may have the
power in some instances to circumvent many of the provisions. In the case of potential discrimination, the
company wishing to behave ethically should be aware of the risk of breaking the rules.

⚫ Marketing
Marketing is one of the main ways of communicating with its customers and this communication should be
truthful and sensitive to the social and cultural impact on society. The marketing strategy should not target
vulnerable groups, create artificial wants or reinforce consumerism. It should also avoid creating stereotypes
or creating insecurity and dissatisfaction.

⚫ Market behaviour
Companies should not take advantage of their dominant position in the market to exploit suppliers or
customers.
An ethical framework should be developed as a part of a overall company's socialresponsibility which
includes
 Economic responsibility
 Legal responsibility
 Ethical responsibility
 Philanthropic responsibility

6.3 Ethical framework for developing financial policies

⚫ Economic responsibility
The company has a responsibility to manage the funds of outside investors in such a way that the required
return is generated.
⚫ Legal responsibility
Companies operate within a legal framework as defined by company law, the various accounting and
environmental standards, labour law etc. It is a duty of the company to comply with all the legal and
regulatory provisions, and to ensure that employees are aware of this policy.

⚫ Ethical responsibility
Ethical responsibilities arise not as a result of legal requirements but as a result of a moral imperative for
companies to operate in an ethical and fair manner. The following approaches are commonly used.
 Mission or value statement
 Codes of ethics
 Reporting/advice channels
 Ethics managers
 Ethics consultants
 Ethics education and training
 Auditing, accounting and reporting

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⚫ Philanthropic responsibility
Philanthropy is the last of the responsibilities of a company and includes all those actions that the
company needs to take in order to improve the life of its employees, to contribute to the local community
and to make a difference to society as a whole. Philanthropic activities include charitable donations, the
provision of recreational facilities for employees, the support to educational institutions and the
sponsoring of athletic and cultural events.

6.4 Stakeholder conflict

A central source of ethical problems is the conflict between shareholders and other stakeholders.
Stakeholder Objectives
Job security, good working conditions, job satisfaction, career
Employees and managers
development and relevant training
Customers Price and quality of the product
Suppliers Regular orders and payments
Fund providers Return on their investment
Society as a whole Pollution, donation from the firm

Strategies for the resolution of stakeholder conflict might include

⚫ Profit-related pay - Pay or bonuses related to the size of profits.
⚫ Rewarding managers with shares - When a private company goes public, managers are invited to subscribe
for shares in the company at an attractive offer price.
⚫ Executive share options plans - Senior managers are given the right to subscribe for shares in the company
at a fixed price at a certain future date.
⚫ Corporate governance - Independent non-executive directors play a more and more important role in
monitoring the executive directors.

6.5 Triple bottom line reporting

Sustainability is to ensure that the development meets the needs of the current generation without
compromising the ability of the future generations to meet theirs.
Concern over environmental issues has led to growing pressure for company’s to report on the impact of their
business activities on the environment.
TBL reporting is a summary of a company’s economic, environmental and social
performance over the previous year.
⚫ Economic - profit, stimulus to the domestic economy by purchasing from local suppliers
⚫ Environmental - the ecological footprint, emissions to soil, water and air, water and energy used
⚫ Social - tax contribution, employment

6.5.1 Advantages of TBL reporting

⚫ Better risk management and higher ethical standards through
 Identifying stakeholder concerns
 Employee involvement
 Good governance
 Performance monitoring
⚫ Improved decision making through
 Stakeholder consultation
 Better information gathering
 Better reporting processes
Attracting and retaining higher calibre employees through practising sustainability and ethical values

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ACCA- Advanced Financial Management (AFM) -Revision Word

6.5.2 Critics of TBL reporting

While the aspirations of the TBL movement are sound, on both practical and conceptual grounds the TBL
is an unhelpful addition to the corporate social responsibility debate and it promises more than it can
deliver.
The rhetoric behind TBL can't in fact provide a smokescreen behind which firms can avoid truly effecting
social and environmental reporting and performance.

6.6 Integrated
reporting
The aim of integrated reporting is to explain how an organisation creates value over time and demonstrate the
linkage between strategy, governance and financial performance and the social, environmental and economic
contexts within which it operates.
Integrated thinking considers the relationships between the operating and financial units within the business
and the capitals that the organisation uses or affects.
Integrated reporting provides a higher quality of information for investors, which enable them to make more
informed decisions and ensure a better allocation of capital across the whole economy, towards sustainable
businesses that focus on longer-term value creation within natural limits and the expectations of society.
Integrated reporting should encourage better mapping of stakeholder interests and give organisations more
confidence in the information they supply in response to shareholder requests.
Furthermore, integrated reporting should encourage business to focus on enhancing the mechanisms for
stakeholder feedback, which may identify issues that have not been considered as important previously but are
concerns that should have an impact on strategy.
The international integrated reporting council (IIRC) guidance requires a statement from those charged with
governance about their responsibility to ensure the integrity of the integrated report and their conclusion about
whether the integrated report is presented in accordance with the IIRC framework. The guidance is therefore
designed to promote accountability and transparency, but this is not all.

7. Management of international trade and finance

Corporate strategy in multinational enterprises

Theory and practice of international trade

Management of Trade agreements

international trade
and finance International monetary institutions

Developments in world financial markets

International financial markets and global financial stability

7.1 Corporate strategy in multinational enterprises

7.1.1 Main strategic reasons for Foreign Direct Investment
⚫ Market seeking
⚫ Raw material seeking
⚫ Production efficiency seeking
⚫ Knowledge seeking
⚫ Political safety seekers
⚫ Economies of scale
⚫ Managerial and marketing expertise
⚫ Technology

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7.1.2 Commonly companies establish an interest abroad by

⚫ Joint ventures
A joint venture is the commitment, for more than a very short duration, of funds, facilities and services
by two or more legally separate interests to an enterprise for their mutual benefit.
 The main advantages of joint ventures are
 Relatively low-cost access to new markets
 Easier access to local capital markets, possibly with accompanying tax incentives or grants
 Use of joint venture partner's existing management expertise, local knowledge, distribution
network, technology, brands, patents and marketing or other skills
 Sharing of risks
 Sharing of costs, providing economies of scale

 The main disadvantages of joint ventures are

 Managerial freedom may be restricted by the need to take account of the views of all the joint
venture partners.
 There may be problems in agreeing on partners' percentage ownership, transfer prices,
reinvestment decisions, nationality of key personnel, remuneration and sourcing of raw
materials and components.
 Finding a reliable joint venture partner may take a long time.
 Joint ventures are difficult to value, particularly where one or more partners have made
intangible contributions

⚫ Licensing
Licensing involves conferring rights to make use of the licensor company's production process on
producers located in the overseas market.
 The main advantages of licensing are
 It can allow fairly rapid penetration of overseas markets.
 It does not require substantial financial resources.
 Political risks are reduced since the licensee is likely to be a local company.
 Licensing may be a possibility where direct investment is restricted or prevented by a country.
 For a multinational company, licensing agreements provide a way for funds to be remitted to
the parent company in the form of licence fees.

 The main disadvantages of licensing are

 The arrangement may give the licensee know-how and technology which it can use in
competing with the licensor after the license agreement has expired.
 It may be more difficult to maintain quality standards, and lower quality might affect the
standing of a brand name in international markets.
 It might be possible for the licensee to compete with the licensor by exporting the produce to
markets outside the licensee's area.
 Although relatively insubstantial financial resources are required, on the other hand relatively
small cash inflows will be generated.

⚫ Management contracts
Management contracts whereby a firm agrees to sell management skills are sometimes used in
combination with licensing. Such contracts can serve as a means of obtaining funds from subsidiaries,
and may be a useful way of maintaining cash flows where other remittance restrictions apply.

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⚫ Overseas subsidiaries
The subsidiaries may be wholly owned or just partly owned by the parent company, and some may be
owned through other subsidiaries. The aim of setting up subsidiaries abroad is to increase the profits
of the multinational's parent company.
⚫ Branches
Firms may choose to establish a branch rather than a subsidiary abroad. Since the remitted profits of
a subsidiary will be taxed at a higher rate than those of a branch. And a subsidiary may be subject to
more legal and accounting formalities than a branch.

7.2 Theory and practice of international trade

⚫ Law of comparative advantage
Countries should specialise in the goods where they have a comparative advantage. And international trade
should be allowed to take place without restrictions on imports or exports.
⚫ Does the law apply in practice
The law of comparative advantage does apply in practice, and countries do specialise in the production of
certain goods. However, there are certain limitations or restrictions on how it operates.
 Free trade does not always exist. Some countries take action to protect domestic industries and
discourage imports.
 Transport costs can be very high in international trade so that it is cheaper to produce goods in the home
country rather than to import them.

7.2.1 Barriers to entry

⚫ Product differentiation barriers
An existing major supplier would be able to exploit its position as a supplier of an established product
that the consumer/customer can be persuaded to believe is better. A new entrant to the market would
have to design a better product, or convince customers of the product's qualities, and this might
involve spending substantial sums of money on R&D, advertising and sales promotion.

⚫ Absolute cost barriers

These exist where an existing supplier has access to cheaper raw material sources or know-how that
the new entrant would not have.
⚫ Economy of scale barriers
These exist where the minimum level of production needed to achieve the greatest economies of scale
is at a high level. New entrants to the market would have to be able to achieve a substantial market
share before they could gain full advantage of potential scale economies.
⚫ Fixed costs
The amount of fixed costs that a firm would have to sustain, regardless of its market share, could be a
significant entry barrier.
⚫ Legal barriers
These are barriers where a supplier is fully or partially protected by law. For example, there are some
legal monopolies (nationalised industries perhaps) and a company's products might be protected by
patent (for example, computer hardware and software).

7.2.2 Trade agreements

⚫ Protectionist measures
 Tariffs or customs duties
 Import quotas
 Hidden export subsidies and import restrictions
 Government action to devalue the currency

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⚫ Arguments against protection

 Reduced international trade - Because protectionist measures taken by one country will almost
inevitably provoke retaliation by others, protection will reduce the volume of international trade.
 Retaliation - Obviously it is to a nation's advantage if it can apply protectionist measures while
other nations do not. But because of retaliation by other countries, protectionist measures to
reverse a balance of trade deficit are unlikely to succeed. Imports might be reduced, but so too
would exports.
 Effect on economic growth - It is generally argued that widespread protection will damage the
prospects for economic growth among the countries of the world, and protectionist measures
ought to be restricted to 'special cases' which might be discussed and negotiated with other
countries.
 Political consequences - Although from a nation's own point of view protection may improve its
position, protectionism leads to a worse outcome for all. Protection also creates political ill-will
among countries of the world and so there are political disadvantages in a policy of protection.

⚫ Arguments in favour of protection

 Employment- Measures can be taken against imports of cheap goods that compete with higher
priced domestically produced goods, and so preserve output and employment in domestic
industries.
 Counter Dumping - Measures might be necessary to counter 'dumping' of surplus production by
other countries at an uneconomically low price.
 Infant industries - Protectionism can protect a country's 'infant industries' that have not yet
developed to the size where they can compete in international markets.
 Declining industries - Without protection, the industries might collapse and there would be se
problems of sudden mass unemployment among workers in the industry.
 Reduction in balance of trade deficit - The success of such measures by one country would depend
on the demand by other countries for its exports being inelastic with regard to price and its demand
for imports being fairly elastic.

⚫ Free trade
Free trade exists where there is no restriction on imports from other countries or exports to other
countries. Free trade can lead to greater competition and efficiency, and achieve better economic
growth worldwide. The European Union (EU) is a free trade area for trade between its member
countries.

⚫ The European Union

The EU is one of several international economic associations.
 There is no restriction on the movement of goods and services between countries.
 There is also complete mobility of the factors of production. A common market will also aim to
achieve stronger links between member countries, for example by harmonising government
economic policies and by establishing a closer political confederation.
 The single European currency, the euro, was adopted by 11 countries of the EU from the inception
of the currency at the beginning of 1999.

⚫ The World Trade Organisation (WTO)

To support the development of international trade, the WTO (with over 100 members) provides a
mechanism for
 To reduce existing barriers to free trade
 To eliminate discrimination in international trade such as tariffs and subsidies

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 To prevent the growth of protection by getting member countries to consult with others before
taking any protectionist measures
 To act as a forum for assisting free trade, by for example administering agreements, helping
countries negotiate and offering a disputes settlement process
 Establishing rules and guidelines to make world trade more predictable
The most favoured nation principle
The WTO encourages free trade by applying the 'most favoured nation' principle where one country
(which is a member of the General Agreement on Tariffs and Trade (GATT)) that offers a reduction in
tariffs to another country must offer the same reduction to all other member countries of GATT.

7.4 International monetary institutions

⚫ The International Monetary Fund (IMF)
The IMF's main purpose is to support the stability of the international monetary system by providing support
to countries with balance of payments problems.
Most countries are members of IMF. Where a member is having difficulties overcoming balance of payments
problems the IMF will
 offer advice on economic policy
 lend money, at subsidised rates to finance short-term exchange rate intervention
IMF loans are conditional on action being taken to reduce domestic demand, and are normally
repayable in three to five years. IMF loan conditions include
 The IMF wants countries which borrow from the IMF to get into a position to start repaying the loans
fairly quickly. To do this, the countries must take effective action to improve their balance of payments
position.
 To make this improvement, the IMF generally believes that a country should take action to reduce the
demand for goods and services in the economy (eg by increasing taxes and cutting government spending).
This will reduce imports and help to put a brake on any price rises. The country's industries should then
also be able to divert more resources into export markets and hence exports should improve in the longer
term.
 With 'deflationary' measures along these lines, standards of living will fall (at least in the short term) and
unemployment may rise. The IMF regards these short-term hardships to be necessary if a country is to
succeed in sorting out its balance of payments and international debt problems.
The IMF has been criticised as being controlled by those who don’t need funds, for failing to control its own
costs and for holding on to its substantial gold reserves.
⚫ The World Bank
The World Bank, partially funded by the IMF, exists to fund reconstruction and redevelopment. Loans are
normally made directly to governments, for periods of 10-20 years and tied to specific projects.
⚫ Central banks
Central banks normally have control over interest rates and support the stability of the financial system.
Collaboration between central banks is supported by the Bank of International Settlements (BIS).
In the context of international trade, a key role of the central bank is to guarantee the convertibility of a
currency (e.g. from £s to $s).

7.5 Developments in world financial markets

7.5.1 Tranching
A tranche is a slice of a security (typically a bond or other credit-linked security) which is funded by
investors who assume different risk levels within the liability structure of that security.
The structure of securitisation deals, referred to as tranching, is standard. In those transactions, claims
on cash flows generated by the collateral are split into several classes of notes, at least three and possibly
more than five (for example, Class A, Class B). Each class is called a tranche and has absolute priority in
the cash flows over the more junior ones.

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All the tranches together make up what is known as the deal's capital structure or liability structure.
They are generally paid sequentially, from the most senior to most junior. The more senior tranches
generally have higher ratings than the lower-rated tranches. For example, senior tranches may be rated
AAA, AA or A. A more junior tranche may be rated BB. Ratings can fluctuate after the debt is issued –
even senior tranches could be rated below investment grade (that is, below BBB).
Typical investors of senior tranches are insurance companies, pension funds and other risk-averse
investors.
Junior tranches are more risky, as they are not secured by specific assets. These tranches tend to be
bought by hedge funds and other investors looking for higher risk-return profiles.
⚫ Benefits of tranching
Tranching is a good way of dividing risk. Anyone who invests in risky loans is taking a chance, but
tranching lets you divide the chances up, so that people who want safety can buy the top (senior)
tranches, get less of a profit, but know that they're not going to lose out unless things go seriously
wrong. People who are willing to take their chances in the lower (junior) tranches know that they're
taking a significant risk, but they can potentially make a lot more money.
⚫ Risks of tranching
 Tranches are very complex; most investors do not really understand the risks associated with each
tranche.
 Tranches may not be divided properly, and the bundling process may be misleading. Investors are
obviously anxious to obtain the most senior tranche – the more junior tranches are more difficult
to 'get rid of'. Therefore some bundles of high-risk loans may be divided into tranches and, say, 80%
of the value of these loans sold as ultra-safe investments. Investors will be unaware of the level of
'rebundling' that occurred before they managed to obtain their 'senior tranche' low-risk bond.

7.5.2 Credit default swaps

Credit default swaps (CDSs) act in a similar way to insurance policies. When two parties enter into a credit
default swap, the buyer agrees to pay a fixed spread to the seller. In return, the seller agrees to purchase
a specified financial instrument from the buyer at the instrument's par value in the event of default.
You could liken this transaction to a house insurance policy – in the event of a fire, the buyer of the policy
will receive whatever the damaged or destroyed goods are worth in monetary terms.
The spread of a CDS is the annual amount the protection buyer must pay the protection seller over
the length of the contract (like an insurance premium), expressed as a percentage of the notional
amount. The more likely the risk of default, the larger the spread. For example, if the CDS spread of
the reference entity is 50 basis points (or 0.5%) then an investor buying $10 million worth of protection
from a bank must pay the bank $50,000 per year. These payments continue until either the CDS contract
expires or the reference entity defaults.
Unlike insurance, however, CDSs are unregulated. This means that contracts can be traded – or
swapped – from investor to investor without anyone overseeing the trades to ensure the buyer has the
resources to cover the losses if the security defaults.
⚫ Uses of CDS – speculation
The CDS market expanded into structured finance from its original confines of municipal bonds and
corporate debt and then into the secondary market where speculative investors bought and sold the
instruments without having any direct relationship with the underlying investment. Their behaviour
was almost like betting on whether the investments would succeed or fail.

7.5.3 Dark pool trading

Dark pools are off-exchange facilities that allow trading of large blocks of shares. They allow brokers
and fund managers to place and match large orders anonymously to avoid influencing the share price.
The transactions are only made public after the trades have been completed. Their popularity has
increased as electronic trading has resulted in the average size of trades being reduced. Traders
placing large orders on the transparent exchanges risk signaling that they are large buyers or sellers.
Such signals could cause the markets to move against them and put the order at risk.

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⚫ Problems with dark pool trading

The regulated exchanges do not know about the transactions taking place until the trades have
been completed. As a result, the prices at which these trades are executed remain unknown until
after the event.
Such a lack of information on significant trades makes the regulated exchanges less efficient. Dark
pools also take trade away from the regulated exchanges, resulting in reduced transparency as
fewer trades are publicly exposed. Such a practice could reduce liquidity in the regulated exchanges
and hinder efficient price-setting.

7.5.4 Initial coin offering

⚫ Definition:
 A company looking to create a new coin, app, or service launches an ICO.
 Interested investors buy in to the offering, either with fiat currency or with preexisting digital tokens
like ether.
 In exchange for their support, investors receive a new cryptocurrency token specific to the ICO.
 ICOs have rapidly come to dominate attention in the cryptocurrency and blockchain industries.

⚫ Initial Characteristics coin offering

 First, ICOs are decentralized, with no single authority governing them.
 Second, ICOs do not oversee them.
 Finally, as a result of decentralization and a lack of regulation, ICOs are much freer in terms of
structure than IPOs.

⚫ ICO Benefits
 A way to raising capital
 companies raising funds via ICO provide a blockchain like bitcoin, rather than a share: a
cryptocurrency token.
 the value of the tokens they purchased during the ICO will climb

⚫ Risks and Criticisms of the ICO

Technology
 Make sure to use a platform that is proven and tested
 Selecting the right blockchain is absolutely key
Legal/Regulation
 not regulated by financial authorities, funds that are lost due to fraudulent initiatives may never be
recovered.
Marketing/Investor Relations
 a team with a good business person, a good technologist and a good financial person, preferably
with someone who has been in the cryptocurrency industry for a while

7.6 International financial markets and global financial stability

7.6.1 Convergence of financial institutions
Many countries abolished restrictions on the integration of banking, insurance and stock trading.
This led to the creation of financial conglomerates with operations in banking, securities and insurance.
⚫ The advantages of the convergence include:
 The creation of economies of scale
 The creation of economies of scope
 The reduction of volatility of earnings

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 The saving of significant search costs for consumers since they can buy all financial products from
one source
 Common accounting standards increase transparency and comparability for investors

7.6.2 money laundering

Globalisation and the free movement of capital have created more opportunities for money laundering.
Money laundering is not only used by organised crime and terrorist organisations but it is also used to
avoid the payment of taxes or to distort accounting information.
Companies must assess the risk of money laundering in their business and take necessary action to
alleviate the risk.
⚫ How to deal with money laundering risk
 Customer due diligence
This is an official term for taking steps to check that your customers’ identity. Business should apply
customer due diligence when:
 Establishing a business relationship
 You have doubts about identification information that you obtained previously
 The customer’s circumstances change
 Assessing customer base
 New customers carrying out large, one-off transactions
 Customers who have been introduced to you by a third party who may not have assessed their
risk potential thoroughly
 Customers who aren't local to your business
 Customers whose businesses handle large amounts of cash
 Customers who are unwilling to provide identification
 Customers who enter into transactions that do not make commercial sense
⚫ How to deal with money laundering risk
 Ongoing monitoring of your business
Staff should be suitably trained to be alert to any potential issues. And a specific member of staff
should be nominated as the person to whom any suspicious activities should be reported.
⚫ Maintaining full and up to date records
Businesses are required to keep full and up to date records for financial reporting and auditing
purposes.

7.6.3 The global financial crisis

The globalisation of the financial markets has created more liquid, efficient and transparent markets, but
it has also created a higher risk of financial contagion, especially in emerging countries. Financial contagion
occurs when crisis in one country spills to other countries.
⚫ Credit crunch
A credit crunch is a crisis caused by banks being too nervous to lend money to customers or to each
other. When they do lend, they will charge higher rates of interest to cover their risk.
As a consequence of credit crunch, bank’s confidence was at an all-time low, they stopped lending to
each other. With bank lending so low, businesses were unable to obtain funding for investments,
resulting in large reductions in output and general business confidence. This lack of confidence had a
spiraling effect. As businesses cut back on production and provision of services, workers started to fear
for their jobs and thus reduced spending on non-essential items. This led to businesses reducing output
further to avoid excessive investment in inventories, workers were made redundant which led to even
less consumer spending and so the spiral continued.

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⚫ The European Sovereign Debt crisis

Since the European single currency is introduced, it assumed that member countries were following
the economic rules of the single currency. It meant that the good credit rating of Germany was
improving the credit rating of countries such as Greece, Portugal and Italy.
Some of the European countries used the increased credit offered to increase consumption and build
up large balance of payment deficits. The increased borrowing was based on the assumption of certain
levels of growth which then did not occur due to the financial crisis of 2007.
The European Sovereign Debt crisis has been increasing in severity since 2010 when Portugal's debt
was downgraded and further exacerbated in March 2011 when Greek debt was downgraded to 'junk'.
This was followed by Ireland being downgraded in July 2011 and Italy in October 2011. France and
Spain were both downgraded in 2012. In a similar manner to the US downgrade of 2011, this could
lead to an increase in the cost of government borrowing, which may lead to rising interest rates.

Globally, countries have been putting austerity measures in place in an attempt to reduce their
spiraling debts. The European Sovereign Debt crisis is a classic example of financial contagion.
As economies slow down, exporting companies suffer from a falling sales. And as government debt is
downgraded and the cost of debt increases, governments often pass on the cost to companies and
consumers in the form of higher interest rates. Therefore, companies with debt of their own will find
themselves trying to meet increasing interest payments while sales revenue is falling.
To try to combat the problem, companies may increase prices to recoup some of their lost sales
revenue. Consumers facing austerity measures in the form of pay cuts or freezes, or more expensive
essential services, will be unable to afford these higher prices and reduce their spending. Companies
will suffer further reductions in sales revenue and the spiral will continue until either confidence grows
again or they go out of business.
Currency fluctuations caused by the crisis can also have a significant effect on company performance.
The euro has weakened against the dollar due to the crisis, therefore Eurozone companies purchasing
goods from the US face increased prices.

8. Strategic business and financial planning for multinationals

Financing an overseas subsidiary

Strategic business and Capital mobility and blocked funds

financial planning for
multinationals Risk exposure

Agency issues

Multinational companies need to develop a financial planning framework in order to make sure that the strategic
objectives and competitive advantages are realised. Such a financial planning framework will include ways of
raising capital and risks related to overseas operations and the repatriation of profits.

8.1 Financing an overseas subsidiary

⚫ The choice of the source of funds will depend on
 The local finance costs, and any subsidies which may be available
 Taxation systems of the countries in which the subsidiary is operating
 Any restrictions on dividend remittances
 The possibility of flexibility in repayments which may arise from the parent/subsidiary relationship

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Multinational companies are able to borrow funds on the euro currency markets and on the euro bonds markets.
When a company decides to raise funds from the local equity market, the company must comply with the
requirements of the local exchanges for listing.

⚫ The listing requirements for the London Stock Exchange are

 Track record requirements
At least 75% of the entity's business must be supported by a revenue earnings record for the three-year
period. The UK listing authority has the discretion to allow a shorter period in certain circumstances.
The company must report significant acquisitions in the three years running up to the flotation.
 Market capitalisation
Market capitalisation and share in public hands
 At least £700,000 for shares at the time of listing
 At least 25% of shares should be in public hands
 Future prospects
 The company must show that it has enough working capital for its current needs and for at least the
next 12 months.
 The company must be able to carry on its business independently and at arm's length from any
shareholders with economic interest.
 A general description of the future plans and prospects must be given.
 If the company gives an optional profit forecast in the document or has already given one publicly, a
report will be required from the sponsor and the Reporting Accountant.

 Audited historical financial information

 This must cover the latest three full years and any published later interim period.
 If latest audited financial data is more than six months old, interim audited financial information is
required.
 Corporate governance
 Split the roles of chairman and CEO
 At least half of the board, excluding the chairman, should comprise independent non-executive
directors; smaller companies should have at least two independent non-executive directors
 Have an independent audit committee, a remuneration committee and a nomination
 committee.
 Provide evidence of a high standard of financial controls and accounting systems
 Acceptable jurisdiction and accounting standards
 The company must be properly incorporated.
 International Financial Reporting Standards and equivalent accounting standards are acceptable.

8.2 Capital mobility and blocked funds

Exchange controls block the flow of foreign exchange into and out of a country, usually to defend the local
currency or to protect reserves of foreign currencies. A government might
⚫ Ration the supply of foreign exchange
⚫ Restrict the types of transaction for which payments abroad are allowed.
⚫ Ways of overcoming blocked funds include
⚫ Transferring price
⚫ Royalty
⚫ Loan to a subsidiary - Parent company can set the interest rate high or low to affect the profits of both
companies
⚫ Management charge

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8.3 Risk exposure

⚫ Political risk
Political risk is the risk the political action will affect the position and value of a company.
Political risk can be assessed by the following factors.
 Government stability
 Political and business ethics
 Economic stability and inflation
 Level of import restrictions
 Remittance restrictions
 Assets seized
 Taxes and regulations on overseas investors
 Investment incentives
In order to limit the effects of political risk, multinational companies might adopt the following strategies.
 Negotiate with host government to obtain a concession agreement
 Take insurance from home country to obtain protection against various threats such as nationalisation,
currency conversion problems, war and revolution
 Obtain funds in local investment markets
 Operating as joint ventures with local investors

⚫ Litigation risks
Businesses that fail to comply with the law run the risk of legal penalties and accompanying bad publicity.
Companies should comply with best practice and being responsive to ethical concerns.
Companies should also implement systems to make sure that the company keeps abreast of changes in the
law, and staffs are kept fully informed. Internal procedures may be designed to minimise the risks from legal
action.

⚫ Cultural risk
Where a business trades with, or invests in, a foreign country additional uncertainty is introduced by the
existence of different customs, laws and language.
It is important for companies to be familiar with the following areas.
 The cultures and practices of customers and consumers in individual markets
 The media and distribution systems in overseas markets
 The different ways of doing business in overseas markets
 The degree to which national cultural differences matter for the product concerned
 The degree to which a firm can use its own 'national culture' as a selling point The balance between local
and expatriate staff must be managed.
 Using expatriate staffs may have the following advantages
 Better technical skills
 Easier to be controlled by senior managers
 Better able than locals to communicate with the corporate centre
 Know more about the firm overall
 Disadvantages of using expatriate in overseas markets
 Cost more
 Culture shock
 Require language training and cultural training
 Have less knowledge of the country

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⚫ Agency issues
Agency issues can be observed in all types and at all levels of organisations, for example between managers
at headquarters and managers of subsidiaries.
Solutions to agency problems can be
 Separate the ratification and monitoring of managerial decisions from their initiation and implementation.
 Managerial compensation packages, which align the interests of top executives with shareholders and
the interests of subsidiary managers to those of head office.
 A multiple of corporate governance mechanism work in unison.

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Other important study guide

1. Bound

kd calculation

Equal amount payment

Bond Bond duration

The modified duration

Convexity

1.1 Bond duration

Duration is the time of each cash flow weighted by its present value.
Example: A bond
(1) A five year 8% annual paying bond with an annual yield of 7% issued by XYZ corporation
(2) The duration of a similar zero coupon bond
The duration of a zero coupon bond is always equal to is life.

1.2 The modified duration

⚫ Gives the percentage change in the value of a bond for a 1% change in the yield.
⚫ Change in bond price= change in yield * modified duration* current value of bond
⚫ Modified duration = duration / (1 + annual yield)
Example: A bond continued
If the yield of the bond increases by 10 basis, its price should decrease by?
the modified duration is?
Comment
The modified duration will not give the correct price change for large changed in yield as the relationship
between the yield and price of a bond is not linear. But for small changes the relationship is very accurate.

1.3 Convexity
⚫ It is possible to find two bonds with similar durations and similar yields but which behave differently as yields
change.
⚫ The coupon bond shows clear advantages over the zero coupon bond.
⚫ Convexity measures the change in modified duration as yield changes.

Example: 2017-Jun-Q4

2. Dividend policy
2.1 Objective of a firm’s dividend policy
When deciding how much cash to distribute to shareholders, the company directors must bear in mind that the
firm’s objective is to maximize shareholder value.

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2.2 Dividend Irrelevancy Theory

Provided all retained earnings are invested in positive NPV projects, shareholder wealth will not be affected by
the dividend policy.
⚫ Assumptions: perfect capital market
 There are no taxes.
 There are no transaction costs, neither direct nor indirect.
 All investors have perfect information, as information is freely available.
In the real world these assumptions do not hold true. Changes in dividend policy, particular reductions in
dividends paid, can have an adverse effect on shareholder wealth.

⚫ Practical influences
 Brokerage fees
If shareholders have a preference for some current income and are paid low dividends or none at all, they
may have to sell some of their shares, which will reduce their wealth, as they will incur brokerage fees. If
shareholders have a preference for capital gains and they were paid a large dividend they would also
incur brokerage fees when they re-invest the dividends received.
 Issue cost of new funds
If a company has a positive NPV project to finance, it is usually cheaper to fund projects via retained
earnings, as most forms of external finance involve incurring considerable issue costs. When shares are
issued in addition to the administration fees, they would be professional advisers' fees, underwriting costs
and prospectus publishing costs. This can be 3% or more of the fees raised.
 The tax efficient
An individual shareholder will usually have a firm preference of how he/she wants his/her return to be
split between dividends and capital gains, as both are subject to different tax rules e.g. annual exemption
for capital gains. The preference will depend on the individual's tax position.
Shareholders are attracted to firms that follow dividend policies consistent with their tax planning
objectives.
 Dividend Signaling
In the real world shareholders do not have perfect information about the investments. Research suggests
that the dividend policy of the company gives a signal to shareholders about the company's performance.
An unexpected change in dividends is regarded as a signal of how the directors view the future prospects
of the company i.e. cut for whatever reason - financial problems.
 Conclusion
Dividend policy should be based on investor preferences for cash dividends now or capital gains in future
from enhanced share value resultant from re-investment into projects with a positive NPV.

2.3 Practical dividend policies

Policy

Constant payout Residual

Stable Zero payout
ratio approach

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⚫ Stable growth pattern

Directors seek to pay a dividend, which increases at a constant rate each year. This policy offers investors a
predictable cash flow and works well for mature firms with stable cash flows. The difficulty is in seeking to
maintain the dividend during recessionary periods.
⚫ Constant payout ratio
In this case a company pays out a certain proportion of its earnings each year. This policy maintains a link
between earnings, reinvestment rate and dividend flow but cash flow is unpredictable for the investor. And
it gives no indication of management intention or expectation.
⚫ Zero dividend policy
This policy is a common option taken by firms during their growth phase as all available surpluses are
reinvested within the business. However, the firm will exhaust its growth opportunities, the firm will begin
to accumulate cash, and a new distribution policy will be required.
⚫ Residual dividend policy
A dividend is paid only if no further positive NPV projects available. This may be popular for firms in growth
phase and. This results in and/or without easy access to alternative sources of funds. This results in a very
volatile dividend stream.

2.4 Share repurchases schemes

If a company wishes to return a large sum of cash to its shareholders, then it might consider a share repurchase
rather than a one-off special dividend.
These are schemes through which a company buys back its shares from shareholders and cancel them. It often
occurs when company
⚫ Has no positive NPV projects
⚫ Wants to increase the share price
⚫ Wants to reduce cost of capital by increase its gearing

⚫ Advantage of share repurchases scheme

For company For shareholders

 Do not have to maintain a high cash dividend level.

 Increase EPS
 Giving a choice of sell or not sell.
 Buying out dissident shareholders
 Saving transaction cost
 Altering capital structure to reduce cost of capital
 Reducing likelihood of a takeover

⚫ Constraints
 Getting approval by general meeting
 Company may pay too high a price for the share
 The shareholders may feel they have received too small a price
 Might be seen as a failure of the current management/company to make better use of the funds through
reinvesting

Dividend policy
2.5 Dividend policy in multinational companies
An additional factor for multinationals is that they have more than one dividend policy to consider
⚫ Dividends to external shareholders
⚫ Dividends between group companies, facilitating the movement of profits and funds within the group

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2.5.1 Dividend capacity for MNCs

Inflation Growth

Legal position Liquidity

Restrictive Blocked
covenants remittance

Dividend capacity
Profitability Access to other
affected by
source of fund

2.5.2 Dividend capacity for MNCs

The government of the host country imposes a restriction on the amount of profit that can be returned
to the parent company, this is known as a ‘block on the remittance of dividends’.
⚫ It is often done through the imposition of strict exchange controls.
⚫ It limits the amount of centrally remitted funds available to pay dividends to parent company
shareholders (i.e. restricts dividend capacity).

How the parent company might try to avoid such a block on remittances

Blocked remittances

Need to circumvent

Loan Transfer Patent Management charges Parallel

Royalties
interest prices fees or fee loan

Parallel loans (currency swaps), whereby the foreign subsidiary lends cash to the subsidiary of another
company requiring funds in the foreign country. In return the parent company would receive the loan of
an equivalent amount of cash in the home country from the other subsidiary’s parent company.

2.5.3 Estimating dividend capacity

Dividend capacity is determined by the free cash flow available to equity investors after net reinvestment.
Reinvestment is that which is required to maintain the operating capacity of the business at the planned
rate of growth. Where new capital has been introduced this is deducted from the capital expenditure
during the year to give the amount of investment financed from the free cash flow.

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⚫ Formula
$m
Operating cash flow X
Add: dividend from joint ventures X
Less: net interest paid (X)
Less: taxation (X)
Gross free cash flow to equity (before capital expenditure) X

Less: capital expenditure (X)

Less: acquisition (X)
Add: disposal X
Add/less: new capital issue/redemption X/(X)

Net free cash flow to equity (dividend capacity) X

Example: 2013-Jun-Q4

3. Performance Evaluating
⚫ Profitability
Gross profit margin; ROCE
Sales margin Asset turnover

⚫ Liquidity
Current ratio; Quick ratio

⚫ Risk
Financial gearing Interest cover

Example: 2015-Jun-Q2

2017-Dec-Q3

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