P4基础

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ACCA- Advanced Financial Management (AFM) Content
CONTENT
Part Advanced Investment Appraisal............................................................................................................... 3
Chapter 1 Capital cost and structure................................................................................................................... 3
1. The weighted average cost of capital – WACC ....................................................................................... 3
2. Risk adjusted WACC ................................................................................................................................ 5
Chapter 2 Investment Appraisal Format ............................................................................................................. 8
1. Net Present Value (NPV) ......................................................................................................................... 8
2. Adjusted Present Value (APV) ................................................................................................................. 8
3. International Investment...................................................................................................................... 10
4. Comments for investment appraisal..................................................................................................... 12
Chapter 3 Other investment appraisal techniques ........................................................................................... 14
1. Investment appraisal techniques that focus on profitability ................................................................ 14
2. Investment appraisal techniques that focus on liquidity ...................................................................... 16
3. Investment appraisal techniques that focus on risk ............................................................................. 16
Chapter 4 Capital rationing ............................................................................................................................... 18
1. Single period capital rationing .............................................................................................................. 18
Chapter 5 Option pricing model ........................................................................................................................ 21
1. Calculation of Basic Options.................................................................................................................. 21
2. Real option ............................................................................................................................................ 26
Part Acquisitions and Mergers .......................................................................................................................29
Chapter 6 Nature of acquisitions and mergers ................................................................................................. 29
1. Organic growth Vs growth by acquisition ............................................................................................. 29
2. Types of merger .................................................................................................................................... 29
3. Factors needs to be considered when M&A ......................................................................................... 30
4. Synergy .................................................................................................................................................. 30
5. Reasons for high failure rate when M&A.............................................................................................. 31
6. Regulation of takeovers ........................................................................................................................ 31
7. Defenses against a bid .......................................................................................................................... 32
Chapter 7 Valuation........................................................................................................................................... 33
1. Asset valuation model........................................................................................................................... 33
2. Valuing intangible ................................................................................................................................. 34
3. Relative valuation models ..................................................................................................................... 35
4. Flow valuation model ............................................................................................................................ 36
5. BSOP method for valuation................................................................................................................... 39
1
ACCA- Advanced Financial Management (AFM) Content
Chapter 8 Payment and financing in M&A ........................................................................................................ 42

1. Cash purchase ....................................................................................................................................... 42
2. Shares for share exchange .................................................................................................................... 42
Part Corporate Reconstruction and Reorganisation ........................................................................................45
Chapter 9 Credit risk and structure model ........................................................................................................ 45
1. What factors will be rating agencies consider? .................................................................................... 45
2. Credit ratings ......................................................................................................................................... 45
Chapter 10 Financial and business reconstruction ........................................................................................... 46
1. Financial Reconstruction ....................................................................................................................... 46
2. Business Re-organisation ...................................................................................................................... 46
Part Treasury and Advanced Risk Management ..............................................................................................49
Chapter 11 Interest rate risk ............................................................................................................................. 49
1. Forward rate agreement-(FRA) ............................................................................................................. 49
2. Interest rate guarantees – (IRGs) – options on FRAs ............................................................................ 49
3. Cap ........................................................................................................................................................ 49
4. Floor ...................................................................................................................................................... 49
5. Collar ..................................................................................................................................................... 49
6. Interest rate futures .............................................................................................................................. 50
7. Exchange traded options ...................................................................................................................... 51
Chapter 12 Foreign exchange risk ..................................................................................................................... 52
1. Forward contacts .................................................................................................................................. 53
2. Currency futures ................................................................................................................................... 53
3. Currency option .................................................................................................................................... 54
4. Netting .................................................................................................................................................. 54
Chapter 13 Interest and currency swaps........................................................................................................... 55
1. Interest swap......................................................................................................................................... 55
2. Forex swap ............................................................................................................................................ 55
3. Currency swap....................................................................................................................................... 55
4. Comments on swaps ............................................................................................................................. 56
2
ACCA-Advanced Financial Management (AFM) Chapter1
Part Advanced Investment Appraisal

Chapter 1 Capital cost and structure
1. The weighted average cost of capital – WACC
1.1 Formula of WACC
𝑬 𝑫
WACC = ke × A+ kd(1 - t)×
𝑬+𝑫 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-K Cost of debt-kd

e at
DVM CAPM Non-traded traded
No growth With growth ke=Rf+(Rm-Rf)×β Kdat=int rate (1-t)
k =PD0 D0 ×(1+g) Irredeemable Redeemable

e k= P0
+g
e
i(1−t)
k = IRR
dat P0
1.2 Portfolio theory
Expected return of portfolio = weighted average return of each shareRisk of portfolio:
𝜎port(A, B) =√σ2a x2+σ2b (1-x)2+2x(1-x)Cov(a,b)
𝜎port(A, B) =√σ2a x2+σ2b (1-x)2+2x(1-x)ρabσaσb
𝜎a = risk (standard deviation) of share A

x= proportion of A
Cov(a,b) = the covariance of share A and share B = ρab𝜎a𝜎b
1.3 Beta
Cov(e, m) 𝜌em 𝜎e 𝜎m 𝜌em 𝜎e
βe = = =
σm 2 σm 2 𝜎m
Cov(e,m)=covariance of return on the shares with returns on the market.
σm = total risk/standard deviation of the returns on the market.
σe = total risk/standard deviation of the returns on the shares.
ρem= correlation coefficient between returns on shares and the market.
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⚫ weighted average beta

βa+b= βa * x +βb*(1- x)
⚫ Problems with CAPM

 Assumes Investors hold well-diversified portfolio
 One period model
 Perfect capital market
 Estimation of future β based on past β
1.4 Calculation of return of market

⚫ We use DVM model to calculate the Rm
d0
Rm (return on FTSE) = (1 + g) + g
𝑃
Key:
d0
P
: dividend yield on the FTSE all share index.
g: nominal GDP growth = (1 + real GDP growth) x (1+inflation)
1.5 Calculation of kd
kd = yield + risk premium
Example: A COMPANY
You are the Chief Financial Officer of A company in the United States. The company’s current credit rating is
assessed at A+. Its total market capitalisation is $3500mn which includes a ten-year syndicated loan of
$500mn due for retirement in three years and 300 m new bondsredeemed at 10 years. The current nominal
yield curve and credit spreads for the retail sector are shown below:
4.7
3.7
2.7
2 3 5 7 10 30
Exhibit 1:30 year yield curve
Rating 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr
Aaa/AAA 4 8 12 18 20 30 50
Aa1/AA+ 8 12 20 30 32 35 60
Aa2/AA 15 24 30 34 40 50 65
Aa3/AA- 24 35 40 45 54 56 78
A1/A+ 28 37 44 55 60 70 82
A2/A 55 65 75 85 95 107 120
Exhibit 2 Yield spreads for retail sector (in basis points).
Required: Estimate the cost of debt
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2. Risk adjusted WACC

2.1 CAPM
E D(1−t)
βasset = βequity×E+D(1−t) + βdebt ×E+D(1−t)
Debt is often assumed to be risk-free and thus the βdebt = 0, in which case the formula reduces to:
E
βasset = βequity×E+D(1−t)
2.2 MM model
⚫ Modigliani and Miller Proposition 2 (with tax)
Vd
ke = k𝑖e +(1-T) (k𝑖e -kd)Ve
(Given in exam)
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Example:12-Dec-Q1
1 Coeden Co is a listed company operating in the hospitality and leisure industry. Coeden Co’s board of directors
met recently to discuss a new strategy for the business. The proposal put forward was to sell all the hotel properties
that Coeden Co owns and rent them back on a long-term rental agreement. Coeden Co would then focus solely on
the provision of hotel services at these properties under its popular brand name. The proposal stated that the funds
raised from the sale of the hotel properties would be used to pay off 70% of the outstanding non-current liabilities
and the remaining funds would be retained for future investments.
The board of directors are of the opinion that reducing the level of debt in Coeden Co will reduce the company’s
risk and therefore its cost of capital. If the proposal is undertaken and Coeden Co focuses exclusively on the
provision of hotel services, it can be assumed that the current market value of equity will remain unchanged after
implementing the proposal.
Coeden Co Financial Information
Extract from the most recent Statement of Financial Position
$’000
Non-current assets (re-valued recently) 42,560
Current assets 26,840
Total assets 69,400
Share capital (25c per share par value) 3,250

Reserves 1,780
Non-current liabilities (5·2% redeemable bonds) 42,000
Current liabilities 2,370
Total capital and liabilities 69,400
Coeden Co’s latest free cash flow to equity of $2,600,000 was estimated after taking into account taxation, interest
and reinvestment in assets to continue with the current level of business. It can be assumed that the annual
reinvestment in assets required to continue with the current level of business is equivalent to the annual amount
of depreciation. Over the past few years, Coeden Co has consistently used 40% of its free cash flow to equity on
new investments while distributing the remaining 60%. The market value of equity calculated on the basis of the
free cash flow to equity model provides a reasonable estimate of the current market value of Coeden Co.
The bonds are redeemable at par in three years and pay the coupon on an annual basis. Although the bonds are
not traded, it is estimated that Coeden Co’s current debt credit rating is BBB but would improve to A+ if the non-
current liabilities are reduced by 70%.
Other Information
Coeden Co’s current equity beta is 1·1 and it can be assumed that debt beta is 0. The risk free rate is estimated to
be 4% and the market risk premium is estimated to be 6%.
There is no beta available for companies offering just hotel services, since most companies own their own buildings.
The average asset beta for property companies has been estimated at 0·4. It has been estimated that the hotel
services business accounts for approximately 60% of the current value of Coeden Co and the property company
business accounts for the remaining 40%.
Coeden Co’s corporation tax rate is 20%. The three-year borrowing credit spread on A+ rated bonds is 60 basis
points and 90 basis points on BBB rated bonds, over the risk free rate of interest.
Required:
(a) Calculate, and comment on, Coeden Co’s cost of equity and weighted average cost of capital before and after
implementing the proposal. Briefly explain any assumptions made. (20 marks)
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(b) Discuss the validity of the assumption that the market value of equity will remain unchanged after the
implementation of the proposal. (5 marks)
(c) As an alternative to selling the hotel properties, the board of directors is considering a demerger of the hotel
services and a separate property company which would own the hotel properties. The property company would
take over 70% of Coeden Co’s long-term debt and pay Coeden Co cash for the balance of the property value.
Required:
Explain what a demerger is, and the possible benefits and drawbacks of pursuing the demerger option as
opposed to selling the hotel properties. (8 marks)
(33 marks)
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Chapter 2 Investment Appraisal Format

1. Net Present Value (NPV)
⚫ 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)
Example：2016-Sep/Dec-Q2-NPV
2. Adjusted Present Value (APV)

2.1 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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2.2 Investment Decision
Investment cashflow
keu
Calculate the Base NPV
2.3 Financing Decision

What rate should be used to discount the financing cash flows?As all financing cash flows are low risk they are
discounted at Kd.
⚫ PV of issue costs
 Grossing up method
 Example
 Finance required £2m (net of issue costs). Issue costs are 3%. Assume that the finance raised will also
have to cover the issue costs.
 Answers
 ￡2m×3/97 = ￡61,856
⚫ PV of cheap loan
 PV of the interest saved (opportunity benefit)
Annual int. saving = Total loan x interest rate X

Annuity factor for x years X
PV of int. saving X
⚫ PV of the tax relief on interest payments = PV of the tax shield

 If tax is delayed one year this is then a calculation of a deferred annuity as tax relief is first received in year 2.
Annual tax relief = Total loan x interest rate x tax rate X
Annuity factor for x years X
Present value factor year one (if tax is delayed one year) X
PV of the tax shield X
2.4 Comments on APV

⚫ Although APV appears complex, its step-by-step approach leads to a clear understanding of all the elements
of the decision process. It can evaluate both a project investment effects and its proposed financing package.
9
⚫ Can be used to evaluate a complex financing package. Quantify any type of financing advantage e.g. allows
management to evaluate the value of a cheap loan.
⚫ APV is based on M+M's with tax gearing theory. It therefore ignores bankruptcy risks, tax exhaustion and
agency costs. It also assumes that the debt is risk free and irredeemable.
Example：2014-Jun-Q2-APV
3. International Investment
3.1 Format
Year 0 1 2 3 4 5
Sales/Receipts FC FC FC FC FC FC
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 (x)
Tax (x) (x) (x)
Additional tax on taxable profits (x) (x) (x) (x)
Total cash flows Discount rate Present (x) x x x x (x)
value
(x) x x x x (x)
Net £ Present Value x/(x)
3.2 Remittances from Subsidiaries

⚫ Political Risk: is the risk that the host country government may take action that will affect the foreign
project/subsidiary thus affecting the value of the firm.
⚫ At one extreme the assets might be destroyed as the result of war or expropriation, however the most likely
problems concern changes to the rules on the remittance of cash out of the host country to the holding
company.
⚫ Companies may try and avoid such a block on remittances by:
Royalties Transfer Pricing Loan Interest Management Charges
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3.2.1 Transfer pricing

⚫ Objectives of transfer pricing
 Maintain divisional autonomy
 Maintain motivation for managers
 Assess divisional performance objectively
 Ensure goal congruence
 Pay lower taxes, duties, and tariffs
 Repatriate funds from foreign subsidiary companies to head office
 Be less exposed to foreign exchange risks
 Build and maintain a better international competitive position
 Enable foreign subsidiaries to match or undercut local competitors’ prices
 Have good relations with governments in the countries in which the multinational firm operates
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⚫ Local regulations and tax regimes

 Tax havens
 A tax haven is a country the has a series of unique characteristics, such as
 Relatively low tax rate
 Bank secrecy
 Strict privacy law
 Stable economy with low political risk
 Lack of exchange controls
 Good communications with the rest of the world
 Developed legal framework
 Import tariffs
 An import tariff is a schedule of duties imposed by a country on imported goods. The tariff can be
levied on a percentage of the value of the import, or as an amount per unit of import.
 Exchange controls
 Imposed by a government on the purchase/sales of foreign currencies by residents or on
the purchase/sales of local currency by non-residents
 Anti-dumping legislation
 ‘Dumping’ is the practice of selling goods/services in an overseas/foreign market at a price lower
than the price or cost in the home market. It might be without motive or it might have an
economic purpose such as trying to put competitors out of business. Anti-dumping legislation
is designed to minimize the impact of this practice.
 Ethical considerations
 There are a number of potential ethical issues for the multinational company to consider
when formulating its transfer pricing strategy
 Social responsibility, reducing amounts paid in customs duties and tax
 By passing a country’s financial regulation via remittance of dividends
 Not operating as a ‘responsible citizen’ in a foreign country
 Reputational loss
 Bad publicity
 Tax evasion
3.3 Exchange Rates

Example PPPT
Spot rate 1.7050 $/£
11
Estimated inflation rates are using PPPT calculate the future expected spot rate for the year three years.
Year USA UK
1 5% 2%
2 3% 4%
3 4% 4%
1+i1st
Our formula
1+i2nd
1.05
Year 1 1.7050 × [ ] = 1.7551
1.02
1.03
Year 2 1.7551 × [1.04] = 1.7382
1.04
Year 3 1.7382 × [ ] = 1.7382
1.04
3.4 Financing foreign projects

A firm planning to invest overseas may choose to raise the finance required inthe international financial
markets.
There is a variety of sources of finance available
⚫ Short-term funding
 Eurocurrency loans
 Syndicated loans
 Short-term syndicated credit facilities
 Multiple option facilities
 Euronotes
⚫ Long-term funding
 Syndicated loans
 Eurobonds
Example：2015-Jun-Q1-Oversea NPV
4. Comments for investment appraisal
4.1 Completeness and accuracy of cash flows

⚫ Overseas NPV comment
Purchasing Power Parity Theory can be used as our best predictor of future spot rates, however it is not
accurate because of the following:
 The future inflation rates are only estimates.
 The market is dominated by speculative transactions (98%) as opposed to trade transactions; therefore,
purchasing power theory breaks down.
 Government intervention: Governments may manage exchange rates, thus defying the forces pressing
towards PPPT.
4.2 Risk Analysis

The project risk should be analyse in more detail before acceptance. The level of analysis will depend on
the project's complexity and materiality. The risk can be analysed in a number of ways Le. Sensitivity analysis,
Scenario planning andsimulation.
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⚫ Overseas NPV comment

 Political Risk
 Evaluation: a multinational would evaluate both the macro risk factors using political risk tables and the
micro risk factors using a variety of techniques such as old hands, the grand tours, the Delphi technique
and quantitative methods.
 Management: of political risk should be one of multinational's highest priorities. Pre-investment strategies
include entering a concession agreement with the host government and taking out political risk insurance.
Post investment strategies include the production of key components abroad, borrowing locally or
worldwide and entering joint venture agreements with local private companies.
 Economic risk
 Economic risk encompasses long term effects of real changes in exchange rates on the market value of
a firm. Economic risk is difficult to quantify but a favoured strategy is to diversity internationally, in
terms of sales, location of production facilities, raw materialsand financing.
4.3 Qualitative factors

⚫ Strategic fit of new project
 Will the project fit into our overall corporate strategy?
 The views of major institutional shareholders
 Will the company's lead investors believe it is a worthwhile project to be undertaken?
 Our shareholders confidence is crucial to maintaining or increasing the share price.
⚫ The real options - (options on real physical assets)

 The conventional NPV approach ignores the potentially valuable real options.
 Opportunities to respond to changing future circumstances in capital investment projects are known as
real options. This includes actions that can be taken after the project has commenced to alter the cash
flows or any future opportunities that arise as a result of having undertaken the project.
 The existence of real options can significantly add to the value of an investment. If investments are judged
only on their expected NPV, and the value embedded in the options are ignored, then an incorrect decision
might result.
⚫ Effect on other stakeholders

 Employees, creditors, debentures holders and the local community
 Managerial resources
 Have we the in house managerial resources to deliver this project. What will the impact be, on our current
operational capabilities?
 The project teams
 The communication skills, enthusiasm and commitment of the project team are as vital to the success of
the project. It is important to ensure that they have an adequate budget to fund all the necessary support
systems.
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Chapter 3 Other investment appraisal techniques

1. Investment appraisal techniques that focus on profitability
1.1 IRR
⚫ Internal rate of return (IRR) of bond
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%+ NL-N ×（H% -L%）
H
⚫ Convertible debt
Convertible debentures give the holder the right not obligation to convert $100 into a no. of shares.
0 (MV) (X) (X)
1-n interest*(1-t) X X
n Higher of (1) redemption (2) X X

conversion value
NPV = NL NPV = NH
NL
H
⚫ Internal rate of return (IRR) for project appraisal

IRR is used in project appraisal to calculate the % return given by a project.
0 (investment) (X) (X)
1 cf X X
n cf X X
NPV = NL NPV = NH
NL
H
⚫ There are a number of problems with the standard IRR calculation

 The decision rule: unconventional projects with different cash flow patterns may have no IRR, more than
one IRR, or a signal IRR.
14
 The assumptions: IRR assumes that the discount rate is the cost of financing the project and is the return
that can be earned on all the returns earned by the project. However, in practice, these rates are likely to
be different, the IRR is unreliable.
 Choosing between project: a project with a high IRR is not necessarily the one offering the highest return
in NPV terns and IRR is therefore an unreliable tool for choosing between mutually exclusive projects.
1.2 MIRR
MIRR = Project’s return
If Project return > Company cost of finance: Accept project
n Terminal value of return phase
MIRR= √ -1
Present value of investment phase
Example –MIRR
A project requires an initial investment of $20,000 and will generate annual cash
flows as follows:
Year Investment phase Return phase

0 -20000
1 4000
2 -2000
3 6000
4 7600
5 10,000
The finance rate (for investment phase) is 12% while the reinvestment rate (for return phase) is equal to the
finance rate.
Required:
What is the MIRR?
⚫ Marginal growth rate

 If we assume that finance and reinvestment rates are the same, then there is a short-cut for calculating
the MIRR.
 The marginal growth rate (MGR) indicates the growth in shareholder value for a project (at the discount
rate).
𝐏𝐕 𝐨𝐟 𝐫𝐞𝐭𝐮𝐫𝐞𝐧 𝟏
1 + MGR = [ ] 1 + MIRR = (1 + MGR)(1 + i)
𝐏𝐕 𝐨𝐟 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐧
Where:
i = discount rate used to calculate the NPV in the first place
Example –MGR and MIRR

A project with the following cash flows is under consideration:
$000 Y0 Y1 Y2 Y3 Y4
Cash flow (20,000) 8,000 12,000 4,000 2,000
15
Cost of capital 8% NPV at 8% = $2,340

Required: calculate the MGR and MIRR
⚫ Comments for MIRR

 Will be unique
 Can deal with different borrowing and reinvestment rates
 Gives the same ranking as the standard NPV approach
 It is a simple percentage
2. Investment appraisal techniques that focus on liquidity

2.1 Project Recovery
Recovery = (PV of investment / PV of return) ×project life
2.2 Duration
The average time taken to recover the value of the project.
Example – Friendly Grinder Project

Projection of the net cash flow for Friendly Grinders project, the cost of capital for the project is 8%.
0 1 2 3 4
Capital investment (34,000)
Incremental project cash flow 7,600 16,500 13,000 10,600
Decommissioning costs (4000)
Net cash flow (34,000) 7,600 16,500 13,000 6,600
Required: Calculate Project duration.
3. Investment appraisal techniques that focus on risk

3.1 Project value at risk (VaR)
⚫ Value at risk (VaR) is a measure of how the market value of an asset or of a portfolio of assets is likely to
decrease over a certain time, the holding period (usually one to ten days), under normal market conditions.
⚫ It is typically used by security house or investment banks to measure the market risk of their asset portfolios.
⚫ VaR = amount at risk to be lost from an investment under usual condition over a given holding period, at
particular confidence level.
⚫ Monte Carlo simulation is used to create the distribution of possible outcomes. After a large number of
iterations have been performed, a distribution is computed.
⚫ Confidence levels are usually set at 95% or 99%.
i.e. for a 95% confidence level, the VaR will give the amount that has a 5% chance of being lost.
3.2 Formulation of Value at Risk

X−μ
Z= σ
VaR = Zσ
Time adjusted:
VaR = Zσ × √T
Example – VaR
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A company has estimated that the expected NPV of a project for five years time will be $50 million, with a
standard deviation of $18.85 million per annum.
Required:
(a) Using a 95% confidence level, identify the value at risk.
(b) Estimate the probability that the project will have a negative NPV.
Example：2014-Dec-Q3
17
Chapter 4 Capital rationing

1. Single period capital rationing
⚫ There is a shortage of funds in the present period that will not arise in following periods. In this situation we
can use profitability index to rank the project and calculate the maximum NPV.
𝐍𝐏𝐕+𝐈𝐧𝐯𝐞𝐬𝐭
Profitability Index = 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
Example – CAPITAL RATIONING

Slow Fashions
Slow Fashions Ltd is considering the following series of investments for the current financial year 2018：
Project bid proposals ($'000) for immediate investment with the first cash return assumed to follow in 12
months and at annual intervals thereafter.
There is no real option to delay any of these projects. All except project P0801, can be scaled down but not
scaled up. P0801 is a potential fixed three-year contract to supply a supermarket chain and cannot be varied.
The company has a limited capital budget of $1.2 million and is concerned about the best way to allocate its
capital to the projects listed. The company has a current cost of finance of 10% but it would take a year to
establish further funding at that rate. Further funding for a short period could be arranged at a higher rate.
Required:
The priori ties for investment
18
2. Multi-period capital rationing
Example: Multi-period capital rationing

A company has identified the following independent investment projects, all of which are divisible and exhibit
constant return to scale. No project can be delayed or done more than once.
Project cash flow at time
0 1 2 3 4
$000 $000 $000 $000 $000
A (10) (20) 10 20 20
B (10) (10) 30 - -
C (5) 2 2 2 2
D - (15) (15) 20 20
E (20) 10 (20) 20 20
F (8) (4) 15 10 -
There is only $20,000 of capital available at year 0 and only 5,000 at year 1, plus the cash inflow from the
projects undertaken at year 0. In each time period thereafter, capital is freely available. The appropriate
discount rate is 10%
Required:
(a) Formulate the NPV linear programme.
(b) Formulate the PV of dividend linear programme.
Answer:
(a) Formulate the NPV linear programme.
Since our objective is to maximise the total NPV from the investments the first stage will be calculate those
NPVs at a discount rate of 10%
Project NPV@10%
$000
A 8.77
B 5.70
C 1.34
D 2.65
E 1.25
F 8.27
We now progress as for a standard linear programme:

1. Define the unknowns
The linear programme will then select the combination of projects, which will maximise the total NPV
Therefore :
Let a = the proportion of project A undertaken
Let b = the proportion of project B undertaken
Let c = the proportion of project C undertaken
Let d = the proportion of project D undertaken
Let e = the proportion of project E undertaken
Let f = the proportion of project F undertaken
And z = the NPV of the combination of projects selected.
2. Formulate the objective function

The objective function to be maximised is:
z = 8.77a + 5.70b + 1.34c +2.65d +1.25e +8.27f
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3. Express the constraints in terms of inequalities including the non-negativities

Subject to the constraints:
Time 0: 10a + 10b + 5c + 20e + 8f < 20
Time 1: 20a + 10b + 15d + 4f < 5 + 2c +10e
Also: 0 < a, b, c, d, e, f ,1
4. Interpret the results

The linear programme when solved will give a values for a, b, c, d, e and f. these will be the proportions of each
project which, should be undertaken to maximise the NPV – an amount given by Z.
(b) Formulate the PV of dividend linear programme.

This method is more flexible and removes the need to calculate the NPVs of the projects as this is taken care of
by the linear programme itself.
The objective is to maximise the cash flows for dividend during the life span of the available projects.
1. Define the unknowns

The linear programme will then select the combination of projects, which will maximise the total NPV
Therefore :
Let a = the proportion of project A undertaken
Let b = the proportion of project B undertaken
Let c = the proportion of project C undertaken
Let d = the proportion of project D undertaken
Let e = the proportion of project E undertaken
Let f = the proportion of project F undertaken
But for the objective function:

And z = the PV of dividend
In addition, the dividend flows must be defined:

Let d0 = dividend flow generate at T0 by the projects selected.
2. Formulate the objective function

The objective function to be maximised is:
𝑑 𝑑 𝑑 𝑑 𝑑
z = 0 + 1 + 22 + 33 + 44
1 1_1 1_1 1_1 1_1
3. Express the constraints in terms of inequalities including the non-negativities

Time 0: 10a + 10b + 5c + 20e + 8f +d0 <20
Time 1: 20a + 10b +15d +4f + d1 < 5 + 2c +10e
Time 2: 15d + 20e + d2 < 10a +30b +2c + 15f
Time 3: d3 < 20a +2c +20d +20e +10f
Time 4: d4 < 20a +2c + 20d +20e
Also: 0 <a, b, c, d, e, f <1
And: d0, d1, d2, d3,d4 >0
4. Interpret the results

The linear programme when solved will give values for a, b, c, d, e and f.
There will be the proportions of each project, which should be undertaken to maximise the PV of dividends – an
amount given by z.
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Chapter 5 Option pricing model

1. Calculation of Basic Options
1.1 Formula
The value of an option = Intrinsic Value + Time

Value
Current share price Time period to expiry
Exercise price Risk Free interest rate
Volatility of the share price

Before expiry date Expiry date
⚫ Intrinsic value
An option's basic or fundamental price or value. It is the profit that a purchaser could make if the option
were exercised immediately.
⚫ The time value

Summary of the determinants of Option Prices
Increase in Call Put
Share Price Increase Decrease
Exercise Price Decrease Increase
Time to expiry Increase Increase
Volatility-σ Increase Increase
Interest rate Increase Decrease
1.2 The Black Scholes Modes -BSOP

⚫ Plugging the number to the Black Scholes Formula
The formula is daunting, but fortunately you do not need to learn it, as it will be given in the exam paper. You
need only be aware the variables which it includes, that is be able to plug in the numbers.
Value of a call option =Ps N(d1)-Xe-rT N(d2)
Where
In (Ps/X) + rT
d1 = + 0.5σ√T
σ√T
d2 = d1 − σ√T Calculate d1+ d2 to two decimal places.
21
The key:
P = Current share price.

s
X = Exercise price.
r = Risk free rate of interest.
T = Time until expiry of option, in years.
σ = volatility of the share price (as measured by the standard Deviation expressed as a decimal)
N(d) = Equals the area under the normal curve up to d (see normal distribution
tables)
e = 2.71828, the exponential constant
In = The natural log (log to the basee)
Xe = Present value of the exercise price calculated by using the continuous discounting
-rT
factors
Example
The current share price of B plc shares = ￡100
The exercise price = ￡95
The risk-free rate of interest = 10% pa
The standard deviation of return on the shares return = 50% The time to expiry - 3 months (one quarter of a
year i.e..25)
Required: Calculate the value of a call option?

The formula is daunting, but fortunately you do not need to learn it, as it will be given in the exam paper. You
need only be aware the variables which it includes, that is be able to plug in the numbers.
Example
Answer:
Step 1: Calculate d1 and d2
ln (Ps/X) + rT
d1 = + 0.5σ√T
σ√𝑇
ln (100/95) +0.1∗.25
d1 = 0.5√.25
+ 0.5 0.5√. 25
.051 +0.025
d1 = + .125
.25
d1 =0.43
d2 = d1 -σ√T
= 0.43 - 0.5 ∗ σ√. 25
= 0.18
Step 2: Use normal distribution tables to find the value of N(d1) and N(d2)
N(d1) =0.5 + 0.1664=0.6664
N(d2) =0.5+0.0714=0.5714
Step 3: Plug these numbers into the Black-Scholes formula

Value of a call option = Ps N(d1)-Xe-rT N(d2)
= 100*0.6664-95e-(0.1* .25)0.5714
= 66.64-92.65*0.5714
= 13.70
The intrinsic value is (100 -95) ￡5 and the time value is ￡8.70
⚫ Put – Call Parity Theorem
If you have calculated the value of a call option using Black-Scholes, then the value of a corresponding put
option can be found using the put call parity formula.
22
This relationship is known as put call parity theorem and it is on the exam formula sheet:
Call P =P P +
Using the put – call parity to value European put options
Continue example
Returning to the early exercise of B plc, where the current share price is ￡100, exercise price is￡95, the risk
free rate of interest is 10%, the standard deviation of
shares return is 50% and the time to expiry is 3 months.
Required: Calculate the value of a put option?
Answer:
Step 1: We have already calculated the value of the call option at ￡13.70
Step 2: Using put call parity
￡13.70 ￡100.00
Call Price Buy a share
+ =
+
Invest the PV
Put price
of the exercise price
-(0.1*.25)
￡95e =92.65
=￡13.70+92.65 -￡100.00= value of a put
=￡6.35
Value of option = Intrinsic Value +Time value
￡6.35 = ￡0 + ￡6.35
1.3 Exam technique in calculation of option

⚫ The risk-free rate adjustment
In option pricing we are using continuous time discounting and the more accurate estimate of the
continuously compounded rate of return is given by:
r = In (1+Rf)
⚫ Dividends adjustment
 Calculate the dividend adjusted share price
 Ps, becomes Ps - PV (dividends) in the Black Scholes formula
⚫ Estimate volatility
 Time adjusted
𝛔 = 𝐬 √𝐭
Where s is the standard deviation of the sample of individual daily returns, t is the number of time periods
in one year. This, for daily data, is normally set as the number of trading day during a year (250 days)
Example - Johnson Matthey

The volatility of the daily returns for Johnson Matthey is 1.3507 percent. The current risk-free rate is 5.34 per
cent based upon the reported yield on a UK one-month Treasury Bill. The current share price for the company
23
is 1639p and the latest dividend yield is 2.1 per cent payable in 90 days later.
Required:
(a) Calculate the annualised volatility for Johnson Matthey and the continuously generated risk-free rate.
(b) Calculate the value of an at the money 90-day call option and, using the put call parity relationship, the value
of a 90-day put option. Both calculations are on the assumption of a European style option and should be
dividend adjusted.
⚫ In the money
If an immediate exercise results in a gain i. e. a positive intrinsic value
⚫ Out of the money
When an option is allowed to lapse to prevent a loss arising i.e. a zero intrinsic value
⚫ At the money
When the share price is equal to the exercise price
1.4 Limitation of the Black Scholes Model

The model assumes that
⚫ The options are European calls.
⚫ There are no transaction costs or taxes.
⚫ The investor can borrow at the risk-free rate.
⚫ The risk-free rate of interest and the share’s volatility is constant over the life of the option.
⚫ It assumes that future share price volatility can be estimated by observing past share price volatility.
⚫ It assumes that the share price follows a random walk and that the possible share prices are based on a
normal distribution.
⚫ No dividends are payable before the option expiry date. (although it is possible to modify the model for
European options see below)
1.5 Sensitivity of options

⚫ The delta is the change in the price of an option for a ￡1 increase in the share price.
 The Delta of call option
Change in the call option price
 Delta Δ = N(d1) = Change in share price
 The delta of put option

Change in the put option price
 Delta Δ =- N(-d1) = Change in share price
⚫ 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)
⚫ Comment on using option to hedge

 Advantages
 Hedging with options eliminates downside risk and is particularly useful when the exposure isuncertain.
 Risk
 Cost: The cost of this type of hedge can be very high.
 Size: Trade option (standard contract size) may not be possible to create a perfect hedge.
 Timing risk: The duration of option may be less or more than protection period.
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 Rebalancing risk: Delta changes as the share price change, to establish a perfect hedge, company need
rebalancing.
Example: Option valuation

An investor holds 200,000 shares in D plc and is considering buying some put options to hedge her investment.
D's current share price is ￡6. The risk-free interest rate is currently 12
% pa and the recent volatility of D plc shares has been 30% pa. She requires European put options with an
exercise price of ￡5 for exercise in two years time.
Required:
(a) Calculate the value that the bank is likely to charge for one put options of the investor's required
specification.
(b) Calculate the number of put option to be bought to hedge the position and their value.
(10 marks)
(2 marks)
(c) A friend informs the investor that she could achieve a safer position by selling call options to construct a
delta hedge. Calculate the number of call options to be sold to construct a delta hedge.
(3 marks)
(Total: 15 marks)
1.6 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
⚫ Rebalancing
 This portfolio will still need rebalancing as the delta value changes.
Change of Delta with Change in Share Price
1.20
1.00
0.80
0.60
Delta
0.40
0.20
0.00
0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60 64 68 72 76 80 84 88 92 96 100
Share Price(X=50)
 If an option is at the money it then the delta is approximately 0.5, as the share price increase by￡1 the
option price increases by ￡0.5.
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2. Real option
⚫ Four generic real options
Real Option Nature of the real option
Delay Call option on the NPV of the project
Expand/contract Call/put option on the cash flows resulting from changed capacity
Call option on the cash flows that would be generated in the alternative use (may
Redeploy
also be extended to a choice between two or more valuable alternatives)
Abandon Put option to sell (dispose) of the assets
26
Example:2011-Jun-Q4
4 MesmerMagic Co (MMC) is considering whether to undertake the development of a new computer game based
on an adventure film due to be released in 22 months. It is expected that the game will be available to buy two
months after the film’s release, by which time it will be possible to judge the popularity of the film with a high
degree of certainty. However, at present, there is considerable uncertainty about whether the film, and therefore
the game, is likely to be successful. Although MMC would pay for the exclusive rights to develop and sell the game
now, the directors are of the opinion that they should delay the decision to produce and market the game until the
film has been released and the game is available for sale.
MMC has forecast the following end of year cash flows for the four-year sales period of the game.
Year 1 2 3 4
Cash flows ($ million) 25 18 10 5
MMC will spend $7 million at the start of each of the next two years to develop the game, the gaming platform,
and to pay for the exclusive rights to develop and sell the game. Following this, the company will require $35 million
for production, distribution and marketing costs at the start of the four-year sales period of the game.
It can be assumed that all the costs and revenues include inflation. The relevant cost of capital for this project is
11%and the risk free rate is 3·5%. MMC has estimated the likely volatility of the cash flows at a standard deviation
of 30%.
Required:
(a) Estimate the financial impact of the directors’ decision to delay the production and marketing of the game.
The Black-Scholes Option Pricing model may be used, where appropriate. All relevant calculations should be
shown. (12 marks)
(b) Briefly discuss the implications of the answer obtained in part (a) above. (5 marks)
(17 marks)
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Example：2016-Jun-Q4-Expansion option
Example: Abandonment option

The conditions have turned favourable for the production of nuclear grade carbon dust under the NASA
agreement. The Board of Directors of Friendly Grinders Plc has decided on the immediate commencement of
the project. Its latest estimate of the net present value of this project is 10 million against the capital build of 90
million. The licence agreement with NASA is indefinite but the life of the current project is ten years. Friendly
Grinders would have the option to sell the technology on for an estimated 40 million. The expected volatility on
the future cash flows is 45%, and the risk-free rate of return is 5%.
Required: whether the project is financially accepted?
Solution:
A B C D
1 Black and Scholes Option Pricing Model(Put)
2
3 Current price 100.00
4 Exercise price 40.00
5 Risk free rate 0.05
6 Time to exercise(years) 10
7 Volatility 0.4500
8
9 d1 1.70678
10 d2 0.28376
11
12 N(d1) 0.04393
13 N(d2) 0.38830
14
15 Put value 5.03
16
This suggests that the net present value of this project is somewhat more than the 10 million identified through
conventional net present value analysis but is now 15.03 million reflecting the value of the abandonment option.
Given that the option to abandon is available at any time during the life of the project then we would expect the
option premium to be more than the £5.03 million calculated for a European style option.
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Part Acquisitions and Mergers

Chapter 6 Nature of acquisitions and mergers
1. Organic growth Vs growth by acquisition
⚫ Organic growth
Organic growth is internally generated growth within the firm.
⚫ Advantages of organic growth and disadvantages of growth by acquisition
 Organic growth permits an organisation to carefully plan its strategic growth in line with stated objectives.
It is less risky than growth by acquisition, which occurs at one go.
 The cost is often much higher in an acquisition. As the bidding company usually has to pay a significant
acquisition premium to acquire the target company.
 Post-acquisition integration problems. The integration process is often a difficult process due to cultural
differences between the two companies.
 An acquisition places an immediate pressure on current management resources to learn to manage the
new business.
⚫ Disadvantages of organic growth and advantages of growth by acquisition
 If a company has chosen to enter a particular market, the quickest way is to purchase an established
company in the product or geographical market. The alternative is to grow organically which may lead to
oversupply and excessive competition.
 To eliminate competition and increase market power in order to be able to exercise some control over
the price of the product. A company may be able to push up the price of the goods sold because customers
have few alternatives e.g. monopoly or by collusion with other producers.
 To acquire the target company's highly trained staff. To apply their talent, knowledge and techniques to
the parent company's existing and future product lines to give them a competitive edge.
 Acquisition enables a company to quickly take advantage of a market opportunity.
2. Types of merger
2.1 Horizontal integration
Two companies in the same industry, whose operations are very closely related, are combined.
⚫ Main motives: economies of scale and increased market power.
⚫ Disadvantage: can be referred to the Competition Commission.
2.2 Vertical integration

Two companies in the same industry, but from different stages of the production chain merger.
⚫ Existing supplier - Leather producer
⚫ Acquirer - Manufacturer of footwear
⚫ Existing customer - Retailer of shoes
E.g. Major players in the oil industry tend to be highly vertically integrated.
⚫ Main motives: Increased certainty of supply or demand and just-in-time stock systems leading to major
savings in stock holding costs.
⚫ Disadvantage: Increasing in operating gearing
2.3 Conglomerate integration

A combination of unrelated businesses, there is no common thread and the only synergy lies with the
29
management skills
⚫ Main motives: Risk reduction through diversification and cost reduction.
⚫ Disadvantage: Low synergy
3. Factors needs to be considered when M&A

⚫ Disclosure risk: It is important to ensure that the information on which the acquisition is made is reliable and
fairly represents the potential earning power, financial position and cash generation of the target company.
⚫ Valuation risk: A substantial acquisition has the potential to alter the acquirer's exposure to financial risk or
its exposure to business risk. This in turn can affect the value its equity investors place on its existing
operations.
⚫ Regulatory risk: An acquisition may raise concern with the government or with other regulatory agencies if
it is seen to be against the public interest. This is particularly likely in the case of horizontal integration where
the combined market share may be perceived as being unfair.
⚫ Combined market power of the entities—this may allow selling price increases and rationalization of the
product range.
⚫ Skills transfer—each firm may have particular strengths that can be transferred into the other as part of an
internal benchmarking process leading to best practice throughout the group.
⚫ Disposal of surplus assets— if there is overlap or even duplication of activities (e.g. research
⚫ and development) then there is potential for rationalisation.
⚫ Security of supply chain— vertical integration backwards may not only reduce input costs but lead to
guaranteed security of the supply of key components.
⚫ Utilisation of brought forward tax losses—the parent firm's tax system may allow brought forward losses in
the acquired firm to be offset against future group profits
4. Synergy
Synergy occurs when combined entity is worth more than the sum of the companies apart.
⚫ Cost Synergy
 Economies of Scale
 Occur through such factors as fixed operating and administrative costs being spread over a larger
production volume. As a result of consolidation of manufacturing capacity on fewer and larger sites, use
of space capacity, increased buyer power i.e. bulk discounts or savings on duplicated central services and
accounting staff costs.
 Economies of Scope
 May occur in marketing as a result of joint advertising and common distribution.
 Elimination of Inefficiency
 If the 'victim' company in a takeover is badly managed itsperformance and hence its value can be
improved by the eliminationof inefficiencies. Improvements could be obtained in the areas ofproduction,
marketing and finance.
⚫ Revenue Synergy
 Monopoly power—leading to possible price increases, although this may attract the attention of
regulators.
 Cross-selling opportunities (i.e. referring customers to products or services provided by other group
companies).
 Surplus assets—can be sold off and proceeds invested in new projects.
⚫ Financial Synergy
 Tax shields/accumulated tax losses
 Another possible financial synergy exists when one company in an acquisition or merger is able to use tax
shields or accumulated tax losses, which would have been unavailable to the other company.
30
 Surplus cash
 Companies with large amounts of surplus cash may see the acquisition of other companies as the only
possible application for these funds. Of course, increased dividends could cure the problem of surplus
cash, but this may be rejected for reasons of tax or dividend stability.
 Corporate risk diversification
 One of the primary reasons put forward for all mergers but especially conglomerate mergers is that the
income of the combined entity will be less volatile (less risky) as its cash flows come from a wide variety
of products and markets. This is a reduction in unsystematic risk but has little or no effect on the
systematic risk.
 Corporate Risk Diversification: - Exam Focus. Will this benefit the shareholders?
 Basic answer: No.
 Shareholders should diversify for themselves, because a shareholder can more easily and cheaply
eliminate unsystematic risk by purchasing unit trusts. Indeed, the majority of investors are well diversified.
Therefore, the more expensive company diversification option is generally not recommended
 Additional answer: However, diversification may have some advantages for shareholders.
 A greater stability of earnings may improve a company's credit rating making it easier and/or cheaper to
get a loan thus lowing the cost of capital and increasing shareholder wealth.
 As a result of the reduced total risk a diversified company may have a lower risk of corporate failure and
of incurring expensive bankruptcy costs.
 If the diversification is into foreign markets where the individuals cannot directly invest themselves this
may lead to a reduction in their systematic risk. However, as it gets easier for individuals to gain access to
foreign markets this argument diminished.
5. Reasons for high failure rate when M&A

⚫ Overvaluation of the target company leading to excessive bid premiums being paid.
⚫ High transaction costs.
⚫ High costs of integrating the companies' systems.
⚫ Actual synergy benefits being less than expected.
⚫ Negative synergy effects (e.g. due to cultural conflict).
⚫ Agency problems, where the directors of the acquiring firm are more interested in "empire building" than in
generating added value for their shareholders.
⚫ Over-optimistic assessment of potential economies of scale.
⚫ Insufficient appreciation of the problems of the merger, in particular personnel problems.
⚫ Excessive concern with matters such as dominance of the boards of directors.
⚫ Inaccurate assessment of future resource needs.
⚫ Incompatibility of systems/processes.
6. Regulation of takeovers
6.1 City Code for Takeovers

The City Code for Takeovers is designed to create equitable treatment between the shareholders of the target
company and to prevent covert action on the part of their directors to frustrate a bid. The City Code has no legal
force but the parties to an acquisition who do not follow it may find that the London market withdraws their
ability to trade in shares on the exchange or imposes other sanctions against them.
6.2 The Role of the Competition Commission
31
⚫ Under the Fair Trading Act, the Office of Fair Trading (OFT) may refer a bid to the Competition Commission if
the OFT thinks that a merger might be against the public interest (i.e. constraining of competition).
⚫ Their investigations may take several months to complete during which time the merger is put on hold. Thus,
giving the target company valuable time to organise its defence. The acquirer may abandon its bid as it may
not wish to become involved in a time-consuming Competition Commission investigation.
6.3 Shareholder and stakeholder models of regulation

⚫ In the UK and US the market-based 'shareholder model' of regulation is used:
 Shareholder model - to protect rights of shareholders.
 Wide shareholder base.
⚫ In contrast, the European model looks at regulation from a wider stakeholder perspective:
 Stakeholder perspective to protect all stakeholders in a company
 Stakeholders include:
 employees
 creditors
 government
 suppliers
 general public
7. Defenses against a bid

7.1 Defenses before a bid is made
⚫ Minimise cash holdings
⚫ Hold strategic cross-shareholdings with other-companies (common in Japan)
⚫ "Poison pills" (e.g. debentures that become instantly redeemable upon takeover)
⚫ "Golden parachutes"—where the directors have the right to leave with substantial pay-outs if the business
is taken over
⚫ "Crown jewels"—sell off assets that might make the company attractive to predators
⚫ "Fat man"—grow the company to such a size that it would not be practical for anybody to buy
7.2 Defenses after a bid is made

⚫ The terms of the offer are unacceptable
⚫ There is no logic/synergy to the merger
⚫ Victim's shares are undervalued and bidder's overvalued
⚫ Appealing to the loyalty of the shareholders
⚫ Seeking a bid from a friendly third party—a "white knight"
⚫ Claiming that the bid is contrary to the City Code
⚫ Appealing to the Competition and Markets Authority that the bid is against public interest
⚫ "Pac-Man defense"—bid for the predator
32
Chapter 7 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
1. Asset valuation model

1.1 Net Book Value (NBV)
⚫ Equity = Assets – Liabilities
⚫ Problems and weaknesses of this method
 Statement of financial position (SOFP) values are often based on historical cost rather than market values.
 Net book value (also called carrying amount) of assets depends on depreciation/ amortisation policies.
 Many key assets are not recorded on the SOFP (e.g. internally generated goodwill).
1.2 Net Realisable Value (NRV)

⚫ Equity = Estimated Net Realisable Value of Assets – Liabilities
This may represent the minimum price that might be acceptable to the present owner of the business.
⚫ Problems and weaknesses of this method include:
 Estimating the NRV of assets for which there is no active market (e.g. a specialist item of equipment).
 It ignores unrecorded assets (e.g. internally-generate goodwill).
1.3 Replacement cost

⚫ This may represent the maximum price a buyer might be prepared to pay.
⚫ Problems and weaknesses of this method include:
 Technological change means it is often difficult to find comparable assets for the purposes of valuation.
 It ignores unrecorded assets.
1.4 Value plus

⚫ Method
 E = Sum of all real net assets at book or replacement cost + Multiplier × annual profit or turnover
 Multiplier
 The multiplier is negotiated between the parties to compensate for goodwill.
33
Example – Cobham Co
The financial statement of Cobham Company is as follow:
$m
Accumulated goodwill 72.50
Development cost 85.25
Leased asset 75.66
Net assets (excluding long and short-term liability) 777.10
Short- and long-term debt 267.40
Profit after tax for current year is 119.04.
Required:
Calculation of the value of Cobham’s equity on the basis of asset value plus earnings multiples of 5 years.
⚫ The above method works well where:
 The target firm is small
 Its principle assets are tangible
 Goodwill only represents a small proportion of the value
2. Valuing intangible
However, for many firms, it is not a particular brand that is the problem, but the large level of intangible asset
that are not recognised on the SOFP.
2.1 Calculating intangible value (CIV)

⚫ A suitable competitor is identified and their return on assets calculated:
Operating profit
Assets employed
 the industry average return can also be used.
 The return on assets is based upon operating profit and tangible assets only and thus before any costs of
financing, extraordinary items and tax.
⚫ The company’s value spread is then calculated.
$
Company operating profit X
Less:
Appropriate ROA x company asset base (X)
Value spread X
⚫ Assuming that the value spread would be earned in perpetuity, the CIV is found as follows:
 Find the post-tax value spread
 Use the likely short-term growth rate to find the expected post-tax value spread at T1
 Find the PV of CIV by using perpetuity model
⚫ The CIV is added to the net asset value to give an overall value of the firm.
Example – CIV
CXM plc operates in the advertising industry. The directors are knee to value the company for the purpose of
negotiating with a potential purchaser and plan to use CIV method to value the intangible element.
In the past year CXM plc made an operating profit of $137.4 m on an asset base of $307 m, Earning are predicted
to grow at 3.4% over the next few years, and the company WACC is 6.5%.
34
A suitable competitor for benchmarking has been identified as R plc. R plc made an operating profit of
$315 m on assets employed in the business of $1,583 million. Corporate tax is 30%.
Required:
What value should be placed on CXM?
2.2 Lev’s knowledge earning method

Steps:
(1) calculate the normal earning (profit after tax)
(2) Isolate the earning driven by intangible assets
$
Normal earning X
Less:
Return on monetary assets (risk free rate x monetary asset) (X)
Return on tangible assets (average return rate x tangible asset) (X)
Earning driven by intangible assets X
⚫ Lev identified the expected returns on assets as the:

 Monetary assets (e.g. receivable, cash) – risk free rate
 Tangible asset – average market return
 Intangible asset – Risk free rate + 6% premium
(3) Discounting the intangibles earnings:

 Five year at the current rate of growth
 Declining growth year on year for next five years
 Year 11 – growing at the long-term predicted growth rate
Example – lev’s knowledge

D plc is a company with a high level of spending on research and development. The normalized earning for the
company have been calculated as $65m.
D plc has $4.5m of monetary assets and $176m of tangible assets. It has an 8% cost of capital and a current
forecast growth rate of 10%, which is expected to fall to a long run rate of 4%. The current risk-free rate is 4%
and the current industry average return on the basis of tangible assets is 7%.
Required:
Calculate the value of intangible assets using Lev’s knowledge earning method.
3. Relative valuation models

3.1 Price/Earning (P/E) ratio method
⚫ E = P/E ratio × (Profit after tax + Constant synergy after tax)
⚫ Proxy problem
Similar company’s P.E maybe applied, however:
 Business risk – i.e. in the same industry
 Finance risk – i.e. have approximately the same level of gearing
 Growth – are growing at about the same rate
⚫ Average P.E problem

Average p.e cannot reflect the company’s most recent situation. Business size, operation, growth rate ...
⚫ Synergy
35
 The earning after acquisition may change because of existence of synergies.

 Two companies in a same industry merger may have a big synergy because of economies of scale or
synergies of vertical integration. Conglomerate integration may lead to a smaller synergy; the synergy is
mainly due to risk reduction.
3.2 Market to net worth (Tobin’s Q)

market capitalisation of the firm
Q =
replacement cost of the firms assets
3.3 Market to book (M/B) value ratios

Market capitalisation of net assets
Market to book ratio =
Book value of net assets
⚫ Comment: problem with model

 Choosing an appropriate comparator – should we use industry average, or an average of similar firms only?
 The ratio the market applies is not constant throughout its business cycle, so strictly the comparator
should be taken only from other companies at the same stage.
Example –M/B ratio

The industry sector average Market to Book ratio for the industry of X plc is 4.024. The book value of X plc is
$3,706m and it has 1,500m shares in issue.
Required:
Find the predicted share price?
4. Flow valuation model

These methods are based upon the principle that the valuation of equity is a reflection of the cash flow received
by investors. The two most common in practice are:
4.1 Dividend valuation model (DVM)

Dividend no growth: Dividend constant growth:
E = D0 / ke E = D0 (1+g) / (ke –g)
4.1.1 Growth rate estimation

⚫ Method 1: Exogenous variables
 By the determination of those exogenous variables such as GDP growth, growth in retail
spending, it is based on that a firm cannot over the very long run grow at a faster rate than its
host economy. This will place a limit upon the firm ‘s ability to expand.
⚫ Method 2: Projecting firm’s fundamental
 By projecting the firm ‘s fundamentals as described in the last section a near-term estimate of
earnings can be produced. This method requires an in-depth knowledge of the firm’s affairs
and a very careful scrutiny of the company’s accounts.
⚫ Method 3: Historical model
𝑛 current. DPSorEPS
g = √DPSorEPS.n.year.ago - 1
⚫ Method 4: Retention model
36
g=rb
Where: r= return on reinvested funds
e.g. ROE, ke
b = proportion of funds retained
EPS-DPS PAT-DIV
b= or
EPS PAT
capital reinvestment.
b= Gross free cash flow to equity
4.1.2 Evaluating of growth rate

i.e. ke x b ≤ growth rate＜ke
Example – Estimating growth

LT plc has a distribution rate of 30% and a cost of equity capital of 9%. Its ROE is currently 15%. This historical
growth in dividend is 12%, and the GDP growth is 4%.
Required:
(a) Forecast and comment the growth rate for LT plc using:
(1) Historical trend estimation
(2) Reinvestment policy
(3) External sector indicators
(b) And select a most appropriate growth rate
4.1.3 Step valuation procedures

 Planning horizon: where existing investment and business opportunities are likely to generate superior
levels of growth or where, in the opposite direction, the company is going through reconstruction and a
period of particularly low growth is anticipated.
 After planning horizon: where it is reasonable to assume a constant level of growth for the life of the
business or that the business has a ‘terminal value’ based upon the capitalised value of its imputed net
assets at that time.
Example – Cobham plc

Cobham’s financial record over the last five years is as follows:
PRICE 2000 2001 2002 2003 2004
DPS 20.2 23.23 25.60 28.15 31
EPS 64.2 75.4 86.4 93.5 94.8
NET ASSET PER
273 311 294 412 457
SHARE
The rate of return required by its equity investors is 7.2 per cent.
Required:
Estimate the value of share by using DVM model.
If we assume that earning per share growth at 8.2% for the next three years, using step procedure to value the
share.
4.2 Free cash flow (FCF)

4.2.1 Free cash flow to firm
37
Earnings before interest and tax (EBIT) X

Less: Tax @ rate% (X)
Add: Depreciation / Capital allowance X
Operating cash flow X
Less: Capital Investment
- replacement of non-current asset (X)
- investment in non-current asset (X)
- Incremental working capital investment (X)
Free cash flow to firm X
WACC
Value of firm
-value of debts
=value of equity
4.2.2 Free cash flow to equity

Earnings before interest and tax (EBIT) X
Less: interest (X)
Earning before tax (EBT) X
Less: Tax @ rate% (X)
Add: Depreciation / Capital allowance X
Operating cash flow X
Less: Capital Investment
- replacement of non-current asset (X)
- investment in non-current asset (X)
- Incremental working capital investment (X)
Free cash flow to equity X
ke
Value of equity
Pay attention: FCFE is also refereed as dividend capacity
⚫ Comment on Free cash flow to equity

 The FCF is the best valuation model, it is based on the future cash flow and the risk associated
with the cash flow.
 However, this depends on accurate estimate of both cash flows and discount rate, we rarely have
access to all the information required to forecast future cash flows.
 The FCF model has placed a higher value on the firm’s equity than the market, this means the
market does not believe in the long run the firm will be able to earn the rate of growth on
reinvestment implied and free cash flow can be sustainable in perpetuity.
⚫ Types of acquisition
 Type I—acquisitions that neither disturb the business risk of the acquiring firm nor require
additional external financing, hence, no change to the acquiring firm's existing cost of capital. This
could be the case in the proposed acquisition of a relatively small competitor (horizontal
integration).
 Discount rates should be the acquiring firm's WACC.
 Type II—acquisitions that do not disturb business risk but do disturb the financial risk of the
acquirer through a change in the debt-to-equity ratio, or through altering exposure to credit risk.
38
 Adjusted Present Value is the technique which appears to deal well with a change in the level
of debt.
 Type III—acquisitions that alter the firm ‘s exposure to business risk (and possibly its exposure to
financial risk and default risk).
 Use a spreadsheet's iteration function to resolve the inconsistency.
 use seed values to estimate the post-acquisition asset beta, regard to the equity beta,
estimate the post-acquisition WACC and use it to value the cash flow streams.
5. BSOP method for valuation

When the loan matures, if the value of the assets is greater than the value of the firm's debt, then the equity
shareholders are entitled to the difference.
If the value of the assets falls below the value of the firm's debts, because of shareholders' limited liability, they
can just liquidate the business and walk away.
Therefore, the equity value in a company represents the premium on a call option written by the lenders on the
underlying assets of the business.
Value of firm
A-L
Limited liability
0
Value of assets(A)
Outstanding
Debt(L)
Unlimited liability
Share option Value of firm
Value of underlying asset Equity share price Value of firm assets in use
Volatility of the underlying Standard deviation of continuously
Standard deviation of asset value
asset generated share returns
Redemption value of outstanding
Exercise price Contract price for settlement
debt
Time As agreed Term to maturity of debt
Risk-free rate Term of option Term of debt
⚫ The exercise prices

In the early applications of the BSM model to the problem of valuation, the firm was assumed to have issued
39
debt in the form of a single, zero coupon bond. In practice, firms issue debt of all sorts 一 some variable
term, some fixed interest, some with convertibility and so on.
⚫ Assess default risk using option pricing models
The value of N(d1) shows how the value of equity changes when the value of the assets changes. This is the
delta of the call option. The value of N(d2) is the probability that a call option will be in the money at
expiration. In this case, it is the probability that the value of the asset will exceed the outstanding debt, i.e.
V > F. The probability of default is therefore given by 1 — N(d2).
Probability of
default
1-N(d2) N(d2)
F V
Example：2014-Jun-Q3
40
Example:2010-Jun-Q2
2 AggroChem Co is undertaking a due diligence investigation of LeverChem Co and is reviewing the potential bid
price for an acquisition. You have been appointed as a consultant to advise the company’s management on the
fi nancial aspects of the bid.
AggroChem is a fully listed company fi nanced wholly by equity. LeverChem is listed on an alternative investment
market. Both companies have been trading for over 10 years and have shown strong levels of profi tability
recently. However, both companies’ shares are thinly traded. It is thought that the current market value of
LeverChem’s shares at 331/3% higher than the book value is accurate, but it is felt that AggroChem shares are
not quoted accurately by the market.
The following information is taken from the fi nancial statements of both companies at the start of the current
year:
AggroChem LeverChem
$’000 $’000
Assets less current liabilities 4,400 4,200
Capital Employed
Equity 4,400 1,200
5-year fl oating rate loan at yield rate plus 3% 3,000
Total capital employed 4,400 4,200
Net operating profi t after tax (NOPAT) 580 430

Net amount retained for reinvestment in assets 180 150
It can be assumed that the retained earnings for both companies are equal to the net reinvestment in assets.
The assets of both companies are stated at fair value. Discussions with the AtReast Bank have led to an
agreement that the fl oating rate loan to LeverChem can be transferred to the combined business on the same
terms. The current yield rate is 5% and the current equity risk premium is 6%. It can be assumed that the risk
free rate of return is equivalent to the yield rate. AggroChem’s beta has been estimated to be 1·26.
AggroChem Co wants to use the Black-Scholes option pricing (BSOP) model to assess the value of the combined
business and the maximum premium payable to LeverChem’s shareholders. AggroChem has conducted a review
of the volatility of the NOPAT values of both companies since both were formed and has estimated that the
volatility of the combined business assets, if the acquisition were to go ahead, would be 35%. The exercise price
should be calculated as the present value of a discount (zero-coupon) bond with an identical yield and term to
maturity of the current bond.
Required:
Prepare a report for the management of AggroChem on the valuation of the combined business following
acquisition and the maximum premium payable to the shareholders of LeverChem. Your report should:
(i) Using the free cash fl ow model, estimate the market value of equity for AggroChem Co, explaining any
assumptions made. (9 marks)
(ii) Explain the circumstances in which the Black-Scholes option pricing (BSOP) model could be used to assess
the value of a company, including the data required for the variables used in the model. (5 marks)
(iii) Using the BSOP methodology, estimate the maximum price and premium AggroChem may pay for
LeverChem. (9 marks)
(iv) Discuss the appropriateness of the method used in part (iii) above, by considering whether the BSOP
modelcan provide a meaningful value for a company. (5 marks)
Professional marks will be awarded in question 2 for the clarity and presentation of the report. (4 marks)
(32 marks)
41
Chapter 8 Payment and financing in M&A

1. Cash purchase
⚫ Advantages and disadvantages
Advantages Disadvantages
When the bidder has sufficient cash, the

merger can be achieved quickly
Cash flow strain must borrow
For the acquiring Cheaper: the consideration is likely to be
(increased gearing) or issue new
company less than a share exchange, as there is less
shares in order to raise the cash
risk to the shareholders
Retains control of their company
Certainty about bids value.

For the target Liable to CGT
Freedom to invest in a wide ranging
shareholders Do not participate in new group
portfolio
⚫ Cash purchasing will cause debts financing

 Debt increasing
 Interests increasing
 Profit after tax decreasing
 Eps decreasing
 Valuating changing
2. Shares for share exchange

⚫ Advantages and Disadvantages
For the acquiring No cash outflow

Dilution of control
company Bootstrapping – P/E ratio game can be played
For the target Postponement of CGT liability Participate in new

Uncertain value
shareholders group
Many bids are mixed - cash or shares - to appeal to the widest range of potential sellers.
⚫ Comment on financing by share for share exchange
Share for share exchange will not normally be regarded as taxable in the hands of the investors.
As the transaction will be achieved by the creation of new shares there will be
an immediate impact upon the gearing of the firm.
Example：2016-Mar/Jun-Q2
42
Example:12-Dec-Q3
3 Sigra Co is a listed company producing confectionary products which it sells around the world. It wants to acquire
Dentro Co, an unlisted company producing high quality, luxury chocolates. Sigra Co proposes to pay for the
acquisition using one of the following three methods:
Method 1
A cash offer of $5·00 per Dentro Co share; or
Method 2
An offer of three of its shares for two of Dentro Co’s shares; or
Method 3
An offer of a 2% coupon bond in exchange for 16 Dentro Co’s shares. The bond will be redeemed in three years at
its par value of $100.
Extracts from the latest financial statements of both companies are as follows:
Sigra Co Dentro Co
$’000 $’000
Sales revenue 44,210 4,680
Profit before tax 6,190 780
Taxation (1,240) (155)
Profit after tax 4,950 625

Dividends (2,700) (275)
Retained earnings for the year 2,250 350
Non-current assets 22,450 3,350

Current assets 3,450 247
Non-current liabilities 9,700 873

Current liabilities 3,600 436
Share capital (40c per share) 4,400 500
Reserves 8,200 1,788
Sigra Co’s current share price is $3·60 per share and it has estimated that Dentro Co’s price to earnings ratio is
12·5%higher than Sigra Co’s current price to earnings ratio. Sigra Co’s non-current liabilities include a 6% bond
redeemable in three years at par which is currently trading at $104 per $100 par value.
Sigra Co estimates that it could achieve synergy savings of 30% of Dentro Co’s estimated equity value by eliminating
duplicated administrative functions, selling excess non-current assets and through reducing the workforce numbers,
if the acquisition were successful.
Required:
(a) Estimate the percentage gain on a Dentro Co share under each of the above three payment methods.
Comment on the answers obtained. (16 marks)
(b) In relation to the acquisition, the board of directors of Sigra Co are considering the following two proposals:
Proposal 1
Once Sigra Co has obtained agreement from a significant majority of the shareholders, it will enforce the remaining
minority shareholders to sell their shares; and
43
Proposal 2
Sigra Co will offer an extra 3 cents per share, in addition to the bid price, to 30% of the shareholders of Dentro Co
on a first-come, first-serve basis, as an added incentive to make the acquisition proceed more quickly.
Required:
With reference to the key aspects of the global regulatory framework for mergers and acquisitions, briefly discuss
the above proposals. (4 marks)
(20 marks)
44
Part Corporate Reconstruction and Reorganisation

Chapter 9 Credit risk and structure model
Default occurs when the value of a borrower's assets falls below the value of their outstanding debt. Two
variables influence the potential loss to the lender: the chanceof default occurring, and the proportion of the
debt that can then be recovered upondefault.
1. What factors will be rating agencies consider?

⚫ industry risk
⚫ country risk
⚫ earnings protection
⚫ financial flexibility
⚫ evaluation of the company's management
2. Credit ratings
Standard & Poors Definition
AAA, AA+, AAA-, AA, AA-, A+ Excellent quality, lowest default risk
A, A-, BBB+ Good quality, low default risk
BBB, BBB-, BB+ Medium rating
BB or below Junk bonds (speculative, high default risk)
Example – Structural model

A firm's assets have a value of $1m and its outstanding debt is $0.4m. The volatility of assets (as given by the
standard deviation of monthly asset values) is 10.23%. Its bank assesses the recoverability of the debt as 80%
and it, in turn, pays LIBOR 5% to raise finance.
Required:
Estimate the probability of bankruptcy and interest rate that the bank should charge on the firm's debt.
45
Chapter 10 Financial and business reconstruction

1. Financial Reconstruction
⚫ Write off any "fictitious" assets (e.g. Goodwill, development expenditure);
⚫ Revalue other assets;
⚫ Reorganise capital structure (e.g. Write off debt in exchange for equity);
⚫ Raise new capital.
2. Business Re-organisation
⚫ Spin-offs, or demergers, in which the ownership of the business does not change, but a new company is
formed with shares in the new company owned by the shareholders of the original business. This results in
two or more companies instead of the original one.
⚫ Sell-offs, which involves the sale of part of the original company to a third party, usually in return for cash.
⚫ Management buyouts, in which the management of the business acquires a substantial stake in and control
of the business which hey managed. Management buyouts will be discussed in more detail in a later section
of this chapter.
⚫ Liquidation, when the entire business is closed down, the assets sold, and the proceeds distributed to
shareholders. This is done when the owners of the business no longer want it, or the business is not seen as
viable.
2.1 Reasons for reconstruction

⚫ Dismantling a conglomerate enterprise in order to focus upon the core business
⚫ Reverse synergy - company is worth more in parts than as a whole e.g. conglomerate discount
⚫ Selling loss making subsidiaries
⚫ Protection from takeover - possibly by disposing of the reasons for the takeover or by producing efficient
cash to fight it effectively
⚫ The business no longer fits within the overall corporate strategy.
⚫ Asset stripper, that is it buys other companies, splits them into smaller units and sells them off
⚫ Cash generation - possibly to fund new acquisitions
⚫ Selling off unwanted assets following an acquisition.
2.2 MBO
An MBO is the purchase of all or part of a business from its owners by its managers. Where the
management team is from outside the existing business, this is referred to as a management buy-in (MBI).
Sometimes the management team will be a combination of an MBO (i.e. existing management) and new
managers (with specialist skills that the existing management team does not have e.g. finance). This is
sometimes referred to as a buy-in management buy-out or a BIMBO.
⚫ Reasons why MBO occur

 The parent company wishes to divest because the business no longer fits within the overall corporate
strategy.
 The parent company needs to improve its liquidity position this is especially apt as buy-outs are normally
for cash.
 The corporate acquisition community may not recognise a company's true potential due to poor earnings
or sluggish growth. In such situations, experienced managers can recognise the potential of a company
when outsiders cannot, and they may offer the best price.
 Management buy-outs are usually quicker to organise as opposed dealing with a number of potential
corporate buyers.
 The parent company may wish to preserve the goodwill developed in a local community due to its
continuing commercial activity in the community. Hence it may prefer a management buyout to a sale to
a third party, which may lead to a total transfer of location
46
 In a receivership, a buy-out may be the management's only/best alternative to redundancy.

 The management team will often not require onerous warranties and indemnity from the divesting group
because they know the business thoroughly. This point in practice can often be very attractive to a
divesting group.
⚫ Benefits of MBO for each part
To the group:  Raise cash quickly
 May have the best price
 Retain beneficial links
 The best way of maximising management co-operations
To the management team:  Favourable price
 Personal motivation
 Quicker decision-making
To the venture capital  Saving on overheads
Better successful chance.
 Needn’t provide management team.
 Will not necessarily provide the majority of the finance.
⚫ Financing an MBO
Buys-outs are financed in such a way that management team acquires control of the business for a relatively
small cash outlay and it is, therefore, an attractive proposition for those with limited financial resources.
The company issues a relatively small amount of equity, (the majority of which is held by the management
team) and therefore need to be financed with a very high level of gearing - highly leveraged.
⚫ Common types of debt in MBO's
Secured medium-term fixed or floating Unsecured short-term high

rate debt. coupon "mezzanine" finance.
Fully utilise company's debt capacity. Balance by "mezzanine" debt
⚫ Mezzanine finance
 Mezzanine finance tends to be used when the company has fully used its debt capacity
 i.e. the bank will not loan any more money because the company cannot give any security and the
company will not or cannot issue any more equity.
 It generally offers interest rates two to five percentage points more than secured debt and frequently
gives the lender some right to a share in equity should the company perform well (warrants - “equity
kicker”)
⚫ Assessing the viability of buy-outs

Both the management buy-out team and the financial backers will wish to be convinced that their proposed
MBO will succeed. It is important to ask the following questions
47
 Why do the current owners wish to sell? If the owners are trying to rid themselves of a loss- making
subsidiary, are the new management being over-confident in believing that they can turn it around into
profitability?
 Does the proposed management team cover all key functions? If not, new appointments should be made
as soon as possible.
 Has a reliable business plan been drawn up, including cash flow projections, and examined by an
investigating accountant?
 Is the proposed purchase price too high?
 Is the financing method viable? The trend is now away from highly geared buy-outs.
⚫ Problems with buy-outs

A common problem with MBOs is that the managers have little or no experience in
financial management or financial accounting.
Other problems are:
 Tax and legal complications
 Difficulties in deciding on a fair price to be paid
 Convincing employees of the need to change working practices
 Inadequate cash flow to finance the maintenance and replacement of tangible non- current assets
 The maintenance of previous employees' pension rights
 Accepting the board representation requirement that many sources of funds will insist on
 The loss of key employees if the company moves geographically, or wage rates are decreased too far, or
employment conditions are unacceptable in other ways
 Maintaining continuity of relationships with suppliers and customers
Example：2017-Dec-Q2
2015-Jun-Q3
48
Part Treasury and Advanced Risk Management

Chapter 11 Interest rate risk
1. Forward rate agreement-(FRA)
⚫ Objective
To lock the company in to a target interest rate. To hedge both adverse and favourable interest rate
movements.
 A 2 - 5 FRA at 5.00 - 4.70
 The agreement starts in 2 months time and ends in 5 months time.
2. Interest rate guarantees – (IRGs) – options on FRAs

Interest rate guarantees like all options protect the company from adverse movements and allow it take
advantage of favourable movements.
⚫ Decision rules
If there is an adverse movement If there is a favourable movement
Exercise the option to protect Allow the option to lapse
IRGs are more expensive than the FRAs as one has to pay for the flexibility to be able to take advantage of a
favourable movement.
⚫ When to hedge using FRAs or IRGs
 FRA is the cheaper way hedge against the potential adverse movement.
 If the treasurer is unsure which way interest will move he may be willing to use the more expensive IRG
to be able to benefit from a potential fall in interest rates.
3. Cap
Interest rate cap— an agreement by the seller of the cap to pay the buyer the excess of the reference interest
rate over the agreed cap rate, based on a notional principal amount.
4. Floor
Interest rate floor— an agreement by the seller of the floor to pay the buyer theexcess of the agreed floor
rate over the reference interest rate based on a notional principal amount.
5. Collar
Interest rate collar (low-cost cap)— a combination of a purchased cap and a written/sold floor agreement. It
protects against rising interest rates but limits participation in falling rates.
49
⚫ Buying an interest rate cap can be expensive in terms of the premium cost. Therefore, by simultaneously
selling a floor a premium can also be received to reduce the net cost of the hedge.
⚫ The effect of the collar is to create both a maximum and a minimum interest rate. The benefit is the reduced
cost of establishing the hedge, but the disadvantage is that it restricts the possible gains from drops in interest
rates compared to simply buying a cap.
⚫ Building a collar is also known as a constructing a "low-cost cap", or " low-cost floor" (i.e. Buy a floor/sell a
cap).
6. Interest rate futures

⚫ To lock the company into the effective interest rate.
⚫ To hedge both adverse and favourable interest rate movements.
⚫ The Price = 100 - market's expectation of the future interest rate at the expiry of the contract.
6.1 Time choosing

Future contracts are issued on a three-month cycle. The contracts mature (expire) at the end of March, June,
September and December. It is normal to choose the first contract to expire after the loan is required or deposit
is made.
⚫ Example:
 Loan required on the 22nd February
 Deposit is made on the 5th June
6.2 No. of contracts

Currency Size
Sterling £500,000
US dollar $1,000,000
The Euro €1,000,000
Japanese Yen ￥12,500,000
⚫ Calculation of no. of contracts:

Loan or deposit amount Loan or deposit period in months
×
Contract size 3 months
 Example:
 A company will have surplus funds of ￡1.4m for 4 months.
 Answer:
 (1.4 / 0.5) x (4/3) = 3.73 ≈ 4 contracts
6.3 Close out
Cash Deposit Loa
Futures Market: Buy futures contacts Sell futures contracts
6.4 Profit/loss on the futures-the tick way

⚫ A tick is the minimum movement in the futures price.
The value of a tick depends on the size of the future contracts
50
￡ contracts = ￡500,000
One tick = ￡500,000 x .0001 x 3/12
7. Exchange traded options

⚫ Call or put options
 A call option gives the holder the right to buy the futures contract.
 A put option gives the holder the right to sell the futures contract
You always buy the option – buy the right to buy or buy the right to sell
⚫ Choosing an exercise price
⚫ Decision point—exercise the option or allow it to lapse
If there is an adverse movement If there is a favourable movement
Exercise the option to protect Allow the option to lapse
Example：2017-Dec-Q4-3
2015-Jun-Q4-1
51
Chapter 12 Foreign exchange risk

⚫ Hedging method
 Invoice in home currency
 One easy way is to insist that all foreign customers pay in your home currency and that your company
pays for all imports in your home currency.
 However, the exchange-rate risk has not gone away, it has just been passed onto the customer. Your
customer may not be too happy with your strategy and simply look for an alternative supplier. Achievable
if you are in a monopoly position, however in a competitive environment this is an unrealistic approach.
 Decide to do nothing
 The company would "win some, lose some".
 If the amount is relatively small and the company expects a favourable movement, then it may be
acceptable to do nothing. Be careful. Predicting exchange rates is a very dangerous game and "more" than
one "expert" had made serious errors of judgement. One additional advantage of this policy is the savings
in transaction costs.
 Leading and lagging
 A company may decide to obtain payment early or pay late if it believes the exchange movement will be
significant between now and the due date.
 For example, if an importer (payment) expects that the currency it is due to pay will depreciate, it may
attempt to delay payment. This may be achieved by agreement or by exceeding credit terms.
 Matching
 When a company has receipts and payments in the same foreign currency due at the same time, it can
simply match them against each other. It is then only necessary to deal on the forex markets for the
unmatched portion of the total transactions. Suppose that ABC plc has the following receipts and
payments in three months time:
US
Receives $16m customer
ABC Plc.
Pays $10m
US
supplier
Unmatched exposure $6m (to be hedged by other methods)

 Money market hedging
 Interest rate parity implies that a money market hedge should give the same results as a forward contract
 Money market hedges may be feasible as a way of hedging for currencies where forward contract are not
available
 This approach has obvious cash flow implications which may prevent a company from using this method
e.g. if a company has a considerable overdraft it may be impossible for it to borrow funds now.
Example – money market hedging

Liverpool plc must make a payment of US $450,000 in 3 months’ time. The company treasurer has determined
the following:
Spot rate: $1.7000 - $1.7040
3 months forward: $1.6902 - $1.6944
6 months forward: $1.6764 - $1.6809
52
Money Market rates Borrowing Deposit

US dollars 6.5% 5%
Sterling 7.5% 6%
Required:
Should a forward contract hedge or a money market hedge be undertaken?
1. Forward contacts
⚫ Comment on forward contract
 The contract can be tailored to  The user may not be able to negotiate good
user’s terms, the price may depend on the size of the
 exact requirement. deal and how the user is rated.
 The trader will know in advanced  Users have to bear the spread of the contract
how much money will be received between the buying and selling price.
or paid.  Forward contract may not be available in the
 Payment is not required until the currencies that the customer requires.
contract is settled.
2. Currency futures
2.1 BUY OR SELL decision
⚫ Currency of the contract: CC
 The size of the contract is always quoted in the currency of the contract.
 Contract size: 62,500 Sterling
Buy CC Sell CC
Buy future Sell future

2.2 Time choosing
We assume that the contracts mature or expire at the end of March, June, September and December. It is
normal to choose the first contract to expiry after the conversion date.
2.3 No. of contracts

⚫ No of contracts = Amount of Non CC / Opening Future price / Contract size
⚫ = CC amount / Contract size
⚫ Pay attention to the currency.
2.4 Comment on future
 There is a single specified price  The futures hedge is imperfect due to:
determined by the market, and not  Basis risk - the future rate (as defined by the
the negotiating strength of the future prices) moves approximately but not
customer. precisely in line with the cash market rate.
 Transaction costs are generally lower  If you are not dealing in whole contracts and have
than for forward contracts. to round to whole contracts
 Because of the process of marking to  Future contract may not be available in the
market, there is no default risk. currencies that the customer requires.
 The procedure for future contract can be
complex.
53
3. Currency option
⚫ A call option gives the holder the right to buy the underlying currency.
⚫ A put option gives the holder the right to sell the underlying currency.
Buy CC Sell CC
Buy Call options Buy put options
⚫ A company will only buy option contracts for hedging purposes
Example：2018 Specimen Q1
4. Netting
Netting&2015-Sep/Dec-Q2-1
54
Chapter 13 Interest and currency swaps

1. Interest swap
Example
Company A wishes to raise ￡10m and to pay interest at a floating rate, as it would like to be able to take
advantage of any fall in interest rates. It can borrow for one year at a fixed rate of10% or at a floating rate of
LIBOR + 1%.
Company B also wishes to raise￡10m. They would prefer to issue fixed rate debt because they want certainty
about their future interest payments, but can only borrow for one year at 13% fixed or LIBOR + 2% floating, as it
has a lower credit rating than company A.
L.I.B.O.R. is 9%.
Required:
Calculate the effective swap rate for each company - assume savings are split equally.
Example 2016 Sep/Dec Q4
2. Forex swap
⚫ Objectives
 To hedge against Forex risk, possibly for a longer period than is possible on the forward market.
 Access to capital markets, in which it may be impossible to borrow directly.
Example - Goldsmith plc
Goldsmith mining plc wishes to hedge 1 year foreign exchange risk, which will arise on an investment in Chile.
The investment is for 800m escudos and is expected to yield amount of1000m escudos in 1 year’s time.
The currency spot rate is 28 escudos to the pound, and the bank has offered a currency swap at 22
escudos/pound with Goldsmith making a net interest payment to the bank of 1% in sterling (assume at T1).
Interest Rates Borrowing Lending
UK 15% 12%
Chile N/A 25%
A forward contract is available at a rate of 30 escudos per pound.

Goldsmith cannot borrow escudos directly and is therefore considering two possible hedging techniques:
(a) Entering into a forward contract for the full 1000m escudos receivable.
(b) Entering into a currency swap for the 800m escudos initial investment, and then a forward contract for the
200m escudos profit element.
Required:
Determine whether Goldsmith should hedge its exposure using a forward contract or a currency swap.
3. Currency swap
A currency swap allows the two counterparties to swap interest rate commitments on borrowings in different
currencies.
Example - Warne Co
Warne Co is Australian firm looking to expand in Germany and is thus looking to raise￠24 million. It can borrow
at the following fixed rates:
A$ 7.0%
￠ 5.6%
55
Euroports Inc is a French company looking to acquire an Australian firm and is looking to borrow A$40 million. It
can borrow at the following rates:
A$ 7.2%
￠ 5.5%
The current spot rate is A$1 = ￠0.6
Required:
Show how a ‘fixed for fixed’ currency swap would work in the circumstances described, assuming the swap is
only for one year and that interest is paid at the end of the year concerned.
4. Comments on swaps
⚫ Advantages of swap
 To obtain cheaper finance than would be possible by borrowing directly.
 To pay a difference type of interest i.e. to alter the debt structure of the company without physically
redeeming old debt or issuing new debt. This can result in substantial saving on redemption costs and
issue costs.
 To gain access to capital markets in which it is not possible to borrow directly e.g. low credit rating
companies may not be able to borrow directly in some fixed rate markets but can obtain fixed rate debt
through swaps.
 Hedging against foreign exchange risk. Swaps can be arranged for up to 30 years, which provides
protection against foreign exchange risk for much longer than the forward market. Currency swaps are
especially useful when dealing with countries that have exchange controls and/or volatile exchange rates.
 The development of many various types of complex swaps helps to meet the specific needs of each
company.
⚫ Risks in using swaps

 Counter party credit risk
 This is the risk that the counter party will default. The risk can be reduced by investigating the credit
worthiness of the counter party before entering into the swap, and by using an intermediary.
 Position risk
 This is the risk due to a beneficial or adverse movement of an interest rate or exchange rate e.g. if we
swap from fixed to floating rate interest and interest rates then rise.
 Spread risk
 This is the risk to a bank or intermediary from warehousing the swap. With warehousing the bank will
arrange a swap with one party and hedge the swap until a suitable counter party can be found. There is a
risk that the spread may change before the counter party is found
 Transparency risk
 This is the risk that the true financial position ceases to be reflected in the accounts e.g. a loan in pounds
is shown in the accounts which has been swapped for dollars. This means that beneficial and adverse
movements, which are of direct relevance to its credit rating, are no longer included.
Example: 2017-Jun-Q3
56

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Chapter 8 Payment and financing in M&A ........................................................................................................ 42

Part Advanced Investment Appraisal

⚫ Market value of equity and debt

Cost of equity-K Cost of debt-kd

DVM CAPM Non-traded traded

No growth With growth ke=Rf+(Rm-Rf)×β Kdat=int rate (1-t)

k =PD0 D0 ×(1+g) Irredeemable Redeemable

𝜎port(A, B) =√σ2a x2+σ2b (1-x)2+2x(1-x)ρabσaσb

𝜎a = risk (standard deviation) of share A

⚫ weighted average beta

⚫ Problems with CAPM

1.4 Calculation of return of market

Required: Estimate the cost of debt

2. Risk adjusted WACC

Total assets 69,400

Share capital (25c per share par value) 3,250

Total capital and liabilities 69,400

Chapter 2 Investment Appraisal Format

£000 £000 £000 £000 £000 £000

2. Adjusted Present Value (APV)

Net CF of investment effect

Base case NPV X/(X)

Present value of financing effect

Adjusted Present Value X/(X)

2.2 Investment Decision

Calculate the Base NPV

2.3 Financing Decision

Annual int. saving = Total loan x interest rate X

⚫ PV of the tax relief on interest payments = PV of the tax shield

Annual tax relief = Total loan x interest rate x tax rate X

Annuity factor for x years X

PV of the tax shield X

2.4 Comments on APV

3.2 Remittances from Subsidiaries

Royalties Transfer Pricing Loan Interest Management Charges

3.2.1 Transfer pricing

⚫ Local regulations and tax regimes

3.3 Exchange Rates

3.4 Financing foreign projects

4.1 Completeness and accuracy of cash flows

4.2 Risk Analysis

⚫ Overseas NPV comment

4.3 Qualitative factors

⚫ The real options - (options on real physical assets)

⚫ Effect on other stakeholders

Chapter 3 Other investment appraisal techniques

0 (MV) (X) (X)

0 (MV) (X) (X)

n Higher of (1) redemption (2) X X

⚫ Internal rate of return (IRR) for project appraisal

0 (investment) (X) (X)

⚫ There are a number of problems with the standard IRR calculation

Year Investment phase Return phase

⚫ Marginal growth rate

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

Example –MGR and MIRR

Cost of capital 8% NPV at 8% = $2,340

⚫ Comments for MIRR