Professional Documents
Culture Documents
AFM Textbook Updated
AFM Textbook Updated
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Syllabus A: Role of The Senior Financial Adviser
Syllabus A1a. Develop strategies for the achievement of the organisational goals
Financial objectives
This can be measured as total shareholder return (dividend yield + capital gain or the
dividend per share plus capital gain divided by initial share price)
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Key decisions:
1. Investment
(in projects or takeovers or working capital) need to be analysed to ensure that they
are bene cial to the investor.
Investments can help a rm maintain strong future cash ows by the achievement of
key corporate objectives
2. Finance
mainly focus on how much debt a rm is planning to use.
Life cycle - A new, growing business will nd it dif cult to forecast cash ows with
any certainty so high levels of gearing are unwise.
Operating gearing - If xed costs are a high proportion of total costs then cash
ows will be volatile; so high gearing is not sensible.
Security - If unable to offer security then debt will be dif cult and expensive to
obtain.
3. Dividends
how returns should be given to shareholders
4. Risk management
mainly involve management of exchange rate and interest rate risk and project
management issues.
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Key Objectives of Financial Management
Taking a commercial business as the most common organisational structure, the key
objectives of nancial management would be to:
• Provide an adequate return on investment bearing in mind the risks that the
business is taking and the resources invested
1. Financial Planning
Management need to ensure that enough funding is available at the right time to
meet the needs of the business.
In the short term, funding may be needed to invest in equipment and stocks, pay
employees and fund sales made on credit.
In the medium and long term, funding may be required for signi cant additions to the
productive capacity of the business or to make acquisitions.
2. Financial Control
Financial control is a critically important activity to help the business ensure that the
business is meeting its objectives.
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3. Financial Decision-making
The key aspects of nancial decision-making relate to investment, nancing and
dividends:
Investments must be nanced in some way – however there are always nancing
alternatives that can be considered.
For example it is possible to raise nance from selling new shares, borrowing from
banks or taking credit from suppliers
If dividends are too high, the business may be starved of funding to reinvest in
growing revenues and pro ts further
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Syllabus A1bc & A2c. Recommend strategies for the management of the nancial resources
of the organisation such that they are utilised in an ef cient, effective and transparent way.
c) Advise the board of directors or management of the organisation in setting the nancial
goals of the business and in its nancial policy development with particular reference to:
6. risk management
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Let's look at these in a bit more detail, hot pants, below..
NPV?
IRR?
–ROCE
– EPS
• Are the current gearing levels minimising the cost of capital for the company?
• Tax implications
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3. Distribution and retention policy
Retained earnings is a great source of nance.. so should we give dividends away?
It depends on...
• Will our investments (funded by retained earnings) increase the share price and
thus shareholder wealth?
• Will paying high dividends mean we need alternative nance for capital
expenditure or working capital requirements?
Will paying low dividends fail to give shareholders their required income levels
• What are the investor preferences for cash dividends now or capital gains in
future from enhanced share value?
– dividends
– gearing levels
– risk
– credit policies
– pricing policies.
• Internal stakeholders
Mission statements and current goals and strategies is important for employees
at all levels
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5. Financial planning and control
The senior nancial executive will need to develop policies on:
• Planning processes
• Business plans
• Budgets
• Evaluating performance
• Risk appetite
• How are risks identi ed, Analysed, Planned for and Monitored?
7. Use of resources
It will be important to develop a framework to ensure all resources (inventory, labour
and noncurrent assets as well as cash) are used to provide value for money.
• economic
• ef cient
• effective
• transparent.
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Syllabus A2. Financial strategy formulation
Syllabus A2a. Assess organisational performance using methods such as ratios and trends
Accounting Ratios
In your exam, you may be required to calculate some ratios in order to support your
strategic analysis of the case.
This section shall only present a summary and list of ratios that could potential be
used in your exam for such purpose.
• PROFITABILITY RATIOS
These are measures of value added being generated by an organisation and include
the following:
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ROE Pro t After Tax - Preference dividends/Shareholders’ Funds
(Ordinary shares + Reserves)
• EFFICIENCY RATIOS
Liquidity
Current Ratio Current Assets / Current Liabilities
Quick Ratio (Current Assets – Inventory) / Current Liabilities
Gearing
Financial Gearing Debt/Equity
Financial Gearing Debt/Debt + Equity
Operational gearing Contribution / PBIT
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• INVESTOR'S RATIOS
You have to sift through evidence and extract meaningful messages for effective
business decisions.
The starting point is often the basic accounting documents that record the
progress of any business, the Income statement & SFP
The income statement is dynamic and describes the ow of money through the
business over a period of time.
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Syllabus A2a. Assess organisational performance using methods such as ratios and trends
Eg One company may revalue its property; this will increase its capital employed and
(probably) lower its ROCE
Eg One company has a year ended 30 June, whereas another has 30 September
If the sector is exposed to seasonal trading, this could have a signi cant impact on
many ratios.
Eg This may be a particular problem with ratios like ROCE as there is no universally
accepted de nition
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4. Comparing to averages
Many of the companies included in the sector may not be a good match to the type
of business being compared
Some companies go for high mark-ups, but usually lower inventory turnover,
whereas others go for selling more with lower margins
1. Industry averages
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Syllabus A2b. Recommend the optimum capital mix and structure within a speci ed business
context and capital asset structure.
The higher a company’s gearing, the more the company is considered risky.
A company with high gearing is more vulnerable to downturns in the business cycle
because the company must continue to service its debt regardless of how bad sales
are.
1. Need to cover high xed costs, may tempt companies to increase sales prices
and so lose sales to competition
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How finance can affect financial position and risk
Operational gearing
• In cases where a business has high xed costs as a proportion of its total costs,
the business is deemed to have a high level of operational gearing.
• If there is a fall in demand, the proportion of xed costs to revenue becomes even
greater. It may turn pro ts into serious losses.
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The normal equation used is:
In this sense total operating costs include both xed and variable operating costs.
Interest cover
The lower the interest cover, the greater the risk that pro t (before interest) will
become insuf cient to cover interest payments.
It is:
It is a better measure of the gearing effect of debt on pro ts than gearing itself.
A value of more than 2 is normally considered reasonably safe, but companies with
very volatile earnings may require an even higher level, whereas companies that
have very stable earnings, such as utilities, may well be very safe at a lower level.
Similarly, cyclical companies at the bottom of their cycle may well have a low interest
cover but investors who are con dent of recovery may not be overly concerned by
the apparent risk.
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Syllabus A2b. Recommend the optimum capital mix and structure within a speci ed business
context and capital asset structure.
Sources of Finance
Operating Leases
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4. Off balance sheet finance
Operating leases also have the attraction of being off-balance sheet nancing, in
that the nance used to acquire use of the leased asset does not appear in the
balance sheet.
Debt v Equity
These are the things you need to think about when asked about raising nance - so
just put all these in your answer and link them to the scenario. Job done.
• Availability of security
Debt will usually need to be secured on assets by either a xed charge (on
speci c assets) or a oating charge (on a speci ed class of assets).
• Economic expectations
If buoyant economic conditions and increasing pro tability expected in the future,
xed interest debt commitments are more attractive than when dif cult trading
conditions lie ahead.
• Control issues
A rights issue will not dilute existing patterns of ownership and control, unlike an
issue of shares to new investors.
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Rights Issues
A 1 for 2 at $4 (MV $6) right issue means….
The current shareholders are being offered 1 share for $4, for every 2 they already
own.
(The market value of those they already own are currently $6)
• Effect on EPS
Obviously this will fall as there are now more shares in issue than before, and the
company has not received full MV for them
To calculate the exact effect simply multiply the current EPS by the TERP /
Market value before the rights issue
Eg Using the above illustration
EPS x 5.33 / 6
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The factors considered when reducing the amount of debt by issuing
equity :
As the proportion of debt increases in a company’s nancial structure, the level of
nancial distress increases and with it the associated costs.
Companies with high levels of nancial distress would nd it more costly to contract
with their stakeholders.
For example, they may have to pay higher wages to attract the right calibre of
employees, give customers longer credit periods or larger discounts, and may have
to accept supplies on more onerous terms.
1. Less nancial distress may therefore reduce the costs of contracting with
stakeholders.
2. Having greater equity would also increase the company’s debt capacity.
This may enable the company to raise additional nance
3. On the other hand, because interest is payable before tax, larger amounts of debt
will give companies greater taxation bene ts, known as the tax shield.
4. Reducing the amount of debt would result in a higher credit rating for the
company and reduce the scale of restrictive covenants.
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Syllabus A2d. Explain the theoretical and practical rationale for the management of risk.
5 step process:
1. Identify Risk
Make list of potential risks continually.
Identify risks facing the company - through consultation with stakeholders
3. Analyse Risk
Prioritise according to threat/likelihood.
Assess the likelihood of the risk occurring - management attention obviously on
the higher probability risks
5. Monitor Risk
Assess risks continually.
Understand the costs involved in the internal controls set up to manage these
risks - and weighed against the bene ts
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Why do all this?
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Syllabus A2e. Assess the organisation’s exposure to business and nancial risk including
operational, reputational, political, economic, regulatory and scal risk.
Identifying Risks
Uncertainty can come from any of the political, economic, natural, socio-
demographic or technological contexts in which the organisation operates.
Categories of risk
• Strategic risks
Typically affect the whole of an organisation and so are managed at board level
• Operational risks
Are managed at risk management level and can be managed and mitigated by
internal controls.
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• Financial risks
The most common nancial risks are those arising from nancial structure
(gearing), interest rate risk, liquidity
• Business risks
• Reputation risk
When the disappointed stakeholder has contractual power over the organisation,
the cost of the reputation risk may be material.
• Market risk
Those arising from any of the markets that a company operates in, such as
where the business gets its inputs, where it sells its products and where it gets its
nance/capital
Market risk re ects interest rate risk, currency risk, and other price risks
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• Entrepreneurial risk
• Credit risk
arises from the possibility of legal action being taken against an organization
• Technology risk
• Environmental risk
arises from changes to the environment over which an organisation has no direct
control,
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• Business probity risk
• Derivatives risk
• Fiscal risks
risk that the new taxes and limits on expenses allowable for taxation purposes
will change.
Health and safety risks include loss of employees' time because of injury and the
risks of having to pay compensation or legal costs because of breaches.
• Liquidity risk
However current liabilities are often a cheap method of nance (trade payables
do not usually carry an interest cost).
Businesses may therefore consider that, in the interest of higher pro ts, it is worth
accepting some risk of insolvency by increasing current liabilities, taking the
maximum credit possible from suppliers.
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Syllabus A2e. Assess the organisation’s exposure to business and nancial risk.
Business Risk
Business risk identi cation is literally putting yourself in the shoes of the
management..
• Political risks
• Economic risks
• Technological changes
• Environmental issues
• Legal issues
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Financial Statement Risk
Simply the risk that the FS are materially misstated (before any audit procedures)
• Business risks can lead to errors on speci c areas of the FS (eg. Technological
change leading to obsolete stock)
• Business risk can have a more general effect on FS (eg. Poor controls leading to
errors)
• Business risks can lead to going concern problems. This too would be a FS risk
(wrong basis of accounting)
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Syllabus A2fg. f) Develop a framework for risk management, comparing and contrasting risk
mitigation, hedging and diversi cation strategies.
g) Establish capital investment monitoring and risk management systems..
1. risk awareness
3. risk management (i.e.strategies for dealing with risk and planned responses
should unprotected risks materialise)
1. Risk awareness
For all material estimates, a formal risk assessment should be carried out to identify:
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Risks may be:
1. strategic
2. tactical
3. operational
Once the potential risks have been identi ed, a monitoring process will be needed to
alert management if they arise.
A useful way to manage risk is to identify potential risks (usually done in either
brainstorming meetings or by using external consultants) and then categorise them
according to the likelihood of occurrence and the signi cance of their potential
impact.
Decisions about how to manage the risk are then based on the assessment made.
These assessments may be time consuming and the executive will need to decide:
As time passes, so the various uncertain events on which the forecasts are based
will occur.
Management must monitor the events as they unfold, reforecast predicted results
and take action as necessary.
The degree and frequency of the monitoring process will depend on the signi cance
of the risk to the project’s outcome.
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3. Risk management
3. diversi cation
Well-diversified portfolios
Therefore a company can not reduce risk further by undertaking diversi cation within
the same system or market.
However, further risk reduction may occur if the diversi cation is undertaken by the
company, on behalf of the shareholders, into a system or market where they
themselves do not invest.
Some studies indicate that even shareholders holding well-diversi ed portfolios may
bene t from risk diversi cation where companies invest in emerging markets.
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Syllabus A2h. Advise on the impact of behavioural nance on nancial strategies / securities
prices and why they may not follow the conventional nancial theories.
Behavioural Finance
Much of conventional nance is based on rational and logical theories, such as the
CAPM and EMH
These theories assume that people, for the most part, behave rationally and
predictably
But the real world is a very messy place people behave very unpredictably.
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The "Anomalies" that behavioural finance seeks to explain:
1. January Effect
Average monthly return for small rms is consistently higher in January than any
other month of the year.
The winning bid in an auction often exceeds the intrinsic value of the item
purchased - maybe due to increased bid aggressiveness as more bidders enter
the market
CAPM says investors with riskier investments should get higher returns - but not
so much!
Shares historically return 10% and government (risk free) bonds 3% - yet shares
are not over 3 times more risky - so why is the return premium so high?
Behavioural nance shows people have a loss aversion tendency- so are more
worried by losses in comparison to potential gains - so in fact a very short-term
view on an investment.
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Key concepts of Behavioural Finance
1. Anchoring
Large Coffee - £5
Medium Coffee - £3.50
Small Coffee - £3
The large is the anchor - get you used to a price (with no logic behind it) thus now
making the medium seem cheap. Especially as small (another anchor) is £3.
A share falls in value from £80 to £30 - it now seems a bargain - but thats just not
rational - you need to see the fundamentals of WHY the price fell not just look at
the £80 anchor
2. Mental Accounting
So a fund set aside for a vacation or a new home, while still carrying substantial
credit card debt is crazy (if the debt is costing more than the deposit account)
So we selectively lter and pay more attention to information that supports our
opinions, while ignoring the rest
An investor "sees" information that supports her original idea and not the
contradictory info
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4. Gambler's Fallacy
A gambler MAY incorrectly use the past info to try and predict the future. This is
crazy. The chance is still 50%
Some investors sell after a share has risen many times in the recent past - surely
it can't continue going up? Of course it can - the past has no effect on the future
in these situations
5. Herd Behaviour
Individually, however, most people would not necessarily make the same choice.
The common rationale that it's unlikely that such a large group could be wrong.
After all, even if you are convinced that a particular idea or course or action is
irrational or incorrect, you might still follow the herd, believing they know
something that you don't. This is especially prevalent in situations in which an
individual has very little experience.
Think about investors in many dot.com companies in the past - all following each
other when fundamentally the businesses were not strong
6. Overcon dence
Overcon dent investors generally conduct more trades than their less-con dent
counterparts.
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Overcon dent investors/traders tend to believe they are better than others at
choosing the best stocks and best times to enter/exit a position.
7. Overreaction Bias
According to EMH semi strong markets, new information should more or less be
re ected instantly in a security's price.
For example, good news should raise a business' share price accordingly, and
that gain in share price should not decline if no new information has been
released since.
Furthermore, it also appears that this price surge is not a permanent trend -
although the price change is usually sudden and sizable, the surge erodes over
time.
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Syllabus A3. Corporate environmental, social, governance
(ESG) and ethical issues
Fundamental Principles
followed
1. Integrity
2. Objectivity
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Act diligently and within appropriate standards when providing professional
services
4. Confidentiality
Don't disclose any con dential information to third parties without proper and
speci c authority
5. Professional behaviour
Refrain from any conduct which might bring discredit to the profession
In the exam question you may have to apply these to a case study - groovy baby..
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Syllabus A3fh. f) Recommend appropriate strategies for the resolution of stakeholder con ict in
speci c situations and advise on alternative approaches that may be adopted
h) Recommend an ethical and governance framework for the development of an organisation’s
nancial management policies, which is grounded in the highest standards of probity and is
fully aligned with the ethical principles of the Association.
ethical decisions.
These are:
If an employee is unsure about this, they should use the mirror test.
If felt to be signi cant, it needs to be reported to the ethics department to deal with it.
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Step 4 - are there safeguards to reduce threats to an acceptable level?
Whether or not you choose to perform the action, it's useful to look in the mirror and
ask yourself:
Is it legal?
What will others think? – How would you feel explaining what you did to a friend, a
parent, a spouse, a child, a manager, or the media?
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Syllabus A3e. Explore the areas within the ethical and governance framework of the
organisation which may be undermined by agency issues and/or stakeholder con icts and
establish strategies for dealing with them.
Agency Relationship
Agency is de ned in relation to a principal. What?! Well all this means is an owner
(principal) lets somebody run her business (manager).
Footballers, lm stars etc all have agents. They work on behalf of the star. The star
hopes that the agent is working in their best interest and not just for their own
commission…
In the case of corporate governance, the principal is a shareholder and the agents
are the directors.
Agency Costs
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Transaction cost theory
General
If items are made within the company itself, therefore, there are no transaction costs
• Company will try to keep as many transaction as possible in-house in order to:
o manage quality
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Are the transaction costs (of dealing with others and not doing the thing
The 3 factors to take into account as to whether the transaction costs are worthwhile
are:
1. Uncertainty
o The more certain we are, the lower the transaction / agency cost
2. Frequency
3. Asset specificity
o The more unique the item, the more worthwhile the transaction / agency cost
is
This can be applied to directors who may take decisions in their own interests also:
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UK corporate governance
Governance
• Independent chairperson
US corporate governance
In the US, statutory requirements for publicly-traded companies are set out in the
Sarbanes-Oxley Act.
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These requirements include:
1. The certi cation of published nancial statements by the CEO and the chief
nancial of cer (CFO)
The Act also requires the Securities and Exchange Commission (SEC) and the main
In Europe most large companies are not listed on a Stock Market, and are often
dominated by a single shareholder with more than 25% of the shares (often a
Banks are powerful shareholders and generally have a seat on the boards of large
companies.
A major difference that exists in the board structure for companies is that the UK has
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It is common in Europe to have a two-tier board structure consisting of a supervisory
representatives.
The Supervisory Board does not have full access to nancial information, is meant to
take an unbiased overview of the company, and is the main body responsible for
employees (trade unions) may introduce perspectives that are not present in some
UK boards.
In particular, many members of the Supervisory Board would not meet the criteria
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Syllabus A3b. Assess the impact on the physical environment and the sustainability of natural
resources arising from alternative organisational business, nancial and investment decisions..
Social and environmental issues in the conduct of business and of ethical behaviour
• Economic activity is only sustainable where its impact on society and the
environment is also sustainable.
Sustainability can be measured empirically or subjectively
Environmental Footprint
Sustainable development
The development that meets the needs of the present without compromising the
ability of future generations to meet their own needs.
Energy, land use, natural resources and waste emissions etc should be consumed at
the same rate they can be renewed.
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Sustainability affects every level of organisation, from the local neighborhood to the
entire planet.
This means calculating the total cost of company activities, including environmental,
economic and social costs
The concept is also explained using the triple ‘P’ headings of ‘People, Planet and
Pro t’
The principle of TBL reporting is that true performance should be measured in terms
of a balance between economic (pro ts), environmental (planet) and social (people)
factors; with no one factor growing at the expense of the others.
The contention is that a corporation that accommodates the pressures of all the
three factors in its strategic investment decisions will enhance shareholder value, as
long as the bene ts that accrue from producing such a report exceeds the costs of
producing it.
Nice article
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Syllabus A4. Management of international trade and nance
Syllabus A4ab. a) Advise on the theory and practice of free trade and the management of
barriers to trade.
b) Demonstrate an up to date understanding of the major trade agreements and common
markets and, on the basis of contemporary circumstances, advise on their policies and
strategic implications for a given business.
Free trade
1. Choice
The diversity of goods available in a domestic economy is increased through the
import of goods that could be uneconomic or impossible to produce at home.
2. Competition
International trade will increase competition in domestic markets, which is likely to
lead to both a reduction in price, together with increasing pressure for new
products and innovation.
3. Economies of scale
By producing both for the home and international markets companies can
produce at a larger scale and therefore take advantage of economies of scale.
4. Specialisation
If a country specialises in producing the goods and services at which it is most
ef cient, it can maximise its economic output.
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Trade barriers
There are a number of ways that a country can seek to restrict imports.
Trade barriers include:
• Quotas
– imposition of a maximum number of units that can be imported e.g. quotas on
the number of cars manufactured outside of Europe that can be imported into the
EU.
• Tariffs
– imposition of an import tax on goods being imported into the country to make
them uncompetitive on price.
• Exchange controls
– domestic companies wishing to buy foreign goods will have to pay in the
currency of the exporter’s country.
To do this they will need to buy the currency involved by selling sterling.
If the government controls the sale of sterling it can control the level of imports
purchased.
• Administrative controls
– a domestic government can subject imports to excessive levels of
administration, paperwork and red tape to slow down and increase the cost of
importing goods into the home economy.
• Embargoes
– the prohibition of commerce and trade with a certain country.
Multinational companies have to nd ways of overcoming these barriers, for
example by investing directly and manufacturing within a country rather than
importing into it.
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Trade agreements and common markets
In many parts of the world, governments have created trade agreements and
common markets to encourage free trade.
However, the World Trade Organisation (WTO) is opposed to these trading blocs
and customs unions (e.g. the European Union) because they encourage trade
between members but often have high trade barriers for nonmembers.
requirements
This rules out returns from portfolio investment and eliminates unit and
investment trusts.
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Syllabus A4c. Discuss how the actions of the World Trade Organisation can affect a
multinational organisation.
Aims are:
The WTO will impose nes, if members are in breach of their rules.
Members of the WTO cannot offer selective free trade deals with another country
without offering it to all other members of the WTO (the most favoured nation
principle).
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The drawbacks of reducing protectionist measures are:
It may be that these industries are developing and in time would be competitive
on a global scale.
They may fail too quickly due to international competition, and would create large
scale unemployment
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Syllabus A4c. Discuss how the actions of the International Monetary Fund and Central Banks
can affect a multinational organisation.
Central banks
Central banks normally have control over interest rates and support the stability of
the nancial system.
In the context of international trade, a key role of the central bank is to guarantee the
convertibility of a currency (eg from £s to $s).
The IMF's main purpose is to support the stability of the international monetary
system by providing support to countries with balance of payments problems; most
countries are members.
IMF loans are conditional on action being taken to reduce domestic demand, and are
normally repayable over a ve-year period.
The IMF has been criticised as being controlled by those who don’t need funds, for
failing to control its own costs and for holding on to its substantial gold reserves.
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The World Bank
The World Bank, partially funded by the IMF, exists to fund reconstruction and
redevelopment.
Loans are normally made directly to governments, for periods of 10-20 years and
tied to speci c projects.
Popularly known as the World Bank, it was also created at Bretton Woods in 1944,
with the aim of nancing the reconstruction of Europe after the Second World War.
The World Bank is now an important source of long-term low interest funds for
developing countries.
It acts as a trustee for the IMF in loans to developing countries and provides
bridging nance for members pending their securing longer term nance for balance
of payments de cits.
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Syllabus A4d. d) Discuss the role of international nancial institutions within the context of a
globalised economy, with particular attention to (the Fed, Bank of England, European Central
Bank and the Bank of Japan).
Its roles
1. conducting the US monetary policy
2. maintaining stability of the nancial system
3. supervising and regulating banking institutions.
Bank of England
The Bank of England is the central bank of the UK.
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European Central Bank (ECB)
was established in 1998 and is based in Frankfurt.
• It is responsible for administering the monetary policy of the EU Eurozone
member states.
• The main objective of the ECB is to maintain price stability within the Eurozone
(keep in ation low).
Bank of Japan
is Japan’s central bank and is based in Tokyo.
In 1997, the Bank was given greater independence from the government.
The bank has ignored government requests to stimulate the Japanese economy.
However in August 2011, the Bank of Japan announced a scheme to offer 3 trillion
yen (approximately $35 billion) in low- interest loans in an attempt to stimulate the
economy.
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Syllabus A4d. Discuss the role of international nancial institutions within the context of a
globalised economy, with particular attention to (the Fed, Bank of England, European Central
Bank and the Bank of Japan).
The Euromarkets
Eurocurrency
refers to a currency held on deposit outside the country of its origin eg Eurodollars
are $US held in a bank account outside the USA.
Eurobonds
are bonds issued (for 3 to 20 years) simultaneously in more than one country.
Eurocurrency loans
The term of these loans can vary from overnight to the medium term.
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Euronotes
Companies issue short-term unsecured notes promising to pay the holder of the
Euronote a xed sum of money on a speci ed date or range of dates in the future.
Euroequity market
These have had only limited success, probably due to the absence of a effective
secondary market reducing their liquidity.
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Syllabus A4e. Discuss the role of the international nancial markets with respect to the
management of global debt, the nancial development of the emerging economies and the
maintenance of global nancial stability.
These are:
3. Managing risk
Overseas debt nance is a useful means of managing risk:
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Risk types Impact of overseas debt finance
If assets are seized, allows the rm to default on the loan (if raised
from the host government) or to use international development
agencies (with in uence over the local government)
Economic The risk of a local devaluation offset by the bene t of lower
repayments on a loan
It will be important to conform to local regulations. Taking when the London Stock
2. At least 25% of the company’s shares must be in public hands when trading
begins
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Syllabus A4f. Discuss the signi cance to the organisation, of latest developments in the world
nancial markets such as the causes and impact of the recent nancial crisis; growth and
impact of dark pool trading systems; the removal of barriers to the free movement of capital;
and the international regulations on money laundering.
EU countries could borrow at a cheap rate - because it was assumed they were
following the economic rules of the single currency.
This effectively meant that the good credit rating of Germany was improving the
credit rating of countries such as Greece, Portugal and Italy.
Some countries used this cheap nance and built up large balance of payments
de cits, hoping to stimulate growth - which the nancial crisis prevented
This European Sovereign Debt crisis has been getting worse - see Greece as an
obvious example
In May 2010 the EU created the European Financial Stability Facility (EFSF) which
provides bailout loans to these countries
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What's all this I hear about "Austerity"?
Many countries are now spending less to decrease their debt - this is what austerity is
Austerity was needed even more when many countries paid to save their banks from
The obvious problem here is people are paid less, less investment is made and ALL
countries suffer - particularly in the EU where these countries trade heavily with each
One nal problem is that the Euro then loses value. This means that buying goods
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Syllabus A4e. Discuss the role of the international nancial markets with respect to the
management of global debt
This problem arose following the oil price increases in the 1970s, when the OPEC
countries invested their large surpluses with banks in the western world.
The banks then lent substantial sums to the less developed countries (LDCs)
The oil price rises fuelled in ation and interest rates increased, forcing most of the
High interest rates and reduced exports placed LDCs in a situation where they could
These problems made economic conditions in many LDCs extremely dif cult,
affecting the position of multinationals and making international banks less willing to
lend.
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Methods of dealing with such excessive debt burdens have been:
5. Drastic changes in the economic policies of the LDC imposed and monitored by
the IMF.
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Syllabus A4f. Discuss the signi cance to the organisation, of latest developments in the world
nancial markets such as the growth and impact of dark pool trading systems
What is it?
The word 'dark' refers to the fact that the share purchase isn't made public until after
Why do this?
Well nowadays there lots of small purchases of shares as individuals can buy and
Therefore a LARGE BLOCK purchase coming up would in uence the share price
Therefore they would rather keep the purchase quiet until after the transaction
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Any problems with this?
Well it needs an alternative exchange - thus making the regulated exchanges less
They also reduce the fairness of a regulated exchange - thus many regulators are
now asking for dark pools to report their volumes of transactions weekly
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Syllabus A4f. Discuss the signi cance to the organisation, of latest developments in the world
nancial markets such as the removal of barriers to the free movement of capital
particularly IFRS
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Syllabus A4g. Demonstrate an awareness of new developments in the macroeconomic
environment, assessing their impact upon the organisation, and advising on the appropriate
response to those developments both internally and externally.capital
Developments
from..
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Syllabus A5. Strategic business and nancial planning for
multinationals
Stock exchanges
Each keeps an index of the value of shares on that exchange; In London, for
example, the FTSE All Share (Financial Times Stock Exchange) index is a measure
of all of the shares listed in London.
In New York, it is the Dow Jones index and in Hong Kong, it is the Hang Seng index.
In the UK, for example, it is a stock exchange requirement that listed companies
comply with the Combined Code on Corporate Governance
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Procedure for obtaining a listing on an international stock exchange
1. legal
2. regulatory
3. compliance
Steps:
This entails a change in its memorandum and articles agreed by the existing
members at a special meeting of the company.
2. The company must then meet the regulatory requirements of the Listing Agency
which, in the UK, is part of the Financial Services Authority (FSA).
3. Once these requirements are satis ed the company is then placed on an of cial
list and is allowed to make a public offering of its shares.
4. Once the company is on the of cial list it must then seek the approval of the
Stock Exchange for its shares to be traded.
5. The London Exchange imposes strict requirements and invariably the applicant
company will need the services of a sponsoring rm that specialises in this type
of work.
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The advantages of seeking a public listing
2. It offers the company access to equity capital from both institutional and private
investors and the sums that can be raised are usually much greater than can be
obtained through private equity sources.
3. Enhances its credibility as investors and the general public are aware that by
doing so it has opened itself to a much higher degree of public scrutiny than is
the case for a rm that is privately nanced.
1. A distributed shareholding does place the rm in the market for corporate control
increasing the likelihood that the rm will be subject to a takeover bid.
2. There is also a much more public level of scrutiny with a range of disclosure
requirements.
3. Financial accounts must be prepared in accordance with IFRS or FASB and with
the relevant GAAP as well as the Companies Acts.
4. Under the rules of the London Stock Exchange companies must also comply with
the governance requirements of the Combined Code
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Syllabus A5aii. i) Advise on the development of a nancial planning framework for a multinational
organisation taking into account:
ii) The mobility of capital across borders and national limitations on remittances and transfer
pricing
One of the drivers of globalisation has been the increased level of mobility of capital
across borders.
1. Economic risk
2. Political risk
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Political risk
This is the risk of loss of control over the foreign entity through intervention of the
local government or other force.
• Financial penalties on imports from the rest of the group such as heavy
interestfree import deposits.
One form of exchange control risk is that the group may accumulate surplus cash
in the country where the subsidiary operates, either as pro ts or as amounts
owed for imports to the subsidiary, which cannot be remitted out of the country.
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Speci c strategic issues for multinational organisations – control
• Within the hierarchy of rms (in a group) goal incongruence may arise when
divisional managers in overseas operations promote their own sel nterest over
those of other divisions and of the organisation generally.
• In order to motivate local management and to obtain the bene t of their local
knowledge, decision making powers should be delegated to them.
However, given the wide geographical spread of divisions, it is dif cult for group
management to control the behaviour of the local managers.
• This gives rise to agency costs, and a dif cult balance between local autonomy
and effective central control.
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Syllabus A5a. a) Advise on the development of a nancial planning framework for a
multinational organisation taking into account:
iii) The pattern of economic and other risk exposures in the different national markets
iv) Agency issues in the central coordination of overseas operations and the balancing of local
nancial autonomy with effective central control.
Bank overdrafts
Bills of exchange
If the importer accepts the bill it is known as a “trade bill”, whereas if the importer
arranges for its bank to accept the bill, it becomes a less risky “bank bill”.
Where payment will be made after the speci ed period of credit, the exporter can sell
the bill at a discount to its face value and receive the cash immediately.
If the bill is dishonoured the exporter can seek legal remedies in the country of the
importer.
Promissory notes
similar, but less common than bills of exchange, since they cannot usually be
discounted prior to maturity.
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Documentary letters of credit
the importer obtains a Letter of Credit from its bank, which guarantees payment to
the exporter via a trade bill. Though slow to arrange, this method is virtually risk free
provided the exporter presents speci ed error free documents (eg shipping
documents, certi cates of origin and a fully detailed invoice) within a speci ed time
period.
The high bank fees for this procedure are normally borne by the importer, and the
DLC is normally reserved for expensive goods only.
Factoring
the factoring company (often the subsidiary of a bank) assumes the responsibility for
collecting the trade debts of another – in this case an exporter.
The factor may provide a range of services (eg providing advances, administering
the sales ledger, credit insurance etc) for an additional fee. Widely regarded as a
useful means of obtaining trade nance and collecting of debts for small or medium
sized exporters.
However the exporter must always bear in mind the eventual consequences of
dispensing with the services of the factor and undertaking the running of the sales
ledger and cash collection activities itself.
Forfaiting
a medium term source of nance whereby a domestic bank will discount a series of
medium term bills of exchange, which have normally been guaranteed by the
importers bank. The forfaiting bank normally forgoes the right of recourse to the
exporter if the bill is dishonoured.
The exporter obtains the bene t of immediate funds, but the bank charges are
expensive. Forfaiting is normally used for the export of capital goods, where the
importer pays in a series of instalments over a period of years.
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Leasing and hire purchase
the exporter sells capital goods to a lessor, which in turn enters into a leasing
agreement with the exporter’s overseas customer.
Alternatively the equipment can be sold to a hire purchase company which resells to
the importer under a HP agreement.
Acceptance credits
a large reputable exporter can arrange for its bank to accept bills of exchange (which
are related to its export activities) on a continuing basis.
These bills can then be discounted at an effective cost, which is lower than the bank
overdraft interest rate.
Produce loans
where an importer acquires commodities for the purpose of immediate resale, it can
raise a loan from its bank, which takes custody of the goods until the importer is able
to sell them.
Thereafter the principal sum, interest and storage costs are repaid to the bank out of
the proceeds of the sale.
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Syllabus A6. Dividend policy in multinationals and transfer
pricing
Dividends policy
financing decision
Investment decision
All our cash will be used for investments, so our shareholders expect low or zero
dividend
They are happy with that because they think we are fab and cool :) and will grow and
their shares will go up hugely in value as we grow
Financing decision
• However, if a company can borrow to nance its investments, it can still pay
dividends.
This is sometimes called borrowing to pay a dividend. There are legal constraints
over a company’s ability to do this;
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• Dividend policy tends to change during the course of a business’s lifecycle.
Young company
Zero / Low dividend
High growth / investment needs
Wants to minimise debt
Mature company
High stable dividend
Lower growth
Able & willing to take on debt
Possibly share buybacks too
It is appropriate for a small company listed on a small stock exchange and owned by
investors seeking maximum capital growth on their investment
A special dividend
Usually when a company raises its normal dividend, the investor expectation is that
this marks a sustained increase.
• The disadvantage can be that the company could not respond quickly to new
business opportunities.
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What to look for when considering investing in other company:
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Syllabus A6ai. a) Determine a corporation’s dividend capacity and its policy given:
i) The corporation’s short- and long-term reinvestment strategy
Smart reinvesting can grow your business quickly, but a poor decision at the wrong
time can harm your long-term growth.
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Reinvesting is Risky
The safest reinvesting options safeguard your money and bring in a small pro t.
Smart investing relies on the ability to manage risk for the greatest reward.
Push the risk too high and you may very well end up with nothing.
A Reinvestment Hierarchy
You need to have the cash ow on hand to cover your current commitments and
the commitments over the next six months
2. A reinvestment in yourself
Training and experiences for yourself and your employees will be a long-term
investment that pays off every time some of that knowledge or some of those
skills are used.
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3. Reinvesting in your business
They increase your pro ts and decrease your expenses, potentially giving you
more capital to work with.
4. External investments
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Syllabus A6a. Determine a corporation’s dividend capacity and its policy given:
ii) The impact of capital reconstruction programmes such as share repurchase agreements
and new capital issues on free cash ow to equity.
Shareholder perks
Some companies (e.g. hotels) offer discounts to shareholders on room bookings and
restaurant meals.
Some retailers provide discount vouchers, which are sent to shareholders at the
same time as the annual report and accounts.
Scrip dividends
When the directors of a company consider that they must pay a certain level of
dividend, but would really prefer to retain funds within the business, they can
introduce a scrip dividend scheme.
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Share repurchases
Companies with cash surpluses may choose to introduce a share buy-back scheme,
whereby the company’s shares are purchased at the company’s instructions on the
open market.
2. With the share buyback scheme, the shareholders can choose whether or not to
3. Share buybacks are normally viewed as positive signals by markets and may
4. Increasing future EPS (because of the reduction in the number of shares in issue)
a subsidiary may pay dividends to a parent company in a way that they bene t from
expected movements in exchange rates
• A company would like to collect early (lead) payments from currencies vulnerable
to depreciation
• A company would like to collect late (lag) from currencies which are expected to
appreciate
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Syllabus A6a. Determine a corporation’s dividend capacity and its policy given:
iv) The corporate tax regime within the host jurisdiction.
Dividend income is taxed differently from Pro t and therefore the tax position of the
investors can in uence their preference.
e.g There is a different tax rate paid on dividends in different countries (somewhere
0% or 5% or 15%)
The parent company can reduce its tax liability by receiving larger amounts of
dividends from subsidiaries in countries where undistributed earnings are taxed.
For subsidiaries of UK companies, all foreign pro ts are liable to UK corporation tax,
with a credit for the tax that has already been paid abroad.
The US government does not distinguish between income earned abroad and
income earned at home.
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Illustration
The corporate tax rate in the home country is 35% and in the overseas country
where a subsidiary is located is 20%.
Both the parent company and the subsidiary have pre-tax pro ts of $1000.
Notice that they have effectively paid 35% (which is the rate in the home
country)
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Syllabus A6c. Develop organisational policy on the transfer pricing of goods and services
across international borders and be able to determine the most appropriate transfer pricing
strategy in a given situation re ecting local regulations and tax regimes.
Transfer Pricing
divisions of the same organisation for goods and services they provide to them.
Usually, each division will report its performance separately. Hence, some monetary
For example, division A might make a component that is used as part of a product
made by division B of the same company, but that can also be sold to the external
1. External sales revenue from sales made to other organisations, valued at the
selling price.
2. Internal sales revenue from sales made to other responsibility centres within the
Multinational transfer pricing is the process of deciding on appropriate prices for the
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When considering a multinational firm, additional objectives are to:
Be aware that multinational rms will be keen to transfer pro ts if possible from
high tax countries to low tax ones.
6. have good relations with governments in the countries in which the multinational
rm operates
Transfer pricing is not simply buying and selling products between divisions.
3. royalty payments
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Ethical issues in transfer pricing
There are a number of potential ethical issues for the multinational company to
consider when formulating its transfer pricing strategy:
• Reputational loss.
• Bad publicity.
• Tax evasion.
Divisional managers are therefore likely to resent being told by head of ce which
products they should make and sell.
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3. Assess divisional performance objectively
the transfer price will achieve this if the decisions which maximize divisional
pro t also happen to maximize group pro t
There’s no point transferring out if the next division doesn’t want to transfer in.
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Practical Transfer Pricing
• Market prices
• Production cost – this can be based on variable or full cost including a mark-up
• Negotiation
If an external market price exists for transferred goods, pro t centre managers will be
aware of the price they could obtain or the price they would have to pay for their
goods on the external market, and they would inevitably compare this price with the
transfer price.
1. Divisional autonomy
A transferor division should be given the freedom to sell output on the open
'Arm's length' transfer prices, which give pro t centre managers the freedom to
negotiate prices with other pro t centres as though they were independent
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2. Corporate profit maximisation
In most cases where the transfer price is at market price, internal transfers should
be expected, because the buying division is likely to bene t from a better quality
Both divisions may bene t from cheaper costs of administration, selling and
transport.
A market price as the transfer price would therefore result in decisions which
Where a market price exists, but the transfer price is a different amount (say, at
standard cost plus), divisional managers will argue about the volume of internal
transfers.
The manager of division Y would resent the loss of his cheap supply from X, and
would be reluctant to buy on the open market.
A wasteful situation would arise where X sells on the open market at $10, where
Y buys at $10, so that administration, selling and distribution costs would have
been saved if X had sold directly to Y at $10, the market price.
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The disadvantages of market value transfer prices
3. Many products do not have an equivalent market price so that the price of a
similar, but not identical, product might have to be chosen.
In such circumstances, the option to sell or buy on the open market does not
really exist.
4. There might be an imperfect external market for the transferred item, so that if the
transferring division tried to sell more externally, it would have to reduce its selling
price.
A variable cost approach entails charging the variable cost (equal to marginal cost)
that has been incurred by the supplying division to the receiving division.
The problem is that with a transfer price at marginal cost, the supplying division does
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Although good economic decisions are likely to result, a transfer price equal to
marginal cost has certain drawbacks:
• Selling division will make a loss as its xed costs cannot be covered.
This is demotivating.
This effect can also distort investment decisions made in each division. For
example, buying division will enjoy in ated cash in ows.
• There is little incentive for selling division to be ef cient if all marginal costs are
covered by the transfer price.
There are two approaches to transfer pricing which try to preserve the economic
information inherent in variable costs while permitting the transferring division to
make pro ts, and allowing better performance valuation .
• Variable cost plus lump sum: transfers are made at variable cost but, periodically,
a transfer is made between the two divisions to account for xed costs and pro t.
• Dual pricing: In this approach, the supplying division transfers out at cost plus a
mark up and the receiving division transfers in at variable cost.
Obviously, the divisional current accounts won’t agree, and some period-end
adjustments will be needed to reconcile those and eliminate ctitious
interdivisional pro ts.
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Transfer prices based on full cost
Under this approach, the full cost (including xed overheads absorbed) incurred by
the supplying division in making the 'intermediate' product is charged to the receiving
division.
The drawback to this is that the division supplying the product makes no pro t on its
work so is not motivated to supply internally.
If a full cost plus approach is used, a pro t margin is also included in this transfer
price.
The supplying division will therefore gain some pro t at the expense of the buying
division.
When a transfer price is based on cost, standard cost should be used, not actual
cost.
A transfer at actual cost would give the supplying division no incentive to control
costs because all of the costs could be passed on to the receiving division.
Actual cost-plus transfer prices might even encourage the manager of the supplying
division to overspend, because this would increase divisional pro t, even though the
organisation as a whole suffers.
The problem with this approach is that it penalizes the supplying division if the
standard cost is unattainable, while it penalizes the receiving division if it is too easily
attainable.
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Negotiated Transfer Prices
In some cases, the divisions of a company are free to negotiate the transfer price
between themselves and then to decide whether to buy and sell internally or deal
with outside parties.
Negotiated transfer prices are often employed when market prices are volatile and
change occurs constantly.
The negotiated transfer price is the outcome of a bargaining process between the
supplying and receiving division.
Transfer price ≤ the lower of net marginal revenue of the receiving division and
the external purchase price
When unit variable costs and/or unit selling prices are not constant, there will be a
pro t-maximising level of output and the ideal transfer price will only be found by
negotiation and careful analysis: -
1. Establish the output and sales quantities that will optimise the pro ts of the
company or group as a whole.
2. Establish the transfer price at which both pro t centres would maximise their
pro ts at this company-optimising output level.
There may be a range of prices within which both pro t centres can agree on the
output level that would maximise their individual pro ts and the pro ts of the
company as a whole.
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Syllabus B: Advanced Investment Appraisal
Syllabus B1. Discounted cash flow techniques
Syllabus B1a. Evaluate the potential value added to an organisation arising from a speci ed
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
i) In ation and speci c price variation
ii) Taxation including tax allowable depreciation and tax exhaustion
What it does is looks at all the projected future CASH in ows and out ows.
Obviously we hope the in ows are more than the out ows. If they are this is called a
positive NPV
The idea that money coming in today is worth more than the same amount of money
coming in in 5 years time. To do this we “discount down” all future cash ows.
This “discounting” takes into account not only the time value of money but also the
required return of our share and debt holders.
This means that if we have a positive NPV (even after discounting the future cash
ows) then the return beats not only the time value of money but it also beats what
the shareholders and debt holders require.
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So they will be happy and the company value (and hence share price) will rise by the
+NPV amount (divided by the number of shares)
NPV Proforma
0 1 2 3 4
Sales x x x x
Costs (x) (x) (x) (x)
Pro t x x x x
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WDAs
• These REDUCE your tax bill!
They are the tax relief on your capital purchases.
These are normally 25% writing down allowances on plant & machinery
• Illustration
Year 0 Buy plant 100
Year 4 Sell plant 20
25% Reducing balance; Tax 30%;
• Answer
Year 1 WDA 100 x 25% = 25 Tax bene t 7.5
Year 2 WDA 75 x 25% = 18.75 Tax bene t 5.625
Year 3 WDA 56.25 x 25% = 14 Tax bene t 4.2
• Year 4 Total tax relief should be (100-20) x 30% = 24. Less bene ts relieved so
far (7.5 + 5.625 + 4.2) = 6.675
Balancing Allowance = Tax bene t 6.675
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Working Capital
Think of this as like oat in a restaurant. Each night in the restaurant represents a
year.
So, lets say a oat of 100 is needed at the start of the night (T0).
Then the following night an extra 20 is required, the following night 30 more & the
nal night 10 less
At the end of the project it all comes back to the owner
T0 T1 T2 T3 T4
Working capital -100 -20 -30 10 140
Always start at T0
Just account for increase or decrease
Final year it all comes back as income
The working capital line should always total zero
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Syllabus B1a iii. Evaluate the potential value added to an organisation arising from a speci ed
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
iii) Single period capital rationing.
In a perfect capital market there is always nance available - in reality there is not,
there are 2 reasons for this:
This is due to external factors such as banks won’t lend any more - why?
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SOFT CAPITAL RATIONING
Company imposes it’s own spending restriction. (This goes against the concept of
shareholder maximisation - which occurs by always investing in positive NVP
projects ) - why?
2. Want to limit exposure and focus on pro tability of small number of projects
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Syllabus B1a iii. Evaluate the potential value added to an organisation arising from a speci ed
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
iii) Single period capital rationing.
Here, divisible investment projects can be ranked in order of desirability using the
profitability index
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Illustration
A Company has 100,000 to invest and has identi ed the following 5 projects. They
are DIVISIBLE.
A 40 20
B 100 35
C 50 24
D 60 18
E 50 10
Solution
A 20/40 0.5 1
B 35/100 0.35 3
C 24/50 0.48 2
D 18/60 0.3 4
E who cares! 5
Plan
(40,000) A 20,000
(50,000) C 24,000
(10,000) 10% of B 3,500
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Syllabus B1a iii. Evaluate the potential value added to an organisation arising from a speci ed
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
iii) Single period capital rationing.
In this case ranking by pro tability index will not necessarily indicate the optimum
investment schedule, since it will not be possible to invest in part of a project.
Unfortunately with indivisible projects there is no model to help us! We simply have
to look at all the possible combinations by trial and error work out which would be the
most pro table. (Highest NPV)
Surplus funds may be left over, but since the highest-NPV combination has been
selected, the amount of surplus funds is irrelevant to the selection of the optimal
investment schedule
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Illustration
A company has 100,000 to invest and has identi ed the following 5 projects. They
are NOT DIVISIBLE.
A 40 20
B 100 35
C 50 24
D 60 18
Solution
A&C 90 44
A&D 100 38
B 100 35
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Syllabus B1a iii. Evaluate the potential value added to an organisation arising from a speci ed
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
iii) Single period and multi-period capital rationing. Multi-period capital rationing to include the
formulation of programming methods and the interpretation of their output
1. Divisible
So here, there's a little scary cheeky monkey to deal with, called linear
programming!
The problem is we don't have enough cash in year 0 or in another year (often
year 1)
2. Indivisible
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Good news!
In the exam you will not be expected to produce the solution to the linear
programming problem. Yay!
bad news :(
You will have to formulate a linear programming model and understand its outputs.
Booo!
So, to recap..
When capital is rationed for MORE than a single period - profitability index won't
Check these projects - all look good but you only have $150 to spend in Year 0 and
$10 to spend in Year 1 :(
Project Yr 0 Yr 1 Yr 2 Yr 3 NPV
A (100) (30) 90 60 20
B (90) (10) 50 60 10
C (80) 20 80 10 30
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The steps to answer these questions are:
(Posh way of saying write down all the projects NPVs and their names next to
them)
(Posh way of saying write down all the costs of each project and say they should
be less than the cash available)
(Posh way of saying you can only do a project up to once and never less than
none (the computer's a bit silly that way))
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Syllabus B1a iv. Evaluate the potential value added to an organisation arising from a speci ed
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
iv) Probability analysis and sensitivity analysis when adjusting for risk and uncertainty in
investment appraisal
Risk
Uncertainty
The analysis so far has assumed that all of the future cash ows are known with
certainty. However, future cash ows are often uncertain or dif cult to estimate.
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A number of techniques are available for handling this complication. Some of these
techniques are quite technical involving computer simulations or advanced
mathematical skills and are beyond the scope of F9.
However, we can provide some very useful information to managers without getting
too technical.
1. Sensitivity Analysis
2. Probability Analysis
3. Simulation
4. Adjusted Payback
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Syllabus B1a iv. Evaluate the potential value added to an organisation arising from a speci ed
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
iv) Probability analysis and sensitivity analysis when adjusting for risk and uncertainty in
investment appraisal
Sensitivity Analysis
Sensitivity analysis shows us which item is critical to the success of the project
The one which has to change the least to make the net present value no longer
positive
Managers should then look at the assumptions behind this key item
Also focus on it in order to increase the likelihood that the project will deliver positive
NPV
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The calculation boyeeeeeeee
• The smaller the percentage, the more sensitive the decision to go ahead is to the
change in the variable
Illustration
ACCA colleges are considering a project which will cost them an initial 10,000
The cash ows expected for the 2 year duration are 10,000pa.
• Solution
PV of project as a whole:
Year 0 1 2
Investment (10,000)
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So the NPV as a whole is 5,615
Sensitivity of Costs
5,615 / (909 + 826) = 323%
Sensitivity of Sales
5,615 / (9,090 + 8,260) = 32%
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Syllabus B1a iv. Evaluate the potential value added to an organisation arising from a speci ed
capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
iv) Probability analysis and sensitivity analysis when adjusting for risk and uncertainty in
investment appraisal
Probability analysis
For example, a range of expected market conditions could be formulated and the
probability of each market condition arising in each of several future years could be
assessed.
The NPVs arising from these combinations could then be assessed and linked to
their joint probabilities.
The expected net present value (ENPV) could be calculated, together with the
probability of the worst-case scenario and the probability of a negative net present
value.
In this way, the downside risk of the investment could be determined and
incorporated into the investment decision.
The term ‘probability’ refers to the likelihood or chance that a certain event will occur,
with potential values ranging from 0 (the event will not occur) to
1 (the event will de nitely occur).
For example, the probability of a tail occurring when tossing a coin is 0.5, and the
probability when rolling a dice that it will show a four is 1/6 (0.166).
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The total of all the probabilities from all the possible outcomes must equal 1, ie some
outcome must occur
Calculating an EV
Formula
• ∑px
It nds the the long run average outcome rather than the most likely outcome
Illustration
A new product cash ows will depend on whether a substitute comes onto the market
or not
• Solution
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Limitations of Probability Analysis
Expected values are more useful for repeat decisions rather than one-off activities,
as they are based on averages.
They illustrate what the average outcome would be if an activity was repeated a
large number of times.
And the average family in the UK has 2.4 children, now Ive never thrown a 3.5
nor met anyone with 2.4 children.
These are just long term averages, whereas in reality outcomes only occure once
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Syllabus B1a v, vi. Evaluate the potential value added to an organisation arising from a
speci ed capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
v) Risk adjusted discount rates
vi) Project duration as a measure of risk.
Payback method
This method focuses on liquidity rather than the pro tability of a product. It is good
for screening and for fast moving environments
The payback period is the length of time that it takes for a project to recoup its initial
cost out of the cash receipts that it generates.
This period is some times referred to as “the time that it takes for an investment to
pay for itself.”
The basic premise of the payback method is that the more quickly the cost of an
investment can be recovered, the more desirable is the investment.
The payback period is expressed in years. When the net annual cash in ow is the
same every year, the following formula can be used to calculate the payback
period….
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Formula / Equation:
*If new equipment is replacing old equipment, this becomes incremental net
annual cash in ow.
It simply measures how long it takes the project to recover the initial cost.
Obviously, the quicker the better.
Illustration
• Solution
Take the decimal (0.1429) and multiply it by 12 to get the months - in this case
1.7 months
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So how useful is this method?
The payback method is not a true measure of the pro tability of an investment.
Rather, it simply tells the manager how many years will be required to recover the
original investment.
Unfortunately, a shorter payback period does not always mean that one
investment is more desirable than another.
Another criticism of payback method is that it does not consider the time value of
money. A cash in ow to be received several years in the future is weighed equally
with a cash in ow to be received right now.
3. Screening
On the other hand, under certain conditions the payback method can be very
useful. It can help identify which investment proposals are in the “ballpark.”
That is, it can be used as a screening tool to help answer the question, “Should I
consider this proposal further?” If a proposal does not provide a payback within
some speci ed period, then there may be no need to consider it further.
When a rm is cash poor, a project with a short payback period but a low rate of
return might be preferred over another project with a high rate of return but a long
payback period.
The reason is that the company may simply need a faster return of its cash
investment.
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5. Quick changing environments
And nally, the payback method is sometimes used in industries where products
become obsolete very rapidly - such as consumer electronics.
Since products may last only a year or two, the payback period on investments
must be very short.
1. Simple
This is because cash ows in the future become harder and harder to predict so
recovering the money as soon as possible is vital.
4. It maximises liquidity
Drawbacks
1. the item with the quickest payback is simply that. What about afterwards, does it
still do well or does it then become obsolete?
2. It ignores the whole pro tability. Also the time value of money is ignored (more of
that later).
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Irregular Cashflows
When the cash ows associated with an investment project changes from year to
year, the simple payback formula that we outlined earlier cannot be used.
Cumulative
When the cumulative cash ow becomes positive then this is when the initial payment
has been repaid and so is the payback period
So in the nal year we need to make 10 more to recoup the initial 800. So, that’s 10
out of 120. 10/120 x 12 (number of months) = 1.
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Syllabus B1a v, vi. Evaluate the potential value added to an organisation arising from a
speci ed capital investment project or portfolio using the net present value (NPV) model.
Project modelling should include explicit treatment and discussion of:
v) Risk adjusted discount rates
vi) Project duration as a measure of risk.
Adjusted Payback
the course
2 Methods
• Add payback to NPV - Only projects with +ve NPV and payback within speci ed
time chosen
• Discount cash ows used in payback with a risk adjusted discount rate
Illustration of method 2
Year Cashflow
0 (1,700)
1 500
2 500
3 600
4 900
5 500
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Calculate discounted payback at a rate of 12%
Solution
1. Cost of debt
2. Cost of equity
If a project gives additional risks then the discount factor should be altered
accordingly. This is called the risk premium
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Syllabus B1b i. Outline the application of Monte Carlo simulation to investment appraisal.
Candidates will not be expected to undertake simulations in an examination context but will be
expected to demonstrate an understanding of:
i. The signi cance of the simulation output and the assessment of the likelihood of project
success
It results in the creation of a distribution curve of all possible cash ows which could
arise from the investment and allows for the probability of the different outcomes to
be calculated.
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Illustration: Monte Carlo simulation
Required:
Solution
• Project A has a lower average pro t but is also less risky (less variability of
possible pro ts).
• Project B has a higher average pro t but is also more risky (more variability of
possible pro ts).
• There is no correct answer. All simulation will do is give the business the above
results. It will not tell the business which is the better project.
• If the business is willing to take on risk, they may prefer project B since it has the
higher average return.
• However, if the business would prefer to minimise its exposure to risk, it would
take on project A. This has a lower risk but also a lower average return.
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Syllabus B1b ii. b) Outline the application of Monte Carlo simulation to investment appraisal.
Candidates will not be expected to undertake simulations in an examination context but will be
expected to demonstrate an understanding of:
ii) The measurement and interpretation of project value at risk.
VaR = amount at risk to be lost from an investment under usual conditions over a
Con dence levels are often set at either 95% (in which case the VaR will provide the
amount that has only a 5% chance of decline) or at 99% (when the VaR considers a
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Illustration
Cow plc estimates the expected NPV of a project to be £100 million, with a standard
deviation of £9.7 million.
Required:
Establish the value at risk using both a 95% and also a 99% con dence level.
Solution
• Using Z = (X - μ) / σ
where
X = result we are considering
μ = mean
σ = standard deviation
• There is a 5% chance of the expected NPV falling to £84 million or less and a 1%
probability of it falling to £77.4 million or below.
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Value at risk can be quantified for a project using simulation to calculate the project’s
standard deviation.
In this context, the standard deviation needs to be adjusted by multiplying by the
square root of the time period ie
• 95% value at risk = 1.645 x standard deviation of project x √time period of the
project
Illustration
A four-year project has an NPV of $2m and a standard deviation of $1m per annum.
Required
Analyse the project’s value at risk at a 95% con dence level.
• The VAR at 95% is 1.645 x 1,000,000 x √4 = $3,290,000
ie worst case NPV (only 5% chance of being worse) = $2m – $3.29m = – $1.29m
Illustration
A simulation has been used to calculate the expected value of a project and is
deemed to be normally distributed with the following results:
Mean = $40,000 (positive)
Standard deviation = $21,000
Calculate the following:
a) The probability that the NPV of the project will be greater than 0.
b) The probability that the NPV will be greater than $45,000.
• a)
Using Z = (X - μ) / σ
μ = $40,000
σ = $21,000
X=0
Z = (0 - 40,000) / 21,000
Z = 1.90
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• From normal distribution table
1.90 = 0.4713 + 0.50 = 0.9713 = 97% probability that NPV >0
• b)
Using Z = (X - μ) / σ
Z = (45,000 - 40,000) / 21,000
Z = 0.24
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Syllabus B1c. Establish the potential economic return (using internal rate of return (IRR) and
modi ed internal rate of return) and advise on a project’s return margin. Discuss the relative
merits of NPV and IRR.
The IRR is essentially the discount rate where the initial cash out (the investment) is
equal to the PV of the cash in.
Consequently, to work out the IRR we need to do trial and error NPV calculations,
using different discount rates, to try and nd the discount rate where the NPV = 0.
The good news is you only need to do 2 NPV calculations and then apply this
formula:
Where..
• L = Lower discount rate
H = Higher discount rate
NPV L = NPV @ lower rate
NPV H = NPV @ higher rate
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If the IRR is higher than the cost of capital, the project should be accepted.
Illustration
If a project had an NPV of 50,000 when discounted at 10%, and -10,000 when
discounted at 15% - what is the IRR?
• Answer
10 + (50,000/60,000) x 5% = 14.17%
If you have a positive NPV, increase the discount rate to get a smaller NPV.
If you have a negative NPV, decrease the discount rate to get a bigger NPV.
Little Tricks
• If all the cash ows are the same
This is an annuity - simply take the Initial Cost / annual in ow - this gives you the
cumulative discount factor (annuity factor).
• Then go to the annuity table and look for this gure (in the row for the number of
years the project is for) - the column in which the gure is found is the IRR!
• If the cash ows are the same and go on forever
• This is a perpetuity - simply take the Annual in ow / Initial cost and turn it into a
percentage. That’s the IRR! Done.
Advantages of IRR
1. Considers the time value of money
2. Easily understood percentage
3. Uses cash not pro ts
4. Considers whole life of project
5. Increases shareholders wealth
Disadvantages of IRR
1. Does not produce an absolute gure (percentage only)
2. Interpolation of the formula means it is only an estimate
3. Fairly complicated to calculate
4. Non conventional cash ows can produce multiple IRRs
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Interpreting the IRR
• The IRR provides a decision rule for investment appraisal, but also provides
information about the riskiness of a project – i.e. the sensitivity of its returns.
• The project will only continue to have a positive NPV whilst the rm’s cost of
capital is lower than the IRR.
• A project with a positive NPV at 14% but an IRR of 15% for example, is clearly
sensitive to:
- an increase in the cost of nance
- an increase in investors’ perception of the potential risks
- any alteration to the estimates used in the NPV appraisal.
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Syllabus B1c. Establish the potential economic return (using internal rate of return (IRR) and
modi ed internal rate of return) and advise on a project’s return margin. Discuss the relative
merits of NPV and IRR.
MIRR
project
MIRR = Project's return
MIRR gives a measure of the maximum cost of nance that the rm could sustain
and allow the project to remain worthwhile.
If Project return > company cost of nance ⇒ Accept project
Calculation of MIRR
There are several ways of calculating the MIRR, but the simplest is to use the
following formula which is provided on the formula sheet in the exam:
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Where
• PVr= the present value of the "return phase" of the project
PVi = the present value of the "investment phase" of the project
re = the rm's cost of capital.
The MIRR assumes a single outflow at time 0 and a single inflow at the end of the
Step 1
Convert all investment phase outlays as a single equivalent payment at time 0.
Basically bring all investment costs to year 0.
Where necessary, any investment costs arising after time 0 must be discounted back
to time 0 using the company’s cost of capital.
Step 2
All net cash ows generated by the project after the initial investment (ie the return
phase cash ows) are converted to a single net equivalent terminal receipt at the end
of the project’s life, assuming a reinvestment rate equal to the company’s cost of
capital.
Step 3
The MIRR can then be calculated employing one of a number of methods, as
illustrated in the following example.
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Example
Cow plc is considering an investment in a project, which requires an immediate
payment of $20,000, followed by a further investment of $5,000 at the end of the rst
year.
The subsequent return phase net cash in ows are expected to arise at the end of the
following years:
Required:
Calculate the modi ed internal rate of return of this project assuming a reinvestment
rate equal to the company’s cost of capital of 8%.
Solution
Step 1:
Single equivalent payment discounted to year 0 at an 8% discount rate:
Year $
0 20,000
1 ($ 5,000 x 0.926 DF@8%) 4,630
Present Value (PV) of investment phase cash ows 24,630
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Step 2:
Single net equivalent receipt at the end of year 5, using an 8% compound rate:
Step 3:
A ve year PV factor can now be established i.e. ($ 24,630 ÷ $ 31,629) = 0.779
Using present value tables, this 5 year factor falls between the factors for 5% and
6% ie 0·784 and 0·747.
Using linear interpolation:
MIRR = 5% + ((0·784 - 0.779) / (0·784 - 0·747)) x (6% - 5%) = 5.13%
Alternatively, the MIRR may be calculated as follows:
MIRR = (5√ ($ 31,629/ $ 24,630)) − 1 = 5.13%
Furthermore, in examples where the PV of return phase net cash ows has already
been calculated, there is yet another formula for computing MIRR (which is given on
the ACCA formulae sheet).
This formula avoids having to establish the Terminal Value of those return phase net
cash ows.
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Advantages of MIRR
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Syllabus B2. Application of option pricing theory in investment
decisions
Syllabus B2a. Apply the Black-Scholes Option Pricing (BSOP) model to nancial product
valuation and to asset valuation:
i) Determine and discuss, using published data, the ve principal drivers of option value (value
of the underlying, exercise price, time to expiry, volatility and the risk- free rate)
ii) Discuss the underlying assumptions, structure, application and limitations of the BSOP
model.
Pricing of options
The pricing model for call options are based on the Black-Scholes
model.
Writers of options need to establish a way of pricing them.
This is important because there has to be a method of deciding what premium to
charge to the buyers.
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The price of the underlying item is the market prices for buying and selling the
underlying item.
However, mid-price is usually used for option pricing, for example, if price is
quoted as 200–202, then a mid-price of 201 should be used.
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The following steps can be used to calculate volatility of underlying item, using
historical information:
5. Then annualise the result using the number of trading days in a year.
The formula = daily volatility x √trading days
Illustration
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Solution
Standard deviation = Daily volatility
= √( 0.00170875 − (0.02155)²)
= 0.035
= 4%
Since there are ve trading days in a week and 52 weeks in a year, we assume the
trading days in a year is 52 x 5 = 260 days.
Annualised volatility = 4% x √260= 64.5%.
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Syllabus B2a. Apply the Black-Scholes Option Pricing (BSOP) model to nancial product
valuation and to asset valuation:
i) Determine and discuss, using published data, the ve principal drivers of option value (value
of the underlying, exercise price, time to expiry, volatility and the risk- free rate)
ii) Discuss the underlying assumptions, structure, application and limitations of the BSOP
model.
Note:
The formula will be given in the examination paper.
You need to be aware only of the variables which it includes, to be able to plug in the
numbers.
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The key:
• Pa = current price of underlying asset (e.g. share price)
Pe = exercise price
r = risk free rate of interest
t = time until expiry of option in years
s = 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 be base e)
Illustration
The current share price of AA plc is £2.90.
Estimate the value of a call option on the share of the company, with an exercise
price of £2.60, and 6 months to run before it expires.
The risk free rate of interest is 6% and the variance of the rate of return on the
shares has been 15%.
Solution
• d1 = (ln(2.9 / 2.6) + (0.06 × 0.5 × 0.15)) / (√0.15 × √0.5)
d1 = 0.6452, approximate to two decimal places = 0.65
d1 = 0.65 – (√0.15 x√0.5)
d1 = 0.3713 rounded to 0.37
• Using the normal distribution table:
Nd1 = N( 0.65) = 0.5 + 0.24 = 0.74
Nd2 = N(0.37) = 0.5 + 0.14 = 0.64
• Using calculator
e^(-rt) = e^(-0.03)
e^(-rt) = 0.97
• Call option price = (2.90 x 0.74) – (2.60 x 0.97 x 0.64) = £0.53
Using the Black-Scholes model to value put options
The put call parity equation is on the examination formula sheet:
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Steps:
1. Step 1: Value the corresponding call option using the Black-Scholes model.
2. Step 2: Then calculate the value the put option using the put call parity equation.
Illustration (continue)
• P = 0.53 – 2.9 + 2.60 (0.97)
P = £0.15
• The risk free rate of interest and the share’s volatility is constant over the life of
the option.
• The future share price volatility can be estimated by observing past share price
volatility.
• The share price follows a random walk and that the possible share prices are
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Application to American call options
• One of the limitations of the Black-Scholes formula is that it assumes that the
If this holds true then the model can also be used to value American call options.
• In fact, if no dividends are payable before the option expiry date, the American
• You will not be asked to value American call options on shares that do pay
Application to shares where dividends are payable before the expiry date
The BlackScholes formula can be adapted to call options with dividends being paid
• Simply deduct the present value of dividends to be paid (before the expiry of the
PV of dividend = De-rt
Where D = dividend
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Illustration
The following information relates to a call option:
Current share price £60
Exercise price £70
Dividend to be paid in 3 month time £1.5
Risk free rate 5%
Expiry date is 5 months.
• The dividend-adjusted share price for Black-Scholes option pricing model can be
calculated as:
PV of dividend = De-rt
r = 0.05
t = 3/12 = 0.25 of a year
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Syllabus B2b. Evaluate embedded real options within a project, classifying them into one of the
real option archetypes.
These are:
1. Timing options
– options to embark on an investment, to defer it or abandon it.
2. Scale options
– options to expand or contract an investment.
3. Staging options
– option to undertake an investment in stages.
4. Growth options
– options to make investments now that may lead to greater opportunities later,
sometimes called ‘toe-in-the-door’ option.
5. Switching option
– options to switch input or output in a production process.
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Valuation of real options
The Black-Scholes model can be used to value real options, but the following should
be noted:
• The exercise price will be replaced by the capital investment (initial investment).
• The price of the underlying item will be replaced by the present value of future
• Volatility of cash ows can be measured using typical industry sector risk.
The option to redeploy or switch exist when the company can use it productive
The switching from one activity to another will be exercised only when the present
value of cash ows from the new activity will exceed the cost of switching.
This could result to a put option if there is a salvage value for the work already
performed, together with a call option arising on the right to commence the new
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Syllabus B2b. Evaluate embedded real options within a project, classifying them into one of the
real option archetypes.
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Real options value will use BSOP and put-call parity and has 5 variables…
1. The underlying asset value (Pa), (the PV of future project cash ows)
2. The exercise price (Pe), (the amount paid / RECEIVED when the call/ PUT option
is exercised)
3. The risk-free (r), which is normally given or taken from the return offered by a
short-dated government bill
4. The volatility (s), which is the project risk (measured by the standard deviation)
5. The time (t), in years, left before the opportunity to exercise ends.
Year 1 2 3 4
Cash ows 20 15 10 5
The relevant cost of capital for this project is 11% and the risk free rate is 4.5%. The
likely volatility (standard deviation) of the cash ows is estimated to be 50%.
Solution to Example 1
NPV without any option to delay the decision:
Year Today 1 2 3 4
Cash ows -35 20 15 10 5
Discounted at 11% -35 18 12.2 7.3 3.3
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NPV = $5.8m
Now let's suppose the company doesn't have to make the decision right now but can
wait for two years...
Year 3 4 5 6
Cash ows 20 15 10 5
Discounted at 11% 14.6 9.9 5.9 2.7
d1 = 0.401899
d2 =-0.30521
N(d1) =0.656121
N(d2) =0.380103
Call value =$9.6m
So the company can delay its decision by two years and can bid as much as $9.6m
instead of $5.8m for the exclusive rights to undertake the project.
The increase in value re ects the time before the decision has to be made and the
volatility of the cash ows
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Example 2: Exploiting a follow-on project
A company is considering a project with a small positive NPV of $3m but there is a
possibility of further expansion using the technologies developed for the initial
project.
Currently, the present values of the cash ows of the second project are estimated to
The standard deviation of the project’s cash ows is likely to be 40% and the risk
Solution to Example 2
The variables to be used in the BSOP model for the second (follow-on) project are
as follows:
Asset Value (Pa) = $90m
Exercise price (Pe) = $140m
Exercise date (t) = Four years
Risk free rate (r) = 5%
Volatility (s) = 40%
Using the BSOP model
d1 = 0.097709
d2 = -0.70229
N(d1 )= 0.538918
N(d2 )= 0.241249
Call value =$20.85m
The overall value to the company is $23.85m, when both the projects are considered
together.
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At present the cost of $140m seems substantial compared to the present value of
Conventional NPV would probably return a negative NPV for the second project and
therefore the company would most likely not undertake the rst project either.
However, there are four years to go before a decision on whether or not to undertake
A lot could happen to the cash ows given the high volatility rate, in that time. The
company can use the value of $23.85m to decide whether or not to invest in the rst
project or whether it should invest its funds in other activities. It could even consider
the possibility that it may be able to sell the combined rights to both projects for
$23.85m.
Duck Co is considering a ve-year project with an initial cost of $37,500,000 and has
Year 1 2 3 4 5
Cash ows 1,496.9 4,938.8 9,946.5 7,064.2 13,602.9
Swan Co has approached Duck Co and offered to buy the entire project for $28m at
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Duck Co’s nance director is of the opinion that there are many uncertainties
surrounding the project and has assessed that the cash ows can vary by a standard
Solution to example 3
Since it is an offer to sell the project as an abandonment option, a put option value is
calculated based on the nance director’s assessment of the standard deviation and
using the Black-Scholes option pricing (BSOP) model, together with the put-call
parity formula.
Although Duck Co will not actually obtain any immediate cash ow from Swan Co’s
offer, the real option computation below, indicates that the project is worth pursuing
The asset value of the real option is the sum of the PV of cash ows foregone in
years three, four and ve, if the option is exercised ($9.9m + $7.1m + $13.6m =
$30.6m)
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Risk-free rate (r) 4%
d1 = 0.588506
d2 = 0.093531
N(d1) = 0.721904
N(d2) = 0.537259
Net present value of the project with the put option is approximately $3m ($3.45m –
$0.45m).
If Swan Co’s offer is not considered, then the project gives a marginal negative net
present value, although the results of any sensitivity analysis need to be considered
as well. It could be recommended that, if only these results are taken into
consideration, the company should not proceed with the project. However, after
taking account of Swan Co’s offer and the nance director’s assessment, the net
present value of the project is positive. This would suggest that Duck Co should
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Syllabus B2c. Assess, calculate and advise on the value of options to delay, expand, redeploy
and withdraw using the BSOP model.
The key here is to be able to delay investment without losing the opportunity,
creating a call option on the future investment.
Illustration
MMC is considering whether to undertake the development of a new computer game
based on an adventure lm due to be released in 24 months.
However, at present, there is considerable uncertainty about whether the lm, and
therefore the game, is likely to be successful.
Year Current 1 2 3 4 5 6
The company will require $35 million for production, distribution and marketing costs
at the start.
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 ows at a standard deviation of
30%.
Required:
Estimate the nancial impact of the directors’ decision to delay the production and
marketing of the game.
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Solution
1. Calculate NPV
Net Present Value = $(2•98 million)
On this basis the project would be rejected.
2. Present value of project’s positive cash ows discounted to current day:
$18•28m + $11•86m + $5•93m + $2•68m = $38•75m
3. Identify variables:
Current price (Pa) = $38•75m
Exercise price (Pe) = $35m
Exercise date = 2 years
Risk free rate = 3•5%
Volatility = 30%
4. Calculate d1 = (ln (Pa/Pe) + r + 0.5xs^2) t) / s√t
d1 = [ln(38•75/35) + (0•035 + 0•5 x 0•30^2) x 2]/(0•30 x √2) =
d1 = (0.10178 + 0.16) / 0.42426 =
d1 = 0•6170
5. Calculate d2 = d1 - s√t
d2 = 0•6170 – (0•30 x √2) = 0•1927
6. Using the Normal Distribution Table provided
N(d1) = 0•5 + 0•2291 + 0•7 x (0•2324 – 0•2291) = 0•7314
N(d2) = 0•5 + 0•0753 + 0•3 x (0•0793 – 0•0753) = 0•5765
7. Value of option to delay the decision
= Pa N(d1) - Pe N(d2) e^(-rt)
= 38•75 x 0•7314 – 35 x 0•5765 x e^(–0•035 x 2)
= 28•34 – 18•81 = $9•53m
8. Overall value of the project = $9•53m – $2•98m = $6•55m
Since the project yields a positive net present value it would be accepted.
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Syllabus B2c. Assess, calculate and advise on the value of options to delay, expand, redeploy
and withdraw using the BSOP model.
Option to abandon
An abandonment options is the ability to abandon the project at a certain stage in the
life of the project.
Whereas traditional investment appraisal assumes that a project will operate in each
year of its lifetime, the rm may have the option to cease a project during its life.
Abandon options gives the company the right to sell the cash ows over the
remaining life of the project for a salvage/scrape value therefore like American put
options.
Where the salvage value is more than the present value of future cash ows over the
remaining life, the option will be exercised.
Illustration
Bulud Co offered Chmura Co the option to sell the entire project to Bulud Co for $28
million at the start of year three. Chmura Co will make the decision of whether or not
to sell the project at the end of year two.
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PV of the cash ow:
year 1 2 3 4 5
present values ($ 000s) 1496.9 4938.8 9946.5 7064.2 3543.9
Required
An estimate of the value of the project taking into account Bulud Co’s offer.
Solution
1. Calculate NPV
NPV of project = $(451,000)
On this basis the project would be rejected.
3. Identify variables:
Current price (Pa) = $38•75m
Exercise price (Pe) = $28,000,000
Exercise date = 2 years
Risk free rate = 4%
Volatility = 35%
5. Calculate d2 = d1 - s√t
d2 = 0•589 – 0•35 x √2 = 0•094
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6. Using the Normal Distribution Table provided
N(d1) = 0•5 + 0•2220 = 0•7220
N(d2) = 0•5 + 0•0375 = 0•5375
7. Call value
= Pa N(d1) - Pe N(d2) e^(-rt)
= $30,613,600 x 0•7220 – $28,000,000 x 0•5375 x e^(–0•04 x 2) = approx.
$8,210,000
9. Net present value of the project with put option = $3,444,000 – $451,000 =
approx. $2,993,000
Since the project yields a positive net present value it would be accepted.
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Syllabus B2c. Assess, calculate and advise on the value of options to delay, expand, redeploy
and withdraw using the BSOP model.
Option to expand
The option to expand exists when rms invest in projects which allow them to make
further investments in the future or to enter new market.
The initial project may be found in terms of its NPV as not worth undertaking.
However, when the option to expand is taken account, the NPV may become
positive and the project worthwhile.
The option will be exercised only when the present value from the expansion is
higher than the extra investment.
Illustration
Cow plc has investigated the opening of a new restaurant in UK.
The initial capital expenditure is estimated at £16 million, whilst the present value of
the net cash in ows is expected to be £16.005 million.
If this rst restaurant is opened, Cow plc would gain the right, but not the obligation
to open a second restaurant in four years time at a capital cost of £22 million.
The present value of the associated future net cash in ows is estimated at £18
million, with a standard deviation of 30%.
If the risk free rate of interest is 3%, determine whether to proceed with the
restaurant projects.
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Solution
1. Calculate NPV
Net Present Value = £16.005 - £16 = £0.005
Since the resulting NPV of £0.005 million is a very small positive amount, this
appraisal suggests that the project is extremely marginal.
2. Identify variables:
Current price (Pa) = $18m
Exercise price (Pe) = $22m
Exercise date = 4 years
Risk free rate = 3%
Volatility = 30%
4. Calculate d2 = d1 - s√t
d2 = 1.965 – (0•30 x √4) = 1.365
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Syllabus B3. Impact of nancing on investment decisions and
APV
Syllabus B3a. Identify and assess the appropriateness of the range of sources of nance
available to an organisation including equity, debt, hybrids, lease nance, venture capital,
business angel nance, private equity, asset securitisation and sale, Islamic nance and
security token offerings. Including assessment on the nancial position, nancial risk and the
value of an organisation.
Debt v Equity
These are the things you need to think about when asked about raising nance - so
just put all these in your answer and link them to the scenario. Job done.
Availability of security
• Debt will usually need to be secured on assets by either:
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a xed charge (on speci c assets) or
a oating charge (on a speci ed class of assets).
Economic expectations
• If buoyant economic conditions and increasing pro tability expected in the future,
xed interest debt commitments are more attractive than when dif cult trading
conditions lie ahead.
Control issues
• A rights issue will not dilute existing patterns of ownership and control, unlike an
issue of shares to new investors.
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Long term finance
These are:
1. Finance Lease
You will notice we have included both operating and nance leases as potential
sources of nance - don’t forget too to mention the possibility of selling your
assets and leasing them back as a way of getting cash.
Be careful though - make sure there are enough assets on the SFP to actually do
this - or your recommendation may look a little silly ;)
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3. Equity
via a placing - does not need to be redeemed, since ordinary shares are truly
permanent nance.
The return to shareholders in the form of dividends depends on the dividend
decision made by the directors of a company, and so these returns can increase,
decrease or be passed.
Dividends are not tax-deductible like interest payments, and so equity nance is
not tax-ef cient like debt nance.
4. Preference Share
These are seen as a form of debt
5. Venture Capital
For companies with high growth and returns potential
This is provided to early/start up companies with high-potential.
The venture capitalist makes money by taking an equity share and then realising
this in an IPO (Initial Public Offering) or trade sale of the company
6. Business angels
are wealthy individuals who invest in start-up and growth businesses in return for
an equity stake.
These individuals are prepared to take high risks in the hope of high returns.
7. Private equity
consists of equity securities in companies that are not publicly traded on a stock
exchange.
Private equity funds might require a 20 – 30% shareholding or/and Rights to
appoint directors
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Equity as nance
Rights Issue
For existing shareholders initially - means no dilution of control
• A 1 for 2 at $4 (MV $6) right issue means….
The current shareholders are being offered 1 share for $4, for every 2 they
already own.
(The market value of those they already own are currently $6)
Effect on EPS
Obviously this will fall as there are now more shares in issue than before, and the
company has not received full MV for them
• To calculate the exact effect simply multiply the current EPS by the TERP /
Market value before the rights issue
Eg Using the above illustration
EPS x 5.33 / 6
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Effect on shareholders wealth
• There is no effect on shareholders wealth after a rights issue.
This is because, although the share price has fallen, they have proportionately
more shares
Equity issues such as a rights issue do not require security and involve no loss of
control for the shareholders who take up the right
2. Placing
Is an arrangement whereby the shares are not all offered to the public.
Instead, the shares are bought by a small number of investors, usually institutional
investors (such as pension funds and insurance companies).
This means low cost - so good for small issues
Placings are likely to be quick.
3. Public Issues
These are underwritten & advertised.
This means they are expensive - so good for large issue
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Asset securitisation
Asset securitisation involves the aggregation of assets into a pool then issuing new
The securities are then sold to investors who share the risk and reward from these
assets.
company ‘sells’ its right to future pro ts in that part of the business for immediate
cash.
The new investors receive a premium (usually in the form of interest) for investing in
• that it allows companies with a credit rating of (for example) BB but with AAA-
This will lead to greatly reduced interest payments as the difference between BB
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Tranches
Higher tranches carry less risk of default (and therefore lower returns) whereas junior
Drawbacks
1. management costs
2. legal fees
3. administration fees
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Islamic Finance - Introduction
Is it moral or ethical to wish wealth into existence without any underlying productive
activity happening?
Islamic Finance is based on the principle that money must never spontaneously
generate money. Instead capital must be made fruitful or “fecundated” by labour,
material or intellectual activity or be invested in a wealth creating activity.
Many of the largest global nancial companies, including Deutsche Bank and
JPMorgan Chase, have established thriving subsidiaries that strive to meet these
requirements
Consequently Islamic Finance frowns upon speculation and applauds risk sharing.
The major difference between Islamic finance and the other finance
Equity Financing not Lending
• Under Islamic nance laws, interest cannot be charged or received due to the
lack of underlying activity
Therefore, Joint ventures under which the lender and the borrower share pro ts
and risks are common because of the strict prohibition of the giving and taking of
interest.
• Due to a ban on speculation, Islamic transactions must be based on tangible
assets such as commodities, buildings or land.
Islamic banking has its emphasis on equity nancing rather than lending
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Investing in businesses that provide goods or services considered contrary to the
principles of Islam is haraam (forbidden) while those that are permitted are
halaal.
• Interest is called riba and an instrument that complies with the dictates of Fiqh al-
Muamalat (Islamic rules on transactions) is described as sharia-compliant.
Instead of charging interest (deemed to be money making money), the lender
agrees to buy the asset or part of the asset themselves (asset making money)
• Riba is absolutely forbidden in Islamic nance. Riba can be seen as unfair from
the perspective of the borrower, the lender and the economy.
For the borrower, riba can turn a pro t into a loss when pro tability is low.
For the lender, riba can provide an inadequate return when unanticipated in ation
arises. In the economy, riba can lead to allocational inef ciency, directing
economic resources to sub-optimal investments
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Mudaraba (equity), Sukuk (debt) & Musharaka (JV)
A type of partnership in which one partner provides the capital (the provider of the
Each gets a prearranged percentage of the pro ts, but the partner providing the
Although provisions can be made where losses can be written off against future
pro ts.
company.
The provider of the nance is not involved in the executive decision-making process.
As the pro ts are shared with the manager and the capital provider but the losses
are beared only by the capital provider this mode is also named pro t sharing – loss
bearing.
Before the manager gets his share, the losses, however, if any, needs to be
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Debt nance (sukuk) eg. Bond issue
• The company sells the certi cate to the investor, who then rents it back to the
The company promises to buy back the bonds at a future date at par value.
• Sukuks must be able to link the returns and cash ows of the nancing to the
• Simple Musharaka
The pro t and the losses needs to be shared.
This method is recommended by Muslim economists as being the most fair and
just method.
In a Musharaka contract all parties may take part in the management or some
parties may not take part in the management (silent partnership).
• Losses need to be born proportionately to the capital provided by each party (pro
rata).
Regarding the pro ts there is a disagreement between the schools whether other
than pro rata distribution is permissible.
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Ijara (leasing) and Murabaha (credit)
Let’s say that you, a small businessperson, wish to go into business selling cars.
A conventional bank would examine your credit history and, if all was acceptable,
You would have to pay back funds on a speci c maturity date, paying interest each
You would use the proceeds to buy the car—and meet other expenses—yourself.
Murabaha
• But in a murabaha transaction, instead of just giving you the cash, the bank itself
You promise to buy them from the bank at a higher price on a future date.
The markup is justi ed by the fact that, for a period, the bank owns the property,
normal loan.
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• A murabaha must be asset-based however, so it can’t help a small businessman
This is far riskier for the bank and thus much harder to obtain.
Most often the lessee returns the asset (and its bene ts) to the lessor.
However some jurists do not permit this latter arrangement on the basis that it
represents more or less a guaranteed nancial return at the outset to the lessor,
• The terms of ijara are exible enough to be applied to the hiring of an employee
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Some generally agreed conditions for ijara are as follows:
1. The leased asset must continue to exist throughout the term of the lease.
Items which are consumed in the process of usage, ammunition for instance,
cannot be leased
maintenance and insurance of the leased item under ijara remains that of the
lessor throughout
3. A price cannot be pre-determined for the sale of the asset at the expiry of the
lease.
However, lessor and lessee may agree the continuation of the lease or the sale of
the leased asset to the lessee under a new agreement at the end of the initial
lease period.
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Syllabus B3b. Discuss the role of, and developments in, Islamic nancing as a growing source
of nance for organisations; explaining the rationale for its use, and identifying its bene ts and
de ciencies.
Basic Idea - IF
Islamic finance has obvious religious reasons for use but also
commercially
Islamic nance does not allow "interest" instead returns come from the risks of
ownership
So the Islamic bank faces similar risks to its client and so is more involved in the
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Advantages of Islamic finance
Remember there should always be a link between the economic activity and the
4. Banks cannot use excessive leverage and are therefore less likely to collapse
5. The rules encourage all parties to take a longer-term view leading to a more
6. Co-operation and pro t creation through ethical and fair activity bene ts the
community as a whole
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Disadvantages of Islamic Finance
Some Murabaha are based on prevailing interest rates rather than economic or
pro t conditions
costs
costs.
Banks need to know more than usual so more due diligence work is required.
regulation.
6. Trading in Sukuk products has been limited, especially since the nancial crisis
8. Can be dif cult to balance the interests of the nancial institution with those of
other stakeholders.
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Initial Coin Offerings
ICOs are a type of crowdfunding or crowd investing tool conducted entirely on the
blockchain.
They lay out a timeline for the project and set a target budget where they describe
the future funds spending (marketing, R&D, etc.) as well as coin distribution (how
many coins are they going to keep for themselves, token supply, etc.).
return of investment when selling their coin later at a possibly higher price.
ICOs are similar to IPOs only if the token represents a stake in the project.
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Syllabus B3c) Discuss the role of green nance for organisations pursuing an environmental/
sustainable agenda.
Green Finance
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Syllabus B3de. d) Calculate the cost of capital of an organisation, including the cost of equity
and cost of debt, based on the range of equity and debt sources of nance. Discuss the
appropriateness of using the cost of capital to establish project and organisational value, and
discuss its relationship to such value.
e) Calculate and evaluate project speci c cost of equity and cost of capital, including their
impact on the overall cost of capital of an organisation. Demonstrate detailed knowledge of
business and nancial risk, the capital asset pricing model and the relationship between equity
and asset betas.
The cost of capital represents the return required by the investors (such
as equity holders, preference holders or banks)
Basically the more risk you take, the more return you expect.
The return for the investors needs to be at least as much as what they can get from
government gilts (these are seen as being risk free). On top of this they would like a
return to cover the extra risk of giving the rm their investment.
The cost of normal debt is cheaper than the cost of equity to the company. This is
because interest on debt is paid out before dividends on shares are paid. Therefore
the debt holders are taking less risk than equity holders and so expect less return.
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Creditor hierarchy
When a company cannot pay its debts and goes into liquidation, it must pay its
creditors in the following order:
1. Creditors with a xed charge
2. Creditors with a oating charge
3. Unsecured creditors
4. Preference shareholders
5. Ordinary shareholders
Each of the above will cost the company more as it heads down the list. This is
because each is taking more risk itself
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Calculating the WACC
Debt 20% 8%
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Illustration
Statement of Financial Position
Reserves 3,000
Solution
Using Book Values:
Equity
Reserves 3,000
5,000
Debt
Loan 1,000
6,000
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Solution
Using Market Values:
Equity
7,500
Debt
8,300
SUMMARY
To Calculate WACC
1. Calculate weighting of each source of capital (as above)
2. Calculate each individual cost of capital
3. Multiply through and add up (as above)
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Dividend Valuation Model
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Illustration
• Share Capital (50c) $2 million
Dividend per share (just paid) 24c
Dividend paid four years ago 15.25c
Current market return = 15%
Risk free rate = 8%
Equity beta 0.8
Solution
Dividend is growing so use DVM with growth model:
• Calculating Growth
Growth not given so have to calculate by extrapolating past dividends as before:
24/15.25 sq root to power of 4 = 1.12 = 12%
So Dividend at end of year 1 = 24 x 1.12
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CAPM
This method also calculates the cost of equity (like dvm) but looks more closely at
the shareholder’s rate of return, in terms of risk.
The more risk a shareholder takes, the more return he will want, so the cost of equity
will increase.
It suggests that any investor would at least want the same return return that they
could get from a “risk free” investment such as government bonds (Greece?!!).
On top of the risk free return, they would also want a return to re ect the extra risk
they are taking by investing in a market share.
They may want a return higher or lower than the average market return depending
on whether the share they are investing in has a higher or lower risk than the
average market risk
The higher or lower requirement compared to the average market premium is called
the beta (β)
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Systematic and non-systematic risk
More technically Beta (β ) = Systematic risk of the investment compared to the
market
1. Systematic risk
Market wide risk - such as state of the economy
All companies, though, do not have the same systematic risk as some are
affected more or less than others by external economic factors
For example, a particular oil company has the diversi able risk that it may drill
little or no oil in a given year.
An investor may mitigate this risk by investing in several different oil companies
as well as in companies having nothing to do with oil.
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An explanation of the graph
• If you have 1 share and this share does badly, then you DO BADLY.
• If you have 10 shares and 1 share does badly, you are sad about 1 share, but
you are still HAPPY about the other 9.
• Therefore with 1 share you are taking more risk than if you have more shares.
This risk is called UNSYSTEMATIC RISK
• So, we can buy more shares and therefore the UNSYSTEMATIC RISK should
GET SMALLER
• You will be always left with some risk that can't be diversi ed away.
This risk is called SYSTEMATIC RISK.
It is BETA (β) in the CAPM formulae
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CAPM continue
2. If beta > 1, the investment is riskier (more volatile) than the market and investors
should demand a higher return than the market return to compensate for the
additional risk.
3. If beta < 1, the investment is less risky than the market and investors would be
satis ed with a lower return than the market return.
Illustration
Risk free rate = 5%
What returns should be required from investments whose beta values are:
(i) 1
(ii) 2
(iii) 0.5
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• (iii) = 5 + 0.5(14 - 5) = 9.5%
The return required from an investment with half the risk as the market.
A lower return than that given by the market is therefore required.
CAPM assumptions
1. Diversi ed investors
2. Perfect market (in fact they are semi strong at best)
3. Risk free return always available somewhere
4. All investors expectations are the same
Advantages of CAPM
1. The relationship between risk and return is market based
2. Correctly looks at systematic risk only
3. Good for appraising speci c projects and works well in practice
Disadvantages of CAPM
2. The return level is only seen as important not the way in which it is given.
For example dividends and capital gains have different tax treatments which may
be more or less bene cial to individuals.
4. Generally CAPM overstates the required return for high beta shares and visa
versa
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DVM or CAPM?
DVM
The current share price and dividend is easily known but..
• it is very dif cult to nd an accurate value for the future dividend growth rate
• using a historic growth rate as a predictor of the future isn't based on fact
The equation:
• (Dividend next year / Share Price) + Growth
might suggest that the rate of return would be lowered if the company reduced its
dividends or the growth rate.
That is not so. All that would happen is that a cut in dividends or dividend growth
rate would cause the market value of the company to fall to a level where
investors obtain the return they require.
CAPM
has a sound theoretical basis, relating the required return of well-diversi ed
shareholders to the systematic risk they face through owning the shares of a
company. However...
• nding suitable values for the risk-free rate of return & equity beta can be dif cult
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DVM difficulties
• The dividend growth model has several dif culties.
For example, it impractically assumes that the future dividend growth rate is
constant.
The dividend decision depends on past trends but also current conditions.
The historic dividend growth rate is used as a substitute for the future dividend
growth rate.
• The model also assumes that business risk, and the cost of equity, are constant
in future periods, but reality shows us that companies are subject to constant
change.
The dividend growth model does not consider risk explicitly in the same way as
the CAPM.
Here, all investors are assumed to hold diversi ed portfolios and as a result only
seek return for the systematic risk of an investment.
• The individual components of the CAPM are found by empirical research and so
the CAPM gives rise to a much smaller degree of uncertainty than that attached
to the future dividend growth rate in the dividend growth model.
For this reason, it is usually suggested that the CAPM offers a better estimate of
the cost of equity than the dividend growth model.
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Ungearing & Regearing
If any if the above do not apply - then we cannot use WACC. We then have to use
CAPM.. adapted…
If we are looking to invest into a different industry we need to use a different beta,
one which represents:
• Business Risk (of new industry)
• Financial Risk (Ours still as we are using our debt and/or equity)
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To do this - follow these 2 simple steps
1. Ungearing
Take the equity beta of a business in the target industry.
Remember, this will represent their business risk and their nancial risk (gearing).
2. Re-Gearing
Take this asset beta and regear it using our gearing ratio as follows:
Illustration
Tax = 30%
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Find the appropriate beta for the main company to use in its CAPM for investing in
an industry different to its own but the same as the proxy company
STEP 1
Ungear the ß of the proxy company:
ßu = ßg [Ve/(Ve + Vd (1 - t))]
= 1⋅4 x 4/4⋅7 = 1⋅1915
STEP 2
Regear the ß:
ßg = 1⋅1915 x (5 + 2 (1 - 0⋅3))/5
= 1⋅525
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Redeemable debt
The company pays the interest and the original amount (capital) back.
So the MV is the interest and capital discounted at the investor’s required rate of
return.
Remember the cost of debt to the company is the debtholder’s required rate of
return. (Tax plays a part here as we shall see later)
Illustration
5 years 12% redeemable debt. MV is 107.59
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The Tax Effect
• Tax reduces the cost of capital to a company because interest payments are tax
deductible.
It was ignored in the last example, but let’s say that that tax was 30%, then the
actual interest cost was not 12 but 12x70% = 8.40
Simply take the interest gure and multiply it by 1 - tax rate%.
Illustration
20% Redeemable debt.
Tax 30%.
What is the interest charge to be used in a cost of capital calculation for a company?
20% x 70% = 14%
Now let’s rework that last example but this time use 10% as a guess and let’s
assume tax of 30%
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Irredeemable debt
The company just pays back the interest (NOT the capital)
So the MV should just be all the expected interest discounted at the investor’s
required rate of return.
Therefore, the cost of debt (the debtholder’s required return) can be calculated as
follows:
• Annual Interest / Market Value
Preference Shares
Treat the same as irredeemable debt except that the dividend payments are never
tax deductible
• Annual Dividend / Market Value
Illustration
Bank Debt
The cost of debt is simply the interest charged. Do not forget to adjust for tax though
if applicable.
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Illustration
7%
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Convertible Debt
Here the investor has the choice to either be paid in cash or take shares from the
company.
To calculate the cost of capital here, simply follow the same rules as for redeemable
debt (an IRR calculation).
The only difference is that the ‘capital’ figure is the higher of:
1. Cash payable
2. Future share payable
Illustration
8% Convertible debt. Redeemable in 5 years at:
Cash 5% premium or
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20 shares per loan note (current MV 4 and expected to grow at 7%)
Tax 30%.
Note :
Interest = 100 x 8% x 70% (tax adj) = 5.6
Capital = higher of 100 x 1.05% (premium) = 105 and 20 x 4 x 1.07 power 5 = 112.2
Terminology
• Floor Value MV without conversion option (basically the above calculation using
cash as capital)
• Conversion Premium MV of loan - convertible shares @ today’s price
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WACC - Putting it all Together
So, you have studied all the bits in isolation, here’s where we get sexy and bring it all
together..
So, this is kind of the proforma you need to set up, when you get a “Calculate the
WACC..” question
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WACC calculated using Asset Beta
Steps:
1. Calculate competitor's Market Value of equity and Market Value of debt
4. Then based on your capital structure, estimate the project’s equity beta (includes
business risk of the competitor and your nancial risk).
6. Calculate WACC
This is an entirely new line of business for Tisa Co. (New business risk)
Tisa Co has 10 million 50c shares trading at 180c each.
Its loans have a current value of $3•6 million and an average after-tax cost of debt of
4•50%.
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Tisa Co’s capital structure is unlikely to change signi cantly following the investment.
(No change in Financial risk)
Elfu Co manufactures electronic parts for cars including the production of a
component similar to the one being considered by Tisa Co.
Elfu Co’s equity beta is 1•40, and it is estimated that the equivalent equity beta for its
other activities, excluding the component production, is 1•25.
Elfu Co has 400 million 25c shares in issue trading at 120c each.
The loans have a current value of $96 million.
It can be assumed that 80% of Elfu Co’s debt nance and 75% of Elfu Co’s equity
nance can be attributed to other activities excluding the component production.
Tax 25%.
Risk free rate 3•5%
Market risk premium 5•8%.
Required
Calculate the cost of capital that Tisa Co should use to calculate the net present
value of the project.
Solution
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Other activities:
MVe = 75% x $480m = $360
MVd = 80% x $96 = $76.8
Elfu Co asset beta of other activities =
1•25 x $360m/($360m + $76•8m x (1 – 0•25)) = 1•078
Assuming that:
25% can be attributed to component activities and
75% can be attributed to other activities:
1•217 = component asset beta x 0•25 + 1•078 x 0•75
Component asset beta = [1•217 – (1•078 x 0•75)]/0•25 = 1•634
4. Then based on your capital structure, estimate the project’s equity beta (includes
business risk of the competitor and your financial risk).
Equity Beta = Asset Beta x ((E + D(1-tax) / E)
Component equity beta based on Tisa Co capital structure =
1•634 x [($18m + $3•6m x 0•75)/$18m] = 1•879
6. Calculate WACC
Ke = 14.40%
Kd = 4.5% (after tax)
Component WACC = (14•40% x $18m + 4•5% x $3•6m)/($18m + $3•6m) =
12•75%
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WACC calculated using ungeared Ke
Illustration 1
Cow Co is an unlisted company producing milk and wants to be listed on a stock
exchange and be nanced entirely by equity.
Cow Co’s closest competitor is Milk Co, a listed company which produces milk
worldwide.
Milk Co:
MV debt = $500
MV equity = $200
Milk Co’s geared cost of equity is estimated at 12% and its pre-tax cost of debt is
estimated at 5%.
Tax is 25%
Required
Calculate Cow Co's WACC.
• Solution:
As Cow Co. wants to be nanced entirely by equity, we will use Milk Co's
Ungeared Ke (includes only equity, NO debts) as WACC.
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Exam standard example (extract)
Mlima Co’s closest competitor is Ziwa Co, a listed company which mines metals
worldwide.
Mlima Co’s directors are of the opinion that after listing Mlima Co’s cost of capital
should be based on Ziwa Co’s ungeared cost of equity.
Ziwa Co’s geared cost of equity is estimated at 16•83% and its pre-tax cost of debt is
estimated at 4•76%.
These costs are based on a capital structure comprising of 200 million shares,
trading at $7 each, and $1,700 million 5% irredeemable bonds, trading at $105 per
$100.
Both Ziwa Co and Mlima Co pay tax at an annual rate of 25% on their taxable pro ts.
Required
Solution
Ziwa Co
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Syllabus B3f. Assess an organisation’s debt exposure to interest rate changes using the
simple Macaulay duration and modi ed duration methods.
investment.
Duration measures the average time to recover the present value of the project (if
Duration captures both the time value of money and the whole of the cash ows of a
project.
Projects with higher durations carry more risk than projects with lower durations.
GNT Co is considering an investment in a corporate bond. The bond has a par value
Required
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1. Determine Gross Redemption Yield
= 4.2%
2. Calculate PV of the annual cash flows (interest + redemption value in the year 5)
1,079•68
= 4•49 years
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Syllabus B3h. Assess the organisation’s exposure to credit risk, including:
i) Explain the role of, and the risk assessment models used by the principal rating agencies
ii) Estimate the likely credit spread over risk free
iii) Estimate the organisation’s current cost of debt capital using the appropriate term structure
of interest rates and the credit spread.
Credit spread
The credit spread is a measure of the credit risk associated with a company.
Credit spreads are generally calculated by a credit rating agency and presented in a
The credit spread is in basis point, which means for example 5 = 0.05%.
credit spread (sometimes referred to as the "default risk premium"), and the formula:
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The criteria used by credit agencies for establishing a company’s credit rating are the
following:
1. Industry risk
measures the how the company’s industrial sector reacts to changes in the
economy.
How cyclical the industry is and how large the peaks and troughs are.
2. Earnings protection
measures how well the company will be able to maintain or protect its earnings in
changing circumstances.
3. Financial flexibility
considers how well the managers are managing and planning for the future of the
company.
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Gearing drift
Gearing drift can cause a rm to move away from its optimal gearing position.
The rm might have to occasionally increase gearing (by issuing debt, or paying a
large dividend or buying back shares) to return to its optimal gearing position.
Signalling to investors
In a perfect capital market, investors fully understand the reasons why a rm
chooses a particular source of nance.
However, in the real world it is important that the rm considers the signalling effect
of raising new nance.
Generally, it is thought that raising new nance gives a positive signal to the market:
the rm is showing that it is con dent that it has identi ed attractive new projects and
that it will be able to afford to service the new nance in the future.
Investors and analysts may well assess the impact of the new nance on a rm's
statement of pro t or loss and balance sheet (statement of nancial position) in order
to help them assess the likely success of the rm after the new nance has been
raised.
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Syllabus B3i. Assess the impact of nancing and capital structure upon the organisation with
respect to:
i) Modigliani and Miller propositions, before
and after tax
iii) Pecking order propositions
These are 3 theories (& pecking order) to see if there is a perfect capital structure
suggests that using some debt will lower the WACC, but if gearing rises above an
acceptable level then the cost of equity will rise dramatically causing the WACC to
rise.
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The cheap cost of debt (as it is ranked before equity in terms of distribution of
earnings and on liquidation), combined with its tax advantage, will cause the WACC
to fall as borrowing increases.
At high gearing the cost of debt also rises because the chance of the company
defaulting on the debt is higher (i.e., bankruptcy risk).
The main problem with the traditional view is that there is no underlying theory to
show by how much the cost of equity should increase because of gearing worries or
the cost of debt should increase because of default risk.
Beyond this minimum point, the WACC increases due to the effect of increasing
nancial risk on the cost of equity and, at higher levels of gearing, due to the effect of
increasing bankruptcy risk on both the cost of equity and the cost of debt.
Although it is more or less realistic, the traditional view remains a purely descriptive
theory.
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This view can be represented by a U shaped graph, where the vertical axis is the
WACC and the horizontal the amount of debt nance.
Next, Modigliani and Miller (MM)
the use of debt transfers more risk to shareholders, and this makes equity more
expensive so that the use of debt does not reduce nance costs ie does not reduce
the WACC.
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Taxation is ignored
Risk is measured entirely by volatility of cash ows.
• Main idea
Debt or Equity - it doesn’t matter
The WACC remains the same throughout
• As a company takes on more debt, the equity holders take on a little more risk
The more debt brings the WACC down but the extra risk for equity holders,
increases Cost of Equity and so the WACC comes back up again
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Main idea
• Taxation
If Debt gets tax relief and equity doesn't then the straight line graph is wrong
The tax will make debt cheaper than equity and so more debt is advantageous at
all levels
However, this still presumes a perfect market where people don't worry about
bankruptcy risk - they do!
Therefore at higher levels of debt, WACC would actually rise in the real, imperfect
market
This is because internally generated funds have no issue costs and needs no time
and effort in persuading others.
Debt is better accepted by the markets than looking for cash via a share issue which
can seem desperate. Issue costs moderate.
Debt nance may also be preferred when a company has not yet reached its optimal
capital structure and it is mainly nanced by equity, which is expensive compared to
debt.
Issuing debt here will lead to a reduction in the WACC and hence an increase in the
market value of the company.
One reason why debt is cheaper than equity is that debt is higher in the creditor
hierarchy than equity, since ordinary shareholders are paid out last in the event of
liquidation.
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Debt is even cheaper if it is secured on assets of the company.
The cost of debt is reduced even further by the tax ef ciency of debt, since interest
payments are an allowable deduction in arriving at taxable pro t.
Debt nance may be preferred where the maturity of the debt can be matched to the
expected life of the investment project.
Equity nance is permanent nance and so may be preferred for investment projects
with long lives.
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Modigliani and Miller propositions
Formulae
Formulae
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2. Proposition 2: cost of equity
Ke = Keu + (1-T) x (Keu-Kd) x Vd/Ve
Ke = cost of equity of a geared company,
Keu = cost of equity in an ungeared company
Kd = cost of debt (pre-tax)
Vd Ve = market value of debt & equity
NB The formula is provided on the Formulae sheet.
3. Proposition 3: WACC
WACCg = Keu (1 − (Vdt/( Ve + Vd))
Illustration
An ungeared company with a cost of equity of 15% is considering adjusting its
gearing by taking out a loan at 10% and using it to buy back equity.
After the buyback the ratio of the market value of debt to the market value of equity
will be 1:1. Corporation tax is 20%.
Required
(a) Calculate the new Ke, after the buyback.
(b) Calculate and comment on the WACC after the buyback
• (a) Ke=15+(1-0.2)(15-10)x1=15+4=20%
• (b) WACC=(0.5x20)+(0.5x10x0.8)=10+4=14%
The use of debt will bring bene t to the company because the lower WACC will
enable future investments to bring greater wealth to the company's shareholders.
Example
Cow plc (an all equity company) has on issue 10,000,000 $1 ordinary shares at
market value of $2.00 each.
Milk plc (a geared company) has on issue:
15,000,000 25p ordinary shares; and
$5,000,000 10% debentures (quoted at 120)
Taking corporation tax at 30%, and assuming that:
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1. The companies are in all other respects identical; and
2. The market value of Cow’s equity and the market value of Milk’s debt are “in
equilibrium”.
1. Bankruptcy costs
The higher the level of gearing the greater the risk of bankruptcy with the
associated “COSTS OF FINANCIAL DISTRESS”.
Vg = Vu + Dt − Present value of costs of nancial distress
2. Agency costs
Costs of restrictive covenants to protect the interests of debt holders at high
levels of gearing.
3. Tax exhaustion
The value of the company will be reduced if advantage cannot be taken of the tax
relief associated with debt interest.
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4. Debt capacity
Generally loans must be secured against a company’s assets and clearly some
assets (eg property) provide better security for loans than other assets (eg high-
tech equipment which may become obsolescent overnight).
The depth of the asset’s second hand market and its rate of depreciation are
important characteristics.
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Syllabus B3i. Assess the impact of nancing and capital structure upon the organisation with
respect to:
ii) Static trade-off theory
Incorporate bankruptcy risk to M and M’s theory and you will arrive at the same
conclusion as the traditional theory of gearing – i.e. that an optimal gearing level
exists.
Firms can reach the optimum level by means of a trade off.
1. Benefits of debt
The bene ts of debt relate to the tax relief that is enjoyed when interest payments
are made – the cheaper debt nance will reduce the weighted average cost of
capital and increase corporate value.
2. Costs of debt
The costs of debt relate to the increases in the costs of nancial distress (eg
bankruptcy costs) and increases in agency costs that arise when the company
exceeds its optimum gearing levels.
The resultant increase in required returns demanded by investors cause the
weighted average cost of capital of the company to increase and hence corporate
value to fall.
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Syllabus B3i) Assess the impact of nancing and capital structure upon the organisation with
respect to:
iv) Agency effects.
Agency effects
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Syllabus B3j. Apply the adjusted present value technique to the appraisal of investment
decisions that entail signi cant alterations in the nancial structure of the organisation, including
their scal and transactions cost implications.
M&Ms theory on gearing tells us that the impact of debt finance is to save tax
This can be quanti ed and added as an adjustment to the PV of a project.
If a question shows an investment has been funded entirely by debt or asks for
project appraisal using ‘the adjusted present value method’, you must
Step 1
Calculate the NPV as if ungeared i.e. Kei
Step 2
Add the PV of the tax saved as a result of the debt used in the project
Step 3
Subtract the cost of issuing new nance
Illustration 1
Cow plc is considering a project that would involve investment of $8 million now and
would yield $2m per annum (after tax) for each of the next ve years.
The project will raise Cow’s debt capacity by $25 million for the duration of the
project at an interest rate of 8%.
The costs of raising this loan are estimated at $100,000 (net of tax).
The company’s existing Ke is 16% and corporation tax is 20%.
Cow currently has a ratio of 1:2 for market value of debt to market value of equity.
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Required
By calculating the APV, recommend whether Cow should accept this project with the
proposed nancing.
Solution
Ke = Kei + (1-T)(Kei-Kd)xVd/Ve
16 = x + (1-0.20)(x-8)x1/2
16 = x + 0.4 (x-8)
16 = x + 0.4x – 3.2 so
19.2 = 1.4x
X = 19.2 / 1.4 = 13.7% this is the cost of equity ungeared.
Round this up to 14% to use the discount tables.
Time 0 1-5
-8 2
DF@14% 1 3.517
PV -8 7.034
NPV = -8 + 7.034 = -0.966
Step 2
Interest payable = $25,000,000 x 8% = $2,000,000 and tax saved = $2,000,000 x
20% = 400,000 or 0.4m
Discount at cost of debt 8% over 5 years = 3.993
PV of tax shield (3.993 x 0.4) = $1.5972
Step 3
Issue costs = $0.1m
APV ($m) = -0.966 + 1.5972 – 0.1 = +$0.5312m
Therefore - Accept
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Syllabus B4. Valuation and the use of free cash ows
Syllabus B4a. Apply asset based, income based and cash ow based models to value equity.
Apply appropriate models, including term structure of interest rates, the yield curve and credit
spreads, to value corporate debt.
Valuations - Introduction
• Financial statements
• Investments held
• Lease agreements
• Budgets
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What are the limitations of the information provided?
• What shareholding is being sold? Does it mean the business carries on?
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Syllabus B4a. Apply asset based, income based and cash ow based models to value equity.
Apply appropriate models, including term structure of interest rates, the yield curve and credit
spreads, to value corporate debt.
Market Capitalisation
It is calculated as follows:
Illustration
Solution
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Syllabus B4a and C2ci. B4a) Apply asset based, income based and cash ow based models
to value equity. Apply appropriate models, including term structure of interest rates, the yield
curve and credit spreads, to value corporate debt.
c) Discuss, assess and advise on the value created from an acquisition or merger of both
quoted and unquoted entities using models such as:
i) ’Book value-plus’ models
2. As a minimum price
NB. If a company is quoted on a market AND is a going concern then the minimum
valuation is..
Market price + Acquisition premium
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There are different ways of measuring assets:
1. Book Values
This would represent the minimum value of a private company - as it is what the
However, even here there is the problem of needing to sell quickly may mean the
Another weakness of this is that this gives a value for the assets when SOLD not
when IN USE.
Therefore, not good for a situation of partial disposal where business and hence
3. Replacement Cost
Here the valuation dif cult - need similar aged assets value.
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If assets are to be sold on an ongoing basis
Illustration
NCA 450
Current Assets 150
Current Liabilities (50)
Solution
X 80% = 382,400
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Syllabus B4a and C2c. B4a) Apply asset based, income based and cash ow based models
to value equity. Apply appropriate models, including term structure of interest rates, the yield
curve and credit spreads, to value corporate debt.
C2c) Discuss, assess and advise on the value created from an acquisition or merger of both
quoted and unquoted entities using models such as:
ii) Market based models
Using PE ratio
Take the earnings of the company you are trying to value and multiply it
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But what we are more concerned with here is how to use this to calculate the value
of a business, again here is the formula to use to calculate the value of ONE share..
Or...
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Share Capital (25c) $100,000
Pro t before tax $260,000
Tax (120,000)
Preference Dividend ($20,000)
Ordinary Dividend ($36,000)
Retained $84,000
PE (for similar company) = 12.5
Solution
Value of Company = PE x Earnings (PAT - Pref divs)
Total Earnings (of 200,000 shares)
140,000 - 20,000 = 120,000 x 200/400 = 60,000
PE 12.5
60,000 x 12.5 = $750,000
Drawbacks of PE model
1. Finding a quoted company that is similar in activity (most have a wide range)
2. A single year’s PE ratio may not be representative
3. The quoted company used to get the PE ratio from may have a totally different
capital structure
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Syllabus B4a. Apply asset based, income based and cash ow based models to value equity.
Apply appropriate models, including term structure of interest rates, the yield curve and credit
spreads, to value corporate debt.
Earnings Yield
Basically this is how much your earnings are as a % of your share price
Solution
300,000 x 1/0.125 = $2,400,000
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Syllabus B4a. Apply asset based, income based and cash ow based models to value equity.
Apply appropriate models, including term structure of interest rates, the yield curve and credit
spreads, to value corporate debt.
Dividend Valuation
Essentially this model presumes that a share price is the PV of all future
dividends
Calculate this (with or without growth) and multiply it by the total number of shares
It is similar to market capitalisation except it doesn’t use the market share price,
rather one worked out using DVM
DVM can be with or without growth.
Note:
• Cost of Equity will be given, or calculated via CAPM
• Take this share price and multiply it by the number of shares
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DVM with growth
Note:
• Dividend + growth = Dividend end of year 1
Solution
Dividend is growing so use DVM with growth model:
Calculating Growth
Growth not given so have to calculate by extrapolating past dividends as before:
24/15.25 sq root to power of 4 = 1.12 = 12%
So Dividend at end of year 1 = 24 x 1.12
Calculate Cost of Equity (using CAPM)
8 + 0.8 (15-8) = 13.6%
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Sylllabus B4a and C2c. B4a) Apply asset based, income based and cash ow based models
to value equity. Apply appropriate models, including term structure of interest rates, the yield
curve and credit spreads, to value corporate debt.
C2c) Discuss, assess and advise on the value created from an acquisition or merger of both
quoted and unquoted entities using models such as:
iii) Cash ow models, including free cash ows.
Discounted Cashflows
Solution
Cash in ow 80 x 70% = 56 - 48 = 8 (in perpetuity)
Value of business = 8 / 0.1 = 80m
So the Equity is the value of all the cash ows less value of debt remember
Equity = 80m - (10 x 1.2) = 68m
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Advantages of DCF Method
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Syllabus B4a and C2b. B4a) Apply asset based, income based and cash ow based models
to value equity. Apply appropriate models, including term structure of interest rates, the yield
curve and credit spreads, to value corporate debt.
C2b) Estimate the potential near-term and continuing growth levels of a corporation’s earnings
using both internal and external measures.
This method is based upon the PV of the free cash flow to equity of an
enterprise.
Free cash flow to equity is the cash flow available to a company from operations
after:
1. interest expenses
2. tax
3. repayment of debt and lease obligations
4. any changes in working capital
5. capital spending on assets needed to continue existing operations (ie
replacement capital expenditure equivalent to economic depreciation)
Remember!
Discounted FCF is used for the calculation of the Value of Company attributable to
equity holders.
Value of Company = PV of Free cash ows (FCF)
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How to calculate the PV of FCF using a CONSTANT annual growth rate
e.g. After four years, the annual growth rate of the FCF to the company will be 3%,
for the foreseeable future.
FCF in Y4 = 100
g = 3%
k = 11%
PV of FCF ( rst 4 years) 500
• PV of FCF, year 5 onwards
= [FCF (in Y4) x (1 + growth rate (g)) / (cost of capital (k) – g) ] x (1+k) (to
the negative power of the number of years before the g is consistent each year)
= (100 x 1.03) / (0.11 - 0.03)] x 1.11 ^ - 4
= 1,287.5 x 0.6587
= 848
Value of Company
• = PV of FCF ( rst 4 years) + PV of FCF, year 5 onwards
= 500 + 848
= 1,348
Example
COW Co’s future sales revenue will increase by 7.5% for the next four years.
After the four years, the annual growth rate of the free cash ows to the company will
be 3.5%, for the foreseeable future.
Operating pro t margins are expected to be 15% in the future.
Although it can be assumed that the current tax-allowable depreciation is equivalent
to the amount of investment needed to maintain the current level of operations, the
company will require an additional investment in assets of 30c per $1 increase in
sales revenue for the next four years.
Tax rate is 25%.
Cost of capital is 11%.
Extract from COW Co's Statement of pro t or loss:
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Solution
Sales revenue in Y1 = $389.1 x 1.075 = $418.3
Operating pro t in Y1 = $418.3 x 15% = $62.7
Additional capital investment in Y1 = ($418.3 - $389.1) x $0.30 = $8.8
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Syllabus B4bc. b) Forecast an organisation’s free cash ow and its free cash ow to equity (pre
and post capital reinvestment).
c) Advise on the value of an organisation using its free cash ow and free cash ow to equity
under alternative horizon and growth assumptions.
Cash that is not retained and reinvested in the business is called free
cash flow.
It represents cash flow available:
• to all the providers of capital of a company
• to pay dividends or nance additional capital projects.
Example
Cow plc has earnings before interest and tax of $200,000 for the current year.
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Depreciation charges for the year have been $5,000 and working capital has
increased by $2,000.
Solution
$
EBIT 200,000
Less: Corporation tax @ 30% (60,000)
Add back: Depreciation (non-cash amount) 5,000
Deduct: Capital expenditure (20,000)
Working capital increases (2,000)
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Syllabus B4bc. b) Forecast an organisation’s free cash ow and its free cash ow to equity (pre
and post capital reinvestment).
c) Advise on the value of an organisation using its free cash ow and free cash ow to equity
under alternative horizon and growth assumptions.
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Illustration
Operating pro t = $168
NCA = $1345
Income tax expense = $15
Interest on loan = $74
During the current year:
(1) Depreciation is charged at 10% per annum on the year end non-current asset
balance and is included in other operating costs in the income statement.
(2) The investment in net working capital in Y0 was $220 and in Y1 increased to
$240.
Required
Prepare a cash ow forecast for the business highlighting the free cash ow to equity
(the dividend capacity).
Solution
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Syllabus B4de. d) Explain the use of the BSOP model to estimate the value of equity of an
organisation and discuss the implications of the model for a change in the value of equity.
e) Explain the role of BSOP model in the assessment of default risk, the value of debt and its
potential recoverability.
The equity of a company can be seen as a call option on the assets of the company
with an exercise price equal to the outstanding debt.
The role of BSOP model in the assessment of default risk is based on the limited
liability property of equity investments.
The value of the rm’s equity can therefore be estimated using a variation of the
Black-Scholes model for the valuation of a European call option.
• The value of N(d1) shows how the value of equity changes when the value of the
assets change.
This is the delta of the call option (delta is covered in more detail in Topic:
Risks).
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,
The probability of default is therefore given by 1 – N(d2).
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Syllabus B5. International investment and nancing decisions
Syllabus B5a. a) Assess the impact upon the value of a project of alternative exchange rate
assumptions.
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Accordingly, the following four-step procedure is recommended for calculating
project cash flows:
1. Compute local currency cash ows from a subsidiary viewpoint as if it were an
independent entity;
2. Calculate the amount and timing of transfers to the parent company in parent's
currency;
3. Translate the PV of cash ows to parent's currency
4. Calculate NPV in parent's currency
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Syllabus B5b. Forecast project or organisation free cash ows in any speci ed currency and
determine the project’s net present value or organisation value under differing exchange rate,
scal and transaction cost assumptions.
1. Allow for host country investment incentives (capital allowance) before applying
the local tax rate to local taxable cash ows.
2. Apply the relevant parent company rate of tax to the taxable/remitted cash ows.
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Consider the following:
In (1) no further tax will be paid in the UK as pro t is taxed in Spain at 20%.
In (2) pro t would be taxed at 30%, 20% in Spain and a further 10% in the UK.
In (3) no further tax will be paid in the UK. The 20% is charged in Spain.
Illustration 1
Suppose that the tax rate on pro ts in Country 1 is 10% and the UK corporation tax
is 20%, and there is a double taxation agreement between the two countries.
A subsidiary of a UK rm operating in Country 1 earns the equivalent of £1 million in
pro t, and therefore pays £100,000 in tax on pro ts.
When the pro ts are remitted to the UK, the UK parent can claim a credit of
£100,000 against the full UK tax charge of £200,000, and hence will only pay
£100,000.
Illustration 2
Cow Co. is considering whether to establish a subsidiary in Slovakia at a cost of
€15,000,000.
The subsidiary will run for 4 years and the net cash ows from the project are:
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There is a withholding tax of 10 percent on remitted pro ts and the exchange rate is
expected to remain constant at €1.50 = $1.
If the required rate of return is 15% what is the present value of the project?
Discount
€ € after WHT Remittance $ Discounted $
factor (15%)
3,000,000 x
Year 2,700,000 / 1.5
3,000,000 0.9 = 0.870 1,566,000
1 = 1,800,000
2,700,000
4,500,000 x
Year 4,050,000 / 1.5
4,500,000 0.9 = 0.756 2,041,200
2 = 2,700,000
4,050,000
7,000,000 x
Year 6,300,000 / 1.5
7,000,000 0.9 = 0.658 2,763,600
3 = 4,200,000
6,300,000
8,000,000 x
Year 7,200,000 / 1.5
8,000,000 0.9 = 0.572 2,745,600
4 = 4,800,000
7,200,000
Total 9,116,400
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Syllabus B5cd c) Evaluate the signi cance of exchange controls for a given investment
decision and strategies for dealing with restricted remittance.
d) Assess and advise on the costs and bene ts of alternative sources of nance available
within the international equity and bond markets.
Remission of funds
Certain costs to the subsidiary may in reality be revenues to the parent company.
For example, royalties, supervisory fees and purchases of components from the
parent company are costs to the project, but result in revenues to the parent.
It is important to note that some of these items may be locally tax-deductible for the
subsidiary but taxable in the hands of the parent.
1. Management Charges
The parent company can impose a charge on subsidiary for the general
management services provided each year.
The fees would normally be based on the number of management hours
committed by the parent on the subsidiary’s activities.
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2. Royalties
The parent company can charge the subsidiary royalties for patent, trade names
or know-how.
Royalties may be paid as a xed amount per year or varying with the volume of
output.
3. Transfer Pricing
The parent can charge arti cially higher prices for goods or services supplied to
the subsidiary as a means of drawing cash out.
This method is often prohibited by the foreign tax authorities.
Political risk
This relates to the possibility that the NPV of the project may be affected by host
country government actions.
These actions can include:
1. Expropriation of assets (with or without compensation!);
2. Blockage of the repatriation of pro ts;
3. Suspension of local currency convertibility;
4. Requirements to employ minimum levels of local workers or gradually to pass
ownership to local investors.
The effect of these actions is almost impossible to quantify in NPV terms, but their
possible occurrence must be considered when evaluating new investments.
High levels of political risk will usually discourage investment altogether, but in the
past certain multinational enterprises have used various techniques to limit their risk
exposure and proceed to invest.
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These techniques include the following:
• Structuring the investment in such a way that it becomes an unattractive target
for government action.
For example, overseas investors might ensure that manufacturing plants in risk-
prone countries are reliant on imports of components from other parts of the
group, or that the majority of the technical “know-how” is retained by the parent
company.
These actions would make expropriation of the plant far less attractive.
• Borrowing locally so that in the event of expropriation without compensation, the
enterprise can offset its losses by defaulting on local loans.
• Prior negotiations with host governments over details of pro t repatriation,
taxation, etc, to ensure no problems will arise. Changes in government, however,
can invalidate these agreements.
• Attempting to be “good citizens” of the host country so as to reduce the bene ts
of expropriation for the host government.
These actions might include employing large numbers of local workers, using
local suppliers, and reinvesting pro ts earned in the host country.
Economic risk
Economic risk is the risk that arises from changes in economic policies or conditions
in the host country that affect the macroeconomic environment in which a
multinational company operates.
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Fiscal risk
Fiscal risk is the risk that the host country may increase taxes or changes the tax
policies after the investment in the host country is undertaken.
Regulatory risk
Regulatory risk is a risk that arises from changes in the legal and regulatory
environment which determines the operation of a company.
Examples are:
• Anti-monopoly laws.
• Copyright laws.
• Employment legislation.
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Financing overseas projects
• Eurocurrency Loan
Eurocurrency loan is a loan by a bank to a company denominated in a currency
of a country other than that in which they are based.
For example, a UK company may require a loan in dollars which it can acquire
from a UK bank operating in the Eurocurrency market. This is called Eurodollar
loan.
The usual approach taken is to match the assets of the subsidiary as far as
possible with a loan in the local currency.
This has the advantage of reducing exposure to currency risk.
However, this reduced risk must be weighed against the interest rate paid on the
loan.
A loan in the local currency may carry a higher interest rate, and it may be
preferable, for example, to arrange a Eurocurrency loan in a major currency
which is highly correlated with the currency of the overseas operations.
• Government grants
Finance may be available from the UK, the overseas government, or an
international body, such as the World Bank.
• Intercompany accounts
Financing by intercompany account is useful in a situation where it is dif cult to
get funds out of the foreign country by way of dividends. This is further discussed
below.
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• Syndicated Loan Market
Syndicated loan market developed from the short-term eurocurrency market. A
syndicate of banks is brought together by a lead bank to provide medium-to long-
term currency loans to large multinational companies.
These loans may run to the equivalent of hundreds of millions of pounds. By
arranging a syndicate of banks to provide the loan, the lead bank reduces its risk
exposure.
• Eurobond
Eurobond are bonds sold outside the jurisdiction of the country in whose currency
the bond is denominated.
Eurobond is a bond issued in more than one country simultaneously, usually
through a syndicate of international banks, denominated in a currency other than
the national currency of the issuer.
They are long-term loans, usually between 3 to 20 years and may be xed or
oating interest rate bonds
An investor subscribing to such a bond issue will be concerned about the
following factors:
● security;
● marketability;
● return on the investment.
• Euroequity
These are equity sold simultaneously in a number of stock markets. They are
designed to appeal to institutional investors in a number of countries. The shares
will be listed and so can be traded in each of these countries.
The reasons why a company might make such an issue rather than an issue in just
its own domestic markets include:
• larger issues will be possible than if the issue is limited to just one market;
wider distribution of shareholders;
to become better known internationally;
queuing procedures which exist in some national markets may be avoided.
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Syllabus C: Acquisitions And Mergers
Syllabus C1. Acquisitions and mergers versus other growth
strategies
Syllabus C1a. Discuss the arguments for and against the use of acquisitions and mergers as
a method of corporate expansion.
• Operating economies
Elimination of duplicate facilities and many other ways.
• Management acquisition
Acquisition of competent and go-ahead team to compensate for lack of internal
management abilities.
• Diversi cation
Securing long-term future by spreading risk through diversi cation.
• Asset backing
Company with high earnings: assets ratios reducing risk through acquiring
company with substantial assets.
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• Quality of earnings
Reducing risk by acquiring company with less risky earnings.
• Growth
Cheaper way of growing than internal expansion.
• Tax factors
Tax ef cient way of transferring cash out of the corporate sector. In some
jurisdictions, it is a means of utilising tax losses by setting them against pro ts of
acquired companies.
• Defensive merger
Stop competitors obtaining advantage.
• Strategic opportunities
Acquiring a company that provides a strategic t.
• Asset stripping
Acquiring an undervalued company in order to sell off the assets to make a pro t.
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FB and Instagram
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Syllabus C1b. Evaluate the corporate and competitive nature of a given acquisition proposal.
Strategy Development
Internal Development
Often called 'Organic growth'
1. Build on company's core competencies
2. Suits a Risk-averse culture
3. Easier to Control & Manage
4. Slow
5. Growth restricted by own competencies
6. Better for growth at home rather than abroad
Strategic Alliances
2+ businesses share resources to pursue a strategy
1. No large initial costs
2. No cultural t problems
3. Specialise on each businesses own competencies
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Types of STRATEGIC ALLIANCE
• Joint Venture
A new organisation is set up
Both venturers put in resources
Formal & slow
• Licence agreement
Allow others to use your resources in a new market
Less Control
If successful the other venturer may then develop their own and thus not need
the licence
Needs little initial costs
Needs trust and cope ration
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Merger or acquisition
A merger
is the combining of two or more companies
An acquisition
A demerger
A demerger involves splitting a company into two separate companies which would
then operate independently of each other.
The equity holders in the company would continue to have an equity stake in both
companies.
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An alternative approach
is that a company may simply purchase the assets of another company rather than
acquiring its business, goodwill, etc.
1. Its directors will produce criteria (size, location, nances, products, expertise,
management) against which targets can be judged.
2. Directors and/or advisors then seek out prospective targets in the business
sectors it is interested in.
3. The team then examines each prospect closely from both a commercial and
nancial viewpoint against criteria.
In general businesses are acquired as going concerns rather than the purchase
of speci c assets.
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Syllabus C1d. Discuss the reasons for the frequent failure of acquisitions to enhance
shareholder value as expected, including the problem of overvaluation.
The acquiring company often pays a signi cant premium over and above the market
value of the target company prior to acquisition.
Agency theory
suggests that takeovers are motivated by the self-interest of the acquirer's
management.
Poor man-management
can be detrimental to successful integration.
Window dressing
can be also a reason for the high failure rate.
It is where companies are not acquired because of the synergies that they may
create, but in order to present a better nancial picture in the short term.
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Syllabus C1e. e) Evaluate, from a given context, the potential for synergy separately classi ed
as:
i) Revenue synergy
ii) Cost synergy
iii) Financial synergy.
Synergy
1. Revenue synergy:
2. Cost synergy:
- which result mainly from reducing duplication of functions and related costs, and
from taking advantage of economies of scale;
o Economies of scope (which may arise from reduced advertising and distribution
costs where combining companies have duplicated activities);
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3. Financial synergy:
- which result from nancing aspects such as the transfer of funds between group
companies to where it can be utilised best, or from increasing debt capacity.
o Use of the accumulated tax losses of one company that may be made available
to the other party in the business combination;
o Diversi cation reduces the variance of operating cash ows giving less
bankruptcy risk and therefore cheaper borrowing;
o Diversi cation reduces risk (however this is a suspect argument, since it only
reduces total risk not systematic risk for well diversi ed shareholders);
o High PE ratio companies can impose their multiples on low PE ratio companies
(however this argument, known as “bootstrapping”, is rather suspect).
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Syllabus C1f. Evaluate the use of alternative methods as a way of obtaining a stock market
listing; including special purpose acquisition companies (SPACs), direct listings, dutch auctions
and reverse takeovers.
Reverse Takeovers
Reverse mergers allow a private company to become public without raising capital,
which considerably simpli es the process.
The reverse merger only converts a private company into a PLC, so is less
dependent on market conditions (because the company is not proposing to raise
capital).
4. Can use company stock as the currency with which to acquire target companies
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Disadvantages of a Reverse Merger
1. Due diligence needed on shell of the PLC company - no pending liabilities etc
2. Risk of current shareholders selling / dumping their shares on the market and the
price falling
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Syllabus C2. Valuation for acquisitions and mergers
Syllabus C2c. Apply appropriate methods, such as: risk- adjusted cost of capital, adjusted net
present values and changing price-earnings multipliers resulting from the acquisition or merger,
to the valuation process where appropriate.
In theory, the value of the acquired company, and hence the maximum amount that
should be paid for it, is the Present Value of the future cash ows of the target
business discounted at the WACC of the acquirer.
Type II acquisitions
These are acquisitions which do not disturb the exposure to business risk, but do
impact upon the acquirer’s exposure to nancial risk, eg through changing the
gearing levels of the acquirer.
Such acquisitions may be valued using the Adjusted Present Value (APV) technique
by discounting the Free Cash Flows of the acquiree using an ungeared cost of equity
and then adjusting for the tax shield.
These are acquisitions that impact upon the acquirer’s exposure to both business
risk and nancial risk.
In order to estimate WACC there is a need to establish the cost of capital of the
combined businesses.
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Syllabus C2d. Demonstrate an understanding of the procedure for valuing high growth start-
ups.
5. unknown competition,
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Syllabus C3. Regulatory framework and processes
Regulation of takeovers
• not issue new shares or purchase or dispose of major assets of the company,
unless agreed prior to the bid, without the agreement of a general meeting;
• not in uence or support the market price of its shares by providing nance or
nancial guarantees for the purchase of its own shares;
• the company may not provide information to some shareholders which is not
made available to all shareholders;
• shareholders must be given suf cient information and time to reach a decision.
No relevant information should be withheld;
• the directors of the company should not prevent a bid succeeding without giving
shareholders the opportunity to decide on the merits of the bid themselves.
Directors and managers should disregard their own personal interest when advising
shareholders.
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Syllabus C3b. Identify the main regulatory issues which are likely to arise in the context of a
given offer and
i) assess whether the offer is likely to be in the shareholders’ best interests
ii) advise the directors of a target entity on the most appropriate defence if a speci c offer is to
be treated as hostile.
When a company is planning a takeover bid for another company, its board of
directors should think about how its own shareholders might react to the bid.
A company does not have to ask its shareholders for their approval of every
takeover.
• If shareholders, and the stock market in general, think the takeover is not a good
one the market value of the company's shares is likely to fall.
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A takeover bid might seem unattractive to shareholders of the bidding company
because:
• It might reduce the net asset backing per share of the company, because the
target company will probably be bought at a price which is well in excess of its
net asset value.
Resistance comes from the target company's board of directors, who adopt
defensive tactics, and ultimately the target company's shareholders, who can refuse
to sell their shares to the bidding company.
The target company will have many shareholders, some of whom will want to accept
the offer for their shares, and some of whom will not.
In addition, the target company's board of directors might resist a takeover even
though their shareholders might want to accept the offer.
Because there are likely to be major differences of opinion about whether to accept a
takeover bid or not, companies in most jurisdictions are subject to formal rules for the
conduct of takeover bids.
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Contesting an offer
The directors of a target company must act in the interests of their shareholders,
• The founder members of the business may oppose the bid, and appeal to the
loyalty of other shareholders.
When a company receives a takeover bid which the board of directors considers
unwelcome, the directors must act quickly to ght off the bid.
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Defensive tactics
The steps that might be taken to thwart a bid or make it seem less attractive include:
• Finding a 'white knight', a company which will make a welcome takeover bid
• Making a counter-bid for the predator company (this can only be done if the
companies are of reasonably similar size)
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Syllabus C4. Financing acquisitions and mergers
Syllabus C4 ac. a) Compare the various sources of nancing available for a proposed cash-
based acquisition.
c) Assess the impact of a given nancial offer on the reported nancial position and
performance of the acquirer.
Forms of consideration
Methods of payment
The takeover will involve a purchase of the shares of the target company for
1. cash
- available cash,
- desired level of gearing,
- shareholders' taxation position and
- change in control.
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An Illustration: Cash purchases
Cow Calf
Net assets (book value) $2,000 $300
Number of shares 100 10
Earnings $3,000 $90
• Expected earnings of $3,090 minus the loss of interest (net of tax) which would
have been obtained from the investment of the $600 in cash which was given up
to acquire Calf
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• The proceeds of a debt issue
This is not an approach that is normally taken, because the act of issuing bonds
will alert the markets to the intentions of the company to bid for another company
and it may lead investors to buy the shares of potential targets, raising their
prices.
This can be done as a short term funding strategy, until the bid is accepted and
then the company is free to make a bond issue.
• Mezzanine nance
This may be the only route for companies that do not have access to the bond
markets in order to issue bonds.
Mezzanine nancing is a hybrid of debt and equity nancing that gives the lender
the rights to convert to an equity interest in the company in case of default, after
venture capital companies and other senior lenders are paid.
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Purchases by share exchange
One company can acquire another company by issuing shares to pay for the
acquisition.
• To raise cash on the stock market, which will then be used to buy the target
company's shares.
Sometimes, a company might acquire another in a share exchange, but the shares
are then sold immediately on a stock market to raise cash for the seller.
Cow has agreed to acquire all the ordinary shares in Calf and has also agreed a
share-for-share exchange as the form of consideration.
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The following information is available.
The agreed share price for Calf will result in its shareholders receiving a premium of
25% on the current share price.
How many new shares must Cow issue to purchase the shares in Calf?
Solution
Use of bonds
• The securities being potentially less marketable, and lacking voting rights
Issuing convertible bonds will overcome some of these drawbacks, by offering the
target shareholders the option of partaking in the future pro ts of the company if they
wish.
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An Illustration: Loan consideration
Assuming no synergy as the result of the acquisition, by how much will the earnings
of Cow be expected to increase next year when the pro ts of Calf are taken into
account?
Solution
$'000 $'000
Calf pro t before tax 2,000
Less: tax (30%) (600)
1,400
Interest on bonds 300
Less: tax reduction (90)
Net increase in interest 210
Increase in pro t after tax for Cow 1,190
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Syllabus C4 ab. a) Compare the various sources of nancing available for a proposed cash-
based acquisition.
b) Evaluate the advantages and disadvantages of a nancial offer for a given acquisition
proposal using pure or mixed mode nancing and recommend the most appropriate offer to
be made.
The predator company can raise cash from many sources to finance the
acquisition, some of the sources are:
The predator company may not have enough cash immediately available to nance
the acquisition and may have to raise the necessary cash through bank loans and
issuing of debt instruments.
Mezzanine nance
Mezzanine nance is a form of nance that combines features of both debt and
equity.
It is usually used when the company has used all bank borrowing capacity and
cannot also raise equity capital.
It offers equity participation in the company either through warrants or share options.
If the venture being nanced is successful the lender can obtain an equity stake in
the company.
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Retained earnings
This method is used when the predator company has accumulated pro ts over time
and is appropriate when the acquisition involves a small company and the
consideration is reasonably low.
Vendor placing
In a vendor placing the predator company issues its shares by placing the shares
with institutional investors to raise the cash required to pay the target shareholders.
Typically the debt used to fund the takeover is secured on the assets of the target
company.
The cash ow generated by the target company is then used to service and repay the
debt.
The target company would normally need to have low existing debt, stable cash ows
and good asset backing.
This approach allows a private equity investor to acquire a large company with
minimal cash or risk, since they are borrowing against the acquired company's
assets and earnings.
A range of different debt is usually used and any short-term debt instruments may
need re- nancing soon after the deal.
The overall aim is to improve the running of the target over a 3-5 year period,
generate additional pro ts, repay the debt and sell the company for a pro t.
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Syllabus C4b. Evaluate the advantages and disadvantages of a nancial offer for a given
acquisition proposal using pure or mixed mode nancing and recommend the most
appropriate offer to be made.
Cash consideration
The offer is made to purchase the shares of the target company for
cash.
The advantages of cash offer to the target entity’s shareholders are that:
1. The price that they will receive is obvious.
It is not like share exchange where the movements in the market price may
change their wealth.
A disadvantage to target shareholders’ for receiving cash is that if the price that they
receive is more than the price paid when purchasing the shares, they may be liable
to capital gains tax.
The main disadvantages to the predator company are that it may deplete the
company’s liquidity position and may increase gearing.
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Example
Cow Co. accepted a takeover offer from Milk Co, a listed company.
The takeover offer is for $2•95 cash per share.
Milk Co has 10 million shares in issue and these are trading for $4•80 each.
Milk Co’s price to earnings (P/E) ratio is 15 and believes that this will enable Cow Co
to operate on a P/E level of 15 as well.
Required:
Estimates the percentage gain in value to a Cow Co share and a Milk Co share
under payment offer.
Solution
• Gain in value to a Cow Co share
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Syllabus C4b. Evaluate the advantages and disadvantages of a nancial offer for a given
acquisition proposal using pure or mixed mode nancing and recommend the most
appropriate offer to be made.
Share exchange
The predator company issues its own shares in exchange for the shares of the target
company and the
2. The shareholders of the target company will participate in the control and pro ts
of the combined entity.
1. It preserves the liquidity position of the company as there are no out ows of cash.
2. Share exchange reduces gearing and nancial risk. However, this may depend
on the gearing of the target company.
3. The predator company can bootstrap earnings per share if its price earnings ratio
is higher than that of the target company.
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The main disadvantages of a share exchange are that:
3. As equity shares are issued this comparatively more expensive than debt capital.
4. The company may not have enough authorized share capital to issue the
additional shares required.
5. There is uncertainty with a share exchange where the movements in the market
price may change their wealth.
Very few companies use debentures, loan stock and preference shares as a means
of paying a purchase consideration on acquisitions.
The main problems of using debentures and loan stock to the predator company are
that:
2. Dif culty in determining appropriate interest rate to attract the shareholders of the
target company.
The main advantages of using debentures and loan stock are that:
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Syllabus C4b. Evaluate the advantages and disadvantages of a nancial offer for a given
acquisition proposal using pure or mixed mode nancing and recommend the most
appropriate offer to be made..
Earn-out arrangements
2. The risk to the predator company is reduced as it is less likely to pay more than
the target is worth.
3. It encourages the management of the target company to work hard as the overall
consideration depends on future performance.
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Syllabus D: Corporate Reconstruction And Re-
Organisation
Syllabus D1. Financial reconstruction
This can occur in a number of circumstances, the most common being when a
company is in nancial dif culties, but also when a company is seeking oatation or
being acquired.
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However, it may be in position to survive, and indeed ourish, by taking up some
future contract or opening in the market.
The only major problem is the cash needed to nance such operations because the
present structure of the company will not be attractive to outside investors.
Possible reconstruction
The changing or reconstruction of the company’s capital could solve these problems.
To do this the company must ask all or some of its existing stakeholders to surrender
existing rights and amount owing in exchange for new rights under a new or
reformed company.
The question is ‘why would the stakeholder be willing to do this? The answer to this
• to remain as they are with the prospect of no return from their investment and no
growth in their investment.
Generally, stakeholders may be willing to give up their existing rights and amounts
owing (which are unlikely to be met) for the opportunity to share in the growth in
pro ts which may arise from the extra cash which can be generated as a
consequence of their actions.
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Syllabus D1a. Assess an organisational situation and determine whether a nancial
reconstruction is an appropriate strategy for a given business situation.
followed:
If this is not the case they will not accept the reconstruction as their agreement is
a requirement for the scheme to take place.
2. The company must have a good chance of being nancially viable and pro table
after the reconstruction.
3. The reconstruction scheme must be fair to all the parties involved, for example
preference shareholders should have preferential treatment over ordinary
shareholders.
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In solving reconstruction questions the following steps can be followed:
2. Check what each party will get if the company were to go on liquidation.
3. Check the suf ciency of the amount of nance that will be raised from the
scheme.
This includes proceeds from the sale of investment, existing assets when new
assets are to be bought to replace them, and reduction in working capital.
4. Check if the parties will be better off under the proposed scheme than under
liquidation.
5. Assess the post-reconstruction nancial viability and pro tability of the company
by calculating post-reconstruction EPS and P/E ratio.
6. Come to a conclusion.
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Syllabus D2. Business re-organisation
Syllabus D2a. Recommend, with reasons, strategies for unbundling parts of a quoted
company.
Unbundling
• to release funds
• to reduce gearing
1. Divestment
2. Demergers
3. Sell-offs
4. Spin-offs
5. Management buy-outs.
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Syllabus D2 ab.a) Recommend, with reasons, strategies for unbundling parts of a quoted
company.
b) Evaluate the likely nancial and other bene ts of unbundling.
Divestment
1. The principal motive for divestment will be if they either do not conform to group
or business unit strategy.
4. To raise more cash possibly to fund new acquisitions or to pay debts in order to
reduce gearing and nancial risk.
5. The management lack the necessary skills for this business sector
6. Protection from takeover possibly by disposing of the reasons for the takeover or
producing suf cient cash to ght it effectively.
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Syllabus D2 ab. a) Recommend, with reasons, strategies for unbundling parts of a quoted
company.
b) Evaluate the likely nancial and other bene ts of unbundling.
Spin-offs/demergers
This is where a new company is created and the shares in the new company are
There is no change in ownership of assets but the assets are transferred to the new
company.
The result is to create two or more companies whereas previously there was only
one company.
Each company now owns some of the assets of the original company and the
shareholders own the same proportion of shares in the new company as in the
original company.
An extreme form of spin-off is where the original company is split up into a number of
separate companies and the original company broken up and it ceases to exist.
Demerger involves splitting a company into two or more separate parts of roughly
comparable size which are large enough to carry on independently after the split.
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The main disadvantages of de-merger are:
1. Economies of scale may be lost, where the de-merged parts of the business had
2. The ability to raise extra nance, especially debt nance, to support new
4. There will be lower revenue, pro ts and status than the group before the de-
merger.
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Syllabus D2 ab. a) Recommend, with reasons, strategies for unbundling parts of a quoted
company.
b) Evaluate the likely nancial and other bene ts of unbundling.
Sell-offs
A Sell-off
• involves selling part of a company to a third party for an agreed amount of funds
or value
The extreme form of sell-off is liquidation, where the owners of the company
voluntarily dissolve the business, sell-off the assets piecemeal, and distribute the
proceeds amongst themselves.
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Syllabus D2c. Advise on the nancial issues relating to a management buy-out and buy-in.
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Advantages of MBOs to disposing company
4. Better publicity can be earned by preserving employer’s jobs rather than closing
the business down.
5. It is better for the existing management to acquire the company rather than it
possibly falling into enemy hands.
2. It offers them the prospects of signi cant equity participation in their company.
4. They can carry out their own strategies, no longer having to seek approval from
the head of ce.
Problems of MBOs
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Sources of nance for MBOs
These include:
• Venture capital.
• The stability of the business’s cash ows and the prospects for future growth.
• The rate of technological change in the industry and the costs associated with the
changing technologies.
• The likely time required for the business to achieve a stock market otation, (so
as to provide an exit route for the venture capitalist).
• Availability of security.
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Conditions attached to provision of nance
• Equity options.
• A right to take a controlling equity stake and so replace the existing management
if the company fails to achieve speci ed performance targets.
Management buy-in
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Syllabus D2 ab. a) Recommend, with reasons, strategies for unbundling parts of a quoted
company.
b) Evaluate the likely nancial and other bene ts of unbundling.
Share repurchase
Therefore if a company has surplus cash and cannot think of any pro table use of
that cash, it can use that cash to purchase its own shares.
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Shares may be purchased either by:
1. Open market purchase – the company buys the shares from the open market at
• Purchase of own shares may be used to take a company out of the public market
the shareholders.
• Purchase of own shares increases earning per share (EPS) and return on capital
employed (ROCE).
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Problems of share repurchase
Shares repurchase may be interpreted as a sign that the company has no new
2. Costs
Compared with a one-off dividend payment, share repurchase will require more
3. Resolution
Shareholders have to pass a resolution and it may be dif cult to obtain their
consent.
4. Gearing
If the equity base is reduced because of share repurchase, gearing may increase
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Syllabus D2 ab. a) Recommend, with reasons, strategies for unbundling parts of a quoted
company.
b) Evaluate the likely nancial and other bene ts of unbundling.
Going private
A public company may occasionally give up its stock market quotation and return
itself to the status of a private company.
The reasons for such move are varied, but are generally linked to the disadvantages
of being in the stock market and the inability of the company to obtain the supposed
bene ts of a stock market quotation.
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Syllabus E: Treasury And Advanced Risk
Management Techniques
Syllabus E1. The role of the treasury function in multinationals
Syllabus E1a. a) Discuss the role of the treasury management function within:
i) The short term management of the organisation’s nancial resources
ii) The longer term maximisation of corporate value
1. Cash management
3. Raising nance
4. Sourcing nance
5. Currency management
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The Association of Corporate Treasurers
exchange rates.
possible.
One of the roles of the nance function is to calculate the business tax liability and to
mitigate that liability as far as possible within the law.
1. Tax avoidance
is the legal use of the rules of the tax regime to one’s own advantage, in order to
reduce the amount of tax payable by means that are within the law.
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2. Tax evasion
is the use of illegal means to reduce one’s tax liability, for example by deliberately
misrepresenting the true state of your affairs to the tax authorities.
The directors of a company have a duty to their shareholders to maximise the post
tax pro ts that are available for distribution as dividends to the shareholders, thus
they have a duty to arrange the company’s affairs to avoid taxes as far as possible.
However, dishonest reporting to the tax authorities (e.g. declaring less income than
actually earned) would be tax evasion and a criminal offense.
While the traditional distinction between tax avoidance and tax evasion is fairly clear,
recent authorities have introduced the idea of tax mitigation to mean conduct that
reduces tax liabilities without frustrating the intentions of Parliament, while tax
avoidance is used to describe schemes which, while they are legal, are designed
to defeat (nullify) the intentions of Parliament.
Thus, once a tax avoidance scheme becomes public knowledge, Parliament will
nearly always step in to change the law in order to stop the scheme from working.
2. calculating the tax liability arising from the pro ts earned each year, and paying
amounts due to the tax authorities on a timely basis.
In practice, most companies (particularly small companies) will seek the advice of
external tax specialists to help them calculate their annual tax liability.
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Investment appraisal and financing viable investments
Typically money is paid out now, with an expectation of receiving cash in ows over a
number of years in the future.
If the €1m was invested to earn interest, it would be worth €1.05m in one year’s
time.
However the investment will give you €2m in one year’s time and another €2m in
two years’ time.
The second question is how this €1m required now should be nanced.
It is more likely that fresh funds will be required, possibly by issuing new shares, or
possibly by raising a loan (e.g. from the bank).
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There are advantages and disadvantages of each possibility.
• Dividends can be suspended if pro ts are low, whereas interest payments have
to be paid each year.
• The bank will typically require security on the company’s assets before it will
advance a loan.
• Interest payments are allowable against tax, whereas dividend payments are not
an allowable deduction against tax
Generally the nance function and the treasury function will work together in
appraising possible investment opportunities and deciding on how they should be
nanced.
A company must also decide on the appropriate level of investment in short term net
assets, i.e. the levels of:
• inventory
• cash balances
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There are advantages in holding large balances of each component of working
capital, and advantages in holding small balances, as below.
inventory customers are happy since low holding costs. less risk of
they
obsolescence costs.
can be immediately provided
with goods
trade receivables customers are happy since less risk of bad debts, good
they
for cash ow.
like credit.
cash creditors are happy since bills more can be invested
elsewhere
can be paid promptly
to earn pro ts.
trade payables preserves your own cash suppliers are happy and may
offer discounts
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Syllabus E1a. a) Discuss the role of the treasury management function within:
iii) The management of risk exposure.
including interest rate, inflation, central bank actions and economic growth.
• The company’s attitude towards foreign currency transactions and the importance
of overseas trading.
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Syllabus E1b. b) Discuss the operations of the derivatives market, including:
i) The relative advantages and disadvantages of exchange traded versus OTC agreements
Exchanges - where buyers and sellers of securities buy and sell securities in one
location
1. the london Stock Exchange and the New York Stock Exchange for the trading of
shares
3. the London International Financial Futures and Options Exchange (LIFFE) for the
trading of derivatives.
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Over the counter (OTC) markets
- where buyers and sellers transact with each other not through an exchange but by
individual negotiation.
The prices at which securities are bought over the counter may be the same as the
corresponding transactions in an exchange, because the buyers and sellers agree
the most competitive price based on constant contact through computers with other
market participants.
Securities that are issued in an over the counter market can be negotiable or non-
negotiable.
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Syllabus E2. The use of nancial derivatives to hedge against
forex risk
Futures
Ticks
A tick is the minimum price movement permitted by the exchange on which the future
contract is traded.
Ticks are used to determine the pro t or loss on the futures contract.
The signi cance of the tick is that every one tick movement in price has the same
money value.
Example 1
If the price of a sterling futures contract changes from $1.3523 to $1.3555, then price
has risen by $0.0032 or 32 ticks.
If you entered/bought into 50 contracts the pro t on the futures contract will be
calculated as:
Ticks are used to calculate the value of a change in price to someone with a long or
a short position in futures.
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If someone has a long position, a rise in the price of the future represents a pro t,
and a fall in price represents a loss.
If someone has a short position, a rise in the price of the future represents a loss,
and a fall represents a pro t.
Margins
When a deal has been made both buyer and seller are required to pay margin to the
clearing house.
This sum of money must be deposited and maintained in order to provide protection
to both parties.
• Initial margin
Initial margin is the sum deposited when the contract is rst made.
This is to protect against any possible losses on the rst day of trading.
The value of the initial margin depends on the future market, risk of default and
volatility of interest rates and exchange rates.
• Variation margin
If the future price moves adversely a payment must be made to the clearing
house, whilst if the future price moves favourably variation margin will be
received from the clearing house.
This implies that margin account is maintained at the initial margin as any daily
pro t or loss will be received or paid the following morning.
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Default in variation margins will result in the closure of the futures contract in
order to protect the clearing house from the possibility of the party providing cash
to cover accumulating losses.
Example 2
Required:
Calculate the cash ow if the future price moves to in day one $1.3700 and 1.3450
day two (variation margin). Assume a short position.
Solution 2
1. Day One
2. Day 2
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Basis and basis risk
Basis is the difference between the futures price and the current cash market price of
the underlying security.
In the case of exchange rates, basis is the difference between the current market
price of a future and the current spot rate of the currency.
At nal settlement date itself, the futures price and the market price of the underlying
item ought to be the same otherwise speculators would be able to make an instant
pro t by trading between the futures market and spot cash market.
Most futures positions are closed out before the contract reaches nal settlement,
hence a difference between the close out future price and the current market price of
the underlying item.
Basis risk may arise from the fact that the price of the futures contract may not move
as expected in relation to the value of the underlying item which is being hedged.
Futures hedge
Hedging with a future contract means that any pro t or loss on the underlying item
will be offset by any loss or pro t made on the future contract.
• Basis risk.
• The “round sum” nature of futures contracts, which can only be bought or sold in
whole number.
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Syllabus E1b iv. b) Discuss the operations of the derivatives market, including:
iv) Risks such as delta, gamma, vega, rho and
theta, and how these can be managed.
Risks
In order to manage a portfolio of options, the dealer must know how the value of the
options will vary with changes in the various factors affecting their price.
Delta
Therefore, the writer of options needs to hold ve times the number of options than
shares to achieve a delta hedge.
A delta value ranges between 0 and +1 for call options, and between 0 and -1 for put
options.
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The actual delta value depends on how far it is in-the-money or out- of-the-money.
The absolute value of the delta moves towards 1 (or -1) as the option goes further in-
the-money (where the price of the option moves in line as the price of the underlying
asset) and shifts towards 0 as the option goes out-of-the-money (where the price of
the option is insensitive to changes in the price of an underlying asset)
At-the- money calls have a delta value of 0.5, and at-the-money puts have a delta
value of -0.5.
Gamma
Gamma = Change in the delta value / Change in the price of the underlying security
Gamma measures the amount by which the delta value changes as underlying
security prices change.
Vega
As indicated above higher volatility increases the price of an option. Therefore any
change in volatility can affect the option premium.
Thus:
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Theta
Theta measures how much the option premium changes with the passage of time.
The passage of time affects the price of any derivative instrument because
derivatives eventually expire. An option will have a lower value as it approaches
maturity.
Thus:
Theta = Change in the option price (due to changes in value) / Change in time to
expiry
Rho
Rho measures how much the option premium responds to changes in interest rates.
Interest rates affect the price of an option because today’s price will be a discounted
value of future cash ows with interest rates determining the rate at which this
discounting takes place.
Thus:
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Syllabus E1a), E2a) and B5d.
E1a) Discuss the role of the treasury management function within:
iii) The management of risk exposure.
E2a) Assess the impact on an organisation to exposure in translation, transaction and
economic risks and how these can be managed.
B5d) Assess the impact of a project upon an organisation’s exposure to translation,
transaction and economic risk.
Translation
• Risk that there will be losses when a subsidiary is translated into the parent
company currency when doing consolidated accounts
Transaction
• Risk of exchange rates moving against you when buying and selling on credit,
between the transaction date and actual payment date
Economic
For example a UK exporter will struggle if sterling appreciated against the euro.
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Options to manage these risks
Hedging, options, futures, swaps and forward rates - more of these later!
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Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
i) The use of the forward exchange market and the creation of a money market hedge
Illustration
According to law of one price what is the predicted exchange rate in 1 year?
• Solution
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Exchange rate now (counter) x (1+ Inf (counter) / 1 + inf (base))
Limitations
Illustration
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What is the future exchange rate as predicted by IRPT?
• Solution
Limitations
1. Government intervention
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Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
i) The use of the forward exchange market and the creation of a money market hedge
£ : $1.5
£0.67:$
• Banks will BUY that foreign currency from them at the HIGHER rate
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Translating Currencies
Translation risk
- NCA and CA value - decrease
- NCL and CL value - increase.
• For instance, if the £ depreciates relative to the $, the exchange rate rises:
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Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
i) The use of the forward exchange market and the creation of a money market hedge
Forward Rates
So, remember what we are looking at here are ways to negate the risk that, in the
future, the exchange rates may move against us
So we have bought or agreed a sale now in a foreign currency, but the cash won’t be
paid (or received) until a future date
Therefore xing yourself in against any possible future losses caused by movements
in the real exchange rate
However - you also lose out if the actual exchange rate moves in your favour as you
have xed yourself in at a forward rate already
Illustration
So, the bank will give the exporter $1,000 in return for £555.
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• NOTE
If importer cannot ful ll the forward contract agreed (maybe because he didnt
receive the goods) the bank will sell the importer the currency and then buy it
back again at the current spot rate.
1. Flexible
2. Straightforward
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Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
i) The use of the forward exchange market and the creation of a money market hedge
The whole idea of a money market hedge is to take the exchange rate NOW even
though the payment is in the future.
By doing this we eliminate the future exchange risk (and possible bene ts too of
course)
So. the foreign payment is in the future, but we are going to get some foreign
currency NOW to pay for it.
We do not need the full amount though, as we can put the foreign money into a
foreign deposit account to earn just enough interest to make the full payment when
ready
We, therefore, calculate how much is needed now by taking the full amount and
discounting it down at the foreign deposit rate
Now we know how much foreign currency we need NOW, we can convert that into
home currency using the spot rate
We now know how much home currency we need. This needs to be borrowed. So,
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Steps:
1. Calculate how much foreign currency needed (discount @ foreign deposit rate)
4. The cost will be the amount borrowed plus interest on that (home currency
borrowing rate)
Illustration
• Borrow just $91 as we then put it on deposit and it attracts 10% interest - to pay
off the whole $100 at the end
• Convert $91 dollars now. We need dollars, so bank SELLS us them. They always
SELL LOW. So 91 / 2 = £45.5
• £45.5 is borrowed now. We will then have to pay interest on this in the UK for a
year.
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Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
i) The use of the forward exchange market and the creation of a money market hedge
The whole idea of a money market hedge is to take the exchange rate NOW even
though the receipt is in the future.
By doing this we eliminate the future exchange risk (and possible bene ts too of
course)
The foreign receipt is in the future, we are going to get eliminate rate risk by getting
that foreign currency NOW.
We do not borrow the full amount though, as the receipt will pay off this loan plus
interest.
We, therefore, calculate how much is needed now by taking the full amount and
discounting it down at the foreign borrowing rate
Now we know how much foreign currency we need NOW, we can convert that into
home currency using the spot rate.
Here the bank are buying foreign currency off us and so will BUY HIGH
The eventual receipt is the amount converted plus the interest earned at home
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Steps:
1. Calculate how much foreign currency needed (discount @ foreign borrowing rate)
4. The receipt will be the amount converted plus interest on that (home currency
deposit rate)
Illustration
1. Calculate how much foreign currency needed (discount @ foreign borrowing rate)
This amount will be deposited at home at 4.5% for 3/12 = 1.125% = 215,110 x
1.125% = £217,530
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Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
iii) Exchange-traded currency futures contracts
Currency Futures
*Calculations of how these work are required only for P4 exam (not F9)
Explanation
When a currency futures contract is bought or sold, the buyer or seller is required to
deposit a sum of money with the exchange, called initial margin.
If losses are incurred as exchange rates and hence the prices of currency futures
contracts change, the buyer or seller may be called on to deposit additional funds
(variation margin) with the exchange
Equally, pro ts are credited to the margin account on a daily basis as the contract is
‘marked to market’.
Most currency futures contracts are closed out before their settlement dates by
undertaking the opposite transaction to the initial futures transaction, ie if buying
currency futures was the initial transaction, it is closed out by selling currency
futures. A gain made on the futures transactions will offset a loss made on the
currency markets and vice versa.
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Advantages
Disadvantages
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Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
iii) Exchange-traded currency futures contracts
Casasophia Co, based in a European country that uses the Euro (€) is due to
receive the payment of US$20 million in four months.
Required:
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• Solution
For a US$ receipt, the ve-month futures contracts (two-month is too short for the
required hedge period) need be bought.
Predicted futures rate = 1•3698 – (1/3 x (1•3698 – 1•3633)) = 1•3676 (when the
ve-month contract is closed out in four months’ time)
• [OR: Futures lock-in rate may be estimated from the spot and ve-month futures
rate:
Note:
Casasophia Co will have $20m and the bank will buy them from it. Therefore the
bank BUYS HIGH and therefore the spot rate $1.3618 per €1 is used.
US$20,000,000/1•3682 = €14,617,746
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Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
iv) Currency swaps
Currency Swaps
currency)
Advantages
1. Easy
Currency swaps are better for managing risk over a longer term (than currency
futures or currency options)
A currency swap is an interest rate swap (between 2 companies) where the loans
are in different currencies.
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During the life of the swap agreement, the companies pay each others’ foreign
currency interest payments. At the end of the swap, the initial exchange of principal
is reversed.
Example
At the same time, the French subsidiary Y wishes to raise $1 million to pay for new
up-to-date capital equipment imported from the US.
The US parent company X could borrow the $1 million and the French subsidiary Y
could borrow the € 1.6 million, each effectively borrowing on the other's behalf. They
would then swap currencies.
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Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
vi) Currency options
Currency Options
A currency option gives its holder the right to buy (call option) or sell (put option) a
quantity of one currency in exchange for another, on or before a speci ed date, at a
xed rate of exchange (the strike rate for the option).
They protect against adverse movements in the actual exchange rate but allow
favourable ones!
Disadvantages
1. The premium
Advantages
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Syllabus E2b. b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
vi) Currency options
Options - calculations
A right to sell (put options) or buy (call options) a currency at the exercise price in the
future
Rules:
Steps:
Will I buy (call options) or sell (put options) the BASE currency?
2. Choose expiry
6. Calculate Premium
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Example - Put options- Extract from the June 13 exam
Required
Advise Kenduri Co on, and recommend, an appropriate hedging strategy for the US$
cash ows it is due to pay in three month.
Contract size £62,500, Exercise price quotation: US$/£1, Premium: cents per £1
Solution
BASE currency is £.
Kenduri Co will pay $2.4m in 3 months, therefore have to sell £ to buy $2.4m,
therefore Kenduri Co would purchase Sterling three-month put options to protect
itself against a strengthening US$ to £.
2. Choose expiry
Kenduri Co will choose Put 3-month expiry options, because it will pay $2.4m in 3
months.
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3. Choose strike (exercise) price
6. Calculate Premium
Note:
Kenduri Co will pay the premium in US$31,200. Kenduri Co have to buy $ from
the bank (the bank will "sell LOW" $, therefore the Spot rate US$1.5938 is used.
£1,519,576 > £1,500,375 FWD, therefore use the Forward rate hedge.
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Example- Call options - Extract from the June 11 exam
Casasophia Co, based in a European country that uses the Euro (€) is due to
receive the nal payment of US$20 million in four months.
Required
Solution
Casasophia Co will receive $20m in 4 months and then will convert them to EUR
(buy EUR), therefore Casasophia Co would purchase Euro call options to protect
itself against a weakening Dollar to the Euro.
2. Choose expiry
Casasophia Co will choose Call 5-month expiry options, because it will receive
$20m in 4 months. The 2-month expiry is too short.
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3. Choose strike (exercise) price
6. Calculate Premium
Note:
Casasophia Co will pay the premium in US$409,500. Casasophia Co have to buy
$ from the bank (the bank will "sell LOW" $, therefore the Spot rate US$1·3585 is
used.
€14,404,311 < €14,681,054 FWD contract, therefore choose badge using the
forward contract.
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Syllabus E2c. c) Advise on the use of bilateral and multilateral netting and matching as tools for
minimising FOREX transactions costs and the management of market barriers to the free
movement of capital and other remittances.
Netting
Netting is setting the debtors and creditors in the group resulting in the
1. Bilateral Netting
The lower balance is netted against the higher balance and the difference is the
amount remaining to be paid.
2. Multilateral Netting
Multilateral netting is a more complex procedure in which the debts of more than
two group companies are netted off against each other.
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The following cash ows are due in three months between Kenduri Co and three of
its subsidiary companies.
The subsidiary companies are Lakama Co, based in the United States (currency
US$), Jaia Co, based in Canada (currency CAD) and Gochiso Co, based in Japan
(currency JPY).
Required:
Calculate the impact of undertaking multilateral netting by Kenduri Co and its three
subsidiary companies for the cash ows due in three months.
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Solution
This would limit the fees that these banks would receive for undertaking the
transactions.
• The central treasury may have dif culties in exercising control that the procedure
demands.
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Syllabus E2c. c) Advise on the use of bilateral and multilateral netting and matching as tools for
minimising FOREX transactions costs and the management of market barriers to the free
movement of capital and other remittances.
Matching
This is the use of receipts in a particular currency to match payment in that same
currency.
Wherever possible, a company that expects to make payments and have receipts in
the same foreign currency should plan to of set it payments against its receipts in
that currency.
Since the company is offsetting foreign payment and receipt in the same currency, it
does not matter whether that currency strengthens or weakens against the
company’s domestic currency because there will be no purchase or sale of the
currency.
Probably, the only exchange risk will be limited to conversion of the net account
balance into the domestic currency.
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Syllabus E3. The use of nancial derivatives to hedge against
interest rate risk
Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure
i) Forward Rate Agreements (FRAs)
ii) Interest rate futures
iii) Interest rate swaps
iv) Interest rate options.
Normal
Inverted
Flat
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The shape of the curve depends on:
In a bit more detail, the shape of the yield curve and thus the expectations of what
the interest rates will be depends on…
1. Liquidity preference
Investors want their cash back quickly therefore charge more for long term loans
which tie up their cash for longer and thus expose it to more risk
2. Expectations
NB. Recession expected means less in ation and less interest rates so producing
an inverted curve
3. Market segmentation
If demand for long-term loans is greater than the supply, interest rates in the long-
term loan market will increase
Differing interest rates between markets for loans of different maturity can also
explain why the yield curve may not be smooth, but kinked
4. Fiscal policy
This can result in short-term interest rates being higher than long-term interest
rates,
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Why is yield curve important?
Therefore, in these circumstances, use short term variable rate borrowing and long
term xed rate.
• Gap Exposure?
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Syllabus E3a.
a) Evaluate, for a given hedging requirement, which of the following is the most appropriate
given the nature of the underlying position and the risk exposure:
i) Forward Rate Agreements (FRAs)
ii) Interest rate futures
iii) Interest rate swaps
iv) Interest rate options.
Forward rate
This locks the company into one rate (no adverse or favourable movement) for a
future loan
If actual borrowing rate is higher than the forward rate then the bank pays the
company the difference and vice versa
Procedure
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Illustration
• Solution
Interest Futures
Calculations of how these work are NOT required in the F9 exam. (ONLY
REQUIRED IN THE P4 EXAM)
You would sell a bond futures contract, and when the interest rate rises, the value
of the bond futures contract will fall.
You would then buy the return of the contract at a normal price, making a pro t.
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As interest rates fall - bond prices increase
• Let’s say you are expecting interest rates to decline in the near future.
When interest rates fall, the price of bonds increase, and so does the bonds
futures contract.
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Syllabus E3a.
a) Evaluate, for a given hedging requirement, which of the following is the most appropriate
given the nature of the underlying position and the risk exposure:
ii) Interest rate futures
The pricing of an interest rate futures contract is determined by the three months
interest rate (r %) contracted for and is calculated as (100 – r).
For example if three months Eurodollar time deposit interest rate is 9%, a three
months Eurodollar futures contract will be priced at (100-9) = 91; and if interest rate
is 10%, the future price = 90= (100-10).
The decrease in price or value of the contract re ects the reduced attractiveness of a
xed rate deposit in times of rising interest rates.
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Ticks and tick values
Example
If three months LIBOR is 7% and the September price of three months sterling future
is 92.70 now, at the end of March (let’s say), the basis is:
Maturity mismatch
Maturity mismatch occurs if the actual period of lending or borrowing does not match
the notional period of the futures contract (three months).
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Example
The company will need £18m in two months time for a period of four months.
The nance director fears that short term interest rates could rise by as much as 150
ticks (ie 1.5%).
LIBOR is currently 6.5% and AA plc can borrow at LIBOR plus 0.75%.
December 93.40
March 93.10
Required:
Assume that it is now 1st December and that exchange traded futures contract
expires at the end of the month, estimate the result of undertaking an interest rate
futures hedge on LIFFE if LIBOR increases by 150 ticks (1.5%).
Solution
• Number of contracts
= (18m × 4) / (0.5m × 3) = 48 contracts.
• Calculate the closing future price using basis and basis risk.
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Calculate opening basis as
Current LIBOR 6.5% = (100 –6.5) = 93.50
Future price = 93.10
Basis = 0.40
This will fall to zero when the contract expires, and it is assumed that it will fall at
an even or linear manner.
There are four months until expiry and the funds are needed in two month time,
therefore the expected basis at the time of borrowing is:
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Syllabus E3a.
a) Evaluate, for a given hedging requirement, which of the following is the most appropriate
given the nature of the underlying position and the risk exposure:
ii) Interest rate futures
LIBOR
It is the rate of interest at which a top-level bank in London can borrow wholesale
LIBID
It is the rate of interest that a top- level bank in London could obtain short-term
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Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
i) Forward Rate Agreements (FRAs)
The bank quotes two-way prices for each FRA period for each borrowing (loan) or
lending (deposit).
Means forward rate agreement that start in 3 months and last for 3 months at a
borrowing rate of 7% and lending rate of 5.25%.
Example
Required:
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1. A company wants to borrow on 1st February 2014 and repay the loan on 1st of
April 2014.
3. A company wants to borrow on 1st January 2014 and repay the loan on 1st of
March 2014
Solution
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Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
i) Forward Rate Agreements (FRAs)
Compensation payment
Compensation period is calculated as the difference between the FRA rate xed and
the LIBOR rate at the xing date (actual LIBOR) multiplied by the amount of the
notional loan/deposit and the period of the loan/deposit.
The FRA therefore protects against the LIBOR but not the risk premium attached to
the customer.
The settlement of FRA is made at the start of the loan period and not at the end and
therefore compensation payment occurs at start of the loan period.
Example
A company will have to borrow an amount of £100 million in four month time for a
period of six months.
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Required:
Solution
The FRA will be 4 v 10 as the money will be needed in four months time and will last
for six months.
Compensation received from the bank (2.8 – 3.68) = -0.88% x100m x 6/12 =
£0.44m
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Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
iii) Interest rate swaps
iv) Interest rate options.
Grants the buyer the right (no obligation) to deal at a speci c interest rate at a future
date.
These protect against adverse movements in the actual interest rate but allow
favourable ones!
2 companies agree to exchange interest rate payments on different terms (eg xed
and variable).
For example one interest rate payment as a xed rate and the other at a oating
rate.
Interest rate swaps can act as a means of switching from paying one type of interest
to another, allowing an organisation to obtain less expensive loans and securing
better deposit rates.
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Advantages
1. Easy
Party A agrees to pay the interest on party B's loan, while party B reciprocates by
paying the interest on A's loan.
If the swap is to make sense, the two parties must swap interest which has different
characteristics.
Assuming that the interest swapped is in the same currency, the most common
motivation for the swap is to switch from paying oating rate interest to xed interest
or vice versa.
Illustration 1
Company A
- has a loan at FLOATING rate (LIBOR + 0.8%) from Bank A
- thinks that the interest rates go up so wants FIXED rate
Company B
- has a loan at FIXED rate (8%) from Bank B
- thinks that the interest rates go down so wants FLOATING rate
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Solution
• Company A can use a swap to change from paying interest at a oating rate of
LIBOR + 0.8% to one of paying xed interest of 8%.
Therefore will effectively pay (8% FIXED + (LIBOR + 0.8%) - (LIBOR + 0.8%)) =
8% (FIXED).
LIBOR or the London Inter-Bank Offered Rate is the rate of interest at which banks
borrow from each other in the London inter-bank market.
However a bank may be able to nd a counterparty more easily, and may have
access to more counterparties in more markets than if the company seeking the
swap tried to nd the counterparty itself.
Swaps are generally terminated by agreeing a settlement interest rate, generally the
current market rate.
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Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
iv) Interest rate options.
Interest rate options calculations are very similar to Interest rate futures calculation
Here we deposit some money - so we want to hedge against a fall in interest rates
MooFace can invest funds at the relevant inter-bank rate less 20 basis points.
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Expected futures price is $96·35 (If interest rates decrease by 0·9%)
Required
Solution
Assume that MooFace will deposit $48,000,000 and therefore need to hedge against
a fall in interest rates and buy call options.
Note:
Time period required for deposit = 4 months (1 February - 1 June).
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Exercise ? Yes No
Gain in basis points 5 0
Underlying investment return ( 4.99% - 20 basis point) = $766,400 $766,400
4·79% x 4/12 x $48,000,000
Premium
0·00432 x $2,000,000 x 3/12 x 32 $(69,120)
0·00121 x $2,000,000 x 3/12 x 32 $(19,360)
Net return $705,280 $747,040
Effective interest rate ($705,280 ($747,040) / $48m x 4·41% 4·67%
12/4months)
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Discussion
The March call option at the exercise price of 94.50 seems to x the rate of return at
4.41%, which is lower than the return on the futures market and should therefore be
rejected.
The March call option at the exercise price of 95.00 gives a higher return compared
to the FRA and the futures if interest rates increase, but does not perform as well if
the interest rates fall.
If MooFace takes the view that it is more important to be protected against a likely
fall in interest rates, then that option should also be rejected.
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Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
iii) Interest rate swaps
Example 1
aCOW plc pays interest at LIBOR plus 1.5% and could borrow xed at 13% per
annum.
Milk plc also has a £20m loan and pays xed interest at 12% per annum.
It could borrow at a variable rate of LIBOR plus 2.5%.
aCOW plc paying Milk plc xed rate plus 0.5% and
Milk plc paying aCOW plc LIBOR plus 2%.
Required:
Calculate the total interest payments of the two companies over the year if LIBOR is
10% per annum
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Solution
LIBOR at 10%
aCOW plc
£
Interest on own loan (10% + 1.5%) x 20m (2,300,000) (11.5%)
Interest received from Milk (10%+2%) x 20m 2,400,000 12%
Interest paid to Milk (12%+0.5%) x 20m (2,500,000) (12.5%)
Total interest payment (2,400,000) (12%)
Milk plc
£
Interest on own loan (12% x 20m) (2,400,000) (12%)
Interest received from aCOW (12% + 0.5%) x 20 2,400,000 12.5%
Interest paid to aCOW (10% +2%) x 20m (2,400,000) (12%)
Total interest payment (2,300,000) 11.5%
Example 2
A company wants to borrow £6 million at a xed rate of interest for four years, but
can only obtain a bank loan at LIBOR plus 80 basis points.
A bank quotes bid and ask prices for a four year swap of 6.45% - 6.50%.
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Required:
(a) Show what the overall interest cost will become for the company, if it arranges a
swap to switch from oating to xed rate commitments.
(b) What will be the cash ows as a percentage of the loan principal for an interest
period if the rate of LIBOR is set at 7%?
Solution 2
(a)
%
Actual interest oating rate (LIBOR + 0.8)
Swap
Receive oating rate interest from bank LIBOR
Pay xed rate (higher-ask price) (6.50)
Overall cost (7.3)
(b)
%
Actual interest oating rate (7 + 0.8) (7.8)
Swap
Receive oating rate interest from bank 7
Pay xed rate (higher-ask price) (6.50) 0.5
Overall cost (7.3)
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Reasons for interest rate swaps
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Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
iv) Interest rate options.
A collar involves the simultaneous purchase and sale of both call and put options at
The main advantage of using a collar instead of options to hedge interest rate risk is
lower cost.
However, the main disadvantage is that, whereas with a hedge using options the
buyer can get full bene t of any upside movement in the price of the underlying
asset, with a collar hedge the bene t of the upside movement is limited or capped as
well.
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Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
iv) Interest rate options.
Have a think (or even better) a look at when we calculated the cost of debt for
You will see that we took the capital and interest and discounted it (at a guessed
This is because you calculate the MV of a loan or a bond by taking its Capital and
The market value of a traded bond will increase as the interest paid on the bond
increases, since the reward offered for owning the bond becomes more
attractive.
If interest payments are more frequent, say every six months rather than every
year, then the present value of the interest payments increases and hence so
does the market value.
3. Redemption value
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If a higher value than par is offered on redemption, the reward offered for owning
the bond increases and hence so does the market value.
4. Period to redemption
The market value of traded bonds is affected by the period to redemption, either
because the capital payment becomes more distant in time or because the
number of interest payments increases.
5. Cost of debt
The present value of future interest payments and the future redemption value
are heavily in uenced by the cost of debt, i.e. the rate of return required by bond
investors.
This rate of return is in uenced by the perceived risk of a company, for example
as evidenced by its credit rating.
As the cost of debt increases, the market value of traded bonds decreases, and
vice versa.
6. Convertibility
If traded bonds are convertible into ordinary shares, the market price will be
in uenced by the likelihood of the future conversion and the expected conversion
value, which is dependent on the current share price, the future share price
growth rate and the conversion ratio.
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Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
iv) Interest rate options.
Valuation of bonds
A ‘plain vanilla’ bond will make regular interest payments to the investors and pay the
capital to buy back the bond on the redemption date when it reaches maturity.
Therefore the value of a redeemable bond is the present value of the future income
stream discounted at the required rate of return (or yield or the internal rate of return)
Example
A company has issued 11% bonds, which are redeemable at par in 3 years’ time.
Required
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Solution
This means that £100 of bonds will have a market value of £102.457.
Remember that there is an inverse relationship between the yield of a bond and its
price or value.
The higher rate of return (or yield) required, the lower the price of the bond, and vice
versa.
The cost of redeemable bond is the internal rate of return or required rate of return or
Example
A 5.6% bond is currently quoted at £95 ex-int. It is redeemable at the end of 5 years
Required
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Solution
The current $250 million borrowing is in the form of a 4% bond which is trading at
$98•71 per $100 and is due to be redeemed at par in three years. The issued bond
Year 1 2 3
3.2% 3.7% 4.2%
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Yield spreads (in basis points)
Required
Calculate the expected percentage fall in the market value of the existing bond if
Solution
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Syllabus E3a. a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
iv) Interest rate options (including
collars).
The spot yield curve can be used to estimate the price or value of a bond
Example
A company wants to issue a bond that is redeemable in four years for its par value or
face value of $100, and wants to pay an annual coupon of 5% on the par value.
Estimate the price at which the bond should be issued and the gross redemption
yield.
The annual spot yield curve for a bond of this risk class is as follows:
Year Rate
1 3.5%
2 4.0%
3 4.7%
4 5.5%
Solution
The market price of the bond should be the present value of the cash ows from the
bond (interest and redemption value) using the relevant year’s yield curve spot rate
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Year 1 2 3 4
Given a market price of $98.57, the gross yield to maturity is calculated as follows:
Note that the yield to maturity of 5.46% is not the same as the four year spot yield
1. The yield to maturity is a weighted average of the term structure of interest rates.
2. The returns from the bond come in earlier years, when the interest rates on the
yield curve are lower, but the largest proportion comes in Year 4.
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