Advanced Financial Management - · PDF fileACCA Paper P4 . Advanced Financial Management . Class Notes . March 2017

ACCA Paper P4

Advanced Financial Management

Class Notes

March 2017

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Contents PAGE

INTRODUCTION TO THE PAPER 5

FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER 7

CHAPTER 1: CFO AND FINANCIAL STRATEGY FORMULATION 13

CHAPTER 2: GOVERNANCE & ETHICS 26

CHAPTER 3: ECONOMIC ENVIRONMENT FOR MULTINATIONALS 31

CHAPTER 4: DISCOUNTED CASH FLOW TECHNIQUES 37

CHAPTER 5: APPLICATION OF OPTION PRICING IN INVESTMENT DECISIONS 55

CHAPTER 6: IMPACT OF FINANCING ON INVESTMENT DECISIONS 64

CHAPTER 7: ADJUSTED PRESENT VALUE 85

CHAPTER 8: INTERNATIONAL INVESTMENT APPRAISAL 90

CHAPTER 9: ACQUISITIONS AND MERGERS 97

CHAPTER 10: BUSINESS VALUATIONS 100

CHAPTER 11: FRAMEWORK 111

CHAPTER 12: CORPORATE RECONSTRUCTION AND REORGANISATION 117

CHAPTER 13: HEDGING FOREIGN EXCHANGE RISK 124

CHAPTER 14: HEDGING INTEREST RATE RISK 140

CHAPTER 15: ISSUES FOR MULTINATIONALS 153







Introduction to the

paper



INTRODUCTION TO THE PAPER


Aim of the paper

The aim of the paper is to apply relevant knowledge, skills and exercise professional

judgement as expected of a senior financial executive or advisor, in taking or

recommending decisions relating to the financial management of an organization.

Outline of the syllabus

A. Role of senior financial adviser in the multinational organisation

B. Advanced investment appraisal

C. Acquisitions and mergers

D. Corporate reconstruction and re-organisation

E. Treasury and advanced risk management techniques

Format of the exam paper

The examination will be a three-hour paper (with the additional 15 minutes reading

and planning time) of 100 marks in total, divided into two sections:

Section A:

Section A will contain a compulsory question, comprising of 50 marks.

Section A will normally cover significant issues relevant to the senior financial

manager or advisor and will be set in the form of a case study or scenario. The

requirements of the section A question are such that candidates will be expected to

show a comprehensive understanding of issues from across the syllabus. The

question will contain a mix of computational and discursive elements. Within this

question candidates will be expected to provide answers in a specified form such as

a short report or board memorandum commensurate with the professional level of

the paper in part or whole of the question.

Section B:

In section B candidates will be asked to answer two from three questions,

comprising of 25 marks each.

Section B questions are designed to provide a more focused test of the syllabus.

Questions will normally contain a mix of computational and discursive elements, but

may also be wholly discursive or evaluative where computations are already

provided.

Candidates will be provided (within the examination paper) with a formulae

sheet as well as present value, annuity and standard normal distribution

tables.




Formulae & tables

provided in the

examination paper



FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER


Modigliani and Miller Proposition 2 (with tax)

ke = kie + (1 – T)(ki

e – kd) e

d

V

V

The Capital Asset Pricing Model

E(rj) = Rf + βj (E(rm) – Rf)

The asset beta formula

βa = e

e d

V

(V V (1- ))e

T

+

d

de

d

))T-1(VV(

)T-1(V

The Growth Model

P0 = 0

e

D (1 + g)

(r - g)

Gordon’s growth approximation

g = bre

The weighted average cost of capital

WACC =

de

e

VV

V ke +

de

d

VV

V kd(1–T)

The Fisher formula

(1 + i) = (1 + r) (1 + h)

Purchasing power parity and interest rate parity

S1 = S0 )h(1

)h(1

b

c

Fo = So

c

b

(1 i )

(1 i )

Modified Internal Rate of Return

MIRR =

1

nR

I

PV

PV

(1 + re) – 1





The Black Scholes Option

Pricing Model

c = Pa N(d1) Pe N(d2) e-rt

Where:

d1 = ts

)t0.5s +(r + )/Pln(P 2ea

and

d2 = d1 – ts

The Put Call Parity relationship

p = c Pa + Pe e -rt





Present value table

Present value of 1 ie (1 + r)-n

Where r = discount rate

n = number of periods until payment

Discount rate (r)

Periods

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% ________________________________________________________________________________

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2

3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5 6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10 11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15 ________________________________________________________________________________ (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% ________________________________________________________________________________

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5 6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9 10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10 11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15





Annuity table

Present value of an annuity of 1 ie

-n1 - (1 + r)

r

Where r = discount rate

n = number of periods

Discount rate (r)

Periods

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% ________________________________________________________________________________

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10 11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11 12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12 13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13 14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14 15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15 ________________________________________________________________________________ (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% ________________________________________________________________________________

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 11 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15





Standard normal distribution table

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3.0

0.0000 0.0398 0.0793 0.1179 0.1554 0.1915 0.2257 0.2580 0.2881 0.3159 0.3413 0.3643 0.3849 0.4032 0.4192 0.4332 0.4452 0.4554 0.4641 0.4713 0.4772 0.4821 0.4861 0.4893 0.4918 0.4938 0.4953 0.4965 0.4974 0.4981 0.4987

0.0040 0.0438 0.0832 0.1217 0.1591 0.1950 0.2291 0.2611 0.2910 0.3186 0.3438 0.3665 0.3869 0.4049 0.4207 0.4345 0.4463 0.4564 0.4649 0.4719 0.4778 0.4826 0.4864 0.4896 0.4920 0.4940 0.4955 0.4966 0.4975 0.4982 0.4987

0.0080 0.0478 0.0871 0.1255 0.1628 0.1985 0.2324 0.2642 0.2939 0.3212 0.3461 0.3686 0.3888 0.4066 0.4222 0.4357 0.4474 0.4573 0.4656 0.4726 0.4783 0.4830 0.4868 0.4898 0.4922 0.4941 0.4956 0.4967 0.4976 0.4982 0.4987

0.0120 0.0517 0.0910 0.1293 0.1664 0.2019 0.2357 0.2673 0.2967 0.3238 0.3485 0.3708 0.3907 0.4082 0.4236 0.4370 0.4484 0.4582 0.4664 0.4732 0.4788 0.4834 0.4871 0.4901 0.4925 0.4943 0.4957 0.4968 0.4977 0.4983 0.4988

0.0160 0.0557 0.0948 0.1331 0.1700 0.2054 0.2389 0.2703 0.2995 0.3264 0.3508 0.3729 0.3925 0.4099 0.4251 0.4382 0.4495 0.4591 0.4671 0.4738 0.4793 0.4838 0.4875 0.4904 0.4927 0.4945 0.4959 0.4969 0.4977 0.4984 0.4988

0.0199 0.0596 0.0987 0.1368 0.1736 0.2088 0.2422 0.2734 0.3023 0.3289 0.3531 0.3749 0.3944 0.4115 0.4265 0.4394 0.4505 0.4599 0.4678 0.4744 0.4798 0.4842 0.4878 0.4906 0.4929 0.4946 0.4960 0.4970 0.4978 0.4984 0.4989

0.0239 0.0636 0.1026 0.1406 0.1772 0.2123 0.2454 0.2764 0.3051 0.3315 0.3554 0.3770 0.3962 0.4131 0.4279 0.4406 0.4515 0.4608 0.4686 0.4750 0.4803 0.4846 0.4881 0.4909 0.4931 0.4948 0.4961 0.4971 0.4979 0.4985 0.4989

0.0279 0.0675 0.1064 0.1443 0.1808 0.2157 0.2486 0.2794 0.3078 0.3340 0.3577 0.3790 0.3980 0.4147 0.4292 0.4418 0.4525 0.4616 0.4693 0.4756 0.4808 0.4850 0.4884 0.4911 0.4932 0.4949 0.4962 0.4972 0.4979 0.4985 0.4989

0.0319 0.0714 0.1103 0.1480 0.1844 0.2190 0.2517 0.2823 0.3106 0.3365 0.3599 0.3810 0.3997 0.4162 0.4306 0.4429 0.4535 0.4625 0.4699 0.4761 0.4812 0.4854 0.4887 0.4913 0.4934 0.4951 0.4963 0.4973 0.4980 0.4986 0.4990

0.0359 0.0753 0.1141 0.1517 0.1879 0.2224 0.2549 0.2852 0.3133 0.3389 0.3621 0.3830 0.4015 0.4177 0.4319 0.4441 0.4545 0.4633 0.4706 0.4767 0.4817 0.4857 0.4890 0.4916 0.4936 0.4952 0.4964 0.4974 0.4981 0.4986 0.4990

This table can be used to calculate N(di), the cumulative normal distribution functions

needed for the Black-Scholes model of option pricing.

If di > 0, add 0.5 to the relevant number above.

If di < 0, subtract the relevant number above from 0.5




Chapter 1

CFO and Financial

Strategy

Formulation



CHAPTER 1 - CFO AND FINANCIAL STRATEGY FORMULATION


Primary financial management objective

Shareholder wealth maximisation which is achieved by;

● increasing the value of the entity

● providing a cash flow to investors via a dividend

Core financial management decisions

Financial management is often described in terms of the three basic decisions to be

made:

● the investment decision,

● the financial decision,

● the dividend decision.

Each of these decisions have to be looked at in far greater detail later on in the course

but as an outline these are the basic considerations:

1. The investment decision

A company may invest its funds in one of three basic areas:

1. Capital assets

2. Working capital

3. Financial assets

The investment decision will be covered in significant detail in chapters 4 - 8

2. The financing decision

When looking at the financing of a business there are 4 basic questions to consider:

1. total funding required,

2. internally generated vs externally sourced,

3. debt or equity,

4. long-term or short-term debt.

The financing decision will be covered later in this chapter and also is chapter 6

3. The dividend decision

The amount of return to be paid in cash to shareholders. This is a critical measure

of the companies’ ability to pay a cash return to its shareholders.

The dividend decision will be covered later in this chapter





Other financial management responsibilities

1. Risk Management

All elements of risk need be identified and mitigated including;

1. Operational

2. Reputational

3. Political

4. Economic

5. Regulatory

6. Fiscal

Risk management will be evident across the entire syllabus, with specific coverage of

interest rate and foreign exchange risk covered in chapter 14 and 15.

2. Communication of financing decisions

Communication has far reaching implications to all stakeholders and as such careful

dialogue must be maintained with both internal and external stakeholders

3. Incorporate adequate financial planning and control

To ensure objectives are adhered to and necessary corrective action is taken to

pursue primary objective.





LONG TERM SOURCES OF FINANCE

Equity relates to the ownership rights in a business.

Ordinary shares

1. Owning a share confers part ownership.

2. High risk investments offering higher returns.

3. Permanent financing.

4. Post-tax appropriation of profit, not tax efficient.

5. Marketable if listed.

Advantages

1. No fixed charges (e.g. interest payments).

2. No repayment required.

3. Carries a higher return than loan finance.

4. Shares in listed companies can be easily disposed of at a fair value.

Disadvantages

1. Issuing equity finance can be expensive in the case of a public issue (see later).

2. Problem of dilution of ownership if new shares issued.

3. Dividends are not tax-deductible.

4. A high proportion of equity can increase the overall cost of capital for the

company.

5. Shares in unlisted companies are difficult to value and sell.

Preference shares

1. Fixed dividend

2. Paid in preference to (before) ordinary shares.

3. Not very popular, it is the worst of both worlds, ie

● not tax efficient

● no opportunity for capital gain (fixed return).





DEBT

The loan of funds to a business without any ownership rights.

1. Paid out as an expense of the business (pre-tax).

2. Risk of default if interest and principal payments are not met.

Security

Charges

The debtholder will normally require some form of security against which the funds

are advanced. This means that in the event of default the lender will be able to take

assets in exchange of the amounts owing.

Covenants

A further means of limiting the risk to the lender is to restrict the actions of the

directors through the means of covenants. These are specific requirements or

limitations laid down as a condition of taking on debt financing. They may include:

1. Dividend restrictions

2. Financial ratios

3. Financial reports

4. Issue of further debt.

Types of debt

Debt may be raised from two general sources, banks or investors.

Bank finance

For companies that are unlisted and for many listed companies the first port of call

for borrowing money would be the banks. These could be the high street banks or

more likely for larger companies the large number of merchant banks concentrating

on ‘securitised lending’.

This is a confidential agreement that is by negotiation between both parties.

Traded investments

Debt instruments sold by the company, through a broker, to investors. Typical

features may include:

1. The debt is denominated in units of $100, this is called the nominal or par value

and is the value at which the debt is subsequently redeemed.

2. Interest is paid at a fixed rate on the nominal or par value.

3. The debt has a lower risk than ordinary shares. It is protected by the charges

and covenants.





OTHER SOURCES

Venture Capital

Capital provided by an organisation for a high risk enterprises which demonstrate

high growth potential. Funds will usually be provided in return for an equity stake in

the business, with a pre-determined exit strategy.

Sale and Leaseback

1. Selling good quality fixed assets such as high street buildings and leasing them

back over many (25+) years.

2. Funds are released without any loss of use of assets.

3. Any potential capital gain on assets is forgone.

Grants

1. Often related to regional assistance, job creation or for high tech companies.

2. Important to small and medium sized businesses (ie unlisted).

3. They do not need to be paid back.

4. Remember the EU is a major provider of loans.

Retained earnings

The single most important source of finance, for most businesses the use of retained

earnings is the core basis of their funding.

Warrants

1. An option to buy shares at a specified point in the future for a specified

(exercise) price.

2. The warrant offers a potential capital gain where the share price may rise above

the exercise price.

3. The holder has the option to buy the share. On a future date at a pre-

determined date.

4. The warrant has many uses including:

● additional consideration when issuing debt.

● incentives to staff.

Convertible loan stock

A debt instrument that may, at the option of the debtholder, be converted into shares.

The terms are determined when the debt is issued and lay down the rate of

conversion (debt: shares) and the date or range of dates at which conversion can

take place.

The convertible is offered to encourage investors to take up the debt instrument. The

conversion offers a possible capital gain (value of shares › value of debt).





BEHAVIOURAL FINANCE

Financial management theory assumes that decisions will always be made in a

rational manner, however this make not be the case and as such irrational decisions

and systematic errors will occur.

This theory undermines the efficient market hypothesis which suggests that no

excessive gains can be made, as information is effectively absorbed in to the share

price. However examples of such irrationality which creates opportunity for arbitrage

include;

Overconfidence

Where investors overestimate the forecasted financial performance, and as a

consequence make inaccurate decisions.

Confirmation Bias

Where investors pay consideration only to information which supports their view and

overlook anything that suggests an error has been made

Conservatism

Where investors are immune to positive information and do not believe that the

outcome is likely to be repeated, as such the information is not absorbed into the

share price.

DIVIDEND POLICY

Dividend decisions relate to the determination of how much and how frequently cash

can be paid out of the profits of an entity as income for its owners. The owners of

profit-making organisations look for reward from their investment in two ways: the

growth of the capital invested (capital gains), and the cash paid out as income

(dividend).

The dividend decision thus has two elements: the amount to be paid out and the

amount to be retained to support the growth of the entity, the latter being a financing

decision; the level and regular growth of dividends represent a significant factor in

determining a profit-making company’s market value, that is the value placed on its

shares by the stock market.





FACTORS INFLUENCING DIVIDEND POLICY

In deciding a company’s dividend policy the following factors should be considered:

1. Profitability

Dividends are paid out of distributable profit and a company cannot pay dividends

which is higher than its distributable profit. For all other things being equal, a

company with stable profits is more likely to be able to pay out a higher percentage

of earnings than a company with fluctuating profits.

2. Liquidity

To pay dividends sufficient liquid funds should be available. Even very profitable

companies might sometimes find it difficult to pay dividends if resources are tied up

in other forms of asset, especially if bank overdraft facilities are not available.

3. Repayment of debt

Dividend pay-out may be made difficult if debt is scheduled for repayment and this

is not financed by a further issue of funds.

4. Restrictive covenants

The articles of association may contain agreed restrictions on dividends. In addition,

some form of debt may have restrictive covenants limiting the amount of dividend

payments or the rate of growth that applies to them.

5. Rate of expansion

Growth companies faced with many investment opportunities may prefer to finance

their expansion by retaining a large proportion of their profit instead of distributing

the profit by way of dividend and asking the existing shareholders to provide extra

money for expansion through rights issue which will incur issue cost.

6. Control

The use of retained earnings to finance new projects preserves the company’s

ownership and control.

7. Policy of competitors

Dividend policies of competitors may influence corporate dividend policy. It may be

difficult, for example, to reduce a dividend for the sake of further investment, when

competitors follow a policy of higher distribution.

8. Signalling effect

This is the information content of dividend. Dividends are seen as signals from the

company to the financial markets and shareholders. Investors perceive dividend

announcements as signals of future prospects for the company. A company should

therefore consider the likely effect on share prices of the announcement of a proposed

dividend.

9. Companies Act restrictions

The Companies Act imposes restrictions on the distribution of profit by companies.

It should be noted that the purpose of the law is to determine the maximum allowable

distribution.





10. The level of gearing

If financial risk is high, for example due to a high level of gearing arising from a

substantial level of debt finance, maintaining a low level of dividend payments can

result in a high level of retained earnings, which will reduce gearing by increasing the

level of reserves. The cash flow from a higher level of retained earnings can also be

used to decrease the amount of debt being carried by a company.

11. Taxation

In some countries dividends and capital gains are subject to different marginal rates

of taxation, usually with capital gains being subject to lower level of taxation than

dividend. This distortion in the personal tax system can have an impact on investors’

preference. The preference would very much depend on the tax position of investors.

This is the clientele effect.

POSSIBLE APPROACHES TO DIVIDEND POLICY

There are four major possibilities a company could adopt as to the pattern of dividend

pay-out over time. These are:

1. Constant Pay-out Ratio

The company pays a constant proportion of earnings available to equity shareholders

as dividend hence dividend per share will fluctuate from year to year in line with

earnings.

2. Stable Dividend Policy

The company pay out a fixed dividend per share irrespective of the earnings available

to equity shareholders.

3. Residual Dividend Policy

Retained earnings are used to fund all profitable projects. Remaining funds (if any)

are used to pay dividends. This policy leads to a very volatile dividend stream over

time.

4. Zero Payout

The company chooses not to pay a dividend as they wish to retain the funds for

reinvestment. This would usually occur in fast growing companies, or those in

financial distress.





DIVIDEND POLICY AND SHAREHOLDERS’ WEALTH

Does the dividend policy adopted by a company have an influence on its shareholders’

wealth? There are broadly two schools of thought in relation to this question. These

theories are the dividend relevance theory and dividend irrelevance theory as

discussed below:

Dividend relevance theory – traditional theory

This argument is that dividends pay-out influences the market value of the company

because of the following practical influences:

1. Signalling effect

In a semi-strong form efficient market, information available to directors is more

substantial than that available to shareholders, so that information asymmetry exists.

Investors perceive dividend announcements as signals of future prospects for the

company. The signalling effect also depends on the dividend expectations in the

market. The size and direction of the share price change will depend on the difference

between the dividend announcement and the expectations of shareholders.

2. Clientele effect

The clientele effect states that shareholders are attracted to particular companies as

a result of being satisfied by their dividend policies. A company with an established

dividend policy is therefore likely to have an established dividend clientele. The

existence of this dividend clientele implies that the share price may change if there

is a change in the dividend policy of the company, as shareholders sell their shares

in order to reinvest in another company with a more satisfactory dividend policy.

3. Bird in hand theory

One argument often put forward for high dividend pay-out is that income in the form

of dividend is more secure than income in the form of capital gains hence investors

place value on high pay-out shares.

4. Preference for current income

Many investors, both individuals and institutional, require cash dividends to finance

current consumption, hence prefer companies paying regular cash dividends and

therefore value their shares more highly.





Dividend irrelevance theory – Modigliani and Miller (M&M)

M&M began by examining the effects of differences in dividend policy on the current

price of shares in an ideal economy characterised by perfect capital markets, no tax,

rational behaviour and perfect certainty.

Under these assumptions, M&M argue that a change in the dividend policy, per say,

will not affect the shareholders’ wealth as the value of a company depended on its

investment decision alone, and not on its dividend or financing decisions.

According to them, investors react to the reasons for change not the change itself.

For example, if dividend is reduced in order to finance expansion, the share price will

not automatically fall. It would be the shareholders’ expectations with respect to the

expansion that influences the share price. Provided the reinvestment is at a rate at

least as higher as that obtainable by the shareholders themselves (for the risk

involved), that is invested in all projects with a positive net present value the market

value of the company should rise correspondingly, hence the cash lost now is

compensated by the increase in the value of their shares. If the funds were actually

reinvested at higher than the expected return for the level of risk, this would increase

shareholders wealth.

Given a set investment policy, a dividend cut now to finance new projects will be

compensated by higher dividends at a later stage. Since investors had perfect

information, they will be indifferent between dividends and capital gains.

Shareholders who are unhappy with the level of dividend declared by a company

could gain a ‘home-made dividend’ by selling some of their shares. This was possible

since there are no transaction costs in a perfect capital market. It theoretically makes

no difference whether the new investment is funded by retention of dividend or new

equity raised.





ALTERNATIVES TO A CASH DIVIDEND

A number of companies have established ways of rewarding shareholders other than

by traditional dividend payments. These methods include:

Scrip dividends

When the directors of a company consider that they must pay a certain level of

dividend, but would really prefer to retain funds within the business, they can

introduce a scrip dividend scheme.

This involves giving ordinary shareholders the choice of receiving dividend in the form

of shares instead of in the form of cash.

Scrip dividend if accepted by shareholders has the advantage of preserving the

liquidity position of the company because it will reduce the cash outflow and enables

the company to use internally generated funds to finance new investments.

Scrip dividend will also lead to a decrease in gearing because of the increase in issued

shares and may help to increase the company’s debt capacity.

A disadvantage of scrip dividend is that it may lead to increase in future dividend

payments as a result of increase in the number of shares (assuming constant dividend

per share).

Another issue is that it is optional and shareholders may not accept the proposal.

In addition, scrip dividend may give wrong signal to the market as to why the

company is making such proposal and may have adverse effect on the share price.

Share repurchases

Companies with cash surpluses, but having no positive NPV projects, may choose to

introduce a share buy-back scheme, whereby the company’s shares are purchased

at the company’s instructions on the open market.

This will have the effect of using up the surplus cash, increasing future EPS (because

of the reduction in the number of shares in issue), changing the gearing level of the

company and (hopefully) reducing the likelihood of a takeover. However share

repurchases are often seen as an admission that the company cannot make better

use of shareholders’ funds.





Example Cedi Plc and Dollar Plc

Cedi plc and Dollar plc both operate department stores in Europe. They operate in

similar markets and are generally considered to be direct competitors. Both

companies have similar earning records over the past ten years and have similar

capital structures. The earnings and dividend record of the two companies over the

past six years is as follows:

CEDI PLC DOLLAR PLC

EPS DPS Share price EPS DPS Share price

Years cents cents cents cents cents cents

20X1 230 60 2,100 240 96 2,200

20X2 150 60 1,500 160 64 1,700

20X3 100 60 1,000 90 36 1,400

20X4 -125 60 800 -110 0 908

20X5 100 60 1,000 90 36 1,250

20X6 150 60 1,400 145 58 1,700

Both companies have 25 million shares in issue. At the beginning of 20X% Dollar

plc made a rights issue. The EPS and DPS have been adjusted in the above table.

The chairman of Cedi plc is concerned that the share price of Dollar plc is higher

than his company’s, despite the fact that Cedi plc has recently earned more EPS

than Dollar plc and frequently during the past six years has paid a higher dividend.

Required:

Discuss:

(a) The apparent dividend policy followed by each company over the past six years

and comment on the possible relationship of those policies to the companies’

market values and current share prices; and

(b) Whether there is an optimal dividend policy for Cedi plc that might increase

shareholders’ value.




Chapter 2

Governance & Ethics

Corporate strategy and financial management

The role of the financial manager is to align the aims of financial management team

with those of the wider corporate strategy. The strategy of the business may be

separated into corporate, business and operational objectives. Financial managers

should be attempting to fulfil those objectives.

The nature of financial management means that it is fundamental to the translation

of strategic aims into financial transactions.

Financial objectives

Financial objectives of commercial companies may include:

1. Maximising shareholders’ wealth

2. Maximising profits

3. Satisficing.

Stakeholders

We tend to focus on the shareholder as the owner and key stakeholder in a business.

A more comprehensive view would be to consider a wider range of interested parties

or stakeholders.

Stakeholders are any party that has both an interest in and relationship with the

company. The basic argument is that the responsibility of an organisation is to

balance the requirements of all stakeholder groups in relation to the relative

economic power of each group.



CHAPTER 2 – GOVERNANCE & ETHICS


Stakeholders (user groups) and their goals

These include:

● Shareholders

● Directors

● Management and employees

● Loan creditors

● Customers

● Suppliers

● The government

● Environmental pressure groups

● The general public

Many of these groups may have conflicting objectives, which need to be reconciled.

Conflict between stakeholder groups

The very nature of looking at stakeholders is that the level of ‘return’ is finite within

an organisation. There is a need to balance the needs of all groups in relation to

their relative strength.

Agency theory

Agency relationships occur when one or more people employ one or more persons as

agent. The persons who employ others are the principals and those who work for

them are called the agent

In an agency situation, the principal delegate some decision-making powers to the

agent whose decisions affect both parties. This type of relationship is common in

business life. For example shareholders of a company delegate stewardship function

to the directors of that company. The reasons why an agents are employed will vary

but the generally an agent may be employed because of the special skills offered, or

information the agent possess or to release the principal from the time committed to

the business.

Principal

Agent



CHAPTER 2 - GOVERNANCE & ETHICS


Goal Congruence

Goal congruence is defined as the state which leads individuals or groups to take

actions which are in their self-interest and also in the best interest of the entity.

For an organisation to function properly, it is essential to achieve goal congruence at

all level. All the components of the organisation should have the same overall

objectives, and act cohesively in pursuit of those objectives.

In order to achieve goal congruence, there should be introduction of a careful

designed remuneration packages for managers and the workforce which would

motivate them to take decisions which will be consistent with the objectives of the

shareholders.

Money as a prime motivator

The most direct use of money as a motivator is payment by results schemes whereby

an employee’s pay is directly linked to his results. However, research has shown that

money is not a single motivator or even the prime motivator.

Ethics

Consideration of ethical implications which may impede shareholder wealth

maximisation as consideration must be given to other stakeholder groups

Modern thinking recognises the link between an ethical approach and enhanced

revenue, by contrast unethical behaviour may have consequences such as customer

and supplier boycotts which impact upon financial and business performance.

Ethical framework for decision making

Integrity

Objectivity

Professional competence

Confidentiality

Professional behaviour



CHAPTER 2 – GOVERNANCE & ETHICS


Environmental Issues

Exam questions may require you to consider environmental issues and their impact

upon corporate objectives.

Ensure that you consider a decision with the potential conflict and damage to the

business reputation

Triple bottom line reporting

Requires the reporting of performance from three perspectives

1. Economic

2. Social

3. Environmental

Environmental indicators could include carbon emissions, renewable energy

consumed as a percentage of total, quantity of waste recycled etc.

Governance

Corporate governance

Clearly the executive directors of a listed company are both decision-makers and

major stakeholders. They are therefore open to the accusation of making key

decisions for their own benefit. Following a number of notable financial scandals in

the UK during the late 20th century (eg the Maxwell affair and the collapse of the

BCCI) the Cadbury Committee was set up to investigate procedures for appropriate

corporate governance.

The Cadbury Code (1992) defined corporate governance as “the system by which

companies are directed and controlled”. This initial document has been subject to

subsequent amendments by the Greenbury, Hampel and Higgs Reports. The

Financial Conduct Authority requires listed companies to confirm that they have

complied with the Code’s provisions or – in the event of non-compliance – to provide

an explanation of their reasons for departure.

International Comparisons

The broad principles of corporate governance are similar in the UK, the USA and

Germany, but there are significant differences in how they are applied. Whereas the

UK and Germany have voluntary corporate governance codes, the US system is based

upon legislation within the Sarbanes-Oxley Act.

United States of America

Corporate governance structure is more formalised, with legally enforceable controls.

These requirements include the certification of published financial statements by the

CEO and the chief financial officer (CFO), faster public disclosures by companies, legal

protection for whistleblowers, a requirement for an annual report on internal controls,

and requirements relating to the audit committee, auditor conduct and avoiding

‘improper’ influence of auditors.



CHAPTER 2 - GOVERNANCE & ETHICS


Germany

As both the UK and Germany are members of the EU, they must both follow EU

directives on company law. A major difference that exists in the board structure for

companies is that the UK has a unitary board (consisting of both executive and non-

executive directors), whereas German companies have a two-tier board of directors.

The Supervisory Board typically includes representatives from major banks that have

historically been large providers of long-term finance to German companies (and are

often major shareholders).

Japan

Although there are signs of change in Japanese corporate governance, much of the

system is based upon negotiation or consensual management rather than upon a

legal or even a self-regulatory framework. Banks as well as representatives of other

companies (in their capacity as shareholders) also sit on the Boards of Directors of

Japanese companies.

It is not uncommon for Japanese companies to have cross holdings of shares with

their suppliers, customers and banks etc., all being represented on each other’s Board

of Directors.




Chapter 3

Economic Environment for

Multinationals

INTERNATIONAL TRADE

International trade occurs to allow companies to enjoy economies of scale, increase

their turnover and profits, use up spare capacity and to promote division of labour.

In economics, theoretical justifications of the benefits of international trade were put

forward by:

● Adam Smith – the theory of absolute advantage.

● David Ricardo – the theory of comparative advantage.

Sources of advantage may include close proximity to raw materials or markets,

access to capital or an available labour force with the necessary skills.

Free trade and protectionism

Free trade is the unhindered movement of goods and services throughout world

markets.

Protectionism aims to boost the economic wealth of the country concerned through

government measures which prevent free trade. However retaliatory measures may

defeat such government action. Protectionist measures may include:

● Tariffs.

● Import quotas.



CHAPTER 3 - ECONOMIC ENVIRONMENT FOR MULTINATIONALS


● Bureaucratic regulations (red tape).

● Exchange controls.

● Government subsidies to domestic industries.

● Imposition of import licenses.

● Devaluation of the currency – making imports more expensive.

● Subsidies to exporters.

Trade blocks

Trade blocs arise where a group of countries conspire to promote trade between

themselves. Trade blocs include:

● Free trade area – free movement of goods and services (no internal tariffs)

between member countries, with external tariffs set individually, eg North

American Free Trade Area (NAFTA).

● Customs union – no internal tariffs between member countries and with

common external tariffs against non-member countries, eg the former

European Economic Community.

● Common market – no internal tariffs, common external tariffs, as well as the

free movement of labour and capital between member countries, eg European

Union.

Gatt and the World Trade Organisation (WTO)

The General Agreement on Tariffs and Trade was set up in 1947 with the aim of

achieving agreements between trading nations to reduce protectionism and to free

international trade by the progressive removal of artificial barriers. Several rounds

of agreement were achieved - notably the Kennedy Round in the mid 1960s, the

Tokyo Round in the late 1970s and the Uruguay Round which ended in 1994.

The treaty at the conclusion of the Uruguay Round created the WTO as a replacement

body to continue the work of GATT into the future. GATT ceased to exist in 1994.

The WTO will press for future reductions on trade barriers in areas such as

agriculture, textiles, intellectual property rights and services. The WTO, based in

Geneva, currently has a membership of about 150 countries. Membership obliges

countries to sign up to an extensive range of agreements, rather than be selective,

as was the case with GATT.

Multinational companies (MNCs)

A MNC owns or controls production or service facilities based in a number of overseas

countries. MNCs may engage in “foreign direct investment” (FDI) in order to seek

markets, raw materials, knowledge, production efficiency, or safety from political

interference. Horizontal or vertical integration and product specialisation have fuelled

the growth of companies such as General Motors, Royal Dutch Shell, BP Amoco,

Nissan and Hitachi and many MNCs now have annual turnovers exceeding the GNPs

of several large countries.



CHAPTER 3 – ECONOMIC ENVIRONMENT FOR MULTINATIONALS


The balance of payments

The balance of payments is a statistical record of a country’s international trade

transactions (current account) and capital transactions with the rest of the world over

a period of time eg

UK balance of payments 2010

£bn

Current account

Exports 200

Imports (215)

Visible balance (15)

Invisibles balance 5

(10)

UK external assets and liabilities: net transactions 2

Balancing item 8

10

N.B. The statistics that are gathered are not wholly perfect and some transactions

will be omitted. Thus the balancing item is unavoidable.

Temporary deficits can be financed by short term borrowing, but persistent balance

of payments deficits usually require government intervention, such as:

● Devaluation of the currency or government intervention on the foreign

exchange markets.

● Raising interest rates.

● Restricting the money supply.

● Imposing tariffs or import quotas.

The international financial institutions

International Monetary Fund (IMF)

Founded in Bretton Woods, New Hampshire in 1944 with the aim of promoting world

trade and maintaining global monetary stability. Assists countries with balance of

payments problems by making loans in the form of Special Drawing Rights.

Such loans are normally dependent upon the country concerned making strict internal

financial adjustments to solve their economic problems.

The International Bank for Reconstruction and Development (IBRD)

Popularly known as the World Bank, it was also created at Bretton Woods in 1944,

with the aim of financing 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.

The Bank for International Settlements (BIS)

Established in Basle, Switzerland in 1930, it acts as a supervisory body for central

banks assisting them in the investment of monetary assets. It acts as a trustee for





the IMF in loans to developing countries and provides bridging finance for members

pending their securing longer term finance for balance of payments deficits.

The Euromarkets

The Euromarkets refer to transactions between banks and depositors/borrowers of

Eurocurrency.

● Eurocurrency refers to a currency held on deposit outside the country of its

origin eg Eurodollars are $US held in a bank account outside the USA.

● Eurocurrency loans are bank loans made to a company, denominated in a

currency of a country other than that in which they are based. The term of

these loans can vary from overnight to the medium term.

● Eurobonds are bonds issued (for 3 to 20 years) simultaneously in more than

one country. They usually involve a syndicate of international banks and are

denominated in a currency other than the national currency of the issuer.

Interest is paid gross.

● Euronotes are issued by companies on the Eurobond market. Companies issue

short-term unsecured notes promising to pay the holder of the Euronote a fixed

sum of money on a specified date or range of dates in the future.

● Euroequity market refers to the international equity market where shares in US

or Japanese companies are placed on as overseas stock exchange (eg London

or Paris). These have had only limited success, probably due to the absence of

a effective secondary market reducing their liquidity.

The global debt problem

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) believing the

default risk to be low. The oil price rises fuelled inflation and interest rates increased,

forcing most of the world’s economies into recession.

High interest rates and reduced exports placed LDCs in a situation where they could

no longer pay interest or repay loans. These problems made economic conditions in

many LDCs extremely difficult, affecting the position of multinationals and making

international banks less willing to lend.

Methods of dealing with such excessive debt burdens have been:

● A programme of debt write-offs by banks and other lenders.

● Rescheduling existing debt repayments.

● Re-selling debt at a discount to recoup capital.

● Provision of additional loans where the debt problem is regarded as temporary.

● Drastic changes in the economic policies of the LDC imposed and monitored by

the IMF.



CHAPTER 3 – ECONOMIC ENVIRONMENT FOR MULTINATIONALS


Risks of foreign trade

Importing from and exporting to foreign countries includes the following categories

of risk:

● Currency risk – sometimes referred to as “exchange rate risk”. It involves the

possibility of financial gains or losses arising out of unpredictable changes in

exchange rates. It can be classified into:

o Translation risk – the gains or losses to be reported when overseas

operations are consolidated into group accounts.

o Economic risk – the possibility that the value of the overseas entity (based

upon the PV of all future cash flows) will change due to unexpected

exchange rate movements arising at sometime in the future.

o Transaction risk – the gains or losses that are made when ultimate

settlement occurs at a date when the exchange rate differs from the rate

prevailing at the date of the original transaction.

● Political risk – the possibility of the financial success of a venture being affected

by the actions of an overseas government or population. Government agencies

can advise on potential risks.

● Physical risk – the likelihood of damage or theft arising from the physical

distances involved and the length of time between despatch and receipt of the

goods by the customer. Normal commercial insurance is, of course, available.

● Credit risk – this is the risk of non-payment for the goods/services involved in

an export transaction. Insurance cover for up to 180 days can be provided by

NCM UK; for longer periods the ECGD may provide this service. Private sector

companies such as Trade Indemnity plc provide similar services.

● Trade risk – the overseas customer may refuse to accept the goods and be

uncooperative in returning them, thus taking advantage of the long physical

distances involved.

● Liquidity risk – this is caused by the duration of the delivery period and the

lengthy periods of credit expected by some overseas customers.

● Cultural risk – there may be misunderstandings caused by differences in trade

practice, religious and moral attitudes, legal systems and language barriers.

Sources of finance for foreign trade

● Bank overdrafts – either in sterling or in the overseas currency.

● Bills of exchange

● Promissory notes

● Documentary letters of credit

● Factoring

● Forfaiting

● Leasing and hire purchase

● Acceptance credits

● Produce loans





● Requesting payment in advance from the importer

Countertrade

This is an agreement in which the export of goods to a country is matched by a

commitment to import goods from that country. This usually occurs because the

foreign importing country either lacks foreign currency, has exchange controls in

place or where there are barriers to imports which can be circumvented by means of

countertrade.

The volume of countertrade is now reported at about 30% of total international

trade. In the case of some Eastern European and Third World countries it is the

only way of organizing international trade because of their shortage of foreign

currency. Many countertrade deals can be highly complex involving many parties.




Chapter 4

Discounted Cash Flow techniques

DISCOUNTED CASH FLOW TECHNIQUES

Discounting cash flow techniques are investment appraisal techniques which take into

account both the time value of money and also total profitability over the project life.

It is therefore superior to both the ARR and the payback as methods of investment

appraisal.

The discounting methods include:

● Net present value,

● Internal rate of return,

● Modified internal rate of return,

● Discounted payback period,

● Duration,

● Profitability index,

● Adjusted present value.

The assumed objective is to maximise the shareholders’ wealth.

Net present value (NPV)

The NPV of a project is the value obtained by discounting all the cash outflows and

inflows at a chosen target rate of return or cost of capital and taking the net total.

That is the present value of inflows minus present value of outflows.

NPV = PV of future cash flows – initial investment.

There are three variables required in calculating NPV. These variables are:

● The number of years of the project,

● The relevant cash flows,



CHAPTER 4 – DISCOUNTED CASH FLOW TECHNIQUES


● Appropriate discount factor (cost of capital).

Decision rule

1. If he NPV is positive, then the cash inflows from the investment will yield a

return in excess of the cost of capital and so the project should be undertaken.

2. If the NPV is negative, the cash inflows from the investment will yield a return

below the cost of capital, and the project should not be undertaken.

3. If the NPV is exactly zero, then the cash inflows from the investment will yield

a return which is exactly the same as the cost of capital, so the company should

be indifferent between undertaking and not undertaking the project.

Internal Rate of Return (IRR)

Internal rate of return is that discount rate which gives a net present value of zero.

Alternatively, the IRR can be described as the maximum cost of capital that can be

applied to finance a project without causing harm to the shareholders.

It is sometimes called the yield, or DCF yield, or internal yield, or discounted rate of

return.

The IRR is found approximately using interpolation. This is given as:

IRR = % % %L

L H

NPVL H L

NPV NPV

Where:

L = lower discount rate (say 10%)

H = higher discount rate (say 15%)

NPVL = net present value of L% = 190

NPVH = net present value of H% = 65

IRR = 10% + (190/ 190-65) x (15% -10%)

= 10% + 7.6% = 17.6%

Decision rule

If the expected (calculated) IRR exceeds the cost of capital, the project should be

undertaken.

Discounted payback period (DPB)

It is the length of time the present values of cash flows from an investment recover

the original cash outlay required by the investment. Through DPB method, the

normal payback period problem of time value of money is resolved.

Relevant cash flows

A relevant cash flow is a future cash flow arising as a result of a decision. The cash

flows that should be included are those specifically generated or incurred as a result

of the accepting or non-accepting of the project.

Relevant cash flows should be judged on the basis of:





● Incremental cash flows,

● Avoidable cash flows, and

● Opportunity cost.

Irrelevant cash flows include:

● Depreciation – not a cash flow item. If profit is given after depreciation, the

depreciation should be added back to get the cash flows.

● Apportioned fixed cost. Fixed costs may appear in a DCF calculation only if it

is known that they will increase as a result of accepting a project.

● Interest payments – this is factored into the discount rate.

● Sunk or past costs.

Working capital

Some capital investment involves an investment in working capital as well as fixed

assets. Working capital should be considered to consist of investments in stocks and

debtors, minus trade creditors.

An increase in working capital reduces cash flows and a reduction in working capital

improves the cash flow in the year that it happens

By convention, in DCF analysis, if a project will require an investment in working

capital, the investment is treated as a cash outflow at the beginning of the year in

which it occurs. The working capital is eventually released or recouped at the end of

the project, when it becomes a cash inflow.

INFLATION AND PROJECT APPRAISAL

Inflation is a general increase in prices leading to a general decline in the real value

of money. In general, the effects are the following:

1. revenue increases

2. cost increases

3. increases discount factor.

‘Money’ cash flows

These are the predictions of the actual sums of money which will be received and

paid taking into account predicted inflation levels. The ‘money’ rate of interest is the

interest rate which is normally quoted and contains an allowance for inflation (for

example, a 20% discount rate may contain an allowance for expected inflation of

5%).

‘Real’ cash flows

These are cash flows expressed in today’s prices. A ‘real’ discount rate is the real

required rate of return after adjusting the money discount rate for the inflation

allowance.





Relationship between money interest rates and real

interest rates

1. Money or Nominal rate is used to discount the nominal cash flows.

2. Real rate is used to discount the real cash flows.

3. Because inflation affect financing needs, is also likely to affect gearing and so

cost of capital.

The relationship between money rate (m), real rate (r) and inflation (i) is given as:

(1 + m) = (1 + r)(1 + i)

Taxation and Project Appraisal

● Tax on cash profit (sales minus expenses).

● Tax savings on capital allowances (tax allowable depreciation).

● Timing of the cash flows.

Capital allowance

The capital allowances are used to reduce the taxable profits and the consequence

reduction in a tax payment should be treated as a cash savings arising from the

acceptance of a project.

The cash savings on the capital allowance = capital allowance

x tax rate

When the asset is eventually sold, the difference between the sale proceeds and the

written down amount at the time of sale will be treated as:

● A balancing charge (taxable profit) if the sale price exceed the written down

balance.

● A balancing allowance (taxable loss) if the sale price is less than written down

balance.





Example Jato Co

Jato Co is considering a project – whether or not to commercialise an innovative

muscle toning device (MTD) that will be used in the treatment of sporting injuries.

It is expected that the commercial life of MTD will be four years after which

technological advances will bring more sophisticated devices to the market and the

sales of MTD will fall to virtually zero. $8,000,000 has been spent in developing and

testing the device over the past year. Initial market research has been conducted

at a cost of $2,500,000 and is due to be paid shortly.

Information on future returns from the investment has been forecast to be as

follows:

Year 1 2 3 4

Units demand 20,000 70,000 125,000 20,000

Selling Price in current price terms ($/unit) 2,000 2,200 1,600 1,500

Variable cost in current price terms ($/unit) 900 1,000 1,020 1,020

Fixed costs in current price terms

($million/year) 10 10 10 10

Selling price inflation and fixed costs inflation are expected to be 5% per year and

variable cost inflation is expected to be 4% per year. Fixed costs represent

incremental fixed production overheads which are wholly attributable to the project.

The production equipment for the new device would cost $120 million and an

additional initial investment of $20 million would be needed for working capital. The

equipment is expected to be sold at the end of four years for $10 million when the

production and sales cease. The average general level of inflation is expected to be

3% per year and working capital would experience inflation of this level.

Capital allowances (tax-allowable depreciation) on a 25% reducing balance basis

could be claimed on the cost of equipment. Profit tax of 30% per year will be

payable one year in arrears. A balancing allowance would be claimed in the fourth

year of operation.

Jato Co has a real cost of capital of 7.8%.

Required: calculate the NPV / IRR / Payback & Discounted payback.





NPV and IRR compared

Single investment decision

A single project will be accepted if it has a positive NPV at the required rate of return.

If it has a positive NPV then, it will have an IRR that is greater than the required rate

of return.

Mutually exclusive projects

Two projects are mutually exclusive if only one of the projects can be undertaken.

In this circumstance the NPV and IRR may give conflicting recommendation.

The reasons for the differences in ranking are:

1. NPV is an absolute measure but the IRR is a relative measure of a project’s

viability.

2. Reinvestment assumption. The two methods are sometimes said to be based

on different assumptions about the rate at which funds generated by the project

are reinvested. NPV assumes reinvestment at the company’s cost of capital

and IRR assumes reinvestment at the IRR.

Decision rule

Where there is conflict between IRR and NPV, accept the project with the larger NPV.

Example 2

Project A Project B

NPV 610 1,026

IRR 20% 18%

Cost of capital: 10%

Required: Which project should be accepted?

Modified internal rate of return (MIRR)

An assumption underlying the NPV method is that any net cash flows generated

during the life of the project will be reinvested elsewhere at the cost of capital (the

discount rate). The IRR method assumes that the net cash flows are reinvested

elsewhere at the IRR.

If the IRR is considerably higher than the cost of capital this is an unlikely assumption.

If the assumption is not valid the IRR method overestimates the projects return.

To help overcome the problem of IRR, a recent innovation is the development of the

modified IRR, described by F. Lefley (January 1997).

Modified IRR has the following benefits:

● It eliminates multiple IRR rates.

● It addresses the reinvestment rate issue and reduces over optimism.

● It produces a result which, when ranking projects, is consistent with the NPV

rule.





● Provides a % rate of return for project evaluation. It is claimed that non-

financial managers prefer a % result to a monetary NPV amount, since a %

helps measure the “headroom” when negotiating with suppliers of funds.

Using this method (MIRR) all cash flows after investment are converted, by assuming

that the cash flows can be reinvested at the cost of capital, to a single cash inflow at

the end of the final year of the project.

Calculating modified internal rate of return (MIRR)

The MIRR assumes a single outflow at time 0 and a single inflow at the end of the

final year of the project. The procedures are as follows:

● Convert all investment phase outlays as a single equivalent payment at time 0.

Where necessary, any investment phase outlays arising after time 0 must be

discounted back to time 0 using the company’s cost of capital.

● All net cash flows generated by the project after the initial investment (ie the

return phase cash flows) 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.

● The MIRR can then be calculated employing one of a number of methods, as

illustrated in the following example.

Example 3 Carter plc

Carter plc is considering an investment in a project, which requires an immediate

payment of £15,000, followed by a further investment of £5,400 at the end of the

first year. The subsequent return phase net cash inflows are expected to arise at

the end of the following years:

Net cash inflows

Year £

1 6,500

2 7,750

3 5,750

4 4,750

5 3,750

Required:

Calculate the modified internal rate of return of this project assuming a

reinvestment rate equal to the company’s cost of capital of 8%.





Duration

Duration is the average time taken to recover the cash flows on an investment. The

average is taken as the value weighted average of the number of the year (1 to n)

in which the cash flows arise. In capital investment, the duration can be calculated

using either the firm’s original outlay, or the present value of its future cash flows as

the basis for the annual weighting.

If duration is based upon the average time to recover the initial capital investment:

1. Calculate the value of each future net cash flow, discounted at the IRR of the

project;

2. Calculate each year’s discounted cash flow as a proportion of the original capital

outlay;

3. Take the time from investment to each discounted cash flow and multiply by

the respective proportion. Finally, sum the weighted year values.

If duration is based upon the average time taken to recover the present value of the

project:

1. Calculate the value of each future net cash flow, discounted at the chosen

hurdle rate;

2. Calculate each year’s discounted cash flow as a proportion of the PV of total

cash inflows;



Example 4 FCF plc

The forecast cash flows relating to a proposed project are:

Year 0 1 2 3 4

Incremental cash

flows

(£34,000) £7,600 £16,500 £13,000 £6,600

Required:

Establish both the duration to recover the original investment (using the

IRR of this project of 11.13%) and the duration to recover the present value

of the project (at an 8% hurdle rate).





CAPITAL RATIONING

Capital rationing occurs whenever there is a budget ceiling or a market constraint on

the amount of funds which can be invested during a specific period of time. It is a

situation where there are insufficient funds to finance all profitable projects.

Causes of capital rationing

There are two causes of capital rationing:

1. Soft or internal capital rationing

Soft capital rationing is often used to refer to situation where, for various reasons,

the firm internally imposes a budget ceiling on the amount of capital expenditure.

It occurs due to internal factors such as:

● Management may be reluctant to issue additional share capital because of the

concern that this may lead to a dilution in control.

● Management may be unwilling to issue share capital if it will lead to a dilution

in earnings per share.

● Management may not want to raise additional debt capital because they do not

want to be committed to large fixed interest payment or due to the concern of

gearing.

● There may be a desire within the company to limit investment to a level that

can be financed solely from retained earnings.

2. Hard or external capital rationing

Hard capital rationing occurs whenever there is a market constraint on the amount

of funds which can be invested during a specific period of time.

This occurs due to external factors such as:

● Raising money through the stock market is not possible because share prices

are depressed.

● There may be restriction on bank lending due to government controls.

● Lending institutions may consider an organisation to be too risky to be granted

further loan facility.

● The cost associated with making small issues of capital may be too great.





Types of capital rationing

The two types of capital rationing are single period and multi period capital rationing.

1. Single period capital rationing

Single period capital rationing is where there are shortages of funds now, but funds

are expected to be freely available in all later periods.

Projects may be:

1. Divisible

An entire project or any fraction of that project may be undertaken. In this event

projects may be ranked by means of a profitability index, which can be calculated

by dividing the present value (or NPV) of each project by the capital outlay required

during the period of restriction.

Projects displaying the highest profitability indices will be preferred. Use of the

profitability index assumes that project returns increase in direct proportion to the

amount invested in each project.

2. Indivisible

An entire project must be undertaken, since it is impossible to accept part of a project

only. In this event the NPV of all available projects must be calculated. These

projects must then be combined on a trial and error basis in order to select that

combination which provides the highest total NPV within the constraints of the capital

available. This approach will sometimes result in some funds being unused.

2. Multi-period capital rationing

This is where available finance is limited not only during the current period, but also

during subsequent periods.

Projects may be:

1. Divisible

In this event, linear programming is used to determine the optimal combination of

projects.

Two techniques, which both result in identical project selections can be used,

ie the objective is to either:

● Maximise the total NPV from the investment in available projects, or

● Maximise the present value (PV) of cash flows available for dividends.

2. Indivisible

In this event, integer programming would be required to determine the optimal

combination of investments.





Example 5 Banden Ltd

Banden Ltd is a highly geared company that wishes to expand its operations. Six

possible capital investments have been identified, but the company only has access

to a total of £620,000. The projects are not divisible and may not be postponed

until a future period. After the projects end, it is unlikely that similar investment

opportunities will occur.

Expected net cash inflows (including salvage value)

Initial

Project Year 1 2 3 4 5 outlay

£ £ £ £ £ £

A 70,000 70,000 70,000 70,000 70,000 246,000

B 75,000 87,000 64,000 180,000

C 48,000 48,000 63,000 73,000 175,000

D 62,000 62,000 62,000 62,000 180,000

E 40,000 50,000 60,000 70,000 40,000 180,000

F 35,000 82,000 82,000 150,000

Projects A and E are mutually exclusive. All projects are believed to be of similar

risk to the company’s existing capital investments.

Any surplus funds may be invested in the money market to earn a return of 9% per

year. The money market may be assumed to be an efficient market. Banden’s cost

of capital is 12% per year.

Required:

Give reasoned advice to Banden Ltd recommending which projects should

be selected.





Multi-period capital rationing

Please remember that you are only likely to be asked to set up the equations for both

the linear programming and integer programming formulations and then to interpret

the output. The actual solving of these equations are computer-based calculations.

Example 6 Barney Ltd

The management team of Barney Ltd has identified the following independent

investment projects, all of which are divisible.

No project can be delayed or performed on more than one occasion. The projected

cash flows during the life of each project are as follows:

Year 0 Year 1 Year 2 Year 3 Year 4

£’000 £’000 £’000 £’000 £’000

Project A (25) (50) 25 50 50

Project B (25) (25) 75 - -

Project C (12.5) 5 5 5 5

Project D - (37.5) (37.5) 50 50

Project E (50) 25 (50) 50 50

Project F (20) (10) 37.5 25 -

The capital available at Year 0 is only £50,000 and only £12,500 is available at Year

1, together with any cash inflows from the projects undertaken at Year 0. From Year

2 onwards there is no restriction on the access to capital. The appropriate cost of

capital is 10%.

Required:

Formulate both:

1. The NPV linear programme, and

2. The PV of dividends linear programme.





Dual Values

Dual values (also referred to as “shadow prices”) reflect the change in the objective

function as a result of having one more or one less unit of scarce resource. In the

context of capital rationing the scarce resource is available cash, so that the dual

price states the change in the objective function if one more unit of currency (eg £1)

becomes available or if one less GB pound is invested.

Shadow prices can therefore be used to calculate the impact of raising additional

finance for further investment or the effect of diverting capital away from current

projects into newly discovered investments.

The dual price depends upon which method is used to formulate the linear

programme ie

● Under the NPV formulation, it reflects the change in the NPV if £1 more or £1

less is available

● Under the PV of dividends formulation, it reflects the change in the PV of

cash available for dividend payments if £1 more or £1 less capital is available.

Dual prices relate only to marginal changes in the availability of capital. Thus,

suppose that a dual value of £1.25 arises under the PV of dividends method, this

means that if an additional £1 of funds became available, the total value of the

objective function would rise by £1.25. It does not necessarily mean that if an

additional £10,000 became available, that the value of the objective function would

increase by (£10,000 x 1.25) £12,500.

Shadow prices can therefore be used to test the validity of new investments which

emerge. The cash flows generated by the new project can be compared with the

cash flows lost by diverting funds from existing investments, thereby calculating the

effect of diversion of that finance.





Example 7 Bruno Ltd

Bruno Ltd is experiencing capital rationing during both Year 0 and Year 1 in relation

to a number of divisible projects. It has used linear programming to develop an

investment strategy over its three year planning horizon for dividend payments,

using a cost of capital of 10%.

Shadow prices have been calculated under the NPV formulation for the two years of

capital constraints and under the PV of dividends formulation for the three year

planning horizon. The dual prices per £1 of capital available are as follows:

NPV method PV of dividends method

£ £

Year 0 0.1 (1 + 0.1) = 1.1

Year 1 0.08 (0.909 + 0.08) = 0.989

Year 2 0 (0.826 + 0) = 0.826

A new investment opportunity has emerged with the following cash flows:

Cash flow

£’000

Year 0 (75)

Year 1 50

Year 2 50

Required:

Appraise the new project using both the NPV dual prices and the PV of

dividend shadow prices.





Example 8 Toby Ltd

The management team of Toby Ltd has identified four indivisible projects, which

require funds to be invested over the next few years, as set out below:

Project A Project B Project C Project D

£ £ £ £

Year 0 17,500 22,500 - 12,500

Year 1 25,000 - 15,000 15,000

Year 2 10,000 30,000 20,000 17,500

The board of directors of that company has approved the following capital

expenditure programme for those same accounting periods:

£

Year 0 40,000

Year 1 35,000

Year 2 42,500

The four projects are expected to produce the following positive net present values:

Project A Project B Project C Project D

Project NPV +£20,000 +£27,500 +£15,000 +£10,000

Required:

Discuss the approach for calculating the optimum mix of projects.





RISK AND UNCERTAINTY

Forecast must consider risk and uncertainty.

Risk

Future events might not be certain, because there are several possible outcomes.

However, it might be possible to predict the likelihood that each possible outcome

will occur. The predictions of risk in the future might be based on statistical

assessment of what has occurred in the past.

With risk analysis, the probabilities might be obtained from analysing what has

happened in the past.

Uncertainty

Uncertainty exist where there are several possible outcomes, but there is little

previous statistical evidence to enable the possible outcomes to be predicted.

Methods of treating risk

The methods of treating risk include:

● sensitivity analysis

● probability estimate of cash flows

● certainty equivalent

● adjusting the discount rate

● simulation modelling.

Sensitivity analysis

Sensitivity analysis is one method of analysing the risk surrounding a capital

expenditure project and enables an assessment to be made of how responsive the

project’s NPV is to changes in the variables that are used to calculate that NPV.

It is applied by varying the expected cash flows of a project to measure what would

happen if the investment were to work out somewhat worse than expected.

The NPV could depend on a number of variables such as

● initial cost or investment

● estimated selling price

● estimated sales volume or quantity

● estimated cost of capital

● estimated operating cost, both fixed and variable

● The number of years of the project.

The basic approach to sensitivity analysis is to calculate the net present value of the

project under alternative assumptions to determine how sensitive it is to changing

conditions.





Sensitivity of cash flows

To find the percentage change required to achieve an NPV of zero, the calculation is

as follows if the variable under consideration is a cash flow item:

% change = NPV of project

100PV of cash flows affected by the variable

Sensitivity of discount factor

This is the discount factor to make the NPV zero and is simply calculated as the

internal rate of return.

Sensitivity of number of years

This is calculated as the discounted payback period.

Monte Carlo simulation

Sensitivity analysis assesses the effect on an overall decision if a single constituent

variable were to change. Monte Carlo simulation is a mathematical model which will

include all combinations of the potential variables associated with the project. It

results in the creation of a distribution curve of all possible cash flows which could

arise from the investment and allows for the probability of the different outcomes to

be calculated.

The steps involved are as follows:

1. Specify all major variables

2. Specify the relationship between those variables

3. Using a probability distribution, simulate each environment.

This is repeated a large number of times until a distribution of net present values

emerge. By the central limit theorem the resulting distribution will approximate

normality and from which project volatility can be estimated.

The advantage of this technique is that it includes all foreseeable outcomes. The

disadvantages are the difficulty in formulating the probability distribution and the

model becoming very complex.

Example 9 CC plc

An expected NPV has already been calculated for the following project of CC plc:

Year Cash flow 10% discount factor Present value

£000 £000

0 Initial investment (100) 1 (100.00)

1-3 Revenues 40 2.487 99.48

3 Scrap value 10 0.751 7.51

NPV +6.99

Required:





Project value at risk

Value at risk (VaR) is the value which can be attached to the downside of a value or

price distribution of known standard deviation and within a given confidence level.

VaR and related measures give an indication of the potential loss in monetary value

which is likely to occur with a given level of confidence. The setting of the confidence

level is necessary because, in principle, if a price distribution is normally distributed

for example, the downside loss is potentially infinite.

Confidence 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

1% chance of loss of value).

Example 10

Andrews 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% confidence

level.




Chapter 5

Application of Option Pricing in

Investment

Decisions

Terminology of Options

The holder or buyer

The holder or buyer of the option is an investor or speculator who pays the option

money as consideration for the right to buy or sell at a fixed price over a limited

period.

The writer or seller

The writer or seller of the option is an organisation or individual who will grant the

option and take the option money in payment for the services. Unlike the holder,

the writer has an obligation to the deal, if the holder is to exercise the right under

the option.

Call option

A call option is the option that gives its holder the right, but not an obligation to buy

the underlying item at the specific price on or before the specific expiry date of the

option. For example, a call option on shares of central college, gives its holder the

right to buy that number of shares in central college at the fixed price on or before

the expiry date of the option.



CHAPTER 5 – APPLICATION OF OPTION PRICING IN INVESTMENT DECISIONS


Put option

A put option is the option that gives its holder the right to sell the underlying item

at the specific price on or before the specific expiry date of the option. For example,

a put option in central college shares, gives its holder the right to sell that number of

shares at the specific price on or before the specific expiry date of the option.

American and European options

European options only allow the option holder to exercise the right on the expiry date

itself and not before. American options allow the holder to exercise the right at any

time up to and including the expiry date of the option.

Striking or exercise price

This is the predetermined price at which the underlying item would be bought or sold

if the holder of the option decides to exercise the right under the option contract.

At, in, and out of the money

If the exercise price is more than the market price of the underlying item, a call

option will be out of money and a put option will be in the money.

If the exercise price is less than the market price of the underlying item, a call option

will be in the money and a put option will be out of the money.

If the exercise price is equal to the market price of the underlying item both call and

put options will be at the money.

Option money or premium

Option premium or money is the fee payable by the holder to the writer. It is the

writers return for the risks they are accepting. The premium will vary in value

according to the market expectations of future values of the underlying assets.

Intrinsic value

Intrinsic value is the difference between the strike price for the option and the current

market price of the underlying item. However, an in-the-money option has an

intrinsic value; but because intrinsic value cannot be negative, an out of the money

option has an intrinsic value of zero.

Factors determining the value(price) of option

The major factors determining the price of options are as follows:

The price of the underlying item

For a call option, the greater the price for the underlying item the greater the value

of the option to the holder. For a put option the lower the share price the greater

the value of the option to the holder.





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.

The exercise price

For a call option the lower the exercise price the greater the value of the option. For

a put option the greater the exercise price, the greater the value of the option.

The exercise price will be stated in terms of the option contract.

Time to expiry of the option

The longer the remaining period to expiry, the greater the probability that the

underlying item will rise in value. Call options are worth more the longer the time to

expiry(time value) because there is more time for the price of the underlying item to

rise. Put options are worth more if the price of the underlying item falls over time.

The term to expiry will also be stated in the terms of the option contract.

Prevailing interest rate

The seller of a call option will receive initially a premium and if the option is exercised

the exercise price at the exercised date. If interest rate rises the present value of

the exercise price will diminish and he will therefore ask for a higher premium to

compensate for his risk.

The risk free rate such as treasury bills is usually used as the interest rate.

Volatility of underlying item

The greater the volatility of the price of the underlying item the greater the probability

of the option yielding profits.

The volatility represents the standard deviation of day-to-day price changes in the

underlying item, expressed as an annualized percentage.

The Black Scholes option pricing model

Black-Scholes model is a model for determining the price of a call option. The model

considers the factors discussed above and states that the market value of a call option

at a particular time can be calculated as:

Option price = PaN(d1) – Pe(Nd2) e-rt

d1 = 2ln / 0.5Pa Pe r s t

s t

d2 = d1 – st

ln = natural log

Nd1 and Nd2 are the normal distribution function of d1 and d2 respectively.

Where:





Pa = current market price of the underlying item

Pe = the exercise price

R = the annual risk free rate in decimals

T = time to expiry of option in years, so six months will be 0.5

years.

S = the standard deviation of the underlying instrument returns.

This measures the volatility of underlying item.





REAL OPTIONS IN INVESTMENT APPRAISAL

Real options are concerned with options related to operational and strategic

decisions, in particular those concerned with investment in projects.

Conventional DCF analysis looks at whether a project is going to add value for

shareholders. In practice, managers of a business are unlikely to consider net

present values of projects alone. Investing in a particular project might lead to other

opportunities that may have been ignored in a DCF analysis. Managers could take

action to help boost a project’s NPV if it falls behind forecast. They can create and

take advantage of options in managing projects.

The flexibility provided by real options in investments appears in many guises. Busby

and Pitts identify the following types:

● Timing options – options to embark on an investment, to defer it or abandon it.

● Scale options – options to expand or contract an investment.

● Staging options – option to undertake an investment in stages.

● Growth options – options to make investments now that may lead to greater

opportunities later, sometimes called ‘toe-in-the-door’ option.

● Switching option – options to switch input or output in a production process.

Based on the P4 syllabus, we have to consider option to delay, expand, redeploy and

withdraw.

Option to delay or defer

An option to delay gives the company the right to undertake the project in a later

period without losing the opportunity creating a call option on the future

investment. This is more applicable if a company has exclusive rights to a project or

product for a specific period.

Option to expand

The option to expand exists when firms invest in projects which allow them to make

further investments in the future or to enter new market. The initial project may be

found in terms of its NPV as not worth undertaking. However, when the option to

expand is taken account, the NPV may become positive and the project worthwhile.

Expansion will normally require additional investment creating a call option.

The option will be exercised only when the present value from the expansion is higher

than the extra investment.





Option to abandon

An abandonment options is the ability to abandon the project at a certain stage in

the life of the project. Whereas traditional investment appraisal assumes that a

project will operate in each year of its lifetime, the firm may have the option to cease

a project during its life.

Abandon options gives the company the right to sell the cash flows over the remaining

life of the project for a salvage/scrape value therefore like American put options.

Where the salvage value is more than the present value of future cash flows over the

remaining life, the option will be exercised.

Option to redeploy or switch

The option to redeploy or switch exist when the company can use it productive assets

for activities other than the original one. The switching from one activity to another

will be exercised only when the present value of cash flows 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 investment at a later stage.

Valuation of real options

The Black-Scholes model can be used to value real options just as financial options

seen earlier, but the following should be noted:

● The exercise price (Pe) will be replaced by the capital investment (initial

investment) for option to delay and expand. Pe for option to abandon is the

proceeds from the sale of the project.

● The price of the underlying (Pa) item will be replaced by the present value of

future cash flows from the project.

● Time to expiry (t) is the time to exercise the option.

● Interest rate is still the risk free rate.

● Volatility of cash flows can be measured using typical industry sector risk.

Example 1 - option to expand – PUT OPTION

Winter plc has investigated the opening of a new restaurant in the Isle of Man. The

initial capital expenditure is estimated at £12 million, whilst the present value of the

net cash inflows is expected to be £12.005 million. Since the resulting NPV of £0.005

million is a very small positive amount, this appraisal suggests that the project is

extremely marginal.

However, if this first restaurant is opened, Winter plc would gain the right, but not

the obligation to open a second restaurant in five years time at a capital cost of £20

million. The present value of the associated future net cash inflows is estimated at

£15 million, with a standard deviation of 28.3%.

If the risk free rate of interest is 6%, determine whether to proceed with the

restaurant projects.





Example 2 - option to abandon – CALL OPTION

Summer plc is undertaking a brewing joint venture with Autumn Inc. This project

requires an initial outlay by Summer plc of £250 million. The present value of the

net cash inflows is expected to be £254 million, with a variance of 9%. The

arrangement thus provides an extremely small positive NPV of £4 million. Summer

plc, however, has the right but not the obligation to sell its share of the joint venture

to Autumn Inc for £150 million at the end of the first five years of the venture.

If the risk free rate of interest is 7%, calculate the value of this abandonment option.

Pricing of share options

Writers of options need to establish a way of pricing them. This is important because

there has to be a method of deciding what premium to charge to the buyers.

The pricing model for call options are based on the Black-Scholes model.

Example 3

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%.

Limitations of the Black-Scholes model

The model has a number of limitations including the following:

● It assumes that no dividends are paid in the period of the option.

● It applies to European call options only, and not to American options.

● It assumes that the risk free rate is known and constant throughout the option

life.

● It assumes that there is no transaction costs and tax effects involved in buying

or selling the option or its underlying item.

● The difficulty of estimating the standard deviation of the returns of the

underlying item to which the model is sensitive, and the use of this historical

measure to estimate future movements.





THE GREEKS

In principle, an option writer could sell options without hedging his position. If the

premiums received accurately reflect the expected pay-outs at expiry, there is

theoretically no profit or loss on average. This is analogous to an insurance company

not reinsuring its business. In practice, however, the risk that any one option may

move sharply in-the-money makes this too dangerous. In order to manage a

portfolio of options, the dealer must know how the value of the options he has sold

and bought will vary with changes in the various factors affecting their price. Such

assessments of sensitivity are measured by the “Greeks”, which can be used by

options traders in evaluating their hedge positions.

1. Delta

For each option held, the delta value can be established i.e.

Delta = Change in option price

Change in price of underlying security

Delta is a measure of how much an option premium changes in response to a change

in the security price. For instance, if a change in share price of 5p results in a change

in the option premium of 1p, then the delta has a value of (1p/5p) 0.2.

Therefore, the writer of options needs to hold five times the number of options than

shares to achieve a delta hedge. The delta value is likely to change during the

period of the option, and so the option writer may need to change his holdings to

maintain his delta hedge position.

Accordingly a writer can hedge a holding of 300,000 shares using options with a delta

value estimated by N(d1) of 0.6, by holding the following number of LIFFE contracts

(each on 1,000 shares).

Number of shares

Delta value Contract size =

300,000

0.6 1,000 = 500 contracts.

A delta value ranges between 0 and +1 for call options, and between 0 and -1 for

put options. The actual delta value depends on how far it is in-the-money or out-of-

the-money.

The absolute value of the delta moves towards 1 (or -1) as the option goes further

in-the-money and shifts towards 0 as the option goes out-of-the-money. At-the-

money calls have a delta value of 0.5, and at-the-money puts have a delta value of

-0.5.

2. Gamma

Gamma measures the amount by which the delta value changes as underlying

security prices change. This is calculated as the:

Change in the delta value

Change in the price of the underlying security





3. Vega

Vega measures the sensitivity of the option premium to a change in volatility. As

indicated above higher volatility increases the price of an option. Therefore any

change in volatility can affect the option premium. Thus:

Vega = Change in the option price

Change in volatility

N.B. Vega is the name of a star, not a letter of the Greek alphabet!!

4. Theta

Theta measures how much the option premium changes with the passage of time.

The passage of time affects the price of any derivative instrument because derivatives

eventually expire. An option will have a lower value as it approaches maturity. Thus:

Theta = Change in the option price (due to changes in value)

Change in time to expiry

5. Rho

Rho measures how much the option premium responds to changes in interest rates.

Interest rates affect the price of an option because today’s price will be a discounted

value of future cash flows with interest rates determining the rate at which this

discounting takes place. Thus:

Rho = Change in the option price

Change in the rate of interest

Summary of the Greeks

Changes in In response to changes in

DELTA Option premium Value of underlying security

GAMMA Delta value Value of underlying security

VEGA Option premium Volatility

THETA Time value in option premium Time to expiry

RHO Option premium Risk free rate of interest




Chapter 6

Impact of financing on investment

decisions

Cost of Capital

The cost of capital is the return that investors expect to be paid for putting funds into

the company. In order words, it is the cost incurred by a company for raising money

to finance its activities.

The elements of cost of capital are:

● The risk-free rate of return – return required from an investment which is

completely free from risk, example return on government securities.

● The risk premium – return to compensate for financial risk (having debts in

capital structure) and business risk (return to compensate for uncertainty about

the future and about a firm’s business prospects).



CHAPTER 6 – IMPACT OF FINANCING ON INVESTMENT DECISIONS


COST OF EQUITY – USING DIVIDEND VALUATION MODEL

With constant annual dividends

Where a company is expected to pay a constant divided in perpetuity the cost of

equity can be calculated as:

Ke =

0 (ex-div)

D

P

With dividend growing at a constant annual rate (g)

Where a company is expected to pay divided at a constant growth rate in perpetuity

the cost of equity can be calculated as:

The Dividend Growth model is:

Ke = 0

0

(1 ) g

P

D g

= g P

D

0

1

Where

Ke = cost of equity g = constant growth rate

D0 = current dividend P0 = ex-div market price

Example 1

A company is expected to pay a constant dividend of 40 pence per share. The current

ex-div market price is £3 per share.

(a) What is the cost of equity?

(b) What is the cost of equity, if anticipated growth in dividends is 10%

per annum?

Cumulative & Ex Dividend Share Price

Ex-div price = cum-div share price - dividend just about to be paid

Cum div price = ex-div price + dividend due

Example 2

A share is quoted cum div at £4.50. The dividend has been declared at £0.50.

What is the probable ex-div price?





Estimating growth rate

The growth ‘g’ can be estimated using either historical pattern or Gordon’s growth

model depending on the information available.

Historic pattern

A growth rate may be estimated from historic dividend pattern, as follows:

1d

dn/1

n

0

= g

Where:

dn = dividend in the past. That is the base dividend.

d0 = the current dividend. That is last dividend paid.

n = number of years of growth.

Example 3

A company currently pays a dividend of 32p. Five years ago the dividend was 20p.

Estimate the growth rate.

Example 4

The dividends of Paulto plc over the last five years are given below:

Year Dividends

£

1 180,000

2 210,000

3 220,000

4 245,000

5 280,000

Paulto plc’s current ex-div market price is £4 and it has in issue 1,000,000 ordinary

shares.

Calculate the company’s cost of equity.

Gordon’s growth model

In Gordon’s growth model, growth is measured as follows:

g = rb

Where:

r = the accounting rate of return/return on re-invested fund

= 100%Book value of equity capital employed

Earnings





b = the earnings retention rate/proportion of funds/profit retained

= Earnings-dividend

100%Earnings

Example 5

Consider the following:

Current cum-div market price £2.5

Current dividend 40 pence

Dividend pay-out ratio 60%

Average return on investment 10%

Calculate the cost of equity.

Cost of Preference Share Capital

The cost of irredeemable preference share capital, paying an annual dividend d in

perpetuity, and having a current ex-div price of Po can be calculated as follows:

Kps = div)-(ex P

)net( D

0

x 100%

Dividends are constant and there is no growth.

Example 6

A company has in issue 100,000 6% Preference shares of £1 each with a market

price of 40p.

What is the cost of preference share capital?

Cost of Non Tradeable Debt

The cost of short-term funds such a bank loans and overdrafts is the current interest

being charged on such funds reduced for the tax effect on the interest.

Kd = I (1-t)

Example 7

A company has 8% bank loan with a book value of £3,000,000.

Calculate the cost of this bank loan.

Assume 30% tax rate.





Cost of Irredeemable Debt

The cost of irredeemable loan notes paying an annual interest in perpetuity and

having a current market price will be calculated as follows:

Kb = ( )

Market Value of debt (ex-int)

Interest l t

Where:

t = rate of corporation tax.

I = annual interest

P0 = ex-interest market price of debt

Example 8

A company has in issue 5% irredeemable loan notes currently quoted at £105.5 cum-

interest per £100 nominal. Assume a corporation tax of 30%.

Calculate the cost of the debenture.

Cost of Redeemable Debt

The cost of redeemable loan notes/debentures is the internal rate of return of the net

cash flows of the capital.

Example 9

A 5% loan notes is currently quoted at £95.84 (ex-int). It is redeemable at the end

of 3 years at £100.

Taking corporation tax at 50%, and ignoring the timing lag for tax savings,

calculate Kd.

Cost of convertible

The cost of convertible debt is calculated in a similar manner to the calculation of the

cost of redeemable debt, EXCEPT that in the final year, one must include the:

- redemption value of the debt, or

- conversion value of the debt

whichever is the GREATER

Example 10

Some 8% convertible debentures have a current market value of £106 per cent. The

debenture will be converted into equity shares in 3 years’ time at the rate of 40

shares per £100 of debentures. The market price is expected to be £3.5 on the date

of conversion.

What is the cost of capital to the company for the convertible debentures?

Assume a corporation tax of 33%.





WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The weighted average cost of capital (WACC) is the average cost of the different

elements within the capital structure of a company, using the market value of each

of the different elements as the basis of the weightings.

Although book values are often easier to obtain they are of doubtful economic

significance, that is, it is more meaningful to use market values.

Assumptions in the use of WACC

WACC can be used as a cut-off or discount rate for calculating NPVs of projected cash

flows for new investments, but the following criteria should be met.

● There is no significant change in capital structure of the company as a result of

the investment.

● The operating risk of the company does not change as a result of the

investment.

● The project to appraise is small relative to the size of the company. It represents

a marginal investment.

Example 11 Hunt plc

The management of Hunt plc is trying to decide upon a cost of capital discount rate

to apply to the evaluation of investment projects.

The company has an issued share capital of 500,000 ordinary £1 shares, with a

current market value cum div of £1.17 per share. It has also issued £200,000 of

10% debentures, which are redeemable at par in 2 years and have a current market

value of £105.30 per cent and £100,000 of 6% preference shares, currently priced

at 40p per share. The preference dividend has just been paid, and the ordinary

dividend and debenture interest are due to be paid in the near future. (The

preference dividend is shown net).

The ordinary share dividend will be £60,000 this year, and the directors have

publicised their view that earnings and dividends will increase by 5% per annum into

the indefinite future.

The fixed assets and working capital of the company are financed by:

£

Ordinary shares of £1 500,000

6% £1 Preference shares 100,000

Debentures 200,000

Reserves 380,000

1,180,000

Required: Calculate the WACC. Assume corporation tax at 50% per annum,

payable one year in arrears.





The Frederick Macaulay duration method

In 1938, Frederick R. Macaulay defined “Duration” as the total weighted average time

for recovery of the payments and principal in relation to the current market price of

a bond.

The maturity of a bond is not a particularly good indication of the timing of the cash

flows associated with that bond, since a significant proportion of those cash flows will

occur prior to maturity – normally in the form of interest payments.

One could calculate an average of the timings of each cash flow, weighted by the size

of those cash flows. Duration is very similar to such an average, but instead of taking

each cash flow as a weighting, duration uses the present value of each cash flow.

Steps required to calculate bond duration

1. Establish the cash flows arising at each future time period;

2. Calculate the present value of these future cash flows, discounted at the IRR

(ie the gross yield to maturity) of the security. Incidentally, the sum of these

figures must be the current price of the bond;

3. Calculate each year’s discounted cash flow as a proportion of the current value

of the bond;



Example 12 - Seven Years

Seven years prior to the maturity of a bond with a 10% coupon, it is trading at a

price of £95.01 per cent and has a gross yield to maturity of 11.063%.

Required:

Using the Macaulay duration method, calculate the bond duration.





Significance of the calculation of duration

Duration is an important measure for fixed-income investors and their advisers, since

bonds with higher durations may have greater price volatility than similar bonds with

lower durations. In general:

● Changes in the value of a bond are inversely related to changes in the rate of

return – ie the lower the yield to maturity, the higher the value of the bond;

● Long-term bonds have higher interest rate risk than shorter term bonds, due

to the greater probability (over the longer time period) of market interest rate

increases; and

● High coupon bonds have less interest rate sensitivity than low coupon bonds,

since the greater the amounts of the cash flows received in the short-term, the

earlier the purchase price of the bond will be recouped.

The Macaulay duration method measures the number of years required to recover

the cost of the bond (taking account of the present value of all interest and capital

cash flows within the future time period). The result is expressed in years.

A measure referred to as Modified Duration (or Volatility) expands on the basic

method, but the ACCA P4 Syllabus only requires a knowledge of the “simple”

Macaulay duration method, as a means of assessing exposure to interest rate

changes.

The basic lessons of “duration” are:

● As maturity increases, the measure of duration will also increase and the market

value of the bond will become more sensitive to changes in the level of interest

rates;

● As the coupon rate of a bond increases, duration will decrease and the value of

the bond will be less sensitive to changes in the level of interest rates; and

● As interest rates rise, duration will decrease and the value of the bond will be

less sensitive to subsequent rate changes.

Example 13 - Macaulay Duration Method

(a) A bond with a five year maturity has a current value of £92.41 per cent, a

coupon rate of 8% and a market yield of 10%.

(b) On the 1 February 2011, a 5.5% Treasury bond (which is redeemable on 1

February 2015), has a market value of £110.28 per cent and a yield to maturity

of 2.75%.

(c) A 6% bond has three years to redemption. It has a current market price of

£89.85 per cent. Interest is paid half-yearly and its market yield is 10% per

annum (ie 5% every six months).

Required:

Using the Macaulay duration method, calculate the duration for each of the

above securities.





Modified Duration

Modified duration looks at how sensitive the value of a security is in relation to the

changes in interest rates, measuring the percent change in a bond’s price for a 1%

change in its yield to maturity.

The formula is - Macauley Duration / (1+ Yield to Maturity /N)

This recognises the inverse relationship that occurs between bond price and interest

rates. This is effectively the price sensitivity.

Credit Rating Agencies

Assess the credit risk by using financial ratios and other financial information. Most

common considerations include maturity period of the debt, debt to asset ratio,

volatility of asset value, cash flow generation, industry and competitive position,

quality of management, capital structure and profitability.

Rating Risk of Default

AAA High Quality – zero risk

AA High Quality – very little risk

A Upper Medium Grade – minimal risk

BBB Medium Grade

BB Lower Medium grade – speculative risk

B Speculative

CCC Poor Quality – considerable risk exposure

CC Highly speculative

C Lowest grade – very high default risk

Macauley Duration / (1+ Yield to Maturity /N)





Credit Spread & cost of debt

Credit spread is the premium over the equivalent return on risk free bond to

compensate the investor for credit risk. The higher the risk the higher the spread.

Cost – risk free return + spread

This is likely to be adjusted for the tax implications when determining cost of capital

Rating 1 Year 2 Year 3 Year 4 Year

AAA 8 16 24 32

A 32 52 72 92

BB 78 128 188 248

B 102 194 274 346

1 basis point = 0.01%

Note the lower the rating the higher the spread, further the yield to maturity

increases with time.

1 year = 2%

2 year = 4%

3 year = 6%

4 Year = 7%

Thus a four year A rated bond will cost 7 + 0.92 = 7.92% whereas a 3 year B rated

bond will cost 6.0 + 2.74 = 8.74%





CAPITAL STRUCTURE THEORY

There are three theories which detail the implications of the firms capital structure

upon the WACC

The traditional view of capital structure

Cost of equity

At relatively low levels of gearing the increase in gearing will have relatively low

impact on Ke. As gearing rises the impact will increase Ke at an increasing rate.

Cost of debt

There is no impact on the cost of debt until the level of gearing is prohibitively high.

When this level is reached the cost of debt rises.

Key point

There is an optimal level of gearing at which the WACC is minimized and the value of

the company is maximised

Cost of capital

Gearing (D/E)

Ke

WACC

Kd





Modigliani and Miller (M&M) – no taxes

Cost of equity

Ke rises at a constant rate to reflect the level of increase in risk associated with

gearing.

Cost of debt

There is no impact on the cost of debt until the level of gearing is prohibitively high.

The assumptions

M&M in 1958 was based on the premise of a perfect capital market in which:

1. Perfect capital market exist where individuals and companies can borrow

unlimited amounts at the same rate of interest.

2. There are no taxes or transaction costs.

3. Personal borrowing is a perfect substitute for corporate borrowing.

4. Firms exist with the same business or systematic risk but different level of

gearing.

5. All projects and cash flows relating thereto are perpetual and any debt

borrowing is also perpetual.

6. All earnings are paid out as dividend.

7. Debt is risk free.

Big idea

The increase in Ke directly compensates for the substitution of expensive equity with

cheaper debt. Therefore the WACC is constant regardless of the level of gearing.

If the weighted average cost of capital is to remain constant at all levels of gearing

it follows that any benefit from the use of cheaper debt finance must be exactly offset

by the increase in the cost of equity.

Cost

of

capital

Gearing (D/E)

Kd

Ke

WACC





Modigliani and Miller – with tax

In 1963 M&M modified their model to include the impact of tax. Debt in this

circumstance has the added advantage of being paid out pre-tax. The effective cost

of debt will be lower as a result.

Implication

As the level of gearing rises the overall WACC falls. The company benefits from

having the highest level of debt possible.

Problems with high gearing

It is rare to find firms who seek to have very high gearing. This is due to problems

such as:

● bankruptcy

● tax exhaustion

● loss of borrowing capacity

● risk attitude of potential investors.

Pecking order theory

A reflection that funding of companies does not follow theoretical rules but instead

often follows the ‘path of least resistance’.

Cost

of

capital

Gearing (D/E)

Kd(1-t)

Ke

WACC





A suggested order is as follows:

1st retained earnings

2nd bank debt

3rd issue of equity.

MODIGLIANI AND MILLER FORMULAE

Proposition 1: value of company

Vg = Vu + Dt

Proposition 2: cost of equity

Keg = (1 )

( *)D t

Keu Keu KbE

or

i i de e d

e

Vk +(1-T)(k -k )

V

*Kb or kd is the PRE-TAX COST OF DEBT for this formula.

NB The formula on the right-hand side is provided on the ACCA P4 Formulae sheet.

Proposition 3: WACC

WACCg = 1Dt

KeuE D

Example 14 - MM

MM Plc is currently wholly equity funded, with an ungeared cost of equity is 9%. They

have 30 million shares in issue, with a current price of F$11 per share, though they

have yet to announce a proposed investment opportunity.

The proposed project requires an initial capital investment of F$80 million, and will

generate an NPV of F$30 million. It is expected that the entity value will increase by

F$110m as soon as the project is announced.

There has been some discussion amongst the directors of FF about how the F$80

million capital investment should be funded. Any new equity would be raised through

a rights issue and any borrowings would be at a pre-tax cost of 7%. Three alternative

financing structures are being considered as follows: FF pays corporate income tax

at 25%.

A: F$80 million equity funding.

B: F$80 million borrowings.

C: F$48 million equity plus F$32 million borrowings.

Required:

(a) Calculate the following, based on Modigliani and Miller’s (MM’s) capital theory

with tax and assuming the project goes ahead for each financing option:

(i) The total value of FF

(ii) The geared cost of equity

(iii) The WACC





Example 15 - Canalot plc

Canalot plc is an all-equity company with an equilibrium market value of £32.5 million

and a cost of capital of 18% per year.

The company proposes to repurchase £5 million of equity and to replace it with 13%

irredeemable loan stock.

Canalot’s earnings before interest and tax are expected to be constant for the

foreseeable future. Corporate tax is at the rate of 35%. All profits are paid out as

dividends.

Required:

Using the assumptions of Modigliani and Miller, explain and demonstrate how this

change in capital structure will affect:

The total value of FF

The geared cost of equity

The WACC

.

Example 16 - Grant plc

Grant plc (an all equity company) has on issue 6,000,000 £1 ordinary shares at

market value of £2.50 each.

Bell plc (a geared company) has on issue:

17,000,000 25p ordinary shares; and

£8,000,000 15% debentures (quoted at 125)

Taking corporation tax at 35%, and assuming that:

1. The companies are in all other respects identical; and

2. The market value of Grant’s equity and the market value of Bell’s debt

are “in equilibrium”.

Calculate the equilibrium price per share of Bell’s equity.





THE CAPITAL ASSET PRICING MODEL (CAPM)

The underlying theory of CAPM

The CAPM assesses investments from the viewpoint of well-diversified shareholders

and considers that when companies invest in projects they must accept that the

majority of their shareholders are well-diversified institutions.

Obviously an investor can reduce risk by holding a portfolio of shares in companies

in different industries, which will to some degree offer different risk/return profiles

over time.

Thus a standard deviation ( or s) is a measure of total risk, and this can be analysed

between:

● UNSYSTEMATIC (aka SPECIFIC or UNIQUE) RISK ie the risk which will

initially disappear as a result of diversification, and

● SYSTEMATIC (aka MARKET) RISK ie the risk which can never be avoided

when investing in company shares.

Specific risk reflects factors which are unique to the company or to the industry in

which it operates, whereas systematic risk reflects market wide factors such as the

state of the economy.

Diversification therefore eliminates the unsystematic risk relating to shares held in a

well-diversified portfolio, but sadly the systematic risk of that portfolio will remain.

Accordingly, CAPM recognises that investors cannot expect to receive a return on

their exposure to unsystematic risk – therefore returns will only be received as a

result of systematic risk, which investors can never avoid.

UNSYSTEMATIC RISK

SYSTEMATIC RISK

Total

portfolio risk(s)

Number of different companies in which shares are held

1

Number of different companies in which shares are held

1 5 9 13 17 21 25





Systematic business risk and systematic financial risk

At a gearing level of zero, the equity shareholders of a company would have to bear

systematic business risk only. However as a company increases its debt levels and

becomes more and more highly leveraged, its equity shareholders will not only have

to face the same level of systematic business risk as before, but will also have to

accept increasing amounts of systematic financial risk.

Accordingly:

● Equity shareholders in an ungeared company bear systematic business

risk only, whereas

● Equity shareholders in an otherwise identical geared company bear the

same level of systematic business risk as before, but will also have to

face an ever increasing level of systematic financial risk as borrowing

levels become greater and greater,

with a consequence increase in the Ke of the company concerned. This is illustrated

below.

Following the M & M with corporation tax theory of 1963, as gearing levels increase,

Ke behaves as follows:

Now that the issue of leverage has been introduced, there becomes a need to

distinguish:

● β asset (βa), which reflects systematic business risk only, and

● β equity (βe), which reflects both systematic business risk TOGETHER WITH

ANY systematic financial risk which MAY exist.

Gearing % D

E

Ke %

SYSTEMATIC BUSINESS RISK

Ke

SYSTEMATIC FINANCIAL RISK





Therefore:

● In the case of an all equity company, βe = βa, since no systematic financial

risk can possibly exist.

● In the case of a geared company, βe > βa, since βe contains both systematic

business risk and systematic financial risk, whereas βa reflects systematic

business risk only.

The theoretical relationship between βa and βe is commonly expressed by the

following formulae:

βa =

d

de

de

de

e βT1VV

T1Vβ

T1VV

V

Project specific cost of capital

Discount rates for capital investment appraisal should be consistent with the risk that

go with the project and as such should take into account both the systematic risk and

the company’s gearing level.

This approach is appropriate where a company is diversifying into another industry

or is undertaking a major new investment which will affect business and financial

risks significantly.

The stages of establishing the specific cost of capital for appraising such investments

are:

● Identify a proxy beta. This is the average equity beta of the industry in which

the project is to be undertaken.

● Ungear the proxy equity beta to remove the financial risk to establish the asset

beta or ungeared equity beta (Beu) using the above formula.

● Regear the asset beta (Beu) to establish the geared equity beta by including

the financial risk that reflects the method of financing the new project. This is

the debt equity ratio of financing the new project or the company’s existing

debt/equity proportion if will not change as a result of the new project.

● Use the re-geared beta (Beg) from above to calculate the project specific cost

of equity using the CAPM formula.

● The project specific WACC can be calculated based on the weighted average of

cost of equity and cost of debt. This WACC will be used to discount the project

cash flows to determine the net present value.





Example 17 - Hotalot plc

Hotalot plc produces domestic electric heaters. The company is considering

diversifying into the production of freezers. Data on four listed companies in the

freezer industry and for Hotalot are shown below:

Freezeup Glowcold Shiverall Topice Hotalot

£’000 £’000 £’000 £’000 £’000

Fixed assets 14,800 24,600 28,100 12,500 20,600

Working capital _9,600 _7,200 11,100 _9,600 12,700

24,400 31,800 39,200 22,100 33,300

Financed by:

Bank loans 5,300 12,600 18,200 4,000 17,400

Ordinary shares* 4,000 9,000 3,500 5,300 4,000

Reserves 15,100 10,200 17,500 12,800 11,900

24,400 31,800 39,200 22,100 33,300

Turnover 35,200 42,700 46,300 28,400 45,000

Earnings per share

(in pence)

25 53.3 38.1 32.3 106

Dividend per share

(in pence)

11 20 15 14 40

Price/earnings ratio 12 10 9 14 8

Beta equity 1.1 1.25 1.30 1.05 0.95

*The par value per ordinary share is 25p for Freezeup and Shiverall, 50p for Topice

and £1 for Glowcold and Hotalot.

Corporate debt may be assumed to be almost risk-free, and is available to Hotalot

at 0.5% above the Treasury Bill rate, which is currently 9% per year. Corporate

taxes are payable at a rate of 35%. The market return is estimated to be 16% per

year. Hotalot does not expect its financial gearing to change significantly if the

company diversifies into the production of freezers.

Required:

(a) Estimate what discount rate Hotalot should use in the appraisal of its proposed

diversification into freezer production.

(b) Discuss whether systematic risk is the only risk that Hotalot’s shareholders

should be concerned with.





WACC of combined activities

This occurs when the company is involved in two or more activities in different

industries.

The stages for calculating the WACC of combined activities are:

1. Identify proxy beta for each activity, ideally from each respective industry.

2. Un-gear each beta to determine the asset beta for each activity.

3. Calculate the market value of each activity.

4. Find the weighted average of the asset betas using the respective market values

of each activity. This represents the combined asset beta of the company.

5. Re-gear the combined asset beta using the debt-equity proportion of the

company to determine the equity beta.

6. Using CAPM, calculate the combined cost of equity.

7. Finally, calculate the combined WACC.

Example 18 - BIGUNDER

Bigunder plc provides training and financial services. The training service accounts

for two-thirds of the value of the company. The company has a debt to total market

value ratio of 30%.

The average beta and debt to total market value for the financial service sector are

0.9 and 25%.

The average beta and debt to total market value for the training service sector are

1.5 and 12%.

Other information:

1. The equity risk premium is 3.5% and the rate of return on short-dated

government stock is 4.5%.

2. Bigunder plc can borrow at 2.5% above the risk free rate.

3. Tax on corporate profit is 40%.

4. Assume that debt is risk free.

Required:

Estimate the cost of equity capital and the weighted average cost of capital for

Bigunder plc.





Example 19 Edwards plc – Combined Asset Beta

Edwards plc is considering the acquisition of a 100% stake in Colman Ltd in order to

achieve backward vertical integration. Considerable savings are anticipated due to

the combination of both the marketing operations and distribution networks of the

two companies. Therefore synergies will arise to create cash flows which are in

excess of the current estimated cash flows of the two separate companies. Upon the

acquisition of Colman Ltd, Edwards plc will immediately sell one of the warehouses

of the target company, providing instant cash inflows of £5 million. The forecast cash

inflows of the merged businesses are as follows:

Year £ millions

2016 5.00

2017 110.00

2018 115.40

2019 121.29

2020 127.70

The cash flows are expected to grow by 1.5% per annum into perpetuity after 2020.

The forecast rate of corporation tax is expected to remain at 30%. The risk free rate

of interest is to be taken at 5% and the expected return on a market portfolio is 9%.

Information currently relating to the two companies is as follows:

Edwards plc Colman Ltd

£m £m

Market values:

Debt 100 20

Equity 900 280

Total 1,000 300

β asset 0.9 2.4

Cost of debt 7% 7%

Edwards plc plans to make a cash offer of £380 million for the purchase of the entire

share capital of Colman Ltd. This cash offer will be funded by additional borrowings

undertaken by Edwards plc.

Advise the directors of Edwards plc whether to proceed with the acquisition.




Chapter 7

Adjusted present value



CHAPTER 7 – ADJUSTED PRESENT VALUE


ADJUSTED PRESENT VALUE (APV)

Traditionally financial management has appraised new investments by discounting

their after-tax operating cash flows to present value at the firm’s weighted average

cost of capital and subtracting the initial investment cost to arrive at an NPV. We

have already noted problems with the use of the WACC and seen that adjustments

are commonly needed to tailor the discount rate to the systematic business risk and

the financial risk of the project under consideration.

M & M based adjustments to the cost of capital form one approach to this problem.

Here we examine another, adjusted present value (APV), which offers significant

advantages.

APV is often described as a “divide and conquer approach”. To do this the project

will first be evaluated as if it were being undertaken by an all-equity company. “Side

effects” like the tax shield on debt and the issue costs being ignored. This first stage

will give us the so-called base NPV or base case NPV. The second stage is to calculate

the present value of the side effects and to add these to the base NPV. The result is

the APV which shows the net effect on shareholder wealth of adopting the project.





Situations where APV is better than NPV

The APV method may be better than NPV because:

1. There is a significant change in capital structure of the company as a result of

the investment.

2. There are subsidised loans or other benefits (grant) associated explicitly with

an individual project and which requires discounting at different rate than that

applied to the mainstream cash flows.

3. The investment involves complex tax payments and tax allowances, and or has

periods when taxation is not paid.

4. The operating risk of the company changes as a result of the investment.

CALCULATION OF THE APV

The APV method therefore sees the value of the project to shareholders as being:

Project value if all equity financed + present value of tax + Present value of

(the base case NPV) shield on the loan other side effects

The APV method involves two stages:

1. Evaluate the project first of all as if it were all equity financed, and so as if the

company were an all equity company to find the ‘based case NPV’.

2. Make adjustment to the based case NPV to allow for the side effects of the

method of financing that has been used. The financing effects may consist of:

(i) Present value of tax savings on interest paid

(ii) Present value of issue costs incurred

(iii) Present value of subsidies/cheap loans.

Issue Cost

The issue cost is the cost associated with raising funds needed to finance the project.

The issue cost is a cash outflow and that its present value should be deducted from

the base case NPV in the calculation of APV. Risk free rate is usually used as the

discount factor in calculating the present value of issue cost.

Example 1

A project requires immediate capital expenditure of £20m. The amount is expected

to be raised from a 1 for 3 rights issue at a price of £2 per share.

Right issue costs are 5% of the amount raised. Assume a risk free rate of 10%.

Required: Calculate the issue cost





Tax savings on interest Paid

Interest payments on debt are tax allowable expense and the APV will increase by

the present value of the tax savings on the interest otherwise called the tax shields.

The calculation of the tax shield depends on whether the interest is payable on a

fixed amount every year or there is equal repayment.

Example 2

A project requires immediate capital expenditure of £20m. The amount will be raised

through a 10% bank loan over a period of 5 years. Tax is paid one year in arrears at

a rate of 30%.

Calculate the present value of tax shields assuming:

(a) 10% interest on the £20m per annum;

(b) the amount will be paid in equal instalments over 5 years

Interest saved on subsidised loans

Interest payments on debt are tax allowable expense and the APV will increase by

the present value of the tax savings on the interest otherwise called the tax shields.

Example 3

A project requires immediate capital expenditure of £20m. The company normally

borrow at 8% but a government loan will be available to finance the project at 6%.

Assume a risk free rate of 5% and that the project is expected to last for 5 years.

Tax rate is 30%.

Required: Calculate the present value of tax shields and present value of subsidy.





PRACTICAL PROBLEMS OF THE APV APPROACH

1. Determining a suitable cost of equity for the initial DCF computation as if the

project was all equity financed, and also establishing the all equity beta are still

based on M&M assumptions.

2. Difficulties in identifying all the cost associated with the method of financing.

3. Difficulties in choosing the correct discount rate used to discount the side effects

such as issue cost and the corporation tax savings on debt capital interest.

Although the risk-free rate of return is assumed.

4. In complex investment decisions the calculations can be extremely long and

hence more difficult.

Example 4 - Strayer

The managers of Strayer Inc are investigating a potential $25 million investment.

The investment would be a diversification away from existing mainstream activities

and into the printing industry. $6 million of the investment would be financed by

internal funds, $10 million by a rights issue and $9 million by long term loans. The

investment is expected to generate pre-tax net cash flows of approximately $5 million

per year, for a period of ten years. The residual value at the end of year ten is

forecast to be $5 million after tax. As the investment is in an area that the

government wishes to develop, a subsidised loan of $4 million out of the total $9

million is available. This will cost 2% below the company's normal cost of long-term

debt finance, which is 8%.

Strayer's equity beta is 0.85, and its financial gearing is 60% equity, 40% debt by

market value. The average equity beta in the printing industry is 1.2, and average

gearing 50% equity, 50% debt by market value.

The risk free rate is 5.5% per annum and the market return 12% per annum. Issue

costs are estimated to be 1% for debt financing (excluding the subsidised loan), and

4% for equity financing. The corporate tax rate is 30%.

Required:

(a) Estimate the Adjusted Present Value (APV) of the proposed

investment. (15 marks)

(b) Comment upon the circumstances under which APV might be a better

method of evaluating a capital investment than Net Present Value

(NPV). (5 marks)

(20 marks)




Chapter 8

International investment

appraisal

Introduction

In essence capital budgeting for overseas investments is similar to domestic

investment appraisal. It includes the following steps:

● Identification of relevant cash flows.

● Dealing with inflation to assess real or nominal cash flows.

● Dealing with tax, including the tax savings on capital allowances.

● Dealing with inter-company transactions, such as management charges and

royalties and cash flow remittance restrictions.

● Estimating future exchange rates (spot rates).

● Dealing with double taxation arrangements.

● Estimating the appropriate cost of capital (discount factor).



CHAPTER 8 – INTERNATIONAL INVESTMENT APPRAISAL


Taxation and international investment appraisal

The following procedure can be applied:

1. Allow for host country investment incentives (capital allowance) before applying

the local tax rate to local taxable cash flows.

2. Apply the relevant parent company rate of tax to the taxable/remitted cash

flows.

3. Adjust point 2 above for any double taxation agreement.

Consider the following:

Italy tax UK tax

(1) 20% 20%

(2) 20% 30%

(3) 20% 18%

In (1) no further tax will be paid in the UK as profit is taxed in Italy at 20%.

In (2) profit would be taxed at 30%, 20% in Italy and a further 10% in the UK.

In (3) no further tax will be paid in the UK. The 20% is charged in Italy.

Double taxation treaties

If an overseas investment takes place in a country that has a different corporation

tax rate to the domestic country, then an opportunity may exist to reduce the global

tax bill through good transfer price planning.

However, if a double taxation treaty exists between the two countries, then this

opportunity will not be available as the investment will ultimately be taxed at the

highest corporation tax between the two countries.

Example 1 - Stella

Stella plc expects to generate pre-tax net operating cash flows for 3 years from its

US subsidiary as follows:

Year 1 Year 2 Year 3

$100m $120m $130m

The corporation tax rate in the US is 25%, and is 30% in the UK. There is a double

taxation treaty in place between the two countries and all tax is paid in the year after

the liability arises.

The current $/£ spot rate is $2/£, and the US dollar is expected to weaken by 10%

per annum against sterling.

Stella uses a sterling cost of capital of 10% for all projects.

Required: Calculate the present value of the cash flows from the US

subsidiary.





Forecasting exchange rates

Exchange rates can be estimated using purchased power parity (PPP) or international

Fisher effect (IFF).

The PPP is used when inflation rates are given and the IFE is used when interest rates

are given.

The formula is simply stated as:

Purchasing power parity and interest rate parity

S1 = S0 )h(1

)h(1

b

c

Fo = So

)i(1

)i(1

b

c

Project discount rates

In the same way as for domestic capital budgeting, project cash flows should be

discounted at a rate that reflects their systematic risk. Many firms assume that

overseas investment must carry more risk than comparable domestic investment and

therefore increase discount rates accordingly.

This assumption, however, is not necessarily valid. Although the total risk of an

overseas investment may be high, in the context of a well-diversified parent company

portfolio much of the risk may be diversified away. Because of the lack of correlation

between the performance of some national economies, the systematic risk of

overseas investment projects may in fact be lower than that of comparable domestic

projects.

It must therefore be realised that the automatic addition of a risk premium simply

because a project is located overseas does not always make sense, and any increase

in the discount rates used for foreign projects should be viewed with caution.

Overcoming exchange controls – block remittances

Block funds are funds in overseas bank accounts subject to exchange controls, such

that restrictions are placed on remitting the funds out of the country.

Example 2 - Startall plc

Startall plc wishes to estimate future exchange rates based upon the following

projections of inflation.

UK USA Bargonia

Year 1 5% 5% 20%

2 5% 5% 30%

3 5% 7% 30%

4 5% 7% 30%

5 5% 7% 30%

Required:

If current spot rates are US$1.60 = £1 and Bargonian Dowl 250 = £1, using the

PPPT, what are the predicted spot rates for the currencies concerned at the end of

each of the next five years?





A number of ways have been devised to try and avoid such restrictions. They mainly

aim to circumvent restrictions on dividends payments out of the account by

reclassifying the payment as something else:

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.

2. Royalties

The parent company can charge the subsidiary royalties for patent, trade names or

know-how. Royalties may be paid as a fixed amount per year or varying with the

volume of output.

3. Transfer Pricing

The parent can charge artificially 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.

Exchange rate risk

Changes in exchange rates can cause considerable variation in the amount of funds

received by the parent company. In theory this risk could be taken into account in

calculating the project’s NPV, either by altering the discount rate or by altering the

cash flows in line with forecast exchange rates. Virtually all authorities recommend

the latter course, as no reliable method is available for adjusting discount rates to

allow for exchange risk.

Political risk

This relates to the possibility that the NPV of the project may be affected by host

country government actions. These actions can include:

● Expropriation of assets (with or without compensation!);

● Blockage of the repatriation of profits;

● Suspension of local currency convertibility;

● Requirements to employ minimum levels of local workers or gradually to

pass ownership to local investors.

The effect of these actions is almost impossible to quantify in NPV terms, but their

possible occurrence must be considered when evaluating new investments. High

levels of political risk will usually discourage investment altogether, but in the past

certain multinational enterprises have used various techniques to limit their risk

exposure and proceed to invest. These techniques include the following:

(a) Structuring the investment in such a way that it becomes an unattractive target

for government action. For example, overseas investors might ensure that

manufacturing plants in risk-prone countries are reliant on imports of

components from other parts of the group, or that the majority of the technical

“know-how” is retained by the parent company. These actions would make

expropriation of the plant far less attractive.

(b) Borrowing locally so that in the event of expropriation without compensation,

the enterprise can offset its losses by defaulting on local loans.





(c) Prior negotiations with host governments over details of profit repatriation,

taxation, etc, to ensure no problems will arise. Changes in government,

however, can invalidate these agreements.

(d) Attempting to be “good citizens” of the host country so as to reduce the benefits

of expropriation for the host government. These actions might include

employing large numbers of local workers, using local suppliers, and reinvesting

profits earned in the host country.

Economic risk

Economic risk is the risk that arises from changes in economic policies or conditions

in the host country that affect the macroeconomic environment in which a

multinational company operates. Examples of economic risk include:

● Government spending policy.

● Economic growth or recession.

● International trading conditions.

● Unemployment levels.

● Currency inconvertibility for a limited time.

Fiscal risk

Fiscal risk is the risk that the host country may increase taxes or changes the tax

policies after the investment in the host country is undertaken. Examples of fiscal

risk include:

● An increase in corporate tax rate.

● Cancellation of capital allowances for new investment.

● Changes in tax law relating to allowable and disallowable tax expenses.

● Imposition of excise duties on imported goods or services.

● Imposition of indirect taxes.

Regulatory risk

Regulatory risk is a risk that arises from changes in the legal and regulatory

environment which determines the operation of a company. Examples are:

● Anti-monopoly laws.

● Health and safety laws.

● Copyright laws.

● Employment legislation.

Financing overseas projects

The chief sources of long-term finance are the following:





1. Equity

The subsidiary is likely to be 100% owned by the parent company. However,

in some countries it is necessary for nationals to hold a stake, sometimes even

a majority of the ordinary shares on issue.

2. Eurocurrency Loan

Eurocurrency loan is a loan by a bank to a company denominated in a currency

of a country other than that in which they are based. For example, a UK

company may require a loan in dollars which it can acquire from a UK bank

operating in the Eurocurrency market. This is called Eurodollar loan.

The usual approach taken is to match the assets of the subsidiary as far as

possible with a loan in the local currency. This has the advantage of reducing

exposure to currency risk.

3. 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.

4. Eurobond

Eurobond are bonds sold outside the jurisdiction of the country in whose

currency the bond is denominated.

Eurobond is a bond issued in more than one country simultaneously, usually

through a syndicate of international banks, denominated in a currency other

than the national currency of the issuer. They are long-term loans, usually

between 3 to 20 years and may be fixed or floating interest rate bonds

5 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;





Example 3 - Brookday plc

Brookday plc is considering whether to establish a subsidiary in the USA. The

subsidiary would cost a total of $20 million, including $4 million for working capital.

A suitable existing factory and machinery have been located and production could

commence quickly. A payment of $19 million would be required immediately, with

the remainder required at the end of year one.

Production and sales are forecast at 50,000 units in the first year and 100,000 units

per year thereafter.

The unit price, unit variable cost and total fixed costs in year one are expected to be

$100, $40 and $1 million respectively. After year one prices and costs are expected

to rise at the same rate as the previous year’s level of inflation in the USA; this is

forecast to be 5% per year for the next 5 years. In addition a fixed royalty of £5 per

unit will be payable to the parent company, payment to be made at the end of each

year.

Brookday has a 4 year planning horizon and estimates that the realisable value of

the fixed assets in 4 years time will be $20 million.

It is the company’s policy to remit the maximum funds possible to the parent

company at the end of each year. Assume that there are no legal complications to

prevent this.

Brookday currently exports to the USA yielding an after tax net cash flow of

£100,000. No production will be exported to the USA if the subsidiary is established.

It is expected that new export markets of a similar worth in Southern Europe could

replace exports to the USA. United Kingdom production is at full capacity and there

are no plans for further expansion in capacity.

Tax on the company’s profits is at a rate of 50% in both countries, payable one year

in arrears. A double taxation treaty exists between the UK and the USA and no

double tax is expected to arise. No withholding tax is levied on royalties payable

from the USA to the UK.

Tax allowable ‘depreciation’ is at a rate of 25% on a straight line basis on all fixed

assets.

Brookday believes that the appropriate beta for this investment is 1.2 The after-

tax market rate of return is 12%, and the risk free rate of interest 7% after tax.

The current spot exchange rate is US $1.300/£1, and the pound is expected to fall in

value by approximately 5% per year relative to the US dollar.

Required:

(a) Evaluate the proposed investment from the viewpoint of Brookday plc. State

clearly any assumptions that you make.

(b) What further information and analysis might be useful in the evaluation of this

project?




Chapter 9

Acquisitions and Mergers

Merger v Acquisition

There are distinct differences which you must be aware of;

● Merger – the joining of two separate entities

● Acquisition – where one entity uses its resources to buy a controlling interest

in another entity.

Acquisition v Organic Growth

As a strategic decision there are reasons for pursuing an acquisition as opposed to

organic growth which include;

● Instant access into new markets

● Overcomes barriers to entry

● Expertise of the acquired entity

● Reduced competition

However the cost which will include a large premium and post-acquisition integration

issues can lead to problems which invariably reduce shareholder wealth.

Synergy

● An expansion policy based on merger or takeover can be justified on the basis

of synergy. (Sometimes stated as 2 + 2 = 5) ie

Value of A plc Value of A plc Value of B plc



CHAPTER 9 – ACQUISITIONS AND MERGERS


and B plc combined operating + operating

independently independently

Acquisitions and mergers are ultimately justified as leading to an increase in

shareholder wealth.

● The potential for synergy is often classified as follows:

Revenue synergy: Sources of which include:

o Economies of vertical integration;

o Market power and the elimination of competition

o Complementary resources eg a company with marketing strengths could

usefully combine with the company owning excellent research and

development facilities.

Cost synergy: Sources of which include:

o Economies of scale (arising from eg larger production volumes and bulk

buying);

o Economies of scope (which may arise from reduced advertising and

distribution costs where combining companies have duplicated activities);

o Elimination of inefficiency;

o More effective use of existing managerial talent.

Financial synergy: Sources of which include:

o Elimination of inefficient management practices;

o Use of the accumulated tax losses of one company that may be made

available to the other party in the business combination;

o Use of surplus cash to achieve rapid expansion;

o Diversification reduces the variance of operating cash flows giving less

bankruptcy risk and therefore cheaper borrowing;

o Diversification reduces risk

o High PE ratio companies can impose their multiples on low PE ratio

companies (however this argument, known as “bootstrapping”, is rather

suspect).

● Conclusions on Synergy

o Synergy is not automatic

o When bid premiums are considered, the consistent winners in mergers

and takeovers are victim company shareholders.

High failure rate of acquisitions

In practice, the shareholders of predator companies seldom enjoy synergistic gains,

whereas the shareholders of victim companies benefit from a takeover. The acquiring

company often pays a significant premium over and above the market value of the

target company prior to acquisition; this problem is particularly acute for the

successful predator following a contested takeover bid.

The reasons advanced for the high failure rate of business combinations from the

perspective of the predator shareholders are as follows:



CHAPTER 9 – ACQUISITIONS AND MERGERS


● Agency theory suggests that takeover bids are primarily motivated by the self-

interest of the managers of bidding companies, who are in pusuit of status and

job security.

● Over-optimistic assessment of the economies of scale or economies of scope

that may be achieved as a result of the business combination;

● Inadequate investigation of the victim company prior to the bid being made, or

insufficient appreciation of the problems that may arise after the acquisition

takes place.

● Insufficient efforts to integrate and yield the anticipated synergy post

acquisition, often the directors become fixated with their next acquisition.

● Directors of the predator company become so obsessed with the success of

their bid that they often over pay thus transferring all the benefit t investors in

the acquired company.

Reverse Takeover

A reverse takeover is where a smaller listed company acquires a larger unlisted

company. However the shares used to acquire the larger company effectively give

control to the company that has been acquired.

The driving force for the acquisition is to enable the larger unlisted company to gain

the benefits of being a larger organisation, though avoiding the long complicated

process to gain such a listing.

Benefits

1. Easier access to capital markets

2. Higher company valuation

3. Ability to undertake further acquisitions

Problems

1. Lack of expertise

2. Reputation

3. Enhanced Risk

Post Acquisition Integration

Often the main cause of failure with business combinations. To avoid this problem it

has been suggested that the following rules be applied

● The individual entities must share more than financial interest, i.e. technology

and market

● Consideration must be given to what we can do for acquired business

● Do not disregard products, markets and customers post acquisition

● Aim to share human resources and promote across entities



CHAPTER 10 – BUSINESS VALUATIONS


Chapter 10

Business Valuations

METHODS OF EQUITY VALUATIONS

The main approaches are:

● The dividend valuation model or dividend growth model;

● The discounted cash flow basis (Free cash flow method);

● The PE ratio (or earnings yield) basis;

● Net assets and calculated intangible value

THE DIVIDEND VALUATION MODEL

This method is based upon the fundamental theory of share valuation, whereby a

current share price is taken to reflect the PV of expected future cash flows, discounted

at the required rate of return of the shareholder. In the case of minority

shareholders, this would represent the PV to infinity of the future dividend stream.

In the case of majority shareholders, these amounts will be increased by the PV of

synergies achieved as a result of the acquisition.

Example 1 Edinburgh plc

The market expects a rate of return of 20% per annum on ordinary shares in

Edinburgh plc, a company which is expected to pay constant annual dividends of 20p

per share.

At what price will the market value the shares?

Example 2 Thorsvedt

Thorsvedt is expected to pay a dividend of 30p per share next year. The market

expects dividends to grow at the rate of 5% per annum and has a required return of

20%.

Estimate the share price.





Example 3 - Lineker

Wright plc has just paid a dividend of 15p per share. The market is in general

agreement with directors’ forecasts of 30% growth in earnings and dividends for the

next 2 years. Thereafter, a reasonable estimate is 15% growth in year 3 followed by

6% growth to perpetuity.

The market’s required return on investments of this risk level is 25% per annum.

Estimate the share value.

Free cash flow or surplus projected cash flow

Free cash flow is cash that is not retained and reinvested in the business.

Unfortunately, there is dispute as to what is included within free cash flow, as can be

seen from the following typical definitions:

1. The free cash flow to the company is the cash flow derived from operations,

after adjustment for working capital changes, for investment and for taxes and

it represents the funds available for distribution to the providers of capital, ie

shareholders and lenders.

2. Free cash flow is the cash flow available to a company from operations after

tax, any changes in working capital and capital spending on assets needed to

continue existing operations (ie replacement capital expenditure equivalent to

economic depreciation).

As can be seen, the main difference between the two definitions is whether or not to

deduct capital expenditure required to expand operations. Throughout these notes

the treatment will be varied as a reminder of the inconsistency. In addition, some

authorities suggest that no adjustment is made for working capital changes in respect

of short-term measures of free cash flow.

Free cash flows are commonly used in financial management:

● To calculate the value of a company and thus a potential share price.

● As an indicator of company performance.

● As a basis for evaluating potential investment projects using NPV technique.

Calculating free cash flow from accounting records

From prepared accounting information, free cash flow can be calculated as:

Profit before interest and tax (PBIT) xxxxx

Less taxation (PBIT x Tax rate) (xxx)

Add non-cash items such as depreciation xxxx

Less capital expenditure (xxxx)

Less increase or add decrease

in net working capital (xxxx)

Free cash flow xxxxx





Free cash flow to equity (dividend capacity)

The free cash flow to equity represents the funds available for distribution to only

ordinary shareholders of the company. Where a company finance a project by issuing

debts, then the shareholders are entitled to the residual cash flows after meeting

interest and principal payments.

This residual cash flow is called free cash flow to equity and is calculated as:

Profit before interest and tax (PBIT) xxxxx

Less interest (xxx)

Less taxation (Profit before tax x tax rate) (xxx)

Add non-cash items such as depreciation xxxx

Less capital expenditure (xxxx)

Less increase or add decrease

in net working capital (xxxx)

Add cash raised from debt issue xxxx

Less debt repayments (xxxx)

Free cash flow to equity xxxxx

Dividend cover

Free cash flow to equity provides a more meaningful figure than the earnings in the

calculation of dividend cover and dividend cover in cash terms can be calculated as:

Dividend cover = Free cash flows to equity

Dividend paid

Example 4 - MLX Ltd

The following data relates to MLX Ltd:

Forecast Income statement for next year

£m

Revenue 1,950.00

Cost of sales (1,314.00)

Gross profit 636.00

Operating expenses (322.50)

Earnings before interest and tax 313.50

Interest charges (24.00)

Profit before tax 289.50

Corporation tax (@ 35%) (101.32)

Profit after tax 188.18

During the year loan repayments are expected to amount to £69 million,

depreciation charges to £30 million, and capital expenditure to £60 million. The

dividend payable is £30 million.

Required:

Calculate:

(a) Free cash flow;

(b) Free cash flow to equity;

(c) Dividend cover based on free cash flows to equity.





Valuing a firm using free cash flow

This method values a business as the present value of future free-cash flows.

The discount rate applicable should be the rate that reflects the level of risk attached

to the cash flows.

Corporate value is calculated as the present value of free cash flows using the

weighted average cost of capital (WACC) as the discount factor.

Corporate value = Value of equity + value of debt

Therefore:

Value of equity = Corporate value – value of debt

Alternatively, value of equity can be calculated as the present value of free cash flows

to equity using cost of equity as the discount factor.

Example 6 Heincarl plc

The directors of Heincarl plc are considering the acquisition of Newscot Ltd, an

unlisted company. The shareholders of Newscot Ltd are willing to sell the business

Example 5 - Talto Ltd

The finance team of Talto Ltd has produced the following forecasts of financial data:

Financial year X1 X2 X3 X4

Net sales 230 261 281 298

Cost of goods sold (50%) 115 131 141 149

Selling and distributive expenses 32 34 36 38

Capital allowance 40 42 42 42

Interest 18 16 14 12

Cash flow needed for asset replacement 50 52 55 58

Corporation tax is at the rate of 30% per year, payable in the year that the taxable

cash flow occurs.

Assume that the company’s weighted average cost of capital is 14%. The market

value of debt is £30 million.

Required:

Calculate the value of the company if:

(a) Cash flows are expected to remain at X4 level into infinity.

(b) Cash flows are expected to remain at X4 level until the end of year 10.

(c) Cash flows are expected to grow by 4% per annum into infinity.





on 1st January 2009 for £500 million. From the perspective of the directors of Heincarl

plc, the projections of the performance of Newscot Ltd are as follows:

Current

year Projections during planning horizon (years)

2008 2009 2010 2011 2012 2013 2014

£m £m £m £m £m £m £m

EBITDA 117.00 138.70 162.57 188.83 217.71 249.48 251.48

Depreciation

&

amortisation (40.00) (42.00) (44.00) (46.00) (48.00) (50.00) (52.00)

EBIT 77.00 96.70 118.57 142.83 169.71 199.48 199.48

Interest

charges _ -_ (32.00) (26.88) (20.19) (11.73) (1.28) _ -__

Profit before

tax 77.00 64.70 91.69 122.64 157.98 198.20 199.48

The assumed rate of corporation tax is 35% p.a. The terminal value of the

investment is treated as a constant perpetuity equal to the free cash flows for the

year 2014. The risk free rate of interest is assumed to be 6% p.a., the return on a

market portfolio is taken to be 13.5%, whilst an asset beta of 1.1 is used for purposes

of the appraisal.

Annual capital expenditure from 2008 onwards is estimated at £20 million each year

indefinitely. Newscot Ltd currently has on issue £400 million of 8% debt and it is

intended that all available cash flows should be applied to repaying this debt at the

earliest opportunity.

Advise the directors of Heincarl plc whether to proceed with the acquisition.





PRICE EARNINGS RATIO BASIS

The P/E ratio produces an earnings-based valuation of shares. This is done by

deciding a suitable P/E ratio and multiplying by the EPS for the shares to be valued.

Value per share = EPS x P/E ratio.

For a given EPS, a higher P/E ratio will result in a higher price. A higher P/E ratio may

indicate;

(a) Expectations that the earnings will grow rapidly in the future, so that a high

price is being paid for future profit prospects.

(b) That the company is a low risk company than a company with a lower P/E

ratio.

Example 7

ABC is a private company operating in the pharmaceutical industry. The current

average PE ratio of the pharmaceutical industry is 16·4 times and it has been

estimated that ABC’s PE ratio is 10% higher than this.

VATA Co, a publicly listed company involved in the production of highly technical and

sophisticated electronic components for complex machinery has decided to acquire

ABC.

The following information is available:

VATA Co ABC

(£000) (£000)

Earnings before tax 1,980 397

Share capital (25p/share) 600 300

The current share price of VATA Co is $9·24 per share. The annual after tax earnings

will increase by $140 million due to synergy benefits resulting from combining the

two companies. However, it is thought that the PE ratio of the combined company

would fall to 14·5 times after the acquisition.

Both companies pay tax at 20% per annum

Required

Calculate the maximum acquisition premium payable using the price-earnings ratio

method.





Valuing intangible assets/intellectual capital

Valuing intangible assets, such as intellectual capital, is not an exact science but

several methods exist to estimate their value.

Market-to-book values

Compare the market value of the company to the book value of the assets. The

difference between the two should be equivalent to the value of the intangibles.

However, this method values the assets based on accounting policies and therefore

may no longer represent their ‘true worth’. A better alternative would be to value

the assets based on realisable value.

Calculated intangible value (CIV)

The CIV involves taking the excess return on intangible assets and uses this figure

as a basis to determine the proportion of return attributable to intangible assets.

The CIV can be calculated using the following steps:

1. Calculate average pre-tax earnings for a given period.

2. Calculate the average year-end tangible assets over the same given period

3. Divide average earnings by the average assets to get the return on assets

(ROA).

4. For the same given period find the industry’s return on assets as average

earnings divided by average tangible asset.

5. Calculate the ‘excess return’. Multiply the industry-average ROA by the

company’s average tangible assets; this shows what the average the company

would earn from that amount of tangible assets. Now subtract that from the

company’s pre-tax earnings.

This figure shows how much more the company earns from its assets than the

industry average.

6. Calculate the given period average income tax rate and multiply this by the

excess return. Subtract the result from the excess return to show the after-tax

premium attributable to intangible assets.

7. Calculate the net present value (NPV) of the premium. This is done by dividing

the premium by an appropriate discount factor such as the company’s cost of

capital. This is the CIV of the company’s intangible assets – the one that does

not appear on the balance sheet.





Example 8 - Emboss plc

The summarised financial information about Emboss plc for the last three years is

provided below:

Income statement for the years ended 31 March:

2009 2010 2011

£millions £millions £millions

Revenue 125 137.5 149.9

Less cash operating cost 37.5 41.3 45

Depreciation 20 22 48

Pre-tax earnings 67.5 74.2 56.9

Taxation 20.25 22.26 17.07

Statement of financial position as at 31March:

2009 2010 2011

£millions £millions £millions

Non-current asset 150 175 201

current assets 48 54 62

198 229 263

Share capital (£1) 30 30 30

retained earnings 148 179 203

178 209 233

Current liabilities 20 20 30

198 229 263

Additional information:

(1) The average pre-tax return on total assets for the industry over three years

has been 15%.

(2) The estimated cost of equity capital for the industry is 10% after tax.

(3) The market price of Emboss plc share is £12 per share at 31 March 2011.

Required:

Calculate the value of the intellectual capital/intangible asset.





APPLYING THE BLACK SCHOLES MODEL TO EQUITY

The Black Scholes Option Pricing (BSOP) model provides a basis for corporate

valuation in cases where traditional methods are either inappropriate, or where they

fail to fully reflect the risks involved. The usual determinants in the valuation of

options need to be redefined, when the valuation of equity is treated as a call option:

Determinants Possible appropriate measures

Valuation of the underlying The fair value of the assets of the company

Exercise price Settlement values of outstanding liabilities

Volatility of the underlying Standard deviation of underlying assets

Risk-free rate of interest Current yield on company debt

Time to expiry Average period to settlement of company liabilities

Where the assets of the company are actively traded and easily liquidated, their

current market value would be appropriate. In the case of most companies, fair

value will normally be based upon the present value of the future cash flows that the

company’s assets are expected to generate over their useful lives.

The volatility of the underlying assets is likely to be the most difficult measure to

estimate accurately. One approach is to estimate the probabilities of the likely future

cash flows of the company and generate a distribution of their present values from

which a standard deviation could be established.

A possible approach to the determination of an exercise price is to assume that the

company’s liabilities consist entirely of debt in the form of a zero coupon bond. If

the company’s debt includes other types of bond, adjustments are necessary as

shown in the following illustration.

Example 9

In March 2007, Northern Rock (a UK bank) reported assets and liabilities at fair values

of £113.2 billion and £110.7 billion respectively. The average term to maturity on

the liabilities of the bank (which consisted of short-term money market borrowing

and deposits) was 100 trading days, whilst the annual number of trading days was

250 approximately. At that time the risk-free rate of interest was 3.5% and the

company had 495.6 million equity shares in issue.

Required:

Using the BSOP (sometimes referred to as the Black Scholes Merton) model,

estimate the share price of Northern Rock in each of the following situations

assuming that the standard deviation of the bank’s assets was 5%.





VALUATION OF DEBT AND PREFERENCE SHARES

Preference shares

Example 10 - Steele Ltd

Steele Ltd has on issue some 9% preference shares of £1 nominal value. Investors

require a return of 12.5% p.a. on these shares.

Estimate the current market price per share.

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.

Irredeemable debt

Example 11 - Koren plc

Koren plc has on issue 7% irredeemable loan stock. The gross return required by

investors is 5% p.a. The corporation tax rate is 30%.

Establish the current market value for this stock.

Redeemable

Example 12

A company has issued some 9% bonds, which are redeemable at par in three years’

time. Investors require an interest yield of 10%.

What will be the current market value of £100 of bond?

Convertible

The value of a convertible cannot fall below its value as debt, but upside potential

exists due to the possibility of an increase in the share price prior to expiry of the

conversion period.

Therefore the theoretical value of a convertible (known as its “formula value”) is

the greater of its value as debt and its value as shares ie its conversion value. In

practice the actual price of convertibles will tend to trade at a value in excess of

formula value, reflecting so called “time value” ie the possibility that the share price

could rise prior to expiry of the conversion period.





Example 13 - Kiely plc

Kiely plc has 11% convertible loan notes on issue. Each £100 unit may be converted

at any time up to the date of expiry (in seven years time) into 15 fully-paid ordinary

shares in Kiely plc. Any loan notes which remain outstanding at the end of the seven

year period are to be redeemed at £120 per cent.

Loan note holders normally require a yield of 9% p.a. on seven year debt and the

market price of the company’s share at the date of conversion is £9.

Calculate the current market value of the convertible loan note.

Valuing bonds based on the yield curve

The spot yield curve can be used to estimate the price or value of a bond. Normally

these rates are published by the central banks or in financial press.

Example 14

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 1 2 3 4

Rate 3.5% 4.0% 4.7% 5.5%

Estimating the yield curve

There are different methods used to estimate a spot yield curve, and the iterative

process based on bootstrapping coupon paying bonds is perhaps the simplest to

understand. The following example demonstrates how the process works.

Example 15

A government has three bonds in issue that all have a face or par value of $100 and

are redeemable in one year, two years and three years respectively. Since the bonds

are all government bonds, let’s assume that they are of the same risk class. Let’s

also assume that coupons are payable on an annual basis.

Bond A, which is redeemable in a year’s time, has a coupon rate of 7% and is trading

at $103.

Bond B, which is redeemable in two years, has a coupon rate of 6% and is trading

at $102.

Bond C, which is redeemable in three years, has a coupon rate of 5% and is trading

at $98.

Determine the yield curve.




Chapter 11

Framework

Mode of Offer

Cash consideration

The offer is made to purchase the shares of the target company for cash. This method

is very appropriate for relatively small acquisitions, unless the acquirer has

accumulation of cash from operations or divestments.

The advantages of cash offer to the target entity’s shareholders are that:

● The price that they will receive is obvious. It is not like share exchange where

the movements in the market price may change their wealth.

● The cash purchase increases the liquidity of the target shareholders who are in

position to alter their investment portfolio to meet any changing opportunities.

A disadvantage to target shareholders’ for receiving cash is that if the price that they

receive is on sale is more than the price paid when purchasing the shares, they may

be liable to capital gains tax.

The advantages to the predator company are that:

● The value of the bid is known and target company shareholders’ are encouraged

to sell their shares.

● It represents a quick and easily understood approach when resistance is

expected.

● The shareholders of the target company are bought out and have no further

participation in the control and profits of the combined entity.

The main disadvantages to the predator company are that it may deplete the

company’s liquidity position and may increase gearing.



CHAPTER 11 – FRAMEWORK


Methods of raising cash

The predator company can raise cash from many sources to finance the acquisition,

some of the sources are:

Borrowing to obtain cash

The predator company may not have enough cash immediately available to finance

the acquisition and may have to raise the necessary cash through bank loans and

issuing of debt instruments.

Mezzanine finance

Mezzanine finance is a form of finance that combines features of both debt and equity.

It is usually used when the company has used all bank borrowing capacity and cannot

also raise equity capital.

It is a form of borrowing which enables a company to move above what is considered

as acceptable levels of gearing. It is therefore of higher risk than normal forms of

borrowing.

Mezzanine finance is often unsecured.

Retained earnings

This method is used when the predator company has accumulated profits over time

and is appropriate when the acquisition involves a small company and the

consideration is reasonably low. This method may be the cheapest option of finance.

Vendor placing

In a vendor placing the predator company issues its shares by placing the shares

with institutional investors to raise the cash required to pay the target shareholders.

Share exchange

The predator company issues its own shares in exchange for the shares of the target

company and the shareholders of the target company become shareholders of the

predator company.

The advantages of a share exchange to target shareholders include:

● Capital gains tax is delayed.

● The shareholders of the target company will participate in the control and profits

of the combined entity.

The main disadvantage is that there is uncertainty with a share exchange where the

movements in the market price may change their wealth.





The advantages to the predator company are that:

● It preserves the liquidity position of the company as there are no outflows of

cash.

● Share exchange reduces gearing and financial risk. However, this may depend

on the gearing of the target company.

● The predator company can bootstrap earnings per share if its price earnings

ratio is higher than that of the target company.

The main disadvantages of a share exchange are that:

● It causes dilution in control.

● It may cause dilution in earnings per share.

● As equity shares are issued this comparatively more expensive than debt

capital.

● The company may not have enough authorized share capital to issue the

additional shares required.

Debentures, Loan stock & preference shares

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:

● It affects gearing and financial risk.

● Difficulty in determining appropriate interest rate to attract the shareholders of

the target company.

● Availability of collateral security against repayment.

The main advantages of using debentures and loan stock are that:

● Interest payments are a tax allowable expense.

● Cost of debt is cheaper than equity.

● Does not dilute control.

The main problems of using preference shares are that:

● Dividends on preference shares are fixed and not tax allowable.

● May not be attractive to target shareholders as preference shares carry no

voting power.

● Preference shares are less marketable.

Earn-out arrangements

An earn-out arrangement is where the purchase consideration is structured such that

an initial payment is made at the date of acquisition and the balance is paid depending

upon the financial performance of the target company over a specified period of time.





The main advantages of earn-out arrangements are that:

● Initial payment is reduced.

● The risk to the predator company is reduced as it is less likely to pay more than

the target is worth. The price is limited to future performance.

● It encourages the management of the target company to work hard as the

overall consideration depends on future performance.





Strategic defences against hostile bids

Post-bid

A target company can use the following to defend itself against a possible takeover:

● Try to convince the shareholders that the terms of the offer are

unacceptable. This can be done using the following:

o Attempt to show that the current share price of the company is

unrealistically low relative to the future potential. Assets revaluation, new

profit forecasts, dividends and promises of rationalisation are commonly

employed here.

o If it is for share for share exchange, the target company can attempt to

convince the shareholders that the offer’s equity is currently overvalued.

The suitability of the bidding company to run the merged business can

also be questioned.

● Lobbying the office of fair trading and or the department of trade and

industry to have the offer referred to the competition commission. This will at

least delay the takeover and may prevent it completely.

● Launching an advertising campaign against the takeover bid. One technique

is to attack the account of the predator company.

● A reverse takeover (Pac Mac), that is make a counter offer for the predator

company. This can be done if the companies are of reasonably similar size.

● Finding a ‘white knight’, a company which will make a welcome takeover bid.

This involves finding a more suitable acquirer and promoting it to compete with

the predator company.

Pre-bid

● Selling crown jewels – the tactic of selling off certain highly valued assets of

the company subject to a bid is called selling the crown jewels. The intention

is that, without the crown jewels, the company will be less attractive.

● Golden parachutes – this is a policy of introducing attractive termination

packages for the senior executives of the victim company. This makes it more

expensive for the predator company.

● Shark repellent – super-majority. The articles of association are changed to

require a very high percentage of shares to approve an acquisition or merger,

say 80%.

● Poison pill

The most commonly used and seeming most effective takeover defence is the

so called poison pill.

An example is the Flip-in pill. This involves the granting of rights to

shareholders, other than the potential acquirer, to purchase the shares of the

target company at a deep discount. This dilutes the ownership interest of the

potential acquirer.





Regulation of takeovers

The regulation of takeovers varies from country to country and mainly concentrates

on controlling directors in order to ensure that all shareholders are treated fairly.

Typically, the rules will require the target company to:

● notify its shareholders of the identity of the bidder and the terms and conditions

of the bid;

● seek independent advice;

● not issue new shares or purchase or dispose of major assets of the company,

unless agreed prior to the bid, without the agreement of a general meeting;

● not influence or support the market price of its shares by providing finance or

financial guarantees for the purchase of its own shares;

● the company may not provide information to some shareholders which is not

made available to all shareholders;

● shareholders must be given sufficient information and time to reach a decision.

No relevant information should be withheld;

● the directors of the company should not prevent a bid succeeding without giving

shareholders the opportunity to decide on the merits of the bid themselves.

Directors and managers should disregard their own personal interest when advising

shareholders.

Competition commission in United Kingdom

Under the terms of this commission, the office of fair trading (OFT) is entitled to

scrutinise all major mergers and takeovers. If the OFT thinks that a merger or

takeover might be against the public interest, it can refer it to competition

commission. If no referral is made to the commission within normally 20 days, the

merger can proceed without fear of a referral.

The function of the competition commission is to advise the government. The

commission can make recommendations to the relevant government department or

to any other body including the companies involved in the bid.

The result of the investigation by the commission might be:

● Withdrawal of the proposal for the merger or takeover, in anticipation of it

rejection by the commission.

● Acceptance or rejection of the proposal by the commission.

● Acceptance of the proposal by the commission subject to the new company

agreeing to certain conditions laid down by the commission, for example on

prices, employment or arrangement for the sale of the group’s products.




Chapter 12

Corporate reconstruction and

reorganisation

BUSINESS REORGANISATION

Unbundling

Unbundling is the process of selling off incidental non-core businesses to release

funds, reduce gearing, and allow management to concentrate on their chosen core

business.

The main forms of Unbundling are:

● Divestment.

● Demergers.

● Sell-offs.

● Spin-offs.

● Management buy-outs.

Divestment

Divestment is a proportional or complete reduction in ownership stake in an

organisation. It is the withdrawal of investment in a business. This can be achieved

either by selling the whole business to a third party or by selling the assets piecemeal.



CHAPTER 12 – CORPORATE RECONSTRUCTION AND REORGANISATION


Reasons for divestment

● The principal motive for divestment will be if they either do not conform to

group or business unit strategy.

● A company may decide to abandon a particular product/activity because it fails

to yield an adequate return.

● Allowing management to concentrate on core business.

● To raise more cash possibly to fund new acquisitions or to pay debts in order to

reduce gearing and financial risk.

● The management lack the necessary skills for this business sector

● Protection from takeover possibly by disposing of the reasons for the takeover

or producing sufficient cash to fight it effectively.

Sell-offs

A sell-off is a form of divestment involving the sale of part of an entity to a third

party, usually in return for cash. The most common reasons for a sell-off are:

● To divest of less profitable and/or non-core business units.

● To offset cash shortages.

The extreme form of sell-off is liquidation, where the owners of the company

voluntarily dissolve the business, sell-off the assets piecemeal, and distribute the

proceeds amongst themselves.

Spin-offs/demergers

This is where a new company is created and the shares in the new company are

owned by the shareholders of the original company which is making the distribution

of assets. There is no change in ownership of assets but the assets are transferred

to the new company. The result is to create two or more companies whereas

previously there was only one company. Each company now owns some of the assets

of the original company and the shareholders own the same proportion of shares in

the new company as in the original company.

An extreme form of spin-off is where the original company is split up into a number

of separate companies and the original company broken up and it ceases to exist.

This is commonly called demerger.

Demerger involves splitting a company into two or more separate parts of roughly

comparable size which are large enough to carry on independently after the split.

The main disadvantages of de-merger are:

● Economies of scale may be lost, where the de-merged parts of the business had

operations in common to which economies of scale applied.

● The ability to raise extra finance, especially debt finance, to support new

investments and expansion may be reduced.

● Vulnerability to takeovers may be increased.

● There will be lower revenue, profits and status than the group before the de-

merger.





Management buy-out (MBO)

A management buy-out is the purchase of a business from its owners by its

managers. For example, the directors of a company in a subsidiary company in a

group might buy the company from the holding company, with the intention of

running it as proprietors of a separate business entity.

Reasons for MBOs

MBOs may exist for several reasons including:

● A parent company wishes to divest itself of a business that no longer fits in with

its corporate objectives and strategy.

● A company/group may need to improve its liquidity. In such circumstances a

buy-out might be particularly attractive as it would normally be for cash.

● A company may decide to abandon a particular product/activity because it fails

to yield an adequate return.

● In administration a buy-out may be the management’s only best alternative to

redundancy.

Advantages of MBOs to disposing company

● To raise cash to improve liquidity.

● If the subsidiary is loss-making, sale to the management will often be better

financially than liquidation and closure costs.

● There is a known buyer.

● Better publicity can be earned by preserving employer’s jobs rather than closing

the business down.

● It is better for the existing management to acquire the company rather than it

possibly falling into enemy hands.

Advantages of buy-out to acquiring management

● It preserves their jobs.

● It offers them the prospects of significant equity participation in their company.

● It is quicker than starting a similar business from scratch.

● They can carry out their own strategies, no longer having to seek approval from

the head office.

Problems of MBOs

● Management may have little or no experience financial management and

financial accounting.

● Difficulty in determining a fair price to be paid.

● Maintaining continuity of relationships with suppliers and customers.

● Accepting the board representation requirement that many sources of funding

may insist on.

● Inadequate cash flow to finance the maintenance and replacement of assets.





Sources of finance for MBOs

Several institutions specialise in providing funds for MBOs. These include:

● The clearing banks.

● Pension funds and insurance companies.

● Venture capital.

● Government agencies and local authorities, for example Scottish Development

Agency.

Factors a supplier of finance will consider before lending

● The purchase consideration. Is the purchase price right or high?

● The level of financial commitment of the buy-out team.

● The management experience and expertise of the buy-out team.

● The stability of the business’s cash flows and the prospects for future growth.

● The rate of technological change in the industry and the costs associated with

the changing technologies.

● The level of actual and potential competition.

● The likely time required for the business to achieve a stock market flotation,

(so as to provide an exit route for the venture capitalist).

● Availability of security.

Conditions attached to provision of finance

● Board representation for the venture capitalist.

● Equity options.

● A right to take a controlling equity stake and so replace the existing

management if the company fails to achieve specified performance targets.

Management buy-in

A management buy-ins occurs when a group of outside managers buys a controlling

stake in a business.

Share repurchase

Any limited company may, if authorised by it articles, purchase its own shares. The

Companies Act permits any company to purchase its own shares. Therefore if a

company has surplus cash and cannot think of any profitable use of that cash, it can

use that cash to purchase its own shares.

Share repurchase is an alternative to dividend policy where the company returns cash

to its shareholders by buying shares from the shareholders in order to reduce the

number of shares in issue.

Shares may be purchased either by:

● Open market purchase – the company buys the shares from the open market

at the current market price.





● Individual arrangement with institutional investors.

● Tender offer to all shareholders.

Reasons for share repurchase

● Shares may be purchased in order to buy out dissident shareholders.

● To adjust the gearing ratio towards an optimal capital structure.

● Reduction in the size of the company.

● Purchase of own shares may be used to take a company out of the public market

and back into private ownership.

● Purchase of own shares provide an efficient means of returning surplus cash to

the shareholders.

● It enables companies to reduce total dividend payments whiles maintaining or

increasing the level of dividend to individual shareholders.

● Purchase of own shares increases earning per share and return on capital

employed.

● To increase the share price by creating artificial demand.

Problems of share repurchase

● Lack of new ideas. Shares repurchase may be interpreted as a sign that the

company has no new ideas for future investment strategy. This may cause the

share price to fall.

● Costs. Compared with a one-off dividend payment, share repurchase will

require more time and transaction costs to arrange.

● Resolution. Shareholders have to pass a resolution and it may be difficult to

obtain their consent.

● Gearing. If the equity base is reduced because of share repurchase, gearing

may increase and financial risk may increase.

Going private

A public company may occasionally give up its stock market quotation and return

itself to the status of a private company.

The reasons for such move are varied, but are generally linked to the disadvantages

of being in the stock market and the inability of the company to obtain the supposed

benefits of a stock market quotation.

Other reasons are:

● To avoid the possibility of takeover by another company.

● Savings of annual listing costs.

● To avoid detailed regulations associated with being a listed company.

● Where the stock market undervalues the company’s shares.

● Protection from volatility in share price with its financial problems.





CAPITAL RECONSTRUCTION SCHEMES

A capital reconstruction scheme is a scheme whereby a company reorganises its

capital structure by changing the rights of its shareholders and possibly the creditors.

This can occur in a number of circumstances, the most common being when a

company is in financial difficulties, but also when a company is seeking floatation or

being acquired.

Financial difficulties

If a company is in financial difficulties it may have no recourse but to accept

liquidation as the final outcome.

Typical financial difficulties

● Large accumulated losses.

● Large arrears of dividends on cumulative preference shares.

● Large arrears of debenture interest.

● No payment of ordinary dividend.

● Market share price below nominal value.

However, it may be in position to survive, and indeed flourish, by taking up some

future contract or opening in the market. The only major problem is the cash needed

to finance such operations because the present structure of the company will not be

attractive to outside investors. To get cash the company will need to reorganise or

reconstruct.

Possible reconstruction

The changing or reconstruction of the company’s capital could solve these problems.

The company can take any or all of the following steps:

● write off the accumulated losses.

● write of the debenture interest and preference share dividend arrears.

● write down the nominal value of the shares.

To do this the company must ask all or some of its existing stakeholders to surrender

existing rights and amount owing in exchange for new rights under a new or reformed

company.

The question is ‘why would the stakeholder be willing to do this? The answer to this

is that it may be preferable to the alternatives which are:

● to accept whatever return they could be given in a liquidation;

● to remain as they are with the prospect of no return from their investment and

no growth in their investment.

Generally, stakeholders may be willing to give up their existing rights and amounts

owing (which are unlikely to be met) for the opportunity to share in the growth in

profits which may arise from the extra cash which can be generated as a consequence

of their actions.

General guidelines in reconstruction

For a reconstruction to be successful the following principles are to be followed:





1. Creditors must be better off under reconstruction than under liquidation. 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 financially viable and profitable

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.

4. Adequate finance is provided for the company’s needs.

In solving reconstruction questions the following steps can be followed:

1. State the above principles of reconstruction.

2. Check what each party will get if the company were to go on liquidation. This

can be done by adding up the break-up values of the assets.

Note the sequence of creditor priorities as followings:

● taxes and unpaid wages

● secured debts, including unpaid interest – fixed charge

● secured debt – floating charge

● unsecured creditors

● preference shareholders including unpaid dividend

● ordinary shareholders.

3. Check the sufficiency of the amount of finance 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. Assess the fairness of the scheme.

5. Assess the post-reconstruction financial viability and profitability of the

company by calculating post-reconstruction EPS and P/E ratio.

6. Come to a conclusion.




Chapter 13

Hedging foreign

exchange risk

EXCHANGE RATES

An exchange rate is the rate at which one country’s currency can be traded in

exchange for another country’s currency.

Variable and base currency

Exchange rate is quoted as the number of one currency for one of another currency.

The base currency is the currency expressed as one and the variable currency is the

currency expressed as the number of a currency for the base currency.



CHAPTER 13 – HEDGING FOREIGN EXCHANGE RISK


Example

Consider the following exchange rate quotation:

$/£

1.500

This means $1.500 dollars is equal to £1. The dollar is the variable currency and the

pound is the base currency.

Bid and offer prices

Bid

A bid is the rate at which the dealer is willing to buy the foreign currency (base

currency) from a customer by paying in home currency (variable currency).

Offer or ask price

It is the rate the dealer will sell the foreign currency (base currency) and buying the

home currency (variable currency).

Spread

The spread is the difference between the bid price and the offer price. The offer price

is slightly higher than the bid price and the difference (spread) exist to compensate

the dealer for holding the risky foreign currency and for providing the services of

converting currencies.

Spot and forward rates

Spot rate is the price at which foreign exchange can be bought or sold today with

payment made within two business days. It is simply the rate of buying or selling

for immediate settlement.

Forward rate is the rate quoted today for delivery at a fixed future date of specified

amount of one currency against another currency. It is simply the buying or selling

now, but settlement at an agreed future date. Note that the agreed future date could

be one month, two, three, six months up to one year, although two years contract

can exist in some currencies like sterling and dollar.

Outright quotation

Outright quotation means that the full price to all of its decimal point is given.

Example

Bid Offer

Spot rate 1.6878 1.7694

One month forward rate 1.6078 1.7574

Here both the spot and forward bid/offer are given in the full decimal places.





Point quotation

A point quotation is the number of points away from the outright spot rate with the

first number referring to points away from the spot bid and second number to points

away from the spot offer price.

Whether the point quotation is subtracted or added to the spot rate is explained by

premium or discount on the exchange rate movements.

Subtract premium from the spot rate and add discount to the spot rate.

Example 1

Bid Offer

Spot rate 1.4432 1.4442

One month forward rate (premium) 58 56





RISK AND FOREIGN EXCHANGE

Foreign exchange risk, basically Currency risk, is the possibility of making profit or

loss as a result of changes in exchange rate. Examples of situations a company may

be exposed to currency risk are:

● Imports of raw materials.

● Exports of finished goods.

● Importation of foreign-manufactured non-current assets.

● Investments in foreign securities.

● Raising an overseas loan.

● Having a foreign subsidiary or being a foreign subsidiary.

The foreign exchange risk exposures are divided broadly into three categories as

follows:

● transaction exposure;

● economic exposure;

● translation exposure.

Transaction exposure

Transaction exposure relates to the gains and losses to be made when settlement

takes place at some future date of a foreign currency denominated contract that has

already been entered into. These contracts may include import or export of goods

on credit terms, borrowing or investing funds denominated in a foreign currency,

receipt of dividends from over-seas, or unfulfilled foreign exchange contract.

Transaction exposure can be protected against by adopting a hedged position: that

is, entering into a counter balancing contract to offset the exposure.

Translation exposure

This arises from the need to consolidate worldwide operations according to

predetermined accounting rules. This is the risk that the organisation will make

exchange losses or gains when the accounting results of its foreign subsidiaries are

translated into the presentation currency of the parent company. Assets, liabilities,

revenue and expenses must be restated into presentation currency of the parent

company in order to be consolidated into the group accounts.

Translation exposure can result from restating the book value of a foreign subsidiary’s

assets at the exchange rate on the balance sheet date. Such exposure will not affect

the firm’s cash flows unless the asset is sold.

Economic exposure

Economic exposure also called operating or competitive exposure or strategic

exposure measures the changes in the present value of the firm resulting from any

changes in the future operating cash flows of the firm caused by an unexpected

changes in exchange rates. The change in value depends on future sale volume,

price and costs.

For example, a UK company might use raw materials which are priced in US dollars,

but export its product mainly within the EU. A depreciation of the pound against the





dollar or appreciation of pound against the Euro will both erode the competitiveness

of this UK company.

The magnitude of economic exposure is difficult to measure as it considers

unexpected changes in exchange rates and also because such changes can affect

firms in many ways.

Relative importance to the financial manager

Transaction and economic exposures both have cash flow consequences for the firm

and they are therefore considered to be extremely important. Economic exposure is

really the long-run equivalent of transaction exposure, and ignoring either of them

could lead to reduction in the firm future cash flows, resulting in a fall in shareholders

wealth.

Both of these exposures should therefore be protected against.

The importance of translation exposure to financial managers is however often

questioned. In financial management terms we ask the question ‘does translation

loss reduces shareholders wealth? The answer is that it is unlikely to be of

consequence to shareholders who should in an efficient market, value shares on the

basis of the firm’s future cash flows, not on assets value in the published accounts.

Unless management believes that translation losses will greatly affect shareholders

there would seem little point in protecting against them.

PROTECTION AGAINST ECONOMIC EXPOSURE

Diversification of financing

If a firm borrows in a foreign currency it must pay back in that same currency. If

that currency should appreciate against the home currency, this can make interest

and principal repayments far more expensive. However, if borrowing is spread across

many currencies it is unlikely they will all appreciate at the same time and therefore

risk can be reduced. Borrowing in foreign currency is only truly justified if returns

will then be earned in that currency to finance repayment and interest.

Diversification of product and supply

If a firm manufactures all its products in one country and that country’s exchange

rate strengthens, then the firm will find it increasingly difficult to export to the rest

of the world. Its future cash flows and therefore its present value would diminish.

However, if it had established production plants worldwide and bought its

components worldwide it is unlikely that the currencies of all its operations revalue

at the same time. It would therefore find that, although it was losing exports from

some of its manufacturing locations, this would not be the case in all of them.

Also if it had arranged to buy its raw materials worldwide it would find that a

strengthening home currency would result in a fall in its input cost and this would

compensate for lost sales.

Currency swaps

Please see later in the chapter for currency swaps





PROTECTION AGAINST TRANSACTION EXPOSURE

Once, a company has decided to hedge a particular foreign currency risk, there are

a number of methods to consider. They can be grouped as internal and external

hedging techniques.

Internal hedging techniques

Invoicing in the home currency

One way of avoiding exchange risk is for an exporter to invoice his foreign customer

in his home currency, or for an importer to arrange with his supplier to be invoiced

in his home currency. However, although either the exporter or importer can avoid

any exchange risk in this way, only one of them can deal in his home currency. The

other must accept the exchange risk.

Although invoicing in the home currency has the advantage of eliminating exchange

rate risk, the company is unlikely to compete well with a competitor who invoice in

the buyers home currency, hence the customer may purchase from the competitor.

Leading and lagging

Leading and lagging is a mechanism whereby a company accelerates (leads) or delay

(lags) payment or receipt in anticipation of exchange rate movements. This

technique can be used only when exchange rate forecasts can be made with some

degree of confidence. Interest rates would also have to be considered in granting

long term credit.

Netting

Netting is setting the debtors and creditors of all the companies in the group resulting

from transactions between them so that only net amount is either paid or received.

There are two types of netting:

1. Bilateral Netting

In the case of bilateral netting, only two companies are involved. The lower balance

is netted against the higher balance and the difference is the amount remaining to

be paid.

2. Multilateral Netting

Multilateral netting is a more complex procedure in which the debts of more than two

group companies are netted off against each other. There are different ways of

arranging for multilateral netting. The arrangement might be co-ordinated by the

company’s own central treasury or alternatively by the company’s bankers. The

common currency in which netting is to be affected needs to be decided on.





Matching

This is the use of receipts in a particular currency to match payment in that same

currency. Wherever possible, a company that expects to make payments and have

receipts in the same foreign currency should plan to of set it payments against its

receipts in that currency.

Since the company is offsetting foreign payment and receipt in the same currency, it

does not matter whether that currency strengthens or weakens against the

company’s domestic currency because there will be no purchase or sale of the

currency.

The process of matching is made simply by having a foreign currency account,

whereby receipts and payments in the currency are credited and debited to the

account respectively. Probably, the only exchange risk will be limited to conversion

of the net account balance into the domestic currency. This account can be opened

in the domestic country or as a deposit account in oversees country.

Factors to consider prior to protecting

The factors may include the following:

● Future exchange rate movement, where the currency is very volatile. The

future movements in exchange rate may depend on a number of factors

including interest rate, inflation, central bank actions and economic growth.

● The availability of a market for the currency in question.

● The cost involved in the hedging, eg commission.

● The ability of the company to absorb foreign exchange losses.

● Expertise within the company.

● the company’s attitude towards foreign currency transactions and the

importance of overseas trading.

Example 2

A group of companies controlled from the USA has subsidiaries in the UK, South

Africa and France. At 31/12/X3, inter-company indebtedness were as follows

Owed by Owed to Amount

UK SA 1,200,000 SA Rand ®

UK FR 480,000 Euro

FR SA 800,000 SA rand

SA UK 74,000 Sterling

SA FR 375,000 Euro

It is the company’s policy to net off inter-company balances to the greatest extent

possible. The central treasury department is to use the following exchange rates for

these purposes:

US $ = R 6.126 / £0.6800 / Euro €0.880

Required:

Calculate the net payment to be made between the subsidiaries after netting of inter-

company balances.





External hedging techniques

External hedging techniques means using the financial markets to hedge foreign

currency movements.

The techniques include the following:

● forward contract,

● money market hedge,

● currency futures contract,

● currency options, and

● currency swaps.

Forward contract

The foreign-exchange forward market is an inter-bank market, where one party

agrees to deliver a specified amount of one currency for another at a specified

exchange rate at a designated date in the future. The designated exchange rate and

date are called the forward rate and settlement (delivery) date respectively. Where

an investor takes a position in the market by buying a forward contract, the investor

is said to be in a long- position, and where he takes a position to sell a forward

contract we say the investor is in a short-position.

A forward contract is a binding contract on both parties. This means that having

made the contract, a company must carry out the agreement, and buy or sell the

foreign currency on the agreed date and at the rate of exchange fixed by the

agreement. If the spot rate moves in the company’s favour, that will be bad for the

company and vice versa.

Money market hedge

The money market is a market where companies and individuals lend and borrow

money for a short period of time. The period of time could be overnight or up to a

year.

Steps in money market hedge are:

● Borrow an appropriate amount in foreign currency today.

● Convert it immediately to the home currency.

● Place it on deposit account in the home currency.

● Settlement.

Example 3

FRT is a company in the UK that trades frequently with companies in the USA.

Transactions to be completed within the next six months are as follows:

Receipts Payments

Three months $350,000 $250,000

Six months £100,000 $1,000,000

Foreign exchange rates ($/£)

Spot 1.4960 – 1.4990





Three months forward 1.4550 – 1.4600

Six months forward 1.4490 – 1.4560

The interest rates available in the money market are:

UK USA

Annual interest 6% - 9% 11% - 14%

Required:

Using the forward contract and money market hedge, devise a foreign exchange

hedging strategy that is expected to maximise the cash flows of FRT.

Synthetic foreign exchange agreements (SAFEs)

In order to reduce the volatility of their exchange rates, some countries (e.g. China,

Russia, India, Brazil, Philippines and Korea) have attempted to ban forward foreign

exchange trading. In these markets, non-deliverable forwards (NDF’s) have been

developed. Although they resemble forward contracts, no physical currency delivery

actually takes place. Instead, the difference between the actual spot rate and the

NDF rate is calculated. This will result in a profit or loss on the transaction between the two counterparties, who merely settle with each other for this net amount.

When this profit or loss is combined with the actual currency exchanged at the

prevailing spot rate, this will effectively fix the ultimate exchange rate in a manner

which resembles a forward exchange contract.

The underlying principles of a SAFE are similar to the procedures employed for a

forward rate agreement (FRA), which is offered by banks for clients who wish to

hedge their interest rate risk.





FUTURES

A futures is a legal binding contract between two parties to buy or to sell a

standardised quantity of an underlying item at a future date, but at a price agreed

today, through the medium of an organised exchange.

Future contracts are forward contracts traded on a future and options exchange.

Underlying item

Underlying item is the quantity of the item which is to be bought or sold under the

futures contract. Each futures contract has a standardised quantity of this underlying

items and the futures contract cannot be undertaken in fractions.

The underlying item may include agricultural products, like meat, cocoa, maize,

energy products, like crude oil gas, financial products, like currency and interest rate,

and stock index futures on shares.

Delivery dates

Financial futures are normally traded on a cycle of three months, March, June,

September and December of each year.

The clearing house

Each futures exchange has a clearing house. When a futures deal has been made

the clearing house assumes the role of counterparty to both the buyer and the seller.

Thus the buyer has effectively bought from the clearing house whilst the seller is

treated as having sold to the clearing house, thus removing the risk of default on the

futures contract. The clearing house imposes upon its members the requirement to

pay “margins”, which effectively acts as a security deposit.

Closing a future position

If you entered the futures contract by buying, then that contract will be closed by

selling and if you entered by selling futures contract, you close by buying. That is, a

position is closed by reversing what you did to enter the futures contract.

A person who bought a futures contract will close by selling and is said to hold a long

position.

A person who sold a futures contract will close by buying and is said to hold a short

position.

Ticks

A tick is the minimum price movement permitted by the exchange on which the future

contract is traded. Ticks are used to determine the profit or loss on the futures

contract. The significance of the tick is that every one tick movement in price has

the same money value.

If someone has a long position, a rise in the price of the future represents a profit,

and a fall in price represents a loss.

If someone has a short position, a rise in the price of the future represents a loss,

and a fall represents a profit.





Margins

When a deal has been made both buyer and seller are required to pay margin to the

clearing house. This sum of money must be deposited and maintained in order to

provide protection to both parties.

Initial margin

Initial margin is the sum deposited when the contract is first made. This is to protect

against any possible losses on the first day of trading. The value of the initial margin

depends on the future market, risk of default and volatility of interest rates and

exchange rates.

Variation margin

Variation margin is payable or receivable to reflect the day-to-day profits or losses

made on the futures contract. If the future price moves adversely a payment must

be made to the clearing house, whilst if the future price moves favourably variation

margin will be received from the clearing house. This process of realising profits or

loss on a daily basis is known as “marking to market”.

This implies that margin account is maintained at the initial margin as any daily profit

or loss will be received or paid the following morning. Default in variation margins

will result in the closure of the futures contract in order to protect the clearing house

from the possibility of the party providing cash to cover accumulating losses.

Example 4

Contract size £62,500

3 months future price $1. 3545

Number of contract entered 50 contracts

Tick value $6.25

Tick size 0.0001

Required:

Calculate the cash flow if the future price moves to in day one $1.3700 and 1.3450

day two (variation margin). Assume a short position.

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 final 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 profit by trading between the futures market and spot cash market.

Most futures positions are closed out before the contract reaches final 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 profit or loss on the underlying item

will be offset by any loss or profit made on the future contract. A perfect hedge is

unlikely because of:

● Basis risk.

● The “round sum” nature of futures contracts, which can only be bought or sold

in whole number.

Currency Futures

A currency futures is an exchange traded agreement between two parties to buy/sell

a particular quantity of one currency in exchange of another currency at a particular

rate on a particular future date.

Typical available futures contracts are as follows:

Futures quantity of currency

per contract

price

quotation tick size

value of one

tick

£/ $ £62,500 $ per £1 $0.0001 $6.25

€/ $ €125,000 $ per €1 $0.0001 $12.50

€/£ €100,000 £ per €1 £0.0001 £10

Example 5 - Franco plc

Assume that it is now 30 June. Franco plc is a company located in the USA that has

a contract to purchase goods from Japan in two months’ time on 1st September. The

payment is to be made in yen and will total 140 million yen.

The managing director of Franco plc wishes to protect the contract against adverse

movements in foreign exchange rates, and is considering the use of currency futures.

The following data are available.

Spot foreign exchange rate:

Yen/$ 128.15

Yen currency futures contracts on SIMEX (Singapore Monetary Exchange).

Contract size 12,500,000 yen. Contract prices are in US$ per yen.

Contract prices:

September 0.007985

December 0.008250

Assume future contract matures at the end of the month.

Assuming the spot exchange rate is 120 yen/$1 on 1st September and that basis risk

decreases steadily in a linear manner.

Required:

Calculate what the result of the hedge is expected to be. Briefly discuss why this

result may not occur.





FORWARD v FUTURES CONTRACTS

Futures contracts differ from forward contracts in a number of ways including the

following:

● Size of the contract

Futures contracts are for multiples of standard-size contracts whereas forward

contracts with a bank can be negotiated for any size desired.

● Maturity

Futures contracts are available only for a set of fixed maturities, the longest of

which is typically for less than a year. A bank will write a forward contract for

maturity up to a year and occasionally for longer than a year.

● Location

Futures trading is conducted by brokers on the flow of an organised exchange,

where orders from all buyers and sellers compete in one central place. Forward

contracts are negotiated with banks at any location in person or by telephone.

● Price

Futures prices are determined through an open outcry process at the ’pit’ in

which the particular contract is traded. Forward contracts prices are quoted by

the bank in the form of bid and offer.

● Counter parties

Purchasers and sellers of futures contracts are unknown to each other, since

the opposite party to every trade is the exchange clearing house. Purchasers

and sellers of forward contracts deal with the bank where they are known, either

personally or by reputation.

● Margin

Futures contracts require payment of margin while no payments are made

under forward contract apart from settlement payment.

Advantages of using futures contracts

1. Futures could be used to hedge both interest rates and foreign currency risk

2. Default risk is minimal as contracts are marked to market daily by the clearing

house, with the protection of the margin payment.

3. There is single specified price, which is transparent. No bid and offer.

Disadvantages of using futures contracts

1. Futures prices might not move by exactly the same amount as the cash market

due to basis risk, and perfect hedges are rare.

2. An initial margin (deposit) is required, and further variation margins may be

necessary.

3. Futures contracts are not very flexible. Contracts are only on standardised size.

4. It is more complex than forward contract.

5. Futures contract is not available in every currency.





Currency Options

A currency option is the right, but not an obligation, to buy (a call option) or sell (put

option) a particular currency at a specified exchange rate on a particular date or at

any time up to a particular date.

Example 6 - Diano plc

Diano plc is a company based in Ghana that trades frequently with companies in the

UK. The national currency of Ghana is the Cedi (GHC).

Transactions to be completed within the next three months are as follows:

Receipts Payments

3 months time £4.8 million £7.6 million

3 months time GHC 5.8 million

Exchange rates GHC/£1

Spot 5.5640 – 5.5910

3 month forward 5.5880 – 5.6190

Ghana Cedi market traded option prices (125,000 Cedis contract size against

sterling) in the UK.

Exercise price (£ per

GHC) June contracts September contracts

Calls Puts Calls Puts

0.175 0.331 0.082 0.476 0.143

0.180 0.112 0.241 0.203 0.314

0.185 0.034 0.530 0.096 0.691

Option premia are in UK pence per Ghana Cedi and are payable up front. The options

are American style.

Assume that it is now 1 June and that option contracts mature on the 15th of the

month.

Diano plc can borrow at an interest rate of 7% per year.

Required:

Show the outcome of using both forward contract and currency options to hedge

foreign currency risk and recommend the best action.





CURRENCY SWAPS

Currency swaps are similar to interest rate swaps, but the underlying obligations are

in different currencies.

Currency swaps are characterised by the following mechanism:

● Initial exchange of principal currencies at the commencement of the swap.

● Exchange of regular interest payment during the life of the swap.

● Final exchange of principal currencies at maturity of the swap.

When currencies are exchanged at the commencement and maturity of the swap, the

same exchange rate is used. In other words, the amounts exchanged at the start of

the swap and at the end are exactly the same.

Example 7 DD plc

DD plc needs to borrow $50m to finance it US subsidiary. DD plc is not well known

in US and can only borrow in US at US basic rate + 3%. DD plc contacts a US

company it has known for many years, FFK plc. FFK plc is in a similar position to DD

plc in that it requires a sterling loan to finance its UK operations. FFK plc can borrow

sterling at 11% per annum fixed and floating rate in US at US base rate + 1%.

The two companies come into a swap arrangement where:

● DD plc will borrow sterling at 9% per annum fixed and FFK plc will borrow dollars

at US base rate + 1%

● DD plc will pay FFK plc US base rate + 1.5% per annum and FFK plc will pay

DD plc sterling 9.5% per annum

● There will be an exchange of principal now and in five years time at the current

spot rate of $8 = £1

● UK base rate is currently 7% and US base rate is 5% per annum.

Required:

Show whether the suggested swap would benefit the two companies.

Benefits of currency swaps

1. Hedging against foreign exchange risk. Swaps can be arranged for up to ten

years which provide protection against exchange rate movements for much

longer periods than forward contracts. It is very useful when dealing with

countries with exchange controls and/or volatile exchange rates.

2. The ability to obtain finance at a cheaper cost than would be possible by

borrowing directly in the relevant market.

3. The opportunity to effectively restructure a company’s capital profile without

physically redeeming debt.

4. Access to capital markets in which it is impossible to borrow directly, for

example because the borrower is relatively unknown in the market or has a

relatively low credit rating.





5. Swaps can be arranged for any sum typically $5m to $50m over varying time

periods, and may be reversed by re-swapping with other counter parties. Hence

it is flexible.

6. There may be low transaction cost, as cost may be limited to the legal fees in

agreeing the documentations and arrangement fees.

Forex Swaps

A forex swap is an agreement between two parties to exchange equivalent amount

of currency for a period and then re-exchange them at the end of the period at a

predetermined agreed rate.

Forex swaps are characterised by the following mechanism:

● Initial exchange of principal currencies at the commencement of the swap.

● Final exchange of principal currencies at maturity of the swap normally at a

different rate.

The purpose of forex swap are to hedge against foreign exchange risk for longer

period, say more than one year, and where it is difficult to raise money directly.

Risk associated with Swaps

1. Credit Risk

This is the risk that the counter party to the swap will default before the end of the

swap and fail to carry out their agreed obligation. Such risk is reduced if a reputable

bank is used as an intermediary to the deal

2. Market Risk

This is the risk that interest rates or exchange rates will move unfavourably against

the company after it has committed itself into the swap.

3. Sovereign Risk

This is the risk associated with the country in whose currency a swap is being

considered. It covers political instability or the possibility of exchange controls being

introduced.

4. Liquidity Risk

Liquidity risk is the risk that the entity will not have access to sufficient cash to meet

its payment obligations when these are due.

Swaptions

Swaption may also be referred as swap option, options on swap or option swap.

Swaptions are combination of swap and option.

In return for the payment of premium by the holder, a swaption gives the right, but

not an obligation, to enter into swap on or before a particular date.

Swaptions are available on an over-the-counter market and are therefore tailored to

the exact specifications of the holder. They may be American or European style.

Swaptions are example of financial engineering. Financial engineering is the

construction of a financial product from a combination of existing derivative products.




Chapter 14

Hedging interest rate risk



CHAPTER 14 - HEDGING INTEREST RATE RISK


INTEREST RATE RISK

Interest rate risk is the risk of incurring losses or higher costs due to an adverse

movement in interest rates or gains as a result of favourable movement in interest

rates. The interest rate exposure can arise due to many reasons including the

following:

● The company has an asset whose market value changes whenever market

interest rates changes.

● The company is expected to make some payment in the future, and the amount

of the payment will depend on the interest rate at that time.

● The company is expecting some income in the future, and the amount of income

received will depend on the interest rate at that time.

LIBOR and LIBID

LIBOR means the London inter-bank offered rate. It is the rate of interest at which

a top-level bank in London can borrow wholesale short-term funds from another bank

in London money markets.

LIBID means the London inter-bank bid rate. It is the rate of interest that a top-level

bank in London could obtain short-term deposits with another bank in London money

markets. The LIBID is always lower than the LIBOR





TERM STRUCTURE OF INTEREST RATES

The “term structure of interest rates” reflects the manner in which the gross

redemption yield on government bonds varies with the term to maturity, ie the period

of time before the stock is to be redeemed. For example, government bonds may be

short-dated (eg repayment within 5 years), medium-dated (repayment between 5

and 20 years) or long-dated (redemption in excess of 20 years). Of course, some

government bonds e.g. 2½% Consols are undated (ie irredeemable).

This data is often presented in the form of a graph to illustrate the “bond yield curve”,

which is created by plotting the gross redemption yield of the bond against the term

to maturity. In normal circumstances the yield curve is upward sloping.

The gross redemption yield reflects the internal rate of return on the cash flows

associated with the bond, ie it incorporates the effect of the current market value of

the bond, the gross interest payments and the redemption value of the bond – in

other words it measures not only the gross interest yield but also the capital gain or

loss to maturity. The calculation of the gross redemption yield is very similar to the

calculation of the cost of redeemable debt for the company – the notable difference

is that interest payments are included gross (as opposed to net of corporation tax as

is used in arriving at Kd).

The normal yield curve

The general shape of the normal upward sloping yield curve appears as follows:

0 5 10 15 20 25

Term to maturity (years)

A normal yield curve slopes upwards because the yield on longer dated bonds is

normally higher than the yield on shorter dated bonds. If you are confused by this

point, remember that your mortgage is only cheaper than your overdraft because the

mortgage is secured on the property, whereas the overdraft is unsecured. The reason

for the upward sloping shape of the yield curve is thought to be based on the following

theories:

● liquidity preference theory

● expectations theory

Gross

Redemption

Yield

%

Bond

Yield Curve





● market segmentation theory.

Liquidity preference theory

Lenders have a natural preference for holding cash rather than securities even low

risk government securities. They therefore need to be compensated for being

deprived of their cash for a longer period of time – hence the higher yield on long-

dated securities and the lower yield on short-dated securities. There is a greater risk

in lending long-term than in lending short-term. To compensate lenders for this risk

they would require a higher return on longer dated investments.

Expectations theory

This theory states that the shape of the yield curve will vary dependent upon a

lender’s expectations of future interest rates (and therefore inflation levels). A curve

that rises from left to right indicates that rates of interest are expected to increase

in the future to reflect the investors fear of rising inflation rates.

Market segmentation theory

The slope of the yield curve is thought to reflect conditions in different segments of

the market. In other words lenders and borrowers tend to confine themselves to a

particular segment of the market and thus it is probably futile to compare short-term

with long-term lending and borrowing. Thus, companies typically finance working

capital with short-term funds and non-current assets with long-term funds. This

leads to different factors affecting short-term and long-term interest rates leading to

irregularities which cause humps, dips or wiggles in the shape of the yield curve.

The inverse yield curve

A yield curve may occasionally slope downwards, since short-term yields may be

higher than long-term yields for the following reasons:

● Expectations. ie if interest rates are currently high, but the market anticipates

a steep fall in the near future, the resultant yield curve will be downward

sloping.

● Government intervention. ie a policy of keeping interest rates relatively high

might have the effect of forcing short-term yields higher than long-term yields.





An inverse yield curve is downwards sloping and its general shape is as follows:

0 5 10 15 20 25

Term to maturity (years)

Significance of the yield curve to financial managers

Financial managers should inspect the current shape of the yield curve when deciding

on the term of borrowings or deposits, since the curve shows the market expectations

of future movement in interest rates.

If the yield curve slopes steeply upwards, it suggests increase in interest rate in the

future. In this case the financial manager should avoid borrowing long-term on

variable rates, since the interest rate charge may increase over the term of the loan.

It would be better to either borrow on long-term fixed rate or short-term variable

rate.

Gross

Redemption

Yield

%

Bond Yield Curve





HEDGING/PROTECTING INTEREST RATE RISK

There are several methods of hedging interest rate risk including the following:

● forward rate agreements

● interest rate options

● interest rate swaps

● interest rate futures.

Forward rate agreements (FRA)

A forward rate agreement for interest rate is similar to forward foreign exchange

contract.

A forward rate agreement offer companies the facility (with a bank) to fix future

interest rates today on either borrowing or lending for a specified future period.

If the actual interest rate proves to be higher than the rate agreed, the bank pays

the company the difference. If the actual rate is less than the rate agreed, the

company pays the difference. This is called compensation payment.

If a company knows for instance that it will take a loan in few months at a floating

rate of interest it may worry what the interest rate will be and try to manage it by

using FRA. The company arranges FRA with a third party (the bank) at a mutually

agreed interest rate for a specified period in advance.

The company then takes the loan on the due date and pays interest at the prevailing

(actual) rate. At the end of the specified period the interest actually paid is compared

with the rate agreed under the FRA and adjustments are made accordingly between

the two parties.

No premium or commission is paid on FRAs.

FRA quotations or prices

FRAs are over-the counter transaction between a bank and a company. The bank

quotes two-way prices for each FRA period for each notional borrowing (loan) or

lending (deposit).

Examples of bank quotations for FRA are:

● 2 v 5 5.75 - 6.00

Means forward rate agreement that start in 2 months and last for 3 months at

a borrowing rate of 6% and lending rate of 5.75%.





Example 1

A bank has quoted the following FRA rates:

2 v 6 5.75 - 6.00

3 v 5 5.78 - 6.13

4 v 7 5.95 - 6.45

Assume that now is 1st November 2008.

Required:

Determine the FRA interest applicable to the following situations:

1. A company wants to borrow on 1st February 2009 and repay the loan on 1st of

April 2009.

2. A company wants to deposit money on 1st January 2009 and expect to with

draw the amount for an investment on 1st of May 2009.

Compensation payment

Compensation period is calculated as the difference between the FRA rate fixed and

the LIBOR rate at the fixing date (actual LIBOR) multiplied by the amount of the

notional loan/deposit and the period of the loan/deposit.

The FRA therefore protects against the LIBOR but not the risk premium attached to

the customer.

The settlement of FRA is made at the start of the loan period and not at the end and

therefore compensation payment occurs at start of the loan period. As a result the

compensation payment should be discount to it present value using the LIBOR rate

at the fixing date over the period of the loan.

Example 2

A company will have to borrow an amount of £100 million in three month time for a

period of six months. The company borrow at LIBOR plus 50 basis points. LIBOR is

currently 3.5%. The treasurer wishes to protect the short-term investment from

adverse movements in interest rates, by using forward rate agreement (FRAs).

FRA prices (%)

3 v 9 3.85 – 3.80

4 v 9 3.58 3.53

5 v 9 3.55 3.45

Required:

Show the expected outcome of FRA:

(a) If LIBOR increases by 0.5%.

(b) If LIBOR decreases by 0.5%.





Example 3

Assume that it is now 1 June. Your company expects to receive £7.1 million from a

large order in five months’ time. This will then be invested in high-quality commercial

paper for a period of four months, after that it will be used to pay part of the

company’s dividend. The treasurer wishes to protect the short-term investment from

adverse movements in interest rates, by using forward rate agreement (FRAs).

FRA prices (%)

4 v 5 3.85 – 3.80

4 v 9 3.58 3.53

5 v 9 3.50 3.45

The current yield on the high-quality commercial paper is LIBOR + 0.60%. LIBOR is

currently 4%.

Required:

If LIBOR falls or increase by 0.5% during the next five months, show the expected

outcome of FRA.

INTEREST RATE FUTURES

Interest rate futures are futures contracts and similar to currency futures. They are

standardised exchange-traded contract agreement now between buyers and sellers,

for settlement at a future date, normally in March, June, September and December.

Pricing futures contracts

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 8%, a three months Eurodollar futures

contract will be priced at (100-8) = 92; and if interest rate is 11%, the future price

= 89= (100-11).

The decrease in price or value of the contract reflects the reduced attractiveness of

a fixed rate deposit in times of rising interest rates.

Ticks and tick values

Examples of ticks and tick values are:

1. For 3 months Eurodollar futures, the amount of the underlying instrument is a

deposit of $1,000,000. With a tick of 0.01%, the value of the tick is:

0.01% x $1m x 3/12 = $25

2. For 3 months sterling, the underlying instrument is a 3 months deposit of

£500,000. With a tick of 0.01%, the value of tick is:

500,000 x 0.01% x 3/12 = £12.5





Basis and basis risk

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:

LIBOR (100 - 7) 93.00

Futures 92.70

0.30%

30 basis points

Maturity mismatch

Maturity mismatch occurs if the actual period of lending or borrowing does not match

the notional period of the futures contract (three months). The number of futures

contract used has to be adjusted accordingly. Since fixed interest is involved, the

number of contracts is adjusted in proportion to the time period of the actual loan or

deposit compared with three months.

Number of contracts =

amount of actual loan/deposit period required for loan/deposit

futures contrat size 3 months

time

Example 4 - AA plc

The monthly cash budget of AA plc shows that the company is likely to need £18m

in two months time for a period of four months. Financial markets have recently

been volatile, and the finance director fears that short term interest rates could rise

by as much as 150 ticks (ie 1.5%). LIBOR is currently 6.5% and AA plc can borrow

at LIBOR plus 0.75%.

LIFFE £500,000 3 months futures prices are as follows:

December 93.40

March 93.10

June 92.75

Required:

Assume that it is now 1st December and that exchange traded futures contract expires

at the end of the month, estimate the result of undertaking an interest rate futures

hedge on LIFFE if LIBOR increases by 150 ticks (1.5%).





INTEREST RATE OPTIONS

1. Options on interest rate futures

Interest rate option is a right, but not obligation, to either borrow or lend a notional

amount of principal for a given interest period, starting on or before a date in the

future (expiry date for the option), at a specified rate of interest (exercise price of

the option).

It is simply options to buy or sell futures.

2. caps, collars and floors

These are hedging techniques that can be used to cover risk on long term borrowing.

As the name implies, a ‘cap’ is the upper-level interest rate, and a ‘floor’ a lower-

level interest rate. With collar a company enters into an arrangement such that it

will borrow for a period of time with a floating interest rate, but it knows it will not

have to pay more than the ‘cap’ rate, but on the other hand it will not be able to pay

less than the ‘floor rate.

Interest rate

10% CAP

open market rate

5% floor

0 time

The open market rate will be applied to the loan as long as it remains between 5%

and 10%. If the open market interest rate goes outside these parameters (say 12%

or 4%) the bank will activate the ‘cap’ or ‘floor’ as appropriate to keep the loan

interest cost between the agreed limits.

The advantage of the collar compared to a normal cap is that the collar has a lower

overall premium cost, due to the potential benefit of floor to the bank.

Interest rate option is a right, but not obligation, to either borrow or lend a notional

amount of principal for a given interest period, starting on or before a date in the

future (expiry date for the option), at a specified rate of interest (exercise price of

the option).





SWAPS

A swap is an agreement between two parties to exchange cash flows related to

specific underlying obligations for an agreed period of time. It is the exchange of

one stream of future cash flows for another stream of future cash flows with different

characteristics.

Example 5

Assume that it is now mid-December.

The finance director of APB plc has recently reviewed the company’s monthly cash

budgets for the next year. As a result of buying new machinery in three months’

time, the company is expected to require short-term finance of £30 million for a

period of two months until the proceeds from a factory disposal become available.

The finance director is concerned that, as a result of increasing wage settlements,

the Central Bank will increase interest rates in the near future.

LIBOR is currently 6% per annum and APB can borrow at LIBOR + 0.9%.

Derivative contracts may be assumed to mature at the end of the month.

The company is considering using interest rate futures, options on interest rate

futures or interest rate collars.

Three months sterling Future (£500,000 contract size, £12.50 tick size)

December 93.870

March 93.790

June 93.680

Options on three months sterling futures (£500,000 contract size, premium

cost in annual %)

Calls Puts

December March June December March June

93750 0.120 0.195 0.270 0.020 0.085 0.180

94250 0.000 0.030 0.085 0.400 0.480 0.555

Required:

Illustrate how the short-term interest risk might be hedged, and the possible results

of the alternative hedges if interest rate increase or decrease by 0.5%.





INTEREST RATE SWAPS

Interest rate swap allows a company to exchange either:

● Fixed rate interest payments into floating rate payment, or

● Floating rate interest payment into fixed rate payments.

Here a company worried about interest rate volatility on a floating rate loan finds a

swap partner with a fixed interest loan who is unworried by interest rate volatility.

The parties swap their interest rate commitments to obtain the interest style they

want. This is operative over the duration of the loans and so provides long-run

hedging. Normally a financial intermediary is employed to find a suitable swap

partner for the arrangement and is paid a fee.

Example 6 Fred plc

Fred plc has a loan of £20m repayable in one year. Fred plc pays interest at LIBOR

plus 1.5% and could borrow fixed at 13% per annum. Martin plc also has a £20m

loan and pays fixed interest at 12% per annum. It could borrow at a variable rate of

LIBOR plus 2.5%.

The companies agree to swap their interest commitments with Fred plc paying Martin

plc fixed rate plus 0.5% and Martin plc paying Fred plc LIBOR plus 2%. An

arrangement fee of £10,000 is charged on each company.

Required:

Calculate the total interest payments of the two companies over the year if LIBOR is

10% per annum

Example 7

A company wants to borrow £6 million at a fixed rate of interest for four years, but

can only obtain a bank loan at LIBOR plus 80 basis points. A bank quotes bid and

ask prices for a four year swap of 6.45% - 6.50%.

Required:

(a) Show what the overall interest cost will become for the company, if it arranges

a swap to switch from floating to fixed rate commitments.

(b) What will be the cash flows as a percentage of the loan principal for an interest

period if the rate of LIBOR is set at 7%?





Reasons for interest rate swaps

Interest rate swaps have several uses including:

1. Long-term hedging against interest rate movements as swaps may be arranged

for periods of several years.

2. The ability to obtain finance at a cheaper cost than would be possible by

borrowing directly in the relevant market.

3. The opportunity to effectively restructure a company’s capital profile without

physically redeeming debt.

4. Access to capital markets in which it is impossible to borrow directly, for

example because the borrower is relatively unknown in the market or has a

relatively low credit rating.




Chapter 15

Issues for Multinationals

TRANSFER PRICING WITHIN MULTINATIONAL

Essentially a transfer price is an internal recharge which is not an actual cash flow,

however it will in effect redistribute income and cost within an organisation and as a

consequence adjust the profit reported by separate divisions.

Whilst this has an internal consequence in the evaluation of divisional management,

it is of particular significance within multinational organisations due to the tax

implications.

Fund Remittance

Transfer pricing can be used in international investments as a way to circumvent any

restrictions relating to blocked funds. The parent company will charge the foreign

subsidiary an inflated amount to ensure a cash flow that might have otherwise not

been possible to obtain.

Tax Implications

Transfer pricing can also be used to minimise the global tax payable, by adjusting

the transfer price to ensure that a low profit is declared in nations of high tax rates

and a larger profit is declared in nations where the rate is more favourable.

This may need the approval of the respective governments who may not take kindly

to such blatant attempts to avoid paying tax. They may enforce that the transaction

is carried out at “arm’s length” using a price that would be applied to an external

customer to ensure that the transaction is fair and tax is collected as it should be.



CHAPTER 15 - ISSUES FOR MULTINATIONALS


ISLAMIC FINANCE

A form of finance that specifically follows the teachings of the Qu’ran.

The teachings of the Qu’ran are the basis of Islamic Law or Sharia. Sharia Law is,

however, not codified and as such the application of both Sharia Law and, by

implication, Islamic Finance is open to more than one interpretation.

Prohibited activities

In Shariah Law there are some activities that are not allowed and as such must not

be provided by an Islamic financial institution, these include:

1. Gambling (Maisir)

2. Uncertainty in contracts (Gharar)

3. Prohibited activities (Haram)

Riba

Interest in normal financing relates to the monetary unit and is based on the principle

of time value of money. Sharia Law does not allow for the earning of interest on

money. It considers the charging of interest to be usury or the ‘compensation without

due consideration’. This is called Riba and underpins all aspects of Islamic financing.

Instead of interest a return may be charged against the underlying asset or

investment to which the finance is related. This is in the form of a premium being

paid for a deferred payment when compared to the existing value.

There is a specific link between the charging of interest and the risk and earnings of

the underlying assets. Another way of describing it is as the sharing of profits

arising from an asset between lender and user of the asset.

Gharar

The prohibition on gharar means that forward contracts and derivatives are not

allowed. Short selling is prohibited because the seller needs to own the asset.

Constructive ownership is acceptable where the goods are under the direct control of

the owner even if the owner does not have physical possession.

Due to the above prohibitions, majority of the conventional financial instruments are

not suitable to Islamic finance.

Forms of Sharia compliant finance

Profit and Loss sharing partnership methods

● Mudaraba – equity finance

A profit sharing contract where one party provides capital and the other the expertise

to invest the capital and manage the activities. There is a pre-agreed ratio of profit

share.





The partner contributing capital is liable to the extent of the capital provided. The

contract can be terminated at any time with reasonable notice.

Mudaraba transactions are appropriate for private equity investments. In the case

of financial institutions and banks, the mudaraba method become applicable as the

bank is a lender to a business it can share in the profits that the business makes

instead of charging an interest on the loan.

The result is that risk is shared equally between lender and borrower. Similarly, if

the bank is a borrower, the lender’s deposit is treated as an equity investment, and

he or she shares in the profit that the bank makes through its investments.

Conventional banks make a profit on the spread between the interest rate charged

to borrowers and paid to depositors – Islamic banks make a profit on the investments

that they make or their borrowers make.

● Musharaka – venture capital

Has more in common with a joint venture than an equity investment. All (or most)

investors will have an active role in managing the business. Where all parties provide

capital as well as skills and expertise and share the profits and losses on agreed basis.

Partners have unlimited liability.

There are different types of musharaka. In permanent musharaka the bank

participates in the equity of a company and receives an annual share of the profits

on a pro rata basis. The period of termination of the contract is not specified. This

financing technique is also referred to as continued musharaka.

Diminishing musharaka is a special form of musharakah, which ultimately results in

the ownership of the asset or the project by the client. The bank participates as a

financial partner, in full or in part, in a project with a given income forecast. An

agreement is signed by the partner and the bank through which the bank receives a

share of the profits as a partner. However, the agreement also provides payment of

a portion of the net income of the project as repayment of the principal financed by

the bank.

Leasing & deferred payment sales

● Murabaha – trade credit

If a consumer wishes to purchase an asset, the bank can buys the asset for the

individual on an agreed upon price between the individual and the seller. The

individual then purchases the asset from the bank at the purchase price plus a mark-

up. However, critics have pointed out that the mark-up has the same connotation

as interest, and this similarity with traditional banking is perhaps one of the reasons

why murabaha contracts are widely accepted.

The sale price of goods is agreed to cover all costs and generate a profit margin. The

time value of money is incorporated in the costs. There is a reassurance that the

‘credit’ is based on trade and not simply a financing transaction.

Murabaha contracts are applied to financing of raw materials, machinery, equipment

and consumer durables as well as short-term trade financing.

● Ijara – lease finance

A bank makes an asset available to a customer for a fixed period in exchange for a

fixed price. At the end of the period, the customer often has the option to pay a fixed

price in return for transfer of ownership of the asset from the bank.





Leasing is emerging as a popular technique of financing among Islamic banks. Under

this scheme of financing, the bank purchases a real asset and leases it to the client.

The period of lease may be from three months to five years or more, and is

determined by mutual agreement according to the nature of the asset. During the

period of lease, the asset remains in the ownership of the bank but the physical

possession of the asset and the right of use is transferred to the lessee. After the

expiry of the leasing period these revert to the lessor. A lease payment schedule is

agreed by the bank and the lessee based on the amount and terms of financing is

agreed upon by the bank and the lessee. The agreement may or may not include a

grace period.

According to the Islamic principles, the maintenance of the asset during the leasing

period is the responsibility of the owner of the asset, as the benefit or rental is linked

to the responsibility of maintenance.





DARK POOL TRADING

The recent financial crisis has seen the alleged (see newspaper article below) growth

of a practice, which is sometimes referred to as “Dark pool trading”. It is also known

as “Dark pool liquidity”, the “Upstairs market”, “Dark liquidity” or simply “Dark pool”.

The term “Dark pool” relates to trades which are concealed from the public – as if

they had been undertaken in “pools of murky water”. Many traders believe that such

activities should be publicised in order to make trading more fair for all parties

involved, so that all such transactions are performed on “a level playing field”.

Dark pool trading refers to the volume of trade created by institutional investors in

financial trading venues or “crossing networks” that are unavailable to the general

public. The bulk of Dark pool liquidity is represented by block trades undertaken

away from the central exchanges. Such transactions are never displayed and are

useful for institutions who wish to deal in large numbers of shares, whilst not

revealing such trades to the open market.

Dark liquidity pools avoid the risk of revealing the actions of such institutions, since

neither the identity of the trader nor the price at which the transactions took place

are displayed. Dark pools are recorded as over-the-counter transactions, but detailed

information is only reported to clients if they so desire and are under a contractual

obligation to do so.

The Upstairs market allows Fund managers to move large blocks of equity shares

without revealing details as to what has actually occurred. The lack of human

intervention within the electronic platforms employed has reduced the time scale for

such trades. The increased responsiveness of equity price movements has made it

extremely difficult to trade large blocks of shares without affecting the price.

A report in “The Independent” newspaper on 25th May 2010 stated:

“Six big investment banks published trading volumes for their “dark pools” for the

first time yesterday, showing them as a tiny fraction of the market and not the major

hidden rivals to stock exchanges that some argue.

Citi, Credit Suisse, Deutsche Bank, J P Morgan Cazenove, Morgan Stanley and UBS

together executed €596 million (£513 million) of equity trades from 15 countries on

their automated crossing systems on Friday, according to Markit data.

That accounted for about 0.4 per cent of all types of cash equity trades in Europe and

1.6 per cent of all over-the-counter (OTC) trades reported on the Markit BOAT service

that day, according to Thomson Reuters data.

Dark pools are electronic platforms that allow would-be buyers and sellers of large

orders of shares to avoid revealing pre-trade information and signalling their

intentions to the rest of the market.

Bankers argue that for the bulk of OTC trades they act purely as dealers, using their

own money or share inventories to take one or another side, or they act in a non-

automated way to match buyers and sellers for big blocks of stock.”



Documents

Advanced Financial Management - · PDF fileACCA Paper P4 . Advanced Financial Management . Class Notes . March 2017