ACCA AFM

64 Most Frequently Asked

Theory Questions- Asra
Q1 . Discuss how a decrease in the value of each of the determinants of the op7on price in the Black-
Scholes op7on pricing model for European op7ons is likely to change the price of a call op7on.

Solu7on. The value of the op.on depends on the following variables.

(i) The price of the security

A decrease in the price of the security will mean that a call op.on becomes less valuable. Exercising the
op.on will mean purchasing a security that has a lower value.

(ii) The exercise price of the op7on

A decrease in the exercise price will mean that a call op.on becomes more
valuable; the profit that can be made from exercising the op.on will have increased.

(iii) Risk-free rate of return

A decrease in the risk-free rate will mean that a call op.on becomes less valuable. The purchase of an
op.on rather than the underlying security will mean that the op.on holder has spare cash available
which can be invested at the risk-free rate of return. A decrease in that rate will mean that it becomes
less worthwhile to have spare cash available, and hence to have an op.on rather than having to buy the
underlying security.

(iv) Time to expiry of the op7on

A decrease in the .me of expiry will mean that a call op.on becomes less valuable,
as the .me premium element of the op.on price has been decreased.

(v) Vola7lity of the security price

A decrease in vola.lity will mean that a call op.on becomes less valuable. A decrease in vola.lity will
decrease the chance that the security price will be above the exercise price when the op.on expires.
Q2. What is triple boIom line repor7ng ?

Solu7on. Triple boBom line (TBL) repor.ng involves providing a quan.ta.ve summary in terms of social,
financial and environmental performance.

The underlying principle is that in order to evaluate a company's true performance against its objec.ves,
and assess the risk to the investor, the investor must consider all three areas.

Under the TBL approach decision making should ensure that each perspec.ve is growing but not at the
expense of the others. That is, economic performance should not come at the expense of the
environment or society. The idea is that an organisa.on which accommodates all three areas will
enhance shareholder value as long as the costs of producing the report are less than the benefits that
arise from it.

Q3. What is benefit of diversified porMolio ?

Solu7on. PorLolio theory states that shareholders who hold a well-diversified porLolio will have
diversified away the unsystema.c or company-specific risk and will be leM with systema.c risk. Following
this a shareholder cannot reduce risk further by undertaking addi.onal diversifica.on in the same
system or market.

A company may be able to achieve further diversifica.on for its shareholders by inves.ng in a system or
market that the individual shareholders do not invest in themselves. Some studies have shown that well-
diversified investors can benefit from risk diversifica.on when companies invest in emerging markets.

Q4. What is difference between APV & NPV as methods of investment appraisal and comment upon
the circumstances under which APV might be a beIer method of evalua7ng a capital investment than
NPV ?

Solu7on. Both APV and NPV are discounted cash flow techniques but differ in the way project finance is
incorporated into the process. With NPV, finance is usually incorporated into the discount rate which is
then applied to project-only (i.e. excluding finance) cash flows. The clearest example of this is when a
project (or company) WACC is used to discount project cash flows.

APV involves a two stage process dealing with project and financing flows separately. Project cash flows
are discounted at an ungeared cost of equity to calculate a base case NPV. Financing side effects are then
discounted at an appropriate rate – usually the pre-tax risk free rate.

APV may be a beBer technique to use than NPV when:

(i) There is a significant change in capital structure as a result of the investment.
(ii) The investment involves complex tax payments and tax allowances, and/or has periods when
taxa.on is not paid.
(iii) Subsidised loans, grants or issue costs exist.
(iv) Financing side effects exist (e.g. the subsidised loan), which require discoun.ng at a different rate
than that applied to the mainstream project.
Q5. Explain the major differences between Islamic finance and other conven7onal forms of finance

Solu7on. Islamic finance rests on the applica.on of Islamic, or Shariah, law.

The main principles of Islamic finance are that:

(a) Wealth must be generated from legi.mate trade and asset-based investment. The use of money for
the purposes of making money is forbidden.
(b) Investment should also have a social and an ethical benefit to wider society beyond pure return.
(c) Risk should be shared.
(d) Harmful ac.vi.es (such as gambling, alcohol and the sale of certain foods) should be avoided.

The raising of term loan debt finance (where the lender would make a straight interest charge,
irrespec.ve of how the underlying assets fare) would violate the principle of sharing risk and of not using
money for the purposes of making money. Under Islamic finance, the charging and receiving of interest
(riba) is strictly prohibited. This is in stark contrast to more conven.onal, Western forms of finance.

One alterna.ve form of finance would be Murabaha, a form of trade credit for asset acquisi.on. Here
the provider of finance would buy the item and then sell it on to buyer at a price that includes an agreed
mark-up for profit. The mark-up is fixed in advance and cannot be increased and the payment is made by
instalments.

Another form of finance would be Islamic bonds, known as sukuk. To be Shariah- compliant, the sukuk
holders must have a proprietary interest in the assets which are being financed. The sukuk holders’
return for providing finance is a share of the income generated by the assets. The key dis.nc.on
between sukuk and murabaha is that sukuk holders have ownership of the cash flows but not the assets
themselves.

Q6. Discuss the possible reasons why company may have switched its strategy of organic growth to
one of growing by acquiring companies.

Solu7on. Company may have switched from a strategy of organic growth to one of growth by
acquisi.on, if it was of the opinion that such a change would result in increasing the value for the
shareholders.

Acquiring a company to gain access to new products, markets, technologies and exper.se will almost
certainly be quicker and may be less costly than developing these internally. Horizontal acquisi.ons may
help Vogel Co eliminate key compe.tors and thereby reduce rivalry and possible overcapacity in its
industry; they may also have enabled Vogel Co to take advantage of economies of scale and to compete
against large rivals. Ver.cal acquisi.ons may help Vogel Co to secure the supply chain and maximise
returns from its value chain.

Organic growth may take a long .me, can be expensive and may result in liBle compe..ve advantage
being established due to the .me taken. Also organic growth, especially into a new area, would need
managers to gain knowledge and exper.se of an area or func.on, which they are not currently familiar
with. Furthermore, in a saturated market, there may be liBle opportunity for organic growth.
Q7. Dis7nguish between the different types of synergy and discuss possible sources of synergy based
on the above scenario.

Solu7on. Synergies arise from an acquisi.on when the value of the new, combined en.ty is greater than
the sum of the two individual values before the acquisi.on. There are three types of synergies: revenue,
cost and financial.

Revenue synergies create higher revenues for the combined en.ty, also crea.ng a higher return on
equity and an extended period of compe..ve advantage.

Cost synergies arise from elimina.ng duplica.on of func.ons and also from economies of scale due to
the size of the new en.ty.

Financial synergies may result from the ability to increase debt capacity or from transferring group funds
to companies where they can be best u.lised.

In this scenario, there may be financial synergies available as Hav Co has significant cash reserves, but
Strand Co is constrained by a lack of funds. This means that the new en.ty may have the funds to
undertake projects that would have been rejected by Strand Co due to a lack of funds. The larger
company may also have an increased debt capacity and therefore addi.onal access to finance. It is also
possible that the new en.ty will have a lower cost of capital as a result of the acquisi.on.

Cost synergies may be available, through the removal of duplica.on in areas such as head office
func.ons, but also in R&D. These synergies are likely to be more short term. Other cost synergies may
arise from a stronger nego.a.ng posi.on with suppliers due to the size of the new en.ty, meaning
beBer credit terms and also lower costs.

Revenue synergies have the poten.al to be the biggest synergies from this acquisi.on, although they are
likely to be the hardest to achieve, and also to sustain. Hav Co can help Strand Co with the marke.ng of
its products, which should result in higher revenues and a longer period of compe77ve advantage.
Combining the R&D ac.vity and the technologies of both companies may mean products can be brought
to market faster too. To achieve these synergies it is important to retain the services of the scien.st
managers of Strand Co. They have been used to complete autonomy as the managers of Strand Co, so
this rela.onship should be managed carefully.
A major challenge in an effec.ve acquisi.on is to integrate processes and systems between the two
companies efficiently and effec.vely in order to gain the full poten.al benefits. OMen, this is done poorly
and can mean that the acquisi.on is ul.mately seen as a failure. Hav Co needs to plan for this before
proceeding with the acquisi.on.
Q8. Discuss the possible ac7ons Vogel Co could take to reduce the risk that the acquisi7on of Tori Co
fails to increase shareholder value .

Solu7on. Vogel Co can take the following ac.ons to reduce the risk that the acquisi.on of Tori Co fails to
increase shareholder value.

Since Vogel Co has a poor track record of adding value from its acquisi.ons it needs to review recent
acquisi.ons to understand why they have not added value ie it should do a post- audit of these
acquisi.ons.

Vogel Co should also ensure that the valua.on is based on reasonable input figures and that proper due
diligence of the perceived benefits is undertaken prior to the offer being made. OMen it is difficult to get
an accurate picture of the target when looking at it from the outside. Vogel Co needs to ensure that it
has sufficient data and informa.on to enable a thorough and sufficient analysis to be undertaken.

The sources of synergy need to be properly assessed to ensure that they are achievable and to iden.fy
what ac.ons Vogel Co needs to undertake to ensure their achievement. Targets should be set for all
areas of synergy and responsibility for achieving these targets should be clearly allocated to members of
Vogels' senior management team.

The board of directors of Vogel Co needs to ensure that there are good reasons to undertake the
acquisi.on, and that the acquisi.on should result in an increase in value for the shareholders. The non-
execu.ve directors should play a crucial role in ensuring that acquisi.ons are made to enhance the value
for the shareholders. Procedures need to be established to ensure that the acquisi.on is not overpaid.
Vogel Co should determine the maximum premium it is willing to pay and not go beyond that figure.
Research indicates that oMen too much is paid to acquire a company and the resultant synergy benefits
are not sufficient to cover the premium paid. OMen this is the result of the management of the acquiring
company wan.ng to complete the deal at any cost, because not comple.ng the deal may be perceived
as damaging to both their own, and their company's, reputa.on. Vogel Co needs to ensure that it has
proper procedures in place to integrate the staff and systems of the target company effec.vely, and also
to recognise that such integra.on takes .me. Vogel Co may decide instead to give the target company a
large degree of autonomy and thus make integra.on less necessary; however, this may result in a
reduc.on in synergy benefits.

Vogel Co should also have strategies in place to retain key staff in the companies that it is acquiring –
these people need to be iden.fied at an early stage and given assurances over their role and
responsibili.es post-acquisi.on. Vogel Co should also be mindful that its own and the acquired
company's staff and management need to integrate and ensure a good working rela.onship between
them.
Q9. Dis7nguish between a divestment through a sell-off and a management buy-in as forms of
unbundling.

Solu7on. Both forms of unbundling involve disposing of the non-core parts of the company.

The divestment through a sell-off normally involves selling part of a company as an en.ty or as separate
assets to a third party for an agreed amount of funds or value. This value may comprise of cash and non
cash based assets. The company can then u.lise the funds gained in alterna.ve, value-enhancing
ac.vi.es.

The MBI is a par.cular type of sell-off which involves selling a division or part of a company to an
external management team, who will take up the running of the new business and have an equity stake
in the business. An MBI is normally undertaken when it is thought that the division or part of the
company can probably be run beBer by a different management team compared to the current one.

Q10. Discuss the advantages and drawbacks of exchange traded op7on contracts compared with over-
the-counter op7ons.

Solu7on.

Advantages

Exchange traded op.ons are readily available on the financial markets, their price and contract details
are transparent, and there is no need to nego.ate these. Greater transparency and .ght regula.ons can
make exchange traded op.ons less risky. For these reasons, exchange traded op.ons’ transac.on costs
can be lower.

The op.on buyer can sell (close) the op.ons before expiry. American style op.ons can be exercised any
.me before expiry and most traded op.ons are American style op.ons, whereas over-the-counter
op.ons tend to be European style op.ons.

Disadvantages

The maturity date and contract sizes for exchange traded op.ons are fixed, whereas over-the-counter
op.ons can be tailored to the needs of par.es buying and selling the op.ons.
Exchange traded op.ons tend to be of shorter terms, so if longer term op.ons are needed, then they
would probably need to be over-the-counter.
A wider range of products (for example, a greater choice of currencies) is normally available in over-the-
counter op.ons markets.
Q11. Dis7nguish between an IPO and a reverse takeover, and discuss whether an IPO or a reverse
takeover would be an appropriate method to obtain a lis7ng.

Solu7on.

The ini.al public offering (IPO) is the conven.onal way to obtain a lis.ng where a company issues and
offers shares to the public. When doing this, the company will follow the normal procedures and
processes required by the stock exchange regarding a new issue of shares and will comply with the
regulatory requirements.

Undertaking a reverse takeover enables a company to obtain a lis.ng without going through the IPO
process.

Compared with an IPO, the main benefits of undertaking a reverse takeover are that it is cheaper, takes
less .me and ensures that company will obtain a lis.ng on a stock exchange.

An IPO can cost between 3% and 5% of the capital being raised because it involves investment banks,
lawyers, and other experts. A marke.ng campaign and issuing a prospectus are also needed to make the
offering aBrac.ve and ensure shares to the public do get sold. A reverse takeover does not need any of
these and therefore avoids the related costs. The IPO process can typically take one or two years to
complete due to hiring the experts, the marke.ng process and the need to obtain a value for the shares.
Addi.onally, the regulatory process and procedures of the stock exchange need to be complied with.
With a reverse takeover, none of these are required and therefore the process is quicker. Finally, there is
no guarantee that an IPO will be successful. In .mes of uncertainty, economic downturn or recession, it
may not aBract the aBen.on of investors and a lis.ng may not be obtained.

However, obtaining a lis.ng through a reverse takeover can have issues aBached to it. The listed ‘shell’
company may have poten.al liabili.es which are not transparent at the outset, such as poten.al
li.ga.on ac.on. A full due diligence of the listed company should be conducted before the reverse
takeover process is started. The IPO process is probably beBer at helping provide the senior
management of company with knowledge of the stock exchange and its regulatory environment. The
involvement of experts and the .me senior management need to devote to the lis.ng process will help
in this regard. Due to the marke.ng effort involved with an IPO launch, it will probably have an investor
following, which a reverse takeover would not. Therefore, a company which has gone through an IPO
would probably find it easier to raise extra funds, whilst a company which has gone through a reverse
takeover may find it more difficult to raise new funding.

Overall, neither op.on of obtaining a lis.ng has a clear advantage over the other. The choice of lis.ng
method depends on the company undertaking the lis.ng and the purpose for which it is doing so.
Q12.Discuss the benefits and drawbacks for using forward contracts compared with using over-the-
counter currency op7ons, and explain why companies may prefer to use exchange-traded deriva7ves
rather than over-the-counter deriva7ves to hedge foreign currency risk.

Solu7on.

Benefits of a forward contract

A forward contract would not involve payment of a large premium upfront to the counterparty.

A forward contract is a simple arrangement to understand, whereas the basis of calcula.on of the
premium for an over-the-counter (OTC) op.on may be unclear.

A forward contract gives a certain receipt for the purposes of budge.ng.

Drawbacks of a forward contract

A forward contract has to be fulfilled, even if the transac.on which led to the forward contract being
purchased is cancelled. Exchange rate movements may mean that the contract has to be fulfilled at an
unfavourable rate. An OTC op.on can be allowed to lapse if it is not needed.

A forward contract does not allow the holder to take advantage of favourable exchange rate movements.
An OTC op.on need not be exercised if the exchange rate moves in the holder’s favour.

A forward contract may only be available for a short .me period, depending on what currencies are
involved. An OTC op.on may be purchased for a longer .me period, over a year.

The rate offered on a forward contract will be determined by a predic.on based on expected interest
rates. The rate offered on an OTC op.on may be more flexible. This may suit a holder who is prepared to
tolerate the risk of some loss in order to have the opportunity to take advantage of favourable exchange
rate movements, but who wishes to use the op.on to set a limit to possible losses.

Reasons why exchange-traded deriva7ves are used

One of the main reasons why the treasury func.on uses exchange-traded deriva.ves is that the
contracts can be bought and sold as required. Also, because the markets are regulated by an exchange,
counterparty risk (the risk of the other party to the transac.on defaul.ng) should be minimised.
Q13. Discuss how incorpora7ng real op7ons into net present value decisions may help companies with
its investment appraisal decisions.

Solu7on.

When making decisions, following investment appraisals of projects, net present value assumes that a
decision must be made immediately or not at all, and once made, it cannot be changed. Real op.ons, on
the other hand, recognise that many investment appraisal decisions have some flexibility.

For example, decisions may not have to be made immediately and can be delayed to assess the impact
of any uncertain.es or risks aBached to the projects. Alterna.vely, once a decision on a project has been
made, to change it, if circumstances surrounding the project change. Finally, to recognise the poten.al
future opportuni.es, if the ini.al project is undertaken.

Real op.ons give managers choices when making decisions about whether or not to undertake projects,
by es.ma.ng the value of this flexibility or choice. Real op.ons take into account the .me available
before a decision, on a project, has to be made, and the risks and uncertain.es aBached to the project. It
uses these factors to es.mate an addi.onal value which can be aBributable to the project. Real op.ons
view risks and uncertain.es as opportuni.es, where upside outcomes can be exploited, and a company
has the op.on to disregard any downside impact.

By incorpora.ng the value of any real op.ons available into an investment appraisal decision, company
will be able to assess the full value of a project.

Q14. Explain the nature of a mudaraba contract and discuss briefly how this form of Islamic finance
could be used to finance the planned expansion.

Solu7on.

One central principle of Islamic finance is that making money out of money is not acceptable, i.e. interest
is prohibited. A mudaraba contract, in Islamic finance, is a partnership between one party that brings
finance or capital into the contract and another party that brings business exper.se and personal effort
into the contract. The first party is called the owner of capital, while the second party is called the agent,
who runs or manages the business. The mudaraba contract specifies how profit from the business is
shared propor.onately between the two par.es. Any loss, however, is borne by the owner of capital,
and not by the agent managing the business. It can therefore be seen that three key characteris.cs of a
mudaraba contract are that no interest is paid, that profits are shared, and that losses are not shared.

If company were to decide to seek Islamic finance for the planned expansion and if the company were to
enter into a mudaraba contract, the company would therefore be entering into a partnership as an
agent, managing the business and sharing profits with the Islamic bank that provided the finance and
which was ac.ng as the owner of capital. The Islamic bank would not interfere in the management of the
business and this is what would be expected if company were to finance the business expansion using
debt such as a bank loan. However, while interest on debt is likely to be at a fixed rate, the mudaraba
contract would require a sharing of profit in the agreed propor.ons.
Q15. Discuss the advantages and disadvantages of using swaps as a means of hedging interest rate risk
for the company.

Solu7on.

Advantages of swaps

Transac.on costs are generally rela.vely low. If company arranged the swap itself, the costs would be
limited to legal fees.

The transac.on costs may also be lower than the costs of termina.ng one loan and arranging another.

The company can, as here, swap a commitment to pay a variable rate of interest which is uncertain with
a guaranteed fixed rate of interest. This allows the en.ty to forecast finance costs on the loan with
certainty.

Swaps are over-the-counter arrangements. They can be arranged in any size and for whatever .me
period is required, unlike traded deriva.ves. The period available for the swap may be longer than is
offered for other interest rate deriva.ves.

Swaps make use of the principle of compara.ve advantage. Company can borrow in the market where
the best deal is available to it, and then use the swap to access the loan finance it actually wants at an
overall cheaper cost.

Disadvantages of swaps

Swaps are subject to counterparty risk, the risk that the other party to the arrangement may default on
the arrangement. This would apply in par.cular if the company arranged the swap itself. If it is arranged
through a bank, the bank can provide a guarantee that the swap will be honoured.

If the company swaps into a fixed rate commitment, it cannot then change that commitment. This means
it cannot take advantage of favourable interest rate changes as it could if it used op.ons. This may be a
par.cular problem if the swap period is more than a few months and interest rates are expected to be
vola.le.

As swaps are over-the-counter instruments, they cannot be easily traded or allowed to lapse if they are
not needed or become no longer advantageous. It is possible that a bank may allow a reswapping
arrangement to reverse a swap which is not required, but this will incur further costs.
Q16.

Treasury staffing

Company’s new chief execu.ve has made the following comments: ‘I understand that the treasury
department has a number of day-to-day responsibili.es, including inves.ng surplus funds for the short-
term liquidity management and hedging against currency and interest rates. However, these tasks could
all be carried out by the junior, less experienced, members of the department. I do not see why the
department needs to employ experienced, expensive staff, as it does not contribute to the strategic
success of the company

Cri7cise the views of the chief execu7ve about the work carried out by the treasury department and
the staff required to do this work.

Solu7on.

The chief execu.ve appears to underes.mate the degree of knowledge required for day-to-day work.
Less experienced staff may be able to arrange borrowing if the lender has already been chosen or, for
example, arrange forward rate agreements to be used if they are prescribed.

However, if judgement is required as to, for example, which lender or hedging instrument to use, using
less experienced staff may mean that a sub-op.mal decision is taken. Poor decisions may result in
opportunity costs, for example, not using the lender who gives the best deal or being commiBed to a
fixed forward rate agreement when an op.on would have allowed the business to take advantage of
favourable rate movements. These opportunity costs may not be as clear as the salary costs of
experienced staff.

As the business operates interna.onally, the treasury department will need to monitor financial market
condi.ons and exchange rates, and other issues which may be significant such as poli.cal developments.
Because of their previous experiences, longer-serving staff are more likely to appreciate the implica.ons
of developments and whether treasury policies and decisions need to change in response to changes in
risk. Senior staff are also needed to manage the work of less experienced staff to prevent or mi.gate the
effect of mistakes which may be costly.

Experienced staff are also needed to establish overall guidelines and policies for treasury ac.vi.es. Their
judgement will be required to establish principles which will mean that ac.ons taken by staff are in line
with the risk appe.te of the business and are sufficiently prudent from the viewpoint of risk
management. Experienced staff will also have greater knowledge of law, accoun.ng standards and tax
regula.ons, which can help the business avoid penal.es and perhaps structure its dealings so that it can,
for example, minimise the level of tax paid.

The chief execu.ve has plans for a major expansion of the business, involving significant investment and
financing decisions. Advice from experienced treasury staff will be invaluable in suppor.ng the decisions
required. If the company is planning a major acquisi.on, the treasury func.on can provide advice on the
structure of considera.on and financing implica.ons. If, as here, a major investment is being
contemplated, experienced staff can advise on transla.ng views on risk into a relevant cost of capital,
which will help ensure that the financial appraisal of the investment is realis.c.
Q17. Discuss why a company may prefer to use the adjusted present value (APV) method, rather than
the net present value (NPV) method.

Solu7on.

Adjusted present values (APVs) separate out a project’s cash flows and allocate a specific discount rate to
each type of cash flow, dependent on the risk aBributable to that par.cular type of cash flow. Net
present value (NPV) discounts all cash flows by the average discount rate aBributable to the average risk
of a project.

One reason why APV may be preferable to NPV is because by separa.ng out different types of cash
flows, the company’s managers will be able to see which part of the project generates what propor.on
of the project’s value. Furthermore, alloca.ng a specific discount rate to a cash flow part helps
determine the value added or destroyed. In this example, the company is able to determine how much
value is being created by the investment and how much by the debt financing. For complex projects,
investment related cash flows could be further dis.nguished by their cons.tuent risk factors, where
applicable.

Q18. Discuss the importance to a company of recognising all of its stakeholders when making a new
project investment decision.

Solu7on.

Importance of recognising stakeholders

A project investment decision is bound to create ‘winners’ and ‘losers’. In any project appraisal, it is
important to iden.fy and recognise the claims of all of the stakeholders for several reasons.

Stakeholder recogni.on is necessary to gain an understanding of the sources of poten.al risk and
disrup.on. Environmental pressure groups, for example, could threaten to disrupt any project that is
perceived as being environmentally damaging, or could threaten legal ac.on.
Stakeholder recogni.on is important in terms of assessing the sources of influence over the objec.ves
and outcomes for the project. Stakeholder influence is assessed in terms of each stakeholder’s power
and interest, with higher power and higher interest combining to generate the highest influence.

Stakeholder recogni.on is necessary in order to iden.fy poten.al areas of conflict and tension between
stakeholders, especially relevant when it is likely that stakeholders of influence will be in disagreement
over the outcomes. A survey of the stakeholders, once mapped in terms of influence, would signal which
stakeholders are likely to cause delays to the project and paralysis by disagreement and whose claims
can then be studied for ways to reduce disagreement.

There is an ethical and reputa.onal case for knowledge of how decisions affect stakeholders, both inside
the organisa.on or external to it. Society can withdraw its support from organisa.ons that it perceives as
unethical or arrogant. This can affect organisa.onal performance by reducing their reputa.ons as
employers and suppliers of future services.

A ‘deep green’ perspec.ve would take an unfavourable view of companies that failed to recognise some
stakeholder claims.
Q19. Comment on the concern that synergy is oben overes7mated, including any steps which could be
taken by the company’s board to address this problem.

Solu7on.

Overes7ma7on of synergy value

There is evidence that bidding companies oMen overes.mate the value of synergy arising from a
poten.al acquisi.on with the result that companies pay too much for their target. When this happens,
there is destruc.on in wealth for the bidding company’s shareholders. There are a number of possible
explana.ons for this problem.

First, merger and acquisi.on ac.vity tends to be driven by the availability of cheap credit. At the peak of
a wave of ac.vity, there may be compe..on for targets, thereby increasing acquisi.on premiums.

Second, conflicts of interest may lead to a biased evalua.on process. Deal advisers such as investment
banks earn a large propor.on of their fees from mergers and acquisi.ons. Their advice on whether an
acquisi.on makes sense is poten.ally biased if they do not look aMer their clients’ interests.

Third, management overconfidence may explain why this occurs. Acquiring companies may overes.mate
the acquisi.on synergy and/or underes.mate the .me it will take to deliver. Management may then be
reluctant to admit mistakes when the facts change, even when there is s.ll .me to back out of a deal.
Agency costs may be also a factor if managers are more interested in pursuing personal goals than
maximising shareholder wealth.
Finally, there may be difficul.es integra.ng the companies due to different work cultures and conflicts of
interest.

Steps to address this problem

The company’s board needs to plan for synergy and take ac.ve steps to ensure that it is delivered. This
responsibility needs to be allocated to someone who can ensure spare cash is u.lised to invest in new
growth opportuni.es, that tax losses are offset as efficiently as possible and that the combined company
avails itself of cheaper financing.
Companies which allocate this responsibility and monitor and review performance tend to be more
successful in crea.ng value. In order to avoid any bias, the deal advisers who stand to profit from an
acquisi.on need to be separate from the evalua.on process. Effec.ve due diligence ensures the financial
documents which form the basis of a valua.on are scru.nised and inspected.
Q20. Discuss how interest rate swaps and currency swaps might be of value to the corporate finance
manager.

Solu7on.

A swap is the exchange of one stream of future cash flows for another stream of future cash flows with
different characteris.cs.

Interest rate and currency swaps offer many poten.al benefits to companies including:

(I) The ability to obtain finance cheaper than would be possible by borrowing directly in the relevant
market. As companies with different credit ra.ngs can borrow at different cost differen.als in for
example the fixed and floa.ng rate markets, a company that borrows in the market where it has a
compara.ve advantage (or least disadvantage) can, through swaps, reduce its borrowing costs. For
example a highly rated company might be able to borrow funds 1.5% cheaper in the fixed rate market
than a lower rated company, and 0.80% cheaper in the floa.ng rate market. By using swaps an
arbitrage gain of 0.70% (1.5% – 0.80%) can be made and split between the par.cipants in the swap.

(II) Hedging against foreign exchange risk. Swaps can be arranged for up to 10 years which provide
protec.on against exchange rate movements for much longer periods than the forward foreign
exchange market. Currency swaps are especially useful when dealing with countries with exchange
controls and/or vola.le exchange rates.

(III)The opportunity to effec.vely restructure a company's capital profile by altering the nature of
interest commitments, without physically redeeming old debt or issuing new debt. This can save
substan.al redemp.on costs and issue costs. Interest commitments can be altered from fixed to
floa.ng rate or vice versa, or from one type of floa.ng rate debt to another, or from one currency to
another.

(IV)Access to capital markets in which it is impossible to borrow directly. For example, companies with a
rela.vely low credit ra.ng might not have direct access to some fixed rate markets, but can arrange
to pay fixed rate interest by using swaps.

(V) The availability of many different types of swaps developed to meet a company's specific needs.
These include amor.sing swaps, zero coupon swaps, callable, puBable or extendable swaps and
swap.ons.
Q21. From the perspec7ve of a corporate financial manager, discuss the advantages and poten7al
problems of using currency swaps.

Solu7on.

Advantages of currency swaps include:

1. They allow companies to undertake foreign currency hedging, oMen for longer periods than is
possible with forwards.

2. They are usually cheaper than long-term forwards, where such products exist.

3. Finance may be obtained at a cheaper rate than would be possible by borrowing directly in the
relevant market. This occurs by taking advantage of arbitrage if a company has a rela.ve funding
advantage in one country.

4. They may provide access to finance in currencies that could not be borrowed directly, e.g. due to
government restric.ons, or lack of a credit ra.ng in the overseas market.

5. Currency swaps offer the opportunity to restructure the company’s debt profile without physically
redeeming debt or issuing new debt.

6. Currency swaps might be used to avoid a country’s exchange control restric.ons.

Poten7al problems include:

1. If the swap is directly with a corporate counterparty the poten.al default risk of the counterparty
must be considered. Swaps arranged with a bank as the direct counterparty tend to be much less
risky.

2. Poli.cal or sovereign risk; the possibility that a government will introduce restric.ons that interfere
with the performance of the swap.

3. Basis risk. With a floa.ng to floa.ng swap, basis risk might exist if the two floa.ng rates are not
pegged to the same index.

4. Exchange rate risk. The swap may result in a worse outcome than would have occurred if no swap had
been arranged.
Q22. Discuss the rela7ve advantages and disadvantages of the use of a money market hedge
compared with using exchange traded deriva7ves for hedging a foreign exchange exposure.

Solu7on.

A money market hedge is a mechanism for the delivery of foreign currency, at a future date, at a
specified rate without recourse to the forward FOREX market. If a company is able to achieve
preferen.al access to the short term money markets in the base and counter currency zones then it can
be a cost effec.ve subs.tute for a forward agreement. However, it is difficult to reverse quickly and is
cumbersome to establish as it requires borrowing/lending agreements to be established denominated in
the two currencies.

Exchange traded deriva.ves such as futures and foreign exchange op.ons offer a rapid way of crea.ng a
hedge and are easily closed out. For example, currency futures are normally closed out and the profit/
loss on the deriva.ve posi.on used to offset the gain or loss in the underlying. The fixed contract sizes
for exchange traded products mean that it is oMen impossible to achieve a perfect hedge and some gain
or loss on the unhedged element of the underlying or the deriva.ve will be carried. Also, given that
exchange traded deriva.ves are priced in a separate market to the underlying there may be
discrepancies in the movements of each and the observed delta may not equal one. This basis risk is
minimised by choosing short maturity deriva.ves but cannot be completely eliminated unless maturity
coincides exactly with the end of the exposure. Furthermore less than perfectly hedged posi.ons require
disclosure under IFRS 39. Although rapid to establish, currency hedging using the deriva.ves market may
also involve significant cash flows in mee.ng and maintaining the margin requirements of the exchange.
Unlike futures, currency op.ons will entail the payment of a premium which may be an expensive way of
elimina.ng the risk of an adverse currency movement.

With rela.vely small amounts, the OTC market represents the most convenient means of locking in
exchange rates. Where cross border flows are common and business is well diversified across different
currency areas then currency hedging is of ques.onable benefit. Where, as in this case, rela.vely
infrequent flows occur then the simplest solu.on is to engage in the forward market for hedging risk.
The use of a money market hedge as described may generate a more favourable forward rate than direct
recourse to the forex market. However the administra.ve and management costs in seqng up the
necessary loans and deposits are a significant considera.on.

Q23. What is economic exposure and how it is managed ?

Solu7on.

Economic exposure relates to the change in the value of a company as a result of unexpected changes in
exchange rates.

Unless there are known contractual future cash flows it is difficult to hedge economic exposure using
op.ons, swaps, or other financial hedges, as the amount of the exposure is unknown.

Economic exposure is normally managed by interna.onally diversifying ac.vi.es, and organising

ac.vi.es to allow flexibility to vary the loca.on of produc.on, the supply sources of raw materials and
components, and interna.onal financing, in response to changes in exchange rates.
Q24. Explain the role of the Interna7onal Monetary Fund (IMF) and its significance to the ac7vi7es of
mul7na7onal companies.

Solu7on.

The Interna.onal Monetary Fund (IMF) was established at the BreBon Wood Conference of 1945. Its
ini.al tasks were to promote world trade and to help support the fixed exchange rate system that existed
at that .me. Support was mainly in the form of temporary loans to member countries which
experienced balance of payments difficul.es.

Such loans were financed by member countries' quota subscrip.ons. Although floa.ng exchange rates
and exchange rate agreements between blocs of countries have replaced the fixed exchange rate system,
the IMF s.ll provides loans to many of its members, par.cularly developing countries. Today loans are
also granted to help countries repay large commercial debts that they have built up from the
interna.onal banking system.

An important feature of most IMF loans is the condi.ons aBached to the loans. Countries receiving IMF
loans are required to take strong economic measures to try to improve or eliminate the economic
problems that made the loans necessary, and to s.mulate medium to long-term economic development.
These condi.ons typically include currency devalua.on, controls over infla.on via the money supply,
public expenditure cuts to reduce government budget deficits and local tax increases.

Loans of up to 25% of a member country's quotas are given without condi.on. A further 25% is available
to countries that 'demonstrate reasonable efforts' to overcome balance of payments difficul.es. Upper
credit tranches of up to a further 75% of quota, normally in the form of standby facili.es, are available
subject to condi.onality agreements. Most loans are for a period of up to five years.

The IMF has undoubtedly been successful in helping to reduce vola.lity in interna.onal exchange rates,
and in facilita.ng world trade. This has beneficial effects on the trading ac.vi.es of mul.na.onal
companies. However, the strong influence of the IMF on the macro-economic policies of developing
na.ons oMen leads to short term defla.on and reduc.ons in the size of markets for mul.na.onal
companies' products.

Conflicts may exist between mul.na.onals, who wish to freely move capital interna.onally, and
governments trying to control the money supply and infla.on. Tax increases oMen accompany economic
austerity measures, import tariff quotas may make opera.ons more difficult and increases in interest
rates raise the cost of finance. In the medium to long term it is hoped that the structural adjustments will
s.mulate economic growth and will increase the size of markets for mul.na.onal companies, but IMF
economic condi.ons may cause significant short to medium term difficul.es for subsidiaries of
mul.na.onals in the countries concerned.
Q25. Warren BuffeI, the stock market investor, views deriva7ves as a ‘7me bomb’, but many
corporate treasurers clearly perceive them as very useful tools for reducing risk. Explain and discuss
the reasons for such divergent viewpoints.

Solu7on.

There is no inconsistency between the views of Warren BuffeB and the views of many corporate
treasurers. Deriva.ves such as futures contracts, swaps and op.ons enable the holder to manage the
risk associated with an underlying posi.on. Thus they can be used to reduce the risk of a posi.on (e.g. if
you are due to receive a certain amount of foreign currency on a known date in the future, you can sell it
forward and thus fix the amount of the receipt in your own home currency to eliminate the currency
risk) or to speculate to increase the risk of a posi.on (e.g. you can buy a financial futures contract for
trading purposes, hoping that you can sell it in the future for more than you paid for it). BuffeB is
concerned about speculators who buy deriva.ves for trading purposes with no underlying need for
them. Corporate treasurers see the value in using deriva.ves to hedge their risk away, thus reducing
their overall risk exposure.

Let us consider BuffeB’s views in more detail. He has been a long-term investor in the US stock market.
As an investor, he would like relevant and reliable financial informa.on on the companies that he is
thinking of inves.ng in. In the past, the financial accoun.ng for deriva.ves has been inadequate
throughout the world. Favouring the historical cost conven.on meant that deriva.ves were stated at
cost in the SOFP, with any profit or loss only being recognised when the deriva.ve was sold. However the
ini.al cost of a deriva.ve is small or even zero, while its market value at a SOFP date might be large. It is
in this sense that BuffeB is correct in having described deriva.ves as a ‘.me-bomb’, wai.ng for their
profit or loss to be recognised in the future, at a .me to be decided by the company holding the
specula.ve posi.on. However, this problem has now been mi.gated somewhat by improved standards
on financial accoun.ng for deriva.ves. Interna.onal Standard IAS 39 now requires all deriva.ves to be
measured at their fair values in each SOFP. This certainly improves the relevance of the SOFP, but the
vola.lity of deriva.ve values means that the descrip.on of a ‘.me-bomb’ is s.ll appropriate. Things can
go wrong very quickly with deriva.ves, so the fact that they were measured at fair value in the previous
SOFP is of liBle comfort to the investor who has seen his company suddenly lose a huge sum of money
through losing control (e.g. Procter and Gamble lost $150m in 1994 when specula.ng on the spread
between the German mark and the US dollar).

The opposite view is generally held by corporate treasurers who see deriva.ves as a means of reducing
risk, whether currency risk, interest rate risk or other market risk. Many treasury departments are set up
as cost centres and instructed not to engage in specula.on. One oMen sees the statement in companies’
Annual Reports that the company does not engage in specula.on with deriva.ve instruments. The
situa.on is less clear-cut where the treasury is set up as a profit centre which may choose to take
specula.ve posi.ons within established limits. It is oMen in these circumstances that the dis.nc.on
between hedging and specula.on becomes blurred in the department’s pursuit of profits, and once
again the .me-bomb can blow up with devasta.ng consequences.
Q26. With reference to purchasing power parity, explain how exchange rate fluctua7ons may lead to
economic exposure.

Solu7on.

Purchasing power parity (PPP) predicts that the exchange rates between two currencies depend on the
rela.ve differences in the rates of infla.on in each country. Therefore, if one country has a higher rate of
infla.on compared to another, then its currency is expected to depreciate over .me. However, according
to PPP the ‘law of one price’ holds because any weakness in one currency will be compensated by the
rate of infla.on in the currency’s country (or group of countries in the case of the euro).

Economic exposure refers to the degree by which a company’s cash flows are affected by fluctua.ons in
exchange rates. It may also affect companies which are not exposed to foreign exchange transac.ons,
due to ac.ons by interna.onal compe.tors.

If PPP holds, then companies may not be affected by exchange rate fluctua.ons, as lower currency value
can be compensated by the ability to raise prices due to higher infla.on levels. This depends on markets
being efficient.

However, a permanent shiM in exchange rates may occur, not because of rela.ve infla.on rate
differen.als, but because a country (or group of countries) lose their compe..ve posi.ons. In this case
the ‘law of one price’ will not hold, and prices readjust to a new and long-term or even permanent rate.
For example, the UK £ to USA $ rate declined in the 20th century, as the USA grew stronger economically
and the UK grew weaker. The rate almost reached parity in 1985 before recovering. Since the financial
crisis in 2009, it has fluctuated between roughly $1.5 to £1 and $1.7 to £1.

In such cases, where a company receives substan.al amounts of revenue from companies based in
countries with rela.vely weak economies, it may find that it is facing economic exposure and its cash
flows decline over a long period of .me.

Q27. Although not mandatory for external repor.ng purposes, one of the members of the BoD
suggested that adop.ng a triple boBom line approach when monitoring the X-IT investment aMer its
implementa.on, would provide a beBer assessment of how successful it has been.

Discuss how adop7ng aspects of triple boIom line repor7ng may provide a beIer assessment of the
success of the organisa7on.

Solu7on.

A triple boBom line (TBL) report provides a quan.ta.ve summary of performance in terms of economic
or financial impact, impact on the environment and impact on social performance. TBL provides the
measurement tool to assess a corpora.on’s or project’s performance against its objec.ves.

The principle of TBL repor.ng is that true performance should be measured in terms of a balance
between economic (profits), environmental (planet) and social (people) factors; with no one factor
growing at the expense of the others. The conten.on is that a corpora.on that accommodates the
pressures of all the three factors in its strategic investment decisions will enhance shareholder value, as
long as the benefits that accrue from producing such a report exceeds the costs of producing it.
Q28. Takeover regula7on generally offers the following condi7ons aimed at protec7ng shareholders:
the mandatory-bid condi7on through sell out rights, the principle of equal treatment, and squeeze-out
rights.
Required: Explain the main purpose of each of the three condi7ons.

Solu7on.

Each of the three condi.ons aims to ensure that shareholders are treated fairly and equitably.

The mandatory-bid condi.on through sell out rights allows remaining shareholders to exit the company
at a fair price once the bidder has accumulated a certain number of shares. The amount of shares
accumulated before the rule applies varies between countries. The bidder must offer the shares at the
highest share price, as a minimum, which had been paid by the bidder previously. The main purpose for
this condi.on is to ensure that the acquirer does not exploit their posi.on of power at the expense of
minority shareholders.

The principle of equal treatment condi.on s.pulates that all shareholder groups must be offered the
same terms, and that no shareholder group’s terms are more or less favourable than another group’s
terms. The main purpose of this condi.on is to ensure that minority shareholders are offered the same
level of benefits, as the previous shareholders from whom the controlling stake in the target company
was obtained.

The squeeze-out rights condi.on allows the bidder to force minority shareholders to sell their stake, at a
fair price, once the bidder has acquired a specific percentage of the target company’s equity. The
percentage varies between countries but typically ranges between 80% and 95%. The main purpose of
this condi.on is to enable the acquirer to gain 100% stake of the target company and prevent problems
arising from minority shareholders at a later date.

Q29. Explain the difference between APV and NPV as methods of investment appraisal and comment
upon the circumstances under which APV might be a beIer method of evalua7ng a capital investment
than NPV.

Solu7on.

Both APV and NPV are discounted cash flow techniques but differ in the way project finance is
incorporated into the process. With NPV, finance is usually incorporated into the discount rate which is
then applied to project-only (i.e. excluding finance) cash flows. The clearest example of this is when a
project (or company) WACC is used to discount project cash flows.

APV involves a two stage process dealing with project and financing flows separately. Project cash flows
are discounted at an ungeared cost of equity to calculate a base case NPV. Financing side effects are then
discounted at an appropriate rate – usually the pre-tax risk free rate.

APV may be a beBer technique to use than NPV when:

(i) There is a significant change in capital structure as a result of the investment.
(ii) The investment involves complex tax payments and tax allowances, and/or has periods when
taxa.on is not paid.
(iii) Subsidised loans, grants or issue costs exist.
(iv) Financing side effects exist (e.g. the subsidised loan), which require discoun.ng at a different rate
than that applied to the mainstream project.
Q30. Explain the major differences between Islamic finance and other conven7onal forms of finance
such as those being considered by Strayer. Iden7fy, and briefly discuss, two Islamic financial
instruments.

Solu7on.

Islamic finance rests on the applica.on of Islamic, or Shariah, law.

The main principles of Islamic finance are that:

• Wealth must be generated from legi.mate trade and asset-based investment. The use of money for
the purposes of making money is forbidden.
• Investment should also have a social and an ethical benefit to wider society beyond pure return.
• Risk should be shared.
• Harmful ac.vi.es (such as gambling, alcohol and the sale of certain foods) should be avoided.

The raising of term loan debt finance as proposed by organisa.ons (where the lender would make a
straight interest charge, irrespec.ve of how the underlying assets fare) would violate the principle of
sharing risk and of not using money for the purposes of making money. Under Islamic finance, the
charging and receiving of interest (riba) is strictly prohibited. This is in stark contrast to more
conven.onal, Western forms of finance.

One alterna.ve form of finance would be Murabaha, a form of trade credit for asset acquisi.on. Here
the provider of finance would buy the item and then sell it on to Strayer at a price that includes an
agreed mark-up for profit. The mark-up is fixed in advance and cannot be increased and the payment is
made by instalments.

Another form of finance would be Islamic bonds, known as sukuk. To be Shariah- compliant, the sukuk
holders must have a proprietary interest in the assets which are being financed. The sukuk holders’
return for providing finance is a share of the income generated by the assets. The key dis.nc.on
between sukuk and murabaha is that sukuk holders have ownership of the cash flows but not the assets
themselves.

Q31. Explain the objec7ves of integrated repor7ng.

Solu7on.
The objec.ves of integrated repor.ng include:

• To improve the quality of informa.on available to providers of financial capital to enable a more
efficient and produc.ve alloca.on of capital.

• To provide a more cohesive and efficient approach to corporate repor.ng that draws on different
repor.ng strands and communicates the full range of factors that materially affect the ability of an
organisa.on to create value over .me.

• To enhance accountability and stewardship for the broad base of capitals (financial, manufactured,
intellectual, human, social and rela.onship, and natural) and promote understanding of their
interdependencies.

• To support integrated thinking, decision making and ac.ons that focus on the crea.on of value over
the short, medium and long term.
Q32. MMC is funded partly by equity and partly by debt. The yield on its five year debt is 5.2% and the
yield on its ten year debt is 5.4% i.e. MMC faces an upward sloping yield curve.
Required:
Explain the possible reasons for an upward sloping yield curve.

Solu7on.

A yield curve may be upward-sloping because of:

Future expecta7ons. If future short-term interest rates are expected to increase then the yield curve
will be upward sloping.

(v) The greater the expected future rise in interest rates, the steeper the upward- slope of the yield curve
will be.

Liquidity preference. It is argued that investors seek extra return for giving up a degree of liquidity
with longer-term investments.

(vi)Other things being equal, the longer the maturity of the investment, the higher the required return,
leading to an upward-sloping yield curve.

Preferred habitat/market segmenta7on. Different investors are more ac.ve in different segments of
the yield curve.

For example banks would tend to focus on the short-term end of the curve, whilst pension funds are
likely to be more concerned with medium- and long- term segments.

An upward-sloping curve could in part be the result of a fall in demand in the longer-term segment of
the yield curve leading to lower bond prices and higher yields.

Q33. Elfu Co has es7mated an annual standard devia7on of $800,000 on one of its other projects,
based on a normal distribu7on of returns. The average annual return on this project is $2,200,000.
Required:
Es7mate the project’s Value at Risk (VAR) at a 99% confidence level for one year and over the project’s
life of five years. Explain what is meant by the answers obtained.

Solu7on.
99% confidence level requires the value at risk (VAR) to be within 2.33 standard devia.ons from the
mean, based on a single tail measure.

Annual VAR = 2.33 × $800,000 = $1,864,000

Five year VAR = $1,864,000 × 5^(1/2) approx. = $4,168,000

The figures mean that Elfu Co can be 99% confident that the cash flows will not fall by more than
$1,864,000 in any one year and $4,168,000 in total over five years from the average returns. Therefore
the company can be 99% certain that the returns will be $336,000 or more every year [$2,200,000 –
$1,864,000]. And it can be 99% certain that the returns will be $6,832,000 or more in total over the five-
year period [$11,000,000 – $4,168,000]. There is a 1% chance that the returns will be less than $336,000
each year or $6,832,000 over the five-year period.
Q34. Explain the different methods of dealing with a capital ra7oning problem, in the circumstances
where
(i) capital is ra7oned in a single period, and
(ii) capital is ra7oned in several periods.

Solu7on.

Shareholder wealth is maximised if a company undertakes all possible posi.ve NPV projects.
Capital ra.oning is where there are insufficient funds to do so.

This shortage of funds may be for a single period only, or for more than one period.
A single period capital ra.oning problem is solved by ranking compe.ng projects according to
profitability index i.e. the NPV of the project divided by the capital investment needed in the restricted
period.

The limited amount of capital available is then allocated to the project(s) with the highest profitability
index, in order to generate the highest possible NPV per unit of investment.

A solu.on to a mul. period capital ra.oning problem cannot be found using profitability indices. This
method can only deal with one limi.ng factor (i.e. one period of shortage). Where there are a number of
limi.ng factors (i.e. a number of periods of shortage) a linear programming model has to be formulated.
The solu.on to the linear programming model will give the combina.on of projects to maximise the NPV
generated.

Q35. Explaining the features of a capital investment monitoring system and discussing the benefits of
maintaining such a system.

Solu7on.

A capital investment monitoring system (CIMS) monitors how an investment project is progressing once
it has been implemented. Ini.ally the CIMS will set a plan and budget of how the project is to proceed. It
sets milestones for what needs to be achieved and by when. It also considers the possible risks, both
internal and external, which may affect the project. CIMS then ensures that the project is progressing
according to the plan and budget. It also sets up con.ngency plans for dealing with the iden.fied risks.

The benefits of CIMS are that it tries to ensure, as much as possible, that the project meets what is
expected of it in terms of revenues and expenses. Also that the project is completed on .me and risk
factors that are iden.fied remain valid. A cri.cal path of linked ac.vi.es which make up the project will
be iden.fied. The departments undertaking the projects will be proac.ve, rather than reac.ve, towards
the management of risk, and therefore possibly be able to reduce costs by having a beBer plan. CIMS can
also be used as a communica.on device between managers charged with managing the project and the
monitoring team. Finally CIMS would be able to re-assess and change the assump.ons made of the
project, if changes in the external environment warrant it.
Q36. Discuss the aims of a free trade area, such as the European Union (EU), and the possible benefits
to companies of opera7ng within the EU.

Solu7on.

A free trade area like the European Union (EU) aims to remove barriers to trade and allow freedom of
movement of produc.on resources such as capital and labour. The EU also has an overarching common
legal structure across all member countries and tries to limit any discriminatory prac.ce against
companies opera.ng in these countries. Furthermore, the EU erects common external barriers to trade
against countries which are not member states.

Companies may benefit from opera.ng within the EU in a number of ways as it currently trades within it.
It should find that it is able to compete on equal terms with rival companies within the EU. Companies
outside the EU may find it difficult to enter the EU markets due to barriers to trade. A common legal
structure should ensure that the standards of food quality and packaging apply equally across all the
member countries. Due diligence of logis.c networks used to transport the food may be easier to
undertake because of common compliance requirements. Having access to capital and labour within the
EU may make it easier for the company to set up branches inside the EU, if it wants to. The company may
also be able to access any grants which are available to companies based within the EU.

Q37. Among the criteria used by credit agencies for establishing a company’s credit ra7ng are the
following: industry risk, earnings protec7on, financial flexibility and evalua7on of the company’s
management. Briefly explain each criterion and suggest factors that could be used to assess it.

Solu7on.
Industry risk measures the resilience of the company’s industrial sector to changes in the economy. In
order to measure or assess this, the following factors could be used:
• Impact of economic changes on the industry in terms how successfully the firms in the industry
operate under differing economic outcomes;
• How cyclical the industry is and how large the peaks and troughs are;
• How the demand shiMs in the industry as the economy changes.

Earnings protec7on measures how well the company will be able to maintain or protect its earnings in
changing circumstances. In order to assess this, the following factors could be used:
• Differing range of sources of earnings growth;
• Diversity of customer base;
• Profit margins and return on capital.

Financial flexibility measures how easily the company is able to raise the finance it needs to pursue its
investment goals. In order to assess this, the following factors could be used:
• Evalua.on of plans for financing needs and range of alterna.ves available;
• Rela.onships with finance providers, e.g. banks;
• Opera.ng restric.ons that currently exist in the form of debt covenants.

Evalua7on of the company’s management considers how well the managers are managing and planning
for the future of the company. In order to assess this, the following factors could be used:
• The company’s planning and control policies, and its financial strategies;
• Management succession planning;
• The qualifica.ons and experience of the managers;
• Performance in achieving financial and non-financial targets.
Q38. Discuss how useful dura7on is as a measure of the sensi7vity of a bond price to changes in
interest rates.

Solu7on.

The sensi.vity of bond prices to changes in interest rates is dependent on their redemp.on dates. Bonds
which are due to be redeemed at a later date are more price-sensi.ve to interest rate changes, and
therefore are riskier.

Dura.on measures the average .me it takes for a bond to pay its coupons and principal and therefore
measures the redemp.on period of a bond. It recognises that bonds which pay higher coupons
effec.vely mature ‘sooner’ compared to bonds which pay lower coupons, even if the redemp.on dates
of the bonds are the same. This is because a higher propor.on of the higher coupon bonds’ income is
received sooner. Therefore these bonds are less sensi.ve to interest rate changes and will have a lower
dura.on.

Dura.on can be used to assess the change in the value of a bond when interest rates change using the
following formula: ΔP=[–D×Δi×P][1+i], where P is the price of the bond, D is the dura.on and i is the
redemp.on yield.

However, dura.on is only useful in assessing small changes in interest rates because of convexity. As
interest rates increase, the price of a bond decreases and vice versa, but this decrease is not
propor.onal for coupon paying bonds, the rela.onship is non-linear. In fact, the rela.onship between
the changes in bond value to changes in interest rates is in the shape of a convex curve to origin, see
below.

Dura.on, on the other hand, assumes that the rela.onship between changes in interest rates and the
resultant bond is linear. Therefore dura.on will predict a lower price than the actual price and for large
changes in interest rates this difference can be significant.

Dura.on can only be applied to measure the approximate change in a bond price due to interest
changes, only if changes in interest rates do not lead to a change in the shape of the yield curve. This is
because it is an average measure based on the gross redemp.on yield (yield to maturity). However, if
the shape of the yield curve changes, dura.on can no longer be used to assess the change in bond value
due to interest rate changes.
Q39. Money laundering is a process in which assets obtained or generated by criminal ac7vity are
moved or concealed to obscure their link with the crime.
Required:
Explain what steps have been taken by global governments and other bodies to prevent interna7onal
money laundering and terrorist financing.

Solu7on.

The free movement of goods, services and capital across na.onal barriers has long been considered a
key factor in establishing stable and independent world economies. However, removing barriers to the
free movement of capital also increases the opportuni.es for interna.onal money laundering and
terrorist financing.

Bodies such as the interna.onal monetary fund (IMF) work in conjunc.on with na.onal governments to
establish a mul.lateral framework for trade and finance, but they are also aware of the possible
opportuni.es this creates for criminals.

Interna.onal efforts to combat money laundering and terrorist financing have resulted in:

• the establishment of an interna.onal task force on money laundering

• the issue of specific recommenda.ons to be adopted by na.on states

• the enactment of legisla.on by many countries on maBers covering:

- the criminal jus.ce system and law enforcement
- the financial system and its regula.on
- interna.onal coopera.on.

Q40. Discuss the benefits to company’s shareholders of receiving repayments through a share buyback
scheme as opposed to the other dividend schemes.

Solu7on.

The main benefit of a share buyback scheme to investors is that it helps to control transac.on costs and
manage tax liabili.es. With the share buyback scheme, the shareholders can choose whether or not to
sell their shares back to the company. In this way they can manage the amount of cash they receive. On
the other hand, with dividend payments, and especially large special dividends, this choice is lost, and
may result in a high tax bill. If the shareholder chooses to re-invest the funds, it will result in transac.on
costs. An added benefit is that, as the share capital is reduced, the earnings per share and the share
price may increase. Finally, share buybacks are normally viewed as posi.ve signals by markets and may
result in an even higher share price.
Q41. Explain what is a dark pool network.

Solu7on.
A dark pool network allows shares to be traded anonymously, away from public scru.ny. No informa.on
on the trade order is revealed prior to it taking place. The price and size of the order are only revealed
once the trade has taken place. Two main reasons are given for dark pool networks: first they prevent
the risk of other traders moving the share price up or down; and second they oMen result in reduced
costs because trades normally take place at the mid-price between the bid and offer; and because
broker-dealers try and use their own private pools, and thereby saving exchange fees.

Although the cri.cism against dark pool systems is that they prevent market efficiency by not revealing
bid-offer prices before the trade, proponents argue that in fact market efficiency is maintained because a
large sale of shares will not move the price down ar.ficially and temporarily.

Q42. Explain the insights which behavioural finance provides about investor behaviour.

Solu7on.
Sewell defines behavioural finance as the influence of psychology on the behaviour of financial
prac..oners and the subsequent effect on markets. Behavioural finance suggests that individual
decision-making is complex and will deviate from ra.onal decision-making. Under ra.onal decision-
making, individual preferences will be clear and remain stable. Individuals will make choices with the aim
of maximising u.lity, and adopt a ra.onal approach for assessing outcomes.

Under behavioural finance, individuals may be more op.mis.c or conserva.ve than appears to be
warranted by ra.onal analysis. They will try to simplify complex decisions and may make different
decisions based on the same facts at different .mes.

Q43. Briefly discuss the main advantage and disadvantage of hedging interest rate risk using an
interest rate collar instead of op7ons.

Solu7on.
The main advantage of using a collar instead of op.ons to hedge interest rate risk is lower cost. A collar
involves the simultaneous purchase and sale of both call and put op.ons at different exercise prices. The
op.on purchased has a higher premium when compared to the premium of the op.on sold, but the
lower premium income will reduce the higher premium payable. With a normal uncovered op.on, the
full premium is payable.

However, the main disadvantage is that, whereas with a hedge using op.ons the buyer can get full
benefit of any upside movement in the price of the underlying asset, with a collar hedge the benefit of
the upside movement is limited or capped as well.

Q44. Explain what is meant by basis risk.

Solu7on.
Basis risk occurs when the basis does not diminish at a constant rate. In this case, if a futures contract is
held un.l it matures then there is no basis risk because at maturity the deriva.ve price will equal the
underlying asset’s price. However, if a contract is closed out before maturity (here the June futures
contracts will be closed two months prior to expiry) there is no guarantee that the price of the futures
contract will equal the predicted price based on basis at that date.
Q45. When examining different currency op7ons and their risk factors, it was no7ced that a long call
op7on had a high gamma value. Explain the possible characteris7cs of a long call op7on with a high
gamma value.

Solu7on.

Gamma measures the rate of change of the delta of an op.on. Deltas range from near 0 for a long call
op.on which is deep out-of-money, where the price of the op.on is insensi.ve to changes in the price of
an underlying asset, to near 1 for a long call op.on which is deep in-the-money, where the price of the
op.on moves in line and largely to the same extent as the price of the underlying asset. When the long
call op.on is at-the-money, the delta is 0.5 but also changes rapidly. Hence, the gamma is highest for a
long call op.on which is at-the-money. The gamma is also higher when the op.on is closer to expiry. It
would seem, therefore, that the op.on is probably trading near at-the-money and has a rela.vely short
.me period before it expires.

Q46. A member of Awan Co’s treasury team has suggested that if op7on contracts are purchased to
hedge against the interest rate movements, then the number of contracts purchased should be
determined by a hedge ra7o based on the delta value of the op7on.

Required:
Discuss how the delta value of an op7on could be used in determining the number of contracts
purchased

Solu7on.

The delta value measures the extent to which the value of a deriva.ve instrument, such as an op.on,
changes as the value of its underlying asset changes. For example, a delta of 0.8 would mean that a
company would need to purchase 1.25 op.on contracts (1/0.8) to hedge against a rise in price of an
underlying asset of that contract size, known as the hedge ra.o. This is because the delta indicates that
when the underlying asset increases in value by $1, the value of the equivalent op.on contract will
increase by only $0.80.

Q47. Discuss the key differences between a Salam contract, under Islamic finance principles, and
futures contracts.

Solu7on.

Islamic principles s.pulate the need to avoid uncertainty and specula.on. In the case of Salam contracts,
payment for the commodity is made at the start of the contract. The buyer and seller of the commodity
know the price, the quality and the quan.ty of the commodity and the date of future delivery with
certainty. Therefore, uncertainty and specula.on are avoided.

On the other hand, futures contracts are marked-to-market daily and this could lead to uncertainty in
the amounts received and paid every day. Furthermore, standardised futures contracts have fixed expiry
dates and pre-determined contract sizes. This may mean that the underlying posi.on is not hedged or
covered completely, leading to limited specula.ve posi.ons even where the futures contracts are used
en.rely for hedging purposes. Finally, only a few commodity futures contracts are offered to cover a
range of different quality grades for a commodity, and therefore price movement of the futures market
may not be completely in line with the price movement in the underlying asset.
Q48. Discuss the advantages of opera7ng treasury ac7vi7es through regional treasury func7ons
compared with:
• Each country having a separate treasury func7on.
• Opera7ng ac7vi7es through a single global treasury func7on.
Solu7on.

Regional func7ons compared with na7onal func7ons

Organising treasury ac.vi.es on a regional basis would be consistent with what is happening in the
group overall. Other func.ons will be organised regionally. A regional treasury func.on may be able to
achieve synergies with them and also benefit from informa.on flows being organised based on the
regional structure.

If, as part of a reorganisa.on, some treasury ac.vi.es were to be devolved outside to a bank or other
third party, it would be simpler to arrange for a single provider on a regional basis than arrange for
separate providers in each country.

A regional func.on will avoid duplica.on of responsibili.es over all the countries within a region. A
regional func.on will have more work to do, with maybe a greater range of ac.vi.es, whereas staff
based na.onally may be more likely to be under-employed. There may be enough complex work on a
regional basis to jus.fy employing specialists in par.cular treasury areas which will enhance the
performance of the func.on. It may be easier to recruit these specialists if recruitment is done regionally
rather than in each country.

Regional centres can carry out some ac.vi.es on a regional basis which will simplify how funds are
managed and mean less cost than managing funds on a na.onal basis. These include pooling cash,
borrowing and inves.ng in bulk, and neqng of foreign currency income and expenditure.

Regional centres could in theory be located anywhere in the region, rather than having one treasury
func.on based in each country. This means that they could be located in the most important financial
centres in each region or in countries which offered significant tax advantages.

Regional func7ons compared with global func7on

A regional func.on could employ experts with knowledge of the regula.ons, prac.ces and culture of the
major countries within the region. It may be more difficult for a global func.on to recruit staff with local
exper.se.

There may be prac.cal issues why individual countries prefer to deal with regional func.ons rather than
a global func.on, for example, a regional func.on will be based in the same, or similar, .me zone as the
countries in its region.

A regional func.on may have beBer ideas of local finance and investment opportuni.es. There may, for
example, be beBer alterna.ves for investment of the surplus funds than the centralised func.on has
been able to iden.fy.
Q49. Discuss how the mandatory bid rule and the principle of equal treatment protects shareholders
in the event of their company facing a takeover bid, and discuss the effec7veness of poison pills and
disposal of crown jewels as defensive tac7cs against hos7le takeover bids.

Solu7on.

Both the mandatory bid rule and the principle of equal treatment are designed to protect minority
shareholders, where an acquirer has obtained a controlling interest of the target company. The
mandatory bid rule provides minority shareholders with the opportunity to sell their shares and exit the
target company at a specified fair share price. This price should not be lower than the highest price paid
for shares, which have already been acquired within a specified period. The principle of equal treatment
requires the acquiring company to offer the same terms to minority shareholders as were offered to the
earlier shareholders from whom the controlling interest was acquired. Both these regulatory devices are
designed to ensure that the minority shareholders are protected financially and are not exploited by the
acquirer.

The purpose of both poison pills and disposal of crown jewels is to make the target company
unaBrac.ve to the acquirer. Poison pills give exis.ng shareholders in the target company the right to buy
addi.onal shares in their company at a discount once the acquiring company has bought a certain
number of shares in the target company. The aim is to make the target company more expensive to
purchase, as the acquirer needs to buy more shares. Disposal of crown jewels involves selling the target
company’s most valuable assets, and therefore making the target company less aBrac.ve to the acquirer.

The effec.veness of either defence tac.c can be limited, as the company’s management would need its
shareholders to authorise such moves (although there are ways in which poison pills can be incorporated
without gaining prior authorisa.on from shareholders). Shareholders may not be willing to do this as
they normally get premiums on their shares during takeover baBles. Addi.onally, disposing of key
strategic assets could substan.ally weaken a company’s compe..ve advantage and therefore its future
poten.al. Such ac.on may be detrimental to the company and therefore shareholders would probably
not approve that course of ac.on.
Q50. Discuss how using real op7ons methodology in conjunc7on with net present value could help
establish a more accurate es7mate of the poten7al value of companies.

Solu7on.

Tradi.onal investment appraisal methods such as net present value assume that an investment needs to
be taken on a now or never basis, and once undertaken, it cannot be reversed. Real op.ons take into
account the fact that in reality, most investments have within them certain amounts of flexibility, such as
whether or not to undertake the investment immediately or to delay the decision; to pursue follow- on
opportuni.es; and to cancel an investment opportunity aMer it has been undertaken. Where there is
increasing uncertainty and risk, and where a decision can be changed or delayed, this flexibility has
value, known as the .me value of an op.on.

Net present value captures just the intrinsic value of an investment opportunity, whereas real op.ons
capture both the intrinsic value and the .me value, to give an overall value for an opportunity. When a
company s.ll has .me available to it before a decision needs to be made, it may have opportuni.es to
increase the intrinsic value of the investment through the strategic decisions it makes.

Inves.ng in new companies with numerous poten.al innova.ve product pipelines may provide
opportuni.es for flexibility where decisions can be delayed and the intrinsic value can be increased
through strategic decisions and ac.ons taken by the company. Real op.ons try to capture the value of
this flexibility within companies with innova.ve product pipelines, whereas net present value does not.

Q51. Explain what porMolio restructuring and organisa7onal restructuring involve.

Solu7on.

PorLolio restructuring involves the acquisi.on of companies, or disposals of assets, business units and/
or subsidiary companies through divestments, demergers, spin- offs, MBOs and MBIs. Organisa.onal
restructuring involves changing the way a company is organised. This may involve changing the structure
of divisions in a business, business processes and other changes such as corporate governance.

The aim of either type of restructuring is to increase the performance and value of the business.

Shareholders are interested in maximising returns from their investments, which companies achieve
through maximising business value, whilst minimising the risks inherent in their investment ac.vity.
Shareholders who are closely linked to a par.cular business do not hold diversified investment
porLolios, and therefore benefit from diversifica.on of risk undertaken by a company, inves.ng in many
different areas. On the other hand, ins.tu.onal shareholders and other shareholders, who hold
diversified porLolios, would not benefit from a company undertaking risk management through
diversifica.on by becoming a conglomerate.
Q52. Explain what a reverse takeover involves and discuss the rela7ve advantages and disadvantages
to a company, of obtaining a lis7ng through a reverse takeover as opposed to an ini7al public offering
(IPO).

Solu7on.
A reverse takeover enables a private, unlisted company, to gain a lis.ng on the stock exchange without
needing to go through the process of an ini.al public offering (IPO). The private company merges with a
listed ‘shell’ company. The private company ini.ally purchases equity shares in the listed company and
takes control of its board of directors. The listed company then issues new equity shares and these are
exchanged for equity shares in the unlisted company, thereby the original private company’s equity
shares gain a lis.ng on the stock exchange. OMen the name of the listed company is also changed to that
of the original unlisted company.

Advantages rela7ve to an IPO

1. An IPO can take a long .me, typically between one and two years, because it involves preparing a
prospectus and crea.ng an interest among poten.al investors. The equity shares need to be valued
and the issue process needs to be administered. Since with the reverse takeover shares in the
private company are exchanged for shares in the listed company and no new capital is being raised,
the process can be completed much quicker.
2. An IPO is an expensive process and can cost between 3% and 5% of the capital being raised due to
involvement of various par.es, such as investment banks, law firms, etc, and the need to make the
IPO aBrac.ve through issuing a prospectus and marke.ng the issue. A reverse takeover does not
require such costs to be incurred and therefore is considerably cheaper.
3. In periods of economic downturn, recessions and periods of uncertainty, an IPO may not be
successful. A lot of senior managerial .me and effort will be spent, as well as expenditure, with
nothing to show for it. On the other hand, a reverse takeover would not face this problem as it does
not need external investors and it is not raising external finance, but is being used to gain from the
poten.al benefits of going public by geqng a lis.ng.

Disadvantages rela7ve to an IPO

1. The ‘shell’ listed company being used in the reverse takeover may have hidden liabili.es and may be
facing poten.al li.ga.on, which may not be obvious at the outset. Proper and full due diligence is
necessary before the process is started. A company undertaking an IPO would not face such
difficul.es.
2. The original shareholders of the listed company may want to sell their shares immediately aMer the
reverse takeover process has taken place and this may affect the share price nega.vely. A lock-up
period during which shares cannot be sold may be necessary to prevent this. [NB: An IPO may need a
lock-up period as well, but this is not usually the case.]
3. The senior management of an unlisted company may not have the exper.se and/or understanding
of the rules and regula.ons which a listed company needs to comply with. The IPO process normally
takes longer and is more involved, when compared to a reverse takeover. It also involves a greater
involvement from external experts. These factors will provide the senior management involved in an
IPO, with opportuni.es to develop the necessary exper.se and knowledge of lis.ng rules and
regula.ons, which the reverse takeover process may not provide.
4. One of the main reasons for gaining a lis.ng is to gain access to new investor capital. However, a
smaller, private company which has become public through a reverse takeover may not obtain a
sufficient analyst coverage and investor following, and it may have difficulty in raising new finance in
future. A well-adver.sed IPO will probably not face these issues and find raising new funding to be
easier.
Q53. Explain the poten7al advantages of undertaking the divestment by means of
(i) a sell-off and
(ii) a demerger

Solu7on.

There are several advantages that are common to both a sell-off and a demerger. Both offer a way to
restructure a company. Restructuring may be to dismantle a conglomerate enterprise in order to focus
upon a core competence, to react to a change in the strategic focus of the company, or to sell off
unwanted assets.

Both forms of restructuring may result in 'reverse synergy', where the separated elements of the
business are worth more than the value of the old combined business.

The main difference between a sell-off and a demerger is that the sell-off involves the sale of part of the
company to a third party, for cash or some other considera.on. Thus control of these assets is lost.
However, funds are raised which can be used to develop other parts of the business, or to make
acquisi.ons.

A demerger need not involve a change in ownership. One or more new companies are created and the
assets of the old company are transferred to these new companies.

Q54. Discuss the advantages and disadvantages of organic growth and growth by acquisi7on.

Solu7on.

Organic growth permits an organisa.on to carefully plan its strategic growth in line with specified
objec.ves. However, when entering new markets there may be a substan.al cost involved with
researching markets and/or buying-in exper.se.

Lead-.mes in establishing produc.on facili.es are rela.vely long in comparison with growth by
acquisi.on, which may be a significant factor when trying to establish or to consolidate market share.

Growth by acquisi7on is oMen not as carefully planned, and may be a rapid reac.on to a perceived
market opportunity.

It permits quick access to new markets or new technology, or the elimina.on of a compe.tor.

Informa.on about the financial and other aBributes of a poten.al acquisi.on target is inevitably less
complete than a company's own internal management informa.on.

This makes the valua.on of a poten.al acquisi.on target difficult, and projec.ons of future cash flows
less precise.

The poten.al for significant savings is oMen not fully known un.l aMer the acquisi.on, when aBempts
are made to ra.onalise and integrate the opera.ons of the two companies.
Growth by acquisi.on may be the only way to achieve very rapid growth.
Q55. Discuss the advantages and disadvantages of borrowing funds from the domes7c banking system
compared to the Euromarkets.

Solu7on.

The Euromarkets can be used for very large borrowings, but if a company wants to borrow a large
amount of money from domes.c banks it might find that some banks are unwilling or unable to offer
such large loans. Syndica.on might have to be used to spread the risk between several banks.

Domes.c banking systems are normally subject to more regula.on and reserve requirements than the
Euromarkets, leading to wider spreads between borrowing and lending rates.

The cost of borrowing on domes.c markets is oMen slightly more expensive than the Euromarkets, and
may involve fixed or floa.ng charges on corporate assets as security for loans.

Few Euromarket loans require security. Domes.c market loans may be either fixed or floa.ng rate, but
bank loans are more likely to be at a floa.ng rate.

An argument in favour of using the domes.c banking system is that banks are specialists in analysing and
monitoring debts. If large loans are agreed by banks this is a sign of good credit standing, and may
facilitate access to cheaper funds on other capital markets.

Q56. Explain briefly, in general terms, why many acquisi7ons in the real world are not successful.

Solu7on.

Common reason why acquisi.ons are unsuccessful

• Lack of industrial or commercial fit: Failure can result from a takeover where the acquired en.ty
turns out not to have the product range or industrial posi.on that the acquirer an.cipated.

• Lack of goal congruence: This may apply not only to the acquired en.ty but, more dangerously, to
the acquirer, whereby disputes over the treatment of the acquired en.ty might well take away the
benefits of an otherwise excellent acquisi.on.

• ‘Cheap’ purchases: The ‘turn around’ costs of an acquisi.on purchased at what seems to be a bargain
price may well turn out to be a high mul.ple of that price.

• Paying too much: The fact that a high premium is paid for an acquisi.on does not necessarily mean
that it will fail. Failure would result only if the price paid is beyond that which the acquirer considers
acceptable to increase sa.sfactorily the long term wealth of its shareholders.

• Failure to integrate effec7vely: An acquirer needs to have a workable and clear plan of the extent to
which the acquired company is to be integrated. The plan must address such problems as differences
in management styles, incompa.bili.es in data informa.on systems, and con.nued opposi.on to the
acquisi.on by some of the acquired en.ty’s staff.
Q57. Explain why synergy might exist when one another company.

Solu7on.

Synergy might exist for several reasons, including:

Economic efficiency gains

Gains might relate to economies of scale or scope.

Economies of scale occur through such factors as fixed opera.ng costs being spread over a larger
produc.on volume, equipment being used more efficiently with higher volumes of produc.on, or bulk
purchasing reducing costs.

Economies of scope may arise from reduced adver.sing and distribu.on costs when companies have
complementary resources. Economies of scale and scope relate mainly to horizontal acquisi.ons and
mergers. Economic efficiency gains may also occur with backward or forward ver.cal integra.on which
might reduce produc.on costs as the 'middle man' is eliminated, improve control of essen.al raw
materials or other resources that are needed for produc.on, or avoid disputes with what were
previously suppliers or customers.

Economic efficiency gains might also result from replacing inefficient management as the result of a
merger/takeover.

Financial synergy

Financial synergy might involve a reduc.on in the cost of capital and risk.

The variability (standard devia.on) of returns of a combined en.ty is usually less than the weighted
average of the risk of the individual companies. This is a reduc.on in total risk, but does not affect
systema.c risk, and hence might not be regarded as a form of synergy by shareholders. However,
reduced variability of returns might improve a company's credit ra.ng making it easier and/or cheaper
to obtain a loan.

Another possible financial synergy exists when one company in an acquisi.on or merger is able to use
tax shields, or accumulated tax losses, which would otherwise have been unavailable to the other
company.

Market power

A large organisa.on, par.cularly one which has acquired compe.tors, might have sufficient market
power to increase its profits through price leadership or other monopolis.c or oligopolis.c means.
Q58. Explain the circumstances in which the Black-Scholes op7on pricing (BSOP) model could be used
to assess the value of a company, including the data required for the variables used in the model.

Solu7on.

Using the BSOP model in company valua.on rests upon the idea that equity is a call op.on, wriBen by
the lenders, on the underlying assets of the business. If the value of the company declines substan.ally
then the shareholders can simply walk away, losing the maximum of their investment. On the other
hand, the upside poten.al is unlimited once the interest on debt has been paid.

The BSOP model can be helpful in circumstances where the conven.onal methods of valua.on do not
reflect the risks fully or where they cannot be used. For example if we are trying to value an unlisted
company with unpredictable future growth.

There are five variables which are input into the BSOP model to determine the value of the op.on.

Proxies need to be established for each variable when using the BSOP model to value a company. The
five variables are: the value of the underlying asset, the exercise price, the 7me to expiry, the vola7lity
of the underlying asset value and the risk free rate of return.

For the exercise price, the debt of the company is taken. In its simplest form, the assump.on is that the
borrowing is in the form of zero coupon debt, i.e., a discount bond. In prac.ce such debt is not used as a
primary source of company finance and so we calculate the value of an equivalent bond with the same
yield and term to maturity as the company’s exis.ng debt. The exercise price in valuing the business as a
call op.on is the value of the outstanding debt calculated as the present value of a zero coupon bond
offering the same yield as the current debt.

The proxy for the value of the underlying asset is the fair value of the company’s assets less current
liabili.es on the basis that if the company is broken up and sold, then that is what the assets would be
worth to the long-term debt holders and the equity holders.

The 7me to expiry is the period of .me before the debt is due for redemp.on. The owners of the
company have that .me before the op.on needs to be exercised, that is when the debt holders need to
be repaid.

The proxy for the vola7lity of the underlying asset is the vola.lity of the business’ assets.

The risk-free rate is usually the rate on a risk less investment such as a short-term government bond.
Q59. Discuss whether or not an increase in dividends is likely to benefit the shareholders
of a publicly quoted company.

Solu7on.

Differing views exist about the effect of dividends on a company’s share price. Several authors, including
Modigliani and Miller (M&M) have argued that dividend policy is irrelevant to the value of a company.
Such arguments are formulated under very restric.ve assump.ons. If such condi.ons existed then
shareholders would not value an increase in dividend payments. However, there are several real world
factors that are likely to influence the preference of shareholders towards dividends or reten.ons (and
hence expected capital gains). These include:

1. Taxa.on. In some countries dividends and capital gains are subject to different marginal rates of
taxa.on, usually with capital gains being subject to a lower level of taxa.on than dividends.

2. Brokerage fees. If shareholders have a preference for some current income and are paid no or low
dividends their wealth will be reduced if they have to sell some of their shares and incur brokerage
fees in order to create current income. Shareholders, especially ins.tu.onal shareholders, oMen rely
on dividends to meet their cash flow needs.

3. The corporate tax treatment of dividends may favour a higher level of reten.on.

4. If the company needs to finance new investment it is usually cheaper to use retained earnings. This is
because most forms of external finance involve issue costs, which, in the case of equity finance can
be three percent or more or the funds raised.

5. Informa.on asymmetry may exist between shareholders and directors. If the market is not strong
form efficient shareholders may have less complete knowledge of the likely future prospects of the
company than directors, which may influence the shareholders’ desire for dividends or capital gains

The implica.ons of an increase in dividends need to be considered by the company. Dividends are oMen
regarded as an unbiased signal of a company’s future prospects, an increase in dividends signalling
higher expected earnings. A company should be careful to inform its shareholders of the reason for any
increase in dividends.

A further factor is the use that the company can make of funds. If the company has a number of possible
posi.ve NPV investments then shareholders will normally favour undertaking these investments (at least
on financial grounds), as they will lead to an increase in shareholder wealth. As previously men.oned
internal finance is cheaper than external finance and, ceteris paribus, would lead to a preference for
reten.ons. If, however, the company has rela.vely few projects and can only invest surplus cash in
money market or other financial investments at an expected zero NPV, rela.ve high dividends or share
repurchase might be preferred.
Q60. Explain the key factors, iden7fied by researchers in the field of behavioural finance, that
contribute to irra7onal and poten7ally detrimental financial decision making.

Solu7on.

Pioneers in the field of behavioural finance have iden.fied the following factors as some of the key
factors that contribute to irra.onal and poten.ally detrimental financial decision making.

Anchoring

Investors have a tendency to aBach or ‘anchor’ their thoughts to a reference point even though it may
have no logical relevance to the decision at hand e.g. investors are oMen aBracted to buy shares whose
price has fallen considerably because they compare the current price to the previous high (but now
irrelevant) price.

Gambler's fallacy

Investors have a tendency to believe that the probability of a future outcome changes because of the
occurrence of various past outcomes e.g. if the value of a share has risen for seven consecu.ve days,
some investors might sell the shares, believing that the share price is more likely to fall on the next day.
This is not necessarily the case.

Herd behaviour

This is the tendency for individuals to mimic the ac.ons (ra.onal or irra.onal) of a larger group. There
are a couple of reasons why herd behaviour happens. The first is the social pressure of conformity most
people are very sociable and have a natural desire to be accepted by a group. The second is the common
ra.onale that it's unlikely that such a large group could be wrong. This is especially prevalent in
situa.ons in which an individual has very liBle experience.

Overreac7on and availability bias

According to the EMH, new informa.on should more or less be reflected instantly in a security's price.
For example, good news should raise a business' share price accordingly. Reality, however, tends to
contradict this theory. OMen, par.cipants in the stock market predictably overreact to new informa.on,
crea.ng a larger than appropriate effect on a security's price.
Q61. Explain how business risk and financial risk are related; and how risk mi7ga7on and risk
diversifica7on can form part of a company’s risk management strategy.

Solu7on.

The owners or shareholders of a business will accept that it needs to engage in some risky ac.vi.es in
order to generate returns in excess of the risk free rate of return. A business will be exposed to differing
amounts of business and financial risk depending on the decisions it makes.

Business risk depends on the decisions a business makes with respect to the services and products it
offers and consists of the variability in its profits. For example, it could be related to the demand for its
products, the rate of innova.on, ac.ons of compe.tors, etc.

Financial risk relates to the vola.lity of earnings due to the financial structure of the business and could
be related to its gearing, the exchange rate risk it is exposed to, its credit risk, its liquidity risk, etc.

A business exposed to high levels of business risk may not be able to take excessive financial risk, and
vice versa, as the shareholders or owners may not want to bear risk beyond an acceptable level.

Risk management involves the process of risk iden.fica.on, of assessing and measuring the risk through
the process of predic.ng, analysing and quan.fying it, and then making decisions on which risks to
assume, which to avoid, which to retain and which to transfer.

As stated above, a business will not aim to avoid all risks, as it will want to generate excess returns.

Dependent on factors such as controllability, frequency and severity of the risk, it may decide to
eliminate or reduce some risks from the business through risk transfer.

Risk mi.ga.on is the process of transferring risks out of a business through, for example, hedging or
insurance, or avoiding certain risks altogether.

Risk diversifica.on is a process of risk reduc.on through spreading business ac.vity into different
products and services, different geographical areas and/or different industries to minimise being
excessively exposed by focusing exclusively on one product/service.

Q62. List are the assump7ons of Black & Scholes Model.

Solu7on.

1. The op.on is a ‘European’ style op.on.

2. The share price follows a log-normal distribu.on and is con.nuously traded.
3. Unrestricted short selling of the underlying security is permiBed.
4. There are no market fric.ons such as taxes or transac.on costs.
5. No dividends are paid during the life of the op.on.
Q63. Explain (in general terms and without presen7ng any calcula7ons) how the Black Scholes op7on
pricing model can be used to value the equity and the debt of a company.

Solu7on.

Use of the Black Scholes model in equity valua7on

The basic idea is that, because of limited liability, shareholders can walk away from a company when the
debt exceeds the asset value. However, when the assets exceed the debts, those shareholders will keep
running the business, in order to collect the surplus.

Therefore, the value of shares can be seen as a call op.on owned by shareholders – we can use the Black
Scholes model to value such an op.on.

Of course it is therefore cri.cal that we can correctly iden.fy the five variables to input into the Black
Scholes model.

For equity valua.on, these are as follows:

t = .me un.l debt is redeemed

r = risk free interest rate
s = standard devia.on of the assets' value
Pa = fair value of the firm’s assets
Pe = amount owed to bank.

Note that the value of Pe will not just be the redemp.on value of the debt. The amount owed to the
bank incorporates all the interest payments as well as the ul.mate capital repayment. In fact, the value
of Pe to input into the Black Scholes model should be calculated as the theore.cal redemp.on value of
an equivalent zero coupon debt.

Use of the Black Scholes model in debt valua7on

The Black Scholes model can also be used in debt valua.on. The value of a (risky) bond issued by a
company can be calculated as the value of an equivalent risk free bond minus the value of a put op.on
over the company's assets.

Therefore, if the value of equity has already been calculated as a call op.on over the company's assets
(as explained above), the value of debt can then be calculated using the put call parity equa.on.
Q64. Briefly discuss the possible benefits to Parent Co of disposing Subsidiary Co through a
management buy-out.

Solu7on.

Management buy-out costs may be less for Parent Co compared with other forms of disposal such as
selling the assets of the company or selling the company to a third party.

It may be the quickest method in raising funds for Parent Co compared to the other methods.

There would be less resistance from the managers and employees, making the process smoother and
easier to accomplish.

Parent Co may retain a beBer rela.onship and beneficial links with Subsidiary Co and may be able to
purchase or sell goods and services to it, as seems to have happened with the management service.

It may be able to get a beBer price for the company. The current management and employees possibly
have the best knowledge of the company and are able to make it successful. Therefore they may be
willing to pay more for it.

It may increase Parent Co’s reputa.on among its internal stakeholders such as the management and
employees. It may also increase its reputa.on with external stakeholders and the markets if it manages
the disposal successfully and efficiently.