AFM Study Notes (2022)

AFM - NOTES
By Mr. ASAD EJAZ
(Association of Chartered Certified Accountants)
www.ACCAGlobalBox.com
Downloaded from - www.ACCAGlobalBox.com
Asad Ejaz
ACA, FCCA, Adv Dip MA CIMA, CISA, APFA.
AFM
Advanced
Financial
Management
AFM: Advanced Financial Management Study Notes
Table of Content
S Content Page
No. No.
1 Basic of Investment Appraisal 1
2 Cost of Capital 17
3 Advanced Investment Appraisal 34
4 International Investment Appraisal 44
5 Acquisition and Merger 53
6 Financial Reconstruction 72
7 Business Reorganization 78
8 Risk Management-Currency 83
9 Risk Management-Interest 94
10 Black Scholes and Real options 101
11 Dividends 105
12 Maths & Formula Tables 107
( www.ACCAGlobalBox.com )
The Investment Appraisal

Capital Budgeting Cycle Steps
➢ Idea Generation
)
➢ Project Screening
FA
➢ Financial & Non-financial Evaluation
AP
➢ Approval
A,
➢ Implementation
IS
➢ Ongoing Monitoring
C
➢ Post Completion Audit
A,
IM
C
Financial Evaluation Methods
A
Basic Methods Advanced Methods
M
❖ Payback Period ❖ Net Present Value NPV
ip
❖ Internal Rate of Return (IRR)
.D
❖ Discounted Payback Period

Cash flows
v
Ad
Relevant Cash flows Irrelevant Cash flows

➢ Future Incremental Cash flows ➢ Sunk Cost/ Historical Cost
A,
➢ Opportunity Cost ➢ Non-cash Depreciation

C
➢ Indirect Costs
C
➢ General Overheads
F
➢ Central Office Overheads

A,
C
(A
Assumptions of Cashflows
az
➢ If Cash flows arise during the period, then it is assumed as it arises at the end
Ej
of that period.
➢ If cash flow arise at the start of the period then it is assumed as if it arises at
ad
the end of the preceding period

As
➢ Period ‘0’ is not a period, instead it represents start of period ‘1’.
Payback Period
It is the time period required to recover the initial investment
SKANS School of Accountancy 1

Decision rule
If Payback Period < Target Payback, Accept the Project. Else Reject the
Project
ILUSTRATION 1
)
Rough Ltd has the opportunity to invest in an investment with the following initial
FA
costs and returns:
AP
A
($000s)
A,
Initial investment (100)
IS
Cash flows Yr 1 50
C
Yr 2 40
A,
Yr 3 30
IM
Yr 4 25
Yr 5 20
C
Residual value Yr 5 5
A
The cost of capital is 10%. And the target ARR is 20%
M
Company uses the straight line method for depreciation.Required:
ip
.D
Using the data of ILUSTRATION 1, Calculate the Payback Period?

v
Ad
Solution
A,
C
F C
A,
C
(A
az
Ej
ad
As

Payback Period of Consistent Cashflows

Consistent cashflows are cashflows that arises in the series of same cashflows over
a period. In case of constant cashflows payback period can be estimated by the
formula
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
)
FA
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤
Key Advantages & Disadvantages
AP
Advantages Disadvantages
A,
1. It is simple to use (calculate) and 1. It does not give a measure of return,
IS
easy to understand as such it can only be used in
C
2. The method is often used as the addition to other investment
A,
first screening device to identify appraisal methods.
IM
projects which are worthy of 2. It does not normally consider the
further investigation. impact of discounted cash flow
C
although a discounted payback
A
may be calculated (see later).
M
3. It only considers cash flow up to the
ip
payback, any cash flows beyond

.D
that point are ignored.

v
Ad
A,
DISCOUNTED CASH FLOW

C
C
The application of the idea that there is a TIME VALUE OF MONEY. What this
F
A,
means is that money received today will have more worth than the same
amount received at some point in the future.
C
(A
Why would you rather have $1,000 now rather than in one year’s time?
az
$1,000 Now ≠ $1,000 1 year Later

Ej
Therefore, we can express Present Values in terms of Future Values using the
ad
following formula of Compounding:

As
FV = PV × (1 + r)n
Where
PV - Present value.

FV - Future value.
r- Rate of Discount, interest or cost of capital per period.
n - Number of periods (years)
The opposite of compounding, where we have the future value (eg an expected
)
FA
cash inflow in a future year) and we wish to consider its value in present value
terms.
AP
Revising the formula
A,
𝐹𝑉
Or PV = FV × (1 + r)-n
IS
𝑃𝑣 = (1 + r)n
C
A,
IM
C
A
M
ip
Net Present Values (NPV)

.D
The NPV of the project is the sum of the PVs of all cashflows that arise as a result
v
of doing the project.

Ad
Decision Rule:-
A,
If NPV of the project, discounted at cost of capital, is positive then Accept the
C
project, Else Reject the Project.

F C
ILUSTRATION 2
A,
Required:
C
(A
Using the data of ILUSTRATION 1, Calculate the NPV of the Project?

az
Ej
ad
As

Solution
)
FA
AP
A,
IS
C
A,
IM
C
A
M
ip
.D

v
Ad
1. A project with a positive NPV 1. Non-financial managers may have
A,
increases the wealth of the difficulty understanding the

C
company’s, thus maximise the concept.

C
shareholders wealth.
F
2. The speed of repayment of the

A,
2. Takes into account the time value original investment is not

C
of money. highlighted.
(A
az
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Internal Rate of Return (IRR)

ad
IRR is the total rate of return offered by an investment over its life. Calculative, The
rate of return at which the NPV equals zero.
As
Formula to calculate
𝐴
𝐼𝑅𝑅 = 𝑎% + [𝐴−𝐵 𝑋(𝑏 − 𝑎)] %
Where:

a%- Small Disc. Rate at which NPV is Preferably positive

A- NPV at a%
b%- Bigger Disc. Rate at which NPV is Preferably negative
B- NPV at b%
Decision Rule
)
If IRR of the project > Cost of capital, Accept the project. Else Reject the Project
FA
ILUSTRATION 4
AP
Required:
Using the data of ILUSTRATION 1 and assuming the NPV at 10% is $34,000 , Calculate the
A,
IRR of the Project?
IS
C
Solution
A,
IM
C
A
M
ip
v .D
Ad
A,
C
F C
A,
C

(A
az
1. More easily understood than NPV 1. Does not indicate the size of the
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by non-accountant being a investment, thus the risk involve in

percentage return on investment. the investment.
ad
2. It Assumes that the Cashflows will be

As
reinvested at the rate of IRR

3. It
can give conflicting signals with
mutually exclusive project.

4. Ifa project has irregular cash flows

there is more than one IRR for that
project (multiple IRRs).
Discounted Payback Period
)
FA
The time period in which initial investment is recovered in terms of present value
is known as discounted payback period.
AP
It is same as simple payback period. The only difference is that the discounted
A,
cash flows are used instead of simple cash flows for calculation.
IS
Decision Rule
C
If Discounted Payback Period < Target Discounted Payback, Accept the
A,
Project. Else Reject the Project
IM
ILUSTRATION 5
C
Required:
A
Using the data of ILUSTRATION 1, Calculate the Discounted payback of the Project?
M
ip
Solution
v.D
Ad
A,
C
F C
A,
C
(A
az
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ad
As

Consistent Cashflows
If Cashflows arises in a series of equal cashflows then it is called Consistent
Cashflows. These are of two Types:
)
FA
Annuity: If Consistent cashflow for a certain Period. e.g Y1-5 or Y3-7
Perpetuity: If Consistent cashflow for infinite period e.g. Y1-∞ or Y3-∞
AP
Present Values of Consistent Cashflows
A,
IS
𝟏−(1 + r)-n
The Annuity Factor (A.F) = 𝒓
C
𝟏
The Perpetuity Factor (P.F) =
A,
𝒓
IM
Annuity Perpetuity
C
If Cashflows Start from Period 1.
A
Annual Cashflow X A.F Annual Cashflow X P.F
M
e.g. Y1-5 $10,000 at Disc. Rate of 10% e.g. Y1-∞ $10,000 at Disc. Rate of 10%
ip
$10,000 X 3.791 =$37,910 $10,000 X (1/10%) = $100,000
.D
If Cashflows Start from Period 0.

v
Annual Cashflow X (A.F + 1) Annual Cashflow X (P.F + 1)

Ad
e.g. Y0-5 $10,000 at Disc. Rate of 10% e.g. Y0-∞ $10,000 at Disc. Rate of 10%
$10,000 X (3.791+1) =$47,910 $10,000 X ((1/10%)+1) = $110,000
A,
If Cashflows Start from Subsequent Period e.g. Year 3.

C
Annual Cashflow X A.F of No. of Annual Cashflow X P.F X D.F of

F C
periods X D.F of preceding period preceding period from Start

A,
from Start
e.g.Y4-8 $10,000 at Disc Rate of 10% e.g. Y4-∞ $10,000 at Disc. Rate of 10%
C
(A
$10,000 X 3.791 X 0.751 =$28,470 $10,000 X (1/10%) X 0.751 = $75,100

az
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ad
As

Performa for Net Present Value

Years 0 1 2 3 4
Sales X X X X
)
FA
Variable Cost (X) (X) (X) (X)
AP
Incremental Fixed Cost (X) (X) (X) (X)
A,
Operating Cashflows X X X X
IS
Tax Expense (X) (X) (X) (X)
C
A,
Tax Savings on Capital X X X X
IM
Allowances
C
Change in Working (X) (X) (X) (X) X
A
Capital M
Initial Investment (X)
ip
.D
Scrap Value X
v
Net Cash flows (X) X X X X

Ad
X Discount Factor X X X X X
A,
Present Values (X) X X X X

C
C
Net Present Value X

F
A,
C
(A
az
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ad
As

The Finance Cost

The Finance Cost will be a relevant cashflow however it will NOT become the part of
cashflows. This is because it is part of cost of capital.
Effect of Taxation in investment appraisal
)
FA
➢ Timing of Tax Cashflows: Either in the same year or in arrears.
➢ Calculation of cashflows
AP
o Tax on Operating Cashflows: Operational Cashflows X Rate of Tax
o Tax Savings on Capital Allowances: Calculate the capital
A,
Allowances/ Balancing Allowances and then multiply with Tax
IS
Rate.
C
Example
A,
Initial Investment = 2000
IM
Capital Allowances = 25% reducing balance
C
A
Useful life = 4 years, Tax rate = 30% payable in arrears, Scrap Value =
M
500
ip
Years Written Capital Tax Timing
.D
Down Allowances Savings

Value @ 25% @ 30%
v
Ad
1 2000 500 150 2
2 1500 375 113 3

A,
C
3 1125 281 84 4
C
4 844 344 103 5

F
A,
Effect of Inflation in investment appraisal:

C
Inflation may be defined as a general increase in prices, leading to general

(A
decline in the real value of money, (decrease in purchasing power).

az
➢ Real Rate of Return (r): Without inflation rate

Ej
➢ Money/ Nominal Rate of Return (m): With Inflation rate

ad
➢ General Inflation (i)

As
The relationship between real and money interest is given below (also see tables)
(1 + m) = (1 + r) (1 + i)

If General inflation rate is If Specific inflation rate is
Money Real Method Money
)
FA
AP
Inflate all Do not Inflate each
Cash flows inflate Cash variable cash flow
A,
with its specific
IS
with general flows.
C
inflation rate. Discount all inflation rate.
A,
Discount Cash flows Discount with
IM
these cash with real money cost of
C
flows with discount capital (calculated
A through real rate
M
and general
ip
.D
preferred inflation rate.

v
Method
Ad
A,
C
F C
A,
C
(A
az
Ej
ad
As

Nominal Operational Cashflow = Real Operational Cashflows X ( 1+ i)n

Sometimes Examiners gives the value in year 1 terms instead of current prices
terms then
Nominal Operational Cashflow = Real Operational Cashflows ( 1+ i)n-1
)
FA
AP
Working Capital Change
Every business requires working capital for its operations.
A,
IS
Calculate working capital change in two steps:
C
1. Calculate working capital requirement one year in advance e.g.
A,
working capital is 10% of sales at the start of each year
IM
2. Calculate incremental working capital by taking change of each year
C
working capital
A
3. In last year, there will be an assumption that all working capital will be
M
recovered (Only for project and not for ongoing business)
ip
ILUSTRATION 5
.D
A company is considering to invest in a project with its life of 4 years. Total

v
working capital required at the beginning of each year is as follows:

Ad
Year Cashflows
A,
$’000
C
1 500
F C
2 700
A,
3 1000
C
(A
4 600
az
Required:
Ej
Calculate the working capital cashflows of each year to be included in NPV

calculation?
ad
As
Solution

Capital rationing
A limit on the level of funding available to a business, there are two types
➢ Hard capital rationing
➢ Soft Capital rationing
)
FA
Hard capital rationing
AP
Externally imposed. Usually by banks
Due to:
A,
Wider economic factors (e.g. a credit crunch)
IS
1.
C
2. Company specific factors
A,
(a) Lack of asset security
IM
(b) No track record
Poor management team.
C
(c)
A
Soft capital rationing M
ip
Internally imposed by senior management.
.D
Issue: Contrary to the rational aim of a business which is to maximise

v
shareholders’ wealth (i.e. to take all projects with a positive NPV) Reasons:
Ad
1. Wish to concentrate on relatively few projects

A,
2. Unwillingness to take on external funds

C
C
3. Only a willingness to concentrate on strongly profitable projects

F
Single period capital rationing

A,
i.e. available finance is only in short supply during the current period, but will
C
(A
become freely available in subsequent periods.

Assumptions of Single Period Capital Rationing
az
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➢ All projects are divisible

➢ Projects will be lost if not undertaken in current year (can not be postponed)
ad
➢ The risk & uncertainty and strategic importance of all projects is same
As
Divisible – An entire project or any fraction of that project may be undertaken.

Projects displaying the highest profitability indices (i.e. NPV/Initial Investment) will
be preferred.

Indivisible – An entire project must be undertaken, since it is impossible to accept

part of a project only. In this event different combination of projects are assessed
with their NPV and the combination with the highest NPV is chosen.
Steps for divisible project

1. Calculate the NPV of each Investment
)
FA
2. Calculate the Profitability indices
3. Ranking
AP
4. Investment Plan
A,
Note: In case of Mutually exclusive Projects, the project with the Higher Profitability
IS
Indices will be ranked and lower will be ignored.
C
Example – Divisible
A,
Project Investment NPV PI Ranking
IM
(NPV/Investment)
C
A 1,000 500 0.5 3rd
A
B 1,200 700
M 0.58 2ND
ip
C 800 300 0.375 4TH
.D
D 700 450 0.642 1ST

v
Ad
Available Funds – $ 2,500

A,
The Investment Schedule

C
C
Project Investment NPV

F
D 700 450
A,
C
B 1,200 700
(A
A 600 300
az
Total 2,500 1,450

Ej
We will do Project D and B complete and Project A 60%.

ad
Example – Non-Divisible
As
Project Investment NPV

A 1,000 500
B 1,200 700

C 800 300
D 700 450
Available Funds – $ 2,500
Projects Combination Total Investment Total NPV
)
FA
A,B 2,200 1,200
AP
A,C,D 2,500 1,250
B,C 2,000 1,000
A,
B,D 1,900 1,150
IS
We will choose combination of A,C,D because it’s gives the best NPV of $1,250
C
A,
IM
Multi-Period Capital Rationing
C
You will remember that when there is limited capital in only one year (single-
A
M
period capital rationing) then we rank the projects based on the NPV per $
invested (the profitability index).
ip
.D
However, it is more likely in practice that investment is needed in more than one
year and that capital is rationed also in more than one year. This situation is known
v
as multi-period capital rationing and the solution requires using linear

Ad
programming techniques.
A,
Sensitivity Analysis
C
C
A technique that considers a single variable at a time and identifies by how much
F
that variable has to change for the decision to change (from accept to reject).
A,
Formula to calculate sensitivity of a particular cashflow: -

C
(A
𝑁𝑃𝑉
𝑆𝑒𝑛𝑠𝑒𝑡𝑖𝑣𝑖𝑡𝑦 (%) = 𝑋 100%
az
𝑃𝑉 𝑜𝑓 𝑎𝑟𝑒𝑎 𝑜𝑓 𝑠𝑒𝑛𝑠𝑡𝑖𝑣𝑖𝑡𝑦
Ej
Formula to calculate sensitivity of cost of capital:-

ad
𝐼𝑅𝑅 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

𝑆𝑒𝑛𝑠𝑒𝑡𝑖𝑣𝑖𝑡𝑦 (%) = 𝑋 100%
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
As

It indicates which variables may impact most upon the net present value (critical
variables) and the extent to which those variables may change before the
investment results in a negative NPV
)
FA
AP
A,
IS
C
A,
IM
C
A
M
ip
v .D
Ad
A,
C
F C
A,
C
(A
az
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As

The Cost of Capital

Risk and Return
The relationship between risk and return is easy to see, the higher the risk, the
higher the required to cover that risk.
)
FA
Overall Return
AP
A combination of two elements determine the return required by an investor for
A,
a given financial instrument.
IS
Risk-free return – The level of return expected of an investment with zero risk to the
C
investor.
A,
Risk premium – The amount of return required above and beyond the risk-free
IM
rate for an investor to be willing to invest in the company investor to be willing to
C
invest in the company
A
M
Degree of Risk
ip
.D
Risk Free High Risk

v
Ad
A,
C
Government Secured Un- Preference Ordinary

C
Debt Loans Secured Shares Shares

F
A,
The WACC
C
(A
Weighted Average Cost of Capital (WACC)

Cost of Equity (Ke) Cost of Debt (Kd) Cost of Preference (Kp)
az
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Cost of equity: the rate of return that is expected by the equity holders of the
company. The symbol used to represent cost of equity is Ke.
ad
Cost of debt: this is the after-tax return expected by the debt holders of the
As
company. The symbol used to represent after-tax cost of debt is Kd(1 – t).
Cost of preference shares: the return expected by the preference shareholders
of the company. The symbol used to represent cost of preference shares is Kp
Cost of Equity
This may be calculated in one of two ways:

1. Dividend Valuation Model (DVM).

2. Capital Asset Pricing Model (CAPM).
Dividend Valuation Model

𝑑𝑑
𝐾𝐾𝑒𝑒 = 𝑃𝑃1 + 𝑔𝑔
)
0
FA
Where,
 D1 = next year dividend = Do (1 + g)
AP
 Po = Current Ex-market value of equity share
 g = sustainable growth rate
A,
Difference between cum dividend and ex dividend price
IS
Ex-dividend price (P0) is the market price excluding dividend and cum-dividend
price is the market price including dividend.
C
Cum-Dividend Price
A,
Less: Dividend
IM
Ex-Dividend Price
C
Estimating Growth
A
There are 2 main methods of determining growth:
M
1 THE AVERAGING METHOD
ip
.D
𝑑𝑑 1
𝑔𝑔 = ( 0�𝑑𝑑 ) �𝑛𝑛 − 1
v
Ad
𝑛𝑛
where
A,
C
do = current dividend
F C
dn = dividend n years ago

A,
g = sustainable growth rate

C
(A
ILUSTRATION 1
az
Munero Ltd paid a dividend of 6p per share 8 years ago, and the current
Ej
dividend is 11p. The current share price is $2.58 ex div

ad
Required:
As
Calculate the cost of equity
Solution

GORDON’S GROWTH MODEL

g=rb
where
r = return on reinvested funds
b = proportion of funds retained
)
FA
ILUSTRATION 2
The ordinary shares of Titan Ltd are quoted at $5.00 ex div. A dividend of 40p is
AP
just about to be paid. The company has an annual accounting rate of return of
12% and each year pays out 30% of its profits after tax as dividends.
A,
IS
Required:
C
Estimate the cost of equity
A,
SOLUTION
IM
C
A
M
ip
v .D
Ad
A,
C
Capital Asset Pricing Model

C
A model that values financial instruments by measuring relative risk. The basis of
F
A,
the CAPM is the adoption of portfolio theory by investors.

Portfolio theory
C
Risk and Return

(A
The basis of portfolio theory is that an investor may reduce risk with no impact
az
on return as a result of holding a mix of investments.

Ej
ad
As

Risk of
portfolio
(σ)
)
FA
AP
A,
No. of shares in portfolio
IS
C
Systematic and non-systematic risk
A,
If we start constructing a portfolio with one share and gradually add other
shares to it we will tend to find that the total risk of the portfolio reduces as
IM
follows:
C
Initially substantial reductions in total risk are possible; however, as the
portfolio becomes increasingly diversified, risk reduction slows down and
A
eventually stops.
M
The risk that can be eliminated by diversification is referred to as
ip
unsystematic risk. This risk is related to factors that affect the returns of
.D
individual investments in unique ways, this may be described as company

specific risk.
v
Ad
The risk that cannot be eliminated by diversification is referred to as

systematic risk. To some extent the fortunes of all companies move
A,
together with the economy. This may be described as economy wide risk.
The relevant risk of an individual security is its systematic risk and it is on this
C
C
basis that we should judge investments. Non-systematic risk can be

F
eliminated and is of no consequence to the well-diversified investor.

A,
Implications
C
(A
1. If an investor wants to avoid risk altogether, he must invest in a portfolio

consisting entirely of risk-free securities such as government debt.
az
2. If the investor holds only an undiversified portfolio of shares he will suffer

Ej
unsystematic risk as well as systematic risk.

ad
3. If an investor holds a ‘balanced portfolio’ of all the stocks and shares

As
on the stock market, he will suffer systematic risk which is the same as
the average systematic risk in the market.
4. Individual shares will have systematic risk characteristics which are
different to this market average. Their risk will be determined by the

industry sector and gearing (see later). Some shares will be more risky
and some less.
β (beta) factor
The method adopted by CAPM to measure systematic risk is an index β. The
β factor is the measure of a share’s volatility in terms of market risk
)
The β factor of the market as a whole is 1. Market risk makes market returns
FA
volatile and the β factor is simply a yardstick against which the risk of other
AP
investments can be measured.
The β factor is critical to applying the CAPM, it illustrates the relationship of
A,
an individual security to the market as a whole or conversely the market
return given the return on an individual security.
IS
For example, suppose that it has been assessed statistically that the returns
C
on shares in XYZ plc tend to vary twice as much as returns from the market
A,
as a whole, so that if market Risk Premium returns went up by 6%, XYZ’s
returns would go up by 12% and if market risk premium returns fell by 4%
IM
then XYZ’s returns would fall by 8%, XYZ would be said to have a β factor of
C
2.
A
Risk Premium Return
M
It is the difference between the market return and risk free rate of return
ip
The security market line

.D
The security market line gives the relationship between systematic risk and
v
return. We know 2 relationships.

Ad
1 The risk-free security

A,
This carries no risk and therefore no systematic risk and therefore has a βeta
C
of zero. Generally, the government securities like Treasury Bills or GILTs are
C
considered risk free

F
A,
2 The market portfolio

C
This represents the ultimate in diversification and therefore contains only

(A
systematic risk. It has a βeta of 1.

az
Ej
ad
As

)
FA
AP
A,
IS
C
A,
IM
C
From the graph, it can be seen that the higher the systematic risk, the higher
A
the required rate of return. M
The relationship between required return and risk can be shown using the
following formula:
ip
Ke = Rf + (Rm - Rf) β
.D
where
v
Ke = required return from individual security

Ad
β = Beta factor of individual security

Rf = risk-free rate of interest
A,
Rm = return on market portfolio

C
F C
ILUSTRATION 3
A,
The market return is 15%. Kite Ltd has a beta of 1.2 and the risk free return is 8%
C
Required:
(A
What is the cost of capital?

az
SOLUTION
Ej
ad
As

The Cost of Debt
Kd for irredeemable debt

𝑖𝑖(1−𝑡𝑡)
𝐾𝐾𝑑𝑑(𝑛𝑛𝑛𝑛𝑛𝑛) = 𝑃𝑃𝑜𝑜
𝑋𝑋100%
)
Where
FA
i = interest paid
AP
t = marginal rate of tax
P0 = ex interest (similar to ex div) market price of the loan stock.
A,
ILUSTRATION 4
IS
The 10% irredeemable loan notes of Rifa plc are quoted at $120 ex-interest.
C
Corporation tax is payable at 30%
A,
Required:
IM
What is the cost of debt net?
C
A
SOLUTION M
ip
v .D
Ad
A,
C
Kd for redeemable debt

C
The Kd(net) for redeemable debt is given by the IRR of the relevant cash flows.
F
A,
The relevant cash flows would be:

C
Years Cashflows
(A
0 Market Value of Loan Note (P0)

1-n Annual Interest Payment i(1-T)
az
n Redemption Value
Ej
ILUSTRATION 5
ad
Woodwork Ltd has 10% loan notes quoted at $102 ex interest redeemable in 5
As
years’ time at par. Corporation tax is paid at 30%.
Required:

Solution
)
FA
AP
A,
IS
C
A,
IM
Convertible debt
C
A loan note with an option to convert the debt into shares at a future date
A
with a predetermined price. In this situation, the holder of the debt has the
M
option therefore the redemption value is the greater of either:
The share value on conversion or
ip
1.
.D
2. The cash redemption value if not converted

v
Ad
ILUSTRATION 6
Continuing the ILUSTRATION 5, it has come to know that the loan note was
A,
convertible into 40 ordinary shares. The expect share price at the redemption
C
date will expected to be $2.6

F C
Required:
A,

C
(A
Solution
az
Ej
ad
As

Non-tradeable debt
A substantial proportion of the debt of companies is not traded. Bank loans and
other non-traded loans have a cost of debt equal to the coupon rate adjusted
for tax.
Kd(net) = Interest (Coupon) rate x (1 – T)
)
FA
ILUSTRATION 7
Trout has a loan from the bank at 12% per annum. Corporation tax is charged
AP
at 30%.
A,
Required:
IS
C
A,
Solution
IM
C
The Calculation of WACC
A
M
Source Proportion (in Market Values) X WACC
ip
Cost
.D
Equity Proportion of Equity X Ke X%

v
Debt Proportion of Debt X Kd(net) X%

Ad
Preference Proportion of Preference X Kp X%

Share
A,
WACC X%
C
C
ILUSTRATION 8
F
Bar plc has 20m ordinary 25p shares quoted at $3, and $8m of loan notes
A,
quoted at $85. The cost of equity has already been calculated at 15% and the
C
cost of debt (net of tax) is 7.6%.

(A
Required:
az
Calculate WACC?
Ej
ad
Solution
As

Capital Structure and WACC

Gearing Theories
The Traditional View
Cost of equity: At relatively low levels of gearing the increase in gearing will have
relatively low impact on Ke. As gearing rises the impact will increase Ke at an
)
increasing rate
FA
Cost of debt: There is no impact on the cost of debt until the level of gearing is
AP
prohibitively high. When this level is reached the cost of debt rises.
A,
IS
C
A,
IM
C
A
M
ip
v .D
Ad
Gearing (D/E)
A,
C
Key point : As the gearing level increases initially the WACC will fall. However,
C
this will happen upto an appropriate gearing level. After that level WACC will
F
start to rise. There is an optimal level of gearing at which the WACC is minimized
A,
and the value of the company is maximized.

C
(A
The MM View (With-out Tax)

Cost of equity: Ke rises at a constant rate to reflect the level of increase in risk
az
associated with gearing.

Ej
Cost of debt: There is no impact on the cost of debt.

ad
Assumptions:
As
1. Perfect capital market exist where individuals and companies can borrow
unlimited amounts at the same rate of interest.
2. Debt is risk free.

The increase in Ke directly compensates for the substitution of expensive

equity with cheaper debt. Therefore, the WACC is constant regardless of
the level of gearing.
)
FA
AP
A,
IS
C
A,
IM
C
A
If the weighted average cost of capital is to remain constant at all levels of
M
gearing it follows that any benefit from the use of cheaper debt finance must
be exactly offset by the increase in the cost of equity.
ip
.D
The MM View (With Tax)

v
In 1963 M&M modified their model to include the impact of tax. Debt in this
Ad
circumstance has the added advantage of being paid out pre-tax. The
effective cost of debt will be lower as a result.
A,
C
Implication: As the level of gearing rises the overall WACC falls. The company
C
benefits from having the highest level of debt possible.

F
A,
C
(A
az
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As

CAPM and MM Combined

Systematic Risk
Equity Beta (βe)
)
Business Risk Financial Risk
FA
Asset Beta (βa)
AP
A,
Business Risk
Risk due to nature of the business operations or the type of industry.
IS
Financial Risk
C
Risk due to inclusion of debt in the financial structure. This Risk will be zero if the
A,
company or investment is 100% equity financed.
Equity Beta (βe)
IM
It is the Beta of a geared Company so it has both Financial and Business Risk
C
Asset Beta (βa)
A
It is the Beta of an un-geared Company so it has Business Risk only.
M
The Formula
𝑽𝑽
ip
• 𝜷𝜷𝒂𝒂 = 𝑽𝑽 +𝑽𝑽 𝒆𝒆(𝟏𝟏−𝑻𝑻) 𝑿𝑿 𝜷𝜷𝒆𝒆
𝒆𝒆 𝒅𝒅
.D
Where:
v
Ve = Market Value of Equity

Ad
Vd = Market Value of Debt

A,
Should Company’s WACC be Used for Investment Appraisal?

C
If the Investment’s Business risk and Financial Risk are similar to the company,
C
then we use the company’s WACC to appraise the investment. However, if any
F
of the risk is different then we have to calculate investment specific cost of

A,
capital.
C
(A
Project Specific Cost of Capital

Following are the steps of calculating the project specific cost of capital.
az
Financial Risk is Different Business Risk is Different

Ej
1. Chose the βe of the company. 1. Identify a proxy company

2. Calculate the βa using the having same Business Risk
ad
company’s current financial 2. Chose the βe of that proxy

As
structure (Un-gearing Beta). company.

𝑉𝑉𝑒𝑒 3. Calculate the βa using the Proxy
𝛽𝛽𝑎𝑎 = 𝑋𝑋 𝛽𝛽𝑒𝑒
𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 (1 − 𝑇𝑇) company’s current financial
3. Calculate βe of the investment structure (Un-gearing Beta).
using capital structure to be

used for the investment. (Re- 𝑉𝑉𝑒𝑒

𝛽𝛽𝑎𝑎 = 𝑋𝑋 𝛽𝛽𝑒𝑒
gearing Beta) 𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 (1 − 𝑇𝑇)
𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 (1 − 𝑇𝑇) 4. Calculate βe of the investment
𝛽𝛽𝑒𝑒 = 𝑋𝑋 𝛽𝛽𝑎𝑎
𝑉𝑉𝑒𝑒 using capital structure to be
4. Use βe to calculate Ke using used for the investment. (Re-
CAPM gearing Beta)
)
𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 (1 − 𝑇𝑇)
FA
5. Calculate WACC
𝛽𝛽𝑒𝑒 = 𝑋𝑋 𝛽𝛽𝑎𝑎
𝑉𝑉𝑒𝑒
AP
5. Use βe to calculate Ke using
CAPM
A,
6. Calculate WACC
IS
ILUSTRATION 9
C
Techno, an all equity agro-chemical firm, is about to invest in a diversification in
A,
the consumer pharmaceutical industry. Its current equity beta is 0.8, whilst the
IM
average equity β of pharmaceutical firms is 1.3. Gearing in the pharmaceutical
industry averages 40% debt, 60% equity. Corporate debt is available at 5%.
C
Rm = 14%, Rf = 4%, corporation tax rate = 30%.
A
Required:
M
What would be a suitable discount rate for the new investment if Techno were to
ip
finance the new project with 30% debt and 70% equity?
v .D
Solution
Ad
A,
C
F C
A,
C
(A
az
Ej
ad
As

Advanced Techniques
Combined Cost of Capital
Sometimes we need to estimate post project (post Acquisition) Cost of Capital.

If the project’s Business and Financial Risk of the project is similar to the previous
)
FA
operations of the business then it’s WACC after Acquisition will not change.
AP
If the Business Risk is similar but only the Financial risk is different then we can use
the Company’s Asset Beta and by using the post project gearing we can first
A,
estimate Beta equity and eventually WACC.
IS
However, if the Business Risk is different then, the post project WACC will be
C
different.
A,
IM
It is important to note that the main element to change will be Beta of the Co. So,
we have to estimate the Weighted Average Beta. It is worth Mentioning that we
C
will always combine Beta (or taking Average of Beta) at an Asset Level.
A
M
Company Project Post Project
ip
(different nature Operations) (different Nature Operations) (Combine)
.D
Pre-Acquisition Co. Target Co. Post-Acquisition Co.

βe (Co.) βe (Inv.)
v
Ad
Un-gear Un-gear
A,
C
βa (Co.) βa (Inv.)
F C
X Proportion of Business X Proportion of Business

A,
Proportion of βa (Co.) Proportion of βa (Co.)

C
(A
ADD βa (Combine)
az
Gear
Ej
ad
βe (Combine)
As
Ke using CAPM
WACC

Exam Note
In the Exam you may have to work it Backwards as well.
ILUSTRATION 10
Techno, an agro-chemical firm, is about to invest in a diversification in the
consumer pharmaceutical industry. Its current equity beta is 1.8 and the firm has
)
50 million share with the share price of $2 each. The firm also have Debt Worth $50
FA
million.
AP
The average equity β of pharmaceutical firms is 1.3 and the Gearing in the
A,
pharmaceutical industry averages 40% debt, 60% equity.
IS
This new Pharmaceutical project will require an additional investment of $20
C
million and the company intends to finance 50% by raising debt from the bank
A,
and remaining by issuing new ordinary shares.
IM
Corporate debt is available at 5%. Rm = 14%, Rf = 4%, corporation tax rate = 30%.
C
A
Required: M
What would be the cost of capital of Techno after the new investment assuming
that the share price will not be effected by the investment.
ip
.D
Solution
v
Ad
A,
C
F C
A,
C
(A
az
Ej
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As

Credit rating
An Alternative used in AFM to derive cost of debt is based on credit spread. Credit
spread is the measure of credit risk associated with company and is generally
calculated by a credit rating agency, presented in a table.
Note: the above table is presented in basis points and 1%=100 basis Points
)
FA
The formula
AP
Kd(net) = (Risk Free Rate + Credit Spread)(1-T)
A,
IS
C
A,
IM
C
A
M
ip
v .D
Ad
Criteria for Establishin Credit rating

A,
 Country Risk: No debt will be rated higher than the country

 Universal Importance: The company’s standing relative the other countries
C
 Industry Risk: The strength and weakness of the industry.

C
 Industry Position: The companies position in the Industry.

F
A,
 Management Evaluation: The companies Planning, Control, Policies

Performance.
C
 Accounting Quality: The Accounting Policies, Qualification, etc.

(A
 Earning Protection: ROCE, Net Profit Margins,

az
 Financial Gearing
 Cash Flow Adequacy
Ej
 Financial Flexibility: Evaluation of Financial Needs, Relationship with

ad
Investors, Covenants
As
Credit Migration
Credit Rating of a borrower may change due to any event and is known as credit
migration. This generally effects the market value of the bond.
Predicting Credit Rating (Kaplan Urwitz Model)

For Quoted Companies

Y=5.67 + 0.011F + 5.13π – 2.36S – 2.85L + 0.007C – 0.87β-2.90σ
For Un-Quoted Companies
Y=4.41 + 0.011F + 6.4π – 2.56S – 2.72L + 0.006C – 0.53σ
Where:
Y is the score of the model
)
F is the size of firms measured in total assets
FA
Π is net income/total assets
AP
S is deb status (subordinated = 1, otherwise = 0) Unsubordinated debt has priority
claim.
A,
L is gearing
C is interest cover (PBIT/Interest)
IS
β is beta of company (CAPM)
C
σ is the variance.
A,
IM
C
A
M
ip
v.D
Ad
A,
C
F C
A,
C
(A
az
Ej
ad
As

Advanced Investment Appraisal
Modified Internal Rate of Return
)
A criticism of the IRR method is that in calculating the IRR, an assumption is that
FA
all cash flows earned by the project can be reinvested to earn a return equal to
AP
the IRR.
A,
Modified internal rate of return is a calculation of the return from a project, as a
percentage yield, where it is assumed that cash flows earned from a project will
IS
be reinvested to earn a return equal to the company’s cost of capital
C
A,
Using MIRR for project appraisal
IM
It might be argued that if a company wishes to use the discounted return on
C
investment as a method of capital investment appraisal, it should use MIRR rather
A
than IRR, because MIRR is more realistic because it is based on the cost of capital
as the reinvestment rate
M
ip
MIRR Formula
.D
1
v
𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑃𝑃ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑛𝑛

Ad
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = � � (1 + 𝑟𝑟𝑒𝑒 ) − 1
𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑃𝑃ℎ𝑎𝑎𝑎𝑎𝑎𝑎
A,
Example
C
C
A business requires a minimum expected rate of return of 8% on its investments. A

F
proposed capital investment has the following expected cash flows and NPV.
A,
C
Year Cash flow Discount Present Value

(A
$ $
0 (60,000) 1.000 (60,000)
az
1 (20,000) 0.926 (18,520)

Ej
2 30,000 0.857 25,710

3 50,000 0.794 39,700
ad
4 40,000 0.735 29,400

As
5 (10,000) 0.681 (6,810)
NPV + 9,480
The modified internal rate of return (MIRR) is:

WHY USE MIRR INSTEAD OF IRR

➢ MIRR assumes reinvestment of cash flows at cost of capital which is more
realistic in case of having a very high IRR.
➢ In case of non-conventional cash flows MIRR produces a single answer.
➢ It is easier to calculate than IRR.
➢ MIRR decision is in line with NPV decision so there are lesser chances of
)
FA
conflict.
AP
Problems of MIRR
➢ It is not an industry preferred method.
A,
➢ MIRR is also a relative measure so it still does not consider size of the project
IS
C
Free cash flow
You might be need to perform a forecast of free cash flows in order to appraise
A,
an investment including a business valuation.
IM
C
Free cash flow is the amount of cash generated by a company or business during
a specified period of time (say one year) minus the cash payments that the
A
company or business is obliged to make. Essential payments include taxation
M
payments and capital expenditure to replace ageing non-current assets
ip
(‘replacement’ capital expenditure). Free cash flow is therefore the amount of

.D
cash generated by the company that management are able to decide how to
use.
v
Ad
Free cash flows for equity (FCFE) might be used in the valuation of the share
A,
capital of a company; whereas free cash flow for the firm (FCF) would be used
for the valuation of the entire business, equity plus debt capital.
C
C
Free cash flow for the firm

F
A,
Free cash flow for the firm is the amount of free cash flow generated by the
business as a whole, regardless of the source of finance. It is therefore calculated
C
without deducting interest payments as an essential cash payment.

(A
az
Calculating free cash flow for the firm

Method 1
Ej
Earnings before interest and tax (EBIT) X

ad
Less tax on EBIT (X)

Add back: Depreciation (and any other non-cash expenditures) X
As
Less: Working capital increases (X)

Plus: Working capital decreases X
Less: Replacement capital expenditure (X)
Free cash flow XX

Free cash flow for equity

Free cash flow for equity is the amount of free cash flow after deduction of interest
payments.
Method 1
Earnings before interest and tax (EBIT) X
)
Less: Interest payments (X)
FA
Profit after Interest X
AP
Less tax on Profit after interest (X)
Add back: Depreciation (and any other non-cash expenditures) X
A,
Less: Working capital increases (X)
Plus: Working capital decreases X
IS
Less: Replacement capital expenditure (X)
C
Free cash flow for equity XX
A,
Method 2
IM
Free Cashflow to Firm X
C
Less: Interest payments (X)
A
Add: Tax savings on interest M X.
Free cash flow for equity XX
ip
Free cash flow and dividend capacity

.D
The ability of a company to source capital investments internally depends not

v
only on the amount of cash flows generated, but also on dividend policy.
Ad
However, the Maximum dividend that the firm should pay equals to free cashflow
to equity.
A,
C
An entity could distribute all of its free cash flow to equity but in practice only a
C
proportion is paid out. A company will retain part of the free cash flow to reinvest
F
in the business.
A,
C
Adjusted present value method (APV method) of project appraisal

(A
Problem with NPV

az
 The total return from the project is based on two different risk i.e. business
Ej
risk and financial risk. But NPV doesn’t segregate these returns between
business risk and financial risk.
ad
As
 It doesn’t incorporate the issue cost of raising the debt finance
 It doesn’t incorporate the subsidy benefits from the subsidized loans

An alternative approach to capital investment appraisal is the adjusted present

value (APV) method.
The APV method may be used when a business entity is considering an investment
in a project that will have different business risks and different financial risks from
its current operations. For example, a business entity might wish to evaluate an
)
investment in a different industry or a different market, and raise new capital to
FA
finance the investment.
AP
The APV method is an alternative to calculating a new cost of equity and a new
A,
WACC, for example using the Modigliani-Miller formulae or the asset beta
formula.
IS
C
The decision rule for the APV method
A,
A project is financially viable and should be undertaken if its adjusted present
IM
value (APV) is positive. The APV of a project contains two elements, and is
calculated as follows:
C
A
Base case NPV M
Add: Present Value of Tax Sheild
Adjusted Present Value .
ip
.D
Base case NPV

v
The base case NPV is calculated assuming the project is financed entirely by
Ad
equity, so that the method of financing is ignored.

A,
It is therefore necessary to calculate the cost of equity in an all-equity company

C
in the same industry or the market in which the capital investment will be made.
C
This can be done by either of the two methods

F
A,
CAPM 𝐾𝐾𝑒𝑒(𝑢𝑢𝑢𝑢) = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝑎𝑎 (𝑅𝑅𝑚𝑚 − 𝑅𝑅𝑓𝑓 )

C
(A
𝑉𝑉
MM 𝐾𝐾𝑒𝑒(𝑔𝑔) = 𝐾𝐾𝑒𝑒(𝑢𝑢𝑢𝑢) + (1 − 𝑇𝑇)(𝐾𝐾𝑒𝑒(𝑢𝑢𝑢𝑢) − 𝐾𝐾𝑑𝑑 ) 𝑉𝑉𝑑𝑑
𝑒𝑒
az
Present value of the tax shield (PV of the tax relief on interest costs)
Ej
When a new project is financed wholly or partly with new debt finance, there will
ad
be tax relief on the interest. The PV of these tax benefits should be included in the
APV of the project.
As
The PV of the tax relief on interest is calculated by:

 Calculate the issue cost (normally grossed up)
 Calculating the savings in taxation arising as a consequence of interest, for
each year of the project

 Calculating the savings from the subsidized Loan net of tax

 Discounting these to a present value, using the pre-tax (before-tax) rate of
interest or risk-free rate on the debt as the discount rate.
Reasons for using the APV method

The APV method might be used in preference to adjusting the weighted average
)
cost of capital (WACC) of the company using the Modigliani-Miller formulas. This
FA
is for several reasons.
AP
 The APV method does not rely on assumptions about the new WACC of the
A,
firm if the project is undertaken.
 The APV method allows for the specific tax relief on the borrowing to
IS
finance the project, and does not assume that the debt will be perpetual
C
debt.
A,
 The APV method allows for other costs, such as the costs of raising new
IM
finance (issue costs).
C
It might be argued that APV is therefore the best method of estimating the effect
A
of a new investment on the value of the business entity, and the wealth of its
M
shareholders.
Comparison of NPV and APV methods
ip
.D
The NPV and the base case NPV are calculated using the same cash flows,
v
except that the cash flows for the base case NPV should exclude ‘other costs’
Ad
such as financing costs, whereas these are included in the calculation of an NPV.
A,
ILUSTRATION
C
Davis Co is considering diversifying its operations different from its main area of
C
business (food manufacturing) into the plastics business. It wishes to gauge an

F
investment project, which involves the acquisition of a molding machine that

A,
costs $450,000. The project is predicted to produce net annual operating cash
C
flows of $220,000 for every of the three years of its life. At the top of this point its
(A
scrap value are going to be zero.

The assets of the project can support debt finance of 40% of its initial cost. Davis
az
is considering borrowing this amount from two different sources

Ej
First, an area government organization has offered to lend $90,000, with no issue
costs, at a subsidized rate of interest of 3% every year. The full $90,000 would be
ad
repayable after 3 years.

As
The rest of the debt would be provided by the bank, at Davis' normal interest rate.
This loan would be repaid in three equal annual
instalments. The balance of finance is going to be provided by a placing of recent
equity.
Issue costs are going to be 5% of funds raised for the equity placing and 2% for
the loan. Debt issue costs are allowable for corporation tax. The industry has a

mean equity beta of 1.368 and a mean debt: equity ratio of 1:5 at market values.
Davis' current equity beta is 1.8 and 20% of its long-term capital is represented by
debt which is generally regarded to be risk free.
The risk-free rate is 10% pa and therefore the expected return on a mean market
portfolio is 15% Corporation tax is at a rate of 30%, payable within the same year.
The machine will attract a 70% initial tax allowable allowance and the balance is
)
to be written off evenly over the rest of the asset life and is allowable against tax.
FA
The firm is for certain that it'll earn sufficient profits against which to offset these
AP
allowances.
Required:
A,
Calculate the adjusted present value and determine whether the
project should be accepted?.
IS
C
SOLUTION
A,
IM
C
A
M
ip
v.D
Ad
A,
C
F C
A,
C
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Debt Capacity
The ability of the business to raise further debt is known as debt capacity.
Duration
It is the weighted average time required to obtain cash flows from the return
phase of project. Another way of saying this is that the duration of the project is
)
FA
the time required to cover one half of the value of investment returns.
AP
Steps to calculate duration
A,
 Find discounted cash flows of return phase
IS
 Find total present value of return phase by adding all discounted cash flows
calculated above
C
 Find proportion of all present values by dividing each present value with
A,
total
IM
 Find weighted average years by multiplying relevant years to above
proportion
C
 Add all weighted years as duration
A
M
Duration can be used in capital investment appraisal to assess the payback on
ip
the project. Unlike payback and discounted payback, however, it takes into
consideration the total expected returns from the entire project (at their
.D
projected value), not just returns up to the payback time.

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If duration of the project is short relative to the life of the project- for example, if
the duration is less than half the expected total life of the project-this means the
A,
most of the returns from the project will be recovered in the early years.
C
C
If duration of the project is large portion of the total life of the project – for example
F
if duration is 75% or more of the total life of the project – this means the most of
A,
the returns from the project will be recovered in later years.

C
(A
It could therefore be argued that duration is the best available method of

assessing the time for an investment to provide its return on capital invested.
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To calculate duration for a project, the negative cash flows at the beginning of
the project are ignored. Duration is calculated using cash flows from the year that
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the cash flows start to turn positive.

As
However, if there are any negative cash flows in any year after the cash flow turn
positive, such as in the final year of the project, these negative cash flows are
included in the calculation of duration (as negative cash flows).

Advantages
 Duration captures both the time value of money and the whole of the cash
flows of a project.
 It is also a measure which can be used across projects to indicate when the
bulk of the project value will be captured.
)
 This measure captures both the full value and time value of the project it is
FA
recommended as a superior measure to either payback or discounted
AP
payback when comparing the time taken by different projects to recover
the investment involved.
A,
Disadvantages
IS
C
 Its disadvantage is that it is more difficult to conceptualize than payback
A,
and may not be employed for that reason.
IM
 It is not an industry preferred Method.
C
Modified Duration
A
It is a measure of sensitivity of the price of bond to a change in interest rates.
M
ip
Macaulay Duration / (1 + GRY) *GRY is gross Redemption Yeild
.D
This can be used to calculate proportionate change in bond price.

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ΔP = - Modified Duration X ΔY X P
A,
Where: Δ is change, P is for price and Y is for yield

C
C
Risk in Investment Appraisal

F
Monte Carlo simulation

A,
Monte Carlo simulation is a method of measuring an expected outcome by

C
means of generating multiple trials or iterations, in order to determine the

(A
expected value of the outcome and also to measure the variability or risk. Monte
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Carlo simulation depends on the fact that by taking the outcomes of a large
number of individual random events (iterations), an accurate measurement of
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the expected value and probability distribution of the outcome will be obtained.
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The use of Monte Carlo simulation modelling is made possible by computers,

which can produce a large number of iterations quickly, to produce a reliable
As
expected value and probability distribution of the outcome.
Steps in Simulation
 Specify major variable.
 Market size.

 Selling price.
 Market growth rate.
 Market share.
 Investment required.
 Residual value of investment.
 Specify the relationship b/w variables to calculate an NPV Sales revenue =
)
market size x market share x selling price.
FA
 Net cash flow = sales revenue (variable cost + fixed cost = taxation) etc
AP
 Simulate the environment and computerized model will generate a range
of NPV across all probability levels
A,
Merits of simulation
IS
 It includes all possible outcomes in the decision making process.
C
 It is relatively easily understood technique.
A,
 It has a wide variety of applications (inventory control, component
IM
replacement, corporate models, etc.)
C
Demerits of simulation
A
 Models can become extremely complex and the time and cost involved in
M
their construction can be more than is gained from the improved decisions.
 Probability distributions may be difficult to formulate
ip
 Accuracy of data output depends upon the accuracy of data input.

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Project value at risk

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Annual volatility of a project

Volatility in this context refers to the possibility that a project’s NPV might be much
A,
higher or lower than the expected value of the NPV. In capital investment
C
appraisal, annual volatility is the standard deviation of the PV of annual cash flows
C
from the project.

F
A,
For any item with a variable value, for which volatility is measured, the statistical
C
volatility increases with the length of the time period over which it is measured.
(A
The relationship is as follows:

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σL = σS × √T
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where
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As
σL is the volatility (standard deviation) over the longer time period

σS is the volatility (standard deviation) over the shorter time period
T is the number of short time periods that make up the long time period.
Example

Expected annual cash flows are $100,000 and the volatility of annual cash flows
is $15,000. Cash flows in any one year are independent of what the cash flows
were in the previous years.
Over a five year period, expected cash flows are $500,000 and the five-year
)
volatility of cash flows is: $15,000 × √ 5 = $33,541.
FA
AP
Project value at risk
A project value at risk is the maximum amount, at a given confidence level, by
A,
which the actual NPV from a project will be worse than the expected value of
the NPV. It can therefore be used to assess the risk in a capital investment project,
IS
which should help management to decide whether or not to invest in the project,
C
taking into consideration the risk as well as the expected return (expected NPV).
A,
Calculating project value at risk
IM
Example
C
A
A simulation model has been used to calculate the expected value of the NPV
M
of a project. This is $282,000. The project has an expected life of ten years, and
the volatility of the PV of the annual cash flows is $30,000.
ip
.D
Normal distribution tables can also be used to calculate the following

v
probabilities:
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At the 95% confidence level, the project value at risk is:

A,
N(0.95) 30,000 √10 = 1.645 × $94,868 = $156,058.

C
At the 95% confidence level, the NPV will not be worse than $282,000 – $156,058
C
= $125,942.
F
A,
At the 99% confidence level, the project value at risk:

C
N(0.99) 30,000 √10 = 2.327 × $94,868 = $220,758.

(A
At the 99% confidence level, the NPV will not be worse than $282,000 - $220,758 =
$61,242.
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International Investment Appraisal
Why Investment Overseas
)
Investing in Overseas may give:
FA
AP
 access to new markets and/or enable it to develop a market for its
products in locations
A,
 Being involved in marketing and selling products in overseas markets may
also help it gain an understanding of the needs of customers, which it may
IS
not have had if it merely exported its products.
C
 Easier and cheaper access to raw materials it needs. It would therefore
A,
make good strategic sense for it to undertake the overseas investment.
 Access to cheaper labour resources and/or access to expertise
IM
 Closer proximity to markets, raw materials and labour resources may
C
reduce costs and gain edge against its competitors. For example,
A
transportation and other costs related to logistics may be reduced if
M
products are manufactured close to the markets where they are sold.
 Risk, such as economic risk resulting from long-term currency fluctuations,
ip
may be reduced where costs and revenues are matched and therefore
.D
naturally hedged.
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 Increase its reputation because it is based in the country within which it

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trades leading to a competitive edge against its rivals.

 International investments might reduce both the unsystematic and
A,
systematic risks for shareholders only hold well diversified portfolios in

C
domestic markets, but not internationally.

F C
Factors affecting foreign investment decisions

A,
C
Companies considering a major capital investment in another country also need

(A
to consider:
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 the exchange rates.

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 the risk of exchange controls and similar cash flow restrictions

 taxation on remittances to the parent company’s country.
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 Transfer Pricing
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Exchange rate risk (currency risk)
Exchange rate risk, also called FOREX risk and currency risk, is the financial risk from
the possibility (or probability) that foreign currency exchange rates will change.
The risk is greater when a foreign exchange rate is volatile, and moves by fairly

large amounts over time, often both up and down. Two aspects to exchange rate
risk are:
 Transaction risk
 Translation risk.
 Economic risk
)
FA
Transaction risk: affects any company that receives income or makes payments
AP
in a foreign currency. It is the risk that when a quantity of foreign currency will be
received or paid at a time in the future, the exchange rate might move between
A,
‘now’ and the time that receipt or payment of the currency will occur. As a
consequence of the exchange rate movement the amount of money received
IS
or paid in the company’s own currency (domestic currency) will be less or more
C
than originally expected.
A,
Exchange rates can move favorably as well as adversely, but the main concern
IM
for risk management is with the possibility and consequences of an adverse
C
exchange rate movement.
A
M
Translation risk: is a financial reporting risk for companies with foreign investments.
For the purpose of preparing consolidated financial accounts, the financial
ip
statements of foreign subsidiaries must be translated into the reporting currency

.D
of the parent multinational. Changes in the exchange rate create gains or losses
on translation, which affect the reported results of the group.
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Economic risk: Also called forecast risk, refers to when a company’s market value
A,
is continuously impacted by an unavoidable exposure to currency fluctuations

C
Predicting Exchange rates

F C
A,
In the exam question we may have to estimate future expected exchange rates.
This can be calculated by using purchase power parity i.e.
C
(A
1 + ℎ𝑎𝑎
𝑆𝑆1 = 𝑆𝑆0 𝑋𝑋
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1 + ℎ𝑏𝑏
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Where:
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S1 = Future Expected Spot Rate

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S0 = Current Spot Rate
ha = Rate of inflation in country a

hb = Rate of inflation in country b
EXAMPLE:
The Current Dollar Sterling exchange rate is given $1.7050/£ Expected Inflation
Rates are:
)
FA
Year USA UK
AP
1 5% 2%
2 3% 4%
A,
3 4% 4%
IS
C
Solution:
A,
IM
C
A
M
ip
v .D
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A,
C
F C
A,
C
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Converting currencies
Quotes Quoted Example Converting foreign currency to home

(Pakistan) currency
Direct Local/foreign Rs. 160/1$ Foreign Currency cashflows X FOREX rates
eg. $10= (160 X 10) = Rs. 1,600
)
FA
Indirect Foreign/local $.00625/Re. Foreign Currency cashflows ÷ FOREX rates
eg. $10 = (10/0.00625) = Rs. 1,600
AP
A,
Note: Do opposite for converting Home Currency to Foreign
IS
Political risk
C
A,
Political risk is the risk for an international company that the government of a
IM
foreign country might take action that affects the operations or profitability of its
C
investment in its country, or places restrictions on the ability of the foreign
subsidiary to remit interest or dividends to the parent country.
A
M
Exchange controls
ip
.D
Exchange controls are actions by a government that:

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 restrict or prevent the ability of its own nationals to buy foreign currency in
order to make payments to foreign suppliers
A,
 restrict or prohibit the payment of interest or dividends to foreign investors,

including payments from subsidiary companies to their foreign parent 
C
restrict the flow (payments) of capital out of the country.

F C
Example
A,
C
Dar Co. is a US based co. and is planning to invest in Pakistan. Due to economic
(A
conditions of Pakistan and to control balance of payment deficit the new govt.
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has proposed that no cashflows from foreign investment can be taken back until
3 years of investment. However, the govt has offered the foreign investors an
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interest rate of 13% for that period. Dar Co.’s net-cashflows and expected
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exchange rates estimation for the next 4 years are:

As
Year: 1 2 3 4
Net Cashflow (Rs.m) 35 40 45 38
Exchange rates (Rs/$) 155 160 168 175

Required:
Prepare the cashflows for home country under the above said circumstances.
Solution
)
FA
AP
A,
IS
C
A,
IM
C
A
M
ip
Taxation and international investment

.D
Presentation of Tax
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Operational cashflow X
A,
Tax on Operational Cashflow (X)

Tax savings on Capital Allowances X.
C
Net Cashflow XX
F C
A,
C
Less: Capital Allowances (X)

(A
Profit after Capital Allowances X

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Tax (X)
Add: Capital Allowances X.
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Net Cashflow XX
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Tax (W-1) (X)
As
Net Cashflow XX
Working 1
Less: Capital Allowances (X)

Profit after Capital Allowances X

Tax (X)
Tax Losses
)
When the project makes profit then the govt. charges tax on that and if the
FA
project suffers losses then the govt. gives relief on that. This relief usually first setoff
AP
against the profits from other projects in that case co. can claim savings
immediately. However, if there are no other profitable projects then these losses
A,
are carried forward against future profits and hence no tax savings are recoded
in the current period.
IS
C
Example
A,
Following are the Operational Cashflows for the next 3 years
IM
C
Years 1 2 3
Operational Cashflow (300) 400

A 1,000
M
ip
Capital Allowances are 200 each year on straight-line basis. The company do not
.D
have sufficient profits and hence any loss has to be carryforward. Rate of tax is
30% payable in the same year the liability arises.
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Required
A,
Prepare Net cashflows for the Next 3 Years

C
C
Solution
F
A,
C
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Withholding tax. Some countries levy a withholding tax on interest or dividends

paid by companies to foreign investors, including foreign parent companies.
Withholding tax is additional tax, reducing the net cash flows for the parent
company from its foreign subsidiary.
Double taxation agreements. Many countries have double taxation agreements
)
with each other. The purpose of a double taxation agreement is to prevent
FA
punitive taxation by taxing profits twice, once in each country. A double taxation
AP
agreement allows an international company to set off the tax payable in its own
country on the profits of or income received from a foreign subsidiary, against the
A,
tax already paid by the subsidiary in its own country. The effect of double taxation
agreements is to help to make international investments more attractive by
IS
avoiding excessive and punitive tax on the pre-tax returns that the investments
C
make.
A,
Example (Double Tax)
IM
C
Following are the rates of Taxation in home country and Foreign Currency. Est the
A
tax rate for each country in different situations assuming Double Tax Treaty exist
M
Situation 1 Situation 1 Situation 1
ip
Home Country 40% 25% 30%

.D
Foreign Country 30% 25% 40%

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Solution
A,
C
F C
A,
C
(A
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Calculation of Tax in Foreign Currency and home currency
 Calculate Tax in foreign currency and make part of foreign cashflows

 Calculate total tax in Home currency and include in additional cashflows
𝑇𝑇𝑇𝑇𝑇𝑇 𝑖𝑖𝑖𝑖 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶

𝑋𝑋 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 → 𝐶𝐶𝐶𝐶𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑖𝑖𝑖𝑖 ℎ𝑜𝑜𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
)
𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑖𝑖𝑖𝑖 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
FA
AP
Transfer Pricing and cashflows in foreign country
A,
If the foreign project is making sales in the home country then it should be
recorded in foreign country. This is because the activity belongs to foreign project.
IS
In that case the price needs to be converted from Home currency to foreign
C
currency first.
A,
Similarly, if the home country is transferring any component to Foreign project
IM
then the contribution will be recorded in ‘Additional Cashflows in Home Currency’
C
whereas the price will be recorded as cost in the Foreign currency cashflows.
A
Example
M
ip
A UK Based firm and is in considering to invest in USA. For that they need to transfer
.D
a component to USA which will have a transfer price of £20 and the UK firm will
incur a variable cost of £14. 1,000 units will have to be made for the first year and
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the exchange rate in year 1 is expected at $1.2355/£.

A,
Required
C
Prepare the cashflows to be included in foreign country as well as in home country

F C
A,
Solution
C
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Features of a foreign country investment appraisal
The features of investing in a foreign country include the following:
)
The investment could be a very high-risk investment, and you might be required
FA
to establish a special cost of capital for evaluating the project, possibly using the
AP
CAPM and a beta factor for the project.
A,
Most of the cash flows for the foreign investment will be in the currency of the
foreign country, although some cash flows might be in the currency of the parent
IS
company.
C
A,
If the foreign country is a developing country, there will probably be expectations
of high rates of inflation in future years and there might be restrictions on the
IM
amount of payments that can be made from the foreign country, due to
C
exchange control restrictions. This means that the cash profits from the project
A
might not be payable immediately in full as dividends to the investing company.
M
Steps of International Investment Cashflows and NPV
ip
.D
 Calculate all the relevant net cashflows related to foreign project directly
v
in the foreign currency.

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 Consider whether any restrictions are placed on remittances and if so,

calculate the cash flows actually received by the parent.
A,
 Convert the net flows into the domestic currency using the expected future
C
exchange rates
C
 Add any other domestic cash flows that arise in the home currency (e.g.
F
additional tax).
A,
 Discount the total net cash flows in the domestic currency at an

C
appropriate cost of capital.

(A
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Acquisition and Merger
Acquisition
)
An acquisition normally involves a larger company (a predator) acquiring smaller
FA
company (a target).
AP
Mergers
A,
A merger is in essence the pooling of interests by two business entities which results
IS
in common Ownership access to new markets and/or enable it to develop a
C
market for its products in locations
A,
IM
However, the financial management issues are broadly the same for mergers as
for acquisitions.
C
A
Types of Merger & Acquisition M
Horizontal integration
ip
.D
When two companies in the same industry, whose operations are very closely
v
related and are combined, integrate. This is known as horizontal merger or

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acquisition.
A,
Vertical integration
C
C
When two companies in the same industry, but from different stages of the
F
production chain are merged. This is known as vertical integration.

A,
C
Conglomerate integration
(A
When two or more companies which are completely unrelated businesses

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combine/merged & there is no common thread, such type of merger is known as

conglomerate. The main synergy lies with the management skills and brand
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name.
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Alternatives to acquisitions
As
A comparison of growth by acquisition and internal growth

Advantages of Acquisition
 By far the most important advantage of an acquisition is that growth is

achieved much more quickly. By making an acquisition, a company
immediately gets bigger. If the target for acquisition has been selected
well, the company should be able to move towards its strategic goals more
)
quickly than if it tried to grow internally.
FA
 It is often argued that when a target company is acquired, it should be
AP
possible to achieve 'synergies' and add value by increasing the combined
profits of the two companies. Synergy is explained in more detail later.
A,
 When a company is trying to grow its business in another country,
acquisition might be better than internal growth, because the company
IS
will acquire skilled employees who already understand the business, the
C
country, its laws and culture and its language.
A,
 Unless a company acquires available target businesses, its competitors
might acquire them instead and the strategic threat from the enlarged
IM
competitor might increase.
C
A
Advantages of Organic Growth M
 There is a high risk that the price paid for an acquisition will be too high, and
ip
the financial return from buying an over-valued company will be low.

.D
 Many acquisitions are failures. This means that an acquisition strategy is a

high- risk strategy. Hie reasons why acquisitions often fail are explained later.
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 With a strategy of internal growth, the company's management should be

able to plan and control the development of the business more effectively,
A,
because the practical problems associated with acquisitions do not arise.

C
The practical problems include difficulties with employees in the acquired

C
company and the management time needed to combine the systems of

F
the two companies after the acquisition.

A,
 An acquisition is not usually 'ideal' and there will be some features of the
C
target company that the acquirer might not want to buy. After the
(A
acquisition, the acquiring company might want to sell off unwanted parts
of the business. This can be a time-consuming process, and the prices
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obtained from selling off these operations and assets might be low.
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Criteria for choosing an acquisition target

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As
The choice of acquisition targets might be based on any of the following criteria:
Strategic aims and objectives. An acquisition target is usually selected because

acquiring the target would help the acquiring company to achieve its strategic

targets. For example, a company might be seeking to grow the business by

expanding its product range for its existing markets, or moving into new
geographical markets. Acquiring a suitable business would enable a company to
expand its product range or move into new geographical markets. Some
companies have pursued a strategy of buying up a large number of small
companies in a fragmented market, with the intention of becoming the largest
)
company and market leader.
FA
AP
Cost and relative size. Although there are occasional examples of small
companies acquiring much larger ones in a 'reverse takeover', target companies
A,
are usually selected because they are affordable.
IS
Opportunity and availability. In many cases, targets for acquisition are selected
C
because of circumstances. An opportunity to acquire a particular company
A,
might arise, and the acquiring company might decide to take the opportunity
whilst it is available.
IM
C
Potential synergy. Acquisition targets might possibly be selected because they
A
provide an opportunity to increase total profits through improvements in
M
efficiency. One reason for the success of private equity funds in acquiring target
companies has been their ability to achieve additional efficiencies and
ip
economies that the previous company management had been unable to do. A
.D
strategy of private equity funds might be to look for target companies that they
consider under-valued, with the intention of improving their operations and
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creating extra value.

A,
Synergy
C
Synergy is sometimes called the '2 + 2 = 5' effect. It is the concept that the
F C
combined sum of two separate entities after a merger or acquisition will be worth
A,
more than their sum as two separate entities. When two separate entities come
together into a single entity', opportunities might arise for increasing profits.
C
Synergies might be divided into three categories:

(A
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Revenue synergies
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Revenue synergies are increases in total sales revenue following a merger or

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acquisition, by increasing total combined market share. For example, if Company

A lias annual sales revenue of $500 million acquires Company B which has annual
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sales revenue of $200 million, the combined revenue of the two companies after
the merger might be, say, $750 million.

Revenue Synergy might occur in following circumstances
 The acquisition or merger creates an enlarged company that is able to

promote its brand more effectively, and market share increases because
customers are attracted by the new brand image.
 The acquisition or merger creates an enlarged company that is able to bid
)
for large contracts, such as contracts to supply the government, which the
FA
two companies were unable to do before they combined due to their
AP
smaller size.
Cost synergies
A,
IS
Cost synergies are reductions in costs as a consequence of a merger or takeover.
C
They might arise because it is possible to improve efficiency. For example, it might
A,
be possible to reduce the size and cost of administrative departments by
combining the administrative functions of the two companies. It is not unusual for
IM
takeovers to result in staff redundancies, partly for tins reason.
C
A
Cost synergies might also be possible by combining other activities, such as
combining warehouse facilities.
M
ip
Experience has shown, however, that companies often have difficulty in

.D
achieving planned cost synergies after a takeover, because combining the

activities of the two companies after the takeover is often a long and complex
v
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process.
A,
Financial synergies
C
A larger (combined) company or group might be able to raise finance in a

C
cheaper way. The enlarged company might have access to financial markets,
F
A,
such as the bond market, that the two individuals’ companies could not access
before the takeover, due to their smaller size.
C
(A
The larger company might also be seen as a lower credit risk, so that it is able to
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borrow from banks at a lower rate of interest.

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The high failure rate of acquisitions

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Many acquisitions fail, and do not provide the value for shareholders that was
As
expected when the acquisition was made. There are several reasons for failure.
 The purchase price paid for an acquisition is often too high.

 The expected synergies do not occur.

 There are serious problems with integrating the acquired company into the
new group.
 Employees in the acquired company might find it difficult to accept the
different culture of the acquiring company, and a new set of policies and
procedures. The loss of staff might be high, and valuable knowledge and
expertise might be lost.
)
 There might be problems with establishing effective management control
FA
in the acquired company. Control systems might have to be reviewed and
AP
changed.
 Senior management in the acquiring company might not give the
A,
acquired company sufficient time and attention to make the acquisition
operationally and financially successful.
IS
 Competitors might react to an acquisition with a new competitive strategy
C
of their own. Increased competition might drive down the profits for all
A,
participants in the market.
IM
Factors effecting the likely success of the bid for Acquisition
C
A
Level of consideration M
The acquirer should offer an initial bid price, keeping in mind a satisfactory
ip
premium over and above the actual market value of the acquire company. A
.D
generous offer would incline the target company to consider the offer positively.
v
Ad
Expectations of future profits

A,
In order to encourage the shareholders of Target Company to retain their shares

C
in the combined company, a potential estimate of future earnings and synergies

C
would be required by them.

F
A,
Future dividend policy

C
(A
Shareholders of Target Company may be sensitive to the dividend policy possibly

being less generous than they have been used to before the acquisition.
az
Tax position
Ej
ad
The shareholders may prefer a future capital gain on sale of shares in acquirer
company to cash consideration, or instant sale of any shares they are given.
As
Changes in shares prices
Shareholders will also take account of any changes in share prices that occur
during the bid price.

Defensive Tactics
When a target company is faced with a hostile tender offer (takeover) the target
company managers and board use defensive measure to delay, negotiate a
batter deal for shareholders or attempt to keep the company independent.
)
Pre-Offer Defense
FA
AP
Poison Pill
A,
This is an attempt to make a company unattractive normally by giving the right
to existing shareholders to buy shares at a very low price. Poison pills have many
IS
variants.
C
A,
Golden Parachutes
IM
Golden parachutes are compensation agreements between the target
C
company and its senior managers. These employment contracts allow the
A
executives to receive lucrative payouts, usually several years‟ worth of salary, if
M
they leave the target company following a change in corporate control. Golden
parachutes may encourage key executives to stay with the target as the
ip
takeover progresses and the target explores all options to generate shareholder
.D
value. Without a golden parachute, some contend that target company

executives might be quicker to seek employment offers from other companies to
v
Ad
secure their financial future.

A,
"Crown Jewel" Defense

C
C
The firm's most valuable assets may be the main reason that the firm became a
F
takeover target in the first place. By selling these or entering into arrangements
A,
such as sale and leaseback, the firm is making itself less attractive as a target.
C
Eternal vigilance
(A
az
Maintain a high share price by being an effective management team and

educate shareholders.
Ej
ad
Cross shareholdings
As
Your company buys a substantial proportion of the shares in a friendly company,

and it has a substantial holding of your shares.
Increasing Levels of Debt

Increases its financial risk, and therefore the company will need to be able to bear
the consequences of this increased risk.
The increased levels of debt would probably be secured against the assets of the
company and therefore the acquirer cannot use them to raise additional debt
finance, and cash resources would be needed to fund the higher interest
)
payments.
FA
AP
Post offer defenses
Litigation
A,
IS
The target company can challenge the acquisition by inviting an investigation by
C
the regulatory authorities or through the courts. The target may be able to sue for
A,
a temporary order to stop the predator from buying any more of its shares.
IM
Green Mail
C
This technique involves an agreement allowing the target to repurchase its own
A
M
shares back from the acquiring company, usually at a premium to the market
price. Greenmail is usually accompanied by an agreement that the acquirer will
ip
not pursue another hostile takeover attempt of the target for a set period.
.D
"Pac-Man" Defense
v
Ad
The target can defend itself by making a counteroffer to acquire the hostile
A,
bidder. This technique is rarely used because, in most cases, it means that a
smaller company (the target) is making a bid for a larger entity. Additionally, once
C
a target uses a Pac-Man defense, it forgoes the ability to use a number of other
C
defensive strategies. For instance, after making a counteroffer, a target cannot

F
A,
very well take the acquirer to court claiming an antitrust violation.

C
White Knight Defense

(A
az
This would involve inviting a firm that would rescue the target from the unwanted
bidder. The white knight would act as a friendly counter-bidder.
Ej
Methods of financing mergers

ad
As
Cash
Advantages to Acquirer
 When the bidder has sufficient cash the merger can be achieved quickly.

 Cheaper: the consideration is likely to be less than a share exchange, as

there is less risk to the shareholders.
 Retains control of their company.
Disadvantages to Acquirer
)
Cash flow strain - usually either must borrow (increased gearing) or issue new
FA
shares in order to raise the cash.
AP
Advantages to Target
A,
 Certainty about bids value
IS
 Freedom to invest in a wide ranging portfolio.
C
Disadvantages to Target
A,
IM
 Liable to CGT
C
 Do not participate in new group synergy benefits
Share exchange.
A
M
ip
Advantages to Acquirer
.D
 No cash outflow
v
Ad
 Bootstrapping – when high P/E ratio Co acquires low P/E co, acquirer will
have to issue less number of shares so EPS rises.
A,
Disadvantages to Acquirer
C
C
Dilution of control
F
A,
Advantages to Target
C
(A
 Postponement of CGT liability

 Participate in new group synergy benefits
az
Ej
Disadvantages to Target
ad
Uncertain value
As
Debt
Preference shares.
Hybrid

The Global Regularity Framework
Key aspects of Takeover Regulation
Mandatory Bid- Rule:
)
The aim of this rule is to protect the minority shareholders by providing them with
FA
the opportunity to exit the company at the fair price once the bidder has
AP
cumulated a certain percentage of the shares. This is why the mandatory bid rule
normally also specifies the price that is to paid for the shares. The bidder normally
A,
required to offer the remaining the shareholders the price not lower than the
highest price for the shares already acquired during the periods specified prior to
IS
the bid.
C
A,
The principle of equal treatment:
IM
The principle of treating all the shareholders equally is fundamental. The principle
C
of equal treatment requires the bidder to offer to minority shareholders as same
A
term as those offered to earlier shareholders from whom the controlling block was
M
acquired.
ip
Transparency of ownership and control:

.D
The transparency enables the regulators to monitor the large shareholders,

v
Ad
minimize agency problems and investigate insider dealing. It also enables that
minority shareholder and the market to monitor the large shareholders who may
A,
able to exercise undue influence exact at the expense of the other shareholdings.
C
The squeeze-out and sell-out rights:

F C
A,
Squeeze out rights gives the bidder who has acquired a specific percentage of
the equity (90%) the right to force minority shareholders to sell their shares.
C
(A
The one-share-one vote:

az
Where the one share-one vote principle is upheld, arrangements restricting voting
Ej
rights are forbidden. Differentiated voting rights, such as non-voting shares and
ad
dual-clan shares with the multiple voting rights, enable some shareholders to
accumulate control at the expense of other shareholders and could provide a
As
significant barrier to potential takeovers.
The break-through rule

The effect of the break-through rule where this is allowed by corporate law, is to
enable a bidder with a specified proportion of the company‟s equity to break-
through the company‟s multiple voting rights and exercise control as if one share-
one vote existed.
Board neutrality and anti-takeover measures
)
FA
Seeking to address the agency issue where management may be tempered to
AP
act in their own interests at the expense of the interest of the shareholders, several
regulatory devices propose board neutrality. For instance the board would not
A,
be permitted to carry out post-bid aggressive defensive tactic (such as selling the
company‟s main assets, known as crown jewels defense, or entering into special
IS
arrangements giving rights to existing shareholders to buy shares at a low price,
C
known as poison pill defense), without prior authority of the shareholders.
A,
General Principles:
IM
C
 All the shareholders of the target company must be treated similarly.
A
 All information disclosed to one or more shareholders of the target
company must be disclosed to all
M
 An offer should only be made if it can be implemented in full individuals or
ip
firms should not make an offer unless they have reason to believe that they
.D
will be able to implement this in full.

 Shareholders must be given sufficient information and advice to enable
v
Ad
them to reach a properly informed decision and mist have sufficient time
to do so. No relevant information should be withheld from them.
A,
 All documentation should be of the highest standards of accuracy. A

documentation produced by the bidding company or the directors of the
C
C
target should be produced to the highest standards of accuracy.

F
 All parties must do everything to ensure that a false market is not created
A,
in the shares of the target company. A false market is created when a

deliberate attempt is made to distort the market in the offeror‟s or target
C
(A
shares. An example would be where false information is either given or

withheld in such a way as to prevent the free negotiation of prices.
az
 Directors of a target company are not permitted to frustrate a takeover bid,

nor to prevent the shareholders from having a chance to decide for
Ej
themselves.
ad
 The directors of both target and bidder must act in the interest of their
respective companies.
As
The Competition Commission
A UK company might have to consider whether its proposed takeover would be

drawn to the attention of the Competition Commission. If the it is thought that a

merger or takeover might be against the public interest, it can refer it to the
Competition Commission.
If a transaction is referred to the Competition Commission and the commission

finds that it results in a substantial lessening of competition in the defined market,
it will specify action to remedy or prevent the adverse effects identified, or it may
)
decide that the merger does not take place.
FA
AP
A,
IS
C
A,
IM
C
A
M
ip
v.D
Ad
A,
C
F C
A,
C
(A
az
Ej
ad
As

Acquisition and Merger Valuation
The need for a valuation
Valuation and the offer price are key issues in a merger or acquisition. In a
takeover:
)
FA
 the acquiring company needs to decide what price it is prepared to offer
AP
for the target company
 the directors of the target company need to decide whether the offer is
A,
acceptable and whether it should be recommended to the shareholder,
and
IS
 the shareholders in the target company need to decide whether they are
C
willing to accept the offer made for their shares.
A,
IM
Valuation Methods
C
A
Market Based
M Asset Based
Cash Flow Based
Methods Methods
ip
Methods
Market Book Value
.D
Dividend
Capitalization Valuation Method
v
Replacement
Ad
P/E Method FCF/FCFE Value

A,
Break-up Value
C
C
Market Based Valuation

F
A,
Market Capitalization:
C
(A
No. of shares X Ex-Dividend Share Price

az
P/E Method
Ej
EPS X Expected P/E Ratio

ad
As
The problem with this valuation method for a private company is that a suitable
estimate must be obtained for both EPS and the P/E ratio.
 The EPS might be the EPS of the target company in the previous year, an
average EPS for a number of recent years or a forecast of EPS in a future
year. Any of these estimates for EPS could be used.

 Since a private company does not have a market value for its shares, the
shares do not have a P/E ratio. A P/E ratio must therefore be selected by
looking at the P/E ratio for similar companies whose shares are traded on
a stock market. The P/E ratio selected might be based on the average P/E
ratio of a number of similar companies whose shares are traded on a
stock market, for which a current P/E ratio is therefore available.
)
FA
Cashflow Based Valuation
AP
Dividend Valuation Method
A,
IS
Market Value = Present Value of future dividends, discounted at cost of equity.
C
𝑑𝑑0 (1 + 𝑔𝑔)
A,
𝑃𝑃0 =
𝐾𝐾𝑒𝑒 − 𝑔𝑔
IM
Note: Above Formula can only be used when growth rate in dividend is constant
C
from Y1. If this is not the case then calculate according to the definition above.
A
M
Free Cashflow Based
ip
 Estimate the relevant incremental free cash flows from the business to be
.D
acquired.
 Discount these cash flows at an appropriate cost of capital that reflects
v
the risk of the investment.

Ad
There are few points to remember in valuing using free cashflow

A,
C
 If the method is FCF then the discount rate should be WACC and if it’s
C
FCFE then the discount rate should be Ke.

F
 Valuing using FCF will give us the total market value i.e. Debt + Equity
A,
whereas, FCFE will give us the value of equity only

C
(A
Asset Based Aproach

az
The business is estimated as being worth the value of its Net Assets.
Ej
Net Assets = Total Assets – Total Liabilities – Preference Share Value

ad
The issue that needs to be consider is whether to use:

As
 Book Values (If below values are not given)

 Replacement Values (if it is going concern)
 Realizable values (if the intent is divestment)
Advantages of Net Asset Method
 It can be used as floor value (minimum value) in mergers and acquisitions.

 It is the only method used in case of liquidation.

 It can be used as valuation method in asset intensive firm. e.g. real estate
business
Problems of Net Assets Method
 It does not consider future prospects of a company.
 It does not consider all intangibles of a company.
)
 It cannot be used in service based industry.
FA
 Replacement cost is difficult to estimate.
AP
CALCULATED INTANGIBLE VALUE (CIV) MODEL
A,
This is the way to calculate the value of intangible assets. The idea behind is that
due to intangible assets the business is generating excess returns over the
IS
industry average.
C
A,
Operating profits of the company XX
IM
Less: Capital Employed X % of Avg ROCE in the industry (XX)
Excess earning XX
C
Adjustment of Tax (XX)
A
After tax Excess Earnings M XX
Present value of excess earning discounted at WACC XX

ip
.D
Example
v
PPL operates in the service industry. The directors are keen to value the
Ad
company for the purposes of negotiating with a potential acquirer and plan to
use the CIV method to value the intangible element.
A,
In the past year PPL made an operating profit of $135m on an asset base of
C
$300m. The company WACC is 6%. A suitable competitor for benchmarking has
C
been identified who generates and average return of 19%

F
Corporation tax is 30%.

A,
C
Required
(A
Calculate the intangible value of PPL

az
Valuation Techniques
Ej
ad
Point of view of Acquirer (Buyer)

Acquirer will want to know about the maximum price that should be paid for
As
acquisition. Hence the value of target company will be
Post-Acquisition Value of parent (Combined Value) XX

Less: Value of the parent company before Acquisition (XX)
Value of the Target Company (The Maximum Value) XX

Post-Acquisition Values
 Earning based Valuation
o Combined earnings = earnings of parent + earnings of target +
synergy earnings
o P/E ratio should be post acquisition.
)
 Cashflow Based Valuation
FA
o Combined cashflows = cashflows of parent + cashflow of target +
AP
synergy cashflows
o WACC should be post acquisition which should be:
A,
 Same as business and financial risk are same
 Marginal cost of capital if business risk is same but financial risk
IS
is different
C
 Risk adjusted cost of capital (post acquisition Beta) if business
A,
risk is different
IM
Example
C
Nema Co, a listed company which manufactures electronic components, is
A
interested in acquiring Roney Co. M
Information on Nema Co and Roney Co
ip
Nema Co has a market debt to equity ratio of 50:50 and an equity beta of 1·18.
.D
Currently Nema Co has a total firm value (market value of debt and equity
v
combined) of $140 million.

Ad
Roney Co has a market debt to equity ratio of 10:90 and an estimated equity
A,
beta of 1·53. Roney Co has a total firm value (market value of debt and equity
C
combined) of $40 million.

F C
Information about combine Company

A,
Following the acquisition, it is expected that the combined company‟s sales

C
revenue will be $51,952,000 in the first year, and its profit margin on sales will be
(A
30% for the foreseeable future. After the first year the growth rate in sales
revenue will be 5·8% per year for the following three years. Following the
az
acquisition, it is expected that the combined company will pay annual interest
Ej
at 6·4% on future borrowings.

ad
The combined company will require additional investment in assets of $513,000

As
in the first year and then 18c per $1 increase in sales revenue for the next three
years. It is anticipated that after the forecasted four-year period, its free cash
flow growth rate will be half the sales revenue growth rate.

It can be assumed that the asset beta of the combined company is the
weighted average of the individual companies‟ asset betas, weighted in
proportion of the individual companies‟ market value.
The current annual government base rate is 4·5% and the market risk premium is
estimated at 6% per year. The Tax rate is 28%.
)
FA
Required:
AP
Evaluates whether the acquisition of Roney Co would be beneficial to Nema Co
and its shareholders. The free cash flow to firm method should be used to
A,
estimate the values of Roney Co and the combined company assuming that the
combined company’s capital structure stays the same as that of Nema Co’s
IS
current capital structure. Include all relevant calculation.
C
A,
Solution
IM
C
A
M
ip
v .D
Ad
A,
C
F C
A,
C
(A
az
Ej
ad
As

Point of view of Acquiree (Seller)
Acquiree will want to know about the minimum price that it should be
accepted for acquisition. Hence the value of target company will be
 PV of the Target Company only.
)
FA
The Synergy Value of the company (Maximum Acquisition Premium)
AP
Post-Acquisition Value of parent (Combined Value) XX
A,
Less: Value of the target company before Acquisition (XX)
Less: Value of the parent company before Acquisition (XX)
IS
Synergy value (Maximum Acquisition Premium) XX
C
A,
Gain and Losses on Acquisition
IM
Acquirer Target
C
Value in view of Acquirer Price Agreed
A
Less: Price agreed Less: Value in view of Acquiree
M
Gain/(Loss) . Gain/(Loss) .
ip
Example (Share to share exchange)

.D
Market value of target company $5 per share, market value of acquirer $4 per
v
share. Acquirer has offered its 3 shares for every 2 shares of Target Company.
Ad
Required
A,
Calculate %age benefits for Target Company.

C
C
Solution
F
A,
C
(A
az
Ej
ad
As
In share for share exchange as soon as acquirer company transfer its shares to
target company, both company’s shareholders will become the owner of
group. So, combine value of group is more relevant here rather than the existing
value of acquirer.

Example (Share to share exchange)

Market value of Target Company is $2.50, market value of acquirer $3.00,
combined market value $4.00.
Acquirer has offered its 2 shares for every 3 shares of Target Company.
Requirement:
)
Calculate %age gain to both the acquirer and target shareholders
FA
AP
Solution
A,
IS
C
A,
IM
C
A
M
ip
v .D
Ad
A,
C
C
Example (Cash offer)

F
Market value of target co. is $4/share. Acquirer has offered $5 each for every
A,
share of Target Company.

C
(A
Required
Calculate %age gain to the target company shareholders.
az
Ej
Solution
ad
As

Example:
M.V of target co is $4/Share. Acquirer has offered $110 worth Bond for every 20
shares of target co.
Required
Calculate %age gain for target company shareholders.
)
FA
Solution
AP
A,
IS
C
A,
IM
C
A
M
ip
v.D
Ad
A,
C
F C
A,
C
(A
az
Ej
ad
As

Financial Reconstruction
Financial Reconstruction
Unprofitable businesses Profitable businesses

(debit balance on (which run out of cash -
)
FA
revenue reserves) overtrading)
AP
A,
IS
C
A,
Continue to Take Agreement No agreement
be remedial with creditors
IM
unprofitable action
C
Promise of
A
future M
profits
ip
.D
Liquidation Capital Reconstruction Liquidation

v
Ad
A,
Assets sold Assets sold

C
off and off and

C
distributed distributed
F
in priority in priority
A,
order order
C
(A
A financial reconstruction is a major reorganization of the capital structure of a

az
company especially when there are serious concerns of going concern. A

reconstruction might involve:
Ej
 the conversion of debt capital into equity

ad
 And possibly the conversion of equity shares from one form to another
As

The purpose of a reconstruction

The purpose of a capital reconstruction is to find a way of allowing the company
to continue in business, and avoid insolvency and liquidation. A reconstruction is
therefore only worth considering:
 if it is likely to be more beneficial to all the parties concerned than a
)
FA
liquidation of the company (and the sale of its assets), and
 the reconstructed company has a good chance of surviving and
AP
restoring itself to profitability.
A,
A reconstruction will benefit all the parties if it is likely to result in them getting
IS
more cash or more value from the reconstruction than from an enforced
C
liquidation of the company.
A,
The challange with a reconstruction scheme
IM
There are some major problems with arranging a capital reconstruction. These
C
are:
A
 finding a reconstruction arrangement that will benefit all the parties, and
M
 Getting all the parties to agree to the proposal.
ip
.D
 Each of the parties involved in a reconstruction (banks who are lending

money, bondholders, unpaid trade creditors and the shareholders)
v
need to believe that the reconstruction offers them the prospect of

Ad
more cash or more value than a liquidation of the company. Each of

A,
the parties will therefore compare what they will probably receive:
C
o if the construction scheme is agreed, and

C
o If the scheme is rejected and liquidation occurs.

F
A,
Financial Reconstruction Answer Plan:

C
(A
1. State the reason why the scheme is required

az
As a result of the recent considerable losses there is inadequate funds

Ej
available to finance the redemption of debentures.

ad
2. The Capital Repayment position – priority order

As
(a) It is common to find in exam situations that there may not be enough
funds to discharge the unsecured creditors. They end up only receiving
say 60p in the $.
(b) The capital repayment position of the unsecured creditors will normally
improve under a scheme, because the cash from the issue of new

equity is used to purchase assets, on which they will have a prior claim
to shareholders
3. Does the scheme raise adequate finance?
4. Whether The Business Will Proceed After The Reconstruction.
)
FA
5. Is the scheme acceptable to all parties?
AP
General points:
a) The “What’s in it for me?” syndrome. Each party must be in at least as good
A,
a position after the scheme as they whether before the scheme or else they
IS
will not agree to the scheme. A secured creditor, who would receive full
C
payment in liquidation, will have to get something extra for agreeing to the
A,
scheme e.g. a higher interest rate.
IM
C
b) Treat all the parties fairly. No party should be treated with disproportionate
favour in comparison with another. This is a matter of subjective judgement.
A
M
Whatever judgement you make remember to justify your answer.
ip
Approach:
.D
The likely situation in the exam is that the company will be liquidated if the
v
scheme is not accepted. Therefore you should compare the position of each
Ad
group:
A,
a) Upon liquidation
C
b) Under the scheme

C
In relation to shares and debentures it may be worthwhile to note their market

F
value before the scheme i.e. their current exit value.

A,
C
6. Conclusion
(A
 Try and reach a sensible conclusion about the scheme, which is justified by
az
your analysis.
Ej
 Don’t be afraid to say that you think the scheme in its current form, will not
ad
be acceptable. Suggest any possible improvements to the scheme,

explaining their logic and appeal.
As

Practice of Financial Reconstruction Plan

Assume that ‘now’ Is dec _2003
Dricom inc. is a manufacturer of mobile phones. The company was successful in

the mid1990s, and established a small chain of retail shops in major domestic
)
cities. In 2001-2002 the company’s new product experienced reliability problems
FA
and competition from technologically superior products, causing sales to fall by
AP
40% from 2000-2001 levels. This led to substantial losses being made in both 2001-
2002 and 2002-2003.
A,
The company’s managers are confident that the technical problems can be
IS
overcome, but this will require an investment of $2.25 milion for new automated
equipment and quality performance, and a new debt or equity issue on the
C
stock market is not possible. Without the new investment, Dricom is unlikely to be
A,
competitive, and might survive the next financial year. With the new investment
IM
‘PBIT’ are forecast to be at least $750,000/year from 2004-2005 for at least five
C
years.
A
DRICOM INC
M
SUMMARISED SOFP AS AT 30-SEP-2003
ip
$'000 $'000
.D
Non-current assets
v
Land and building 1500

Ad
Plant and machinery

2100
(NET)
A,
__________
C
3600
C
Current assets
F
Inventory 1340
A,
Receivables 1090
C
Cash at bank and in

(A
35
hand
az
_________
2465
Ej
_________
ad
Total assets 6065

_________
As
Called up share capital

1000
($1 par value)
Share premium
945
account
Revenue reserves -240

_________
1705
Non-current liabilities
Term loan (from BXT
800
bank)
9% debenture 2016 500
)
FA
8% convertible
1000
debenture 2005
AP
10% loan stock 2011 500
_________
A,
2800
IS
Current liabilities
C
Overdraft 620
A,
Other payables 940
_________
IM
1560
C
_________
A
Total equity and M 6065
liabilities
ip
_________
.D
NOTES:
v
1) The 9% straight debenture is secured by a fixed charge on the company’s

Ad
main factory building, the convertible debenture and term loan by a

A,
floating charge on non-current assets. The loan stock and overdraft are
C
unsecured.
C
2) The land and buildings are believed to have a realizable value 20% less
F
than than their net book value.

A,
3) If the company ceased trading, inventories would be sold @ 50% of their

C
book value.
(A
4) The new equipment would result in 50 staff being made redundant, with
az
an immediate after-tax cost of $500,000. If the company were to be

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liquidated , after-tax redundancy payments would total $1 million.

Redundancy payments may be assumed to rank before UNSECURED
ad
PAYABLES 
As
5) Obsolete machinery with a net book value of $800,000 will be sold for
$300,000 irrespective of whether or not the new investment takes place.
The remainder of the plant and machinery could be disposed of at net
book value. All disposal values are after tax..

6) The overdraft currently cost 10% per year and the bank term loan 12% per
year.
7) The company’s current share price is 23 CENTS, loan stock price $78,
straight debenture price $90 and convertible debenture price $94. All
marketable debt has a PAR and redemption value of $100 
)
FA
DRICOM FINANCE DRICTOR believes that a corporate RESTRUCTURING could
AP
solve the company’s problems, and has made the following proposals:
A,
1) Existing shareholders are to be offered 28 cents per share to redeem
IS
their shares, which would then be CANCELLED.
2) $1 million would be provided by a venture capital organization in
C
return for 700,000 new 25 cents par value ordinary shares.
A,
3) The company’s directors and employees would subscribe to 500,000
IM
new 25 cents ordinary shares at a price of 150 cents per share.
C
4) The convertible debentures is to be replaced by new ordinary shares
A
(par value25 cents), with 60 ordinary shares for every $100 nominal
M
value loan stock.
ip
5) The term loan is to be renegotiated with the bank and the total
.D
amount of the loan increased to $2 million. This would have an

expected interest charge of 13% per annum. A floating charge on
v
Ad
non-current assets could be offered on the overdraft.

6) All other long-term loans would remain unchanged.
A,
C
Apart from the directors, none of the above parties have yet been consulted
C
regarding the proposed reconstruction.

F
Following a reconstruction, no corporate tax is expected to be paid for at least

A,
two years. The corporate tax rate is 33%

C
The Average price/earnings ratio in DRICOM’S industry is 12:1

(A
az
Ej
ad
As

Business Reorganization
Business Reorganization
A capital reconstruction is a major change in the capital structure and ownership
)
FA
of a company in financial difficulties. A business reorganization is similar, in the
sense that it often involves a change in capital structure and a change in
AP
ownership. However, a reorganization normally involves a company that is not in
financial difficulties as the result of a business strategy decision, such as selling off
A,
a non-core part of the group's business operations, or de-merging two divisions of
a company into two entirely separate and independent companies.
IS
C
Portfolio Reconstruction
A,
 Portfolio restructuring involves the acquisition of companies, or disposals of
assets, business units and/or subsidiary companies through divestments,
IM
demergers, spin-offs, MBOs and MBIs.
C
 It involves making additions to or disposals from companies businesses.
A
 It includes Divestments, Demergers, spin-offs or management buy-outs.
M
Organizational Reconstruction
ip
 It involves changing the organizational structure of the firm.

.D
 Organizational restructuring involves changing the way a company is

v
organized. This may involve changing the structure of divisions in a

Ad
business, business processes and other changes such as corporate

governance.
A,
 The aim of either type of restructuring is to increase the performance and

C
value of the business

F C
Leveraged Recapitalization
A,
 In leveraged Recapitalization a firm replaces the majority of its equity with

C
a package of debt securities.

(A
 The high level of debt in the company discourages other companies to

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make take-over bids.

 Companies should be
Ej
o Relatively debt free

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o Consistent cash flows

As
Debt/Equity Swaps
 The value of the swap is determined usually at current market rates.
 Management may offer higher exchange values to share- and debt
holders to force them participate in the swap.

Leveraged buy-outs (LBOs)

 It refers to the takeover of a company that utilizes mainly debt to finance
the buyout and company is de-listed.
 A small group of individuals, possibly including existing shareholders
and/or management buys all the company's shares.
)
FA
Advantages
 Protection from Share price movement
AP
 No hostile bids
 Focus on Long-term Performance
A,
 Minimized agency costs
IS
Disadvantages
C
 Shares don’t trade publicly anymore.
A,
 Bankrupt if the cash flow risk is too high.
IM
Unbundling
C
Unbundling is a process by which a large company with several different lines of
A
business retains one or more core businesses and sells off the remaining assets,
M
product/service lines, divisions or subsidiaries.
ip
Unbundling is a Portfolio Restructuring Strategy and It includes the following:
.D
 Divestment
 Demergers
v
 Sell - Offs
Ad
 Spin - Off
 Carve Outs
A,
 Management Buy Out

C
C
Divestments
F
Divestment is the partial or complete sale or disposal of physical and

A,
organizational assets, the shutdown of facilities and reduction in workforce in

C
order to free funds for investment in other areas of strategic interest.

(A
Divestments are undertaken for a variety of reasons. They may take place as a
 Corrective action in order to reverse unsuccessful previous acquisitions.
az
 Divestments may also be take place as a response to a cyclical downturn

Ej
in the activities of a particular unit or line of business. normally to reduce

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costs or to increase return on assets

As
Demergers
A demerger is the splitting up of corporate bodies into two or more separate
bodies, to ensure share prices reflect the true value of underlying operations.
A demerger is the opposite of a merger. It is the splitting up of a corporate body
into two or more separate and independent bodies.

The main advantage of a demerger is • Economies of scale may be lost.
its greater operational efficiency and • The smaller companies which result
)
FA
the greater opportunity to realize from the demerger will have lower
value. A two-division company with turnover, profits and status than the
AP
one loss making division and one group before the demerger.
profit making, fast growing division • There may be higher overhead
A,
may be better off by splitting the two costs as a percentage of turnovers.
divisions. The profitable division may • The ability to raise extra finance,
IS
acquire a valuation well in excess of especially debt finance, to support
C
its contribution to the merged new investments and expansion may
A,
company. be reduced.
IM
• Vulnerability to takeover may be
increased.
C
A
Sell-offs M
A sell-off is a form of divestment involving the sale of part of a company to a
third party, usually another company. Generally, cash will be received in
ip
exchange.
v .D
Reasons for Sell-Off

Ad
 As part of its strategic planning, it has decided to restructure, concentrating

management effort on particular parts of the business. Control problems may
A,
be reduced if peripheral activities are sold off.

C
 It wishes to sell off a part of its business which makes losses, and so to improve
C
the company's future reported consolidated profit Performance.

F
 In order to protect the rest of the business from takeover, it may choose to sell
A,
a part of the business which is particularly attractive to a buyer.

C
 The company may be short of cash.

(A
 A subsidiary with high risk in its operating cash flows could be sold.
az
 A subsidiary could be sold at a profit.

Ej
Spin-offs
ad
In a spin-off, a new company is created whose shares are owned by the

As
shareholders of the original company which is making the distribution of assets.

In a spin-off, there is no change in the ownership of assets, as the shareholders
own the same proportion of shares in the new company as they did in the old
company.
Reasons:

 The change may make a merger or takeover of some part of the business
easier in the future, or may protect parts of the business from predators.
 There may be improved efficiency and more streamlined management
within the new structure.
 It may be easier to see the value of the separated parts of the business
now that they are no longer hidden within a conglomerate.
)
FA
 The requirements of regulatory agencies might be met more easily within
the new structure.
AP
Carve-Out
A,
A carve-out is the creation of a new company, by detaching parts of the
company and selling the shares of the new company to the public. In a carve-
IS
out, a new company is created whose shares are owned by the public with the
C
parent company retaining a substantial fraction of the shares. Parent companies
A,
undertake carve-outs in order to raise funds in the capital markets. These funds
IM
can be used for the repayment of debt or creditors or it can be retained within
the firm to fund expansion. Carved out units tend to be highly valued.
C
A
Management buy-outs (MBOs) M
A management buy-out is the purchase of all or part of the business by its
managers. The main complication with management buy-outs is obtaining the
ip
consent of all parties involved. Venture capital may be an important source of

.D
financial backing.
v
Ad
Reasons for a management Buy-out

 The subsidiary may be peripheral to the group's mainstream activities, and
A,
no longer fit in with the group's overall strategy.

C
 The group may wish to sell off a loss-making subsidiary, and a

C
management team may think that it can restore the subsidiary's fortunes.
F
 The parent company may need to raise cash quickly.

A,
 The best offer price might come from a small management group
C
wanting to arrange a buy-out.

(A
 When a group has taken the decision to sell a subsidiary, it will probably
az
get better co-operation from the management and employees.

Ej
 The sale can be arranged more quickly than a sale to an external party.
 The selling organization is more likely to be able to maintain beneficial links
ad
with a segment sold to management rather than to an external party.

As
Problems with buy-outs

 Managers may have little or no experience of entrepreneur skills.
 Difficulties in deciding on a fair price to be paid
 Convincing employees of the need to change working practices

 Inadequate cash flow to finance the maintenance and replacement of

tangible fixed assets
 The maintenance of previous employees' pension rights
 Accepting the board representation requirement that many sources of
funds will insist upon
 The loss of key employees.
)
FA
 Maintaining continuity of relationships with suppliers and customers
AP
Advantages of MBOs to disposing company
 To raise cash quickly to improve liquidity.
A,
 Known buyer
IS
 If subsidiary is loss making then sale to management will be better
financially than liquidation
C
 Better publicity
A,
IM
Advantages of MBOs to management
 It preserves their jobs.
C
 It offers a chance to become owner of the company
A
 It is quicker than starting a similar business from scratch
M
 They can carry out their own strategies, no longer required approval from
ip
head office.
.D
 They have detail knowledge and relevant skills.

v
Buy-ins
Ad
'Buy-in' is when a team of outside managers, as opposed to managers who are

already running the business, mount a takeover bid and then run the business
A,
themselves.
C
A management buy-in might occur when a business venture is running into

C
trouble, and a group of outside managers see an opportunity to take over the
F
business and restore its profitability.

A,
C
(A
az
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ad
As

Risk Management: Currency
The Role of Treasury
 managing the liquidity and cash flows of the organisation
)
managing the foreign exchange positions and cash flows
FA

 helping to obtain finance for the organisation
AP
 managing the exposures to financial risk, by hedging currency exposures,
interest rate exposures and other risk exposures.
A,
Currency Transaction Risk
IS
A transaction risk occurs when a payment of a foreign currency is required at a
C
future date, or when a receipt of a payment in a foreign currency will occur at
A,
a future date. A transaction risk occurs because the exchange rate could move
IM
adversely between ‘now’ and the time that the currency payment or receipt
C
happens, with the result that either:
A
 it costs more to buy the foreign currency to make the currency
payment, or
M
 there is less income when a currency payment is received and the
ip
currency is converted into domestic currency by selling it to a bank.

v.D
Government Measures to Stabilize Exchange Rates

Ad
The most effective way for a government to manage its exchange rate today, if
A,
it wished to do so, would be to increase or reduce domestic interest rates on its

C
currency. Raising or reducing interest rates should affect the demand for the
C
currency from investors.

F
A,
There are several exchange rate policies that a government might adopt. These
C
include:
(A
 free floating (‘benign neglect’ of the exchange rate)

az
 managed floating of the currency

Ej
 a fixed exchange rate policy, with the exchange rate fixed against a major
currency or a basket of world currencies
ad
As

QUOTES
Quotes Quoted Example (Pakistan) Converting foreign
currency to local
Direct Local/foreign Rs. 100/1$ Multiply eg. $10=
(100 X 10) = Rs. 1,000
)
Indirect Foreign/local $0.01/1Re. Divide eg. $10 =
FA
(10/0.01) = Rs. 1,000
AP
This will always makes you confuse because in Pakistan we use direct quote but
A,
in UK and also in ACCA exams there is indirect quote
IS
BID and OFFER Rates
C
NOTE: Remember the rule. (BANK ALWAYS WIN).
A,
 Hence bank always buy the foreign currency at low price and sell it at
IM
high price (Direct quote).
C
 Hence bank always give few foreign currency and receive more foreign
currency against local. (Indirect Quote)
A
Bid price is a price at which bank is willing to buy foreign currency
M
Offer price is a price at which bank is willing to sell foreign currency.
ip
.D
NOTE: Our prospective is opposite as if we want to sell foreign currency then it

means bank will buy.
v
Ad
Customer  Receiving foreign currency  we want to sell foreign currency 

A,
bank will buy  use Bid Price

C
C
Supplier  Paying foreign currency  we want to Buy foreign currency  bank

F
will Sell  use Offer Price

A,
C
Bid offer
(A
Direct (Rs./$) 98 100

Indirect ($/Rs.) 0.0102 0.0100
az
Ej
NOTE: Bid Rate will be lower in Direct Quote and Higher in Indirect Quote
ad
and Vice Versa for Offer.

As
Hedging
The purpose of hedging an exposure to currency risk is to remove (or reduce)
the possibility that a future transaction involving a foreign currency will have to
be made at a less favorable exchange rate than expected.

Methods of Hedging Exposures to Foreign Exchange Risk

Internal External
- Invoicing in home currency - Forward Rate Agreement
- Leading and Lagging - Money Market Hedge
- Matching - Futures
)
FA
- Netting - Options
AP
Internal Hedging Techniques
Invoicing In Home Currency
A,
One easy way is to insist that all foreign customers pay in your home currency
IS
and that your company pays for all imports in your home currency
C
A,
Leading & Lagging
IM
If an importer (payment) expects that the currency it is due to pay will
depreciate, it may attempt to delay payment. This may be achieved by
C
agreement or by exceeding credit terms.
A
If an exporter (receipt) expects that the currency it is due to receive will
M
depreciate over the next three months it may try to obtain payment
immediately. This may be achieved by offering a discount for
ip
immediate payment.
v.D
Matching
Ad
When a company has receipts and payments in the same foreign currency due
at the same time, it can simply match them against each other.
A,
NOTE: In the exam where possible we will always do matching first

C
C
Netting
F
Netting is a process in which all transaction of group companies are converted

A,
into the same currency and then credit balances are netted off against the
C
debit balances, so that only reduced net amounts remain due to be paid or
(A
received.
Multilateral netting involves minimising the number of transactions taking place
az
through each country’s banks. This would limit the fees that these banks would
Ej
receive for undertaking the transactions and therefore governments who do not
allow multilateral netting want to maximise the fees their local banks receive.
ad
As
On the other hand, some countries allow multilateral netting in the belief that
this would make companies more willing to operate from those countries and
any banking fees lost would be more than compensated by the extra business
these companies and their subsidiaries bring into the country.

The advantage of using a central treasury for multilateral netting is that the
central treasury can coordinate the information about inter-group balances.
There will be a smaller number of foreign exchange transactions, which will
mean lower commission and transmission costs. There will be less loss of interest
through money being in transit. The foreign exchange rates available may be
more advantageous as a result of large transaction sizes resulting from
)
consolidation. The netting arrangements should make cash flow forecasting
FA
easier in the group.
AP
Steps
A,
1. Covert all cashflows into base currency.
IS
2. Enter all the amounts each company owes to the others and convert to
C
the agreed settlement currency.
A,
3. Add across and down the table to determine total receipts and total
IM
payments for each company.
4. Determine the net receivable or payable for each company.
C
Advantages:
A
 The number of currency transactions can be minimized, saving
M
transaction costs and focusing the transaction risk onto a smaller set of
ip
transactions that can be more effectively hedged.
.D
 It may also be the case, if exchange controls are in place limiting

currency flows across borders, that balances can be offset, minimizing
v
overall exposure. Where group transactions occur with other companies

Ad
the benefit of netting is that the exposure is limited to the net amount
A,
reducing hedging costs and counterparty risk.

C
Disadvantages:
F C
 Some jurisdictions do not allow netting arrangements, and there may be

A,
taxation and other cross border issues to resolve. It also relies upon all
C
liabilities being accepted – and this is particularly important where

(A
external parties are involved.

 There will be costs in establishing the netting agreement and where third
az
parties are involved this may lead to re-invoicing or, in some cases, re-
Ej
contracting.
Illustration
ad
Kenduri Co is a large multinational company based in the UK with a number of

As
subsidiary companies around the world. Currently, foreign exchange exposure as

a result of transactions between Kenduri Co and its subsidiary companies is
managed by each company individually. Kenduri Co is considering whether or
not to manage the foreign exchange exposure using multilateral netting from the

UK, with the Sterling Pound (£) as the base currency. If multilateral netting is
undertaken, spot mid-rates would be used.
The following cash flows are due in three months between Kenduri Co and three
of its subsidiary companies. The subsidiary companies are Lakama Co, based in
the United States (currency US$), Jaia Co, based in Canada (currency CAD) and
)
FA
Gochiso Co, based in Japan (currency JPY).
AP
Owed by Owed to Amount
Kenduri Co Lakama Co US$ 4.5 million
A,
Kenduri Co Jaia Co CAD 1.1 million
IS
Gochiso Co Jaia Co CAD 3.2 million
C
Gochiso Co Lakama Co US$ 1.4 million
A,
Jaia Co Lakama Co US$ 1.5 million
IM
Jaia Co Kenduri Co CAD 3.4 million
Lakama Co Gochiso Co JPY 320 million
C
Lakama Co Kenduri Co US$ 2.1 million
A
M
Exchange rates available to Kenduri Co
ip
US$/£1 CAD/£1 JPY/£1
.D
Spot 1.5938–1.5962 1.5690–1.5710 131.91–133.59

3-month forward 1.5996–1.6037 1.5652–1.5678 129.15–131.05
v
Ad
Required
Calculate net amount owed by or to each part using netting approach
A,
C
Solution
F C
A,
C
(A
az
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ad
As

External Hedging Techniques
Forward Rate Agreement (FRA)

It is an immediately firm and binding contract for the purchase or sale of a
specified quantity of a stated foreign currency at a rate of exchange fixed at
the time the contract is made for performance (delivery of the currency and
)
FA
payment for it) at a future time which is agreed when making the contract.
AP
Money Market Hedge
Money market hedging involves borrowing in one currency, converting the
A,
money borrowed into another currency and putting the money on deposit until
the time at which the transaction is completed.
IS
C
Payments
A,
Home Currency Foreign Currency
IM
NOW 1) Take Loan and Covert 2) Deposit in Bank
Principle in Foreign Currency
C
LATER 1) Settle Loan 3) Withdraw from Bank
A
Principle and make payment
M
+
ip
Interest
.D
Illustration (From BPP)

v
A Thai company owes a New Zealand company NZ$3,000,000, payable in 3

Ad
months' time. The current exchange rate is Thai Baht 19.0300–19.0500 = NZ$1.
The Thai company elects to use a money market hedge to manage the
A,
exchange risk. The current annual borrowing and investing rates in the two
C
countries are:
C
New Zealand Thailand

F
% %
A,
Investing 2.5 4.5

C
Borrowing 3.0 5.2

(A
Required
Calculate the cost to the Thai company of using a money market hedge.
az
Ej
Solution
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As

Receipts
Home Currency Foreign Currency
NOW 2) Covert in Home 1) Take Loan
Principle Currency and deposit in
Bank
)
FA
LATER 4) Withdraw from Bank 3) Receive the Amount
Principle and Settle Loan
AP
+
Interest
A,
Illustration (From BPP)
IS
An Australian company is due to receive ¥15,000,000 from a Japanese company,
C
payable in 4 months' time. The current exchange rate is ¥62.6000–62.8000 = A$1.
A,
The Australian company elects to use a money market hedge to manage the
IM
exchange risk. The current annual borrowing and investing rates in the two
countries are:
C
Australia Japan
A
% M %
Investing 4.5 2.7
Borrowing 6.0 3.3
ip
Required
.D
Calculate the amount the Australian company will receive if it uses a money
v
market hedge.
Ad
Solution
A,
C
F C
A,
C
(A
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As

Currency Futures
Currency futures are contracts for the purchase/sale of a standard quantity of
one currency in exchange for a second currency. Futures contracts are priced
at the exchange rate for the transaction.
Key Points
)
FA
 They are Exchange Traded derivatives contracts.
 Traded in Derivative market where ‘Futures’ are traded and over her
AP
commodities can’t be bought or sold but only their contracts can be.
 The contract prices are dependent on underlying commodities
A,
 Standardized contract sizes and are available in only major currencies
IS
 There are four settlement dates MAR/JUNE/SEPT/DEC.
C
 The Transaction Amount will always be in foreign Currency with respect to
A,
company
IM
 Market Currency will always be opposite to currency of contract size
 Convert each exchange rate in the form of direct from Market point of
C
view e.g. if Market is in USA then convert all exchange rate into $/other
A
currency. M
 Opening Price means todays price
ip
 Closing Price means Price at the settlement date
.D
 Settlement date must be earlier or at expiry date

 Different way to hedge if Market and Home Currency are same and if
v
Ad
both are different

 On Closing (Settlement) date the contract needs to be closed i.e. if the
A,
contract is bought initially then it has to be settled by selling it and Vice

C
Versa.
C
 This future market only gives out Gain/Loss which will be settled in actual
F
 At Expiry date the Future contract price and the spot price both will be
A,
same
C
Basis Risk
(A
It is a risk that the future prices will not move in line with the spot market. In
az
question we always assumes that this risk is zero

INITIAL MARGIN
Ej
When a futures hedge is set up the market is concerned that the party opening
ad
a position by buying or selling futures will not be able to cover any losses that
may arise. Hence, the market demands that a deposit is placed into a margin
As
account with the broker being used – this deposit is called the ‘initial Margin’.
These funds still belong to the party setting up the hedge but are controlled by
the broker and can be used if a loss arises. Indeed, the party setting up the
hedge will earn interest on the amount held in their account with their broker.
The broker in turn keeps a margin account with the exchange so that the

exchange is holding sufficient deposits for all the positions held by brokers‟
clients.
MARKING TO MARKET
In the scenario given above, the gain was worked out in total on the transaction
date. In reality, the gain or loss is calculated on a daily basis and credited or
)
FA
debited to the margin account as appropriate. This process is called ‘marking to
market’.
AP
Currency options
A,
Currency options give the buyer the right but not the obligation to buy or sell a
IS
specific amount of foreign currency at a specific exchange rate (the strike
C
price) on or before a predetermined future date.
Key Points in addition to Futures
A,
IM
 For this protection, the buyer has to pay a premium.
C
 A currency option may be either a call option (Option to Buy Future
Contracts) or a put option (Option to sell future contracts)
A
 Currency option contracts limit the maximum loss to the premium paid up-
M
front and provide the buyer with the opportunity to take advantage of
ip
favorable exchange rate movements.

.D
 Options are of two types, traded and over the counter, and both have
different kinds of benefits.
v
Ad
o Traded options are standard sizes and are thus 'tradable' which
means they can be sold on to other parties if not required. OTC
A,
options are designed for a specific purpose and are therefore

unlikely to be suitable for another party.
C
o OTC options are tailored specifically for a particular transaction,

C
ensuring maximum protection from currency movements. As traded

F
A,
options are of a standard size, the full amount of the transaction

may not be hedged, as fractions of options are not available.
C
(A
az
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ad
As

Currency Future Answer

No. Description Market Currency = Home Currency Market Currency ≠ Home Currency
)
FA
and
explanation
AP
1 Setup Payment Buy Payment Sell
Type of Receipt  Sell Receipt  Buy
A,
Contract
IS
Expiry Immediate after Settlement Date
C
No. of 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
Contacts 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
A,
2 Expected
IM
Closing Opening Date Closing date
C
Price
Spot
A
Market Current Spot given or Assume FRA
M
ip
Future Opening Price Balancing Closing Price
.D
Market 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
→ Answer
𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
v
3 Outcome
Ad
A,
Outcome in Opening Price Opening Price
future
C
Market Less: Closing Price Less: Closing Price

C
Gain or Loss Gain or Loss

F
A,
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑜𝑜𝑜𝑜 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑜𝑜𝑜𝑜 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
C
(A
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅

Net Transaction Amount X Closing Spot Transaction Amount ÷ Closing Spot
z
Outcome
a
Add: Gain (OR Less: Loss) Add: Gain (OR Less: Loss)
Ej
Net Outcome Net Outcome

ad
As

Currency Options Answer

No. Description Market Currency = Home Currency Market Currency ≠ Home Currency
)
FA
and
explanation
AP
1 Setup Payment Call Option Payment Put Option
A,
Type of Receipt  Put option Receipt  Call Option
Contract
IS
Expiry Immediate after Settlement Date
C
Strike Price All given in the question
A,
(Exercise
IM
Price)
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
C
No. of
Contacts 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
A
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
M
Premium
𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
100 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑋𝑋 100
ip
2 Expected Same Price as of Future
.D
Closing
v
Price
3 Outcome Ad
A,
Outcome in Exercise Price Exercise Price
C
future Less: Closing Price Less: Closing Price

C
Market Gain or Loss Gain or Loss

F
Exercise Yes / No Exercise Yes / No

A,
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
C
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅

(A
Net Transaction Amount X Closing Spot Transaction Amount ÷ Closing Spot

z
Outcome Less: Premium Less: Premium

a
Ej
Add: Gain Add: Gain

Net Outcome Net Outcome
ad
As

Risk Management: Interest
Interest Rate Risk Management
Interest rate risk (IRR) can be explained as the impact on an institution’s financial
)
condition if it is exposed to negative movements in interest rates. This risk can either
FA
be translated as an increase of interest payments that it has to make against
AP
borrowed funds or a reduction in income that it receives from invested funds.
Hedging
A,
IS
The purpose of hedging an exposure to interest rate risk is to remove (or reduce)
C
the possibility that a future borrowing or investments will have to be made at a
less favorable interest rate than expected.
A,
IM
Methods of Hedging Exposures to Interest Rate Risk
C
 Forward rate Agreement (FRA)
 Interest Rate Future
A
M
 Options
ip
 Interest Rate Swaps

.D
 COLLAR
v
Ad
Forward Rate Agreement (FRA)

FRA is a contract in which two parties agree on interest rate to be paid on a
A,
notional amount at a specified future time. A co. can enter into an FRA with a
C
bank that fixes the rate of interest for borrowing at a certain time in the futures. In
C
case of borrowing, If the actual interest rate proves to be:

F
 Higher than the rate agreed  The bank pays the co, the difference
A,
 Lower than the rate agreed  Co, pays the bank the Difference
C
(A
Illustration
Example It is 30 June. Lynn plc will need a £10 million 6 month fixed rate after 3
az
months. Company is expecting that interest rate will rise in future and wants to
hedge using an FRA. The following FRA are available:
Ej
3-6 FRA 5%- 5.5%

ad
3-9 FRA 5.5% - 6%

Lynn can borrow in market at Libor + 50 basis points.
As
Required
What is the result of the FRA and the effective loan rate if the 6 month Libor rates
has moved to
1. 5%

2. 9%
Solution
)
FA
AP
A,
IS
C
A,
IM
C
A
M
Interest Rate Futures
ip
It is very similar to Currency futures, however, in that interest-bearing security as

.D
an underlying asset
v
Ad
Key Points in addition to Currency Futures

A,
 The price of interest rate future will be: 100 – LIBOR.

C
 Only LIBOR will be hedged

C
 They have a contract length which generally is 3 month.

F
A,
Interest Rate Options

C
It is very similar to Currency options, however, in that interest-bearing security as

(A
an underlying asset
az
Interest Rate Collar

Ej
It is an attempt to reduce the premium fee by selling the options to other party.
ad
By creating collar we may have to be exposed to adverse movements as well.

As
Interest Rate SWAPS

An interest rate swap is an agreement between two parties, such as a company

and a bank that deals in swaps, for a period of time that is usually several years
for the exchange of interest payments. Swaps are therefore usually long-term
agreements on interest rates.
The interest rate payments that are exchanged in a ‘coupon swap’ are as follows:
 One party to the swap pays a fixed rate (the swap rate).
)
 The other party pays interest at a reference rate or benchmark rate for the
FA
interest period, such as LIBOR.
AP
The purpose of an interest rate swap is often to:
A,
 swap a variable rate of interest payment (or receipt) into a fixed interest
rate payment (or receipt)
IS
 swap a fixed rate of interest payment (or receipt) into a variable rate of
C
interest payment (or receipt).
A,
Illustration
IM
Company A wants to borrow at a floating rate, and can do so at LIBOR + 0.50%.
C
Company B wants to borrow at a fixed rate, and can do so at 6.40%. However,
A
an opportunity for these company exist as company A can borrow at a fixed rate
M
5.5% and company B, can borrow at a variable rate of LIBOR + 1%
ip
Required:
.D
Calculate the SWAP net outcome

v
Write SWAP Terms

Ad
Solutions
A,
C
F C
A,
C
(A
az
Ej
ad
As

The Calculation of Forward Rates
(𝟏𝟏 + 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒚𝒚𝒚𝒚𝒚𝒚𝒚𝒚 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓)𝒏𝒏

𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 = − 𝟏𝟏
(𝟏𝟏 + 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝒚𝒚𝒚𝒚𝒚𝒚𝒚𝒚 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓)𝒏𝒏−𝟏𝟏
)
Illustration
FA
AP
The annual spot yield curve for bonds of a given risk class are as follows:
A,
Maturity Yield
One year 3.0%
IS
Two years 3.6%
C
Three years 4.3%
A,
Four years 5.1%
IM
Five years 5.8%
C
Solution
A
M
ip
v .D
Ad
A,
C
F C
A,
C
(A
az
Ej
ad
As

Interest Rate Future Answer
No. Description and explanation Formulas
)
1 Setup Borrow  Sell
FA
Type of Contract Investment  Buy
AP
Expiry Date Immediate after investing or borrowing date
No. of Contracts 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑋𝑋 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
A,
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ
2 Expected Closing Price
IS
Opening Date Closing date
C
A,
Spot Market Current Spot Price given or Assume FRA
IM
Future Market Opening Price Balancing Closing Price
C
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑡𝑡𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
→ Answer
A
M
3 Outcome
Outcome in future Market Opening Price
ip
.D
Less: Closing Price
Gain or Loss
v
Ad
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑜𝑜𝑜𝑜 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ
A,
1,200
C
Net Outcome Interest:

𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑋𝑋 (𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 + 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝) 𝑋𝑋 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
C
12
F
Add: Gain (Or Less Loss)

A,
Net Outcome
C
(A
a z
Ej
ad
As

Interest Rate Options Answer
No. Description and Formulas
)
explanation
FA
1 Setup Borrow  Put Option
AP
Type of Contract Investment  Call Option
Expiry Date Immediate after investing or borrowing date
A,
Exercise Price Chose all that are given
No. of Contracts 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑋𝑋 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
IS
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑒𝑒 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ
C
Premium 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ
A,
1,200
2 Expected Closing Price Same Price as of Future
IM
3 Outcome
C
Outcome in future Exercise Price
A
Market
M
Less: Closing Price
Gain or Loss
ip
.D
Exercise? Yes/No
v
Ad
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ
1,200
A,
Net Outcome Interest:
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑋𝑋 (𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 + 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝) 𝑋𝑋 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
C
12
C
Less: Premium cost

F
A,
Add: Gain
C
Net Outcome
(A
a z
Ej
ad
As

Interest Rate Collar Answer
No. Description and explanation Formulas
)
1 Net Outcome of Interest rate options with Value
FA
best exercise Price
AP
Type of Contract Borrow  Sell Call Option @ highest exercise price
Investment  Sell Put Option @ lowest exercise price
A,
2 Premium Income 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ
IS
1,200
3 Outcome Exercise Price
C
Outcome in future Market
A,
Less: Closing Price
IM
Gain or Loss
C
Exercise? Yes/No
A
M
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ
ip
1,200
v .D
Net Outcome of Collar No.1 + No.2 – No.3
Ad
A,
C
FC
A,
C
(A
a z
Ej
ad
As

Option Pricing
Option Pricing and the determinants
Call Option:The right but not the obligation to buy a particular asset at an exercise
)
price
FA
Put Option: The right but not an obligation to sell a particular asset at an exercise
AP
price
The Value of the Option will depend on the following factors
A,
IS
Determinants Value of Call Value of Put
Option if Option if
C
increases increases
A,
IM
Pa = Current Price of underlying Asset Increase Decrease
C
Pe = Exercise Price Decrease Increase
T = Time to expiry (in Years)

A
Increase Increase
M
ip
S = Standard Deviation Increase Increase
.D
r = Risk free rate Increase Decrease

v
Ad
N (d) = Normal Distribution Value See from the Normal distribution

table
A,
C
C
The Black Scholes Model

F
A,
THE Black-Scholes model values options before the expiry date and takes
account of all the determinants that effect the value of option
C
(A
𝐶𝐶 = 𝑃𝑃𝑎𝑎 𝑁𝑁(𝑑𝑑1 ) − 𝑃𝑃𝑒𝑒 𝑁𝑁(𝑑𝑑2 )𝑒𝑒 −𝑟𝑟𝑟𝑟

az
𝑃𝑃 = 𝐶𝐶 − 𝑃𝑃𝑎𝑎 + 𝑃𝑃𝑒𝑒 𝑒𝑒 −𝑟𝑟𝑟𝑟

Ej
Where:
ad
𝑃𝑃
ln � 𝑎𝑎 � + (𝑟𝑟 + 0.5𝑆𝑆 2 )𝑡𝑡
𝑃𝑃𝑒𝑒
As
𝑑𝑑1 =
𝑆𝑆√𝑡𝑡
𝑑𝑑2 = 𝑑𝑑1 − 𝑆𝑆√𝑡𝑡
If ‘d’ is positive then  N(d) = 0.5 + Value from Table

If ‘d’ is negative then  N(d) = 0.5 - Value from Table
Example
The current share price of X Company is $17. What should be the price of a Call
Option and Put Option on the company’s shares at an exercise price of $16.50,
if the expiry date is in six months, the standard deviation of annual returns on the
)
share is 12% and the risk-free rate of return is 7% per year?
FA
Pa = 17
AP
Pe = 16.5
r = 7%
A,
t = 6 months to expiry, t = 0.50.
s = 0.12
IS
C
Solution
A,
IM
C
A
M
ip
v .D
Ad
A,
C
F C
A,
C
(A
az
Ej
ad
As

The Greeks
Delta
In Black-Scholes model, the value of N(d1) can be used to indicate the amount
of the underlying shares (or other instruments) which the writer of an option should
hold in order to hedge the option position.
)
Delta = change in call option price ÷ change in the price of the shares
FA
AP
N(d1) = Delta
The appropriate „hedge ratio‟ N(d1) is referred to as the delta value; hence the
term delta hedge. The delta value is valid if the price changes are small.
A,
IS
DELTA HEDGING CALL OPTION
C
A bank that writes a large number of options has an option portfolio. It might
A,
want to create a hedge for its exposure to adverse price movements.
IM
A bank that writes call options can create an option position that is delta neutral
C
by purchasing a quantity of the underlying item. For example, a bank that has
A
written call options on the shares of XYZ Company can hedge the position by
holding some shares in XYZ.
M
ip
If the value of the underlying shares goes up, the value of the call options will
.D
also go up. The bank will incur a loss on its options position, because it has
written options. However, it makes a gain on the rise in the value of the
v
Ad
underlying shares.
A,
A delta neutral position will exist when the rise in the value of the options (=
C
benefit to the option holders and loss for the option writer) is matched by an
C
equal rise in the value of the shares held by the option writer (bank). This will
F
leave the bank with neither a loss nor a gain.

A,
The number of shares that a call option writer should hold to create a delta
C
hedge is
(A
No. of shares to held = No. of Call options to sell X N(d1)

Similarly:
az
No. of call options to sell = No. of shares held / N(d1)

Ej
For example if the delta value for call options on 1,000,000 shares of XYZ
ad
Company at an exercise price of $15 is 0.45, a delta hedge will be created by

holding 450,000 of the shares
As
(1,000,000 × 0.45) = 450,000.
Note: For put option use N(- d1)

Other Greeks
Change in: Due to change in:
Delta Option price Underlying asset

value
)
Gamma Delta Underlying asset
FA
value
AP
Vega Option price Volatility
A,
Rho Option price Interest rate
IS
Theta Option price Time to expiry
C
A,
The Real Options
IM
C
The conventional NPV method assumes that a project commences immediately
and proceeds until it finishes, as originally predicted. Therefore, it assumes that a
A
M
decision has to be made on a now or never basis, and once made, it cannot be
changed. It does not recognize that most investment appraisal decisions are
ip
flexible and give managers a choice of what actions to undertake.

.D
The real options method estimates a value for this flexibility and choice, which is
v
Ad
present when managers are making a decision on whether or not to undertake

a project. Real options build on net present value in situations where uncertainty
A,
exists and, for example: (i) when the decision does not have to be made on a
now or never basis, but can be delayed, (ii) when a decision can be changed
C
C
once it has been made, or (iii) when there are opportunities to exploit in the
F
future contingent on an initial project being undertaken. Therefore, where an

A,
organization has some flexibility in the decision that has been, or is going to be
made, an option exists for the organization to alter its decision at a future date
C
(A
and this choice has a value

az
To Value that we will use the same Black Scholes Option Pricing models. There
will be three different situations i.e.
Ej
Option to delay  Call Option

ad
Option to expand  Call Option

Option to abandon  Put Option
As

Dividends
Free cash flow and dividend capacity
The ability of a company to source capital investments internally depends not
only on the amount of cash flows generated, but also on dividend policy.
)
However, the Maximum dividend that the firm should pay equals to free cashflow
FA
to equity.
AP
An entity could distribute all of its free cash flow to equity but in practice only a
proportion is paid out. A company will retain part of the free cash flow to reinvest
A,
in the business.
IS
C
Dividend Policies
A,
Stable Dividend
IM
Some companies follow a policy of paying fixed dividend per share irrespective
C
of the level of earning year after year. Such firm creates reserves i.e dividend
A
equalization reserves to enable them to pay the fixed dividend even in case of
M
insufficient earnings.it more suits to those companies having stable earnings.
 Dividend level (growth) should be related to profit levels (Growth).
ip
 Retain profit should be linked with the investments of new projects.

v.D
Advantages of Stable Dividend Policy:

Ad
A Stable dividend policy is advantageous to both investors and company on

account of the following:
A,
 It is sign of continued normal operations of company.

C
 It stabilizes market value of shares.

C
 It creates confidence among investors.

F
 It improves credit standing and making financing easier.

A,
 It meets requirements of institutional investors who prefer companies with

C
stable dividends.
(A
Dangers of Stable dividend policy

az
In spite of many advantages, the stable dividend policy suffers from certain
Ej
limitations. Once a stable dividend policy is followed by a company, it is not

easier to change it. If stable dividends are not paid to shareholders on any
ad
account including insufficient profits, the financial standing of company in minds

As
of investors is damaged and they may like to dispose of their holdings. It

adversely affects the market price of shares of the company. And if companies
pay stable dividends in spite of its incapacity it will be suicidal in long run.
Constant payout ratio

It means payment of fixed percentage of net earnings as dividends every year.

The amount of dividend in such a policy fluctuates in direct proportion to earnings
of company. The policy of constant payout is preferred by the firms because it is
related to their ability to pay dividends.
Stable Dividend plus extra dividend: Some companies follow a policy of paying
)
constant low dividend per share plus an extra dividend in the years of high profit.
FA
Such a policy is most suitable to the firm having fluctuating earnings from year to
AP
year.
Residual dividend
A,
Companies using the residual dividend policy choose to rely on internally
IS
generated equity to finance any new projects. As a result, dividend payments
C
can come out of the residual or leftover equity only after all project capital
A,
requirements are met. These companies usually attempt to maintain balance in
their debt/equity ratios before making any dividend distributions, deciding on
IM
dividends only if there is enough money left over after all operating and
C
expansion expenses are met.
A
M
A primary advantage of the dividend-residual model is that with capital-projects
budgeting, the residual dividend model is useful in setting longer-term dividend
ip
policy. A significant disadvantage is that dividends may be unstable.

.D
Irregular Dividend Policy:

v
Ad
Some companies follow irregular dividend payments on account of following:

 Uncertainty of Business.
A,
 Unsuccessful Business operations

C
 Lack of liquid resources.

C
 Fear of adverse effects of regular dividend on financial standing of

F
company.
A,
C
No Dividend Policy:
(A
A company may follow a policy of paying no dividends presently because of its

az
unfavorable working capital position or on account of requirements of funds for

future expansion and growth.
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As

FM: Financial Management Study Notes
)
FA
P
A
A
IS
,C
A
Math and Formula Table
IM
C
A
M
ip
D
dv
,A
A
C
C
,F
A
C
(A
z
ja
E
d
sa
A
By: Asad Ejaz (ACA, FCCA, Adv. Dip MA CIMA, CISA, APFA)
107
Formulae
Modigliani and Miller Proposition 2 (with tax)
Vd
k e = kie + (1 – T)(kie – k d )
Ve
)
FA
Two asset portfolio
sp = w2a s2a + w2b s2b + 2wawbrab sasb
P
A
A
The Capital Asset Pricing Model
IS
E(ri ) = Rf + βi (E(rm ) – Rf )
,C
A
The asset beta formula
IM
⎡ Ve ⎤ ⎡ V (1 – T) ⎤
C
βa = ⎢ βe ⎥ + ⎢ d
βd ⎥
⎢⎣ (Ve + Vd (1 – T)) ⎥⎦ ⎢⎣ (Ve + Vd (1 – T)) ⎥⎦
A
M
ip
The Growth Model

D
Do (1 + g)
Po =
dv
(re – g)
,A
Gordon’s growth approximation

A
g = bre
C
C
,F
The weighted average cost of capital

A
⎡ V ⎤ ⎡ V ⎤
WACC = ⎢ e ⎥ ke + ⎢ d ⎥ k (1 – T)
C
⎢⎣ Ve + Vd ⎥⎦ ⎢⎣ Ve + Vd ⎥⎦ d
(A
z
The Fisher formula

ja
(1 + i) = (1 + r)(1+h)
E
d
sa
Purchasing power parity and interest rate parity

A
(1+hc ) (1+ic )
S1 = S0 x F0 = S0 x
(1+hb ) (1+ib )
Modified Internal Rate of Return
1
⎡ PV ⎤ n
MIRR = ⎢ R ⎥ 1 + re – 1
⎢⎣ PVI ⎥⎦
( )
The Black-Scholes option pricing model
)
FA
c = PaN(d1) – PeN(d2 )e –rt
P
Where:
A
ln(Pa / Pe ) + (r+0.5s2 )t
A
d1 =
s t
IS
d2 = d1 – s t
,C
A
The Put Call Parity relationship
IM
p = c – Pa + Pee –rt
C
A
M
ip
D
dv
,A
A
C
C
,F
A
C
(A
z
ja
E
d
sa
A
[P.T.O.
Present Value Table
Present value of 1 i.e. (1 + r)–n

Where r = discount rate
n = number of periods until payment
Discount rate (r)
)
FA
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
P
1 )
0·990 )
0·980 )
0·971 )
0·962 )

0·952 )
0·943 )
0·935 )
0·926 )
0·917 )
0·909 1
A
2 )
0·980 )
0·961 )
0·943 )
0·925 )
0·907 )
0·890 )
0·873 )

0·857 )
0·842 )
0·826 2
A
3 )
0·971 )
0·942 )
0·915 )
0·889 )
0·864 )
0·840 )
0·816 )
0·794 )
0·772 )

0·751 3
4 ) ) ) )
) ) ) )
) ) 4
IS
0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683

5 )

0·951 )
0·906 )
0·863 )
0·822 )
0·784 )
0·747 )
0·713 )
0·681 )

0·650 )
0·621
5
,C
6 )
0·942 )
0·888 )
0·837 )
0·790 )
0·746 )
0·705 )
0·666 )
0·630 )

0·596 )

0·564 6
A
7 )
0·933 )
0·871 )
0·813 )
0·760 )
0·711 )
0·665 )
0·623 )

0·583 )

0·547 )

0·513 7
IM
8 )
0·923 )

0·853 )
0·789 )
0·731 )
0·677 )
0·627 )

0·582 )

0·540 )

0·502 )
0·467 8
9 )
0·941 )
0·837 )
0·766 )
0·703 )
0·645 )

0·592 )

0·544 )

0·500 )
0·460 )
0·424 9
C

10 )
0·905 )
0·820 )
0·744 )
0·676 )
0·614 )

0·558 )

0·508 )
0·463 )
0·422 )
0·386
10

11 )
0·896 )
0·804 )
0·722 )

0·650 )

0·585 )

0·527
A
)
0·475 )
0·429 )
0·388 )

0·305
11
M

12 )
0·887 )
0·788 )
0·701 )
0·625 )

0·557 )
0·497 )
0·444 )
0·397 )

0·356 )
0·319
12

13 )
0·879 )
0·773 )
0·681 )
0·601 )

0·530 )
0·469 )
0·415 )
0·368 )
0·326 )
0·290
13
ip

14 )
0·870 )

0·758 )
0·661 )

0·577 )

0·505 )
0·442 )
0·388 )
0·340 )
0·299 )
0·263
14
D
15 )
0·861 )
0·743 )
0·642 )
0·555 )
0·481 )
0·417 )
0·362 )
0·315 )
0·275 )
0·239
15
dv
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
,A
1 )
0·901 )
0·893 )
0·885 )
0·877 )
0·870 )
0·862 )
0·855 )
0·847 )
0·840 )
0·833 1
A
2 )
0·812 )
0·797 )
0·783 )
0·769 )

0·756 )
0·743 )
0·731 )
0·718 )
0·706 )
0·694 2
C
3 )
0·731 )
0·712 )
0·693 )
0·675 )

0·658 )
0·641 )
0·624 )
0·609 )

0·593 )

0·579 3
C
4 )

0·659 )
0·636 )
0·613 )

0·592 )

0·572 )

0·552 )

0·534 )

0·516 )
0·499 )
0·482 4
,F

5 )

0·593 )

0·567 )

0·543 )

0·519 )
0·497 )
0·476 )

0·456 )
0·437 )
0·419 )
0·402
5
A
6 )

0·535 )

0·507 )
0·480 )

0·456 )
0·432 )
0·410 )
0·390 )
0·370 )

0·352 )
0·335 6
C
7 )
0·482 )

0·452 )
0·425 )
0·400 )
0·376 )

0·354 )
0·333 )
0·314 )
0·296 )
0·279 7
(A
8 )
0·434 )
0·404 )
0·376 )

0·351 )
0·327 )
0·305 )
0·285 )
0·266 )
0·249 )
0·233 8
9 )
0·391 )
0·361 )
0·333 )
0·308 )
0·284 )
0·263 )
0·243 )
0·225 )
0·209 )
0·194 9

10 )

0·352 )
0·322 )
0·295 )
0·270 )
0·247 )
0·227 )
0·208 )
0·191 )
0·176 )
0·162
10
z
ja

11 )
0·317 )
0·287 )
0·261 )
0·237 )
0·215 )
0·195 )
0·178 )
0·162 )
0·148 )
0·135
11
E

12 )
0·286 )

0·257 )
0·231 )
0·208 )
0·187 )
0·168 )

0·152 )
0·137 )
0·124 )
0·112
12
d

13 )

0·258 )
0·229 )
0·204 )
0·182 )
0·163 )
0·145 )
0·130 )
0·116 )
0·104 )
0·093
13
sa

14 )
0·232 )
0·205 )
0·181 )
0·160 )
0·141 )
0·125 )
0·111 )
0·099 )
0·088 )
0·078
14

15 )
0·209 )
0·183 )
0·160 )
0·140 )
0·123 )
0·108 )
0·095 )
0·084 )
0·074 )
0·065
15
A
Annuity Table
– (1 + r)–n
Present value of an annuity of 1 i.e. 1————––
r
Where r = discount rate

n = number of periods
)
FA
Discount rate (r)
Periods
P
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
A
A
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
IS
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
,C
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5
A
IM
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
C
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360
A
7·024 6·710 6·418 6·145 10
M
11 10·368
10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
ip
12 11·255
11·26 10·575
10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
D
13 12·134
12·13 11·348
11·35 10·635
10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004
13·00 12·106
12·11 11·296
11·30 10·563
10·56 9·899 9·295 8·745 8·244 7·786 7·367 14
dv
15 13·865
13·87 12·849
12·85 11·938
11·94 11·118
11·12 10·380
10·38 9·712 9·108 8·559 8·061 7·606 15
,A
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
A
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
C
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
C
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
,F
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
A
C
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6
(A
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
z
ja
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10
E
11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
d
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
sa
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
A
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
[P.T.O.
Standard normal distribution table
0·00 0·01 0·02 0·03 0·04 0·05 0·06 0·07 0·08 0·09
0·0 0·0000 0·0040 0·0080 0·0120 0·0160 0·0199 0·0239 0·0279 0·0319 0·0359
0·1 0·0398 0·0438 0·0478 0·0517 0·0557 0·0596 0·0636 0·0675 0·0714 0·0753
0·2 0·0793 0·0832 0·0871 0·0910 0·0948 0·0987 0·1026 0·1064 0·1103 0·1141
0·3 0·1179 0·1217 0·1255 0·1293 0·1331 0·1368 0·1406 0·1443 0·1480 0·1517
)
FA
0·4 0·1554 0·1591 0·1628 0·1664 0·1700 0·1736 0·1772 0·1808 0·1844 0·1879
P
0·5 0·1915 0·1950 0·1985 0·2019 0·2054 0·2088 0·2123 0·2157 0·2190 0·2224
A
0·6 0·2257 0·2291 0·2324 0·2357 0·2389 0·2422 0·2454 0·2486 0·2517 0·2549
0·7 0·2580 0·2611 0·2642 0·2673 0·2704 0·2734 0·2764 0·2794 0·2823 0·2852
A
0·8 0·2881 0·2910 0·2939 0·2967 0·2995 0·3023 0·3051 0·3078 0·3106 0·3133
IS
0·9 0·3159 0·3186 0·3212 0·3238 0·3264 0·3289 0·3315 0·3340 0·3365 0·3389
,C
1·0 0·3413 0·3438 0·3461 0·3485 0·3508 0·3531 0·3554 0·3577 0·3599 0·3621
A
1·1 0·3643 0·3665 0·3686 0·3708 0·3729 0·3749 0·3770 0·3790 0·3810 0·3830
IM
1·2 0·3849 0·3869 0·3888 0·3907 0·3925 0·3944 0·3962 0·3980 0·3997 0·4015
C
1·3 0·4032 0·4049 0·4066 0·4082 0·4099 0·4115 0·4131 0·4147 0·4162 0·4177
1·4 0·4192 0·4207 0·4222 0·4236 0·4251 0·4265 0·4279 0·4292 0·4306 0·4319
A
M
1·5 0·4332 0·4345 0·4357 0·4370 0·4382 0·4394 0·4406 0·4418 0·4429 0·4441
ip
1·6 0·4452 0·4463 0·4474 0·4484 0·4495 0·4505 0·4515 0·4525 0·4535 0·4545
1·7 0·4554 0·4564 0·4573 0·4582 0·4591 0·4599 0·4608 0·4616 0·4625 0·4633
D
1·8 0·4641 0·4649 0·4656 0·4664 0·4671 0·4678 0·4686 0·4693 0·4699 0·4706
dv
1·9 0·4713 0·4719 0·4726 0·4732 0·4738 0·4744 0·4750 0·4756 0·4761 0·4767
,A
2·0 0·4772 0·4778 0·4783 0·4788 0·4793 0·4798 0·4803 0·4808 0·4812 0·4817
2·1 0·4821 0·4826 0·4830 0·4834 0·4838 0·4842 0·4846 0·4850 0·4854 0·4857
A
2·2 0·4861 0·4864 0·4868 0·4871 0·4875 0·4878 0·4881 0·4884 0·4887 0·4890
C
C
2·3 0·4893 0·4896 0·4898 0·4901 0·4904 0·4906 0·4909 0·4911 0·4913 0·4916
,F
2·4 0·4918 0·4920 0·4922 0·4925 0·4927 0·4929 0·4931 0·4932 0·4934 0·4936
A
2·5 0·4938 0·4940 0·4941 0·4943 0·4945 0·4946 0·4948 0·4949 0·4951 0·4952
C
2·6 0·4953 0·4955 0·4956 0·4957 0·4959 0·4960 0·4961 0·4962 0·4963 0·4964
(A
2·7 0·4965 0·4966 0·4967 0·4968 0·4969 0·4970 0·4971 0·4972 0·4973 0·4974
2·8 0·4974 0·4975 0·4976 0·4977 0·4977 0·4978 0·4979 0·4979 0·4980 0·4981
z
2·9 0·4981 0·4982 0·4982 0·4983 0·4984 0·4984 0·4985 0·4985 0·4986 0·4986
ja
E
3·0 0·4987 0·4987 0·4987 0·4988 0·4988 0·4989 0·4989 0·4989 0·4990 0·4990
d
sa
This table can be used to calculate N(d), the cumulative normal distribution functions needed for the Black-Scholes model
of option pricing. If di > 0, add 0·5 to the relevant number above. If di < 0, subtract the relevant number above from 0·5.
A
End of Question Paper

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AFM - NOTES

By Mr. ASAD EJAZ

(Association of Chartered Certified Accountants)

The Investment Appraisal

❖ Discounted Payback Period

Relevant Cash flows Irrelevant Cash flows

➢ Opportunity Cost ➢ Non-cash Depreciation

➢ Central Office Overheads

the end of the preceding period

➢ Period ‘0’ is not a period, instead it represents start of period ‘1’.

SKANS School of Accountancy 1

Using the data of ILUSTRATION 1, Calculate the Payback Period?

SKANS School of Accountancy 2

Payback Period of Consistent Cashflows

payback, any cash flows beyond

that point are ignored.

DISCOUNTED CASH FLOW

$1,000 Now ≠ $1,000 1 year Later

following formula of Compounding:

SKANS School of Accountancy 3

Net Present Values (NPV)

of doing the project.

project, Else Reject the Project.

Using the data of ILUSTRATION 1, Calculate the NPV of the Project?

SKANS School of Accountancy 4

Key Advantages & Disadvantages

increases the wealth of the difficulty understanding the

company’s, thus maximise the concept.

2. The speed of repayment of the

2. Takes into account the time value original investment is not

Internal Rate of Return (IRR)

SKANS School of Accountancy 5

a%- Small Disc. Rate at which NPV is Preferably positive

Key Advantages & Disadvantages

by non-accountant being a investment, thus the risk involve in

2. It Assumes that the Cashflows will be

reinvested at the rate of IRR

SKANS School of Accountancy 6

4. Ifa project has irregular cash flows

Discounted Payback Period

SKANS School of Accountancy 7

If Cashflows Start from Period 0.

Annual Cashflow X (A.F + 1) Annual Cashflow X (P.F + 1)

If Cashflows Start from Subsequent Period e.g. Year 3.

Annual Cashflow X A.F of No. of Annual Cashflow X P.F X D.F of

periods X D.F of preceding period preceding period from Start

$10,000 X 3.791 X 0.751 =$28,470 $10,000 X (1/10%) X 0.751 = $75,100

SKANS School of Accountancy 8

Performa for Net Present Value

Net Cash flows (X) X X X X

Present Values (X) X X X X

Net Present Value X

SKANS School of Accountancy 9

The Finance Cost

Effect of Taxation in investment appraisal

Down Allowances Savings

1 2000 500 150 2

2 1500 375 113 3

4 844 344 103 5