AFM - NOTES
By Mr. ASAD EJAZ
(Association of Chartered Certified Accountants)
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Asad Ejaz
ACA, FCCA, Adv Dip MA CIMA, CISA, APFA.
AFM
Advanced
Financial
Management
AFM: Advanced Financial Management
Study Notes
Table of Content
S
No.
1
2
3
4
5
6
7
8
9
10
11
12
Content
Basic of Investment Appraisal
Cost of Capital
Advanced Investment Appraisal
International Investment Appraisal
Acquisition and Merger
Financial Reconstruction
Business Reorganization
Risk Management-Currency
Risk Management-Interest
Black Scholes and Real options
Dividends
Maths & Formula Tables
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No.
1
17
34
44
53
72
78
83
94
101
105
107
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AFM: Advanced Financial Management
Study Notes
The Investment Appraisal
Capital Budgeting Cycle Steps
Idea Generation
➢
Project Screening
➢
Financial & Non-financial Evaluation
➢
Approval
➢
Implementation
➢
Ongoing Monitoring
➢
Post Completion Audit
C
IM
A,
C
IS
A,
AP
FA
)
➢
A
Financial Evaluation Methods
Advanced Methods
M
Basic Methods
❖ Net Present Value NPV
❖ Internal Rate of Return (IRR)
❖ Discounted Payback Period
.D
ip
❖ Payback Period
Ad
v
Cash flows
Relevant Cash flows
➢
➢
➢
➢
➢
Sunk Cost/ Historical Cost
Non-cash Depreciation
Indirect Costs
General Overheads
Central Office Overheads
(A
C
A,
F
C
C
A,
➢ Future Incremental Cash flows
➢ Opportunity Cost
Irrelevant Cash flows
az
Assumptions of Cashflows
As
ad
Ej
➢ If Cash flows arise during the period, then it is assumed as it arises at the end
of that period.
➢ If cash flow arise at the start of the period then it is assumed as if it arises at
the end of the preceding period
➢ 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
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AFM: Advanced Financial Management
Study Notes
Decision rule
If Payback Period < Target Payback, Accept the Project. Else Reject the
Project
)
ILUSTRATION 1
M
A
C
IM
Cash flows Yr 1
50
Yr 2
40
Yr 3
30
Yr 4
25
Yr 5
20
Residual value
Yr 5
5
The cost of capital is 10%. And the target ARR is 20%
IS
A,
Initial investment
A,
C
A
($000s)
(100)
AP
FA
Rough Ltd has the opportunity to invest in an investment with the following initial
costs and returns:
.D
ip
Company uses the straight line method for depreciation.Required:
Ad
v
Using the data of ILUSTRATION 1, Calculate the Payback Period?
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Solution
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AFM: Advanced Financial Management
Study Notes
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
FA
)
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤
The method is often used as the
first screening device to identify
projects which are worthy of
further investigation.
A,
C
2.
1. It does not give a measure of return,
as such it can only be used in
addition to other investment
appraisal methods.
IM
It is simple to use (calculate) and
easy to understand
2. It does not normally consider the
impact of discounted cash flow
although a discounted payback
may be calculated (see later).
M
A
1.
IS
A,
Disadvantages
C
Advantages
AP
Key Advantages & Disadvantages
A,
Ad
v
.D
ip
3. It only considers cash flow up to the
payback, any cash flows beyond
that point are ignored.
C
C
DISCOUNTED CASH FLOW
(A
C
A,
F
The application of the idea that there is a TIME VALUE OF MONEY. What this
means is that money received today will have more worth than the same
amount received at some point in the future.
Ej
az
Why would you rather have $1,000 now rather than in one year’s time?
$1,000 Now ≠ $1,000 1 year Later
As
ad
Therefore, we can express Present Values in terms of Future Values using the
following formula of Compounding:
FV = PV × (1 + r)n
Where
PV -
Present value.
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FV rn -
Study Notes
Future value.
Rate of Discount, interest or cost of capital per period.
Number of periods (years)
AP
FA
)
The opposite of compounding, where we have the future value (eg an expected
cash inflow in a future year) and we wish to consider its value in present value
terms.
𝐹𝑉
(1 + r)n
Or
PV = FV × (1 + r)-n
.D
ip
M
A
C
IM
A,
C
𝑃𝑣 =
IS
A,
Revising the formula
Net Present Values (NPV)
Ad
v
The NPV of the project is the sum of the PVs of all cashflows that arise as a result
of doing the project.
A,
Decision Rule:-
Required:
(A
C
ILUSTRATION 2
A,
F
C
C
If NPV of the project, discounted at cost of capital, is positive then Accept the
project, Else Reject the Project.
As
ad
Ej
az
Using the data of ILUSTRATION 1, Calculate the NPV of the Project?
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Study Notes
Ad
v
Key Advantages & Disadvantages
Advantages
A,
A project with a positive NPV
increases the wealth of the
company’s, thus maximise the
shareholders wealth.
(A
C
Takes into account the time value
of money.
Disadvantages
1. Non-financial managers may have
difficulty
understanding
the
concept.
2. The speed of repayment of the
original
investment
is
not
highlighted.
Ej
az
2.
A,
F
C
C
1.
.D
ip
M
A
C
IM
A,
C
IS
A,
AP
FA
)
Solution
ad
Internal Rate of Return (IRR)
As
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.
Formula to calculate
𝐴
𝐼𝑅𝑅 = 𝑎% + [𝐴−𝐵 𝑋(𝑏 − 𝑎)] %
Where:
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a%Ab%B-
Study Notes
Small Disc. Rate at which NPV is Preferably positive
NPV at a%
Bigger Disc. Rate at which NPV is Preferably negative
NPV at b%
)
Decision Rule
FA
If IRR of the project > Cost of capital, Accept the project. Else Reject the Project
AP
ILUSTRATION 4
Required:
A,
C
IS
A,
Using the data of ILUSTRATION 1 and assuming the NPV at 10% is $34,000 , Calculate the
IRR of the Project?
(A
C
A,
F
C
C
A,
Ad
v
.D
ip
M
A
C
IM
Solution
Key Advantages & Disadvantages
Disadvantages
More easily understood than NPV
by non-accountant being a
percentage return on investment.
As
ad
Ej
1.
az
Advantages
1. Does
not indicate the size of the
investment, thus the risk involve in
the investment.
2. It Assumes that the Cashflows will be
reinvested at the rate of IRR
3. It
can give conflicting signals with
mutually exclusive project.
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AFM: Advanced Financial Management
Study Notes
4. If
a project has irregular cash flows
there is more than one IRR for that
project (multiple IRRs).
FA
)
Discounted Payback Period
AP
The time period in which initial investment is recovered in terms of present value
is known as discounted payback period.
IS
A,
It is same as simple payback period. The only difference is that the discounted
cash flows are used instead of simple cash flows for calculation.
IM
A,
C
Decision Rule
If Discounted Payback Period < Target Discounted Payback, Accept the
Project. Else Reject the Project
C
ILUSTRATION 5
A
Required:
.D
ip
M
Using the data of ILUSTRATION 1, Calculate the Discounted payback of the Project?
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
Solution
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Study Notes
Consistent Cashflows
FA
)
If Cashflows arises in a series of equal cashflows then it is called Consistent
Cashflows. These are of two Types:
Perpetuity: If Consistent cashflow for infinite period e.g. Y1-∞ or Y3-∞
𝟏−(1 + r)-n
A,
C
The Perpetuity Factor (P.F) =
𝒓
𝟏
𝒓
Perpetuity
C
Annuity
IM
The Annuity Factor (A.F) =
IS
A,
Present Values of Consistent Cashflows
AP
Annuity: If Consistent cashflow for a certain Period. e.g Y1-5 or Y3-7
A
If Cashflows Start from Period 1.
Annual Cashflow X P.F
e.g. Y1-∞ $10,000 at Disc. Rate of 10%
$10,000 X (1/10%) = $100,000
Ad
v
.D
ip
M
Annual Cashflow X A.F
e.g. Y1-5 $10,000 at Disc. Rate of 10%
$10,000 X 3.791 =$37,910
If Cashflows Start from Period 0.
C
A,
Annual Cashflow X (A.F + 1)
Annual Cashflow X (P.F + 1)
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
If Cashflows Start from Subsequent Period e.g. Year 3.
Annual Cashflow X P.F X
preceding period from Start
D.F
of
e.g. Y4-∞ $10,000 at Disc. Rate of 10%
$10,000 X (1/10%) X 0.751 = $75,100
As
ad
Ej
az
(A
C
A,
F
C
Annual Cashflow X A.F of No. of
periods X D.F of preceding period
from Start
e.g.Y4-8 $10,000 at Disc Rate of 10%
$10,000 X 3.791 X 0.751 =$28,470
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Study Notes
Performa for Net Present Value
2
3
4
Sales
X
X
X
X
Variable Cost
(X)
(X)
(X)
Incremental Fixed Cost
(X)
(X)
Operating Cashflows
X
X
Tax Expense
(X)
(X)
Tax Savings on Capital
Allowances
X
Working
(X)
Ad
v
Scrap Value
Net Cash flows
FA
AP
A,
C
IS
A,
(X)
X
X
(X)
(X)
X
X
(X)
(X)
(X)
X
C
C
X
X
X
X
X
X
X
X
X
X
(X)
X
X
X
X
X
As
ad
Ej
az
(A
C
A,
F
Net Present Value
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(X)
(X)
A,
X Discount Factor
Present Values
(X)
.D
ip
Initial Investment
(X)
C
in
A
Change
Capital
X
)
1
IM
0
M
Years
9
AFM: Advanced Financial Management
Study Notes
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.
FA
)
Effect of Taxation in investment appraisal
A,
C
IS
A,
AP
➢ Timing of Tax Cashflows: Either in the same year or in arrears.
➢ Calculation of cashflows
o Tax on Operating Cashflows: Operational Cashflows X Rate of Tax
o Tax Savings on Capital Allowances: Calculate the capital
Allowances/ Balancing Allowances and then multiply with Tax
Rate.
Initial Investment = 2000
A
C
Capital Allowances = 25% reducing balance
IM
Example
1
2000
2
1500
3
1125
4
844
Capital
Allowances
@ 25%
Tax
Savings
@ 30%
Timing
500
150
2
375
113
3
281
84
4
344
103
5
Ad
v
Written
Down
Value
A,
F
C
C
A,
Years
.D
ip
M
Useful life = 4 years, Tax rate = 30% payable in arrears, Scrap Value =
500
(A
C
Effect of Inflation in investment appraisal:
az
Inflation may be defined as a general increase in prices, leading to general
decline in the real value of money, (decrease in purchasing power).
Ej
➢ Real Rate of Return (r): Without inflation rate
As
ad
➢ Money/ Nominal Rate of Return (m): With Inflation rate
➢ General Inflation (i)
The relationship between real and money interest is given below (also see tables)
(1 + m) = (1 + r) (1 + i)
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Study Notes
If General inflation rate is
If Specific inflation rate is
Real Method
Money
Inflate all
Cash flows
with general
inflation rate.
Discount
these cash
flows with
Do not
inflate Cash
flows.
Discount all
Cash flows
with real
discount
Inflate each
variable cash flow
with its specific
inflation rate.
Discount with
money cost of
capital (calculated
through real rate
and general
inflation rate.
.D
ip
M
A
C
IM
A,
C
IS
A,
AP
FA
)
Money
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
preferred
Method
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Study Notes
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
AP
FA
)
Nominal Operational Cashflow = Real Operational Cashflows ( 1+ i)n-1
Working Capital Change
IS
A,
Every business requires working capital for its operations.
A,
C
Calculate working capital change in two steps:
IM
1. Calculate working capital requirement one year in advance e.g.
working capital is 10% of sales at the start of each year
A
C
2. Calculate incremental working capital by taking change of each year
working capital
M
3. In last year, there will be an assumption that all working capital will be
.D
ip
recovered (Only for project and not for ongoing business)
ILUSTRATION 5
Ad
v
A company is considering to invest in a project with its life of 4 years. Total
working capital required at the beginning of each year is as follows:
C
A,
Year
A,
F
C
1
2
(A
C
3
$’000
500
700
1000
600
az
4
Cashflows
Ej
Required:
As
ad
Calculate the working capital cashflows of each year to be included in NPV
calculation?
Solution
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Study Notes
Capital rationing
A limit on the level of funding available to a business, there are two types
FA
)
➢ Hard capital rationing
➢ Soft Capital rationing
AP
Hard capital rationing
Externally imposed. Usually by banks
Wider economic factors (e.g. a credit crunch)
2.
Company specific factors
(b)
No track record
(c)
Poor management team.
C
Lack of asset security
M
A
(a)
IM
A,
C
1.
IS
A,
Due to:
.D
ip
Soft capital rationing
Internally imposed by senior management.
Ad
v
Issue: Contrary to the rational aim of a business which is to maximise
shareholders’ wealth (i.e. to take all projects with a positive NPV) Reasons:
Wish to concentrate on relatively few projects
2.
Unwillingness to take on external funds
3.
Only a willingness to concentrate on strongly profitable projects
A,
F
C
C
A,
1.
Single period capital rationing
(A
C
i.e. available finance is only in short supply during the current period, but will
become freely available in subsequent periods.
Ej
az
Assumptions of Single Period Capital Rationing
➢ All projects are divisible
As
ad
➢ Projects will be lost if not undertaken in current year (can not be postponed)
➢ The risk & uncertainty and strategic importance of all projects is same
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.
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Study Notes
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
AP
FA
)
Calculate the NPV of each Investment
Calculate the Profitability indices
Ranking
Investment Plan
IS
A,
1.
2.
3.
4.
A,
C
Note: In case of Mutually exclusive Projects, the project with the Higher Profitability
Indices will be ranked and lower will be ignored.
Example – Divisible
NPV
A
1,000
500
B
1,200
700
C
800
D
700
PI
Ranking
(NPV/Investment)
IM
Investment
C
Project
3rd
0.58
2ND
300
0.375
4TH
450
0.642
1ST
Investment
NPV
700
450
B
1,200
700
A
600
300
Total
2,500
1,450
Ej
az
(A
C
D
A,
F
Project
C
C
The Investment Schedule
A,
Available Funds – $ 2,500
Ad
v
.D
ip
M
A
0.5
ad
We will do Project D and B complete and Project A 60%.
As
Example – Non-Divisible
Project
Investment
NPV
A
1,000
500
B
1,200
700
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Study Notes
C
800
300
D
700
450
Total Investment
Total NPV
A,B
2,200
1,200
A,C,D
2,500
1,250
B,C
2,000
1,000
B,D
1,900
1,150
IS
A,
AP
FA
Projects Combination
)
Available Funds – $ 2,500
IM
A,
C
We will choose combination of A,C,D because it’s gives the best NPV of $1,250
C
Multi-Period Capital Rationing
.D
ip
M
A
You will remember that when there is limited capital in only one year (singleperiod capital rationing) then we rank the projects based on the NPV per $
invested (the profitability index).
C
C
Sensitivity Analysis
A,
Ad
v
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
as multi-period capital rationing and the solution requires using linear
programming techniques.
A,
F
A technique that considers a single variable at a time and identifies by how much
that variable has to change for the decision to change (from accept to reject).
𝑆𝑒𝑛𝑠𝑒𝑡𝑖𝑣𝑖𝑡𝑦 (%) =
𝑁𝑃𝑉
𝑋 100%
𝑃𝑉 𝑜𝑓 𝑎𝑟𝑒𝑎 𝑜𝑓 𝑠𝑒𝑛𝑠𝑡𝑖𝑣𝑖𝑡𝑦
Ej
az
(A
C
Formula to calculate sensitivity of a particular cashflow: -
As
ad
Formula to calculate sensitivity of cost of capital:𝑆𝑒𝑛𝑠𝑒𝑡𝑖𝑣𝑖𝑡𝑦 (%) =
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𝐼𝑅𝑅 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝑋 100%
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
15
AFM: Advanced Financial Management
Study Notes
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
.D
ip
M
A
C
IM
A,
C
IS
A,
AP
FA
)
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
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Study Notes
The Cost of Capital
Risk and Return
FA
)
The relationship between risk and return is easy to see, the higher the risk, the
higher the required to cover that risk.
AP
Overall Return
IS
A,
A combination of two elements determine the return required by an investor for
a given financial instrument.
A,
C
Risk-free return – The level of return expected of an investment with zero risk to the
investor.
M
A
C
IM
Risk premium – The amount of return required above and beyond the risk-free
rate for an investor to be willing to invest in the company investor to be willing to
invest in the company
.D
ip
Degree of Risk
High Risk
C
UnSecured
Preference
Shares
Ordinary
Shares
(A
C
The WACC
Secured
Loans
A,
F
Government
Debt
C
A,
Ad
v
Risk Free
Ej
az
Weighted Average Cost of Capital (WACC)
Cost of Equity (Ke)
Cost of Debt (Kd)
Cost of Preference (Kp)
As
ad
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.
Cost of debt: this is the after-tax return expected by the debt holders of the
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:
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Study Notes
1.
Dividend Valuation Model (DVM).
2.
Capital Asset Pricing Model (CAPM).
)
Dividend Valuation Model
𝑑𝑑
𝐾𝐾𝑒𝑒 = 𝑃𝑃1 + 𝑔𝑔
FA
0
A,
C
IS
A,
AP
Where,
 D1 = next year dividend = Do (1 + g)
 Po = Current Ex-market value of equity share
 g = sustainable growth rate
Difference between cum dividend and ex dividend price
Ex-dividend price (P0) is the market price excluding dividend and cum-dividend
price is the market price including dividend.
Cum-Dividend Price
IM
Less: Dividend
C
Ex-Dividend Price
M
A
Estimating Growth
.D
ip
There are 2 main methods of determining growth:
1 THE AVERAGING METHOD
Ad
v
1
𝑑𝑑
𝑔𝑔 = ( 0�𝑑𝑑 ) �𝑛𝑛 − 1
𝑛𝑛
C
C
A,
F
do = current dividend
A,
where
dn = dividend n years ago
(A
C
g = sustainable growth rate
az
ILUSTRATION 1
ad
Ej
Munero Ltd paid a dividend of 6p per share 8 years ago, and the current
dividend is 11p. The current share price is $2.58 ex div
As
Required:
Calculate the cost of equity
Solution
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AFM: Advanced Financial Management
Study Notes
GORDON’S GROWTH MODEL
)
return on reinvested funds
proportion of funds retained
FA
g=rb
where
r
=
b
=
IS
A,
AP
ILUSTRATION 2
The ordinary shares of Titan Ltd are quoted at $5.00 ex div. A dividend of 40p is
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,
C
Required:
Estimate the cost of equity
C
A,
Ad
v
.D
ip
M
A
C
IM
SOLUTION
As
ad
Ej
az
(A
C
A,
F
C
Capital Asset Pricing Model
A model that values financial instruments by measuring relative risk. The basis of
the CAPM is the adoption of portfolio theory by investors.
Portfolio theory
Risk and Return
The basis of portfolio theory is that an investor may reduce risk with no impact
on return as a result of holding a mix of investments.
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
IS
A,
AP
FA
)
Risk of
portfolio
(σ)
A,
C
No. of shares in portfolio
A,
F
C
C
A,
Ad
v
.D
ip
M
A
C
IM
Systematic and non-systematic risk
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
follows:
Initially substantial reductions in total risk are possible; however, as the
portfolio becomes increasingly diversified, risk reduction slows down and
eventually stops.
The risk that can be eliminated by diversification is referred to as
unsystematic risk. This risk is related to factors that affect the returns of
individual investments in unique ways, this may be described as company
specific risk.
The risk that cannot be eliminated by diversification is referred to as
systematic risk. To some extent the fortunes of all companies move
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
basis that we should judge investments. Non-systematic risk can be
eliminated and is of no consequence to the well-diversified investor.
az
(A
C
Implications
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.
If the investor holds only an undiversified portfolio of shares he will suffer
unsystematic risk as well as systematic risk.
As
ad
Ej
2.
3.
If an investor holds a ‘balanced portfolio’ of all the stocks and shares
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
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AFM: Advanced Financial Management
Study Notes
industry sector and gearing (see later). Some shares will be more risky
and some less.
β (beta) factor
M
A
C
IM
A,
C
IS
A,
AP
FA
)
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
volatile and the β factor is simply a yardstick against which the risk of other
investments can be measured.
The β factor is critical to applying the CAPM, it illustrates the relationship of
an individual security to the market as a whole or conversely the market
return given the return on an individual security.
For example, suppose that it has been assessed statistically that the returns
on shares in XYZ plc tend to vary twice as much as returns from the market
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%
then XYZ’s returns would fall by 8%, XYZ would be said to have a β factor of
2.
The risk-free security
A,
1
Ad
v
.D
ip
Risk Premium Return
It is the difference between the market return and risk free rate of return
The security market line
The security market line gives the relationship between systematic risk and
return. We know 2 relationships.
The market portfolio
(A
C
2
A,
F
C
C
This carries no risk and therefore no systematic risk and therefore has a βeta
of zero. Generally, the government securities like Treasury Bills or GILTs are
considered risk free
As
ad
Ej
az
This represents the ultimate in diversification and therefore contains only
systematic risk. It has a βeta of 1.
SKANS School of Accountancy
21
Study Notes
C
IM
A,
C
IS
A,
AP
FA
)
AFM: Advanced Financial Management
Ad
v
.D
ip
M
A
From the graph, it can be seen that the higher the systematic risk, the higher
the required rate of return.
The relationship between required return and risk can be shown using the
following formula:
Ke =
Rf + (Rm - Rf) β
where
Ke =
required return from individual security
β
=
Beta factor of individual security
=
risk-free rate of interest
Rm
=
return on market portfolio
A,
F
C
C
A,
Rf
(A
C
ILUSTRATION 3
The market return is 15%. Kite Ltd has a beta of 1.2 and the risk free return is 8%
az
Required:
What is the cost of capital?
As
ad
Ej
SOLUTION
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AFM: Advanced Financial Management
Study Notes
The Cost of Debt
Kd for irredeemable debt
=
=
=
)
FA
Where
i
t
P0
𝑋𝑋100%
interest paid
marginal rate of tax
ex interest (similar to ex div) market price of the loan stock.
AP
𝑃𝑃𝑜𝑜
IS
A,
𝑖𝑖(1−𝑡𝑡)
𝐾𝐾𝑑𝑑(𝑛𝑛𝑛𝑛𝑛𝑛) =
A,
C
ILUSTRATION 4
The 10% irredeemable loan notes of Rifa plc are quoted at $120 ex-interest.
Corporation tax is payable at 30%
A
C
IM
Required:
What is the cost of debt net?
C
A,
Ad
v
.D
ip
M
SOLUTION
A,
F
C
Kd for redeemable debt
The Kd(net) for redeemable debt is given by the IRR of the relevant cash flows.
Ej
az
(A
C
The relevant cash flows would be:
Years Cashflows
0
Market Value of Loan Note (P0)
1-n
Annual Interest Payment i(1-T)
n
Redemption Value
As
ad
ILUSTRATION 5
Woodwork Ltd has 10% loan notes quoted at $102 ex interest redeemable in 5
years’ time at par. Corporation tax is paid at 30%.
Required:
What is the cost of debt net?
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
IM
A,
C
IS
A,
AP
FA
)
Solution
The cash redemption value if not converted
Ad
v
2.
.D
ip
M
A
C
Convertible debt
A loan note with an option to convert the debt into shares at a future date
with a predetermined price. In this situation, the holder of the debt has the
option therefore the redemption value is the greater of either:
1.
The share value on conversion or
A,
F
C
C
A,
ILUSTRATION 6
Continuing the ILUSTRATION 5, it has come to know that the loan note was
convertible into 40 ordinary shares. The expect share price at the redemption
date will expected to be $2.6
(A
C
Required:
What is the cost of debt net?
As
ad
Ej
az
Solution
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AFM: Advanced Financial Management
Study Notes
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.
)
Interest (Coupon) rate x (1 – T)
FA
Kd(net) =
IS
A,
AP
ILUSTRATION 7
Trout has a loan from the bank at 12% per annum. Corporation tax is charged
at 30%.
A,
C
Required:
What is the cost of debt net?
A
C
IM
Solution
WACC
X%
X%
X%
X%
C
C
A,
Ad
v
.D
ip
M
The Calculation of WACC
Source
Proportion (in Market Values) X
Cost
Equity
Proportion of Equity X Ke
Debt
Proportion of Debt X Kd(net)
Preference
Proportion of Preference X Kp
Share
WACC
(A
C
A,
F
ILUSTRATION 8
Bar plc has 20m ordinary 25p shares quoted at $3, and $8m of loan notes
quoted at $85. The cost of equity has already been calculated at 15% and the
cost of debt (net of tax) is 7.6%.
ad
Ej
az
Required:
Calculate WACC?
As
Solution
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
Capital Structure and WACC
Gearing Theories
The Traditional View
FA
)
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
Gearing (D/E)
C
A,
Ad
v
.D
ip
M
A
C
IM
A,
C
IS
A,
AP
Cost of debt: There is no impact on the cost of debt until the level of gearing is
prohibitively high. When this level is reached the cost of debt rises.
(A
C
A,
F
C
Key point : As the gearing level increases initially the WACC will fall. However,
this will happen upto an appropriate gearing level. After that level WACC will
start to rise. There is an optimal level of gearing at which the WACC is minimized
and the value of the company is maximized.
The MM View (With-out Tax)
Ej
az
Cost of equity: Ke rises at a constant rate to reflect the level of increase in risk
associated with gearing.
ad
Cost of debt: There is no impact on the cost of debt.
As
Assumptions:
1. Perfect capital market exist where individuals and companies can borrow
unlimited amounts at the same rate of interest.
2. Debt is risk free.
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Study Notes
A
C
IM
A,
C
IS
A,
AP
FA
)
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.
.D
ip
M
If the weighted average cost of capital is to remain constant at all levels of
gearing it follows that any benefit from the use of cheaper debt finance must
be exactly offset by the increase in the cost of equity.
C
A,
Ad
v
The MM View (With Tax)
In 1963 M&M modified their model to include the impact of tax. Debt in this
circumstance has the added advantage of being paid out pre-tax. The
effective cost of debt will be lower as a result.
As
ad
Ej
az
(A
C
A,
F
C
Implication: As the level of gearing rises the overall WACC falls. The company
benefits from having the highest level of debt possible.
SKANS School of Accountancy
27
AFM: Advanced Financial Management
Study Notes
CAPM and MM Combined
AP
FA
Financial Risk
IS
A,
Business Risk
Asset Beta (βa)
)
Systematic Risk
Equity Beta (βe)
𝒅𝒅
A,
Where:
Ve = Market Value of Equity
Vd = Market Value of Debt
Ad
v
𝒆𝒆
.D
ip
M
A
C
IM
A,
C
Business Risk
Risk due to nature of the business operations or the type of industry.
Financial Risk
Risk due to inclusion of debt in the financial structure. This Risk will be zero if the
company or investment is 100% equity financed.
Equity Beta (βe)
It is the Beta of a geared Company so it has both Financial and Business Risk
Asset Beta (βa)
It is the Beta of an un-geared Company so it has Business Risk only.
The Formula
𝑽𝑽
• 𝜷𝜷𝒂𝒂 = 𝑽𝑽 +𝑽𝑽 𝒆𝒆(𝟏𝟏−𝑻𝑻) 𝑿𝑿 𝜷𝜷𝒆𝒆
(A
C
A,
F
C
C
Should Company’s WACC be Used for Investment Appraisal?
If the Investment’s Business risk and Financial Risk are similar to the company,
then we use the company’s WACC to appraise the investment. However, if any
of the risk is different then we have to calculate investment specific cost of
capital.
As
ad
Ej
az
Project Specific Cost of Capital
Following are the steps of calculating the project specific cost of capital.
Financial Risk is Different
Business Risk is Different
1. Chose the βe of the company.
1. Identify a proxy company
2. Calculate the βa using the
having same Business Risk
2. Chose the βe of that proxy
company’s current financial
company.
structure (Un-gearing Beta).
𝑉𝑉𝑒𝑒
3. Calculate the βa using the Proxy
𝛽𝛽𝑎𝑎 =
𝑋𝑋 𝛽𝛽𝑒𝑒
company’s current financial
𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 (1 − 𝑇𝑇)
structure (Un-gearing Beta).
3. Calculate βe of the investment
using capital structure to be
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Study Notes
𝑉𝑉𝑒𝑒
𝑋𝑋 𝛽𝛽𝑒𝑒
𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 (1 − 𝑇𝑇)
4. Calculate βe of the investment
using capital structure to be
used for the investment. (Regearing Beta)
𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 (1 − 𝑇𝑇)
𝛽𝛽𝑒𝑒 =
𝑋𝑋 𝛽𝛽𝑎𝑎
𝑉𝑉𝑒𝑒
5. Use βe to calculate Ke using
CAPM
6. Calculate WACC
used for the investment. (Regearing Beta)
𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 (1 − 𝑇𝑇)
𝛽𝛽𝑒𝑒 =
𝑋𝑋 𝛽𝛽𝑎𝑎
𝑉𝑉𝑒𝑒
4. Use βe to calculate Ke using
CAPM
5. Calculate WACC
IS
A,
AP
FA
)
𝛽𝛽𝑎𝑎 =
M
A
C
IM
A,
C
ILUSTRATION 9
Techno, an all equity agro-chemical firm, is about to invest in a diversification in
the consumer pharmaceutical industry. Its current equity beta is 0.8, whilst the
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%.
Rm = 14%, Rf = 4%, corporation tax rate = 30%.
Ad
v
.D
ip
Required:
What would be a suitable discount rate for the new investment if Techno were to
finance the new project with 30% debt and 70% equity?
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Solution
SKANS School of Accountancy
29
AFM: Advanced Financial Management
Study Notes
Advanced Techniques
Combined Cost of Capital
AP
FA
)
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
operations of the business then it’s WACC after Acquisition will not change.
IS
A,
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
estimate Beta equity and eventually WACC.
IM
A,
C
However, if the Business Risk is different then, the post project WACC will be
different.
.D
ip
Post Project
(Combine)
Post-Acquisition Co.
Un-gear
C
A,
F
βa (Co.)
C
A,
Un-gear
Project
(different Nature Operations)
Target Co.
βe (Inv.)
Ad
v
Company
(different nature Operations)
Pre-Acquisition Co.
βe (Co.)
M
A
C
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
will always combine Beta (or taking Average of Beta) at an Asset Level.
X Proportion of Business
Proportion of βa (Co.)
ADD
βa (Combine)
Gear
ad
Ej
az
(A
C
X Proportion of Business
Proportion of βa (Co.)
βa (Inv.)
As
βe (Combine)
Ke using CAPM
WACC
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AFM: Advanced Financial Management
Study Notes
Exam Note
In the Exam you may have to work it Backwards as well.
AP
FA
)
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
million.
IS
A,
The average equity β of pharmaceutical firms is 1.3 and the Gearing in the
pharmaceutical industry averages 40% debt, 60% equity.
IM
A,
C
This new Pharmaceutical project will require an additional investment of $20
million and the company intends to finance 50% by raising debt from the bank
and remaining by issuing new ordinary shares.
A
C
Corporate debt is available at 5%. Rm = 14%, Rf = 4%, corporation tax rate = 30%.
.D
ip
M
Required:
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.
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
Solution
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AFM: Advanced Financial Management
Study Notes
Credit rating
FA
AP
Note: the above table is presented in basis points and 1%=100 basis Points
The formula
)
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.
Ad
v
.D
ip
M
A
C
IM
A,
C
IS
A,
Kd(net) = (Risk Free Rate + Credit Spread)(1-T)
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Criteria for Establishin Credit rating
 Country Risk: No debt will be rated higher than the country
 Universal Importance: The company’s standing relative the other countries
 Industry Risk: The strength and weakness of the industry.
 Industry Position: The companies position in the Industry.
 Management Evaluation: The companies Planning, Control, Policies
Performance.
 Accounting Quality: The Accounting Policies, Qualification, etc.
 Earning Protection: ROCE, Net Profit Margins,
 Financial Gearing
 Cash Flow Adequacy
 Financial Flexibility: Evaluation of Financial Needs, Relationship with
Investors, Covenants
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)
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Study Notes
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
.D
ip
M
A
C
IM
A,
C
IS
A,
AP
FA
)
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
Π is net income/total assets
S is deb status (subordinated = 1, otherwise = 0) Unsubordinated debt has priority
claim.
L is gearing
C is interest cover (PBIT/Interest)
β is beta of company (CAPM)
σ is the variance.
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33
AFM: Advanced Financial Management
Study Notes
Advanced Investment Appraisal
)
Modified Internal Rate of Return
IS
A,
AP
FA
A criticism of the IRR method is that in calculating the IRR, an assumption is that
all cash flows earned by the project can be reinvested to earn a return equal to
the IRR.
A,
C
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
be reinvested to earn a return equal to the company’s cost of capital
IM
Using MIRR for project appraisal
.D
ip
M
A
C
It might be argued that if a company wishes to use the discounted return on
investment as a method of capital investment appraisal, it should use MIRR rather
than IRR, because MIRR is more realistic because it is based on the cost of capital
as the reinvestment rate
Ad
v
MIRR Formula
1
A,
𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑃𝑃ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑛𝑛
� (1 + 𝑟𝑟𝑒𝑒 ) − 1
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = �
𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑃𝑃ℎ𝑎𝑎𝑎𝑎𝑎𝑎
C
C
Example
Ej
As
ad
0
1
2
3
4
5
Cash flow
$
(60,000)
(20,000)
30,000
50,000
40,000
(10,000)
az
Year
(A
C
A,
F
A business requires a minimum expected rate of return of 8% on its investments. A
proposed capital investment has the following expected cash flows and NPV.
NPV
Discount
1.000
0.926
0.857
0.794
0.735
0.681
Present Value
$
(60,000)
(18,520)
25,710
39,700
29,400
(6,810)
+ 9,480
The modified internal rate of return (MIRR) is:
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Study Notes
AP
FA
)
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
conflict.
A,
C
IS
A,
Problems of MIRR
➢
It is not an industry preferred method.
➢
MIRR is also a relative measure so it still does not consider size of the project
Free cash flow
C
IM
You might be need to perform a forecast of free cash flows in order to appraise
an investment including a business valuation.
Ad
v
.D
ip
M
A
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
company or business is obliged to make. Essential payments include taxation
payments and capital expenditure to replace ageing non-current assets
(‘replacement’ capital expenditure). Free cash flow is therefore the amount of
cash generated by the company that management are able to decide how to
use.
C
C
A,
Free cash flows for equity (FCFE) might be used in the valuation of the share
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.
az
(A
C
A,
F
Free cash flow for the firm
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
without deducting interest payments as an essential cash payment.
As
ad
Ej
Calculating free cash flow for the firm
Method 1
Earnings before interest and tax (EBIT)
Less tax on EBIT
Add back: Depreciation (and any other non-cash expenditures)
Less: Working capital increases
Plus: Working capital decreases
Less: Replacement capital expenditure
Free cash flow
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X
(X)
X
(X)
X
(X)
XX
35
AFM: Advanced Financial Management
Study Notes
Method 2
Free Cashflow to Firm
Less: Interest payments
Add: Tax savings on interest
Free cash flow for equity
X
(X)
X.
XX
FA
X
(X)
X
(X)
X
(X)
X
(X)
XX
.D
ip
M
A
C
IM
A,
C
IS
A,
AP
Method 1
Earnings before interest and tax (EBIT)
Less: Interest payments
Profit after Interest
Less tax on Profit after interest
Add back: Depreciation (and any other non-cash expenditures)
Less: Working capital increases
Plus: Working capital decreases
Less: Replacement capital expenditure
Free cash flow for equity
)
Free cash flow for equity
Free cash flow for equity is the amount of free cash flow after deduction of interest
payments.
C
A,
Ad
v
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
to equity.
(A
C
A,
F
C
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
in the business.
Adjusted present value method (APV method) of project appraisal
As
ad
Ej
az
Problem with NPV
 The total return from the project is based on two different risk i.e. business
risk and financial risk. But NPV doesn’t segregate these returns between
business risk and financial risk.
 It doesn’t incorporate the issue cost of raising the debt finance
 It doesn’t incorporate the subsidy benefits from the subsidized loans
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Study Notes
An alternative approach to capital investment appraisal is the adjusted present
value (APV) method.
AP
FA
)
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
finance the investment.
A,
C
IS
A,
The APV method is an alternative to calculating a new cost of equity and a new
WACC, for example using the Modigliani-Miller formulae or the asset beta
formula.
M
.D
ip
Base case NPV
Add: Present Value of Tax Sheild
Adjusted Present Value
.
A
C
IM
The decision rule for the APV method
A project is financially viable and should be undertaken if its adjusted present
value (APV) is positive. The APV of a project contains two elements, and is
calculated as follows:
A,
Ad
v
Base case NPV
The base case NPV is calculated assuming the project is financed entirely by
equity, so that the method of financing is ignored.
𝑉𝑉
𝐾𝐾𝑒𝑒(𝑔𝑔) = 𝐾𝐾𝑒𝑒(𝑢𝑢𝑢𝑢) + (1 − 𝑇𝑇)(𝐾𝐾𝑒𝑒(𝑢𝑢𝑢𝑢) − 𝐾𝐾𝑑𝑑 ) 𝑉𝑉𝑑𝑑
az
MM
𝐾𝐾𝑒𝑒(𝑢𝑢𝑢𝑢) = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝑎𝑎 (𝑅𝑅𝑚𝑚 − 𝑅𝑅𝑓𝑓 )
(A
C
CAPM
A,
F
C
C
It is therefore necessary to calculate the cost of equity in an all-equity company
in the same industry or the market in which the capital investment will be made.
This can be done by either of the two methods
𝑒𝑒
As
ad
Ej
Present value of the tax shield (PV of the tax relief on interest costs)
When a new project is financed wholly or partly with new debt finance, there will
be tax relief on the interest. The PV of these tax benefits should be included in the
APV of the project.
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
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
 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.
AP
FA
)
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
is for several reasons.
C
IM
A,
C
IS
A,
 The APV method does not rely on assumptions about the new WACC of the
firm if the project is undertaken.
 The APV method allows for the specific tax relief on the borrowing to
finance the project, and does not assume that the debt will be perpetual
debt.
 The APV method allows for other costs, such as the costs of raising new
finance (issue costs).
.D
ip
M
A
It might be argued that APV is therefore the best method of estimating the effect
of a new investment on the value of the business entity, and the wealth of its
shareholders.
Comparison of NPV and APV methods
A,
Ad
v
The NPV and the base case NPV are calculated using the same cash flows,
except that the cash flows for the base case NPV should exclude ‘other costs’
such as financing costs, whereas these are included in the calculation of an NPV.
As
ad
Ej
az
(A
C
A,
F
C
C
ILUSTRATION
Davis Co is considering diversifying its operations different from its main area of
business (food manufacturing) into the plastics business. It wishes to gauge an
investment project, which involves the acquisition of a molding machine that
costs $450,000. The project is predicted to produce net annual operating cash
flows of $220,000 for every of the three years of its life. At the top of this point its
scrap value are going to be zero.
The assets of the project can support debt finance of 40% of its initial cost. Davis
is considering borrowing this amount from two different sources
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
repayable after 3 years.
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
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Study Notes
A,
C
IS
A,
AP
FA
)
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.
The firm is for certain that it'll earn sufficient profits against which to offset these
allowances.
Required:
Calculate the adjusted present value and determine whether the
project should be accepted?.
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
.D
ip
M
A
C
IM
SOLUTION
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AFM: Advanced Financial Management
Study Notes
Debt Capacity
The ability of the business to raise further debt is known as debt capacity.
Duration
AP
FA
)
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
the time required to cover one half of the value of investment returns.
IS
A,
Steps to calculate duration
M
A
C
IM
A,
C
 Find discounted cash flows of return phase
 Find total present value of return phase by adding all discounted cash flows
calculated above
 Find proportion of all present values by dividing each present value with
total
 Find weighted average years by multiplying relevant years to above
proportion
 Add all weighted years as duration
Ad
v
.D
ip
Duration can be used in capital investment appraisal to assess the payback on
the project. Unlike payback and discounted payback, however, it takes into
consideration the total expected returns from the entire project (at their
projected value), not just returns up to the payback time.
C
C
A,
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
most of the returns from the project will be recovered in the early years.
(A
C
A,
F
If duration of the project is large portion of the total life of the project – for example
if duration is 75% or more of the total life of the project – this means the most of
the returns from the project will be recovered in later years.
Ej
az
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.
As
ad
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
the cash flows start to turn positive.
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).
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Study Notes
Advantages
IS
A,
AP
FA
)
 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
recommended as a superior measure to either payback or discounted
payback when comparing the time taken by different projects to recover
the investment involved.
A,
C
Disadvantages
C
IM
 Its disadvantage is that it is more difficult to conceptualize than payback
and may not be employed for that reason.
 It is not an industry preferred Method.
A
Modified Duration
Macaulay Duration / (1 + GRY)
.D
ip
M
It is a measure of sensitivity of the price of bond to a change in interest rates.
*GRY is gross Redemption Yeild
Ad
v
This can be used to calculate proportionate change in bond price.
A,
ΔP = - Modified Duration X ΔY X P
C
C
Where: Δ is change, P is for price and Y is for yield
A,
F
Risk in Investment Appraisal
Monte Carlo simulation
As
ad
Ej
az
(A
C
Monte Carlo simulation is a method of measuring an expected outcome by
means of generating multiple trials or iterations, in order to determine the
expected value of the outcome and also to measure the variability or risk. Monte
Carlo simulation depends on the fact that by taking the outcomes of a large
number of individual random events (iterations), an accurate measurement of
the expected value and probability distribution of the outcome will be obtained.
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
expected value and probability distribution of the outcome.
Steps in Simulation
 Specify major variable.
 Market size.
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AFM: Advanced Financial Management
Study Notes
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.
 Net cash flow = sales revenue (variable cost + fixed cost = taxation) etc
 Simulate the environment and computerized model will generate a range
of NPV across all probability levels
IS
A,
AP
FA
)






C
IM
A,
C
Merits of simulation
 It includes all possible outcomes in the decision making process.
 It is relatively easily understood technique.
 It has a wide variety of applications (inventory control, component
replacement, corporate models, etc.)
Ad
v
.D
ip
M
A
Demerits of simulation
 Models can become extremely complex and the time and cost involved in
their construction can be more than is gained from the improved decisions.
 Probability distributions may be difficult to formulate
 Accuracy of data output depends upon the accuracy of data input.
Project value at risk
A,
F
C
C
A,
Annual volatility of a project
Volatility in this context refers to the possibility that a project’s NPV might be much
higher or lower than the expected value of the NPV. In capital investment
appraisal, annual volatility is the standard deviation of the PV of annual cash flows
from the project.
= σS × √T
Ej
σL
az
(A
C
For any item with a variable value, for which volatility is measured, the statistical
volatility increases with the length of the time period over which it is measured.
The relationship is as follows:
As
ad
where
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
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Study Notes
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.
AP
FA
)
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.
IM
A,
C
IS
A,
Project value at risk
A project value at risk is the maximum amount, at a given confidence level, by
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,
which should help management to decide whether or not to invest in the project,
taking into consideration the risk as well as the expected return (expected NPV).
Calculating project value at risk
A
C
Example
.D
ip
M
A simulation model has been used to calculate the expected value of the NPV
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.
Ad
v
Normal distribution tables can also be used to calculate the following
probabilities:
A,
F
C
C
A,
At the 95% confidence level, the project value at risk is:
N(0.95) 30,000 √10 = 1.645 × $94,868 = $156,058.
At the 95% confidence level, the NPV will not be worse than $282,000 – $156,058
= $125,942.
As
ad
Ej
az
(A
C
At the 99% confidence level, the project value at risk:
N(0.99) 30,000 √10 = 2.327 × $94,868 = $220,758.
At the 99% confidence level, the NPV will not be worse than $282,000 - $220,758 =
$61,242.
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AFM: Advanced Financial Management
Study Notes
International Investment Appraisal
)
Why Investment Overseas
AP
FA
Investing in Overseas may give:
A,
F
C
C
A,
Ad
v
.D
ip
M
A
C
IM
A,
C
IS
A,
 access to new markets and/or enable it to develop a market for its
products in locations
 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
not have had if it merely exported its products.
 Easier and cheaper access to raw materials it needs. It would therefore
make good strategic sense for it to undertake the overseas investment.
 Access to cheaper labour resources and/or access to expertise
 Closer proximity to markets, raw materials and labour resources may
reduce costs and gain edge against its competitors. For example,
transportation and other costs related to logistics may be reduced if
products are manufactured close to the markets where they are sold.
 Risk, such as economic risk resulting from long-term currency fluctuations,
may be reduced where costs and revenues are matched and therefore
naturally hedged.
 Increase its reputation because it is based in the country within which it
trades leading to a competitive edge against its rivals.
 International investments might reduce both the unsystematic and
systematic risks for shareholders only hold well diversified portfolios in
domestic markets, but not internationally.
(A
C
Factors affecting foreign investment decisions
the exchange rates.
the risk of exchange controls and similar cash flow restrictions
taxation on remittances to the parent company’s country.
Transfer Pricing
As
ad
Ej




az
Companies considering a major capital investment in another country also need
to consider:
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
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Study Notes
large amounts over time, often both up and down. Two aspects to exchange rate
risk are:
FA
)
 Transaction risk
 Translation risk.
 Economic risk
A,
C
IS
A,
AP
Transaction risk: affects any company that receives income or makes payments
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
‘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
or paid in the company’s own currency (domestic currency) will be less or more
than originally expected.
M
A
C
IM
Exchange rates can move favorably as well as adversely, but the main concern
for risk management is with the possibility and consequences of an adverse
exchange rate movement.
Ad
v
.D
ip
Translation risk: is a financial reporting risk for companies with foreign investments.
For the purpose of preparing consolidated financial accounts, the financial
statements of foreign subsidiaries must be translated into the reporting currency
of the parent multinational. Changes in the exchange rate create gains or losses
on translation, which affect the reported results of the group.
C
A,
Economic risk: Also called forecast risk, refers to when a company’s market value
is continuously impacted by an unavoidable exposure to currency fluctuations
A,
F
C
Predicting Exchange rates
Ej
az
(A
C
In the exam question we may have to estimate future expected exchange rates.
This can be calculated by using purchase power parity i.e.
ad
Where:
𝑆𝑆1 = 𝑆𝑆0 𝑋𝑋
1 + ℎ𝑎𝑎
1 + ℎ𝑏𝑏
As
S1 = Future Expected Spot Rate
S0 = Current Spot Rate
ha = Rate of inflation in country a
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AFM: Advanced Financial Management
Study Notes
hb = Rate of inflation in country b
EXAMPLE:
AP
UK
2%
4%
4%
IS
A,
USA
5%
3%
4%
A,
C
Year
1
2
3
FA
)
The Current Dollar Sterling exchange rate is given $1.7050/£ Expected Inflation
Rates are:
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
.D
ip
M
A
C
IM
Solution:
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Study Notes
Converting currencies
Quotes
Example
(Pakistan)
Local/foreign Rs. 160/1$
Converting foreign currency to home
currency
Foreign Currency cashflows X FOREX rates
eg. $10= (160 X 10) = Rs. 1,600
Foreign Currency cashflows ÷ FOREX rates
eg. $10 = (10/0.00625) = Rs. 1,600
FA
)
Direct
Quoted
Note: Do opposite for converting Home Currency to Foreign
A,
C
Political risk
IS
A,
AP
Indirect Foreign/local $.00625/Re.
M
A
C
IM
Political risk is the risk for an international company that the government of a
foreign country might take action that affects the operations or profitability of its
investment in its country, or places restrictions on the ability of the foreign
subsidiary to remit interest or dividends to the parent country.
.D
ip
Exchange controls
Ad
v
Exchange controls are actions by a government that:
A,
F
C
C
A,
 restrict or prevent the ability of its own nationals to buy foreign currency in
order to make payments to foreign suppliers
 restrict or prohibit the payment of interest or dividends to foreign investors,
including payments from subsidiary companies to their foreign parent 
restrict the flow (payments) of capital out of the country.
(A
C
Example
As
ad
Ej
az
Dar Co. is a US based co. and is planning to invest in Pakistan. Due to economic
conditions of Pakistan and to control balance of payment deficit the new govt.
has proposed that no cashflows from foreign investment can be taken back until
3 years of investment. However, the govt has offered the foreign investors an
interest rate of 13% for that period. Dar Co.’s net-cashflows and expected
exchange rates estimation for the next 4 years are:
Year:
1
2
3
4
Net Cashflow (Rs.m)
35
40
45
38
Exchange rates (Rs/$)
155
160
168
175
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AFM: Advanced Financial Management
Study Notes
Required:
Prepare the cashflows for home country under the above said circumstances.
.D
ip
M
A
C
IM
A,
C
IS
A,
AP
FA
)
Solution
Taxation and international investment
Ad
v
Presentation of Tax
A,
F
C
C
A,
Operational cashflow
Tax on Operational Cashflow
Tax savings on Capital Allowances
Net Cashflow
X
(X)
X.
XX
X
(X)
X
(X)
X.
XX
X
(X)
XX
Working 1
Operational cashflow
Less: Capital Allowances
X
(X)
As
ad
Ej
az
(A
C
Operational cashflow
Less: Capital Allowances
Profit after Capital Allowances
Tax
Add: Capital Allowances
Net Cashflow
Operational cashflow
Tax (W-1)
Net Cashflow
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Study Notes
Profit after Capital Allowances
Tax
X
(X)
)
Tax Losses
A,
C
IS
A,
AP
FA
When the project makes profit then the govt. charges tax on that and if the
project suffers losses then the govt. gives relief on that. This relief usually first setoff
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
are carried forward against future profits and hence no tax savings are recoded
in the current period.
Example
Operational Cashflow
(300)
400
3
A
2
M
1
1,000
.D
ip
Years
C
IM
Following are the Operational Cashflows for the next 3 years
Ad
v
Capital Allowances are 200 each year on straight-line basis. The company do not
have sufficient profits and hence any loss has to be carryforward. Rate of tax is
30% payable in the same year the liability arises.
A,
Required
C
C
Prepare Net cashflows for the Next 3 Years
As
ad
Ej
az
(A
C
A,
F
Solution
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AFM: Advanced Financial Management
Study Notes
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.
A,
C
IS
A,
AP
FA
)
Double taxation agreements. Many countries have double taxation agreements
with each other. The purpose of a double taxation agreement is to prevent
punitive taxation by taxing profits twice, once in each country. A double taxation
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
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
avoiding excessive and punitive tax on the pre-tax returns that the investments
make.
C
IM
Example (Double Tax)
Ad
v
Home Country
Foreign Country
Situation 1
30%
40%
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Solution
Situation 1
25%
25%
.D
ip
Situation 1
40%
30%
M
A
Following are the rates of Taxation in home country and Foreign Currency. Est the
tax rate for each country in different situations assuming Double Tax Treaty exist
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Study Notes
Calculation of Tax in Foreign Currency and home currency
AP
FA
𝑇𝑇𝑇𝑇𝑇𝑇 𝑖𝑖𝑖𝑖 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝑋𝑋 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 → 𝐶𝐶𝐶𝐶𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑖𝑖𝑖𝑖 ℎ𝑜𝑜𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑖𝑖𝑖𝑖 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
)
 Calculate Tax in foreign currency and make part of foreign cashflows
 Calculate total tax in Home currency and include in additional cashflows
IS
A,
Transfer Pricing and cashflows in foreign country
A,
C
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.
In that case the price needs to be converted from Home currency to foreign
currency first.
M
A
C
IM
Similarly, if the home country is transferring any component to Foreign project
then the contribution will be recorded in ‘Additional Cashflows in Home Currency’
whereas the price will be recorded as cost in the Foreign currency cashflows.
.D
ip
Example
A,
Ad
v
A UK Based firm and is in considering to invest in USA. For that they need to transfer
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
the exchange rate in year 1 is expected at $1.2355/£.
C
Required
(A
C
As
ad
Ej
az
Solution
A,
F
C
Prepare the cashflows to be included in foreign country as well as in home country
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
Features of a foreign country investment appraisal
)
The features of investing in a foreign country include the following:
IS
A,
AP
FA
The investment could be a very high-risk investment, and you might be required
to establish a special cost of capital for evaluating the project, possibly using the
CAPM and a beta factor for the project.
A,
C
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
company.
M
A
C
IM
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
amount of payments that can be made from the foreign country, due to
exchange control restrictions. This means that the cash profits from the project
might not be payable immediately in full as dividends to the investing company.
.D
ip
Steps of International Investment Cashflows and NPV
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
 Calculate all the relevant net cashflows related to foreign project directly
in the foreign currency.
 Consider whether any restrictions are placed on remittances and if so,
calculate the cash flows actually received by the parent.
 Convert the net flows into the domestic currency using the expected future
exchange rates
 Add any other domestic cash flows that arise in the home currency (e.g.
additional tax).
 Discount the total net cash flows in the domestic currency at an
appropriate cost of capital.
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AFM: Advanced Financial Management
Study Notes
Acquisition and Merger
)
Acquisition
AP
FA
An acquisition normally involves a larger company (a predator) acquiring smaller
company (a target).
IS
A,
Mergers
IM
A,
C
A merger is in essence the pooling of interests by two business entities which results
in common Ownership access to new markets and/or enable it to develop a
market for its products in locations
A
C
However, the financial management issues are broadly the same for mergers as
for acquisitions.
.D
ip
Horizontal integration
M
Types of Merger & Acquisition
C
C
Vertical integration
A,
Ad
v
When two companies in the same industry, whose operations are very closely
related and are combined, integrate. This is known as horizontal merger or
acquisition.
(A
C
A,
F
When two companies in the same industry, but from different stages of the
production chain are merged. This is known as vertical integration.
Conglomerate integration
ad
Ej
az
When two or more companies which are completely unrelated businesses
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
name.
As
Alternatives to acquisitions
A comparison of growth by acquisition and internal growth
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
Advantages of Acquisition
A
C
IM
A,
C
IS
A,
AP
FA
)
 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.
 It is often argued that when a target company is acquired, it should be
possible to achieve 'synergies' and add value by increasing the combined
profits of the two companies. Synergy is explained in more detail later.
 When a company is trying to grow its business in another country,
acquisition might be better than internal growth, because the company
will acquire skilled employees who already understand the business, the
country, its laws and culture and its language.
 Unless a company acquires available target businesses, its competitors
might acquire them instead and the strategic threat from the enlarged
competitor might increase.
M
Advantages of Organic Growth
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
.D
ip
 There is a high risk that the price paid for an acquisition will be too high, and
the financial return from buying an over-valued company will be low.
 Many acquisitions are failures. This means that an acquisition strategy is a
high- risk strategy. Hie reasons why acquisitions often fail are explained later.
 With a strategy of internal growth, the company's management should be
able to plan and control the development of the business more effectively,
because the practical problems associated with acquisitions do not arise.
The practical problems include difficulties with employees in the acquired
company and the management time needed to combine the systems of
the two companies after the acquisition.
 An acquisition is not usually 'ideal' and there will be some features of the
target company that the acquirer might not want to buy. After the
acquisition, the acquiring company might want to sell off unwanted parts
of the business. This can be a time-consuming process, and the prices
obtained from selling off these operations and assets might be low.
As
ad
Criteria for choosing an acquisition target
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
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AFM: Advanced Financial Management
Study Notes
AP
FA
)
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.
IS
A,
Cost and relative size. Although there are occasional examples of small
companies acquiring much larger ones in a 'reverse takeover', target companies
are usually selected because they are affordable.
C
IM
A,
C
Opportunity and availability. In many cases, targets for acquisition are selected
because of circumstances. An opportunity to acquire a particular company
might arise, and the acquiring company might decide to take the opportunity
whilst it is available.
A,
Ad
v
.D
ip
M
A
Potential synergy. Acquisition targets might possibly be selected because they
provide an opportunity to increase total profits through improvements in
efficiency. One reason for the success of private equity funds in acquiring target
companies has been their ability to achieve additional efficiencies and
economies that the previous company management had been unable to do. A
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
creating extra value.
C
Synergy
az
(A
C
A,
F
C
Synergy is sometimes called the '2 + 2 = 5' effect. It is the concept that the
combined sum of two separate entities after a merger or acquisition will be worth
more than their sum as two separate entities. When two separate entities come
together into a single entity', opportunities might arise for increasing profits.
Synergies might be divided into three categories:
Ej
Revenue synergies
As
ad
Revenue synergies are increases in total sales revenue following a merger or
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
sales revenue of $200 million, the combined revenue of the two companies after
the merger might be, say, $750 million.
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
Revenue Synergy might occur in following circumstances
AP
FA
)
 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
two companies were unable to do before they combined due to their
smaller size.
IS
A,
Cost synergies
A
C
IM
A,
C
Cost synergies are reductions in costs as a consequence of a merger or takeover.
They might arise because it is possible to improve efficiency. For example, it might
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
takeovers to result in staff redundancies, partly for tins reason.
.D
ip
M
Cost synergies might also be possible by combining other activities, such as
combining warehouse facilities.
C
Financial synergies
A,
Ad
v
Experience has shown, however, that companies often have difficulty in
achieving planned cost synergies after a takeover, because combining the
activities of the two companies after the takeover is often a long and complex
process.
(A
C
A,
F
C
A larger (combined) company or group might be able to raise finance in a
cheaper way. The enlarged company might have access to financial markets,
such as the bond market, that the two individuals’ companies could not access
before the takeover, due to their smaller size.
Ej
az
The larger company might also be seen as a lower credit risk, so that it is able to
borrow from banks at a lower rate of interest.
ad
The high failure rate of acquisitions
As
Many acquisitions fail, and do not provide the value for shareholders that was
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.
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Study Notes
IM
A,
C
IS
A,
AP
FA
)
 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
in the acquired company. Control systems might have to be reviewed and
changed.
 Senior management in the acquiring company might not give the
acquired company sufficient time and attention to make the acquisition
operationally and financially successful.
 Competitors might react to an acquisition with a new competitive strategy
of their own. Increased competition might drive down the profits for all
participants in the market.
A
C
Factors effecting the likely success of the bid for Acquisition
M
Level of consideration
A,
Expectations of future profits
Ad
v
.D
ip
The acquirer should offer an initial bid price, keeping in mind a satisfactory
premium over and above the actual market value of the acquire company. A
generous offer would incline the target company to consider the offer positively.
A,
F
C
C
In order to encourage the shareholders of Target Company to retain their shares
in the combined company, a potential estimate of future earnings and synergies
would be required by them.
(A
C
Future dividend policy
az
Shareholders of Target Company may be sensitive to the dividend policy possibly
being less generous than they have been used to before the acquisition.
ad
Ej
Tax position
As
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.
Changes in shares prices
Shareholders will also take account of any changes in share prices that occur
during the bid price.
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
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.
AP
FA
Pre-Offer Defense
IS
A,
Poison Pill
A,
C
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
variants.
IM
Golden Parachutes
C
C
"Crown Jewel" Defense
A,
Ad
v
.D
ip
M
A
C
Golden parachutes are compensation agreements between the target
company and its senior managers. These employment contracts allow the
executives to receive lucrative payouts, usually several years‟ worth of salary, if
they leave the target company following a change in corporate control. Golden
parachutes may encourage key executives to stay with the target as the
takeover progresses and the target explores all options to generate shareholder
value. Without a golden parachute, some contend that target company
executives might be quicker to seek employment offers from other companies to
secure their financial future.
(A
C
A,
F
The firm's most valuable assets may be the main reason that the firm became a
takeover target in the first place. By selling these or entering into arrangements
such as sale and leaseback, the firm is making itself less attractive as a target.
az
Eternal vigilance
ad
Ej
Maintain a high share price by being an effective management team and
educate shareholders.
As
Cross shareholdings
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
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AFM: Advanced Financial Management
Study Notes
Increases its financial risk, and therefore the company will need to be able to bear
the consequences of this increased risk.
AP
FA
)
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.
Post offer defenses
IS
A,
Litigation
IM
A,
C
The target company can challenge the acquisition by inviting an investigation by
the regulatory authorities or through the courts. The target may be able to sue for
a temporary order to stop the predator from buying any more of its shares.
C
Green Mail
.D
ip
M
A
This technique involves an agreement allowing the target to repurchase its own
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
not pursue another hostile takeover attempt of the target for a set period.
Ad
v
"Pac-Man" Defense
(A
C
A,
F
C
C
A,
The target can defend itself by making a counteroffer to acquire the hostile
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
a target uses a Pac-Man defense, it forgoes the ability to use a number of other
defensive strategies. For instance, after making a counteroffer, a target cannot
very well take the acquirer to court claiming an antitrust violation.
az
White Knight Defense
Ej
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.
As
ad
Methods of financing mergers
Cash
Advantages to Acquirer
 When the bidder has sufficient cash the merger can be achieved quickly.
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
 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
AP
FA
Cash flow strain - usually either must borrow (increased gearing) or issue new
shares in order to raise the cash.
IS
A,
Advantages to Target
A,
C
 Certainty about bids value
 Freedom to invest in a wide ranging portfolio.
IM
Disadvantages to Target
A
C
 Liable to CGT
 Do not participate in new group synergy benefits
.D
ip
M
Share exchange.
Advantages to Acquirer
A,
Ad
v
 No cash outflow
 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,
F
Dilution of control
C
C
Disadvantages to Acquirer
(A
C
Advantages to Target
Ej
az
 Postponement of CGT liability
 Participate in new group synergy benefits
ad
Disadvantages to Target
As
Uncertain value
Debt
Preference shares.
Hybrid
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Study Notes
The Global Regularity Framework
Key aspects of Takeover Regulation
)
Mandatory Bid- Rule:
A,
C
IS
A,
AP
FA
The aim of this rule is to protect the minority shareholders by providing them with
the opportunity to exit the company at the fair price once the bidder has
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
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
the bid.
IM
The principle of equal treatment:
.D
ip
M
A
C
The principle of treating all the shareholders equally is fundamental. The principle
of equal treatment requires the bidder to offer to minority shareholders as same
term as those offered to earlier shareholders from whom the controlling block was
acquired.
Transparency of ownership and control:
C
A,
Ad
v
The transparency enables the regulators to monitor the large shareholders,
minimize agency problems and investigate insider dealing. It also enables that
minority shareholder and the market to monitor the large shareholders who may
able to exercise undue influence exact at the expense of the other shareholdings.
A,
F
C
The squeeze-out and sell-out rights:
(A
C
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.
az
The one-share-one vote:
As
ad
Ej
Where the one share-one vote principle is upheld, arrangements restricting voting
rights are forbidden. Differentiated voting rights, such as non-voting shares and
dual-clan shares with the multiple voting rights, enable some shareholders to
accumulate control at the expense of other shareholders and could provide a
significant barrier to potential takeovers.
The break-through rule
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AFM: Advanced Financial Management
Study Notes
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 breakthrough the company‟s multiple voting rights and exercise control as if one shareone vote existed.
FA
)
Board neutrality and anti-takeover measures
A,
C
IS
A,
AP
Seeking to address the agency issue where management may be tempered to
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
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
arrangements giving rights to existing shareholders to buy shares at a low price,
known as poison pill defense), without prior authority of the shareholders.
C
IM
General Principles:
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
.D
ip
M
A
 All the shareholders of the target company must be treated similarly.
 All information disclosed to one or more shareholders of the target
company must be disclosed to all
 An offer should only be made if it can be implemented in full individuals or
firms should not make an offer unless they have reason to believe that they
will be able to implement this in full.
 Shareholders must be given sufficient information and advice to enable
them to reach a properly informed decision and mist have sufficient time
to do so. No relevant information should be withheld from them.
 All documentation should be of the highest standards of accuracy. A
documentation produced by the bidding company or the directors of the
target should be produced to the highest standards of accuracy.
 All parties must do everything to ensure that a false market is not created
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
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.
 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
themselves.
 The directors of both target and bidder must act in the interest of their
respective companies.
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
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AFM: Advanced Financial Management
Study Notes
merger or takeover might be against the public interest, it can refer it to the
Competition Commission.
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
.D
ip
M
A
C
IM
A,
C
IS
A,
AP
FA
)
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.
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
Acquisition and Merger Valuation
The need for a valuation
FA
)
Valuation and the offer price are key issues in a merger or acquisition. In a
takeover:
IM
A,
C
IS
A,
AP
 the acquiring company needs to decide what price it is prepared to offer
for the target company
 the directors of the target company need to decide whether the offer is
acceptable and whether it should be recommended to the shareholder,
and
 the shareholders in the target company need to decide whether they are
willing to accept the offer made for their shares.
M
A
C
Valuation Methods
Market Based
Methods
Market
Capitalization
Ad
v
.D
ip
Cash Flow Based
Methods
Dividend
Valuation Method
P/E Method
Replacement
Value
Break-up Value
C
C
A,
FCF/FCFE
Asset Based
Methods
Book Value
A,
F
Market Based Valuation
(A
C
Market Capitalization:
az
No. of shares X Ex-Dividend Share Price
Ej
P/E Method
As
ad
EPS X Expected P/E Ratio
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.
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Study Notes
FA
)
 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.
AP
Cashflow Based Valuation
IS
A,
Dividend Valuation Method
𝑑𝑑0 (1 + 𝑔𝑔)
𝐾𝐾𝑒𝑒 − 𝑔𝑔
IM
𝑃𝑃0 =
A,
C
Market Value = Present Value of future dividends, discounted at cost of equity.
M
A
C
Note: Above Formula can only be used when growth rate in dividend is constant
from Y1. If this is not the case then calculate according to the definition above.
Ad
v
.D
ip
Free Cashflow Based
 Estimate the relevant incremental free cash flows from the business to be
acquired.
 Discount these cash flows at an appropriate cost of capital that reflects
the risk of the investment.
C
A,
There are few points to remember in valuing using free cashflow
(A
C
A,
F
C
 If the method is FCF then the discount rate should be WACC and if it’s
FCFE then the discount rate should be Ke.
 Valuing using FCF will give us the total market value i.e. Debt + Equity
whereas, FCFE will give us the value of equity only
az
Asset Based Aproach
Ej
The business is estimated as being worth the value of its Net Assets.
ad
Net Assets = Total Assets – Total Liabilities – Preference Share Value
As
The issue that needs to be consider is whether to use:
 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.
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
AP
FA
)
 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.
 Replacement cost is difficult to estimate.
M
A
C
IM
Operating profits of the company
Less: Capital Employed X % of Avg ROCE in the industry
Excess earning
Adjustment of Tax
After tax Excess Earnings
A,
C
IS
A,
CALCULATED INTANGIBLE VALUE (CIV) MODEL
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
industry average.
.D
ip
Present value of excess earning discounted at WACC
XX
(XX)
XX
(XX)
XX
XX
(A
C
A,
F
C
C
A,
Ad
v
Example
PPL operates in the service industry. The directors are keen to value the
company for the purposes of negotiating with a potential acquirer and plan to
use the CIV method to value the intangible element.
In the past year PPL made an operating profit of $135m on an asset base of
$300m. The company WACC is 6%. A suitable competitor for benchmarking has
been identified who generates and average return of 19%
Corporation tax is 30%.
az
Required
Calculate the intangible value of PPL
ad
Ej
Valuation Techniques
As
Point of view of Acquirer (Buyer)
Acquirer will want to know about the maximum price that should be paid for
acquisition. Hence the value of target company will be
Post-Acquisition Value of parent (Combined Value)
Less: Value of the parent company before Acquisition
Value of the Target Company (The Maximum Value)
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XX
(XX)
XX
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AFM: Advanced Financial Management
Study Notes
IM
A,
C
IS
A,
AP
FA
)
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
o Combined cashflows = cashflows of parent + cashflow of target +
synergy cashflows
o WACC should be post acquisition which should be:
 Same as business and financial risk are same
 Marginal cost of capital if business risk is same but financial risk
is different
 Risk adjusted cost of capital (post acquisition Beta) if business
risk is different
M
A
C
Example
Nema Co, a listed company which manufactures electronic components, is
interested in acquiring Roney Co.
Ad
v
.D
ip
Information on Nema Co and Roney Co
Nema Co has a market debt to equity ratio of 50:50 and an equity beta of 1·18.
Currently Nema Co has a total firm value (market value of debt and equity
combined) of $140 million.
A,
F
C
C
A,
Roney Co has a market debt to equity ratio of 10:90 and an estimated equity
beta of 1·53. Roney Co has a total firm value (market value of debt and equity
combined) of $40 million.
ad
Ej
az
(A
C
Information about combine Company
Following the acquisition, it is expected that the combined company‟s sales
revenue will be $51,952,000 in the first year, and its profit margin on sales will be
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
acquisition, it is expected that the combined company will pay annual interest
at 6·4% on future borrowings.
As
The combined company will require additional investment in assets of $513,000
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.
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
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.
FA
)
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%.
A,
C
IS
A,
AP
Required:
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
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
current capital structure. Include all relevant calculation.
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
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M
A
C
IM
Solution
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Study Notes
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
IS
A,
IM
Gain and Losses on Acquisition
XX
(XX)
(XX)
XX
A,
C
Post-Acquisition Value of parent (Combined Value)
Less: Value of the target company before Acquisition
Less: Value of the parent company before Acquisition
Synergy value (Maximum Acquisition Premium)
AP
The Synergy Value of the company (Maximum Acquisition Premium)
FA
)
 PV of the Target Company only.
Target
Price Agreed
Less: Value in view of Acquiree
Gain/(Loss)
.
.D
ip
M
A
C
Acquirer
Value in view of Acquirer
Less: Price agreed
Gain/(Loss)
.
Ad
v
Example (Share to share exchange)
Market value of target company $5 per share, market value of acquirer $4 per
share. Acquirer has offered its 3 shares for every 2 shares of Target Company.
C
C
A,
Required
Calculate %age benefits for Target Company.
As
ad
Ej
az
(A
C
A,
F
Solution
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.
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
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.
AP
FA
)
Requirement:
Calculate %age gain to both the acquirer and target shareholders
C
C
A,
Ad
v
.D
ip
M
A
C
IM
A,
C
IS
A,
Solution
(A
C
A,
F
Example (Cash offer)
Market value of target co. is $4/share. Acquirer has offered $5 each for every
share of Target Company.
Ej
az
Required
Calculate %age gain to the target company shareholders.
As
ad
Solution
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AFM: Advanced Financial Management
Study Notes
Example:
M.V of target co is $4/Share. Acquirer has offered $110 worth Bond for every 20
shares of target co.
FA
)
Required
Calculate %age gain for target company shareholders.
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
.D
ip
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A
C
IM
A,
C
IS
A,
AP
Solution
SKANS School of Accountancy
71
AFM: Advanced Financial Management
Study Notes
Financial Reconstruction
Financial Reconstruction
A,
C
IS
A,
AP
FA
)
Unprofitable businesses
Profitable businesses
(debit
balance
on (which run out of cash revenue reserves)
overtrading)
Take
Agreement No agreement
remedial with creditors
action
Promise of
future
profits
.D
ip
M
A
C
IM
Continue to
be
unprofitable
Capital Reconstruction
A,
C
Liquidation
Assets sold
off and
distributed
in priority
order
(A
C
A,
F
C
Assets sold
off and
distributed
in priority
order
Ad
v
Liquidation
Ej
az
A financial reconstruction is a major reorganization of the capital structure of a
company especially when there are serious concerns of going concern. A
reconstruction might involve:
As
ad
 the conversion of debt capital into equity
 And possibly the conversion of equity shares from one form to another
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AFM: Advanced Financial Management
Study Notes
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:
FA
)
 if it is likely to be more beneficial to all the parties concerned than a
liquidation of the company (and the sale of its assets), and
IS
A,
AP
 the reconstructed company has a good chance of surviving and
restoring itself to profitability.
A,
C
A reconstruction will benefit all the parties if it is likely to result in them getting
more cash or more value from the reconstruction than from an enforced
liquidation of the company.
IM
The challange with a reconstruction scheme
A
C
There are some major problems with arranging a capital reconstruction. These
are:
M
 finding a reconstruction arrangement that will benefit all the parties, and
.D
ip
 Getting all the parties to agree to the proposal.
C
A,
Ad
v
 Each of the parties involved in a reconstruction (banks who are lending
money, bondholders, unpaid trade creditors and the shareholders)
need to believe that the reconstruction offers them the prospect of
more cash or more value than a liquidation of the company. Each of
the parties will therefore compare what they will probably receive:
C
o if the construction scheme is agreed, and
A,
F
o If the scheme is rejected and liquidation occurs.
(A
C
Financial Reconstruction Answer Plan:
az
1. State the reason why the scheme is required
As
ad
Ej
As a result of the recent considerable losses there is inadequate funds
available to finance the redemption of debentures.
2. The Capital Repayment position – priority order
(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
SKANS School of Accountancy
73
AFM: Advanced Financial Management
Study Notes
equity is used to purchase assets, on which they will have a prior claim
to shareholders
3. Does the scheme raise adequate finance?
FA
)
4. Whether The Business Will Proceed After The Reconstruction.
AP
5. Is the scheme acceptable to all parties?
General points:
C
IM
A,
C
IS
A,
a) The “What’s in it for me?” syndrome. Each party must be in at least as good
a position after the scheme as they whether before the scheme or else they
will not agree to the scheme. A secured creditor, who would receive full
payment in liquidation, will have to get something extra for agreeing to the
scheme e.g. a higher interest rate.
.D
ip
M
A
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.
Whatever judgement you make remember to justify your answer.
Approach:
C
C
a) Upon liquidation
b) Under the scheme
A,
Ad
v
The likely situation in the exam is that the company will be liquidated if the
scheme is not accepted. Therefore you should compare the position of each
group:
(A
C
A,
F
In relation to shares and debentures it may be worthwhile to note their market
value before the scheme i.e. their current exit value.
6. Conclusion
Ej
az
 Try and reach a sensible conclusion about the scheme, which is justified by
your analysis.
As
ad
 Don’t be afraid to say that you think the scheme in its current form, will not
be acceptable. Suggest any possible improvements to the scheme,
explaining their logic and appeal.
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AFM: Advanced Financial Management
Study Notes
Practice of Financial Reconstruction Plan
Assume that ‘now’ Is dec _2003
M
A
C
IM
A,
C
IS
A,
AP
FA
)
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
and competition from technologically superior products, causing sales to fall by
40% from 2000-2001 levels. This led to substantial losses being made in both 20012002 and 2002-2003.
The company’s managers are confident that the technical problems can be
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
stock market is not possible. Without the new investment, Dricom is unlikely to be
competitive, and might survive the next financial year. With the new investment
‘PBIT’ are forecast to be at least $750,000/year from 2004-2005 for at least five
years.
.D
ip
DRICOM INC
SUMMARISED SOFP AS AT 30-SEP-2003
$'000
$'000
_________
ad
As
SKANS School of Accountancy
2100
__________
3600
35
Total assets
Called up share capital
($1 par value)
Share premium
account
Revenue reserves
1500
1340
1090
Ej
az
(A
C
A,
F
Current assets
Inventory
Receivables
Cash at bank and in
hand
C
C
A,
Ad
v
Non-current assets
Land and building
Plant and machinery
(NET)
2465
_________
6065
_________
1000
945
-240
75
AFM: Advanced Financial Management
Study Notes
_________
Non-current liabilities
Term loan (from BXT
bank)
9% debenture 2016
8% convertible
debenture 2005
10% loan stock 2011
1705
800
FA
)
500
500
_________
A,
C
Current liabilities
Overdraft
Other payables
2800
A
C
IM
620
940
_________
.D
ip
M
Total equity and
liabilities
IS
A,
AP
1000
1560
_________
6065
_________
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
NOTES:
1) The 9% straight debenture is secured by a fixed charge on the company’s
main factory building, the convertible debenture and term loan by a
floating charge on non-current assets. The loan stock and overdraft are
unsecured.
2) The land and buildings are believed to have a realizable value 20% less
than than their net book value.
3) If the company ceased trading, inventories would be sold @ 50% of their
book value.
4) The new equipment would result in 50 staff being made redundant, with
an immediate after-tax cost of $500,000. If the company were to be
liquidated , after-tax redundancy payments would total $1 million.
Redundancy payments may be assumed to rank before UNSECURED
PAYABLES 
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..
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AFM: Advanced Financial Management
Study Notes
FA
)
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 
IS
A,
AP
DRICOM FINANCE DRICTOR believes that a corporate RESTRUCTURING could
solve the company’s problems, and has made the following proposals:
C
A,
Ad
v
.D
ip
M
A
C
IM
A,
C
1) Existing shareholders are to be offered 28 cents per share to redeem
their shares, which would then be CANCELLED.
2) $1 million would be provided by a venture capital organization in
return for 700,000 new 25 cents par value ordinary shares.
3) The company’s directors and employees would subscribe to 500,000
new 25 cents ordinary shares at a price of 150 cents per share.
4) The convertible debentures is to be replaced by new ordinary shares
(par value25 cents), with 60 ordinary shares for every $100 nominal
value loan stock.
5) The term loan is to be renegotiated with the bank and the total
amount of the loan increased to $2 million. This would have an
expected interest charge of 13% per annum. A floating charge on
non-current assets could be offered on the overdraft.
6) All other long-term loans would remain unchanged.
As
ad
Ej
az
(A
C
A,
F
C
Apart from the directors, none of the above parties have yet been consulted
regarding the proposed reconstruction.
Following a reconstruction, no corporate tax is expected to be paid for at least
two years. The corporate tax rate is 33%
The Average price/earnings ratio in DRICOM’S industry is 12:1
SKANS School of Accountancy
77
AFM: Advanced Financial Management
Study Notes
Business Reorganization
Business Reorganization
A,
C
IS
A,
AP
FA
)
A capital reconstruction is a major change in the capital structure and ownership
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
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 non-core part of the group's business operations, or de-merging two divisions of
a company into two entirely separate and independent companies.
M
A
C
IM
Portfolio Reconstruction
 Portfolio restructuring involves the acquisition of companies, or disposals of
assets, business units and/or subsidiary companies through divestments,
demergers, spin-offs, MBOs and MBIs.
 It involves making additions to or disposals from companies businesses.
 It includes Divestments, Demergers, spin-offs or management buy-outs.
A,
F
C
C
A,
Ad
v
.D
ip
Organizational Reconstruction
 It involves changing the organizational structure of the firm.
 Organizational restructuring involves changing the way a company is
organized. This may involve changing the structure of divisions in a
business, business processes and other changes such as corporate
governance.
 The aim of either type of restructuring is to increase the performance and
value of the business
As
ad
Ej
az
(A
C
Leveraged Recapitalization
 In leveraged Recapitalization a firm replaces the majority of its equity with
a package of debt securities.
 The high level of debt in the company discourages other companies to
make take-over bids.
 Companies should be
o Relatively debt free
o Consistent cash flows
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.
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AFM: Advanced Financial Management
Study Notes
AP
Advantages
Protection from Share price movement
No hostile bids
Focus on Long-term Performance
Minimized agency costs
IS
A,




FA
)
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.
IM
A,
C
Disadvantages
 Shares don’t trade publicly anymore.
 Bankrupt if the cash flow risk is too high.
C
Unbundling
C
C
A,
Ad
v
.D
ip
M
A
Unbundling is a process by which a large company with several different lines of
business retains one or more core businesses and sells off the remaining assets,
product/service lines, divisions or subsidiaries.
Unbundling is a Portfolio Restructuring Strategy and It includes the following:
 Divestment
 Demergers
 Sell - Offs
 Spin - Off
 Carve Outs
 Management Buy Out
As
ad
Ej
az
(A
C
A,
F
Divestments
Divestment is the partial or complete sale or disposal of physical and
organizational assets, the shutdown of facilities and reduction in workforce in
order to free funds for investment in other areas of strategic interest.
Divestments are undertaken for a variety of reasons. They may take place as a
 Corrective action in order to reverse unsuccessful previous acquisitions.
 Divestments may also be take place as a response to a cyclical downturn
in the activities of a particular unit or line of business. normally to reduce
costs or to increase return on assets
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.
SKANS School of Accountancy
79
Study Notes
IM
A,
C
IS
A,
AP
FA
Disadvantages
• Economies of scale may be lost.
• The smaller companies which result
from the demerger will have lower
turnover, profits and status than the
group before the demerger.
• There may be higher overhead
costs as a percentage of turnovers.
• The ability to raise extra finance,
especially debt finance, to support
new investments and expansion may
be reduced.
• Vulnerability to takeover may be
increased.
A
C
Advantages
The main advantage of a demerger is
its greater operational efficiency and
the greater opportunity to realize
value. A two-division company with
one loss making division and one
profit making, fast growing division
may be better off by splitting the two
divisions. The profitable division may
acquire a valuation well in excess of
its contribution to the merged
company.
)
AFM: Advanced Financial Management
Ad
v
.D
ip
M
Sell-offs
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
exchange.
Ej
az
(A
C
A,
F
C
C
A,
Reasons for Sell-Off
 As part of its strategic planning, it has decided to restructure, concentrating
management effort on particular parts of the business. Control problems may
be reduced if peripheral activities are sold off.
 It wishes to sell off a part of its business which makes losses, and so to improve
the company's future reported consolidated profit Performance.
 In order to protect the rest of the business from takeover, it may choose to sell
a part of the business which is particularly attractive to a buyer.
 The company may be short of cash.
 A subsidiary with high risk in its operating cash flows could be sold.
 A subsidiary could be sold at a profit.
As
ad
Spin-offs
In a spin-off, a new company is created whose shares are owned by the
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:
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Study Notes
AP
FA
)
 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.
 The requirements of regulatory agencies might be met more easily within
the new structure.
A
C
IM
A,
C
IS
A,
Carve-Out
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 carveout, a new company is created whose shares are owned by the public with the
parent company retaining a substantial fraction of the shares. Parent companies
undertake carve-outs in order to raise funds in the capital markets. These funds
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.
Ad
v
.D
ip
M
Management buy-outs (MBOs)
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
consent of all parties involved. Venture capital may be an important source of
financial backing.
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Reasons for a management Buy-out
 The subsidiary may be peripheral to the group's mainstream activities, and
no longer fit in with the group's overall strategy.
 The group may wish to sell off a loss-making subsidiary, and a
management team may think that it can restore the subsidiary's fortunes.
 The parent company may need to raise cash quickly.
 The best offer price might come from a small management group
wanting to arrange a buy-out.
 When a group has taken the decision to sell a subsidiary, it will probably
get better co-operation from the management and employees.
 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
with a segment sold to management rather than to an external party.
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
SKANS School of Accountancy
81
Study Notes
AP
FA
 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.
 Maintaining continuity of relationships with suppliers and customers
)
AFM: Advanced Financial Management
IM
A,
C
IS
A,
Advantages of MBOs to disposing company
 To raise cash quickly to improve liquidity.
 Known buyer
 If subsidiary is loss making then sale to management will be better
financially than liquidation
 Better publicity
Ad
v
.D
ip
M
A
C
Advantages of MBOs to management
 It preserves their jobs.
 It offers a chance to become owner of the company
 It is quicker than starting a similar business from scratch
 They can carry out their own strategies, no longer required approval from
head office.
 They have detail knowledge and relevant skills.
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Buy-ins
'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
themselves.
A management buy-in might occur when a business venture is running into
trouble, and a group of outside managers see an opportunity to take over the
business and restore its profitability.
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Study Notes
Risk Management: Currency
The Role of Treasury
AP
FA
)
managing the liquidity and cash flows of the organisation
managing the foreign exchange positions and cash flows
helping to obtain finance for the organisation
managing the exposures to financial risk, by hedging currency exposures,
interest rate exposures and other risk exposures.
IS
A,




Currency Transaction Risk
A
C
IM
A,
C
A transaction risk occurs when a payment of a foreign currency is required at a
future date, or when a receipt of a payment in a foreign currency will occur at
a future date. A transaction risk occurs because the exchange rate could move
adversely between ‘now’ and the time that the currency payment or receipt
happens, with the result that either:
Ad
v
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M
 it costs more to buy the foreign currency to make the currency
payment, or
 there is less income when a currency payment is received and the
currency is converted into domestic currency by selling it to a bank.
Government Measures to Stabilize Exchange Rates
A,
F
C
C
A,
The most effective way for a government to manage its exchange rate today, if
it wished to do so, would be to increase or reduce domestic interest rates on its
currency. Raising or reducing interest rates should affect the demand for the
currency from investors.
(A
C
There are several exchange rate policies that a government might adopt. These
include:
As
ad
Ej
az
 free floating (‘benign neglect’ of the exchange rate)
 managed floating of the currency
 a fixed exchange rate policy, with the exchange rate fixed against a major
currency or a basket of world currencies
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
Quoted
Example (Pakistan)
Direct
Local/foreign
Rs. 100/1$
Indirect
Foreign/local
$0.01/1Re.
Converting foreign
currency to local
Multiply eg. $10=
(100 X 10) = Rs. 1,000
Divide eg. $10 =
(10/0.01) = Rs. 1,000
AP
FA
Quotes
)
QUOTES
IS
A,
This will always makes you confuse because in Pakistan we use direct quote but
in UK and also in ACCA exams there is indirect quote
.D
ip
M
A
C
IM
A,
C
BID and OFFER Rates
NOTE: Remember the rule. (BANK ALWAYS WIN).
 Hence bank always buy the foreign currency at low price and sell it at
high price (Direct quote).
 Hence bank always give few foreign currency and receive more foreign
currency against local. (Indirect Quote)
Bid price is a price at which bank is willing to buy foreign currency
Offer price is a price at which bank is willing to sell foreign currency.
Ad
v
NOTE: Our prospective is opposite as if we want to sell foreign currency then it
means bank will buy.
C
C
A,
Customer  Receiving foreign currency  we want to sell foreign currency 
bank will buy  use Bid Price
(A
C
A,
F
Supplier  Paying foreign currency  we want to Buy foreign currency  bank
will Sell  use Offer Price
offer
100
0.0100
Ej
az
Direct (Rs./$)
Indirect ($/Rs.)
Bid
98
0.0102
As
ad
NOTE: Bid Rate will be lower in Direct Quote and Higher in Indirect Quote
and Vice Versa for Offer.
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.
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AP
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
- Netting
- Options
)
Study Notes
FA
AFM: Advanced Financial Management
A,
C
IS
A,
Internal Hedging Techniques
Invoicing In Home Currency
One easy way is to insist that all foreign customers pay in your home currency
and that your company pays for all imports in your home currency
Ad
v
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A
C
IM
Leading & Lagging
If an importer (payment) expects that the currency it is due to pay will
depreciate, it may attempt to delay payment. This may be achieved by
agreement or by exceeding credit terms.
If an exporter (receipt) expects that the currency it is due to receive will
depreciate over the next three months it may try to obtain payment
immediately. This may be achieved by offering a discount for
immediate payment.
C
C
A,
Matching
When a company has receipts and payments in the same foreign currency due
at the same time, it can simply match them against each other.
NOTE: In the exam where possible we will always do matching first
As
ad
Ej
az
(A
C
A,
F
Netting
Netting is a process in which all transaction of group companies are converted
into the same currency and then credit balances are netted off against the
debit balances, so that only reduced net amounts remain due to be paid or
received.
Multilateral netting involves minimising the number of transactions taking place
through each country’s banks. This would limit the fees that these banks would
receive for undertaking the transactions and therefore governments who do not
allow multilateral netting want to maximise the fees their local banks receive.
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.
SKANS School of Accountancy
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Study Notes
AP
FA
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
easier in the group.
)
AFM: Advanced Financial Management
IS
A,
Steps
C
A,
Ad
v
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ip
M
A
C
IM
A,
C
1. Covert all cashflows into base currency.
2. Enter all the amounts each company owes to the others and convert to
the agreed settlement currency.
3. Add across and down the table to determine total receipts and total
payments for each company.
4. Determine the net receivable or payable for each company.
Advantages:
 The number of currency transactions can be minimized, saving
transaction costs and focusing the transaction risk onto a smaller set of
transactions that can be more effectively hedged.
 It may also be the case, if exchange controls are in place limiting
currency flows across borders, that balances can be offset, minimizing
overall exposure. Where group transactions occur with other companies
the benefit of netting is that the exposure is limited to the net amount
reducing hedging costs and counterparty risk.
As
ad
Ej
az
(A
C
A,
F
C
Disadvantages:
 Some jurisdictions do not allow netting arrangements, and there may be
taxation and other cross border issues to resolve. It also relies upon all
liabilities being accepted – and this is particularly important where
external parties are involved.
 There will be costs in establishing the netting agreement and where third
parties are involved this may lead to re-invoicing or, in some cases, recontracting.
Illustration
Kenduri Co is a large multinational company based in the UK with a number of
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
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AFM: Advanced Financial Management
Study Notes
UK, with the Sterling Pound (£) as the base currency. If multilateral netting is
undertaken, spot mid-rates would be used.
Owed to Amount
Lakama Co
Jaia Co
Jaia Co
Lakama Co
Lakama Co
Kenduri Co
Gochiso Co
Kenduri Co
A
C
IM
A,
C
IS
A,
US$ 4.5 million
CAD 1.1 million
CAD 3.2 million
US$ 1.4 million
US$ 1.5 million
CAD 3.4 million
JPY 320 million
US$ 2.1 million
M
Owed by
Kenduri Co
Kenduri Co
Gochiso Co
Gochiso Co
Jaia Co
Jaia Co
Lakama Co
Lakama Co
AP
FA
)
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$), Jaia Co, based in Canada (currency CAD) and
Gochiso Co, based in Japan (currency JPY).
C
A,
Ad
v
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ip
Exchange rates available to Kenduri Co
US$/£1
CAD/£1
JPY/£1
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
Required
Calculate net amount owed by or to each part using netting approach
As
ad
Ej
az
(A
C
A,
F
C
Solution
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AFM: Advanced Financial Management
Study Notes
AP
FA
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
payment for it) at a future time which is agreed when making the contract.
)
External Hedging Techniques
A,
C
IS
A,
Money Market Hedge
Money market hedging involves borrowing in one currency, converting the
money borrowed into another currency and putting the money on deposit until
the time at which the transaction is completed.
.D
ip
M
A
C
IM
Payments
Home Currency
Foreign Currency
NOW
1) Take Loan and Covert 2) Deposit in Bank
Principle in Foreign Currency
LATER
1) Settle Loan
3) Withdraw from Bank
Principle
and make payment
+
Interest
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
Illustration (From BPP)
A Thai company owes a New Zealand company NZ$3,000,000, payable in 3
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
exchange risk. The current annual borrowing and investing rates in the two
countries are:
New Zealand
Thailand
%
%
Investing
2.5
4.5
Borrowing
3.0
5.2
Required
Calculate the cost to the Thai company of using a money market hedge.
As
ad
Solution
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FA
IS
A,
Receipts
Home Currency
Foreign Currency
NOW
2) Covert in Home
1) Take Loan
Principle Currency and deposit in
Bank
LATER
4) Withdraw from Bank
3) Receive the Amount
Principle
and Settle Loan
+
Interest
)
Study Notes
AP
AFM: Advanced Financial Management
Ad
v
.D
ip
M
A
C
IM
A,
C
Illustration (From BPP)
An Australian company is due to receive ¥15,000,000 from a Japanese company,
payable in 4 months' time. The current exchange rate is ¥62.6000–62.8000 = A$1.
The Australian company elects to use a money market hedge to manage the
exchange risk. The current annual borrowing and investing rates in the two
countries are:
Australia
Japan
%
%
Investing
4.5
2.7
Borrowing
6.0
3.3
Required
Calculate the amount the Australian company will receive if it uses a money
market hedge.
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Solution
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AFM: Advanced Financial Management
Study Notes
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.
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
.D
ip
M
A
C
IM
A,
C
IS
A,
AP
FA
)
Key Points
 They are Exchange Traded derivatives contracts.
 Traded in Derivative market where ‘Futures’ are traded and over her
commodities can’t be bought or sold but only their contracts can be.
 The contract prices are dependent on underlying commodities
 Standardized contract sizes and are available in only major currencies
 There are four settlement dates MAR/JUNE/SEPT/DEC.
 The Transaction Amount will always be in foreign Currency with respect to
company
 Market Currency will always be opposite to currency of contract size
 Convert each exchange rate in the form of direct from Market point of
view e.g. if Market is in USA then convert all exchange rate into $/other
currency.
 Opening Price means todays price
 Closing Price means Price at the settlement date
 Settlement date must be earlier or at expiry date
 Different way to hedge if Market and Home Currency are same and if
both are different
 On Closing (Settlement) date the contract needs to be closed i.e. if the
contract is bought initially then it has to be settled by selling it and Vice
Versa.
 This future market only gives out Gain/Loss which will be settled in actual
 At Expiry date the Future contract price and the spot price both will be
same
Basis Risk
It is a risk that the future prices will not move in line with the spot market. In
question we always assumes that this risk is zero
INITIAL MARGIN
When a futures hedge is set up the market is concerned that the party opening
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
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
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AFM: Advanced Financial Management
Study Notes
exchange is holding sufficient deposits for all the positions held by brokers‟
clients.
AP
FA
)
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
debited to the margin account as appropriate. This process is called ‘marking to
market’.
IS
A,
Currency options
IM
A,
C
Currency options give the buyer the right but not the obligation to buy or sell a
specific amount of foreign currency at a specific exchange rate (the strike
price) on or before a predetermined future date.
Key Points in addition to Futures
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
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A
C
 For this protection, the buyer has to pay a premium.
 A currency option may be either a call option (Option to Buy Future
Contracts) or a put option (Option to sell future contracts)
 Currency option contracts limit the maximum loss to the premium paid upfront and provide the buyer with the opportunity to take advantage of
favorable exchange rate movements.
 Options are of two types, traded and over the counter, and both have
different kinds of benefits.
o Traded options are standard sizes and are thus 'tradable' which
means they can be sold on to other parties if not required. OTC
options are designed for a specific purpose and are therefore
unlikely to be suitable for another party.
o OTC options are tailored specifically for a particular transaction,
ensuring maximum protection from currency movements. As traded
options are of a standard size, the full amount of the transaction
may not be hedged, as fractions of options are not available.
SKANS School of Accountancy
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Study Notes
→
C
C
(A
C
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑜𝑜𝑜𝑜 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Ej
a
z
Transaction Amount X Closing Spot
ad
Add: Gain (OR Less: Loss)
Net Outcome
AP
IS
A,
A,
C
.D
ip
M
given or Assume FRA
A,
𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
IM
A
C
Closing date
Ad
v
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
Outcome
Outcome in Opening Price
future
Market
Less: Closing Price
Gain or Loss
Net
Outcome
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
Balancing Closing Price
Answer
Opening Price
Less: Closing Price
Gain or Loss
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑜𝑜𝑜𝑜 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
Transaction Amount ÷ Closing Spot
Add: Gain (OR Less: Loss)
Net Outcome
As
3
Payment Sell
Receipt  Buy
Opening Price
A,
F
Future
Market
Market Currency ≠ Home Currency
FA
Currency Future Answer
No. Description Market Currency = Home Currency
and
explanation
1
Setup
Payment Buy
Type of
Receipt  Sell
Contract
Expiry
Immediate after Settlement Date
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
No. of
Contacts
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
2
Expected
Closing
Opening Date
Price
Spot
Market
Current Spot
)
AFM: Advanced Financial Management
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IM
A,
C
IS
A,
Payment Put Option
Receipt  Call Option
AP
FA
Market Currency ≠ Home Currency
M
A
C
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑋𝑋 100
Ej
a
z
Transaction Amount X Closing Spot
Less: Premium
Add: Gain
Net Outcome
ad
Net
Outcome
(A
C
A,
F
C
C
A,
Outcome
Outcome in Exercise Price
future
Less: Closing Price
Market
Gain or Loss
Exercise
Yes / No
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Exercise Price
Less: Closing Price
Gain or Loss
Exercise
Yes / No
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
Transaction Amount ÷ Closing Spot
Less: Premium
Add: Gain
Net Outcome
As
3
Ad
v
.D
ip
Currency Options Answer
No. Description Market Currency = Home Currency
and
explanation
1
Setup
Payment Call Option
Type of
Receipt  Put option
Contract
Expiry
Immediate after Settlement Date
Strike Price
All given in the question
(Exercise
Price)
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
No. of
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Contacts
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
Premium
𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
100
2
Expected
Same Price as of Future
Closing
Price
Study Notes
)
AFM: Advanced Financial Management
SKANS School of Accountancy
93
AFM: Advanced Financial Management
Study Notes
Risk Management: Interest
Interest Rate Risk Management
AP
FA
)
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
be translated as an increase of interest payments that it has to make against
borrowed funds or a reduction in income that it receives from invested funds.
IS
A,
Hedging
Ad
v
.D
ip
M
A
C
Methods of Hedging Exposures to Interest Rate Risk
 Forward rate Agreement (FRA)
 Interest Rate Future
 Options
 Interest Rate Swaps
 COLLAR
IM
A,
C
The purpose of hedging an exposure to interest rate risk is to remove (or reduce)
the possibility that a future borrowing or investments will have to be made at a
less favorable interest rate than expected.
(A
C
A,
F
C
C
A,
Forward Rate Agreement (FRA)
FRA is a contract in which two parties agree on interest rate to be paid on a
notional amount at a specified future time. A co. can enter into an FRA with a
bank that fixes the rate of interest for borrowing at a certain time in the futures. In
case of borrowing, If the actual interest rate proves to be:
 Higher than the rate agreed  The bank pays the co, the difference
 Lower than the rate agreed  Co, pays the bank the Difference
As
ad
Ej
az
Illustration
Example It is 30 June. Lynn plc will need a £10 million 6 month fixed rate after 3
months. Company is expecting that interest rate will rise in future and wants to
hedge using an FRA. The following FRA are available:
3-6 FRA 5%- 5.5%
3-9 FRA 5.5% - 6%
Lynn can borrow in market at Libor + 50 basis points.
Required
What is the result of the FRA and the effective loan rate if the 6 month Libor rates
has moved to
1. 5%
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AFM: Advanced Financial Management
Study Notes
M
A
C
IM
A,
C
IS
A,
AP
FA
)
2. 9%
Solution
Ad
v
.D
ip
Interest Rate Futures
It is very similar to Currency futures, however, in that interest-bearing security as
an underlying asset
A,
Key Points in addition to Currency Futures
A,
F
C
C
 The price of interest rate future will be: 100 – LIBOR.
 Only LIBOR will be hedged
 They have a contract length which generally is 3 month.
az
(A
C
Interest Rate Options
It is very similar to Currency options, however, in that interest-bearing security as
an underlying asset
As
ad
Ej
Interest Rate Collar
It is an attempt to reduce the premium fee by selling the options to other party.
By creating collar we may have to be exposed to adverse movements as well.
Interest Rate SWAPS
SKANS School of Accountancy
95
AFM: Advanced Financial Management
Study Notes
AP
FA
)
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
interest period, such as LIBOR.
IM
A,
C
IS
A,
The purpose of an interest rate swap is often to:
 swap a variable rate of interest payment (or receipt) into a fixed interest
rate payment (or receipt)
 swap a fixed rate of interest payment (or receipt) into a variable rate of
interest payment (or receipt).
Illustration
Ad
v
Required:
Calculate the SWAP net outcome
Write SWAP Terms
.D
ip
M
A
C
Company A wants to borrow at a floating rate, and can do so at LIBOR + 0.50%.
Company B wants to borrow at a fixed rate, and can do so at 6.40%. However,
an opportunity for these company exist as company A can borrow at a fixed rate
5.5% and company B, can borrow at a variable rate of LIBOR + 1%
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Solutions
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AFM: Advanced Financial Management
Study Notes
The Calculation of Forward Rates
)
AP
Illustration
(𝟏𝟏 + 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒚𝒚𝒚𝒚𝒚𝒚𝒚𝒚 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓)𝒏𝒏
− 𝟏𝟏
(𝟏𝟏 + 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝒚𝒚𝒚𝒚𝒚𝒚𝒚𝒚 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓)𝒏𝒏−𝟏𝟏
FA
𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 =
IM
A,
C
Yield
3.0%
3.6%
4.3%
5.1%
5.8%
C
Maturity
One year
Two years
Three years
Four years
Five years
IS
A,
The annual spot yield curve for bonds of a given risk class are as follows:
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
.D
ip
M
A
Solution
SKANS School of Accountancy
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Study Notes
Interest Rate Future Answer
No.
Description and explanation
1
Setup
Type of Contract
Expiry Date
No. of Contracts
FA
IS
A,
AP
Future Market
Opening Price
given or Assume FRA
IM
Current Spot Price
M
𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
Outcome
Outcome in future Market
→
A
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑡𝑡𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
C
Spot Market
Closing date
A,
C
Opening Date
.D
ip
Opening Price
Balancing Closing Price
Answer
Ad
v
Less: Closing Price
Gain or Loss
C
A,
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑜𝑜𝑜𝑜 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ
1,200
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑋𝑋 (𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 + 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝) 𝑋𝑋 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
Interest:
12
Add: Gain (Or Less Loss)
Net Outcome
Ej
a
z
(A
C
A,
F
C
Net Outcome
ad
3
Expected Closing Price
As
2
Formulas
Borrow  Sell
Investment  Buy
Immediate after investing or borrowing date
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑋𝑋 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ
)
AFM: Advanced Financial Management
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AFM: Advanced Financial Management
Interest Rate Options Answer
No.
Description and
explanation
1
Setup
Type of Contract
Expiry Date
Exercise Price
No. of Contracts
FA
)
Formulas
IM
C
A
Exercise Price
Less: Closing Price
Gain or Loss
M
Expected Closing Price
Outcome
Outcome in future
Market
A,
C
IS
A,
AP
Borrow  Put Option
Investment  Call Option
Immediate after investing or borrowing date
Chose all that are given
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑋𝑋 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑒𝑒 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ
1,200
Same Price as of Future
.D
ip
Premium
Yes/No
Ad
v
Exercise?
A,
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ
1,200
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑋𝑋 (𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 + 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝) 𝑋𝑋 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
Interest:
12
C
C
Net Outcome
A,
F
Less: Premium cost
ad
Ej
a
z
(A
C
Add: Gain
Net Outcome
As
2
3
Study Notes
SKANS School of Accountancy
99
AFM: Advanced Financial Management
)
FA
AP
Exercise?
A,
C
Less: Closing Price
Gain or Loss
IM
Outcome
Outcome in future Market
C
3
A
Premium Income
Borrow  Sell Call Option @ highest exercise price
Investment  Sell Put Option @ lowest exercise price
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ
1,200
Exercise Price
M
2
Formulas
Value
IS
A,
Interest Rate Collar Answer
No.
Description and explanation
1
Net Outcome of Interest rate options with
best exercise Price
Type of Contract
Study Notes
Yes/No
Ad
v
.D
ip
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ
1,200
No.1 + No.2 – No.3
As
ad
Ej
a
z
(A
C
A,
F
C
C
A,
Net Outcome of Collar
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
Option Pricing
Option Pricing and the determinants
The Value of the Option will depend on the following factors
IS
A,
AP
FA
)
Call Option:The right but not the obligation to buy a particular asset at an exercise
price
Put Option: The right but not an obligation to sell a particular asset at an exercise
price
Value of Call
Option if
increases
Value of Put
Option if
increases
Pa = Current Price of underlying Asset
Increase
Pe = Exercise Price
Decrease
Increase
T = Time to expiry (in Years)
Increase
Increase
.D
ip
M
A
C
IM
A,
C
Determinants
S = Standard Deviation
Ad
v
r = Risk free rate
Increase
Increase
Increase
Decrease
See from the Normal distribution
table
C
C
A,
N (d) = Normal Distribution Value
Decrease
A,
F
The Black Scholes Model
Ej
az
(A
C
THE Black-Scholes model values options before the expiry date and takes
account of all the determinants that effect the value of option
As
ad
Where:
𝐶𝐶 = 𝑃𝑃𝑎𝑎 𝑁𝑁(𝑑𝑑1 ) − 𝑃𝑃𝑒𝑒 𝑁𝑁(𝑑𝑑2 )𝑒𝑒 −𝑟𝑟𝑟𝑟
𝑃𝑃 = 𝐶𝐶 − 𝑃𝑃𝑎𝑎 + 𝑃𝑃𝑒𝑒 𝑒𝑒 −𝑟𝑟𝑟𝑟
𝑃𝑃
ln � 𝑎𝑎 � + (𝑟𝑟 + 0.5𝑆𝑆 2 )𝑡𝑡
𝑃𝑃𝑒𝑒
𝑑𝑑1 =
𝑆𝑆√𝑡𝑡
𝑑𝑑2 = 𝑑𝑑1 − 𝑆𝑆√𝑡𝑡
If ‘d’ is positive then  N(d) = 0.5 + Value from Table
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AFM: Advanced Financial Management
Study Notes
If ‘d’ is negative then  N(d) = 0.5 - Value from Table
A,
C
IS
A,
AP
FA
)
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?
Pa = 17
Pe = 16.5
r = 7%
t = 6 months to expiry, t = 0.50.
s = 0.12
As
ad
Ej
az
(A
C
A,
F
C
C
A,
Ad
v
.D
ip
M
A
C
IM
Solution
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AFM: Advanced Financial Management
Study Notes
FA
AP
Delta = change in call option price ÷ change in the price of the shares
)
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.
IS
A,
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.
IM
A,
C
DELTA HEDGING CALL OPTION
A bank that writes a large number of options has an option portfolio. It might
want to create a hedge for its exposure to adverse price movements.
.D
ip
M
A
C
A bank that writes call options can create an option position that is delta neutral
by purchasing a quantity of the underlying item. For example, a bank that has
written call options on the shares of XYZ Company can hedge the position by
holding some shares in XYZ.
A,
Ad
v
If the value of the underlying shares goes up, the value of the call options will
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
underlying shares.
Ej
az
(A
C
A,
F
C
C
A delta neutral position will exist when the rise in the value of the options (=
benefit to the option holders and loss for the option writer) is matched by an
equal rise in the value of the shares held by the option writer (bank). This will
leave the bank with neither a loss nor a gain.
The number of shares that a call option writer should hold to create a delta
hedge is
No. of shares to held = No. of Call options to sell X N(d1)
Similarly:
No. of call options to sell = No. of shares held / N(d1)
As
ad
For example if the delta value for call options on 1,000,000 shares of XYZ
Company at an exercise price of $15 is 0.45, a delta hedge will be created by
holding 450,000 of the shares
(1,000,000 × 0.45) = 450,000.
Note: For put option use N(- d1)
SKANS School of Accountancy
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AFM: Advanced Financial Management
Study Notes
Due to change in:
Option price
Underlying asset
value
Delta
Underlying asset
value
Vega
Option price
Volatility
Rho
Option price
Interest rate
Theta
Option price
Time to expiry
AP
IS
A,
Gamma
A,
C
Delta
FA
Change in:
)
Other Greeks
C
IM
The Real Options
.D
ip
M
A
The conventional NPV method assumes that a project commences immediately
and proceeds until it finishes, as originally predicted. Therefore, it assumes that a
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
flexible and give managers a choice of what actions to undertake.
az
(A
C
A,
F
C
C
A,
Ad
v
The real options method estimates a value for this flexibility and choice, which is
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
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
once it has been made, or (iii) when there are opportunities to exploit in the
future contingent on an initial project being undertaken. Therefore, where an
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
and this choice has a value
As
ad
Ej
To Value that we will use the same Black Scholes Option Pricing models. There
will be three different situations i.e.
Option to delay  Call Option
Option to expand  Call Option
Option to abandon  Put Option
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AFM: Advanced Financial Management
Study Notes
Dividends
AP
FA
)
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
to equity.
A,
C
IS
A,
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
in the business.
Dividend Policies
Ad
v
.D
ip
M
A
C
IM
Stable Dividend
Some companies follow a policy of paying fixed dividend per share irrespective
of the level of earning year after year. Such firm creates reserves i.e dividend
equalization reserves to enable them to pay the fixed dividend even in case of
insufficient earnings.it more suits to those companies having stable earnings.
 Dividend level (growth) should be related to profit levels (Growth).
 Retain profit should be linked with the investments of new projects.
(A
C
A,
F
C
C
A,
Advantages of Stable Dividend Policy:
A Stable dividend policy is advantageous to both investors and company on
account of the following:
 It is sign of continued normal operations of company.
 It stabilizes market value of shares.
 It creates confidence among investors.
 It improves credit standing and making financing easier.
 It meets requirements of institutional investors who prefer companies with
stable dividends.
As
ad
Ej
az
Dangers of Stable dividend policy
In spite of many advantages, the stable dividend policy suffers from certain
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
account including insufficient profits, the financial standing of company in minds
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
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AFM: Advanced Financial Management
Study Notes
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.
AP
FA
)
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.
Such a policy is most suitable to the firm having fluctuating earnings from year to
year.
M
A
C
IM
A,
C
IS
A,
Residual dividend
Companies using the residual dividend policy choose to rely on internally
generated equity to finance any new projects. As a result, dividend payments
can come out of the residual or leftover equity only after all project capital
requirements are met. These companies usually attempt to maintain balance in
their debt/equity ratios before making any dividend distributions, deciding on
dividends only if there is enough money left over after all operating and
expansion expenses are met.
.D
ip
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
policy. A significant disadvantage is that dividends may be unstable.
(A
C
A,
F
C
C
A,
Ad
v
Irregular Dividend Policy:
Some companies follow irregular dividend payments on account of following:
 Uncertainty of Business.
 Unsuccessful Business operations
 Lack of liquid resources.
 Fear of adverse effects of regular dividend on financial standing of
company.
No Dividend Policy:
As
ad
Ej
az
A company may follow a policy of paying no dividends presently because of its
unfavorable working capital position or on account of requirements of funds for
future expansion and growth.
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Study Notes
A
,C
IS
A
A
P
FA
)
FM: Financial Management
A
sa
d
E
ja
z
(A
C
A
,F
C
C
A
,A
dv
D
ip
M
A
C
IM
Math and Formula Table
By: Asad Ejaz (ACA, FCCA, Adv. Dip MA CIMA, CISA, APFA)
107
Formulae
Modigliani and Miller Proposition 2 (with tax)
Vd
Ve
FA
)
k e = kie + (1 – T)(kie – k d )
Two asset portfolio
IS
A
A
P
sp = w2a s2a + w2b s2b + 2wawbrab sasb
The Capital Asset Pricing Model
IM
A
,C
E(ri ) = Rf + βi (E(rm ) – Rf )
The asset beta formula
ip
M
A
C
⎡
⎤
⎤ ⎡ V (1 – T)
Ve
d
βa = ⎢
βe ⎥ + ⎢
βd ⎥
⎢⎣ (Ve + Vd (1 – T)) ⎥⎦ ⎢⎣ (Ve + Vd (1 – T)) ⎥⎦
D
The Growth Model
Do (1 + g)
dv
Po =
,A
(re – g)
A
Gordon’s growth approximation
The weighted average cost of capital
⎡ V
⎤
⎡ V
⎤
e
d
⎥ ke + ⎢
⎥ k (1 – T)
WACC = ⎢
⎢⎣ Ve + Vd ⎥⎦
⎢⎣ Ve + Vd ⎥⎦ d
z
(A
C
A
,F
C
C
g = bre
ja
The Fisher formula
A
sa
d
E
(1 + i) = (1 + r)(1+h)
Purchasing power parity and interest rate parity
S1 = S0 x
(1+hc )
(1+hb )
F0 = S0 x
(1+ic )
(1+ib )
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Modified Internal Rate of Return
1
⎡ PV ⎤ n
MIRR = ⎢ R ⎥ 1 + re – 1
⎢⎣ PVI ⎥⎦
)
(
FA
)
The Black-Scholes option pricing model
P
c = PaN(d1) – PeN(d2 )e –rt
ln(Pa / Pe ) + (r+0.5s2 )t
IS
A
d1 =
A
Where:
s t
The Put Call Parity relationship
A
sa
d
E
ja
z
(A
C
A
,F
C
C
A
,A
dv
D
ip
M
A
C
p = c – Pa + Pee –rt
IM
A
,C
d2 = d1 – s t
[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
2%
3%
4%
5%
6%
7%
8%
9%
10%
1
2
3
4
5
0·990
)
0·980
)
0·971
)
0·961
)
0·951
)
0·980
)
0·961
)
0·942
)
0·924
)
0·906
)
0·971
)
0·943
)
0·915
)
0·888
)
0·863
)
0·962
)
0·925
)
0·889
)
0·855
)
0·822
)
0·952
)
0·907
)
0·864
)
0·823
)
0·784
)
0·943
)
0·890
)
0·840
)
0·792
)
0·747
)
0·935
)
0·873
)
0·816
)
0·763
)
0·713
)
0·926
)
0·857
)
0·794
)
0·735
)
0·681
)
0·917
)
0·842
)
0·772
)
0·708
)
0·650
)
0·909
)
0·826
)
0·751
)
0·683
)
0·621
)
1
2
3
4
5
6
7
8
9
10
0·942
)
0·933
)
0·923
)
0·941
)
0·905
)
0·888
)
0·871
)
0·853
)
0·837
)
0·820
)
0·837
)
0·813
)
0·789
)
0·766
)
0·744
)
0·790
)
0·760
)
0·731
)
0·703
)
0·676
)
0·746
)
0·711
)
0·677
)
0·645
)
0·614
)
0·705
)
0·665
)
0·627
)
0·592
)
0·558
)
0·666
)
0·623
)
0·582
)
0·544
)
0·508
)
0·630
)
0·583
)
0·540
)
0·500
)
0·463
)
0·596
)
0·547
)
0·502
)
0·460
)
0·422
)
0·564
)
0·513
)
0·467
)
0·424
)
0·386
)
6
7
8
9
10
11
12
13
14
15
0·896
)
0·887
)
0·879
)
0·870
)
0·861
)
0·804
)
0·788
)
0·773
)
0·758
)
0·743
)
0·722
)
0·701
)
0·681
)
0·661
)
0·642
)
0·650
)
0·625
)
0·601
)
0·577
)
0·555
)
0·585
)
0·557
)
0·530
)
0·505
)
0·481
)
0·527
)
0·497
)
0·469
)
0·442
)
0·417
)
0·475
)
0·444
)
0·415
)
0·388
)
0·362
)
0·429
)
0·397
)
0·368
)
0·340
)
0·315
)
0·388
)
0·356
)
0·326
)
0·299
)
0·275
)
0·305
)
0·319
)
0·290
)
0·263
)
0·239
)
11
12
13
14
15
(n)
11%
12%
13%
14%
1
2
3
4
5
0·901
)
0·812
)
0·731
)
0·659
) 0·593
)
0·893
)
0·797
)
0·712
)
0·636
) 0·567
)
0·885
)
0·783
)
0·693
)
0·613
)
0·543
)
6
7
8
9
10
0·535
)
0·482
) 0·434
)
0·391
)
0·352
)
0·507
)
0·452
) 0·404
)
0·361
)
0·322
)
0·317
)
0·286
)
0·258
)
0·232
)
0·209
)
0·287
)
0·257
)
0·229
)
0·205
)
0·183
)
A
IS
A
,C
IM
A
C
A
M
ip
D
dv
16%
17%
18%
19%
20%
0·877
)
0·769
)
0·675
)
0·592
)
0·519
)
0·870
)
0·756
)
0·658
)
0·572
)
0·497
)
0·862
)
0·743
)
0·641
)
0·552
) 0·476
)
0·855
)
0·731
)
0·624
)
0·534
) 0·456
)
0·847
)
0·718
)
0·609
)
0·516
) 0·437
)
0·840
)
0·706
)
0·593
)
0·499
) 0·419
)
0·833
)
0·694
)
0·579
)
0·482
) 0·402
)
1
2
3
4
5
0·480
)
0·425
) 0·376
)
0·333
)
0·295
)
0·456
)
0·400
)
0·351
)
0·308
)
0·270
)
0·432
)
0·376
)
0·327
)
0·284
)
0·247
)
0·410
)
0·354
)
0·305
)
0·263
)
0·227
)
0·390
)
0·333
)
0·285
)
0·243
)
0·208
)
0·370
)
0·314
)
0·266
)
0·225
)
0·191
)
0·352
)
0·296
)
0·249
)
0·209
)
0·176
)
0·335
)
0·279
)
0·233
)
0·194
)
0·162
)
6
7
8
9
10
0·261
)
0·231
)
0·204
)
0·181
)
0·160
)
0·237
)
0·208
)
0·182
)
0·160
) 0·140
)
0·215
)
0·187
)
0·163
)
0·141
) 0·123
)
0·195
)
0·168
)
0·145
)
0·125
)
0·108
)
0·178
)
0·152
)
0·130
)
0·111
)
0·095
)
0·162
)
0·137
)
0·116
)
0·099
)
0·084
)
0·148
)
0·124
)
0·104
)
0·088
)
0·074
)
0·135
)
0·112
)
0·093
)
0·078
)
0·065
)
11
12
13
14
15
,F
C
C
A
,A
15%
A
C
(A
z
ja
E
sa
d
11
12
13
14
15
P
1%
A
Periods
(n)
FA
)
Discount rate (r)
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Annuity Table
– (1 + r)–n
Present value of an annuity of 1 i.e. 1————––
r
r = discount rate
n = number of periods
FA
)
Where
Periods
(n)
2%
3%
4%
5%
6%
7%
8%
9%
1
2
3
4
5
0·990
1·970
2·941
3·902
4·853
0·980
1·942
2·884
3·808
4·713
0·971
1·913
2·829
3·717
4·580
0·962
1·886
2·775
3·630
4·452
0·952
1·859
2·723
3·546
4·329
0·943
1·833
2·673
3·465
4·212
0·935
1·808
2·624
3·387
4·100
0·926
1·783
2·577
3·312
3·993
0·917
1·759
2·531
3·240
3·890
0·909
1·736
2·487
3·170
3·791
1
2
3
4
5
6
7
8
9
10
5·795
6·728
7·652
8·566
9·471
5·601
6·472
7·325
8·162
8·983
5·417
6·230
7·020
7·786
8·530
5·242
6·002
6·733
7·435
8·111
5·076
5·786
6·463
7·108
7·722
4·917
5·582
6·210
6·802
7·360
4·767
5·389
5·971
6·515
7·024
4·623
5·206
5·747
6·247
6·710
4·486
5·033
5·535
5·995
6·418
4·355
4·868
5·335
5·759
6·145
6
7
8
9
10
11
12
13
14
15
10·368
10·37
11·255
11·26
12·134
12·13
13·004
13·00
13·865
13·87
9·787
10·575
10·58
11·348
11·35
12·106
12·11
12·849
12·85
9·253
9·954
10·635
10·63
11·296
11·30
11·938
11·94
8·760
9·385
9·986
10·563
10·56
11·118
11·12
8·306
8·863
9·394
9·899
10·380
10·38
7·887
8·384
8·853
9·295
9·712
7·499
7·943
8·358
8·745
9·108
7·139
7·536
7·904
8·244
8·559
6·805
7·161
7·487
7·786
8·061
6·495
6·814
7·103
7·367
7·606
11
12
13
14
15
(n)
11%
12%
13%
15%
16%
17%
18%
19%
20%
1
2
3
4
5
0·901
1·713
2·444
3·102
3·696
0·893
1·690
2·402
3·037
3·605
0·885
1·668
2·361
2·974
3·517
0·877
1·647
2·322
2·914
3·433
0·870
1·626
2·283
2·855
3·352
0·862
1·605
2·246
2·798
3·274
0·855
1·585
2·210
2·743
3·199
0·847
1·566
2·174
2·690
3·127
0·840
1·547
2·140
2·639
3·058
0·833
1·528
2·106
2·589
2·991
1
2
3
4
5
6
7
8
9
10
4·231
4·712
5·146
5·537
5·889
4·111
4·564
4·968
5·328
5·650
3·998
4·423
4·799
5·132
5·426
3·889
4·288
4·639
4·946
5·216
3·784
4·160
4·487
4·772
5·019
3·685
4·039
4·344
4·607
4·833
3·589
3·922
4·207
4·451
4·659
3·498
3·812
4·078
4·303
4·494
3·410
3·706
3·954
4·163
4·339
3·326
3·605
3·837
4·031
4·192
6
7
8
9
10
5·938
6·194
6·424
6·628
6·811
5·687
5·918
6·122
6·302
6·462
5·453
5·660
5·842
6·002
6·142
5·234
5·421
5·583
5·724
5·847
5·029
5·197
5·342
5·468
5·575
4·836
4·988
5·118
5·229
5·324
4·656
4·793
4·910
5·008
5·092
4·486
4·611
4·715
4·802
4·876
4·327
4·439
4·533
4·611
4·675
11
12
13
14
15
6·207
6·492
6·750
6·982
7·191
IS
A
,C
IM
A
C
A
M
ip
D
dv
,A
A
C
C
,F
A
C
(A
z
ja
E
d
11
12
13
14
15
14%
10%
A
1%
sa
A
P
Discount rate (r)
[P.T.O.
0·02
0·0080
0·0478
0·0871
0·1255
0·1628
0·03
0·0120
0·0517
0·0910
0·1293
0·1664
0·04
0·0160
0·0557
0·0948
0·1331
0·1700
0·05
0·0199
0·0596
0·0987
0·1368
0·1736
0·06
0·0239
0·0636
0·1026
0·1406
0·1772
0·07
0·0279
0·0675
0·1064
0·1443
0·1808
0·08
0·0319
0·0714
0·1103
0·1480
0·1844
0·09
0·0359
0·0753
0·1141
0·1517
0·1879
0·5
0·6
0·7
0·8
0·9
0·1915
0·2257
0·2580
0·2881
0·3159
0·1950
0·2291
0·2611
0·2910
0·3186
0·1985
0·2324
0·2642
0·2939
0·3212
0·2019
0·2357
0·2673
0·2967
0·3238
0·2054
0·2389
0·2704
0·2995
0·3264
0·2088
0·2422
0·2734
0·3023
0·3289
0·2123
0·2454
0·2764
0·3051
0·3315
0·2157
0·2486
0·2794
0·3078
0·3340
0·2190
0·2517
0·2823
0·3106
0·3365
0·2224
0·2549
0·2852
0·3133
0·3389
P
1·0
1·1
1·2
1·3
1·4
0·3413
0·3643
0·3849
0·4032
0·4192
0·3438
0·3665
0·3869
0·4049
0·4207
0·3461
0·3686
0·3888
0·4066
0·4222
0·3485
0·3708
0·3907
0·4082
0·4236
0·3508
0·3729
0·3925
0·4099
0·4251
0·3531
0·3749
0·3944
0·4115
0·4265
0·3554
0·3770
0·3962
0·4131
0·4279
0·3577
0·3790
0·3980
0·4147
0·4292
0·3599
0·3810
0·3997
0·4162
0·4306
0·3621
0·3830
0·4015
0·4177
0·4319
1·5
1·6
1·7
1·8
1·9
0·4332
0·4452
0·4554
0·4641
0·4713
0·4345
0·4463
0·4564
0·4649
0·4719
0·4357
0·4474
0·4573
0·4656
0·4726
0·4370
0·4484
0·4582
0·4664
0·4732
0·4382
0·4495
0·4591
0·4671
0·4738
0·4394
0·4505
0·4599
0·4678
0·4744
0·4406
0·4515
0·4608
0·4686
0·4750
0·4418
0·4525
0·4616
0·4693
0·4756
0·4429
0·4535
0·4625
0·4699
0·4761
0·4441
0·4545
0·4633
0·4706
0·4767
2·0
2·1
2·2
2·3
2·4
0·4772
0·4821
0·4861
0·4893
0·4918
0·4778
0·4826
0·4864
0·4896
0·4920
0·4783
0·4830
0·4868
0·4898
0·4922
0·4788
0·4834
0·4871
0·4901
0·4925
0·4793
0·4838
0·4875
0·4904
0·4927
0·4798
0·4842
0·4878
0·4906
0·4929
0·4803
0·4846
0·4881
0·4909
0·4931
0·4808
0·4850
0·4884
0·4911
0·4932
0·4812
0·4854
0·4887
0·4913
0·4934
0·4817
0·4857
0·4890
0·4916
0·4936
2·5
2·6
2·7
2·8
2·9
0·4938
0·4953
0·4965
0·4974
0·4981
0·4940
0·4955
0·4966
0·4975
0·4982
0·4941
0·4956
0·4967
0·4976
0·4982
0·4943
0·4957
0·4968
0·4977
0·4983
0·4945
0·4959
0·4969
0·4977
0·4984
0·4946
0·4960
0·4970
0·4978
0·4984
0·4948
0·4961
0·4971
0·4979
0·4985
0·4949
0·4962
0·4972
0·4979
0·4985
0·4951
0·4963
0·4973
0·4980
0·4986
0·4952
0·4964
0·4974
0·4981
0·4986
0·4987
0·4987
0·4988
0·4988
0·4989
0·4989
0·4989
0·4990
0·4990
A
,C
IM
A
C
A
M
ip
D
dv
,A
A
C
C
,F
A
C
(A
z
ja
E
0·4987
A
sa
d
3·0
)
0·01
0·0040
0·0438
0·0832
0·1217
0·1591
FA
0·0
0·1
0·2
0·3
0·4
0·00
0·0000
0·0398
0·0793
0·1179
0·1554
IS
A
Standard normal distribution table
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.
End of Question Paper
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