ACCA
Advanced Financial Management (AFM)
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First edition 2007, Eleventh edition January 2018
ISBN 9781 5097 1661 6
e ISBN 9781 5097 1691 3
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Preface
Contents
Welcome to BPP Learning Media's ACCA Passcards for Advanced Financial Management (AFM).
 They focus on your exam and save you time.
 They incorporate diagrams to kickstart your memory.
 They follow the overall structure of the BPP Study Texts, but BPP's ACCA Passcards are not just a
condensed book. Each card has been separately designed for clear presentation. Topics are self contained
and can be grasped visually.
 ACCA Passcards are still just the right size for pockets, briefcases and bags.
Run through the Passcards as often as you can during your final revision period. The day before the exam, try
to go through the Passcards again! You will then be well on your way to passing your exams.
Good luck!
For reference to the Bibliography of the Advanced Financial Management (AFM) Passcards please go to:
www.bpp.com/learning-media/about/bibliographies
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Preface
1
2
3
4
5
6
7a
7b
8
Page
The role of the senior financial advisor
1
Financial strategy formulation
5
Ethical and governance issues
13
Trading and planning in a multinational
environment
19
Discounted cash flow techniques
35
Application of option pricing theory in
investment decisions
41
Impact of financing on investment
decisions and adjusted present values 45
Valuation and the use of free cash flows 61
International investment and financing
decisions
65
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Contents
Page
9
Acquisitions and mergers v other growth
strategies
73
10
Valuation for acquisitions and mergers 81
11
Regulatory framework and processes
93
12
Financing mergers and acquisitions
99
13–14 Reconstruction and reorganisation
105
15
The role of the treasury function in
multinationals
113
16
The use of financial derivatives to hedge
against foreign exchange risk
115
17
The use of financial derivatives to hedge
against interest rate risk
125
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1: The role of the senior financial advisor
Topic List
Senior financial executives are required to make crucial
decisions, including those related to investment,
financing, distribution and retention.
Financial management
Financial planning
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Financial
management
Financial
planning
Financial objectives
Non-financial objectives
The prime financial objective is to maximise the
market value of the company’s shares. Primary
targets are profits and dividend growth. Other targets
may be the level of gearing, profit retentions, operating
profitability and shareholder value indicators.
Non-financial objectives do not negate financial
objectives, but they do mean that the primary
financial objectives may be modified. They take
account of ethical considerations.
Examples
Why profit maximisation is not a
sufficient objective




Risk and incertainty
Profit manipulation
Sacrifice of future profits?
Dividend policy
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




Employee welfare
Management welfare
Society’s welfare
Service provision
Responsibilities towards customers/suppliers
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Investment
decisions
Investment decisions include:
 New projects
 Takeovers
 Mergers
 Sell-off/divestment
The financial manager must:
 Identify decisions
 Evaluate them
 Decide optimal fund allocation
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Financing
decisions
Financial decisions include:
 Long-term capital structure
Need to determine source,
cost and risk of long-term
finance.
 Short-term working capital
management
Balance between profitability
and liquidity is crucial.
Dividend
decisions
Dividend decisions may affect
views of the company’s long-term
prospects, and thus the shares’
market values.
Payment of dividends limits the
amount of retained earnings
available for re-investment.
1: The role of the senior financial advisor
1/27/2018 1:50:50 AM
Financial
management
Financial
planning
Strategic planning
Key elements of financial planning
The formulation, evaluation and selection of
strategies to prepare a long-term plan of action to
attain objectives. Strategic decisions should be
suitable, feasible and acceptable.
 Long-term investment and short-term cash flow
 Surplus cash
 How finance raised
 Long-term direction
 Matching activities to environment/resources
Strategic analysis means analysing the
organisation in its environment, its resources,
competences, mission and objectives.
Strategic choice involves generating and evaluating
strategic options and selecting strategy.
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Strategic cash flow management
Planning involves a long horizon, uncertainties and
contingency plans.
Strategic fund management
Consideration of which assets are essential and
how easily assets can be sold.
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2: Financial strategy formulation
Topic List
Assessing corporate performance
Formulating the correct financial strategy is crucial for
business success. The four main areas of financial
strategy are capital structure policy, dividend policy, risk
management and capital investment monitoring.
Financial strategy
Risk and risk management
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Assessing corporate
performance
Profitability and return
 Return on capital employed
 Profit margin
 Asset turnover
Debt and gearing
 Gearing (proportion of debt in long-term capital)
 Interest cover
 Cash flow ratio (cash inflow:total debts)
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Financial
strategy
Risk and risk
management
Liquidity ratios
 Current ratio
 Inventory turnover
 Receivables’ days
 Acid test ratio
 Payables’ days
Stock market ratios
 Dividend yield
 Earnings per share
 Price/earnings ratio
 Interest yield
 Dividend cover
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Comparisons with
previous years
Comparisons with other
companies in same industry
% growth in profit
% growth in revenue
Changes in gearing ratio
Changes in current/quick ratios
Changes in inventory/
receivables turnover
 Changes in EPS, market price,
dividend
Remember however
 Inflation – can make figures
misleading
 Compare to rest of
industry/environment, or
economic changes
These can put improvements on
previous years into perspective if
other companies are doing better,
and provide further evidence of
effect of general trends.





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 Growth rates
 Retained profits
 Non-current asset levels
Comparisons with companies
in different industries
Investors aiming for diversified
portfolios need to know
differences between industrial
sectors.





Sales growth
Profit growth
ROCE
P/E ratios
Dividend yields
2: Financial strategy formulation
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Assessing corporate
performance
Estimating cost of equity
 Theoretical valuation models, eg capital asset
pricing model (CAPM) or dividend growth model.
 The cost of equity indicates the shareholders'
expected return. This can be compared to actual
return (dividend yield + capital gain ie total
shareholder return) in order to assess corporate
performance.
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Financial
strategy
Risk and risk
management
Practicalities in issuing new shares




Costs
Income to investors
Tax
Effect on control
1/27/2018 1:55:32 AM
Assessing corporate
performance
Pecking order
 Retained earnings
 Debt
 Equity
Whether lenders are prepared to lend (security)
Availability of stock market funds
Future trends
Restrictions in loan agreements
Maturity of current debt
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Risk and risk
management
Suitability of capital structure







Feasibility of capital structure





Financial
strategy
Company financial position/stability of earnings
Need for a number of sources
Time period of assets matched with funds
Change in risk-return
Cost and flexibility
Tax relief
Minimisation of cost of capital
Acceptability of capital structure




Risk attitudes
Loss of control by directors
Excessive costs
Too heavy commitments
2: Financial strategy formulation
1/27/2018 1:55:32 AM
Assessing corporate
performance
Financial
strategy
Risk and risk
management
Dividend policy
Dividend decisions determine the amount of, and
the way in which, a company’s profits are distributed
to its shareholders.
Ways of paying dividends
Theories of why dividends are paid





Residual theory
Target payout ratio
Dividends as signals
Taxes
Agency theory
 Cash
 Shares (stock)
 Share repurchases
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Assessing corporate
performance
Types of risk









Systematic and unsystematic
Business
Financial
Political
Economic
Fiscal
Regulatory
Operational
Reputational
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Financial
strategy
Risk and risk
management
Risk management
Overriding reason for managing risk is to maximise
shareholder value.
Risk mitigation
The process of minimising the likelihood of a risk
occurring or the impact of that risk if it does occur.
2: Financial strategy formulation
1/27/2018 1:55:32 AM
Assessing corporate
performance
Financial
strategy
Risk and risk
management
Behavioural finance examines psychological factors behind
financial decision making.
Examples:
Behavioural finance helps explain why:

Boards believe that the market undervalues their
shares
Overconfidence
Investors and managers have a tendency to overestimate their
own abilities.

Many acquisitions are over-valued

Unsystematic risk seems to matter to investors
Search for patterns, herding and cognitive dissonance
Investors look for patterns which can be used to justify investment decisions. This can lead to herding, where people
buy (or sell) shares because share prices are rising (or falling);
this can help to explain stock market bubbles (or crashes).

Managers fail to terminate investment strategies that
are unlikely to succeed.
Narrow framing
Many investors fail to see the bigger picture and focus too much
on short-term fluctuations in share price movements.
Conservatism
Investors and managers are resistant to changing their
opinion.
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3: Ethical and governance issues
Topic List
Ethical aspects
Ethics have become increasingly important in formulating
financial strategies. Financial managers must remember
to build ethical considerations into the decision-making
process.
Reporting
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Ethical
aspects
Human resource
management
Business
ethics
Marketing
Market behaviour
Product development
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Reporting
Minimum wage, discrimination
Social and cultural impact
Dominant position, treatment of
suppliers and customers
Animal testing, sensitivity to
culture of different countries
and markets
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Ethical
aspects
Triple bottom line decision making
Triple bottom line proxy indicators
Economic
Environmental
Economic impact
 Gross operating surplus
 Dependence on imports
 Stimulus to domestic economy by purchasing
locally produced goods and services
Social
Triple bottom line reporting: a quantitative
summary of a company’s economic,
environmental and social performance over the
previous year.
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Reporting
Social impact
 Organisation’s tax contribution
 Employment
Environmental impact
 Ecological footprint
 Emissions to soil, water and air
 Water and energy use
3: Ethical and governance issues
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Ethical
aspects
Financial
capital
Manufactured
capital
Reporting
Intellectual
capital
Integrated reporting
Human
capital
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Social and
relationship
capital
Natural
capital
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Principles of integrated reporting
Integrated reports should be based on a number of
principles:







Strategic focus and future orientation
Connectivity of information
Stakeholder responsiveness
Materiality
Conciseness
Reliability and completeness
Consistency and comparability
Integrated thinking involves consideration of the
interrelationships between operating and financial
units and the capitals the business uses.
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Contents of integrated report
Organisational overview and external environment
Governance structure and value creation
Business model
Opportunities and risks
Strategy and resource allocation
Performance – achievement of strategic objectives
and impact on capitals
 Basis of preparation and presentation






3: Ethical and governance issues
1/27/2018 1:48:22 AM
Notes
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4: Trading and planning in a multinational
environment
Topic List
Trade
Institutions
Global financial stability
Multinationals’ strategy
Risk
(004)AC12(PC)FEB18_CH04.indd 19
The growth of international trade brings benefits and risks
for the corporation. The globalisation of international
markets facilitates the flow of funds to emerging markets
but may create instability.
Multinational businesses operate through subsidiaries,
affiliates or joint ventures in more than one country, and
produce and sell products globally. Revenues are
repatriated to the parent company in the form of dividends,
royalties or licence payments. Overseas operations’ ability
to repatriate funds can have a major impact on the parent
company’s ability to pay dividends to external shareholders
and finance its investment plans.
1/27/2018 1:47:43 AM
Trade
Institutions
Global financial
stability
International trade
World output of goods and services is increased if
countries specialise in the production of
goods/services in which they have a comparative
advantage and trade to obtain other goods and
services.
Multinationals’
strategy
Risk
Barriers to market entry





Product differentiation barriers
Absolute cost barriers
Economy of scale barriers
The level of fixed costs
Legal/patent barriers
Protectionist measures
Comparative advantage
Countries specialising in what they produce, even
if they are less efficient (in absolute terms) in
production of all types of good, is the comparative
advantage justification of free trade, without
protectionism or trade barriers.
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






Tariffs or customs duties
Import quotas
Embargoes
Hidden subsidies
Import restrictions
Restrictive bureaucratic procedures
Currency devaluations
1/27/2018 1:47:51 AM
The role of free trade areas
World Trade Organisation and
International Monetary Fund
A free trade area like the European Union (EU)
aims to:
 Remove barriers to trade and allow freedom of
movement of production resources such as
capital and labour
 Provide a common set of regulations across
all member countries, this may help to reduce
compliance costs
 Limit any discriminatory practice (for
example favouring domestic firms in the
awarding of government contracts).
The EU also erects common external trade
barriers against countries which are not member
states.
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WTO aims





Reduce existing barriers to free trade
Eliminate discrimination in
international trade (in eg tariffs and
subsidies)
Prevent growth of protection by
getting member countries to consult
with others first
Act as a forum for assisting free trade,
and offering a disputes settlement
process
Establish rules and guidelines to
make world trade more predictable
4: Trading and planning in a multinational environment
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Trade
Institutions
IMF aims



Promote international monetary co-operation,
and establish code of conduct for international
payments.
Provide financial support to countries with
temporary balance of payments deficits.
Ensure that countries take effective action to
improve their balance of payments position eg
by taking action to reduce the demand for goods
and services.
IMF criticisms


IMF loans can lead to economic stagnation as
countries struggle to repay these loans.
Deflationary policies imposed by the IMF may
damage the profitability of multinationals'
subsidiaries by reducing their sales in the local
market.
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Global financial
stability
Multinationals’
strategy
Risk
World Bank (IBRD)
Supplements private finance and lends money on a
commercial basis for capital projects, usually direct to
governments or government agencies.
Central Banks
Central banks support the stability of the financial system.
The growth of international trade has created a higher risk
of financial contagion. Many countries in emerging
economies have borrowed heavily in recent years, mainly in
dollars due to low interest rates in the US following the
credit crunch. If there is a slow down in their export markets
and an increase in US interest rates then these economies
will require stimulus programmes from their central banks.
1/27/2018 1:47:51 AM
Trade
Institutions
The credit crunch
The credit crunch first became a global issue in
early 2007.
How the global crisis happened.
Billions of dollars of ‘sub-prime’ mortages in the US
Rise in interest rates caused defaults on such
mortgages
Collateralised debt obligations (CDOs) containing
sub-prime mortgages sold onto hedge funds
Value of CDOs fell due to defaults
Huge losses by the banks
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Global financial
stability
Multinationals’
strategy
Risk
Financial reporting
Common accounting standards are increasing
transparency and comparability for investors –
improving capital market efficiency and facilitating
cross-border investment.
Monetary policy
In advanced economies, monetary policy has
encompassed the task of controlling inflation.
Interest rates are commonly set by central banks
independent of Government – enhancing credibility
and so lowering inflation expectations.
A low inflation environment is conducive to
long-term business planning and investment.
4: Trading and planning in a multinational environment
1/27/2018 1:47:51 AM
Trade
Institutions
Global financial
stability
Trends in global financial markets
Integration and globalisation – fostered by
liberalisation of markets and technological
change; creating more efficient allocation of
capital and economic growth
 Growth of derivatives markets – advances in
technology, financial engineering and risk
management have enhanced demand for more
complex derivatives products
 Securitisation – eg sale of loan books by banks.
Now a common form of financing, leading to
increased bond issuance
 Convergence of financial institutions –
abolition of barriers to entry in various segments
of financial services industries has led to
conglomerates with operations in banking,
securities and insurance
Multinationals’
strategy
Risk
Effects of financial sector convergence

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Economies of scale
Economies of scope: a factor of production can
be employed to produce multiple products
 Reduced earnings volatility
 Reduced search costs for consumers


Money laundering
A side effect of globalisation and the free movement
of capital has been a growth in money laundering,
and there has been increased legislation and
regulation to combat it.
1/27/2018 1:47:51 AM
Trade
Institutions
Strategic reasons for FDI
 Market seeking
 Raw material seeking
 Production efficiency
seeking
 Knowledge seeking
 Political safety
seeking
 Economies of scale
 Managerial and
marketing expertise
 Technology
 Financial economies
 Differentiated products
Management contracts: a firm agrees to sell
management skills – sometimes used in combination
with licensing. Can serve as a means of obtaining funds
from subsidiaries, where other remittance restrictions
apply.
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Global financial
stability
Multinationals’
strategy
Risk
Ways to establish an interest abroad
 Joint ventures – industrial co-operation
(contractual) or joint-equity
 Licensing agreements
 Management contracts
 Subsidiary
 Branches
Many multinationals use a combination of
methods for servicing international markets.
4: Trading and planning in a multinational environment
1/27/2018 1:47:51 AM
Trade
Institutions
Global financial
stability
Multinationals’ financial planning
Multinational companies need to develop a financial planning
framework to ensure that the strategic objectives and
competitive advantages are realised. Such a financial planning
framework will include ways of raising capital and risks related
to overseas operations and the repatriation of profits.
Finance for overseas investment depends
on:
 Local finance costs, and any available subsidies
 Tax systems of the countries (best group structure may
be affected by tax systems)
 Any restrictions on dividend remittances
 Possible flexibility in repayments arising from the
parent/subsidiary relationship
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Multinationals’
strategy
Risk
A company raising funds from local
equity markets must comply with the
listing requirements of the local exchange.
Blocked funds
Multinationals can counter exchange
controls by management charges or
royalties.
Control systems
Large and complex companies may be
organised as a heterarchy, an organic
structure with significant local control.
1/27/2018 1:47:52 AM
Dividend capacity
The dividend capacity of a company depends on: after tax
profits, investment plans, foreign dividends.
Dividend capacity / FCFE
Revenue after operating costs, interest and tax
+
Dividends from foreign affiliates and subsidiaries
–
Free cash flow to equity (FCFE)
FCFE = Maximum dividend that could be paid to ordinary
shareholders out of the current year’s cash flows
Net investment in non-current assets
–
Net investment in working capital
+
Net debt issued
+
Net equity issued
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4: Trading and planning in a multinational environment
1/27/2018 1:47:52 AM
Trade
Institutions
Global financial
stability
Dividend repatriation
Factors affecting dividend repatriation
policies
Financing – how much needed for
dividends/investment at home?
Tax – often the primary reason for the firm’s

repatriation policies
Managerial control – regularised dividends restrict
discretion of foreign managers (so reducing agency
problems)
Timing – to take advantage of possible currency
movements (although these are difficult to forecast
in practice)

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
Multinationals’
strategy
Risk
UK companies subsidiaries’ foreign profits are
liable to UK corporate tax, whether repatriated or
not, with a credit for tax already paid to the host
country.
Similarly, the US government does not distinguish
between income earned abroad and income
earned at home and gives credit to MNCs
headquartered in the US for tax paid to foreign
governments.
Collecting early (lead) payments from currencies
 vulnerable to depreciation and late (lag) from
currencies expected to appreciate will benefit
from expected movements in exchange rates.
1/27/2018 1:47:52 AM
Transfer prices
Are prices at which goods or services are
transferred from one process or department to
another or from one member of a group to another.
Using market value transfer prices
Giving profit centre managers freedom to negotiate
prices with other profit centres results in
market-based transfer prices.
Transfer price bases
 Standard cost
 Marginal cost: at marginal cost or with gross
profit margin added
 Opportunity cost
 Full cost: at full cost, or at a full cost plus price
 Market price
 Market price less a discount
 Negotiated price, which could be based on any
of the other bases
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Transfer pricing motivations
Evaluation of performance of divisions
Management incentives
Cost allocation between divisions
Financing considerations – to boost or to
disguise the profitability of a subsidiary
 External factors, including taxes, tariffs, rule of
origin tests and exchange controls




4: Trading and planning in a multinational environment
1/27/2018 1:47:52 AM
Trade
Institutions
Global financial
stability
Multinationals’
strategy
Risk
Transfer price regulation
Tax authorities often use an arm's length standard: price intra-firm trade of multinationals as if it took place
between unrelated parties acting in competitive markets.
Method 1: use price negotiated between unrelated
parties C and D as proxy for intra-firm transfer A to B
C
Arm’s length transfer
A
D
Method 2: use price at which A sells to unrelated
party C as proxy
A
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B
Arm’s length
transfer
B
Intrafirm transfer
Intrafirm transfer
C
1/27/2018 1:47:52 AM
Arm’s length pricing methods (tangible
goods)
Transaction-based
 Comparable uncontrolled price (CUP) 
 Resale price (RP) 
 Cost plus (C+) 
Profit-based
 Profit split (PS)

PS: common when there are no suitable product
comparables (CUP) or functional comparables
(RP and C+). Profits on a transaction earned by
two related parties are split between the parties,
usually on basis of return on operating assets:
operating profits to operating assets.
Page 31
(004)AC12(PC)FEB18_CH04.indd 31

CUP: based on a product comparable transaction,
possibly between different parties but in similar
circumstances – a method preferred by tax
authorities.

RP: tax auditor looks for firms at similar trade levels
that perform a similar distribution function (a
functional comparable) – method best used when
distributor adds relatively little value, making it
easier to estimate. Profit margin derived from that
earned by comparable distributors, subtracted from
known retail price to determine transfer price.

C+: appropriate mark-up (estimated from similar
manufacturers) added to costs of production,
measured using recognised accounting principles.
4: Trading and planning in a multinational environment
1/27/2018 1:47:52 AM
Trade
Institutions
Global financial
stability
Litigation risks
Factors in assessing political risk





Government stability
Political and business ethics
Economic stability/inflation
Degree of international
indebtedness
Financial infrastructure




Level of import restrictions
Remittance restrictions
Assets seized
Special taxes and regulations
on overseas investors, or
investment incentives
Dealing with political risk






Negotiations with host government
Insurance (eg ECGD)
Production strategies
Contacts with customers
Financial management eg borrowing funds locally
Management structure eg joint ventures
(004)AC12(PC)FEB18_CH04.indd 32
Risk
Multinationals’
strategy
Can generally be reduced by keeping abreast
of changes, acting as a good corporate citizen
and lobbying.
Cultural risks
Should be taken into account when deciding
where to sell abroad, and how much to
centralise activities.
Environmentally
sensitive
Environmentally
insensitive
Adaptation necessary
Standardisation possible
 Fashion clothes
 Convenience foods
 Industrial and agricultural products
 World market products, eg jeans
1/27/2018 1:47:52 AM
Agency issues
Agency relationships exist between the CEOs of
conglomerates (the principals) and the strategic
business unit (SBU) managers that report to these
CEOs (agents).
The interests of the individual SBU managers may
be incongruent not only with the interests of the
CEOs, but also with those of the other SBU
managers.
Each SBU manager may try to make sure his or
her unit gets access to critical resources and
achieves the best performance at the expense of
the performance of other SBUs and the whole
organisation.
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Solutions to agency problems in
multinationals
Multiple mechanisms may be needed, working in
unison. Eg:
 Board of directors: separate ratification and
monitoring of managerial decisions from
initiation to implementation
 Executive incentive systems can reduce
agency costs and align the interests of
managers and shareholders by making top
executives’ pay contingent on the value they
create for the shareholders
4: Trading and planning in a multinational environment
1/27/2018 1:47:52 AM
Notes
(004)AC12(PC)FEB18_CH04.indd 34
1/27/2018 1:47:52 AM
5: Discounted cash flow techniques
Topic List
In this chapter, we discuss the evaluation of projects using
the net present value (NPV) method and the internal rate of
return.
NPVs
The NPV method is extended to include inflation and
specific price variation, taxation and the assessment of
fiscal risk and multi-period capital rationing.
Internal rate of return
Uncertainty
(005)AC12(PC)FEB18_CH05.indd 35
We also look at the potential internal rate of return and
approaches to assessing project uncertainty.
1/27/2018 1:44:32 AM
NPVs
Net present value (NPV)
The sum of the discounted cash flows less the
initial investment.
Decision criterion
Invest in a project if its net present value is positive
ie when NPV > 0
Do not invest in a project if its net present value is
zero or negative, ie when NPV  0
Uncertainty
Real and nominal discount factors
What nominal rate (i) should be used for discounting
cash flows, if the real rate is r and the rate of inflation h?
(l + i) = (1 + r)(1 + h)
(the Fisher equation,
given in exam)
The net effect of inflation
on the NPV of a project
will depend on three
inflation rates: the rates
for revenues, costs, and
the discount factor.
Tax effects on NPV


(005)AC12(PC)FEB18_CH05.indd 36
Internal
rate of return risk
Corporate taxes
Value added taxes


Other local taxes
Capex tax
allowances
1/27/2018 1:44:45 AM
Capital rationing
Capital rationing problem exists when there are insufficient funds to finance all available profitable projects.
Single period case 1
Fractional investment allowed: rank the
alternatives according to the ratio of NPV to initial
investment (the profitability index.)
Single period case 2
Fractional investment not allowed: a more
systematic approach may be needed to find the
NPV-maximising combination of entire projects subject
to the investment constraint.
A multi-period capital rationing problem can be
formulated as an integer programming problem.
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The Monte Carlo method
Amounts to adopting a particular probability
distribution for the uncertain (random) variables that
affect the NPV and then using simulations to
generate values of the random variables.
Project Value at Risk
Measures the maximum fall that could be expected
in the NPV of a project with a certain level of
confidence. The standard deviation of the project
needs to be adjusted by multiplying by the square
root of the time period.
5: Discounted cash flow techniques
1/27/2018 1:44:45 AM
NPVs
Internal
rate of return risk
Uncertainty
IRR
The discount rate at which NPV equals zero.
 The IRR calculation also produces the breakeven cost
of capital and allows calculation of the margin of safety.
 If the cash flows change signs then the IRR may not
be unique: this is the multiple IRR problem.
 With mutually exclusive projects, the decision
depends not on the IRR but on the cost of capital
being used.
Decision criteria using IRR
A project will be selected as long as the IRR
is not less than the cost of capital.
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1/27/2018 1:44:46 AM
Modified IRR (MIRR)
Re-investment rate
MIRR is the IRR which would result without the
assumption that project proceeds are reinvested at
the IRR rate.
The NPV method assumes that cash flows can be
reinvested at the cost of capital over the life of the
project.
1
Calculate the present value of the return phase
(the phase of the project with cash inflows)
2
Calculate the present value of the investment
phase (the phase with cash outflows)
3
Calculate MIRR using the following formula:
PVR
MIRR =
PV1
1
n
(1+ r e) –1
This formula is given in the exam.
Page 39
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Selection of investments based on the higher IRR
assumes that cash flows can be reinvested at the
IRR over the life of the project.
The IRR assumption is unlikely to be valid and so
the NPV method is likely to be superior. The better
reinvestment rate assumption will be the cost of
capital used for the NPV method.
Decision criterion
If MIRR is greater than the required rate of return:
accept
If MIRR is lower than the required rate of return:
reject
5: Discounted cash flow techniques
1/27/2018 1:44:46 AM
NPVs
Internal
rate of return risk
Uncertainty
To describe the uncertainty of a potential investment the following techniques may be used:
 Payback period the quicker the payback the less reliant a project is on the later, more uncertain, cash
flows.
 Discounted payback period uses the discounted cash flows and is a better method since it adjusts for
time value.
 Sensitivity analysis an analysis of what % change in one variable would be needed for the NPV of a
project to fall to zero. Calculated as NPV of project/PV of cash relating to the uncertain variable.
 Simulation an analysis of how changes in more than 1 variable may affect the NPV of a project.
 Project duration is a measure of the average time over which a project delivers its value: it is
calculated by weighting each year of the project by the % of the present value of the cash inflows recovered
in that year.
(005)AC12(PC)FEB18_CH05.indd 40
1/27/2018 1:44:46 AM
6: Application of option pricing theory in
investment decisions
Topic List
Options concepts
Real options
(006)AC12(PC)FEB18_CH06.indd 41
Option valuation techniques can be applied to capital
budgeting exercises in which a project is coupled with a
put or call option. For example, the firm may have the
option to abandon a project during its life. This amounts
to a put option on the remaining cash flows associated
with the project. Ignoring the value of these real options
(as in standard discounted cash flow techniques) can
lead to incorrect investment evaluation decisions.
1/27/2018 1:43:58 AM
Options
concepts
Options
Real
options
Determinants of option values
An option is a contract that gives one party the option to
enter into a transaction either at a specific time in the future
or within a specific future period at a price that is agreed
when the contract is issued.
 The buyer of a call option acquires the right, but not the
obligation, to buy the underlying at a fixed price.
 The buyer of a put option acquires the right, but not the
obligation, to sell the underlying shares at a fixed price.
In the money option: intrinsic value is +ve
At the money option: intrinsic value is zero
Out of the money option: intrinsic value is –ve
(006)AC12(PC)FEB18_CH06.indd 42
 The higher the exercise price, the lower
the probability that the call will be in the
money.
 As the current price of the underlying
asset goes up, the higher the
probability that the call will be in the
money.
 Both a call and put will increase in
price as the underlying asset becomes
more volatile.
 Both calls and puts will benefit from
increased time to expiration.
 The higher the interest rate, the lower
the present value of the exercise price.
1/27/2018 1:44:01 AM
Options
concepts
Real options
Strategic options – known as real options –
arising from a project can increase the project value.
They are ignored in standard discounted cash flow
(DCF) analysis, which computes a single present value.
Option to delay
When a firm has exclusive rights to a project or product for
a specific period, it can delay taking this project or product
until a later date. For a project not selected today on NPV
or IRR grounds, the rights to the project can still have value.
Option to expand
Is when firms invest in projects allowing further
investments later, or entry into new markets, possibly
making the NPV +ve. The initial investment may be seen
as the premium to acquire the option to expand.
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(006)AC12(PC)FEB18_CH06.indd 43
Real
options
Option to abandon
Is if the firm has the option to cease a project
during its life. Abandonment is effectively the
exercising of a put option. The option to abandon is
a special case of an option to redeploy.
Option to redeploy
Is when company can use its productive assets for
activities other than the original one. The switch will
happen if the PV of cash flows from the new
activity will exceed costs of switching.
Black-Scholes valuation
In applying Black-Scholes valuation techniques to
real options, simulation methods are typically used
to overcome the problem of estimating volatility.
6: Application of option pricing theory in investment decisions
1/27/2018 1:44:02 AM
Options
concepts
Determinants of option values






Exercise price (Pe)
Price of underlying asset (Pa)
Volatility of underlying asset (s)
Time to expiration (t)
Interest rate (r)
Intrinsic and time value
Real
options
Black-Scholes formulae
C = Pa N(d1 ) – PeN(d 2 )e – rt
⎛P
In ⎜⎜ a
P
d1 = ⎝ e
⎞
⎟ + (r + 0.5s 2 )t
⎟
⎠
s t
d 2 = d1 – s t
These formulae are given in the exam.
Put option
Real options are highly examinable.
(006)AC12(PC)FEB18_CH06.indd 44
P = C – Pa + Pe e – rt
1/27/2018 1:44:02 AM
7a: Impact of financing on investment
decisions and adjusted present values
Topic List
Sources of finance
Duration
Credit risk
Modigliani & Miller
Other theories
The cost of capital is the rate of return required by investors
in order to supply their funds to the company. It is also the
rate of return a company must earn in a project in order to
maintain its market value. There are two forms of capital to a
firm, equity and debt, and each supplier of capital requires a
return which is determined by the risks each type of investor
faces.
The overall cost of capital to the firm is the weighted
average of the cost of equity and the cost of debt.
APV approach
(007)AC12(PC)FEB18_CH07a.indd 45
1/27/2018 1:43:38 AM
Sources of
finance
Duration
Equity
Credit
risk
Venture
capital
Modigliani
& Miller
Business
angels
Other
theories
APV
approach
Asset
securitisation
Sources of finance
Short-term/
long-term
debt
(007)AC12(PC)FEB18_CH07a.indd 46
Lease
finance
Hybrids
Islamic
finance
1/27/2018 1:43:41 AM
Sources of
finance
Duration
Credit
risk
Modigliani
& Miller
Other
theories
APV
approach
Islamic finance operates under the principle that there should be a link between the economic activity that
creates value and the financing of that activity.
Advantages of Islamic
finance
Drawbacks of Islamic
finance
 Islamic funds are available worldwide
 Gharar (uncertainty, risk, speculation) is not
allowed
 Excessive profiteering is not allowed
 Banks cannot use excessive leverage
 All parties take a long-term view
 Emphasis on mutual interest and co-operation
 No international consensus on Sharia’a
interpretations
 No standard Sharia’a model, which leads to
higher transaction costs
 Additional compliance work increases
transaction costs
 Islamic banks cannot minimise risk through
hedging
 Some Islamic products may not be compatible
with financial regulations
 Limited trading in Sukuk products
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7a: Impact of financing on investment decisions and adjusted present values
1/27/2018 1:43:41 AM
Sources of
finance
Duration
Credit
risk
Modigliani
& Miller
Other
theories
APV
approach
Islamic finance
transaction
Similar to
Features
Murabaha
Trade credit/loan
Pre-arranged mark up for convenience of later payment, no interest
Musharaka
Venture capital
Profit share per contract, no dividends, losses per capital contribution,
both parties participate
Mudaraba
Equity
Profit share per contract, no dividends, losses borne by capital
provider, organisation runs business
Ijara
Leasing
Whatever the other features, lessor remains asset owner and incurs
risks of ownership
Sukuk
Bonds
Underlying tangible asset in which holder shares may be asset-based
(sale/leaseback) or asset-backed (securitisation)
Salam
Forward contract
Commodity sold for future delivery, cash received at discount from
financial institution, payments received in advance
Istisna
Phased payments
Project funding, initial payment and then instalments from business
undertaking the project
(007)AC12(PC)FEB18_CH07a.indd 48
1/27/2018 1:43:41 AM
Cost of equity
ke =
Cost of irredeemable debt
d0 (1 + g)
P0
+g
kd =
i(1 – T)
P0
Cost of redeemable debt
g = br
g is growth rate of dividends
b is proportion of profits retained
r is rate of return on investments
CAPM
IRR calculation, including amount payable on
redemption
WACC
é
ù
é Vd ù
ú ke + ê
ú kd (1 - T )
ë Ve + Vd û
ë Vd + Ve û
WACC = ê
Ve
E(r i) = Rf + i (E(rm) – Rf)
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7a: Impact of financing on investment decisions and adjusted present values
1/27/2018 1:43:42 AM
Sources of
finance
Duration
Beta factors of portfolios
Portfolio of all stock –
market securities
Beta factor 1
Portfolio of risk-free –
securities
Beta factor 0
Investors’ portfolio
Beta factor weighted
average of individual
beta factors
–
(007)AC12(PC)FEB18_CH07a.indd 50
Credit
risk
Modigliani
& Miller
Other
theories
APV
approach
Limitations of CAPM
 Difficulties in determining excess return
 Difficulties in determining risk-free rate
 Errors in statistical analysis used to calculate
betas
 Assumption that investment market is efficient
 Assumption that portfolios are well-diversified
1/27/2018 1:43:42 AM
Geared betas
Exam formula
May be used to obtain an appropriate required
return when an investment has differing business
and finance risks from the existing business.
Weaknesses in the formula
(007)AC12(PC)FEB18_CH07a.indd 51
Vd(1 – T)
Ve

 +
(Ve + Vd(1 – T)) e (Ve + Vd(1 – T)) d
Where
 Difficult to identify firms with identical operating
characteristics
 Estimate of beta factors not wholly accurate
 Assumes that cost of debt is risk-free
 Does not include growth opportunities
 Differences in cost structures and size will
affect beta values between firms
Page 51
a =
a = asset (or ungeared) beta
e = equity (or geared) beta
d = beta factor of debt in the geared company
Vd = market value of debt in the geared company
Ve = market value of equity capital in the geared company
T = rate of corporate tax
7a: Impact of financing on investment decisions and adjusted present values
1/27/2018 1:43:42 AM
Sources of
finance
Duration
Credit
risk
Duration (Macaulay duration)
The weighted average length of time to the receipt
of a bond’s benefits (coupon and redemption value).
The weights are the present values of the benefits
involved.
Modigliani
& Miller
Other
theories
APV
approach
Properties of duration
 Longer-dated bonds have longer durations
 Lower-coupon bonds will have longer
durations
 Lower yields will give longer durations
Calculating duration
1
Multiply PV of cash flows for each time period
by the time period and add together.
2
Add the PV of cash flows in each period
together.
3
Divide the result of step 1 by the result of
step 2.
(007)AC12(PC)FEB18_CH07a.indd 52
1/27/2018 1:43:42 AM
Modified duration
Modified duration =
In fact, the actual relationship between price and yield
is given by the line below.
Macaulay duration
Price
1 + gross redemption yield
Modified duration predicts a linear relationship
between the yield and the price. If the modified
duration is 2.75 then, if required yields rise by 1%,
the bond price will fall by 2.75%. This is a useful
measure of the price sensitivity (risk) of a bond
to changes in interest rates.
Yield
The impact of convexity (ie non-linear relationship) will
be that the modified duration will tend to overstate the
fall in a bond’s price and understate the rise. The
problem of convexity only becomes an issue with more
substantial fluctuations in the yield.
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7a: Impact of financing on investment decisions and adjusted present values
1/27/2018 1:43:42 AM
Sources of
finance
Duration
Credit risk (or ‘default risk’)
is the risk for a lender that the
borrower may default on interest
payments and/or repayment of
principal.
Credit risk for an individual loan or
bond is measured by estimating:
 Probability of default –
typically, using information on
borrower and assigning a credit
rating (eg Standard & Poor’s,
Moody’s, Fitch)
 Recovery rate – the fraction of
face value of an obligation
recoverable once the borrower
has defaulted
(007)AC12(PC)FEB18_CH07a.indd 54
Credit
risk
Modigliani
& Miller
Other
theories
APV
approach
Standard & Poor’s
Moody’s
AAA
Aaa
Highest quality, lowest default risk
AA
Aa
High quality
A
A
Upper medium grade quality
BBB
Baa
Medium grade quality
BB
Ba
Lower medium grade quality
B
B
CCC
Caa
Poor quality (high default risk)
Speculative
CC
Ca
Highly speculative
C
C
Lowest grade quality
Credit migration
Is the change in the credit rating after a bond is issued.
1/27/2018 1:43:42 AM
Determinants of cost of debt capital




Credit rating of company
Maturity of debt
Risk-free rate at appropriate maturity
Corporate tax rate
Credit spread
Is the premium required by an investor in a
corporate bond to compensate for the credit risk
of the bond.
Yield on corporate bond = Risk free rate + Credit
spread
Cost of debt capital = (1 – Tax rate)(Risk free rate –
Credit spread)
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7a: Impact of financing on investment decisions and adjusted present values
1/27/2018 1:43:43 AM
Sources of
finance
Duration
Credit
risk
Modigliani
& Miller
Other
theories
APV
approach
MM theory (no tax)
MM and cost of equity
The use of debt would only transfer more
risk to the shareholders, therefore will not
reduce the WACC.
Vd
Ve
Where ke
= cost of equity in a geared company
i
ke
= cost of equity in an ungeared company
Vd, Ve = market values of debt and equity
kd
= pre-tax cost of debt
This formula is given in the exam.
MM theory (with tax)
Debt actually saves tax (due to tax relief
on interest payments) therefore firms
should only use debt finance.
(007)AC12(PC)FEB18_CH07a.indd 56
k e = k ie + (1 − T)(k ie − k d )
Limitations of MM theory
 Too risky in reality to have high levels of gearing
 Assumes perfect capital markets
 Does not consider bankruptcy risks, tax exhaustion,
agency costs and increased borrowing costs as risk rises
1/27/2018 1:43:43 AM
Sources of
finance
Duration
Credit
risk
Static trade-off theory
Problems with financial distress costs
Direct financial
distress
Page 57
(007)AC12(PC)FEB18_CH07a.indd 57
Other
theories
APV
approach
Agency theory
A firm in a static position will adjust their gearing levels
to achieve a target level of gearing.
 Legal and admin
costs associated with
bankruptcy
Modigliani
& Miller
The optimal capital structure will occur where the
benefits of the debt received by the shareholders
matches the costs of debt imposed on the
shareholders.
Indirect financial
distress




Higher cost of capital
Loss of sales
Downsizing
High staff turnover
7a: Impact of financing on investment decisions and adjusted present values
1/27/2018 1:43:43 AM
Sources of
finance
Duration
Credit
risk
Modigliani
& Miller
Other
theories
APV
approach
Pecking order theory
Predictions
Is, unlike the MM models, based on the idea
of information asymmetry: investors have a
lower level of information about the company
than its directors do. As a result, shareholders
use directors’ actions as a signal to indicate
what directors believe about the company
with their superior information.
 To finance new investment, firms prefer internal
finance to external finance.
(007)AC12(PC)FEB18_CH07a.indd 58
 If retained earnings differ from investment outlays,
the firm adjusts its cash balances or marketable
securities first, before either taking on more debt or
increasing its target payout rate.
 Internal finance is at the top, and equity is at the
bottom, of the pecking order. A single optimal
gearing ratio does not exist: a result similar to the
MM model with no taxes.
1/27/2018 1:43:43 AM
Sources of
finance
Duration
Credit
risk
Adjusted present value (APV) approach
Modigliani
& Miller
Other
theories
APV
approach
Steps in applying APV
The adjusted present value (APV) method of
valuation is based on the Modigliani Miller model
with taxation.
1
Calculate the NPV as if the project was
i
financed entirely by equity (use ke)
2
Add the PV of the tax saved as a result of the
debt used to finance the project (use kd)
We assume that the primary benefit of borrowing is
the tax benefit and that the most significant cost of
borrowing is the added risk of bankruptcy.
3
Subtract the cost of issuing new finance
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7a: Impact of financing on investment decisions and adjusted present values
1/27/2018 1:43:43 AM
Notes
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1/27/2018 1:43:43 AM
7b: Valuation and the use of free cash flows
Topic List
Free cash flows
Equity evaluations
(008)AC12(PC)FEB18_CH07b.indd 61
This chapter mainly focuses on the use of free cash
flows and their use for valuation puposes.
It also briefly recaps equity valuation methods from your
earlier studies for the Financial Management exam.
1/27/2018 1:43:19 AM
Free cash
flows
Equity
evaulations
Free cash flow (FCF)
Free cash flow (FCF)
=
Earnings before interest and taxes (EBIT)
less Tax on EBIT
plus Non cash charges (eg depreciation)
less Capital expenditures
less Net working capital increases
plus Net working capital decreases
plus Salvage value received
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1/27/2018 1:43:22 AM
Forecasting dividend capacity
The dividend capacity of a firm is measured by its
free cash flow to equity (FCFE).
Direct method of calculating FCFE
Indirect method
Net income (EBIT – Net interest – Tax paid)
FCF
add
Depreciation
less
(Net interest + Net debt paid)
less
Total net investment
add
add
Net debt issued
Tax benefit from debt
(Net interest × Tax rate)
add
Net equity issued
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7b: Valuation and the use of free cash flows
1/27/2018 1:43:22 AM
Free cash
flows
Equity
evaulations
Firm valuation using FCF
Terminal values and company valuation
Value of the firm is the sum of the discounted free
cash flows over the appropriate time horizon.
Value of the firm is the present value over the
forecast period + terminal value of cash flows
beyond the forecast period.
Assuming constant growth, use the Gordon model:
Firm valuation using FCFE
PV0 =
Where
FCF0 (1 + g)
k−g
g = growth rate
k = cost of capital
(008)AC12(PC)FEB18_CH07b.indd 64
1
Calculate value of equity (present value of
FCFE discounted at the cost of equity)
2
Calculate value of debt
3
Value = Value of equity + Value of debt
1/27/2018 1:43:22 AM
8: International investment and financing
decisions
Topic List
Companies that undertake overseas projects are subject
to exchange rate risks as well as other risks such as
exchange controls, taxation and political action.
NPV and international projects
Capital budgeting methods for multinational companies
can incorporate these additional complexities in the
decision-making process.
Exchange controls
Exchange rate risks
Capital structure
(009)AC12(PC)FEB18_CH08.indd 65
1/27/2018 1:43:04 AM
NPV and
international projects
Exchange
controls
Exchange
rate risks
Capital
structure
Purchasing power parity
NPVs for international projects
Absolute purchasing parity theory: prices of products in different
countries will be the same when expressed in the same currency.
Alternative purchasing power parity relationship: changes in
exchange rates are due to differences in the expected inflation rates
between countries.
Alternative methods for calculating
the NPV from an overseas project:
International Fisher effect
1 + ic
1 + ib
=
1 + hc
1 + hb
This equation is given in the exam.
In the absence of trade or capital flows restrictions, real interest rates
in different countries will be expected to be the same. Differences in
interest rates reflect differences in inflation rates.
(009)AC12(PC)FEB18_CH08.indd 66
 Convert foreign project cash
flows into local currency using
a forecast exchange rate. Then
discount at the local cost of
capital. This is the method that
is usually tested.
 Discount cash flows in foreign
country's currency from project
at adjusted discount rate for
that currency and then convert
resulting NPV at spot exchange
rate.
1/27/2018 1:43:07 AM
Effect of exchange rates on NPV
Effect on exports
When there is a devaluation of sterling relative to a
foreign currency, the sterling value of cash flows
increases and NPV increases. The opposite
happens when the domestic currency appreciates.
When a multinational company sets up a subsidiary
in another country in which it already exports, the
relevant cash flows (and NPV) for evaluation of the
project should account for loss of export earnings in
the particular country.
Impact of transaction costs
Transaction costs are incurred when companies
invest abroad due to currency conversion or other
administrative expenses. These should also be
taken into account.
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8: International investment and financing decisions
1/27/2018 1:43:07 AM
NPV and
international projects
Taxes in international context
Host country
 Corporate taxes
 Investment allowances
 Withholding taxes
Exchange
controls
Exchange
rate risks
Capital
structure
Tax haven characteristics
 Low tax on foreign investment or sales income
earned by resident companies
 Low withholding tax on dividends paid to the
parent
Home country
 Stable government and currency
 Double taxation relief
 Foreign tax credits
 Adequate financial services support facilities
Subsidies
The benefit from concessionary loans should be included in the NPV calculation as the difference between the
repayment when borrowing under market conditions and the repayment under the concessionary loan.
(009)AC12(PC)FEB18_CH08.indd 68
1/27/2018 1:43:08 AM
NPV and
international projects
Exchange
controls
Exchange
rate risks
Capital
structure
Exchange controls
Strategies
Types:
Multinational company strategies to overcome
exchange controls:
 Rationing supply of foreign exchange.
Payments abroad in foreign currency are
restricted, preventing firms from buying as much
as they want from abroad.
 Transfer pricing, where the parent company
sells goods or services to the subsidiary and
obtains payment
 Restricting types of transaction for which
payments abroad are allowed, eg suspending or
banning payment of dividends to foreign
shareholders, such as parent companies in
multinationals: blocked funds problem.
 Royalty payments adjustments, when a parent
company grants a subsidiary the right to make
goods protected by patents
For an overseas project, we include only the
proportion of cash flows that are expected to be
repatriated in the NPV calculation.
 Management charges levied by the parent
company for costs incurred in the management
of international operations
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 Loans by the parent company to the subsidiary:
setting interest rate at appropriate level
8: International investment and financing decisions
1/27/2018 1:43:08 AM
NPV and
international projects
Exchange
controls
Exchange
rate risks
Capital
structure
Transaction exposure
Economic exposure
Is the risk of adverse exchange rate movements
between the date the price is agreed and the date
cash is received/paid, arising during normal
international trade.
Is the risk that the present value of a company’s
future cash flows might be reduced by adverse
exchange rate movements.
Translation exposure
Is the risk that the organisation will make exchange
losses when the accounting results of its foreign
branches or subsidiaries are translated.
Translation losses can arise from restating the book
value of a foreign subsidiary’s assets at the
exchange rate on the statement of financial position
date – only important if changes arise from loss of
economic value.
(009)AC12(PC)FEB18_CH08.indd 70
Economic exposure:
 Can be longer-term (continuous currency
depreciation)
 Can arise even without trade overseas (effects of
pound strengthening)
1/27/2018 1:43:08 AM
NPV and
international projects
Exchange
controls
Overseas subsidiaries
Parent company needs to consider a number of
issues when setting up an overseas subsidiary:






Amount of equity capital
Whether parent owns 100% of equity
Profit retention by subsidiary
Amount of subsidiary’s debt
Amount of subsidiary’s working capital
Whether subsidiary should obtain local listing
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Exchange
rate risks
Capital
structure
Choice of finance







Finance costs
Taxation systems
Restrictions on dividend remittances
Flexibility in repayments
Reduction in systematic risk
Access to foreign capital
Agency costs
8: International investment and financing decisions
1/27/2018 1:43:08 AM
NPV and
international projects
International borrowing options
(1) Borrow in the same currency as the inflows from
the project
(2) Borrow in a currency other than the currency of
the inflows, with a hedge in place
(3) Borrow in a currency other than the currency of
 the inflows, without hedging the currency risk
 Option (3) exposes the company to exchange
rate risk which can substantially change the
profitability of a project.
(009)AC12(PC)FEB18_CH08.indd 72
Exchange
controls
Exchange
rate risks
Capital
structure
Advantages of international borrowing
 Availability: domestic financial markets, except
larger countries and the eurozone, generally
lack the depth and liquidity to accommodate
large or long-maturity debt issues.
 Lower cost of borrowing: in eurobond
markets interest rates are normally lower than
borrowing rates in national markets.
 Lower issue costs: cost of debt issuance is
normally lower than the cost of debt issue in
domestic markets.
1/27/2018 1:43:08 AM
9: Acquisitions and mergers v other growth
strategies
Topic List
Acquisitions and mergers
Shareholder value issues
Reverse takeovers
Firms may decide to increase the scale of their
operations through a strategy of internal organic growth
by investing money to purchase or create assets and
product lines internally.
Alternatively, companies may decide to grow by buying
other companies in the market, thus acquiring
‘ready-made’ tangible and intangible assets and product
lines.
A reverse takeover is a mechanism for achieving an
acquisition and a stock market listing at the same time.
(010)AC12(PC)FEB18_CH09.indd 73
1/27/2018 1:42:41 AM
Acquisitions
and mergers
Operating
economies
Management
of acquisition
Diversification
Shareholder
value issues
Asset backing
Reverse
takeovers
Earnings
quality
Acquistions and Mergers
Finance/
liquidity
Internal expansion
costs
Tax
Defensive
merger
Economic
efficiency
Factors in a takeover
 Cost of acquisition
 Reaction of predator’s shareholders
 Reaction of target’s shareholders
(010)AC12(PC)FEB18_CH09.indd 74



Form of purchase consideration
Accounting implications
Future policy (eg dividends, staff)
1/27/2018 1:42:46 AM
Vertical merger
Supplier
Aim: control of
supply chain
Backward merger
Conglomerate merger
Horizontal merger
Two merging firms
produce similar products
in the same industry
Aim: increase market
power
Two firms operate in
different industries
Aim: diversification
Firm
Forward merger
Customer/distributor
Aim: control of
distribution
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9: Acquisitions and mergers v other growth strategies
1/27/2018 1:42:47 AM
Acquisitions
and mergers
Shareholder
value issues
Reverse
takeovers
Takeover strategy
Acquire
Growth prospects limited
Younger company with higher growth rate
Potential to sell other products to existing
customers
Company with complementary product range
Operating at maximum capacity
Company making similar products operating below capacity
Under-utilising management
Company needing better management
Greater control over supplies or customers
Company giving access to customer/supplier
Lacking key clients in targeted sector
Company with right customer profile
Improve statement of financial position
Company enhancing EPS
Increase market share
Important competitor
Widen capability
Key talents and/or technology
(010)AC12(PC)FEB18_CH09.indd 76
1/27/2018 1:42:47 AM
Acquisitions
and mergers
Shareholder
value issues
Reverse
takeovers
Synergy
Revenue synergy exists when the acquisition will
result in higher revenues, higher return on equity or
a longer period of growth for the acquiring company.
Revenue synergies arise from:
Sources of financial synergy
 Diversification
 Use of cash slack
 Tax benefits
 Debt capacity
(a) Increased market power
(b) Marketing synergies
(c) Strategic synergies
Cost synergy results from economies of scale. As
scale increases, marginal cost falls and this will be
manifested in greater operating margins for the
combined entity.
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9: Acquisitions and mergers v other growth strategies
1/27/2018 1:42:47 AM
Acquisitions
and mergers
Shareholder
value issues
Reverse
takeovers
Failures to enhance shareholder value
Why do many acquisitions fail to enhance shareholder value?
Agency theory: takeovers may be motivated by self-interested acquirer
management wanting:



Diversification of management’s own portfolio
Use of FCF to increase size of the firm
Acquisitions that increase firm’s dependence on management
Value is transferred from shareholders to managers of acquiring firm.
Hubris hypothesis: bidding company bids too much because managers
of acquiring firms suffer from hubris, excessive pride and arrogance.
Behavioural finance: this examines the
psychological factors than can drive
decision making. For example, many
takeover bids are contested and this can
mean that the bid price will be pushed to
excessively high levels. This can be
explained in psychological terms in that
there is a stronger desire to possess
something because there is a threat of it
being taken away from you. This is
sometimes called loss aversion bias.
Market irrationality argument: when a company’s shares seem
overvalued, management may exchange them for an acquiree firm:
merger. The lack of synergies or better management may lead to a failing
merger.
(010)AC12(PC)FEB18_CH09.indd 78
1/27/2018 1:42:47 AM
Acquisitions
and mergers
Shareholder
value issues
Reverse
takeovers
Reverse Takeovers
This term relates to a situation where a large unquoted company negotiates a takeover by a smaller quoted
company by a share for share exchange.
To acquire the larger company a large number of the small company shares will have to be issued. This will
mean that the large company will hold the majority of shares and will therefore have control of the
combined company.
The company will then often be renamed, and it is normal for the larger company to impose its own name on
the new entity.
Aims of a reverse takeover
A reverse takeover is a route to a company obtaining a stock market listing. Compared to an initial public
offering (IPO), a reverse takeover is quicker, and cheaper.
In addition a reverse takeover results in two companies combining together, with the possibility of synergies
resulting from this combination.
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9: Acquisitions and mergers v other growth strategies
1/27/2018 1:42:47 AM
Notes
(010)AC12(PC)FEB18_CH09.indd 80
1/27/2018 1:42:47 AM
10: Valuation for acquisitions and mergers
Topic List
Valuation issues
Asset-based models
Market-based models
Cash-based models
There are a number of models for valuing acquisitions
and mergers. Each give a different insight into the
potential value of an acquisition.
First, we consider the ‘overvaluation problem’: the
problem that when a company acquires another
company, it often pays more than the company’s current
market value.
High-growth start-ups
(011)AC12(PC)FEB18_CH10.indd 81
1/27/2018 1:57:23 AM
Valuation
issues
Asset-based
models
The overvaluation problem
Is paying more than the current market value, to
acquire a company.
 During an acquisition, there is typically a fall in
the price of the bidder and an increase in the
price of the target.
 The overvaluation problem may arise as
miscalculation of potential synergies or
overestimation of ability of acquiring firm's
management to improve performance.
 Both errors will lead to a higher price than
current market value.
(011)AC12(PC)FEB18_CH10.indd 82
Market-based
models
Cash-based
models
High-growth
start-ups
Asset-based models
 The book value of the net assets can be used as a
starting point for negotiating the acquisition price
for a small company.
 However this valuation ignores the profit of the
company so a premium is normally negotiated
based on a multiple of the firm's profits; this is
called a 'book value plus' model.
Problems in asset-based evaluation
 Ignores value of intangibles
 Realisation of assets
 Contingent liabilities
1/27/2018 1:57:26 AM
Intangible assets
Measuring intangible assets
Differ from tangible assets as they do not have
physical substance' and as such are often not
recognised on the statement of financial position
although they create value for the investors.
Calculated intangible values (CIV) – calculates an
‘excess return’ on tangible assets, which is used to
determine the proportion of return attributable to
intangible assets.
Examples of intangible assets
 Goodwill
 Brands
 Patents
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 Customer loyalty
 Research and
development
10: Valuation for acquistions and mergers
1/27/2018 1:57:26 AM
Valuation
issues
Asset-based
models
Market-based
models
Cash-based
models
High-growth
start-ups
Market-based models – P/E method
P/E ratio =
Market value
EPS
So market value per share = EPS × P/E ratio
Decide suitable P/E ratio and multiply by EPS:
an earnings-based valuation.
EPS could be historical EPS or prospective future EPS. For a
given EPS, a higher P/E ratio will result in a higher price.
High P/E ratio may indicate:



Optimistic expectations
Security of earnings
Status
Earnings yield valuation model
Market value =
(011)AC12(PC)FEB18_CH10.indd 84
Earnings
Earnings yield
1/27/2018 1:57:26 AM
Valuation
issues
Asset-based
models
Cash-based
models
Market-based
models
High-growth
start-ups
Cash-based models – dividend valuation method
P0 =
D
re
Where P0 is price at time 0
D is dividend (constant)
re is cost of equity
Page 85
(011)AC12(PC)FEB18_CH10.indd 85
P0
=
D0 (1 + g)
re – g
Where D0 is dividend in current year
g is dividend growth rate
Three ways to estimate g:
 Historical estimates: extrapolate past values
 Rely on analysts’ forecasts
 Use the company’s return on equity and retention
rate of earnings (g = ROE × retention rate)
10: Valuation for acquistions and mergers
1/27/2018 1:57:26 AM
Valuation
issues
Asset-based
models
Market-based
models
Cash-based
models
High-growth
start-ups
Features





Based on expected future income
Can be used to value minority stake
Growth rate difficult to estimate
Dividend policy may change
Companies that don’t pay dividends don’t have
zero values
Discounted cash flow method
Value investment using expected after-tax cash flows
of investment and appropriate cost of capital.
(011)AC12(PC)FEB18_CH10.indd 86
1/27/2018 1:57:26 AM
FCF model
3
1 Calculate FCF.
FCF = Earnings before interest and taxes
(EBIT)
e
Calculate WACC from cost of equity (K ) and cost
d
of debt (K ).
Vd
Ve
WACC = K e ×
+ (1 − T) × K d ×
Vd + Ve
(Vd + Ve )
Where
T is the tax rate
less Tax on EBIT
Vd is the value of the debt
plus Non-cash charges
Ve is the value of equity
less Capital expenditures
less Net working capital increases
4
Discount FCF at WACC to obtain value of
firm.
plus Salvage values received
5
Calculate equity value.
plus Net working capital decreases
Equity value = Value of the firm – value of debt
2 Forecast FCF and terminal value.
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10: Valuation for acquistions and mergers
1/27/2018 1:57:26 AM
Valuation
issues
Asset-based
models
Market-based
models
Cash-based
models
High-growth
start-ups
FCFE
Firm valuation using FCFE
Terminal values and company valuation
Value of the firm is the sum of the discounted free
cash flows to equity over the appropriate time
horizon.
Value of the firm is the present value over the
forecast period + terminal value of cash flows
beyond the forecast period.
Assuming constant growth, use the Gordon model:
Firm valuation using FCFE
PV0 =
Where
FCFE 0 (1 + g)
k−g
g = growth rate
k = cost of equity
(011)AC12(PC)FEB18_CH10.indd 88
1
Calculate value of equity (present value of
FCFE discounted at the cost of equity)
2
Calculate value of debt
3
Value = Value of equity + Value of debt
1/27/2018 1:57:26 AM
Acquisitions that change financial risk: APV
Acquisition is valued by discounting FCF by
ungeared cost of equity, then adding PV of tax
shield.
APV = – Initial investment + value of acquired company
if all-equity financed + PV of debt tax shields
If APV is +ve, acquisition should be undertaken.
4
Discount FCF at ungeared cost of equity to
obtain NPV of ungeared firm or project
5
Calculate interest tax shields
6
Discount interest tax shields at pre-tax cost of
debt to obtain PV of interest tax shields
7
APV =
plus
plus
=
less
=
APV calculation steps
1
Calculate FCF (as previously)
2
Forecast FCFs and terminal value
3
Ungeared beta of firm is calculated from geared beta:

 =
U
NPV of ungeared firm or project
PV of interest tax shields
excess cash and marketable securities
market value of firm
market value of debit
market value of equity
G
1 + (1 − T)
D
E
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10: Valuation for acquistions and mergers
1/27/2018 1:57:26 AM
Valuation
issues
Asset-based
models
Market-based
models
Change in business risk
1
Estimate value of acquiring company before acquisition
2
Estimate value of acquired company before acquisition
3
Estimate value of synergies
4
Estimate beta coefficients for equity of acquiring and
acquired company, using CAPM
5
Estimate asset beta for each company
6
Calculate asset beta for combined entity
7
Calculate geared beta of the combined firm
8
Calculate WACC for combined entity
9
Use WACC derived in step 8 to discount cash
flows of combined entity post-acquisition
(011)AC12(PC)FEB18_CH10.indd 90
Cash-based
models
High-growth
start-ups
A problem with WACC
If WACC weights are not consistent with
the values derived, the valuation is
internally inconsistent.
Then, we use an iterative procedure:
 Go back and re-compute the beta
using a revised set of weights closer to
the weights derived from the valuation.
 The process is repeated until assumed
weights and weights calculated are
approximately equal.
Value of equity: difference between the
value of the firm and the value of debt.
1/27/2018 1:57:26 AM
Valuation
issues
Asset-based
models
Valuation of high-growth start-ups
Typical characteristics of start-ups: few revenues,
untested products, unknown product demand,
high development/ infrastructure costs.
Steps in valuation
Identify drivers (eg market potential, resources
of the business, management team)
Forecasting growth
Growth in earnings (g) = b × ROE
For most high growth start-ups, b = 1 and sole
determinant of growth is the return on invested
capital (ROE), estimated from industry projections
or evaluation of management, marketing
strengths, and investment.
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(011)AC12(PC)FEB18_CH10.indd 91
Market-based
models
Cash-based
models
High-growth
start-ups
Valuation methods
Asset-based method not appropriate: most investment of a
start-up is in people, marketing and/or intellectual rights that
are treated as expenses rather than capital.
Market-based methods also present problems: difficult to
find comparable companies; usually no earnings to calculate
P/E ratios (but price-to-revenue ratios may help).
10: Valuation for acquistions and mergers
1/27/2018 1:57:27 AM
Valuation
issues
Asset-based
models
Market-based
models
Cash-based
models
High-growth
start-ups
Valuing start-ups (continued)
Start-up firms are difficult to value using normal techniques.
The value of a firm can be thought of in these terms:
 If the firm fails to generate enough value to repay its loans, then its value = 0; shareholders
have the option to let the company die at this point.
 If the firm does generate enough value then the extra value belongs to the shareholder
 In this case shareholders can pay off the debt (this is the exercise price) and continue in
their ownership of the company (ie just as the exercise of a call option results in the
ownership of an asset).
 The Black-Scholes model can be applied because shareholders have a call option on the
business. The protection of limited liability creates the same effect as a call option
because there is an upside if the firm is successful, but shareholders lose nothing other
than their initial investment if it fails.
(011)AC12(PC)FEB18_CH10.indd 92
1/27/2018 1:57:27 AM
11: Regulatory framework and processes
Topic List
The agency problem can have a significant impact on
mergers and acquisitions. Takeover regulation is a key
device in protecting the interests of all stakeholders.
Global issues
Different models of regulation have been used in the UK
and in continental Europe. EU level regulation seeks to
create convergence in takeover regulation.
UK and EU regulation
Defensive tactics
(012)AC12(PC)FEB18_CH11.indd 93
1/27/2018 1:41:33 AM
Global
issues
UK and EU
regulation
Defensive
tactics
Agency problem
Takeover regulation
The agency problem and the issues arising from
the separation of ownership and control have
potential impact on mergers and acquisitions.
Takeover regulation can:
Potential conflicts of interest
Two models of regulation
 Protection of minority shareholders. Transfers
of control may turn existing majority shareholders
of the target into minority shareholders.
 Target company management measures to
prevent the takeover, which could run against
stakeholder interests.
 UK/US/Commonwealth countries: market-based
model – case law-based, promotes protection of
shareholder rights especially.
 Continental Europe: 'block-holder' or stakeholder
system – codified or civil law-based, seeking to
protect a broader group of stakeholders: creditors,
employees, national interest.
(012)AC12(PC)FEB18_CH11.indd 94
 Protect the interests of minority shareholders
and other stakeholders
 Ensure a well-functioning market for corporate
control
1/27/2018 1:41:36 AM
Global
issues
UK takeover regulation
Mergers and acquisitions in the UK subject to:




City Code
Companies Act
Financial Services and Markets Act 2000
Criminal Justice Act 1993 (insider dealing provisions)
City Code
The City Code on takeovers and mergers:
 Originally voluntary code for takeovers/mergers of
UK companies – now has statutory basis
 Administered by the Takeover Panel
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(012)AC12(PC)FEB18_CH11.indd 95
UK and EU
regulation
Defensive
tactics
City Code Principles
 Similar treatment for all shareholders
 Sufficient time and information for
informed decision
 Directors must act in interests of whole
company
 Avoid false markets in shares
 Offer only made if it can be fully
implemented
 Offeree company not distracted for
excessive time by offer for it
11: Regulatory framework and processes
1/27/2018 1:41:36 AM
Global
issues
UK and EU
regulation
Defensive
tactics
Competition and Markets Authority
EU Takeovers Directive
The Competition and Markets Authority (CMA) can accept or
reject proposed merger, or lay down certain conditions, if
there would be a substantial lessening of competition.
Effective from May 2006 – to converge
market-based and stakeholder systems.
Substantial lessening of competition tests:
 Turnover test (£70 million min. for investigation by
CMA)
 Share of supply test (25%)
European Union
Mergers fall within jurisdiction of the EU (which will evaluate
it, like the CMA in UK) where, following the merger:
(a) Worldwide turnover of more than €5 billion per annum
(b) EU turnover of more than €250 million per annum
(012)AC12(PC)FEB18_CH11.indd 96
Takeovers Directive principles
 Mandatory-bid rule: required at 30%
holding, in UK
 Equal treatment of shareholders
 Squeeze-out rule and sell-out rights: in
UK, 90% shareholder buys all shares
 Principle of board neutrality
 Break-through rule: bidder able to set
aside multiple voting rights (but countries
can opt out of this)
1/27/2018 1:41:36 AM
%
Consequence of share stake levels
3%
Beneficial interests must be disclosed to company – Disclosure and Transparency Rules
10%
Shareholders controlling 10%+ of voting rights may requisition company to serve s793 notices
Notifiable interests rules become operative for institutional investors and non-beneficial stakes
30%
City Code definition of effective control. Takeover offer becomes compulsory.
50%+
CA 2006 definition of control (at this level, holder can pass ordinary resolutions)
Point at which full offer can be declared unconditional with regard to acceptances
75%
Major control boundary: holder able to pass special resolutions
90%
Minority may be able to force majority to buy ouy their stake. Equally, majority may able to
require minority to sell out.
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11: Regulatory framework and processes
1/27/2018 1:41:36 AM
Global
issues
UK and EU
regulation
Defensive
tactics
Defensive tactic
Explanation
Golden parachutes
Compensation payments made to eliminated top-management of target
firm
Poison pill
Attempt to make firm unattractive to takeover, eg by giving existing
shareholders right to buy shares cheaply
White knights and white squires
Inviting a firm that would rescue the target from the unwanted bidder. A
‘white squire’ does not take control of the target.
Crown jewels
Selling firm’s valuable assets or arranging sale and leaseback, to make
firm less attractive as target
Pacman defence
Mounting a counter-bid for the attacker
Litigation or regulatory defence
Inviting investigation by regulatory authorities or Courts
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12: Financing mergers and acquisitions
Topic List
Questions on the subjects discussed in this chapter may
be regularly set in the compulsory section of this exam.
Questions could involve calculations.
Financing methods
A bidding firm might finance an acquisition either by cash
or by a share offer or a combination of the two. We
consider how a financial offer can be evaluated in terms
of the impact on the acquiring company and criteria for
acceptance or rejection.
Effects of offer
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Financing
methods
Effects
of offer
Methods of financing mergers
Funding cash offers
Payment can be in the form of:
 Cash
 Share exchange
 Convertible debt
Methods of financing a cash offer:
 Retained earnings – common when a firm acquires a
smaller firm
 Sale of assets
 Issue of shares, using cash to buy target firm's shares
 Debt issue – but, issuing bonds will alert the market to the
intentions of the company to bid for another company and
may lead investors to buy shares of potential targets, raising
their prices
 Bank loan facility from a bank – a possible short-term
strategy, until bid is accepted: then the company can make a
bond issue
 Mezzanine finance – may be the only route for companies
without access to bond markets
The choice will depend on:
 Available cash
 Desired levels of gearing
 Shareholders' tax position
 Changes in control
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Use of convertible debt
Problems with using debentures, loan stock, preference
shares:
Mezzanine finance
 Establishing a rate of return attractive to target
shareholders
With cash purchase option for target
company's shareholders, bidding company
may arrange mezzanine finance – loans
that are:
 Effects on the gearing of acquiring company
 Short-to-medium-term
 Change in structure of target shareholders’ portfolios
 Unsecured ('junior' debt)
 Securities potentially less marketable, possibly lacking
voting rights
 At higher rate of interest than secured
debt (eg LIBOR + 4% to 5%)
Convertible debt can overcome some such problems,
offering target shareholders the opportunity to gain from
future profits of company.
 Often, giving lender option to exchange
loan for shares after the takeover
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12: Financing mergers and acquisitions
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Financing
methods
Effects
of offer
Cash or paper?
Company and existing shareholders
Dilution of EPS
May be a fall in EPS attributable to existing shareholders if purchase consideration is in
equity shares
Cost to the company
Loan stock to back cash offer: tax relief on interest, lower cost than equity. May be lower
coupon if convertible
Gearing
Highly geared company may not be able to issue further loan stock for cash offer
Control
Major share issue could change control
Authorised share capital increase May be required if consideration is shares: requires General Meeting resolution
Borrowing limits increase
General Meeting resolution required if borrowing limits need to change
Shareholders in target company
Taxation
If consideration is cash, many investors may suffer CGT
Income
If consideration is not cash, arrangement must mean existing income is maintained, or be
compensated by suitable capital gain or reasonable growth expectations
Future investments
Shareholders who want to retain stake in target business may prefer shares
Share price
If consideration is shares, recipients will want to be sure that shares retain their values
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Effects
of offer
Financing
methods
EPS before and after a takeover
If a company acquires another by issuing shares, its
EPS will go up or down according to the P/E ratio at
which target company was bought.
 If target company's shares bought at higher P/E
ratio than predator company's shares, predator
company's shareholders suffer fall in EPS.
 If target company's shares valued at a lower P/E
ratio, the predator company's shareholders
benefit from rise in EPS.
Buying companies with a higher P/E ratio will result
in a fall in EPS unless there is profit growth to offset
this fall.
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Dilution of earnings may be acceptable if there is:
 Earnings growth
 Superior quality of earnings acquired
 Increase in net asset backing
Post-acquisition integration
A clear programme should be in place, re-defining
objectives and strategy.
The approach adopted will depend on:
 The culture of the organisation;
 The nature of the company acquired; and
 How it fits into the amalgamated organisation
(eg horizontally, vertically, or in diversified
conglomerate)
12: Financing mergers and acquisitions
1/27/2018 1:41:19 AM
Financing
methods
Effects
of offer
A post acquisition value can help to assess the result of an acquisition (including how it was financed).
Depending on the information provided, a post-acquisition valuation can be calculated as:
1
Estimate the group’s post-acquisition earnings including synergies
2
Use a given post-acquisition P/E ratio to value these earnings
or
1
Estimate the group’s post acquisition cash flows including synergies
2
Calculate the average asset beta of the group and regear to reflect the group’s gearing.
Calculate an appropriate cost of capital and complete a cash flow valuation.
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13–14: Reconstruction and reorganisation
Topic List
Reorganisations of business operations and business
structures are a constant feature of business life.
Financial reconstruction
Business reorganisations include various methods of
unbundling companies, including include sell-offs,
spin-offs, carve-outs, and management buyouts.
Divestment and other changes
MBOs and buy-ins
Firm value
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Corporate restructuring may typically take place when
companies are in difficulties or are seeking a change in
focus.
1/27/2018 1:40:47 AM
Financial
reconstruction
Divestment and
other changes
MBOs and
buy-ins
Firm
value
Capital reconstruction scheme
Is a scheme where a company re-organises its
capital structure, often to avoid liquidation.
Steps in a capital reconstruction
Providers of finance will need to be convinced that
the return is attractive.
Company must therefore prepare cash/profit
forecasts.
1
Estimate position of each party if
liquidation is to go ahead
 Creation of new share capital at different
nominal value
2
Assess additional sources of finance
 Cancellation of existing share capital
3
Calculate and assess new position, and
compare for each party with step 1
4
Check company is financially viable
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 Conversion of debt or equity
Most importantly, a scheme of reconstruction
needs to treat all parties fairly and offer
creditors a better deal than liquidation.
1/27/2018 1:40:50 AM
Leveraged recapitalisation
A firm replaces most of its equity with a package of debt securities
consisting of both senior and subordinated debt.
Leveraged capitalisations are used to discourage corporate raiders
who will not be able to borrow against assets of the target firm to
finance the acquisition.
To avoid financial distress from a high debt level, the company
should have stable cash flows and not require substantial ongoing
capital expenditure to retain their competitive position.
Leveraged buy-outs
A group of private investors uses debt financing to purchase a
company or part of it. The company increases its level of leverage
but (unlike leveraged recapitalisations) no longer has access to
equity markets.
A higher level of debt will increase the company’s geared beta; a
lower level of debt will reduce it.
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Debt-equity swaps





In an equity/debt swap, shareholders are
given the right to exchange stock for a
predetermined amount of debt (ie bonds)
in the same company.
In a debt/equity swap, debt is exchanged
for a predetermined amount of stock.
After the swap takes place, the preceding
asset class is cancelled for the newly
acquired asset class.
Debt-equity swaps may occur because
the company must meet certain
contractual obligations, such as
maintaining a debt/equity ratio below a
certain number.
A company may issue equity to avoid
making coupon and face value payments
in the future.
13–14: Reconstruction and reorganisation
1/27/2018 1:40:51 AM
Financial
reconstruction
Demerger
Is the splitting up of a corporate body into two or
more separate bodies, to ensure share prices
reflect the true value of underlying operations.
Sell-off
Is the sale of part of a company to a third party,
generally for cash.
Organisational restructuring typically involves
changes in divisional structures or hierarchy, and
often accompanies restructuring of ownership
(portfolio restructuring).
Divestment and
other changes
MBOs and
buy-ins
Firm
value
Disadvantages of demergers
 Loss of economies of scale
 Ability to raise extra finance reduced
 Vulnerability to takeover increased
Reasons for sell-offs






Strategic restructuring
Sell off loss-making part
Protect rest of business from takeover
Cash shortage
Reduction of business risk
Sale at profit
A divestment is a partial or complete reduction in ownership stake in an organisation.
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Spin-offs and carve-outs
Spin-off: a new company is created whose
shares are owned by the shareholders of
original company. There is no change in asset
ownership, but management may change. In a
carve-out, part of the firm is detached and a
new company’s shares are offered to the
public.
Going private
Occurs when a group of investors buys all
the company’s shares. The company ceases
to be listed on a stock exchange.
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Advantages of spin-offs to investors
 Merger or takeover of only part of business
made easier
 Improved efficiency/management
 Easier to see value of separate parts
 Investors can adjust shareholdings
Advantages of going private to company




Costs of meeting listing requirements saved
Company protected from volatility in share prices
Company less vulnerable to hostile takeover bids
Management can concentrate on long-term
business
13–14: Reconstruction and reorganisation
1/27/2018 1:40:52 AM
Financial
reconstruction
Management buy-outs (MBOs)
Is the purchase of all or part of a business by its
managers. The managers generally need financial
backers (venture capital) who will want an equity
stake.
Reasons for company agreeing to MBO are similar to
those for sell-off, also:
 When best offer price available is from MBO
 When group has decided to sell subsidiary, best
way of maximising management co-operation
 Sale can be arranged quickly
 Selling organisation more likely to retain
beneficial links with sold segment
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Divestment and
other changes
MBOs and
buy-ins
Firm
value
Evaluation of MBOs by investors







Management skills of team
Reasons why company is being sold
Projected profits, cash flows and risks
Shares/selected assets being bought
Price right?
Financial contribution by management team
Exit routes (flotation, share repurchase)
Venture capital
Venture capitalists are often prepared to fund
MBOs. They typically require shareholding, right to
appoint some directors and right of veto on certain
business decisions.
1/27/2018 1:40:52 AM
Performance of MBOs
Management-owned companies typically achieve
better performance.
Possible reasons:




Favourable price
Personal motivation
Quicker decision-making/flexibility
Savings on overheads
Buy-ins
Are when a team of outside managers mount a
takeover bid and then run the business themselves.
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Problems with MBOs






Lack of financial experience
Tax and legal complications
Changing work practices
Inadequate cash flow
Board representation by finance suppliers
Loss of employees/suppliers/customers
Buy-ins often occur when a business is in trouble or
shareholder/managers wish to retire. Finance
sources are similar to buy-outs. They work best if
management quality improves, but external
managers may face opposition from employees.
13–14: Reconstruction and reorganisation
1/27/2018 1:40:52 AM
Financial
reconstruction
Unbundling and firm value
Unbundling affects the value of the firm through
changes in return on equity and the asset beta.
Growth rate following a restructuring:
Divestment and
other changes
MBOs and
buy-ins
Firm
value
When firms divest themselves of existing
investments, they affect the expected return on
assets (ROA), as good projects increase ROA and
bad projects reduce it.
g = b × re
Where
re is the return on equity (ie Ke)
b is the retention rate
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Investment decisions taken by firms affect their
riskiness and therefore the asset beta a.
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15: The role of the treasury function in
multinationals
Topic List
Role
(015)AC12(PC)FEB18_CH15.indd 113
The treasury function of a multinational company should
deal with short-term decisions in a way that is consistent
with the long-term management objective of maximising
shareholder value.
The treasury function deals with the management of
short-term assets of a company and its risk exposure.
You should understand the principal money market
instruments that are available.
1/27/2018 1:40:20 AM
Role
Treasury will advise on the management of risk exposure ie whether and how to do it.
The main arguments in favour of risk management (hedging) are based on the idea that in an imperfect capital
market there is no guarantee of being able to raise finance, so hedging can have a number of beneficial effects
by:
(a) Attracting investors: because there is a lower probability of the firm encountering financial distress.
(b) Encouraging managers to invest for the future: especially for highly geared firms, there is a risk of
underinvestment. Hedging reduces the incentive to underinvest since it reduces the volatility of future
earnings.
(c) Attracting other stakeholders: for example, suppliers and customers are more likely to look for long-term
relationships with firms that have a lower risk of financial distress.
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1/27/2018 1:40:27 AM
16: The use of financial derivatives to hedge
against foreign exchange risk
Topic List
FX markets
Money market hedging
Futures
Swaps
Any future payments or distributions payable in a foreign
currency carry a risk that the foreign currency will
depreciate in value before the foreign currency payment
is received and is exchanged into the home currency.
While there is a chance of profit if the price of the foreign
currency increases, most investors and lenders would
give up the possibility of currency exchange profit if they
could avoid or ‘hedge’ the risk of currency exchange loss.
Options
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FX
markets
Money market
hedging
Exchange rates
An exchange rate is the price of one currency
expressed in another currency.
 The spot rate at time t0 is the price for delivery
at t0.
Futures
Swaps
Options
Term/reference currency
Bank:
sells
buys
LOW
HIGH
For example, if UK bank is buying and selling
dollars, selling (offer) price may be $/£1.50,
buying (bid) price may be $/£1.53.
 A forward rate at t0 is a rate for delivery at time
t1. This is different from whatever the new spot
rate turns out to be at t1.
Term and base currencies
If a currency is quoted as say $/£1.50, the $ is the
term (or reference) currency, the £ is the base
currency.
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 Direct quote is amount of domestic
currency equal to one foreign currency unit.
 Indirect quote is amount of foreign
currency equal to one domestic unit.
1/27/2018 12:04:04 AM
Forward exchange contract
Forward rates as adjustments to spot rates
 A firm and binding contract between a bank and
its customer
 For the purchase/sale of a specified quantity of a
stated foreign currency
 At a rate fixed at the time the contract is made
 For performance at a future time agreed when
contract is made
Closing out is the process of the bank requiring the
customer to fulfil the contract by selling or buying at
spot rate.
Forward rate cheaper
– quoted at discount
Forward rate more expensive – quoted at premium
Add discounts, or subtract premiums from spot
rate.
Is the process of setting off credit against debit
balances within a group of companies so that only
the reduced net amounts are paid by currency
flows. Multilateral netting involves offsetting
several companies’ balances.
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Interest rate parity must hold between spot rates
and forward rates (for the interest rate period),
otherwise arbitrage profits can be made:
f0 = s 0
Netting
Page 117
Interest rate parity
(1 + i c )
(1 + i b )
Where f0
s0
ic
ib
= forward rate
= spot rate
= interest rate in overseas country
= interest rate in base country
16: The use of financial derivatives to hedge against foreign exchange risk
1/27/2018 12:04:04 AM
Money market
hedging
FX
markets
Futures
Swaps
Options
Money market hedging
Future foreign currency payment
Future foreign currency receipt
(a) Borrow now in home currency
(a) Borrow now in foreign currency
(b) Convert home currency loan to foreign currency
(b) Convert foreign currency loan to home currency
(c) Put foreign currency on deposit
(c) Put home currency on deposit
(d) When have to make payment
(d) When cash received
(i) Make payment from deposit
(i) Take cash from deposit
(ii) Repay home currency borrowing
(ii) Repay foreign currency borrowing
Remember
International Fisher effect
(016)AC12(PC)FEB18_CH16.indd 118
1 + ia 1 + h a
=
1 + ib 1 + hb
1/27/2018 12:04:04 AM
FX
markets
Futures
Money market
hedging
Swaps
Options
Futures terminology
Closing out a futures contract means entering a
second futures contract that reverses the effect of the
first.
Contract size is the fixed minimum quantity that can
be bought/sold.
Basis risk is the risk that futures price movement
may differ from underlying currency movement.
Tick size is the smallest measured movement in
contracts price (movement to fourth decimal place).
Contract price is in US dollars. eg $/£0.6700.
Settlement date is the date when trading on a
futures contract ceases and accounts are settled.
Basis is futures price – spot price.
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FX
markets
Money market
hedging
Advantages of futures


Transaction costs lower than forward contracts
Futures contract not closed out until cash
receipt/payment made
Futures
Swaps
Options
Disadvantages of futures
 Can’t tailor to user’s exact needs
 Only available in limited number of currencies
 Hedge inefficiencies
 Conversion procedures complex if dollar is not
one of the two currencies
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Step 1 Setup process
(a) Choose which contract (settlement date after date currency needed) and type
(b) Choose number of contracts
Amount being hedged
Size of contract
Convert using today’s futures contract price if amount being hedged is in US dollars
(c) Calculate tick size: Minimum price movement × Standard contract size
Step 2 Estimate closing futures price
Step 3 Hedge outcome
(May have to adjust closing spot price using basis,
assuming basis declines evenly over life of contract)
(a) Outcome in futures market
Short-cut for calculating the
effective futures rate = Opening
futures price – Closing basis
Futures profit = Tick movement × Tick value × Number of contracts
(b) Net outcome
Spot market payment (closing spot rate)
Futures profit/(loss) (closing spot rate unless US company)
Net outcome
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(x)
x
(x)
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FX
markets
Money market
hedging
Currency swaps
In a currency (or ‘cross-currency’) swap,
equivalent amounts of currency and interest cash
flows are swapped for a period. However the original
borrower remains liable to the lender (counter party
risk). A cross-currency swap is an interest rate swap
with cash flows in different currencies.
Advantages of currency swaps







Flexibility – any size and reversible
Can gain access to debt in other currencies
Restructuring currency base of liabilities
Conversion of fixed to/from floating rate debt
Absorbing excess liquidity
Cheaper borrowing
Obtaining funds blocked by exchange controls
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Futures
Swaps
Options
Risks of swaps
 Credit risk
(Counterparty defaults)
 Position or market risk
(Unfavourable market movements)
 Sovereign risk
(Political disturbances in other countries)
 Spread risk
(For banks which combine swap and hedge)
 Transparency risk
(Accounts are misleading)
1/27/2018 12:04:05 AM
Example
Edward Ltd wishes to borrow US dollars to
finance an investment in the USA. Edward’s
treasurer is concerned about the high
interest rates the company faces because it
is not well-known in the USA. Edward Ltd
should make an arrangement with an
American company, Gordon Inc, attempting
to borrow sterling in the UK money
markets.
1
Gordon borrows US $ and Edward borrows £.
The two companies then swap funds at the
current spot rate.
2
Edward pays Gordon the annual interest cost on
the $ loan. Gordon pays Edward the annual
interest cost on the £ loan.
3
At the end of the period, the two companies
swap back the principal amounts at the spot
rates/predetermined rates.
An FX swap is simply a spot currency transaction that will be reversed, in a single transaction, by an offsetting
forward transaction at a pre-specified date.
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FX
markets
Money market
hedging
Currency option
Is a right to buy or sell currency at a stated
rate of exchange at some time in the future.
Call – right to buy at fixed rate
Put – right to sell at fixed rate
Over the counter options (OTCs) are
tailor-made options suited to a company’s
specific needs.
Traded options are contracts for standardised
amounts, only available in certain currencies.
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Futures
Swaps
Options
Why option is needed
 Uncertainty about foreign currency receipts
or payments (timing and amount)
 Support tender for overseas contract
 Allow publication of price lists in foreign
currency
 Protect import/export of price-sensitive
goods
Choosing the right option
Complicated by lack of US dollar options UK
company wishing to sell US dollars can
purchase £ call options (options to buy sterling
with dollars).
1/27/2018 12:04:05 AM
17: The use of financial derivatives to hedge
against interest rate risk
Topic List
FRAs
IR futures
IR swaps
The value of a firm’s assets, liabilities and cashflows is
affected by changes in interest rates. Various derivatives
are available to reduce interest rate risk, including
forward rate agreements, interest rate futures contracts,
interest rate swaps and options.
Here we deal with the application of these derivative
contracts for hedging.
IR options
The Greeks
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FRAs
IR
futures
IR
swaps
IR
options
The
Greeks
Interest rate risk
Fixed v floating rate debt
Change in interest rates may make borrowing chosen the less attractive option
Currency of debt
Effect of adverse movements if borrow in another currency
Term of loan
Having to re-pay loan at time when funds not available => need for new loan at
higher interest rate
Forward rate agreement
An FRA means that the interest rate will be
fixed at a certain time in the future.
Loans > £500,000, period < 1 year.
 5.75–5.70 means a borrowing rate can be fixed
at 5.75%
 ‘3–6’ FRA starts in three months time and lasts
for three months
 Basis point is 0.01%
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FRAs
IR
futures
IR
swaps
Interest rate futures
Hedge against interest rate movements. The
terms, amounts and periods are standardised.
IR
options
The
Greeks
Example
LIFFE three months sterling futures £500,000 points
of 100% price 92.50.
Tick size will be:
 The futures prices will vary with changes in
interest rates.
 Outlay to buy futures is less than buying the
financial instrument.
£500,000 × 0.01% × 3/12 = £12.50
A 2% movement in the futures price would represent
200 ticks. Gain on a single contract would be
200 × £12.50 = £2,500.
 Price of short-term futures quoted at discount
to 100 par value (93.40 indicates deposit
trading at 6.6%).
 Long-term bond futures prices quoted at % of
par value.
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FRAs
IR
futures
IR
swaps
IR
options
The
Greeks
Step 1 Setup process
(a) Choose which contract: date should be after borrowing/lending begins.
(b) Choose type: sell if protecting against an increase in rates, buy if protecting against a fall.
(c) Choose number of contracts:
Loan exposure
Futures contract size
(d) Calculate tick size: Min price movement as % 

Loan period
Length of futures contract
Length of futures contract
12 months
 Futures contract size
Step 2 Estimate closing futures price
May have to adjust using basis.
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Step 3 Hedge outcome
(a) Futures outcome
Opening futures price: (X)
Closing futures price:
Movement in ticks:
Futures outcome: Tick movement Tick value  Number of contracts
X
–X
X
X
(b) Net outcome
Payment in spot market
Futures market profit/(loss)
Net payment
(X)
X
(X)
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1/27/2018 12:04:34 AM
FRAs
IR
swaps
IR
futures
Interest rate swaps
IR
options
The
Greeks
Uses of interest rate swaps
Are agreements where parties exchange interest
commitments. In simplest form, two parties swap
interest with different characteristics. Each party
borrows in market in which it has comparative
advantage.





Switching from paying one type of interest to another
Raising less expensive loans
Securing better deposit rates
Managing interest rate risk
Avoiding charges for loan termination
Swap valuation
An interest rate swap can be valued as the NPV of the net cash flows
under the swap. At the start of the swap the swap contract is designed to
give an NPV of zero based on the current FRA rates.
The swap will be designed so that the bank makes a reasonable return,
the bank will expect to at least make an NPV of 0 from the deal.
Although at the start of the swap the present value of the swap is zero
the value of the swap will change as rates fluctuate.
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Complications
 Bank commission costs
 One company having better
credit rating in both relevant
markets – should borrow in
comparative advantage
market but must want
interest in other market
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FRAs
IR
futures
IR
swaps
Interest rate option
 If a company needs to hedge borrowing, purchase put options
 If a company needs to hedge lending, purchase call options
To calculate effect of options, use same proforma as currency options.
UK long gilt futures options (LIFFE) £100,000 100ths of 100%.
Strike
Calls
Puts
price
Nov
Dec
Jan
Nov
Dec
Jan
1.27
1.34
0.29
0.69
1.06
11,350 0.87
 Strike price is price paid for futures contract
 Numbers under each month represent premium paid for options
 Put options more expensive than call as interest rates predicted to rise
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The
Greeks
Interest rate caps, collars
and floor
Grants the buyer the right, to deal at an agreed
interest rate at a future maturity date.
Page 131
IR
options
 Caps set an interest rate
ceiling
 Floors set a lower limit to rates
 Collars mean buying a cap
(put) and selling a floor (call)
for a borrower (an investor will
buy a call and sell a put)
17: The use of financial derivatives to hedge against interest rate risk
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FRAs
IR
futures
Greeks
Delta – change in call option price/change in value of share
Gamma – change in delta value/change in value of share
Theta – change in option price over time
Rho – change in option price as interest rates change
Vega – change in option price as volatility changes
Gamma
Higher for share which is close to expiry and 'at
the money' 
IR
swaps
IR
options
The
Greeks
Delta hedging
Determines number of shares required to create
the equivalent portfolio to an option, and hence
hedge it.
Vega
Is the change in value of an option (call or put)
resulting from a 1% point change in its volatility.

+ve gamma means that a position benefits from movement
–ve theta means the position loses money if the underlying asset price does not move
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Notes
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