Table of Contents
Foreword............................................................................................................................................. 1
Chapter 0: Revision from Financial Management ............................................................................... 19
Chapter 1: Introduction to Advanced Financial Management ............................................................. 45
Chapter 2: Investment Appraisal ........................................................................................................ 62
Chapter 3: Cost of capital & Risk adjusted WACC ............................................................................. 134
Chapter 4: Option Valuation ............................................................................................................ 160
Chapter 5: Mergers & Acquisitions................................................................................................... 185
Chapter 6: Corporate Reconstruction............................................................................................... 222
Chapter 7: Introduction to Risk Management .................................................................................. 242
Chapter 8: Foreign Exchange Risk Management............................................................................... 256
Chapter 9: Interest Rate Risk Management ...................................................................................... 294
Chapter 10: Dividend Policy ............................................................................................................. 331
1
Foreword
‘By the ACCA, for the ACCA’
These notes are designed with a simple mission, to fill the gap for Indian students who don’t find comfort
in studying from notes that are framed in a complex manner. Our priority at Zell is to improve the results
our students achieve by providing all that they need, be it quality education, state of the art infrastructure
and techniques or the next step, the content that perfectly fits in making the trifecta or the winning
formula.
Here at Zell, we don’t worry about the background, prior knowledge or preferences someone has. The
aim is simple, by the time a student is done with a paper, they are on the same page as anyone else and
that for us, should be enough knowledge to be able to call them a professional truly.
Keeping all this in mind, we bring to you these notes, created by us, for you, to truly help make the
difference and turn your journey of ACCA into an even better one. This is just the beginning; there is more
in store.
Thank you
Credits
Authored By:
Riddhi Chheda
Designed By:
Geeta Shewani
For June 2023 to March 2024 examination sittings
2
Exam Formulae and Math Tables
1. Modigliani and Miller Proposition 2 (with tax)
𝑘𝑒 = 𝑘𝑒𝑖 + (1 − 𝑇)(𝑘𝑒𝑖 − 𝑘𝑑 )
𝑉𝑑
𝑉𝑒
2. The Capital Asset Pricing Method
𝐸(𝑟𝑖 ) = 𝛽𝑖 + (𝐸(𝑟𝑚 ) − 𝑅𝑓 )
3. The Asset Beta Formula
𝛽𝑎 = [𝑉 + 𝑉
𝑒
𝑉𝑒
𝑑
𝛽]
(1−𝑇)) 𝑒
𝑉 (1−𝑇)
+ [𝑉 + 𝑑𝑉
𝑒
𝑑
𝛽 ]
(1−𝑇)) 𝑑
4. The Growth Model
𝑃0 =
𝐷0 (1 + 𝑔)
(𝑟𝑒 − 𝑔)
5. Gordon’s growth approximation
𝑔 = 𝑏𝑟𝑒
6. The weighted average cost of capital
WACC = [𝑣
𝑉𝑒
𝑒+ 𝑉𝑑
] 𝑘𝑒 + [
𝑉𝑑
𝑉𝑒+ 𝑉𝑑
] 𝑘𝑑 (1 − 𝑇)
7. The Fisher Formula
(1 + i) = (1 + r)(1 + h)
8. Purchasing power parity and interest rate parity
𝑆1 = 𝑆0 ×
(1+ ℎ𝑐 )
(1+ ℎ0)
𝐹𝑂 = 𝑆0 ×
9. Modified Internal Rate of Return
1
𝑀𝐼𝑅𝑅 = [
𝑃𝑉𝑅 𝑛
]
𝑃𝑉1
(1 + 𝑟𝑒 ) − 1
(1+ 𝑖𝑐)
(1+ 𝑖𝑏 )
3
10. The Black-Scholes option pricing model
𝑐 = 𝑃𝑎 𝑁(𝑑1 ) − 𝑃𝑒 𝑁(𝑑2 )𝑒 −𝑟𝑡
Where:
𝑑1 =
𝑃
𝐼𝑛 ( 𝑃𝑎 ) + (𝑟 + 0.5𝑠 2 )𝑡
𝑒
𝑠
√𝑡
𝑠
𝑑2 = 𝑑1 − √
𝑡
The Put Call Parity relationship
P = c - 𝑃𝑎 + 𝑃𝑒 𝑒 −𝑟𝑡
4
Best way to study
Planning how to study
Before starting the preparation for any paper, you should always make a macro level plan on how to go
about preparing for the exam. Understand what is expected of you to be able to clear the exam with high
scores. It is important to set targets and stick to them, to ensure that you stay on track and progress in
your ACCA journey.
Have a plan from the beginning about where you want to be at the end of the month or two months, then
work backwards and understand what you must do to stay on track. Then, at the start of every week,
make a brief plan about how much needs to be covered every day, resulting in the timely completion of
the exam.
Break your macro plan intro studying along with the professor/recordings, examination month and final
revision. Plan how many hours can you give every day and make a schedule accordingly. Ensure that you
can give quality hours without distractions. The quantity of hours doesn’t matter.
How to approach the exam
Knowing how much importance ACCA places on application-based learning is important. You must
understand that rote learning in any exam for any concept will mostly amount to zero marks being scored.
Further, students tend to take many days after the classes conclude for their self-preparation phase, which
tends to work negatively. The maximum time you should take after completing the classes is 21 days, after
which, while you might practice more, the retention of the vast range of topics covered in class will
become faint.
The ideal approach is to watch/attend lectures and keep up with the pace, practicing 40% of the question
bank alongside, to cement conceptual understanding. Once classes conclude, ensure the remaining 60%
of the question bank is solved, followed by at least three mock examinations before attempting the main
exam.
5
Exam month





In the exam month, ensure that you finish the portion as soon as possible and shift all focus to
completing the question bank. Remember, completing the textbook alone is not enough, whereas
completing the question bank gives you a higher chance of clearing the exam.
If you are done with your question bank, repeat the question bank or key questions you marked
before the exam. Only 40% of your total time should be allocated to building a conceptual
understanding, the remaining 60% to solve questions.
Ensure you do not get into the habit of reading a question and then reading the answer. This
approach will make you seek answers in the exam and not seek solutions on your own. Read a
question, solve it on your own, check the answer. If it is incorrect, solve the question again to get
another answer, rather than reading the explanation to understand what you did wrong. That
should always be the last resort.
Familiarize yourself with the scientific calculator, the CBE exam platform and other tools to ensure
you are comfortable with the same in the actual exam.
Ensure you complete 100% of the portion. Do not skip anything as the exam will test you on a
range of interconnected topics, and leaving parts of the portion will guarantee you are losing
certain marks.
Exam strategy
There are certain things to be kept in mind before attempting the main exam.
1. Remain calm before the exam. Do not study at the last moment, as going into the exam with a
fresh mind will allow you to tackle the questions more easily.
2. The examination is 3 hours 15 minutes long, which means you have 195 minutes for 100 marks,
or simply 1.95 minutes per mark. Ensure you don’t get overboard with the time you take to solve
a question at hand. The following approach could also be implemented – 90 minutes for Section
A and 50 minutes for each Section B question.
3. Read the requirements carefully. Pay attention to the verb used, define, explain, calculate,
evaluate etc., to understand what the examiner is seeking to ensure you answer on those lines.
4. Do not go for quantity when you are answering questions. The examiner will award one mark per
valid statement and one mark only per valid point. Do not elaborate on points to simply write
more.
5. Do not sit and recalculate the answer you got more than twice, as you are likely to calculate it in
the same way you did previously, by repeating the same mistake if any. This is a massive waste of
your crucial time. Rather move faster and revisit key questions at the end, recalculating your
answers at that point will possibly reveal mistakes and allow you to rectify them, thus scoring
more marks.
6
Elements
Syllabus wise study material
The study material is curated in a manner where the syllabus provided by ACCA has been covered in vast
depth, and the order is set in a way that the flow of concepts within the material suits a student.
Illustration
Various AYK style questions test the student on their ability to remember and understand concepts
thoroughly before moving to analytical questions.
Quiz
Further, there are primarily application-based quiz questions, introducing the student to analytical and
evaluative questions to bring the student one step closer to actual exam-style questions.
Recap
After the end of every main chapter, there is a recap page summarizing all the important topics, formulae
etc., to enable ease of revision for the student.
Mind Maps
Mind maps are flowcharts that summarize the information visually, making it more likely for a student to
retain the knowledge and build upon it. These are present at the end of the book to enable last-minute
revision by simply spending time on those pages.
7
Nimbus™ Preparation tools
Interactive notes with gamification
The articulated version of the notes is available on the platform, allowing students to get fully immersed
in their learning and complete more in less or equivalent time they spend reading the book.
Case studies
Case studies are specifically tailored to address the audience commonly using these notes. Having
interesting case studies based on current affairs, covering key organizations etc., contribute to further
professional development.
Technical articles
ACCA’s technical articles are placed strategically in the material, allowing students to understand when
they are supposed to go through these all-important technical articles.
Exam experience
The system mimics the exam experience to ensure that the student has conceptually and technically
mastered the paper before appearing for the exam. This includes various objective questions, live
spreadsheets and word processors to practice typing, presentation and most importantly, time
management.
Question Bank & Test Series
The students have access to unit tests, half portion tests, progressive tests, mock tests and unlimited
practice tests with all performance data allowing them to know where they stand, the improvements
required before the exam day arrives.
Flashcards and Interactive mind maps for revision
Flashcards help students quiz themselves, which is more effective as a revision technique than simply
reading through pages. Interactive mind maps allow the student the power to take a detailed glance
through a whole chapter or large concept in minutes while revising at the same time.
Check the last page of this book for more information on Nimbus™ LMS by Zell
8
ACCA support
Examining team guidance/Exam technique & reports
The examiners’ reports are an essential study resource. Read them to learn about mistakes that students
commonly make in exams and how to avoid them.
Practice tests
Practice Tests are an interactive study support resource that will replicate the format of all the exams
available as on-demand computer-based exams (CBEs). They will help you to identify your strengths and
weaknesses before you take an exam.
As well as giving you an insight into a live exam experience, Practice Tests will also provide feedback on
your performance. Once you complete the test, you will receive a personalized feedback diagram showing
how you have performed across the different areas of the syllabus.
Specimen exams
The specimen exam indicates how the exam will be assessed, structured and the likely style and range of
questions that could be asked. Any student preparing to take this exam should familiarize themselves with
the exam style.
Technical articles
There is a range of technical articles available on ACCAs website under ‘Study support resources’. These
include a range of simplified articles on complex topics, study support videos, articles on exam technique
etc. making it an important tool to be practiced when nearing the exam.
FAQs
Various commonly asked questions about the style of the examination, the coverage, computer-based
exam setup etc., are covered here to allow a student to stay up to date and ensure their understanding is
aligned with that of the ACCA body.
Question practice – ACCA practice platform
Question practice is a vital part of exam preparation. Practicing in the CBE environment provides a
fantastic opportunity to get fully prepared for the real exam.
The ACCA Practice Platform contains a range of content that allows you to attempt questions to time and
then mark and debrief your answers. It also contains a blank workspace that allows you to answer
constructed response questions from other sources in the CBE environment.
9
Past Exam library
Past exams are made available to view and become familiar with the styles of questions that you may face
in your exam.
Make sure you log into the ACCA Practice Platform early in your studies - completing your practice in the
CBE environment is the only way to prepare for your exam fully.
CBE Support
Getting ready for your CBE includes getting familiar with the CBE functionality and how to use it to your
advantage in the exam. You should be thinking about your exam approach well before exam day itself.
There are series of videos that will help you get ready for your exam. It includes what to think about before
your exam day, exam strategy, how to manage your CBE workspace effectively and techniques you could
use to plan and complete your answers.
10
Syllabus
Introduction to the Syllabus
The aim of the syllabus is to apply relevant knowledge, skills and exercise professional judgement as
expected of a senior financial executive or advisor, in taking or recommending decisions relating to the
financial management of an organization in private and public sectors.
This syllabus develops upon the core financial management knowledge and skills covered in the Financial
Management syllabus and prepares candidates to advise management and/or clients on complex strategic
financial management issues facing an organization.
The syllabus starts by exploring the role and responsibility of a senior executive or advisor in meeting
competing needs of stakeholders within the business environment of multinationals. The syllabus then
re-examines investment and financing decisions, with the emphasis moving towards the strategic
consequences of making such decisions in a domestic, as well as international, context. Candidates are
then expected to develop further advisory skills in planning strategic acquisitions and mergers and
corporate re-organizations.
The next part of the syllabus re-examines, in the broadest sense, the existence of risks in business and the
sophisticated strategies which are employed in order to manage such risks. It builds on what candidates
would have covered in the Financial Management syllabus.
Section F of the syllabus contains outcomes relating to the demonstration of appropriate digital and
employability skills in preparing for and taking the AFM examination. This includes being able to access
and open exhibits, requirements and response options from different sources and being able to use the
relevant functionality and technology to prepare and present response options in a professional manner.
These skills are specifically developed by practicing and preparing for the AFM exam, using the learning
support content for computer-based exams available via the practice platform and the ACCA website and
will need to be demonstrated during the live exam.
Main capabilities
On successful completion of this exam, candidates should be able to:
a. Explain and evaluate the role and responsibility of the senior financial executive or advisor in
meeting conflicting needs of stakeholders and recognise the role of international financial
institutions in the financial management of multinationals
b. Evaluate potential investment decisions and assessing their financial and strategic consequences,
both domestically and internationally
c. Assess and plan acquisitions and mergers as an alternative growth strategy
d. Evaluate and advise on alternative corporate re-organization strategies
e. Apply and evaluate alternative advanced treasury and risk management techniques
f. Apply employability and technology skills
11
ACCA Performance Objectives
Objective
Chapter in Text
PO1 Ethics and professionalism
Chapter 1: Introduction to Advanced Financial
Management
Chapter 1: Introduction to Advanced Financial
Management
Chapter 10: Further Study Material
Chapter 10: Further Study Material
Chapter 2: Investment Appraisal
Chapter 8: Interest rate risk management
Chapter 6: Corporate Reconstruction
Chapter 4: Option Valuation
PO2 Stakeholder relationship management
PO3 Strategy and innovation
PO5 Leadership and management
PO9 Evaluate investment and financing decisions
PO11 Identify and manage financial risk
PO21 Business advisory
PO22 Data analysis and decision support
12
Examination Structure
The syllabus is assessed by a three-hour 15 minutes examination.
Section A (1 x 50mks)
Section A will always be a single 50-mark case study, which will contain four professional marks in which
candidates are required produce a business document such as a report or a briefing paper for the board
of directors. Candidates should understand that they will be expected to undertake calculations, draw
comparison against relevant information where appropriate, analyze the results and offer
recommendations or conclusions as required.
Financial managers are required to look across a range of issues which affect an organization and its
finances, so candidates should expect to see the case study focus on a range of issues from at least two
syllabus sections from A - E. These will vary depending on the business context of the case study.
Section B (2 x 25mks)
Section B will consist of two compulsory 25-mark questions. All section B questions will be scenario based
and contain a combination of calculation and narrative marks. There will not be any wholly narrative
questions.
All topics and syllabus sections will be examinable in either section A or section B of the exam, but every
exam will have question(s) which have a focus on syllabus sections B and E.
Total 100 marks
13
Professional Skills
The Strategic Professional Options Exams will expect candidates to demonstrate the following
Professional Skills:




Communication
Analysis and Evaluation*
Scepticism (and Judgement)
Commercial Acumen
Analysis and Evaluation have been combined into one overall skill, as it has been deemed that for the
Options exams, analysis is done in order to arrive at a thorough and comprehensive evaluation of a matter.
Judgement is added to the Skepticism descriptor for Advanced Audit and Assurance (AAA) only, as it is a
defined requirement for auditors.
The professional skills section of the syllabus links to all others and provides a range of professional skills
which the candidate must demonstrate in the exam. These professional skills will make candidates more
employable, or if already in work, will enhance their opportunities for advancement.
14
Format of the exam, including professional skills
The syllabus is assessed by a three-hour 15 minutes computer-based examination (CBE).
Section A
Section A will always be a single 50-mark case study. The 50 marks will comprise of 40 technical marks
and 10 professional skills marks. All four of the professional skills will be examined in Section A. The
professional skill” Communication” will only appear in the Section A question, because that is where a
request for a specific format for the answer (e.g., report format) will be made.
Section B
Section B will consist of two compulsory 25-mark questions. The 25 marks in each question will comprise
of 20 technical marks and 5 professional skills marks. Section B questions will contain a combination of
professional skills appropriate to the question. Each question will contain a minimum of two professional
skills from Analysis and Evaluation, Skepticism and Commercial Acumen.
Total 100 marks
15
Question presentation
The wording for the Professional Skills at the end the Section A question will be:
Professional marks will be awarded for the demonstration of skill in communication, analysis and
evaluation, skepticism and commercial acumen in your answer.
(10 marks)
For Section B questions, only the Professional Skills being tested in that question will appear, so for
example:
Professional marks will be awarded for the demonstration of skill in skepticism and commercial acumen
in your answer.
(5 marks)
Details of the professional skills for AFM
In the ACCA’s detailed AFM study guide, the professional skills are fully explained as shown below.
1) Communication
In summary, this means you have to express yourself clearly and convincingly through the appropriate
medium while being sensitive to the needs of the intended audience.
In summary, this means you have to probe, question and challenge information and views presented to
you, to fully understand business issues and to establish facts objectively, based on ethical and
professional values.
16
2) “Skepticism” in the AFM exam
Having a questioning approach is key for this skill. That questioning needs to lead to effective challenges
of information, of evidence provided and assumptions stated. This includes the ability to identify
contradictory evidence and remaining skeptical about information that has been provided in the scenario.
AFM often uses theoretical models which include assumptions and also can include stakeholders in
question scenarios making statements about their beliefs and perceptions of a matter and candidates can
be required to challenge those statements. These challenges, however, cannot simply be in the abstract.
Reasons for issues and problems with any assumptions/statements are needed before challenges can be
upheld and deemed appropriate.
All of this means that candidates need to apply professional judgement to draw conclusions and make
properly informed decisions which are appropriate to the organization.
3) “Commercial Acumen” in the AFM exam
All AFM questions are set within a commercial scenario. These will mostly be for-profit organizations, but
they can include public sector organizations and also not-for-profit organizations. Whatever context is
used, candidates need to understand what does and does not work in such an organizational scenario,
therefore any advice or recommendations have to be practical and plausible in the given situation.
To demonstrate this skill effectively candidates will need to use the question scenario information to draw
evidence that relates to the organizational context but also take any other practical commercial
considerations into account. Organizations do not operate in a vacuum so candidates need to look at
external constraints and opportunities where relevant and also consider the validity/reasonableness of
any assumption that the organization may be working under, given the external environment. Awareness
of internal constraints within an organization should also be accounted for.
To ensure that candidates take a considered forward-looking approach recognition is needed of the
possible consequences of past and future actions so that the right choices can be exercised.
4) General advice from the ACCA examining team


Make sure you include the most important, relevant, and crucial points relating to the
requirement. Use your judgment to consider which points are the most convincing and compelling
and only include additional less important points if you are not sure you have made enough valid
points to achieve all the technical marks available for the requirement.
Show deep/clear understanding of underlying or causal issues and integrate or link information
from various parts of the scenario or different exhibits.
17

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
Only make relevant points and try not to include superfluous information or make unsupported
points. Bland statements with no application do not demonstrate professionalism nor does
including information which does not address the requirements.
Avoid repeating points already made. Professionally competent candidates do not needlessly
repeat information. They may reinforce a previous point, but this is usually made as a
development of a point rather than repetition.
Address the requirements as written, taking particular notice of the verb used. Answering the
question asked is an indication of your ability to read and comprehend instructions appropriately
as is a demonstration of professionalism expected in the workplace.
Show your ability to prioritise and make points in a logical and progressive way, building your
response to a question.
Structure and present your answers in a professional manner through faithfully simulating the
task as would be expected of a professional accountant.
Demonstrate evidence of your knowledge from previous learning or wider reading and apply this
knowledge appropriately to strengthen arguments and make points more convincing.
Demonstrating professionalism is not about linguistic eloquence or having an extensive
vocabulary or having perfect grammar, it is about the ability to express points clearly, factually,
and concisely and show credibility in what you are saying.
18
5) Time management and planning
For time management purposes, candidates should allocate time based on the technical marks available,
as the professional skills marks should not be thought of as separate requirements. Remember
professional skills marks are earned as you work through the technical marks by providing comprehensive
and relevant responses to the technical requirements. In terms of time management, it is important to
use the approach that will suit you best:



If 15 minutes are spent reading the examination requirements (it may be sensible to allocate time
to this), your time allocation should be 2.25 minutes per mark (180/80). This gives 90 minutes for
section A and 45 minutes for each section B question.
If you do not allow a specific amount of time for reading and planning (a more straightforward
approach but the risk is that you run out of time) your time allocation will be 2.4 minutes per mark
(195/80). This gives 97 minutes for section A and 49 minutes for each section B question.
If you plan to spend more or less time on reading and planning, your time allocation per mark will
be different.
In terms of the technical requirements, you should consider how many marks there are for the
requirement and then decide how many different points need to be made to achieve these marks. For the
Strategic Professional Options examinations this is normally on the basis of one mark per point, possibly
with an extra mark for more fully developing the same point.
The professional skills will be worth 20 marks out of the total 100 in the exam.
Make sure you practice plenty of questions before the exam date, and focus on developing your
professional skills as well as your technical skills.
19
Chapter 0: Revision from Financial Management
20
Topic 1:
Nature and purpose of financial management
From a company perspective, the core purpose of financial management is the maximization of
shareholder wealth.
Choosing the source of
finance
Company
(Goal : Maximization of
shareholders wealth)
Investment in
Investment in
Working Capital
Non Current Assets
Dividend decisions
21
1. Financing decision
A company will need to know from where to source money from in the first place, the financing decision
is basically choosing the most optimum method to acquire funding. It is vital that the shareholder
demands are well understood before making the financing decision.
2. Investment decision
The investment decision is figuring where to effectively deploy/invest the funds to yield results that fit the
company’s objectives and goals. Investment decisions are crucial for a company as they can turn out to
be important areas of return generation, and that is why also become important from the shareholders’
perspective.
3. Dividend decision
For a profit seeking company, the financial objective will be to make profitable investments. Thus, after
making a profitable investment decision, shareholders usually expect returns in the form of dividends.
The important decision, as a financial manager here, is to what extent must the profits earned be
distributed among the shareholders as dividends, because a certain amount of the profits earned could
be re-invested into the business, which would work towards the common objective of maximization of
shareholder wealth.
As you can see that each of these elements work together, and each decision taken will affect the other,
therefore it is essential that the entire company’s objectives and demands of shareholders are thoroughly
understood before making any of the above decisions.
22
Topic 2:
Treasury Function
Treasury management (or treasury operations) includes management of an enterprise's holdings, with
the ultimate goal of managing the firm's liquidity and mitigating its operational, financial and reputational
risk.
Treasury Management includes a firm's collections, disbursements, concentration, investment and
funding activities. In larger firms, it may also include financial risk management.
Core functions of Corporate Treasury Department include:
1. Cash and liquidity management:



Cash and liquidity management is often described as treasury's 'primary duty.'
Essentially, a company needs to be able to meet its financial obligations as they fall due, i.e., to
pay employees, suppliers, lenders and shareholders.
This can also be described as the need to maintain liquidity, or solvency of the company: a
company needs to have the funds available that will enable it to stay in business.
2. Risk management:




Risk management is the discipline of managing financial risks to allow the company to meet its
financial obligations and ensure predictable business performance.
The aim of Risk Management is to identify, measure, and manage risks that could have a
significant impact on the business' goals.
It is important to note that the objective is not to eliminate all risk.
Treasurers are typically responsible for managing Liquidity risk, Market risk, Credit risk and
Operational risk.
3. Corporate Finance:

Looking after contacts with banks and rating agencies, as well as discussions with credit insurers
and, if applicable, suppliers concerning periods allowed for payment, in conjunction with the
procurement of finance, also form part of the treasurer's core business.
International treasury function
The rapid shift of economic activity to corporations going global has companies coming to face
multiple treasury management issues like:
 Transferring cash across countries
 Netting and matching currency payments
 Setting of transfer prices
 Investment strategies for short terms across international money markets
 Governance issues
23
Centralizing the treasury management
Companies have to choose between having a centralized treasury management function or not. Following
are the advantages of having it centralized and not:
Centralized Treasury
Management
Decentralized Treasury
Management
•Foreign exposures can be managed better as a
group
•One company does not borrow multiple times as
one branch might have idle cash
•No duplication of treasury skills/department
•Transfer prices can be better establised as a
group
•Individual companies can have autonomy
•Companies can become responsibility centres
•Companies might have better understanding of
local conditions
24
Topic 3:
Financial ratios
Earnings per share (EPS) = Earnings (profit attributable to shareholders)/no. of shares
P/E Ratio = Market price of a share / Earnings per share
Financial Gearing = Debt / Equity
Interest cover = PBIT / Interest
Current ratio = Current assets / Current Liabilities
Inventory turnover days = Inventory / COS x 365 days
Payables turnover days = Payables / Credit Purchase x 365 days
Receivables turnover days = Inventory / Credit Sales x 365 days
ROCE = Net profit / Capital Employed x 100% (Capital employed = Total assets – current liabilities)
Illustration 1:
Three proposals were put forward for further consideration after a meeting of the executive directors of
Ennea Co to discuss the future investment and financing strategy of the business. Ennea Co is a listed
company operating in the haulage and shipping industry.
Proposal 1
To increase the company’s level of debt by borrowing a further $20 million and use the funds raised to
buy back share capital.
Proposal 2
To increase the company’s level of debt by borrowing a further $20 million and use these funds to invest
in additional non-current assets in the haulage strategic business unit.
Proposal 3
To sell excess non-current haulage assets with a net book value of $25 million for $27 million and focus
on offering more services to the shipping strategic business unit. This business unit will require no
additional investment in non-current assets. All the funds raised from the sale of the non-current assets
will be used to reduce the company’s debt.
25
Ennea Co financial information
Extracts from the forecast financial position for the coming year
Non-Current Assets
Current Assets
$m
282
66
Total Assets
348
Equity & Liabilities
Share Capital (40c per share par value)
Retained Earnings
Total Equity
Non-Current Liabilities
Current Liabilities
Total Liabilities
Total Liabilities & Capital
48
123
171
140
37
177
348
Ennea Co’s forecast after tax profit for the coming year is expected to be $26 million, and its current share
price is $3·20 per share. The non-current liabilities consist solely of a 6% medium term loan redeemable
within seven years. The terms of the loan contract stipulate that an increase in borrowing will result in an
increase in the coupon payable of 25 basis points on the total amount borrowed, while a reduction in
borrowing will lower the coupon payable by 15 basis points on the total amount borrowed.
Ennea Co’s effective tax rate is 20%. The company’s estimated after-tax rate of return on investment is
expected to be 15% on any new investment. It is expected that any reduction in investment would suffer
the same rate of return.
Required:
(a) Estimate and discuss the impact of each of the three proposals on the forecast statement of financial
position, the earnings and earnings per share, and gearing of Ennea Co.
(20 marks)
(b) An alternative suggestion to proposal three was made where the non-current assets could be leased
to other companies instead of being sold. The lease receipts would then be converted into an asset
through securitisation. The proceeds from the sale of the securitised lease receipts asset would be
used to reduce the outstanding loan borrowings
26
Required:
Explain what the securitisation process would involve and what would be the key barriers to Ennea
Co undertaking the process.
(5 marks)
(25 marks)
Solution:
Forecast financial position
Amounts in $'000
Current
Proposal 1
Proposal 2
Proposal 3
Non-current assets
Current assets
2,82,000
66,000
2,82,000
64,720
3,02,000
67,720
2,57,000
63,682
Total assets
3,48,000
3,46,720
3,69,720
3,20,682
Current liabilities
Non-current liabilities.
37,000
1,40,000
37,000
1,60,000
37,000
1,60,000
37,000
1,13,000
Total liabilities
1,77,000
1,97,000
1,97,000
1,50,000
Share capital (40c/share)
Retained earnings
48,000
1,23,000
45,500
1,04,220
48,000
1,24,720
48,000
1,22,682
Total equity
Total liabilities and capital
1,71,000
3,48,000
1,49,720
3,46,720
1,72,720
3,69,720
1,70,682
3,20,682
Proposal 1
26,000
Proposal 2
26,000
Proposal 3
26,000
-960
-960
-320
-320
Adjustments to forecast earnings Current
Initial profit after tax
26,000
Interest payable on additional
borrowing
($20m x 6% x (1-0-2))
Additional interest payable on
extra coupon
($160m x 0-25% x (1-0-2))
Interest saved on less borrowing
($27m x 6% x (1-0-2))
Interest saved on lower coupon
($113m x 0-15% x (1-0-2))
Return on additional investment
($20m x 15%)
Return lost on less investment
1296
136
3,000
27
($25m x 15%)
Profit on sale of non-current
assets
-3,750
Adjusted profit after tax
26,000
24,720
27,720
2,000
25,682
Adjustments to forecast earnings
Gearing
%
(non-current
liabilities/equity)
Number of shares ('000)
Earnings per share (adjusted
profit after
tax/number of shares)
Current
81-9%
Proposal 1
106-9%
Proposal 2
92-6%
Proposal 3
66-2%
120,000
113,750
120,000
120,000
21-67c
21-73c
23-10c
21-40c
Note: Gearing defined as non-current liabilities/ (non-current liabilities + equity) and/or using the
market value of equity is acceptable as well.
The profit from the sale of the assets for proposal 3, of $2,000,000, is assumed to be after tax. Answers
which consider the profit to be before tax, and therefore only take into account $1,600,000 as the net
profit will receive full credit.
Tutorial Note (Explanations are not required for the answer but are included to explain the approach
taken)
Explanations of the financial position based on the three proposals
Proposal 1 Debt is increased by $20m and share capital reduced by the same amount as follows: from par
value = $20m x 40c/320c = $2·5m; from retained earnings = $20m x 280c/320c = $17·5m.
Additional interest payable totaling $1,280,000 ($960,000 + $320,000) is taken off retained earnings due
to reduction in profit after tax and taken off current assets because presumably it is paid from cash. Note
that an alternative answer would be to add the additional interest payable to current liabilities.
Proposal 2 Debt and non-current assets are increased by $20m.
Additional interest payable as above, plus the additional investment of $20 million, will generate a rate of
return of 15%, which is $3,000,000 income. Net impact is $1,720,000 income which is added to retained
earnings as an addition to profit after tax and added to current assets as a cash income (presumably).
Proposal 3 Net non-current assets are reduced by the $25 million, their value at disposal. Since they were
sold for $27 million, this is how much the non-current liabilities are reduced by, and the profit of $2 million
is included in the retained earnings.
28
Interest saved totals $1,432,000 ($1,296,000 + $136,000). The reduction in investment of $25 million will
lose $3,750,000, at a rate of return of 15%. Net impact is $2,318,000 loss which is subtracted from earnings
as a reduction from profit after tax and deducted from current assets as a cash expense (presumably).
Overall, therefore the profit is reduced by $318,000 [$2,000,000 – $2,318,000].
If the profit from the sale of the asset is assumed to be $1,600,000 ($2,000,000 less tax), then the
statement of financial position, EPS and gearing figures will all change to reflect this.
Discussion
Proposals 1 and 3 appear to produce opposite results to each other. Proposal 1 would lead to a small
increase in the earnings per share (EPS) due to a reduction in the number of shares, although profits would
decrease by approximately 5% due to the increase in the amount of interest payable as a result of
increased borrowings. However, the level of gearing would increase substantially (by about 30%).
With proposal 3, although the overall profits would fall because of the lost earnings due to downsizing
being larger than the gain in interest saved and profit made on the sale of assets, this is less than proposal
1 (1·2%). Gearing would reduce substantially (19·2%).
Proposal 2 would give a significant boost in the EPS from 21·67c/share to 23·10c/share, which the other
two proposals do not. This is mainly due to an increase in earnings through extra investment. However,
the amount of gearing would increase by more than 13%.
Overall, proposal 1 appears to be the least attractive option. The choice between proposals 2 and 3 would
be between whether the company would prefer larger EPS or less gearing. This would depend on factors
such as the capital structure of the competitors, the reaction of the equity market to the proposals, the
implications of the change in the risk profile of the company and the resultant impact on the cost of
capital. Ennea Co should also bear in mind that the above are estimates, and the actual results will
probably differ from the forecasts.
29
Topic 4:
Methods of Investment appraisal under Uncertainty
Probability analysis
Probability analysis is essentially assigning weights (probabilities) across a range of outcomes and then
taking the average of them to come to the expected value. The expected value is the weighted average of
all the possible outcomes based on probabilities.
The expected value is calculated as follows:
EV = ∑ 𝒑𝒙
–
–
Where, p = probability
x = the value of an outcome
Advantages of using expected values:
•
•
•
Easy to compute.
Includes all possible outcomes.
Weights are assigned to their respective outcomes; thus, highly probable outcomes are given
more importance.
Provides managers with the best possible outcome and the worst possible outcome, along with
the probability of each outcome occurring.
Limitations of using expected values:
•
•
•
•
Probabilities derived are forecasts based on historic information and are usually subjective. As the
future is different and might differ from the past.
Expected value does not give the actual outcome but just the average of the actual outcome.
Does not consider the investors risk attitude.
Does not lead directly to a correct decision.
30
Illustration 2:
The following are a set of possible annual cash flows that company WLR Plc might receive, below are a set
of probabilities assigned to each outcome:
Annual Cash flow ($)
Probability
80,000
0.2
90,000
0.4
60,000
0.4
EV = (80,000 x 0.2) +(90,000 x 0.4) +(60,000 x 0.4)
EV = $76,000. This means that on an average WLR plc will receive an annual cash flow of $76,000.
Illustration 3:
Stigmak plc is considering an investment of $400,000 in a non-current asset. The investment is expected
to generate surplus funds over the 5-year life of the project. Unfortunately, the annual cash flows from
the investment cannot be accurately determined, but the following probability distribution has been
established:
Annual Cash flow ($)
Probability
60,000
0.4
90,000
0.5
165,000
0.1
At the end of its five-year life, the asset is expected to have a scrap value of $49,000. Stigmak plc has a
cost of capital of 4%.
Advice Stigmak plc should go ahead with the investment.
Solution:
Expected value = (60,000 x 0.4) +(90,000 x 0.5) + (165,000 x 0.1) = 85,500
NPV based on expected value:
31
Cash flow
Amount ($)
Discount factor @ 4%
Present Value
Year 1-5: Annual cash flow
85,500
4.452 [AF @ 4% for 5 years]
380,646
Year 0: Investment
Year 5 scrap
(400,000)
49,000
1
0.784 [DF @ 4% for 5th year]
(400,000)
38,416
NPV
19,062
Comment: The project is financially viable as it has a positive NPV, however, the final decision depends
on the risk appetite of the company.
Sensitivity analysis
Sensitivity analysis basically measures how much a project variable needs to change for the NPV to
become 0 (or how far can a specific variable change until the project loses its financial viability). Thus, this
basically measures how sensitive a project variable is to the overall investment decision.
It basically tests the tolerance, how low can the NPV fall due to a change in any of the variables.
If sensitivity of selling price per unit is 10%, the project would still be acceptable if the selling price would
fall by 10%.
If it falls by 10%, NPV is ZERO.
If it falls by more than 10%, NPV will be negative and the project would become unacceptable.
Sensitivity analysis is carried out by first selecting a project variable (E.g., Sales) then calculating the
change required to make the NPV zero. This analysis helps managers assess the critical project variables
that need to be closely monitored while implementing an investment project. Sensitivity analysis is not
considered as a method of incorporating risk, as it does not take the probability of a project variable
changing into consideration.
𝑺𝒆𝒏𝒔𝒊𝒕𝒊𝒗𝒊𝒕𝒚 𝒕𝒐 𝒂 𝒗𝒂𝒓𝒊𝒂𝒃𝒍𝒆 =
𝑵𝑷𝑽
× 𝟏𝟎𝟎
𝑷𝒐𝒔𝒕 𝒕𝒂𝒙 𝑷𝑽 𝒐𝒇 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 𝒂𝒇𝒇𝒆𝒄𝒕𝒆𝒅
NPV is adjusted for tax, thus for a fair comparison, the cash flows are also adjusted for tax, this is calculated
as: Cash flow x (1-Tax rate). As studied earlier, tax is charged on cash inflows and benefits are given for
cash outflows, therefore we adjust every cash flow for the tax to get an accurate value.
32
Decision Rule
The lower the sensitivity margin, the more sensitive that specific project variable is to the investment
decision. A lower sensitivity margin basically means that a small change in the forecast could potentially
reverse the decision to invest in a project.
So, the close to 0% the sensitivity of a variable is, the more critical it is to the project.
Advantages of using sensitivity analysis:
•
•
Provides additional information that assists managers in making a better investment decision.
Easy to calculate.
Disadvantages of sensitivity analysis
•
•
•
Does not directly point to a correct decision.
Cannot process more than one variable changing at the same time.
Does not take the probability of a variable changing into consideration.
Illustration 4:
A project is expected to earn $40,000 annually as sales revenue over the project’s four-year life. The
project has an NPV of $7,000. The relevant discount rate and the tax rate is 10% and 25%, respectively.
Calculate the sensitivity of the selling price to the investment.
Solution:
Sensitivity of selling price = [7000/ (3.16987x40,000x (1-0.25))]
= 7.36%
This means that only a 7.36% change in the selling price estimate could lead to the project yielding a
negative NPV.
33
Illustration 5:
Investing $35,000 today will potentially lead to receiving $22,000 yearly as a contribution. This estimate
is based on selling a volume of 11,000 units at a selling price of $11. Annual variable and fixed costs are
expected to be $9 per unit and $5,000, respectively. The project is expected to run for 4 years, with a
discount rate of 10% and corporation tax at the rate of 30%.
Calculate the NPV of the project.
Calculated the sensitivity of the calculation for the following:
A.
B.
C.
D.
Initial Investment
Sales volume
Selling price per unit
Rate of discount
Solution:
Cash flow
Amount $
Discount factor @10%
PV @ 10%
Year 1-4: revenue
121,000
3.17 [AF for 4 years]
383,570
Year 1-4: Variable cost
(99,000)
3.17
(313,830)
Year 1-4: contribution
22,000
3.17
69,740
Year 1-4: Fixed cost
(5,000)
3.17
(15,850)
Net operating c/f
17,000
3.17
53,890
Year 1-4: Tax @ 30%
(5,100) [17,000 x 0.3]
3.17
(16,167)
Year 0: Investment
(35,000)
1
35,000
NPV
2,723
The project is financially viable as it has a positive NPV, however, the final decision depends on the risk
appetite of the company.
Calculation of sensitivity:
(i)
(ii)
(iii)
Initial investment sensitivity = 2,723/35,000 = 7.78%
Sales price sensitivity = (NPV/PV of revenue post tax)
= [2,723/ (383,570x0.7)]
= 1.01%
Sales volume sensitivity = NPV/PV of contribution post-tax
= [2,723/ (69,740x0.7)]
= 5.58%
34
(iv)
Discount factor sensitivity (calculation of IRR):
Calculating second NPV with a discount factor of 15%
Cash flow
Amount $
Discount factor @ 15%
PV
Year 1-4: revenue
121,000
2.855
345,455
Year 1-4: Variable cost
(99,000)
2.855
(282,645)
Year 1-4: contribution
22,000
2.855
62,810
Year 1-4: Fixed cost
(5,000)
2.855
(14,275)
Net operating c/f
17,000
2.855
48,535
Year 1-4: Tax @ 30%
Year 0: Investment
(5,100) [17000 2.855
x 0.3]
(35,000)
1
NPV
(1,026)
IRR = 10% + [2723/ (2723+1026)] x (15%-10%) = 13.63%
Sensitivity to discount factor = (13.36%-10%)/10% = 33.6%
(14,561)
(35,000)
35
Simulation
Simulation overcomes the limitation of sensitivity analysis by assessing the effect of changing multiple
variables at the same time. It is a complex process and is usually a computer aided technique. It is carried
out by varying the input variables to assess the various possible outcomes. This process helps an entity
process various outcomes and assess the potential impact of each variable changing.
Four stages of simulation
Step 1: Specify major variables like investment costs, operating costs, market details, etc.
Step 2: Specify the relationships between variables to calculate an NPV
Sales revenue = market size × market share × selling price
Net cash flow = sales revenue – (variable costs + fixed costs + taxation), etc.
Step 3: Simulate the environment:
- Select different values of each variable within the parameters set and compute an NPV
- Repeat the process many times to create a probability distribution of returns.
Step 4: The results of a simulation exercise will be a probability distribution of NPVs.
Instead of choosing between expected values, decision makers can now take the dispersion of outcomes
and the expected return into account.
Advantages of simulation
• Easy to interpret.
• Includes all possible outcomes.
• Provides additional information that assists managers in making a better investment decision.
Disadvantages of simulation
•
•
Simulation tends to be expensive, and the potential benefits might not outweigh the cost.
Complex and hard to calculate.
36
Risk adjusted weighted average cost of capital
As mentioned earlier, WACC cannot be used to appraise an investment that has a different risk profile
than the company’s current operations.
In such circumstances, the risk adjusted weighted average cost of capital can be to compute a suitable
cost of capital.
Risk adjusted WACC can be used as a discount rate to appraise an investment if:
1. The business risk (operational risk) of the investment is different from the risk of the company’s
current operations.
2. The capital structure (debt-to-equity ratio) of the business is unchanged. In other words, if the
financial risk of the business remains unchanged.
3. No systematic risk remains as it is assumed that the investors maintain a diversified portfolio.
In order to calculate the risk adjusted WACC, we need to understand that risk is bifurcated as follows:
Risk
Unsystematic
Systematic
Business risk
Financial risk
(assumed to be
eliminated)
37
Systematic risk is divided into:
Business Risk
•Business risk relates to the risk that a company will
have to face due to its operations.
•For example, Vodafone Idea and Jio will have a
similar business risk or TATA motors, and Maruti will
have a similar business risk.
Financial Risk
•Financial risk represents the proportion of debt-toequity that a company maintains.
•It is very rare for companies to have the same
financial risk as companies will raise finance in order
to specifically match their needs.
Calculation for Risk Adjusted WACC
You will need to understand the following terms to compute risk adjusted WACC:

Asset beta (Ba/Bu): Measures the business risk faced by a company. This is also known as
ungeared beta, because the term ‘geared’ means including financial risk.

Equity beta (Be/Bg): Measures the business risk and the financial risk of a company. This is also
known as geared beta, as the equity beta is multiple that includes the business risk combined with
the financial risk of a company.
Risk Adjusted WACC:
𝑽𝒆
]
𝜷𝒂 = [
𝑽𝒆 + 𝑽𝒅 (𝟏 − 𝑻)𝜷𝒆
Where,
– Ba = Asset Beta
– Be = Equity Beta
– Ve = market value of company’s shares
– Vd = Market value of company’s debt
– T = Tax rate
The whole idea in the exam is to be able to estimate the cost for equity for a company. For example, you
will be given a company, ABC, that manufactures cars, but it is deciding to invest in manufacturing soap.
38
Thus, you will be given data of a ‘proxy’ company that also manufactures soap (to represent a similar risk
profile). Thus, you will have to perform the following steps to compute the risk adjusted WACC:
De-gear the
proxy co.
Re-gear
Calculate 𝐊 𝐞
Calculate WACC
1. De-gear the proxy company:
In most questions, you will be given the equity beta of the proxy company (which represents both
financial and business risk). The goal is to get the asset beta of the proxy company as we only need
the business risk from that entity. Thus, we will enter the proxy company’s market values of debt
and equity in the above formula to compute the asset beta.
2. Re-gear:
In the previous step, we basically separated the proxy company’s financial risk from the business risk,
in this step we are combining the business risk with our company’s financial risk thus re-gearing the
asset beta with the suitable financial risk. Therefore, we enter our company’s market values of debt
and equity in the above formula along with the asset beta found in the previous step.
3. Compute Ke:
In this step, we basically take the Equity beta that was computed in the previous step and use it in the
CAPM formula to compute the cost of equity that is suitable for our company.
4. Compute WACC:
Calculate WACC using the normal method.
39
Illustration 6:
YEEZUS Co is a shoe manufacturer whose D/E ratio is 60:40. The pre-tax cost of debt may be assumed to
be 10%, and this represents the risk-free rate of return. The beta value of the company’s equity is 1.2. The
average return on stocks in the market is 14%. The corporation tax rate is 30%. The company is considering
a furniture manufacturing project. Hemis Co is a furniture manufacturing company. It has an equity beta
of 1.60 and a D/E ratio of 20:80. YEEZUS Co maintains its existing capital structure after the
implementation of the new project.
Calculate the suitable cost of capital for the project
Solution:
Step 1 – De-gearing the proxy
Ba = Be [Ve/Ve+Vd(1-T)]
Ba = 1.6 [0.8/(0.8+0.2*(0.7)]
Ba = 1.36
Step 2 =Regearing Beta to YEEZUS gearing level
= Be [0.4/0.4+(0.6*0.7)]
Be = 2.7
Step 3: Calculate Ke & Kd
Ke = 0.1 + 2.7(0.14-0.1)
Ke = 20.8%
Kd = 0.1*0.7 = 7%
Step 4: Appropriate rate for the project
Discount rate = Ke x proportion of equity + Kd x proportion of debt
= [0.208 x 0.4] + [0.07*0.6]
= 12.52%
40
Topic 5:
Forex terminologies
•
Spot rate: The exchange rate for transactions that are going to take place immediately. Basically, this
is the rate at which currency can be exchanged today. For example, $3/1£.
•
Forward rate: It is the rate at which the settlement price for a transaction that will take place on a
predetermined future date.
For example, Current spot rate $3/1£ 2-month forward rate $3.04/£1
•
Bid/offer spread: This is a common area where students get confused. This is the difference
between the buying and the selling prices offered at the close of each business day. The bid rate is
the rate at which the bank is willing to buy currency from a customer, the offer rate is the rate at
which the bank will sell currency to the customer. It is presented as follows:
E.g., £ is the home currency. The US $/£ at the close of business was: 1.888-2.404
This means that the bank will buy 1£ for 1.888$ and will be willing to sell 1£ in exchange for $2.404. A
simple way to remember which is the buy rate and offer rate is to remember that the bank will always
make a profit. Thus, the bank will always sell home currency at a rate higher than at which it will buy the
same currency.
41
Predicting future exchange rates
This section will help you understand how banks come up with the forward rate. There are two theories
that help with this, they are as follows:
 Interest rate parity theory (IRPT)
The IRPT claims that the difference between the interest rate between two countries is equal to the
difference between the forward exchange rate and the spot exchange rate.
IRPT predicts that exchange rates will vary to eliminate price differences between countries.
(Assume US is the foreign currency and UK is the home currency)
Forward rate US$/£ = Spot US$/£ x (1 + US interest rate) number of years
(1 + UK interest rate) number of years
Forward rate = Spot x (1 + foreign interest rate) number of years
(1 + home interest rate) number of years
IRPT predicts that the country with the higher interest rate will see the forward rate for its currency
depreciate in value.
 Purchasing [power parity theory (PPPT)
This theory is based on the idea that the exchange rate between two countries depends on the relative
inflation rates within the respective countries.
The forward rate can be estimated using PPPT using the following formula:
(Assume US is the foreign currency and UK is the home currency)
Forward rate US$/£ = Spot US$/£ x (1 + US inflation rate)number of years
(1 + UK inflation rate) number of years
Forward rate = Spot x (1 + foreign inflation rate) number of years
(1 + home inflation rate) number of years
PPPT predicts that the country with the higher inflation rate will have its exchange rate depreciate in
value.
42
Topic 6:
Islamic finance
This section is similar to what was studied in F9; however, you will be required to write a theory answer
in AFM. For that reason, you should memorize each type of Islamic finance.
Islamic finance is different to the traditional system of finance even though it serves the same purpose.
Islamic finance is based on the rulings of sharia law on financial and commercial transactions. Islamic
finance is based on the following principles:



Finance cannot be sourced to or from activities that are not accepted in Islam. For example,
gambling, alcohol, etc.
All parties involved must be fairly treated and should be able to make informed decisions without
being cheated.
Interest (known as riba) is forbidden in Islamic finance. Interest is replaced by earnings generated
through an underlying investment activity. It is further explained below.
How returns are earned
The traditional banks get funds by allowing investors to deposit their money in exchange for interest.
Banks make a profit by lending those funds at a higher interest rate than the interest they pay out to the
depositors. This process is forbidden in Islam.
In an Islamic bank, the funds received by depositors is channeled to an underlying investment activity
which will earn profit. The depositor will earn a share in profit after a management fee is deducted by the
bank.
Thus, interest is replaced with cash flows from productive sources, such as activities that generate wealth.
43
Sources of Islamic finance
These are critical to remember as Islamic finance is broadly classified into 2 categories of finance
techniques:
Islamic sources of finance
Fixed income
1) Murabaha
2) Ijara
3) Sukuk
Equity finance
1) Mudaraba
2) Musharaka
Fixed income
1) Murabaha
You can remember this as a form of trade credit. The main difference is that with a mubaraha, the
bank will actually take physical ownership of the asset. This asset will then be sold to the borrower
for a profit, but the payment is made over a fixed number of instalments. The period of the
repayments could be extended, but no additional mark-up nor any penalties can be added by the
bank.
2) Ijara
You can remember this as a form of lease finance. The way an ijara contract works is, the bank will
provide the asset or equipment such as motor vehicles or machinery to the customer in exchange for
a fixed price over a specified period. The following are the specifications of an ijara contract:



The use of the leased asset must be specified in the contract.
The lessee is not responsible for the major maintenance of the underlying asset, the responsibility
lies with the lessor (bank).
Although, the lessee is responsible for the general maintenance of the asset.
An Islamic lease is like an operating lease but shows the redemption features that are similar to that
of a finance lease.
44
3) Sukuk
This can be called an Islamic bond. Traditionally investors will invest in a company’s bond that will pay
out a fixed amount of interest before the company pays out its dividends. This, again, is forbidden in
Islamic finance. Instead, investment in sukuk will be linked to an underlying asset, thus the sukuk
holder becomes a partial owner in that asset and profit (returns) is linked to the performance of the
underlying asset. A sukuk holder will have a right to profits but will also equally bear any losses.
Equity finance
1) Mudaraba
This is similar to equity finance. A mudaraba forms a type of partnership where one partner gives
money to another partner for investing in a commercial enterprise. The first partner is called ‘rab-ulmal,’ this partner provides funds for investment. The second partner is known as ‘mudarib,’ this
partner provides investment and management expertise.
Mudaraba is a contract where one party provides all the capital, and the other uses their knowledge
to manage the investment. The profits generated are shared in a pre-determined ratio, but the losses
are solely borne by the ‘rab-ul-mal.’ Thus, it is similar to equity finance.
2) Musharaka
This is similar to a joint venture or partnership. Musharaka is a relationship where two or more parties
form an agreement to contribute capital to a business and share both profits and losses pro rata. All
providers of capital are entitled to participate in management but are not required to do so. Losses
are borne by every partner in proportion to their respective capital contributions, while profit is
distributed in accordance with a pre-determined ratio.
We shall now study some new types of contracts that were not a part of the FM syllabus:
Istisna (for constructed assets): Istisna is similar to Murabaha but for assets that needs to be constructed.
A bank finances the construction of the asset from a contractor and then further sells it to the customer
or the company which required the building.
Salam contracts: Salam contracts originated in the agricultural sector to meet the financial needs of
farmers. Salam contracts originated in the agricultural sector to assist farming communities. The bank
finances the farmer's needs by making an upfront payment (at an agreed-upon price) for the products to
be delivered on a specific day. The bank may then enter into a series of back-to-back contracts to sell the
product at a higher price on the specified date.
45
Chapter 1: Introduction to Advanced Financial
Management
46
Introduction to AFM
Before diving into any chapter, you need to understand that this is a P-Level paper and will have to be
approached in a different manner. What this paper essentially asks of you is to be in the position of a
financial manager and to accurately interpret and make professional decisions regarding investment
appraisal, mergers and acquisitions, corporate reconstruction and risk management. If you read financial
articles/news regularly, you will be 5 steps ahead of every other student.
Most importantly, judgement is the crucial element the examiner is looking for, questions in AFM will not
specifically tell you what you need to compute. For example, the question will ask you whether it is worth
investing in a certain project or not, rather than asking you to compute the NPV. Thus, you need to have
professional judgement as to which concept can is best used to assess which scenario. This study text has
been curated in such a way to help you use the head points and concepts as a framework/blueprint to
assess any scenario and impart professional judgement in the AFM exam.
47
Roles and responsibilities of a Financial Manager
This chapter concerns the different areas a financial manager needs to be thorough with. As studied
earlier, the primary goal of most profit-driven companies is to increase shareholder wealth. However, a
financial manager will have to consider the impact of its decisions on various other stakeholders while
setting its objectives.
In order to achieve those goals, a financial manager makes decisions in the following areas:
Investment decisions
(Grow investments
organically or through
acquisitions?)
Financing decisions
Dividend decisions
(Where does company get
the money from?)
(How much to give back to
shareholders?)
Refer Skill level FM topic: Financial Management Function to revisit the importance of Financial
Management from Chapter 1: Topic 1.
It is also important to understand the more specialized roles that a financial managers role entails, they
are as follows:







Identifying, selecting, and allocating resources for investments
Interaction with stakeholders
Identifying and raising funds with the goal of lowering the cost of capital
Acquisition and instrument valuations
Financial management and planning
Risk Management
Profit retention and distribution of dividends
48
Refer Skill level FM topic: Financial Markets & Treasury Function to revise the role of treasury function
and how the same is connected with financial control from Chapter 1: Topic 2.
Example:
Background
As of 15th March 2021 – Infosys has the 5th largest market Cap in India, which stood at 576,275.68crs.
As of March 2021, Infosys’s balance sheet showed consolidated cash and cash equivalents of 17,612.00crs.
Either make a small table of the financials – Sales, PAT, Cash, Market Cap, Debt
The company has multiple options to utilize their funds
 Pay out Dividend
 Strategically acquire a company
 Invest it into the company’s growth (R&D facilities)
 Opt for a share buyback
Infosys is a mature company spends on an average of 0.6% into R&D facilities – since it is a service-based
business and unlike Samsung that has spent 10% of their revenues in R&D due to the nature of the
industry.
Infosys reports over 73 subsidiaries and has 15 acquisitions spending xyz. This indicates Infosys does not
need to grow via the inorganic route. Thus, it is left with two alternatives to make use of the money which
they have: Dividends/Share buy-back.
Thus, Infosys needs to make appropriate financial decisions after considering the impact each of the
decisions is going to have. This is an important topic and is taught later in this chapter.
Indicators for shareholder wealth
It is essential to have indicators that help the company assess whether they are adding value to
shareholder wealth or not. The following are some of the indicators used to measure the
increase/decrease in shareholder wealth:





Earnings per share (EPS)
Dividends per share (DPS)
Return on capital employed (ROCE)
Return on shareholder capital (ROSC)
Revenue, operating profit and net profit
49
You should be familiar with computing each of the above ratios, as learnt in the skill level. As this is a
P-level exam, the questions will not tell you to specifically calculate these ratios, but you will be asked to
assess the growth in shareholder value and comment on the same.
But remember this is a P-level paper, so you will need to consider every other external factor that can
affect shareholder growth as well. Factors such as interest rates, foreign exchange rates, general economic
climate, inflation can also have an impact on the shareholder.
Refer Skill level FM topic: Ratio Analysis to revisit the ratios a financial manager needs to be updated
on and the breakdown of the same from Chapter 1: Topic 3.
Agency theory
Agency relationships exist when one party, the principal, hires another party, the agent, to perform
specific tasks on behalf of the former. For example, there is a principal-agent relationship between
shareholders and the company. The shareholders, despite being the owners of the company, do not
participate in its operations and rely on management to understand and pursue their goals. Conflicts
between the objectives of both parties are common in such relationships, this is referred to as an agency
problem by the parties to the relationship.
A comparable issue is prevalent even in organizations where shareholders (principal) entrust the
management. Management of finances in collaboration with management (the agent). Some of the areas
of contention could be directors' pay, non-payment of dividends, and very low pay. Shareholders may
object to the high level of borrowings and gearing used.
Solution to the Agency problem
Essentially all that needs to be done is to find ways that will align the shareholders' goals to that of the
directors. Creating appropriate managerial reward schemes to encourage managers to take the same risk
as investors and to align the manager's time horizon with that of the shareholder. Including executive
share option schemes, in which managers are given the option to purchase shares at a reduced or lower
price. This will encourage managers to work toward increasing share price and, as a result, shareholder
wealth.
Non-Executive Director presence on the board and having remuneration and nomination committees
comprised of non-executive directors, as defined by the relevant corporate governance code. Holding
annual general meetings and having financial statements audited can improve shareholder confidence.
50
Impact on Financial Management decisions
This is the most important section of the chapter as it is most likely to appear in the exam. These are the
essential impacts a financial manager will have to consider before making any financial decision:
Strategic
impact
Financial
impact
Financial
manager's
decisions
Regulatory
impact
Environmental impact
Ethical
impact
1. Strategic Impact
 Does the financial decision strategically fit the organization?
 Are the resources available to the organization being used in the most efficient manner?
 How does the decision affect the overall risk profile of the company?
 How will the stakeholders and shareholders react to the decision?

2. Financial Impact
 How are the key ratios such as gearing, liquidity, return ratios affected?
 How will the decision affect the share price of the company?
 Is the cost of capital affected?
 Is the company’s liquidity at risk?
3. Regulatory Impact
 Is the company meeting the industry regulatory requirement?
 Is the company complying with every legal aspect?
 In case of the company being public, is the company complying with stock exchange
requirements?
51
4. Ethical Impact
 Has the interest of every stakeholder been taken into account?
 Is the decision ethical and in line with good corporate governance?
 Has the company exceeded its legal obligations, if at all?
5. Environmental Impact
 Does the decision in any way meet current needs at the expense of future generations' ability to
meet their own? If this is the case, the decision will have a negative impact on the environment.
 Compliance with Kyoto Protocol and carbon trading mechanism emission regulations.
 Compliance with government and local regulatory bodies' requirements for conversion, recycling,
and sustainable development.
It is as important to know where the above points can be used as to remembering the points itself. The
questions asked will not be straightforward, the examiner will just ask you to discuss the effects of a
financial decision or to discuss key issues that the board should consider before making a decision. The
above points can be used as a blueprint to framing a solid answer.
Illustration 1:
Mezza Co (June 2011)
Mezza Co is a large food manufacturing and wholesale company. It imports fruit and vegetables from
countries in South America, Africa and Asia, and packages them in steel cans, plastic tubs and frozen foods
for sale to supermarkets around Europe.
Its suppliers range from individual farmers to Government run cooperatives and farms run by its own
subsidiary companies. In the past, Mezza Co has been very successful in its activities and has an excellent
corporate image with its customers, suppliers and employees.
Indeed, Mezza Co prides itself on how it has supported local farming communities around the world and
has consistently highlighted these activities in its annual reports.
However, in spite of buoyant stock markets over the last couple of years, Mezza Co’s share price has
remained static. It is thought that this is because there is little scope for future growth in its products.
As a result, the company’s directors are considering diversifying into new areas. One possibility is to
commercialise a product developed by a recently acquired subsidiary company. The subsidiary company
is engaged in researching solutions to carbon emissions and global warming and has developed a high
carbon absorbing variety of plants that can be grown in warm, shallow seawater.
52
The plant would then be harvested into carbon-neutral bio-fuel. This fuel, if widely used, is expected to
lower carbon production levels.
Currently, there is a lot of interest among the world’s governments in finding solutions to climate change.
Mezza Co’s directors feel that this venture could enhance its reputation and result in a rise in its share
price. They believe that the company’s expertise would be ideally suited to commercialising the product.
On a personal level, they feel that the venture’s success would enhance their generous remuneration
package, which includes share options. It is hoped that the resulting increase in the share price would
enable the options to be exercised in the future.
Mezza Co has identified the coast of Maienar, a small country in Asia, as an ideal location, as it has a large
area of warm, shallow waters. Mezza Co has been operating in Maienar for many years and as a result,
has a well-developed infrastructure to enable it to plant, monitor and harvest the crop.
Mezza Co’s directors have strong ties with senior government officials in Maienar and the country’s
politicians are keen to develop new industries, especially ones with a long-term future.
The area identified by Mezza Co is a rich fishing ground for local fishermen, who have been fishing there
for many generations. However, the fishermen are poor and have little political influence. The general
perception is that the fishermen contribute little to Maienar’s economic development.
The coastal area, although naturally beautiful, has not been well developed for tourism. It is thought that
the high carbon absorbing plant if grown on a commercial scale, may have a negative impact on fish stocks
and other wildlife in the area. The resulting decline in fish stocks may make it impossible for the fishermen
to continue with their traditional way of life.
Required: Discuss the key issues that the directors of Mezza Co should consider when making the
decision about whether or not to commercialise the new product, and suggest how these issues may
be mitigated or resolved. (17 marks)
53
Solution:
(Note on solution: This question can be answered in a variety of ways, and the suggested answer below
is merely indicative. Reasonable responses that consider alternatives or additions to the two issues
discussed below will be given credit.)
The overarching goal of the board of directors should be to maximize Mezza Co's long-term value and, as
a result, the value to its shareholders. As a result, any decision should be made with this goal as the
primary goal in mind.
However, taking into account the company's responsibility to its stakeholders, the directors should also
try to minimize the negative consequences of the project's implementation.
The first critical question to ask is whether the new project will add value to the company. At first glance,
the investment in the new venture appears to be beneficial to the company. As a tool for combating
climate change, the product would meet market needs for an extended period of time.
It could help the company's corporate reputation by assisting in the fight against the negative effects of
climate change. Furthermore, it may allow the research subsidiary company to conduct future research
and development projects in related products.
However, whether the positive factors described above result in an increase in the company's value merits
further discussion and investigation. The company must assess the likely income generated by the
investment as well as the inherent risk of the venture.
Assuming that this is a new product, the uncertainty and risk to income flows will most likely be significant.
The directors should also consider the fact that their remuneration package includes share options, which
may induce them to act in an overly risky manner in which they benefit from rising share prices but lose
nothing if the share price falls. This may not be advantageous to shareholders or other stakeholders who
do not own such options.
Before making a decision, the project's due diligence procedures must be completed. The company's
directors must conduct a thorough assessment of how realistic the revenue and income estimates are
likely to be.
They would also need to assess the likelihood of competitors and alternative products that could affect
the product's future sales. A thorough investigation of the uncertainties and risks is required, which may
include the use of techniques such as sensitivity, probability, and project duration analysis. Risks must be
considered when determining the likely value added. This is especially important if the directors are to
persuade shareholders and other stakeholders that they are not taking unacceptable risks. Realistic time
scales for the commercialization of the product must be determined, possibly by looking at how other
companies completed similar projects. The sufficiency of the company’s required expertise and
infrastructure must be evaluated.
54
The location of the plant product is the second critical issue for the directors to consider. A variety of
factors would make the location ideal for Mezza Co. The location provides the ideal conditions for the
plant to grow in sufficient quantities to be subsidized.
Because the relationship with the government is strong and the government wants to develop new
industries, the project is likely to be viewed favorably. As a result, many legal and administrative barriers
may be removed to allow production to begin as soon as possible.
Finally, Mezza Co already has the necessary infrastructure in place, so start-up costs are likely to be
significantly lower. These factors would benefit Mezza Co financially and may make the investment viable.
However, using this area for the project raises ethical and environmental concerns. It may be perceived
that the relationship with the government is too close, preventing proper government scrutiny.
The livelihood of the affected fishermen, as well as the impact on wildlife and the environment, must be
considered. Proceeding with the project may have a significant negative impact on Mezza Co’s reputation
and may contradict the company’s (and the directors’) values.
As a result, the directors face the conundrum that the project will be perceived as benefiting the global
environment while harming the local environment.
A number of actions could be taken by the board of directors to mitigate or eliminate the negative impact.
Given the fishermen’s lack of a significant “voice” or “power,” Mezza’s board could try to conceal the
issue, but such a situation is unlikely given their personal values.
The directors could meet with the leaders of the fishermen’s community to explain the project’s benefits
and consequences for the fishermen, possibly giving the fishermen first priority for the new jobs created
by the project.
They could persuade and collaborate with the government to partially develop the area for tourists while
also leaving areas for fishermen to continue their work. This may be feasible if the entire area is not
required for plant cultivation at the same time. These additional wealth-enhancing opportunities may
persuade the fishermen of the project’s viability.
The company could continue to look for new areas to cultivate the crop and possibly conduct research
and development to create crops that are not harmful to the fish stock and wildlife. These steps, however,
would be costly, and Mezza Co would have to weigh the potential revenues against the additional costs.
In terms of its relationship with the government, Mezza Co may be able to demonstrate that it
collaborated with the government to improve fishermen’s livelihoods. It could also ensure that it follows
the proper procedure in terms of legal and administrative requirements, even if this means delaying the
product’s launch.
Before embarking on the project, Mezza Co must weigh the likely positive benefits against the costs, both
direct and indirect to the community. It must consider the impact on long-term value creation, and
corporate reputation will play a significant role in determining this.
55
Although Maienar’s government may try to approve the project quickly, Mezza Co should consider the
full impact of the proposed project, alternatives, and consequences, and try to manage the entire process
to ensure that the company’s reputation is not negatively impacted.
Environmental Issues and additional reporting:
Kyoto
Protocol
Ethics &
Corporate
Governance
Environmental
Issues & Additional
reporting
TBL
Reporting
Integrated
Reporting
Kyoto Protocol
The Kyoto Protocol was an international treaty which extended the 1992 United Nations Framework
Convention on Climate Change (UNFCCC) that commits state parties to reduce greenhouse gas emissions,
based on the scientific consensus that global warming is occurring and that human-made CO2 emissions
are driving it. The Kyoto Protocol was adopted in Kyoto, Japan, on 11 December 1997 and entered into
force on 16 February 2005. There were 192 parties to the Protocol in 2020.
Countries signing the agreement were required to reduce their carbon emissions or reach an emission
target for which they can benefit of a secondary market for carbon credits multilaterally exchanged from
each other.
Organizations in various countries may volunteer to reduce their emissions in return for a financial
government incentive. If they overachieve their target, they can sell their credits or bank their excess
allowances. If they underachieve, they will have to buy credits.
56
Triple Bottom Line (TBL) reporting – 3 P’s
This refers to an alternate form of reporting vital company information to shareholders. Note that this is
not enforceable but just a framework that companies can use to improve the relationship with their
shareholders, as just the annual report might not be enough for all the stakeholders.
TBL refers to reporting to shareholders in three areas mainly:
Planet
People
Profit
TBL Reporting



People – The social equity bottom line
Planet – The environmental bottom line
Profit – The economic bottom line
Amis to strike a balance between economic profits, environmental concerns, and social concerns. A good
corporate citizen company will build a good reputation if it strikes a balance between the three factors
mentioned.
Acts as a tool for assessing performance in relation to stated goals. Each factor is evaluated using a variety
of proxies. Operating profit and the impact of the business on the local economy are examples of
economic impact proxies.
The environmental impact of proxies includes carbon emissions, recycled waste, water use, and the use
of scarce resources. Fair pay, working conditions, and standards are examples of social impact proxies.
The following are some of the benefits of using TBL reporting:
57




Increased reputation Improved brand awareness and recognition Increased customer loyalty and
retention.
Attract the best talent/employees.
Reduce legal expenses.
Concentrate on improving corporate governance and value creation systems.
Example:
In the food industry, there are several issues that are beginning to become more prominent in regard to
corporate responsibility. These include the use of genetically-modified organism (GMO) foods, animal
welfare practices, use of antibiotics and growth hormones in livestock, giving back to communities,
sustainable and fair-trade agriculture prospects, health/safety and labor/human rights concerns (Maloni
and Brown, 2006).
One way that McDonald’s attempts to be a responsible corporation is through the promotion of
sustainable farming methods. McDonald’s joined Unilever and Nestle in pledging to shift to entirely
sustainably-sourced palm oil by 2015. Clearcutting for palm tree plantation systems is a source of
greenhouse gases, and the scales of the materials these companies use indirectly leads to a great deal of
these negative outcomes. By shifting to sustainable practices for palm oil, this negative climate effect can
be mitigated to a certain extent (Scott, 2011). Palm oil is not the only agricultural product that McDonald’s
has sought to obtain using sustainable methods.
In Europe, the company has launched an initiative called Flagship Farms to showcase sustainability
practices used by farms supplying McDonald’s. Examples include soil, water, and energy use for animal
welfare and employee well-being. One poultry farmer, for instance, supplies 25 million eggs per year to
McDonald’s from his 48,000-bird free-range flock. This program is meant to highlight 36 Journal of
58
Strategic Innovation and Sustainability Vol. 11(1) 2016 successful sustainability practices in agriculture to
show other farmers and suppliers what can be done (Spackman, 2009). A final example of McDonald’s
efforts at corporate responsibility can be found in its funding and support of the Ronald McDonald House.
This entity provides housing and some limited indirect financial support for families whose children are
undergoing treatment for life-threatening illnesses.
The group is funded not only by McDonald’s, but also by a number of the suppliers in its supply chain
(Smith, 1994). While these are each good examples, McDonald’s isn’t entirely without fault. Recently, the
negative publicity surrounding its employee pay scales has begun to grow. Negativity surrounding its
contributions to the growing American obesity epidemic has also continued to grow, despite efforts by
the company to introduce and promote salad items and healthier low-fat options (Maloni and Brown,
2006; Petrak, 2005). Whether the positive efforts by the company outweigh the negative aspects of the
business model remains to be seen and will likely need to be addressed in the near future to avoid a
continued public backlash against the company.
CONCLUSION: In summary, McDonald’s represents a company that is a solid player in supply chain
management. As a global company, they understand what it takes to bring food from farm to fork
effectively while still making a sizable profit. They also taken significant steps to promote and effect
corporate responsibility in both their own actions and in their respective supplier companies. While there
is always improvement to be achieved, they are a company with many positive attributes to analyze and
emulate in the global business arena.
Integrated Reporting (IR)
Similar to TBL, the purpose of IR is to improve the relationship between the shareholders and the
directors, however it is not enforceable by law.
Integrated reporting, which has recently gained popularity, aims to communicate how an organization's
strategy, governance, performance, and prospects create value for the organization's stakeholders in the
short, medium, and long term, within a given environment.
IIRC (International Integrated Reporting Council) was formed in 2010 and gave out the requirements to
be followed while preparing an Integrated Report (IR).
IR assists companies in making decisions that are more sustainable and consistent with organizational
strategy by encouraging them to focus on long-term value creation.
The IR framework identifies six capitals to report, namely:
59
Financial
capital
Social
capital
Manufactur
-ed capital
Integrated
Reporting
Human
capital
Natural
capital
Intellectual
capital
1.
2.
3.
4.
5.
6.
Financial capital: Money, funding used.
Manufactured capital: Building, equipment, machinery used by the company.
Human capital: Skills, experience, the loyalty of employees.
Intellectual capital: Patents, brands, technical know-how.
Natural capital: Natural resources like water, land, minerals etc.
Social capital: Relationships maintained with other organizations and stakeholder groups.
IR encourages businesses to provide performance information pertaining to all of these types of capital,
which entails gathering more data in this regard through the effective use of information systems.
Among the guiding principles of IR established by the IIRC are:





Strategic focus and future orientation of reporting
Connectivity of various factors influencing value creation
Performance in relation to all key stakeholder relationships
Disclosure of information relevant to the creation of value in the short, medium, and long term
Reliability and completeness of information Report conciseness
60
Ethics and corporate governance
You might have to briefly recommend an ethical framework to the directors around running the company,
including good corporate governance.
All senior financial staff would be required to sign up for and follow an ethical financial policy framework.
A typical code would address issues such as:





Acting in accordance with the ACCA principles.
Disclosing any potential conflicts of interest to the appropriate company member as soon as
possible; ensuring full, fair, accurate, complete, objective, timely, and understandable disclosure
in all reports and documents that the company files and ensuring all company financial practises
concerning accounting, internal accounting, and auditing.
Adhering to all internal policies, as well as all external rules and regulations.
Using and controlling assets and other resources responsibly.
Promoting ethical behaviour among subordinates and peers, as well as fostering an environment
of ongoing education and the exchange of best practises.
The fundamental principles of code of ethics are:
Integrity
Objectivity
Professional
competance
and due care
Confidentiality
Professional
behaviour
1. Integrity – Members shall be straightforward and honest in all professional and business relationships. The
ACCA rulebook goes on to state that integrity implies not merely honesty, but fair dealing and truthfulness.
2. Objectivity – Members shall not allow bias, conflicts of interest or the undue influence of others to
compromise their professional or business judgement.
3. Professional competence and due care – Members have a continuing duty to maintain professional
knowledge and skill at a level required to ensure that clients or employers receive competent professional
service.
61
4. Confidentiality – Members shall respect the confidentiality of information acquired as a result of professional
and business relationships, and shall not disclose any such information to third parties without proper and
specific authority or unless there is a legal or professional right or duty to disclose. Similarly, confidential
information acquired as a result of professional and business relationships shall not be used to the personal
advantage of members or third parties.
5. Professional behavior – Members shall comply with relevant laws and regulations and shall avoid any action
that may discredit the profession. The ACCA Rulebook goes further, and states that members shall behave
with courtesy and consideration towards all with whom they come into contact in a professional capacity.
Once a framework has been developed, it is critical that all decisions adhere to it, this will entail:





All employees explicitly signing up to the framework.
Providing employees with guidelines to apply to ethical decisions.
Providing resources for consultation in ethical quandaries.
Ensuring unethical behaviour can be reported without repercussions.
Taking disciplinary action where violations occur.
62
Chapter 2: Investment Appraisal
63
Introduction
This chapter dives deeper into the topic with methods of investment appraisal that are slightly more
advanced than what was learnt in F7. However, apart from the sums being more complex, you will have
to use professional judgements to comment on certain aspects of the investment project. Thus, bear in
mind that you will have to not only explain the manner in which the NPV is arrived at, but also the various
assumptions used to get to that figure and the reason for choosing that particular method of investment
appraisal. So, pay attention to the concept behind each technique, and you will score marks.
Free cash flows
Cash that is not retained and reinvested in the business is called free cash flow (FCF). It represents all the
cash flow available to all providers of capital. This approach is considered ideal for valuation as it is not
based on profits but on actual cash flows. Cash available after expenditure and investment in the business
is represented by free cash flows. FCF can be used for a variety of purposes, like;




Investment evaluation. (Investment appraisal)
Assessing a company’s worth (Business valuation)
Performance evaluation and management (Performance Management)
Policy formulation for dividends
FCF is typically calculated using the incremental cash flow approach, in which all the cash flows generated
by a project are calculated on a yearly basis and then used for evaluation.
FCF is the money a company has left over after paying its operating expenses and capital expenditures. It
is the money that remains after paying for items such as payroll, rent, and taxes, and a company can use
it as it pleases.
Revenue
Costs
Investment
Free Cash
Flows
(FCF)
FCF only include relevant cash flows, thus we could say that they are basically net relevant cash flows.
The adjusted accounting profit is a different approach that is rarely used, in which we start with cash flows
and add back all non-cash items and expenses. Make the necessary adjustments, including deductions, to
arrive at the free cash flows for any additional investments and debt repayment.
64
Investment Appraisal methods
Investment Appraisal
NPV
IRR
MIRR
Discounted
payback
period
Macaulay
duration
1. Net Present Value (NPV): This is basically calculated by discounting all the relevant cash flows with a
relevant discount factor (which is usually the company’s WACC), to get the present value of the
project’s future and present cash flows and then taking the sum of them.
2. Internal rate of return (IRR): This essentially tell us the maximum returns a project can generate.
3. Modified internal rate of return (MIRR): IRR suffers from several limitations thus, MIRR is a better
version of MIRR.
4. Discounted payback: Represents the amount of time it takes to recover the initial investment based
on discounted cash flows.
5. Macaulay duration: Represents the average time taken to recover the sum of the present values of
the project.
Net Present Value (NPV)
NPV in AFM is basically the same as studied in F9, however, pay closer attention to the advantages,
disadvantages and assumptions as they will come as they could be asked as a theory question. Thus, this
is just revision conceptually.
Computation: Net present value is calculated by discounting all future cash flows related to a project to
present terms and adding up the present values. For the purpose of calculating the average return
required by investors, the cost of capital is discounted.
Decision rule: If the NPV is positive, the project must be accepted because it provides more return
than is required by investors. If the NPV is negative, it should be rejected.
65
Relevant Cash flows
Only cash flows that occur or get affected purely due to the investment appraisal decision will be deemed
as a relevant cash flow. Therefore, any future incremental cash flows arising due to the investment
decision are said to be relevant cash flows.
Listed below are some of the irrelevant cash flows that must be excluded from the NPV computation.
Sunk Cost
Interest Cost
Costs that are already incurred before the project/ Costs that occur irrespective of the
investment decision. For example, research expenditure is spent on getting data for the project.
Interest and finance costs are to be excluded as they are already included in the WACC.
(Discount rate)
Dividend Payment/ This too is included in the discount rate. (Cost of equity is indirectly dividend payment)
Share repurchases
Non-Cash items
For example, depreciation, unrealized gain or losses, deferred income/expenses, provisions and
impairments
Apportioned/Existing Do not mistake this for project specific fixed costs as those are a relevant cash flow, apportioned
Fixed cost
fixed costs are head office costs etc.
66
Time Value of Money
Although previously studied at the applied Skills level, it is essential that you critically revise this concept.
Discounting is the process of converting a future cash flow into present terms. It is the inverse of
compounding. To determine the present value of a single cash flow, do the following:
Present value
Present value = Future cash flow/(1+r)n
The faster method is to use the present value discount factor table, which is given to you in the exam.
Note: 1/(1+r)n is known as the PV factor or the discount factor, and it can be obtained from the
discount table.
Illustration 1
Calculate the present value of $1331 to be received 3 years from now at a discount rate of 10%p.a.?
Solution
Present value = 1331 x 0.7513 (Present value table discount factor for 3 years at 10%)
= $1000
Annuity
An annuity is a constant annual cash flow. Thus, the present value of the annuity is the present value of a
constant cash flow occurring for a certain number of years.
Present vale (PV of annuity) = Constant cash flow x Annuity Factor (AF)
Note: Just like the present value table, the annuity factor can be found in the annuity table
Illustration 2
Calculate the present value of $1000 to be received for 5 years starting from the end of year 1 at a discount
of 10%p.a.?
Solution
Present value annuity = $1000 x 3.7908
= $3790.8
67
Perpetuity
A perpetuity is a cash flow that goes on for eternity. However, due to the time value of money, we get an
absolute value. It is calculated by dividing the cash flow by the discount factor.
In AFM, delayed perpetuity is what we will be paying more attention as this concept is applied frequently
throughout the entire syllabus. It is the same as perpetuity except for the fact that the cash flows start
after Year 1.
Present value of a perpetuity = [Constant annual cash flow (1+g)] / (r-g)
Present value of a delayed perpetuity = [Constant annual cash flow (1+g)] x discount factor / (r-g)
Illustration 3
Calculate the present value of $1000 to be received in perpetuity starting from the end of year 1 and
growing at 2%p.a using a discount rate of 10% p.a.?
Solution:
Present value of perpetuity = [1000 x (1+0.02)] / (0.1-0.02)
Present value = $12,750
Illustration 4
Calculate the present value of $1000 to be received in perpetuity starting from the end of year 5 and
growing at 2% p.a. using a rate of 10% p.a.?
Solution:
Present value of delayed perpetuity = [1000 x (1.02) x 0.683] / (0.1-0.02)
= $8708.25
68
Inflation in Investment Appraisal
Inflation is common in investment appraisal questions and will most likely come as a section A question.
Investment appraisal questions can be solved using either the real method and the money method.

Real Method: No cash flows are inflated, nor is the discount rate, thus the rate used must be the
real cost of capital.

Money/Nominal method: All the cash flows, including the discount rate must be inflated
according to the inflation rate given, thus you need to be using the money rate of capital.
The general rule of thumb is to use the real method when there is just a single inflation rate given to you
in the question. However, the money method must be used when there are multiple inflation rates for
specific cash flows given.
The reason for this is because if only a single inflation rate is applied to all cash flows, they will be cancelled
out either way, as the same inflation rate would have to be applied to the cost of capital. Thus, we use
the real method when there is just a single inflation rate given to you.
The relation between the money and the real cost of capital is given below, and this formula is given to
you in the exam.
(1+i) = (1+r) (1+h)
Where, I = Money or nominal cost of capital
r = Real cost of capital
h = Inflation
Nominal
The currency monetary value
Real
Takes into account the effect of inflation
Presents the current headline monetary figure
Provides a guide to actual purchasing power and the
opportunity cost of workers
69
Tax impact on investment appraisal
The key concept to remember for taxation is that tax is levied only on profits, not on cash flows. Tax
payable is a relevant cash flow and is deducted from the investment appraisal process. The below
proforma is designed specifically to assist you to compute the tax.
Working note for tax
Operating cash flows
Less: Tax allowable depreciation (This is just a deduction to tax given by the govt. and not an actual
cash flow, thus it does not form a part of the main proforma)
XX
(XX)
Taxable profit
Tax charged (Taxable profit x Tax rate)
XX
XX
The tax charged will be deducted from the year in which the profit arises unless mentioned otherwise.
This ‘otherwise’ is going to occur more frequently than not as the examiner could ask you to charge tax in
a variety of ways.
Tax could be charged in arrears which basically means one year after the profit arises. At times if there is
a loss, you could be asked to first deduct any previous year losses and then charge tax. In that case, you
will need to deduct any previous year’s loss with the taxable profit. Basically, you will be tested in a
number of ways, just pay attention to what the question says.
The examiner’s normal assumption is that an asset is bought at the start of the first year of the project
and, hence, the first TAD is available for Year 1.
The allowance and tax saving for Year 1 will be calculated at the end of Year 1, which is T1, and as tax is
paid one year in arrears, the timing of the cash flow will be one year later, which is T2.
Rounding is a key technique in your exam as it saves time and by keeping the numbers simple, fewer
mistakes will be made. Here it has been decided to round in thousands and use one decimal place.
Students must ensure that they can calculate tax savings using different tax regimes. For instance, the
next problem you face may have tax allowances granted on a straight-line basis and the tax could be
payable immediately at each year end.
70
Working capital computation
Working capital is a recoverable investment in inventory, receivables etc. It is invested at the start of the
project; with incremental additions every year (if given in question) and all the working capital cash
outflows are finally recovered by the end of the project’s life.
For example, if a project requires a working capital at 10% of sales at the start of every year for a threeyear project starting in Jan 2013 with sales (all values in $000) of 300, 400 and 500 respectively, then the
working capital cash flow would be arrived at as follows:
Working note
Year
Working capital (10% of sales)
WC investment required
0
(30)
(30)
1
(40)
(10)
2
(50)
(10)
3
50
The above is a working note, and the WC investment required is the amount that should be taken to the
main proforma.
Main proforma for computing Free cash flows (FCF) also including NPV
The critical part while solving an investment appraisal question is identifying what are the relevant cash
flows that should be considered while computing the NPV. The following proforma will help you tackle
any investment appraisal question.
(The following is an example for a project with a 3-year life)
Year
Operating revenues
Operating costs
Net operating cash flow
Taxation (Working note)
Initial Investment
Scrap Value
Working capital (Working note)
Free cash flows
Discount factor
Present value
NPV = Sum of Present values above
0
1
X
(X)
X
(X)
2
X
(X)
X
(X)
3
X
(X)
X
(X)
(X)
X
X
X
X
X
X
X
X
(X)
(X)
(X)
1
(X)
(X)
X
X
X
71
Just studying the proforma is not enough. You need to understand how it functions, as this is essentially
the proforma used to compute the actual value gained for anything. It looks complicated, but it all boils
down to deducting relevant cash outflows from relevant cash inflows. Thus, it is essential to practice exam
kit questions, as only then will the identification of relevant cash flows come naturally to you.
The question could give you cash flows that do not change and are constant throughout the life of the
project. In that case, it would be time consuming to use the above proforma and would be much faster to
use annuities instead. Thus, the following approach must be used if you are dealing with an annuity. (The
concept is the same as the previous proforma the only difference is that we are using annuities here).
Alternate approach
Year
0
1-3
4
Cash Flow
(X)
X
(X)
Discount factor
1
X (annuity factor)
X (PV discount factor)
PV
(X)
X
(X)
NPV = sum of PVs
Answering theory part of an NPV question
You could be asked for the reasoning behind choosing NPV over other methods of investment appraisal
or for the limitations behind using NPV. The question will be like a real-life case study, and you will have
to frame your points according to the question. You will be given a certain circumstance that the project
is in, thus you will have to expand on the below points and relate whatever you can with the question.
You will be given 1 mark per valid statement.
Advantages of using NPV




It is not based on profits and it is based on cash flows.
It takes into account the time value of money.
It considers the entire life of the project.
It is in line with the primary objective of maximizing shareholder wealth.
Disadvantages of using NPV



It is necessary to have knowledge about the cost of capital.
It can be misleading if trying to compare projects with different lives.
It can be difficult to explain the intricate workings of management without a financial background.
72
Illustration 5
Allegro Technologies Co (ATC), a listed company based in Europe, has been involved in manufacturing
motor vehicle parts for many years. Although not involved in the production of complicated engine
components previously, ATC recently purchased the patent rights for $2m to produce an innovative
energy saving engine component which would cut carbon-based emissions from motor vehicles
substantially.
ATC has spent $5m developing prototypes of the component and undertaking investigative research
studies. The research studies came to the conclusion that the component will have a significant
commercial potential for a period of five years, after which newer components would come into the
market, and the sales revenue from this component would fall to virtually nil. The research studies have
also found that in the first two years (the development phase), there will be considerable training and
development costs and fewer components will be produced and sold. However, sales revenue is expected
to grow rapidly in the following three years (the commercial phase).
It is estimated that in the first year, the selling price would be $1,000 per component, the variable costs
would be $400 per component, and the total direct fixed costs would be $1,500,000. Thereafter, while
the selling price is expected to increase by 8% per year, the variable and fixed costs are expected to
increase by 5% per year for the next four years. Training and development costs are expected to be 120%
of the variable costs in the first year, 40% in the second year and 10% in each of the following three years.
The estimated average number of engine components produced and sold per year is given in Table 1
Year
Units produced and sold
1
7,500
2
20,000
3
50,000
4
60,000
5
95,000
There is considerable uncertainty as to the exact quantity that could be produced and sold and the
estimated standard deviation of units produced and sold is expected to be as much as 30%.
Machinery costing $120,000,000 will need to be installed prior to commencement of the component
production. ATC has enough space in its factory to manufacture the components and therefore will incur
no additional rental costs. Tax allowable depreciation is available on the machinery at 10% straight line
basis. It can be assumed that, depending on the written down value, a balancing adjustment will be made
at the end of the project, when the machinery is expected to be sold for $40,000,000. ATC makes sufficient
profits from its other activities to take advantage of any tax loss relief available from this project.
Initially, ATC will require additional working capital for the project of 20% of the first year’s sales revenue.
Thereafter every $1 increase in sales revenue will require a 10% increase in working capital.
Although this would be a major undertaking for ATC, it is confident that it can raise the finance required
for the machinery and the first year’s working capital. The financing will be through a mixture of a rights
issue and a bank loan, in the same proportion as the market values of its current equity and debt capital.
Any annual increase in working capital after the first year will be financed by internally generated funds.
73
Largo Co, a company based in South-East Asia, has approached ATC with a proposal to produce some of
the parts required for the component at highly competitive rates. In exchange, Largo Co would expect
ATC to sign a five-year contract giving Largo Co the exclusive production rights for the parts.
Staccato Innovations Co (SIC) is a listed company involved in the manufacture of innovative engine
components and engines for many years. As the worldwide demand for energy saving products has
increased, it has successfully developed and sold products designed to reduce carbon emissions. SIC has
offered to buy the production rights of the component and the machinery from ATC for $113,000,000
after the development phase has been completed in two-years’ time.
Solution:
Main working
Year
Sales
Variable cost
Fixed cost
Training and
Development
Free cash flow
before tax
Taxation W1
Scrap
Working
Capital W2
Initial
Investment
Free cash flow
Discount
factor @12%
Present Value
NPV
Comment
(Always has 1
Mark)
Taxation W1
Year
0
-15,00,000
1
75,00,000
-30,00,000
-15,00,000
-36,00,000
2
2,16,00,000
-84,00,000
-15,75,000
-33,60,000
3
5,83,20,000
-2,20,50,000
-16,53,750
-22,05,000
4
7,55,82,720
-2,77,83,000
-17,36,438
-27,78,300
5
12,92,46,451
-4,61,89,238
-18,23,259
-46,18,924
-6,00,000
82,65,000
3,24,11,250
4,32,84,983
7,66,15,031
25,20,000
7,47,000
-40,82,250
-62,56,997
-14,10,000
-36,72,000
-17,26,272
-53,66,373
-89,23,006
4,00,00,000
1,36,74,645
5,10,000
0.893
53,40,000
0.797
2,66,02,728
0.712
3,16,61,613
0.636
12,13,66,670
1
-12,00,00,000
-12,15,00,000
1
-12,15,00,000
4,55,430
42,55,980
1,89,41,142
2,01,36,786
6,88,14,902
-88,95,760
If the NPV of the project is positive, company should go ahead with the project and If the NPV is
negative the company should not go ahead with the project. However, it depends on the risk appetite
of the company
1
2
3
4
5
74
Free Cash flow
before tax
Tax allowed
Depreciation
Balance
Allowance
Taxable Cash
Flow
Tax 20%
-6,00,000
82,65,000
3,24,11,250
4,32,84,983
-1,20,00,000
-1,20,00,000
-1,20,00,000
-1,20,00,000
7,66,15,031
-3,20,00,000
-1,26,00,000
-37,35,000
2,04,11,250
3,12,84,983
4,46,15,031
-25,20,000
Benefit
-7,47,000
40,82,250
Pay Tax
62,56,997
89,23,006
Reference (Not required in Exam)
Investment
Year 1 Dep
WDV - 1
Year 2 Dep
WDV - 2
Year 3 Dep
WDV - 3
Year 4 Dep
WDV - 4
Scrap Value
Balancing allowance or Charge
12,00,00,000
1,20,00,000
10,80,00,000
1,20,00,000
9,60,00,000
1,20,00,000
8,40,00,000
1,20,00,000
7,20,00,000
4,00,00,000
3,20,00,000
Working Capital W2
Year
Working
Capital
Requirement
Incremental Working -15,00,000
Capital Required
1
2
3
4
5
-14,10,000
-36,72,000
-17,26,272
-53,36,373
1,36,74,645
Assesses whether ATC should undertake the project of developing and commercializing the innovative
engine component before taking SIC’s offer into consideration. Show all relevant calculations.
75
Internal Rate of Return (IRR)
This is basically the discount rate at which the NPV will be equal to zero. Thus, IRR is the maximum return
the investors can expect to receive from a certain project. It is a useful indicator for assessing the viability
of an investment project.
Computation: IRR is computed by calculating two NPV’s, both with different discount rates (can be
anything) for a single set of cash flows. Use the figures in the below formula to compute IRR.
Decision rule: If the IRR exceeds the projects relevant cost of capital (discount rate), the project is
financially viable.
𝑵𝑷𝑽𝑳
𝑰𝑹𝑹 = 𝑳 + (𝑵𝑷𝑽
𝑳 − 𝑵𝑷𝑽𝑯
–
–
–
–
) × ( 𝑯 − 𝑳)
L = Lower discount rate
H= Higher discount rate
NPVL= NPV calculated at L
NPVH= NPV calculated at H
Answering theory part of an IRR question
Similar to NPV, you will need to use the below points as a framework for tailor making your answer
according to what the question demands.
Advantages of using IRR as an investment appraisal technique




It takes the time value of money into an account.
It is not based on profit which is open to manipulation but on cash flows.
It considers the whole life of the project.
Simple to interpret and helps managers make a rough estimation of the required rate of return.
76
Limitations of using IRR as an investment appraisal technique
 When there are non-conventional cash flows present in the computation, there could be multiple
IRR’s which renders the evaluation uncertain.
 IRR makes an assumption that interim cash flows are reinvested at the internal rate of return
when in reality, they are most likely to be re-invested at the firm's cost of capital. (MIRR
overcomes this limitation)
 IRR cannot be used to assess mutually exclusive projects and could lead to a conflicting decision
with the NPV.
 If cash inflows are not sufficient to cover the initial investment calculation of IRR is not possible
Illustration 6
If a project has an NPV of $20m at a discount rate of 10% and $ (4m) at 20% calculate the IRR?
Solution:
IRR = (0.1 + (20 x (0.2-0.1)))/(20+4)
IRR = 18.3%
Note: Calculations are performed according to how they would be on excel and it is important you start
practicing there
77
Modified Internal Rate of Return
Modified internal rate of return is a metric used to solve the shortcomings of IRR, such as multiple IR’'s
and impractical reinvestment assumptions.
The MIRR can be equated to the return on investment of a project when compared to the cost of capital
to determine whether to undertake the project.
𝟏
𝑴𝑰𝑹𝑹 = {(𝑷𝑽𝒓)𝒏 𝒙 (𝟏 + 𝒓𝒆 )} − 𝟏
𝑷𝑽𝒊)
Where,
– PVr = Sum of the present value of all the cash inflows
– PVi = Present value of the investment phase of the project.
– re = Required rate of return (firms cost of capital)
– n = Life of project in years
Decision rule: If MIRR > Cost of capital than the project is financially viable.
Answering the theory part of an MIRR question
You are more likely to get MIRR in the exam rather than IRR and it is critical that you understand why
MIRR is more ideal than IRR and where it is best suited for investment appraisal.
Advantages of using MIRR in investment appraisal
MIRR shares all the advantages of MIRR given above. Most importantly, MIRR overcomes the unrealistic
assumption of interim cash flows being re-invested at IRR. Thus, MIRR computes a more accurate estimate
than IRR.
Disadvantages of using MIRR in investment appraisal



MIRR is more complicated to compute than IRR.
It is necessary to distinguish the investment phase and return phases to calculate their present
values.
The assumption that cash is reinvested at the cost of capital could also be misleading as the
deposit rate would be more ideal.
78
Use MIRR Spreadsheet function in CBE to save time.
👩🏫 Illustration 7
A project that has the following free cash flows is under assessment:
Year
Free
flows
0
cash (40000)
1
16000
2
24000
3
8000
4
4000
Cost of capital is 8%
Calculate the MIRR and comment on the project’s financial viability.
Solution:
Year
Free cash flows
0
(40000)
1
16000
2
24000
3
8000
4
4000
Discount factor
Present value
1
(40000)
0.9259
14814.4
0.87573
20575
0.7938
6350.4
0.7350
2940
PVr = (14814.4+20575+6350.4+2940)
= 44680
pVi = (40000)
Re = 8%
N=4
MIRR = [(PVr/pVi)1/n x (1+re)] – 1
= [(44680/40000)1/4 x (1+0.08)] – 1
MIRR = 11%
79
Illustration 8
Tisa Co is considering an opportunity to produce an innovative component which, when fitted into motor
vehicle engines, will enable them to subsidize fuel more efficiently. The component can be manufactured
using either process Omega or process Zeta. Although this is an entirely new line of business for Tisa Co,
it is of the opinion that developing either process over a period of four years and then selling the
productions rights at the end of four years to another company may prove lucrative. The annual after‐tax
cash flows for each process are as follows:
Process Omega:
Year
After-tax cash flows
0
(3800)
1
1220
2
1153
3
1386
4
3829
1
643
2
546
3
1055
4
5990
Process Zeta:
Year
After-tax cash flows
0
(3800)
Assume the relevant cost of capital for both processes to be 13%
Requirement:
Calculate the net present value (NPV), the internal rate of return (IRR) and the modified internal rate of
return (MIRR) for Process Omega. Given that the NPV, IRR and MIRR of Process Zeta are $1.64 million,
26.6% and 23.3% respectively, recommend which process, if any, Tisa Co should proceed with and explain
your recommendation.
Solution:
Consider the cost of capital as 13%
For process omega


We need to Calculate IRR
Calculate the NPV as per Discount Factor
80
Year
After Tax Cash
Flow
Discount Factor
@ 13%
PV
NPV @ 13%
0
-3800
1
1220
2
1153
3
1386
4
3829
1
0.885
0.783
0.693
0.613
-3800
1490.174
1079.7
902.799
960.498 2347.17
Year
After Tax Cash
Flow
Discount Factor
@ 20%
PV
NPV @ 20%
0
-3800
1
1220
2
1153
3
1386
4
3829
1
0.833
0.694
0.579
0.482
-3800
664.514
1016.26
800.182
802.494
1845.58
1
1220
2
1153
3
1386
4
3829
0.76923
0.59172
0.45517
0.35013
938.462
682.249
630.86
1340.64
3
4
IRR
L+(NPVL/(NPVL(NPVH)))*(H-L)
13%+(1490/1490664)*(20% -13%)
25.63%
Year
0
After Tax Cash -3800
Flow
Discount Factor 1
@ 20%
PV
-3800
NPV @ 20%
-207.7903435
IRR
L+(NPVL/(NPVL(NPVH)))*(H-L)
13%+(1490/1490-(207)*(30% -13%)
27.92%
MIRR
Year
Investment Phase
0
Returns phase
1
2
81
After Tax Cash -3800
Flow
Discount Factor 1
@ 13%
PV
-3800
3800
MIRR
IRR
MIRR
1220
1153
1386
3829
0.885
0.783
0.693
0.613
1079.7
5290.17
902.799
960.498
2347.17
(PVr/Pvi)^(1/n)*(1+r)-1
(5290/3800)^(1/4)*(1+13%)
-1
22.74%
Omega
27.92%
22.74%
Zeta
26.60%
23.30%
Comments on IRR_And also mention demerits
of IRR


Based on First NPV, calculate the second NPV on assumed DF (Basis of assumption Explained)
Using the Formula Calculate the IRR
Payback and discounted payback period
Payback period measures the time taken to recover the initial investment. It is more viable to be used as
a technique to assess the liquidity of a project. As, shorter the payback period, the more liquid and less
risky will the investment be.
Payback is rarely used it suffers from a huge limitation of not considering the time value of money.
Discounted payback is similar to the payback period except for the fact that it discounts the cash flows to
get a more accurate estimate. Thus it overcomes the limitation of the payback period.
Decision rule: If the project meets the payback period target, the project should be accepted.
However, while comparing two projects, the project with the shorter payback period should be chosen.
82
Illustration 9
The following are the free cash flows of company BDAA plc that has a cost of capital of 10%:
Year
Free cash flows
0
(2100)
1
400
2
500
3
1000
4
500
5
200
Solution:
Year
0 (current year)
1
2
3
4
5
Cash flows
(1700)
400
500
1000
500
200
Discount factor
1
0.909
0.826
0.751
0.683
0.621
Present value
(1700)
364
413
751
342
124
Cumulative cash flows
(1700)
(1336)
(923)
(172)
0 [170/342]
Thus, the discounted payback period is 3.5 years
Macaulay duration
This is a slightly more advanced method of investment appraisal as compared to payback and discounted
payback and is more likely to be asked in the exam.
Macaulay duration will help you compute the present value of the project if the cash flows are discounted
using the cost of capital. However, if the cash flows are discounted using the IRR, Macaulay duration will
compute the average time it takes to recover the initial investment of the project.
After understanding how it is computed, you will see that Macaulay duration is nothing but the weighted
average time until cash flows are received. The weightage is given according to the year in which the cash
flows arise.
Macaulay duration is an important indicator as it is frequently used in practice, especially while assessing
the price sensitivity of bonds which we will see later on in the syllabus.
Macaulay duration takes the time value of money and the entire length of the project into consideration.
Thus, it is more advantageous to use than discounted payback as that does not consider cash flows after
the initial investment is recovered.
83
Steps for Computation:
1. The annual return phase FCF are discounted at the suitable discount rate to get the present value.
2. The present values are multiplied by the year i.e., 1 in the first year, 2 in the second year and so on.
The (PV x Year) values are added up.
3. The sum of (PV x year) values are computed as above and then divided by the sum of the PV of the
return phase cash flows.
Macaulay Duration =
∑(𝐏𝐕 𝐱 𝐘𝐞𝐚𝐫)
∑𝐏𝐕
Decision rule: If the project meets the duration target, the project should be accepted. However, while
comparing two projects, the project with the shorter duration should be chosen.
Answering theory a question for duration
In addition to all of the points given in each of the above (payback, discounted payback and Macaulay
duration) investment appraisal methods, you will have to state how exactly does assessing each of these
durations help with investment appraisal.
The main area that all three of these methods will assist you is in evaluating the liquidity hence the risk of
a project. As a shorter duration will indicate that the company will recover its investment quickly, thus
reducing the element of uncertainty. Although NPV and MIRR are the main methods to be used, if
management would like to include the element of liquidity and risk as a factor into evaluating an
investment project, then duration measures can be used.
Illustration 10
Assuming a project has the following cash flows calculate the Macaulay duration if the cost of capital is
10%
Year
Free
flows
0
cash ($20,000)
1
$8,000
2
$12,000
3
$4,000
84
Solution:
Year
Free cash flows
0
($20,000)
1
$8,000
2
$12,000
3
$4,000
Discount factor
Present value
1
20000
0.909
7272
0.826
9912
0.751
3004
∑ (PV x Year) = (7272*1)+(9912*2)+(3004*3)
∑ PV = 20188
Macaulay duration = ∑ (PV x Year) / ∑ PV
= 36108/20188
= 1.79 years
= 36108
85
Foreign Investment appraisal and NPV
This is used when a firm would like to estimate the NPV of a project set up (by its subsidiary for most of
the time) in a foreign country. The computation is conceptually the same as a regular NPV question, just
with a few tweaks.
A concept you should be aware of before diving into the computation is that ‘Management fees’ is
essentially a royalty that is paid by the subsidiary to the parent company. Thus, it is an income to the
parent while it is an expense to the subsidiary company.
Use the following steps to compute the NPV for any foreign investment appraisal question:
PART 1 (Foreign Currency)
Step 1: Estimate the projects cash flows in the foreign country and charge tax at the applicable rate.
Step 2: Convert the foreign currency post-tax cash flow into home currency using the estimated exchange
rates (Either using IRPT or PPPT).
PART 2 (Home currency)
Step 3: Add any parent/home firm cash flows relating to this project like royalties, management fees and
charge tax on these in addition to any top up tax (explained below) on foreign cash flows.
Step 4: Discount the next cash flows at the firm’s cost of capital and calculate the NPV.
After performing the aforementioned steps, you will successfully have computed an accurate net present
value generated from conducting an investment appraisal in a foreign country in home currency terms.
86
Illustration 11
Let us imagine you work for a US company that wants to set up a telecommunication company in India.
The project costs INR 6 billion to set up. A local business conglomerate has agreed to buy the business for
INR 10 billion in 5 years. In the meanwhile, the project will generate cash inflows of INR 2 billion in the
first year, thereby growing at 10% per annum. Variable cash outflows are 30% of the cash inflows and
fixed costs are INR 200 million per annum. Initial investment of INR 6 billion is required, including INR 1
billion working capital. The difference is depreciable based on the 5-year straight-line method. Corporate
tax rate is 33% and a 10% tax rate applies to any dividends paid.
The following schedule shows cash flows of the project for five years:
Year
1
2
3
4
5
Cash inflows
CI
2,000
2,200
2,420
2,662
2,928
Less: variable cash outflows
VC
600
660
726
799
878
Less: fixed cash outflows
FC
200
200
200
200
200
Less: depreciation
D
1000
1000
1000
1000
1000
200
340
494
663
850
Cash flows before corporate tax
Less: corporate tax
Tc
66
112
163
219
280
Add: depreciation
D
1,000
1,000
1,000
1,000
1,000
1,134
1,228
1,331
1,444
1,569
113
123
133
144
157
1,021
1,105
1,198
1,300
1,412
After-tax corporate tax flows
Less: dividend tax
Net free cash flows
Td
Now, that we have determined the project cash flows in foreign currency, we need to work out the
relevant net present value. There are two approaches: (a) home currency approach and (b) foreign
currency approach.
Answer:
Home Currency Approach
In the home currency approach, the net present value of a foreign project is determined by (a) converting
the foreign-currency cash flows of the project to the domestic currency based on the expected forward
exchange rates, and (b) discounting the cash flows based on the domestic currency cost of capital.
In the above example, the INR cash flows will be converted to USD based on the forward exchange rate
forecasted based on either relative purchasing power parity or relative interest rate parity. USD equivalent
cash flows can be discounted using USD cost of capital.
87
Forward exchange rates can be determined based on the difference in interest rates between the
domestic currency:
𝑭𝒕 = 𝑺𝟎 𝒙
𝟏 + 𝒓𝒅
𝟏 + 𝒓𝒅
Where Fi and S0 are the forward exchange rate t years in future and spot exchange rate time 0 respectively
expressed as the domestic currency per unit of foreign currency (i.e. USD per INR in this case), r d is the
nominal interest rate in domestic currency i.e. USD and rf is the nominal interest rate in foreign currency
i.e. INR
If the current USD/INR exchange rate is 0.0086 and the expected interest rate for INR and USD are 6% and
4% respectively, we can work out the following forward rates and convert the cash flows to USD:
Net repatriable cash flows
Forward exchange rate
Net free cash flows in USD
C
f
C×f
1,021
0.0084
$8.61
1,105
0.0083
$9.15
1,198
0.0081
$9.73
1,300
0.0080
$10.36
1,412
0.0078
$11.04
The initial investment of INR 6 billion equals USD 51.60 million. The terminal value of the project is INR 9
billion (=INR 10 billion multiplied by (1 – dividend tax rate of 10%)). It equals USD 70.37 million (=INR 9
billion multiplied by a 5-year forward rate of 0.0095).
Under the home currency approach, you will discount the cash flows based on the USD cost of
capital which is 10%. You can adjust the discount rate up by 5%, reflecting the additional risk.
Discounting the cash flows at 15%, the project NPV works out to $15.60 million:
Year
Net repatriable cash flows in USD
Add: Terminal cash flows
Initial investment
Total cash flows
Discount factor at 15%
Present value of cash flows
Net present value (USD)
0
(51.60)
(51.60)
1.0000
(51.60)
15.60
1
$8.61
2
$9.15
3
$9.73
4
$10.36
5
$11.04
$70.37
8.61
0.8696
7.49
9.15
0.7561
6.92
9.73
0.6575
6.40
10.36
0.5718
5.92
81.41
0.4972
40.48
Foreign Currency Approach
In the foreign-currency approach, the foreign-currency cash flows are discounted based on the implied
cost of capital that would apply to the foreign currency to arrive at the foreign-currency NPV.
The NPV denominated in foreign currency (INR) is then converted to domestic currency (USD) using
the spot exchange rate.
88
Net present value under this second approach should be equal to the NPV under the first approach i.e.
domestic currency approach.
The implied cost of capital roughly equals the domestic currency cost of capital adjusted for the
differences in inflation rates, i.e. 15%, plus the nominal interest rate difference of 2%, i.e. 17.3%.
Year
Net repatriable cash flows
in USD
Add: terminal cash flows
Initial investment
Total cash flows
Discount factor at 17%
Present value of cash
flows
Net present value (INR)
Spot exchange rate
Net present value (USD)
0
1
1,021
2
1,105
3
1,198
4
1,300
5
1,412
9,000
(6,000)
(6,000)
1.0000
(6,000)
1,021
0.8525
870
1,105
0.7268
803
1,198
0.6196
742
1,300
0.5282
687
10,412
0.4503
4,689
1,790.86
0.0086
15.40
Please note that the net present value under both approaches is (almost) the same. The difference is
attributable to rounding error.
Predicting exchange rates
Exchange rates can be predicted either using the (PPPT) purchasing power parity theory or the (IRPT)
interest rate parity theory and are given as follows (given in formula sheet).
𝑺𝟏 = 𝑺𝟎 𝒙
𝟏 + 𝒉𝒄
𝟏 + 𝒉𝒃
𝑭𝟎 = 𝑺𝟎 𝒙
𝟏 + 𝒊𝒄
𝟏 + 𝒊𝒃
Where, S1 or F0 = Depict the future spot rate or forward rate
S0 = Spot rate
Hb = Base (home) currency rate
Hc = Counter (foreign) currency inflation
ib = base (home) currency interest
ic = Counter (foreign) currency interest
The above was explained in depth in the F9 syllabus. The exchange rates calculated can be used to further
convert the foreign currency cash flows into home currency cash flows.
89
Top up tax
When cash flows arising in the foreign country are being brought back to the home country, it would be
an income to the company in the home country, and tax is payable on that, however, the tax would also
have been levied on its subsidiary on operating profits that arose in the foreign country. Thus, this would
lead to the tax being charged twice for the same cash flows. Hence certain countries have tax agreements
to solve this issue.
‘Top up tax’ is a concept that resolves this issue of double tax being levied.
If the tax rate in the home country is more than the foreign country, then top up tax is applicable. The
way it works is, for example the home country tax rate is 35%, and the foreign tax rate is 30%, tax of 30%
will first be charged on operational profits arising in the foreign country, but the additional tax of only 5%
will be charged on the foreign currency profits, once brought back to the home country (Step 3).
India has Double Taxation Avoidance Agreement (DTAA) with 88 countries, but presently 85 has been in
force. The DTAA treaty has been signed in order to avoid double taxation on the same declared asset in
two different countries.
90
Tax effects in foreign NPV
As in domestic NPV questions, tax is charged on operating profits and shown as an outflow even in foreign
NPV, however there may be few additional points to bear in mind.



Top-up domestic tax on foreign taxable profit may be chargeable after conversion of cash flows
into home currency. This is only applicable if the tax rate in the home country is more than the
foreign country besides, it will be mentioned in the question.
For management fees, royalties are charged to the foreign investment by the parent company,
they are treated as a regular, relevant cash outflow in the computation. However, they will need
to be added back as a cash inflow in the home currency in Part 2. And income is tax chargeable
thus, to make up for no tax being charged on it in Part 1 (because treated as outflow), you will
have to charge tax at the domestic tax rate only on the management fee and treat the tax as a
cash outflow in Part 2.
If the question states that losses in a particular year are carried forward to the next year for tax
purposes, then the losses will be written off against the next year profits for the purpose of
calculating tax. No tax will be payable or no refunds will be due in the first year, but in the next
year, when the company makes profits, these losses can be reduced to arrive at the profits subject
to tax.
Illustration 12
Hogwarts Co is a Europe based company. It is considering a 3-year project in India. The project will require
an initial investment of 81m Indian Rupees (Rs) and will have a residual value of 10m Rs.
The project's pre-tax net Rs inflows are expected to be:
Year 1
Year 2
Year 3
35m
80m
50m
The European parent company will charge the overseas project with £2m of management charges each
year.
The current spot rate is 5 Rs - £1. EU inflation is expected to be 4% per annum, and Indian inflation is
expected to be 7% per annum.
The Indian tax is 20% which must be paid promptly. For tax purposes, all deficits are taken over and
deducted from the first available income. Depreciation will be given on a straight-line basis, and any
residual value will be taxed at 20%. The European Union levy is 30% which is due one year in advance.
Hogwarts Co recently undertook a similar risk project in the EU and used 11% as a suitable discount rate.
Calculate the NPV of the project in £
91
Solution:
Home currency
Home currency
Home currency
Home currency
In millions'
Year
Pre-tax Cash Flows
Management fees
(2m x forex rate)
Pre-tax net cash
flows
initial investment
Scrap
Tax (working capital
2)
Net cash flows in
India
Net cash flow in EU
(Converted)
Management
Income
Tax
on
management
income @30%
Top up tax @ 10%
Free cash flows
DF
PV
Home currency
NPV
Foreign Currency
Foreign Currency
Foreign Currency
Foreign Currency
Foreign Currency
Foreign Currency
Foreign Currency
Home currency
Home currency
Home currency
0
1
35
-10.288
2
80
-10.58
3
50
-10.88
4
24.712
69.42
39.12
0
-8.0264
10
-4.424
-81
24.712
61.3936
44.696
-16.2
4.80404
11.6056
8.21618
2
2
2
0.6
0.6
0.6
13.0056
0.812
10.56055
0.75864
8.85754
0.731
6.47486
0.40662
-1.0066
0.659
0.66335
-81
-16.2
1
-16.20000
6.30249
Forex rate (working note 1)
Rs/ £
Spot rate
Year 1:
Year 2:
Year 3:
5
5.14
5.29
5.45
6.80404
0.901
6.13044
92
Tax (working note 1)
For Part 1
Year
Operating CF
TAD
Taxable cash flow
Loss carried forward
Taxable cash flow
Tax @20%
For Part 2
Taxable cf in Eu (just conversion to the home currency
0
1
24.712
27
-2.288
0
Top up Tax
2
69.42
27
42.42
-2.288
40.132
8.0264
3
39.12
17
22.12
7.58639
4.06618
0.75864
0.40662
22.12
4.424
Illustration 13
Yilandwe, whose currency is the Yilandwe Rand (YR), has faced extremely difficult economic challenges in
the past 25 years because of some questionable economic policies and political decisions made by its
previous governments. Although Yilandwe’s population is generally poor, its people are nevertheless well‐
educated and ambitious. Just over three years ago, a new government took office and since then, it has
imposed a number of strict monetary and fiscal controls, including an annual corporation tax rate of 40%,
in an attempt to bring Yilandwe out of its difficulties. As a result, the annual rate of inflation has fallen
rapidly from a high of 65% to its current level of 33%. These strict monetary and fiscal controls have made
Yilandwe’s government popular in the larger cities and towns but less popular in the rural areas, which
seem to have suffered disproportionately from the strict monetary and fiscal controls
It is expected that Yilandwe’s annual inflation rate will continue to fall in the coming few years as follows:
Year
Inflation rate
1
2
3 onwards
22%
14.7%
9.8%
93
Yilandwe’s government has decided to continue the progress made so far by encouraging foreign direct
investment into the country. Recently, government representatives held trade shows internationally and
offered businesses a number of concessions, including:
(i)
(ii)
zero corporation tax payable in the first two years of operation; and
an opportunity to carry forward tax losses and write them off against future profits made
after the first two years.
The government representatives also promised international companies investing in Yilandwe prime
locations in towns and cities with good transport links.
Imoni Co
Imoni Co, a large listed company based in the USA with the US dollar ($) as its currency, manufactures
high tech diagnostic components for machinery, which it exports worldwide. After attending one of the
trade shows, Imoni Co is considering setting up an assembly plant in Yilandwe where parts would be sent
and assembled into a specific type of component, which is currently being assembled in the USA. Once
assembled, the component will be exported directly to companies based in the European Union (EU).
These exports will be invoiced in Euro (€).
Assembly plant in Yilandwe: financial and other data projections
It is initially assumed that the project will last for four years. The four‐year project will require investments
of YR21,000 million for land and buildings, YR18,000 million for machinery and YR9,600 million for working
capital to be made immediately. The working capital will need to be increased annually at the start of each
of the next three years by Yilandwe’s inflation rate, and it is assumed that this will be released at the end
of the project’s life.
It can be assumed that the assembly plant can be built very quickly, and production started almost
immediately. This is because the basic facilities and infrastructure are already in place as the plant will be
built on the premises and grounds of a school. The school is ideally located near the main highway and
railway lines. As a result, the school will close, and the children currently studying there will be relocated
to other schools in the city. The government has kindly agreed to provide free buses to take the children
to these schools for a period of six months to give parents time to arrange appropriate transport in the
future for their children.
94
The current selling price of each component is €700, and this price is likely to increase by the average EU
rate of inflation from year 1 onwards. The number of components expected to be sold every year is as
follows:
Year
Sales component units (000s)
1
150
2
480
3
730
4
360
The parts needed to assemble into the components in Yilandwe will be sent from the USA by Imoni Co at
the cost of $200 per component unit, from which Imoni Co would currently earn a pre‐tax contribution of
$40 for each component unit. However, Imoni Co feels that it can negotiate with Yilandwe’s government
and increase the transfer price to $280 per component unit. The variable costs related to assembling the
components in Yilandwe are currently YR15,960 per component unit. The current annual fixed costs of
the assembly plant are YR4,600 million. All these costs, wherever incurred, are expected to increase by
that country’s annual inflation every year from year 1 onwards.
Imoni Co pays corporation tax on profits at an annual rate of 20% in the USA. The tax in both the USA and
Yilandwe is payable in the year that the tax liability arises. A bilateral tax treaty exists between Yilandwe
and the USA. Tax allowable depreciation is available at 25% per year on the machinery on a straight‐line
basis.
Imoni Co will expect annual royalties from the assembly plant to be made every year. The normal annual
royalty fee is currently $20 million, but Imoni Co feels that it can negotiate this with Yilandwe’s
government and increase the royalty fee by 80%. Once agreed, this fee will not be subject to any
inflationary increase in the project’s four‐year period.
If Imoni Co does decide to invest in an assembly plant in Yilandwe, its exports from the USA to the EU will
fall and it will incur redundancy costs. As a result, Imoni Co’s after‐tax cash flows will reduce by the
following amounts:
Year
Redundancy and lost contribution
1
20,000
2
55,697
3
57,368
4
59,089
Imoni Co normally uses its cost of capital of 9% to assess new projects. However, the finance director
suggests that Imoni Co should use a project specific discount rate of 12% instead.
Other financial information
Current spot rates
Euro per Dollar
YR per Euro
YR per Dollar
€0.714/$1
YR142/€1
YR101.4/$1
95
Forecast future rates based on expected inflation rate differentials
Year
YR/$1
Year
YR/€1
1
120.1
1
165.0
2
133.7
2
180.2
3
142.5
3
190.2
4
151.3
4
200.8
Expected inflation rates
EU expected inflation rate: Next two years
Eu expected inflation rate: Year 3 onwards
USA expected inflation rate: Year 1 onwards
5%
4%
3%
Required:
(a) Discuss the possible benefits and drawbacks to Imoni Co of setting up its own assembly plant in
Yilandwe, compared to licensing a company based in Yilandwe to undertake the assembly on its
behalf. (5 marks)
(b) Prepare a report which:
 Evaluates the financial acceptability of the investment in the assembly plant in Yilandwe (21
marks)
 Discusses the assumptions made in producing the estimates, and the other risks and issues
which Imoni Co should consider before making the final decision; (17 marks)
 Provides a reasoned recommendation on whether or not Imoni Co should invest in the
assembly plant in Yilandwe. (3 marks)
Professional marks will be awarded in part (b) for the format, structure and presentation of the report.
Solution:
(a) Benefits of own investment as opposed to licensing
Imoni Co may be able to benefit from setting up its own plant as opposed to licensing in a number of ways.
Yilandwe wants to attract foreign investment and is willing to offer a number of financial concessions to
foreign investors, which may not be available to local companies. The company may be able to control
the quality of the components more easily and offer better and targeted training facilities if it has direct
control of the labour resources. The company may also be able to maintain the confidentiality of its
products, whereas assigning the assembly rights to another company may allow that company to imitate
the products more easily.
96
Investing internationally may provide opportunities for risk diversification, especially if Imoni Co’s
shareholders are not well‐diversified internationally themselves. Finally, direct investment may provide
Imoni Co with new opportunities in the future, such as follow‐on options.
Drawbacks of own investment as opposed to licensing
Direct investment in a new plant will probably require higher upfront costs from Imoni Co compared to
licensing the assembly rights to a local manufacturer. It may be able to utilize these saved costs on other
projects. Imoni Co will most likely be exposed to higher risks involved with an international investment
such as political risks, cultural risks and legal risks. With licensing, these risks may be reduced somewhat.
The licensee, because it would be a local company, may understand the operational systems of doing
business in Yilandwe better. It will therefore be able to get off‐the‐ ground quicker. Imoni Co, on the other
hand, will need to become familiar with the local systems and culture, which may take time and make it
less efficient initially. Similarly, investing directly in Yilandwe may mean that it costs Imoni Co more to
train the staff and possibly require a steeper learning curve from them. However, the scenario does say
that the country has a motivated and well‐educated labour force and this may mitigate this issue
somewhat.
(b) Report on the proposed assembly plant in Yilandwe
This report considers whether or not it would be beneficial for Imoni Co to set up a parts assembly
plant in Yilandwe. It takes account of the financial projections, presented in detail in appendices 1 and
2, discusses the assumptions made in arriving at the projections and discusses other non‐financial
issues which should be considered. The report concludes by giving a reasoned recommendation on
the acceptability of the project.
Assumptions made in producing the financial projections
It is assumed that all the estimates such as sales revenue, costs, royalties, initial investment costs,
working capital, and costs of capital and inflation figures are accurate. There is considerable
uncertainty surrounding the accuracy of these and a small change in them could change the forecasts
of the project quite considerably. A number of projections using sensitivity and scenario analysis may
aid in the decision-making process.
It is assumed that no additional tax is payable in the USA for the profits made during the first two
years of the project’s life when the company will not pay tax in Yilandwe either. This is especially
relevant to year 2 of the project.
No details are provided on whether or not the project ends after four years. This is an assumption
which is made, but the project may last beyond four years and therefore may yield a positive net
present value. Additionally, even if the project ceases after four years, no details are given about the
97
sale of the land, buildings and machinery. The residual value of these non‐current assets could have
a considerable bearing on the outcome of the project.
It is assumed that the increase in the transfer price of the parts sent from the USA directly increases
the contribution which Imoni Co earns from the transfer. This is probably not an unreasonable
assumption. However, it is also assumed that the negotiations with Yilandwe’s government will be
successful with respect to increasing the transfer price and the royalty fee. Imoni Co needs to assess
whether or not this assumption is realistic.
The basis for using a cost of capital of 12% is not clear, and an explanation is not provided about
whether or not this is an accurate or reasonable figure. The underpinning basis for how it is
determined may need further investigation.
Although the scenario states that the project can start almost immediately, in reality, this may not be
possible and Imoni Co may need to factor in possible delays.
It is assumed that future exchange rates will reflect the differential in inflation rates between the
respective countries. However, it is unlikely that the exchange rates will move fully in line with the
inflation rate differentials.
Other risks and issues
Investing in Yilandwe may result in significant political risks. The scenario states that the current
political party is not very popular in rural areas and that the population remains generally poor. Imoni
Co needs to assess how likely it is that the government may change during the time it is operating in
Yilandwe and the impact of the change. For example, a new government may renege on the current
government’s offers and/or bring in new restrictions. Imoni Co will need to decide what to do if this
happens.
Imoni Co needs to assess the likelihood that it will be allowed to increase the transfer price of the
parts and the royalty fee. Whilst it may be of the opinion that currently, Yilandwe may be open to
such suggestions, this may depend on the interest the government may get from other companies to
invest in Yilandwe. It may consider that agreeing to such demands from Imoni Co may make it
obligated to other companies as well.
The financial projections are prepared on the basis that positive cash flows from Yilandwe can be
remitted back to the USA. Imoni Co needs to establish that this is indeed the case and that it is likely
to continue in the future.
Imoni Co needs to be careful about its ethical stance and its values, and the impact on its reputation,
given that a school is being closed in order to provide it with the production facilities needed.
98
Whilst the government is funding some of the transport costs for the children, the disruption this will
cause to the children and the fact that after six months the transport costs become the parents’
responsibility, may have a large, negative impact on the company’s image and may be contrary to the
ethical values which the company holds. The possibility of alternative venues should be explored.
Imoni Co needs to take account of cultural risks associated with setting up a business in Yilandwe. The
way of doing business in Yilandwe may be very different, and the employees may need substantial
training to adapt to Imoni Co’s way of doing business. On the other hand, the fact that the population
is well educated, motivated and keen may make this process easier to achieve.
Imoni Co should assess and value alternative real options which it may have. For example, it could
consider whether licensing the production of the components to a local company may be more
financially viable; it could consider alternative countries to Yilandwe, which may offer more benefits;
it could consider whether the project can be abandoned if circumstances change against the company;
entry into Yilandwe may provide Imoni Co with other business opportunities.
Recommendation
The result from the financial projections is that the project should be accepted because it results in a
positive net present value. It is recommended that the financial projections should be considered in
conjunction with the assumptions, the issues and risks, and the implications of these before a final
decision is made.
There is considerable scope for further investigation and analysis. It is recommended that sensitivity
and scenario analysis be undertaken to take into consideration continuing the project beyond four
years and so on. The value of any alternative real options should also be considered and incorporated
into the decision.
Consideration must also be given to the issues, risks and factors beyond financial considerations, such
as the impact on the ethical stance of the company and the impact on its image, if the school affected
is closed to accommodate it.
Report compiled by: AN Accountant
Date: XX/XX/XXXX
99
APPENDICES
Appendix 1
(All amounts in YR, million)
Year
Sales revenue (w2)
Parts costs (w2)
Variable costs (w2)
Fixed costs
Royalty fee (w3)
Tax allowable depreciation
0
1
18,191
(5,188)
(2,921)
(5,612)
(4,324)
(4,500)
2
66,775
(19,060)
(10,720)
(6,437)
(4,813)
(4,500)
3
111,493
(31,832)
(17,901)
(7,068)
(5,130)
(4,500)
4
60,360
(17,225)
(9,693)
(7,760)
(5,468)
(4,500)
Taxable profits/(loss)
Tax loss carried forward
(4,354)
21,245
15,714
Taxation (40%)
Add back loss carried fwd
Add back depreciation
0
0
4,500
4,500
45,062
(4,354)
40,708
(16,283)
4,354
4,500
Cash flows after tax
Working capital
Land,
buildings
machinery
146
(2,112)
25,745
(1,722)
33,279
(1,316)
13,928
14,750
(1,966)
24,023
31,963
28,678
(9,600)
and (39,000)
Cash flows (YR, millions)
(48,600)
(6,286)
4,500
100
(All amounts in $,000s)
Year
Exchange rate
0
101.4
1
120.1
2
133.7
3
142.5
4
151.9
Remittable flows
(479,290)
Contribution (part
sales)
($120 + inflation
per unit)
Royalty (w3)
Tax on contribution
and royalty (20%)
Cash flows
(479,290)
(16,370)
179,678
224,302
188,795
18,540
61,108
95,723
48,662
36,000
(10,908)
36,000
(19,422)
36,000
(26,345)
36,000
(16,924)
27,262
257,364
329,680
256,493
Discount
factors
(12%)
Present Values
1
0.893
0.797
0.712
0.636
(479,290)
24,345
205,119
234,732
163,130
Net present value project before considering the impact of the lost contribution and redundancy is
approximately $148.0 million.
Lost contribution and redundancy cost
The lost contribution and redundancy costs are small compared to the net present value and would
therefore have a minimal impact of reducing the net present value by $0.1 million approximately
(Note: Full credit will be given if the assumption is made that the amounts are in $000s instead of $.)
Appendix 2: workings
(W1) Unit prices and costs including inflation
Year
Selling price (€)
Parts ($)
Variable costs (YR)
1
735
288
19,471
2
772
297
22,333
3
803
306
24,552
4
835
315
26,925
101
(W2) Sales revenue and costs
In YR millions Year
Year
Sales revenue
Parts costs
Variable costs
1
150 x 735 x 165 =
18,191
150 × 288 x
120.1 = 5,188
150 x 19,471 =
2,921
2
480 x 772 x 180.2 =
66,775
480 x 297 x 133.7 =
19,060
480 x 22,333 =
10,720
3
730 x 803 x 190.2 =
111,493
730 x 306 x 142.5 =
31,832
730 x 24,522 =
17,901
4
360 x 835 x 200.8 =
60,360
360 x 315 x 151.9 =
17,225
360 x 26,925 = 9,693
(W3) Royalty fee
$20 million x 1.8 = $36 million
This is then converted into YR at the YR/$ rate for each year: 120.1, 133.7, 142.5 and 151.9 for years
1 to 4 respectively.
(Note: Credit will be given for alternative, relevant approaches to the calculations, and to the
discussion of the assumptions, risks and issues)
102
Incorporating risk in project appraisal
In order to make the most successful investment appraisal decision, one would need to take as many
factors into consideration as possible. The investment appraisal methods previously learnt helped assess
the profitability of the project (NPV & IRR). We shall now learn how to incorporate risk into the investment
appraisal process.
Sensitivity analysis is a method of quantifying the risk associated with any variable in investment appraisal.
Sensitivity essentially measures the change (in percentage terms) required by a variable (sales price, for
example) to make the NPV of the entire project 0. In other words, by how much per cent does a certain
variable need to change in order to reverse the investment appraisal decision.
For example, for a positive NPV project, if the sensitivity to changes in sales volume is 10%, this means
that if the number of units sold was to reduce by 10%, the project is no longer financially viable.
𝑺𝒆𝒏𝒔𝒊𝒕𝒊𝒗𝒊𝒕𝒚 𝒕𝒐 𝒂 𝒗𝒂𝒓𝒊𝒂𝒃𝒍𝒆 =
𝑵𝑷𝑽
𝒙 𝟏𝟎𝟎
𝑷𝑽 𝒑𝒐𝒔𝒕 − 𝒕𝒂𝒙 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘𝒔 𝒂𝒇𝒇𝒆𝒄𝒕𝒆𝒅 𝒅𝒖𝒆 𝒕𝒐 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒗𝒂𝒓𝒊𝒂𝒃𝒍𝒆
The following are the cash flows normally asked:
Sensitivity for;
Sum of PV cash flows to be taken from main proforma
Sales price
Sales volume
Discount rate
Revenue x (1-Tax rate)
(Revenue – variable costs) x (1-Tax rate)
(IRR – costs of capital) x 100%/cost of capital
Sensitivity for any variable could be asked, all you need to do is take the sum of the PV post-tax cash flows
and then use it in the aforementioned formula.
How Sensitivity Analysis Works
Sensitivity analysis can be used to help make predictions about the share prices of public companies. Some
of the variables that affect stock prices include company earnings, the number of shares outstanding, the
debt-to-equity ratios (D/E), and the number of competitors in the industry. The analysis can be refined
about future stock prices by making different assumptions or adding different variables. This model can
also be used to determine the effect that changes in interest rates have on bond prices. In this case, the
interest rates are the independent variable, while bond prices are the dependent variable.
103
Investors can also use sensitivity analysis to determine the effects different variables have on their
investment returns.
Sensitivity analysis allows for forecasting using historical, true data. By studying all the variables and the
possible outcomes, important decisions can be made about businesses, the economy, and making
investments.
Assume Sue is a sales manager who wants to understand the impact of customer traffic on total sales. She
determines that sales are a function of price and transaction volume. The price of a widget is $1,000, and
Sue sold 100 last year for total sales of $100,000. Sue also determines that a 10% increase in customer
traffic increases transaction volume by 5%. This allows her to build a financial model and sensitivity
analysis around this equation based on what-if statements. It can tell her what happens to sales if
customer traffic increases by 10%, 50%, or 100%. Based on 100 transactions today, a 10%, 50%, or 100%
increase in customer traffic equates to an increase in transactions by 5%, 25%, or 50%, respectively. The
sensitivity analysis demonstrates that sales are highly sensitive to changes in customer traffic.
Sensitivity vs Scenario Analysis
In finance, a sensitivity analysis is created to understand the impact a range of variables has on a given
outcome. It is important to note that a sensitivity analysis is not the same as scenario analysis. As an
example, assume an equity analyst wants to do a sensitivity analysis and a scenario analysis around the
impact of earnings per share (EPS) on a company’s relative valuation by using the price-to-earnings (P/E)
multiple.
The sensitivity analysis is based on the variables that affect valuation, which a financial model can depict
using the variables’ price and EPS. The sensitivity analysis isolates these variables and then records the
range of possible outcomes. On the other hand, for scenario analysis, the analyst determines a certain
scenario, such as a stock market crash or change in industry regulation. He then changes the variables
within the model to align with that scenario. Put together, the analyst has a comprehensive picture. He
now knows the full range of outcomes, given all extremes, and has an understanding of what the
outcomes would be, given a specific set of variables defined by real-life scenarios.
Benefits of Sensitivity Analysis



It acts as an in-depth study of all the variables and its predictions may be far more reliable
It allows decision-makers to identify where they can make improvements in the future
It allows for the ability to make sound decisions about companies, the economy, or their
investments.
104
Limitations of Sensitivity Analysis
The outcomes are all based on assumptions because the variables are all based on historical data. This
means it isn’t exactly accurate, so there may be room for error when applying the analysis to future
predictions.
Illustration 14
pDur05 project’s annual operating cash flows commence at the end of year four and last for a period of
15 years. The project generates annual sales of 300,000 units at a selling price of $14 per unit and incurs
total annual relevant costs of $3,230,000. Although the costs and units sold of the project can be predicted
with a fair degree of certainty, there is considerable uncertainty about the unit selling price. The
department uses a required rate of return of 11% for its projects, and inflation can be ignored.
Investments required:
Year
Investment
0
$2,500,000
1
$1,200,000
2
$1,400,000
Required: Calculate the net present value of project pDur05. Calculate and comment on what percentage
fall in the selling price would need to occur before the net present value falls to zero. (6 marks)
Solution:
PDur05
Annual sales revenue = $14 x 300,000 units = $4,200,000
Annual costs = $3,230,000
Annual cash flows = $970,000
Net present value of PDur05 =
($2,500,000) + ($1,200,000 x 1.11) + ($1,400,000 x 1.112) + $970,000 x 7.191 x 1.11-3
- ($2,500,000) + ($1,081,000) + ($1,136,000) + $5,100,000
= $383,000
In order for the net present value to fall to nil, the PV of the project's annual cash flows needs to equal to:
$2,500,000+ $1,081,000 + $1,136,000 = $4,717,000
Annual cash flows need to reduce to: $4,717,000/(7.191 x 1.113) = $897,110
Sales revenue would reduce to: $897,110 + $3,230,000
105
$4,127,110Selling price would fall to: $4,127,110/300,000 units = $13.76
Percentage fall = ($14.00-$13.76)/$14 × 100% 1.7%
[Note: The estimate of the annual cash flows will differ if tables are used rather than a calculator. This is
acceptable and will allow for when marking]
Comment: The net present value of the project is very sensitive to changes in the selling price of the
product. A small fall in the selling price would reduce the net present value to nil or negative and make
the project not worthwhile.
Capital Rationing
The primary objective of financial management is to maximize shareholder wealth, this is done by
undertaking all positive NPV projects. Capital rationing is when there are insufficient funds to do so.
The following are some of the important capital rationing terms you need to be familiar with:
 Hard capital rationing (External): The finance available to invest is limited by external factors. For
example, limited lending by the bank.
 Soft capital rationing (Internal): This is when the company itself imposes limitations on capital
availability.
 Single period rationing: shortage of capital for one period only.
 Multi-period rationing: Shortage of capital for more than one period.
 Divisible projects: The projects that cannot be part invested in. It can either be invested in entirely
or not.
 Mutually exclusive projects: Two or more projects cannot be invested together at the same time.
Divisible projects for single period rationing
The profitability index (PI) must be used when allocating limited capital amongst divisible projects.
Formula: PI = NPV / Initial Investment
Projects are then ranked according to the PI in descending order and funds are allocated accordingly.
Indivisible projects for single period rationing
When spreading limited capital among indivisible projects for a single time, the trial-and-error approach
is used, in which various project combinations are attempted to determine where the NPV
is105subsidized.
106
In such situations, it is presumed that all surplus un-invested funds receive a return equal to the cost of
capital, implying that any un-invested funds produce no surplus for the entity.
Illustration 15
Bhargavi plc currently has 4 investments under consideration, and the company has $130,000 available
to invest. Investments must commence from year 0.
Project
Initial Investment (Year 0)
NPV $
A
B
C
D
45,000
101,000
55,000
60,000
23,000
34,000
23,000
(5,000)
Required: Determine which projects should be taken up, with a view to maximize shareholder wealth:
a.
b.
c.
d.
If all projects are divisible
If the projects are indivisible
If projects are indivisible and project A and B are mutually exclusive
If project E must be accepted under any circumstance and all projects are divisible
Solution:
Project
NPV
Initial Investment
Profitability Index
Ranking
A
B
C
D
E
23000
34000
22000
15000
(5000)
45000
101000
55000
60000
50000
0.5
0.34
0.4
0.25
-
1
3
2
4
Based on the PI with the available funds of $130,000
iv.
If projects are divisible
According to the ranking, we can invest in project A, C and 30% of B (30,000/101,000)
Giving us a total NPV of $55200 (23000 + 22000 +(30% of 34000))
107
ii. If projects are indivisible using trial and error method
Possible contribution
NPV
A+C
45000
B alone
34000
C+D
37000
D+A
38000
Since A+C gives the highest NPV, it should be the project that should be undertaken.
iii. If projects A and B are mutually exclusive, we select the next best option from above, which is A+D
iv. E must be invested in, thus $50000 worth of capital is tied, which leaves us with $80000. We then
allocate $80000 the same way as (i).
Therefore we can invest in E, A and 63% of C(35000/55000)
The NPV would result to $31860 [23000+(63%x22000)-5000
Multi period capital rationing
In order to resolve capital constraints for more than one period, we cannot use PI. Instead, linear
programming, a graphical technique where in the various constraints on capital are formulated into
equations are solved, is used.
In AFM, you will not be tested on solving the equations, however you could be asked to interpret the
solution and possibly form the constraint equations as well.
The following are the steps used in developing the constraints




Denote the proportion of each project to be pursued using a variable (alphabet)
Formulate the objective function as NPVmax = ∑ NPV of each project x proportion
Further, for each year create a constraint showing the maximum funds available and the
requirement for each project.
Solve and comment on the interpretation.
Illustration 16
Arbore Co is a large listed company with many autonomous departments operating as investment centers.
It sets investment limits for each department based on a three‐year cycle. Projects selected by
departments would have to fall within the investment limits set for each of the three years. All
departments would be required to maintain a capital investment monitoring system and report on their
findings annually to Arbore Co’s board of directors. The Durvo department is considering the following
five investment projects with three years of initial investment expenditure, followed by several years of
positive cash inflows.
108
The department’s initial investment expenditure limits are $9,000,000, $6,000,000 and $5,000,000 for
years one, two and three respectively. None of the projects can be deferred, and all projects can be
scaled down but not scaled up.
Project
pDur01
pDur02
pDur03
pDur04
pDur05
Year one
(Immediately)
$4,000,000
$800,000
$3,200,000
$3,900,000
$2,500,000
Year two
$1,100,000
$2,800,000
$3,562,000
$0
$1,200,000
Year three
$2,400,000
$3,200,000
$0
$200,000
$1,400,000
Project net
present value
$464,000
$244,000
$352,000
$320,000
Not provided
pDur05 project’s annual operating cash flows commence at the end of year four and last for a period of
15 years. The project generates annual sales of 300,000 units at a selling price of $14 per unit and incurs
total annual relevant costs of $3,230,000. Although the costs and units sold of the project can be predicted
with a fair degree of certainty, there is considerable uncertainty about the unit selling price. The
department uses a required rate of return of 11% for its projects, and inflation can be ignored.
The Durvo department’s managing director is of the opinion that all projects which return a positive net
present value should be accepted and does not understand the reason(s) why Arbore Co imposes capital
rationing on its departments. Furthermore, she is not sure why maintaining a capital investment
monitoring system would be beneficial to the company.
Requirement:
(a) Explain the different methods of dealing with a capital rationing problem, in the circumstances
where (i) capital is rationed in a single period, and (ii) capital is rationed in several periods. (5 marks)
(b) Formulate an appropriate capital rationing model, based on the above investment limits, that
maximises the net present value for department Durvo. Finding a solution for the model is not
required. (3 marks)
(c) Assume the following output is produced when the capital rationing model in part (b) above is
solved:
Category 1: Total Final Value
$1,184,409
Category 2: Adjustable Final Values
Project pDur01: 0.958
Project pDur02: 0.407
Project pDur03: 0.732
109
Project pDur04: 0.000
Project pDur05: 1.000
Category 3:
Constraints Utilized
Slack
Year one: $9,000,000
Year one: $0
Year two: $6,000,000
Year two: $0
Year three: $5,000,000
Year three: $0
Required:
Explain the figures produced in each of the three output categories. (5 marks)
Provide a brief response to the managing director’s opinions by:
(i)
(ii)
Explaining why Arbore Co may want to impose capital rationing on its departments; (2 marks)
Explaining the features of a capital investment monitoring system and discussing the benefits of
maintaining such a system. (4 marks).
Solution:
(a) Shareholder wealth is maximised if a company undertakes all possible positive NPV projects.
Capital rationing is where there are insufficient funds to do so.
This shortage of funds may be for a single period only or for more than one period. A single period
capital rationing problem is solved by ranking competing projects according to the profitability index
i.e., the NPV of the project divided by the capital investment needed in the restricted period.
The limited amount of capital available is then allocated to the project(s) with the highest profitability
index in order to generate the highest possible NPV per unit of investment.
A solution to a multi period capital rationing problem cannot be found using profitability indices. This
method can only deal with one limiting factor (i.e., one period of shortage). Where there are a number
of limiting factors (i.e., a number of periods of shortage), a linear programming model has to be
formulated. The solution to the linear programming model will give the combination of projects to
maximise the NPV generated.
110
(b) A multi‐period capital rationing model would use linear programming and is formulated as follows: If:
Y1 = investment in project PDur01; Y2 = investment in project PDur02; Y3 = investment in project
PDur03; Y4 investment in project PDur04; and Y5 = investment in project PDur05.
Then the objective is to maximise
464Y1 + 244Y2 + 352Y3 + 320Y4 + 383Y5
Given the following constraints
Year 1: 4,000Y1 + 800Y2 + 3,200Y3 + 3,900Y4 + 2,500Y5  9,000
Year 2: 1,100Y1 + 2,800Y2 + 3,562Y3 + 0Y4 + 1,200Y5  6,000
Year 3: 2,400Y1 + 3,200Y2 + 0Y3 + 200Y4 + 1,400Y5  5,000
And where Y1, Y2, Y3, Y4, Y5  0
(c) Category 1: Total Final Value. This is the maximum net present value that can be earned within the
three‐year constraints of capital expenditure by undertaking whole, part or none of the five projects.
This amount is less than the total net present value of all five projects if there were no constraints.
Category 2: Adjustable Final Values. These are the proportions of projects undertaken within the
constraints to maximize the net present value. In this case, all of the project PDur05, 95.8% of project
PDur01, 73.2% of project PDur03 and 40.7% of project PDur02 will be undertaken.
Category 3: Constraints utilised, slack. This indicates to what extent the constraint limits are used and
whether any investment funds will remain unused. The figures indicate that, in order to achieve
maximum net present value, all the funds in all three years are used up, and no funds remain unused.
(d)
(i) Normally, positive net present value projects should be accepted as they add to the value of the
company by generating returns in excess of the required rate of return (the discount rate). However, in
this case, Arbore Co seems to be employing soft capital rationing by setting internal limits on capital
available for each department, possibly due to capital budget limits placed by the company on the
amounts it wants to borrow or can borrow. In the latter case, the company faces limited access to capital
from external sources, for example, because of restrictions in bank lending, costs related to the issue of
new capital and lending to the company being perceived as too risky. This is known as hard capital
rationing and can lead to soft capital rationing.
(ii) A capital investment monitoring system (CIMS) monitors how an investment project is progressing
once it has been implemented. Initially, the CIMS will set a plan and budget of how the project is to
proceed. It sets milestones for what needs to be achieved and by when. It also considers the possible risks,
111
both internal and external, which may affect the project. CIMS then ensures that the project is progressing
according to the plan and budget. It also sets up contingency plans for dealing with the identified risks.
The benefits, to Arbore Co, of CIMS are that it tries to ensure, as much as possible, that the project meets
what is expected of it in terms of revenues and expenses. Also, that the project is completed on time and
risk factors that are identified remain valid. A critical path of linked activities which make up the project
will be identified. The departments undertaking the projects will be proactive, rather than reactive,
towards the management of risk, and therefore possibly be able to reduce costs by having a better plan.
CIMS can also be used as a communication device between managers charged with managing the project
and the monitoring team. Finally, CIMS would be able to re‐assess and change the assumptions made of
the project, if changes in the external environment warrant it.
Refer Skill level FM topic: Sources of Finance to revisit Islamic Finance from Chapter 1: Topic 6.
Cryptocurrency and Initial Coin Offerings (ICOs)
Cryptocurrency

Cryptocurrency, sometimes called crypto-currency or crypto, is any form of currency that exists
digitally or virtually and uses cryptography to secure transactions.

Cryptocurrencies don't have a central issuing or regulating authority, instead using a
decentralized system to record transactions and issue new units.

Cryptocurrency is a digital payment system that doesn't rely on banks to verify transactions. It’s a
peer-to-peer system that can enable anyone anywhere to send and receive payments. Instead of
being physical money carried around and exchanged in the real world, cryptocurrency payments
exist purely as digital entries to an online database describing specific transactions.

When you transfer cryptocurrency funds, the transactions are recorded in a public ledger.

Cryptocurrency is stored in digital wallets.
112
Initial Coin Offerings (ICOs)

An initial coin offering (ICO) is the cryptocurrency industry’s equivalent of an initial public offering
(IPO).

A company seeking to raise money to create a new coin, app, or service can launch an ICO as a
way to raise funds.

Interested investors can buy into an initial coin offering to receive a new cryptocurrency token
issued by the company.

It is often a form of crowdfunding, although a private ICO which does not seek public investment
is also possible.

In an ICO, a quantity of cryptocurrency is sold in the form of "tokens" ("coins") to speculators or
investors, in exchange for legal tender or other (generally established and more stable)
cryptocurrencies such as Bitcoin or Ether. The tokens are promoted as future functional units of
currency if or when the ICO's funding goal is met and the project successfully launches.

An ICO can be a source of capital for start-up companies. ICOs can allow start-ups to avoid
regulations that prevent them from seeking investment directly from the public, and
intermediaries such as venture capitalists, banks, and stock exchanges, which may demand
greater scrutiny and some percentage of future profits or joint ownership.

ICOs may fall outside existing regulations, depending on the nature of the project, or be banned
altogether in some jurisdictions, such as China and South Korea.
Advantages of ICOs:







The Benefits of ICOs
Anyone Can Buy Tokens.
Tokens Are Sold Globally.
Token Economy Liquidity Premium.
Less Barrier to Entry.
The Business Model That Beats “Free”
Instant Buy-In.
113
Disadvantages of ICOs:





Many ICO projects have a low success rate.
If the ICO project fails, the tokens will lose value and become worthless.
ICO-related regulatory mechanisms are not fully available.
There are a huge number of scam possibilities.
It is easy to be used by malicious companies to cause uneven ICOs.
Adjusted Present Value (APV)
This is an important concept and is based on adjusting the NPV, to get a more accurate estimate. Under
general circumstances, the discount rate is used for the appraisal of all investments in the cost of capital
of the company.
This is because it assumes that all projects are funded from a pool of funds made up of all sources of
finance and hence the average return required on all sources put together must be used for appraising
investments.
However, in specific instances where project specific debt finance is applicable and subsidized interest is
charged on the project’s debt finance. In such cases, you will have to use the APV approach.
APV evaluates the proposal by dividing the investment cashflows from the funding cashflows, ensuring
that the project is completely equity funded and only integrating the financing effects. The Modigliani and
Miller approach of tax capital structure is the foundation of the APV method.
Advanced Present Value of APV-computation
$000’s
Base case NPV (@ ungeared cost of equity)
XX
PV of issue costs (net of tax)
(XX)
PV of tax savings on interest
XX
PV of net of tax subsidized interest
XX
APV
XX
Note: The PV of the above cash flows is arrived at by using the risk-free rate of return or whatever rate is
mentioned to be used in the exam.
114
If issue costs are given as a % of funds needed, then the funds need to be grossed up to include the issue
costs as well.
Steps for solving the above table
Step 1. Base
case NPV
Step 2. PV of
issue costs (net
of tax)
Step 3. PV of
Subsidized
Interest (net of
tax)
Step 4. PV of
tax benefit on
interest
Step 1: Base case NPV
The base case PV is essentially the NPV you compute normally however; we need to get to the NPV using
the ungeared cost of equity here. We will learn more about the conceptual part of this later in the syllabus.
Use the following formula to get to the ungeared cost of equity.
𝒊
𝒊
𝑽
𝒌𝒆 = 𝒌 + {( 𝟏 − 𝐓) (𝐤 − 𝒌𝒅 ) 𝒙𝑽−𝒅
𝒆
𝒆
𝒆
Where Ke = Geared cost of equity
Kei = Ungeared cost of equity
Vd = Value of debt
Ve = Value of equity (market value basis)
In the above process, we are basically de-gearing or removing the effect that debt financing has on the
cost of equity.
Step 2: Present value of issue costs (net of tax)
In reality, when you go to a bank for a loan, you will notice that there is always an issue cost that is charged
to you. The same goes for a company, issue costs need to be paid for issuing debt and equity. However,
issue costs are to be grossed up during computation, this is because issue cost is not treated as a separate
cost, but is included in the loan amount and paid off gradually.
115
Unless it is mentioned otherwise in the question.
For example, if the issue cost for equity is 8% and the Ve = 80000.
Issue cost will be = 80000*0.08/0.92 = $6956.5.
Step 3: Present value of subsidized interest (net of tax)
Government or other entities may make interest available to the firm at a subsidized rate. Thus you will
need to add this amount to the base NPV as there is a reduction in a relevant cash outflow. The
computation is fairly logical, calculate interest saved (net of tax) and further multiply it by the annuity
factor to get the present value over the course of the project. You need to use the normal borrowing rate
for comparison to quantify the interest subsidy received.
Step 4: Present value of tax benefit on interest
Here’s where things get slightly more complicated. As there is interest being paid out and interest expense
is tax deductible. Thus we will have to calculate the tax benefit on the interest payments. We need to
compute an interest payment table as interest by banks must be paid on an EMI basis.
The computation is as follows:
For example, if interest is 10% for an 82000 loan to be repaid in 3 years, the annual repayment amount is
computed by dividing the opening balance with the annuity factor i.e. 2.487. Thus, annual repayment =
82000/2.487. Further, you will have to compute a normal interest payment table in order to get each
yearly interest payment. The final step is multiplying the interest payments with the tax rate and getting
them to the present value.
Illustration 17
Knives Co. is considering expanding its activities beyond its primary sector (toy manufacturing) into the
stationery industry. It wishes to assess an acquisition project that entails the procurement of a $450,000
molding machine. For each of the project's three years of operation, net average operating cash flows of
$220,000 are anticipated. Its scrap value will be zero at the end of this period.
The assets of the project can support debt finance of 40% of its initial cost. Blades is considering borrowing
this amount from two different sources. First, a local government organization has offered to lend
$90,000, with no issue costs, at subsidized interest rate of 3% per annum. The full $90,000 would be
repayable after 3 years. The rest of the debt would be provided by the bank at Blade’' normal interest
rate. This bank loan would be repaid in three equal annual instalments.
The balance of finance will be provided by a placing of new equity. Issue costs will be 5% of funds raised
for the equity placing and 2% for the bank loan. Debt issue costs are allowable for corporation tax.
116
The risk-free rate is 10% pa and the ungeared cost of equity has been calculated as 16%. Further, the
base case NPV, including tax benefit on capital allowances, has been calculated as $5,370. Corporation
tax is at a rate of 30%, payable in the same year. It may be assumed that the normal borrowing rate of
the Knives Co is equivalent to the risk-free rate.
Calculate the APV and determine whether the project is worthwhile.
Solution:
APV
Base case NPV
Less: PV of issue costs (W1)
Add: PV of subsidized int (net of tax) (W2)
Add: PV of tax benefit on int (W3)
Adjusted present value
Since APV is positive, accept project
5370
15497
10967
6865
7706
W1 PV of subsided int-net of tax
Equity (5% x 27000/0.95)
Bank loan (2% x (90000/0.98)*(1-0.3)
Total
14211
1286
15497
W2 PV of subsidized int-net of tax
Normal borrowings rate
Available interest rate
Subsidy in interest
Subsidy in interest= 7% x 9000 x (1-0.3)
PV of benefit for 3 yrs. (4410 x 2.487, A.F 3yrs 10%
10%
3%
7%
4410%
10968%
W3 PV of tax benefit on interest
Interest on Govt funding (3% x 90000)
2700
Bank loan
Yearly repayment = 91836/2.487
36926
EMI or Yearly Payment
Principal/Annuity factor 36926.71278
Year
Opening Balance Interest
1
2
3
91,837
64,094
33,576
9,184
6,409
3,358
EMI or Annual Closing Balance
payment
36,927
36,927
36,927
64,094
33,576
7
117
Interest Benefit Calculations
Year
1
2
3
Bank Loan
Interest
9,184
6,409
3,358
Govt Interest Total Interest
2,700
2,700
2,700
11,884
9,109
6,058
Tax Benefits
@30%
3,565.10
2,732.81
1,817.29
DF
PV
0.909
0.826
0.751
3,240.68
2,257.30
1,364.79
6862.765
Answering theory section of an APV question
The following are some of the benefits of using the APV approach


Systematic approach to appraising projects with specific financing.
Can be geared to suit any type of financing structure.
The following are some of the limitations of using APV:


Subject to several limitations under the Modigliani and Miller with tax capital structure theory
such as tax benefit exhaustion, agency costs, bankruptcy costs etc.
Assumes perfect financial markets, no transaction rates, and other Modigliani and Miller
assumptions.
International APV
The Steps will be modified from APV Method to suit the international factors as follows:
Step 1: Base case NPV
Discount rate to be used will be cost of equity allowing for project risk, but excludes financial risk – by
using International CAPM with an ungeared world β.
Step 2: Adjustments
Adjustments are to be made for:
118
Tax relief on
debt interest
and issue cost
Subsidies from
foreign
governments
Projects
financed by
loans raised
locally
Restriction on
remittances
Step 3: APV
APV
= Step 1 +/- Step 2
= Base case NPV +/- Adjustments
International Trade and Finance
Need for international trade.
In today's world, free trade is encouraged, and all countries are advised to avoid any trade barriers for the
following reasons:
•
•
•
•
Give customers a specialize variety of goods to choose from.
Improved efficiency and increased competition
Increase the number of markets in which products are sold to achieve economies of scale.
Companies that in a particular product are able to sell their core products well.
Trade barriers
A few methods by which some nations restrict free trade barrier imports are:




Import quotas on the maximum number of units that can enter the country.
Tariffs and taxes on specific imports
Payment restrictions to specific countries, thereby prohibiting foreign trade
Embargoes, i.e. prohibitions on trading with a nation
119
Role of WTO
The World Trade Organization (WTO), headquartered in Geneva, Switzerland, works to promote
international commerce and trade by pursuing the following goals:
•
•

Ensuring that all member countries follow international trade agreements.
Serving as a point of contact for future trade negotiations.
Assist in the resolution of any disputes between nations over trade and other issues
Role of IMF (International Monetary fund)
The International Monetary Fund, or IMF, is an organization that works to ensure the stability of exchange
rates and a multilateral system of international credit. Its goals are as follows:
•
•
•
Promoting a currency system that is freely convertible.
International liquidity management.
Serving as a source of credit for ineligible members (members that have a balance of payments
deficit)
BIS (Bank for International System)
The Bank for International System is an organization that works to improve international financial and
monetary cooperation and to serve as a bank for all national central banks. The BIS is comprised of the
majority of central banks.
Role of World Bank
The World Bank is an international organization that was established to aid in the financing of economic
development. Its goals are as follows:
•
•
•
Long-term funds are lent to developing economies at market interest rates for capital projects.
Providing subsidized loans to economically disadvantaged countries.
Encourage private-sector trade by lending or investing in developing countries.
The following are some significant Principal Central Banks
The Federal Reserve
system
USA
European Central Bank
(ECB)
Euro zone
120
Bank of Japan
Japan
The Bank of England
UK
Role of treasury functions
The treasury functions
The treasury functions within an organization serve the following purposes:
•
•
•
•
•
•
•
Raising long-term sources of finance
Involvement in capital investment decisions
Cash management
Currency management
Risk management
Managing international tax liability
Creating dividend policy
Money Laundering
Money laundering is the process of concealing income or assets obtained from criminal activities in order
to disassociate the source of the crime.
Organizations such as the International Monetary Fund (IMF) have been encouraging international
participation in combating money laundering activities by:



Establishment of international participation in the fight against money laundering.
Specific recommendations on measures to be implemented by countries are issued.
Advising on the development and implementation of legislation in countries seeking to prosecute
individuals or organizations involved in these activities and to regulate financial systems.
Collateralized debt obligations

CDOs, or collateralized debt obligations, are securitized loans that allow banks to generate cash from
their loans (assets) to lend to others.

Banks that lend money to borrowers in the form of home and vehicle loans sell these outstanding
loans to a special purpose vehicle (SPV) for cash.
121

After that, the SPV sells bonds to other banks and hedge funds. These bonds are backed by the income
stream generated by the mortgage or loan holder, which has now become an asset of the SPV.

To give investors the option of choosing to subscribe to bonds consistent with their risk appetite,
generally, CDO’s are divided into tranches:
Tranche 1
Tranche 2
Tranche 3
•(Highest risk) This is known as the 'equity' tranche, and it typically accounts
for 5-10% of the total value of the mortgages in the pool. Throughout the
life of the CDO, the equity tranche will absorb any losses caused by
mortgage holder default, up to the point where the principal underpinning
the tranche is depleted. At this point, the investment has no value.
•(Intermediate risk) This is also known as the'mezzanine tranhce,' and it
consists of approximately 10% of the principal and will absorb any losses
not absorbed by the equity tranche until its principal is also exhausted.
•(Lowest risk) This is made up of AAA-rated loans, which is the highest credit
rating given by a credit rating agency. This is a pool value balance that will
absorb any residual losses.
Dark Pool Trading
Dark pool trading is the practice of trading large volumes of listed stocks without the traders' (generally
institutional investors) interest being made public on the regular stock exchange. As a result, these
traders' prices are determined anonymously, and the trade is only declared publicly after it has been
agreed upon. Large volume traders who use dark pool trading systems prevent signals from reaching the
markets in order to reduce large fluctuations in share price or market movement against them.
122
The main argument in favor of the dark pool trading system is that by preventing large movements in the
share price due to volume sales, the markets' artificial price volatility would be reduced, and the markets'
efficiency would be maintained. Contrary arguments assert that dark pool trading systems reduce market
efficiency because such traders do not contribute to price changes. Furthermore, because the majority of
individuals who use the markets to trade equity shares are unaware of the trade, transparency is reduced.
This, in turn, reduces liquidity in the markets, potentially jeopardizing their efficiency. The ultimate risk is
that a lack of transparency and liquidity will result in an uncontrolled spread of risks, similar to what
caused the recent global financial crisis.
The Sub-prime crisis and toxic assets





The global and sub-prime crises that erupted at the start of the twenty-first century were the result
of increased sub-prime lending.
Because this type of lending was frequently collateralized, and because only banks and financial
institutions were permitted to trade in CDOs, banks held a large number of assets on their balance
sheets that were backed by mortgages and loans.
Mortgage defaults began to occur as a result of falling property prices and rising unemployment,
affecting holders of CDOs, particularly Tranche 1 and Tranche 2.
Investors and institutions began to question the quality of assets held in the form of CDOs in banks
and other institutions, resulting in liquidity stagnation (what we call the global credit crunch).
Since then, the term toxic assets have been used to refer to assets that banks trade in order to reduce
risk and earn a stable income.
The European Debt Crisis






With the introduction of the Euro, some Eurozone countries will be able to borrow at much lower
rates than previously.
The increased ability to borrow allowed countries such as Portugal, Ireland, Italy, Greece, Spain,
and Cyprus to borrow more funds, and instead of investing in long-term development, many of
these countries increased consumer spending, which did not contribute to GDP growth or deliver
the required returns. Aside from that, the Eurozone's borrowing limits for its member countries
were not strictly adhered to.
The early-twentieth-century global financial crisis caused a credit crunch for banks. Many of these
banks had made loans to both governments and private organizations throughout Europe.
Because the governments were unable to repay and service interest payments on some of their
debt, they faced short-term liquidity issues.
Other, more financially strong EU members, such as Germany, were forced to devise ad hoc
'bailout' packages to meet the needs of the EU's insolvent members.
As a result of rising yields (due to increased perceived risk), nations' credit ratings have been
lowered, making it even more difficult to raise capital.
123




The EU has responded to the foregoing by raising the minimum level of bank capitalization,
establishing the European Financial Stability Facility (EFSF), and establishing the European
Financial Stabilization Mechanism (EFSM) to raise funds to stabilize banks and countries in
trouble.
The ECB has also attempted to increase liquidity by collaborating with other central banks and
purchasing government debt securities to provide cash.
The IMF has also contributed by providing loans to emphasize the importance of strict austerity
measures in the future.
In the future, radical changes that could result in Germany leaving the Eurozone or Greece and
other defaulting nations being kicked out of the Eurozone cannot be ruled out.
NPV Analysis for Foreign Projects
There are two methods to calculate NPV in case of foreign investment projects.
The following charts gives a step by step analysis on both the methods:
124
Step 1: Estimate the
project's cashflow post tax
in overseas currency
Conventional Approach
Standard Approach
Step 2: Convert the
cashflows to home
currency
Step 2: Convert the
company Cost of capital
(CoC) to an overseas
equivalent using IRP
Step 3: Add any home
country cashflows, like tax
Step 3: Use adjusted CoC to
find NPV in overseas
currency
Step 4: Discount the net
home country cashflows at
the company's CoC
Step 4: Convert the NPV
into Sterling equivalent
Step 5: Add PV of any
additional home country
flows, like tax
Generally Conventional approach is preferred.
Use NPV Spreadsheet function in CBE to save time.
125
Format for Conventional Approach:
Year
FC Sales/receipts
Less:
FC Variable costs
FC Wages & materials
FC Incremental Fixed costs
0
1
x
2
x
3
x
4
x
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
FC Untaxed royalties & Mgmt.
charges
FC Tax allowable depreciation
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
FC Taxable profits
Less: FC Tax
Add: FC Tax allowable depreciation
x
(x)
x
x
(x)
x
x
(x)
x
x
(x)
x
5
Less: FC Initial outlay
Add: Realizable value
(x)
Add/Less: Working capital
(x)
(x)
(x)
(x)
(x)
x
Net foreign CF
x Exchange rate (based on PPPT)
(x)
x
x
x
x
x
x
x
x
x
x
x
Home currency CF
Less: HC Tax on foreign taxable
profits
HC Untaxed royalties & Mgmt.
charges
Less: HC Tax on royalties & mgmt.
charges
Net home currency CF
x Discounting factor
Home currency PV
Home currency NPV
x
(x)
X
(x)
x
(x)
x
(x)
x
(x)
x
(x)
x
x
x
x
(x)
(x)
(x)
(x)
x
x
x
x
x
x
x
x
x
x
x
x
x
(x)
x
(x)
x
x
x
x
126
Illustration 18
Talam Co, a listed company, aims to manufacture innovative engineering products which are
environmentally friendly and sustainable. These products have been highly marketable because of their
affordability. Talam Co’s mission statement also states its desire to operate to the highest ethical
standards. These commitments have meant that Talam Co has a very high reputation and a high share
price compared to its competitors.
Talam Co is considering a new project, the Uwa Project, to manufacture drones for use in the agricultural
industry, which are at least 50% biodegradable, at competitive prices. The drones will enable farmers to
increase crop yields and reduce crop damage. Manufacture of drones is a new business area for Talam
Co. The project is expected to last for four years. Talam Co will also work on the Jigu Project (a follow‐on
project to the Uwa Project) to make 95%+ biodegradable drones. It is expected that the Jigu Project will
last for a further five years after the Uwa Project has finished. If the Uwa Project is discontinued or sold
sooner than four years, the Jigu Project could still be undertaken after four years.
Uwa Project
The following number of drones are expected to be produced and sold:
Year
1
Number of drones 4,300
produced and sold
2
19,200
3
35,600
4
25,400
In the first year, for each drone, it is expected that the selling price will be $1,200 and the variable costs
will be $480. The total annual direct fixed costs will be $2,700,000. After the first year, the selling price is
expected to increase by 8% annually, the variable costs by 4%
annually and the fixed costs by 10% annually, for the next three years. Training costs are expected to be
200% of the variable costs in year 1, 60% in year 2, and 10% in each of years 3 and 4. There is substantial
uncertainty about the drones produced and sold, and Talam Co estimates the project to have a standard
deviation of 30%.
At the start of every year, the Uwa Project will need working capital. In the first year, this will be 20% of
sales revenue. In subsequent years, the project will require additional or a reduction in working capital of
10% for every $1 increase or decrease in sales revenue respectively. The working capital is expected to be
fully recovered when the Uwa Project ceases.
The Uwa Project will need $35,000,000 of machinery to produce the drones at the start of the project.
Tax allowable depreciation is available on the machinery at 15% per year on a straight‐line basis. The
machinery is expected to be sold for $7,000,000 (post‐inflation) at the end of the project. Talam Co makes
sufficient profits from its other activities to take advantage of any tax loss relief. Tax is paid in the year it
falls due.
Jigu Project as a real option Talam Co estimates that Jigu Project’s cash flows are highly uncertain and its
standard deviation is 50%. It is estimated that $60,000,000 will be required at the start of the project in
four years’ time. Using conventional net present value, Talam Co’s best estimate is that net present value
of the project will be $10,000,000 at the start of the project.
127
The following figures were estimated for the Jigu Project using the real options method.
Asset value (Pa) = $46,100,000 (to nearest 100,000)
Exercise price (Pe) = $60,000,000
Exercise date (t) = 4 years
Risk‐free rate (r) = 2.30%
Volatility (s) = 50%
d1 = 0.329 d2 = –0.671 N(d1) = 0.6288 N(d2) = 0.2510
Call option value: $15,258,399
It can be assumed that the call option value is accurate.
Talam Co’s finance director wants to know how the asset value of $46,100,000 has been
estimated.
Honua Co’s offer
Honua Co, whose main business is drone production, has approached Talam Co with an
offer to buy the Uwa Project in its entirety from Talam Co, for $30,000,000 at the start of
the third year of the project’s life.
Talam Co has calculated some figures to assess the value of Honua Co’s offer using the real
options method, as follows:
d1 = 0.779 d2 = 0.355 N(d1) = 0.7821 N(d2) = 0.6387
Talam Co’s finance director has requested that the value of Honua Co’s offer is estimated using the real
options method. She has also requested to know the amounts of the initial variables which would have
been used to calculate the d1, d2, N(d1) and N(d2) figures.
It can be assumed that the d1, d2, N(d1) and N(d2) figures are accurate.
Additional information
Both Honua Co and Talam Co pay corporation tax at an annual rate of 20%. Talam Co has estimated Uwa
Project’s and Jigu Project’s risk‐adjusted cost of capital at 11%, based on Honua Co’s asset beta. Talam Co
believes that SOFR, which is currently 2.30%, provides a
good estimate of the risk‐free rate of interest.
128
Required:
(a) Discuss how incorporating real options into net present value decisions may help Talam Co with its
investment appraisal decisions.
(b) Prepare a report for the board of directors (BoD) of Talam Co which:
(i) Estimates, showing all relevant calculations, the net present value of the Uwa Project before
considering the offer from Honua Co and the Jigu Project
(ii) Addresses the requests made by the finance director about the initial variables and estimated value of
the offer from Honua Co using the real options method
(iii) Assesses whether the Uwa Project should be undertaken, using the results from, and discusses the
assumptions made in, the calculations in (b)(i) and (b)(ii) above.
Professional marks will be awarded in part (b) for the format, structure and presentation of the report.
Solution:
(a) When making decisions, following investment appraisals of projects, net present value assumes that
a decision must be made immediately or not at all, and once made, it cannot be changed. Real options,
on the other hand, recognise that many investment appraisal decisions have some flexibility.
For example, decisions may not have to be made immediately and can be delayed to assess the impact of
any uncertainties or risks attached to the projects. Alternatively, once a decision on a project has been
made, to change it, if circumstances surrounding the project change. Finally, to recognise the potential
future opportunities, if the initial project is undertaken, like the Jigu Project.
Real options give managers choices when making decisions about whether or not to undertake projects,
by estimating the value of this flexibility or choice. Real options take into account the time available before
a decision, on a project, has to be made, and the risks and uncertainties attached to the project. It uses
these factors to estimate an additional value which can be attributable to the project. Real options view
risks and uncertainties as opportunities, where upside outcomes can be exploited, and a company has the
option to disregard any downside impact.
By incorporating the value of any real options available into an investment appraisal decision, Talam Co
will be able to assess the full value of a project.
(b) Report to the board of directors (BoD), Talam Co
Introduction
This report assesses whether or not the Uwa Project should be undertaken based on its value from an
initial net present value (NPV) calculation, and then taking into account the options provided by the offer
from Honua Co and the Jigu Project. As part of the assessment, a discussion of the assumptions and their
impact on the assessment is provided.
129
Assessment
The value of the Uwa Project based on just the initial NPV is a small negative amount of $(6,000)
approximately (appendix 1). This would indicate that the project is not worth pursuing, although the result
is very marginal. The offer from Honua Co, and the Jigu Project, using the real options method, gives an
estimated value of $17,668,000 (appendix 2), which is positive and substantial. This indicates that the Uwa
Project should be undertaken.
Assumptions
The following assumptions have been made when calculating the values in appendices 1 and 2.
Since the Uwa Project is in a different industry to Talam Co’s current activities, the project‐specific, risk‐
adjusted cost of capital of 11% based on Honua Co’s asset beta is used. It is assumed that Honua Co’s
asset beta would provide a good approximation of the business risk inherent in drone production.
It is assumed that all the variables used to calculate the values of the projects in appendices 1 and 2 are
correct and accurate. Furthermore, it is assumed all the variables such as inflation rates, tax rates, interest
rates and volatility figures, remain as forecast through the period of each project. It is also assumed that
the time periods related to the projects and the offer from Honua is accurate and/or reasonable.
The Black‐Scholes option pricing (BSOP) model is used to estimate the real option values of the Jigu Project
and the Honua Co offer. The BSOP model was developed for financial products and not for physical
products, on which real options are applied. The BSOP model assumes that a market exists to trade the
underlying project or asset without restrictions, within frictionless financial and product markets.
The BSOP model assumes that the volatility or risk of the underlying asset can be determined accurately
and readily. Whereas for traded financial assets this would most probably be reasonable, as there is likely
to be sufficient historical data available to assess the underlying asset’s volatility, this is probably not going
to be the case for real options. For large, one‐off projects, there would be little or no historical data
available. Volatility in such situations would need to be estimated using simulation models, such as the
Monte‐Carlo simulation, with the need to ensure that the model is developed accurately and the data
input used to generate outcomes reasonably reflects what is likely to happen in practice.
The BSOP model assumes that the real option is a European‐style option which can only be exercised on
the date when the option expires. In some cases, it may make more strategic sense to exercise an option
earlier. The real option is more representative of an American‐style option which can be exercised before
expiry. Therefore, the BSOP model may underestimate the true value of an option.
Real options models assume that any contractual obligations involving future commitments made
between parties will be binding, and will be fulfilled. For example, it is assumed that Honua Co will fulfil
its commitment to purchase the project from Talam Co at the start of the third year for $30 million and
there is therefore no risk of non‐fulfilment of that commitment.
130
The BSOP model does not take account of behavioural anomalies which may be displayed by managers
when making decisions.
Conclusion
The initial recommendation is that the Uwa Project should be undertaken when the offer from Honua Co
and going ahead with the Jigu Project are included. Taken together, these result in a significant positive
NPV. However, one or more of the above assumptions may not apply and therefore NPV value is not a
‘correct’ value.
Instead, the appendices provide indicative value which can be attached to the flexibility of a choice of
possible future actions which are embedded with the Uwa Project and indicate that it should be
undertaken.
Report compiled by:
Date
APPENDICES:
Appendix 1 (Part (b) (i)):
Net present value computation of the Uwa Project before incorporating the offer from Honua Co and the
financial impact of the Jigu Project. All figures are in $000s.
Year
Sales revenue (W1)
Less:
Variable costs (W2)
Fixed costs
Training costs
Cash flows before tax
Tax (W3)
Working capital
Machinery purchase and sale
Net cash flows
Present value of cash flows
(discounted at 11%)
0
(1,032)
(35,000)
(36,032)
(36,032)
1
5,160
2
24,883
3
49,840
4
38,405
2,064
2,700
4,128
(3,732)
1,796
(1,972)
9,581
2,970
5,749
6,583
(267)
(2,496)
18,476
3,267
1,848
26,249
(4,200)
1,144
(3,908)
(3,521)
3,820
3,100
23,193
16,959
13,716
3,594
1,372
19,723
(1,495)
4,356
7,000
29,584
19,488
131
Approximate net present value of the project = $(6,000)
Workings:
Working 1 (w1): Sales revenue
Year
Units produced and
sold
Selling price ($)
(inflated at 8%)
Sales
revenue
($000s)
1
4,300
2
19,200
3
35,600
4
25,400
1,200
1,296
1,400
1,512
5,160
24,883
49,840
38,405
1
4,300
2
19,200
3
35,600
4
25,400
480
499
519
540
2,064
9,581
18,476
13,716
1
(3,732)
2
6,583
3
26,249
4
19,723
(5,250)
(5,250)
(5,250)
(12,250)
(8,982)
(1,796)
1,333
267
20,999
4,200
7,473
1,495
Working 2 (w2): Variable costs
Year
Units produced and
sold
Variable costs per
unit ($)(inflated at
4%)
Total variable costs
($000s)
Working 3 (w3): Tax
Year
Cash flows before
tax
Tax
allowable
depreciation
Taxable cash flows
Tax payable (20%)
Appendix 2 (Part (b) (ii):
Jigu Project: Asset value
Asset value of Jigu Project of $46,100,000 is estimated as present value of future cash
flows related to the project:
$70,000,000 × 1.11–4, where $70,000,000 = $60,000,000 + $10,000,000.
132
Note: To prepare for a Black Scholes question in the Computer Based Exam (CBE), make sure
you understand how to use the spreadsheet functions LN, EXP, SQRT and NORMSDIST.
Honua Co offer, initial variables used to calculate the d1, d2, N(d1) and N(d2) figures:
Asset value (Pa) = $16,959,000 + $19,488,000 = $36,447,000 (cash flows foregone)
Exercise price (Pe) = $30,000,000
Exercise date (t) = 2 years
Risk‐free rate (r) = 2.30%
Volatility (s) = 30%
Value of Honua Co offer
Value of Honua Co’s offer
Call value: $36,447,000 × 0.7821 – $30,000,000 × 0.6387 × 𝑒 (–0.023 × 2) = $10,205,640
Honua Co’s offer is equivalent to a put option.
Put value: $10,205,640 – $36,447,000 + $30,000,000 × × 𝑒 (–0.023 × 2) = $ = $2,409,899
Estimated total value arising from the two real options Value of Jigu Project:
$15,258,399
Value of Honua Co’s offer: $2,409,899
Estimated total value from the two real options: $2,409,899 + $15,258,399 = $17,668,298
133
134
Chapter 3: Cost of capital & Risk adjusted WACC
135
Introduction
A major part of this chapter is just a revision from F9, however, there are certain additional concepts (riskadjusted WCC) that are new. This chapter teaches you the concepts behind the cost of capital, but the
application for this chapter is prominent in; Chapter 4: Mergers & Acquisitions, Chapter 5: Corporate
reconstruction and Investment Appraisal. Thus, it is critical that you understand the concepts of this
chapter thoroughly.
Weighted average cost of capital (WACC)
WACC is the average return required by all investors. This includes preference shareholders, banks,
debenture holders etc. The WACC so calculated is generally used to appraise investment projects and
thus, is used as the discount factor for NPV calculation.
The WACC is to be computed by calculating the individual returns expected by the various sources and
then calculating a weighted average (based on market value weights i.e. based on the percentage of
funding from each source on the market values)
The following is an example, can be used as revision for the weighted average cost of capital computation:
Cost of equity = 10%
Cost of preference shares = 8%
Cost of debt (after-tax) = 6%
Market value of equity = $100m
Market value of preference shares = $30m
Market value of debentures = $70m
Sources
Cost – k
Market value
Weightage (%)
Cost x weightage %
Equity
Preference
10%
8%
$100m
$30m
100/200 = 0.5
30/200 = 0.15
10% x 0.5 = 5%
8% x 0.15 = 1.2%
Debentures
Total
6%
$70m
$200m
70/00 = 0.35
6% x 0.35 = 2.1%
WACC = 8.3%
136
Computing the cost of equity
The cost of equity can be computed using either of the following methods:



Capital asset pricing model (based on the risk faced by the company)
Modigliani and Miller’s with tax proposition 2 for capital structure
The dividend growth model (DGM)
AFM, does not spoon feed the method you are supposed to use to solve the question. For example, the
question might ask for you to compute the cost of equity. However, they will not tell you whether to use
CAPM or DGM method. You need to assess that yourself based on the information provided to you in the
exam.
Dividend growth model
The cost of equity under the dividend growth model is calculated based on the assumption that the return
expected by shareholders is the present value of all dividends receivable from the share and using the
following calculations:
Ke = d1 + g
P0
Or
Ke = d0(1+g) + g
P0
P0 = Current share price(Ex Div)
D0 = Current dividend
d1 = Dividend in one year’s time
137
g = Annual growth in dividends
Key points to remember during the calculation of Ke using DVM:
•
•
•
•
Keep an eye out for whether the dividend is for the current year or the previous year. This will
alter how you substitute in the preceding formulae.
If the question specifies cum-dividend share price, it means you must subtract the immediately
due dividend from the ex-dividend share price to arrive at the ex-dividend share price.
If the question states that a dividend was recently paid, you DO NOT need to deduct the dividend
to determine the ex-dividend share price because only an immediately payable dividend is
deductible.
If growth is not explicitly stated, we can calculate growth using either of the following methods:
Constant growth estimation (Leaps approach)
g = (D0/Dn)1/n – 1
Where,
D0 = Current dividend
Dn = Dividend n years ago
An easy way to remember is: g = (newest/oldest)1/n – 1
Gordon’s growth model
g = br
Where,
b = proportion of retained earnings
r = returns on the re-invested funds
In AFM, you will need to accurately assess when you need to use the growth models. The question will
not mention it. They might just give you the proportion of retained earnings = 30% and return on reinvested funds = 16%, randomly in a question. You have to apply growth to the computation wherever
possible.
Basically, if any of the above variables are subtly given to you in the exam, you have to apply the growth
model as it makes your estimate more accurate.
And the entire essence of finance is essentially estimating future outcomes accurately.
138
Illustration 1
Darpan Plc has paid the following annual dividends over the past 5 years;
Year
Dividends payable
20X9 (current year)
48 cents (Payable soon)
20X8
42 cents
20X7
38 cents
20X6
30 cents
20X5
28 Cents
If the current market price is $9.58, estimate cost of equity for Darpan plc?
Solution:
g = ((0.48/0.28)1/4)-1 = 9%
ExP0 = 9.58-0.48 = 9.1
D1 = 0.48 x 1.09 = 0.5232
Ke = (0.52/9.1)+0.09
Ke = 14.7%
139
Illustration 2
Vyshnav plc has a current share price of $5.00 ex-div and has recently paid out a dividend of $0.25 per
share which represents a dividend payout ratio of 40%. The company makes an average return of 14% on
re-invested funds. Calculate the cost of equity for Vyshnav plc.
Solution:
g = 60% x 14% = 8.4%
D1 = 0.25 x 1.084 = 0.271
Ke = (0.271/5) + 0.084
= 13.82%
Modigliani and Miller with tax proposition 2, capital structure
Modigliani and Miller developed a theory in 1963 that relates the cost of equity and debt to the company's
gearing (financial risk). They devised a formula for calculating the cost of equity of an ungeared (no debt
funding) company in comparison to a similar company with debt.
Formula:
𝒊
𝒊
𝑽𝒅
𝒌𝒆 = 𝒌 + {( 𝟏 − 𝐓) (𝐤 − 𝒌𝒅 )
𝒆
𝒆
𝑽𝒆
Where,
– Ke = Geared cost of equity
– Kei = Ungeared cost of equity
– Vd = Value of debt
– Ve = Value of equity (market value basis)
– Kd = Cost of debt
– T = Tax rate in %
AFM Focused
This is the same formula that was applied in APV. We shall now understand the concept behind it. In F9,
we studied that the financial risk of a company has an impact on its cost of equity. Thus this formula is
used when you need to find the cost of equity if the company was debt-free or if the company is planning
to change their capital structure.
140
It is common to get a question that asks you to compute the cost of equity if a company was planning to
change its capital structure. To do that, you need to compute the kei with its current structure (D/E ratio)
first, further use that kei to compute the ke with its new capital structure. In addition, the formula can be
used to compute the cost of equity when only the ungeared cost of equity and the other variables are
made available to you.
Illustration 3
Keagan Ltd. is a company with a debt-to-equity ratio of 30:70. The company has a cost of equity of 12%.
It intends to change its capital structure to achieve a debt/equity ratio of 45:55. If the cost of debt of the
company is 4% p.a., the tax rate of 30% calculate the cost of equity.
Solution:
De-gearing the cost of equity (find kei)
Ke = Kei + [(1-T)(kei-kd) x (Vd/Ve)]
0.12= kei + [(1 – 0.3) x (kei-0.04) x (30/70)]
0.12 = kei + [(0.7kei – 0.028) x 0.43]
0.12 = kei + [(0.3kei – 0.012)]
Kei = 10.15% or 10%
Inserting kei with new capital structure to find new ke
Ke = 0.1015 + [(1-0.3)x(0.1015-0.04)x45/55]
Ke = 13.68%
Capital asset pricing model (CAPM)
The capital asset pricing model computes the cost of equity based on the systematic risk faced by the
company (Beta β).
CAPM assumes that all investors are diversified and, as a result, unsystematic risk has been eliminated
(risk arising due to all money being invested in few entities). It only considers systematic risk for investors,
i.e. risk affecting all companies regardless of the degree of diversification.
141
The Beta or the risk coefficient of the company is a measure of how much risk (volatility in earnings) exist
in an entity. The following is how Beta is interpreted:

If β<1 indicates that the company is less risky than the market as a whole, and thus rational
investors would expect returns lower than the average market return.

If β>1, it means that the company is riskier than the market as a whole, and rational investors
would expect higher returns than the average market return.

If β=1, it means that investors in the company are taking the same risk as the market's average
risk and, as a result, should receive the same return as the market's average return.

If β=0, the investment is risk-free (such as government securities), and the investor should only
be eligible for risk-free returns.
Remember, the risk coefficient of any company incorporates both the financial risk (how much of gearing
the company operates with i.e. D/E) and business risk (based on operation activities).
Using CAPM, we can estimate Ke as below:
𝑲𝒆 = 𝑹𝒇 + (𝑹𝒎 − 𝑹𝒓 )𝜷
Where,
– Ke = cost of equity
– Rf = Risk free rate
– Rm = Market return
– B = Beta (measures the systematic risk)
– (Rm-Rf) = Risk premium
The Rf can be represented as treasury bills or risk-free rate
142
Answering theory section for CAPM in AFM
In the exam, we will be asked to explain the reasons or benefits of using CAPM to estimate the cost of
equity. In addition, you will be asked to state the assumptions behind the CAPM formula, so is it necessary
to remember the points.
The following are some of the benefits of using CAPM over DGM:
 Relates return to risk, which is the foundation of finance.
 Does not suffer from limitations of DGM such as estimation uncertainty associated with dividends
(D0) or growth (g)
 Encourages diversifying and considers only systematic risks.
 Provides a more rational basis for arriving at the return required by equity shareholders.
 Facilitates calculation of risk adjusted weighted average cost of capital. (Explained later on)
CAPM, being a great tool, also has a significant amount of assumptions, thus the estimates are contingent
upon how realistic these assumptions are:
• It is presumptuous that markets are perfect capital markets.
• Unrestricted borrowing or lending at risk-free interest rates.
• Unsystematic risk is removed.
• Decision-makers who use logic.
• Investor expectations are consistent, and information is readily available.
• Calculations are only valid for a single period.
Calculating the cost of debt
Cost of irredeemable debt
This again is basically a revision from F9. The cost of debt (kd) for irredeemable debt (where the principal
is not repaid, but the interest paid in perpetuity) is calculated using the following formula:
𝑲𝒅 =
𝒊[𝟏 − 𝒕]
𝑷𝟎
Formula:
Where,
Kd = cost of debt (net of tax)
i = Annual interest (not in decimal)
t = Marginal tax rate (as a decimal)
P0 = Current market price of debt (ex-interest)
143
Cost of redeemable debt
Year
Description
Year 0
Current
market (x)
price (ExP0)
Coupon interest (1- X
t)
Redemption value
X
Year 1-n
Year n
Cash
flows
Discount rate PV high
high
(assumed)
X
(X)
Discount
rate PV low
low (assumed)
X
(X)
X
X
X
X
X
X
NPVH
X
X
NPVL
Now, use the same IRR formula as used in investment appraisal, with the discount rates and NPV’s above.
Thus, Kd (net of tax) = IRR of the investment
Cost of non-traded debt (bank loan)
The cost of debt for a bank loan is computed as follows:
Kd = Interest rate x (1-T)
Cost of debt using the credit risk spread method
In AFM, you might have to estimate the cost of capital using a credit or the default risk premium. There is
nothing complicated about this, this concept is essentially just a method of incorporating credit ratings
(provided by credit rating agencies like CRISIL, S&P) into the cost of debt.
Formula: Kd (net of tax) = (Rf + Credit spread) x (1-T)
Where,
Credit spread is obtained from a table that will be given to you in the exam. Note that the table gives you
credit spread in terms of basis points. 100 basis points = 1%, it is crucial that you remember this as it
comes in the exam 9 out of 10 times. For example, 22 basis points = 0.22%.
The following is an example of a credit risk table:
Table of Credit spreads for Individual company bonds
Rating
1 yr.
2 yrs.
3 yrs.
5 yrs.
7 yrs.
10 yrs.
30 yrs.
AAA
AA
A
5
15
40
10
25
50
15
30
57
22
37
65
27
44
71
30
50
75
55
65
90
144
BBB
BB
B+
65
210
375
80
235
402
88
240
415
95
250
425
126
265
425
149
275
440
175
290
450
All you have to do is match the years to maturity of the bond with the rating (given in the exam) to get
the credit spread which should be used in the computation. If the exact year is not present on the table,
you will need to take the mean of the year’s closest to it. The question will also mention whether the table
is presenting the spread in terms of basis points or normal percentage terms (extremely rare).
145
Illustration 4
a) Zavala Inc currently has an issue of 4% irredeemable bonds quoted at $100 cum int. Corporation
tax is at 25%. Compute the cost of debt.
b) Cayde plc has issued 9% bonds redeemable at an 11% premium in six years. If the bonds are
presently trading at $100 compute the cost of debt (Tax rate is 30%)
c) The current return on government risk-free bonds is 2.6%. B plc has 6 years bond in issue with an
AA rating. Corporation tax is at 25%.
Calculate the Kd for such bonds (use the above table)
Solution:
a) Kd = [4*0.75]/96 = 3.125%
b) We need to compute the IRR
C/F
D.F.@ 10%
PV
D.F. @ 5%
PV
(100)
1
(100)
1
(100)
6.3 [9*0.7]
4.355
27.44
5.076
31.98
110
0.564
62.04
0.746
82.06
(10.52)
IRR = 0.05+[(14.04/(14.04+10.52))*(0.1-0.05)]
IRR = 7.8%
c) Mean between year 5 and 7 to get an approximation for year 6
Credit spread for AA bon in year 6 = (37+44)/2 = 40.5 basis points
Kd = (0.026+0.00405)x0.75
= 2.3%
14.04
146
Computing the WACC
Having calculated the cost of equity and debt, the WACC can then be computed as a weighted average,
based on market value weightings. An Illustration is provided at the start of this chapter.
The following are some points to keep in my mind while calculating the market value of any instruments:
•
•
•
Ascertain the number of instruments based on the book values (For example, if there are $1,000,000
of equity in the SOFP with each share having a book value of $0.25/ share, then the number of shares
is $1,000,000/0.25 = 4m shares.
Obtain the market value of the instrument.
Multiply the market value with the number of instruments to get the total market value (which
represents the extent to which the company is funded by the particular source of finance!)
When can the “Current” WACC be used for investment appraisal?
The WACC of a company is calculated using its existing share capital structure, which is essentially
indicative of the company's current risk from the investor's perspective. The current/existing WACC can
be used for appraisal of investments only in the following situations:


When the business risk is UNALTERED i.e. the line of business of a project is NOT different from
the current business activity of the company.
When the financial risk is UNALTERED i.e. taking up the project will not significantly change the
current debt-to-equity ratio of the company.

Risk-Adjusted WACC
In circumstances when an entity intends to appraise a project in a new sector (i.e. is undertaking an activity
which is substantially different from its current business operations), a risk-adjusted WACC based on the
risk associated with the new business operation needs to be computed.
147
Sectorial differences in availability of capital and cost of raising such capital is caused on account of
various factors enlisted herewith:




Capital structure choices peculiar to each sector, e.g., Asset-heavy sectors like Infrastructure and
Realty tend to have more debt in their books.
Government Policies
Risk perception of the investor
Unforeseen factors like COVID-19 Restrictions in various sectors for Foreign Direct investments
(FDI) and restrictions on debt investments by Foreign Institutional Investors (FIIs)
148
De-gearing and Re-gearing
Before diving into this, you first need to know the difference between the asset beta and equity beta,
which is as follows:


Asset beta: This is the risk coefficient of an entity that represents the risk related to the entity’s
business operations.
Equity beta: This is the risk coefficient of an entity that represents the combined risk related to
both the entity’s business operations and financial gearing.
When an entity intends to appraise a project in a new sector, it cannot use its current WACC. Thus this is
a method in which the company can incorporate the risk coefficient into its WACC. The entire process of
de-gearing and re-gearing relates to separating the asset beta from the equity beta. This is done as we
need to use an appropriate risk coefficient in the CAPM formula.
In order to ascertain the risk coefficient for the new project with different business risks from the existing
operations, the following steps are undertaken:


Identification of proxy company beta, which reflects the business risk (asset beta) of the project
the company wants to undertake. However, you will find that the question usually gives you the
equity beta of the proxy company, but we cannot use this as it also included the financial risk of
the proxy.
The proxy equity beta is de-geared to remove the financial risk to get the asset beta, which solely
represents the business operation risk of the proxy company. This can be done by using the
following formula:
Formula (given in exam):
𝜷𝒂 = [
𝑽𝒔 (𝟏−𝑻
]
(𝑽𝒆 + 𝑽𝒅 (𝟏−𝑻))
𝑽𝒔 (𝟏−𝑻
𝜷 ]
(𝑽𝒆 + 𝑽𝒅 (𝟏−𝑻)) 𝒂
+[
Where,
–
–
–
–
–
Ba = The asset beta
Be = Equity beta
Ve = Market value for equity
Vd = Market value of debt
T = Corporate tax rate

The asset beta obtained above is re-geared to put in the financial risk that incorporates the
company’s level of debt/equity. By doing so, we get Be that reflects the financial risk of the
company and the business risk of the new venture.
149
Computation: The computation of Risk adjusted WACC involves the following:
Step 1: Estimate a suitable risk coefficient through de-gearing and re-gearing
Step 2: Using the beta value so computed for estimating the cost of equity using CAPM
Step 3: Calculating the cost of debt or kd
Step 4: Taking the weighted average of the cost of all the sources of finance to get WACC.
Illustration 5
T Co is considering an opportunity to produce an innovative component which, when fitted into motor
vehicle engines, will enable them to utilize fuel more efficiently. The component can be manufactured
using either process O or process Z. Although this is an entirely new line of business for T Co, it is of the
opinion that developing either process over a period of four years and then selling the productions rights
at the end of four years to another company may prove lucrative. The annual after‐tax cash flows for each
process are as follows:
Year
After‐taxcashflows($000)
Process Z
Year
After‐taxcashflows($000)
0
1
1,220
2
(3,800)
1
643
2
(3,800)
0
3
1,153
1,386
4
3,829
1,055
4
5,990
3
546
T Co has 10 million 50c shares trading at 180c each. Its loans have a current value of $3.6 million and an
average after‐tax cost of debt of 4.50%. T Co’s capital structure is unlikely to change significantly following
the investment in either process.
E Co manufactures electronic parts for cars, including the production of a component similar to the one
being considered by T Co. E Co’s equity beta is 1.40, and it is estimated that the equivalent equity beta for
its other activities, excluding the component production, is 1.25. E Co has 500 million 25c shares in issue,
trading at 120c each. Its debt finance consists of variable rate loans redeemable in seven years. The loans
paying interest at base rate plus 120 basis points have a current value of $96 million. It can be assumed
that 80% of E Co’s debt finance and 75% of E Co’s equity finance can be attributed to other activities
excluding the component production. Both companies pay annual corporation tax at a rate of 25%. The
current base rate is 3.5%, and the market risk premium is estimated at 5.8%.
Required: Provide a reasoned estimate of the cost of capital that Tisa Co should use to calculate the net
present value of the two processes. Include all relevant calculations.
Solution:
Use E Co’s information to estimate the component project’s asset beta. Then based on T Co’s capital
structure, estimate the component project’s equity beta and the weighted average cost of capital. Assume
that the beta of debt is zero.
150
E Co MVe = $1.20 × 500m shares = $600m
E Co MVd = $96m
E Co portfolio asset beta = 1.40 × $600m/($600m + $96m × (1 – 0.25)) = 1.25
E Co asset beta of other activities =
1.25 × $360m/($360m + $76.8m × (1 – 0.25)) = 1.078
1.25 = component asset beta × 0.25 + 1.078 × 0.75
Component asset beta = [1.25 – (1.078 × 0.75)]/0.25 = 1.766
Component equity beta based on T Co capital structure =
1.766 × [($18m + $3.6m × 0.75)/$18m] = 2.0309
Using CAPM, component Ke = 3.5% + 2.0309 × 5.8% = 15.30%
Component WACC = (15.30% × $18m + 4.5% × $3.6m)/($18m + $3.6m) = 13.5%
Capital structure and financing theory
This section is concerned with the theory aspect of the cost of capital. The examiner will judge your
knowledge regarding the underlying assumptions and concepts behind computing the cost of capital.
In addition, you will also be required to know the various theories around a capital structure that were
previously devised.
A company will have to determine the proportion of debt and equity to use for financing its
operations/investments. The various practical considerations and the theories behind capital structure in
a company, that has an effect on the WACC and value of the company is explained below.
151
Practical considerations
This is frequently tested as a theory question in mergers and acquisitions. There are certain factors that a
company has to consider before choosing a source of finance, which are as follows:
1. Cost: The higher the cost of funding, the lower the firm’s profit. Debt financing is typically less
expensive than equity financing. This is because debt providers take less risk than equity providers.
This is due to the guaranteed receipt of interest payments, as opposed to dividends paid to equity
holders, which are highly dependent on company profits.
2. Tax benefits: Debt interest is tax deductible whereas returns provided in the form of dividends are
not tax-deductible.
3. Duration: Firms typically match the duration of assets purchased with the type of debt they choose
to incur. Long-term debt is more expensive than short-term debt. This is because lenders typically
perceive long-term loans or equity as having a higher risk. Long-term finance, on the other hand, has
the advantage of the security, whereas short-term finance can be withdrawn.
4. Term structure of interest rates: The relationship between the interest rates charged for loans of
varying maturities is described by term structure on interest rates. While long-term instruments are
generally more expensive, in certain abnormal economic conditions, short-term borrowings are less
expensive than long-term sources.
5. Gearing: Gearing is the debt-to-equity finance ratio. High gearing indicates that the company is riskier,
and thus, even though debt financing is less expensive, a company may limit the amount of debt to
contain the risk.
6. Availability: Companies do not have always have the freedom of choosing the type of finance they
desire. They need to first assess what finance can be made available to them.
7. Security: To raise finance in the form of debt, it may be essential to offer some form of security
(tangible assets), and the availability of the same shall determine how a company intends to finance
itself.
8. Covenants: These are restrictions laid down by the lenders, which, if violated, provides them with the
irrevocable right to call back funds at short notice. Any further source of financing used by the
company must not result in violation of existing covenants.
9. Issue costs: The costs of issuing traded instruments will be higher than the costs of issuing non-traded
sources of finance. Even in this case, equity instruments may be more expensive to issue due to
underwriting costs, for example, and this will be taken into account.
152
Theoretical considerations
The aim of any company is to maximize value, and in order to maximize the value it must try to minimize
its WACC.
The following are three theories that discuss the relationship between the gearing of the company and
the impact it has on the WACC.



Traditional theory
Modigliani and Miller 1958 theory
Modigliani and Miller 1958 with tax theory
Traditional tax theory
The traditional theory states that at low levels of gearing equity, shareholders perceive risk as low thus,
the increase in the proportion of debt compared to equity will lower the WACC.
However, taking a larger proportion of debt will increase the level of gearing, and at high levels of gearing,
equity holders will perceive the company as high risk as there will be increased volatility with company
profits because debt interest will have to be paid first.
Therefore, after a certain point increasing the portion of debt further will lead to the WACC rising as the
expected increase in shareholder returns (Ke) will outweigh the cheaper debt finance.
Conclusion
Point X is the optimal level of gearing. At point X, the WACC will be minimized, thus the combined value
of the firm will be maximized here.
Implication of finance
153
Companies should gear up (taking advantage of cheaper debt) until it reaches optimal point X and then
raises a mix of debt to equity to maintain this level of gearing. We can even see from the diagram, as soon
as the debt is raised beyond point X, the WACC starts to rise.
Flaw
Companies can only find optimal point X by trial and error.
Modigliani and Miller’s theory (Without tax 1958)
M&M proposed that investors are rational and thus, the required return of equity (ke) is directly
proportional to the increase in gearing. Thus, according to M&M, there is a linear relationship between Ke
and gearing (D/E).
The theory states that companies should take advantage of cheaper debt as it exactly offsets the increase
in Ke (that occurs due to an increase in gearing). Therefore stating that the offset will keep the WACC
constant, regardless of any increase or decrease in gearing.
Conclusion
The WACC and the value of the firm is unaffected by changes in gearing levels and gearing is irrelevant.
Implication of finance
Choice of finance is irrelevant to shareholder wealth as the company can use any mix of funds and the
value of the firm will be unaffected.
Assumption



No taxation
Perfect capital markets, where investors have the same information and act rationally on
receiving that information
No transaction cost
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
Debt is risk free and is issued to replace equity
Modigliani and Miller’s theory (with tax 1963)
This theory is an improvement on M&M's previous model. The main difference in this model is that, in
addition to the increase incorporating the impact of the change in gearing on Ke and the lowering effect
on WACC due to cheaper debt being substituted for equity, M&M identified an additional saving for the
company when it has more debt-saving on interest payments.
In other words, while the increase in Ke due to increased gearing is offset by increased use of debt, which
is less expensive due to tax savings on interest payments, having more debt finance results in a decrease
in WACC.
Conclusion
Companies should gear up completely, i.e. only source debt finance in order to minimize WACC/ increase
the MV of the company. The optimal capital structure is 99.9% gearing.
Implication of finance
The company should use as much debt as possible and maintain a high level of gearing.
Flaws
High levels of gearing will lead to the following problems:




Taking on many obligatory interest payments will increase the risk of the company becoming
bankrupt.
It will have an impact on borrowing and debt capacity.
The cost of borrowing will increase as gearing increases.
If the company keeps taking on debt (increasing its finance cost), the tax benefit will eventually be
exhausted.
155


Difference in risk attitude between the directors and the shareholders.
Restrictions in the MOA and AOA
Pecking order theory
The pecking order theory is a practical approach to funding which argues that firms should raise finance
in the following order:
1. Internally generated funds (Retained earnings)
2. Debt funds
3. New equity
This order is based on the existence of high issue costs for new debt and equity issues, the complexity of
the financing process, and the difficulties associated with justifying any new issue.
Illustration 6
Cordial Co is a listed company operating in the hospitality and leisure industry. Cordial Co’s board of
directors met recently to discuss a new strategy for the business. The proposal put forward was to sell all
the hotel properties that Cordial Co owns and rent them back on a long‐term rental agreement. Cordial
Co would then focus solely on the provision of hotel services at these properties under its popular brand
name. The proposal stated that the funds raised from the sale of the hotel properties would be used to
pay off 70% of the outstanding non‐current liabilities, and the remaining funds would be retained for
future investments. The board of directors are of the opinion that reducing the level of debt in Cordial Co
will reduce the company’s risk and therefore, its cost of capital. If the proposal is undertaken and Cordial
Co focuses exclusively on the provision of hotel services, it can be assumed that the current market value
of equity will remain unchanged after implementing the proposal.
Cordial Co: Extract from the most recent Statement of Financial Position
Non‐current assets (re‐valued recently)
Current assets
Total assets
Share capital (25c per share par value)
Reserves
Non‐current liabilities (5.2% redeemable bonds)
Current liabilities
Total capital and liabilities
$000
42,560
26,840
69,400
3,250
21,780
42,000
2,370
69,400
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Cordial Co’s latest free cash flow to equity of $2,600,000 was estimated after taking into account taxation,
interest and reinvestment in assets to continue with the current level of business. It can be assumed that
the annual reinvestment in assets required to continue with the current level of business is equivalent to
the annual amount of depreciation. Over the past few years, Cordial Co has consistently used 40% of its
free cash flow to equity on new investments while distributing the remaining 60%. The market value of
equity calculated on the basis of the free cash flow to equity model provides a reasonable estimate of the
current market value of Cordial Co. The bonds are redeemable at par in three years and pay the coupon
on an annual basis. Although the bonds are not traded, it is estimated that Cordial Co’s current debt credit
rating is BBB but would improve to A+ if the non‐current liabilities are reduced by 70%.
Other information
Cordial Co’s current equity beta is 1.1 and it can be assumed that debt beta is 0. The risk-free rate is
estimated to be 4% and the market risk premium is estimated to be 6%. There is no beta available for
companies offering just hotel services, since most companies own their own buildings. The average asset
beta for property companies has been estimated at 0.4. It has been estimated that the hotel services
business accounts for approximately 60% of the current value of Cordial Co and the property company
business accounts for the remaining 40%. Cordial Co’s corporation tax rate is 20%. The three‐year
borrowing credit spread on A+ rated bonds is 60 basis points and 90 basis points on BBB rated bonds over
the risk free rate of interest.
Required:
(a) Calculate, and comment on, Cordial Co’s cost of equity and weighted average cost of capital before
and after implementing the proposal. Briefly explain any assumptions made.
(b) Discuss the validity of the assumption that the market value of equity will remain unchanged after
the implementation of the proposal.
157
Solution:
(a) Before implementing the proposal
Cost of equity = 4% + 1.1 × 6% = 10.6%
Cost of debt = 4% + 0.9% = 4.9%
Market value of debt (MVd):
Per $100: $5.2 × 1.049–1 + $5.2 × 1.049–2 + $105.2 × 1.049–3 = $100.82
Total value = $42,000,000 × $100.82/$100 = $42,344,400
Market value of equity (MVe):
As share price is not given, use the free cash flow growth model to estimate this. The question
states that the free cash flow to equity model provides a reasonable estimate of the current
market value of the company.
Assumption 1: Estimate growth rate using the rb model. The assumption here is that free cash
flows to equity which are retained will be invested to yield at least at the rate of return required
by the company’s shareholders. This is the estimate of how much the free cash flows to equity will
grow by each year.
r = 10.6% and b = 0.4, therefore g is estimated at 10.6% × 0.4 = 4.24%
MVe = 2,600 × 1.0424/(0.106 – 0.0424) approximately = $42,614,000
The proportion of MVe to MVd is approximately 50:50
Therefore, cost of capital:
10.6% × 0.5 + 4.9% × 0.5 × 0.8 = 7.3%
Assumption 2: The question does not provide an asset beta for hotel services only, which is the
approximate measure of Cordial Co’s business risk once the properties are sold. Assume that
Cordial Co’s asset beta is a weighted average of the property companies’ average beta and hotel
services beta.
Asset beta of hotel services only:
0.61 = Asset beta (hotel services) × 60% + 0.4 × 40% Asset beta (hotel services only) approximately
= 0.75
Cordial Co, hotel services only, estimate of equity beta:
MVe = $42,614,000 (Based on the assumption stated in the question)
MVd = Per $100: $5.2 × 1.046–1 + $5.2 × 1.046–2 + $105.2 × 1.046–3 = $101.65
Total value = $12,600,000 × $101.65/$100 = $12,807,900 say $12,808,000
0.75 = equity beta × 42,614/(42,614 + 12,808 × 0.8)
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0.75 = equity beta × 0.806
Equity beta = 0.93 Cordial Co, hotel services only, the weighted average cost of capital
Cost of equity = 4% + 0.93 × 6% = 9.6%
Cost of capital = 9.6% × 0.769 + 4.6% × 0.231 × 0.8 = 8.2%
Before proposal
After proposal
Cost of equity
10.5%
9.6%
WACC
7.3%
8.2%
Comments
Implementing the proposal would increase the asset beta of Cordial Co because the hotel services
industry on its own has a higher business risk than a business which owns its own hotels as well.
However, the equity beta and cost of equity both decrease because of the fall in the level of debt
and the consequent reduction in the company’s financial risk. The company’s cost of capital
increases because the lower debt level reduces the extent to which the weighted average cost of
capital can be reduced due to the lower cost of debt. Hence the board of directors is not correct
in assuming that the lower level of debt will reduce the company’s cost of capital.
(b) It is unlikely that the market value of equity would remain unchanged because of the change in
the growth rate of free cash flows and sales revenue and the change in the risk situation due to
the changes in the business and financial risks of the new business.
In estimating the asset beta of Cordial Co as offering hotel services only, no account is taken of
the changes in business risk due to renting rather than owning the hotels. A revised asset beta
may need to be estimated due to changes in the business risk.
The market value of equity is used to estimate the equity beta and the cost of equity of the
business after the implementation of the proposal. But the market value of equity is dependent
on the cost of equity, which is, in turn, dependent on the equity beta. Therefore, neither the cost
of equity nor the market value of equity is independent of each other and they both will change
as a result of the change in business strategy.
159
160
Chapter 4: Option Valuation
161
Introduction
The concepts from this chapter are tested in cohesion with advanced investment appraisal questions. The
concepts are similar to risk management; however, this section focuses more on the BSOP (Black Scholes
Option Pricing Model) and how a derivative option can be used for investment projects. Options and
futures will be studied in detail in the risk management chapter.
Terminologies
1. Option: An option grants the holder the right, but not the obligation, to buy or sell the underlying
asset on a specified date at an exercise price (a fixed price). The option writer is the other party in this
transaction. Because the writer bears all of the risks, there is an upfront premium (fees) payable when
purchasing the option. When purchasing an option, an attempt is made to determine the appropriate
premium to pay. Options are classified as either OTC (over the counter) or traded (standardized
contracts sold in the market).
2. Call option: An option to purchase the underlying asset at a predetermined price (exercise price) on
a predetermined date.
Call Option = Right to Buy
3. Put option: An option to sell the underlying asset at an exercise price on a predetermined date.
Put Option = Right to Sell
4. European vs. American option: A European option can be exercised only on the expiry date, whereas
American options can be exercised at any time expiry. Note that they have nothing to do with the
region/country itself.
A tip to remember:
European = Expiry
American = Any time
5. Exercise Price or Strike Price: The price fixed at which the underlying may be bought or sold. It is
denoted by Pe .
6. Spot price: This is the current market price of the underlying good or share. It is denoted by Pa .
7. Holder of the Option: A holder or buyer is the person holding the right in the option. This is the person
who has bought the option. He has the right, but does not have the obligation to perform.
8. Writer of the Option: A writer or seller is the person who gives the right to the buyer to buy or sell
the goods at a later date. He collects upfront premium which is non-refundable. He carries no right,
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but has an obligation to perform. In both call and put options, maximum income he earns is the
premium collected.
9. In money, out of the money & at the money:
In the Money
At the Money
Out of the Money
Meaning
Call Option
P𝑎 > Pe
Where one would make gains on
exercising
P𝑎 = Pe
Where no gains or losses are
made on exercising
P𝑎 < Pe
Where one would make losses on
exercising
Put Option
Pe > P𝑎
Pe = P𝑎
P𝑒 < P𝑎
Note that in the AFM exam, you will always be the investor or holder of the option, never the writer.
10. Value of an option: The price (premium) that is paid or received for purchasing or selling options is
called the value of an option. It can be split into two parts:
a. Intrinsic Value: The intrinsic value is the difference between the underlying spot price and the strike
price, to the extent that this is in favor of the option holder.
So, for Call option, Intrinsic value = Max{ P𝑎 − Pe , 0}
For a Put option, Intrinsic value = Max{ P𝑒 − Pa , 0}
An option can never have a negative intrinsic value, this is mainly because it never gets exercised in that
situation, bringing the Intrinsic value to zero.
b. Time Value: The option premium is always greater than the intrinsic value. This extra money is for the
risk which the option writer/seller is undertaking. This is called the time value.
Time value is the amount the option trader is paying for a contract above its intrinsic value, with the belief
that prior to expiration the contract value will increase because of a favorable change in the price of the
underlying asset. The longer the length of time until the expiry of the contract, the greater the time value.
Time value = option premium – intrinsic value
163
Illustration 1:
If a colleague of yours Mr. Tom Cruise offers to sell you shares of Microsoft for $150 on 15 th December
2013, you have an option.
a) If, on the 15th December 2013, the actual price of the share is $160, will you exercise the option or
not? What is the intrinsic value of the option on 15th December 2013?
b) If, on the other hand, the actual share price of Microsoft on 15th December 2013 is $145, what would
you do?
c) A friend, Mr. Peter offered to buy shares of Ludo pls held by you for $5 on 5th December 2013, what
kind of option do you now hold?
d) If, on the 5th December 2013, the actual price of the share is $4.50, will you exercise the option or
not? What is the intrinsic value of the option on 5th December 2013?
e) If the actual share price of Ludo plc on 5th December 2013 is $5.50, what would you do?
Solution:
a) From your point of view, it is a call option. Thus, it is favourable for you as you can obtain the share
for $150 using the option instead of $160.
Thus, intrinsic value = 160-150 = $10
b) You would lapse the option in this case as $145 is out of the money.
Intrinsic value = $0
c) This is a put option for you, and you will exercise the option as you can sell it for 5$ instead of $4.5.
Intrinsic value = 5-4.5 = $0.5 per share
d) You would lapse the option in this case as you can sell the shares at a higher rate in the money market
itself.
Intrinsic value = $0
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Factors affecting the value of a share option
Note that the value of an option and the exercise price of an option is not the same thing. The value that
is being referred to is the upfront premium mentioned earlier. Think of the value of an option as the
desirability of the option that increases and decreases based on the favorability of exercising the option.
On the expiry date: The value of the share option on the expiry date is equivalent to its intrinsic value
because that is the benefit you get from exercising the option. In addition, the derivative market moves
inversely to the share of the market, thus due to the way these markets’ function, the value of a share
option on the date of expiry is equal to its intrinsic value.
Until the expiry date: The value of the share option up till the date of expiry is influenced by the following
factors:
1. Share price: Think from the perspective of the option holder, the value of an option will be affected by
the movement in the underlying share’s price. If the value of the share price starts to rise:
 Call option: A call option would increase in value as the exercise price set at the
predetermined date would have been lower than the increased share price. Thus,
effectively making the option desirable as the exercise price is cheaper than the current
market value of the share.
 Put option: A put option would decrease in value as, logically you could sell it for a higher
value in the share market (due to the increase in value) itself rather than exercising it in
the options market.
2. Exercise price: The exercise price (also known as strike price) set can also have an effect on the value
of an option, again think from the perspective of the option holder. If there is an increase in the exercise
price then:
 Call option: The value of a call option will decrease as the share could then be bought
from the market itself at a cheaper rate.
 Put option: The value of a put option would increase in value as the option could
effectively be sold at a higher rate (exercise price) in the options market rather than the
share market.
3. Time to expiry: If there is an increase in the time frame in which the option can be exercised, using the
standard concept behind uncertainty there will be an increase in both the value of a call option and put
option. (Increase in uncertainty increases the risk, which applies to both options).
4.Volatility: Again, the same case applies here, as volatility increases the risk with both options, thus an
increase in volatility will result in the rise of both a put option and a call option.
5. Interest (borrowing) rate: A general increase in interest rates in the market will gradually affect the call
and put option as follows:
165
 Call option: Because the exercise price must be paid in the future, the present value (time
value of money) of the exercise price decreases as interest rates rise. This lowers the cost
of exercising the call option and thus adds value to the current call option value.
 Put option: Because having a call option allows the share purchase to be postponed,
having a call option becomes more valuable when interest rates are high because the
money can be left in the bank, which will generate a higher return.
Increase in:
Value of Call option
Value of Put option
Share price
Exercise price
Time to expiry
Volatility
Interest rate
Increases
Decreases
Increases
Increases
Increases
Decreases
Increases
Increases
Increases
Decreases
Note: These concepts were all explained under the assumption that there is going to be an increase in
each of the above variables, however it works the opposite way if there is a decrease in each of the
variables. (The concepts will be the same)
Options example
Reserve Bank of India (RBI) was expected to announce their monetary policy on 29th September. While it
is hard for anyone to guess what kind of decision RBI would take, the general expectation in the market
was that RBI would slash the repo rates by 25 basis points. For people not familiar with monetary policy
and repo rates, I would suggest you read this –
http://zerodha.com/varsity/chapter/key-events-and-their-impact-on-markets/
RBI’s monetary policy is one of the most eagerly awaited events by the market participants as it tends to
have a major impact on the market’s direction. Here are few empirical market observations this trader
has noted in the backdrop market events –



The market does not really move in any particular direction, especially 2 – 3 days prior to the
announcement. He finds this applicable to stocks as well – ex: quarterly results
Before the event/announcement market’s volatility invariably shoots up
Because the volatility shoots up, the option premiums (for both CE and PE) also shoot up
While, I cannot vouch for his first observations, the 2nd and 3rd observation does make sense.
So in the backdrop of RBI’s policy announcement, ample time value, and increased volatility (see image
below), he decided to write options on the 28th of September.
166
Nifty was somewhere around 7780, hence the strike 7800 was the ATM option. The 7800 CE was trading
at 203 and the 7800 PE was trading at 176, both of which he wrote and collected a combined premium of
Rs.379/-.
Here is the option chain showing the option price
Why are you shorting 7800 CE and 7800 PE?
Since there was ample time to expiry and increased volatility, I believe that the options are expensive, and
premiums are higher than usual. I expect the volatility to decrease eventually and, therefore, the
167
premiums to decrease as well. This would give me an opportunity to buyback both the options at a lower
price
Why did you choose to short ATM option?
There is a high probability that I would place market orders at the time of exit, given this, I want to ensure
that the loss due to impact cost is minimized. ATM options have lesser impact cost; therefore it was a
natural choice.
For how long do you plan to hold the trade?
Volatility usually drops as we approach the announcement time. From empirical observation, I believe
that the best time to square of these kinds of trade would be minutes before the announcement. RBI is
expected to make the announcement around 11:00 AM on September 29th; hence I plan to square off
the trade by 10:50 AM.
What kind of profits do you expect for this trade?
I expect around 10 – 15 points profits per lot for this trade.
What is your stop loss for this trade?
Since the trade is a play on volatility, it's best to place SL based on Volatility and not really on the option
premiums. Besides, this trade comes with a predefined ‘time-based stop loss – remember, no matter what
happens, the idea is to get out minutes before RBI makes the announcement.
Black Scholes Option Pricing Model
The Black Scholes option pricing model is one used to calculate the value of an option based on the five
factors identified above.
The BSOP formulae (given in the exam) helps you compute the value of a Call option.
The BSOP model is generally applicable for European options only.
However, the value of a Put option is computed using the Put-Call Parity formula (also given in the exam).
Assumptions of the BSOP model
This frequently appears in the exam as a theory question. The BSOP model is based on the following
assumptions:





There are no transaction costs.
Investors can borrow unlimited funds at a risk-free rate of return.
The estimates for volatility and interest rate are accurate.
The movements in share prices are based on the normal distribution
No dividends are payable before the option expiry.
168
Valuation procedure for Call option
Formula:
𝒄 = 𝑷𝒂 𝑵(𝒅𝟏 ) − 𝑷𝒆 𝑵(𝒅𝟐 )𝒆−𝒓𝒕
𝑷
𝑰𝒏 ( 𝑷𝒂 ) + (𝒓 + 𝟎. 𝟓𝒔𝟐 )𝒕
𝒆
𝒅𝟏 =
𝑺√𝑻
𝒅𝟐 = 𝒅𝟏 − 𝑺√𝑻
For excel, use : c = (Pa*N(d1)) – (Pe*N(d2)*(e^(-rt )))
Where,
– Pa = share price
– Pe = exercise price
– r = annual risk-free rate of return
– s = standard deviation of the rate of the return on shares (share price volatility measure)
– e = exponential constant = 2.7183
– In = Natural log
d1 and d2 to be computed to two decimals
N(d1 ) & N(d2 ) are the cumulative values to be read from the normal distribution tables in conjunction
with the instructions mentioned below these tables (given in the exam)
169
The above table can be used to calculate N(d1 ), the cumulative normal distribution function needed for
the Black-Scholes model of option pricing. The marking is to help you understand the below example
If d1 > 0, add 0.5 to the relevant number above & if d1 < 0, subtract the relevant number above from 0.5.
For example, if d1 is 0.25 (match the first two digits with the leftmost column and the remaining digits
with the topmost row), N(d1 ) = 0.0987 + 0.5 = 0.5987.
Illustration 2
Calculate the value of a call option with the following parameters:
Current share price of Ikora plc = $100
Exercise price = $90
Risk-free of a return = 6%
Standard deviation of returns on the share = 40%
The time to expiry of option = 3 months
Solution:
Pa
100
Pe
R
90
0.06
T
S
E
In
0.25
0.4
2.7183
𝐝𝟏
𝐝𝟐
0.7018
0.5018
(Num) 𝐝𝟏 =
In(100/90)+(0.06+(0.5*0.16))*0.25
(Den) d1 =
0.14036
0.2
d1
d2
0.7018
0.5018
N(d1 )
N(d2 )
C=
0.758
0.6915
14.49167915
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Call option = 14.5
Valuation procedure for a Put option
The value of a put option cannot be obtained using the Black Scholes model. However, the value of a put
option can be obtained from the value of a call option with similar variables used by the BSOP model.
The Put Call Parity relation formula (given):
p=c–P+Pe
171
Illustration 3
Calculate the value of a put option with the following parameters:
Current share price of Ikora plc = $100
Exercise price = $90
Risk-free of a return = 6%
Standard deviation of returns on the share = 40%
The time to expiry of option = 3 months
Call option = 14.5
Solution:
Pa
Pe
r
t
s
e
In
D1
D2
e^-rt =
(Num)d1 =
S root T =
D1 =
D2 =
Nd1
Nd2
C=
P=
P=
100
90
0.06
0.25
0.4
2.7183
0.7018
0.5018
2.7183^(-0.06*0.25) = 0.25
In(100/90) +(0.06+0.5*0.16))*0.25
0.14036
0.2
0.7018
0.5018
0.758
0.6915
14.49167915
14.5-100+(90*2.7183^(-0.06*0.25))
3.160065674
Put option = 3.16
BSOP and dividends payable
An assumption in the BSOP model is that there are no dividends payable. If dividends are payable, then
the following adjustment needs to be made in the computation:
Step 1: Compute the PV of dividends payable by doing: dividend x e-rt
Step 2: Deduct the PV of dividends payable from Pa
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Greek measures
These are few terms that you have to study as they are commonly referenced in the exam. In fact, they
might use these terms in the question themselves instead of the English words.

Delta: This measures the change in the value of an option due to $1 change in the underlying asset
(i.e., in our above example, the share price). The value of delta is N(d1).

Gamma: This measures the rate of change of delta as the value of the underlying asset (i.e., in our
above examples, the share price) changes.

Vega: This measures the change in option value due to a 1% change in volatility.

Theta: This measures the rate of change in an option’s value due to time passing.

Rho: This measures the change in the option value due to changes in interest rate (risk-free rate).
Delta hedge
Hedge refers to a method in which one attempts to eliminate/mitigate risk. A delta hedge is used in the
following circumstances:

You are a writer of a call option (you’ve given somebody else the option to buy shares at a future
date), and now you want to hedge yourself. In this scenario, you could adopt a delta hedge to
protect yourself from the risk of losing money. This is done by doing an opposite matching
transaction in the money market. Thus, you will buy shares in the money market to hedge yourself
against the shares that you have promised to sell in the derivative market. By doing this, you will
have nullified the effect of gains or losses.
The number of shares to purchase = Number of call options sold x N(d1)

You now hold a number of shares and want to protect yourself against a fall in share price, the
same concept can be used here. You can hedge yourself by adopting a delta hedge by selling CALL
options. Thus, again having successfully nullified the effect of gains or losses, as gains from one
market will be set by losses in the other market and vice versa.
The number of CALL options to be written = Number of shares / N(d1)
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Note: It is possible to achieve the same hedge objective as described above by writing a call option or
obtaining a put option. In this case,
The number of put options to be obtained would be = Number of shares / N(-d1)
Illustration 4
If Mr. H holds 135 shares of a company and wishes to adopt a delta hedge, with the delta an option on
these shares computed as 0.45. How many CALL options would he have to sell?
Solution:
The number of CALL options to be written = Number of shares / N(d1)
= 135/0.45
= 300
Real options in Investment decision-making
Real options are financial options that become available at a later date within the context of a specific
investment or project. Real options increase the value or worthiness of an investment, and there may be
instances where investment with a negative NPV that would never have been rejected under normal
circumstances becomes appealing with a positive NPV once the option value is considered.
The following are some types of real options in a project:

Option to delay or defer the project
(CALL)
The point here is to be able to delay investment without losing the opportunity, creating a call
option on the future investment.

Option to expand project
(CALL)
It may be possible to adjust the scale of an investment depending on the market conditions.

Option to switch resources
(PUT)
It may be possible to switch the use of assets should market conditions change.

Option to abandon/sell before the end of the project
(PUT)
If a project has clearly identifiable stages such that investment can be staggered, then
management have to decide whether to abandon or continue at the end of each stage.
174
Types of real options
CALL
1) Option to delay the project
2) Option to expand the project
PUT
1) Option to swtich
resources
2) Option to abandon/sell
before the end of the
project
Case study
Consider the example of the oil company, which has the opportunity to acquire a five-year license on a
block. When developed, the block is expected to yield 50 million barrels of oil. The current price of a barrel
of oil from this field is, say, $10, and the present value of the development cost is $600 million. Thus the
NPV of the opportunity is simply: $500 million – $600 million = –$100 million
175
Faced with this valuation, the company would obviously pass up the opportunity. But what would option
valuation make of the same case?
Such a valuation would recognize the importance of uncertainty. There are two major sources of
uncertainty affecting the value of the block: the quantity and the price of the oil. The company can make
a reasonable estimate of the quantity of the oil by analyzing historical exploration data in geologically
similar areas. Similarly, historical data on the variability of oil prices are readily available.
Assume for the sake of argument that these two sources of uncertainty jointly result in a 30 percent
standard deviation (σ) around the growth rate of the value of operating cash inflows. Holding the option
also obliges the company to incur the annual fixed costs of keeping the reserve active—let us say, $15
million. This represents a dividend-like payout of 3 percent (that is, 15/500) of the value of the asset. We
already know that the duration of the option, t, is five years and that the risk-free interest rate, r, is 5
percent, leading us to estimate option value at
ROV = (500e –0.03*5)*{(0.58)} – (600e –0.05*5)*{(0.32)}
= $251 million – $151 million = +$100 million.
Where does this $200 million difference come from?
Consider a simple financial option, available at $17 for an exercise price of $70 when the stock is trading
at $83. A buyer who exercised the option immediately would have a payoff of $13 but would be $4 out of
pocket, having paid $17 for the option. The $4 represents the value of the flexibility inherent in not having
to decide whether to make the full investment immediately, flexibility whose value an NPV analysis would
recognize as zero. So too, in this case: the $200 million is the equivalent of the $4. Ultimately, then, the
option valuation recognizes the value of learning. This is important because strategic decisions are rarely
one-time events, particularly in investment-intensive industrial sectors. NPV, which relies on all-ornothing, “go/no go” decisions and doesn’t properly recognize the value of learning more before a full
commitment is made, is for that reason often inadequate. In fact, NPV’s inadequacy can be stated in the
precise terms of the real-options model. Of the six variables in that model, NPV analysis recognizes only
two: the present value of expected cash flows and the present value of fixed costs. Option valuation offers
greater comprehensiveness, capturing NPV plus the value of flexibility—that is, the expected value of the
change in NPV over the option’s life
Where does this $200 million difference come from? Consider a simple financial option, available at $17
for an exercise price of $70 when the stock is trading at $83. A buyer who exercised the option
immediately would have a payoff of $13 but would be $4 out of pocket, having paid $17 for the option.
The $4 represents the value of the flexibility inherent in not having to decide whether to make the full
investment immediately, flexibility whose value an NPV analysis would recognize as zero. So too, in this
case: the $200 million is the equivalent of the $4. Ultimately, then, the option valuation recognizes the
value of learning. This is important because strategic decisions are rarely one-time events, particularly in
investment-intensive industrial sectors. NPV, which relies on all-or-nothing, “go/no go” decisions and
doesn’t properly recognize the value of learning more before a full commitment is made, is for that reason
often inadequate. In fact, NPV’s inadequacy can be stated in the precise terms of the real-options model.
176
Of the six variables in that model, NPV analysis recognizes only two: the present value of expected cash
flows and the present value of fixed costs. Option valuation offers greater comprehensiveness, capturing
NPV plus the value of flexibility—that is, the expected value of the change in NPV over the option’s life.
Valuing real options using BSOP model
This is the most important part of the chapter as this area is tested most in the exam. This section assists
you in understanding what figures will up the variables used in the BSOP model. This can get confusing,
but just remember the instructions given below, and you will not face any issues.
The five variables that go into the BSOP model are to be substituted as follows:

Exercise price (Pe): The exercise price will not be directly given to you; you will have to pick it out from
the question.
 In the case of the aforementioned call options, the investment required for delaying the
project, expanding the project, or expanding the project will be the exercise price.
 In the case of the aforementioned put options, the salvage or abandonment value on
switching resources for the project will be the exercise price.

Share price (Pa): The share price will not be directly given to you; you will have to pick it out from the
question.
 In the case of the aforementioned call options, the PV for future cash flows arising from
the project's continuation (excluding the initial investment) will be the share price.
 In the case of the aforementioned put options, the PV of the cash flows foregone by
switching resources or abandoning the project will be the share price.

Time to expiry (t): The time until when a definite/final decision needs to be taken.

Volatility (s): This will be given to you as the standard deviation of the project.

Risk-free rate (r): Given directly in the question.
Illustration 5
Tridex, an IT training provider, has decided to set up a project in Burbank. They have the option of
expanding the business to Texas 2 years from now. The NPV of the project in Burbank based on its project
in Burbank based on its project life is estimated at ($1.23m).
An investment of $5m is required to expand to Texas 2 years from now, and the present value of the cash
receipts from this project is projected at $7m with a standard deviation of returns of 55%. If the risk-free
rate of return is 5%, calculate and comment on the value of the real option?
177
Solution:
Variables
Pa
$7m
Pe
$5m
r
5%
Denominator
0.777817459
t
2
d1 =
0.9501
s
55%
N(d1)
0.829
Calculations
In(Pa/Pe)
0.3365
e^-rt
0.9048
D1
calculation
Numerator =
0.3365+(0.05+(0.5*(0.55^2)))*2
0.739
d2 =
0.1722
N(d2) =
0.5684
Call option =
(7*0.829)-(5*0.5675)*0.9048
3.23493
Illustration 6
Allegro Technologies Co (ATC), a listed company based in Europe, has been involved in manufacturing
motor vehicle parts for many years. Although not involved in the production of complicated engine
components previously, ATC recently purchased the patent rights for $2m to produce an innovative
energy saving engine component which would cut carbon-based emissions from motor vehicles
substantially.
ATC has spent $5m developing prototypes of the component and undertaking investigative research
studies. The research studies came to the conclusion that the component will have a significant
commercial potential for a period of five years, after which, newer components would come into the
market, and the sales revenue from this component would fall to virtually nil. The research studies have
also found that in the first two years (the development phase), there will be considerable training and
development costs and fewer components will be produced and sold. However, sales revenue is expected
to grow rapidly in the following three years (the commercial phase).
It is estimated that in the first year, the selling price would be $1,000 per component, the variable costs
would be $400 per component, and the total direct fixed costs would be $1,500,000. Thereafter, while
the selling price is expected to increase by 8% per year, the variable and fixed costs are expected to
increase by 5% per year for the next four years. Training and development costs are expected to be 120%
of the variable costs in the first year, 40% in the second year and 10% in each of the following three years.
The estimated average number of engine components produced and sold per year is given in Table 1.
178
Year
Units produced and sold
1
7,500
2
20,000
3
50,000
4
60,000
5
95,000
There is considerable uncertainty as to the exact quantity that could be produced and sold and the
estimated standard deviation of units produced and sold is expected to be as much as 30%. Machinery
costing $120,000,000 will need to be installed prior to commencement of the component production. ATC
has enough space in its factory to manufacture the components and therefore will incur no additional
rental costs. Tax allowable depreciation is available on the machinery at 10% straight line basis. It can be
assumed that, depending on the written down value, a balancing adjustment will be made at the end of
the project, when the machinery is expected to be sold for $40,000,000. ATC makes sufficient profits from
its other activities to take advantage of any tax loss relief available from this project.
Initially, ATC will require additional working capital for the project of 20% of the first year’s sales revenue.
Thereafter every $1 increase in sales revenue will require a 10% increase in working capital.
Although this would be a major undertaking for ATC, it is confident that it can raise the finance required
for the machinery and the first year’s working capital. The financing will be through a mixture of a rights
issue and a bank loan, in the same proportion as the market values of its current equity and debt capital.
Any annual increase in working capital after the first year will be financed by internally generated funds.
Largo Co, a company based in South-East Asia, has approached ATC with a proposal to produce some of
the parts required for the component at highly competitive rates. In exchange, Largo Co would expect
ATC to sign a five-year contract giving Largo Co the exclusive production rights for the parts.
Staccato Innovations Co (SIC) is a listed company involved in the manufacture of innovative engine
components and engines for many years. As the worldwide demand for energy saving products has
increased, it has successfully developed and sold products designed to reduce carbon emissions. SIC has
offered to buy the production rights of the component and the machinery from ATC for $113,000,000
after the development phase has been completed in two-years’ time.
Additional Information
ATC, Extracts from its latest Statement of Financial Position
Non – current assets
Current assets less current liabilities
6% Bank loan
Share capital
Reserves
$m
336
74
156
52
202
ATC shares have a face value of $0.50 per share and are currently trading at $3.50 per share. ATC’s beta
has been quoted at approximately 1.3 over the past year
SIC, Extract from its latest Statement of Financial Position
179
Non – current assets
Current assets less current liabilities
5% Bank loan (2016-2018)
Share capital
Reserves
$m
417
157
92
125
357
SIC shares have a face value of $1 per share and are currently trading at $3.00 per share. Its loan notes
are trading at $102 per $100. SIC’s beta has been quoted at approximately 1.8 over the past year
Other data
Tax rate applicable to ATC and SIC
20%
It can be assumed that tax is payable in the same year as the profits on which it is changed.
Estimated risk-free rate of return
3%
Historic equity market risk premium
6%
Required: Prepare a report to the Board of Directors of ATC that:
(i)
Assesses whether ATC should undertake the project of developing and commercialising the
innovative engine component before taking SIC’s offer into consideration. Show all relevant
calculations.
(13 marks)
(ii)
Assesses the value of the above project if ATC takes SIC’s offer into consideration. Show all
relevant calculations.
(10 marks)
(iii)
Discusses the approach taken and the assumptions made for parts (i) and (ii) above. (8 marks)
(iv)
Discusses possible implications of ATC entering into a contractual agreement with Largo Co.
Include in the discussion suggestions of how any negative impact may be reduced. (5 marks)
(v)
Professional marks for format, structure and presentation of the report.
(4 marks)
(40 marks)
180
Solution:
Report to the ATC Board of Directors
Assessment of the investment in the engine component project
This report recommends whether or not ATC would benefit by investing in the engine component project
by considering the following alternatives open to it, and explains the approach taken in each case and the
assumptions made:
–
–
The value of the project without the SIC offer to buy the project on completion of the two-year
development phase.
The value of the project after taking into account SIC’s offer. The report also considers the possible
implications of the offer made by Largo Co on the project.
Approach taken
The approach taken is to estimate the net present value (NPV) of the project based on the given estimates
of costs and revenues without the SIC offer (see appendices one and three).
This is followed by a revised estimate of the value of the project after taking into consideration SIC’s offer.
This is based on viewing the project as a real option to abandon (put option) the project and using BlackScholes Option Pricing (BSOP) model to give an estimate of this value (see appendix two).
Assumptions made and initial assessment
In calculating the value of the project, the following assumptions have been made:





Since this is a new venture for ATC but an ongoing business for SIC, an estimate of the project’s risk,
as measured by the project’s risk-adjusted beta, is made (appendix three, working W4) using SIC’s
business risk (SIC’s asset beta) but ATC’s financial risk (project equity beta). This risk-adjusted beta is
used to calculate the cost of equity and then the cost of capital (discount rate) for the project
(appendix three, working w4).
As part of the W4 calculation in appendix three, it is assumed that debt is riskless and has a beta of
zero.
Unless indicated otherwise, it is assumed that all cash flows occur at the end of the year.
The patent purchase cost and the investigative research costs are past costs, and therefore not part
of the calculation of the value of the project, which is based on future cash flows.
The option for ATC is the opportunity to ‘sell’ the project to SIC after two years if the cash flows do
not appear to be favourable, hence this is a put option to abandon a project. Since the option is
exercised after two years, it can be considered to be a ‘European’ type option, and the BSOP model
can be applied, together with the put-call parity relationship.
181
Based on the calculations in the appendices, from the cost and revenue estimates provided, the net
present value before considering the SIC option is negative at $9,359,000 approximately (appendix one).
However, after taking into account the value of the put option, the net present value is positive at
$8,087,000 approximately (appendix two). Therefore, it would be beneficial for ATC to undertake the
project, if it can decide whether to continue with the project or sell it to SIC for $133,000,000 after a
period of two years. However, without this option, it should not proceed with the project.
ATC will not actually obtain the value of the option; however, the option value takes into account the
volatility or uncertainty of the project. In this case, it indicates that the project is worth pursuing because
the volatility may result in increases in future cash flows, and the project becomes profitable. On the other
hand, the project can be abandoned for $113,000,000 in two years if the likelihood of sufficient future
cash flows remains doubtful. The value attached to this choice is $17,446,000 approximately (appendix
two). In the meantime, ATC can put into place mechanisms to make the production and sales targets more
certain and profitable. Therefore, the time ATC has before it needs to make a decision is reflected in the
value of the project by considering real options using the BSOP model.
The BSOP model makes several assumptions such as perfect markets, constant interest rates and
lognormal distribution of asset prices. It also assumes that volatility can be assessed and stays constant
throughout the life of the project and that the underlying asset can be traded. Neither of these
assumptions would necessarily apply to real options. Therefore, the Board needs to treat the value
obtained as indicative rather than definitive and take the assumptions and limitations into consideration
before making a final decision.
Implications of the Largo Co offer on the value of the project
From the above discussion, it is evident that the project has a negative net present value if it is not
considered in conjunction with an option to abandon. The abandonment option makes the project viable.
However, if ATC enters into a five-year contractual agreement with Largo Co, then this may make the twoyear offer by SIC to buy the project redundant. There is no guarantee that SIC would continue to ask Largo
Co to produce the parts and ATC would not be able to honor the contract and keep the SIC’s offer open
at the same time. ATC would need to consider the impact of the cost savings from the agreement with
Largo Co against the possible loss of the option. The Board may also wish to consider how binding the
contract would be legally and also consider the negative impact on ATC’s reputation and additional costs
if it breaches the contract in future.
In order to mitigate the impact of the issue, the Board may wish to approach Largo Co to discuss the terms
of the contract and the provision of possible exclusion clauses. The Board may also want to investigate
the reasons behind Largo Co’s insistence on a five-year contract and offer alternatives such as asking Largo
Co to produce components for other ATC products if this venture should cease. Alternatively, the Board
may initiate discussions with SIC to consider whether it would be willing to honor the contract should the
project be sold to them in two years.
In summary, the initial recommendation is that, based on the projected revenue and cost estimates, the
project should be pursued if it is taken together with SIC’s offer to buy the project after two years.
182
However, on its own, it is not worthwhile. The offer by Largo Co may make SIC’s offer invalid initially, but
the Board should consider alternatives, some of which are suggested above.
Appendix 1
Net present value calculation (ignoring SIC offer)
Year
0
$’000
Sales revenue (w1)
Less
Variable costs
Fixed costs
Training
and
development
1
2
3
4
5
7,500
21,600
58,300
75,540
129,200
3,000
1,500
3,600
8,400
1,575
3,360
22,050
1,654
2,205
27,780
1,736
2,778
46,170
1,823
4,617
Cash flows before tax
Taxation (w3)
Working capital
Machinery
Net cash flows
Present values (12%, w4)
(600)
2,520
(1,410)
8,265
747
(3,670)
32,391
(4,078)
(1,724)
43,246
(6,249)
(5,366)
75,590
(8,718)
13,670
510
455
5,342
4,259
26,589
18,926
31,361
20,102
120,542
68,399
(1,500)
(120,000)
(121,500)
(121,500)
Net present value is approximately $(9,359,000)
Appendix 2
Value of put option (incorporating the offer from SIC)
Present value of underlying asset (Pa) = $107,427,000 (approximately)
(This is the sum of the present values of the cash flows foregone in years 3, 4 and 5)
Price offered by Largo Co (Pe) $113,000,000
Risk-free rate of interest (r) 3%
Volatility of underlying asset (s) = 30%
Time to expiry of option (t) 2 years
d1- [In(107,427,000/113,000,000) + (0.03+0.5 x 0.32) x 21/[0.3 x 21 = 0.234
d2= 0.234-0.3x21/2 -0.190
183
N(d1) = 0.5+0.0925 0.5925
N(d2) 0.5-0.0753 0.4247
Call value = $107,427,000x0.5925-$113,000,000x0.4247xe-0.03x2 = approx. $18,454,000
Put value = $18,454,000-$107,427,000 + $113,000,000xe-0.03x2 = approx. $17,446,000
Net present value with put option = $17,446,000 - $9,359,000 approx. $8,087,000
Appendix 3
W1
Year
Units produced and sold
Unit price ($)
Sales revenue ($’000)
1
7,500
1,000
7,500
2
20,000
1,080
21,600
3
50,000
1,166
58,300
4
60,000
1,259
75,540
5
95,000
1,360
129,200
W2
Year
Units produced and sold
Unit variable costs ($)
Variable costs ($’000)
1
7,500
400
3,000
2
20,000
420
8,400
3
50,000
441
22,050
4
60,000
463
27,780
5
95,000
486
46,170
W3
Year
Cash flows before tax ($’000)
Tax allowable dep’n ($’000)
Taxable flows ($’000)
Taxation (20%) ($’000)
1
(600)
(12,000)
(12,600)
(2,520)
2
8,265
(12,000)
(3,735)
(747)
3
32,391
(12,000)
20,391
4,078
4
43,246
(12,000)
31,246
6,249
5
75,590
(32,000)
43,590
8,718
W4
Asset beta of project = 1.8 x (3 x 125)/(3 x 125 + 92 x 1.02 x 0.8) = 1.50
Equity beta: project beta adjusted for financial risk of ATC = 1.5 x (3.5 x 104 + 156 x 0.8)/(3.5 x 104)= 2.014
Cost of equity = 3&+2.014 x 6% 15.08%
WACC (discount rate) = (15.08% x 364 + 6% x 0.8 x 156)/520 = 11.996% approx. 12%.
184
185
Chapter 5: Mergers & Acquisitions
186
Introduction
This chapter is essentially an advanced version of business valuation that was taught in F9. This area
focuses more on the practical aspects and teaches you additional methods of valuing a business. This
chapter heavily relates to the due diligence role many financial service companies have to offer. Basically,
before a company merges or acquires another, that company (known as the predator company) needs
reassurance that they aren’t over-paying to acquire any entity. Thus, that’s where this chapter comes into
play.
Key terminology
1. Merger: A merger is an agreement that combines two existing entities into one new company.
2. Acquisition: An acquisition is when a larger company (predator company) buys out a smaller company
(target company)
3. Buying out assets and liabilities: At times, rather than transferring ownership directly of a company,
the assets and liabilities of that company are bought out instead.
4. Synergy: Synergy is defined as the benefit resulting from a combination that would not exist if the
two entities continued to operate separately. Synergies can arise as a result of resources shared,
economies of scale, changes in the entity's size and borrowing capacity, tax set-off and related
benefits, and pooling of managerial talent.
5. Type I acquisition: An acquisition where the business risk (Ba) and the financial risk (d/e ratio) is not
affected.
6. Type II acquisition: An acquisition where the financial risk is unaffected, however, the business risk is
altered.
7. Type III acquisition: An acquisition whereby both the business risk and the financial risk is altered.
187
Acquisition versus Organic growth
When a business has the desire to expand or grow, it has two options. The first being organic growth and
the second via acquisition. There is no set rule as to which is going to be the best choice, it is contingent
on the various economic and business factors that surround the company. Thus, the following are the
benefits of both methods, you will have to use professional judgement to choose the most appropriate
method.
Benefits of acquisitions over organic growth







It is a much quicker process to grow, as it could take years to develop a functioning and profitable
product line while acquiring a company that has one is basically instantaneous.
(Apart from all the legal work)
If you consider expanding in the same line of business, it reduces the number of competitors in
the market.
You will have the right to ownership of all the resources of the predator company.
Reduces the chance of entry of a new entity in the market and thus, no over-production or oversupply issues.
Increases the market share.
Gives the benefit of tax relief in case of a loss-making company being acquired.
Risk gets reduced due to diversified investment.
Challenges of acquisition over organic growth:





An acquisition involves paying out a huge amount of money, with no guarantee that the company
acquired will perfectly fit in with the current organization, nor is there any guarantee that the
company will continue to remain profitable. Thus, it is far more risky than organic growth.
Cost of acquisitions ae much higher than when doing a project through an organic growth route.
For example, is it more expensive to buy a coffee from the Taj or to just buy the same beans and
make it at home?
There may be problems while integrating the new company into the current organization’s
operations.
It creates immediate pressure on existing management to take care of the expanded business
lines.
Diversification mainly occurs in daily jobs of the managers and employees and therefore can
hamper the growth of the company. Also, the reason of diversification is also questioned on the
grounds that it could have been achieved just by mere holding of shares in the other company
rather than acquiring the same.
188
Case study – Bjyus and Aakash institute transaction – Inorganic growth preferred in the ed-tech market
About the acquiree company
Blackstone Group-backed Aakash Educational Services Limited (AESL) is a thirty-three year old coaching
institute that offers test prep services for medical and engineering entrance exams, school board exams,
KVPY (Kishore Vaigyanik Protsahan Yojna), NTSE (National Talent Search Examination), Olympiads, and
other foundation level exams to students in classes 8-10 for school boards and junior competitive exams.
These offerings by the offline major are categorized under three brands – Aakash Medical, Aakash IIT-JEE,
and Aakash Foundations. It has its presence in more than 200 coaching centers across the country.
Aakash institute started its journey when the people considered the coaching institutions as not a growing
business, but Aakash build its name and fame in the market by working rigorously as well as ever since its
inception, the company stayed reliable to its students in the education market till date as it changed with
the time and need of the students.
About the acquirer company
Bangalore-based BYJU’S was founded by Byju Raveendran and Divya Gokulnath in 2011 as an educational
company that offers online video-based learning programs for the K-12 segment and competitive exams.
The company has seen steady growth for four years in the education sector and launched the Byju, the
Learning App, in August 2015. BYJU’S strongly believes in a Freemium business model wherein it offers
customers both complimentary and paid (premium) services. The approach of the BYJU’S in providing
knowledge with highly creative visual contents, one-on-one learning process, and other facilities has led
to the success of BYJU’S in a very small span in the competitive world. Byju has been able to rightly blend
the technology and knowledge to today’s generation.
BYJU’S is backed by marquee investors like Mary Meeker, Yuri Milner, Chan-Zuckerberg Initiative, Tencent,
Sequoia Capital, Tiger Global, and others. It is estimated to have raised over USD 2 billion in funding to
date. BYJU’S has also acquired several start-ups and businesses to expand its offerings and push its market
share and ed-tech penetration through its subsidiaries. Here is the list of the companies that are acquired
by BYJU’S:Year
2021
2020
2020
Acquired Company
Toppr
WhiteHat Jr.
Label App
2019
2018
Osmo
Math Adventures
2017
2017
TutorVista, including Edurite
Vidyartha
Market
Students of Class 5 to 12 in India
Coding for school going kids
Lab-like simulations for science
students
School going kids in the US
Developmental maths for K-3
Age group
US-based college students
Career advice
Amount Paid by Byju’s
$150 million
$300 million
Undisclosed
$120 million
Undisclosed
Undisclosed
Undisclosed
189
Analysis of the deal
From collaboration to acquisition
BYJU’S and Aakash’s team started talking in the month of June 2020 last year. At that time, they discussed
the possibility of working jointly and working together. The discussion about acquisition started in the
month of October, and they were able to come to an agreement in December. And in April 2021, BYJU’S
finally acquired Aakash through a strategic merger. Managing Director & Co-Promoter Aakash Chaudhry
and his family are giving up their entire stake in the firm for a 70:30 cash-equity deal under which they
will receive an undisclosed stake in BYJU’S for about 30 percent of the payment.
Benefits for Byju
Test – prep as an important market for Ed-tech players
Among the four major areas of ed-tech i.e., K-12, test prep, skill development, and online certification,
the test prep is considered to be the evergreen market for Ed-tech as the students are obsessed with the
grades, the right coaching and guidance provide them the admission in top colleges of engineering and
medical courses. The test prep is also helpful to people to get gilt-edged government jobs. Online test
prep start-ups are growing tremendously because of these reasons. By acquiring the Aakash, the BYJU’S
makes its presence in the test prep segment the best choice for the students as it provides the blend of
both the technology of the BYJU’S and the expertise of the Aakash, so the students can learn from home
as well as take guidance from the experts.
Create base in the brick and mortar style coaching education
No matter how much the technology is evolving, the traditional way of teaching i.e. the physical presence
of both students and the teacher is still irreplaceable and BYJU’S knows it. Though BYJU’S had acquired
several educational companies in the past, the acquisition deal of its with Aakash is the first offline
acquisition that it has been into. As the Aakash has very little presence in the ed-tech industry. The major
reason why the deal is done is pretty clear, as BYJU’S has not had traditional classroom coaching for a
while now, while Aakash has a pretty strong base there.
BYJU’S has a stronghold in the school education segment, while Aakash, on the other hand, is a leader in
the competitive exams segment. The merger was done in order to take advantage of this cross-segment
diversification.
For the test prep market, it is difficult to replicate the rigor and intensity of competitive exams online. The
students need a group studying environment and some interactions with teachers during preparation,
which can only be achieved through offline play. To have only online models for test preparations is very
far right now for the ed-tech companies to achieve. This deal will be a medium to reach the towns & cities
that are still untouched by the BYJU’S because their enhanced adoption of online learning may still be a
few years away.
190
What’s next
BYJU’S had a strong presence across urban markets even before the pandemic fueled the recent Ed-tech
boom. Since the mandatory lockdowns from March 2020, the company claims to have added 25 million+
students to its platform. It also secured more than $1.2 Billion in funding last year, taking the total funding
amount to $2.1 Billion, and hit the decacorn status at a $12 Billion valuation. However, a significant
amount of that funding went into acquisitions.
The future of learning is hybrid, and this union will bring together the best of offline and online learning,
The high-tech as well as tried and tested platform of BYJU combined with the skilled faculty of Aakash
Institutes will prepare a model of hybrid learning where students would be able to learn through the
online medium as well as will be able to seek offline guidance from its brick and mortar presence, as and
when they required. As we combine our expertise to create impactful experiences for students. The
pandemic has brought the importance and urgency of the blended format of learning to the forefront.
Byju’s cited industry reports and said that the test preparation and after-school tutoring (high school)
segment is estimated to be a USD 7-8 billion opportunity in India and is expected to witness 55-60 %
growth over the next 4-5 years.
Also, the existing subscribers of BYJU’S, especially those who are studying in grades 9-12 can automatically
opt for AESL’s core entrance exam courses, thereby creating stickiness for the BYJU’S platform. As far as
Aakash Educational Services is concerned, the deal with BYJU’S will enable them to add online learning to
its services. The acquisition will allow the two biggest entities of their respective business to build the
largest omnichannel for students in India.
BYJU’S will not likely make any changes to Akash’s existing core business through its acquisition. However,
it is noted by a press release that it has plans to make new investments to accelerate the growth of the
traditional educational institutional chain. The deal will also help BYJU’S introduce new verticals, topics,
and languages to its online platform.
The following are few factors that encourage companies to take the acquisition route:







Quick and rapid entry into a new market
Synergistic benefits
It may help obtain some core competencies and access to unique resources
If the company invests in a company that has a different line of operation, the predator company
is diversifying its risk.
It could help the company reach the threshold volume required for listing, as it could increase its
asset and equity base.
Increased capacity to raise finance. (As predator company will have access to more assets)
To sustain revenues and shareholder wealth.
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Important issues to consider while acquiring companies
The points listed below are to be used as a blueprint and linked with the respective case study given to
you in the exam.









Employees, organizational structure, culture, the existing remuneration levels, ability to retain
employees.
Production capacity, currently utilized capacity, the further investment needed to expand.
Sales levels, expected growth, normal trading terms, need for sales and marketing expenditure.
Past financial performance and current financial position, accounting policies followed by the
company, trends in sales revenue and profits affecting financial success.
Liquidity position, foreign exchange exposure, interest rate exposure, the current level of
borrowing and related complications.
Prevalent tax rates and the existence of any disputes, litigation relating to income or any other
taxes.
Other valuation related factors like actuarial valuation of pensions, the existence of guarantees,
potential litigation or any contingent liabilities that exist to may arise as a result of pursuing the
acquisition.
Legal aspects relating to the mode and methods of transfer of ownership.
Technology skill of the entity and its employees and extent of integration possible with predator
IT systems.
Regulatory aspect in take overs
It is important to regulate merges and acquisitions as at times, it could potentially create a monopoly
situation where a single entity the complete control of supply and production.
Thus, a takeover may be referred to the Office of Fair Trading (OFT) to ensure that the acquisition or
merger does not affect or reduce competition in anyway.
In the UK, the city code on take-overs and mergers is used to regulate take-overs. Some of the key
principles laid down in the code are as follows:





This code is to be enforced by stock exchanges and other regulated bodies
The code stipulates that all shareholders of both the target and predator company be informed
as soon as the bid to acquire is made.
Approval of the shareholders is a pre-requisite for the completion of the deal.
The valuation and return forecast need to be reviewed in certain instances by a firm of
professional accountants.
An independent (third party) valuation is also required.
192
Identifying possible acquisition targets
Once it is decided that external or inorganic growth is the next step, the acquiring company needs to
follow the following steps:
Strategic Steps
Tactical Steps
Step 1: Appraise possible
acquisitions
Step 1: Launch a dawn raid subject
to regulations
Step 2: Select the best target
Step 2: Make a public offer
Step 3: Decide on the financial
strategy
Step 3: Try to achieve >50% of
target company's shares
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Information required for assessment of acquisition
The following information needs to be obtained with respect to the target company:
Organisation
•Organisation chart and hierarchy of KMPs
•Employee analysis
•Unionisation relations and pension arrangements
Sales & Marketing
•Past and future sales volume product-wise and regionwise
•Market position and major customer groups
•Detailed assessment of market and customer base
Production, supply &
distribution
•Total production capacity and current usage level
•Estimated future capital requirement
•Detailed calculation of overhead burden due to under
production
Technology
Accounting information
•Details of particular technical skills inherent in the
organisation
•Past and future estimated R&D expenditure
•Historic consolidated and separate financial accounts
•Detailed description of accounting policies
•Explanation of major variation in sales, overheads and
margins
Treasury income
•Detailed description of bank facilities and external
loans along with security, amount,terms, restrictive
covenants and trust deeds of facilities
•Details of forward exchange contract positions and
exchange management policies
Tax information
•Past tax computations and filings
•Significant ongoing disputes
•Trading losses brought forward
Other information
•Contingent liabilities, forward contracts, loss making
contracts not provided for
•Details of shareholding - preference and equity along
with voting restrictions
194
Synergy
Synergy is the combined power of a group of things when they are working together that is greater than
the total power achieved by each working separately.
In case of mergers, synergy can be defined as s two or more entities coming together to produce a
result not independently obtainable.
It can be easily explained as 1+1 = 3, meaning if entity A and B are merging to form AB,
Market Value of AB
>
Combined Market Value of A and B.
Sources of Synergy
Cost Synergy
Revenue Synergy
Financial Synergy
Sources of
Synergy
1. Revenue Synergy:
 Combination of market power
 Elimination of competition
 Economies of vertical integration
 Benefit of complementary resources
2. Cost Synergy:
 Economies of scale
 Economies of scope
195
3. Financial Synergy:
 Tax shield
 Risk diversification
 Elimination of inefficiency
 Better opportunities for growth
Impact of merger on stakeholders
Stakeholder
Shareholders of Acquiring company
Shareholders of Target company
Employees of Acquiring company
Employees of Target company
Society
Lenders/debt holders
Impact
Benefit of synergy, increase in wealth
Premium received on existing shares
See the merger as an opportunity for higher salaries along with
increase in scope of work
View the merger as a dreadful event, as it might lead of
redundancy of their roles due to duplication of managers
Merger should benefit the society as a whole leading to better
products at lower prices for customers. However, sometimes
they also create monopolies if not monitored correctly
Becomes repayable due to change of risk, acquirer will have to
look for alternate funds
Methods of financing take-over
You can acquire a company by buying out the entire equity value or by buying out the company’s assets
and liabilities.
1. Cash: An acquisition may be made by paying out cash directly to the shareholders of the target
company.
When this is done, the following are the benefits:


The entire process is quicker to achieve, as it is a direct payment of cash.
It tends to be cheaper as the seller faces lesser risk.
o No dilution of predator company control for shareholders
However, there are some issues with using this method of financing, such as:



It could create liquidity problems for the predator company post-acquisition.
As the target company shareholders will have most likely sold the company at a premium of its
current value. Target company shareholders will have to pay capital gains tax.
Owners in the target entity would no longer be required to engage in the risk and rewards
associated with the post-acquisition combination of organizations.
196
2. Shares: An acquisition may also be made by issuing shares of the predator company and transferring
them to the target company’s shareholders. Note, this is not the same as selling shares currently in
issue.
In the exam, you will have to practically show the share for share exchange, thus the following
example is for further understanding as to how exactly this works.
Company A is acquiring company B for $60 million through a share-for-share exchange.
Company A has 10 million shares currently at $30 per share. Company B has 1 million shares at $50
per share.
Thus, Company A will have to issue 2 million new shares ($60m/$30) and exchange this with the 1
million shares in company B. (This part you will have to compute yourself in the exam). Company B’s
shareholders will exchange their 1 million shares for the 2 million shares in company A (which is
basically worth $60 million, which is the buying price).
Therefore, Company A has effectively bought out Company B, and company B’s shareholders will
effectively have exchanged 1 share in company B for 2 shares (2 million shares/ 1 million shares) in
the new company A. Thus at a premium of $10 million in total and at $10 per share (2 x $30/1 x $50).
We can now say this was a 2 for 1 share exchange from company A’s perspective.
197
When this method is taken up, the following are some of the benefits:



No cash strain for the acquirer
No capital gains liability for target company shareholder immediately
Both the predator and target company shareholders in the post-acquisition structure.
However, there are some issues with using this mode of financing, such as:


Leads to dilution of control as owner.
Valuation of shares is debatable and a matter of judgement.
3. Bond issue: An acquisition could also be financed through the issue of bonds to the target company
shareholders. This is similar to the share-for-for share exchange, except over here, the predator
company issues bonds and exchanges them for target company shares/ownership.
The following are some of the benefits of choosing this route:
 No cash strain for the predator company.
 The target company shareholders are eligible to receive yearly fixed interest income.
 No loss of control, as in the previous option, there was a dilution of share ownership.
However, there are certain issues with this method of acquisition, they are as follows:


It increases the financial risk of the predator company, as this will increase the liabilities and fixed
interest payments.
Target company shareholders do not get to participate in profits after the take-over, as they are
now bond holders, not shareholders.
198
Illustration 1
Sigra Co is a listed company producing confectionary products which it sells around the world. It wants to
acquire Dentro Co, an unlisted company producing luxury chocolates. Sigra Co proposes to pay for the
acquisition using one of the following three methods:
Method 1
A cash offer of $5.00 per Dentro Co share; or
Method 2
An offer of three of its shares for two of Dentro Co’s shares; or
Method 3
An offer of a 2% coupon bond in exchange for 16 Dentro Co’s shares. The bond will be redeemed in three
years at its par value of $100.
Extracts from the latest financial statements of both companies are as follows:
Sales revenue
Profit before tax
Taxation
Profit after tax
Dividends
Retained earnings for the year
Non‐current assets
Current assets
Non‐current liabilities
Current liabilities
Share capital (40c per share)
Reserves
Sigra Co
$000
44,210
––––––
6,190
(1,240)
––––––
4,950
(2,700)
––––––
2,250
––––––
22,450
3,450
9,700
3,600
4,400
8,200
Dentro Co
$000
4,680
–––––
780
(155)
–––––
625
(275)
–––––
350
–––––
3,350
247
873
436
500
1,788
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Sigra Co’s current share price is $3.60 per share, and it has been estimated that Dentro Co’s price to
earnings ratio is 12.5% higher than Sigra Co’s current price to earnings ratio. Sigra Co’s non‐current
liabilities include a 6% bond redeemable in three years at par which is currently trading at $104 per $100
par value. Sigra Co estimates that it could achieve synergy savings of 30% of Dentro Co’s estimated equity
value by eliminating duplicated administrative functions, selling excess non‐current assets and through
reducing the workforce numbers, if the acquisition were successful.
Required:
a) Explain briefly, in general terms, why many acquisitions in the real world are not successful
(5 marks)
b) Estimate the percentage gain on a Dentro Co share under each of the above three payment
methods. Comment on the answers obtained. (16 marks)
c) In relation to the acquisition, the board of directors of Sigra Co are considering the following two
proposals:
Proposal 1
Once Sigra Co has obtained an agreement from a significant majority of the shareholders, it will
enforce the remaining minority shareholders to sell their shares.
Proposal 2
Sigra Co will offer an extra 3 cents per share, in addition to the bid price, to 30% of the shareholders
of Dentro Co on a first‐come, first‐serve basis as an added incentive to make the acquisition proceed
more quickly.
Required:
With reference to the key aspects of the global regulatory framework for mergers and acquisitions,
briefly discuss the above proposals.
(4 marks)
(Total: 25 marks)
200
Solution:
(a) Common reason why acquisitions are unsuccessful
Lack of industrial or commercial fit
Failure can result from a takeover where the acquired entity turns out not to have the product range or
industrial position that the acquirer anticipated.
Lack of goal congruence
This may apply not only to the acquired entity but, more dangerously, to the acquirer, whereby disputes
over the treatment of the acquired entity might well take away the benefits of an otherwise excellent
acquisition.
‘Cheap’ purchases
The ‘turn around’ costs of an acquisition purchased at what seems to be a bargain price may well turn out
to be a high multiple of that price.
Paying too much
The fact that a high premium is paid for an acquisition does not necessarily mean that it will fail. Failure
would result only if the price paid is beyond that which the acquirer considers acceptable to increase
satisfactorily the long term wealth of its shareholders.
Failure to integrate effectively
An acquirer needs to have a workable and clear plan of the extent to which the acquired company is to
be integrated. The plan must address such problems as differences in management styles,
incompatibilities in data information systems, and continued opposition to the acquisition by some of the
acquired entity’s staff.
(b) Number of Sigra Co shares = 4,400,000/0.4 = 11,000,000 shares
Sigra Co earnings per share (EPS) = $4,950,000/11,000,000 shares = 45c/share
Sigra Co price to earnings (PE) ratio = $3.6/$0.45 = 8
Dentro PE ratio = 8 × 1.125 = 9
Dentro Co shares = $500,000/0.4 = 1,250,000 shares
Dentro Co EPS = $625,000/1,250,000 = 50c/share
Estimate of Dentro Co value per share = $0.5 × 9 = $4.50/share
201
Cash offer
Dentro share percentage gain under cash offer
$0.50/$4.50 × 100% = 11.1%
Share‐for‐share exchange
Equity value of Sigra Co = 11,000,000 × $3.60 =
Equity value of Dentro Co = 1,250,000 × $4.50 =
Synergy savings = 30% × $5,625,000 =
$39,600,000
$5,625,000
$1,688,000
Total equity value of combined company
$46,913,000
Number of shares for share‐for‐share exchange 11,000,000 +
[1,250,000 × 3/2] =
12,875,000
Expected share price of combined company Dentro share $3.644/ share
percentage gain under share‐for‐share offer [($3.644 × 3 – $4.50 ×
2)/2]/$4.50 × 100% = 21.5%
Bond offer
Rate of return
$104 = $6 × (1 + r)–1 + $6 × (1 + r)–2 + $106 × (1 + r)–3
If r is 5%, price is $102.72 If r is 4%, price is $105.55
r is approximately = 4% + (105.55 – 104)/(105.55 – 102.72) × 1% = 4.55%
Price of new bond = $2 × 1.0455–1 + $2 × 1.0455–2 + $102 × 1.0455–3 = $93.00
Value per share = $93.00/16 = $5.81/share Dentro share percentage gain under bond offer Bond offer:
($5.81 – $4.50)/$4.50 × 100% = 29.1%
Comments
An initial comparison is made between the cash and the share‐for‐share offers. Although the share‐for‐
share exchange gives a higher return compared to the cash offer, Dentro Co’s shareholders may prefer
the cash offer as the gains in the share price are dependent on the synergy gains being achieved. However,
purchase for cash may mean that the shareholders face an immediate tax burden. Sigra Co’s shareholders
would probably prefer the cash option because the premium would only take $625,000 of the synergy
benefits ($0.50 × 1,250,000 shares), whereas a share‐for‐share exchange would result in approximately
$1,209,000 of the synergy benefits being given to the Dentro Co shareholders (21.5% × $4.50 × 1,250,000
shares).
202
The bond offer provides an alternative which may be acceptable to both sets of shareholders. Dentro Co’s
shareholders receive the highest return for this, and Sigra Co’s shareholders may be pleased that a large
proportion of the payment is deferred for three years. In present value terms, however, a very high
proportion of the projected synergy benefits are given to Dentro Co’s shareholders (29.1% × $4.50 ×
$1,250,000 = $1,637,000).
(c) The regulatory framework within the European Union, the EU takeovers directive, will be used to
discuss the proposals. However, it is acceptable for candidates to refer to other directives and discuss the
proposals on that basis.
Proposal 1
With regards to the first proposal, the directive gives the bidder squeeze‐out rights, where the bidder can
force minority shareholders to sell their shares. However, the limits set for squeeze‐out rights are
generally high (UK: 90%; Belgium, France, Germany and the Netherlands: 95%; Ireland 80%). It is likely,
therefore, that Sigra Co will need a very large proportion of Dentro Co’s shareholders to agree to the
acquisition before they can force the rest of Dentro Co’s shareholders to sell their shares. Dentro Co’s
minority shareholders may also require Sigra Co to purchase their shares, known as sell‐out rights.
Proposal 2
With regards to the second proposal, the principle of equal treatment in the directive requires that all
shareholders should be treated equally. In general terms, the bidder must offer minority shareholders the
same terms as those offered to other shareholders. It could be argued here that the principle of equal
treatment is contravened because later shareholders are not offered the extra 3 cents per share, even
though the 30% is less than a majority shareholding. It is highly unlikely that Sigra Co will be allowed to
offer these terms.
Reasons why mergers fail





Lack of fit syndrome: Sometimes management styles or corporate cultures don’t fit in well
together for the two merged companies leading to a downfall.
Lack of industrial or commercial fit: In case of horizontal or vertical take overs, the target entity
not having the required level of product range or industrial position creates a lack of fit too.
Lack of goal congruence: This applies to the acquiring entity wherein disputes over the correct
use of the target entity might take away the entire purpose of a rather good acquisition.
Cheap purchases: The purchase consideration to be paid is not the only consideration to be made
by the acquiring entity, but also, the input of its own resources, management training time, cash
to be spent, etc. has to be considered before making the decision to acquire a firm.
Failure to integrate effectively: This is a management problem that can be resolved by effective
early-on planning. Different management styles, incompatibilities in data information systems,
hierarchies, continued disputes from the target company’s management, etc. must be worked
out before the actual take over takes place.
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
Inability to manage change: Although most points above talk about pre-planning, there is a
considerable amount of effort that goes into understanding the fact that post-takeover, entities
need to accept the change in scenario – from established routines and practices. Most takeovers
fail due to the inability to adjust to new situations post-merger.
Defenses against take-over
When the predator company decides to undertake a hostile take-over, i.e. a takeover where the target
company’s management does not want to be taken over, however, they do not have the power to stop
it.
Thus, management tends to undertake various strategies to try to defend the take-over, they are as
follows:

At times, the predator company tries to create a conflict between the shareholders and the board
of directors by enticing the shareholders to sell off the company. Thus, clear communications with
shareholders to prevent the takeover will help the target company.

White Knight: This is where the directors find a friendly bidder (the white knight), they would
prefer being acquired by, and goes with that option.

Crown jewels: Selling off the most valuable assets of the company to make the company less
attractive.

Poison pill: This is a strategy where the directors make the target company unpleasant for a takeover. For example, poison pills sometimes give existing shareholders the right to buy more shares
at a reduced price, effectively diluting the ownership interest of a new, hostile party.

Scorched earth: Similar to crown jewels, where the target company sells off all the assets that
disrupt the motive of the acquirer.

Golden parachute: A golden parachute is a significant sum of money given to top executives if
their company is taken over by another company and the executives are fired as a result of the
merger or takeover.

Pac-man defense: In a Pac-Man defense, the target company then attempts to acquire the
company that made the hostile takeover attempt, in an effort to prevent potential buyers.

Fat man: The target company will purposely acquire unattractive assets, thus making the
company less appealing to the acquirer.
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Valuation Methods
Asset Based
•Net Book Value
•Net Realisable Value
Market Based
•Market Cap
•P/E Ratio
•Earnings Yield
•Market to Book ratio
Cashflow Based
•Free cashflow
•EVA
•Dividend valuation
The value of intangible assets can be ascertained using the CIV (Calculated Intangible value).
Asset based Method – Net book value
The value of equity of a company using the net book value method is the difference between the total
assets and total liabilities.
Value of equity = Book value of Total assets – Book value of Total Liabilities
Asset based Method – Net Realizable value
The value of equity of a company using the net book value method is the difference between the realizable
value of assets and settlement value liabilities.
Value of equity = Realizable of Total assets – Settlement value of Total Liabilities (Book value most of the
time)
205
Market value method – Market cap method
Value of equity = Total number of shares x market price per share
Market value method – P/E ratio method
Value of equity per share = Earnings per share x P/E ratio
Total value of equity = Total number of shares x Value of equity per share
The P/E ratio used above should be that of a suitable company that reflects a similar line of business
operations and financial risk (this company will be given to you in the question). Generally, if the P/E ratio
of a quoted company is used to value an unquoted company, the ratio is reduced by 20% to reflect a
general difference between quoted and unquoted companies.
Market value method – Earnings yield method
Earnings yield is nothing but the inverse of the P/E ratio. The concept above applies here as well.
Value of equity per share = Earnings yield x Total number of shares.
OR
Value of equity per share = Total number of shares / P/E ratio.
Market value method – Tobin’s Q or market to book ratio
(Rarely asked in AFM)
Value of equity = Market to book ratio of a comparative company x Book value of target company.
206
Illustration 2
The board of directors of Jinxed Network Inc is considering making an offer to purchase MVM, a private
company in the same industry. If MVM Co is purchased, it is proposed to continue operating the company
as a going concern in the same line of business.
Summarized details from the most recent financial statements for Jinxed network and MVM are shown
below:
Jinxed
Balance Sheet as at 31 March
$m
$m
33
58
29
24
3
-------56
--------147
Freehold property
Plant & equipment
Inventory
Receivables
Cash
Total Assets
Equity and liabilities
Ordinary Shares
Reserves
MVM
Balance Sheet as at 31 March
$000
$000
460
1,310
330
290
20
-------640
-------2,410
35
43
--------78
38
31
--------147
Shareholders funds
Medium term bank loan
Cuurent liabilities
160
964
-------1,124
768
518
--------2,410
Jinxed Network has 50 cent ordinary shares, MVM has 25 cent ordinary shares
Jinxed Network
Year
PAT $m
Dividend $m
MVM
PAT $000
Dividend $000
T5
T4
T3
T2
T1
14.30
15.56
16.93
18.42
20.04
9.01
9.80
10.67
11.60
12.62
143
162
151
175
183
85.0
93.5
93.5
102.8
113.1
207
T5 is five years ago and T1 is the most recent year.
MVM’s shares are owned by a small number of private individuals. Its managing director, who receives an
annual salary of $120,000 dominates the company. This is $40,000 more than the average salary received
by managing directors of similar companies. The managing director would be replaced, if Jinxed Network
purchases MVM.
The freehold property has not been revalued for several years and is believed to have a market value of
$800,000.
The balance sheet value of the plant and equipment is thought to reflect its replacement cost fairly, but
its value, if sold, is not likely to exceed $800,000. Approximately $55,000 of inventory is obsolete and
could only be sold as scrap for $5,000.
The ordinary shares of Predator are currently trading at 420 cents ex-div. A suitable cost of equity is
subject to corporation tax of 30%.
Required:
Calculate the value of the target company using:
i. Net book value
ii. Net realizable value
iii. P/E ratio method
Solution:
1 Net assets valuation
Targeting is being purchased as a going concern, so realizable values are irrelevant
$000
Net assets per account (1,892 – 768)
1,124
Adjustments to freehold property (800 – 460)
340
Adjustments to inventory
(50)
--------
Valuation
1,414
Say $1.4m
P/E ratio Valuation
A suitable P/E ratio for Target will be based on the P/E ratio of Predator as both companies are in the
same industry.
208
P/E of Predator (70m x $4.30)/$20.04m or 430/28.63 = 15.02
The adjustments: - Downwards by 20% pr 0.20 i.e. multiply by 0.80
1. Target is a private company, and its shares may be less liquid.
2. Target is a private company, and it may have a less detailed compliance environment and
therefore, maybe riskier.
A suitable P/E ratio for Target therefore 15.02 x 0.80 = 12.02
(Multiplying by 0.80 results in the 20% reduction)
Target’s PAT + Synergy after tax:
$183,000 + ($40,000 x 7%) = $ 209,800
After adjusting for the savings in the director’s remuneration.
The estimated value is therefore $209,800 x 12.02 = $2,521,796 ~ $2.5m
Cashflow based method – Free Cashflow method
This methods under Cashflow are all based on the cash flows (actual earnings) of the company, not only
current earnings but also with estimated future earnings for the rest of the company’s life.
The free cash flows of the company can be used for finding out the value of the firm. The Future cashflows occurring ‘during the planning horizon’ and ‘after the planning horizon’ may be estimated, and the
present value of these cash-flows may be computed to compute the value of the company.
The planning horizon is the period where the firm can earn a high return, and there is growth registered.
Beyond the planning horizon, returns are expected to reach a steady state.
The standard Entity’s free cash-flows value can be estimated as follows, it is similar to computing the NPV
of a project: (Note this is not the same as equity value)
PBIT
Less: Tax on PBIT
Add: Depreciation (non-cash expense)
Add: Non-cash expenses
Operating cash flows
Less: Replacement and incremental non-current investment and working capital
XX
(XX)
XX
XX
XX
(XX)
Free Cash-flows
Discount factor (Appropriate cost of capital x Free cash-flows)
Present Value of free cash-flows (Entity value)
XX
(XX)
XX
209
Remember, we do not use the entity’s value to buy out a firm, we use the equity value. Thus, in order to
get the equity value of the entire company, we need to take the sum of the free cash-flows and subtract
it from the total value of debt of the company.
However, at times to get to the value of equity directly (as the question might not give you all the variables
above to work with). You may use the following method:
PBT (after deducting interest)
Less: tax on PBT
Less: Debt repayments made during the year
Add: Additional debt funds now raised
Free cash-flows to equity
Less: Discount factor (USE COST OF DEBT ONLY, NOT WACC)
Present value of Free-cash flows to equity
XX
(XX)
(XX)
XX
XX
(XX)
XX
Note that we do not want to discount to get the value of the firm, but directly the value of equity, thus
we do not use WACC, but only the cost of debt to discount the cash-flows.
Illustration 3
A company is preparing for a free cash-flow forecast in order to calculate the value of equity. The following
information is available:
Sales: Current sales are $500m. Growth is expected to be 8% in year 1, falling by 2% pa in year 2 until sales
level out in year 5, where they are expected to remain constant in perpetuity. The operating profit margin
will be 10% for the first two years and 12% thereafter. Tax is charged at 30% in the year profit arises.
Depreciation in the current year will be $7m, increasing by $1m pa over the planning horizon before
levelling off, and replacement asset investment is assumed to equal depreciation. Incremental investment
in assets is expected to be $3.2m, $1.9m, $1.4m and $0.5m in the years 1 to 4.
Required:
Calculate the value of equity if the value of corporate debt is $120m and the company has a WACC of
15%. You may use the free cash-flows to entity method for this purpose.
210
Solution:
The NPV format is used to show you the similarities and to clarify the concept
Year 0 is only for starting a new company and we are here valuing a company which is already onto
operations
1
2
3
4
Sales
Variable costs
Fixed costs
Operating cash
flow
Taxation
Incremental
Investment
Incremental
working capital
Net cash flows
Discount factor
15%
540
572
595
607
5th
onwards
607
54
57
71.44
73
73
-16
-3.2
-17
-1.9
-21
-1.4
-22
-0.5
-22
35
0.87
38
0.756
49
0.658
51
0.572
51
3.813
Present value
Value of entity
Less: Value of
debt
Value of equity
30
314
-120
29
32
29
194
Year
0
194
Last uear onwards
its pepetuity
We
will
use
Perpetuity
formula
It is a delayed
perpetuity
(Perpetuity* Df of
one year before)
211
Cashflow based method – EVA
EVA is nothing but Economic Value Added. The value of a company under this method is calculated as the
EVA divided by the WACC. This value, when reduced by the value of debt, gives the value of equity.
EVA = Net operating profit after tac (NOPAT) – (WACC x Capital employed)
Illustration 4
The net operating profit after tax of AV plc is $320m. The WACC has been computed as 11%, and the value
of total assets less current liabilities is $100m. Compute the value of the firm’s equity assuming that the
value of debt is $1500m?
Solution
EVA = 320 – (0.11*100) = 309m
Value of entity = 309/0.11 = $2809m
Value of equity = 2809-1500 = $1309m
Cashflow based method – Dividend valuation method
The dividend valuation model calculates the value of equity as the PV of dividends paid out in perpetuity
to shareholders
Formula for DVM:
DVM without dividend growth: Ke = d 0
ExP0
Where,
Ke = Cost of equity
d0 = Annual dividend
P0 = Current share price (Ex Div/after the dividend is paid)
When the dividend is expected to grow at a constant rate, then:
DVM with constant dividend growth: Ke = d1 + g
ExP0
D1 = D0(1+g)
212
Where,
P0 = Current share price(Ex Div)
D0 = Current dividend
d1 = Dividend in one year’s time
g = Annual growth in dividends
Generally, once a company pays out dividends, its share price tends to reduce by the amount of dividend
paid. Thus,
Cum div/Cum P0 = share price before the dividend is paid
Ex-div/ExP0 = Cum P0 – d0 (share price immediately after dividend is paid)
Illustration 5
Nente Co (JUN 12)
Nente Co, an unlisted company, designs and develops tools and parts for specialist machinery. The
company was formed four years ago by three friends, who own 20% of the equity capital in total, and a
consortium of five business angel organizations, who own the remaining 80%, in roughly equal
proportions. Nente Co also has a large amount of debt finance in the form of variable rate loans. Initially,
the amount of annual interest payable on these loans was low and allowed Nente Co to invest internally
generated funds to expand its business. Recently though, due to a rapid increase in interest rates, there
has been limited scope for future expansion and no new product development.
The Board of Directors, consisting of the three friends and a representative from each business angel
organization, met recently to discuss how to secure the company’s future prospects. Two proposals were
put forward, as follows:
Proposal 1
To accept a takeover offer from Mije Co, a listed company, which develops and manufactures specialist
machinery tools and parts. The takeover offer is for $2.95 cash per share or a share‐for‐share exchange
where two Mije Co shares would be offered for three Nente Co shares. Mije Co would need to get the
final approval from its shareholders if either offer is accepted:
Proposal 2
To pursue an opportunity to develop a small prototype product that just breaks even financially but gives
the company exclusive rights to produce a follow‐on product within two years.
The meeting concluded without agreement on which proposal to pursue.
After the meeting, Mije Co was consulted about the exclusive rights. Mije Co’s directors indicated that
they had not considered the rights in their computations and were willing to continue with the takeover
offer on the same terms without them.
213
Currently, Mije Co has 10 million shares in issue, and these are trading for $4.80 each. Mije Co’s price to
earnings (P/E) ratio is 15. It has sufficient cash to pay for Nente Co’s equity and a substantial proportion
of its debt and believes that this will enable Nente Co to operate on a P/E level of 15 as well. In addition
to this, Mije Co believes that it can find cost‐based synergies of $150,000 after tax per year for the
foreseeable future. Mije Co’s current profit after tax is $3,200,000.
The following financial information relates to Nente Co and to the development of the new product.
Sales revenue
Profit before interest and tax
Interest
Tax
Profit after tax
Dividends
Extract from the most recent statement of financial position
Net non‐current assets
Current assets
Total Assets
Share capital (40c per share par value)
Reserves
Non‐current liabilities: Variable rate loans
Current liabilities
Total liabilities and capital
8,780
1,230
(455)
(155)
620
Nil
$000
10,060
690
–––––––
10,750
960
1,400
6,500
1,890
–––––––
10,750
–––––––
In arriving at the profit after tax amount, Nente Co deducted tax allowable depreciation and other non‐
cash expenses totaling $1,206,000. It requires an annual cash investment of $1,010,000 in non‐current
assets and working capital to continue its operations.
Nente Co’s profits before interest and tax in its first year of operation were $970,000 and have been
growing steadily in each of the following three years, to their current level. Nente Co’s cash flows grew at
the same rate as well, but it is likely that this growth rate will reduce to 25% of the original rate for the
foreseeable future.
Nente Co currently pays interest of 7% per year on its loans, which is 380 basis points over the government
base rate, and corporation tax of 20% on profits after interest. It is estimated that an overall cost of capital
of 11% is reasonable compensation for the risk undertaken on an investment of this nature.
New product development (Proposal 2)
214
Developing the new follow‐on product will require an investment of $2,500,000 initially. The total
expected cash flows and present values of the product over its five‐year life, with a volatility of 42%
standard deviation, are as follows:
Year(s)
Cash flows ($000)
Present values($000)
Now
–
–
1
–
–
2
(2,500)
(2,029)
3to7(intotal)
3,950
2,434
Required:
a) Explain why synergy might exist when one company merges with or takes over another company.
(7 marks)
b) Prepare a report for the Board of Directors of Nente Co that:
i. Estimates the current value of a Nente Co share, using the free cash flow to firm methodology.
(7 marks)
ii. Estimates the percentage gain in value to a Nente Co share and a Mije Co share under each
payment offer.
(8 marks)
iii. Estimates the percentage gain in the value of the follow‐on product to a Nente Co share, based
on its cash flows and on the assumption that the production can be delayed following the
acquisition of the exclusive rights of production.
(8 marks)
iv. Discusses the likely reaction of Nente Co and Mije Co shareholders to the takeover offer, including
the assumptions made in the estimates above and how the follow‐on product’s value can be
utilised by Nente Co.
(8 mark)
Professional marks will be awarded in part (b) for the presentation, structure and clarity of the
answer.
(4 marks)
c) Explain the circumstances in which the Black‐Scholes option pricing (BSOP) model could be used to
assess the value of a company, including the data required for the variables used in the model.
(8 marks)
(Total: 50 marks)
215
Solution:
Synergy might exist for several reasons, including:
Economic efficiency gains
Gains might relate to economies of scale or scope. Economies of scale occur through such factors as fixed
operating costs being spread over a larger production volume, equipment being used more efficiently
with higher volumes of production, or bulk purchasing reducing costs.
Economies of scope may arise from reduced advertising and distribution costs when companies have
complementary resources. Economies of scale and scope relate mainly to horizontal acquisitions and
mergers. Economic efficiency gains may also occur with backward or forward vertical integration, which
might reduce production costs as the 'middle man' is eliminated, improve control of essential raw
materials or other resources that are needed for production, or avoid disputes with what were previously
suppliers or customers.
Economic efficiency gains might also result from replacing inefficient management as the result of a
merger/takeover.
Financial synergy
Financial synergy might involve a reduction in the cost of capital and risk.
The variability (standard deviation) of returns of a combined entity is usually less than the weighted
average of the risk of the individual companies. This is a reduction in total risk but does not affect
systematic risk and hence might not be regarded as a form of synergy by shareholders. However, reduced
variability of returns might improve a company's credit rating making it easier and/or cheaper to obtain a
loan.
Another possible financial synergy exists when one company in an acquisition or merger is able to use tax
shields or accumulated tax losses, which would otherwise have been unavailable to the other company.
Market power
A large organization, particularly one which has acquired competitors, might have sufficient market power
to increase its profits through price leadership or other monopolistic or oligopolistic means.
(b) REPORT TO THE BOARD OF DIRECTORS, NENTE CO
IMPACT OF THE TAKEOVER PROPOSAL FROM MIJE CO AND PRODUCTION RIGHTS OF THE FOLLOW‐ON
PRODUCT
The report considers the value of the takeover to Nente Co and Mije Co shareholders based on a cash
offer and on a share‐for‐share offer. It discusses the possible reaction of each group of shareholders to
216
the two offers and how best to utilize the follow‐on product opportunity. The significant assumptions
made in compiling the report are also explained.
The appendices to the report show the detailed calculations in estimating the equity value of Nente Co,
the value to Nente Co and Mije Co shareholders of acquiring Nente Co by cash and by a share‐for‐share
exchange, and the value to Nente Co of the exclusive rights to the follow‐on product. The results of the
calculation are summarized below:
Estimated price of a Nente Co share before the takeover offer and follow‐on product is £2.90/share
(Appendix i)
Estimated increase in share price
Cash offer (Appendix ii)
Share-for-share exchange
Nente Co
1.7%
17.9%
Mije Co
9.4%
6.9%
Estimate of the value per share of the follow‐on product to Nente Co is 8.7% (Appendix iii)
It is unlikely that Nente Co shareholders would accept the cash offer because it is little more than the
estimated price of a Nente Co share before the takeover offer. However, the share‐for‐share offer gives a
larger increase in value of a share of 17.9%. Given that the normal premium on acquisitions ranges from
20% to 40%, this is closer to what Nente Co shareholders would find acceptable. It is also greater than the
additional value from the follow‐on product. Therefore, based on the financial figures, Nente Co’s
shareholders would find the offer of a takeover on a share‐for‐ share exchange basis the most attractive
option. The other options considered here yield a lower expected percentage increase in share price.
Mije Co shareholders would prefer the cash offer so that they can maximize the price of their shares and
also not dilute their shareholding, but they would probably accept either option because the price of their
shares increases. However, Mije Co shareholders would probably assess whether or not to accept the
acquisition proposal by comparing it with other opportunities that the company has available to it and
whether this is the best way to utilize its spare cash flows.
The calculations and analysis in each case is made on a number of assumptions. For example, in order to
calculate the estimated price of a Nente Co share, the free cash flow valuation model is used. For this, the
growth rate, the cost of capital and the effective time period when the growth rate will occur (perpetuity
in this instance) are all estimates or based on assumptions. For the takeover offer, the synergy savings
and P/E ratio value are both assumptions. For the value of the follow‐on product and the related option,
the option variables are estimates, and it is assumed that they would not change during the period before
the decision. The value of the option is based on the possibility that the option will only be exercised at
the end of the two years, although it seems that the decision can be made any time within the two years.
The follow‐on product is initially treated separately from the takeover, but Nente Co may ask Mije Co to
take the value of the follow‐on product into consideration in its offer. The value of the rights that allow
Nente Co to delay making a decision are themselves worth $603,592 (Appendix iii) and add just over 25c
or 8.7% to the value of a Nente Co share. If Mije Co can be convinced to increase their offer to match this
217
or the rights could be sold before the takeover, then the return for Nente Co’s shareholders would be
much higher at 26.6% (17.9% + 8.7%).
In conclusion, the most favorable outcome for Nente Co shareholders would be to accept the share‐for‐
share offer and try to convince Mije Co to take the value of the follow‐on product into consideration. Prior
to accepting the offer, Nente Co shareholders would need to be assured of the accuracy of the results
produced by the computations in the appendices.
Report compiled by:
XXX Date:
XXX (Note: Credit will be given for alternative relevant discussion and suggestions)
218
APPENDICES Appendix
i: Estimate of Nente Co Equity Value Based on Free Cash Flows
Company value = Free cash flows (FCF) × (1 + growth rate (g))/(cost of capital (k) – g)
k = 11%
Past g = (latest profit before interest and tax (PBIT)/earliest PBIT) 1/no. of years of growth – 1
Past g = (1,230/970)1/3 – 1 = 0.0824
Future g = ¼ × 0.0824 = 0.0206
FCF Calculation
FCF = PBIT + non‐cash flows – cash investment – tax
FCF = $1,230,000 + $1,206,000 – $1,010,000 – ($1,230,000 × 20%) = $1,180,000
Company value = $1,180,000 × 1.0206/(0.11 – 0.0206) = $13,471,000
Equity value = $13,471,000 – $6,500,000 = $6,971,000
Per share = $6,971,000/2,400,000 shares = $2.90
Appendix ii: Estimated Returns to Nente Co and Mije Co Shareholders Cash Offer
Gain in value to a Nente Co share = ($2.95 – $2.90)/$2.90 = 1.7%
Additional earnings after acquisition = $620,000 + $150,000 = $770,000
Additional EPS created from acquisition = $770,000/10,000,000 = 7.7c/share
Increase in share price based on P/E of 15 = 7.7c × 15 = $1.16
Additional value created = $1.16 × 10,000,000 =
$11,600,000
Less: paid for Nente Co acquisition = ($2.95 × 2.4m shares)
$(7,080,000)
Value added for Mije shareholders =
$4,520,000
Gain in value to a Mije Co share = $4,520,000/10,000,000 = 45.2c
or 45.2c/480c = 9.4%
Share‐for‐share Offer
Earnings combined company = $620,000 + $150,000 + $3,200,000 = $3,970,000
219
Shares in combined company = 10,000,000 + 2,400,000 × 2/3 = 11,600,000 EPS = 34.2c/share
[$3,970,000/11,600,000]
Expected share price = 34.2c × 15 = 513c or $5.13/share
Three Nente Co shares = $2.90 × 3 = $8.70
Gain in value to a Mije Co share = ($5.13 – $4.80)/$4.80 = 6.9%
Gain in value to a Nente Co share = ($10.26 – $8.70)/$8.70 = 17.9%
Appendix iii: Increase in Value of Follow‐On Product
Present value of the positive cash flows = $2,434,000
Present value of the cash outflow = $(2,029,000)
Net present value of the new product = $405,000
Based on conventional NPV, without considering the value of the option to delay the decision, the project
would increase the value of the company by $405,000.
Considering the value of the option to delay the decision
Price of asset (PV of future positive cash flows) = $2,434,000
Exercise price (initial cost of project, not discounted) = $2,500,000
Time to expiry of option = 2 years
Risk free rate (estimate) = 3.2%
Volatility = 42%
d1 = [ln(2,434/2,500) + (0.032 + 0.5 × 0.422 ) × 2]/(0.42 × 21/2) = 0.359
d2 = 0.359 – (0.42 × 21/2) = –0.235 N(d1) = 0.5 + (0.1368 + 0.9 × (0.1406 – 0.1368)) = 0.6402
N(d2) = 0.5 – (0.0910 + 0.5 × (0.0948 – 0.0910)) = 0.4071
Value of option to delay the decision = 2,434,000 × 0.6402 – 2,500,000 × 0.4071 × e–(0.032 × 2)
= $1,558,247 – $954,655 = $603,592
The project increases the value of the company by $603,592 or 25.1c per share ($603,592/2,400,000
shares). In percentage terms, this is an increase of about 8.7% (25.1c/290c).
Using the BSOP model in company valuation rests upon the idea that equity is a call option, written by the
lenders, on the underlying assets of the business. If the value of the company declines substantially, then
220
the shareholders can simply walk away, losing the maximum of their investment. On the other hand, the
upside potential is unlimited once the interest on debt has been paid.
The BSOP model can be helpful in circumstances where the conventional methods of valuation do not
reflect the risks fully or where they cannot be used. For example, if we are trying to value an unlisted
company with unpredictable future growth.
There are five variables which are input into the BSOP model to determine the value of the option. Proxies
need to be established for each variable when using the BSOP model to value a company. The five
variables are the value of the underlying asset, the exercise price, the time to expiry, the volatility of the
underlying asset value and the risk-free rate of return.
For the exercise price, the debt of the company is taken. In its simplest form, the assumption is that the
borrowing is in the form of zero-coupon debt, i.e., a discount bond. In practice, such debt is not used as a
primary source of company finance, and so we calculate the value of an equivalent bond with the same
yield and term to maturity as the company’s existing debt. The exercise price in valuing the business as a
call option is the value of the outstanding debt calculated as the present value of a zero-coupon bond
offering the same yield as the current debt.
The proxy for the value of the underlying asset is the fair value of the company’s assets, less current
liabilities on the basis that if the company is broken up and sold, then that is what the assets would be
worth to the long‐term debt holders and the equity holders.
The time to expiry is the period of time before the debt is due for redemption. The owners of the company
have that time before the option needs to be exercised, that is when the debt holders need to be
repaid. The proxy for the volatility of the underlying asset is the volatility of the business’ assets. The risk‐
free rate is usually the rate on a riskless investment such as a short‐term government bond.
Intangibles Valuation – CIV (Calculated Intangible Value)
This method is used to compute the value of intangible assets of the company.
The CIV method involves the following steps:
Step 1: Compute the return on Assets ratio i.e. return on capital employed for a suitable proxy company
or the industry average.
Step 2: Compute the value spread as follows:
Target company operating profits
Less: ROA x Target company assets
Value spread
XX
(XX)
XX
221
Step 3: The value spread is subject to tax, and the PV of this net of tax amount is used to compute the CIV
(by treating it as perpetuity). The CIV is combined with the intangible net asset value to arrive at the
overall value of the firm.
Illustration 6
Almeida Villa Co is in the process of being acquired by Jolly Co and wants to value its business, including
the intangibles using CIV
The company has a WACC of 6.5% and the operating profit in the previous year was $120 m on an asset
base of $350m. A suitable proxy company has an operating profit of $200m on an asset base of $800m,
and corporation tax is 30%. Calculate the value of Almeida Villa, including CIV.
Solution:
Proxy company ROA
Target operating profit
Less: (target assets x proxy ROA)
Before tax value spread
Tax @30%
After tax value spread
Total value = 350 + 300
25%
120
-87.5
32.5
-9.75
22.75
350
700
222
Chapter 6: Corporate Reconstruction
223
Introduction
This chapter is only going to include the theory aspect of this syllabus area as the practical aspects have
been covered in previous chapters and only theory needs to be applied in this chapter.
Corporate Failure
If a company struggles, it is unable to generate a sufficient long-term return on investment or is unable to
fulfil its external obligations. You might have to use your professional judgement to determine whether
the company is under financial distress.
Revenue
failure
Failure of
capital
mgmt
Cost
failure
5 core causes of
financial distress
Failure in
liability
mgmt
Failure in
asset
mgmt
Note, in the exam, you might have to compute indicators that will point you to the above points.
Practical indicators of financial distress







Ratio analysis
Information from published final accounts – like a worsening cash flow, important off-balance
sheet items, etc.
Going concern evaluation
Information from the Director’s report – that act like a warning signal towards the future
Information from the press
Information about the environmental areas
Financial issues – borrowing facilities not being agreed to, massive debt repayment being due,
major restructuring of debt, arrears of dividends, negative operating cash flows, etc.
224



Loss of KMPs and key staff without replacement, loss of a major customer/market, labour
difficulties, etc.
Non-compliance with statutory requirements
Pending legal claims
Once, financial distress is identified, action needs to be taken to overcome the situation.
Companies in financial distress have two options: liquidate their business operations and pay investors
back or re-construct their company with the help of investors.
Liquidation
Liquidation refers to a situation where the assets of the company are sold off and used to pay off the
liabilities.
When liquidating, the following steps may be undertaken:
Step 1: All assets are realized at the net realizable value.
Step 2: The cash raised is used to settle liabilities in the correct legal order of priority:
•Secured lenders
1
•Other lenders
2
•Preference sharehoders, if any
3
•Equity shareholders
4
Reconstruction
You will be tested on the effect of a reconstruction plan on different stakeholders and the acceptability of
the plan in an exam question. Reconstruction is a process in which existing capital and liabilities are
restructured in order to revive the company's fortunes.
From the above, it may be required to be:



Ascertain the impact on the books (assets and liabilities) post construction and calculate the postacquisition book value of the equity shares in a company.
Calculate/ Compute key ratios to ensure that the re-construction scheme revives fortunes. (Ratio
analysis)
Calculate the market value of equity based on expected future free cash flows and use it to
understand and discuss the impact on the various stakeholders who must corporate and support
reconstruction.
225
At times, calculate the market value of equity based on expected future free cash flows and use it to
understand and discuss the impact on the various stakeholders that are associated with the
reconstruction both directly and indirectly.
Corporate reconstruction of an Insolvent Company
An insolvent company can consider taking one of the following steps:
1. Company Voluntary Arrangement (CVA):
A company voluntary arrangement (CVA) is a procedure that allows a company:
 To settle debts by paying only a proportion of the amount that it owes to creditors.
 To come to some other arrangement with its creditors over the payment of its debts.
CVA is useful for companies under cash flow pressure. It consists of writing off debt balances against
shareholder’s capital and creditors’ capitals and therefore affects creditors rights.
However, it is designed in such a way that creditors benefit is maximized.
Steps for CVA:
1.
2.
3.
4.
Court application is made to call a meeting between the company and creditors.
Reconstruction scheme is discussed in the meeting and the matter is put to vote.
If the reconstruction scheme gets >75% votes in favour, it is sanctioned by the court.
Once the court sanctions it, it is binding on all creditors.
2. Administration orders:
 Shareholders, directors or any one of the creditors can apply for an administration order.
 The company continues its operations while there is a recovery plan put in place to achieve a
better return for future of creditors.
 New management could be brought in place.
 It tries to revive the company in an alternate plan than liquidation.
Corporate reconstruction of a Solvent Company
Solvent companies may also undertake a reconstruction for one or more of the following reasons:





To reorganize the statement of financial position
To improve the image of the company to outsiders
To cut down on net tax cost of borrowing
To repay borrowings
To improve security of borrowings
There are 4 types of reorganizations used by solvent companies depending on their situation:
226
Conversion of debt to equity
•Generally happens when convertible debt holders
exercise their rights
•This improves the equity base of the company
•This situation mostly arises when company is
mainly financed by short term borrowings
Concersion of equity to debt
•Generally involves conversion of preference to
some form of debt
•It constitutes of reduction of capital and therefore
regulations relating to redemption must apply
•One benefit of this is interest on debt being tax
deductible
Conversion of debt from one
form to another
•This conversion is undertaken to improve security,
flexibility or reduce cost of borrowing
•Overdraft and trade credits have no security
requirement
•Leasing could be a better way to improve flexibility
Conversion of equity from
one form to another
•This is done to simplify the capital structure
•Having smaller units seems more attractive to
shareholders
•Issuing bonus shares out of reserves also is a good
mode of tidying up and also acts in favour of good
image of the company in eyes of investors
Illustration 1
RAM plc is a company that manufactures a variety of personal computers that are sold to retailers as well
as directly to individuals and businesses via online sales.
Due to a number of technical issues, the company's sales have dropped significantly in the last year,
resulting in a $160,000 operating loss. As a result, the company has accumulated losses on its retained
earnings, and there is a significant risk of insolvency.
To avoid this, the company's financial advisers have proposed a reconstruction plan.
227
Balance Sheet at 31112/20X9 (statement of financial position)
Assets
Non - current assets
Current assets
$000
Inventory
Receivables
Cash
Net Current Assets
Total Assets
410
220
25
Equity and Liabilities
Share Capital (Sl shares)
Retained Earnings
TotaI Equity
Non - current liabilities -Bank loan
Current liabilities
Payables
Overdraft
Total Equity and Liabilities
$000
1,100
655
1,755
200
(50)
150
1200
205
200
405
1755
Notes:
1. Except for inventory, if the company was liquidated, all assets could be sold for their book values.
Following an examination, it was discovered that $220k of the inventory is obsolete, but the
remainder could be sold for book value. Furthermore, $90k of the receivables are unrecoverable.
2. To be successful, a scheme of reconstruction would need to raise $195k of cash to invest in new
manufacturing processes.
3. Given the company's risk profile, any new equity capital providers will demand a return of at least 18
percent.
4. The current interest rates for a bank loan are 8% and 6% for an overdraft. The bank loan has been
secured.
228
The following reconstruction scheme is proposed:




Each existing share's nominal value will be reduced to 50c.
AXL Bank (which provides both the overdraft and the loan) will convert half of the overdraft and
one-third of the loan into 200,000 new shares.
Leela and sons, a venture capital firm, will provide $400k in new funding by purchasing new shares
at $1.25 per share. The funds will be used to repay payables as well as to invest in the new
manufacturing process.
Following the reconstruction, the company is expected to generate $320K in profit before interest
and tax per year. Tax is due at a rate of 28%. Assume there are no tax losses.
Solution:
(a) Liquidation
Assuming that there are no liquidator's fees, in the event of liquidation, the distribution will be as follows
Assets to distribute
Per SOFP
Less inventory write off
Less receivables write off
Net
$000
Distribution:
Secured Bank Loan
Unsecured
Payables
Overdraft
$000
1755
(220)
(90)
1,445
(1,200)
245
205
200
(405)
(160)
Notes:
 Unsecured creditors will only receive 245/405 = 60% of the amount owing.
 Ordinary shareholders will receive nothing.
229
(b)
Post-reconstruction EPS
Earnings post-reconstruction
PBIT
Bank loan interest (213 x 1,200 x 8%)
Overdraft interest (1/2 x 200 x 6%)
$000
320
(64)
(6)
PBT
250
Tax at 28%
(70)
PAT
180
Number of shares post-reconstruction
= 200,000 (existing s/h) + 200,000 (bank) + 320,000 (venture capitalist)
= 720,000
Post-reconstruction forecast EPS
= 180/720 = 25c per share. Return on equity to venture capital company = 25c/125c = 20%
This is above the target required return of 18% and is therefore acceptable to the venture capital
company.
(b) Effective return to bank on converted capital
Capital foregone = (1/2 × 200,000) + (1/3 × 1,200,000) = $500,000
Number of shares in exchange = 200,000
Earnings generated = 200,000 × 25c = $50,000
Therefore return = $50,000/$500,000 = 10%
230
(c) Acceptability
Existing ordinary shareholders. If the company is liquidated, then the existing ordinary shareholders will
get nothing.
In a reconstruction, the existing ordinary shareholders will lose control of the company (they will only own
200/720 = 28% of the equity), but they are likely to earn 25c per new ordinary share. Based on the original
nominal value of each share this represents a return of 25c/$1 = 25%.
Given the return that the providers of new capital are likely to receive, the scheme seems very generous
to the existing shareholders. It is likely that the bank and the venture capital providers would want the
scheme to be amended so as to make it less generous to the existing shareholders.
Bank
If the company is liquidated, the bank is likely to recover the full amount of the secured loan but will only
recover 60% of the overdraft. Following the reconstruction, the bank will only get a return of 10% on the
capital converted into equity but will continue to receive interest on the remaining loan and overdraft at
the existing rate.
Given that 1/3 of the secured loan is converted into equity and the forecast return on this is only 2% more
than the current loan interest, this is unlikely to be acceptable to the bank.
Practical re-construction approaches

Spin-off/demerger: It is the separation of two or more parts of an organization into separate business
entities in order to increase focus and effectiveness in company management.

Sell-off: Is when a portion of an organization is sold for cash to a third party in order to raise capital
for core operations.

Management buy-outs (MBO): Is when a company's management buys a significant stake in the
company. The majority of MBOs are highly leveraged.

Management Buy-in (MBI): When a manager or a management team from outside the organization
raises the requisite funds, purchases them, and takes over as the company's new management, this
is known as a buyout.
231
The following are some of the advantages of an MBO:





The acquirers are the management itself, thus they will already have in-depth knowledge about
the business’ operations.
The buyers are known and familiar to the organization.
It could help managers and employees retain their jobs.
Employees are now incentivized to work towards and agree to the terms of the re-construction.
Quicker as there will be no induction required for the acquirers.
The following are some of the important factors to consider while under-taking an MBO:
•
•
•
•
Is it reasonable to expect management to turn the company around?
Will the company be able to continue operating without additional funding?
Is the business worth the time and effort that management devotes to its shareholders?
Is the MBO's price and conditions in the best interests of all parties involved in the transaction?
The following are some of the disadvantages of an MBO:


It is risky for management as they might lose the personal wealth that they are putting in.
At times, the board of directors run companies that are owned by a larger parent company. Thus,
an MBO could lead to the company no longer receiving any form of corporate support.
The above will help you frame a strong answer for the theory section in your exam, thus do not forget to
link the points to the case study to secure maximum marks.
The questions relating to corporate reconstruction relate to applying whatever is above to basic concepts.
There are several variations with respect to the questions that will appear, thus be thorough with basic
concepts in order to comfortably solve any variation with ease.
Illustration 2
In order to raise funds for future projects, the management of Bento Co, a large manufacturing company,
is considering disposing of one of its subsidiary companies, Okazu Co, which is involved in manufacturing
rubber tubing. They are considering undertaking the disposal through a management buy‐out (MBO) or a
management buy‐in (MBI). Bento Co wants $60 million from the sale of Okazu Co. Given below are
extracts from the most recent financial statements for Okazu Co:
232
Year ending 30 April (all amounts in $OOO) 20X5
Total non—current assets
40,800
Total current assets
Total assets
Equity
Non-current liabilities
Current liabilities
Trade and other payables
Bank Overdraft
Total current liabilities
Total equity and liabilities
Year ending 30 April (all amounts in $OOO)
12,300
53, 100
24,600
Sales revenue
Operating profit
Finance costs
Profit before tax
Taxation
Profit for the year
7,900
4,000
11,900
53, 100
20X5
54,900
12,200
1,600
10,600
2, 120
8480
Notes relating to the financial statements above:
(i)
Current assets, non‐current assets and the trade and other payables will be transferred to the
new company when Okazu Co is sold. The bank overdraft will be repaid by Bento Co prior to the
sale of Okazu Co.
(ii) With the exception of the bank overdraft, Bento Co has provided all the financing to Okazu Co.
No liabilities, except the trade and other payables specified above, will be transferred to the new
company when Okazu Co is sold.
(iii) It is estimated that the market value of the non‐current assets is 30% higher than the book value
and the market value of the current assets is equivalent to the book value.
(iv) The group finance costs and taxation are allocated by Bento Co to all its subsidiaries in pre‐
agreed proportions.
233
Okazu Co’s senior management team has approached Dofu Co, a venture capital company, about the
proposed MBO. Dofu Co has agreed to provide leveraged finance for a 50% equity stake in the new
company on the following basis:
(i)
$30 million loan in the form of an 8% bond on which interest is payable annually, based on the
loan amount outstanding at the start of each year. The bond will be repaid on the basis of fixed
equal annual payments (constituting of interest and principal) over the next four years
(ii) $20 million loan in the form of a 6% convertible bond on which interest is payable annually.
Conversion may be undertaken on the basis of 50 equity shares for every $100 from the
beginning of year five onwards
(iii) 5,000,000 $1 equity shares for $5,000,000.
Okazu Co’s senior management will contribute $5,000,000 for 5,000,000 $1 equity shares and own the
remaining 50% of the equity stake.
As a condition for providing the finance, Dofu Co will impose a restrictive covenant that the new
company’s gearing ratio will be no higher than 75% at the end of its first year of operations, and then fall
to no higher than 60%, 50% and 40% at the end of year two to year four respectively. The gearing ratio is
determined by the book value of debt divided by the combined book values of debt and equity.
After the MBO, it is expected that earnings before interest and tax will increase by 11% per year, and
annual dividends of 25% on the available earnings will be paid for the next four years. It is expected that
the annual growth rate of dividends will reduce by 60% from year five onwards following the MBO. The
new company will pay tax at a rate of 20% per year. The new company’s cost of equity has been estimated
at 12%.
Required:
(a) Distinguish between a management buy‐out (MBO) and a management buy‐in (MBI). Discuss the
relative benefits and drawbacks to Okazu Co if it is disposed through a MBO instead of a MBI.
(5 marks)
(b) Estimate, showing all relevant calculations, whether the restrictive covenant imposed by Dofu Co
is likely to be met.
(12 marks)
(c) Discuss, with supporting calculations, whether or not an MBO would be beneficial for Dofu Co and
Okazu Co’s senior management team.
(8 marks)
(Total: 25 marks)
234
Solution:
(a) A management buy‐out (MBO) involves the purchase of a business by the management team running
that business. Hence, an MBO of Okazu Co would involve the takeover of that company from Bento
Co by Okazu Co’s current management team. However, a management buy‐in (MBI) involves
purchasing a business by a management team brought in from outside the business.
The benefits of a MBO relative to a MBI to Okazu Co are that the existing management is likely to have
detailed knowledge of the business and its operations. Therefore, they will not need to learn about
the business and its operations in a way which a new external management team may need to. It is
also possible that a MBO will cause less disruption and resistance from the employees when compared
to a MBI. If Bento Co wants to continue doing business with the new company after it has been
disposed of, it may find it easier to work with the management team which it is more familiar with.
The internal management team may be more focused and have better knowledge of where costs can
be reduced, and sales revenue increased in order to increase the overall value of the company.
The drawbacks of a MBO relative to a MBI to Okazu Co may be that the existing management may
lack new ideas to rejuvenate the business. A new management team, through their skills and
experience acquired elsewhere, may bring fresh ideas into the business. It may be that the external
management team already has the requisite level of finance in place to move quickly and more
decisively, whereas the existing management team may not have the financial arrangements in place
yet. It is also possible that the management of Bento Co and Okazu Co have had disagreements in the
past, and the two teams may not be able to work together in the future if they need to. It may be that
a MBI is the only way forward for Okazu Co to succeed in the future.
(b) Annuity (8%, 4 years) = 3.312
Annuity payable per year on loan = $30,000,000/3.312 = $9,057,971
Interest payable on convertible loan, per year = $20,000,000 × 6% = $1,200,000
Annuity interest on 8% bond
(All amounts in $000)
Year-end
1
2
3
4
Opening loan balance
30,000
23,342
16,151
8,385
Interest at 8%
2,400
1,867
1,292
671
Annuity
(9,058)
(9,058)
(9,058)
(9,058)
Closing loan balance
23,342
16,151
8,385
(2)*
235
*The loan outstanding in year 4 should be zero. The small negative figure is due to rounding.
Estimate Of profit and retained earnings after MBO (All amounts in $000s)
Year end
Operating profit
1
13,542
Finance costs
3,600
Profit before tax
2
15,032
3
16,686
4
18,521
3,067
2,492
1,871
9,942
11,965
14,194
16,650
Taxation
1,988
2,393
2,839
3,330
Profit for the year
7,954
9,572
11,355
13,320
Dividends
1,988
2,393
2,839
3,330
Retained earnings
5,965
7,179
8,516
9,990
Estimate Of gearing
(All amounts in $OOOs)
Year end
1
2
3
4
Book value of equity
15,965*
23,144
31,160
41,650
Book value of debt
43,342
36,151
28,385
20,000
Gearing
73%
61%
47%
32%
Covenant
75%
60%
50%
40%
Covenant breached?
No
Yes
No
No
*The book value of equity consists of the sum of the 5,000,000 equity shares which Dofu Co and Okazu
Co’s senior management will each invest in the new company (total 10,000,000), issued at their nominal
value of $1 each, and the retained earnings from year 1. In subsequent years the book value of equity is
increased by the retained earnings from that year.
The gearing covenant is forecast to be breached in the second year only and by a marginal amount. It is
forecast to be met in all the other years. It is unlikely that Dofu Co will be too concerned about the
covenant breach.
(c) Based on the net asset valuation method, the value of the new company is approximately: 1.3 ×
$40,800,000 + $12,300,000 – $7,900,000 approx. = $57,440,000
236
Dividend Valuation Model
Year
1
2
3
4
Total
Dividend
($000s)
1,989
2,393
2,839
3,330
DF (12%)
0.893
0.797
0.712
0.636
PV
($000s)
1,776
1,907
2,021
2,118
7,822
Annual dividend growth rate, years 1 to 4 = (3,330/1,989)1/3 – 1 = 18.7%
Annual dividend growth rate after year 4 = 7.5% [40% × 18.7%]
Value of dividends after year 4 = ($3,330,000 × 1.075)/(0.12 – 0.075) × 0.636 = $50,594,000 approximately
Based on the dividend valuation model, the value of new company is approximately: $7,822,000 +
$50,594,000 = $58,416,000
The $60 million asked for by Bento Co is higher than the current value of the new company’s net assets
and the value of the company based on the present value of future dividends based on the dividend
valuation model. Although the future potential of the company represented by the dividend valuation
model, rather than the current value of the assets, is probably a better estimate of the potential of the
company, the price of $60 million seems excessive.
Nevertheless, both the management team and Dofu Co are expected to receive substantial dividends
during the first four years, and Dofu Co’s 8% bond loan will be repaid within four years.
Furthermore, the dividend valuation model can produce a large variation in results if the model’s variables
are changed by even a small amount. Therefore, the basis for estimating the variables should be examined
carefully to judge their reasonableness, and sensitivity analysis applied to the model to demonstrate the
impact of the changes in the variables. The value of the future potential of the new company should also
be estimated using alternative valuation methods, including free cash flows and price‐earnings methods.
It is therefore recommended that the MBO should not be rejected at the outset but should be considered
further. It is also recommended that the management team and Dofu Co try to negotiate the sale price
with Bento Co.
237
Illustration 3
Baylon Co. is a conglomerate with a wide variety of business divisions. One of its divisions, a training firm,
is underperforming. According to the Finance Director, this business unit could be sold for its book value
of $25 million by selling its non-current properties.
The directors addressed the potential sale at a recent Board meeting, as well as two options for using the
$25 million proceeds:
Proposal 1: Pay off some debt finance with half of the proceeds, and invest the other half in new noncurrent assets for an existing publishing business unit.
Proposal 2: Invest the entire sum to acquire some new non-current assets and create a new advertising
business unit.
The Finance Director was asked to prepare some estimates at the conclusion of the Board meeting to
demonstrate the possible effect of these two proposals on Ray Co's projected statement of financial
position and forecast earnings for the coming year.
Extract from the following statement of financial position for next year
Non-Current Assets
$000
92,650
Current Assets
Total Assets
16,620
109,270
Equity and liabilities
Share Capital - $1 par value
50,000
Reserves
20,550
Total equity
70,550
Non- Current liabilities
30,000
Current liabilities
8,720
109,270
Ray Co’s forecast after-tax profit for next year is $15.6 million.
238
Other information:
Ray Co's overall after-tax profit comes from the training sector, which accounts for 10% of the total.
Ray Company is taxed at a rate of 20% per year, with an expected after-tax return on the publishing
business unit of 8%. The advertisement investment is projected to yield a 13 percent after-tax return.
Bank loans with a fixed interest rate of 6% make up the non-current liabilities.
Required:
(a) Estimate the impact of the two proposals on next year’s forecast earnings and forecast financial
position.
(b) Evaluate the decision to sell the training business unit, and advise the Board of Directors which (if
either) proposal should be accepted.
Solution:
(a) Impact on SOFP and earnings:
Earnings
Current
$000
15,600
Forecast after-tax profit
Profits foregone by selling
training business (10%)
Interest saved by
paying off debt
($12.5m x 6% x (1-0.20))
Extra returns generated:
— 8% on publishing
investment (8% x $12.5m)
— 13% on advertising
investment
Adjusted profit after tax
15,600
Change
Proposal 1
$000
15,600
(1,560)
Proposal 2
$000
15,600
(1,560)
600
1,000
3,250
15,640
+40
17,290
+1690
SOFP
Current
Proposal 1
Proposal 2
Non-current Assets
Current Assets
Total Assets
$000
92,650
16,620
109,270
$000
80,150
16,660
96,180
$000
92,650
18,310
110,960
Equity and Liabilities
Share Capital
50,000
50,000
50,000
239
Reserves
Total equity
20,550
70,550
20,590
70,590
22,240
72,240
Non-current liabilities
Current liabilities
30,000
8,720
109,270
17,500
8,720
96,180
30,000
8,720
110,960
Workings and notes:
Proposal 2 (looks like the easier option, so start with that)
Easy figures: Reduce NCA by $25m to show the sale of training, but then increase it by $25m to show
investment in advertising. No net impact.
No change to financing, so share capital and NCL stay the same.
No information to the contrary, so assume CL stay the same.
Adjust reserves figure to reflect a likely increase in earnings of $1.690m.
Balance off SOFP, entering CA as a balancing figure.
Proposal 1
Easy figures: Reduce NCA by $25m to show the sale of training, but then increase it by $12.5m to show
investment in publishing.
Reduce NCL by $12.5m (no change in share capital).
No information to the contrary, so assume CL stay the same.
Adjust reserves figure to reflect likely increase in earnings of $0.040m.
Balance off SOFP, entering CA as a balancing figure.
(b) Evaluation of the proposals
The training business unit is underperforming, so it does seem sensible to consider disposing of it.
However, it is not clear whether the under-performance is a long-term problem or whether it is just a
short-term blip. Before making a final decision, it would be sensible to assess the possibility of the training
business performance improving in the near future.
The training business has non-current assets worth $25 million and is expected to generate after-tax
profits of $1.56 million – a return of 6.24%. This is lower than the return on investment in both the
publishing and the advertising sectors, so the proposals to sell the training business and re-invest the
proceeds elsewhere make good financial sense.
Proposal 2, in particular, looks very attractive. Earnings are expected to increase significantly because of
the high level of return expected in the advertising sector. The only concern is whether the directors have
240
the necessary expertise to invest in this new sector. If not, it might be very difficult for Ray Co to achieve
this high level of return.
Proposal 1 is not as financially attractive – the after-tax profit figure is likely to stay almost the same. Also,
it is not clear why the directors are considering paying off some of the debt here. Interest rates are fairly
low, the company’s gearing is not excessive, and the interest cover is high. An excessive amount of debt
finance can cause problems for a company, but a moderate amount of debt (like Ray Co has) is actually a
positive thing, given that it enables a company to benefit from tax relief on its interest payments.
Recommendation
As long as it can be shown that the training business underperformance is a long-term problem, it makes
sense to dispose of this business unit. On balance, Proposal 2 looks a more attractive option, given that it
involves investment in a highly profitable industry, and avoids the unnecessary repayment of debt under
Proposal 1.
241
242
Chapter 7: Introduction to Risk Management
243
Introduction
All company’s operations come with a certain amount of risk. Political risk, economic risk, market risk,
regulatory risk, foreign exchange risk, interest rate risk, and so on are some examples of different types
of risk. Risk must be recognized, managed, and, where possible, mitigated using appropriate tools and
techniques.
Risk Management
Risk management is the process of identifying, assessing and controlling threats to an organization's
capital and earnings.
A successful risk management program helps an organization consider the full range of risks it faces.
Risk management also examines the relationship between risks and the cascading impact they could have
on an organization's strategic goals.
Risk management has perhaps never been more important than it is now. The risks modern organizations
face has grown more complex, fueled by the rapid pace of globalization. New risks are constantly
emerging, often related to and generated by the now-pervasive use of digital technology.
Risk Framework
Risk management allows a balance to be struck between taking risks and reducing them.
Effective risk management can add value to any organization. In particular, companies operating in the
investment industry rely heavily on risk management as the foundation that allows them to withstand
market crashes.
An effective risk management framework seeks to protect an organization's capital base and earnings
without hindering growth.
The risk framework should cover 3 areas:



Risk awareness
Risk assessment and monitoring
Risk management
244
Risk awareness
Risk
assessment
and monitoring
Risk
management
Risk awareness
Risk awareness is the raising of understanding within the population of what risks exist, their potential
impacts, and how they are managed.
For appraisal of investment projects, a formal risk assessment should be carried out to identify the
potential risks and the probabilities of them occurring.
The types of risks affecting the project or the organization must be identified in order to put a monitoring
process in place. Types of Risks:
245
Strategic Risk
•Strategic risk is the risk that failed business
decisions may pose to a company.
•Technological changes, senior management
turnover, merger integration, regulatory changes,
etc.
Tactical Risk
•Tactical risk is the risk of failure of driving decisions
and/or actions within an organization.
•Credit risk, legal risk, market risk, IT risk, etc.
Operational Risk
•Operational risk is the risk of losses caused by
flawed or failed processes, policies, systems or
events that disrupt business operations.
•Fraud, human error, cybercrime, etc.
Risk Assessment and Monitoring
Risk assessment is the identification of hazards that could negatively impact an organization's ability to
conduct business.
Broadly speaking, a risk assessment is the combined effort of:


Identifying and analysing potential events that may negatively impact individuals, assets and/or
the environment and;
Making judgments "on the tolerability of the risk on the basis of a risk analysis" while considering
influencing factors.
Risk assessment is an inherent part of a broader risk management strategy to help reduce any potential
risk-related consequences.
Risk assessment and monitoring methods generally adopted by companies:
246
Internal Audit
•Most companies set up an internal audit
department to help them assess the risk internally.
•Such a department has the main responsibility of
creating and running risk monitoring systems.
Information Systems
•After identification of risk factors, information
systems are put in place to record, report and
mitigate the risk.
•This usually includes Management Information
Systems (MIS) and Executive Information Systems
(EIS).
Risk Strategies
Hedging
Mitigati
on
Diversifi
cation
Risk strategies
1. Mitigation:
•
Risk mitigation is the process of planning and developing methods and options to reduce threats
or risks.
•
Steps in a risk mitigation plan:
a. Identify possible risk events
b. Make a risk assessment
c. Prioritize risks
d. Track risks
e. Implement actions and assess progress
247
2. Hedging:
• Risk mitigation is the process of planning and developing methods and options to reduce threats
or risks.
• Hedging often involves a trade in derivatives in order to reduce or eliminate the risk.
•
Reasons for hedging:
a. Overconcentration: Having a significant exposure to a specific investment and protecting
oneself against it.
b. Tax implications: A taxable event gets created by selling a position and hedging might be able
to reduce or avoid the tax.
3. Diversification:
•
•
•
•
Diversification is a technique that reduces risk by allocating investments across various financial
instruments, industries, and other categories.
It aims to minimize losses by investing in different areas that would each react differently to the
same event.
Unsystematic risk can be mitigated through diversification while systematic or market risk is
generally unavoidable.
A diversified portfolio may lead to better opportunities, enjoyment in researching new assets, and
higher risk-adjusted returns.
Risk Strategies
Companies can adopt 4 approaches towards a risk, often called as 4T:
Tolerate risk
Transfer risk
Terminate risk
Treat risk
248
Following is the summary table to remember easily:
Likelihood
High
Low
Impact
Low
Treat
Tolerate
High
Terminate
Transfer
1. Tolerate or ignore (If impact and likelihood of occurring is low)
•
•
•
Tolerating Risk is where no action is taken to mitigate or reduce a risk.
This may be because the cost of instituting risk reduction or mitigation activity is not cost-effective
or the risks of impact are at so low that they are deemed acceptable to the business.
Even when these risks are tolerated, they should be monitored because future changes may make
it no longer tolerable.
2. Transfer risk (If likelihood is low and impact is high)
Transferring Risk can be achieved through the use of various forms of insurance, or the payment to third
parties who are prepared to take the risk on behalf of the organization
3. Terminate or avoid risk (If both likelihood and impact is high)
•
•
•
Termination is the approach that should be most favoured where possible and simply involves
risk elimination.
This can be done by altering an inherently risky process or practice to remove the risk.
The same can be used when reviewing practices and processes in all areas of the business.
4. Treat risk i.e. mitigate, diversify or hedge (If likelihood is high but the impact is low)
•
•
Treating Risk is a method of controlling risk through actions that reduce the likelihood of the risk
occurring or minimize its impact prior to its occurrence.
Also, there are contingent measures that can be developed to reduce the impact of an event once
it has occurred.
249
Specific types of risks
Political risk
Economic risk
Regulatory risk
Fiscal risk
Political Risk
•
•
•
•
Political risk is the risk an investment's returns could suffer as a result of political changes or
instability in a country.
Instability affecting investment returns could stem from a change in government, legislative
bodies, other foreign policymakers or military control.
Political risks may arise from policy changes by governments to change controls imposed on
exchange rates and interest rates. Moreover, political risk may be caused by actions of legitimate
governments such as controls on prices, outputs, activities, and currency and remittance
restrictions.
There are many kinds of political risks which can affect business: potential political and economic
instability, labour problems, local product safety and environmental laws.
Measurement of Political risk
Various methods are used to measure political risk:
1. Old hands – Experts are asked to provide advice on the risk of investment.
2. Grand tours – A selection of employees are sent to inspect a potential investment by meeting
government officials, business heads, local leaders to understand the situation in the country.
3. Surveys – Indices are assessed by groups of experts using Delphi techniques by ranking key risk
variables.
4. Quantitative measures – Factors GNP and ethnic fractionalization are merged to give overall scores to
the countries. Business Environment Risk Index (BERI) is a very popular measure that scores nations out
of 100, zero being the lowest score for undesirable business conditions.
250
Management of Political risk
There are several ways to manage political risk, depending on what stage of investment one is at.
PRIOR TO INVESTMENT
Pre-trading or concession
agreements
Planned local ownership
•Dates must be set to allow
transfer of ownership of the
company to local nationals.
•The dates must be spread out
in the long run so that benefits
of foreign ownership can be
achieved.
•Before investments are made,
agreements should be
discussed and secured with
the government.
•This should be done in
advance to avoid confusions
and conflicts in the future.
•This discussion must be
regarding roles,
responsibilities, remittance of
funds, etc.
Political risk insurance
•Risk can be transferred by
taking insurance.
•Such insurance can be taken
for protection from
nationalisation, war,
revolution, etc.
•Export Credit Guarantee
Department (ECGD) in the UK
provides required insurance to
businesses.
DURING INVESTMENT
Production
strategies
•Taking decisions
regarding:
1.Local sourcing
2.Producing in
the host country
3.Foreign
sourcing
•Locally sourced
products also
help the
economy to
grow.
Control of
Processes
•Patents and
processes help
companies to
never divulge
their secrets.
•Also, additional
benefit of
patents is that
they can be
enforced
globally.
Distribution
control
•Companies like
to hold on to
their own
distribution
channels mainly
as it avoids
expropriation
and misuse of
assets.
•Pipelines,
shipping
facilities,
distribution lines
can be
controlled.
Market control
Location
•Markets can be
secured through
copywriting,
patents,
trademarks,
logos, etc.
•This helps avoid
political risk as
local markets
with unprotected
goods get
exploited easily.
•Control on the
location for some
major operations
are controlled
and overlooked
carefully
•This is done to
avoid political
pressure in less
stable
economies.
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Mitigation of Political risk
A lot of political risk can be moderated or eased with the correct decision about the source of funds:
Local Finance
Borrow Globally
- Can be raised to maintain local
authoriries interest in the business
and its growth
- Host government intervention
reduces considerably as it may cause
a major retaliation from a number of
countries who are financing the
company
- There may be wealthy locals who
may be interested in financing
- However, cost of these funds may
turn out to be expensive
- However, global finance comes with
a number of new risks, like
repatriation restrictions, foreign
taxes, etc.
Economic Risk



Economic risk is referred to as the risk exposure of an investment made in a foreign country due
to changes in the business conditions or adverse effect of macroeconomic factors.
Economic risk arises from uncertainty about economic outcomes. For example, economic risk may
be the chance that macroeconomic conditions like exchange rates, government regulation, or
political stability will affect an investment or a company's prospects.
It affects the affordability of imports, exports and value of repatriated profits.
Measurement of Economic risk
Risk—or the probability of a loss—can be measured using statistical methods that are historical predictors
of investment risk and volatility.
Commonly used risk management techniques include



Standard deviation
Sharpe ratio
Beta.
252
Management of Economic risk



Economic risks can have devastating effects on the business as well as the lives of individuals.
Everything can be managed by exercising proper due diligence.
Business organizations exposed to economic risks should be aware of the current affairs that may
have a short-term or long-term impact. Change in FED reserve rate or unpleasant news can affect
markets globally.
An entity should get regular updates about the operations of the foreign entity. This will help
the company to stay in touch with the operations.
Mitigation of Economic risk





One of the easiest ways to reduce economic risk is to invest in international mutual funds. This
fund invests money in different stock markets around the globe. It comes with higher risk with
higher rewards. It also provides diversification into various economies. Thus, the MNC is
financially protected from getting affected due to the economic factors of a specific country.
To protect against foreign party default, the company can enter into an insurance contract that
will cover probable loss due to such default.
The further company can take the letter of credit from foreign banks before dispatching goods
to a foreign country.
In order to hedge against fluctuations in the exchange rates, the company can enter into forward
contracts or deal with money market instruments. It will help the company to reduce the
unknown loss due to foreign exchange rates.
Monthly reporting of financial activities and operational activities is essential for the
management of economic risk abroad.
Regulatory Risk



Regulatory and legal risks occur from negligence or a deliberate failure to comply with client
obligations. It comes under the purview of the regulatory framework that governs standards for
products, clients, and business activities.
Regulatory risk is the risk that a change in laws and regulations will materially impact a security,
business, sector, or market.
A change in laws or regulations made by the government or a regulatory body can increase the
costs of operating a business, reduce the attractiveness of an investment, or change the
competitive landscape in a given business sector. In extreme cases, such changes can destroy a
company's business model.
253
Management of Regulatory risk


Companies may have an internal audit department, take assistance of consulting firm or set up
their own permanent regulatory team.
Steps to manage regulatory risk are:
Identify
applicable
laws
Monitor
and update
regularly
Confirm all
projects
conform
with the
plan
Understand
the impact
of laws
Develop a
regulatory
risk plan
Fiscal Risk


Fiscal risk is the risk that the government will increase tax rates and alter taxation policies in such
a way that will impact the present value of cashflows of projects for companies.
In case of MNCs, global taxation policies are to be scrutinized, thus making fiscal risk very crucial
and hard to ignore.
Management of Fiscal risk



Tax must be factored in all projects and relevant cashflow calculations.
Consideration must be given to future and potential tax rates.
An external tax consultant, or a tax expert or an internal taxation team must be involved in
analysis of projects.
254
Incorporating risk in investment appraisal
There is risk and uncertainty in investment assessment decision-making because it is based on a huge
number of assumptions. (This is usually asked as a theory question)
Some strategies for incorporating risk into capital investment decision-making, i.e. investment appraisal,
include:

Expected values: Expected values are weighted averages of potential outcomes. For example, if
sales demand is likely to be 50 million units (with a 0.6 likelihood) or 75 million units (with a 0.4
chance), we may utilise the estimated value of (50 x 0.6) + (75 x 0.4) = 60 units for investment
evaluation purposes.

Simulation: This is a technique that enables the various variables influencing investment decisions
and various combinations to be tested. This allows the company to determine which of the various
NPV outcomes is most likely to occur.

Sensitivity analysis: Sensitivity analysis is a measure of the amount of variation in a variable that
can be tolerated before making a decision based on NPV changes (from accepting to reject). In
other words, it determines how much of a percentage change a specific variable must undergo
for the NPV to become zero, implying that the project is no longer financially viable.

Risk-adjusted cost of capital: When the risk profile of a project differs significantly from the
company's current operations, a risk-adjusted WACC may be used to assess it. You can expand on
this based on what was learnt in business valuation.
Refer Skill level FM topic: Investment appraisal: Under Uncertainty to revisit the different Methods of
Investment appraisal under Uncertainty from Chapter 1: Topic 4.
New types of risk valuation techniques are explained below:
Value at Risk (VaR)
VaR is a measure of how the market value of a company's asset portfolio may decrease over a given time
period. It is a measure of the maximum loss in asset value that a company could suffer under normal
economic conditions.
The VaR is calculated at either a 95% or a 100% confidence level. This means that the company's chances
of losing the amount equal to VaR are 5% and 1%, respectively. VaR for a given period is calculated as
follows:
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Formula: VaR for a period = Zσ
Where,
Z = 1.65 for 95% and 2.33 for 99% confidence level (these numbers will not be given to you, so it is best
that you memorize these numbers)
σ = standard deviation for the value of asset portfolio or return from the project
VaR for more than one period is computed as follows:
Formula: VaR for more than one period = Σ(VaR for each period)2
Illustration 1
Consider a portfolio consisting of a $200,00,000 investment in share XYZ and a $200,00,000 investment
in share ABC. The daily standard deviation of both shares is 1% and that the coefficient of correlation
between them is 0.3. You are required to determine the 10-day 99% value at risk for the portfolio?
Solution:
The standard deviation of the daily change in the investment in each asset is $2,00,000 i.e.
0.2mn. The variance of the portfolio’s daily change is
V = 0.22 + 0.22 + 2 x 0.3 x 0.2 x 0.2 = 0.104 mn
σ (Standard Deviation) = √0.104𝑚𝑛 = 0.322mn
Accordingly, the standard deviation of the 10-day change is
0.322 lakhs x √10 = $1.018mn
Z score for 1% is 2.33. This means that 1% of a normal distribution lies more than 2.33 standard deviations
below the mean. The 10-day 99 percent value at risk is therefore
2.33 × $1.018mn = $ 2.372mn
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Chapter 8: Foreign Exchange Risk Management
257
Meaning of Foreign Exchange Risk
Foreign exchange risk is the risk arising due to changes in foreign exchange (forex). Foreign exchange risk
can broadly be grouped into three types:

Economic risk: This refers to the long-term risk arising due to changes in exchange rates, further
affecting a country’s competitiveness. For example, favourable exchange rate movements can
make companies manufacturing pens in India cheaper than companies manufacturing pens in
America, because the American currency has historically been stronger than the Indian currency.

Translation risk: Exchange rate risk, which affects the value of assets and liabilities in the
consolidated financial position for corporate reporting purposes. For example, a UK company
invests Rs.100m in assets of an Indian subsidiary when the exchange rate is Rs.80/1£, resulting in
an investment of £2.5m in assets. The asset’s value is still Rs.100m after 5 years, but the exchange
rate is now Rs.125/1£. This is shown as £1.6m in asset reporting, giving the incorrect impression
that the asset’s value has decreased. Translation risk is notional.

Transaction risk: This risk arises as a result of exchange rate fluctuations between the transaction
date and the date of settlement or payment. This could happen during a purchase, sale, or other
similar transaction. Transaction risk must be hedged, which can be accomplished through a
variety of techniques that will be discussed.
Internal hedging techniques
Internal hedging techniques are basic approaches to managing foreign exchange risk that organizations
can consider, and they include:





Leading (for payments)
Lagging (for receipts)
Matching and netting-off
Maintaining foreign currency Bank accounts
Invoicing in home currency
1. Leading (for payments)
In the event that exchange rates are expected to change adversely, Leading refers to payments earlier
than normal credit terms specified. This causes credit losses from suppliers but compensates for
future negative exchange rate movements.
258
2. Lagging (for receipts)
Payments to suppliers are delayed to take advantage of projected favourable foreign exchange
fluctuations. However, this could have a negative influence on future business with the
aforementioned supplier, who may refuse to accept the payment delay.
3. Maintaining foreign currency bank accounts
All foreign currency receipts must be kept in the same currency in order to be used for future
payments. While this mitigates foreign currency risk to a large extent, surplus monies that may be put
to better use elsewhere may be held idle in the foreign currency bank account.
4. Invoicing in home currency
This entails avoiding foreign currency transactions by invoicing all customers in the local currency.
While this may appear to be simple, it may encounter some opposition and loss of business if the
counter-party is dissatisfied with the arrangement.
5. Matching and netting off
Matching is the process of balancing the accounts of two or more parties with a written agreement
to net off the accounts. Netting off is the process of balancing the accounts of two or more parties in
a group. It is done to reduce the size of external hedging requirements.
For example, a company is going to receive $5mn in one subsidiary and at the same time, another
subsidiary is supposed to pay $2mn. Clearly, the group only has a net exposure of $3mn and therefore,
only requires hedging of the net amount.
Multilateral Netting
Multilateral netting is a payment mechanism whereby accounts payable can be offset against
accounts receivable among three or more counterparties, leading to fewer transactions and invoices.
It involves minimising the number of transactions taking place through banks, thereby reducing the
bank convenience charges to be paid by the companies.
There are two methods in which calculations can be presented:
Method 1: Tabular or transactions method
Step 1: Prepare the table with names of each company written down the side and across the top.
Step 2: Convert all owings into a common base currency. Input them into the table.
Step 3: Add across and down the table, calculate the total amount payable and receivable by each
company.
Step 4: Convert the amount back to the original currency.
259
Method 2: Diagrammatical method
Step 1: Convert all owings to a common base currency using spot rates.
Step 2: Clear the overlap of any bilateral debts.
Step 3: Clear the smallest leg of any 3-way circuits. Then 4-way circuits need to be cleared, then 5way and so on.
Step 4: Convert back to the original currencies.
Illustration 1
X, Y, and Z are three companies within the same UK based international group. W is a company outside of
the group. The following liabilities have been identified for the forthcoming year:
Owed by
X
Y
Y
Z
Z
W
W
Owed to
Y
X
W
X
Y
X
Z
Amount (millions)
€39
£10
$20
¥200
€15
$15
¥100
Mid-market spot rates are:
£1 = $2.00
£1 = €1.50
£1 = ¥250
Required: Establish the net indebtedness that would require external hedging.
Solution:
Tabular method
X
X
Y
Z
W
£10m
200m Yen
$15m
Y
€39m
Z
W
$20m
€15m
100m Yen
These amounts represent amounts owed BY the firm in the left-hand column TO the firm listed across the
top.
260
Now convert to £ at spot rate, and add across and down:
X
Y
26
Z
W
X
Y
Z
W
10
0.8
7.5
10
Total (down)
Total (across)
18.3
26
36
20
0.4
10.8
10
7.9
Net total
(7.7)
16
(10.4)
21
10
0.4
Total (across)
26
20
10.8
7.9
The easiest way to interpret this is for X and Z to pay £7.7m and £10.4m respectively to Y (which now
receives £18.1 m in total). If Y then pays
£2.1 m to W, all companies have the correct net payments or receipts.
Convert these back into the original currencies and the final transactions are:
X pays Y €11.55m
Z pays Y €15.6m
Y pays W $4.2m
261
262
263
External hedging techniques
External hedging techniques involve the company engaging in another transaction in order to protect
itself on a main-stream transaction, for example, to protect itself against currency exchange rate
movements on an invoice, the company may engage or transact in a hedging instrument. External hedging
techniques include the following, they are divided as over the counter (OTC) and publicly traded:
External hedging techniques
Over the counter (OTC)
1)Forward contract
2)Money Market Hedges
Publicly tradded
1) Futures contracts
2) Currency options
3) Currency swaps
Refer Skill level FM topic: Risk Management: Foreign exchange risk to revisit the importance of
Financial Management from
Chapter 1: Topic 5.
Forward contracts
A forward contract is an agreement in which the price at which a company will transact or buy/sell a
specific currency is fixed today.
The future date is frequently quoted at a discount or premium to the current rate. Remember the rule
'ADDISSUPREM' to compute the forward rate from the spot rate i.e., add the discount and subtract the
premium. Banks quote forex rates as, for example, $4.66-4.62/1£ where $ is the home currency, the lower
rate will always be the rate for selling home currency to the bank, and the higher rate will be for buying
foreign currency from the bank. Because banks will always intend to make a profit.
For instance, if the spot rate is $3.64 - $3.68/1£ and the discount is 0.08-0.14, the forward rate will be
$3.72 - $3.81/1£. Thus, the buy rate must be used if the company has to make a payment in foreign
264
currency and use the sell rate if the company is making a sale in a foreign currency. The advantages of
using a forward contract are as follows:



There is a degree of certainty on the future transaction date.
It is easy to obtain
Forward contracts are ‘over the counter,’ which means that it is not a publicly traded instrument
and it is an instrument tailor-made to the company’s needs.
The following are some of the issues with using a forward contract:

A forward contract fixes the price at a future date in order to be hedged against adverse price
movement, thus the holder will lose out on any profit in case the price moves favourably.
Illustration 2
A firm from the UK just bought some goods form a US supplier for $150,000 with payment due in 6
months. The exchange rates area:
Spot rate: $0.61-0.63/1£
Six month premium: 0.06-0.04.
Calculate the 6-month forward rate and the amount payable by the UK firm in £.
Solution
Forward rate: 0.61-0.06 / 0.63-0.04 = 0.55-0.59
Net payment (forward) = $150000/0.55 = £272727.3
Synthetic Foreign Exchange Agreements (SAFEs)

Forex trading is certainly legal in the vast majority of countries around the world, and very few
countries prohibit speculative currency trading.

Banning forex trading is mainly done because it is extremely risky and that is why strict regulations
are imposed to regulate exchange rate volatility and also to prevent financial losses to citizens.

Examples of countries where forex trading is banned:
 India
 China
 Brazil
 Taiwan
 South Korea
265

Non-Deliverable Forwards (NDFs) are made available in such countries.

NDF is a type of forward currency exchange rate agreement designed to provide a currency hedge
over a specific forward period.

No currency is actually delivered in this case, but only profit or loss is settled between the parties.

A notional principal agreement, like an FRA, a SAFE provides risk control usually linked but not
attached to another position or transaction.

A SAFE is equivalent to a forward period currency swap without a principal exchange.
Money Market Hedge (MMH)
This concept is frequently tested in the exam. The whole idea of an MMH is to lock in the company’s future
cash flows at a certain exchange rate, thus providing certainty at a point in the future. The result is similar
to that of a forward contract and thus is used whenever a forward contract is not available to be used.
A money market hedge is not a special type of contract or anything but just smartly uses a foreign bank
and interest rates to hedge its position. The working is slightly complicated but keeps these points in mind,
and it is hard to go wrong
If the company needs to make payments in the future in a foreign currency
•
•
•
•
Borrow in the domestic currency
Convert it into the overseas currency
Invest the money borrowed in an overseas bank (make a deposit)
At the end of the term, that money can be used to make the overseas payment.
If the company has a receipt in the future in a foreign currency
•
•
•
•
Borrow in the overseas currency. (This is what will be used to make the foreign payment)
Convert into domestic currency
Invest the money in a domestic bank
Withdraw domestic investment and use the receipt to pay off the overseas loan.
266
Illustration 3
Reaper plc is a UK based company and is expected to pay $300,000 in 4 months’ time, but is now
considering a money market hedge. The following details are available:
Spot rate: $3/£ ± 0.002
4-month forward rate: $2.99/£ ± 0.04$
UK
USA
Borrow
6%
4.3%
Deposit
5.6%
4%
Required:
a) Construct an MMH for the future payment in 4 months’ time
b) If Reaper were to now sell goods to a customer and expects to receive $400,000 in four months’
time, how would you now use MMH.
Solution:
a) This is a receipt transaction thus, an MMH would require to create an asset (deposit) overseas and
a(borrow) domestically.
The loan will not be for an entire year thus, we first calculate the effective interest rate, which is:
Domestic borrow rate = 6%*4/12 = 2%
Overseas deposit rate = 4%*4/12 = 1.33%
The company is going to convert the domestic loan into a foreign currency
(To get an idea of what exactly is happening, refer to the points on MMH in case overseas payments
above)
267
b) This is a receipt transaction thus, an MMH would require to create a liability (borrow) overseas and an
asset (deposit) domestically.
The payment will not be for an entire year thus, we first calculate the effective interest rate, which is:
Overseas borrow rate = 4.3%*4/12 = 1.43%
Domestic deposit rate = 5.6%*4/12 = 1.86%
(To get an idea of what exactly is happening, refer to the points on MMH in case overseas payments
above)
Futures
Futures essentially serve the same purpose as a forward contract; however, they are publicly traded and
not otc, which causes complications in computing the effective hedge amount. A futures contract, as
previously stated, is a hedging instrument that is traded in standard sizes known as 'lots.'
These are traded on the futures market and can be bought or sold based on the needs of the company.
The goal of a foreign exchange futures contract is to lock in an exchange rate for a future transaction. The
futures and options market is designed to move in the opposite direction of the money market. As a result
of contracting in the futures market, any losses in the currency (money market) transaction are offset by
gains in the futures market transaction and vice versa.
Another anomaly about futures is that a contract is bought by paying a margin. This margin will be typically
be around 3%-12% (not important) of the value of the underlying asset, it only acts as a security for the
contract.
In exam questions, you will either need to:
a. Determine the effectiveness of the hedge, provide the future and spot prices on the date of the
transaction or;
b. Estimate the futures price based on the spot price after adjusting for the remaining basis risk.
268
The difference between the spot rate and the future rate at any given time is referred to as basis risk.
Remember, the futures price is just an estimation of what the price could be in the future and thus will
fluctuate. Due to market forces, the spot price and futures price will gradually begin to converge and
eventually become the same on the futures contract's expiration date.
Ideally, any movement in the spot rate is accompanied by a corresponding movement in the future rate,
which will offset the losses/gains. In reality, however, there may be a slight difference in the rate at which
the spot rate and the futures rate move. This can result in hedge inefficiency and is known as 'Basis risk.'
The following are the steps to be followed while setting up a futures hedge:
Step 1: Do we contract to buy or sell futures?
The contract could be denominated in either the home currency or the foreign currency. If the forward
contract is denominated in the home currency, then and the company needs to make a payment in a
foreign currency, they will have to buy foreign currency by selling home currency, thus they will have to
sell futures contracts. Using the same logic, follow the below table to know whether to buy or sell futures:
Buy/sell futures
Futures contract denominated
in foreign currency
PAYMENT
Buy Futures
Futures contract denominated
in home currency
RECEIPT
PAYMENT
RECEIPT
Sell futures
Sell futures
Buy futures
Step 2: How many contracts do we buy?
As they are traded in fixed lots, we will need to match the contract size with the size of the position that
the company wants to hedge. The calculation is explained below
Step 3: What should the expiry date of the futures be?
Futures contracts expire at regular fixed cycles, the question will mention the frequency of the cycle and
the months in which they will expire. You will have to select the expiry closest but after the actual
transaction date (in the money market).
The following is an elaborate example as to how you are supposed to solve sums in the exam, follow every
step as each step carries marks in the exam.
269
Solving a future’s sum in the exam
Imagine it is 10 July. A UK company has a US$6.65m invoice to pay on 26 August. They are concerned that
exchange rate fluctuations could increase the £ cost and, hence, seek to effectively fix the £ cost using
exchange traded futures. The current spot rate is $1.71110/£1.
Research shows that £/$ futures, where the contract size is denominated in £, are available on the CME
Europe exchange at the following prices:
September expiry – 1.71035
December expiry – 1.70865
The contract size is £100,000, and the futures are quoted in US$ per £1. (This is the ‘lot’ size that was
mentioned earlier).
Setting up the hedge
1. Which expiry Date? – September:
The first futures to mature after the expected payment date (transaction date) are chosen. As the
expected transaction date is 26 August, the September futures which mature at the end of
September will be chosen.
2. Buy/Sell? – Sell:
As the contract size is denominated in £ and the UK company will be selling £ to buy $ they should
sell the futures.
3. How many contracts? – 39
As the amount to be hedged is in $ it needs to be converted into £ as the contact size is
denominated in £. This conversion will be done using the chosen futures price. Hence, the number
of contracts required is ($6.65m ÷ 1.71035)/£100,000 ≈ 39.
Summary
The company will sell 39 September futures at $1.71035/£1. (Doing this calculation itself will fetch you a
decent amount of marks.)
Outcome on 26 August (will be given in question):
On 26 August, the following was true:
Spot rate – $1.65770/£1
September futures price – $1.65750/£1
Actual cost:
$6.65m/1.65770 = £4,011,582 (Just converting to £)
270
Gain/loss on futures:
As the exchange rate has moved adversely for the UK company, a gain should be expected on the
futures hedge.
Sell – on 10 July
Buy back – on 26 August
Gain
$/£1
1.71035
(1.65750)
0.05285
This gain is in terms of $ per £ hedged. Hence, the total gain is:
0.05285 x 39 contracts x £100,000 = $206,115
Summary
All of the above is essential basic knowledge. As the exam is set at a particular point in time, you are
unlikely to be given the futures price and spot rate on the future transaction date. Hence, an effective
rate would need to be calculated using a basis. Alternatively, the future spot rate can be assumed to equal
the forward rate and then an estimate of the futures price on the transaction date can be calculated using
basis. The calculations can then be completed as above.
Estimating futures prices
As mentioned above, the question will most likely not directly give you the futures prices on the date at
which you are going to close the position (You are selling futures contracts in this scenario, thus you will
have to buy them back in order to close the position and vice versa).
Basis points will be used to predict futures prices. ‘Tick’ and ‘Basis’ are used interchangeably, and as
mentioned earlier, the spot price and futures price become the same value on the expiry date of the
contract. However, we rarely close the position on the exact expiry date, it is closed on the date of the
transaction you want to hedge. Thus, we need to predict the futures price on that date. The basis is
deemed to change at a fixed rate, as eventually, the basis will become ‘zero.’
Thus, if you logically think about it, predicted futures price = current futures price + unexpired basis.
Unexpired basis is basically the expected basis on the date that you are closing the position.
Unexpired basis = current basis x the difference between contract length and months left for transaction
/ contract length
The following is how you can predict future prices (continuing example above):
271
Now (10 July)
26 August
Futures
$1.71035
$1.6579 ( 1.655770+0.000217)
Spot
$1.7110
$1.65770 (given)
Basis
0.00065
0.000217 (0.00065*1/3 = unexpired basis)
As you can see, the futures price predicted does not exactly match what was given in the question as the
futures price on the position close date, this is due to the basis risk. You will then have to use this rate to
further compute the hedge effect as done in the previous example.
Foreign exchange futures – other issues (important for understanding)
Initial margin
When a futures hedge is set up, the market is concerned that the party opening a position by buying or
selling futures will not be able to cover any losses that may arise. Hence, the market demands that a
deposit is placed into a margin account with the broker being used – this deposit is called the ‘initial
margin’.
These funds still belong to the party setting up the hedge but are controlled by the broker and can be used
if a loss arises. Indeed, the party setting up the hedge will earn interest on the amount held in their account
with their broker. The broker, in turn keeps a margin account with the exchange so that the exchange is
holding sufficient deposits for all the positions held by brokers’ clients. In the scenario above, the CME
contract specification for the £/$ futures states that an initial margin of $1,375 per contract is required.
Hence, when setting up the hedge on 10 July, the company would have to pay an initial margin of $1,375
x 39 contracts = $53,625 into their margin account. At the current spot rate, the £ cost of this would be
$53,625/1.71110 = £31,339.
Marking to market (low chance of appearing as a sum, but crucial for understanding how futures and
options transactions work)
In the scenario given above, the gain was worked out in total on the transaction date. In reality, the gain
or loss is calculated on a daily basis and credited or debited to the margin account as appropriate. This
process is called ‘marking to market’.
Hence, having set up the hedge on 10 July, a gain or loss will be calculated based on the futures settlement
price of $1.70925/£1 on 11 July. This can be calculated in the same way as the total gain was calculated:
272
$/£1
Sell – on 10 July
1.71035
Settlement price – 11 July
(1.70925)
Gain
0.00110
Gain in ticks – 0.00110/0.00001 = 110
Total gain – 110 ticks x $1 x 39 contracts = $4,290
This gain would be credited to the margin account, taking the balance on this account to $53,625 +
$4,290 = $57,915.
At the end of the next trading day (Monday 14 July), a similar calculation would be performed:
Settlement price – 11 July
Settlement price – 14 July
Gain
$/£1
1.70925
(1.70805)
0.00120
Gain in ticks – 0.00120/0.00001 = 120
Total gain – 120 ticks x $1 x 39 contracts = $4,680.
This gain would also be credited to the margin account, taking the balance on this account to $57,915 +
$4,680 = $62,595.
Similarly, at the end of the next trading day (15 July), the calculation would be performed again:
Settlement price – 14 July
Settlement price – 15 July
Loss
$/£1
1.70805
(1.71350)
0.00545
Loss in ticks – 0.00545/0.00001 = 545
Total loss – 545 ticks x $1 x 39 contracts = $21,255.
This loss would be debited to the margin account, reducing the balance on this account to $62,595 –
$21,255 = $41,340.
This process would continue at the end of each trading day until the company chose to close out their
position by buying back 39 September futures.
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Lock-in Rate
For futures hedge, it is easier and faster to use the concept of Lock-in rate.
The benefit of using this rate is also that calculations of financial result of the hedge are possible without
having the spot rate on the transaction date.
Lock-in-rate = Opening futures price + Unexpired basis on the transaction date.
Basis = Differences between spot and implied futures price.
Illustration 4
MLM is a large listed company based in Switzerland and uses Swiss Francs as its currency. It manufactures
chocolate and imports a key ingredient, cocoa.
It is due to make a payment of $9,975,000 in 4 months’ time to a supplier of cocoa.
The current spot rate is $1.2846 per 1 CHF.
Exchange traded futures (Contract size CHF 125,000)
3-month expiry
5-month expiry
$ per CHF
$1.2859
$1.2871
Required:
(i)
(ii)
(iii)
(iv)
Illustrate how MLM could set up a hedge to protect itself from the forex exposure using the CHF
future above?
What is the result of the futures hedge in 4 months’ time the spot rate is $1.1025 per CHF?
What is the result of the futures hedge using the predicted futures rate approach?
How would the hedge have been set up differently if MLM decided to use USD futures of
contract size $500,000 to hedge its exposure. There is no need to show the result of the hedge
in your answer.
Solution:
Example 1
(i) To set up a hedge against payment of $9.975m in 4 months
Sell CHF futures for 5 months @ 1.2871
No. of futures = ($9.975/1.2871)*125000 = 62 contracts
274
(ii)
Futures
Now
1.2871
4 months
1.103 (calculated)
Spot
1.2846
1.1025
Basis
0.0025
0.0005 (based on
0.0025*1/5)
In currency market,
Payment $9.975m/1.1025 = 9,047,619 CHF
Gain on futures = (1.2871-1.103) x 62 x 125000 / 1.1025 = 1294126 CHF
Net payment =9047619-1294126 7753493 CHF
(iii) Predicted futueres rate = 1.2871 -0.0005 1.2866
Result = 9,975,000/1.2866 7,752,993 CHF
(iv) To set up a hedge against payment of $9.975m in 4 months with USD futures Buy USD futures for 5
months
No. of futures = $9.975/$0.5=20 contracts (always rounded up)
Options
An option to serves the same purpose as that of a futures contract, however, the difference between an
option and futures is that the holder of the option has a chance to make a profit in case of favorable price
movement.
A currency option gives the holder the right, but not the duty, to purchase or sell a currency at a specific
price at a specific time in the future. The option will be lapsed if the exchange rate on the currency market
moves in your favor, and it will be exercised if the movement is adverse in order to hedge yourself.
If the holder desires to obtain/purchase a certain currency, a 'CALL' option must be purchased, and if the
holder wishes to sell a specific currency, a 'PUT' option must be purchased. All of the other principles
discussed in the chapter on option pricing also apply here.
275
Long and short positions
A ‘long position’ is one held if you believe the value of the underlying asset will rise. For instance, if you
own shares in a company, you have a long position as you presumably believe the shares will rise in value
in the future. You are said to be long in that company.
A ‘short position’ is one held if you believe the value of the underlying asset will fall. For instance, if you
buy options to sell a company’s shares, you have a short position as you would gain if the value of the
shares fell. You are said to be short in that company.
Solving an options sum in the exam
The computation is similar to that of a futures sum, however, there is added element of a premium
payment here. As mentioned earlier, the holder has the choice to exercise the option or not, the price for
this is the premium and must be paid regardless.
Scenario
Imagine that today is the 30 July. A UK company has a €4.4m receipt expected on 26 August. The current
spot rate is £0.7915/€1. They are concerned that adverse exchange rate fluctuations could reduce the £
receipt but are keen to benefit if favourable exchange rate fluctuations were to increase the £ receipt.
Hence, they have decided to use €/£ exchange traded options to hedge their position.
Research shows that €/£ options are available on the CME Europe exchange. The contract size is €125,000,
and the futures are quoted in £ per €1. The options are American options and, hence, can be exercised at
any time up to their maturity date.
Setting up the hedge
1. Date? – September:
The available options mature at the end of March, June, September and December. The choice is
made in the same way as relevant futures contracts are chosen.
2. Calls/Puts? – Puts:
As the contract size is denominated in € and the UK company will be selling € to buy £, they should
take the options to sell € for £ – put options. Similar to futures, use the following table:
276
Call/Put option
Futures contract denominated
in foreign currency
PAYMENT
Buy Calls
Futures contract denominated in
home currency
RECEIPT
PAYMENT
Buy Puts
Buy Puts
RECEIPT
Buy Calls
3. Which exercise price? – £ 0.79250/€1
An extract from the available exercise prices showed the following:
Exercise
£/€1
0.79000
0.79250
price
Put premiums
£/€1
0.00465
0.00585
As the company is selling €, it wants the maximum net £ receipt for each € sold. The maximum net receipt
is the exercise price minus the premium cost.
This is calculated below:
Exercise price
£/€1
0.79000
0.79250
Put premiums
£/€1
0.00465
0.00585
Net receipt
£/€1
0.7900 – 0.00465 = 0.78535
0.79250 – 0.00585 = 0.78665
Hence, the company will choose the 0.79250 exercise price as it gives the maximum net receipt.
Alternatively, the outcome for all available exercise prices could be calculated.
In the exam, either both rates could be fully evaluated to show which is the better outcome for the
organization, or one exercise price could be evaluated, but with a justification for choosing that exercise
price over the other. You will be awarded full marks for choosing any exercise price in the exam.
277
4. How many? – 35
This is calculated in a similar way to the calculation of the number of futures. Hence, the number of
options required is:
€4.4m/€0.125m ≈ 35
Summary
The company will buy 35 September put options with an exercise price of £0.79250 /€1
Premium to pay – £/€0.00585 x 35 contracts x €125,000 = £25,594
Outcome on 26 August:
On 26 August, the following was true:
Spot rate – £ 0.79650/€1
As there has been a favorable exchange rate move, the option will be allowed to lapse, the funds will be
converted at the spot rate, and the company will benefit from the favorable exchange rate movements.
Hence, €4.4m x 0.79650 = £3,504,600 will be received. The net receipt after deducting the premium paid
of £25,594 will be £3,479,006.
Note:
Strictly a finance charge should be added to the premium cost as it is paid when the hedge is set up.
However, the amount is rarely significant and, hence, it will be ignored in this.
If we assume an adverse exchange rate move had occurred and the spot rate had moved to £ 0.78000/€1,
then the options could be exercised, and the receipt arising would have been:
Receipt
Exercise option:
Pay – 35 x 125,000
Receive
4.375m x 0.79250
Underhedged amount
Buy £ at spot (£0.78/€1)
Deduct premium cost
Net receipt – see Note 1
€4,400,000
(€4,375,000)
–
£3,467,188
€25,000
(€25,000)
0
£19,500
£3,486,688
(£25,594)
£3,461,094
278
Notes:
This net receipt is effectively the minimum receipt as if the spot rate on 26 August is anything less than
the exercise price of £ 0.79250/€1, the options can be exercised, and approximately £3,461,094 will be
received. Small changes to this net receipt may occur as the €25,000 underhedged will be converted at
the spot rate prevailing on the 26 August transaction date. Alternatively, the underhedged amount could
be hedged on the forward market. This has not been considered here as the underhedged amount is
relatively small.
Summary
Much of the above is also essential basic knowledge. You are unlikely to be given the spot rate on the
transaction date. However, the future spot rate can be assumed to equal the forward rate, which is likely
to be given in the exam. The ability to do this may earn up to six marks in the exam. Equally, another one
or two marks could be earned for reasonable advice.
Illustration 5
Bender plc, a UK-based importer, expects to make a $5 million payment on March 21st. Today is February
1st. It intends to use options to hedge the foreign exchange risk.
The spot rate is $1.6045-1.6095 $/£. The options available with contract size = £31,250 and the premium
payable (quoted as US cents per £1) are provided below
Exercise price
Calls
Dec
Mar
Jun
Puts
Dec
Mar
Jun
1.55
1.60
1.65
1.7
7.1
2.4
0.8
0.3
8.2
3.9
0.85
0.35
10.3
5.7
1.3
0.4
0.4
2.1
5.5
10.3
0.45
3.5
7.3
12.5
0.85
4.6
9.7
14.5
(i)
(ii)
(iii)
(iv)
Illustrate how a hedge could be set up if the company wishes to use the option closest to the
current spot?
Evaluate the hedge if the spot rate on 23rd March is $1.6335-$1.6461/£1
Evaluate the hedge if the spot rate on 26th March is $1.5335-$1.5460/£
How would the hedge have been set up if the option contracts were USD contracts with contracts
a size of $125,000.
279
Solution:
(i) To set up a hedge against a payment of $5m on 21st March Obtain £ PUT options for March @ 1.6
No: of options contracts = $5m/(1.6 x 31250) = 100 contracts
We just converted the contract size to dollars at the chosen exercise price. Note: You can choose any of
the exercise prices as the effect will be the same and you will be awarded full marks.
(ii) On 23rd March,
Company has an option to buy $5m at 1.6 or at a spot rate of 1.6335
In this case it is preferrable to lapse the option completely and transact at the spot rate itself
Thus, payment = $5m/1.6335 = £3060912
Premium (payable regardless) = $0.035 x 31250 x 100/1.6045 £68168 = Net payment 3060912+68168
£3129080
(iii) On 26th March
Company has an option to buy $5m at 1.6 or at the spot rate of 1.5335
They would prefer to exercise option and transact @1.6
Hence payment $5m / 1.6 = £3125000
Premium (payable regardless) - $0.035 x 31250 x 100/1.6045 - £68168
Net payment = 3125000+68168 = £3,193,168
(iv) To set up a hedge against payment of $5m on 21st march
Obtain $ CALL options for March
No. of options- $5m/125000-40 contracts
280
Advantages and Disadvantages of Options
The following are some of the advantages:


It gives the holder a choice
Increased lock in rate options
The following are some of the disadvantages:



Dealing with it can be complex.
It necessitates the payment of an option premium, which can be quite costly.
There is no leeway in the size of standardised market traded instruments.
Forex Swaps





In case of a forex swap, parties agree to swap equivalents amount of currency for a period and
then re-swap them at the end of the period at a pre-decided swap rate.
A foreign exchange swap refers to an agreement to simultaneously borrow one currency and lend
another currency at an initial date, then exchanging the amounts at maturity.
Leg 1 is the transaction at the prevailing spot rate. Leg 2 is the transaction at the predetermined
forward rate.
Short-dated foreign exchange swaps include overnight, tom-next, spot-next and spot-week
Foreign exchange swaps and cross currency swaps differ in interest payments.
Leg 1 at the Initial Date
The first leg is a transaction at the prevailing spot rate. The parties swap amounts of the same value in
their respective currencies at the spot rate. The spot rate is the exchange rate at the initial date.
Leg 2 at Maturity
The second leg is a transaction at the predetermined forward rate at maturity. The parties swap amounts
again, so that each party receives the currency they loaned and returns the currency they borrowed.
281
The forward rate is the exchange rate on a future transaction, determined between the parties, and is
usually based on the expectations of the relative appreciation/depreciation of the currencies.
Expectations stem from the interest rates offered by the currencies, as demonstrated in the interest rate
parity. If currency A offers a higher interest rate, it is to compensate for expected depreciation against
currency B and vice versa.
Currency Swaps or Cross-currency Swaps

A currency swap is an agreement in which two parties exchange the principal and interest of a loan in
one currency for the principal and interest in another.

The equivalent principal amounts are exchanged at the spot rate at the start of the swap.

Throughout the duration of the swap, each party pays interest on the swapped principal loan amount.

The principal amounts are swapped back at the end of the swap at either the prevailing spot rate or
a pre-agreed rate, such as the rate of the original principal exchange. Using the original rate would
eliminate the swap's transaction risk.

Currency swaps are used to obtain foreign currency loans at a lower interest rate than a company
could obtain by borrowing directly in a foreign market or to hedge transaction risk on foreign currency
loans that have already been obtained.
282
Foreign Exchange Swap vs. Currency Swap



Foreign exchange swaps and cross currency swaps are very similar and are often mistaken as
synonyms.
The major difference between the two is interest payments. In a currency swap, both parties must
pay periodic interest payments in the currency they are borrowing. Unlike a foreign exchange
swap where the parties own the amount they are swapping, cross currency swap parties are
lending the amount from their domestic bank and then swapping the loans.
While foreign exchange swaps are riskless because the swapped amount acts as collateral for
repayment, cross currency swaps are slightly riskier.
Illustration 6
An American company may be able to borrow at a rate of 6% in the United States, but it needs a loan in
rand for an investment in South Africa, where the relevant borrowing rate is 9%. At the same time, a South
African company wishes to finance a project in the United States, where the direct borrowing rate is 11%,
compared to 8% in South Africa.
A fixed-for-fixed currency swap allows each party to benefit from the interest rate of the other. In this
case, the American company can borrow US dollars at 6% and then lend the funds to the South African
company at 6%. The South African company can borrow South African rand at 8% and then lend the same
amount to the US company. Currency swaps can also involve exchanging two variable rate loans or a fixed
rate loan for a variable rate loan. Consider the following scenario: a company swaps fixed-rate borrowing
for variable-rate borrowing.
Barrow Co, a company based in the USA, wants to borrow €500m over five years to finance an investment
in the Eurozone. Today’s spot exchange rate between the Euro and US $ is €1·1200 = $1.
Barrow Co’s bank can arrange a currency swap with Greening Co. The swap would be for the principal
amount of €500m, with a swap of principal immediately and in five years’ time, with both these exchanges
being at today’s spot rate.
Barrow Co’s bank would charge an annual fee of 0.4% in € for arranging the swap. The benefit of the swap
will be split equally between the two parties.
The relevant borrowing rates for each party are as follows:
USA
Eurozone
Barrow Co
3.6%
EURIBOR + 1.5%
Greening Co
4.5%
EURIBOR + 0.8%
283
Solution:
We will see what the gain on the swap for each party will be.
USA
Eurozone
Gain on swap
Bank fee
Final gain
Barrow Co
3.6%
EURIBOR + 1.5%
0.8%
(0.2%)
0.6%
Greening Co
4.5%
EURIBOR + 0.8%
0.8%
(0.2%)
0.6%
Benefit
0.9%
0.7%
1.6%
(0.4%)
1.2%
Using this gain to work out the overall result for each company, we can provide an Illustration of how the
swap could work as follows:
Barrow Co borrows
Greening Co borrows
Swap
Greening Co receives
Barrow Co pays
Barrow Co receives
Greening Co pays
Net result
Bank fee
Overall result
Barrow Co
3.6%
Greening Co
EURIBOR + 0.8%
(EURIBOR)
EURIBOR
(2.9%)
EURIBOR + 0.7%
0.2%
EURIBOR + 0.9%
2.9%
3.7%
0.2%
3.9%
The overall result shows each party paying 0.6% less than they would have paid if they had borrowed
directly in the foreign markets.
Barrow Co’s original principal amount of €500m would be exchanged at the inception of the swap for
$446,428,517. The principal would be swapped back five years later, at the end of the agreement, at the
original spot rate.
284
Illustration 7
Currency Swaps (Dec 04 Adapted)
a) From the perspective of a corporate financial manager, discuss the advantages and potential
problems of using currency swaps. (10 marks)
b) Galeplus plc, a UK‐based company, has been invited to purchase and operate a new
telecommunications centre in the republic of Perdia. The purchase price is 2,000 million rubbits. The
Perdian government has built the centre in order to improve the country’s infrastructure but has
currently not got enough funds to pay money owed to the local constructors. Galeplus would purchase
the centre for a period of three years, after which it would be sold back to the Perdian government
for an agreed price of 4,000 million rubbits. Galeplus would supply three years of technical expertise
and training for local staff, for an annual fee of 40 million rubbits, after Perdian taxation. Other after‐
tax net cash flows from the investment in Perdia are expected to be negligible during the three‐year
period. Perdia has only recently become a democracy, and in the last five years, has experienced
inflation rates of between 25% and 500%. The managers of Galeplus are concerned about the foreign
exchange risk of the investment. Perdia has recently adopted economic stability measures suggested
by the IMF, and inflation during the next three years is expected to be between 15% per year and 50%
per year. Galeplus’s bankers have suggested using a currency swap for the purchase price of the
factory, with a swap of principal immediately and in three years’ time, both swaps at today’s spot
rate. The bank would charge a fee of 0.75% per year (in sterling) for arranging the swap. Galeplus
would take 75% of any net arbitrage benefit from the swap after deducting bank fees. Relevant
borrowing rates are:
Galeplus
Perdian counterparty
UK
6.25%
8.3%
Perdia
PIBOR + 2.0%
PIBOR + 1.5%
NB: PIBOR is the Perdian interbank offered rate, which has tended to be set at approximately the current
inflation level. Inflation in the UK is expected to be negligible.
Exchange rates
Spot
85.4 rubbits
3-year forward rate
Not available
285
Required:
(i) Estimate the potential annual percentage interest saving that Galeplus might make from using a
currency swap relative to borrowing directly in Perdia. (6 marks)
(ii) Assuming the swap takes place as described, provide a reasoned analysis, including relevant
calculations, as to whether or not Galeplus should purchase the communications center. The relevant
risk adjusted discount rate may be assumed to be 15% per year. (9 marks)
(Total: 25 marks)
Solution:
(a) Currency swaps have the following advantages:
(i)
(ii)
(iii)
(iv)
(v)
(vi)
They allow companies to engage in foreign currency hedging for longer periods of time than
forwards.
They are typically less expensive than long-term forwards, where such products are available.
Financing may be obtained at a lower cost than borrowing directly in the relevant market. This is
accomplished by utilising arbitrage if a company has a relative funding advantage in one country.
They may provide access to finance in currencies that could not be borrowed directly, for example,
due to government restrictions or a lack of credit rating in the international market.
Currency swaps allow the company to restructure its debt profile without physically redeeming
or issuing new debt.
Currency swaps may be used to circumvent a country's exchange controls.
Potential issues include:
(i)
(ii)
(iii)
(iv)
If the swap is with a corporate counterparty, the counterparty's potential default risk must be
considered. Swaps arranged with a bank as the direct counterparty are far less risky.
Political or sovereign risk; the possibility that a government will impose restrictions on the swap's
performance.
The risk of the basis. Basis risk may exist with a floating-to-floating swap if the two floating rates
are not pegged to the same index.
Exchange rate volatility. The swap could result in a worse outcome than if no swap had been
arranged.
286
(b)
(i) Interest rate differentials
Fixed rate
6.25%
8.30%
(2.05%)
Galeplus
Counterparty
Floating rate
PIBOR + 2%
PIBOR + 1.5%
0.5%
The overall arbitrage opportunity from using a currency swap is 2.55% per year. Bank fees are 0.75% per
year, leaving 1.8%; 75% of 1.8% is 1.35%. That would be the benefit per year to Galeplus in terms of
interest saving from using a currency swap.
(ii) Assuming inflation rates in Perdia are between 15% and 50% per year, the best and worst case
exchange rates are:
Spot
Year 1
Year 2
Year 3
Year
Purchase Cost
Fees
Sale price
Discount factors (15%)
Present values
0
(2,000)
(2,000)
1
(2,000)
Rubbits /£
Best Case
85.40
98.21
112.94
129.88
Cash flows (million rubbits)
1
2
40
40
40
0.870
34.8
40
0.756
30.24
Worst Case
85.40
128.10
192.15
288.23
3
40
4,000
4,040
0.658
2,658.32)
287
With a currency swap, 2,000 million of the Year 3 cash flows will be at the current spot rate of 85.40
rubbits/£, with the remainder at the end of the Year 3 spot rate.
Worst-case rates
Estimated NPV
Best-case rates
Estimated NPV
Discounted cash flows (£ million)
(23.42)
0.27
(£2.92 million)
(23.42)
0.35
£2.95 million
0.16
20.07
0.27
25.75
The financial viability of the investment depends upon exchange rate movements. The greater the
depreciation in the value of the rubbit relative to the pound, the worse the outcome of the investment.
This is due to the Year 3 price of the telecommunications center remaining constant no matter what the
exchange rate is at the time.
These estimates assume that exchange rates remain in the above range. In reality, they could be better
or worse. Additionally, non‐financial factors such as political risk would influence the decision. For
example, given the government’s current cash flow position, how likely is the payment of 4,000 million
rubbits to be made in three years’ time? Other factors such as taxation in the UK would also need to be
considered.
Unless there are strong strategic reasons for buying the center, for example, possible future cash flow
benefits beyond Year 3, the investment is not recommended. In order for the investment to take place, a
better hedge against currency risk would need to be found, or the price to be received in Year 3
renegotiated to reflect the impact of adverse exchange rate changes.
Illustration 8
Awaan Co
Awan Co is expecting to receive $48,000,000 on 1 February 20X4, which will be invested until it is required
for a large project on 1 June 20X4. Due to uncertainty in the markets, the company is of the opinion that
it is likely that interest rates will fluctuate significantly over the coming months, although it is difficult to
predict whether they will increase or decrease.
Awan Co’s treasury team want to hedge the company against adverse movements in interest rates using
either forward rate agreements (FRAs), interest rate futures or options on interest rate futures. Awan Co
can invest funds at the relevant inter‐bank rate of less than 20 basis points. The current inter‐bank rate is
4.09%. However, Awan Co is of the opinion that interest rates could increase or decrease by as much as
0.9% over the coming months.
The following information and quotes are provided from an appropriate exchange on $ futures and
options. Margin requirements can be ignored.
Three‐month $ futures, $2,000,000 contract size
288
Prices are quoted in basis points at 100 – annual % yield
December 20X3: 94.80
March 20X4: 94.76
June 20X4: 94.69
Options on three‐month $ futures, $2,000,000 contract size, option premiums are in annual %
Calls
December
0.342
0.097
Strike
March
0.432
0.121
June
0.523
0.289
94.50
95.00
Puts
December
0.090
0.312
March
0.119
0.417
June
0.271
0.520
Voblaka Bank has offered the following FRA rates to Awan Co:
1–7: 4.37%
3–4: 4.78%
3–7: 4.82%
4–7: 4.87%
It can be assumed that settlement for the futures and options contracts is at the end of the month and
that basis diminishes to zero at contract maturity at a constant rate, based on monthly time intervals.
Assume that it is 1 November 20X3 now and that there is no basis risk.
Required:
(a) Based on the three hedging choices Awan Co is considering, recommend a hedging strategy for the
$48,000,000 investment, if interest rates increase or decrease by 0.9%. Support your answer with
appropriate calculations and discussion. (19 marks)
(b) A member of Awan Co’s treasury team has suggested that if option contracts are purchased to hedge
against the interest rate movements, then the number of contracts purchased should be determined by
a hedge ratio based on the delta value of the option.
Required: Discuss how the delta value of an option could be used in determining the number of
contracts purchased. (6 marks) (Total: 25 marks)
Solution:
(a) Using forward rate agreements (FRAs), FRA rate 4.82% (3–7), since the investment will take place in
three months’ time for a period of four months.
If interest rates increase by 0.9% to 4.99%
289
Investment return = 4.79% × 4/12 × $48,000,000 = $766,400
Payment to Voblaka bank = (4.99% – 4.82%) × $48,000,000 × 4/12 = $(27,200)
Net receipt = $739,200
Effective annual interest rate = 739,200/48,000,000 × 12/4 = 4.62%
If interest rates decrease by 0.9% to 3.19%
Investment return = 2.99% × 4/12 × $48,000,000 = $478,400
Receipt from Voblaka Bank = (4.82% – 3.19%) × $48,000,000 × 4/12 = $260,800 Net receipt = $739,200
Effective annual interest rate (as above) 4.62%
Using futures
Need to hedge against a fall in interest rates, therefore go long in the futures market. Awan Co needs
March contracts as the investment will be made on 1 February. No. of contracts needed =
$48,000,000/$2,000,000 × 4 months/3 months = 32 contracts.
Basis
Current price (on 1/11) – futures price = total basis
(100 – 4.09) – 94.76 = 1.15
Unexpired basis = 2/5 × 1.15 = 0.46
If interest rates increase by 0.9% to 4.99%
Investment return (from above) = $766,400
Expected futures price = 100 – 4.99 – 0.46 = 94.55
Loss on the futures market (0.9455 – 0.9476) × $2,000,000 × 3/12 × 32 $(33,600)
Net return = $732,800
Effective annual interest rate = $732,800/$48,000,000 × 12/4 = 4.58%
If interest rates decrease by 0.9% to 3.19%
Investment return (from above) = $478,400
Expected futures price = 100 – 3.19 – 0.46 = 96.35
Gain on the futures market (0.9635 – 0.9476) × $2,000,000 × 3/12 × 32 $254,400 Net
return = $732,800
Effective annual interest rate (as above) = 4.58%
Using options on futures
Need to hedge against a fall in interest rates, therefore buy call options. As before, Awan Co needs 32
March call option contracts ($48,000,000/$2,000,000 × 4 months/3 months).
If interest rates increase by 0.9% to 4.99%
290
Exercise price
Futures price
Exercise?
Gain in basis points
Underlying investment return
(from above)
Gain on options (0.0005 x
2,000,000 x 3/12 x 32, 0)
Premium
0.00432 x $2,000,000 x 3/12 x 32
0.00121 x $2,000,000 x 3/12 x 32
Net return
Effective interest rate
94.50
94.55
Yes
5
$766,400
95.00
94.55
No
0
$766,400
$8,000
$0
$(69,120)
$705,280
4.41%
$(19,360)
$747,040
4.67%
If interest rates decrease by 0.9% to 3.19%
Exercise price
Futures price
Exercise?
Gain in basis points
Underlying investment return
(from above)
Gain on options
(0.0185 x 2,000,000 x 3/12 x 32)
(0.0135 x 2,000,000 x 3/12 x 32)
Premium
0.00432 x $2,000,000 x 3/12 x 32
0.00121 x $2,000,000 x 3/12 x 32
Net return
Effective interest rate
94.50
96.35
Yes
185
$478,400
95.00
96.35
Yes
135
$478,400
$296,000
$216,000
$(69,120)
$705,280
4.41%
$(19,360)
$675,040
4.22%
Discussion
The FRA offer from Voblaka Bank gives a slightly higher return compared to the futures market;
however, Awan Co faces a credit risk with over‐the‐counter products like the FRA, where Voblaka
Bank may default on any money owing to Awan Co if interest rates should fall. The March call option
at the exercise price of 94.50 seems to fix the rate of return at 4.41%, which is lower than the return
on the futures market and should therefore be rejected. The March call option at the exercise price
of 95.00 gives a higher return compared to the FRA and the futures if interest rates increase but does
not perform as well if the interest rates fall. If Awan Co takes the view that it is more important to be
protected against a likely fall in interest rates, then that option should also be rejected. The choice
291
between the FRA and the futures depends on Awan Co’s attitude to risk and return, the FRA gives a
small, higher return but carries a credit risk. If the view is that the credit risk is small and it is unlikely
that Voblaka Bank will default on its obligation, then the FRA should be chosen as the hedge
instrument.
(b) The delta value measures the extent to which the value of a derivative instrument, such as an option,
changes as the value of its underlying asset changes. For example, a delta of 0.8 would mean that a
company would need to purchase 1.25 option contracts (1/0.8) to hedge against a rise in the price of
an underlying asset of that contract size, known as the hedge ratio. This is because the delta indicates
that when the underlying asset increases in value by $1, the value of the equivalent option contract
will increase by only $0.80. The option delta is equal to N(d1) from the Black‐Scholes Option Pricing
(BSOP) formula. This means that the delta is constantly changing when the volatility or time to expiry
change. Therefore, even when the delta and hedge ratio are used to determine the number of option
contracts needed, this number needs to be updated periodically to reflect the new delta.
Illustration 9
The Armstrong Group is a multinational group of companies. Today is 1 September. The treasury manager
at Massie Co, one of Armstrong Group’s subsidiaries based in Europe, has just received notification from
the group’s head office that it intends to introduce a system of netting to settle balances owed within the
group every six months. Previously inter‐ group indebtedness was settled between the two companies
concerned. The predicted balances owing to, and owed by, the group companies at the end of February
are as follows:
Owed by
Armstrong (USA)
Horan (South Africa)
Giffen (Denmark)
Massie (Europe)
Armstrong (USA)
Horan (South Africa)
Giffen (Denmark)
Owed to
Horan (South Africa)
Massie (Europe)
Armstrong (USA)
Armstrong (USA)
Massie (Europe)
Giffen (Denmark)
Massie (Europe)
Local currency million (m)
US $12.17
SA R42.65
D Kr21.29
US $19.78
€1.57
D Kr16.35
€1.55
292
The predicted exchange rates, used in the calculations of the balances to be settled, are as follows
1 D Kr =
1 US $ =
1 SAR =
1€=
D Kr
1.0000
5.4855
0.5114
7.4571
US $
0.1823
1.0000
0.0932
1.3591
SAR
1.9554
10.7296
1.0000
14.5773
€
0.1341
0.7358
0.0686
1.0000
Settlement will be made in dollars, the currency of Armstrong Group, the parent company. Settlement
will be made in the order that the company owing the largest net amount in dollars will first settle with
the company owed the smallest net amount in dollars. Note: D Kr is Danish Krone, SA R is South African
Rand, US $ is United States dollar, and € is Euro.
Required:
(a)
(i) Calculate the inter‐group transfers which are forecast to occur for the next period. (8 marks)
(ii) Discuss the problems which may arise with the new arrangement. (3 marks)
Owed by
Armstrong (USA)
Horan (South Africa)
Giffen (Denmark)
Massie (Europe)
Armstrong (USA)
Horan (South Africa)
Giffen (Denmark)
Owed to
Horan (South Africa)
Massie (Europe)
Armstrong (USA)
Armstrong (USA)
Massie (Europe)
Giffen (Denmark)
Massie (Europe)
Owed to
Giffen (De)
Armtg (US)
Horan (SA)
Massie (Eu)
---------------Owed by
Owed to
Net
Giffen (De)
$m
3.88
Armtg (US)
$m
12.17
2.11
2.13
--------------(5.99)
(14.30)
2.98
23.66
(3.01))
9.36
Local currency (m)
US $12.17
SA R42.65
D Kr21.29
US $19.78
€1.57
D Kr16.35
€1.55
Owed by
Horan (SA)
$m
2.98
3.97
-------------(6.95)
12.17
5.22
$m
12.17
3.97
3.88
19.78
2.13
2.98
2.11
Massie (Eu)
$m
19.78
------------(19.78)
8.21
(11.57)
Total
$m
2.98
23.66
12.17
8.21
293
Under the terms of the arrangement, Massie, as the company with the largest debt, will pay Horan
$5.22m, as the company with the smallest amount owed. Then Massie will pay Armstrong $6.35m, and
Giffen will pay Armstrong $3.01 m.
(ii) The Armstrong Group may have problems if any of the governments of the countries where the
subsidiaries are located object to multilateral netting. However, this may be unlikely here. The new system
may not be popular with the management of the subsidiaries because of the length of time before
settlement (up to six months). Not only might this cause cash flow issues for the subsidiaries, but the
length of time may mean that some of the subsidiaries face significant foreign exchange risks. The system
may possibly have to allow for immediate settlement in certain circumstances, for example, if transactions
are above a certain size or if a subsidiary will have significant cash problems if amounts are not settled
immediately.
294
Chapter 9: Interest Rate Risk Management
295
Introduction
The risk of interest rate changes resulting in losses for the company is referred to as interest rate risk.
Interest rate risk may exist under the following conditions:


When a company wishes to borrow or invest at a later date but is unsure of the interest rates that
will be in effect at that time.
When a company has a variable rate loan or investment and is unsure of the exact pay-out at the
next reset date. Essentially, the date on which the bank will use the variable rate for the next
period will be determined.
The following are the interest rate hedging instruments you will learn in this chapter:
1.
2.
3.
4.
5.
Forward rate agreements (FRA)
Interest rate hedging guarantees (IRG)
Interest rate futures
Interest rate options (on futures)
Interest swap
Forward rate agreements
FRAs are used to lock the interest rate on loan or a deposit that will commence on a future date. It is an
agreement to fix the effective interest rate at which the company will be able to borrow at a future date.
Effective interest rate is the actual interest rate applied to the investment or loan. These are called as
over the counter agreements (OTC), which are tailor made to the company’s needs.
In market terminology, an FRA on a notional four-month loan/deposit starting in six months time is called
a ‘6v10 FRA/6-10 FRA.’ The first digit represents the number of months remaining for the loan/deposit to
commence and the digit to the right represents the number of months from today to the end of the
loan/deposit’s term.
The aim of FRA is to:
•
•
Lock the company to a target interest rate.
Protect the company from any adverse movements, but preventing the company from gaining
any favorable movements too.
For example, if GYNA Co needs to borrow money and enters into an FRA with its bank to lock in the interest
rate at 6%. If the market interest rate turns out to be higher when the loan commences, GYNA Co will be
protected, however, if the interest rate falls to say 5% GYNA will not benefit from this as they are locked
into paying 6% interest.
However, in practice, this transaction is done in a slightly different manner. The company enters into a
normal loan with an entity but independently organizes a forward rate agreement with a bank. An FRA
for a loan is carried out in the following manner:
296
1) Interest is paid on loan as usual.
2) If the interest is less than the agreed forward rate, the bank pays the difference to the borrower.
3) If the interest rate is more than the agreed forward rate, the borrower pays the bank the
difference.
It is crucial to remember this table:
Borrowing
Depositing
FRA > Market interest rate
Holder pays the bank the difference
between FRA and market interest.
Bank pays the holder the difference
between FRA and market interest.
FRA < Market interest rate
Bank pays the holder the difference
between FRA and market interest.
Holder pays the bank the difference
between FRA and market interest.
LIBOR is a term that will show up in almost every sum, and it is nothing but the base market interest rate.
It stands for London Inter-Bank Offer rate.
Banks quote interest rates as, for example, 5%-5.5%, the lower rate will always be the interest receivable
for depositing with the bank, and the higher rate will be for borrowing from the bank. Because banks will
always intend to make a profit.
Illustration 1:
A company wishes to borrow $20 million in seven month time for a four-month period. It can normally
borrow from its bank at LIBOR + 0.5%. The company is worried about the risk of a sharp rise in interest
rates in the near future.
A bank quotes FRA rates of:
4 v 11: 5.4%-5.5%
7 v 11: 5.3%-5.25%
The LIBOR will be 6% in 6 month time.
Required: Compute the gain/loss on FRA and who will need to make the compensation payment.
Solution:
The FRA borrowing rate relevant to the company is 5.3%. The company will pay LIBOR+0.5% which is
6%+0.5% = 6.5%. FRA > interest rate thus, the company will get compensated by 1.2% (6.5%-5.3%)
Interest compensation will be = 1.2%*(4/12) *$20 million = $80,000
297
How does a bank set the interest rate for FRA
It is calculated as the balancing figure of the following equation:
(1 + Rate of year 0 to 1) x (1 + Rate of year 1 to 2) = Rate of year 0 to
2
This is the balancing figure to be calculated
llustration 2:
Stone Co's yield curve has been calculated as:
Year
1
2
3
Individual yield curve (%)
3.96
4.25
4.56
Calculate what will be rate of interest the bank would quote for 12-24 FRA.
Solution:
This means that Stone Co will have to pay interest of 3.96% if it wants to borrow money for 1 year, 4.25%
if it wants to borrow for 2 years etc.
An alternative to borrowing for 2 years at 4.25% throughout is to borrow for 1 year initially at 3.96% and
then to borrow for another year in 1 years’ time at an unknown rate. The company could fix the interest
rate in one year's time by asking the bank to quote a rate for a12 – 24 FRA.
The rate quoted by the bank would be the rate r, so that:
1.0396 × (1 + r) = 1.04252
Rearranging this gives r = 4.54%.
Hence the 12 – 24 FRA rate for Stone Co would be 4.54%.
What does shorting a contract mean?
Going short is a method to make money when there is a fall in the market price. The way it works is, an
individual will borrow shares from somewhere (usually a financial institution) with a promise to return
them at a certain date in the future. Thus, if you feel that there is going to be a fall in the market price,
you will sell the shares at the current market price and further, buy them back at a lower price (If your
assumptions are correct and the price falls) from the market. This way, you will make a profit as you
bought back the security at a lower price than you sold it for and will satisfy your promise by returning
the security back from where you borrowed it.
Going long is the opposite of this, and you make a profit when the prices rise.
298
Options on FRAs:
Interest rate guarantees (IRGs)
These are Floors, Caps, and Collars are the types of IRGs we shall study them below.
Borrowers point of view (Cap)
Borrowers will want to protect themselves against the rise in interest rate. They would want to fix a
maximum ceiling for which they are willing to pay interest. This maximum limit set is known as a CAP. For
example, ABC Co. is a borrower and assume the prevailing interest rate is 11% they want to borrow in the
future. ABC is under the impression that the interest rate is going to rise to 12%. If ABC Co. holds an
interest rate cap of 11%, they will effectively only be paying 11% even if the interest rate rises to 12%.
However, if the interest rate falls below 11% the borrower can take advantage of this movement and lapse
the cap option. This is similar to taking a short position.
Investor’s point of view (Floor)
Investors would not want their returns to fall below a certain rate, thus they would want to fix a minimum
amount they can accept as returns. This is done by dealing in an interest rate Floor option. The minimum
limit set is known as a FLOOR. For example, ABC Co. is a borrower and assume the prevailing interest rate
is 11% they want to invest in the future. ABC is under the impression that the interest rate is going to fall
to 9%. If ABC Co. holds an interest rate floor for 11%, they will effectively only receive 11% even if the
interest rate falls to 9%. However, if the interest rises to 14% the investor can take advantage of this
movement and lapse the cap option. This is similar to going long.
Collar
Collar is nothing but a combination of a CAP and a FLOOR. These are usually used by companies investing
or borrowing variable rate loans, where they need to be protected against an upward and a downward
movement. We shall see how both of these work in the example below.
299
Illustration 3
An Indian company has predicted a funding requirement of INR 2,825,000 for a 6-month period beginning
12 months from now. An IRG is available at 4% for a premium of 0.1123 percent of the loan amount.
Compute the net interest cost to the company if the actual interest rate for the duration of the
borrowings is (i) 8% and (ii) 3.5%
Solution
Market Rate
IRG Rate
Interest to be paid on
Premium
Net Interest Rate
Interest Value in Millions
In Total Value
(i)
8%
4%
4%
0.11%
4.112300%
0.058086238
58086.2375
(ii)
3.50%
4%
3.50%
0.11%
3.612300%
0.051023738
51023.7375
Interest Rate Futures (IRF)


An interest rate future is conceptually similar to a currency future. Standard size instruments are
traded in the futures market and can be bought/sold based on the needs of the company. The
goal of interest rate futures is to lock the company into a specific interest rate for a future
transaction.
Any losses incurred in a money market transaction, such as borrowing or depositing, are offset by
gains in the futures market transaction and vice versa.
300
Types of IRFs:
Short Term Interest Rate
Futures (STIRs)
•Standardized exchange traded forward contracts
•Notional deposit with period of generally 3 months
Bond Futures
•Contracts on stand quantity of notional
governement bonds
•On final delivery date, if the position is not closed,
settlement happens physically
How Interest rate futures are quoted
There are instruments that can be bought or sold. Interest rate forwards are quoted in quite a peculiar
manner.
For example, if the forward agreement was 11%. It would be quoted as 89. That is 100-11 (100-n). Always
remember that the IRF quote will always be inversely related to the interest rate it is representing.
Settlement price is used in IRFs (Open price should be ignored).
𝑵𝒐. 𝒐𝒇 𝒄𝒐𝒏𝒕𝒓𝒂𝒄𝒕𝒔 𝒏𝒆𝒆𝒅𝒆𝒅 =
𝑳𝒐𝒂𝒏 𝒐𝒓 𝑫𝒆𝒑𝒐𝒔𝒊𝒕 𝒂𝒎𝒐𝒖𝒏𝒕
𝑪𝒐𝒏𝒕𝒓𝒂𝒄𝒕 𝒔𝒊𝒆
×
𝑳𝒐𝒂𝒏 𝒐𝒓 𝑫𝒆𝒑𝒐𝒔𝒊𝒕 𝑷𝒆𝒓𝒊𝒐𝒅 𝒊𝒏 𝒎𝒐𝒏𝒕𝒉𝒔
𝑪𝒐𝒏𝒕𝒓𝒂𝒄𝒕 𝒅𝒖𝒓𝒂𝒕𝒊𝒐𝒏
Ticks and tick values
𝐓𝐢𝐜𝐤 𝐯𝐚𝐥𝐮𝐞 = 𝐏𝐫𝐢𝐧𝐜𝐢𝐩𝐚𝐥 𝐚𝐦𝐨𝐮𝐧𝐭 × One basis point X
𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐦𝐨𝐧𝐭𝐡𝐬
𝟏𝟐
301
Reference rate
Futures exchange
Notional
deposit
Tick size
London Futures Exchange
Futures
exchange
shortform
LIFFE
3 month GBP
£5,00,000
3 month Euro
ICE Futures Europe
LIFFE/Eurex
€1 million
3 month EuroDollar
Chicago Mercantile
Exchange
Tokyo Financial
Exchange/London
Futures Exchange
CME
$1 million
TFE/LIFFE
¥100
million
£5,00,000 x 0.0001 x
3/12 = £12.50
€1 million x 0.0001 x
3/12 = €25
$1 million x 0.0001 x
3/12 = $25
¥100 million x 0.00005 x
3/12 = ¥1250
3 month EuroYen
Only for 3-month EuroYen futures, the tick size is 0.005% or 0.00005.
Lock-in rate = 100 – (Current futures price + Unexpired basis on transaction date)
Basis = (100 – Spot rate of interest or current SOFR rate) – Futures price
Borrower’s point of view
Borrowers will want to protect themselves against a rise in interest rates. When there is a rise in the
interest rate, the IRF quote will go down, thus a borrower will have to take a short position, lets
understand this with an example.
For example, ABC Co. is a borrower and assume the prevailing interest rate is 11% they want to borrow in
the future. ABC is under the impression that the interest rate is going to rise to 12%. Thus, the IRF quote
would currently be 89. and would become 88 if the interest rate rises to 12% in the future. By taking a
short position, you will have sold IRF’s at 89 and bought them back at 88, thus making a profit whilst
having effectively off-set the loss with the rise in the interest rate in the money market. (Rise from 11%12% off-set by profit from selling IRF’s at 89 and buying back at 88).
302
Investors point of view
Investors would want to protect themselves against the fall in interest rate. When there is a fall in the
interest rate, the IRF quote will go up, thus a borrower will have to take a long position, lets understand
this with an example.
For example, ABC Co. is an investor and assume the prevailing interest rate is 11% they want to invest in
the future. ABC is under the impression that the interest rate is going to fall to 9%. Thus, the IRF quote
would currently be 89. and would become 91.00 if the interest rate fell to 9% in the future. By taking a
long position, you will have bought IRF’s at 89.00 and sold them at 91, thus making a profit whilst having
effectively off-set the loss with the fall in the interest rate in the money market.
Illustration 4
Jolly Ltd. is a consumer biscuit wholesaler. The firm's business is primarily seasonal in nature. In 6 months
a year, fir has a large cash deposit, especially near Christmas time, and another 6 months firm cash crunch,
forcing it to borrow money to cover its exposures for running the business.
It is expected that the firm will borrow £50 million for the duration of the slack season, which will last
approximately 3 months.
The following are the current market quotations:



Spot:
5.50%-5.75%
3x6:
5.59%-5.82%
3x9: 5.64%-5.94%
3 month £50,000 future contract maturing in a period of 3 months is quoted at 94.15 (5.85%).
Requirement:
a) How an FRA shall be useful if the actual interest rate after 3 months turnout to be:
i. 4.5%
ii. 6.5%
b) How 3 months future contract shall be useful for the company if interest rate turns out as
mentioned in a).
303
Solution
a)
If the rate turns out to be 4.5%
FRA rate
Actual interest rate
Loss/(Gain)
Note gain is shown in negative
because you are the borrower
FRA Payment/(Receipts)
5.94%
4.50%
1.44%
£360,000
(£50m x 1.44% x 6/12)
Interst after 6 months on £50 million £1,125,00
at actual rates.
(£50m x 4.5% x 6/12)
Net outflow
£1,485,000
If the rate turns out to be
6.5%
5.94%
6.50%
(0.56%)
(£140,000)
(£50m x 0.56% x 6/12)
£1,625,00
(£50m x 6.5% x 6/12)
£1,485,000
Thus by entering into FRA, the firm has committed itself to a rate of 5.94% as follows:
(£1485000/£50000000) x 100 x (12/6) = 5.94%
b) Since the firm is a borrower, it will like to off-set interest costs by profit on the future contract.
Accordingly, if the interest rate rises, it will gain hence it should sell (short) interest rate futures.
(The steps to solve an interest rate futures question is the same as that of forex futures)
Step 1: Find the no. of contracts to purchase:
No. of contracts = Amount of borrowing x Duration of Loan
Contract size
3 months
= (£50,000,000/£50,000) x (6/3) = 2000 Contracts
The following outcome in the given two scenarios shall be as follows:
Interest for 6 months on £50
million at actual rates
If the rate turns out to be 4.5%
94.15
95.5 (100-4.5%)
1.35%
£337,500
(£50,000 x 2000 x 1.35% x 3/12)
£1,125,000
(£50million x 4.5% x 6/12)
If the rate turns out to be 6.5%
94.15
93.5 (100-6.5%)
(0.65%)
(£162,500)
(£50,000 x 2000 x 0.65% x 3/12)
£1,625,000
(£50million x 6.5% x 6/12)
Net outflow
£1,462,500
£1,462,000
Sell to open
Buy to close
Loss/(Gain)
Cash Payment (Receipt)
304
Therefore the firm has successfully locked itself in the interest rate:
(£1462500/£50,000,000) x 100 x (12/6) = 5.85%
Interest Rate Options
This is similar to interest rate futures except that the option holder has a right and not an obligation to
satisfy the contract. What this means is that even if the interest rate moves favouorably, you can take
advantage of the favourable movement and lapse the contract. While in a forwards contract, you have no
option to lapse the contract, and you will be locked in at the interest rate.
This benefit comes with a cost, and an upfront premium payment is that cost. If a company is depositing
money, it would have purchased futures under an IRF, and if it is using options, it would need a contract
to obtain a Call option.
If a company is borrowing money, it would have purchased futures under an IRF, and if it is using options,
it would need to obtain a Put option. Typically, Interest options are taken on interest rate futures, we shall
see how this works in the below example. This hedge works similar to an interest rate futures hedge,
except in options, you can lapse the contract in case there is a favourable movement in interest rate.
How Interest rate options are quoted
Same as futures.
The following is a comprehensive example of all the above concepts it is essential to understand what’s
given below and to keep practicing as it tends to get confusing if you fall out of practice.
305
ACCA AFM Technical Article
Assume Wardegul Co has a newly-acquired subsidiary in Euria, where the local currency is the dinar (D).
The subsidiary expects to receive D27,000,000 and wants to invest this D27,000,000. Assume it is now 1
October 2017, and the subsidiary expects to receive the money on 31 January 2018. It wishes the money
to be invested for five months until 30 June 2018.
Currently, the central bank base rate in Euria is 4·2%, but Wardegul Co’s treasury team has seen
predictions that the central bank base rate could increase by up to 1·1% or fall by up to 0·6% between
now and 31 January 2018. The treasury team believes that Wardegul Co can invest funds at the central
bank base rate of less than 30 basis points.
The treasury team normally hedge interest rate exposure by using whichever of the following products is
most appropriate:

Forward rate agreements (FRAs)

Interest rate futures

Options on interest rate futures
Treasury function guidelines emphasize the importance of mitigating the impact of adverse movements
in interest rates. However, they also allow staff to take into consideration upside risks associated with
interest rate exposure when deciding which instrument to use. A local bank in Euria, with which Wardegul
Co has not dealt before, has offered the following FRA rates:

4–9: 5·02%

5–10: 5·10%
The treasury team has also obtained the following information about exchange traded Dinar futures and
options:
Three-month D futures, D500,000 contract size
Prices are quoted in basis points at 100 – annual % yield
December 2017
March 2018
June 2018
94.84
94.78
94.66
306
Options on three-month D futures, D500,000 contract size, option premiums are in annual %
December
0.417
0.078
Call
March
0.545
0.098
June
0.678
0.160
94.25
95.25
December
0.071
0.393
Put
March
0.094
0.529
June
0.155
0.664
It can be assumed that futures and options contracts are settled at the end of each month. Basis can be
assumed to diminish to zero at contract maturity at a constant rate, based on monthly time intervals. It
can also be assumed that there is no basis risk and there are no margin requirements.
Requirements
Recommend a hedging strategy for the D27,000,000 investment, based on the hedging choices which
treasury staff are considering if interest rates increase by 1·1% or decrease by 0·6%. Support your answer
with appropriate calculations and discussion. (18 marks)
Approaching the question
Read the requirements carefully
You should read the requirements first before reading the scenario in detail. Knowing what your answer
has to cover, and therefore what the key data will be will help you analyze the scenario.
Breaking down the requirements for Wardegul Co:
Recommend
hedging strategy
a You’ll have to make a clear recommendation based on your calculations. Anyone
reading
the
recommendation
should
be
able
to
see:
•
How
much
would
be
received
under
each
instrument
• The effective annual interest rate for each instrument so that they can compare
the results of the hedging choices with the interest rate currently available.
Based on the hedging You need to consider all the hedging instruments for which data is given, including
choices which treasury both the options.
staff are considering
If interest rates increase You should assess, for all the hedging instruments, what will happen if interest rates
by 1·1% or decrease by rise or fall.
0·6%
Support your answer You should make some comments on any calculation you carry out in the Advanced
with
appropriate Financial Management exam. However, mentioning discussion in the question
requirements here indicates that a number of marks will be available for comments
307
calculations
discussion
and (four marks maximum per the marking scheme). Therefore, a single sentence
comment won’t be enough.
Identify the important data in the scenario
For interest rate hedging questions, you need to identify the information that will affect the calculations
for each instrument. Let’s have another look at the scenario, with the important data highlighted and
referenced to explanations below.
Assume Wardegul Co has a newly-acquired subsidiary in Euria, where the local currency is the dinar (D).
The subsidiary expects to receive D27,000,000 and wants to invest this D27,000,000.
Wants to invest this D27,000,000
Forward rate agreements
Possibilities are:
Futures
Options
Buy now (go long), Buy call option
sell later
• Pay money to bank if base
rate exceeds FRA rate
• Receive money from the
bank if the FRA rate is
greater than the base rate
Assume it is now 1 October 2017, and the subsidiary expects to receive the money on 31 January 2018.
Forward rate agreements
Futures
It is now 1 Oct 2017 and the A period of four months, so Choose futures dated
subsidiary
expects
to look for a 4–x agreement
after January – March is
receive the money on 31
the closest date
Jan 2018
Options
Choose
options
dated after January
– March is the
closest date
308
It wishes the money to be invested for five months until 30 June 2018.
Forward rate agreements
The money to be Four months to start of
invested
for
five investment + five months
months until 30 June to end of investment =
2018
nine months, so select 4–
9 agreement
Futures
Contracts are for three
months, so adjust
contracts calculation
so that five-month
period is covered
Options
Contracts are for
three months, so
adjust
contracts
calculation so that
five-month period is
covered
Calculate
investment Calculate investment Calculate investment
return for five months
return for five months return
for
five
months
Calculate transaction with
the bank for five months
Adjust effective annual
interest rate calculation
for interest being received
for five months
Adjust effective annual
interest
rate
calculation for interest
being received for five
months
Adjust
effective
annual interest rate
calculation
for
interest
being
received for five
months
Currently, the central bank base rate in Euria is 4·2%,
Forward
rate
agreements
Currently, the central bank Affects calculation
base rate in Euria is currently of:
4.2%
• Future interest
rates
Futures
Options
Affects calculations of: Affects calculations of:
• Future interest rates • Future interest rates
• Basis
• Basis
But Wardegul Co’s treasury team has seen predictions that the central bank base rate could increase
by up to 1·1% or fall by up to 0·6% between now and 31 January 2018.
309
Forward rate agreements
Affects future interest rates
and
hence:
• Actual investment return
• Transaction with bank
The central bank base
rate could increase by
up to 1.1% or fall by up
to 0.6%
Futures
Affects future interest
rates
and hence:
• Actual investment
return
•
Calculation
of
expected futures price
and hence result on
the futures market
Options
Affects future interest
rates
and hence:
• Actual investment
return
•
Calculation
of
expected futures price
and hence whether
options are exercised
or
not
• Calculation of gain if
options are exercised
The treasury team believes that Wardegul Co can invest funds at the central bank base rate of less 30
basis points.
Wardegul Co can
invest funds at the
central bank base rate
of less 30 basis points
Forward rate agreements
Affects actual investment
return:
• If the rate rises to 5.3%,
investment-return will be
5.0%
• If the rate falls to 3.6%,
investment return will be
3.3%
Futures
Affects actual investment
return:
• If the rate rises to 5.3%,
investment-return will be
5.0%
• If the rate falls to 3.6%,
investment return will be
3.3%
Options
Affects actual investment
return:
• If the rate rises to 5.3%,
investment -return will be
5.0%
• If the rate falls to 3.6%,
investment return will be
3.3%
The treasury team normally hedges interest rate exposure by using whichever of the following products
is most appropriate:

Forward rate agreements (FRAs)

Interest rate futures

Options on interest rate futures
Treasury function guidelines emphasize the importance of mitigating the impact of adverse movements
in interest rates. However, they also allow staff to take into consideration upside risks associated with
interest rate exposure when deciding which instrument to use.
310
A local bank in Euria, with which Wardegul Co has not dealt before, has offered the following FRA rates:

4–9: 5·02%

5–10: 5·10%
The treasury team has also obtained the following information about exchange traded Dinar futures and
options:
Three-month D futures, D500,000 contract size
Forward rate Futures
agreements
Three-month D500,000
Affects
calculations
of:
futures
• Number of futures
contracts
• Result on futures contracts
Options
Prices are quoted in basis points at 100 – annual % yield
December 2017
March 2018
June 2018
94.84
94.78
94.66
Options on three-month futures, D500,000 contract size, option premiums are in annual %
311
Forward rate
agreements
Futures
Options
Options on three-month
futures, D500,000 contract
size
December
0.417
0.078
Call
March
0.545
0.098
Affects calculation
is of:
• Number of
options contracts
• Gain if options
are exercised
• Option premium
June
0.678
0.160
94.25
95.25
December
0.071
0.393
Put
March
0.094
0.529
June
0.155
0.664
It can be assumed that futures and options contracts are settled at the end of each month. Basis can be
assumed to diminish to zero at contract maturity at a constant rate, based on monthly time intervals. It
can also be assumed that there is no basis risk and there are no margin requirements.
Forward rate
agreements
Basis can be
assumed to diminish
to zero at contract
maturity at a
constant rate, based
on monthly time
intervals
Futures
Options
Use in basis calculation:
• Period between
investment date (31
January) and contract
maturity date (31 March)
(two months)
Use in basis calculation:
• Period between investment date
(31 January) and contract maturity
date (31 March) (two months)
• Period between today’s
date (1 October) and
contract date (31 March)
(six months)
Let’s now review the answer:
Forward rate agreement
• Period between today’s date (1
October) and contract date (31
March) (six months)
312
FRA 5.02% (4 – 9) since the investment will take place in four months’ time for a period of five months.
If interest rates increase by 1.1% to 5.3%
Actual investment return 5.0% × 5/12 × D27,000,000
Payment to bank (5.3% – 5.02%) × 5/12 × D27,000,000
D
562,500
(31,500)
Net receipt
Effective annual interest rate 531,000/27,000,000 × 12/5
531,000
4.72%
Actual investment return 3.3% × 5/12 × D27,000,000
Receipt from bank (5.02% – 3.6%) × 5/12 × D27,000,000
Net receipt
Effective annual interest rate as above
531,000/27,000,000 × 12/5
D
371,250
159,750
531,000
4.72%
Comment: The two calculations should give the same effective annual interest rate.
Futures
Buy futures now (go log buy futures now (go long in the futures market), as the hedge is against a fall in
interest rates.
Use March contracts, as an investment will be made on 31 January.
Number of contracts = D27,000,000 ÷ D500,000 × 5 months ÷ 3 months = 90 contracts
Basis Current price
(1 October) – futures price = basis
(100 – 4.20) – 94.78 = 1.02
Unexpired basis on 31 January = 2/6 × 1.02 = 0.34
313
If interest rates increase by 1.1% to 5.3%
Actual investment return 5.0% × 5/12 × D27,000,000
Expected futures price: 100 – 5.3 – 0.34 = 94.36
Loss on the futures market: (0.9436 – 0.9478) ×
D500,000 × 3/12 × 90
Net return
Effective annual interest rate 515,250/27,000,000 × 12/5
D
562,500
(47,250)
515,250
4.58%
If interest rates fall by 0.6% to 3.6%
Actual investment return 3.3% × 5/12 × D27,000,000
Expected futures price: 100 – 3.6 – 0.34 = 96.06
Profit on the futures market: (0.9606 – 0.9478) × D500,000 × 3 /12 × 90
Net receipt
Effective annual interest rate 515,250/27,000,000 × 12/5
D
371,250
144,000
515,250
4.58%
Options
Buy call options as need to hedge against a fall in interest rates
Use March contracts, as an investment will be made on 31 January.
Number of contracts = D27,000,000 ÷ D500,000 × 5 months ÷ 3 months = 90 contracts
Basis
Current price (1 October) – futures price = basis
(100 – 4.20) – 94.78 = 1.02
Unexpired basis on 31 January = 2/6 × 1.02 = 0.34
If interest rates increase by 1.1% to 5.3%
Exercise price
Expected futures price: 100 – 5.3 – 0.34 = 94.36
Exercise?
Gain in basis points
Actual investment return 5.0% × 5/12 × D27,000,000
Gain from options 0.0011 × D500,000 × 3/12 × 90
Premium
0.00545 × D500,000 × 3/12 × 90
0.00098 × D500,000 × 3/12 × 90
Net return
Effective interest rate
94.25
94.36
Yes
11
D
562,500
12,375
95.25
94.36
No
0
D
562,500
0
(61,313)
513,562
(11,025)
551,475
314
513,562/27,000,000 × 12/5
551,475/27,000,000 × 12/5
Exercise price
Expected futures price: 100 – 3.6 – 0.34 = 96.06
Exercise?
Gain in basis points
Actual investment return 3.3% × 5/12 × D27,000,000
Gain from options
0.0181 × D500,000 × 3/12 × 90
0.0081 × D500,000 × 3/12 × 90
Premium
0.00545 × D500,000 × 3/12 × 90
0.00098 × D500,000 × 3/12 × 90
Net return
Effective interest rate
513,562/27,000,000 × 12/5
451,350/27,000,000 × 12/5
4.56%
94.25
96.06
Yes
181
371,250
4.90%
95.25
96.06
Yes
81
371,250
203,625
91,125
(61,313)
513,562
(11,025)
451,350
4.56%
4.01%
Comment
If one of the options is exercised for both interest rates, as the 94.25 is here, the calculations should
give the same result.
As these are CALL options, options to buy, choose the LOWER price and so:
• If the exercise price is LOWER than the expected futures price, EXERCISE
• If the exercise price is HIGHER than the expected futures price, DO NOT EXERCISE
315
Illustration 5
Alecto Co, a large listed company, based in Europe, is expecting to borrow €22,000,000 in four months’
time on 1 May 20X2. It expects to make full repayment of the borrowed amount nine months from now.
Currently, there is some uncertainty in the markets, with higher than normal rates of inflation, but an
expectation that the inflation level may soon come down. This has led some economists to predict a rise
in interest rates and others suggesting an unchanged outlook or maybe even a small fall in interest rates
over the next six months.
Although Alecto Co is of the opinion that it is equally likely that interest rates could increase or fall by 0.5%
in four months, it wishes to protect itself from interest rate fluctuations by using derivatives. The company
can borrow at LIBOR plus 80 basis points, and LIBOR is currently 3.3%. The company is considering using
interest rate futures, options on interest rate futures or interest rate collars as possible hedging choices.
The following information and quotes from an appropriate exchange are provided on Euro futures and
options. Margin requirements may be ignored.
Three-month Euro futures, €1,000,000 contract, tick size 0.01% and tick value €25.
March 96.27
June 96.16
September 95.90
Options on three-month Euro futures, €1,000,000 contract, tick size 0.01% and tick value €25. Option
premiums are in annual %.
March
0.279
0.012
Calls
June
0.391
0.090
Strike
September
0.446
0.263
96.00
96.5
March
0.006
0.196
Puts
June
0.163
0.581
September
0.276
0.754
It can be assumed that settlement for both the futures and options contracts is at the end of the month.
It can also be assumed that the basis diminishes to zero at contract maturity at a constant rate and that
time intervals can be counted in months.
Required:
(a) Briefly discuss the main advantage and disadvantages of hedging interest rate risk using an interest
rate collar instead of options. (4 marks)
(b) Based on the three hedging choices Alecto Co is considering and assuming that the company does not
face any basic risk, recommend a hedging strategy for the €22,000,000 loan. Support your
recommendation with appropriate comments and relevant calculations in €. (17 marks)
(c) Explain what is meant by basis risk and how it would affect the recommendation made in part (b)
above. (4 marks) (Total: 25 marks)
316
Solution:
(a) The main advantage of using a collar instead of options to hedge interest rate risk is lower cost. A
collar involves the simultaneous purchase and sale of both call and puts options at different exercise
prices. The option purchased has a higher premium when compared to the premium of the option sold,
but the lower premium income will reduce the higher premium payable. With a normal uncovered option,
the full premium is payable. However, the main disadvantage is that, whereas with a hedge using options,
the buyer can get the full benefit of any upside movement in the price of the underlying asset, with a
collar hedge, the benefit of the upside movement is limited or capped as well.
(b) Using Futures
Need to hedge against a rise in interest rates, therefore go short in the futures market. Alecto Co needs
June contracts as the loan will be required on 1 May.
No. of contracts needed = €22,000,000/€1,000,000 × 5 months/3 months
= 36.67 say 37 contracts.
Basis
Current price (on 1/1) – futures price = total basis
(100 – 3.3) – 96.16 = 0.54
Unexpired basis = 2/6 × 0.54 = 0.18
If interest rates increase by 0.5% to 3.8%
Cost of borrowing funds = 4.6% × 5/12 × €22,000,000 = €421,667
Expected futures price = 100 – 3.8 – 0.18 = 96.02
Gain on the futures market = (9,616 – 9,602) × €25 × 37 = €12,950
Net cost = €408,717
Effective interest rate = 408,717/22,000,000 × 12/5 = 4.46%
If interest rates decrease by 0.5% to 2.8%
Cost of borrowing funds = 3.6% × 5/12 × €22,000,000 = €330,000
Expected futures price = 100 – 2.8 – 0.18 = 97.02
317
Loss on the futures market = (9,616 – 9,702) × €25 × 37 = €79,550
Net cost = €409,550 Effective interest rate = 409,550/22,000,000 × 12/5 = 4.47%
(Note: Net cost should be the same. Difference is due to rounding the number of contracts)
Using Options on Futures
Need to hedge against a rise in interest rates, therefore buy put options. As before, Alecto Co needs 37
June put option contracts (€22,000,000/€1,000,000 × 5 months/ 3 months).
If interest rates increase by 0.5% to 3.8%
Exercise price
Futures price
Exercise?
Gain in basis points
Underlying investment return (from above)
Gain on options (0 and €25 x 48 x 37)
Premium
16.3 x €25 x 37
58.1 x €25 x 37
Net cost
Effective interest rate
96.0
96.02
No
0
€421,667
€0
96.50
96.02
Yes
48
€421,667
€44,400
€15,078
€436,745
4.76%
€53,743
€431,010
4.70%
If interest rates decrease by 0.5% to 2.8%
Exercise price
Futures price
Exercise?
Gain in basis points
Underlying investment return (from above)
Gain on options (0 and €25 x 48 x 37)
Premium
16.3 x €25 x 37
58.1 x €25 x 37
Net cost
Effective interest rate
96.00
97.02
No
0
€330,000
€0
96.50
97.02
No
48
€330,000
€0
€15,078
€345,078
3.76%
€53,743
€383,743
4.19%
318
Using a collar
Buy June put at 96.00 for 0.163 and sell June call at 96.50 for 0.090.
Premium payable = 0.073
If interest rates increase by 0.5% to 3.8%
Exercise price
Futures price
Exercise?
Underlying investment return (from above)
Premium
7.3 x €25 x 37
Net cost
Effective interest rate
Buy Put
96.0
96.02
No
€421,667
Sell Call
96.50
96.02
NO
€15,078
€428,420
4.67%
If interest rates decrease by 0.5% to 2.8%
Exercise price
Futures price
Exercise?
Underlying investment return (from above)
Premium
7.3 x €25 x 37
Loss on exercise (52 x €25 x 37)
Net cost
Effective interest rate
Buy Put
96.0
97.02
No
330,000
Sell Call
96.50
97.02
Yes
€15,078
€48,100
€384,853
4.20%
Hedging using the interest rate futures market fixes the rate at 4.47%, whereas with options on futures
or a collar hedge, the net cost changes. If interest rates fall in the future, then a hedge using options gives
the most favorable rate. However, if interest rates increase, then a hedge using futures gives the lowest
interest payment cost, and hedging with options give the highest cost, with the cost of the collar hedge
being in between the two. If Alecto Co’s aim is to fix its interest rate, whatever happens to future rates,
then the preferred instrument would be futures.
This recommendation is made without considering margin and other transactional costs and basis risk,
which is discussed below. These need to be taken into account before a final decision is made.
(Note: Credit will be given for alternative approaches to the calculations in part (b))
319
(c) Basis risk occurs when the basis does not diminish at a constant rate. In this case, if a futures contract
is held until it matures, then there is no basis risk because, at maturity, the derivative price will equal the
underlying asset’s price. However, if a contract is closed out before maturity (here, the June futures
contracts will be closed two months prior to expiry), there is no guarantee that the price of the futures
contract will equal the predicted price based on the basis at that date. For example, in part (b) above, the
predicted futures price in four months assumes that the basis remaining is 0.18, but it could be more or
less. Therefore the actual price of the futures contract could be more or less. This creates a problem in
that the effective interest rate for the futures contract above may not be fixed at 4.47%, but may vary and
therefore, the amount of interest that Alecto Co pays may not be fixed or predictable. On the other hand,
it could be argued that the basis risk will probably be smaller than the risk exposure to interest rates
without hedging, and therefore, although some risk will exist, its impact will be smaller.
Interest rate swaps
Interest rate swaps typically involve exchanging one stream of future payments based on a fixed interest
rate for another set of future payments based on a floating interest rate. Understanding the concepts of
fixed-rate loans vs floating-rate loans is therefore critical to understanding interest rate swaps.
A fixed interest rate is an interest rate on a debt or other security that remains constant throughout the
term of the contract or until the security matures. Floating interest rates, on the other hand, fluctuate
over time, with interest rate changes typically based on an underlying benchmark index. Interest rate
swaps frequently use floating interest rate bonds, with the bond's interest rate based on the London
Interbank Offered Rate (LIBOR). In a nutshell, the LIBOR rate is the average interest rate charged by the
leading banks in the London interbank market to each other for short-term loans.
How an interest rate swap works
Interest rate swaps take place between two parties – one receiving fixed-rate interest payments and the
other receiving floating-rate payments – reach a consensus that they would prefer the other party's loan
arrangement over their own. The party receiving floating-rate payments decides that they would prefer a
guaranteed fixed rate, whereas the party receiving fixed-rate payments believes that interest rates may
rise, and in order to take advantage of that situation if it occurs – to earn higher interest payments – they
would prefer to have a floating rate, one that will rise if and when there is a general uptrend in interest
rates.
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Illustration 6
Vyshnav plc wishes to raise $50million and wishes to raise it via fixed rate debt. Their options are a LIBOR
+ 80 points on a variable rate basis and a 6% fixed rate basis.
David Co. also wishes to raise $50 million at a variable rate. They have been offered the funding at a
variable of LIBOR + 50 points and at a fixed rate of 5%.
Vyshnav plc and David Co have been doing business with each other for years, and they have both agreed
to carry out an interest rate swap as it is in both companies interest.
Requirement:
Calculate the effective interest rate swap for each company- assuming the benefits are shared equally
between the counter parties.
Solution
Want
Borrow
Vyshnav plc
Fixed rate
6%
Variable rate
L + 0.8%
David Co.
Variable rate
L + 0.5%
Fixed rate
5%
Benefit
Total
L + 6.5%
L + 5.8%
0.70%
The benefit of the interest rate is shared betweeen both parties equally
Benefit (0.7%)
6% - 0.35%
5.65%
L + 0.5% - 0.35%
L + 0.15%
Swap needed
David pays Vyshnav
Vyshnav pays David
LIBOR
4.85%
Illustration 7
Company A has a 12 month loan at a variable rate of SOFR + 50 basis points but, due to fears over interest
rate rises, would like to swap to a fixed rate. It can currently borrow at 5.40% fixed.
Company B currently has a 12 month loan at a fixed rate of 4.85% but would like to swap to variable. It
can currently borrow at a variable rate of SOFR + 65 basis points.
The bank is currently quoting 12 month swap rates of 4.50 (bid) and 4.52 (ask).
Required: Show how the swap via the intermediary would work.
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Solution:


Co A already has a variable outflow so must receive SOFR from the bank to convert this to fixed.
It will pay the bank the ask rate.
Similarly, Co B must pay the bank variable and receive fixed at the bid rate.
Actual borrowing
Payment to bank
Receipt from bank
A
(SOFR + 0.5%)
(4.52%)
SOFR
B
(4.85%)
(SOFR)
4.50%
Net interest rates after swap
(5.02%)
(SOFR + 0.35%)
Open market cost – no swap
Saving
(5.40%)
38 basis points
(SOFR + 0.65%)
30 basis points
Note: In this case A can borrow variable cheaper but B can get the best fixed rates. In this case the total
potential saving = D fixed + D variable = 55 + 15 = 70 basis points.
Of this, 2 basis points have gone to the bank via the spread in quoted prices, leaving 68 to be shared
between the two companies.
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The interest rate yield curve
The yield curve basically indicates future interest rate changes, the slope will give an idea of what future
interest rates are going to look like. The yield(return) of debt security varies with respect the term
structure(duration) of the security. This is because the risk is related to return, and term structure is a
factor that varies the risk profile (same concept of risk and return). Term structure of interest rates refers
to the way in which the yield (return) of a debt security or bond varies according to the term structure of
the security.
Above is a normal upward sloping yield curve, this suggests that interest rates will rise in the future, it also
indicates that there is going to be ac. A manager would therefore have to:


Avoid borrowing long-term on variable rates since interest payments may increase considerably over
the long term of the loan.
Rather choose short-term variable rate loans or long-term fixed rate loans instead.
The yield curve will not always necessarily be upward sloping (other types of the yield curve is not tested
in AFM), however, the slope of the yield curve at any point is the result of the following three theories
acting together.

Expectations-theory
Expectations theory states that an investor would earn the same amount of interest by investing in
a one-year bond today and rolling that investment into a new one-year bond a year later, as
compared to buying a two-year bond today itself. The implication is that long-term interest rates
contain a prediction of future short-term interest rates.
For example, a twenty-year bond is equal to buying two ten-year bonds in succession. But investors
attach a higher risk to longer maturities due to some intrinsic factors not explained or predicted. The
liquidity preference theory explains why.

Liquidity preference theory
An investor would naturally prefer to have more liquid (shorter maturity) investments over locking
in its capital for a longer period of time. Thus, investors will expect a higher return if their
investment is for a longer duration.
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
Market-segmentation-theory
The market segmentation theory states that there are different players in the short-term end of the
market and the long-term end of the market.
This theory states that the bond market is completely different and segmented for bonds with
different maturities. The interest rate for a bond with a given maturity is determined by the supply
and demand for bonds in that segment with no effect from the returns on bonds in other segments.
This theory explains the ‘kink’ seen in the middle of the curve where the short end of the curve meets
the long end – it is a natural disturbance where two different curves are joining, and the influence of
both the short-term factors and long-term factors are weakest.
Bond Valuation and bond yields
The following is a technical article which best explains this concept.
Bonds and their variants, such as loan notes, debentures and loan stock, are IOUs issued by governments
and corporations as a means of raising finance. They are often referred to as fixed income or fixed interest
securities to distinguish them from equities in that they often (but not always) make known returns for
the investors (the bond holders) at regular intervals. These interest payments paid as bond coupons, are
fixed, unlike dividends paid on equities, which can be variable. Most corporate bonds are redeemable
after a specified period of time. Thus, a ‘plain vanilla’ bond will make regular interest payments to the
investors and pay the capital to buy back the bond on the redemption date when it reaches maturity.
This article, the first of two related articles, will consider how bonds are valued and the relationship
between the bond value or price, the yield to maturity and the spot yield curve.
Illustration 8
How much would an investor pay to purchase a bond today, which is redeemable in four years for its
nominal value or face value of $100 and pays an annual coupon of 5% on the nominal value? The
required rate of return (or yield) for a bond in this risk class is 4%.
As with any asset valuation, the investor would be willing to pay, at the most, the present value of the
future income stream discounted at the required rate of return (or yield). Thus, the value of the bond can
be determined as follows:
Year
Year 1
Year 2
Year 3
Year 4
Cash flows
$5
$5
$5
$105
PV (4%)
5 x 1.04-1 = 4.81
5 x 1.04-2 = 4.62
5 x 1.04-3 = 4.44
105 x 1.04-4 = 89.75
Value/price (sum of the PV of flows) = $103.62
Note: Mathematically, for year one, 5 / 1.041 is the same as 5 x 1.04-1, and similarly for all the years
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If the required rate of return (or yield) was 6%, then using the same calculation method, the price of the
bond would be $96.53. And where the required rate of return (or yield) is equal to the coupon – 5% in this
case – the current price of the bond will be equal to the nominal value of $100.
Thus, there is an inverse relationship between the yield of a bond and its price or value. The higher rate
of return (or yield) required, the lower the price of the bond, and vice versa. However, it should be noted
that this relationship is not linear but convex to the origin.
The plain vanilla bond with annual coupon payments in the above example is the simpler type of bond.
In addition to the plain vanilla bond, candidates – as part of their Advanced Financial
Management studies and exam – are required to have knowledge of, and be able to deal with, more
complicated bonds such as bonds with coupon payments occurring more frequently than once a year;
convertible bonds and bonds with warrants which contain optional features; and more complicated
payment features such as repayment mortgage or annuity type payment structures.
Yield to maturity (YTM) (also known as the [Gross] Redemption Yield (GRY))
If the current price of a bond is given, together with details of coupons and redemption date, then this
information can be used to compute the required rate of return or yield to maturity of the bond.
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Illustration 9
A bond paying a coupon of 7% is redeemable in five years at nominal value ($100) and is currently
trading at $106.62. Estimate its yield (required rate of return).
$106.62 = 7$ x (1+r)-1 + $7 x (1 + r) -2 + …. + $107 x (1 + r ) -5
The internal rate of return approach can be used to obtain r. Since the current price is higher than $100,
or must be lower than 7%.
Initially, try 5% as r:
$7 x 4.3295 [5%, five - year annuity] + $100 x 0.7835 [PV 5%, five - year] = $30.31 + $78.35 = $108.66
Try 6% as r:
$7 x 4.2124 [6%, five - year annuity] + $100 x 0.7473 [PV 6%, five - year] =
$29.49 + $74.73 = $104.22
Yield = 5% + (108.66 – 106.62 / 108.66 – 104.22) x 1% = 5.46%
The 5.46% is the yield to maturity (YTM) (or redemption yield) of the bond. The YTM is the rate of return
at which the sum of the present values of all future income streams of the bond (interest coupons and
redemption amount) is equal to the current bond price. It is the average annual rate of return the bond
investors expect to receive from the bond till its redemption. YTMs for bonds are normally quoted in the
financial press based on the closing price of the bond. For example, a yield often quoted in the financial
press is the bid yield. The bid yield is the YTM for the current bid price (the price at which bonds can be
purchased) of a bond.
Term structure of interest rates and the yield curve
The yield to maturity is calculated implicitly based on the current market price, the term to maturity of
the bond and the amount (and frequency) of coupon payments. However, if a corporate bond is being
issued for the first time, its price and/or coupon payments need to be determined based on the required
yield. The required yield is based on the term structure of interest rates, and this needs to be discussed
before considering how the price of a bond may be determined.
It is incorrect to assume that bonds of the same risk class, which are redeemed on different dates,
would have the same required rate of return or yield. In fact, it is evident that the markets demand
different annual returns or yields on bonds with differing lengths of time before their redemption (or
maturity), even where the bonds are of the same risk class. This is known as the term structure of
interest rates and is represented by the spot yield curve or simply the yield curve.
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For example, a company may find that if it wants to issue a one-year bond, it may need to pay interest at
3% for the year, if it wants to issue a two - year bond, the markets may demand an annual interest rate of
3. 5%, and for a three-year bond the annual yield required may be 4.2%. Hence, the company would need
to pay interest at 3% for one year, 3.5% each year, for two years, if it wants to borrow funds for two years;
and 4.2% each year, for three years, if it wants to borrow funds for three years. In this case, the term
structure of interest rates is represented by an upward sloping yield curve.
The normal expectation would be of an upward sloping yield curve on the basis that bonds with a longer
period of maturity would require a higher interest rate as compensation for risk. Note here that the bonds
considered may be of the same risk class, but the longer time period to maturity still adds to higher
uncertainty.
However, it is entirely normal for yield curves to be of many different shapes depending on the
perceptions of the markets on how interest rates may change in the future. Three main theories have
been advanced to explain the term structure of interest rates or the yield curve: expectations hypothesis,
liquidity-preference hypothesis and market-segmentation hypothesis. Although it is beyond the remit of
this article to explain these theories, many textbooks on investments and financial management cover
these in detail.
Valuing bonds based on the yield curve
Annual spot yield curves are often published by the financial press or by central banks (for example, the
Bank of England regularly publishes UK government bond yield curves on its website). The spot yield
curve can be used to estimate the price or value of a bond.
Illustration 10
A company wants to issue a bond that is redeemable in four years for its nominal value or face value of
$100, and wants to pay an annual coupon of 5% on the nominal value. Estimate the price at which the
bond should be issued.
The annual spot yield curve for a bond of this risk class is as follows:
One-year
3.5%
Two-year
4.0%
Three-year
4.7%
Four-year
5.5%
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The four-year bond pays the following stream of income:
Year
Payments
1
$5
2
$5
3
$5
4
$105
This can be simplified into four separate bonds with the following payment structure:
Year
Bond 1
Bond 2
Bond 3
Bond 4
1
$5
2
3
4
$5
$5
$105
Each annual payment is a single payment in that particular year, much like a zero-coupon bond, and its
present value can be determined by discounting each cash flow by the relevant yield curve rate, as
follows:
Bond 1
$5 x 1.035-1 = $4.83
Bond 2
$5 x 1.04-2 = $4.62
Bond 3
$5 x 1.047-3= $4.36
Bond 4
$105 x 1.055-4 = $84.76
The sum of these flows is the price at which the bond can be issued, $98.57.
The yield to maturity of the bond is estimated at 5.41% using the same methodology as example 2.
Some important points can be noted from the above calculation; firstly, the 5.41% is lower than 5.5%
because some of the ret urns from the bond come in earlier years when the interest rates on the yield
curve are lower, but the largest proportion comes in Year 4. Secondly, the yield to maturity is a weighted
average of the term structure of interest rates. Thirdly, the yield to maturity is calculated after the price
of the bond has been calculated or observed in the markets, but theoretically, it is the term structure of
interest rates that determines the price or value of the bond.
Mathematically:
Bond price =
Coupon x (1+r1)-¹ + coupon x (1+r2)-² + ... + coupon x (1+rn)-n + redemption value x (1+rn)-n
Where r1, r2, etc. are spot interest rates based on the yield curve and n is the number of time periods in
which an amount of the coupon is paid and, finally, the value when the bond is redeemed.
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In this article, it is assumed that coupons are paid annually, but it is common practice to pay coupons
more frequently than once a year. In these circumstances, the coupon payments need to be reduced,
and the time period frequency needs to be increased.
Estimating the yield curve
There are different methods used to estimate a spot yield curve, and the iterative process based on
bootstrapping coupon paying bonds is perhaps the simplest to understand. The following example
demonstrates how the process works.
Illustration 11
A government has three bonds in an issue that all have a face or nominal value of $100 and are
redeemable in one year, two years and three years, respectively. Since the bonds are all government
bonds, let’s assume that they are of the same risk class. Let’s also assume that coupons are payable on
an annual basis. Bond A, which is redeemable in a year’s time, has a coupon rate of 7% and is trading at
$103. Bond B, which is redeemable in two years, has a coupon rate of 6% and is trading at $102. Bond C,
which is redeemable in three years, has a coupon rate of 5% and is trading at $98. Determine the yield
curve of each bond.
Solution:
To determine the yield curve, each bond’s cash flows are discounted in turn to determine the annual
spot rates for the three years, as follows:
Bond A: $103 = $107 x (1+r₁)-¹
r₁ = 107/103-1 = 0.0388 or 3.88%
Bond B: $102 = $6 x 1.03881 + 106 x (1+r2)-²
r2 = [106 / (102-5.78)]1/2. 1= 0.0496 or 4.96%
Bond C: $98 $5 x 1.0388¹ + $5 x 1.04962 + 105 x (1+r3)-3
r3 = [105 / (98-4.81 -4.54)]1/3-1 = 0.0580 or 5.80%
The annual spot yield curve is, therefore:
Year
1 3.88%
2 4.96%
3 5.80%
Discussion of other methods of estimating the spot yield curve, such as using multiple regression
techniques and observation of spot rates of zero-coupon bonds, is beyond the scope of the Advanced
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Financial Management syllabus.
As stated in the previous section, often, the financial press and central banks will publish estimated spot
yield curves based on government issued bonds. Yield curves for individual corporate bonds can be
estimated from these by adding the relevant spread to the bonds. For example, the following table of
spreads (in basis points) is given for the retail sector.
Rating
AAA
AA
A
1 year
14
29
46
2 year
25
41
60
3 year
38
55
76
Illustration 12
Continuing Illustration 11, if a company called Mason Retail Co has a credit rating of AA, how would its
individual yield curve be like?
Solution:
Mason Retail Co has a credit rating of AA, then its individual yield curve – based on the government
bond yield curve and the spread table above – may be estimated as:
Year 1
4.17%
Year 2
5.37%
Year 3
6.35%
These would be the rates of return an investor buying bonds issued by Mason Retail Co would expect,
and therefore Mason Retail Co would use these rates as discount rates to estimate the price or value of
coupons when it issues new bonds. And Mason Retail Co’s existing bonds’ market price would reflect its
individual yield curve.
Conclusion
This article considered the relationship between bond prices, the yield curve and the yield to maturity. It
demonstrated how bonds can be valued and how a yield curve may be derived using bonds of the same
risk class but of different maturities. Finally, it showed how individual company yield curves may be
estimated.
Swaptions
 A swaption, also known as a swap option or options on swaps, refers to an option to enter into
an interest rate swap or some other type of swap.
 Swaptions are hybrid instruments that have the benefits of both swaps and options.
 In exchange for an options premium, the buyer gains the right but not the obligation to enter
into a specified swap agreement with the issuer on a specified future date.
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
In exchange for an options premium, the buyer gains the right but not the obligation to enter
into a specified swap agreement with the issuer on a specified future date
Illustration 13
Shun Co has a $10 million loan, repayable in 5 years, at SOFR + 2%. SOFR is currently at 6%. The company
is thus exposed to the risk of fluctuating interest rates.
The treasurer believes that SOFR will stay low for the next two years, after which period, however, the
outlook is at best uncertain. She would like to hedge this risk but is not sure if the current swap rate is the
best available. The treasurer wants to lock in the swap rate in two years' time for the following three years
and have the flexibility to benefit from a lower swap rate should swap rates fall.
This is achieved by buying a 2-year option on a 3-year pay fixed 7% swap.
The decision that will have to be made in two years is illustrated below:
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Chapter 10: Dividend Policy
332
Introduction
This chapter is quite insignificant and easy to grasp, however, the chances of you being asked a question
from this chapter as a sub-question in Section A or B are both high.
Dividend irrelevancy theory by Modigliani and Miller
According to Modigliani and Miller, in perfect capital markets, shareholders are apathetic to dividends if
directors invest in projects with a positive net present value rather than paying off dividends.
Assuming a situation of an efficient market, existing shareholders will be indifferent about the pattern of
payment of dividends. The value of the firm will remain same even if dividends are paid or held by the
company for infinite number of years.
In other words, investors would be unconcerned about whether they received dividends or future capital
growth.
Efficient market is one where:
(1) Trading is cost less, and access to the financial markets is free;
(2) Information about borrowing and lending opportunities is freely available; and
(3) There are many traders, and no single trader can have a significant impact on market prices.
In reality, this theory is criticized, and the following are some of the reasons why:






It may negatively impact shareholders’ wealth
It affects investors’ liquidity requirements
It may impact investors’ tax planning
Signalling effect: Investors may perceive a failure to pay dividends as a sign of financial distress.
Clientele effect: A sudden change in the company’s dividend policies based on the availability of
projects for investment may disrupt the investors’ need for liquidity as well as their tax plans.
Bird in the hand theory:
‘A bird in the hand is worth two in the bush’ i.e., receiving a dividend pay-out now is always
considered more secure than income in the form of capital gain in the future
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Dividend policies in practice
In practice, dividend policies look like this:
 Constant Pattern: This method of dividend payment requires a consistent pattern of dividend
payment, which may include:
 Paying out a constant dividend every year.
 Consistent dividend growth year after year.
 Maintaining a consistent payout ratio, i.e. the same percentage of profit.
2. Stable Dividend Policy: This is most commonly used dividend policy wherein steady and predictable
dividends are paid each year.
3. Residual Dividend Policy: The dividends paid are equal to the funds available after all investments in
positive NPV projects have been made. This policy is most practical but can lead to a high level of volatility
in dividends.
4. Zero dividend policy: A zero dividend policy is one in which no dividends are paid to investors; instead,
any free cash-flows generated are reinvested in the company in the form of positive NPV investments.
This policy is generally used by start-ups and companies having growth opportunities.
Alternatives to Cash dividends
 Scrip dividends: This is an alternative to cash dividends in which shareholders receive additional
shares for free. This will then provide investors with the opportunity to sell these shares and generate
the necessary income. The benefits of scrip dividends include the ability of the company to retain
excess cash for future investment without affecting the shareholders.
Advantages of Scrip dividends:



Increase in shareholding without paying broker’s commissions or stamp duty
No need for cash to pay dividend
Might result in tax savings in certain circumstances
Disadvantages of Scrip dividends:
 Reduces company’s gearing, hence increasing the borrowing capacity
 Share-buyback: Although not a type of dividend in and of itself, this is seen as an alternative to
dividends in which a company with excess cash buys back shares at the current market price and
cancels them. Obviously, this is subject to restrictive covenants, tax implications, and legal constraints.
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Advantages of Share buyback:






Gives flexibility to the company to not arrange cash
Increases EPS through a reduction in number of shares
Uses available funds effectively when there are no good investment opportunities available
Creation of a market where no active market exists for the company’s shares
Capital structure gets altered by reduction in Cost of capital
Reduces the possibility of a takeover
Disadvantages of Share buyback:





Leads to chaos in a general meeting relating to the repurchase price
If the price is too high, company ends up paying higher
If the price is too low, the shareholders may not be satisfied
Premium paid is adjusted against Securities premium and then against distributable profits. When
adjusted against distributable profits, it reduces the future dividend capacity
May be seen as a failure of the management to find better investment opportunities
Factors to consider when developing a dividend policy







Legal constraints and regulations that may limit dividend payments.
Profit and liquidity levels
The effect of a high dividend payout on dividends
Any covenants that limit dividend payments.
Tax implications for the company and its shareholders
Additional financing and investment opportunities are now available.
Inflation and other market factors that may have an impact on the return required by investors.
Dividend capacity for multi-nationals
As previously discussed, the dividends paid by a company are influenced by a wide range of practical
considerations. However, when dealing with multinational corporations with operations across national
borders, there may be additional restrictions on funds repatriation (blocking).
The following are some methods for overcoming blocking and remitting return to the parent:




By increasing transfer prices paid by subsidiary to parent
By making payments to parent in the form of royalties, payments for patents, management fees
and others
By extending loans to parent
By charging subsidiary with heavy head office expenses
335

By making parallel loans: Here, a subsidiary lends money to a subsidiary of another company in
its own country. In return, the parent company takes loan of equivalent amount in its home
country from the subsidiary’s parent company.
Free Cash Flow to Equity for MNCs
Free cash flow to equity is a measure of how much cash is available to the equity shareholders of a
company after all expenses, reinvestment, and debt are paid. FCFE is a measure of equity capital usage.
The FCFE metric is often used by analysts in an attempt to determine the value of a company.
FCFE, as a method of valuation, gained popularity as an alternative to the dividend discount model (DDM),
especially for cases in which a company does not pay a dividend.
FCFE = Operating Cash flow + Dividends from Joint Ventures – Net interest paid – Tax
Net Free Cash flow to equity can be defined as the potential dividend capacity of the business, which can
be given as:
Net FCFE = Gross FCFE – Capital Expenditure + Disposals – Acquisitions + New capital issued
336
Illustration 1:
What is the current year net free cash flow to equity (i.e. the potential dividend capacity) for the following
business? Figures are being taken from the company’s cash flow statement :
Particulars
Capital expenditure
Acquisition of new subsidiary company
Current year
5000
3250
Previous year
4000
0
Disposal of old subsidiary
Equity dividends paid
Taxation paid
Operating cash inflow
Interest paid
Dividend from joint venture
New ordinary shares issued
2500
750
2750
10000
3150
1500
1000
1000
700
2000
8000
2950
800
1000
Solution:
Gross FCFE = $(10,000 + 1500 – 3150 – 2750) = $5600m
Net FCFE [potential dividend capacity] = $(5600 – 5000 – 3250 + 2500 + 1000) = $850m
This potential can then be compared to the actual dividend to determine whether there has been an over
or under distribution.
Transfer pricing in multi-nationals
Multinational corporation (MNC), also called transnational corporation, any corporation that is registered
and operates in more than one country at a time. Generally the corporation has its headquarters in one
country and operates wholly or partially owned subsidiaries in other countries.
Transfer pricing refers to the prices of goods and services that are exchanged between commonly
controlled legal entities within an enterprise. International transfer pricing specifically, does not only
include buying and selling products between divisions, but also covers:
 Head office charging the subsidiary for various services
 Royalty payments across the group
 Interest payments on borrowings across the group.
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When determining transfer prices, keep the following in mind:
 Transfer prices must allow the subsidiaries to compete and be commercially viable.
 Be regarded favorably by the government involved.
 Be ethical and avoid any reputational damage, negative publicity, or being perceived as a form of
tax evasion.
 Reduce international tax liability by setting legally acceptable but advantageous prices.
 Repatriate funds from foreign subsidiaries to head office.
 Aim to pay lower taxes and tariffs.
Types of Transfer Pricing Systems
Transfer
Pricing
system
Market Price
basis
Cost basis
Negotiated
basis
Full Cost
Variable Cost
Variable Cost
Plus
Dual Pricing
Refer Performance Management (PM) subject for basics of Transfer price setting.
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Local Regulations and Tax regimes on Transfer Pricing
 Use of Tax Havens:
 A tax haven is a country that offers foreign businesses and individuals minimal or no tax liability
for their bank deposits in a politically and economically stable environment.

They have tax advantages for corporations and for the very wealthy, and obvious potential for
misuse in illegal tax avoidance schemes.

Tax havens encourage foreign depositors by offering tax advantages to corporations and the
wealthy.

Many have secrecy laws that block information on their deposits from foreign tax authorities.

Depositing money in a tax haven is legal as long as the depositor pays the taxes required by the
home jurisdiction.

The top tax havens currently are the British Virgin Islands, Cayman Islands, Bermuda, The
Netherlands, Switzerland, Luxembourg, Hong Kong, the Cayman Islands, Jersey, Singapore, and
the United Arab Emirates.
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 Import Tariffs:

Import tariffs are taxes charged by the customs authority on the importation of goods into a
country.

Usually, the value of the imported goods determines the amount that will be levied on them. In
some context, import tariffs also means import duties, customs duties, tariffs or import tax.

Tariffs are a way for governments to not only collect revenue but also protect domestic
businesses. Tariffs increase the price of imported goods, making domestic goods cheaper in
comparison.

Therefore, a country having import tariff demotivates companies in that nation to import from
other countries and subsidiaries in other countries. This point must be considered relevant while
deciding on a transfer price to such a country.
 Local regulations:

Exchange controls are government-imposed limitations on the purchase and/or sale of currencies.

These controls allow countries to better stabilize their economies by limiting in-flows and outflows of currency, which can create exchange rate volatility.

Important methods of exchange control are:
(1) Intervention
(2) Exchange Clearing Agreements
(3) Blocked Accounts
(4) Payment Agreements
(5) Gold Policy
(6) Rationing of Foreign Exchange
(7) Multiple Exchange Rates.

The government's major aim of exchange control is to manage or prevent an adverse balance of
payments position on national accounts.
340
 Anti-dumping legislation:

An anti-dumping duty is a protectionist tariff that a domestic government imposes on foreign
imports that it believes are priced below fair market value.

In order to protect their respective economy, many countries impose duties on products they
believe are being dumped in their national market; this is done with the rationale that these
products have the potential to undercut local businesses and the local economy.

While the intention of anti-dumping duties is to save domestic jobs, these tariffs can also lead to
higher prices for domestic consumers.

In the long-term, anti-dumping duties can reduce the international competition of domestic
companies producing similar goods.
Ethical issues in Transfer Pricing
Transfer pricing and the methods used for the calculation of the same are absolutely critical to the entities
involved in the transfer.
However, while doing so, there are also a number of potential ethical questions that arise for the multinational company which can be summarized as below:
Not fulfilling
social
responsibilities
by paying lower
tariffs
Tax evasion
Bypassing
financial
regulations by
remitting
dividends
Ethical issues
in Transfer
Pricing
Not operating
as a
responsible
citizen of a
foreign country
Negative
publicity
Reputational
loss
Chapter 11: Past Paper Theory Questions
1
Introduction to Advanced Financial Management
1. Explain the objectives of integrated reporting.
Answer:
The objectives of integrated reporting include:

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
To improve the quality of information available to providers of financial capital to enable a more
efficient and productive allocation of capital.
To provide a more cohesive and efficient approach to corporate reporting that draws on different
reporting strands and communicates the full range of factors that materially affect the ability of
an organization to create value over time.
To enhance accountability and stewardship for the broad base of capitals (financial,
manufactured, intellectual, human, social and relationship, and natural) and promote
understanding of their interdependencies.
To support integrated thinking, decision making and actions that focus on the creation of value
over the short, medium and long term
2
Investment Appraisal
2. Discuss the role of the World Trade Organization (WTO) and the possible benefits and drawbacks of
reducing protectionist measures.
Answer:
The World Trade Organization (WTO) was set up to continue to implement the General Agreement on
Tariffs and Trade (GATT), and its main aims are to reduce the barriers to international trade. It does this
by seeking to prevent protectionist measures such as tariffs, quotas and other import restrictions. It also
acts as a forum for negotiation and offering settlement processes to resolve disputes between countries.
The WTO encourages free trade by applying the most favored nation principle between its members,
where reduction in tariffs offered to one country by another should be offered to all members. Whereas
the WTO has had notable success, some protectionist measures between groups of countries are
nevertheless allowed and some protectionist measures, especially non‐tariff based ones, have been
harder to identify and control.
A company could benefit from reducing protectionist measures because its actions would make other
nations reduce their protectionist measures against it. Normally countries retaliate against each other
when they impose protectionist measures. A reduction in these may allow companies to benefit from
increased trade and economic growth. Such a policy may also allow companies to specialize and gain
competitive advantage in certain products and services, and compete more effectively globally. Its actions
may also gain political capital and more influence worldwide. Possible drawbacks of reducing protectionist
policies mainly revolve around the need to protect certain industries. It may be that these industries are
developing and in time would be competitive on a global scale. However, inaction to protect them now
would damage their development irreparably. Protection could also be given to old, declining industries,
which, if not protected, would fail too quickly due to international competition, and would create large
scale unemployment making such inaction politically unacceptable. Certain protectionist policies are
designed to prevent ‘dumping’ of goods at a very cheap price, which hurt local producers.
3. Explain the role of the International Monetary Fund (IMF) and its significance to the activities of
multinational companies.
Answer:
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The International Monetary Fund (IMF) was established at the Bretton Wood Conference of 1945.
Its initial tasks were to promote world trade and to help support the fixed exchange rate system
that existed at that time.
Support was mainly in the form of temporary loans to member countries which experienced
balance of payments difficulties. Such loans were financed by member countries' quota
subscriptions.
Although floating exchange rates and exchange rate agreements between blocs of countries have
replaced the fixed exchange rate system, the IMF still provides loans to many of its members,
particularly developing countries.
3
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Today loans are also granted to help countries repay large commercial debts that they have built
up from the international banking system.
An important feature of most IMF loans is the conditions attached to the loans. Countries
receiving IMF loans are required to take strong economic measures to try to improve or eliminate
the economic problems that made the loans necessary, and to stimulate medium to long‐term
economic development.
These conditions typically include currency devaluation, controls over inflation via the money
supply, public expenditure cuts to reduce government budget deficits and local tax increases.
Loans of up to 25% of a member country's quotas are given without condition. A further 25% is
available to countries that 'demonstrate reasonable efforts' to overcome balance of payments
difficulties. Upper credit tranches of up to a further 75% of quota, normally in the form of standby
facilities, are available subject to conditionality agreements. Most loans are for a period of up to
five years.
The IMF has undoubtedly been successful in helping to reduce volatility in international exchange
rates, and in facilitating world trade. This has beneficial effects on the trading activities of
multinational companies.
However, the strong influence of the IMF on the macro‐economic policies of developing nations
often leads to short term deflation and reductions in the size of markets for multinational
companies' products.
Conflicts may exist between multinationals, who wish to freely move capital internationally, and
governments trying to control the money supply and inflation.
Tax increases often accompany economic austerity measures, import tariff quotas may make
operations more difficult and increases in interest rates raise the cost of finance.
In the medium to long term it is hoped that the structural adjustments will stimulate economic
growth and will increase the size of markets for multinational companies, but IMF economic
conditions may cause significant short to medium term difficulties for subsidiaries of
multinationals in the countries concerned.
4. Explaining the features of a capital investment monitoring system and discussing the benefits of
maintaining such a system.
Answer:
A capital investment monitoring system (CIMS) monitors how an investment project is progressing once
it has been implemented. Initially the CIMS will set a plan and budget of how the project is to proceed. It
sets milestones for what needs to be achieved and by when. It also considers the possible risks, both
internal and external, which may affect the project. CIMS then ensures that the project is progressing
according to the plan and budget. It also sets up contingency plans for dealing with the identified risks.
The benefits of CIMS are that it tries to ensure, as much as possible, that the project meets what is
expected of it in terms of revenues and expenses. Also, that the project is completed on time and risk
factors that are identified remain valid. A critical path of linked activities which make up the project will
be identified. The departments undertaking the projects will be proactive, rather than reactive, towards
the management of risk, and therefore possibly be able to reduce costs by having a better plan. CIMS can
4
also be used as a communication device between managers charged with managing the project and the
monitoring team. Finally, CIMS would be able to re‐assess and change the assumptions made of the
project, if changes in the external environment warrant it.
5. Discuss the importance to a company of recognising all of its stakeholders when making a new project
investment decision.
Answer:
Importance of recognizing stakeholders A project investment decision is bound to create ‘winners’ and
‘losers’.
In any project appraisal, it is important to identify and recognize the claims of all of the stakeholders for
several reasons. Stakeholder recognition is necessary to gain an understanding of the sources of potential
risk and disruption.
Environmental pressure groups, for example, could threaten to disrupt any project that is perceived as
being environmentally damaging, or could threaten legal action. Stakeholder recognition is important in
terms of assessing the sources of influence over the objectives and outcomes for the project.
Stakeholder influence is assessed in terms of each stakeholder’s power and interest, with higher power
and higher interest combining to generate the highest influence. Stakeholder recognition is necessary in
order to identify potential areas of conflict and tension between stakeholders, especially relevant when
it is likely that stakeholders of influence will be in disagreement over the outcomes.
A survey of the stakeholders, once mapped in terms of influence, would signal which stakeholders are
likely to cause delays to the project and paralysis by disagreement and whose claims can then be studied
for ways to reduce disagreement.
There is an ethical and reputational case for knowledge of how decisions affect stakeholders, both inside
the organization or external to it. Society can withdraw its support from organizations that it perceives as
unethical or arrogant. This can affect organizational performance by reducing their reputations as
employers and suppliers of future services. A ‘deep green’ perspective would take an unfavorable view
of companies that failed to recognize some stakeholder claims.
5
6. Discuss why a company may prefer to use the adjusted present value (APV) method, rather than the
net present value (NPV) method.
Answer:

Adjusted present values (APVs) separate out a project’s cash flows and allocate a specific discount
rate to each type of cash flow, dependent on the risk attributable to that particular type of cash
flow.

Net present value (NPV) discounts all cash flows by the average discount rate attributable to the
average risk of a project.

One reason why APV may be preferable to NPV is because by separating out different types of
cash flows, the company’s managers will be able to see which part of the project generates what
proportion of the project’s value.

Furthermore, allocating a specific discount rate to a cash flow part helps determine the value
added or destroyed.
7. Explain what steps have been taken by global governments and other bodies to prevent international
money laundering and terrorist financing.
Answer:

The free movement of goods, services and capital across national barriers has long been
considered a key factor in establishing stable and independent world economies. However,
removing barriers to the free movement of capital also increases the opportunities for
international money laundering and terrorist financing.

Bodies such as the international monetary fund (IMF) work in conjunction with national
governments to establish a multilateral framework for trade and finance, but they are also aware
of the possible opportunities this creates for criminals.

International efforts to combat money laundering and terrorist financing have resulted in:
 The establishment of an international task force on money laundering
 The issue of specific recommendations to be adopted by nation states
 The enactment of legislation by many countries on matters covering: – the criminal justice
system and law enforcement – the financial system and its regulation – international
cooperation
6
8. Explain the major differences between Islamic finance and other conventional forms of finance.
Answer:
Islamic finance rests on the application of Islamic, or Shariah, law. The main principles of Islamic finance
are that:

Wealth must be generated from legitimate trade and asset‐based investment. The use of money
for the purposes of making money is forbidden.

Investment should also have a social and an ethical benefit to wider society beyond pure return.

Risk should be shared.

Harmful activities (such as gambling, alcohol and the sale of certain foods) should be avoided.

Under Islamic finance, the charging and receiving of interest (riba) is strictly prohibited. This is in
stark contrast to more conventional, Western forms of finance.

One alternative form of finance would be Murabaha, a form of trade credit for asset acquisition.
Here the provider of finance would buy the item and then sell it on to the company at a price
that includes an agreed mark‐up for profit. The mark‐up is fixed in advance and cannot be
increased and the payment is made by instalments.

Another form of finance would be Islamic bonds, known as sukuk. To be Shariah‐ compliant, the
sukuk holders must have a proprietary interest in the assets which are being financed. The sukuk
holders’ return for providing finance is a share of the income generated by the assets.

The key distinction between sukuk and murabaha is that sukuk holders have ownership of the
cash flows but not the assets themselves.
7
9. Discuss whether a Mudaraba contract would be an appropriate method of financing the investment
and discuss why the bank may have concerns about providing finance by this method.
Answer:
A Mudaraba contract would involve the bank providing capital to invest in the development. The company
itself would manage the investment which the capital funded. Profits from the investment would be
shared with the bank, but losses would be solely borne by the bank.
A Mudaraba contract is essentially an equity partnership, so a company might not face the threat to its
credit rating which it would if it obtained ordinary loan finance for the development.
A Mudaraba contract would also represent a diversification of sources of finance. It would not require the
commitment to pay interest that loan finance would involve. Company would maintain control over the
running of the project.
A Mudaraba contract would offer a method of obtaining equity funding without the dilution of control
which an issue of shares to external shareholders would bring. This is likely to make it appealing to
company’s directors, given their desire to maintain a dominant influence over the business.
The bank would be concerned about the uncertainties regarding the rental income from the development.
Although the lack of involvement by the bank might appeal to a company's directors, the bank might not
find it so attractive. The bank might be concerned about information asymmetry – that company’s
management might be reluctant to supply the bank with the information it needs to judge how well its
investment is performing.
10. Discuss the aims of a free trade area, such as the European Union (EU), and the possible benefits to
companies of operating within the EU.
Answer:









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 labor.
The EU also has an overarching common legal structure across all member countries and tries to
limit any discriminatory practice against companies operating in these countries.
Furthermore, the EU erects common external barriers to trade against countries which are not
member states.
A company may benefit from operating within the EU in a number of ways as follows:
It should find that it is able to compete on equal terms with rival companies within the EU.
Companies outside the EU may find it difficult to enter the EU markets due to barriers to trade.
A common legal structure should ensure that the standards of food quality and packaging apply
equally across all the member countries.
Due diligence of logistic networks used to transport the food may be easier to undertake because
of common compliance requirements.
Having access to capital and labor within the EU may make it easier for the company to set up
branches inside the EU, if it wants to.
8

The company may also be able to access any grants which are available to companies based within
the EU.
11. Discuss the key differences between a Salam contract, under Islamic finance principles, and futures
contracts.
Answer:
Islamic principles stipulate the need to avoid uncertainty and speculation. In the case of Salam contracts,
payment for the commodity is made at the start of the contract. The buyer and seller of the commodity
know the price, the quality and the quantity of the commodity and the date of future delivery with
certainty. Therefore, uncertainty and speculation are avoided.
On the other hand, futures contracts are marked‐to‐market daily and this could lead to uncertainty in the
amounts received and paid every day. Furthermore, standardized futures contracts have fixed expiry
dates and pre‐determined contract sizes. This may mean that the underlying position is not hedged or
covered completely, leading to limited speculative positions even where the futures contracts are used
entirely for hedging purposes. Finally, only a few commodity futures contracts are offered to cover a range
of different quality grades for a commodity, and therefore price movement of the futures market may not
be completely in line with the price movement in the underlying asset
9
Cost of capital & Risk adjusted WACC
12. Explain the difference between APV and NPV as methods of investment appraisal and comment
upon the circumstances under which APV might be a better method of evaluating a capital investment
than NPV.
Answer:
Both APV and NPV are discounted cash flow techniques but differ in the way project finance is
incorporated into the process.
With NPV, finance is usually incorporated into the discount rate which is then applied to project‐only (i.e.
excluding finance) cash flows. The clearest example of this is when a project (or company) WACC is used
to discount project cash flows.
APV involves a two-stage process dealing with project and financing flows separately. Project cash flows
are discounted at an ungeared cost of equity to calculate a base case NPV. Financing side effects are then
discounted at an appropriate rate – usually the pre‐tax risk-free rate.
APV may be a better technique to use than NPV when:
(i) There is a significant change in capital structure as a result of the investment.
(ii) The investment involves complex tax payments and tax allowances, and/or has periods when taxation
is not paid.
(iii) Subsidized loans, grants or issue costs exist.
(iv) Financing side effects exist (e.g. the subsidized loan), which require discounting at a different rate than
that applied to the mainstream project.
10
Option Valuation
13. Explain the circumstances in which the Black‐Scholes option pricing (BSOP) model could be used to
assess the value of a company, including the data required for the variables used in the model.
Answer:










Using the BSOP model in company valuation rests upon the idea that equity is a call option,
written by the lenders, on the underlying assets of the business.
If the value of the company declines substantially then the shareholders can simply walk away,
losing the maximum of their investment. On the other hand, the upside potential is unlimited
once the interest on debt has been paid.
The BSOP model can be helpful in circumstances where the conventional methods of valuation
do not reflect the risks fully or where they cannot be used.
For example, if we are trying to value an unlisted company with unpredictable future growth.
There are five variables which are input into the BSOP model to determine the value of the option.
Proxies need to be established for each variable when using the BSOP model to value a company.
The five variables are: the value of the underlying asset, the exercise price, the time to expiry, the
volatility of the underlying asset value and the risk-free rate of return.
For the exercise price, the debt of the company is taken. In its simplest form, the assumption is
that the borrowing is in the form of zero coupon debt, i.e., a discount bond. In practice such debt
is not used as a primary source of company finance and so we calculate the value of an equivalent
bond with the same yield and term to maturity as the company’s existing debt.
The exercise price in valuing the business as a call option is the value of the outstanding debt
calculated as the present value of a zero coupon bond offering the same yield as the current debt.
The proxy for the value of the underlying asset is the fair value of the company’s assets less current
liabilities on the basis that if the company is broken up and sold, then that is what the assets
would be worth to the long‐term debt holders and the equity holders.
The time to expiry is the period of time before the debt is due for redemption. The owners of the
company have that time before the option needs to be exercised, that is when the debt holders
need to be repaid.
The proxy for the volatility of the underlying asset is the volatility of the business’ assets. The
risk‐free rate is usually the rate on a riskless investment such as a short‐term government bond.
11
14. Discuss how using real options methodology in conjunction with net present value could help
establish a more accurate estimate of the potential value of companies.
Answer:







Traditional investment appraisal methods such as net present value assume that an investment
needs to be taken on a now or never basis, and once undertaken, it cannot be reversed.
Real options take into account the fact that in reality, most investments have within them certain
amounts of flexibility, such as whether or not to undertake the investment immediately or to
delay the decision; to pursue follow‐ on opportunities; and to cancel an investment opportunity
after it has been undertaken.
Where there is increasing uncertainty and risk, and where a decision can be changed or delayed,
this flexibility has value, known as the time value of an option.
Net present value captures just the intrinsic value of an investment opportunity, whereas real
options capture both the intrinsic value and the time value, to give an overall value for an
opportunity.
When a company still has time available to it before a decision needs to be made, it may have
opportunities to increase the intrinsic value of the investment through the strategic decisions it
makes.
Investing in new companies with numerous potential innovative product pipelines may provide
opportunities for flexibility where decisions can be delayed and the intrinsic value can be
increased through strategic decisions and actions taken by the company.
Real options try to capture the value of this flexibility within companies with innovative product
pipelines, whereas net present value does not.
15. Explain the significance of the time until expiry and the interest rate in the context of option
valuation.
Answer:
Time
An option’s price consists of two elements, its intrinsic value and its time premium. The time premium
diminishes over time to zero at the point that the option expires. Theta measures how much time value
is lost over time. It is generally expressed as an amount lost per day. Theta reduces the value of both put
and call options for holders. The change in theta for in the money and out of the money options is broadly
linear. At the money options have the greatest time premium and greatest theta. Theta for at the money
options does not change in a linear fashion, but changes more rapidly as the expiry date approaches.
Interest rate
Rho measures how the option price varies with changes in interest rates. An option’s rho is the amount
of change in value for a 1% change in the option’s risk free interest rate. The rho is positive for call options
if the risk‐free interest rate increases and negative for put options. Compared with other factors affecting
option price, the interest rate is not a significant influence, as interest rates often move slowly. A change
in interest rates will be more significant the longer the time until expiry of an option.
12
16. Discuss the advantages and drawbacks of exchange traded option contracts compared with over‐
the‐counter options.
Answer:
Advantages



Exchange traded options are readily available on the financial markets, their price and contract
details are transparent, and there is no need to negotiate these.
Greater transparency and tight regulations can make exchange traded options less risky. For these
reasons, exchange traded options’ transaction costs can be lower.
The option buyer can sell (close) the options before expiry. American style options can be
exercised any time before expiry and most traded options are American style options, whereas
over‐the‐counter options tend to be European style options.
Disadvantages



The maturity date and contract sizes for exchange traded options are fixed, whereas over‐the‐
counter options can be tailored to the needs of parties buying and selling the options.
Exchange traded options tend to be of shorter terms, so if longer term options are needed, then
they would probably need to be over‐the‐counter.
A wider range of products (for example, a greater choice of currencies) is normally available in
over‐the‐counter options markets.
17. Explain how the Black Scholes option pricing model can be used to value the equity and the debt of
a company.
Answer:
Use of the Black Scholes model in equity valuation
The basic idea is that, because of limited liability, shareholders can walk away from a company when the
debt exceeds the asset value. However, when the assets exceed the debts, those shareholders will keep
running the business, in order to collect the surplus. Therefore, the value of shares can be seen as a call
option owned by shareholders – we can use the Black Scholes model to value such an option.
Of course, it is therefore critical that we can correctly identify the five variables to input into the Black
Scholes model. For equity valuation, these are as follows:
t = time until debt is redeemed
r = risk free interest rate
s = standard deviation of the assets' value
Pa = fair value of the firm’s assets
Pe = amount owed to bank.
13
Note that the value of Pe will not just be the redemption value of the debt. The amount owed to the bank
incorporates all the interest payments as well as the ultimate capital repayment. In fact, the value of Pe
to input into the Black Scholes model should be calculated as the theoretical redemption value of an
equivalent zero coupon debt.
Use of the Black Scholes model in debt valuation The Black Scholes model can also be used in debt
valuation. The value of a (risky) bond issued by a company can be calculated as the value of an equivalent
risk-free bond minus the value of a put option over the company's assets. Therefore, if the value of equity
has already been calculated as a call option over the company's assets, the value of debt can then be
calculated using the put call parity equation
18. Explain what is meant by an option’s rho and discuss the impact of changes in interest rates on the
appraisal of the investment.
Answer:






The sensitivity of the valuation of options to interest rate changes can be measured by the
option’s rho.
The option’s rho is the amount of change in the option’s value for a 1% change in the risk‐free
interest rate.
The rho is positive for calls and so will be positive if the risk‐free interest rate does increase.
However, interest rates tend to move quite slowly and the interest rate is often not a significant
influence on the option’s value, particularly for short‐term options.
However, many real options are longer term and will have higher rhos than short‐ term options.
A change in interest rates will be more significant the longer the time until expiry of an option.
In addition, there are possible indirect economic effects of interest rate changes, such as on the
return demanded by finance providers and hence on the cost of capital.
14
Mergers & Acquisitions
19. Discuss how the mandatory bid rule and the principle of equal treatment protects shareholders in
the event of their company facing a takeover bid, and discuss the effectiveness of poison pills and
disposal of crown jewels as defensive tactics against hostile takeover bids.
Answer:

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

Both the mandatory bid rule and the principle of equal treatment are designed to protect minority
shareholders, where an acquirer has obtained a controlling interest of the target company.
The mandatory bid rule provides minority shareholders with the opportunity to sell their shares
and exit the target company at a specified fair share price. This price should not be lower than the
highest price paid for shares, which have already been acquired within a specified period.
The principle of equal treatment requires the acquiring company to offer the same terms to
minority shareholders as were offered to the earlier shareholders from whom the controlling
interest was acquired.
Both these regulatory devices are designed to ensure that the minority shareholders are
protected financially and are not exploited by the acquirer.
The purpose of both poison pills and disposal of crown jewels is to make the target company
unattractive to the acquirer.
Poison pills give existing shareholders in the target company the right to buy additional shares in
their company at a discount once the acquiring company has bought a certain number of shares
in the target company.
The aim is to make the target company more expensive to purchase, as the acquirer needs to buy
more shares.
Disposal of crown jewels involves selling the target company’s most valuable assets, and therefore
making the target company less attractive to the acquirer. The effectiveness of either defense
tactic can be limited, as the company’s management would need its shareholders to authorize
such moves (although there are ways in which poison pills can be incorporated without gaining
prior authorization from shareholders).
Shareholders may not be willing to do this as they normally get premiums on their shares during
takeover battles.
Additionally, disposing of key strategic assets could substantially weaken a company’s competitive
advantage and therefore its future potential. Such action may be detrimental to the company and
therefore shareholders would probably not approve that course of action.
15
20. Distinguish between an IPO and a reverse takeover.
Answer:
The initial public offering (IPO) is the conventional way to obtain a listing where a company issues and
offers shares to the public. When doing this, the company will follow the normal procedures and processes
required by the stock exchange regarding a new issue of shares and will comply with the regulatory
requirements. Undertaking a reverse takeover enables a company to obtain a listing without going
through the IPO process. The BoD of a company would initially take control of a ‘shell’ listed company by
buying some shares in that company and taking over as its BoD. The ‘shell’ listed company was probably
a normal listed company previously, but is no longer trading. New equity shares in the listed company
would then be exchanged for that company’s shares, with the external appearance that the listed
company has taken over that company. But in reality if a company has now effectively got a listing, having
taken control of the listed company previously. Normally, the name of the original listed company would
then be changed to that company.
Compared with an IPO, the main benefits of undertaking a reverse takeover are that it is cheaper, takes
less time and ensures that companies will obtain a listing on a stock exchange. An IPO can cost between
3% and 5% of the capital being raised because it involves investment banks, lawyers, and other experts.
A marketing campaign and issuing a prospectus are also needed to make the offering attractive and ensure
shares to the public do get sold. A reverse takeover does not need any of these and therefore avoids the
related costs.
The IPO process can typically take one or two years to complete due to hiring the experts, the marketing
process and the need to obtain a value for the shares. Additionally, the regulatory process and procedures
of the stock exchange need to be complied with.
With a reverse takeover, none of these are required and therefore the process is quicker. Finally, there is
no guarantee that an IPO will be successful. In times of uncertainty, economic downturn or recession, it
may not attract the attention of investors and a listing may not be obtained.
With reverse takeover, because the transaction is an internal one, between two parties, it will happen
and the company will be listed. However, obtaining a listing through a reverse takeover can have issues
attached to it. The listed ‘shell’ company may have potential liabilities which are not transparent at the
outset, such as potential litigation action. A full due diligence of the listed company should be conducted
before the reverse takeover process is started. The IPO process is probably better at helping provide the
senior management with knowledge of the stock exchange and its regulatory environment. The
involvement of experts and the time senior management need to devote to the listing process will help in
this regard. Due to the marketing effort involved with an IPO launch, it will probably have an investor
following, which a reverse takeover would not. Therefore, a company which has gone through an IPO
would probably find it easier to raise extra funds, whilst a company which has gone through a reverse
takeover may find it more difficult to raise new funding. Overall, neither option of obtaining a listing has
a clear advantage over the other. The choice of listing method depends on the company undertaking the
listing and the purpose for which it is doing so.
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21. Explain briefly, in general terms, why many acquisitions in the real world are not successful.
Answer:
Common reason why acquisitions are unsuccessful
Lack of industrial or commercial fit: Failure can result from a takeover where the acquired entity turns out
not to have the product range or industrial position that the acquirer anticipated.
Lack of goal congruence: This may apply not only to the acquired entity but, more dangerously, to the
acquirer, whereby disputes over the treatment of the acquired entity might well take away the benefits
of an otherwise excellent acquisition.
‘Cheap’ purchases: The ‘turn around’ costs of an acquisition purchased at what seems to be a bargain
price may well turn out to be a high multiple of that price.
Paying too much: The fact that a high premium is paid for an acquisition does not necessarily mean that
it will fail. Failure would result only if the price paid is beyond that which the acquirer considers acceptable
to increase satisfactorily the long-term wealth of its shareholders.
Failure to integrate effectively: An acquirer needs to have a workable and clear plan of the extent to which
the acquired company is to be integrated. The plan must address such problems as differences in
management styles, incompatibilities in data information systems, and continued opposition to the
acquisition by some of the acquired entity’s staff.
22. Evaluate how reliable the estimates of the synergies for the combined company are likely to be and
discuss the factors which may prevent the forecast synergies from being achieved.
Answer:
Reliability of synergy estimates: The reliability of the estimates may vary depending on the synergies
involved. The synergies relating to size and services offered will depend on the ability to gain large
contracts and sometimes neither company has had recent success in doing this.
Other synergies may be easier to obtain. Duplication of premises in some locations should be eliminated
easily. Combining central administrative functions should reduce some staffing costs, although these are
likely to be smaller synergies than the potential operational synergies.
Problems with achieving synergies: A significant problem may be lack of unity at the top of the company.
If lack of unity at board level becomes apparent to staff, it may be difficult to achieve unity at employee
level. An unhappy management’s role in the combined company may also make synergies difficult to
achieve. They will have a significant shareholding and a place on the board, so it will be difficult for him
not to be involved. Possibly they have the abilities and desire to achieve changes in operational practices
which other board members lack. However, if a chairman from such a management is given the leading
role he requires, there may be a change in management style which may upset long‐serving staff. Some
may leave, jeopardizing the continuity which seems to have been an important part of company’s success.
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Another reason for possible problems with staff is the differing remuneration arrangements. Company’s
staff may have stayed with the company because both their job prospects and their remuneration have
been safe. Attempts to change their employment conditions may lead to resistance and employee
departures. The success of the acquisition may also depend on how well the staff of the two businesses
integrate. Integration may be difficult to achieve.
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Corporate Reconstruction
23. Explain the potential advantages for a company of undertaking the divestment by
means of
(i) a sell‐off and
(ii) a demerger.
Answer:
There are several advantages that are common to both a sell‐off and a demerger. Both offer a way to
restructure a company. Restructuring may be to dismantle a conglomerate enterprise in order to focus
upon a core competence, to react to a change in the strategic focus of the company, or to sell off
unwanted assets.
Both forms of restructuring may result in 'reverse synergy', where the separated elements of the business
are worth more than the value of the old combined business.
The main difference between a sell‐off and a demerger is that the sell‐off involves the sale of part of the
company to a third party, for cash or some other consideration. Thus, control of these assets is lost.
However, funds are raised which can be used to develop other parts of the business, or to make
acquisitions.
A demerger need not involve a change in ownership. One or more new companies are created and the
assets of the old company are transferred to these new companies.
The key question for any company is whether or not it wishes to maintain control of all of its assets. If it
does then a demerger is a more appropriate form of restructuring than a sell‐off.
24. Distinguish between a divestment through a sell‐off and a management buy‐in as forms of
unbundling.
Answer:
Both forms of unbundling involve disposing the non‐core parts of the company.
The divestment through a sell‐off normally involves selling part of a company as an entity or as separate
assets to a third party for an agreed amount of funds or value. This value may comprise of cash and non‐
cash based assets.
The company can then utilize the funds gained in alternative, value‐enhancing activities. The management
buy‐in is a particular type of sell‐off which involves selling a division or part of a company to an external
management team, who will take up the running of the new business and have an equity stake in the
business. A management buy‐in is normally undertaken when it is thought that the division or part of the
company can probably be run better by a different management team compared to the current one.
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25. Explain how sukuk bonds could be used (instead of more conventional loan notes) to fund a project.
Answer:
Sukuk bonds Sukuk bonds are a type of Islamic financing method.
Under traditional method, the loan note holder will receive interest (to be paid before dividends). This is
prohibited under Islamic law. Instead, Islamic bonds (or sukuk) are linked to an underlying asset, such that
a sukuk holder is a partial owner in the underlying assets and profit is linked to the performance of the
underlying asset.
So, for example, a sukuk holder will participate in the ownership of the company issuing the sukuk and
has a right to profits (but will equally bear their share of any losses).
There are two types of sukuk bonds:
 Asset based – raising finance where the principal is covered by the capital value of the asset but the
returns and repayments to sukuk holders are not directly financed by these assets.
 Asset backed – raising finance where the principal is covered by the capital value of the asset but the
returns and repayments to sukuk holders are directly financed by these assets. Asset backed sukuk bonds
are often considered to be more akin to equity finance.
26. Explain what a dark pool network is and why a company may want to dispose of its equity stake in
a company through one, instead of through the stock exchange where company’s shares are listed.
Answer:
A dark pool network allows shares to be traded anonymously, away from public scrutiny. No information
on the trade order is revealed prior to it taking place. The price and size of the order are only revealed
once the trade has taken place. Two main reasons are given for dark pool networks: first they prevent the
risk of other traders moving the share price up or down; and second they often result in reduced costs
because trades normally take place at the mid‐price between the bid and offer; and because broker‐
dealers try and use their own private pools, and thereby saving exchange fees.
If a company sells a large holding all at once, the price of shares may fall temporarily and significantly, and
it may not receive the value based on the current price. By utilizing a dark pool network, companies may
be able to keep the price of the share largely intact, and possibly save transaction costs. Although the
criticism against dark pool systems is that they prevent market efficiency by not revealing bid‐offer prices
before the trade, proponents argue that in fact market efficiency is maintained because a large sale of
shares will not move the price down artificially and temporarily.
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27. Distinguish between a management buy‐out (MBO) and a management buy‐in (MBI).
Answer:
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A management buy‐out (MBO) involves the purchase of a business by the management team
running that business.
A management buy‐in (MBI) involves purchasing a business by a management team brought in
from outside the business.
The benefits of a MBO relative to a MBI to are that the existing management is likely to have
detailed knowledge of the business and its operations. Therefore, they will not need to learn
about the business and its operations in a way which a new external management team may need
to.
It is also possible that a MBO will cause less disruption and resistance from the employees when
compared to an MBI.
If a company wants to continue doing business with the new company after it has been disposed
of, it may find it easier to work with the management team which it is more familiar with.
The internal management team may be more focused and have better knowledge of where costs
can be reduced and sales revenue increased, in order to increase the overall value of the company.
The drawbacks of a MBO relative to a MBI to a company may be that the existing management
may lack new ideas to rejuvenate the business. A new management team, through their skills and
experience acquired elsewhere, may bring fresh ideas into the business.
It may be that the external management team already has the requisite level of finance in place
to move quickly and more decisively, whereas the existing management team may not have the
financial arrangements in place yet.
It is also possible that the management of two companies have had disagreements in the past and
the two teams may not be able to work together in the future if they need to.
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Introduction to Risk Management
28. Explain how business risk and financial risk are related; and how risk mitigation and risk
diversification can form part of a company’s risk management strategy.
Answer:
The owners or shareholders of a business will accept that it needs to engage in some risky activities in
order to generate returns in excess of the risk-free rate of return. A business will be exposed to differing
amounts of business and financial risk depending on the decisions it makes. Business risk depends on the
decisions a business makes with respect to the services and products it offers and consists of the variability
in its profits. For example, it could be related to the demand for its products, the rate of innovation,
actions of competitors, etc. Financial risk relates to the volatility of earnings due to the financial structure
of the business and could be related to its gearing, the exchange rate risk it is exposed to, its credit risk,
its liquidity risk, etc. A business exposed to high levels of business risk may not be able to take excessive
financial risk, and vice versa, as the shareholders or owners may not want to bear risk beyond an
acceptable level.
Risk management involves the process of risk identification, of assessing and measuring the risk through
the process of predicting, analyzing and quantifying it, and then making decisions on which risks to
assume, which to avoid, which to retain and which to transfer. As stated above, a business will not aim to
avoid all risks, as it will want to generate excess returns. Dependent on factors such as controllability,
frequency and severity of the risk, it may decide to eliminate or reduce some risks from the business
through risk transfer. Risk mitigation is the process of transferring risks out of a business through, for
example, hedging or insurance, or avoiding certain risks altogether. Risk diversification is a process of risk
reduction through spreading business activity into different products and services, different geographical
areas and/or different industries to minimize being excessively exposed by focusing exclusively on one
product/service.
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29. Discuss how each category of risk, in terms of severity and frequency, may be managed.
Answer:
Risks which fall into the severe and frequent category need immediate attention, as they could threaten
the company’s survival or derail its long‐term strategy. The aim here would be to reduce the severity of
the risks and the frequency with which they occur quickly. It may mean avoiding certain actions or
abandoning certain projects, even if they could be profitable in the long term. Where a company has a
real option, and does not need to take action which will result in high frequency and high severity of risk,
it may prefer to wait and see what happens.
Where the frequency of risks occurring is high but their impact is not severe, action needs to be taken so
that such risks do not become severe in the future. For example, the company could put systems into
place to detect these risks early and plans to deal with them if they do occur. Where the same kind of risks
occur often, the company may decide to have set processes for dealing with them. For example, where
there is a loss of relatively unskilled staff, the company may decide to replace staff quickly with casual
workers, but also have appropriate training facilities in place.
If there are risks which are severe but only happen occasionally or infrequently, the company should try
to insure against these. Contingency plans could also be put into place to mitigate the severity. For
example, if the consequences of IT failure are high when a business decides to move to a new system, it
could put appropriate contingencies into place. These may include secondary backup IT systems or initially
trialing the new system on a few business units before undertaking a complete role out.
Risks which are neither severe, nor frequent, should be monitored and kept under review, but no
significant action should be taken. It is possible that any significant action would incur costs which would
likely be higher than the benefits derived from eliminating such risks. Monitoring such risks will ensure
that should they move out of this category into the more severe/frequent categories, the company can
start to take appropriate action.
30. Among the criteria used by credit agencies for establishing a company’s credit rating are the
following: industry risk, earnings protection, financial flexibility and evaluation of the company’s
management. Briefly explain each criterion and suggest factors that could be used to assess it.
Answer:
Industry risk measures the resilience of the company’s industrial sector to changes in the economy. In
order to measure or assess this, the following factors could be used:
 Impact of economic changes on the industry in terms how successfully the firms in the industry operate
under differing economic outcomes;
 How cyclical the industry is and how large the peaks and troughs are;
 How the demand shifts in the industry as the economy changes. Earnings protection measures how well
the company will be able to maintain or protect its earnings in changing circumstances. In order to assess
this, the following factors could be used:
 Differing range of sources of earnings growth;
 Diversity of customer base;
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 Profit margins and return on capital. Financial flexibility measures how easily the company is able to
raise the finance it needs to pursue its investment goals. In order to assess this, the following factors could
be used:
 Evaluation of plans for financing needs and range of alternatives available;
 Relationships with finance providers, e.g. banks;
 Operating restrictions that currently exist in the form of debt covenants. Evaluation of the company’s
management considers how well the managers are managing and planning for the future of the company.
In order to assess this, the following factors could be used:
 The company’s planning and control policies, and its financial strategies;
 Management succession planning;
 The qualifications and experience of the managers;
 Performance in achieving financial and non‐financial targets.
Foreign Exchange Risk Management
31. Discuss the advantages of multilateral netting by a central treasury function within the company.
Answer:
Setting the transfer price at market price should enable a fair assessment of the performance of both the
buying and selling divisions. Both internal and external sales will be accounted for at the same price.
However, this may distort performance in that the costs of internal sales may be lower than external sales.
For example, administration costs should be lower and there should be no costs of bad debts. These cost
savings should be shared between the two divisions to give a fair picture. If the selling division has spare
capacity, selling at incremental cost rather than market price may provide greater certainty that the
buying division will use the selling division.
In theory, using market price should mean that the central treasury function has to intervene less. Simple
market price provides an objective measure over which the divisions should agree. However, in reality,
there may be complications that require central intervention. The market price may be difficult to
determine or may fluctuate wildly, and central treasury may have to decide which price to use. If it is
decided that an allowance should be made for costs of internal transfer being lower, central treasury may
have to determine what this should be as it may vary significantly between products and divisions.
Specifying the transaction takes place at market price is designed to ensure that the buying division buys
from the selling division, rather than an external supplier if the buying and selling division have failed to
agree a price. The implicit assumption is that the buying division will use the selling division because of
better service from, and greater dependability of, dealing within the group. This may not necessarily be
the case. If the buying division previously purchased internally as a result of a low transfer price, forcing
it to pay market price may mean it chooses an external supplier for non‐price reasons.
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32. With reference to purchasing power parity, explain how exchange rate fluctuations may lead to
economic exposure.
Answer:
Purchasing power parity (PPP) predicts that the exchange rates between two currencies depend on the
relative differences in the rates of inflation in each country. Therefore, if one country has a higher rate of
inflation compared to another, then its currency is expected to depreciate over time. However, according
to PPP the ‘law of one price’ holds because any weakness in one currency will be compensated by the rate
of inflation in the currency’s country (or group of countries in the case of the euro).
Economic exposure refers to the degree by which a company’s cash flows are affected by fluctuations in
exchange rates. It may also affect companies which are not exposed to foreign exchange transactions,
due to actions by international competitors.
If PPP holds, then companies may not be affected by exchange rate fluctuations, as lower currency value
can be compensated by the ability to raise prices due to higher inflation levels. This depends on markets
being efficient.
However, a permanent shift in exchange rates may occur, not because of relative inflation rate
differentials, but because a country (or group of countries) lose their competitive positions. In this case
the ‘law of one price’ will not hold, and prices readjust to a new and long‐term or even permanent rate.
For example, the UK £ to USA $ rate declined in the 20th century, as the USA grew stronger economically
and the UK grew weaker. The rate almost reached parity in 1985 before recovering. Since the financial
crisis in 2009, it has fluctuated between roughly $1.5 to £1 and $1.7 to £1.
In such cases, where a company receives substantial amounts of revenue from companies based in
countries with relatively weak economies, it may find that it is facing economic exposure and its cash flows
decline over a long period of time.
33. Discuss the advantages and disadvantages of using swaps as a means of hedging interest rate risk.
Answer:
Advantages of swaps
Transaction costs are generally relatively low. If a company arranged the swap itself, the costs would be
limited to legal fees. The transaction costs may also be lower than the costs of terminating one loan and
arranging another.
A company can, as here, swap a commitment to pay a variable rate of interest which is uncertain with a
guaranteed fixed rate of interest. This allows a company to forecast finance costs on the loan with
certainty.
Swaps are over‐the‐counter arrangements. They can be arranged in any size and for whatever time period
is required, unlike traded derivatives. The period available for the swap may be longer than is offered for
other interest rate derivatives.
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Swaps make use of the principle of comparative advantage. A company can borrow in the market where
the best deal is available to it, and then use the swap to access the loan finance it actually wants at an
overall cheaper cost.
Disadvantages of swaps
Swaps are subject to counterparty risk, the risk that the other party to the arrangement may default on
the arrangement. This would apply in particular if a company arranged the swap itself. If it is arranged
through a bank, the bank can provide a guarantee that the swap will be honored.
If a company swaps into a fixed rate commitment, it cannot then change that commitment. This means it
cannot take advantage of favorable interest rate changes as it could if it used options. This may be a
particular problem if the swap period is more than a few months and interest rates are expected to be
volatile.
As swaps are over‐the‐counter instruments, they cannot be easily traded or allowed to lapse if they are
not needed or become no longer advantageous. It is possible that a bank may allow a re-swapping
arrangement to reverse a swap which is not required, but this will incur further costs.
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Interest Rate Risk Management
34. Explain the possible reasons for an upward sloping yield curve.
Answer:
A yield curve may be upward‐sloping because of:
(i) Future expectations. If future short‐term interest rates are expected to increase then the yield curve
will be upward sloping. The greater the expected future rise in interest rates, the steeper the upward‐
slope of the yield curve will be.
(ii) Liquidity preference. It is argued that investors seek extra return for giving up a degree of liquidity with
longer‐term investments. Other things being equal, the longer the maturity of the investment, the higher
the required return, leading to an upward‐sloping yield curve.
(iii) Preferred habitat/market segmentation. Different investors are more active in different segments of
the yield curve. For example, banks would tend to focus on the short‐term end of the curve, whilst
pension funds are likely to be more concerned with medium‐term and long‐term segments. An upward‐
sloping curve could in part be the result of a fall in demand in the longer‐term segment of the yield curve
leading to lower bond prices and higher yields.
35. Discuss the advantages of hedging with interest rate caps and collars.
Answer:
Interest rate caps and collars are available as over the counter (OTC) transactions with a bank, or may be
devised using market‐based interest rate options (options on interest rate futures). They may be used to
hedge current or expected interest receipts or payments.
An interest rate cap is a series of call options on a notional amount of principal, exercisable at regular
intervals over the term to expiry of the cap. The effect of a cap is to place an upper limit on the interest
rate to be paid, and is therefore useful to a borrower of funds who will be paying interest at a future date.
By purchasing a cap, a borrower will limit the net interest paid to the agreed cap strike price (less any
premium paid for the cap). OTC caps are available for periods of up to ten years and can thus protect
against long‐term interest rate movements.
As with all options, if interest rates were to move in a favorable direction, the buyer of the cap could let
the option lapse and take advantage of the more favorable rates in the spot market. The main
disadvantage of options is the premium cost. An interest rate collar option reduces the premium cost by
limiting the possible benefits of favorable interest rate movements.
A collar involves the simultaneous purchase and sale of options, or in the case of OTC collars the equivalent
to this. The premium paid for the purchase of one option would be partly or wholly offset by the premium
received from the sale of another option. A borrower using an OTC collar would in effect buy a cap at one
strike price, to secure a maximum interest cost, and sell a floor at a lower strike rate, which sets a
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minimum interest cost. The effective interest cost would be somewhere between the exercise price for
the floor and the exercise price for the cap. The premium cost would be the cost of the cap less the selling
price of the floor. A zero cost collar is a collar for which the cost of the cap is offset exactly by the sales
value of the floor.
36. Discuss the disadvantages and advantages of not undertaking a swap and being liable to pay interest
at floating rates.
Answer:
Disadvantages of swap arrangement
The swap represents a long‐term commitment at a time when interest rates appear uncertain. It may be
that interest rates rises are lower than expected. In this case, a company will be committed to a higher
interest rate and its finance costs may be higher than if it had not taken out the finance arrangements. a
company may not be able to take action to relieve this commitment if it becomes clear that the swap was
unnecessary. Particularly during Year 1, the extra commitment to interest payments may be an important
burden at a time when a company will have significant development and launch costs. a company will be
liable for an arrangement fee. However, other methods of hedging which could be used will have a cost
built into them as well.
Advantages of swap arrangement
The swap means that the annual interest payment liability will be fixed. This is a certain figure which can
be used in budgeting. Having a fixed figure may help planning, particularly as a number of other costs
associated with the investment are uncertain. The directors will be concerned not just about the
probability that floating rates will result in a higher commitment than under the swap, but also be
concerned about how high this commitment could be. The directors may feel that rates may possibly rise
to a level which would give a company multiple problems in meeting its commitments and regard that as
unacceptable. Any criticism after the end of the loan period will be based on hindsight. What appeared to
be the cheapest choice at that stage may not have been what appeared most likely to be the cheapest
choice when the loan was taken out. In addition, criticism of the directors for not choosing the cheapest
option fails to consider risk. The cheapest option may be the riskier. The directors may reasonably take
the view that the saving in cost is not worth the risks incurred. The swap is for a shorter period than the
loan and thus allows a company to reconsider the position in four years’ time. It may choose to take out
another swap then on different terms, or let the arrangement lapse and pay floating rate interest on the
loan, depending on the expectations at that time of future interest rates.
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37. Discuss how interest rate swaps and currency swaps might be of value to the corporate financial
manager.
Answer:
A swap is the exchange of one stream of future cash flows for another stream of future cash flows with
different characteristics. Interest rate and currency swaps offer many potential benefits to companies
including:
(i) The ability to obtain finance cheaper than would be possible by borrowing directly in the relevant
market. As companies with different credit ratings can borrow at different cost differentials in for example
the fixed and floating rate markets, a company that borrows in the market where it has a comparative
advantage (or least disadvantage) can, through swaps, reduce its borrowing costs. For example, a highly
rated company might be able to borrow funds 1.5% cheaper in the fixed rate market than a lower rated
company, and 0.80% cheaper in the floating rate market. By using swaps an arbitrage gain of 0.70% (1.5%
– 0.80%) can be made and split between the participants in the swap.
(ii) Hedging against foreign exchange risk. Swaps can be arranged for up to 10 years which provide
protection against exchange rate movements for much longer periods than the forward foreign exchange
market. Currency swaps are especially useful when dealing with countries with exchange controls and/or
volatile exchange rates.
(iii) The opportunity to effectively restructure a company's capital profile by altering the nature of interest
commitments, without physically redeeming old debt or issuing new debt. This can save substantial
redemption costs and issue costs. Interest commitments can be altered from fixed to floating rate or vice
versa, or from one type of floating rate debt to another, or from one currency to another.
(iv) Access to capital markets in which it is impossible to borrow directly. For example, companies with a
relatively low credit rating might not have direct access to some fixed rate markets, but can arrange to
pay fixed rate interest by using swaps.
(v) The availability of many different types of swaps developed to meet a company's specific needs. These
include amortizing swaps, zero coupon swaps, callable, puttable or extendable swaps and swaptions.
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38. Discuss the advantages and disadvantages of arranging a swap through a bank rather than
negotiating directly with a counterparty.
Answer:
In practice, most swaps are arranged through banks that run a 'swaps book'. There are several advantages
in dealing with a bank rather than directly with another company.
1. In dealing with a bank, there is no problem about finding a swaps counterparty with an equal and
opposite swapping requirement. The bank will arrange a swap to meet the specific requirements of each
individual customer, as to amount and duration of the swap.
2. In dealing with a bank, the credit risk is that the bank might default, whereas in dealing directly with
another company, the credit risk is that the other company might default. Banks are usually a much lower
credit risk than corporates.
3. Banks are specialists in swaps, and are able to provide standard legal swaps agreements. The operation
of the swap is likely to be administratively more straightforward. The significant drawback to using a bank
is that the bank will want to make a profit from its operations. In practice, it will generally do this by
charging different swap rates for fixed rate payments and fixed rate receipts on different swaps.
39. Briefly discuss the main advantage and disadvantage of hedging interest rate risk using an interest
rate collar instead of options.
Answer:
The main advantage of using a collar instead of options to hedge interest rate risk is lower cost. A collar
involves the simultaneous purchase and sale of both call and put options at different exercise prices. The
option purchased has a higher premium when compared to the premium of the option sold, but the lower
premium income will reduce the higher premium payable. With a normal uncovered option, the full
premium is payable.
However, the main disadvantage is that, whereas with a hedge using options the buyer can get full benefit
of any upside movement in the price of the underlying asset, with a collar hedge the benefit of the upside
movement is limited or capped as well.
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40. When examining different currency options and their risk factors, it was noticed that a long call
option had a high gamma value. Explain the possible characteristics of a long call option with a high
gamma value.
Answer:
Gamma measures the rate of change of the delta of an option. Deltas range from near 0 for a long call
option which is deep out‐of‐money, where the price of the option is insensitive to changes in the price of
an underlying asset, to near 1 for a long call option which is deep in‐the‐money, where the price of the
option moves in line and largely to the same extent as the price of the underlying asset. When the long
call option is at‐the‐money, the delta is 0.5 but also changes rapidly.
Hence, the gamma is highest for a long call option which is at‐the‐money. The gamma is also higher when
the option is closer to expiry. It would seem, therefore, that the option is probably trading near at‐the‐
money and has a relatively short time period before it expires.
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Dividend Policy
41. A company is unsure whether to pay a special, one‐off large dividend from its dividend capacity and
retained funds, followed by small annual dividend payments; or to undertake a periodic share buyback
scheme over the next few years. Discuss the benefits to the company’s shareholders of receiving
repayments through a share buyback scheme as opposed to the dividend scheme discussed above.
Answer:
The main benefit of a share buyback scheme to investors is that it helps to control transaction costs and
manage tax liabilities. With the share buyback scheme, the shareholders can choose whether or not to
sell their shares back to the company. In this way they can manage the amount of cash they receive. On
the other hand, with dividend payments, and especially large special dividends, this choice is lost, and
may result in a high tax bill.
If the shareholder chooses to re‐invest the funds, it will result in transaction costs. An added benefit is
that, as the share capital is reduced, the earnings per share and the share price may increase. Finally,
share buybacks are normally viewed as positive signals by markets and may result in an even higher share
price.