CFAP 4 – BUSINESS FINANCE
DECISIONS
STUDY MATERIAL & FORMULA BOOK
COMPREHENSIVE QUESTIONS & CASE STUDIES
By Muzzammil Munaf
| ACA | Financial Advisor | Trainer|
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
Table of Contents
1. BFD ICAP Past Papers Analysis .............................................................................................................. 1
2. CFAP-4 ICAP Syllabus
...................................................................................................................... 17
3. Formula Book ........... .......................................................................................................................... 20
4. Sources of Equity Finance .................................................................................................................... 62
5. Sources of
– Debt Finance ........... ................................ ................................ ........................................... 71
6. Introduction to Capital Structure
........................................................................................................... 77
7. Weighted Average Cost of Capital ..................................................................................................... 82
8. Yield to Maturity and Pre-tax Cost of Debt .................................................................................... 120
9. Capital Structure and Gearing Theories ............................................................................................ 124
10. Marginal Cost of Capital..................... ................................................................................................ 141
11. Arbitrage from MM theory -with taxation ........................................................................................ 143
12. Capital Asset Pricing Model ............................. .................................................................................. 146
13. Portfolio Theory ......................... ................................ ......................................................................... 185
14. Rights Issue and-Dividend Policy ............................. ......................................................................... 208
15. Case studies on Evaluating
Sources of Finance ................. ............................. ............................. 234
16. Capital Investment Appraisal............................................................................................................ 262
17. Asset Replacement Decisions............................................................................................................ 330
18. Capital Rationing Decisions .......................................................................................................... 349
19. Lease vs Borrow ..................... ............................................................................................................. 365
20. Adjusted Present Value .................................................................................................................... 384
21. Business Valuation .............................. .............................................................................................. 402
22. Mergers and Acquisitions ................................................................................................................ 433
23. Foreign Exchange Risk Management ..............................................................................................526
24. Interest Rate Risk Management .......... .............................. ............................................................ 580
25. International Investment Appraisal ................................................................................................ 630
26. Credit Risk Management ....... ................................ ..........................................................................652
27. Liquidity Risk Management ........................................................... ................................................. 673
Always a mentor | Muzzammil Munaf
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
ICAP PAST PAPERS ANALYSIS
ATTEMPT WISE ANALYSIS
Segment
BFD
Attempt
/ Year
2022
Winter
Name
Ques
Part
Chapter
Area
Description
Marks
Malik
Consultancy
Company
Limited
1
a
International
Investment
Appraisal
International
Investment
Appraisal
Recommend, with supporting calculations, if the board should proceed with the investment
opportunity in Turkey.
14
BFD
2022
Winter
Malik
Consultancy
Company
Limited
1
b
International
Investment
Appraisal
International
Investment
Appraisal
Discuss whether it is appropriate to use the existing cost of capital to appraise an international
project.
5
BFD
2022
Winter
Malik
Consultancy
Company
Limited
1
c
Forex
Exchange Risk
Management
Transaction
Risk
Currency
Swap
Explain the additional risk that arises when using local debt to fund the investment in Turkey and
explain how Malik could use swap agreements to reduce risk when converting future cash flows in
Turkish Lira into Pakistan Rupees.
6
BFD
2022
Winter
NPP
Limited
2
a
Mergers and
Acquisitions
Mergers and
Acquisitions
Explain the meaning of synergy and suggest what might create synergies for NPP if the takeover of
NH were to proceed.
4
BFD
2022
Winter
NPP
Limited
2
b
Mergers and
Acquisitions
Mergers and
Acquisitions
Explain the purpose of due diligence and the steps that NPP should undertake prior to finalising
the offer with NH.
6
BFD
2022
Winter
NPP
Limited
2
c
Mergers and
Acquisitions
Mergers and
Acquisitions
Determine the terms of the share for share exchange assuming that NPP pays the maximum
theoretical price for NH.
5
BFD
2022
Winter
NPP
Limited
2
d
Mergers and
Acquisitions
Mergers and
Acquisitions
Advise whether the existing shareholders of NH and NPP are likely to approve the offer and
quantify any gains that the respective shareholders would receive if NPP pays the maximum
theoretical price for NH.
7
Always a mentor | Muzzammil Munaf
Page 1 of 690
Page 1 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
Segment
BFD
Attempt
/ Year
2022
Winter
Name
Ques
Part
Chapter
Area
Description
Marks
Multan
Textiles
Limited
3
a
Forex
Exchange Risk
Management
Reverse
Futures
Money Market
Hedge
Explain, with supporting calculations, how the company can hedge against exchange rate risk in
five months' time.
14
BFD
2022
Winter
Multan
Textiles
Limited
3
b
Interest Rate
Risk
Management
Interest rate
options
Explain how the company can protect against an interest rate rise using OTC interest rate options.
4
BFD
2022
Winter
Multan
Textiles
Limited
3
c
Dividend
Policy
Dividend
Policy
Advise the board on the practical matters that should be considered when deciding on whether a
dividend should be paid. Recommend, with reasons, whether a dividend should be paid in March
2023.
4
BFD
2022
Winter
Oakaan
Limited
4
a
Portfolio
theory
Portfolio
theory
Use both portfolio analysis and CAPM to determine the overall business risk and return of the
enlarged business, assuming OL acquires just one of the target companies. Consider each
acquisition separately.
7
BFD
2022
Winter
Oakaan
Limited
4
b
Portfolio
theory
Portfolio
theory
Advise the board of OL which model is more suitable to its circumstances, and then recommend
which investment the company should make.
4
BFD
2022
Winter
Oakaan
Limited
4
c
Sources of
finance
Sources of
finance
Explain, with supporting calculations, the amount of new debt that should be issued and the likely
issue price.
4
BFD
2022
Winter
Adventure
Travel
Limited
5
a
Business
Valuation
Business
Valuation
Determine the weighted average cost of capital which should be used to appraise the acquisition
of KVH.
6
BFD
2022
Winter
Adventure
Travel
Limited
5
b
Business
Valuation
Business
Valuation
Estimate the value of KVH using shareholder value analysis.
6
Always a mentor | Muzzammil Munaf
Page 2 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
Segment
BFD
Attempt
/ Year
2022
Winter
Name
Ques
Part
Adventure
Travel
Limited
5
c
1
a
Chapter
Area
Description
Marks
Business
Valuation
Business
Valuation
Explain, with calculations, the sensitivity of the valuation in KVH determined in part (b) to AT's
weighted average cost of capital.
4
Financial Risk
Management
Currency
Futures
Recommend, with supporting calculations and explanations, if CM should proceed and hedge the
sale of copper in six months' time. In doing so, compare a hedging strategy with the expected no
hedge position and state your answers in USD.
4
Based on the expected USD receipt on the sale of copper from part (a), explain, with calculations,
how CM could hedge against the fall in value of the USD using:
(i) forward contract
(ii) futures contract
(iii) options contract
10
2022
Summer
Curum
Metals
Limited
BFD
2022
Summer
Curum
Metals
Limited
1
b
Financial Risk
Management
Forward
Futures
Options
BFD
2022
Summer
Curum
Metals
Limited
1
c
Financial Risk
Management
Forward
Futures
Options
Discuss your results in part (b) and recommend a hedging strategy for the expected USD receipt
on the sale of copper.
3
BFD
2022
Summer
Curum
Metals
Limited
1
d
Financial Risk
Management
Futures
Explain why the outcome of a futures hedge cannot be determined with absolute certainty.
3
BFD
2022
Summer
Pamir
Estates
Limited
2
a
Business
Valuation
Business
Valuation
Determine a range of valuations using the valuation methods set out by Pamir's board of directors
and recommend, along with reasons, an issue price at which the new shares in Kurumdy will be
offered to investors prior to it commencing to trade on the Pakistan Stock Exchange.
14
BFD
2022
Summer
Pamir
Estates
Limited
2
b
Business
Valuation
Business
Valuation
Discuss reasons why the shares may trade at a higher or lower price than the price suggested by
the free cash valuation in part (a).
3
BFD
2022
Summer
Pamir
Estates
Limited
2
c
Business
Valuation
Business
Valuation
Advise the board of directors on matters to be included in due diligence which will be expected by
potential investors to support the new company listing before it proceeds with the spin-off of
Kurumdy.
4
BFD
2022
Summer
Centaurus
Pakistan
Limited
3
a
Weighted
average cost
of capital
Weighted
average cost
of capital
Calculate the current market value of the redeemable bonds and CP's overall gearing ratio (using
market values) after phase one of its expansion strategy.
2
BFD
Always a mentor | Muzzammil Munaf
Page 3 of 690
Page 3 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
Segment
Attempt
/ Year
Name
Ques
Part
Chapter
Area
BFD
2022
Summer
Centaurus
Pakistan
Limited
3
b
Capital Asset
Pricing Model
Capital Asset
Pricing Model
Calculate CP's cost of equity using the Arbitrage Pricing Theory and Capital Asset Pricing Model
(CAPM), and briefly explain the difference in your answers.
4
BFD
2022
Summer
Centaurus
Pakistan
Limited
3
c
Weighted
average cost
of capital
Weighted
average cost
of capital
Calculate the current weighted average cost of capital (WACC) for CP before embarking on phase
two of the expansion strategy using the cost of equity from part (b) calculated using the CAPM.
4
BFD
2022
Summer
Centaurus
Pakistan
Limited
3
d
Capital Asset
Pricing Model
Capital Asset
Pricing Model
Calculate the expected equity beta for CP after commencement of phase two of the project and
calculate the revised cost of equity for CP using CAPM.
4
BFD
2022
Summer
Centaurus
Pakistan
Limited
3
e
Weighted
average cost
of capital
Weighted
average cost
of capital
Explain, with relevant calculations, how a change in CP's credit rating from AAA to A may impact
the market value of CP's corporate bonds.
3
BFD
2022
Summer
Centaurus
Pakistan
Limited
3
f
Weighted
average cost
of capital
Weighted
average cost
of capital
Recalculate the WACC for CP after embarking on phase two of the project and explain why the
WACC has changed.
3
BFD
2022
Summer
Infrapower
Limited
4
a
Adjusted
Present Value
Adjusted
Present Value
Evaluate the proposed solar power plant investment by calculating the adjusted present value
(APV) and its modified internal rate of return (MIRR).
16
BFD
2022
Summer
Infrapower
Limited
4
b
Adjusted
Present Value
Investment
Appraisal
Adjusted
Present Value
MIRR
Write a report to IP's board of directors which evaluates the proposed engineering project. Your
report should include an explanation of APV and MIRR, their respective advantages and
disadvantages, and include a recommendation in your report as to whether IP should proceed with
a pilot for its new solar power plant design.
6
BFD
2022
Summer
Go Limited
4
a
Investment
Appraisal
Capital
Rationing
Determine an optimal investment strategy for the Rs. 150 million assuming:
(i) Partial investment in each opportunity is possible.
(ii) Partial investment in each opportunity is not possible.
7
BFD
2022
Summer
Go Limited
4
b
Investment
Appraisal
Asset
Replacement
Decisions
Determine the optimal replacement cycle for the fleet of vehicles using the information provided.
5
BFD
2022
Summer
Go Limited
4
c
Sources of
finance
Sources of
finance
Prepare a briefing note for Go's board of directors which explains the impact of introducing debt
finance into Go's capital structure and evaluates the respective costs of each proposed source of
finance.
5
Always a mentor | Muzzammil Munaf
Description
Page 4 of 690
Marks
Page 4 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
Segment
Attempt
/ Year
BFD
2021
Winter
BFD
Name
Ques
Part
Chapter
Area
Description
Marks
Alpha
Foods
Limited
1
a
Mergers and
Acquisitions
Mergers and
Acquisitions
Calculate the current gearing of Alpha and the expected gearing level of the new combined entity,
AFFL, immediately following the proposed acquisition and evaluate the result.
4
2021
Winter
Alpha
Foods
Limited
1
b
Mergers and
Acquisitions
Mergers and
Acquisitions
Forecast the expected after-tax WACC of AFFL immediately following acquisition.
9
BFD
2021
Winter
Alpha
Foods
Limited
1
c
Mergers and
Acquisitions
Mergers and
Acquisitions
Determine the expected impact on gearing and WACC immediately following the proposed sale of
the division and recommend after critically evaluating the directors’ view, if Alpha should proceed
with the sale.
7
BFD
2021
Winter
Cooler
Limited
2
a
Investment
Appraisal
Net Present
Value
Recommend if the directors should proceed to launch the ChillMax50 production based on the
assumptions provided by the directors of Cooler Limited. You are advised to present your workings
in rupees in million.
18
BFD
2021
Winter
Cooler
Limited
2
b
Investment
Appraisal
Sensitivity
Analysis
Calculate the sensitivity of your analysis in part (a) to expected sales volumes and sales price and
comment on your results.
7
MAC
2021
Winter
FitOut
Limited
3
a
Forecasting
and
budgeting
Forecasting
and
budgeting
Provide the following for FitOut for the two years ending 30 November 2022 and 2023:
(i)Forecasted statement of profit or loss, dividends and retained profit
(ii)Forecasted statement of financial position
(iii)Forecasted statement of cash flows
11
MAC
2021
Winter
FitOut
Limited
3
b
Forecasting
and
budgeting
Forecasting
and
budgeting
Comment, with appropriate calculations, on whether FitOut is likely to meet its stated financial
objectives at the end of 30 November 2022 and 30 November 2023.
4
BFD
2021
Winter
FitOut
Limited
3
c
Sources of
finance
Sources of
finance
Discuss the financing options available to FitOut to manage any forecast cash deficit identified in
part (a).
5
MAC
2021
Winter
Clean & Co
4
a
Linear
programming
Linear
programming
Assuming that a graphical linear programming solution is to be used to maximise profit in the
month of December:
(i) State the constraints and objective function.
(ii) Determine the maximum profit that can be made in December.
12
MAC
2021
Winter
Clean & Co
4
b
Linear
programming
Linear
programming
Determine resource slack assuming Clean operates at maximum profit.
3
MAC
2021
Winter
Clean & Co
4
c
Linear
programming
Shadow Price
Explain the concept of shadow price and calculate the shadow price of a machine hour.
4
Always a mentor | Muzzammil Munaf
Page 5 of 690
Page 5 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
Segment
Attempt
/ Year
Name
Ques
Part
Chapter
Area
BFD
2021
Winter
Multicorp
Limited
5
a
Financial Risk
Management
Interest Rate
Swap
Explain the purpose and counterparty risk of entering into an interest rate swap agreement and
also the benefits of an interest rate swap to the board of MC.
5
BFD
2021
Winter
Multicorp
Limited
5
b
Financial Risk
Management
Interest Rate
Swap
Evaluate the financial impact to both MC and CH that will result from the swap terms proposed by
the bank.
7
BFD
2021
Winter
Multicorp
Limited
5
c
Financial Risk
Management
Interest Rate
Swap
Recommend revised interest rate swap terms which are more likely to be acceptable to the boards
of directors of both MC and CH.
4
MAC
2021
Summer
Avion
Limited
1
a
Decision
making
Decision
making
Determine which component should be made during the next month to maximise contribution
and determine the profit that this decision will generate.
7
MAC
2021
Summer
Avion
Limited
1
b
Decision
making
Decision
making
Calculate the change in profit resulting for the proposed new pricing policy and comment on your
result.
5
MAC
2021
Summer
Avion
Limited
c
Decision
making
Decision
making
Calculate the additional alloy that Avion should buy in order to deliver additional units of the
component chosen in part (a) subject to any existing machine constraints. Also, recommend the
maximum premium to pay as % of the current alloy cost per kg to ensure an overall profit margin
of 20% for the month is achieved.
7
MAC
2021
Summer
Craft
Furniture
Ltd.
2
a
Working
Capital
Management
Working
Capital
Management
Prepare a cashflow forecast for the year to 31 December 2021, assuming:
(i) CFL does not change its working capital management policies.
(ii) CFL's proposed changes to working capital management policies are implemented from 1
January 2021.
12
MAC
2021
Summer
Craft
Furniture
Ltd.
2
b
Working
Capital
Management
Working
Capital
Management
Discuss the forecast impact of the new working capital management policies on profitability,
cashflow, payable days and receivable days and make a recommendation whether or not to
implement the new working capital management policies.
6
BFD
2021
Summer
Zebra Ltd.
(ZL)
3
a
Financial Risk
Management
Futures
Options
Discuss the relevant considerations when deciding between futures and options contracts to
hedge ZL's interest rate risk.
6
BFD
2021
Summer
Zebra Ltd.
(ZL)
b
Financial Risk
Management
Futures
Options
Assuming KIBOR has increased by 0.75% at 1 June, illustrate the possible results of:
(i) a futures hedge
(ii) an options hedge
Also recommend the best solution to ZL.
11
1
3
Always a mentor | Muzzammil Munaf
Description
Page 6 of 690
Marks
Page 6 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
Segment
Attempt
/ Year
Name
Ques
Part
Chapter
Area
Description
Marks
BFD
2021
Summer
QuickCook
Ltd
4
a
International
Investment
Appraisal
International
Investment
Appraisal
Evaluate whether or not QCL should commence manufacturing ovens in Turkey. As part of your
evaluation, comment on the cost, price and inflation assumptions made by the Directors of QCL.
17
BFD
2021
Summer
QuickCook
Ltd
4
b
International
Investment
Appraisal
International
Investment
Appraisal
Discuss how QCL might reduce the impact of restrictions on dividend remittance from Turkey to
Pakistan after the investment had taken place if the government of Turkey imposed such a policy.
4
BFD
2021
Summer
5
a
Mergers and
Acquisitions
Mergers and
Acquisitions
Determine a valuation for WL’s equity shares by using SIL's risk adjusted weighted average cost of
capital.
20
BFD
2021
Summer
5
b
Mergers and
Acquisitions
Mergers and
Acquisitions
Compare the value of SIL and WL shareholdings before and after the merger to determine if their
shareholders are likely to accept the terms of the share for share exchange offer proposed by SIL’s
directors.
5
BFD
2020
Winter
KP Ltd
1
a
Weighted
average cost
of capital
Weighted
average cost
of capital
Calculate the WACC of KPL.
6
BFD
2020
Winter
KP Ltd
1
b
Capital Asset
Pricing Model
Capital Asset
Pricing Model
Explain the purpose of the Capital Asset Pricing Model (CAPM) and discuss the weaknesses of
CAPM as a way of estimating KPL's required return to its shareholders.
3
BFD
2020
Winter
KP Ltd
1
c
Weighted
average cost
of capital
Weighted
average cost
of capital
Comment on the finance director's statement regarding the role of WACC as KPL's 'minimum
average rate of return'.
3
BFD
2020
Winter
KP Ltd
1
d
Weighted
average cost
of capital
Weighted
average cost
of capital
Discuss the circumstances under which KPL's current WACC can be used as the discount rate for
new project investment appraisal, and indicate other methods to determine a suitable discount
rate that could be adopted when it is not appropriate to use the current WACC.
5
BFD
2020
Winter
KP Ltd
1
e
Capital Asset
Pricing Model
Capital Asset
Pricing Model
Determine a suitable risk adjusted discount rate to evaluate the new diversified product.
5
BFD
2020
Winter
Eco Energy
2
a
Investment
Appraisal
Net Present
Value / MIRR
Evaluate the proposed energy monitor implementation project by calculating the net present value
of the new project and its modified internal rate of rate return.
12
SuperSky
Internationa
l Airlines
Ltd
SuperSky
Internationa
l Airlines
Ltd
Always a mentor | Muzzammil Munaf
Page 7 of 690
Page 7 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
Segment
Attempt
/ Year
Name
Ques
Part
Chapter
Area
BFD
2020
Winter
Eco Energy
2
b
Investment
Appraisal
BFD
2020
Winter
Dynamic
Ltd
3
a
BFD
2020
Winter
Dynamic
Ltd
3
b
BFD
2020
Winter
Peshawar
Engineering
Company
Ltd
BFD
2020
Winter
MAC
2020
Winter
Peshawar
Engineering
Company
Ltd
Super
Cakes Ltd
MAC
2020
Winter
MAC
Description
Marks
Sensitivity
Analysis
Write a report to EE's board of directors which evaluates the energy monitoring project. Your
report should also include consideration of non-financial factors and an explanation of the benefits
of performing sensitivity analysis and simulation prior to making a final decision.
8
Business
Valuation
Business
Valuation
Prepare a range of valuations for the shares of Dynamic Ltd. All valuations should be prepared as
at 30 September 2020 and use year-end discount factors, where applicable, presenting your
answers to the nearest thousand rupees.
15
Business
Valuation
Business
Valuation
Comment on the suitability of the assumptions made by the directors of Dynamic Ltd for preparing
the valuations in part (a).
5
Calculate the PKR amount receivable by PEC on 31 December 2020 if it uses:
§no hedge, evaluate using the expected spot rate
§a forward contract with PEC's bank
§a money market hedge
§an over-the-counter option with PEC's bank
11
4
a
Financial Risk
Management
Forward
Money Market
Hedge
OTC Option
4
b
Financial Risk
Management
Financial Risk
Management
Discuss the issues that should be taken into account by the PEC board when it considers whether
or not PEC should hedge the receipt of 20 million Bangladeshi Taka (BDT) at 31 December 2020.
7
5
a
Variance
Analysis
Variance
Analysis
Calculate the relevant sales, materials, labour and variable overhead variances for the month of
November 2020.
11
Super
Cakes Ltd
5
b
Variance
Analysis
Variance
Analysis
Provide an operating statement reconciling budget contribution to actual contribution and actual
profit for the month of November 2020.
4
2020
Winter
Super
Cakes Ltd
5
c
Variance
Analysis
Variance
Analysis
Prepare a report which explains the impact of the November 2020 operating statement to the
board of Super Cakes Ltd and actions the board should consider.
5
MAC
2019
Winter
Awam
Limited
1
a
Working
Capital
Management
Working
Capital
Management
Advise whether it would be feasible for AL to adopt any of the above options.
15
MAC
2019
Winter
Awam
Limited
1
b
Working
Capital
Management
Working
Capital
Management
In case of opting for factoring arrangement with KI, briefly discuss the difficulties which AL may
encounter. Also discuss how these difficulties can be resolved.
4
BFD
2019
Winter
Karakorum
Limited
2
a
Mergers and
Acquisitions
Mergers and
Acquisitions
Using the free cash flow method, determine the maximum price that KL may pay to the
shareholders of SL.
13
Always a mentor | Muzzammil Munaf
Page 8 of 690
Page 8 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
Segment
Attempt
/ Year
Name
Ques
Part
Chapter
Area
Description
Marks
BFD
2019
Winter
Karakorum
Limited
2
b
Mergers and
Acquisitions
Mergers and
Acquisitions
Assume that the offer of Rs. 450 million is accepted by SL’s shareholders. Discuss the impact of this
acquisition on control, gearing and earnings per share of KL if it is funded:
(i) with new debt at 10%; or (ii) by issuance of shares.
10
BFD
2019
Winter
Ghauri
Limited
3
a
Investment
Appraisal
Net Present
Value
Advise whether it is feasible for GL to bid for tender at a price suggested by the marketing director.
21
BFD
2019
Winter
3
b
Investment
Appraisal
Sensitivity
Analysis
Estimate the project’s sensitivity to: (i) sales price (ii) cost of capital
4
BFD
2019
Winter
4
a
Financial Risk
Management
Options
Determine the net profit/(loss) for GIL, if advice of the Investment Board has been followed.
12
BFD
2019
Winter
4
b
Financial Risk
Management
Options
Briefly discuss the relative advantages of using exchange traded options and over-the-counter
(OTC) options.
4
BFD
2019
Winter
5
a
Portfolio
theory
Mutual Funds
Using alpha value, recommend which mutual fund should be selected for investment.
14
BFD
2019
Winter
Ghauri
Limited
Greenline
Investments
Limited
Greenline
Investments
Limited
Tezgam
Investment
Limited
Tezgam
Investment
Limited
5
b
Portfolio
theory
Mutual Funds
Briefly discuss the limitations of using the alpha value for evaluating the investment.
3
BFD
2019
Summer
Yellow
Limited
1
a
Mergers and
Acquisitions
Mergers and
Acquisitions
Determine the share exchange ratio which must be offered to WL’s shareholders to gain their
acceptance. Also assess whether this ratio would be acceptable to YL’s shareholders.
18
BFD
2019
Summer
Yellow
Limited
1
b
Mergers and
Acquisitions
Mergers and
Acquisitions
Identify and discuss other relevant factors that directors and shareholders of both companies may
consider while evaluating the proposed takeover.
6
BFD
2019
Summer
Red Limited
2
a
Investment
Appraisal
Asset
Replacement
Decisions
Advise the most feasible option to the company.
15
BFD
2019
Summer
Red Limited
2
b
Investment
Appraisal
Sensitivity
Analysis
Carry out a sensitivity analysis in respect of the following at which your decision in (a) above would
change:
(i) Ratio of maintenance cost between both options
(ii) Dollar rate
8
MAC
2019
Summer
Blue
Limited
3
-
Working
Capital
Management
Working
Capital
Management
Determine the minimum additional running finance amount that BL should seek from the banks.
16
Always a mentor | Muzzammil Munaf
Page 9 of 690
Page 9 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
Segment
Attempt
/ Year
BFD
2019
Summer
Orange
Limited
BFD
2019
Summer
Orange
Limited
BFD
2019
Summer
BFD
Name
Ques
Part
Chapter
4
a
Financial Risk
Management
4
Green
Limited
2019
Summer
Green
Limited
BFD
2019
Summer
Green
Limited
BFD
2019
Summer
BFD
Description
Marks
Forwards
Options
Advise which hedging option OL should adopt if expected spot rate on 31 August 2019 is JPY/PKR
0.7181 – 0.7355.
10
b
Financial Risk
Management
Interest Rate
Futures
Determine how beneficial would it be for OL to use interest rate futures to hedge interest rate risk
if at the end of nine months, interest rates:
(i) rise by 1.50% and futures price move to 85.25.
(ii) fall by 0.25% and futures price move to 86.75.
5
5
a
Right issue
and dividend
theory
Right issue
and dividend
theory
Calculate GL’s share price after the right issue, assuming that GL's current P/E ratio remains the
same. Also comment on Shahid Khan’s viewpoint regarding no effect on P/E ratio.
4
5
b
Dividend
Policy
Dividend
Policy
Comment on the viewpoint of Saleem Qadir in the light of Miller & Modigliani (MM) Theory of
Dividend Irrelevance.
3
5
c
Dividend
Policy
Dividend
Policy
Justify using MM Theory of Dividend Irrelevance that value of the company under each option
would remain the same. Assume that there are no internal funds available with the company and
GL would have to finance the proposed redemption from the profit for the current year and/or
through right issue.
9
Green
Limited
5
d
Financing of
Projects
Financing of
Projects
Evaluate both financing options proposed by the directors and recommend which option should
be selected.
6
2018
Winter
Sun Public
Limited
1
a
Mergers and
Acquisitions
Demerger
Evaluate the financial viability of the demerger scheme for the shareholders of SPL using 10 years’
time horizon.
19
BFD
2018
Winter
1
b
Mergers and
Acquisitions
Demerger
List any four additional information that would assist the directors in evaluating the decision of
demerger.
4
BFD
2018
Winter
Sun Public
Limited
The Pluto
Group
Limited Pakistan
2
a
Financial Risk
Management
Multilateral
Netting
Determine the amount of savings which can be achieved by PGL by using multilateral netting.
6
BFD
2018
Winter
The Pluto
Group
Limited Pakistan
2
b
Financial Risk
Management
Interest Rate
Swap
Interest Rate
Futures
Advise the best interest rate hedging strategy for KSL.
11
BFD
2018
Winter
Venus
Trading
Limited
3
-
Adjusted
Present Value
Adjusted
Present Value
Evaluate the above proposed contract by using adjusted present value method.
21
Always a mentor | Muzzammil Munaf
Area
Page 10 of 690
Page 10 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
Segment
Attempt
/ Year
MAC
2018
Winter
BFD
2018
Winter
BFD
2018
Summer
BFD
2018
Summer
BFD
2018
Summer
Weta
Pakistan
Limited
BFD
2018
Summer
Aqeeq
Pakistan
(Private)
Limited
BFD
2018
Summer
OJ Limited
MAC
2018
Summer
MAC
2018
Summer
Name
Ques
Part
Jupiter
Limited
4
-
Transfer
Pricing
Mars
Investment
Limited
5
-
1
Tulip Textile
Limited
Weta
Pakistan
Limited
Ikraam
(Private)
Limited
Ikraam
(Private)
Limited
Chapter
Description
Marks
Transfer
Pricing
Develop a production plan on the basis of overall profitability of the company and determine the
increase in profit that could be achieved as compared to the existing policy.
23
Investment
Appraisal
Capital
Rationing
Determine the optimum investment mix for MIL if: (a) all projects are divisible and can be scaled
upwards up to 50% and (b) all projects are indivisible and excess funds can be invested at 8% per
annum.
16
-
Mergers and
Acquisitions
Mergers and
Acquisitions
Evaluate whether the proposed acquisition would be beneficial for the existing shareholders of TTL
and BTL
25
2
a
Portfolio
theory
Portfolio
theory
Determine which company would you recommend for investment by WPL.
10
2
b
Portfolio
theory
Portfolio
theory
Determine the revised systematic risk and expected return of WPL's equity investment portfolio
after investing in the company identified in part (a) above. Briefly discuss the impact of revised
systematic risk and expected return.
6
3
-
Financial Risk
Management
Currency
Futures
Money Market
Hedge
Advise which hedging option should APL adopt if expected spot rates at 31 August 2018 and 31
December 2018 are Rs. 116.60 and Rs. 118.50 respectively.
15
4
-
Investment
Appraisal
MIRR
On the basis of modified internal rate of return, determine whether OJL should carry out research
on upgradation of EDS-1.
25
5
a
Variance
Analysis
Variance
Analysis
Compute the sales variances (price, mix, market share and market size) for the quarter ended 31
March 2018.
12
5
b
Variance
Analysis
Variance
Analysis
Prepare a brief commentary for the board of directors of IPL on the above variances and their
impact on profitability of the company.
7
Investment
Appraisal
Weighted
average cost
of capital
Advise whether CT should initiate expansion of its steel production capacity by disposing of its
investment properties.
18
Dividend
Policy
Briefly discuss any four factors which influence the dividend policy of a company.
4
BFD
2017
Winter
CT Limited
1
-
Investment
Appraisal
Weighted
average cost
of capital
BFD
2017
Winter
GSI
Company
Limited
2
a
Dividend
Policy
Always a mentor | Muzzammil Munaf
Area
Page 11 of 690
Page 11 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
Segment
Attempt
/ Year
Name
Ques
Part
Chapter
Area
BFD
2017
Winter
GSI
Company
Limited
2
b
Weighted
average cost
of capital
Weighted
average cost
of capital
Estimate the effect on GSI’s weighted average cost of capital by the end of financial year 2018 if
the stock analyst viewpoint remains valid.
20
BFD
2017
Winter
Moderax
Company
Pakistan
Limited
3
-
International
Investment
Appraisal
International
Investment
Appraisal
Advise whether MCL should proceed with the above investment.
24
MAC
2017
Winter
Sohrab
Industries
Limited
4
-
Working
Capital
Management
Working
Capital
Management
Determine which option SIL should adopt, if any.
15
BFD
2017
Winter
Captain
(Private)
Limited
5
a
Financial Risk
Management
Currency
Futures
Money Market
Hedge
Advise the feasible hedging options for each of the above transactions.
11
BFD
2017
Winter
Captain
(Private)
Limited
5
b
Financial Risk
Management
Stock Futures
Devise the hedging strategy using stock future contracts and calculate the net outcome and hedge
efficiency assuming that CPL’s incremental rate of borrowing is 10% per annum.
8
Net Present
Value
Calculation of
WACC
Evaluate the above investment by using discounted cash flow technique.
27
Description
Marks
BFD
2017
Summer
Dr Tahir
Lodhi
1
-
Investment
Appraisal
Weighted
average cost
of capital
MAC
2017
Summer
Hamid
Limited
2
-
Transfer
Pricing
Transfer
Pricing
Develop a production plan on the basis of overall profitability of the company and determine the
increase in profit that could be achieved on the basis thereof, as compared to the profit under the
existing policy.
25
BFD
2017
Summer
Jhelum
Motors
Limited
3
a
Financial Risk
Management
Currency
Futures
Money Market
Hedge
Advise which of the two hedging options would be more feasible for JML if expected spot rates at
the end of August, September and October are Rs. 106.50, Rs. 105.00 and Rs. 106.20 respectively.
12
BFD
2017
Summer
Jhelum
Motors
Limited
3
b
Financial Risk
Management
Interest Rate
Futures
Explain how JML could use interest rate future to hedge its exposure to interest rate risk. Also
determine whether it would be beneficial for JML to use interest rate futures if at the end of three
months, spot interest rate and future prices move to 7.5% and 92.2 respectively.
5
Always a mentor | Muzzammil Munaf
Page 12 of 690
Page 12 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
Segment
Attempt
/ Year
MAC
2017
Summer
BFD
2017
Summer
BFD
2017
Summer
BFD
2016
Winter
Ramzi
Corporation
BFD
2016
Winter
Ramzi
Corporation
BFD
2016
Winter
Suffer
Limited
BFD
2016
Winter
BFD
2016
Winter
Suffer
Limited
Malik
Investments
Limited
BFD
2016
Winter
MAC
2016
Winter
Name
Chapter
Area
-
Budgeting
Budgeting
Advise the most feasible selling price per bottle which SBL may fix for the next year.
14
5
a
Business
Valuation
Business
Valuation
Advise MPL about the IPO price and suggest the number of shares to be offered in the IPO
assuming that entire amount would be spent in year 0.
14
5
b
Business
Valuation
Business
Valuation
Write a brief memorandum to the board of directors discussing the advantages of leverage, for the
shareholders of the company.
3
1
a
Financial Risk
Management
Interest Rate
Swap
Calculate the net amounts that RC would pay or receive each year on the swap transaction. Also
determine the net interest rate payable by RC if it chooses to exercise the swap option.
Discuss the merit(s) and demerit(s) of the swap transaction for RC.
11
1
b
Financial Risk
Management
Interest Rate
Futures
Assume that spot rate of interest on 31 May 2017 moves to 8.5% per annum and theprice of June
interest rate futures falls to 90, demonstrate how short-term interest rate futures can be used by
RC to hedge against any rise in interest rate. Also determine the effective rate of interest on the
loan and hedge efficiency.
6
2
a
Investment
Appraisal
Net Present
Value
Using the net present value method, advise SL whether it would be feasible for the company to
establish manufacturing plant.
23
2
b
Investment
Appraisal
Sensitivity
Analysis
Estimate the project’s sensitivity to the direct material costs.
3
3
a
Investment
Appraisal
Capital
Rationing
Determine the optimum investment mix for MIL.
11
Malik
Investments
Limited
3
b
Investment
Appraisal
Capital
Rationing
Assume that MIL wishes to invest in all the remaining available projects including upward scaling.
For this purpose, it is negotiating a financing arrangement. Advise the maximum interest rate
which MIL may offer.
9
Smart
Limited
4
-
Variance
Analysis
Variance
Analysis
Prepare a statement reconciling budgeted contribution for September 2016 with the actual
contribution, using planning and operational variances.
17
Shah
Brothers
Limited
Mars
Petroleum
(Private)
Limited
Mars
Petroleum
(Private)
Limited
Ques
Part
4
Always a mentor | Muzzammil Munaf
Description
Page 13 of 690
Marks
Page 13 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
Segment
Attempt
/ Year
BFD
2016
Winter
Mangal
Limited
BFD
2016
Winter
BFD
Name
Part
Chapter
Area
Description
Marks
5
a
Mergers and
Acquisitions
Mergers and
Acquisitions
Discuss whether the proposed acquisition would be beneficial for the existing shareholders of ML
and SL if:
- the market is weak form efficient;
- the market is strong form efficient.
10
Mangal
Limited
5
b
Mergers and
Acquisitions
Mergers and
Acquisitions
Discuss the other factors which may influence the interests of the shareholders.
10
2016
Summer
Golden
Industries
Limited
1
a
Sources of
finance
Sources of
finance
Write a report for presentation to the board of directors covering the following matters:
(a) Analysis of GIL’s policy with respect to cash flow management and its impact on
GIL’s cost of capital and its ability to pay dividend.
6
BFD
2016
Summer
Golden
Industries
Limited
1
b
Sources of
finance
Sources of
finance
Revised value of net assets, profit after tax and cash flows if GIL increases its debt
equity ratio to:
- 60:40 which is the maximum limit allowed by GIL’s banks.
- 50:50 which is the prevailing industry norm in which GIL operates.
12
BFD
2016
Summer
Golden
Industries
Limited
1
c
Sources of
finance
Sources of
finance
Suggestions and recommendations regarding anticipated cash flows and future dividend
prospects.
7
BFD
2016
Summer
Violet
Telecom
Ltd.
2
a
Mergers and
Acquisitions
Mergers and
Acquisitions
Determine the ratio of share exchange which must be offered to shareholders of BTL to gain their
acceptance and assess whether this ratio would be acceptable to shareholders of VTL also.
12
BFD
2016
Summer
Violet
Telecom
Ltd.
2
b
Mergers and
Acquisitions
Mergers and
Acquisitions
Discuss five other relevant factors that the directors/shareholders of both companies may consider
in evaluating the proposed merger.
5
BFD
2016
Summer
White
Garments
Limited
3
-
Investment
Appraisal
Asset
Replacement
Decisions
Determine the preferred replacement policy for the cutting machine.
17
BFD
2016
Summer
4
-
Financing of
Projects
Financing of
Projects
Analyse both the financing options and recommend which financing option should be selected.
24
BFD
2016
Summer
5
-
Investment
Appraisal
Lease vs
Borrow
Recommend whether it would be advisable for SRS to purchase the cars.
17
Modern
Vehicles
Limited
SilverLine
Rental
Services
Ques
Always a mentor | Muzzammil Munaf
Page 14 of 690
Page 14 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
Segment
Attempt
/ Year
Name
BFD
2015
Winter
BFD
Ques
Part
Chapter
Area
Description
Marks
National
Airline
Limited
1
-
Mergers and
Acquisitions
Mergers and
Acquisitions
Based on an analysis of Free Cash Flows, calculate the bid price that the local group may offer for
the acquisition of 40% stake in NAL.
21
2015
Winter
Ryan Group
2
a
Mergers and
Acquisitions
Demerger
Analyze and comment whether NPL would be able to comply with debt-equity covenant imposed
by the bank over the five-year period.
12
BFD
2015
Winter
Ryan Group
2
b
Mergers and
Acquisitions
Demerger
Briefly discuss the difficulties that may be encountered by management of NPL after the buy-out.
3
BFD
2015
Winter
Wonder
Limited
3
-
Financial Risk
Management
Currency
Futures
Money Market
Hedge
Analyse and devise a hedging strategy for WL and ME.
10
BFD
2015
Winter
Akhtar
4
a
Portfolio
theory
Portfolio
theory
Briefly discuss the difference between systematic risk and unsystematic risk.
2
BFD
2015
Winter
Akhtar
4
b
Portfolio
theory
Portfolio
theory
Determine the systematic risk and expected return of Akhtar’s equity investment portfolio if he
goes ahead with his proposed investments. Also discuss briefly the impact of revised systematic
risk on Akhtar’s investment decision.
7
BFD
2015
Winter
Akhtar
4
c
Dividend
Policy
Dividend
Policy
Evaluate the implication of Ravi Limited and Jhelum Limited’s proposed financial strategies and
advise Akhtar on how these strategies might affect his investment decisions.
8
BFD
2015
Winter
Impression
Home
Furnishing
Limited
5
a
Sources of
finance
Sources of
finance
Advise the management regarding the amount to be raised in terms of debt and equity.
8
BFD
2015
Winter
Impression
Home
Furnishing
Limited
5
b
Sources of
finance
Sources of
finance
In a recent report, treasurer of the company has forecasted that in one year’s time, yield to
maturity of both TFCs would decline to 10% and company’s PE ratio would increase to 6.3.
Assuming that the treasurer’s predictions hold true, determine the increase in profit before interest
and tax during the next year, to ensure that desired debt equity ratio is maintained.
7
BFD
2015
Winter
Sandra
Limited
6
-
International
Investment
Appraisal
International
Investment
Appraisal
Recommend whether it is feasible for SL to assemble Ferris.
22
Always a mentor | Muzzammil Munaf
Page 15 of 690
Page 15 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP PAST PAPERS ANALYSIS
TOPIC WISE ANALYSIS
Particulars
2015
Winter
2016
Summer
2016
Winter
2017
Summer
2017
Winter
2018
Summer
2018
Winter
2019
Summer
2019
Winter
2020
Winter
2021
Summer
2021
Winter
2022
Summer
2022
Winter
Grand
Total
Weight
%
100
100
83
61
85
81
77
100
100
80
81
61
100
100
1,158
100%
37
3%
74
6%
16
1%
BFD
Adjusted Present Value
21
Business Valuation
22
17
Capital Asset Pricing Model
International Investment Appraisal
22
36
Portfolio theory
9
Sources of finance
15
34
46
17
20
27
8
8
18
25
16
23
25
25
23
24
23
20
19
25
25
49
20
6
5
20
14
16
8
4
Foreign Exchange Risk Management
17
17
19
16
15
17
15
16
16
19
18
Liquidity Risk Management
7%
226
20%
22
235
20%
11
53
5%
4
79
7%
46
4%
20
30
3%
4
20
2%
4
32
3%
171
15%
18
2%
35
3%
191
100%
12
10
Rights issue and dividend policy
86
12
17
Interest Rate Risk Management
17
20
18
Credit Risk Management
MAC (discontinued from Summer 2022)
16
21
16
Weighted average cost of capital
Forex Exchange Risk Management
21
24
Investment Appraisal
Mergers and Acquisitions
20
-
-
17
Budgeting
39
15
19
23
-
-
20
19
39
-
-
14
Decision making
19
14
7%
19
10%
Forecasting and budgeting
15
15
8%
Linear programming
19
19
10%
Sources of finance
5
5
3%
48
25%
56
29%
15
8%
Transfer Pricing
25
Variance Analysis
19
Working Capital Management
Grand Total
Always a mentor | Muzzammil Munaf
23
17
20
15
100
100
100
100
100
100
100
Page 16 of 690
100
100
100
100
100
100
100
1,349
Page 16 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP SYLLABUS
CFAP 4 – ICAP SYLLABUS
Always a mentor | Muzzammil Munaf
Page 17 of 690
Page 1 of 3
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP SYLLABUS
Always a mentor | Muzzammil Munaf
Page 18 of 690
Page 2 of 3
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CFAP-4 ICAP SYLLABUS
Always a mentor | Muzzammil Munaf
Page 19 of 690
Page 3 of 3
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
SUMMARY AND FORMULAE BOOK
WEIGHTED AVERAGE COST OF CAPITAL ........................................................................................................ 3
ALTERNATE CALCULATION OF WACC: ....................................................................................................... 7
WACC AND MARKET VALUES: ..................................................................................................................... 7
CAPITAL STRUCTURE THEORIES ...................................................................................................................... 8
TRADITIONAL THEORY: ................................................................................................................................ 8
MM THEORY IGNORING TAXATION: ......................................................................................................... 8
MM THEORY ALLOWING FOR TAXATION: ................................................................................................ 9
RISK AND INVESTMENTS – PORTFOLIO THEORY ....................................................................................... 11
SINGLE ASSET PORTFOLIO ......................................................................................................................... 11
TWO-ASSET PORTFOLIO ............................................................................................................................. 11
CORRELATION COEFFICIENT OF INVESTMENT RETURNS: .................................................................... 12
THREE-ASSET PORTFOLIO .......................................................................................................................... 13
CAPITAL ASSET PRICING MODEL (CAPM) ............................................................................................... 14
TREYNOR RATIO .......................................................................................................................................... 15
SHARPE RATIO ............................................................................................................................................. 15
RISK ADJUSTED WACC: .............................................................................................................................. 16
BETA ............................................................................................................................................................... 16
RIGHTS ISSUE ................................................................................................................................................... 17
YIELD ADJUSTED THEORETICAL EX-RIGHTS PRICE ................................................................................ 17
DIVIDEND POLICY ............................................................................................................................................ 18
THEORIES OF DIVIDEND POLICY ............................................................................................................... 18
INVESTMENT APPRAISAL ............................................................................................................................... 20
ACCOUNTING RATE OF RETURN: .............................................................................................................. 20
PAYBACK PERIOD: ....................................................................................................................................... 20
DISCOUNTED CASH FLOW METHOD: ....................................................................................................... 21
MODIFIED IRR: ............................................................................................................................................. 21
ECONOMIC IRR:............................................................................................................................................ 22
CAPITAL RATIONING....................................................................................................................................... 23
SINGLE PERIOD CAPITAL RATIONING: ..................................................................................................... 23
Always a mentor | Muzzammil Munaf
Page 20 of 690
Page 1 of 42
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
MULTI-PERIOD CAPITAL RATIONING: ..................................................................................................... 23
ASSET REPLACEMENT DECISIONS: ........................................................................................................... 23
LEASE v/s BORROW DECISION: ................................................................................................................. 24
ADJUSTED PRESENT VALUE ........................................................................................................................... 26
BUSINESS VALUATION .................................................................................................................................... 28
ASSET BASED VALUATION ......................................................................................................................... 28
EARNINGS BASED VALUATION ................................................................................................................. 28
CASH FLOW BASED VALUATION .............................................................................................................. 30
Free cash flow based valuation.................................................................................................................. 31
EFFICIENT MARKET HYPOTHESIS .............................................................................................................. 32
MERGERS AND ACQUISITIONS ...................................................................................................................... 33
FOREX AND HEDGING ..................................................................................................................................... 34
EXCHANGE RATE: ........................................................................................................................................ 34
MATCHING LONG TERM ASSETS AND LIABILITIES ............................................................................... 35
MONEY MARKET HEDGE ............................................................................................................................ 36
FORWARD CONTRACT ................................................................................................................................ 36
OPTION CONTRACT .................................................................................................................................... 38
INTEREST RATE RISK: .................................................................................................................................. 40
Forward rate agreements (FRAs); .............................................................................................................. 40
INTEREST RATE SWAPS .............................................................................................................................. 41
CREDIT ARBITRAGE ..................................................................................................................................... 41
INTEREST RATE FUTURES ........................................................................................................................... 41
INTEREST RATE OPTIONS ........................................................................................................................... 41
INTERNATIONAL INVESTMENT APPRAISAL ............................................................................................... 42
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
SUMMARY AND FORMULAE: REFER DURING EXAM
WEIGHTED AVERAGE COST OF CAPITAL
WACC can be commonly calculated as:
WACC =
[(MVe x Ke) + {MVd x Kd(1 − t)} + (MVp x Kp)]
(MVe + MVd + MVp)
Whereas:
MVe = Market Value of Equity
MVd = Market Value of Debt
MVp = Market Value of Preference Shares
Ke = Cost of Equity
Kd = Cost of Debt
t = Tax rate
Kp = Cost of Preference Shares
If interest payments are not tax-deductible (in a rare case), then the component of (1-t) will be eliminated.
Hence it will become:
WACC =
[(MVe x Ke) + (MVd x Kd) + (MVp x Kp)]
(MVe + MVd + MVp)
While evaluating the WACC of a Company, we shall pick up market values of the debt and equity
components and not their book value.
COSTS OF THE DIFFERENT SOURCES OF CAPITAL:
Source of Capital
Ordinary shares
Preference shares
Debt (Bonds/loans etc.)
Cost of Capital
Cost of Equity ‘Ke’(e.g. Dividend)
Cost of Preference Shares ‘Kp’ (e.g. Preference dividend)
Cost of Debt ‘Kd’(e.g. interest)
TAXES AND WEIGHTED AVERAGE COST OF CAPITAL:
Payments to owners (dividend) are not tax-deductible for the Company whereas interest costs are taxdeductible, which means they provide tax savings.
After-tax cost of debt = Before-tax cost of debt (1 – t)
Whereas ‘t’ denotes the tax rate and the tax savings are denoted by ‘(1 – t)’ in our calculations.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
MARKET VALUE OF DEBT AND COST OF DEBT:
Term
Face value
Coupon Rate
Coupon dates
Maturity Date
Term to maturity
Redemption value
Market Value
The rate required
by the lender (Kd)
Description
Reference value on which coupon interest is calculated and it is defined at the
time of issuance of the debt.
The rate of interest the debt issuer will pay on the face value of the debt
instrument is expressed as a percentage.
Dates on which the bond issuer will make interest payments.
The date on which the debt will mature and the debt issuer will pay the
debtholder the pre-agreed redemption value of the debt.
The period during which debt holders will receive interest payments on the
debt.
It is the value at which the debt shall be redeemed. It may or may not be
equal to the face value.
Price at which debt holder could sell the debt instrument to another investor.
The current rate of return offered by debt instruments similar to a credit
rating or term to maturity. It is the cost of debt.
MARKET VALUE OF DEBT:
Irredeemable debt: MV of such debt can be calculated through the present value of perpetuity interest
cash flows as:
MV of irredeemable debt =
Interest (1 − t)
Kd
Alternatively, the post-tax cost of debt (Kd) can be calculated as:
Kd =
Interest (1 − t)
MV of irredeemable debt
Whereas interest is the amount of coupon interest payable on the irredeemable debt.
Redeemable debt: MV of redeemable debt can be calculated as:
MV of redeemable debt = PV of interest cash flows + PV of redemption value
The present values are computed by discounting them with K d. To calculate the Kd, the future cash flows
will be plotted against the MV of redeemable debt and Kd will be calculated by using the IRR method.
In the case of debt convertible to equity, the process will be the same as redeemable debt except that the
redemption amount shall be higher of the two i.e. redemption amount and conversion value of the shares.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
PRE-TAX AND POST-TAX COST OF DEBT (KD):
Lender’s required rate of return = Company’s pre-tax Kd
Company’s pre-tax cost Kd x (1 – t) = Company’s post-tax Kd
Exam Approach: As mentioned above, WACC calculations involve post-tax Kd.
Irredeemable debt: The post-tax Kd can be calculated as [pre-tax Kd x (1-t)].
Redeemable debt: The approach is different since gain/loss on redemption is not taxable.
If the scenario only has lenders’ required rate of return (pre-tax Kd):
MV of debt: Plot all pre-tax cash flows and discount with the lenders’ required rate of return.
Post-tax Kd: Plot MV of debt, all post-tax cash flows and calculate IRR.
If the scenario provides MV of debt:
Plot the MV of debt and post-tax cash flows, calculate the IRR. This is the post-tax Kd.
If the scenario provides post-tax Kd and requires MV of debt, plot post-tax cash flows, and discount the
present values with the post-tax Kd. This is the MV of debt.
Rule of thumb: Pre-tax cash flows will be discounted with pre-tax Kd and post-tax cash flows will be
discounted with a post-tax Kd.
MARKET VALUE OF EQUITY AND COST OF EQUITY BY DIVIDEND VALUATION MODEL
DIVIDEND VALUATION MODEL
Constant Dividend Model
If a company pays nearly 100% of its profits as dividends, the market value of its share can be computed
through the constant dividend model as follows:
P0 =
D0
Ke
Whereas:
Po = Current market value of the share
Do = Latest dividend at time 0
Ke = Cost of equity
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
Dividend growth model:
If a company is expected to pay cash dividends growing at a constant rate of ‘g’ % per annum, the market
value of its share can be computed through the dividend growth model:
P0 =
D0 (1+g)
OR
Ke −g
D
1
P0 = K −g
e
Whereas you can compute growth (‘g’) as follows:
Past Dividend Patterns
g=[
Earning retention model
(Gordon’s growth model)
Current Dividend
Dividend n years ago
1
( )
n
]
g= bxr
−1
Whereas:
Whereas:
g = annual growth rate in dividends in perpetuity
b = proportion of earnings retained
r = rate of return on equity or return the company
will make on its investments
n (periods of growth) = No of years − 1
Points to remember:
In case multiple growth rates are given, the market value of shares can be computed by adding up the
present value of all the future dividends discounted at the cost of equity.
Through the dividend valuation model, the price of the equity instrument calculated is always ex-dividend.
(whereas cum-dividend price means inclusive of dividend).
When Ke is calculated through the dividend valuation model, the prices to be taken are also ex-dividend.
Alternatively, the Cost of Equity can be computed as:
Ke =
D0
P0
And
Ke =
D0 (1+g)
+g
Po
OR
D
K e = P1 + g
o
The cost of equity calculated is post-tax as it is based on dividends which are already post-tax.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
The same post-tax cost of equity of a company is the pre-tax rate of return required by the equity-holders
because they pay additional tax when dividends are received.
If a situation provides the post-tax rate required by the equity-holders (e.g. 8.5%) and the tax rate applicable
on the dividends they receive (e.g. 15%), first convert it to the pre-tax rate required by the equity holders
[i.e. 8.5% / (1-15%) = 10%] as this is the post-tax cost of equity of the Company and then use it for further
calculations.
ALTERNATE CALCULATION OF WACC:
For a Company having stable profits, paying out 100% profits as dividends, and having irredeemable debt,
the WACC can also be calculated as follows:
WACC (Pre − tax) =
PBIT
MVe + MVd
WACC (Post − tax) =
PBIT (1 − t)
MVe + MVd
And
WACC AND MARKET VALUES:
For a company with constant annual ‘cash profits’ (i.e. PBIT), there is a relationship between WACC and
market value. If we assume that annual cash profits are a constant amount in perpetuity, the total value of
a company, equity plus debt capital, is calculated as follows:
Total Market Value of the Company =
PBIT (1 − t)
WACC (Post − tax)
From the above relationship, the following conclusions can be made:
The lower the WACC, the higher the total value of the company will be (equity + debt capital), for any given
amount of annual profits. Similarly, the higher the WACC, the lower the total value of the company.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
CAPITAL STRUCTURE THEORIES
TRADITIONAL THEORY:
The traditional view of gearing is that there is an optimum level of gearing for a company, where WACC is
minimized.
Points to remember:
 According to traditional theory, change in Ke cannot be precisely estimated when the gearing level
changes.
 Hence, as financial risk (D/E ratio) changes, the WACC changes and it cannot be used to discount for a
project that changes financial risk.
 The marginal cost of capital is calculated and used to discount such projects.
MM THEORY IGNORING TAXATION:
Assumptions:
 There is a perfect capital market in which investors have the same information and also act rationally.
 There is no taxation and debt is risk-free (freely-available) to both companies and investors.
 There are no transaction costs involved in buying or selling shares or debt capital.
MM argued that if corporate taxation is ignored, the total market value of a company is determined by just
two factors:
 The total earnings of the company; and
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
 The business risk of the company, which determines the WACC. WACC is not affected by financial
gearing, but it is affected by the perceived business risk of investing in the company. WACC is higher
for companies with higher business risk.
 Therefore, market values of companies in the same industry should be strictly in proportion to their net
operating income.
They argued that an increase in financial gearing will have the following effect:
 As the level of gearing increases, there is a greater proportion of cheaper debt capital in the capital
structure of the firm. However, the cost of equity rises as gearing increases.
 As gearing increases, the net effect of the greater proportion of cheaper debt and the higher cost of
equity is that the WACC remains unchanged. The effect of the higher cost of equity is exactly equal to
the offsetting effect of having a larger proportion of debt capital in the capital structure.
 The WACC is the same at all levels of financial gearing.
 The total value of the company (MVe + MVd) is therefore the same at all levels of financial gearing.
MM concluded that there is no optimum level of gearing a company should achieve.
MM Formulae: no taxation
WACCG = WACCU
MVG = MVU
Keg = Keu + (D/E) x (Keu – Kd)
Note: Changes in financial risk (D/E
ratio) do not affect the WACC of the Company. Therefore, WACC can be used as a discount rate for a project
that affects financial risk, provided business risk is the same.
MM THEORY ALLOWING FOR TAXATION:
MM argued that allowing for corporate tax relief (tax shield) on interest, an increase in gearing will have the
following effect:
 As the level of gearing increases: there is a greater proportion of cheaper debt capital in the capital
structure of the firm. However, the cost of equity rises as gearing increases.
 the net effect of the greater proportion of cheaper debt and the higher cost of equity is that the WACC
becomes lower. Increases in gearing therefore result in a reduction in the WACC.
 The WACC is at its lowest at the highest practicable level of gearing.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
 There are practical limitations on gearing that stop it from reaching very high levels. For example,
lenders will not provide more debt capital except at a much higher cost, due to the high credit risk or
insolvency risk.
The conclusions that MM reached were that:
 The total value of a geared company is higher than for an identical all-equity company by the amount
of tax shield. This benefit accrues to the shareholders of the geared Company and is reflected in the
market value of Equity of the Company.
 There is an optimum level of gearing that a company should be trying to achieve. A company should
be trying to make its gearing to the maximum practicable level, in order to maximise its value.
MM
formulae:
with
taxation
𝐌𝐕𝐠 = 𝐌𝐕𝐮 + (𝐃 𝐱 𝐭)
𝐊 𝐞𝐠 = 𝐊 𝐞𝐮 + (𝐊 𝐞𝐮 − 𝐊 𝐝 ) 𝐱
𝐖𝐀𝐂𝐂𝐠 = 𝐊𝐞𝐮 [𝟏 −
𝐃(𝟏 − 𝐭)
𝐄
𝐃𝐱𝐭
]
𝐄+𝐃
Note: Changes in financial risk (D/E ratio) do affect the WACC of the Company. Therefore, WACC can not
be used as a discount rate for a project that affects financial risk.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
RISK AND INVESTMENTS – PORTFOLIO THEORY
SINGLE ASSET PORTFOLIO
Return of a single asset portfolio
Risk of a single asset portfolio
Weighted average of probable returns [ ∑ x /n ], [ ∑ Px ]
Standard deviation from expected return (volatility of probable
returns)
Standard Deviation:
σA = √∑ P (R A − ̅̅̅̅
R A )2
σA
P
RA
̅̅̅̅
RA
Standard deviation or risk
Probability
Adjusted probable return
Expected Return (weighted average of probable returns)
TWO-ASSET PORTFOLIO
Return from a two-asset portfolio:
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
Risk of a two-asset portfolio:
CORRELATION COEFFICIENT OF INVESTMENT RETURNS:
Correlation coefficient =
Covariance
σA x σB
Correlation coefficient =
∑ P(R A − ̅̅̅̅
R A )(R B − ̅̅̅̅
RB)
σA x σB
Covariance = ∑ P(R A − ̅̅̅̅
R A )(R B − ̅̅̅̅
RB)
DIVERSIFICATION / RISK MITIGATION:
 A correlation coefficient can range from +1 (perfect positive correlation) to – 1 (perfect negative
correlation) whereas close to zero indicates very little correlation between investment returns.
 When returns in a portfolio are positively correlated, this means that when the returns from one of the
investments is higher than expected, the returns from the other investments will also be higher than
expected.
 When returns from two different investments in a portfolio are negatively correlated, this means that
when the returns from one of the investments is higher than expected, the returns from the other
investment will be lower than expected.
 Investment risk is reduced most effectively by having investments in a portfolio whose returns are
negatively correlated, or where there is not much correlation (diversification).
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
THREE-ASSET PORTFOLIO
Return of a three-asset portfolio:
The expected return from a three-asset portfolio is the weighted average of the returns from the three
investments.
RP = (RA x WA) + (RB x WB) + (RC x WC)
RA / RB / RC = Return from individual securities
WA / WB / WC = Weight of security in the portfolio
Risk of a three-asset portfolio:
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
CAPITAL ASSET PRICING MODEL (CAPM)
SYSTEMATIC AND UNSYSTEMATIC RISK
 The total risk involved in holding securities (shares) divides into risk specific to the company
(unsystematic) and risk due to variations in market activity (systematic).
 Systematic risk includes, for example, the risk that the market crashes as a result of a global recession,
war or natural catastrophe. It cannot be diversified away.
 Non-systematic or unsystematic risk applies to a single investment or class of investments, and can be
reduced or eliminated by diversification.
SYSTEMATIC RISK AND THE CAPM
CAPM FORMULA
RA = Rf + (Rm – Rf ) x β
Whereas
RA
= Required return of the security/portfolio
Rf
= Risk free rate
Rm
= Market return
β
= Beta factor of the security/portfolio
Rm - Rf = Equity Risk Premium
Beta can be calculated as follows:
𝛔
𝐀
𝑺
×𝛔
𝛃 = 𝐒𝐘𝐒
OR
𝛃 = 𝐀𝐌 𝐀
𝛔𝐦
Whereas
σm
σA
σSYS A
SAM
CoVAM
SAM x σA x σm
Beta Factors
1
0
Less than 1
More than 1
𝛔𝐦
OR
𝛃=
𝐂𝐨𝐕𝐀𝐌
𝛔𝐦𝟐
OR
𝑺
𝛃 = 𝐀𝐌
× 𝛔𝐀 × 𝛔𝐦
𝛔𝐦𝟐
= Market risk
= Total risk of a security
= Systematic risk of a security
= Correlation Coefficient of security with the market
= Covariance of security with the market
= Covariance of security with the market
This is the measurement of systematic risk for the stock market as a whole.
This is the systematic risk for risk-free investments. Returns on risk-free
investments are unaffected by market risk and variations in market returns.
Systematic risk is lower than for the market on average.
Systematic risk is higher than for the market on average.
The beta factor reflects the fact that different market sectors, and individual companies within each market
sector, are exposed to different degrees of systematic risk.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
Alpha (α) = Actual expected return – CAPM return
 If alpha is +ve – it means investment is viable.
 If alpha is -ve, it means investment is detrimental.
 If alpha is nil, it means investment is only offering return exactly equal to what is required on the basis
of its systematic risk.
TREYNOR RATIO
This is also called the reward to volatility ratio.
SHARPE RATIO
This is also called the reward to variability ratio.
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
RISK ADJUSTED WACC:
If the business risk of the new project is different from the business risk of a company's existing operations,
the company's shareholders will expect a different return to compensate them for this new level of risk.
Hence, the appropriate WACC, which should be used to discount the new project’s cash flows, is not the
company's existing WACC, but a ‘risk-adjusted’ WACC, which incorporates this new required return to the
shareholders (Cost of Equity).
Calculating a risk-adjusted WACC:
 Find the appropriate equity beta (βe) from a suitable quoted company.
 Adjust the available equity beta to convert it to an asset beta (βa) degear it.
 Re-adjust the asset beta to reflect the project’s own financial risk/gearing levels (D/E ratio) and regear
the beta equity (βe).
 Use the regeared beta equity (βe) to find the project specific Cost of Capital (Ke).
 Use this Ke and Kd to find the WACC. This is the (project specific) risk adjusted WACC.
 Evaluate the project with the risk adjusted discount rate.
BETA
Asset Beta (also known as unlevered beta) is the beta of a company without the impact of debt. It is also
known as the volatility of returns for a company, without taking into account its financial leverage. It
compares the risk of an unlevered company to the risk of the market.
𝛃𝐚 = 𝛃𝐞 ×
𝐄
𝐃
+ 𝛃𝐝 ×
𝐄 + 𝐃 (𝟏 − 𝐭)
𝐄 + 𝐃 (𝟏 − 𝐭)
All companies in same industry sharing same business risk should have same asset beta.
Equity beta (βe) is also known as geared beta or company beta. It is the beta of a geared company and it
represents both business risk & financial risk. It denotes the risk of the shareholders.
Debt beta (βd) approximates to zero mostly. Therefore, the formula of beta asset simplifies to:
𝛃𝐚 = 𝛃𝐞 ×
Always a mentor | Muzzammil Munaf
𝐄
𝐄 + 𝐃 (𝟏 − 𝐭)
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
RIGHTS ISSUE
A rights issue is a large issue of new shares to raise cash by a listed company. It involves offering the new
shares to existing shareholders in proportion to their existing shareholding.
FURTHER ISSUE OTHER THAN RIGHT ISSUE: Members may decide to issue shares other than a rights
issue, by way of a special resolution passed by them in a general meeting, generally termed as a public
offering.
THE ISSUE PRICE: The share price of the new shares in a rights issue or further issue shall be determined
by the Company. There are no set guidelines for it, however, they are generally issued at a 10-15% lower
value than the market value.
For example, a company planning a 1 for 4 rights issue when the market price of its shares is Rs. 900, might
offer the new shares in the rights issue at a fixed price in the region of Rs 800 to Rs 860.
THEORETICAL EX-RIGHTS PRICE: A theoretical ex-rights price (TERP) is the market price that a stock will
theoretically have following a new rights issue.
Old no of shares
No of further issued shares
Total no of shares post issue (A)
xxx
xxx
xxx
The market value of existing shares (No of shares x market value before issue)
Amount raised by further issue (No of further shares x issue price)
The ex-right market value of total shares (B)
xxx
xxx
xxx
Theoretical ex-right price (B / A)
xxx
YIELD ADJUSTED THEORETICAL EX-RIGHTS PRICE
Normally we presume that when we do a rights issue, the money from it generates the same rate of return
as existing funds. But, if the new money raised is likely to earn a different return from the current return (i.e.
+ve NPV from the new project), the yield-adjusted TERP should be calculated.
Old no of shares
No of further issued shares
Total no of shares post issue (A)
xxx
xxx
xxx
The market value of existing shares (No of shares x market value before issue)
Amount raised by further issue (No of further shares x issue price)
Impact of positive NPV (new projects from further issue) [yield adjustment]
The ex-right market value of total shares (B)
xxx
xxx
xxx
xxx
Yield adjusted theoretical ex-right price (B / A)
xxx
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
DIVIDEND POLICY
THEORIES OF DIVIDEND POLICY
Three of these theories are:
 The traditional view of dividend policy.
 Residual theory; and
 Modigliani and Miller’s dividend irrelevance theory
TRADITIONAL VIEW OF DIVIDEND POLICY
The traditional view of dividend policy is that the amount of dividend should be at a level that enables the
company to maximize the value of its shares.
RESIDUAL THEORY OF DIVIDEND POLICY
The residual theory of dividend policy is that the optimal amount of dividends should be decided as follows.
 If a company has capital investment opportunities that will have a positive NPV, it should invest in them
because they will add to the value of the company and its shares.
 The capital to invest in these projects should be obtained internally (from earnings) if possible.
 The amount of dividends paid by a company should be the residual amount of earnings remaining after
all these available capital projects have been funded by retained earnings.
 In this way, the company will maximize its total value and the market price of its shares.
MODIGLIANI AND MILLER’S DIVIDEND IRRELEVANCE THEORY
 Modigliani and Miller (MM) developed a theory to suggest that dividend policy is irrelevant, and the
level of dividends paid out by a company does not matter.
 The total market value of a company will be the same regardless of whether the dividend payout ratio
is 0%, 100%, or any ratio in between.
 MM argued that the value of a company’s shares depends on the rate of return it can earn from its
business. ‘Earning power’ matters, but dividends do not.
LINTNER MODEL:




A model theorizing how a publicly-traded company sets its dividend policy.
The model states that dividends are paid according to two factors.
The first is the net present value of earnings, with higher values indicating higher dividends.
The second is the sustainability of earnings; that is, a company may increase its earnings without
increasing its dividend payouts until managers are convinced that it will continue to maintain such
earnings.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
 An adjustment factor is applied to the dividends as per the payout ratio – as per the managers and
directors of the Company. It may vary year on year based on future profitability expectations.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
INVESTMENT APPRAISAL
ACCOUNTING RATE OF RETURN:
𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐢𝐧𝐠 𝐑𝐚𝐭𝐞 𝐨𝐟 𝐑𝐞𝐭𝐮𝐫𝐧 (𝐀𝐑𝐑) =
* Average Investment Value =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭 (𝐩𝐞𝐫 𝐚𝐧𝐧𝐮𝐦)
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 ∗
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐂𝐨𝐬𝐭+𝐑𝐞𝐬𝐢𝐝𝐮𝐚𝐥 𝐕𝐚𝐥𝐮𝐞
𝟐
+ 𝑾𝒐𝒓𝒌𝒊𝒏𝒈 𝑪𝒂𝒑𝒊𝒕𝒂𝒍
Rule of thumb:
If ARR is equal to or greater than the target/benchmark rate of return, the project is acceptable otherwise
should be rejected.
PAYBACK PERIOD:
The payback period refers to the amount of time it takes to recover the cost of an investment. Simply put,
the payback period is the length of time an investment reaches a break-even point.
The desirability of an investment is directly related to its payback period. Shorter paybacks mean more
attractive investments.
Discounted payback period – It represents the amount of time by which the investment will reach its
breakeven by using PV of Cashflows.
If cashflows are uneven then, the fraction of last year will be calculated as:
𝐔𝐧𝐜𝐨𝐯𝐞𝐫𝐞𝐝 𝐚𝐦𝐨𝐮𝐧𝐭 𝐨𝐟 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐫 𝐏𝐕 𝐨𝐟 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰
𝐓𝐨𝐭𝐚𝐥 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐫 𝐏𝐕 𝐨𝐟 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐟𝐨𝐫 𝐭𝐡𝐚𝐭 𝐲𝐞𝐚𝐫
Note: The above fraction will give the answer in years if you want to convert this fraction into months / days
then multiply it with 12 and 365 respectively.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
DISCOUNTED CASH FLOW METHOD:
Points to remember
Cash flows - future and incremental
Sunk costs to be ignored.
Cash flows - direct consequence
Interest costs to be ignored.
Incremental working capital
Discount rate has impact of interest costs.
Non cash items to be ignored
Impact of inflation (specific/general)
Depreciation/tax payments and savings
Depreciation/tax payments and savings
Net present value (NPV) is the difference between the present value of cash inflows and the present value
of cash outflows over a period of time.
 It is used to calculate the total value today of a future stream of payments.
 If the NPV of a project or investment is positive, it means that the project or investment will be viable,
and therefore attractive. Vice versa for the negative NPV.
 If NPV is zero, the project can be undertaken because it is covering the Cost of capital.
 If NPV is negative, the project shall not be undertaken
The Internal Rate of Return (IRR) is a discount rate that makes the net present value (NPV) of all cash flows
equal to zero in a discounted cash flow analysis.
If a project IRR is equal to or higher than the minimum acceptable rate of return, it should be undertaken.
It the IRR is lower than the minimum required return, it should be rejected.
𝐈𝐑𝐑 = 𝐀% +
A% = Lower discount rate
NPVA = Positive NPV
𝐍𝐏𝐕𝐀
(𝐁% − 𝐀%)
𝐍𝐏𝐕𝐀 − 𝐍𝐏𝐕𝐁
B% = Lower discount rate
NPVB = Negative NPV
MODIFIED IRR:
Since the IRR assumes that the positive cashflows are reinvested at IRR, however this is not the case
practically, therefore The modified internal rate of return (MIRR) was introduced which assumes that positive
cash flows are reinvested at the company's cost of capital and that the initial outlays are financed at the
firm's financing cost.
𝐌𝐈𝐑𝐑 = (
Always a mentor | Muzzammil Munaf
𝐏𝐕𝐑
) (𝟏 𝐱 𝐫𝐞 ) − 𝟏
𝐏𝐕𝐈
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
PVR = the PV of the return phase (the phase of the project with cash inflows)
PVI = the PV of the investment phase (the phase of the project with cash outflows)
re = the cost of capital
ECONOMIC IRR:
The IRR ignores the impact of externality, therefore EIRR was introduce which takes into account the impact
of externalities in the calculation of required rate of return.
OTHER USEFUL CONCEPT & FORMULAE:
Inflation:
Real cashflows are uninflated cashflows whereas nominal cashflows are inflated or money cashflows.
Real cash flows are discounted by real rate whereas nominal cash flows are discounted by nominal rate. The
method to calculate real rate or nominal rate is as follows - Fisher effect formula
(𝟏 + 𝐧) = (𝟏 + 𝐫)(𝟏 + 𝐢)
i = general inflation rate
r = real rate
n = nominal rate
 If cashflows are post-tax, then After tax discount rate will be used.
 If cashflows are nominal, then Nominal discount rate will be used.
 If business risk and financial risk both are same, then existing WACC will be used. Otherwise Risk
Adjusted WACC will be used
 Tax depreciation and tax gain/loss on disposal are always nominal figures.
 Do not inflate Tax payments/savings, even if tax is in arrears
 Real cashflows can only be used when all cashflows of a year as well as the discount rate for that year
all are inflating by a same rate. Otherwise use nominal cashflows.
 Tax depreciation and tax gain/loss need to be deflated when using real cashflows option
Equivalent periodic rates:
(𝟏 + 𝐚) = (𝟏 + 𝐞𝐫)𝐞𝐧
a = annual rate
er = equivalent periodic rate (half yearly/quarterly/monthly)
en = no. of equivalent periods in one year
Perpetuity: P = R/I whereas ‘R’ is the constant cash flows and ‘i’ is the discount rate.
 For cashflows growing at a constant growth rate till infinity, use dividend growth model.
 When cashflows are Cyclical, then use Equivalent annual cashflows concept.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
CAPITAL RATIONING
SINGLE PERIOD CAPITAL RATIONING:
DIVISIBLE PROJECTS (there will be no surplus
cash left in this case)
INDIVISIBLE PROJECTS (any unused funds are
assumed to have been invested at only cost of
capital generating zero NPV)
Calculate Profitability Index by using the formula
PI = NPV/Initial Investment.
Rank each project on the basis of PI.
Allocate funds on the basis of ranking.
Calculate NPVs of all possible combination of
projects within the available capital limit and then
choose the combination with highest NPV. This
can be achieved through trial & error.
Mutually exclusive projects cannot be undertaken simultaneously.
MULTI-PERIOD CAPITAL RATIONING:
If there are only two projects the linear programming can be solved using graphical approach in the usual
way.
Step 1: Define variables.
Step 2: Construct an objective function
Step 3: Construct inequalities to represent the constraints.
Step 4: Plot the constraints on a graph
Step 5: Identify the feasible region. This is an area that represents the combinations of projects that are
possible in the light of the constraints.
Step 6: Identify the proportion of the projects that lead to the optimum value of the objective function.
Step 7: Quantify the optimum solution.
ASSET REPLACEMENT DECISIONS:
Objective is to find out replacement cycle with least PV of costs.
Equivalent Annual Cost Method
For each replacement option, compute PV of
cashflows of first cycle only.
Calculate Equivalent Annual cost by using PV
annuity formula.
Choose the option with least value.
To be used when cashflows follow cyclical pattern
i.e. when there is no inflation or single rate of
inflation.
Always a mentor | Muzzammil Munaf
LCM Method
Prepare cashflows of all replacement options for
number of years equal to LCM or for fairly long
period of time (25-30 years)
Calculate and compare PV of cashflows of all
options. The option with least PV of costs is the
best option.
To be used when cashflows don’t follow cyclical
pattern.
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
LEASE v/s BORROW DECISION:
Acquisition Decision
Cashflows will be prepared in the same manner
as for any project investment appraisal scenario.
We will assume that the asset will be purchased
by the company using available pool of funds (D
+ E). Accordingly, tax depreciation, tax gain or
loss will be incorporated for tax working.
Financing Cashflows will not form part of overall
cashflows for decision here.
Discounting will be done using company’s
appropriate Cost of Capital/ WACC/ Required
rate.
Financing Decision
Plot all relevant cashflows separately for both
option (Lease v/s Borrow & Buy) including
financing cashflows where relevant:
Discounting the cashflows under both options
with same incremental borrowing rate (IRR of the
loan)
The option with either higher +ve NPV or lower ve NPV (PV of costs) will be selected.
The financing decision is considered separately
from the investment decision.
If NPV is +ve then decision is favorable. If NPV is
-ve then decision is not favorable.
For acquisition decision take all cashflows of the project (only project related no financing cashflows) and
discount the same with After-tax Cost of capital/WACC:
For financing decision, follow the steps:
Step 1: Determination of Discount rate for lease or borrow decision
If tax is payable in the same year then, take the interest rate I on loan (incremental borrowing rate) as given
in the question. Make it after tax rate i.e. I x (1-t). this rate will be the IRR of loan and to be used as discount
rate.
If tax is payable in arrears then, calculate accurate IRR of the loan by plotting all loan cashflows including
tax savings on interest. This IRR of loan will be used as discount rate.
Step 2: Borrow or Buy Option
If cashflows for acquisition decision have already been plotted, then the net cashflows of acquisition
decision will be used without any further working.
If the question is just a financing question, then cashflows will be prepared similar to those of acquisition
decision.
Discount these Cashflows via IRR of loan
As discount rate being used is the IRR of loan so all loan cashflows when discounted with this rate will have
zero PV. Accordingly, there is no need to incorporate loan cashflows in the working.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
Step 3: Leasing Option
In preparing cashflows of this option include lease cashflows and also include all the operational
costs/savings as included under both the acquisition & borrowing decisions to ensure we are comparing
like with like.
Points to remember
Don’t include the initial investment under the leasing option. Instead include outflows of lease rentals also
include tax benefits on lease payments.
Don’t include tax savings on depreciation as tax benefit.
If security deposit is given in the question then include it and it will be an outflow at time 0.
If salvage vale is given in the question then Include it at end as an inflow net of any purchase cost for lessee.
If the rentals are payable quarterly/semi-annually then discount them using equivalent periodic rate but the
tax benefit will be discounted using annual rate.
Discount rate will be the IRR of loan
Step 4: Decision Making
Compare the two NPVs calculated. The option with comparatively higher +ve NPV or comparatively lower
-ve NPV (PV of costs) will be chosen.
SENSITIVITY ANALYSIS:
𝐒𝐞𝐧𝐬𝐢𝐭𝐢𝐯𝐢𝐭𝐲 𝐨𝐟 𝐚 𝐯𝐚𝐫𝐢𝐚𝐛𝐥𝐞 =
𝐍𝐏𝐕 𝐨𝐟 𝐭𝐡𝐞 𝐩𝐫𝐨𝐣𝐞𝐜𝐭
𝐏𝐕 𝐨𝐟 𝐚𝐥𝐥 𝐜𝐚𝐬𝐡𝐟𝐥𝐨𝐰𝐬 𝐨𝐟 𝐭𝐡𝐞 𝐯𝐚𝐫𝐢𝐚𝐛𝐥𝐞 (𝐧𝐞𝐭 𝐨𝐟 𝐭𝐚𝐱)
For example:
𝐒𝐞𝐧𝐬𝐢𝐭𝐢𝐯𝐢𝐭𝐲 𝐨𝐟 𝐯𝐨𝐥𝐮𝐦𝐞 /𝐜𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 =





𝐍𝐏𝐕 𝐨𝐟 𝐭𝐡𝐞 𝐩𝐫𝐨𝐣𝐞𝐜𝐭
𝐏𝐕 𝐨𝐟 𝐚𝐥𝐥 𝐜𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 (𝐧𝐞𝐭 𝐨𝐟 𝐭𝐚𝐱)
In case of tax in arrears, the tax effects will need to be discounted carefully.
Sensitivity of Project life means by what % the estimated project life may decrease to turn NPV zero.
Sensitivity of a Project Life = Project life – Discounted payback period / Project life
Sensitivity of a discount rate means at what discount rate the NPV of the project will be zer
Sensitivity of discount rate = (IRR of Project – Discount rate) / Discount rate
By this technique, we can also determine change required in a particular variable for a desired change in
NPV of the project.
% Change required in a variable = Desired Change in NPV of project / PV of all cashflows of the variable
(net of tax).
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
EXPECTED VALUES:
𝐄𝐗𝐏𝐄𝐂𝐓𝐄𝐃 𝐕𝐀𝐋𝐔𝐄 = 𝚺𝐏𝐗
VALUE OF PERFECT INFORMATION:
𝐕𝐀𝐋𝐔𝐄 𝐎𝐅 𝐏𝐄𝐑𝐅𝐄𝐂𝐓 𝐈𝐍𝐅𝐎𝐑𝐌𝐀𝐓𝐈𝐎𝐍
= 𝐄𝐗𝐏𝐄𝐂𝐓𝐄𝐃 𝐕𝐀𝐋𝐔𝐄 𝐖𝐈𝐓𝐇𝐎𝐔𝐓 𝐏𝐄𝐑𝐅𝐑𝐄𝐂𝐓 𝐈𝐍𝐅𝐎𝐑𝐌𝐀𝐓𝐈𝐎𝐍
+ 𝐄𝐗𝐏𝐄𝐂𝐓𝐄𝐃 𝐕𝐀𝐋𝐔𝐄 𝐖𝐈𝐓𝐇 𝐏𝐄𝐑𝐅𝐄𝐂𝐓 𝐈𝐍𝐅𝐎𝐑𝐌𝐀𝐓𝐈𝐎𝐍
SIMULATION :
Step 1: Allocate random numbers to each category
Step 2: Assign a value to each category level
Step 3: Generate a list of random numbers and select the category level that corresponds to each number
Step 4: Repeat for as many simulation as required
Step 5: use the simulated values as though they are the actual values occurring in the real system.
ADJUSTED PRESENT VALUE
BASE CASE NPV: THE INVESTMENT DECISION
Find the project ß asset
Calculate the base case discount
rate = Keu by putting the ß
asset in the CAPM formula
Caclulate the base case NPV
Once the base case NPV is identified, the PV of the financing is evaluated.
The financing decision
 issue costs
 tax relief
As all financing cash flows are low risk, they are discounted at either the Kd or the risk-free rate.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
Grossing up
A firm will know how much finance is required for the investment. Issue costs of finance will usually be
quoted on top. It will therefore be necessary to gross up the funds to be raised.
PV of debt issue costs
As always, calculations involving debt must take account of the tax effects.
Equity issue costs
Not tax deductible
Debt issue costs
Are tax deductible
Issue Costs
Method:
Issue costs at To
PV of the tax relief (issue costs x tax rate x discount factor)
PV of the issue costs
(XXX)
XXX
(XXX)
PV of the tax relief on interest payments
The PV of the tax relief on interest payments is also known as the PV of the tax shield.
The method adopted depends on the information given:
Debentures – interest paid at a fixed amount each year
Annual tax relief = Total loan × interest rate × tax rate
Annuity factor for n years
Year one discount factor (if tax is delayed one year)
PV of the tax shield
XXX
XXX
XXX
XXX
The repayments will be made up of both interest and capital elements.
Step 1: Find the amount of the repayment
Annual amount = (Amount of the loan/Relevant annuity factor)
Step 2: Compute the annual interest charge.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
BUSINESS VALUATION
For debt valuation, refer the area of WACC where calculation of market value of multiple debt instruments
has been discussed.
For equity valuation, we have primarily two types of companies:
Quoted Companies already have a share price valuation: this is the current market price of the shares.
Unquoted Companies a business valuation may be carried out.
VALUATION MODELS
ASSET BASED VALUATION
Net asset value (Based on balance sheet value)
This approach uses the book values for assets and liabilities. These figures are readily-available from the
accounts ledgers of the company. However, noncurrent assets might be stated at historical cost less
accumulated depreciation, and this might bear no resemblance to a company’s current value.
Net Asset Value (Based on Net Realisable Value - NRV)
If net assets can be valued according to the disposal value of the assets, this would indicate the amount
that could be obtained for the shareholders of the company in the event that the company is liquidated
and its assets sold off.
Net Asset Value (Based on replacement value)
Replacement value measures the value of net assets at their cost of acquisition on the open market.
Note: All intangible assets are ignored unless they have a market value and they could be sold.
EARNINGS BASED VALUATION
P/E Ratio Method
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
Earnings Yield Method
Earnings Growth Model
Dividend Yield Model
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
CASH FLOW BASED VALUATION
Dividend valuation model
Dividend valuation model (with growth)
Shareholder value analysis
Shareholder value analysis estimates a value for the equity capital of a company by calculating the present
value of all future annual free cash flows to obtain a valuation for the entire company and then deducting
the value of the company’s debt capital.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
Free cash flow based valuation
Free cash flow is the amount before taking into account any transaction with debt or equity holders.
Free cash flows to the firm (FCFF)
Free cash flows to the firm:
Profit after tax
xxx
Add: Interest
xxx
Less: Tax on interest
(xxx)
xxx
Less: working capital investment
(xxx)
Add: non cash expenses
xxx
Less: Capital expenditure
(xxx)
Free cash flows to the firm
xxx
It will be discounted using WACC. After discounting Deduct the market value of debt (because it represents
the total value of the company i.e. its market value of Debt + Equity).
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
Free cash flows to the equity (FCFE)
Free cash flows to the equity:
Profit after tax
xxx
Less: working capital investment
(xxx)
Add: non cash expenses
xxx
Less: Capital expenditure
(xxx)
xxx
Add: Borrowing obtained
xxx
Less: Repayment
(xxx)
Free cash flows to the equity
xxx
OR
Free cash flows to the equity:
Free cash flows to the firm
xxx
Interest expense
(xxx)
Tax on interest expense
xxx
Add: Borrowing obtained
xxx
Less: Repayment
(xxx)
Free cash flows to the equity
xxx
It will be discounted directly by using Ke because it directly represents the cashflows available to the
shareholders unlike Free cashflows to company method because it represents the total cashflows available
to the financers of the business i.e. E+D.
EFFICIENT MARKET HYPOTHESIS
The more shareholder is knowledgeable, the more share price is accurate.
Weak form efficiency
 Shareholder is very less knowledgeable of the future of Company
 Share price is usually determined on the basis of historical value/performance.
 Shareholder is not usually aware of the future events unless publically announced.
 Share price given in the question will not have effect of merger/acquisition benefits.
Semi-strong form efficiency
 Partially knowledgeable.
 Those having inside information always get benefit of the future plans.
Strong form efficiency
 Shareholder is very knowledgeable of the future of Company.
 Share price usually has the impact of future value/performance.
 Shareholder is very well aware of the future events unless publically announced.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
 Share price given in the question will have effect of merger/acquisition benefits.
MERGERS AND ACQUISITIONS
A merger is in essence the pooling of interests by two
business entities which results in common ownership.
An acquisition normally involves a larger company (a
predator) acquiring a smaller company (a target).
Generally both referred to as mergers for PR reasons:
 It portrays a better message to the customers of the target
company.
 To appease the employees of the target company.
An alternative approach is that a company may simply purchase the assets of another company rather than
acquiring its business, goodwill, etc.
Methods of financing mergers
In general a purchaser and a vendor will need to agree on three basic issues in regard to an acquisition:
 Whether shares or assets are to be purchased.
 Type of consideration.
 Financial value.
Although determination of value is likely to take place prior to the decision on the type of consideration,
they are considered here in reverse order (see later chapter) as the complexity of valuation necessitates its
own chapter.
SHAREHOLDER GAIN ANALYSIS
Cash Consideration
Cash Received
xxx
Less: Current Selling Price
(xxx)
Gain to share holders
xxx
Share Exchange
Combined company share price
xxx
Less: Current Selling Price
(xxx)
Gain to existing shareholders
xxx
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
FOREX AND HEDGING:
EXCHANGE RATE:
An exchange rate is the value of a country's currency vs. that of another country or economic zone. Most
exchange rates are free-floating and will rise or fall based on supply and demand in the market. Some
currencies are not free-floating and have restrictions.
The word buying and selling is always used from the perspective of foreign exchange dealer/bank.
The rate at which the dealer buys is the Buying Rate (when a customer receives foreign currency as in case
of exports, the customer sells and dealer buys. The applicable rate will be buying rate).
The rate at which the dealer sells is the Selling Rate (when a customer has to make payment of foreign
currency as in case of imports, the customer buys and dealer sells (applicable rate would be selling rate).
Exchange Rates are quoted in two styles:
Direct Quote
Units of Local currency per unit of Foreign
currency. E.g. Rs/$
Buying will be on Selling will be on lower
higher rate.
rate.
Indirect Quote
Units of Foreign currency per unit of Local
currency. E.g. $/Rs
Buying will be on lower Selling will be on
rate.
higher rate.
The spot rate at time t0 is the price for delivery at t0. A forward rate at t0 is a rate for delivery at time t1.
This is different from whatever the new spot rate turns out to be at t1.
PURCHASE POWER PARITY THEORY:
𝐅𝐮𝐭𝐮𝐫𝐞 𝐬𝐩𝐨𝐭 𝐫𝐚𝐭𝐞𝐚/𝐛 = 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐒𝐩𝐨𝐭 𝐫𝐚𝐭𝐞𝐚/𝐛
Whereas
(𝟏 + 𝐢%𝐚 )
(𝟏 + 𝐢%𝐛 )
a and b are currencies
i%a and i%b are inflation rates of currencies a and b
INTEREST RATE PARITY THEORY:
𝐅𝐨𝐫𝐰𝐚𝐫𝐝 𝐫𝐚𝐭𝐞𝐚/𝐛 = 𝐒𝐩𝐨𝐭 𝐫𝐚𝐭𝐞𝐚/𝐛
Whereas
(𝟏 + 𝐫%𝐚 )
(𝟏 + 𝐫%𝐛 )
a and b are currencies
r%a and r%b are the interest rates of currencies a and b
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
FOREIGN EXCHANGE RISK AND HEDGING:
In the case of payment in foreign currencies, there is a risk that foreign currency might be appreciated
against local currency. And in the case of receipt in foreign currencies, there is a risk that foreign currency
might be depreciated against local currency.
How to hedge the foreign currency risk?
MATCHING LONG TERM ASSETS AND LIABILITIES
A company might also try to match assets and liabilities in the same currency, to reduce exposures to foreign
exchange risk.
MATCHING RECEIPTS AND PAYMENTS
When a company has receipts and payments in the same foreign currency due at same time, it can simply
match them against each other. It is then only necessary to deal on the foreign exchange markets (like
Forward contract) for the unmatched portion of the total transactions. The company can also invest its
foreign currency income in the country of the currency and make overseas payments with these assets.
NETTING
Unlike matching, netting is not technically a method of managing transaction risk. The objective is simply
to save transactions costs by netting off inter-company balances before arranging payment. Many
multinational groups of companies engage in intra-group trading. Where related companies located in
different countries trade with each other, there is likely to be inter-company indebtedness denominated in
different currencies.
In the case of bilateral netting, only two companies are involved. The lower balance is netted off against
the higher balance and the difference is the amount remaining to be paid.
Multilateral netting is a more complex procedure in which the debts of more than two group companies
are netted off against each other. There are different ways of arranging multilateral netting. The
arrangement might be co-ordinated by the company's own central treasury or alternatively by the
company's bankers.
The steps to be followed are:
 Construct a table with companies receiving money down the left side and companies making payments
across the top.
 Enter all the amounts each company owes to the others and convert to the agreed settlement currency.
 Add across and down the table to determine total receipts and total payments for each company.
 Determine the net receivable or payable for each company.
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
Note: For converting different currency amounts into common currency balances average of buying and
selling rates are used.
MONEY MARKET HEDGE
Future Payment in Foreign Currency
Steps
 Calculate the amount of foreign currency to be purchased and invested. (the amount of foreign currency
payment will be equal to Amount of Foreign currency invested + interest to be earned)
 Amount to be borrowed in local currency to purchase the foreign currency above. (by converting the
amount of foreign currency to be invested at spot rate)
 Total cost will be Amount borrowed + Interest paid
 Calculate the Effective rate (Total Cost / Foreign Currency Payment)
Note: Foreign currency payment will be made by the amount invested.
Future Receipt in Foreign Currency
Steps
 Calculate the amount of foreign currency to be borrowed. (the amount of foreign currency receipt will
be equal to Amount to be borrowed + interest to be paid)
 Amount borrowed will be converted into local currency at spot rate.
 The above amount of local currency will be invested.
 Total receipt will be Amount of local currency invested + interest earned.
 Calculate the Effective rate (Total Receipt / Foreign Currency Receipt).
Note: Amount of loan taken in foreign currency will be paid by the foreign currency receipt.
DERIVATIVES
FORWARD CONTRACT
 A forward contract is a contract with a bank that covers a specific amount of foreign currency for delivery
at an agreed date at an exchange rate agreed now.
 Forward contracts are over the counter (negotiated) & binding contracts.
 In case a forward contract cannot be honored, it has to be closed out. Close out is done by entering
into an opposite transaction of equal foreign currency at spot rate or respective forward rate. The close
out gain or loss is received or paid by the customer.
Concept of Premium and Discount
 In case of Direct quote, to calculate forward rate from a given spot rate:
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
Premium is added
Discount is deducted
 In case of Indirect quote, to calculate forward rate from a given spot rate:
Premium is deducted
Discount is added
FUTURES CONTRACT
A currency future is a standardized contract to buy or sell a fixed amount of currency at a fixed rate at a
fixed future date. It is the standardized that makes it possible to trade them on an exchange which in turn
increase liquidity.
Buying the futures contract means receiving the contract currency.
Selling the futures contract means supplying the contract currency.
Hedge set up (at the date of hedging)
Buy or Sell?
Do now what has to be done in future.
Which date contract to be selected?
Choose the one which maturity date is post transaction date and which is comparatively closer to the
transaction date too.
No. of contracts?
Use rounding off principle (actual transaction quantity / standard contract size)
Note: In case of indirect currency hedge, convert transaction amount into local currency first, using futures
rate.
HEDGE OUTCOME (AT THE TRANSACTION DATE)
Purchase / Sell actual transaction quantity at the spot rate on the date of transaction.
Close out futures contracts. This is done by doing an exactly opposite transaction in the futures market as
compared to what was done at the time of hedging. Close out gain/loss is received or paid by the customer
as the case may be.
Note: In case of indirect currency hedge, convert this futures market gain/loss amount into local currency
first, using spot rate at the date of transaction.
Actual outcome is the sum of spot market outcome and futures market gain/loss.
Hedge efficiency ratio can be calculated by: Futures market gain or loss / Spot market gain or loss
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
Basis and Basis Risk
 It is the difference between future price and the spot rate (Basis = Future price – Spot rate)
 Basis risk is the risk that the price of a currency future will vary from the price of the underlying asset
(the spot rate)
 It is assumed that the difference between the spot rate and futures price (the 'basis') falls over time but
there is a risk that basis will not decrease in this predictable way (which will create an imperfect hedge).
There is no basis risk when a contract is held to maturity.
 In the absence of specific information in examination, we assume that Basis reduces steadily/equally
over time.
Other Important Points
A future contract does not result in a perfect hedge (means actual outcome is not equal to target outcome)
usually because of following two factors:
1.
2.
Quantity Risk i.e. standard quantity under futures contract may not be exactly equal to the actual
transaction quantity.
Basis risk
Note: In case when these two risks are eliminated (Standard quantity is equal to transaction quantity & basis
is constant), the actual outcome would be exactly equal to target outcome.
A future contract involves payment of initial security deposit and periodic mark-to-market settlements. This
is done by exchange to manage credit risk.
If basis is greater than the sum of borrowing and transaction costs, then arbitrage gain is possible by
purchasing on spot and selling in futures market simultaneously.
OPTION CONTRACT
 An option contract is an agreement giving its holder a right but not an obligation to buy or sell specific
quantity of an item at a specific price (strike price/exercise price) within a stipulated / pre-defined time.
 An option to buy something is called “Call Option”
 An option to sell something is called “Put Option”
 Option contracts can be “over the counter” as well as “exchange traded”.
 Over the counter options are tailor-made options suited to a company’s specific needs. Traded options
are contracts for standardized amounts, only available in certain currencies.
 A ‘European style option’ can only be exercised on its maturity date while the ‘American style option’
can be exercised anytime on or before its maturity date.
 There are two parties to an option contract:
Writer (seller)- the party that bears the risk and so receives premium.
Holder (buyer)- the party that enjoys the right (with no obligation) and so pays premium.
 When an option is feasible to exercise then it is said to be ‘in the money’ if it is not feasible then it is
said to be ‘out of the money’.
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SUMMARY AND FORMULAE BOOK
 In deciding whether an option should be exercise or not, the premium paid is irrelevant it is only used
at end to calculate the actual transaction cost.
Hedge Set up (at the date of hedging)
Call option or Put option?
Do now what has to be done in future.
Which date contract to be selected?
Select the one which has maturity date post transaction date and which is comparatively closer to the
transaction date too.
Which Strike/Exercise price?
In case of put option, it should be the one with maximum net receipt (strike price – premium). In case of
call option, it should be the one with minimum total cost (strike price + premium).
No. of contracts?
Use rounding off principle (actual transaction qty / standard contract size)
Notes
 In case of indirect currency options, convert transaction amount into local currency first, using strike
price of option.
 Calculate premium cost that needs to be paid on the basis of standard quantity under option contracts.
 In case of indirect currency options, convert premium cost into local currency using spot rate at the
date of hedging.
Hedge Outcome (at the transaction date)
 If exercise price is less than the spot rate on the transaction date then, exercise the option otherwise
the option will lapse.
 In case when option lapse, then purchase/sell actual transaction quantity at the spot rate on the date
of transaction.
 If it is feasible to exercise the option, then Purchase/Sell standard option quantity at the exercise price
and any difference between the actual quantity and the standard quantity has to be bought or sold at
spot rate on transaction date.
 When calculating the actual outcome, consider the amount of premium paid at the date of hedge.
 In case when option contract can be re-sold by the holder, then in deciding at the transaction date for
an in the money option, compare intrinsic value (Exercise price – Spot rate) with premium that can be
earned by selling the option. If intrinsic value is lower, sold the option. If intrinsic value is higher, exercise
the option.
 For an out of money option, if there is any premium on re-sale, then it is better to avail it by selling the
option.
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
SUMMARY AND FORMULAE BOOK
INTEREST RATE RISK:
 Increase in interest rates in case of expected future borrowing, upcoming roll over of fixed rate loan or
upcoming re-pricing of variable rate loan.
 Decrease in interest rates in case of expected future deposit, upcoming roll over of fixed rate deposit
or upcoming re-pricing of variable rate deposit.
HEDGING METHODS
Forward rate agreements (FRAs);
An FRA, like a forward exchange contract, is a binding agreement between a bank and a customer. It is an
agreement that fixes an interest rate ‘now’ for a future interest period.
 An FRA for an interest period starting at the end of month 3 and lasting until the end of month 9 is a
3v9 FRA or a 3/9 FRA.
 Similarly, an FRA for a three-month period starting at the end of month 2 is a 2v5 FRA or a 2/5 FRA.
Buying and selling FRAs: FRAs are bought and sold.
 If a company wishes to fix an interest rate (cost) for a future borrowing period, it buys an FRA. In other
words, buying an FRA fixes a forward rate for short-term borrowing.
 If a company wishes to fix an interest rate (income) for a future deposit period, it sells an FRA. Selling
an FRA fixes a forward rate for a short-term deposit.
The counterparty bank sells an FRA to a buyer and buys an FRA from a seller.
How an FRA works: An FRA works by comparing the fixed rate of interest in the FRA agreement with a
benchmark rate of interest, such as KIBOR or LIBOR. The comparison takes place at the beginning of the
notional interest period for the FRA.
 If the FRA rate is higher than the benchmark rate (KIBOR), the buyer of the FRA must make a payment
to the seller of the FRA, in settlement of the contract
 If the FRA rate is lower than the benchmark rate (KIBOR), the buyer of the FRA receives a payment from
the seller of the FRA, in settlement of the contract.
The amount of the payment is calculated from the difference between the FRA rate and the benchmark rate
(Libor, Kibor etc) applied to the notional principal amount for the FRA and calculated for the length of the
interest period in the agreement.
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SUMMARY AND FORMULAE BOOK
INTEREST RATE SWAPS
In a swap agreement, the parties agree to exchange ‘interest payments’ on a notional amount of principal,
at agreed dates throughout the term of the agreement. The interest rate payments that are exchanged in a
‘coupon swap’ are as follows:
 One party to the swap pays a fixed rate (the swap rate).
 The other party pays interest at a reference rate or benchmark rate for the interest period, such as
KIBOR.
The purpose of an interest rate swap is to:
 swap a variable rate of interest payment (or receipt) into a fixed interest rate payment (or receipt); or
 swap a fixed rate of interest payment (or receipt) into a variable rate of interest payment (or receipt).
CREDIT ARBITRAGE
 Step 1: Identify the potential saving (if any).
 Step 2: Decide on how the saving is to be shared and the expense that should be achieved after the
swap.
 Step 3: List the interest on the actual borrowings in a column for each company.
 Step 4: Write the total interest that should be achieved after the swap for each company as the totals
in the columns.
 Step 5: Set one payment under the swap to reduce the recipient’s cost to zero.
 Step 6: Set the second payment so as to increase the nil cost of the first recipient to its expected total
expense (see step 2).
INTEREST RATE FUTURES
 Interest rate futures are priced as 100 – interest rate therefore, if a future price is 94 it means interest
rate is 6%.
 The mechanism of Interest rate futures is fundamentally similar to Stock/Currency futures.
 In case of borrowing, Hedge strategy will be Sell now (at the date of hedge) and Buy later (at the date
of close out).
 In case of deposit, the Hedge strategy will be Buy now (at the date of hedge) and Sell later (at the date
of close out).
INTEREST RATE OPTIONS
Many interest rate options are arranged over-the-counter (OTC). These include:
 Borrowers’ options and lenders’ options; and
 Caps, floors and collars.
Options on interest rate futures are traded on the futures exchanges where the interest rate futures are also
traded.
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SUMMARY AND FORMULAE BOOK
INTERNATIONAL INVESTMENT APPRAISAL
 Step 1 : Estimate the project post tax cash flows in overseas currency
 Step 2: Convert the projected cash flow into home currency by using the exchange rate
 Step 3 : Discount the converted cashflows at the company’s cost of capital to arrive at the NPV
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SOURCES OF EQUITY FINANCE
SOURCES OF EQUITY FINANCE
SOURCES OF LONG-TERM AND SHORT-TERM FINANCE
Sources of finance and financial management
An important aspect of financial management is the choice of methods of financing for a company’s assets.
Companies use a variety of sources of finance and the aim should be to achieve an efficient capital structure
that provides:
 a suitable balance between short-term and long-term funding
 adequate working capital
 a suitable balance between equity and debt capital in the long-term capital structure.
Sources of short-term funds
Sources of short-term funding are used to finance some current assets. (In some cases, companies operate
with current liabilities in excess of current assets, but this is unusual.) Most of the usual sources of shortterm finance have been described in an earlier chapter on working capital. Briefly, these are:
 bank overdraft
 short-term bank loans
 suppliers (trade payables).
The main points to note about these sources of finance are as follows.
Bank overdraft
A company might arrange a bank overdraft to finance its need for cash to meet payment obligations. An
overdraft facility is negotiated with a bank, which sets a limit to the amount of overdraft that is allowed.
From the point of view of the bank, the company should be expected to use its overdraft facility as follows:
 The overdraft should be used to finance short-term cash deficits from operational activities. The
company’s bank balance ought to fluctuate regularly between deficit (overdraft) and surplus. There
should not be a ‘permanent’ element to the overdraft, and an overdraft should not be seen as a longterm source of funding.
 An overdraft facility is for operational requirements and paying for running costs. An overdraft should
not be used to finance the purchase of long-term (non-current) assets.
 The bank normally has the right to call in an overdraft at any time, and might do so if it believes the
company is not managing its finances and cash flows well.
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SOURCES OF EQUITY FINANCE
Short-term bank loans
Short-term bank loans might be arranged for a specific purpose, for example to finance the purchase of
specific items. Unlike an overdraft facility, a bank loan is for a specific period of time, and there is a
repayment schedule.
Trade payables
A company should try to negotiate favourable credit terms from its suppliers. Trade credit from suppliers
has no cost, and is therefore an attractive method of short-term finance. However, a company should
honour its credit arrangements and pay its suppliers on time at the end of the greed credit period. It is
inappropriate for a company to increase the amount of its trade payables by taking excess credit and making
payments late.
Debt factoring
Companies that use debt factors to collect their trade receivables might obtain financing for most of their
trade receivables from the factor. Factoring was explained in the earlier chapter on the management of
trade receivables. One of the services offered by a factor is to provide finance for up to 70% or 80% of the
value of outstanding trade receivables that the factor has undertaken to collect.
Operating leases
In some cases, operating leases might be an alternative to obtaining short-term finance. Operating leases
are similar to rental agreements for the use of non-current assets, although they might have a longer term.
(Rental agreements are usually very short term.).
Companies that obtain the use of non-current assets with operating lease agreements avoid the need to
purchase the assets and to finance these purchases with capital.
Operating leases might be used extensively by small and medium-sized business enterprises which find it
difficult to obtain finance to pay for non-current asset purchases.
Sources of long-term funds
Long-term funding is required for a company’s long-term assets and also to finance working capital. The
main sources of long-term capital are:
 equity finance
 debt finance
 lease finance (finance leases).
Debt finance and lease finance are dealt with in the next chapter.
For some companies, long-term finance might be provided in the form of venture capital. Venture capital
is described in the later chapter on sources of finance for small and medium-sized enterprises.
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SOURCES OF EQUITY FINANCE
Introduction to equity finance
Equity finance is finance provided by the owners of a company – its ordinary shareholders, also called equity
shareholders. (Some forms of irredeemable preference share might be regarded as equity finance, but in
practice irredeemable preference shares are rare in public companies.)
New equity finance can be raised by issuing new shares for cash, or issuing new shares to acquire a
subsidiary in a takeover. Methods of issuing new shares are described in the next section of this chapter.
For most companies, however, the main source of new equity finance is internal, from retained profits.
Internal sources of finance and dividend policy
When companies retain profits in the business, the increase in retained profits adds to equity reserves. The
retained capital, in principle, is reinvested in the business and contributes towards further growth in profits.
Increasing long-term capital by retaining profits has several major benefits for
companies.
 When new equity is raised by issuing shares, there are large expenses associated with the costs of the
issue. When equity is increased through retained earnings, there are no issue costs because no new
shares are issued.
 The finance is readily-available, without having to present a case to a bank or new shareholders.
Shareholder approval is not required for the retention of earnings.
However, there may be a limit to the amount of earnings available for retention. There are three main
reasons for this.
 The company might not earn large profits. Earnings can only be retained if the company is profitable.
 Retained earnings must be used efficiently, to provide a suitable return on investment. Unless retained
earnings contribute to future growth in earnings and dividends, shareholders will demand higher
dividends and lower earnings retention.
 Earnings are either retained or paid out to shareholders as dividends. By retaining earnings, a company
is therefore withholding dividends from its shareholders. A company might have a dividend policy, and
its shareholders might have expectations about what future dividends ought to be. Earnings retention
is therefore restricted by the constraints of dividend policy.
Dividend policy is considered in more detail in a later section of this chapter.
Long-term finance and working capital management Improvements in working capital efficiency can also
release cash. Efficient inventory management, collection of trade receivables and payment of trade payables
can reduce the requirement for working capital. A reduction in working capital generates a one-off
additional source of cash funding that can be used for investment.
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SOURCES OF EQUITY FINANCE
RAISING NEW EQUITY EXTERNALLY
Private companies and public companies: issuing new shares Companies can raise equity capital externally
by issuing new shares for cash, but the opportunity to do so is much more restricted for private companies
than for public companies.
Private companies and issuing shares for cash
Private companies cannot offer their shares for sale to the general investing public, and shares in private
companies cannot be traded on a stock market. They can sell shares privately to investors but it is usually
difficult to find investors who are willing to put cash into equity investments in private companies.
The existing owners of a company might not have enough personal capital to buy more shares in their
company. Existing shareholders are therefore a limited source of new capital.
Other investors usually avoid investing in the equity of private companies because the shares are not traded
on a stock exchange, and consequently they might be:
 difficult to value
 difficult to sell when the shareholder wants to cash in the investment.
Small companies and most medium-sized companies are private companies, and most are unable to raise
significant amounts of new equity capital by issuing shares. They rely on retained earnings for new equity
capital, but given their small size, profits are relatively small and this restricts the amount of retained profits
they can reinvest in the business.
Public companies and new share issues
Public companies may offer their shares to the general public. Many public companies arrange for their
shares to be traded on a stock market. The stock market can be used both as a market for issuing new
shares for cash, and also a secondary market where investors can buy or sell existing shares of the company.
The existence of a secondary market and stock market trading in shares means that:
 the shares of a company have a recognisable value (their current stock market price) and
 shareholders can sell their shareholdings in the market whenever they want to cash in their
shareholding.
However, before their shares can be traded on a stock exchange, a public company must:
 satisfy the regulatory authorities that the company and its shares comply with the appropriate
regulatory requirements, and appropriate information about the company and its shares will be made
available to investors, and
 obtain acceptance by the appropriate stock exchange for trading in the shares.
In Pakistan, there is a main stock market operated by the London Stock Exchange, and a secondary market
for shares in smaller companies, the Alternative Investments Market or AIM. (Companies wanting to have
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SOURCES OF EQUITY FINANCE
their shares accepted for trading on AIM must meet certain regulatory requirements, but these are not as
onerous as the requirements for companies on the main market.)
Electronic trading platforms for secondary market trading in shares have been developed and are capturing
a substantial proportion of the total volume of secondary market trading in shares of the major companies,
especially in the USA and the European Community.
Methods of issuing new shares for cash
There are three main methods of issuing new shares for cash:
 Issuing new shares for purchase by the general investing public: this is called a public offer.
 Issuing new shares to a relatively small number of selected investors: this is called a placing.
 Issuing new shares to existing shareholders in a rights issue.
Public offer
A public offer is an offer of new shares to the general investing public. Because of the high costs involved
with a public issue, these are normally large share issues that raise a substantial amount of money from
investors.
In many countries, including the UK and USA, a company whose shares are already traded on the stock
market cannot make a public offer of new shares without shareholder permission (which is unlikely to be
obtained, because existing shareholders would suffer a dilution in their shareholding in the company and
would own a smaller proportion of the company).
Instead, companies whose shares are already traded on the stock market will use a rights issue or a placing
when it wishes to issue new shares for cash. A public offer might be used to bring the shares of a company
to the stock market for the first time. The US term for this type of share issue is an Initial Public Offering or
IPO. The company comes to the stock market for the first time in a ‘stock market flotation’. In the UK, the
terms ‘prospectus issue’ and ‘offer for sale’ are also used to describe a public offer.
The shares that are offered to investors in an IPO might be a combination of:
 new shares (issued to raise cash for the company) and
 shares already in issue that the current owners are now selling.
Only the new shares issued by the company in the IPO will provide new equity capital for the company.
Example
Stabba is a company that is being converted from private to public company status and is planning a stock
market flotation with a public offer of shares.
In the flotation, the company wants to raise $800 million in cash for investment in its businesses. Issue costs
will be 5% of the total amount of capital raised. The company’s investment bank advisers have suggested
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that a share price of $8 to $9 per share should be sustainable after the flotation, and a suitable issue price
per share would therefore be $8.
Required
How many new shares should be issued and sold in the public offer?
Answer
 Cash required after issue costs (= 95% of cash raised): $800 million
 Capital required before issue costs deducted: $800 million/0.95 = $842.1 million
 Number of shares to issue to raise $842.1 million = $842.1m/$8 = 105,262,500.
Offer for sale by tender
In a normal public offer, the issue price for the new shares is a fixed price and the new shares are offered at
that price. With an offer for sale by tender, investors are invited to apply to purchase any amount of shares
at a price of their own choosing. The actual issue price for the new shares is the minimum price tendered
by investors that will be sufficient for all the shares in the issue to be sold. Offers for sale by tender are now
very uncommon.
Placing
A placing involves the sale of a relatively small number of new shares, usually to selected investment
institutions. A placing raises cash for the company when the company does not need a large amount of
new capital. A placing might be made by companies whose shares are already traded on the stock exchange,
but which now wishes to issue a fairly small amount of new shares.
The prior approval of existing shareholders for a placing should be obtained.
Stock exchange introduction
In a stock exchange introduction, a company brings its existing shares to the stock market for the first time,
without issuing new shares and without raising any cash. The company simply obtains stock market status,
so that its existing shares can be traded on the stock market.
The rules of the stock exchange might require that a minimum percentage of the shares of the company
should be held by the general investing public. If so, a stock exchange introduction is only possible for a
company that has already issued shares to the public but without having them traded on the stock market.
A stock market introduction is rare, but might be used by a well-established company (formerly a private
company) whose shares are now held by a wide number of individuals and institutions.
When a company makes a stock market introduction, it is able at some time in the future to issue new
shares for cash, should it wish to do so, through a placing or a rights issue.
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Rights issue
A rights issue is a large issue of new shares to raise cash, by a company whose shares are already traded on
the stock market.
Company law about rights issues varies between countries. In the UK, any company (public or private)
wishing to issue new shares to obtain cash must issue them in the form of a rights issue, unless the
shareholders agree in advance to waive their ‘rights’. Large new share issues by existing stock market
companies will therefore always take the form of a rights issue.
A rights issue involves offering the new shares to existing shareholders in proportion to their existing
shareholding. For example, if a company has 8 million shares in issue already, and now wants to issue 2
million new shares to raise cash, a rights issue would involve offering the existing shareholders one new
share for every four shares that they currently hold (2 million: 8 million = a 1 for 4 rights issue).
Rights issues are described in more detail in the next chapter.
Underwriting of new share issues
Large new issues of shares for cash are usually underwritten. When an issue is underwritten, a group of
investment institutions (the underwriters) agree to buy up to a maximum stated quantity of the new shares
at the issue price, if the shares are not purchased by other investors in the share issue. Each underwriter
agrees to buy up to a maximum quantity of the new shares, in return for an underwriting commission (an
agreed percentage of the issue value of the shares they underwrite).
The advantage of underwriting is that it ensures that there will be no unsold shares in the issue, and the
company can be certain of raising the expected amount of cash.
The main disadvantage of underwriting is the cost (the underwriting commission payable by the company
to the underwriters).
If a company does not want to pay to underwrite a rights issue, it might offer the new shares at a very low
price compared to the market price of the existing shares. The very low price should, in theory, attract
investors and ensure a successful share issue. This type of low-priced share issue is called a deep-discounted
issue.
Both public offers and rights issues are commonly underwritten.
Share repurchases
Instead of increasing their equity capital by issuing new shares, a company might repurchase some of its
equity shares and cancel them. The shares might be repurchased in the stock market, or bought back
directly from some shareholders. The effect of repurchasing shares and cancelling them is to reduce the
company’s equity capital, with a corresponding fall in cash.
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For example, suppose that a company has 200 million shares of $1 each (par value) in issue and the shares
have a market price of $3. It might repurchase 5 million shares at this market price and cancel them. The
cost of $15 million would result in a reduction in share capital and reserves of $15 million, and a reduction
in cash of $15 million. It would be left with 195 million shares in issue.
There two main reasons why a company might repurchase and cancel shares.
 It has more cash than it needs and the surplus cash is earning a low return. There is no foreseeable
requirement for the surplus cash. Buying back and cancelling some shares will therefore increase the
earnings per share for the remaining shares, and so might result in a higher share price for the remaining
shares. In this situation, the company is overcapitalised and share repurchases can bring its total capital
down to a more suitable level.
 Debt capital is readily-available and is cheaper than equity. A company might therefore repurchase
some of its shares and cancel them, and replace the cancelled equity with debt capital, by issuing new
corporate bonds or by borrowing from a bank. The result will be a capital structure with higher financial
gearing.
PREFERENCE SHARES
Near-debt
Near-debt is a term to describe finance that is neither debt nor equity, but is closer to debt in characteristics
than equity.
Various types of preference shares might be described as near-debt. They are not debt finance, but neither
are they equity. In financial reporting, preference shares are more likely to be shown in the statement of
financial position (balance sheet) as long-term liabilities, rather than equity, although this depends on the
characteristics of the shares.
Basic features of preference shares
The basic features of preference shares are as follows:
 Most preference shares are issued with a fixed rate of annual dividend. For example, a company might
issue 7% preference shares of $1, with dividends of $0.035 per share payable every six months
(dividends of $0.07 per $1 share every year). If the company’s annual profits rise or fall, the preference
dividend remains the same.
 Preference dividends are paid out of after-tax profits. Preference dividends, like equity dividends, do
not attract tax relief. This usually means that preference shares are a more expensive form of capital for
companies than debt finance.
 Preference shareholders will be entitled to receive dividends out of profits before any remaining profit
can be distributed to equity shareholders as equity dividends.
 If the company goes into liquidation, preference shareholders rank ahead of equity shareholders, but
after providers of debt finance, in the right to payment out of the proceeds from sale of the company’s
assets.
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Preference shares do not have any significant advantages for investors or for companies above straight
debt finance. They are fairly uncommon, except perhaps in companies financed largely by venture capital.
In financial reporting, preference shares might be shown in the statement of financial position (balance
sheet) as debt finance rather than equity, and preference share dividends are reported as interest costs in
the income statement if the preference shares are reported as debt. However, even if preference dividends
are reported as interest costs, they do not attract tax relief.
Types of preference shares
A company might issue different classes of preference shares. Each class of preference shares might have
different characteristics; for example one class of shares might pay a dividend of 5% and another might pay
a dividend of 6%; one class might be redeemable preference shares and another irredeemable shares, and
so on.
The different types of preference shares are summarised below.
 Redeemable preference shares are redeemable by the company, typically at their par value, at a
specified date in the future. Irredeemable preference shares are perpetual shares and will not be
redeemed.
 Cumulative preference shares are shares for which the dividend accumulates if the company fails to
make a dividend payment on schedule. For example, if a company fails to make a dividend payment to
its cumulative preference shareholders in one year, because it does not have enough cash for example,
the unpaid dividend is added to the next year’s dividend. The arrears of preference dividend must be
paid before any dividend payments on equity shares can be resumed. With non-cumulative preference
shares, unpaid dividends in any year do not accumulate, and will not be paid at a later date.
 Participating preference shares: These shares give their owners the right to participate, to a certain
extent, in excess profits of the company when it has a good year. The dividend rate is therefore not
necessarily fixed each year. For this reason, the coupon dividend rate tends to be lower than for other
types of preference shares.
Convertible preference shares: These are similar to convertible bonds. They give the shareholders the right
to convert their shares at a future date into a fixed quantity of equity shares in the company.
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SOURCES OF DEBT FINANCE
SOURCES OF DEBT FINANCE
USING DEBT CAPITAL
The nature of debt finance
The term ‘debt finance’ is used to describe finance where:
 the borrower receives capital, either for a specific period of time (redeemable debt) or possibly in
perpetuity (irredeemable debt)
 the borrower acknowledges an obligation to pay interest on the debt for as long as the debt remains
outstanding, and
 the borrower agrees to repay the amount borrowed when the debt matures (reaches the end of the
borrowing period).
For companies, the most common forms of debt finance are:
 borrowing from banks
 issuing debt securities.
Debt finance might be secured against assets of the borrower. When a debt is secured, the lender has the
right to seek repayment of the outstanding debt out of the secured asset or assets, in the event that the
borrower fails to make payments of interest and repayments of capital on schedule. The secured assets
provide a second source of repayment if the first source fails.
When a debt is unsecured, the lender does not have this second source of repayment in an event of default
by the borrower.
For both secured and unsecured debt, the borrower is usually required to give certain undertakings or
‘covenants’ to the lender, including an undertaking to make interest payments in full and on time. The
borrower will be in default for any breach of covenant, and the lenders will then have the right to take legal
action against the borrower to recover the debt.
Long-term, medium-term and short-term debt finance
Debt finance can be long-term, medium-term or short-term finance. For companies:
 long-term finance is usually obtained by issuing bonds. Bonds might also be called loan stock or
debentures.
 medium-term debt finance (with a maturity of up to about five or seven years) is usually in the form of
bank loans, but a company might also issue bonds with a maturity of just a few years. Medium-dated
bonds are often called ‘notes’.
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 short-term debt finance is usually in the form of a bank overdraft or similar bank facility. Large
companies might be able to obtain short-term debt finance in other ways, such as:
o by issuing short-term debt securities in the money markets as commercial paper, within a
commercial paper programme
o by arranging a ‘bills acceptances’ programme with a bank.
Irredeemable debt
Debt capital might be irredeemable or ‘permanent’. However, irredeemable debt is not common, and
virtually all debt is redeemable (or possibly convertible, see below).
Committed and uncommitted funds
Most debt finance is committed, which means that the lender has undertaken to provide the finance until
the agreed maturity of the debt. The borrower does not have the risk that the lender will demand immediate
repayment of the debt, without notice before the agreed maturity date.
Some lending is uncommitted, which means that the lender is not obliged to lend the money, and having
lent the money can demand immediate repayment at any time. A bank overdraft facility is normally
uncommitted lending by the bank, and the bank has the right to demand immediate repayment at any time.
A bank overdraft can therefore be a fairly risky type of borrowing for a company.
Interest payments
The frequency of interest payments varies according to the type of debt.
 For a bank loan or a bond, the interest payable is calculated on the full amount of the debt.
 For a bank overdraft (or a revolving credit with a bank), interest is charged only on the current overdraft
balance.
For example, if a company has a loan of $100,000, it will pay interest on the full amount of the loan. However,
if it has a bank overdraft facility of $100,000, it will pay interest only on the overdraft balance, typically with
interest charged on a daily basis.
The interest rate on most medium-term bank loans is a floating rate or variable rate. This means that the
rate of interest is adjusted for each successive payment period, according to any changes that have occurred
in the interest rate since the beginning of the previous interest period. Lending to companies is at either a
margin above the bank’s base rate or a margin above another reference rate of interest, such as the London
Inter-bank Offered Rate (LIBOR).
For example, the interest rate on a bank loan might be payable every six months at six-month LIBOR plus
1%. At the beginning of each six-monthly interest period, the interest for the period will be fixed at whatever
the current six-month LIBOR rate happens to be, plus 1%.
The interest rate on most bonds and notes is at a fixed coupon rate. The interest payable in each interest
period is a fixed amount, calculated as the fixed coupon percentage of the nominal value of the bonds. For
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example, if a company issues 6% bonds with interest payable every six months, the company will pay $3 for
every $100 nominal value of bonds every six months.
Tax relief on interest
Interest costs are an allowable expense for tax purposes. This can make debt finance an attractive ‘cheap’
source of finance.
Example
A company borrows $10 million at an interest cost of 5% per year. The rate of taxation is 30%.
The company will pay $500,000 each year in interest. Its tax payments to the government will be reduced
by $150,000 (30% × $500,000). The net cost of interest is therefore $350,000, and the after-tax cost of debt
is 3.5% ($350,000/$10 million, or 5% × (100 – 30)).
In comparison, dividends on shares are not an allowable cost for tax purposes. Dividends are paid out of
after-tax profits.
Straight debt
The term ‘straight debt’ means a fixed amount of redeemable debt at a fixed rate of interest.
For example, a company might issue $200 million of 6% bonds, with a maturity of 15 years. The company
will pay interest of $12 million each year on the bonds, for 15 years, and at the end of the 15 years, the
company will redeem the bonds, usually at par value or face value, and so would return $200 million to the
bondholders.
Access to the bond markets for companies
Many companies cannot borrow by issuing bonds in the bond markets. Private companies are prohibited
by law from offering bonds to the general public; therefore if these companies want to borrow, they must
seek a bank loan or find investors who are willing to invest in their bonds or loan notes.
Large public companies are able to raise capital by issuing bonds in the international bond markets, and
they usually pay to have their bonds given a credit rating by one or more credit rating agencies such as
Moody’s and Standard & Poor’s. Investment institutions are often prepared to invest in corporate bonds
with a good credit rating (an ‘investment grade’ rating) if the return (‘yield’) is attractive. Bonds in the
international markets are usually denominated in US dollars or euros, although there are some issues in
other currencies such as yen, Swiss francs and British pounds.
Smaller public companies outside the US find it more difficult to issue bonds in the bond market, because
the amount of debt they need to raise is often too small to interest major investors, and only major investors
buy bonds.
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There is a much larger market in the US for corporate bonds, denominated in US dollars. By offering a high
fixed rate of interest, companies are often able to issue bonds even though they are not ‘investment grade’
(i.e. ‘sub-investment grade bonds’ or ‘junk bonds’).
The secondary market in bonds is operated by bond dealers in banks, and the liquidity of the secondary
market is variable. Many investors in bonds hold them as long-term investments and do not acquire them
for short-term reasons. Unlike equity share prices, bond prices are generally fairly stable and do not offer
investors an opportunity for quick capital gains from buying and re-selling.
Debt finance and risk for the borrower
Although debt capital is cheap, particularly in view of the tax relief on interest payments, it can also be a
risky form of finance for a company.
 Lenders have a prior right to payment, before the right of shareholders to a dividend. If a company has
low profits before interest and a large amount of debt, the profits available for dividends could be very
small.
 There is always a risk that the borrower will fail to meet interest payments or the repayment of debt
principal on schedule. If a borrower is late with a payment, or misses a payment, there is a default on
the loan. A default gives the lenders the right to take action against the borrower to recover the loan.
In comparison with providers of debt capital, equity shareholders do not have similar rights for nonpayment of dividends.
Companies should therefore avoid excessive amounts of debt finance, because of the default risk. (However,
there are differing views about how much debt finance is ‘safe’ and how high debt levels can rise before the
capital structure of a company becomes too risky.)
CONVERTIBLE BONDS AND BONDS WITH WARRANTS ATTACHED
Sometimes, companies issue bonds with an equity element included or attached. These bonds are
sometimes called ‘hybrid debt’ securities, because they combine debt and equity features. (For financial
reporting purposes, companies are required to segregate the debt from the equity element in the statement
of financial position (balance sheet)).
The two main types of hybrid debt instrument are:
 convertible bonds, and
 bonds with equity warrants attached.
Convertible bonds
Convertible bonds are bonds that give their holder the right, but not the obligation, at a specified future
date to convert their bonds into a specific quantity of new equity shares.
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 If the bondholders choose to exercise the right, they will become shareholders in the company, but will
surrender their bonds.
 If the bondholders decide not to exercise their right to convert, the bonds will be redeemed at maturity.
Example
A company might issue $100 million of 3% convertible bonds. The bonds might be convertible into equity
shares after five years, at the rate of 20 shares for each $100 of bonds. If the shares are not converted, the
company will have the right to redeem them at par immediately. Alternatively, the bonds will be redeemed
after ten years. For the first five years, the company will pay interest on the convertible bonds. After five
years, the bondholders must decide whether or not to convert the bonds into
shares.
 If the market value of 20 shares is higher than the market value of $100 of the convertibles, the
bondholders will exercise their right and convert the bonds into shares. They will make an immediate
capital gain on their investment. For example, if the share price is $6, the bondholders will exchange
$100 of bonds for 20 shares, and the value of their investment will rise to $120.
 If the market value of 20 shares is lower than the market value of $100 of the convertibles, the
bondholders will not exercise their right to convert, and will hold their bonds until they are redeemed
by the company (which will be either immediately or at the end of the tenth year).
Conversion premium
When convertible bonds are first issued, the market value of the shares into which the bonds will be
convertible is always less than the market value of the convertibles.
This is because convertibles are issued in the expectation that the share price will rise before the date for
conversion. Investors will hope that the market value of the shares will rise by enough to make the market
value of the shares into which the bonds will be convertible higher than the value of the convertible as a
‘straight bond’.
The amount by which the market value of the convertible exceeds the market value of the shares into which
the bonds will be convertible is called the conversion premium.
Example
A company issues 4% convertibles bonds at a price of $101.50. The bonds will be convertible after six years
into equity shares at the rate of 30 shares for every $100 of bonds. The current market price of the
company’s shares is $2.50.
The market price of the bonds is $101.50 for every $100 face value of bonds.
The conversion premium is therefore $101.50 – (30 × $2.50) = $26 for every $100 of convertibles.
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Bonds with warrants attached
A company might issue bonds with share warrants attached.
Share warrants are a form of option, giving the holder of a warrant in a company the right, but not the
obligation, to subscribe for a specified quantity of new shares in the company at a future date, at a fixed
purchase price.
Example
A company might issue ten-year 4% bonds with warrants attached. Each $1,000 of bonds might give the
holder the right to subscribe for ten new shares in the company after four years, at a price of $5.50 per
share.
 If the share price is higher than $5.50 when the date for exercising the warrants arrives, the warrant
holder will exercise his right to buy new shares at $5.50.
 If the share price is less than $5.50 when the date for exercising the warrants arrives, the warrant holder
will not exercise the warrants, and will let his rights lapse.
Comparison of convertibles and bonds with warrants
Bonds with warrants attached are similar to convertibles, and the advantages of issuing them are similar.
The main difference between bonds with warrants and convertibles is that:
 With convertibles, the right to subscribe for equity shares is included in the bond itself, and if the bonds
are converted, the investor gives up the bonds in exchange for the equity shares.
 With bonds with warrants, the warrants are detachable from the bonds. The bonds are therefore
redeemed at maturity, in the same way as straight bonds. The warrants are separated from the bonds,
and the warrant holder either exercises the warrants to subscribe for new shares when the time to do
so arrives, or lets the warrants lapse.
Since warrants are detachable from the bonds, they can be traded separately. The right to subscribe for
new shares belongs to the owner of the warrants, not the bondholder. This means that an investor can
buy bonds with warrants attached when the company issues them, sell the warrants in the stock market
and retain the bonds.
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INTRODUCTION TO CAPITAL STRUCTURE
INTRODUCTION TO CAPITAL STRUCTURE
FINANCIAL GEARING
The UK term ‘gearing’ and the US term ‘leverage’ mean the same thing. They both refer to the fact that a
small change in one item can lead to a much bigger change in something else. The term ‘gearing’ is derived
from the mechanics of the motor car and the way in which a movement in a small gear wheel makes a much
bigger movement in a larger gear wheel. The term ‘leverage’ is derived from the idea that a small amount
of pressure at one end of a lever can move a much larger item at the other end of the lever.
In financial analysis, there are two types of gearing:
 Financial gearing, which is concerned with the way in which a small change in profits before interest
and tax can result in larger proportional changes in earnings (profits after tax).
 Operational gearing is concerned with the way in which a small change in sales revenue results in a
much greater proportional change in operating profits (profits before interest and tax).
Definition of financial gearing
The long-term capital of a company can be categorised as either equity capital or debt capital. Financial
gearing measures the extent to which a company is financed by debt capital. There are several ways of
measuring the financial gearing ratio. Unless you are given an instruction or a strong hint to do something
else in the examination, you should measure a financial gearing ratio as follows:
Either A:
𝐃𝐞𝐛𝐭 𝐂𝐚𝐩𝐢𝐭𝐚𝐥
𝐱 𝟏𝟎𝟎%
𝐄𝐪𝐮𝐢𝐭𝐲 𝐂𝐚𝐩𝐢𝐭𝐚𝐥
Or B:
𝐃𝐞𝐛𝐭 𝐂𝐚𝐩𝐢𝐭𝐚𝐥
𝐱 𝟏𝟎𝟎%
𝐄𝐪𝐮𝐢𝐭𝐲 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 + 𝐃𝐞𝐛𝐭 𝐂𝐚𝐩𝐢𝐭𝐚𝐥
Using definition (A), a company is said to be high-geared when debt capital exceeds equity capital, therefore
the ratio exceeds 100%. With definition (B), high gearing is indicated by a ratio above 50%.
An all-equity company has a financial gearing ratio of 0%.
Gearing can be measured either by:
 Value sin the statement of financial position (balance sheet values), in which case equity is the total of
equity share capital plus reserves, or
 current market values of equity and debt capital (with variable interest debt such as bank loans valued
at their face value and bonds valued at their current market price).
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INTRODUCTION TO CAPITAL STRUCTURE
For financial management purposes, capital gearing should normally be calculated using market values, not
book values (‘balance sheet values’). However, if an examination question gives you information about
values in the statement of financial position (balance sheet values), you should be prepared to calculate and
comment on financial gearing using the ‘balance sheet values’ provided.
Example
Company X has 1 million $1 ordinary shares with a current market price of $3 each. It is also financed by
$1million of 5% bonds with a current market value of 102.00 and $500,000 of bank loans.
What is the company’s financial gearing?
Answer
MV of equity = 1 million shares × $3 = $3 million
MV of debt = $1 million × (1.02) + $500,000 = $1,520,000
Gearing = $1,520,000m/($3 million + $1,520,000) = 33.6%.
The significance of financial gearing
If the level of financial gearing is high, the company might have difficulties in meeting its obligations to pay
interest and repay the debt capital on time. High gearing can therefore be risky, and a company should
avoid excessive debt and gearing above a level that it can comfortably afford.
Another feature of financial gearing is that with higher-geared companies, the earnings per share change
rises or falls by a much larger percentage amount, in response to increases or falls in operating profit (profit
before interest and tax). The following example illustrates this point.
Example
Two companies Entity A and Entity B are identical in every respect, with the exception of their capital
structure. Both Entities have assets of $1,000,000, and both have annual profits before interest and tax of
$100,000. However, Entity A is an all equity company, with 1,000,000 shares of $1, and Entity B is a 50%geared company, with 500,000 shares of $1 and $500,000 of 8% debt. The rate of taxation is 30%.
The earnings per share (EPS) of each company is calculated as follows:
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INTRODUCTION TO CAPITAL STRUCTURE
Now suppose that the profits before interest and tax increase by 50% to $150,000. The change in EPS will
be as follows:
The percentage change in the EPS in the geared company is greater than the percentage change in EPS in
the ungeared company.
This rule applies to financial gearing generally. When a company has some debt capital (i.e., has some
gearing), a percentage change in profits before interest and tax results in a larger percentage change in
EPS. The higher the gearing, the greater the percentage change in EPS will be.
Income gearing or interest gearing
Financial gearing is a ratio comparing the value of debt and the value of total capital or the value of equity.
Income gearing, also called interest gearing, measures annual interest charges as a percentage of profits
before interest and tax. It therefore shows what percentage of profits available to cover interest payments
are actually needed to make the interest payments. A ratio of 33% or more would probably be considered
very high.
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INTRODUCTION TO CAPITAL STRUCTURE
Example
A company made profits before interest and tax of $800,000. It has $5 million of 6% debt.
The income gearing ratio, or interest gearing ratio, is:
This ratio is high, indicating that the company might have too much debt finance for the amount of profits
that it is earning.
GEARING, RISK AND RETURN
Gearing and risk
High gearing is risky for equity investors. Risk can be defined as volatility in EPS. If an investor buys shares
in a company with high operational gearing and high financial gearing, EPS will be volatile. This means that
a relatively small percentage change in actual sales, above or below the expected or budgeted level, will
result in a much greater percentage change, up or down, in EPS.
Risk-seeking investors might want to invest in such companies, hoping that sales will be higher than
expected, and EPS much higher. An investor looking for fairly stable and predictable annual EPS will want
to avoid companies with high operational and financial gearing. They would prefer allequity companies in
which variable costs are a high proportion of total costs.
Gearing and return
To compensate them for the risk of high volatility in EPS, investors in a high-geared company will expect a
higher return on their investment than investors in a low-geared company.
For example, suppose that an investor could invest in shares at a cost of $10 per share, knowing for certain
that the annual EPS would be $1 or 10% every year. If the same investor could invest the same $10 in a
company with high operational and financial gearing, he would want to expect a return in excess of 10% to
compensate him for the higher risk. For example, he might expect a return of 14%. Because of the high
gearing, a fairly small change in annual sales above or below expectation will result in a much larger change
in EPS, and the actual EPS could turn out to be far more than 14%, but could also be much less.
Gearing and share prices
Higher gearing is riskier, and investors in high-geared companies will expect a higher return as
compensation for the risk. Gearing will also affect share prices, because share prices are linked to expected
return.
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
Table of Contents
WEIGHTED AVERAGE COST OF CAPITAL ........................................................................................................ 2
COST OF EQUITY, COST OF DEBT AND THE WEIGHTED AVERAGE COST OF CAPITAL (WACC) ........ 2
Cost of Equity Illustrations .........................................................................................................................13
Illustrations of irredeemable debt ............................................................................................................16
Illustrations of Redeemable debt: .............................................................................................................20
WACC Full Length Illustrations [All previous concepts combined] .....................................................25
ICAP SUMMER 2014: QUESTION ...............................................................................................................29
ICAP SUMMER 2014: SOLUTION ...............................................................................................................30
ICAP WINTER 2017: QUESTION .................................................................................................................31
ICAP WINTER 2017: SOLUTION .................................................................................................................32
ACCA F9 - 2013 JUNE: QUESTION .............................................................................................................34
ACCA F9 - 2013 JUNE: SOLUTION .............................................................................................................35
ACCA F9 DECEMBER 2017: QUESTION .....................................................................................................36
ACCA F9 DECEMBER 2017: SOLUTION .....................................................................................................37
ACCA F9 DINLA CO: QUESTION .................................................................................................................38
ACCA F9 DINLA CO: SOLUTION .................................................................................................................39
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WEIGHTED AVERAGE COST OF CAPITAL
WEIGHTED AVERAGE COST OF CAPITAL
COST OF EQUITY, COST OF DEBT AND THE WEIGHTED AVERAGE COST OF CAPITAL (WACC)
The cost of capital for investors is the return that investors require from their investment. Companies must
be able to make a sufficient return from their own capital investments to pay the returns required by their
shareholders and holders of debt capital. The cost of capital for investors therefore establishes a cost of
capital for companies.
 For each company there is a cost of equity. This is the return required by its shareholders, in the form
of dividends or share price growth.
 There is a cost for each item of debt finance. This is the yield required by the lender or bond investor.
 When there are preference shares, there is also a cost of preference share capital.
The cost of capital for a company is the return that it must make on its investments so that it can afford to
pay its investors the returns that they require.
The cost of capital for investors and the cost of capital for companies should theoretically be the same.
However, they are different because of the differing tax positions of investors and companies.
 The cost of capital for investors is measured as a pre-tax cost of capital
 The cost of capital for companies recognises that interest costs are an allowable expense for tax
purposes, and the cost of debt capital to a company should allow for the tax relief that companies
receive on interest payments, reducing their tax payments. The cost of debt capital for companies is
measured as an after-tax cost.
The weighted average cost of capital (WACC) is the average cost of all the sources of capital that a company
uses. This average is weighted, to allow for the relative proportions of the different types of capital in the
company’s capital structure.
WACC can be commonly calculated as:
𝐖𝐀𝐂𝐂 =
[(𝐌𝐕𝐞 𝐱 𝐊𝐞) + {𝐌𝐕𝐝 𝐱 𝐊𝐝(𝟏 − 𝐭)} + (𝐌𝐕𝐩 𝐱 𝐊𝐩)]
(𝐌𝐕𝐞 + 𝐌𝐕𝐝 + 𝐌𝐕𝐩)
Whereas:
MVe = Market Value of Equity
MVd = Market Value of Debt
MVp = Market Value of Preference Shares
t = Tax rate
Ke = Cost of Equity
Kd = Cost of Debt
Kp = Cost of Preference Shares
If interest payments are not tax-deductible (in a rare case), then the component of (1-t) will be eliminated.
Hence it will become:
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WEIGHTED AVERAGE COST OF CAPITAL
𝐖𝐀𝐂𝐂 =
[(𝐌𝐕𝐞 𝐱 𝐊𝐞) + (𝐌𝐕𝐝 𝐱 𝐊𝐝) + (𝐌𝐕𝐩 𝐱 𝐊𝐩)]
(𝐌𝐕𝐞 + 𝐌𝐕𝐝 + 𝐌𝐕𝐩)
WACC ILLUSTRATIONS
Illustration 1:
The capital structure of Cyan Limited is as follows:





Share Capital (5 million shares) valuing Rs 50 million.
Share Premium amounting to Rs 5 million.
Retained Earnings = 15 million.
Price to book value ratio = 1.8
Cost of equity = 18%
 Market value of debt = 45 million
 Cost of debt = 11%
Calculate WACC of the Company.
Solution 1:
Share Capital
Share premium
Retained Earnings
Total Equity (BV)
Price to book value
Total Equity (MV)
50,000,000
5,000,000
15,000,000
70,000,000
1.80
126,000,000
Debt (MV)
45,000,000
WACC
Equity
Debt
126,000,000
45,000,000
171,000,000
Price to book value = Price of equity/Book value of Equity
1.8 = Price of equity / 70,000,000
Price of equity = 70,000,000 x 1.8
Price of equity = 126,000,000
18%
11%
22,680,000
4,950,000
27,630,000
16.16% WACC
WACC = [(126 Mn x 18%) + (45 Mn x 11%)]/(126 Mn + 45 Mn)
WACC = 16.16%
Illustration 2:
Jameel Limited (JL) has in issue 8 million shares with a market value of Rs 7·16 per share. The return required
by the shareholders is 12%.
The Company also has in issue 8·5% bonds with a total nominal value of Rs 20 million and a cost of debt of
8.22%. The market value of each Rs 100 bond is Rs 103·42.
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
The Company is planning to invest a significant amount of money into a new business area with an IRR of
9.8%. Advise the company whether it can invest in the project or not.
Solution 2:
WACC
Equity
Debt
MV
57,280,000
20,684,000
77,964,000
Cost
12.00%
8.50%
WACC (8,631,740/77,964,000)
6,873,600
1,758,140
8,631,740
11.07%
Nominal value of bonds
20,000,000
Nominal value of one bond
Market value of one bond
100.00
103.42
Market value of bonds (20 Mn/100*103.42)
20,684,000
Illustration 3:
The capital structure of the Youth Avenue is as follows:
Share Capital = Rs 100 million
Retained Earnings and other reserves = Rs 40 million
Preference shares = Rs 40 million
Long term loan = Rs 50 million
Bank Overdraft = Rs 10 million
Price to book value ratio = 1.2 (ordinary shares)
All other sources of finances are stated at values equal to their market values.
Cost of Equity (Ke) = 16%
Cost of long-term debt (Kd) = 7%
Cost of preference shares (Kp) = 13%
Rate of bank overdraft = 5%
Calculate WACC of the Company.
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WEIGHTED AVERAGE COST OF CAPITAL
Solution 3:
Capital structure
Equity
Pref shares
Long term loan
Bank OD
MV
168,000,000
40,000,000
50,000,000
10,000,000
268,000,000
Cost
16%
13%
7%
5%
WACC (36.08 Mn / 268 Mn)
26,880,000
5,200,000
3,500,000
500,000
36,080,000
13.46%
OR it can be calculated through weightage of each item of capital structure
Capital structure
Equity
Pref shares
Long term loan
Bank OD
MV
168,000,000
40,000,000
50,000,000
10,000,000
268,000,000
Weight (MV/Total)
62.69%
14.93%
18.66%
3.73%
100.00%
Cost
16%
13%
7%
5%
Weight x Cost
10.03%
1.94%
1.31%
0.19%
13.46%
Illustration 4:
AMH Co wishes to calculate its current weighted average cost of capital for use as a discount rate in
investment appraisal.
Financial position extracts as at 31 December 2019
Total fixed assets = Rs 157 million
Net working capital = Rs 16 million
Long term debt = Rs 39 million
The price to book value ratio is 1.3 for ordinary shares whereas the book value of debt is equal to its market
value.
Cost of debt = 8%
Cost of equity = 12%
Required: Weighted Average Cost of Capital.
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WEIGHTED AVERAGE COST OF CAPITAL
Solution 4:
Working Capital = Current assets - Current Liabilities
NCA + CA = E + NCL + CL
NCA + CA - CL = E + NCL
NCA + CA - CL - NCL = E
157 + 16 - 39 = E
E = 134
Book value of equity
P/B ratio
Market value of equity
Market value of debt
WACC
Equity
Debt
134,000,000
1.30
174,200,000
39,000,000
MV
174,200,000
39,000,000
213,200,000
Cost
12.00%
8.00%
WACC (24.024 Mn / 213.2 Mn)
20,904,000
3,120,000
24,024,000
11.27%
COMPARING THE COST OF EQUITY AND COST OF DEBT
The cost of equity is always higher than the cost of debt capital. This is because equity investment in a
company is always riskier than investment in the debt capital of the same company.
 Interest on debt capital is often fixed: bondholders for example receive a fixed amount of annual interest
on their bonds. In contrast, earnings per share are volatile and can go up or down depending on
changes in the company’s profitability.
 Providers of debt capital have a contractual right to receive interest and the repayment of the debt
principal on schedule. If the company fails to make payments on schedule, the debt capital providers
can take legal action to protect their legal or contractual rights. Shareholders do not have any rights to
dividend payments.
 Providers of secured debt are able to enforce their security if the company defaults on its interest
payments or capital repayments.
 In the event of insolvency of the company and liquidation of its assets, providers of debt capital are
entitled to payment of what they are owed by the company before the shareholders can receive any
payment themselves out of the liquidated assets.
Since equity has a higher investment risk for investors, the expected returns on equity are higher than the
expected returns on debt capital.
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WEIGHTED AVERAGE COST OF CAPITAL
In addition, from a company’s perspective, the cost of debt is also reduced by the tax relief on interest
payments. This makes debt finance even lower than the cost of equity.
The effect of more debt capital, and higher financial gearing, on the WACC is considered in more detail
later.
THE CREDITOR HIERARCHY
The creditor hierarchy refers to the order in which proceeds are distributed in the event of a company
insolvency and winding up (liquidation of its assets).
 At the top of the hierarchy are secured creditors such as debenture holders and banks who are entitled
to unpaid interest and the principal outstanding on any loan.
 The next are unsecured creditors, such as providers of unsecured debt capital and trade payables.
 Next are preference shareholders, if the company has any preference shares in issue. If there are several
different classes of preference shares, their priority ranking for payment depends on their relative class
rights.
 Ordinary shareholders are at the bottom of the hierarchy and are only entitled to repayment of capital
once all debt holders and preference shareholders have been paid in full.
The further down the hierarchy a finance provider the greater the risk of loss of capital. The return required
in compensation therefore increases and the cost of equity will always exceed the cost of debt and
preference shares.
There is also a priority ranking for annual income.
 Providers of debt capital receive payment of interest out of the company’s profits before interest and
tax.
 Preference shareholders are paid dividends out of after-tax profits. If the company is unable to pay
preference dividends in any year, the unpaid dividend accumulates in he case of cumulative preference
shares, and the arrears of unpaid dividends must be paid in full before dividend payments to ordinary
shareholders can be resumed.
 Ordinary shareholders (equity shareholders) are paid dividends out of distributable profits at the
discretion of the company’s directors. For ordinary shareholders there is a risk that the dividends and
share price will be adversely affected by volatile earnings, and lower-than-expected annual profits.
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WEIGHTED AVERAGE COST OF CAPITAL
COST OF EQUITY
Methods of calculating the cost of equity
The cost of equity is the annual return expected by ordinary shareholders, in the form of dividends and
share price growth. However, share price growth is assumed to occur when shareholder expectations are
raised about future dividends. If future dividends are expected to increase, the share price will also increase
over time. At any time, the share price can be explained as a present value of all future dividend
expectations.
Using this assumption, we can therefore say that the current value of a share is the present value of future
dividends in perpetuity, discounted at the cost of equity (i.e. the return required by the providers of equity
capital). There are two methods that you need to know for estimating what the share price in
a company ought to be:
 the dividend valuation model
 the dividend growth model, sometimes called the Gordon growth model.
Each of these methods for obtaining a share price valuation uses a formula that includes the cost of equity
capital. The same models can therefore be used to estimate a cost of equity if the share price is known. In
other words, the dividend valuation model and dividend growth model can be used either:
 to calculate an expected share price when the cost of equity is known, or
 to calculate the cost of equity when the share price is known.
Another method of estimating the cost of capital is the capital asset pricing model or CAPM. This is an
alternative to using a dividend valuation model method, and it produces a different estimate of the cost of
equity. This is considered in the later chapters.
THE DIVIDEND VALUATION MODEL METHOD OF ESTIMATING THE COST OF EQUITY
If it is assumed that future annual dividends are expected to remain constant into the foreseeable future,
the cost of equity can be calculated by re-arranging the dividend valuation model as follows.
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 (𝐊𝐞) =
𝐂𝐨𝐧𝐬𝐭𝐚𝐧𝐭 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝
𝐌𝐚𝐫𝐤𝐞𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲
where:
 Ke is the cost of equity
 Constant dividend = the expected future annual dividend.
 Market value of equity is the ex-dividend share price.
The formula assumes that dividends are paid annually.
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WEIGHTED AVERAGE COST OF CAPITAL
Alternatively, the market value of equity shares can be calculated as:
𝐌𝐚𝐫𝐤𝐞𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 =
𝐂𝐨𝐧𝐬𝐭𝐚𝐧𝐭 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 (𝐊𝐞)
‘Ex dividend’ means that if the company will pay a dividend in the near future, the share price must be a
price that excludes this dividend.
For example, a company might declare on 1 March that it will pay a dividend of Rs 60 per share to all holders
of equity shares on 30 April, and the dividend will be paid on 31 May. Until 30 April the share price allows
for the fact that a dividend of Rs 60 will be paid in the near future and the shares are said to be traded ‘cum
dividend’ or ‘with dividend’. After 30 April, if shares are sold, they are traded without the entitlement to
dividend, or ‘ex dividend’. This is the share price to use in the cost of equity formula whenever a dividend is
payable in the near future and shares are being traded cum dividend.
Example
A company’s shares are currently valued at $8.20 and the company is expected to pay an annual dividend
of $0.70 per share for the foreseeable future. The cost of equity in the company can therefore be estimated
as:
 (0.70/8.20) = 0.085 or 8.5%.
Example
A company’s shares are currently valued at $8.20 and the company is expected to pay an annual dividend
of $0.70 per share for the foreseeable future.
The next annual dividend is payable in the near future and the share price of $8.20 is a cum dividend price.
The cost of equity in the company can therefore be estimated as:
 0.70/(8.20 – 0.70) = 0.70/7.50 = 0.093 or 9.3%.
Constant Dividend Illustration
A company is expected to pay an annual dividend of Rs 1.70 per share for the foreseeable future. The cost
of equity of the company is estimated at 9%. Find the market value of a share of the Company.
THE DIVIDEND GROWTH MODEL METHOD OF ESTIMATING THE COST OF EQUITY
If it is assumed that the annual dividend will grow at a constant percentage rate into the foreseeable future,
the cost of equity can be calculated by re-arranging the dividend growth model.
𝐊𝐞 =
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𝐃𝐨 (𝟏 + 𝐠)
+𝐠
𝐌𝐕
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WEIGHTED AVERAGE COST OF CAPITAL
where:





Ke is the cost of equity
do = the latest annual dividend for the year that has just been paid
g is the annual growth rate in dividends, expressed as a proportion (4% = 0.04, 2.5% = 0.025 etc.)
do (1 + g) is therefore the expected annual dividend next year
MV is the share price ex dividend.
The formula assumes that dividends are paid annually.
Alternatively, the market value can be computed as:
𝐌𝐕 =
𝐃𝐨 (𝟏 + 𝐠)
𝐊𝐞 − 𝐠
Example
A company’s share price is $8.20. The company has just paid an annual dividend of $0.70 per share, and the
dividend is expected to grow by 3.5% into the foreseeable future. The next annual dividend will be paid in
one year’s time. The cost of equity in the company can be estimated as follows:
Ke =
= 0.123 or 12.3%
Example
A company’s share price is $5.00. The next annual dividend will be paid in one year’s time and dividends are
expected to grow by 4% per year into the foreseeable future. The next annual dividend is expected to be
$0.45 per share. The next annual dividend = d (1 + g). The cost of equity in the company can be estimated
as follows:
Ke =
= 0.13 or 13%.
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WEIGHTED AVERAGE COST OF CAPITAL
CALCULATION OF GROWTH
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WEIGHTED AVERAGE COST OF CAPITAL
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WEIGHTED AVERAGE COST OF CAPITAL
Cost of Equity Illustrations
Illustration 1:
Latest dividend paid = Rs 9 per share
Reference dividend = Rs 7 per share
Time = 4 years
Ke = 14%
Calculate market value per share.
Solution 1:
MV = Do x (1+g) / (Ke - g)
MV = 9 x (1 + 6.48%) / (14% - 6.48%)
MV = 127.44
The MV per share of the Company is Rs 127.44.
g = (Latest div/Oldest Div)^(1/t) - 1
g = (9 / 7)^(1/4) - 1
g = 6.48%
Illustration 2:
Latest dividend paid = Rs 45 per share
Reference dividend = Rs 25 per share
Time = 5 years
Market value per share = Rs 366
Calculate the cost of equity.
Solution 2:
Ke = [Do (1 + g)/MV] + g
Ke = [45 x (1 + 12.47%)/366] + 12.47%
Ke = 26.3%
g = (Latest div/Ref div)^(1/time) - 1
g = (45/25)^(1/5) - 1
g = 12.47%
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WEIGHTED AVERAGE COST OF CAPITAL
Illustration 3:
Hassan Limited has in issue 8 million shares with a return of 8% required by the shareholders. A dividend of
Rs 62 per share for 2019 has just been paid. The pattern of recent dividends is as follows:
Year
Dividend
share (Rs)
2016
2017
2018
2019
55
58
59
62
per
Calculate market value of the Company’s share using dividend growth model.
Solution 3:
g = (62/55)^(1/3) - 1
g = 4.07%
MV = Do x (1 + g)/(Ke - g)
MV = 62 x (1 + 4.07%) / (8% - 4.07%)
MV = 1,642
Illustration 4:
STC Limited (STCL) wishes to calculate its current cost of equity. The following financial information relates
to STCL:
The ordinary shares of the Company have an ex div market value of Rs 470 per share and an ordinary
dividend of Rs 37 per share has just been paid. Historic dividend payments have been as follows:
Year
Dividend
share (Rs)
2016
2017
2018
2019
28
30
33
37
per
Calculate the cost of equity for ordinary shares of STC Limited.
Always a mentor | Muzzammil Munaf
Page 94 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
Solution 4:
Ke = [Do x (1 + g)/MV] + g
Ke = [D1 /MV] + g
g = (37/28)^(1/3) - 1
g = 9.74%
Ke = [37 x (1+9.74%) / 470] + 9.74%
Ke = 18.38%
Note: Capital Asset Pricing Model shall be discussed later.
COST OF DEBT CAPITAL
Each item of debt finance for a company has a different cost. This is because different types of debt capital
have differing risk, according to whether the debt is secured, whether it is senior or subordinated debt, and
the amount of time remaining to maturity. (Note: Longer-dated debt normally has a higher cost than
shorter-dated debt).
Cost of variable rate debt (floating rate debt)
The cost of debt can be calculated as either a pre-tax cost or an after-tax cost. Investors are interested in
the pre-tax cost. Companies that borrow are interested in the after-tax cost of debt, for the purpose of
calculating their cost of capital.
 The pre-tax cost of variable rate debt (also called floating rate debt), such as the cost of a bank loan, is
the current interest rate payable on the debt.
 The after-tax cost of variable rate debt is the pre-tax cost multiplied by a factor (1 – t), where ‘t’ is the
rate of tax on company profits.
For example, suppose that a company is currently paying interest at 6% on its bank loan of $10 million, and
the rate of tax on company profits is 25%. The pre-tax cost of the debt is 6% and the after-tax cost is 6 (1 –
0.25) = 4.5%.
For the purpose of calculating a weighted average cost of capital (WACC, explained later), the cost of the
debt would be its after-tax cost of 4.5% and its market value (for the purpose of weighting the cost of
capital) would be $10 million, which is the amount of the loan.
Cost of irredeemable fixed rate debt (perpetual bonds)
The cost of irredeemable fixed rate bonds, which might be described as perpetual
bonds, is calculated as follows:
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
𝐏𝐫𝐞 − 𝐭𝐚𝐱 𝐊𝐝 =
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭
𝐌𝐚𝐫𝐤𝐞𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐃𝐞𝐛𝐭
𝐏𝐨𝐬𝐭 − 𝐭𝐚𝐱 𝐊𝐝 =
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 (𝟏 − 𝐭)
𝐌𝐚𝐫𝐤𝐞𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐃𝐞𝐛𝐭
where:
 Kd is the cost of the debt capital
 Interest is the annual interest payable on each $100 (nominal value) of the bonds.
 t is the rate of tax on company profits.
Example
The coupon rate of interest on a company’s irredeemable bonds (‘perpetual bonds’) is 6% and the market
value of the bonds is 103.60. The tax rate is 25%.
(a) The pre-tax cost of the debt is 6/103.60 = 0.058 or 5.8%.
(b) The after-tax cost of the bonds is 6 (1 – 0.25)/103.60 = 0.043 or 4.3%.
Illustrations of irredeemable debt
Illustration No 1:
Aleena Limited (AL) has in issue 8·5% irredeemable bonds with a total nominal value of Rs 500 million (Rs
100 nominal value for each bond). The pre-tax market interest rate is 8.04%.
Find the market value of the irredeemable bonds.
Solution 1:
Interest = 500 x 8.5%
Interest = 42.5
MV = 42.5 / 8.04%
MV = 528.6
Illustration No 2:
Aleena Limited (AL) has in issue 8·5% irredeemable bonds with a total nominal value of Rs 500 million (Rs
100 nominal value for each bond). The tax rate applicable is 30% and the post-tax market interest rate is
5.63%.
Find the market value of the irredeemable bonds.
Always a mentor | Muzzammil Munaf
Page 96 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
Solution 2:
Interest = 500 x 8.5%
Interest = 42.5
Post-tax interest = 42.5 x (1 - 30%)
Post-tax interest = 29.75
MV = 29.75 / 5.63%
MV = 528.4
Illustration No 3:
The coupon rate of interest on a company’s irredeemable bonds (nominal value of Rs 100 each) is 7% and
the market value of the bonds is 108.93. The tax rate applicable to the Company is 30%.
(a) Find the pre-tax cost of the debt.
(b) Find the post-tax cost of the debt.
Solution 3:
MV = Interest / Kd
Kd = Interest / MV
Kd = 7 / 108.93
Kd = 6.43%
Kd = Post tax Interest / MV
Kd = 4.9 / 108.93
Kd = 4.5%
Post tax Kd = Pre-tax Kd x (1 - 0.3)
Post tax Kd = 4.5%
Illustration No 4:
Aleena Limited (AL) has in issue 8·5% irredeemable bonds with a total nominal value of Rs 500 million. The
market value of each Rs 100 bond is Rs 105·72.
Find the pre-tax cost of debt of the irredeemable bonds.
Always a mentor | Muzzammil Munaf
Page 97 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
Solution 4:
Nominal value
Interest @ 8.5%
Market value (500 Mn/100x105.72)
Pre-tax Kd
500,000,000
42,500,000
528,600,000
8.04%
Illustration No 5:
Aleena Limited (AL) has in issue 8·5% irredeemable bonds with a total nominal value of Rs 500 million. The
market value of each Rs 100 bond is Rs 105·72. The tax rate applicable to the Company is 30%.
Find the post-tax cost of debt of the irredeemable bonds.
Solution 5:
Nominal value
Interest @ 8.5%
Interest @ 8.5% - Post tax
Market value (500 Mn/100x105.72)
Post tax Kd (Post tax Int/MV)
500,000,000
42,500,000
29,750,000
528,600,000
5.63%
Cost of redeemable fixed rate debt (redeemable fixed rate bonds)
The cost of redeemable bonds is their redemption yield. This is the return, expressed as an average annual
interest rate or yield, that investors in the bonds will receive between ’now’ and the maturity and redemption
of the bond, taking the current market value of the bonds as the investment. It is the investment yield at
which the bonds are currently trading in the bond market.
This is calculated as the rate of return that equates the present value of the future cash flows payable on
the bond (to maturity) with the current market value of the bond. In other words, it is the IRR of the cash
flows on the bond to maturity, assuming that the current market price is a cash outflow.
𝐌𝐕 𝐨𝐟 𝐫𝐞𝐝𝐞𝐞𝐦𝐚𝐛𝐥𝐞 𝐝𝐞𝐛𝐭 = 𝐏𝐕 𝐨𝐟 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰𝐬 + 𝐏𝐕 𝐨𝐟 𝐫𝐞𝐝𝐞𝐦𝐩𝐭𝐢𝐨𝐧 𝐯𝐚𝐥𝐮𝐞
The present values are computed by discounting them with Kd. To calculate the Kd, the future cash flows
will be plotted against the MV of redeemable debt and Kd will be calculated by using the IRR method.
In the case of debt convertible to equity, the process will be the same as redeemable debt except that the
redemption amount shall be higher of the two i.e. redemption amount and conversion value of the shares.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
Pre-tax and post-tax cost of debt (Kd):
Lender’s required rate of return = Company’s pre-tax Kd
Company’s pre-tax cost Kd x (1 – t) = Company’s post-tax Kd
Exam Approach: As mentioned above, WACC calculations involve post-tax Kd.
Irredeemable debt: The post-tax Kd can be calculated as [pre-tax Kd x (1-t)].
Redeemable debt: The approach is different since gain/loss on redemption is not taxable.
 If the scenario only has lenders’ required rate of return (pre-tax Kd):
o MV of debt: Plot all pre-tax cash flows and discount with the lenders’ required rate of return.
o Post-tax Kd: Plot MV of debt, all post-tax cash flows and calculate IRR.
 If the scenario provides MV of debt:
o Plot the MV of debt and post-tax cash flows, calculate the IRR.
o This is the post-tax Kd.
 If the scenario provides post-tax Kd and requires MV of debt, plot post-tax cash flows, and discount the
present values with the post-tax Kd. This is the MV of debt.
Rule of thumb: Pre-tax cash flows will be discounted with pre-tax Kd and post-tax cash flows will be
discounted with a post-tax Kd.
Example: The current market value of a company’s 7% loan stock is 96.25. Annual interest has just been
paid. The bonds will be redeemed at par after four years. The rate of taxation on company profits is 30%.
Calculate the after-tax cost of the bonds for the company:
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
Illustrations of Redeemable debt:
Illustration No 1:
A company has issued 7% loan stock having a nominal value of Rs 100 per bond. Annual interest has just
been paid and the bonds will be redeemed at par after four years. The lenders’ required rate of return is
8.14%. The tax rate applicable to the Company is 30%. Calculate the market value and post tax cost of the
loan stock.
Solution 1:
Particulars
Interest
Redemption
Net CF
PV @ 8.14%
MV
Year 0
Year 1
Year 2
Year 3
Year 4
96.24
7.00
7.00
6.47
7.00
7.00
5.99
7.00
7.00
5.54
7.00
100.00
107.00
78.24
Particulars
Market value
Interest
Redemption
Net CF
PV @8%
PV @8%
PV @4%
PV @4%
Post tax Kd (IRR)
Year 0
Year 1
Year 2
Year 3
Year 4
4.90
4.90
4.54
4.90
4.90
4.20
4.90
4.90
3.89
4.90
100.00
104.90
77.10
4.71
4.53
4.36
89.67
(96.24)
(96.24)
(96.24)
(6.50)
(96)
7.03
6.00%
Illustration No 2:
A company has issued 7% loan stock having a nominal value of Rs 100 per bond. Annual interest has just
been paid and the bonds will be redeemed at a premium of 8% after four years. The lenders’ required rate
of return is 8.14%. The tax rate applicable to the Company is 30%.
Required
a) Calculate the market value of the loan stock.
b) Calculate the post-tax cost of loan stock for the Company.
Always a mentor | Muzzammil Munaf
Page 100 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
Solution 2:
Particulars
Interest
Redemption
Net CF
PV @ 8.14%
MV
Year 0
Year 1
Year 2
Year 3
Year 4
102.09
7.00
7.00
6.47
7.00
7.00
5.99
7.00
7.00
5.54
7.00
108.00
115.00
84.09
Particulars
Market value
Interest
Redemption
Net CF
PV @8%
PV @8%
PV @4%
PV @4%
Post tax Kd (IRR)
Year 0
Year 1
Year 2
Year 3
Year 4
4.90
4.90
4.54
4.90
4.90
4.20
4.90
4.90
3.89
4.90
108.00
112.90
82.98
4.71
4.53
4.36
96.51
(102.09)
(102.09)
(102.09)
(6.47)
(102)
8.02
6.12%
Illustration No 3:
Javed Limited (JL) has in issue 7% bonds redeemable after six years. The bonds are redeemable at a 5%
premium to their nominal value of Rs 100 per bond and have a current market value of Rs 104·50 per bond.
Find the cost of debt of the redeemable bonds.
Solution 3:
Particulars
Market value
Interest
Redemption
Net CF
PV @ 10%
PV @ 10%
PV @ 5%
PV @ 5%
Pre-tax Kd (IRR)
Year 0
(104.50)
(104.50)
(104.50)
(14.74)
(104.50)
9.38
6.77%
Always a mentor | Muzzammil Munaf
Year 1
7.00
7.00
6.36
Year 2
7.00
7.00
5.79
Year 3
7.00
7.00
5.26
Year 4
7.00
7.00
4.78
Year 5
7.00
7.00
4.35
Year 6
7.00
105.00
112.00
63.22
6.67
6.35
6.05
5.76
5.48
83.58
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
Illustration No 4:
Javed Limited (JL) has in issue 7% bonds redeemable after six years. The bonds are redeemable at a 5%
premium to their nominal value of Rs 100 per bond and have a current market value of Rs 104·50 per bond.
JL pays corporate tax at an annual rate of 30% per year. Find the post-tax cost of debt of the redeemable
bonds.
Solution 4:
Year 0
(104.50)
(104.50)
(104.50)
9.98
(104.50)
(1.28)
4.76%
Particulars
Market value
Interest
Redemption
Net CF
PV @ 3%
PV @ 3%
PV @ 5%
PV @ 5%
Post-tax Kd (IRR)
Year 1
4.90
4.90
4.76
Year 2
4.90
4.90
4.62
Year 3
4.90
4.90
4.48
Year 4
4.90
4.90
4.35
Year 5
4.90
4.90
4.23
Year 6
4.90
105.00
109.90
92.04
4.67
4.44
4.23
4.03
3.84
82.01
Illustration No 5:
Dynamic Co is financed by 7% bonds with a nominal value of Rs 100 per bond, which will be redeemed in
seven years at a discount of 2%. The bonds have a total nominal value of Rs 140 million. The rate required
by the lenders is 6.8% and the Company is subject to a corporate tax rate of 30%. Calculate the market value
of the bond and post-tax cost of debt of the Company.
Solution 5:
Particulars
Interest
Redemption
Net CF
PV @ 6.8%
MV
Year 0
Particulars
Market value
Interest
Redemption
Net CF
Post tax Kd (IRR)
Year 0
99.82
(99.82)
(99.82)
4.68%
Year 1
7.00
7.00
6.55
Year 1
4.90
4.90
Always a mentor | Muzzammil Munaf
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
7.00
7.00
6.14
7.00
7.00
5.75
7.00
7.00
5.38
7.00
7.00
5.04
7.00
7.00
4.72
7.00
98.00
105.00
66.25
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
4.90
4.90
4.90
4.90
4.90
4.90
4.90
4.90
4.90
4.90
4.90
98.00
102.90
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
COST OF CONVERTIBLE DEBT: The cost of a convertible bond is the higher of:
 the cost of the bond as a straight bond that will be redeemed at maturity, and
 the IRR of the relevant cash flows assuming that the conversion of the bonds into equity will take place.
The cost of capital of the bond as a straight bond is only the actual cost of the bond if the bonds are not
converted into shares at the conversion date. The IRR of the relevant cash flows is the cost of the convertible
bond assuming that conversion will take place.
The relevant cash flows for calculating this yield (IRR) are:




the current market value of the bonds (Year 0 outflow)
annual interest on the bonds up to the time of conversion into equity (annual inflows)
tax relief on the interest (annual outflows)
the expected market value of the shares, at conversion date, into which the bonds can be converted.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
COST OF PREFERENCE SHARES
For irredeemable preference shares, the cost of capital is calculated in the same way as the cost of equity
assuming a constant annual dividend, and using the dividend valuation model.
𝐊𝐩 =
𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝
𝐌𝐚𝐫𝐤𝐞𝐭 𝐕𝐚𝐥𝐮𝐞
where:
 Kp is the cost of the preference shares
 Dividend = the expected future annual dividend
 Market Value is the share price ex dividend.
For redeemable preference shares, the cost of the preference shares is calculated in the same way as the
pre-tax cost of redeemable debt. (Dividend payments are not subject to tax relief, therefore the cost of
preference shares is calculated ignoring tax, just as the cost of equity ignores tax.)
CALCULATING THE WEIGHTED AVERAGE COST OF CAPITAL (WACC)
Method of calculating the WACC
The weighted average cost of capital (WACC) is a weighted average of the (after-tax) cost of all the sources
of capital for the company. The weightings given to each item of finance in the capital structure should be
its total market value.
WACC =
[(MVe x Ke) + {MVd x Kd(1 − t)} + (MVp x Kp)]
(MVe + MVd + MVp)
Source of Finance
Market Value
Cost (K)
MV x Cost
Equity
Preference Shares
Debt
MVe
MVp
MVd
Ke
Kp
Kd
MVe x Ke
MVp x Kp
MVd x Kd
Total
∑MV
∑kMV
WACC = ∑kMV / ∑MV
Example
A company has 10 million shares each with a value of $4.20, whose cost is 7.5%. It has $30 million of 5%
bonds with a market value of 101.00 and an after-tax cost of 3.5%. It has a bank loan of $5 million whose
after-tax cost is 3.2%. It also has 2 million 8% preference shares of $1 whose market price is $1.33 per share
and whose cost is 6%. Calculate the WACC.
Always a mentor | Muzzammil Munaf
Page 104 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
WACC Full Length Illustrations [All previous concepts combined]
Illustration 01:
The following information has been taken from the statement of financial position of Hadi Fabrics Limited
(HFL) as on June 30, 2020, a listed company:
Liabilities and Equity
Rs ‘000
Assets
Rs ‘000
Ordinary Share Capital
Retained Earnings
15,000
29,000
Non-current assets
50,000
6% preference shares
8% long term bonds
5.5% bank loan
Current liabilities
6,000
8,000
5,000
7,000
Current assets
Cash and cash equivalents
4,000
16,000
Total Assets
70,000
Total Liabilities and Equity
70,000
The ordinary shares of HFL have a nominal value of Rs 10 per share and a current ex-dividend market price
of Rs 16·10 per share. A dividend of 1·90 per share has just been paid. The pattern of dividends has been as
follows:
Year
Dividend per share (Rs)
2017
1.70
2018
1.75
2019
1.85
2020
1.90
The 6% preference shares of HFL have a nominal value of Rs 10 per share and an ex-dividend market price
of Rs 8.64 per share.
Always a mentor | Muzzammil Munaf
Page 105 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
The 8% long term bonds of HFL have a nominal value of Rs 100 per bond. The required rate of return by
the lender is 9.10%. Annual interest has just been paid and the bonds are redeemable in five years’ time at
a 10% premium to the nominal value.
Corporate tax applicable to HFL is 30%.
Required:
Calculate the post-tax weighted average cost of capital of HFL on a market value basis. (11 marks)
Solution 1:
Equity
Market value of equity (15,000 / 10 x 16.10)
24,150
Cost of equity [Do x (1+g)/MV + g]
Latest dividend
Reference/Oldest dividend
Time
Growth (1.9/1.7)^(1/3) - 1
1.90
1.70
3.00
3.78%
Cost of equity [1.9 x (1+3.78%)/16.10 + 3.78%]
16.02%
Preference shares
Market value of pref shares (6,000/10 x 8.64)
Kp (Pref div / MV = 0.6 / 8.64)
5,184
6.94%
Bank Loan
Market value of bank loan
Post tax cost of bank loan [5.5% x (1-0.3)]
MV of bonds
Interest
Redemption
Net Cash Flows
PV @ 9.10%
MV
Always a mentor | Muzzammil Munaf
5,000
3.85%
Year 0
8,176
Year 1
640
640
587
Page 106 of 690
Year 2
640
640
538
Year 3
640
640
493
Year 4
640
640
452
Year 5
640
8,800
9,440
6,107
Page 26 of 39
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
Post tax Kd
Market value
Interest
Redemption
Net Cash Flows
PV @ 10%
PV @ 10%
PV @ 5%
PV @ 5%
Post tax Kd
Year 0
Year 1
(8,176)
448
(8,176)
448
(8,176)
407
(1,014)
(8,176)
427
658
6.97%
Year 2
448
448
370
Year 3
448
448
337
Year 4
448
448
306
Year 5
448
8,800
9,248
5,742
406
387
369
7,246
A% + [NPVa / (NPVa - NPVb)] x (B% - A%)
WACC
Ordinary shares
Pref shares
Long term bonds
Bank Loan
MV
24,150
5,184
8,176
5,000
42,510
Cost %
Cost
16.02%
6.94%
6.97%
3.85%
3,869.82
360.00
569.78
192.50
4,992
WACC (4,992/42,510)
11.74%
Illustration 02:
Jahanzeb Limited (JL) has the following capital structure:
Liabilities and Equity
Rs ‘000
Ordinary Share Capital
Retained Earnings
230,000
247,000
5% preference shares
6% long term bonds
7% bank loan
50,000
110,000
30,000
Total Liabilities and Equity
667,000
The ordinary shares of JL are currently trading at Rs 14·26 per share on an ex dividend basis and have a
nominal value of Rs 10 per share. Ordinary dividends are expected to grow in the future by 4% per year and
a dividend of 2·25 per share has just been paid.
Always a mentor | Muzzammil Munaf
Page 107 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
The 5% preference shares have an ex-dividend market value of Rs 10·56 per share and a nominal value of
Rs 10 per share. These shares are irredeemable.
The 6% long term bonds of JL are currently trading at Rs 95·45 per bond on an ex-interest basis and will be
redeemed at their nominal value of Rs 100 per loan note in four years’ time.
The bank loan has a fixed interest rate of 7% per year. JL pays corporation tax at a rate of 30%.
Required:
Calculate the post-tax weighted average cost of capital of HFL on a market value basis. (9 marks)
Solution 2:
Equity
Market value (230,000 / 10 x 14.26)
Cost of equity [2.25 x (1+4%)/14.26] + 4%
327,980
20.41%
Preference shares
Market value (50,000 / 10 x 10.56)
Cost of pref shares (0.5/10.56)
52,800
4.73%
Bank Loan
Market value
Post tax cost of bank loan
30,000
4.90%
Long term bonds
Market value
Interest
Redemption
Net Cash Flows
PV @ 10%
PV @ 10%
Year 0
Year 1
(104,995)
4,620
(104,995) 4,620
(104,995) 4,200
(15,219)
PV @ 5%
PV @ 5%
(104,995)
1,885
Post tax Kd (IRR)
4,400
Year 2
4,620
4,620
3,818
Year 3
4,620
4,620
3,471
Year 4
4,620
110,000
114,620
78,287
4,190
3,991
94,298
5.55%
A% + [NPVa / (NPVa - NPVb)] x (B% - A%)
Always a mentor | Muzzammil Munaf
Page 108 of 690
Page 28 of 39
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
WACC
Ordinary shares
Pref shares
Long term bonds
Bank Loan
MV
327,980
52,800
104,995
30,000
515,775
Cost %
20.41%
4.73%
5.55%
4.90%
WACC (76,737/515,775)
Cost
66,939
2,500
5,828
1,470
76,737
14.88%
ICAP SUMMER 2014: QUESTION
Always a mentor | Muzzammil Munaf
Page 109 of 690
Page 29 of 39
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
ICAP SUMMER 2014: SOLUTION
Always a mentor | Muzzammil Munaf
Page 110 of 690
Page 30 of 39
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
ICAP WINTER 2017: QUESTION
Always a mentor | Muzzammil Munaf
Page 111 of 690
Page 31 of 39
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
ICAP WINTER 2017: SOLUTION
WACC as at June 30, 2017
WACC as at June 30, 2018
Change in GSI's WACC
WACC as at June 30, 2017
Equity - ordinary shares
Debt - 11% debentures
10.98%
12.68%
1.7%
WACC (573.96/5,225.08)
MV
4,190.40
1,034.68
5,225.08
10.98%
Equity Book Value (2,500 + 992)
P/B ratio
Equity - MV
3,492.00
1.20
4,190.40
Cost%
12.25%
5.9%
Cost
513.32
60.63
573.96
Existing cost of equity - Ke
Ke = {Do x (1+g)/MV} + g
Ke = {298 x (1 + 4.8%)/4,190.4} + 4.8%
Ke = 12.25%
Calculation of growth
Div for 2017
Div for 2013
Time (years)
G (298/247)^(1/4)-1
MV of debentures
Interest
Redemption
Net cash flows
PV @ 9%
MV
2018
105.60
105.60
96.88
1,034.68
2019
105.60
105.60
88.88
2020
105.60
105.60
81.54
2021
2022
105.60
105.60
960.00
105.60 1,065.60
74.81
692.57
2018
2019
2020
2021
73.92
73.92
73.92
73.92
73.92
73.92
73.92
73.92
960.00
73.92 1,033.92
Post tax Kd
MV
Interest - Post tax
Redemption
Net cash flows
Post tax Kd (IRR)
2017
(1,034.68)
(1,034.68)
5.9%
Always a mentor | Muzzammil Munaf
Page 112 of 690
298.00
247.00
4.00
4.80%
2022
Page 32 of 39
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
WACC as at June 30, 2018
Equity - ordinary shares
Debt - 11% debentures
MV
2,949.14
1,090.07
4,039.21
Cost%
15.90%
3.97%
New WACC (512.19/4,039.21)
Cost
468.91
43.28
512.19
12.68%
Equity BV as at June 30, 2018
P/B ratio
Equity - MV as at June 30, 2018
4,213.05
0.70
2,949.14
Equity BV as at June 30, 2018
Equity as at June 30, 2017
Expected profit [1,752.72x(1+profit growth)]x(1-t)
Loss of investments [1,310 x 35% x 1.1 x (1-30%)]
Dividend for 2018 {298 x (1 + 4.8%)}
Equity BV as at June 30, 2018 - estimated
3,492.00
1,386.40
(353.05)
(312.30)
4,213.05
Profit growth
Profit - 2017
Profit - 2013
Time (years)
Growth
1,752.72
1,075.00
4.00
13.00%
Revised cost of equity - Ke
Ke = {Do x (1+g)/MV} + g
Ke = {312.3 x (1 + 4.8%)/2,949.14} + 4.8%
Ke = 15.9%
MV of debentures
Interest
Redemption
Net cash flows
PV @ 7%
MV
1,090.07
Post tax Kd
MV
Interest - Post tax
Redemption
Net cash flows
Post tax Kd (IRR)
2018
(1,090.07)
(1,090.07)
3.97%
Always a mentor | Muzzammil Munaf
2019
105.60
105.60
98.69
2020
105.60
105.60
92.24
2021
2022
105.60
105.60
960.00
105.60 1,065.60
86.20
812.94
2019
73.92
73.92
2020
73.92
73.92
2021
2022
73.92
73.92
960.00
73.92 1,033.92
Page 113 of 690
Page 33 of 39
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
ACCA F9 - 2013 JUNE: QUESTION
Always a mentor | Muzzammil Munaf
Page 114 of 690
Page 34 of 39
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
ACCA F9 - 2013 JUNE: SOLUTION
MV
37,600
1,200
3,135
1,000
42,935
Ordinary shares
Preference shares
Bonds
Bank Loan
K
12.15%
10.00%
4.76%
4.76%
WACC (4,885 / 42,935)
4,568
120
149
48 In line with the market rate of bonds
4,885 Variable rate is always in line with the market.
11.4%
Ordinary shares
No of ordinary shares (4,000 / 0.5)
MV per share
MV of ordinary shares
8,000
4.70
37,600
Preference shares
No of preference shares (3,000/1)
MV per pref share
MV of preference shares
3,000
0.40
1,200
Cost of pref shares -- Kp
Div (1 x 4%)
MV
Kp (0.04 / 0.4)
0.04
0.40
10%
Bonds
No of bonds (3,000 / 100)
MV per bond
MV of bonds
30.00
104.50
3,135
Post tax Kd
0
MV
Post tax interest
Redemption
Net Cash Flows
(104.50)
(104.50)
Post tax Kd (IRR)
4.76%
Ke
Do (latest dividend)
MV per share
Growth
Ke [Do x (1+g)/MV + g]
0.363
4.70
4.11%
12.15%
Growth
Latest div
Oldest div
Time
Growth (lat/old)^(1/t)-1
0.363
0.309
4.00
4.11%
1
2
3
4
5
4.90
4.90
4.90
4.90
4.90
4.90
4.90
4.90
4.90
4.90
Post tax interest: 100 x 7% x (1 - 30%)
Always a mentor | Muzzammil Munaf
6
4.90
105.00
109.90
4.90
Page 115 of 690
Page 35 of 39
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
ACCA F9 DECEMBER 2017: QUESTION
Always a mentor | Muzzammil Munaf
Page 116 of 690
Page 36 of 39
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
ACCA F9 DECEMBER 2017: SOLUTION
Cum dividend price
Ex dividend price
Latest dividend
7.52 this includes the impact of latest dividend
7.07 this does not include the impact of latest dividend
0.45 for the year 20X7
Ordinary shares
Preference shares
Bonds
Bank Loan
MV
169.68
3.10
10.23
3.00
186
WACC (21/186)
11.2%
K
11.70%
8.06%
5.39%
5.39%
19.85
0.25
0.55
0.16 In line with the market rate of bonds
21 Variable rate is always in line with the market.
Ordinary shares
No of ordinary shares (12 / 0.5)
MV per share
MV of ordinary shares
24
7.07
169.68
Preference shares
No of preference shares (5/0.5)
MV per pref share
MV of preference shares
10
0.31
3.10
Cost of pref shares -- Kp
Div (0.5 x 5%)
MV
Kp (0.04 / 0.31)
0.03
0.31
8.06%
Bonds
No of bonds (10 / 100)
MV per bond
MV of bonds
0.1
102.34
10.23
Post tax Kd
0
MV
Post tax interest
Redemption
Net Cash Flows
(102.34)
(102.34)
Post tax Kd (IRR)
5.39%
1
2
3
4.90
4.90
4.90
4.90
4.90
4.90
Post tax interest: 100 x 7% x (1 - 30%)
4.90
Always a mentor | Muzzammil Munaf
Page 117 of 690
Ke
Do (latest dividend)
MV per share
Growth
Ke [Do x (1+g)/MV + g]
0.450
7.07
5.02%
11.70%
Growth
Latest div
Oldest div
Time
Growth (lat/old)^(1/t)-1
0.450
0.370
4.00
5.02%
4
4.90
105.00
109.90
Page 37 of 39
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
ACCA F9 DINLA CO: QUESTION
Always a mentor | Muzzammil Munaf
Page 118 of 690
Page 38 of 39
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
WEIGHTED AVERAGE COST OF CAPITAL
ACCA F9 DINLA CO: SOLUTION
Ordinary shares
Preference shares
Bonds
Bank Loan
MV
391,920
2,800.00
10,499.50
3,000.00
408,220
K
10.10%
8.93%
5.57%
5.25%
39,596.80
250.00
584.56
157.50 In line with the market rate of bonds
40,589 Variable rate is always in line with the market.
WACC (40,589/408,220)
9.9%
Ordinary shares
No of ordinary shares (23,000/ 0.25)
MV per share
MV of ordinary shares
92,000
4.26
391,920
Preference shares
No of preference shares (5,000/1)
MV per pref share
MV of preference shares
5,000
0.56
2,800.00
Cost of pref shares -- Kp
Div (1 x 5%)
MV
Kp (0.05/0.56)
Ke
Do (latest dividend)
MV per share
Growth
Ke [Do x (1+g)/MV + g]
0.250
4.26
4.00%
10.10%
0.05
0.56
8.93%
Bonds
No of bonds (11,000 / 100)
MV per bond
MV of bonds
110.00
95.45
10,499.50
Post tax Kd
0
1
MV
Post tax interest
Redemption
Net Cash Flows
(95.45)
(95.45)
4.50
4.50
Post tax Kd (IRR)
5.57%
2
4.50
4.50
Post tax interest: 100 x 6% x (1 - 25%)
4.50
Always a mentor | Muzzammil Munaf
Page 119 of 690
3
4
4.50
4.50
4.50
4.50
5
4.50
100.00
104.50
Page 39 of 39
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
YIELD TO MATURITY AND PRE-TAX COST OF DEBT
YIELD TO MATURITY AND PRE-TAX COST OF DEBT
Each item of debt finance for a company has a different cost. This is because debt capital has differing risk,
according to whether the debt is secured, whether it is senior or subordinated debt, and the amount of time
remaining to maturity.
Furthermore, the cost of debt differs for different periods of borrowing. This is because lenders might
require compensation for the risk of having their cash tied up for longer and/or there might be an
expectation of future changes in interest rates.
The market value of a bond is the present value of the future cash flows that must be paid to service the
debt, discounted at the lender’s required rate of return (pre-tax cost of debt).
The lender’s required rate of return (the pre-tax cost of debt) is the IRR of the cash flows (pre-tax) that must
be paid to service the debt.
CASE 01:
A company has issued a bond that will be redeemed in 4 years. The bond has a nominal interest rate of 6%.
The required rate of return on the bond is 6%.
Required: Calculate what the market value of the bond would be if the required rate of return (i.e. the pretax cost of debt) was 5% or 6% or 7%.
Solution 1:
There is an inverse relationship between the lender’s required rate of return and the market value. The cash
flows do not change. The investor can increase his rate of return by offering less for the bond. If the investor
offers more the rate of return falls.
Always a mentor | Muzzammil Munaf
Page 120 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
YIELD TO MATURITY AND PRE-TAX COST OF DEBT
CASE 02:
A company wants to issue a bond that is redeemable at par in four years and pays interest at 6% of nominal
value.
The annual spot yield curve for a bond of this class of risk is as follows:
Maturity
One year
Two years
Three years
Four years
Yield
3.0%
3.5%
4.2%
5.0%.
Required
Calculate the price that the bond could be sold for (this is the amount that the company could raise) and
then use this to calculate the gross redemption yield (yield to maturity, cost of debt).
Solution 2: An investor will receive a stream of cash flows from this bond and will discount each of those
to decide how much he is willing to pay for them.
The first year flow will be discounted at 3.0%, the second year flow at 3.5% and so on. (Note that the twoyear rate of 3.5% does not mean that this is the rate in the second year. It means that this is the average
annual rate for a flow in 2 years’ time).
The company would need to issue a Rs.100 nominal value bond for Rs.103.94.
The cost of debt (gross redemption yield) of the bond can be calculated in the usual way by calculating the
IRR of the flows that the company faces.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
YIELD TO MATURITY AND PRE-TAX COST OF DEBT
Using interpolation, the before-tax cost of the debt is:
4% + 3.32/(3.32 + 3.94) x (6 – 4)% = 4.91%
The cost of the debt is therefore estimated as 4.91%. This is the average cost that the entity is paying for
this debt.
CASE 03: Extract from Q5 ICAP SUMMER 2021
SuperSky International Airlines Ltd. (SIL) currently has Rs. 2,000 million of corporate bonds. The average
maturity of SIL’s corporate bonds is 18 years. SIL currently has 'AA' credit rating.
The current yield on Pakistan government bonds is 3.75% for all bond maturities.
Required: Calculate pre-tax cost of debt or gross redemption yield on the above bond.
Always a mentor | Muzzammil Munaf
Page 122 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
YIELD TO MATURITY AND PRE-TAX COST OF DEBT
Solution 3:
Always a mentor | Muzzammil Munaf
Page 123 of 690
Page 4 of 4
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL STRUCTURE AND GEARING THEORIES
Contents
CAPITAL STRUCTURE AND GEARING THEORIES .......................................................................................... 2
ALTERNATE CALCULATION OF WACC: ....................................................................................................... 2
WACC AND MARKET VALUES ...................................................................................................................... 2
THE TRADITIONAL VIEW OF GEARING AND WACC ................................................................................. 3
THE MODIGLIANI-MILLER VIEW: IGNORING CORPORATE TAXATION................................................. 4
THE MODIGLIANI-MILLER VIEW: ALLOWING FOR CORPORATE TAXATION .....................................10
MM Theory: ICAP SUMMER 2008 .............................................................................................................15
ICAP SUMMER 2008 SOLUTION: ...............................................................................................................16
PECKING ORDER THEORY...........................................................................................................................17
Always a mentor | Muzzammil Munaf
Page 124 of 690
Page 1 of 17
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL STRUCTURE AND GEARING THEORIES
CAPITAL STRUCTURE AND GEARING THEORIES
ALTERNATE CALCULATION OF WACC:
For a Company having stable profits, paying out 100% profits as dividends, and having irredeemable debt,
the WACC can also be calculated as follows:
WACC (Pre − tax) =
PBIT
MVe + MVd
AND
WACC (Post − tax) =
PBIT (1 − t)
MVe + MVd
WACC AND MARKET VALUES
For a company with constant annual ‘cash profits’ (i.e. PBIT), there is a relationship between WACC and
market value. If we assume that annual cash profits are a constant amount in perpetuity, the total value of
a company, equity plus debt capital, is calculated as follows:
𝐓𝐨𝐭𝐚𝐥 𝐌𝐚𝐫𝐤𝐞𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐂𝐨𝐦𝐩𝐚𝐧𝐲 =
𝐏𝐁𝐈𝐓 (𝟏 − 𝐭)
𝐖𝐀𝐂𝐂 (𝐏𝐨𝐬𝐭 − 𝐭𝐚𝐱)
From the above relationship, the following conclusions can be made:
 The lower the WACC, the higher the total value of the company will be (equity + debt capital), for any
given number of annual profits.
 Similarly, the higher the WACC, the lower the total value of the company.
The aim should therefore be to achieve a level of financial gearing that minimizes the WACC, to maximize
the value of the company. There are different theories about the relationship between WACC and gearing.
The three you need to know are:
1.
2.
3.
The traditional theory of WACC and gearing
Modigliani and Miller’s theory of WACC, ignoring taxation
Modigliani and Miller’s theory of WACC, allowing for taxation
COST OF CAPITAL AND GEARING
For a given level of annual cash profits before interest and tax, the value of a company (equity + debt) is
maximised at the level of gearing where WACC is lowest. This should also be the level of gearing that
optimises the wealth of the company’s equity shareholders.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL STRUCTURE AND GEARING THEORIES
The question is therefore: Is there a level of gearing where the WACC is minimised?
If WACC is minimised at a particular level of gearing a company should try to achieve a capital structure
where this minimum WACC occurs.
However, there are different theories about the relationship between WACC and gearing. The three you
need to know are:
 The traditional theory of WACC and gearing
 Modigliani and Miller’s theory of WACC, ignoring taxation
 Modigliani and Miller’s theory of WACC, allowing for taxation.
THE TRADITIONAL VIEW OF GEARING AND WACC
The traditional view of gearing is that there is an optimum level of gearing for a company, where WACC is
minimised. This theory is based on the following assumptions.
 As gearing increases, the cost of equity rises. However, as gearing increases, there is also a greater
proportion of debt capital in the capital structure, and the cost of debt is cheaper than the cost of
equity.
 As gearing increases, WACC is therefore affected by a higher cost of equity, but a larger proportion of
cheaper debt capital.
 At lower levels of gearing, as gearing increases, the effect of having more debt capital has a bigger
effect on the WACC than the rising cost of equity. Consequently the WACC falls as gearing increases.
 However, after a certain level of gearing is reached, if gearing continues to increase, the increase in the
cost of equity has a greater effect on WACC than the larger proportion of cheap debt capital. The WACC
starts to rise.
The traditional view of gearing is therefore that an optimum level of gearing exists, where WACC is
minimised and the value of the company is maximised. A graph of WACC at different levels of gearing can
be drawn as a saucer-shaped or bowl-shaped curve.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL STRUCTURE AND GEARING THEORIES
The greatest weakness with traditional theory is that it is based on assumptions and observation. It does
not provide any guidance about how to identify or calculate:
 the level of gearing where WACC is minimised, or
 the WACC at the optimal gearing level.
THE MODIGLIANI-MILLER VIEW: IGNORING CORPORATE TAXATION
The traditional view of gearing and WACC was challenged by Modigliani and Miller (MM) in the 1950s.
Initially, their arguments were based on the assumption that corporate taxation, and the tax relief on
interest, could be ignored.
You do not need to know Modigliani and Miller’s arguments in detail, only the main assumptions on which
their arguments were based and the conclusions they reached.
Assumptions
MM made several assumptions in making their propositions.
 There is a perfect capital market in which investors all have the same information and also act rationally.
Consequently, they all share the same expectations about the future earnings of a company and also
the level of its business risk.
 There is no taxation.
 Debt is risk-free and freely-available to both companies and investors.
 There are no transaction costs involved in buying or selling shares or debt capital.
It is not possible to explain properly the relevance of the assumptions about risk-free debt, its availability
and the absence of transaction costs in buying and selling shares. These assumptions were used by MM to
justify their views and explain how investors were indifferent to the gearing of companies because they are
able to adjust their own personal gearing by borrowing and buying or selling shares.
Modigliani and Miller’s propositions: ignoring taxation
MM argued that if corporate taxation is ignored, an increase in financial gearing will have the following
effect:
 As the level of gearing increases, there is a greater proportion of cheaper debt capital in the capital
structure of the firm.
 However, the cost of equity rises as gearing increases.
 As gearing increases, the net effect of the greater proportion of cheaper debt and the higher cost of
equity is that the WACC remains unchanged. The effect of the higher cost of equity is exactly equal to
the offsetting effect of having a larger proportion of debt capital in the capital structure.
 The WACC is the same at all levels of financial gearing.
 The total value of the company (equity + debt capital) is therefore the same at all levels of financial
gearing.
Always a mentor | Muzzammil Munaf
Page 127 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL STRUCTURE AND GEARING THEORIES
Modigliani and Miller therefore reached the conclusion that the level of gearing is irrelevant for the value
of a company. There is no optimum level of gearing that a company should be trying to achieve.
MM’s theory is sometimes called the ‘net operating income’ approach because MM argued that, in the
absence of taxation, the total market value of a company is determined by just two factors:
 The total earnings of the company (profit after interest, if tax is ignored).
 The business risk of the company, which determines the WACC. WACC is not affected by financial
gearing, but it is affected by the perceived business risk of investing in the company. WACC is higher
for companies with higher business risk.
Modigliani-Miller formulae: no taxation
There are three formulae for the Modigliani and Miller theory, ignoring corporate taxation. These are shown
below. The letter ‘U’ refers to an ungeared company (all-equity company) and the letter ‘G’ refers to a
geared company.
1. WACC
The WACC in a geared company and the WACC in an identical but ungeared (all-equity) company are the
same:
WACCg = WACCu
2. Total value of the company (equity plus debt capital)
The total value of an ungeared company is equal to the total value of an identical geared company
(combined value of equity + debt capital):
MVg = MVu
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CAPITAL STRUCTURE AND GEARING THEORIES
This total value can be calculated for a company with constant annual operating profits (profits before
interest) as: Annual operating profits/WACC.
3. Cost of equity
The cost of equity in a geared company is higher than the cost of equity in an ungeared company, by an
amount equal to:
 the difference between the cost of equity in the ungeared company and the cost of debt (KEU – KD)
 multiplied by the ratio of the market value of debt to the market value of equity in the geared company
(D/E).
where
Keg = the cost of equity in a geared company
Keu = cost of equity in an ungeared company
Kd = the cost of debt in the geared company
D = the market value of debt capital in the geared company
E = the market value of equity in the geared company
Example: An all-equity company has a market value of $60 million and a cost of equity of 8%. It borrows
$20 million of debt finance, costing 5%, and uses this to buy back and cancel $20 million of equity. Tax relief
on debt interest is ignored.
Required: According to Modigliani and Miller, if taxation is ignored, what would be the effect of the higher
gearing on (a) WACC (b) total market value of the company and (c) the cost of equity in the company?
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CAPITAL STRUCTURE AND GEARING THEORIES
Example: A company has $500 million of equity capital and $100 million of debt capital, all at current
market value. The cost of equity is 14% and the cost of the debt capital is 8%. The company is planning to
raise $100 million by issuing new shares. It will use the money to redeem all the debt capital.
Required: According to Modigliani and Miller, if the company issues new equity and redeems all its debt
capital, what will be the cost of equity of the company after the debt has been redeemed? Assume that
there is no corporate taxation.
Answer
In the previous example, the Modigliani-Miller formulae were used to calculate a cost of equity in a geared
company, given the cost of equity in the company when it is ungeared (all-equity). This example works the
other way, from the cost of equity in a geared company to a cost of equity in an ungeared company. The
same formulae can be used.
Using the known values for the geared company, we can calculate the cost of equity in the ungeared
company after the debt has been redeemed.
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL STRUCTURE AND GEARING THEORIES
TRADITIONAL THEORY AND MM THEORY WITHOUT TAXATION ILLUSTRATIONS:
Question 01:
Company A has in issue 200,000 shares with an ex-dividend market value of Rs 12 per share and debt with
a market value of Rs 1,000,000. The company distributes all its earnings. The Cost of Debt is 9% and the
investors of the company charge a premium of 6% above the cost of debt for the risk associated with the
industry in which the company is operating.
The company does not have any positive NPV opportunities in addition to current operation, so it is
considering to change it capital structure in order to attract further value for the firm. Two directors of the
company have the following proposals for the same:
Director A
Since the company has no positive NPV ventures available with it so the market value of the company can
only be enhanced by taking more debt finance in order to buy back the equity (replacing costly capital with
much cheaper source of finance). The debt finance is cheaper and will led the overall WACC to reduce. Since
the earnings before interest and tax is constant for many years so the reduced WACC will result in an
increase in market value of the firm and its equity shares in specific. The Company should obtain a bank
loan of Rs 400,000 this would not increase the cost of debt the company is currently has but will increase
the Ke by 1% (New Ke = 16%)
Director B
Since the introduction of new debt to buy back of equity will not add any further resources to the company
so the profit before tax will not increase. Any benefit from the introduction of debt (cheaper cost capital)
will be exactly set off by the increase in cost of equity since the shareholders will be bearing extra financial
risk. This would ensure no change in the market value of the company. The company, instead; should look
for new investment opportunities to increase the PBIT and thus market value of the company.
Required:
Assume that you are the investment advisor appointed by the company. You are required to calculate the
market value of the company and its WACC using the assumptions of:
1.
2.
Director A (Advocate of traditional Theory)
Director B (Advocate of MM theory without taxation)
Question 02: Following data pertains to Jamal and Company:
Debt to equity ratio
WACC
Kd
Total market value of the firm
Always a mentor | Muzzammil Munaf
40:60
15%
10%
Rs 4,000,000
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CAPITAL STRUCTURE AND GEARING THEORIES
The management has proposed to change the debt equity ratio to 30:70. This would not affect the cost of
debt. 100% payout is followed.
Required
Calculate the market value of the company and components of capital along with the cost of capitals and
overall cost of capital of the company.
Question 03:
Following is the data of 'MNB Limited':
Debt equity ratio
Market value of Equity
Cost of equity
Cost of debt
100% equity financed
Rs 200,000
20%
10%
The company is considering to introduce some debt to buy back equity. The company's proposed debt to
equity ratio is 50:50. The company follows 100% payout policy.
Required:
Recalculate the market values and cost of debt and equity as per MM theory without taxation.
Question 04:
Company A and B are in steel manufacturing business for the last many years. Due to size disparity Company
B manages to earn a PBIT of Rs 640,000 which is 1.6 multiple of Company A which is small in terms of capital.
Cost of equity of Company B is 34% where as its value of equity is Rs 1,000,000. The market value of debt
of A limited is Rs 1,000,000.
Both companies follow 100% payout policy and cost of debt for both the Companies is 10%.
Required:
Prepare a market value of cost of capital profile for both companies.
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL STRUCTURE AND GEARING THEORIES
THE MODIGLIANI-MILLER VIEW: ALLOWING FOR CORPORATE TAXATION
Modigliani and Miller revised their arguments to allow for corporate taxation and the fact that there is tax
relief on interest. You do not need to know the arguments they used to reach their conclusions, but you
must know what their conclusions were.
Modigliani and Miller argued that allowing for corporate taxation and tax relief on interest, an increase in
gearing will have the following effect:
 As the level of gearing increases, there is a greater proportion of cheaper debt capital in the capital
structure of the firm. However, the cost of equity rises as gearing increases.
 As gearing increases, the net effect of the greater proportion of cheaper debt and the higher cost of
equity is that the WACC becomes lower. Increases in gearing therefore result in a reduction in the
WACC.
 The WACC is at its lowest at the highest practicable level of gearing.
 There are practical limitations on gearing that stop it from reaching very high levels. For example,
lenders will not provide more debt capital except at a much higher cost, due to the high credit risk or
insolvency risk.
The conclusions that MM reached were that:
 The total value of the company is higher for a geared company than for an identical all-equity company.
 The value of a company will rise, for a given level of annual cash profits before interest and tax, as its
gearing increases.
 There is an optimum level of gearing that a company should be trying to achieve. A company should
be trying to make its gearing as high as possible, to the maximum practicable level, in order to maximise
its value.
A graph showing the relationship between WACC and gearing, according to MM’s theory with taxation, is
as follows:
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CFAP 04 – BUSINESS FINANCE DECISIONS
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CAPITAL STRUCTURE AND GEARING THEORIES
Modigliani-Miller formulae: allowing for taxation
There are three formulae for the Modigliani and Miller theory, allowing for corporate taxation. These are
shown below. The letter ‘U’ refers to an ungeared company (all-equity company) and the letter ‘G’ refers to
a geared company.
1. WACC
The WACC in a geared company is lower than the WACC in an all-equity company.
𝐖𝐀𝐂𝐂𝐠 = 𝐖𝐀𝐂𝐂𝐮 𝐱 [𝟏 −
𝐃𝐱𝐭
(𝐃 + 𝐄)
where ‘t’ is the rate of taxation.
2. Value of a company
The total value of a geared company (equity + debt) is equal to the total value of an identical ungeared
company plus the value of the ‘tax shield’. This is the market value of the debt in the geared company
multiplied by the rate of taxation (D x t).
𝐌𝐕𝐠 = 𝐌𝐕𝐮 + (𝐃 𝐱 𝐭)
3. Cost of equity
The cost of equity in a geared company is higher than the cost of equity in an ungeared company, by a
factor equal to:
 the difference between the cost of equity in the ungeared company and the cost of debt (Keu – Kd)
 multiplied by the ratio (1 – t) x D/E
𝐊𝐞𝐠 = 𝐊𝐞𝐮 +
(𝟏 − 𝐭)𝐃
(𝐊𝐞𝐮 − 𝐊𝐝)
𝐄
When making calculations for the effect of gearing on the WACC and cost of equity, when you allow for
taxation, it is usually necessary to begin by calculating the effect of a change in gearing on total market
value and the market value of equity. In other words, you will usually have to begin with the formula MVg
= MVu + (D x t).
Example: An all-equity company has a market value of $60 million and a cost of equity of 8%. It borrows
$20 million of debt finance, costing 5%, and uses this to buy back and cancel $20 million of equity. The rate
of taxation on company profits is 25%.
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CAPITAL STRUCTURE AND GEARING THEORIES
According to Modigliani and Miller:
(a) Market value
The market value of the company after the increase in its gearing will be: VG = VU +Dt
VG = $60 million + ($20 million × 0.25) = $65 million.
The market value of the debt capital is $20 million; therefore the market value of the equity in the geared
company is $45 million ($65 million – $20 million).
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CAPITAL STRUCTURE AND GEARING THEORIES
MM THEORY WITH TAXATION ILLUSTRATIONS:
Question 01:
Book value of Debt
Coupon rate of interest
Pre-tax Kd
Tax Rate
= 8,000,000
= 8%
= 10%
= 30%
Calculate the value of tax shield (i.e. Present value of tax savings)
Question 02:
Book value of Debt
Coupon rate of interest
Pre-tax Kd
Tax Rate
= 11,500,000
= 10%
= 12.5%
= 30%
Calculate the value of tax shield (i.e. Present value of tax savings)
Question 03:
Market value of Debt
Pre-tax Kd
Tax Rate
= 9,000,000
= 11%
= 30%
Calculate the value of tax shield (i.e. Present value of tax savings)
Question 04:
Hateem Textiles Limited is an all-equity company with a market capitalization of Rs 7,000,000. The Company
is considering introducing some debt in its capital structure to increase the market value of the Company.
An amount of Rs 2,500,000 is proposed to be raised at a current market interest rate of 9%. That raise will
be used to buy back issued equity.
Required: Calculate the market value of the Company using:
a) MM theory without taxes
b) MM theory with taxes (tax rate is 30%)
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL STRUCTURE AND GEARING THEORIES
Question 05:
Dynamic Art Limited is an all-equity company with a market capitalization of Rs 4,000,000. The Company is
considering introducing some debt in its capital structure to increase the market value of the Company. An
amount of Rs 1,000,000 is proposed to be raised at a current market interest rate of 7%. That raise will be
used to buy back issued equity.
Required: Calculate the market value of the Company using:
a) MM theory without taxes
b) MM theory with taxes (tax rate is 30%)
Question 06:
An all-equity company is considering introducing debt finance in its capital structure. Details are as under:
PBIT
Tax Rate
Ke
= 200,000
= 30%
= 15%
Debt finance of Rs 500,000 will be raised at a cost of debt (K d) of 10% to buy back the equity.
Required:
a) Calculate the market value of the existing company.
b) Calculate Ke of the geared/levered Company.
c) Calculate WACC of the geared/levered Company.
Question 07:
The capital structure of Lumina Limited is as under:
Equity
= 4,000,000
Debt
= 1,200,000
Ke
= 20%
Kd
= 8%
The company follows a policy of 100% payout for dividends and is considering the following two options:
a) To obtain further debt of Rs 500,000 at a Kd of 8% and redeem equity component.
b) To issue the right shares of Rs 500,000 and pay-off the debt component.
The tax rate applicable is 30%.
Required:
a) Calculate the MV and WACC of the existing Company.
b) Calculate the MV, Ke, and WACC of the Company if the Company obtains debt.
c) Calculate the MV, Ke, and WACC of the Company if the Company issues the right shares.
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL STRUCTURE AND GEARING THEORIES
Question 08:
The capital structure of Haroon Limited is as under:
Equity
Debt
Ke
Kd
= 800,000
= 200,000
= 18%
= 7.5%
The Company is considering issuing debt finance of Rs 100,000 at a K d of 7.5%. Calculate revised MV, Ke
and WACC.
MM Theory: ICAP SUMMER 2008
Jalib Limited (JL) is planning to invest in a project which would require an initial investment of Rs. 399 million.
The project would have a positive net present value of Rs. 60 million if funded only from equity. There are
no internal funds available for this investment and the company wants to finance the project through debt.
However, JL’s existing TFCs contain a covenant that at any point in time, the debt to equity ratio in terms of
Market Values should not exceed 1:1.
Currently, the market values of JL’s equity (40 million shares are outstanding) and debt are Rs. 672 million
and Rs. 599 million respectively. Markets can be assumed to be strong form efficient.
Required:
a) Using Modigliani & Miller theory relating to capital structure, calculate the minimum amount of equity
that the company will have to issue to comply with the TFCs’ covenant (Tax rate is 35%)
b) Advise the Board of Directors as regards the following:
 the right share ratio and the price at which right shares may be issued to raise the amount of equity
as determined in (a) above, without affecting the market price of shares.
 What would be the impact on the market price of the company’s shares if the required amount of
equity is arranged by issue of shares at Rs. 14 per share?
(Round off all the amounts to nearest millions and price computations to two decimal places) (15 marks)
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL STRUCTURE AND GEARING THEORIES
ICAP SUMMER 2008 SOLUTION:
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL STRUCTURE AND GEARING THEORIES
PECKING ORDER THEORY
Pecking order theory is a view about how companies seek to raise new capital that contradicts views of capital
structure based on Modigliani and Miller theory or the traditional view of WACC.
Pecking order theory suggests that when companies try to raise new capital, they are not concerned with
minimising the WACC. They look for cheap capital and convenient access to new capital.
Many companies have a preferred order for sources of finance as follows i) Retained earnings ii) New debt
iii) New equity
It therefore goes against the theory that companies have a unique combination of debt and equity which
will minimise their cost of capital.
The reason for the order of preference of sources of finance may be due to the ease of obtaining the finance.
 Retained earnings are easily accessible and have no issue costs. Financial managers might therefore
consider retained earnings to have no cost, although this is not correct.
 It is cheaper to raise debt finance than equity and it is possible to raise smaller amounts when required.
Bank finance in particular is relatively quick and inexpensive to obtain, even though the bank will charge
an arrangement fee for any loan that it provides.
 The cost of raising capital by issuing new shares for cash is quite high. They include for example the
costs of professional fees of investment banking advisers, accountants and lawyers, underwriting fees,
costs of meeting regulatory requirements and so on.
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MARGINAL COST OF CAPITAL
MARGINAL COST OF CAPITAL
In order to identify its position on the WACC curve, every time a company is considering new finance it
should compare the marginal cost (MC) of that finance to its existing WACC.
 If MC of the finance is less than the existing WACC it is acceptable as it will reduce the company’s WACC.
 If MC of the finance is greater than the existing WACC it is not acceptable as it will increase the
company’s WACC. In this case the company should seek an alternative source. (For example, it could
raise finance in proportions to its existing market values of debt and equity as this would at least
maintain the existing WACC).
Estimating the marginal cost of finance
The marginal cost of debt is calculated as follows:
Alternatively, it can be calculated as:
‘Change in required returns on capital / Change in capital structure’
[Refer the class lecture to understand the above formula]
Estimating the increased demands of the shareholders for accepting new debt is difficult to do in practice.
The following example, in the first instance, appraises a project together with proposed finance by looking
at the total impact on the market value of equity.
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MARGINAL COST OF CAPITAL
ILLUSTRATIONS OF MARGINAL COST OF CAPITAL:
ILLUSTRATION 01: MARGINAL COST OF CAPITAL WITH TRADITIONAL THEORY
Required: Calculate the marginal cost of capital for this project and evaluate whether we should invest in
this project or not?
ILLUSTRATION 02: MARGINAL COST OF CAPITAL WITH MM THEORY
Required: Calculate the marginal cost of capital of the Company.
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ARBITRAGE FROM MM THEORY WITH TAXATION
ARBITRAGE FROM MM THEORY WITH TAXATION
MM demonstrated their theory with a series of examples. These showed that in the world characterised by
their assumptions, the market value of equivalent companies (i.e., companies with the same size of earnings
before tax and of the same business risk) with different levels of gearing would fall into the equilibrium
predicted by their model.
Investors (who are assumed to have perfect knowledge) would be able to identify any circumstance where
a component of capital in one of the companies was undervalued or overvalued compared to the other.
Such circumstances would allow the investors to sell shares in one company in order to invest in the other
in order to make a gain. This process of simultaneously buying and selling shares (or currency, or
commodities) in order to take advantage of differing prices for the same or similar assets is called arbitrage
and any gain achieved is called an arbitrage gain.
Illustration 01:
Consider the following details for two cement manufacturing companies:
Income Statement
Earnings before interest and tax
Interest
Taxation at 30%
Dividend
Costs
Cost of equity
Cost of debt [post tax: 8% x (1-0.3)]
WACC
Light Limited Dark Limited
------------ Rs -----------642.86
642.86
(80.00)
642.86
562.86
(192.86)
(168.86)
450.00
394.00
15.00%
0.00%
15.00%
17.13%
5.60%
13.64%
Required: Salman holds 10% of Light Limited and is seeking to know whether there are any arbitrage
opportunities available if he sells his holding in Light Limited and invests in Dark Limited.
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ARBITRAGE FROM MM THEORY WITH TAXATION
Illustration 02:
Consider the following details for two cement manufacturing companies:
Income Statement
Earnings before interest and tax
Interest
Taxation at 30%
Dividend
Market Value
Equity
Debt
Total
Light Limited Dark Limited
------------ Rs -----------642.86
642.86
(80.00)
642.86
562.86
(192.86)
(168.86)
450.00
394.00
3,000.00
3,000.00
2,000.00
1,000.00
3,000.00
Required: Considering the change in the scenario now, suggest Salman whether there are any arbitrage
opportunities available if he sells his 10% holding in Light Limited and invests in Dark Limited.
Illustration 03:
Consider the following details:
Income Statement
A
B
------------ Rs -----------Earnings before interest and tax
Interest
10,000.00
-
10,000.00
(2,000.00)
10,000.00
8,000.00
Taxation at 30%
(3,000.00)
(2,400.00)
Dividend
7,000.00
5,600.00
Cost of equity
20.00%
26.67%
Cost of debt [post tax: 10% x (1-0.3)]
0.00%
7.00%
WACC
20.00%
17.07%
Costs
Required:
-
Calculate market values of both the Companies.
Fareed holds 10% shareholding in Company B. He wants to move towards the ungeared Company.
Devise the hedging strategy and calculate arbitrage gain or loss, if any.
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ARBITRAGE FROM MM THEORY WITH TAXATION
Illustration 04:
ABC Limited and DEF Limited are in same industry but have different capital structure. ABC is an all equity
Company with Ke = 17.5%. Other details are as under:
Particulars
ABC
DEF
------------ Rs -----------Earnings before interest and tax
125,000.00
Interest
-
125,000.00
(20,000.00)
PBT
125,000.00
105,000.00
Taxation at 30%
(37,500.00)
(31,500.00)
PAT
87,500.00
73,500.00
Market Value
Equity
?
325,000
Debt
-
200,000
Total
?
525,000.00
Required:
i)
ii)
Identify the overvalued Company.
Calculate the arbitrage gain for an investor holding 10% stock of the overvalued Company.
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
Contents
CAPITAL ASSET PRICING MODEL .............................................................................................................................................. 2
THE CAPM METHOD OF ESTIMATING THE COST OF EQUITY ............................................................................... 2
Ke FROM CAPM – ICAP WINTER 2020: QUESTION ..................................................................................................... 3
Ke FROM CAPM – ICAP WINTER 2020: QUESTION ..................................................................................................... 4
Ke FROM CAPM – ICAP SUMMER 2008: QUESTION ................................................................................................... 5
Ke FROM CAPM – ICAP SUMMER 2008: SOLUTION ................................................................................................... 6
RISK AND INVESTMENTS ......................................................................................................................................................... 7
ASSET BETAS, EQUITY BETAS AND DEBT BETAS ...................................................................................................... 13
CAPM and the WACC ............................................................................................................................................................... 15
PROJECT-SPECIFIC DISCOUNT RATES ............................................................................................................................ 18
SUMMER 2009 GHI LIMITED: QUESTION ...................................................................................................................... 26
SUMMER 2009 GHI LIMITED: SOLUTION ...................................................................................................................... 27
SUMMER 2012 MAC FERTILIZER LIMITED: QUESTION .......................................................................................... 28
SUMMER 2012 MAC FERTILIZER LIMITED: SOLUTION .......................................................................................... 29
WINTER 2010 COPPER INDUSTRIES LIMITED: QUESTION ................................................................................... 31
WINTER 2010 COPPER INDUSTRIES LIMITED: SOLUTION ................................................................................... 32
ARBITRAGE PRICING MODEL .............................................................................................................................................. 33
ILLUSTRATION OF ARBITRAGE PRICING THEORY/MODEL: ................................................................................ 34
ICAP SUMMER 2022 CP LIMITED: QUESTION ............................................................................................................. 35
ICAP SUMMER 2022 CP LIMITED: SOLUTION ............................................................................................................. 36
Always a mentor | Muzzammil Munaf
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CAPITAL ASSET PRICING MODEL
CAPITAL ASSET PRICING MODEL
THE CAPM METHOD OF ESTIMATING THE COST OF EQUITY
Another approach to calculating the cost of equity in a company is to use the capital asset pricing model
(CAPM). The CAPM is considered in more detail in the next sections. The formula for the model:
Ke = Rf + (Rm – Rf) x βe
Where
Ke = the cost of equity for a company’s shares
Rf = the risk-free rate of return: this is the return that investors receive on risk-free investments such as
government bonds
Rm = the average return on market investments as a whole, excluding risk-free investments
βe = the beta factor for the company’s equity shares. The nature of the beta factor is explained in the next
sections.
Example
The rate of return available for investors on government bonds is 4%. The average return on market
investments is 7%. The company’s equity beta is 0.92. Using the CAPM, the company’s cost of equity is
therefore:
 4% + 0.92 (7 – 4)% = 6.76%.
Example
A company’s shares have a current market value of $13.00. The most recent annual dividend has just been
paid. This was $1.50 per share.
Required
Estimate the cost of equity in this company in each of the following circumstances:
(a) The annual dividend is expected to remain $1.50 into the foreseeable future.
(b) The annual dividend is expected to grow by 4% each year into the foreseeable future
(c) The CAPM is used, the equity beta is 1.20, the risk-free cost of capital is 5% and the expected market
return is 14%.
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CAPITAL ASSET PRICING MODEL
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RISK AND INVESTMENTS
Risk and return in investments: Investors invest in shares and bonds in the expectation of making a return.
The return that they want from any investment could be described as:
 a return as reward for providing funds and keeping those funds invested, plus
 a return to compensate the investor for the risk.
As a basic rule, an investor will expect a higher return when the investment risk is higher.
What is investment risk?
Investors in bonds, investors in shares and companies all face investment risk. In the case of bonds, the risks
for the investor are as follows:
 The bond issuer may default, and fail to pay the interest on the bonds, or fail to repay the principal at
maturity.
 There may be a change in market rates of interest, including interest yields on bonds. A change in yields
will alter the market value of the bonds. If interest rates rise, the market value of bonds will fall, and the
bond investor will suffer a loss in the value of his investment.
In the examination, you might be told to assume that debt capital is risk-free for the purpose of analysing
the cost of equity. In practice however, only government debt denominated in the domestic currency of the
government is risk-free.
In the case of equity shares, the risks for the investor are that:
 the company might go into liquidation, or,
 much more significantly, the company’s profits might fluctuate, and dividends might also rise or fall
from one year to the next.
For investors in equities, the biggest investment risk comes from uncertainty and change from one year to
the next in annual profits and dividends. Changes in expected profits and dividends will affect the value of
the shares. Bigger risk is associated with greater variability in annual earnings and dividends.
When a company invests in a new project, there will be an investment risk. This is the risk that actual returns
from the investment will not be the same as the expected returns but could be higher or lower. This
investment risk for companies is similar to the investment risk facing equity investors.
Some types of investment are riskier than others because of the nature of the industry and markets. For
example, investments by a supermarkets group in building a new supermarket is likely to be less risky than
investment by an IT company in a new type of software. This is because the IT business is inherently riskier
than the supermarkets business. When business risk is higher, returns are less predictable or more volatile,
and the expected returns should be higher to compensate for the higher business risk.
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Diversification to reduce risk: building an investment portfolio
To a certain extent, an investor can reduce the investment risk – in other words, reduce the volatility of
expected returns – by diversifying his investments, and holding a portfolio of different investments.
Creating a portfolio of different investments can reduce the variation of returns from the total portfolio,
because if some investments provide a lower-than-expected return, others will provide a higher-thanexpected return. Extremely high or low returns are therefore less likely to occur.
Similarly, a company could reduce the investment risk in its business by diversifying, and building a portfolio
of different investments. However, it can be argued that there is no reason for a company to diversify its
investments, because an investor can achieve all the diversification, he requires by selecting a diversified
portfolio of equity investments.
An investment portfolio consisting of all stock market securities (excluding risk-free securities), weighted
according to the total market value of each security, is called the market portfolio.
Systematic and unsystematic risk
Although investors can reduce their investment risk by diversifying, not all risk can be eliminated. There will
always be some investment risk that cannot be eliminated by diversification.
 When the economy is weak and in recession, returns from the market portfolio as whole are likely to
fall. Diversification will not protect investors against falling returns from the market as a whole
 Similarly, when the economy is strong, returns from the market as a whole are likely to rise. Investors in
all or most shares in the market will benefit from the general increase in returns.
Therefore, there are two types of risk:
 Unsystematic risk, which is risk that is unique to individual investments or securities, that can be
eliminated through diversification.
 Systematic risk, or market risk. This is risk that cannot be diversified away, because it is risk that affects
the market as a whole, and all investments in the market in the same way.
Implications of systematic and unsystematic risk for portfolio investment
The distinction between systematic risk and unsystematic risk has important implications for investment.
 Investors expect a return on their investment that is higher than the risk-free rate of return (unless they
invest 100% in risk-free investments).
 The higher expected return is to compensate investors for the higher investment risk.
 By diversifying, and investing in a wide range of different securities, investors can eliminate unsystematic
risk. This is because if some investments in the portfolio perform much worse than expected, others will
perform much better. The good-performing and poor-performing investments ‘cancel each other out’.
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 In a well-diversified portfolio, the unsystematic risk is therefore zero. Investors should therefore not
require any additional return to compensate them for unsystematic risk.
 The only risk for which investors should want a higher return is systematic risk. This is the risk that the
market as a whole will perform worse or better than expected.
Components of the capital asset pricing model (CAPM)
The capital asset pricing model (CAPM) establishes a relationship between investment risk and expected
return from individual securities. It can also be used to establish a relationship between investment risk and
the expected return from specific capital investment projects by companies.
Systematic risk in securities
As explained earlier, systematic risk is risk that cannot be eliminated by diversifying. Every individual security,
with the exception of risk-free securities, has some systematic risk. This is the same systematic risk that
applies to the market portfolio as a whole, but the amount of systematic risk for the shares in an individual
company might be higher or lower than the systematic risk for the market portfolio as a whole.
Since investors can eliminate unsystematic risk through diversification and holding a portfolio of shares,
their only concern should be with the systematic risk of the securities they hold in their portfolio. The return
that they expect to receive should be based on their assessment of systematic risk, rather than total risk
(systematic + unsystematic risk) in the security.
The CAPM assumes that investors hold diversified investment portfolios and are therefore concerned with
systematic risk only and not unsystematic risk.
The systematic risk of a security can be compared with the systematic risk in the market portfolio as a whole.
 A security might have a higher systematic risk than the market portfolio. This means that when the
average market return rises, due perhaps to growth in the economy, the return from the security should
rise by an even larger amount.
Similarly, if the average market return falls due to deterioration in business conditions, the return from
the security will fall by an even larger amount.
 A security might have a lower systematic risk than the market portfolio, so that when the average market
return rises, the return from the security will rise, but by a smaller amount. Similarly, when the average
market return falls, the return from the security will also fall, but by a smaller amount.
A risk-free security has no systematic risk, because returns on these securities are unaffected by changes in
market conditions. The shares of every individual company, however, have some systematic risk.
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The beta factor of a security
The systematic risk for an individual security is measured as a beta factor. This is a measurement of the
systematic risk of the security, in relation to the systematic risk of the market portfolio as a whole.
The beta factor for the market portfolio itself = 1.0.
Beta factor of risk-free securities
Risk-free investments provide a predictable and secure return. They have no systematic risk.
In the real world there are no risk-free investments, but short-term government debt issued in the domestic
currency can normally be regarded as very safe investments. The current yield on short-term government
debt is usually taken as a risk-free return. In the UK this is the current yield on UK government Treasury bills.
Since they have no systematic risk, the beta factor for risk-free securities = 0.
The risk-free rate of return varies between different countries, and can go up or down. The beta factor of a
risk-free security, however, is 0 at all times.
Beta factor of company securities.
The formula for calculating a security’s beta factor is as follows:
𝐁𝐞𝐭𝐚 𝐟𝐚𝐜𝐭𝐨𝐫 𝐨𝐟 𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐲 𝐒 =
𝐒𝐲𝐬𝐭𝐞𝐦𝐚𝐭𝐢𝐜 𝐫𝐢𝐬𝐤 𝐨𝐟 𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐲
𝐒𝐲𝐬𝐭𝐞𝐦𝐚𝐭𝐢𝐜 𝐫𝐢𝐬𝐤 𝐨𝐟 𝐭𝐡𝐞 𝐦𝐚𝐫𝐤𝐞𝐭 𝐚𝐬 𝐚 𝐰𝐡𝐨𝐥𝐞
The ‘market as a whole’ is the market portfolio.
The beta factor for the shares of an individual company:
 must always be higher than the risk-free beta factor (higher than 0)
 will be less than 1.0 if its systematic risk is less than the systematic risk for the market portfolio as a
whole.
 will be more than 1.0 if its systematic risk is greater than the systematic risk for the market portfolio as
a whole.
When the beta factor for an individual security is greater than 1, the increase or fall in its expected return
(ignoring unsystematic risk) will be greater than any given increase or decrease in the return on the market
portfolio as a whole (= the ‘market return’).
When the beta factor for a security is less than 1, the security is relatively low-risk. The expected increase or
decrease in its expected return (ignoring unsystematic risk) will be less than any given increase or decrease
in the market return.
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Beta factors for stock market companies (quoted companies) are measured statistically from historical stock
market data (using regression analysis) and are available on the internet from sources such as Datastream
and the London Business School Risk Management Service.
Formula for the CAPM: The formula for the capital asset pricing model is used to calculate the expected
return from a security (ignoring unsystematic risk).
Ke = Rf + (Rm – Rf) x Be
where:
Ke is the required return from a security S
Rf is the risk-free rate of return
Rm is the expected market return
βe is the beta factor for a given share of a company.
The expected return from an individual security will therefore vary up or down as the return on the market
as a whole goes up or down. The size of the increase or fall in the expected return will depend on:
 the size of the change in the returns from the market as a whole, and
 the beta factor of the individual security.
Example: The risk-free rate of return is 4% and the return on the market portfolio is 8.5%. What is the
expected return from shares in companies X and Y if:
 the beta factor for company X shares is 1.25
 the beta factor for company Y shares is 0.90?
Answer:
Company X: Ke = 4% + 1.25 (8.5 – 4)% = 9.625%
Company Y: RS = 4% + 0.90 (8.5 – 4)% = 8.05%.
The market premium
If an investor invests in a portfolio of risk-free assets, he will receive the risk-free rate of return, which is the
interest yield on those risk-free assets.
To compensate an investor for investing in the market portfolio, the expected return must be higher than
on risk-free investments. The market premium is the difference between the expected return on the market
portfolio and a portfolio of risk-free investments.
Market premium = Rm – Rf
where:
Rm is the market rate of return (the expected return on the market portfolio).
Rf is the risk-free rate of return.
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If you look again at the CAPM formula, you will see that the market premium is an element in the formula
for the CAPM. The return required from shares in any company by an investor who holds a diversified
portfolio should consist of:
 the return on risk-free securities
 plus a premium for the systematic investment risk: this premium is the market premium multiplied by
the beta factor for the particular security.
The beta factor of a small portfolio
A portfolio of investments containing just a few securities will not be fully representative of the market
portfolio, and its systematic risk will therefore be different from the systematic risk for the market as a whole.
The relationship between the systematic risk of a small portfolio and the systematic risk of the market as a
whole can be measured as a beta factor for the portfolio. A beta factor for a portfolio is the weighted
average value of the beta factors of all the individual securities in the portfolio. The weighting allows for the
relative proportions of each security in the portfolio.
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Alpha factor
The beta factor for shares is a measure of systematic risk and it ignores variations in the equity returns
caused by unsystematic risk factors. When shares yield more or less than their expected return (based on
the CAPM), the difference is an abnormal return. This abnormal return might be referred to as the alpha
factor. The alpha factor for a security is simply the balancing figure in the following formula:
Actual return of a security = Rf + [(Rm – Rf) x Be]+ α
Example
The return on shares of company A is 11%, but its normal beta factor is 1.10. The risk-free rate of return is
5% and the market rate of return is 8%.
There is an abnormal return on the shares:
Actual return of A = 11%
Required return of A = 5% + [(8 – 5)% x 1.10] = 8.3%
Difference is α = 11% - 8.8% = 2.7%
ASSET BETAS, EQUITY BETAS AND DEBT BETAS
Asset beta
When a company has no debt capital and is ungeared, its beta factor reflects the business risk of its business
operations. The beta factor is higher for ungeared companies with higher business risk.
The beta factor for a company’s business operations is called its asset beta.
If the company continues with the same business operations, its business risk will not change and its asset
beta remains constant.
Equity beta and debt beta
When a company takes on debt capital and its gearing increases, there is financial risk as well as business
risk. The cost of equity increases to compensate equity investors for the financial risk. The ‘equity beta’ a
company is the beta factor of its equity capital, that allows for both business risk and financial risk.
 The equity beta in an ungeared company is lower than the equity beta in a geared company because
there is no financial risk in an ungeared company.
 The equity beta in an ungeared company is equal to the asset beta: it allows for business risk only, with
no financial risk.
 The equity beta in a geared company is therefore higher than the company’s asset beta.
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Debt capital also has a beta factor (a ‘debt beta’), although this is much lower than the equity beta.
Formula for asset beta, equity beta and debt beta
There is a formula for the relationship between a company’s asset beta, equity beta and debt beta.
𝐁𝐚 = 𝐁𝐞 𝐱
[𝐃(𝟏 − 𝐭)]
𝐄
+ 𝐁𝐝 𝐱
[𝐄 + 𝐃(𝟏 − 𝐭)]
[𝐄 + 𝐃(𝟏 − 𝐭)]
where:
βa = the company’s asset beta: this is the same as the equity beta for an ungeared (all-equity) company
βeg = the beta factor of equity in the company: if the company has debt capital, this ‘equity beta’ is the
‘geared beta’ for the company’s equity capital
βd = the beta factor for the debt capital in the company
D = the market value of debt in the company
E = the market value of equity in the company
Assumption that the debt beta is 0
It is often assumed that the beta factor of debt capital in a company is very small and it is therefore possible
to assume that is actually 0. In other words, it is often assumed that a company’s debt capital is risk-free.
If it is assumed that corporate debt is risk-free, this formula simplifies to:
𝐁𝐚 = 𝐁𝐞 𝐱
𝐄
[𝐄 + 𝐃(𝟏 − 𝐭)]
If we assume that debt is risk-free, the asset beta of a company is lower than the equity beta factor by a
𝐄
factor of: [𝐄+𝐃(𝟏−𝐭)]
You should see from the formula that if the company is ungeared and is all-equity financed, the asset beta
and the equity beta are the same, because D = 0.
Example
Plassid Company has an equity beta of 1.25. The beta factor of its debt capital is 0.05. The total market value
of the shares of Plassid is $600 million and the total market value of its debt capital is $200 million. The rate
of corporate taxation is 30%.
Required:
(a) Calculate the asset beta of the company.
(b) Re-calculate the asset beta of Plassid assuming that the debt capital is risk-free.
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It is often assumed that debt capital is risk-free because the estimate of the asset beta is not affected
significantly by this simplifying assumption.
Relevance of asset beta
The asset beta is a beta factor that reflects the business risk of a particular business operation. It can be
used to estimate a cost of equity capital for a specific capital investment project and so a project specific
discount rate for use with DCF analysis. This is explained in a later section.
CAPM and the WACC
The capital asset pricing model can be used to calculate a cost of equity for any company. It can also be
used to calculate a cost of capital for corporate debt, but this is less likely to feature in your examination.
The cost of equity calculated using the CAPM can then be used in the calculation of the company’s weighted
average cost of capital.
The CAPM probably provides a more reliable estimate of the cost of equity than the dividend valuation
model or the dividend growth model, because:
 The CAPM ignores volatility in returns caused by unsystematic risk factors, which should not affect the
cost of equity for well-diversified investors.
 the beta factor for each company is measured statistically from historical stock market data.
In your examination you might be required to calculate a cost of equity using the CAPM and then use your
cost of equity to calculate a WACC.
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Company value and cost of capital
The previous chapter explained how the cost of capital can be calculated from expected returns (dividends
or interest) and the market value of securities. It is also possible, using the same mathematical method, to
calculate what the market value of shares or bonds ought to be, given expectations of future returns
(dividends and interest) and the cost of capital. One basic rule is that for a given size of expected future
returns, the total value of a company is higher when the cost of capital is lower.
By making simplifying assumptions of constant annual operating profits, and paying out all earnings as
dividends each year, we can state a formula linking the total value of a company to its WACC:
𝐓𝐨𝐭𝐚𝐥 𝐦𝐚𝐫𝐤𝐞𝐭 𝐯𝐚𝐥𝐮𝐞 (𝐞𝐪𝐮𝐢𝐭𝐲 + 𝐝𝐞𝐛𝐭) =
𝐏𝐁𝐈𝐓 (𝟏 − 𝐭)
𝐖𝐀𝐂𝐂
There is a direct relationship between expected future returns for investors, the cost of capital and the total
market value of a company.
A similar concept is applied in investment appraisal and DCF analysis of capital projects. There is a
relationship between:
 the future cash flows that a capital investment project will be expected to provide
 the cost of capital, and
 the value that the future cash flows will create.
With investment appraisal using DCF analysis, the expected future cash flows (cash profits) from a capital
investment project are discounted at a cost of capital. The total value of the company should increase if the
project has a positive NPV when the cash flows are discounted at the appropriate cost of capital. The
expected increase in the value of the company should be the amount of the NPV.
The appropriate cost of capital for calculating the NPV should be a cost of capital that represents the
investment risk of the project and the returns that the project must earn to meet the requirements of the
providers of the capital.
Average and marginal cost of capital
The marginal cost of capital of a capital investment project is the additional minimum return that the project
must provide to meet the requirements of the providers of the capital. The cost of the additional capital
required for a new capital investment project can be defined as the marginal cost of capital. There will be
an increase in the total value of the company from investing in a project only if its NPV is positive when its
cash flows are discounted at the marginal cost of the capital.
The average cost of capital is the cost of capital of all existing capital, debt and equity. This is represented
by the WACC.
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Capital investments should be discounted at their marginal cost of capital, but are usually discounted at the
company’s WACC.
This is because it is generally assumed that the effect of an individual project on the company’s marginal
cost of capital is not significant; therefore, all investment projects can be evaluated using DCF analysis and
the WACC, on the assumption that the WACC will be unchanged by investing in the new project.
In some cases, however, this assumption is not valid. The marginal cost of capital is not the WACC in cases
where:
 The capital structure will change because the project is a large project that will be financed mainly by
either debt or equity capital, and the change in capital structure will alter the WACC. If the WACC
changes, the marginal cost of capital and the WACC will not be the same.
 A new capital project might have completely different business risk characteristics from the normal
business operations of the company. If the business risk for a project is completely different, the
required return from the project will also be different. In such cases, the CAPM might be used to
establish a suitable marginal cost of capital for capital investment appraisal of the specific project.
Using the CAPM for capital investment appraisal
Some types of capital investment projects are more-risky than others because the business risk is greater.
For example, the systematic risk of investing in the manufacture of cars may be higher than the systematic
risk of investing in a retailing business. Investing in the construction of residential houses might be less risky
than investing in the construction of office blocks. Similarly, the risk of investing in one country may be
higher than the risk of investing in another country, due to differences in the business environment or
economic conditions.
Since different types of business operation have different business risk, the asset betas of each type of
business operation are also different.
When there are significant differences in business risk between different capital investment projects, if
follows that the required return from particular investments should be adjusted to allow for differences in
systematic risk.
If a beta factor for a particular project can be established, a risk-adjusted cost of capital can be applied to
the project. This risk-adjusted cost of capital should then be used to calculate the project NPV.
The calculation of a project-specific discount rate is explained in the next section.
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PROJECT-SPECIFIC DISCOUNT RATES
The need for project-specific discount rates
A specific discount rate should be used for DCF appraisal of capital projects where either:
 the business risk of the new project is different from the business risk of the company’s other business
operations, or
 the financial risk will be different because financing the project will involve a major change in the
company’s capital structure.
For examination purposes, the syllabus focuses on obtaining a cost of capital for specific projects where the
business risk will be significantly different.
Proxy companies and proxy betas
To calculate a suitable cost of capital to use in DCF analysis for a specific project where business risk is
different from the company’s normal business operations, the first step is to estimate the business risk.
The business risk of a business operation or capital investment project can be measured by the asset beta
for that type of business.
An estimate of the asset beta can be obtained from the beta factors of quoted companies that operate in
the same industry and markets. For example, if a housebuilding company is considering a project to
construct a new road bridge, for which the business risk will be very different, it can estimate an asset beta
for a bridgebuilding project by obtaining the beta factors of quoted companies in the bridgebuilding
industry.
These companies that operate in the relevant industry and markets are called ‘proxy companies’ and the
beta factors of their shares are called ‘proxy equity betas’.
It is assumed that the business risk within the proxy equity betas of these proxy companies is similar to the
business risk in the new capital investment project that the company is considering.
Using proxy betas to estimate an asset beta
For each of the proxy companies selected, an asset beta can be calculated using the asset beta formula. In
your examination you might be told to assume that debt capital in the proxy companies is risk-free;
therefore, the asset beta for each company can be calculated using the formula:
𝐁𝐚 = 𝐁𝐞 𝐱
𝐄
[𝐄 + 𝐃(𝟏 − 𝐭)]
The asset betas for the proxy companies will not be exactly the same, but they should be similar.
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
An asset beta for the capital investment project might therefore be estimated as the average of the asset
betas of the proxy companies. For example if three proxy companies have been selected and their asset
betas are 1.14, 1.20 and 1.22, an estimate of a suitable asset beta would be (1.14 + 1.20 + 1.23)/3 = 1.19.
Using an asset beta to calculate an equity beta: re-gearing the asset beta
An asset beta measures business risk but not financial risk. If a company is geared, or intends to finance a
project with a mixture of equity and debt capital, the equity beta for the project will be higher than the asset
beta.
The asset beta should therefore be re-geared, and converted into an equity beta, using the asset beta
formula and data about the capital structure of the company.
For examination purposes it will normally be assumed that the company’s debt
capital is risk-free, therefore the equity beta is calculated as:
𝐁𝐚 = 𝐁𝐞 𝐱
𝐄
[𝐄 + 𝐃(𝟏 − 𝐭)]
Having calculated an equity beta, the CAPM can be used to calculate a cost of equity for the project.
 This cost of equity can then be used to calculate a weighted average cost of capital for the project,
allowing for the capital structure of the company.
 Alternatively, an examination question might instruct you to assume that the project-specific cost of
equity you calculate should be used as the discount rate (cost of capital) for capital investment appraisal
of the project.
Summary of the steps for calculating a project-specific discount rate
The steps for calculating a project-specific discount rate for a project with different business risk can be
summarised as follows.
 Identify some proxy companies.
 For each of these proxy companies, obtain the available market data about their capital structure and
beta factors.
 For each proxy company, convert the available data in to an asset beta, using the asset beta formula.
 Calculate an average asset beta from the asset betas of the proxy companies.
 Convert this asset beta into a ‘geared equity’ beta for the company, using available data about its capital
structure. You will normally be told to assume that the debt capital of the company is risk-free.
 This geared equity beta should be used to calculate a cost of equity for the project, using the CAPM.
 Either this cost of equity can then be used in the calculation of a weighted average cost of capital for
the project, or you will be instructed to use the cost of equity as the cost of capital for DCF analysis of
the capital investment project.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
Example
An all-equity company operates in an industry where its beta factor is 0.90. It is considering whether to
invest in a completely different industry. In this other industry, the average debt/equity ratio is 40% and the
average beta factor is 1.25. The risk-free rate of return is 4% and the average market return is 7%. If the
company does invest in this other industry, it will remain all-equity financed. The rate of taxation is 30%.
Assume that debt is risk-free.
Required: What cost of capital should be used to evaluate the proposed investment?
Example
A company is planning to invest in a project in a new industry where it has not invested before. The asset
beta for the project has been estimated as 1.35. The project will be financed two-thirds by equity capital
and one-third by debt capital. The rate of taxation on company profits is 30%.
Assume that the debt capital is risk-free.
The risk-free rate of return is 3% and the market return is 8%.
What cost of equity should be used to calculate the marginal cost of capital for this project?
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
Example
A company is considering whether to invest in a new capital project where the business risk will be
significantly different from its normal business operations. The company is financed 80% by equity capital
and 20% by debt capital.
It has identified three companies in the same industry as the proposed capital investment and has obtained
the following information about them:
(1) Company 1 has an equity beta of 1.05 and is financed 30% by debt capital and 70% by equity.
(2) Company 2 has an equity beta of 1.24 and is financed 50% by debt capital and 50% by equity.
(3) Company 3 has an equity beta of 1.15 and is financed 40% by debt capital and 60% by equity.
The risk-free rate of return is 5% and the market rate of return is 8%. Tax on company profits is at the rate
of 30%. Assume that the debt capital in each company is risk-free.
Required:
Calculate a project-specific discount rate for the project, assuming that this is:
(a) the project-specific cost of equity for the project, or
(b) the weighted average of the project-specific equity cost and the company’s cost of debt capital.
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
Answer
Asset betas can be calculated for each proxy company as follows:
The average of these asset betas is (0.81 + 0.73 + 0.78)/3 = 0.77.
The asset beta for the capital project is 0.77. This should now be re-geared to obtain an equity beta for the
project.
0.77 = Be x 80 / [80 + 20(1-0.30)]
Be = 0.77 [80 + 20(1-0.30)] / 80
Be = 0.90
The project-specific cost of equity is now calculated using the CAPM:
Ke = 5% + 0.90 (8 – 5)% = 7.7%
 The project-specific discount rate is taken to be a weighted average cost of capital, this is calculated as
follows:
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
Summary: using the CAPM to obtain a project-specific discount rate
The WACC is often used as the cost of capital in capital expenditure appraisal because it is assumed that
individual projects will not significantly affect the WACC. The WACC is therefore an acceptable measure of
the marginal cost of capital.
A different situation arises when a new project will significantly affect the capital gearing or have significantly
different business risk. In these cases, an appropriate cost of equity capital can be estimated using the asset
beta formula, and assuming a risk-free cost of debt capital. The CAPM can therefore be used to obtain a
project specific discount rate.
Illustration 01:
The beta asset in a certain industry is prevailing at 1.2. Company A operates in the same industry with a
debt-to-equity ratio of 40:60. Company B is an all-equity Company and operates in the same industry as
Company A. Tax applies at the rate of 30%.
The market return is 16% and the risk-free rate is 10%.
Required:
i)
ii)
Calculate the Beta equity of both the Companies.
Calculate the Cost of equity (Ke) of both the Companies.
Illustration 02:
Company A is an all-equity company with an industry prevailing beta asset of 1.5. The Company is
considering introducing debt with the debt-to-equity ratio of 20:80.
Required: Calculate the cost of equity post the debt issuance if the market return is 15% and the risk-free
rate is 8%. Corporate tax applies at 30%.
Illustration 03:
Sector
Company
Beta equity of Company X
Debt to equity ratio
Tax rate
= Education
= Company X
= 1.8
= 20:80
= 30%
Sector
Company
Beta equity of Company X
Debt to equity ratio
Tax rate
= Construction
= Company Y
= 2.6
= 65:35
= 30%
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
Required:
i)
ii)
Calculate beta asset of both the Companies.
Comment on the riskiness of the Companies from the perspective of sector as well as capital structure.
Illustration 04:
The beta equity of Company stands at 2.2 with a debt to equity ratio of 50:50. The company is considering
conducting a new project in the same industry through further debt. The revised debt to equity ratio will be
75:25. Calculate the revised beta equity.
RISK ADJUSTED WACC:
Illustration 01:
Company A operates in the sector of chemicals with a debt to equity ratio of 50:50 and the tax applies at a
rate of 30%. The cost of equity of the Company is 18% and cost of debt is 9%.
Required:
a) Calculate WACC.
b) State which rate should be used as a discount rate for evaluation of a project the Company wants to
undertake in the same sector:
 With the same debt to equity ratio of 50:50; or
 With the debt to equity ratio of 75:25.
Illustration 02:
Company A operates in the sector of chemicals with a debt to equity ratio of 50:50 and the tax applies at a
rate of 25%. The cost of equity of the Company is 18% and cost of debt is 9%.
The Company wants to invest in the oil and gas sector and the new project will have a debt to equity ratio
of 65:35. For this purpose, details of a reference company having projects only in the oil and gas sector are
as follows:
Beta equity
Debt to equity ratio
Risk free rate
Market Return
= 2.1
= 60:40
= 9%
= 15%
Required: Calculate risk adjusted WACC of the new project to be undertaken by Company A.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
Illustration 03:
Company Z operates in the sector of banking with a debt to equity ratio of 40:60 and the tax applies at a
rate of 30%.
The Company wants to invest in the pharmaceutical sector and the new project will have a debt to equity
ratio of 65:35. For this purpose, details of a reference company having projects only in the pharmaceutical
sector are as follows:
Beta equity
Debt to equity ratio
Risk free rate
Market Return
= 2.0
= 65:35
= 10%
= 16%
Required:
a) Calculate risk adjusted WACC of the new project to be undertaken by Company Z.
b) Calculate risk adjusted WACC considering the new project is to be financed with a debt to equity ratio
of 30:70.
c) Calculate risk adjusted WACC considering the new project is to be financed with a debt to equity ratio
of 70:30.
Illustration 04:
Best Plastics Limited (BPL) is engaged in the manufacturing of plastic products.
Total Market value of the BPL
Debt to equity ratio
Cost of debt (pre-tax)
Cost of equity
Beta equity of BPL
Tax rate
= Rs 7,000,000
= 3/5
= 9%
= 17%
= 1.96
= 30%
Debt of BPL is risk-free and irredeemable. BPL is now considering diversifying its operations and undertake
a new project in pharma industry. It has identified the following details a reference company completely
operating in pharma industry.
Debt
Equity
Tax rate
Beta equity
= Rs 4,000,000
= Rs 6,000,000
= 25% (5% less than all other industries)
= 2.15
The Company is planning to finance the project in the debt-to-equity ratio of 30:70.
Required:
a) Calculate current WACC of BPL.
b) Calculate appropriate discount rate for the new project.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
SUMMER 2009 GHI LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
SUMMER 2009 GHI LIMITED: SOLUTION
Company is all financed (Ba = Be) (WACC = Ke)
Ke = 14%
Particulars
Weight of debt
Weight of equity
Kd
Ke
WACC [(KexE)+(KdxDx(1-t))]/(E+D)
0%
0%
100%
0%
10.80%
10.80%
10%
10%
90%
8%
11.20%
10.60%
40%
40%
60%
10%
12.00%
9.80%
50%
50%
50%
12%
12.80%
10.30%
Rf
Rm
Beta Equity
Ke = Rf + (Rm - Rf) x Be
6%
10%
1.20
10.80%
6%
10%
1.30
11.20%
6%
10%
1.50
12.00%
6%
10%
1.70
12.80%
Ke is in a rising trend because the financial risk is increasing.
Lowest WACC is 9.80% hence optimal capital structure.
Company should maintain a capital structure ratio of 40% debt/assets.
Revenue
Variable cost
Fixed cost
PBIT
PBIT (1 - t)
200
(120)
(40)
40
26 This should be divided by WACC for MV of Co.
This PBIT apparently has income from old and new business both therefore, MVs cannot be
calculated.
Nonetheless, MV is not relevant for decision making since it will mathematically be highest
with the lowest WACC i.e. PBIT (1-t) / WACC = MV of the Co.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
SUMMER 2012 MAC FERTILIZER LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
SUMMER 2012 MAC FERTILIZER LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
WINTER 2010 COPPER INDUSTRIES LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
WINTER 2010 COPPER INDUSTRIES LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
ARBITRAGE PRICING MODEL
The CAPM is a "single factor" model. It calculates a return on an investment by relating the market risk
premium to the systematic risk of the investment. Researchers claim to have identified other factors that
also affect return, including:




company size;
unexpected changes in interest rates;
unexpected changes in industrial production levels; and
unexpected inflation
Multi-factor models have been developed. The best known of these is the arbitrage pricing model. The
model is similar to the CAPM in that it relates a risk premium to the underlying risk factor. However, whereas
the CAPM says that there is only one such factor (systematic risk) the arbitrage pricing model says there are
several. Therefore, according to this model, an investor requires a return to compensate for each of these
separate risk factors.
Systematic risk is by far the most important determinant of return, but it probably is not the only one.
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
ILLUSTRATION OF ARBITRAGE PRICING THEORY/MODEL:
Company A wants to determine its Ke through arbitrage pricing model. The relevant Arbitrage Pricing
Theory factors are shown below together with their appropriate β weighting:
The company’s recent quoted equity beta is 1.25 whereas average market return on the Pakistan Stock
Exchange is 10% and risk free rate is 4%.
Required: Calculate the cost of equity of the company using the Arbitrage Pricing Theory and the Capital
Asset Pricing Model (CAPM), and briefly explain the difference in your answers.
Solution
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
ICAP SUMMER 2022 CP LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
ICAP SUMMER 2022 CP LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
Always a mentor | Muzzammil Munaf
Page 182 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
Always a mentor | Muzzammil Munaf
Page 183 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL ASSET PRICING MODEL
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
PORTFOLIO THEORY
Contents
PORTFOLIO THEORY ........................................................................................................................................................................ 2
SINGLE ASSET PORTFOLIO ....................................................................................................................................................... 2
TWO-ASSET PORTFOLIO ........................................................................................................................................................... 2
CORRELATION COEFFICIENT OF INVESTMENT RETURNS:...................................................................................... 3
DIVERSIFICATION / RISK MITIGATION: ............................................................................................................................ 3
THREE-ASSET PORTFOLIO ........................................................................................................................................................ 4
ICAP SUMMER 2008 MR FARAZ: QUESTION.................................................................................................................. 9
ICAP SUMMER 2008 MR FARAZ: SOLUTION ............................................................................................................... 10
ICAP WINTER 2015 AKHTAR: QUESTION...................................................................................................................... 12
ICAP WINTER 2015 AKHTAR: SOLUTION ...................................................................................................................... 13
ICAP SUMMER 2018 WETA PAKISTAN: QUESTION ................................................................................................. 14
ICAP SUMMER 2018 WETA PAKISTAN: SOLUTION ................................................................................................. 14
ICAP SUMMER 2015 AZAD TEXTILE: QUESTION ....................................................................................................... 16
ICAP SUMMER 2015 AZAD TEXTILE: SOLUTION ....................................................................................................... 17
MUTUAL FUNDS: ........................................................................................................................................................................ 19
ICAP SUMMER 2011 FR SOCIETY: QUESTION ............................................................................................................. 20
ICAP SUMMER 2011 FR SOCIETY: SOLUTION ............................................................................................................. 21
ICAP WINTER 2019 TEZGAM INVESTMENT: QUESTION ....................................................................................... 22
ICAP WINTER 2019 TEZGAM INVESTMENT: SOLUTION ....................................................................................... 23
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
PORTFOLIO THEORY
PORTFOLIO THEORY
Portfolio theory suggests that investors can reduce the total risk on their investments by diversifying their
portfolio of investments. It is used to construct a portfolio minimizing risk for a given level of expected
return for investors trying to develop efficient portfolios.
It provides a comparison based on risk and returns which helps in taking decisions. However, portfolio
theory does not discuss about what should be the fair return of a security.
SINGLE ASSET PORTFOLIO
Return of a single asset portfolio
Weighted average of probable returns [ ∑ x /n ], [ ∑ Px ]
Risk of a single asset portfolio
Standard deviation from expected return (volatility of
probable returns)
Standard Deviation:
σA = √∑ P (R A − ̅̅̅̅
R A )2
Whereas
σA
P
RA
̅̅̅̅
RA
Standard deviation or risk
Probability
Adjusted probable return
Expected Return (weighted average of probable returns)
TWO-ASSET PORTFOLIO
Return from a two-asset portfolio:
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
PORTFOLIO THEORY
Risk of a two-asset portfolio:
CORRELATION COEFFICIENT OF INVESTMENT RETURNS:
Correlation coefficient =
Covariance
σA x σB
Correlation coefficient =
∑ P(R A − ̅̅̅̅
R A )(R B − ̅̅̅̅
RB)
σA x σB
Covariance = ∑ P(R A − ̅̅̅̅
R A )(R B − ̅̅̅̅
RB)
DIVERSIFICATION / RISK MITIGATION:
 A correlation coefficient can range from +1 (perfect positive correlation) to – 1 (perfect negative
correlation) whereas close to zero indicates very little correlation between investment returns.
 When returns from different investments in a portfolio are positively correlated, this means that when
the returns from one of the investments is higher than expected, the returns from the other investments
will also be higher than expected.
 When returns from two different investments in a portfolio are negatively correlated, this means that
when the returns from one of the investments is higher than expected, the returns from the other
investment will be lower than expected.
 Investment risk is reduced most effectively by having investments in a portfolio whose returns are
negatively correlated, or where there is not much correlation (diversification).
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
PORTFOLIO THEORY
THREE-ASSET PORTFOLIO
Return of a three-asset portfolio:
The expected return from a three-asset portfolio is the weighted average of the returns from the three
investments.
RP = (RA x WA) + (RB x WB) + (RC x WC)
Whereas:
RA / RB / RC = Return from individual securities
WA / WB / WC = Weight of security in the portfolio
Risk of a three-asset portfolio:
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
PORTFOLIO THEORY
SINGLE SECURITY PORTFOLIO
Case 01:
Probability
20%
50%
30%
Return Security A
8%
15%
16%
Return Security B
2%
18%
24%
Required: Determine the expected return and risk of both the securities.
Case 02:
Probability
30%
40%
30%
Return Security A
24%
16%
8%
Return Security B
18%
16%
14%
Required: Determine the expected return and risk of both the securities.
TWO SECURITIES PORTFOLIO
Case 01:
Security A
Security B
Return
24%
16%
Weight
35%
65%
Required: Determine the expected return of the portfolio.
Case 02:
Standard Deviation
Weight
Return
Security A
10%
50%
28%
Security B
6%
50%
19%
Required: Determine the risk of the portfolio if both the securities have a correlation of +1, 0, and -1.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
PORTFOLIO THEORY
Case 03:
Standard Deviation
Weight
Return
Security A
8%
60%
16%
Security B
12%
40%
22%
Required: Determine the risk of the portfolio if both the securities have a correlation of +1, 0, and -1.
CO-VARIANCE AND CORRELATION:
Case 01:
Probability
30%
40%
30%
Return Security A
8%
12%
16%
Return Security B
10%
15%
18%
Required:
-
Calculate the expected return and standard deviation of both the securities.
Calculate co-relation between them and determine the risk of the portfolio if we invest 50% in each
of the two securities.
Case 02:
Probability
50%
30%
20%
Return Security A
12%
8%
18%
Return Security B
10%
12%
16%
Required:
-
Calculate the expected return and standard deviation of both the securities.
Calculate co-relation between them and determine the risk of the portfolio if we invest 50% in each
of the two securities.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
PORTFOLIO THEORY
CAPITAL ASSET PRICING MODEL:
Case 1:
An investor has the following details regarding the benchmark entity of FMCG sector:
Benchmark return
Risk associated to benchmark security (SD)
Risk free return
= 18%
= 4.0%
= 8.0%
Advise whether he should invest in the following securities:
Company
IMC
Donark
Britishia
Vinar
Cleep
Judica
Aimsia
Expected Return
24%
19%
16%
12%
36%
17%
25%
Risk (SD)
5%
6%
2%
2%
5%
3%
8%
Case 2:
Risk free rate
Market Return
Market Risk (SDm)
= 6.2%
= 10.8%
= 3.2%
Expected Return from security A
Risk of security A
Correlation of security A and market
= 12%
= 4%
= 0.9
Required: Advise whether to invest in security A.
Case 3:
Risk free rate
Market Return
Market Risk (SDm)
= 8%
= 15%
= 10.8%
Expected Return from security A
Risk of security A
Correlation of security A and market
= 16%
= 9%
= 0.75
Required: Calculate Alpha value and advise whether to invest in security A.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
PORTFOLIO THEORY
Case 4:
Risk free rate
Market Return
= 8%
= 16%
Beta of security A
= 0.7
Required: Calculate expected return of the security A.
Case 5:
Risk free rate
Market Return
= 8%
= 16%
Required return of security A
= 20%
Required: Calculate beta of the security A.
Case 6:
Probability
20%
50%
30%
Market Return
15%
18%
16%
Return Security A
24%
9%
13%
Return Security B
12%
16%
14%
Risk free rate = 7.5%
Required: Determine which security should be invested in.
Case 7:
Probability
25%
50%
25%
Market Return
30%
25%
40%
Return Security A
20%
30%
40%
Return Security B
22%
28%
40%
Risk free rate = 10%
Required: Determine which security should be invested in.
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PORTFOLIO THEORY
ICAP SUMMER 2008 MR FARAZ: QUESTION
Always a mentor | Muzzammil Munaf
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PORTFOLIO THEORY
ICAP SUMMER 2008 MR FARAZ: SOLUTION
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PORTFOLIO THEORY
Always a mentor | Muzzammil Munaf
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PORTFOLIO THEORY
ICAP WINTER 2015 AKHTAR: QUESTION
Always a mentor | Muzzammil Munaf
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PORTFOLIO THEORY
ICAP WINTER 2015 AKHTAR: SOLUTION
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PORTFOLIO THEORY
ICAP SUMMER 2018 WETA PAKISTAN: QUESTION
ICAP SUMMER 2018 WETA PAKISTAN: SOLUTION
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PORTFOLIO THEORY
After selecting the company C, overall risk profile of WPL would be improved from 1.25 to 1.15. The
reduction in expected return from 17.25% to 16.35% may be a cause of concern for WPL.
However, the reduction in expected return is compensated by reduction in risk from 8.6% to 8.36% i.e.
combined standard deviation. Now it is the decision of the management whether this trade off between
risk and return is acceptable to WPL.
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PORTFOLIO THEORY
ICAP SUMMER 2015 AZAD TEXTILE: QUESTION
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PORTFOLIO THEORY
ICAP SUMMER 2015 AZAD TEXTILE: SOLUTION
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PORTFOLIO THEORY
Always a mentor | Muzzammil Munaf
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PORTFOLIO THEORY
MUTUAL FUNDS:
Illustration:
Amount of investment available
Net asset value as at acquisition
Front end load (FEL)
Date of investment
= Rs 500,000
= Rs 10.50 per unit
= 3%
= July 1, 2019
Redemption date
Cash dividend received
Bonus units
Net asset value at redemption
Back end load (BEL)
= Dec 31, 2019
= Rs 12,000
= 10%
= 10.4
= 2%
Always a mentor | Muzzammil Munaf
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PORTFOLIO THEORY
ICAP SUMMER 2011 FR SOCIETY: QUESTION
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PORTFOLIO THEORY
ICAP SUMMER 2011 FR SOCIETY: SOLUTION
Always a mentor | Muzzammil Munaf
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PORTFOLIO THEORY
ICAP WINTER 2019 TEZGAM INVESTMENT: QUESTION
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PORTFOLIO THEORY
ICAP WINTER 2019 TEZGAM INVESTMENT: SOLUTION
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RIGHTS ISSUE AND DIVIDEND POLICY
Contents
RIGHTS ISSUE AND DIVIDEND POLICY .................................................................................................................................. 2
RIGHTS ISSUES ............................................................................................................................................................................... 2
DIVIDEND POLICY......................................................................................................................................................................... 8
ICAP WINTER 2012 ABM LIMITED: QUESTION .......................................................................................................... 14
ICAP WINTER 2012 ABM LIMITED: SOLUTION .......................................................................................................... 15
ICAP SUMMER 2019 GREEN LIMITED: QUESTION.................................................................................................... 17
ICAP SUMMER 2019 GREEN LIMITED: SOLUTION .................................................................................................... 18
ACCA F9 2015 JUNE GRENARP CO: QUESTION ......................................................................................................... 19
ACCA F9 2015 JUNE GRENARP CO: SOLUTION ......................................................................................................... 20
ACCA AFM 2019 SEPTEMBER CADNAM CO: QUESTION ....................................................................................... 21
ACCA AFM 2019 SEPTEMBER CADNAM CO: SOLUTION ....................................................................................... 22
ACCA AFM 2018 JUNE ARTHURU GROUP: QUESTION .......................................................................................... 24
ACCA AFM 2018 JUNE ARTHURU GROUP: SOLUTION .......................................................................................... 25
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RIGHTS ISSUE AND DIVIDEND POLICY
RIGHTS ISSUE AND DIVIDEND POLICY
RIGHTS ISSUES
A rights issue is an issue for shares for cash, where the new shares are offered to existing shareholders in
proportion to their current shareholding.
The issue price
The share price of the new shares in a rights issue should be lower than the current market price of the
existing shares. Pricing the new shares in this way gives the shareholders an incentive to subscribe for them.
There are no fixed rules about what the share price for a rights issue should be, but as a broad guideline
the issue price for the rights issue might be about 10% - 15% below the market price of existing shares just
before the rights issue.
For example, if a company is planning a 1 for 3 rights issue and the market price of its shares is $6, it might
offer the new shares in the rights issue at a fixed price in the region of $5.10 to $5.40.
The theoretical ex-rights price
When a company announces a rights issue, the market price of the existing shares just before the new issue
takes place is called the ‘cum rights’ price. (‘Cum rights’ means ‘with the rights’). The theoretical ex-rights
price is what the share price ought to be, in theory, after the rights issue has taken place.
 All the shares will have the same market price after the issue.
 In theory, since the new shares will be issued at a price below the cum rights price, the theoretical price
after the issue will be lower than the cum rights price. The theoretical ex-rights price is simply the
weighted average price of the current shares ‘cum rights’ and the issue price for the new shares in the
rights issue.
Example: A company with 20 million shares in issue announces a 2 for 5 rights issue at a price of $3 per
share. The market price of the existing shares before the rights issue is $3.70.
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RIGHTS ISSUE AND DIVIDEND POLICY
The value of rights
In theory, the holder of five shares in the company in the previous example could buy two new shares in
the rights issue for $3 each, and these two shares will be expected to rise in value to $3.50, a gain of $0.50
for each new share or $1.00 in total for the five existing shares.
We can therefore say that the theoretical value of the rights is:
 $0.50 for each new share issued, or
 $0.20 ($1.00/5 shares) for each current share held.
Shareholders are allowed to sell their rights to subscribe for the shares in the rights issue, and investors who
buy the rights are entitled to subscribe for shares in the rights issue at the rights issue price. The most
common way of stating the value of rights is the value of the rights for each existing share. In the example,
the theoretical value of the shares would normally be stated as $0.20.
The shareholders’ choices
When a company announces a rights issue, the shareholders have the following choices:
 They can take up their rights, and buy the new shares that have been offered to them.
 They can renounce their rights, and sell the rights in the market. By selling rights, the shareholder is
selling to another investor the right to subscribe for the new shares at the issue price.
 They can take up some rights and renounce the rest. This is a combination of the two options above.
 They can do nothing. If they do nothing, their existing shares will fall in value after the rights issue
(perhaps from the cum rights price to the theoretical exrights price), and they will suffer a loss in the
value of their investment. The company might try to sell the new shares to which the ‘do-nothing’
shareholders were entitled, and pay them any surplus receipts above the rights issue price. However,
the ‘do-nothing’ shareholders are still likely to suffer a loss.
If a shareholder takes up his rights, in theory he will be no worse and no better off. Similarly, if a shareholder
renounces his rights and sells them, he will be no better and no worse off.
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RIGHTS ISSUE AND DIVIDEND POLICY
 If a shareholder takes up his rights, he will be required to subscribe $5 in cash to purchase each new
share. In theory, the value of his shares will rise from $25 for every four shares he owns to $30 for every
five shares that he owns, but he has paid an additional $5 to the company. In theory, he will therefore
be neither better off nor worse off. In practice, the gain or loss on his investment will depend on what
the actual share price is after the rights issue (since the actual share price might be higher or lower than
the theoretical ex-rights price).
 If the shareholder renounces his rights and sells them, the theoretical value of his rights will be $0.25
($(6 – 5)/4 shares)) for each existing share. If he sells his rights at this price, he will earn $1 for every four
shares that he owns. After the rights issue, the value of his four shares will fall, in theory, from $6.25 to
$6 each, or from $25 to $24 for every four shares. There will be a theoretical fall in his investment value
by $1 for every four shares held, but this is offset by the sales value of the rights. In theory, he will
therefore be neither better off nor worse off.
THEORETICAL EX RIGHT PRICE / DECISION MAKING
Illustration 01:
Company A has 400,000 shares in issues which are trading at Rs 80 per share prior to the right issue. The
Company is planning to issue 100,000 right shares at the rate of Rs 60 per share to existing shareholders.
Talal, a shareholder, holds 700 shares of the Company.
Required:
 Calculate theoretical ex right price.
 Demonstrate the effect on Talal if he:
o Subscribe the right offer.
o Does nothing.
o Sells the right letters in the market.
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RIGHTS ISSUE AND DIVIDEND POLICY
Illustration 02:
Good Steel Limited (GSL) has 2,000,000 shares in issues which are trading at Rs 5 per share prior to the right
issue. The Company is planning to issue 500,000 right shares at the rate of Rs 4 per share to existing
shareholders.
Mr. Aslam holds 1,200 shares in the above Company.
Required:
 Calculate theoretical ex right price.
 Calculate the value of right per share.
 Demonstrate the effect on Mr. Aslam if he:
o Subscribe the right offer.
o Does nothing.
o Sells the right letters in the market.
 Suggest a strategy through which Aslam should have no effect on his wealth.
YIELD ADJUSTED THEORETICAL EX RIGHT PRICE:
Illustration 01:
Good Steel Limited (GSL) has 2,000,000 shares in issues which are trading at Rs 5 per share prior to the right
issue. The Company is planning to issue 500,000 right shares at the rate of Rs 4 per share to existing
shareholders.
The amount of the right proceeds will be invested in a project earning return at the rate of 15% per year in
perpetuity. Cost of equity of the shareholders is 12%.
Required: Calculate the yield adjusted theoretical ex-right price.
Illustration 02:
Adeel Limited (AL) has 4,000,000 shares in issues which are trading at Rs 1.5 per share prior to the right
issue. The Company is planning to issue 1,800,000 right shares at the rate of Rs 1.125 per share to existing
shareholders.
The amount of the right proceeds will be invested in a project earning return at the rate of 15% per year in
perpetuity. Cost of equity of the shareholders is 12.5%.
Required: Calculate the yield adjusted theoretical ex-right price.
Always a mentor | Muzzammil Munaf
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RIGHTS ISSUE AND DIVIDEND POLICY
FURTHER ISSUANCE OF SHARES EXCEPT RIGHT:
Illustration 01:
Arham Limited (AL) has 25,000 shares in issue trading at a price of Rs 40 per share. The Company is planning
to issue further shares at Rs 32 per share for raising an amount of Rs 200,000.
The proceeds will be invested in a project earning Rs 67,500 in perpetuity. The cost of equity is prevailing
at 20%.
Required: Demonstrate the impact on the existing as well as new shareholders.
Illustration 02:
Arham Limited (AL) has 25,000 shares in issue trading at a price of Rs 40 per share. The Company is planning
to issue further shares at Rs 33.25 per share for raising an amount of Rs 200,000.
The proceeds will be invested in a project earning Rs 67,500 in perpetuity. The cost of equity is prevailing
at 20%.
Required: Demonstrate the impact on the existing as well as new shareholders.
Illustration 03:
Arham Limited (AL) has 25,000 shares in issue trading at a price of Rs 40 per share. The Company is planning
to issue further shares for raising an amount of Rs 200,000.
The proceeds will be invested in a project earning Rs 67,500 in perpetuity. The cost of equity is prevailing
at 20%.
It is mandated by the board of directors that the benefit of NPV of the new project should accrue to the
existing shareholders only.
Required:
 Calculate the price at which new shares should be issued.
 Demonstrate the impact on the existing as well as new shareholders.
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RIGHTS ISSUE AND DIVIDEND POLICY
Illustration 04:
Arham Limited (AL) has 25,000 shares in issue trading at a price of Rs 40 per share. The Company is planning
to issue further shares for raising an amount of Rs 200,000. The proceeds will be invested in a project earning
Rs 67,500 in perpetuity. The cost of equity is prevailing at 20%.
It is mandated by the board of directors that the benefit of NPV of the new project should accrue to the
new shareholders only.
Required:
 Calculate the price at which new shares should be issued.
 Demonstrate the impact on the existing as well as new shareholders.
Illustration 05:
Arham Limited (AL) has 25,000 shares in issue trading at a price of Rs 40 per share. The Company is planning
to issue further shares for raising an amount of Rs 200,000.
The proceeds will be invested in a project earning Rs 67,500 in perpetuity. The cost of equity is prevailing
at 20%.
It is mandated by the board of directors that the benefit of NPV of the new project should accrue to the
existing and new shareholders in the ratio of 50:50.
Required:
 Calculate the price at which new shares should be issued.
 Demonstrate the impact on the existing as well as new shareholders.
Illustration 06:
Arham Limited (AL) has 25,000 shares in issue trading at a price of Rs 40 per share. The Company is planning
to issue further shares for raising an amount of Rs 200,000.
The proceeds will be invested in a project earning Rs 67,500 in perpetuity. The cost of equity is prevailing
at 20%.
Required: Calculate the price range within which new shares can be issued.
Always a mentor | Muzzammil Munaf
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RIGHTS ISSUE AND DIVIDEND POLICY
Illustration 07:
Dual Stone Limited has 5,000,000 shares in issue trading at a price of Rs 5 per share. The Company is
planning to issue further shares for raising an amount of Rs 500,000.
The proceeds will be invested in a project earning Rs 100,000 per year in perpetuity. The cost of equity is
prevailing at 10%.
Required: Calculate the price range within which new shares can be issued.
DIVIDEND POLICY
The relationship between the dividend decision and the financing decision
Total earnings are retained or paid out in dividends. Retained earnings are the surplus profits available to
the company for investment after dividend has been paid. Dividends reduce equity capital.
When a company wants to raise more capital for investment, it could do so by paying no dividend at all and
retaining 100% of earnings. The only external capital it then needs to raise is the amount by which its capital
requirements exceed its earnings.
In practice, however, not many companies would do this. Instead, they have a dividend policy that they
make known to their shareholders and try to apply in practice (subject to profits being large enough). Even
when they want to raise fresh capital, they will probably continue to pay dividends.
Shareholder preferences
Some shareholders prefer to receive dividends from their equity investments. Others are not concerned
about dividends and would prefer the company to reinvest all its earnings in order to pursue growth
strategies that will increase the market value of the shares. Many shareholders prefer a mixture of dividends
and retaining some profits for share price growth. (For many years, for example, software giant Microsoft
had a policy of retaining its earnings to invest in growth, with no dividend payouts.)
Shareholders will buy and hold shares of companies that pursue a dividend policy consistent with their
preferences for dividends or share price growth, and companies might try to pursue a dividend policy
consistent with the preferences of most of their shareholders.
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RIGHTS ISSUE AND DIVIDEND POLICY
The nature of dividend policy
In practice dividend policy might be stated in terms of an intention of the board of directors to increase
annual dividends inline with growth in earnings per share.
When dividends increase by the same proportionate amount as the rise in EPS, it is said to maintain a
constant ‘payout ratio’.
Shareholders can monitor the future profit expectations of the company to predict the amount of dividends
they are likely to receive in the future.
Theories of dividend policy
There are several theories about dividend policy. These theories are intended to identify the optimal number
of dividends that a company should pay to the shareholders. Three of these theories are:
 the traditional view of dividend policy
 residual theory
 Modigliani and Miller’s theory of the irrelevance of dividend policy.
Traditional view of dividend policy
The traditional view of dividend policy is that the amount of dividend payments should be at a level that
enables the company to maximise the value of its shares. Retaining earnings adds to earnings growth in the
future, and earnings growth will enable the company to increase dividends in the future.
For example, suppose that a company pays out 40% of its earnings in dividends and retains the remaining
60% of earnings which it can reinvest in the business to earn a return of 10% per year. For every $100 of
earnings in the current year, it will pay dividends of $40 and by reinvesting $60 it will add to future annual
earnings by 6% (= 60% × 10%) each year. Annual earnings next year will be $106.
Similarly, if a company retains only 20% of its earnings which it can reinvest at 10%, for every $100 of
earnings in the current year, it will pay dividends of $80 and by reinvesting $20 it will add to future annual
earnings by 2% (= 20% × 10%) each year. Annual earnings next year will be $102.
There is a model for the valuation of shares based on expectations of future dividend growth, known as
Gordon’s growth model or the dividend growth model. This model is described in a later chapter on
valuation.
According to traditional theory of dividend policy, the optimal dividend policy is the dividends and
retentions policy that maximises the share price using the dividend growth model to obtain a share price
valuation.
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RIGHTS ISSUE AND DIVIDEND POLICY
Residual theory of dividend policy
The residual theory of dividend policy is that the optimal amount of dividends should be decided as follows.
 If a company has capital investment opportunities that will have a positive NPV, it should invest in them
because they will add to the value of the company and its shares.
 The capital to invest in these projects should be obtained internally (from earnings) if possible.
 The amount of dividends paid by a company should be the residual amount of earnings remaining after
all these available capital projects have been funded by retained earnings.
 In this way, the company will maximise its total value and the market price of its shares.
A practical problem with residual theory is that annual dividends will fluctuate, depending on the availability
of worthwhile capital projects. Shareholders will therefore be unable to predict what their dividends will be.
Modigliani and Miller’s theory of the irrelevance of dividend policy
Modigliani and Miller (MM) developed a theory to suggest that dividend policy is irrelevant, and the level
of dividends paid out by a company does not matter. The total market value of a company will be the same
regardless of whether the dividend payout ratio is 0%, 100% or any ratio in between.
Their theory was based on certain assumptions. One of these was that taxation (and the differing tax position
of shareholders and companies) can be ignored. Their theory assumes a tax-free situation.
MM argued that the value of a company’s shares depends on the rate of return it can earn from its business.
‘Earning power’ matters, but dividends do not. They argued that if a company has opportunities for investing
in capital projects with a positive NPV, they can either:
 use retained earnings to finance the investment, or
 pay out earnings and dividends and obtain the equity that it needs for capital investment from the stock
market.
For example, if a company has earnings of $100 million and investment opportunities costing $100 million
that have a positive NPV, it does not matter whether it pays no dividend and invests all its earnings on the
capital projects, or whether it pays dividends of $100 million and raises new equity capital of $100 million
for the capital project investments.
If the company pays out dividends and raises new equity capital, the existing shares will fall in value by the
amount of the dividend payments. However, this loss of value will be replaced by the new equity raised in
the market, so the total value of the company’s equity will be unaffected.
 Loss in value of existing shares = Amount of dividends paid
 Total value of equity before the dividend payment and equity issue = Total value of equity after the
dividend payment and equity issue.
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RIGHTS ISSUE AND DIVIDEND POLICY
Whenever shareholders want cash, it does not matter whether they obtain it in the form of dividends or by
selling their shares in the market. One initial criticism of this theory of dividend irrelevance was that some
shareholders have a preference for high dividends, so dividend policy does matter.
MM responded by arguing that companies often have a consistent dividend policy with a constant payout
ratio. Shareholders will be attracted to holding shares in the companies whose dividend policy is consistent
with their own dividend preference.
Criticisms of irrelevance theory
However, there are other criticisms of MM’s theory of dividend irrelevance:
 The theory assumes that there are no costs involved in raising new equity capital, so that there is no
cost difference between retaining earnings and raising new equity.
 Similarly, MM assumed that there are no costs involved in selling shares, so that shareholders should
be indifferent between getting cash in the form of dividends or getting it by selling some shares.
 MM assumed that shareholders possess perfect information about the returns that will be obtained by
companies from their new capital investments. Since future earnings can be predicted with confidence,
MM argued that share prices would remain close to their real value. In practice, however, this is not the
case. Shareholders cannot always assess the real value of their shares with confidence: this is one reason
why many shareholders prefer high cash dividends instead of the prospect of bigger capital gains in
the future.
DIVIDEND POLICY ILLUSTRATIONS:
Illustration 01:
Consider the following for Company A:
Retention %
Dividend
Growth
Ke
0%
800,000
0%
14%
25%
600,000
5%
15%
40%
480,000
7%
16%
Required: Determine the optimum dividend payout policy as per traditional view.
Illustration 02:
Market value per share of Company A is Rs 80 and the cost of equity is 15%. Determine the market value
of the share as per MM Dividend Irrelevance Theory if the Board decides to pay dividend:
a) Rs 5 per share
b) Rs 4 per share
c) Decides not to pay dividend.
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RIGHTS ISSUE AND DIVIDEND POLICY
Illustration 03:
Consider the following information regarding Haris Limited (HL) as at December 31, 2020:
Existing no of shares
Price per share as at Jan 1, 2020
Cost of equity
Profit for the year
80,000
Rs 15
20%
Rs 240,000
HL wants Rs 560,000 to invest in a new project for which following two options are available:
a) Not to pay dividend at all and utilise existing profit.
b) Distribute dividend amounting to Rs 2 per share and utilise remaining profit.
The remaining shortfall shall be covered by issuing right shares at the price prevailing at year end under
each of the above options.
Required: Determine the appropriate course of action in light of the MM Dividend Irrelevance Theory.
Illustration 04:
Consider the following information regarding Sega Motors (SM) as at June 30, 2018:
Existing no of shares
Price per share as at July 1, 2017
Cost of equity
Profit for the year
20,000,000
Rs 80
14.4%
Rs 250,000,000
SM wants Rs 600,000,000 to invest in a new project for which following two options are available:
c) Not to pay dividend at all and utilise existing profit.
d) Distribute dividend amounting to Rs 2 per share and utilise remaining profit.
The remaining shortfall shall be covered by issuing right shares at the price prevailing at year end under
each of the above options.
Required: Determine the appropriate course of action in light of the MM Dividend Irrelevance Theory.
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
RIGHTS ISSUE AND DIVIDEND POLICY
LINTNER MODEL
Illustration 01:
Consider the following information for Company A:
Prior year’s dividend
Current year’s EPS
Company’s payout ratio
= Rs 16 per share
= Rs 40 per share
= 60%
Required: Calculate the dividend for current year as per Lintner Model if the adjustment factor is 25%.
Illustration 02:
Consider the following information for Company B:
Prior year’s dividend
Current year’s EPS
Company’s payout ratio
= Rs 9.8 per share
= Rs 20 per share
= 60%
Required: Calculate the dividend for current year as per Lintner Model if the adjustment factor is
a) 45%
b) 20%
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
RIGHTS ISSUE AND DIVIDEND POLICY
ICAP WINTER 2012 ABM LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
Page 221 of 690
Page 14 of 26
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
RIGHTS ISSUE AND DIVIDEND POLICY
ICAP WINTER 2012 ABM LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
Page 222 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
RIGHTS ISSUE AND DIVIDEND POLICY
Always a mentor | Muzzammil Munaf
Page 223 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
RIGHTS ISSUE AND DIVIDEND POLICY
ICAP SUMMER 2019 GREEN LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
Page 224 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
RIGHTS ISSUE AND DIVIDEND POLICY
ICAP SUMMER 2019 GREEN LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
RIGHTS ISSUE AND DIVIDEND POLICY
ACCA F9 2015 JUNE GRENARP CO: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
RIGHTS ISSUE AND DIVIDEND POLICY
ACCA F9 2015 JUNE GRENARP CO: SOLUTION
Current share price
Right issue price (3.5 x 80%)
3.50
2.80
Total proceeds from right issue
Issue cost
Net proceeds from right issue
11,200,000
(280,000)
10,920,000
Ordinary share capital
Per share nominal value
Existing no of shares (10/0.5)
New shares issue (20/5 x 1)
Total shares after right issue
10,000,000
0.50
20,000,000
4,000,000
24,000,000
Market price per loan note
5% premium on the market price
Redemption value from right issue
104.00
5.20
109.20
Market value of shares before the right issue (20 x 3.5)
Net proceeds from the right issue
Total market value after right shares
70,000,000
10,920,000
80,920,000
Redemption value from right issue
Total amount available for redemption
No of loan notes that can be redeemed (10,920,000/109.2)
109.20
10,920,000
100,000
Interest saved (100,000 x 100 x 8%)
Post tax interest saved [800,000 x (1-30%)]
800,000
560,000
Existing net earnings
Net of tax interest saved
Revised earnings after interest is saved
Revised number of shares
Revised EPS (8,960,000/24,000,000)
Existing P/E Multiple (3.5/0.42)
Revised share price (0.373 x 8.33)
8,400,000
560,000
8,960,000
24,000,000
0.373
8.33
3.11
Existing MV of all shares (3.5 x 20 mn shares)
New MV of all shares (3.11 x 24 Mn shares)
70,000,000
74,666,667
4,666,667
(11,200,000)
(6,533,333)
Additional cash provided by shareholders in right issue
Net decrease in shareholders wealth
There is decrease in shareholders wealth as the right issue amount does not justify the increase.
Had the P/E multiple been increased, the valuation would have been better here.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
RIGHTS ISSUE AND DIVIDEND POLICY
ACCA AFM 2019 SEPTEMBER CADNAM CO: QUESTION
Always a mentor | Muzzammil Munaf
Page 228 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
RIGHTS ISSUE AND DIVIDEND POLICY
ACCA AFM 2019 SEPTEMBER CADNAM CO: SOLUTION
Always a mentor | Muzzammil Munaf
Page 229 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
RIGHTS ISSUE AND DIVIDEND POLICY
Always a mentor | Muzzammil Munaf
Page 230 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
RIGHTS ISSUE AND DIVIDEND POLICY
ACCA AFM 2018 JUNE ARTHURU GROUP: QUESTION
Always a mentor | Muzzammil Munaf
Page 231 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
RIGHTS ISSUE AND DIVIDEND POLICY
ACCA AFM 2018 JUNE ARTHURU GROUP: SOLUTION
Always a mentor | Muzzammil Munaf
Page 232 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
RIGHTS ISSUE AND DIVIDEND POLICY
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
Contents
CASE STUDIES ON EVALUATING SOURCES OF FINANCE ............................................................................ 2
WINTER 2015 IMPRESSION HOME: QUESTION ........................................................................................ 2
WINTER 2015 IMPRESSION HOME: SOLUTION ........................................................................................ 3
SUMMER 2016 GOLDEN INDUSTRIES: QUESTION ................................................................................... 5
SUMMER 2016 GOLDEN INDUSTRIES: SOLUTION ................................................................................... 7
ICAP SUMMER 2014 GRAND POWER: QUESTION ..................................................................................10
ICAP SUMMER 2014 GRAND POWER: SOLUTION ..................................................................................11
ACCA F9 JUNE 2019 CORFE CO: QUESTION ............................................................................................13
ACCA F9 JUNE 2019 CORFE CO: SOLUTION.............................................................................................14
ACCA F9 JUNE 2018 TIN CO: QUESTION ..................................................................................................16
ACCA F9 JUNE 2018 TIN CO: SOLUTION ..................................................................................................17
ACCA F9 2015 DECEMBER KQK CO: QUESTION ......................................................................................18
ACCA F9 2015 DECEMBER KQK CO: SOLUTION ......................................................................................19
ACCA AFM 2020 SEPTEMBER KINGTIM CO: QUESTION ........................................................................21
ACCA AFM 2020 SEPTEMBER KINGTIM CO: SOLUTION ........................................................................23
ICAP SUMMER 2022 GO LIMITED: QUESTION ........................................................................................26
ICAP SUMMER 2022 GO LIMITED: SOLUTION ........................................................................................26
Always a mentor | Muzzammil Munaf
Page 234 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
WINTER 2015 IMPRESSION HOME: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
WINTER 2015 IMPRESSION HOME: SOLUTION
PE Multiple = Price / Earning
MV of Equity - Existing
MV of Debt - Existing
New investment
Total Co value post investment
6,090.00
5,567.60
2,500.00
14,157.60
MV of Equity - Existing
PBIT
Interest (5,000 x 14%)
PBT
Tax @ 30%
PAT
PE Multiple
MV of Equity (PAT x 6)
2,150.00
(700.00)
1,450.00
(435.00)
1,015.00
6.00
6,090
MV of Debt - Existing
Interest
Redemption CF (5,000x1.1)
PV @ 12%
MV
Equity
Debt
Year 1
700.00
700.00
625.00
Year 2
700.00
5,500.00
6,200.00
4,942.60
5,567.60
Post Inv
7,078.80
7,078.80
Existing To be issued
6,090.00
988.80
5,567.60
1,511.20
Market value of old and new debt after 1 year at a yield to maturity of 10%
MV of Debt - Existing
Interest
Redemption CF (5,000x1.1)
PV @ 10%
MV
Year 1
700.00
5,500.00
6,200.00
5,636.36
5,636.36
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
MV of Debt - New
Interest (1,511.2 x 12%)
Redemption CF (1,511.20 x 1.1)
PV @ 10%
MV
Year 1
181.34
181.34
164.86
1,710.22
Year 1
181.34
181.34
149.87
Total debt
7,346.59
The MV of equity should be of the same amount
P/E Multiple
Desired PAT (7,346.59/6.30)
7,346.59
6.30
1,166.12
Desired profit after tax
1,166.12
Desired profit before tax (1,166.12/0.7)
Add: Old interest (5,000 x 14%)
Add: New interest (1,511.20 x 12%)
Desired PBIT
Existing PBIT
Net increase in PBIT
1,665.89
700.00
181.34
2,547.24
2,150.00
397.24
Always a mentor | Muzzammil Munaf
Page 237 of 690
Year 1
181.34
181.34
136.25
Year 1
181.34
1,662.32
1,843.66
1,259.25
Page 4 of 28
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
SUMMER 2016 GOLDEN INDUSTRIES: QUESTION
Always a mentor | Muzzammil Munaf
Page 238 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
Always a mentor | Muzzammil Munaf
Page 239 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
SUMMER 2016 GOLDEN INDUSTRIES: SOLUTION
Always a mentor | Muzzammil Munaf
Page 240 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
Always a mentor | Muzzammil Munaf
Page 241 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
Always a mentor | Muzzammil Munaf
Page 242 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
ICAP SUMMER 2014 GRAND POWER: QUESTION
Always a mentor | Muzzammil Munaf
Page 243 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
ICAP SUMMER 2014 GRAND POWER: SOLUTION
Always a mentor | Muzzammil Munaf
Page 244 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
Always a mentor | Muzzammil Munaf
Page 245 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
ACCA F9 JUNE 2019 CORFE CO: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
ACCA F9 JUNE 2019 CORFE CO: SOLUTION
Always a mentor | Muzzammil Munaf
Page 247 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
Always a mentor | Muzzammil Munaf
Page 248 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
ACCA F9 JUNE 2018 TIN CO: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
ACCA F9 JUNE 2018 TIN CO: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
ACCA F9 2015 DECEMBER KQK CO: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
ACCA F9 2015 DECEMBER KQK CO: SOLUTION
Always a mentor | Muzzammil Munaf
Page 252 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
Always a mentor | Muzzammil Munaf
Page 253 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
ACCA AFM 2020 SEPTEMBER KINGTIM CO: QUESTION
Always a mentor | Muzzammil Munaf
Page 254 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
Always a mentor | Muzzammil Munaf
Page 255 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
ACCA AFM 2020 SEPTEMBER KINGTIM CO: SOLUTION
Always a mentor | Muzzammil Munaf
Page 256 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
Always a mentor | Muzzammil Munaf
Page 258 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
ICAP SUMMER 2022 GO LIMITED: QUESTION
ICAP SUMMER 2022 GO LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
Always a mentor | Muzzammil Munaf
Page 260 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CASE STUDIES ON EVALUATING SOURCES OF FINANCE
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
Contents
CAPITAL INVESTMENT APPRAISAL ........................................................................................................................................................................................ 2
ACCOUNTING RATE OF RETURN (ARR) METHOD ..................................................................................................................................................... 3
THE PAYBACK METHOD OF CAPITAL INVESTMENT APPRAISAL ....................................................................................................................... 7
NET PRESENT VALUE (NPV) METHOD OF INVESTMENT APPRAISAL ............................................................................................................ 10
INTERNAL RATE OF RETURN (IRR) METHOD............................................................................................................................................................ 11
SUMMARY: COMPARISON OF THE FOUR INVESTMENT APPRAISAL METHODS ..................................................................................... 14
MODIFIED INTERNAL RATE OF RETURN (MIRR) ..................................................................................................................................................... 14
ICAP WINTER 2014 (DIFFERENTIAL CASH FLOWS): QUESTION ....................................................................................................................... 20
ICAP WINTER 2014 (DIFFERENTIAL CASH FLOWS): SOLUTION ....................................................................................................................... 21
ICAP JUNE 2015 (SHUT DOWN DECISION): QUESTION ....................................................................................................................................... 22
ICAP JUNE 2015 (SHUT DOWN DECISION): SOLUTION ....................................................................................................................................... 23
ICAP SUMMER 2014 (TARGET IRR): QUESTION ....................................................................................................................................................... 24
ICAP SUMMER 2014 (TARGET IRR): SOLUTION ....................................................................................................................................................... 25
ICAP WINTER 2013 (DECISION MAKING – RESTRUCTURING): QUESTION ................................................................................................. 27
ICAP WINTER 2013 (DECISION MAKING – RESTRUCTURING): SOLUTION ................................................................................................. 28
MIRR ICAP SUMMER 2018: QUESTION ........................................................................................................................................................................ 30
MIRR ICAP SUMMER 2018: SOLUTION ........................................................................................................................................................................ 31
SENSITIVITY ANALYSIS ....................................................................................................................................................................................................... 34
ICAP WINTER 2016 SUFFER LIMITED: QUESTION ................................................................................................................................................... 39
ICAP WINTER 2016 SUFFER LIMITED: QUESTION ................................................................................................................................................... 41
ICAP SUMMER 2017 TAHIR LODHI: QUESTION ....................................................................................................................................................... 43
ICAP SUMMER 2017 TAHIR LODHI: SOLUTION ....................................................................................................................................................... 44
ICAP WINTER 2019 GHAURI LIMITED: QUESTION ................................................................................................................................................. 46
ICAP WINTER 2019 GHAURI LIMITED: SOLUTION ................................................................................................................................................. 48
ICAP WINTER 2020 ECO ENERGY: QUESTION ........................................................................................................................................................... 49
ICAP WINTER 2020 ECO ENERGY: SOLUTION ........................................................................................................................................................... 51
ICAP WINTER 2021 COOLER LIMITED: QUESTION.................................................................................................................................................. 54
ACCA F9 2014 DECEMBER UFTIN CO: QUESTION ................................................................................................................................................... 60
ACCA F9 2014 DECEMBER UFTIN CO: SOLUTION ................................................................................................................................................... 61
ICAP WINTER 2015 SANDRA LIMITED: QUESTION ................................................................................................................................................ 63
ICAP WINTER 2015 SANDRA LIMITED: SOLUTION ................................................................................................................................................ 64
DISCOUNTED PAYBACK PERIOD .................................................................................................................................................................................... 65
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
CAPITAL INVESTMENT APPRAISAL
CAPITAL EXPENDITURE
the basis for making the investment decision
Financial accounting
method
Accounting
rate of reurn
(ARR)
Cash flow
method
Making an investment that will provide an
adequate investment return over time
Payback
period
Specific
applications
Discounted cash flow
(DCF)
Creating additional
value in the business
Making a good
investment return
Net Present
Value (NPV)
Sensitivity Analysis
Discounted
payback
period
Internal Rate of
Return (IRR) AND
Modified Rate of
Return (MIRR)
Asset replacement
decisions
Capital Rationing
Lease vs Borrow
Decisions
CAPITAL EXPENDITURE, INVESTMENT APPRAISAL AND CAPITAL BUDGETING
Capital expenditure
Capital expenditure is spending on non-current assets, such as buildings and equipment, or investing in a
new business. As a result of capital expenditure, a new non-current asset appears on the statement of
financial position (balance sheet), possibly as an ‘investment in subsidiary’.
In contrast revenue expenditure refers to expenditure that does not create long-term assets, but is either
written off as an expense in the income statement in the period that it is incurred, or that creates a shortterm asset (such as the purchase of inventory).
Capital expenditure initiatives are often referred to as investment projects, or ‘capital projects’. They can
involve just a small amount of spending, but in many cases large amounts of expenditure are involved.
A distinction might possibly be made between:
 essential capital spending to replace worn-out assets and maintain operational capability
 discretionary capital expenditure on new business initiatives that are intended to develop the business
make a suitable financial return on the investment.
Investment appraisal
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
Before capital expenditure projects are undertaken, they should be assessed and evaluated. As a general
rule, projects should not be undertaken unless:
 they are expected to provide a suitable financial return, and
 the investment risk is acceptable.
Investment appraisal is the evaluation of proposed investment projects involving capital expenditure. The
purpose of investment appraisal is to make a decision about whether the capital expenditure is worthwhile
and whether the investment project should be undertaken.
Methods of investment appraisal
There are four methods of evaluating a proposed capital expenditure project. Any or all of the methods can
be used, but some methods are preferable to others, because they provide a more accurate and meaningful
assessment.
The four methods of appraisal are:
 Accounting rate of return (ARR) method
 Payback method
 Discounted cash flow (DCF) methods:
o Net present value (NPV) method
o Internal rate of return (IRR) method
Each method of appraisal considers a different financial aspect of the proposed capital investment.
Other specific methods include asset replacement decisions, lease vs borrow decisions, sensitivity analysis
and capital rationing.
ACCOUNTING RATE OF RETURN (ARR) METHOD
The accounting rate of return (ARR) from an investment project is the accounting profit, usually before
interest and tax, as a percentage of the capital invested. It is similar to return on capital employed (ROCE),
except that whereas ROCE is a measure of financial return for a company or business as a whole, ARR
measures the financial return from specific capital project.
The essential feature of ARR is that it is based on accounting profits, and the accounting value of assets
employed.
Decision rule for the ARR method
The decision rule for capital investment appraisal using the ARR method is that a capital project meets the
criteria for approval if its expected ARR is higher than a minimum target ARR or minimum acceptable ARR.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
Alternatively, the decision rule might be to approve a project if the return on capital employed (ROCE) of
the company as a whole will increase as a result of undertaking the project.
Definition of ARR
If accounting rate of return (ARR) is used to decide whether or not to make a capital investment, we calculate
the expected annual accounting return over the life of the project. The financial return will vary from one
year to the next during the project; therefore, we have to calculate an average annual return.
If the ARR of the project exceeds a target accounting return, the project would be undertaken. If its ARR is
less than the minimum target, the project should be rejected and should not be undertaken.
Unfortunately, a standard definition of accounting rate of return does not exist. There are two main
definitions:
 Average annual profit as a percentage of the average investment in the project
 Average annual profit as a percentage of the initial investment.
You would normally be told which definition to apply. If in doubt, assume that capital employed is the
average amount of capital employed over the project life.
𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐄𝐦𝐩𝐥𝐨𝐲𝐞𝐝 =
[𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐜𝐨𝐬𝐭 𝐞𝐪𝐮𝐢𝐩𝐦𝐞𝐧𝐭 + 𝐑𝐞𝐬𝐢𝐝𝐮𝐚𝐥 𝐕𝐚𝐥𝐮𝐞]
+ 𝐖𝐨𝐫𝐤𝐢𝐧𝐠 𝐂𝐚𝐩𝐢𝐭𝐚𝐥
𝟐
However, you might be expected to define capital employed as the total initial investment (capital
expenditure + working capital investment).
Profits will vary from one year to the next over the life of an investment project. As indicated earlier, profit
is defined as the accounting profit, after depreciation but before interest and taxation. Since profits vary
over the life of the project, it is normal to use the average annual profit to calculate ARR.
Profit is calculated using normal accounting rules, and is after deduction of depreciation on non-current
assets.
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
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CAPITAL INVESTMENT APPRAISAL
Illustration 01:
Initial outlay
Life
Residual value
Working Capital
= Rs 500,000
= 5 years
= Rs 100,000
= Rs 150,000
Year
EBITDA
1
150,000
2
200,000
3
250,000
4
270,000
5
180,000
Required: Calculate ARR of the project.
Illustration 02:
Consider the following details for Company A.
Project
Term (years)
Investment (Rs)
Residual value (Rs)
A
7
350,000
0
B
5
350,000
0
C
5
350,000
0
EBITDA over the term
904,000
770,000
630,000
Required: Calculate ARR.
Illustration 03:
A company is considering a project which requires an investment of Rs.120,000 in machinery.
The machinery will last four years after which it will have scrap value of Rs.20,000. The investment in
additional working capital will be Rs.15,000.
The expected annual profits before depreciation are:
Year
1
2
3
4
Rs.45,000
Rs.45,000
Rs.40,000
Rs.25,000
The company requires a minimum accounting rate of return of 15% from projects of this type.
Required: Advise whether the project should be undertaken.
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
THE PAYBACK METHOD OF CAPITAL INVESTMENT APPRAISAL
Definition of payback
Payback is measured by cash flows, not profits. It is the length of time before the cash invested in a project
will be recovered (paid back) from the net cash returns from the investment project.
For example, suppose that a project will involve capital expenditure of $80,000 and the annual net cash
returns from the project will be $30,000 each year for five years. The expected payback period is:
 $80,000 / $30,000 = 2.67 years
Decision rule for the payback method
Using the payback method, a maximum acceptable payback period is decided, as a matter of policy. The
expected payback period for the project is calculated.
 If the expected payback is within the maximum acceptable time limit, the project is acceptable.
 If the expected payback does not happen until after the maximum acceptable time limit, the project is
not acceptable.
The time value of money is ignored, and the total return on investment is not considered.
Example
A company requires all investment projects to pay back their initial investment within three years. It is
considering a new project requiring a capital outlay of $140,000 on plant and equipment and an investment
of $20,000 in working capital. The project is expected to earn the following net cash receipts:
Should the investment be undertaken?
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CAPITAL INVESTMENT APPRAISAL
Note: The payback period of 2 years 9 months is calculated as follow.
(1) Payback occurs during the third year. At the beginning of year 3 the cumulative cash flow is $(70,000).
During the year there are net cash flows of $90,000. The cumulative cash flow therefore starts to become
positive, assuming even cash flows through the year, after 70,000/90,000 of the year = 0.78 year.
(2) A decimal value for a year can be converted into months by multiplying by 12, or into days by multiplying
by 365. So 0.78 years = 9 months (= 0.78 × 12) or 285 days (= 0.78 × 365).
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
Illustration 01: Consider the following for Company A:
Initial outlay
Constant cashflows per year in perpetuity
= 100,000
= 24,000
Required: Calculate the payback period.
Illustration 02: Consider the following for Company A:
Initial outlay
Project Life
= 50,000
= 3 years
Net cash inflows
Year 1
Year 2
Year 3
= 20,000
= 24,000
= 28,000
Required: Calculate the payback period.
Illustration 03: Consider the following for Company A:
Initial outlay
Residual value
Project Life
= 400,000
= 40,000
= 3 years
Net cash flows constant in three years
Sales
Cost
Interest
= 450,000
= 246,000
= 40,000
Depreciation is taken as per straight line method. Tax applies at the at of 30%.
Required: Calculate the payback period.
Illustration 04: Consider the following for Company A:
Initial outlay
Residual value
Project Life
= 300,000
= 30,000
= 3 years
Net cash flows constant in three years
Sales
Cost
= 270,000
= 100,200
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CAPITAL INVESTMENT APPRAISAL
Depreciation is taken as per straight line method. Tax applies at the at of 45%.
Required: Calculate the payback period.
NET PRESENT VALUE (NPV) METHOD OF INVESTMENT APPRAISAL
With the NPV method of investment appraisal, all the future cash flows from an investment are converted
into a present value by discounting each future cash flow at the investment cost of capital. This cost of
capital is the return required from the investment.
The present value of a future cash inflow from a capital project is the amount that would have to be invested
now at the cost of capital to obtain that cash flow in the future. For example suppose that a project is
expected to provide a cash return of $40,000 after two years and a further $50,000 after three years, and
the company needs to make a return of 10% per year. The NPV approach to investment appraisal is to
convert these expected future cash inflows into their present value equivalent.
 The present value of these future cash flows would be the amount that the company would need to
invest now at 10% per year to obtain a return of $40,000 after two years and another $50,000 after three
years.
 The present value of the expected cash flows is therefore the value to the company, in terms of ‘today’s
value’ of those cash flows in the future.
Calculating the NPV of an investment project
In NPV analysis, all future cash flows from a project are converted into a present value, so that the value of
all the annual cash outflows and cash inflows can be expressed in terms of ‘today’s value’.
The net present value (NPV) of a project is the net difference between the present value of all the costs
incurred and the present value of all the cash flow benefits (savings or revenues).
 If the present value of benefits exceeds the present value of costs, the NPV is positive.
 If the present value of benefits is less than the present value of costs, the NPV is negative.
 The NPV is 0 when the PV of benefits and the PV of costs are equal.
The decision rule is that, ignoring other factors such as risk and uncertainty, and non-financial
considerations, a project is worthwhile financially if the NPV is positive or zero. It is not worthwhile if the
NPV is negative.
The net present value of an investment project is also a measure of the value of the investment. For example,
if a company invests in a project that has a NPV of $2 million, the value of the company should increase by
$2 million.
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CAPITAL INVESTMENT APPRAISAL
INTERNAL RATE OF RETURN (IRR) METHOD
The internal rate of return method (IRR method) is another method of investment appraisal using DCF.
The internal rate of return of a project is the discounted rate of return on the investment.
 It is the average annual investment return from the project
 Discounted at the IRR, the NPV of the project cash flows must come to 0.
The internal rate of return is therefore the discount rate that will give a net present value = $0.
The investment decision rule with IRR
A company might establish the minimum rate of return that it wants to earn on an investment. If other
factors such as non-financial considerations and risk and uncertainty are ignored:
 If a project IRR is equal to or higher than the minimum acceptable rate of return, it should be undertaken
 It the IRR is lower than the minimum required return, it should be rejected.
Since NPV and IRR are both methods of DCF analysis, the same investment decision should normally be
reached using either method.
The internal rate of return is illustrated in the diagram below:
Calculating the IRR of an investment project
The IRR of a project can be calculated by inputting the project cash flows into a financial calculator. In you
examination, you might be required to calculate an IRR without a financial calculator. An approximate IRR
can be calculated using interpolation.
To calculate the IRR, you should begin by calculating the NPV of the project at two different discount rates.
 One of the NPVs should be positive, and the other NPV should be negative. (This is not essential. Both
NPVs might be positive or both might be negative, but the estimate of the IRR will then be less reliable.)
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CAPITAL INVESTMENT APPRAISAL
 Ideally, the NPVs should both be close to zero, for better accuracy in the estimate of the IRR.
When the NPV for one discount rate is positive NPV and the NPV for another discount rate is negative, the
IRR must be somewhere between these two discount rates.
Although in reality the graph of NPVs at various discount rates is a curved line, as shown in the diagram
above. Using the interpolation method, we assume that the graph is a straight line between the two NPVs
that we have calculated. We can then use linear interpolation to estimate the IRR, to a reasonable level of
accuracy.
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CAPITAL INVESTMENT APPRAISAL
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CAPITAL INVESTMENT APPRAISAL
SUMMARY: COMPARISON OF THE FOUR INVESTMENT APPRAISAL METHODS
A comparison of the four investment appraisal methods is given in the table below. The key points to note
are that:
 DCF is superior to the ARR method and payback method of investment appraisal
 It is often equally as good to use NPV or IRR
 However, NPV has two advantages over IRR
o The NPV method indicates the value that the investment should add (if the NPV is positive) or the
value that it will destroy (if the NPV is negative).
o When there are two or more mutually exclusive projects, the NPV will always identify the project
that should be selected. This is the project that will provide the highest value (NPV).
 The IRR method has the advantage of being more easily understood by nonaccountants
 Another disadvantage of the IRR method is that a project might have two or more different IRRs, when
some annual cash flows during the life of the project are negative.
MODIFIED INTERNAL RATE OF RETURN (MIRR)
A criticism of the IRR method is that in calculating the IRR, an assumption is that all cash flows earned by
the project can be reinvested to earn a return equal to the IRR.
For example, suppose that a project has an NPV of + Rs.300,000 when discounted at the cost of capital of
8%, and the IRR of the project is 14%. In calculating the IRR, an assumption would be that all cash flows
from the project will be reinvested as soon as they are received to earn a return of 14% - even though the
company’s cost of capital is only 8%.
Modified internal rate of return is a calculation of the return from a project, as a percentage yield, where it
is assumed that cash flows earned from a project will be reinvested to earn a return equal to the company’s
cost of capital. So in the previous example of the project with an NPV of Rs.300,000 at a cost of capital of
8%, MIRR would be calculated using the assumption that project cash flows are reinvested when they are
received to earn a return of 8% per year.
Using MIRR for project appraisal
It might be argued that if a company wishes to use the discounted return on investment as a method of
capital investment appraisal, it should use MIRR rather than IRR, because MIRR is more realistic because it
is based on the cost of capital as the reinvestment rate.
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CAPITAL INVESTMENT APPRAISAL
Calculating MIRR
Approach
The MIRR of a project is calculated as follows:
Step 1: Calculate the total PV of the cash flows involved in the investment phase of the project. Do this by
taking the negative net cash flows in the early years of the project, and discount these to a present value. If
the only negative cash flow is at time 0, the PV of the investment phase is this cash flow. However, if there
are negative cash flows in Year 1, or Year 1 and 2, discount these to a present value and add them to the
Year 0 cash outflow.
Step 2: Take the cash flows from the year that the project cash flows start to turn positive and compound
these to an end-of-project terminal value, assuming that cash flows are reinvested at the cost of capital. For
example, if cash flows are positive from Year 1 of a five-year project:





Compound the cash flow in Year 1 to end-of-year 5 value using cost of capital as compound rate.
Compound the cash flow in Year 2 to end-of-year 5 value using cost of capital as compound rate.
Compound the cash flow in Year 3 to end-of-year 5 value using cost of capital as compound rate.
Compound the cash flow in Year 4 to end-of-year 5 value using cost of capital as compound rate.
Add the compounded values for each year to the cash flow at the end of Year 5.
The total of the compounded values is the total value of returns during the ‘recovery’ phase of the project,
expressed as an end-of-project value.
Step 3: The MIRR is then calculated as follows:
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CAPITAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
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CAPITAL INVESTMENT APPRAISAL
QUESTIONS OF NPV / IRR / MIRR
Question 01: ABC Limited is considering to launch a new product. Details are as under:
 Initial outlay
 Sales
= Rs 500,000
Year
1
2
3
4






Variable Cost
Fixed Cost
Depreciation
Residual value
Tax Rate
Discount Rate
Units
20,000
25,000
20,000
15,000
Selling price
40
35
32
30
= Rs 20 per unit
= Rs 100,000 per year
= Allowed on straight line basis
= Rs 150,000
= 30% (payable in the year in which liability arises)
= 12%
Required: Calculate NPV of the project.
Question 02:
A company is considering to launch a new product. Details are as under:







Initial outlay
Term
Annual sale
Variable cost
Fixed Cost
Residual value
Discount rate
= Rs 200,000
= 4 years
= 10,000 units at the rate of Rs 15 per unit
= 40%
= 20,000 per year
= Rs 40,000
= 12%
Required: Calculate NPV of the project (ignore taxation).
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
Question 03:
A company is considering to launch a new product. Details are as under:






Initial outlay
Term
Variable cost
Fixed Cost
Residual value
Discount rate
= Rs 200,000
= 4 years
= 40%
= 20,000 per year
= Rs 40,000
= 12%
Required: Determine the minimum no of units to be sold at Rs 15 per unit for the project to be vailable for
the Company (ignore taxation).
Question 04:
A company is considering to launch a new product. Details are as under:









Initial outlay
Selling price
Variable Cost
Fixed Cost
Residual value
Term
Depreciation
Discount rate
Tax rate
= Rs 500,000
= Rs 80 per unit
= Rs 50 per unit
= 60,000 per year
= Rs 80,000
= 5 years
= 20% reducing balance method
= 10%
= 30%
Required: Determine the minimum no of units to be sold for the project to be viable for the Company.
DIFFERENTIAL CASH FLOWS:
Question 01: Consider the following for a Company:
Machine A (Existing)
Capacity
20,000 units
Life
3 years
Book Value
Rs 180,000
Residual value if sold
Rs 35,000
now
Residual value at end
Nil
Selling Price
Rs 120
Variable Cost
Rs 50
Fixed Cost
Rs 150,000 per year
Demand
32,000 units
Always a mentor | Muzzammil Munaf
New Machine
Cost
Rs 900,000
Life
3 years
Residual value at end
Rs 250,000
Capacity
40,000 units
Selling Price
Variable Cost
Fixed Cost
Demand
Page 279 of 690
Rs 130 per unit
Rs 45 per unit
Rs 125,000 per year
32,000 units
Page 18 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
Required: Determine whether the Company should continue with machine A or buy the new one. The
applicable discount rate is 10%.
Question 02:
A university has 200 students enrolled in their MBBS program before the classes have commenced.
Following is the fee structure per student per year which is payable in advance.
 Fee
 Other charges
 Term
= 40,000
= 2,000
= 5 years
The cost of course material is Rs 3,000 per student provided free by the University. Faculty charges per
year are Rs 120,000.
The University plans to commence the MBBS (AI) program and expects that all 200 students will get
themselves transferred to MBBS (AI). The fee structure is as follows:
 Fee
 Other charges
 Course life
= 45,000
= 2,000
= 5 years
The cost of course material is Rs 10,000 per student provided free by the University.
Faculty for MBBS (AI) will charge Rs 250,000 every year. Further, the University will have to incur the following
expenditure at the time of introduction:




New Computer
Old Computers (NRV)
Software
Preliminary expenses
= Rs 1,000,000
= Rs 250,000
= Rs 1,200,000
= Rs 200,000
Required: Find the additional number of students that must be enrolled for the said introduction to
become viable for the University. (Discount rate = 8%)
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP WINTER 2014 (DIFFERENTIAL CASH FLOWS): QUESTION
ZC Limited (ZCL) manufactures metal containers for the paints industry. Presently, ZCL has eight machines
which were purchased 3 years ago at a cost of Rs. 1.8 million each having useful life of 8 years with zero
salvage value. The production capacity of these machines is 300,000 containers per annum which is
sufficient to meet the existing demand.
ZCL anticipates that the demand would increase to 540,000 containers next year and would remain stable
in the foreseeable future. The new demand can be met by replacing all the existing machines with 3 hi-tech
machines that are available in the market at a cost of Rs. 10 million each. The new machines will have an
estimated useful life of 5 years with salvage value of Rs. 2 million each.
The following information is also available:
a) Selling price of each container is Rs. 50 which is expected to increase by 10% per annum from year 2
onwards.
b) Existing raw material cost is 45% of sales which is anticipated to reduce to 42% of sales by using the
new machines.
c) The introduction of new machines would reduce the monthly labour cost by Rs. 146,000 but would
increase the overhead expenses, excluding depreciation by Rs. 2 million per annum.
d) All expenses are expected to increase by 8% from year 2 onwards.
e) The existing machines can be sold at Rs. 1.2 million each excluding disposal costs of Rs. 60,000 per
machine.
f) The increased production capacity will require additional working capital of Rs. 3 million.
g) ZCL follows a policy of charging depreciation using straight line method.
h) It evaluates cost of investment by applying the discount rate of 20%.
i) Applicable tax rate for ZCL is 35%.
Required:
a) Calculate the Net Present Value (NPV) if the existing machines are replaced with the new hi-tech
machines.
(10)
b) Assume that the NPV of the incremental cash flows is negative and the management is considering to
shelve the plan of replacing the machines. Discuss other financial and non-financial factors which should
be taken into consideration before management takes a final decision.
(05)
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CAPITAL INVESTMENT APPRAISAL
ICAP WINTER 2014 (DIFFERENTIAL CASH FLOWS): SOLUTION
Existing machines
Cost (1.8 x 8) - Mn
NBV today [14.4 / 8 x 5]
Capacity (containers per annum)
8
14,400,000
9,000,000
300,000
RV if sold now [1.2 x 8]
Disposal cost [60,000 x 8]
Net disposal value
9,600,000
(480,000)
9,120,000
NPV of differential cash flows
Differential sales (W1)
Differential RM Cost (W2)
Incremental other costs (W3)
Depreciation of new machines
Tax @ 35%
Add back depreciation
Working Capital
I/O and R/V of new machines
Disposal of old machines
Net Cash Flows
PV @ 20%
Differential NPV
NBV of old machines
Net disposal value
Gain on disposal
9,000,000
9,120,000
120,000
Net disposal value
PV of tax [tax x (1+ 20%)^-1]
Net cash received
9,120,000
(35,000)
9,085,000
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
12,000,000 13,200,000 14,520,000 15,972,000 17,569,200
(4,590,000) (5,049,000) (5,553,900) (6,109,290) (6,720,219)
(248,000)
(267,840)
(289,267)
(312,409)
(337,401)
(4,800,000) (4,800,000) (4,800,000) (4,800,000) (4,800,000)
2,362,000
3,083,160
3,876,833
4,750,301
5,711,580
(826,700) (1,079,106) (1,356,891) (1,662,605) (1,999,053)
4,800,000
4,800,000
4,800,000
4,800,000
4,800,000
(3,000,000)
3,000,000
(30,000,000)
6,000,000
9,085,000
(23,915,000) 6,335,300
6,804,054
7,319,941
7,887,696 17,512,527
(23,915,000) 5,279,417
4,725,038
4,236,077
3,803,866
7,037,892
1,167,289
Sales unit under new machines
Sale price per unit [growth @ 10%]
Differential sales (W1)
540,000
50.00
27,000,000
300,000
50.00
15,000,000
12,000,000
540,000
55.00
29,700,000
300,000
55.00
16,500,000
13,200,000
540,000
60.50
32,670,000
300,000
60.50
18,150,000
14,520,000
540,000
66.55
35,937,000
300,000
66.55
19,965,000
15,972,000
540,000
73.21
39,530,700
300,000
73.21
21,961,500
17,569,200
RM cost under new machines [42%]
RM cost under old machines [45%]
Differential RM cost (W2)
11,340,000
6,750,000
4,590,000
12,474,000
7,425,000
5,049,000
13,721,400
8,167,500
5,553,900
15,093,540
8,984,250
6,109,290
16,602,894
9,882,675
6,720,219
Labour cost saving (8% growth)
Increm. Overhead (8% growth)
Incremental other costs (W3)
1,752,000
(2,000,000)
(248,000)
1,892,160
(2,160,000)
(267,840)
2,043,533
(2,332,800)
(289,267)
2,207,015
(2,519,424)
(312,409)
2,383,577
(2,720,978)
(337,401)
Always a mentor | Muzzammil Munaf
Page 282 of 690
Sales unit under old machines
Sale price per unit [growth @ 10%]
Page 21 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP JUNE 2015 (SHUT DOWN DECISION): QUESTION
Kamyab Mart (KM), a large departmental store, was inaugurated two years ago in Peshawar with high
financial prospects. However, in a recently concluded meeting, sponsors have shown concerns over its actual
performance. Following information is available in this regard:
i)
The sponsors had appraised the investment in KM over a period of 5 years by using discount rate of
17%.
ii) Store set-up cost (mainly comprised of furniture and fixtures) was Rs. 5 million with no realizable value.
iii) Annual sales were estimated at Rs. 22 million in first year and expected to grow at 18% per annum.
However, only 70% of the estimated sale was achieved in the first year. Growth in year 2 was 10% which
is expected to continue in future.
iv) Margin on sales was estimated at 18%. However, actual margin on sales is only 12%.
v) Administrative costs were estimated at Rs. 1.20 million and expected to rise by 15% per annum.
vi) Working capital is primarily comprised of inventory which forms 25% of annual sales.
vii) Tax depreciation is allowed at 25% on reducing balance method.
viii) If at any time the sponsors decide to close down KM, working capital would be realized at 80% of its
value.
ix) Applicable tax rate is 35%.
Required:
a) Advise whether sponsors should continue to operate KM over a period of three more years or close it
down now. (10)
b) Besides the computations carried out in (a) above, highlight the matters that may be considered by
sponsors before taking the above decision. (06)
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP JUNE 2015 (SHUT DOWN DECISION): SOLUTION
Cash flows on closing down [4.66 x 80%]
NPV if the business is continued
3.73
4.14 Should continue the business.
Cash flows on closing down
Working capital at the end of 2 years
Recovery
4.66
80%
Cash flows if business is continued
Net cash flows
DF
PV
NPV
1
0.18
0.8547
0.16
4.14
Cash flows of 5 years as per the actual scenario
Annual sales (10% growth)
Cost of sales (100% - 12% = 88%)
Admin cost (15% growth)
Tax depreciation
Tax @ 35%
Add back depreciation
Set up cost
Working capital injected at the start
Working capital invesment/divestment
Net cash flows
Working Capital
Budgeted/Actual Sales
Based on sales
3
6.24
0.6244
3.90
Year 0
(5.00)
(5.50)
(10.50)
Year 1
15.40
(13.55)
(1.20)
(1.25)
(0.60)
1.25
1.27
1.91
Year 2
16.94
(14.91)
(1.38)
(0.94)
(0.28)
0.94
(0.42)
0.23
Year 3
18.63
(16.40)
(1.59)
(0.70)
(0.05)
0.70
(0.47)
0.18
Year 4
20.50
(18.04)
(1.83)
(0.53)
0.11
0.53
(0.51)
0.12
Year 5
22.55
(19.84)
(2.10)
(1.58)
(0.98)
1.58
5.64
6.24
22.00
5.50
16.94
4.24
1.27
18.63
4.66
(0.42)
20.50
5.12
(0.47)
22.55
5.64
(0.51)
(5.64)
5.00
(1.25)
3.75
3.75
(0.94)
2.81
2.81
(0.70)
2.11
2.11
(0.53)
1.58
1.58
(1.58)
-
Depreciation
Opening Cost
Depreciation
Ending cost
Always a mentor | Muzzammil Munaf
2
0.12
0.7305
0.09
Page 284 of 690
Page 23 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP SUMMER 2014 (TARGET IRR): QUESTION
Always a mentor | Muzzammil Munaf
Page 285 of 690
Page 24 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP SUMMER 2014 (TARGET IRR): SOLUTION
Since the company wants to achieve an IRR of 18%, the PV of costs at 18% should be equal to PV of revenues.
PV of all the costs
Land
Land transfer fee
Levelling costs
Architect's fee
PV of construction costs (W1)
PV of all the costs
250,000,000
20,000,000
40,000,000
15,000,000
412,249,565
737,249,565
For construction costs we need to determine the area first.
PV of construction costs (W1)
% of completion
Total area (sq ft) - W2
142,600
Rate of cons. (growth 15%)
Construction cost paid in advance
PV @ 18% (first being adv - year 0)
Total PV of construction costs
Year 0
Year 1
Year 2
Year 3
20%
30%
35%
15%
28,520
42,780
49,910
21,390
3,000
3,450
3,968
4,563
85,560,000 147,591,000 198,017,925 97,594,549
85,560,000 125,077,119 142,213,391 59,399,055
412,249,565
Total area (sq ft) - W2
Cov Area Amenities Total Area No of Apr
A
1,800
20%
2,160
B
1,250
18%
1,475
C
900
16%
1,044
Total area (sq ft)
20
32
50
43,200
47,200
52,200
142,600
The present value of revenue should be equal to Rs 737.249 Mn.
Always a mentor | Muzzammil Munaf
Page 286 of 690
Page 25 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
Total price for all the apartments:
If the price of all the apartments is 'x' then:
Down payment: 0.1x
Quarterly payments: 16R
x = 0.1x + 16R
x - 0.1x = 16R
0.9x = 16R
R = 0.05625x
Annuity factor for the quarterly payments:
R
1.00
i (18% / 4)
4.50%
n (4 x 4)
16.00
[1 - {(1+4.5%)^-16}] / 4.5%
By solving this formula:
DF
11.2340
737.249 = 0.1x + R x (11.2340)
737.249 = 0.1x + 0.05625x (11.2340)
737.249 = 0.1x + 0.6319x
737.249 = 0.7319x
737.249 / 0.7319 = x
x = 1,007.31 million
This is the price for all the apartments.
Total price for the apartments
Total sq ft
Price per sqft
1,007,310,000
142,600
7,063.88
Price for apartment A [2,160 x 7,063.88]
Price for apartment B [1,475 x 7,063.88]
Price for apartment C [1,044 x 7,063.88]
15,257,992
10,419,230
7,374,696
Always a mentor | Muzzammil Munaf
Page 287 of 690
Page 26 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP WINTER 2013 (DECISION MAKING – RESTRUCTURING): QUESTION
Always a mentor | Muzzammil Munaf
Page 288 of 690
Page 27 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP WINTER 2013 (DECISION MAKING – RESTRUCTURING): SOLUTION
Particulars
Year 0
Year 1
Year 2
Savings in overheads (30.356 + 12)
Cost after restructuring - W1
Payment of GHP - W2
Savings in staff salaries - W3
Net cash flows
DF @ 15%
PV
NPV
(49,356,000)
(49,356,000)
1.0000
(49,356,000)
215,872,846
*DF for perpetuity = R/i
This gives value at end of Year 2 so multiply by (1 + 0.15)^-2
as well.
Cost after restructuring - W1
Flight meals (150,000 x 350)
Janitorial services firm
Fleets on rentals (45k x 40 x 12)
Other support staff (50 x GS x 1.15)
Always a mentor | Muzzammil Munaf
42,356,097
42,356,097
(98,520,000) (98,520,000)
(78,969,600) (118,454,400)
49,356,000
84,453,600
(85,777,503) (90,164,703)
0.8696
0.7561
(74,589,133) (68,177,469)
Year 3 and
onwards*
42,356,097
(98,520,000)
137,100,000
80,936,097
5.0410
407,995,448
52,500,000
12,000,000
21,600,000
12,420,000
98,520,000
Page 289 of 690
Page 28 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
Payment of GHP - W2
Annual Average cost
Annual Overtime allowance (AC / 125 x 25)
Annual Gross Salary
Kitchen
390,000
(78,000)
312,000
Janitorial
Van drivers
240,000
360,000
(48,000)
(72,000)
192,000
288,000
Supp staff
270,000
(54,000)
216,000
Annual Basic Salary (75% of gross)
GHP (36 monthly basic salaries = 3 annual)
No of staff
Total GHP departmentwise
Total GHP on a company level
234,000
702,000
100
70,200,000
246,780,000
144,000
432,000
120
51,840,000
216,000
648,000
80
51,840,000
162,000
486,000
150
72,900,000
Overtime allowance departmentwise
Overtime allowance total
7,800,000
27,420,000
5,760,000
5,760,000
8,100,000
Gross salaries departmentwise
Gross salaries total
31,200,000
109,680,000
23,040,000
23,040,000
32,400,000
Savings in staff salaries - W3
Savings in overtime allowance
Year 1
27,420,000
Year 2
27,420,000
Year 3
27,420,000
Annual gross salaries
Less: Not opt for GHP
Savings in gross salaries
109,680,000 109,680,000
(87,744,000) (52,646,400)
21,936,000
57,033,600
109,680,000
109,680,000
Total saving in salaries
49,356,000
137,100,000
Always a mentor | Muzzammil Munaf
Page 290 of 690
84,453,600
Page 29 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
MIRR ICAP SUMMER 2018: QUESTION
OJ Limited (OJL) is a manufacturer of industrial products and has decided to launch a new specialised
industrial product “EDS-1”. Following information is available in this regard:
i)
Initial investment in the new plant including installation and commissioning is estimated at Rs. 45
million. The plant is expected to have a useful life of four years which would be depreciated at 25% on
reducing balance method.
ii) The new plant would be installed at OJL’s premises which were purchased several years ago for Rs. 40
million and have a market value of Rs. 25 million. These would be sold if not utilized for this project.
iii) The residual values of premises and equipment would be Rs. 30 million and Rs. 10 million respectively
after 4 years.
iv) It is estimated that sales of EDS-1 would be 25,000 units in the first year and the selling price would be
Rs. 1,660 per unit.
v) The costs of production are estimated as under:
 Each unit would require:
o material worth Rs. 210
o 2 hours of skilled labour at Rs. 145 per hour
o 3 hours of unskilled labour at Rs. 125 per hour
o variable overheads of Rs. 80
 Annual fixed production overheads would increase by Rs. 5 million.
 Material price is expected to increase by 10% per annum, labour cost by 7% per annum and all
other costs by 8% per annum.
Management believes that the demand would be much higher if EDS-1 could be upgraded to “EDS-Adv”.
The upgraded product would have the same production cost but would be sold for Rs. 1,850 per unit.
However, after the introduction of EDS-Adv, the demand of EDS-1 would reduce significantly and it would
not be feasible to produce it.
Research on upgradation and its introduction in the market would require one year. A technical consultant
would have to be hired at a cost of Rs. 20 million. Research materials would cost Rs. 10 million. 10% of the
existing research department’s time would be used for this research. The annual administrative cost of OJL’s
research department is Rs. 12 million.
There is 80% probability that EDS-Adv would be developed successfully and demand would then be 33,500
units in the first year. If research does not prove successful, OJL would continue to sell EDS-1. The demand
for both products and their selling prices are estimated to grow @ 5% and 12% respectively.
OJL’s cost of capital is 12%.
Required:
On the basis of modified internal rate of return, determine whether OJL should carry out research on
upgradation of EDS-1. (25)
(Ignore taxation and assume that all cash flows arise at the end of each year except otherwise specified.)
Always a mentor | Muzzammil Munaf
Page 291 of 690
Page 30 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
MIRR ICAP SUMMER 2018: SOLUTION
Always a mentor | Muzzammil Munaf
Page 292 of 690
Page 31 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
Page 293 of 690
Page 32 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
RISK AND UNCERTAINTY IN CAPITAL INVESTMENT APPRAISAL
The problem of risk and uncertainty
Investment projects are long-term projects, often with a time scale of many years. When the cash flows for
an investment project are estimated, the estimates might be incorrect. Estimates of cash flows might be
wrong for two main reasons:
 risk in the investment, and
 uncertainty about the future.
Risk exists when the actual outcome from a project could be any of several different possibilities, and it is
not possible in advance to predict which of the possible outcomes will actually occur.
The simplest example of risk is rolling a dice. When a dice is rolled, the result will be 1, 2, 3, 4, 5 or 6. These
six possible outcomes are known in advance, but it is not possible in advance to know which of these
possibilities will be the actual outcome.
With risk assessment, it is often possible to estimate the probabilities of different outcomes. For example,
we can predict that the result of rolling a dice will be 1, 2, 3, 4, 5 or 6, each with a probability of 1/6. Risk
can often be measured and evaluated mathematically, using probability estimates for each possible future
outcome.
Uncertainty exists when there is insufficient information to be sure about what will happen, or what the
probability of different possible outcomes might be. For example, a business might predict that sales in
three years’ time will be £500,000, but this might be largely guesswork, and based on best-available
assumptions about sales demand and sales prices.
Uncertainty occurs due to a lack of sufficient information about what is likely to happen. It is possible to
assess the uncertainty in a project, but with less mathematical precision than for the assessment of risk.
Management should try to evaluate the risk and uncertainty, and take it into account, when making their
investment decisions. In other words, investment decisions should consider the risk and uncertainty in
investment projects, as well as the expected returns and NPV.
Methods of assessing risk and uncertainty
There are several methods of analysing and assessing risk and uncertainty. In particular:
 Sensitivity analysis can be used to assess a project when there is uncertainty about future cash flows
 Probability analysis can be used to assess projects in which there is risk.
Other methods of risk and uncertainty analysis include:




risk modelling and simulation
risk-adjusted discount rates
adjusted payback
discounted payback as one of the criteria for investing in capital projects.
Always a mentor | Muzzammil Munaf
Page 294 of 690
Page 33 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
SENSITIVITY ANALYSIS
The purpose of sensitivity analysis: assessment of project uncertainty Sensitivity analysis is a useful but
simple technique for assessing investment risk in a capital expenditure project when there is uncertainty
about the estimates of future cash flows. It is recognised that estimates of cash flows could be inaccurate,
or that events might occur that will make the estimates wrong.
The purpose of sensitivity analysis is to assess how the NPV of the project might be affected if cash flow
estimates are worse than expected.
Methods of sensitivity analysis
Sensitivity analysis can be used to calculate the percentage amount by which benefits must fall below
estimate or costs rise above estimate before the project NPV becomes negative.
For example, by how much (in percentage terms) would sales volumes need to fall below the expected
volumes, before the project NPV became negative? Or by how much (in percentage terms) would running
costs need to exceed the expected amount before the NPV became negative?
Always a mentor | Muzzammil Munaf
Page 295 of 690
Page 34 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
Estimating the sensitivity of a project to changes in the cost of capital
The sensitivity of the project to a change in the cost of capital can be found by calculating the project IRR.
This can be compared with the company’s cost of capital.
Always a mentor | Muzzammil Munaf
Page 296 of 690
Page 35 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
The sensitivity of the project to changes in the cost of capital is quite small. The cost of capital is 10% but
the cost of capital would have to be over 17.2% before the NPV became negative.
Always a mentor | Muzzammil Munaf
Page 297 of 690
Page 36 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ILLUSTRATIONS OF SENSITIVITY ANALYSIS
Illustration 01: Consider the following details for Company A.
Sales
140,000
Variable Cost
(56,000)
Cont Margin
84,000
Fixed Cost
(14,000)
PBIT
70,000
Interest
(20,000)
PBT
50,000
Tax @ 30%
(15,000)
PAT
35,000
Required: Calculate the sensitivity of each of the above elements.
Illustration 02: Consider the following details for Company A.
Initial Outlay
100,000
Sales (8,500 units)
85,000
Variable Cost (8,500 units)
40,767
Discount rate
10%
3 years
Term
Residual value
-
Required: Calculate the NPV and sensitivity of each of the following elements.
a) Initial Outlay
d) Volume
b) Selling Price
e) Discount Rate
Always a mentor | Muzzammil Munaf
Page 298 of 690
c) Variable Cost
Page 37 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
Illustration 03: Consider the following details for Company A.
Initial outlay
450,000
Residual value
200,000
Annual Sales
Variable Cost
Year 1
300,000 Year 1
120,000
Year 2
400,000 Year 2
160,000
Year 3
600,000 Year 3
240,000
Depreciation (reducing balance)
20%
Tax rate
30%
Discount Rate
10%
Required: Calculate sensitivity of initial outlay and allied cash flows.
Illustration 04: Consider the following details for Company A.
Cost of the asset
60,000
Residual value
10,000
Life of asset
3 years
Per unit (Rs)
Sale price
15.00
Material
5.00
Other variable OH
2.00
Production (units)
Year 1
5,000
Year 2
2,400
Year 3
3,000
Fixed overheads per year
3,000
Depreciation (reducing balance)
25%
Tax rate
30%
Discount Rate
10%
Required: Calculate safety margin for:
a) Sales / Sale Price
d) Fixed overheads
g) Production/sales units
b) Material Cost
e) Cost of the asset
h) Cost of capital or WACC
Always a mentor | Muzzammil Munaf
Page 299 of 690
c) Other variable cost
f) Residual value
i) Project life
Page 38 of 68
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP WINTER 2016 SUFFER LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
Page 301 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP WINTER 2016 SUFFER LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
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CAPITAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
Page 303 of 690
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP SUMMER 2017 TAHIR LODHI: QUESTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP SUMMER 2017 TAHIR LODHI: SOLUTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
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CAPITAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
Page 306 of 690
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP WINTER 2019 GHAURI LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
Page 308 of 690
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP WINTER 2019 GHAURI LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP WINTER 2020 ECO ENERGY: QUESTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP WINTER 2020 ECO ENERGY: SOLUTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
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CAPITAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
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CAPITAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP WINTER 2021 COOLER LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
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CAPITAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP WINTER 2021 COOLER LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
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CFAP 04 – BUSINESS FINANCE DECISIONS
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CAPITAL INVESTMENT APPRAISAL
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CAPITAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
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CAPITAL INVESTMENT APPRAISAL
ACCA F9 2014 DECEMBER UFTIN CO: QUESTION
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ACCA F9 2014 DECEMBER UFTIN CO: SOLUTION
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CFAP 04 – BUSINESS FINANCE DECISIONS
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CAPITAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
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CAPITAL INVESTMENT APPRAISAL
ICAP WINTER 2015 SANDRA LIMITED: QUESTION
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
ICAP WINTER 2015 SANDRA LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
DISCOUNTED PAYBACK PERIOD
Instead of using the ordinary payback to decide whether a project is acceptable, discounted payback might
be used as an alternative. A maximum discounted payback period is established and projects should not be
undertaken unless they pay back within this time.
A consequence of applying a discounted payback rule (and the same applies to ordinary payback) is that
projects are unlikely to be accepted if they rely on cash profits in the long-term future to make a suitable
financial return. Since longer-term estimates of cash flows are usually more unreliable than estimates in the
shorter term, using discounted payback as a criterion for project selection will result in the rejection of risky
projects.
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
A discounted payback period is calculated in the same way as the ‘ordinary’ payback period, with the
exception that the cash flows of the project are converted to their present value. The discounted payback
period is the number of years before the cumulative NPV of the project reaches $0.
Year
0
1
2
3
4
5
6
Annual cash flow $
(200,000)
(40,000)
30,000
120,000
150,000
100,000
50,000
The discounted period for a capital investment is always longer than the ‘ordinary’ non-discounted payback
period.
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
DISCOUNTED PAYBACK PERIOD
Illustration: Consider the following for Company A:
Initial outlay
Residual value
Year
Annual Sales
Variable Cost
Fixed Cost
= 500,000
= 100,000
1
400,000
40%
50,000
2
600,000
40%
50,000
3
500,000
40%
50,000
4
200,000
40%
50,000
Tax applies at 30% whereas tax depreciation is allowable on a straight line basis.
Required: Calculate the discounted payback period using a discount rate of 10%.
Solution:
Particulars
Initial outlay
Residual value
Sales (post tax)
VC (post tax)
FC (Post tax)
Tax shield on depreciation
Net Cash Flow
PV @ 10%
NPV
Y-0
(500,000)
(500,000)
(500,000)
128,593
Y-1
280,000
(112,000)
(35,000)
30,000
163,000
148,182
Y-2
420,000
(168,000)
(35,000)
30,000
247,000
204,132
Year Opening
1 (500,000)
2 (351,818)
3 (147,686)
CF
148,182
204,132
154,020
Closing
(351,818)
(147,686)
Y-3
350,000
(140,000)
(35,000)
30,000
205,000
154,020
Y-4
100,000
140,000
(56,000)
(35,000)
30,000
179,000
122,259
2 years 11 months and 16 days
= 147,686/154,020
0.96 x12
Always a mentor | Muzzammil Munaf
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11.51
0.51 x30
15.20
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL INVESTMENT APPRAISAL
BAILOUT PAYBACK PERIOD
Illustration 01: Consider the following for Company A:
Initial outlay
= 1,000,000
If exit at year 1 – RV
= 700,000
If exit at year 2 – RV
= 650,000
Cash inflow year 1
= 200,000
Cash inflow year 2
= 150,000
Required: Calculate the bailout payback period.
Solution 1:
Particulars
Initial outlay
Cash inflow
Year 1
Year 2
Y-0
(1,000,000)
Opening
(1,000,000)
(800,000)
Y-1
200,000
Y-2
150,000
CF
200,000
150,000
Closing
(800,000)
(650,000)
RV
700,000 Cannot opt for bailout here
650,000 Can opt out at this point
Bailout pay-back period: 2 years
Illustration 02: Consider the following for Company A:
Initial outlay
= 2,000,000
If exit at year 1 – RV
= 1,400,000
If exit at year 2 – RV
= 1,200,000
Cash inflow year 1
= 400,000
Cash inflow year 2
= 400,000
Required: Calculate the bailout payback period.
Solution 2:
Particulars
Initial outlay
Cash inflow
Year 1
Year 2
Y-0
(2,000,000)
Opening
(2,000,000)
(1,600,000)
Y-1
Y-2
400,000
400,000
CF
400,000
400,000
Closing
(1,600,000)
(1,200,000)
RV
1,400,000 Cannot opt for bailout here
1,200,000 Can opt out at this point
Bailout pay-back period: 2 years
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
Contents
ASSET REPLACEMENT DECISIONS ........................................................................................................ 2
THE NATURE OF ASSET REPLACEMENT DECISIONS .................................................................... 2
THE EQUIVALENT ANNUAL COST METHOD .................................................................................. 3
LOWEST COMMON MULTIPLE METHOD ........................................................................................ 8
ICAP WINTER 2012 CDN: QUESTION ............................................................................................. 13
ICAP WINTER 2012 CDN: SOLUTION ............................................................................................. 13
ICAP SUMMER 2019 RED LIMITED: QUESTION ........................................................................... 14
ICAP SUMMER 2019 RED LIMITED: SOLUTION ........................................................................... 15
ICAP SUMMER 2022 GO LIMITED: QUESTION............................................................................. 18
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
ASSET REPLACEMENT DECISIONS
THE NATURE OF ASSET REPLACEMENT DECISIONS
An asset replacement decision involves deciding how frequently a non-current asset should be replaced,
when it is in regular use, so that when the asset reaches the end of its useful life, it will be replaced by an
identical asset.
In other words, this type of decision is about what is the most appropriate useful economic life of a noncurrent asset, and how frequently it should be replaced. Here we are not dealing with a one-off decision
about whether or not to acquire an asset. Instead we are deciding when to replace an asset we are currently
using with another new asset; and then when the new asset has been used up, replacing it again with an
identical asset; and so on in perpetuity. We are evaluating the cycle of replacing the machine – considering
the various options for how long we should keep it before replacing it.
The decision rule is that the preferred replacement cycle for an asset should be the least-cost replacement
cycle. This is the frequency of replacement that minimises the PV of cost.
The cash flows to consider
The cash flows that must be considered when making the asset replacement decision are:
The capital cost (purchase cost) of the asset
 The maintenance and operating costs of the asset: these will usually increase each year as the asset gets
older
 Tax relief on the running costs (which are allowable expenses for tax purposes)
 Tax relief on the asset (tax-allowable depreciation)
 The scrap value or resale value of the asset at the end of its life.
The main problem with evaluating an asset replacement decision is comparing these costs over a similar
time frame. For example, how can we compare the PV of costs for asset replacement cycles of one, two,
three, four and five years? For example, you cannot simply compare the PV of cost over a two-year
replacement cycle with the PV of cost over a three-year replacement cycle, because you would be
comparing costs over two years with costs over three years, which is not a fair comparison.
Methods of evaluation
A method is needed for comparing the different replacement cycles over a common period of time. There
are three methods of doing this:
 the lowest common multiple method
 the finite time method
 the equivalent annual cost method: this is the method normally used.
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
The equivalent annual cost method is the method normally used, and the only one of these three methods
that you need to know for your examination. It is the only method described here.
THE EQUIVALENT ANNUAL COST METHOD
The equivalent annual cost method of calculating the most cost-effective replacement cycle for assets is as
follows:
 For each choice of replacement cycle, the PV of cost is calculated over one full replacement cycle, with
the asset purchased in year 0 and disposed of at the end of the life cycle.
 This PV of cost is then converted into an equivalent annual cost or annuity. The equivalent annual cost
is calculated by dividing the PV of cost of the life cycle by the annuity factor for the cost of capital, for
the number of years in the life cycle.
The replacement cycle with the lowest equivalent annual cost is selected as the least-cost replacement cycle.
Example
NTN is considering its replacement policy for a particular machine, which it intends to replace every year,
every two years or every three years. The machine has purchase cost of $17,000 and a maximum useful life
of three years. The following information is also relevant:
The cost of capital for NTN is 10%. What is the optimum replacement cycle? Ignore taxation. Use the
equivalent annual cost method.
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
Answer
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
Illustration 01: EQUIVALENT ANNUAL COST
Persia Limited is considering its replacement policy for a particular machine, which it intends to replace
every year, every two years or every three years. The machine has a purchase cost of Rs 20,000 and a
maximum useful life of three years.
The Company has a cost of capital of 10% and the following information is also relevant:
Year
1
2
3
Maintenance/running
costs of machine
2,000
2,500
4,000
Scrap value if sold
at end of year
9,000
6,000
3,000
Required: Determine the optimum replacement cycle (ignore taxation).
Illustration 02: EQUIVALENT ANNUAL COST
Seljuk Limited is considering its replacement policy for an item of equipment which has a maximum useful
life of four years. The machine has purchase cost of Rs 30,000.
The Company has a cost of capital of 12% and following information is also relevant:
Year
1
2
3
4
Maintenance/running
costs of machine
4,000
5,000
6,500
8,000
Scrap value if sold
at end of year
15,000
10,000
6,000
1,000
Required: Determine the optimum replacement cycle (ignore taxation).
Illustration 03: EQUIVALENT ANNUAL COST
Oghuz Limited is considering its replacement policy for an item of equipment which has a maximum useful
life of three years. The machine has purchase cost of Rs 20,000.
The Company has a cost of capital of 12% and following information is also relevant:
Year
Operating costs
1
2
3
9,000
10,500
11,900
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Scrap value if sold
at end of year
14,000
11,500
8,400
Page 6 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
Required: Determine the optimum replacement cycle (ignore taxation).
Illustration 04: EQUIVALENT ANNUAL COST (With Taxation)
Ottoman Limited is considering its replacement policy between a 4-years replacement cycle or a 5-years
replacement cycle for an item of equipment which has a maximum useful life of five years.
The machine has a purchase cost of Rs 2,500 million and is subject to:
 an initial allowance of 50%; and
 depreciation of 20% based on reducing balance method.
The Company has a cost of capital of 10% and tax is applicable at 35% (payable in the same year). Following
information is also relevant:
Year
Operating costs
1
2
3
4
5
100
150
225
320
450
Scrap value if sold
at end of year
---1,200
900
Required: Determine the optimum replacement cycle.
Solution
4 years' cycle
Operating cost
Depreciation (W1)
Tax deductions
Tax benefit @ 35%
Add back depreciation
Initial outlay / Res Value
Net Cash Flows
PV @ 10%
NPV of expenditure
Year 0
Year 1
(100.00)
(1,500.00)
(1,600.00)
560.00
1,500.00
(2,500.00)
(2,500.00)
460.00
(2,500.00)
418.18
(1,628.67)
NPV
DF @ 10% for 4 years
Equivalent Annual Cost
1,628.67
3.1698
513.81
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Year 2
(150.00)
(200.00)
(350.00)
122.50
200.00
(27.50)
(22.73)
Page 336 of 690
Year 3
Year 4
(225.00) (320.00)
(160.00) 560.00
(385.00) 240.00
134.75
(84.00)
160.00 (560.00)
1,200.00
(90.25) 796.00
(67.81) 543.68
Page 7 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
Depreciation (W1)
Opening Cost
Initial allowance
Depreciation
Closing Cost
Year 1
Year 2
2,500.00 1,000.00
(1,250.00)
(250.00) (200.00)
1,000.00
800.00
5 years' cycle
Operating cost
Depreciation (W1)
Tax deductions
Tax benefit @ 35%
Add back depreciation
Initial outlay / Res Value
Net Cash Flows
PV @ 10%
NPV of expenditure
Year 0
Year 1
(100.00)
(1,500.00)
(1,600.00)
560.00
1,500.00
(2,500.00)
(2,500.00)
460.00
(2,500.00)
418.18
(1,990.93)
NPV
DF @ 10% for 5 years
Equivalent Annual Cost
1,990.93
3.7907
525.21
Depreciation (W1)
Opening Cost
Initial allowance
Depreciation
Closing Cost
Year 3
Year 4
800.00
640.00
(160.00) 560.00
640.00 1,200.00
Year 2
(150.00)
(200.00)
(350.00)
122.50
200.00
(27.50)
(22.73)
Year 3
(225.00)
(160.00)
(385.00)
134.75
160.00
(90.25)
(67.81)
Year 4
(320.00)
(128.00)
(448.00)
156.80
128.00
(163.20)
(111.47)
Year 5
(450.00)
388.00
(62.00)
21.70
(388.00)
900.00
471.70
292.89
Year 1
Year 2
2,500.00 1,000.00
(1,250.00)
(250.00) (200.00)
1,000.00
800.00
Year 3
800.00
(160.00)
640.00
Year 4
640.00
(128.00)
512.00
Year 5
512.00
388.00
900.00
4 years cycle is better since it has a lower equivalent annual cost.
LOWEST COMMON MULTIPLE METHOD
This approach involves choosing the lowest cost of the different possible cycles over a common time frame.
The common time frame is a period (lowest common multiple) into which the lowest possible number of
complete cycles for each possibility will fit. For example:
 If a company was considering a 1 year or a 2 years replacement cycle, the lowest common multiple
would be 3.
 If a company was considering 1 year, 2 years or 3 years replacement cycle, the lowest common multiple
would be 6 (as in the above example).
 If a company was considering a 4 years or a 6 years replacement cycle, the lowest common multiple
would be 12.
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
This method is useful because it can take inflation into account whereas the equivalent annual cost method
cannot do this.
Whilst the method is straightforward, it is easy make a mistake when identifying the cash flows.
Question 01: LCM METHOD
Sogut Limited is considering its replacement policy for an item of equipment which has a maximum useful
life of three years. The machine has purchase cost of Rs 20,000.
The Company has a cost of capital of 5% and following information is also relevant:
Year
Operating costs
1
2
3
9,000
10,500
11,900
Scrap value if sold
at end of year
14,000
11,500
8,400
Required: Determine the optimum replacement cycle using LCM method (ignore taxation).
Solution 01:
1 year's 6 cycles:
Initial outlay
Residual value
Operating costs
Net Cash Flows
PV @ 5%
NPV
Year 0
(20,000)
(20,000)
(20,000)
(81,211)
Year 1
(20,000)
14,000
(9,000)
(15,000)
(14,286)
Year 2
(20,000)
14,000
(9,000)
(15,000)
(13,605)
Year 3
(20,000)
14,000
(9,000)
(15,000)
(12,958)
Year 4
(20,000)
14,000
(9,000)
(15,000)
(12,341)
Year 5
(20,000)
14,000
(9,000)
(15,000)
(11,753)
Year 6
14,000
(9,000)
5,000
3,731
2 year's 3 cycles:
Initial outlay
Residual value
Operating costs
Net Cash Flows
PV @ 5%
NPV
Year 0
(20,000)
(20,000)
(20,000)
(75,516)
Year 1
(9,000)
(9,000)
(8,571)
Year 2
(20,000)
11,500
(10,500)
(19,000)
(17,234)
Year 3
(9,000)
(9,000)
(7,775)
Year 4
(20,000)
11,500
(10,500)
(19,000)
(15,631)
Year 5
(9,000)
(9,000)
(7,052)
Year 6
11,500
(10,500)
1,000
746
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
3 year's 2 cycles:
Initial outlay
Residual value
Operating costs
Net Cash Flows
PV @ 5%
NPV
Year 0
(20,000)
(20,000)
(20,000)
(76,639)
Year 1
(9,000)
(9,000)
(8,571)
Year 2
(10,500)
(10,500)
(9,524)
Year 3
(20,000)
8,400
(11,900)
(23,500)
(20,300)
Year 4
(9,000)
(9,000)
(7,404)
Year 5
(10,500)
(10,500)
(8,227)
Year 6
8,400
(11,900)
(3,500)
(2,612)
Option 2 is better with lowest NPV. Hence, replace machine every 2 years -- 3 cycles.
Question 02: LCM METHOD WITH INFLATION
Baghdad Limited is considering its replacement policy for an item of equipment which has a maximum
useful life of three years. Currently, the machine has purchase cost of Rs 3,200,000.
The Company has a cost of capital of 18% and following information based on current prices is also
relevant:
Year
Maintenance costs
1
2
3
130,000
245,000
480,000
Scrap value if sold
at end of year
-1,280,000
700,000
Inflation applicable is as follows:
 Purchase cost of the machine
 Maintenance cost
 Scrap value
: 10%
: 15%
: 8%
Required: Determine the optimum replacement cycle using LCM method (ignore taxation).
Solution 02:
2 year's 3 cycles:
Initial outlay
Residual value
Operating costs
Net Cash Flows
PV @ 18%
NPV
Year 0
Year 1
Year 2
(3,200,000)
(3,872,000)
1,492,992
(149,500) (324,013)
(3,200,000) (149,500) (2,703,021)
(3,200,000) (126,695) (1,941,267)
(6,699,437)
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Year 3
Year 4
Year 5
(4,685,120)
1,741,426
(197,714) (428,507) (261,476)
(197,714) (3,372,201) (261,476)
(120,335) (1,739,344) (114,294)
Year 6
2,031,199
(566,700)
1,464,499
542,497
Page 10 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
Working
= 3,200,000 x 1.1^2 AND x 1.1^4
= 1,280,000 x 1.08^2 AND x 1.08^4 AND x 1.08^6
= 130,000 x 1.15^1 AND 3 AND 5
= 245,000 x 1.15^2 AND 4 AND 6
3 year's 2 cycles:
Initial outlay
Residual value
Operating costs
Net Cash Flows
PV @ 18%
NPV
Year 0
Year 1
(3,200,000)
(149,500)
(3,200,000) (149,500)
(3,200,000) (126,695)
(6,391,773)
Year 2
Year 3
(4,259,200)
881,798
(324,013) (730,020)
(324,013) (4,107,422)
(232,701) (2,499,904)
Year 4
Year 5
Year 6
1,110,812
(227,371) (492,783) (1,110,269)
(227,371) (492,783)
543
(117,275) (215,400)
201
Working
= 3,200,000 x 1.1^3
= 700,000 x 1.08^3 AND 700,000 x 1.08^6
= 130,000 x 1.15^1 AND 4
= 245,000 x 1.15^2 AND 5
= 480,000 x 1.15^3 AND 6
3 year's 2 cycles -- is a better option.
Question 03: ICAP SUMMER 2016 LCM METHOD WITH INFLATION+TAX
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
Solution 03:
3 cycles of 4 years
Year 0
Year 1
Year 2
Maintenance cost
(660,000) (726,000)
Depreciation
(5,000,000) (3,750,000)
Allowable deductions
(5,660,000) (4,476,000)
Tax benefit
1,698,000 1,342,800
Add back depreciation
5,000,000 3,750,000
Initial outlay
(20,000,000)
Residual value
Net cash flows
(20,000,000) 1,038,000
616,800
PV @ 15%
(20,000,000)
902,609
466,389
NPV
(38,017,594)
Year 3
Year 4
Year 5
(1,331,000) (2,049,740) (966,306)
(2,812,500) (6,006,488) (6,077,531)
(4,143,500) (8,056,228) (7,043,837)
1,243,050
2,416,868 2,113,151
2,812,500
6,006,488 6,077,531
(24,310,125)
2,431,013
(87,950) (21,511,984) 1,146,845
(57,829) (12,299,547)
570,185
Year 6
Year 7
Year 8
(1,062,937) (1,948,717) (3,001,024)
(4,558,148) (3,418,611) (7,300,923)
(5,621,085) (5,367,328) (10,301,947)
1,686,326 1,610,199
3,090,584
4,558,148 3,418,611
7,300,923
(29,549,109)
2,954,911
623,389
(338,519) (26,504,638)
269,508
(127,262) (8,664,413)
Year 9
Year 10
Year 11
Year 12
(1,414,769) (1,556,245) (2,853,117) (4,393,800)
(7,387,277) (5,540,458) (4,155,343) (8,874,318)
(8,802,046) (7,096,703) (7,008,460) (13,268,117)
2,640,614 2,129,011 2,102,538
3,980,435
7,387,277 5,540,458 4,155,343
8,874,318
3,591,713
1,225,845
572,766
(750,579)
3,178,348
348,462
141,579
(161,332)
594,056
Depreciation
(2,812,500)
(4,558,148) (3,418,611)
(7,387,277) (5,540,458) (4,155,343)
(5,000,000) (3,750,000)
(6,006,488) (6,077,531)
(7,300,923)
(8,874,318)
4 cycles of 3 years
Year 0
Year 1
Year 2
Year 3
Maintenance cost
(660,000) (726,000) (1,331,000)
Depreciation
(5,000,000) (3,750,000) (15,880,500)
Allowable deductions
(5,660,000) (4,476,000) (17,211,500)
Tax benefit
1,698,000 1,342,800
5,163,450
Add back depreciation
5,000,000 3,750,000 15,880,500
Initial outlay
(20,000,000)
(23,152,500)
Residual value
4,630,500
Net cash flows
(20,000,000) 1,038,000
616,800 (14,689,550)
PV @ 15%
(20,000,000)
902,609
466,389
(9,658,618)
NPV
(37,085,445)
Year 4
Year 5
Year 6
Year 7
(878,460) (966,306) (1,771,561) (1,169,230)
(5,788,125) (4,341,094) (18,383,664) (6,700,478)
(6,666,585) (5,307,400) (20,155,225) (7,869,708)
1,999,976 1,592,220
6,046,567 2,360,913
5,788,125 4,341,094 18,383,664 6,700,478
(26,801,913)
5,360,383
1,121,516
625,914 (17,166,524) 1,191,682
641,230
311,190
(7,421,562)
447,998
Year 8
Year 9
Year 10
Year 11
Year 12
(1,286,153) (2,357,948) (1,556,245) (1,711,870) (3,138,428)
(5,025,359) (21,281,389) (7,756,641) (5,817,481) (24,635,868)
(6,311,512) (23,639,337) (9,312,887) (7,529,351) (27,774,296)
1,893,454
7,091,801 2,793,866 2,258,805
8,332,289
5,025,359 21,281,389 7,756,641 5,817,481 24,635,868
(31,026,564)
6,205,313
7,183,425
607,300 (20,087,398) 1,237,620
546,935 12,377,286
198,528
(5,710,092)
305,921
117,560
2,313,403
Depreciation
(5,000,000) (3,750,000) (15,880,500)
(5,788,125) (4,341,094) (18,383,664) (6,700,478)
(5,025,359) (21,281,389) (7,756,641) (5,817,481) (24,635,868)
4 cycles of 3 years
Year 0
Year 1
Year 2
Year 3
Maintenance cost
(660,000) (726,000) (1,331,000)
Depreciation
(5,000,000) (3,750,000) (15,880,500)
Allowable deductions
(5,660,000) (4,476,000) (17,211,500)
Tax benefit
1,698,000 1,342,800
5,163,450
Add back depreciation
5,000,000 3,750,000 15,880,500
Initial outlay
(20,000,000)
(23,152,500)
Residual value
4,630,500
Net cash flows
(20,000,000) 1,038,000
616,800 (14,689,550)
PV @ 15%
(20,000,000)
902,609
466,389
(9,658,618)
NPV
(37,085,445)
Year 4
Year 5
Year 6
Year 7
(878,460) (966,306) (1,771,561) (1,169,230)
(5,788,125) (4,341,094) (18,383,664) (6,700,478)
(6,666,585) (5,307,400) (20,155,225) (7,869,708)
1,999,976 1,592,220
6,046,567 2,360,913
5,788,125 4,341,094 18,383,664 6,700,478
(26,801,913)
5,360,383
1,121,516
625,914 (17,166,524) 1,191,682
641,230
311,190
(7,421,562)
447,998
Year 8
Year 9
Year 10
Year 11
Year 12
(1,286,153) (2,357,948) (1,556,245) (1,711,870) (3,138,428)
(5,025,359) (21,281,389) (7,756,641) (5,817,481) (24,635,868)
(6,311,512) (23,639,337) (9,312,887) (7,529,351) (27,774,296)
1,893,454
7,091,801 2,793,866 2,258,805
8,332,289
5,025,359 21,281,389 7,756,641 5,817,481 24,635,868
(31,026,564)
6,205,313
7,183,425
607,300 (20,087,398) 1,237,620
546,935 12,377,286
198,528
(5,710,092)
305,921
117,560
2,313,403
Depreciation
(5,788,125) (4,341,094) (18,383,664) (6,700,478)
(5,025,359) (21,281,389) (7,756,641) (5,817,481) (24,635,868)
-
Option 2 is better.
-
(5,000,000) (3,750,000) (15,880,500)
Option 2 is better.
Always a mentor | Muzzammil Munaf
Page 341 of 690
Page 12 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
ICAP WINTER 2012 CDN: QUESTION
ICAP WINTER 2012 CDN: SOLUTION
Always a mentor | Muzzammil Munaf
Page 342 of 690
Page 13 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
ICAP SUMMER 2019 RED LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
Page 343 of 690
Page 14 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
ICAP SUMMER 2019 RED LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
Page 344 of 690
Page 15 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
Always a mentor | Muzzammil Munaf
Page 345 of 690
Page 16 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
Always a mentor | Muzzammil Munaf
Page 346 of 690
Page 17 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
ICAP SUMMER 2022 GO LIMITED: QUESTION
ICAP SUMMER 2022 GO LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
Page 347 of 690
Page 18 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ASSET REPLACEMENT DECISIONS
Always a mentor | Muzzammil Munaf
Page 348 of 690
Page 19 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
Contents
CAPITAL RATIONING DECISIONS ......................................................................................................... 2
SINGLE PERIOD CAPITAL RATIONING: NON-DIVISIBLE PROJECTS ......................................... 4
ICAP WINTER 2016 MALIK INVESTMENTS: QUESTION .............................................................. 8
ICAP WINTER 2016 MALIK INVESTMENTS: SOLUTION .............................................................. 9
MULTIPERIOD CAPITAL RATIONING ............................................................................................. 10
ICAP WINTER 2018 MARS LIMITED: QUESTION ......................................................................... 11
ICAP WINTER 2018 MARS LIMITED: SOLUTION ......................................................................... 11
ICAP SUMMER 2022 GO LIMITED: QUESTION............................................................................. 14
ICAP SUMMER 2022 GO LIMITED: SOLUTION............................................................................. 15
Always a mentor | Muzzammil Munaf
Page 349 of 690
Page 1 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
CAPITAL RATIONING DECISIONS
The nature of capital rationing
Capital rationing occurs where there are insufficient funds available to invest in all projects that have a
positive Net Present Value. Capital is in short supply; therefore a decision has to be made about which
investment projects to invest in with the capital that is available. There are two types of capital rationing.
 Hard capital rationing: This occurs when the shortage of capital is imposed by external factors, such as
the refusal by a bank to advance any more money or an inability to raise more capital by issuing new
shares or bonds.
 Soft capital rationing: This occurs when the shortage of capital is imposed internally by management
decision, such as setting limits to the capital budget for the year. In other words, the directors of a
company might decide that in the capital budget, total capital spending must not exceed a specified
amount.
Single period capital rationing: divisible projects
Single period capital rationing describes a situation where the capital available for investment is in limited
supply, but for one time period only (one year only). The limitation in supply is usually ‘now’ – in Year 0. In
all other time periods, capital will be in unlimited supply.
A decision needs to be made about which projects to invest in. Projects will not be undertaken unless they
have a positive NPV, but when there is capital rationing a choice must be made between alternative projects
that all have a positive NPV. The method of reaching the decision about which projects to select for
investment depends on whether the investments are fully divisible, or indivisible.
Fully divisible projects
Assumption: Projects are fully divisible and therefore a part-investment can be made in a capital project
leading to a partial return (proportional to the amount invested). For example suppose that an investment
costing $100,000 is fully divisible and has an expected NPV of + $20,000. If capital is in short supply, it would
be possible to invest a proportion of the $100,000, to obtain the same proportion of the NPV of + $20,000.
For example, it would be possible to invest only $50,000 in the project and the expected NPV would then
be + $10,000.
Deciding which projects to invest in: When projects are fully divisible, the projects selected for investment
should be those that maximise the total NPV per $1 of capital invested (in the year of capital rationing). The
technique is to calculate for each project the NPV per $1 of capital invested (in the year of capital rationing),
and to prioritise the projects for investment by ranking them in order of NPV per $1 invested.
The ratio of NPV to capital investment is sometimes called the profitability index. The decision rule is
therefore to invest in the projects with the highest profitability index, up to the limit of the investment
capital available.
Always a mentor | Muzzammil Munaf
Page 350 of 690
Page 2 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
Always a mentor | Muzzammil Munaf
Page 351 of 690
Page 3 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
SINGLE PERIOD CAPITAL RATIONING: NON-DIVISIBLE PROJECTS
When investment projects are non-divisible, the investment in a project can be either 0% or 100%, and
nothing else. Part-investment is not possible.
The selection of investments should be those that offer the maximum NPV with the capital available. Finding
the combination of projects that maximises NPV is a matter of trial-and-error, and testing all the possible
combinations of investments that can be undertaken with the capital available.
Question 01: DIVISIBLE PROJECTS
A company has Rs 10,000 to invest and has the following projects which are fully divisible and mutually
independent.
Project
A
B
C
D
Initial Outlay (Rs)
10,000
4,200
2,800
3,000
NPV (Rs)
12,500
8,400
3,080
3,900
Required: Devise the investment plan for the Company.
Always a mentor | Muzzammil Munaf
Page 352 of 690
Page 4 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
Question 02: DIVISIBLE PROJECTS
A company has Rs 100,000 to invest and has the following projects which are fully divisible and mutually
independent.
Project
A
B
C
D
E
Initial Outlay (Rs)
100,000
20,000
10,000
40,000
30,000
NPV (Rs)
200,000
100,000
(5,000)
160,000
540,000
Required: Devise the investment plan for the Company.
Question 03: INDIVISIBLE PROJECTS
A company has Rs 3,000,000 to invest and has the following projects which are indivisible and mutually
independent.
Project
A
B
C
Initial Outlay (Rs)
1,600,000
1,200,000
1,000,000
NPV (Rs)
660,000
1,200,000
700,000
Required: Devise the investment plan for the Company.
Question 04:
A company has Rs 50 million to invest and has the following projects which are fully divisible and are
mutually independent.
Funds are only limited at the moment and will be available unlimited at WACC of 10% in coming years.
Year
0
1
2
3
Project A
(15)
(15)
20
25
Cash Flows (Rs in million)
Project B
Project C
Project D
(30)
(35)
(10)
-10
(20)
-10
20
60
20
26
Project E
-(25)
50
--
Required: Devise the investment plan for the Company at the moment.
Always a mentor | Muzzammil Munaf
Page 353 of 690
Page 5 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
Question 05: MUTUALLY EXCLUSIVE PROJECTS
A company has Rs 100 million to invest and has the following projects to consider against a discount rate
of 20%.
All projects are fully divisible, however, projects C and D are mutually exclusive.
Funds are only limited at the moment and will be available unlimited in coming years.
Year
0
1
2
Project A
(20)
(30)
80
Cash Flows (Rs in million)
Project B
Project C
Project D
(40)
(50)
(40)
5
(25)
(5)
55
115
75
Project E
(30)
(20)
80
Required: Devise the investment plan for the Company.
Question 06: MUTUALLY DEPENDANT/INDIVISIBLE PROJECTS
A company has Rs 43 million to invest and has the following projects to consider.
All the projects are indivisible. Projects A, B and C are mutually exclusive whereas Projects D and E are
mutually dependant.
Project
A
B
C
D
E
Outlay
(10.5)
(6.4)
(9.7)
(12.2)
(13.1)
NPV
4.74
1.32
5.73
1.31
10.67
Required: Devise the investment plan for the Company.
Question 07: SCALING UP OF PROJECTS
A company has Rs 1,500 million to invest and has the following projects to consider. Projects A and B are
mutually exclusive whereas project C can be scaled upward by 20%. All the projects are fully divisible.
Project
A
B
C
D
E
Outlay
(400)
(450)
(600)
(550)
(800)
NPV
220
232
232
92.4
(85)
Required: Devise the investment plan for the Company.
Always a mentor | Muzzammil Munaf
Page 354 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
Question 08: SCALING DOWN
A company has Rs 1,000 million to invest and has the following projects to consider.
Project
A
B
C
D
E
F
Outlay
(300)
(120)
(240)
(512)
(800)
(400)
NPV
223
25
136.6
204
374
163
Projects A and B are mutually dependant. Project C can be scaled downward but cannot be scaled upward.
All other projects are indivisible.
Required: Devise the investment plan for the Company.
Question 09: SINGLE PROJECT INDIVISIBLE
A company has Rs 1,200 million to invest and has the following projects to consider.
Project
01
02
03
04
05
06
Outlay
(620)
(640)
(240)
(1,000)
(120)
(400)
NPV
55
69
20
72
19
29
Project 01 is indivisible whereas all other projects are fully divisible.
Required: Devise the investment plan for the Company.
Always a mentor | Muzzammil Munaf
Page 355 of 690
Page 7 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
QUESTION 10: PROJECT SYNERGY
A company has Rs 100,000 to invest and has the following projects to consider.
Project
X
Y
Z
Outlay
(100,000)
(50,000)
(40,000)
NPV
25,000
11,000
8,000
If projects Y and Z are conducted together, they will achieve a synergy of Rs 4,400 in NPV. All projects are
fully divisible.
Required: Devise the investment plan for the Company.
ICAP WINTER 2016 MALIK INVESTMENTS: QUESTION
Always a mentor | Muzzammil Munaf
Page 356 of 690
Page 8 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
ICAP WINTER 2016 MALIK INVESTMENTS: SOLUTION
Projects
A
B
C
D
E
F
Inv
(150.00)
(200.00)
(250.00)
(225.00)
(60.00)
(100.00)
NPV
18.00
34.00
24.00
24.00
9.00
14.00
PI
0.12
0.17
0.10
0.11
0.15
0.14
Rank
4.00
1.00
6.00
5.00
2.00
3.00
Investment Plan 1:
B
E (Scale up 20%)
F
D
Inv
(200.00)
(72.00)
(100.00)
(128.00)
NPV
34.00
10.80
14.00
13.65
72.45
LO
300.00
228.00
128.00
-
Investment Plan 2:
B
E (Scale up 20%)
A
F
Inv
(200.00)
(72.00)
(150.00)
(78.00)
NPV
34.00
10.80
18.00
10.92
73.72
LO
300.00
228.00
78.00
-
Remaining available projects when Inv Plan 2 is adopted:
Inv
2017
2018
2019
F (remaining 22%)
(22.00)
6.60
6.60
6.60
C (scale up 20%)
(300.00) 108.00
108.00
84.00
D (scale up 20%)
(270.00) 120.00
120.00
120.00
Net Cash Flows
(592.00) 234.60
234.60
210.60
Calculate the IRR of these combined projects:
2020
6.60
60.00
66.60
2021
6.60
60.00
66.60
15%
This rate is effectively the maximum interest rate I can offer to the bank.
Because this is the maximum I can earn on the investment financing by the bank.
Always a mentor | Muzzammil Munaf
Page 357 of 690
Page 9 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
MULTIPERIOD CAPITAL RATIONING
Always a mentor | Muzzammil Munaf
Page 358 of 690
Page 10 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
ICAP WINTER 2018 MARS LIMITED: QUESTION
ICAP WINTER 2018 MARS LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
Page 359 of 690
Page 11 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
Always a mentor | Muzzammil Munaf
Page 360 of 690
Page 12 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
Always a mentor | Muzzammil Munaf
Page 361 of 690
Page 13 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
ICAP SUMMER 2022 GO LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
Page 362 of 690
Page 14 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
ICAP SUMMER 2022 GO LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
Page 363 of 690
Page 15 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CAPITAL RATIONING DECISIONS
Always a mentor | Muzzammil Munaf
Page 364 of 690
Page 16 of 16
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
Contents
LEASE VS BORROW DECISION............................................................................................................... 2
ACQUISITION DECISION ..................................................................................................................... 2
FINANCING DECISION ......................................................................................................................... 2
QUESTIONS ON ASSET REPLACEMENT DECISIONS ..................................................................... 3
ICAP SUMMER 2008 MOHANI LIMITED: QUESTION ................................................................... 6
ICAP SUMMER 2008 MOHANI LIMITED: SOLUTION ................................................................... 7
ICAP SUMMER 2010 DS LEASING: QUESTION............................................................................... 9
ICAP SUMMER 2010 DS LEASING: SOLUTION ............................................................................. 10
ICAP WINTER 2013 SUPREME GROUP: QUESTION .................................................................... 12
ICAP WINTER 2013 SUPREME GROUP: SOLUTION .................................................................... 13
ICAP SUMMER 2016 SILVERLINE: QUESTION .............................................................................. 15
ICAP SUMMER 2016 SILVERLINE: SOLUTION .............................................................................. 16
ACCA F9 DECEMBER 2018 MELANIE CO: QUESTION ................................................................. 18
ACCA F9 DECEMBER 2018 MELANIE CO: SOLUTION ................................................................. 18
Always a mentor | Muzzammil Munaf
Page 365 of 690
Page 1 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
LEASE VS BORROW DECISION
ACQUISITION DECISION
Cashflows will be prepared in the same manner as for any project investment appraisal scenario.
 We will assume that the asset will be purchased by the company using available pool of funds (D + E).
Accordingly, tax depreciation, tax gain or loss will be incorporated for tax working.
 Financing Cashflows will not form part of overall cashflows for decision here.
 Discounting will be done using company’s appropriate Cost of Capital/ WACC/ Required rate.
FINANCING DECISION
Plot all relevant cashflows separately for both option (Lease v/s Borrow & Buy) including financing cashflows
where relevant:
 Discounting the cashflows under both options with same incremental borrowing rate (IRR of the loan)
 The option with either higher +ve NPV or lower -ve NPV (PV of costs) will be selected.
 The financing decision is considered separately from the investment decision.
If NPV is +ve then decision is favorable. If NPV is -ve then decision is not favorable.
For acquisition decision take all cashflows of the project (only project related no financing cashflows) and
discount the same with After-tax Cost of capital/WACC:
For financing decision, follow the steps:
Step 1: Determination of Discount rate for lease or borrow decision
 If tax is payable in the same year then, take the interest rate I on loan (incremental borrowing rate) as
given in the question. Make it after tax rate i.e. I x (1-t). this rate will be the IRR of loan and to be used
as discount rate.
 If tax is payable in arrears then, calculate accurate IRR of the loan by plotting all loan cashflows including
tax savings on interest. This IRR of loan will be used as discount rate.
Step 2: Borrow or Buy Option
 If cashflows for acquisition decision have already been plotted, then the net cashflows of acquisition
decision will be used without any further working.
 If the question is just a financing question, then cashflows will be prepared similar to those of acquisition
decision.
Always a mentor | Muzzammil Munaf
Page 366 of 690
Page 2 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
Discount these Cashflows via IRR of loan – As discount rate being used is the IRR of loan so all loan cashflows
when discounted with this rate will have zero PV. Accordingly, there is no need to incorporate loan cashflows
in the working.
Step 3: Leasing Option
In preparing cashflows of this option include lease cashflows and also include all the operational
costs/savings as included under both the acquisition & borrowing decisions to ensure we are comparing
like with like.
Points to remember
 Don’t include the initial investment under the leasing option. Instead include outflows of lease rentals
also include tax benefits on lease payments.
 Don’t include tax savings on depreciation as tax benefit.
 If security deposit is given in the question then include it and it will be an outflow at time 0.
 If salvage vale is given in the question then Include it at end as an inflow net of any purchase cost for
lessee.
 If the rentals are payable quarterly/semi-annually then discount them using equivalent periodic rate
but the tax benefit will be discounted using annual rate.
 Discount rate will be the IRR of loan
Step 4: Decision Making
Compare the two NPVs calculated. The option with comparatively higher +ve NPV or comparatively lower
-ve NPV (PV of costs) will be chosen.
QUESTIONS ON ASSET REPLACEMENT DECISIONS
Question 01:
Crimson has decided to undertake a project which requires a new machine at a cost of Rs 3 million. The
machine has a useful life of three years and a residual value of Rs 500,000 at the end of that time. The
machine will produce cash operating surpluses of Rs.1.6 million each year.
Allowable initial allowance is 25% and normal depreciation is 10% under the reducing balance method. Tax
on profits is payable at the rate of 32% and Crimson has an after-tax cost of capital of 20%. The Company
is considering two different forms of finance.
It could borrow Rs 3 million in order to purchase the asset. A loan is available at a pre-tax interest rate of
14% (payable in arrears). The principal on the loan would be repaid at the end of the three years.
Alternatively, Crimson could lease the asset at a cost of Rs.1.3 million each year for three years, with the
lease payments payable in arrears at the end of each year.
Required: Should the asset be acquired, and if so which financing method should be used?
Always a mentor | Muzzammil Munaf
Page 367 of 690
Page 3 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
Solution 1:
Particulars
Machine
Residual value
Tax shield on depreciation
Operating CF (net of tax)
Net Cash Flows
PV @ 20%
NPV
Year 0
Year 1
Year 2
(3,000,000)
312,000
64,800
1,088,000
1,088,000
(3,000,000)
1,400,000
1,152,800
(3,000,000)
1,166,667
800,556
131,111 Postive - the Company should invest
Cost of the asset
Year 1 initial allowance
Year 1 - depreciation
NBV
Year 2 - depreciation
NBV
Year 3 - Balancing ch/all
NBV = RV
3,000,000
(750,000)
(225,000)
2,025,000
(202,500)
1,822,500
(1,322,500)
500,000
Cost
RV
3,000,000
500,000
2,500,000
Year 3
500,000
423,200
1,088,000
2,011,200
1,163,889
240,000
72,000
64,800
423,200
In case of discounting financing cash flows (lease vs borrow), you have got 2 options:
- Post tax weighted average cost of capital (Post tax WACC)
- Post tax borrowing rate (rate of the loan)
Loan rate x (1 - t) = 14% x (1-32%) = 9.52% when tax is payable in the same year
Calculate the IRR of the loan if the tax is payable in arrear
Option 01: Discounting based on WACC:
In case of borrowing
Year 0
Payment of interest
Tax benefit on interest
Repayment of principal
Tax benefit on depreciation
Scrap value
Net Cash Flows
PV @ 20%
NPV @ 20%
(1,498,463)
Always a mentor | Muzzammil Munaf
Year 1
(420,000)
134,400
312,000
26,400
22,000
Page 368 of 690
Year 2
(420,000)
134,400
64,800
(220,800)
(153,333)
Year 3
(420,000)
134,400
(3,000,000)
423,200
500,000
(2,362,400)
(1,367,130)
Page 4 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
In case of leasing
Lease rentals
Tax benefit on lease rentals
Year 0
Net Cash Flows
PV @ 20%
NPV @ 20%
(1,862,130)
Year 1
(1,300,000)
416,000
Year 2
(1,300,000)
416,000
Year 3
(1,300,000)
416,000
(884,000)
(736,667)
(884,000)
(613,889)
(884,000)
(511,574)
Option 02: Discounting based on IRR of the loan:
In case of borrowing
Year 0
Payment of interest
Tax benefit on interest
Repayment of principal
Tax benefit on depreciation
Scrap value
Net Cash Flows
PV @ 9.52%
PV @ 9.52%
(1,958,323)
Year 1
(420,000)
134,400
312,000
26,400
24,105
Year 2
(420,000)
134,400
64,800
(220,800)
(184,082)
Year 3
(420,000)
134,400
(3,000,000)
423,200
500,000
(2,362,400)
(1,798,345)
In case of leasing
Lease rentals
Tax benefit on lease rentals
Year 0
Year 1
(1,300,000)
416,000
Year 2
(1,300,000)
416,000
Year 3
(1,300,000)
416,000
Net Cash Flows
PV @ 9.52%
PV @ 9.52%
(2,217,088)
(884,000)
(807,159)
(884,000)
(736,996)
(884,000)
(672,933)
-
-
OR
In case of borrowing
Amount borrowed
Tax benefit on depreciation
Scrap value
Net Cash Flows
PV @ 9.52%
PV @ 9.52%
Always a mentor | Muzzammil Munaf
Year 0
(3,000,000)
(3,000,000)
(3,000,000)
(1,958,323)
Year 1
312,000
312,000
284,879
Page 369 of 690
Year 2
64,800
64,800
54,024
Year 3
423,200
500,000
923,200
702,774
Page 5 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
In case of borrowing
Payment of interest
Tax benefit on interest
Repayment of principal
Net Cash Flows
PV @ 9.52%
PV @ 9.52%
Equal to the loan amount
Year 0
(3,000,000)
Year 1
(420,000)
134,400
(285,600)
(260,774)
Year 2
(420,000)
134,400
(285,600)
(238,107)
Year 3
(420,000)
134,400
(3,000,000)
(3,285,600)
(2,501,119)
ICAP SUMMER 2008 MOHANI LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
Page 370 of 690
Page 6 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
ICAP SUMMER 2008 MOHANI LIMITED: SOLUTION
Option 1: Leasing
Year 0
Payment of security deposit
(320,000)
Lease payment
(860,000)
Tax benefit on lease payment
Disposal value
Tax on gain on disposal (400 - 320) x 0.35
Net Cash Flow
(1,180,000)
PV @ 7.15%
(1,180,000)
NPV @ 7.15%
(2,590,567)
= 11% x (1 - 35%)
Year 1
(860,000)
301,000
-
Year 2
(860,000)
301,000
-
Year 3
(860,000)
301,000
-
Year 4
(860,000)
301,000
-
(559,000)
(521,699)
(559,000)
(486,886)
(559,000)
(454,397)
(559,000)
(424,075)
Year 5
301,000
400,000
(28,000)
673,000
476,490
7.15%
PV of the borrowed amount
3,200,000
Interest rate
11%
3,200,000 = R x ((1-(1.11^-5))/0.11)
Hence, R = 3,200,000 / ((1-((1-(1.11^-5))/0.11
PV of the borrowed amount
Interest rate
DF @ 11% - annuity for five years
R (fixed annual payment)
Option 2: Borrowing
Loan repayment
Tax benefit on interest
Insurance (post tax) (96 x 0.65)
Tax benefit on depreciation
Salvage value
Net Cash Flow
PV @ 7.15%
NPV @ 7.15%
Always a mentor | Muzzammil Munaf
3,200,000
11%
3.6959
865,824
Year 0
(2,323,974)
Year 1
(865,824)
123,200
(62,400)
616,000
(189,024)
(176,411)
Page 371 of 690
Year 2
(865,824)
103,418
(62,400)
50,400
(774,407)
(674,504)
Year 3
(865,824)
81,459
(62,400)
45,360
(801,405)
(651,441)
Year 4
(865,824)
57,086
(62,400)
40,824
(830,315)
(629,903)
Year 5
(865,824)
30,029
(62,400)
227,416
400,000
(270,779)
(191,714)
Page 7 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
OR
Option 2: Borrowing
Amount borrowed
Insurance (post tax) (96 x 0.65)
Tax benefit on depreciation
Salvage value
Net Cash Flow
PV @ 7.15%
NPV @ 7.15%
Year 0
(3,200,000)
(3,200,000)
(3,200,000)
(2,323,976)
Loan schedule
Balance at Year 0
Interest @ 11%
Depreciation schedule
3,200,000
352,000 123,200 Cost
3,552,000
Res value
(865,824)
Max. deductible
2,686,176
295,479 103,418
2,981,655
Year 1 - initial allow.
(865,824)
Year 1 - normal dep.
2,115,831
232,741
81,459 Year 2 - dep
2,348,572
Year 3 - dep
(865,824)
Year 4 - dep
1,482,748
Year 4 - balancing ch/all
163,102
57,086
1,645,850
(865,824)
780,026
85,798
30,029
865,824
(865,824)
0.00
Repayment at Year 1
Interest @ 11%
Repayment at Year 2
Interest @ 11%
Repayment at Year 3
Interest @ 11%
Repayment at Year 4
Interest @ 11%
Repayment at Year 5
Always a mentor | Muzzammil Munaf
Year 1
(62,400)
616,000
553,600
516,659
Page 372 of 690
Year 2
(62,400)
50,400
(12,000)
(10,452)
Year 3
(62,400)
45,360
(17,040)
(13,851)
Year 4
(62,400)
40,824
(21,576)
(16,368)
Year 5
(62,400)
227,416
400,000
565,016
400,037
3,200,000
(400,000)
2,800,000
Tax benefit
1,600,000
160,000
1,760,000
144,000
129,600
116,640
649,760
2,800,000
616,000
50,400
45,360
40,824
227,416
Page 8 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
ICAP SUMMER 2010 DS LEASING: QUESTION
DS Leasing Company Limited has been approached by BP Industries Limited, with a request to arrange a 4year lease contract in respect of a state-of-the-art machine. The cost of machine is Rs. 20 million and the
expected useful life is 4 years. The residual value at the end of lease term is estimated at 10% of cost.
DS would finance the purchase of machine by borrowing at 16% per annum. The interest would be payable
annually and the principal amount would have to be repaid in four equal annual installments commencing
from the end of first year.
DS provides free-of-cost maintenance services for all its leased assets. These services are provided by the
company’s Maintenance Department whose costs are mostly fixed. If BP acquires this service from any other
vendor, it would have to pay an annual fee of 3% of the cost of machine. Insurance cost will be borne by BP
and is estimated at 4% of the cost of machine.
The tax rate applicable to both companies is 35% and the tax is payable in the next year. Allowable initial
and normal deprecation on the machine is 25% and 10% respectively. The weighted average cost of capital
of DS and BP are 18% and 20% respectively.
Both companies follow the same financial year. It may be assumed that the purchase would be finalized on
the last day of the financial year.
Required:
a) Calculate the annual rental (payable in advance) which DS should charge in order to break even on
the lease contract. (08)
b) Assume that BP has the following two options for financing the cost of machine:
a. DS has offered to lease the machine at an annual rental of Rs. 7 million, payable in advance.
b. EFT Bank has offered to finance the machine at 18% per annum. The loan including interest
would be repayable in 4 equal annual installments to be paid at the end of each year.
Insurance costs would be borne by BP.
Determine which course of action BP should follow. (12)
Always a mentor | Muzzammil Munaf
Page 373 of 690
Page 9 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
ICAP SUMMER 2010 DS LEASING: SOLUTION
Requirement a: PV of costs
Amount borrowed
Tax benefit on depreciation
Residual value
Net Cash Flows
PV @ 11% (W1)
Total PV of Costs
Machine cost
Res value
Max deductible
20,000,000
2,000,000
18,000,000
Dep Y1 - initial
Dep Y1 - normal
Dep Y2 - normal
Dep Y3 - normal
Dep Y4 - balancing
5,000,000
1,500,000
1,350,000
1,215,000
8,935,000
18,000,000
IRR of the loan (W1)
Amount borrowed
Principal repayment
Interest @ 16%
Tax benefit on interest
Net Cash Flows
IRR
Year 0
(20,000,000)
(20,000,000)
(20,000,000)
(14,354,613)
Year 1
-
Year 2
2,275,000
2,275,000
1,846,441
Year 3
472,500
472,500
345,488
Year 4
425,250
2,000,000
2,425,250
1,597,587
Year 5
3,127,250
3,127,250
1,855,871
Year 0
Year 1
Year 2
Year 3
Year 4
20,000,000
(5,000,000) (5,000,000) (5,000,000) (5,000,000)
(3,200,000) (2,400,000) (1,600,000) (800,000)
1,120,000
840,000
560,000
20,000,000 (8,200,000) (6,280,000) (5,760,000) (5,240,000)
11%
Year 5
280,000
280,000
Tax benefit
1,750,000
525,000
472,500
425,250
3,127,250
At the break even position, PV of costs should be equal to PV of income (i.e. Rentals)
Total PV of Costs
(14,354,613)
DF of income (W2)
2.3579
Retals (Component 'R')
6,087,987
DF for income (W2)
Rental income
Tax on rental income
Net income
DF @ 11%
DF
Always a mentor | Muzzammil Munaf
Year 0
1.00
1.00
1.00
2.3579
Year 1
1.00
(0.35)
0.65
0.5856
Page 374 of 690
Year 2
1.00
(0.35)
0.65
0.5276
Year 3
1.00
(0.35)
0.65
0.4753
Year 4
(0.35)
(0.35)
(0.2306)
Year 5
-
Page 10 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
Requirement b (a)
Lease rental
Tax benefit on rental
Net Cash Flows
DF @ 12.4% (W3)
NPV in leasing option
Year 0
Year 1
Year 2
Year 3
(7,000,000) (7,000,000) (7,000,000) (7,000,000)
2,450,000 2,450,000 2,450,000
(7,000,000) (4,550,000) (4,550,000) (4,550,000)
(7,000,000) (4,048,043) (3,601,461) (3,204,147)
(16,318,678)
IRR of the 18% loan (W3)
Amount borrowed
Principal repayment
Interest @ 18%
Tax benefit on interest
Net Cash Flows
IRR of the loan (post tax)
Year 0
Year 1
Year 2
Year 3
Year 4
20,000,000
(5,000,000) (5,000,000) (5,000,000) (5,000,000)
(3,600,000) (2,700,000) (1,800,000) (900,000)
1,260,000
945,000
630,000
20,000,000 (8,600,000) (6,440,000) (5,855,000) (5,270,000)
12.4%
Year 1
Year 2
Year 3
Year 4
Int @ 18%
3,600,000
2,700,000
1,800,000
900,000
20,000,000
15,000,000
10,000,000
5,000,000
Borrowing Option
Amount borrowed
Residual value
Tax benefit on depreciation
Maintenance cost
Tax saving on maintenance cost
Net Cash Flows
PV @ 12.4%
NPV in borrowing option
Year 0
(20,000,000)
(20,000,000)
(20,000,000)
(15,848,363)
Always a mentor | Muzzammil Munaf
Year 1
(600,000)
(600,000)
(533,808)
Page 375 of 690
Year 2
2,275,000
(600,000)
210,000
1,885,000
1,492,034
Year 3
472,500
(600,000)
210,000
82,500
58,097
Year 4
2,450,000
2,450,000
1,534,973
Year 5
-
Year 5
315,000
315,000
Year 4
Year 5
2,000,000
425,250 3,127,250
(600,000)
210,000
210,000
2,035,250 3,337,250
1,275,124 1,860,189
Page 11 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
Machine cost
Res value
Max deductible
20,000,000
2,000,000
18,000,000
Dep Y1 - initial
Dep Y1 - normal
Dep Y2 - normal
Dep Y3 - normal
Dep Y4 - balancing
5,000,000
1,500,000
1,350,000
1,215,000
8,935,000
18,000,000
Cost of machine
Percentage
Maintenance cost
20,000,000
3%
600,000
1,750,000
525,000
472,500
425,250
3,127,250
Decision: Borrowing is better since NPV is less negative in this case.
ICAP WINTER 2013 SUPREME GROUP: QUESTION
Always a mentor | Muzzammil Munaf
Page 376 of 690
Page 12 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
ICAP WINTER 2013 SUPREME GROUP: SOLUTION
Rental Company (SM Car i.e. 1000 CC)
Car Purchase
Residual value
Down payment (10%)
CF other than rental
PV @ 12%
Total PV
Year 0
(1,000,000)
100,000
(900,000)
(900,000)
(786,515)
Year 1
-
Year 2
-
Year 3 Year 4 Year 5
200,000
200,000
113,485
Since at IRR, the NPV is zero, therefore PV of rentals would be same positive PV i.e. 786,515
PV of rentals
DF (annuity of 60 monthly payments)
DF (annuity of 60 monthly payments)
R = PV / DF
786,515
= [1 - (1 + 12%/12)^(-5 x 12)] / (12%/12)
= [1 - (1 + 1%)^(-60)] / 1%
44.9550
17,496 Monthly rental for 1000 CC Car
Rental Company (DGM Car i.e. 1300 CC)
Car Purchase
Residual value
Down payment (10%)
CF other than rental
PV @ 12%
Total PV
Year 0
(1,500,000)
150,000
(1,350,000)
(1,350,000)
(1,179,772)
Year 1
-
Year 2
-
Year 3 Year 4 Year 5
300,000
300,000
170,228
Since at IRR, the NPV is zero, therefore PV of rentals would be same positive PV i.e. 786,515
Always a mentor | Muzzammil Munaf
Page 377 of 690
Page 13 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
PV of rentals
DF (annuity of 60 monthly payments)
DF (annuity of 60 monthly payments)
R = PV / DF
1,179,772
= [1 - (1 + 12%/12)^(-5 x 12)] / (12%/12)
= [1 - (1 + 1%)^(-60)] / 1%
44.9550
26,243 Monthly rental for 1000 CC Car
Rental Company (GM Car i.e. 1800 CC)
Car Purchase
Residual value
Down payment (10%)
CF other than rental
PV @ 12%
Total PV
Year 0
(2,000,000)
200,000
(1,800,000)
(1,800,000)
(1,573,029)
Year 1
-
Year 2
-
Year 3 Year 4 Year 5
400,000
400,000
226,971
Since at IRR, the NPV is zero, therefore PV of rentals would be same positive PV i.e. 786,515
PV of rentals
DF (annuity of 60 monthly payments)
DF (annuity of 60 monthly payments)
R = PV / DF
1,573,029
= [1 - (1 + 12%/12)^(-5 x 12)] / (12%/12)
= [1 - (1 + 1%)^(-60)] / 1%
44.9550
34,991 Monthly rental for 1000 CC Car
Rental per month
Insurance (3% of car value)/12
Gross Rental Amount
Maintenance allowance
Fuel reimbursement
Financing of down payment (DP x 13%/12)
Total monthly cost for the Company
SM (1000
DGM
GM (1800
CC)
(1300 CC)
CC)
17,496
26,243
34,991
2,500
3,750
5,000
19,996
29,993
39,991
5,000
7,000
10,000
15,000
20,000
25,000
1,083
1,625
2,167
41,079
58,618
77,158
Total monthly cost for the Company
Existing allowance
Monthly additional cost / (savings)
No of employees
Total monthly additional cost / (savings)
Net monthly additional cost / (savings)
Net annual additional cost / (savings)
41,079
58,618
77,158
40,000
65,000
90,000
1,079
(6,382) (12,842)
80
16
8
86,315 (102,106) (102,737)
(118,528)
(1,422,338)
Allowance vs lease
Company should opt for the leasing option.
Always a mentor | Muzzammil Munaf
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Page 14 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
ICAP SUMMER 2016 SILVERLINE: QUESTION
Always a mentor | Muzzammil Munaf
Page 379 of 690
Page 15 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
ICAP SUMMER 2016 SILVERLINE: SOLUTION
Always a mentor | Muzzammil Munaf
Page 380 of 690
Page 16 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
Always a mentor | Muzzammil Munaf
Page 381 of 690
Page 17 of 19
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
ACCA F9 DECEMBER 2018 MELANIE CO: QUESTION
ACCA F9 DECEMBER 2018 MELANIE CO: SOLUTION
Always a mentor | Muzzammil Munaf
Page 382 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LEASE VS BORROW
Always a mentor | Muzzammil Munaf
Page 383 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
Contents
ADJUSTED PRESENT VALUE ................................................................................................................... 2
THE INVESTMENT DECISION ............................................................................................................. 2
PV OF DEBT ISSUE COSTS ................................................................................................................... 3
CALCULATING THE APV ...................................................................................................................... 5
ICAP WINTER 2018 VENUS: QUESTION .......................................................................................... 8
ICAP WINTER 2018 VENUS: SOLUTION .......................................................................................... 9
ACCA P4 JUNE 2018 TIPPLETINE CO: QUESTION ....................................................................... 11
ACCA P4 JUNE 2018 TIPPLETINE CO: SOLUTION ....................................................................... 13
ICAP SUMMER 2022 INFRAPOWER: QUESTION ......................................................................... 14
ICAP SUMMER 2022 INFRAPOWER: SOLUTION ......................................................................... 16
Always a mentor | Muzzammil Munaf
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Page 1 of 18
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
ADJUSTED PRESENT VALUE
The APV method is used if a new project has a different financial risk (debt-to-equity ratio) from the
company, i.e., the overall capital structure of the company changes. APV consists of two different decisions:
APV consists of two different decisions:
APV
Value of a geared project
= investing decision
+ financing decision
= Value of an all equity financed project + PV of financing side effects
Illustration: Adjusted present value
Base case NPV
minus: PV of other costs
plus: PV of tax relief on interest X
Adjusted present value (APV)
XXX
(XXX)
XXX
XXX
THE INVESTMENT DECISION
The project is evaluated as though it were being undertaken by an all-equity company with all financing
side effects ignored. The financial risk is quantified later in the second part of the APV analysis – the
financing decision. Therefore:
 ignore the financial risk in the investment decision process
 use a beta that reflects just the business risk, i.e. ß asset.
Find the project ß asset
Calculate the base case
discount rate = Keu by
putting the ß asset in
the CAPM formula
Caclulate the base case
NPV
Once the base case NPV is identified, the PV of the financing is evaluated.
The financing decision
 issue costs
 tax relief
As all financing cash flows are low risk, they are discounted at either the Kd or the risk-free rate.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
Grossing up
A firm will know how much finance is required for the investment. Issue costs of finance will usually be
quoted on top. It will therefore be necessary to gross up the funds to be raised.
Example: The finance required for a planned investment is $2m (net of issue costs). Issue costs are 3%. And
the finance raised will also have to cover the issue costs. What are the issue costs and what sum will need
to be raised altogether?
Solution
 The $2m is 97% of the amount to be raised:





Therefore, ($2m/0.97) = $2,061,856 will be needed.
Issue costs are 3%
3% × $2,061,856 = $61,856
Issue costs can be calculated in one stage as:
$2m × 3/97 = $61,856
PV OF DEBT ISSUE COSTS
As always, calculations involving debt must take account of the tax effects.
Equity issue costs
Not tax
deductible
Debt issue costs
Are tax
deductible
Issue costs at To
PV of the tax relief (issue costs x tax rate x discount factor)
PV of the issue costs
(XXX)
XXX
(XXX)
Issue Costs
Method:
PV of the tax relief on interest payments
The PV of the tax relief on interest payments is also known as the PV of the tax shield. The method adopted
depends on the information given:
Always a mentor | Muzzammil Munaf
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Page 3 of 18
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
Debentures – interest paid at a fixed amount each year
Annual tax relief = Total loan × interest rate × tax rate
Annuity factor for n years
Year one discount factor (if tax is delayed one year)
PV of the tax shield
XXX
XXX
XXX
XXX
The repayments will be made up of both interest and capital elements.
Step 1: Find the amount of the repayment
Annual amount = (Amount of the loan/Relevant annuity factor)
Step 2: Compute the annual interest charge.
Example:
Always a mentor | Muzzammil Munaf
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Page 4 of 18
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
CALCULATING THE APV
Base case NPV
minus: PV of other costs
plus: PV of tax relief on interest X
Adjusted present value (APV)
XXX
(XXX)
XXX
XXX
Question 01:
A company operating in the insurance industry is considering whether to diversify by investing in a project
in the transport industry.
The company has a gearing ratio of 30% debt and 70% equity, and its equity beta is 0.940. Its debt capital
is risk-free.
The transport industry has an average equity beta of 1.362, and firms in the transport industry on average
have a gearing ratio of 40% debt to 60% equity.
The risk-free rate of return is 5.3% and the expected market return is 8.3%. The rate of taxation on profits is
23%.
The cash flows of the project after tax will be:
Year 0
Years 1–3
Rs (600,000)
Rs 250,000
The investment of Rs 600,000 would be financed by Rs 400,000 of new equity and Rs 200,000 of new debt.
Issue costs are 5% of the funds raised for equity and 2% of the funds raised for debt capital. The company
obtains borrows Rs 204,081 in the form of a three-year amortising loan at 5.3% interest.
The risk-free cost of capital is 5.3%. The rate of taxation on profits is 23%. Issue costs are allowable for tax
purposes.
Required:
i)
ii)
Calculate the base case NPV.
Calculate the PV of the issue costs for financing the project. Assume that tax is paid in the year following
the year in which the taxable profit occurs.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
Solution 01:
a) Base Case NPV
Initial outlay
Inflow
Net CF
PV @ 8% (W1)
Base Case NPV
Year 0
(600,000)
(600,000)
(600,000)
44,274
Year 1
250,000
250,000
231,481
Year 2
250,000
250,000
214,335
Year 3
250,000
250,000
198,458
W1:
Beta asset = Beta equity x E / [E + D(1-t)]
Beta asset = 1.362 x 60 / [60 + 40(1-0.23)]
Beta asset
0.90
CAPM (Ke) = Rf + (Rm - Rf) x Beta asset
CAPM (Ke) = 5.3% + (8.3% - 5.3%) x 0.90
Ke
8.00%
Ke of an ungeared company in transport industry
Amount needed
Issue cost
Amount raised
Equity -- 400,000 / 95 x 100
Amount needed
Issue cost
Amount raised
Debt -- 200,000 / 98 x 100
95%
5%
100%
421,053
98%
2%
100%
204,082
b) APV
Base Case NPV
Issue cost of equity (400,000/95 x 5)
Issue cost of debt (200,000/98 x 2)
PV of tax benefit of issue costs (W2)
PV of tax benefit on interest (W3)
Adjusted Present Value
Always a mentor | Muzzammil Munaf
44,274
(21,053)
(4,082)
5,490
4,410
29,040
Page 389 of 690
Page 6 of 18
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
W2: PV of tax benefit on issue costs
Issue cost of equity (400,000/95 x 5)
Issue cost of debt (200,000/98 x 2)
Tax benefit at the end of Year 1
Discounted at year 0 @ 5.3%
Issue cost Tax @ 23%
21,053
4,842
4,082
939
5,781
5,490
W3: PV of tax benefit on interest
Interest amount (W4)
Tax benefit
PV of tax benefit @ Pre-tax Kd/Rf (i.e. 5.3%)
Total PV of tax benefit on interest
Year 2
10,816
2,488
2,244
4,410
W4: Loan schedule
Opening Balance (200,000/98x100)
Interest
Repayment (W5)
Closing balance
Year 1
204,082
10,816
(75,362)
139,535
W5: Yearly payment of loan
PV of the loan
DF @ 5.3% (annuity for 3 years)
R = (PV / DF)
204,082
2.7080
75,362
Always a mentor | Muzzammil Munaf
Page 390 of 690
Year 2
139,535
7,395
(75,362)
71,568
Year 3
7,395
1,701
1,457
Year 4
3,793
872
710
Year 3
71,568
3,793
(75,362)
(1)
Page 7 of 18
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
ICAP WINTER 2018 VENUS: QUESTION
Always a mentor | Muzzammil Munaf
Page 391 of 690
Page 8 of 18
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
ICAP WINTER 2018 VENUS: SOLUTION
Construction industry:
- Mobilisation advance
- Progress Billings
- Retention Money
Total contract value
1,000
Mob advance
Mob advance (amount)
20%
200
Year 1
Year 2
Year 3
SOC
40%
30%
30%
Retention Money
Bill
400
300
300
1,000
Adv
(80)
(60)
(60)
(200)
Net
320
240
240
5%
Ret.
(16)
(12)
(12)
(40)
Cash
304
228
228
760
40
Billed amount - is for tax purposes
Always a mentor | Muzzammil Munaf
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Page 9 of 18
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
Particulars
Progress Billing (%)
Year 0
Year 1
10%
Year 2
25%
Year 3
35%
Year 4
30%
Year 5
0%
Progress Billing (Rs Mn)
Direct Mat
Subcontracting
Other direct costs
Depreciation (W1)
Amount subject to tax
Tax (W2)
Depreciation (W1)
375.0
(250.0)
125.0
1.0000
125.0
(2.12)
150.0
(280.0)
(103.0)
(137.5)
(370.5)
138
(233)
(37.5)
(7.5)
(278.0)
0.8834
(245.6)
375.0
(140.0)
(50.0)
(103.0)
(11.3)
70.8
11
82
(93.8)
(18.8)
(30.5)
0.7804
(23.8)
525.0
(140.0)
(50.0)
(103.0)
(10.1)
221.9
10
232
(131.3)
(26.3)
74.5
0.6894
51.4
450.0
(140.0)
(50.0)
(103.0)
(9.1)
147.9
(21)
9
136
(112.5)
82.0
(22.5)
83.0
0.6090
50.6
75.0
75.0
0.5380
40.3
Year 2
(370.5)
70.8
(299.8)
-
Year 3
(299.8)
221.9
(77.9)
-
Year 4
(77.9)
147.9
70.0
(21)
Mobilisation advance
Plant / Res value
Retention Money
Net Cash Flows
DF @ 13.2% (W3)
PV @ 13.2%
Base Case NPV
W1
Cost
Dep Year 1
Dep Year 2
Dep Year 3
Dep Year 4
250.0
(137.5)
(11.25)
(10.13)
(9.11)
(168.0)
82.01
Residual value
W2
Brought forward losses
For the year
Brought forward losses
Tax @ 30%
Year 0
-
Year 1
(370.5)
(370.5)
-
W3: Ke of an ungeared company
Ke = Rf + (Rm - Rf) x Beta asset
Ke = 9% + 6% x 0.7
Ke = 13.2%
Always a mentor | Muzzammil Munaf
Page 393 of 690
Page 10 of 18
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
Calculation of APV
Base Case NPV
Issue cost (250 / 99% x 1%)
Tax benefit on issue cost discounted from year 1
Net impact of issue cost
PV of tax benefit on loan interest (W4)
Adjusted Present Value
(2.12)
(2.53)
0.69
(1.84)
24.01
20.05
W4 Loan interest
Year 0
Loan amount
Interest @ 10%
Tax benefit
PV @ 10%
PV of tax savings on interest
24.01
Year 1
252.53
25.25
7.58
6.89
Year 2
252.53
25.25
7.58
6.26
Year 3
252.53
25.25
7.58
5.69
Year 4
252.53
25.25
7.58
5.17
W5 Running finance
Opening cash
Net cash flow for the year
Interest payment
Closing balance
Year 1
375.00
(278.00)
(17.68)
79.32
Year 2
79.32
(30.50)
(17.68)
31.15
Year 3
31.15
74.50
(17.68)
87.97
Year 4
87.97
83.01
(17.68)
153.30
ACCA P4 JUNE 2018 TIPPLETINE CO: QUESTION
Tippletine Co is based in Valliland. It is listed on Valliland’s stock exchange but only has a small number of
shareholders. Its directors collectively own 45% of the equity share capital.
Tippletine Co’s growth has been based on the manufacture of household electrical goods. However, the
directors have taken a strategic decision to diversify operations and to make a major investment in facilities
for the manufacture of office equipment.
Details of investment
The new investment is being appraised over a four-year time horizon. Revenues from the new investment
are uncertain and Tippletine Co’s finance director has prepared what she regards as cautious forecasts. She
predicts that it will generate $2 million operating cash flows before marketing costs in Year 1 and $14·5
million operating cash flows before marketing costs in Year 2, with operating cash flows rising by the
expected levels of inflation in Years 3 and 4.
Marketing costs are predicted to be $9 million in Year 1 and $2 million in each of Years 2 to 4.
The new investment will require immediate expenditure on facilities of $30·6 million. Tax allowable
depreciation will be available on the new investment at an annual rate of 25% reducing balance basis. It can
be assumed that there will either be a balancing allowance or charge in the final year of the appraisal. The
Always a mentor | Muzzammil Munaf
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Page 11 of 18
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
finance director believes the facilities will remain viable after four years, and therefore a realisable value of
$13·5 million can be assumed at the end of the appraisal period.
The new facilities will also require an immediate initial investment in working capital of $3 million. Working
capital requirements will increase by the rate of inflation for the next three years and any working capital at
the start of Year 4 will be assumed to be released at the end of the appraisal period.
Tippletine Co pays tax at an annual rate of 30%. Tax is payable with a year’s time delay. Any tax losses on
the investment can be assumed to be carried forward and written off against future profits from the
investment.
Predicted inflation rates are as follows:
Year
1
8%
2
6%
3
5%
4
4%
Financing the Investment
Tippletine Co has been considering two choices for financing all of the $30·6 million needed for the initial
investment in the facilities:
 A subsidised loan from a government loan scheme, with the loan repayable at the end of the four years.
Issue costs of 4% of the gross finance would be payable. Interest would be payable at a rate of 30 basis
points below the risk-free rate of 2·5%. In order to obtain the benefits of the loan scheme, Tippletine
Co would have to fulfil various conditions, including locating the facilities in a remote part of Valliland
where unemployment is high.
 Convertible loan notes, with the subscribers for the notes including some of Tippletine Co’s directors.
The loan notes would have issue costs of 4% of the gross finance. If not converted, the loan notes would
be redeemed in six years’ time. Interest would be payable at 5%, which is Tippletine Co’s normal cost
of borrowing. Conversion would take place at an effective price of $2·75 per share. However, the loan
note holders could enforce redemption at any time from the start of Year 3 if Tippletine Co’s share price
fell below $1·50 per share. Tippletine Co’s current share price is $2·20 per share.
Issue costs for the subsidised loan and convertible loan notes would be paid out of available cash reserves.
Issue costs are not allowable as a tax-deductible expense.
In initial discussions, the majority of the board favoured using the subsidised loan. The appraisal of the
investment should be prepared on the basis that this method of finance will be used. However, the chairman
argued strongly in favour of the convertible loan notes, as, in his view, operating costs will be lower if
Tippletine Co does not have to fulfil the conditions laid down by the government of Valliland. Tippletine
Co’s finance director is skeptical, however, about whether the other shareholders would approve the issue
of convertible loan notes on the terms suggested. The directors will decide which method of finance to use
at the next board meeting.
Always a mentor | Muzzammil Munaf
Page 395 of 690
Page 12 of 18
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
Other information
Humabuz Co is a large manufacturer of office equipment in Valliland. Humabuz Co’s geared cost of equity
is estimated to be 10·5% and its pre-tax cost of debt to be 5·4%. These estimates are based on a capital
structure comprising $225 million 6% irredeemable bonds, trading at $107 per $100, and 125 million $1
equity shares, trading at $3·20 per share. Humabuz Co also pays tax at an annual rate of 30% on its taxable
profits.
Required:
(a) Calculate the adjusted present value for the investment on the basis that it is financed by the subsidised
loan and conclude whether the project should be accepted or not. Show all relevant calculations. (17 marks)
(b) Discuss the issues which Tippletine Co’s shareholders who are not directors would consider if its directors
decided that the new investment should be financed by the issue of convertible loan notes on the terms
suggested. (8 marks)
ACCA P4 JUNE 2018 TIPPLETINE CO: SOLUTION
Base Case NPV
Operating cash flows before mark
Marketing costs
Depreciation/Bal charge
Amount subject to tax
Tax @ 30% - in arrears
Add back depreciation
Initial outlay + Res value
Working capital
Net cash flows
PV @ 9%
Base case NPV
Working capital
Inflation rate
Working Capital
Additional working capital
0
1
2
2,000.00 14,500.00
(9,000.00) (2,000.00)
(7,650.00) (5,737.50)
(14,650.00) 6,762.50
7,650.00
5,737.50
(30,600.00)
(3,000.00)
(240.00)
(194.40)
(33,600.00) (7,240.00) 12,305.60
(33,600.00) (6,642.20) 10,357.38
(918.87)
(3,000.00)
(3,000.00)
3
15,225.00
(2,000.00)
(4,303.13)
8,921.88
4,303.13
(171.72)
13,053.28
10,079.53
4
5
15,834.00
(2,000.00)
590.63
14,424.63
(310.31) (4,327.39)
(590.63)
13,500.00
3,606.12
30,629.81 (4,327.39)
21,698.93 (2,812.50)
8.00%
6.00%
5.00%
(3,240.00) (3,434.40) (3,606.12)
(240.00)
(194.40)
(171.72)
4.00%
3,606.12
3,606.12
Depreciation
Opening NBV
Initial allowance
Depreciation
Closing NBV
1
2
3
4
30,600.00 22,950.00 17,212.50 12,909.38
(7,650.00) (5,737.50) (4,303.13)
590.63
22,950.00 17,212.50 12,909.38 13,500.00
Amount subject to tax
Carry forward
Taxable income
(14,650.00) 6,762.50
8,921.88 14,424.63
14,650.00 (6,762.50) (7,887.50)
1,034.38 14,424.63
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
Calculation of APV
Base case NPV
Issue costs (30,600/96 x 4)
Tax shield on sub. Loan
Subsidy benefit - net of tax
Adjusted Present Value
Tax shield on sub. Loan
Loan amount
Interest rate
Tax rate
Discount factor (AF for 4 years @ Kd = 5%)
Tax shield on sub. Loan
Subsidy benefit - net of tax
Loan amount
Benefit of interest (5% - 2.2%)
Net of tax effect (1 - 30%)
Discount factor (AF for 4 years @ Kd = 5%)
Tax shield on sub. Loan
(918.87)
(1,275.00)
716.13
2,127
648.94
30,600 since issue costs are paid out of cash, not to gross up.
2.20%
30%
3.5459
716
30,600
2.80%
70%
3.5459
2,127
ICAP SUMMER 2022 INFRAPOWER: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
Always a mentor | Muzzammil Munaf
Page 398 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
ICAP SUMMER 2022 INFRAPOWER: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
ADJUSTED PRESENT VALUE
Always a mentor | Muzzammil Munaf
Page 401 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
Contents
BUSINESS VALUATION ............................................................................................................................ 2
NATURE AND PURPOSE OF BUSINESS VALUATIONS ................................................................. 2
INCOME BASED VALUATION METHODS ........................................................................................ 3
DIVIDEND VALUATION MODELS ...................................................................................................... 5
SHAREHOLDER VALUE ANALYSIS .................................................................................................... 6
FREE CASH FLOWS TO THE FIRM (FCFF) ......................................................................................... 7
FREE CASH FLOWS TO THE EQUITY (FCFE) .................................................................................... 8
ASSET BASED VALUATION MODELS ................................................................................................ 9
EFFICIENT MARKET HYPOTHESIS (EMH) ...................................................................................... 10
ICAP SUMMER 2015 AJAR CEMENT: QUESTION ........................................................................ 14
ICAP SUMMER 2015 AJAR CEMENT: SOLUTION ........................................................................ 15
ICAP SUMMER 2017 MARS PTEROLEUM: QUESTION ............................................................... 19
ICAP SUMMER 2017 MARS PTEROLEUM: SOLUTION ............................................................... 20
ICAP WINTER 2020 DYNAMIC LIMITED: QUESTION.................................................................. 22
ICAP WINTER 2020 DYNAMIC LIMITED: SOLUTION.................................................................. 23
ICAP SUMMER 2022 PAMIR: QUESTION ...................................................................................... 26
ICAP SUMMER 2022 PAMIR: SOLUTION ...................................................................................... 28
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
BUSINESS VALUATION
NATURE AND PURPOSE OF BUSINESS VALUATIONS
Reasons for business valuation
This section describes various techniques for calculating a value for the shares of a company, or the value
of an entire company (equity plus debt). There are several reasons why a valuation might be required.
Quoted companies – Quoted companies already have a share price valuation: this is the current market
price of the shares. The main reason for making a business valuation for a quoted company is when there
is a takeover bid. In a takeover bid, the bidder always offers more for the shares in the target company than
their current market price. A valuation might be made by the bidder in order to establish a fair price or a
maximum price that he will bid for the shares in the target company. The valuation placed on a target
company by the bidder can vary substantially, depending on the plans that the bidder has for the target
company after the takeover has been completed.
Unquoted companies – For unquoted companies, a business valuation may be carried out for any of the
following reasons:
 The company might be converted into a public limited company with the intention of launching it on
to the stock market. When a company comes to the stock market for the first time, an issue price for
the shares has to be decided.
 When shares in an unquoted company are sold privately, the buyer and seller have to agree a price.
The buyer has to decide the minimum price he is willing to accept and the seller has to decide the
maximum price he is willing to pay.
 When there is a merger involving unquoted companies, a valuation is needed as a basis for deciding
on the terms of the merger.
 When a shareholder in an unquoted company dies, a valuation is needed for the purpose of establishing
the tax liability on his estate.
Valuation models
There are two broad approaches to valuing companies.
 Income-based valuation models which focus on the future earnings or cash flows of the company.
 Asset-based valuation models which focus on the value of the company’s assets.
There are many different techniques within these two broad approaches and they lead to different
valuations of the business.
All the valuation methods described in this chapter have a rational basis. This means that there is logic to
the valuation, and the valuation is obtained through objective analysis and assessment.
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
INCOME BASED VALUATION METHODS
P/E ratio method
A price/earnings ratio or P/E ratio is the ratio of the market value of a share to the annual earnings per
share. For every company whose shares are traded on a stock market, there is a P/E ratio. For private
companies (companies whose shares are not traded on a stock market) a suitable P/E ratio can be selected
and used to derive a valuation for the shares.
A simple method of estimating a value for a company in the absence of a stock market value is:
Value = EPS × Estimated P/E ratio.
 The EPS might be the EPS in the previous year, an average EPS for a number of recent years or a forecast
of EPS in a future year.
 The P/E ratio is selected as a ratio that seems appropriate or suitable. The selected ratio might be based
on the average P/E ratio of a number of similar companies whose shares are traded on a stock market,
for which a current P/E ratio is therefore available.
Example
The EPS of a private company, ABC Company, was $1.50 last year and is expected to rise to $1.80 next year.
Similar companies whose shares are quoted on the stock market have P/E ratios ranging from 10.0 to 15.6.
The average P/E ratio of these companies is 12.5.
A valuation of the company might be to take the prospective EPS and apply the average P/E ratio for similar
companies:
Valuation = $1.80 × 12.5 = $22.50 per share.
An alternative evaluation might be to take the actual EPS last year and apply the lowest P/E ratio of any
other similar stock market company, reduced by, say, 10% to allow for the fact that ABC Company is a
private company and does not have a stock market quotation.
Valuation = $1.80 × (90% × 10) = $16.20.
Here, a P/E ratio of 9 (= 90% × 10) has been used in the valuation.
Another valuation might be to use the EPS for last year and a P/E ratio of 9. This would give a share value
of $1.50 × 9 = $13.50.
From this example, it might be apparent that the P/E ratio valuation method has a number of weaknesses:
 It is based on subjective opinions about what EPS figure and what P/E ratio figure to use.
 It is not an objective or scientific valuation method.
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
 It is based on accounting measures (EPS) and not cash flows. However, the value of an investment such
as an investment in shares ought to be derived from the cash that the investment is expected to provide
to the investor (shareholder).
However, the P/E ratio valuation method is commonly used as one approach to valuation for:
 the valuation of a private company seeking a stock market listing for the first time.
 the valuation of a company for the purpose of making a takeover bid.
The main advantage of a P/E ratio valuation is its simplicity. By taking the annual earnings of the company
(profits after tax) and multiplying this by a P/E ratio that seems ‘appropriate’, an estimated valuation for the
company’s shares is obtained. This provides a useful benchmark valuation for negotiations in a takeover, or
for discussing the flotation price for shares with the company’s investment bank advisers.
Earnings yield method
With the earnings yield method of valuation, a company’s shares are valued using its annual earnings and
a suitable earnings yield.
Earnings yield % = Annual earnings / Market value of shares
Using the earnings yield method of valuation, this formula is adapted as follows:
Market value of shares = Annual earnings / Earnings yield %
A suitable earnings yield for a private company might be similar to the earnings yield on shares in similar
quoted companies.
It might be more appropriate to select an earnings yield that is higher than the earnings yield for similar
quoted companies, to allow for the higher risk of investing in private companies.
The earnings yield method of valuation is essentially a variation of the P/E ratio method of valuation and is
subject to the same criticisms.
Example
The earnings of Kickstart, a private company, were $450,000 last year. Stock market companies in the same
industry provide an earnings yield of about 9% to their shareholders.
Using the earnings yield method of valuation, suggest a suitable valuation for the equity shares in Kickstart.
Answer
If an appropriate earnings yield for Kickstart is 9%, the valuation of its equity would be:
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
$450,000/9% = $5,000,000.
However, since Kickstart is a private company, a higher earnings yield should possibly be used for the
valuation. If an appropriate earnings yield for Kickstart is 10%, say, the valuation of its equity would be:
$450,000/10% = $4,500,000.
The valuation depends on arbitrary assumptions about a suitable earnings yield to apply, as well as
assumptions about expected annual earnings.
DIVIDEND VALUATION MODELS
Dividend valuation and growth model: constant annual dividends
Covered in the area of weighted average cost of capital.
CASH FLOW VALUATION METHOD
Discounted cash flow basis
A discounted cash flow basis might be used when a takeover of a company is under consideration, to value
either (1) the company in total (equity and debt capital) or (2) the company’s equity shares only.
The basic assumptions in a DCF-based valuation are as follows.
 The acquisition of the target company is a form of capital investment by the company making the
acquisition.
 Like any other capital investment, it can be evaluated by DCF, using the NPV method.
 After the target company is acquired, its cash flows will come under the control of the company making
the acquisition.
 A maximum valuation for the target company can therefore be obtained by estimating the future cash
flows from acquiring the company, and discounting these to a present value at a suitable cost of capital
(perhaps the acquiring company’s WACC).
Discounting estimated free cash flows and shareholder value analysis
One way of estimating the cash profits or cash flows from a major acquisition is to estimate the free cash
flows of the target company and discount these to a present value. Free cash flow is the annual cash flow
after paying for all essential expenditures.
This method makes the following assumptions:
 Free cash flow can be defined in a variety of different, although similar ways. One definition is that free
cash flow in each year is the total earnings before interest, tax, depreciation and amortisation, less
essential payments of interest, tax and purchases of replacement capital expenditure. Another definition
of free cash flow is explained later.
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
 The annual free cash flows that a company is expected to earn in perpetuity can be discounted to a
present value, using the company’s weighted average cost of capital (WACC) as the discount rate.
 This discounted value of future free cash flows gives a total valuation for the company’s equity capital
(shares) plus its debt capital.
 The fair value of the company’s shares is therefore the present value of these free cash flows minus the
current market value of the company’s debt. This is known as shareholder value and the approach is
sometimes known as shareholder value analysis (SVA).
Note that free cash flow is based on annual operating cash flows, not annual operating profit.
SHAREHOLDER VALUE ANALYSIS
Shareholder value analysis estimates a value for the equity capital of a company by:
 Calculating the present value of all future annual free cash flows to obtain a valuation for the entire
company, and then
 Deducting the value of the company’s debt capital.
Value of equity
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
Measuring free cash flow
Free cash flow can be defined as the amount of cash that is available for management to use in any way
they want (at their discretion), after all essential payments have been made.
Essential payments include payments of taxation on profits, and should also include payments for the
purchase of essential replacement non-current assets.
FREE CASH FLOWS TO THE FIRM (FCFF)
Profit before interest and tax (PBIT)
Less: Taxation on PBIT
Add: Depreciation
Add: Non-cash expenses
Operating cash flow
Less investment:
Replacement non-current asset investment
Incremental non-current asset investment
Incremental working capital investment
Free cash flows to the Firm
XXX
(XXX)
XXX
XXX
XXX
(XXX)
(XXX)
(XXX)
XXX
Free cash flows to the firm are discounted by WACC to get the market value of the whole company (equity
+ debt). Deducting market value of debt will provide the market value of equity.
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
FREE CASH FLOWS TO THE EQUITY (FCFE)
Free cash flows to the company (as calculated above)
Debt financing cash flows
Less: Interest paid
Add: Tax savings on interest paid
Less: Repayment of loan
Add: Receipt of loan
Free cash flows to the Equity
XXX
(XXX)
XXX
XXX
XXX
XXX
Free cash flows to the equity are discounted by Cost of Equity (Ke) to get the market value of the equity
only.
A comparison of both the methods
FREE CASH FLOWS (FCF)
Free cash flows to the Firm
(FCFF)
Free cash flows to the Equity
(FCFE)
Cash available for both
equity and debtholders
Cash available only to the
equityholders
To be discounted from
WACC of the company
To be discounted from the
Cost of Equity (Ke)
MV of the Company =
FCFF / WACC
Always a mentor | Muzzammil Munaf
MV of Equity =
FCFE / Ke
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
ASSET BASED VALUATION MODELS
Asset based valuation models use the net tangible assets of a business as a valuation. Different figures arise
from the different valuation placed on the business assets and liabilities.
Net asset value (‘balance sheet basis’, taken from the statement of financial position)
This approach uses the book values for assets and liabilities. These figures are readily-available from the
account’s ledgers of the company. However, non-current assets might be stated at historical cost less
accumulated depreciation, and this might bear no resemblance to a company’s current value.
Some important intangible assets such as internal goodwill and the value of the company’s human capital
(e.g., the skills of its employees) are ignored because they are not included in the balance sheet. At best this
method will provide the minimum value of a target company.
Net asset value (net realisable value)
This method may be used when the assets of the company are valuable, and their current disposable value
might be worth more than the expected future dividends or earnings that the company will provide from
using the assets. This valuation may be appropriate if the intention is for the business to be liquidated and
the assets sold. A company can never be worth less than its break-up value.
Example
A company has assets that have been valued at $20 million. This valuation is based on the current disposal
value of the assets. The company has $4 million of liabilities. It has share capital of 200,000 shares of $0.25
each.
A valuation of the shares based on the net asset value of the company would be:
$(20 million − 4 million) / 200,000 shares = $80 per share.
Net asset value (replacement value)
Replacement value measures the value of net assets at their cost of acquisition on the open market. Whilst
this is likely to be a more accurate cost than book values it will still undervalue the company as intangible
assets will be excluded. In addition, it will be very difficult to identify and value individual assets and
liabilities.
All asset-based valuation methods can be criticised, because unless there is an intention to sell off all or
some of a company’s assets, the value of a business comes from the expected returns it will generate, not
the reported value of its assets.
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
THE VALUATION OF DEBT AND PREFERENCE SHARES
Covered in the area of weighted average cost of capital.
EFFICIENT MARKET HYPOTHESIS (EMH)
The efficiency of capital markets and fair prices
Investors in securities such as shares and convertible bonds want to be confident that the price they pay for
their securities is a fair price. In order for market prices to be fair, it is important that the stock market should
be able to process the relevant available information about companies and that investors should have
immediate access to this information and act on it when making decisions about buying and
selling shares.
The efficient markets hypothesis provides a rational explanation of how share prices change in organised
stock markets. The hypothesis is based on the assumption that share prices change in a logical and
consistent way, in response to new information that becomes available to investors. The speed with which
share prices change depends on how quickly new information reaches investors, and this varies with the
efficiency of the market.
The nature of capital market efficiency
There are four types of capital market efficiency:
 Operational efficiency. A capital market is efficient operationally when transaction costs for buying and
selling shares are low, and do not discourage investors from taking decisions to buy or sell.
 Informational efficiency. A capital market is efficient ‘informationally’ when available information about
companies is processed and made available to investors.
 Pricing efficiency. A market has pricing efficiency when investors react quickly to new information that
is made available in the market, so that current share prices are a fair reflection of all this information.
For pricing efficiency to exist, a capital market must also be operationally and informationally efficient.
 Allocational efficiency. When there is allocational efficiency in a capital market, available investment
funds are allocated to their most productive use. Allocational efficiency arises from pricing efficiency.
Research into stock market efficiency focuses on pricing efficiency.
Efficiency therefore refers to the speed with which information is made available to the market, and the
response of market prices to this information. In an efficient market, all investors are reasonably well
informed at the same time about new developments that might affect market prices, so that some investors
with ‘insider knowledge’ cannot exploit their knowledge to make profits at the expense of other investors.
If all relevant information is made available to all investors at the same time, all investors are able to make
decisions at the same time about buying or selling investment, and about whether current prices are too
high or too low. Although the concept of market efficiency applies to all financial markets, it is probably
most easily understood in the context of equity shares and the equity markets.
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
The purpose of the efficient market hypothesis (EMH)
The efficient market hypothesis (EMH) is a theory of market efficiency, based on research into share price
behaviour in stock markets. The purpose of this research is to establish the extent to which capital markets
show pricing efficiency.
According to this theory there are three possible levels or ‘forms’ of market efficiency:
 weak form efficiency
 semi-strong form efficiency, and
 strong form efficiency.
Each financial market can be categorised as being weak form, semi-strong form or strong form efficient.
In equities markets, the way in which share prices move in response to available information varies according
to the efficiency of the market.
Weak form efficiency
The efficient markets hypothesis states that when a market has weak form efficiency, share prices respond
to the publication of historical information, such as the previous year’s financial statements.
When the market displays a weak form, it also means that the current share price embodies all the historical
information that is known about the company and its shares, including information about share price
movements in the past. Until the next publication of more historical information about the company, there
is no other information about the company that will affect the share price in any obvious way.
The weak form suggests that the current price reflects all past prices and that past prices and upward or
downward trends in the share price cannot be used to predict whether the price will go up or down in the
future. Share prices do rise and fall, with supply and demand in the market, but the next price movement is
equally likely to be up as down.
Random walk theory (versus Chartism)
A weak form of stock market efficiency is consistent with the random walk theory. This is the theory that
share prices move up and down randomly over time, in response to the arrival of favourable or unfavourable
information on the market.
Random walk theory is opposed to the view that future share price movements can be predicted from
patterns of share price movements in the past, since patterns repeat themselves, and historical trends can
be used to predict future trends. Some stock market analysts believe that they can predict future movements
in share prices from recognisable patterns of share price movement. These analysts are sometimes called
chartists, because recognisable patterns of share price movements can be illustrated by graphs or charts of
share prices over a period of time. Chartism does not have a rational justification.
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
Semi-strong form efficiency
When a market has semi-strong form efficiency, current share prices reflect all publicly-available information
about the company and its prospects, in addition to historical information. For example, share prices might
respond to a new announcement by a company about its trading prospects for the remainder of the year.
Similarly, the share price might also respond to an announcement that the company is seeking to make a
new acquisition, or a major new investment.
If a market displays semi-strong form efficiency, share prices should move when new information becomes
available to the public, but not before. For example, if a company is planning a major acquisition, the share
price should not be affected by unconfirmed rumours in the market. However, the share price will react to
the official announcement of a takeover bid by a company.
It also means that individuals who have access to information that has not yet been made public (‘inside
information’) will be able to buy or sell the shares in advance of the information becoming public, and make
a large personal profit. This is because the inside information will indicate whether the share price is likely
to go up or down, and the individual can buy or sell accordingly.
Using inside information to make a personal profit from trading in shares is called insider dealing, which is
illegal in countries with well-established stock markets.
Strong form efficiency
When a market has strong form efficiency, current share prices reflect all relevant information about the
company as soon as it comes into existence, even if it has not been made publicly-available. In other words,
the share price reflects all inside information as well as publicly-available information. The market is so
efficient that all information is immediately transmitted throughout the market instantly, and all investors
have access to this same information.
If the stock market has strong form efficiency, it is impossible for individuals to profit from insider trading,
because there is no inside knowledge that the market has not already found out about.
In practice, research suggests that most markets have weak form efficiency, but some well-developed
markets such as the New York Stock Exchange and London Stock Exchange are semi-strong form efficient.
Example
A company decides to undertake a major capital investment. The investment will be in a five-year project,
and over the course of the five years, the company’s directors believe that the net profits will add $125
million to the value of the company’s shares.
The company made the decision to invest on 1st October Year 1, and the first year of profits from the
investment will be Year 2. It announces the investment and the expected benefits to the stock market on
1st December. It is assumed that the stock market investors believe the company’s estimate that the project
will add $125 million to share values.
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BUSINESS VALUATION
 If the stock market has strong form efficiency, the company’s share price should go up on 1st October,
as soon as the decision to invest is made. The total increase in share value should be $125 million.
 If the stock market has semi-strong form efficiency, the share price should go up on 1st December,
when the investment and its expected benefits are announced to the market and so become public
information. (Between 1st October and 1st December, the information is ‘inside information’).
 If the stock market displays weak form efficiency, the share price will not be affected by the
announcement on 1st December Year 1. The share price will eventually respond, after each of the next
five years, when the actual historical profits of the company, including the profits from the new
investment, are announced.
Implications of strong capital market efficiency
There are several theoretical implications of market efficiency. If a capital market has strong efficiency:
 Share prices will be fair at all times and reflect all information about a company. This means that there
is no ‘good time’ or ‘bad time’ to try issuing new shares or bonds.
 Companies will gain no benefit from trying to manipulate their financial results and present their
performance and financial position in a favourable light. In a market with strong-form efficiency,
investors will see through the pretence and will understand the true financial position of the company.
 For investors there will never be any ‘bargains’ in the stock market, where share prices are under-valued.
Similarly, there will be no over-priced shares that clever investors will sell before a share price fall.
 If the capital market has strong form efficiency, if a company invests in any new capital project with a
positive net present value, the share price should respond by going up to reflect the increase in the
value of the company represented by the project NPV.
Factors that may have an impact on the market value of shares
In practice, research suggests that most markets have either weak form or semi-strong form efficiency.
Factors which may impact on the efficiency of the market include:
 The marketability and liquidity of shares. The greater the volume of shares traded the more opportunity
there is to reflect new information in the share price.
 Availability of information. Not all information can be available to all investors at the same time. Shares
which are traded more by professional dealers are more likely to reflect full information as they can
afford to pay for better monitoring systems and may have better access to early information.
 Pricing anomalies. Share prices may be affected by investor behaviour at the end of the tax year.
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
ICAP SUMMER 2015 AJAR CEMENT: QUESTION
Always a mentor | Muzzammil Munaf
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BUSINESS VALUATION
ICAP SUMMER 2015 AJAR CEMENT: SOLUTION
Always a mentor | Muzzammil Munaf
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Always a mentor | Muzzammil Munaf
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Always a mentor | Muzzammil Munaf
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BUSINESS VALUATION
ICAP SUMMER 2017 MARS PTEROLEUM: QUESTION
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BUSINESS VALUATION
ICAP SUMMER 2017 MARS PTEROLEUM: SOLUTION
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Always a mentor | Muzzammil Munaf
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BUSINESS VALUATION
ICAP WINTER 2020 DYNAMIC LIMITED: QUESTION
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BUSINESS VALUATION
ICAP WINTER 2020 DYNAMIC LIMITED: SOLUTION
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BUSINESS VALUATION
Always a mentor | Muzzammil Munaf
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Always a mentor | Muzzammil Munaf
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ICAP SUMMER 2022 PAMIR: QUESTION
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Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
ICAP SUMMER 2022 PAMIR: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
Always a mentor | Muzzammil Munaf
Page 431 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
BUSINESS VALUATION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Contents
MERGERS AND ACQUISITIONS ............................................................................................................. 3
ICAP SUMMER 2009 MNO CHEMICALS: QUESTION .................................................................. 11
ICAP SUMMER 2009 MNO CHEMICALS: SOLUTION .................................................................. 12
ICAP WINTER 2009 TARBELLA ENTREPRISES: QUESTION........................................................ 14
ICAP WINTER 2009 TARBELLA ENTREPRISES: SOLUTION ........................................................ 15
ICAP WINTER 2009 BANNU HOLDINGS: QUESTION ................................................................. 16
ICAP WINTER 2009 BANNU HOLDINGS: SOLUTION ................................................................. 17
ICAP SUMMER 2010 MK LIMITED: QUESTION ............................................................................ 20
ICAP SUMMER 2010 MK LIMITED: SOLUTION ............................................................................ 21
ICAP WINTER 2010 PLATINUM LTD: QUESTION ........................................................................ 24
ICAP WINTER 2010 PLATINUM LTD: SOLUTION ........................................................................ 25
ICAP SUMMER 2011 ARA VENTURE: QUESTION ........................................................................ 27
ICAP SUMMER 2011 ARA VENTURE: SOLUTION ........................................................................ 28
ICAP SUMMER 2011 URD PAKISTAN: QUESTION ...................................................................... 30
ICAP SUMMER 2011 URD PAKISTAN: SOLUTION ...................................................................... 31
ICAP WINTER 2011 IBN SEENA: QUESTION ................................................................................. 34
ICAP WINTER 2011 IBN SEENA: SOLUTION ................................................................................. 35
ICAP SUMMER 2013 TAXILA POWER: QUESTION ...................................................................... 37
ICAP SUMMER 2013 TAXILA POWER: SOLUTION ...................................................................... 38
ICAP SUMMER 2014 MODERN GARMENTS: QUESTION ........................................................... 41
ICAP SUMMER 2014 MODERN GARMENTS: SOLUTION ........................................................... 42
ICAP WINTER 2015 NATIONAL AIRLINE: QUESTION ................................................................ 43
ICAP WINTER 2015 NATIONAL AIRLINE: SOLUTION ................................................................ 45
ICAP SUMMER 2018 TULIP TEXTILE: QUESTION ........................................................................ 46
ICAP SUMMER 2018 TULIP TEXTILE: SOLUTION ........................................................................ 47
ICAP WINTER 2016 MANGAL LIMITED: QUESTION ................................................................... 50
ICAP WINTER 2016 MANGAL LIMITED: SOLUTION ................................................................... 51
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2019 YELLOW LIMITED: QUESTION ................................................................... 54
ICAP SUMMER 2019 YELLOW LIMITED: SOLUTION ................................................................... 55
ICAP WINTER 2019 KARAKORUM: QUESTION............................................................................ 58
ICAP WINTER 2019 KARAKORUM: SOLUTION ............................................................................ 60
ICAP SUMMER 2021 SUPERSKY: QUESTION ................................................................................ 62
ICAP SUMMER 2021 SUPERSKY: SOLUTION ................................................................................ 64
ICAP WINTER 2021 ALPHA FOODS: QUESTION .......................................................................... 67
ICAP WINTER 2021 ALPHA FOODS: SOLUTION .......................................................................... 68
ACCA AFM 2020 MARCH WESTPARLEY CO: QUESTION ........................................................... 72
ACCA AFM 2020 MARCH WESTPARLEY CO: SOLUTION ........................................................... 74
ACCA AFM 2019 SEPTEMBER KERRIN CO: QUESTION .............................................................. 79
ACCA AFM 2019 SEPTEMBER KERRIN CO: SOLUTION .............................................................. 80
DEMERGERS ......................................................................................................................................... 82
ICAP WINTER 2012 KLR: QUESTION .............................................................................................. 83
ICAP WINTER 2012 KLR: SOLUTION .............................................................................................. 84
ICAP WINTER 2015 RYAN GROUP: QUESTION ........................................................................... 88
ICAP WINTER 2015 RYAN GROUP: SOLUTION............................................................................ 89
ICAP 2018 WINTER SUN PUBLIC: QUESTION .............................................................................. 90
ICAP 2018 WINTER SUN PUBLIC: SOLUTION .............................................................................. 91
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
MERGERS AND ACQUISITIONS
Merger or acquisition
A merger is in essence the pooling of interests by two business entities which results in common ownership.
 An acquisition normally involves a larger company (a predator) acquiring a smaller company (a target).
 Generally, both referred to as mergers for PR reasons:
o It portrays a better message to the customers of the target company.
o To appease the employees of the target company.
 An alternative approach is that a company may simply purchase the assets of another company rather
than acquiring its business, goodwill, etc.
Types of mergers: The arguments put forward for a merger may depend on its type:
 Horizontal integration.
 Vertical integration.
 Conglomerate integration.
Horizontal Integration: Two companies in the same industry, whose operations are very closely related,
are combined, e.g. Glaxo with Welcome and the banks and building societies mergers, e.g. Lloyds and TSB.
Main motives: economies of scale, increased market power, improved product mix.
Disadvantage: can be referred to relevant competition authorities.
Vertical integration: Two companies in the same industry, but from different stages of the production
chain merger. e.g., major players in the oil industry tend to be highly vertically integrated.
Main motives: increased certainty of supply or demand and just-in-time inventory systems leading to major
savings in inventory holding costs.
Conglomerate integration: A combination of unrelated businesses, there is no common thread and the
main synergy lies with the management skills and brand name, e.g., General Electrical Corporation and
Tomkins (management) or Virgin (brand).
Main motives: risk reduction through diversification and cost reduction (management) or improved
revenues (brand).
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Corporate and competitive aspects of mergers
Need to decide in an exam question what is happening – i.e. is it a:






Merger
Acquisition
simply a purchase of assets
demerger
spinoff
Management Buy Out, etc.
Methods of mergers and acquisitions
Though the terms are used loosely to describe a variety of activities, in every case the end result is that two
companies become a single enterprise, in fact if not in name, the end result is achieved by:
 transfer of assets
 transfer of shares
SYNERGY
As in other areas of the syllabus the ultimate justification of any policy is that it leads to an increase in value,
i.e., it increases shareholder wealth. As in capital budgeting where projects should be accepted if they have
a positive NPV, in a similar way combinations should be pursued if they increase the wealth of shareholders.
Example: Suppose firm A has a market value of £2m and it combines with firm B, market value £2m, with
considerations at current market prices. If the resultant new firm AB has a market value in excess of £4m
then the combination can be counted as a success, if less it will be a failure.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Essentially, for a successful combination we should be looking for a situation where:
Market value of combined companies (AB) > Market value of A + Market value of B
If this situation occurs, we have experienced synergy, that is, the whole is worth more than the sum of the
parts. This is often expressed as ‘the 2 + 2 = 5 effect’.
Revenue synergy – Sources of revenue synergy include economies of vertical integration, market
power/eliminate competition and complementary resources.
Cost synergy – Sources of cost synergy include economies of scale, economies of scope, and elimination
of inefficiency (e.g., best practice sharing).
Financial synergy – Sources of financial synergy include:
 Elimination of inefficiency – including inefficient financial management practice Bargain buying:
o Tax shields/accumulated tax losses.
o Buying low geared companies with good asset backing in order that they may be geared
up to obtain the benefit of the corporation tax shield on debt.
 Surplus cash.
 Risk diversification – diversification normally reduces risk. If the earnings of the combined companies
simply stay the same (i.e., no operating economies are obtained) there could still be an increase in value
of the company due to the lower risk.
 Diversification and financing.
Other sources of synergy are surplus managerial talent and speed.
The need for a valuation
Valuation and the offer price are key issues in a merger or acquisition. When a merger is negotiated, the
two companies need to reach agreement on the valuation of shares in each company for the purpose of
deciding the terms of the merger. In a takeover:
 The acquiring company needs to decide what price it is prepared to offer for the target company
 The directors of the target company need to decide whether the offer is acceptable and whether it
should be recommended to the shareholder, and
 The shareholders in the target company need to decide whether they are willing to accept the offer
made for their shares.
Types of acquisition
Risk profile: Acquisitions might impact the risk profile of acquiring company. There are two aspects to it:
 Financial risk: the financial risk of the acquiring company might change because of a change in financial
gearing due to the method used to finance the acquisition.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
 Business risk. The target company might operate in an industry or market sector where the business
risk is very different from the business risk profile of the acquiring company. When this happens, the
business risk profile of the company will change as a result of the acquisition.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2009 MNO CHEMICALS: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2009 MNO CHEMICALS: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2009 TARBELLA ENTREPRISES: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2009 TARBELLA ENTREPRISES: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2009 BANNU HOLDINGS: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2009 BANNU HOLDINGS: SOLUTION
SIBBI ENGINEERING (PRIVATE) LIMITED [SEL]
Equity of employees of ZEL
BoD of BHL
Total equity in SEL
Value of assets
Financed by debt
Always a mentor | Muzzammil Munaf
90%
10%
270
30
300
2,100
1,800
Page 449 of 690
Since the company, SEL, is new,
the opening reserves will be zero.
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
OPTION 1: Commercial Bank
Gross Profit
Operating expenses
Operating profit
Other income
Financial charges (1,800 x 11%)
Profit before tax
Tax @ 30%
Profit after tax
Share Capital
Reserves
Total equity
Total debt
Gearing % [D / (D + E)]
Required Gearing
Condition met
Year 1
1,060.90
(488.00)
572.90
237.60
(198.00)
612.50
(183.75)
428.75
300.00
428.75
728.75
1,800.00
2,528.75
Year 2
1,092.73
(502.64)
590.09
261.36
(198.00)
653.45
(196.03)
457.41
300.00
886.16
1,186.16
1,800.00
2,986.16
Year 3
1,125.51
(517.72)
607.79
287.50
(198.00)
697.29
(209.19)
488.10
300.00
1,374.26
1,674.26
1,800.00
3,474.26
71%
75%
YES
60%
70%
YES
52%
60%
YES
Year 4
Year 5
1,159.27 1,194.05
(533.25) (549.25)
626.02
644.80
316.25
347.87
(198.00) (198.00)
744.27
794.67
(223.28) (238.40)
520.99
556.27
300.00
300.00
1,895.25 2,451.52
2,195.25 2,751.52
1,800.00 1,800.00
3,995.25 4,551.52
45%
50%
YES
Cash available at the end of 5 years (2,541.52 x 75%)
Enough cash will be present to pay off the loan.
The owners of SEL do not have to even dilute their equity in this option.
40%
50%
YES
1,838.64
(1,800.00)
38.64
OPTION 2: Investment Bank
Operating profit will be same as option 1
Other income
Financial charges
Profit before tax
Tax @ 30%
Profit after tax
Year 1
572.90
216.00
(180.00)
608.90
(182.67)
426.23
Year 2
590.09
216.00
(180.00)
626.09
(187.83)
438.26
Year 3
607.79
216.00
(135.00)
688.79
(206.64)
482.15
Year 4
626.02
216.00
(90.00)
752.02
(225.61)
526.42
Year 5
644.80
216.00
(45.00)
815.80
(244.74)
571.06
Share Capital
Reserves
Total equity
300.00
426.23
726.23
300.00
864.49
1,164.49
300.00
1,346.64
1,646.64
300.00
1,873.06
2,173.06
300.00
2,444.12
2,744.12
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Opening balance of cash
Profit x 75%
Repayment of principal
Closing balance of cash
319.67
319.67
319.67
328.70
(450.00)
198.37
Equity at the end
No of shares (300/10)
Break up value per share
198.37
361.61
(450.00)
109.98
109.98
394.81
(450.00)
54.79
Year 3
1,646.64
30.00
54.89
Year 4
2,173.06
30.00
72.44
54.79
428.30
(450.00)
33.09
So at the commencement of Year 4, the break up value per share is almost Rs 55 which is greater than Rs 25.
Hence, the investment bank will definitely exercise the option of conversion.
And therefore, the owners will have to dilute their equity.
Even the situation is same at the commencement of Year 5, hence equity seems sure to get diluted.
Option of Rs 25 is far less than the expected break up value of the Company.
Therefore, option 1 seems better in all the aspects:
- Profitability
- Cash composition
- Equity protection
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2010 MK LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2010 MK LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2010 PLATINUM LTD: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2010 PLATINUM LTD: SOLUTION
Value of the proposed bid based on PL's current share price:
No of shares to be issued to DL (19.2/6 x 7)
Existing EPS of PL (231/90)
Value of shares of PL (2.57 x 15)
Total value of bid (22.4 x 38.50)
22.40
2.57
38.50
862.40
Expected share price and earnings of PL post acquisition
Earnings of PL before the acquisition
Earnings of DL before the acquisition
Post acquisition synergy
Combined earnings post acquisition
231.00
58.00
24.00
313.00
Total no of shares (90 + 22.4)
EPS after acquisition (313/112.40)
Share price of PL post acquisition (2.78 x 18)
112.40
2.78
50.12
Will DL accept the offer of share for share exchange?
Existing earning of DL
No of shares of DL
EPS of DL (58/19.2)
P/E Multiple
Share price of DL currently (3.02 x 19)
58.00
19.20
3.02
19.00
57.40
Six shares of DL will be taken PL (57.40 x 6)
Seven shares of PL will be given (50.12 x 7)
Gain in %
344.38
350.87
2%
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Evaluate the offer of the debentures
Share price of DL currently
Value of 2 shares of DL (57.40 x 2)
Present value of 3 zero coupon debentures
Gain in %
57.40
114.79
130.18
13.4%
Gain % is more in the case of opting for debentures.
And practically, the risk is also reduced because debentures represent debt.
Debt holders do not carry risks as compared to shareholders of a company.
Hence the proposal of debentures will be looked into very favorably.
Present value of 3 zero coupon debentures
Redemption value (100 x 3)
Redemption at the end of (years)
Discount rate
PV [300 x (1.11)^-8]
Always a mentor | Muzzammil Munaf
300
8
11%
130.18
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2011 ARA VENTURE: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2011 ARA VENTURE: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2011 URD PAKISTAN: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2011 URD PAKISTAN: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2011 IBN SEENA: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2011 IBN SEENA: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2013 TAXILA POWER: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2013 TAXILA POWER: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2014 MODERN GARMENTS: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2014 MODERN GARMENTS: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2015 NATIONAL AIRLINE: QUESTION
Always a mentor | Muzzammil Munaf
Page 475 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 476 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2015 NATIONAL AIRLINE: SOLUTION
Always a mentor | Muzzammil Munaf
Page 477 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2018 TULIP TEXTILE: QUESTION
Always a mentor | Muzzammil Munaf
Page 478 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2018 TULIP TEXTILE: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2016 MANGAL LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2016 MANGAL LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2019 YELLOW LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2019 YELLOW LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 488 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 489 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2019 KARAKORUM: QUESTION
Always a mentor | Muzzammil Munaf
Page 490 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 491 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2019 KARAKORUM: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 493 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2021 SUPERSKY: QUESTION
Always a mentor | Muzzammil Munaf
Page 494 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 495 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP SUMMER 2021 SUPERSKY: SOLUTION
Always a mentor | Muzzammil Munaf
Page 496 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 497 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Both sets of shareholders gain from the merger, so are likely to approve the share for share exchange.
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2021 ALPHA FOODS: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2021 ALPHA FOODS: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 501 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 502 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 503 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ACCA AFM 2020 MARCH WESTPARLEY CO: QUESTION
Always a mentor | Muzzammil Munaf
Page 504 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 505 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ACCA AFM 2020 MARCH WESTPARLEY CO: SOLUTION
Always a mentor | Muzzammil Munaf
Page 506 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 507 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 508 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 509 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 510 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ACCA AFM 2019 SEPTEMBER KERRIN CO: QUESTION
Always a mentor | Muzzammil Munaf
Page 511 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ACCA AFM 2019 SEPTEMBER KERRIN CO: SOLUTION
Cash offer (per share)
Danton - existing no of shares (35/0.25)
Total cash offer (13.10 x 140)
13.10
140.00
1,834.00
Pre-acquisition valuations
No of shares of Kerrin Co (375/0.5)
MV of Kerrin Co shares (5.28 x 750)
Post tax earnings [381.9 x (1 - 20%)]
Current P/E ratio of Kerrin Co (3,960/305.52)
750.00
3,960.00
305.52
12.96
Danton co earnings [(116.3 + 2.5) x (1 - 20%)]
Danton Co P/E Ratio [12.96 x (1 + 20%)]
MV of Danton Co shares (95.04 x 15.55)
95.04
15.55
1,478.23
Combined Co pre-acquisition MV (3,960 + 1,478)
5,438.23
Post-acquisition valuation
Post tax earnings post acquisition
Kerrin Co
Danton Co
Revenue and cost synergies [15.2 x (1 - 20%)]
Financial cost synergy [5.3 x (1 - 20%)]
Post tax earnings post acquisition
Always a mentor | Muzzammil Munaf
305.52
95.04
12.16
4.24
416.96
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Combined Co P/E Ratio (12.96 x 1.1)
Combined Co post-acquisition MV (416.96 x 14.26)
14.26
5,944.87
Allocation of wealth
OLD SH NEW SH
Kerrin Co Danton Co
TOTAL
Pre-acquisition MV
30% premium (1,478.23 x 30%)
Remaining premium for old shareholders
Total MV
3,960.00
63.17
4,023.17
5,438.23
443.47
63.17
5,944.87
MV of Kerrin Co's old shareholders
Existing no of shares
Post acquisition share price
MV to new shareholders
New shares to be issued (1,921.7/5.36)
4,023.17
750.00
5.36
1,921.70
358.24
Danton Co - existing no of shares
1,478.23
443.47
1,921.70
140.00
Kerrin Co will take 140 Mn shares of Danton Co and issue 358.24 Mn new shares of Kerrin Co to the
shareholders of Danton Co
Share for share exchange ratio (358.24/140)
2.56
Kerrin Co will issue 2.56 new shares for every 1 share of Danton Co.
Kerrin Co will issue approximately 18 new shares for every 7 shares of Danton Co.
(Multiplying both 2.56 and 1 by 7 to get whole numbers)
Value achieved in share for share offer
Value achieved in cash offer
1,921.70
1,834.00
Clearly, shareholders of Danton Co will be happy to have shares of Kerrin Co as the value is greater.
However, existing shareholders of Kerrin Co will be happy to give cash offer as it increases their benefit.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
DEMERGERS
The aim of a demerger is to create separate businesses which together have a higher value than the
original company. Following a demerger:
 shareholders own the same proportion of shares in the new business or businesses as they did in the
previous one.
 each company owns a share of the assets of the original company.
 the new company or companies generally have new management who can take the individual
companies in diverging directions.
 each company could eventually be sold separately.
 the original company may no longer exist, with all its assets distributed to the new business.
Selloffs
A company may selloff parts of the business for a number of reasons, such as:




to raise cash
to prevent a lossmaking part of the business from lowering the overall performance business
to concentrate on the core areas of the business
to dispose of a desirable part of the business to protect the rest from the threat of a takeover.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2012 KLR: QUESTION
Always a mentor | Muzzammil Munaf
Page 515 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2012 KLR: SOLUTION
Always a mentor | Muzzammil Munaf
Page 516 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 517 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 518 of 690
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 519 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2015 RYAN GROUP: QUESTION
Always a mentor | Muzzammil Munaf
Page 520 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP WINTER 2015 RYAN GROUP: SOLUTION
Always a mentor | Muzzammil Munaf
Page 521 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP 2018 WINTER SUN PUBLIC: QUESTION
Always a mentor | Muzzammil Munaf
Page 522 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
ICAP 2018 WINTER SUN PUBLIC: SOLUTION
Always a mentor | Muzzammil Munaf
Page 523 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 524 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
MERGERS AND ACQUISITIONS
Always a mentor | Muzzammil Munaf
Page 525 of 690
Page 93 of 93
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Contents
FOREIGN EXCHANGE RISK MANAGEMENT ....................................................................................... 3
DIRECT AND INDIRECT EXCHANGE RATES: ................................................................................... 3
MATCHING LONG TERM ASSETS AND LIABILITIES ..................................................................... 4
NETTING ................................................................................................................................................. 4
ICAP WINTER 2018 PLUTO: QUESTION........................................................................................... 5
ICAP WINTER 2018 PLUTO: SOLUTION ........................................................................................... 6
FORWARD CONTRACT ........................................................................................................................ 7
ICAP SUMMER 2008 MOMIN INDUSTRIES: QUESTION .............................................................. 8
ICAP SUMMER 2008 MOMIN INDUSTRIES: SOLUTION .............................................................. 9
ICAP SUMMER 2015 ZAIN EXPORTERS: QUESTION .................................................................... 9
ICAP SUMMER 2015 ZAIN EXPORTERS: SOLUTION................................................................... 10
MONEY MARKET HEDGE .................................................................................................................. 11
ICAP WINTER 2009 QALAT INDUSTRIES: QUESTION ................................................................ 12
ICAP WINTER 2009 QALAT INDUSTRIES: SOLUTION ................................................................ 13
ICAP WINTER 2010 SILVER LIMITED: QUESTION........................................................................ 14
ICAP WINTER 2010 SILVER LIMITED: SOLUTION........................................................................ 15
FUTURES CONTRACT ......................................................................................................................... 16
ICAP WINTER 2017 CPL: QUESTION .............................................................................................. 23
ICAP WINTER 2017 CPL: SOLUTION .............................................................................................. 24
ICAP SUMMER 2018 AQEEQ PAKISTAN: QUESTION ................................................................. 25
ICAP SUMMER 2018 AQEEQ PAKISTAN: SOLUTION.................................................................. 26
CROSS RATES....................................................................................................................................... 28
ICAP 2017 WINTER CAPTAIN (PRIVATE) LIMITED: QUESTION ............................................... 29
ICAP 2017 WINTER CAPTAIN (PRIVATE) LIMITED: SOLUTION ............................................... 30
OPTION CONTRACTS ......................................................................................................................... 31
ICAP SUMMER 2009 DEF SECURITIES: QUESTION...................................................................... 35
ICAP SUMMER 2009 DEF SECURITIES: SOLUTION...................................................................... 36
Always a mentor | Muzzammil Munaf
Page 526 of 690
Page 1 of 54
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP WINTER 2019 GREENLINE INVESTMENTS: QUESTION ................................................... 37
ICAP WINTER 2019 GREENLINE INVESTMENTS: SOLUTION ................................................... 38
CURRENCY OPTIONS ......................................................................................................................... 38
ICAP SUMMER 2019 ORANGE LIMITED: QUESTION .................................................................. 44
ICAP SUMMER 2019 ORANGE LIMITED: SOLUTION .................................................................. 45
ICAP WINTER 2020 PESHAWAR ENGINEERING: QUESTION.................................................... 46
ICAP WINTER 2020 PESHAWAR ENGINEERING: SOLUTION.................................................... 47
ICAP SUMMER 2022 CM LIMITED: QUESTION ............................................................................ 49
ICAP SUMMER 2022 CM LIMITED: SOLUTION ............................................................................ 51
FOREIGN CURRENCY SWAP ............................................................................................................. 53
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
FOREIGN EXCHANGE RISK MANAGEMENT
DIRECT AND INDIRECT EXCHANGE RATES:
An exchange rate is the value of a country's currency vs. that of another country or economic zone. Most
exchange rates are free-floating and will rise or fall based on supply and demand in the market. Some
currencies are not free-floating and have restrictions.
The word buying and selling is always used from the perspective of foreign exchange dealer/bank.
 The rate at which the dealer buys is the Buying Rate (when a customer receives foreign currency as in
case of exports, the customer sells and dealer buys. The applicable rate will be buying rate).
 The rate at which the dealer sells is the Selling Rate (when a customer has to make payment of foreign
currency as in case of imports, the customer buys and dealer sells (applicable rate would be selling rate).
 Exchange Rates are quoted in two styles:
Direct Quote
Indirect Quote
Units of Local currency per unit of foreign
currency. E.g., Rs/$
Units of Foreign currency per unit of Local
currency. E.g., $/Rs
Buying will be on
higher rate.
Buying will be on
lower rate.
Selling will be on lower
rate.
Selling will be on
higher rate.
Question:
Convert the following quotes into the required currencies:
S No
Particulars
Amount
Currency
1
2
3
4
5
6
7
8
9
10
Payment to supplier
Receipts from customer
Receipts from customer
Receipts from customer
Importer to pay
Importer to pay
Importer to pay
Importer to pay
Receipts from customer
Payment to supplier
2,000,000
5,000,000
250,000
250,000
600,000
600,000
3,000,000
3,000,000
10,000,000
500,000
USD
ER
ER
ER
USD
USD
GBP
GBP
Yen
PKR
Always a mentor | Muzzammil Munaf
Page 528 of 690
Req
Currency
PKR
PKR
PKR
PKR
PKR
PKR
USD
USD
GBP
USD
Rate
Rs/USD 102.3 – 102.9
Rs/ER 120.1 – 120.8
Rs/ER 125 – 126
ER/Rs 0.0085 – 0.0084
Rs/USD 101 – 102
USD/Rs 0.009 – 0.0095
USD/GBP 1.55 – 1.58
GBP/USD 0.62 – 0.63
Yen/GBP 140 – 141
Rs/USD 105 – 106
Page 3 of 54
IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
FOREIGN EXCHANGE RISK AND HEDGING:
In the case of payment in foreign currencies, there is a risk that foreign currency might be appreciated
against local currency. And in the case of receipt in foreign currencies, there is a risk that foreign currency
might be depreciated against local currency.
How to hedge the foreign currency risk?
MATCHING LONG TERM ASSETS AND LIABILITIES
A company might also try to match assets and liabilities in the same currency, to reduce exposures to foreign
exchange risk.
MATCHING RECEIPTS AND PAYMENTS
When a company has receipts and payments in the same foreign currency due at same time, it can simply
match them against each other. It is then only necessary to deal on the foreign exchange markets (like
Forward contract) for the unmatched portion of the total transactions. The company can also invest its
foreign currency income in the country of the currency and make overseas payments with these assets.
NETTING
Unlike matching, netting is not technically a method of managing transaction risk. The objective is simply
to save transactions costs by netting off inter-company balances before arranging payment. Many
multinational groups of companies engage in intra-group trading. Where related companies located in
different countries trade with each other, there is likely to be inter-company indebtedness denominated in
different currencies.
In the case of bilateral netting, only two companies are involved. The lower balance is netted off against
the higher balance and the difference is the amount remaining to be paid.
Multilateral netting is a more complex procedure in which the debts of more than two group companies
are netted off against each other. There are different ways of arranging multilateral netting. The
arrangement might be co-ordinated by the company's own central treasury or alternatively by the
company's bankers.
The steps to be followed are:
 Construct a table with companies receiving money down the left side and companies making payments
across the top.
 Enter all the amounts each company owes to the others and convert to the agreed settlement currency.
 Add across and down the table to determine total receipts and total payments for each company.
 Determine the net receivable or payable for each company.
Note: For converting different currency amounts into common currency balances average of buying and
selling rates are used.
Always a mentor | Muzzammil Munaf
Page 529 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP WINTER 2018 PLUTO: QUESTION
Always a mentor | Muzzammil Munaf
Page 530 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP WINTER 2018 PLUTO: SOLUTION
The spot rate at time t0 is the price for delivery at t0.
A forward rate at t0 is a rate for delivery at time t1. This is different from whatever the new spot rate turns
out to be at t1.
PURCHASE POWER PARITY THEORY:
𝐅𝐮𝐭𝐮𝐫𝐞 𝐬𝐩𝐨𝐭 𝐫𝐚𝐭𝐞𝐚/𝐛 = 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐒𝐩𝐨𝐭 𝐫𝐚𝐭𝐞𝐚/𝐛
Whereas
(𝟏 + 𝐢%𝐚 )
(𝟏 + 𝐢%𝐛 )
a and b are currencies
i%a and i%b are inflation rates of currencies a and b
INTEREST RATE PARITY THEORY:
𝐅𝐨𝐫𝐰𝐚𝐫𝐝 𝐫𝐚𝐭𝐞𝐚/𝐛 = 𝐒𝐩𝐨𝐭 𝐫𝐚𝐭𝐞𝐚/𝐛
Whereas
(𝟏 + 𝐫%𝐚 )
(𝟏 + 𝐫%𝐛 )
a and b are currencies
r%a and r%b are the interest rates of currencies a and b
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
FORWARD CONTRACT
 A forward contract is a contract with a bank that covers a specific amount of foreign currency for delivery
at an agreed date at an exchange rate agreed now.
 Forward contracts are over the counter (negotiated) & binding contracts.
 In case a forward contract cannot be honored, it has to be closed out. Close out is done by entering
into an opposite transaction of equal foreign currency at spot rate or respective forward rate. The close
out gain or loss is received or paid by the customer.
Concept of Premium and Discount
 In case of Direct quote, to calculate forward rate from a given spot rate:
o Premium is added
o Discount is deducted
 In case of Indirect quote, to calculate forward rate from a given spot rate:
o Premium is deducted
o Discount is added
Illustration:
ABC Limited imports rice from Egypt and then exports it to Germany. The Company has undertaken two
contracts for the purchase and sell of rice.
Contract 1
Contract 2
Quantity
6,000 tonnes
7,000 tonnes
Import price
10.0 EGP / ton
10.5 EGP / ton
Export Price
2.80 € / ton
2.92 € / ton
Delivery
1 month from now
2 months from now
Following are the details of forward contracts:
Forward (1 month)
Forward (2 months)
Forward (3 months)
EGP
Rs 10 – 11
Rs 11 – 12.5
Rs 11.6 – 12.9
Euro
Rs 160 – 165
Rs 163 – 167
Rs 165 – 169
 Payment is to be done on delivery.
 Receipt will be done in 1 month time of delivery
Required: Calculate profit/loss over each of the contracts.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Solution:
Contract 1 6,000 tonnes
Contract 2 7,000 tonnes
Import (EGP) Payment time
60,000 1 month
73,500 2 months
Export (Euro) Receipt time
16,800 2 months
20,440 3 months
Contract 1:
Payment: 6,000 x 10 EGP / Ton x Rs 11
Receipts: 6,000 x 2.8 Euro / Ton x Rs 163
Profit / (Loss)
(660,000)
2,738,400
2,078,400
Contract 2:
Payment: 7,000 x 10.5 EGP / Ton x Rs 12.5
Receipts: 7,000 x 2.92 Euro / Ton x Rs 165
Profit / (Loss)
(918,750)
3,372,600
2,453,850
ICAP SUMMER 2008 MOMIN INDUSTRIES: QUESTION
Momin Industries Limited (MIL) is engaged in the business of export of superior quality basmati rice to USA
and EU countries. On May 15, 2008, MIL negotiated an order from TLI Inc. (TLI), a USA based company, for
the supply of 10,000 tons of rice at the rate of US$ 2,000 per ton. Immediately after acceptance of the order
by MIL, the Government imposed a ban on the export of rice.
In view of the long-standing relationship, MIL has offered to supply rice through Thailand which has been
accepted by TLI. After due consultation with the Thai Company, MIL and TLI agreed to the following terms
and conditions on May 31, 2008:
 The quantity and price per ton will remain unchanged.
 First consignment of 4,000 tons will be shipped in the last week of June 2008 and the balance will be
shipped during the last week of July 2008.
 Shipment will be made directly to TLI.
 TLI will make payment to MIL after one month of shipment.
It was agreed with the Thai Company that MIL shall make the payment on shipment, at the rate of Thai Bhat
50,000 per ton.
MIL has a policy to hedge all foreign currency transactions in excess of Rs. 25 million by obtaining forward
cover.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
MIL’s bank has arranged the forward cover and advised the following exchange rates on May 31, 2008:
Spot
1 month forward
2 months forward
3 months forward
Thai Bhat
Buy
Rs 2.33
Rs 2.30
Rs 2.28
Rs 2.26
USD
Buy
Rs 65.12
Rs 65.45
Rs 65.77
Rs 66.10
Sell
Rs 2.36
Rs 2.33
Rs 2.31
Rs 2.29
Sell
Rs 65.24
Rs 65.57
Rs 65.89
Rs 66.22
The bank charges a commission of 0.01% on each transaction.
Required: Calculate the profit or loss on the above transaction if the shipments are made according to the
agreed schedule.
ICAP SUMMER 2008 MOMIN INDUSTRIES: SOLUTION
Receipts:
= 4,000 tons x USD 2,000 / ton x Rs 65.77
= 6,000 tons x USD 2,000 / ton x Rs 66.10
Payments:
= 4,000 x THB 50,000 / ton x Rs 2.33
= 6,000 x THB 50,000 / ton x Rs 2.31
526,160,000
793,200,000
1,319,360,000
(466,000,000)
(693,000,000)
(1,159,000,000)
Commission:
Receipts -- 1,319,360,000 x 0.01%
Payments -- 1,159,000,000 x 0.01%
Profit over the contract
(131,936)
(115,900)
160,112,164
ICAP SUMMER 2015 ZAIN EXPORTERS: QUESTION
On May 25, 2015, Zain Exporters Enterprises (ZEE) received an order from Windmill Inc. (WI), a USA based
company for supply of 7,500 tonnes of cotton yarn. The price was agreed at USD 2,500 per ton. Payment
is to be made within 30 days of shipment.
On May 27, 2015, due to fire in warehouse, stock of yarn cotton was completely destroyed. Since ZEE was
unable to get the required quantity locally, it offered to supply cotton yarn from Egypt, which was accepted
by WI. It was agreed that the quantity and price per ton would remain the same. However, the order would
be dispatched in two shipments as follows:
 4,000 tonnes on June 30, 2015
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
 3,500 tonnes on July 31, 2015
It was agreed between the Egyptian Company and ZEE that payments would be made on shipment, at the
rate of Egyptian Pound (EGP) 18,000 per ton. ZEE has a policy to hedge all foreign currencies through
forward cover. ZEE’s bank has arranged the forward cover and advised the following exchange rates on May
31, 2015:
Spot
1 month forward
2 months forward
3 months forward
EGP
Buy
Rs 13.36
Rs 13.45
Rs 13.60
Rs 13.80
USD
Buy
Rs 101.95
Rs 101.70
Rs 101.55
Rs 101.30
Sell
Rs 13.56
Rs 13.65
Rs 13.80
Rs 14.00
Sell
Rs 102.10
Rs 101.85
Rs 102.70
Rs 101.45
The bank charges a commission of 0.01% on the transactions.
Required: Determined the profit or loss on the above transactions if shipments are made as per the agreed
schedule. (05 marks)
ICAP SUMMER 2015 ZAIN EXPORTERS: SOLUTION
Receipts:
= 4,000 tons x USD 2,500 / ton x Rs 101.55
= 3,500 tons x USD 2,500 / ton x Rs 101.30
Payments:
= 4,000 x EGP 18,000 / ton x Rs 13.65
= 3,500 x EGP 18,000 / ton x Rs 13.80
Commission:
Receipts -- 1,319,360,000 x 0.01%
Payments -- 1,159,000,000 x 0.01%
Profit over the contract
Always a mentor | Muzzammil Munaf
1,015,500,000
886,375,000
1,901,875,000
(982,800,000)
(869,400,000)
(1,852,200,000)
(190,188)
(185,220)
49,299,593
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
MONEY MARKET HEDGE
Future Payment in Foreign Currency
Steps
 Calculate the amount of foreign currency to be purchased and invested. (the amount of foreign currency
payment will be equal to Amount of Foreign currency invested + interest to be earned)
 Amount to be borrowed in local currency to purchase the foreign currency above. (by converting the
amount of foreign currency to be invested at spot rate)
 Total cost will be Amount borrowed + Interest paid
 Calculate the Effective rate (Total Cost / Foreign Currency Payment)
Note: Foreign currency payment will be made by the amount invested.
Future Receipt in Foreign Currency
Steps
 Calculate the amount of foreign currency to be borrowed. (the amount of foreign currency receipt will
be equal to Amount to be borrowed + interest to be paid).
 Amount borrowed will be converted into local currency at spot rate.
 The above amount of local currency will be invested.
 Total receipt will be Amount of local currency invested + interest earned.
 Calculate the Effective rate (Total Receipt / Foreign Currency Receipt).
Note: Amount of loan taken in foreign currency will be paid by the foreign currency receipt.
Illustration:
ABC Limited has bought a shipment from USA and has to pay USD 4,000,000 in 90 days. The Company is
planning to go for either forward cover or money market hedge:
Spot rate
Forward (3 months)
Tenure
1 month
3 months
Deposit Rate
7%
7%
Rs / USD
Rs / USD
84.5 – 85.0
85.6 – 86.2
USD
Borrowing rate
10.25%
10.75%
Deposit Rate
11%
12%
PKR
Borrowing Rate
14%
14.5%
Required: Advise the management on the choice of the hedging instrument.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP WINTER 2009 QALAT INDUSTRIES: QUESTION
Qalat Industries Limited (QIL) is a medium sized company which carries out extensive trading (imports as
well as exports) with various German companies. The management of QIL is concerned about the recent
fluctuations in the exchange rate parity between Pak Rupee (Rs.) and Euro (€). They are considering hedging
the following transactions which they expect to undertake, on December 15, 2009:
Nature of transaction
i) Import of IT equipment
ii) Export of sports goods
iii) Export of medical instruments
iv) Import of machinery
Amount
€ 223,500
€ 98,500
€ 77,000
Rs 22,500,000
Due date of payment/receipt
June 15, 2010
March 15, 2010
June 15, 2010
March 15, 2010
Other relevant information is as follows:
i)
According to QIL’s bank the following exchange rates are expected to prevail on Dec 15, 2009:
€1
Buy
Sell
Spot
Rs 124.22
Rs 124.52
3 months forward
Rs 123.62
Rs 123.96
6 months forward
Rs 123.21
Rs 123.54
ii)
Interest rate on borrowing and lending in respective currencies are as follows:
Rs
€
3-months / 6 months borrowing
11%
5%
3-months / 6 months lending
6.5%
3%
Required:
a) Calculate the net rupee receipts/payments that QIL should expect from the above transactions under
each of the following alternatives:
i) Hedging through forward cover
ii) Hedging through money market
Determine which would be the better alternative for QIL. (Ignore transaction costs)
(12 marks)
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP WINTER 2009 QALAT INDUSTRIES: SOLUTION
For exports goods receipts on Mar 15 (Euro):
98,500
Option 1: Forward contract (98,500 x 123.62)
12,176,570
Option 2: Money market hedge
Borrow from FC account [98,500 x (1+0.05x3/12)^-1
97,284
Invest FC in LC (97,284 x 124.22)
Interest on investment (@ 6.5% for 3 months)
Total amount obtained in LC
12,084,618
196,375
12,280,994
Returned to FC account after obtaining receipt
Net effective rate
98,500
124.68
Option 2 i.e. money market hedge is better.
For payments/receipts on Jun 15:
Import of IT equipment -- Payment
Export of med ins -- Receipt
Net Payment
(223,500)
77,000
(146,500)
Option 1: Forward contract (146,500 x 123.54)
18,098,610
Option 2: Money market hedge
Invest in FC Account [146,500 x (1+3% x 6/12)^-1]
144,335
Borrow in LC (144,335 x 124.52)
Interest on borrowing (@ 11% for 6 months)
Total amount to be returned to LC account
FC to be obtained after 6 months
Net effective exchange rate
17,972,594
988,493
18,961,087
146,500
129.43
Option 1 i.e. forward contract is better.
Always a mentor | Muzzammil Munaf
Page 538 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP WINTER 2010 SILVER LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
Page 539 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP WINTER 2010 SILVER LIMITED: SOLUTION
For the transaction at June 30, 2011
Receipt
$ 1,224,000
Payment
$ (1,347,000)
Net payment
$ (123,000)
Option 1: Forward contract [123,000 x (3.110 + 0.164)]
402,702
3.274
Option 2: Money market hedge
Lend in USD (FC) [123,000 x (1+5.8% x 6/12)^-1]
119,534
To be borrowed in LC (MYR) (@ 3.110)
Interest expense @ 7.9% for 6 months
Total amount to be paid in LC (MYR)
Amount to be received from FC account
Net effective rate
371,749
14,684
386,433
123,000
3.14
Option 2 i.e. Money market hedge is better.
For the transaction at March 31, 2011
Receipt
$ 1,020,000
Payment
$ (775,000)
Net receipt
$ 245,000
Option 1: Forward contract [245,000 x (3.030 + 0.071)]
759,745
3.10
Option 2: Money market hedge
Borrow in USD [245,000 x (1+7.2% x 3/12)^-1]
240,668
Convert the borrowed FC in LC (MYR) (@ 3.030)
Interest income
Total amount to be obtained in LC (MYR)
Amount paid back to FC account
Net effective rate
729,224
12,032
741,256
245,000
3.03
Option 1 i.e. forward is better.
Always a mentor | Muzzammil Munaf
Page 540 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
FUTURES CONTRACT
A currency future is a standardized contract to buy or sell a fixed amount of currency at a fixed rate at a
fixed future date. It is the standardized that makes it possible to trade them on an exchange which in turn
increase liquidity.
 Buying the futures contract means receiving the contract currency.
 Selling the futures contract means supplying the contract currency.
Hedge set up (at the date of hedging)
 Buy or Sell?
Do now what has to be done in future.
 Which date contract to be selected?
Choose the one which maturity date is post transaction date and which is comparatively closer to the
transaction date too.
 No. of contracts?
Use rounding off principle (actual transaction quantity / standard contract size)
Note: In case of indirect currency hedge, convert transaction amount into local currency first, using futures
rate.
Hedge Outcome (at the transaction date)
 Purchase / Sell actual transaction quantity at the spot rate on the date of transaction.
 Close out futures contracts. This is done by doing an exactly opposite transaction in the futures market
as compared to what was done at the time of hedging. Close out gain/loss is received or paid by the
customer as the case may be.
Note: In case of indirect currency hedge, convert this futures market gain/loss amount into local currency
first, using spot rate at the date of transaction.
 Actual outcome is the sum of spot market outcome and futures market gain/loss.
 Hedge efficiency ratio can be calculated by: Futures market gain or loss / Spot market gain or loss
Basis and Basis Risk
 It is the difference between future price and the spot rate (Basis = Future price – Spot rate).
 Basis risk is the risk that the price of a currency future will vary from the price of the underlying asset
(the spot rate).
 It is assumed that the difference between the spot rate and futures price (the 'basis') falls over time but
there is a risk that basis will not decrease in this predictable way (which will create an imperfect hedge).
There is no basis risk when a contract is held to maturity.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
 In the absence of specific information in examination, we assume that Basis reduces steadily/equally
over time.
Other Important Points
 A future contract does not result in a perfect hedge (means actual outcome is not equal to target
outcome) usually because of following two factors:
o Quantity Risk i.e. standard qty under futures contract may not be exactly equal to the actual
transaction qty.
o Basis risk
Note: In case when these two risks are eliminated (Standard Qty is equal to transaction qty & basis is
constant), the actual outcome would be exactly equal to target outcome.
 A future contract involves payment of initial security deposit and periodic mark-to-market settlements.
This is done by exchange to manage credit risk.
 If basis is greater than the sum of borrowing and transaction costs, then arbitrage gain is possible by
purchasing on spot and selling in futures market simultaneously.
Question 01:
Today is Oct 1, 2014. Spot price of Jamal Limited is Rs 7.5 per share. Mr. Kamran wants to buy 3,150 shares
of the Company on Oct 20, 2014. The Company acquired shares in future market (in a size limit of 1,000
shares) at Rs 7.6 per share. Settlement date of the future is Oct 29, 2014.
Assumption 1: On Oct 20, 2014, spot rates and future rates turn out to be Rs 10 and Rs 10.09 per share.
Assumption 2: On Oct 20, 2014, spot rates and future rates turn out to be Rs 6.5 and Rs 6.6 per share.
Required: Calculate the net pay-offs in the strategy.
Solution 01:
Solving assumption 1:
Step 1: Transaction in the futures market
1-Oct
Future buy -- (7.6 x 3,000)
20-Oct
Future sell -- (10.09 x 3,000)
Gain received from futures
(22,800)
30,270
7,470
Step 2: Transaction in the ready (spot) market
20-Oct
Buy shares (10 x 3,150)
Futures gain
Effective cost
(31,500)
7,470
(24,030)
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Step 3: Effectiveness of Hedge
Target cost (3,150 x 7.5)
Effective cost
Net Loss
23,625
(24,030)
(405)
Step 4: Analysing the net loss -- 2 reasons:
1: Movement in both the markets
Change in spot (10 - 7.5) = 2.5 Loss x 3000
Change in future (10.09 - 7.6) = 2.49 Gain x 3000
Movement in both the markets
(7,500)
7,470
(30)
2: Unhedged portion (3,150 - 3,000) = 150 shares
Loss on unhedged shares [150 x (7.5 - 10)
(375)
Step 3 is optional, step 4 is sufficient
Alternate method of doing step 4 (calculation of hedge)
Step 4: Calculation of hedge effectiveness (alternate method)
Delta in spot market (10 - 7.5) x 3,150
(7,875)
Delta in futures market (10.09 - 7.6) x 3,000
7,470
(405)
Solving assumption 2:
Step 1: Transaction in the futures market
1-Oct
Future buy -- (7.6 x 3,000)
20-Oct
Future sell -- (6.6 x 3,000)
Loss paid in futures
(22,800)
19,800
(3,000)
Step 2: Transaction in the ready (spot) market
20-Oct
Buy shares (6.5 x 3,150)
Futures loss
Effective cost
(20,475)
(3,000)
(23,475)
Always a mentor | Muzzammil Munaf
Page 543 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Step 3: Effectiveness of Hedge
Target cost (3,150 x 7.5)
Effective cost
Net Gain
23,625
(23,475)
150
Step 4: Effectiveness of Hedge
Delta in spot market (7.5 - 6.5) x 3,150
Delta in futures market (7.6 - 6.6) x 3,000
3,150
(3,000)
150
Question 02:
A company is planning to sell 30,360 shares of Jack Limited on May 10. Spot rate today (April 5) is Rs 42.
Following future contracts are available in the market of different maturities. (Standard contract size is 1,000
shares).
April
May
June
42.5
44.2
45.5
Required:
i)
ii)
Calculate the payoffs of the strategy if the spot and future rates on May 10 is Rs 38 and Rs 38.2.
Calculate the payoffs of the strategy if the spot and future rates on May 10 is Rs 50 and Rs 50.3.
Solution 02:
Assumption 1 solution:
Step 1: Transaction in the futures market
Future sell (30,000 x 44.2)
Future buy (30,000 x 38.2)
Gain receved from futures market
1,326,000
(1,146,000)
180,000
Step 2: Transaction in the ready (spot) market
Spot sell (30,360 x 38)
Gain receved from futures market
Always a mentor | Muzzammil Munaf
1,153,680
180,000
1,333,680
Page 544 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Step 3: Effectiveness of Hedge
Target cost (30,360 x 42)
Effective proceeds
Net Gain
1,275,120
1,333,680
58,560
Step 4: Effectiveness of Hedge
Delta in spot market (42 - 38) x 30,360
Delta in futures market (44.2 - 38.2) x 3,000
Net Gain
(121,440)
180,000
58,560
Assumption 2 solution:
Step 1: Transaction in the futures market
Future sell (30,000 x 44.2)
Future buy (30,000 x 50.3)
Loss from futures market
1,326,000
(1,509,000)
(183,000)
Step 2: Transaction in the ready (spot) market
Spot sell (30,360 x 50)
Loss from futures market
Net effective proceeds
1,518,000
(183,000)
1,335,000
Step 3: Effectiveness of Hedge
Target cost (30,360 x 42)
Net effective proceeds
Net Gain
1,275,120
1,335,000
59,880
Step 4: Effectiveness of Hedge
Delta in spot market (50 - 42) x 30,360
Delta in futures market (44.2 - 50.3) x 3,000
Net Gain
242,880
(183,000)
59,880
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Question 03:
A company is planning to buy 67,100 shares of Sultan Limited on November 15. Spot rate today (October
10) is Rs 132. Following future contracts are available in the market of different maturities.
October
November
December
Rs 133.0
Rs 134.5
Rs 135.0
Required:
Calculate the payoffs of the strategy if the spot and future rates on Nov 15 is Rs 128 and Rs 128.6
Self-practice.
Question 04:
A US Company is expecting to pay GBP 2.1 million by mid of December. Current spot rate is 1.5 – 1.6
USD/GBP. The Company decides to hedge the position through futures contract. Price for future contract is
as under:
Sep 2011
Dec 2011
Mar 2012
Contract size
1.5552 USD/GBP
1.5556 USD/GBP
1.5564 USD/GBP
62,500 GBP
Required:
Set up the appropriate hedge and find the hedge outcome if spot on actual transaction date along with
future prices are as under:
Ready
Futures
1.612 – 1.620 USD/GBP
December 1.610 USD/GBP
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Solution 04:
Calculation of no of contracts:
Required
2,100,000
Contract size
62,500
Required / Contract Size 33.60
Rounded off to
34.00
34 x 62,500 =
2,125,000
Step 1: Transaction in the futures market
Future buy (2,125,000 GBP x 1.5556)
Future sell (2,125,000 GBP x 1.610)
Gain received from forward market
(3,305,650)
3,421,250
115,600
Step 2: Transaction in the spot market
Spot buy (2,100,000 x 1.620)
Gain received from forward market
Net effective cost
(3,402,000)
115,600
(3,286,400)
Step 3: Effectiveness of Hedge
Target cost (2,100,000 x 1.6)
Net effective proceeds
Net Gain
(3,360,000)
(3,286,400)
73,600
Step 4: Effectiveness of Hedge
Delta in spot market (1.6 - 1.62) x 2,100,000
Delta in futures market (1.5556 - 1.610) x 2,125,000
Net Gain
Always a mentor | Muzzammil Munaf
Page 547 of 690
(42,000)
115,600
73,600
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP WINTER 2017 CPL: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP WINTER 2017 CPL: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP SUMMER 2018 AQEEQ PAKISTAN: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP SUMMER 2018 AQEEQ PAKISTAN: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
CROSS RATES
A cross rate is an exchange rate between two currencies computed by reference to a third currency, usually
the US dollar.
The exchange rate for two currencies might be derived as a cross rate. This means that they are not traded
directly on the FX markets, but both currencies are traded through the US dollar.
For example, if the exchange rate for the US dollar against the Hong Kong dollar (HKD/USD) is 8.1000 and
the rate for the US dollar against the Canadian dollar (CAD/USD) is 1.2475, the cross rate for the Hong Kong
dollar against the Canadian dollar (HKD/CAD) is 8.1000/1.2475, which is C$1 = HK$6.4930.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP 2017 WINTER CAPTAIN (PRIVATE) LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
Page 554 of 690
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP 2017 WINTER CAPTAIN (PRIVATE) LIMITED: SOLUTION
Contract values:
CNY (5,000 x 700)
USD (3,000 x 92)
3,500,000
276,000
Bangladeshi contract - USD
Contract value in USD (3,000 x 91)
276,000
Forward (276,000 x 107)
29,532,000
Money market
Borrowing in USD @ 2.75% [276,000x(1+2.75%x3/12]^-1
Convert into PKR and invest (274,115.46 x 107.40)
Deposit into PKR @ 6.5% [29,440,000x(1+6.5%x3/12)]
274,115.46
29,440,000
29,918,400
Spot
3 months discount
Forward rate
107.40
(0.403)
107.00
In the case of Bangladeshi contract, money market is a better option because our receipts are higher.
Chineese contract - CNY
Contract value in CNY (5,000 x 700)
3,500,000
Spot rate CNY/PKR: (107.4/6.67)
3 months forward (107.40-0.403) / (6.67 + 0.067)
Receipts under forwards (3,500,000 x 15.88)
16.10
15.88
55,586,982
Money market
Borrow CNY @ 9% [3,500,000x(1+9%x3/12)^-1]
Convert into PKR and deposit (3,422,983 x 16.10)
Deposit in PKR @ 6.5% [55.116 x (1+6.5%x3/12)]
3,422,983
55,116,696
56,012,342
In the case of Chineese contract, money market is a better option because our receipts are higher.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
OPTION CONTRACTS
While futures act as liability on an investor, requiring him/her to follow up on a contract by a pre-set due
date, an options contract gives an individual the right to do so. Options and futures are similar trading
products that provide investors with the chance to make money and hedge current investments.
Options are a type of derivative, and hence their value depends on the value of an underlying instrument.
It has different types and styles, which can be used for different strategies.
Definition of an option
An option is something that gives its holder the right, but not the obligation, to take a particular course of
action at some time in the future. Typically, an option gives its holder the right, but not the obligation, either
to buy or to sell a quantity of a particular item on or before a specified date in the future, at a price that is
fixed in the contract.
Financial options, commodity options and real options
There are different types of option.
 A financial option is a contract that gives its holder the right, but not the obligation, either to buy or to
sell a quantity of a financial item on or before a specified date in the future, at a price that is fixed in
the contract. There are financial options in currencies, interest rates, share prices and stock index values.
For example, an option in shares of company Z might give its holder the right to sell 1,000 shares in
company Z on 31st March at a price of Rs.100 per share.
 With a commodity option, the option holder has the right to buy or sell a quantity of a specified
commodity, such as a quantity of wheat, or a quantity of a metal such as gold or copper.
Call options and put options
Financial options are either call options or put options.
 A call option gives its holder the right to purchase the underlying item in the option agreement.
 A put option gives its holder the right to sell the underlying item in the option agreement.
For example, a call option on 1,000 shares in company Z gives its holder the right to buy 1,000 shares in
company Z at the price agreed in the option contract, and a put option on 1,000 shares in company Z would
give its holder the right to sell 1,000 shares in company Z at the agreed price.
Expiry date: American, European and Bermudan options
An option agreement has an expiry date, after which the option lapses and the agreement comes to an end.
 An American-style option can be exercised by its holder at any time on or before the expiry date.
 A European-style option can be exercised only at the expiry date for the option and not before.
 A Bermudan option can be exercised on a restricted series of dates.
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FOREIGN EXCHANGE RISK MANAGEMENT
The terms do not refer to the countries where these types of option are available. All three types of option
agreement are made throughout the world.
For example, if a company holds an American-style call option to buy US$500,000 in exchange for euros at
a rate of 1.2000 (US$/€1) with an expiry date of 20 September, the company can exercise its right to buy
the $500,000 at the agreed rate at any time up to and including 20th September. However, if the option is
not exercised by that date, it will lapse (cease to exist).
OTC and exchange-traded options
Some financial options are arranged directly between buyer and seller. Directly-negotiated options are
called over-the-counter options or OTC options. Examples of OTC options include borrowers’ and lenders’
options, caps, floors and collars. Currency options might also be arranged in OTC agreements.
Some options are traded on an exchange. Traded share options and some currency options are exchangetraded. In addition, there are options on futures contracts, and all options on futures are traded on the
futures exchange where the underlying futures are traded.
BUYING AND SELLING (WRITING) OPTIONS
When understanding option contract meaning, one needs to understand that there are two parties involved,
a buyer (also called the holder), and a seller who is referred to as the writer.
Exercise price or strike price – The exercise price for an option is the price at which the holder can:
 Buy the underlying item, in the case of a call option, or
 Sell the underlying item, in the case of a put option.
With OTC options, the exercise price is agreed between the option buyer and the option seller. With
exchange-traded options, options are available for buying or selling at a limited range of fixed strike prices,
and buyers and sellers agree on the price at which they will make a transaction in the options at one of
these prices.
For example, the following table shows exercise prices that might be available on the CME exchange for US
dollar/euro currency options on a day in the past, and the prices of the most recent transactions in those
options.
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Rights and obligations of buyer and seller
Options are bought and sold. The seller of an OTC option is often called the option writer. Selling an OTC
option is often called ‘writing an option’. For exchange-traded options, it is more usual to refer to ‘sellers’
of options, who have a short position in the options.
 The option buyer or option holder has the right to exercise the option but is not obliged or contractually
required to do so.
 On the other hand, the seller or writer of the option is contractually obliged to sell or buy the underlying
item if the option is exercised by its holder.
Option premium = option price
Options are bought and sold at a price, which is called the option premium. This is paid by the buyer of the
option to the option seller/writer when the option agreement is made. The option writer therefore receives
the premium no matter whether the option is subsequently exercised or not.
The table of currency options above shows current prices for US dollar/euro traded currency options. For
example, September call options at a strike price of $1.22 in $/€ were being traded at a price of 0.34. In this
particular example, this premium price is stated in US cents per euro. Each traded option on the CME
exchange is for 125,000 euros in exchange for US dollars, and the cost of one September call option was
therefore $425 (125,000 × $0.0034).
Similarly, the premium for a December put option at a strike price of $1.25 was $6,125 (125,000 × $0.0490).
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Exercising options: Options are in-the-money, at-the-money or out-of-the-money.
 An option is in-the-money when its exercise price (strike price) is more favourable to the option holder
than the current market price of the underlying item.
 An option is at-the-money when its exercise price (strike price) is exactly equal to the current market
price of the underlying item.
 An option is out-of-the-money when its exercise price (strike price) is less favourable to the option
holder than the current market price of the underlying item.
An option will only be exercised if it is in-the-money: When an option is exercised, the value of the
option is the difference between the exercise price and the current market price of the underlying item.
Exercising call options
A call option will only be exercised if the market price of the underlying item is higher than the exercise
price for the option. For example, a European call option on 1,000 shares in company Z with a strike price
of Rs.100 per share will only be exercised if the market price of the share is above Rs.100 at expiry.
Exercising put options
Similarly, a put option will only be exercised if the market price of the underlying item is lower than the
exercise price for the option. For example, a European put option on 2,000 shares in company XY with a
strike price of Rs.80 per share will only be exercised if the market price of the share is below Rs.80 at expiry.
HEDGING WITH OPTIONS: Financial options can be used to hedge exposures to the risk of adverse
movements in exchange rates, interest rates, bond prices and share prices. Hedging with options differs
from hedging with forward contracts, money market hedges, FRAs and futures, in several important ways.
 The hedge has a cost. A hedge should normally be created by buying options rather than selling/writing
options, and the option buyer must pay the premium to obtain the options to create the hedge.
 An option does not have to be exercised. It will only be exercised if it is in-the-money. If it is out-ofthe-money, the option holder will let the option lapse and buy or sell the underlying item in the cash
market, at the more favourable market price. This means that an option holder can use the options as
a protection against adverse movements in the market rate, but can take advantage of any favourable
movement in the market rate.
Example: Hedging with options
An investor holds 5,000 shares in another company, XYZ, which have a current market price of $6.00. The
investor will want to sell the shares in a few months’ time, in April, but not before then. He is concerned that
the share price might fall between now and April, but is also aware of the possibility that it could rise.
The investor can hedge the exposure to market risk (share price risk) by purchasing a put option on 5,000
shares in XYZ, for expiry in April. Suppose the strike price of the option is $6.00, so that the option is at-themoney when written.
If the share price falls below $6.00 before April, say to $5.50, the investor can exercise the option and sell at
the strike price of $6.00.
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
On the other hand, if the share price rises above $6.00, say to $7.00, he can let the option lapse and sell the
shares at the market price of $7.00.
Creating a hedge – The rule for creating a hedge with options is as follows:
 To hedge against the risk of a rise in the price of the underlying item, buy call options
 To hedge against the risk of a fall in the price of the underlying item, buy put options
ICAP SUMMER 2009 DEF SECURITIES: QUESTION
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP SUMMER 2009 DEF SECURITIES: SOLUTION
1: Call Option -- American (can be exercised at anytime)
a) Now (1 June)
Marlet Price (Spot)
Ex Price (Cost)
Gain
b) 30 June (at maturity) -- Close out
170
(155)
15
Marlet Price (Future)
Ex Price (Cost)
DF @ 14.5% (1 month)
PV of gain in 1 month
173.00
(155.00)
18.00
0.9881
17.79
Conclusion in case of call options -- Give preference to close out
2: Put Option --- European -- Can only be exercised on June 30
Exercise price
Spot @ 1 June
1 month future
3.50
4.25 Benefit to exercise in the market since both the
4.35 prices are higher than exercise price
Conclusion in case of put options -- do not exercise the option
Out of context strategy:
Ready market -- buy
Future -- sell (1 month)
Interest cost (4.25 @ 14.5% for 1 month)
Arbitrage gain
Always a mentor | Muzzammil Munaf
4.25
4.35
0.10
(0.05)
0.05
Page 561 of 690
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP WINTER 2019 GREENLINE INVESTMENTS: QUESTION
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP WINTER 2019 GREENLINE INVESTMENTS: SOLUTION
LP1 -- Call Option
Strike price = 240
10% gain -- 240 x 1.1
20% gain -- 240 x 1.2
264
288
250,000 x 60% x (264 - 240)
250,000 x 40% x (288 - 240)
Premium (250,000 x 7)
Net gain - LP1
SP2 -- Call Option
Strike price = 16
10% gain -- 16 x 1.1
20% gain -- 16 x 1.2
3,600,000
4,800,000
8,400,000
(1,750,000)
6,650,000
960,000
720,000
1,680,000
(1,000,000)
680,000
142.74
126.88
500,000 x (158.6 - 155)
Premium (550,000 x 4.5)
Net Loss - LP1
NM4 -- Put Option
Strike price = 285.5
10% gain -- 285.5 x 90%
20% gain -- 285.5 x 80%
17.6
19.2
1,000,000 x 60% x (17.6 - 16)
1,000,000 x 40% x (17.8 - 16)
Premium (1,000,000 x 1)
Net gain - SP2
BD3 -- Put
Strike price = 158.6
10% gain -- 158.6 x 90%
20% gain -- 158.6 x 80%
1,800,000 All at maturity
(2,250,000)
(450,000)
256.95
228.40
300,000 x 60% x (285.5 - 256.95)
300,000 x 40% --- out the money
Premium (300,000 x 8)
Net gain - NM4
5,139,000
(2,400,000)
2,739,000
CURRENCY OPTIONS
A currency option gives its holder the right to buy (call option) or sell (put option) a quantity of one currency
in exchange for another, on or before a specified date, at a fixed rate of exchange (the strike rate for the
option).
 Currency options can be purchased over-the-counter or on an exchange. Currency options are traded
on some exchanges.
 Traded currency options are for a standard quantity of one currency in exchange for another currency,
and strike prices are quoted as exchange rates. The premiums are normally quoted as an amount in
one currency per unit of the other currency. For example, traded options on currency futures for US$ £ are for £62,500 and are priced in US cents per £1.
Hedging with currency options
The steps for using exchange-traded currency options to hedge an exposure to currency risk are as follows:
Step 1: Determine the type of contract – call or put – by looking at the currency requirement in the contract
currency. Decide on the exercise price, if necessary.
Step 2: Determine number of contracts.
Step 3: Buy calls/puts option contracts as required – a company will only buy option contracts for hedging
purposes. Determine option premium – usually payable upfront.
Always a mentor | Muzzammil Munaf
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FOREIGN EXCHANGE RISK MANAGEMENT
Include the opportunity cost of funds, i.e. assume the company will have to borrow the cost of the options
between now and conversion date.
Step 4: On the settlement date compare the option price with the prevailing spot to determine whether the
option would be exercised or allowed to lapse.
Ensure you state this in your answer!
Step 5: Determine net cash flows. If the number of contracts required needed rounding then there will be
some exchanges at the prevailing spot rate.
Gains or losses on options and the effective exchange rate
The effective exchange rate that is obtained from a hedge with options on currency futures depends on
what happens when the settlement date arrives, and whether the option is exercised or not.
Illustration 01: Perfect Hedge
A US company expects to pay €1 million at the end of March and buys 8 call options on March euro currency
futures at a strike price of 1.2400 US$/€ and a premium of 3.43 US cents per euro. Calculate the position of
the US company if the spot exchange rate (US$/€1) in March is:
a)
b)
c)
d)
e)
$1.2000
$1.2200
$1.2500
$1.2800
$1.3000
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Solution 01:
Illustration 02: Imperfect Hedge
The Pongo plc is a UK based import-export company. It has an invoice, which it is due to pay on 30 June, in
respect of $350,000. The company wishes to hedge its exposure to risk using currency options with an
exercise price of $1.50/£. The current $/£ spot rate is 1.5190 – 1.5230. On the exchange, the contract size is
£25,000.
Option premiums are given in cents per pound. Assume that it is now the 31 March and that UK £ interest
rates are 12%.
Required:
Calculate the cash flows in respect to the payment if the spot rate is: 1.4810 – 1.4850 on the 30 June.
Always a mentor | Muzzammil Munaf
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FOREIGN EXCHANGE RISK MANAGEMENT
Solution 02:
Step 1: Determine the type of contract – contracts are in £, we need to sell £ to get $ so buy put options
on £. Decide on the exercise price – not necessary here.
Step 2: Determine number of contracts. $350,000 ÷ 1.5 ÷ 25,000 = 9.33 say 9 contracts.
Step 3: Buy 9 June put contracts at an exercise price of $1.50. Determine option premium – usually payable
upfront. Option premium = 0.124 × 25,000 × 9 = $27,900.
Assume the option premium is payable upfront. $27,900/1.5190 = £18,367.
Also include the opportunity cost of funds – final cost of options = £18,367 × 1.03 = £18,918.
Step 4: On the settlement date compare the option price ($1.50) with the prevailing spot ($1.4810) to
determine whether the option would be exercised or allowed to lapse.Exercise (‘sell the big number’).
Sell 9 × 25 = £225,000.
Buy 225,000 × 1.5 = $337,500.
Step 5: Determine net cash flows.
Payments in real world
Buy $s and sell £s using options
Shorfall
Buy at spot (12,500 ÷1.4810)
Cost of option
$
(350,000)
337,500
________
(12,500)
________
12,500
Net payments in £s
£
(225,000)
(8,440)
(18,918)
___________
(252,358)
___________
Illustration 03: Imperfect Hedge
Using the circumstances described in illustration 02 above, suppose Pongo plc is also due to receive
$275,000 from a US customer on 30 September. Exchange quotes for September option contracts are as
follows:
Required:
Calculate the cash flows in respect to the receipt if the spot rate is 1.5250 – 1.5285 on the 30 September.
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Solution 03:
Step 1: Determine the type of contract – contracts are in £, we need to sell $ to get £ so buy call options
on £. Decide on the exercise price – not necessary here.
Step 2: Determine number of contracts. $275,000 ÷ 1.5 ÷ 25,000 = 7.33 say 7 contracts.
Step 3: Buy 7 September call contracts at an exercise price of $1.50. Determine option premium – usually
payable upfront. Option premium = 0.08 × 25,000 × 7 = $14,000.
Assume the option premium is payable upfront: $14,000/1.5190 = £9,217. Also include the opportunity cost
of funds. Final cost of options = £9,217 × 1.06 = £9,770.
Step 4: On the settlement date compare the option price ($1.50) with the prevailing spot ($1.5285) to
determine whether the option would be exercised or allowed to lapse. Exercise (‘buy the low number’).
Buy 7 × 25 = £175,000.
Sell 175,000 × 1.5 = $262,500.
Step 5: Determine net cash flows.
Illustration 04: Imperfect Hedge
A company in Belgium expects to pay US$2 million to a supplier in Arabia. It is now November and the
payment is due in March. The current spot rate is 1.2100. The company wants to use currency options to
hedge the exposure.
Each currency option is for 125,000 euros and the value of 1 tick (0.0001) is $12.50. The strike price is of
$1.2200 = €1 for the options, and that the premium for a March put option at this strike price is 2.75 US
cents per euro. Calculate the payout if:
a) the spot rate in March when the dollars must be paid is $1.2500 = €1
b) spot rate in March when the dollars must be paid is $1.1800 = €1
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Solution 04:
To hedge 1,639,344 euros, the company needs to buy 13.1 put options (1,639,344 euros/125,000 euros per
contract).
The company will probably buy 13 put options. The cost of the premium will be 13 contracts × 125,000 ×
$0.0275 = $44,687.50. The company will buy these dollars spot at $1.2100, and so the cost of buying the
options (in euros) will be €36,931.82.
(a) The spot rate in March when the dollars must be paid is $1.2500 = €1
The company will let the option lapse and purchase the dollars spot at $1.2500. The effective exchange rate
is as follows:
(b) The spot rate in March when the dollars must be paid is $1.1800 = €1
The company will exercise the option to sell the 13 futures contracts at $1.2200.
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP SUMMER 2019 ORANGE LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP SUMMER 2019 ORANGE LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP WINTER 2020 PESHAWAR ENGINEERING: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP WINTER 2020 PESHAWAR ENGINEERING: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP SUMMER 2022 CM LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
ICAP SUMMER 2022 CM LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
FOREIGN CURRENCY SWAP
A currency swap, also called cross-currency swap, is an agreement in which two parties exchange the
principal amount of a loan and the interest in one currency for the principal and interest in another currency.
It is commonly used to hedge against currency risk. However, it is also used exchanging two variable rate
loans, or fixed rate borrowing for variable rate borrowing.
The nature of currency swaps
A swap is a contract under which two or more parties agree to exchange cash flows on underlying positions.
Currency swaps have the following features:
 The swap is between two different currencies. One party pays interest on an amount of principal in one
currency. The other party pays interest on an equivalent amount of principal in a different currency.
 The interest rates that are swapped need not be a fixed rate in exchange for a floating rate. A currency
swap can be between a fixed rate in one currency and a (different) fixed rate in the other currency.
 There is an actual exchange of principal. There must be an exchange of principal at the end of the swap,
at a rate of exchange that is fixed at the beginning of the swap. (There might also be an actual exchange
of principal at the beginning of the swap, but this is not usual.)
EXAMPLE:
A UK company has taken an opportunity to borrow US$180 million in the bond markets, by issuing a sevenyear bond. However, it wants to have its interest liabilities in sterling, not dollars. It might therefore arrange
a seven-year currency swap in which the agreed exchange rate is £1 = US$1.80.
For the seven years of the swap, the UK Company will receive fixed rate interest in US dollars from the swap
counterparty. The interest received on each interest payment date will be interest for the period at the
agreed swap rate for US dollars, on $180 million.
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
FOREIGN EXCHANGE RISK MANAGEMENT
The UK Company will pay interest in the swap on £100 million, also at a fixed rate agreed in the swap.
The interest received in US dollars can be used to meet the dollar interest liabilities on the bonds. This leaves
the company with net interest obligations in sterling.
At the end of the swap, there is an exchange of principal. The UK company will receive US$180 million from
the swap counterparty and in exchange must pay £100 million. It will use the US$180 million to redeem the
dollar bonds.
The effects of the currency swap may be summarised as follows:
Bonds
Currency swap
Net effect
Interest
Principal payments (end of the swap)
Pay dollars
Receive dollars
Pay sterling
Pay sterling
Pay dollars ($180 million)
Receive dollars ($180 million)
Pay sterling
Pay sterling
The effect of the currency swap has therefore been to borrow in one currency, but swap the interest and
loan principal repayment liabilities into a different currency. Currency swaps are therefore used to hedge
long-term currency risk.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Contents
INTEREST RATE RISK MANAGEMENT ..................................................................................................................2
FORWARD RATE AGREEMENTS .........................................................................................................................2
INTEREST RATE FUTURES ...................................................................................................................................7
ICAP WINTER 2016 RAMZI CORPORATION: QUESTION ...........................................................................15
ICAP WINTER 2016 RAMZI CORPORATION: SOLUTION ...........................................................................15
ICAP SUMMER 2017 JML: QUESTION ............................................................................................................16
ICAP SUMMER 2017 JML: SOLUTION ............................................................................................................16
ICAP SUMMER 2019 ORANGE LIMITED: QUESTION ..................................................................................17
ICAP SUMMER 2019 ORANGE LIMITED: SOLUTION...................................................................................17
INTEREST RATE OPTIONS .................................................................................................................................18
ICAP SUMMER 2021 ZEBRA LIMITED: QUESTION ......................................................................................21
ICAP SUMMER 2021 ZEBRA LIMITED: SOLUTION.......................................................................................21
ACCA AFM 2020 MARCH BOULLAIN CO: QUESTION .................................................................................26
ACCA AFM 2020 MARCH BOULLAIN CO: SOLUTION .................................................................................27
INTEREST RATE SWAPS .....................................................................................................................................29
INTEREST RATE SWAP: CREDIT ARBITRAGE ................................................................................................33
ICAP WINTER 2008 IMRAN LIMITED: QUESTION .......................................................................................39
ICAP WINTER 2008 IMRAN LIMITED: SOLUTION .......................................................................................39
ICAP WINTER 2016 RAMZI CORPORATION: QUESTION ...........................................................................40
ICAP WINTER 2016 RAMZI CORPORATION: SOLUTION ...........................................................................41
ICAP WINTER 2018 KS LIMITED: QUESTION ................................................................................................42
ICAP WINTER 2018 KS LIMITED: SOLUTION ................................................................................................43
ICAP WINTER 2021 MULTICORP LIMITED: QUESTION ..............................................................................44
ICAP WINTER 2021 MULTICORP LIMITED: SOLUTION ..............................................................................45
ACCA AFM SEPTEMBER 2020 FITZHARRIS CO: QUESTION ......................................................................48
ACCA AFM SEPTEMBER 2020 FITZHARRIS CO: SOLUTION ......................................................................49
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
INTEREST RATE RISK MANAGEMENT
The effect of a change in interest rates
Interest rates can move up or down, although economists are often able to predict the direction of future
movements. A movement in interest rates can affect companies in either a positive or a negative way.
 If a company has borrowed at a variable rate of interest, it will have to pay higher interest costs if the
interest rate goes up, and lower interest costs if the rate goes down.
 If a company has borrowed at a fixed rate of interest, for example by issuing bonds, it will continue to
pay the same rate of interest even if market interest rates go down. However, competitors who have
borrowed at a variable rate of interest, or competitors who decide to issue fixed rate bonds after the
rate has fallen, will gain a competitive advantage.
 An investor in fixed rate bonds who expects to sell the bonds before their maturity will also be affected
by a change in interest rates. A rise in interest yields will result in a fall in the price of existing fixed rate
bonds. A fall in the market interest rate will send bond prices up.
Hedging methods
Some organisations might wish to hedge their exposures to interest rate risk. They might also want to take
advantage, if possible, from any favourable movements in interest rates. There are several ways in which
risks can be hedged and opportunities to benefit from interest rate changes can be exploited.
Common methods include:




forward rate agreements (FRAs);
interest rate swaps;
interest rate futures; and
interest rate options
FORWARD RATE AGREEMENTS
A forward rate agreement (FRA) is a forward contract for an interest rate. FRAs are negotiated ‘over-thecounter’ with a bank. In some respects, an FRA is similar to a forward exchange rate. It is a contract arranged
‘now’ that fixes the rate of interest for a future loan or deposit period starting at some time in the future.
For example, an FRA can be used to fix the interest rate on a six-month loan starting in three months’ time.
Banks are able to quote forward rates for interest rates because there is a large and active money market,
and banks are able to borrow and deposit funds short-term. As a result, if a bank can borrow for nine
months at one rate of interest and deposit funds for three months at another rate of interest, it can work
out a rate to quote to a customer that wants to borrow between the end of month 3 and the end of month
9. A ‘forward rate’ can be fixed now that will guarantee the bank a profit on the transaction.
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
The features of an FRA agreement
An FRA, like a forward exchange contract, is a binding agreement between a bank and a customer. It is an
agreement that fixes an interest rate ‘now’ for a future interest period.
a) An FRA for an interest period starting at the end of month 3 and lasting until the end of month 9 is a
3v9 FRA or a 3/9 FRA.
b) Similarly, an FRA for a three-month period starting at the end of month 2 is a 2v5 FRA or a 2/5 FRA.
An FRA is an agreement that fixes a forward interest rate on a notional amount of money.
Buying and selling FRAs: FRAs are bought and sold:
a) If a company wishes to fix an interest rate (cost) for a future borrowing period, it buys an FRA. In other
words, buying an FRA fixes a forward rate for short-term borrowing.
b) If a company wishes to fix an interest rate (income) for a future deposit period, it sells an FRA. Selling
an FRA fixes a forward rate for a short-term deposit.
The counterparty bank sells an FRA to a buyer and buys an FRA from a seller.
Notional loans and deposits
A forward exchange contract for currency is an agreement to buy and sell currency at a future date, when
there will be an exchange of currencies between the two parties.
An FRA is different. It is not an actual agreement to take out a loan or to make a deposit. An FRA is an
agreement on a notional loan or deposit, not an actual loan or deposit. The size of the notional amount of
principal (the notional loan or deposit) is specified in the FRA agreement.
How an FRA works?
An FRA works by comparing the fixed rate of interest in the FRA agreement with a benchmark rate of
interest, such as KIBOR or LIBOR. The comparison takes place at the beginning of the notional interest
period for the FRA.
c)
If the FRA rate is higher than the benchmark rate (KIBOR), the buyer of the FRA must make a payment
to the seller of the FRA, in settlement of the contract.
d) If the FRA rate is lower than the benchmark rate (KIBOR), the buyer of the FRA receives a payment from
the seller of the FRA, in settlement of the contract.
The amount of the payment is calculated from the difference between the FRA rate and the benchmark rate
(LIBOR rate), applied to the notional principal amount for the FRA and calculated for the length of the
interest period in the agreement.
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
EXAMPLE: Suppose that a company knows that it will need to borrow Rs.5 million in three months’ time
for a period of six months. The company can hedge its exposure to the risk of a rise in the six-month interest
rate by buying a 3 v 9 FRA for a notional principal amount of Rs.5 million.
If the bank’s FRA rates for 3 v 9 FRAs are 5.40 – 5.36, the rate applied to the agreement will be 5.40%. The
company has fixed the rate that it will pay on the loan at 5.4%.
Settlement of the FRA
Suppose that at the end of month 3, six-month KIBOR is 6.25%.
The FRA is settled by a payment from the bank (seller) to the buyer of the FRA. The difference between the
FRA rate and KIBOR is 0.85%.
The payment to settle the FRA will therefore be based on an interest difference of: 0.85% × Rs.5 million ×
6/12 = Rs.21,250.
The actual payment will be less than this, because the FRA is settled immediately, at the beginning of the
notional interest period, and not at the end of the period.
The Rs.21,250 is therefore discounted from an end-of-interest period value to a start-of-interest period
value, using the reference rate of interest as the discount rate.
This PV is the amount received in settlement of the FRA.
Suppose that at the end of month 3, six-month KIBOR is 4.75%.
The FRA is settled by a payment from the buyer of the FRA to the bank (seller). The difference between the
FRA rate and KIBOR is 0.65%.
The payment to settle the FRA will therefore be based on this interest rate difference: 0.65% × Rs.5 million
× 6/12 = Rs.16,250.
Again, because the payment is at the beginning of the interest period and not at the end of the period, the
Rs.16,250 is discounted to a present value at the reference rate of interest.
This PV is the amount of the payment in settlement of the FRA.
Conclusion: using an FRA to hedge an interest rate risk exposure
 An FRA can therefore be used by a borrower to hedge an exposure to a future increase in the spot
interest rate, or to protect a depositor against a future fall in the interest rate.
 However, the user of an FRA cannot benefit from any favourable movement in the interest rate, because
the FRA fixes the rate and is a binding contract.
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Question 01:
A company knows that it will need to borrow £10 million in three months for a twelve-month period. It can
borrow funds at LIBOR +50 basis points. LIBOR rates today are at 5% but the Company’s treasurer expects
rates to go up to about 6% over the next few weeks. So the treasurer is concerned that the Company will
be forced to borrow at higher rates unless some sort of hedge is transacted to protect the borrowing
requirement.
The treasurer decides to buy a 3-y-15 (‘three fifteens’) FRA to cover the twelve-month period beginning
three months from now. A bank quotes 5½% for the FRA which the Company buys for a notional £10
million.
Three months from now rates have indeed gone up to 6% so the treasurer must borrow funds at 6½% (the
LIBOR rate plus spread). However, the Company will receive a settlement amount.
Required: Results of FRA and effective rate of financing.
Solution 01:
Interest expense paid to the borrowing bank [10 million x 6.5%]
Received from FRA bank
Net cost of borrowing
Effective rate of financing [600,000 / 10 million]
[6% = 5.5% FRA and 0.5% spread]
(650,000)
50,000
(600,000)
6%
Question 02:
A company might wish to borrow £10 million in six months’ time for a three-month period. It can normally
borrow from its bank at LIBOR +0.50%. The current three-month LIBOR rate is 5.25% but the Company is
worried about the risk of a sharp rise in interest rates in the future. A bank quotes FRA rates of:
3-v-9: 5.45% – 5.40%
6-v-9: 5.30% – 5.25%
Required:
a) How should the Company establish a hedge against its interest rate risk using an FRA?
b) Suppose that at settlement date for the FRA, the LIBOR reference rate is fixed at 6.5%. What will be the
effective borrowing rate for the Company?
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Solution 02:
Interest cost [10 million x (6.5% + 0.5%) x 3/12]
Settlement of FRA [10 million x (6.5% - 5.3%) x 3/12]
Net borrowing cost for 3 months
Effective rate [145,000 / 10,000,000 x 12/3]
[5.8% = 5.3% FRA + 0.5% Spread]
(175,000)
30,000
145,000
5.8%
Question 03: ACCA F9 DECEMBER 2015
GXJ Co, whose home currency is the dollar, wishes to borrow €12 million for a period of six months in three
months’ time. The lending bank will fix the interest rate for the loan period at its prevailing lending interest
rate when the loan is taken out.
The finance director of GXJ Co believes this lending interest rate could be a minimum of 3·5% per year or a
maximum of 5·5% per year. Interest on the euro loan would be payable at the end of the loan period.
The finance director of GXJ Co would like to hedge the interest rate risk arising from the future loan and
the company’s bank has offered a 3–9, 4·5%–3·5% forward rate agreement.
Required: Evaluate the proposed forward rate agreement as a way of managing the interest rate risk
anticipated by GXJ Co. (3 marks)
Solution 03:
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
INTEREST RATE FUTURES
An interest rate future is a financial derivative that allows exposure to changes in interest rates, where the
price moves inversely to interest rates. These are futures contracts based on an interest-bearing financial
instrument. Most often, futures are cash-settled. Like many other derivatives, futures contracts can be used
for hedging or speculative purposes.
Prices
The futures price for interest rate futures is the annual interest rate. However, the rate is deducted from 100,
which means that:
 A rate of 4% per year is indicated by a futures price of 96.0000 (100 – 4)
 A rate of 5.2175% is indicated by a futures price of 94.7825
 A price of 93.5618 represents an annual interest rate for the three-month deposit of 6.4382%.
A reason for pricing STIRs in this way is that:
 when interest rates go up, the value of a future will fall, and
 when interest rates fall, the price of the future will rise.
Hedging short-term interest rate exposures with interest rate futures
Interest rate futures can be used to hedge exposures to the risk of a rise or fall in short-term interest rates.
Using short-term interest rate futures is similar to using currency futures to hedge a currency exposure.
However, the following rules need to be applied.
 If the aim is to hedge against the risk of an increase in the short-term interest rate, the hedge is created
by selling futures. If the interest rate does go up, futures prices will fall, and there will be a profit on
the short position in STIRs
 If the aim is to hedge the risk of a fall in the short-term interest rate, the hedge is created by buying
futures. If the interest rate does fall, futures prices will go up.
Interest rate futures are futures for three-month deposits. If a company wishes to hedge an interest rate risk
for a different interest period, such as two months, four months or six months, the number of futures to
create the hedge should be adjusted by a factor: (Interest period to be hedged/3 months).
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Illustration 01:
Global Inc wishes to borrow €9,000,000 for one month starting in 5 weeks’ time. Calculate the number of
contracts required (Note: one 3-months contract is for €1,000,000).
Solution 01:
Number of contracts = (9,000,000/1,000,000 ) × 1/3 = 3
Illustration 02:
It is now the end of July. A company expects to borrow £10.5 million for two months from the end of
October, in three months’ time and is concerned about the risk of a rise in the sterling interest rate. It
decides to hedge the exposure with sterling futures. Each future is for a three-month deposit of £500,000.
Required: Calculate the number of contracts required.
Solution 02:
Number of contracts = (10,500,000/500,000) x (2 months/3 months) = 14 contracts
Illustration 03:
A company will need to borrow 8 million euros from the end of May. It is now January.
The company is concerned about the risk of a rise in the euro interest rate and it wishes to hedge its position
with futures. The current spot euro interest rate is 3.50% (for both three months and six months) and the
current June futures price is the same, 96.50. The value of 1 tick for futures contract is €25 (€1,000,000 ×
0.0001 × 3/12).
Required
 How should the company hedge its interest rate exposure if it plans to borrow the 8 million euros for
three months.
 Suppose that in May when the company borrows the 8 million euros, the three-month and six-month
spot rate is 4.25% and the June futures price is the same, 95.75 (100 – 4.25). Calculate the effective
annual interest rate that the company has secured with its futures hedge if it borrows the 8 million
euros for three months.
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Solution 03:
Illustration 04:
A company will need to borrow 8 million euros from the end of May. It is now January. The company is
concerned about the risk of a rise in the euro interest rate and it wishes to hedge its position with futures.
The current spot rate is 3.50% (for both three months and six months) and the current June futures price is
the same, 96.50. The value of 1 tick for a 433urodol futures contract is: €25 (€1,000,000 × 0.0001 × 3/12).
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Required
 How should the company hedge its interest rate exposure if it plans to borrow the 8 million euros for
six months.
 Suppose that in May when the company borrows the 8 million euros, the three-month and six-month
spot 433urodol rate is 4.25% and the June futures price is the same, 95.75 (100 – 4.25). Calculate the
effective annual interest rate that the company has secured with its futures hedge if it borrows the 8
million euros for six months.
Solution 04:
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Illustration 05:
A UK company will need to borrow £4.75 million for three months from the beginning of September. It is
now April. The company is concerned about the risk of a rise in the LIBOR rate and wishes to hedge its
position with futures. The current spot three-month LIBOR 5.45% and the current futures price is the same,
94.55.
Required: How should a hedge for the interest rate exposure be created, and what will be the effective
interest rate for the loan from September if the spot LIBOR rate is 5.14% in early September and the
September futures price is the same, 94.86? The value of one tick for a ‘short sterling’ future is £12.50
(£500,000 × 0.0001 × 3/12).
Solution 05:
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Illustration 06:
A company will need to borrow US$20 million for three months from the end of October. It is now the end
of June. The company is concerned about the risk of a rise in the US$ LIBOR rate and wishes to hedge its
position with futures. The current spot three-month US$ LIBOR is 4.30% and the current December futures
price is 96.30.
The value of 1 tick for a future is $25 (1,000,000 US$ x 0.0001 x 3/12).
Required: How should a hedge for the interest rate exposure be created, and what will be the effective
interest rate for the loan from October if the spot US$ LIBOR rate is 4.10% and the December futures price
at this date is 96.06?
Solution 06:
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Illustration 07:
A company will need to borrow £60 million for four months from the end of April. It is now the end of
November. The company is concerned about the risk of a rise in the LIBOR rate and wishes to hedge its
position with futures. The current spot three-month LIBOR is 5.50% and the current June sterling interest
rate futures price is 94.85. The company is able to borrow at LIBOR + 0.75%.
One tick is 0.01% and the value of a tick is £6.25. The nominal three-month deposit in a sterling futures
contract is £500,000.
Required
 How should a hedge for the interest rate exposure be created?
 What will be the actual effective cost of borrowing the £60 million at the end of April if LIBOR at that
time is 5.25%?
 What will be the actual effective cost of borrowing the £60 million at the end of April if LIBOR at that
time is 5.75%?
Solution 07:
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
ICAP WINTER 2016 RAMZI CORPORATION: QUESTION
ICAP WINTER 2016 RAMZI CORPORATION: SOLUTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
ICAP SUMMER 2017 JML: QUESTION
ICAP SUMMER 2017 JML: SOLUTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
ICAP SUMMER 2019 ORANGE LIMITED: QUESTION
ICAP SUMMER 2019 ORANGE LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
INTEREST RATE OPTIONS
Interest rate options are financial derivatives that allow investors to hedge or speculate on the directional
moves in interest rates. An interest rate option gives a buyer the time-limited right to take delivery of an
interest rate product at a pre-set rate in the future, in exchange for a premium.
Interest rate options are cash settled, which is the difference between the exercise strike price of the option,
and the exercise settlement value determined by the prevailing spot yield.
Features of interest rate options
An interest rate option grants the buyer of the option the right, but not the obligation, to deal at an agreed
interest rate at a future maturity date. On the date of expiry of the option, the buyer must decide whether
or not to exercise the right.
An interest rate option is an option on a notional loan or deposit (or an option on an interest rate future),
where the loan or deposit period begins:
 On the expiry date for the option for a European-style option; or
 On or before the expiry date for the option, for an American-style option.
The option guarantees a maximum or a minimum rate of interest for the option holder, and interest rate
options are therefore sometimes called interest rate guarantees or IRGs.
 A call option is the right to buy (in this case to receive interest at the specified rate). It guarantees a
maximum rate of interest.
 A put option is the right to sell (that is, the right to pay interest at the specified rate). It guarantees a
minimum rate of interest.
The maximum or minimum rate of interest guaranteed by the option is the strike rate for the option, in
comparison with an agreed benchmark rate of interest, such as LIBOR or euribor.
An interest rate option is for a notional loan or deposit. If it is exercised, an actual loan or deposit is not
created. Instead, the option is ‘cash-settled’ by a payment from the writer of the option to the option holder.
Types of interest rate option
Many interest rate options are arranged over-the-counter (OTC). These include:
 Borrowers’ options and lenders’ options; and
 Caps, floors and collars.
Options on interest rate futures are traded on the futures exchanges where the interest rate futures are also
traded.
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Borrowers’ options
A borrower’s option guarantees a maximum borrowing rate for the option holder. The strike rate for the
option is compared with an agreed reference rate or benchmark interest rate, such as LIBOR.
 It the reference rate of interest is higher than the strike rate when the option reaches expiry, the option
will be exercised. The option writer must make a payment to the option holder for the difference
between the actual interest rate (reference rate) and the strike rate for the option.
 It the reference rate of interest is lower than the strike rate when the option reaches expiry, the option
holder will let the option lapse.
The premium for the option might be expressed either:
 As an actual percentage of the notional principal amount, or
 As an annual rate of interest on the notional principal amount.
A borrower’s option can be used to fix a maximum effective borrowing rate for a future short-term loan,
but allow the option holder to benefit from any fall in the interest rate up to the expiry date for the option.
EXAMPLE: Borrower’s Options
A company intends to borrow US$10 million in four months’ time for a period of three months, but is
concerned about the volatility of the US dollar LIBOR rate.
The three-month US$ LIBOR rate is currently 3.75%, but might go up or down in the next four months.
The company therefore takes out a borrower’s option with a strike rate of 4% for a notional three-month
loan of US$10 million.
The expiry date is in four months’ time. The option premium is the equivalent of 0.5% per annum of the
notional principal. For simplicity, we shall suppose that the company is able to borrow at the US dollar LIBOR
rate.
(a) If the three-month US dollar LIBOR rate is higher than the option strike rate at expiry, the option will be
exercised. If the three-month LIBOR rate is 6%, the company will exercise the option, and the option
writer will pay the option holder an amount equal to the difference between the strike rate for the
option (4%) and the reference rate (6%). The payment will be based on 2% of $10 million for three
months. (This payment is discounted because a borrower’s option is settled at the beginning of the
notional interest period, and not at the end of the interest period).
(b) If the three-month US dollar LIBOR rate is lower than the option strike rate at expiry, the option will not
be exercised. For example, if the LIBOR rate after four months is 3%, the option will not be exercised
and will lapse.
These possible outcomes are summarised in the table below, assuming (for the purpose of illustration) a
spot LIBOR rate at the option expiry date of (a) 6% and (b) 3%.
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
If the borrower can borrow at the reference rate of interest, a borrower’s option sets the maximum
borrowing cost at the strike rate plus the option premium cost.
Lenders’ options
A lender’s option guarantees a minimum deposit rate (savings rate) for the option holder. In all other
respects, it is similar to a borrower’s option. The strike rate for the option is compared with an agreed
reference rate or benchmark interest rate, such as LIBOR.
 If the reference rate of interest is lower than the strike rate when the option reaches expiry, the option
will be exercised. The option writer must make a payment to the option holder for the difference
between the actual interest rate (reference rate) and the strike rate for the option.
 If the reference rate of interest is higher than the strike rate when the option reaches expiry, the option
holder will let the option lapse.
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
ICAP SUMMER 2021 ZEBRA LIMITED: QUESTION
ICAP SUMMER 2021 ZEBRA LIMITED: SOLUTION
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INTEREST RATE RISK MANAGEMENT
Always a mentor | Muzzammil Munaf
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INTEREST RATE RISK MANAGEMENT
Always a mentor | Muzzammil Munaf
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INTEREST RATE RISK MANAGEMENT
Always a mentor | Muzzammil Munaf
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INTEREST RATE RISK MANAGEMENT
Always a mentor | Muzzammil Munaf
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INTEREST RATE RISK MANAGEMENT
ACCA AFM 2020 MARCH BOULLAIN CO: QUESTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
ACCA AFM 2020 MARCH BOULLAIN CO: SOLUTION
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
INTEREST RATE SWAPS
Interest rate swaps (IRS) are the exchange of one set of cash flows for another. Because they trade overthe-counter (OTC), the contracts are between two or more parties according to their desired specifications
and can be customized in many different ways.
The features of an interest rate swap
An interest rate swap is an agreement between two parties, such as a company and a bank that deals in
swaps, for a period of time that is usually several years. Swaps are therefore usually long-term agreements
on interest rates.
In a swap agreement, the parties agree to exchange ‘interest payments’ on a notional amount of principal,
at agreed dates throughout the term of the agreement.
The interest rate payments that are exchanged in a ‘coupon swap’ are as follows:
 One party to the swap pays a fixed rate (the swap rate).
 The other party pays interest at a reference rate or benchmark rate for the interest period, such as
KIBOR.
The purpose of an interest rate swap is to:
 swap a variable rate of interest payment (or receipt) into a fixed interest rate payment (or receipt); or
 swap a fixed rate of interest payment (or receipt) into a variable rate of interest payment (or receipt).
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Example: ’plain-vanilla-swap’
A company arranges a four-year swap with a bank, with the notional principal amount of Rs.20 million under
the following terms:
 The company pays fixed interest on the Rs.20 million every 6m at say, 4.25%
 The bank pays interest on the Rs.20 million every 6m at the six-month KIBOR rate for that period.
The payment dates coincide so the swap payments are simply settled by a net payment for the difference
in rates from one party to the other. There will be eight exchanges of interest payments over the life of the
four-year swap but there is never an exchange of principal).
If the 6m KIBOR rate for a period = 5.00%
The bank pays the company 0.75% interest (5.00% – 4.25%) on Rs.20 million for 6m.
If the 6m KIBOR rate for a period = 3.00%
The company pays the bank 1.25% interest (4.25% - 3.00%) on Rs.20 million for six months.
The payments in a plain vanilla swap are at the end of each notional interest period, therefore the amounts
payable are not discounted (unlike an FRA).
The advantage of using swaps is that a company can alter its net liabilities from fixed to floating rate or
floating to fixed rate, without having to alter or re-negotiate its actual loans or bond issues. For example, a
company with fixed rate bonds can swap from fixed to floating rate liabilities with a swap, without having
to redeem the bonds early and negotiate a floating rate loan with a bank.
Example: Interest rate swap
A company borrows from its bank for five years at KIBOR plus 150 basis points. It wants its interest rate
liabilities to be fixed, so it makes a five-year swap transaction with a bank, in which it pays a fixed rate of
5.8% and receives KIBOR.
As a result of the swap, the company’s net interest obligations are fixed at 7.3%.
Loan payments
(KIBOR + 1.50%)
Swap
Receive the floating
Pay the fixed
Net interest cost
KIBOR
(5.80%)
(7.30%)
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
The effect of a coupon swap
In a coupon swap, one party pays a fixed rate of interest and the other pays ‘the floating’, which is the
variable reference rate of interest, such as six-month KIBOR. For a company with a loan or bonds in issue,
the effect of arranging a swap can therefore be:
 to swap from floating rate liabilities to fixed rate liabilities, or
 to swap from fixed rate interest liabilities to floating rate liabilities.
Example: Floating to fixed interest rate swap
A company has a bank loan of £10 million on which it pays variable rate interest at KIBOR + 1%. The loan
has five more years to maturity. The company is worried about the risk that interest rates will soon rise, and
it wants to set a limit on its interest costs.
It might therefore arrange a five-year swap with a bank, with swap settlemts to coincide with the interest
payments on its bank loan.
The bank might quote rates of 5.34 – 5.39 for a five-year swap in sterling.
Under the SWAP the company will receive the floating rate to offset the floating rate payments on its bank
loan and will pay fixed rate of 5.39%.
The swap therefore alters the net interest payments for the company as follows:
The company had a floating rate liability of KIBOR + 1%, and has now changed this into a net fixed interest
liability of 6.39%.
On each interest payment date, the company will pay KIBOR + 1% in interest on its bank loan, and under
the swap agreement will receive or pay the difference between KIBOR for the period and the fixed rate of
5.39%.
The company might subsequently change its mind. For example, after two years, it might decide that it
wants a floating rate liability again. If so, it can go back to a floating rate liability by arranging with the bank
to cancel the swap and agreeing a cancellation payment (for the value of the swap at the date of
cancellation).
It can be easier to see how a swap works by considering cash flows.
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Fixed to floating
Example: Fixed to floating interest rate swap
A company has 5% bonds in issue with a nominal value of 40 million euros. The bonds have ten more years
to maturity.
The company wants to exchange its fixed rate liability for a floating rate liability in euros. A bank quotes the
following rate for a ten-year swap: 4.22 – 4.25. The company can achieve an effective interest cost by
arranging a swap as follows:
INTEREST RATE SWAP: CREDIT ARBITRAGE
Swaps can be used to obtain a lower interest rate on borrowing. This is possible because banks can identify
opportunities for ‘credit arbitrage’ which arise as a result of differences in the rates of interest at which
different companies can borrow.
When an opportunity for credit arbitrage exists, one of the following situations will occur:
Example: Credit arbitrage – situation 1
Company A wants to borrow at a variable rate of interest and Company B wants to borrow at a fixed rate.
Company A pays higher rates of interest than Company B on both variable and fixed rate borrowing as
follows:
The difference between the fixed borrowing costs of the two companies (0.75%) is less than the difference
between the variable rate borrowing costs (1%). There is a gain of 0.25% available.
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
This can be shown by comparing the difference between A borrowing fixed and B borrowing variable to A
borrowing variable and B borrowing fixed.
Therefore, the companies could save 0.25% between them if A borrows fixed, B borrows variable but they
construct a swap so that A ends up with variable and B ends up with fixed.
Assume that the saving is divided equally giving them 0.125% each. This means that after the swap A’s
variable rate of interest should be KIBOR + 1.375 which is 0.125% less than it would be able to obtain
without the swap. Similarly, B’s fixed rate interest should be 6.375% which is 0.125% less than it would be
able to obtain without the swap.
Setting up the swap
Step 1: Identify the potential saving (if any).
Step 2: Decide on how the saving is to be shared and the expense that should be achieved after the swap.
Step 3: List the interest on the actual borrowings in a column for each company.
Step 4: Write the total interest that should be achieved after the swap for each company as the totals in
the columns.
Step 5: Set one payment under the swap to reduce the recipient’s cost to zero.
Step 6: Set the second payment so as to increase the nil cost of the first recipient to its expected total
expense (see step 2).
Example: Credit arbitrage – situation 2
Company C wants to borrow at a fixed rate of interest and Company D wants to borrow at a variable rate.
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INTEREST RATE RISK MANAGEMENT
Company C pays higher rates of interest than Company D on both variable and fixed rate borrowing as
follows:
The difference between the variable borrowing costs of the two companies (1.0%) is less than the difference
between the fixed borrowing costs (1.25%). There is a gain of 0.25% available.
This can be shown by comparing the difference between C borrowing fixed and D borrowing variable to C
borrowing variable and D borrowing fixed.
Therefore, the companies could save 0.25% between them if C borrows variable, D borrows fixed but they
construct a swap so that C ends up with fixed and D ends up with variable.
Assume that the saving is divided equally giving them 0.125% each. This means that after the swap C’s fixed
rate should be 7.625% which is 0.125% less than it would be able to obtain without the swap.
Similarly, D’s variable rate should be KIBOR + 0.375%which is 0.125% less than it would be able to obtain
without the swap.
The swap is set up as follow:
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Question 01:
Company A can borrow at 13% fixed rate or KIBOR + 4%, whereas Company B can borrow at 12% fixed or
KIBOR + 2%. Company B wishes to borrow at fixed rates whereas Company A wants variable rates. Both the
companies wish to create swap which would benefit both. Any benefits accruing from swap will be shared
by both entities equally.
Required: Calculate the payoffs of swap for both parties.
Solution 01:
Company A
Fixed rate = 13%
Variable rate = K + 4%
Company B
Fixed rate = 12%
Variable rate = K + 2%
WISH: Company A wants 'variable rate'
WISH: Company B wants 'fixed rate'
Case 1:
Rates
Company A
Variable rate = K + 4%
Company B
Fixed rate = 12%
---------->
Total outcome = K + 16%
Case 2:
Rates
Company A
Fixed rate = 13%
Company B
Variable rate = K + 2%
---------->
Total outcome = K + 15%
Saving = 1% (16% - 15%, K = constant)
Cash Flow
Want/Wish
Saving (equally div)
Net
Co. A
Variable
K + 4%
(0.5%)
K + 3.5%
Co. B
Fixed
12%
(0.5%)
11.50%
SWAP (Hedge Setup)
To original bank
From Co A to Co B
From Co B to Co A
Net
Co. A
( 13% )
(K)
9.5%
K + 3.5%
Co. B
(K + 2%)
K
(9.5%)
11.50%
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Question 02:
Shakir Limited wishes to borrow 300 million euros for five years at variable rates to start a project in
Germany. The cheapest rate at which it can borrow is LIBOR + 1%.
The bankers to the Company have suggested to setup a swap arrangement with a German Company, that
is planning to borrow at fixed rate. Finance available to that German Company is 11% or LIBOR + 1.5%.
Shakir Limited can borrow at fixed rates of 9%. Devise a hedge which would benefit both the parties.
Required: Calculate the payoffs of swap for both parties.
Solution 02:
Variable
Fixed
Shakir Limited
L + 1%
9%
German Company
L + 1.5%
11%
Case 1:
WISH
Shakir Limited
Variable rate = L + 1%
German Company
Fixed rate = 11%
---------->
Total outcome = L + 12%
Case 2:
SWAP
Shakir Limited
Fixed rate = 9%
German Company
Variable rate = L + 1.5%
---------->
Total outcome = K + 10.5%
Arbitrage Savings -- 1.5%
Cash Flow
Wish
Saving (equally div)
Net
Shakir
L + 1%
(0.75%)
L + 0.25%
German Co
11%
(0.75%)
10.25%
SWAP (Hedge Setup)
To original bank
From Shakir to German Co
From German Co to Shakir
Shakir
( 9% )
(L)
8.75%
L + 0.25%
German Co
(L + 1.5%)
L
(8.75%)
10.25%
Question 03:
Matured Limited, a manufacturer of tomato ketchup, is in the process of expanding its existing
manufacturing facility in view of a surge in demand in the market. The cost of the new facility is estimated
at Rs 174 million, to be financed by equity and bank borrowings in equal proportion. The borrowing is
available at a fixed mark-up of 10% or at KIBOR + 2.0%.
Another Company, Golden Age Limited, engaged in garment manufacturing, has been awarded a threeyear contract for factory uniforms by a large group of industries. This order requires expansion in facilities,
Always a mentor | Muzzammil Munaf
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INTEREST RATE RISK MANAGEMENT
the cost of which is estimated at Rs 250 million. 70% of the cost is to be financed through equity and 30%
through debt. Negotiations finalised with the bank indicate a fixed mark up of 12.5% or KIBOR + 4.25%.
Required:
a) An investment bank has offered an interest swap arrangement to the two companies. Should the
Companies accept its offer? (06)
b) Assuming that both the companies agree on a swapping arrangement on loans amounting to Rs
75.0 million each and the actual KIBOR for the year is 9.0%, compute the amount that will be paid
by one company to the other. (Assume profit on the swap arrangement is to be shared equally).
Solution 03:
Variable
Fixed
Mature
K + 2%
10%
Case 1:
WISH
Mature
Variable rate = K + 2%
Golden
Fixed rate = 12.5%
---------->
Total outcome = K + 14.5%
Case 2:
SWAP
Mature
Fixed rate = 10%
Golden
Variable rate = K + 4.25%
---------->
Total outcome = K + 14.25%
Arbitrage Savings -- 0.25%
Loan amount
Golden
K + 4.25
12.5%
Mature
87
Wish
Saving (equally div)
Net
SWAP (Hedge Setup)
To original bank
From Mature to Golden
From Golden to Mature
Golden
75 Hedge is always setup on the lower amount
Mature
K + 2%
(0.125%)
K + 1.875%
Golden
13%
(0.125%)
12.375%
Mature
( 10% )
(K)
8.125%
K + 1.875%
Golden
(K + 4.25%)
K
(8.125%)
12.375%
Payment about if K = 9%
Mature to Golden
From Golden to Mature
Net - From Mature to Golden
Loan amount
Net - From Mature to Golden
Always a mentor | Muzzammil Munaf
9%
-8.125%
0.875%
75,000,000
656,250
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
ICAP WINTER 2008 IMRAN LIMITED: QUESTION
Imran Limited wants to borrow Rs. 70 million for two years with interest payable at six monthly intervals.
Due to recent hike in inflation, the company expects that the rate of interest is likely to rise over the next 2
years.
The company can borrow this amount from a local bank at a floating rate of KIBOR plus 2% but wants to
explore the use of swap to protect it from any interest rate increase, during the next two years. Another
bank has offered the company that it will be willing to receive a fixed rate of 11% in exchange for payments
of six-month KIBOR.
Required:
a) Calculate the six-monthly interest payments if the swap arrangement is in place.
b) Calculate the net amount receivable/payable by each party to the swap at the end of the first 6 months
if:
 KIBOR is 13.5%.
 KIBOR is 9%.
ICAP WINTER 2008 IMRAN LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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INTEREST RATE RISK MANAGEMENT
ICAP WINTER 2016 RAMZI CORPORATION: QUESTION
Always a mentor | Muzzammil Munaf
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INTEREST RATE RISK MANAGEMENT
ICAP WINTER 2016 RAMZI CORPORATION: SOLUTION
Always a mentor | Muzzammil Munaf
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INTEREST RATE RISK MANAGEMENT
ICAP WINTER 2018 KS LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
ICAP WINTER 2018 KS LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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INTEREST RATE RISK MANAGEMENT
ICAP WINTER 2021 MULTICORP LIMITED: QUESTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
ICAP WINTER 2021 MULTICORP LIMITED: SOLUTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
ACCA AFM SEPTEMBER 2020 FITZHARRIS CO: QUESTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
ACCA AFM SEPTEMBER 2020 FITZHARRIS CO: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTEREST RATE RISK MANAGEMENT
(b)
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
Contents
INTERNATIONAL INVESTMENT APPRAISAL...................................................................................... 2
FEATURES OF INVESTMENT IN A FOREIGN COUNTRY ............................................................... 2
NPV ANALYSIS FOR FOREIGN PROJECTS ....................................................................................... 6
INTERNATIONAL COST OF CAPITAL ................................................................................................ 7
COUNTRY RISK PREMIUM .................................................................................................................. 8
ICAP SUMMER 2014 MODERN GARMENTS: QUESTION ............................................................. 9
ICAP SUMMER 2014 MODERN GARMENTS: SOLUTION ........................................................... 10
ICAP WINTER 2017 MODERAX: QUESTION ................................................................................. 12
ICAP WINTER 2017 MODERAX: SOLUTION ................................................................................. 13
ICAP SUMMER 2021 QUICKCOOK: QUESTION ............................................................................ 15
ICAP SUMMER 2021 QUICKCOOK: SOLUTION ............................................................................ 17
ACCA AFM 2020 SEPTEMBER COLVIN CO: QUESTION .............................................................. 20
ACCA AFM 2020 SEPTEMBER COLVIN CO: SOLUTION .............................................................. 21
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
INTERNATIONAL INVESTMENT APPRAISAL
FEATURES OF INVESTMENT IN A FOREIGN COUNTRY
The features of investing in a foreign country include the following:
The investment could be a very high-risk investment, and you might be required to establish a special cost
of capital for evaluating the project, possibly using the CAPM and a beta factor for the project.
 Most of the cash flows for the foreign investment will be in the currency of the foreign country,
although some cash flows might be in the currency of the parent company.
 If the foreign country is a developing country, there will probably be expectations of high rates of
inflation in future years. If so, estimated cash flows should be calculated allowing for the expected
inflation rates. (These cash flows including an allowance for inflation should be discounted at the
money cost of capital.)
 If the foreign country is a developing country, there might be restrictions on the amount of payments
that can be made from the foreign country, due to exchange control restrictions. This means that the
cash profits from the project might not be payable immediately in full as dividends to the investing
company.
International DCF appraisal: Market perfection
There are two methods for calculating the NPV of an overseas project. A Pakistani company investing
overseas could either:
 discount the cash flows in the foreign currency using a foreign rate appropriate to that currency, and
then convert the resulting NPV to rupees at the spot exchange rate or
 convert the project cash flows into rupees and then discount at a rupee discount rate.
In conditions of capital market perfection, the two methods would result in the same rupee NPV. This is
because the future spot rates would be linked to the current spot rates by the differential interest rates and
inflation rates inherent in the discount rate.
Future spot rates might be found using interest rate parity, purchasing power parity or the international
Fisher effect.
Example: Foreign investment appraisal





A Pakistani company is considering an investment in a project in Fiji.
The current exchange rate for the Fijian dollar is Rs.50 = $1.
The discount rate for the project in Fiji would be 10%.
The discount rate for similar projects in Pakistan is 8%.
The project requires an initial investment of $100,000 and will lead to cash inflows of $50,000 per
annum for the next three years.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
 The NPV of the project in rupees can be found as follows:
Method 1: Discount the foreign currency cash flows using the foreign currency rate and translate to
rupees at the spot rate
Method 2: Translate the future cash flows in rupees using the future spot rate and then discount
these using the rupee discount rate.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
International DCF appraisal: Market imperfection
In the above example, the two approaches give the same answer. However, this would not be the case if
there were market imperfections, for example exchange controls. Market perfection does not exist in reality
(though markets can be very efficient).
If there are imperfections DCF analysis should be carried out in two stages, and two net present values
should be calculated.
 Stage 1. Calculate an NPV for the project on the basis of cash flows for the subsidiary in the foreign
country. This should be an NPV based on foreign currency cash flows. If the NPV is positive and the risk
seems acceptable, you should proceed to Stage 2.
 Stage 2. Consider the project from the viewpoint of the parent company, and estimate the cash
payments and receipts for the parent company in its own currency. These might include costs incurred
in the parent company’s own country to set up the project. They will also include the dividend or interest
payments received from the foreign subsidiary, in the currency of the parent company. These cash flows
should be discounted at an appropriate cost of capital, which might be different from the cost of capital
used in Stage 1.
The Stage 2 analysis uses different cash flows from the Stage 1 analysis.
 Stage 1 evaluates the cash flows and cash profits in the foreign country.
 Stage 2 evaluates the actual returns received by the parent company.
This approach to evaluating the NPV of a foreign investment therefore involves two separate NPV
calculations:
 Calculating the NPV of the cash flows in the foreign country, at an appropriate cost of capital.
 If this NPV is positive, calculating a different NPV for the estimated cash flows for the project in the
company’s domestic currency, probably using the WACC as the discount rate.
The cash flows in the company’s domestic currency will be different from the cash flows in the currency of
the foreign country for several reasons:
 There may be some costs incurred in the company’s domestic currency and outside the country where
the investment is made. For example, the company’s head office may incur costs in its own currency to
establish the project in the foreign country.
 There may be restrictions on dividend payments and other cash transfers out of the country where the
investment is made.
 The amount paid as dividends from the foreign country will also vary over time with changes in the
foreign exchange rate between the currency of the investment country and the currency of the investing
company.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
The project is financially viable only if both NPVs are positive.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
The project has a positive NPV for the Pakistani company so it should be accepted. Note, that the NPV is
much smaller (at Rs.635,000) than it was under conditions of market perfection (at Rs.1,217,000).
NPV ANALYSIS FOR FOREIGN PROJECTS
NPV Analysis on Projects
Step 1:
Estimate the project's cash flows post-tax in the overseas currency
Step 2:
Step 2:
Convert the company cost of capital to an
overseas equivalent
Convert the flows to home currency
Step 3:
Step 3:
Add any home country cash flows e.g. tax
Use adjusted cpst of capital to find NPV in
overseas currency
Step 4:
Step 4:
Discount the net home country cash flows at
the company cost of capital
Convert the currency into local currency
equivalent
Step 5:
Calculate the NPV
Always a mentor | Muzzammil Munaf
Step 5:
Add in the PV of any additional home country
flows e.g. tax
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
INTERNATIONAL COST OF CAPITAL
CAPM revisited
Evaluation of an investment requires a company to estimate future free cash flows, and discount these cash
flows at an appropriate discount rate.
The appropriate discount rate is the opportunity cost of capital that will prevail over the life of the
investment. Models used to estimate the cost of capital use capital markets as a basis of comparison to find
the appropriate rate.
Investors on the market assess the risk of shares and decide the level of return that they require to
compensate them for that level of risk. They then price the shares accordingly to equate their expectation
of future cash flows from the shares to the return they demand.
The CAPM is based on the recognition of a single source of risk and one risk premium to be charged on a
share. This is the systematic risk which is a measured using the β of the share. The formula for the CAPM is
repeated here for your convenience.
As can be seen above, using the CAPM involves estimating a risk free rate, identifying the market and
identifying the average return on the market. It also involves comparison of a share’s returns to those of
the market in order to identify the β value of the share.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
COUNTRY RISK PREMIUM
Using CAPM to estimate the cost of equity in developing countries is problematic because the beta does
not adequately capture the country risk. To reflect the increased risk associated with investing in a
developing country, a country risk premium is added to the market risk premium when using the CAPM.
The general risk of the developing country is reflected in its sovereign yield spread. This is the difference in
the yields between the developing country’s government bonds (denominated in developed market’s
currency) and treasury bonds of similar maturity.
To estimate the equity risk premium for a country, adjust the sovereign yield spread by the ratio of volatility
between country’s equity market and its government bond market (for bond denominated in the developed
market’s currency). A more volatile equity market increases the country risk premium, all
other things being equal. The revised CAPM equation is stated as follows:
The country risk premium can be calculated as follows:
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
ICAP SUMMER 2014 MODERN GARMENTS: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
ICAP SUMMER 2014 MODERN GARMENTS: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
ICAP WINTER 2017 MODERAX: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
ICAP WINTER 2017 MODERAX: SOLUTION
Always a mentor | Muzzammil Munaf
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
ICAP SUMMER 2021 QUICKCOOK: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
ICAP SUMMER 2021 QUICKCOOK: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
ACCA AFM 2020 SEPTEMBER COLVIN CO: QUESTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
ACCA AFM 2020 SEPTEMBER COLVIN CO: SOLUTION
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
INTERNATIONAL INVESTMENT APPRAISAL
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CREDIT RISK MANAGEMENT
Contents
CREDIT RISK MANAGEMENT ................................................................................................................. 2
COSTS AND BENEFITS OF GIVING CREDIT ..................................................................................... 2
DEBT FACTORS AND INVOICE DISCOUNTING .............................................................................. 7
SETTLEMENT DISCOUNTS ................................................................................................................ 11
ICAP 2019 WINTER AWAM LIMITED: QUESTION ....................................................................... 16
ICAP 2019 WINTER AWAM LIMITED: SOLUTION ....................................................................... 17
ICAP SUMMER 2019 BLUE LIMITED: QUESTION ......................................................................... 19
ICAP SUMMER 2019 BLUE LIMITED: SOLUTION ......................................................................... 20
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CREDIT RISK MANAGEMENT
CREDIT RISK MANAGEMENT
COSTS AND BENEFITS OF GIVING CREDIT
Business entities that sell to other businesses normally sell on agreed credit terms. Often ‘standard’ credit
terms are applied for most business transactions, such as 30 days or 60 days from the date of the invoice.
Most sales to consumers are for cash, but some businesses might even sell to consumers on credit.
Benefits of giving credit
 By giving credit, sales volume will be higher. Higher sales volumes result in higher contribution, and
higher profit.
 If a business does not give credit to customers, customers are likely to buy from competitors who do
offer credit.
Cost of giving credit – There are several costs of giving credit.
 Finance costs: There is a finance cost. Trade receivables must be financed. The longer the period of
credit allowed to customers, the bigger the investment in working capital must be. The cost of investing
in trade receivables is usually calculated as: Average trade receivables in the period × Cost of capital for
the period
 Bad debt costs: Selling on credit creates a risk that the customer might never pay for the goods supplied.
The cost of bad debts is usually measured as the amount of sales revenue due from the customers, that
is written off as non-collectable.
 Administration costs: Additional administration costs might be incurred in negotiating credit terms with
customers, and monitoring the credit position of customers. In dealing with problems about the cost
of trade receivables, you should consider only the incremental administration costs incurred as a
consequence of providing credit.
Example: Cost of giving credit
Green Company currently offers customers 30 days’ credit. Annual credit sales are Rs.12 million, the
contribution/sales ratio is 25% and bad debts are 1% of sales.
The company has estimated that if it increased credit to 60 days, total annual sales would increase by 10%,
but bad debts would rise to 1.5% of sales. The cost of capital for Green Company is 9%.
Assume that a year has 360 days.
Required: Estimate the effect on annual profit of increasing the credit period from 30 to 60 days.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CREDIT RISK MANAGEMENT
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CREDIT RISK MANAGEMENT
Giving credit to customers results in higher costs, in particular higher interest costs and some bad debts.
These costs must be kept under control. To do this, trade receivables must be properly managed.
Good management of trade receivables involves systems for:
 Deciding whether to give customers credit, and how much credit to give them
 Monitoring payments
 Collecting overdue payments.
Giving credit
There should be procedures for deciding whether to give credit to a customer, and if so, how much. The
procedures should differ between existing customers wanting extra credit, and new customers asking for
credit for the first time. This is because existing customers already have a credit history. A company knows
from experience whether an existing customer is likely to pay on time, or might have difficulty with
payments.
When deciding whether or not to give extra credit to an existing customer, the decision can therefore be
based largely on whether the customer has paid promptly in the past, and so whether on the basis of past
performance the customer appears to be a good credit risk.
For new business customers, a variety of credit checks might be carried out.
 Asking for trade references from other suppliers to the customer who already give credit
 Asking for a reference from the customer’s bank
 Making credit checks to discover whether any court judgements have been made against the customer
for non-payment of debts
 Credit checks on small businesses can be purchased from credit reference agencies
 For business customers, asking for a copy of the most recent financial statements and carrying out a
ratio analysis. Banks can usually persuade a business customer to provide a copy of its financial
statements for decisions about granting a bank loan; but it is much more difficult for nonbanks to do
so, for decisions about giving trade credit
 Using reports from the company’s salesmen. If a company sales representative has visited the business
premises of the customer, a report about the apparent condition of the customer’s business might be
used to decide about whether or not to offer credit.
Usually, a company establishes credit policy guidelines that should be followed when giving credit to a new
business customer. For example, a company might have a credit policy that for a new business customer,
subject to a satisfactory credit check, it would be appropriate to offer credit for up to Rs.2,000 for 30 days.
This credit limit might then be reviewed after several months, if the customer pays invoices promptly within
the credit terms.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CREDIT RISK MANAGEMENT
The credit terms set for each customer will consist of:
 A credit period: The customer should be required to pay invoices within a stated number of days. Credit
limits of 30 days or 60 days are common.
 A credit limit: This is the maximum amount of credit that the customer will be permitted. The limit is
likely to be small at first for a new customer, increasing as the trading relationship develops.
 Interest charges on overdue payments: It might also be a condition of giving credit that the customer
agrees to pay interest on any overdue payment. However, interest charges on late payments can create
bad feeling, and customers who are charged interest might take their business to a rival supplier.
Interest charges on late payments are therefore uncommon in practice.
(Note: Credit checks on individuals should be carried out by companies that give credit to customers, such
as banks and credit card companies. Many companies, however, might give credit to corporate customers
but ask for cash payment/credit card payment from individuals.)
Monitoring payments
A company should have a system for monitoring payments of invoices by customers. A regular report should
be produced listing the unpaid debts, and which of these are overdue. This report might be called an aged
debtors list’or aged receivables list.
A typical report might summarise the current position by showing how much money is owed by customers
and for how long the money has been owed. A simple example of a summary is shown below.
The report will also provide a detailed list of the unpaid invoices in each time period. By monitoring regular
reports, the team responsible for collecting payments can decide which customers to ‘chase’ for payment
and also to assess whether collections of receivables is under control. In the example above, if the company
has normal credit terms of 30 days, it might be concerned that such a large amount of receivables – over
Rs.5 million, remain unpaid after 30 days.
Efficient collection of debts
When credit is given to customers, there should be efficient procedures for ensuring that customers pay on
time, and that action is taken to obtain overdue payments. Procedures for efficient debt collection include
the following:
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CREDIT RISK MANAGEMENT
 Sending invoices to customers promptly, as soon as the goods or services have been provided.
 Sending regular statements to credit customers, showing how much they owe in total and how much
is currently due for payment. Statements act as a reminder to customers to make a payment.
 Ensuring that credit terms are not exceeded, and the customer is not allowed to take longer credit or
more credit than agreed.
Procedures for chasing overdue payments include:
 Telephone calls
 Reminder letters
 Taking a decision to withhold further supplies and further credit until an overdue debt is paid.
In extreme cases, measures might include:
 Using the services of a debt collection agency.
 Sending an official letter from a solicitor, threatening legal action.
 Legal action – obtaining a court judgement against the customer to force the customer to pay. This is
a measure of last resort, to be taken only when there is a breakdown in the trading relationship.
Bad debts and reducing bad debts
When a company gives credit, there will be some bad debts. Bad debts are an expense in the income
statement and have a direct impact on profitability. A company should try to minimise its bad debts, whilst
accepting that even with efficient collection procedures some losses are unavoidable. For example some
customers might become insolvent and go out of business still owing money. There are several ways in
which bad debts can be reduced:
 More extensive and careful credit checking procedures when deciding whether to give credit to
customers
 More efficient collection procedures
 Reducing the amount of credit in total. As the total amount of credit given to customers increases, there
will be an increase in the cost of bad debts, and the proportion of receivables that become bad debts.
Reducing the total amount of credit will therefore reduce bad debts. However reducing the amount of
credit to customers will probably result in lower sales revenue and lower gross profit.
Example: Bad debts
A company has annual sales of Rs.20 million and all customers are given credit of 60 days. Gross profit on
sales is 40%. Currently bad debts are 1.5% of sales. The cost of capital for the company is 10%.
Management is concerned about the high level of bad debts and they estimate that by reducing credit
terms to 30 days for all customers, bad debts can be reduced to 0.5% of sales. However total sales revenue
is likely to fall by 5% as a consequence of making the credit terms less generous.
Required: Calculate estimated effect on annual profit of reducing the credit terms from 60 days to 30 days.
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CREDIT RISK MANAGEMENT
DEBT FACTORS AND INVOICE DISCOUNTING
Debt factors and the services they provide
Companies might use a factoring organisation to assist with the management of receivables and also to
help with the financing of receivables.
Debt factors are specialist organisations. They specialise in:
 assisting client firms to administer their trade receivables ledger;
 providing short-term finance to client firms, secured by the trade receivables;
Always a mentor | Muzzammil Munaf
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IQ SCHOOL OF FINANCE
CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CREDIT RISK MANAGEMENT
 in some cases, providing insurance against bad debts.
The services of a debt factor can be particularly useful for a small-to-mediumsized company that:
 has a large number of credit customers;
 does not have efficient debt collection procedures and therefore has a fairly high level of bad debts;
and
 does not have sufficient finance for its working capital.
A debt factor offers three main services to a client business:
 the administration of the client’s trade receivables;
 credit insurance; and
 debt finance.
Trade receivables administration
A factor will take over the administration of trade receivables on behalf of a client. It sends out invoices on
behalf of the client. Each invoice shows that the factor has issued the invoice, and the invoice asks for
payment to be made to a bank account under the control of the factor. The factor collects the payments,
and chases customers who are late with payment. The factor is also responsible for the client’s trade
receivables ledger, recording details of invoices and payments received in the ledger on behalf of the client.
The factor makes a charge for this service, typically an agreed percentage of the value of invoices sent out.
Credit insurance
If the factor is given the task of trade receivables administration, it may also agree (for an additional fee) to
provide insurance against bad debts for the client. This is known as without recourse factoring or nonrecourse factoring. If a customer of the client fails to pay an invoice that was issued by the factor, the factor
will accept the bad debt loss itself, and the factor will pay the client the full amount of the unpaid invoice.
A factor will only provide without recourse factoring for invoices that are approved in advance by the factor.
This is to prevent the client from giving credit to highrisk customers and exposing the factor to the risk of
bad debts.
However, factors also provide with recourse factoring. With this type of arrangement, if a customer of the
client fails to pay an invoice, the factor will not pay anything to the client, and the client must suffer the bad
debt loss. (If the factor has already made a payment to the client against the security of the receivable, the
client must repay the money it has received.)
Debt finance
The factor will provide advances of up to 80% of the face value of the client’s trade receivables, for all
receivables that are approved by the factor. The finance is provided at an agreed rate of interest, and is
Always a mentor | Muzzammil Munaf
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CREDIT RISK MANAGEMENT
repayable when the customers’ invoices are eventually paid. In effect, this means that when a customer pays
the factor will remit the remaining 20% of the money to the client, less the interest (and other fees).
The costs of factoring services
The costs of a factoring service might therefore consist of:
 a service fee for the administration and collection of trade receivables;
 a commission charge, based on the total amount of trade receivables, for a non-recourse factoring
service; and
 interest charges for finance advanced against the trade receivables.
Benefits and disadvantages of using a factor
 There should be savings in internal administration costs, because the factor administers the trade
receivables ledger.
 With non-recourse factoring, there is a reduction in the cost of bad debts.
 A factor is a source of finance for trade receivables.
The disadvantages of using a factor are as follows.
 Interest charges on factor finance are likely to be higher than other sources of finance.
 Effect on customer goodwill. The factor is unlikely to treat the client’s customers with the same degree
of care and consideration that the client’s own sales ledger administration team would.
 The client’s reputation may be affected by the need to use a factor. Customers might believe that using
a factor is a sign of financial weakness.
Evaluation of a factor’s services
To assess the cost of using the services of a factor, you need to compare the total costs of the alternative
policies. As indicated above, the costs you will probably need to consider are:
 Costs of receivables ledger administration
 Costs of bad debts
 Financing costs for trade receivables.
Example: Debt factoring
Blue Company has annual credit sales of Rs. 1,000,000. Credit customers take 45 days to pay. Bad debts are
2% of sales. The company finances its trade receivables with a bank overdraft, on which interest is payable
at an annual rate of 15%.
A factor has offered to take over administration of the receivables ledger and collections for a fee of 2.5%
of the credit sales. This will be a non-recourse factoring service. It has also guaranteed to reduce the
payment period to 30 days. It will provide finance for 80% of the trade receivables, at an interest cost of 8%
per year.
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CREDIT RISK MANAGEMENT
Blue Company estimates that by using the factor, it will save administration costs of Rs.8,000 per year.
Required
What would be the effect on annual profits if Blue Company decides to use the factor’s services? (Assume
a 365-day year).
Invoice discounting
Invoice discounting is similar to the provision of finance by a factor. A difference is that whereas a factor
provides finance against the security of all approved invoices of the client, an invoice discounter might
provide finance against only a small number of selected invoices.
Another difference between a debt factor and an invoice discounter is that the invoice discounter will only
provide finance services. An invoice discounter will not administer the trade receivables ledger or provide
protection against the risk of bad debt. The invoice to the customer is sent out by the client firm, and
payment is collected by the client firm (and paid into a special bank account set up for the purpose).
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CREDIT RISK MANAGEMENT
Steps in invoice discounting
The company issues an invoice to a customer for the stated amount The invoice is then discounted with the
discounter resulting in the company receiving an agreed percentage of the invoice value. The discounter
collects the cash from the customer and returns the remaining balance (after deduction of the amount
advanced and the interest cost) to the company.
Example - Invoice discounting: A company might need to arrange finance for an invoice for Rs.3 million
to a customer, for which the agreed credit period is 90 days. An invoice discounter might be prepared to
finance 80% of the invoiced amount, at an interest rate of 10%.
The company will issue the invoice to the customer for Rs.3 million. The invoice discounter provides the
company with a payment of Rs.2.4 million (80% of Rs.3 million). After 90 days, the invoice discounter will
expect repayment of the Rs.2.4 million advance, plus interest of Rs.59,178.
If the customer pays promptly, this repayment will be made out of the Rs.3 million invoice payment by the
customer. The invoice discounter will take Rs.2,459,178 and the remaining Rs.540,822 will go to the
company.
SETTLEMENT DISCOUNTS
The nature and purpose of settlement discounts: The cost of financing trade receivables can be high.
More important perhaps, if a company has a large investment in trade receivables, it might have cash flow
problems and liquidity difficulties.
A company might therefore try to minimise its investment in trade receivables. One way of doing this is to
ensure that collection procedures are efficient. Another policy for reducing trade receivables is to offer a
discount for early payment of an invoice. This type of discount is called a settlement discount (or early
settlement discount, or cash discount).
For example, a company might offer its customers normal credit terms of 60 days, but a discount of 2% for
payment within ten days of the invoice date. If customers take the discount, there will be a reduction in
average trade receivables.
Evaluating a settlement discount: The benefit of a settlement discount is that it reduces average trade
receivables, and this reduces the annual interest cost of investing in trade receivables. On the other hand,
the discounts taken by customers reduce annual profit.
Evaluating a proposal to offer settlement discounts to customers therefore involves comparing the
improvements in cash flow and reductions in interest cost with the cost of the discounts allowed.
The implied interest cost of settlement discounts
One way of evaluating a settlement discount is to calculate the implied interest cost of offering settlement
discounts.
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CREDIT RISK MANAGEMENT
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CREDIT RISK MANAGEMENT
The cost calculated above is the cost associated with a 50 day period. The annual cost can be estimated in
one of two ways:
 as a straight multiple; or
 as an equivalent period rate
Annualised interest cost of settlement discounts as a straight multiple
The implied interest cost is multiplied by the number of times the length in the reduction of the payment
period fits into a year.
Annualised interest cost of settlement discounts as an equivalent period rate
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CREDIT RISK MANAGEMENT
Calculating the total annual costs
An alternative method of calculating the cost of settlement discounts, compared with a policy of not offering
discounts, would be to compare the total annual costs with each policy.
Example: Entity X borrows on overdraft at an annual interest rate of 15%. It has annual credit sales of Rs.5
million, and all customers buy on credit. Customers are normally required to pay within 45 days. Entity X
offers a 1.5% discount if payment is made within ten days. 60% of customers take the discount. What is the
annual cost of the discount policy?
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CREDIT RISK MANAGEMENT
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CREDIT RISK MANAGEMENT
ICAP 2019 WINTER AWAM LIMITED: QUESTION
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BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
CREDIT RISK MANAGEMENT
ICAP 2019 WINTER AWAM LIMITED: SOLUTION
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CREDIT RISK MANAGEMENT
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CREDIT RISK MANAGEMENT
ICAP SUMMER 2019 BLUE LIMITED: QUESTION
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CREDIT RISK MANAGEMENT
ICAP SUMMER 2019 BLUE LIMITED: SOLUTION
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CREDIT RISK MANAGEMENT
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CFAP 04 – BUSINESS FINANCE DECISIONS
BY MUZZAMMIL MUNAF | ACA | ADVISOR | TRAINER |
LIQUIDITY RISK MANAGEMENT
Contents
LIQUIDUITY RISK MANAGEMENT ........................................................................................................ 2
LIQUIDITY ............................................................................................................................................... 2
THE LENGTH OF CASH OPERATING CYCLE .................................................................................... 5
ANALYSING THE CASH OPERATING CYCLE ................................................................................... 8
ACCA F9 JUNE 2017 PANGI CO: QUESTION ................................................................................... 9
ACCA F9 JUNE 2017 PANGI CO: SOLUTION ................................................................................. 10
ACCA F9 2013 JUNE TGA CO: QUESTION ..................................................................................... 11
ACCA F9 2013 JUNE TGA CO: SOLUTION ..................................................................................... 12
CASH FLOW FORECASTS................................................................................................................... 13
ICAP SUMMER 2021 CRAFT FURNITURE: QUESTION ................................................................ 15
ICAP SUMMER 2021 CRAFT FURNITURE: SOLUTION ................................................................ 17
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LIQUIDITY RISK MANAGEMENT
LIQUIDUITY RISK MANAGEMENT
LIQUIDITY
Liquidity for an entity means having access to sufficient cash to meet all payment obligations when they fall
due. The main sources of liquidity for a business are:
 Cash flows from operations: a business expects to make its payments for operating expenditures out of
the cash that it receives from operations.
 Cash comes in when customers eventually pay what they owe (and from cash sales).
 Holding ‘liquid assets’: these are assets that are either in the form of cash already (money in a bank
account) or are in the form of investments that can be sold quickly and easily for their fair market value.
 Access to a ‘committed’ borrowing facility from a bank (a ‘revolving credit facility’). Large companies
are often able to negotiate an arrangement with a bank whereby they can obtain additional finance
whenever they need it.
A key element of managing working capital is to make sure the organisation has sufficient liquidity to meet
its payment commitments as they fall due. Having sufficient liquidity is a key to survival in business. If there
is insufficient liquidity, then even if the entity is making profits, it will go out of business.
If the entity cannot pay what it owes when the payment is due, legal action will probably be taken to recover
the unpaid money and the entity will be put into liquidation. In practice, banks are usually the unpaid
creditors who put illiquid entities into liquidation.
The liquidity of a business entity can be assessed by analysing:
 Its liquidity ratios; and
 The length of its cash operating cycle.
Liquidity ratios
A liquidity ratio is used to assess the liquidity of a business. There are two liquidity ratios:
Formula: Current ratio
Current ratio = Current assets / Current liabilities
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LIQUIDITY RISK MANAGEMENT
Key assumptions and aspects of the current ratio




Focuses on 12 months horizon (does not deal with immediate liquidity).
Assumes all current assets can be liquidated in 12 months.
It is assumed that inventory will be converted into cash within 12 months.
Affected by maturity mismatch problem (Liabilities due in 12 months maturing before the assets
realising in 12 months)
Formula: Quick ratio
Quick ratio = Current assets excluding inventory / Current liabilities
Key assumptions and aspects of the quick ratio
 Focuses on 12 months horizon (does not deal with immediate liquidity).
 Assumes all current assets can be liquidated (except inventories in all forms) in 12 months.
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THE LENGTH OF CASH OPERATING CYCLE
There are three main elements in the cash operating cycle:
 The average length of time that inventory is held before it is used or sold
 The average credit period taken from suppliers
 The average length of credit period taken by (or given to) credit customers.
A cash cycle or operating cycle is measured as follows.
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Calculating the inventory turnover period
For a company in the retail sector or service sector of industry, the average inventory turnover period is
normally calculated as follows:
Calculating the average collection period
The average period for collection of receivables can be calculated as follows:
Calculating the average payables period
The average period of credit taken from suppliers before payment of trade payables can be calculated as
follows:
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LIQUIDITY RISK MANAGEMENT
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ANALYSING THE CASH OPERATING CYCLE
The cash operating cycle can be analysed to assess whether the total investment in working capital is too
large or possibly too small. The analysis can be made by comparing each element of the cash operating
cycle, and the cash operating cycle as a whole, with:
 the cash operating cycle of other companies in the same industry
 the company’s own cash operating cycle in previous years, to establish whether it is getting longer or
shorter.
Comparisons with other companies in the industry
As a general rule, the inventory turnover period, average collection period and average payment period
should be about the same for all companies operating in the same industry. If there are differences, there
might be reasons. For example a company with an unusually large proportion of sales to other countries
might have a longer average collection period because of the longer time that it takes to deliver goods to
customers.
If it is not possible to explain significant differences in any ratio between a company’s own turnover periods
and the industry average, the differences might be due to inefficient working capital management (or
possibly efficient management). For example an unusually long inventory turnover period compared with
the industry average might indicate inefficiency due to excessive holding of inventory. Slow-moving
inventory might also indicate that a write off of obsolete inventory might be necessary at some time in the
near future.
Comparisons with previous years: trends
There might be a noticeable trend over time in a company’s turnover ratios from one year to the next. A
trend towards longer or shorter turnover and cycle times should be investigated.
A particular cause for concern might be a trend towards longer inventory turnover periods and longer
average collection times, which might be an indication of excessive inventories (inefficient inventory
management) or inefficient collection procedures for trade payables.
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ACCA F9 JUNE 2017 PANGI CO: QUESTION
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ACCA F9 JUNE 2017 PANGI CO: SOLUTION
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LIQUIDITY RISK MANAGEMENT
ACCA F9 2013 JUNE TGA CO: QUESTION
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ACCA F9 2013 JUNE TGA CO: SOLUTION
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CASH FLOW FORECASTS
Cash flow forecasts, like cash budgets, are used to predict future cash requirements, or future cash surpluses.
However, unlike cash budgets:
 They are prepared throughout the financial year, and are not a part of a formal budget plan
 They are often prepared in much less detail than a cash budget.
The main objectives of cash flow forecasting, like the purposes of a cash budget, are to:
 Make sure that the entity is still expected to have sufficient cash to meet its payment commitments as
they fall due.
 Identify periods when there will be a shortfall in cash resources, so that financing can be arranged
 Identify whether there will be a surplus of cash, so that the surplus can be invested
 Assess whether operating activities are generating the cash that is expected from them.
The main focus of cash flow forecasting is likely to be operating cash flows, although some investing and
financing cash flows might also be significant.
Techniques for preparing a cash flow forecast
There are no rules about how to prepare a cash flow forecast. A forecast need not be in the same amount
of detail as a cash budget. However there are two basic approaches that might be used:
 Producing a cash flow forecast similar to a statement of cash flows prepared using the indirect method
 Forecasting cash flows by estimating revenues and costs to arrive at an estimate of earnings before
interest, tax and depreciation (EBITDA).
Cash flow statement approach
One way of preparing a cash flow forecast for a period of time is to produce a statement similar to a
statement of cash flows in financial reporting. The general structure of the forecast will therefore be as
follows:
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LIQUIDITY RISK MANAGEMENT
ICAP SUMMER 2021 CRAFT FURNITURE: QUESTION
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ICAP SUMMER 2021 CRAFT FURNITURE: SOLUTION
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