AFM - NOTES By Mr. ASAD EJAZ (Association of Chartered Certified Accountants) www.ACCAGlobalBox.com Downloaded from - www.ACCAGlobalBox.com Asad Ejaz ACA, FCCA, Adv Dip MA CIMA, CISA, APFA. AFM Advanced Financial Management AFM: Advanced Financial Management Study Notes Table of Content S No. 1 2 3 4 5 6 7 8 9 10 11 12 Content Basic of Investment Appraisal Cost of Capital Advanced Investment Appraisal International Investment Appraisal Acquisition and Merger Financial Reconstruction Business Reorganization Risk Management-Currency Risk Management-Interest Black Scholes and Real options Dividends Maths & Formula Tables ( www.ACCAGlobalBox.com ) Page No. 1 17 34 44 53 72 78 83 94 101 105 107 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes The Investment Appraisal Capital Budgeting Cycle Steps Idea Generation ➢ Project Screening ➢ Financial & Non-financial Evaluation ➢ Approval ➢ Implementation ➢ Ongoing Monitoring ➢ Post Completion Audit C IM A, C IS A, AP FA ) ➢ A Financial Evaluation Methods Advanced Methods M Basic Methods ❖ Net Present Value NPV ❖ Internal Rate of Return (IRR) ❖ Discounted Payback Period .D ip ❖ Payback Period Ad v Cash flows Relevant Cash flows ➢ ➢ ➢ ➢ ➢ Sunk Cost/ Historical Cost Non-cash Depreciation Indirect Costs General Overheads Central Office Overheads (A C A, F C C A, ➢ Future Incremental Cash flows ➢ Opportunity Cost Irrelevant Cash flows az Assumptions of Cashflows As ad Ej ➢ If Cash flows arise during the period, then it is assumed as it arises at the end of that period. ➢ If cash flow arise at the start of the period then it is assumed as if it arises at the end of the preceding period ➢ Period ‘0’ is not a period, instead it represents start of period ‘1’. Payback Period It is the time period required to recover the initial investment SKANS School of Accountancy 1 AFM: Advanced Financial Management Study Notes Decision rule If Payback Period < Target Payback, Accept the Project. Else Reject the Project ) ILUSTRATION 1 M A C IM Cash flows Yr 1 50 Yr 2 40 Yr 3 30 Yr 4 25 Yr 5 20 Residual value Yr 5 5 The cost of capital is 10%. And the target ARR is 20% IS A, Initial investment A, C A ($000s) (100) AP FA Rough Ltd has the opportunity to invest in an investment with the following initial costs and returns: .D ip Company uses the straight line method for depreciation.Required: Ad v Using the data of ILUSTRATION 1, Calculate the Payback Period? As ad Ej az (A C A, F C C A, Solution SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 2 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Payback Period of Consistent Cashflows Consistent cashflows are cashflows that arises in the series of same cashflows over a period. In case of constant cashflows payback period can be estimated by the formula FA ) 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 AP Key Advantages & Disadvantages Disadvantages 1. It is simple to use (calculate) and 1. It does not give a measure of return, as such it can only be used in addition to other investment appraisal methods. A, C 2. It does not normally consider the impact of discounted cash flow although a discounted payback may be calculated (see later). M A first screening device to identify projects which are worthy of further investigation. IM 2. The method is often used as the C easy to understand IS A, Advantages A, Ad v .D ip 3. It only considers cash flow up to the payback, any cash flows beyond that point are ignored. C C DISCOUNTED CASH FLOW (A C A, F The application of the idea that there is a TIME VALUE OF MONEY. What this means is that money received today will have more worth than the same amount received at some point in the future. Ej az Why would you rather have $1,000 now rather than in one year’s time? $1,000 Now ≠ $1,000 1 year Later As ad Therefore, we can express Present Values in terms of Future Values using the following formula of Compounding: FV = PV × (1 + r)n Where PV - Present value. SKANS School of Accountancy 3 AFM: Advanced Financial Management FV rn - Study Notes Future value. Rate of Discount, interest or cost of capital per period. Number of periods (years) AP FA ) The opposite of compounding, where we have the future value (eg an expected cash inflow in a future year) and we wish to consider its value in present value terms. 𝐹𝑉 + r)n Or PV = FV × (1 + r)-n .D ip M A C IM A, C 𝑃𝑣 = (1 IS A, Revising the formula Net Present Values (NPV) Ad v The NPV of the project is the sum of the PVs of all cashflows that arise as a result of doing the project. A, Decision Rule:- Required: (A C ILUSTRATION 2 A, F C C If NPV of the project, discounted at cost of capital, is positive then Accept the project, Else Reject the Project. As ad Ej az Using the data of ILUSTRATION 1, Calculate the NPV of the Project? SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 4 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Ad v Key Advantages & Disadvantages .D ip M A C IM A, C IS A, AP FA ) Solution Advantages project with a positive NPV increases the wealth of the company’s, thus maximise the shareholders wealth. A, F C C A, 1. A (A C 2. Takes into account the time value 1. Non-financial managers may have difficulty understanding the concept. 2. The speed of repayment of the original investment is not highlighted. Ej az of money. Disadvantages ad Internal Rate of Return (IRR) As IRR is the total rate of return offered by an investment over its life. Calculative, The rate of return at which the NPV equals zero. Formula to calculate 𝐴 𝐼𝑅𝑅 = 𝑎% + [𝐴−𝐵 𝑋(𝑏 − 𝑎)] % Where: SKANS School of Accountancy 5 AFM: Advanced Financial Management a%Ab%B- Study Notes Small Disc. Rate at which NPV is Preferably positive NPV at a% Bigger Disc. Rate at which NPV is Preferably negative NPV at b% ) Decision Rule FA If IRR of the project > Cost of capital, Accept the project. Else Reject the Project AP ILUSTRATION 4 Required: A, C IS A, Using the data of ILUSTRATION 1 and assuming the NPV at 10% is $34,000 , Calculate the IRR of the Project? (A C A, F C C A, Ad v .D ip M A C IM Solution Key Advantages & Disadvantages Disadvantages az Advantages Ej 1. More easily understood than NPV As ad by non-accountant being a percentage return on investment. 1. Does not indicate the size of the investment, thus the risk involve in the investment. 2. It Assumes that the Cashflows will be reinvested at the rate of IRR 3. It can give conflicting signals with mutually exclusive project. SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 6 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes 4. If a project has irregular cash flows there is more than one IRR for that project (multiple IRRs). FA ) Discounted Payback Period AP The time period in which initial investment is recovered in terms of present value is known as discounted payback period. IS A, It is same as simple payback period. The only difference is that the discounted cash flows are used instead of simple cash flows for calculation. IM A, C Decision Rule If Discounted Payback Period < Target Discounted Payback, Accept the Project. Else Reject the Project C ILUSTRATION 5 A Required: .D ip M Using the data of ILUSTRATION 1, Calculate the Discounted payback of the Project? As ad Ej az (A C A, F C C A, Ad v Solution SKANS School of Accountancy 7 AFM: Advanced Financial Management Study Notes Consistent Cashflows FA ) If Cashflows arises in a series of equal cashflows then it is called Consistent Cashflows. These are of two Types: Perpetuity: If Consistent cashflow for infinite period e.g. Y1-∞ or Y3-∞ 𝟏−(1 + r)-n 𝒓 A, C The Annuity Factor (A.F) = IS A, Present Values of Consistent Cashflows AP Annuity: If Consistent cashflow for a certain Period. e.g Y1-5 or Y3-7 𝟏 Perpetuity C Annuity IM The Perpetuity Factor (P.F) = 𝒓 A If Cashflows Start from Period 1. Annual Cashflow X P.F e.g. Y1-∞ $10,000 at Disc. Rate of 10% $10,000 X (1/10%) = $100,000 Ad v .D ip M Annual Cashflow X A.F e.g. Y1-5 $10,000 at Disc. Rate of 10% $10,000 X 3.791 =$37,910 If Cashflows Start from Period 0. C A, Annual Cashflow X (A.F + 1) Annual Cashflow X (P.F + 1) e.g. Y0-5 $10,000 at Disc. Rate of 10% e.g. Y0-∞ $10,000 at Disc. Rate of 10% $10,000 X (3.791+1) =$47,910 $10,000 X ((1/10%)+1) = $110,000 If Cashflows Start from Subsequent Period e.g. Year 3. Annual Cashflow X P.F X preceding period from Start D.F of e.g. Y4-∞ $10,000 at Disc. Rate of 10% $10,000 X (1/10%) X 0.751 = $75,100 As ad Ej az (A C A, F C Annual Cashflow X A.F of No. of periods X D.F of preceding period from Start e.g.Y4-8 $10,000 at Disc Rate of 10% $10,000 X 3.791 X 0.751 =$28,470 SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 8 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Performa for Net Present Value 2 3 4 Sales X X X X Variable Cost (X) (X) (X) Incremental Fixed Cost (X) (X) Operating Cashflows X X Tax Expense (X) (X) Tax Savings on Capital Allowances X (X) Ad v Net Cash flows FA AP X (X) (X) X X (X) (X) (X) X X X X X X X X X X (X) X X X X C C X As ad Ej az (A C A, F X (X) A, X Discount Factor Net Present Value IS A, (X) Scrap Value Present Values X .D ip Initial Investment (X) A, C Working C in SKANS School of Accountancy (X) (X) X A Change Capital ) 1 IM 0 M Years 9 AFM: Advanced Financial Management Study Notes The Finance Cost The Finance Cost will be a relevant cashflow however it will NOT become the part of cashflows. This is because it is part of cost of capital. FA ) Effect of Taxation in investment appraisal A, C IS A, AP ➢ Timing of Tax Cashflows: Either in the same year or in arrears. ➢ Calculation of cashflows o Tax on Operating Cashflows: Operational Cashflows X Rate of Tax o Tax Savings on Capital Allowances: Calculate the capital Allowances/ Balancing Allowances and then multiply with Tax Rate. Initial Investment = 2000 A C Capital Allowances = 25% reducing balance IM Example Years Written Down Value 1 2000 Ad v Tax Savings @ 30% Timing 500 150 2 2 1500 375 113 3 3 1125 281 84 4 4 844 344 103 5 A, F C C Capital Allowances @ 25% A, .D ip M Useful life = 4 years, Tax rate = 30% payable in arrears, Scrap Value = 500 (A C Effect of Inflation in investment appraisal: az Inflation may be defined as a general increase in prices, leading to general decline in the real value of money, (decrease in purchasing power). Ej ➢ Real Rate of Return (r): Without inflation rate As ad ➢ Money/ Nominal Rate of Return (m): With Inflation rate ➢ General Inflation (i) The relationship between real and money interest is given below (also see tables) (1 + m) = (1 + r) (1 + i) SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 10 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes If General inflation rate is If Specific inflation rate is Real Method Money Inflate all Cash flows with general inflation rate. Discount these cash flows with Do not inflate Cash flows. Discount all Cash flows with real discount Inflate each variable cash flow with its specific inflation rate. Discount with money cost of capital (calculated through real rate and general inflation rate. .D ip M A C IM A, C IS A, AP FA ) Money As ad Ej az (A C A, F C C A, Ad v preferred Method SKANS School of Accountancy 11 AFM: Advanced Financial Management Study Notes Nominal Operational Cashflow = Real Operational Cashflows X ( 1+ i)n Sometimes Examiners gives the value in year 1 terms instead of current prices terms then AP FA ) Nominal Operational Cashflow = Real Operational Cashflows ( 1+ i)n-1 Working Capital Change IS A, Every business requires working capital for its operations. A, C Calculate working capital change in two steps: IM 1. Calculate working capital requirement one year in advance e.g. working capital is 10% of sales at the start of each year A C 2. Calculate incremental working capital by taking change of each year working capital M 3. In last year, there will be an assumption that all working capital will be .D ip recovered (Only for project and not for ongoing business) ILUSTRATION 5 Ad v A company is considering to invest in a project with its life of 4 years. Total working capital required at the beginning of each year is as follows: C A, Year A, F C 1 2 (A C 3 $’000 500 700 1000 600 az 4 Cashflows Ej Required: As ad Calculate the working capital cashflows of each year to be included in NPV calculation? Solution SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 12 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Capital rationing A limit on the level of funding available to a business, there are two types FA ) ➢ Hard capital rationing ➢ Soft Capital rationing AP Hard capital rationing Externally imposed. Usually by banks Wider economic factors (e.g. a credit crunch) 2. Company specific factors (b) No track record (c) Poor management team. C Lack of asset security M A (a) IM A, C 1. IS A, Due to: .D ip Soft capital rationing Internally imposed by senior management. Ad v Issue: Contrary to the rational aim of a business which is to maximise shareholders’ wealth (i.e. to take all projects with a positive NPV) Reasons: Wish to concentrate on relatively few projects 2. Unwillingness to take on external funds 3. Only a willingness to concentrate on strongly profitable projects A, F C C A, 1. Single period capital rationing (A C i.e. available finance is only in short supply during the current period, but will become freely available in subsequent periods. Ej az Assumptions of Single Period Capital Rationing ➢ All projects are divisible As ad ➢ Projects will be lost if not undertaken in current year (can not be postponed) ➢ The risk & uncertainty and strategic importance of all projects is same Divisible – An entire project or any fraction of that project may be undertaken. Projects displaying the highest profitability indices (i.e. NPV/Initial Investment) will be preferred. SKANS School of Accountancy 13 AFM: Advanced Financial Management Study Notes Indivisible – An entire project must be undertaken, since it is impossible to accept part of a project only. In this event different combination of projects are assessed with their NPV and the combination with the highest NPV is chosen. Steps for divisible project IS A, AP FA ) 1. Calculate the NPV of each Investment 2. Calculate the Profitability indices 3. Ranking 4. Investment Plan A, C Note: In case of Mutually exclusive Projects, the project with the Higher Profitability Indices will be ranked and lower will be ignored. Investment NPV A 1,000 500 B 1,200 700 C 800 D 700 C 0.58 2ND 300 0.375 4TH 450 0.642 1ST Ad v M A 3rd Investment NPV 700 450 B 1,200 700 A 600 300 Total 2,500 1,450 Ej az (A C D A, F Project C C The Investment Schedule 0.5 A, Available Funds – $ 2,500 PI Ranking (NPV/Investment) IM Project .D ip Example – Divisible ad We will do Project D and B complete and Project A 60%. As Example – Non-Divisible Project Investment NPV A 1,000 500 B 1,200 700 SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 14 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes C 800 300 D 700 450 Total Investment Total NPV A,B 2,200 1,200 A,C,D 2,500 1,250 B,C 2,000 1,000 B,D 1,900 1,150 IS A, AP FA Projects Combination ) Available Funds – $ 2,500 IM A, C We will choose combination of A,C,D because it’s gives the best NPV of $1,250 C Multi-Period Capital Rationing .D ip M A You will remember that when there is limited capital in only one year (singleperiod capital rationing) then we rank the projects based on the NPV per $ invested (the profitability index). C C Sensitivity Analysis A, Ad v However, it is more likely in practice that investment is needed in more than one year and that capital is rationed also in more than one year. This situation is known as multi-period capital rationing and the solution requires using linear programming techniques. A, F A technique that considers a single variable at a time and identifies by how much that variable has to change for the decision to change (from accept to reject). 𝑆𝑒𝑛𝑠𝑒𝑡𝑖𝑣𝑖𝑡𝑦 (%) = 𝑁𝑃𝑉 𝑋 100% 𝑃𝑉 𝑜𝑓 𝑎𝑟𝑒𝑎 𝑜𝑓 𝑠𝑒𝑛𝑠𝑡𝑖𝑣𝑖𝑡𝑦 Ej az (A C Formula to calculate sensitivity of a particular cashflow: - As ad Formula to calculate sensitivity of cost of capital:𝑆𝑒𝑛𝑠𝑒𝑡𝑖𝑣𝑖𝑡𝑦 (%) = SKANS School of Accountancy 𝐼𝑅𝑅 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑋 100% 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 15 AFM: Advanced Financial Management Study Notes As ad Ej az (A C A, F C C A, Ad v .D ip M A C IM A, C IS A, AP FA ) It indicates which variables may impact most upon the net present value (critical variables) and the extent to which those variables may change before the investment results in a negative NPV SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 16 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes The Cost of Capital Risk and Return FA ) The relationship between risk and return is easy to see, the higher the risk, the higher the required to cover that risk. AP Overall Return IS A, A combination of two elements determine the return required by an investor for a given financial instrument. A, C Risk-free return – The level of return expected of an investment with zero risk to the investor. M A C IM Risk premium – The amount of return required above and beyond the risk-free rate for an investor to be willing to invest in the company investor to be willing to invest in the company .D ip Degree of Risk High Risk C UnSecured Preference Shares Ordinary Shares (A C The WACC Secured Loans A, F Government Debt C A, Ad v Risk Free Ej az Weighted Average Cost of Capital (WACC) Cost of Equity (Ke) Cost of Debt (Kd) Cost of Preference (Kp) As ad Cost of equity: the rate of return that is expected by the equity holders of the company. The symbol used to represent cost of equity is Ke. Cost of debt: this is the after-tax return expected by the debt holders of the company. The symbol used to represent after-tax cost of debt is Kd(1 – t). Cost of preference shares: the return expected by the preference shareholders of the company. The symbol used to represent cost of preference shares is Kp Cost of Equity This may be calculated in one of two ways: SKANS School of Accountancy 17 AFM: Advanced Financial Management Study Notes 1. Dividend Valuation Model (DVM). 2. Capital Asset Pricing Model (CAPM). ) Dividend Valuation Model 𝑑𝑑 𝐾𝐾𝑒𝑒 = 𝑃𝑃1 + 𝑔𝑔 FA 0 A, C IS A, AP Where, D1 = next year dividend = Do (1 + g) Po = Current Ex-market value of equity share g = sustainable growth rate Difference between cum dividend and ex dividend price Ex-dividend price (P0) is the market price excluding dividend and cum-dividend price is the market price including dividend. Cum-Dividend Price IM Less: Dividend C Ex-Dividend Price M A Estimating Growth .D ip There are 2 main methods of determining growth: 1 THE AVERAGING METHOD Ad v 1 𝑑𝑑 𝑔𝑔 = ( 0�𝑑𝑑 ) �𝑛𝑛 − 1 C A, F do = current dividend C where A, 𝑛𝑛 dn = dividend n years ago (A C g = sustainable growth rate az ILUSTRATION 1 ad Ej Munero Ltd paid a dividend of 6p per share 8 years ago, and the current dividend is 11p. The current share price is $2.58 ex div As Required: Calculate the cost of equity Solution SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 18 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes GORDON’S GROWTH MODEL ) return on reinvested funds proportion of funds retained FA g=rb where r = b = IS A, AP ILUSTRATION 2 The ordinary shares of Titan Ltd are quoted at $5.00 ex div. A dividend of 40p is just about to be paid. The company has an annual accounting rate of return of 12% and each year pays out 30% of its profits after tax as dividends. A, C Required: Estimate the cost of equity C A, Ad v .D ip M A C IM SOLUTION As ad Ej az (A C A, F C Capital Asset Pricing Model A model that values financial instruments by measuring relative risk. The basis of the CAPM is the adoption of portfolio theory by investors. Portfolio theory Risk and Return The basis of portfolio theory is that an investor may reduce risk with no impact on return as a result of holding a mix of investments. SKANS School of Accountancy 19 AFM: Advanced Financial Management Study Notes IS A, AP FA ) Risk of portfolio (σ) A, C No. of shares in portfolio A, F C C A, Ad v .D ip M A C IM Systematic and non-systematic risk If we start constructing a portfolio with one share and gradually add other shares to it we will tend to find that the total risk of the portfolio reduces as follows: Initially substantial reductions in total risk are possible; however, as the portfolio becomes increasingly diversified, risk reduction slows down and eventually stops. The risk that can be eliminated by diversification is referred to as unsystematic risk. This risk is related to factors that affect the returns of individual investments in unique ways, this may be described as company specific risk. The risk that cannot be eliminated by diversification is referred to as systematic risk. To some extent the fortunes of all companies move together with the economy. This may be described as economy wide risk. The relevant risk of an individual security is its systematic risk and it is on this basis that we should judge investments. Non-systematic risk can be eliminated and is of no consequence to the well-diversified investor. az (A C Implications 1. If an investor wants to avoid risk altogether, he must invest in a portfolio consisting entirely of risk-free securities such as government debt. If the investor holds only an undiversified portfolio of shares he will suffer unsystematic risk as well as systematic risk. As ad Ej 2. 3. If an investor holds a ‘balanced portfolio’ of all the stocks and shares on the stock market, he will suffer systematic risk which is the same as the average systematic risk in the market. 4. Individual shares will have systematic risk characteristics which are different to this market average. Their risk will be determined by the SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 20 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes industry sector and gearing (see later). Some shares will be more risky and some less. β (beta) factor M A C IM A, C IS A, AP FA ) The method adopted by CAPM to measure systematic risk is an index β. The β factor is the measure of a share’s volatility in terms of market risk The β factor of the market as a whole is 1. Market risk makes market returns volatile and the β factor is simply a yardstick against which the risk of other investments can be measured. The β factor is critical to applying the CAPM, it illustrates the relationship of an individual security to the market as a whole or conversely the market return given the return on an individual security. For example, suppose that it has been assessed statistically that the returns on shares in XYZ plc tend to vary twice as much as returns from the market as a whole, so that if market Risk Premium returns went up by 6%, XYZ’s returns would go up by 12% and if market risk premium returns fell by 4% then XYZ’s returns would fall by 8%, XYZ would be said to have a β factor of 2. The risk-free security A, 1 Ad v .D ip Risk Premium Return It is the difference between the market return and risk free rate of return The security market line The security market line gives the relationship between systematic risk and return. We know 2 relationships. The market portfolio (A C 2 A, F C C This carries no risk and therefore no systematic risk and therefore has a βeta of zero. Generally, the government securities like Treasury Bills or GILTs are considered risk free As ad Ej az This represents the ultimate in diversification and therefore contains only systematic risk. It has a βeta of 1. SKANS School of Accountancy 21 Study Notes C IM A, C IS A, AP FA ) AFM: Advanced Financial Management Ad v .D ip M A From the graph, it can be seen that the higher the systematic risk, the higher the required rate of return. The relationship between required return and risk can be shown using the following formula: Ke = Rf + (Rm - Rf) β where Ke = required return from individual security β = Beta factor of individual security = risk-free rate of interest Rm = return on market portfolio A, F C C A, Rf (A C ILUSTRATION 3 The market return is 15%. Kite Ltd has a beta of 1.2 and the risk free return is 8% az Required: What is the cost of capital? As ad Ej SOLUTION SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 22 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes The Cost of Debt Kd for irredeemable debt = = = ) FA Where i t P0 𝑋𝑋100% interest paid marginal rate of tax ex interest (similar to ex div) market price of the loan stock. AP 𝑃𝑃𝑜𝑜 IS A, 𝑖𝑖(1−𝑡𝑡) 𝐾𝐾𝑑𝑑(𝑛𝑛𝑛𝑛𝑛𝑛) = A, C ILUSTRATION 4 The 10% irredeemable loan notes of Rifa plc are quoted at $120 ex-interest. Corporation tax is payable at 30% A C IM Required: What is the cost of debt net? C A, Ad v .D ip M SOLUTION A, F C Kd for redeemable debt The Kd(net) for redeemable debt is given by the IRR of the relevant cash flows. Ej az (A C The relevant cash flows would be: Years Cashflows 0 Market Value of Loan Note (P0) 1-n Annual Interest Payment i(1-T) n Redemption Value As ad ILUSTRATION 5 Woodwork Ltd has 10% loan notes quoted at $102 ex interest redeemable in 5 years’ time at par. Corporation tax is paid at 30%. Required: What is the cost of debt net? SKANS School of Accountancy 23 AFM: Advanced Financial Management Study Notes IM A, C IS A, AP FA ) Solution The cash redemption value if not converted Ad v 2. .D ip M A C Convertible debt A loan note with an option to convert the debt into shares at a future date with a predetermined price. In this situation, the holder of the debt has the option therefore the redemption value is the greater of either: 1. The share value on conversion or A, F C C A, ILUSTRATION 6 Continuing the ILUSTRATION 5, it has come to know that the loan note was convertible into 40 ordinary shares. The expect share price at the redemption date will expected to be $2.6 (A C Required: What is the cost of debt net? As ad Ej az Solution SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 24 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Non-tradeable debt A substantial proportion of the debt of companies is not traded. Bank loans and other non-traded loans have a cost of debt equal to the coupon rate adjusted for tax. ) Interest (Coupon) rate x (1 – T) FA Kd(net) = IS A, AP ILUSTRATION 7 Trout has a loan from the bank at 12% per annum. Corporation tax is charged at 30%. A, C Required: What is the cost of debt net? A C IM Solution WACC X% X% X% X% C C A, Ad v .D ip M The Calculation of WACC Source Proportion (in Market Values) X Cost Equity Proportion of Equity X Ke Debt Proportion of Debt X Kd(net) Preference Proportion of Preference X Kp Share WACC (A C A, F ILUSTRATION 8 Bar plc has 20m ordinary 25p shares quoted at $3, and $8m of loan notes quoted at $85. The cost of equity has already been calculated at 15% and the cost of debt (net of tax) is 7.6%. ad Ej az Required: Calculate WACC? As Solution SKANS School of Accountancy 25 AFM: Advanced Financial Management Study Notes Capital Structure and WACC Gearing Theories The Traditional View FA ) Cost of equity: At relatively low levels of gearing the increase in gearing will have relatively low impact on Ke. As gearing rises the impact will increase Ke at an increasing rate Gearing (D/E) C A, Ad v .D ip M A C IM A, C IS A, AP Cost of debt: There is no impact on the cost of debt until the level of gearing is prohibitively high. When this level is reached the cost of debt rises. (A C A, F C Key point : As the gearing level increases initially the WACC will fall. However, this will happen upto an appropriate gearing level. After that level WACC will start to rise. There is an optimal level of gearing at which the WACC is minimized and the value of the company is maximized. The MM View (With-out Tax) Ej az Cost of equity: Ke rises at a constant rate to reflect the level of increase in risk associated with gearing. ad Cost of debt: There is no impact on the cost of debt. As Assumptions: 1. Perfect capital market exist where individuals and companies can borrow unlimited amounts at the same rate of interest. 2. Debt is risk free. SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 26 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes A C IM A, C IS A, AP FA ) The increase in Ke directly compensates for the substitution of expensive equity with cheaper debt. Therefore, the WACC is constant regardless of the level of gearing. .D ip M If the weighted average cost of capital is to remain constant at all levels of gearing it follows that any benefit from the use of cheaper debt finance must be exactly offset by the increase in the cost of equity. C A, Ad v The MM View (With Tax) In 1963 M&M modified their model to include the impact of tax. Debt in this circumstance has the added advantage of being paid out pre-tax. The effective cost of debt will be lower as a result. As ad Ej az (A C A, F C Implication: As the level of gearing rises the overall WACC falls. The company benefits from having the highest level of debt possible. SKANS School of Accountancy 27 AFM: Advanced Financial Management Study Notes CAPM and MM Combined AP FA Financial Risk IS A, Business Risk Asset Beta (βa) ) Systematic Risk Equity Beta (βe) 𝒅𝒅 A, Where: Ve = Market Value of Equity Vd = Market Value of Debt Ad v 𝒆𝒆 .D ip M A C IM A, C Business Risk Risk due to nature of the business operations or the type of industry. Financial Risk Risk due to inclusion of debt in the financial structure. This Risk will be zero if the company or investment is 100% equity financed. Equity Beta (βe) It is the Beta of a geared Company so it has both Financial and Business Risk Asset Beta (βa) It is the Beta of an un-geared Company so it has Business Risk only. The Formula 𝑽𝑽 • 𝜷𝜷𝒂𝒂 = 𝑽𝑽 +𝑽𝑽 𝒆𝒆(𝟏𝟏−𝑻𝑻) 𝑿𝑿 𝜷𝜷𝒆𝒆 (A C A, F C C Should Company’s WACC be Used for Investment Appraisal? If the Investment’s Business risk and Financial Risk are similar to the company, then we use the company’s WACC to appraise the investment. However, if any of the risk is different then we have to calculate investment specific cost of capital. As ad Ej az Project Specific Cost of Capital Following are the steps of calculating the project specific cost of capital. Financial Risk is Different Business Risk is Different 1. Chose the βe of the company. 1. Identify a proxy company 2. Calculate the βa using the having same Business Risk 2. Chose the βe of that proxy company’s current financial company. structure (Un-gearing Beta). 𝑉𝑉𝑒𝑒 3. Calculate the βa using the Proxy 𝛽𝛽𝑎𝑎 = 𝑋𝑋 𝛽𝛽𝑒𝑒 company’s current financial 𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 (1 − 𝑇𝑇) structure (Un-gearing Beta). 3. Calculate βe of the investment using capital structure to be SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 28 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes 𝑉𝑉𝑒𝑒 𝑋𝑋 𝛽𝛽𝑒𝑒 𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 (1 − 𝑇𝑇) 4. Calculate βe of the investment using capital structure to be used for the investment. (Regearing Beta) 𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 (1 − 𝑇𝑇) 𝛽𝛽𝑒𝑒 = 𝑋𝑋 𝛽𝛽𝑎𝑎 𝑉𝑉𝑒𝑒 5. Use βe to calculate Ke using CAPM 6. Calculate WACC used for the investment. (Regearing Beta) 𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 (1 − 𝑇𝑇) 𝛽𝛽𝑒𝑒 = 𝑋𝑋 𝛽𝛽𝑎𝑎 𝑉𝑉𝑒𝑒 4. Use βe to calculate Ke using CAPM 5. Calculate WACC IS A, AP FA ) 𝛽𝛽𝑎𝑎 = M A C IM A, C ILUSTRATION 9 Techno, an all equity agro-chemical firm, is about to invest in a diversification in the consumer pharmaceutical industry. Its current equity beta is 0.8, whilst the average equity β of pharmaceutical firms is 1.3. Gearing in the pharmaceutical industry averages 40% debt, 60% equity. Corporate debt is available at 5%. Rm = 14%, Rf = 4%, corporation tax rate = 30%. Ad v .D ip Required: What would be a suitable discount rate for the new investment if Techno were to finance the new project with 30% debt and 70% equity? As ad Ej az (A C A, F C C A, Solution SKANS School of Accountancy 29 AFM: Advanced Financial Management Study Notes Advanced Techniques Combined Cost of Capital AP FA ) Sometimes we need to estimate post project (post Acquisition) Cost of Capital. If the project’s Business and Financial Risk of the project is similar to the previous operations of the business then it’s WACC after Acquisition will not change. IS A, If the Business Risk is similar but only the Financial risk is different then we can use the Company’s Asset Beta and by using the post project gearing we can first estimate Beta equity and eventually WACC. IM A, C However, if the Business Risk is different then, the post project WACC will be different. .D ip Post Project (Combine) Post-Acquisition Co. Un-gear C A, F βa (Co.) C A, Un-gear Project (different Nature Operations) Target Co. βe (Inv.) Ad v Company (different nature Operations) Pre-Acquisition Co. βe (Co.) M A C It is important to note that the main element to change will be Beta of the Co. So, we have to estimate the Weighted Average Beta. It is worth Mentioning that we will always combine Beta (or taking Average of Beta) at an Asset Level. X Proportion of Business Proportion of βa (Co.) ADD βa (Combine) Gear ad Ej az (A C X Proportion of Business Proportion of βa (Co.) βa (Inv.) As βe (Combine) Ke using CAPM WACC SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 30 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Exam Note In the Exam you may have to work it Backwards as well. AP FA ) ILUSTRATION 10 Techno, an agro-chemical firm, is about to invest in a diversification in the consumer pharmaceutical industry. Its current equity beta is 1.8 and the firm has 50 million share with the share price of $2 each. The firm also have Debt Worth $50 million. IS A, The average equity β of pharmaceutical firms is 1.3 and the Gearing in the pharmaceutical industry averages 40% debt, 60% equity. IM A, C This new Pharmaceutical project will require an additional investment of $20 million and the company intends to finance 50% by raising debt from the bank and remaining by issuing new ordinary shares. A C Corporate debt is available at 5%. Rm = 14%, Rf = 4%, corporation tax rate = 30%. .D ip M Required: What would be the cost of capital of Techno after the new investment assuming that the share price will not be effected by the investment. As ad Ej az (A C A, F C C A, Ad v Solution SKANS School of Accountancy 31 AFM: Advanced Financial Management Study Notes Credit rating FA AP Note: the above table is presented in basis points and 1%=100 basis Points The formula ) An Alternative used in AFM to derive cost of debt is based on credit spread. Credit spread is the measure of credit risk associated with company and is generally calculated by a credit rating agency, presented in a table. Ad v .D ip M A C IM A, C IS A, Kd(net) = (Risk Free Rate + Credit Spread)(1-T) As ad Ej az (A C A, F C C A, Criteria for Establishin Credit rating Country Risk: No debt will be rated higher than the country Universal Importance: The company’s standing relative the other countries Industry Risk: The strength and weakness of the industry. Industry Position: The companies position in the Industry. Management Evaluation: The companies Planning, Control, Policies Performance. Accounting Quality: The Accounting Policies, Qualification, etc. Earning Protection: ROCE, Net Profit Margins, Financial Gearing Cash Flow Adequacy Financial Flexibility: Evaluation of Financial Needs, Relationship with Investors, Covenants Credit Migration Credit Rating of a borrower may change due to any event and is known as credit migration. This generally effects the market value of the bond. Predicting Credit Rating (Kaplan Urwitz Model) SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 32 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes As ad Ej az (A C A, F C C A, Ad v .D ip M A C IM A, C IS A, AP FA ) For Quoted Companies Y=5.67 + 0.011F + 5.13π – 2.36S – 2.85L + 0.007C – 0.87β-2.90σ For Un-Quoted Companies Y=4.41 + 0.011F + 6.4π – 2.56S – 2.72L + 0.006C – 0.53σ Where: Y is the score of the model F is the size of firms measured in total assets Π is net income/total assets S is deb status (subordinated = 1, otherwise = 0) Unsubordinated debt has priority claim. L is gearing C is interest cover (PBIT/Interest) β is beta of company (CAPM) σ is the variance. SKANS School of Accountancy 33 AFM: Advanced Financial Management Study Notes Advanced Investment Appraisal ) Modified Internal Rate of Return IS A, AP FA A criticism of the IRR method is that in calculating the IRR, an assumption is that all cash flows earned by the project can be reinvested to earn a return equal to the IRR. A, C Modified internal rate of return is a calculation of the return from a project, as a percentage yield, where it is assumed that cash flows earned from a project will be reinvested to earn a return equal to the company’s cost of capital IM Using MIRR for project appraisal .D ip M A C It might be argued that if a company wishes to use the discounted return on investment as a method of capital investment appraisal, it should use MIRR rather than IRR, because MIRR is more realistic because it is based on the cost of capital as the reinvestment rate Ad v MIRR Formula 1 A, 𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑃𝑃ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑛𝑛 � (1 + 𝑟𝑟𝑒𝑒 ) − 1 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = � 𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑃𝑃ℎ𝑎𝑎𝑎𝑎𝑎𝑎 C C Example Ej As ad 0 1 2 3 4 5 Cash flow $ (60,000) (20,000) 30,000 50,000 40,000 (10,000) az Year (A C A, F A business requires a minimum expected rate of return of 8% on its investments. A proposed capital investment has the following expected cash flows and NPV. NPV Discount 1.000 0.926 0.857 0.794 0.735 0.681 Present Value $ (60,000) (18,520) 25,710 39,700 29,400 (6,810) + 9,480 The modified internal rate of return (MIRR) is: SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 34 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes AP FA ) WHY USE MIRR INSTEAD OF IRR ➢ MIRR assumes reinvestment of cash flows at cost of capital which is more realistic in case of having a very high IRR. ➢ In case of non-conventional cash flows MIRR produces a single answer. ➢ It is easier to calculate than IRR. ➢ MIRR decision is in line with NPV decision so there are lesser chances of conflict. A, C IS A, Problems of MIRR ➢ It is not an industry preferred method. ➢ MIRR is also a relative measure so it still does not consider size of the project Free cash flow C IM You might be need to perform a forecast of free cash flows in order to appraise an investment including a business valuation. Ad v .D ip M A Free cash flow is the amount of cash generated by a company or business during a specified period of time (say one year) minus the cash payments that the company or business is obliged to make. Essential payments include taxation payments and capital expenditure to replace ageing non-current assets (‘replacement’ capital expenditure). Free cash flow is therefore the amount of cash generated by the company that management are able to decide how to use. C C A, Free cash flows for equity (FCFE) might be used in the valuation of the share capital of a company; whereas free cash flow for the firm (FCF) would be used for the valuation of the entire business, equity plus debt capital. az (A C A, F Free cash flow for the firm Free cash flow for the firm is the amount of free cash flow generated by the business as a whole, regardless of the source of finance. It is therefore calculated without deducting interest payments as an essential cash payment. As ad Ej Calculating free cash flow for the firm Method 1 Earnings before interest and tax (EBIT) Less tax on EBIT Add back: Depreciation (and any other non-cash expenditures) Less: Working capital increases Plus: Working capital decreases Less: Replacement capital expenditure Free cash flow SKANS School of Accountancy X (X) X (X) X (X) XX 35 AFM: Advanced Financial Management Study Notes Method 2 Free Cashflow to Firm Less: Interest payments Add: Tax savings on interest Free cash flow for equity X (X) X. XX FA X (X) X (X) X (X) X (X) XX .D ip M A C IM A, C IS A, AP Method 1 Earnings before interest and tax (EBIT) Less: Interest payments Profit after Interest Less tax on Profit after interest Add back: Depreciation (and any other non-cash expenditures) Less: Working capital increases Plus: Working capital decreases Less: Replacement capital expenditure Free cash flow for equity ) Free cash flow for equity Free cash flow for equity is the amount of free cash flow after deduction of interest payments. C A, Ad v Free cash flow and dividend capacity The ability of a company to source capital investments internally depends not only on the amount of cash flows generated, but also on dividend policy. However, the Maximum dividend that the firm should pay equals to free cashflow to equity. (A C A, F C An entity could distribute all of its free cash flow to equity but in practice only a proportion is paid out. A company will retain part of the free cash flow to reinvest in the business. Adjusted present value method (APV method) of project appraisal As ad Ej az Problem with NPV The total return from the project is based on two different risk i.e. business risk and financial risk. But NPV doesn’t segregate these returns between business risk and financial risk. It doesn’t incorporate the issue cost of raising the debt finance It doesn’t incorporate the subsidy benefits from the subsidized loans SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 36 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes An alternative approach to capital investment appraisal is the adjusted present value (APV) method. AP FA ) The APV method may be used when a business entity is considering an investment in a project that will have different business risks and different financial risks from its current operations. For example, a business entity might wish to evaluate an investment in a different industry or a different market, and raise new capital to finance the investment. A, C IS A, The APV method is an alternative to calculating a new cost of equity and a new WACC, for example using the Modigliani-Miller formulae or the asset beta formula. M .D ip Base case NPV Add: Present Value of Tax Sheild Adjusted Present Value . A C IM The decision rule for the APV method A project is financially viable and should be undertaken if its adjusted present value (APV) is positive. The APV of a project contains two elements, and is calculated as follows: A, Ad v Base case NPV The base case NPV is calculated assuming the project is financed entirely by equity, so that the method of financing is ignored. 𝑉𝑉 𝐾𝐾𝑒𝑒(𝑔𝑔) = 𝐾𝐾𝑒𝑒(𝑢𝑢𝑢𝑢) + (1 − 𝑇𝑇)(𝐾𝐾𝑒𝑒(𝑢𝑢𝑢𝑢) − 𝐾𝐾𝑑𝑑 ) 𝑉𝑉𝑑𝑑 az MM 𝐾𝐾𝑒𝑒(𝑢𝑢𝑢𝑢) = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝑎𝑎 (𝑅𝑅𝑚𝑚 − 𝑅𝑅𝑓𝑓 ) (A C CAPM A, F C C It is therefore necessary to calculate the cost of equity in an all-equity company in the same industry or the market in which the capital investment will be made. This can be done by either of the two methods 𝑒𝑒 As ad Ej Present value of the tax shield (PV of the tax relief on interest costs) When a new project is financed wholly or partly with new debt finance, there will be tax relief on the interest. The PV of these tax benefits should be included in the APV of the project. The PV of the tax relief on interest is calculated by: Calculate the issue cost (normally grossed up) Calculating the savings in taxation arising as a consequence of interest, for each year of the project SKANS School of Accountancy 37 AFM: Advanced Financial Management Study Notes Calculating the savings from the subsidized Loan net of tax Discounting these to a present value, using the pre-tax (before-tax) rate of interest or risk-free rate on the debt as the discount rate. AP FA ) Reasons for using the APV method The APV method might be used in preference to adjusting the weighted average cost of capital (WACC) of the company using the Modigliani-Miller formulas. This is for several reasons. C IM A, C IS A, The APV method does not rely on assumptions about the new WACC of the firm if the project is undertaken. The APV method allows for the specific tax relief on the borrowing to finance the project, and does not assume that the debt will be perpetual debt. The APV method allows for other costs, such as the costs of raising new finance (issue costs). .D ip M A It might be argued that APV is therefore the best method of estimating the effect of a new investment on the value of the business entity, and the wealth of its shareholders. Comparison of NPV and APV methods A, Ad v The NPV and the base case NPV are calculated using the same cash flows, except that the cash flows for the base case NPV should exclude ‘other costs’ such as financing costs, whereas these are included in the calculation of an NPV. As ad Ej az (A C A, F C C ILUSTRATION Davis Co is considering diversifying its operations different from its main area of business (food manufacturing) into the plastics business. It wishes to gauge an investment project, which involves the acquisition of a molding machine that costs $450,000. The project is predicted to produce net annual operating cash flows of $220,000 for every of the three years of its life. At the top of this point its scrap value are going to be zero. The assets of the project can support debt finance of 40% of its initial cost. Davis is considering borrowing this amount from two different sources First, an area government organization has offered to lend $90,000, with no issue costs, at a subsidized rate of interest of 3% every year. The full $90,000 would be repayable after 3 years. The rest of the debt would be provided by the bank, at Davis' normal interest rate. This loan would be repaid in three equal annual instalments. The balance of finance is going to be provided by a placing of recent equity. Issue costs are going to be 5% of funds raised for the equity placing and 2% for the loan. Debt issue costs are allowable for corporation tax. The industry has a SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 38 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes A, C IS A, AP FA ) mean equity beta of 1.368 and a mean debt: equity ratio of 1:5 at market values. Davis' current equity beta is 1.8 and 20% of its long-term capital is represented by debt which is generally regarded to be risk free. The risk-free rate is 10% pa and therefore the expected return on a mean market portfolio is 15% Corporation tax is at a rate of 30%, payable within the same year. The machine will attract a 70% initial tax allowable allowance and the balance is to be written off evenly over the rest of the asset life and is allowable against tax. The firm is for certain that it'll earn sufficient profits against which to offset these allowances. Required: Calculate the adjusted present value and determine whether the project should be accepted?. As ad Ej az (A C A, F C C A, Ad v .D ip M A C IM SOLUTION SKANS School of Accountancy 39 AFM: Advanced Financial Management Study Notes Debt Capacity The ability of the business to raise further debt is known as debt capacity. Duration AP FA ) It is the weighted average time required to obtain cash flows from the return phase of project. Another way of saying this is that the duration of the project is the time required to cover one half of the value of investment returns. IS A, Steps to calculate duration M A C IM A, C Find discounted cash flows of return phase Find total present value of return phase by adding all discounted cash flows calculated above Find proportion of all present values by dividing each present value with total Find weighted average years by multiplying relevant years to above proportion Add all weighted years as duration Ad v .D ip Duration can be used in capital investment appraisal to assess the payback on the project. Unlike payback and discounted payback, however, it takes into consideration the total expected returns from the entire project (at their projected value), not just returns up to the payback time. C C A, If duration of the project is short relative to the life of the project- for example, if the duration is less than half the expected total life of the project-this means the most of the returns from the project will be recovered in the early years. (A C A, F If duration of the project is large portion of the total life of the project – for example if duration is 75% or more of the total life of the project – this means the most of the returns from the project will be recovered in later years. Ej az It could therefore be argued that duration is the best available method of assessing the time for an investment to provide its return on capital invested. As ad To calculate duration for a project, the negative cash flows at the beginning of the project are ignored. Duration is calculated using cash flows from the year that the cash flows start to turn positive. However, if there are any negative cash flows in any year after the cash flow turn positive, such as in the final year of the project, these negative cash flows are included in the calculation of duration (as negative cash flows). SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 40 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Advantages IS A, AP FA ) Duration captures both the time value of money and the whole of the cash flows of a project. It is also a measure which can be used across projects to indicate when the bulk of the project value will be captured. This measure captures both the full value and time value of the project it is recommended as a superior measure to either payback or discounted payback when comparing the time taken by different projects to recover the investment involved. A, C Disadvantages C IM Its disadvantage is that it is more difficult to conceptualize than payback and may not be employed for that reason. It is not an industry preferred Method. A Modified Duration Macaulay Duration / (1 + GRY) .D ip M It is a measure of sensitivity of the price of bond to a change in interest rates. *GRY is gross Redemption Yeild Ad v This can be used to calculate proportionate change in bond price. A, ΔP = - Modified Duration X ΔY X P C C Where: Δ is change, P is for price and Y is for yield A, F Risk in Investment Appraisal Monte Carlo simulation As ad Ej az (A C Monte Carlo simulation is a method of measuring an expected outcome by means of generating multiple trials or iterations, in order to determine the expected value of the outcome and also to measure the variability or risk. Monte Carlo simulation depends on the fact that by taking the outcomes of a large number of individual random events (iterations), an accurate measurement of the expected value and probability distribution of the outcome will be obtained. The use of Monte Carlo simulation modelling is made possible by computers, which can produce a large number of iterations quickly, to produce a reliable expected value and probability distribution of the outcome. Steps in Simulation Specify major variable. Market size. SKANS School of Accountancy 41 AFM: Advanced Financial Management Study Notes Selling price. Market growth rate. Market share. Investment required. Residual value of investment. Specify the relationship b/w variables to calculate an NPV Sales revenue = market size x market share x selling price. Net cash flow = sales revenue (variable cost + fixed cost = taxation) etc Simulate the environment and computerized model will generate a range of NPV across all probability levels IS A, AP FA ) C IM A, C Merits of simulation It includes all possible outcomes in the decision making process. It is relatively easily understood technique. It has a wide variety of applications (inventory control, component replacement, corporate models, etc.) Ad v .D ip M A Demerits of simulation Models can become extremely complex and the time and cost involved in their construction can be more than is gained from the improved decisions. Probability distributions may be difficult to formulate Accuracy of data output depends upon the accuracy of data input. Project value at risk A, F C C A, Annual volatility of a project Volatility in this context refers to the possibility that a project’s NPV might be much higher or lower than the expected value of the NPV. In capital investment appraisal, annual volatility is the standard deviation of the PV of annual cash flows from the project. = σS × √T Ej σL az (A C For any item with a variable value, for which volatility is measured, the statistical volatility increases with the length of the time period over which it is measured. The relationship is as follows: As ad where σL is the volatility (standard deviation) over the longer time period σS is the volatility (standard deviation) over the shorter time period T is the number of short time periods that make up the long time period. Example SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 42 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Expected annual cash flows are $100,000 and the volatility of annual cash flows is $15,000. Cash flows in any one year are independent of what the cash flows were in the previous years. AP FA ) Over a five year period, expected cash flows are $500,000 and the five-year volatility of cash flows is: $15,000 × √ 5 = $33,541. IM A, C IS A, Project value at risk A project value at risk is the maximum amount, at a given confidence level, by which the actual NPV from a project will be worse than the expected value of the NPV. It can therefore be used to assess the risk in a capital investment project, which should help management to decide whether or not to invest in the project, taking into consideration the risk as well as the expected return (expected NPV). Calculating project value at risk A C Example .D ip M A simulation model has been used to calculate the expected value of the NPV of a project. This is $282,000. The project has an expected life of ten years, and the volatility of the PV of the annual cash flows is $30,000. Ad v Normal distribution tables can also be used to calculate the following probabilities: A, F C C A, At the 95% confidence level, the project value at risk is: N(0.95) 30,000 √10 = 1.645 × $94,868 = $156,058. At the 95% confidence level, the NPV will not be worse than $282,000 – $156,058 = $125,942. As ad Ej az (A C At the 99% confidence level, the project value at risk: N(0.99) 30,000 √10 = 2.327 × $94,868 = $220,758. At the 99% confidence level, the NPV will not be worse than $282,000 - $220,758 = $61,242. SKANS School of Accountancy 43 AFM: Advanced Financial Management Study Notes International Investment Appraisal ) Why Investment Overseas AP FA Investing in Overseas may give: A, F C C A, Ad v .D ip M A C IM A, C IS A, access to new markets and/or enable it to develop a market for its products in locations Being involved in marketing and selling products in overseas markets may also help it gain an understanding of the needs of customers, which it may not have had if it merely exported its products. Easier and cheaper access to raw materials it needs. It would therefore make good strategic sense for it to undertake the overseas investment. Access to cheaper labour resources and/or access to expertise Closer proximity to markets, raw materials and labour resources may reduce costs and gain edge against its competitors. For example, transportation and other costs related to logistics may be reduced if products are manufactured close to the markets where they are sold. Risk, such as economic risk resulting from long-term currency fluctuations, may be reduced where costs and revenues are matched and therefore naturally hedged. Increase its reputation because it is based in the country within which it trades leading to a competitive edge against its rivals. International investments might reduce both the unsystematic and systematic risks for shareholders only hold well diversified portfolios in domestic markets, but not internationally. (A C Factors affecting foreign investment decisions the exchange rates. the risk of exchange controls and similar cash flow restrictions taxation on remittances to the parent company’s country. Transfer Pricing As ad Ej az Companies considering a major capital investment in another country also need to consider: Exchange rate risk (currency risk) Exchange rate risk, also called FOREX risk and currency risk, is the financial risk from the possibility (or probability) that foreign currency exchange rates will change. The risk is greater when a foreign exchange rate is volatile, and moves by fairly SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 44 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes large amounts over time, often both up and down. Two aspects to exchange rate risk are: FA ) Transaction risk Translation risk. Economic risk A, C IS A, AP Transaction risk: affects any company that receives income or makes payments in a foreign currency. It is the risk that when a quantity of foreign currency will be received or paid at a time in the future, the exchange rate might move between ‘now’ and the time that receipt or payment of the currency will occur. As a consequence of the exchange rate movement the amount of money received or paid in the company’s own currency (domestic currency) will be less or more than originally expected. M A C IM Exchange rates can move favorably as well as adversely, but the main concern for risk management is with the possibility and consequences of an adverse exchange rate movement. Ad v .D ip Translation risk: is a financial reporting risk for companies with foreign investments. For the purpose of preparing consolidated financial accounts, the financial statements of foreign subsidiaries must be translated into the reporting currency of the parent multinational. Changes in the exchange rate create gains or losses on translation, which affect the reported results of the group. C A, Economic risk: Also called forecast risk, refers to when a company’s market value is continuously impacted by an unavoidable exposure to currency fluctuations A, F C Predicting Exchange rates Ej az (A C In the exam question we may have to estimate future expected exchange rates. This can be calculated by using purchase power parity i.e. ad Where: 𝑆𝑆1 = 𝑆𝑆0 𝑋𝑋 1 + ℎ𝑎𝑎 1 + ℎ𝑏𝑏 As S1 = Future Expected Spot Rate S0 = Current Spot Rate ha = Rate of inflation in country a SKANS School of Accountancy 45 AFM: Advanced Financial Management Study Notes hb = Rate of inflation in country b EXAMPLE: AP UK 2% 4% 4% IS A, USA 5% 3% 4% A, C Year 1 2 3 FA ) The Current Dollar Sterling exchange rate is given $1.7050/£ Expected Inflation Rates are: As ad Ej az (A C A, F C C A, Ad v .D ip M A C IM Solution: SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 46 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Converting currencies Quotes Example (Pakistan) Local/foreign Rs. 160/1$ Converting foreign currency to home currency Foreign Currency cashflows X FOREX rates eg. $10= (160 X 10) = Rs. 1,600 Foreign Currency cashflows ÷ FOREX rates eg. $10 = (10/0.00625) = Rs. 1,600 FA ) Direct Quoted Note: Do opposite for converting Home Currency to Foreign A, C Political risk IS A, AP Indirect Foreign/local $.00625/Re. M A C IM Political risk is the risk for an international company that the government of a foreign country might take action that affects the operations or profitability of its investment in its country, or places restrictions on the ability of the foreign subsidiary to remit interest or dividends to the parent country. .D ip Exchange controls Ad v Exchange controls are actions by a government that: A, F C C A, restrict or prevent the ability of its own nationals to buy foreign currency in order to make payments to foreign suppliers restrict or prohibit the payment of interest or dividends to foreign investors, including payments from subsidiary companies to their foreign parent restrict the flow (payments) of capital out of the country. (A C Example As ad Ej az Dar Co. is a US based co. and is planning to invest in Pakistan. Due to economic conditions of Pakistan and to control balance of payment deficit the new govt. has proposed that no cashflows from foreign investment can be taken back until 3 years of investment. However, the govt has offered the foreign investors an interest rate of 13% for that period. Dar Co.’s net-cashflows and expected exchange rates estimation for the next 4 years are: Year: 1 2 3 4 Net Cashflow (Rs.m) 35 40 45 38 Exchange rates (Rs/$) 155 160 168 175 SKANS School of Accountancy 47 AFM: Advanced Financial Management Study Notes Required: Prepare the cashflows for home country under the above said circumstances. .D ip M A C IM A, C IS A, AP FA ) Solution Taxation and international investment Ad v Presentation of Tax A, F C C A, Operational cashflow Tax on Operational Cashflow Tax savings on Capital Allowances Net Cashflow X (X) X. XX X (X) X (X) X. XX X (X) XX Working 1 Operational cashflow Less: Capital Allowances X (X) As ad Ej az (A C Operational cashflow Less: Capital Allowances Profit after Capital Allowances Tax Add: Capital Allowances Net Cashflow Operational cashflow Tax (W-1) Net Cashflow SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 48 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Profit after Capital Allowances Tax X (X) ) Tax Losses A, C IS A, AP FA When the project makes profit then the govt. charges tax on that and if the project suffers losses then the govt. gives relief on that. This relief usually first setoff against the profits from other projects in that case co. can claim savings immediately. However, if there are no other profitable projects then these losses are carried forward against future profits and hence no tax savings are recoded in the current period. Example Operational Cashflow (300) 400 3 A 2 M 1 1,000 .D ip Years C IM Following are the Operational Cashflows for the next 3 years Ad v Capital Allowances are 200 each year on straight-line basis. The company do not have sufficient profits and hence any loss has to be carryforward. Rate of tax is 30% payable in the same year the liability arises. A, Required C C Prepare Net cashflows for the Next 3 Years As ad Ej az (A C A, F Solution SKANS School of Accountancy 49 AFM: Advanced Financial Management Study Notes Withholding tax. Some countries levy a withholding tax on interest or dividends paid by companies to foreign investors, including foreign parent companies. Withholding tax is additional tax, reducing the net cash flows for the parent company from its foreign subsidiary. A, C IS A, AP FA ) Double taxation agreements. Many countries have double taxation agreements with each other. The purpose of a double taxation agreement is to prevent punitive taxation by taxing profits twice, once in each country. A double taxation agreement allows an international company to set off the tax payable in its own country on the profits of or income received from a foreign subsidiary, against the tax already paid by the subsidiary in its own country. The effect of double taxation agreements is to help to make international investments more attractive by avoiding excessive and punitive tax on the pre-tax returns that the investments make. C IM Example (Double Tax) Ad v Home Country Foreign Country Situation 1 30% 40% As ad Ej az (A C A, F C C A, Solution Situation 1 25% 25% .D ip Situation 1 40% 30% M A Following are the rates of Taxation in home country and Foreign Currency. Est the tax rate for each country in different situations assuming Double Tax Treaty exist SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 50 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Calculation of Tax in Foreign Currency and home currency AP FA 𝑇𝑇𝑇𝑇𝑇𝑇 𝑖𝑖𝑖𝑖 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 → 𝐶𝐶𝐶𝐶𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑖𝑖𝑖𝑖 ℎ𝑜𝑜𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑖𝑖𝑖𝑖 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 ) Calculate Tax in foreign currency and make part of foreign cashflows Calculate total tax in Home currency and include in additional cashflows IS A, Transfer Pricing and cashflows in foreign country A, C If the foreign project is making sales in the home country then it should be recorded in foreign country. This is because the activity belongs to foreign project. In that case the price needs to be converted from Home currency to foreign currency first. M A C IM Similarly, if the home country is transferring any component to Foreign project then the contribution will be recorded in ‘Additional Cashflows in Home Currency’ whereas the price will be recorded as cost in the Foreign currency cashflows. .D ip Example A, Ad v A UK Based firm and is in considering to invest in USA. For that they need to transfer a component to USA which will have a transfer price of £20 and the UK firm will incur a variable cost of £14. 1,000 units will have to be made for the first year and the exchange rate in year 1 is expected at $1.2355/£. C Required (A C As ad Ej az Solution A, F C Prepare the cashflows to be included in foreign country as well as in home country SKANS School of Accountancy 51 AFM: Advanced Financial Management Study Notes Features of a foreign country investment appraisal ) The features of investing in a foreign country include the following: IS A, AP FA The investment could be a very high-risk investment, and you might be required to establish a special cost of capital for evaluating the project, possibly using the CAPM and a beta factor for the project. A, C Most of the cash flows for the foreign investment will be in the currency of the foreign country, although some cash flows might be in the currency of the parent company. M A C IM If the foreign country is a developing country, there will probably be expectations of high rates of inflation in future years and there might be restrictions on the amount of payments that can be made from the foreign country, due to exchange control restrictions. This means that the cash profits from the project might not be payable immediately in full as dividends to the investing company. .D ip Steps of International Investment Cashflows and NPV As ad Ej az (A C A, F C C A, Ad v Calculate all the relevant net cashflows related to foreign project directly in the foreign currency. Consider whether any restrictions are placed on remittances and if so, calculate the cash flows actually received by the parent. Convert the net flows into the domestic currency using the expected future exchange rates Add any other domestic cash flows that arise in the home currency (e.g. additional tax). Discount the total net cash flows in the domestic currency at an appropriate cost of capital. SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 52 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Acquisition and Merger ) Acquisition AP FA An acquisition normally involves a larger company (a predator) acquiring smaller company (a target). IS A, Mergers IM A, C A merger is in essence the pooling of interests by two business entities which results in common Ownership access to new markets and/or enable it to develop a market for its products in locations A C However, the financial management issues are broadly the same for mergers as for acquisitions. .D ip Horizontal integration M Types of Merger & Acquisition C C Vertical integration A, Ad v When two companies in the same industry, whose operations are very closely related and are combined, integrate. This is known as horizontal merger or acquisition. (A C A, F When two companies in the same industry, but from different stages of the production chain are merged. This is known as vertical integration. Conglomerate integration ad Ej az When two or more companies which are completely unrelated businesses combine/merged & there is no common thread, such type of merger is known as conglomerate. The main synergy lies with the management skills and brand name. As Alternatives to acquisitions A comparison of growth by acquisition and internal growth SKANS School of Accountancy 53 AFM: Advanced Financial Management Study Notes Advantages of Acquisition A C IM A, C IS A, AP FA ) By far the most important advantage of an acquisition is that growth is achieved much more quickly. By making an acquisition, a company immediately gets bigger. If the target for acquisition has been selected well, the company should be able to move towards its strategic goals more quickly than if it tried to grow internally. It is often argued that when a target company is acquired, it should be possible to achieve 'synergies' and add value by increasing the combined profits of the two companies. Synergy is explained in more detail later. When a company is trying to grow its business in another country, acquisition might be better than internal growth, because the company will acquire skilled employees who already understand the business, the country, its laws and culture and its language. Unless a company acquires available target businesses, its competitors might acquire them instead and the strategic threat from the enlarged competitor might increase. M Advantages of Organic Growth Ej az (A C A, F C C A, Ad v .D ip There is a high risk that the price paid for an acquisition will be too high, and the financial return from buying an over-valued company will be low. Many acquisitions are failures. This means that an acquisition strategy is a high- risk strategy. Hie reasons why acquisitions often fail are explained later. With a strategy of internal growth, the company's management should be able to plan and control the development of the business more effectively, because the practical problems associated with acquisitions do not arise. The practical problems include difficulties with employees in the acquired company and the management time needed to combine the systems of the two companies after the acquisition. An acquisition is not usually 'ideal' and there will be some features of the target company that the acquirer might not want to buy. After the acquisition, the acquiring company might want to sell off unwanted parts of the business. This can be a time-consuming process, and the prices obtained from selling off these operations and assets might be low. As ad Criteria for choosing an acquisition target The choice of acquisition targets might be based on any of the following criteria: Strategic aims and objectives. An acquisition target is usually selected because acquiring the target would help the acquiring company to achieve its strategic SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 54 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes AP FA ) targets. For example, a company might be seeking to grow the business by expanding its product range for its existing markets, or moving into new geographical markets. Acquiring a suitable business would enable a company to expand its product range or move into new geographical markets. Some companies have pursued a strategy of buying up a large number of small companies in a fragmented market, with the intention of becoming the largest company and market leader. IS A, Cost and relative size. Although there are occasional examples of small companies acquiring much larger ones in a 'reverse takeover', target companies are usually selected because they are affordable. C IM A, C Opportunity and availability. In many cases, targets for acquisition are selected because of circumstances. An opportunity to acquire a particular company might arise, and the acquiring company might decide to take the opportunity whilst it is available. A, Ad v .D ip M A Potential synergy. Acquisition targets might possibly be selected because they provide an opportunity to increase total profits through improvements in efficiency. One reason for the success of private equity funds in acquiring target companies has been their ability to achieve additional efficiencies and economies that the previous company management had been unable to do. A strategy of private equity funds might be to look for target companies that they consider under-valued, with the intention of improving their operations and creating extra value. C Synergy az (A C A, F C Synergy is sometimes called the '2 + 2 = 5' effect. It is the concept that the combined sum of two separate entities after a merger or acquisition will be worth more than their sum as two separate entities. When two separate entities come together into a single entity', opportunities might arise for increasing profits. Synergies might be divided into three categories: Ej Revenue synergies As ad Revenue synergies are increases in total sales revenue following a merger or acquisition, by increasing total combined market share. For example, if Company A lias annual sales revenue of $500 million acquires Company B which has annual sales revenue of $200 million, the combined revenue of the two companies after the merger might be, say, $750 million. SKANS School of Accountancy 55 AFM: Advanced Financial Management Study Notes Revenue Synergy might occur in following circumstances AP FA ) The acquisition or merger creates an enlarged company that is able to promote its brand more effectively, and market share increases because customers are attracted by the new brand image. The acquisition or merger creates an enlarged company that is able to bid for large contracts, such as contracts to supply the government, which the two companies were unable to do before they combined due to their smaller size. IS A, Cost synergies A C IM A, C Cost synergies are reductions in costs as a consequence of a merger or takeover. They might arise because it is possible to improve efficiency. For example, it might be possible to reduce the size and cost of administrative departments by combining the administrative functions of the two companies. It is not unusual for takeovers to result in staff redundancies, partly for tins reason. .D ip M Cost synergies might also be possible by combining other activities, such as combining warehouse facilities. C Financial synergies A, Ad v Experience has shown, however, that companies often have difficulty in achieving planned cost synergies after a takeover, because combining the activities of the two companies after the takeover is often a long and complex process. (A C A, F C A larger (combined) company or group might be able to raise finance in a cheaper way. The enlarged company might have access to financial markets, such as the bond market, that the two individuals’ companies could not access before the takeover, due to their smaller size. Ej az The larger company might also be seen as a lower credit risk, so that it is able to borrow from banks at a lower rate of interest. ad The high failure rate of acquisitions As Many acquisitions fail, and do not provide the value for shareholders that was expected when the acquisition was made. There are several reasons for failure. The purchase price paid for an acquisition is often too high. The expected synergies do not occur. SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 56 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes IM A, C IS A, AP FA ) There are serious problems with integrating the acquired company into the new group. Employees in the acquired company might find it difficult to accept the different culture of the acquiring company, and a new set of policies and procedures. The loss of staff might be high, and valuable knowledge and expertise might be lost. There might be problems with establishing effective management control in the acquired company. Control systems might have to be reviewed and changed. Senior management in the acquiring company might not give the acquired company sufficient time and attention to make the acquisition operationally and financially successful. Competitors might react to an acquisition with a new competitive strategy of their own. Increased competition might drive down the profits for all participants in the market. A C Factors effecting the likely success of the bid for Acquisition M Level of consideration A, Expectations of future profits Ad v .D ip The acquirer should offer an initial bid price, keeping in mind a satisfactory premium over and above the actual market value of the acquire company. A generous offer would incline the target company to consider the offer positively. A, F C C In order to encourage the shareholders of Target Company to retain their shares in the combined company, a potential estimate of future earnings and synergies would be required by them. (A C Future dividend policy az Shareholders of Target Company may be sensitive to the dividend policy possibly being less generous than they have been used to before the acquisition. ad Ej Tax position As The shareholders may prefer a future capital gain on sale of shares in acquirer company to cash consideration, or instant sale of any shares they are given. Changes in shares prices Shareholders will also take account of any changes in share prices that occur during the bid price. SKANS School of Accountancy 57 AFM: Advanced Financial Management Study Notes Defensive Tactics ) When a target company is faced with a hostile tender offer (takeover) the target company managers and board use defensive measure to delay, negotiate a batter deal for shareholders or attempt to keep the company independent. AP FA Pre-Offer Defense IS A, Poison Pill A, C This is an attempt to make a company unattractive normally by giving the right to existing shareholders to buy shares at a very low price. Poison pills have many variants. IM Golden Parachutes C C "Crown Jewel" Defense A, Ad v .D ip M A C Golden parachutes are compensation agreements between the target company and its senior managers. These employment contracts allow the executives to receive lucrative payouts, usually several years‟ worth of salary, if they leave the target company following a change in corporate control. Golden parachutes may encourage key executives to stay with the target as the takeover progresses and the target explores all options to generate shareholder value. Without a golden parachute, some contend that target company executives might be quicker to seek employment offers from other companies to secure their financial future. (A C A, F The firm's most valuable assets may be the main reason that the firm became a takeover target in the first place. By selling these or entering into arrangements such as sale and leaseback, the firm is making itself less attractive as a target. az Eternal vigilance ad Ej Maintain a high share price by being an effective management team and educate shareholders. As Cross shareholdings Your company buys a substantial proportion of the shares in a friendly company, and it has a substantial holding of your shares. Increasing Levels of Debt SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 58 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Increases its financial risk, and therefore the company will need to be able to bear the consequences of this increased risk. AP FA ) The increased levels of debt would probably be secured against the assets of the company and therefore the acquirer cannot use them to raise additional debt finance, and cash resources would be needed to fund the higher interest payments. Post offer defenses IS A, Litigation IM A, C The target company can challenge the acquisition by inviting an investigation by the regulatory authorities or through the courts. The target may be able to sue for a temporary order to stop the predator from buying any more of its shares. C Green Mail .D ip M A This technique involves an agreement allowing the target to repurchase its own shares back from the acquiring company, usually at a premium to the market price. Greenmail is usually accompanied by an agreement that the acquirer will not pursue another hostile takeover attempt of the target for a set period. Ad v "Pac-Man" Defense (A C A, F C C A, The target can defend itself by making a counteroffer to acquire the hostile bidder. This technique is rarely used because, in most cases, it means that a smaller company (the target) is making a bid for a larger entity. Additionally, once a target uses a Pac-Man defense, it forgoes the ability to use a number of other defensive strategies. For instance, after making a counteroffer, a target cannot very well take the acquirer to court claiming an antitrust violation. az White Knight Defense Ej This would involve inviting a firm that would rescue the target from the unwanted bidder. The white knight would act as a friendly counter-bidder. As ad Methods of financing mergers Cash Advantages to Acquirer When the bidder has sufficient cash the merger can be achieved quickly. SKANS School of Accountancy 59 AFM: Advanced Financial Management Study Notes Cheaper: the consideration is likely to be less than a share exchange, as there is less risk to the shareholders. Retains control of their company. ) Disadvantages to Acquirer AP FA Cash flow strain - usually either must borrow (increased gearing) or issue new shares in order to raise the cash. IS A, Advantages to Target A, C Certainty about bids value Freedom to invest in a wide ranging portfolio. IM Disadvantages to Target A C Liable to CGT Do not participate in new group synergy benefits .D ip M Share exchange. Advantages to Acquirer A, Ad v No cash outflow Bootstrapping – when high P/E ratio Co acquires low P/E co, acquirer will have to issue less number of shares so EPS rises. A, F Dilution of control C C Disadvantages to Acquirer (A C Advantages to Target Ej az Postponement of CGT liability Participate in new group synergy benefits ad Disadvantages to Target As Uncertain value Debt Preference shares. Hybrid SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 60 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes The Global Regularity Framework Key aspects of Takeover Regulation ) Mandatory Bid- Rule: A, C IS A, AP FA The aim of this rule is to protect the minority shareholders by providing them with the opportunity to exit the company at the fair price once the bidder has cumulated a certain percentage of the shares. This is why the mandatory bid rule normally also specifies the price that is to paid for the shares. The bidder normally required to offer the remaining the shareholders the price not lower than the highest price for the shares already acquired during the periods specified prior to the bid. IM The principle of equal treatment: .D ip M A C The principle of treating all the shareholders equally is fundamental. The principle of equal treatment requires the bidder to offer to minority shareholders as same term as those offered to earlier shareholders from whom the controlling block was acquired. Transparency of ownership and control: C A, Ad v The transparency enables the regulators to monitor the large shareholders, minimize agency problems and investigate insider dealing. It also enables that minority shareholder and the market to monitor the large shareholders who may able to exercise undue influence exact at the expense of the other shareholdings. A, F C The squeeze-out and sell-out rights: (A C Squeeze out rights gives the bidder who has acquired a specific percentage of the equity (90%) the right to force minority shareholders to sell their shares. az The one-share-one vote: As ad Ej Where the one share-one vote principle is upheld, arrangements restricting voting rights are forbidden. Differentiated voting rights, such as non-voting shares and dual-clan shares with the multiple voting rights, enable some shareholders to accumulate control at the expense of other shareholders and could provide a significant barrier to potential takeovers. The break-through rule SKANS School of Accountancy 61 AFM: Advanced Financial Management Study Notes The effect of the break-through rule where this is allowed by corporate law, is to enable a bidder with a specified proportion of the company‟s equity to breakthrough the company‟s multiple voting rights and exercise control as if one shareone vote existed. FA ) Board neutrality and anti-takeover measures A, C IS A, AP Seeking to address the agency issue where management may be tempered to act in their own interests at the expense of the interest of the shareholders, several regulatory devices propose board neutrality. For instance the board would not be permitted to carry out post-bid aggressive defensive tactic (such as selling the company‟s main assets, known as crown jewels defense, or entering into special arrangements giving rights to existing shareholders to buy shares at a low price, known as poison pill defense), without prior authority of the shareholders. C IM General Principles: As ad Ej az (A C A, F C C A, Ad v .D ip M A All the shareholders of the target company must be treated similarly. All information disclosed to one or more shareholders of the target company must be disclosed to all An offer should only be made if it can be implemented in full individuals or firms should not make an offer unless they have reason to believe that they will be able to implement this in full. Shareholders must be given sufficient information and advice to enable them to reach a properly informed decision and mist have sufficient time to do so. No relevant information should be withheld from them. All documentation should be of the highest standards of accuracy. A documentation produced by the bidding company or the directors of the target should be produced to the highest standards of accuracy. All parties must do everything to ensure that a false market is not created in the shares of the target company. A false market is created when a deliberate attempt is made to distort the market in the offeror‟s or target shares. An example would be where false information is either given or withheld in such a way as to prevent the free negotiation of prices. Directors of a target company are not permitted to frustrate a takeover bid, nor to prevent the shareholders from having a chance to decide for themselves. The directors of both target and bidder must act in the interest of their respective companies. The Competition Commission A UK company might have to consider whether its proposed takeover would be drawn to the attention of the Competition Commission. If the it is thought that a SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 62 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes merger or takeover might be against the public interest, it can refer it to the Competition Commission. As ad Ej az (A C A, F C C A, Ad v .D ip M A C IM A, C IS A, AP FA ) If a transaction is referred to the Competition Commission and the commission finds that it results in a substantial lessening of competition in the defined market, it will specify action to remedy or prevent the adverse effects identified, or it may decide that the merger does not take place. SKANS School of Accountancy 63 AFM: Advanced Financial Management Study Notes Acquisition and Merger Valuation The need for a valuation FA ) Valuation and the offer price are key issues in a merger or acquisition. In a takeover: IM A, C IS A, AP the acquiring company needs to decide what price it is prepared to offer for the target company the directors of the target company need to decide whether the offer is acceptable and whether it should be recommended to the shareholder, and the shareholders in the target company need to decide whether they are willing to accept the offer made for their shares. M A C Valuation Methods Market Based Methods Market Capitalization Ad v .D ip Cash Flow Based Methods Dividend Valuation Method P/E Method Replacement Value Break-up Value C C A, FCF/FCFE Asset Based Methods Book Value A, F Market Based Valuation (A C Market Capitalization: az No. of shares X Ex-Dividend Share Price Ej P/E Method As ad EPS X Expected P/E Ratio The problem with this valuation method for a private company is that a suitable estimate must be obtained for both EPS and the P/E ratio. The EPS might be the EPS of the target company in the previous year, an average EPS for a number of recent years or a forecast of EPS in a future year. Any of these estimates for EPS could be used. SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 64 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes FA ) Since a private company does not have a market value for its shares, the shares do not have a P/E ratio. A P/E ratio must therefore be selected by looking at the P/E ratio for similar companies whose shares are traded on a stock market. The P/E ratio selected might be based on the average P/E ratio of a number of similar companies whose shares are traded on a stock market, for which a current P/E ratio is therefore available. AP Cashflow Based Valuation IS A, Dividend Valuation Method 𝑑𝑑0 (1 + 𝑔𝑔) 𝐾𝐾𝑒𝑒 − 𝑔𝑔 IM 𝑃𝑃0 = A, C Market Value = Present Value of future dividends, discounted at cost of equity. M A C Note: Above Formula can only be used when growth rate in dividend is constant from Y1. If this is not the case then calculate according to the definition above. Ad v .D ip Free Cashflow Based Estimate the relevant incremental free cash flows from the business to be acquired. Discount these cash flows at an appropriate cost of capital that reflects the risk of the investment. C A, There are few points to remember in valuing using free cashflow (A C A, F C If the method is FCF then the discount rate should be WACC and if it’s FCFE then the discount rate should be Ke. Valuing using FCF will give us the total market value i.e. Debt + Equity whereas, FCFE will give us the value of equity only az Asset Based Aproach Ej The business is estimated as being worth the value of its Net Assets. ad Net Assets = Total Assets – Total Liabilities – Preference Share Value As The issue that needs to be consider is whether to use: Book Values (If below values are not given) Replacement Values (if it is going concern) Realizable values (if the intent is divestment) Advantages of Net Asset Method It can be used as floor value (minimum value) in mergers and acquisitions. SKANS School of Accountancy 65 AFM: Advanced Financial Management Study Notes AP FA ) It is the only method used in case of liquidation. It can be used as valuation method in asset intensive firm. e.g. real estate business Problems of Net Assets Method It does not consider future prospects of a company. It does not consider all intangibles of a company. It cannot be used in service based industry. Replacement cost is difficult to estimate. M A C IM Operating profits of the company Less: Capital Employed X % of Avg ROCE in the industry Excess earning Adjustment of Tax After tax Excess Earnings A, C IS A, CALCULATED INTANGIBLE VALUE (CIV) MODEL This is the way to calculate the value of intangible assets. The idea behind is that due to intangible assets the business is generating excess returns over the industry average. .D ip Present value of excess earning discounted at WACC XX (XX) XX (XX) XX XX (A C A, F C C A, Ad v Example PPL operates in the service industry. The directors are keen to value the company for the purposes of negotiating with a potential acquirer and plan to use the CIV method to value the intangible element. In the past year PPL made an operating profit of $135m on an asset base of $300m. The company WACC is 6%. A suitable competitor for benchmarking has been identified who generates and average return of 19% Corporation tax is 30%. az Required Calculate the intangible value of PPL ad Ej Valuation Techniques As Point of view of Acquirer (Buyer) Acquirer will want to know about the maximum price that should be paid for acquisition. Hence the value of target company will be Post-Acquisition Value of parent (Combined Value) Less: Value of the parent company before Acquisition Value of the Target Company (The Maximum Value) SKANS School of Accountancy ( www.ACCAGlobalBox.com ) XX (XX) XX 66 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes IM A, C IS A, AP FA ) Post-Acquisition Values Earning based Valuation o Combined earnings = earnings of parent + earnings of target + synergy earnings o P/E ratio should be post acquisition. Cashflow Based Valuation o Combined cashflows = cashflows of parent + cashflow of target + synergy cashflows o WACC should be post acquisition which should be: Same as business and financial risk are same Marginal cost of capital if business risk is same but financial risk is different Risk adjusted cost of capital (post acquisition Beta) if business risk is different M A C Example Nema Co, a listed company which manufactures electronic components, is interested in acquiring Roney Co. Ad v .D ip Information on Nema Co and Roney Co Nema Co has a market debt to equity ratio of 50:50 and an equity beta of 1·18. Currently Nema Co has a total firm value (market value of debt and equity combined) of $140 million. A, F C C A, Roney Co has a market debt to equity ratio of 10:90 and an estimated equity beta of 1·53. Roney Co has a total firm value (market value of debt and equity combined) of $40 million. ad Ej az (A C Information about combine Company Following the acquisition, it is expected that the combined company‟s sales revenue will be $51,952,000 in the first year, and its profit margin on sales will be 30% for the foreseeable future. After the first year the growth rate in sales revenue will be 5·8% per year for the following three years. Following the acquisition, it is expected that the combined company will pay annual interest at 6·4% on future borrowings. As The combined company will require additional investment in assets of $513,000 in the first year and then 18c per $1 increase in sales revenue for the next three years. It is anticipated that after the forecasted four-year period, its free cash flow growth rate will be half the sales revenue growth rate. SKANS School of Accountancy 67 AFM: Advanced Financial Management Study Notes It can be assumed that the asset beta of the combined company is the weighted average of the individual companies‟ asset betas, weighted in proportion of the individual companies‟ market value. FA ) The current annual government base rate is 4·5% and the market risk premium is estimated at 6% per year. The Tax rate is 28%. A, C IS A, AP Required: Evaluates whether the acquisition of Roney Co would be beneficial to Nema Co and its shareholders. The free cash flow to firm method should be used to estimate the values of Roney Co and the combined company assuming that the combined company’s capital structure stays the same as that of Nema Co’s current capital structure. Include all relevant calculation. As ad Ej az (A C A, F C C A, Ad v .D ip M A C IM Solution SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 68 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Point of view of Acquiree (Seller) Acquiree will want to know about the minimum price that it should be accepted for acquisition. Hence the value of target company will be IS A, IM Gain and Losses on Acquisition XX (XX) (XX) XX A, C Post-Acquisition Value of parent (Combined Value) Less: Value of the target company before Acquisition Less: Value of the parent company before Acquisition Synergy value (Maximum Acquisition Premium) AP The Synergy Value of the company (Maximum Acquisition Premium) FA ) PV of the Target Company only. Target Price Agreed Less: Value in view of Acquiree Gain/(Loss) . .D ip M A C Acquirer Value in view of Acquirer Less: Price agreed Gain/(Loss) . Ad v Example (Share to share exchange) Market value of target company $5 per share, market value of acquirer $4 per share. Acquirer has offered its 3 shares for every 2 shares of Target Company. C C A, Required Calculate %age benefits for Target Company. As ad Ej az (A C A, F Solution In share for share exchange as soon as acquirer company transfer its shares to target company, both company’s shareholders will become the owner of group. So, combine value of group is more relevant here rather than the existing value of acquirer. SKANS School of Accountancy 69 AFM: Advanced Financial Management Study Notes Example (Share to share exchange) Market value of Target Company is $2.50, market value of acquirer $3.00, combined market value $4.00. Acquirer has offered its 2 shares for every 3 shares of Target Company. AP FA ) Requirement: Calculate %age gain to both the acquirer and target shareholders C C A, Ad v .D ip M A C IM A, C IS A, Solution (A C A, F Example (Cash offer) Market value of target co. is $4/share. Acquirer has offered $5 each for every share of Target Company. Ej az Required Calculate %age gain to the target company shareholders. As ad Solution SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 70 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Example: M.V of target co is $4/Share. Acquirer has offered $110 worth Bond for every 20 shares of target co. FA ) Required Calculate %age gain for target company shareholders. As ad Ej az (A C A, F C C A, Ad v .D ip M A C IM A, C IS A, AP Solution SKANS School of Accountancy 71 AFM: Advanced Financial Management Study Notes Financial Reconstruction Financial Reconstruction Take Agreement No agreement remedial with creditors action Promise of future profits Liquidation Capital Reconstruction Liquidation Assets sold off and distributed in priority order Assets sold off and distributed in priority order (A C A, F C C Ad v .D ip M A C IM Continue to be unprofitable A, A, C IS A, AP FA ) Unprofitable businesses Profitable businesses (debit balance on (which run out of cash revenue reserves) overtrading) Ej az A financial reconstruction is a major reorganization of the capital structure of a company especially when there are serious concerns of going concern. A reconstruction might involve: As ad the conversion of debt capital into equity And possibly the conversion of equity shares from one form to another SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 72 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes The purpose of a reconstruction The purpose of a capital reconstruction is to find a way of allowing the company to continue in business, and avoid insolvency and liquidation. A reconstruction is therefore only worth considering: FA ) if it is likely to be more beneficial to all the parties concerned than a liquidation of the company (and the sale of its assets), and IS A, AP the reconstructed company has a good chance of surviving and restoring itself to profitability. A, C A reconstruction will benefit all the parties if it is likely to result in them getting more cash or more value from the reconstruction than from an enforced liquidation of the company. IM The challange with a reconstruction scheme A C There are some major problems with arranging a capital reconstruction. These are: M finding a reconstruction arrangement that will benefit all the parties, and .D ip Getting all the parties to agree to the proposal. C A, Ad v Each of the parties involved in a reconstruction (banks who are lending money, bondholders, unpaid trade creditors and the shareholders) need to believe that the reconstruction offers them the prospect of more cash or more value than a liquidation of the company. Each of the parties will therefore compare what they will probably receive: C o if the construction scheme is agreed, and A, F o If the scheme is rejected and liquidation occurs. (A C Financial Reconstruction Answer Plan: az 1. State the reason why the scheme is required As ad Ej As a result of the recent considerable losses there is inadequate funds available to finance the redemption of debentures. 2. The Capital Repayment position – priority order (a) It is common to find in exam situations that there may not be enough funds to discharge the unsecured creditors. They end up only receiving say 60p in the $. (b) The capital repayment position of the unsecured creditors will normally improve under a scheme, because the cash from the issue of new SKANS School of Accountancy 73 AFM: Advanced Financial Management Study Notes equity is used to purchase assets, on which they will have a prior claim to shareholders 3. Does the scheme raise adequate finance? FA ) 4. Whether The Business Will Proceed After The Reconstruction. AP 5. Is the scheme acceptable to all parties? General points: C IM A, C IS A, a) The “What’s in it for me?” syndrome. Each party must be in at least as good a position after the scheme as they whether before the scheme or else they will not agree to the scheme. A secured creditor, who would receive full payment in liquidation, will have to get something extra for agreeing to the scheme e.g. a higher interest rate. .D ip M A b) Treat all the parties fairly. No party should be treated with disproportionate favour in comparison with another. This is a matter of subjective judgement. Whatever judgement you make remember to justify your answer. Approach: C C a) Upon liquidation b) Under the scheme A, Ad v The likely situation in the exam is that the company will be liquidated if the scheme is not accepted. Therefore you should compare the position of each group: (A C A, F In relation to shares and debentures it may be worthwhile to note their market value before the scheme i.e. their current exit value. 6. Conclusion Ej az Try and reach a sensible conclusion about the scheme, which is justified by your analysis. As ad Don’t be afraid to say that you think the scheme in its current form, will not be acceptable. Suggest any possible improvements to the scheme, explaining their logic and appeal. SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 74 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Practice of Financial Reconstruction Plan Assume that ‘now’ Is dec _2003 M A C IM A, C IS A, AP FA ) Dricom inc. is a manufacturer of mobile phones. The company was successful in the mid1990s, and established a small chain of retail shops in major domestic cities. In 2001-2002 the company’s new product experienced reliability problems and competition from technologically superior products, causing sales to fall by 40% from 2000-2001 levels. This led to substantial losses being made in both 20012002 and 2002-2003. The company’s managers are confident that the technical problems can be overcome, but this will require an investment of $2.25 milion for new automated equipment and quality performance, and a new debt or equity issue on the stock market is not possible. Without the new investment, Dricom is unlikely to be competitive, and might survive the next financial year. With the new investment ‘PBIT’ are forecast to be at least $750,000/year from 2004-2005 for at least five years. .D ip DRICOM INC SUMMARISED SOFP AS AT 30-SEP-2003 $'000 $'000 _________ ad As SKANS School of Accountancy 2100 __________ 3600 35 Total assets Called up share capital ($1 par value) Share premium account Revenue reserves 1500 1340 1090 Ej az (A C A, F Current assets Inventory Receivables Cash at bank and in hand C C A, Ad v Non-current assets Land and building Plant and machinery (NET) 2465 _________ 6065 _________ 1000 945 -240 75 AFM: Advanced Financial Management Study Notes _________ Non-current liabilities Term loan (from BXT bank) 9% debenture 2016 8% convertible debenture 2005 10% loan stock 2011 1705 800 FA ) 500 500 _________ A, C Current liabilities Overdraft Other payables 2800 A C IM 620 940 _________ .D ip M Total equity and liabilities IS A, AP 1000 1560 _________ 6065 _________ As ad Ej az (A C A, F C C A, Ad v NOTES: 1) The 9% straight debenture is secured by a fixed charge on the company’s main factory building, the convertible debenture and term loan by a floating charge on non-current assets. The loan stock and overdraft are unsecured. 2) The land and buildings are believed to have a realizable value 20% less than than their net book value. 3) If the company ceased trading, inventories would be sold @ 50% of their book value. 4) The new equipment would result in 50 staff being made redundant, with an immediate after-tax cost of $500,000. If the company were to be liquidated , after-tax redundancy payments would total $1 million. Redundancy payments may be assumed to rank before UNSECURED PAYABLES 5) Obsolete machinery with a net book value of $800,000 will be sold for $300,000 irrespective of whether or not the new investment takes place. The remainder of the plant and machinery could be disposed of at net book value. All disposal values are after tax.. SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 76 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes FA ) 6) The overdraft currently cost 10% per year and the bank term loan 12% per year. 7) The company’s current share price is 23 CENTS, loan stock price $78, straight debenture price $90 and convertible debenture price $94. All marketable debt has a PAR and redemption value of $100 IS A, AP DRICOM FINANCE DRICTOR believes that a corporate RESTRUCTURING could solve the company’s problems, and has made the following proposals: C A, Ad v .D ip M A C IM A, C 1) Existing shareholders are to be offered 28 cents per share to redeem their shares, which would then be CANCELLED. 2) $1 million would be provided by a venture capital organization in return for 700,000 new 25 cents par value ordinary shares. 3) The company’s directors and employees would subscribe to 500,000 new 25 cents ordinary shares at a price of 150 cents per share. 4) The convertible debentures is to be replaced by new ordinary shares (par value25 cents), with 60 ordinary shares for every $100 nominal value loan stock. 5) The term loan is to be renegotiated with the bank and the total amount of the loan increased to $2 million. This would have an expected interest charge of 13% per annum. A floating charge on non-current assets could be offered on the overdraft. 6) All other long-term loans would remain unchanged. As ad Ej az (A C A, F C Apart from the directors, none of the above parties have yet been consulted regarding the proposed reconstruction. Following a reconstruction, no corporate tax is expected to be paid for at least two years. The corporate tax rate is 33% The Average price/earnings ratio in DRICOM’S industry is 12:1 SKANS School of Accountancy 77 AFM: Advanced Financial Management Study Notes Business Reorganization Business Reorganization A, C IS A, AP FA ) A capital reconstruction is a major change in the capital structure and ownership of a company in financial difficulties. A business reorganization is similar, in the sense that it often involves a change in capital structure and a change in ownership. However, a reorganization normally involves a company that is not in financial difficulties as the result of a business strategy decision, such as selling off a non-core part of the group's business operations, or de-merging two divisions of a company into two entirely separate and independent companies. M A C IM Portfolio Reconstruction Portfolio restructuring involves the acquisition of companies, or disposals of assets, business units and/or subsidiary companies through divestments, demergers, spin-offs, MBOs and MBIs. It involves making additions to or disposals from companies businesses. It includes Divestments, Demergers, spin-offs or management buy-outs. A, F C C A, Ad v .D ip Organizational Reconstruction It involves changing the organizational structure of the firm. Organizational restructuring involves changing the way a company is organized. This may involve changing the structure of divisions in a business, business processes and other changes such as corporate governance. The aim of either type of restructuring is to increase the performance and value of the business As ad Ej az (A C Leveraged Recapitalization In leveraged Recapitalization a firm replaces the majority of its equity with a package of debt securities. The high level of debt in the company discourages other companies to make take-over bids. Companies should be o Relatively debt free o Consistent cash flows Debt/Equity Swaps The value of the swap is determined usually at current market rates. Management may offer higher exchange values to share- and debt holders to force them participate in the swap. SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 78 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes AP Advantages Protection from Share price movement No hostile bids Focus on Long-term Performance Minimized agency costs IS A, FA ) Leveraged buy-outs (LBOs) It refers to the takeover of a company that utilizes mainly debt to finance the buyout and company is de-listed. A small group of individuals, possibly including existing shareholders and/or management buys all the company's shares. IM A, C Disadvantages Shares don’t trade publicly anymore. Bankrupt if the cash flow risk is too high. C Unbundling C C A, Ad v .D ip M A Unbundling is a process by which a large company with several different lines of business retains one or more core businesses and sells off the remaining assets, product/service lines, divisions or subsidiaries. Unbundling is a Portfolio Restructuring Strategy and It includes the following: Divestment Demergers Sell - Offs Spin - Off Carve Outs Management Buy Out As ad Ej az (A C A, F Divestments Divestment is the partial or complete sale or disposal of physical and organizational assets, the shutdown of facilities and reduction in workforce in order to free funds for investment in other areas of strategic interest. Divestments are undertaken for a variety of reasons. They may take place as a Corrective action in order to reverse unsuccessful previous acquisitions. Divestments may also be take place as a response to a cyclical downturn in the activities of a particular unit or line of business. normally to reduce costs or to increase return on assets Demergers A demerger is the splitting up of corporate bodies into two or more separate bodies, to ensure share prices reflect the true value of underlying operations. A demerger is the opposite of a merger. It is the splitting up of a corporate body into two or more separate and independent bodies. SKANS School of Accountancy 79 Study Notes IM A, C IS A, AP FA Disadvantages • Economies of scale may be lost. • The smaller companies which result from the demerger will have lower turnover, profits and status than the group before the demerger. • There may be higher overhead costs as a percentage of turnovers. • The ability to raise extra finance, especially debt finance, to support new investments and expansion may be reduced. • Vulnerability to takeover may be increased. A C Advantages The main advantage of a demerger is its greater operational efficiency and the greater opportunity to realize value. A two-division company with one loss making division and one profit making, fast growing division may be better off by splitting the two divisions. The profitable division may acquire a valuation well in excess of its contribution to the merged company. ) AFM: Advanced Financial Management Ad v .D ip M Sell-offs A sell-off is a form of divestment involving the sale of part of a company to a third party, usually another company. Generally, cash will be received in exchange. Ej az (A C A, F C C A, Reasons for Sell-Off As part of its strategic planning, it has decided to restructure, concentrating management effort on particular parts of the business. Control problems may be reduced if peripheral activities are sold off. It wishes to sell off a part of its business which makes losses, and so to improve the company's future reported consolidated profit Performance. In order to protect the rest of the business from takeover, it may choose to sell a part of the business which is particularly attractive to a buyer. The company may be short of cash. A subsidiary with high risk in its operating cash flows could be sold. A subsidiary could be sold at a profit. As ad Spin-offs In a spin-off, a new company is created whose shares are owned by the shareholders of the original company which is making the distribution of assets. In a spin-off, there is no change in the ownership of assets, as the shareholders own the same proportion of shares in the new company as they did in the old company. Reasons: SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 80 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes AP FA ) The change may make a merger or takeover of some part of the business easier in the future, or may protect parts of the business from predators. There may be improved efficiency and more streamlined management within the new structure. It may be easier to see the value of the separated parts of the business now that they are no longer hidden within a conglomerate. The requirements of regulatory agencies might be met more easily within the new structure. A C IM A, C IS A, Carve-Out A carve-out is the creation of a new company, by detaching parts of the company and selling the shares of the new company to the public. In a carveout, a new company is created whose shares are owned by the public with the parent company retaining a substantial fraction of the shares. Parent companies undertake carve-outs in order to raise funds in the capital markets. These funds can be used for the repayment of debt or creditors or it can be retained within the firm to fund expansion. Carved out units tend to be highly valued. Ad v .D ip M Management buy-outs (MBOs) A management buy-out is the purchase of all or part of the business by its managers. The main complication with management buy-outs is obtaining the consent of all parties involved. Venture capital may be an important source of financial backing. As ad Ej az (A C A, F C C A, Reasons for a management Buy-out The subsidiary may be peripheral to the group's mainstream activities, and no longer fit in with the group's overall strategy. The group may wish to sell off a loss-making subsidiary, and a management team may think that it can restore the subsidiary's fortunes. The parent company may need to raise cash quickly. The best offer price might come from a small management group wanting to arrange a buy-out. When a group has taken the decision to sell a subsidiary, it will probably get better co-operation from the management and employees. The sale can be arranged more quickly than a sale to an external party. The selling organization is more likely to be able to maintain beneficial links with a segment sold to management rather than to an external party. Problems with buy-outs Managers may have little or no experience of entrepreneur skills. Difficulties in deciding on a fair price to be paid Convincing employees of the need to change working practices SKANS School of Accountancy 81 Study Notes AP FA Inadequate cash flow to finance the maintenance and replacement of tangible fixed assets The maintenance of previous employees' pension rights Accepting the board representation requirement that many sources of funds will insist upon The loss of key employees. Maintaining continuity of relationships with suppliers and customers ) AFM: Advanced Financial Management IM A, C IS A, Advantages of MBOs to disposing company To raise cash quickly to improve liquidity. Known buyer If subsidiary is loss making then sale to management will be better financially than liquidation Better publicity Ad v .D ip M A C Advantages of MBOs to management It preserves their jobs. It offers a chance to become owner of the company It is quicker than starting a similar business from scratch They can carry out their own strategies, no longer required approval from head office. They have detail knowledge and relevant skills. As ad Ej az (A C A, F C C A, Buy-ins 'Buy-in' is when a team of outside managers, as opposed to managers who are already running the business, mount a takeover bid and then run the business themselves. A management buy-in might occur when a business venture is running into trouble, and a group of outside managers see an opportunity to take over the business and restore its profitability. SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 82 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Risk Management: Currency The Role of Treasury AP FA ) managing the liquidity and cash flows of the organisation managing the foreign exchange positions and cash flows helping to obtain finance for the organisation managing the exposures to financial risk, by hedging currency exposures, interest rate exposures and other risk exposures. IS A, Currency Transaction Risk A C IM A, C A transaction risk occurs when a payment of a foreign currency is required at a future date, or when a receipt of a payment in a foreign currency will occur at a future date. A transaction risk occurs because the exchange rate could move adversely between ‘now’ and the time that the currency payment or receipt happens, with the result that either: Ad v .D ip M it costs more to buy the foreign currency to make the currency payment, or there is less income when a currency payment is received and the currency is converted into domestic currency by selling it to a bank. Government Measures to Stabilize Exchange Rates A, F C C A, The most effective way for a government to manage its exchange rate today, if it wished to do so, would be to increase or reduce domestic interest rates on its currency. Raising or reducing interest rates should affect the demand for the currency from investors. (A C There are several exchange rate policies that a government might adopt. These include: As ad Ej az free floating (‘benign neglect’ of the exchange rate) managed floating of the currency a fixed exchange rate policy, with the exchange rate fixed against a major currency or a basket of world currencies SKANS School of Accountancy 83 AFM: Advanced Financial Management Study Notes Quoted Example (Pakistan) Direct Local/foreign Rs. 100/1$ Indirect Foreign/local $0.01/1Re. Converting foreign currency to local Multiply eg. $10= (100 X 10) = Rs. 1,000 Divide eg. $10 = (10/0.01) = Rs. 1,000 AP FA Quotes ) QUOTES IS A, This will always makes you confuse because in Pakistan we use direct quote but in UK and also in ACCA exams there is indirect quote .D ip M A C IM A, C BID and OFFER Rates NOTE: Remember the rule. (BANK ALWAYS WIN). Hence bank always buy the foreign currency at low price and sell it at high price (Direct quote). Hence bank always give few foreign currency and receive more foreign currency against local. (Indirect Quote) Bid price is a price at which bank is willing to buy foreign currency Offer price is a price at which bank is willing to sell foreign currency. Ad v NOTE: Our prospective is opposite as if we want to sell foreign currency then it means bank will buy. C C A, Customer Receiving foreign currency we want to sell foreign currency bank will buy use Bid Price (A C A, F Supplier Paying foreign currency we want to Buy foreign currency bank will Sell use Offer Price offer 100 0.0100 Ej az Direct (Rs./$) Indirect ($/Rs.) Bid 98 0.0102 As ad NOTE: Bid Rate will be lower in Direct Quote and Higher in Indirect Quote and Vice Versa for Offer. Hedging The purpose of hedging an exposure to currency risk is to remove (or reduce) the possibility that a future transaction involving a foreign currency will have to be made at a less favorable exchange rate than expected. SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 84 Downloaded from - www.ACCAGlobalBox.com AP Methods of Hedging Exposures to Foreign Exchange Risk Internal External - Invoicing in home currency - Forward Rate Agreement - Leading and Lagging - Money Market Hedge - Matching - Futures - Netting - Options ) Study Notes FA AFM: Advanced Financial Management A, C IS A, Internal Hedging Techniques Invoicing In Home Currency One easy way is to insist that all foreign customers pay in your home currency and that your company pays for all imports in your home currency Ad v .D ip M A C IM Leading & Lagging If an importer (payment) expects that the currency it is due to pay will depreciate, it may attempt to delay payment. This may be achieved by agreement or by exceeding credit terms. If an exporter (receipt) expects that the currency it is due to receive will depreciate over the next three months it may try to obtain payment immediately. This may be achieved by offering a discount for immediate payment. C C A, Matching When a company has receipts and payments in the same foreign currency due at the same time, it can simply match them against each other. NOTE: In the exam where possible we will always do matching first As ad Ej az (A C A, F Netting Netting is a process in which all transaction of group companies are converted into the same currency and then credit balances are netted off against the debit balances, so that only reduced net amounts remain due to be paid or received. Multilateral netting involves minimising the number of transactions taking place through each country’s banks. This would limit the fees that these banks would receive for undertaking the transactions and therefore governments who do not allow multilateral netting want to maximise the fees their local banks receive. On the other hand, some countries allow multilateral netting in the belief that this would make companies more willing to operate from those countries and any banking fees lost would be more than compensated by the extra business these companies and their subsidiaries bring into the country. SKANS School of Accountancy 85 Study Notes AP FA The advantage of using a central treasury for multilateral netting is that the central treasury can coordinate the information about inter-group balances. There will be a smaller number of foreign exchange transactions, which will mean lower commission and transmission costs. There will be less loss of interest through money being in transit. The foreign exchange rates available may be more advantageous as a result of large transaction sizes resulting from consolidation. The netting arrangements should make cash flow forecasting easier in the group. ) AFM: Advanced Financial Management IS A, Steps C A, Ad v .D ip M A C IM A, C 1. Covert all cashflows into base currency. 2. Enter all the amounts each company owes to the others and convert to the agreed settlement currency. 3. Add across and down the table to determine total receipts and total payments for each company. 4. Determine the net receivable or payable for each company. Advantages: The number of currency transactions can be minimized, saving transaction costs and focusing the transaction risk onto a smaller set of transactions that can be more effectively hedged. It may also be the case, if exchange controls are in place limiting currency flows across borders, that balances can be offset, minimizing overall exposure. Where group transactions occur with other companies the benefit of netting is that the exposure is limited to the net amount reducing hedging costs and counterparty risk. As ad Ej az (A C A, F C Disadvantages: Some jurisdictions do not allow netting arrangements, and there may be taxation and other cross border issues to resolve. It also relies upon all liabilities being accepted – and this is particularly important where external parties are involved. There will be costs in establishing the netting agreement and where third parties are involved this may lead to re-invoicing or, in some cases, recontracting. Illustration Kenduri Co is a large multinational company based in the UK with a number of subsidiary companies around the world. Currently, foreign exchange exposure as a result of transactions between Kenduri Co and its subsidiary companies is managed by each company individually. Kenduri Co is considering whether or not to manage the foreign exchange exposure using multilateral netting from the SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 86 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes UK, with the Sterling Pound (£) as the base currency. If multilateral netting is undertaken, spot mid-rates would be used. Owed to Amount Lakama Co Jaia Co Jaia Co Lakama Co Lakama Co Kenduri Co Gochiso Co Kenduri Co A C IM A, C IS A, US$ 4.5 million CAD 1.1 million CAD 3.2 million US$ 1.4 million US$ 1.5 million CAD 3.4 million JPY 320 million US$ 2.1 million M Owed by Kenduri Co Kenduri Co Gochiso Co Gochiso Co Jaia Co Jaia Co Lakama Co Lakama Co AP FA ) The following cash flows are due in three months between Kenduri Co and three of its subsidiary companies. The subsidiary companies are Lakama Co, based in the United States (currency US$), Jaia Co, based in Canada (currency CAD) and Gochiso Co, based in Japan (currency JPY). C A, Ad v .D ip Exchange rates available to Kenduri Co US$/£1 CAD/£1 JPY/£1 Spot 1.5938–1.5962 1.5690–1.5710 131.91–133.59 3-month forward 1.5996–1.6037 1.5652–1.5678 129.15–131.05 Required Calculate net amount owed by or to each part using netting approach As ad Ej az (A C A, F C Solution SKANS School of Accountancy 87 AFM: Advanced Financial Management Study Notes AP FA Forward Rate Agreement (FRA) It is an immediately firm and binding contract for the purchase or sale of a specified quantity of a stated foreign currency at a rate of exchange fixed at the time the contract is made for performance (delivery of the currency and payment for it) at a future time which is agreed when making the contract. ) External Hedging Techniques A, C IS A, Money Market Hedge Money market hedging involves borrowing in one currency, converting the money borrowed into another currency and putting the money on deposit until the time at which the transaction is completed. .D ip M A C IM Payments Home Currency Foreign Currency NOW 1) Take Loan and Covert 2) Deposit in Bank Principle in Foreign Currency LATER 1) Settle Loan 3) Withdraw from Bank Principle and make payment + Interest Ej az (A C A, F C C A, Ad v Illustration (From BPP) A Thai company owes a New Zealand company NZ$3,000,000, payable in 3 months' time. The current exchange rate is Thai Baht 19.0300–19.0500 = NZ$1. The Thai company elects to use a money market hedge to manage the exchange risk. The current annual borrowing and investing rates in the two countries are: New Zealand Thailand % % Investing 2.5 4.5 Borrowing 3.0 5.2 Required Calculate the cost to the Thai company of using a money market hedge. As ad Solution SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 88 Downloaded from - www.ACCAGlobalBox.com FA IS A, Receipts Home Currency Foreign Currency NOW 2) Covert in Home 1) Take Loan Principle Currency and deposit in Bank LATER 4) Withdraw from Bank 3) Receive the Amount Principle and Settle Loan + Interest ) Study Notes AP AFM: Advanced Financial Management Ad v .D ip M A C IM A, C Illustration (From BPP) An Australian company is due to receive ¥15,000,000 from a Japanese company, payable in 4 months' time. The current exchange rate is ¥62.6000–62.8000 = A$1. The Australian company elects to use a money market hedge to manage the exchange risk. The current annual borrowing and investing rates in the two countries are: Australia Japan % % Investing 4.5 2.7 Borrowing 6.0 3.3 Required Calculate the amount the Australian company will receive if it uses a money market hedge. As ad Ej az (A C A, F C C A, Solution SKANS School of Accountancy 89 AFM: Advanced Financial Management Study Notes Currency Futures Currency futures are contracts for the purchase/sale of a standard quantity of one currency in exchange for a second currency. Futures contracts are priced at the exchange rate for the transaction. As ad Ej az (A C A, F C C A, Ad v .D ip M A C IM A, C IS A, AP FA ) Key Points They are Exchange Traded derivatives contracts. Traded in Derivative market where ‘Futures’ are traded and over her commodities can’t be bought or sold but only their contracts can be. The contract prices are dependent on underlying commodities Standardized contract sizes and are available in only major currencies There are four settlement dates MAR/JUNE/SEPT/DEC. The Transaction Amount will always be in foreign Currency with respect to company Market Currency will always be opposite to currency of contract size Convert each exchange rate in the form of direct from Market point of view e.g. if Market is in USA then convert all exchange rate into $/other currency. Opening Price means todays price Closing Price means Price at the settlement date Settlement date must be earlier or at expiry date Different way to hedge if Market and Home Currency are same and if both are different On Closing (Settlement) date the contract needs to be closed i.e. if the contract is bought initially then it has to be settled by selling it and Vice Versa. This future market only gives out Gain/Loss which will be settled in actual At Expiry date the Future contract price and the spot price both will be same Basis Risk It is a risk that the future prices will not move in line with the spot market. In question we always assumes that this risk is zero INITIAL MARGIN When a futures hedge is set up the market is concerned that the party opening a position by buying or selling futures will not be able to cover any losses that may arise. Hence, the market demands that a deposit is placed into a margin account with the broker being used – this deposit is called the ‘initial Margin’. These funds still belong to the party setting up the hedge but are controlled by the broker and can be used if a loss arises. Indeed, the party setting up the hedge will earn interest on the amount held in their account with their broker. The broker in turn keeps a margin account with the exchange so that the SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 90 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes exchange is holding sufficient deposits for all the positions held by brokers‟ clients. AP FA ) MARKING TO MARKET In the scenario given above, the gain was worked out in total on the transaction date. In reality, the gain or loss is calculated on a daily basis and credited or debited to the margin account as appropriate. This process is called ‘marking to market’. IS A, Currency options IM A, C Currency options give the buyer the right but not the obligation to buy or sell a specific amount of foreign currency at a specific exchange rate (the strike price) on or before a predetermined future date. Key Points in addition to Futures As ad Ej az (A C A, F C C A, Ad v .D ip M A C For this protection, the buyer has to pay a premium. A currency option may be either a call option (Option to Buy Future Contracts) or a put option (Option to sell future contracts) Currency option contracts limit the maximum loss to the premium paid upfront and provide the buyer with the opportunity to take advantage of favorable exchange rate movements. Options are of two types, traded and over the counter, and both have different kinds of benefits. o Traded options are standard sizes and are thus 'tradable' which means they can be sold on to other parties if not required. OTC options are designed for a specific purpose and are therefore unlikely to be suitable for another party. o OTC options are tailored specifically for a particular transaction, ensuring maximum protection from currency movements. As traded options are of a standard size, the full amount of the transaction may not be hedged, as fractions of options are not available. SKANS School of Accountancy 91 Study Notes → C C (A C 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑜𝑜𝑜𝑜 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 Ej a z Transaction Amount X Closing Spot ad Add: Gain (OR Less: Loss) Net Outcome AP IS A, A, C .D ip M given or Assume FRA A, 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 IM A C Closing date Ad v 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 Outcome Outcome in Opening Price future Market Less: Closing Price Gain or Loss Net Outcome 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 Balancing Closing Price Answer Opening Price Less: Closing Price Gain or Loss 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑜𝑜𝑜𝑜 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 Transaction Amount ÷ Closing Spot Add: Gain (OR Less: Loss) Net Outcome As 3 Payment Sell Receipt Buy Opening Price A, F Future Market Market Currency ≠ Home Currency FA Currency Future Answer No. Description Market Currency = Home Currency and explanation 1 Setup Payment Buy Type of Receipt Sell Contract Expiry Immediate after Settlement Date 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 No. of Contacts 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 2 Expected Closing Opening Date Price Spot Market Current Spot ) AFM: Advanced Financial Management SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 92 Downloaded from - www.ACCAGlobalBox.com IM A, C IS A, Payment Put Option Receipt Call Option AP FA Market Currency ≠ Home Currency M A C 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑋𝑋 100 Ej a z Transaction Amount X Closing Spot Less: Premium Add: Gain Net Outcome ad Net Outcome (A C A, F C C A, Outcome Outcome in Exercise Price future Less: Closing Price Market Gain or Loss Exercise Yes / No 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 Exercise Price Less: Closing Price Gain or Loss Exercise Yes / No 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 Transaction Amount ÷ Closing Spot Less: Premium Add: Gain Net Outcome As 3 Ad v .D ip Currency Options Answer No. Description Market Currency = Home Currency and explanation 1 Setup Payment Call Option Type of Receipt Put option Contract Expiry Immediate after Settlement Date Strike Price All given in the question (Exercise Price) 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 No. of 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 Contacts 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 Premium 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 100 2 Expected Same Price as of Future Closing Price Study Notes ) AFM: Advanced Financial Management SKANS School of Accountancy 93 AFM: Advanced Financial Management Study Notes Risk Management: Interest Interest Rate Risk Management AP FA ) Interest rate risk (IRR) can be explained as the impact on an institution’s financial condition if it is exposed to negative movements in interest rates. This risk can either be translated as an increase of interest payments that it has to make against borrowed funds or a reduction in income that it receives from invested funds. IS A, Hedging Ad v .D ip M A C Methods of Hedging Exposures to Interest Rate Risk Forward rate Agreement (FRA) Interest Rate Future Options Interest Rate Swaps COLLAR IM A, C The purpose of hedging an exposure to interest rate risk is to remove (or reduce) the possibility that a future borrowing or investments will have to be made at a less favorable interest rate than expected. (A C A, F C C A, Forward Rate Agreement (FRA) FRA is a contract in which two parties agree on interest rate to be paid on a notional amount at a specified future time. A co. can enter into an FRA with a bank that fixes the rate of interest for borrowing at a certain time in the futures. In case of borrowing, If the actual interest rate proves to be: Higher than the rate agreed The bank pays the co, the difference Lower than the rate agreed Co, pays the bank the Difference As ad Ej az Illustration Example It is 30 June. Lynn plc will need a £10 million 6 month fixed rate after 3 months. Company is expecting that interest rate will rise in future and wants to hedge using an FRA. The following FRA are available: 3-6 FRA 5%- 5.5% 3-9 FRA 5.5% - 6% Lynn can borrow in market at Libor + 50 basis points. Required What is the result of the FRA and the effective loan rate if the 6 month Libor rates has moved to 1. 5% SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 94 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes M A C IM A, C IS A, AP FA ) 2. 9% Solution Ad v .D ip Interest Rate Futures It is very similar to Currency futures, however, in that interest-bearing security as an underlying asset A, Key Points in addition to Currency Futures A, F C C The price of interest rate future will be: 100 – LIBOR. Only LIBOR will be hedged They have a contract length which generally is 3 month. az (A C Interest Rate Options It is very similar to Currency options, however, in that interest-bearing security as an underlying asset As ad Ej Interest Rate Collar It is an attempt to reduce the premium fee by selling the options to other party. By creating collar we may have to be exposed to adverse movements as well. Interest Rate SWAPS SKANS School of Accountancy 95 AFM: Advanced Financial Management Study Notes AP FA ) An interest rate swap is an agreement between two parties, such as a company and a bank that deals in swaps, for a period of time that is usually several years for the exchange of interest payments. Swaps are therefore usually long-term agreements on interest rates. The interest rate payments that are exchanged in a ‘coupon swap’ are as follows: One party to the swap pays a fixed rate (the swap rate). The other party pays interest at a reference rate or benchmark rate for the interest period, such as LIBOR. IM A, C IS A, The purpose of an interest rate swap is often to: swap a variable rate of interest payment (or receipt) into a fixed interest rate payment (or receipt) swap a fixed rate of interest payment (or receipt) into a variable rate of interest payment (or receipt). Illustration Ad v Required: Calculate the SWAP net outcome Write SWAP Terms .D ip M A C Company A wants to borrow at a floating rate, and can do so at LIBOR + 0.50%. Company B wants to borrow at a fixed rate, and can do so at 6.40%. However, an opportunity for these company exist as company A can borrow at a fixed rate 5.5% and company B, can borrow at a variable rate of LIBOR + 1% As ad Ej az (A C A, F C C A, Solutions SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 96 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes The Calculation of Forward Rates ) AP Illustration (𝟏𝟏 + 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒚𝒚𝒚𝒚𝒚𝒚𝒚𝒚 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓)𝒏𝒏 − 𝟏𝟏 (𝟏𝟏 + 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝒚𝒚𝒚𝒚𝒚𝒚𝒚𝒚 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓)𝒏𝒏−𝟏𝟏 FA 𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 = IM A, C Yield 3.0% 3.6% 4.3% 5.1% 5.8% C Maturity One year Two years Three years Four years Five years IS A, The annual spot yield curve for bonds of a given risk class are as follows: As ad Ej az (A C A, F C C A, Ad v .D ip M A Solution SKANS School of Accountancy 97 Study Notes Interest Rate Future Answer No. Description and explanation 1 Setup Type of Contract Expiry Date No. of Contracts FA IS A, AP Future Market Opening Price given or Assume FRA IM Current Spot Price M 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 Outcome Outcome in future Market → A 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑡𝑡𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 C Spot Market Closing date A, C Opening Date .D ip Opening Price Balancing Closing Price Answer Ad v Less: Closing Price Gain or Loss C A, 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑜𝑜𝑜𝑜 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ 1,200 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑋𝑋 (𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 + 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝) 𝑋𝑋 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 Interest: 12 Add: Gain (Or Less Loss) Net Outcome Ej a z (A C A, F C Net Outcome ad 3 Expected Closing Price As 2 Formulas Borrow Sell Investment Buy Immediate after investing or borrowing date 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑋𝑋 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ ) AFM: Advanced Financial Management SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 98 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Interest Rate Options Answer No. Description and explanation 1 Setup Type of Contract Expiry Date Exercise Price No. of Contracts FA ) Formulas IM C A Exercise Price Less: Closing Price Gain or Loss M Expected Closing Price Outcome Outcome in future Market A, C IS A, AP Borrow Put Option Investment Call Option Immediate after investing or borrowing date Chose all that are given 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑋𝑋 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑒𝑒 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ 1,200 Same Price as of Future .D ip Premium Yes/No Ad v Exercise? A, 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ 1,200 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑋𝑋 (𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 + 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝) 𝑋𝑋 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 Interest: 12 C C Net Outcome A, F Less: Premium cost ad Ej a z (A C Add: Gain Net Outcome As 2 3 Study Notes SKANS School of Accountancy 99 AFM: Advanced Financial Management ) FA AP Exercise? A, C Less: Closing Price Gain or Loss IM Outcome Outcome in future Market C 3 A Premium Income Borrow Sell Call Option @ highest exercise price Investment Sell Put Option @ lowest exercise price 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑋𝑋 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ 1,200 Exercise Price M 2 Formulas Value IS A, Interest Rate Collar Answer No. Description and explanation 1 Net Outcome of Interest rate options with best exercise Price Type of Contract Study Notes Yes/No Ad v .D ip 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑋𝑋 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿ℎ 1,200 No.1 + No.2 – No.3 As ad Ej a z (A C A, F C C A, Net Outcome of Collar SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 100 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Option Pricing Option Pricing and the determinants Value of Call Option if increases Value of Put Option if increases Pa = Current Price of underlying Asset Increase Decrease Pe = Exercise Price Decrease Increase T = Time to expiry (in Years) Increase Increase .D ip M A IM A, C Determinants C The Value of the Option will depend on the following factors IS A, AP FA ) Call Option:The right but not the obligation to buy a particular asset at an exercise price Put Option: The right but not an obligation to sell a particular asset at an exercise price S = Standard Deviation Ad v r = Risk free rate Increase Increase Decrease See from the Normal distribution table C C A, N (d) = Normal Distribution Value Increase A, F The Black Scholes Model Ej az (A C THE Black-Scholes model values options before the expiry date and takes account of all the determinants that effect the value of option As ad Where: 𝐶𝐶 = 𝑃𝑃𝑎𝑎 𝑁𝑁(𝑑𝑑1 ) − 𝑃𝑃𝑒𝑒 𝑁𝑁(𝑑𝑑2 )𝑒𝑒 −𝑟𝑟𝑟𝑟 𝑃𝑃 = 𝐶𝐶 − 𝑃𝑃𝑎𝑎 + 𝑃𝑃𝑒𝑒 𝑒𝑒 −𝑟𝑟𝑟𝑟 𝑃𝑃 ln � 𝑎𝑎 � + (𝑟𝑟 + 0.5𝑆𝑆 2 )𝑡𝑡 𝑃𝑃𝑒𝑒 𝑑𝑑1 = 𝑆𝑆√𝑡𝑡 𝑑𝑑2 = 𝑑𝑑1 − 𝑆𝑆√𝑡𝑡 If ‘d’ is positive then N(d) = 0.5 + Value from Table SKANS School of Accountancy 101 AFM: Advanced Financial Management Study Notes If ‘d’ is negative then N(d) = 0.5 - Value from Table A, C IS A, AP FA ) Example The current share price of X Company is $17. What should be the price of a Call Option and Put Option on the company’s shares at an exercise price of $16.50, if the expiry date is in six months, the standard deviation of annual returns on the share is 12% and the risk-free rate of return is 7% per year? Pa = 17 Pe = 16.5 r = 7% t = 6 months to expiry, t = 0.50. s = 0.12 As ad Ej az (A C A, F C C A, Ad v .D ip M A C IM Solution SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 102 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes FA AP Delta = change in call option price ÷ change in the price of the shares ) The Greeks Delta In Black-Scholes model, the value of N(d1) can be used to indicate the amount of the underlying shares (or other instruments) which the writer of an option should hold in order to hedge the option position. IS A, N(d1) = Delta The appropriate „hedge ratio‟ N(d1) is referred to as the delta value; hence the term delta hedge. The delta value is valid if the price changes are small. IM A, C DELTA HEDGING CALL OPTION A bank that writes a large number of options has an option portfolio. It might want to create a hedge for its exposure to adverse price movements. .D ip M A C A bank that writes call options can create an option position that is delta neutral by purchasing a quantity of the underlying item. For example, a bank that has written call options on the shares of XYZ Company can hedge the position by holding some shares in XYZ. A, Ad v If the value of the underlying shares goes up, the value of the call options will also go up. The bank will incur a loss on its options position, because it has written options. However, it makes a gain on the rise in the value of the underlying shares. Ej az (A C A, F C C A delta neutral position will exist when the rise in the value of the options (= benefit to the option holders and loss for the option writer) is matched by an equal rise in the value of the shares held by the option writer (bank). This will leave the bank with neither a loss nor a gain. The number of shares that a call option writer should hold to create a delta hedge is No. of shares to held = No. of Call options to sell X N(d1) Similarly: No. of call options to sell = No. of shares held / N(d1) As ad For example if the delta value for call options on 1,000,000 shares of XYZ Company at an exercise price of $15 is 0.45, a delta hedge will be created by holding 450,000 of the shares (1,000,000 × 0.45) = 450,000. Note: For put option use N(- d1) SKANS School of Accountancy 103 AFM: Advanced Financial Management Study Notes Due to change in: Option price Underlying asset value Gamma Delta Underlying asset value Vega Option price Volatility Rho Option price Interest rate Theta Option price Time to expiry AP IS A, A, C Delta FA Change in: ) Other Greeks C IM The Real Options .D ip M A The conventional NPV method assumes that a project commences immediately and proceeds until it finishes, as originally predicted. Therefore, it assumes that a decision has to be made on a now or never basis, and once made, it cannot be changed. It does not recognize that most investment appraisal decisions are flexible and give managers a choice of what actions to undertake. az (A C A, F C C A, Ad v The real options method estimates a value for this flexibility and choice, which is present when managers are making a decision on whether or not to undertake a project. Real options build on net present value in situations where uncertainty exists and, for example: (i) when the decision does not have to be made on a now or never basis, but can be delayed, (ii) when a decision can be changed once it has been made, or (iii) when there are opportunities to exploit in the future contingent on an initial project being undertaken. Therefore, where an organization has some flexibility in the decision that has been, or is going to be made, an option exists for the organization to alter its decision at a future date and this choice has a value As ad Ej To Value that we will use the same Black Scholes Option Pricing models. There will be three different situations i.e. Option to delay Call Option Option to expand Call Option Option to abandon Put Option SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 104 Downloaded from - www.ACCAGlobalBox.com AFM: Advanced Financial Management Study Notes Dividends AP FA ) Free cash flow and dividend capacity The ability of a company to source capital investments internally depends not only on the amount of cash flows generated, but also on dividend policy. However, the Maximum dividend that the firm should pay equals to free cashflow to equity. A, C IS A, An entity could distribute all of its free cash flow to equity but in practice only a proportion is paid out. A company will retain part of the free cash flow to reinvest in the business. Dividend Policies Ad v .D ip M A C IM Stable Dividend Some companies follow a policy of paying fixed dividend per share irrespective of the level of earning year after year. Such firm creates reserves i.e dividend equalization reserves to enable them to pay the fixed dividend even in case of insufficient earnings.it more suits to those companies having stable earnings. Dividend level (growth) should be related to profit levels (Growth). Retain profit should be linked with the investments of new projects. (A C A, F C C A, Advantages of Stable Dividend Policy: A Stable dividend policy is advantageous to both investors and company on account of the following: It is sign of continued normal operations of company. It stabilizes market value of shares. It creates confidence among investors. It improves credit standing and making financing easier. It meets requirements of institutional investors who prefer companies with stable dividends. As ad Ej az Dangers of Stable dividend policy In spite of many advantages, the stable dividend policy suffers from certain limitations. Once a stable dividend policy is followed by a company, it is not easier to change it. If stable dividends are not paid to shareholders on any account including insufficient profits, the financial standing of company in minds of investors is damaged and they may like to dispose of their holdings. It adversely affects the market price of shares of the company. And if companies pay stable dividends in spite of its incapacity it will be suicidal in long run. Constant payout ratio SKANS School of Accountancy 105 AFM: Advanced Financial Management Study Notes It means payment of fixed percentage of net earnings as dividends every year. The amount of dividend in such a policy fluctuates in direct proportion to earnings of company. The policy of constant payout is preferred by the firms because it is related to their ability to pay dividends. AP FA ) Stable Dividend plus extra dividend: Some companies follow a policy of paying constant low dividend per share plus an extra dividend in the years of high profit. Such a policy is most suitable to the firm having fluctuating earnings from year to year. M A C IM A, C IS A, Residual dividend Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can come out of the residual or leftover equity only after all project capital requirements are met. These companies usually attempt to maintain balance in their debt/equity ratios before making any dividend distributions, deciding on dividends only if there is enough money left over after all operating and expansion expenses are met. .D ip A primary advantage of the dividend-residual model is that with capital-projects budgeting, the residual dividend model is useful in setting longer-term dividend policy. A significant disadvantage is that dividends may be unstable. (A C A, F C C A, Ad v Irregular Dividend Policy: Some companies follow irregular dividend payments on account of following: Uncertainty of Business. Unsuccessful Business operations Lack of liquid resources. Fear of adverse effects of regular dividend on financial standing of company. No Dividend Policy: As ad Ej az A company may follow a policy of paying no dividends presently because of its unfavorable working capital position or on account of requirements of funds for future expansion and growth. SKANS School of Accountancy ( www.ACCAGlobalBox.com ) 106 Downloaded from - www.ACCAGlobalBox.com Study Notes A ,C IS A A P FA ) FM: Financial Management A sa d E ja z (A C A ,F C C A ,A dv D ip M A C IM Math and Formula Table By: Asad Ejaz (ACA, FCCA, Adv. Dip MA CIMA, CISA, APFA) 107 Formulae Modigliani and Miller Proposition 2 (with tax) Vd Ve FA ) k e = kie + (1 – T)(kie – k d ) Two asset portfolio IS A A P sp = w2a s2a + w2b s2b + 2wawbrab sasb The Capital Asset Pricing Model IM A ,C E(ri ) = Rf + βi (E(rm ) – Rf ) The asset beta formula ip M A C ⎡ ⎤ ⎤ ⎡ V (1 – T) Ve d βa = ⎢ βe ⎥ + ⎢ βd ⎥ ⎢⎣ (Ve + Vd (1 – T)) ⎥⎦ ⎢⎣ (Ve + Vd (1 – T)) ⎥⎦ D The Growth Model Do (1 + g) dv Po = ,A (re – g) A Gordon’s growth approximation The weighted average cost of capital ⎡ V ⎤ ⎡ V ⎤ e d ⎥ ke + ⎢ ⎥ k (1 – T) WACC = ⎢ ⎢⎣ Ve + Vd ⎥⎦ ⎢⎣ Ve + Vd ⎥⎦ d z (A C A ,F C C g = bre ja The Fisher formula A sa d E (1 + i) = (1 + r)(1+h) Purchasing power parity and interest rate parity S1 = S0 x (1+hc ) (1+hb ) F0 = S0 x (1+ic ) (1+ib ) ( www.ACCAGlobalBox.com ) Downloaded from - www.ACCAGlobalBox.com Modified Internal Rate of Return 1 ⎡ PV ⎤ n MIRR = ⎢ R ⎥ 1 + re – 1 ⎢⎣ PVI ⎥⎦ ) ( FA ) The Black-Scholes option pricing model P c = PaN(d1) – PeN(d2 )e –rt ln(Pa / Pe ) + (r+0.5s2 )t IS A d1 = A Where: s t The Put Call Parity relationship A sa d E ja z (A C A ,F C C A ,A dv D ip M A C p = c – Pa + Pee –rt IM A ,C d2 = d1 – s t [P.T.O. Present Value Table Present value of 1 i.e. (1 + r)–n Where r = discount rate n = number of periods until payment 3% 4% 5% 6% 7% 8% 9% 10% 1 2 3 4 5 0·990 ) 0·980 ) 0·971 ) 0·961 ) 0·951 ) 0·980 ) 0·961 ) 0·942 ) 0·924 ) 0·906 ) 0·971 ) 0·943 ) 0·915 ) 0·888 ) 0·863 ) 0·962 ) 0·925 ) 0·889 ) 0·855 ) 0·822 ) 0·952 ) 0·907 ) 0·864 ) 0·823 ) 0·784 ) 0·943 ) 0·890 ) 0·840 ) 0·792 ) 0·747 ) 0·935 ) 0·873 ) 0·816 ) 0·763 ) 0·713 ) 0·926 ) 0·857 ) 0·794 ) 0·735 ) 0·681 ) 0·917 ) 0·842 ) 0·772 ) 0·708 ) 0·650 ) 0·909 ) 0·826 ) 0·751 ) 0·683 ) 0·621 ) A 1 2 3 4 5 6 7 8 9 10 0·942 ) 0·933 ) 0·923 ) 0·941 ) 0·905 ) 0·888 ) 0·871 ) 0·853 ) 0·837 ) 0·820 ) 0·837 ) 0·813 ) 0·789 ) 0·766 ) 0·744 ) 0·790 ) 0·760 ) 0·731 ) 0·703 ) 0·676 ) 0·746 ) 0·711 ) 0·677 ) 0·645 ) 0·614 ) 0·705 ) 0·665 ) 0·627 ) 0·592 ) 0·558 ) 0·666 ) 0·623 ) 0·582 ) 0·544 ) 0·508 ) 0·630 ) 0·583 ) 0·540 ) 0·500 ) 0·463 ) 0·596 ) 0·547 ) 0·502 ) 0·460 ) 0·422 ) 0·564 ) 0·513 ) 0·467 ) 0·424 ) 0·386 ) 6 7 8 9 10 11 12 13 14 15 0·896 ) 0·887 ) 0·879 ) 0·870 ) 0·861 ) 0·804 ) 0·788 ) 0·773 ) 0·758 ) 0·743 ) 0·722 ) 0·701 ) 0·681 ) 0·661 ) 0·642 ) 0·650 ) 0·625 ) 0·601 ) 0·577 ) 0·555 ) 0·585 ) 0·557 ) 0·530 ) 0·505 ) 0·481 ) 0·527 ) 0·497 ) 0·469 ) 0·442 ) 0·417 ) 0·475 ) 0·444 ) 0·415 ) 0·388 ) 0·362 ) 0·429 ) 0·397 ) 0·368 ) 0·340 ) 0·315 ) 0·388 ) 0·356 ) 0·326 ) 0·299 ) 0·275 ) 0·305 ) 0·319 ) 0·290 ) 0·263 ) 0·239 ) 11 12 13 14 15 (n) 11% 12% 13% 14% 1 2 3 4 5 0·901 ) 0·812 ) 0·731 ) 0·659 ) 0·593 ) 0·893 ) 0·797 ) 0·712 ) 0·636 ) 0·567 ) 0·885 ) 0·783 ) 0·693 ) 0·613 ) 0·543 ) 6 7 8 9 10 0·535 ) 0·482 ) 0·434 ) 0·391 ) 0·352 ) 0·507 ) 0·452 ) 0·404 ) 0·361 ) 0·322 ) 0·317 ) 0·286 ) 0·258 ) 0·232 ) 0·209 ) 0·287 ) 0·257 ) 0·229 ) 0·205 ) 0·183 ) A IM A C A M ip D dv 16% 17% 18% 19% 20% 0·877 ) 0·769 ) 0·675 ) 0·592 ) 0·519 ) 0·870 ) 0·756 ) 0·658 ) 0·572 ) 0·497 ) 0·862 ) 0·743 ) 0·641 ) 0·552 ) 0·476 ) 0·855 ) 0·731 ) 0·624 ) 0·534 ) 0·456 ) 0·847 ) 0·718 ) 0·609 ) 0·516 ) 0·437 ) 0·840 ) 0·706 ) 0·593 ) 0·499 ) 0·419 ) 0·833 ) 0·694 ) 0·579 ) 0·482 ) 0·402 ) 1 2 3 4 5 0·480 ) 0·425 ) 0·376 ) 0·333 ) 0·295 ) 0·456 ) 0·400 ) 0·351 ) 0·308 ) 0·270 ) 0·432 ) 0·376 ) 0·327 ) 0·284 ) 0·247 ) 0·410 ) 0·354 ) 0·305 ) 0·263 ) 0·227 ) 0·390 ) 0·333 ) 0·285 ) 0·243 ) 0·208 ) 0·370 ) 0·314 ) 0·266 ) 0·225 ) 0·191 ) 0·352 ) 0·296 ) 0·249 ) 0·209 ) 0·176 ) 0·335 ) 0·279 ) 0·233 ) 0·194 ) 0·162 ) 6 7 8 9 10 0·261 ) 0·231 ) 0·204 ) 0·181 ) 0·160 ) 0·237 ) 0·208 ) 0·182 ) 0·160 ) 0·140 ) 0·215 ) 0·187 ) 0·163 ) 0·141 ) 0·123 ) 0·195 ) 0·168 ) 0·145 ) 0·125 ) 0·108 ) 0·178 ) 0·152 ) 0·130 ) 0·111 ) 0·095 ) 0·162 ) 0·137 ) 0·116 ) 0·099 ) 0·084 ) 0·148 ) 0·124 ) 0·104 ) 0·088 ) 0·074 ) 0·135 ) 0·112 ) 0·093 ) 0·078 ) 0·065 ) 11 12 13 14 15 ,F C C A ,A 15% A C (A z ja E sa d 11 12 13 14 15 P 2% ,C 1% IS A Periods (n) FA ) Discount rate (r) ( www.ACCAGlobalBox.com ) Downloaded from - www.ACCAGlobalBox.com Annuity Table – (1 + r)–n Present value of an annuity of 1 i.e. 1————–– r r = discount rate n = number of periods FA ) Where 2% 3% 4% 5% 6% 7% 8% 9% 1 2 3 4 5 0·990 1·970 2·941 3·902 4·853 0·980 1·942 2·884 3·808 4·713 0·971 1·913 2·829 3·717 4·580 0·962 1·886 2·775 3·630 4·452 0·952 1·859 2·723 3·546 4·329 0·943 1·833 2·673 3·465 4·212 0·935 1·808 2·624 3·387 4·100 0·926 1·783 2·577 3·312 3·993 0·917 1·759 2·531 3·240 3·890 0·909 1·736 2·487 3·170 3·791 IS A 1 2 3 4 5 6 7 8 9 10 5·795 6·728 7·652 8·566 9·471 5·601 6·472 7·325 8·162 8·983 5·417 6·230 7·020 7·786 8·530 5·242 6·002 6·733 7·435 8·111 5·076 5·786 6·463 7·108 7·722 4·917 5·582 6·210 6·802 7·360 4·767 5·389 5·971 6·515 7·024 4·623 5·206 5·747 6·247 6·710 4·486 5·033 5·535 5·995 6·418 4·355 4·868 5·335 5·759 6·145 6 7 8 9 10 11 12 13 14 15 10·368 10·37 11·255 11·26 12·134 12·13 13·004 13·00 13·865 13·87 9·787 10·575 10·58 11·348 11·35 12·106 12·11 12·849 12·85 9·253 9·954 10·635 10·63 11·296 11·30 11·938 11·94 8·760 9·385 9·986 10·563 10·56 11·118 11·12 8·306 8·863 9·394 9·899 10·380 10·38 7·887 8·384 8·853 9·295 9·712 7·499 7·943 8·358 8·745 9·108 7·139 7·536 7·904 8·244 8·559 6·805 7·161 7·487 7·786 8·061 6·495 6·814 7·103 7·367 7·606 11 12 13 14 15 (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 2 3 4 5 0·901 1·713 2·444 3·102 3·696 0·893 1·690 2·402 3·037 3·605 0·885 1·668 2·361 2·974 3·517 0·877 1·647 2·322 2·914 3·433 0·870 1·626 2·283 2·855 3·352 0·862 1·605 2·246 2·798 3·274 0·855 1·585 2·210 2·743 3·199 0·847 1·566 2·174 2·690 3·127 0·840 1·547 2·140 2·639 3·058 0·833 1·528 2·106 2·589 2·991 1 2 3 4 5 6 7 8 9 10 4·231 4·712 5·146 5·537 5·889 4·111 4·564 4·968 5·328 5·650 3·998 4·423 4·799 5·132 5·426 3·889 4·288 4·639 4·946 5·216 3·784 4·160 4·487 4·772 5·019 3·685 4·039 4·344 4·607 4·833 3·589 3·922 4·207 4·451 4·659 3·498 3·812 4·078 4·303 4·494 3·410 3·706 3·954 4·163 4·339 3·326 3·605 3·837 4·031 4·192 6 7 8 9 10 5·938 6·194 6·424 6·628 6·811 5·687 5·918 6·122 6·302 6·462 5·453 5·660 5·842 6·002 6·142 5·234 5·421 5·583 5·724 5·847 5·029 5·197 5·342 5·468 5·575 4·836 4·988 5·118 5·229 5·324 4·656 4·793 4·910 5·008 5·092 4·486 4·611 4·715 4·802 4·876 4·327 4·439 4·533 4·611 4·675 11 12 13 14 15 A 6·207 6·492 6·750 6·982 7·191 IM A C A M ip D dv ,A A C C ,F A (A z ja E sa d 11 12 13 14 15 P 1% ,C Periods (n) C Discount rate (r) A 10% [P.T.O. 0·02 0·0080 0·0478 0·0871 0·1255 0·1628 0·03 0·0120 0·0517 0·0910 0·1293 0·1664 0·04 0·0160 0·0557 0·0948 0·1331 0·1700 0·05 0·0199 0·0596 0·0987 0·1368 0·1736 0·06 0·0239 0·0636 0·1026 0·1406 0·1772 0·07 0·0279 0·0675 0·1064 0·1443 0·1808 0·08 0·0319 0·0714 0·1103 0·1480 0·1844 0·09 0·0359 0·0753 0·1141 0·1517 0·1879 0·5 0·6 0·7 0·8 0·9 0·1915 0·2257 0·2580 0·2881 0·3159 0·1950 0·2291 0·2611 0·2910 0·3186 0·1985 0·2324 0·2642 0·2939 0·3212 0·2019 0·2357 0·2673 0·2967 0·3238 0·2054 0·2389 0·2704 0·2995 0·3264 0·2088 0·2422 0·2734 0·3023 0·3289 0·2123 0·2454 0·2764 0·3051 0·3315 0·2157 0·2486 0·2794 0·3078 0·3340 0·2190 0·2517 0·2823 0·3106 0·3365 0·2224 0·2549 0·2852 0·3133 0·3389 P 1·0 1·1 1·2 1·3 1·4 0·3413 0·3643 0·3849 0·4032 0·4192 0·3438 0·3665 0·3869 0·4049 0·4207 0·3461 0·3686 0·3888 0·4066 0·4222 0·3485 0·3708 0·3907 0·4082 0·4236 0·3508 0·3729 0·3925 0·4099 0·4251 0·3531 0·3749 0·3944 0·4115 0·4265 0·3554 0·3770 0·3962 0·4131 0·4279 0·3577 0·3790 0·3980 0·4147 0·4292 0·3599 0·3810 0·3997 0·4162 0·4306 0·3621 0·3830 0·4015 0·4177 0·4319 1·5 1·6 1·7 1·8 1·9 0·4332 0·4452 0·4554 0·4641 0·4713 0·4345 0·4463 0·4564 0·4649 0·4719 0·4357 0·4474 0·4573 0·4656 0·4726 0·4370 0·4484 0·4582 0·4664 0·4732 0·4382 0·4495 0·4591 0·4671 0·4738 0·4394 0·4505 0·4599 0·4678 0·4744 0·4406 0·4515 0·4608 0·4686 0·4750 0·4418 0·4525 0·4616 0·4693 0·4756 0·4429 0·4535 0·4625 0·4699 0·4761 0·4441 0·4545 0·4633 0·4706 0·4767 2·0 2·1 2·2 2·3 2·4 0·4772 0·4821 0·4861 0·4893 0·4918 0·4778 0·4826 0·4864 0·4896 0·4920 0·4783 0·4830 0·4868 0·4898 0·4922 0·4788 0·4834 0·4871 0·4901 0·4925 0·4793 0·4838 0·4875 0·4904 0·4927 0·4798 0·4842 0·4878 0·4906 0·4929 0·4803 0·4846 0·4881 0·4909 0·4931 0·4808 0·4850 0·4884 0·4911 0·4932 0·4812 0·4854 0·4887 0·4913 0·4934 0·4817 0·4857 0·4890 0·4916 0·4936 2·5 2·6 2·7 2·8 2·9 0·4938 0·4953 0·4965 0·4974 0·4981 0·4940 0·4955 0·4966 0·4975 0·4982 0·4941 0·4956 0·4967 0·4976 0·4982 0·4943 0·4957 0·4968 0·4977 0·4983 0·4945 0·4959 0·4969 0·4977 0·4984 0·4946 0·4960 0·4970 0·4978 0·4984 0·4948 0·4961 0·4971 0·4979 0·4985 0·4949 0·4962 0·4972 0·4979 0·4985 0·4951 0·4963 0·4973 0·4980 0·4986 0·4952 0·4964 0·4974 0·4981 0·4986 0·4987 0·4987 0·4988 0·4988 0·4989 0·4989 0·4989 0·4990 0·4990 A ,C IM A C A M ip D dv ,A A C C ,F A C (A z ja E 0·4987 A sa d 3·0 ) 0·01 0·0040 0·0438 0·0832 0·1217 0·1591 FA 0·0 0·1 0·2 0·3 0·4 0·00 0·0000 0·0398 0·0793 0·1179 0·1554 IS A Standard normal distribution table This table can be used to calculate N(d), the cumulative normal distribution functions needed for the Black-Scholes model of option pricing. If di > 0, add 0·5 to the relevant number above. If di < 0, subtract the relevant number above from 0·5. End of Question Paper ( www.ACCAGlobalBox.com )