ACCA (AFM)
ADVANCED FINANCIAL
MANAGEMENT
COMPLETE SUBJECT NOTES
BY VERTEX LEARNING SOLUTIONS
Valid Until Dec 2024
Copyright Notice
©️ https://vls-online.com 2023. All Rights Reserved
The material contained within this electronic publication is protected under International and UK
Copyright Laws and treaties, and as such any unauthorized reprint or use of this material is strictly
prohibited. You may not copy, forward, or transfer this publication or any part of it, whether in
electronic or printed form, to another person, or entity.
Reproduction or translation of any part of this work without the permission of the copyright
holder is against the law.
You’re downloading and use of this eBook requires, and is an indication of, your complete
acceptance of these ‘Terms of Use.’
You do not have any right to resell or give away part, or the whole, of this eBook.
1
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
TABLE OF CONTENTS
CHAPTER
TOPIC
PAGE NO.
1
Financial Strategy Formulation
3
2
Financial Strategy Evaluation
16
3
Discounted Cash Flow Techniques
30
4
Application of Option Pricing Theory to Investment
40
Decisions
5
International Investment Decisions
44
6
Cost of Capital and Changing Risk
51
7
Financing and Credit Risk
60
8
Valuation for Acquisitions and Mergers
69
9
Acquisitions Strategic Issues and Regulation
84
10
Financing Acquisitions and Mergers
94
11
The Role of the Treasury Function
105
12
Managing Currency Risk
111
13
Managing Interest Rate Risk
132
14
Financial Reconstruction
148
15
Business Reorganization
153
16
Planning and Trading Issues for Multinationals
160
2
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Chapter 1 - Financial Strategy Formulation
The Principal Financial Objective of a Company
Financial Objectives
Traditionally Financial objectives have been considered as the basic financial
objective of a company.
The primary financial objectives are to maximize shareholders wealth in terms of
increasing in value of entity (Increase in share value) and providing returns to
investors in form of dividends
Non-Financial Objectives
Achieving Non-Financial objectives is essential for long term sustainability of an
entity. These non-financial objectives can be achieved along with financial
objectives
e.g., a manufacturing company that is aiming to differentiate itself based on
quality will require targets for defect rates. This does not negate the importance
of financial objectives but emphasizes the need for companies to have other
targets than the maximization of shareholders' wealth
Financial Strategy Formulation
Financial strategy should organize an organization’s resources to maximize return
to shareholders
Financial management is often described in terms of the three basic decisions to
be made
 Investment decisions
 Financing decisions
 Dividend decisions
3
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Investment Decisions
Investment decisions are often seen as the key mechanism for creating
shareholders wealth. A company may invest in one of the three basic areas
1. Capital assets
2. Financial assets
3. Working capital
Investment decisions has been covered in significant details in later chapters
Financing Decisions
For making investment decisions successful, financial managers need to carefully
decide how to finance these investments
Before finalizing any financing decision, financial manager should consider

the total funds required

whether these should be internally or externally sourced

Should Debt or equity Finance be raised

Long term debt or short-term debt should be suitable
Financing decisions has been covered in later chapters in great details
Dividend Decisions
Dividend is the amount of return to be paid in cash to shareholders. Dividend
decisions may affect the view of long-term prospects of the company. Payment
of dividend limits the amount of retain earnings available for reinvestment. Due to
this reason, it is very critical decision to be made by financial managers as How
much dividend shall be paid
Risk Management Decisions
Risk management decisions, in the AFM exam, mainly involve management of
exchange rate and interest rate risk and project management issues.
4
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Volatility of the organization cashflows may have a significant influence on
organization’s approach to risk management
Dividend Policy
Dividend decisions relate to the determination of how much and how frequently
cash can be paid out of the profits of an organization as income for its owners
The owners of profit-making organization will be rewarded in two ways
1) Capital gain (rise in value of shares)
2) Dividend (cash paid out to owners)
Factors Influencing a Dividend Policy
The following factors will be considered when deciding the dividend policy of an
organization
Profitability
Dividend is paid out of profits and a company cannot pay dividends which is
higher than its distributable profits. A company with stable profits is more likely to
be able to pay out a higher percentage of earnings than a company with
fluctuating profits
Liquidity
Cash should be available to pay out dividends. Even more profitable companies
might not be liquid enough and find it difficult to pay dividends to its owners
Debt Repayment
Dividend policy will be affected if debt is schedule to be repaid. This is a concern
when debt is not replaced by other source of finance
5
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Covenants
Companies article of association or the debt holder may impose restrictive
covenants limiting the amount of dividend to be paid to its shareholders
Expansion
Companies may be encouraged to finance their investment from retain earnings
rather than other sources of finance. Therefore, they will limit the amount of
dividend to be paid and prefers to invest in more profitable projects which will
ultimately enhance shareholders value
Signaling effect
Dividends are seen as signal from the company to financial markets and
Shareholders. Investors perceive dividend announcements as signals of future
prospects for the company
Taxations
Dividends and capital gains are subject to tax in various jurisdictions. Normally
dividend payment is taxed higher than capital gains. This fact also put an
influence on dividend policy of an organization
Practical Dividend Policies
One of the following patterns a company could adopt to pay out dividends over
time
1. Constant Payout Ratio
A company can pay a constant proportion of earnings as dividends to its
Shareholders e.g., 10% of profits
Dividend per share will be fluctuated by increase or decrease in profits
6
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
2. Stable Dividend Policy
A company will pay a fixed amount of dividend per share irrespective of the
earnings available to its shareholders
3. Residual Policy
All positive NPV Projects will be invested from retain earnings first. Remaining
amount will be paid out as dividends to shareholders
4. Zero Pay-Out Policy
A company may wish to retain earnings for reinvestment and do not pay any
dividend to its shareholders. This usually occurs in fast growing companies or those
in financial distress
Dividend Policy and Shareholders Wealth
Does the dividend policy adopted by a company have an influence on its
shareholders’ wealth?
There are two school of thoughts to answer this question
1. Dividend relevance theory
2. Dividend Irrelevance theory
1. Dividend Relevance Theory
The argument is that dividend policy has an influence on the market value of the
company due to the following reasons
Signaling Effect
Dividends are seen as signal from the company to financial markets and
Shareholders. Investors perceive dividend announcements as signals of future
prospects for the company
7
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Clientele Effect
Clientele effect says that shareholders are attracted to the companies as a result
of their dividend policies. A company with an established dividend policy is
therefore likely to have an established dividend clientele. The existence of this
dividend clientele implies that the share price may change if there is a change in
the dividend policy of the company
Secured Income
One argument is that income inform of dividend is more secured than income
inform of capital gain. Therefore, investors place value on high pay out shares
Dividend as Income
Many investors require cash dividends to finance their daily routine consumptions
e.g., Retired individuals. Therefore, prefers cash dividend rather than increase in
share price
2. Dividend Irrelevance Theory (M&M) Theory:
Modigliani and miller say that change in dividend policy will not affect
shareholders wealth because value of company is dependent upon investment
decisions alone and not on its dividend or financing decisions
According to them, investors react to the reasons for change not the change
itself. For example, if dividend is reduced in order to finance expansion, the share
price will not automatically fall. It would be the shareholders’ expectations with
respect to the expansion that influences the share price.
Most of the positive NPV projects will be undertaken. Therefore, a cash lost now
will be compensated by increase in the share price.
Given a set investment policy, a dividend cut now to finance new projects will be
compensated by higher dividends at a later stage. Since investors had perfect
8
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
information, they will be indifferent between dividends and capital gains.
Shareholders who are unhappy with the level of dividend declared by a
company could gain a ‘home-made dividend’ by selling some of their shares. This
was possible since there are no transaction costs in a perfect capital market. It
theoretically makes no difference whether the new investment is funded by
retention of dividend or new equity raised.
Alternative to Cash Dividends
Rather than paying dividend as cash, companies have adopted different ways
of rewarding shareholders. The most common are scrip dividends and share
buybacks which are discussed as under.
Scrip Dividends
Scrip dividend is a process of providing shareholders with an option to receive
shares in form of dividend instead of cash. It allows shareholders to increase the
size of shareholding with the company.
Scrip dividend will boost liquidity position of the company because it will reduce
the cash outflow and enables the company to reinvest these funds in positive NPV
projects.
Scrip dividend will also lead to a decrease in gearing because of the increase in
issued shares and may help to increase the company’s debt capacity.
A drawback of scrip dividends is that it may lead to increased dividend payment
in future due to issue of additional shares being issued (Assuming constant
dividend per share.
Another issue is that scrip dividend is optional, and shareholders might not accept
it.
9
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Share Buybacks
Companies with cash surpluses, but having no positive NPV projects, may choose
to introduce a share buy-back scheme where they buy back their own shares in
open market.
Advantages of share buybacks:

Avoids increasing expectations of higher dividends in future (which may be
a problem if dividends are increased).

Provides disaffected shareholders with an exit route, in this sense it is a
defense against a takeover.

Taxed as a capital gain which may be advantageous if the tax on capital
gains is below the rate used to tax dividend income.

If shares are under-valued, the company may be able to buy shares at a
low price which will benefit the remaining shareholders. Fewer shares will
improve EPS and DPS ratios
Special Dividend
Another way of returning a significant amount of cash to shareholders is by a
special dividend, a cash payment far in excess of the dividend payments that are
normally made.
This has a similar effect of returning significant amounts of cash to shareholders,
but unlike a share buyback it impacts all shareholders. A special dividend is more
attractive than a share buy-back if shares are over-valued, and avoids
shareholders potentially diluting their control by participating in a share buyback.
Ethics
For financial strategy to be successful it needs to be communicated and
supported by key stakeholder groups.
10
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Stakeholders can broadly be categorized into:
1. Internal – Directors, employees
2. Connected – shareholders, banks, customers, suppliers
3. External – government, pressure groups, general public
Many of these groups may have conflicting objectives which may create ethical
issues that need to be carefully managed.
Ethics And Stakeholder Conflict
Ethical issues often arise from a conflict between the needs of different
stakeholder groups. There is a need to balance the needs of all groups in relation
to their relative strength.
Example of Stakeholder Conflict
1. Shareholders vs Directors
Shareholders generally want the company’s profits to increase because it affects
the dividend and capital gains so that they will be reluctant if company pays high
wages to its management
The relationship between management and shareholders is sometimes referred
to as an agency relationship, in which managers’ act as agents for the
shareholders
2. Shareholders vs Debt Holders
Debt holders may be more risk averse than shareholders, because it is only
shareholders who will benefit if risky projects succeed.
3. Shareholders and External Stakeholders
The impact of a company's activities may impact adversely on its environment,
e.g., noise, pollution.
11
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
4. Governance
Safeguarding against the risk of unethical behavior may also include the
adoption of a corporate governance framework of decision making that restricts
the power of executive directors (ED’s) and increases the role of independent
non-executive directors (NED’s) in the monitoring of their duties.
In some countries this can include a non-executive supervisory board with
representatives from the company's internal stakeholder groups including the
finance providers, employees and the company's management. It ensures that
the actions taken by the board are for the benefit of all the stakeholder groups
and to the company as a whole.
5. Integrated Reporting
Aim of integrated reporting is to explain to providers of financial capital how an
organisation creates value over time
Integrated reporting is a combination of qualitative and quantitative information
which can be explained by the help of six capitals
These capitals are:
1. Financial Capital
Funds available, obtained through financing or generated through
operations
2. Human Capital
Support for organisation's governance framework and ethical values
3. Intellectual Capital
Intangibles providing competitive advantage (patents, copyrights e.tc)
12
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
4. Social Capital
Shared
norms,
common
values
and
behaviors
Key
stakeholder
relationships, willingness to engage with stakeholders
5. Manufactured Capital
Manufactured
physical
objects
used
(buildings,
equipment,
and
infrastructure)
6. Natural Capital
Renewable and non-renewable environmental resources and processes
Triple Bottom Line(3BL)
3BL aims to measure entity’s performance from three perspective.
1. Economic
2. Social
3. Environmental
The concept behind the triple bottom line is that companies should focus as
much on social and environmental issues as they do on profits.
Focusing on and reporting the company’s environmental and social impact may
build and enhance its reputation. Increasing reputation may increase the longterm revenue of the company
Consideration and improvement of working standards and consulting employees
as part of this process, when assessing social factors, may help in retaining and
attracting high performing, high caliber employees.
This will benefit the company in the long term because of increased employee
motivation and performance. Employee involvement may also help reduce the
13
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
costs related to the company’s risk management activity and thus have a direct
cost reduction impact.
Monitoring and reporting on the performance of employees and managers as
part of the assessment of economic and social factors may help identify areas
where work can be done more effectively and efficiently. It may help managers
reconsider business processes and question areas where improvements can be
made.
Behavioral Finance
Financial management theories assume that decisions will always be made in a
rational manner. However, managers may make irrational decisions due to
various psychological factors.
Some of the main psychological factors affecting managerial decision-making
are:
Managerial Decisions
Overconfidence
Investor tends to overestimate their own abilities as a result they make irrational
decision
Entrapment
Managers are also reluctant to admit that they are wrong (they become trapped
by their past decisions). This helps to explain why managers persist with financial
strategies that are unlikely to succeed.
Agency Issues
Managers may follow their own self-interest, instead of focusing on shareholders
14
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Investors Decisions
Search for Patterns
Investors look for patterns which can be used to justify investment. This might
involve analysing a company's past returns and using this to extrapolate future
performance.
Narrow Framing
many investors fail to see the bigger picture and focus too much on short-term
fluctuations in share price movements
Availability Bias
people will often focus more on information that is prominent (available).
Prominent information is often the most recent information; this may help to
explain why share prices move significantly shortly after financial results are
published
Conservatism
Investors may be resistant to changing their opinion, for example, if a company's
profits are better than expected the share price may not react significantly
because investors underreact to this news.
15
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Chapter 2 - Financial Strategy Evaluation
Financing Decisions
The primary objective of a profit-making company is normally assumed to be to
maximize shareholder wealth
To be able to minimize the overall cost of finance, it is important initially to be able
to estimate the costs of each finance type.
Cost of Equity
Cost of equity can be determined by one of the following two methods
1. Capital asset pricing model
2. Dividend valuation model
Capital Asset Pricing Model (CAPM)
Capital asset pricing model is used to estimate cost of equity (ke). The CAPM
model is based upon the assumption that investors are well diversified so will have
eliminated all the unsystematic (specific) risk from their portfolios so only
systematic risk is relevant.
Unsystematic Risks
Unsystematic risks are company specific risks which can be eliminated by
diversification.
Systematic Risks:
Risk that will remain even if a diversified portfolio has been created because it is
determined by general market factors.
16
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Market risk is caused by factors which affect all industries and businesses e.g.
Interest rates, tax legislation, exchange rates and economic boom or recession
e.tc
Systematic risk is the sum of business risk and financial risk. The systematic risk of a
company can be assessed by equity beta of the company.
If company is financed entirely by equity, the systematic risk representing equity
beta will be business risk alone, in which case the equity beta will be the same as
the asset beta.
If the company has debt and equity both in its capital structure, the systematic
risk reflected by the equity beta will include both business risk and financial risk.
Business Risk
Business risk arises from the type of business an organization is involved in and
relates to uncertainty about the future and the organization’s business prospects.
Some common business risks are political risk , economic risk, fiscal risk, operational
risk, reputational risk e.tc
Financial Risk
Financial risk is volatility of earnings due to the financial policies of a business.
Financial risk arises due to the use of debt as a source of finance, and hence is
related to the capital structure of a company. It brings volatility to shareholders
returns because of Interest rate payments on these debts .
17
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Relationship Between Business and Financial Risk
A business with high business risk may be restricted in the amount of financial risk
it can sustain because, if financial risk is also high, this may push total risk above
the level that is acceptable to shareholders.
CAPM Formula
𝒌𝒆 = 𝑹𝑭 + (𝑩 × (𝑹𝑴 − 𝑹𝑭)
Where,
Ke = the cost of equity
Rf = risk free rate of return
Rm = expected return in the market
Rm – Rf = Rp = Risk premium
B =Beta factor (discussed below)
Beta Factor
Beta factor is a measure of the sensitivity of a share to movements in the overall
market. A beta factor measures market risk.
A beta factor of 1 is average because it means that the average change in the
return on a share has been the same as the market. Therefore, beta greater than
1 can be riskier and beta less than 1 can be less risky to the market
Further we need to distinguish the difference b/w beta asset and beta equity.
18
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Beta Equity
Beta equity represents both business and financial risk. In case of geared
company Beta equity will be Greater than Beta asset because of inclusion of
financial risk along with business risk of an entity.
Beta Asset
Beta asset (Ba) reflects Business risk only. Ungeared company will have no
financial risk in its capital structure therefore its Beta asset will be equal to beta
equity (Which will ultimately be used in CAPM formula to arrive at cost of equity)
Example:
Ali plc has an equity beta of 1.2. Assume there is a market premium for risk of 6%,
and the risk-free rate is 4%
Solution:
Using CAPM formula we can estimate cost of equity as
𝒌𝒆 = 𝑹𝒇 + (𝑩𝒆𝒕𝒂 𝒙 𝑹𝒊𝒔𝒌 𝒑𝒓𝒆𝒎𝒊𝒖𝒎
𝟒% + (𝟏. 𝟐 𝒙 𝟔%)
𝒌𝒆 = 𝟏𝟏. 𝟐%
Dividend Valuation Model
Cost of equity can also be estimated using dividend valuation model (DVM). This
model assumes that Dividend will grow at constant rate for a foreseeable future.
The formula for DVM is shows as under
𝒌𝒆 =
𝑫(𝟏 + 𝒈)
+𝒈
𝑴𝑽
19
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Where
D = current year dividend
G = Growth on dividends
MV = Market value is the ex-dividend share price means share price excluding
any declared dividend
Example
A company's share price is $10. The company has just paid an annual dividend of
$1.20 per share, and the dividend is expected to grow by 2% into the foreseeable
future
Required: Estimate cost of equity?
Solution:
𝒌𝒆 =
𝑫(𝟏 + 𝒈)
+𝒈
𝑴𝑽
$𝟏. 𝟐𝟎(𝟏 + 𝟐%)
+ 𝟐%
$𝟏𝟎
Ke= 14.24%
How to Estimate Growth?
Growth can be estimated using one of the following two methods
1. Average Growth model
2. Garden Growth model
20
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Average Growth Model
This model estimates growth on historic dividends .therefore it is also knowing as
historic growth model
𝟏⁄
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐲𝐞𝐚𝐫 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝒏
(
) −𝟏
𝑯𝒊𝒔𝒕𝒐𝒓𝒊𝒄 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅
For example:
2018
Dividend
per 18
2019
2020
2021
20
21
24
share
Required: estimate Growth?
Solution:
𝟏
𝟐𝟒 ⁄𝟑
( ) −𝟏
𝟏𝟖
G=10%
Garden Growth Model
This model estimates Growth on Future dividends, can be expressed by a formula
𝑮 = 𝒃𝒓
Where as
b = the proportion of earnings reinvested for growth
r = the rate of return on those reinvested earnings (return on equity)
21
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Example
A company has reported profits of $4 million and declared a dividend of $2million
dollars and requires return on equity of 10%.
Estimate Growth?
Solution:
Out of $4million profit for year, $2million has been paid out as dividends suggests
that remaining $2million (50%) has been retained for reinvestment
Using Garden growth model, Growth can be estimated as
𝑮 = 𝟓𝟎% 𝒙 𝟏𝟎%
G=5%
Cost of Debt
Bank Loan
A company will obtain tax relief on a bank loan therefore the post-tax cost of
debt for a bank loan will be
𝑰𝒏𝒕𝒆𝒓𝒔𝒕 % 𝒙 (𝟏 − 𝒕𝒂𝒙 𝒓𝒂𝒕𝒆 )
Example
A company has obtained a $5 million loan charging 15% Interest on it. Tax rate is
30%. Calculate cost of debt for a bank loan?
𝟓% 𝒙 (𝟏 − 𝟑𝟎%)
𝟑. 𝟓%
22
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Irredeemable Loan Notes
Cost of debt for irredeemable loan notes will be
𝒌𝒅 =
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑨𝒎𝒐𝒖𝒏𝒕 𝒙 (𝟏 − 𝒕𝒂𝒙 𝒓𝒂𝒕𝒆)
𝒙 𝟏𝟎𝟎
𝑴𝒂𝒓𝒌𝒆𝒕 𝒗𝒂𝒍𝒖𝒆
Example
The 10% irredeemable loan notes of Ali plc having a market value of $120. Tax is
payable at 30%. Calculate cost of debt
Solution:
Note: par value will always be $100 therefore Interest amount will be
$10($100*10%)
$𝟏𝟎 ∗ (𝟏 − 𝟑𝟎%)
𝒙𝟏𝟎𝟎
$𝟏𝟐𝟎
= 𝟓. 𝟖𝟑%
Redeemable Loan Notes
Cost of debt for a redeemable loan note can be estimated using IRR functions.
The following steps needs to be followed.
1. Calculate after tax interest
2. Calculate NPV Using Any two rates of cost of capital e.g., 10% and 1% or
any other two
3. Calculate IRR .This will be the cost of debt for redeemable loan notes
Example
The current market value of a company’s 6% loan stock is $99. The bonds will be
redeemed at $102 after four years. The rate of taxation on company profits is 20%.
Calculate the after-tax cost of debt for the company.
23
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Solution:
1. Interest
$𝟔 ∗ (𝟏 − 𝟎. 𝟐𝟎) = $𝟒. 𝟖
2. NPV using 2 rates
Years
Cash
flows DF@5%
($)
Market
Present
values($)
0
(99)
1
(99)
1-4
4.8
3.546
17.02
102
0.823
83.95
value
Interest
Redemption 4
value
NPV
1.97
Years
Market
Cash flows DF@10%
Present
($)
values($)
0
(99)
1
(99)
1-4
4.8
3.170
15.22
102
0.683
69.67
value
Interest
Redemption 4
value
NPV
(14.11)
24
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
3. IRR
𝑳 𝒏𝒑𝒗
𝑳 + 𝑳 𝒏𝒑𝒗−𝑯 𝑵𝒑𝒗 𝒙 𝑯 − 𝑳
𝟓% +
𝟏. 𝟗𝟕
𝒙(𝟏𝟎% − 𝟓%)
𝟏. 𝟗𝟕 − (−𝟏𝟒. 𝟏𝟏)
𝟓. 𝟔%
This 5.6% is the estimated cost of debt for redeemable bonds
Convertible Loan Notes
Cost of debt for a redeemable loan note can be estimated using IRR functions. In
convertible loan notes Investor has a choice to redeem its investment or convert
it into ordinary shares at the end of loan notes life.
Example
Continuing from previous example, let’s say Loan notes will be redeemed at $102
or converted into 50 ordinary shares with a market value of $2.10 per share.
In this case Investor will Accept the most lucrative option. Now investor will either
get $102 as redemption amount or $105 (50 x $2.10) as share conversion option.
Share conversion option being the most beneficial will be accepted by investor.
The cost of debt for convertible option will now be calculated as
Years
Cash
DF@5%
flows ($)
Market
Present
Df@10%
values($)
Present
values
0
(99)
1
(99)
1
(99)
Interest
1-4
4.8
3.546
17.02
3.170
15.22
Conversion
4
105
0.823
86.42
0.683
71.72
value
value
NPV
4.44
(12.06)
25
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
𝟓% +
𝟒. 𝟒𝟒
𝒙(𝟏𝟎% − 𝟓%)
𝟒. 𝟒𝟒 − (−𝟏𝟐. 𝟎𝟔)
6.35%
Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) is the rate that a company is
expected to pay on average to all its providers of capital to finance its assets.
WACC commonly include cost of Equity, Preference and Debt Sources.
How to calculate WACC?
1. Calculate cost of each finance source (Discussed above )
2. Calculate market value of each finance source (discussed below)
3. Use the following function to derive wacc
𝒌𝒆 [
𝑽𝒆
𝑽𝒅
] + 𝑲𝒅(𝟏 − 𝒕) [
]
𝑽𝒆 + 𝑽𝒅
𝑽𝒆 + 𝑽𝒅
Where,
Ve = total market value of equity
Vd = total market value of debt
Ke = cost of equity
Kd = cost of debt
26
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Market Value of each Finance Source
Market value of Equity
𝒎𝒂𝒓𝒌𝒆𝒕 𝒗𝒂𝒍𝒖𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 𝒙 𝒏𝒐. 𝒐𝒇 𝒔𝒉𝒂𝒓𝒆𝒔
Hint: Market value per share should exclude any dividends declared .it should be
ex dividend share price
Market Value of Debt
Bank Loan
Bank loan normally have no market value, its book value will be assumed as
market value
Other Loan Notes
𝑩𝒐𝒐𝒌 𝒗𝒂𝒍𝒖𝒆 𝒙
𝒎𝒂𝒓𝒌𝒆𝒕 𝒗𝒂𝒍𝒖𝒆
𝟏𝟎𝟎
Credit Rating
A bond's credit rating will also affect the return that is required by investors. Credit
rating agencies uses its own system to determine creditworthiness of individuals,
companies and even countries.
An example of the ratings used by a major credit ratings agency are shown below
Standards & poor’s
Definitions
AAA, AA+, AAA–, AA, AA–, A+
Excellent quality, lowest default risk
A, A–, BBB+
Good quality, low default risk
BBB, BBB–, BB+
Medium rating
BB or below
Junk bonds (speculative, high default
risk)
27
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
Credit rating is inversely proportional to cost of debt means that higher the credit
rating lowers the cost of debt obtained and vice versa
A company with AA+ credit rating will have low cost of debt because of having
low credit risk as compared to a company having B+ ratings
Yield Spread
The extra return (or yield spread) required by investors on a bond will depend on
its credit rating, and its maturity. These are often quoted as basis points over the
risk-free rate of return.
𝟏𝟎𝟎 𝑩𝒂𝒔𝒊𝒔 𝒑𝒐𝒊𝒏𝒕𝒔 = 𝟏%
Assessing Corporate Performance
You may be expected to use ratio analysis to evaluate the success of a financial
strategy.
Ratios are normally split into four categories: profitability, debt, liquidity, and
shareholder investor ratios. In the context of assessing performance, it is most likely
that profitability and shareholder investor ratios will be most relevant. You need to
learn these formulas
Key Profitability Ratios
Return on capital employed (ROCE)
𝑷𝑩𝑰𝑻
𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
or
𝒑𝒓𝒐𝒇𝒊𝒕 𝒎𝒂𝒓𝒈𝒊𝒏 𝒙 𝒂𝒔𝒔𝒆𝒕 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓
Shareholders Investor Ratio
Total Shareholders Return
28
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content
𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒚𝒊𝒆𝒍𝒅 + 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒈𝒂𝒊𝒏
Return on Equity
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔
𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔 𝒇𝒖𝒏𝒅𝒔
Earnings Per Share
𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙
𝒏𝒐. 𝒐𝒇 𝒔𝒉𝒂𝒓𝒆𝒔 𝒊𝒔𝒔𝒖𝒆𝒅
Price Earnings Ratio
𝑴𝒂𝒓𝒌𝒆𝒕 𝒑𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
29
VERTEX LEARNING SOLUTIONS - https://vls-online.com Click to go to Table of Content