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P4 - AFM - NOTES - 2020/2021
Advanced Financial Reporting
Advanced Financial Reporting (Association of Chartered Certified Accountants)
NOTES
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ACCA – AFM
ADVANCED FINANCIAL MANAGEMENT
STUDY NOTES
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Contents
Sr. #
TOPIC
Page #
1.
Investment Appraisal
01
2.
Net Present Value (NPV)
07
3.
Investment Appraisal in Capital Rationing Situation
14
4.
Weighted Average Cost of Capital (WACC)
24
5.
CAPM
35
6.
Mergers and Acquisitions
59
7.
Business Valuation
70
8.
Gain and Losses on Acquisition
80
9.
Corporate Restructuring
87
10.
Foreign Currency risk Management
93
11.
Option Contract
107
12.
Option on Interest Rate Future
114
13.
Limitations and Assumptions
139
14.
Reverse Takeovers – an Explanation
159
15.
Reverse Takeovers – the Potential Drawbacks
162
16.
Islamic Finance
164
17.
Expected Values, Decision Trees and Combined
probabilities
179
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Advanced Financial Management - AFM
INVESTMENT APPRAISAL
Decision Making
Short term
Long term
Capital expenditure:
Capital expenditure is expenditure which results in the acquisition of non-current assets or an improvement in
their earning capacity. It is not charged as an expense in the income statement; the expenditure appears as a noncurrent asset in the Statement of financial position.
Revenue expenditure:
Charged to the income statement and is expenditure which is incurred.
(i)
For the purpose of the trade of the business this includes expenditure classified as selling and distribution,
administration expenses and finance charges.
(ii)
To maintain the existing earning capacity of non-current asset.
Investment Appraisal:A detailed evaluation of projects or investments viability and its effects on shareholders wealth is called investment
appraisal.
Relevant Cash flows in Investment Appraisal
Relevant cash flows are those cash flows which are:
•
Directly related with the project.
•
Incremental
•
Future cash flows
Any cash flows or cost incurred in the past, or any committed cost which will be incurred regardless of whether the
investment is undertaken or not is a non-relevant cash flows e.g. sunk cost, Allocated/General fixed overheads etc.
The other cash flows, which should be considered as Relevant Cash flows, are as follow:
•
Opportunity Cost:
•
Tax:
•
Residual value:
•
Infra-structure Costs:
•
Marketing Costs:
•
Human resource costs:
Assumptions of Timing of Cash flows
 If Cash flows arise during the period, then it is assumed as it arises at the end of that period.
 If cash flow arises 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’.
pg. 1 of 186
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Time Value of Money
Sum of money received today has more worth than same sum of money received in future because of these reasons.
•
Inflation
•
Opportunity to reinvest
•
Risk and uncertainty
Simple interest
1.
1000 x 10% = $100
2.
1000 x 10% = $100
3.
1000 x 10% = $100
Cash flows are not reinvested each year
Compound interest
1.
1000 x 10% = 100 + 1000 = 1100
2.
1100 x 10% = 110 + 1100 = 1210
3.
1210 x 10% = 121 + 1210 = 1331
Cash flows are reinvested each year resulting in higher principal that increases the interest amount.
We can also calculate the future amounts using this formula
FV = PV (1+r)n
FV= future value= 1331
PV= Present Value= 1000
1331 = 1000 x (1+10%)3
Discounting
Where r = cost of capital = WACC = required rate of return
PV = FV (1+r)-n
Assumption:
All cash flows are reinvested in the same project or any other at a given rate of return (cost of capital).
Year
1
2
3
Cash flows
1000
2000
3000
pg. 2 of 186
Df@12%
0.893
0.797
0.712
PV
892.9
1594.39
2135
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Consistent Cash flows
If Cash flows arises in a series of equal cash flows then it is called Consistent Cash flows. These are of two Types:
Annuity: If Consistent cash flow for a certain Period. e.g Y1-5 or Y3-7
Perpetuity: If Consistent cash flow for infinite period e.g. Y1-∞ or Y3-∞
Present Values of Consistent Cash flows
The Annuity Factor =
𝟏−(1 + r)-n
𝒓
The Perpetuity Factor =
𝟏
𝒓
Annuity
Perpetuity
If Cash flows Start from Period 1.
Annual Cash flow X Annuity Factor
Annual Cash flow X Perpetuity Factor
e.g. Y1-5 $10,000 at Disc. Rate of 10%
e.g. Y1-∞ $10,000 at Disc. Rate of 10%
$10,000 X 3.791(from annuity table) =$37,910
$10,000 X (1/10%) = $100,000
If Cash flows Start from Period 0.
Annual Cash flow X (Annuity Factor + 1)
Annual Cash flow X (Perpetuity Factor + 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 Cash flows Start from Subsequent Period e.g. Year 3.
Annual Cash flow X Annuity Factor of No. of periods Annual Cash flow X Perpetuity Factor X Discount factor of
X Discount factor of preceding period from Start
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
e.g. Y4-∞ $10,000 at Disc. Rate of 10%
$10,000 X (1/10%) X 0.751 = $75,100
Perpetuities with growth:
•
Cash flow with constant growth.
•
Unlimited time period.
•
Growth starts from year 1
1.
Single growth model:
PV = Cash flow (1+ g)
COC – g
2.
Multi growth model:
1
2
Cash flow
CF1
CF2
3
CF3
4
CF4
D.F @ 10%
0.751
0.683
pg. 3 of 186
0.909
0.826
5-∞
CF4 x (1+g)
COC -g
x 0.683
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Example:
Cash flow in Year 1 is 1000 it will increase with a growth of 5% for next 4 years then at a constant growth of 2% for
foreseeable future COC 10% .Calculate PV?
1
2
3
4
5
5-∞
Cash flow
1000
1080
1166
1260
1360
1360 x (1+0.02)
0.10 -0.02
D.F @ 10%
0.909 0.826
0.751
0.683
0.621
x 0.621
PV
909
892
875.67
860.58 844.56 10768.14
PV = 15154
Annuity with growth:
You will receive $100 Cash flows for 5 years and cash flows will grow at a rate of 5% starting from year 1 and discount
factor of 10%. Calculate PV.
Years
Cash flows@ 5 % growth
Df@10%
PV
1
105
0.909
95.45
OR
PV
PV =100 x [
[
2
110.25
0.826
90.86
3
115.76
0.751
86.94
1 +𝑔
]
1− ( 1 −𝑟 )^𝑛
𝑟 −𝑔
1 +0 .05
1− ( 1 −0 .1 )^5
0 .1−0.05
4
121.55
0.683
83.02
5
127.63
0.621
79.26
435.53
=constant CF x (1+g)
(1+0.05)
= 435
]
Investment Appraisal Techniques
 Payback Period
 Net Present Value NPV
 Internal Rate of Return (IRR)
 Discounted Payback Period
 Modified Internal Rate of Return (MIRR)
 Duration
 Adjusted Present Value (APV)
Payback period method:
Definition:The time period, in which initial investment is recovered, known as payback period. The number of years for the
cash out lay to be matched by cash inflows.
pg. 4 of 186
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Formula:For constant (Even) cash flows:
Payback period =
Initial investment
Annual inflows
For Uneven cash flows:
Draw a cumulative cash flow column, then calculate project payback period. Answer should
be compared with the target payback period of the business.
Decision rule:- Feasibility
Decision:
If payback period is less than target payback period then ACCEPT the project.
If payback period is more than target payback period then REJECT the project.
Comparison Decision:
Project with minimum payback period should be preferred.
Advantages of payback period:• It is simple to calculate and easy to understand.
• Payback period method can also be used as a basic screening device at the first stage for short list projects.
• It considers cash flows rather than accounting profits, that’s why chances of manipulation are very low.
• Payback period method indirectly avoids risk as it gives favor to those investments which have short payback
periods. This method helps the company to grow, minimize risk and maximize liquidity.
• In the situation of capital rationing, it can be used to identify the projects which generate additional cash for
investment quickly.
Disadvantages of payback period:• It does not consider the time value of money.
• It does not consider the whole life of project cash flows. It might be possible that it will favor the projects, giving
high cash inflows in the starting years only and giving very low cash inflows in the remaining years.
• There is no specific criteria or rule which can justify that company’s target payback period is measured
accurately that why it is difficult to measure target payback period.
• It may lead to excessive investment in short term projects.
• It does not consider the risk and uncertainty in the projects. Uncertainty of cash inflows can deteriorate the
results.
• It does not focus on shareholders wealth maximization.
Discounted Payback period
Definition:
 The time period in which initial investment is recovered in terms of present value is known as discounted
payback period
 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.
pg. 5 of 186
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Decision Rule

Feasibility Decision:
If payback period is less than target payback period then ACCEPT the project.
If payback period is more than target payback period then REJECT the project.

Comparison Decision :
Project with minimum payback period should be preferred.
Years Cash flows
D.F @ 10% Present Values
Cumulative Values
0
(500000)
1.000
(500000)
(500000)
1
300,000
0.909
272,700
(227300)
2
200,000
0.826
165,200
(62100)
3
200,000
0.751
150,200
4
600,000
0.683
409,800
Discounted Payback

= 2 years + (62.100/ 150,200 x 12)
= 2 years and 5 months
It takes into account the time value of money and timings of cash flows.
pg. 6 of 186
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NET PRESENT VALUE (NPV)
Formula to calculate NPV:NPV=PV of cash inflows - PV of cash outflows.
Decision Rule:If NPV of the project is positive, accept the project If NPV
of the project is negative, reject the project.
Advantages of Net Present Value:
Net Present Value method takes into account the time value of money and this is giving a better picture of the
projects viability.
• It considers the whole life of the project because all cash flows relating to the project life is incorporated in its
calculations.
• It gives an indication about the increase or decrease in the wealth of shareholders. Its decisions rule is consistent
with the objective of maximization of shareholders wealth.
• It focuses on cash flows rather than accounting profit, so it takes into account the relevancy and irrelevancy of
cash flows.
• It can also be used for projects with non-conventional cash flows.
• It gives a better ranking of mutually exclusive projects.
• It assumes that cash flows are reinvested at the company’s cost of capital.
• NPV is technically more superior method to IRR because of its less rigid assumptions.
Disadvantages’ of Net Present Value:
• It involves complex calculations as compared to other techniques.
• Managers feel it difficult to explain the calculations of Net Present Value method.
• It does not take into account the risk and uncertainty of estimates and scarcity of resources.
• Cost of capital used in NPV calculation is difficult to calculate and gets subjective when we incorporate risk and
uncertainty within companies cost of capital.
pg. 7 of 186
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Years
0
1
2
3
4
Sales
X
X
X
X
Variable Cost
(X)
(X)
(X)
(X)
Incremental Fixed Cost
(X)
(X)
(X)
(X)
Operating Cash flows
X
X
X
X
Tax Expense
(X)
(X)
(X)
(X)
Tax Savings on Capital Allowances
X
X
X
X
(X)
(X)
(X)
X
Change in Working Capital
(X)
Initial Investment
(X)
Scrap Value
X
Net Cash flows
(X)
X
X
X
X
Discount Factor
X
X
X
X
X
Present Values
(X)
X
X
X
X
Net Present Value
X
Capital Allowances
•
Straight line basis
•
Reducing balance basis
Straight Line Basis

Formula 1
Capital Allowance = Investment Cost – Scrap Value
Useful Life

Formula 2
(Investment Cost – Scrap Value) x %age of allowance

Tax Savings on Capital Allowances Capital Allowance x Tax rate
Reducing Balance basis
Example
Initial Investment = 2000
Capital Allowances = 25% reducing balance
Useful life = 4 years, Tax rate = 30% (payable in same year), Scrap Value = 500
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Years
Advanced Financial Management - AFM
Written Down Value
Capital Allowances @ 25%
Tax Savings @ 30%
Timing
1
2000
500
150
1
2
1500
375
113
2
3
1125
281
84
3
4
844-500
344
103
4
In the last year:
• If the written down value > the scrap value we calculate balancing allowance.
• If the written down value < the scrap value we calculate balancing charge.
• If the scrap value is after tax, we calculate capital allowance rather than balancing allowance or balancing
charge.
INFLATION
Real rate of return/cost of capital
Real rate of interest reflects the rate of return that would be required in the absence of inflation.
Money rate of return/cost of capital
Money or nominal rate of return is rate that will be required in presence of inflation.
Relationship between real and nominal rates of interest (Fisher formula)
(1 + m) = (1 + r) (1 + i)
Where i= rate of inflation/RPI
rate of interest)
r = real rate of interest
m = nominal (money
Money cash flows are those cash flows in which the effect of specific inflation has been adjusted.
Real cash flows are those cash flows which have not been adjusted for inflation.
pg. 9 of 186
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Methods to be used in Investment Appraisal
If General inflation rate is given
If Specific inflation
rates are given
If General inflation rate is
given
Real Method
Money
Method
Inflate all
Cash flows
with general
inflation rate.
Discount
these cash
flows with
money
Do not
inflate Cash
flows.
Discount all
Cash flows
with real
discount
rate.
preferred
Method
If Specific inflation rate is
given
Money
Method
Inflate each
variable cash flow
with its specific
inflation rate.
Discount with
money cost of
capital (calculated
through real rate
and general
inflation rate.
Nominal Cashflow = Real cashflows ( 1+ i)n
Sometimes Examiners gives the value in year 1 terms instead of current prices terms then
Nominal Cashflow = Real cashflows ( 1+ i)n-1
Working capital change
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Step 1
Calculate working capital requirement one year in
advance e.g. working capital is 10% of sales at the
start of each year
Step 2
Calculate incremental working capital by taking
change of each year working capital and in last year
of project (not in ongoing business) there will be an
assumption that all working capital will be recovered.
Sensitivity Analysis



It assess how responsive is the project’s Net Present Value to the changes in a given variable.
It considers each variable in isolation.
Formula to calculate sensitivity of a particular variable:Sensitivity =
•
•
•
Net present value
%
After-tax Present value of particular variable
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.
It assesses how responsive is the project’s Net Present Value to the changes in a given variable.
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.
Sensitivity analysis
Selling price sensitivity
Variable cost sensitivity
Fixed cost sensitivity
Contribution/Sales volume sensitivity
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Scarp value sensitivity
Initial investment sensitivity (without tax)
Initial investment sensitivity (with tax)
Cost of capital sensitivity:
•
Calculate IRR of the project and compare it with the cost of capital.
•
If cost of capital increases to IRR, NPV will be zero.
Project life sensitivity:
•
Calculate discounted payback period and compare it with the total project life.
•
If total life reduces to the level of discounted payback period, NPV will be zero.
Advantages
•
This is not a complicated theory to understand.
•
Information will be presented to management in a form, which facilitates subjective judgment to decide
the likelihood of the various possible outcomes considered.
•
Indicates just how critical are some of the forecast which are considered to be uncertain, those areas then
can be carefully monitored.
Disadvantages
•
It assumes that changes to variables can be made independently or in isolation. However it’s unrealistic
as they are often interdependent.
•
It only identifies how far a variable needs to change; it does not look at the probability of such a change.
•
It is not an optimizing technique. It provides information on the basis of which decision can be made.
•
Critical factors may be those over which managers have no control.
Simulation
Sensitivity analysis considered the effect of changing one variable at a time.
Monte Carlo simulation improves on this by looking at the impact of many variables changing at the same time.
Using mathematical modeling it produce a distribution of the possible outcomes from the project.
Steps in Simulation
 Specify major variable.
Market size.
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.
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
Simulate the environment and computerized model will generate a range of NPV across all probability levels

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.)

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.
pg. 13 of 186
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Investment Appraisal in Capital Rationing Situation
Capital rationing:
Where the finance available for capital expenditure is limited to an amount which prevents acceptance of all new
projects with a positive NPV, the company is said to experience “capital rationing”. There are two types of capital
rationing.
Hard capital rationing:
• It is due to external factors.
• Company cannot raise funds by issuing new shares because of stock prices are depressed in stock market.
• There may restrictions on bank lending due to government control.
• Your company may be too risky for further loan from banking institution.
• Cost of new funds may be too high.
Soft capital rationing:
• It is due to internal factors.
• Management may be reluctant to issue further shares because of dilution in control of company.
• Management may be unwilling to issue further shares because of dilution in EPS.
• Company has a policy to finance the new project only from retained earnings.
• Management may not raise further debt because of fixed commitment of interest payments.
Single period capital rationing
I.e. available finance is only in short supply during the current period, but will become freely available in subsequent
periods.

Assumptions of Single Period Capital Rationing
• All projects are divisible
• Projects will be lost if not undertaken in current year( cannot 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 will be preferred.
Problems of Profitability index – other than assumptions stated above
• It can only be used in divisible projects.
• This method doesn’t consider the variation in cash flows.
• It doesn’t consider the absolute size of the project.

Indivisible – An entire project must be undertaken, since it is impossible to accept part of a project
only. In this event the NPV of all available projects must be calculated.
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Multi -period capital rationing
Discuss in detail below.
If Projects are Divisible:
Project
Investment
NPV
Profitability Index
Ranking
A
1,000
500
0.5
3rd
B
1,200
700
0.58
2ND
C
800
300
0.375
4TH
D
700
450
0.642
1ST
Funds Available 2500
Project
Investment
NPV
D
700
450
B
1,200
700
A
600
300
Total
2500
1450
Investment schedule
We will do project B and D complete and 60% of project A.
If Projects are Non-Divisible:
Project
Investment
NPV
A
1,000
500
B
1,200
700
C
800
300
D
700
450
Funds available $2500
pg. 15 of 186
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Projects Combination
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
Investment schedule
We will do combination of project A, C &D because it gives the best NPV of $1250.
Multi-Period Capital Rationing
Capital rationing is the situation when the company has several projects that they wish to invest it, but only have a
limited amount of capital available for investment.
You will remember that when there is limited capital in only one year (single-period capital rationing) then
we rank the projects based on the NPV per $ invested (the profitability index).
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. As you will see in the example that follows, you
will not be required to solve the problem, but you may be required to formulate the problem.
Linear programming
 Define objective function (maximize NPV)
 Define constrains (funds are limited)
 Final Values
Indivisible 0 or 1
Divisible 0 to 1
Example
Four indivisible projects are available.
Funds are required for two years and resulting NPVs are:
Project A
Project B
Year 0
17500
22500
Year 1
25000
Year 2
10000
Npv
20000
pg. 16 of 186
Project C
Project D
12500
15000
15000
30000
20000
17500
27500
15000
10000
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Funds are available
Year 0
40,000
Year 1
35,000
Year 2
42,500
Calculate the optimum mix of projects.
Answer
Maximize = 20,000A+27,500B+15,000C+10,000D
Constraints
Year 0 17,500A+22,500B+12,500D≤40,000
Year 1 25,000A+15,000C+15,000D≤35,000
Year 2 10,000A+30,000B+20,000C17,500≤425,00
Final Values
If projects are indivisible then
A, B, C, D = 0 or 1
If projects are divisible then
A, B, C, D = 0 to 1
Linear programming
The board of Bazza Inc. has approved the following investment expenditure over the next three years.
Year 1
$16,000
Year 2
$14,000
Year 3
$17,000
You have identified four investment opportunities which require different amounts of investment.
Project 1
Project 2
Project 3
Project 4
Year1
7,000
9,000
0
5,000
Year2
10,000
0
6,000
6,000
Year3
4,000
12,000
8,000
7,000
NPV
8,000
11,000
6,000
4,000
Which combination of projects will result in the highest overall NPV while remaining within the annual
investment constraints?
The problem can be formulated as a linear programming problem as follows.
Let
Y1 be investment in project 1
Y2 be investment in project 2
Y3 be investment in project 3
Y4 be investment in project 4
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
Objective function
Maximize Y1 x 8,000 + Y2 x 11,000 + Y3 x 6,000 + Y4 x 4,000

Subject to the three annual investment constraints:
Y1 x 7,000 + Y2 x 9,000 + Y3 x 0 + Y4 x 5,000 ≤16,000 (Year 1 constraint)
Y1 x 10,000 + Y2 x 0 + Y3 x 6,000 + Y4 x 6,000 ≤ 14,000 (Year 2 constraint)
Y1 x 4,000 + Y2 x 12,000 + Y3 x 8,000 + Y4 x 7,000 ≤ 17,000 (Year3 constraint)
When the objective function and constraints are fed into a computer program, the results are:
Y1 = 1, Y2 = 1, Y3 = 0, Y4 = 0
This means that project 1 and project 2 will be selected and project 3 and project 4 will not. The NPV
of the investment scheme will be equal to $19,000.
Note that the following solution also satisfies the constraints.
Y1 = 0, Y2 = 0, Y3 = 1, Y4 = 1
However, this is not the optimal solution since the combined NPV of projects 3 and 4 is $10,000, which is lower
than the value derived above.
Internal Rate of Return (IRR)
The minimum return that projects can generate. Or. The cost of capital at which NPV is ZERO.
It’s the maximum cost of capital that should be acceptable for evaluating investment projects. As any increased in
the cost above IRR will result in negative NPV.
𝐼𝑅𝑅 = 𝑎% + [
𝐴
𝐴−𝐵
𝑋(𝑏 − 𝑎)] %
Where:
a%- Small Disc. Rate at which NPV is Preferably positive
A- NPV at a%
b%- Bigger Disc. Rate at which NPV is Preferably negative
B- NPV at b%
Year
Cash flows
Dis. Factor @ 10%
Present Values
0
(400)
1.000
NPV
214
Year
Cash flows
Dis. Factor @ 20%
Present Values
0
(400)
1.000
NPV
(25)
pg. 18 of 186
1
(600)
0.909
2
400
0.826
3
500
0.751
4
400
0.683
5
200
0.621
6
100
0.564
1
(600)
0.833
2
400
0.694
3
500
0.579
4
400
0.482
5
200
0.402
6
100
0.335
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= 19%
19% is the maximum cost of capital that should be acceptable as it’s the rate where NPV of the project will be
zero.
Decision Rule:Feasibility Decision:
• If IRR of the project > Benchmark Cost of Capital, then Accept the project because the project is adding value to
the owners wealth resulting in positive NPV.
• If IRR of the project < Benchmark Cost of Capital, then Reject the project because the project is destroying value
in shape of negative NPV.
Comparison Decision:
Project with higher IRR shall be preferred.
Advantages of IRR:
• IRR takes into account the time value of money and thus giving a better picture of the projects viability.
• It considers the timing and life of the project.
• IRR is easier to understand as compared to NPV.
• Risk can be incorporated into decision making by adjusting the company’s target discount rate.
PROBLEMS WITH IRR
• IRR assumes that all the cash flows are reinvested in the project at calculated IRR which may be invalid in case
of high IRR.
• IRR produces multiple answers in case of non-conventional cash flows.
• IRR is not helpful in choosing the best answer in case of mutually exclusive projects because IRR is a relative
measure and it does not consider the size of the project.
MODIFIED INTERNAL RATE OF RETURN
Modified internal rate of return (MIRR) provides the same result as IRR but it assumes that positive cash flows are
reinvested at the firm's cost of capital.
For example, suppose that a project has an NPV of +$300,000 when discounted at a cost of capital of 8%, and the
IRR of the project is 24%. In calculating the IRR, an assumption would be that all cash flows from the project are
reinvested as soon as they are received to earn a return of 24% even though the company’s cost of capital is 8%.To
reinvest cash flows at such a high rate is unrealistic .
NPV method implicitly assumes that project cash flows can be reinvested at the discount rate used to calculate NPV.
This is a realistic assumption, because it is reasonable to assume that project cash flows could be used to reduce the
firm's capital requirements. Any funds that are used to reduce the firm's capital requirements allow the firm to avoid
the cost of capital on those funds. Just by reducing its equity capital and debt, the firm could "earn" its cost of capital
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on funds used to reduce its capital requirements. If we were to rank projects by their IRRs, we would be implicitly
assuming that project cash flows could be reinvested at the project's IRR.
MIRR would be calculated on the assumption that project cash flows are reinvested, when received, to earn a return
equal to 8% per year. MIRR is more realistic because it’s based on the cost of capital as the reinvestment rate.
MIRR 1st FORMULA
1
𝑃𝑉 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑃ℎ𝑎𝑠𝑒 𝑛
𝑀𝐼𝑅𝑅 = [
𝑃𝑉 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 𝑃ℎ𝑎𝑠𝑒
] (1 + 𝑟𝑒 ) − 1
Year
0
1
2
3
4
5
6
Cash flows
(400)
(600)
400
500
400
200
100
Dis. Factor @ 10%
1.000
0.909
0.826
0.751
0.683
0.621
0.564
Present Values
(400)
(545)
330
376
273
124
56
NPV
214
1
1159 6
𝑀𝐼𝑅𝑅 = [
945
] (1 + 10%) − 1
=13.8%
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.
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
Capital Investment projects & duration
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.
Steps to calculate duration
• 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
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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.
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.
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.
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.
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).
Advantages
• 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.
Disadvantages
• 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.
Example
Duration
0
1
2
3
4
5
6
Total
D.F.10% P.V of return phase
43.31
57.40
46.72
26.95
16.14
190.52
Proportion of present value
0.2273
0.3013
0.2452
0.1415
0.0847
Weighted years
0.4546
0.9039
0.9809
0.7073
0.5082
3.55
Duration(=sum of weighted years)
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Duration of 3.55 reflects the project will recover its return phase cash flows in weighted average time of 3.55 years
compare to total life of 6 years of the project.
Example 2
The project duration is calculated by first calculating the discounted cash flow for each future year, and then
weighting each discounted cash flow according to its time of receipt, as follows:
Years
0
1
2
3
4
5
6
7
8
Cash flows
(500)
(600)
700
600
500
100
50
(20)
20
D.F @ 10%
1
0.909
0.826
0.751
0.683
0.621
0.564
0.531
0.467
PV
(500)
(545)
578
451
342
62
28
(10)
9
0.40
0.31
0.23
0.04
0.02
(0.007)
0.006
0.80
0.93
0.94
0.2
0.12
(0.049)
0.048
Proportion
each year
of
Weighted
average years
Duration
1460
3
MODIFIED DURATION
Modified duration measures the sensitivity of the price of a bond to a change in the interest rates.
Using the example on duration, the modified duration of the bond is
2.84/(1 + 0.035) = 2.74
This can be used to determine the proportionate change in bond price for a given change in yield as follows.
Where:
ΔP = change in bond price
ΔY = change in yield
P = current market price of the bond
PROPERTIES OF MODIFIED DURATION
As the modified duration is derived from the Macaulay duration, it shares the same properties.
• Longer dated bonds will have higher modified durations – that is, bonds which are due to be redeemed at a
later are more price-sensitive to changes in interest rates and are therefore more risky.
• Lower coupon bonds will have higher modified durations
• Lower yields will give higher modified durations
• The higher the modified duration, then the greater the sensitivity of that bond to a change in the yield.
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THE BENEFITS AND LIMITATIONS OF DURATION
• Benefits
•
o
It allows bonds of different maturities and coupon rates to be directly compared.
o
If a bond portfolio is constructed based on weighted average duration, it is possible to determine portfolio
values changes based on interest rate changes.
o
Managers may be able to modify interest rate risk by changing the duration of bond portfolio.
Limitations
o
The main limitation of duration is that it assumes a linear relationship between interest rates and price that
is, it assumes that for a certain percentage change in interest rates will be an equal percentage change in
price.
o
However as interest rates change the bond price is unlikely to change in a linear fashion.
o
Convexity is another method which take into account the non-linear relation.
EXAMPLE
AFC Co has taken a four-year £80,000,000 loan out to part-fund the setting up of four branches. As an alternative
to paying the principal on the loan as one lump sum at the end of the fourth year, BFC Co could pay off the loan in
equal annual amounts over the four years similar to an annuity. In this case, an annual interest rate of 2% would
be payable, which is the same as the loan’s gross redemption yield (yield to maturity).
Calculate the modified duration of the loan if it is repaid in equal amounts.
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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
WACC
Weighted Average Cost of
Capital
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 Equity:
It can be calculated using one for the following method.
•
Dividend Valuation model
•
Capital asset pricing model
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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
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Cost of Equity:
Cost of equity: the dividend growth model method
If it is assumed that the annual dividend will grow at a constant percentage rate into the foreseeable future, the cost
of equity can be calculated as follows:
Where:
KE is the cost of equity
Do = the annual dividend for the year that has just ended g is the annual growth rate in
dividends, expressed as a proportion (8% = 0.08, etc.) MV is the share price ex dividend d
(1 + g) is therefore the expected dividend next year=D1
Example:
A company's share price is $11.70. The company has just paid an annual dividend of $1.40 per share, and
the dividend is expected to grow by 3% into the foreseeable future. The
cost of equity in the company can be estimated as
follows:
Two methods to calculate growth
1. Historic Estimate
Example
Year End
Dividend per share
$
2007 0.24
2008 0.27
2009 0.29 2010 0.32
g= 3√(0.32/0.24) -1 g=10%
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2. Gordon's growth approximation
Gordon's growth approximation is an estimate of future dividend growth, expressed by the formula:
g = b re
Where:
g = the annual rate of dividend growth
b = the proportion of earnings (or free cash flow) reinvested for growth, and r e = the
rate of return on those reinvested earnings
Always use Ke as ROE because over the longer term it will sustain and attainable.
Example:
A company reported profits after interest and tax of $6 million and paid dividends of $4 million. This ratio of dividend
payments to earnings is fairly typical of the company's dividend policy. The company's cost of equity is 12%.
The proportion of profits reinvested for growth is 0.33 (2/6).
An estimate of the future growth rate in annual dividends, using Gordon's growth Approximation is:
0.33x0.12 = 0.04 or 4.0%.
CAPITAL ASSET PRICING MODEL
The capital asset pricing model (CAPM) is used to calculate the required rate of return (ke). It assumes investor’s
hold a diversified portfolio so it’s require return based only on systematic risk.
Systematic risk is how market factors effect that investment. Market factors
are:- • Macroeconomic variables
•
Political factors
The measure is relative to the benchmark of the market portfolio which has a βeta factor of 1.
TOTAL RISK
Unsystematic risk
Company specific factors
Can be eliminated by
Systematic risk
General economic factors
cannot be eliminated
Diversification
By holding a portfolio, the unsystematic risk is diversified away but the systematic risk is not and will be present in
all portfolios. If we were to enlarge our portfolio to include approximately 25 shares we would expect the
unsystematic risk to be reduced to close to zero, the implication being that we may eliminate the Unsystematic
portion of overall risk by spreading investment over a sufficiently diversified portfolio.
Advantages of CAPM;
• It generates a theoretically derived relationship between required return and systematic risk, which has been
subject to frequent empirical research and testing.
• It explicitly takes into Account Company’s level of systematic risk relative to stock market as a whole.
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•
•
•
•
•
•
•
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Clearly superior to wacc in providing discount rate for investment appraisal. Criticisms of CAPM
CAPM is a single period model. This means that the values calculated are only valid for a finite period of time
and will need to be recalculated or updated at regular intervals.
CAPM assumes no transaction costs associated with trading securities.
Any beta value calculated will be based on historic data which may be not appropriate currently. This is
particularly so if the company has changed the capital structure of the business or the type of business it is
trading in.
The market return may change considerably over short periods of time.
CAPM assumes an efficient investment market where it is possible to diversify away risk. This is not necessarily
the case, meaning that some unsystematic risk may remain.
Additionally, the idea that all unsystematic risk is diversified away will not hold true if stocks change in terms of
volatility. As stocks change over time it is very likely that the portfolio becomes less than optimal.
CAPM assumes all stocks relate to going concerns, this may not be the case.
Assumptions of CAPM
• It is assumed that investors are rational & will hold a well-diversified portfolio (unsystematic risk will be
reduced to minimum level).
• Transaction cost is low or nil.
• Investors have homogeneous expectations about the market.
• Market is perfect and all investors have same level of information & no individual can dominate the
market.
• Debt beta is zero.
• There is no cost of acquiring information.
• No individual can dominate the market.
Beta: It is a relative systematic risk of company’s earnings with the market systematic risk. As market risk =1
Beta can be > 1 more risky compare to market
Beta can be < 1 less risky compare to market
Cost of Equity = Rf + β (Risk Premium)
Cost of Equity = Rf + β (Rm-Rf)
Where:
KE = THE cost of equity in the company
RF= the risk-free rate of return
Return on govt stock, treasury yield, gilt edged security
RM = the return on the market portfolio of securities that are not risk-free
(Rm-Rf) = Market risk premium or equity risk premium
The CAPM method of estimating the cost of equity is an alternative to a dividend-based estimate using the dividend
growth model. The two methods will normally produce differing estimates.
Example: A company's shares have a current market value of $25.00. The most recent annual dividend has just been
paid. This was $2.00 per share.
Required: Calculate the cost of equity in this company in each of the following circumstances:
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(b)
(c)
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The annual dividend is expected to remain $2.00 into the foreseeable future.
The annual dividend is expected to grow by 2% each year into the foreseeable future.
The CAPM is used, the equity beta is 1.20, the risk-free cost of capital is 5% and the expected market return
is 9%.
Answer:
COST OF DEBT
Each item of debt finance for a company has a different cost. This is because debt capital has differing risk, according
to whether the debt is secured, whether it is senior or subordinated debt, and the amount of time remaining to
maturity. Cost of debt is adjusted for taxation because of the tax savings available on annual interest. The different
types of debt are:
 Irredeemable debt
 Redeemable debt (redeemable fixed rate bonds)
 Variable rate debt (floating rate debt)
 Non-tradable debt
 Convertible debt
 Corporate debt
Irredeemable debt

As we know that MV is the P.V of the future Cash flows.

MV of irredeemable bond

Required return of debt holders =

Kd =


Never deduct tax in calculation of market value and required rate of return.
Always take after-tax interest in calculation of cost of debt because interest is a tax allowable expense.
 Redeemable debt (redeemable fixed rate bonds)
Market value is the present value of all future interest and principal amount.
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Year
Cash Flow
D.F @ yield
P.Values
1-5
Interest
Annuity factor
××
5
Redemption Value
Discount factor
××
×××
Required rate of return of debt holders
The required return on redeemable bonds is their redemption yield. This is calculated as the rate of return that
equates the present value of the future cash flows payable on the bond (to maturity) with the current market value
of the bond. In other words, it is the IRR of the cash flows on the bond to maturity, assuming that the current market
price is a cash outflow.
Other names of required returns are yield till maturity (YTM) or gross redemption yield (GRY).
Cost of debt
Same method of IRR will be used here but in case of Kd but we have to take after tax value of interest.
Example
The current market value of a company’s 7% loan stock is 96.25. Annual interest has just been paid. The bonds will
be redeemed at par after four years. The rate of taxation on company profits is 30%.
Required:
Calculate the after-tax cost of the bonds for the company
Year
Cash Flow
D.F @ 5%
P.Values
D.F @ 10%
P.Values
0
(96.25)
1.000
(96.25)
1.000
(96.25)
1–4
4.90
3.546
17.38
3.170
15.53
4
100
0.823
82.30
0.683
68.30
3.43
(12.42)
Kd (1 – t) =
= 6.08%
➢
Variable or Floating Rate Debt
Company will pay what you demand. If Interest rate and required rate are same then market value will be same
as redemption.
Kd=Interest % x (1-t)
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 Non-tradable Debt
An example of non-tradable debt is bank loan.
Kd=Interest % x (1-t)
Convertible Loan
• Here bond holders have choice to either redeem the debt or convert the debt into predetermined number of
shares.
• The method of calculating cost of debt for convertible is same as calculating the cost of debt of redeemable
debt.
• The problem here is that we do not know whether the bond holder would exercise the conversion option or
not. Therefore we take higher value of redemption value or conversion value.
• Conversion Value is calculated as:
• Conversion Value = M.V per share at time of conversion x No. of Shares
M.V at the time of conversion = Current M.v ×
(1+g) ^n Where,
g = Share price growth
n = no. of years in conversion
Market value of convertible Debt
Year
1–5
5
Cash Flow
Interest
Higher off Redemption OR
Conversion value
D.F @ ytm
A.F
D.F
M.V
P.Values
××
××
×××
Cost of debt Example
The current market value of a company’s 7% loan stock is 96.25. Annual interest has just been paid. The bonds will
be redeemed at par after four years or convertible into 20 ordinary shares. Current share price is $4.44 and it is
expected that it will grow with a growth of 5% per year. The rate of taxation on company profits is 30%.
Required:
Calculate the after-tax cost of the bonds for the company.
Answer:
Conversion Value = 20× 4.44 × 1.05^4=$108
Redemption Value=$100
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Investors are rational and will choose the higher Value
Year
Cash Flow
D.F @ 10%
P.Values
D.F @ 5%
P.Values
–
(96.25)
4.90
108
1.000
3.170
0.683
(96.25)
15.53
73.76
1.000
3.546
0.823
(96.25)
17.38
88.88
(7)
10
Kd (1 – t) =
=7.94 %
The yield curve (term structure of interest rates)
The yield is the return on an investment, such as the interest or dividends received from holding a particular security.
Whereas a yield curve on a graph in which the yield of fixed-interest debt is plotted against the length of time they
have to run to maturity.
The cost of new debt can be estimated by reference to a yield curve.
The cost of fixed-rate debt is commonly referred to as the Interest yield'.
The interest yield on debt capital varies with the remaining term to maturity of the debt.
 As a general rule, the interest yield on debt increases with the remaining term to maturity. For example, it should
normally be expected that the interest yield on a fixed-rate bond with one year to maturity/redemption will be
lower than the yield on a similar bond with ten years remaining to redemption. Interest rates are normally
higher for longer maturities to compensate the lender for tying up his funds for a longer time.
 When interest rates are expected to fall in the future, interest yields might vary inversely with the remaining
time to maturity. For example, the yield on a one-year bond might be higher than the yield on a ten-year bond
when rates are expected to fall in the next few months.
 When interest rates are expected to rise in the future, the opposite might happen, and yields on longer-dated
bonds might be much higher than on shorter-dated bonds as investors will get higher yields when interest rates
rise.
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Yield curves are widely used in the financial services industry. Two points that should be noted about a yield curve
are that:
 Yields are gross yields, ignoring taxation (pre-tax yields).
 A yield curve is constructed for 'risk-free' debt securities, such as government bonds. A yield curve therefore
shows 'risk-free yields'.
As the name implies, risk-free debt is debt where the investor has no credit risk whatsoever, because it is certain
that the borrower will repay the debt at maturity. Debt securities issued in their domestic currency by the
government should always be risk-free: yield curves are therefore constructed for government bonds.
The yield curve and non-risk-free debt: spreads
The interest yield on other debt, such as corporate bonds and loans, is higher than the yield on risk-free debt with
the same maturity. For example, the interest rate on a sterling bond of ABC Company with two years to maturity
will be higher than the interest yield on a two-year UK government bond. The higher yield is to compensate investors
in corporate bonds for the fact that the debt is not risk-free. The company might default.
'Spread' is the difference between the risk-free rate of return (the yield curve) and the cost of debt for the same
maturity that is not risk-free. For example, if the risk-free return on five-year government bonds is 5.4% and the
spread for a company's five-year bonds is 80 basis points, the yield on the company bonds is:
 Yield curve + Spread ➢ =5.40%+ 0.80% = 6.20%.
KD (1-t) = (Yield on similar Government debt + Credit Risk Premium) x (1-t)
The size of spreads
The size of the spread allows for the additional risk in the debt that is not risk-free. The spread is therefore higher
for debt that has a higher risk for investors or lenders. Many large companies are given a credit rating by a credit
rating agency, such as Moody's, Standard & Poor's and Fitch. (Strictly, the company's debt is given a credit rating,
but it is common to speak of companies having a credit rating rather than the debt having a credit rating.)
 The top credit rating is a 'triple-A' credit rating.
 Spreads are lowest for the top Credit ratings, and higher for lower credit ratings.
Credit Ratings
Each credit rating agency uses its own credit rating system. The most well-known are the rating systems of Standard
& Poor's and Moody's. Their ratings for bonds are set out in the table below.
Moody's credit
Standard & Poor's
credit ratings
AAA
AA
A
BBB
pg. 32 of 186
Ratings
Investment
Highest rating
Still high quality debt
grade
Aaa
Aa
A
Baa
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Sub-Investment grade (*junk*)
BB
Major uncertainties
about the ability of the
borrower to pay interest
and repay principal on
Time
B
CCC
CC
C
D
In default
Ba
B
Caa
Ca
C
D
Standard & Poor's credit ratings are also modified by ‘+’and '-' signs. A ‘+’ sign indicates a better credit rating and
a'-' indicates a lower credit rating.

Credit ratings are
therefore
AAA,
AA+,
AA,
AA-,
A+,
A,
A-,
BBB+, BBB,
BBB-, BB+, BB, BB- and so on.

The lowest investment grade credit rating is BBB-.
Moody's credit ratings are modified in a similar way, but using the numbers 1, 2 and 3.

Credit ratings are
therefore
Aaa,
Aa1,
Aa2,
Aa3,
Al,
Baal,
Baa2, Baa3,
Ba1, Ba2, Ba3 and so on.

The lowest investment grade rating is Baa3.
A2,
A3,
Sub-investment grade debt, also called 'junk bonds', is a speculative investment for the lender or bondholder, and
yields required by investors are normally much higher than on investment grade debt.
Spreads and credit ratings:
Spreads vary according to:

The risk characteristics of the industry

The time remaining to maturity for the debt, and

The credit rating.
Example:
Yield spreads on US bonds for companies in the construction industry are as follows:
Spreads:
Rating:
AAA / Aaa
AA+ / Aa1
AA / Aa2
AA- / Aa3
A+ / A1
A / A2
A- / A3
pg. 33 of 186
1
2
6
9
15
24
32
45
Years to maturity
2
3
5
4
10
15
10
16
24
15
24
34
24
30
40
35
45
60
45
58
78
60
75
100
7
20
30
44
52
75
95
120
10
25
38
55
64
88
112
142
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This table would show, for example, that if a company wants to issue seven year bonds, and the credit rating for the
bonds is expected to be AA-, the company will expect to pay a yield on the bonds that is 52 basis points above the
risk-free rate. If the yield curve shows the risk-free rate on US government bonds (Treasuries’) to be 6.6%, the yield
on the company’s bonds will be 6.6% + 0.52% = 7.12%.
Method of calculating the WACC
The WACC is a weighted average of the (after-tax) cost of all the sources of capital for the company. Steps for
Calculating WACC

Calculate cost of each source of finance. e.g. Ke , Kd

Calculate market value of each source of finance
•

M.v of Equity =
× M.v per share
•
M.v of Debt =
× M.v per bond
•
Bank loan market value = book value
Calculate WACC using this formula:
Source
Equity
Debt
Preference Share
Proportion (in Market Values) X Cost
Proportion of Equity X Ke
Proportion of Debt X Kd(net)
Proportion of Preference X Kp
WACC
pg. 34 of 186
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WACC
X%
X%
X%
X%
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CAPM
Risk
Systematic
Risk
Systematic
Risk
Business Risk
Unsystematic
Risk
Financial Risk
Systematic Risk
From the shareholder perspective, systematic risk is the sum of business risk and financial risk, Systematic risk is the
risk that remains after a shareholder has diversified investments in a portfolio, so that the risk specific to individual
companies has been diversified away and the shareholder is faced with risk relating to the market as a whole. Market
risk and diversifiable risk are therefore other names for systematic risk. From a shareholder perspective, the
systematic risk of a company can be assessed by equity beta of the company. If the company has debt in its capital
structure, the systematic risk reflected by the equity beta will include both business risk and financial risk. If company
is financial entirely by equity, the systematic risk reflected by the equity beta will be business risk alone, in which
case the equity beta will be the same as the asset beta.
Business risk arises due to the nature of a company’s business operations, which determines the business sector
into which it is classified, and to the way in which a company conducts its business operations. Business risk is the
variability in shareholder returns that arises as a result of business operations. It can therefore be related to the way
in which profit before interest and tax (PBIT or operating profit) changes as revenue or turnover changes. This can
be assessed from a shareholder perspective by calculating operational gearing, which essentially looks at the relative
proportions of fixed operating costs to variable operating costs. One measure of operational gearing that can be
used is (100 ×contribution/ PBIT), although other measures are also used.
Financial Risk
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. Financial risk is the variability in shareholder returns that arises due to the need to pay interest on debt.
Financial risk can be assessed rom a shareholder perspective in two ways. Firstly, balance sheet gearing can be
calculated. Secondly, the interest coverage ratio can be calculated
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Beta
Equity=geared
beta
Relative
systematic
Risk=Beta
Business Risk
Financial Risk
Beta Asset=
ungeared beta
Business Risk
However, it is not simply a case that the βasset equals the sum of the βequity and the βdebt. What also need to be taken
into account is the proportions of equity and debt:
βAsset =βequity
Finally, we need to take into account tax relief on interest payments, (as it will affect the financial risk exposure of
shareholders). This now gives rise to a very important equation for the exam:
We assume βDebt is zero.
Where:
βEquity’s known as the equity Beta. It measures the systematic business risk and the systematic financial risk of the
company’s shares. βAsset is known as the asset beta. It measures the systematic business risk only. β Debt is known
as the debt beta. It measures the systematic risk of the company’s debt securities.
Example # 1:
B plc has a gearing ratio (D: E) of 1: 2 and its shares have a beta value (βEquity) of 1.45. The corporation tax rate is
30%, debt is assumed to be risk free. Calculate beta asset ?
Solution:
Four Implications
This analysis gives rise to four important implications:
A company’s equity beta will always be greater than is asset beta. This is because the equity beta measures both
business and financial risk, while the asset beta measures business risk only.
βe>βa
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The one exception to this is where the company is all equity financed, and so only has systematic business risk, and
has no financial risk. In those circumstances its equity beta and its asset beta will be the same. Then β e = β a
Companies in the same area of business, (i.e. they have the same business risk), will have the same asset beta.
Companies in the same area of business will not have the same equity beta, unless they also happen to have the
same gearing ratios. (Means financial risk same).
IF Company is operating in more than one division
If the company operates on a divisional basis and each division is in a different business area. Then:1) Find suitable proxy company for each division and find βa’s of each proxy for each division field.
2) Combine βa of both divisions to calculate weighted average βa.
Weighted average βa = βa 1st division x % + βa 2nd division x %
% proportion will be given in exam according to revenue share, asset share or any other basis
3)
4)
5)
Re gear the calculated weighted average βa using company’s own gearing level.
Calculate Ke using CAPM
Calculate WACC
Example:
ABC is made up of two divisions
Division
Asset βeta
Food
0.75
40%
Clothes
1.80
60%
Proportion of the Business
The company gearing level is 32%.
Tax =25%
βa= (0.75 x 40%)+(1.80 x 60%)
= 1.38
1.38 =
68
x βe
68+32(1-0.25)
1.38= 68 x βe
92
Βe =1.87
Example:
ABC Ltd is operating in power sector and has a beta of 1.2 •
•
After tax cost Kd = 6%
•
Equity risk premium = 7%
•
Rf = 5 %
•
Tax rate = 30%
Gearing level is at 40%.
ABC Ltd wants to diversify into cement business.
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XYZ co is in Cement business it has a beta of 1.60.It does not pay tax and D/E = 2:3
Calculate WACC of ABC Ltd .After investing in Cement business .(cement will 30% of total business and gearing will
remain same) Solution:
•
XYZ co: ungear the beta of proxy co for cement division
βa=βe
βa = 1.60 [ 3/3+2] βa = 0.96
•
ABC Ltd: un gear the beat of Abc company for power business
βa = βe
βa = 1.2 [60/60+40(1-0.3)] βa = o.82
•
Calculate Weighted Average beta Asset of both power and cement business
βa AVg = 0.82 x 70% + 0.96 x 30%
= 0.86
Regear it with current gearing of ABC Ltd.
0.86 = βe [60/60+40(1-0.3)]
Βe = 1.26
•
Calculate Ke using CAPM Ke = 5% + 1.26 x 7%
Ke = 13.8%
•
WACC = Ke
+ Kd (after tax)
= 13.8% [60/60+40] +6%[40/60+40]
WACC = 10.7%
Example:
ABC Ltd is operating in power sector and textile sector and has a beta of 1.45.
•
Gearing level is at 40%
•
Kd after tax = 6%
•
Equity risk premium = 7%
•
Rf = 5%
•
TAX = 30%
It wants to dispose of its power business.
XYZ co is in power business. It has a beta of 1.16.
MV/ share = $3/ share
Shares = 400 m
Debt MV 108 per 100 Book value = $576m
Calculate WACC of ABC Ltd after disposal of power business. (Power business is 40% of total and gearing will
remain same.
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Solution:
•
XYZ Ltd
Ungear beta equity of power proxy XYZ co :
βa = βe
•
βa = 1.16 [1200/1200+622(1-0.3)] βa = 0.85
ABC Ltd the total equity beta of ABC company to calculate total weighted average beta Ungear βa of
ABC Ltd βa = βe
βa = 1.45 [60/60+40(1-0.3)]
βa = 0.99
•
Calculate βa of textile
Βa of total business= βa of power x 40% + βa of textile x 60%
0.99 = 0.85 x 40% + βa of textile x 60%
βa of textile = 1.08
•
Calculate βe by regearing the calculated beta asset of textile division
1.08 = βe
Βe = 1.58
•
Calculate Ke by using CAPM
Ke = 5% + 1.58 (7%)
Ke = 16%
•
WACC = Ke
+ Kd (after tax)
= 16%[60/60+40] +6%[40/60+40]
WACC = 12%
EXAMPLE
A company is planning to invest in a new project that is significantly different from its existing business operations.
This company is financed 30% by debt and 70% by equity. It has located three companies with business operations
similar to the proposed investment, and details of these companies are as follows:
Company A has an equity beta of 0.81 and is financed 25% by debt and 75% by equity.
Company B has an equity beta of 0.98 and is financed 40% by debt and 60% by equity. Company C has an equity
beta of 1.16 and is financed 50% by debt and 50% by equity.
Assume that the risk-free rate of return is 4% per year, and that the equity risk premium is 6% per year. Assume
also that all the companies pay tax at a rate of 30% per year. Calculate a project-specific discount rate for the
proposed investment.
Solution
Ungearing the proxy equity betas: Asset beta for Company A
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Asset beta for Company B =
Asset beta for Company C =
Averaging the asset betas:
Re gearing the average asset beta: 0.669 = βe x 70/(70 + 30(1 – 0.30)) = βe x 0.769. Hence βe = 0.669/0.769 =
0.870
If the re gearing equation were used:
βe = 0.669 x (1 + (1 – 0.30)30/70) = 0.870
Calculating the project-specific discount rate:
E(ri) = Rf + βi (E(rm) – Rf) = 4 + (0.870 x 6) = 4 + 5.22 = 9.2%
Example
Henry Training provides training for companies in the computer and telecommunications sectors. In recent years,
Henry has diversified into the financial services sector. This business now accounts for one third of the company’s
total revenue.
Jupiter is one of the few competitors in Henry’s line of business. However, Jupiter is only involved in the training
business. Jupiter has an estimated beta of 1·5. The average beta for the financial services sector is 0·9. Average
market gearing (debt to total market value) in the financial services sector is estimated at 25%.
Other summary statistics for both companies for the year ended 31 December 2007 are as follows:
Gearing (debt to total market value)
Henry
30%
Jupiter
12%
The equity risk premium is 3·5% and the rate of return on short-dated government stock is 4·5%. Both companies
can raise debt at 2·5% above the risk free rate.
Tax on corporate profits is 40%.
Required:
Estimate the cost of equity capital and the weighted average cost of capital for Henry Training
WACC and market value
For a company with constant annual 'cash profits', there is an important connection between WACC and market
value. (Note: 'Cash profits' are cash flows generated from operations, before deducting interest costs.)
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If we assume that annual cash profits are a constant amount in perpetuity, the total value of a company, equity
plus debt capital, is calculated as follows:
From this formula, the following conclusions can be made:

The lower the WACC, the higher the total value of the company will be (equity + debt capital), for
any given amount of annual profits.

Similarly, the higher the WACC, the lower the total value of the company.
The aim should therefore be to achieve a level of financial gearing that minimizes the WACC, in order to
maximize the value of the company.
Capital Structure Theories:
These theories explain the impact on the cost of capital of the company due to change in the capital structure of
the company. It includes the following theories:

The Traditional View

Modigliani-Miller (MM) Theory (without tax)

Modigliani-Miller (MM) Theory (with tax)
The traditional view of gearing and WACC
The traditional view of gearing is that there is an optimum level of gearing for a company. This is the level of
gearing at which the WACC is minimized.
The traditional view of gearing and WACC - Continued

The traditional View towards cost of capital is that there is an optimal capital structure at which
Optimum gearing % = minimum WACC
The company’s weighted average cost of capital is at its minimum.

Under the traditional view, the cost of equity increases as the level of gearing increases because of
higher financial risk but the relationship between cost of equity and WACC is non-linear. As a result,
WACC decreases initially due to increased borrowing until it reaches its minimum and then it starts to
increase. This lowest point represents the optimal capital structure at which WACC is at its minimum
AND MV is maximum.
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The Modigliani-Miller propositions: ignoring corporate Taxation
Modigliani-Miller stated that, in the absence of tax, a company’s capital structure would have no impact on its
WACC.
Assumptions

A perfect capital market exists.

Debt is risk-free and freely available at the same cost to investors and companies alike.

All the assumptions of Traditional View Apply as well. Explanation

Kd will remain constant at all level of gearing because there is no financial distress cost.

Ke will increase as gearing level increase because it will increase the financial risk and beta equity

The cheaper effect of Kd will exactly cancel off the increasing effect of Ke and wacc will remain
constant at every level of gearing.

As wacc is not changing so there will be no change in market value.
Modigliani and Miller therefore reached the conclusion that the level of gearing is irrelevant for the value of a
company. There is no optimum level of gearing that a company should be trying to achieve.
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The Modigliani-Miler view: allowing for corporate taxation
Modigliani-Miller stated that, with tax, a company’s capital structure is maximum debt.

•
•
Assumptions
A perfect capital market exists.
Debt is risk-free and is lower because of tax savings and freely available at the same cost to investors
and companies alike.
Explanation
• Kd(1-T) will remain constant at all level of gearing because there is no financial distress cost.
• Ke will increase as gearing level increase because it will increase the financial risk and beta equity
• The cheaper effect of Kd will dominate the increasing effect of Ke and wacc will be declining at at every level of
gearing.
• As wacc is is declining at every level of gearing so market value is increasing with gearing.
• The total value of the company is therefore higher for a geared company than for an identical allequity
company/The value of a company will rise, for a given level of annual cash profits before interest, as its gearing
increases.
Modigliani and Miller therefore reached the conclusion that because of tax relief on interest, there is an optimum
level of gearing that a company should be trying to achieve. A company should be trying to make its gearing as high
as possible, to the maximum practicable level, in order to maximize its value.
Modigliani-Miller formulae: allowing for taxation
Cost of equity
The cost of equity in a geared company is higher than the cost of equity in an ungeared company, by a factor equal
to:

The difference between the cost of equity in the ungeared company and the cost of debt, (K EU-KD)

Multiplied by the ratio
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Example: 1
An ABC co is currently in trading business and wants to diversify into new business.
Haizum Co, a listed company is in same business in which abc co wants to diversify Haizum Co’s cost of equity is
estimated to be 14% and it pays tax at 28%. Haizum Co has 15 million shares in issue trading at $2·53 each and $40
million bonds trading at $94·88 per $100. The five-year government debt yield is currently estimated at 4·5% and
the market risk premium at 4%
Abc co has market value of equity of $60 million. It borrows $20 million of debt finance, costing 5%.The rate of
taxation on company profits is 25%.
According to Modigliani and Miller:
(a) Identify the suitable proxy co and ungear its cost of equity
KEU= 10%
b) Regear it with Abc co gearing
KEG=11.25%
Example
Mlima Co’s closest competitor is Ziwa Co, a listed company which mines metals worldwide. Mlima Co’s directors are
of the opinion that after listing Mlima Co’s cost of capital should be based on Ziwa Co’s ungeared cost of equity. Ziwa
Co’s cost of capital is estimated at 9·4%, its geared cost of equity is estimated at 16·83% and its pre-tax cost of debt
is estimated at 4·76%. These costs are based on a capital structure comprising of 200 million shares, trading at $7
each, and $1,700 million 5% irredeemable bonds, trading at $105 per $100. Both Ziwa Co and Mlima Co pay tax at
an annual rate of 25% on their taxable profits.
Calculate ungear cost of equity of Ziwa co.
Relevance for capital investment appraisal
The Modigliani and Miler formulae can be used to re-calculate the cost of equity and the WACC in a company where
the level of gearing changes, provided there is no change in the overall business risk and the company is therefore
similar in all respects except for its gearing.
When a company plans a new capital investment that will alter its gearing, without affecting its business risk profile,
the MM formulae can be used to calculate the cost of equity and WACC at the new level of gearing. The new WACC
can then be used as the discount rate for calculating the NPV of the proposed project.
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Assumptions of WACC
• Existing WACC can only be used as a cost of capital for new investment appraisal project if the following
conditions are met:
• Business risk of the project should be same as the existing business risk of the company and by business risk we
mean the nature of the business or the type of industry should remain same.
• Financial risk of the project should be same as the existing financial risk of the company, where financial risk is
the level of gearing.(gearing should remain same)
• Size of the project should be smaller or comparable to the existing size of the company.
• Required return of investors should remain same.
DETERMINATION OF ‘DISCOUNT RATE’ FOR APPRAISAL OF PROJECT
Undertaking the project will alter the
company's capital structure
NO
Yes
If new project is in same line of
existing business
Regardless of Whether the project
have same or different systematic
bussiness risk Use APV method
YES=The project in same area
of bussiness
NO=project is in a
different area of
bussiness
Co's existing WACC is
suitable
Risk adjusted WACC
STEPS FOR THE DETERMINATION RISK ADJUSTED WACC
• Find a suitable proxy company having same level of operations.
• Ungear βe to find the asset βeta.
• Re-gear βa to find the project equity βeta. Use either:o
•
The company’s existing gearing level or
o The specified gearing level post project
Use the calculated beta equity , calculate Ke CAPM .
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•
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Find the relevant Kd(1-t)
Use WACC Formula, project Ke, Kd(1-t) and gearing level stated in (c) i) or ii) above to find the Risk Adjusted
WACC-a nominal cost of capital.:
Example # 1:
SKANS is an education services provider with a debt: equity ratio of 1:3. It wishes to diversify into the professional
publications of ACCA & CA students, using an NPV analysis. The company does not intend to change its capital
structure.
Suppose that BPP is a typical professional book publisher. It has an equity beta of 1.25 and a debt: equity ratio of 1:
2. Because BPP is in the same area of business as the project, it is known as the pure-play company.
If Rf = 6%, Rm = 14% and Tc = 30% - and it is assumed that the debt is risk free.
Required:
Calculate risk adjusted WACC for the project.
Solution
Stage One - The asset beta of BPP – the pure-play comparison company – is calculated and then used as an estimate
of the asset beta of SKANS publishing project. Using
This asset beta reflects the systematic business risk of publishing books
Stage Two - Having estimated an asset beta for the publishing project, we can now estimate an equity beta for the
project; to reflect both the systematic business risk of professional publication and the systematic financial risk of
SKANS capital structure.
Stage Three: - Using CAPM calculate Ke
Ke Publication Project = Rf + [Rm - Rf] βEquity
Ke Publication Project = 6% + [14% - 6%] X 1.142 = 15.14%
Therefore the cost of equity capital for the project is 15.14%
Stage # Four: - Using the following formula
E
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If a cost of debt capital is needed but no cost of debt is given, we can make use of the fact that the question allows
use to assume the debt beta is zero. In these circumstances;
Kd = Rf
And KdAT = Rf X (1 – TC)
Therefore, KdAt = 6 X (1 – 0.30) = 4.2%
Example:
Fruit and Veg plc both grow strawberries and potatoes; by both turnover and profit, 70% of the company’s business
is strawberries and 30% is involved with producing potatoes. The company’s equity beta is 1.64 and its debt: equity
ratio is 2:5. Strawberry plc is a competitor company which specializes in strawberry production. Its equity beta is
1.25 and its debt: equity ratio is 1:3.
The risk free interest rate is 7% and the market return is 15%. The corporate tax rate is 30%. Corporate debt can be
assumed to be risk free.
Required:
Fruit and Veg plc wish to evaluate a potato investment (which will not change the company’s existing capitals
structure) and so need a suitable discount rate to apply to their NPV analysis.
The approach to be taken here is as follows.
1.
The asset beta of Strawberry plc can be Identified
3
2.
The asset beta of Fruit and Vet plc can also be identified.
5
3.
Fruit and Veg’s asset beta measures the systematic business risk of the company. If fact it represents a
weighted average of the risk of both the strawberry business and the potato business, as follows:
βFrunit and Veg Asset =0.70 X βStrawberry Asset
+ 0.30 βPotato Asset
Therefore, using our knowledge of both Strawberry plc’s asset beta and Fruit and Veg plc’s asset beta, we
can identify the asset beta for potato production.
1.281=(0.70 X 1.013) + (0.30 X βPotato Asset) And so:
4.
This is effectively the end of Stage One of the risk-adjusted WACC analysis, and the remainder of analysis
follow as normal:
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Stage Two:
1.
Stage Three:
Ke Potato = 7% + [15% − 7%] − 2.441 = 26.5%
Stage Four:
Therefore, 20.3% would be an appropriate NPV discount rate for Fruit and Veg plc to use in order to evaluate
potato projects.
Example
Louis Co’s non-current liabilities consist entirely of $100 nominal value bonds which are redeemable in four years at
the nominal value, on which the company pays a coupon of 5·4%. The debt is rated at B+ and the credit spread on
B+ rated debt is 80 basis points above the risk-free rate of return.
Book value of debt is $340 million and market value of equity is $979 million
Proposed luxury transport investment project by Louis Co
Louis Co wants to invest in luxury transport business.
Although there is no beta for companies offering luxury forms of travel in the tourist industry, Reka Co, a listed
company, offers passenger transportation services on coaches, trains and luxury vehicles. About 15% of its business
is in the luxury transport market and Reka Co’s equity beta is 1·6. It is estimated that the asset beta of the non-luxury
transport industry is 0·80. Reka Co’s shares are currently trading at $4·50 per share and its debt is currently trading
at $105 per $100. It has 80 million shares in issue and the book value of its debt is $340 million. The debt beta is
estimated to be zero.
General information
The corporation tax rate applicable to all companies is 20%. The risk-free rate is estimated to be 4% and the market
risk premium is estimated to be 6%
Calculate Project specific discount rate of Luxury transport for Louis co?
pg. 48 of 186
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ADUSTED PRESENT VALUE
The APV method shows how the NPV of a project can be increased or decreased by project financing effects.
When to Use Adjusted Present Value (APVs):
Business Risk
Unchanged
Financial Risk
Change
Unchanged
Existing WACC
Risk Adjusted WACC
Change
APV
APV
** When financial risk changes due to new project, always use APV The APV method described as a 'DIVIDE AND
CONQUER' approach.
Broadly speaking, APV consist of two different decisions which are as follows:
Conditions:
•
Same or different Business Risk
•
Different Financial Risk
Adjusted Present Value
= Base Case NPV + Present Value of tax shield
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. 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. Calculate Cost of Equity (Ungeared) Rf+ Asset Beta (RmRf)
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:
- Calculating the interest costs in each year
- Calculating the savings in taxation arising as a consequence, for each year of the project
- Discounting these savings in taxation to a present value, using the pre-tax (before-tax) rate of interest on the
debt as the discount rate.
It is also important to include post tax cost or savings resulting in using debt. These are generally issue cost on debt
and government subsidy
The decision rule for the APV method
If, Adjust Present Value is positive
If, Adjust Present Value is Negative
pg. 49 of 186
=
=
Accept the project
Reject the project
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Performa of Adjusted Present Value (APV):
Investment Decision
Base Case NPV
XXX
Financing Decisions
Present value of issue cost
Debt
Present value of Tax Shield
Simple
X
Subsidized Loan
X
Present value of interest savings on subsidized loan
Present value of tax loss on interest savings
Present value of tax savings due to Debt capacity
Adjusted Present Value
(x)
X
X
X
XXXX
Present value of Issuance cost:
Issue costs might be an allowable expense for the tax purposes.
When they are tax- allowable, the PV of issue costs must allow for the reduction in tax payments that will occur. The
PV of the issue costs is therefore net of the present value of any tax relief on the costs. As always calculation
involving debt must take account of the tax effects. Normally, situation is as follows:
Issuance Cost
Equity Issue
cost
Not tax allowable
expense
Debt issue
cost
Tax allowable
expense
Issuance Cost
xxx
Tax Relief on issuance cost (Tax rate x Issue cost)
Present Value of Tax Relief (Tax relief x discount factor)( if tax one year arrear)
PV of the Issue cost
pg. 50 of 186
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xxx
xxx
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Present value of Tax Shield on interest payment:
The Present value of the tax relief on interest payment is also known as the present value of the tax shield.
The method adopted depends on the information given:
Debentures:
Tax savings on Interest payments
(Gross loan x interest rate x Tax rate)
Annuity {Simple or deferred (if one year in delay)}
Present value of TAX shield
XXX
XXX
XXXX
EXAMPLE:
A company is considering a project that would cost $100,000 and it will be financed 60% by equity and 40% by
debt (pre-tax cost 4%). Tax is at 30%. Issuance cost of equity is 4% and issuance cost of debt is 2 %. Debt is raised
for 5 years
Issuance Cost
Funds required: $100,000
Equity Required: $60,000
Debt Required: $40,000
Equity Raised: 60,000/96% = 62,500
Equity Issuance Cost=62,500-60,000= 2,500
Debt Raised = 40,000/98%= 40,816
Debt issuance cost = 40,816-40,000= 816
Tax savings @ 30% =
Net Debt issuance cost =
P.V of tax shield
P.V of tax savings on interest payment.
Gross loan × interest rate × Tax rate =
40816 x 4% x 30%
Annuity factor @ before tax KD =
P.V of tax shield
(245)
571
490
4.452
=
Amortizing loan:
The repayment will be made up of both interest and capital
Step 1: Find the amount of the repayment
Annual amount =
Amount of the loan / Annuity Factor
Step 2: Calculate the annual interest charge using amortizing table
pg. 51 of 186
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Subsidized or cheap loan:
First step is same to calculate tax shield on interest payment.
1)
2)
3)
Tax savings on Interest payments
(Gross loan x interest rate x Tax rate)
Annuity {Simple or deferred (if one year in delay)}
Present value of TAX shield
XXX
XXX
XXXX
P.V of Interest savings on subsidized loan.
Gross subsidized loan × interest rate saving
Annuity factor @ (decided above) = X P.V of interest savings shield
XXX
= XXX
P.V of tax loss on Interest savings.
Gross subsidized loan × interest rate saving × tax rate
Annuity factor @ (decided above)
P.V of tax loss
= XXX
=X
= XXX
Note: step 2 and 3 will be solved separately, if tax is payable in arrears but if tax is payable in the same year then use
this single step.
P.V of after tax Interest savings on subsidized loan.
Gross subsidized loan × interest rate saving (1-T)
Annuity factor @ (decided above)
P.V of after tax interest savings shield
= XXX
=X
= XXX
EXAMPLE: 2 (if tax is payable in the same year)
A company is considering a project that would cost $100,000 and it will be financed 60% by subsidized debt (interest
cost 4%) and 40% by normal debt (pre-tax cost 7%). Tax is at 30%. Normal loan issuance cost of debt is 2 %.Debt is
raised for 5 years. It is assumed in this example only that there is no issuance cost on subsidized debt. Risk free rate
is 5%.
Issuance Cost
Funds required:
Subsidized debt required:
Normal Debt Required:
Subsidized debt Raised
Normal Debt Raised
Debt issuance cost
Tax savings @ 30%
Net Debt issuance Cost
$100,00
$60,000
$40,000
= 60,000
= 40,000/98%= 40,816
= 816
= (245)
= 571
Tax Shield
Normal Loan
40,816 × 7% × 30% =
Annuity factor @ 5 % =
$ 857
4.329
pg. 52 of 186
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Present Value of Tax shield
$3710
Subsidized loan
60,000 × 4% × 30% =
Annuity factor @ 5 % =
Present Value of Tax shield
$720
4.329
3117
P.V of after tax Interest savings on subsidized loan.
60,000 × 3% x ( 1-0.30 )
= 1260
Annuity factor @ 5%
= 4.329
P.V of interest savings
= 5455
EXAMPLE: 2 Continued
When Tax is payable in arrears
Issuance Cost
Funds required:
Subsidized debt required:
Normal Debt Required:
Subsidized debt Raised
Normal Debt Raised
Debt issuance cost
Tax savings @ 30% x 1.05^-1
Net Debt issuance Cost
$100,000
$60,000
$40,000
= 60,000
= 40,000/98%= 40,816
= 816
= (233)
= 583
Tax Shield
Normal Loan
40,816 × 7% × 30%
Annuity factor @ 5 % x 1.05^-1
Present Value of Tax shield
= $ 857
=4.12
$3533
Subsidized loan
60,000 × 4% × 30% =
Annuity factor @ 5 % x 1.05^-1
Present Value of Tax shield
$720
=4.12
2966
P.V of Interest savings on subsidized loan.
60,000 × 3%
Annuity factor @ 5%
P.V of interest savings
= 1800
= 4.329
= 7792
P.V of tax loss on Interest savings.
60,000 × 3% × 30%
Normal Annuity factor × Discount factor of 1st year
P.V of tax loss
= 540
= 4.123
= 2226
pg. 53 of 186
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Debt Capacity:
Debt finances a project because of the associated tax shield. If a project brings about an increase in the borrowing
capacity of the firm, it will increase the potential tax shield available.
Note
An Exam trick is to give both the amount of debt actually raised and the increase in debt capacity brought by the
project. It is the theoretical debt capacity which the tax shield should be based.
In simple words, tax shield will be calculated on total amount of debt capacity of the company. No matter how much
company actually used the amount of debt from that debt capacity.
For example, if a question told that actual debt rose is $200,000 but you are also told in the question that the
investment is believed to add $500,000 to the company's debt capacity. Then present value of tax shield will be
calculated on the $500,000 (this is theoretical amount).
DEBT CAPACITY
For example in previous example because of new project debt capacity rises to $ 120,000.
Answers:
Deb capacity
= $120,000
Debt Raised
= $ 100,000
Unutilized capacity
= $ 20,000
Why we use APV method?
Conceptually, the APV is relatively easy to understand. The method separates the investment decision from the
financing decision by breaking the traditional DF into two parts. The first part (the investment decision) discounts
cash flows at an equity rate of return/ cost of equity (Key) to calculate base case npv. The second part (the financing
decision) discounts the interest tax shield to the present value at a rate of return that reflect the risk in actually
achieving these tax benefits. The two parts are then summed to derive the value of the entire enterprise.
The traditional discounted cash flow method where in debt free cash flows are discounted to the present at the
WACC may not be appropriate in every circumstance. The WACC assumes a static debt to equity ratio presumably
at an optimal capital structure.
However, many companies do not expect to have static level of debt to equity, particularly in situations involving
highly leveraged transactions. Under these types of situations, the Adjusted Present Value Method may be a better
method. The APV separates the value of operations from value created or destroyed by how the company is
financed. The APV maybe a better tool to analyze the value of entities with unique financing. As such, the APV can
also be used as a management tool to break out the value created from specific managerial decisions.
The APV is based upon a principle of value addition that analysts can use with valuations.
Difference of WACC & APV Approach
The APV method is a powerful tool. APV’s approach is to analyze financial maneuvers separately and then at their
value to that of the business. WACC approach is to adjust the discount rate to reflect the financial enhancement.
Analysts apply the adjusted discount rate directly to the business cash flows. WACC is supposed to handle financial
side effects automatically, without requiring any addition after the fact.
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APV is used instead of NPV for appraising the project. When the capital structure and the financial risk of the new
project are different from the existing structure of the company.
The benefit of APV is that it breaks the problem down into the value of project itself (if equity financed) and the
value of financing (whereas as the effect of financing is taken account of and the WACC when calculating regular
NPV). This makes APV flexible enough to cover many different types of real world financing arrangements such as
•
Change in gearing level over the project life
•
Issuance cost of equity and debt properly
•
The proper impact of subsidized loan
Using debt for financing has the tax advantage and interest payment is deductible. This tax deduction has a source
of value for the firm. In the normal NPV calculation, this additional value is accounted for in the WACC.
Unlike APV, the normal assumption in NPV is that all cash flows are financed using the same WACC and remain
constant each year. Therefore, when dealing with changing financial risk and more complicated financial situation,
APV is preferable appraisal method over NPV.
INTERNATIONAL INVESTMENT APPRAISAL
There are four adjustments in international investment appraisal.
1.
Exchange Rate prediction:
EXAMPLE:
The Current Dollar Sterling exchange rate is given $/£ 1.7050 Expected Inflation Rates are:
Year
USA
UK
1
5%
2%
2
3%
4%
3
4%
4%
Find the expected spot rate for next three years.
SOLUTION:
pg. 55 of 186
Year
Calculation
Future Expected Spot
Year 1
1.7050 x (1.05/1.02)
1.7551
Year 2
1.7551 x (1.03/1.04)
1.7382
Year 3
1.7382 x (1.04/1.04)
1.7382
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Taxation
 The level of taxation on a project’s profits will depend on the relationship between the tax rates in
the home and overseas country.
 The question will always assume a double-tax treaty project always taxed at higher rate.
EXAMPLE:
What will be the rate of tax on a project carried out in the US by a UK company in each of the following
scenarios?
Scenarios
UK TAX
US TAX
A
33%
<
40%
B
33%
=
33%
C
33%
>
25%
Scenario A – No further UK tax to pay on the project’s $ profits. Profits taxed at 40% in US.
Scenario B – No further UK tax to pay on the project’s $ profits. Profits taxed at 33% in US.
Scenario C – Project’s profits would be taxed at 33%. 25% in US and further 8% tax payable in the
UK.
3.
Inter-Company Cash flows
Inter-company cash flows, such as transfer prices (intercompany transactions), royalties and management
charges, can also affect the tax computations.
Example: A project carried out by a US subsidiary of a UK company is due to earn revenues of $100m in
the US in Year 2 with associated costs of $30m. Royalty payments of $10m will be made by US subsidiary
to UK. Assume tax is paid at 25% in the US and 33%; and assume a forecast $/£ spot rate of $1.50/£.
What are the cash flows associated with the project?
Year 2
$m
Revenues
100
Costs
(30)
Royalties
(10)
Pre-Tax profit
60
25% US Tax
(15)
Remit to Parent
45*
£ Cash Flow
30 -
*45/1.50
Royalties
6.7
$10m/1.50
UK Tax
(5.4)**
After Tax Cash flow
£31.3m
pg. 56 of 186
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Remittance
Remittance occurs where an overseas government places a limit on the funds the can repatriated back to
the holding company.
This restriction will change the cash flows that are received by the holding company.
Example:
A project’s after US-tax $ cash flow is as follows ($m):
YEAR
0
1
2
3
(10)
3
4
6
In any one year, only 50% of cash flows generated can be remitted back to the parent. The blocked funds
can be released back to parent in the year after the end of project Q. Identify the cash flows to be
evaluated?
YEAR
1
2
3
Net Cash Flow
3
4
6
Blocked Funds
(1.5)
(2)
(3)
Remit to Parent (Final Cash flows)
1.5
2
3
4
6.5
INTERNATIONAL INVESTMENT APPRAISAL PROFORMA:
Year
0
FC
Sales/receipts
payments:
Variable costs
Wages/materials
Incremental fixed
Costs
Untaxed royalties /
mgt charges etc
Tax allowable depreciation
Taxable profits
Foreign tax @ say
20%
Add: Tax allowable
Depreciation
Initial outlay
Realizable value
Working capital
pg. 57 of 186
1
FC
x
2
FC
x
3
FC
x
4
FC
X
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
x
(x)
x
(x)
x
(x)
X
(x)
(x)
(x)
(x)
x
x
x
X
(x)
(x)
(x)
X
(x)
5
FC
(x)
(x)
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Net foreign CF
(x)
x
x
x
X
x
0
1
FC
x
2
FC
x
3
FC
x
4
FC
X
5
FC
x
(x)
x
(x)
x
(x)
x
(x)
X
(x)
x
x
x
x
X
(x)
(x)
(x)
(x)
x
x
x
x
0.862
x
0.743
x
0.641
x
0.552
x
FC
Exchange rate x
(based on PPPT)
Home currency CF
Domestic tax on
foreign taxable
profits @30% 20% = 10%
Untaxed royalties /
mgt charges etc Domestic
tax on
royalties etc. @30%
Net home
currency CF
DF (say 16%)
Home currency
PV
Home currency NPV
x
(x)
1
(x)
0.476
x
INTERNATIONAL APV
INVESTMENT SIDE
• Same Performa as in Investment Appraisal
• Discount with Un-gear cost of equity.
Parent Co home currency cash flows
• Additional Tax
• Incremental contribution or royalty income
• Contribution Loss
• Discount with parent co Cost of capital
Financing Side
• Issuance Cost of Equity and Debt
• Present Value of Tax saving on Interest
• Subsidized Loan
• Debt Capacity
First convert each year data into parent company currency using exchange rates then discount with before Tax Kd
or Rf of parent company.
pg. 58 of 186
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Mergers and Acquisitions
Mergers
A merger is in essence the pooling of interests by two business entities which results in common Ownership.
Acquisitions
An acquisition normally involves a larger company (a predator) acquiring smaller company (a target).
•
Generally both referred to as mergers for PR reasons:
i.
It portrays a better message to the customers of the target company.
ii.
To appease the employees of the target company.
•
An alternative approach is that a company may simply purchase the assets of another company rather
than acquiring its business, goodwill,
Types of merger
There are 3 main types of mergers
1.
Horizontal integration.
2.
Vertical integration.
3.
Conglomerate integration.
1.
Horizontal integration
When two companies in the same industry, whose operations are very closely related& are combined,
integrate .This is known as horizontal integration/merger.
Main Benefits of horizontal integration includes economies of scale, increased market power& improved
product mix.
Disadvantages of such type of integration are that it can be referred to relevant competition authorities.
2.
Vertical integration
When two companies in the same industry, but from different stages of the production chain are merged.
This is known as vertical integration.
For example
1.
A company combines with its supplier
2.
Major players in the oil industry tend to be highly vertically integrated.
Main benefits of such type of integration include increased certainty of supply or demand and just-in time
inventory systems leading to major savings in inventory holding costs.
3.
Conglomerate integration
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.
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Main benefits of conglomerate integration are 1) risk reduction through diversification, 2) cost reduction
(management) &3) improved revenues (brand).
Growth strategy
The companies can grow in 2 ways i.e. either organically or by acquisition/merger. Whatever will be the growth
strategy, assuming a standard profit maximizing company, the primary purpose of any growth strategy should be to
increase shareholder wealth?
Comparison of Organic growth & growth by acquisition
1. Organic Growth
Organic growth is internally generated growth within the firm.
No external growth should be considered unless the organic alternative has been dismissed as inferior.
Advantages of organic growth
• Organic growth allows planning of strategic growth in line with stated objectives of company.
• It is less risky because it is done over time i.e. more understanding of business
• The Cost in organic growth is lower
• Organic Growth Avoids problems of integrating new acquired companies i.e. the integration process is often
a difficult process due to cultural differences between the two companies.
• By organic Growth, an immediate pressure on current management resources to learn to manage the new
business will be avoided
Disadvantages of organic growth
• It requires time to enter a new product or geographical market.
• It increases the risk of over-supply and excessive competition.
• It increased the competition as more competitor are in market.
• Organic growth Might result in low market power as compared to acquisition strategy &by increased
market power companies are able to exercise some control over the price of the product, e.g. monopoly
or by collusion with other producers.
• Organic growth may give lesser competitive edge as compared to acquisition i.e. Acquisition results in the
Acquisition of the target company's staff & highly trained staff may give a competitive edge
2.
Growth by Acquisition
It is the growth achieved by merger/acquisition of Target Company.
Advantages of growth by acquisition
• It is the quickest way to enter a new product or geographical market.
• It reduces the risk of over-supply and excessive competition.
• Acquisition results in decrease competition as fewer competitors are available in market.
• Acquisition results in Increase market power& by increased market power companies are able to exercise
some control over the price of the product, e.g. monopoly or by collusion with other producers.
• Acquisition results in the Acquisition of the target company's staff & highly trained staff may give a
competitive edge
pg. 60 of 186
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Disadvantages of growth by acquisition
As compared to Organic growth, growth by acquisition does not allow the planning of strategic growth in line
with stated objectives.
It is more risky than organic growth because it is not done over time & might have lesser understanding of
business of Target Company
The cost is often much higher in an acquisition due to significant acquisition premiums.
It increases the problems of integrating new acquired companies i.e. the integration process is often a difficult
process due to cultural differences between the two companies.
An acquisition places an immediate pressure on current management resources to learn to manage the new
business.
Reasons for Acquisition:
• Synergy is a key reason given for growth by acquisitions
• Entry to new markets and industries.
• To acquire the target company's staff and know-how.
• Managerial motives /Arrogance factor/Hubris hypothesis.
• Diversification.
• A defense mechanism to prevent being taken over.
• A means of improving liquidity.
• Improved ability to raise finance.
• A reduction of risk by acquiring substantial assets (if the predator has a high earnings to net asset ratio and
is in a risky business).
• To obtain a growth company (especially if the predator's growth is declining).
Synergy Benefits
Synergy
The existence of synergies increases shareholder`s value in an acquisition growth strategy. TYPES OF SYNERGIES
1. Revenue Synergy
Revenue synergy exists when the acquisition of the target company will result in higher revenues for the acquiring
company, higher return on equity or a longer period of growth. Revenue synergies arise from:
•
Increased market power
•
Marketing synergies
•
Strategic synergies
Revenue synergies are more difficult to quantify relative to financial and cost synergies.
When companies merge, cost synergies are relatively easy to assess pre-deal and to implement post-deal. But
revenue synergies are more difficult. It is hard to be sure how customers will react to the new market/product (In
pg. 61 of 186
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financial services mergers, massive customer defection is quite common)& whether customers will actually buy the
new products & how it react to new expanded total systems capabilities.
2.
Cost Synergy
A cost synergy results primarily from the existence of economies of scale. As the level of operation increases,
the marginal cost falls and this will be manifested in greater operating margins for the combined entity. The
resulting costs from economies of scale are normally estimated to be substantial.
3.
Financial Synergy
Sources of Financial Synergy
There are many factors which results in financial synergy. These include:

Diversification
▪ Diversification is the process of acquiring another firm/co. as a way of reducing risk. It cannot
create wealth for two publicly traded firms, with diversified stockholders, but it could create wealth
for private firms or closely held publicly traded firms. A takeover, motivated only by diversification
considerations, has no effect on the combined value of the two firms involved in the takeover. The
value of the combined firms will always be the sum of the values of the independent firms.
▪ In the case of private firms or closely held firms, where the owners may not be diversified
personally, there might be a potential value gain from diversification.

Cash Slack
▪ When a firm with significant excess cash acquires a firm, with great projects but insufficient capital,
the combination can create value. Managers may reject profitable investment opportunities to take
over a cash-poor firm with good investment opportunities, or vice versa. The additional value of
combining these two firms lies in the present value of the projects that would not have been taken
if they had stayed apart, but can now be taken because of the availability of cash.

Tax Benefits
▪ The tax paid by two firms combined together may be lower than the taxes paid by them as
individual firms. If one of the firms has tax deductions that it cannot use because it is losing money,
while the other firm has income on which it pays significant taxes, the combining of the two firms
can lead to tax benefits that can be shared by the two firms. The value of this synergy is the present
value of the tax savings that accrue because of this merger. The assets of the firm being taken over
can be written up to reflect new market value, in some forms of mergers, leading to higher tax
savings from depreciation in future years.

Debt Capacity:
▪ By combining the two firms, each of which has little or no capacity to carry debt, it is possible to
create a firm that may have the capacity to borrow money and create value. Diversification will lead
to an increase in debt capacity and an increase in the value of the firm, has to be weighed against the
immediate transfer of wealth that occurs to existing bondholders in both firms from
▪ The stockholders. When two firms in different businesses merge, the combined firm will have less
variable earnings, and may be able to borrow more (have a higher debt ratio) than the individual
firms.
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Appropriate Target for Acquisitions
• Following factors should be considered to choose an appropriate Target
• Benefits for acquiring undervalued company
• Diversification
• Operating synergy
• Tax savings:
• Increase the debt capacity
• Disposal of cash slack
• Access to cash resources
• Control of the company:
In this case the objective is to find a target firm which is badly managed and whose stock has underperformed
the market. The management of an existing company is not able to fully utilize the potential of the assets of the
company and the bidding company feels that it has greater expertise or better management methods.
• Access to key technology
Why acquisitions fail
• Over-optimistic assessment of economies of scale.
• Once a company has been bought, management moves on to identify the next target rather than ensuring that
the predicted synergy is realized.
• Inadequate preliminary investigation combined with an inability to implement the amalgamation efficiently.
• Winner’s curse – where two or more predators bid to buy a target & the winner often had to pay an excessive
premium to secure the deal.
• Dominance of subjective factors such as the status of the respective board of directors.
• Difficulty of valuation i.e. correct value of target company/firm\Culture differences
• Loss of key personnel from target company
• Capital structure
• Integration difficulties - e.g. systems, operations
Factors effecting the likely success of the bid for Acquisition
(1)
Level of consideration
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.
(2)
Expectations of future profits
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.
(3)
Future dividend policy
Shareholders of Target Company may be sensitive to the dividend policy possibly being less generous than
they have been used to before the acquisition.
(4)
Tax position
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.
(5)
Changes in shares prices
Shareholders will also take account of any changes in share prices that occur during the bid price.
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Defenses to Takeover/Merger/Acquisition
When a target company is faced with a hostile tender offer (takeover) ,the target managers and board use defensive
measure to delay, negotiate a batter deal for shareholders ,or attempt to keep the company independent.
Defensive measure can be implemented either before or after a takeover attempt has begun. Strategic Defenses can
be split into pre-bid and post-bid defenses.
Pre Offer Defense
•
Poison Pill
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.
•
Poison Put
Whereas poison pills grant common shareholders certain rights in a hostile takeover attempt, poison puts
give rights to the target company's bondholders. In the event of a takeover, poison puts allow bondholders
have the right to sell their bonds back to the target at a redemption price that is pre-specified in the bond
Agreement, typically above par value.
•
Staggered Board of Directors
Instead of electing the entire board of directors each year at the company's annual meeting, a company
may arrange to stagger the terms for board members so that only a portion of the board seats are due for
election each year.
•
Golden Parachutes
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.
•
Eternal vigilance
Maintain a high share price by being an effective management team and educate shareholders.
•
Cross shareholdings
Your company buys a substantial proportion of the shares in a friendly company, and it has a substantial
holding of your shares.
•
Strong dividend Policy
The level of cash dividend is often held to influence share price.
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Post offer defenses
•
Litigation
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.
•
Green Mail
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.
•
"Crown Jewel" Defense
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.
"Pac-Man" Defense
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.
•
White Knight Defense
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.
Methods of financing mergers
Type of Consideration
The means of transferring the financial value of the shares or assets of the business, the consideration, can be
satisfied in a combination of several alternatives:
1. Cash
2. Debt
3. Preference shares.
4. Ordinary shares.
5. Debt and preference share consideration that can be convertible into ordinary shares.
6. Share and loan stock used as consideration are known as 'paper issues'.
7. If a share exchange is used the target company's shares are purchased using shares of the predator.
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1.
Advanced Financial Management - AFM
Cash
It is the most popular method (especially after stock market declines in early years.)
For the Acquirer
Advantages
Disadvantages
When the bidder has sufficient cash the merger can be Cash flow strain - usually either must borrow
achieved quickly.
(increased gearing) or issue new shares in order to
raise the cash.
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.
For the Target Shareholders
Advantages
Disadvantages
Certainty about bids value
Liable to CGT
Freedom to invest in a wide ranging portfolio.
Do not participate in new group synergy benefits
The cash to fund the purchase may have been raised by a rights issue before the takeover bid.
2.
Shares
It is the second most popular method.
For the Acquirer
Advantages
Disadvantages
No cash outflow
Dilution of control
Bootstrapping – when high P/E ratio Co acquires low
P/E co, acquirer will have to issue less number of
shares so EPS rises.
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For the Target Shareholders
Advantages
Disadvantages
Postponement of CGT liability
Uncertain value
Participate in new group synergy benefits
Choice of payment type
a)
Sometimes investors are given a choice in the method of payment, with the logic that different forms
of payment might be attractive to different types of investor.
b)
Could influence the success or failure of a bid.
c)
Problematic for the bidder in that the cash needs and the number of shares to be issued is not known.
d)
Capital structure may alter in an unplanned manner.
e)
Ideally a bidder would like to tailor the form of the bid to that favored by major investors in the
targeted company.
Control

if a large number of shares are issued then control
of the company may alter

Increases in authorized capital may be needed
Increases in borrowing limits may be required The 
cost to the company will vary with debt, equity and
convertible loan stocks

There may be a dilution of earnings per share The
level of gearing resultant on an issue of debt to
finance a cash acquisition may be unacceptable.
Share price shareholders want shares that will at least
retain their value
Future investments some shareholders may prefer
shares to maintain an investment in the company
Taxation Liability may be deferred if the consideration
was in shares
Income Shareholders will want a minimum income
stream.
Factors used to decide payment type
Predator and its shareholders
Target company shareholders
The Global Regularity Framework
Introduction
Takeover regulation is an important corporate governance device that seeks to protect the interest of minority
shareholder and other types of stakeholders and ensure a well-functioning market for corporate control.
Potential conflict of interests
Takeover regulation seeks to regulate the conflicts of interest between the management and shareholders of both
target and bidder
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There are two main agency problems that emerge in the context of a takeover that regulation seeks to address:
 The first is the possibility that management of the target company may implement the measure to prevent the
takeovers even if these are against the stakeholder’s interest.
 The second is the protection of minority shareholders. In addition to existing minority shareholders, transfers
of control may turn existing majority shareholders of the target into minority shareholders.
Key aspects of Takeover Regulation
The following seven regulatory devices are available to traitors and aim at the protection of shareholders.
1.
Mandatory Bid- Rule:
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 as cumulated a certain percentage of the shares. National thresholds
vary between countries what the trend has been for these to decrease over the years. In UK these thresholds is
specified by the city code for takeovers and mergers and is at 30%. This rule is based on the grounds once the
bidder obtains the control he may exploit his position at the expense of minority shareholders.
This 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.
2.
The principle of equal treatment:
The principle of treating all the shareholders equally is fundamental in all western, European countries in general
terms. 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.
3.
Transparency of ownership and control:
The disclosure of information about major shareholding is an important element of investor protection in a wellfunctioning corporate market. 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.
4.
The squeeze-out and sell-out rights:
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.
Sell-out rights enable minority shareholders to require the majority shareholder to purchase their shares.
5.
The one-share-one vote:
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.
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6.
The break-through rule
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 break-through the company’s multiple voting rights and exercise control
as if one share-one vote existed.
7.
Board neutrality and anti-takeover measures
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.
General Principles:
• 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.
• Sufficient information, advice and time to be given for a properly informed decision ‘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 t0 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 (formerly called the Monopolies and Mergers Commission). Under the terms of the
Monopolies and Mergers Act, the Office of Fair Trading (OFT) is entitled to scrutinize and possibly reject all major
mergers and takeovers. If the OFT thinks that a merger or takeover might be against the public interest, it can
refer it to the Competition Commission.
• 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 (or, in the case of a completed
merger, is reversed).
• Any person aggrieved by a decision of the OFT, the Secretary of State or the Competition Commission in
connection with a reference or possible reference, may apply to the Competition Appeal Tribunal (CAT) for a
review if that decision.
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Advanced Financial Management - AFM
BUSINESS VALUATION
Method of Valuation
Cash flow
based
model
Dividend
Valuation
model
Free Cash
flow to
Firm FCFF
Free cash
flow to
Equity
FCFE
Net Asset
method
Combine
Company
Value
Valuation
Based on
APV
Net asset
Value
Market Relative
based model
P/E ratio
Or
Earning
Yield
Price/cas
h flow
Calculated
Intangible
Value (CIV )
CASH-FLOW BASED METHOD
DIVIDEND VALUATION MODEL
The dividend valuation model (or growth model) suggests that the market value of a share is supported by the
present value of future dividends Formula
MV =
Where:
MV = share price g = future annual growth rate
D0 = dividend at Time 0
Ke = rate of return required by the equity shareholders
Three inputs have to be estimated if this approach is to be used: D0, g and Ke.
D0 This is the dividend that has either just been paid or is just about to be paid: it is the current dividend. g = this is
estimate by looking directly at the historical dividend growth rate and assuming this will continue in the future. OR
Gordon’s growth approximation:
G=b x r g = b x Cost of equity
Where: b =( 1-dividend payout ratio).
r= Cost of equity
Ke can be estimated using the capital asset pricing model: Required rate of return, Ke = Rf + β( Rm – Rf )
DIVIDEND VALUATION MODEL ( TWO METHODS)
Single Growth model:
MV =
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Multiple Growth model:
Year
1
2
3
Dividends
D1
D2
D3
4-∞
D3 ( 1 + g)
Ke − g
Discount factor @ Ke
Discount factor of
last year
Market Capitalization= Mv/share × number of shares
ASSUMPTIONS
 It is assumed that current dividend payout ratio reflects the normal dividend capacity of business.
 It is assumed that dividend will increase with constant growth for the foreseeable future.
 Required return of investors (Ke) will remain constant for the foreseeable future.
 Dividend Growth model estimates market value according to the non-controlling shareholders. In order to get
control of the company acquirer will have to pay some extra amount as control premium.
Example
Now end of 2016.
Dividend history, expected dividends and cost of capital, Lirio Co
Year
2013
2014
2015
2016
Number of
$1
equity shares in
issue (000)
60,000
60,000
80,000
80,000
Total
dividends
paid ($ 000)
12,832
13,602
19,224
20,377
It is expected that dividends will grow at the historic rate in current policy.
Expected dividends and dividend growth rates in new policy.
Year to end of February 2017
$4,760,000 will be paid as dividends.
Year to end of February 2018
Dividends paid will be the same amount as the previous year.
Year to end of February 2019
Dividends paid will be $0·31 per share.
In future years from February 2019
Dividends will grow at an annual rate of 7%.
Lirio Co’s cost of equity capital is estimated to be 12%.
Decide shareholders will choose which policy?
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FREE CASH FLOWS
Free Cash Flow from Firm
PBIT
XX
Tax
(X)
Depreciation
X
Working Capital Change
(X)
CAPEX
(X)
FCFF
Discount this using weighted average cost of capital.
Scenario 1: Single Growth Model.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝐴𝑙𝑢𝑒 𝑜𝑓 𝐵𝑢𝑠𝑖𝑛𝑒𝑠𝑠 =
𝐹𝐶𝐹𝐹(1 + 𝑔)
𝑊𝐴𝐶𝐶 − 𝑔
2
3
4
5 - inf
FCFF2
FCFF3
FCFF4
Scenario 2: Multiple Growth Model
Year
1
Free
cash
FCFF1
flows to firm
Discount
factor @
WACC
Discount factor of
Preceding year
P.V= Market Value of Business
Market Value of Equity = Market Value of Business – Market Value of Debt
Historic Growth
Historic cost based on sales or operating profits.
FCFE
Free Cash Flow To Equity
PBIT
XX
Tax @ 30%
(X)
Depreciation
X
Working Capital Change
(X)
Interest ( 1 – 1)
(X)
CAPEX
(X)
FCFE
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Discount using cost of equity
Scenario 1 Single Growth Model
Market Value of Equity =
Scenario 2 Multiple Growth Model
Year
Free cashflows
to equity
1
2
3
4
FCFE ( 1 + g)
FCFE
FCFE
FCFE
FCFE
Ke − g
Discount factor
@ Ke
P.V= Market Value of Equity
Discount factor of
last year
How to Calculate Growth in FCFE model
Historical Growth
Based on Sales or Operating profits
Gordon Growth
g=bxr
r = Cost of Equity
b=
Return on equity is not suitable therefore use cost of equity.
Other formulas to calculate FCFE
Free Cash Flows to Equity
PBIT
Interest
PBT
Tax @ 30%
Depreciation
W. Cap change
CAPEX
Free Cash Flows to Equity
Free Cash flow to firm
Interest (1 – t)
pg. 73 of 186
XX
(X)
X
(X)
X
(X)
(X)
FCFE
XX
(X)
FCFE
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Assumptions of Free Cash Flows
 It is assumed that level of free cash flows reflect the normal capacity of business.
 It is assumed that free cash flows will grow with constant growth rate for the foreseeable future.
 Required return of investors will remain constant.
 It is company policy to have consistent re-investments in CAPEX.
 Interest rate or Interest amount will remain constant (loan amount will be constant)
 It is assumed that replacements CAPEX are equivalent to the annual depreciation (only when mentioned in
question).
Example
Coeden Co’s latest free cash flow to equity of $2,600,000 was estimated after taking into account taxation, interest
and reinvestment in assets to continue with the current level of business. It can be assumed that the annual
reinvestment in assets required to continue with the current level of business is equivalent to the annual amount
of depreciation. Over the past few years, Coeden Co has consistently used 40% of its free cash flow to equity on
new investments while distributing the remaining 60%. The market value of equity calculated on the basis of the
free cash flow to equity model provides a reasonable estimate of the current market value of Coeden Co. Coeden
Co’s current equity beta is 1·1 and it can be assumed that debt beta is 0. The risk free rate is estimated to be 4%
and the market risk premium is estimated to be 6%. Calculate Market value of Coeden Co.
Example
Rayn Co’s annual sales growth rate is expected to be 5% and the profit margin before interest and tax is expected to
be 17·25% of sales revenue, for the next four years. It can be assumed that the current tax allowable depreciation
will remain equivalent to the amount of investment needed to maintain the current level of operations, but that the
company will require an additional investment in assets of 40c for every $1 increase in sales revenue. After the four
years, the annual growth rate of the company’s free cash flows is expected to be 3% for the foreseeable future.
Cost of capital is 9%.The corporation tax rate applicable to all companies is 22%.
Financial information: Rayn Co
Given below are extracts from Rayn Co’s latest statement of profit or loss and statement of financial position for the
year ended 30 November 2015.
2015
$ million
Sales revenue
14,980
Profit before interest and tax (PBIT)
2,584
Interest
720
Pre-tax profit
1,864
Calculate Market value of Rayn Co (Firm Value).
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Example
Frank is a fully listed company financed wholly by equity.
The following information is taken from the financial statements of company at the start of the current year:
$‘’000’’
Assets less current liabilities
4400
Capital Employed
Equity
4400
Net operating profit after tax (NOPAT)
580
Net amount retained for reinvestment in assets
180
It can be assumed that the retained earnings for company is equal to the net reinvestment in assets.
The current yield rate is 5% and the current equity risk premium is 6%. It can be assumed that the risk free rate of
return is equivalent to the yield rate. Frank’s beta has been estimated to be 1·26.
Required:
(i)
Using the free cash flow model, estimate the market value of equity for Frank Co.
Example
The following financial information relates to Rayn Co and to the development of the new product.
Rayn Co financial information
$’000
Sales revenue
8,780
PBIT
1,230
Interest
(455)
Tax
(155)
PAT
620
Balance sheet Extract
$000
Net non-current assets
10,060
Current assets
690
Total Assets
10,750
Share capital (40c per share par value
960
Reserves
1,400
Non-current liabilities: Variable rate loans
6,500
Current liabilities
1,890
Total liabilities and capital
10,750
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In arriving at the profit after tax amount, Rayn Co deducted tax allowable depreciation and other non-cash expense
totaling $1,206,000. It requires an annual cash investment of $1,010,000 in non-current assets and working capital
to continue its operations.
Rayn Co’s profits before interest and tax in its first year of operation were $970,000 and have been growing steadily
in each of the following three years, to their current level. Rayn Co’s cash flows grew at the same rate as well, but it
is likely that this growth rate will reduce to 25% of the original rate for the foreseeable future.
It is estimated that an overall cost of capital of 11% is reasonable compensation for the risk undertaken on an
investment of this nature.
Required:
Estimates the current value of a Rayn Co share, using the free cash flow to firm methodology.
Asset Based Approach
The business is estimated as being worth the value of its Net Assets.
Net Assets = Total Assets – Total Liabilities – Preference Share Value
Adjustments:
Monetary assets: book value
Tangible assets:
•
Replacement value( if purpose is going concern)
•
Realizable Value( if purpose is of disposal)
•
Book value( if above values are not available)
Intangible Assets: consider if market value is available
Inventory: at NRV
Receivable: less any allowance for doubtful debt
Liabilities: redemption value
PROBLEMS & ADVANTAGES OF NET ASSETS METHOD
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.
Advantages of Net Asset Method
 It can be used as floor value (minimum value) in mergers and acquisitions.
 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.
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CALCULATED INTANGIBLE VALUE (CIV) MODEL
Step 1: Identify suitable proxy company or industry ‘return on capital employed.’
Step 2
PBIT of Target Company
XX
Capital Employed of target. x Industry ROCE
(XX)
Excess earnings or value surplus
XX
Tax
(XX)
After-tax Excess Earnings or value surplus
P.V of all intangibles
= Excess Earnings (1-T)
WACC
XX
Total Value = Capital Employed + P.V of Intangibles
MARKET RELATIVE BASED APPROACH
Price/Earning Method / Earnings Multiple
This method relies on finding listed companies in similar businesses to the company being valued (the target
company), and then looking at the relationship they show between share price and earnings.
P/E ratio = Market Value of Share / Earnings per Share
Market Value of Target Company = Earnings per Share of Target Company X P/E Ratio of Proxy or (Industry
Average) Adjustments:
 Adjust earnings for one off exceptional items (After-tax).
 If target company is a private company then downwards adjust the calculated market value because:
 Public company has better image over private company
 Public company shares are more marketable and liquid
 Public company is less risky as compared to private company.
 If private company has better growth prospects then upwards adjust the calculated market value.
 For better analysis use forecasted earnings.
 MV of Target co=Forecasted Earnings x P/E Ratio of Industry
 In exam we will calculate both values (using historic earnings and forecasted earnings) and suggest that market
value of the company should be in between.
INCOME BASED APPROACH
Earning Yield Method:
Earnings yield = Earnings per share/ Market value per share.
For example, if EPS was £1 per share and the market price per share was £10, then the earnings yield would be 10%.
Earnings yield is the mirror image of the PRICE-EARNINGS RATIO.
MARKET VALUE OF TARGET COMPANY/ SHARE = EPS OF TARGET COMPANY X 1/
EARNING YIELD (PROXY)
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Problems of P/E ratio method
 Historical values used in calculations
 Single year data is being considered
 Difficult to find suitable proxy company
Example
Zayn Co’s has medical equipment manufacturing business and directors want to sell the company to Sino co. The
value of the sell-off will be based on the medical and dental equipment manufacturing industry. Sino Co has
estimated that Rayn Co’s manufacturing business should be valued at a factor of 1·2 times higher than the industry’s
average price-to-earnings ratio. Currently the industry’s average earnings-pershare is 30c and the average share
price is $ 2.4.The corporation tax rate applicable to all companies is 22%.
Financial information: Zayn Co
Given below are extracts from Zayn Co’s latest statement of profit or loss and statement of financial position for the
year ended 30 November 2015.
2015
$ million
Sales revenue
6420
Profit before interest and tax (PBIT)
963
Interest
216
Pre-tax profit
747
Calculate Market value of Zayn Co.
OTHER MEASURES
Price to Cash Flow Ratio/ Cash flow multiple
M.V of target = Free cash flow of target x price to CF ratio of proxy
Price to Book Value/ Book Value Multiple
M.V of target = Book value of target x price to book value of proxy
Valuation Using Apv Method
Same Business Risk and Different Financial Risk:
Use Adjusted Present Value
Investment Side
Calculate free cash flows of target Company and discount these free cash flows at un-geared cost of equity.
FINANCING SIDE
 Issue costs
 Present value of tax shield
 Present value of interest savings on subsidized loan.
 Discount all of these using risk-free rate or cost of debt
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Market value of business = Base case NPV + Present Value of tax shield
Market value of equity = Market value of business – market value of debt Benefit = Market value of equity – cost of
acquisition
Valuation Techniques
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
Value of the combined company
Less: Value of the parent company before Acquisition
Value of the Target Company (The Maximum Value)
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
PV of the Target Company.
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CORPORATE RESTRUCTURING
TYPES OF RECONSTRUCTION
Financial Reconstruction
•
It involves changing the capital structure of the firm.
•
It also includes Leveraged Recapitalization, Leveraged Buy-Outs and Debt for Equity swap.
Portfolio Reconstruction
•
It involves making additions to or disposals from companies businesses.
•
It includes Divestments, Demergers, spin-offs or management buy-outs.
Organizational Reconstruction
•
It involves changing the organizational structure of the firm.
Financial Restructuring Reasons:
•
Company going towards Default
•
Reconstruction for Value Creation
•
Facing Downfall so restructure to improve Performance
•
No innovation in products
•
Statutory and Legal Compliance
Steps: - It is assumed that company is no longer operational.
Prepare a Liquidation Statement and calculate what each party gets if the company were to go in Liquidation.
Liquidation Statement
Realizable value of Assets
XX
Liquidation Fees
(xx)
Redundancy Cost
(xx)
Secure Creditors
(xx)
Unsecured Creditors
Trade Payable
(xx)
Overdraft
(xx)
Preference shares Ordinary Shares
XX
Steps: - Bond Holders/Banks is risk averse in nature therefore will not be ready to take up risk.
Evaluate the effects of Restructuring Proposals on the following, (you may have to calculate in exam)
•
Fund Flow Forecasts (Cash Inflow & Cash Outflow) from additional resources and investments
•
Forecasted Earning per Share
•
Market value on the basis of forecasted Cash Flows and P/E Ratios.
Analyze the Restructuring Proposal and check whether the parties will be better off under the proposed scheme
compare to liquidation.
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•
•
•
•
•
Advanced Financial Management - AFM
Increase in interest rate from existing level
Offer higher nominal value to existing bondholders
Offer majority shares to debt holders.
Offer security to unsecured to debt holders
Fixed Charge offered to existing floating charge debt holders.
CONCLUSION: Come to conclusion and discuss whether it is a successful restructuring scheme or not.
Financial Reconstruction Answer Plan:
1. State the reason why the scheme is required
As a result of the recent considerable losses there is inadequate funds available to finance the redemption of
debentures.
2. Does the scheme raise adequate finance?
3. 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 equity is used to purchase assets, on which they will have a prior claim to
shareholders
4. The Finance Generated From Reconstruction Plan and Whether Its Greater Than Required.
5. Whether The Business Will Proceed After The Reconstruction.
6. Is the scheme acceptable to all parties?
General points:
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.
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:
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) Upon liquidation
b) Under the scheme
In relation to shares and debentures it may be worthwhile to note their market value before the scheme i.e.
their current exit value.
7.
Conclusion

Try and reach a sensible conclusion about the scheme, which is justified by your analysis.
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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.
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
Relatively debt free
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.
Leveraged buy-outs (LBOs)
•
It refers to the takeover of a company that utilizes mainly debt to finance the buyout and company is delisted.
•
A small group of individuals, possibly including existing shareholders and/or management buys all the
company's shares.
Advantages
•
Protection from Share price movement
•
No hostile bids
•
Focus on Long-term Performance
•
Minimized agency costs
Disadvantages
•
Shares don’t trade publicly anymore.
•
Bankrupt if the cash flow risk is too high.
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.
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It includes the following:
Divestment
Demergers
Spin - Off
Sell - Offs
Carve Outs
Management Buy Out
Business Re-Organization Unbundling
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.
Advantages of demergers
• 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.
Disadvantages of demergers • 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.
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Sell-offs
A sell-off is the sale of part of a company to a third party, generally for cash.
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.
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.
Liquidations
The extreme form of a sell-off is where the entire business is sold off in liquidation. In a voluntary dissolution, the
shareholders might decide to close the whole business, sell off all the assets and distribute net funds raised to
shareholders.
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:
a) 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.
b) There may be improved efficiency and more streamlined management within the new structure.
c) 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.
d) The requirements of regulatory agencies might be met more easily within the new structure.
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 carve-out, 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.
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.
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Venture capital may be an important source of financial backing.
A management buy-out is the purchase of all or part of a business from its owners by its managers.
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
• 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
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
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.
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.
They may bring fresh ideas and experience.
They may bring better finance for company.
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FOREIGN CURRENCY RISK MANAGEMENT
FOREX
How
to
Convert
Currency
How
Currency
Fluctuates
Types
of
Foreign
Hedging Methods
Risk
RISK MANAGEMENT
Quotes
Direct
Indirect
Quoted
Local/foreign
Foreign/local
Example (Pakistan)
Rs. 100/1$
$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
QUOTES
EXCHANGE RATE CONVERSION
Bid
Offer/ask
Bank Buy
Bank Sell
1.2320 $/£
1.2324 $/£
When dealing with converting foreign currency, it is important to consider the following points ➢
consider yourself at Adverse Position
In case of Receipt (Lower
Receipt)
➢
Always
In case of Payments (Higher
Payment)
In Currency Division
In case of Receipt, Sell Currency, Exports, Gain or Income
Divide with Higher
Currency Rate
In case of Payment, Buy Currency, Import, Loss or Expense
Divide with Lower
Currency Rate
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HOW CURRENCY FLUCTUATES
Supply & Demand
• Speculation
• Export and Import
• Foreign Direct Investment (FDI)
• Foreign Currency Loans
PURCHASING POWER PARITY (PPP)
It follows ‘’ law of one price’’. Commodities price between two economies should have the same value, if price
changes because of inflation, exchange rate will absorb this impact and will change.
According to PPP the exchange rate between two currencies can be explained by the difference between inflation
rated in respective countries.
PPP says country with HIGH inflation rate normally faces the decrease in its currencies value and a country with a
LOW inflation rate has an expectation of increase in its currencies value.
The businesses normally use PPP for calculation of expected spot rate against the forward rate offered by banks.
𝑭𝒖𝒕𝒖𝒓𝒆 𝑺𝒑𝒐𝒕 𝑹𝒂𝒕𝒆 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑺𝒑𝒐𝒕 𝒓𝒂𝒕𝒆 𝑿
𝟏 + 𝒊𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝒊𝒏 𝟏𝒔𝒕 𝒄𝒐𝒖𝒏𝒕𝒓𝒚
𝟏 + 𝒊𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝒊𝒏 𝟐𝒏𝒅 𝒄𝒐𝒖𝒏𝒕𝒓𝒚
INTEREST RATE PARITY (IRP)
This concept says that the difference between 2 currencies worth can be explained by interest rate structure in the
countries of these 2 currencies.
According to IRP a country with a high interest rate structure normally has a currency at discount in relation to
another currency whose country has a low interest rate structure & vice versa.
HIGH INTEREST in country
LOWER will be the value of currency
LOWER INTEREST in country
HIGHER will be the value of currency
We can predict forward rate between two currencies by using interest rate parity concept as follows;
𝟏+𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆 𝒊𝒏 𝟏𝒔𝒕 𝒄𝒐𝒖𝒏𝒕𝒓𝒚
𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑹𝒂𝒕𝒆 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑺𝒑𝒐𝒕 𝒓𝒂𝒕𝒆 𝑿 𝟏+𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆 𝒊𝒏 𝟐𝒏𝒅 𝒄𝒐𝒖𝒏𝒕𝒓𝒚
FISHER EFFECT
This concept tells us the relation between interest rate and inflation.
It assumes that real interest rate between two economies is same and nominal interest rates are different because
of inflation.

Countries with relatively high rate of inflation will generally have high nominal rates of interest, partly
because high interest rates are a mechanism for reducing inflation.

USA
1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate]

UK
1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate]
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TYPES OF FOREIGN
EXCHANGE RISK
TRANSLATION RISK
• Translation risk refers to the possibility of accounting loss that could occur because of foreign subsidiary, as a
result of the conversion of the value of assets and liabilities which are denominated in foreign currency, due to
movements in exchange rate. Parent company will face this risk if subsidiary is in depreciating currency
environment.
• This risk is involved where a parent company has foreign subsidiaries in a depreciating currency environment.
TRANSLATION RISK HEDGING
• Arrange Maximum Borrowing in Subsidiary Co. currency.
• Maintain Surplus Assets in Parent Co. currency which will reduce the overall exposure of Translation risk.
ECONOMIC RISK
• Long-term movement in the rate of exchange which puts the company at some competitive disadvantage is
known as economic risk. E.g. if competitor currency starts depreciating or our company currency starts
appreciating.
• It may affect a company’s Performance even if the company does not have any foreign currency transactions.
ECONOMIC RISK HEDGING
• Shift manufacturing to cheaper labor areas
• Create innovative and differentiate units to create brand loyalty
• Diversify into new products and into new markets
TRANSACTION RISK - INTERNAL HEDGING METHOD
TRANSACTION RISK
•
Transaction risk refers to adverse changes in the exchange rate before the transaction is finally settled.
Hedging Methods
Internal Hedging Methods
•
Invoice in Home Currency
•
Matching Foreign Currency (Receipts and Payments)
•
Netting
Invoice in Home Currency
Suitability: Monopoly power & customer has no option. Supplier agrees to invoice in your currency.
Matching Foreign Currency (Receipts and Payments)
Match the balances of receipts and payments. Timing and currencies should be same
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.
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Step 1:
Convert all transactions of group companies or in case of multilateral netting the other non-group companies in to
the same currency (normally the parent Co currency) using mid spot rates.
Step 2:
Prepare the Transaction matrix (Netting Table)
USA
UK
Europe
Total Receipts
Receipts
USA
X
x
x
Xx
Read Across
UK
X
x
x
Xx
Europe
X
x
x
Xx
Total Payments
(xx)
(xx)
(xx)
Total Receipts
Xx
xx
xx
Net Amounts
(xx)
(xx)
xx
Step 3:
Companies with negative balance will pay the amounts to companies having positive balance.
Netting is a process whereby the debt between group member companies or between group members and other
parties can be reduced.
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.
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, re-contracting.
Example
The following cash flows are due in three months between KRish Co and three of its subsidiary companies. The
subsidiary companies are LALA Co, based in the United States (currency US$), Trudeau Co, based in Canada (currency
CAD) and Shinzo Co, based in Japan (currency JPY).Amounts are in million.
Owed by
KRish Co
KRish Co
Shinzo Co
pg. 96 of 186
Owed to
LALA Co
Trudeau Co
Trudeau Co
Amount
US$ 4·5 million
CAD 1·1 million
CAD 3·2 million
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Shinzo Co
Trudeau Co
Trudeau Co
LALA Co
LALA Co
Advanced Financial Management - AFM
LALA Co
LALA Co
KRish Co
Shinzo Co
KRish Co
Exchange rates available to KRish Co
US$/£1
Spot
1·2938–1·2962
US$ 1·4 million
US$ 1·5 million
CAD 3·4 million
JPY 320 million
US$ 2 . 1
CAD/£1
1·6690–1·6710
JPY/£1
131·91–133·59
Calculate net amount owed by or to each part using netting approach
TRANSACTION RISK - EXTERNAL HEDGING METHOD
Forward Contract:
A forward contract is an agreement made today between a buyer and seller to exchange a specified quantity of an
underlying asset at a predetermined future date, at a price agreed upon today. It is a legally binding contract
between two parties to buy or sell in future at a pre-determined rate and a pre-specified date.
Example
Home Currency is British Pound £ , Exports receipts = $ 500,000 after six months
Spot Rate = 1.30 – 1.31 $/£
Six month forward rate = 1.32 – 1.33 $/£
Expected Net Receipt if Forward Contract is taken = $500,000/1.33 = £ 375,940
Advantages
• Eliminate currency risk, as foreign exchange costs are determined upfront.
• They are tailor made and can be matched against the time period of exposure as well as for the cash size of the
exposure, therefore they are referred to as a complete hedge.
• They are easy to understand.
Disadvantages
• It is subject to default risk.
• There may be difficult to find counter-party.
• They are legally binding so difficult to cancel.
TRANSACTION RISK - EXTERNAL HEDGING METHOD
Money Market Hedging:
Use of the short-term money markets to borrow or deposit funds. This gives the company the opportunity to
exchange currency today at the prevailing spot rate.
Steps of Setting-up Money Market Hedge
1.
Borrow – borrow funds in the currency in which you need the money.
2.
Translate – exchange the funds today avoiding exposure to fluctuations in the rate.
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Deposit – deposit the funds in the currency in which you eventually want the funds until such time as you will
need them.
Foreign Currency Receipts / Exports Steps:
a) Calculate present value of foreign currency using borrowing rate of foreign currency and take loan of this
amount.
Present Value = Foreign Currency amount
(1+ borrowing rate of FCY)
a)
Convert that present value into home currency using spot exchange rate.
b)
Deposit the home currency at the deposit rate of home currency. Total receipts= Home currency × (1 +
lending rate of HCY)
FOREIGN CURRENCY PAYMENTS / IMPORTS
Steps:
a) Calculate present value of foreign currency using lending rate of foreign currency and deposit that amount.
Present Value = Foreign Currency amount
(1+ lending rate of FCY)
a)
Convert that present value into home currency using spot exchange rate.
b)
Borrow the home currency at the borrowing rate of home currency.
Total payment= Home currency × (1 + borrowing rate of HCY )
 A money market hedge is a mechanism for the delivery of foreign currency, at a future date, at a specified rate
without recourse to the forward FOREX market. If a company is able to achieve preferential access to the short
term money markets in the base and counter currency zones then it can be a cost effective substitute for a
forward agreement. However, it is difficult to reverse quickly and is cumbersome to establish as it requires
borrowing/lending agreements to be established denominated in the two currencies.
 With relatively small amounts, the OTC market represents the most convenient means of locking in exchange
rates. Where cross border flows are common and business is well diversified across different currency areas
then currency hedging is of questionable benefit. Where, as in this case, relatively infrequent flows occur then
the simplest solution is to engage in the forward market for hedging risk. The use of a money market hedge as
described may generate a more favorable forward rate than direct recourse to the forex market. However the
administrative and management costs in setting up the necessary loans and deposits are a significant
consideration.
Derivatives:
•
Future Settlement
•
Initial amount to be paid is nil or low
•
Drive their value from some underlying
•
Traded in two types of market
•
(Over the counter Market & Exchange Traded)
Over-the-Counter Derivatives
Exchange-Traded Derivatives
Customized Contracts
Standardized Contracts
Any Amount
Standardized Contract Size (e.g. $ 62,500)
Available in any Currency
Major Currencies
pg. 98 of 186
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Settlement on any date
Settlement Date – Mar/Jun/Sept/Dec
No Initial margin requirement
Initial Margin Requirement
Gain or Loss settled at maturity
Gain or Loss settled on daily basis using ‘Mark to
Market”
High Risk of Default
Counter Party is another Investor
Counter Party is clearing house.
E.G FORWARD CONTRACTS
E.G FUTURE CONTACTS
TRANSACTION RISK - EXTERNAL HEDGING METHOD
FUTURE CONTRACT
• Futures are standardized contracts traded on a regulated exchange to make or take delivery of a specified
quantity of a foreign currency, or a financial instrument at a specified price, with delivery or settlement at a
specified future date.
• They are Exchange Traded derivatives contracts.
• Standardized contract sizes and are available in only major currencies
• There are four settlement dates MAR/JUNE/SEPT/DEC.
• Minimum movement is in ticks
• Tick = Contract size x 0.01%
• For Japanese ¥ = Contract size x 0.0001%
• If you want to buy any currency in Future
Buy future contracts
• If you want to sell any currency in Future
Sell future contracts
• Think according to contract size currency
Example 1
Country USA, Currency $
Export £300,000
Contract size £62,500
Solution
Sell £ future contracts
Example 2
Country UK, Currency £
Export $600,000
Contract Size £62,500
Solution
Buy £ Future Contracts
Example 3
Currency €
Export £600,000
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Contract size £62,500
Solution
Sell £ Future Contracts
Example 4
Currency ¥
Imports $1,000,000
Contract size ¥1.5million
Solution
Sell ¥ Future Contracts
Steps in future contract hedging
1)
Identify the amount of currency to be hedged
2)
Decide whether to buy or sell future
3)
Identify the settlement date expiring immediately after the payment is due to be paid or received
Transaction Amount
4)
Calculate no of contracts
Contract Size
If transaction currency is different from the contract size currency then using future rate convert that transaction
amount currency into the same currency of contract size.
.
5)
Close the future contract by taking opposite position:
Buy £ Future
1.50 $/£
Sell £ Future 1.60 $/£
Gain
0.10 $/£ x No.of Contracts x Contract size
Gain or loss will be in $ amount if $ amount is not home currency, then using transaction date spot rate,
convert this into home currency.
6)
Actual buying or selling of currency in market
xxx
Gain or loss in future contract
xx
Net Receipt or payment
xx
Example:
Home Currency
Exports
Spot
June Future
March Future
Contract Size On
1st May
Spot
June Future
pg. 100 of 186
£ 1st Jan
$400,000 at 1st May
1.40-1.41 $/£
1.45 $/£
1.44 $/£
£ 25,000
1.466-1.467 $/£
1.47 $/£
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Answer:
Exports
$400,000
Buy £ Future
June Contract @ 1.45 $/£
Calculate no of contracts
= 11
Close the Future by
Buy Future @ 1.45
Sell Future @ 1.47
0.02 $/£ x 11 x £25000 = $5500
Gain £ = $5500/ 1.4670$/£ = £ 3749
Sell 400,000 at actual market rate
400000/1.4670$/£
= £272665
Gain
= £3749
Total Receipt
£276414
Types of Future
TYPE: 1
1.
Opening Future rate is given
2.
Closing Future rate is given
3.
Closing Spot rate is given
TYPE: 2
1.
Opening Future rate is given
2.
Closing Future rate is not given
3.
Closing Spot rate is given
BASIS = Current Spot rate – Opening Future Rate
Difference
Remaining Basis =
x remaining months
Closing Future = Closing Spot +/- Remaining Basis
EXAMPLE:
Home Currency € Now 1st June
Import $600,000 1st Nov
Spot rate 1.2020 – 1.2022 $/ €
Sept Future - 1.2420 $/ €
Dec Future - 1.2520 $/ €
•
Contract size € 25,000
•
1st Nov Spot rate - 1.2710 – 1.2720 $/ €
Solution:
Imports $ 600,000
Sell € future
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Dec contract @ 1.2520 $/ €
No of Contract = (600,000 / 1.2520) / 25,000 = 19 Contracts
Basis = 1.2020 -1.2520 = (0.05/7) x 2 = 0.0143
Closing Future = Closing Spot +/- Remaining Basis
= 1.2710 + 0.0143
= 1.2853
Close the future contract
Sell € Future - 1.2520 $/ €
Buy € Future - 1.2853 $/ €
LOSS
0.0333 x 19 x 25,000 = $15,818
LOSS in € = $ 15,818/1.2710 $/ €= 12,445
BUY $ 600,000 in Actual Market
•
600,000 / 1.2710 = € 472,069
LOSS
= €12,445
Total Payment
= € 484,514
Type 3
1)
Opening Future Rate is Given
2)
Closing Future Rate is not Given
3)
Closing Spot Rate is not Given
It is assumed that all parity theories hold true & forward rate will be equal to the Future Spot Rate.
FUTURE CONTRACT
Step 1:
Identify the amount of currency to be hedged Step 2:
Decide whether to buy or sell future
If you want to buy currency buy that currency future
If you want to sell currency sell that currency future
Think according to the contract size currency
Step 3:
Identify the settlement date expiring immediately after the payment is due to be paid or received
Step 4:
Calculate no of contracts
If transaction currency is different from the contract size currency then using future rate convert that transaction
amount currency into the same currency of contract size.
pg. 102 of 186
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Step 5:
BASIS = Current Spot rate – Opening Future Rate
Remaining Basis =
x remaining months
Basis Risk – It’s the risk that current spot will not reduce over the time to exactly match the opening future rate.
Lock in Rate= opening future rate ± Remaining Basis (opposite to normal rule)
Convert the foreign currency into home currency using Lock in rate.
It is a legally binding contract between two parties to buy or sell in future at a pre-determined rate and a pre-specified
date.
Advantages
 The commission charges for futures trading are relatively small as compared to other type of investments.
 Futures contracts are highly leveraged financial instruments which permit achieving greater gains using a limited
amount of invested funds.
 It is possible to open short as well as long positions. Position can be reversed easily.
 Lead to high liquidity.
Disadvantages
 Leverage can make trading in futures contracts highly risky for a particular strategy.
 Futures contract is standardized product and written for fixed amounts and terms.
 Lower commission costs can encourage a trader to take additional trades and lead to over-trading.
It offers only a partial hedge.
 It is subject to basis risk which is associated with imperfect hedging using futures.
Imagine it is 10 July 2017. A UK company has a US$6.65m invoice to pay on 26 August 2014. They are concerned that
exchange rate fluctuations could increase the £ cost and, hence, seek to effectively fix the £ cost using exchange
traded futures. The current spot rate is $/£1.7111.
Research shows that $/£ futures, where the contract size is denominated in £, are available on the CME Europe
exchange at the following prices:
September expiry – 1.7103
December expiry – 1.7086
The contract size is £100,000 and the futures are quoted in US$ per £1.
SETTING UP THE HEDGE
1. US$6.65m payment
2. Settlement Date – September:
3. Sell £ future
4. Contracts 39
($6.65m ÷ 1.7103)/£100,000 ≈ 39.
pg. 103 of 186
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Outcome on 26 August:
On 26 August the following was true:
Spot rate – $/£ 1.6577
September futures price – $/£1.6575 Gain/loss on futures:
As the exchange rate has moved adversely for the UK company a gain should be expected on the futures hedge.
$/£
Sell – on 10 July
1.7103
Buy back – on 26 August
Gain
(1.6575)
0.0528
This gain is in terms of $ per £ hedged. Hence, the total gain is:
0.0528 x 39 contracts x £100,000 = $205,920
Alternatively, the contract specification for the futures states that the tick size is 0.0001$ and that the tick value is
$10. Hence, the total gain could be calculated in the following way:
0.0528/0.0001 = 528 ticks
528 ticks x $10 x 39 contracts = $205,920
This gain is converted at the spot rate to give a £ gain of:
$205,920/1.6577 = £124,220
SUMMARY
All of the above is essential basic knowledge. As the exam is set at a particular point in time you are unlikely to be
given the futures price and spot rate on the future transaction date. Hence, an effective rate would need to be
calculated using basis. Alternatively, the future spot rate can be assumed to equal the forward rate and then an
estimate of the futures price on the transaction date can be calculated using basis. The calculations can then be
completed as above.
INITIAL MARGIN
When a futures hedge is set up the market is concerned that the party opening a position by buying or selling futures
will not be able to cover any losses that may arise. Hence, the market demands that a deposit is placed into a margin
account with the broker being used – this deposit is called the ‘initial
Margin’.
These funds still belong to the party setting up the hedge but are controlled by the broker and can be used if a loss
arises. Indeed, the party setting up the hedge will earn interest on the amount held in their account with their broker.
The broker in turn keeps a margin account with the exchange so that the exchange is holding sufficient deposits for
all the positions held by brokers’ clients.
pg. 104 of 186
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In the scenario above the CME contract specification for the $/£ futures states that an initial margin of $1,375 per
contract is required.( assumption)
Hence, when setting up the hedge on 10 July the company would have to pay an initial margin of $1,375 x 39
contracts = $53,625 into their margin account. At the current spot rate the £ cost of this would be $53,625/1.7111
= £31,339.
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’.
Hence, having set up the hedge on 10 July a gain or loss will be calculated based on the futures
Settlement price of $/£1.7092 on 11 July. This can be calculated in the same way as the total gain was calculated:
$/£
Sell – on 10 July
1.7103
Settlement price – 11 July
(1.7092)
Gain
0.0011
Gain in ticks – 0.00110/0.0001 = 11
Total gain – 11 ticks x $10 x 39 contracts = $4,290
This gain would be credited to the margin account taking the balance on this account to $53,625 + $4,290 = $57,915.
At the end of the next trading day (Monday 14 July), a similar calculation would be performed:
$/£
Settlement price – 11 July
1.7092
Settlement price – 14 July
(1.7080)
Gain
0.0012
Gain in ticks – 0.0012/0.0001 = 12
Total gain – 12 ticks x $10 x 39 contracts = $4,680.
This gain would also be credited to the margin account taking the balance on this account to $57,915 + $4,680 =
$62,595.
Similarly, at the end of the next trading day (15 July), the calculation would be performed again:
$/£
Settlement price – 14 July
1.7080
$/£
Settlement price – 15 July
(1.7135)
Loss
0.0055
Loss in ticks – 0.0055/0.0001 = 55
pg. 105 of 186
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Total loss – 55 ticks x $10 x 39 contracts = $21,450.
This loss would be debited to the margin account, reducing the balance on this account to $62,595 – $21,450 =
$41,145.
This process would continue at the end of each trading day until the company chose to close out their position by
buying back 39 September futures.
MAINTENANCE MARGIN, VARIATION MARGIN AND MARGIN CALLS
Having set up the hedge and paid the initial margin into their margin account with their broker, the company may
be required to pay in extra amounts to maintain a suitably large deposit to protect the market from losses the
company may incur. The balance on the margin account must not fall below what is called the ‘maintenance margin’.
In our scenario, the CME contract specification for the $/£ futures states that a maintenance margin of $1,250 per
contract is required. Given that the company is using 39 contracts, this means that the balance on the margin account
must not fall below 39 x $1,250 = $48,750. As you can see, this does not present a problem on 11 July or 14 July as
gains have been made and the balance on the margin account has risen. However, on 15 July a significant loss is
made and the balance on the margin account has been reduced to $41,340, which is below the required minimum
level of $48,750.
Hence, the company must pay an extra $7,410 ($48,750 – $41,340) into their margin account in order to maintain
the hedge. This would have to be paid for at the spot rate prevailing at the time of payment unless the company has
sufficient $ available to fund it. When these extra funds are demanded it is called a ‘margin call’. The necessary
payment is called a ‘variation margin’.
If the company fails to make this payment, then the company no longer has sufficient deposit to maintain the hedge
and action will be taken to start closing down the hedge. In this scenario, if the company failed to pay the variation
margin the balance on the margin account would remain at $41,340, and given the maintenance margin of $1,250
this is only sufficient to support a hedge of $41,340/$1,250 ≈ 33 contracts. As 39 futures contracts were initially sold,
six contracts would be automatically bought back so that the markets exposure to the losses the company could
make is reduced to just 33 contracts. Equally, the company will now only have a hedge based on 33 contracts and,
given the underlying transaction’s need for 39 contracts, will now be under hedged.
Conversely, a company can draw funds from their margin account so long as the balance on the account remains at,
or above, the maintenance margin level, which, in this case, is the $48,750 calculated.
pg. 106 of 186
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OPTION CONTRACT
•
•
•
•
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.
For this protection, the buyer has to pay a premium.
A currency option may be either a call option or a put option
Currency option contracts limit the maximum loss to the premium paid up-front and provide the buyer with the
opportunity to take advantage of favorable exchange rate movements.
TYPES:
CALL OPTION Right to buy at a specified rate
PUT OPTION Right to sell at a specified rate
OPTION BUYER – OPTION HOLDER LONG POSITION
OPTION SELLER – OPTION WRITER SHORT POISTION American Option – can be exercised at any time before
maturity European Option – can be exercised at maturity only.
OPTION CONTRACT
Step 1:
Identify the amount of currency to be hedged
Step 2:
Decide whether to buy Call or Put
If you want to buy any currency in future call
If you want to sell any currency in future put
Think according to the contract size currency
Step 3:
Identify the settlement date expiring immediately after the payment is due to be paid or received
Step 4:
Identify the exercise price
Solve with two exercise prices at least with highest premium (it is expensive because it is best) and second highest
premium so you can justify in exam which exercise price is best
Step 5:
Calculate no of contracts
Step 6:
Calculate the premium cost = No of contract x Contract size x Premium
If premium answer is not in your home currency then using current spot rate convert it into home currency.
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Step 7:
NOTE: It is assumed that option will be exercised.
Exercise the option
×××
Over or under hedge amount
× ××
Premium
×××
Net Amount
×××
•
•
A currency option is an agreement involving a right, but not an obligation, to buy or sell a certain amount of
currency at a stated rate of exchange (the exercise price) at some time in the future.
Currency options protect against adverse exchange rate movements while allowing the investor to take
advantage of favorable exchange rate movements. They are particularly useful in situations where the cash flow
is not certain to occur (eg when tendering for overseas contracts).
Options are of two types, traded and over the counter, and both have different kinds of benefits.
• 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.
• Traded options are more flexible in that they cover a period of time (American options, whereas OTC options
are fixed date (European options).
• OTC options can be agreed for a longer period than the standard two-year maximum offered by traded options.
This gives greater flexibility and protection from currency movements in the longer term should the transaction
require it.
• 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.
Example
IEM Co is a large listed company based in Ireland and uses UK sterling as its currency. A payment of US$1,060,000
which is due in four months time The current spot rate is US$1·0530 per £1.
The following derivative products are available to IEM Co to manage the exposures of the US$ payment and the
interest on the loan:
Exchange-traded currency futures
Contract size £125,000 price quotation: US$ per £1
3-month expiry
1·0542
6-month expiry
1·0545
Exchange-traded currency options
Contract size £125,000, exercise price quotation: US$ per £1, premium: cents per £1
Call Options
Exercise price
1·05
1·06
pg. 108 of 186
Put Options
3-month expiry
6-month expiry
1·87
2·75
1·34
2·22
3-month expiry
1·41
1·88
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2·16
2·63
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Required:
Advise IEM Co on an appropriate hedging strategy to manage the foreign exchange exposure of the US$ payment
in four months’ time. Show all relevant calculations, including the number of contracts bought or sold in the
exchange-traded derivative markets
Example
Pearson Co, based in a European country that uses the Euro (€). It has just completed a major project in the USA and
is due to receive the final payment of US$30 million in four months. Exchange Rates available to Pearson
Spot
US$1·3585–US$1·3618
Currency Futures (Contract size €125,000, Quotation: US$ per €1)
2-month expiry
1·3633
5-month expiry
1·3698
Currency Options (Contract size €125,000, Exercise price quotation: US$ per €1, cents per Euro)
Calls
Puts
Exercise price 2-month expiry
5-month expiry 2-month expiry
5-month
1·36
2·35
2·80
2·47
2·98
1·38
1·88
2·23
4·23
4·64
Advise Pearson Co on, and recommend, an appropriate hedging strategy for the US$ income it is due to receive
in four months. Include all relevant calculations.
Example OTC option
Lignum Co ( home currency euro ) regularly trades with companies based in Zuhait, a small country in South America
whose currency is the Zupesos (ZP). It recently sold machinery for ZP140 million, which it is about to deliver to a
company based there. It is expecting full payment for the machinery in four months. Although there are no exchange
traded derivative products available for the Zupesos, Medes Bank has offered Lignum Co a choice of over-thecounter derivative products.
Lignum Co can purchase either Euro call or put options from Medes Bank at an exercise price equivalent to the
current spot exchange rate of ZP142 per €1. The option premiums offered are: ZP7 per €1 for the call option or ZP5
per €1 for the put option.
The premium cost is payable in full at the commencement of the option contract. Lignum Co can borrow money at
the base rate plus 150 basis points and invest money at the base rate minus 100 basis points in France.
What is the net receipt in euros ?
INTEREST RATE RISK MANAGEMENT
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.
pg. 109 of 186
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METHODS OF HEDGING INTEREST RATE RISK
• Forward rate Agreement (FRA)
• Interest Rate Future
• Options
• Interest Rate Swaps
• CAP, FLOOR & COLLAR
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.
• The “buyer” of FRA is partly wishing to protect itself against a rise in rates while the “seller” is a party protecting
itself against an interest rate decline.
• FRAs can be used to hedge transactions of any size or maturity and offer an alternative ta interest rate futures
for hedging purpose.
• FRAs do not involve any margin requirements.
Forward Rate Agreement (FRA)
A co, can enter into a FRA with a bank that fixes the rate of interest for borrowing at a certain time in the futures.
If the actual interest rate proves to be
Higher than the rate agreed
lower than the rate agreed
The bank pays the co, the
Difference
Co, pays the bank the
difference
FORWARD RATE AGREEMENT
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.
a)
What is the result of the FRA and the effective loan rate if the 6 month Libor rates has moved to
1.
5%
2.
9%
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Solution
Company will select 3-9 FRA at 6% and it will lock its position at
FRA+spread=6%+0.5%=6.5%
Whether interest rate rises or falls lynn cost is locked at 6.5%
a)
The forward rate agreement required is 3-9.
(i)
At 5% because interest rates have fallen, Lynn plc will pay the bank:
£
FRA payment £10 million x (6% - 5%) x 6/12
(50,000)
Payment on underlying loan (5% +0.5%)x £10 million x 6/12
(275,000)
Net payment on loan
(325,000)
Effective interest rate on loan
(ii)
6.50%
At 9% because interest rates have risen, the bank will pay Lynn plc
£
FRA receipt £10 million x (9% - 6%) x 6/12
150,000
Payment on underlying loan at market rate 9.5% x £10 million x
6/12
(475,000)
Net payment on loan
(325,000)
Effective interest rate on loan
6.50%
INTEREST RATE FUTURE
IMPORTANT TERMS
a)
BUY FUTURE RIGHT TO RECEIVE INTEREST (DEPOSIT) SELL FUTURE RIGHT TO PAY INTEREST (BORROW)
b)
PRICE OF THE CONTRACT IS DETERMINED AS (100 – r)
r = Libor interest rate
If Libor 11%
= (100-11) =89
If Libor 5%
= (100-5) =95
c)
d)
e)
f)
TICK VALUE=CONTRACT SIZE X 0.01 % x 3/12
Settlement date = March, June, September & December
Contract size= standardized normally in £500000, £1000000.
Basis = Current spot rate( current Libor) – opening future rate
Remaining Basis =
x remaining months
Closing future = Closing Spot (closing Libor) ± Remaining Basis (based on Trend)
Basis Risk – It’s the risk that current spot will not reduce over the time to exactly match the opening future
rate.
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Advanced Financial Management - AFM
No. of contracts
= amount of loan /deposit
Contract size
x time period of loan
3
METHODS OF HEDGING INTEREST RATE RISK
STEPS:
• Identify the borrowing or lending amount.
• Decide whether to buy or sell future
If you want to receive interest = buy future=Lender
If you want to pay interest = sell future=Borrower
• Identify the settlement date expiring immediately after the loan is taken
• No of Contracts = amount of loan /deposit x time period of loan
Contract size
3
• Basis = Current spot rate( current Libor) – opening future rate
Difference
Remaining Basis =
x remaining months
Total months
•
Closing future = Closing Spot (closing Libor) ± Remaining Basis (based on Trend)
Close the future contract by comparing opening future with the closing future and calculate gain or loss.
Opening future rate
xx
Closing future rate
xx
Gain/Loss
xx
Gain/Loss =
•
(no of ticks) x tick value x number of contracts
0.01%= tick size
Actual lending or Borrowing from market
Loan amount x (Actual Interest + Spread) x months/12
xxx
Gain/Loss on Future contract
= xx/(xx)
Effective Cost or income
xx
Advantages of futures
• An important advantage of futures as a hedging instrument is the flexibility of closing a position at any time
before delivery date, so that the hedge can be timed to match exactly the underlying borrowing, lending or
investment transaction. In contrast, the settlement date or exercise date for FRAs and European-style interest
rate options is set for an exact date when the transaction is arranged; giving the user no timing flexibility should
the loan or investment date be slightly delayed or brought forward.
• The user of futures also has the opportunity to benefit from current market prices, should these seem
particularly favorable, by closing a position before the loan or investment takes place.
Disadvantages of futures
• Initial margins and variation margins tie up cash in deposits for the sale or purchase transaction until the futures
position is closed.
• There can be a considerable amount of administrative work to manage futures positions efficiently.
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Futures are a short-term hedging method, and most contracts traded on an exchange are for the next one or
two delivery dates. The range of available interest rate contracts is fairly limited and restricted to the major
currencies.
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OPTION ON INTEREST RATE FUTURE
An interest rate option is an option on a notional borrowing or a deposit which guarantees a minimum or a maximum
rate of interest (called strike price) for the option holder. The option is settled in cash. This product is available on
payment of an upfront fee called a premium.
STEPS:
•
Identify the amount of borrowing/lending
•
Decide whether to Buy Call or Put Option
Call option=Right to buy= Buy future=If you want to receive interest=Lender
Put option= Right to Sell= Sell future=If you want to pay interest =Borrower
•
Identify the settlement date expiring immediately after the loan is taken
•
Identify the best Exercise Price
Select lower
Put Option
Exercise Price interest rate + Premium Cost
Select higher
Call Option
Exercise Price interest rate - Premium Cost
•
No of Contracts = amount of loan /deposit x time period of loan
Contract size
3
•
Calculate Premium Cost = ticks x tick value x number of contracts
•
Decide whether to exercise the option or not by comparing strike price with basis adjusted closing future
price.
•
Actual lending or Borrowing from market
Loan amount x (Actual Interest + Spread) x months/12
xxx
Gain/Loss on Future contract
= xx/ (xx)
Premium Cost
xx
Effective Cost or income
xx
METHODS OF HEDGING INTEREST RATE RISK
Interest Rate CAPS
• An interest rate cap is a series of borrower’s option which sets the limit on maximum interest rate.
• A CAP fixed the interest rate to be paid on the borrowing.
JAN
MAR
JUN
CAP @
6%
6%
6%
Interest Rate (Market)
8%
9%
4%*
2% (Gain)
3% (Gain)
4%
*Interest rate will be paid at 4% as Cap will not be exercised
High upfront premium Cost
Interest Rate FLOOR
• An interest rate floor is a series of Lenders options that protects the lender against a decline in the floating
interest rates. A floor guarantees that the interest rate received on a deposit will not be less than a specified
level.
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High upfront premium Cost
Floor @
Interest Rate
JAN
6%
4%
2% (Gain)
MAR
6%
5%
1% (Gain)
JUN
6%
9%
9%
COLLAR
An interest rate collar is a combination of a cap and a floor transacted simultaneously.
BORROWER COLLAR


Buy Cap
Buy Put options /Lock the
maximum interest cost

Sell Floor
Sell Call option /Lock the minimum interest
cost
E.g. put option is bought at 95.00(5% exercise price).
Whenever interest rate rises above this level it will be
exercised and company will pay maximum cost of 5%.
PREMIUM PAID


E.g. Call option is Sold at 96.00(4% exercise price).
Whenever interest rate falls below this level it will be exercised
by lenders and company will have to pay minimum cost of 4%.

PREMIUM RECEIVED
Advantage: Reduced Premium
Cost
Disadvantage: Borrower will have to pay
minimum interest
cost in any case
Lender’s Collar
Sell Cap
Sell Put options /Lock the maximum
interest Income
Buy Floor
Buy Call option /Lock the minimum
interest Income
•
•
E.g. put option is sold at 95.00(5% exercise price).
Whenever interest rate rises above this level it will be exercised by
borrower and Lender will receive maximum Income of 5%.
•
PREMIUM Received
•
•
E.g. Call option is bought at 96.00(4% exercise price). Whenever
interest rate falls below this level it will be exercised by lenders and
will receive minimum income of 4%.
PREMIUM Paid
•
Advantage: Reduced Premium Cost
Disadvantage: Lender has set limit to its
maximum interest income.
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Methods of Hedging Interest Rate Risk
Interest Rate COLLAR
An interest rate collar is a combination of a cap and a floor transacted simultaneously. The buyer of an interest rate
cap, purchases an interest rate cap while selling a floor indexed to the same interest rate, for the same amount and
covering the same period.
BORROWER COLLAR
• Set a collar contract by buying Put option at higher rate and selling call option at lower rate and also calculate
net premium cost
• Compare call or put strike prices with closing future rates to calculate gain and losses
1.
2.
3.
4.
Actual Borrowing from Market
Gain or loss on Collar
Net premium cost
Effective Cost
xx
xx
xx
X
LENDER COLLAR
• Set a collar contract by selling Put option at higher rate and buying call option at lower rate and also calculate
net premium cost
• Compare call or put strike prices with closing future rates to calculate gain and losses
1.
2.
3.
4.
Actual Deposit from Market
Gain or loss on Collar
Net premium cost
Effective Income
xx
xx
xx
X
Interest Rate SWAP
It’s instrument in which two parties agree to exchange interest rate cash flows based on a specified notional amount
from a fixed rate to a floating rate (or vice versa) or from one floating rate to another called plain vanilla swap.
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Borrow from bank
•
(Floating interest rate)
Receive from swap agent
•
(Floating interest rate)
Pay to swap agent
•
(Fixed interest rate)
After swap cost
•
Fixed interest cost
Over the counter Interest Rate SWAP
It’s instrument in which two parties agree to exchange interest rate cash flows based on a specified notional amount
from a fixed rate to a floating rate (or vice versa) or from one floating rate to another
Example
Firm A has a credit rating of BBB and is about to arrange a loan' of UK10 million.. It can obtain this loan at either a
fixed rate of 9.25% or a floating rate of LIBOR +1.5%. Firm A has approached a Swap dealer with the request to
arrange an interest rate swap that could potentially lower its interest cost.
Firm B, another client of the Swap dealer, is about to raise the same amount priced at a floating rate of LIBOR +0.5%.
It shall be provided a price of 7.5% if it wishes to raise this amount on a fixed rate. Firm B has a credit rating of AA
and has made it clear that it would be willing to enter into a swap agreement if two-thirds of the potential swap
benefits are passed on to it.
Illustrate how the Swap dealer can proceed with the arrangement, with the Swap fee being 0.10% from each
party?
Methods of Hedging Interest Rate Risk
Interest Rate SWAP
EXAMPLE:
ARRANGEMENT FOR AN INTEREST RATE SWAP
•
•
Make two possible swaps by combining fixed rate of Part A with floating rate of party B and then combine fixed
rate of party B and floating rate of party A, select the cheaper combination.
Difference between these two combinations will be savings and Firm A and B should borrow now in the chosen
structure.
Firm b should borrow at fixed rate 7.5% and company A should borrow at floating rate of Libor + 1.5%
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Distribute the savings between both parties as per the arrangement provided otherwise divide equally.
Deduct the swap dealer's fee from the savings to compute the Net savings.
Swap Fees
Net Savings
Share of A (1/3)
0.25%
0.10%
0.15%
Share of B (2/3)
0.50%
0.10%
0.40%
Deduct the Net savings from the interest rate that each party would have paid, had it not arranged for a swap and
taken loan directly in its desire exposure. This shall become the final interest cost to be borne by each parry.
Preferred Price
Net Savings
Final Cost
Firm A
9.25%
0.15%
9.10%
Firm B
Libor + 0.5%
0.40%
LIBOR + 0.10%
Given that the interest rate to be paid to the bank and the final cost is now available, the interest rate for the cash
flows to be exchanged between the parties shall be computed. The simplest way to compute these rates is to make
the party that has borrowed a floating rate, receive the same floating rate from the other party. The equation should
than be solved for the fourth variable which is the fixed rate that is to be paid to the other party by the floating rate
payer.
Arrange for Swap
Firm A
Firm B
Borrow Floating
(LABOR + 1.5%)
Borrows Fixed
(7.5%)
Pays to B
(9.00%)
Receives from A
9.00%
Receives from B
LIBOR + 1.5%
Pays to A
(LIBOR+1.5%)
Net Cost
(9.00%)
(LIBOR)
Swap Fee
(0.10%)
(0.10%)
Final Cost
(9.10%)
(LIBOR+ 0.10%)
Advantages of swaps
• Swaps are flexible instruments for managing interest rates for longer- term funding (and investments), as a
separate measure from managing the debt (or investment portfolio) itself.
• As a hedging instrument, swaps give management the opportunity to:
• manage the fixed/floating rate balance of debts or investments, and
• Take action in anticipation of future interest rate changes, without having to repay existing loans, take out new
loans or alter an investment portfolio.
• Fixing the cost of debt for an extended period can improve the credit perception of a company, particularly in
an environment of rising interest rates, as it reduces a company's financial risk exposures.
• There is an active swaps market and positions can be changed over time as required. It is also relatively easy,
when necessary, to close a swaps position by termination, reversal or buyout.
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EXAMPLE
AFC Co has taken a four-year £80,000,000 loan out to part-fund the setting up of four branches. Interest will be
payable on the loan at a fixed annual rate of 2·2% or a floating annual rate based on the yield curve rate plus 0·40%.
The loan’s principal amount will be repayable in full at the end of the fourth year.
An interest rate swap contract with a counterparty, where the counterparty can borrow at an annual floating rate
based on the yield curve rate plus 0·8% or an annual fixed rate of 3·8%. Bank would charge a fee of 20 basis points
each to act as the intermediary of the swap. Both parties will benefit equally from the swap contract.
(b) Demonstrate how AFC Co could benefit from the swap offered by Bank
SWAPTION
An interest rate swaption is an option on a swap where one counter party (buyer) has paid a premium to the other
counter party(seller) for an option to choose whether the swap will actually go into effect on some future Date.
There are two types of swaption.
Payer swaption: a payer swaption gives the buyer the right to be the fixed-rate payer(and floating rate receiver)in a
pre-specified swap at a pre-specified date .the payer swaption is almost like a protective put in that it allows the
holder to pay a set fixed rate, even if rates have increased.
Receiver swaption: a receiver swaption gives the buyer the right to be the fixed rate receiver (and floating rate
payer) at some future date. The receiver swaption is the reverse of the payer swaption.in this case, the holder must
expect rates to fall, and the swap ensures receipt of a higher fixed rate while paying a lower floating rate.
Payer swaption
If market interest rates are high at the expiration of the swaption,the holder of the payer swaption will exercise the
option to pay a lower rate through the swap than the holder of the swaption would pay with a regular swap
purchased in the market. If interest rates are low, the holder would let the swaption expire worthless and only lose
the premium paid.
Receiver swaption
If interest rates are high, the holder of the swaption would let it expire worthless and only lose the premium paid.
If market interest rates are low, the swaption would be exercised in order to receive cash flows based on an interest
rate higher than the market rate.
CURRENCY SWAP
A currency swap is an agreement in which two parties exchange the principal amount of a loan and the interest in
one currency for the principal and interest in another currency.
At the inception of the swap, the equivalent principal amounts are exchanged at the spot rate.
During the length of the swap each party pays the interest on the swapped principal loan amount. At the end of the
swap the principal amounts are swapped back at either the prevailing spot rate, or at a pre-agreed rate such as the
rate of the original exchange of principals. Using the original rate would remove transaction risk on the swap.
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FIXED FOR FIXED SWAP
An American company may be able to borrow in the United States at a rate of 6%, but requires a loan in rand for an
investment in South Africa, where the relevant borrowing rate is 9%. At the same time, a South African company
wishes to finance a project in the United States, where its direct borrowing rate is 11%, compared to a borrowing
rate of 8% in South Africa.
Each party can benefit from the other's interest rate through a fixed-for-fixed currency swap. In this case, the
American company can borrow U.S. dollars for 6%, and then it can lend the funds to the South African company at
6%. The South African company can borrow South African rand at 8%, and then lend the funds to the U.S. Company
for the same amount.
CROSS CURRENCY PLAIN VANILLA SWAP/FIXED FOR FLOATING SWAP
Barrow Co, a company based in the USA, wants to borrow €500m over five years to finance an investment in the
Eurozone.
Today’s spot exchange rate between the Euro and US $ is €1·1200 = $1.
Barrow Co’s bank can arrange a currency swap with Greening Co. The swap would be for the principal amount of
€500m, with a swap of principal immediately and in five years’ time, with both these exchanges being at today’s spot
rate.
Barrow Co’s bank would charge an annual fee of 0.4% in € for arranging the swap.
The benefit of the swap will be split equally between the two parties. The relevant borrowing rates for each party
are as follows:
Barrow Co
Greening Co
USA
3.6%
4.5%
Eurozone
EURIBOR + 1.5%
EURIBOR + 0.8%
Barrow Co
Greening Co
Swap Combinations
USA
3.6%
4.5%
EURIBOR+6%
Eurozone
EURIBOR + 1.5%
EURIBOR + 0.8%
EURIBOR+4.4%
Gain on swap
1.6%
Bank fee
(0.2%)
(0.2%)
(0.4%)
Final gain
0.6%
0.6%
1.2%
Barrow Co
Barrow Co borrows
Greening Co borrows
Greening Co
3.6%
EURIBOR + 0.8%
Swap
Greening Co receives
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(EURIBOR)
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Barrow Co pays
EURIBOR
Barrow Co receives
(2.9%)
Greening Co pays
2.9%
Net result
EURIBOR + 0.7%
3.7%
Bank fee
0.2%
0.2%
Overall result
EURIBOR + 0.9%
3.9%
Why Risk Management?
Risk, in this context, refers to the volatility of returns (both positive and negative) that can be quantified through
statistical measures such as probabilities, standard deviations and correlations between different returns.
Its management is about decisions made to change the volatility of returns a corporation is exposed to, for example
changing a company’s exposure to floating interest rates by swapping them to fixed rates for a fee.
The volatility of returns of a project should be managed if it results in increasing the value to a corporation. Given
that the market value of a corporation is the net present value (NPV) of its future cash flows discounted by the return
required by its investors, then higher market value can either be generated by increasing the future cash flows or by
reducing investors’ required rate of return (or both). A risk management strategy that increases the NPV at a lower
comparative cost would benefit the corporation.
The return required by investors is the sum of the risk free rate and a premium for the risk they undertake. If investors
hold well-diversified portfolios of investments then they are only exposed to systematic risk as their exposure to
firm-specific risk has been diversified away. Therefore, the risk premium of their required return is based on the
capital asset pricing model (CAPM). Research suggests companies with diverse equity holdings do not increase value
by diversifying company specific risk, as their equity holders have already achieved this level of risk diversification.
Moreover, risk management activity designed to transfer systematic risk would not provide additional benefits to a
corporation because, in perfect markets, the benefits achieved from risk management activity would at least equal
the costs of undertaking such activity.
Such an argument would not apply to smaller companies which have concentrated, non-diversified equity holdings.
In this case the equity holders, because they are exposed to both specific and systematic risk, would benefit from
risk diversification by the company. Therefore smaller companies can and should undertake risk management.
However, empirical research studies have found that risk management is undertaken mostly by larger companies
with diverse equity holdings and not by the smaller companies. The accepted reason for this is that the costs related
to risk management are large and mostly fixed
In addition to the ability of larger companies to undertake risk management, market imperfections may provide
the motivation for them to do so.
The following discussion considers the circumstances which may result in providing such opportunities.
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Taxation
Risk management may help in reducing the amount of tax that a corporation pays by reducing the volatility of the
corporation’s earnings. Where a corporation faces taxation schedules that are progressive (that is the corporation
pays proportionally higher amounts of tax as its profits increase), by reducing the variability of that corporation’s
earnings and thereby staying in the same low tax bracket will reduce the tax payable.
Insolvency and financial distress
A corporation may find itself in a situation of being insolvent when it cannot meet its financial obligations as they fall
due. Financial distress is a situation that is less severe than insolvency in that a corporation can operate on a day-today basis, but it finds that these operations are difficult to conduct because the parties dealing with it are concerned
that it may become insolvent in the future. When facing financial distress a corporation will incur additional costs,
both direct and indirect, due to the situation it is facing.
Academics exploring this area postulate that because stakeholders are subject to the corporation’s full risk, as
opposed to only systematic risk, which is faced by the corporation’s equity holders, the stakeholders would demand
greater compensation for their participation. Where an organisation actively manages its risk and prevents (or
reduces the possibility of) situations of financial distress, it will find it easier to contract with its stakeholders and at
a lower cost. Hence, the more volatile the cash flows of a corporation, the more likely the need to manage its risk in
order to reduce the costs related to financial distress.
External funding and agency costs
Another consequence of financial distress is the impact this may have on the corporation’s ability to undertake
profitable future investment. Financial distress may make the cost of external debt and equity funding so expensive
that a corporation and its management may be forced reject profitable projects. Academics refer to this as the under
investment problem.
Equity holders in effect hold a call option on a corporation’s assets and debt holders can be considered to have
written the option. In cases of low financial distress the company may be considered to be similar to an at-themoney option for its equity holders, and, therefore, they would be more willing to undertake risky projects as they
would benefit from any increase in profitability, but the impact of any loss is limited. In the case of substantial
financial distress, the option could be considered to be well out-of-money. In this situation there is little (or no)
benefit to equity holders of undertaking new projects, as the benefits of these will pass to the debt holders initially.
However, debt holders would be reluctant to lend to a severely distressed company in any case.
Therefore, when raising debt capital, a corporation that is subject to low levels of financial distress would face higher
agency costs, with lenders imposing higher borrowing costs and more restrictive covenants. Whereas debt holders
get a fixed return on their investment, any additional benefit due to higher profits would go to the equity holders.
This would make the debt holders reluctant to allow the corporation to undertake risky projects or to lend more
finance to the corporation because they would not gain any benefit from the risky projects.
A corporation that faces high levels of financial distress would find it difficult to raise equity capital in order to
undertake new investments. If corporations try to raise equity finance for relatively less risky projects then the profits
earned from such projects would initially go to the debt holders and the equity holders will gain only residual profits.
Therefore equity holders would put pressure on the corporation and its management to reject good, low risk
projects, which may have been acceptable to the bondholders. Therefore, risk management in reducing financial
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distress by reducing the volatility of the corporation’s cash inflows may help the management to obtain an optimal
mix of debt and equity, and to undertake profitable projects.
Capital structure and information asymmetry
Risk management can help a corporation obtain an optimal capital structure of debt and equity to maximise its value.
Since risk management stabilises the variability of cash inflows, this would enable a corporation to take more debt
finance in its capital structure. Stable cash flows indicate less risk and therefore debt holders would become more
willing to lend to the corporation. Since debt is cheaper to finance than equity because of lower required rates of
return and the tax shield, taking on more debt should increase the value of the corporation. Risk management can
help achieve this.
Academics have observed that managers would prefer to use internally generated funds rather than going to the
external markets for funds because it is cheaper and less intrusive on the corporation. They suggest that borrowing
money from the external markets, whether equity or debt, would involve parties who do not have the complete
information about the corporation. This information asymmetry would make the external sources of funds more
expensive. If risk management stabilises the cash flows that the corporation receives from year to year, then this
would enable managers to plan when the necessary internal funds will become available for future investments with
greater accuracy. They will then be able to align their investment policies with the availability of funding.
Manager behaviour towards risk management
In his seminal paper, Rene Stulz suggests that managers, whose performance reward structure includes large equity
stakes in a corporation, are more likely to reduce the corporation’s risk, as opposed to managers whose performance
reward structure is based primarily on equity options. Managers who hold concentrated equity stakes in a
corporation face increased levels of risk when compared to other equity holders. As discussed previously, investors
hold well-diversified portfolios and face exposure to systematic risk only. But managers with concentrated equity
stakes would face both systematic and unsystematic risk. Therefore, they have a greater propensity to reduce the
unsystematic risk.
However, if investors do not reward corporations that are reducing unsystematic risk, because they have diversified
this risk away themselves. And if a corporation’s managers use the corporation’s resources to reduce unsystematic
risk, thereby reducing the corporation’s value. Then it is worth exploring under what circumstances would equity
investors allow managers to act to reduce unsystematic risk and whether such actions could actually result in the
value of the corporation increasing.
Stulz argues that encouraging managers to hold concentrated equity positions but allowing them to reduce
unsystematic risk at the same time, may enable them to act in the best interests of the corporation and the result
may be an increase in the corporate value. He explains that managers, who do not have to worry about risks that
are not under their control (because they have hedged them away), would be able to focus their time, expertise and
experience on the strategies and operations that they can control. This focus may result in the increase in the value
of the corporation, although the impact of this increase in value is not easily measurable or directly attributable to
risk management activity.
As an aside, one could pose the question, why don’t managers, who are rewarded by equity, diversify the risk of
concentrated equity investments themselves? They could sell equity in their own corporation and replace it by
buying equity in other corporations. In this way they do not have to hold concentrated equity positions and then
would be like the normal equity holders facing only systematic risk. A research study on wealth management, which
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looked at concentrated equity positions and risk management, found that senior managers are reluctant to reduce
their concentrated equity positions because any attempt to sell the equity would send negative signals to the
markets, and cause their corporation’s value to decrease unnecessarily.
Contrary to the behaviour of managers who hold concentrated equity stakes, managers who own equity options,
which will be converted into equity at a future date, will actively seek to increase the risk of a corporation rather
than reduce it. Managers who hold equity options are interested in maximising the future price of the equity.
Therefore in order to maximise future profits and the price of the equity, they will be more inclined to undertake
risky projects (and less inclined to manage risk). Equity options, as a form of reward, have been often criticised
because they do not necessarily make managers behave in the best interests of the corporation or its equity
investors, but encourage them to act in an overly risky manner.
OPTION PRICING
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
VALUE OF an OPTION= Intrinsic value + time Value
Call option Value= (Market value – exercise price) + time Value
Put option Value = (Exercise price- market value) + time Value
DETERMINANTS OF CALL OPTION PRICES
Increase In
Value of a Call
Value of a Put
Pa= price of underlying
Share Price
Increase
Decrease
Pe = Exercise price
Exercise Price
Decrease
Increase
Time= t ( in years)
Time to Expiry
Increase
increase
S=standard deviation ( in decimal
)
Volatility
Increase
increase
Risk free rate = Rf ( in decimal
Interest Rate
Increase
Decrease
VALUE AT RISK
• Value at risk (VAR) is the minimum amount by which the value of an investment portfolio will fall over a given
period of time at a given level of probability.
• Alternatively, it is defined as the maximum amount that it may lose at a given level of confidence Level.
Example:
• Assume VAR is $100,000 at 5% probability, or that it is $100,000 at 95% confidence level.
• The first definition implies that there is a 5% chance that the loss will exceed $100,000, or that we are 95% sure
that it will not exceed $100,000.
• VAR can be defined at any level of probability or confidence, but the most common probability levels are 1, 5
and 10%.
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In general the VAR will be given by:
VAR = k x σ x fund value
VAR = k x σ*
Where - k is determined by the probability level, σ is the standard deviation and
σ* is the standard deviation in dollar amount( there is no need to multiply with fund value)
VAR is calculated for some specific time perio , if it is calculated for different period than a year then we have to
convert annual standard deviation into that period standard deviation.
. σ annual= σ quarter x √4
. σ annual= σ six monthly x √2
. σ 3 year= σ annual x √3
Having defined the VAR, we can define the project value at risk (PVAR),
PVAR - As the loss that may occur at a given level of probability over the life of the project.
Example
The annual cash flows from a project are expected to follow the normal distribution with a mean of $50,000 and
standard deviation of $10,000. The project has a 10 year life. What is the PVAR if probability is 5%? The PVAR for a
year is:
PVAR = 1.645 x $10,000 = $16,450
The PVAR that takes into account the entire project life is:
PVAR = 1.645 x $10,000 x √10 = $52,019; this is the maximum amount by which the value of the project will fall at a
confidence level of 95%.
So far we have used the normal distribution to calculate the VAR. The assumption that project cash flows or values
follow the normal distribution may not be plausible.
Example
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.
Normal distribution tables can also be used to calculate the following probabilities:
 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.
 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.
ADVANTAGES
• It’s easy to understand
• Comparing VAR of different assets and portfolios
• The VAR provides an indication of the potential riskiness of a project
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THE BLACK SCHOLES MODEL
THE Black-Scholes model values options before the expiry date and takes account of all the determinants that effect
the value of option
Value of a Call Option = Pa N (d1) – Pe N (d2) e ^-rt
2
Where d1=
d2 = d1 – S √T
Pa = Current Price of a underlying asset
Pe = Exercise Price R= Risk Free Rate
t = time until expiry of options in years
S = Volatility of the share price
Example:
The current share price of TYZ Co
The exercise price
The risk free interest rate
Standard deviation of return on the shares
Time to Expiry
= $120
= $100
= 12%
= 40%
= 3 months
Calculate the value of call option
Solution:
d1 = In (120/100) + (0.12 + 0.5 x 0.4^2)0.25 / 0.4 √0.25 = 1.16 d2 = 1.16 - 0.4 √0.25 = 0.96 N (d1) = 0.5 + 0.3770 =
0.8770
N (d2) = 0.5 + 0.3315 = 0.8315
Value of Call Option = 120 x 0.8770 – 100 x 0.8315 x 2.71828 ^ (- 0.12 x 0.25)
THE Black-Scholes model values options before the expiry date and takes account of all the determinants that effect
the value of option
Value of a PUT option = c – Pa + Pe x e^-rt
Step 1 : Value the corresponding call option using Black Scholes Model Step 2 : Calculate the value of a put option
using the above formula
Assumptions and Limitations
• No Transaction Costs or taxes
• Options are European calls
• Investor can borrow at the risk-free rate
• Risk free rate and share price volatility is constant over the period
• No dividends before expiration
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AMERICAN CALL OPTIONS
If no dividends are payable before the option expiry date, the American call option will be worth the same as
European Call Option
Calculate the ‘Dividend adjusted share price ‘
Deduct the present value of dividends to be paid from current Share Price
Pa, becomes Pa – PV (dividends) in Black Scholes Model.
Pa adjusted = Pa – Dividend × e-(rt)
DISADVANTAGES
• Value At Risk can be misleading: false sense of security
• VAR does not measure worst case loss
• The resulting VAR is only as good as the inputs and assumptions
• Different Value At Risk methods lead to different results
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.
Delta = change in call option price ÷ change in the price of the shares
Nd1 = 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.
For long call options (and/or short put options), delta has a value between 0 and 1.
For long put options (and/or short call options), delta has a value between 0 and -1.
DELTA HEDGING CALL OPTION
Delta hedging allows us to determine the number of shares that we must buy to create the equivalent portfolio to
an option and hedge it.
Investing at risk free rate = buying share portfolio + selling call options •
share price movement.
Delta hedge is only valid for small
Delta value is likely to change during the period of hedge so continuous rebalancing is required that is why it is an
expensive hedge
Example
What is the number of call options that you would have to sell in order to hedge a holding of 200,000 shares, if the
delta value (N(d1)) of options is 0.8?
Assume that option contracts are for the purchase or sale of units of 1,000 shares.
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Answer
The delta hedge can be calculated by the following formula.
Number of Contracts
= Number of Shares
Delta of Option x size of contract
= 200000
0.8 x 1000
= 250
If in this example the price of shares increased by $1, the value of the call options would increase by $800 per
contract. Since however we were selling these contracts the increase in the value of our holding of shares, 200,000
x $1, would be matched by the decrease in our holding of option contracts 250 x $800.
DELTA HEDGING PUT OPTION
Investing at risk free rate = buying share portfolio + Buy Put options
Put option delta= N(-d1)
If D1 is positive then N(-d1) = 0.5 - Table value
If D1 is negative then N(-d1) = 0.5 + Table value
OTHER POINTS ABOUT DELTA VALUES
The table below shows approximate values of delta for different types of options and the position of the exercise
In the Money
At the Money
Out of the Money
Call
Approaching 1
Approx. 0.5
Approaching 0
Put
Approaching -1
Approx. -0.5
Approaching 0
OTHER POINTS ABOUT DELTA VALUES
The factors influencing delta are:
The exercise price
The time to expiration
The risk-free rate of return
The volatility in the returns on the share
GAMMA
Gamma = Change in Delta Value/ Change in price of the underlying share
 It measures the extent to which delta changes when the share price changes.
 The higher the gamma value, the more difficult it is for the option writer to maintain a delta hedge because the
delta value increases more for a given change in share price.
 Gamma values will be highest for a share which is close to expiry and is 'at the money‘
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THETA
• Theta is the change in an option's price (specifically its time premium) over time
• An option's price has two components, its intrinsic value and its time premium. When it expires, an option has
no time premium.
• Thus the time premium of an option diminishes over time towards zero and theta measures how much value is
lost over time, and therefore how much the option holder will lose through retaining their options.
• Theta is usually expressed as an amount lost per day.
• At the money options have the greatest time premium and thus the greatest theta.
RHO:
• Rho measures the sensitivity of option prices to interest rate changes
• An option's rho is the amount of change in value for a 1% change in the risk-free interest rate.
• Rho is positive for calls and negative for puts
• Interest rate is the least significant influence on change in price and interest rate tends to change slowly and in
small times.
• Long-term options have larger RHO than short-term options. The more time there is until expiration, the greater
the effect of a change in interest rates.
VEGA:
• Vega measures the sensitivity of an option's price to a change in its implied volatility
• Vega is the change in value of an option that results from a 1% point change in its volatility. If a dollar option
has a vega of 0.4, its price will increase by 40 cents for a 1% point increase in its volatility.
• Vega is the same for both calls and puts.
• Long-term options have larger vega than short-term options. The longer the time period until the option expires,
the more uncertainty there is about the expiry price.
SUMMARY OF GREEKS
Change in
With
Delta
Option Value
Underlying Asset Value
Gamma
Delta
Underlying Asset Value
Theta
Time Premium
Time
Rho
Option Value
Interest rates
Trenching/ Securitization
A tranche is a slice of a security (typically a bond or other credit-linked security) which is funded by investors who
assume different risk levels within the liability structure of that security.
SECURITIZATION THROUGH COLLATERALIZED DEBT OBLIGATIONS (CDOS)
One common use of securitization occurs when banks lend through mortgages, credit cards, car loans or other forms
of credit, they invariably move to ‘lay off’ their risk by a process of securitization. Such loans are an asset on the
statement of financial position, representing cash flow to the bank in future years through interest payments and
eventual repayment of the principal sum involved. By securitizing the loans, the bank removes the risk attached to
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its future cash receipts and converts the loan back into cash, which it can lend again, and so on, in an expanding
cycle of credit formation.
Securitization is achieved by transferring the lending to specifically created companies called ‘special purpose
vehicles’ (SPVs). In the case of conventional mortgages, the SPV effectively purchases a bank’s mortgage book for
cash, which is raised through the issue of bonds backed by the income stream flowing from the mortgage holder. In
the case of sub-prime mortgages, the high levels of risk called for a different type of securitization, achieved by the
creation of derivative-style instruments known as ‘collateralized debt obligations’ or CDOs.
Securitization may be also appropriate for an organization which wants to enhance its credit rating by using low-risk
cash flows, such as rental income from commercial property, which will be diverted into a "ring-fenced" SPV.
SECURITIZATION THROUGH COLLATERALIZED DEBT OBLIGATIONS (CDOS)
(Continued)
CDOs are a way of repackaging the risk of a large number of risky assets such as sub-prime mortgages. Unlike a bond
issue, where the risk is spread thinly between all the bond holders, CDOs concentrate the risk into investment layers
or ‘tranches’, so that some investors take proportionately more of the risk for a bigger return and others take little
or no risk for a much lower return.
Each tranche of CDOs is securitized and ‘priced’ on issue to give the appropriate yield to the investors. The
investment grade tranche of CDOs will be the most highly priced, giving a low yield but with low risk attached. At
the other end, the ‘equity’ tranche carries the bulk of the risk – it will be very lowly priced but with a high potential,
but very risky, yield. There is more detail on this in the next section.
CDOs are, therefore, a mechanism whereby losses are transferred to investors with the highest appetite for risk
(such as hedge funds), leaving the bulk of CDOs’ investors (mainly other banks) with a low risk source of cash flow.'
THE STRUCTURE OF CDOS
An example of a possible structure for a CDO is as follows. For a pool of mortgages taken over by the SPV, three
tranches of CDOs are created:
Tranche 1 (highest risk) known as the ‘equity’ tranche and normally comprising about 10% of the value of the
mortgages in the pool. Throughout the CDOs’ life, the equity tranche will absorb any losses brought about by default
on the part of mortgage holders, up to the point that the principal underpinning the tranche is exhausted. At this
point the investment is worthless.
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Tranche 2 (intermediate risk or ‘mezzanine’ tranche) consists of around 10% of the principal and will absorb any
losses not absorbed by the equity tranche until the point at which its principal is also exhausted.
Tranche 3 (AAA or ‘senior’ tranche) consists of the balance of the pool value and will absorb any residual losses.
THE STRUCTURE OF CDOS (Continued)
When cash flows are received from borrowers in the form of interest payments and loan repayments, these
payments are paid to tranche 3 first until their obligation is fulfilled, then tranche 2, and anything left over is paid to
the equity tranche. Any defaults hit tranche 1 first, then tranche 2 and so on. The repayments represent a ‘waterfall’
of cash with the investors holding the tranches like buckets. The senior tranches get filled first, the mezzanine holders
get filled next and anything left falls into the equity pools at the bottom.
Example
A bank has made a number of mortgage loans to customers with a current total value of $350 million. The mortgages
have an average term to maturity of ten years. The net income from the loans is 7% per year.
The bank will use 85% of the mortgage pool as collateral for a securitization with the following structure:
75% of the collateral value to support a tranche of A-rated loan notes offering investors 6% per year.
15% of the collateral value to support a tranche of B-rated loan notes offering investors 11% per year.
10% of the collateral value to support a tranche of subordinated certified which are unrated.
EXAMPLE (Continued)
The estimated cash flows for this arrangement would be as follows:
Cash inflows
In flows from mortgages $350m x 7% = $24.5m
Cash outflows
A-rated loan notes
$350m x 85% x 75% x 6% = $13.4m
B-rated loan notes
$350m x 85% x 15% x 11% = $4.9m
Total outflows = $13.4m + $4.9m = $18.3m
The difference between the inflows and the outflows is returned to the high-risk unrated certificates.
Difference in cash flows = $24.5m – $18.3m = $6.2m
The subordinated certificates have a value of $350m x 85% x 10% = $29.75m.
The return on this high-risk investment is $6.2m/$29.75m = 20.8%
Benefits of Tranching
• Trenching is a good way of dividing risk. Anyone who invests in risky loans is taking a chance, but trenching lets
you divide the chances up, so that people who want safety can buy the top (senior) tranches, get less of a profit,
but know that they're not going to lose out unless things go seriously wrong.
• People who are willing to take their chances in the lower (junior) tranches know that they're taking a significant
risk, but they can potentially make a lot more money.
• Securitization can offer issuers higher credit ratings and lower borrowing costs
• One of the major allures of securitization for issuers is off-balance-sheet treatment, meaning that the assets
included in the reference portfolio are wiped off the originator's financial statements.
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Risks of Tranching
• Tranches are very complex; most investors do not really understand the risks associated with each tranche.
• Tranches may not be divided properly and the bundling process may be misleading. Investors are obviously
anxious to obtain the most senior tranche – the more junior tranches are more difficult to 'get rid of'. Default
risk will be there, success of tranching depends upon the quality of underlying loan portfolio.
• It is assumed here that default in asset side is uncorrelated with liability side.
• Timing risk may be there of matching of interest receipts on receivables and payments on Asset backed
securities.
Dark Pool trading
• A dark pool network allows shares to be traded anonymously, away from public scrutiny.
• No information on the trade order is revealed prior to it taking place. The price and size of the order are only
revealed once the trade has taken place.
MAIN REASONS:
• It prevent the risk of other traders moving the share price up or down;
• It result in reduced costs because trades normally take place at the mid-price between the bid and offer; and
because broker-dealers try and use their own private pools, and thereby saving exchange fees.
• Dark pools are an 'alternative' trading system that allows participants to trade without displaying quotes
publically. The transactions are only made public after the trades have been completed.
PROBLEMS WITH DARK POOL TRADING SYSTEM:
 Prices at which these trades are executed remain unknown until after the event.
 Lack of information on significant trades makes the regulated exchanges less efficient
 Resulting in reduced transparency as fewer trades are publicly exposed
 Reduce liquidity in the regulated exchanges and hinder efficient price-setting.
Dark Pool Trading defeats the purpose of fair and regulated markets with large numbers of participants and
threatens the healthy and transparent development of these markets.
CREDIT DEFAULT SWAPS
A credit default swap is a specific type of counterparty agreement which allows the transfer of third-party credit risk
from one party to the other.
• It is similar to insurance because – in the event of a fire, the buyer of the policy will receive whatever the
damaged or destroyed goods are worth in monetary terms.
• It provides the buyer of the contract, who often owns the underlying credit, with protection against default, a
credit rating downgrade, or another negative credit event.
• The buyer of CDS agrees to pay a fixed spread to the seller of the CDS. The more likely the risk of default, the
larger the spread.
For example,
If the CDS spread is 200 basis points (or 2.0%) then a party buying $10 million worth of CDS from a bank must pay
the bank $200,000 per year. These payments continue until either the CDS contract expires or party defaults.
• CDSs are unregulated. This means that contracts can be traded – or swapped – from investor to investor without
anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults.
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USES OF CREDIT DEFAULT SWAPS:
Speculative investors bought and sold the instruments without having any direct relationship with the underlying
investment. Speculators to "place their bets" about the credit quality of a particular reference entity:
EXAMPLE:
A hedge fund believes that a company (ABC Co) will shortly default on its debt of $20 million. The hedge fund may
therefore buy $20 million worth of CDS protection for, say, 2 years, with (ABC Co) as the reference entity, at a spread
of 1000 basis points (10%) per annum.
If (ABC Co) does default after, say, one year, then the hedge fund will have paid $2000,000 to the bank but will then
receive $20 million (assuming zero recovery rate). The bank will incur a $1.8 million loss unless it has managed to
offset the position before the default.
If (ABC Co) does not default, then the CDS contract will run for two years and the hedge fund will have paid out $4
million to the bank with no return. The bank makes a profit of $4 million; the hedge fund makes a loss of the same
amount.



What would happen if the hedge fund decided to liquidate its position after a certain period of time in an
attempt to lock in its gains or losses? Say after one year the market considers ABC Co to be at greater risk of
default, and the spread widens from 1000 basis points to 2,500.
The hedge fund may decide to sell $20 million protection to the bank for one year at this higher rate. Over
the two years, the hedge fund will pay the bank $4 million (2 x 10% x $20 million) but will receive $5 million
(1 x 25% x $20 million) – a net profit of $1million (as long as (ABC Co) does not default in the second year)
A CDS contract can be used as a hedge or insurance policy against the default of a bond or loan. An individual
or company that is exposed to a lot of credit risk can shift some of that risk by buying protection in a CDS
contract.
Example
A pension fund owns $20 million of a 5-year bond issued by XYZ Co. In order to manage the risk of losses in the event
of a default by XYZ Co, CDS of a notional amount of $20 million were bought by the pension funds to hedge the risk.
Assume the CDS trades at 500 basis points (5%) which means that the pension fund will pay the bank an annual
premium of $1 million.
If XYZ Co does not default on the bond, the pension fund will pay a total premium of 5 x $1000,000 = $5 million to
the bank and will receive the $20 million back at the end of the 5 years. Although it has lost $5 million, the pension
fund has hedged away the default risk.
If XYZ Co defaults on the bond after, say, 2 years, the pension fund will stop paying the premiums and the bank
will refund the $20 million to compensate for the loss. The pension fund's loss is limited to the premiums it had
paid to the bank (2 x $1000,000 = $2000,000) – if it had not hedged the risk, it would have lost the full $20 million.
THE ROLE OF CDS IN THE GLOBAL ECONOMIC CRISIS
 Once an obscure financial instrument for banks and bondholders, CDSs are now at the heart of the recent credit
crisis.
 American International Group (AIG) – the world's largest insurer – could issue CDSs without putting up any real
collateral as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps;
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there was no limit. Thanks to fair value accounting, AIG could book the profit from, say, a five-year credit default
swap as soon as the contract was sold, based on the expected default rate. In many cases, the profits it booked
never materialized.
On 15 September 2007 the bubble burst when all the major credit-rating agencies downgraded AIG. At issue
were the soaring losses in its CDSs. The first big write-off came in the fourth quarter of 2007, when AIG reported
an $11 billion charge. It was able to raise capital once, to repair the damage. But the losses kept growing. The
moment the downgrade came, AIG was forced to come up with tens of billions of additional collateral
immediately. This was on top of the billions it owed to its trading partners. It didn't have the money. The world's
largest insurance company was bankrupt.
As soon as AIG went bankrupt, all those institutions which had hedged debt positions using AIG CDSs had to
mark down the value of their assets, which at once reduced their ability to lend. The investment banks had no
ability to borrow, as the collapse of the CDS market meant that no one was willing to insure their debt. The
credit crunch had started in earnest
Real options
Real options’ valuation methodology adds to the conventional net present value (NPV) estimations by taking account
of real life flexibility and choice.
NET PRESENT VALUE (NPV) AND REAL OPTIONS
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.
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.
ESTIMATING THE VALUE OF REAL OPTIONS
Although there are numerous types of real options, in the AFM paper, candidates are only expected to explain and
compute an estimate of the value attributable to three types of real options:
• The option to delay a decision to a future date (which is a type of call option.
• The option to abandon a project once it has commenced if circumstances no longer justify the continuation of
the project (which is a type of put option), and
• The option to exploit follow-on opportunities which may arise from taking on an initial project (which is a type
of call option).
It can be assumed that real options are European-style options, which can be exercised at a particular time in the
future and their value will be estimated using the Black-Scholes Option Pricing (BSOP) model and the put-call parity
to estimate the option values. However, assuming that the option is a Europeanstyle option and using the BSOP
model may not provide the best estimate of the option’s value (see the section on limitations and assumptions
below).
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Five variables are used in calculating the value of real options using the BSOP model as follows:
1. The underlying asset value (Pa), which is the present value of future cash flows arising from the project after
option expiry.
2. The exercise price (Pe), which is the amount paid when the call option is exercised (future expenditure) or
amount received if the put option is exercised (sale proceeds).
3. The risk-free (r), which is normally given or taken from the return offered by a short-dated government bill.
Although this is normally the discrete annualized rate and the BSOP model uses the continuously compounded
rate, for AFM purposes the continuous and discrete rates can be assumed to be the same when estimating the
value of real options.
4. The volatility (s), which is the risk attached to the project or underlying asset, measured by the standard
deviation.
5. The time (t), which is the time, in years, that is left before the opportunity to exercise ends.
The following three examples demonstrate how the BSOP model can be used to estimate the value of each of the
three types of options. Example 1: Delaying the decision to undertake a project
A company is considering bidding for the exclusive rights to undertake a project, which will initially cost $35m.
The company has forecast the following end of year cash flows for the four-year project.
Year
1
2
3
4
Cash flows ($m)
20
15
10
5
The relevant cost of capital for this project is 11% and the risk free rate is 4.5%. The likely volatility (standard
deviation) of the cash flows is estimated to be 50%.
Solution:
NPV without any option to delay the decision
Year
Today
1
2
3
4
Cash flows ($)
-35m
20m
15m
10m
5m
PV (11%) ($)
-35m
18.0m
12.2m
7.3m
3.3m
NPV = $5.8m
Example 1: Delaying the decision to undertake a project - Continued
Supposing the company does not have to make the decision right now but can wait for two years before it needs to
make the decision.
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NPV with the option to delay the decision for two years
Year
3
4
5
6
Cash flows ($)
20m
15m
10m
5m
PV (11%) ($)
14.6m
9.9m
5.9m
2.7m
Variables to be used in the BSOP model:
Asset value (Pa) = $14.6m + $9.9m + $5.9m + $2.7m = $33.1m
Exercise price (Pe) = $35m
Exercise date (t) = Two years
Risk free rate (r) = 4.5%
Volatility (s) = 50%
Using the BSOP model
d1
0.401899
d2
-0.30521
N(d1)
0.656121
N(d2)
0.380103
Call value
$9.6m
Based on the facts that the company can delay its decision by two years and a high volatility, it can bid as much as
$9.6m instead of $5.8m for the exclusive rights to undertake the project. The increase in value reflects the time
before the decision has to be made and the volatility of the cash flows.
Example 2: Exploiting a follow-on project
A company is considering a project with a small positive NPV of $3m but there is a possibility of further expansion
using the technologies developed for the initial project. The expansion would involve undertaking a second project
in four years’ time. Currently, the present values of the cash flows of the second project are estimated to be $90m
and its estimated cost in four years is expected to be $140m. The standard deviation of the project’s cash flows is
likely to be 40% and the risk free rate of return is currently 5%.
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Solution:
The variables to be used in the BSOP model for the second (follow-on) project are as follows: Asset Value (Pa) =
$90m
Exercise price (Pe) = $140m
Exercise date (t) = Four years
Risk free rate (r) = 5%
Volatility (s) = 40%
Using the BSOP model
d1
0.097709
d2
-0.70229
N(d1)
0.538918
N(d2)
0.241249
Call value
$20.85m
The overall value to the company is $23.85m, when both the projects are considered together. At present the cost
of $140m seems substantial compared to the present value of the cash flows arising from the second project.
Conventional NPV would probably return a negative NPV for the second project and therefore the company would
most likely not undertake the first project either. However, there are four years to go before a decision on whether
or not to undertake the second project needs to be made. A lot could happen to the cash flows given the high
volatility rate, in that time. The company can use the value of $23.85m to decide whether or not to invest in the first
project or whether it should invest its funds in other activities. It could even consider the possibility that it may be
able to sell the combined rights to both projects for $23.85m.
Example 3: The option to abandon a project
Duck Co is considering a five-year project with an initial cost of $37,500,000 and has estimated the present values of
the project’s cash flows as follows:
Year
Present
($ 000s)
1
2
3
4
5
1,496.9
4,938.8
9,946.5
7,064.2
13,602.9
values
Swan Co has approached Duck Co and offered to buy the entire project for $28m at the start of year three. The risk
free rate of return is 4%. Duck Co’s finance director is of the opinion that there are many uncertainties surrounding
the project and has assessed that the cash flows can vary by a standard deviation of as much as 35% because of
these uncertainties.
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Solution:
Swan Co’s offer can be considered to be a real option for Duck Co. Since it is an offer to sell the project as an
abandonment option, a put option value is calculated based on the finance director’s assessment of the standard
deviation and using the Black-Scholes option pricing (BSOP) model, together with the put-call parity formula.
Although Duck Co will not actually obtain any immediate cash flow from Swan Co’s offer, the real option computation
below, indicates that the project is worth pursuing because the volatility may result in increases in future cash flows.
Without the real option
Year
1
Present values ($ 000s)
Present
1,496.9
value
of
2
3
4
5
4,938.8
9,946.5
7,064.2
13,602.9
cash
flows
approx.
=
$37,049,300
Cost of initial investment = $37,500,000
NPV of project = $37,049,300 – $37,500,000 = $(450,700)
Example 3: The option to abandon a project - Continued
With the real option
The asset value of the real option is the sum of the PV of cash flows foregone in years three, four and five, if the
option is exercised ($9.9m + $7.1m + $13.6m = $30.6m)
Asset value (Pa)
$30.6m
Exercise Price (Pe)
$28m
Risk-free rate (r)
4%
Time to exercise (t)
Two years
Volatility (s)
35%
d1
0.588506
d2
0.093531
N(d1)
0.721904
N(d2)
0.537259
Call Value
8.20
Put Value
$3.45m
Net present value of the project with the put option is approximately $3m ($3.45m – $0.45m).
If Swan Co’s offer is not considered, then the project gives a marginal negative net present value, although the results
of any sensitivity analysis need to be considered as well. It could be recommended that, if only these results are
taken into consideration, the company should not proceed with the project. However, after taking account of Swan
Co’s offer and the finance director’s assessment, the net present value of the project is positive. This would suggest
that Duck Co should undertake the project.
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LIMITATIONS AND ASSUMPTIONS
EUROPEAN-STYLE OPTIONS OR AMERICAN-STYLE OPTIONS
The BSOP model is a simplification of the binomial model and it assumes that the real option is a European-style
option, which can only be exercised on the date that the option expires. An American-style option can be exercised
at any time up to the expiry date. Most options, real or financial, would, in reality, be American-style options.
If the underlying asset on which the option is based is due to receive some income before the option’s expiry; say
for example, a dividend payment for an equity share, then an early exercise for an option on that share may be
beneficial. With real options, a similar situation may occur when the possible actions of competitors may make an
exercise of an option before expiry the better decision. In these situations the American-style option will have a
value greater than the equivalent European-style option.
Because of these reasons, the BSOP model will either underestimate the value of an option or give a value close to
its true value. Nevertheless, estimating and adding the value of real options embedded within a project, to a net
present value computation will give a more accurate assessment of the true value of the project and reduce the
propensity of organizations to under-invest.
OTHER LIMITATIONS OF REAL OPTIONS
The BSOP model requires further assumptions to be made involving the variables used in the model, the primary
ones being:
• The BSOP model assumes that the underlying project or asset is traded within a situation of perfect markets
where information on the asset is available freely and is reflected in the asset value correctly. Further it assumes
that a market exists to trade the underlying project or asset without restrictions (that is, that the market is
frictionless)
• The BSOP model assumes that interest rates and the underlying asset volatility remain constant until the expiry
time ends. Further, it assumes that the time to expiry can be estimated accurately
• The BSOP model assumes that the project and the asset’s cash flows follow a lognormal distribution, similar to
equity markets on which the model is based
• The BSOP model does not take account of behavioral anomalies which may be displayed by managers when
making decisions, such as over- or under-optimism
• The BSOP model assumes that any contractual obligations involving future commitments made between parties,
which are then used in constructing the option, will be binding and will be fulfilled. For example, in example
three above, it is assumed that Swan Co will fulfil its commitment to purchase the project from Duck Co in two
years’ time for $28m and there is therefore no risk of non-fulfillment of that commitment.
Nature of multinational
• A multinational is one which own or control production facilities or subsidiaries or services facilities outside the
country in which it is based.
• Competitive advantage of multinational
• There are many strategic reasons for engaging in foreign investment which include following:
• New market
• New source of raw material
• Production efficiency
• Expertise
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Political safety
Economies of scale
Managerial and marketing expertise
Technology
Financial economies
Commonly used means to establish an interest abroad include:
Joint venture
Licensing agreements
Management contracts
Branches
Subsidiaries
Joint
Joint ventures
The two distinct types of joint venture are industrial co-operation (contractual) and joint-equity. A contractual joint
venture is for a fixed period and the duties and responsibility of the parties are contractually defined. A joint-equity
venture involves investment, is of no fixed duration and continually evolves.
The main advantages and disadvantages of joint ventures
Advantages
• Relatively low-cost access to new markets.
• Easier access to local capital markets, possibly with accompanying tax incentives or grants.
• Use of joint venture partner's existing management expertise, local knowledge, distribution network,
technology, brands, patents and marketing or other skills Sharing of risks.
• Sharing of risks.
• Sharing of costs, providing economies of scale.
Disadvantages
• Managerial freedom may be restricted by the need to take account of the views of all the joint venture partners.
• There may be problems in agreeing on partners' percentage ownership, transfer prices, reinvestment decisions,
nationality of key personnel, remuneration and sourcing of raw materials and components.
• Finding a reliable joint venture partner may take a long time.
• Joint ventures are difficult to value, particularly where one or more partners have made intangible
contributions.
Exporting
Exporting may be direct selling by the firm's own export division into the overseas markets, or it may be indirect
through agents, distributors, trading. Exporting may be unattractive because of tariffs, quotas or other import
restrictions in overseas markets, and local production may be the only feasible option in the case of bulky products,
such as cement and flat glass.
Licensing
Licensing involves conferring rights to make use of the licensor company's production process on producers located
in the overseas market. Licensing is an alternative to FDI by which overseas producers are given rights to use the
licensor's production process in return for royalty payments. The main advantages and disadvantages of licensing
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Advantages
• It can allow fairly rapid penetration of overseas markets.
• It does not require substantial financial resources.
• Political risks are reduced since the licensee is likely to be a local company.
• Licensing may be a possibility where direct investment is restricted or prevented by a country.
• For a multinational company, licensing agreements provide a way for funds to be remitted to the parent
company in the form of license fees.
Disadvantages
• The arrangement may give the licensee know-how and technology which it can use in competing with the
licensor after the license agreement has expired.
• It may be more difficult to maintain quality standards, and lower quality might affect the standing of a brand
name in international markets.
• It might be possible for the licensee to compete with the licensor by exporting the produce to markets outside
the licensee's area.
• Although relatively insubstantial financial resources are required, on the other hand relatively small cash inflows
will be generated.
Management contracts
Management contracts whereby a firm agrees to sell management skills are sometimes used in combination with
licensing. Such contracts can serve as a means of obtaining funds from subsidiaries, and may be a useful way of
maintaining cash flows where other remittance restrictions apply.
Overseas subsidiaries
The subsidiaries may be wholly owned or just partly owned, and some may be owned through other subsidiaries.
Whatever the reason for setting up subsidiaries abroad, the aim is to increase the profits of the multinational's
parent company. However, there are different approaches to increasing profits that the multinational might take.
At one extreme, the parent company might choose to get as much money as it can from the subsidiary, and as quickly
as it can. This would involve the transfer of all or most of the subsidiary's profits to the parent company.
At the other extreme, the parent company might encourage a foreign subsidiary to develop its business gradually,
to achieve long-term growth in sales and profits. To encourage growth, the subsidiary would be allowed to retain a
large proportion of its profits, instead of remitting the profits to the parent company.
Branches
Firms that want to establish a definite presence in an overseas country may choose to establish a branch rather than
a subsidiary. Key elements in this choice are as follows:
Taxation
In many countries the remitted profits of a subsidiary will be taxed at a higher rate than those of a branch, as profits
paid in the form of dividends are likely to be subject to a withholding tax
Formalities
• As a separate entity, a subsidiary may be subject to more legal and accounting formalities than a branch.
• However a separate legal entity, a subsidiary may be able to claim more reliefs and grants than a branch.
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Marketing
A local subsidiary may have a greater profile for sales and marketing purposes than a branch.
Theory and practice of international trade
Business enterprises are now also becoming increasingly “internationalized” by the development of multinational
activities beyond pure import and export trade.
Theory of international trade
In the modern economy, production is based on a high degree of specialization. Specialization increases productivity
and raises the standard of living. International trade extends the principle of the division of labor and specialization
to countries.
International trade arises for a number of reasons;
Different goods require different proportions of factor inputs in their production.
• Economic resources are unevenly distributed throughout the world.
• The international mobility of resources is extremely limited.
The law of comparative advantage
The significance of the law of comparative advantage is that it provides a justification for the following beliefs:
• Countries should specialize in what they produce, even when they are less efficient (in absolute terms) in
producing every type of good. They should specialize in the goods where they have a comparative advantage
(they are relatively more efficient in producing).
• International trade should be allowed to take place without restrictions on imports or exports i.e. there should
be free trade.
Does the law apply in practice?
The law of comparative advantage does apply in practice, and countries do specialize in the production of certain
goods. However, there are certain limitations or restrictions on how it operates.
• Free trade does not always exist. Some countries take action to protect domestic industries and discourage
imports. This means that a country might produce goods in which it does not have a comparative advantage.
• Transport costs (assumed to be nil in the examples above) can be very high in international trade so that it is
cheaper to produce goods in the home country rather than to import them.
The advantages of international trade
• Some countries have a surplus of raw materials to their needs, and others have a deficit. A country with a surplus
(e.g. of oil) can take advantage of its resources to export them. A country with a deficit of a raw material must
either import it.
• International trade increases competition among suppliers in the world's markets. Greater competition reduces
the likelihood of a market for a good in a country being dominated by a monopolist. The greater competition
will force firms to be competitive and so will increase the pressures on them to be efficient, and also perhaps to
produce goods of a high quality.
• International trade creates larger markets for a firm's output, and so some firms can benefit from economies of
scale by engaging in export activities.
• There may be political advantages to international trade, because the development of trading links provides a
foundation for closer political links. An example of the development of political links based on trade is the
European Union.
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Barriers to entry
Barriers to entry are factors which make it difficult for suppliers to enter a market. Multinationals may face various
entry barriers. All these barriers may be more difficult to overcome if a multinational is investing abroad because of
such factors as unfamiliarity with local consumers and government favoring local firms. Strategies of expansion and
diversification imply some logic in carrying on operations. It might be a better decision, although a much harder one,
to cease operations or to pull out of a market completely. There are likely to be exit barriers making it difficult to
pull out of a market.
Product differentiation barriers
An existing major supplier would be able to exploit its position as supplier of an established product that the
consumer/customer can be persuaded to believe is better. A new entrant to the market would have to design a
better product, or convince customers of the product's qualities, and this might involve spending substantial sums
of money on R&D, advertising and sales promotion.
Absolute cost barriers
These exist where an existing supplier has access to cheaper raw material sources or know-how that the new entrant
would not have. This gives the existing supplier an advantage because its input costs would be cheaper in absolute
terms than those of a new entrant.
Economy of scale barriers
These exist where the minimum level of production needed to achieve the greatest economies of scale is at a high
level. New entrants to the market would have to be able to achieve a substantial market share before they could
gain full advantage of potential scale economies, and so the existing firms would be able to produce their output
more cheaply.
Fixed costs
The amount of fixed costs that a firm would have to sustain, regardless of its market share, could be a significant
entry barrier.
Legal barriers
These are barriers where a supplier is fully or partially protected by law. For example, there are some legal
monopolies (nationalized industries perhaps) and a company's products might be protected by patent (for example,
computer hardware and software).
Trade agreements
Free trade
Free trade exists where there is no restriction on imports from other countries or exports to other countries. The
European Union (EU) is a free trade area for trade between its member countries. In practice, however, there are
many barriers to free trade because governments wish to protect home industries against foreign competition.
Protectionist measures
Protectionist measures may be implemented by a government, but commonly exceeds what governments are
prepared to allow.
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Protection can be applied in several ways, including the following:
•
Tariffs or customs duties
•
Import quotas
•
Hidden export subsidies and import restrictions
•
Government action to devalue the currency
Tariffs or customs duties
Tariffs or customs duties are taxes on imported goods. The effect of a tariff is to raise the price paid for the imported
goods by domestic consumers, while leaving the price paid to foreign producers the same, or even lower. The
difference is transferred to the government sector.
An ad valorem tariff is one which is applied as a percentage of the value of goods imported. A specific tariff is a fixed
tax per unit of good.
Import quotas
Import quotas are restrictions on the quantity of a product that is allowed to be imported into the country. The
quota has a similar effect on consumer welfare to that of import tariffs, but the overall effects are more complicated.
•
Both domestic and foreign suppliers enjoy a higher price, while consumers buy less.
•
Domestic producers supply more.
•
There are fewer imports (in volume).
•
The Government collects no revenue
Hidden export subsidies and import restrictions
An enormous range of government subsidies and assistance for exports and deterrents against imports have been
practiced, such as:
•
For exports – export credit guarantees (government-backed insurance against bad debts for overseas sales),
financial help (such as government grants to the aircraft or shipbuilding industry) and State assistance via
the Foreign Office.
•
For imports – complex import regulations and documentation, or special safety standards demanded from
imported goods and so on.
Government action to devalue the currency
If a government allows its currency to fall in value, imports will become more expensive to buy. This will reduce
imports by means of the price mechanism, especially if the demand and supply curves for the products are elastic.
Arguments against protection
Arguments against protection are as follows:
Reduced international trade
Because protectionist measures taken by one country will almost inevitably provoke retaliation by others, protection
will reduce the volume of international trade. This means that the following benefits of international trade will be
reduced.
Specialization.
Greater competition and so greater efficiency among producers.
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The advantages of economies of scale among producers who need world markets to achieve their economies and so
produce at lower costs.
Retaliation
Obviously it is to a nation's advantage if it can apply protectionist measures while other nations do not. But because
of retaliation by other countries, protectionist measures to reverse a balance of trade deficit are unlikely to succeed.
Imports might be reduced, but so too would exports.
Effect on economic growth
It is generally argued that widespread protection will damage the prospects for economic growth among the
countries of the world, and protectionist measures ought to be restricted to 'special cases' which might be discussed
and negotiated with other countries.
Political consequences
Although from a nation's own point of view protection may improve its position, protectionism leads to a worse
outcome for all. Protection also creates political ill-will among countries of the world and so there are political
disadvantages in a policy of protection.
Arguments in favour of protection
•
Imports of cheap goods
•
Dumping
•
Retaliation
•
Infant industries
•
Declining industries
•
Reduction in balance of trade deficit
Imports of cheap goods
Measures can be taken against imports of cheap goods that compete with higher priced domestically produced
goods, and so preserve output and employment in domestic industries. The advantages of more employment at a
reasonably high wage for domestic labor are greater than the disadvantages that protectionist measures would
bring.
Dumping
Measures might be necessary to counter 'dumping' of surplus production by other countries at an uneconomically
low price. Although dumping has short-term benefits for the countries receiving the cheap goods, the longer-term
consequences would be a reduction in domestic output and employment, even when domestic industries in the
longer term might be more efficient.
Retaliation
Any country that does not take protectionist measures when other countries are doing so is likely to find that it
suffers all of the disadvantages and none of the advantages of protection.
Infant industries
Protectionism can protect a country's 'infant industries' that have not yet developed to the size where they can
compete in international markets. Less developed countries in particular might need to protect industries against
competition from advanced or developing countries.
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Declining industries
Without protection, the industries might collapse and there would be severe problems of sudden mass
unemployment among workers in the industry.
Reduction in balance of trade deficit
However, because of retaliation by other countries, the success of such measures by one country would depend on
the demand by other countries for its exports being inelastic with regard to price and its demand for imports being
fairly elastic.
The EU
The EU is one of several international economic associations. It dates back to 1957 (the Treaty of Rome) and now
consists of 27 countries, including formerly communist Eastern European countries.
The EU incorporates a common market combining different aspects.
A free trade area exists when there is no restriction on the movement of goods and services between countries. This
has been extended into a customs union.
A common market encompasses the idea of a customs union but has a number of additional features. In addition to
free trade among member countries there is also complete mobility of the factors of production. A British citizen
has the freedom to work in any other country of the EU, for example. A common market will also aim to achieve
stronger links between member countries, for example by harmonizing government economic policies and by
establishing a closer political confederation.
The single European currency, the euro, was adopted by 11 countries of the EU from the inception of the currency
at the beginning of 1999.
The single European market
The EU set the end of 1992 as the target date for the removal of all existing physical, technical and fiscal barriers
among member states, thus creating a large multinational European Single Market.
The elimination of these trade barriers will directly benefit multinational companies, making it easier for them to
engage in business across the European Union without having to deal with differing regulations (and other trade
barriers) within each country of the EU.
Elimination of trade restrictions
• Physical barriers (e.g. customs inspection) on goods and services have been removed for most products.
Companies have had to adjust to a new VAT regime as a consequence.
• Technical standards (e.g. for quality and safety) should be harmonized.
• Governments should not discriminate between EU companies in awarding public works contracts.
• Telecommunications should be subject to greater competition.
• It should be possible to provide financial services in any country.
• There should be free movement of capital within the community.
• Professional qualifications awarded in one member state should be recognized in the others.
• The EU is taking a co-ordinated stand on matters related to consumer protection.
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Remaining barriers
There are many areas where harmonization is a long way from being achieved. Here are some examples:
• Company tax rates, which can affect the viability of investment plans, vary from country to country within the
EU.
• While there have been moves to harmonization, there are still differences between indirect tax rates imposed
by member states.
• There are considerable differences in prosperity between the wealthiest EU economies (e.g. Germany) and the
poorest (e.g. Greece). This has meant that grants are sometimes available to depressed regions, which might
affect investment decisions; and that different marketing strategies are appropriate for different markets
• Differences in workforce skills can have a significant effect on investment decisions. The workforce in Germany
is perhaps the most highly trained, but also the most highly paid, and so might be suitable for products of a high
added value.
• Some countries are better provided with road and rail infrastructure than others. Where accessibility to a
market is an important issue, infrastructure can mean significant variations in distribution costs.
North American Free Trade Agreement (NAFTA)
Canada, the US and Mexico formed the North American Free Trade Agreement (NAFTA) which came into force in
1994. This free trade area covering a population of 360 million and accounting for economic Output of US$6,000
billion annually is almost as large as the European Economic Area (EEA), and is thus the second largest free trade
area after the EEA.
Under NAFTA, virtually all tariff and other (non-tariff) barriers to trade and investment between the NAFTA members
are to be eliminated over a 15-year period. In the case of trade with non-NAFTA members, each NAFTA member will
continue to set its own external tariffs, subject to obligations under GATT.
The World Trade Organization (WTO)
The World Trade Organization (WTO) is a global international organization dealing with the rules of trade between
nations.
The World Trade Organization (WTO) was formed in 1995 to continue to implement the GATT. The WTO has well
over 100 members, including the entire EU. Its aims include:
 To reduce existing barriers to free trade.
 To eliminate discrimination in international trade such as tariffs and subsidies.
 To prevent the growth of protection by getting member countries to consult with others before taking any
protectionist measures.
 To act as a forum for assisting free trade, by for example administering agreements, helping countries negotiate
and offering a disputes settlement process.
 Establishing rules and guidelines to make world trade more predictable.
The most favored nation principle
Most favored nation: a principle in the GATT international trade agreement binding the parties to grant each other
treatment which is as favorable as that offered to any other GATT member in respect of tariffs and other trading
conditions.
The WTO encourages free trade by applying the 'most favored nation' principle where one country that offers a
reduction in tariffs to another country must offer the same reduction to all other member countries of GATT.
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Impact on protectionist measures
Although the WTO has helped reduce the level of protection, some problems still remain.
 Special circumstances (for example economic crises, the protection of an infant industry, and the rules of the
EU) have to be admitted when protection or special low tariffs between a groups of countries are allowed.
 A country in the WTO may prefer not to offer a tariff reduction to another country because it would have to
offer the same reduction to all other GATT members.
 In spite of much success in reducing tariffs, the WTO has had less effect in dealing with many non-tariff barriers
to trade that countries may set up. Some such barriers, for example those in the guise of health and safety
requirements, can be very difficult to identify.
 New agreements are not always accepted initially by all members.
Nevertheless, the WTO exists to help business, and ultimately businesses should be able to benefit from the
expanded opportunities a freer global market brings, even if in certain countries some businesses may suffer through
losing the benefits of protection.
International monetary institutions
The International Monetary Fund (IMF) and the World Bank are closely related. Both were set up in 1944 as United
Nation’s agencies to establish a stable global economic framework.
The IMF was set up partly with the role of providing finance for any countries with temporary balance of payments
deficits.
The World Bank aims to reduce poverty and to support economic development.
The International Monetary Fund
The main importance of the IMF to multinational organizations is that the IMF will step in to provide advice and to
provide financial support to countries with temporary balance of payments deficits.
The IMF and financial support for countries with balance of payment difficulties
If a country has a balance of payments deficit on current account, it must either borrow capital or use up official
reserves to offset this deficit. Since a country's official reserves will be insufficient to support a balance of payments
deficit on current account for very long, it must borrow to offset the deficit.
The IMF can provide financial support to member countries. Most IMF loans are repayable in three to five years.
Of course, to lend money, the IMF must also have funds. Funds are made available from subscriptions or 'quotas' of
member countries. The IMF uses these subscriptions to lend foreign currencies to countries which apply to the IMF
for help.
IMF loan conditions
The preconditions that the IMF places on its loans to debtor countries vary according to the individual situation of
each country, but the general position is as follows:
• The IMF wants countries which borrow from the IMF to get into a position to start repaying the loans fairly
quickly. To do this, the countries must take effective action to improve their balance of payments position.
• To make this improvement, the IMF generally believes that a country should take action to reduce the demand
for goods and services in the economy (e.g. by increasing taxes and cutting government spending). This will
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reduce imports and help to put a brake on any price rises. The country's industries should then also be able to
divert more resources into export markets and hence exports should improve in the longer term.
With 'deflationary' measures along these lines, standards of living will fall (at least in the short term) and
unemployment may rise. The IMF regards these short-term hardships to be necessary if a country is to succeed in
sorting out its balance of payments and international debt problems.
The existence of the IMF affects multinational companies by bringing a measure of financial stability by:
• Ensuring that national currencies are always convertible into other foreign currencies.
• Stabilizing the position of countries that are having difficulties repaying international loans. However it has been
suggested that the strict terms attached to IMF loans can lead to economic stagnation as countries struggle to
repay these loans. Deflationary policies imposed by the IMF may damage the profitability of multinationals'
subsidiaries by reducing their sales in the local market. Higher interest rates are likely to be introduced to
suppress domestic consumers' demand for imports . However, higher interest rates will tend to dampen
domestic investment and could result in increased unemployment and loss of business confidence.
The World Bank
The World Bank lends to creditworthy governments of developing nations to finance projects and policies that will
stimulate economic development and alleviate poverty.
The World Bank consists of two institutions:
The IBRD focuses on middle-income and creditworthy poorer countries, while the IDA focuses exclusively on the
world’s poorest countries. Both the IBRD and the IDA aim to provide finance for projects concerned with the
development of agriculture, electricity, transport (which are likely to have an impact on the poorest people) on
attractive terms. IBRD loans must normally be repaid within 15 years, and IDA loans are interest free and have a
maturity of up to 40 years.
The existence of the World Bank affects multinational companies by bringing a measure of financial stability by
helping to finance infrastructure projects in developing economies. This allows multinational companies participate
directly in infrastructure projects. It also creates a platform for multinational companies to invest in such countries.
A pre-condition for such investment is normally that there is a reliable electricity and transport infrastructure and
the World Bank helps to provide this.
European Central Bank
The European Central Bank (ECB) is based in Frankfurt. It is responsible for administering the monetary policy of the
EU Eurozone member states and is thus one of the world's most powerful central banks. The main objective of the
ECB is to maintain price stability within the Eurozone (keep inflation low). Its key tasks are to define and implement
monetary policy for the Eurozone member states and to conduct foreign exchange operations.
The main relevance of the ECB to a multinational organization is that by keeping inflation low, the ECB can help to
create long-term financial stability.
Bank of England
The Bank of England is the central bank of UK that performs all the functions of a central bank. The most important
of these functions is the maintenance of price stability and support of British economic policies (thus promoting
economic growth).
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Stable prices and market confidence in sterling are the two main criteria for monetary stability. The bank aims to
meet inflation targets set by the Government by adjusting interest rates (determined by the Monetary Policy
Committee which meets on a monthly basis).
The bank can also operate as a 'lender of last resort' – that is, it will extend credit when no other institution will.
US Federal Reserve System
The Federal Reserve System (known as the Fed) is the central banking system of the US. Its responsibilities and
powers have evolved significantly over time. Its current main duties include conducting the US monetary policy,
maintaining stability of the financial system and supervising and regulating banking institutions.
The Fed also acts as the 'lender of last resort' to those institutions that cannot obtain credit elsewhere and the
collapse of which would have serious repercussions for the economy. However, the Fed's role as lender of last resort
has been criticized, as it shifts risk and responsibility from the lenders and borrowers to the general public in the
form of inflation.
Bank of Japan
The Bank of Japan is Japan's central bank and is based in Tokyo. Following several restructures in the 1940s, the
bank's operating environment evolved during the 1970s whereby the closed economy and fixed foreign currency
exchange rate was replaced with a large open economy and variable exchange rate. In 1997, a major revision of the
Bank of Japan Act was intended to give the bank greater independence from the Government, although the bank
had already been criticized for having excessive independence and lack of accountability before these revisions were
introduced. However, the Act has tried to ensure a certain degree of dependence by stating that the bank should
always maintain in close contact with the Government to ensure harmony between its currency and monetary
policies and those of the Government.
Planning in a multinational environment Eurocurrency markets:
 Eurocurrency is currency which is held by individuals and institutions outside the country of issue of that
currency.
 Eurodollars are US dollars deposited with, or borrowed from, a bank outside the US.
 Euro credits are medium- to long-term international bank loans which may be arranged by individual banks or
by syndicates of banks. Syndication of loans increases the amounts available to hundreds of millions, while
reducing the exposure of individual banks.
Eurobonds:
A Eurobond is a bond sold outside the jurisdiction of the country in whose currency the bond is denominated.
Eurobonds are long-term loans raised by international companies or other institutions and sold to investors in
several countries at the same time.
How are Eurobonds issued?
Step 1 A lead manager is appointed from a major merchant bank; the lead manager liaises with the credit rating
agencies and organizes a credit rating of the Eurobond.
Step 2 the lead manager organizes an underwriting syndicate (of other merchant banks) who agrees the terms of
the bond (e.g. interest rate, maturity date) and buy the bond.
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Step 3 the underwriting syndicate then organizes the sale of the bond; this normally involves placing the bond with
institutional investors.
Advantages of Eurobonds:
 Eurobonds are 'bearer instruments', which means that the owner does not have to declare their identity.
 Interest is paid gross and this has meant that Eurobonds have been used by investors to avoid tax.
 Eurobonds create a liability in a foreign currency to match against a foreign currency asset.
 They are often cheaper than a foreign currency bank loan because they can be sold on by the investor, who will
therefore accept a lower yield in return for this greater liquidity.
 They are also extremely flexible. Most Eurobonds are fixed rate but they can be floating rate or linked to the
financial success of the company.
 They are typically issued by companies with excellent credit ratings and are normally unsecured, which makes
it easier for companies to raise debt finance in the future.
Disadvantages of eurobonds :
 Like any form of debt finance, there will be issue costs to consider and there may also be problems if gearing
levels are too high.
– A borrower contemplating a Eurobond issue must consider the foreign exchange risk of a long-term foreign
currency loan. If the money is to be used to purchase assets which will earn revenue in a currency different
to that of the bond issue, the borrower will run the risk of exchange losses if the currency of the loan
strengthens against the currency of the revenues out of which the bond (and interest) must be repaid.
Compliance with listing requirements
When a company decides to raise funds from the local equity markets, the company must comply with the
requirements of the local exchanges for listing.
Listing requirements for the London Stock Exchange:
The listing requirements for the London Stock Exchange are:
– Track record requirements
– Market capitalization
– Future prospects
– Audited historical financial information
– Corporate governance
– Acceptable jurisdiction and accounting standards
– Other considerations
Track record requirements:
The track record requirements are:
– At least 75% of the entity's business must be supported by a revenue earnings record for the three-year period.
The UK listing authority has the discretion to allow a shorter period in certain circumstances.
– The company must report significant acquisitions in the three years running up to the flotation.
Market capitalization:
Market capitalization and share in public hands:
– At least £700,000 for shares at the time of listing.
– At least 25% of shares should be in public hands.
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Future prospects:
The company must show that it has enough working capital for its current needs and for at least the next 12 months.
 The company must be able to carry on its business independently and at arm's length from any shareholders
with economic interest.
 A general description of the future plans and prospects must be given.
 If the company gives an optional profit forecast in the document or has already given one publicly, a report will
be required from the sponsor and the Reporting Accountant.
 This must cover the latest three full years and any published later interim period.
 If latest audited financial data is more than six months old, interim audited financial information is required.
Corporate governance:
UK companies are expected to:
• Split the roles of chairman and CEO.
• Except for smaller companies (below FTSE 350), at least half of the board, excluding the chairman, should
comprise independent non-executive directors; smaller companies should have at least two independent nonexecutive directors
• Have an independent audit committee, a remuneration committee and a nomination committee
• Provide evidence of a high standard of financial controls and accounting systems
Acceptable jurisdiction and accounting standards:
The company must be properly incorporated.
International Financial Reporting Standards and equivalent accounting standards are acceptable.
Capital mobility and blocked funds
Blocked funds:
Exchange controls block the flow of foreign exchange into and out of a country, usually to defend the local currency
or to protect reserves of foreign currencies.
Dealing with blocked funds:
Ways of overcoming blocked funds include the following:
 The parent company could sell goods or services to the subsidiary and obtain payment. The amount of this
payment will depend on the volume of sales and also on the transfer price for the sales.
 A parent company which grants a subsidiary the right to make goods protected by patents can charge a royalty
on any goods that the subsidiary sells. The size of any royalty can be adjusted to suit the wishes of the parent
company's management.
 If the parent company makes a loan to a subsidiary, it can set the interest rate high or low, thereby affecting the
profits of both companies. A high rate of interest on a loan, for example, would improve the parent company's
profits to the detriment of the subsidiary's profits.
 Management charges may be levied by the parent company for costs incurred in the management of
international operations.
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Risk exposure
Political risks for multinationals:
Political risk is the risk that political action will affect the position and value of a company.
When a multinational company invests in another country by setting up a subsidiary, it may face a political risk of
action by that country's government which restricts the multinational's freedom.
If a government tries to prevent the exploitation of its country by multinationals, it may take various measures:
• Import quotas could be used to limit the quantities of goods that a subsidiary can buy from its parent company.
• Import tariffs could make imports (such as from parent companies) more expensive and domestically produced
goods therefore more competitive.
• Legal standards of safety or quality (non-tariff barriers) could be imposed on imported goods to prevent
multinationals from selling goods through a subsidiary which have been banned as dangerous in other countries.
• Exchange control regulations could be applied .
• A government could restrict the ability of foreign companies to buy domestic companies.
• A government could nationalize foreign-owned companies and their assets (with or without compensation to
the parent company).
• A government could insist on a minimum shareholding in companies by residents. This would force a
multinational to offer some of the equity in a subsidiary to investors in the country where the subsidiary
operates.

Dealing with political risks :
These are various strategies that multinational companies can adopt to limit the effects of political risk:

Negotiations with host government:
The aim of these negotiations is generally to obtain a concession agreement. This would cover matters such as
the transfer of capital, remittances and products, access to local finance, government intervention and taxation,
and transfer pricing.

Insurance:
In the UK, the Export Credits Guarantee Department provides protection against various threats, including
nationalization, currency conversion problems, war and revolution.

Production strategies:
It may be necessary to strike a balance between contracting out to local sources and producing directly.

Financial management:
A multinational obtains funds in local investment markets, these may be on terms that are less favorable than
on markets abroad, but would mean that local institutions suffered if the local Government intervened.
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Litigation risks
Legal impacts:
Companies may face government legislation or action in any jurisdiction that extends over its whole range of
activities. Important areas may include:
 Export and import controls for political, environmental, or health and safety reasons.
 Favorable trade status for particular countries, e.g. EU membership, former Commonwealth countries. ▪Law of
ownership. Especially in developing countries, there may be legislation requiring local majority ownership of a
firm or its subsidiary in that country, for example.
 Acceptance of international trademark, copyright and patent conventions.
 Determination of minimum technical standards that the goods must meet e.g. noise levels and contents.
Standardization measures, such as packaging sizes.
 Pricing regulations.

Dealing with legal risks:
One aspect of minimizing problems from governmental intervention is social and commercial good citizenship,
complying with best practice and being responsive to ethical concerns.

Other steps:
Companies may wish to take all possible steps to avoid the bad publicity resulting from a court action. This
includes implementing systems to make sure that the company keeps abreast of changes in the law, and staff
are kept fully informed.

Internal procedures may be designed to minimize the risks from legal action. Contracts may be drawn up
requiring binding arbitration in the case of disputes.

Of course, compliance with legislation may involve extra costs, However, these costs may also act as a significant
barrier to entry, benefiting companies that are already in the industry.
Cultural risks
Cultural risks affect the products and services produced and the way organizations are managed and staffed.
Businesses should take cultural issues into account when deciding where to sell abroad, and how much to centralize
activities.
Challenges of different cultures:
Where a business trades with, or invests in, a foreign country additional uncertainty is introduced by the existence
of different customs, laws and language. The following areas may be particularly important.
 The cultures and practices of customers and consumers in individual markets
 The media and distribution systems in overseas markets
 The different ways of doing business in overseas markets
 The degree to which national cultural differences matter for the product concerned (e.g. washing machines
where some countries prefer front-loading machines and others prefer top-loading machines) ▪The degree to
which a firm can use its own 'national culture' as a selling point
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Dealing with cultural risk:





Deciding which markets to enter:
Making the right choices about which markets to enter are a key element in dealing with cultural risk. When
deciding what types of country it should enter the major criteria for this decision should be as follows:
Market attractiveness. This concerns such indicators as GNP/head and forecast demand.
Competitive advantage. This is principally dependent on prior experience in similar markets, language and
cultural understanding.
Risk. This involves an analysis of political stability, the possibility of government intervention and similar external
influences.
Management of human resources:
The balance between local and expatriate staff must be managed. There are a number of influences.
Expatriate staff is sometimes favored over local staff.
 Poor educational opportunities in the market may require the import of skilled technicians and managers.
For example, expatriates have been needed in many Western firms' operations in Russia and Eastern
Europe, simply because they understand the importance of profit.
 Expatriates might be better able than locals to communicate with the corporate center.
 The expatriate may know more about the firm overall, which is especially important if they are fronting a
sales office
The use of expatriates in overseas markets has certain disadvantages.
They cost more (e.g. subsidized housing, school fees).
 Culture shock. The expatriate may fail to adjust to the culture this is likely to lead to poor management
effectiveness, especially if the business requires personal contact.
 A substantial training programed might be needed.
Dividend policy in multinationals and transfer pricing
Dividend capacity
The dividend capacity of a multinational company depends on its after-tax profits, investment plans and foreign
dividends. The potential dividend that can be paid, i.e the dividend capacity of the firm, can be estimated as follows.
Dividend Capacity
$
PBIT
XX
Tax @ 30%
(X)
Depreciation
X
Working Capital Change
(X)
Interest ( 1 – 1)
(X)
CAPEX
(X)
Net borrowings
X
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Dividends from subsidiaries
X
Additional tax on dividends
X
Dividend Capacity
xxx
$
Free Cash flow to equity
XX
Net borrowings
X
Dividends from subsidiaries
X
Additional tax on dividends
(X)
Dividend Capacity
Xxx
Dividend Policies
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.
Constant payout ratio
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.
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.
Advantages of Stable Dividend Policy: A Stable dividend policy is advantageous to both investors and company on
account of the following:
(a) It is sign of continued normal operations of company.
(b) It stabilizes market value of shares.
(c) It creates confidence among investors.
(d) It improves credit standing and making financing easier.
(e) It meets requirements of institutional investors who prefer companies with stable dividends.
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.
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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.
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.
Irregular Dividend Policy: Some companies follow irregular dividend payments on account of following:
(a) Uncertainty of Business.
(b) Unsuccessful Business operations
(c) Lack of liquid resources.
(d) Fear of adverse effects of regular dividend on financial standing of company.
No Dividend Policy: 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.
Transfer pricing
A transfer price may be defined as the price at which goods or services are transferred from one process or
department to another or from one member of a group to another.
The arm's length standard:
The arm's length standard states that intra-firm trade of multinationals should be priced as if they took place
between unrelated parties acting at arm's length in competitive markets.
The main methods of establishing 'arm's length' transfer prices of tangible goods include:
 Comparable uncontrolled price (CUP)
 Resale price (RP)
 Cost plus (C+)
 Profit split (PS)
The CUP method:
The CUP method looks for a comparable product to the transaction in question, either in terms of the same product
being bought or sold by the MNC in a comparable transaction with an unrelated party, or the same or similar product
being traded between two unrelated parties under the same or similar circumstances. The product so identified is
called a product comparable. All the facts and circumstances that could materially affect the price must be
considered.
Tax authorities prefer the CUP method over all other pricing methods for at least two reasons.
 It incorporates more information about the specific transaction than does any other method; i.e. it is transaction
and product specific.
 CUP takes the interests of both the buyer and seller into account since it looks at the price as determined by the
intersection of demand and supply.
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The RP method:
Where a product comparable is not available, and the CUP method cannot be used, an alternative method is to focus
on one side of the transaction, either the manufacturer or the distributor, and to estimate the transfer price using a
functional approach.
Under the RP method, the tax auditor looks for firms at similar trade levels that perform similar distribution functions
(ie a functional comparable). The RP method is best used when the distributor adds relatively little value to the
product so that the value of its functions is easier to estimate. The assumption behind the RP method is that
competition among distributors means that similar margins (returns) on sales are earned for similar functions. The
RP method backs into the transfer price by subtracting a profit margin, derived from margins earned by comparable
distributors engaged in comparable functions, from the known retail price to determine the transfer price. As a
result, the RP method evaluates the transaction only in terms of the buyer. The method ensures that the buyer
receives an arm's length return consistent with returns earned by similar firms engaged in similar transactions.
Since the resale margin is determined in an arm's length manner, but nothing is done to ensure that the
manufacturer's profit margin is consistent with margins earned by other manufacturers, the adjustment is one-sided.
Under the RP method, having determined the buyer's arm's length margin, all excess profit on the transaction is
assigned to the seller. Thus the RP method tends to overestimate the transfer price since it gives all unallocated
profits on the transaction to the upstream manufacturer. We call this contract distributor case, since the
manufacturer is contracting out the distribution stage to the lowest bidder.
The C+ method:
The C+ method starts with the costs of production, measured using recognized accounting principles, and then adds
an appropriate mark-up over costs. The appropriate mark-up is estimated from those earned by similar
manufacturers.
The assumption is that in a competitive market the percentage mark-ups over cost that could be earned by other
arm's length manufacturers would be roughly the same. The C+ method works best when the producer is a simple
manufacturer without complicated activities so that its costs and returns can be more easily estimated.
In order to use the C+ method, the tax authority or the MNC must know the accounting approach adopted by the
unrelated parties, such as: what costs are included in the cost base before the mark-up over costs is calculated. Is it
actual cost or standard cost?
Are only manufacturing costs included or is the cost base the sum of manufacturing costs plus some portion of
operating costs? The larger the cost base, the smaller should be the profit mark-up, or gross margin, over costs.
The PS method:
When there are no suitable product comparable (the CUP method) or functional comparable (the RP and C+
methods), the most common alternative method is the PS method, whereby the profits on a transaction earned by
two related parties are split between the parties. The PS method allocates the consolidated profit from a transaction,
or group of transactions, between the related parties. Where there are no comparable that can be used to estimate
the transfer price, this method provides an alternative way to calculate or 'back into' the transfer price. The most
commonly recommended ratio to split the profits on the transaction between the related parties is return on
operating assets (the ratio of operating profits to operating assets). The PS method ensures that both related parties
earn the same ROA.
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REVERSE TAKEOVERS – AN EXPLANATION
An RTO involves a smaller quoted company taking over a larger unquoted company by a share-for-share exchange.
In order to acquire the larger unquoted company, a large number of shares in the quoted company will have to be
issued to the shareholders of the larger unquoted company. Hence, after the takeover the current shareholders in
the larger unquoted company will hold the majority of the shares in the quoted company and will therefore have
control of the quoted company.
REVERSE TAKEOVERS – THE POTENTIAL BENEFITS
As previously stated, an RTO is effectively a way that a currently unquoted company can achieve a listing. Hence,
just as with an IPO, the company obtains the benefits of the public trading of its securities. These benefits include:
•
Easier access to capital markets
As a listed company, more finance is likely to be available and the cost of that finance is likely to be lower than
if the company was still unquoted.
•
Higher company valuation
As the shares in the company will be listed, potential investors will deem the shares to be less risky as the
company will have to abide by the relevant rules and regulations. Additionally, they will know that the shares
are liquid and that whenever they wish to sell there will be a willing buyer. As a result of this, investors are likely
to attribute a higher value to the shares.
•
Enhanced ability to carry out further takeovers
Once the shares in a company are listed, the company is able to acquire other companies through further sharefor-share exchanges.
Enhanced ability to use share based incentive plans
Once the shares of a company are listed, share based incentive plans can be used as a key tool to attract and retain
good quality employees.
In addition to the above, an RTO has a number of other potential benefits when compared to a normal IPO.
These include the following:
Speed
An IPO can often take between one and two years to complete whereas an RTO can be completed in as little as 30
days. Furthermore, the work required to complete an IPO can mean that the managers of a company have less time
to run the company, which may prove detrimental to the growth prospects of the company.
The variability of market conditions can also make the speed of an RTO attractive, as in the time taken to prepare
for an IPO, the market may deteriorate such that the IPO is not finally worth completing. Furthermore, particular
circumstances in a market may make RTOs attractive. For instance, in China the IPO process is notoriously slow and
there is usually a significant queue of companies waiting to carry out an IPO. An RTO allows a company to jump this
queue.
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Cost
Just as an IPO is a time-consuming process, it is also an expensive one due to the volume of work required by
investment banks, sponsors, accountants and other advisers. An RTO will usually, but not always, cost less.
Availability
In a market downturn it is not easy to convince investors to support an IPO, whereas this does not seem to be the
case with RTOs. Studies have shown that the volume of RTO transactions is far more resilient to market downturns.
During the market correction that followed the bursting of the dotcom bubble, the number of RTOs actually
increased while the number of IPOs fell very significantly.
Similarly, the fall in the number of RTOs was less than the fall in the number of IPOs following the more recent
financial crisis. This is probably because, with an RTO, the deal is fundamentally between the shareholders of the
quoted and unquoted companies involved and, hence, market sentiment has much less import.
Furthermore, while an RTO is often accompanied by a concurrent secondary offering to raise new finance, the
amount of new finance being raised in both $ and % terms is usually less than that which is raised during an IPO.
Hence, even in a downturn, investors are often more willing to support an RTO rather than an IPO.
Existing analyst coverage
A listed company subject to an RTO is likely to have existing analyst coverage and, after the RTO, this analyst coverage
usually continues. However, companies that use an IPO may struggle to get significant analyst coverage especially if
they are smaller. Without reasonable analyst coverage, potential investors may not have much awareness of the
company and, hence, are unlikely to want to invest in the company.
REVERSE TAKEOVERS – THE POTENTIAL DRAWBACKS
RTOs do, however, have a number of potential drawbacks when compared to an IPO and any company considering
an RTO should be aware of these.
Lack of expertise
A company achieving a listing through an RTO may find that it does not have the expertise to understand and deal
with all the regulations and procedures that listed companies must comply with. The long process of listing through
an IPO can be viewed as a valuable training period and any company that has been through the process is in a better
position to deal with the requirements of the exchange than a company catapulted onto the market through an RTO.
Hence, any company considering an RTO must consider the need to hire and/or retain staff from the existing listed
company who are able to keep the company compliant with all the relevant regulations.
Reputation
As previously discussed, an RTO has often been viewed as a poor man’s IPO. Hence, companies that achieve their
listing in this way may be viewed less favorably by investors than companies that have completed an IPO.
Risk
As a result of the lower level of scrutiny that is applied to an RTO compared to an IPO, investors must be aware of
the higher level of risk that is attached to companies achieving a listing in this way. In particular, the unquoted
company carrying out an RTO must ensure that there is a thorough investigation of the listed company which they
are taking over so that all potential problems and liabilities are revealed.
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Regulation
Although RTOs can generally be completed more quickly than an IPO as there is less regulation and scrutiny involved,
it must be recognized that there are still a significant amount of regulatory hurdles to overcome.
Regulation
It should be understood that RTOs are, to some extent, combinations of acquisitions and IPOs and, as such, are
potentially complex and difficult deals to manage. By way of example, two regulatory issues that may arise are now
discussed:
 Suspension
The Financial Conduct Authority’s (FCA) standard view is that when an RTO is announced or leaked, there will
generally be insufficient information publicly available on the proposed transaction. In particular, information
on the unquoted company contemplating the takeover could well be limited compared to the information that
is available on listed companies. As a result of this, the listed company will not be able to accurately assess its
financial position and inform the market. Hence, the FCA will often consider that a suspension of trading in the
shares is appropriate. This standard view can be rebutted, but there is significant work required to achieve this.
However, this work is essential as the listed company will not want to contemplate a scenario where its listing
is suspended and is quite likely to walk away from the proposed transaction were this to occur.
 Mandatory offer
If, individually or with their closely connected persons or friends, any shareholder in the unquoted company
carrying out an RTO will on completion of the transaction hold shares that carry 30% or more of the voting rights
of the listed company, then that shareholder will be required to make a general cash offer for the remaining
shares in the listed company under the mandatory bid rule. This would obviously undermine the reason for
doing the RTO in the first place. While the takeover panel will usually consent to a waiver of this requirement
as long as certain conditions are satisfied, it is another regulatory obstacle which must be navigated around
carefully.
Share price decrease
Many listed companies which could make potential RTO targets are in that position because of past problems. Hence,
they may have shareholders who are keen to exit from the company as soon as a suitable opportunity arises and,
hence, they may ‘dump’ their shares shortly after the RTO has completed. To safeguard against the risk of a ‘dump’
occurring, the shareholders may need to guarantee that they will not sell their shares until a certain period of time
has elapsed since the deal is completed. This is called a lock-up and/or a lock-up period.
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REVERSE TAKEOVERS – THE POTENTIAL DRAWBACKS
Cost
While a reverse takeover is usually cheaper than an IPO, there are still significant direct and indirect costs involved
and, hence, the total cost can easily be far more than was originally anticipated. A number of these costs are now
considered:
Regulatory costs
As mentioned previously, an RTO is a complex transaction and to ensure that the regulatory hurdles are successfully
overcome will incur significant cost.
Acquisition cost
As a result of an RTO being seen as an easier and quicker option than an IPO, especially in the Chinese market, the
value of potential listed company targets are often at a significant premium to their true value.
Acquisition cost - continued
Furthermore, the pressure to find a target has resulted in some unusual combinations such as a mobile computer
game developer getting listed through the acquisition of a shoe company! It is hard to imagine there were any
synergy gains available here and, indeed, resolving cultural and other issues that may well have arisen would have
further added to the indirect cost of achieving the listing.
Investor relations
Although an RTO may benefit from existing analyst coverage, RTO transactions only really introduce liquidity to a
previously private company if there is real investor interest in the company. In many cases, in order to generate this
interest, a comprehensive investor relations and investor marketing programme will be required. This is another
potential indirect cost of an RTO.
Behavioral Finance
Behavioral finance considers the impact of psychological factors on financial decision-making. This challenges the
idea that share prices and investor returns are determined by rational economic criteria.
1.
Psychological factors affecting decision making
Behavioral finance examines the psychological factors that lie behind financial decision making; some of the
main factors are listed below.

Overconfidence
Investors and managers have a tendency to overestimate their own abilities.

Search for patterns, herding and cognitive dissonance
Investors look for patterns which can be used to justify investment decisions. This might involve analyzing
a company’s past returns and using this to extrapolate future Proformance. It might also involve comparing
peaks or troughs in the stock market to historic peaks and troughs in previous decades. This type of behavior
can lead to herding, where people buy (or sell) shares because share prices are rising (or falling) and can
help to explain stock market bubbles (or crashes). Herding is also based on the psychological comfort of
following the crowd.
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A stock market bubble can emerge because investors buy shares simply because share prices have been
rising in the past, this then creates a stronger rise in share prices which in turn creates a stronger demand
for shares. Share prices can therefore be driven up to a level that is not justified given the future profit
potential due investors following the crowd and continuing to buy shares.
This is compounded by a reluctance of investors to admit that they are wrong (sometimes referred to as
cognitive dissonance).
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 about a company, and this may help to explain why share
prices move significantly shortly after financial results are published.
Conservatism
Investors and managers are resistant to changing their opinion so, for example, if a company’s profits are
better than expected the share price may not react significantly because investors under react to this news
2.
Share valuation
Behavioral finance suggests that managers are over-confident in their own abilities. This helps to explain why
most boards believe that the market undervalues their shares. This can lead to managers taking actions that
may not be in their shareholders best interests, such as delisting from the stock market or defending against a
takeover bid that they believe undervalues their company.
3.
Acquisitions
Behavioral finance can also explain why many acquisitions are over-valued, this aspect of behavioral finance is
covered in chapter 10.
4.
CAPM
Behavioral finance conflicts with theories (such as the capital asset pricing model) that suggest that asset prices
and investor returns are determined in a rational manner, based on the anticipated risk and future cash flows
of a share.
For example, narrow framing can mean that if a single share in a large portfolio performs badly in a particular
week then logically this should not matter greatly to an investor who is investing in shares over say a twenty
year period. However in reality it does seem to matter, so investors are showing a greater aversion to risk than
the capital asset pricing model (which argues that diversified investors should only care about systematic risk)
suggests they should.
5.
Financial strategy
Behavioral factors such as overconfidence and cognitive dissonance can also explain why managers persist with
investment strategies that are unlikely to succeed. For example, in the face of economic logic managers will
often delay decisions to terminate projects for behavioral reasons.
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ISLAMIC FINANCE
Islamic finance is finance that is compliant with Sharia'a law.
Islamic finance transactions are based on the concept of sharing risk and reward between the investor and the user
of funds.
The object of an Islamic finance undertaking is not simply the pursuit of profit, but that the economic benefits of the
enterprise should extend to goals such as social welfare and full employment. Making profits by lending alone and
the charging of interest is for bid den under Sharia'a law. The business of trading goods and investment in Sharia'a
acceptable enterprises form the core of Islamic finance.
Riba
Riba (interest) is for bid den in Islamic finance.
Riba is generally interpreted as the predetermined interest collected by a lender, which the lender receives over and
above the principal amount it has lent out. The Quranic ban on riba is absolute. Riba can be viewed as unacceptable
from three different perspectives, as outlined below.

For the borrower
Riba creates unfairness for the borrower when the enterprise makes a profit which is less than the interest
payment, turning their profit in to a loss.

For the lender
Riba creates unfairness for the lender in high inflation environments when the returns are likely to be below the
rate of inflation.

For the economy
Riba can result in inefficient allocation available resources in the economy and may contribute to instability of
the system. In an interest-based economy, capitalis directed to the borrower with the highest credit worthiness
rather than the borrower who would make the most efficient use of the capital.
Islamic finance contracts
Musharaka
– a partnership contract
Mudaraba
– a form of equity where a partnership exists and profits and losses are shared
Murabaha
– a form of credit sale
Ijara
– a form of lease
Sukuk
– similar to a bond
Mudaraba Contract
A mudaraba transaction is a partnership transaction in which only one of the partners (the rab al mal) contributes
capital, and the other (the mudarib) contributes skill and expertise. The contributor of capital has no right to interfere
in the day to day operations of the business. Due to the fact that one of the partners is running the business and the
other is solely providing capital, the investor has to rely heavily on the mudarib, their ability to manage the business
and their honesty when it comes to profit share payments.
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Mudaraba transactions are particularly suited to private equity investments or for clients depositing money with a
bank.
Profit & loss
Capital Expertise
Profit & loss
In vesting P a r tner
Business Partner
(RabalMal)
(Mudarib)
Business Partner
(Mudarib)
The roles of and the returns received by the rab-al-mal and mudarib under a mudaraba contract

Capital injection
The investor provides capital for the project or company. Generally, an investor will not provide any capital
unless a clearly defined business plan is presented to them. In this structure, the investor provides 100% of the
capital.

Skill and expertise
The business manager's contribution to the partnership is their skill and expertise in the chosen industry or area.

Profit and loss
Any profits will be shared between the partners according to the ratios agreed in the original contract. Any
losses are solely attributable to the investor due to the fact that they are the sole provider of all capital to the
project. In the event of a loss, the business manager does not receive any compensation (mudarib share) for
their efforts. The only exception to this is when the business manager has been negligent, in which case they
become liable for the total loss.
The investor in a mudaraba transaction is only liable to the extent of the capital they have provided. As a result,
the business manager cannot commit the business for any sum which is over and above the capital provided.
The mudaraba contract can usually be terminated at any time by either of the parties giving a reasonable notice.
Typically, conditions governing termination are included in the contract so that any damage to the business or
project is eliminated in the event that the investor would like to take their equity out of the venture.
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The rab al mal has no right to interfere with the operations of the business, meaning this situation is similar to
an equity investment on a stock exchange.
Musharaka partnership contract
Musharaka transactions are typically suitable for investments in business ventures or specific business projects, and
need to consist of at least two parties, each of which is known as musharik. It is widely used in equity financing.
Once the contract has been agreed between the partners, the process can be broken down into the following two
main components.
•
All partners bring a share of the capital as well as expertise to the business or project. The partners do not
have to provide equal amounts of capital or equal amounts of expertise.
•
Any profits will be shared between the partners according to the ratios agreed in the original contract. To
the contrary, any losses that the project might incur are distributed to the partners strictly in proportion to
capital contributions. Although profits can be distributed in any proportion by mutual consent, it is not
permissible to fix a lump sum profit for any single partner. This transaction is similar to venture capital, for
example a management buyout, where both parties contribute both capital and expertise. The venture
capitalist will want board representation and therefore provides expertise and they will also want
management to provide capital to demonstrate their commitment.
Murabaha contract
Instruments with predictable returns are typically favoured by banks and their regulators since the reliance on thirdparty profit calculations is eliminated.
A murabaha transaction is a deferred payment sale or an instalment credit sale and is mostly used for the purchase
of goods for immediate delivery on deferred payment terms. In its most basic form, this transaction involves the
seller and buyer of a good, as can be seen below.
Simple murabaha structure
Seller
Buyer
1. Deliver goods today
2. Pay for goods later
As part of the contract between the buyer and the seller, the price of the goods, the mark-up, the delivery date and
payment date are agreed. The sale of the goods is immediate, against future payment. The buyer has full knowledge
of the price and quality of goods they buy. In addition, the buyer is also aware of the exact amount of mark-up they
pay for the convenience of paying later. In the context of trading, the advantage to the buyer is that they can use
the goods to generate a profit in their business and subsequently use the profit to repay the original seller.
The underlying asset can vary, and can include raw materials and goods for resale.
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Sharia'a prescribes that certain conditions are required for a sales contract (which include murabaha contracts) to
exist.
• The object in the contract must actually exist and be owned by the seller.
• The object is offered for a price and both object and price are accepted (the price should be within fair market
range).
• The object must have a value.
• The object in question and its exchange may not be prohibited by Sharia'a.
• The buyer in the contract has the right to demand that the object is of suitable quality and is not defective.
• A bank can provide finance to a business in a murabaha transaction as follows.
• The manager of the business identifies an asset that the business wants to buy.
• The bank agrees to buy the asset, and to resell it to the business at an agreed (fixed) price, higher than the
original purchase price of the asset.
• The bank will pay for the asset immediately but agrees to payment from the business under a deferred payment
arrangement (murabaha).
• The business therefore obtains the asset 'now' and pays for it later. This is similar in effect to arranging a bank
loan to purchase the asset, but it is compliant with Sharia'a law.
Ijara contract
An ijara transaction is the Islamic equivalent of a lease where one party (lessor) allows another party (lessee) to use
their asset against the payment of a rental fee. Two types of leasing transactions exist: operating and finance leases.
The only distinction between the two is the presence or absence o fa purchase undertaking from the lessee to buy
the asset at the end of the lease term. In a finance lease, this purchase undertaking is provided at the start of the
contract. The lessor cannot stipulate that they will only lease the asset if the lessee signs a purchase undertaking.
Not every asset is suitable for leasing. The asset needs to be tangible, non-perishable, valuable, identifiable and
quantifiable.
In an operating lease, depicted in Figure1, the lessor leases the asset to the lessee for a pre-agreed period and the
lessee pays pre-agreed periodic rentals. The rental or lease payments can either be fixed for the period or floating
with periodical refixing.
Figure1: Operating lease
At the end of the period, the lessee can either request to extend the lease or hand the asset back to the lessor. When
the asset is returned to the lessor at the end of the period, they can either lease it to another counter party or sell
the asset in the open market. If the lessor decides to sell the asset, they may offer it to the lessee.
In a finance lease, as depicted in Figure 2, the process is the same as for an operating lease, with the exception that
the lessor amortises the asset over the term of the lease and at the end of the period the asset will be sold to the
lessee.
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Figure2:Finance lease
As with an operating lease, rentals can be fixed for the period or floating. As part of the lease agreement, the amount
at which the lessee will purchase the asset upon expiry of the lease is specified.
In both forms of ijara the lessor is the owner of the asset and incurs all risk associated with ownership. While the
lessee bears the responsibility for wear and tear, day to day maintenance and damage, the lessor is responsible for
major maintenance and insurance. Due to the fact that the lessee is using the asset on a daily basis, they are often
in a better position to determine maintenance requirements, and are generally appointed by the lessor as an agent
to ensure all maintenance is carried out. In addition, the lessee is, in some cases, similarly appointed as agent for
the lessor to insure the asset.
In the event of a total loss of the asset, the lessee is no longer obliged to pay the future periodic rentals. However,
the lessor has full recourse to any insurance payments.
Sukuk is about the finance provider having ownership of real assets and earning a return sourced from those assets.
This contrasts with conventional bonds where the investor has a debt instrument earning the return predominately
via the payment of interest (riba). Riba or excess is not allowed under Sharia law. There has been considerable debate
as to whether sukuk instruments are akin to conventional debt or equity finance. This is because there are two types
of sukuk:
Asset based – raising finance where the principal is covered by the capital value of the asset but the returns and
repayments to sukuk holders are not directly financed by these assets.
Asset backed – raising finance where the principal is covered by the capital value of the asset but the returns and
repayments to sukuk holders are directly financed by these assets.
There are fundamental differences between these. The diagrams set out below explain the mechanics of how each
sukuk operates.
ASSET-BASED SUKUK
Sukuk Al-ijarah: financing acquisition of asserts or raising capital through sale and lease back.
1.
Sukuk holders subscribe by paying an issue price to a special purpose vehicle (SPV) company.
2.
In return, the SPV issues certificates indicating the percentage they own in the SPV.
3.
The SPV uses the funds raised and purchases the asset from the obligor (seller).
4.
In return, legal ownership is passed to the SPV.
5.
The SPV then, acting as a lessor, leases the asset back to the obligor under an Ijarah agreement.
6.
The obligor or lessee pays rentals to the SPV, as the SPV is the owner and lessor of the asset.
7.
The SPV then make periodic distributions (rental and capital) to the sukuk holders.
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ASSET-BACKED SUKUK
Sukuk: Securitisation of Leasing Portfolio
1.
Sukuk holders subscribe by paying an issue price to a SPV company.
2.
In return, the SPV issues certificates indicating the percentage they own in the SPV.
3.
The SPV will then purchase a portfolio of assets, which are already generating an income stream.
4.
In return, the SPV obtains the title deeds to the leasing portfolio.
5.
The leased assets will be earning positive returns, which are now paid to the SPV Company.
6.
The SPV then makes periodic distributions (rental and capital) to the sukuk holders.
7.
With an asset-based sukuk, ownership of the asset lies with the sukuk holders via the SPV. Hence, they would
have to maintain and insure the asset. The payment of rentals provides the return and the final redemption
of the sukuk is at a pre-agreed value. As the obligor is the lessee, the sukuk holders have recourse to him if
default occurs. This makes this type of sukuk more akin to debt or bonds.
Asset-backed sukuk certainly have the attributes of equity finance – the asset is owned by the SPV. All of the risks
and rewards of ownership passes to the SPV. Hence, should the returns fail to arise the sukuk holders suffer the
losses. In addition, redemption for the sukuk holders is at open market value, which could be nil
Salam means a contract in which advance payment is made for goods to be delivered at a future date. The seller
undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at
the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified
leaving no ambiguity leading to dispute. Bai Salam covers almost everything which is capable of being definitely
described as to quantity, quality and workmanship. For Islamic banks, this product is ideal for agriculture financing,
however, this can also be used to finance the working capital needs of the customers.
The permissibility of Salam is an exception to the general rule that prohibits forward sale.
The Salam transaction is subject to the strict conditions as follows:
1.
It is necessary for the validity of Salam that the buyer pays the price in full to the seller at the time of
affecting the sale.
2.
Only those goods can be sold through a Salam contract in which the quantity and quality can be exactly
specified e.g. precious stones cannot be sold on the basis of Salam because each stone differ in quality,
size, weight and their exact specification is not possible.
3.
Salam cannot be affected on a particular commodity or on a product of a particular field or farm e.g. Supply
of wheat of a particular field or the fruit of a particular tree 4. All quality, quantity and date is specified.
ISTISNA
It is a specific kind of a Bai (sale) where the sale of the commodity is transacted before the commodity comes into
existence.
Istisna is an agreement culminating in a sale at an agreed price whereby the purchaser places an order to
manufacture, assemble or construct (or cause so to do) anything to be delivered at a future date. It becomes an
obligation of the manufacturer or the builder (as the case may be) to deliver the asset of agreed specifications at the
agreed period of time. As the sale is executed at the time of entering into the Istisna contract, the contracting parties
need not renew an exchange of offer and acceptance after the subject matter is prepared. Istisna can be used for
providing the facility of financing the manufacture or construction ofhouses, plants, projects and building of bridges,
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roads and highways etc. After giving prior notice, either party can cancel the contract before the manufacturing
party has begun its work. Once the work starts, the contract cannot be cancelled unilaterally.
Bond Valuation
Bond value or price
Example
How much would an investor pay to purchase a bond today, which is redeemable in four years for its par value or
face value of $100 and pays an annual coupon of 5% on the par value? The required rate of return (or yield) for a
bond in this risk class is 4%.
As with any asset valuation, the investor would be willing to pay, at the most, the present value of the future income
stream discounted at the required rate of return (or yield). Thus, the value of the bond can be determined as follows:
If the required rate of return (or yield) was 6%, then using the same calculation method, the price of the bond would
be $96.53. And where the required rate of return (or yield) is equal to the coupon – 5% in this case – the current
price of the bond will be equal to the par value of $100.
Thus, there is an inverse relationship between the yield of a bond and its price or value. The higher rate of return (or
yield) required, the lower the price of the bond, and vice versa. However, it should be noted that this relationship is
not linear, but convex to the origin.
Yield to maturity (YTM) (also known as the [Gross] Redemption Yield (GRY)) If the current price of a bond is given,
together with details of coupons and redemption date, then this information can be used to compute the required
rate of return or yield to maturity of the bond.
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Example 2
A bond paying a coupon of 7% is redeemable in five years at par ($100) and is currently trading at $106.62.
Estimate its yield (required rate of return).
Years
Cash flows
5%
PV
6%
0
(106.62)
1
(106.62)
1
(106.62)
1-5
7
4.329
30.31
4.2124
29.49
5
100
0.7835
78.35
0.7473
74.73
2.04
(2.4)
Yield = 5% + (2.04 / 2.04 + 2.4) x 1% = 5.46%
5.46% is the yield to maturity (YTM) (or redemption yield) of the bond. The YTM is the rate of return at which the
sum of the present values of all future income streams of the bond (interest coupons and redemption amount) is
equal to the current bond price. It is the average annual rate of return the bond investors expect to receive from the
bond till its redemption.
Term structure of interest rates and the yield curve
The yield to maturity is calculated implicitly based on the current market price, the term to maturity of the bond and
amount (and frequency) of coupon payments. However, if a corporate bond is being issued for the first time, its price
and/or coupon payments need to be determined based on the required yield. The required yield is based on the
term structure of interest rates and this needs to be discussed before considering how the price of a bond may be
determined.
It is incorrect to assume that bonds of the same risk class, which are redeemed on different dates, would have the
same required rate of return or yield. In fact, it is evident that the markets demand different annual returns or yields
on bonds with differing lengths of time before their redemption (or maturity), even where the bonds are of the same
risk class. This is known as the term structure of interest rates and is represented by the spot yield curve or simply
the yield curve.
For example, a company may find that if it wants to issue a one - year bond, it may need to pay interest at 3% for
the year, if it wants to issue a two - year bond, the markets may demand an annual interest rate of 3. 5%, and for a
three-year bond the annual yield required may be 4.2%. Hence, the company would need to pay interest at 3% for
one year; 3.5% each year, for two years, if it wants to borrow funds for two years; and 4.2% each year, for three
years, if it wants to borrow funds for three years. In this case, the term structure of interest rates is represented by
an upward sloping yield curve.
The normal expectation would be of an upward sloping yield curve on the basis that bonds with a longer period of
maturity would require a higher interest rate as compensation for risk. Note here that the bonds considered may be
of the same risk class but the longer time period to maturity still adds to higher uncertainty.
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Valuing bonds based on the yield curve
Annual spot yield curves are often published by the financial press or by central banks (for example, the Bank of
England regularly publishes UK government bond yield curves on its website). The spot yield curve can be used to
estimate the price or value of a bond.
Example 3
A company wants to issue a bond that is redeemable in four years for its par value or face value of $100, and wants
to pay an annual coupon of 5% on the par value. Estimate the price at which the bond should be issued.
The annual spot yield curve for a bond of this risk class is as follows:
One-year
3.5%
Two-year
4.0%
Three-year
4.7%
Four-year
5.5%
The four-year bond pays the following stream of income:
Year
Payments
1
$5
2
$5
3
$5
4
$105
This can be simplified into four separate bonds with the following payment structure:
Year
Bond 1
Bond 2
Bond 3
Bond 4
1
$5
2
3
4
$5
$5
$105
Each annual payment is a single payment in that particular year, much like a zero-coupon bond, and its present value
can be determined by discounting each cash flow by the relevant yield curve rate, as follows:
The sum of these flows is the price at which the bond can be issued, $98.57.
The yield to maturity of the bond is estimated at 5.41% using the same methodology as example 2.
Some important points can be noted from the above calculation; firstly, the 5.41% is lower than 5.5% because some
of the ret urns from the bond come in earlier years, when the interest rates on the yield curve are lower, but the
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largest proportion comes in Year 4. Secondly, the yield to maturity is a weighted average of the term structure of
interest rates. Thirdly, the yield to maturity is calculated after the price of the bond has been calculated or observed
in the markets, but theoretically it is term structure of interest rates that determines the price or value of the bond.
Mathematically:
How to calculate spot yield
There are different methods used to estimate a spot yield curve, and the iterative process based on bootstrapping
coupon paying bonds is perhaps the simplest to understand. The following example demonstrates how the process
works.
Example 4
A government has three bonds in issue that all have a face or par value of $100 and are redeemable in one year, two
years and three years respectively. Since the bonds are all government bonds, let’s assume that they are of the same
risk class. Let’s also assume that coupons are payable on an annual basis. Bond A, which is redeemable in a year’s
time, has a coupon rate of 7% and is trading at $103. Bond B, which is redeemable in two years, has a coupon rate
of 6% and is trading a t $102. Bond C, which is redeemable in three years, has a coupon rate of 5% and is trading at
$98.
To determine the yield curve, each bond’s cash flows are discounted in turn to determine the annual spot rates for
the three years, as follows:
The annual spot yield curve is therefore:
Year
1
2
3
88%
4.96%
5.80%
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Exam Level examples
A company wants to issue AA rated bond that is redeemable in four years for its par value or face value of $100, and
wants to pay an annual coupon of 5% on the par value. Estimate the price at which the bond should be issued.
The annual spot yield curve for a bond of this risk class is as follows:
One-year
Two-year
3.5%
4.0%
Three-year 4.7% Four-year 5.5%
Rating
Year 1
Year 2
Year 3
Year 4
AAA
14
25
38
52
AA
29
41
55
70
A
46
60
76
90
BBB
61
75
91
105
Answer:
Years
1
2
3
4
Cash flows
5
5
5
105
Discount
factors
=1.0379^-1
=1.0441^-2
=1.0525^-3
=1.062^-4
4.82
4.59
4.29
82.55
96.25
MV
Example:
A company wants to issue AA rated bond that is redeemable in four years for its par value or face value of $100, and
wants to issue bond at par value. Estimate the coupon at which the bond will be fully subscribed.
The
annual spot
yield
curve for
a
bond
of
this
risk
class
is
as
follows:
Oneyear 3.5%
Two- 4.0%
year
Three-4.7%
year
Four- 5.5%
year
Rating
Year
1
Year
2
Year
3
Year
4
AAA
14
25
38
52
AA
29
41
55
70
A
46
60
76
90
BBB
61
75
91
105
pg. 174 of 186
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Answer:
Years
0
1
2
3
4
4
Cash flows
(100)
X
X
X
X
100
=1.0379^-1
=1.0441^-2
=1.0525^-3
=1.062^-4
=1.062^-4
0.9635X
0.9173X
0.8577X
0.7861X
78.61
Discount
factors
1
100=0.9635X+0.9173X+0.8577X+0.7861X+78.61
100-78.61=3.5264X
X=6.07=6.07 %
Example
The directors are considering the following two alternative options when issuing the new bond:
(i)
Issue the new bond at a fixed coupon of 5% but at a premium or discount, whichever is appropriate to
ensure full take up of the bond; or
(ii)
Issue the new bond at a coupon rate where the issue price of the new bond will be $100 per unit and
equal to its par value.
The following extracts are provided on the current government bond yield curve and yield spreads for the sector in
which Cooperates: Current Government Bond yield curve
Years
1
2
3
4
5
3·2%
3·7%
4·2%
4·8%
5·0%
Bond Yield Spread
Bond Rating
AAA
AA
A
BBB
1 year
5
16
65
102
2 years
9
22
76
121
3 years
14
30
87
142
4 years
19
40
100
167
5 years
25
47
112
193
Calculate Market value of the first option and identify it is issued on discount or premium
Calculate Coupon of second option.
DETERMINATION OF INTEREST RATE FORWARDS
Supposing that a bank assesses and quotes the following rates to a company, based on the annual spot yield curve
for that company’s risk class:
One-year: 3.50%
Two-year: 4.60%
Three-year: 5.40%
Four-year: 6.10%
Five-year: 6.30%
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This indicates that the company would have to: pay interest at 3.50% if it wants to borrow a sum of money for one
year; pay interest at 4.60% per year if it wants to borrow a sum of money for two years; pay interest at 5.40% per
year if it wants borrow a sum of money for three years; and so on.
Alternatively, for a two-year loan, the company could opt to borrow a sum of money for only one year, at an interest
rate of 3.50%, and then again for another year, commencing in one year’s time, instead of borrowing the money for
a total of two years.
Although the company would be uncertain about the interest rate in one year’s time, it could request a forward
rate from the bank that is fixed today – for example, through a 12v24 forward rate agreement (FRA). The question
then arises: how may the value of the 12v24 FRA be determined?
Difference between these two is the duration of loan.
12V24
Total months
Period of hedging (after 12 months company wants to borrow)
A forward rate commencing in one year for a borrowed sum lasting a year can be calculated as follows:
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In summary:
Supposing the company wants to borrow a sum of money for three years on the basis of the above rates:
i
it
could pay
annual interest at
a
rate
of
5.40% in
each
of
the
three years, or
ii
it could pay interest at a rate 3.50% in the first year, 5.71% in the second year and 7.02% in the third year,
or iii. it could pay annual interest at a rate of 4.60% in each of the first two years and 7.02% in the third
year.
USING INTEREST RATE FORWARDS TO VALUE A SIMPLE INTEREST RATE SWAP CONTRACT
Supposing the above company has $100m borrowings in the form of variable interest rate loans repayable in five
years and pays interest annually equivalent to annual forward rates. It expects interest rates to increase in the future
and is therefore keen to fix its interest rate payments.
The bank offers to swap the variable interest rate payments for a fixed rate, such that the company pays a fixed rate
of interest to the bank in exchange for receiving a variable rate of return from the bank based on the above yield
rates less 50 basis points. The variable rate receipts from the bank will then be used to pay the interest on the loan.
The fixed equivalent rate of interest the company will pay the bank for the swap can be calculated as follows:
The current expected amounts of interest the company expects to receive from the bank, based on year 1 forward
rate and years 2, 3, 4 and 5 forward rates are:
Year 1
Year 2
Year 3
Year 4
Year 5
0.0300 x $100m = $3.00m
0.0521 x $100m = $5.21m
0.0652 x $100m = $6.52m
0.0773 x $100m = $7.73m
0.0660 x $100m = $6.60m
Note: The rates used to calculate the annual amounts are reduced by 50 basis points or 0.5%.
At the start of the swap, the net present value of the swap receipts based on the variable rates from the bank will
be the same as the costs based on the fixed amount paid to the bank.
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Let’s say R is the fixed amount of interest the company will pay the bank, then
Removing the brackets, the above expands to:
2.90m – 0.966R + 4.76m – 0.914R + 5.57m – 0.854R +
6.10m – 0.789R + 4.86m – 0.737R= 0
Simplifying this, adding all the $ flows together and R-flows together, gives:
24.19m – 4.26R = 0
$5.68m = R
In percentage = $5.68m/$100m = 5.68%
In practice the receipts and payments of the swap would be netted off such that the company will expect to pay
$2.68m ($5.68m – $3.00m) to the bank in year one, and expect to receive $0.84m ($6.52m – $5.68m) from the bank
in year three, and so on for the other years. The present values of these n et annual flows, discounted at the yield
curve rates, will be zero. The fixed rate of 5.68% is lower than the five-year spot rate of 6.30% because some of the
receipts and payments related to the swap contract occur in earlier years when the spot yield curve rate is lower.
Although at the commencement of the contract, the present value of the swap is zero, as interest rates fluctuate,
the value of the swap will change. For example, if interest rates increase and the company pay interest at a fixed
rate, then the swap’s value to the company will increase. The value of the swap contract will also change as the swap
approaches maturity, and the number of receipts and payments reduce.
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Expected values, decision trees and combined probabilities
A commonly used way of evaluating decisions is via the use of expected values.
An expected value summarises all the different possible outcomes by weighting the possible outcomes by their
probabilities and then summing the result.
A decision tree is a diagrammatic representation of a problem, where the decision maker needs to consider the
logical sequence of events.
Since one event may depend upon another, we may get situations where event one has a certain probability of
occurring and event two, which depends on event one occurring, has another probability of occurring. In such
circumstances, we have a situation of combined probabilities Eg if event one has a 0.6 chance of occurring and
subsequent event two a 0.75 chance of occurring, then overall the probability of both events occurring is:
0.6 x 0.75 = 0.45
ie a 45% chance of occurring.
Scenario
Brisport Master Motor Co (Brisport) designs, manufactures and sells a range of components for the motor car
industry. The design team has recently designed a new component for inclusion into hybrid cars. The component
greatly enhances the battery ‘road time’ and therefore reduces the frequency with which the battery has to be
recharged.
The company can either sell the design now, for its initial market value of $400,000, or attempt to develop the design
into a marketable product, which can be supplied to the motor industry. This development would have an initial
outlay of $300,000 now and the component would take one year to be developed. In such a fast moving market, the
component is likely to have a market life as a saleable product of just five years after development.
If the company decides to develop the component, the chances of succeeding in developing the design into the
marketable product are 80%. If the attempt to develop fails, the design can only be sold, in one year’s time, for half
of its earlier market value.
If the attempt to develop the design succeeds the company has a choice of either selling both the design and the
rights to sell the developed component, or marketing the component themselves.
Selling the design would yield $300,000 in one year’s time and $160,000 in royalty payments for each of the five
years thereafter (years 2 to 6).
If the component is marketed by Brisport then there is a 75% probability that the product will be popular and will
generate cash inflows of $440,000 per annum but there is a 25% probability that it will be unpopular and it will
generate cash outflows of $55,000 per annum. Both cash flow figures are also for each of years 2 to 6.
Brisport uses a weighted average cost of capital of 7% to discount its future cash flows. The management of Brisport
Master Motor Co seeks your advice as to their best course of action.
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Solution
There are two decisions which need to be taken by the company:
1.
sell the design or develop it
2.
if it is developed, then whether to sell the design and the rights to sell the developed component, or market
it themselves
In order to evaluate decision 1, decision 2 needs to be evaluated first. In other words, the values we use in decision
1 need to be determined by the decision we take in decision 2.
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Decision 2
The net present value ($000s) on the 75% path is 1,686 – 300 = 1,386.
Taken together with the net present value ($000s) on the 25% path of
(211) – 300 = (511)
there is an expected net present value of choosing to market the component of ($000s): [0.75 x 1,386] + [0.25 x
(511)] = 1,040 – 128 = 912
This is a higher value than the option of selling the design and the rights to sell the developed component for a net
present value of $594,000 ($894,000 – $300,000). Therefore, if the development goes ahead, it will be more
beneficial to market the product.
Of course, we still need to evaluate decision 1, whether to develop at all. The ‘success’ of the expected present value
of $912,000 in decision 2 has an 80% chance of arising, but there is a 20% chance of the development not succeeding
and recouping just half of the initial market value, that being $187,000 in present value terms, resulting in the
company being worse off by $113,000 in present value terms after taking the development costs into account.
Hence, the expected net present value of the development option of decision 1 can be calculated ($000s): = [0.80 x
912] + [0.20 x (113)] = 730 – 23 = 707
Since this is higher than the option to sell the design at time 0, $400,000, on an expected value basis, the component
should be developed and marketed.
Attitude to risk
The expected value approach assumes risk neutrality, but not all management decision makers are risk neutral. A
risk averse management would, in this scenario, be concerned with the 20% probability of being $113,000 worse off
in present value terms should the development decision go on to fail.
Furthermore, having taken the decision (at node 2) that marketing the component is preferred to selling both the
design and developed component there is a further risk of losses, since there is a 25% chance of the component
being unpopular leaving the company worse off by $511,000 in present value terms.
Combined with the 80% probability of the development being successful, there is an overall 20% chance of this
$511,000 loss. This 20% is known as a conditional probability since it depends upon the 80%
(0.80) success rate firstly and then depends on the 25% (0.25) unpopularity chance. Hence,
0.80 x 0.25 = 0.20 ie 20%
For completeness, there is of course a 75% chance of the component being popular if marketed, and hence the
overall combined probability of a successful development together with a marketing campaign which results in
popularity is: 0.80 x 0.75 = 0.60 i.e. 60%
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Summary
Net present
Outcome
Probability
value ($000s)
Development succeeds and component is popular
60%
Development succeeds but component is unpopular 20%
Development fails
20%
1,386
(511)
(113)
Therefore, be aware that expected values can lead to a false sense of security. The expected NPV of $707,000 is an
average. In other words, it is the average NPV if the decision is repeated over and over again. But is that useful in
this situation? This is a one-off development of a product and therefore only one of the outcomes listed in the table
above will actually occur. (This is analogous to tossing a coin once. We know that the outcome will either be a head
or a tail, not the expected value of ‘half a head’ or ‘half a tail’). As can be seen above, there is a 40% chance that the
NPV will be negative, and that is maybe a risk that the company is not prepared to take.
Furthermore, be aware that the analysis largely depends upon the values of the probabilities prescribed. Often these
are subjective estimates made by the decision makers and it would only take relatively small changes in these to
alter one of the decisions.
For example, in decision 2, if the probability of successful marketing falls to 55%, then the expected NPV of
‘marketing’ falls to:
[0.55 x 1,386] + [0.45 x (511)] = 762 – 230 = 532
This is now a lower value than the option of selling the design and the rights to sell the developed component for a
net present value of $594,000.
Such sensitivity analysis can be performed on other variables within the model.
Of course, decision models such as this are only as good as the information used. In reality there would probably be
a much wider range of possible outcomes than the discrete outcomes described above.
Patterns of behavior
Are all financial decisions rational? The assumption that they are underpins theories of economic behaviour and
stock market models, such as the efficient market hypothesis.
Why then do stock market booms and busts occur if investors are acting rationally? Rational behaviour surely implies
no shocks, with stock markets showing steady movements in share prices, but not sudden spurts. However,
unexpected and significant news could still result in sudden shocks.
Also, why are some mergers and acquisitions considered to be poor deals? If a listed company is being acquired,
surely the acquisition price should be based on the market value of its shares, if the markets are valuing it fairly. Why
then is there uncertainty about the true value of many acquired companies? Why also do many acquisitions run into
difficulties?
If proper due diligence has been done and decisions are made rationally, surely the directors of the acquiring
company will only go ahead if the combination stands a very good chance of success.
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Behavioural finance attempts to explain how decision makers take financial decisions in real life, and why their
decisions might not appear to be rational every time and, hence, have unpredictable consequences. Behavioural
finance has been described as ‘the influence of psychology on the behaviour of financial practitioners’ (Sewell, 2005).
Behavioural finance seeks to examine the following assumptions of rational decision making by investors and
financial managers:
1. Financial decision makers seek to maximise their utility and do so by trying to maximise portfolio or company
value.
2. They take financial decisions based on analysis of relevant information.
3. The analysis of financial information that they undertake is rational, objective and risk-neutral.
Let’s look at how behavioural factors may influence decision making and, therefore, stock markets’ and companies’
financial strategies.
Investors
Maximisation of utility
Rational decision making by investors implies that their decisions about their investment portfolios will aim to
maximise their long-term wealth and, hence, their utility. However, behavioural factors may influence investors to
take decisions that are not the best ones for achieving maximum value from their portfolios. Investors may have
preferences for particular stocks on non-financial grounds – for example, companies that they consider are acting
with social responsibility. They may also avoid ’sin stocks’ – companies operating in sectors that they regard as
unethical.
Investor utility may also be linked to the process of decision making. Some investors hold on to shares with prices
that have fallen over time and are unlikely to recover. They may do this because it will cause them psychological
hurt to admit, even only to themselves, that their decision to invest was wrong. This is known as cognitive
dissonance.
Analysis of relevant information
Behavioural finance next looks at the basis that investors use to take decisions. It suggests that decisions may not be
based on an assessment of relevant financial information, but on other grounds. Investors may use information that
is not relevant but is readily available, possibly to simplify the decision making process (known as anchoring). For
example, investors may buy shares that in the past have had high values, on the grounds that these represent their
true potential values, even though rational analysis suggests that the prices of these shares will remain low in the
future Investors may also believe that the probability of a future outcome will be influenced by how often the same
outcome has occurred in the past. A non-financial example of this idea would be the situation when a coin is flipped
eight times, comes up as tails every time and it is said that heads is more likely the ninth time as, by the ‘law of
averages’, heads must come up soon.
If the value of a company’s shares has risen for some time, investors will be using similar logic to the coin example if
they sell those shares on the grounds that the shares have gained in value for ‘long enough’ and their price must
therefore soon start to fall, even if rational analysis suggest that the rise in price will continue. This is known as the
gambler’s fallacy.
Another deviation from rational analysis is the herd instinct, where investors buy or sell shares in a company or
sector because many other investors have already done so. Explanations for investors following a herd instinct
include social conformity, the desire not to act differently from others. Following a herd instinct may also be due to
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individual investors lacking the confidence to make their own judgements, believing that a large group of other
investors cannot be wrong. If many investors follow a herd instinct to buy shares in a certain sector, for example the
IT sector, this can result in significant price rises for shares in that sector and lead to a stock market bubble.
Investors may not therefore base their decisions on rational analysis, but there is also evidence to suggest that stock
market ‘professionals’ often don’t do so either. Studies have shown that there are traders in stock markets who do
not base their decisions on fundamental analysis of company performance and prospects. They are known as noise
traders.
Characteristics associated with noise traders include making poorly timed decisions and following trends. Chartism,
using analysis of past share prices as a basis for predicting the future, is an example of noise trading.
Fund managers may also be subject to behavioural influences. Fund managers who wish to give the impression that
they are actively managing their investment portfolios, may periodically reposition their portfolios into new sectors,
even though the old sectors continue to have good prospects. Some fund managers also ignore companies with low
market capitalisation, with the result that their shares are not purchased and their value remains low (known as
small capitalisation discount).
Rational, objective and risk-neutral analysis
Investors may base their decision on an analysis of available information, but behavioural finance has highlighted
that this analysis can be subjective. One aspect is confirmation bias, taking an approach or paying attention to
evidence that confirms investors’ current beliefs about their investments and ignoring evidence that casts doubt on
their beliefs. In the dotcom boom, some investors used a variety of methods to value high-tech companies at a large
premium, but ignored models such as cash flow valuation models that indicated the worth of those companies was
much lower.
Another aspect of investor bias is attitudes towards risks. Rational theory suggests that risk-neutral investors will
adopt a long-term approach based on expected values. However, behavioural finance has highlighted various
attitudes towards the risks of making profits or losses. Some investors may be attracted by a company that offers
the possibility of making very high returns, even if the possibility is not very great (again, the dotcom boom provides
evidence of this).
Other investors may have regret aversion, avoiding investments that have the risk of making losses, even though
expected value analysis suggests that, in the long-term, they will make significant capital gains. Investors with regret
aversion may also prefer to invest in companies that look likely to make stable, but low, profits, rather than
companies that may make higher profits in some years but possibly losses in others.
There is also evidence that many investors pay most attention to the last set of financial results and other recent
information about a company, and take less notice of data that has been available for a while. Explanations for this
have included recent information being more readily accessible and more immediate in investors’ minds than older
information. A consequence of this may be over-reaction when companies release information, with share prices
rising or falling quickly after information is released and then going back in the opposite direction to an equilibrium
value over time.
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Behavioural finance also suggests that there may be a momentum effect in stock markets. A period of rising share
prices may result in a general feeling of optimism that price rises will continue and an increased willingness to invest
in companies that show prospects for growth. If a momentum effect exists, then it is likely to lengthen periods of
stock market boom or bust.
Finance managers
Behavioural finance studies have also looked at decision making by managers of companies. They have identified
factors that affect investment decisions of all types, but particularly focused on mergers and acquisitions, since many
do not appear to fulfil the expectations of the acquiring company.
Maximisation of utility
Companies can be regarded as maximising their utility by long-term maximisation of their shareholders’ wealth.
However, it is not just behavioural finance that casts doubt on whether company managers are seeking this objective
for their shareholders. Agency theory also highlights that managers may have different objectives from shareholders,
such as maximising their own short-term rewards and expanding the company by acquisition or other means in order
to enhance their own reputation.
However, behavioural finance has highlighted that managers’ objectives may not be explainable rationally. Studies
have looked at contested takeovers, where different companies bidding against each other has forced the
acquisition price up to a level that was significantly greater than many outside the companies involved thought was
reasonable. One theory for this is that once managers enter into competition, it makes acquiring a company that
others have sought to buy as well, a source of satisfaction in itself. The acquirer’s managers are unwilling to let
someone else have what they have been trying to acquire (known as loss aversion bias).
Analysis of relevant information
There is also evidence that when managers choose to bid for another company, the factor is sometimes not a rational
assessment of the target’s potential, but their belief in their own abilities. Some managers of acquiring companies
seem to believe that, however poor the outlook for the target seems, their own considerable management skills will
improve its prospects after the merger takes place. A symptom of this belief could be managers arguing that the
target should be valued not using its own price-earnings ratio, but using the (higher) price-earnings ratio of the
acquirer.
Once an acquisition or any other strategy has been implemented, what influences managers may be the need to
show that they have made the right decisions. Managers may feel that a failing strategy would damage their
reputation, and possibly their future prospects. Therefore, they may decide to commit more funds trying to ensure
that the strategy is successful, rather than admitting defeat and taking steps to mitigate losses (known as
entrapment).
Rational, objective and risk-neutral analysis
Managers may also be subjective when they analyse information. Also, they may have confirmation bias, paying
attention to information that suggests that an acquisition will enhance value and ignoring evidence that indicates
that the target will not be a good buy. They may also seek information that provides a simple yardstick for their own
decision making, however flawed that information may be. The value put on the target company by its own directors
may be subject to considerable bias, but the acquirer’s directors may regard it as a good indication of what the
target’s fair value is.
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Limitations of behavioural finance
Critics of the behavioural finance approach have argued that even if individuals make irrational decisions when left
by themselves, participating in finance markets helps discipline them to act rationally by giving them opportunities
to learn from their experiences. The consequences of irrational decisions are shortterm anomalies. In the longerterm general theories, such as the efficient market hypothesis, will apply.
Conclusion
Behavioural finance has identified a number of factors that may take individuals away from a process of taking
decisions to maximise economic utility on the basis of rational analysis of all the information supplied. If these factors
apply in practice, they can lead to movements from what would be considered a fair price for an individual company’s
shares, and the market as a whole to a period where share prices are collectively very high or low. For an acquisition,
it can lead to a purchase price that differs significantly from what appears to be a rational valuation.
pg. 186 of 186
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EXAMPLE 1 Henry
Jupiter is a suitable proxy co
Ba = 1.5 x
88
= 1.39
88 + 12(0.6)
Financial sector
Ba = 0.9 x
75
= 0.75
75 + 25(0.6)
Calculate Avg Ba
0.75 x 1/3 +
1.38 x 2/3
= 1.18
Now Regear with the own co gearing
1.18
= Be x 70
= 1.48
70 + 30(0.6)
Now calculate ke by using CAPM
Ke = Rf + Be ( Rm- Rf)
=4.5% + 1.48(3.5%)
= 9.7%
Kd =( 4.5% + 2.5% ) x 0.6
= 4.2%
WACC = 9.7 % x 0.7 + 4.2% x 0.3 = 8%
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EXAMPLE 2 MLIMA CO
EXAMPLE 3 LOUIS CO
Use Reka Co’s information to estimate the component project’s asset beta. Then based on Louis Co’s
capital structure, estimate the component project’s equity beta and weighted average cost of capital.
Assume that the beta of debt is zero.
Reka Co MVe = $4.50 x 80m shares = $360m
Reka Co MVd = $105/100 x 340 = $357m
Reka Co portfolio asset beta =
βa = βe x E
E + D ( 1-T)
βa = 1.6 x 360/ 360 + 357 ( 1 – 0.2 )
βa = 0.892
βa of non luxury transport = 0.80
Calculate βa of luxury transport
0.892= luxury transport asset beta x 0•15 + 0.80 x 0•85
luxury transport asset beta = [0.892 – (0.80 x 0•85)]/0•15 = 1•413
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Component equity beta based on Louis Co capital structure =
1.413 =βe x
979
979 + 347.3 ( 1-0.2)
Be = 1.81
Using CAPM,
Ke = 4% + 1•81 x 6% = 14•88% ≈ 15%
Kd = Rf + credit spread
= 4 % + ( 0.8 )
= 4.8%
Component WACC = (15% x $979 + 4.8%( 1- 0.2) x $347.3m)
($979m +$347.3m)
= 12%
W-1
M.V of debt=
Yrs
1-4
4
C.F
5.4
100
D.F
3.562
0.829
PV
19.235
82.9
102
Total value = 102/100X340= 347.3
Example 4 Lirio co
If the large project is not undertaken and dividend growth rate is maintained at the historic level
Dividend history
Year to end of February
2013
2014
2015
2016
Number of $1 equity shares in issue (000)
60,000 60,000 80,000 80,000
Total dividends paid ($000)
12,832 13,602 19,224 20,377
Dividend per share
$0·214 $0·227 $0·240 $0·255
Average dividend growth rate = (0·255/0·214)1/3 – 1 = 1·0602 (or say 6%)
Expected dividend in February 2017 = $0·255 x 1·06 = $0·270
Lirio Co, estimate of value if large project is not undertaken =
$0·270/(0·12 – 0·06) = $4·50 per share or $360 million market capitalization
Dividend capacity funds left after transfer
$4,760,000
Annual dividend per share after transfer
$0·0595
Annual dividend paid (end of February 2017 and February 2018) $0·0595
Dividend paid (end of February 2019)
$0·3100
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New growth rate
7%
Lirio Co, estimate of value if large project is undertaken
=$0·0595 x 1·12–^1+ $0·0595 x 1·12–^2+ $0·3100 x 1·12–^3
+ [$0·3100 x 1·07/(0·12 – 0·07)] x 1·12–^3 = $5·04 per share or $403 million market capitalisation
Example 5 Rayn co
Years
1
2
3
4
5
Sales revenue@ 5%
15729
16515
17341
18208
PBIT @ 17.25%
2713
2849
2991
3141
Tax @ 22%
(597)
(627)
(658)
(691)
Capex
(299.6 )
(314.4)
(330.4)
(346.8)
FCFF
1816
1907.6
2002.6
2103.2
Disc @ 9%
0.917
0.842
0.772
0.708
0.708
p.v
1665
1606
1546
1489
25562
2103.2 x ( 1+0.03)/ 0.09-0.03
= 31868
Example 6 Frank
Co is financed entirely by equity therefore we can assume that its cost of capital is the same as its cost
of equity.
Estimated market value = Free Cash Flow (FCF) x (1 + g) / (ke – g)
Where g = growth rate
ke = cost of capital
Free Cash Flow = NOPAT – net investment in assets
= $580,000 = $180,000 = $400,000
Cost of equity (ke) = RI + β (Rm – RI) = 5 + (6 x 1.26) = 12.56%
Growth rate
= retention rate x cost of capital
= (180 / 580) x 12.56 = 3.90%
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Estimated market value = 400,000 x (1.039) / (0.1256 – 0.039) = $4,799,076
Example 7 Rayn co
Estimate of current value of Rayn Co’s equity based on free cash flows
Total value = Free cash flows × (1 + growth rate (g))/(Cost of capital (k) – g)
k = 11%
Past growth rate = (latest profit before interest and tax (PBIT) / Earliest PBIT) 1/no of periods of growth - 1
Past g = (1,230/970) 1/3 - 1 = 0.0824
Future g = 0.25 × 0.0824 = 0.0206
Free cash flow calculation
Free cash flow (FCF) = PBIT + non-cash flows – cash investment – tax
FCF = 1,230,000 + 1,206,000 – 1,010,000 – (1,230,000 × 20%) = $1,180,000
Total value = $1,180,000 × 1.0206/(0.11 – 0.0206) = $13,471,007
Equity value = $13,471,007 - $6,500,000 = $6,971,007
Number of shares = $960,000/$0.40 = 2.4 million
Equity value per share = $6,971,007/2.4 million shares = $2.90
Example 8 sin co
Sin co Be = 1.10
Mv of E = 60
Mv of D = 40
Ba = 1.10 x 60/ 60+40(1-0.22)
Ba = 0.72
Hank co Ba = 0.68
Ba(avg) = 0.72 x 60 + 0.68 x 21
60+21
= 0.709
60+21
0.709= Be x 60/(60+40(1-0.2)
Be= 1.078
Ke= 4.3 + 1.078(7) = 11.85
WACC = 11.85 x 0.6 + 6 (1-0.22) x0.4 = 8.9 ≈ 9%
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Example 9 Nemar co
Value of combined company
Year
1
$000
51,952
15,586
(4,364)
(513)
10,709
0.917
9,825
Sales revenue – growth rate 5.8%
Operating profit (30% of sales)
Tax at 28%
Less additional investment (W1)
Free cash flow
Discount factor 9% (W2)
Discounted cash flow
2
3
4
$000
$000
$000
54,965 58,153
61,526
16,490
17,446
18,458
(4,617)
(4,885)
(5,168)
(542)
(574)
(607)
11,331
11,987 12,683
0.842
0.772
0.708
9,541
9,256
8,985
Total discounted cash flows (years 1 – 4)
37,607
Terminal value (W3)
151,566
Total value of combined company
189,173
Synergy benefits
= Total value of combined company – total value of individual companies
= $189,173,000 – ($140,000,000 + $40,104,000)
= $9,069,000
Premium required to purchase Fodder Co = 25% of equity
Equity = 90% of $40,104,000 = $36,093,600
Premium = $9,023,400
Net benefits to Pursuit’s shareholders = $9,069,000 – $9,023,400 = $45,600
Workings
(1) Additional investment
Year
Sales revenue increase ($000)
18% of increase
1
See note below
2
54,965 – 51,952 = 3,013
542
3
58,153 – 54,965 = 3,188
574
4
61,526 – 58,153 = 3,373
607
Note – the additional investment for Year 1 is given in the question
(2) Combined company cost of capital
Asset beta is calculated using the formula:
Asset beta (nemar ) = 1.18 (0.5/[0.5 + 0.5 (1 – 0.28)]) = 0.686 (assume debt beta = 0)
Asset beta (roney ) = 1.53 (0.9/[0.9 + 0.1 (1 – 0.28)]) = 1.417 (assume debt beta = 0)
Asset beta (combined company)
= [(0.686 $140m) + (1.417 $40.095m)]/(140m + 40.095m) = 0.849
Equity beta (combined company) = 0.849 [0.5 + (0.5 0.72)]/0.5 = 1.46
Cost of equity (ke) = 4.5% + 1.46 6% = 13.26%
WACC = [13.26% 0.5] + [6.4% (0.5 0.72)] = 8.93% (say 9%)
(3) Terminal value
Growth rate is halved to 2.9% pa.
PV of cash flows in perpetuity = 12,683 [1.029/(0.09 – 0.029)] = $213,948
Discounted back to year 0 = $213,948 0.708 = $151,566
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Example 10 Rayn co
Cash offer
Gain in value to a Rayn Co shareholder = ($2.95 – $2.90)/$2.90 = 1.7%
Additional earnings post-acquisition = $620,000 + $150,000 = $770,000
Additional earnings per share = $770,000/10m = 7.7c per share
Using the P/E ratio to calculate the increase in share price = 15 × 7.7c = $1.16
Additional value created = $1.16 × 10 million = $11.6 million
Less cost of acquisition = ($2.95 × 2.4 million) = $7.08 million
Value added for Meon Co shareholders = 11.6 million – 7.08 million = $4.52 million
Gain in value to a shareholder of Meon = $4.52m/10m = 45.2c
45.2c/480c = 9.4%
Share-for-share offer
Earnings of combined company = $770,000 (from above) + $3,200,000 = $3,970,000
Total number of shares in combined number = 10 million + (2.4million × 2/3) = 11,600,000
EPS of combined company = $3.97m/11.6m = 34.2c
Expected share price using P/E ratio = 34.2 × 15 = 513c = $5.13
Gain in value to a shareholder of Meon Co = ($5.13 – $4.80)/$4.80 = 6.9%
Current value of three shares in Rayn Co = $2.90 × 3 = $8.70
Gain in value to a shareholder of Rayn Co = ((2 × $5.13) – $8.70) /$8.70 = 17.9%
Example 11 Abel co
Abel Co ’s current value = $3.2 x 380m = $1,216m
Abel Co, profit after tax = $158·2m x 0·8 = $126·56m
Abel Co, PE ratio before acquisition = $1,216m/$126·56m = 9·61
Abel Co, PE ratio after acquisition = 9.61 x 1·17 = 11.24
Adam Co, PE ratio before acquisition = 9.61 x 1·3 = 12.49
Adam Co’s current value = 12.49 x ($23·0 x 0·8) = $230.6m
Value created from combined company
($126·56m + 0·5 x $23·0m x 0·8 + $7.5m) x 11.24 = $1,610·24
Maximum premium = ($1,610·24m) – ($1,216m + $230·6m) = $163.64m
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Example 12 Krish co
Based on spot mid-rates: US$1·295/£1; CAD1·67/£1; JPY132·75/£1
In £000
Payments from
UK
R
UK
e
USA
3,474.9
c
Canada
658.7
e
Japan
i
USA
Canada
1,621.6
2,035.9
1,158.2
Japan
Total
3,657.5
1,081.08
5,714.3
1,916.2
2,574.9
2,410·5
2,410·5
Total payments
4,133.6
4,032.1
3,194.2
2,997.3
p
Total receipts
3,657.5
5,714.3
2,574.9
2,410·5
t
Net receipt/(payment) (476.1)
1682.2
(619.3)
(586.8)
Each of krish Co, trudeau Co and shinzo Co will make payments of £ equivalent to the amount given
above to Lala Co. 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
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Example 13 : IEM Co
The foreign exchange exposure of the dollar payment due in four months can be hedged using the
following derivative products:
Forward rate ;
Exchange-traded futures contracts; and
Exchange-traded options contracts
Using the forward rate
Forward rate = 1·0542 + [(1·0545 – 1·0542) x 1/3] = 1.0543
Payment = US$1,060,000/1·0543 = £1005406
Using futures contract
Since a dollar payment needs to be made in four months’ time, Co needs to hedge. Hence, the
company should go short and the six-month futures contract is undertaken. It is assumed that the basis
differential will narrow in proportion to time.
[ predict futures rate based on spot rate: 1·0530 + [(1·0545 – 1·0530) x 4/6] = 1·054]
Expected payment = US$1,060,000/1·054 = £1005693
No. of contracts sold = £1005693/£125,000 = 8 contracts
Using options contracts
Exercise price US$1·06/CHF1
Payment = US$1,060,000/1·05 = £1009523
Buy £1009523/£125,000 =8 contracts
payment = £1009523
Premium payable = 8 x £125,000 x 0·0216 = $21600
In £ = $21600/1·0530 = £20513
Amount not hedged = US$1,060,000 – (38 x £125,000 x 1·05) = US$10,000
Use forward contracts to hedge this = US$10,000/1·0543 = £9485
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Total payment = £1009523 + £20513 + £9485 = £1039521
Exercise price US$1·07/CHF1
Payment = US$1,060,000/1·06 = £1000000
Buy 1000000/125,000 = 8 contracts
payment =£1000000
Premium payable = 8 x£125,000 x 0·0263 = US$26300
In £ = 26300/1·0530 = £24976
Amount over- under hedged = US$1,060,000 – (8 x 125,000 x 1·06) = 0
Total payment = £1000000 + £24976= £1024976
Example 14; pearson co
(a) Hedging strategy
Forward contract
Receipt in € = US$30m/1.3676 = €21936239
Futures contract
A 2 month contract is too short for the required hedge period therefore we must use a 5 month
contract.
The contract will be closed out in four months’ time.
Predicted futures rate = 1.3698 – [1/3 x (1.3698 – 1.3633)] = 1.3676
Using the predicted futures rate, expected receipt = US$30m/1.3676 = €21936239
Number of contracts = €21936239/€125,000 = 175 contracts
Options
With options the holder has the right but not the obligation to exercise the option (that is, the option
will be
exercised if it is beneficial to the holder). However there is a premium to be paid for this flexibility,
making
options more expensive than futures and forward contracts.
To protect itself against a weakening US$, co will purchase Euro call options.
Exercise price = $1.36
Receipts = $30m/1.36 = €22058824
Number of contracts = €22058824/€125,000 = 176 contracts
With 176 contracts, receipts = €125,000 x 176 = €22000000
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Premium payable = $0.0280 x 176 x 125,000 = $616000 (or $616000/1.3585 = €453441)
Amount not hedged = US$30m – (176 x €125,000 x 1.36) = US$80,000
This amount can be hedged using a 4 month forward contract as follows:
US$80,000/1.3676= €58497
Total receipts = €22000000 - €453441 + €58497 = €21605056
Exercise price $1.38
Receipts = $30m/1.38 = €21739130
Number of contracts = €21739130/€125,000 = 173.8 contracts (purchase 174 contracts)
With 115 contracts, receipts = €125,000 x 174 = €21750000
Premium payable = $0.0223 x 174 x 125,000 = US$485025 (or $485025/1.3585 = €357030)
Amount over hedged = US$30m – (174 x €125,000 x 1.38) = US$15000
This amount can be hedged using a 4 month forward contract as follows:
US$15000/1.3623 = €11011
Total receipts = €21750000 – €357030 - €11011 = €21381959
Example 15 ; Lignum co
Transactions exposure, as faced by Lignum Co in situation one, lasts for a short while and is easier to
manage by means of derivative products or more conventional means. Here Lignum Co has access to
two derivative products: an OTC forward rate and OTC option. Using the forward rate gives a higher
return of €963,988, compared to options where the return is €936,715 (see appendix I). However, with
the forward rate, Lignum Co is locked into a fixed rate (ZP145·23 per €1) whether the foreign exchange
rates move in its favour or against it. With the options, the company has a choice and if the rate moves
in its favour, that is if the Zupeso appreciates against the Euro, then the option can be allowed to lapse.
Lignum Co needs to decide whether it is happy receiving €963,988, no matter what happens to the
exchange rate over the four months or whether it is happy to receive at least €936,715 if the ZP
weakens against the €, but with a possibility of higher gains if the Zupeso strengthens
Lignum Co should also explore alternative strategies to derivative hedging. For example, money
markets, leading and lagging, and maintaining a Zupeso account may be possibilities. If information on
the investment rate in Zupesos could be obtained, then a money market hedge could be considered.
Maintaining a Zupeso account may enable Lignum Co to offset any natural hedges and only convert
currency periodically to minimise transaction costs.
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Example 16 AFC Co
(b)
AFC Co
Counterparty
2·2%
3·8%
1·6%
Yield rate + 0·8%
0·4%
Fixed rate
Floating rate
Yield rate + 0·4%
Interest rate differential
Co has a comparative advantage in borrowing at the fixed rate and the counterparty has a comparative
advantage in borrowing at the floating rate. Total possible benefit before Bank’s fee is 1·2%, which if
shared equally results in a benefit of 0·6% each, for both CMC Co and the counterparty.
CMC Co
CMC Co borrows at
Counterparty
2·2%
Counterparty borrows at
Yield rate + 0·8%
Advantage
60 basis points
60 basis points
Net result
Yield rate – 0·2%
3·2%
SWAP
Counterparty receives
Yield rate
CMC Co pays
Yield rate
Counterparty pays
2·4%
CMC Co receives
2·4%
After paying the 20 basis point fee, CMC Co will effectively pay interest at the yield curve rate and
benefit by 40 basis points or 0·4%, and the counterparty will pay interest at 3·4% and benefit by 40 basis
points or 0·4% as well
Example 17 ; AFC Co
Annuity factor, 4 years, 2% = 3·808
Equal annual amounts repayable per year = CHF80,000,000/3·808 = CHF21008403
Macaulay duration
(21008403x 0·980 x 1 year +
21008403x 0·961 x 2 years +
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21008403x 0·942 x 3 years +
21008403x 0·924 x 4 years)/80,000,000 =2.47years
Modified duration = 2·47/1·02 = 2·42 years
The equation linking modified duration (D), and the relationship between the change in interest rates
(∆i) and change in price or value of a bond or loan (∆P) is given as follows:
∆P = [–D x ∆i x P]
(P is the current value of a loan or bond and is a constant)
The size of the modified duration will determine how much the value of a bond or loan will change when
there is a change in interest rates. A higher modified duration means that the fluctuations in the value of
a bond or loan will be greater, hence the value of 2·42 means that the value of the loan or bond will
change by 2·42 times the change in interest rates multiplied by the original value of the bond or loan.
The relationship is only an approximation because duration assumes that the relationship between the
change in interest rates and the corresponding change in the value of the bond or loan is linear. In fact,
the relationship between interest rates and bond price is in the form of a curve which is convex to the
origin (i.e. non-linear). Therefore duration can only provide a reasonable estimation of the change in the
value of a bond or loan due to changes in interest rates, when those interest rate changes are small.
Example 18 ; Bond yield
(i) Value of 5% coupon bond
$5 x 1•0385^–1 + $5 x 1•0446^–2 + $5 x 1•0507^–3 + $5 x 1•0580^–4 + $105 x 1•0612^–5 = $95•72
Hence the bond will need to be issued at a discount if only a 5% coupon is offered.
(ii) New coupon rate for bond valued at $100 by the markets
Since the 5% coupon bond is only valued at $95•72, a higher coupon needs to be offered. This coupon
amount can be calculated by finding the yield to maturity of the 5% coupon bond discounted at the above
yield curve. This yield to maturity will be the coupon amount for the new bond such that its face value will
be $100.
Therefore,
if
the
yield
to
maturity
is
denoted
by
YTM
then
$5 x (1 + YTM)^–1 + $5 x (1 + YTM)^–2 + $5 x (1 + YTM)^–3 + $5 x (1 + YTM)^–4 + $105 x (1 + YTM)^–5
= $95•72
Solve by trial and error, assume YTM is 5•5%. This gives the bond value as $97•86.
Assume YTM is 6%; this gives the bond value as $95•78, which is close enough to $95•72
$5 x (1•06)^–1 + $5 x (1•06)^–2 + $5 x (1•06)^–3 + $5 x (1•06)^–4 + $105 x (1•06)^–5 = $95•78
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Hence if the coupon payment is 6% or $6 per $100 bond unit then the bond market value will equal the
par value at $100.
$6 x (1•06)^–1 + $6 x (1•06)^–2 + $6 x (1•06)^–3 + $6 x (1•06)^–4 + $106 x (1•06)^–5 = $100
Alternatively:
Take R as the coupon rate, such that:
(R x 1•0385^–1) + (R x 1•0446^–2) + (R x 1•0507^–3) + (R x 1•0580^–4) + (R x 1•0612^–5) + (100 x
1•0612^–5) = $100
4•2826R + 74•30 = $100
R = 6% or $6 per $100
Advice:
If only a 5% coupon is offered, the bonds will have to be issued at just under a 4•3% discount. To raise
the full $150 million, if the bonds are issued at a 4•3% discount, then 1,567,398 $100 bond units need to
be issued, as opposed to 1,500,000. This is an extra 67,398 bond units for which Co will need to pay an
extra $6,739,800 when the bonds are redeemed in five years.
On the other hand, paying a higher coupon every year of 6% instead of 5% will mean that an extra
$1,500,000 is needed for each of the next five years.
If the directors feel that the drain in resources of $1,500,000 every year is substantial and that the
project’s profits will cover the extra $6,739,800 in five years’ time, then they should issue the bond at a
discount and at a lower coupon rate.
On the other hand, if the directors feel that they would like to spread the amount payable then they should
opt for the higher coupon alternative
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