P4 MISCELLANEOUS TOPICS
P4 MISCELLANEOUS TOPICS
1
SINGLE PERIOD AND MULTI-PERIOD CAPITAL RATIONING. MULTI-PERIOD CAPITAL RATIONING TO INCLUDE THE FORMULATION OF
PROGRAMMING METHODS AND THE INTERPRETATION OF THEIR OUTPUT
2
PROJECT DURATION AS A MEASURE OF RISK
3
PROBABILITY ANALYSIS AND SENSITIVITY ANALYSIS WHEN ADJUSTING FOR RISK AND UNCERTAINTY IN INVESTMENT APPRAISAL
4
OUTLINE THE APPLICATION OF MONTE CARLO SIMULATION TO INVESTMENT APPRAISAL.
5
ESTABLISH THE POTENTIAL ECONOMIC RETURN (USING INTERNAL RATE OF RETURN (IRR) AND MODIFIED INTERNAL RATE OF
RETURN) AND ADVISE ON A PROJECT’S RETURN MARGIN. DISCUSS THE RELATIVE MERITS OF NPV AND IRR.
6
THE MEASUREMENT AND INTERPRETATION OF PROJECT VALUE AT RISK.
SINGLE PERIOD AND MULTI-PERIOD CAPITAL RATIONING. MULTI-PERIOD CAPITAL RATIONING TO INCLUDE THE FORMULATION OF PROGRAMMING METHODS AND THE INTERPRETATION OF THEIR OUTPUT
Reluctance to issue additional share capital because
of concerns that this may lead to outsiders gaining
control of the business
Unwillingness to issue additional share capital if it
will lead to a dilution of earnings per share.
Unwillingness to commit to large fixed interest
payments
Restriction on capital expenditure budgets
Investment restriction to a level that can be
financed solely from retained earnings
Soft capital rationing
Internal budget ceiling being imposed on such expenditure by
management
Multi-period capital
rationing
Restriction on an organisation's ability to invest
capital funds
external limitations being applied to the company, as when
additional borrowed funds cannot be obtained
Hard capital rationing
Restrictions on bank lending due to government
control
Costs associated with making small issues of capital
may be too great
Lending institutions may consider an organisation to
be too risky to be granted further loan facilities
For single period capital rationing problems, divisible projects are ranked according to the profitability index
When capital rationing is present across multiple periods, linear programming may be used to solve the problem of which projects to undertake
PROJECT DURATION AS A MEASURE OF RISK
Duration
Project duration is a measure of the average time over which a project delivers its value.
It is calculated by weighting each year of the project by the % of the present value of the cash inflows received in that year.
The lower the project duration the lower the risk of the project.
A duration of 2.19 means that project delivers its value over 2.19 years i.e. it has the same duration as a project that delivers 100% of its cash inflows in 2.19 years time.
This method looks at the cash flows over the whole life of the project (unlike techniques like payback)
Calculation:
1
Calculate PV of all cash flows
2
Multiply each PV of cashflow by the year
3
Divide sum of 1) by sum of 2)
Study Guide: Assess an organisation’s debt exposure to interest rate changes using the simple Macaulay duration and modified duration methods.
Study Guide: Discuss the benefits and limitations of duration including the impact of convexity.
Properties of duration
The basic features of sensitivity to interest rate risk will all be mirrored in the duration calculation.
Longer-dated bonds will have longer durations.
Lower-coupon bonds will have longer durations. The ultimate low-coupon bond is a zero-coupon bond where the duration will be the maturity.
Lower yields will give longer durations. In this case, the PV of flows in the future will rise if the yield falls, extending the point of balance, therefore lengthening the
duration.
Modified duration
Modified duration is a measure of the sensitivity of the price of a bond to a change in interest rates.
Rather than looking at the weighted average time it takes to receive the bond's benefits, modified duration measures how sensitive the price of the bond is to a change in the interest
rate.
Where GRY is gross redemption yield
There is an inverse relationship between yield and bond price, therefore the modified duration figure is expressed as a negative number.
The benefits and limitations of duration
Benefits:
Duration allows bonds of different maturities and coupon rates to be directly compared. This makes decision making regarding bond finance easier and more effective.
If a bond portfolio is constructed based on weighted average duration, it is possible to determine portfolio value changes based on estimated changes in interest rates.
Managers may be able to modify interest rate risk by changing the duration of the bond portfolio – for example, by adding shorter maturity bonds or those with higher coupons (which
will reduce duration), or by adding longer maturity bonds or those with lower coupons (which will increase duration).
Limitations:
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
there will be an equal percentage change in price.
However, as interest rates change the bond price is unlikely to change in a linear fashion. Rather, it will have some kind of convex relationship with interest rates (see below).
Duration can only be applied to measure the approximate change in bond price due to changes in interest rates if the interest rate change does not lead to a change in the shape of the
yield curve.
PROBABILITY ANALYSIS AND SENSITIVITY ANALYSIS WHEN ADJUSTING FOR RISK AND UNCERTAINTY IN INVESTMENT APPRAISAL
Sensitivity analysis measures the change in a particular variable which can be tolerated before the NPV of a project reduces to zero
OUTLINE THE APPLICATION OF MONTE CARLO SIMULATION TO INVESTMENT APPRAISAL.
NB: Candidates will not be expected to undertake simulations in an examination context but will be expected to demonstrate an understanding of (i) Simple
model design (ii) The different types of distribution controlling the key variables within the simulation (iii) The significance of the simulation output
and the assessment of the likelihood of project success (iv) The measurement and interpretation of project value at risk.
Monte Carlo Simulation
The Monte Carlo method of estimating a project's NPV assumes that the key factors affecting NPV can be modelled as a probability distribution.
The method amounts to adopting a particular probability distribution for the uncertain (random) variables that affect the NPV and then using
simulations to generate values of the random variables.
The basic idea is to generate through simulation thousands of values for the parameters or variables of interest and use those variables to derive the
NPV for each possible simulated outcome.
From the resulting values we can derive the distribution of the NPV.
ESTABLISH THE POTENTIAL ECONOMIC RETURN (USING INTERNAL RATE OF RETURN (IRR) AND MODIFIED INTERNAL RATE OF RETURN) AND ADVISE ON A PROJECT’S RETURN MARGIN. DISCUSS THE RELATIVE MERITS
OF NPV AND IRR
Internal Rate of Return
A project will only be selected if its internal rate of return exceeds the cost of capital or target rate of return.
The internal rate of return (IRR) of any investment is the discount rate at which the NPV is equal to zero. Alternatively, the IRR can be thought of as the return that is delivered
by a project.
Modified internal rate of return (MIRR)
The modified internal rate of return is the IRR that would result if it was not assumed that project proceeds were reinvested at the IRR.
The modified internal rate of return (MIRR) overcomes the problem of the reinvestment assumption and the fact that changes in the cost of capital over the life of the project
cannot be incorporated in the IRR method.
The MIRR is calculated on the basis of investing the inflows at the cost of capital.
Advantages of MIRR
MIRR assumes the reinvestment rate is the company's cost of capital. IRR assumes that the reinvestment rate is the IRR itself, which is usually untrue.
In many cases where there is conflict between the NPV and IRR methods, the MIRR will give the same indication as NPV, which is the correct theoretical method. This helps
when explaining the appraisal of a project to managers, who often find the concept of rate of return easier to understand than that of NPV.
Disadvantages of MIRR
MIRR, like all rate of return methods, suffers from the problem that it may lead an investor to reject a project which has a lower rate of return but, because of its size,
generates a larger increase in wealth.
In the same way, a high-return project with a short life may be preferred over a lower-return project with a longer life.
THE MEASUREMENT AND INTERPRETATION OF PROJECT VALUE AT RISK.
The project value at risk is the potential loss of a project with a given probability.
Value at risk (VAR) is the minimum amount by which the value of an investment or 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.
For example, we may say that the 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.
EVALUATE THE USE OF THE REVERSE TAKEOVER AS A METHOD OF ACQUISITION AND AS A WAY OF OBTAINING A STOCK MARKET LISTING
Reverse takeover
A reverse takeover involves a large unlisted company being bought by a smaller listed company using a share for share exchange. The larger company will then be the dominant partner in a listed
company. This is both a method of acquisition and a way of obtaining a stock market listing.
The term ‘reverse takeover’ describes a situation where a smaller quoted company (Company S) takes over a larger unquoted company (Company L) by a share for share exchange.
To acquire Company L, a large number of Company S shares will have to be issued to Company L’s shareholders. This will mean that Company L will hold the majority of shares and will therefore
have control of the company.
The company will then often be renamed, and it is normal for the larger company (Company L) to impose its own name on the new entity.
Advantages of a reverse takeover
Compared to an IPO, a reverse takeover has a number of potential advantages:
Speed
An IPO typically takes between 1 and 2 years. Over this period a prospectus needs to be prepared, and investor road shows will be required to drum up interest in the listing. The shares will
need to be priced and the share issue will need to be administered.
By contrast a reverse takeover can be completed in a matter of months, perhaps even as quickly as one month.
Cost
An IPO is a lengthy process and will involve guidance an advice from investment banks acting as sponsors. The costs of an IPO can be between 5% and 35% of the amount of finance raised. A reverse
takeover will have significantly lower issue costs.
Availability
In a downturn, it may be difficult to stimulate investor appetite for an IPO. This is not an issue for a reverse takeover.
Disadvantages of a reverse takeover
Risk
There is the risk that the listed company being used to facilitate a reverse takeover may have some liabilities that are not clear from its financial statements (e.g. potential future
litigation). So it is essential that a full investigation (due diligence) of the listed company is undertaken prior to the reverse takeover.
Lack of expertise
Running a listed company requires an understanding of the regulatory procedures required to comply with stock market rules. There is the risk that the unlisted company that is engineering the
reverse takeover does not have a full understanding of these requirements. To manage this risk it is wise to retain key management from the listed company to act in an advisory capacity.
Share price decrease
If the shareholders in the listed company sells their shares after the reverse takeover then this could lead to a drop in the share price. This risk can be managed by making the deal conditional
on the shareholders guaranteeing that they will not sell their shares for a period of time afterwards (e.g. six months). This is sometimes called a lock-up period.
Lack of sufficient analyst coverage and investor following
One of the main reasons for gaining a listing is to gain access to new investor capital. However, a smaller, private company which has become public through a reverse takeover may not obtain a
sufficient analyst coverage and investor following, and it may have difficulty in raising new finance in future. A well-advertised IPO will probably not face these issues and find raising new
funding to be easier.