[P4 Revision Notes]
ACCA P4: ADVANCED FINANCIAL
MANAGEMENT
BY
SIR SHOAIB YAQOOB
[CLASS NOTES]
Revision Notes
BY SHOAIB YAQOOB
Table of Contents
Investment Appraisal
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02
Basic Investment Appraisal…………………………………………………………… 02
MIRR…………………………………………………………………………................ 20
Duration……………………………………………………………………………........ 21
Capital Rationing………………………………………………………………………. 23
Weighted Average Cost of Capital (WACC)………………………………………… 27
Adjusted Present Value ((APV)………………………………………………………. 53
International Investment Appraisal…………………………………………………… 60
Merger & Acquisition
64
Corporate Restructuring
96
Risk Management & Treasury
103
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➢
➢
➢
➢
➢
➢
➢
➢
➢
➢
➢
➢
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Foreign Currency Risk Management………………………………………………… 103
Interest Rate Risk Management……………………………………………………… 122
Why Risk Management?....................................................................................... 137
Option Pricing Theory…………………………………………………………………. 142
Value at Risk (VAR)…………………………………………………………………… 144
Greeks…………………………………………………………………………………... 146
Delta Hedging……………………………………………………………………………146
Bond Duration………………………………………………………………………….. 149
Tranching……………………………………………………………………………….. 151
Dark Pool Trading ……………………………………………………………………. 154
Credit Default Swaps …………………………………………………………………. 154
Real Options …………………………………………………………………………… 156
Multinational Operation ………………………………………………………………..162
Dividend Capacity & Policy…………………………………………………………… 178
Reverse Takeover…………………………………………………………………….. 183
Islamic Finance
188
Bond Valuation
194
Interest Rate Forwards
199
Conditional Probability
202
Patterns of Behavior
206
Formulae & Tables
210
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Revision Notes
BY SHOAIB YAQOOB
INVESTMENT APPRAISAL
Decision Making
Short term
Long term
INVESTMENT APPRAISAL:A detailed evaluation of projects or investments viability and its effects on shareholders wealth is called
investment appraisal.
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 non-current 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.
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’.
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
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Simple interest
1.
2.
3.
1000 x 10% = $100
1000 x 10% = $100
1000 x 10% = $100
Cash flows are not reinvested each year
Compound interest
1.
2.
3.
1000 x 10% = 100 + 1000 = 1100
1100 x 10% = 110 + 1100 = 1210
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
Df@12%
0.893
0.797
0.712
PV
892.9
1594.39
2135
Consistent Cash flows
If Cash flows arises in a series of equal cashflows then it is called Consistent Cashflows. These are
of two Types:
Annuity: If Consistent cashflow for a certain Period. e.g Y1-5 or Y3-7
Perpetuity: If Consistent cashflow for infinite period e.g. Y1-∞ or Y3-∞
Present Values of Consistent Cashflows
The Annuity Factor =
𝟏−(1 + r)-n
The Perpetuity Factor =
𝟏
𝒓
𝒓
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ANNUITY
It will apply when
• Consistent annual cash flows
• Limited time period
• First cash flow starts from year 1
The annuity factor (AF) is the name given to the sum of the individual DFs. The formula for the
annuity factor is:
Present value = Constant Cash Flow x AF
1 − (1 + r)−𝑛
𝐴𝐹 =
𝑟
Example 1:
A payment of $3600 is to be made every year for seven years, the first payment occurring in
one year’s time. The interest rate is 8%. What is the PV of the annuity?
Solution
The AF can be found using the formula:
𝐴𝐹 =
1−(1.08)−7
𝑟0.08
= 5.206
Therefore, the Pv of the annuity is $3600 x 5.206 = $18,741.60
Advanced Annuities
•
•
•
Consistent annual cash flows
Limited time period
First cash flow starts from year 0
PV = Cash Flow x (1 + AFP *n-1)
N* = total number of year. (Total number of years should be counted by ignoring year 0)
Example 2:
A 5 year $600 annuity is starting today. The interest rate is 10%. What is the PV?
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BY SHOAIB YAQOOB
Solution
This is essentially a standard 4-year annuity with an additional payment at T0. The PV could be
calculated as follows:
To
T1
T2
T3
T4
CF
600
600
600
600
600
PV
600
+
600 X 4-year 10% AF
PV = 600+ 600 x 3.17 =600+ 1902 = $2,502
The same answer can be found more quickly by adding 1 to the AF
PV = 600 x(1 +3.17) = 600 x 4.17 =$2,502
Delayed Annuities
•
•
•
Consistent annual cash flows
Limited time period
First cash flow starts after year 1
Some regular cash flows may start later than T1
These are dealt with by:
1. Applying the appropriate factor to the cash flow as normal
2. Discounting your answer back to T0
PV = Cash Flow x AF x Discount Factor of last year (from which annuity starts)
Example 2:
For delayed cash flows, applying the standard annuity factor will find the value of cah flows
one year before they began, which in this illustration is T 2. To find the PV, an additional
calculation is required the value must be discounted back to T0.
What is the PV of $200 incurred each year for four years, starting in three years’ time, if the
discount rate is 5%?
Solution
To
T1
T2
T3
T4
T5
T6
200
200
200
200
CF
PV
2.
1.
Step 1. Discount the annuity as usual
Step 2. Discount the answer back to T0
200 x 4 yr 5% AF = 200 x 3.546 = 709.2
709.2 x 2yr 5% DF = 709.2 x 0.907 = $643
Note that this gives the value of the annuity at T2
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PERPETUITY
Discounting Perpetuities
•
•
•
Consistent cash flows
Unlimited time period
First cash flow starts from year 1
The PV of perpetuity is found using the formulae
𝑃𝑉 =
1
𝑟
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
𝑟
OR
PV = Cash Flow x
1
𝑟
is known as the perpetuity factor
Example
What is the present value of $3,000 received in one year’s time and forever if the interest rate
is 10%?
Solution
$3,000
PV =
0.1
= $30,000
Advanced Perpetuities
•
•
•
Consistent annual cash flows
Unlimited time period
First cash flow starts from year 0
PV = Cash Flow x (
1
𝑟
+1 )
Example
What is the present value of $2,000 perpetuity which is due to commence immediately if the
interest rate is 9%?
Solution
This is essentially a standard perpetuity with an additional payment at T0. The PV could be
calculated as follows:
CF
To
T1
2000
2000
T2
T3
T4
∞
PV = (2000) + (2000 x 9% perpetuity formulae)
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Revision Notes
BY SHOAIB YAQOOB
Again, the same answer can be found more quickly by adding 1 to the perpetuity factor.
1
2000 x (1 +
) = 2000 x 12.11 = $24,222
0.09
Delayed Perpetuities
•
•
•
Consistent annual cash flows
Unlimited time period
First cash flow starts after year 1
PV = Constant cash flow x
1
𝑟
x Discount factor of last year
Example
Discount Rate is 10%
Solution
To
PV = 100 x
1
0.10
T1
T2 ………………………T6
T7
T8-∞
100
100
100
x 0.621
= $621
Perpetuities with growth:
•
•
•
Cash flow with constant growth.
Unlimited time period.
Growth starts from year 1
Single growth model:
PV = Cash flow (1+ g)
COC – g
Multi growth model:
Cash flow
1
CF1
2
CF2
3
CF3
4
CF4
D.F @ 10%
0.909
0.826
0.751
0.683
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 8% for next 4 years then at a constant
growth of 2% for foreseeable future COC 10% .Calculate PV?
Solution
1
1000
2
1080
4
Cash flow
1166
3
1260
5
1360
D.F @ 10%
PV
0.909
909
0.826
892
0.751
875.67
0.683
860.58
0.621
844.56
6-∞
1360 x (1+0.02)
0.10 -0.02
x 0.621
10768.14
PV = 15154
Annuity with growth:
Example:
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.
Solution
Years
Cash flows@ 5 % growth
Df@10%
PV
1
105
0.909
95.45
2
110.25
0.826
90.86
3
115.76
0.751
86.94
4
121.55
0.683
83.02
5
127.63
0.621
79.26
PV = 435.53
OR
1−(
PV=constant cash flow x [
1−(
=100 x
[
1+0.05 𝑛
)
1+0.1
0.1−0.05
1+𝑔 𝑛
)
1+𝑟
𝑟−𝑔
] 𝑥(1 + 𝑔)
] 𝑥 (1 + 0.05)
PV = 435
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Revision Notes
BY SHOAIB YAQOOB
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.
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.
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BY SHOAIB YAQOOB
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.
Advantages:
•
It considers the time value of money and timing of cash flows
Disadvantages:
•
•
Cash flows after the period are ignored
Life of project, size of project (amount of investment and cash flows) is ignored
❑
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
0
1
2
3
Cash flows
(500000)
300,000
200,000
200,000
D.F @ 10%
1.000
0.909
0.826
0.751
Present Values Cumulative Values
(500000)
(500000)
272,700
(227300)
165,200
(62100)
150,200
4
600,000
0.683
409,800
Discounted Payback = 2 years + (62.100/ 150,200 x 12)
= 2 years and 5 months
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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.
Assumptions of NPV
Timing of Cash flows:
1.
2.
3.
4.
Initial investment is Zero (immediate or today) unless told otherwise
First cash flow will be taken from T1 unless mentioned
During the year cash flows will be assumed as Year-end cash flows
Start of year cash flows will be assumed as Year-end cash flows of previous year
About Taxation:
1.
2.
3.
4.
5.
Tax rate will remain constant throughout project life and for all companies involved
Post-tax cost of capital will be used for NPV
Tax payment will be made in the same year in which profit occurs
Capital allowances will be taken from first year of project operation unless specified clearly
Expenses will be tax allowable if clearly specified about discount rate/cost of capital/
required rate of return
6. Discount rate will remain constant throughout the year
About Inflation:
1. Inflation rate will remain constant throughout the project life
2. Cost of Capital will be given in Nominal terms unless specified clearly
3. Inflation will be taken from T1 unless specified clearly
About Working Capital Cash Flows:
1. Working Capital Investment will be required at the start of each year to support the sales
2. Full of Working Capital at the end of the project life
3. No recovery of working capital if project is continued
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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.
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
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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)
Capital allowance
(X)
(X)
(X)
(X)
Operating profits
X
X
X
X
Tax Expense
(X)
(X)
(X)
(X)
Capital Allowance
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
Years
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
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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.
Exception
-If Asset has been bought on the last working days of previous year then claim first capital
allowance in year Zero.
-If scarp value is given after tax , then instead of calculating balancing allowance/charge ,simply
calculate capital allowance in last year
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
r = real rate of interest
m = nominal (money rate of interest)
o Money cash flows are those cash flows in which the effect of specific inflation has been adjusted.
O Real cash flows are those cash flows which have not been adjusted for inflation.
CAPITAL INVESTMENT MONITORING SYSTEM (CIMS)
A capital investment monitoring system (CIMS) monitors how an investment project is progressing
once it has been implemented. Initially the CIMS will set a plan and budget of how the project is to
proceed.
It sets milestones for what needs to be achieved and by when. It also considers the possible risks,
both internal and external, which may affect the project. CIMS then ensures that the project is
progressing according to the plan and budget. It also sets up contingency plans for dealing with the
identified risks.
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Benefits:
The benefits of CIMS are that it tries to ensure, as much as possible, that the project meets what is
expected of it in terms of revenues and expenses. Also that the project is completed on time and risk
factors that are identified remain valid.
A critical path of linked activities which make up the project will be identified. The departments
undertaking the projects will be proactive, rather than reactive, towards the management of risk, and
therefore possibly be able to reduce costs by having a better plan.
CIMS can also be used as a communication device between managers charged with managing the
project and the monitoring team. Finally CIMS would be able to re-assess and change the assumptions
made of the project, if changes in the external environment warrant it.
METHODS TO BE USED IN INVESTMENT APPRAISAL
If General inflation rate is
given
Real Method
Money
Method
Inflate all
Cash flows
with general
inflation rate.
Discount
these cash
flows with
money
discount rate.
Do not inflate
Cash flows.
Discount all
Cash flows
with real
discount rate.
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.
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Working capital change
•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
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Selling price sensitivity
Variable cost sensitivity
Fixed cost sensitivity
Contribution/Sales volume sensitivity
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.
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SIMULATION
Sensitivity analysis considered the effect of changing one variable at a time.
The assessment of the volatility (or standard deviation) of the net present value of a project entails
the simulation of the financial model using estimates of the distributions of the key input parameters
and an assessment of the correlations between variables. Some of these variables are normally
distributed but some (such as the decommissioning cost) are assumed to have limit values and a
most likely value. Given the shape of the input distributions, simulation employs random numbers
to select specimen value for each variable in order to estimate a ‘trial value’ for the project NPV.
This is repeated a large number of times until a distribution of net present values emerge. By the
central limit theorem, the resulting distribution will approximate normality and from which project
volatility can be estimated.
In its simplest form, Monte Carlo simulation assumes that the input variables are uncorrelated.
However, more sophisticated modelling can incorporate estimates of the correlation between
variables. Other refinements such as the Latin Hypercube technique can reduce the likelihood of
spurious results occurring through chance in the random number generation process. The output
from a simulation will give the expected net present value for the project and a range of other
statistics including the standard deviation of the output distribution. In addition, the model can rank
order the significance of each variable in determining the project net present value.
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
 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.
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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
NPV
0
(400)
1.000
Year
Cash flows
Dis. Factor @ 20%
Present Values
NPV
0
(400)
1.000
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
214
(25)
= 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.
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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 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
𝑃𝑉 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 𝑃ℎ𝑎𝑠𝑒
1
𝑛
𝑀𝐼𝑅𝑅 = [𝑃𝑉 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑃ℎ𝑎𝑠𝑒] (1 + 𝑟𝑒 ) − 1
Year
Cash flows
Dis. Factor @ 10%
Present Values
NPV
0
(400)
1.000
(400)
214
1
(600)
0.909
(545)
2
400
0.826
330
3
500
0.751
376
4
400
0.683
273
5
200
0.621
124
6
100
0.564
56
1
1159 6
𝑀𝐼𝑅𝑅 = [
945
] (1 + 10%) − 1
=13.8%
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MIRR 2ND FORMULA
1
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 𝑃ℎ𝑎𝑠𝑒 𝑛
𝑀𝐼𝑅𝑅 = [
Year
Cash flows
Inflating Factor @
10%
Terminal Values
Total
𝑃𝑉 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑃ℎ𝑎𝑠𝑒
] −1
2
400
(1.10)^4
3
500
(1.10)^3
4
400
(1.10)^2
5
200
(1.10)^1
6
100
586
666
484
220
100
2056
1
2056 6
𝑀𝐼𝑅𝑅 = [
945
] −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
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
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.
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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.
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)
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.
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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) •
risk & uncertainty and strategic importance of all projects is same
The
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
Funds available $2500
450
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.
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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
Year 1
25000
Year 2
10000
Npv
20000
Project C
22500
Project D
12500
15000
15000
30000
20000
17500
27500
15000
10000
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+0C+12,500D≤40,000
Year 1 25,000A+0B+15,000C+15,000D≤35,000
Year 2 10,000A+30,000B+20,000C 17,500D≤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
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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
➢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.
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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:
Cost of debt:
Cost of preference shares:
The rate of return that is
paid to the equity
holders of the company
This is after tax return
paid to the debt
holders of the company
The return paid to the
preference shareholders of
the company
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 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%
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 re = 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%.
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CAPITAL ASSET PRICING MODEL (CAPM)
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
Systematic risk
Company specific factors
General economic factors
Can be eliminated by
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.
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.
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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
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.
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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
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).
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.
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.
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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:
(a) The annual dividend is expected to remain $2.00 into the foreseeable future.
(b) The annual dividend is expected to grow by 2% each year into the foreseeable future.
(c) The CAPM is used, the equity beta is 1.20, the risk-free cost of capital is 5% and the
expected market return is 9%.
Answer:
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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)
MV of Redeemable Bonds/Debentures
Where
Annual Interest = Nominal Value of bond x Coupon Rate
Market value is the present value of all future interest and principal amount.
Year
Cash Flow
D.F @ yield
P.Values
1-5
Interest
Annuity factor
××
5
Redemption Value
Discount factor ××
×××
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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)
➢
Non-tradable Debt
An example of non-tradable debt is bank loan.
Kd=Interest % x (1-t)
➢
Convertible Loan
Subscribing to convertible loan notes is beneficial if the share price increases, aligning their interests with
shareholders. The conversion terms also mean that the loan notes will not necessarily have to be repaid
in a few years’ time. This may be significant if the company does not have the cash available for
redemption then.
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However, on the other hand, it is treated as debt which results in increased gearing and as being in
preference as compared to the shareholders, it is payable before dividends, thus, resulting in distribution
of less money to the shareholders.
Secondly, the shareholders may be concerned by the interest rate on the convertible notes being the
company’s normal cost of borrowing. The option to convert is an advantage for convertible loan note
holders. They would often effectively pay for this option by receiving a lower rate of interest on the loan
notes.
Thirdly, it will disturb or change the balance of shareholdings the directors who held the notes a greater
percentage of share capital and possibly more influence over the company.
•
•
•
•
•
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
M.V
D.F @ ytm
A.F
D.F
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
Investors are rational and will choose the higher Value
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Year
Cash Flow
D.F @ 10%
0
1– 4
4
(96.25)
4.90
108
1.000
3.170
0.683
P.Value
D.F @ 5%
(96.25)
15.53
73.76
(7)
1.000
3.546
0.823
`
P.Values
(96.25)
17.38
88.88
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.
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.
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More than one Risk Free Rate
Yield Curve
•
•
•
•
Relationship between required rate of return of government bonds and time to maturity
Require rate of return of government bonds will be higher for bonds of longer maturity
Yield curve theories
i.
Expectation theory
ii.
Liquidity Theory
iii.
Market Segmentation Theory
Spot Yield curve for government bonds will be used instead of single risk free rate
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 riskfree debt with the same maturity. For example, the interest rate on a sterling bond of ABC Company
with twoyears 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 riskfree. 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.
Standard & Poor's
credit ratings
AAA
AA
A
BBB
Moody's credit Ratings
Investment Grade
Highest rating
Still high quality debt
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
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,
A2,
A3,
Baal, Baa2, Baa3,
Ba1, Ba2, Ba3 and so on.

The lowest investment grade rating is Baa3.
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
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
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%.
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Determining Credit Rating
The credit agency will have taken the following criteria into consideration when assessing credit rating:
Country
A company’s debt would not normally be rated higher than the credit ratings of its country of origin.
The rating will also have depended on standing relative to other companies in the same country.
Industry
The credit agency will have taken account of the impact of the recession in the country. Company’s
position within the industry compared with competitors will also have been assessed. If similar recent
developments by competitors have been more successful, this is likely to have had an adverse impact
on company’s rating.
Management
The credit agency will have made an overall assessment of management and succession planning. It
will have looked at business and financing strategies and planning and controls. It will also have
assessed how successful the management has been in terms of delivering financial results. The credit
agency may have believed the poor returns on recent developments show shortcomings in
management decision-making processes and it may have rated the current management team poorly.
Financial
The credit agency will have analysed financial results, using measures such as return on capital
employed. The agency will also have assessed possible sources of future earnings growth. It may
have been sceptical about prospects, certainly for the short term, given company’s recent problems.
The credit agency will also have assessed the financial position of the company, looking at its gearing
and working capital management, and considering whether it has enough cash to finance its needs.
The agency will also have looked at the entity’s relationship with its bankers and its debt covenants,
to assess how flexible its sources of finances are if it comes under stress. It may well have been
worried about the company’s gearing being higher than the industry average and concerned about the
high levels of cash it needs to finance operations. It will also have assessed returns on developmentsin-progress compared with commitments to repay loans. Greater doubt about the company’s ability to
meet its commitments is likely to have been a significant factor in the fall in its rating.
The agency will also have needed reassurance about the quality of the financial information it was
using, so it will have looked at the audit report and accounting policies.
Impact of Fall of Credit Rating & Raising of Financial Capital
A company may not have increased problems raising debt finance if debtholders do not react in the
same way as the credit rating agency. They may attach different weightings to the criteria which they
use. They may also come to different judgements about the quality of management & financial stability
and external factors which the management could not have controlled.
However, it is probable that the fall in credit rating will result in it having more difficulty raising debt
finance. Banks may be less willing to provide loans and investors less willing to subscribe for bonds.
Even if debt finance is available, it may come with covenants restricting further debt or gearing
levels. This will mean that if substantial additional finance is required, it is more likely to have to make
a rights issue or issue new equity on the stock market. Shareholders may be faced with the choice of
subscribing large amounts for new capital or having their influence diluted. This may particularly worry
the more cautious shareholders.
Even if company can obtain the debt it needs, the predicted increase in yield to maturity may be
matched by debtholders demanding a higher coupon rate on debt. This will increase finance costs,
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and decrease profits and earnings per share, with a possible impact on share price. It will also mean
that fewer funds are available for paying dividends.
Loan finance or bonds will also come with repayment covenants. These may require building up a
fund over time which will be enough to redeem the debt at the end of its life. Given uncertainties over
cash flows, this commitment to retain cash may make it more difficult to undertake major
developments or pay an acceptable level of dividend.
The fall in credit rating may result in its cost of equity rising as well as its cost of debt. In turn, weighted
average cost of capital will rise. This will affect its investment choices and hence its ability to
generate wealth for shareholders.
Criteria used for Credit Rating
Industry risk measures the resilience of the company’s industrial sector to changes in the economy. In
order to measure or assess this, the following factors could be used:
•
•
•
Impact of economic changes on the industry in terms of how successfully the firms in the industry
operate under differing economic outcomes
How cyclical the industry is and how large the peaks and troughs are
How the demand shifts in the industry as the economy changes.
Earnings protection measures how well the company will be able to maintain or protect its earnings in
changing circumstances. In order to assess this, the following factors could be used:
•
•
•
Differing range of sources of earnings growth
Diversity of customer base
Profit margins and return on capital.
Financial flexibility measures how easily the company is able to raise the finance it needs to pursue its
investment goals. In order to assess this, the following factors could be used:
•
•
•
Evaluation of plans for financing needs and range of alternatives available
Relationships with finance providers, e.g. banks
Operating restrictions that currently exist as debt covenants.
Evaluation of the company’s management considers how well the managers are managing and
planning for the future of the company. In order to assess this, the following factors could be used:
•
•
•
•
The company’s planning and control policies, and its financial strategies
Management succession planning
The qualifications and experience of the managers
Performance in achieving financial and non-financial targets.
Merits of Debt Finance
To Investors
• Fixed return
• Appointment of liquidator in case of default
• Secured against assets (Fixed charge vs Floating charge)
• Prior claim than equity
To Company
• Cheap sources as compared to equity
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Revision Notes
•
•
•
•
BY SHOAIB YAQOOB
No voting right be debt holder
No growth in interest payment in years of profit
No immediate dilution in earnings and dividend per share
Low issue cost as compared to equity
Demerits of Debt Finance
To Investors
• No voting right
• No growth in interest payment in years of profit
• In unsecured debentures, risk will be high
To Company
• Limit to use as mortgage assets for further loans
• In years of losses, interest will be burden
• Damage of reputation in case of default
• Reduced borrowing capacity
• Real cost is high
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 of Debt =
× M.v per bond
Bank loan market value = book value ➢
Calculate WACC using this formula:
𝑾𝑨𝑪𝑪 = [𝑲𝒆 ×
× M.v per share
𝑬
𝑫
] + [𝑲𝒅 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙 ×
]
𝑬+𝑫
𝑫+𝑬
Where:
E = Market value of Equity
D = Market Value of Debt
Ke = Cost of Equity
Kd after tax = After Tax Cost of Debt / Kd (1-t)
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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
Proportion of the Business
Food
0.75
40%
Clothes
1.80
60%
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
•
Gearing level is at 40%.
•
After tax cost Kd = 6%
•
Equity risk premium = 7%
•
Rf = 5 %
•
Tax rate = 30%
ABC Ltd wants to diversify into cement business.
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)
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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.
•
•
•
•
•
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
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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
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%
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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:
Henry
Jupiter
Gearing (debt to total market value)
30%
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.)
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.
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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 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.
Optimum gearing % = minimum WACC
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.
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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.
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,
(KEU-KD)

Multiplied by the ratio
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Example
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%.
co.
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
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.:
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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
E
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%
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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.
Solution
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
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:
3.
4.
This is effectively the end of Stage One of the risk-adjusted WACC analysis, and the
remainder of analysis follow as normal:
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.
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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?
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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 Unchanged
Change
Change
Existing WACC
Risk Adjusted WACC
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 that 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 allequity company in the same industry or the market in which the capital investment will be made.
• Use the same pro-forma as in Investment Appraisal
• Use Ke (Ungeared) as Discount Factor using Asset Beta
1.
Un-gear the Equity Beta of proxy Co (if nature of business changes)
Un-gear the Equity Beta of own Co (if nature of new project remains same)
Calculate Cost of Equity (Ungeared)→ Rf+ Asset Beta (Rm- Rf)
2.
Un-gear the Cost of Equity (geared) of proxy Co (if nature of business not same)
Un-gear the Cost of Equity (geared) of own Co (if nature of business is same)
Calculate Cost of Equity Geared→ Ke (un-geared) + (1-t)(Ke ungeared - Kd) x D/E
Calculated answer will be Base Case NPV
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.
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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
=
=
Accept the project
Reject the project
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
Subsidized Loan
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
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
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Issuance Cost
xxx
Tax Relief on issuance cost (Tax rate x
Issue cost)
xxx
Present Value of Tax Relief (Tax relief x discount factor)( if tax one year arrear)
xxx
PV of the Issue cost
xxx
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)
XXX
Annuity {Simple or deferred (if one year in delay)}
XXX
Present value of TAX shield
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
Solution
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% =
(245)
Net Debt issuance cost =
571
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
=
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
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Subsidized or cheap loan:
First step is same to calculate tax shield on interest payment.
1)
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
2)
3)
P.V of Interest savings on subsidized loan.
Gross subsidized loan × interest rate saving
Annuity factor @ (decided above)
P.V of interest savings shield
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
XXX
XXXX
XXX
X
XXX
= 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 % =
Present Value of Tax shield
$ 857
4.329
$3710
Subsidized loan
60,000 × 4% × 30% =
Annuity factor @ 5 % =
$720
4.329
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Present Value of Tax shield
BY SHOAIB YAQOOB
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:
$100,000
Subsidized debt required:
$60,000
Normal Debt Required:
$40,000
Subsidized debt Raised
= 60,000
Normal Debt Raised
= 40,000/98% = 40,816
Debt issuance cost
= 816
Tax savings @ 30% x 1.05^-1 = (233)
Net Debt issuance Cost
= 583
Tax Shield
Normal Loan
40,816 × 7% × 30%
= $ 857
Annuity factor @ 5 % x 1.05^-1 =4.12
Present Value of Tax shield
$3533
Subsidized loan
60,000 × 4% × 30% =
$720
Annuity factor @ 5 % x 1.05^-1 =4.12
Present Value of Tax shield
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
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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.
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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. 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.
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INTERNATIONAL INVESTMENT APPRAISAL
There are four adjustments in international investment appraisal.
Exchange Rate prediction:
1.
EXAMPLE:
The Current Dollar Sterling exchange rate is given $/£ 1.7050 Expected Inflation Rates are:
Year
1
USA
5%
UK
2%
2
3%
4%
3
4%
4%
Find the expected spot rate for next three years.
SOLUTION:
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
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.
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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
-
Royalties
6.7
UK Tax
(5.4)**
After Tax Cash flow
£31.3m
*45/1.50
$10m/1.50
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
(10)
3
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
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INTERNATIONAL INVESTMENT APPRAISAL PROFORMA:
Year
0
1
2
3
4
5
FC
FC
FC
FC
FC
FC
x
x
x
X
Variable costs
(x)
(x)
(x)
(x)
Wages/materials
(x)
(x)
(x)
(x)
Incremental fixed
(x)
(x)
(x)
(x)
(x)
(x)
(x)
(x)
Tax allowable depreciation
(x)
(x)
(x)
(x)
Taxable profits
x
x
x
X
Foreign tax @ say
(x)
(x)
(x)
(x)
x
x
x
X
Sales/receipts
payments:
Costs
Untaxed royalties /
mgt charges etc
20%
Add: Tax allowable
Depreciation
Initial outlay
(x)
Realizable value
X
Working capital
(x)
(x)
(x)
(x)
(x)
x
Net foreign CF
(x)
x
x
x
X
x
0
1
FC
2
FC
3
FC
4
FC
5
FC
x
x
x
X
x
x
(x)
x
(x)
x
(x)
X
(x)
x
x
x
x
X
FC
Exchange rate x
(based on PPPT)
Home currency CF
Domestic tax on
(x)
foreign taxable
profits @30% 20% = 10%
Untaxed royalties /
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mgt charges etc
Domestic tax on
royalties etc. @30%
Net home
currency CF
(x)
DF (say 16%)
Home currency
PV
1
(x)
(x)
(x)
(x)
(x)
x
x
x
x
0.862
x
0.743
x
0.641
x
0.552
x
x
0.476
x
Home currency NPV
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.
Competitive Advantage
Investing in Overseas may give:
•
•
•
•
•
•
•
•
access to new markets and/or enable it to develop a market for its products in locations
Being involved in marketing and selling products in overseas markets may also help it gain an
understanding of the needs of customers, which it may not have had if it merely exported its
products.
Easier and cheaper access to raw materials it needs. It would therefore make good strategic sense
for it to undertake the overseas investment.
Access to cheaper labour resources and/or access to expertise
Closer proximity to markets, raw materials and labour resources may reduce costs and gain edge
against its competitors. For example, transportation and other costs related to logistics may be
reduced if products are manufactured close to the markets where they are sold.
Risk, such as economic risk resulting from long-term currency fluctuations, may be reduced where
costs and revenues are matched and therefore naturally hedged.
Increase its reputation because it is based in the country within which it trades leading to a
competitive edge against its rivals.
International investments might reduce both the unsystematic and systematic risks for
shareholders only hold well diversified portfolios in domestic markets, but not internationally.
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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
Horizontal integration.
Vertical integration.
Conglomerate integration.
1.
2.
3.
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.
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 justintime inventory systems leading to major savings in inventory holding costs.
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.
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
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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
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
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.
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•
•
•
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 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

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
•

•
•
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.
Problems in achieving synergies
•
•
Lack of Unity at the top management and could also flow down at the employee level.
Significant shareholding and a place on the board of any party might affect and creates strong
influence on the other party thus limiting the scope and arising of difficulties in achieving synergies.
Differing remuneration packages and changes in employment conditions result in problematic
situations for employees.
Integration between staff of two different companies are difficult to achieve.
•
•
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
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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.
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.
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.
Changes in shares prices
Shareholders will also take account of any changes in share prices that occur during the
bid price.
(3)
(4)
(5)
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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 prespecified 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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Increasing Levels of Debt
Increases its financial risk, and therefore the company will need to be able to bear the consequences
of this increased risk.
The increased levels of debt would probably be secured against the assets of the company and
therefore the acquirer cannot use them to raise additional debt finance, and cash resources would be
needed to fund the higher interest payments.
Many tax jurisdictions worldwide allow debt interest to be deducted from profits before the amount of
tax payable is calculated on the profits. Increasing the amount of debt finance will increase the amount
of interest paid, reducing the taxable profits and therefore the tax paid. Modigliani and Miller referred
to this as the benefit of the tax shield in their research into capital structure, where their amended
capital proposition demonstrated the reduction in the cost of capital and increase in the value of the
firm, as the proportion of debt in the capital structure increases.
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.
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Mitigating Risks if Acquisition fails to increase shareholder value
A company which pursues a policy of acquisitions, it needs to determine whether or not this has
been too aggressive and detailed assessments have been undertaken. Acquirer should ensure
that the valuation is based on reasonable input figures and that proper due diligence of the
perceived benefits is undertaken prior to the offer being made. Often it is difficult to get an accurate
picture of the target when looking at it from the outside. It needs to ensure that it has sufficient data
and information to enable a thorough and sufficient analysis to be undertaken.
The sources of synergy need to be properly assessed to ensure that they are achievable and what
actions needs to undertake to ensure their achievement. This is especially so for the revenuebased synergies. An assessment of the impact of the acquisition on the risk of the combined
company needs to be undertaken to ensure that the acquisition is not considered in isolation but
as part of the whole company.
The Board of Directors needs to ensure that there are good reasons to undertake the acquisition,
and that the acquisition should result in an increase in value for the shareholders.
A post-completion audit may help to identify the reasons behind why acquisition have failed to
create value. Once these reasons have been identified, strategies need to be put in place to
prevent their repetition in future acquisitions.
Procedures need to be established to ensure that the acquisition is not overpaid. Acquirer should
determine the maximum premium it is willing to pay and not go beyond that figure. Often this is the
result of the management of the acquiring company wanting to complete the deal at any cost,
because not completing the deal may be perceived as damaging to both their own, and their
company’s reputation. The acquiring company’s management may also want to show that the
costs related to undertaking due diligence and initial negotiation have not been wasted. Formal
procedures need to be established which allow managers to step back without loss of personal
reputation.
It needs to ensure that it has proper procedures in place to integrate the staff and systems of the
target company effectively, and also to recognise that such integration takes time.
Acquisition Risks
There are many risks in acquisitions which have both a high likelihood of occurring and potentially
a significant impact upon your business if they do occur. The principal risks to which might be
exposed in an acquisition are as follows:
1. Disclosure risk: in making an acquisition it is important to ensure that the information upon
which the acquisition is made is reliable and fairly represents the potential earning power, financial
position and cash generation of the business. As part of a due diligence exercise it would be
necessary to ensure that the financial accounts have not been unduly manipulated to give a more
attractive view of the business than the underlying reality would support. To this end it is important
to ensure that the income statement can be supported by the reported cash flow. In addition to this
all other company documents should, in due course, be scrutinised as part of a full due diligence
exercise.
2. Valuation risk: a substantial acquisition has the potential to alter the risk of the acquirer either
because of an alteration in the fund’s exposure to financial risk or in its exposure to market risk.
Ultimately the value of a company to its equity investors depends upon the potential returns it offers
to them and the risk of those returns. A substantial acquisition can impact upon the perceived risk
attaching to the equity which investors have already subscribed and hence the value they place
upon the fund.
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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.
1.
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 achieved quickly.
Cash flow strain - usually either must borrow
(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 Shareholder
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.
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BY SHOAIB YAQOOB
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.
For the Target Shareholders
Advantages
Disadvantages
Postponement of CGT liability
Uncertain value
Participate in new group synergy benefits
Choice of payment type
a)
b)
c)
d)
e)
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.
Could influence the success or failure of a bid.
Problematic for the bidder in that the cash needs and the number of shares to be issued is
not known.
Capital structure may alter in an unplanned manner.
Ideally a bidder would like to tailor the form of the bid to that favored by major investors in
the targeted company.
Factors used to decide payment type
Predator and its shareholders
Target company shareholders
Control
.Share price shareholders want shares that will at
if a large number of shares are issued then least retain their value
.Future investments
some shareholders may
control of the company may alter
Increases in authorized capital may be needed prefer shares to maintain an investment in the
Increases in borrowing limits may be required company
The cost to the company will vary with debt, .Taxation
Liability may be deferred if the consideration was
equity and convertible loan stocks
There may be a dilution of earnings per share in shares
The level of gearing resultant on an issue of .Income
debt to finance a cash acquisition may be Shareholders will want a minimum income stream.
unacceptable.
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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
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 well-functioning 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.
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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.
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
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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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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/cash
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 )
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DIVIDEND VALUATION MODEL (TWO METHODS)
Single Growth model:
MV =
Multiple Growth model:
Year
Dividends
1
D1
2
D2
Discount factor @
Ke
3
D3
4-∞
D3 ( 1 + g)
Ke − g
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.
Limitations of Dividend Model
•
•
•
•
•
Historical growth rate is used for prediction of future dividend growth rate and cost of equity
Dividend Model does not consider risk explicitly so it is inferior to CAPM Model of estimating
Ke
Dividend Model is unable to cater changes in Cost of equity by changes in debt equity ratio
The dividend valuation model is based on a number of factors such as: an accurate estimation
of the dividend growth rate, a non-changing cost of equity and a predictable future dividend
stream growing in perpetuity. The dividend valuation model assumes that dividends and their
growth rate are the sole drivers of corporate value, which is probably not accurate.
Although the dividend irrelevancy theory proposed by Modigliani and Miller suggests that
corporate value should not be affected by a corporation’s dividend policy, in practice changes
in dividends do matter for two main reasons.
First, dividends are used as a signaling device to the markets and unexpected changes in
dividends paid and/or dividend growth rates are not generally viewed positively by them.
Changes in dividends may signal that the company is not doing well and this may affect the
share price negatively.
Second, corporate dividend policy attracts certain groups of shareholders or clientele. In the
main this is due to personal tax reasons. For example, higher rate taxpayers may prefer low
dividend payouts and lower rate taxpayers may prefer higher dividend payouts. A change in
dividends may result in the clientele changing and this changeover may result in excessive
and possibly negative share price volatility.
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Example
Now end of 2016.
Dividend history, expected dividends and cost of capital, Lirio Co
Year
2013
2014
2015
Number
of 60,000
60,000
80,000
$1 equity
shares in
issue (000)
Total dividends 12,832
13,602
19,224
paid ($ 000)
2016
80,000
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
Tax
Depreciation
Working Capital Change
CAPEX
XX
(X)
X
(X)
(X)
FCFF
Discount this using weighted average cost of capital.
Scenario 1:
Single growth Model
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝐴𝑙𝑢𝑒 𝑜𝑓 𝐵𝑢𝑠𝑖𝑛𝑒𝑠𝑠 =
𝐹𝐶𝐹𝐹(1 + 𝑔)
𝑊𝐴𝐶𝐶 − 𝑔
Scenario 2:
Multiple Growth Model
Year
1
Free
cash
FCFF1
flows to firm
2
3
4
FCFF2
FCFF3
FCFF4
Discount
factor @
WACC
5 - inf
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.
Limitation of Free Cash Flow to Firm Method
The valuation method used in perspective of both the acquirer and the combined company is based
on estimates and assumptions:
•
•
•
The growth is expected not to increase in the future years and is based on past growth rates
There are no explanations of calculations or estimation of cost of capital (unless provided)
The assumption of perpetuity is made and the assumption of growth in perpetuity is over-optimistic
and may give a higher estimate of the equity value when estimating the values of acquiree and the
combined company, and this may not be valid.
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The basis for the synergy benefits such as higher growth rates of sales revenue and profit margins
needs to be explained and justified. It is not clear how these estimates have been made.
Whereas it may be possible to estimate the asset beta of a listed company such as the acquirer, it
may be more difficult to provide a reasonable estimate for the asset beta of acquiree. Therefore, the
estimate of the cost of capital of the combined company may not be accurate.
The costs related to the acquisition process would need to be factored in.
Therefore, whereas the free cash flow method of estimating corporate values is theoretically sound,
using it in practice to estimate values is open to errors and judgements.
FREE CASH FLOW TO EQUITY (FCFE)
FREE CASH FLOW TO EQUITY
PBIT
Tax @ 30%
Depreciation
Working Capital Change
Interest ( 1 – 1)
CAPEX
XX
(X)
X
(X)
(X)
(X)
FCFE
Discount using cost of equity
Scenario 1 Single Growth Model
Market Value of Equity =
Scenario 2 Multi Growth Model
Year
Free
cashflows to
equity
1
2
3
4
FCFE ( 1 + g)
FCFE
FCFE
FCFE
FCFE
Ke − g
Discount factor of
last year
Discount
factor @ Ke
P.V= Market Value of Equity
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.
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Other formulas to calculate FCFE
Free Cash Flows to Equity
PBIT
Interest
PBT
Tax @ 30%
Depreciation
W. Cap change
CAPEX
XX
(X)
X
(X)
X
(X)
(X)
FCFE
Free Cash Flows to Equity
Free Cash flow to firm XX
Interest (1 – t)
(X)
FCFE
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.
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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).
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:
Assets less current liabilities
Capital Employed
Equity
$‘’000’’
4400
4400
Net operating profit after tax (NOPAT)
580
Net amount retained for reinvestment in
180
assets
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.
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Example
The following financial information relates to Rayn Co and to the development of the new product.
Rayn Co financial information
Sales revenue
$’000’
8,780
PBIT
1,230
Interest
(455)
Tax @ 20%
(155)
PAT
620
Balance sheet Extract
Net non-current assets
Current assets
Total Assets
Share capital (40c per share par value
Reserves
Non-current liabilities: Variable rate loans
Current liabilities
Total liabilities and capital
$000
10,060
690
10,750
960
1,400
6,500
1,890
10,750
In arriving at the profit after tax amount, Rayn Co deducted tax allowable depreciation and other noncash expense totaling $1,206,000. It requires an annual cash investment of $1,010,000 in noncurrent 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.
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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
Basic Asset Based Method
Assets
Non Current Assets
Current Assets
$
X
X
Total Assets
X
Less: Liabilities
Non-Current Liabilities
Current Liabilities
Net Assets = Value of Equity
(X)
(X)
X
Notes
I.
II.
Assets can be valued at NRV, Replacement Cost and Book Value
Intangible assets will be ignored
Asset Based Method – With Value of Intangible Assets
Assets
Non Current Assets
Property, Plant & Equipment
Intangible Assets using CIV Method
Current Assets
$
X
X
X
Total Assets
X
Less: Liabilities
Non-Current Liabilities
Current Liabilities
Net Assets = Value of Equity
(X)
(X)
X
Notes
I.
II.
Assets can be valued at NRV, Replacement Cost and Book Value
Value of intangible assets can be calculated using Calculated Intangible value (CIV ) method
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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.
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
XX
P.V of all intangibles = Excess Earnings (1-T)
WACC
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.
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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)
Problems of P/E ratio method
 Historical values used in calculations
 Single year data is being considered
 Difficult to find suitable proxy company
LIMITATIONS TO EQUITY VALUATION METHODS
Price to Earnings (P/E) Ratio Method
Difficulty to identify Quoted Co. similar to unquoted Co. so selection of suitable P/E ratio may be difficult
(Industry Average vs Similar Quoted Co.)
Using P/E Ratio of quoted company for valuation of unquoted company can be misleading due to:
•
•
•
•
Different in size of business operations, activities and level of business risk
Difference in capital structure
Difference in accounting policies
Confidence of public
Net Asset Method (Balance Sheet Method)
Historical cost balance sheet values do not reflect current asset valuations: debtor and stock figures
may be unreliable
NRV gives the lowest value of equity which is not acceptable to shareholders of Target Company
Business is acquired generally on the basis of earning potential and future earnings growth rather than
considering the value of assets it have
In case of NRV based valuation, assets of company are unique and resale values for such assets may
be unavailable, so it will be rough estimate
Valuation of intangibles may create problem
•
•
Difficult to select similar company and its suitable ROA
Similar company may also have intangible assets
Less suitable for service sector organizations because there assets are mostly intangible likes skilled
human resource and intellectual assets
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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-toearnings 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
Sales revenue
Profit before interest and tax (PBIT)
Interest
Pre-tax profit
6420
963
216
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
Market value of business = Base case NPV + Present Value of tax shield
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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
X
Less: Value of the parent company before Acquisition
(X)
Value of the Target Company (The Maximum Value)
X
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.
Gain and Losses on Acquisition
Acquirer
Value in view of Acquirer
Less: Price agreed
Gain/(Loss)
.
Target
Price Agreed
Less: Value in view of Acquiree
Gain/(Loss)
.
MARKET VALUE OF COMBINE BUSINESS USING CASHFLOWS
Different Business Risk and Different Financial Risk:
Market value of combined company
 Step 1: Un-gear βe of both acquirer and Target company to calculate βa.
 Step 2: Calculated weighted average βa using above calculated βa weighting them
according to their current market values.
 Step 3: Re-gear the calculated βa (w.avg) using post acquisition gearing and calculate βe.
 Step 4: Calculate cost of equity using CAPM and WACC using post-acquisition gearing.
 Step 5: Calculate combined free cash flows to the firm and using combined WACC, calculate
combined market value of business.
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M.V of Equity = M.V of Business – Total Debt
Synergy Benefit = Combined M.V – M.V of Acquirer. – M.V of Target
Synergy benefit= Maximum premium to be paid
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Example
Sino co wants to acquire Hank Co.Sino Co is of the opinion that as a result of acquiring
Hank Co, the cost of capital will be based on the equity beta and the cost of debt of the
combined company.
The asset beta of the combined company is the individual companies ‘asset betas weighted
in proportion of the individual companies’ market value of equity.
Sino Co has a market debt to equity ratio of 40:60 and an equity beta of 1·10.
It can be assumed that the proportion of market value of debt to market value of equity will
be maintained after the two companies combine.
Currently, Sino Co’s total firm value (market values of debt and equity combined) is $60,000
million and Hank Co’s asset beta is 0·68.
Additional information
– The estimate of the risk free rate of return is 4·3% and of the market risk premium is 7%.
– The corporation tax rate applicable to all companies is 22%.
–Hank Co’s current share price is $3 per share, and it can be assumed that the book value
and the market value of its debt are equivalent. Number of shares are 7 million.
– The pre-tax cost of debt of the combined company is expected to be 6.0%.
Calculate combine Cost of capital?
Example
Nemar Co, a listed company which manufactures electronic components, is interested in
acquiring Roney Co.
Information on Nema Co and Roney Co
Nemar Co
Nemar Co has a market debt to equity ratio of 50:50 and an equity beta of 1·18. Currently
Nemar Co has a total firm value (market value of debt and equity combined) of $140 million.
Roney Co has a market debt to equity ratio of 10:90 and an estimated equity beta of 1·53.
Roney Co has a total firm value (market value of debt and equity combined) of $40 million.
Information about combine Company
Following the acquisition, it is expected that the combined company’s sales revenue will be
$51,952,000 in the first year, and its profit margin on sales will be 30% for the foreseeable
future. After the first year the growth rate in sales revenue will be 5·8% per year for the
following three years. Following the acquisition, it is expected that the combined company
will pay annual interest at 6·4% on future borrowings.
The combined company will require additional investment in assets of $513,000 in the first
year and then 18c per $1 increase in sales revenue for the next three years. It is anticipated
that after the forecasted four-year period, its free cash flow growth rate will be half the sales
revenue growth rate.
It can be assumed that the asset beta of the combined company is the weighted average of
the individual companies’ asset betas, weighted in proportion of the individual companies’
market value.
The current annual government base rate is 4·5% and the market risk premium is estimated
at 6% per year. The Tax rate is 28%.
Required:
Evaluates whether the acquisition of Roney Co would be beneficial to Nemar Co and
its shareholders. The free cash flow to firm method should be used to estimate the
values of Roney Co and the combined company assuming that the combined
company’s capital structure stays the same as that of Nemar Co’s current capital
structure. Include all relevant calculation.
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METHODS OF FINANCING MERGERS
SHARE FOR SHARE EXCHANGE
Example
Market value of target company $5 per share, market value of acquirer $4 per share.
Acquirer has offered its 3 shares for every 2 shares of Target Company.
Calculate %age benefits for Target Company.
Solution:
Value Offered = 3 x 4
Value of Target = 2 x 5
Gain
$
= $12.00
= $10.00
$2.00
Gain %age= 2/10 x 100
20%
In share for share exchange as soon as acquirer company transfer its shares to target
company, both company’s shareholders will become the owner of group so combine value of
group is more relevant here rather than the existing value of acquirer.
Example
Market value of Target Company is $2.50, market value of acquirer $3.00, combined market
value $4.00.
Acquirer has offered its 2 shares for every 3 shares of Target Company.
Requirement: Calculate %age gain to both the acquirer and target shareholders.
Solution:
Gain to Target Co
Value offer (Based on combine value)
2x4
Value of target co 3 x 2.5
Gain
= 0.5/7.5
$8
7.5
0.5
6.67%
Gain to Acquirer
Post-acquisition value
( COMBINE VALUE)
Pre-acquisition value
4
Gain
1
=1/3
33.33 %
3
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Combined Market Value
o
o
o
o
Earning Based (P/E will be given, synergy/year given)
Based on total synergy
Based on combine free cash flow and combined WACC
Based on combine Free cashflows to equity and price to cashflow ratio.
EARNING BASED:
 Combine Earnings = Acquirer Earnings + Target Earnings + Synergy/year ➢ Combine Market
Value = Combined Earnings x P/E of Group
Combine market value
 Combine M.V/Share =
Combine Market Value
Combine market value based on total synergy
M.V of Acquirer + M.V of target Co + Total Synergy = Combine M.V of Equity
Combine market value
 Combine M.V/Share =
Combine market value based on free cash flows
Step 1:
Calculate Combine M.V by discounting FCFF with combined WACC.
Step 2:
Combined M.V of Equity = M.V of Business – Total Debt M.V (consolidated Debt)
Combine market value
 Combine M.V/Share =
Based on combine FCFE and price to cashflow ratio:
 Combine FCFE = Acquirer FCFE + Target FCFE + cash based Synergy/year
 ➢ Combine Market Value = Combined FCFE x P/CF of Group
Combine market value
 Combine M.V/Share =
CASH OFFER
Example:
Market value of target co. is $4/share. Acquirer has offered $5 each for every share of
Target Company. Calculate %age gain to the target company shareholders.
Solution
Gain to Target Co
Cash Offer
Value of target co
Gain
5
4
1
25 %
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Combined Market Value
Calculate combine M.V using any method given.
Combine market value−cash paid

Combine M.V/Share =
Existing acquirer shares
BOND OFFER
Example:
M.V of target co is $4/Share. Acquirer has offered $110 worth Bond for every 20 shares of
target co. Calculate %age gain for target company shareholders.
Solution
Gain to Target Co
Value of bond/ shares offered=110/20
Value of target co
Gain
$5.5
$4
1.5
37 %
STEPS
Combine Market Value (In-order to calculate acquirers gain)
Calculate combined market value using given method
➢ Combine M.V/Share =
Combine market value−value of debt
Existing acquirer shares
MIX OFFER
•
•
•
Cash + share offer
Cash + bond offer
Bond + share offer
Combine value can be calculated using combine the individual formula of calculating combine
market value
Cash + share offer
➢ Combine M.V/Share =
Example: Market value of target company $5 per share. Company has offered $107 worth
bond for 25 shares of Target Company plus $1.50 cash for every share of Target Company.
Requirement: Calculate %age gain to the target company.
Solution
Value of Offer
Shares
Cash
107/25
4.28
1.50
5.78
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Value of target
(5.00)
Gain
0.78
Gain percentage
15.60%
Example: Market value of target company $5 per share. Acquirer has offered $0.25 cash and
its 3 shares for every 2 shares of Target Company. Market value of acquirer is $3 per share
and market value of Combine Company is $ 3.5 per share.
Requirement: Calculate %age gain to the target company.
Solution
Value of Offer
Shares offer =3.5 x 3
10.5
Cash = 2X 0.25
0.5
11
Value of target = 2 x 5
(10)
Gain
1
Gain percentage
10%
Example
Rayn Co, an unlisted company, designs and develops tools and parts for specialist machinery.
The Board of Directors, consisting of the three friends and a representative from each
business angel organisation, met recently to discuss how to secure the company’s future
prospects. Proposal was put forward, as follows:
To accept a takeover offer from Meon Co, a listed company, which develops and manufactures
specialist machinery tools and parts. The takeover offer is for $2·95 cash per share or a shareforshare exchange where two Meon Co shares would be offered for three Rayn Co shares.
Meon Co would need to get the final approval from its shareholders if either offer is accepted;
Currently, Meon Co has 10 million shares in issue and these are trading for $4·80 each. Meon
Co’s price to earnings (P/E) ratio is 15. It has sufficient cash to pay for Rayn Co’s equity and
a substantial proportion of its debt, and believes that this will enable Rayn Co to operate on a
P/E level of 15 as well. In addition to this, Meon Co believes that it can find cost-based
synergies of $150,000 after tax per year for the foreseeable future. Meon Co’s current profit
after tax is $3,200,000. Rayn Co share price is 2.90$ / share.
Rayn Co PAT is $ 620,000. Number of shares are 2.4 million.
Required:
(ii) Estimates the percentage gain in value to a Rayn Co share and a Meon Co share
under each payment offer;
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Example
Abel Co, a listed engineering company, manufactures large scale plant and machinery for
industrial companies.
Abel Co is c u r r e n t l y c o n s i d er i n g acquiring Adam Co, an unlisted company.
Given below are extracts of financial information for the two companies for the year ended
30 April 2014.
Sales Revenue
PBDIT
Interest
Depreciation
Pre- tax profit
Non-current assets
Current assets
7% unsecured bond
Other
non-current
and current liabilities
Share
capital
(50c/share)
Reserves
Abel
Million
790.2
244.4
13.8
72.4
158.2
Adam
Million
124.6
37.4
4.30
10.1
23
723.9
142.6
212.4
98.2
46.5
40
20.2
190
20
464.1
64.5
Abel Co’s current share price is $3.2 per share and it is estimated that Adam Co’s price-toearnings (PE) ratio is 30 % higher than Abel Co’s PE ratio. After the acquisition, when Adam
becomes part of Abel Co, it is estimated that Abel Co’s PE ratio will increase by 17%.
It is estimated that the combined company’s annual after-tax earnings will increase by $7.5
million due to the synergy benefits resulting from combining Abel Co and Adam.
Calculate the Maximum Premium to acquire Adam?
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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
•
•
•
Portfolio restructuring involves the acquisition of companies, or disposals of assets,
business units and/or subsidiary companies through divestments, demergers, spin-offs,
MBOs and MBIs.
It involves making additions to or disposals from companies businesses.
It includes Divestments, Demergers, spin-offs or management buy-outs.
Organizational Reconstruction
•
•
•
It involves changing the organizational structure of the firm.
Organisational restructuring involves changing the way a company is organised. This may
involve changing the structure of divisions in a business, business processes and other
changes such as corporate governance.
The aim of either type of restructuring is to increase the performance and value of the
business
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
Step: 1 - 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
Liquidation Fees
Redundancy Cost
Secure Creditors
Unsecured Creditors
Trade Payable
Overdraft
Preference shares Ordinary Shares
XX
(xx)
(xx)
(xx)
(xx)
(xx)
XX
Step: 2 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.
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Step 3: Analyze the Restructuring Proposal and check whether the parties will be better off under
the proposed scheme compare to liquidation.
•
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
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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.
✓ 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 de-listed.
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.
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Unbundling
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.
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.
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.
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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.
Share Buyback Scheme
The main benefit of a share buyback scheme to investors is that it helps to control transaction costs
and manage tax liabilities. With the share buyback scheme, the shareholders can choose whether or
not to sell their shares back to the company. In this way they can manage the amount of cash they
receive.
On the other hand, with dividend payments, and especially large special dividends, this choice is lost,
and may result in a high tax bill. If the shareholder chooses to re-invest the funds, it will result in
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transaction costs. An added benefit is that, as the share capital is reduced, the earnings per share and
the share price may increase.
Finally, share buybacks are normally viewed as positive signals by markets and may result in an even
higher share price.
Triple Line Bottom Report (TBL)
An assessment by the management of a corporation’s performance in the three factors – economic,
environmental and social, that make up the TBL report will result in an improvement in the financial
position, if long-term shareholder value is increased as a result of the report being produced.
The benefits that accrue from the assessment and production of a TBL report must exceed the costs
of undertaking the report. It is likely to be the case that the costs of producing the report are relatively
easy to measure but the financial benefits may be more difficult to measure and may take place over
a longer time period.
Focusing on and reporting the company’s environmental and social impact may build and enhance its
reputation. Increasing reputation may increase the long-term revenue of the company. On the other
hand, if it does not follow (or even try to lead) its competitors in this area then the loss of reputation
may damage its revenues stream and lower its corporate value.
Consideration and improvement of working standards and consulting employees as part of this
process, when assessing social factors, may help in retaining and attracting high performing, high
calibre employees.
This will benefit the company in the long term because of increased employee motivation and
performance. Employee involvement may also help reduce the costs related to the company’s risk
management activity and thus have a direct cost reduction impact.
Improvement of due diligence procedures as part of the economic factor assessment may help limit
direct legal costs and indirect costs incurred in maintaining stakeholder relationships.
Communication with stakeholders and thus improving the quality of reporting may result in
improvements in governance procedures. This in turn would lead to a reduction of the costs related to
risk management.
Assessing and improving the environmental factor impact in the TBL report may result in making efforts
to reduce its carbon footprint by placing less reliance on exports and developing local expertise in
producing the inputs it needs.
This may reduce the risk of supplier related problems and alleviate problems related to possible
inventory shortfalls. It may also improve reputation, leading to long-term financial benefits.
Monitoring and reporting on the performance of employees and managers as part of the assessment
of economic and social factors may help identify areas where work can be done more effectively and
efficiently. It may help managers reconsider business processes and question areas where
improvements can be made.
In all the above examples, the result of the assessment required in producing the TBL report and
comparing the corporation’s progress in relation to its aim of becoming a sustainable organisation will
create opportunities which senior managers can develop into financial benefits.
The extent to which these opportunities are successfully developed depends on the quality of
assessment and the organisation’s ability to enable change to happen.
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FOREIGN CURRENCY RISK MANAGEMENT
FOREX
How
to
Currency
Convert
How
Currency
Fluctuates
Types
Risk
of
Foreign
Hedging Methods
RISK MANAGEMENT
QUOTES
Quotes
Quoted
Example (Pakistan)
Converting foreign
currency to local
Direct
Local/foreign
Rs. 100/1$
Indirect
Foreign/local
$0.01/1Re.
Multiply eg. $10= (100 X
10) = Rs. 1,000
Divide eg. $10 = (10/0.01)
= Rs. 1,000
EXCHANGE RATE CONVERSION
Bid
Bank Buy
1.2320 $/£
Offer/ask
Bank Sell
1.2324 $/£
When dealing with converting foreign currency, it is important to consider the following points ➢
Always consider yourself at Adverse Position
In case of Receipt (Lower
Receipt)
➢
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;
𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑹𝒂𝒕𝒆 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑺𝒑𝒐𝒕 𝒓𝒂𝒕𝒆 𝑿
𝟏 + 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆 𝒊𝒏 𝟏𝒔𝒕 𝒄𝒐𝒖𝒏𝒕𝒓𝒚
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
The exposure is in the form of translation exposure, where a subsidiary’s assets are being
translated from the subsidiary’s different local currency. The local currency is facing an
imminent depreciation.
Translation of currency is an accounting entry where subsidiary accounts are incorporated
into the group accounts. No physical cash flows in or out of the company.
•
•
In such cases, spending money to hedge such risk means that the group loses money overall,
reducing the cash flows attributable to shareholders. However, translation losses may be
viewed negatively by the equity holders and may impact some analytical trends and ratios
negatively. The most efficient way to hedge translation exposure is to match the assets and
liabilities.
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
The present value of future sales of a locally produced and sold good is being eroded because
of overseas products being sold for a relatively cheaper price. The case seems to indicate that
because the US$ has depreciated against the Euro, it is possible to sell the goods at the same
dollar price but at a lower Euro price. This is known as economic exposure.
Economic exposure, which is not part of transactions exposure, is long-term in nature and
therefore more difficult to manage. There are for example, few derivatives which are offered
over a long period, with the possible exception of swaps.
A further issue is that economic exposure may cause a substantial negative impact to a
company’s cash flows and value over the long period of time.
A strategic, long-term viewpoint needs to be undertaken to manage risk of this nature, such as
locating production in countries with favourable exchange rates and cheaper raw material and
labour inputs or setting up a subsidiary company in the country to create a natural hedge for
the majority of the cash flows.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
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TRANSACTION RISK - INTERNAL HEDGING METHOD
TRANSACTION RISK
A possible exposure due to the receipt it is expecting in four months in a foreign currency, and the
possibility that the exchange rates may move against it between now and in four months’ time. This
is known as transactions exposure.
Transactions exposure, lasts for a short while and is easier to manage by means of derivative
products or more conventional means. A company has access to two derivative products: an OTC
forward rate and OTC option.
A company should also explore alternative strategies to derivative hedging. For example, money
markets, leading and lagging, and maintaining a foreign currency account may be possibilities. If
information on the investment rate in foreign currency could be obtained, then a money market
hedge could be considered. Maintaining a foreign currency account may enable to offset any natural
hedges and only convert currency periodically to minimise transaction costs.
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.
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.
The advantage of using a central treasury for multilateral netting is that the central treasury can
coordinate the information about inter-group balances. There will be a smaller number of foreign
exchange transactions, which will mean lower commission and transmission costs. There will
be less loss of interest through money being in transit. The foreign exchange rates available
may be more advantageous as a result of large transaction sizes resulting from consolidation.
The netting arrangements should make cash flow forecasting easier in the group.
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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)
Receipts
Read Across
USA
UK
Europe
Total
Payments
Total Receipts
Net Amounts
USA
X
X
X
(xx)
UK
x
x
x
(xx)
Europe
x
x
x
(xx)
Xx
(xx)
xx
(xx)
xx
xx
Total Receipts
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.
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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$), Trudeau Co, based in Canada (currency CAD) and Shinzo Co, based in
Japan (currency JPY).Amounts are in million.
Owed by
KRish Co
KRish Co
Shinzo Co
Shinzo Co
Trudeau Co
Trudeau Co
LALA Co
LALA Co
Owed to
LALA Co
Trudeau Co
Trudeau Co
LALA Co
LALA Co
KRish Co
Shinzo Co
KRish Co
Amount
US$ 4·5 million
CAD 1·1 million
CAD 3·2 million
US$ 1·4 million
US$ 1·5 million
CAD 3·4 million
JPY 320 million
US$ 2.1 million
Exchange rates available to KRish Co
Spot
US$/£1
CAD/£1
JPY/£1
1·2938–1·2962
1·6690–1·6710
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 predetermined 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.
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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
3.
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.
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.
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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
Customized Contracts
Any Amount
Available in any Currency
Settlement on any date
No Initial margin requirement
Gain or Loss settled at maturity
High Risk of Default
Counter Party is another Investor
E.G FORWARD CONTRACTS
Exchange-Traded Derivatives
Standardized Contracts
Standardized Contract Size (e.g. $ 62,500)
Major Currencies
Settlement Date – Mar/Jun/Sept/Dec
Initial Margin Requirement
Gain or Loss settled on daily basis using
‘Mark to Market”
Counter Party is clearing house.
E.G FUTURE CONTACTS
Benefits & Drawbacks of Forward Contract in comparison to Over the Counter
Option (OTC)
Benefits
•
•
•
A forward contract would not involve payment of a large premium upfront to the counterparty.
A forward contract is a simple arrangement to understand, whereas the basis of calculation of the
premium for an over‑the‑counter (OTC) option may be unclear.
A forward contract gives a certain receipt for the purposes of budgeting.
Drawbacks
•
•
•
•
A forward contract has to be fulfilled, even if the transaction which led to the forward contract being
purchased is cancelled. Exchange rate movements may mean that the contract has to be fulfilled at an
unfavourable rate. An OTC option can be allowed to lapse if it is not needed.
A forward contract does not allow the holder to take advantage of favourable exchange rate
movements. An OTC option need not be exercised if the exchange rate moves in the holder’s favour.
A forward contract may only be available for a short time period, depending on what currencies are
involved. An OTC option may be purchased for a longer time period, over a year.
The rate offered on a forward contract will be determined by a prediction based on expected interest
rates. The rate offered on an OTC option may be more flexible. This may suit a holder who is prepared
to tolerate the risk of some loss in order to have the opportunity to take advantage of favourable
exchange rate movements, but who wishes to use the option to set a limit to possible losses.
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Advantages & Disadvantages of Over the Counter Options (OTC) and Exchange
Traded Options (ETO)
Advantages
Exchange traded options are readily available on the financial markets, their price and contract
details are transparent, and there is no need to negotiate these. Greater transparency and tight
regulations can make exchange traded options less risky. For these reasons, exchange traded
options’ transaction costs can be lower. The option buyer can sell (close) the options before
expiry. American style options can be exercised any time before expiry and most traded options
are American style options, whereas over-the-counter options tend to be European style
options.
Disadvantages
The maturity date and contract sizes for exchange traded options are fixed, whereas over-thecounter options can be tailored to the needs of parties buying and selling the options. Exchange
traded options tend to be of shorter terms, so if longer term options are needed, then they would
probably need to be over-the-counter. A wider range of products (for example, a greater choice
of currencies) is normally available in over-the-counter options markets.
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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
Contract size £62,500
Solution
Sell £ Future Contracts
Example 4
Currency ¥
Imports $1,000,000
Contract size ¥1.5million
Solution
Sell ¥ Future Contracts
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Steps in future contract hedging
1)
2)
3)
Identify the amount of currency to be hedged
Decide whether to buy or sell future
Identify the settlement date expiring immediately after the payment is due to be paid or
received
4)
Calculate no of contracts →
Transaction Amount
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
7)
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
£ 1st Jan
$400,000 at 1st
May
1.40-1.41 $/£
1.45 $/£
1.44 $/£
£ 25,000
1.466-1.467 $/£
1.47 $/£
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
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Types of Future
TYPE: 1
1.
2.
3.
Opening Future rate is given
Closing Future rate is given
Closing Spot rate is given
TYPE: 2
1.
2.
3.
Opening Future rate is given
Closing Future rate is not given
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
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
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Type 3
1)
2)
3)
Opening Future Rate is Given
Closing Future Rate is not Given
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.
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.
Basis risk occurs when the basis does not diminish at a constant rate. In this case, if a futures
contract is held until it matures then there is no basis risk because at maturity the derivative price
will equal the underlying asset’s price.
However, if a contract is closed out before maturity, there is no guarantee that the price of the
futures contract will equal the predicted price based on basis at that date.
On the other hand, it could be argued that the basis risk will probably be smaller than the risk
exposure to interest rates without hedging and therefore, although some risk will exist, its impact
will be smaller.
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.
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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.
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
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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.
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
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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
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
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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.
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.
Step 7:
NOTE: It is assumed that option will be exercised.
Exercise the option
×××
Over or under hedge amount
× ××
Premium
×××
Net Amount
×××
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•
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.
•
•
•
o
Traded options are standard sizes and are thus 'tradable' which means they can be sold on to
other parties if not required. OTC options are designed for a specific purpose and are therefore
unlikely to be suitable for another party.
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
3-month expiry
1·87
1·34
Put Options
6-month expiry
2·75
2·22
3-month expiry
1·41
1·88
6-month expiry
2·16
2·63
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
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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-the-counter
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 ?
Preferred Hedging Choice
•
•
•
•
•
Forward contracts binding whereas the options give the company choice to let the option lapse.
Futures are marked-to-market daily and require a margin.
Therefore, basis risk still exists with futures contracts. Although forward contracts give a
smaller return, there are no basis risk and margin requirements.
Forwards contain a higher risk of default as they are not market traded.
Exercising the options at a specific exercise price depends on a company’s attitude towards
risk.
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.
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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.
Use of Derivatives for Mitigating Interest rate Risk
Derivatives offer an opportunity for a firm to vary its exposure to interest rate risk at a given rate of
interest on the underlying principal (hedging) or to decrease the rate of interest on its principal at
an increased level of risk exposure. For hedging purposes derivatives permit the management of
exposure either for the long term (swaps) or for the short term (Forward Rate Agreements (FRAs),
Interest Rate Futures (IRFs), Interest Rate Options (IROs) and hybrids). With forward and futures
contracts, the mechanism of hedging is the same in that an offsetting position is struck such that
both parties forego the possibility of upside in order to eliminate the risk of downside in the
underlying rate movements. Where the option to benefit from favourable rate movements is
required or in situations where there is uncertainty whether a hedge will be required, then an IRO
may be the more appropriate but higher cost alternative. Such hedging can be more or less efficient
depending upon the ability to set up perfectly matched exposures with zero default risk. Matching
depends upon the nature of the contract. With OTC agreements the efficiency of the match may be
perfect but the risk of default remains. With traded derivatives, the efficiency of the match may be
less than perfect either through size effects or because of the lack of a perfect match on the
underlying (for example the use of a LIBOR derivative against an underlying reference rate which
is not LIBOR). There will also be basis risk where the maturity of the derivative does not coincide
exactly with the underlying exposure.
Where a company forms a view that future spot rates will be lower than those specified by the
forward yield curve they may decide to alter their exposure to interest rate risk in order to capture
the benefit of the reduced rate. This can be achieved through the use of IROs. Alternatively,
leveraged swap or leveraged FRA positions can be taken to avoid the upfront cost of an IRO. For
example, taking multiples of the variable leg of a swap (i.e. agreeing to swap fixed for variable)
where a higher than market fixed rate is swapped for ‘n’ multiples of the variable rate. However, as
a number of cases have demonstrated it may be very difficult with these types of arrangement to
gauge the degree of risk exposure and to ensure that they are effectively managed by the firm. In
the 1990s a number of companies in the US and elsewhere took leveraged positions, without
recognising the degree of their exposure and took losses that threatened the survival of the firm.
METHODS OF HEDGING INTEREST RATE RISK
•
•
•
•
•
Forward rate Agreement (FRA)
Interest Rate Future
Options
Interest Rate Swaps
CAP, FLOOR & COLLAR
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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
Co, pays the bank the
Difference
difference
FORWARD RATE AGREEMENT
Example
It is 30 June. Lynn plc will need a £10 million 6 month fixed rate after 3 months. Company is
expecting that interest rate will rise in future and wants to hedge using an FRA.
The following FRA are available
3-6 FRA 5%- 5.5%
3-9 FRA 5.5% - 6%
Lynn can borrow in market at Libor + 50 basis points.
a)
1.
What is the result of the FRA and the effective loan rate if the 6 month Libor rates has
moved to
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)
(i)
The forward rate agreement required is 3-9.
At 5% because interest rates have fallen, Lynn plc will pay the bank:
FRA payment £10 million x (6% - 5%) x 6/12
Payment on underlying loan (5% +0.5%)x £10 million x
6/12
Net payment on loan
Effective interest rate on loan
(ii)
£
(50,000)
(275,000)
(325,000)
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
Payment on underlying loan at market rate 9.5% x £10
million x 6/12
Net payment on loan
Effective interest rate on loan
£
150,000
(475,000)
(325,000)
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.
g)
No. of contracts
= amount of loan /deposit x time period of loan
Contract size
3
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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.
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
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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.
•
High upfront premium Cost
JAN
6%
Floor @
4%
5%
MAR
6%
JUN
6%
Interest Rate
9%
2% (Gain)
1% (Gain)
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
Interest Rate Collar for loan
i.
ii.
iii.
iv.
v.
Obtain a put option to set maximum interest rate on loan (CAP).
Payment of premium cost for holding put option.
Grant a call option to third party to set minimum interest rate on loan (FLOOR).
Receipt of premium from third party for granting call option.
Actual Date of borrowing
•
•
LIBOR > CAP = Exercise the option at strike price
LIBOR < FIOOR = Transfer benefit to third party for exercising call option (buy future)
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Loan Interest
•
Protect Company
Buy a put option – a cap
- Set a higher limit – maximum cost
Open market interest rate
Sell a call option – a floor
- Sets a lower limit – minimum cost
%
Market LIBOR > CAP
Actual Interest on Loan
(X)
Premium Cost
(X)
Premium receipt on call option
Gain received on future (put option)
(Sell Future Price – Buy Future Price)
X
X
Net Interest Cost
(X)
Market LIBOR < FLOOR
%
Actual Interest on Loan
(X)
Premium Cost
(X)
Premium receipt on call option
Gain transferred to third party on future
(Sell Future Price – Buy Future Price)
Net Interest Cost
X
(X)
(X)
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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.
Interest Rate Collar for deposit
vi.
vii.
viii.
ix.
x.
Obtain a put option to set maximum interest rate on deposit (FLOOR).
Payment of premium cost for holding call option.
Grant a put option to third party to set minimum interest rate on deposit (CAP).
Receipt of premium from third party for granting put option.
Actual Date of Deposit
•
•
LIBOR < FLOOR = Exercise the option at strike price
LIBOR > CAP = Transfer benefit to third party for exercising put option (sell future)
Deposit Interest
Benefits counterparty
Sell a put option – a cap
- Set a higher limit – maximum receipts
Open market interest rate
Buy a call option – a floor
- Sets a lower limit – minimum receipts
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Interest Rate Collar for Deposit
Market LIBOR < FLOOR
%
Actual Interest on Deposit
X
Premium Cost
(X)
Premium receipt on put option
Gain received on future (call option)
(Sell Future Price – Buy Future Price)
X
X
Net Interest Receipts
(X)
Market LIBOR > CAP
%
Actual Interest on Loan
(X)
Premium Cost
(X)
Premium receipt on call option
Gain transferred to third party on future
(Sell Future Price – Buy Future Price)
X
(X)
(X)
Net Interest Cost
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
•
•
1.
2.
3.
4.
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
Actual Borrowing from Market
Gain or loss on Collar
Net premium cost
Effective Cost
xx
xx
xx
X
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LENDER COLLAR
•
1.
2.
3.
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
Actual Deposit from Market
Gain or loss on Collar
Net premium cost
Effective Income
xx
xx
xx
X
Advantage of Interest Rate Collar
The main advantage of using a collar instead of options to hedge interest rate risk is lower cost. A
collar involves the simultaneous purchase and sale of both call and put options at different exercise
prices.
The option purchased has a higher premium when compared to the premium of the option sold, but
the lower premium income will reduce the higher premium payable. With a normal uncovered option,
the full premium is payable.
Disadvantage of Interest Rate Collar
However, the main disadvantage is that, whereas with a hedge using options the buyer can get full
benefit of any upside movement in the price of the underlying asset, with a collar hedge the benefit
of the upside movement is limited or capped as well.
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%
• Distribute the savings between both parties as per the arrangement provided otherwise divide
equally.
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•
Deduct the swap dealer's fee from the savings to compute the Net savings.
Share of A (1/3)
Share of B (2/3)
Swap Fees
0.10%
0.10%
0.25%
0.50%
Net Savings
0.15%
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.
Firm A
Firm B
Preferred Price
9.25%
Libor + 0.5%
Net Savings
0.15%
0.40%
Final Cost
9.10%
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
Borrow Floating
Pays to B
Receives from B
Net Cost
Swap Fee
Final Cost
Firm A
(LABOR + 1.5%)
(9.00%)
LIBOR + 1.5%
(9.00%)
(0.10%)
(9.10%)
Borrows Fixed
Receives from A
Pays to A
Firm B
(7.5%)
9.00%
(LIBOR+1.5%)
(LIBOR)
(0.10%)
(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.
Disadvantages
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•
The swap represents a long-term commitment at a time when interest rates appear uncertain. It
may be that interest rates rises are lower than expected.
Pault Co will be liable for an arrangement fee. However, other methods of hedging which could
be used will have a cost built into them as well.
•
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.
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: 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.
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.
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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.
Advantages & Disadvantages of Currency Swap
Advantages
•
•
•
•
Payment of interest in currency of the counterparty e.g ($) can be used to match the income will receive
from the rail franchise, reducing foreign exchange risk.
It will be able to obtain the swap for the amount it requires and may be able to reverse the swap by
exchanging with the other counterparty and is more certain than the other methods of hedging risk.
The cost of a swap may also be cheaper than other methods of hedging, such as options.
The swap can be used to change company’s debt profile if it is weighted towards fixed-rate debt and
its directors want a greater proportion of floating rate debt, to diversify risk and take advantage of
probable lower future interest rates.
Disadvantages
•
•
•
•
The counterparty may default. This would leave company liable to pay interest on the loan in its
currency. The risk of default can be reduced by obtaining a bank guarantee for the counterparty.
The swap may not be a worthwhile means of hedging currency risk if the exchange rate is
unpredictable.
If it is assumed that exchange rates are largely determined by inflation rates, the predicted inflation
rate is unstable, making it more difficult to predict future exchange rates confidently.
A company swapping a fixed rate commitment in for example (Eurozone) for a floating rate in for
example ($). If the inflation is increasing in $ country and there is a risk that interest rates will increase
as a result, increasing Eurozone finance costs.
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.
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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:
USA
Eurozone
USA
Eurozone
Gain on swap
Bank fee
Final gain
Barrow Co
3.6%
EURIBOR + 1.5%
Greening Co
4.5%
EURIBOR + 0.8%
Barrow Co
3.6%
EURIBOR + 1.5%
Greening Co
4.5%
EURIBOR + 0.8%
(0.2%)
0.6%
(0.2%)
0.6%
Barrow Co borrows
Greening Co borrows
Swap
Greening Co receives
Barrow Co pays
Barrow Co receives
Greening Co pays
Net result
Bank fee
Overall result
Barrow Co
3.6%
Swap Combinations
EURIBOR+6%
EURIBOR+4.4%
1.6%
(0.4%)
1.2%
Greening Co
EURIBOR + 0.8%
(EURIBOR)
EURIBOR
(2.9%)
EURIBOR + 0.7%
0.2%
EURIBOR + 0.9%
2.9%
3.7%
0.2%
3.9%
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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.
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-to-day 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.
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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-the-money 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 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
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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 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.
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RISK DIVERSIFICATION
Risk diversification, especially into diverse business sectors, has often been stated as a reason for
undertaking mergers and acquisitions (M&A’s). Like individuals holding well-diversified portfolios, a
company with a number of subsidiaries in different sectors could reduce its exposure to unsystematic
risk. Another possible benefit of diversification is sometimes argued to be a reduction in the volatility of
cash flows, which may lead to a better credit rating and a lower cost of capital.
The argument against this states that since individual investors can undertake this level of risk
diversification both quickly and cheaply themselves, there is little reason for companies to do so. Indeed,
research suggests that markets do not reward this risk diversification.
Nevertheless, a company, undertaking M&A’s may have beneficial outcomes, especially if the sovereign
fund has its entire investment in the holding company and is not well-diversified itself. In such a situation
unsystematic risk reduction can be beneficial.
If a company is able to identify undervalued companies and after purchasing the company can increase
the value for the holding company overall, by increasing the value of the undervalued companies, then
such M&As activity would have a beneficial impact on the funds invested. However, for this strategy to
work, it is must to:
(i) Possess a superior capability or knowledge in identifying bargain buys ahead of its competitor
companies. To achieve this, it must have access to better information, which it can tap into quicker, and/or
have superior analytical tools. A company should assess whether or not it does possess such capabilities,
otherwise its claim is not valid;
(ii) Ensure that it has quick access to the necessary funds to pursue an undervalued acquisition. Even
if the company possesses superior knowledge, it is unlikely that this will last for a long time before its
competitors find out; therefore it needs to have the funds ready, to move quickly. Given that it has access
to sovereign funds from a wealthy source, access to funds is probably not a problem;
(iii) Set a maximum ceiling for the price it is willing to pay and should not go over this amount, or the
potential value created will be reduced. If, in its assessment, the company is able to show that it meets
all the above conditions, then the strategy of identifying and pursuing undervalued companies may be
valid.
Raising Equity Capital to pay off the Floating rate debt
Reducing the amount of debt by issuing equity and using the cash raised from this to reduce the amount
borrowed changes the capital structure of a company and needs to consider all the possible implications
of this. As the proportion of debt increases in a company’s financial structure, the level of financial distress
increases and with it the associated costs. Companies with high levels of financial distress would find it
more costly to contract with their stakeholders.
For example, they may have to pay higher wages to attract the right calibre of employees, give customers
longer credit periods or larger discounts, and may have to accept supplies on more onerous terms.
Furthermore, restrictive covenants may make it more difficult to borrow funds (debt and equity) for future
projects. On the other hand, because interest is payable before tax, larger amounts of debt will give
companies greater taxation benefits, known as the tax shield. However, reducing the amount of debt
would result in a higher credit rating for the company and reduce the scale of restrictive covenants.
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Having greater equity would also increase the company’s debt capacity. This may enable the company
to raise additional finance and undertake future profitable projects more easily. Less financial distress
may also reduce the costs of contracting with stakeholders.
The process of changing the financial structure can be expensive. Therefore, there is a need to determine
the costs associated with early redemption of debt. The contractual clauses of the bond should indicate
the level and amount of early redemption penalties. Issuing new equity can be expensive especially if the
shares are offered to new shareholders, such as costs associated with underwriting the issue and
communicating or negotiating the share price. Even raising funds by issuing rights can be expensive. As
well as this, there will be a need to determine the extent to which the current shareholders will be able to
take up the rights and the amount of discount that needs to be given on the rights issue to ensure 100%
take up.
The impact on the current share price from the issue of rights needs to be considered as well. Studies on
rights issues seem to indicate that the markets view the issue of rights as a positive signal and the share
price does not reduce to the expected theoretical ex-rights price.
However, this is mainly because the markets expect the funds raised to be used on new, profitable
projects. Using funds to reduce the debt amount may not be viewed so positively.
A company may also have to provide information and justification to the market because both the existing
shareholders and any new shareholders will need to be assured that the company is not benefiting one
group at the expense of the other.
If sufficient information is not provided then either shareholder group may discount the share price due
to information asymmetry. However, providing too much information may reduce the competitive position
of the company.
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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
Volatility
Increase
increase
Interest Rate
Increase
Decrease
S=standard deviation ( in
decimal )
Risk free rate = Rf ( in
decimal
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
Calculate the value of call option
= $120
= $100
= 12%
= 40%
= 3 months
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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
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)
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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%.
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%?
Solution
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.
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Solution
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
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
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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 • Delta hedge is only valid
for small share price movement.
• 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.
Solution
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.
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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‘
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.
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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
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MACAULAY DURATION
Duration (Macaulay Duration) is the weighted average time to receive a bond’s benefits (annual interest
and redemption value) with the weights being the present value of benefits to be received.
➢ Duration compares two bonds by giving each an overall risk weighting.
➢ Steps to calculate Duration
• Find the present value of future cash flows
• Find total present value 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
EXAMPLE & SOLUTION
Example
Magic Inc has a bond (Bond X) in issue whi9ch has a nominal value of $1,000 and is
redeemable at par Bond X is a 6% bond maturing in three years’ time and has a gross
redemption yield (GRY) at 3.5%. The current price of the bond is $1070.12.
Required:
Calculate the duration of the bond.
Solution:
1
2
3
Cash Flow
60
60
1060
Discount Factor (3.5%)
0.966
0.934
0.902
Present Value
57.96
56.04
956.12
Proportion of each year
0.0541
0.0524
0.8935
Weighted average years
0.0541
0.1048
2.6805
Total
1070.12
2.84
PROPERTIES OF MACAULAY 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 zerocoupon bond where duration will be the maturity.
• Lower yields will give longer durations. In this case, the present values of flows in the future will
rise if the yield falls, extending the point of balance, therefore lengthening the duration
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MODIFIED DURATION
Modified Duration measures the sensitivity of the price of a bond to a change in the interest rates.
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
1 + 𝐺𝑅𝑌
Using the example on duration, the modified duration of the bond is
2.84/(1+.035) = 2.74
This can be used to determine the proportionate change in bond price for a given change in yield as
follows.
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
Δ𝑃
P x ΔY
Where:
∆𝑃 = Change in bond Price
∆𝑌 = 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 – i.e. bonds which are due to be
redeemed at a later date 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
THE BENEFITS AND LIMITATIONS OF DURATION
Benefits
•
•
•
It allows bonds of different maturities and coupon rates to be directly compared
If a bond portfolio is constructed based on weighted average duration, it is possible to
determine portfolio values changes based on interest changes
Managers may be able to modify interest rate risk by changing the duration of bond portfolio
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 will be an equal
percentage change in price
However as interest rates change the bond price is unlikely to change in a linear fashion
Convexity is another method which take into account the non-linear relation
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TRANCHING/ 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)
A securitisation of this type is a common method of refinancing in a large business. After the securitisation
of mortgages, car loan securitisation is the most important source of refinancing in the US and in Europe.
Structured finance arrangements such as this are also used in a variety of other industries from banking
to entertainment. The process of credit enhancement is the process whereby a relatively high risk cash
flow (car loans) can be converted into a range of collateralised loan obligations satisfying the varying risk
appetites of different investors.
In the securitisation process a rating agency would normally advise on the structure of the liabilities
created such that the AAA tranche will attract investors such as banks and other financial institutions who
demand a low level of risk exposure. This reduction in risk for the senior and intermediate level notes is
balanced by a significant transfer of risk to the subordinated certificate holders. Tranching the issue rather
than creating a single issue of an asset backed security is the most important mechanism for credit
enhancement.
Other approaches can entail insuring the risk of the issue through the use of credit default swaps or by
transferring a greater asset pool than is securitised (over collateralisation).
Benefits
•
•
The finance costs of the securitisation may be lower than the finance costs of ordinary loan capital.
The securitisation matches the assets of the future cash flows to the liabilities to loan note holders.
Risks have effectively been transferred to the loan note holders.
Risks
•
•
•
Not all of the tranches may appeal to investors. The risk-return relationship on the subordinated
certificates does not look very appealing, with the return quite likely to be below what is received on
the C-rated loan notes. Even the C-rated loan note holders may question the relationship between the
risk and return.
If a company seeks funding from other sources for other developments, transferring out a lower risk
income stream means that the residual risks associated with the rest of the company’s portfolio will be
higher. This may affect the availability and terms of other borrowing.
It appears that the size of the securitisation should be large enough for the costs to be bearable.
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 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
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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.
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.
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.
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.
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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.
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.
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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 thirdparty 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; 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.
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•
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 P4 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
European style 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 P4 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
Example:
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 = $5.8m
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Example 1: Delaying the decision to undertake a project - Continued
Supposing the company does not have to make the decision right now but can wait for two years
before it needs to make the decision.
NPV with the option to delay the decision for two years
Year
3
4
5
6
Cash flows ($)
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.
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Example 3: The option to abandon a project
Duck Co is considering a five-year project with an initial cost of $37,500,000 and has estimated the
present values of the project’s cash flows as follows:
Year
1
Present values
($ 000s)
1,496.9
2
3
4
5
4,938.8
9,946.5
7,064.2
13,602.9
Swan Co has approached Duck Co and offered to buy the entire project for $28m at the start of year
three. The risk free rate of return is 4%. Duck Co’s finance director is of the opinion that there are
many uncertainties surrounding the project and has assessed that the cash flows can vary by a
standard deviation of as much as 35% because of these uncertainties.
Solution:
Swan Co’s offer can be considered to be a real option for Duck Co. Since it is an offer to sell the project
as an abandonment option, a put option value is calculated based on the finance director’s assessment
of the standard deviation and using the Black-Scholes option pricing (BSOP) model, together with the
put-call parity formula.
Although Duck Co will not actually obtain any immediate cash flow from Swan Co’s offer, the real
option computation below, indicates that the project is worth pursuing because the volatility may result
in increases in future cash flows.
Without the real option
Year
Present
values ($
000s)
1
1,496.9
2
3
4
5
4,938.8
9,946.5
7,064.2
13,602.9
Present
value
of
cash
flows
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
approx.
=
$37,049,300
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)
Exercise Price (Pe)
Risk-free rate (r)
Time to exercise (t)
Volatility (s)
d1
$30.6m
$28m
4%
Two years
35%
0.588506
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d2
N(d1)
N(d2)
Call Value
Put Value
BY SHOAIB YAQOOB
0.093531
0.721904
0.537259
8.20
$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.
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 Americanstyle 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.
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NATURE OF MULTINATIONAL
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•
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•
•
•
•
•
•
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•
•
•
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
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.
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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
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.
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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.
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 intheir 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.
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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.
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).
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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.
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.
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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.
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.
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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.
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, the rules of
the EU) have to be admitted when protection or special low tariffs between a group 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 nontariff 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 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.
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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).
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.
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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.
Step 3 The underwriting syndicate then organizes the sale of the bond; this normally involves placing
the bond with institutional investors.
Advantages of Eurobonds:
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•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 threeyear 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.
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.
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•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 non-executive 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.
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:
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•
•
•
•
•
•
•
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.
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.
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▪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
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
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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.
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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
Tax @ 30%
Depreciation
Working Capital Change
Interest ( 1 – 1)
CAPEX
Net borrowings
Dividends from subsidiaries
Additional tax on dividends
Dividend Capacity
$
XX
(X)
X
(X)
(X)
(X)
X
X
X
xxx
Free Cash flow to equity
Net borrowings
Dividends from subsidiaries
Additional tax on dividends
Dividend Capacity
$
XX
X
X
(X)
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.
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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.
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
residualdividend 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.
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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.
Setting the transfer price at market price should enable a fair assessment of the performance of both
the buying and selling divisions. Both internal and external sales will be accounted for at the same
price. However, this may distort performance in that the costs of internal sales may be lower than
external sales. For example, administration costs should be lower and there should be no costs of bad
debts. These cost savings should be shared between the two divisions to give a fair picture.
If the selling division has spare capacity, selling at incremental cost rather than market price may
provide greater certainty that the buying division will use the selling division.
In theory, using market price should mean that the central treasury function has to intervene less.
The market price may be difficult to determine or may fluctuate wildly, and central treasury may have
to decide which price to use. If it is decided that an allowance should be made for costs of internal
transfer being lower, central treasury may have to determine what this should be as it may vary
significantly between products and divisions.
Specifying the transaction takes place at market price is designed to ensure that the buying division
buys from the selling division, rather than an external supplier. This implicit assumption may however
make both the divisions to focus more on low transfer price thus compromising the quality of services
they render.
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; ie 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 markup 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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CENTRALISED TREASURY DEPARTMENT
•
•
•
•
•
•
Avoids the need to have many bank accounts and may therefore reduce transactions costs and
high bank charges.
Large cash deposits may give access to a larger, diverse range of investment opportunities and
it may be able to earn interest on a short-term basis, to which smaller cash deposits do not have
access.
On the other hand, if bulk borrowings are required, it may be possible to negotiate lower interest
rates, which it would not be able to do on smaller borrowings.
An opportunity to match income and expenditure and reduce the need for excessive risk
management, and thereby reduce costs related to this.
Hire experts, which smaller, diverse treasury management departments may not have access to.
A centralised treasury function may be better able to access what is beneficial as a whole,
whereas local treasury functions may lead to dysfunctional behaviour.
DECENTRALISED TREASURY DEPARTMENT
•
•
•
•
It could be argued that decentralised treasury departments are better able to match and judge
the funding required with the need for asset purchases for investment purposes on a local level.
Response time is quick when opportunities arise and so could be more effective and efficient.
Individual departments within a subsidiary may have better relationships with the treasury
departments of that subsidiary and are therefore able to present their case without lengthy
bureaucratic delays.
Senior management and directors are more empowered and have greater autonomy. This in turn
may increase their levels of motivation, as they are more in control of their own future, resulting
in better decisions being made.
REGIONAL TREASURY FUNCTIONS
Organising treasury activities on a regional basis would be consistent with what is happening in the
group overall. A regional treasury function may be able to achieve synergies with them and also
benefit from information flows being organised based on the regional structure.
A regional function will avoid duplication of responsibilities over all the countries within a region. A
regional function will have more work to do, with maybe a greater range of activities, whereas staff
based nationally may be more likely to be under-employed.
There may be enough complex work on a regional basis to justify employing specialists which is
easier as compared to the national treasury function for the better performance. Regional centres
can carry out some activities on a regional basis which will simplify how funds are managed and
mean less cost than managing funds on a national basis.
Regional centres could in theory be located anywhere in the region, rather than having one treasury
function based in each country producing significant tax advantages and experiencing different
cultures.
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A regional function could employ experts with knowledge of the regulations, practices and culture of
the major countries within the region. It may be more difficult for a global function to recruit staff with
local expertise.
A regional function may have better ideas of local finance and investment opportunities.
REVERSE TAKEOVERS – AN EXPLANATION
An RTO involves a smaller quoted company taking over a larger unquoted company by a share-forshare 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 share-for-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.
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.
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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.
Regulation
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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.
WARRANT
A warrant is an option attached to another financial instrument on issue which can be detached and
negotiated independently of the underlying issue. Warrants are usually exercised over a longer term than
traded options but can be valued in exactly the same way using the Black Scholes Option Pricing Model
by inserting into the standard formula.
The Black Scholes model makes a number of restrictive assumptions:
1. The warrant is a ‘European’ style option.
2. The share price follows a log-normal distribution and is continuously traded.
3. Unrestricted short selling of the underlying security is permitted.
4. There are no market frictions such as taxes or transaction costs.
5. No dividends are paid during the life of the warrant.
MEZZANINE DEBT
Mezzanine debt is one mechanism by which a small, high growth firm can raise debt finance where the
risk of default is high and/or there is a low level of asset coverage for the loan. For example, if raising a
loan of would raise the market gearing of the firm from zero (assuming there is no current outstanding
debt) to let’s say 15% (debt to total capitalisation). This increase in borrowing against what might be
presumed to be specialised equipment and the forward cost of operation may not be attractive to the
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commercial banking sector and may need specialized venture finance. The issue of warrants gives the
lender the opportunity to participate in the success of the venture but with a reasonable level of coupon
assured.
However, the disadvantage for the current equity investors is that the value of their investment will be
reduced by the value of the warrants issued. The extent to which this will be worthwhile depends upon
the value of the firm on the assumption that the project proceeds and is financed in the way described.
This should ultimately decide the maximum value that they would be prepared to pay to finance the new
project.
SYNDICATION VS BOND ISSUE
Syndication is where a group of banks combine with one bank taking the lead in the arrangement.
Syndication allows banks to offer much larger loans in combination than would be feasible singly, and
given the range of banks involved can tailor loans (perhaps across different currencies) to more exactly
match our requirements. The management of the syndicate lies with the arranging bank but the effective
cost will be somewhat higher than with a conventional loan but usually much lower than the cost of raising
the necessary finance through a bond issue.
A bond issue is where the debt is securitised and floated onto the capital market normally with a fixed
interest coupon and a set redemption date. Initial set up costs can be high especially if the issue is
underwritten. A loan of the size envisaged is towards the low end of what would normally be raised
through this means. Some bond issues can be syndicated in that a number of borrowers of similar risk
are combined by the investment bank chosen to manage the issue.
The advantage of syndication is that it reduces the costs of issue. However, it may be that the best offer
would entail accepting a variable rate based on LIBOR which would have to be swapped out if we wished
to minimise interest rate risk.
Agency Problems
Principal – agent relationship
Agency Costs
Increased supervision
Motivational impact
Impact on performance and not producing better results
Difference in cultural and divergent backgrounds
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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
Mudaraba
Murabaha
Ijara
Sukuk
– a partnership contract
– a form of equity where a partnership exists and profits and losses are shared
– a form of credit sale
– a form of lease
– 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.
Mudaraba transactions are particularly suited to private equity investments or for clients depositing
money with a bank.
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Profit & loss
Capital Expertise
Profit & loss
Investing P a r tner
Business P a r tner
(RabalMal)
(Mudarib)
Business P a rtner
(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.
•
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.
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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 third-party 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.
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.
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•
•
•
•
•
•
•
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.
Figure2:Finance lease
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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.
Sukuk holders subscribe by paying an issue price to a special purpose vehicle (SPV) company.
In return, the SPV issues certificates indicating the percentage they own in the SPV.
The SPV uses the funds raised and purchases the asset from the obligor (seller).
In return, legal ownership is passed to the SPV.
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.
1.
2.
3.
4.
5.
ASSET-BACKED SUKUK
Sukuk: Securitisation of Leasing Portfolio
Sukuk holders subscribe by paying an issue price to a SPV company.
In return, the SPV issues certificates indicating the percentage they own in the SPV.
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.
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
1.
2.
3.
7.
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the sukuk holders suffer the losses. In addition, redemption for the sukuk holders is at open market
value, which could be nil
SALAM
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, 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.
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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.
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).
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Years
0
1-5
5
BY SHOAIB YAQOOB
Cash flows
(106.62)
7
100
5%
1
4.329
0.7835
PV
(106.62)
30.31
78.35
2.04
6%
1
4.2124
0.7473
(106.62)
29.49
74.73
(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.
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.
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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 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:
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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%
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
3.5%
Two-year
4.0%
Three-year 4.7% Four-year 5.5%
Rating
Year 1
AAA
14
AA
29
A
46
BBB
61
Year 2
25
41
60
75
Year 3
38
55
76
91
Year 4
52
70
90
105
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Answer:
Years
Cash flows
Discount
factors
MV
1
5
=1.0379^-1
2
5
=1.0441^-2
3
5
=1.0525^-3
4
105
=1.062^-4
4.82
96.25
4.59
4.29
82.55
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 Year Year Year
1
2
3
4
AAA
14
25
38
52
AA
29
41
55
70
A
46
60
76
90
BBB
61
75
91
105
Answer:
Years
Cash flows
Discount
factors
0
(100)
1
X
=1.0379^-1
2
X
=1.0441^-2
3
X
=1.0525^-3
4
X
=1.062^-4
4
100
=1.062^-4
1
0.9635X
0.9173X
0.8577X
0.7861X
78.61
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)
(ii)
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
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.
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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
3·2%
Bond Yield Spread
2
3·7%
3
4·2%
Bond Rating 1 year
2 years
3 years
AAA
5 9 14 19 25 AA 16 22 30 40 47
A
65
76
87
BBB
102
121
142
167
193
4
4·8%
5
5·0%
4 years
5 years
100
112
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%
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
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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.
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.
EXPECTED VALUES, DECISION TREES AND COMBINED PROBABILITIES
A commonly used way of evaluating decisions is via the use of expected values.
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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.
Solution
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There are two decisions which need to be taken by the company:
sell the design or develop it
if it is developed, then whether to sell the design and the rights to sell the developed
component, or market it themselves
1.
2.
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.
Decision 2
The net present value ($000s) on the 75% path is 1,686 – 300 = 1,386.
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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
Development succeeds and component is popular 60%
Development succeeds but component is unpopular 20%
Development fails
20%
value ($000s)
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.
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PATTERNS OF BEHAVIOUR
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.
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.
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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 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
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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.
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.
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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.
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 longer-term 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.
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Revision Notes
BY SHOAIB YAQOOB
P4: ADVANCED FINANCIAL MANAGEMENT
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