NOTES
(Association of Chartered Certified Accountants)
www.ACCAGlobalBox.com
ADVANCED FINANCIAL
MANAGEMENT
NOTES
BY
TAHA POPATIA
Volume # 1
ACCA Global Box
1|Pag e
Sequence of compiled notes
1. Roles and responsibilities of senior financial manager
2. Net Present Value
3. Internal rate of return
4. Real rate and Nominal rate
5. Modified Internal Rate of Return
6. Capital Rationing
7. Capital Investment monitoring system
8. Free cash flows
9. Acquisitions and mergers versus other growth strategies
10. Criteria for choosing an appropriate target for acquisition
11. Different types of Synergies with respect to mergers and acquisitions
12. Different forms of consideration to acquire a target company
13. Defences against a hostile takeover bids
14. Explanations for the high failure rate of acquisitions in enhancing shareholder value
15. Factors to consider when determining which source or sources of finance are chosen to finance
a possible cash bid
16. IPO and a reverse takeover
17. Keypoints from takeover directives
18. Management buy-out and Management buy-in
19. Maximum Consideration and Maximum Premium
20. Portfolio restructuring and organisational restructuring
21. Reverse takeover
22. Introduction to dividend policy
23. Competitive advantages a company may gain over its competitors (who only invest in domestic
projects) for investing in overseas projects
24. Market price system of transfer pricing
25. Forecasting Exchange rates
26. Criteria for credit rating
27. Impact of the fall in credit rating
28. Beta asset and Beta equity
29. Business risk and financial risk
30. Existing wacc and the risk adjusted wacc
31. Adjusted present value
32. Mezzanine facility
33. Macaulay's duration
34. Modified duration
35. Advantages and drawbacks of exchange traded option contracts compared with over-thecounter options
36. Advantages and drawbacks of using currency swaps
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Sequence of compiled notes
37. Advantages of multilateral netting by a central treasury function
38. Benefits of centralised and decentralised treasury departments
39. Estimating the futures price at any specific date
40. Foreign exchange risk management - currency futures
41. Forward contracts compared with over-the-counter option - foreign currency
42. Interest rate swap
43. Lock in rates
44. Mark-to-market and margins for future
45. Staff in treasury department
46. Ticks
47. Why exchange traded derivatives may be used rather than over the counter derivatives to hedge
foreign currency risk
48. Project Value at Risk
49. Islamic Finance
50. Behavioural finance
51. Dark pool trading systems
52. International Monetary fund
53. Greeks
54. Types of real options
55. Why to incorporate real options value into net present value
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Roles and Responsibilities of senior financial manager BY TAHA POPATIA

The principal role is the maximisation of shareholders wealth.

Shareholders wealth can be maximised by 1. Increasing the value of the company 2. Providing
cash flow to shareholders via dividend.

In order to achieve the above objective a financial manager must take three types of decisions:
o Investment decisions: Identifying the best investment opportunities.
o Financing decisions: Deciding how to finance them.
o Dividend decision: Deciding how much dividend shall be paid.
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Net Present Value- AFM BY TAHA POPATIA

Net Present Value = Present Value of Cash Inflows – Present Value of Cash Outflows

Involves discounting the relevant cash flows for each year of the project using an appropriate
cost of capital

If the Net Present Value is positive, organisation may undertake the project

If the Net Present Value is negative, organisation may not undertake the project

The technique takes account of the time value of money


In case of real cash flows (In today’s prices), use the real rate
In case of money cash flows (Includes inflation), use the nominal rate

In questions involving specific inflation rates, nominal rate method is usually more reliables
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Internal Rate of Return- AFM BY TAHA POPATIA





IRR is the rate of return that is delivered by a project
A project is accepted if the IRR of the project is greater than the cost of capital or the target rate
of return
If project cash flows are discounted to calculate the Net Present Value using the Internal rate of
return as the discounting percentage, the NPV will be zero
It can be found by linear interpolation using:
It assumes that cash flows can be reinvested at the IRR over the life of the project. In contrast,
the NPV method assumes that cash flows can be reinvested at the cost of capital over the life of
the project
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Real rate and Nominal rate- AFM BY TAHA POPATIA





The difference between the real rate(real cost of capital) and nominal rate (nominal cost of
capital) arises due to inflation
In times of inflation, the fund providers will require a return made up of two elements:
o Real return for the use of their funds
o Additional return to compensate for inflation
The mathematical connection between the real cost of capital and the money cost of capital is
as follows:
 (1+money cost of capital) = (1+real cost of capital)(1+rate of inflation)
We use money rate if cash flows are expressed in actual number of currency that will be
received or paid
We use real rate if cash flows are expressed in constant price terms (that is, in terms of their
value at time 0)
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Modified Internal Rate of Return- AFM BY TAHA POPATIA

Modified internal rate of return
o is a calculation of the return from a project
o as a percentage yield
o with the assumption that cash flows earned from a project will be reinvested to earn a
return equal to the company’s cost of capital

Method # 1

Method # 2
N = project life in years
A = end of investment period investment returns during the recovery phase of the project
B = the present value of the capital investment in the investment phase

An advantage of MIRR compared to IRR is that MIRR assumes the reinvestment rate is the
company’s cost of capital. IRR assumes that the reinvestment rate is the IRR itself, which is
usually untrue

A disadvantage of MIRR is that it may lead an investor to reject a project which has a lower rate
of return but because of its size generates a larger increase in wealth. In the same way, a highreturn project with a short life may be preferred over a lower-return project with a longer life
Example
Method # 1



Cost of capital = 10%
Year
Cash flows
Discount factor
Present Values
$s
@ 10%
$s
0
(20,000)
1.0000
(20,000)
1
(10,000)
0.9091
(9,091)
2
8,000
0.8264
6,612
3
18,000
0.7513
13,524
4
15,000
0.6830
10,245
Present value of the investment phase = 20,000 + 9,091 = $ 2,9091
ACCA Global Box
Present value of the return phase = 6,612 + 13,524 + 10,245 = $ 30,381
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Modified Internal Rate of Return- AFM BY TAHA POPATIA

((30,381/2,9091)^(1/4)) x (1+10%) – 1 = 11.20%
Method # 2


Cost of capital = 10%
Year
Cash flows
Discount factor
Present Values
$s
@ 10%
$s
0
(20,000)
1.0000
(20,000)
1
(10,000)
0.9091
(9,091)
Year
Cash flows
Compound
Present Values
$s
@ 10%
$s
2
8,000
x(1+10%)^2
9,680
3
18,000
x(1+10%)^1
19,800
4
15,000
1
15,000
Present value of the investment phase = 20,000 + 9,091 = $ 2,9091

End of investment phase investment returns = 9,680 + 19,800 + 15,000 = $ 44,480

(44,480/29,091)^(1/4)-1 = 11.20%
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Capital Rationing- AFM BY TAHA POPATIA

Capital rationing occurs when there is insufficient capital available.

Ideally a company must undertake all projects with positive net present value, but at times due
to capital rationing a company may not be able to do so.

A decision has to be made about which projects to invest in with the capital that is available.

Two forms of capital rationing are:
o Hard capital rationing, which may arise due to one of the following reasons:
 Limited access to capital from external sources
 Restrictions in bank lending
 Lending to the company is perceived to be too risky
 Costs associated with making small issues of capital may be too great
o Soft capital rationing, which may arise due to one of the following reason:
 Limits set by the management on capital available for each department
 Management wants to avoid dilution of control by issuing new shares
 Management may be unwilling to issue additional capital if it will lead to a
dilution of earnings per share.

Capital rationing may occur for:
o A single period only – funds are limited for current period only
o Multiple periods –funds are limited for more than one time period

The method used to solve capital rationing projects also depends upon whether projects are
o Divisible projects – Can be undertaken completely or in fractions
Or
o Indivisible projects – Must be undertaken completely or not at all
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Capital Investment monitoring system- AFM BY TAHA POPATIA
Introduction


It monitors how an investment project is progressing once it has been implemented.
Initially the system will set the 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.
It 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.



Benefits

It tries to ensure as much as possible that:
o The project meets what is expected of it in terms of revenues and expenses.
o The project is completed on time

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.

Acts as a communication device between managers charged with managing the project and the
monitoring team.

It helps reassess and change the assumptions made of the project, if changes in external
environment warrant it.
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Free Cashflows summary BY TAHA POPATIA
Free cash
flows
To Company
(WACC)
To Equity
(Ke)
Free cash flow to company / firm





Various possible definitions
Freely available to the company
That is amount freely available to everyone involved in financing
Is calculated after deduction of all NECESSARY / UNAVOIDABLE capital expenditures
In short this the amount after deduction of necessary expenditures and before taking account of any
transaction with anyone financing the company (whether equity or debt)
When all free cash flows are discounted at WACC, we get total value of the company under consideration
Value of
the
company /
firm
Value of
the debts
Value of
equity
Free cash flows basic format (cash flows before transaction with owners)
Profit after tax
Add : Tax provision
Less : tax paid
Add : interest expense
Less : Tax savings due to interest expense
Add / less : non-cash expense adjustments
Add / Less : working capital changes
Less : Purchase of necessary fixed assets ( replacement capital expenditure )
Free Cash flow to the firm / company
XXX
XXX
(XXX)
XXX
(XXX)
XXX/(XXX)
XXX/(XXX)
(XXX)
xxx
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Free Cashflows summary BY TAHA POPATIA
Example # 1
Method # 1
Profit after tax
Add : Interest Expense
Less : tax savings on interest
Add : depreciation
Less : Replacement asset expense
Less : Increase in current assets
Free cash flow to the firm / company
24
10
(2)
30
(10)
(3)
49
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Free Cashflows summary BY TAHA POPATIA
Method # 2
Profit before interest and tax
Less : Tax expense 20% of 40
Add : depreciation
Less : Replacement asset expense
Less : Increase in current assets
Free cash flow to the firm / company
40
(8)
30
(10)
(3)
49
Free cash flow to equity holders ( when discounted with cost of equity to present value = value of equity)
Free cash flow to firm
Less : Interest expense
Add : tax savings
Add/Less : Any transactions carried out with debt holders
Free cash flow to equity
XXX
XXX
(XXX)
XXX/(XXX)
XXX
Free cash flow to firm
Less : Interest expense
Add : tax savings due to interest expense (10 x 20%)
Add/Less : Any transactions carried out with debt holders (repayment of (20) and issuance of 69)
Free cash flow to equity
49
(10)
2
49
90
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Acquisitions and mergers versus other growth strategies- AFM BY TAHA POPATIA
Acquisitions and Mergers
Quicker, a company immediately gets bigger
Gives rise to integration problem, as each
company has its own culture, history and ways of
operation
Preferred when a company wishes to expand
operations into new products, markets and
technologies
Horizontal acquisitions may help eliminate
competitors
There are various practical problems associated
with acquisitions and mergers with which
management has to deal leading to time pressure
There may exist aspects about target company
which are kept hidden from acquiring company
during acquisition process
If the acquired company does not perform as well
as it was envisaged, then the effect on the
acquiring company may be catastrophic
Acquisitions and Mergers
High cost
Acquirer obtains management control
There is no such issue
Organic Growth
Takes a long time
There are no integration problems
Organic growth into a new area would need
managers to gain knowledge and expertise of an
area or function, with which they are not currently
familiar with
The growth is internal and hence competitors may
keep operating
The company’s management should be able to
plan and control the development of the business
more effectively.
There is no such issue
Less risky
Joint venture
Low cost as it is shared with joint venture partner
Control is shared with other partners
May lead to conflicts of interest and
disagreements between joint venture partners
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Criteria for choosing an appropriate target for acquisition- AFM BY TAHA POPATIA
Strategic aims and objectives of the acquirer
Diversification
Opportunity and availability
Access to key technology
Tax savings
For example, a company might be seeking to grow
the business by expanding its product range or
move into new geographical markets. Acquiring a
suitable business would enable a company to
expand its product range or move into new
geographic market
The target operates in a line of business which is
different from the acquiring firm’s business in
order to diversify its operations
An opportunity to acquire a particular company
might arise, and the acquiring company might
decide to take the opportunity whilst it is available
Acquirer may decide to acquire a target company
which has access to better technology
The target company may have excess carried
forward tax losses and the acquirer may be
interested in acquiring such company in order to
enjoy the tax savings by reduction in tax liability
due to tax losses.
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Different types of synergies- AFM BY TAHA POPATIA
There are three main types of synergy that can arise from acquisitions and mergers:

Revenue synergy
 They are increases in total sales revenue following a merger or acquisition, by increasing
total combined market share.
 It may arise in circumstances where the enlarged company is able to promote its brand
more effectively or when the company is able to bid for large contracts, such as to supply
goods to government, which the two smaller companies were previously unable to do so
due to their small size.

Cost synergy
 They are reductions in total costs following a merger or acquisition.
 Prime reason is economies of scale.
 Also, duplicate departments may be dissolved. As one department is now able to fulfil
the needs for entire company.

Financial synergy
 They are reductions in expenses such as finance cost.
 Larger company may be able to borrow funds at a lower rate as it may be seen as a lower
credit risk company.
 It may also arise when a firm with significant excess cash acquires a firm with great
projects but insufficient capital. The combination may create value.
 Combined company may be able to enjoy the tax benefit which was previously not
possible with individual companies.
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Different forms of consideration to acquire a target company- AFM BY TAHA POPATIA
Acquiring company can pay consideration in various forms including payment in cash, a share exchange
offer or issuing convertible loan stock. There can also be a combination of more than one of these forms
as well.
Cash

Target Company offered a fixed cash sum.

Suitable when the acquirer :
o Has sufficient cash available in reserves,
o Will be able to borrow funds from a bank for financing easily
Or
o Wishes to obtain cash by issuing bonds

Target company shareholders certainty about the bid’s value, unlike the shares offer in which
their bid value depends upon what the market value of share prices will be.

It helps acquirer to maintain full control in the new company, since Target Company
shareholders will not be part of the new company in terms of share ownership.
Share exchange

New shares are issued by the acquirer and exchanged with the shares in the target company.

Acquirer does not have to raise cash.


Target company shareholders become shareholders in the new company as well.
Overall share capital increases.

Gearing level decreases
Convertible loan stock

This method of consideration is not used commonly.

Convertible loan stock is a loan which gives the holder, a right but not an obligation, to convert
its loan stock into ordinary shares of the company, at a predetermined price and time.

This will benefit the target company shareholders in a sense that after the agreed time period
they may exercise the option to convert into ordinary shares if the share prices are in their
favour.

The target shareholders will receive a fixed/agreed interest each year until the
conversion/redemption date.
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Defences against hostile takeover bid- AFM BY TAHA POPATIA
A hostile takeover bid occurs when the board of the target company rejects a takeover offer and refuses
to recommend it to the shareholders. In a hostile takeover, the target company’s management does not
wish the takeover to go through.
There are a number of defensive measures that the management may take to fight a takeover bid.
GOLDEN PARACHUTE
POISON PILL
WHITE KNIGHTS
CROWN JEWELS
PACMAN DEFENCE
LITIGATION OR
REGULATORY DEFENCE
A large payment or other financial compensation guaranteed to a company
executive if they should be dismissed as a result of a merger or takeover.
An attempt to make company unattractive for the bidding company,
normally by giving right to existing shareholders to buy shares at a very low
price.
Inviting a company making an acceptable counter-offer for a company facing
a hostile takeover bid.
The crown jewel defence is a strategy in which the target company sells off
its most attractive assets to a friendly third party or spin off the valuable
assets in a separate entity. Consequently, the unfriendly bidder is less
attracted to the company assets.
It is an aggressive strategy. The company threatened with a hostile takeover
“turns the tables” by attempting to acquire its would-be buyer.
The target company seeks government intervention. In order for this
strategy to be effective, it would have to prove that the takeover was against
the public interest.
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Explanations for the high failure rate of acquisitions in enhancing shareholder valueAFM BY TAHA POPATIA

Lack of fit in terms of management styles.

Difference in cultures of two companies may lead to integration problem.

Insufficient time being given by senior management to the acquired company in order to make
the acquisition operationally successful.

Competitors might react to an acquisition with a new competitive strategy of their own.
Increased competition might drive down the profits for all the participants in the market.

The expected synergies do not occur.

The target firm may be valued incorrectly and hence acquirer may result in paying a high
purchase price
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Factors to consider when determining which source or sources of finance are chosen to
finance a possible cash bid- AFM BY TAHA POPATIA
AVAILABILITY

Although there are various sources of finance such as rights issue, bank loan, mezzanine finance
or convertible loan notes there is no guarantee that they will necessarily be available.

The success of rights issue will depend on the willingness and ability of the director-shareholders
to subscribe.

Obtaining bank loan or mezzanine finance may be difficult if a company is highly geared.

Convertible debt issue may depend on the terms and how possible subscribers view the future
prospects of the company.
COST

Cost of equity is generally higher than cost of debt.

Issue cost of equity are also likely to be higher than cost of debt.

Fixed interest cost on bank loan may become a burden if interest rates fall.
DIRECTORS PREFERENCE

The choice will also be determined by board’s attitude to gearing, the board may feel that it has
reached, or exceeded, the gearing level which it would regard as desirable. If this is the case, the
board would have to use equity finance.
CONTROL

Implications of the different sources of finance for control of the company may also be
considered.

An issue of shares arising from the convertible debt would change the balance of shareholdings,
so the directors would have to decide how significant this would be.

Mezzanine finance may also offer conversion rights, but possibly under certain circumstances.

Bank loan will have no impact on share capital, but the bank may impose certain restrictions,
including restriction on the sale of assets, limitations of dividends, or requiring accounting
figures, liquidity and solvency ratios, not to go beyond certain levels.
MIX OF FINANCE

The board may consider a mix of finance as well.
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IPO and a reverse takeover- AFM BY TAHA POPATIA
INITIAL PUBLIC OFFER

Conventional way to obtain listing where a company issues and offers shares to the public.

The company will have to follow the normal procedures and processes required by the stock
exchange regarding a new issue of shares and will comply with the regulatory requirements.

An IPO can cost between 3% to 5% of the capital being raised because it involves investment
banks, lawyers, and other experts.

A marketing campaign and issuing of prospectus are also needed to make the offering attractive
and ensure shares to the public do get sold.

The IPO process can typically take one or two years to complete due to hiring the experts, the
marketing process and the need to obtain a value for the shares.

Regulatory process and procedures of the stock exchange need to be complied with.

There is no guarantee that an IPO will be successful.

It times of uncertainty, economic downturn or recession, it may not attract the attention of
investors and a listing may not be obtained.

Due to the marketing effort involved with an IPO launch, it will probably have an investor
following, which a reverse takeover would not.
REVERSE TAKEOVER

Enables a company to obtain listing without going through the IPO process.

An active private company takes control and merges with a dormant public company. These
dormant public companies are called "shell corporations" because they rarely have assets or net
worth aside from the fact that they previously had gone through an IPO process.

Reverse takeover is cheaper, takes less time and ensures that a company will obtain listing on a
stock exchange.

The shell company may have potential liabilities which are not transparent at the outset, such as
potential litigation action.

A full due diligence of the listed company should be conducted before the reverse takeover
process is started.
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Keypoints from takeover directives- AFM BY TAHA POPATIA
The principle of equal treatment

It stipulates that all shareholders must be offered equal terms.

Minority shareholders must be offered same terms as those offered to earlier shareholders from
whom the controlling block was acquired.
Squeeze-out rights

This condition allows the bidder to force minority shareholders to sell their stake, at a fair price,
once the bidder has acquired a specified percentage of the target company’s equity.

The percentage varies from country to country.

The main purpose of this condition is to enable the acquirer to gain 100% stake of the target
company and prevent problems arising from minority shareholders at a later date.
Mandatory-bid condition through sell out rights

It allows remaining shareholders to exit the company at a fair price once the bidder has
accumulated a certain number of shares.

The amount of shares accumulated before the rule applies varies between countries.

The bidder must offer the shares at the highest share price, as a minimum, which had been paid
by the bidder previously.

The main purpose for this condition is to ensure that the acquirer does not exploit their position
of power at the expense of minority shareholders.
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Management buy-out and Management buy-in - AFM BY TAHA POPATIA
Management buy-out
Purchase of all or part of the business by its own
managers
Existing management is likely to have detailed
knowledge of the business and its operations
It will cause less disruption and resistance from
the employees
Existing management may lack new ideas
Management buy-in
Purchase of all or part of the business by a team of
outside managers
External management will need to gain knowledge
of the business and its operations
It may face resistance from existing employees
New ideas may pour in from the experience
acquired by the external management team
elsewhere
In both cases, it is usually the case that the management team do not have sufficient capital of their
own to afford the business they are trying to buy, and they have to rely on the support of venture
capital finance
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Maximum consideration / Maximum premium- AFM BY TAHA POPATIA

Market value of acquirer pre-acquisition
:
$500 million

Market value of target pre-acquisition
:
$300 million

Market value of entire company after acquisition
:
$900 million
Therefore,

Synergy created due to acquisition : Market value of new company – pre acquisition values of
target and acquirer =
$900 – ($500 + $300)
=
$100 million.

Synergy represents the maximum benefit from the acquisition.
Maximum consideration

The maximum consideration that the acquiring company will be willing to pay to target company
shareholders can be calculated with keeping in mind that the maximum the acquirer will be
willing to pay will be the amount that does not make acquirer worse off than the position it had
before acquisition.
Postacquisition
value(A)
Consideration to
target company
shareholders (B)
$900 million
$900 million
$900 million
$900 million
$900 million
$350 million
$375 million
$400 million
$425 million
$450 million
Remaining value that
Increase in wealth of
Acceptability to
will belong to
Acquirer’s shareholders
Acquirer’s
Acquirer’s shareholders (C – Pre- acquisition value)
shareholders
(C = A-B)
$550 million
$50 million
Yes
$525 million
$25 million
Yes
$500 million
$0 million
No gain
$475 million
($25 million)
No
$450 million
($50 million)
No

Above table demonstrates that the maximum to be paid should be $400 million. Any excess
above this amount will lead to a loss in wealth and hence this is the maximum that the acquiring
company shareholders will be willing to pay.

If acquirer pays maximum consideration, all synergy relevant benefits are transferred to the
target company shareholders.
Maximum premium

Maximum premium = All synergy benefits = Market value of company after acquisition
transaction – (Pre-acquisition value of both companies before acquisition transaction).

Maximum premium = Maximum consideration – Market value of target pre-acquisition.
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Portfolio restructuring and organisational restructuring- AFM BY TAHA POPATIA
PORTFOLIO RESTRUCTURING

Involves the acquisition of companies, or disposals of assets, business units and/or subsidiary
companies through divestment, demergers, spin-offs, MBOs and MBIs.
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.
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Reverse takeover- AFM BY TAHA POPATIA

STEPS IN REVERSE TAKEOVER:
o Private company buys enough shares in a public company to control the public company.
o The private company’s shareholders then exchange its shares in the private company for
shares in the public company.

POTENTIAL BENEFITS:
o Route to obtain a stock market listing much quickly and at comparatively lower cost in
comparison to IPO.
o Company obtains benefits of the public trading of its securities including: easier access to
capital markets, higher company valuation and enhanced ability to carry out further
takeovers.

POTENTIAL DRAWACKS:
o Lack of expertise to understand and deal with all the regulations and procedures that
listed companies must comply with.
o There is a risk that the listed company being used to facilitate reverse takeover may have
some liabilities and problems that are revealed after the transaction. This risk is
comparatively lower in IPO, which involves a higher level of scrutiny in comparison to
reverse takeover.
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Introduction to Dividend Policy- AFM BY TAHA POPATIA

A company has to decide how much of the profit after tax that the company has earned must be
paid in form of dividend and how much amount must be retained in the business.
COMPANIES THAT MAY PAY LOW DIVIDEND
 Young companies
 Growing companies
 Companies having profitable investment
opportunities
 Companies who want to minimise the
amount of debt in capital structure

Different dividend policies include:
o Stable
o Constant payout
o Zero dividend
o Residual approach to dividends

Practical influences on dividend policy:
o Legal
o Level of cash flows
o Availability of other sources of finance
COMPANIES THAT MAY PAY HIGH DIVIDEND
 Stable and mature companies
 Companies without any growth
opportunity
 Companies who cannot foresee any
profitable investment opportunities
 Companies able and willing to acquire debt
finance to support its capital structure
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Competitive advantages a company may gain over its competitors (who only invest in
domestic projects) for investing in overseas projects - AFM BY TAHA POPATIA

Investing overseas may give company access to new markets and/or enable it to develop a
market for its products in locations where none existed before.

Involved in marketing and selling products in overseas markets may also help a company gain an
understanding of the needs of customers, which it may not have had if it merely exported its
products.

Investing overseas may give company easier and cheaper access to raw materials it needs.

Investing in projects internationally may give company access to cheaper labour resources
and/or access to expertise which may not be readily available locally. This could therefore lead
to reduction in costs and give company an edge against its competitors.

Closer proximity to markets, raw materials and labour resources may enable a company to
reduce its costs. 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.
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Market price system of transfer pricing - AFM BY TAHA POPATIA








Fair assessment of the performance of both the buying and selling divisions.
Both internal and external sales accounting for at the same price.
Simple market price provides an objective measure over which the divisions should agree.
The market price may be difficult to determine or may fluctuate wildly making it difficult to
establish a market price system of transfer pricing.
The buying division may prefer buying from selling division rather than an external supplier
because of better service from, and greater dependability of, dealing within the group.
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 costs 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.
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Forecasting exchange rates - AFM BY TAHA POPATIA
In an international investment appraisal question, it is very common to forecast/estimate future
exchange rates in order to convert foreign currency cash flows into our own currency.
The two methods of estimating future spot exchange rates are:
Purchasing power parity theory

States that spot rates between two currencies will change over time in relation to the rate of
inflation in the countries from which the currencies originate.

Example:
Question
Current spot exchange rate is 1.30 dollars = 1 pound
Expected inflation rates are:
Year
US
UK
1
3%
1%
2
2%
4%
3
1%
3%
Required:
Work out the expected spot rate for the next three years in accordance with purchasing power parity
theory
Formula: Future spot rate = Spot x (1+inflation in US)/(1+inflation in UK)
Year
Computation
1
1.30 x (1+3%)/(1+1%) = 1.3257
2
1.3257 x (1+3%)/(1+1%) = 1.3520
3
1.3520 x (1+3%)/((1+1%) = 1.37877
Interest rate parity theory

States that it is possible to predict future spot exchange rates from differences in interest rates
between the currencies.

Example:
Question
Current spot exchange rate is 1.30 dollars = 1 pound
Expected interest rates are:
Year
US
UK
1
3%
1%
2
2%
4%
3
1%
3%
Required:
Work out the expected spot rate for the next three years in accordance with interest rate parity
theory
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Forecasting exchange rates - AFM BY TAHA POPATIA
Formula: Future spot rate = Spot x (1+interest rate in US)/(1+interest rate in UK)
Year
Computation
1
1.30 x (1+3%)/(1+1%) = 1.3257
2
1.3257 x (1+3%)/(1+1%) = 1.3520
3
1.3520 x (1+3%)/((1+1%) = 1.37877
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Criteria that a credit rating agency considers when assessing a company’s credit ratingAFM BY TAHA POPATIA
The credit agency will take account of the following criteria into consideration when assessing a
company’s credit rating:
Country

No issuer’s debt will be rated higher than the country of origin of the issuer.

Rating will also depend on company’s standing relative to other companies in the country.
Industry

The strength of the industry within the country, measured by the impact of economic forces,
cyclical nature of the industry, demand factors, etc.

Company’s position within the industry compared with competitors will also be assessed.
Management evaluation

Overall assessment of management and succession planning.

Assessment of how successful management has been in terms of delivering financial results.
Financial

Analysis of financial results.

Assessment of financial position, looking at a company’s gearing and working capital
management, and considering whether company has enough cash to finance its needs.

Company’s relationship with its bankers and debt covenants, to assess how flexible its sources of
finances are if it comes under stress.
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Impact of the fall in credit rating on a company’s ability to raise financial capital and
on its shareholders’ return- AFM BY TAHA POPATIA

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.

Debt holders will demand higher coupon rate on debt.

Additional debt may have other restrictive covenants, restricting company to buy or sell assets.

It may also result in a company’s cost of equity and cost of debt rising. In turn company’s
weighted average cost of capital will rise as well.
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Beta asset and Beta equity- AFM BY TAHA POPATIA
Beta asset

Also known as unlevered beta.

Beta of the company without the impact of debt.

Reflects the business risk of a company’s business operations.
Beta equity

Also known as levered beta.

Beta of the company with the impact of debt.

Reflects the business risk and financial risk both for a company.

Beta equity in a geared company is therefore higher than the company’s asset beta.
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Business risk and financial risk- AFM BY TAHA POPATIA
Business risk

Refers to the company’s ability to generate sufficient revenue to cover its operational expenses.

Arises from the type of business an organisation is involved in and relates to uncertainty about
the future and the organisation’s business prospects.
Financial risk

Refers to the risks relating to the structure of finance the organisation has.

The higher the gearing the higher the risk.

It is the risk that equity shareholders will receive very less or no returns.
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Existing wacc and the risk adjusted wacc- AFM BY TAHA POPATIA
Existing WACC

Company’s existing WACC can be used a discount rate if both, business risk and financial risk are
likely to stay the same.
Risk adjusted WACC

If a company is evaluating a project with business risk which is different from the existing
business risk of the company. Company can calculate a risk adjusted weighted average cost of
capital to reflect the different business risk.

Also, if the financial risk of the new investment is different due to change in the capital
structure, the change can be incorporated by recalculating the WACC using the new capital
structure weightings. This may be suitable when the change is insignificant or the new project
can be treated as a separate business with its own long term gearing.
An alternative approach to investment appraisal is APV method.
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Adjusted present value- AFM BY TAHA POPATIA
ADJUSTED PRESENT VALUE = BASE CASE NET PRESENT VALUE + FINANCING IMPACT
Introduction

This method separates the investment element of the decision from the financing element.

This method is recommended when there are complex funding arrangements such as subsidised
loan from government or for projects which will have different business risks and different
financial risks from the existing operations of the company.
Step # 1: Base case net present value

This is the first step in APV approach.

Net present value of the project is calculated assuming that the project is financed 100% by
equity.

The discount rate used therefore is cost of equity, reflecting the business risk for the type of
business in which the investment will be made (asset beta is used).

Financial risk is ignored.
Step # 2: Financing impact

Financing impact includes costs of raising new equity to finance the project, the costs of
obtaining debt finance, tax relief on the interest etc.

As all cash flows are low risk cash flows they are discounted using either cost of debt or the risk
free rate.
Step # 3: Add the values calculated in step # 1 and step # 2
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Mezzanine facility- AFM BY TAHA POPATIA





Most risky type of debt from the lender’s point of view.
Low in the priority list of repayment in the event of liquidation.
High risk.
High interest rate is paid for this high risk.
Lender typically has a warrant (legal right in writing) enabling him or her to convert the security
into equity at a predetermined price per share if the loan is not paid on time or in full.
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Macaulay’s duration- AFM BY TAHA POPATIA
Macaulay’s duration





It is the weighted average length of time to the receipt of a bond’s benefits (coupon and
redemption value) the weights being the present value of the benefits involved.
Captures both the time value of money and the whole of the cash flows.
It is useful in allowing bonds of different maturities and coupon rates to be compared.
In order to calculate the duration of a bond, the present value of the annual cash flows and the
price or value at which the bond are trading at need to be determined.
Duration = Sum of PV of cash flows multiplied by respective years / market price of bond.
Example

Redemption yield: 4.2%

Market price of bond: $ 1,079.68

Coupon rate: 6%

Due to be redeemed at par in five years
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Modified duration- AFM BY TAHA POPATIA
Modified duration

It is a measure of the sensitivity of the price of a bond to a change in interest rates

Modified duration = Macaulay duration / (1+gross redemption yield)
Example

Current market price of bond: $ 60,000,000

Macaulay duration: 2.47 years

Gross redemption yield: 2%

Modified duration = Macaulay’s duration / (1+gross redemption yield)


This can be used to determine the proportionate change in bond price for a given change in yield
as follows:

Change in bond price = -modified duration x change in yield x current market price of the bond

Note that there is an inverse relationship between yield and bond price, therefore the modified
duration figure is expressed as a negative number

A higher modified duration means that the fluctuations in the value of a bond will be greater

If, in the above example, the yield increased by 0.5%, the change in price can be calculated as
follows: Change in bond price = -2.42 x 0.5% x 60,000,000 = - $726,000

Thus for a 0.5% increase in yield, the bond price will fall by $726,000

However, it is only useful in assessing small changes in interest rates because of convexity. As
interest rates increase, the price of a bond decreases and vice versa, but this decrease is not
proportional, the relationship is non-linear.

Duration, on the other hand, assumes that the relationship between changes in interest rates
and the resultant bond is linear. Therefore duration will predict a lower price that the actual
price and for large changes in interest rates this difference can be significant
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Advantages and drawbacks of exchange traded option contracts compared with overthe-counter options - AFM BY TAHA POPATIA
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 wide range of products (for example, a greater choice of currencies) is normally available in
over-the-counter options markets.
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Advantages and drawbacks of currency swaps - AFM BY TAHA POPATIA

It allows the two counterparties to swap interest rate commitments on borrowings in different
currencies.

It has two elements:
o An exchange of principals in different currencies
o An exchange of interest rates
Advantages

Ideal for companies investing abroad, because it will involve payment of interest in the currency
in which company will receive income abroad.

Company will be able to obtain swap for the amount it requires and may be able to reverse the
swap by exchanging with the other counterparty. Other methods of hedging risk may be less
certain.

The cost of a swap may also be cheaper than other methods of hedging, such as options.
Disadvantages

The counterparty may default. Although the risk of default can be reduced by obtaining a bank
guarantee for the counterparty.
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Advantages of multilateral netting by a central treasury function - AFM BY TAHA
POPATIA

Central treasury function can coordinate the information about inter-group balances.

Smaller number of foreign exchange transactions.

Smaller number of transactions will also mean lower commission and transaction costs.

Less loss of interest through money being in transit.

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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Benefits of centralised and decentralised treasury departments
- AFM BY TAHA POPATIA
BENEFITS OF A CENTRALISED TREASURY DEPARTMENT

Avoids the need to have many bank accounts.

Reduces transaction costs and high bank charges.

Large cash deposits may give company 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.

If bulk borrowings are required, it may be possible for a company to negotiate lower interest
rates, which it would not be able to do on smaller borrowings.

A centralised treasury function can offer the opportunity for a company to match income and
expenditure and reduce the need for excessive risk management, and thereby reduce costs
related to this.

A centralised treasury management department could higher 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 for company as a
whole, whereas local treasury functions may lead to dysfunctional behaviour.
BENEFITS OF A DECENTRALISED TREASURY DEPARTMENT

They are better able to match and judge the funding required with the need for asset purchases
for investment purposes on a local level.

They may be able to respond quicker when opportunities arise and so could be more effective
and efficient.

Decentralised treasury departments may make the subsidiary companies’ senior management
and directors, more empowered and have greater autonomy. This in turn may increase their
level of motivation, as they are more in control of their own future, resulting in better decisions
being made.
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Estimating the futures value - AFM BY TAHA POPATIA

We assume that the difference between spot and future price falls linearly to zero over life of
the future in exam questions.

This is logical because if you buy the futures on the last day it must be same as spot rate.

In real life it does not have to fall linearly and hence the future price may be a little bit different
from the estimate, we call it basis risk.

If the future price is lower than spot it will stay lower than spot. If it is higher than spot it will
stay higher than spot.
Question
1st October 2020
Spot Rate
$ 1.30 / Pound
December futures
$ 1.25 / Pound
st
Estimate the futures price on 31 November 2020?
31st November 2020
$ 1.35 / Pound
?
Answer
Steps (Refer the table after steps)
1. Calculate difference between 1st October 2020 spot rate and December futures on 1st October
2020 (1.30-1.25 = 0.05). This difference is called the basis.
2. On the last day of December, the December futures price and the spot price will be exact equal
and hence the basis will be zero.
3. In exam questions we assume that the basis falls linearly to zero over the life of the future.
4. Basis on 31st November 2020 can be calculated as 0.05/3 x 1 = 0.017. This is because 0.05 will
reduce to 0 over three months or 0.05/3 per month reduction.
5. We know spot on 31st November 2020, so we put that value.
6. December futures value on 31st November 2020 is calculated as difference between Spot on 31st
November 2020 and the basis (1.35-0.017).
Spot Rate
December futures
Basis
1st October 2020
1.30
1.25
0.05
31st November 2020
1.35
1.33
0.017
31st December 2020
X
X
0
Notes
ACCA Global Box

Since spot rates have gone up between 1st October 2020 and 31st November 2020, the futures
price will go up as well.

In real life the basis may not reduce linearly over the life of future and we call it basis risk.
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Currency futures- AFM BY TAHA POPATIA

Right to convert at a fixed rate on a future date.

There are only four different conversion dates: March futures, June futures, September futures
and December futures.

March future means the right to convert at the last date of March.

Because of these restricted dates, very few people actually use them to convert money.

These futures are actually traded, and just like the exchange rates go up and down similarly
future prices go up and down.

A lot of people use them for gambling, the settlement is done when the future deal closes. For
example you may buy $ 1 million futures today and then sell them after one week. If the futures
price has gone up during the week the dealer will pay you the profit on the deal. If the futures
price have gone down you will pay the dealer.

Depending upon the credit rating of the person, the dealer will obviously keep a certain deposit
with him, submitted at the start of the deal.

If a person thinks that the future prices will go up for example from $ 1.50 to $1.60, he can buy
the futures today at $1.50 and sell them after a week at $1.60. The dealer will pay the profit of
$0.10.

You can also, call the dealer and sell $ 1 million futures at $1.50 and then after a week buy $ 1
million futures at $ 1.40. If this happens the dealer will pay the difference.

If a person has bought march futures for example. He can sell the futures at anytime, however
he must sell and close the deal before 31st of march.

As spot goes up, so does the future. And gain on one cancel the loss on the other.

If we are supposed to close a future deal on 12th of November for example, we should go for
December futures.

In an exam question always go for the first future after the date of transaction.

In forward rate, you convert the currency at any specifc date.

In case of future contract, you close the deal before the four specified dates

Slide 44, future price was given at the transaction date. However in an exam question the future
price on the transaction date may not be available and we may have to calculate it ourself.

Start with 32 min lecture
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Forward contracts compared with over the counter options - AFM BY TAHA POPATIA
FORWARD CONTRACTS
No payment of premium upfront
Gives a certain receipt/payment value for the
purpose of budgeting
Contract has to be fulfilled, even if the transaction
which led to the forward contract being purchased
is cancelled
Does not allow the holder to take advantage of
favourable exchange rate movements
OVER THE COUNTER OPTIONS
Involves payment of premium
Receipt/payment depends upon whether option
will be exercised or not
It can be allowed to lapse
It need not be exercised if the exchange rate
moves in the holder’s favour
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Interest rate swap advantages and disadvantages - AFM BY TAHA POPATIA
ADVANTAGES

Transaction costs are generally low.

Swapping a variable interest rate commitment with a guaranteed fixed rate of interest, allows a
company to forecast finance costs on the loan.

Swaps are over-the-counter arrangements. They can be arranged in any size and for whatever
time period is required, unlike traded derivatives.
DISADVANTAGES

Subject to counterparty risk, the risk that the other party to the arrangement may default on the
arrangement. If it is arranged through a bank, the bank can provide a guarantee that the swap
will be honoured.

If a company swaps into a fixed rate commitment, it cannot then change to commitment. This
means it cannot take advantage of favourable interest rate changes as it could if it used options.

As swaps are over-the-counter instruments, they cannot be easily traded or allowed to lapse if
they are not needed or become no longer advantageous. It is possible that a bank may allow a
reswapping arrangement to reverse a swap which is not required, but this will incur further
costs.
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Lock in rates - AFM BY TAHA POPATIA



Lock in rate is the effective fixed rate to apply giving net effect of converting transaction at spot
together with gain/loss on futures.
In real life we don’t know what the future price will be and what the spot rate will be in future,
so we can use the lock in rate in such cases to predict the future receipts/payments.
Example:
1st March 2020
Spot rate
$ 1.5 / Pound
Future price (June futures)
$ 1.2 / Pound
Assuming that there is no basis risk, calculate the effective rate
1st May 2020
Unknown
Unknown
Answer

This is a real life scenario because in real life we are not aware of spot rate and future price on
1st march 2020.
1st March 2020
1st May 2020
30 June 2020
Spot Rate
1.50
xx
X
December futures
1.20
xx
X
Basis
0.30
0.1
0

Although we are unaware of what future price and spot rates will be on 1st May 2020, but we do
know that the difference between these two will be 0.1, the unexpired basis and also, spot rate
will be higher than the futures price. Also, both the spot rate and the futures price will come
closer to each other as basis reach 0 on 30th June 2020, in case of June futures.

Method # 1: Current futures price +/- unexpired basis = 1.20 + 0.10 = $ 1.30 / Pound. We use +/sign since over here future prices are less than the spot rate on 1st March 2020 so they will
increase.

Method # 2: Spot rate +/- expired basis = 1.50 – 0.20 = $ 1.30 / Pound.

We can use this predicted rate to in our exam questions for conversion. Do note that this is
again a predicted rate and furthermore it includes the converted amount as well as gain/loss on
future transaction.
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Mark to market and margins for futures- AFM BY TAHA POPATIA

The mark-to-market process begins with the company having to deposit an amount (the initial
margin) in a margin account with the futures exchange when it takes out the futures.

The margin account will remain open as long as the futures are open.

The profit or loss on the futures is calculated daily and the margin account is adjusted for the
profit or loss.

The maintenance margin is the minimum balance which has to be maintained on the margin
account.

If the losses on the futures are so large that the balance on the margin account is less than the
maintenance margin, then the futures exchange will make a demand (a margin call) for an extra
payment (the variation margin) to increase the balance on the account back to the maintenance
margin.
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Staff in treasury department - AFM BY TAHA POPATIA
Experienced

Experienced staff is needed to establish overall guidelines and policies for treasury activities.

They will also have greater knowledge of law, accounting standards, and tax regulations which
can help the business avoid penalties and perhaps structure its dealings so that it can, for
example, minimise the level of tax paid.

If a company is planning a major acquisition, the treasury function can provide advice on the
structure of consideration and financing implications.

Senior staffs are also needed to manage the work of less experienced staff to prevent or
mitigate the effect of mistakes which may be costly.
Inexperienced

May be able to arrange borrowing if the lender has already been chosen or, for example,
arrange forward rate agreements to be used if they are prescribed.

May lead to sub-optimal decision making if judgement is required.

Poor decisions may result in opportunity costs, for example, not using the lender who gives the
best deal or being committed to a fixed forward rate agreement when an option would have
allowed the business to take advantage of favourable rate movements.
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Ticks- AFM BY TAHA POPATIA




Tick is the smallest movement on the futures price.
Futures prices are quoted to 4 decimal places, and so the smallest movement in the futures
price is 0.0001, we call it one tick.
If the futures price has for exam increased by 0.0005 we can also say that the price has
increased by 5 ticks.
Ticks are used to calculate gain or loss on a future contract.
Question

A company is based in UK.

Today is 10 September 2020 and the spot rate is $ 1.3 / pound.

Company has to pay $ 250,000 to a supplier based in US on 15 December 2020.

December future price on 10 September 2020, $/Pound (Pound 50,000 contracts): $1.25 /
pound.

Spot on 15 December 2020: $ 1.235 / Pound.
Answer

Start a future deal on 10th September 2020.

The transaction involves selling the contract currency in this case, since we will sell the pounds
to get $s for payment to the supplier and therefore we will sell futures

Number of contracts: ($250,000/$1.25) / Pounds 50,000 = 4 contracts.

Sell 4 September futures at $1.25 / pound.

On transaction date: $ 250,000 / $1.235 = Pounds 202, 429.

Now estimate the futures price on 15th December 2020

10th September 2020 to 31st December 2020, total days : 112 days

15th December to 31st December 2020, total days: 16 days.

0.05/112 x 16 = 0.007
Spot Rate
December futures
Basis
10st September 2020
1.3
1.25
0.05
15th December 2020
1.235
1.2280
0.007
31st December 2020
X
X
0

Gain on futures deal: Contracts x contract size x (sell rate – buy rate).


Gain on futures deal: 4 contracts x Pound 50,000 x ($1.25-$1.2280) = $ 4,400.
Gain in terms of pounds: 4,400/1.235 = Pound 3,563.

Net payment = Pounds 202,429 – Pound 3,563 = Pound 198,866.

In the above example we can also use ticks to calculate the gain on future transaction.

Since each tick is: 0.0001. $1.25 - $1.2280 = $0.022 movement in above future price represents
movement of 220 ticks.
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Ticks- AFM BY TAHA POPATIA

We can calculate tick value per contract as well: Pound 50,000 x 0.0001 = $5. Tick value of $5
shows that if future price goes up by 1 tick there will be a gain on each contract of $5.

Gain on future deal of $ 4,400 as calculated in above example can also be calculated as:
 Contracts x ticks x tick value
 4 x 220 x 5 = $4,400.
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Why exchange traded derivatives may be used rather than over the counter derivatives
to hedge foreign currency risk - AFM BY TAHA POPATIA

ETD contracts can be bought and sold as required. Also, because the markets are regulated by
an exchange, counterparty risk (the risk of the other party to the transaction defaulting) is
minimised.
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Project Value at Risk- AFM BY TAHA POPATIA

When we calculate the NPV of a project, the problem is that, the actual NPV may turn out to be
higher or lower because the cash flows used to compute NPV are uncertain.

Value at Risk helps calculate with a certain degree of confidence what the greatest fall in the
NPV will be.

Where k is determined by the probability level,
over which we want to calculate the VAR.

VAR is based on normal distribution theory.
is the standard deviation and N is the periods
Note: students are not required to go into details of how formula is derived and all concepts behind
normal distribution
Question # 1

Information for a project is as follows:
o Standard deviation: $ 800,000, based on a normal distribution of returns
o Average annual return on the project: $ 2,200,000
o Confidence level: 99%
o Project life: 5 years

Estimate the project’s value at risk for one year and over the project’s life and explain what is
meant by the answers obtained.
Answer # 1

Using normal distribution theory 99% confidence level requires VAR to be within 2.33 standard
deviations from the mean, based on a single tail measure.


Annual VAR = 2.33 x 800,000 = $ 1,864,000

Five year VAR = 2.33 x 800,000 x 51/2 = $ 4,168,000

The figures mean that company can be 99% confident that the cash flows will not fall by more
than $ 1,864,000 in any one year and $ 4,168,000 in total over five years from the average
returns. Therefore the company can be 99% certain that the returns will be $ 336,000 or more
every year ($ 2,200,000 - $ 1,864,000). And it can be 99% certain that the returns will be
$ 6,832,000 or more in total over the five-year period ($ 11,000,000 - $ 4,168,000). There is a 1%
chance that the returns will be less than $ 336,000 each year or $ 6,832,000 over the five-year
period.
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Project Value at Risk- AFM BY TAHA POPATIA
Question # 2

Information for a project is as follows:
o Standard deviation: $ 400,000 annually, based on a normal distribution of returns
o Project life: 5 years

Calculate the project’s value at risk at 95% and 90% confidence level.
Answer # 2
Question # 3
Project
Net present value
Value at risk (over the project’s life)
95% confidence level
90% confidence level
 Compare the two projects
A
$2,054,000
B
$2,293,000
$1,103,500
$860,000
$1,471,000
$1,147,000
Answer # 3

VAR provides an indication of the potential riskiness of a project.

If company invests in project B then it can be 95% confident that the present value will not fall
by more than $1,471,000 over its life. Hence the project will still produce a positive net present
value. However, there is a 5% chance that the loss could be greater than $1,471,000.

With project A, the potential loss in value is smaller and therefore it is less risky.

It should be noted that the VAR calculations indicate that the investments involve different risk.

When risk is taken into account, the choice between the projects is not clear cut and depends on
the company’s risk attitude to risk and return. Project B gives the higher potential net present
value but is riskier, whereas project A is less risky but gives smaller net present value.
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Islamic Finance- AFM BY TAHA POPATIA
Principles that are followed in Islamic finance

Interest cannot be charged.

Engaging in speculation is not allowed.

Finance cannot be provided to products detrimental to society such as alcohol, gambling etc.

Based on the principle of sharing profits and losses.

Stresses on the need for ethical behaviour and for honesty and integrity.
Murabaha

Trade credit or loan.

The bank will purchase the asset and then sell it to the business or individual at a ‘profit’ in
recognition of the convenience of paying later.

Bank buys asset at $100 and sells it to customer at $125 making a profit of $25.

Customer can pay $125 in instalments.
Ijara

Leasing.

The bank makes available to the customer the use of assets for a fixed period and price.

The bank remains the owner of the asset and incurs the risk of ownership.

This means that the bank is responsible for the major maintenance of the asset.

Customer pays lease rentals.

Ownership is transferred to the customer at the end of the term either by way of a gift deed or
selling the asset for nominal amount.
Mudaraba

Equity finance.

There are two parties in mudaraba, the provider of capital is called rab-ul-mal while the
management and work is responsibility of the other who is called mudarib.

Profits are shared according to a pre-agreed contract whereas the losses are solely attributable
to the provider of capital.

Rab-ul-mal is not involved in management and execution of decisions.
Musharaka

Venture capital.

Both the parties contribute capital to the business and participate in managing the business.

Profits are shared according to a pre-agreed contract whereas losses are shared according to
capital contribution ratio.

Organisation = mudareb. Finance provide = rab-ul-maal.
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Islamic Finance- AFM BY TAHA POPATIA

Under diminishing musharaka, mudareb keeps paying greater amount to rub ul maal so that he
eventually becomes the owner of the venture capital.
Sukuk

They are debt finance linked to an underlying asset.

The sukukholder is the partial owner in the underlying asset.

Profit is linked to the performance of the underlying asset.

There is no guaranteed income.
Salam

Forward contract.

Prohibited for certain assets.

Commodity is sold today for future delivery.

Cash is received immediately (today) from the financial institution.

Delivery arrangements such as quantity, quality and time of delivery are decided immediately.

The sale is generally at a discount so that financial institution can earn profit.

The financial institution may sell the contract to another buyer for profit.

Salam arrangements are prohibited for gold, silver and other money-type assets.
Istisna

Phased payments.

These are used for long term construction projects.

Subject matter is raw material which has the characteristics of being transformed.

The bank finances the project with the client paying an initial deposit, followed by installments
during the course of construction.

At the completion of the project, the asset is delivered to the client.
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Behavioural Finance- AFM BY TAHA POPATIA
Introduction

It considers the impact of psychological factors on financial decision making and 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.

It seeks to examine the following assumptions of rational decision making by investors and
financial managers:
o Financial decision makers seek to maximise their utility and do so by trying to maximise
portfolio or company value.
o They take financial decisions based on analysis of relevant information.
o They analysis of financial information that they undertake is rational, objective and riskneutral.
INVESTORS
Maximisation of utility

Rational decision making: Investors aim to maximise long-term wealth and hence utility.

Behavioural factors may influence investors to take decisions that are not the best ones for
achieving maximum value:
o Preferences for companies that investors consider are acting with social responsibility.
o Avoid “sin stocks” .
o 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, that
their decision to invest was wrong. This is known as cognitive dissonance.
Analysis of relevant information

Rational decision making: Analyse the future prospects of the company.

Behavioural factors:
o Anchoring, Investors may use information that is not relevant but is readily available,
possibly to simplify the decision making process. 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.
o Gambler’s fallacy, selling shares on the ground that the shares have gained in value for
“long enough” and their price must therefore soon start to fall, even if the rational
analysis suggests that the rise in price will continue.
o Herd behaviour, Investors buy or sell shares in a company or sector because many other
investors have already done so.
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Behavioural Finance- AFM BY TAHA POPATIA
Rational, objective and risk-neutral analysis

Rational decision making: Base decision on an analysis of available information.

Behavioural factors:
o Confirmation bias, paying attention to evidence that confirms investors’ current belief
about their investments and ignoring evidence that casts doubt on their beliefs.
FINANCIAL MANAGERS
Maximisation of utility

Rational decision making: Long term maximisation of shareholders wealth.

Behavioural factors:
o Loss aversion bias, Acquiring managers are unwilling to let someone else have what they
have been trying to acquire. Studies have looked at contested takeovers, where different
companies bidding against each other have forced the acquisition price up to a level that
was significantly greater than reasonable.
Analysis of relevant information

Managers may pay more for a target company than rational, having an unrealistic opinion as to
their skills.
Rational, objective and risk-neutral analysis

Just as previously explained in respect of investors, there may be 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.
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Dark pool trading systems- AFM BY TAHA POPATIA
Introduction to dark pool trading systems

They are off-exchange facilities that allow trading of large blocks of shares between
anonymous parties.

It can skip market forces and get a price that is better suited to both buyer and seller.

The trade is only announced once it is completed.

They prevent signals reaching the market in order to minimise large fluctuations in the
share price. This is done because when significant volume of shares is involved in trading,
even a small change in share price can translate into a lot of money.

Dark pools and their lack of transparency defeat the purpose of fair and regulated
markets with large numbers of participants and threaten the healthy and transparent
development of these markets.
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International Monetary Fund- AFM BY TAHA POPATIA

International monetary fund was set up in 1944.

Its role is to oversee the global financial systems, in particular to stabilise international exchange
rates, help countries to achieve balance of payments and facilitate in the country’s development
through influencing the economic policies of the country in question.

Where necessary, it offers temporary loans, from member states’ deposits, to countries facing
severe financial and economic difficulties. These temporary loans are often offered with
different levels of conditions.

IMF believes that in order to regain control of the balance of payments, the country should take
action to reduce the level of demand for goods and services. To achieve this, the IMF often
requires countries to adopt strict austerity measures such as reducing public spending and
increased taxation, as condition of the loan.

These measures may cause standards of living to fall and unemployment to rise. The IMF regards
these as short-term hardships necessary to help countries sort out their balance of payment
difficulties and international debt problems.

The IMF has faced a number of criticisms for the conditions it imposes.
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Greeks- AFM BY TAHA POPATIA
Delta






Change in option price / change in value of share.
The value of N(d1) can be used to indicate the amount of the underlying shares which the writer
of an option should hold in order to hedge (eliminate the risk of) the option position.
Delta = change in option price / change in the price of shares.
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.
If share price goes up, the option price will go up if it is a call option or down if it is a put option.
GAMMA




Change in delta value / Change in the price of the underlying
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.
The value of gamma for an option is very low as the certainty increases that the option will
expire in the money or out of the money.
The value of gamma increases with uncertainty as to whether the option will expire in the
money or out of the money.
THETA




Theta is a measure of the sensitivity of the option price to the remaining time to expiry of the
option. It is the change in options price (specifically its time premium) over time.
Option premium has two components intrinsic value and time value. Theta deals with time
value.
Theta measures how much value is lost over time. Usually expressed as an amount lost per day.
The nearer the expiration date, the higher the theta and the farther away the expiration date,
the lower the theta.
RHO



Measures the sensitivity of options prices to interest rate changes.
An options rho is the amount of change in value for a 1% change in risk free interest rate. Rho is
positive for calls and negative for puts.
As exercise price has to be paid in the future, therefore the higher the interest rates the lower
the present value of the exercise price. This reduces the cost of exercising and thus adds value to
the current call option value.
VEGA


Vega measures the change in value of an option that results from a 1% change in the volatility of
the underlying item
Long term options have larger vegas than short term options. The longer the time period until
the option expires, the more uncertainty there is about the expiry price.
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Greeks- AFM BY TAHA POPATIA
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Types of real options- AFM BY TAHA POPATIA
There are many different classifications of real options. For the purposes of the AFM syllabus, we use
the following four generic headings:
OPTION TO DELAY/DEFER
OPTION TO SWITCH/REDEPLOY
OPTION TO EXPAND/FOLLOW-ON
OPTIONS TO ABANDON
Option to delay an investment until new
information is available. This happens when a
company has exclusive rights to a project or
product, it can delay taking this project or product
until a later date. It creates a call option. For
example, a company paid certain amount to
acquire a license to produce a particular product
anytime over the period of coming 4 years.
Assume that the net present value today for
investment is negative. The company may decide
to invest further amount at any time over the
license period if the net present value will become
positive.
It exists when the company can use its productive
assets for activities other than the original one.
This may occur when the forecasts of the activity
that was initially started may turn out to be wrong
and it could be beneficial to stop the project and
use resources somewhere else. It creates a put
option.
It exists when firms invest in projects which allow
them to make further investments in the future or
to enter new markets. The initial investment may
be considered as a premium payment. Further
investment is undertaken only if the present value
from the expansion will be higher than the
additional investment. It creates a call option.
It is the option to abandon a project during its life.
This option might be used if the forecast initially
prepared turn out to be incorrect or new
information changes the expected payback. It
creates a put option.
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Why to incorporate real options value into net present value- AFM BY TAHA POPATIA




Net present value method of investment appraisal assumes that a decision must be made
immediately or not at all, and once made, it cannot be changed.
Real options, on the other hand, recognise that many investment appraisal decisions have some
flexibility:
o For example, decisions may not have to be made immediately and can be delayed to
assess the impact of any uncertainties or risks attached to the projects.
o Alternatively, once a decision on a project has been made, to change it, if circumstances
surrounding the project change.
o Finally, to recognise the potential future opportunities, if the initial project is undertaken.
Real options help estimate the value of this flexibility or choice and recognises the fact that the
additional value created from this flexibility can be attributed to the project.
By incorporating the value of any real options available into an investment appraisal decision, a
company will be able to assess the full value of a project.
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