ACCA P4
Advanced Financial
Management
December 2011 Exams
Capital asset pricing
model
CAPM basics
Arbitrage
CAPM basics 1
The CAPM formula
• E (ri) = Rf + βi (E (rm) – Rf)
Where E (ri) is expected return from security / project
• Rf is risk-free rate of return
• E(rm) is expected return from market
• βi is beta factor of security / project
• (E (rm) – Rf) is market premium for risk
This formula is given in the exam.
Slide 3
CAPM basics 2
Capital asset pricing model
• Based on a comparison of the systematic risk of individual
investments with the risks of all shares in the market
CAPM assumes:
• Investors / companies require return in excess of risk-free
rate
• Unsystematic risk can be diversified away and no premium is
required for it
• Investors / companies require a higher return from
investments where systematic risk is greater
CAPM Basics 3
Beta factor of portfolios
• Portfolio consisting of all (non risk-free) securities on
stock market will have beta factor of 1
• Portfolio consisting entirely of risk-free securities will have
beta factor of 0
• Beta factor of investor’s portfolio is weighted average of
beta factors of securities in portfolio
• Investors should decide on desired β levels, invest in low β
shares when returns falling, high β shares when returns rising
CAPM Basics 4
• Investors should consider international diversification through
investment in different countries or multinationals
• Market segmentation may complicate situation
Slide 6
CAPM Basics 5
Problems with CAPM
Assumptions unrealistic?
• Zero insolvency costs
• Investment market efficient
• Investors hold well-diversified portfolios
• Perfect capital market
Slide 7
CAPM Basics 6
Problems with CAPM continued
Required estimates difficult to make:
• Excess return
• Risk-free rate (govt. securities’ rates vary with lending terms)
• β factors difficult to calculate
• Hard to determine risk-free rate, systematic risk and
expected return on market portfolio
Slide 8
CAPM Basics 7
CAPM and returns
• CAPM can be used to calculate the required return on
projects
• Particularly projects with significantly different business risk
characteristics to a company’s current operations
• CAPM produces a discount rate based on systematic risk
and can be used to compare projects of different risk classes
• CAPM assumes company’s investors wish investments to be
evaluated as if they are capital market securities
Slide 9
CAPM Basics 8
Limitations of CAPM in investment decisions
• Hard to estimate returns under different economic
environments
• CAPM is single period, but investments are evaluated over
time
• Difficult to model complications in decision-making
Slide 10
CAPM Basics 9
Geared betas
• May be used to obtain an appropriate required return when
an investment has differing business and finance risks from
the existing business
Slide 11
CAPM Basics 10
Where:
• βa = asset (or ungeared) beta
• βe = equity (or geared) beta
• βd = beta factor of debt in the geared company
• Vd = market value of debt in the geared company
• Ve = market value of equity capital in the geared company
• T = rate of corporate tax
Slide 12
CAPM Basics 11
Weaknesses in the formula
• Difficult to identify firms with identical operating
characteristics
• Estimate of beta factors not wholly accurate
• Assumes that cost of debt is risk-free
• Does not include growth opportunities
• Differences in cost structures and size will affect beta values
between firms
Slide 13
Arbitrage 1
Arbitrage pricing theory
• The theory assumes that the return on each security is based
on a number of independent factors
Arbitrage 2
• Where E (rj) is expected return on security
• B1 is sensitivity to changes in Factor 1
• F1 is difference between Factor 1 actual and expected values
• B2 is sensitivity to changes in Factor 2
• F2 is difference between Factor 2 actual…e is a random term
• Main problem – identifying macroeconomic factors and risk
Slide 15
Arbitrage 3
Factor analysis
• Analysis used to determine factors to which security returns
are sensitive
Four key factors indicated by research are:
• Unanticipated inflation
• Changes in industrial production levels
• Changes in risk premiums on bonds
• Unanticipated changes in interest rate term structure
Slide 16
Arbitrage 4
Arbitrage trading
• Trading will occur if certain combinations of securities are
expected to produce higher returns than indicated by risk
sensitivities
Slide 17
Chapter 1
The role and
responsibility of senior
financial executive
Financial management
Financial planning
Financial management 1
Financial objectives
• The prime financial objective is to maximise the market
value of the company’s shares
• Primary targets are profits and dividend growth
• Other targets may be the level of gearing, profit retentions,
operating profitability and shareholder value indicators
Slide 19
Financial management 2
Why profit maximisation is not a sufficient objective
• Risk and uncertainty
• Profit manipulation
• Sacrifice of future profits?
• Dividend policy
Slide 20
Financial management 3
Non-financial objectives
• Non-financial objectives do not negate financial objectives
• However they do mean that the primary financial objectives
may be modified
• They take account of ethical considerations
Slide 21
Financial management 4
Examples - non-financial objectives
• Employee welfare
• Management welfare
• Society’s welfare
• Service provision
• Responsibilities towards customers / suppliers
Slide 22
Financial management 5
Investment decisions
Investment decisions include:
• New projects
• Takeovers
• Mergers
• Sell-off / Divestment
Slide 23
Financial management 6
The financial manager must:
• Identify decisions
• Evaluate them
• Decide optimal fund allocation
Slide 24
Financial management 7
Financing decisions
Financing decisions include:
• Long-term capital structure
• Need to determine source, cost and risk of long-term finance
• Short-term working capital management
• Balance between profitability and liquidity is crucial
Slide 25
Financial management 8
Dividend decisions
• Dividend decisions may affect views of the company’s longterm prospects, and thus the shares’ market values
• Payment of dividends limits the amount of retained earnings
available for re-investment
Slide 26
Financial planning 1
Strategic planning
• The formulation, evaluation and selection of strategies to
prepare a long-term plan of action to attain objectives
• Strategic decisions should be suitable, feasible and
acceptable
• Long-term direction
• Matching activities to environment / resources
Slide 27
Financial planning 2
Key elements of financial planning
• Planning involves a long horizon, uncertainties and
contingency plans
• Consideration of which assets are essential and how easily
assets can be sold
• Long-term investment and short-term cash flow
• Surplus cash
• How finance raised
• Profitable
Slide 28
Financial planning 6
• Strategic analysis means analysing the organisation - its
resources, competences, mission and objectives
• Strategic choice involves generating and evaluating strategic
options and selecting strategy
Slide 29
Financial planning 7
Strategic cash flow management
• Planning involves a long horizon, uncertainties and
contingency plans
Strategic fund management
• Consideration of which assets are essential and how easily
assets can be sold
Slide 30
Financial planning 8
Strategic planning
• Selection of products / markets
• Target profits
• Purchase of major non-current assets
• Debt / equity mix
• Growth v dividend payout
Slide 31
Financial planning 9
Tactical planning
• Other non-current asset purchases
• Efficient / effective resource usage
• Pricing
• Lease v buy
• Scrip v cash dividends
Slide 32
Financial planning 10
Tactical planning and control
• Conflict may arise between strategic planning (need to invest
in more expensive machinery, R&D) and tactical planning
(cost control)
Slide 33
Financial planning 11
• Johnson and Scholes separate power groups into 'internal
coalitions' and 'external stakeholder groups'
Slide 34
Financial planning 12
Stakeholder goals
• Shareholders
–
Providers of risk capital, aim to maximise wealth
• Suppliers
–
To be paid full amount by date agreed, and continue
relationship (so may accept later payment)
• Long-term lenders
–
Slide 35
To receive payments of interest and capital by due date
Financial planning 13
Stakeholder goals continued
• Employees
–
To maximise salaries and benefits; also prefer continuity
in employment
• Government
–
Political objectives such as sustained economic growth
and high employment
• Management
–
Slide 36
Maximising their own rewards
Chapter 2
Financial strategy
formulation
Assessing corporate performance
Financial strategy
Risk and risk management
Assessing corporate performance 1
Probability and return
• Return on capital employed
• Profit margin
• Asset turnover
Debt and gearing
• Debt ratio (Total debts: Assets)
• Gearing (Proportion of debt in long-term capital)
• Interest cover
• Cash flow ratio (Cash inflow: Total debts)
Slide 38
Assessing corporate performance 2
Liquidity ratios
• Current ratio
• Acid test ratio
• Inventory turnover
• Receivables’ days
• Payables’ days
Slide 39
Assessing corporate performance 3
Stock market ratios
• Dividend yield
• Interest yield
• Earnings per share
• Dividend cover
• Price / earnings ratio
Slide 40
Assessing corporate performance 4
Comparisons with previous years
•
% growth in profit
•
% growth in turnover
•
Changes in gearing ratio
•
Changes in current / quick ratios
•
Changes in inventory / receivables’ turnover
•
Changes in EPS, market price, dividend
Slide 41
Assessing corporate performance 5
Remember however
• Inflation – can make figures misleading
• Results in rest of industry / environment, or economic
changes
Comparisons with companies in same industry
• These can put improvements on previous years into
perspective if other companies are doing better
• Also can provide further evidence of effect of general trends
• Eg growth rates, retained profits, non-current asset levels
Slide 42
Assessing corporate performance 6
Comparisons with companies in different industries
• Investors aiming for diversified portfolios need to know
differences between industrial sectors
• Sales growth
• Profit growth
• ROCE
• P/E ratios
• Dividend yields
Slide 43
Assessing corporate performance 7
Economic Value Added (EVATM)
• EVATM = NOPAT - (cost of capital x capital employed)
Adjustments to NOPAT
• Add:
–
Interest on debt
–
Goodwill written off
–
Accounting depreciation
–
Increases in provisions
–
Net capitalised intangibles
Slide 44
Assessing corporate performance 8
Adjustments to capital employed
• Add:
–
Cumulative goodwill written off
–
Cumulative depreciation written off
–
NBV of intangibles
–
Provisions
Slide 45
Assessing corporate performance 9
Types of sources of funds
Shares
• Ownership stake
• Equity (full voting rights)
• Preference (prior right to dividends)
• All companies can use rights issues
• Listed companies can use offer for sale / placing
Slide 46
Assessing corporate performance 10
Debt / Bonds
•
Fixed or floating rate
•
Zero coupon (no interest)
•
Convertible loan stock
•
Bank loans
•
Security over property may be required
Slide 47
Assessing corporate performance 11
Comparison of finance sources
When comparing different sources of finance, the following
factors will generally be important:
• Cost
• Flexibility / time period available
• Commitments
• Uses
• Speed / availability
• Certainty of raising amounts
Slide 48
Assessing corporate performance 12
Estimating cost of equity
• Theoretical valuation models, eg Capital Asset Pricing
Model (CAPM) or Arbitrage Pricing Theory (APT)
• Bond-yield-plus-premium approach: adds a judgmental
risk premium to the interest rate on the firm’s own long-term
debt
• Market-implied estimates using discounted cash flow (DCF)
approach (based on an assumption on earnings growth rate of
earning of the company)
Slide 49
Assessing corporate performance 13
Practicalities in issuing new shares
• Costs
• Income to investors
• Tax effect
•
Effect on control
Slide 50
Assessing corporate performance 14
Ethical framework for business
• In order of priority:
(1) Economic responsibility
(2) Legal responsibility
(3) Ethical responsibility
(4) Philanthropic responsibility
Slide 51
Financial strategy 1
Suitability of capital structure
• Company financial position / stability of earnings
• Need for a number of sources
• Time period of assets matched with funds
• Change in risk-return
• Cost and flexibility
• Tax relief
• Minimisation of cost of capital
Slide 52
Financial strategy 2
Feasibility of capital structure
• Whether lenders are prepared to lend (security)
•
Availability of stock market funds
•
Future trends
•
Restrictions in loan agreements
•
Maturity of current debt
Slide 53
Financial strategy 3
Acceptability of capital structure
• Risk attitudes
• Loss of control by directors
• Excessive costs
• Too heavy commitments
Slide 54
Financial strategy 4
Pecking order
• Retained earnings
• Debt
• Equity
Slide 55
Financial strategy 5
Dividend policy
• Dividend decisions determine the amount of, and the way in
which, a company’s profits are distributed to its shareholders
Ways of paying dividends
• Cash
• Shares (stock)
• Share repurchases
Slide 56
Financial strategy 6
Theories of why dividends are paid
• Residual theory
• Target payout ratio
• Dividends as signals
• Tax implications
•
Agency theory
Slide 57
Risk and risk management 1
Types of risk
• Systematic and unsystematic
• Business
• Financial
• Political
• Economic
• Fiscal / regulatory
• Operational
• Reputational
Slide 58
Risk and risk management 2
Risk management
• Over-riding reason for managing risk is to maximise
shareholder value
Risk mitigation
• The process of minimising the likelihood of a risk occurring
or the impact of that risk if it does occur
Slide 59
Risk and risk management 3
Portfolio theory
• Used to reduce unsystematic risk by diversification
Hedging
• Financial – use financial instruments
• Operational – real options
Slide 60
Chapter 3a
Conflicting stakeholder
interests
Stakeholders
Corporate governance
Stakeholders 1
Separation of ownership and management:
• Ordinary (equity) shareholders are owners of the company,
but the company is managed by its board of directors
Central source of stakeholder conflict:
• Difference between the interests of managers and those of
owners
Slide 62
Stakeholders 2
Sources of stakeholder conflict
• Short-termism
• Sales objective (instead of shareholder value)
• Overpriced acquisitions
• Resistance to takeovers
• Relationships with stakeholders may be difficult
Slide 63
Stakeholders 3
The transaction costs economics theory
• This postulates that the governance structure of a
corporation is determined by transaction costs
• The transactions costs include search and information costs,
bargaining costs and policing and enforcement costs
Slide 64
Corporate governance 1
Agency theory
• Proposes that individual team members act in their own selfinterest
• Individual well-being however depends on the well-being of
other individuals and on the performance of the team
• Corporations are sets of contracts between principals
(suppliers of finance) and agents (management)
Slide65
Corporate governance 2
The agency problem
• Managers don’t have significant shareholdings, what stops
them under-performing and over-rewarding themselves?
Goal congruence
• Accordance between the objectives of agents acting within an
organisation and the objectives of the organisation as a whole
Slide 66
Corporate governance 3
Management incentives may enhance congruence:
• Profit-related pay
• Rights to subscribe at reduced price
• Executive share-option plans
• However management may adopt creative accounting
• Sound corporate governance is another approach
Slide 67
Corporate governance 4
UK Corporate Governance Code (formerly The
Combined Code)
• Directors responsible for corporate governance
Board of Directors
• Meet regularly
• Matters refer to board
• Division of responsibilities
• Committees – audit, nomination, remuneration
Slide 68
Corporate governance 5
Executive directors
• Limits on service contracts
• Emoluments decided by remuneration committee and fully
disclosed
Non-executive directors
• Majority independent
• No business / financial links
• Don’t participate in options
• Appointed for specified term
Slide 69
Corporate governance 6
• Auditors provide external assurance
• Financial reports link directors to shareholders and other
users
Accountability and audit
• Audit committee of non-executive directors
• Consider need for internal audit function
• Accounts contain corporate governance statement
• Directors review and report on internal controls
Slide 70
Corporate governance 7
Annual general meeting
• 20 days’ notice
• Separate resolutions on separate issues
• All committees answer questions
Slide 71
Corporate governance 8
• The Higgs report stresses the importance of the board
including a balance of executive and non-executive directors
• No individual or small group can dominate decision-making
• The report also lays down criteria for establishing the
independence of non-executive directors
• Also stresses the need to separate the roles of Chairman
and Chief Executive
Slide 72
Corporate governance 9
International comparisons
USA
• By means of Stock Exchange regulation, stringent reporting
requirements, tightened by Sarbanes-Oxley
• The US system is based on control by legislation/regulation,
more rules on directors’ duties than in UK
• Major creditors are often on boards
Slide 73
Corporate governance 10
Europe
• By means of tax law
• Also two tier board system to protect shareholder interests
• In Germany, banks have longer term role, may have equity
stake
• Separate supervisory board has workers’ and shareholders’
representatives
Slide 74
Corporate governance 11
Japan
• Flexible approach to governance, low level of regulation
• All stakeholders collaborate
• Stock market is less open, more links with banks than in UK
• Policy boards (long-term)
• Functional boards (executive)
• Monocratic boards (symbolic)
Slide 75
Corporate governance 12
Management culture
• Management culture comprises views on management and
methods of doing business
• Multinationals may have particular problems imposing the
parent company’s culture overseas eg American practices in
Europe
Slide 76
Chapter 3b
Ethical issues in financial
management
Ethical dimension
Ethical aspects
Ethical dimension
Ethical considerations are part of the non-financial objectives
of an organisation
They will tend to include:
• Employee and management welfare
• Welfare of society
• Responsibilities to customers and supplies
• Leadership in R & D
• Minimum standard of service provision
Slide 78
Ethical aspects 1
Business ethics
Human resource management
• Minimum wage, discrimination
Marketing
• Social and cultural impact
Market behaviour
• Dominant position, treatment of suppliers and customers
Slide 79
Ethical aspects 2
Business ethics continued
Product development
• Animal testing, sensitivity to culture of different countries and
markets
Slide 80
Chapter 3c
Environmental issues
Business practice
Regulation
Business practice 1
Green issues and business practice
• Direct environmental impacts on business – eg:
–
Changes affecting costs or resource availability
–
Impact on demand
–
Effect on power balances between competitors in a
market
• Indirect environmental impacts - eg:
–
Slide 82
Legislative change; pressure from customers or staff as a
consequence of concern over environmental problems
Business practice 2
Environmental reporting
• Many companies produce an external report for external
stakeholders, covering:
–
How business activity impacts on environment
–
An environmental objective (eg use of 100% recyclable
materials within x years)
–
The company's approach to achieving and monitoring
these objectives
–
An assessment of its success towards achieving the
objectives
–
An independent verification of claims made
Slide 83
Business practice 3
Company’s environmental policy
• May include reduction / management of risk to the business,
motivating staff and enhancement of corporate reputation
Sustainability
• Refers to the concept of balancing growth with
environmental, social and economic concerns
Slide 84
Business practice 4
Triple bottom line decision making
Triple bottom line reporting
• A quantitative summary of a company’s economic,
environmental and social performance over the previous year
Slide 85
Business practice 5
Triple bottom line proxy indicators
Economic impact
• Gross operating surplus
• Dependence on imports
• Stimulus to domestic economy by purchasing locally produced
goods and services
Slide 86
Business practice 6
Triple bottom line proxy indicators continued
Social impact
• Organisation’s tax contribution
• Employment
Environmental impact
• Ecological footprint
• Emissions to soil, water and air
• Water and energy use
Slide 87
Regulation 1
Carbon trading
• Allows companies which emit less than their allowance to sell
the right to emit CO2 to another company
1997 Kyoto Protocol to the UNFCCC
• Advised signatories to reduce total greenhouse gas emissions
by 2012, compared to 1990 levels
• EU15 reduction target: 8%
Slide 88
Regulation 2
UNFCCC
• United Nations Framework Convention on Climate Change
agreements:
• To develop programmes to slow climate change
• To share technology and co-operate to reduce greenhouse
gas emissions
• To develop a greenhouse gas inventory listing national
sources and sinks
Slide 89
Regulation 3
Environment agency
• Mission: to protect or enhance environment, so as to
promote the objective of achieving sustainable development
Slide 90
Regulation 4
Environmental audit
• An audit that seeks to assess the environmental impact of a
company's policies
The auditor will check whether the company’s environmental
policy:
• Satisfies key stakeholder criteria
• Meets legal requirements
• Complies with British Standards or other local regulations
Slide 91
Chapter 4
Trading and planning in a
multi-national
environment
Trade
Institutions
International financial markets
Global financial stability
Multinationals’ strategy
Risk
Trade 1
International trade
• World output of goods / services increased if countries
specialise in production of goods / services in which they have
a comparative advantage
• And trade to obtain other goods and services
Slide93
Trade 2
Comparative advantage
• Countries specialising in what they produce, even if they are
less efficient (in absolute terms) in production of all types of
good
• This is the comparative advantage justification of free trade,
without protectionism or trade barriers
Slide 94
Trade 3
Barriers to market entry
• Product differentiation barriers
• Absolute cost barriers
• Economy of scale barriers
• The level of fixed costs
• Legal / patent barriers
Slide 95
Trade 4
Protectionist measures
• Tariffs or customs duties
•
Import quotas
•
Embargoes
•
Hidden subsidies
•
Import restrictions
•
Restrictive bureaucratic procedures
•
Currency devaluations
Slide 96
Trade 5
Why protect trade?
• To combat imports of cheap goods
• To counter ‘dumping’
• Infant industries might need special treatment
• Declining industries might need special treatment
• Protection might reduce a trade deficit
Slide 97
Trade 6
What’s wrong with trade protection?
• Mutually beneficial trade may be reduced
• There may be retaliation
• Economic growth prospects may be damaged
• Political ill-will may be created
• The EU combines a free trade area with a customs union
(mobility of factors of production)
Slide 98
Institutions 1
World Trade Organisation – aims
• Reduce existing barriers to free trade
• Eliminate discrimination in international trade (in eg tariffs
and subsidies)
• Prevent growth of protection by getting member countries
to consult with others first
• Act as a forum for assisting free trade, and offering a
disputes settlement process
• Establish rules and guidelines to make world trade more
predictable
Slide 99
Institutions 2
International Monetary Fund – aims
• Promote international monetary co-operation, and
establish code of conduct for international payments
• Provide financial support to countries with temporary
balance of payments deficits
• Provide for orderly growth of international liquidity
Slide 100
Institutions 3
World Bank (IBRD)
• Supplements private finance and lends money on a
commercial basis for capital projects
• Usually direct to governments or government agencies
Bank for International Settlements (BIS)
• The banker for central banks
• Promotes co-operation between central banks
• Provides facilities for international co-operation
Slide 101
International financial markets 1
• Globalisation of financial markets has contributed to financial
instability
• Despite facilitating the transfer of funds to emerging markets
Slide 102
International financial markets 2
European Monetary System (EMS) – purposes
• To stabilise exchange rates between member countries
• To promote economic convergence in Europe
• To develop European Economic and Monetary Union (EMU)
Slide 103
International financial markets 3
Arguments for EMU
• Economic policy stability
• Facilitation of trade
• Lower interest rates
• Preservation of the City’s position
Slide 104
International financial markets 4
Arguments against EMU
• Loss of national control over economic policy
• The need to compensate for weaker economies
• Confusion in transition to EMU
• Lower confidence arising from loss of national pride
Slide 105
Global financial stability 1
• The global debt crisis arose as governments in less developed
countries took on levels of debt above their ability to finance
Resolving the global debt crisis
• Restructure or rescheduled debt
• Economic reforms to improve balance of trade
• Lending governments write off some of the debts
• Convert some debt into equity
Slide 106
Global financial stability 2
Negative impacts on multinational firms
• Deflationary policies damage profitability
• Devaluation of currency
• Reduction in imports by developing countries
• Increased reliance on host countries for funding
Slide 107
Multinationals’ strategy 1
Strategic reasons for Foreign Direct Investment (FDI)
• Market seeking / raw material seeking
• Production efficiency / technology seeking
• Knowledge seeking
• Political safety seeking
• Economies of scale / financial economies
• Managerial and marketing expertise
• Differentiated products
Slide 108
Multinationals’ strategy 2
Ways to establish an interest abroad
• Joint ventures – industrial co-operation (contractual) or
joint-equity
• Licensing agreements
• Management contracts
• Subsidiary
• Branches
Slide 109
Multinationals’ strategy 3
Management contracts:
• A firm agrees to sell management skills – sometimes used in
combination with licensing
• Can serve as a means of obtaining funds from subsidiaries,
where other remittance restrictions apply
• Many multinationals use a combination of methods for
servicing international markets
Slide 110
Multinationals’ strategy 4
Multinationals’ financial planning
• Multinational companies need to develop a financial planning
framework
• This is to ensure that the strategic objectives and competitive
advantages are realised
• It will include ways of raising capital and risks related to
overseas operations and the repatriation of profits
Slide 111
Multinationals’ strategy 5
Finance for overseas investment depends on:
• Local finance costs, and any available subsidies
• Tax systems of the countries (best group structure may be
affected by tax systems)
• Any restrictions on dividend remittances
• Possible flexibility in repayments arising from the
parent / subsidiary relationship
Slide 112
Multinationals’ strategy 6
• A company raising funds from local equity markets must
comply with the listing requirements of the local exchange
Blocked funds
• Multinationals can counter exchange controls by management
charges or royalties
Control systems
• Large and complex companies may be organised as a
heterarchy, an organic structure with significant local control
Slide 113
Risk 1
Factors in assessing political risk
• Government stability
• Political and business ethics
• Economic stability / inflation
• Degree of international indebtedness
• Financial infrastructure
• Level of import restrictions
Slide 114
Risk 2
Factors in assessing political risk continued
• Remittance restrictions
• Assets seized
• Special taxes and regulations on overseas investors, or
investment incentives
Slide 115
Risk 3
Dealing with political risk
• Negotiations with host government
•
Insurance (eg ECGD)
•
Production strategies
•
Contacts with customers
•
Financial management – eg, borrowing funds locally
•
Management structure, eg joint ventures
Slide 116
Risk 4
Litigation risks
• Can generally be reduced by keeping abreast of changes,
acting as a good corporate citizen and lobbying
Cultural risks
• Should be taken into account when deciding where to sell
abroad, and how much to centralise activities
Slide 117
Risk 5
Agency issues
• Agency relationships exist between the CEOs of
multinationals conglomerates (the principals)
and
• The strategic business unit (SBU) managers that report to
these CEOs
• The interests of the individual SBU managers may be
incongruent not only with the interests of the CEOs
• But also with those of the other SBU managers
Slide 118
Risk 6
Agency issues continued
• Each SBU manager may try to make sure his or her unit gets
access to critical resources
And
• Achieves the best performance at the expense of the
performance of other SBUs and the whole organisation
Slide 119
Risk 7
Solutions to agency problems in multinationals
• Multiple mechanisms may be needed, working in unison
• Examples: Board of directors: separate ratification and
monitoring of managerial decisions from initiation to
implementation
• Executive incentive systems can reduce agency costs and align
the interests of managers and shareholders
• This can be done by making top executives’ pay contingent on
the value they create for the shareholders
Slide 120
Chapter 5
DCF and free cash flow
NPVs
Internal rate of return
Free cash flow
NPVs 1
Net present value
• The sum of the discounted cash flows less the initial
investment
Decision criteria
• Invest in a project if its net present value is positive ie when
NPV > 0
• Do not invest in a project if its net present value is zero or
negative, ie when NPV ≤ 0
Slide 122
NPVs 2
Real and nominal discount factors
• What nominal rate (i) should be used for discounting cash
flows if the real rate is r and the rate of inflation h?
• The net effect of inflation on the NPV of a project will depend
on three inflation rates: the rates for revenues, costs, and
the discount factor
• Use the Fisher equation (given in exam)
• (l + i) = (1 + r)(1 + h)
Slide 123
NPVs 3
The tax effect on NPV
• Corporate taxes
• Value added taxes
• Other local taxes
• Capital expenditure tax allowances
Slide 124
NPVs 4
Capital rationing
• Capital rationing problem exists when there are insufficient
funds to finance all available profitable projects
Case 1
• Fractional investment allowed: rank alternatives according to
the ratio of NPV to initial investment or the benefit cost ratio
Slide 125
NPVs 5
Capital rationing continued
Case 2
Fractional investment not allowed
• A more systematic approach may be needed to find the NPV
maximising combination of entire projects subject to the
investment constraint
• This is provided by the mathematical technique of integer
programming
Slide 126
NPVs 6
Capital rationing continued
• The multi-period capital rationing problem can be formulated
as an integer programming problem
The Monte Carlo method
• Amounts to adopting a particular probability distribution for
the uncertain (random) variables that affect the NPV
• Then using simulations to generate values of the random
variables
Slide 127
NPVs 7
Project Value at Risk
• The minimum amount by which the value of an investment or
portfolio will fall over a given period of time at a given level of
probability
Slide 128
Internal rate of return 1
IRR
• The discount rate at which NPV equals zero
• The IRR calculation also produces the breakeven cost of
capital and allows calculation of the margin of safety
• If the cash flows change signs then the IRR may not be unique:
this is the multiple IRR problem
• With mutually exclusive projects, the decision depends not
on the IRR but on the cost of capital being used
Slide 129
Internal rate of return 2
• A project will be selected as long as the IRR is not less than
the cost of capital
Slide 130
Internal rate of return 3
Modified internal rate of return (MIRR)
• The IRR which would result without the assumption that
project proceeds are reinvested at the IRR rate
• Calculate present value of the return phase (the phase of the
project with cash inflows)
• Calculate the present value of the investment (the phase with
cash outflows)
Slide 131
Internal rate of return 4
MIRR continued
• Calculate MIRR using the following formula:
• This formula is given in the exam
Slide 132
Internal rate of return 5
Re-investment rate
• The NPV method assumes that cash flows can be reinvested
at the cost of capital over the life of the project
• The IRR assumes that cash flows can be reinvested at the IRR
over the life of the project
• The IRR assumption is unlikely to be valid and so the NPV
method is likely to be superior
• The better reinvestment rate assumption will be the cost of
capital used for the NPV method
Slide 133
Internal rate of return 6
Decision criterion
• If MIRR is greater than the required rate of return: ACCEPT
• If MIRR is lower than the required rate of return: REJECT
Slide 134
Free cash flow 1
Free cash flow (FCF)
• Free Cash Flow = Earnings before Interest and Taxes (EBIT)
• less Tax on EBIT
• plus Non cash charges (eg depreciation)
• less Capital expenditures
• less Net working capital increases
• plus Net working capital decreases
• plus Salvage value received
Slide 135
Free cash flow 2
Forecasting FCF
Constant growth
• FCF0 is the free cash flow at beginning
• n is the number of years
Slide 136
Free cash flow 3
Forecasting FCF continued
Differing growth rates
• Forecast each element of FCF separately using appropriate
rate
Forecasting dividend capacity
• Dividend capacity of a firm is measured by its free cash flow
to equity (FCFE)
Slide 137
Free cash flow 4
Direct method of calculating FCFE
• Net income (EBIT - net interest - tax paid)
• Add depreciation
• Less total net investment
• Add net debt issued
• Add net equity issued
Slide 138
Free cash flow 5
Indirect method
• Free cash flow
• Less (net interest + net debt paid)
• Add Tax benefit from debt (net interest x tax rate)
Slide 139
Free cash flow 6
Firm valuation using FCF
• Value of the firm is the sum of the discounted free cash flows
over the appropriate time horizon
• Assuming constant growth, use the Gordon model:
Slide 140
Free cash flow 7
Terminal values and company valuation
• Value of the firm is the present value over the forecast period
+ terminal value of cash flows beyond the forecast period
Firm valuation using FCFE
• Calculate value of equity (present value of FCFE discounted at
the cost of equity)
• Calculate value of debt
• Value = value of equity + value of debt
Slide 141
Chapter 6
Application of option
pricing decisions in
investment decisions
Option concepts
Real options
Options concepts 1
Options
• An option is a contract that gives one party the option to
enter into a transaction
• Either at a specific time or within a specific future period at a
price that is agreed when the contract is made
Slide 143
Options concepts 2
• The buyer of a call option acquires the right, but not the
obligation, to buy the underlying at a fixed price
• The buyer of a put option acquires the right, but not the
obligation, to sell the underlying shares at a fixed price
• In the money option:
intrinsic value is +ve
• At the money option:
intrinsic value is zero
• Out of the money option:
Slide 144
intrinsic value is –ve
Options concepts 3
Determinants of options values
• The higher the exercise price, the lower the probability that
the call will be in the money
• As the current price of the underlying asset goes up, the
higher the probability that the call will be in the money
• Both a call and put will increase in price as the underlying
asset becomes more volatile
Slide 145
Options concepts 4
Determinants of options values continued
• Both calls and puts will benefit from increased time to
expiration
• The higher the interest rate, the lower the present value of
the exercise price
Slide 146
Real options 1
• Strategic options – known as real options – arising from a
project can increase the project value
• They are ignored in standard DCF analysis, which computes a
single present value
Option to delay
• When a firm has exclusive rights to a project or product for a
specific period, it can delay taking this up until a later date
• For a project not selected today on NPV or IRR grounds, the
rights to the project can still have value
Slide 147
Real options 2
Option to expand
• When firms invest in projects allowing further investments
later
• Or entry into new markets, possibly making the NPV +ve
• The initial investment may be seen as the premium to acquire
the option to expand
Slide 148
Real options 3
Option to abandon
• If the firm has the option to cease a project during its life
• Abandonment is effectively the exercising of a put option
• The option to abandon is a special case of an option to
redeploy
Slide 149
Real options 4
Option to redeploy
• When company can use its productive assets for activities
other than the original one
• The switch will happen if the PV of cash flows from the new
activity will exceed costs of switching
Black-Scholes valuation
• When applying Black-Scholes valuation techniques to real
options
• Simulation methods are typically used to overcome the
problem of estimating volatility
Slide 150
Real options 5
Slide 151
Real options 6
Determinants of options values
• Exercise price (Pe)
• Price of underlying asset (Pa)
• Volatility of underlying asset (s)
• Time to expiration (t)
• Interest rate (r)
• Intrinsic and time value
Slide 152
Chapter 7
Impact of financing and
APV method
Duration
Credit risk
Credit enhancement
Modigliani and Miller
Other theories
APV approach
Duration 1
Duration (Macaulay duration)
• The weighted average length of time to the receipt of a
bond’s benefits (coupon and redemption value)
• The weights are the present values of the benefits involved
Properties of duration
• Longer-dated bonds have longer durations
• Lower-coupon bonds will have longer durations
• Lower yields will give longer durations
Slide 154
Duration 2
Calculating duration
• 1) PV of cash flows for each time period by the time period
and add together
• 2) Add the PV of cash flows in each period together
• Divide the result of step 1 by the result of step 2
Modified duration
• = Macaulay duration/1 + gross redemption yield
• Modified duration shares the same properties as Macaulay
duration
Slide 155
Credit risk 1
Credit risk (or default risk)
• The risk for a lender that the borrower may default on
interest payments and / or repayment of principal
• Credit risk for an individual loan or bond is measured by
estimating:
• Probability of default – typically, using information on
borrower and assigning a credit rating (eg Standard & Poor’s,
Moody’s, Fitch)
• Recovery rate – the fraction of face value of an obligation
recoverable once the borrower has defaulted
Slide 156
Credit risk 2
• Credit migration is change in the credit rating after a bond
is issued
Slide 157
Credit risk 3
Determinants of cost of debt capital
• Credit rating of company
• Maturity of debt
• Risk-free rate at appropriate maturity
• Corporate tax rate
Slide 158
Credit risk 4
Credit spread
• The premium required by an investor in a corporate bond to
compensate for the credit risk of the bond
• Yield on corporate bond = risk free rate + credit spread
• Cost of debt capital = (1 – tax rate)(risk free rate – credit
spread)
Slide 159
Credit risk 5
Option pricing models to assess default risk
• The equity of a company can be seen as a call option on
the assets of the company
• with an exercise price equal to the outstanding debt
• Expected losses are a put option on the assets of the firm
• with an exercise price equal to the value of the outstanding
debt
Slide 160
Credit risk 6
From the Black-Scholes formula, the probability of default
depends on three factors:
• The debt / asset ratio
• The volatility of the company assets
• The maturity of debt
Slide 161
Credit enhancement
Internal credit enhancement
• Excess spread
• Over-collateralisation
External credit enhancement
• Surety bonds
• Letters of credit
• Cash collateral accounts
Slide 162
Modigliani and Miller 1
MM theory (no tax)
• The use of debt would only transfer more risk to the
shareholders, therefore will not reduce the WACC
MM theory (with tax)
• Debt actually saves tax (due to tax relief on interest
payments) therefore firms should only use debt finance
Slide 163
Modigliani and Miller 2
MM and cost of equity
Slide 164
Modigliani and Miller 3
Limitations of MM theory
• Too risky in reality to have high levels of gearing
• Assumes perfect capital markets
• Does not consider bankruptcy risks, tax exhaustion, agency
costs and increased borrowing costs as risk rises
Slide 165
Other theories 1
Static trade-off theory
• A firm in a static position will adjust their gearing levels to
achieve a target level of gearing
• Problems with financial distress costs
• Direct financial distress costs
• Legal and admin costs associated with bankruptcy
Slide 166
Other theories 2
Indirect financial distress costs
• Higher cost of capital
• Loss of sales
• Downsizing
• High staff turnover
Agency theory
• Optimal capital structure is where benefits of debt received
by shareholders matches costs of debt imposed on the
shareholders
Slide 167
Other theories 3
Pecking order theory
• Unlike the MM models, it based on the idea of information
asymmetry:
• Investors have a lower level of information about the
company than its directors do
• Shareholders use directors' actions as a signal to what
directors believe about the company with their superior
information
Slide 168
Other theories 4
Predictions
• To finance new investment, firms prefer internal finance to
external finance
• If retained earnings differ from investment outlays, the firm
adjusts its cash balances or marketable securities first
• Before either taking on more debt or increasing its target
payout rate
Slide 169
Other theories 5
Predictions continued
• Internal finance is at the top, and equity is at the bottom, of
the pecking order
• A single optimal debt equity ratio does not exist: a result
similar to the MM model with no taxes
Slide 170
APV approach 1
Adjusted present value (APV) approach
• The adjusted present value (APV) method of valuation is
based on the Modigliani Miller model with taxation
• It assumes that the primary benefit of borrowing is the tax
benefit
• And that the most significant cost of borrowing is the added
risk of bankruptcy
Slide 171
APV approach 2
Steps in applying APV
• Calculate the NPV as if the project was financed entirely by
equity (use ke)
• Add the PV of the tax saved as a result of the debt used to
finance the project (use kd)
• Subtract the cost of issuing new finance
Slide 172
Chapter 8
International investment
decisions
NPV and international projects
Exchange controls
Exchange rate risks
Capital structure
NPV and international projects 1
Purchasing power parity
Absolute purchasing parity theory:
• Prices of products in different countries will be the same
when expressed in the same currency
Alternative purchasing power parity relationship:
• Changes in exchange rates are due to differences in the
expected inflation rates between countries
Slide 174
NPV and international investment 2
International Fisher effect
• This equation is given in the exam
• With no trade or capital flows restrictions, real interest
rates in different countries will be expected to be the same
• Differences in interest rates reflect differences in inflation
rates
Slide 175
NPV and international investment 3
NPVs for international projects
Alternative methods for calculating the NPV from an overseas
project:
• Convert project cash flows into sterling and discount at
sterling discount rate to calculate NPV in sterling terms
OR
• Discount cash flows in host country's currency from project
at adjusted discount rate for that currency
• Then convert resulting NPV at spot exchange rate
Slide 176
NPV and international investment 4
Effect of exchange rates on NPV
• When there is a devaluation of sterling relative to a foreign
currency, the sterling value of cash flows and NPV increase
• The opposite happens when the domestic currency
appreciates
Slide 177
NPV and international investment 5
Effect on exports
• A multinational company sets up a subsidiary in another
country in which it already exports
• The relevant cash flows for evaluation of the project should
account for loss of export earnings in the particular country
Impact of transaction costs
• Transaction costs are incurred when companies invest abroad
due to currency conversion or other administrative expenses
• These should also be taken into account
Slide 178
NPV and international projects 6
Taxes in international context
Host country
• Corporate taxes
• Investment allowances
• Withholding taxes
Home country
• Double taxation relief
• Foreign tax credits
Slide 179
NPV and international projects 7
Tax haven characteristics
• Low tax on foreign investment or sales income earned by
resident companies
• Low withholding tax on dividends paid to the parent
• Stable government and currency
• Adequate financial services support facilities
Slide 180
NPV and international projects 8
Subsidies
• The benefit from concessionary loans should be included in
the NPV calculation as:
• The difference between repayment of borrowing under
market conditions and repayment under the concessionary
loan
Slide 181
Exchange controls 1
Exchange controls – types
Rationing supply of foreign exchange
• Payments abroad in foreign currency are restricted,
preventing firms from buying as much as they want from
abroad
Restricting types of transaction for which
• Payments abroad are allowed, eg suspending or banning
payment of dividends to foreign shareholders
• Eg parent companies in multinationals: blocked funds
problem
Slide 182
Exchange controls 2
• For an overseas project, only the proportion of cash flows
that are expected to be repatriated in the NPV calculation
Slide 183
Exchange controls 3
Strategies
• Multinational company strategies to overcome exchange
controls:
Transfer pricing
• Where the parent company sells goods or services to the
subsidiary and obtains payment
Royalty payments adjustments
• When a parent company grants a subsidiary the right to make
goods protected by patents
Slide 184
Exchange controls 4
Loans by the parent company to the subsidiary:
• Setting interest rate at appropriate level
Management charges
• Levied by the parent company for costs incurred in the
management of international operations
Slide 185
Exchange rate risks 1
Transaction exposure
• The risk of adverse exchange rate movements between the
date the price is agreed and the date cash is received/paid
• Arising during normal international trade
Slide 186
Exchange rate risks 2
Translation exposure
• Risk that organisation will make exchange losses when
accounting results of foreign branches/subsidiaries are
translated
• Translation losses can arise from restating the book value of a
foreign subsidiary’s assets at:
– The exchange rate on the statement of financial position
date – only important if changes arise from loss of
economic value
Slide 187
Exchange rate risks 3
Economic exposure
• The risk that the present value of a company’s future cash
flows might be reduced by adverse exchange rate movements
• Can be longer-term (continuous currency depreciation)
• Can arise even without trade overseas (effects of pound
strengthening)
Slide 188
Capital structure 1
Capital structure of a MNC
Special factors
• Global taxation
•
Exchange risk
•
Political risk
•
Business risk
Slide 189
Capital structure 2
International borrowing options
• Borrow in the same currency as the inflows from the project
• Borrow in a currency other than the currency of the inflows,
with a hedge in place
• Borrow in a currency other than the currency of the inflows,
without hedging the currency risk
• This option exposes the company to exchange rate risk which
can substantially change the profitability of a project
Slide 190
Capital structure 3
Advantages of international borrowing
Availability
• Many smaller domestic financial markets might lack the depth
and liquidity to accommodate large or long-maturity debt
issues
Lower cost of borrowing in Eurobond markets
• Interest rates are normally lower than borrowing rates in
national markets
Slide 191
Capital structure 4
Advantages of international borrowing continued
Lower issue costs
• Cost of debt issuance is normally lower than the cost of debt
issue in domestic markets
Slide 192
Chapter 9
Acquisitions and mergers
vs growth
Acquisitions and mergers
Shareholder value issues
Acquisitions and mergers 1
Mergers and acquisitions - reasons
• Operating economies
• Management of acquisition
• Diversification
• Asset backing
• Earnings quality
Slide 194
Acquisitions and mergers 2
Mergers and acquisitions - reasons continued
• Finance / liquidity
• Internal expansion costs
• Tax
• Defensive merger
• Economic efficiency
Slide 195
Acquisitions and mergers 3
Factors in a takeover
• Cost of acquisition
• Form of purchase consideration
• Reaction of predator’s shareholders
• Accounting implications
• Reaction of target’s shareholders
• Future policy (eg dividends, staff)
Slide 196
Acquisitions and mergers 4
Vertical merger – backward merger
• With supplier – aim to control supply chain
Vertical merger – forward merger
• With customer / distributor – aim to control distribution
Horizontal merger
• The two merging firms produce similar products in the same
industry – aim to increase market power
Conglomerate merger
• Two firms in different industries – aim of diversification
Slide 197
Acquisitions and mergers 5
Takeover strategy – what to acquire
• Growth prospects limited – younger company with higher
growth rate
• Potential to sell other products to existing customers
– company with complementary product
• Operating at maximum capacity – company making
similar products operating below capacity
• Under-utilising management – company needing better
management
Slide 198
Acquisitions and mergers 6
Takeover strategy – what to acquire continued
• Greater control over supplies or customers – company
giving access to customer / supplier
• Lacking key clients in targeted sector – company with
right customer profile
• Improve balance sheet – company enhancing EPS
• Increase market share – important competitor
• Widen capability – key talents and / or technology
Slide 199
Shareholder value issues 1
Failures to enhance shareholder value
• Why do many acquisitions fail to enhance shareholder value?
• Agency theory: Takeovers may be motivated by selfinterested acquirer management wanting:
– Diversification of management's own portfolio
– Use of free cash flow to increase size of the firm
– Acquisitions that increase firm's dependence on
management
– Value is transferred from shareholders to managers of
acquiring firm
Slide 200
Shareholder value issues 2
Hubris hypothesis
• Bidding company bids too much because managers of
acquiring firms suffer from hubris, excessive pride and
arrogance
Market irrationality argument
• When a company’s shares seem overvalued, management may
exchange them for an acquiree firm ie merger
• The lack of synergies or better management may lead to a
failing merger
Slide 201
Shareholder value issues 3
Pre-emptive theory
• Several firms may compete for opportunity to merge with
target to achieve cost savings
• Winning firm could improve market position and gain market
share
• It can be rational for the first firm to pre-empt a merger with
its own takeover attempt
Window dressing
• Where companies are acquired to present a better short
term financial picture
Slide 202
Shareholder value issues 4
Synergy – Revenue synergy
• Acquisition will result in higher revenues, higher return on
equity or longer period of growth for the acquiring company
• Revenue synergies arise from:
(a) Increased market power
(b) Marketing synergies
(c) Strategic synergies
Slide 203
Shareholder value issues 5
Synergy – cost synergy
• Results from economies of scale
• As scale increases, marginal cost falls leading to greater
operating margins for the combined entity
Sources of financial synergy
• Diversification
• Use of cash slack
• Tax benefits
• Debt capacity
Slide 204
Shareholder value issues 6
Possible reasons for high failure rate of acquisitions
• Agency theory
• Valuation errors
• Market irrationality
• Pre-emptive theory
• Window dressing
Slide 205
Chapter 10
Valuations for
acquisitions and mergers
Valuation issues
Type I
Type II
Type III
High-growth start-ups
Intangible assets
Valuation issues 1
The over-valuation problem
• Paying more than the current market value, to acquire a
company
• During an acquisition, there is typically a fall in the price of
the bidder and an increase in the price of the target
• Overvaluation may arise as miscalculation of potential
synergies or
• Overestimation of ability of acquiring firm's management to
improve performance
• Both lead to a higher price than current market value
Valuation issues 2
Estimating earnings growth
• Gordon constant growth model:
Slide 208
Valuation issues 3
Three ways to estimate g:
• Historical estimates: extrapolate past values
• Rely on analysts’ forecasts
• Use the company’s return on equity and retention rate of
earnings (g = ROE x retention rate)
Slide 209
Valuation issues 4
Business risk of combined entity
• The risk associated with the unique circumstances of the
combined company
• Affected by the betas of the individual entities (target and
predator) and the beta of the resulting synergy
Asset beta
• The weighted average of the betas of the target, predator
and synergy of the combined entity
Slide 210
Valuation issues 4
Geared equity beta
• Calculate value of debt (net of tax)
• Divide by value of equity
• Multiply the above by difference between beta of combined
entity and beta of debt
• Add the above to the beta of the combined entity
Slide 211
Valuation issues 5
Acquisitions and acquirer’s risk
• Acquisition type I – does not affect financial risk or
business risk
• Acquisition type II – does affect financial risk but does not
affect business risk
• Acquisition type III – affects both financial risk and business
risk
Slide 212
Type I 1
Type 1 valuations
• Methods of value company:
(1) Book value-plus models
(2) Market-relative models
(3) Cash flow models, including EVATM, MVA
Slide 213
Type I 2
Book value-plus models
• Use statement of financial position as starting point
• Total Asset Value less Long-term and short-term payables =
Company's Net Asset Value
• Book value of net assets is also 'equity shareholders' funds':
the owners' stake in the company
Slide 214
Type I 3
Market-relative models (P/E ratio)
• P/E ratio = Market value/EPS
• Market value = P/E ratio x EPS
• Decide suitable P/E ratio and multiply by EPS: an earningsbased valuation
• EPS could be historical EPS or prospective future EPS
• For a given EPS, a higher P/E ratio will result in a higher price
Slide 215
Type I 4
High P/E ratio may indicate:
•
Optimistic expectations
•
Security of earnings
•
Status
Slide 216
Type 1 5
Q ratio
• The market value of company assets (MV) divided by
replacement cost of the assets (RC)
• Q = MV/RC
• Equity version of Q:
–
Slide 217
Qe = MV – Market value of debt/RC – Total debt
Type 1 6
Q ratio continued
Points to note
• RC of capital is difficult to estimate so is proxied by the book
value of capital
• The equity Q ie Qe is approximated as:
• Qe = Market value of equity/Equity capital
• If Q <1, management has destroyed the value of contributed
capital: firm is vulnerable to takeover
• If Q >1, management has increased the value of contributed
capital
Slide 218
Type 1 7
Free cash flow model
Step 1
• Calculate Free Cash Flow (FCF)
• FCF = Earnings before interest and tax (EBIT)
• Less: Tax on EBIT
• Plus: Non-cash charges
• Less: Capital expenditures
Slide 219
Type I 8
Free cash flow model continued
• Less: Net working capital increases
• Plus: Salvage values received
• Plus: Net working capital decreases
Step 2
• Forecast FCF and Terminal Value
Slide 220
Type 1 9
Step 3
• Calculate from cost of equity (Ke ) and cost of debt (Kd)
where
• T is the tax rate
• Vd is the value of the debt
• Ve is the value of equity
Slide 221
Type I 10
• Step 4
• Discount free cash flow at WACC to obtain value of firm
• Step 5
• Calculate equity value
• Equity Value = Value of the firm – Value of debt
Slide 222
Type I 11
EVA approach
• EVA = NOPAT – (WACC x Capital Employed)
• Or, EVA = (ROIC – WACC) x Capital Employed
where
• NOPAT = Net Operating Profits After Taxes
• ROIC= Return on Invested Capital
• WACC = Weighted average cost of capital
Slide 223
Type I 12
EVA approach continued
• Value of firm = Value of invested capital + sum of discounted
EVA
• Subtract value of debt from value of company to get value of
equity
Slide 224
Type I 13
Market value added (MVA) approach
• Shows how much management has added to the value of
capital contributed by the capital providers
• MVA = Market Value of Debt + Market Value of Equity –
Book Value of Equity
• MVA related to EVA: MVA is simply PV of future EVAs of the
company
• If market value and book value of debt are the same, MVA is
the difference between market value of common stock and
equity capital of the firm
Slide 225
Type II 1
Type II valuations – adjusted present value (APV)
• Acquisition is valued by discounting Free Cash Flows by
ungeared cost of equity, then adding PV of tax shield
• APV = – Initial Investment + Value of acquired company if
all-equity financed + PV of Debt Tax Shields
• If APV is +ve, acquisition should be undertaken
Slide 226
Type II 2
APV calculation
• Step 1
–
Forecast FCF (as previously)
• Step 2
–
Forecast FCFs and Terminal Value
• Step 3
–
Slide 227
Ungeared beta of firm is calculated from geared beta:
Type II 3
• Step 4
–
Discount cash flow at ungeared cost of equity to obtain
NPV of ungeared firm or project
• Step 5
–
Calculate interest tax shields
• Step 6
–
Slide 228
Discount interest tax shields at pre-tax cost of debt to
obtain PV of interest tax shields
Type II 4
Step 7
• APV = NPV of ungeared firm or project
• Plus PV interest tax shields
• Plus excess cash and marketable securities
• Less market value of contingent liabilities
= Market value of the firm
• Less: Market value of debt
= MARKET VALUE OF EQUITY
Slide 229
Type III 1
Type III iterative valuations
• Estimate value of acquiring company before acquisition
• Estimate value of acquired company before acquisition
• Estimate value of synergies
• Estimate beta coefficients for equity of acquiring and acquired
company, using CAPM
• Estimate asset beta for each company
Slide 230
Type III 2
Type III iterative valuations continued
• Calculate asset beta for combined entity
• Calculate geared beta of the combined firm
• Calculate WACC for combined entity
• Use WACC derived above to discount cash flows of
combined entity post-acquisition
• Value of equity: difference between the value of the firm
and the value of debt
Slide 231
Type III 3
A problem with WACC
• If WACC weights are not consistent with the values derived,
the valuation is internally inconsistent
• Then, we use an iterative procedure:
– Go back and re-compute the beta using a revised set of
weights closer to the weights derived from the valuation
– The process is repeated until assumed weights and weights
calculated are approximately equal
Slide 232
High-growth start-ups 1
Valuation of high-growth start-ups
• Typical characteristics of start-ups:
• Few revenues, untested products, unknown product demand,
high development / infrastructure costs
Slide 233
High-growth start-ups 2
Steps in valuation
• Identify drivers eg market potential, resources of the
business, management team
• Period of projection – needs to be long-term
Slide 234
High-growth start-ups 3
Steps in valuation continued
Forecasting growth
Growth in earnings (g) = b x ROIC
• For most high growth start-ups, b = 1 and sole determinant
of growth is the return on invested capital (ROIC)
• This is estimated from industry projections or evaluation of
management, marketing strengths, and investment
Slide 235
High-growth start-ups 4
Valuation methods
• Asset-based method not appropriate:
• Most investment of a start-up is in people, marketing and / or
intellectual rights
• These are treated as expenses rather than capital
• Market-based methods also present problems:
• Difficult to find comparable companies; usually no earnings to
calculate PE ratios (but price-to-revenue ratios may help)
Slide 236
High-growth start-ups 6
Slide 237
Intangible assets 1
Intangible assets
• Differ from tangible assets as they do not have ‘physical
substance’
Examples of intangible assets
• Goodwill
• Brands
• Patents
• Customer loyalty
• Research and development
Slide 238
Intangible assets 2
Market-to-book value
• Measures intangible assets as the difference between book
value of tangible assets and market value of the firm
• Tobin’s ‘q’ = Market value of firm/Replacement cost of
assets
• Used to compare intangible assets of firms in same industry
serving the same markets and with similar tangible noncurrent assets
Slide 239
Intangible assets 3
• Calculated intangible values (CIV) - calculates an ‘excess
return’ on tangible assets
• This is used to determine the proportion of return
attributable to intangible assets
• Lev’s knowledge earnings method separates earnings
deemed to come from intangible assets, which are then
capitalised
Slide 240
Intangible assets 4
Methods of valuing intangible assets
• Relief from royalties
• Premium profits
• Capitalisation of earnings
• Comparison with market transactions
Slide 241
Intangible assets 5
Valuing product patents as options
• Identify value of underlying asset (based on expected cash
flows)
• Identify standard deviation of cash flows
• Identify exercise price of the option
• Identify expiry date of the option
• Identify cost of delay (the greater the delay, the lower the
value of cash flows)
Slide 242
Chapter 11
Regulatory framework
and processes
Global issues
UK and EU regulation
Defensive tactics
Global issues 1
Agency problem
• The issues arising from the separation of ownership and
control have potential impact on mergers and acquisitions
• Potential conflicts of interest
• Protection of minority shareholders
• Transfers of control may turn existing majority shareholders
of the target into minority shareholders
• Target company management measures to prevent the
takeover, which could run against stakeholder interests
Slide 244
Global issues 2
Takeover regulation
• Protect the interests of minority shareholders and other
stakeholders, and
• Ensure a well-functioning market for corporate control
Slide 245
Global issues 3
Two models of regulation
UK / US / Commonwealth countries
• Market-based model – case law-based, promotes protection
of shareholder rights especially
Continental Europe
• ‘Block-holder' or stakeholder system – codified or civil law
based
• Seeking to protect a broader group of stakeholders:
creditors, employees, national interest
Slide 246
UK and EU regulation 1
UK takeover regulation
• Mergers and acquisitions in the UK subject to:
•
City Code
•
Companies Acts 1985 and 2006
•
Financial Services and Markets Act 2000
•
Criminal Justice Act 1993 (insider dealing provisions)
Slide 247
UK and EU regulation 2
City Code
• The City Code on Takeovers and Mergers:
–
Originally voluntary code for takeovers / mergers of UK
companies
–
Now has statutory basis, in line with EU Takeover
Directive
–
Administered by the Takeover Panel
Slide 248
UK and EU regulation 3
City Code principles
• All offeree’s shareholders treated similarly
• Information available to all shareholders
• Shareholders given sufficient information / advice
• Shareholders given time to make decision
• Directors not to frustrate takeover
• No oppression of minorities
• Offer to all shareholders when control (30%) acquired
Slide 249
UK and EU regulation 4
Competition Commission
• Office of Fair Trading thinks a merger may be against the
public interest, it can refer to the Competition Commission
• The CC can accept or reject proposal, or lay down certain
conditions, if competition substantially reduced
• Substantial lessening of competition tests:
• Turnover test (£70m min. for investigation by CC)
• Share of supply test (25%)
Slide 250
UK and EU regulation 5
European Union
• Mergers will fall within jurisdiction of the EU (which will
evaluate it, like the CC in UK) where, following the merger:
(a) Worldwide turnover of more than €5bn per annum
(b) EU turnover of more than €250m per annum
Slide 251
UK and EU regulation 6
EU Takeovers Directive
• Effective from May 2006 – to converge market based and
stakeholder systems
Takeovers Directive principles
• Mandatory-bid rule: required at 30% holding, in UK
• Equal treatment of shareholders
• Squeeze-out rule and sell-out rights: in UK, 90% shareholder
buys all shares
Slide 252
UK and EU regulation 7
EU Takeovers Directive continued
• Principle of board neutrality
• Break-through rule: bidder able to set aside multiple voting
rights (but countries can opt out of this)
Slide 253
UK and EU regulation 8
Bid timetable summary
• Talks (optional)
• Announcement of offer then 28 days until
• Last date for posting of offer document = D day
• Last date for posting of offeree board circular – D day + 14
• First closing date – D day + 21
• Last date for announcements by offeree – D day + 39
Slide 254
UK and EU regulation 9
Bid timetable summary continued
• Earliest date for withdrawal of acceptances by shareholders –
D day + 42
• Last date for revision of offer – D day + 46
• Last day an offer can be declared unconditional as to
acceptances – D day + 60
Slide 255
UK and EU regulation 10
Consequence of share stake levels
• Any - company may enquire on ultimate ownership under
s793 CA 2006
• 3% - beneficial interests must be disclosed to company –
Disclosure and Transparency Rules
• 10% - Shareholders controlling 10%+ of voting rights may
requisition company to serve s793 notices
• Notifiable interests rules become operative for institutional
investors and non-beneficial stakes
Slide 256
UK and EU regulation 11
Consequence of share stake levels continued
• 30% - City Code definition of effective control. Takeover
offer becomes compulsory
• 50% - CA 1985 definition of control (At this level, holder can
pass ordinary resolutions)
• Point at which full offer can be declared unconditional with
regard to acceptances
Slide 257
UK and EU regulation 12
Consequence of share stake levels continued
• 75% - Major control boundary: holder able to pass special
resolutions
• 90% - Minorities may be able to force majority to buy out
their stake
• Equally, majority may be able to require minority to sell out
Slide 258
Defensive tactics 1
Golden parachutes
• Compensation payments made to eliminated top-management
of target firm
Poison pill
• Attempt to make firm unattractive to takeover, eg by giving
existing shareholders right to buy shares cheap
White knights and white squires
• Inviting a firm that would rescue the target from an unwanted
bidder. A ‘white squire’ does not take control of the target
Slide 259
Defensive tactics 2
Crown jewels
• Selling firm’s valuable assets or arranging sale and leaseback,
to make firm less attractive as target
Pacman defence
• Mounting a counter-bid for the attacker
Litigation or regulatory defence
• Inviting investigation by regulatory authorities or Courts
Slide 260
Chapter 12
Financing mergers and
acquisitions
Financing methods
Effect of offer
Financing methods 1
Methods of financing mergers
• Payment can be in the form of:
–
Cash
–
Share exchange
–
Convertible loan stock
Slide 262
Financing methods 2
Methods of financing mergers continued
• The choice will depend on:
–
Available cash
–
Desired levels of gearing
–
Shareholders' tax position
–
Changes in control
Slide 263
Financing methods 3
Funding cash offers
• Methods of financing a cash offer:
–
Retained earnings – common when a firm acquires a
smaller firm
–
Sale of assets
–
Issue of shares, using cash to buy target firm’s shares
Slide 264
Funding methods 4
Funding cash offers continued
– Debt issue – but, issuing bonds will alert the market to the
intentions of the company to bid for another company
– This may lead investors to buy shares of potential targets,
raising their prices
– Bank loan facility – a possible short-term strategy, until bid
is accepted: then the company can make a bond issue
– Mezzanine finance – may be the only route for companies
without access to bond markets
Slide 265
Funding methods 5
Use of convertible loan stock
• Problems with using debentures, loan stock, preference
shares:
–
Establishing a rate of return attractive to target
shareholders
–
Effects on the gearing of acquiring company
–
Change in structure of target shareholders' portfolios
–
Securities potentially less marketable, possibly lacking
voting rights
Slide 266
Funding methods 6
• Convertible loan stock can overcome some such problems
• Offers target shareholders the opportunity to gain from
future profits of company
Slide 267
Funding methods 7
Mezzanine finance
• With cash purchase option for target company's
shareholders, bidding company may arrange mezzanine
finance
• Short-to-medium term
• Unsecured ('junior' debt)
• At higher rate of interest than secured debt (eg LIBOR + 4%
to 5%)
• Often, giving lender option to exchange loan for shares after
the takeover
Slide 268
Funding methods 8
Cash or paper? – Company and existing shareholders
Dilution of EPS
• May be a fall in EPS attributable to existing shareholders if
purchase consideration is in equity shares
Cost to the company
• Loan stock to back cash offer, tax relief on interest, lower
cost than equity. May be lower coupon if convertible
Gearing
• Highly geared company may not be able to issue further loan
stock for cash offer
Slide 269
Funding methods 9
Cash or paper? – Company and existing shareholders
Control
• Major share issue could change control
Authorised share capital increase
• May be required if consideration is shares; requires General
Meeting resolution
Borrowing limits increase
• General Meeting resolution required if borrowing limits need
to change
Slide 270
Funding methods 10
Cash or paper? – Shareholders in target company
Taxation
• If consideration is cash, many investors may suffer CGT
Income
• If consideration is not cash, arrangement must mean existing
income is maintained
• Or be compensated by suitable capital gain or reasonable
growth expectations
Slide 271
Funding method 11
Cash or paper? – Shareholders in target company
Future investments
• Shareholders who want to retain stake in target business may
prefer shares
Share price
• If consideration is shares, recipients will want to be sure that
shares retain their values
Slide 272
Effects of offer 1
EPS before and after a takeover
• If a company acquires another by issuing shares
• Then its EPS will go up or down according to the P/E ratio at
which target company was bought
• If target company's shares bought at higher P/E ratio than
predator company's shares, predator company's shareholders
suffer fall in EPS
• If target company's shares valued at a lower P/E ratio, the
predator company's shareholders benefit from rise in EPS
Slide 273
Effects of offer 2
• Buying companies with a higher P/E ratio will result in a fall in
EPS unless there is profit growth to offset this fall
• Dilution of earnings may be acceptable if there is:
– Earnings growth
– Superior quality of earnings acquired
– Increase in net asset backing
Slide 274
Effects of offer 3
Post-acquisition integration
• A clear programme should be in place, re-defining objectives
and strategy
The approach adopted will depend on:
• The culture of the organisation
• The nature of the company acquired, and
• How it fits into the amalgamated organisation eg horizontally,
vertically, or in diversified conglomerate?
Slide 275
Chapters 13 - 14
Reconstruction and
reorganisation
Financial reconstruction
Divestment and other changes
MBOs and buy-ins
Firm value
Financial reconstruction 1
Capital reconstruction scheme
• A scheme where a company re-organises its capital structure,
often to avoid liquidation
Slide 277
Financial reconstruction 2
Steps in a capital reconstruction
• Estimate position of each party if liquidation is to go ahead
• Assess additional sources of finance
• Design reconstruction
• Calculate and assess new position, and compare for each
party with first step
• Check company is financially viable
A scheme of reconstruction needs to treat all parties fairly and
offer creditors a better deal than liquidation
Slide 278
Financial reconstruction 3
• Providers of finance will need to be convinced that the return
is attractive
• Company must therefore prepare cash / profit forecasts
• Creation of new share capital at different nominal value
• Cancellation of existing share capital
• Conversion of debt or equity
Slide 279
Financial reconstruction 4
Leveraged recapitalisation
• A firm replaces most of its equity with a package of debt
securities consisting of both senior and subordinated debt
• Used to discourage corporate raiders not able to borrow
against assets of the target firm to finance the acquisition
• To avoid financial distress from a high debt level, the company
should have stable cash flows
• Company should not require substantial ongoing capital
expenditure to retain their competitive position
Slide 280
Financial reconstruction 5
Leveraged buyouts
• A group of private investors uses debt financing to purchase a
company or part of it
• The company increases its level of leverage but no longer has
access to equity markets
• A higher level of debt will increase the company’s geared
beta; a lower level of debt will reduce it
Slide 281
Financial reconstruction 6
Debt equity swaps
• In an equity / debt swap, shareholders are given the right to
exchange stock for a predetermined amount of debt
• In a debt / equity swap, debt is exchanged for a
predetermined amount of stock
• After the swap takes place, the preceding asset class is
cancelled for the newly acquired asset class
Slide 282
Financial reconstruction 7
Debt equity swaps continued
• Debt-equity swaps may occur because the company must
meet certain contractual obligations
• A typical example is maintaining a debt / equity ratio below a
certain number
• A company may issue equity to avoid making coupon and face
value payments in the future
Slide 283
Divestment and other changes 1
Demerger
• The splitting up of a corporate body into two or more
separate bodies
• To ensure share prices reflect the true value of underlying
operations
Disadvantages of demergers
• Loss of economies of scale
• Ability to raise extra finance reduced
• Vulnerability to takeover increased
Slide 284
Divestment and other changes 2
Sell-off
• The sale of part of a company to a third party, generally for
cash
Slide 285
Divestment and other changes 3
Reasons for sell-offs
• Strategic restructuring
• Sell off loss-making part
• Protect rest of business from takeover
• Cash shortage
• Reduction of business risk
• Sale at profit
• A divestment is a partial or complete reduction in
ownership stake in an organisation
Slide 286
Divestment and other changes 4
Spin-offs and carve-outs
Spin-off
• A new company is created whose shares are owned by the
shareholders of original company
• There is no change in asset ownership, but management may
change
• In a carve-out, part of the firm is detached and a new
company’s shares are offered to the public
Slide 287
Divestment and other changes 5
Advantages of spin-offs to investors
• Merger / takeover of only part of a business made easier
• Improved efficiency / management
• Easier to see value of separate parts
• Investors can adjust shareholdings
Slide 288
Divestment and other changes 6
Going private
• When a group of investors buys all the company’s shares
• The company ceases to be listed on a stock exchange
Advantages of going private to company
• Costs of meeting listing requirements saved
• Company protected from volatility in share prices
• Company less vulnerable to hostile takeover bids
• Management can concentrate on long-term business
Slide 289
MBOs and buy-ins 1
Management buy-outs
• The purchase of all or part of a business by its managers
• The managers generally need financial backers (venture
capital) who will want an equity stake
Venture capital
• Venture capitalists are often prepared to fund MBOs
• They typically require shareholding, right to appoint some
directors and right of veto on certain business decisions
Slide 290
MBOs and buy-ins 2
Reasons for company agreeing to MBO are similar to
those for sell-off, also:
• When best offer price available is from MBO
• When group has decided to sell subsidiary, best way of
maximising management co-operation
• Sale can be arranged quickly
• Selling organisation more likely to retain beneficial links with
sold segment
Slide 291
MBOs and buy-ins 3
Evaluation of MBOs by investors
• Management skills of team
• Reasons why company is being sold
• Projected profits, cash flows and risks
• Shares / selected assets being bought
• Price right?
• Financial contribution by management team
• Exit routes (flotation, share repurchase)
Slide 292
MBOs and buy-ins 4
Performance of MBOs
• Management-owned companies typically achieve better
performance
Possible reasons:
• Favourable price
• Personal motivation
• Quicker decision-making / flexibility
• Savings on overheads
Slide 293
MBOs and buy-ins 5
Problems with MBOs
• Lack of financial experience
• Tax and legal complications
• Changing work practices
• Inadequate cash flow
• Board representation by finance suppliers
• Loss of employees / suppliers / customers
Slide 294
MBOs and buy-ins 6
Buy-ins
• When a team of outside managers mount a takeover bid and
then run the business themselves
• Buy-ins often occur when a business is in trouble or
shareholder / managers wish to retire
• Finance sources are similar to buy-outs
• They work best if management quality improves, but external
managers may face opposition from employees
Slide 295
Firm value 1
Unbundling and firm value
• Unbundling affects the value of the firm through changes in
return on assets and the asset beta
• When firms divest themselves of existing investments, they
affect the expected return on assets (ROA)
• This is due to the fact that good projects increase ROA and
bad projects reduce it
• Investment decisions taken by firms affect their riskiness and
therefore the asset beta βa
Slide 296
Firm value 2
• Growth rate following a restructuring:
• ROA is the return on the net assets of the company
• b is the retention rate
• D is the book value of debt
• E is the book value of equity
• i is the cost of debt
• T is the corporate tax rate
Slide 297
Chapters 15
The treasury function in
multinationals
Markets
Instruments
The Greeks
Markets 1
Financial markets
• Direct / Indirect finance from lenders / savers:
–
Households
–
Firms
–
Government
–
Overseas
–
Invested in financial markets and financial intermediaries
eg banks
Slide 299
Markets 2
• Funds from financial markets and financial intermediaries
eventually reach borrowers / spenders:
–
Firms
–
Governments
–
Households
–
Overseas
Slide 300
Markets 3
Capital markets
• In which the securities that are traded have long maturities,
ie represent long-term obligations for the issuer
• Securities that trade in capital markets include shares and
bonds
• Primary market: a financial market in which new issues are
sold by issuers to initial buyers
• Secondary market: a market in which securities that have
already been issued can be bought and sold
Slide 301
Markets 4
• Secondary markets can be organised as exchanges or over
the counter (OTC)
• Where buyers and sellers transact with each other through
individual negotiation
• Securities that are issued in an over the counter market and
can be resold are negotiable securities
Money markets
• Securities traded have short maturities, less than a year,
and repayment of funds borrowed is required within a short
period of time
Slide 302
Instruments 1
Coupon bearing instruments
Money Market Deposits
• Very short-term loans between institutions, including
governments
• Either fixed – with agreed interest and maturity dates, or
call deposits – with variable interest and deposit
• Can be terminated on notice
Slide 303
Instruments 2
Coupon bearing instruments continued
Certificate of Deposit (CD)
• Either negotiable or non-negotiable certificate of receipt
for funds deposited at an financial institution
• For a specified term and paying interest at a specified rate
Slide 304
Instruments 3
Coupon bearing instruments continued
Repurchase Agreement (repo)
• Loan secured by a marketable instrument, usually a Treasury
Bill or a bond
• Typical term: 1-180 days
• Counterparty sells on agreed date and simultaneously agrees
to buy back instrument later for agreed price
Slide 305
Instruments 4
Discount instruments
Treasury Bill (T-bill)
• Debt instruments issued by central governments with
maturities ranging from one month up to one year
Banker’s Acceptances
• Negotiable bills issued by firms to finance transactions
such as imports or purchase of goods
• Guaranteed (accepted) by a bank, for a fee
Slide 306
Instruments 5
Discount instruments continued
Commercial Paper (CP)
• Short-term unsecured corporate debt with maturity up to
270 days but typically about 30 days
• Used by corporations with good credit ratings to finance
short term expenditure
Slide 307
Instruments 6
Derivatives
Forward rate agreement (FRA)
• Cash settled OTC forward contract on a short term loan
Futures contract
• Standardised agreement to buy / sell asset at set date and
price
• Interest rate future: underlying is debt security, or based on
interbank deposit
Slide 308
Instruments 7
Derivatives continued
Interest rate swap
• Two parties exchange payments stream at one interest rate
for stream at a different rate
Interest rate option
• An instrument sold by option writer to option holder, for a
price known as a premium
Slide 309
The Greeks 1
• Delta – change in call option price / change in value of share
• Gamma – change in delta value / change in value of share
• Theta – change in option price over time
• Rho – change in option price as interest rates change
• Vega – change in option price as volatility changes
Delta hedging
• Determines number of shares required to create the
equivalent portfolio to an option, and hence hedge it
Slide 310
The Greeks 2
Gamma
• Higher for share which is close to expiry and 'at the money’
• +ve gamma means that a position benefits from movement
• -ve theta means the position loses money if the underlying
asset price does not move
Vega
• Change in value of an option (call or put) resulting from a 1%
point change in its volatility
Slide 311
Chapters 16
Hedging forex risk
FX markets
Money market hedging
Futures
Swaps
Options
FX markets 1
Exchange rates
• An exchange rate is the price of one currency expressed in
another currency
• The spot rate at time t0 is the price for delivery at t0
• A forward rate at t0 is a rate for delivery at time t1
• This is different from whatever the new spot rate turns out
to be at t1
Slide 313
FX markets 2
Term and base currencies
• If a currency is quoted as say £/$1.50, the $ is the term
(or reference) currency, the £ is the base currency
Bank
sells LOW
buys HIGH
• For example, if UK bank is buying and selling dollars, selling
(offer) price may be £/$1.50, buying (bid) price may be
£/$1.53
Slide 314
FX markets 3
• Direct quote is amount of domestic currency equal to one
foreign currency unit
• Indirect quote is amount of foreign currency equal to one
domestic unit
Slide 315
FX markets 4
Forward exchange contracts
• A firm and binding contract between a bank and its customer
• For the purchase / sale of a specified quantity of a stated
foreign currency
• At a rate fixed at the time the contract is made
• For performance at a future time agreed when contract is
made
• Closing out is the process of the bank requiring the
customer to fulfil the contract by selling or buying at spot rate
Slide 316
FX markets 5
Netting
• The process of setting off credit against debit balances within
a group of companies so that only the reduced net amounts
are paid by currency flows
• Multilateral netting involves offsetting several companies’
balances
Slide 317
FX markets 6
Forward rates as adjustments to spot rates
• Forward rate cheaper – Quoted at discount
• Forward rate more expensive – Quoted at premium
• Add discounts, or subtract premiums from spot rate
Slide 318
FX markets 7
Interest rate parity
• Interest rate parity must hold between spot rates and
forward rates (for the interest rate period)
• Otherwise arbitrage profits can be made:
Slide 319
FX markets 8
Where
• f0 = forward rate
• s0 = spot rate
• ic = interest rate in overseas country
• ib = interest rate in base country
Slide 320
Money market hedging 1
Future foreign currency payment
• Borrow now in home currency
• Convert home currency loan to foreign currency
• Put foreign currency on deposit
• When have to make payment
(a) Make payment from deposit
(b) Repay home currency borrowing
Slide 321
Money market hedging 2
Future foreign currency receipt
• Borrow now in foreign currency
• Convert foreign currency loan to home currency
• Put home currency on deposit
• When cash received
(a) Take cash from deposit
(b) Repay foreign currency borrowing
Slide 322
Money market hedging 3
Remember
Slide 323
Futures 1
Futures terminology
• Closing out a futures contract means entering a second
futures contract that reverses the effect of the first
• Contract size is the fixed minimum quantity that can be
bought / sold
• Contract price is in US dollars eg $/£ 0.6700
• Settlement date is the date when trading on a futures
contract ceases and accounts are settled
• Basis is spot price – futures price
Slide 324
Futures 2
Futures terminology continued
• Basis risk is the risk that futures price movement may differ
from underlying currency movement
• Tick size is the smallest measured movement in contracts
price (movement to fourth decimal place)
Slide 325
Futures 3
Transactions not involving US dollars
• If trading one non-US dollar currency with another
• Sell one type of future (to get dollars) and buy other type
(with dollars)
• Then reverse both contracts when receipt / payment made
Slide 326
Futures 4
What type of contract?
• Receive currency on future date – NOW sell currency
futures – ON FUTURE DATE buy currency futures
• Pay currency on future date – NOW buy currency futures
– ON FUTURE DATE sell currency futures
• Receive $ on future date – NOW buy currency futures –
ON FUTURE DATE sell currency futures
• Pay $ on future date – NOW sell currency futures –
ON FUTURE DATE buy currency futures
Slide 327
Futures 5
Advantages of futures
• Transaction costs lower than forward contracts
• Futures contract not closed out until cash receipt / payment
made
Slide 328
Futures 6
Disadvantages of futures
• Can’t tailor to user’s exact needs
• Only available in limited number of currencies
• Hedge inefficiencies
• Conversion procedures complex if dollar is not one of the
two currencies
Slide 329
Futures 7
Set up process
(a)
Choose which contract (settlement date after date
currency needed) and type
(b)
Choose number of contracts = Amount being
hedged/Size of contract
Convert using today’s futures contract price if amount
being hedged is in US dollars
(c)
Slide 330
Calculate tick size: Minimum price movement × Standard
contract size
Futures 8
Estimate closing futures price
• May have to adjust closing spot price using basis, assuming
basis declines evenly over life of contract
Hedge outcome
• Outcome in futures market
• Futures profit = Tick movement × Tick value × Number of
contracts
Slide 331
Futures 9
Net outcome
• Spot market payment (closing spot rate) (x)
• Futures profit / (loss) (closing spot rate unless US company)
• Net outcome
Slide 332
(x)
x
Swaps 1
Currency swaps
• In a currency swap equivalent amounts of currency and
interest cash flows are swapped for a period
• However the original borrower remains liable to the lender
(counter party risk)
• A cross-currency swap is an interest rate swap with cash
flows in different currencies
Slide 333
Swaps 2
Advantages of currency swaps
• Flexibility – any size and reversible
• Can gain access to debt in other currencies
• Restructuring currency base of liabilities
• Conversion of fixed to / from floating rate debt
• Absorbing excess liquidity
• Cheaper borrowing
• Obtaining funds blocked by exchange controls
Slide 334
Swaps 3
Risks of swaps
• Credit risk (Counterparty defaults)
• Position or market risk (Unfavourable market movements)
• Sovereign risk (Political disturbances in other countries)
• Spread risk (For banks which combine swap and hedge)
• Transparency risk (Accounts are misleading)
Slide 335
Swaps 4
Example
• Edward Ltd wishes to borrow US dollars to finance an
investment in the USA
• Edward’s treasurer is concerned about the high interest rates
the company faces as it is not well-known in the USA
• Edward Ltd should make an arrangement with an American
company, Gordon Inc
• Gordon Inc is attempting to borrow sterling in the UK money
markets
Slide 336
Swaps 5
Example continued
• Gordon borrows US $ and Edward borrows £
• The two companies then swap funds at the current spot rate
• At the end of the period, the two companies swap back the
principal amounts at the spot rates / predetermined rates
• Edward pays Gordon the annual interest cost on the $ loan
• Gordon pays Edward the annual interest cost on the £ loan
Slide 337
Swaps 6
FX swap
• A spot currency transaction that will be reversed by an
offsetting forward transaction at a pre-specified date
Slide 338
Options 1
Currency option
• A right to buy or sell currency at a stated rate of exchange at
some time in the future
• Call – right to buy at fixed rate
• Put – right to sell at fixed rate
• Over the counter options are tailor-made options suited
to a company’s specific needs
• Traded options are contracts for standardised amounts,
only available in certain currencies
Slide 339
Options 2
Why option is needed
• Uncertainty of foreign currency receipts or payments (timing
and amount)
• Support tender for overseas contract
• Allow publication of price lists in foreign currency
• Protect import / export of price-sensitive goods
Slide 340
Options 3
Choosing the right option
• Complicated by lack of US dollar options
• UK company wishing to sell US dollars can purchase £ call
options (options to buy sterling with dollars)
• Strike price – may need to use exercise price to convert
US dollars
Surplus cash
• If option contracts don’t cover amount to be hedged, convert
remainder at spot price on day of exercise or with formal
contract
Slide 341
Options 4
What type of contract?
• Receive currency at future date – buy currency put option
NOW – sell currency on FUTURE DATE
• Buy currency at future date – buy currency call option
NOW – buy currency at FUTURE DATE
• Receive $ at future date – buy currency call option NOW –
buy currency on FUTURE
• Pay $ at future date – buy currency put option NOW –
sell currency on FUTURE DATE
Slide 342
Chapter 17
Hedging interest rate
risk
FRAs
IR futures
IR swaps
IR options
FRAs 1
Interest rate risk
• Fixed v floating rate debt - change in interest rates may
make borrowing chosen the less attractive option
• Currency of debt - effect of adverse movements if borrow
in another currency
• Term of loan - having to re-pay loan at time when funds not
available means need for new loan at higher interest rate
Slide 344
FRAs 2
• An FRA means that the interest rate will be fixed at a certain
time in the future
• Loans > £500,000, period < 1 year
• 5.75-5.70 means a borrowing rate can be fixed at 5.75%
• ‘3-6’ FRA starts in three months and lasts for three months
• Basis point is 0.01%
Slide 345
IR futures 1
Interest rate futures
• To hedge against interest rate movements
• The terms, amounts and periods are standardised
• The futures prices will vary with changes in interest rates
• Outlay to buy futures is less than buying the financial
instrument
• Price of short-term futures quoted at discount to 100 per
value (93.40 indicates deposit trading at 6.6%)
• Long-term bond futures prices quoted at % of par value
Slide 346
IR futures 2
Example
• LIFFE three month sterling futures £500,000 points of 100%
price 92.50
• Tick size will be:
–
£500,000 × 0.01% × 3/12 = £12.50
–
A 2% movement in the futures price would represent
200 ticks
–
Gain on a single contract would be 200 × £12.50 =
£2,500
Slide 347
IR futures 3
Step 1 set up process
(a) Choose which contract: Date should be after
borrowing / lending begins
(b) Choose type: Assuming you are borrower sell if rates
expected to rise, buy if rates expected to fall
(c) Choose number of contracts: Exposure / contract size x
Loan period / length of contract
Calculate tick size: Min price movement as %
length of contract / 12 months x contract size
Slide 348
IR futures 4
Step 2 estimate closing futures price
• May have to adjust using basis
Step 3 hedge outcome
(a)Futures outcome
–
Opening futures price:
–
Closing futures price:
–
Movement in ticks:
–
Futures outcome: Tick movement × Tick value ×
Number of contracts
Slide 349
IR futures 5
(b) Net outcome
–
Payment in spot market
–
Futures market profit / (loss)
–
Net payment
Slide 350
(X)
X
(X)
IR swaps 1
Interest rate swaps
• Agreements where parties exchange interest commitments
• In simplest form, two parties swap interest with different
characteristics
• Each party borrows in market in which it has comparative
advantage
Slide 351
IR swaps 2
Uses of interest rate swaps
• Switching from paying one type of interest to another
• Raising less expensive loans
• Securing better deposit rates
• Managing interest rate risk
• Avoiding charges for loan termination
Slide 352
IR swaps 3
Complications with interest rate swaps
• Bank commission costs
• One company having better credit rating in both relevant
markets
• Should borrow in comparative advantage market but must
want interest in other market
Slide 353
IR swaps 4
Example
Slide 354
IR swaps 5
• Companies may decide to use a swap rather than terminating
their original loans
• Costs of termination and taking out a new loan may be too
high
• If LIBOR is at 8%, neither party will gain or lose
• Any rate other than 8% will result in gain / loss
Slide 355
IR options 1
Interest rate options
• Grants the buyer the right to deal at an agreed interest rate
at a future maturity date
• If a company needs to hedge borrowing, purchase put
options
• If a company needs to hedge lending, purchase call options
• To calculate effect of options, use same proforma as
currency options
• UK long gilt futures options (LIFFE) £100,000 100ths of 100%
Slide 356
IR options 2
• Strike price is price paid for futures contract.
• Numbers under each month represent premium paid for
options
• Put options more expensive than call as interest rates
predicted to rise
Slide 357
IR options 3
Interest rate caps, collars and floor
• Caps set an interest rate ceiling
• Floors set a lower limit to rates
• Collars mean buying a cap and selling a floor
Slide 358
Chapter 18
Dividend policy in
multinationals and
transfer pricing
Dividend policy
Transfer pricing
Dividend policy 1
Dividend capacity
• The dividend capacity of a company depends on:
after tax profits, investment plans, foreign dividends
Free cash flow to equity (FCFE)
• FCFE = dividends that could be paid to shareholders
• = Net profit after tax + Depreciation + Foreign Dividends –
Total Net Investment + Net Debt Issuance + Net Share
Issuance
Slide 360
Dividend policy 2
Factors affecting dividend repatriation
• Financing – how much needed for dividends / investment at
home?
• Tax – often the primary reason for the firm’s repatriation
policies
• Managerial control – regularised dividends restrict
discretion of foreign managers (so reducing agency problems)
• Timing – to take advantage of possible currency movements
(although these are difficult to forecast in practice)
Slide 361
Dividend policy 3
Tax issues
• A companies’ subsidiaries’ foreign profits are liable to UK
corporate tax, whether repatriated or not
• With a credit for tax already paid to the host country
• Similarly, the US government does not distinguish between
income earned abroad and income earned at home
• It gives credit to MNCs headquartered in the US for tax paid
to foreign governments
Slide 362
Dividend policy 4
Timing of dividend payments
• Collecting early (lead) payments from currencies vulnerable
to depreciation and late (lag) from currencies expected to
appreciate
• This will mean benefit from expected movements in exchange
rates
Slide 363
Transfer pricing 1
Transfer price
• Prices at which goods or services are transferred from one
process or department to another or from one member of a
group to another
Slide 364
Transfer pricing 2
Transfer price bases
• Standard cost
• Marginal cost: at marginal cost or with gross profit margin
added
• Opportunity cost
• Full cost: at full cost, or at a full cost plus price
• Market price
• Market price less a discount
• Negotiated price, based on any of the other bases
Slide 365
Transfer pricing 3
Using market value transfer prices
• Giving profit centre managers freedom to negotiate prices
with other profit centres results in market based transfer
prices
Slide 366
Transfer pricing 4
Transfer price regulation
• Tax authorities often use an arm's length standard:
• Price intra-firm trade of multinationals as if it took place
between unrelated parties acting in competitive markets
• Method 1 - use price negotiated between unrelated parties
C and D as proxy for intra-firm transfer A to B
• Method 2 - use price at which A sells to unrelated party C
as proxy
Slide 367
Transfer pricing 5
Arm’s length pricing methods (tangible goods)
Transaction-based
• Comparable uncontrolled price (CUP)
• Resale price (RP)
• Cost plus (C+)
Profit based
• Comparable profit method (CPM)
• Profit split (S)
Slide 368
Transfer pricing 6
Comparable uncontrolled price (CUP)
• Based on a product comparable transaction, possibly between
different parties but in similar circumstances
• A method preferred by tax authorities
Cost plus (C+)
• Appropriate mark-up (estimated from similar manufacturers)
added to costs of production
• Measured using recognised accounting principles
Slide 369
Transfer pricing 7
Resale price (RP)
• Tax auditor looks for firms at similar trade levels that
perform a similar distribution function
• Method best used when distributor adds relatively little value,
making it easier to estimate
• Profit margin derived from that earned by comparable
distributors, subtracted from known retail price to determine
transfer price
Slide 370
Transfer pricing 8
Comparable profit method (CPM)
• Method is based on premise of similar financial ratios and
performance of companies in similar industries
Profit split (PS)
• Common when there are no suitable product comparables
(CUP) or functional comparables (RP and C+)
• Profits on a transaction earned by two related parties are split
between the parties
• Usually on basis of return on operating assets: operating
profits to operating assets
Slide 371
Chapter 19
Recent developments
Developments in world financial markets
Developments in world trade
Developments in world financial markets 1
The credit crunch
• The credit crunch first became a global issue in early 2007
• Billions of dollars of ‘sub-prime’ mortgages in the US
• Rise in interest rates caused defaults on such mortgages
• Collateralised debt obligations (CDOs) containing sub-prime
mortgages sold onto hedge funds
• Value of CDOs fell due to defaults
• Huge losses by the banks
Slide 373
Developments in world financial markets 2
Financial reporting
• Common accounting standards are increasing
transparency and comparability for investors
• Improving capital market efficiency and facilitating crossborder investment
Slide 374
Developments in world financial markets 3
Monetary policy
• In advanced economies, monetary policy has encompassed
the task of controlling inflation
• Interest rates are commonly set by central banks
independent of Government
• This enhances credibility and so lowers inflation expectations
• A low inflation environment is conducive to long-term
business planning and investment
Slide 375
Developments in world financial markets 4
The credit crunch and IFRS
• IAS 39: Entities must value financial assets and liabilities at ‘fair
value’
• Markets collapse
• Banks forced to write down assets to fair value
• Reduction in lending capacity
• Further uncertainty
• Further write downs of assets to fair value and so on
Slide 376
Developments in world financial markets 5
Tranching
• Where claims on cash flows are split into several classes
(such as Class A, Class B)
Benefits of tranching
• A good way of dividing risk
• Potential to make a lot of money from ‘junior’ tranches
Risks of tranching
• Very complex / may not be divided properly
• Rebuilding
Slide 377
Developments in world financial markets 6
Credit default swaps
• Allows the transfer of third party credit risk from one party
to another
• Similar to insurance policies
• ‘Spread’ is similar to an insurance premium
• CDS market is unregulated
Uses of CDS
• Speculation
• Hedging
Slide 378
Developments in world financial markets 7
Trends in global financial markets
• Integration and globalisation – fostered by liberalisation
of markets and technological change
• Creating more efficient allocation of capital and economic
growth
• Growth of derivatives markets – advances in technology,
financial engineering and risk management
• Led to enhanced demand for more complex derivatives
products
Slide 379
Developments in world financial markets 8
Securitisation – eg sale of loan books by banks
• Now a common form of financing, leading to increased bond
issuance
Convergence of financial institutions
• Abolition of barriers to entry in various segments of financial
services industries
• Has led to conglomerates with operations in banking,
securities and insurance
Slide 380
Developments in world financial markets 9
Effects of financial sector convergence
• Economies of scale
• Economies of scope: a factor of production can be employed
to produce multiple products
• Reduced earnings volatility
• Reduced search costs for consumers
Slide 381
Developments in world financial markets 10
Money laundering
• A side effect of globalisation and the free movement of capital
has been a growth in money laundering
• There has been increased legislation and regulation to combat
it
Slide 382
Developments in international trade 1
• Trade financing has become easier for companies to obtain
• Financing for international trade transactions includes
commercial bank loans within the host country
• Also loans from international lending agencies
• Trade bills may be discounted through foreign banks, for
short-term financing
• Eurodollar financing is another method for providing foreign
financing
Slide 383
Developments in international trade 2
• Eurodollar loans are short-term working-capital loans,
unsecured and usually in large amounts
• The Eurobond market is widely used for long-term funds
for multinational US companies
• In many countries, development banks provide
intermediate- and long-term loans to private enterprises
Slide 384
Developments in international trade 3
Regulation
• Globalisation creates incentives for governments to intervene
in favour of domestic MNCs
• In respect of ‘macroeconomic’ and ‘macrostructural’ policies
Pressure groups
• Trans-nationally networked pressure groups can influence the
public and put pressure on governments to take measures
against MNCs
Slide 385