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ACCA Paper P4

Advanced Financial
Management

Class Notes

June 2011

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Typeset by Debbie Crossman

Ken Preece January 2011
All rights reserved. No part of this publication may be reproduced, stored in a
retrieval system, or transmitted, in any form or by any means, electronic,
mechanical, photocopying, recording or otherwise, without the prior written
permission of Ken Preece.
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Contents
PAGE
INTRODUCTION TO THE PAPER 5
FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER 7
CHAPTER 1: ISSUES IN CORPORATE GOVERNANCE 13
CHAPTER 2: ADVANCED INVESTMENT APPRAISAL SECTION 1 39
CHAPTER 3: ADVANCED INVESTMENT APPRAISAL SECTION 2 63
CHAPTER 4: COST OF CAPITAL 97
CHAPTER 5: EFFICIENT MARKET HYPOTHESIS 121
CHAPTER 6: THEORIES OF GEARING 129
CHAPTER 7: PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL 147
CHAPTER 8: ADJUSTED PRESENT VALUE 191
CHAPTER 9: VALUATIONS, ACQUISITIONS AND MERGERS SECTION 1 205
CHAPTER 10: VALUATIONS, ACQUISITIONS AND MERGERS SECTION 2 231
CHAPTER 11: VALUATIONS, ACQUISITIONS AND MERGERS SECTION 3 257
CHAPTER 12: CORPORATE RECONSTRUCTION AND REORGANISATION 281
CHAPTER 13: CORPORATE DIVIDEND POLICY 291
CHAPTER 14: MANAGEMENT OF INTERNATIONAL TRADE AND FINANCE 301
CHAPTER 15: HEDGING FOREIGN EXCHANGE RISK 317
CHAPTER 16: FUTURES AND OPTIONS 345
CHAPTER 17: HEDGING INTEREST RATE RISK 375
CHAPTER 18: SWAPS 407
CHAPTER 19: INTERNATIONAL INVESTMENT APPRAISAL 423


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Introduction to the
paper


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INTRODUCTION TO THE PAPER
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Aim of the Paper
The aim of the paper is to apply relevant knowledge, skills and exercise
professional judgement as expected of a senior financial executive or advisor, in
taking or recommending decisions relating to the financial management of an
organisation.
Outline of the syllabus
A. Role and responsibility towards stakeholders
B. Economic environment for multinationals
C. Advanced investment appraisal
D. Acquisitions and mergers
E. Corporate reconstruction and re-organisation
F. Treasury and advanced risk management techniques
G. Emerging issues in finance and financial management
Format of the Exam Paper
The examination will be a three-hour paper (with the additional 15 minutes reading
and planning time) of 100 marks in total, divided into two sections:
Section A
Section A will contain two compulsory questions, comprising between 50
and 70 marks in total.
Section A will normally cover significant issues relevant to the senior financial
manager or advisor and will be set in the form of a short case study or scenario.
The requirements of the section A questions are such that candidates will be
expected to show a comprehensive understanding of issues from across the
syllabus. Each question will contain a mix of computational and discursive
elements. Each question in section A will comprise of between 25 and 40
marks. Candidates will be expected to provide answers in a specified form such as
a short report or board memorandum commensurate with the professional level of
the paper.
Section B
In section B candidates will be asked to answer two from three questions,
comprising of between 15 and 25 marks each.
Section B questions are designed to provide a more focused test of the syllabus
with, normally, one question being wholly discursive.
Candidates will be provided (within the examination paper) with a
formulae sheet as well as present value, annuity and standard normal
distribution tables.

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Formulae & tables
provided in the
examination paper



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FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER
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Formulae

Modigliani and Miller Proposition 2 (with tax)
k
e
= k
i
e
+

(1 T)(k
i
e
k
d
)
e
d
V
V


Two asset portfolio
s
p
=
b a ab b a
2
b
2
b
2
a
2
a
s s r w w 2 + s w + s w

The Capital Asset Pricing Model
E(r
j
) = R
f
+
j
(E(r
m
) R
f
)

The asset beta formula

a
=
(

+
e
d e
e
)) T - 1 ( V V (
V

+
(

+
d
d e
d
)) T - 1 ( V V (
) T - 1 ( V


The Growth Model
P
0
=
g) - (r
g) + (1 D
e
0


Gordons growth approximation
g = br
e


The weighted average cost of capital
WACC =
|
|

\
|
+
d e
e
V V
V
k
e
+
|
|

\
|
+
d e
d
V V
V
k
d
(1T)

The Fisher formula
(1 + i) = (1 + r) (1 + h)

Purchasing power parity and interest rate parity
S
1
= S
0

) h (1
) h (1
b
c
+
+
F
o
= S
o

) i (1
) i (1
b
c
+
+


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Modified Internal Rate of Return
MIRR =
n
1
I
R
PV
PV
|
|

\
|
(1 + r
e
) 1

The Black Scholes Option
Pricing Model
c = P
a
N(d
1
) P
e
N(d
2
) e
-rt


Where:
d
1
=
t s
)t 0.5s + (r + ) /P ln(P
2
e a

and
d
2
= d
1
t s


The Put Call Parity relationship
p = c P
a
+ P
e
e

-rt


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FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER
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Present value table
Present value of 1 i.e. (1 + r)
-n

Where r = discount rate
n = number of periods until payment
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
________________________________________________________________________________
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5

6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10

11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15
________________________________________________________________________________

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
________________________________________________________________________________
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5

6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10

11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15

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Annuity table
Present value of an annuity of 1 i.e.
r
r) + (1 - 1
-n


Where r = discount rate
n = number of periods
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
________________________________________________________________________________
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5

6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10

11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11
12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12
13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15
________________________________________________________________________________

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
________________________________________________________________________________
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5

6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10

11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 11
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15

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FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER
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Standard normal distribution table
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0
0.1
0.2
0.3
0.4

0.5
0.6
0.7
0.8
0.9

1.0
1.1
1.2
1.3
1.4

1.5
1.6
1.7
1.8
1.9

2.0
2.1
2.2
2.3
2.4

2.5
2.6
2.7
2.8
2.9

3.0
0.0000
0.0398
0.0793
0.1179
0.1554

0.1915
0.2257
0.2580
0.2881
0.3159

0.3413
0.3643
0.3849
0.4032
0.4192

0.4332
0.4452
0.4554
0.4641
0.4713

0.4772
0.4821
0.4861
0.4893
0.4918

0.4938
0.4953
0.4965
0.4974
0.4981

0.4987
0.0040
0.0438
0.0832
0.1217
0.1591

0.1950
0.2291
0.2611
0.2910
0.3186

0.3438
0.3665
0.3869
0.4049
0.4207

0.4345
0.4463
0.4564
0.4649
0.4719

0.4778
0.4826
0.4864
0.4896
0.4920

0.4940
0.4955
0.4966
0.4975
0.4982

0.4987
0.0080
0.0478
0.0871
0.1255
0.1628

0.1985
0.2324
0.2642
0.2939
0.3212

0.3461
0.3686
0.3888
0.4066
0.4222

0.4357
0.4474
0.4573
0.4656
0.4726

0.4783
0.4830
0.4868
0.4898
0.4922

0.4941
0.4956
0.4967
0.4976
0.4982

0.4987
0.0120
0.0517
0.0910
0.1293
0.1664

0.2019
0.2357
0.2673
0.2967
0.3238

0.3485
0.3708
0.3907
0.4082
0.4236

0.4370
0.4484
0.4582
0.4664
0.4732

0.4788
0.4834
0.4871
0.4901
0.4925

0.4943
0.4957
0.4968
0.4977
0.4983

0.4988
0.0160
0.0557
0.0948
0.1331
0.1700

0.2054
0.2389
0.2703
0.2995
0.3264

0.3508
0.3729
0.3925
0.4099
0.4251

0.4382
0.4495
0.4591
0.4671
0.4738

0.4793
0.4838
0.4875
0.4904
0.4927

0.4945
0.4959
0.4969
0.4977
0.4984

0.4988
0.0199
0.0596
0.0987
0.1368
0.1736

0.2088
0.2422
0.2734
0.3023
0.3289

0.3531
0.3749
0.3944
0.4115
0.4265

0.4394
0.4505
0.4599
0.4678
0.4744

0.4798
0.4842
0.4878
0.4906
0.4929

0.4946
0.4960
0.4970
0.4978
0.4984

0.4989
0.0239
0.0636
0.1026
0.1406
0.1772

0.2123
0.2454
0.2764
0.3051
0.3315

0.3554
0.3770
0.3962
0.4131
0.4279

0.4406
0.4515
0.4608
0.4686
0.4750

0.4803
0.4846
0.4881
0.4909
0.4931

0.4948
0.4961
0.4971
0.4979
0.4985

0.4989
0.0279
0.0675
0.1064
0.1443
0.1808

0.2157
0.2486
0.2794
0.3078
0.3340

0.3577
0.3790
0.3980
0.4147
0.4292

0.4418
0.4525
0.4616
0.4693
0.4756

0.4808
0.4850
0.4884
0.4911
0.4932

0.4949
0.4962
0.4972
0.4979
0.4985

0.4989
0.0319
0.0714
0.1103
0.1480
0.1844

0.2190
0.2517
0.2823
0.3106
0.3365

0.3599
0.3810
0.3997
0.4162
0.4306

0.4429
0.4535
0.4625
0.4699
0.4761

0.4812
0.4854
0.4887
0.4913
0.4934

0.4951
0.4963
0.4973
0.4980
0.4986

0.4990
0.0359
0.0753
0.1141
0.1517
0.1879

0.2224
0.2549
0.2852
0.3133
0.3389

0.3621
0.3830
0.4015
0.4177
0.4319

0.4441
0.4545
0.4633
0.4706
0.4767

0.4817
0.4857
0.4890
0.4916
0.4936

0.4952
0.4964
0.4974
0.4981
0.4986

0.4990

This table can be used to calculate N(d
i
), the cumulative normal distribution
functions needed for the Black-Scholes model of option pricing.
If d
i
> 0, add 0.5 to the relevant number above.
If d
i
< 0, subtract the relevant number above from 0.5
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Chapter 1
Issues in corporate
governance


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CHAPTER 1 ISSUES IN CORPORATE GOVERNANCE
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CHAPTER CONTENTS
FINANCIAL OBJECTIVES ------------------------------------------------ 15
THE UK CORPORATE GOVERNANCE CODE ----------------------------- 17
CODE OF BEST PRACTICE 17
INTERNATIONAL COMPARISONS OF CORPORATE GOVERNANCE -- 36
UNITED STATES OF AMERICA 36
GERMANY 36
JAPAN 37
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FINANCIAL OBJECTIVES
Advanced Financial Management is concerned with the following key decisions:
- What to invest in (INVESTMENT DECISIONS)
- How to finance the investment (FINANCING DECISIONS)
- The level of dividend distributions (DIVIDEND DECISIONS).
Objectives
Primary objective: to maximise the wealth of shareholders. A positive NPV equates
(in theory) to an increase in shareholder wealth.
Secondary objectives may be e.g. meeting financial targets (say satisfactory
ROCE), meeting productivity targets, establishing brands and quality standards and
effective communication with customers, suppliers, employees.
As an alternative to maximising the wealth of shareholders a company must in
reality consider satisficing objectives for each of the major stakeholders.
Stakeholders (user groups) and their goals
These include:
Shareholders
Ownership is separate from control. Institutional investors may have different
requirements from private shareholders. Information is provided to
shareholders via published financial statements, forecasts by directors
responding to takeover bids, investment analysts and the financial press.
Directors
The key decisions are made by directors, who are the stakeholders with the
most to lose their jobs, their investments and their reputation. Does this
influence their decisions? Hence the extensive work on corporate governance
matters.
Management and employees
Obviously they require long-term security and appropriate rewards
(pay/benefits). Should performance related incentives be offered e.g. share
options, long-term incentive plans (LTIPs)?
Loan creditors
Covenants in loan agreements may restrict gearing and dividend levels and
the sale of assets. Loan creditors would have remedies if the company
defaults.
Customers
No doubt these should be the most important interest group of all.
Suppliers
Must be reliable if not, consider internal production (vertical integration)
The government
Environmental pressure groups
The general public
Many of these groups may have conflicting objectives, which need to be reconciled.
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Corporate governance
Clearly the executive directors of a listed company are both decision-makers and
major stakeholders. They are therefore open to the accusation of making key
decisions for their own benefit. Following a number of notable financial scandals in
the UK during the late 20
th
century (e.g the Maxwell affair and the collapse of the
BCCI) the Cadbury Committee was set up to investigate procedures for appropriate
corporate governance.
The Cadbury Code (1992) defined corporate governance as the system by which
companies are directed and controlled. This initial document has been subject to
subsequent amendments by the Greenbury, Hampel and Higgs Reports. The
Financial Services Authority requires listed companies to confirm that they have
complied with the Code provisions or in the event of non-compliance to provide
an explanation of their reasons for departure.

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THE UK CORPORATE GOVERNANCE CODE

Code of best practice
Section A: Leadership
A.1 The Role of the Board
Main Principle: Every company should be headed by an effective board
which is collectively responsible for the long-term success of the company.
Supporting Principles
The boards role is to provide entrepreneurial leadership of the company
within a framework of prudent and effective controls which enables risk to be
assessed and managed. The board should set the companys strategic aims,
ensure that the necessary financial and human resources are in place for the
company to meet its objectives and review management performance. The
board should set the companys values and standards and ensure that its
obligations to its shareholders and others are understood and met.
All directors must act in what they consider to be the best interests of the
company, consistent with their statutory duties (as set out in the Companies
Act 2006).
Code Provisions
1.1 The board should meet sufficiently regularly to discharge its duties effectively.
There should be a formal schedule of matters specifically reserved for its
decision. The annual report should include a statement of how the board
operates, including a high level statement of which types of decisions are to
be taken by the board and which are to be delegated to management.
1.2 The annual report should identify the chairman, the deputy chairman (where
there is one), the chief executive, the senior independent director and the
chairmen and members of the board committees. It should also set out the
number of meetings of the board and its committees and individual
attendance by directors.
1.3 The company should arrange appropriate insurance cover in respect of legal
action against its directors.
A.2 Division of Responsibilities
Main Principle: There should be a clear division of responsibilities at the
head of the company between the running of the board and the executive
responsibility for the running of the companys business. No one individual
should have unfettered powers of decision.
Code Provision
2.1 The roles of chairman and chief executive should not be exercised by the
same individual. The division of responsibilities between the chairman and
chief executive should be clearly established, set out in writing and agreed by
the board.
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A.3 The Chairman
Main Principle: The chairman is responsible for leadership of the board and
ensuring its effectiveness on all aspects of its role.
Supporting Principle
The chairman is responsible for setting the boards agenda and ensuring that
adequate time is available for discussion of all agenda items, in particular
strategic issues. The chairman should also promote a culture of openness and
debate by facilitating the effective contribution of non-executive directors in
particular and ensuring constructive relations between executive and non-
executive directors.
The chairman is responsible for ensuring that the directors receive accurate,
timely and clear information. The chairman should ensure effective
communication with shareholders.
Code Provision
3.1 The chairman should on appointment meet the independence criteria set out
in B.1.1 below. A chief executive should not go on to be chairman of the
same company. If, exceptionally, a board decides that a chief executive
should become chairman, the board should consult major shareholders in
advance and should set out its reasons to shareholders at the time of the
appointment and in the next annual report. (Compliance or otherwise with
this provision need only be reported for the year in which the appointment is
made).
A.4 Non-executive Directors
Main Principle: As part of their role as members of a unitary board, non-
executive directors should constructively challenge and help develop
proposals on strategy.
Supporting Principle
Non-executive directors should scrutinise the performance of management in
meeting agreed goals and objectives and monitor the reporting of
performance. They should satisfy themselves on the integrity of financial
information and that financial controls and systems of risk management are
robust and defensible. They are responsible for determining appropriate
levels of remuneration of executive directors and have a prime role in
appointing and, where necessary, removing executive directors, and in
succession planning.
Code Provisions
4.1 The board should appoint one of the independent non-executive directors to
be the senior independent director to provide a sounding board for the
chairman and to serve as an intermediary for the other directors when
necessary. The senior independent director should be available to
shareholders if they have concerns which contact through the normal
channels of chairman, chief executive or other executive directors has failed
to resolve or for which such contact is inappropriate.
4.2 The chairman should hold meetings with the non-executive directors without
the executives present. Led by the senior independent director, the non-
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executive directors should meet without the chairman present at least
annually to appraise the chairmans performance and on such other occasions
as are deemed appropriate.
4.3 Where directors have concerns which cannot be resolved about the running of
the company or a proposed action, they should ensure that their concerns are
recorded in the board minutes. On resignation, a non- executive director
should provide a written statement to the chairman, for circulation to the
board, if they have any such concerns.
Section B: Effectiveness
B.1 The Composition of the Board
Main Principle: The board and its committees should have the appropriate
balance of skills, experience, independence and knowledge of the company
to enable them to discharge their respective duties and responsibilities
effectively.
Supporting Principles
The board should be of sufficient size that the requirements of the business
can be met and that changes to the boards composition and that of its
committees can be managed without undue disruption, and should not be so
large as to be unwieldy.
The board should include an appropriate combination of executive and non-
executive directors (and, in particular, independent non-executive directors)
such that no individual or small group of individuals can dominate the boards
decision taking.
The value of ensuring that committee membership is refreshed and that
undue reliance is not placed on particular individuals should be taken into
account in deciding chairmanship and membership of committees.
No one other than the committee chairman and members is entitled to be
present at a meeting of the nomination, audit or remuneration committee, but
others may attend at the invitation of the committee.
Code Provisions
1.1 The board should identify in the annual report each non-executive director it
considers to be independent. The board should determine whether the
director is independent in character and judgement and whether there are
relationships or circumstances which are likely to affect, or could appear to
affect, the directors judgement. The board should state its reasons if it
determines that a director is independent notwithstanding the existence of
relationships or circumstances which may appear relevant to its
determination, including if the director:
has been an employee of the company or group within the last five
years;
has, or has had within the last three years, a material business
relationship with the company either directly, or as a partner,
shareholder, director or senior employee of a body that has such a
relationship with the company;
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has received or receives additional remuneration from the company
apart from a directors fee, participates in the companys share option or
a performance-related pay scheme, or is a member of the companys
pension scheme;
has close family ties with any of the companys advisers, directors or
senior employees;
holds cross-directorships or has significant links with other directors
through involvement in other companies or bodies;
represents a significant shareholder; or
has served on the board for more than nine years from the date of their
first election.
1.2 Except for smaller companies (i.e. those below the FTSE 350 throughout the
year immediately prior to the reporting year), at least half the board,
excluding the chairman, should comprise non-executive directors determined
by the board to be independent. A smaller company should have at least two
independent non-executive directors.
B.2 Appointments to the Board
Main Principle: There should be a formal, rigorous and transparent
procedure for the appointment of new directors to the board.
Supporting Principles
The search for board candidates should be conducted, and appointments
made, on merit, against objective criteria and with due regard for the benefits
of diversity on the board, including gender.
The board should satisfy itself that plans are in place for orderly succession
for appointments to the board and to senior management, so as to maintain
an appropriate balance of skills and experience within the company and on
the board and to ensure progressive refreshing of the board.
Code Provisions
2.1 There should be a nomination committee which should lead the process for
board appointments and make recommendations to the board. A majority of
members of the nomination committee should be independent non-executive
directors. The chairman or an independent non-executive director should
chair the committee, but the chairman should not chair the nomination
committee when it is dealing with the appointment of a successor to the
chairmanship. The nomination committee should make available its terms of
reference, explaining its role and the authority delegated to it by the board.
(This requirement would be met by including the information on the company
website).
2.2 The nomination committee should evaluate the balance of skills, experience,
independence and knowledge on the board and, in the light of this evaluation,
prepare a description of the role and capabilities required for a particular
appointment.
2.3 Non-executive directors should be appointed for specified terms subject to re-
election and to statutory provisions relating to the removal of a director. Any
term beyond six years for a non-executive director should be subject to
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particularly rigorous review, and should take into account the need for
progressive refreshing of the board.
2.4 A separate section of the annual report should describe the work of the
nomination committee, including the process it has used in relation to board
appointments. An explanation should be given if neither an external search
consultancy nor open advertising has been used in the appointment of a
chairman or a non-executive director.
B.3 Commitment
Main Principle: All directors should be able to allocate sufficient time to the
company to discharge their responsibilities effectively.
Code Provisions
3.1 For the appointment of a chairman, the nomination committee should prepare
a job specification, including an assessment of the time commitment
expected, recognising the need for availability in the event of crises. A
chairmans other significant commitments should be disclosed to the board
before appointment and included in the annual report. Changes to such
commitments should be reported to the board as they arise, and their impact
explained in the next annual report.
3.2 The terms and conditions of appointment of non-executive directors should be
made available for inspection (at the companys registered office and at the
AGM). The letter of appointment should set out the expected time
commitment. Non-executive directors should undertake that they will have
sufficient time to meet what is expected of them. Their other significant
commitments should be disclosed to the board before appointment, with a
broad indication of the time involved and the board should be informed of
subsequent changes.
3.3 The board should not agree to a full time executive director taking on more
than one non-executive directorship in a FTSE 100 company nor the
chairmanship of such a company.
B.4 Development
Main Principle: All directors should receive induction on joining the board
and should regularly update and refresh their skills and knowledge.
Supporting Principles
The chairman should ensure that the directors continually update their skills
and the knowledge and familiarity with the company required to fulfil their
role both on the board and on board committees. The company should
provide the necessary resources for developing and updating its directors
knowledge and capabilities.
To function effectively, all directors need appropriate knowledge of the
company and access to its operations and staff.
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Code Provisions
4.1 The chairman should ensure that new directors receive a full, formal and
tailored induction on joining the board. As part of this, directors should avail
themselves of opportunities to meet major shareholders.
4.2 The chairman should regularly review and agree with each director their
training and development needs.
B.5 Information and Support
Main Principle: The board should be supplied in a timely manner with
information in a form and of a quality appropriate to enable it to discharge
its duties.
Supporting Principles
The chairman is responsible for ensuring that the directors receive accurate,
timely and clear information. Management has an obligation to provide such
information but directors should seek clarification or amplification where
necessary.
Under the direction of the chairman, the company secretarys responsibilities
include ensuring good information flows within the board and its committees
and between senior management and non-executive directors, as well as
facilitating induction and assisting with professional development as required.
The company secretary should be responsible for advising the board through
the chairman on all governance matters.
Code Provisions
5.1 The board should ensure that directors, especially non-executive directors,
have access to independent professional advice at the companys expense
where they judge it necessary to discharge their responsibilities as directors.
Committees should be provided with sufficient resources to undertake their
duties.
5.2 All directors should have access to the advice and services of the company
secretary, who is responsible to the board for ensuring that board procedures
are complied with. Both the appointment and removal of the company
secretary should be a matter for the board as a whole.
B.6 Evaluation
Main Principle: The board should undertake a formal and rigorous annual
evaluation of its own performance and that of its committees and
individual directors.
Supporting Principles
The chairman should act on the results of the performance evaluation by
recognising the strengths and addressing the weaknesses of the board and,
where appropriate, proposing new members be appointed to the board or
seeking the resignation of directors.
Individual evaluation should aim to show whether each director continues to
contribute effectively and to demonstrate commitment to the role (including
commitment of time for board and committee meetings and any other duties).
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Code Provisions
6.1 The board should state in the annual report how performance evaluation of
the board, its committees and its individual directors has been conducted.
6.2 Evaluation of the board of FTSE 350 companies should be externally facilitated
at least every three years. A statement should be made available of whether
an external facilitator has any other connection with the company. (This
requirement would be met by including the information on the company
website).
6.3 The non-executive directors, led by the senior independent director, should be
responsible for performance evaluation of the chairman, taking into account
the views of executive directors.
B.7 Re-election
Main Principle: All directors should be submitted for re-election at regular
intervals, subject to continued satisfactory performance.
Code Provisions
7.1 All directors of FTSE 350 companies should be subject to annual election by
shareholders. All other directors should be subject to election by shareholders
at the first annual general meeting (AGM) after their appointment, and to re-
election thereafter at intervals of no more than three years. Non-executive
directors who have served longer than nine years should be subject to annual
re-election. The names of directors submitted for election or re-election
should be accompanied by sufficient biographical details and any other
relevant information to enable shareholders to take an informed decision on
their election.
7.2 The board should set out to shareholders in the papers accompanying a
resolution to elect a non-executive director why they believe an individual
should be elected. The chairman should confirm to shareholders when
proposing re-election that, following formal performance evaluation, the
individuals performance continues to be effective and to demonstrate
commitment to the role.
Section C: Accountability
C.1 Financial and Business Reporting
Main Principle: The board should present a balanced and understandable
assessment of the companys position and prospects.
Supporting Principle
The boards responsibility to present a balanced and understandable
assessment extends to interim and other price-sensitive public reports and
reports to regulators as well as to information required to be presented by
statutory requirements.
Code Provisions
1.1 The directors should explain in the annual report their responsibility for
preparing the annual report and accounts, and there should be a statement by
the auditor about their reporting responsibilities.
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1.2 The directors should include in the annual report an explanation of the basis
on which the company generates or preserves value over the longer term (the
business model) and the strategy for delivering the objectives of the company
(This explanation would ideally be located within the Business Review required
by CA 2006).
1.3 The directors should report in annual and half-yearly financial statements that
the business is a going concern, with supporting assumptions or qualifications
as necessary.
C.2 Risk Management and Internal Control
(The Turnbull Guidance, last updated in October 2005, suggests means of
applying this part of the Code)
Main Principle: The board is responsible for determining the nature and
extent of the significant risks it is willing to take in achieving its strategic
objectives. The board should maintain sound risk management and
internal control systems.
Code provision
2.1 The board should, at least annually, conduct a review of the effectiveness of
the companys risk management and internal control systems and should
report to shareholders that they have done so. The review should cover all
material controls, including financial, operational and compliance controls.
C.3 Audit Committee and Auditors
(The FRC Guidance on Audit Committees - formerly referred to as the Smith
Guidance - suggests means of applying this part of the Code)
Main Principle: The board should establish formal and transparent
arrangements for considering how they should apply the corporate
reporting and risk management and internal control principles and for
maintaining an appropriate relationship with the companys auditor.
Code provisions
3.1 The board should establish an audit committee of at least three, or in the case
of smaller companies (i.e. those below the FTSE 350 throughout the year
immediately prior to the reporting year) two, independent non-executive
directors. In smaller companies the company chairman may be a member of,
but not chair, the committee in addition to the independent non-executive
directors, provided he or she was considered independent on appointment as
chairman. The board should satisfy itself that at least one member of the
audit committee has recent and relevant financial experience.
3.2 The main role and responsibilities of the audit committee should be set out in
written terms of reference and should include:
to monitor the integrity of the financial statements of the company and
any formal announcements relating to the companys financial
performance, reviewing significant financial reporting judgements
contained in them;
to review the companys internal financial controls and, unless expressly
addressed by a separate board risk committee composed of independent
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directors, or by the board itself, to review the companys internal control
and risk management systems;
to monitor and review the effectiveness of the companys internal audit
function;
to make recommendations to the board, for it to put to the shareholders
for their approval in general meeting, in relation to the appointment, re-
appointment and removal of the external auditor and to approve the
remuneration and terms of engagement of the external auditor;
to review and monitor the external auditors independence and
objectivity and the effectiveness of the audit process, taking into
consideration relevant UK professional and regulatory requirements;
to develop and implement policy on the engagement of the external
auditor to supply non-audit services, taking into account relevant ethical
guidance regarding the provision of non-audit services by the external
audit firm, and to report to the board, identifying any matters in respect
of which it considers that action or improvement is needed and making
recommendations as to the steps to be taken.
3.3 The terms of reference of the audit committee, including its role and the
authority delegated to it by the board, should be made available (e.g. by
including the information on the company website). A separate section of the
annual report should describe the work of the committee in discharging those
responsibilities.
3.4 The audit committee should review arrangements by which staff of the
company may, in confidence, raise concerns about possible improprieties in
matters of financial reporting or other matters. The audit committees
objective should be to ensure that arrangements are in place for the
proportionate and independent investigation of such matters and for
appropriate follow-up action.
3.5 The audit committee should monitor and review the effectiveness of the
internal audit activities. Where there is no internal audit function, the audit
committee should consider annually whether there is a need for an internal
audit function and make a recommendation to the board, and the reasons for
the absence of such a function should be explained in the relevant section of
the annual report.
3.6 The audit committee should have primary responsibility for making a
recommendation on the appointment, re-appointment and removal of the
external auditor. If the board does not accept the audit committees
recommendation, it should include in the annual report, and in any papers
recommending appointment or re-appointment, a statement from the audit
committee explaining the recommendation and should set out reasons why
the board has taken a different position.
3.7 The annual report should explain to shareholders how, if the auditor provides
non-audit services, auditor objectivity and independence is safeguarded.
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Section D: Remuneration
D.1 The Level and Components of Remuneration
Main Principle: Levels of remuneration should be sufficient to attract,
retain and motivate directors of the quality required to run the company
successfully, but a company should avoid paying more than is necessary
for this purpose. A significant proportion of executive directors
remuneration should be structured so as to link rewards to corporate and
individual performance.
Supporting Principle
The performance-related elements of executive directors remuneration should
be stretching and designed to promote the long-term success of the company.
The remuneration committee should judge where to position their company
relative to other companies. But they should use such comparisons with
caution, in view of the risk of an upward ratchet of remuneration levels with
no corresponding improvement in performance.
They should also be sensitive to pay and employment conditions elsewhere in
the group, especially when determining annual salary increases.
Code Provisions
1.1 In designing schemes of performance-related remuneration for executive
directors, the remuneration committee should follow the provisions in
Schedule A to this Code.
1.2 Where a company releases an executive director to serve as a non-executive
director elsewhere, the remuneration report (required by UK legislation)
should include a statement as to whether or not the director will retain such
earnings and, if so, what the remuneration is.
1.3 Levels of remuneration for non-executive directors should reflect the time
commitment and responsibilities of the role. Remuneration for non-executive
directors should not include share options or other performance- related
elements. If, exceptionally, options are granted, shareholder approval should
be sought in advance and any shares acquired by exercise of the options
should be held until at least one year after the non-executive director leaves
the board. Holding of share options could be relevant to the determination of
a non-executive directors independence (as set out in provision B.1.1).
1.4 The remuneration committee should carefully consider what compensation
commitments (including pension contributions and all other elements) their
directors terms of appointment would entail in the event of early termination.
The aim should be to avoid rewarding poor performance. They should take a
robust line on reducing compensation to reflect departing directors
obligations to mitigate loss.
1.5 Notice or contract periods should be set at one year or less. If it is necessary
to offer longer notice or contract periods to new directors recruited from
outside, such periods should reduce to one year or less after the initial period.
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D.2 Procedure
Main Principle: There should be a formal and transparent procedure for
developing policy on executive remuneration and for fixing the
remuneration packages of individual directors. No director should be
involved in deciding his or her own remuneration.
Supporting Principles
The remuneration committee should consult the chairman and/or chief
executive about their proposals relating to the remuneration of other
executive directors. The remuneration committee should also be responsible
for appointing any consultants in respect of executive director remuneration.
Where executive directors or senior management are involved in advising or
supporting the remuneration committee, care should be taken to recognise
and avoid conflicts of interest.
The chairman of the board should ensure that the company maintains contact
as required with its principal shareholders about remuneration.
Code Provisions
2.1 The board should establish a remuneration committee of at least three, or in
the case of smaller companies two, independent non-executive directors. In
addition the company chairman may also be a member of, but not chair, the
committee if he or she was considered independent on appointment as
chairman. The remuneration committee should make available its terms of
reference, explaining its role and the authority delegated to it by the board.
Where remuneration consultants are appointed, a statement should be made
available of whether they have any other connection with the company (This
requirement would be met by including the information on the company
website).
2.2 The remuneration committee should have delegated responsibility for setting
remuneration for all executive directors and the chairman, including pension
rights and any compensation payments. The committee should also
recommend and monitor the level and structure of remuneration for senior
management. The definition of senior management for this purpose should
be determined by the board but should normally include the first layer of
management below board level.
2.3 The board itself or, where required by the Articles of Association, the
shareholders should determine the remuneration of the non-executive
directors within the limits set in the Articles of Association. Where permitted
by the Articles, the board may however delegate this responsibility to a
committee, which might include the chief executive.
2.4 Shareholders should be invited specifically to approve all new long-term
incentive schemes (as defined in the Listing Rules) and significant changes to
existing schemes, save in the circumstances permitted by the Listing Rules.
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Section E: Relations with shareholders
E.1 Dialogue with Shareholders
Main Principle: There should be a dialogue with shareholders based on the
mutual understanding of objectives. The board as a whole has
responsibility for ensuring that a satisfactory dialogue with shareholders
takes place.
Supporting Principles
Whilst recognising that most shareholder contact is with the chief executive
and finance director, the chairman should ensure that all directors are made
aware of their major shareholders issues and concerns.
The board should keep in touch with shareholder opinion in whatever ways
are most practical and efficient.
Code Provisions
1.1 The chairman should ensure that the views of shareholders are communicated
to the board as a whole. The chairman should discuss governance and
strategy with major shareholders. Non-executive directors should be offered
the opportunity to attend scheduled meetings with major shareholders and
should expect to attend meetings if requested by major shareholders. The
senior independent director should attend sufficient meetings with a range of
major shareholders to listen to their views in order to help develop a balanced
understanding of the issues and concerns of major shareholders.
1.2 The board should state in the annual report the steps they have taken to
ensure that the members of the board, and, in particular, the non-executive
directors, develop an understanding of the views of major shareholders about
the company, for example through direct face-to-face contact, analysts or
brokers briefings and surveys of shareholder opinion.
E.2 Constructive Use of the AGM
Main Principle: The board should use the AGM to communicate with
investors and to encourage their participation.
Code Provisions
2.1 At any general meeting, the company should propose a separate resolution on
each substantially separate issue, and should, in particular, propose a
resolution at the AGM relating to the report and accounts. For each
resolution, proxy appointment forms should provide shareholders with the
option to direct their proxy to vote either for or against the resolution or to
withhold their vote. The proxy form and any announcement of the results of
a vote should make it clear that a vote withheld is not a vote in law and will
not be counted in the calculation of the proportion of the votes for and against
the resolution.
2.2 The company should ensure that all valid proxy appointments received for
general meetings are properly recorded and counted. For each resolution,
where a vote has been taken on a show of hands, the company should ensure
that the following information is given at the meeting and made available as
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soon as reasonably practicable on a website which is maintained by or on
behalf of the company:
the number of shares in respect of which proxy appointments have been
validly made;
the number of votes for the resolution;
the number of votes against the resolution; and
the number of shares in respect of which the vote was directed to be
withheld.
2.3 The chairman should arrange for the chairmen of the audit, remuneration and
nomination committees to be available to answer questions at the AGM and
for all directors to attend.
2.4 The company should arrange for the Notice of the AGM and related papers to
be sent to shareholders at least 20 working days before the meeting.
Schedule A: The design of performance-related
remuneration for executive directors
The remuneration committee should consider whether the directors should be
eligible for annual bonuses. If so, performance conditions should be relevant,
stretching and designed to promote the long-term success of the company. Upper
limits should be set and disclosed. There may be a case for part payment in shares
to be held for a significant period.
The remuneration committee should consider whether the directors should be
eligible for benefits under long-term incentive schemes. Traditional share option
schemes should be weighed against other kinds of long-term incentive scheme.
Executive share options should not be offered at a discount save as permitted by
the relevant provisions of the Listing Rules.
In normal circumstances, shares granted or other forms of deferred remuneration
should not vest, and options should not be exercisable, in less than three years.
Directors should be encouraged to hold their shares for a further period after
vesting or exercise, subject to the need to finance any costs of acquisition and
associated tax liabilities.
Any new long-term incentive schemes which are proposed should be approved by
shareholders and should preferably replace any existing schemes or, at least, form
part of a well considered overall plan incorporating existing schemes. The total
potentially available rewards should not be excessive.
Payouts or grants under all incentive schemes, including new grants under existing
share option schemes, should be subject to challenging performance criteria
reflecting the companys objectives, including non-financial performance metrics
where appropriate. Remuneration incentives should be compatible with risk policies
and systems.
Grants under executive share option and other long-term incentive schemes should
normally be phased rather than awarded in one large block.
Consideration should be given to the use of provisions that permit the company to
reclaim variable components in exceptional circumstances of misstatement or
misconduct.
In general, only basic salary should be pensionable. The remuneration committee
should consider the pension consequences and associated costs to the company of
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basic salary increases and any other changes in pensionable remuneration,
especially for directors close to retirement.
Schedule B: Disclosure of corporate governance
arrangements
Corporate governance disclosure requirements are set out in three places:
FSA Disclosure and Transparency Rules, which set out certain mandatory
disclosures;
FSA Listing Rules, which include the comply or explain requirement; and
The UK Corporate Governance Code (in addition to providing an explanation
where they choose not to comply with a provision, companies must disclose
specified information in order to comply with certain provisions).
These requirements are summarised below. There is some overlap between the
mandatory disclosures required under the Disclosure and Transparency Rules and
those expected under the UK Corporate Governance Code. Areas of overlap are
summarised in the Appendix to this Schedule. In respect of disclosures relating to
the audit committee and the composition and operation of the board and its
committees, compliance with the relevant provisions of the Code will result in
compliance with the relevant Rules.
Disclosure and Transparency Rules
The Disclosure and Transparency Rules (DTR) concern audit committees or bodies
carrying out equivalent functions.
DTR set out requirements relating to the composition and functions of the
committee or equivalent body:
An issuer must have a body which is responsible for performing the functions
set out below, and at least one member of that body must be independent
and at least one member must have competence in accounting and/or
auditing.
The requirements for independence and competence in accounting and/or
auditing may be satisfied by the same member or by different members of the
relevant body.
An issuer must ensure that, as a minimum, the relevant body must:
(1) monitor the financial reporting process;
(2) monitor the effectiveness of the issuers internal control, internal audit
where applicable, and risk management systems;
(3) monitor the statutory audit of the annual and consolidated accounts;
(4) review and monitor the independence of the statutory auditor, and in
particular the provision of additional services to the issuer.
The following disclosures are required:
The issuer must make a statement available to the public disclosing
which body carries out the above functions and how it is composed.
This can be included in the corporate governance statement as described
below.
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Compliance with the relevant provisions of the UK Corporate Governance
Code (as set out in the Appendix to this Schedule) will result in
compliance with much of the DTR.
Issuers are required to produce a corporate governance statement that
must be either included in the directors report; or in a separate report
published together with the annual report; or on the issuers website, in
which case there must be a cross-reference in the directors report.
DTR requires that the corporate governance statements must contain a
reference to the corporate governance code to which the company is
subject (for companies with a Premium listing this is the UK Corporate
Governance Code). DTR requires that, to the extent that it departs from
that code, the company must explain which parts of the code it departs
from and the reasons for doing so. Compliance with the comply or
explain rule will also satisfy these requirements.
DTR sets out certain information that must be disclosed in the corporate
governance statement i.e. the statement must contain:
o A description of the main features of the companys internal control
and risk management systems in relation to the financial reporting
process. DTR states that an issuer which is required to prepare a
group directors report must include in that report a description of
the main features of the groups internal control and risk
management systems in relation to the process for preparing
consolidated accounts.
o The information required by SI 2008 No. 410 [The Large and
Medium-sized Companies and Groups (Accounts and Reports)
Regulations 2008], where the issuer is subject to its requirements.
o A description of the composition and operation of the issuers
administrative, management and supervisory bodies and their
committees. Compliance with the provisions of the UK Corporate
Governance Code (as set out in the Appendix to this Schedule) will
satisfy the requirements of DTR.
Listing Rules
The Listing Rules state that in the case of a company that has a Premium listing of
equity shares, the following items must be included in its annual report and
accounts:
a statement of how the listed company has applied the Main Principles set out
in the UK Corporate Governance Code, in a manner that would enable
shareholders to evaluate how the principles have been applied;
a statement as to whether the listed company has:
o complied throughout the accounting period with all relevant provisions
set out in the UK Corporate Governance Code; or
o not complied throughout the accounting period with all relevant
provisions set out in the UK Corporate Governance Code, and if so,
setting out:
(i) those provisions, if any, it has not complied with;
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(ii) in the case of provisions whose requirements are of a continuing
nature, the period within which, if any, it did not comply with some
or all of those provisions; and
(iii) the companys reasons for non-compliance.
The UK Corporate Governance Code
In addition to the comply or explain requirement in the Listing Rules, the Code
includes specific requirements for disclosure which must be provided in order to
comply.
The annual report should include:
a statement of how the board operates, including a high level statement of
which types of decisions are to be taken by the board and which are to be
delegated to management;
the names of the chairman, the deputy chairman (where there is one), the
chief executive, the senior independent director and the chairmen and
members of the board committees;
the number of meetings of the board and those committees and individual
attendance by directors;
where a chief executive is appointed chairman, the reasons for their
appointment (this only needs to be done in the annual report following the
appointment);
the names of the non-executive directors whom the board determines to be
independent, with reasons where necessary;
a separate section describing the work of the nomination committee, including
the process it has used in relation to board appointments and an explanation
if neither external search consultancy nor open advertising has been used in
the appointment of a chairman or a non-executive director;
any changes to the other significant commitments of the chairman during the
year;
a statement of how performance evaluation of the board, its committees and
its directors has been conducted;
an explanation from the directors of their responsibility for preparing the
accounts and a statement by the auditors about their reporting
responsibilities;
an explanation from the directors of the basis on which the company
generates or preserves value over the longer term (the business model) and
the strategy for delivering the objectives of the company;
a statement from the directors that the business is a going concern, with
supporting assumptions or qualifications as necessary;
a report that the board has conducted a review of the effectiveness of the
companys risk management and internal control systems;
a separate section describing the work of the audit committee in discharging
its responsibilities;
where there is no internal audit function, the reasons for the absence of such
a function;
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where the board does not accept the audit committees recommendation on
the appointment, re-appointment or removal of an external auditor, a
statement from the audit committee explaining the recommendation and the
reasons why the board has taken a different position;
an explanation of how, if the auditor provides non-audit services, auditor
objectively and independence is safeguarded;
a description of the work of the remuneration committee as required under
the Large and Medium-Sized Companies and Groups (Accounts and Reports)
Regulations 2008 including, where an executive director serves as a non-
executive director elsewhere, whether or not the director will retain such
earnings and, if so, what the remuneration is;
the steps the board has taken to ensure that members of the board, in
particular the non-executive directors, develop an understanding of the views
of major shareholders about their company.
The following information should be made available (which may be met by placing
the information on a website that is maintained by or on behalf of the company):
the terms of reference of the nomination, audit and remuneration committees,
explaining their role and the authority delegated to them by the board;
the terms and conditions of appointment of non-executive directors;
where performance evaluation has been externally facilitated, a statement of
whether the facilitator has any other connection with the company; and
where remuneration consultants are appointed, a statement of whether they
have any other connection with the company.
The board should set out to shareholders in the papers accompanying a resolution
to elect or re-elect directors:
sufficient biographical details to enable shareholders to take an informed
decision on their election or re-election;
why they believe an individual should be elected to a non-executive role; and
on re-election of a non-executive director, confirmation from the chairman
that, following formal performance evaluation, the individuals performance
continues to be effective and to demonstrate commitment to the role.
The board should set out to shareholders in the papers recommending appointment
or reappointment of an external auditor:
if the board does not accept the audit committees recommendation, a
statement from the audit committee explaining the recommendation and from
the board setting out reasons why they have taken a different position.
Additional guidance
The Turnbull Guidance and FRC Guidance on Audit Committees contain further
suggestions as to information that might usefully be disclosed in the internal control
statement and the report of the audit committee respectively.
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Appendix: Overlap between the disclosure and transparency
rules and the UK Corporate Governance Code

DISCLOSURE AND TRANSPARENCY
RULES
UK CORPORATE GOVERNANCE CODE

Sets out minimum requirements on
composition of the audit committee or
equivalent body.
Provision C.3.1
Sets out recommended composition of
the audit committee.


Sets out minimum functions of the audit
committee or equivalent body.

Provision C.3.2
Sets out the recommended minimum
terms of reference for the audit
committee.

The composition and function of the
audit committee or equivalent body must
be disclosed in the annual report.

Provision A.1.2
The annual report should identify
members of the board committees.

Provision C.3.3
The annual report should describe the
work of the audit committee. Further
recommendations on the content of the
audit committee report are set out in
the FRC Guidance on Audit Committees.


The corporate governance statement
must include a description of the main
features of the companys internal
control and risk management systems in
relation to the financial reporting
process.


Provision C.2.1
The Board must report that a review of
the effectiveness of the risk
management and internal control
systems has been carried out. Further
recommendations on the content of the
internal control statement are set out in
the Turnbull Guidance.
The corporate governance statement
must include a description of the
composition and operation of the
administrative, management and
supervisory bodies and their
committees.
This requirement overlaps with a
number of different provisions of the
Code:
A.1.1: the annual report should include
a statement of how the board operates.
A.1.2: the annual report should identify
members of the board and board
committees.
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B.2.4: the annual report should
describe the work of the nomination
committee.
C.3.3: the annual report should
describe the work of the audit
committee.
D.2.1: a description of the work of the
remuneration committee should be
made available. [Note: in order to
comply with DTR this information will
need to be included in the corporate
governance statement].

Schedule C: Engagement principles for institutional
shareholders
This schedule has been superseded by the Stewardship Code for institutional
investors.
Principle 1: Dialogue with companies
Main Principle: Institutional shareholders should enter into a dialogue
with companies based on the mutual understanding of objectives.
Principle 2: Evaluation of Governance Disclosures
Main Principle: When evaluating companies governance arrangements,
particularly those relating to board structure and composition, institutional
shareholders should give due weight to all relevant factors drawn to their
attention.
Principle 3: Shareholder Voting
Main Principle: Institutional shareholders have a responsibility to make
considered use of their votes.
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INTERNATIONAL COMPARISONS OF CORPORATE
GOVERNANCE
The broad principles of corporate governance are similar in the UK, the USA and
Germany, but there are significant differences in how they are applied. Whereas
the UK and Germany have voluntary corporate governance codes, the US system is
based upon legislation within the Sarbanes-Oxley Act.
United States of America
Whereas the UK has historically relied upon a system of self-regulation and
voluntary codes of best practice, the USA corporate governance structure is more
formalised, with legally enforceable controls.
In the US, statutory requirements for publicly-traded companies are set out in the
Sarbanes-Oxley Act. These requirements include the certification of published
financial statements by the CEO and the chief financial officer (CFO), faster public
disclosures by companies, legal protection for whistleblowers, a requirement for an
annual report on internal controls, and requirements relating to the audit
committee, auditor conduct and avoiding improper influence of auditors.
The Act also requires the Securities and Exchange Commission (SEC) and the main
stock exchanges to introduce further rules, relating to matters such as the
disclosure of critical accounting policies, the composition of the Board and the
number of independent directors. The Act has also established an independent
body to oversee the accounting profession, which is known as the Public Company
Accounting Oversight Board. Managers must be careful to comply with regulations
to avoid possible legal action against the company or themselves individually.
Germany
As both the UK and Germany are members of the EU, they must both follow EU
directives on company law. A major difference that exists in the board structure for
companies is that the UK has a unitary board (consisting of both executive and
non-executive directors), whereas German companies have a two-tier board of
directors. The Supervisory Board of non-executives (Aufsichtsrat) has
responsibility for corporate policy and strategy and the Management Board of
executive directors (Vorstand) has responsibility primarily for the day-to-day
operations of the company.
The Supervisory Board typically includes representatives from major banks that
have historically been large providers of long-term finance to German companies
(and are often major shareholders). The Supervisory Board does not have full
access to financial information, is meant to take an unbiased overview of the
company, and is the main body responsible for safeguarding the external
stakeholders interests. The presence on the Supervisory Board of representatives
from banks and employees (trade unions) may introduce perspectives that are not
present in some UK boards. In particular, many members of the Supervisory Board
would not meet the criteria under UK Corporate Governance Code for their
independence.
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Japan
Although there are signs of change in Japanese corporate governance, much of the
system is based upon negotiation or consensual management rather than upon a
legal or even a self-regulatory framework. Banks as well as representatives of
other companies (in their capacity as shareholders) also sit on the Boards of
Directors of Japanese companies.
It is not uncommon for Japanese companies to have cross holdings of shares with
their suppliers, customers and banks etc., all being represented on each others
Board of Directors. There are often three boards of directors: Policy Boards,
responsible for strategy and comprised of directors with no functional responsibility;
Functional Boards, responsible for day to day operations; and largely symbolic
Monocratic Boards. The interests of the company as a whole should dictate the
actions of these boards. This is in contrast to the UK or USA systems where, at
least in theory, the board should act primarily in the best interests of the
shareholders, being the owners of the company.

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Chapter 2
Advanced
investment
appraisal section
1


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CHAPTER CONTENTS
INVESTMENT APPRAISAL TECHNIQUES ------------------------------- 41
1. ACCOUNTING RATE OF RETURN 41
2. PAYBACK PERIOD 42
3. DISCOUNTED CASH FLOW 42
CONGO LTD --------------------------------------------------------------- 44
INFLATION AND DISCOUNTED CASH FLOW -------------------------- 48
MONEY CASH FLOWS 48
REAL CASH FLOWS 48
RELATIONSHIP BETWEEN MONEY INTEREST RATES AND REAL INTEREST RATES 48
TAXATION AND INVESTMENT APPRAISAL ---------------------------- 50
CAPITAL RATIONING ---------------------------------------------------- 52
WHAT ARE THE 2 TYPES OF CAPITAL RATIONING? 52
CAPITAL RATIONING AND TIME 52
SINGLE PERIOD CAPITAL RATIONING 53
MULTI-PERIOD CAPITAL RATIONING 56

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INVESTMENT APPRAISAL TECHNIQUES

Assumed objective is
Selection of those projects which will maximise the wealth of the owners (or
shareholders) of the enterprise. Involves a consideration of FUTURE events, not
PAST performance.
Accepted techniques are
1. Accounting Rate of Return (alternatively called Return on Investment)
2. Payback Period
3. Discounted Cash Flow, of which there are two major variants:
(a) Net Present Value
(b) Internal Rate of Return (alternatively called Yield)
1. Accounting rate of return
The ARR (or ROI) is a measure of relative project profitability, which expresses:
1. The expected average annual profit (after allowing for depreciation, but before
taxation) emerging from a project,
AS A PERCENTAGE OF
2. The investment involved. Normally the average investment over the life of the
project is used, but initial investment is sometimes employed.
Advantages
It is relatively easy to understand
The required figures are readily available from accounting data.
The ROI technique is frequently used as an assessment of managements
actual (hindsight) performance.
It gives an indication as to whether available projects are meeting target
returns on capital employed.
Disadvantages
Based on accounting profits not cash flows - the success of an enterprise
depends on its ability to generate cash. The ability to invest depends on
availability of cash.
Ignores the time value of money
It is relative rate of return, thus ignores the size of the project
No set rules (theoretical or practical) for determining the cut-off rate of
return.
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2. Payback period
The Payback Period demonstrates how long an enterprise must expect to wait
before the after-tax cash flows generated by the project allow it to recoup the initial
amount invested. Thus it gives an investor an idea of how long their money will
be at risk; a short payback period is taken to reveal low risk, and a long payback -
high risk.
Advantages
The most tried and tested of all methods
Easy to calculate and understand
An enterprise with limited cash resources is obviously concerned with speed of
return.
Some companies combine DCF techniques with the payback method.
Disadvantages
Does not measure profitability nor increases in shareholders wealth, since it
ignores cash flows expected to arise beyond the payback period.
Ignores the time value of money (but discounted payback sometimes used).
No set rules (theoretical or practical) for determining the minimum acceptable
payback period.
May be difficult to measure the initial amount invested when e.g. net outlays
arise in both the initial and final years of a project.
3. Discounted cash flow
DCF is a method of capital investment appraisal which takes account of:
1. The overall cash flows arising from projects, and
2. The timing of those cash flows.
Only relevant cash flows are considered (i.e. those future cash flows which arise as
a result of those projects) and the timing effect is incorporated by means of the
discounting technique.
Both the Accounting Rate of Return and the Payback approaches are surpassed by
the DCF methods. The basic arguments are:
it is better to consider cash rather than profits because cash is how investors
will eventually see their rewards (i.e. dividends, interest, or the proceeds from
the sale of the shares or debentures).
the timing of the cash flows is important because early cash receipts can be
reinvested to earn interest.
it is important to consider the cash flows arising over the entire life of a
project.
The technique of discounting reduces all future cash flows to current equivalent
values (present values) by allowing for the interest which could have been earned if
the cash had been received immediately.
There are two common techniques, net present value and internal rate of return,
but net terminal value can be used.
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DCF Net present value
The NPV of a project is the net value of a projects cash flows after discounting (i.e.
allowing for reinvestment) at the companys cost of capital. Projects with a negative
NPV should be rejected.
N.B. Cost of capital is the average required return which is set by the market for
the company in view of the risk associated with its operations.
Provided that:

1. The project under consideration is of average risk for the company, and
2. There is no restriction on access to capital,
a positive NPV provides the best theoretical estimate of the total absolute increase
in wealth which accrues to an enterprise as a result of accepting that project.
However in the short run the use of the NPV rule may not lead to good profits being
reported in the published accounts of the enterprise although in the long term
cash flows and reported profits should move in tandem.
The NPV rule has a sound theoretical basis and is likely to produce investment
decision advice of consistently good quality.
DCF Internal rate of return (economic return/yield)
The IRR (or Economic return) of a project is that discount rate which when applied
to a projects cash flows provides an NPV of zero. The IRR is therefore the expected
earning rate of an investment. If the IRR of a project exceeds the cost of capital
of that enterprise, that project is acceptable.
When considering a single project in isolation IRR will give the same decision as
NPV (i.e. if the NPV of a project is positive, its IRR will exceed the cost of capital).
However, when choosing between mutually exclusive projects, the two techniques
may conflict and (subject to the provisos set out above) NPV always provides the
correct solution.
Disadvantages of IRR
1. IRR provides a relative (as opposed to an absolute) result, and may give
incorrect decision advice if mutually exclusive projects:

o Are of different size, or
o Have unequal lives.
2. May be multiple IRRs or no IRR
3. Cannot adapt to expected changes in cost of capital during the life of a
project.
4. Makes an inconsistent assumption about the rate at which cash surpluses can
be reinvested; it assumes they are reinvested at whatever the IRR happens to
be. The companys cost of capital is a more appropriate reinvestment rate i.e.
the assumption underlying NPV.
5. More difficult to calculate than the theoretically more sound NPV approach.
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Congo Ltd
Congo Ltd is considering the selection of one of a pair of mutually exclusive
investment projects. Both would involve purchase of machinery with a life of five
years
Project 1 would generate annual cash flows (receipts less payments) of 200,000;
the machinery would cost 556,000 and have a scrap value of 56,000.
Project 2 would generate annual cash flows of 500,000; the machinery would cost
1,616,000 and have a scrap value of 301,000.
Congo uses the straight-line method for providing depreciation.
Its cost of capital is 15 per cent per annum. Assume that annual cash flows arise
on the anniversaries of the initial outlay, that there will be no price changes over
the project lives and that acceptance of one of the projects will not alter the
required amount of working capital.
Requirements
(i) Calculate for each project
(a) the accounting rate of return (i.e. the percentage of the average
accounting profit to the average book value of investment) to the
nearest 1%.
(b) the net present value
(c) the internal rate of return (Yield or Economic return) to the nearest 1%,
and
(d) the payback period to one decimal place.
Ignore taxation.
(ii) WITHOUT ANY REFERENCE TO THE INCREMENTAL YIELD METHOD, briefly
explain which one of the discounted cash flow techniques used in part (i) of
this question should be used by the management of Congo Ltd, in deciding
whether Project 1 or Project 2 should be undertaken.
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Suggested solution to Congo Ltd
(i) Summary of results
Project 1 2
a) Accounting rate of return 33% 25%
b) Net present value (000) 142 210
c) Internal rate of return (Economic return) 25% 20%
d) Payback period (years) 2.8 or 3 3.2 or 4
Summary of rankings
Better project
a) Accounting rate of return 1
b) Net present value 2
c) Internal rate of return 1
d) Payback period 1
WORKINGS
Project 1 Project 2
(a) Accounting rate of return 000 000
Initial investment 556 1,616
Scrap value (56) (301)

Total depreciation 500 1,315

Annual depreciation 100 263

Cash flows 200 500
Depreciation (see above) (100) (263)

Average accounting profit 100 237

Project 1 Project 2
000 000
Average book value of investment (000)
(556 + 56) 306
(1,616 + 301) 958
Accounting rate of return 33% 25%
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(b) Net present value
000 000
Year
0 Initial outlay (556) (1,616)
1 5 Cash flows
200 x 3.352 670
500 x 3.352 1,676
5 Residual value
56 x 0.497 28
301 x 0.497 ___ 150
Net present value (000) 142 210

(c) Internal rate of return (Economic return)
000 000
By trial and error
Try 20%
Initial outlays (556) (1,616)
Cash flows 598 1,495
Residual values _22 _121
NPV (000) 64 NIL

Try 25%
Initial outlays (556) (1,616)
Cash flows 538 1,345
Residual values __18 __99
NPV (000) NIL (172)

IRR 25% 20%

(d) Payback period

000 000
Annual cash flows 200 500
Initial investment 556 1,616

Payback period in years

If cash flows arose during each year 2.8 3.2
If cash flows arose at year end (as in this
question)
3 4
(ii) Investment Decision
This example illustrates the conflict which will often be found between the two
discounted cash flow appraisal techniques in a ranking decision.
Under the net present value criterion, project 2 is preferred because it has a
higher net present value when the project cash flows are discounted at the
cost of capital. On the other hand project 1 has the higher internal rate of
return.
To decide which method of ranking is correct it is necessary to consider the
assumed objective of the firm, which is to maximise the wealth of the
providers of finance. Both projects earn more than the required rate of return
but project 2 generates larger cash surpluses in excess of the required
amounts than project 1, as can be seen from the net present value
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calculations. It is these cash surpluses which improve the wealth of the
owners of the firm.
IRR provides a relative (as opposed to an absolute) result, and may give
incorrect decision advice if mutually exclusive projects are of different size (as
in this instance) or have unequal lives.
IRR makes an inconsistent assumption about the rate at which cash surpluses
can be reinvested; it assumes they are reinvested at whatever the IRR
happens to be. The companys cost of capital is a more appropriate
reinvestment rate i.e. the assumption underlying NPV.
Accordingly PROJECT 2 IS PREFERRED TO PROJECT 1 and this can be justified
by the following argument:
Project 1 is relatively more profitable than project 2, but it is smaller. The
two projects are mutually exclusive, which means that only one of them can
be accepted. It is better for the owners of the company to receive the large
cash surpluses from a large adequately profitable project than to receive the
smaller cash surpluses from a small very profitable project. Taken to
extremes, a return of ten per cent on 1,000 is better than a return of one
thousand per cent on a penny.
Tutorial Note
This question examines the conflicting rankings sometimes given by the NPV
and IRR technique. You may wish to add a graph to amplify your solution to
part (c).
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INFLATION AND DISCOUNTED CASH FLOW
The mechanics of allowing for inflation are basically easy to handle in DCF
calculations. The real difficulty is one of predicting what the rate will be. At this
point we will discuss the mechanics.
There are two possible techniques:
1. discount money (nominal) cash flows at the money (nominal) discount rate.
2. discount real cash flows at the real discount rate.
Money cash flows
These are the predictions of the actual sums of money which will be received and
paid taking into account predicted inflation levels. The money rate of interest is
the interest rate which is normally quoted and contains an allowance for inflation
(for example, a 20% discount rate may contain an allowance for expected inflation
of 5%).
Real cash flows.
These are cash flows expressed in todays prices. A real discount rate is the real
required rate of return after adjusting the money discount rate for the inflation
allowance.
Relationship between money interest rates and real
interest rates
Suppose we can invest money in a bank to earn 7% per annum interest. However,
we expect inflation to be 4% per annum next year. If I invest 1 this must grow to
1.04 to keep pace with inflation. So, if I have 1.07 cash in the bank after one
year, the real interest I have received is 1.07 - 1.04 = 3p. When compared with
the capital required to keep pace with inflation (1.04), this shows a return of
0.03/1.04 = 2.9%.
The formula which relates real and money interest rates is as follows:
1 + r = 1 + m or, according to the ACCA Formula Sheet, (1 + i) = (1 + r)(1 + h)
1 + i
Where r is the real interest rate, m is the money interest rate and i is the rate of
inflation.
Thus 1 + r = 1.07/1.04 in the above example, giving r = 0.029 or 2.9%.
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Example
A project requires an outlay of 1.5m in year 0 and will repay cash flows in real
terms (todays prices) as follows:
Year 000
1 670
2 500
3 1,200
The companys money cost of capital is 15%. Appraise the project if inflation is
estimated to remain at 5% per annum.
Method 1: Compute the real discount rate and discount the real cash flows
1 + r = 1+ m = 1.155 = 1.1
1 + i 1.05
Thus r = 0.1 or 10%
Real cash flow 10% factor Present value
Year
0 (1,500) 1 (1,500)
1 670 1/1.1 609.1
2 500 1/1.1
2
413.2
3 1,200 1/1.1
3
901.6
NPV 423.9

Method 2: Compute the money cash flows, using the rate of inflation and discount
at the money discount rate.
Money cash flow 15.5% factor Present value
Year
0 (1,500) 1 (1,500)
1 670 x 1.05 = 703.5 1/1.155 609.1
2 500 x 1.05
2
= 551.25 1/1.155
2
413.2
3 1,200 x 1.05
3
=1,389.15 1/1.155
3
901.6
NPV 423.9
Please note that discount rates have been computed as opposed to looked up in
tables, to ensure that accuracy is obtained for the reconciliation.
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TAXATION AND INVESTMENT APPRAISAL
Example 1
A company buys a fixed asset for 10,000 at the beginning of an accounting
period (1 January 2001) to undertake a two year project.
Net trading revenues at t
1
and t
2
are 5,000 per annum.
The company sells the fixed asset on the last day of the second year for 6,000.
Corporation tax = 33%. Writing down allowance = 25% reducing balance.
Required
Calculate the net cashflows for the project.
Solution to example 1

t
0
t
1
t
2
t
3


Net trading revenue 5,000 5,000
Tax at 33% (1,650) (1,650)
Fixed asset (10,000)
Scrap proceeds 6,000
Tax savings on WDAs _____ ____ 825 495
Net cashflow (10,000) 5,000 10,175 (1,155)
WORKING
Tax savings on writing down allowances
Tax relief
at 33%
Timing

t
0
Investment in fixed asset 10,000
t
1
WDA @ 25% (2,500) 825 t
2

7,500
t
2
Proceeds (6,000)
Balancing allowance (1,500) 495 t
3

Example 2
A company buys a fixed asset for 10,000 at the end of the previous accounting
period (31 December 2000) to undertake a two year project.
Net trading revenues at t
1
and t
2
are 5,000 per annum.
The fixed asset has zero scrap value when it is disposed of at the end of year 2.
Corporation tax = 33%. Writing down allowance = 25% reducing balance.
Required
Calculate the net cashflows for the project.
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Solution to example 2
t
0
t
1
t
2
t
3


Net trading revenue 5,000 5,000
Tax at 33% (1,650) (1,650)
Fixed asset (10,000)
Tax savings on
WDAs
_____ 825 619 1,856
Net cashflow (10,000) 5,825 3,969 206
WORKING
Tax savings on writing down allowances
Tax relief at 3% Timing

t
0
Investment in fixed asset 10,000

t
0
WDA @ 25% (2,500) 825 t
1

7,500
t
1
WDA @25% (1,875) 619 t
2

5,625
t
2
Proceeds ____

Balancing allowance (5,625) 1,856 t
3

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CAPITAL RATIONING
Where the finance available for capital expenditure is limited to an amount which
prevents acceptance of all new projects with a positive NPV, the company is said to
experience capital rationing.
What are the 2 types of capital rationing?
They are:
1. Hard capital rationing
This applies when a company is restricted from undertaking all worthwhile
investment opportunities due to external factors over which it has no control.
These factors may include government monetary restrictions and the general
economic and financial climate (eg, a depressed stock market, which precludes a
rights issue of ordinary shares).
2. Soft capital rationing
This applies when a company decides to limit the amount of capital expenditure
which it is prepared to authorise. Segments of divisionalised companies often have
their capital budgets imposed by the main board of directors. A company may
purposely curtail its capital expenditure for a number of reasons eg, it may consider
that it has insufficient depth of management expertise to exploit all available
opportunities without jeopardising the success of both new and ongoing operations.
Capital rationing and time
Capital rationing may exist in a:
1. Single period
i.e. available finance is only in short supply during the current period, but will
become freely available in subsequent periods.
Projects may be:
(i) Divisible An entire project or any fraction of that project may be
undertaken. In this event projects may be ranked by means of a
profitability index, which can be calculated by dividing the present value (or
NPV) of each project by the capital outlay required during the period of
restriction.
Projects displaying the highest profitability indices will be preferred. Use of
the profitability index assumes that project returns increase in direct
proportion to the amount invested in each project.
(ii) Indivisible An entire project must be undertaken, since it is impossible to
accept part of a project only. In this event the NPV of all available projects
must be calculated. These projects must then be combined on a trial and
error basis in order to select that combination which provides the highest total
NPV within the constraints of the capital available. This approach will
sometimes result in some funds being unused.
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2. Multi-period
i.e. available finance is limited not only during the current period, but also during
subsequent periods.
Projects may be:
(i) Divisible - In this event, linear programming is used to determine the
optimal combination of projects. Two techniques, which both result in
identical project selections can be used i.e. the objective is to either:
Maximise the total NPV from the investment in available projects, or
Maximise the present value (PV) of cash flows available for dividends.
(ii) Indivisible - In this event, integer programming would be required to
determine the optimal combination of investments.
Single period capital rationing
Example of single period capital rationing
Banden Ltd is a highly geared company that wishes to expand its operations. Six
possible capital investments have been identified, but the company only has access
to a total of 620,000. The projects are not divisible and may not be postponed
until a future period. After the projects end, it is unlikely that similar investment
opportunities will occur.
Expected net cash inflows (including salvage value)
Initial
Project Year 1 2 3 4 5 outlay

A 70,000 70,000 70,000 70,000 70,000 246,000
B 75,000 87,000 64,000 180,000
C 48,000 48,000 63,000 73,000 175,000
D 62,000 62,000 62,000 62,000 180,000
E 40,000 50,000 60,000 70,000 40,000 180,000
F 35,000 82,000 82,000 150,000
Projects A and E are mutually exclusive. All projects are believed to be of similar
risk to the companys existing capital investments.
Any surplus funds may be invested in the money market to earn a return of 9% per
year. The money market may be assumed to be an efficient market. Bandens cost
of capital is 12% per year.
Required
(a) Calculate:
(i) The expected net present value;
(ii) The expected profitability index associated with each of the six projects.
Rank the projects according to both of these investment appraisal methods
and explain briefly why these rankings differ.
(b) Give reasoned advice to Banden Ltd recommending which projects should be
selected.
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Solution to single period capital rationing example
(a) (i) Calculation of expected Net Present value
Project NPV
A. 70,000 x 3.605 - 246,000 = 6,350
B. 75,000 x 0.893 + 87,000 x 0.797 + 64,000
x 0.712 - 180,000 = 1,882
C. 48,000 x 0.893 + 48,000 x 0.797 + 63,000
x 0.712 + 73,000 x 0.636 - 175,000 = (2,596)
D. 62,000 x 3.037 - 180,000 = 8,294
E. 40,000 x 0.893 + 50,000 x 0.797 + 60,000
x 0.712 + 70,000 x 0.636 + 40,000 x 0.567
- 180,000 = 5,490
F. 35,000 x 0.893 + 82,000 x 0.797 + 82,000
x 0.712 - 150,000 = 4,993
(ii) Calculation of Profitability Index
Present value of cash inflows initial outlay:
Project PI
A. 252,350/246,000 = 1.026
B. 181,882/180,000 = 1.010
C. 172,404/175,000 = 0.985
D. 188,294/180,000 = 1.046
E. 185,490/180,000 = 1.031
F. 154,993/150,000 = 1.033

Ranking NPV P.I
1 D D
2 A F
3 E E
4 F A
5 B B
6 C C
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The rankings differ because NPV is an absolute measure of the benefit from a
project, whilst profitability index is a relative measure, and shows the benefit
per of outlay. Where the initial outlays vary in size the two methods may
give different rankings.
(b) In a capital rationing situation, the projects should be selected which give the
greatest total NPV from the limited outlay available.
A and E are mutually exclusive.
C is not considered as it has a negative NPV.
Total outlay is limited to 620,000.
Possible selections are:
Projects Expected NPV Total NPV Outlay in 000

A, B, D (6,350 + 1,882 + 8,294) 16,526 (246 + 180 + 180) 606
A, B, F (6,350 + 1,882 + 4,993) 13,225 (246 + 180 + 150) 576
A, D, F (6,350 + 8,294 + 4,993) 19,637 (246 + 180 + 150) 576
B, D, E (1,882 + 8,294 + 5,490) 15,666 (180 + 180 + 180) 540
B, D, F (1,882 + 8,294 + 4,993) 15,169 (180 + 180 + 150) 510
B, E, F (1,882 + 5,490 + 4,993) 12,365 (180 + 180 + 150) 510
D, E, F (8,294 + 5,490 + 4,993) 18,777 (180 + 180 + 150) 510
The recommended selection is projects A, D and F
Tutorial note: Neither the NPV nor PI rankings will necessarily be appropriate
because of the sheer size of these indivisible investments. In this particular
instance, because of the similarity in size of the projects, only three can be
undertaken, and the NPV ranking clearly leads to A, D and E. Profitability
index will not work if projects are indivisible or where multiple limiting factors
exist. The PI might lead to the incorrect solution of D, E and F.
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Multi-period capital rationing
Please remember that you are only likely to be asked to set up the
equations for both the linear programming and integer programming
formulations and then to interpret the output. The actual solving of these
equations are computer-based calculations.
Example of multi-period capital rationing using linear
programming
The management team of Barney Ltd has identified the following independent
investment projects, all of which are divisible.
No project can be delayed or performed on more than one occasion. The projected
cash flows during the life of each project are as follows:
Year 0 Year 1 Year 2 Year 3 Year 4
000 000 000 000 000
Project A (25) (50) 25 50 50
Project B (25) (25) 75 - -
Project C (12.5) 5 5 5 5
Project D - (37.5) (37.5) 50 50
Project E (50) 25 (50) 50 50
Project F (20) (10) 37.5 25 -
The capital available at Year 0 is only 50,000

and only 12,500 is available at Year
1, together with any cash inflows from the projects undertaken at Year 0. From
Year 2 onwards there is no restriction on the access to capital. The appropriate
cost of capital is 10%.
Formulate both:
1. The NPV linear programme, and
2. The PV of dividends linear programme.
Multi-period capital rationing solutions for divisible projects
NPV formulation
Since the objective is to maximise the total NPV from these projects, it is initially
necessary to calculate the NPV of each project at a discount rate of 10%:
Year 0 Year 1 Year 2 Year 3 Year 4 Total
NPV
Discount factor
(10%)
1.000 0.909 0.826 0.751 0.683
000 000 000 000 000 000
Project A (25) (45.45) 20.65 37.55 34.15 +21.90
Project B (25) (22.73) 61.95 - - +14.22
Project C (12.5) 4.55 4.13 3.75 3.42 +3.35
Project D - (34.09) (30.97) 37.55 34.15 +6.64
Project E (50) 22.73 (41.30) 37.55 34.15 +3.13
Project F (20) (9.09) 30.98 18.77 - +20.66
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The combination of projects, which will maximise the total NPV can now be
specified, where:
a = the proportion of Project A to be undertaken
b = the proportion of Project B to be undertaken
c = the proportion of Project C to be undertaken
d = the proportion of Project D to be undertaken
e = the proportion of Project E to be undertaken
f = the proportion of Project F to be undertaken
The objective function, which represents the maximum NPV that can be earned, is:
z = 21.90a + 14.22b + 3.35c + 6.64d + 3.13e + 20.66f
This is subject to the following constraints:
Year 0 : 25a + 25b + 12.5c + 50e + 20f 50
Year 1 : 50a + 25b + 37.5d + 10f 12.5 + 5c + 25e
Furthermore : 0 a, b, c, d, e, f 1
When solved, the linear programme will provide the proportions of each project
which should be undertaken in order to establish the value of z, which represents
the maximum NPV achievable in view of the limitation of available capital.
Notice that the first constraint relates to the limited capital available at Year 0. The
second constraint concerns the capital limitation at Year 1, which is of course eased
by the Project C and E cash inflows, which can also be used to fund investment
needs at that time.
The third constraint shows that each project can only be undertaken once and that
it is impossible to undertake a negative quantity of any project. This non-negative
rule is essential, since if it were excluded a computer model may well establish that
negative quantities of a project could make cash inflows available that would be
included within the solution!!
PV of dividends formulation
The combination of projects, which will maximise the PV of cash flows available for
dividends must be specified, where:
a = the proportion of Project A to be undertaken
b = the proportion of Project B to be undertaken
c = the proportion of Project C to be undertaken
d = the proportion of Project D to be undertaken
e = the proportion of Project E to be undertaken
f = the proportion of Project F to be undertaken
The objective function will be based upon the premise that:
z = the PV of dividends.
The dividend flows need to be defined for each year up to the point where the
investment with the longest life ceases in this case up to the end of Year 4 i.e.
d
0
= the dividend flow generated at Year 0 by the projects selected
d
1
= the dividend flow generated at Year 1 by the projects selected
d
2
= the dividend flow generated at Year 2 by the projects selected
d
3
= the dividend flow generated at Year 3 by the projects selected
d
4
= the dividend flow generated at Year 4 by the projects selected
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Therefore the objective function, which represents the present value of the
maximum dividends, discounted at the cost of capital of 10% is:
z = d
0
+
1 . 1
d
1
+
2
2
1 . 1
d
+
3
3
1 . 1
d
+
4
4
1 . 1
d

alternatively
z = d
0
+ 0.909 d
1
+ 0.826 d
2
+ 0.751 d
3
+ 0.683 d
4

This is subject to the following constraints:
Year 0 : 25a + 25b + 12.5c + 50e + 20f + d
0
50
Year 1 : 50a + 25b + 37.5d + 10f + d
1
12.5 + 5c + 25e
Year 2 : 37.5d + 50e + d
2
25a + 75b + 5c + 37.5f
Year 3 : d
3
50a + 5c + 50d + 50e + 25f
Year 4 : d
4
50a + 5c + 50d + 50e
Furthermore : 0 a, b, c, d, e, f 1
Additionally : d
0
, d
1
, d
2
, d
3
, d
4
0
When solved, the linear programme will provide the proportions of each project
which should be undertaken in order to establish the value of z, which represents
the maximum PV of dividends earned in view of the capital constraints.
With an NPV formulation, we only have constraints for the periods during which
capital rationing exists (in this instance, Years 0 and 1), whereas under the
dividend formulation we have a constraint for every year of potential project cash
flows (in this case, Years 0 to 4).
The available funds are the same as in the NPV formulation (i.e. available capital
together with cash inflows from the projects); however the dividend flow for each
period must also be included. Furthermore an additional non-negative constraint is
used, since the dividends must be greater than or equal to zero. If this constraint
were excluded, a computer model may specify negative dividend payments, which
make cash inflows available that could be used to finance more projects!!
One advantage of the PV of dividends formulation is that it removes the need to
even calculate the NPV of each investment opportunity, since the discounting
process is carried out by the linear programme as part of the calculation of the
solution.
Notice the only difference in the value of z in these formulations is as follows:
Under the NPV formulation, z provides the NPV of the project returns,
whereas
Under the PV of dividends formulation, z provides the PV of the project
returns.
Dual values
Dual values (also referred to as shadow prices) reflect the change in the objective
function as a result of having one more or one less unit of scarce resource. In the
context of capital rationing the scarce resource is available cash, so that the dual
price states the change in the objective function if one more unit of currency (e.g.
1) becomes available or if one less GB pound is invested.
Shadow prices can therefore be used to calculate the impact of raising additional
finance for further investment or the effect of diverting capital away from current
projects into newly discovered investments.
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The dual price depends upon which method is used to formulate the linear
programme i.e.
Under the NPV formulation, it reflects the change in the NPV if 1 more or
1 less is available
Under the PV of dividends formulation, it reflects the change in the PV of
cash available for dividend payments if 1 more or 1 less capital is available.
Dual prices relate only to marginal changes in the availability of capital. Thus,
suppose that a dual value of 1.25 arises under the PV of dividends method, this
means that if an additional 1 of funds became available, the total value of the
objective function would rise by 1.25. It does not necessarily mean that if an
additional 10,000 became available, that the value of the objective function would
increase by (10,000 x 1.25) 12,500.
Shadow prices can therefore be used to test the validity of new investments which
emerge. The cash flows generated by the new project can be compared with the
cash flows lost by diverting funds from existing investments, thereby calculating the
effect of diversion of that finance.
Example of the use of dual values in linear programming
Bruno Ltd is experiencing capital rationing during both Year 0 and Year 1 in relation
to a number of divisible projects. It has used linear programming to develop an
investment strategy over its three year planning horizon for dividend payments,
using a cost of capital of 10%.
Shadow prices have been calculated under the NPV formulation for the two years of
capital constraints and under the PV of dividends formulation for the three year
planning horizon. The dual prices per 1 of capital available are as follows:
NPV method PV of dividends method

Year 0 0.1 (1 + 0.1) = 1.1
Year 1 0.08 (0.909 + 0.08) = 0.989
Year 2 0 (0.826 + 0) = 0.826
A new investment opportunity has emerged with the following cash flows:
Cash flow
000
Year 0 (75)
Year 1 50
Year 2 50
Appraise the new project using both the NPV dual prices and the PV of dividend
shadow prices.
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Solution to example of the use of dual values in linear
programming
Appraisal using NPV dual values
The NPV of the new investment project is:
Year Cash flow
Discount
factor
Present value
000 @ 10% 000
0 (75) 1 (75)
1 50 0.909 45.45
2 50 0.826 41.3
NPV 11.75
The net dual value of the new investment project (i.e. the impact of diverting funds
from the current investment strategy) is:
Year Cash flow Shadow price Opportunity cost
000 000
0 (75) 0.1 (7.5)
1 50 0.08 4
2 50 0 - _
Net dual value (3.5)
Accordingly, the NPV of the current investment strategy would fall by 3,500 if the
new project were accepted. However, Bruno Ltd would benefit from the positive
NPV of that new investment opportunity. Therefore:
000
NPV of new project 11.75
Net dual value (3.5)
Net benefit of undertaking new project 8.25
This indicates that this project is worth further consideration, since if it were
accepted in full (and in doing so does not violate the marginality assumption of dual
values) it would result in the value of the objective function increasing by 8,250.
Appraisal using PV of dividends dual values
The net dual value of the new investment project (i.e. the impact of diverting funds
from the current investment strategy) is:
Year Cash flow Shadow price Opportunity cost
000 000
0 (75) 1.1 (82.5)
1 50 0.989 49.45
2 50 0.826 41.3
Net dual value (i.e. net benefit of undertaking new
project)
8.25
The two techniques will always provide the same result, but as can be seen the PV
of dividends dual prices technique is far quicker and simpler to solve.
Again, the project is worth considering; the linear programme should therefore be
reformulated (by including the new project) and then re-solved.
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Example of multi-period capital rationing using integer
programming
The management team of Toby Ltd has identified four indivisible projects, which
require funds to be invested over the next few years, as set out below:
Project A Project B Project C Project D

Year 0 17,500 22,500 - 12,500
Year 1 25,000 - 15,000 15,000
Year 2 10,000 30,000 20,000 17,500
The board of directors of that company has approved the following capital
expenditure programme for those same accounting periods:

Year 0 40,000
Year 1 35,000
Year 2 42,500
The four projects are expected to produce the following positive net present values:
Project A Project B Project C Project D
Project NPV +20,000 +27,500 +15,000 +10,000
You are required to discuss the approach for calculating the optimum mix
of projects.
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Multi-period capital rationing solution for indivisible projects
The problem is to identify that combination of investment projects which will
produce the highest possible total NPV (within the annual funding limitations).
For instance, if Projects C and D were undertaken, they would satisfy the annual
capital constraints, because the combined investment for Year 0 is 12,500, for
Year 1 is 30,000 and for Year 2 is 37,500, whilst achieving a total positive NPV of
25,000.
On the other hand, if Projects A and B were selected, they would also remain within
the annual capital limitations. The combined investment for Year 0 is 40,000, for
Year 1 is 25,000 and for Year 2 is 40,000, whilst achieving a total positive NPV of
47,500. This amount exceeds the NPV earned by the combination of Projects C
and D.
This problem can be solved by an integer programming formulation. The
procedures would be to establish the value of variables Y
A
, Y
B
, Y
C
and Y
D
for each of
the four projects, which maximise the total net present value i.e.
Maximise: 20,000 Y
A
+ 27,500 Y
B
+ 15,000 Y
C
+ 10,000 Y
D
Subject to three annual capital investment constraints:
Year 0 : 17,500 Y
A
+ 22,500 Y
B
+ 0 Y
C
+ 12,500 Y
D
40,000
Year 1 : 25,000 Y
A
+ 0 Y
B
+ 15,000 Y
C
+ 15,000 Y
D
35,000
Year 2 : 10,000 Y
A
+ 30,000 Y
B
+ 20,000 Y
C
+ 17,500 Y
D
42,500
The solution to the above problem would result in Y
A
= 1, Y
B
= 1, Y
C
= 0, Y
D
= 0.
In other words, both Project A and Project B would be selected, whilst the other two
projects would be rejected and the positive NPV of the entire investment strategy
would be 47,500.
Notice that the above solution is superior to the combination of Y
A
= 0, Y
B
= 0, Y
C

= 1, Y
D
= 1, since the combined positive NPV of Project C and Project D is only
25,000, as already stated.

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Chapter 3
Advanced
investment
appraisal section
2


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CHAPTER CONTENTS
MODIFIED INTERNAL RATE OF RETURN ------------------------------ 65
CALCULATING THE MIRR 65
FREE CASH FLOW -------------------------------------------------------- 68
DEFINITION OF FREE CASH FLOW 68
FREE CASH FLOW TO EQUITY 69
RISK AND UNCERTAINTY ----------------------------------------------- 74
SENSITIVITY ANALYSIS 74
PROBABILITY AND EXPECTED VALUES 75
MONTE CARLO SIMULATION 75
PROJECT VALUE AT RISK 76
DURATION ---------------------------------------------------------------- 78
GENTO LTD --------------------------------------------------------------- 80
HULME LTD --------------------------------------------------------------- 85
BAILEY PLC --------------------------------------------------------------- 91

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MODIFIED INTERNAL RATE OF RETURN
To assist in remedying some of the deficiencies of IRR, a technique called Modified
Internal Rate of Return (MIRR) has been developed. MIRR has certain advantages
in that it:
Eliminates the possibility of multiple internal rates of return.
Addresses the reinvestment rate issue i.e. it does not make the assumption
that the companys reinvestment rate is equal to whatever the project IRR
happens to be.
Provides rankings which are consistent with the NPV rule (which is not always
the case with IRR).
Provides a % rate of return for project evaluation. It is claimed that non-
financial managers prefer a % result to a monetary NPV amount, since a %
helps measure the headroom when negotiating with suppliers of funds.
Calculating the MIRR
The MIRR assumes a single outflow at time 0 and a single inflow at the end of the
final year of the project. The procedures are as follows:
Convert all investment phase outlays as a single equivalent payment at time
0. Where necessary, any investment phase outlays arising after time 0 must
be discounted back to time 0 using the companys cost of capital.
All net cash flows generated by the project after the initial investment (i.e. the
return phase cash flows) are converted to a single net equivalent terminal
receipt at the end of the projects life, assuming a reinvestment rate equal to
the companys cost of capital.
The MIRR can then be calculated employing one of a number of methods, as
illustrated in the following example.
Example
Carter plc is considering an investment in a project, which requires an immediate
payment of 15,000, followed by a further investment of 5,400 at the end of the
first year. The subsequent return phase net cash inflows are expected to arise at
the end of the following years:
Net cash inflows
Year
1 6,500
2 7,750
3 5,750
4 4,750
5 3,750
You are required to calculate the modified internal rate of return of this
project assuming a reinvestment rate equal to the companys cost of
capital of 8%.
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Solution
Single equivalent payment discounted to year 0 at an 8% discount rate:
Year
0 15,000
1 (5,400 x 0.926) _5,000
Present Value (PV) of investment phase cash flows 20,000
Single net equivalent receipt at the end of year 5, using an 8% compound rate:
Year 8% compound factors
1 6,500 1.3605 8,843
2 7,750 1.2597 9,763
3 5,750 1.1664 6,707
4 4,750 1.08 5,130
5 3,750 1 3,750
Terminal Value (TV) of return phase cash flows 34,193
The above compound factors are produced with a calculator.
A five year PV factor can now be established i.e.(20,000 34,193) = 0.585
Using present value tables, this 5 year factor falls between the factors for 11% and
12% i.e. 0.593 and 0.567. Using linear interpolation:
MIRR = 11% +
0.567) - (0.593
0.585) - 0.593 (
x (12% - 11%) = 11.3%
Alternatively, the MIRR may be calculated as follows;
MIRR =
000 , 20
193 , 34
5
1 = 11.3%
Furthermore, in examples where the PV of return phase net cash flows has already
been calculated, there is yet another formula for computing MIRR (which is given
on the ACCA formulae sheet). This formula avoids having to establish the Terminal
Value of those return phase net cash flows i.e.
PV of return phase net cash flows
(6,500 x 0.926) + (7,750 x 0.857) + (5,750 x 0.794) + (4,750 x 0.735) + (3,750 x
0.681) = 23,271
MIRR = 1 - 1.08
000 , 20
271 , 23
5
|
|

\
|
= 11.3%
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The reservations which are often cited concerning the MIRR technique include:
In what are claimed to be the very exceptional circumstances where the
reinvestment rate exceeds the companys cost of capital, the MIRR will
underestimate the projects true rate of return.
The determination of the life of a project can have a significant effect on the
actual MIRR, if the difference between the projects IRR and the companys
cost of capital is large.
Like IRR, the MIRR is biased towards projects with short payback periods and
large initial cash inflows.
The extent to which this method is being used in industry is unclear and only
time will tell whether it eventually becomes popular.
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FREE CASH FLOW

Definition of free cash flow
Free cash flow is cash that is not retained and reinvested in the business.
Unfortunately, there is dispute as to what is included within free cash flow, as can
be seen from the following typical definitions:
1. The free cash flow to the company is the cash flow derived from operations,
after adjustment for working capital changes, for investment and for taxes
and it represents the funds available for distribution to the providers of
capital, i.e. shareholders and lenders.
2. Free cash flow is the cash flow available to a company from operations after
tax, any changes in working capital and capital spending on assets needed to
continue existing operations (i.e. replacement capital expenditure equivalent
to economic depreciation).
As can be seen, the main difference between the two definitions is whether or not
to deduct capital expenditure required to expand operations. Throughout these
notes the treatment will be varied as a reminder of the inconsistency. In addition,
some authorities suggest that no adjustment is made for working capital changes in
respect of short-term measures of free cash flow.
Example
Hawthorns plc has earnings before interest and tax of 225,000 for the current
year. Depreciation charges for the year have been 15,000 and working capital
has increased by 2,500. The company needs to invest 22,500 to acquire non-
current assets. Profits are subject to taxation @ 30% p.a.
Calculate free cash flow.
Solution

EBIT 225,000
Less: Corporation tax @ 30% (67,500)
157,500
Add back: Depreciation (non-cash amount) 15,000
Deduct: Capital expenditure (22,500)
Working capital increases (2,500)
Free cash flow 147,500
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Free cash flow to equity
The dividend capacity of a company is measured by its free cash flow to equity.
Free cash flow to equity can be calculated by establishing the free cash flow
described above, and then:
Deducting any interest payments and any loan repayments; and
Adding any cash inflows arising from the issue of debt.
Free cash flow to equity is thought by some authorities to provide a superior
measure of dividend cover i.e.

Example
The following data relates to Molineux Ltd:
Forecast Income statement for 2010
m
Revenue 1,950.00
Cost of sales (1,314.00)
Gross profit 636.00
Operating expenses (322.50)
Earnings before interest and tax 313.50
Interest charges (24.00)
Profit before tax 289.50
Corporation tax(@ 35%) (101.32)
Profit after tax 188.18
During the year loan repayments are expected to amount to 69 million,
depreciation charges to 30 million and capital expenditure to 60 million.
You are required to calculate:
(a) Free cash flow;
(b) Free cash flow to equity.
Dividend cover (in terms of free cash flow)
Free cash flow to equity
Dividends paid
=
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Solution
(a) Free cash flow
m
EBIT 313.50
Less: Corporation tax (@ 35% thereon) (109.72)
203.78
Add back: Depreciation (non-cash amount) 30.00
Deduct: Capital expenditure (60.00)
Free cash flow 173.78
(b) Free cash flow to equity
Method One
m
Free cash flow (as above) 173.78
Deduct: Loan repayments (69.00)
Interest charges, net of tax [24m x (1 0.35)] (15.60)
Free cash flow to equity 89.18
Method Two
m
Profit after tax 188.18
Add back: Depreciation (non-cash amount) 30.00
Deduct: Capital expenditure (60.00)
Loan repayments (69.00)
Free cash flow to equity 89.18
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Example
The following information relates to the forecasts of Bescot plc for the forthcoming
year:
000
Capital expenditure for expansion 100
Capital expenditure to replace existing non-current assets 240
Depreciation charges 300
Amounts raised from fresh bond issue 120
Increase in working capital 220
Interest paid 40
Repayment of loans 60
Profit from operations 1,880
Corporation tax paid (@ 30%) 552
Ordinary share capital (@ 25p par value) 1,840
Dividend paid for the year is expected to be 5p per share
You are required to calculate:
(a) Free cash flow;
(b) Free cash flow to equity;
(c) Dividend cover based upon free cash flow to equity.
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Solution
(a) Free cash flow
000
Profit from operations (EBIT) 1,880
Deduct: Corporation tax (@ 30% thereon) (564)
1,316
Add back: Depreciation (non-cash amount) 300
Deduct: Capital expenditure to replace existing non-current assets (240)
Capital expenditure for expansion (ARGUABLY, THIS SHOULD NOT
BE DEDUCTED IN ARRIVING AT FREE CASH FLOW)
(100)
Increase in working capital (220)
Free cash flow 1,056
(b) Free cash flow to equity
Method One
000
Free cash flow (as above) 1,056
Deduct: Loan repayments (60)
Interest charges, net of tax [40,000 x (1 0.3)] (28)
Add: Proceeds of bond issue 120
Free cash flow to equity 1,088
Method Two
000
EBIT 1,880
Interest charges (40)
Corporation tax (552)
Profit after tax (i.e. Earnings after interest and tax) 1,288
Add back: Depreciation (non-cash amount) 300
Deduct: Increase in working capital (220)
Capital expenditure [240,000 + 100,000] (340)
Loan repayments (60)
Add: Amounts raised from bond issue 120
Free cash flow to equity 1,088
(c) Dividend cover

ie, =
000 , 368
000 , 288 , 1
= 3.5 times
WORKING:
Dividends for the year:
Number of shares in issue =
25 . 0
1,840,000
= 7,360,000
Dividends for the year = 7,360,000 x 0.05 = 368,000
The normal dividend cover calculation is:
Earnings after interest and tax
Dividends for the year

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The above result is thought by some authorities to be misleading, since it is
cash (and not earnings) that is used to pay dividends. Therefore, dividend
cover based upon free cash flow to equity may be used, as follows:

ie =
000 , 368
000 , 088 , 1
= 2.96 times
This would be considered a satisfactory level of assurance for ordinary
shareholders.
Dividend cover (in terms of free cash flow)
Free cash flow to equity
Dividends paid
=
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RISK AND UNCERTAINTY
Risk occurs where there are several possible outcomes for each component of a
decision and probabilities can be assigned for each possible outcome. This allows
for the calculation of an expected value based upon the probability of each
outcome.
Uncertainty occurs where there are several possible outcomes, but the probability
attaching to each cannot be established.
Sensitivity analysis
A technique which assesses the effect on an overall decision if a single constituent
variable were to change i.e. how sensitive is the investment decision to a change in
a single aspect (e.g. sales revenue, material price, project life, etc). This allows for
the consideration of a range of possible outcomes. Sadly the technique does not
take into account the interdependence of the variables i.e. the technique ignores
the interaction of the constituent variables.
Procedure
Firstly, calculate the expected NPV, using the best estimates available.
Then, calculate for each input factor (e.g. initial investment, sales price, wage rate,
discount rate, residual value, etc) the necessary percentage change which would
cause the NPV to become zero.
To find the percentage change required to achieve an NPV of zero, the calculation is
as follows:
% change = 100
variable the by affected flows cash of PV
project of NPV

Illustration
An expected NPV has already been calculated for the following project:
Year Cash flow 10% discount factor Present value
000 000
0 Initial investment (100) 1 (100.00)
1-3 Revenues 40 2.487 99.48
3 Scrap value 10 0.751 7.51
NPV +6.99

From these results, the sensitivity to each variable, which would create an NPV of 0
is:
Initial investment:
100
99 . 6

x 100 = an increase of 7%
Annual revenues:
48 . 99
99 . 6

x 100 = a decrease of 7%
Scrap value:
51 . 7
99 . 6

x 100 = a decrease of 93%
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Discount factor: (this requires the calculation of the IRR, since this would cause the
NPV to be 0. The IRR is, of course, established by trial and error),
ie:
Year Cash flow Try 13% Try 14%
000 DF 000 DF 000
0 (100) 1 (100) 1 (100)
1-3 40 2.361 94.44 2.322 92.88
3 10 0.693 6.93 0.675 6.75
NPV +1.37 -0.37
IRR = 13% + ( ) % 13 % 14
37 . 0 37 . 1
37 . 1

+
= 13.79%
Cost of capital will have to increase by 37.9% (i.e. from 10% to 13.79%) for an
NPV of 0 to arise.
Project life: Clearly if the project life were for a shorter period than 3 years an NPV
of 0 would at some point arise. Accurate calculations are in this case not possible,
since at a life of less than 3 years, the scrap value would be greater, but the precise
amount is unknown.
Probability and expected values
A probability distribution of expected cash flows could be estimated and used to
calculate the expected value of the NPV and measure risk (normally the standard
deviation of that NPV). This aspect will be demonstrated during the lectures
dealing with Project Value at Risk (VAR) and the Capital Asset Pricing Model
(CAPM).
This expected value is unlikely to be the same amount as one of the specific
outcomes, since it is based upon a weighted average calculation. Whilst the
expected value is simple to calculate and easy to understand, it does suffer from
the following limitations:
Probabilities usually have to be estimated and therefore may be inaccurate or
unreliable;
Expected values are long-term averages, which assume repetition of the task
and may clearly be inappropriate for one-off projects;
Does not take into account the decision makers attitude to risk think of a
banker!;
May not take into account the time value of money.
Monte Carlo simulation
Sensitivity analysis assesses the effect on an overall decision if a single constituent
variable were to change. Monte Carlo simulation is a mathematical model which
will include all combinations of the potential variables associated with the project. It
results in the creation of a distribution curve of all possible cash flows which could
arise from the investment and allows for the probability of the different outcomes
to be calculated. The steps involved are as follows:
1. Specify all major variables
2. Specify the relationship between those variables
3. Using a probability distribution, simulate each environment.
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The advantage of this technique is it includes all foreseeable outcomes. The
disadvantages are the difficulty in formulating the probability distribution and the
model becoming very complex.
Project value at risk
Value at risk (VaR) is the value which can be attached to the downside of a value or
price distribution of known standard deviation and within a given confidence level.
VaR and related measures give an indication of the potential loss in monetary value
which is likely to occur with a given level of confidence. The setting of the
confidence level is necessary because in principle, if a price distribution is normally
distributed for example, the downside loss is potentially infinite.
Confidence levels are often set at either 95% (in which case the VaR will provide
the amount that has only a 5% chance of decline) or at 99% (when the VaR
considers a 1% chance of loss of value).
Example
Andrews plc estimates the expected NPV of a project to be 100 million, with a
standard deviation of 9.7 million.
Establish the value at risk using both a 95% and also a 99% confidence
level.
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Solution
Using Z =

- X
and establishing Z from the normal distribution tables i.e. at a
95% confidence level, 1.65 is the value for a one tailed 5% probability of decline
(i.e. 0.4505) and at a 99% confidence level, 2.33 is the value for a one tailed 1%
probability of loss of NPV (i.e.0.4901).
At 95% confidence level, Z =
9.7
100 - X
= 1.65;
therefore X = (9.7 x 1.65) + 100 = 84.
At 99% confidence level, Z =
9.7
100 - X
= 2.33;
therefore X = (9.7 x 2.33) + 100 = 77.4.
There is a 5% chance of the expected NPV falling to 84 million or less and a 1%
probability of it falling to 77.4 million or below.
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DURATION
Duration is the average time taken to recover the cash flows on an investment.
The average is taken as the value weighted average of the number of the year (1 to
n) in which the cash flows arise. In capital investment, the duration can be
calculated using either the firms original outlay, or the present value of its future
cash flows as the basis for the annual weighting.
If duration is based upon the average time to recover the initial capital investment:
1. Calculate the value of each future net cash flow, discounted at the IRR of the
project;
2. Calculate each years discounted cash flow as a proportion of the original
capital outlay;
3. Take the time from investment to each discounted cash flow and multiply by
the respective proportion. Finally, sum the weighted year values.
If duration is based upon the average time taken to recover the present value of
the project:
1. Calculate the value of each future net cash flow, discounted at the chosen
hurdle rate;
2. Calculate each years discounted cash flow as a proportion of the PV of total
cash inflows;
3. Take the time from investment to each discounted cash flow and multiply by
the respective proportion. Finally, sum the weighted year values.
Example
The forecast cash flows relating to a proposed project are:
Year 0 1 2 3 4
Incremental cash flows (34,000) 7,600 16,500 13,000 6,600
Establish both the duration to recover the original investment (using the IRR of this
project of 11.13%) and the duration to recover the present value of the project (at
an 8% hurdle rate).
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Solution
Duration taken to recover the original investment
Year 1 2 3 4
1. Discount cash inflows @ 11.13% 6,839 13,361 9,473 4,327
2. Proportion of initial outlay (34,000) 0.201 0.393 0.279 0.127
3. Proportion multiplied by year number 0.201 0.786 0.837 0.508
Finally, sum these to provide the duration i.e. on average the company will take
2.332 years to recover the initial investment i.e. an indication of project
uncertainty (see below).
Duration taken to recover the present value of the project
Year 1 2 3 4
1. Discount cash inflows @ 8% 7,037 14,146 10,320 4,851
2. Proportion of project PV (36,354) 0.194 0.389 0.284 0.133
3. Proportion multiplied by year number 0.194 0.778 0.852 0.532
Finally, sum these to provide the duration i.e. on average the company will take
2.356 years to recover half the present value of the project i.e. a different
indication of project uncertainty. The longer the duration, the greater the
uncertainty attaching to future returns!!
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Gento Ltd
Gento Ltd has been invited to make a tender for a contract to manufacture six
special processing machines. Manufacture would take a total of three years,
commencing immediately (1st August 2005), and the contract price would be
payable in two equal instalments, the first on 1st August 2005 and the second on
31st July 2008. The company would manufacture two machines each year.
The following estimates are available about the resources required to produce the
special processing machines:
(1) Materials
Type of
material
Quantity
per
machine
Amount in
stock now
Original
cost of
stock per
ton
Current
purchase
price per
ton
Current
realisable
value per
per ton
tons tons
Gamma 20 60 700 1,000 800
Zeta 10 20 500 750 see below
Gamma is used regularly by the company on many contracts. Zeta is used
rarely and if the existing stock is not applied to this contract it will have to be
disposed of immediately at a net cost of 100 per ton. Materials required for
the contract must be purchased and paid for annually in advance.
Replacement costs of Gamma and Zeta and the realisable value of Gamma
are expected to increase at an annual compound rate of 20%.
(2) Labour
Each of six machines will require 3,000 hours of skilled labour and 5,000 hours
of unskilled labour. Current wage rates are 4 per hour for skilled labour and
3 per hour for unskilled labour.
Gento Ltd expects to suffer a shortage of skilled labour during the year to 31st
July 2006 so that acceptance of the contract would make it necessary to give
up other work on which a contribution of 7 per hour, net of skilled labour
costs, would be earned. (The other work would require no unskilled labour).
For the year to 31st July 2006 only, the company expects to have 20,000
surplus unskilled labour hours. Gento Ltd has an agreement with its labour
force whereby it lays off employees for whom there is no work and pays them
two-thirds of their normal wages during the layoff period.
All wage rates are expected to increase at an annual compound rate of 15%.
(3) Overheads
Overhead costs are currently allocated to contracts at a rate of 14 per skilled
labour hour, calculated as follows:

Fixed overheads (including equipment depreciation of 5) 11.00
Variable overheads 3.00
14.00
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Special equipment will be required for this contract, and will be purchased on 1st
August 2005 at a cost of 200,000 payable immediately. It will be sold on 31st
July 2008 for 50,000. Both fixed and variable overheads are expected to increase
in line with the Retail Price Index.
Gento Ltd has a cost of capital of 20% per annum in money terms. The Retail Price
Index is expected to increase in the future at an annual compound rate of 15%.
Assume that all payments will arise on the last day of the year to which they relate
except where otherwise stated. Assume also that input prices will change annually
at midnight on 31st July.
You are required to:
(a) Calculate the minimum price at which Gento Ltd should be willing to
undertake the contract to manufacture the six special processing machines
based on the information given above.
(b) Provide brief explanations of the figures you have used, and
(c) Comment on other factors, not reflected in your calculations, which may affect
the minimum acceptable price.

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Gento Ltd solution
(a) Calculation of minimum price
Present value of costs
Date 1.8.05 31.7.06 31.7.07 31.7.08
Year 0 1 2 3
Reference to workings
000 000 000 000
Equipment (200) - - 50
Materials
Gamma 1 (40) (48) (57.6) -
Zeta 2 2 (18) (21.6) -
Labour
Skilled 3 - (66) (27.6) (31.74)
Unskilled 4 - (10) (34.5) (39.67)
Variable
overheads

5

-

(18)

(20.7)

(23.81)
Net cash
outflows
(238) (160) (162.0) (45.22)
Money
Discount Factor
20%

1.0 0.833 0.694 0.579
(238) (133.28) (112.43) (26.18)
Total PV of costs = (509.89)
The minimum contract price will be such that the PV of the cash received just
covers the total PV of the costs, i.e. 509,890.
If X = Total price paid
2
X
will be received on 1.8.05 (Year 0) and
2
X
on 31.7.08 (year 3)
The PV of these cash inflows will be
2
X
+
2
X 579 . 0
= 0.7895X
For the minimum price therefore
0.7895X = 509,890
X = 645,839
The minimum total contract price is 645,839
WORKINGS
(1) Material Gamma
2 machines p.a. each requiring 20 tons at current price.
Cost for 2006 = 2 x 20 x 1,000 = 40,000 (paid in advance Year 0)
2007 = 40,000 x 1.20 = 48,000 (Year 1)
2008 = 40,000 x (1.20)
2
= 57,600 (Year 2)
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(2) Material Zeta
2 machines p.a. requiring 10 tons each.
Costs for 2006
20 tons used from stock produce a cost saving of 20 x 100 = 2,000
(Year 0)
Costs for 2007 = 20 x 750 x 1.20 = 18,000 (Year 1)
2008 = 20 x 750 x (1.20)
2
= 21,600 (Year 2)
(3) Skilled Labour
Annual requirement = 2 x 3,000 hours = 6,000 hours.
Year 1 6,000 hours at opportunity cost (4 + 7) = 66,000
Year 2 6,000 hours at normal wage rate 6,000 x 4 x
1.15 = 27,600
Year 3 6,000 x 4 x (1.15)
2
= 31,740
(4) Unskilled Labour
Annual requirement 2 x 5,000 hours = 10,000 hours.
Year 1 only: 20,000 surplus hours
Extra wages payable for 10,000 hours worked = 10,000 x 3 x 1/3 =
10,000
Year 2 10,000 x 3 x 1.15 = 34,500
Year 3 10,000 x 3 x 1.15
2
= 39,675.
(5) Variable Overheads
6,000 x 3 p.a. = 18,000 p.a. rising by 15%.
(b) Brief explanation of the figures used
(1) General approach
The general approach is to estimate the relevant money cash flows
associated with each cost, that is the cash flows after allowing for
expected rates of inflation. These cash flows are then discounted at the
money cost of capital which contains an element of inflation.
(2) Material Gamma
This material is used on many contracts. The extra requirement on this
contract will therefore be met by purchasing extra material at current
replacement cost.
(3) Material Zeta
If existing stock is not applied to this contract, it will have to be disposed
of immediately at a net cost of 100 per ton. The 20 tons now in stock
will therefore be valued as a cash inflow of 100 per ton, because the
use of this material will actually produce cost savings to the organisation
as a whole.
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(4) Skilled Labour
In year one the use of skilled labour does not in fact produce any extra
cash outlay on labour, because the men would be employed on other
work if this contract was not accepted. However the use of skilled
labour on this contract means that revenues from the other work are
lost. The measure of this loss is 7 contribution per skilled labour hour,
but since this contribution is after deducting 4 per hour for labour, the
total relevant opportunity cost per hour is 7 + 4 = 11.
(5) Unskilled Labour
In year one the incremental cost to the organisation is the payment of
the remaining one-third of normal wage rates for 10,000 hours to the
men who are at present laid off.
(6) Overheads
It is assumed that fixed overheads will be unchanged as a result of the
decision. Accordingly, only variable overheads are relevant costs.
(c) Discussion of other factors affecting the minimum acceptable price
(1) It has been assumed that all estimates of cash flows, inflation rates etc
can be made with certainty. This is unrealistic. Allowance for
uncertainty can be incorporated into the appraisal in various ways. An
assessment can be made of the sensitivity of the project to a number
of variables (e.g. price level changes). Alternatively several estimates
can be made for each variable and subjective probabilities attached
to each with a view to quantifying the uncertainty.
(2) The relationship between the risk characteristics of the project and
the present portfolio of projects being undertaken by Gento Ltd must be
taken into account with a view to a possible reduction in the overall risk
of the firm.
(3) Taxation should be included in the analysis to obtain a realistic
minimum price.
(4) The availability of working capital to finance the project has been
assumed. The first instalment received at 1st August 2005 will cover
the cost of the equipment and materials required at this date but extra
cash will be required in Years 1 and 2.
(5) This project must be appraised in relation to any other alternatives
which might be available in competition for the scarce resources of the
firm.
(6) The effect of accepting the project on future trading should be
considered, particularly in two respects:
(i) the possibility of losing future trade from present customers
perhaps affected by the transfer of the skilled labour.
(ii) the desirability of influencing the proposed customer on the
present contract, by offering a lower tender, in the hope of
obtaining more lucrative contracts later.
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Hulme Ltd
Hulme Ltd is considering the manufacture of a new product, the Champ, to add to
its existing range. Manufacture would commence on 1 January 2007 and 100,000
Champs would be produced and sold each year for three years. The directors of
Hulme Ltd expect to be able to charge a price of 6 per Champ during 2007 and to
increase the price during 2008 and 2009 in line with increases in the Retail Price
Index. The Index is expected to increase in the future at an annual compound rate
of 10%.
The following costs are involved in producing Champs.
Labour. Each Champ requires hour of skilled labour and hour of unskilled
labour (1 January 2007) wage rates are 3 per hour for skilled labour and 2 per
hour for unskilled labour. For 2007 only Hulme Ltd expects to have 100,000
surplus hours of unskilled labour. Whether or not Champs are manufactured, the
employees concerned will be retained and paid by the company. All labour costs
are expected to increase at an annual compound rate of 20%.
Materials. Each Champ requires 2kgs of Alpha and 1 kg of Beta. Hulme Ltd
currently holds in stock 200,000 kgs of Alpha and 100,000 kgs of Beta. The stock
of Alpha originally cost 0.40 per kg and has a current realisable value of 0.30 per
kg. The current buying price is 0.50 per kg. The stock of Beta originally cost
0.80 per kg and has a current realisable value of 0.90 per kg. The current
buying price is 1.10 per kg. Alpha is used regularly by the company on many
products. Beta is used rarely and the only use for the existing stock, if it is not
applied to the manufacture of Champs, is to sell it immediately.
Materials required to manufacture Champs must be purchased and paid for
annually in advance. Replacement costs and realisable values of Alpha and Beta
are expected to increase at an annual compound rate of 10%.
Overheads. It is the policy of the company to allocate all overhead costs to its
various products. The calculated overhead cost per unit for Champs, at current
price, is as follows:

Allocated head office fixed costs (rent, rates, administration, etc) 0.70
Depreciation 30,000 100,000 0.30
Variable overheads 0.50
1.50
Head office costs and variable overheads are expected to increase in line with the
Retail Price Index. The machine required to manufacture Champs was bought
some years ago. Its current book value is 90,000, and the above depreciation
charge is based on a remaining life of three years at the end of which the machine
will have no scrap or re-sale value. If it is not used to produce Champs the
machine will be sold immediately for 150,000.
Hulme Ltd has a cost of capital of 20% per annum in money terms.
Assume that all receipts and payments (except costs of materials and machine sale
proceeds) will arise on the last day of the year to which they relate.
Assume also that input prices will change annually on 31 December.
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Requirements
(a) Prepare calculations showing whether Hulme Ltd should undertake production
of the Champ.
(b) Provide brief explanations of the figures you have used.
(c) Comment on factors which are not included in your calculations but which
may affect the decision.
Ignore taxation.
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Hulme Ltd solution
(a) Cash flows resulting from manufacture and sale of champs

Ref. to
Workings
Time 0 Time 1 Time 2 Time 3
000 000 000 000
Machine (150) - - -
Labour (1) - (75) (210) (252)
Materials
Alpha (2) (100) (110) (121) -
Beta (3) (90) (121) (133) -
Overheads (4) - (50) (55) (61)
Total outflows (340) (356) (519) (313)
Sales (5) - 600 660 726
Net inflow/(outflow) (340) 244 141 413

20% discount factor 1.000 0.833 0.694 0.579

Present value (340) 203 98 239
Net present value = +200,000
On the basis of the estimates given, production of Champs is worthwhile.
Note Time 0 is taken to be the date on which manufacture would
commence, i.e. 1 January 2007; time 1 is 31 December 2007, etc
WORKINGS
For explanations of the figures used, see part (b)
(1) Labour cost
Year 1 Skilled 25,000 hours @ 3 75,000
Unskilled No cost incurred
75,000
Year 2 Skilled 25,000 x (3 x 1.2) 90,000
Unskilled 50,000 x (2 x 1.2) 120,000
210,000
Year 3 Year 2 cost x 1.2 252,000
(2) Material Alpha
Current buying price is 50p per kg, rising at 10% per annum.
Time 0 cost 50p x 200,000 = 100,000
Time 1 cost 100,000 x 1.1 = 110,000
Time 2 cost 110,000 x 1.1 = 121,000
(3) Material Beta
Quantity held is enough for one year
Time 0 realisable value 100,000 x 90p = 90,000
Time 1 buying price 100,000 x 1.10 x 1.1 = 121,000
Time 2 buying price 121,000 x 1.1 = 133,100
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(4) Overheads
The only relevant cost are variable overheads, which rise at 10% per
annum.
Year 1 cost 100,000 x 50p = 50,000
Year 2 cost 50,000 x 1.1 = 55,000
Year 3 cost 55,000 x 1.1 = 60,500
(5) Sales
The selling price rises at 10% per annum
Year 1 100,000 x 6 = 600,000
Year 2 600,000 x 1.1 = 660,000
Year 3 660,000 x 1.1 = 726,000
(b) Brief explanations of figures used
(1) Machine
Although the machine is owned already, it has an opportunity cost if
used on this project, which is the revenue foregone if it is not sold now
for 150,000.
(2) Labour
In the first year of the project the company will have to pay for extra
skilled labour only, as there is enough surplus unskilled labour to cover
the necessary 50,000 hours on the project. As this unskilled labour is
paid whether or not the Champs are produced, there is no relevant
unskilled labour cost in year 1 of the project.
In years 2 and 3 of the project the company will have to pay for extra
skilled and unskilled labour.
(3) Material Alpha
Alpha is used regularly by the company on many projects. If existing
stocks are used to manufacture Champs, the company will have to buy
in more stocks of Alpha for its other projects. The relevant cost of Alpha
is thus always its buying price, which is expected to rise by 10% per
annum.
(4) Material Beta
Present stocks of Beta are sufficient for the first years production of
Champs. Since there is no alternative use for Beta within the company,
the opportunity cost of existing stocks is the realisable value of 90p per
kg.
After one year present stocks will be exhausted, and the relevant cost of
further supplies of Beta will be the buying price.
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(5) Overheads
Fixed costs allocated from head office will be irrelevant to this decision
as they will be incurred whether or not Champs are produced.
Depreciation is irrelevant to a project appraisal based on cash flows.
The only relevant cost is, therefore, the variable overhead.
(c) Factors not included in the calculations which may affect the decision
(i) Availability of more profitable projects
The project has been appraised in its own right, but it should be
compared with alternative uses for the funds employed, particularly if
there are constraints on capital or other resources.
(ii) Scarcity of resources
The calculations assume that there is no scarcity in supply of the
resources used on the project, e.g. that sufficient supplies of Alpha or
skilled labour are available at the prices stated and that the use of them
will not affect the quantities available for the companys normal
operations. If there is a scarcity in supply, the opportunity cost of these
resources will include the lost contribution through not using the
resources on alternative projects.
(iii) Risk and uncertainty of estimates
Most of the figures used in the project appraisal are subject to
uncertainty. The decisions might be affected by revised estimates of the
following:
(1) The sales price/sales volume relationship. Marketing of the Champ
may encourage others to compete with the new product, leading to
reduced sales, or to reduced selling price, or to a combination of
the two.
(2) The rate of inflation, which could lead to revised forecasts for costs
and the cost of capital.
(3) The length of the project
(4) Whether head office fixed costs would be unaltered by the new
project. In practice, the addition of a new line is likely to increase
fixed costs. Additional staff may be employed in accounts,
despatch or stores (for example) not directly connected with the
new product line, but ultimately resulting from the increased
turnover. The need for additional storage area may require the
utilisation of space which could otherwise have been sub-let. If so,
the rental income foregone would be treated as a relevant cash
outflow.
Other more general possibilities, such as a change of government or a
change in fiscal policy, may affect the profitability of the project.
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(iv) Management and labour skills
The calculation assumes that the necessary skills exist for this new
project or that they can be quickly acquired without any initial problems.
In practice this would be a major factor in the decision.
(v) Technological change
Changing technology may render the Champ obsolete before the end of
three years.
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Bailey plc
Bailey plc is developing a new product, the Oakman, to replace an established
product, the Shepard, which the company has marketed successfully for a number
of years. Production of the Shepard will cease in one year whether or not the
Oakman is manufactured. Bailey plc has recently spent 75,000 on research and
development relating to the Oakman. Production of the Oakman can start in one
years time.
Demand for the Oakman is expected to be 5,000 units per annum for the first three
years of production and 2,500 units per annum for the subsequent two years. The
products total life is expected to be five years.
Estimated unit revenues and costs for the Oakman, at current prices, are as
follows.

Selling price per unit 35.00
Costs per unit
Materials and other consumables 8.00
Labour (see (1) below) 6.00
Machine depreciation and overhaul (see (2) below) 12.50
Other overheads (see (3) below) _9.00
35.50
Loss per unit 0.50
(1) Each Oakman requires two hours of labour, paid 3 per hour at current prices.
The labour force required to produce Oakmans comprises six employees, who
are at present employed to produce Shepards. If the Oakman is not
produced, these employees will be made redundant when production of the
Shepard ceases. If the Oakman is produced, three of the employees will be
made redundant at the end of the third year of its life, when demand halves,
but the company expects to be able to find work for the remaining three
employees at the end of the Oakmans five year life. Any employee who is
made redundant will receive a redundancy payment equivalent to 1,000
hours wages, based on the most recent wage rate at the time of the
redundancy.
(2) A special machine will be required to produce the Oakman. It will be
purchased in one years time (just before production begins). The current
price of the machine is 190,000. It is expected to last for five years and to
have no scrap or resale value at the end of that time. A major overhaul of the
machine will be necessary at the end of the second year of its life. At current
prices the overhaul will cost 60,000. As the machine will not produce the
same quantity of Oakmans each year, the directors of Bailey plc have decided
to spread its original cost and the cost of the overhaul equally between all
Oakmans expected to be produced (i.e. 20,000 units). Hence the combined
charge per unit for depreciation and overhaul is 12.50 [(190,000 + 60,000)
20,000 units].
(3) Other overheads at current prices comprise variable overheads of 4.00 per
unit and head office fixed costs of 5.00 per unit, recovered on the basis of
labour time.
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All wage rates are expected to increase at an annual compound rate of 15%. The
selling price per unit and all costs other than labour are expected to increase in line
with the Retail Price Index. The Index is expected to increase in the future at an
annual compound rate of 10%.
Corporation tax at 35% on net cash income is payable in full one year after the
income arises. 25% writing down tax allowances are available on the machine.
Bailey plc has a money cost of capital, net of corporation tax, of 20% per annum.
Assume that all receipts and payments will arise on the last day of the year to
which they relate. Assume also that all current prices given above have been
operative for one year and are due to change shortly. Subsequently all prices will
change annually.
Requirements:
(a) Prepare calculations, with explanations, showing whether Bailey plc should
undertake production of the Oakman.
(b) Discuss the particular investment appraisal problems created by the existence
of high rates of inflation.
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Bailey plc solution
(a) Investment appraisal of production of Oakmans
Year 1 2 3 4 5 6 7

Contribution before
labour costs 139,150 153,065 168,371 92,604 101,865
Labour cost (39,675) (45,626) (52,470) (30,170) (34,696)
Redundancy
payments (15,741)
Redundancy
payments avoided 20,700
Machine overhaul (79,860)
_____ ______ ______ ______ _____ ______ ______
20,700 99,475 27,579 100,160 62,434 67,169
Tax at 35% (7,245) (34,816) (9,653) (35,056) (21,852) (23,509)
Cost of machine (209,000)
Tax saved on
WDAs ______ 18,288 13,716 10,287 7,715 5,786 17,359
Net cash flows (188,300) 110,518 6,479 100,794 35,093 51,103 (6,150)

20% factors 0.833 0.694 0.579 0.482 0.402 0.335 0.279

Present value (156,854) 76,699 3,751 48,583 14,107 17,120 (1,716)
Net present value = +1,690
Conclusion
Bailey plc should, on the basis of the positive net present value, undertake
production of the Oakman. However, the decision is fairly marginal, and the
estimate of all variables should be carefully reviewed to ensure that the
decision to produce is the correct one.
Explanatory notes
If the current date (per question) is taken as year 0, production will
commence and the machine will be purchased one year later at the end of
year 1. Revenue and costs will arise initially during year 2. Current (year 0)
prices are due to change shortly and therefore two price increases will occur
before the start of production (year 0 and year 1 increases).
(1) Contribution from sales before labour costs
These cash flows have been grouped as they all inflate at 10% per
annum. At current values the cash flow per unit is as follows:

Sales price 35
Material and other consumables (8) (It is assumed that there is
no change in head office
fixed costs if Oakman is
produced)
Variable overheads (4)
Net contribution before labour
costs 23

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Year Production units Contribution before labour costs
Unit/ Total/
2 5,000 23 x (1.1)
2
139,150
3 5,000 23 x (1.1)
3
153,065
4 5,000 23 x (1.1)
4
168,371
5 2,500 23 x (1.1)
5
92,604
6 2,500 23 x (1.1)
6
101,865
(2) Labour cost
At current prices the labour cost per unit of 2 hours x 3 is included as
the six employees would not be paid if the Oakman were not produced.
Year Production units Labour costs
Unit/ Total/
2 5,000 6 x (1.15)
2
39,675
3 5,000 6 x (1.15)
3
45,626
4 5,000 6 x (1.15)
4
52,470
5 2,500 6 x (1.15)
5
30,170
6 2,500 6 x (1.15)
6
34,696
(3) Redundancy payment
This is the payment to the three redundant employees in four years
time.
Year 4: 3 men x 1,000 hours x 3 x (1.15)
4
= 15,741 outflow.
(4) Redundancy payments avoided
If the Oakman were not produced, there would be a payment to the six
employees who would be made redundant. This is avoided and hence is
an incremental cash inflow.
Year1: 6 men x 1,000 hours x 3 x 1.15 = 20,700 inflow.
(5) Purchase and maintenance of machine
These are the cash flows that will be incurred at year 1 and two years
later at year 3
Purchase cost at year 1: 190,000 x 1.1 = 209,000.
Overhaul cost at year 3: 60,000 x (1.1)
3
= 79,860.
(6) Overhead costs
It is assumed that the overhead costs will be allowed for tax in the year
in which they are incurred.
(7) Taxation
All tax paid on accounting profit is based on the previous years cash
flow at 35%.
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(8) Writing down allowances and tax savings
WDA Tax
saved
Timing

Cost paid at end of first
year (t
1
)

209,000

WDA year 1 (52,250) 52,250 18,288 t
2

156,750
WDA year 2 (39,188) 39,188 13,716 t
3

117,563
WDA year 3 (29,391) 29,391 10,287 t
4

88,172
WDA year 4 (22,043) 22,043 7,715 t
5

66,129
WDA year 5 (16,532) 16,532 5,786 t
6
49,597
Proceeds end of year 6 -__
Balancing allowance 49,597 49,597 17,359 t
7
(9) The production of Oakman has been evaluated by considering the
incremental change in the companys cash flows caused by a decision to
produce. These have been valued at the actual cash flow in each year
after allowing for the differing effects of inflation on each item. These
money cash flows have then been discounted at the money cost of
capital (net of corporation tax).
The 75,000 already spent on research and development is a sunk cost
and is therefore irrelevant to our calculations.
(b) Discussion of investment appraisal problems caused by high inflation
rates.
The existence of high rates of inflation creates problems in investment
appraisal by contributing to the uncertainty attached both to the cash flows
themselves and the appropriate discount rate. It is unlikely that in any
investment appraisal situation each cash flow stream will be affected in the
same way by specific price changes. The budget must predict as accurately
as possible the anticipated level of inflation.
Higher rates of inflation will tend to be more volatile than lower rates,
especially as government action will be directed to reducing them. With
different inflation rates applying to each item (e.g. materials and labour) the
value of an investment could be highly sensitive to changes in those rates.
The extent to which the effect of inflation can be passed on by income
increases (e.g. raising product selling price) must also become less certain as
government controls, competitors reactions and the elasticity of demand
become more important.
The conventional treatment of inflation is to discount the anticipated money
cash flows at a money discount rate. This money rate would normally be
derived from the so-called dividend valuation model, to give the
shareholders required rate of return and the required rate of return for other
suppliers of capital such as debenture holders. Such a required rate of return
will consist of both a real rate reflecting the time value of money to the
providers of funds, plus an additional return to compensate for the decrease
in purchasing power caused by inflation.
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Clearly, with higher anticipated inflation rates, such a money rate will be
higher than with lower rates. However, the company must anticipate such a
required rate of return when evaluating capital projects. With high inflation
rates this anticipation becomes more difficult, as again the expectations of the
shareholders as to the effect of inflation on them will become more diverse.
Also with the increased probability of changes in inflation in the future, the
required rate of return is unlikely to be constant over the life of the project.
The company will be faced with increasing uncertainty as to whether it is
acting in the best interests of shareholders by accepting or rejecting a
particular project.
Finally, it should be noted that the above comments refer to the problems
presented to investment appraisal by expected or anticipated inflation. The
correct treatment in capital budgeting of unanticipated inflation has so far
defied a workable solution, and this represents a serious gap in the theory of
financial decision making.

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Chapter 4
Cost of capital



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CHAPTER 4 COST OF CAPITAL
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CHAPTER CONTENTS
PURPOSE OF COST OF CAPITAL ---------------------------------------- 99
CALCULATING THE COMPONENT COSTS OF CAPITAL --------------- 100
1. COST OF EQUITY SHARE CAPITAL 100
2. COST OF PREFERENCE SHARE CAPITAL 102
3. COST OF DEBT 102
CALCULATING THE WEIGHTED AVERAGE COST OF CAPITAL ------- 104
MAIN ASSUMPTIONS UNDERLYING USE OF WACC AS THE DISCOUNT
RATE --------------------------------------------------------------------- 107
JUSTIFICATION FOR THE USE OF WACC ----------------------------- 108
SOURCES OF FINANCE ------------------------------------------------- 109
SOURCES OF SHORT-TERM FINANCE 109
SOURCES OF LONG-TERM FINANCE 110
SMALL AND MEDIUM-SIZED ENTITIES (SMES) 110
QUESTION (NEVADA PLC) --------------------------------------------- 112
QUESTION (CRYSTAL PLC) -------------------------------------------- 114
QUESTION (NILE PLC) ------------------------------------------------- 117

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PURPOSE OF COST OF CAPITAL
As a discount rate for NPV or cut-off rate for IRR.
(N.B. Cost of Capital is sometimes denoted by the letter r, whilst in other texts it
is denoted by the letter k. The note which follows uses the latter notation).
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CALCULATING THE COMPONENT COSTS OF CAPITAL

1. Cost of equity share capital
(a) Retained earnings (an opportunity cost)
Ke =
div) - (ex P
D
0

Example 1 (Naylor plc)
Naylor plc is expected to pay a constant annual net dividend of 30p per ordinary
share. The current market price per share is 2.30 (cum-div). The dividend is
about to be paid.
What is Ke?
Solution 1 (Naylor plc)
Ke =
p 30 p 230
p 30

= 15%
(b) Fresh issue of equity
Two views:
(i) Ke =
f P
D
0


Example 2 (Goodman plc)
Goodman plc wishes to finance a new project by the issue 40,000 ordinary shares
of 2.50 each, out of which share issue (flotation) costs of 8% of issue price have
to be paid. New shareholders expect constant annual dividends of 32.2p per share.
What is Ke?
Solution 2 (Goodman plc)
Ke =
50 . 2 x % 92
p 2 . 32
= 14%
(ii) Carsberg recommends that share issue costs are treated as a year 0 cash
outflow of the project for which the share capital is raised. Thus share issue
costs do not affect Ke. In Example 2, Ke would be calculated as follows:
Ke =
50 . 2
p 2 . 32
= 12.9%
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(c) Growth
The Dividend Growth model is:
Ke = g
P
) g 1 ( D
0
0
+
+

= g
P
D
0
1
+
Example 3
Current cum-div price 2.20
Impending dividend 20p
Expected growth p.a. 10%
Calculate Ke
Solution 3
Ke = % 10
2
p 22
+ = 21%
Two methods of estimating future growth
(i) Historical growth in dividends
Example 4 (Talbot plc)
The dividends of Talbot plc over the last five years have been:
Year Annual Net Dividends
2004 150,000
2005 172,000
2006 195,380
2007 230,100
2008 262,350
Estimate the historical growth rate as a prediction of future growth.
Solution 4 (Talbot plc)
Dividend in 2004 (1 + g)
4
= Dividend in 2008

(1 + g)
4
=
2004 in Dividend
2008 in Dividend



=
000 , 150
350 , 262

= 1.749

(1 + g) =
4
749 . 1 = 1.15

g = 15%
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(ii) Use of Gordon growth approximation
g = br
where: b = proportion of earnings retained p.a.
r = average return on reinvested funds.
Strictly only applicable to all-equity companies, but is often used for geared
companies as an approximation of growth rates.
Example 5
Establish an estimate of future growth and of Ke if:
Proportion of earnings distributed p.a. 60%
Average return on reinvested funds 10%
Current cum-div price 1.08
Impending dividend 12p
Solution 5
g = 40% x 10% = 4%
Ke =
p 96
p 48 . 12
+ 4% = 17%
2. Cost of preference share capital
Kps =
div) - (ex P
) net ( D
0

3. Cost of debt
(a) Irredeemable
Kb =
int) - (ex debt of Value Market
) t l ( Interest

(b) Redeemable
IRR exercise
Example 6
A 5% debenture is currently quoted at 95.84 (ex-int). It is redeemable at the end
of 3 years at 100.
Taking corporation tax at 50%, and ignoring the timing lag for tax savings,
calculate Kd.
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Solution 6
Year Try DF @ 4%
0 Cost (95.84) 1.00 (95.84)
1 Interest 5(0.5) 0.962 2.41
2 Interest 2.50 0.925 2.31
3 Interest & Redemption 102.50 0.889 91.12
NPV NIL
Therefore, Kb = IRR = 4%
NB Try 3% (NPV + 2.74) and 5% (NPV - 2.63), then by linear interpolation
Kb = 3% +
37 . 5
74 . 2
x 2% = 4.02%
i.e. linear interpolation tends to overstate the IRR of normal cash flows
(c) Convertible
The cost of convertible debt is calculated in a similar manner to the calculation of
the cost of redeemable debt, EXCEPT that in the final year, one must include the:
- redemption value of the debt, or
- conversion value of the debt
whichever is the GREATER.
(d) Floating rate debt
The cost of floating rate debt (e.g. most bank loans and overdrafts) is the current
interest rate being charged on such funds.
Accordingly, if a company is paying interest at LIBOR + 8%, when LIBOR is set at
5% p.a. and corporation tax rates are at 30%, Kd will be calculated as follows:
Kd = (5% + 8%) x (1 0.3) = 9.1%
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CALCULATING THE WEIGHTED AVERAGE COST OF
CAPITAL (WACC)
Difficult to associate a project with a specific source of finance, as a pool of
resources are available in order to invest in projects. Thus a WACC is an
appropriate discount rate/cut off rate.
Example 7 (Whyte plc)
Whyte plc has on issue:
(a) 500,000 ordinary shares of 1 each, whose ex-div share price is 2. A
constant dividend of 36p per share will be paid on these for several years
hence.
(b) 500,000 6% preference shares of 1 each, whose ex-div share price is 50p.
(c) 1,000,000 10% irredeemable debentures, quoted at 75 (ex-interest).
Calculate K
0
(i.e. the WACC) assuming Corporation Tax at 40%.
Solution 7 (Whyte plc)
Market Value Component Cost

Equity (m @ 2) 1,000,000 18% 180,000
Prefs (m @ 50p) 250,000 12% 30,000
Debt (1m @ 75) 750,000 8%* 60,000
2,000,000 270,000
K
0
=
000 , 000 , 2
000 , 270
= 13.5%
*K
b
=
75
) 4 . 0 1 ( 10
= 8%
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Comprehensive example (Hunt plc)
The management of Hunt plc is trying to decide upon a cost of capital discount rate
to apply to the evaluation of investment projects.
The company has an issued share capital of 500,000 ordinary 1 shares, with a
current market value cum div of 1.17 per share. It has also issued 200,000 of
10% debentures, which are redeemable at par in 2 years and have a current
market value of 105.30 per cent and 100,000 of 6% preference shares, currently
priced at 40p per share. The preference dividend has just been paid, and the
ordinary dividend and debenture interest are due to be paid in the near future.
(The preference dividend is shown net).
The ordinary share dividend will be 60,000 this year, and the directors have
publicised their view that earnings and dividends will increase by 5% per annum
into the indefinite future.
The fixed assets and working capital of the company are financed by:

Ordinary shares of 1 500,000
6% 1 Preference shares 100,000
Debentures 200,000
Reserves 380,000
1,180,000
Calculate the WACC. Assume corporation tax at 50% per annum, payable
one year in arrears
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Solution to comprehensive example (Hunt plc)
Ke = % 5
p 12 17 . 1
) 05 . 1 ( p 12
+

= 17%
Kps =
p 40
p 6
= 15%
Kb
Year Capital Interest Tax Net Try DF @ 8% Net

0 (95.30) (95.30) 1.00 (95.30)
1 10 10 0.926 9.26
2 100 10 (5) 105 0.857 89.99
3 (5) (5) 0.794 (3.97)
-0.02
Therefore, Kb = IRR = 8%
WACC
Market Value Component Cost

Equity (m @ 1.05) 525,000 17% 89,250
Prefs (100K @ 40p) 40,000 15% 6,000
Debt (200K @ 95.30) 190,600 8% 15,248
755,600 110,498
Ko =
600 , 755
498 , 110
= 14.6%
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MAIN ASSUMPTIONS UNDERLYING USE OF WACC AS THE
DISCOUNT RATE
1. Only under conditions of perfect capital markets will the costs of capital
calculated represent the true opportunity cost of funds used.
2. The project must be small relative to the size of the company (i.e. it
represents a marginal investment). This is because the costs of capital
calculated refer to the minimum required return of marginal investors and
therefore are only appropriate for the evaluation of marginal changes in the
companys total investment.
3. Using the existing market value mix of funds as weights in the calculation
assumes that in the long run funds will be raised in this proportion (i.e. in the
long run the capital structure of the company will remain unchanged). This
implies that the current gearing ratio is thought to be optimal.
4. No attempt is made to match a project with a particular source of funds. All
funds are regarded as forming a pool out of which all projects are financed
(the pool concept).
5. The project is of average risk for the firm and will cause no change in the risk
of the company as perceived by investors. This is because the cost of capital
estimates are only valid for the existing level of risk in the enterprise.
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JUSTIFICATION FOR THE USE OF WACC
NOTE. For simplicity of explanation, the following example uses the IRR technique
of investment appraisal. It is emphasised that most authorities would advocate use
of the NPV approach.
Illustration
Whyte plc has the following capital costs:
Ko = 13.5%
Ke = 18%
Kb = 8%
Suppose that in March 2008 the company proposes to raise debt at 8% to finance
Project A whose IRR is 12%. Whyte plc accepts Project A since IRR > Kb.
Subsequently in June 2008 Whyte plc considers the issue of equity at 18% to
finance Project B whose IRR is 17%. However the company rejects Project B since
IRR < Ke.
Is it logical to reject a project yielding 17%, whilst accepting one yielding 12%?
The use of WACC (at 13.5%) would have provided the logical answer i.e.
Reject Project A (with an IRR of 12%), and
Accept Project B (with an IRR of 17%)
Therefore generally do not test the viability of a project by reference to its specific
financing source, but by reference to WACC.
The only exception to this rule is when the finance is provided (by e.g. a local
authority or government department) to assist in the financing of a specific project
undertaken for that agency.
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SOURCES OF FINANCE

Sources of short-term finance
Bank overdrafts
If cash outflows from a bank current account exceed inflows for a temporary period,
a clearing bank may provide an overdraft. Overdrafts may be arranged speedily,
but are subject to review by the bank, may be renewable and offer a level of
flexibility, whilst interest is only paid on the overdrawn amount.
Overdrafts are technically repayable on demand and may require some form of
security or guarantee. Interest is often payable at a variable rate (ie benchmark
rate plus a premium) and an arrangement fee is normally payable upon the initial
grant of the facility.
Short-term loans
Bank loans are an agreement for the provision of a specific fixed sum for a
predetermined period at an agreed interest rate. A term loan is provided in full at
the start of the loan period and is repaid at a specified time or in instalments over a
period of agreed dates.
Bank loans are only repayable on the agreed dates, but are more expensive and
less flexible than overdrafts. The terms of the loan must be adhered to and the
bank may impose loan covenants with which the borrower must comply.
Trade credit
Raw materials are normally purchased on credit and this effectively represents an
interest free short-term loan. It is important to remember that payment delays
would worsen the credit rating of the company and that additional credit may then
be difficult to obtain. The loss of settlement discounts that suppliers may offer for
early payment must be considered.
Lease finance
Instead of the outright purchase of a non-current asset, a company may choose to
obtain the temporary use of that asset by means of an operating lease, whereby
the risks and rewards of ownership are retained by the lessor (ie the legal owner).
An operating lease contract between a lessor and lessee is for the hire of a specific
asset, whereby the lessee has possession and use of equipment for a period which
is shorter than the economic useful life of the asset, but the lessee is committed to
pay specified rentals during the period of the lease. The lessor is normally
responsible for repairs and maintenance and the lease can sometimes be cancelled
at short notice.
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Sources of long-term finance
The main sources are:
Fixed interest capital (i.e. debt finance) and preference share capital;
Equity finance, which is commonly raised by rights issues, placings, offers for
sale or public issues following a stock exchange introduction. Details may be
found in your Study Manual.
Two other long-term sources of finance available to businesses are:
Lease finance
A long-term leasing arrangement is likely to be finance lease, ie a lease that
transfers substantially all the risks and rewards incidental to the ownership of an
asset to the lessee. Legal title may or may not eventually be transferred.
The lessor is likely to be a bank or other financial institution, which does not
normally trade in the type of asset concerned. The lessee normally becomes
responsible for the cost of repairs and maintenance.
The substance of a finance lease arrangement is that the lessee is effectively
borrowing in order to have use of a non-current asset for substantially the whole of
its useful economic life and thereby becomes liable for all lease payments. In
contrast, an operating lease is equivalent to the short-term rental of an asset from
an organisation which normally trades in that type of asset.
Venture capital
Venture capital is the provision of risk bearing capital, normally provided in return
for an equity stake in companies with high growth potential.
The 3i Group (a member of the FTSE 100 Index) is one of the worlds oldest
venture capital organisations and is involved in schemes in Europe, the USA and
the Far East. The 3i Group is prepared to invest in companies with a highly
motivated management team, having a well defined strategy and target market,
which are committed to innovation and a proven ability to outperform competitors.
Venture capitalists may provide finance for business start-ups, the development of
existing businesses, management buyouts and the realisation of the investments of
existing owners who wish to exit their companies.
Where company directors seek assistance from a venture capitalist they must
expect that the institution will require an equity stake in the company, need
convincing that the business will be successful, seek representation on the
companys board of directors, demand exceptional returns on their investment and
expect an obvious ultimate exit route.
Small and medium-sized entities (SMEs)
The funding gap
SMEs normally have difficulty obtaining equity finance from third parties. They
normally rely on finance from retentions, bank borrowings and rights issues. Such
companies are often considered risky, since they may not have an established track
record, lack the necessary assets to offer as security, have inexperienced
management and inadequate financial control systems.
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The funding (or equity) gap becomes crucial when they wish to expand beyond
their limited sources of finance, but are not yet mature enough for a stock market
quotation.
A major problem for SMEs in obtaining equity finance is their inability to offer an
easy exit route for any investors wishing to dispose of their shares. The company
could, of course, purchase its own shares back from shareholders, but this uses
cash that could be more profitably employed elsewhere in the business of the
company.
The maturity gap
This presents a further problem for SMEs, who may ideally wish to obtain medium-
term loans. This arises due to the mismatching of the maturity of assets and
liabilities. Since the SME can secure long-term loans with mortgages against their
property assets, they find that longer term borrowing is much easier to obtain than
the medium term loans that they require.
Investors
Due to lack of security and a risk-averse attitude, banks have been reluctant to
make large investments in SMEs. However, investment has become more readily
available from:
Venture capitalists (as above)
Business Angels These are wealthy private individuals prepared to invest in
start-up or expanding companies. Business Angels provide more modest
sums than venture capitalists. They normally wish to obtain an equity holding
and this will permit the company to gain access to the Angels network of
contacts and accumulated business experience.

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Question (Nevada plc)
(i) Nevada plc has issued 10 million ordinary shares of a nominal value of 1
each. Details of the companys earnings and dividends per share during the
past four years are as follows:
Year ended31 December Earnings per share Dividend per share
2003 35p 26p
2004 33p 27p
2005 43p 29p
2006 42p 30p
The current (December 2006) market value of each ordinary share of Nevada
plc is 2.35 cum div. The 2006 dividend of 30p per share is due to be paid in
January 2007.
Required
Estimate the cost of capital for Nevada plcs ordinary share capital.
(ii) Ten years ago California plc issued 2.5 million 6% redeemable debentures at
a price of 98 per cent. The debentures are redeemable six years from now
at a price of 102 per cent. They are currently quoted at 59 per cent, ex
interest.
Required
Estimate the cost of capital for California plcs redeemable debentures.
(iii) The following figures are from the current balance sheet of Delaware plc
000
Ordinary share capital
Authorised: 10,000,000 shares of 1 10,000
Issued: 8,000,000 shares of 1 8,000
Share premium account 2,000
Revenue reserves _6,000
Shareholders funds 16,000
12% Irredeemable debentures 4,000

An annual ordinary dividend of 20p per share has just been paid. In the past,
ordinary dividends have grown at a rate of 10% per annum and this rate of
growth is expected to continue. Annual interest has recently been paid on the
debentures. The ordinary shares are currently quoted at 2.75 and the
debentures at 80 per cent.
Required
Estimate the weighted average cost of capital for Delaware plc.
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Solution (Nevada plc)
(i) Cost of ordinary shares
Growth rate in dividend = 1
26
30
3
= 0.049 (i.e. 4.9%)
Cost of equity = g
P
D
0
1
+
= 049 . 0
30 - 235
049 . 1 x 30
+
= 0.2025 (i.e. 20.25%)
(ii) Cost of redeemable debentures
Time Flow 20% factor PV 15% factor PV

0 (59) 1 (59.000) 1 (59.000)
1-6 6 3.326 19.956 3.784 22.704
6 102 0.335 34.170 0.432 44.064
(4.874) 7.768
By interpolation:
IRR = ) 15 20 ( x
874 . 4 768 . 7
768 . 7
15
+
+ = 18.07
Cost of debentures = 18.07%
(iii) Weighted average cost of capital
Cost of equity = 1 . 0
275
1 . 1 20
+

= 0.18 (i.e. 18%)


Cost of debenture =
80
12
= 15%
Weighted average cost of capital =
0.80) (4m + 2.75) (8m
15%) 0.80 (4m + 18%) 2.75 8m



=
520 , 2
444
= 17.6%
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Question (Crystal plc)
The following figures have been extracted from the most recent accounts of Crystal
plc.
Balance sheet as on 30 June 2007
000 000
Fixed assets 10,115
Investments 821
Current assets 3,658
Less current liabilities 1,735
_1,923
12,859
Ordinary share capital
Authorised: 4,000,000 ordinary shares of 1
Issued: 3,000,000 ordinary shares of 1 3,000
Reserves 6,542
Shareholders funds 9,542
7% Debentures 1,300
Corporation tax _2,017
12,859
Summary of profits and dividends
Year ended 30 June: 2003 2004 2005 2006 2007
000 000 000 000 000
Profit after interest and before tax 1,737 2,090 1,940 1,866 2,179
Less tax 573 690 640 616 719
Profit after interest and tax 1,164 1,400 1,300 1,250 1,460
Less dividends 620 680 740 740 810
Added to reserves 544 720 560 510 650
The current (1 July 2007) market value of Crystal plcs ordinary shares is 3.27 per
share cum div. An annual dividend of 810,000 is due for payment shortly. The
debentures are redeemable at par in ten years time. Their current market value is
77.10 per cent. Annual interest has just been paid on the debentures. There
have been no issues or redemptions of ordinary shares or debentures during the
past five years.
The current rate of corporation tax is 33%, and the current basic rate of income tax
is 25%. Assume that there have been no changes in the system or rates of
taxation during the last five years.
Required
(a) Estimate the cost of capital which Crystal plc should use as a discount rate
when appraising new investment opportunities.
(b) Discuss any difficulties and uncertainties in your estimates.
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Solution (Crystal plc)
(a) The post-tax weighted average cost of capital
(i) Ordinary shares
Market value of shares cum div 3.27
Less dividend per share (810 3,000) 0.27
3.00
The formula for calculating the cost of equity when there is dividend
growth is
K
e
= g
P
) g 1 ( D
0
0
+
+

In this case we can estimate the future rate of growth (g) from the
average growth in dividends over the past four years.
810 = 620(1 + g)
4

(1 + g)
4
=
620
810
= 1.3065

(1 + g) = 1.069
g = 0.069 = 6.9%
K
e
= 069 . 0
3
1.069 0.27
=

= 16.5%
(ii) 7% Debentures
In order to find the post-tax cost of the debentures, which are
redeemable in ten years time, it is necessary to find the discount rate
(IRR) which will give the future post-tax cash flows a present value of
77.10.
The relevant cash flows are:
1. annual interest payments, net of tax, which are 100 x 7% x 67%
= 4.69 (for ten years);
2. a capital repayment of 100 (in ten years time)
It is assumed that tax relief on the debenture interest arises at the same
time as the interest payment. In practice the cash flow effect is unlikely
to be felt for about a year, but this will have no significant effect on the
calculations.
Try 8% PV
Current market value of debentures (77.10)
Annual interest payments net of tax 4.69 x 6.710 31.47
Capital repayment 100 x 0.463 46.30
NPV 0.67

Try 9% PV
Current market value of debentures (77.10)
Annual interest payments net of tax 4.69 x 6.418 30.10
Capital repayment 100 x 0.422 42.20
NPV (4.80)
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IRR = % ) 8 9 ( x
80 . 4 67 . 0
67 . 0
% 8 |

\
|

+
+ = 8.12%
(iii) The weighted average cost of capital
Market value Cost
000 % 000
Equity 9,000 16.50 1,485
7% Debentures 1,002 8.12 81
10,002 1,566
WACC (K
o
) = 100 x
002 , 10
566 , 1
= 15.7%
The above calculations suggest that a discount rate in the region of 16%
might be appropriate.
(b) Difficulties and uncertainties arise in a number of areas.
(i) The cost of equity. The above calculation assumes that all shareholders
have the same marginal cost of capital and the same dividend
expectations, which is unrealistic. In addition, it is assumed that
dividend growth has been and will be at a constant rate of 6.9%. In
fact, actual growth in the years 2003/04 and 2006/07 was in excess of
9%, while in the year 2005/2006 there was no dividend growth. 6.9%
is merely the average rate of growth for the past four years. The rate of
future growth will depend more on the return from future projects
undertaken than on the past dividend record.
(ii) The use of the weighted average cost of capital. Use of the weighted
average cost of capital as a discount rate is only justified where the
company in question has achieved what it believes to be the optimal
capital structure (the mix of debt and equity) and where it intends to
maintain this structure in the long term.
(iii) The projects themselves. The weighted average cost of capital makes
no allowance for the business risk of individual projects. In practice
some companies, having calculated the WACC, then add a premium for
risk. This risk premium should vary from project to project, since not all
projects are equally risky. In general, the riskier the project the higher
the discount rate which should be used. Ideally, the use of the capital
asset pricing model should provide a suitable risk adjusted discount rate,
which is obviously preferable to the result of the dividend growth model,
which has been used in the solution to part a) of this question
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Question (Nile plc)
Nile plc is considering an investment in projects, which will be financed from the
issue of new ordinary shares and debentures in a mix, which will hold its gearing
ratio approximately constant. It wishes to estimate the cost of capital for purposes
of appraising the projects, which would be small in relation to the companys
present scale of operations.
The company has an issued share capital of 1 million ordinary shares of 1 each; it
has also issued 800,000 of 8% debentures. The market price of ordinary shares is
4.76 per share and debentures are priced at 79.40 per cent. Dividends and
interest are payable annually. An ordinary dividend has just been paid; and the
next instalment of interest is payable in the near future. Debentures are
redeemable at par in eight years time.
Dividends relating to the last five years have been as follows:
Year 2002 2003 2004 2005 2006
000 000 000 000 000
Total dividends 200 230 230 260 300
Assume that there have been no changes in the system or rates of taxation during
the last five years and that the current rate of corporation tax is 40 per cent.
Ignore personal taxation.
Required:
(a) Estimate the cost of capital which Nile plc should use as a discount rate for
purposes of investment appraisal, and
(b) Discuss any difficulties and uncertainties in your estimation.
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Solution (Nile plc)
(a) Estimate of cost of capital
(i) Cost of equity, based on assumed constant growth rate
K
e
= g
P
) g 1 ( D
0
0
+
+

The future expected growth in dividends may be estimated from the
historical growth rate which can be seen to be approximately 10.7%, i.e.
Average growth rate, g, may be calculated as follows:
2002 Dividend (1 + g)
4
= 2006 Dividend
(1 + g)
4
=
Dividend 2002
Dividend 2006
=
200,000
300,000

= 1.5
Now, g can be found by use of compound interest tables, or by the use
of a calculator:
1 + g =
4
5 . 1
= 1.107
g = 10.7%
Now the growth model can be employed:
K
e
= 107 . 0
p 476
107 . 1 ( p 30
+
= 107 . 0
476p
33.21p
=
= 17.68%
(ii) Cost of debt (after corporation tax)
The effective cost of the debentures to the company allowing for
corporation tax of 40% on interest paid (an allowable charge against
profits) can be calculated by the following IRR method.

Try 10% Try 11%
Year Cash flow DF DF

0 (71.40)* 1.0 (71.40) 1.0 (71.40)
1-8 (8 x 60%) 4.80 5.335 25.61 5.146 24.70
8 100 0.467 46.70 0.434 43.40
+0.91 -3.30
K
b
= |

\
|
+
+ % 1 x
30 . 3 91 . 0
91 . 0
% 10
= 10% + 0.22%
= 10.22%
* Ex-interest price = 79.40 - 8 = 71.40
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(iii) Calculation of WACC
Using market value weightings:

Market value K%

Ordinary shares:
1m @ 4.76
= 4,760,000 x 17.68 = 841,568

Debentures:
100
4 . 71
x 000 , 800
= 571,200 x 10.22 = 58,377
5,331,200 899,945
WACC (K
o
) =
5,331,200
899,945
= 16.88% (say 17%)
(b) Difficulties and uncertainties in estimating WACC
The concept of the cost of capital is perhaps the most difficult of all the DCF
concepts and one about which there is still considerable controversy.
The approach taken above employs the weighted average cost of capital
concept. It is based on the following basic principles:
(i) The cost of capital required for investment appraisal is the cost of raising
more capital in the market. The historical cost of existing capital is
irrelevant. It is for this reason that current yields (returns related to
current market prices) are used.
(ii) It is assumed that the company will maintain approximately the same
mix of capital as hitherto and that the consequent weighted average
cost of capital is an appropriate measure of the future cost. This is
managements declared intention in this case, although it is probably
unrealistic in practice.
The difficulties and uncertainties in the estimation of the cost of capital are as
follows:
(i) Growth rate the expected future growth rate of dividends has been
obtained from the historical average growth rate of the last five years.
(ii) Current share price it is assumed that the current share price is a
reflection on logical investor behaviour in the market and reflects the
markets anticipation of future dividends unaffected by extraneous
events or influences. This will frequently not be the case.
(iii) Corporation tax it is assumed that the future rate of corporation tax
will remain at 40%. Any change in the rate, or for that matter in the
system of taxation, would affect the earnings available for distribution
and therefore the future dividend growth rate.
(iv) Risk class it is assumed that the project to be appraised is of the same
risk class as existing project.

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Chapter 5
Efficient market
hypothesis


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CHAPTER CONTENTS
EFFICIENT MARKET HYPOTHESIS------------------------------------- 123
1. DEFINITION AND FORMS OF EFFICIENCY 123
2. THE IMPLICATIONS OF THE EMH FOR FINANCIAL MANAGERS 124
EFFICIENT MARKET HYPOTHESIS ILLUSTRATION ------------------ 125
EFFICIENT MARKET HYPOTHESIS SOLUTION ----------------------- 126
FUNCTIONS PERFORMED BY THE CAPITAL MARKET 126
EFFICIENT MARKET HYPOTHESIS 126

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EFFICIENT MARKET HYPOTHESIS

1. Definition and forms of efficiency
Definition
An efficient market is one in which the market price of all securities traded on it
instantly and perfectly reflect all new information as it becomes available.
If this is correct, a companys real financial position, with respect to both current
and future profitability, will be reflected in its share price.
The implication for an investor is that he can rarely outperform the market,
because it will already have anticipated developments in the future and have
reflected these in the share price. Therefore the best course of action for an
investor is to hold a well-diversified portfolio of shares to reduce overall risk.
Other areas of financial management, such as the dividend valuation model,
Modigliani and Millers arbitrage proof, the dividend irrelevancy hypothesis and
aspects of mergers and takeovers rely on the existence of an efficient market.
Forms of Market Efficiency
(i) Weak form
Share prices reflect all the information contained in the record of past prices and
past trading volumes. As a result it is not possible to predict future share price
movements by reference to past trends. Share prices follow a random walk.
Accordingly a chartist (technical analyst) must regard the stock market as being
totally inefficient.
(ii) Semi-strong form
Share prices also reflect all current publicly available information. Therefore prices
will change only when new information is published. As a result it would only be
possible to predict share price movements if unpublished information were known
(insider dealing). Accordingly fundamental analysis is a waste of effort if the stock
market is semi-strong efficient.
(iii) Strong form
Share prices reflect all information which is relevant to the company.
If this is the case then share price movements can never be predicted.
Gains through insider dealing are not possible because shares are priced absolutely
fairly. The government must not consider the stock market to be strong form
efficient, because of its attempts to outlaw insider dealing.
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2. The implications of the EMH for financial managers
In their book Principles of Corporate Finance, Richard Brealey, Stewart Myers and
Franklin Allen describe six lessons of market efficiency as follows:
Lesson 1 - Markets Have No Memory.
The weak form of the EMH states that a study of past price changes will not be
helpful in predicting future price changes, i.e. markets have no memory. This
means that there is no right time to issue shares and the common reluctance of
managers to make a new issue after a price fall has no basis in theory.
Lesson 2 - Trust Market Prices.
In an efficient market the price of a security is reliable and allows for all available
information about that security. This means that it is not possible for most
investors to achieve consistently above average returns, i.e. you cannot beat the
market.
Lesson 3 - Read the Entrails.
If the market is efficient, the current price incorporates all available information
about the future. Therefore, a careful study of security prices will provide a lot of
information about investors expectations of the future, since investors are heavily
influenced by economic prospects.
Lesson 4 - There Are No Financial Illusions.
Attempts to improve the image of the company through such cosmetic operations
as bonus issues and changes in accounting policies or methods (e.g. depreciation
methods) are unlikely to have any material effects on market values in the long-
run. In fact they may be regarded as a sign of weakness and not of strength.
Lesson 5 - The Do-It-Yourself Alternative.
Rational investors operating in an efficient market will not pay others to do what
they can do equally well themselves. Diversification for its own sake will not
enhance market values, because shareholders could achieve the same results for
themselves, much more cheaply, by holding shares in a variety of companies.
Lesson 6 - Seen One Stock, Seen Them All.
In buying shares investors are simply buying an expected return for a given level of
risk. Where two shares have the same risk and return characteristics they will be
seen by the market as perfect substitutes one for the other (just like similar brands
of coffee). The homogeneous nature of many securities results in the demand for
the companys shares being very elastic.
N.B. Most studies of this subject have been based on Wall Street or the London
Stock Exchange, which are surely more efficient than most other stock markets.
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EFFICIENT MARKET HYPOTHESIS ILLUSTRATION
Company A has 2 million shares in issue and company B, 6 million.
On day 1 the market value per share is 2 for A and 3 for B.
On day 2 the management of B decides, at a private meeting, to make a cash
takeover bid for A at a price of 3.00 per share. The takeover will produce large
operating savings with a present value of 3.2 million.
On day 4 B publicly announces an unconditional offer to purchase all shares of A at
a price of 3.00 per share with settlement on day 15. Details of the large savings
are not announced and are not public knowledge.
On day 10 B announces details of the savings which will be derived from the
takeover.
Requirements
(a) Briefly outline the major functions performed by the capital market and
explain the importance of each function for corporate financial management.
How does the existence of a well functioning capital market assist financial
management?
(b) Describe the efficient market hypothesis and explain the difference between
the three forms of the hypothesis which have been distinguished.
(c) Ignoring tax and the time-value of money between day 1 and 15, and
assuming the details given are the only factors having an impact on the share
price of A and B, determine the day 2, day 4 and day 10 share price of A and
B if the market is:
1. semi-strong form efficient, and
2. strong form efficient,
in each of the following separate circumstances:
(i) the purchase consideration is cash as specified above, and
(ii) the purchase consideration, decided upon on day 2 and publicly
announced on day 4, is one newly issued share of B for each share of A.
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EFFICIENT MARKET HYPOTHESIS SOLUTION

Functions performed by the capital market
Important points are as follows:
1. Functions
a source of new finance (the primary market)
provides a market for those who already hold securities (a secondary market).
2. Importance of each function
(1) The primary market
Provides a focal point for would-be borrowers and lenders and enables the
typically small sums provided by lenders to be combined into the large
amounts required by borrowers.
An efficient primary market enables companies to raise finance quickly and
with relatively low transaction costs.
(2) The secondary market
Provides liquidity for investors.
An efficient (perfect) market is a precondition for the application of many of
the financial management decision rules.
Efficient market hypothesis
Important points to make are:
(i) The EMH - states that the current share price reflects all available information
about a security and that the market will react correctly and immediately to
new information which emerges.
(ii) The weak form - the current price reflects all information about past prices
and past trading volumes.
(iii) The semi-strong form - the current share price reflects all publicly available
information (e.g. published accounts).
(iv) The strong form - the current price reflects all available information - both
public and private.
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Illustration continuation of solution
The important thing in answering this type of question is to be methodical. The
first step is to get a clear idea of what is required. Here the question is asking for
the prices of two different shares on three different days with two forms of the
efficient market hypothesis and two alternative forms of purchase consideration, a
total of 2 x 3 x 2 x 2 = 24 prices! Set up a series of grids that will show the
eventual answers.
(i) Cash consideration
(1) Semi-strong form
Day Share A Share B Note
2 2.00 3.00 1
4 3.00 2.67 2
10 3.00 3.20 3
Notes
1 Only publicly available information affects share prices under the
semi-strong form. No information is publicly available until day 4
so prices remain unaltered from day 1 levels.
2 Offer made known so A rises to offer price. B is apparently paying
6m for assets worth 4m. The apparent loss of 2m spread over
6 million shares causes the price to fall by 33p.
3 News of savings publicly available so price of B increases by 3.2m
spread over 6 million shares, i.e. increase of 53p.
(2) Strong form
Day Share A Share B Note
2 3.00 3.20 4
4 3.00 3.20 4
10 3.00 3.20 4
4 Strong form so all information, public and private, is immediately
reflected in share price. Final price, as per note 3, operates from
day 2.
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(ii) Share issue
1. Semi-strong form
Day Share A Share B Note
2 2.00 3.00 1
4 2.75 2.75 5
10 3.15 3.15 6
5 The best way to see this is to think of a new merged company A
and B with 8 million shares. The share price will be the markets
view of the total value of the company divided by the number of
shares. On day 4 savings are not public so total value is (2m x
2) + (6m x 3) = 22m. The share price is therefore 22m 8m
= 2.75.
6 Savings known so total value increases to 22m + 3.2m =
25.2m and the share price = 25.2m 8m = 3.15.
2. Strong form
Day Share A Share B Note
2 3.15 3.15 7
4 3.15 3.15 7
10 3.15 3.15 7
7 As with note 4, all information reflected immediately so final price
calculated in note 6 is in effect from day 2.

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Chapter 6
Theories of gearing



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CHAPTER CONTENTS
THE TRADITIONAL VIEW ---------------------------------------------- 131
MODIGLIANI & MILLER TAX IGNORED (1958) ------------------- 132
GRAPH 132
FORMULAE 132
ASSUMPTIONS 133
ARBITRAGE IN A WORLD WITH NO TAXES 133
MODIGLIANI & MILLER INCLUDING CORPORATION TAX (1963)135
GRAPH 135
CORPORATION TAX POSITION (U AND G IN WORLD WITH TAXES) 135
EQUILIBRIUM POSITION M & M 136
FORMULAE 136
WHY DO COMPANIES NOT ATTEMPT A 99.9% DEBT STRUCTURE? 137
PECKING ORDER THEORY ---------------------------------------------- 139
STATIC TRADE-OFF THEORY ------------------------------------------- 140
SOLVENCY RATIOS ----------------------------------------------------- 141
1. GEARING RATIO 141
2. INTEREST COVER 141
BERLAN AND CANALOT ------------------------------------------------ 142

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THE TRADITIONAL VIEW

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MODIGLIANI AND MILLER TAX IGNORED (1958)
All companies with the same earnings in the same risk class have the same future
income stream and should therefore have the same value, independent of capital
structure.
Graph
Modigliani & Miller (no tax)

Formulae
Vg = Vu
Keg =
E
D
) Kb Keu ( Keu +
Kog = Keu
N.B. These formulae may be derived from the expressions which include the effect
of corporation tax treating t = 0
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Assumptions
Investors are rational
Investors have the same view of the future
Personal and corporate gearing are perfect substitutes
Information is freely available
No transaction costs
No tax
Firms can be grouped into similar risk classes.
The arbitrage proof, which incorporates these assumptions, can be used to
support this M & M proposition.
Arbitrage in a world with no taxes
Assume two companies, identical in every respect, except G is financed by 1,000
of 10% irredeemable debt trading at par. The above assumptions hold. The
traditional view of the two companies would be:
U (ungeared) G (geared)

EBIT 500 500
Interest -_ (100)
Dividends 500 400

Cost of Equity (assumed) 20% 25%

E (equity) 2,500 1,600
D (debt) - _ 1,000
V (total) 2,500 2,600

WACC 20% 19.2%
If an investor owned 1% of Gs equity (income 4) he should arbitrage i.e.
1. Sell his stake in G for 16
2. Adopt same financial risk as in G by borrowing personally a proportional
amount at 10% i.e. 1,000 x 1% = 10.
3. Invest 26 in U to obtain 1.04% of Us equity (26 2,500)
4.
Dividends from U (1.04% x 500) 5.20
Interest on borrowings (10% x 10) (1.00)
Net income 4.20
i.e. the investor is better off as a result of arbitrage
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If one person makes the switch, many other investors will sell their shares in G and
purchase equity shares in U. Gs share price will fall, whilst Us share price will
rise. Assuming Gs share price is the only one which changes, then the equilibrium
will arise where the net income from the two equity investments is identical.

i.e. Dividends from U (balance) 5.00
Interest (1.00)
Net 4.00
5 dividend from U = 1% of shares
1% represents a 25 investment, of which 10 is borrowed. Therefore sales
proceeds from Gs shares in equilibrium must be 15
Accordingly all Gs shares are worth 1,500 in equilibrium
Thus: Vg = Vu
(1,500 + 1,000) = 2,500
Ke in G is now
500 , 1
400
= 26.7%
and WACC is
500 , 2
500
= 20%
Therefore: Kog = Keu = 20%
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MODIGLIANI AND MILLER INCLUDING CORPORATION
TAX (1963)
The values of companies with the same earnings in the same risk class are no
longer independent. Companies with a higher gearing ratio have a greater net
future income stream (purely due to corporation tax relief on interest payments)
and therefore a higher value.
Graph


D
E
Corporation tax position (U and G in world with taxes)
Assume corporation tax rate is 35%. The net of tax distributions to investors are
shown in the following table:

EBIT 500 500
Interest - (100)
Profit before tax 500 400
Tax (35%) (175) (140)
Dividends 325 260
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Equilibrium position M & M
M & M argue that as G pays less tax it can distribute more to its investors. The
difference in equilibrium values is explained by the present value of the tax shield
on debt interest available to G. As Gs debt is irredeemable this difference can be
measured by
Kb
t x Kb x D
= Dt
therefore Vg = Vu + Dt
where Vu = value of an equivalent ungeared company
Assuming U is correctly valued and its cost of equity is 20%, then we calculate the
equilibrium value of G with reference to U

Value of U =

20 . 0
325

= 1,625

Dt = 1,000 x 0.35 = 350
Value of G 1,975
CONCLUSION: a 99.9% debt structure is optimal!!!
Formulae
Vg = Vu + Dt
Keg =
E
) t 1 ( D
*) Kb Keu ( Keu

+ or
e
d
d
e
i
e
i
V
V
) k - T)(k - (1 + k
*Kb or k
d
is the PRE-TAX COST OF DEBT for this formula.
N.B. The formula on the right-hand side is provided on the ACCA P4 Formulae sheet
Kog = |

\
|
+

D E
Dt
1 Keu
Capital structure illustration (Grant plc)
Grant plc (an all equity company) has on issue 6,000,000 1 ordinary shares at
market value of 2.50 each.
Bell plc (a geared company) has on issue:
17,000,000 25p ordinary shares; and
8,000,000 15% debentures (quoted at 125)
Taking corporation tax at 35%, and assuming that:
1. The companies are in all other respects identical; and
2. The market value of Grants equity and the market value of Bells debt
are in equilibrium;
Calculate the equilibrium price per share of Bells equity.
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Solution
Vg = Vu + Dt
N.B. D =
100
125
x 000 , 000 , 8 = 10m
m
Vu = 6,000,000 @ 2.50 = 15
Dt = 10,000,000 x 35% = 3.5
Vg = 18.5m

m
E = (balancing figure) 8.5
D (as above) 10_
Vg (as above) 18.5m

Price per share =
m 17
m 5 . 8

= 50p
Why do companies not attempt a 99.9% debt structure?
1. Bankruptcy costs
The higher the level of gearing the greater the risk of bankruptcy with the
associated COSTS OF FINANCIAL DISTRESS.
Vg = Vu + Dt Present value of costs of financial distress
2. Agency costs
Costs of restrictive covenants to protect the interests of debt holders at high levels
of gearing.
3. Tax exhaustion
The value of the company will be reduced if advantage cannot be taken of the tax
relief associated with debt interest.
4. Debt capacity
Generally loans must be secured against a companys assets and clearly some
assets (e.g. property) provide better security for loans than other assets (e.g. high-
tech equipment which may become obsolescent overnight). The depth of the
assets second hand market and its rate of depreciation are important
characteristics.
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5. Personal taxes (MILLERS CRITIQUE 1977)
Investors will be concerned with returns net of all taxes
If a firms income is paid out as debt interest, corporation tax savings are
made (see M & M 1963) but investors will have to pay income tax on debt
interest.
If a firms income is paid out as an equity return, corporation tax has to be
paid but personal tax can be saved (e.g. by avoidance of capital gains tax
using exemptions).
In deciding its gearing level, a firm should consider its corporation tax position
and the personal tax position of its investors if it wishes to maximise their
wealth.
In his 1977 article, Miller argues that firms will gear up until marginal
investors face a personal tax cost of holding debt equal to the corporation tax
saving. At this point there is no further advantage of gearing.
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PECKING ORDER THEORY
The Pecking Order Theory is that a companys capital structure decision is not
determined by the costs and benefits of using a combination of debt and equity
finance to minimise the cost of capital.
The theory suggests that a company has a well defined order of preference in
relation to available sources of finance i.e.
(a) The first preference is the use of retained earnings, since internal finance is
readily accessible, has no issue costs and does not involve negotiating with
third parties, such as banks.
(b) If external finance has to be used (because the company has identified more
positive NPV projects than can be financed by retentions alone), bank
borrowings, loan stock and debentures are the initial preferred source of
external finance. The cost of issuing new debt is normally much smaller than
the cost of equity issues. Furthermore it is possible to raise smaller amounts
of debt than of equity.
When raising debt, initially it is advisable to issue low risk secured debt, and
when there are no more assets available as security, then to issue unsecured
debt with a consequent higher risk and higher cost.
(c) If, after the companys level of debt capacity is reached, there remain further
positive NPV projects that remain to be financed, the final and least preferred
source of finance is the issue of new equity capital.
Accordingly there appears to exist a financing pecking order i.e. first use retained
profits, then secured debt, then unsecured debt and finally equity.
A more sophisticated explanation of the Pecking Order Theory was developed in
1984, when it was suggested that the order of preference stemmed from the
existence of asymmetry of information between the company and the capital
markets. This term refers to the fact that company management are likely to have
a much better idea of the true worth of the companys shares than do outside
investors.
Accordingly if a company wishes to raise new project finance and the capital market
has underestimated the benefits of the project, company management (with their
inside information) will be aware that the market has undervalued the company.
They would therefore choose to finance the project through retentions, so that
when the market discovers the true value of the project, existing shareholders will
benefit. If retained earnings are inadequate, the company would choose to raise
debt finance in preference to a new equity issue (since they would not wish to issue
new equity shares which are undervalued by the market).
However if the companys management believe that investors are overvaluing the
benefits of the new project and therefore placing too high value on the companys
shares, they would prefer to issue new equity at that overvalued price.
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STATIC TRADE-OFF THEORY
This variation on the 1963 with corporate tax theory of Modigliani and Miller arrives
at a conclusion, which is similar to that of the traditional theory of gearing i.e. there
exists an optimum level of leverage that companies should attempt to attain.
Provided a company is in a static position i.e. not in a period of extreme growth, it
is likely to have a gearing policy that is stable over time. This is achieved by
striking a balance between the benefits and the costs of raising debt.
The benefits of debt relate to the tax relief that is enjoyed when interest payments
are made the cheaper debt finance will reduce the weighted average cost of
capital and increase corporate value.
The costs of debt relate to the increases in the costs of financial distress (e.g.
bankruptcy costs) and increases in agency costs that arise when the company
exceeds its optimum gearing levels. The resultant increase in required returns
demanded by investors cause the weighted average cost of capital of the company
to increase and hence corporate value to fall.
There is accordingly, in theory, a trade-off between these two effects and hence the
cost of capital and the value of the company will be optimised. However,
subsequent research suggests that there is little evidence of the static trade-off
theory operating in the real world.
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SOLVENCY RATIOS

1. Gearing Ratio
This indicates the relationship between:
Equity : Fixed return securities (or Debt) on issue
It may be based upon balance sheet values (in which case Equity will comprise
ordinary share capital and reserves) or upon stock exchange values (in which event
the shares and debentures on issue are valued at mid market price).
Illustration
Called-up Share Capital:
250,000 of ordinary shares of 25p, quoted price 53p 55p
500,000 of 7% preference shares of 1, quoted price 71p 73p
Reserves 100,000
Loans: 200,000 of 12% irredeemable debentures market yield currently 10%
You are required to calculate the Capital Gearing Ratio, based upon
(a) Book values
(b) Market values
Solution to illustration
(a) Book values = (250,000 + 100,000) : (500,000 + 200,000) = 0.5 : 1
(b) Market values = 540,000 : (360,000 + 240,000) = 0.9 : 1
N.B. Gearing ratios are expressed in a number of ways e.g.
Equity
Debt

Debt Equity
Debt
+

Debt may include long-term borrowings only or both short and long-term debt.
A further problem is the classification of hybrid securities e.g preference shares. In
the above illustration they have been classified as debt, but this is open to debate
when the ratio is calculated for the benefit of lenders.
2. Interest cover
ie
Interest Gross
Tax and Interest before Earnings

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Berlan and Canalot
Berlan plc
Berlan plc has annual earnings before interest and tax of 15m. These earnings
are expected to remain constant. The market price of the companys ordinary
shares is 86 pence per share cum.div. and of debentures 105.50 per debenture
ex-interest. An interim dividend of six pence per share has been declared.
Corporate tax is at the rate of 35% and all available earnings are distributed as
dividends.
Berlans long-term capital structure is shown below:
000
Ordinary shares (25 pence par value) 12,500
Reserves 24,300
36,800
16% debentures 31.12.2007 (100 par value) 23,697
60,497
Required:
Calculate the cost of capital of Berlan plc according to the traditional theory of
capital structure. Assume that it is now 31 December 2004.
Canalot plc
Canalot plc is an all-equity company with an equilibrium market value of 32.5
million and a cost of capital of 18% per year.
The company proposes to repurchase 5 million of equity and to replace it with
13% irredeemable loan stock.
Canalots earnings before interest and tax are expected to be constant for the
foreseeable future. Corporate tax is at the rate of 35%. All profits are paid out as
dividends.
Required:
(a) Using the assumptions of Modigliani and Miller, explain and demonstrate how
this change in capital structure will affect:
(i) the market value
(ii) the cost of equity
(iii) the cost of capital
of Canalot plc.
(b) Explain any weakness of both the traditional and Modigliani and Miller theories
and discuss how useful they might be in the determination of the capital
structure for a company.
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Berlan and Canalot solution
Berlans weighted average cost of capital
Cost of equity
000
Earnings before interest and tax 15,000
Interest (16% x 23,697) 3,792
11,208
Tax (35% x 11,208) _3,923
Earnings 7,285
Dividend (full distribution) 7,285
NIL

Number of shares = 12.5 million x 4 = 50 million

Pence
Market price per share: cum div 86
Less interim dividend declared _6
Ex div 80p

Value of shares = 50 million x 80p = 40 million

Cost of equity capital, using the dividend valuation model and assuming constant
dividends
=
000 , 40
7285
= 18.21%
Cost of debt
A market value higher than redemption value implies that the cost (pre-tax) is less
than the nominal rate of 16%.
Using 8% and 9% as discount rates.
Year
8%
factors
PV
9%
factors
PV
0 Market value (105.50) 1 (105.50) 1 (105.50)
1-3 Interest (net of tax) 10.40 2.577 26.80 2.531 26.32
3 Redemption 100.00 0.794 79.40 0.772 77.20
+0.70 1.98
Cost of debt = % 1 X
98 . 1 7 . 0
7 . 0
% 8 |

\
|
+
+ = 8.26%
Market value of debt =
100
50 . 105
x million 697 . 23 = 25 million
Value of debt plus equity = (25 + 40) million = 65 million
Weighted average cost of capital
WACC =
65
25
x % 26 . 8
65
40
x % 21 . 18 + = 14.38%
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Changes to capital structure: Canalot plc
(a) (i) Market value
Using a Modigliani-Miller formula for the value of a geared company
(with irredeemable debt):
Vg = Vu + Dt
When Canalot replaces equity with loan stock, the company will increase
in value by the tax shield, Dt.
= 5 million debt issued x 35% tax rate
= 1.75 million
The market value of the company increases to
32.5 million + 1.75 million = 34.25 million
The market value of equity becomes
34.25 million 5 million = 29.25 million
(ii) The cost of equity
This can be computed
- from first principles, or
- by using the MM formula for Ke
From first principles
Consider the distribution of profits before and after the change in capital
structure.
Before the change, equity earnings = 18% x market value of
32.5 million = 5.85 million.
Pre-tax profits =
65
100
x million 85 . 5 = 9 million.
After the debt issue:
000
Earnings before interest and tax 9,000
Less interest: 5m x 13% _650
8,350
Tax (35% x 8,350) 2,922
Equity earnings (= dividend) 5,428
Cost of equity =
250 , 29
428 , 5
= 18.56%
The cost of equity has increased by 0.56% because of the increased
financial risk experienced by shareholders.
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Using the MM formula for Ke:
Keg =
E
) t 1 ( D
) Kb Keu ( Keu

+
=
25 . 29
) 35 . 0 1 ( 5
%) 13 % 18 ( % 18

+ = 18.56%
(iii) Weighted average cost of capital
Again, this can be computed either from first principles or by using the
MM formula for WACC.
From first principles
WACC = 65 . 0 x % 13 x
25 . 34
5
% 56 . 18 x
25 . 34
25 . 29
+ = 17.08%
Using the MM formula for WACC
WACCg = |

\
|
+

D E
Dt
1 Keu
= |

\
|

25 . 34
35 . 0 x 5
1 % 18 = 17.08%
The WACC has declined from 18%, reflecting the benefits of tax relief on
interest.
(b) Weaknesses of the traditional and Modigliani-Miller theories
The traditional theory of capital structure is an intuitive theory, which is not
supported by a rigorous model building approach, as is the case with
Modigliani and Millers work. It describes how the weighted average cost of
capital declines as gearing increases until a point is reached where WACC is at
its lowest and starts to increase with further increases in gearing. It therefore
suggests that there is an optimal capital structure at which the firm has its
lowest cost of capital and highest value. Unfortunately, because the theory is
purely descriptive, it does not suggest a method of finding that optimal capital
structure, except by trial and error.
The traditional view predicts an optimal WACC position, because it effectively
suggests that the relationship between the cost of equity and gearing is non-
linear. In this respect it is in conflict with the capital asset pricing model and
much of modern financial management theory.
Modigliani and Millers theory, used in our discussion of Canalot plc, suggests
that the only advantage of borrowing is the tax relief on debt interest. The
theory results directly from the assumptions that they make. Some of these
are unrealistic, for example:
(i) that individuals and companies can borrow at the same interest rate
(ii) that interest rates do not increase with gearing
(iii) that personal borrowing (which is not covered by limited liability) is no
different from corporate borrowing
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(iv) that the capital market is perfect
(v) that (although corporate taxes are considered) personal taxes are
ignored.
Although these assumptions are unrealistic, there is still some logic in MMs
suggestion that companies should borrow as much as they can in order to
take advantage of tax relief. However, their theory also ignores possible costs
arising at high levels of gearing, such as:
(i) Bankruptcy costs: both direct (sale of assets below going concern
value) and indirect (increased time spent controlling a company which is
near bankruptcy).
(ii) Agency costs: for example, restrictive covenants in loan agreements
which hinder the companys freedom of operation.
(iii) Tax exhaustion: inability to take advantage of the all tax relief on the
high debt interest because of a lack of taxable profits.
(iv) Debt capacity: inability to offer sufficient security to be able to borrow
to a high level of gearing.
At some level of gearing these costs will start to outweigh the benefits of tax
relief, implying that optimal gearing is achieved at a level just below this
point.
Unfortunately, while the MM theory allows predictions of the effect of
borrowing on the cost of capital, it does not enable this optimal borrowing
level to be established, because it ignores the costs at high gearing.
Miller, in a later paper, argues that when personal taxes are introduced, the
capital structure does not affect the firms cost of capital. However, this too
ignores bankruptcy costs and other costs of high gearing.
In summary neither the traditional nor the MM view of capital structure
presents a practical method for identifying a companys optimal capital
structure. This can only be achieved by intelligent trial and error. However,
Modigliani and Miller do at least identify the various factors which affect the
cost of capital and, at reasonable levels of borrowing, enable the company to
predict the effect of increasing or decreasing gearing on the value of the firm.

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Chapter 7
Portfolio theory and
the capital asset
pricing model


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CHAPTER CONTENTS
PRINCIPLES OF PORTFOLIO THEORY -------------------------------- 149
THE UNDERLYING THEORY OF CAPM --------------------------------- 158
SYSTEMATIC AND UNSYSTEMATIC RISK ----------------------------- 159
THE SECURITY MARKET LINE------------------------------------------ 161
SYSTEMATIC BUSINESS RISK AND SYSTEMATIC FINANCIAL RISK166
ASSUMPTIONS, ADVANTAGES AND LIMITATIONS OF CAPM ------- 172
ARBITRAGE PRICING THEORY AND FAMA & FRENCH THREE FACTOR
MODEL ------------------------------------------------------------------- 174
CYGNET PLC ------------------------------------------------------------- 175
FIVE WEALTHY INDIVIDUALS ----------------------------------------- 179
DELL PLC----------------------------------------------------------------- 184
NELSON PLC ------------------------------------------------------------- 186

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PRINCIPLES OF PORTFOLIO THEORY
In 1952, Harry Markowitz developed portfolio theory, which is based upon a very
simple principle. Any investment (whether an investment in shares or an
investment in projects), should never be viewed in isolation, but should instead be
considered as part of an overall portfolio of shares or projects.
As everyones grandmother might say Dont put all of your eggs in one basket!!
Portfolio theory uses statistical techniques to prove that grandmother is correct!!
The features of portfolio theory are dealt with in detail in the following illustration.
Illustration 1 (Pastel plc)
Pastel plc is considering whether to accept one of two major new investment
opportunities Project 1 and Project 2. Each project would require an immediate
outlay of 10,000 and Pastel plc expects to have available enough resources to
undertake only one of them.
The directors of Pastel plc believe that returns from existing activities and from the
new projects will depend upon which of three economic environments prevails
during the coming year. They estimate returns for the coming year (that is cash
flows to be received at the end of the year plus project value at that time), and the
probabilities of the three possible environments, as follows:
Environment A Environment B Environment C
Probability of environment 0.3 0.4 0.3

Returns from Project 1 12,500 12,500 9,500
Returns from Project 2 10,000 11,750 13,000
Aggregate returns from
existing portfolio of projects
90,000 120,000 130,000
The company has a current market value of 100,000. The directors of Pastel plc
believe that the risk and returns per of market value of their existing activities
are similar to those for the stock market as a whole, including their dependence on
whichever economic environment prevails. The current rate of interest on short-
dated government securities and on bank deposit account is 10% per annum.
You are required to prepare calculations for the directors of Pastel plc
showing which, if either, of the two proposed projects should be accepted.
Ignore inflation and taxation
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Solution 1 (Pastel plc)
(a) Choice between proposed projects
(i) Conversion of data into period rates of return
Period rate of return = End of year value Start of year value
Start of year value
Environment PROJECT 1 PROJECT 2
EXISTING
PORTFOLIO

A
10
10 5 . 12

= 25%
10
10 10

= 0%
100
100 90

= -10%

B
10
10 5 . 12

= 25%
10
10 75 . 11

= 17.5%
100
100 120

= 20%

C
10
10 5 . 9

= -5%
10
10 13

= 30%
100
100 130

= 30%
(ii) Calculation of expected returns (Er) and standard deviations for each
PROJECT w Rates of
Return
Expected return
(Er)
Deviations
(r Er)
w(r Er)
2
s()
% % %
1 0.3 25 7.5 + 9 24.3
0.4 25 10.0 + 9 32.4
0.3 -5 (1.5) -21 132.3
16.0 189.0 = 13.75%

2 0.3 0 - -16 76.8
0.4 17.5 7.0 + 1.5 0.9
0.3 30 9.0 +14 58.8
16.0 136.5 = 11.68%
Existing
Portfolio 0.3 -10 (3.0) -24 172.8
and 0.4 20 8.0 + 6 14.4
Market 0.3 30 9.0 +16 76.8
14.0 264.0 = 16.25%
(iii) Naive analysis
Provided that investors are generally risk averse, if two mutually exclusive
projects have identical expected returns, the preferred project is that with the
smaller amount of risk (i.e. standard deviation or variance). In this instance:
Er s()
Project 1 16% 13.75%
Project 2 16% 11.68%
Since, they have the same expected returns; it would appear that Project 2 is
preferred as it has the lower standard deviation. Furthermore, given that the
existing projects of Pastel plc provide a lower level of expected return (14%)
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for a higher level of risk (a standard deviation of 16.25%) than Project 2, it
appears that Project 2 would be an acceptable investment for Pastel plc to
undertake.
(iv) Portfolio approach
The above approach is considered naive because THE MARGINAL PROJECT
SHOULD NOT BE VIEWED IN ISOLATION, BUT AS PART OF THE OVERALL
PORTFOLIO OF PROJECTS i.e.
(a) Period rates of return
Environment
EXISTING PORTFOLIO plus
PROJECT 1
EXISTING PORTFOLIO plus
PROJECT 2
A
110
110 5 . 102

= - 6.82%
110
110 100

= - 9.09%

B
110
110 5 . 132

= 20.45%
110
110 75 . 131

= 19.77%

C
110
110 5 . 139

= 26.82%
110
110 143

= 30.00%
(b) Calculation of expected returns (Er) and standard deviation for each
PROJECT w
Rates of
Return
Expected
return (Er)
Deviations
(r Er)
w(r Er)
2


s()
% % %
Existing +
Proj. 1
0.3 -6.82 -2.046 -21.0 132.30
0.4 20.45 8.18 +6.27 15.73
0.3 26.82 8.046 +12.64 47.93
14.18 195.96 = 14.00%

Existing +
Proj. 2
0.3 -9.09 -2.727 -23.27 162.45
0.4 19.77 7.908 +5.59 12.50
0.3 30.00 9.000 +15.82 75.08
14.18 250.03 = 15.81%
CORRELATION CO-EFFICIENTS
Where the two assets behave in an absolutely identical way, there is perfect
positive correlation (+ 1), where they behave in directly opposing ways there is
perfect negative correlation ( 1) and where there is no observable relationship
between the two, there is zero correlation (0). The formula to calculate a
correlation coefficient (which is not provided on the ACCA formula sheet) is:
(r)
PROJECT, EXISTING
=
EXISTING PROJECT
) EXISTING , PROJ (
s s
COV

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(1) Calculations of covariances
PROJECT 1 and EXISTING PORTFOLIO
w Project 1 Existing Portfolio Covariance
Deviations (r-Er) Deviations (r-Er) Project, Existing
0.3 + 9 - 24 - 64.8
0.4 + 9 + 6 21.6
0.3 - 21 + 16 - 100.8
- 144
PROJECT 2 and EXISTING PORTFOLIO
w Project 2 Existing Portfolio Covariance
Deviations (r-Er) Deviations (r-Er) Project, Existing
0.3 - 16 - 24 115.2
0.4 + 1.5 + 6 3.6
0.3 + 14 + 16 67.2
+ 186
(2) Standard deviations (already calculated)
s
PROJ.1
= 13.75% s
PROJ.2
= 11.68% s
EXISTING
= 16.25%
(3) Correlation coefficients

PROJ. 1, EXISTING
=
25 . 16 x 75 . 13
144
= -0.64
(Fairly high degree of negative correlation!)

PROJ. 2, EXISTING
=
25 . 16 x 68 . 11
186 +
= +0.98
(Extremely high level of positive correlation!)
The above analysis shows that the expanded portfolio (including Project 1) would
be less risky than the expanded portfolio (including Project 2). Whilst Project 1 on
its own is more risky than Project 2. Once more both portfolios show identical
expected returns.
The reason for this decision change is the correlation between each of the proposed
projects and the existing portfolio i.e.
(a) The returns of Project 1 and the existing portfolio are negatively correlated,
whilst
(b) The returns of Project 2 and the existing portfolio show a high degree of
positive correlation.
FORMULAE
Fortunately formulae exist to avoid the necessity for the laborious calculations
shown on page 151 of this solution. These formulae are:
Expected return from portfolio Er
p
= w
a
Er
a
+ w
b
Er
b

where w
a
is the proportion invested in the shares of Company a
and, w
b
is the proportion invested in the shares of Company b
Er
p
is simply a weighted average of the expected returns from each investment.
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Risk of portfolio (s
p
) =
ab b a b a
2
b
2
b
2
a
2
a
s s w w 2 + s w + s w
N.B. s
a
s
b

ab
= Cov [Er
a
Er
b
]
NOTE: Provided
ab
(correlation coefficient) is less than +1, the risk of the
portfolio (the or s of the combined returns) will be less than the weighted average
risk of the portfolios two components.
Relating these formulae to the Pastel problem and treating each new project as a
and the existing portfolio as b, the expected return and total risk of the existing
portfolio and Project 1 are as follows:
Er
p
= |

\
|
+ |

\
|
% 14 x
11
10
% 16 x
11
1
= 14.18%
s
p
= |

\
|
+ |

\
|
+ |

\
|
64 . 0 x 25 . 16 x 75 . 13 x
11
10
x
11
1
x 2 25 . 16 x
11
10
75 . 13 x
11
1
2 2

= 6364 . 23 2335 . 218 5625 . 1 + = 14.00%
And the expected return and total risk of the existing portfolio and Project 2 are as
follows:
Er
p
= |

\
|
+ |

\
|
% 14 x
11
10
% 16 x
11
1
= 14.18%
s
p
= |

\
|
+ |

\
|
+ |

\
|
98 . 0 x 25 . 16 x 68 . 11 x
11
10
x
11
1
x 2 25 . 16 x
11
10
68 . 11 x
11
1
2 2

= 7445 . 30 2335 . 218 1275 . 1 + + = 15.81%
Notice how these formulae provide the same results as the calculations performed
on page 151, which thankfully will never have to be repeated thanks to these
formulae.
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APPENDIX (To be read after studying the Capital Asset Pricing Model)
The analysis using portfolio theory can be improved upon further by taking into
consideration the Capital Asset Pricing Model. This shows that an investment
projects risk can be split into two components: Systematic and Unsystematic Risk.
The unsystematic risk of an investment project can be eliminated when it is held as
part of an efficient well diversified investment portfolio.
Therefore, in evaluating the expected return from a project, it should be viewed,
not in relation to the projects total risk, but just to the systematic portion of that
risk, which cannot be eliminated.
The CAPM gives an expression for the return required from a single investment,
project j:
Er
j
= R
f
+ (Er
m
R
f
)
j
where Er
j
= required return from investment j
Rf = risk-free return
Er
m
= expected overall return on the market portfolio

j
=
( )
2
m
jm
s
COV

s
m
2
= variance of the returns from a market portfolio
COV (jm) = covariance of returns of project j with the returns from the market
The data given by this question provides
r
f
= 10%
Er
m
= 14%
s
m
2
= 264
COV
(PROJECT 1 & MARKET)
= 144
COV
(PROJECT 2 & MARKET)
= +186
N.B. The question states that the risk and returns on the existing portfolio are
similar to those of the stock market as a whole.
Thus the in each case is:


PROJECT 1
=
264
144
= 0.545

PROJECT 2
=
264
186
= +0.705
Therefore the required return on each project is:
PROJECT 1: ( )
264
-144
% 10 % 14 % 10 + = 7.8%
PROJECT 2: ( )
264
186
% 10 % 14 % 10 + = 12.8%
whilst the expected return on both projects = 16%
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In conclusion, this analysis shows that, whilst the return expected from both
projects (16%) is above that required (Project 1: 7.8%, Project 2: 12.8%), given
their individual levels of systematic risk, Project 1 is preferred since it provides the
greatest excess return over required return and hence will add most to
shareholders wealth. Notice that this conclusion is the complete opposite to that
reached via the naive analysis.
An alternative expression for the calculation of is:

j
=
m
jm j
s
s

where s
j
= standard deviation of the returns of investment j

jm
= the correlation coefficient between the returns of j and the returns
from the market portfolio
s
m
= standard deviation of the returns from a market portfolio
Hence the correlation coefficient between the returns of these projects and the
market are:

PROJECT 1, MARKET
=
( )
m 1 PROJ
MARKET & 1 P
s s
COV
=
25 . 16 x 75 . 13
144

=
4375 . 223
144
= 0.644
thus
PROJECT 1
=
25 . 16
644 . 0 x 75 . 13
= 0.545

PROJECT 2, MARKET
=
( )
m 2 PROJ
MARKET & 2 P
s s
COV
=
25 . 16 x 68 . 11
186 +

=
8 . 189
186 +
= +0.98
thus
PROJECT 2
=
25 . 16
98 . 0 x 68 . 11
= +0.704*
*slight difference from main solution due to rounding
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Illustration 2
The following data are available:
Er
m
= 20% R
f
= 8%
s
m
= 6% s
f
= 0%
Mr R Atkinson has 100 of his own money and he wishes to invest in Portfolio L
which lies along the Capital Market Line (CML), above the market portfolio (Portfolio
M) where the ratio
R
f
, M : M , L = 2 : 1
As a result he must borrow 50 of additional funds (so that the ratio of PERSONAL
FUNDS : BORROWING = 2 : 1) at the risk-free rate. He places the total of 150
in the shares of companies which represent Portfolio M.
Calculate
(a) Er
L
(i.e. expected return from the total investment), and
(b) s
L
(i.e. the risk of that portfolio)
Solution 2
(a) Expected return from the total investment
Using basic common sense, this can be calculated as follows:
Amounts
invested
Annual
income

Own funds (2) 100
Borrowed funds (1) 50
150 x 20% = 30
Interest paid (50) x 8% = (4)
100 26
Therefore Er
L
will obviously be (26 100) = 26% p.a.
Alternatively, E
rL
can be calculated using the normal formula i.e.
Er
L
= w
a
Er
a
+w
b
Er
b

= (1.5 x 20%) + ([1 1.5] x 8%) = 26% p.a.
(b) The total risk of the portfolio
If only the personal funds of Mr Atkinson had been invested (i.e. 100), s
L
would
only be 6%. However, since he borrowed a further 50, s
L
will clearly increase to
(1.5 x 6%) = 9%
Alternatively, s
L
can be calculated using the normal formula i.e.
s
p
=
ab b a b a
2
b
2
b
2
a
2
a
s s w w 2 + s w + s w
= 0%) x 6% x 1.5] - [1 x 1.5 x (2 + 0%) x 1.5] - ([1 + 6%) x (1.5
2
= 9%
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For Portfolio L
( ) [ ] ( ) 8% 1.5 1 20% 1.5 + = L r =26%
6% 1.5 =
L
= 9%


L
M
% 26
L
=
r

20% =
rM

8% =
rF

p
Capital Market Line
6% 9%
0
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THE UNDERLYING THEORY OF CAPM
The CAPM assesses investments from the viewpoint of well-diversified shareholders
and considers that when companies invest in projects they must accept that the
majority of their shareholders are well-diversified institutions (i.e. pension funds,
insurance companies, unit trusts and investment trust companies). In fact only
about 13% of the shares in UK quoted companies are held by individuals and many
of these are so wealthy that they can invest their savings in a number of different
companies in various market sectors.
Obviously an investor can reduce risk by holding a portfolio of shares in companies
in different industries, which will to some degree offer different risk/return profiles
over time. For instance an investor holding shares in both BP and British Airways
should find that if oil prices increase the share price of BP should rise, whereas the
share price of BA would probably fall. Obviously an oil price decrease would cause
an opposite effect on the share prices of the two companies.
Provided that the returns on shares do not demonstrate perfect positive correlation,
any additional investment brought into a shareholders portfolio should (subject to
the point made in the next paragraph) cause the overall risk of the portfolio to
reduce.
Suppose an investor who has built up a small portfolio in the shares of (say) three
companies now decides to add to that portfolio the shares of a few more companies
in different market sectors. He should find a substantial risk reduction as the
additional investments are added to the portfolio. However as the shares of more
and more companies (in different sectors) are added to the portfolio, the risk
reduction will eventually slow down and once the portfolio increases up to about 16
to 20 companies (again in different market sectors) the risk reduction will
eventually cease.
Thus a standard deviation ( or s) is a measure of total risk, and this can be
analysed between:
UNSYSTEMATIC (aka SPECIFIC or UNIQUE) RISK i.e. the risk which will
initially disappear as a result of diversification, and
SYSTEMATIC (aka MARKET) RISK i.e. the risk which can never be
avoided when investing in company shares.
Specific risk reflects factors which are unique to the company or to the industry in
which it operates, whereas systematic risk reflects market wide factors such as the
state of the economy.
Diversification therefore eliminates the unsystematic risk relating to shares held in
a well-diversified portfolio, but sadly the systematic risk of that portfolio will
remain.
Accordingly, CAPM recognises that investors cannot expect to receive a return on
their exposure to unsystematic risk therefore returns will only be received as a
result of systematic risk, which investors can never avoid.
CAPM uses a factor, which compares the systematic risk of the shares of a
company with the systematic risk of the market. The higher the , the greater the
return the investor demands as compensation for the systematic risk borne.
Obviously unsystematic risk (which is diversified away by holding the shares of a
sufficient number of companies) can be ignored.
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SYSTEMATIC AND UNSYSTEMATIC RISK

CAPM formulae
CAPM provides the return that would be required by a well-diversified, risk-averse
investor. The formula can be expressed in a variety of ways, e.g.:
E(r
i
) = R
f
+
i
(E(r
m
) R
f
)
K
e
= R
f
+ [R
m
R
f
]
Required return = r
f
+ (Er
m
rf)
j

where:
R
f
= the risk free rate of interest (e.g. the return on 90 day Treasury bills)
R
m
= the average return on a market portfolio (e.g. the return on FTSE 100
constituents)
[R
m
R
f
] = the market risk premium or excess market return
(beta) = an index which compares the systematic risk of the investment with
the systematic risk of the market portfolio
The above CAPM formula appears in one form or another on formulae sheets
provided by the accountancy bodies. However the following formulae for
calculating are not provided in the examination and must therefore be committed
to memory:
UNSYSTEMATIC RISK
SYSTEMATIC RISK
Total
portfolio
risk(s)
Number of different companies in which shares are held
1
Number of different companies in which shares are held
1 5 9 13 17 21 25
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Formulae for calculating
Formula one

j
=
m
j jm
s
s

Where
jm
= correlation coefficient between the investment and the market
s
j
= total risk of the investment
s
m
= total risk of the market, which is entirely systematic risk since
the market is totally diversified.
Formula two

j
=
( )
2
m
jm
s
COV

Where COV
(jm)
= covariance between the investment and the market
s
m
2
= variance of the market (i.e. the standard deviation
squared).
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THE SECURITY MARKET LINE
The security market line is a graph of the capital asset pricing model i.e.

There are accordingly two benchmarks for and for the Security market line, i.e.
The return on a risk free security, which obviously carries no systematic risk
and therefore has a of 0;
The return on the market portfolio, which due to its ultimate diversification
carries only systematic risk and will always have a of 1.
An investment with a:
of 0 is referred to as a risk free investment;
of 1 is called a neutral investment (since its risk is equivalent to that of the
market);
of > 1 is termed an aggressive investment (since it is riskier than average);
of < 1 is called a defensive investment (since it is less risky than the market
average)
Accordingly if an investor wishes to hold equity shares despite the existence of a
bear market, he would be advised to invest in defensive investments, since their
prices would fall more slowly than the market average. During a bull market an
investor should hold aggressive investments, since their increases in value would
outpace the market average.
Security
market line
-0.5 0 0.5 1 1.5
Systematic risk ()
R
m

Return
%
R
f

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Illustration 3
In the case that follows, four states-of-the-world are considered with respect to
future prospects for real growth in Gross National Product. State 1 represents a
relatively serious recession, State 2 is a mild recession, State 3 is a mild recovery
and State 4 is a strong recovery. The probabilities of these alternative future
states-of-the-world are set forth in column 2 of the table below. Estimates of
market returns and project rates of return are set forth in the remaining columns.
Summary of information Morton Company
(1) (2) (3) (4) (5) (6) (7)
State
of
world
Subjective
probability
Market
return
Project rates of return
Project 1 Project 2 Project 3 Project 4
w r
m


1 0.1 0.15 0.30 0.30 0.09 0.05
2 0.3 0.05 0.10 0.10 0.01 0.05
3 0.4 0.15 0.30 0.30 0.05 0.10
4 0.2 0.20 0.40 0.40 0.08 0.15
The Morton Company is considering four projects in a capital expansion
programme. The economics staff projected the future course of the market
portfolio over the estimated life span of the projects under each of the four states-
of-the-world (first three columns in the table); it is recommended the use of a risk-
free rate of return of 5 per cent. The finance department provided the estimates of
project return conditions on the state-of-the-world (columns 4 to 7 above). Each
project involves an outlay of approximately 50,000.
Assuming that the projects are independent and that the firm can raise sufficient
funds to finance all four projects, which projects would be accepted using the
capital asset pricing model?
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Solution 3
In Table 1 the data provided by market relationships are utilised to calculate the
expected return on the market along with its variance. The probabilities of the
future states-of-the-world are multiplied by the associated market returns and their
products are summed to obtain the expected market return (Er
m
) of 10 per cent.
Table 1: Calculation of Market Parameters
Col.
no.
(1) (2) (3) (4) (5) (6) (7)
State of
world
w R
m
wR
m
(R
m
Erm) (R
m
Erm)
2
w(R
m
Erm)
2


1 0.1 0.15 0.015 0.25 0.0625 0.00625
2 0.3 0.05 0.015 0.05 0.0025 0.00075
3 0.4 0.15 0.060 0.05 0.0025 0.00100
4 0.2 0.20 0.040 0.10 0.0100 0.00200
Er
m
= 0.10 Var(R
m
) = 0.01
The expected market return (Er
m
) is used in calculating the variance of the market
returns. This is shown in columns 5 to 7. The expected return is deducted from the
return under each state, and deviations from Erm in column 5 are squared in
column 6. In column 7 the squared deviations are multiplied by the probabilities of
each expected future state (which appear in column 2). The products are summed
to give the variance of the market return. (N.B. The square root of the variance
which does not have to be calculated in this instance is its standard deviation).
A similar procedure is followed in Table 2 for calculating the expected return and
the covariance for each of the four individual projects. The expected return is
obtained by multiplying the probability of each state by the associated forecast
return. The deviations of the return under the state from the expected return are
next calculated in column 5. The deviations of the market returns from their mean
are repeated for convenience in column 6. In column 7, the deviations of project
returns are multiplied by the deviations of the market returns. In column 8 the
figures established in column 7 are multiplied by the probability factors to
determine the covariance for each of the four projects.
In Table 3, the beta for each project is calculated as the ratio of its covariance to
the variance of the market return, and they are employed in Table 4 to estimate
the required return on each project in terms of the security market line
relationship. The risk-free rate of return is 5 per cent, with a market risk premium
of (10% 5%) i.e. 5 per cent.
Required returns as shown in column 2 of Table 4 are deducted from the estimated
returns for each individual project (calculated in column 4 of Table 2) to derive the
excess returns. These relations may be depicted graphically. The CAPM criterion
accepts the projects with positive excess returns, which appear above the security
market line. It rejects those with negative excess returns (plotted below the
security market line).
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Table 2: Calculation of Expected Returns and Covariances for Projects
Col
no
(1) (2) (3) (4) (5) (6) (7) (8)
State
of
world
w r
j
wr
j
(r
j
-Er
j
)(r
m
-Er
m
) w(r
j
-Erj)(r
m
-Er
m
)

P
1
1 0.1 0.30 0.03 (0.50)(0.25) = 0.125 0.0125
2 0.3 0.10 0.03 (0.10)(0.05) = 0.005 0.0015
3 0.4 0.30 0.12 (+0.10)(+0.05) = 0.005 0.0020
4 0.2 0.40 0.08 (+0.20)(+0.10) = 0.020 0.0040
Er
1
= 0.20

Cov(r
1
,r
m
) = 0.0200

P
2
1 0.1 0.30 0.03 (0.44)(0.25) = 0.110 0.0110
2 0.3 0.10 0.03 (0.24)(0.05) = 0.012 0.0036
3 0.4 0.30 0.12 (+0.16)(+0.05) = 0.008 0.0032
4 0.2 0.40 0.08 (+0.26)(+0.10) = 0.026 0.0052
Er
2
= 0.14 Cov(r
2
,r
m
) = 0.0230

P
3
1 0.1 0.09 0.009 (0.12)(0.25) = 0.030 0.0030
2 0.3 0.01 0.003 (0.02)(0.05) = 0.001 0.0003
3 0.4 0.05 0.020 (+0.02)(+0.05) = 0.001 0.0004
4 0.2 0.08 0.016 (+0.05)(+0.10) = 0.005 0.0010
Er
3
= 0.030 Cov(r
3
,r
m
) = 0.0047

P
4
1 0.1 0.05 0.005 (0.13)(0.25) = 0.0325 0.00325
2 0.3 0.05 0.015 (0.03)(0.05) = 0.0015 0.00045
3 0.4 0.10 0.04 (+0.02)(+0.05) = 0.0010 0.00040
4 0.2 0.15 0.03 (+0.07)(+0.10) = 0.0070 0.00140
Er
4
= 0.08 Cov(r
4
,r
m
) = 0.00550
Table 3: Calculation of the Betas

1
= 0.0200 0.01 = 2.00

2
= 0.0230 0.01 = 2.30

3
= 0.0047 0.01 = 0.47

4
= 0.0055 0.01 = 0.55
Table 4: Calculation of Excess Returns
(1) (2) (3) (4)
Project Measurement of required return Expected
return
Excess return %
(alpha value)
P
1
r
1
= 0.05 + 0.05(2.0) = 0.150 0.200 + 5.00
P
2
r
2
= 0.05 + 0.05(2.3) = 0.165 0.140 2.50
P
3
r
3
= 0.05 + 0.05(0.47) = 0.0735 0.030 4.35
P
4
r
4
= 0.05 + 0.05(0.55) = 0.0775 0.080 + 0.25
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An all-equity company

Note conflict between dividend valuation model (DVM) & CAPM with projects P2 and
P4.
ke (using DVM) is assumed to be 12%
To construct the SECURITY MARKET LINE
Return
When 0 5%
At 1 10%
Security
Market Line
0
5
10
15
20
25
0.5 1.0 1.5 2.0 2.5 of
project
P1
P2
P3
P4
E
x
p
e
c
t
e
d

&

R
e
q
u
i
r
e
d

R
e
t
u
r
n

o
n

P
r
o
j
e
c
t


%

ke
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SYSTEMATIC BUSINESS RISK AND SYSTEMATIC
FINANCIAL RISK
At a gearing level of zero, the equity shareholders of a company would have to bear
systematic business risk only. However as a company increases its debt levels and
becomes more and more highly leveraged, its equity shareholders will not only
have to face the same level of systematic business risk as before, but will also have
to accept increasing amounts of systematic financial risk.
Accordingly:
Equity shareholders in an ungeared company bear systematic
business risk only, whereas
Equity shareholders in an otherwise identical geared company bear the
same level of systematic business risk as before, but will also have to
face an ever increasing level of systematic financial risk as borrowing
levels become greater and greater,
with a consequence increase in the Ke of the company concerned. This is
illustrated below.
Following the M & M with corporation tax theory of 1963, as gearing levels increase,
Ke behaves as follows:

Now that the issue of leverage has been introduced, there becomes a need to
distinguish:
asset (a), which reflects systematic business risk only, and
equity (e), which reflects both systematic business risk TOGETHER
WITH ANY systematic financial risk which MAY exist.
Gearing % D
E
Ke
%
SYSTEMATIC BUSINESS RISK
Ke
SYSTEMATIC
FINANCIAL RISK
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Therefore:
In the case of an all equity company, e = a, since no systematic financial
risk can possibly exist.
In the case of a geared company, e > a, since e contains both
systematic business risk and systematic financial risk, whereas a reflects
systematic business risk only.
The theoretical relationship between a and e is commonly expressed by the
following formulae:

a
=
( ) ( )
( )
( ) ( )
|
|

\
|
+

+
|
|

\
|
+
d
d e
d
e
d e
e

T 1 V V
T 1 V

T 1 V V
V

a
=
( )
( )
( ) t 1 D E
t 1 D

t 1 D E
E

d e
+

+
+

The latter version will now be used throughout this course.
Illustration 4
Giles plc is an all-equity company whose coefficient is 0.95. Stiles plc is a levered
company in all other respects has the same risk and operating characteristics as
Giles.
The capital structure of Stiles plc is as follows:
Nominal value Market value
m m
Equity 6 15
Debt 4 6
10 21
The debentures of Stiles plc are virtually risk-free and the corporation tax rate is
40%.
What would be the predicted of the equity of Stiles plc?
Solution 4
Since the debt of Stiles plc may be assumed to be risk free:

a
=
( ) t 1 D E
E

e
+

Therefore since Giles plc is an all equity company within the same industry as Stiles
plc, the
e
of Stiles plc can be calculated as follows:

e
=
( )
E
t 1 D E

a
+

=
( )
15
4 . 0 1 6 15
x 95 . 0
+

= 1.178
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Illustration 5
Hotalot plc produces domestic electric heaters. The company is considering
diversifying into the production of freezers. Data on four listed companies in the
freezer industry and for Hotalot are shown below:
Freezeup Glowcold Shiverall Topice Hotalot
000 000 000 000 000
Fixed assets 14,800 24,600 28,100 12,500 20,600
Working capital _9,600 _7,200 11,100 _9,600 12,700
24,400 31,800 39,200 22,100 33,300

Financed by:
Bank loans 5,300 12,600 18,200 4,000 17,400
Ordinary shares* 4,000 9,000 3,500 5,300 4,000
Reserves 15,100 10,200 17,500 12,800 11,900
24,400 31,800 39,200 22,100 33,300

Turnover 35,200 42,700 46,300 28,400 45,000
Earnings per share
(in pence)
25 53.3 38.1 32.3 106
Dividend per share
(in pence)
11 20 15 14 40
Price/earnings ratio 12 10 9 14 8
Beta equity 1.1 1.25 1.30 1.05 0.95
*The par value per ordinary share is 25p for Freezeup and Shiverall, 50p for Topice
and 1 for Glowcold and Hotalot.
Corporate debt may be assumed to be almost risk-free, and is available to Hotalot
at 0.5% above the Treasury Bill rate, which is currently 9% per year. Corporate
taxes are payable at a rate of 35%. The market return is estimated to be 16% per
year. Hotalot does not expect its financial gearing to change significantly if the
company diversifies into the production of freezers.
Required:
(a) The equity beta of Hotalot is 0.95 and the alpha value 1.5%. Explain the
meaning and significance of these values to the company.
(b) Estimate what discount rate Hotalot should use in the appraisal of its
proposed diversification into freezer production.
(c) Corporate debt is often assumed to be risk-free. Explain whether this is a
realistic assumption and calculate how important this assumption is likely to
be to Hotalots estimate of a discount rate in (b) above. For this purpose
assume that Hotalot and the four freezer companies all have a debt beta of
0.3.
(d) Discuss whether systematic risk is the only risk that Hotalots shareholders
should be concerned with.
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Solution 5
(a) Alpha and beta values
The equity beta is a measure of the systematic risk of the companys shares that
is, the relative volatility of the shares compared with the market as a whole.
Systematic risk, which is caused by general economic and market factors, cannot
be eliminated by diversification. The equity beta can be estimated as
m
m
s
sj j

where
jm
is the correlation between the returns of the share and the returns of the
market, and s
j
and s
m
are the standard deviations of the returns of the share and
the market respectively.
An equity beta of 0.95 for Hotalot plc suggests that if the stock market return
moves up or down by 10%, the return on Hotalot will be expected to move by 0.95
x 10% = 9.5%. In other words, Hotalots returns are slightly less volatile than the
market as a whole, because its beta is just less than 1.
The capital asset pricing model shows how the expected returns of a share will
depend on its beta value. If the actual returns of the share are higher or lower
than the CAPM prediction, the share is said to have an abnormal return. The alpha
value is the measure of this abnormal return, that is, the difference between the
actual return and that predicted by the CAPM. In the case of Hotalot the alpha
value is positive, at 1.5%, which should cause investors to buy the shares. This in
turn will increase the price, forcing down the excess return until alpha falls to zero.
Thus alpha values should only be temporary. In a well diversified portfolio the
alpha value is expected to be zero.
(b) Discount rate for the appraisal of the proposed diversification into
freezers
First, estimate the average equity beta in the freezer industry, then degear this
figure. Regear it up to Hotalots debt/equity ratio and apply the CAPM to find
Hotalots cost of equity. A WACC can then be calculated for Hotalot.
Average equity beta in the freezer industry
Company Value of shares* Equity Beta factor
F 16 million x 0.25 x 12 = 48 million 1.1
G 9 million x 0.533 x 10 = 48 million 1.25
S 14 million x 0.381 x 9 = 48 million 1.30
T 10.6 million x 0.323 x 14 = 48 million 1.05
192 million
*Value of shares = Number of shares x eps x PE ratio
Since all the companies have the same market value of shares, the average equity
beta is simply:
4
05 . 1 30 . 1 25 . 1 1 . 1 + + +
= 1.175
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Total value of debt in the companies is:
million
F: 5.3
G: 12.6
S: 18.2
T: 4.0
40.1 million
The average debt/equity ratio in the freezer industry is therefore
192
1 . 40

Degearing the equity beta:

a
=
( ) t 1 D E
E

e
+

=
( ) 35 . 0 1 1 . 40 192
192
175 . 1
+
= 1.035
The market value of Hotalots shares is (4 million x 1.06 x 8) = 33.92 million,
the market value of its debt is 17.4 million. Then regearing the beta to Hotalots
debt/equity ratio:

e
=
E
) t 1 ( D E

a
+

=
( )
92 . 33
65 . 0 x 4 . 17 92 . 33
x 035 . 1
+
= 1.38
The required return on Hotalots equity, from the CAPM
= R
f
+ (R
m
R
f
)
= 9% + (16% 9%) 1.38 = 18.66%
The weighted average cost of capital for Hotalots new diversification is
=
( )
( )
( ) 4 . 17 92 . 33
4 . 17
x 35 . 0 1 % 5 . 9
4 . 17 92 . 33
92 . 33
x % 66 . 18
+
+
+
= 14.42%
(c) The assumption that corporate debt is risk-free
Corporate debt is not risk-free. There is a risk of default which implies that the
debt has a positive beta. Studies show that corporate debt is likely to have a beta
of between 0.2 and 0.3.
From the information given in this question Hotalot must have a debt beta of
0.0714 since its Kd = 9% + (16% 9%) 0.0714 = 9.5%. However the
instruction in the question is to assume a debt beta of 0.3, and this must, of
course, be observed.
Assuming that all corporate debt has a beta of 0.3, both the degearing and
regearing calculations in part (b) above will need to be adjusted.
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The asset beta of an organisation is the weighted average of the beta of equity
and the beta of debt. The asset beta is the same as the degeared beta, so:
a =
( ) ( ) 65 . 0 x 1 . 40 192
65 . 0 x 1 . 40
x 3 . 0
65 . 0 x 1 . 40 192
192
x 175 . 1
+
+
+
=1.07
This is the revised degeared for the freezer industry.
Regearing to Hotalots level of gearing -
1.07 =
( )
( )
( ) 65 . 0 x 4 . 17 92 . 33
65 . 0 x 4 . 17
x 3 . 0
65 . 0 x 4 . 17 92 . 33
92 . 33
x e
+
+
+

1.07 = 075 . 0 750 . 0 x e +
e = 1.327
Applying the CAPM gives Hotalots cost of equity as
9% + (16% 9%) 1.327 = 18.29%
Hotalots WACC then becomes
32 . 51
4 . 17
x 65 . 0 x % 5 . 9
32 . 51
92 . 33
x % 29 . 18 + = 14.18%
compared with the original estimate of 14.42%. The margin of error on these
estimates is, however, quite high which means that the assumption that
corporate debt is risk-free is unlikely to have a significant effect on the accuracy of
Hotalots estimates.
(d) Does systematic risk give the complete picture?
The capital asset pricing model assumes that Hotalots shareholders are well
diversified and are only concerned with systematic risk. Undiversified or partly
diversified shareholders should also be concerned with unsystematic risk and
should seek a total return appropriate to the total risk that they face.
Even well diversified shareholders might be concerned with unsystematic risk. The
total risk of a company comprises systematic and unsystematic risk. It is total risk
(the total variability of cash flows) which determines the probability of a company
failing, and the investor experiencing additional bankruptcy costs. The greater the
expected bankruptcy costs and the greater the probability of corporate failure, the
more concerned investors are likely to be with the total risk and not just systematic
risk.
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ASSUMPTIONS, ADVANTAGES AND LIMITATIONS OF
CAPM
Assumptions
All shareholders hold the market portfolio. Although this is questionable in
practice, even a limited spread of shareholdings produces some
diversification, therefore this assumption is appropriate;
A perfect capital market (e.g. no transaction costs, information about risk and
return is freely available);
The ability of investors to both borrow and lend at the risk free rate of
interest;
All forecasts are made for a single time period only;
All investors share the same uniform expectations concerning future earnings
streams and are only concerned with risk and return.
Advantages
It demonstrates that unsystematic risk can be diversified away, therefore the
only risk premium required is for systematic risk only;
Probably the best practical method for establishing the Ke of a publicly traded
company;
It highlights the relationship between risk and return, based upon stock
market performance and provides a measure of the risk of shares held within
a well-diversified portfolio and measures the required rate of return in view of
that level of risk;
Helps to provide a risk adjusted discount rate for use in investment appraisal.
Limitations
It concentrates purely upon systematic risk and is therefore of limited use for
investors who do not hold a well-diversified portfolio;
Since CAPM only considers the level of return to investors, it ignores the
manner in which that return is received. Therefore, it treats dividends and
capital gains as equally desirable to investors, thus totally ignoring the tax
position of individual investors;
It is purely a single period model, therefore not ideal for use in projects which
extend for multiple periods;
The model requires the use of data which can be difficult to obtain i.e.
(i) The risk free rate of interest: It is necessary to take the best proxy
measure of a short-term default free rate e.g. UK 90 day Treasury bills;
(ii) The return on the market portfolio: Should the FT all-share index be
used, or the FTSE 100, or the FTSE 350, or a world composite share
price index?;
(iii) Beta: Clearly this should strictly be based on subjective probabilities of
future events, but since this is impracticable in practice, regression
analysis is often used to compare the historical behaviour of individual
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securities with the behaviour of a suitable market index within the same
time period.
CAPM tends to overstate the required return of high beta securities and to
understate the required return of low beta securities. The returns of small
companies, returns on certain days of the week or months of the year have in
practice been observed to differ from those expected from CAPM.
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ARBITRAGE PRICING THEORY AND FAMA & FRENCH
THREE FACTOR MODEL
Arbitrage Pricing Theory (APT), which was first introduced by S A Ross in 1976,
is an alternative theory of risk and return. It states that the risk premium on a
share depends on that shares exposure to a number of factors, and not simply Er
m
.
The problem is that APT does not state what these factors are, but researchers
have identified several possibilities, including unanticipated changes in the level of
industrial production; the rate of inflation; the effect of the yield curve; real rates of
interest; levels of personal consumption; money supply in the economy and risk
premiums on bonds.
APT states that the required return from Security A is expressed as follows:
Required return = r
f
+ [Er
F1
r
f
]
F1
+ [Er
F2
r
f
]
F2
+ [Er
F3
r
f
]
F3

Where:
Er
F1
= expected return arising from factor 1

F1
=
1 F
1 F , A A
s
s

APT has less constraining assumptions than CAPM. For instance, it is not a single
factor model and does not require some of the perfect market assumptions of
CAPM. The major weakness of APT is that it is extremely difficult to identify the
relevant factors and the sensitivity of such factors for individual companies. Hence
APT is difficult to use as a practical decision-making technique.
The Fama and French three factor model was derived in 1993, when two
American academics considered that CAPM could be significantly improved by
introducing two further factors in addition to market risk i.e. Size effect: Investors
find small (less actively traded) companies more risky than larger entities, and
Distress factor: The ratio of book value of equity to market value of equity is
compared. The more market value falls towards book value, the greater the
companys exposure to financial distress.
Fama and Frenchs three factor model is as follows:
Required return = r
f
+ [Er
m
rf]
jm
+ [SMB]
js
+ [HML]
jd

Where:

jm
is the normal equity beta of the company applied to the excess market return,

js
is the companys factor loading for the size effect where [SMB] is the difference
in return between a portfolio of the smallest stocks in the economy and a portfolio
of the largest stocks, and

jd
is the factor loading for the distress effect where [HML] is the difference in
return between a portfolio of the highest book to market value stocks and a
portfolio of the lowest book to market value stocks.
To calculate the SMB and HML premia, Fama and French used stocks quoted on the
New York Stock Exchange, the American Stock Exchange and the NASDAQ.
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Cygnet plc
Cygnet plc is a large listed company, which owns a variety of businesses in the
retailing sector. It now wishes to diversify into brewing and has consequently
highlighted two possible target companies in the brewing sector, Parched Ltd and
Fullup Ltd.
The following data has been collected regarding each target company, the existing
activities of Cygnet plc and the market generally.
Parched Ltd Fullup Ltd Cygnet plc Market
Expected return 15% 16% 18% 25%
Risk 10% 12% 15% 20%
Risk is measured as the standard deviation of possible returns around the average
(or expected) return.
Correlation coefficients of targets with:
- existing activities of Cygnet plc; and
- the market generally;
are estimated as follows:
Parched Ltd Fullup Ltd
Cygnet plc 0.85 0.40
Market 0.25 0.95
The risk-free rate is to be taken as 5% and either target will represent 10% of the
now enlarged Cygnet plc (that is the existing operations of Cygnet plc will represent
90% of the expanded company and the new acquisition will form the remaining
10% of Cygnets extended business operation).
Required
Appraise each of the target companies using:
(i) portfolio theory; and
(ii) capital asset pricing model
explaining briefly the basis of each method and state which you recommend in this
case.
NOTE: It is thought that for purposes of portfolio theory, the shareholders of
Cygnet plc would accept an increase of 1% in risk to achieve a 0.5% increase in
return or alternatively to accept a 0.5% decrease in return in order to achieve a 1%
decrease in risk.
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Cygnet plc solution
(i) Portfolio theory approach
We calculate the expected return and risk of the following combinations:
- Cygnet plc with Parched Ltd
- Cygnet plc with Fullup Ltd
Cygnet plc and Parched Ltd
Expected return is given by
w
a
Er
a
+ w
b
Er
b

Where w
a
= proportion represented by Cygnet plc
w
b
= proportion represented by Parched Ltd
Er
a
= expected return from Cygnet plc
Er
b
= expected return from Parched Ltd
Return = (0.9 x 18%) + (0.1 x 15%)
= 17.7%
Risk of the combination is given by
s
p
=
ab b a b a
2
b
2
b
2
a
2
a
s s w w 2 + s w + s w
where s
a
= risk of Cygnet plc
s
b
= risk of Parched Ltd

ab
= correlation coefficient of one with the other.
s
p
= ( ) ( ) ( ) 85 . 0 x 10 x 15 x 1 . 0 x 9 . 0 x 2 10 x 1 . 0 15 x 9 . 0
2 2
+ +
= ( ) 95 . 22 1 25 . 182 + +
= 14.36%
Cygnet plc and Fullup Ltd
Return = (0.9 x 18%) + (0.1 x 16%)
= 17.8%
s
p
= ( ) ( ) ( ) 4 . 0 x 12 x 15 x 1 . 0 x 9 . 0 x 2 12 x 1 . 0 15 x 9 . 0
2 2
+ +
= ( ) 96 . 12 44 . 1 25 . 182 + +
= 14.02%
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Summary
Return Risk
Cygnet plc 18% 15%
Cygnet plc and Parched Ltd 17.7% 14.36%
Cygnet plc and Fullup Ltd 17.8% 14.02%
Both takeovers decrease both risk and return. The combination of Cygnet plc and
Fullup Ltd decreases risk by a greater extent and decreases return by a lesser
extent and hence is preferred to the alternative.
In deciding whether the combination is better than Cygnet plcs existing operations
alone we use the information about shareholders attitudes to risk.
The decrease in risk is just under 1%. The acceptable decrease in return
corresponding to this is 0.5%. The actual decrease is 0.2%, and hence the
takeover of Fullup Ltd is worthwhile.
(ii) CAPM approach
We calculate, for each target company, its beta factor and hence the minimum
required return from each company. Comparison of this with the expected return
from each company then determines whether the takeover is worthwhile.
Parched Ltd

j
=
m
j jm
s
s

Where
jm
= correlation coefficient between the investment (Parched Ltd)
with the market
s
j
= risk of the investment
s
m
= risk of the market.
Hence
j
=
20
10 25 . 0
= 0.125
The CAPM formula now gives
Minimum required return = R
f
+ (Er
m
- R
f
)
j

= 5 + (25 - 5)0.125
= 7.5%
Fullup Ltd

j
=
20
12 x 95 . 0
= 0.57
Minimum required return = 5 + (25 - 5)0.57 = 16.4%
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Summary
Required return Expected return
Parched Ltd 7.5% 15%
Fullup Ltd 16.4% 16%
Thus, the takeover of Fullup is not worthwhile, since the expected return is less
than that required to compensate shareholders for the systematic risk in the
company. The takeover of Parched should go ahead.
Explanation of the methods and conclusion
Portfolio theory appraises a proposed investment from the point of view of the fit
that it has with the existing operations of the company. The aim is always to
increase return and decrease risk. Sometimes both these effects are not possible
at the same time, in which case one takes into account the shareholders attitudes
to risk (indifference curves). This is, however, difficult in practice.
Unlike portfolio theory, which considers an investment in combination with the
existing portfolio of investments and seeks to obtain satisfactory changes in return
for changes in total risk, CAPM considers an investment in isolation. This is
because the existing portfolio is assumed to be fully diversified and can thus
be ignored. At the point of full diversification only systematic risk remains in a
portfolio. Provided that the new investment being considered makes a sufficient
return to compensate for its level of systematic risk, it is satisfactory. Again this is
in stark contrast to portfolio theory which is concerned with total risk rather
than just systematic risk. A benefit of CAPM is that the conclusion on the
acceptability of an investment would be universally held by all fully diversified
investors.
In this case, since Cygnet plc is large and quoted, it is reasonable to suppose that
its shareholders are well diversified and therefore the CAPM approach would seem
to be the more appropriate. Parched Ltd is thus the preferred takeover target.
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Five Wealthy Individuals
Five wealthy individuals have each put 200,000 at your disposal to invest for the
next two years. The funds can be invested in one or more of four specified projects
and in the money market. The projects are not divisible and cannot be postponed.
The investors require a minimum return of 24% over the two years.
Details of these possible investments are:
Initial
cost
Return over
two years
Expected standard deviation of
returns over two years
00 (%) (%)
Project 1 600 22 7
Project 2 400 26 9
Project 3 600 28 15
Project 4 600 34 13
Money market (minimum) 100 18 5
Correlation coefficients of returns (over two years)
Between
projects
Between projects and the market
portfolio
Between projects and the
money market

1 and 2: 0.70 1 and market: 0.68 1 and money market: 0.40
1 and 3: 0.62 2 and market: 0.65 2 and money market: 0.45
1 and 4: 0.56 3 and market: 0.75 3 and money market: 0.55
2 and 3: 0.65 4 and market: 0.88 4 and money market: 0.60
2 and 4: 0.57
3 and 4: 0.76 Between the money market and
the market portfolio: 0.40

The risk-free rate is estimated to be 16%, the market return 27% and the variance
of returns on the market 100% (all for the two-year period).
Required:
(a) Evaluate how the 1m should be invested using
(i) portfolio theory,
(ii) the capital asset pricing model (CAPM)
Portfolio risk may be assessed using the formula
s
p
=
ab b a b a
2
b
2
b
2
a
2
a
s s w w 2 + s w + s w
(b) Explain why portfolio theory and CAPM might give different solutions as to
how the 1m should be invested.
(c) Discuss the main problems of using CAPM in investment appraisal.
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Suggested solution to Five Wealthy Individuals
(a) How the 1 million should be invested
(i) Using portfolio theory
Consider the possible combinations for investing 1 million and the return that
will be made from each combination:
Projects Portfolio return
A: 1 and 2 0.6 x 22% + 0.4 x 26% = 23.6%
*B: 2 and 3 0.4 x 26% + 0.6 x 28% = 27.2%
*C 2 and 4 0.4 x 26% + 0.6 x 34% = 30.8%
D: 1 and money market: 0.6 x 22% + 0.4 x 18% = 20.4%
E: 2 and money market: 0.4 x 26% + 0.6 x 18% = 21.2%
*F: 3 and money market: 0.6 x 28% + 0.4 x 18% = 24.0%
*G: 4 and money market: 0.6 x 34% + 0.4 x 18% = 27.6%
H: Money market only: 18%
The minimum required return is 24%.
* Therefore, only alternatives B, C, F and G are acceptable.
To choose between these we must examine portfolio risk, using the formula
given in the question.
Alternative B: Projects 2 and 3
Portfolio risk: = ( ) ( ) ( ) 15 x 9 x 65 . 0 x 6 . 0 x 4 . 0 x 2 15 x 6 . 0 9 x 4 . 0
2 2 2 2
+ +
= 08 . 136 = 11.67%
Alternative C: Projects 2 and 4
Portfolio risk: = ( ) ( ) ( ) 13 x 9 x 57 . 0 x 6 . 0 x 4 . 0 x 2 13 x 6 . 0 9 x 4 . 0
2 2 2 2
+ +
= 81 . 105 = 10.29%
Alternative F: Project 3 and the money market
Portfolio risk: = ( ) ( ) ( ) 5 x 5 1 x 55 . 0 x 4 . 0 x 6 . 0 x 2 5 x 4 . 0 5 1 x 6 . 0
2 2 2 2
+ +
= 8 . 104 = 10.24%
Alternative G: Project 4 and the money market
Portfolio risk = ( ) ( ) ( ) 5 x 3 1 x 6 . 0 x 4 . 0 x 6 . 0 x 2 5 x 4 . 0 3 1 x 6 . 0
2 2 2 2
+ +
= 56 . 83 = 9.14%
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In order to rank the investment combinations, we need to summarise return
and risk.
Combination Portfolio expected Return Portfolio risk
2 and 3 27.2% 11.67%
2 and 4 30.8% 10.29%
3 and money market 24.0% 10.24%
4 and money market 27.6% 9.14%
In ranking the portfolios, we are looking for high return and low risk
(assuming risk-averse investors). It may therefore be said that:
(1) Combination 2 and 4 is better than 2 and 3 because it has a higher
return and lower risk.
(2) Combination 4 and the money market is better than both 2 and 3 and
3 and the money market because it has a higher return and lower risk.
The choice between combinations 2 and 4 and 4 and the money market is
impossible to make without further data on the investors risk/return
preferences.
However, an attempt to make the decision may be possible by calculating the
coefficient of variation, which employs the following formula:
Coefficient of Variation =
turn Re Expected
Deviation dard tan S

In the case of 2 and 4 this is (10.29% 30.8%) = 0.334, and in the case of
4 and the money market this is (9.14% 27.6%) = 0.331. Clearly the
combination of 4 and the money market is marginally preferable, since it
offers the lower level of risk per 1% of return. However, this technique is
open to criticism as the decision is too close for comfort!!.
(ii) Using the CAPM
First calculate the beta factors of the projects using the formula:
m
j jm
s
s

Project Beta
1
10
7 x 68 . 0

= 0.476
2
10
9 x 65 . 0

= 0.585
3
10
5 1 x 75 . 0

= 1.125
4
10
3 1 x 88 . 0

= 1.144
Money market
10
5 x 4 . 0

= 0.20
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Now calculate the betas of the combinations with returns above 24%. The
beta of a portfolio is the weighted average of the betas of the component
investments.
Combination Portfolio beta
2 and 3 (0.4 x 0.585) + (0.6 x 1.125) = 0.909
2 and 4 (0.4 x 0.585) + (0.6 x 1.144) = 0.920
3 and money market (0.6 x 1.125) + (0.4 x 0.20) = 0.755
4 and money market (0.6 x 1.144) + (0.4 x 0.20) = 0.766
Now find the required return of the portfolio, using the CAPM, and compare it
with its expected return:
Combination CAPM required return Expected return
2 and 3 16% + (27% 16%) 0.909 = 26% 27.2%
2 and 4 16% + (27% 16%) 0.920 = 26.12% 30.8%
3 and money
market
16% + (27% 16%) 0.755 = 24.3% 24.0%
4 and money
market
16% + (27% 16%) 0.766 = 24.43% 27.6%
Using the CAPM, all combinations except 3 and the money market are
expected to earn above their minimum required return. If the investors
require the greatest excess return, the choice would be projects 2 and 4,
since its excess return i.e. alpha value, is (30.8% 26.12%) = 4.68%.
(b) Why portfolio theory and the CAPM might give different solutions
The portfolio theory calculations assume that each portfolio can be viewed in
isolation from any other investments which the wealthy individuals may hold. As
shown in the answer above, the aim is to find the combination of investments with
the most satisfactory trade-off of expected return and risk. Some potential
combinations can be eliminated, but ultimately the final choice is a subjective one
which depends on the investors attitude to risk. The portfolio theory approach
recognises that investments must be viewed as part of a portfolio, but it effectively
makes the assumption that the chosen portfolio will account for all the investors
funds.
The capital asset pricing model assumes that the investor already holds a widely
diversified portfolio (the market portfolio). New investments are appraised by
considering their effect on the market portfolio in terms of return and risk. In doing
this it becomes apparent that only the systematic risk of the investment is relevant,
that is the proportion of the risk which is dependent on general economic and
market factors. Unsystematic risk is eliminated when the investment is added to
the market portfolio. The result is a simple formula for appraising a new
investment (or combination of new investments) in terms of systematic risk,
measured by the beta factor.
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In summary
Portfolio theory
assumes the new investments are an addition to the investors total portfolio;
considers the total risk of the portfolio of investments.
CAPM
assumes the new investments are a small addition to the market portfolio;
considers only systematic risk of the new investments
Investments which have high total risk but low systematic risk will be appraised
more favourably by the CAPM than by portfolio theory.
(c) The main problems of using CAPM in investment appraisal
The problems of using CAPM include
(i) the assumptions behind the model
(ii) the difficulty in obtaining data
(iii) the accuracy of the model in explaining investment and security returns
Many of the assumptions behind the model are unrealistic. The assumptions
include:
(i) Investors can borrow and lend easily at the risk-free rate of return
(ii) No transaction costs or market imperfections exist
(iii) Information about the risk and return of investments is freely available
(iv) Investors measure risk by the standard deviation of expected returns
(v) All investors have the same expectations about future profits and dividends
and are single-period terminal wealth maximisers. This is based only on risk
and return.
Obtaining data for the model is difficult. It is an ex-ante model which requires
data for expected returns and risk of the investment and the market. The practical
difficulty of forecasting such risk and returns means that the model is usually
applied using historical ex-post data, requiring the beta to be stable over time.
The model requires the risk-free rate, and the market return. What is the
appropriate measure of the risk-free rate and the market return? Over what period
should data be used? At what interval should observations be made? What is the
market the UK all-share index, or a world composite share price index, or some
other measure e.g. the FTSE 100 index? These are only some of the possible data
problems.
The accuracy of the model has been questioned by many pieces of empirical
research. CAPM requires alpha, the intercept term, not to be significantly different
from zero; many studies suggest that it is significantly different from zero. Low
beta securities earn higher returns than CAPM would predict, and higher beta
securities earn lower returns. Company size, seasonality, day of the week,
dividend yield, and price-earnings ratios are among the factors that are said to
explain observed returns in addition to the systematic risk.
Such problems raise serious questions about the accuracy of using CAPM in
investment appraisal.
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Dell plc
You have purchased the following data from a merchant bank.
Company
Forecast total
equity return
Standard deviation of
total equity return
Covariance with
market return

Dell plc 17% 6.3% 32%
Baseball plc 12% 4.8% 19%
Burnden plc 14% 4.7% 24%
Roker plc 21% 6.9% 43%
The market return, market standard deviation and market variance are 14.5%, 5%
and 25% respectively, and the risk free rate is 6%. Returns and all other data
relate to a one-year period.
Required:
(a) Estimate the differences between the required returns and the forecast total
equity returns (that is the alpha values) for each of these companies shares
and explain what use alpha values might be to financial managers.
(b) Briefly discuss reasons for the existence of alpha values, and whether or not
the same alpha values would be expected to exist in one years time.
Suggested solution to Dell plc
(a) The alpha value is any abnormal return that exists relative to the required
return from an investment, as estimated by using the capital asset pricing
model (CAPM). The beta of the companies shares may be estimated from:
=
m
Jm
Variance
iance var Co

The beta estimates are:
Dell
25
32
= 1.28
Baseball
25
19
= 0.76
Burnden
25
24
= 0.96
Roker
25
43
= 1.72
Required returns Forecast returns Alpha
Dell 6% + (14.5% - 6%) 1.28 = 16.88% 17% +0.12%
Baseball 6% + (14.5% - 6%) 0.76 = 12.46% 12% -0.46%
Burnden 6% + (14.5% - 6%) 0.96 = 14.16% 14% -0.16%
Roker 6% + (14.5% - 6%) 1.72 = 20.62% 21% +0.38%
A positive alpha value implies that it is possible to make a higher than normal
return, for the systematic risk taken. A negative alpha implies a lower than
normal return.
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A financial manager wishing to invest in shares might favour those with a
positive alpha, subject to the shares satisfying other selection criteria such as
the desired level of risk.
If a positive or negative alpha exists for the shares of the company of the
financial manager, and the market is at least semi-strong form efficient, the
alpha would be expected to move to zero as the companys share price
changes due to arbitrage profit taking. For example in theory a company with
a positive alpha would expect relatively high demand for its shares, increasing
share price and thereby decreasing return until the alpha is zero.
(b) Positive or negative alpha values exist for shares most of the time. If CAPM is
a realistic model alpha values should only be temporary and the same alpha
values would not be expected to exist in a years time.
Alpha may exist due to inaccuracies and/or limitations of the CAPM model
including:
(i) CAPM tends to overstate the required return of high beta securities and
to understate the required return of low beta securities. The returns of
small companies, returns on certain days of the week or months of the
year are observed to differ from those expected from CAPM.
(ii) Data input into the model may be inaccurate. For example it is
impossible to accurately calculate the market risk and return.
(iii) Other factors in addition to systematic risk might influence required
return. The arbitrage pricing theory (APT) suggests that a multi-factor
model is necessary.
(iv) CAPM is based upon a number of unrealistic assumptions.
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Nelson plc
The management of Nelson plc wish to estimate their firms equity beta. Nelson
has had a stock market listing for only two months and the financial manager feels
that it would be inappropriate to attempt to estimate beta from the actual share
price behaviour over such a short period. Instead, it is proposed to ascertain, and
where necessary adjust, the observed equity betas of other companies operating in
the same industry and with the same operating characteristics as Nelson, as these
should be based on similar levels of systematic risk and be capable of providing an
accurate estimate of Nelsons beta.
Three companies have been identified as firms having operations in the same
industry as Nelson which utilise identical operating characteristics. However, only
one company, Oak plc, operates exclusively in the same industry as Nelson. The
other two companies have some dissimilar activities or opportunities, in addition to
operating characteristics which are identical to those of Nelson.
Details of the three companies are:
(i) Oak plc. Observed equity beta 1.12. Capital structure at market values is
60% equity, 40% debt.
(ii) Beech plc. Observed equity beta 1.11. It is estimated that 30% of the
current market value of Beech is caused by risky growth opportunities which
have an estimated beta of 1.9. The growth opportunities are reflected in the
observed beta. The current operating activities of Beech are identical to those
of Nelson. Beech is financed entirely by equity.
(iii) Pine plc. Observed equity beta 1.14. Pine has two divisions East and West.
Easts operating characteristics are considered to be identical to those of
Nelson. The operating characteristics of West are considered to be 50% more
risky than those of East. In terms of financial valuation East is estimated as
being twice as valuable as West. Capital structure of Pine at market values is
75% equity, 25% debt.
Nelson is financed entirely by equity. The tax rate is 40%.
Required:
(a) Assuming all debt is virtually risk-free, determine three estimates of the likely
equity beta of Nelson plc. The three estimates should be based, separately,
on the information provided for Oak, Beech and Pine plc.
(b) Explain why the estimated beta of Nelson, when eventually determined from
observed share price movements, may differ from those derived from the
approach employed in a) above.
(c) Specify the reasons why a company which has a high level of share price
volatility and is generally considered to be extremely risky, can have a lower
beta value, and therefore lower systematic risk, than an equally geared firm
whose share price is much less volatile.
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Suggested solution to Nelson plc
(a) Estimates of likely beta

a
=
( ) t 1 D E
E

e
+
+
( )
( ) t 1 D E
t 1 D

d
+


But assumed d = 0

a
=
( ) t 1 D E
E

e
+

Therefore e =
( )
E
t 1 D E
a
+

(i) The beta of Oaks equity must be degeared to reflect Nelsons all equity
status
Hence,

a
=
( ) t 1 D E
E

e
+

=
( ) 4 . 0 1 4 6
6
x 12 . 1
+
= 0.8
(ii) To obtain a beta for Nelson, we must isolate the beta of Beechs current
operating activities.
Hence 1.11 = ( Current operations x 0.7) + (1.9 x 0.3)
1.11 = ( Current operations x 0.7) + 0.57
0.54 = Current operations x 0.7
Current operations =
7 . 0
54 . 0
= 0.77
(iii) In this case we must degear Pines equity beta to remove the financial
risk carried by Pine and then isolate the beta of Pines Eastern Division.

a
=
( ) t 1 D E
E

e
+

=
( ) 4 . 0 1 25 75
75
x 14 . 1
+
= 0.95
overall = 2/3
E
+ 1/3
W

0.95 = 2/3
E
+ 1/3
W

= 2/3
E
+ 1/3 x 1.5
E

= 2/3
E
+ 1/2
E

= 7/6
E

Therefore a = 0.95 x 6/7 = 0.814
Note that this calculation could have been performed by firstly isolating the beta of
the Eastern division and then by degearing to remove the financial risk carried by
Pine.
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(b) Reasons for estimated beta differences
The reasons include:
(i) Statistical estimation
Estimates of beta derived from observed share prices are usually the results
of a linear regression. They are, therefore, an estimate of the share beta
rather than a precise determination of that beta. Even if the true underlying
betas are identical, the regression estimates may differ. Normally betas of
portfolios are considered to be more reliable than betas of individual
securities.
(ii) Changes in operations
While the firms may currently have identical operating activities, by the time a
valid estimate of Nelsons beta can be made from actual share price data
(probably at least three years hence) the operating practices may have
changed.
(iii) Abnormal share price behaviour
The period immediately following a firms quotation on a stock exchange may
produce non-typical share price behaviour. The inclusion of such a period in
the observations used to determine beta may distort the calculations.
(iv) Size difference
Difference in size between Nelson and the other companies may cause a
difference in perceived risk which is reflected in the beta estimation.
Generally, smaller companies are perceived as being of greater risk than
larger firms.
(v) Differences in current cost structures
Although firms may appear to have identical operating characteristics,
differences in cost structures (e.g. caused by differences in the ages of
production equipment) can affect beta. Usually, the higher the proportion of
fixed costs the higher will be beta.
(vi) Growth opportunities of Nelson
Investors may perceive Nelson as having opportunities for growth and its
actual share price, share price behaviour and beta may reflect growth
opportunities as well as current activities.
(vii) Degearing process
The approach used to degear betas is derived from the Modigliani and Miller
1963 hypothesis. If any of the assumptions of their theory are violated (e.g.
risk free and permanent debt) then the procedure is invalid. In general terms
any of the criticisms levelled against the Modigliani and Miller 1963 theory
(e.g. bankruptcy costs, tax exhaustion, personal taxes, etc) could be used to
criticise our calculations above.
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(c) Share price volatility and systematic risk
The reasons for the lower beta value of a company with high share price volatility
stem from the differences between total risk and systematic risk. Total risk,
represented by measures of total share price (or return) volatility, comprise:
systematic risk + unsystematic risk
The unsystematic element of total risk is not connected with economy-wide factors
but is unique to a particular firm. This unsystematic risk can largely be diversified
away in a widely spread portfolio. The systematic risk results from the connection
between the share and the economy, or stock market, generally and cannot be
diversified away in a portfolio. It is this systematic risk, measured by beta, which is
of relevance.
For example, the success of a mineral prospecting company is unlikely to be a
function of the economy generally and is more likely to be determined by factors
unique to the firm. While the firms share price may be very volatile and the share
is extremely risky if held in isolation, the small level of dependence on the economy
means the share is largely risk-free in a portfolio context. Hence, large total risk
but small systematic risk is to be expected from this type of firm.
However, a manufacturing company may have a far greater dependence on the
economy and so its systematic risk is higher, even though its total risk is lower than
that of the prospecting firm.

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Chapter 8
Adjusted present
value



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CHAPTER 8 ADJUSTED PRESENT VALUE
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CHAPTER CONTENTS
ADJUSTED PRESENT VALUE ------------------------------------------- 193
POLYCALC PLC ---------------------------------------------------------- 194
TOVELL PLC ------------------------------------------------------------- 196
ALASTAIR BROWN PLC ------------------------------------------------- 201

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ADJUSTED PRESENT VALUE
Traditionally financial management has appraised new investments by discounting
their after-tax operating cash flows to present value at the firms weighted average
cost of capital and subtracting the initial investment cost to arrive at an NPV. We
have already noted problems with the use of the WACC and seen that adjustments
are commonly needed to tailor the discount rate to the systematic business risk and
the financial risk of the project under consideration.
M & M based adjustments to the cost of capital form one approach to this problem.
Here we examine another, adjusted present value (APV), which offers significant
advantages.
APV is often described as a divide and conquer approach. To do this the project
will first be evaluated as if it were being undertaken by an all-equity company.
Side effects like the tax shield on debt and the issue costs being ignored. This
first stage will give us the so-called base NPV or base case NPV. The second stage
is to calculate the present value of the side effects and to add these to the base
NPV. The result is the APV which shows the net effect on shareholder wealth of
adopting the project.
The APV method therefore sees the value of the project to shareholders as being:
Project value if all equity financed + present value of tax + Present value of
(the base case NPV) shield on the loan other side effects
Weaknesses of the APV technique
(a) The process of degearing an equity beta of a levered company in the new
industry to obtain a suitable asset beta for an all-equity firm relies upon the M
& M 1963 case. When market imperfections such as bankruptcy costs are
introduced, it is unlikely that the M & M 1963 position is valid.
(b) The discount rates used to evaluate the various side effects can be difficult to
determine. Normally the risk-free rate is used to evaluate the corporation tax
savings on loan interest and issue costs. This is valid if the firm is certain that
it will be earning sufficient profits to take immediate advantage of the tax
relief. If the firm were not certain, then the situation is more risky and a
higher discount rate should be used. The problem is how much higher? This
would largely be a matter of educated guesswork.
(c) In complex investment decisions the calculations can be extremely long.
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Polycalc plc
Polycalc plc is an internationally diversified company. It is presently considering
undertaking a capital investment in Australia to manufacture agricultural fertilizers.
The project would require immediate capital expenditure of A$15m, plus A$5m of
working capital which would be recovered at the end of the projects four year life.
It is estimated that an annual revenue of A$18m would be generated by the
project, with annual operating costs of A$5m. Straight-line depreciation over the
life of the project is an allowable expense against company tax in Australia, which is
charged at a rate of 50%, payable at each year-end without delay. The project can
be assumed to have a zero scrap value.
Polycalc plans to finance the project with a 5m 4-year loan at 10% from the Euro-
sterling market, plus 5m of retained earnings. The proposed financing scheme
reflects the belief that the project would have a debt capacity of two-thirds of
capital cost. Issue costs on the Euro debt will be 2 % and are tax deductible.
In the UK the fertilizer industry has an equity beta of 1.40 and an average
debt:equity gearing ratio of 1:4. Debt capital can be assumed to be virtually risk-
free. The current return on UK government stock is 9% and the excess market
return is 9.17%.
Corporate tax in the UK is at 35% and can be assumed to be payable at each year-
end without delay. Because of a double-taxation agreement, Polycalc will not have
to pay any UK tax on the project. The company is expected to have a substantial
UK tax liability from other operations for the foreseeable future.
The current A$/ spot rate is 2.0000 and the A$ is expected to depreciate against
the at an annual rate of 10%.
Required
Using the Adjusted Present Value technique, advise the management of Polycalc on
the projects desirability.
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Polycalc solution
Base-case discount rate
asset = 1.40 x
( ) 35 . 0 1 1 4
4
+
= 1.20
Base-case discount rate = 9% + (9.17% x 1.20) = 20%
Project tax charge and cash flows in A$m (Years 1 to 4)
Tax Cash flow
Revenue 18 18
Operating costs (5) (5)
Depreciation (15 4) (3.75)
Taxable profit 9.25
Tax charge @ 50% 4.625 (4.625)
8.375
Base-case net present value calculation in m
Year A$m
Exch.
Rate
increasing
at 10% pa m
20%
Discount
rate
m PV of
cash flows
0 (15 + 5) = (20) 2 = (10) x 1 = (10)
1 8.375 2.2 = 3.807 x 0.833 = 3.171
2 8.375 2.42 = 3.461 x 0.694 = 2.402
3 8.375 2.662 = 3.146 x 0.579 = 1.821
4 (8.375 + 5) = 13.375 2.9282 = 4.568 x 0.482 = 2.202
Base-case NPV = (0.404m)
PV of tax shield
Based upon debt capacity created i.e.
3
2
x
2
m 15 $ A
= 5m (which happens to be equal to the loan raised)
Annual tax relief on interest = 5m x 0.10 x 0.35 = 175,000
PV of tax relief for 4 years: 175,000 x 3.170 = 554,750
PV of issue costs
5m x 0.025 x (1 0.35) = 81,250
Adjusted present value
m
Base case NPV (0.404)
PV of tax shield 0.555
PV of issue costs (0.081)
Adjusted present value 0.07m or +70,000 approx
Therefore accept project and finance it in the manner indicated.
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Tovell plc
The selection of appropriate discount rates for capital investments has frequently
been a problem for the finance director of Tovell plc. The company has adopted a
strategy of diversification into many different industries, in order to reduce risk for
the companys shareholders. This has resulted in frequent changes in the
companys gearing level and widely fluctuating risks of individual investments.
The current project under appraisal, an investment in the fast food industry where
Tovell has no other investments, is expected to generate pre-tax operating cash
flows of 420,000 in the first year, rising by 5% per year for the five year expected
life of the project. After five years the land and buildings are expected to have a
realisable value of 1,250,000 (after any tax effects), the same as their original
cost, but in order to continue operations major new investment in equipment would
be required at that time. Other fixed assets would have negligible value after five
years. The total initial outlay of the project (net of issue costs) is 2.3 million, and
all but the land and buildings, attracts a 25% per year capital allowance on a
reducing balance basis.
The project would be financed by a 800,000 fixed rate loan from a regional
development agency at a subsidised interest rate of 6% per year, 3% less than
Tovell could borrow at in the capital market. The remainder of the finance would be
provided by an underwritten rights issue at a 10% discount on current market price
with total underwriting and issue costs of 5% of gross proceeds. The investment is
believed to add 1 million to the companys debt capacity.
Current financial data for Tovell and the fast food industry includes:
Tovell plc Fast food industry (average)
P/E ratio 12 20
Dividend yield 5% 3%
Equity beta 1.1 1.4
Debt beta 0.2 0.25
Gearing (debt/equity):
Book values 1.1 to 1 1.6 to 1
Market values 0.4 to 1 1 to 1
Share price 470 pence n.a.
Number of ordinary shares 3.5 million n.a.
The corporate tax rate is currently 30% per year, and tax is payable one year in
arrears
Treasury bills are currently yielding 5% per year after tax, and the return required
by well diversified investors is 12.5% per year.
Required:
(a) Provide a reasoned explanation as to whether you would support the
companys strategy of diversifying into many different industries.
(b) Prepare a report for the finance director of Tovell plc advising on the financial
viability of the proposed fast food investment. Include in the report an
assessment of the limitations of the method of appraisal that you have used.
Supporting calculations should form an appendix to your report.
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Tovell plc solution
(a) Candidates are expected to show understanding of the theoretical and
practical arguments relating to corporate diversification into several
industries.
Tovell has a strategy of diversifying into many industries in order to reduce
risk of the companys shareholders. Rational shareholders should already be
well diversified, in order to eliminate unsystematic risk. If shareholders are
not well diversified this may be achieved quickly and cheaply through the
purchase of such investments as general unit trusts. The expense of the
company undertaking diversification is likely to be much greater than that of
individual investors in the company diversifying themselves, and therefore
sub-optimal strategy from the investors viewpoint. As the primary objective
of companies is usually assumed to be the maximisation of shareholder
wealth the strategy would not normally be recommended.
However, diversification might have beneficial effects for shareholders
including:
(i) Less volatile internal cash flows, making servicing existing debt less
risky, and therefore increasing the debt capacity of the company.
Greater use of debt with no extra risk could reduce the overall cost of
capital, and increase shareholder wealth.
(ii) If diversification is into foreign markets where exchange controls or
other barriers prevent or restrict shareholders directly investing (i.e.
segmented markets), it might be possible for shareholders to reduce
their systematic risk through Tovell investing in such markets which
have risk-return combinations which would not otherwise be available to
shareholders.
(iii) If a company fails there are many bankruptcy costs including receivers
fees and the possibility of assets being sold cheaply in a forced-sale.
Such costs may significantly reduce wealth of shareholders. A
diversified company may have a lower risk of corporate failure because
of reduced total risk of the company (measured by variance of returns).
Shareholders may be willing to accept the costs of diversification if the
probability of corporate failure is reduced.
(b) Candidates are required to select an appropriate investment evaluation
technique (hopefully APV) in a diversification situation where gearing levels
have changed, to show understanding of its limitations, and to prepare a
report supported by the financial valuation of given data.
Report on the financial viability of the fast food investment
The proposed investment is in an industry where the company has no existing
activities, and differs in risk to the companys existing activities, as is
evidenced by the equity betas of the company and the industry. The
investment is to be financed 800,000 by debt and 1,578,947 equity, a
gearing level of approximately 0.5 to 1, which is significantly different from
the companys current market weighted gearing of 0.4 to 1.
As the investment results in a change in capital structure, is not marginal
relative to the size of the company, and does not have the same level of
systematic risk as the company, the current weighted average cost of capital
should not be used as the discount rate.
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There is no easy way to adjust the weighted average cost to take into account
these changes. It is recommended that the fast food investment is evaluated
using the adjusted present value (APV) technique. This approach examines
directly the effects of the financing methods that are being used, which, for
this investment relate to tax relief on interest payments, the benefit of a
subsidised loan, and issue costs associated with the rights issue.
The estimated APV of the investment is MINUS 113,620, which suggests that
the investment is not financially viable. However, this ignores the potentially
valuable option to continue operations after the initial five year period by
further investment in equipment. Any final decision should include
consideration of the financial effects of this option, and any other
opportunities that might arise as a result of diversifying into the fast food
industry.
Limitations of APV
APV offers an opportunity to evaluate investments where gearing and risk
differ from the companys existing operation. However, it has its limitations
including:
(i) The equation for asset betas in a taxed world assumes that cash flows
are perpetuities. The cash flows for this investment are not perpetuities.
(ii) APV requires the identification of all financing side effects and their
discount at a rate reflecting their risk. In a complex investment
situation, especially an overseas investment, it might be difficult to
identify relevant financing side effects, and their appropriate discount
rates.
Appendix
APV = Base NPV plus the present value of financing side effects.
Base case NPV
This may be estimated by discounting net cash flows by the discount rate
applicable to the risk associated with an ungeared investment. As the
investment is in the fast food industry the base case NPV should be estimated
using data from this industry.
asset =
( )
( )
( ) t 1 D E
t 1 D

t 1 D E
E

d e
+

+
+

asset = 1.4 x
( ) 3 . 0 1 1 1
1
+
+ 0.25 x
( )
( ) 3 . 0 1 1 1
3 . 0 1 1
+


= 0.823 + 0.103 = 0.926
Using CAPM
K
e
ungeared = r
F
+ (Er
M
r
F
) asset
= 5% + (12.5% 5%) 0.926 = 11.945%
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Base case NPV (000)
Year 0 1 2 3 4 5 6
Operating flows 420 441 463 486 511
Taxation (126) (132) (139) (146) (153)
Tax saved by
Capital allowances* 79 59 44 33 100
Initial outlay (2,300)
Realisable value ______ ___ ___ ___ ____ 1,250 ____
Net flows (2,300) 420 394 390 391 1,648 (53)
Discount factors 1.00 .893 .798 .713 .637 .569 .508
Present values (2,300) 375 314 278 249 938 (27)
Base case NPV = (173,000)
*Capital allowances
Year Written-down value Allowance Tax saving Available year
1 1,050 262 79 2
2 788 197 59 3
3 591 148 44 4
4 443 111 33 5
5 (Balancing) 332 332 100 6
(It might be argued that the tax saving is a relatively safe cash flow and should be
discounted at a rate lower than the ungeared cost of equity. If so the resultant
base case NPV would be slightly larger).
Financing side effects
(i) Tax relief on interest payments (assumed available years 2 6)
The benefit from the investment in terms of increased debt capacity is 1
million. Although only 800,000 is being borrowed, the APV should be based
upon theoretical benefits of the debt capacity as these are available to the
company and may be used through debt issues for other investments (these
too must be evaluated on their own impact on debt capacity).
The tax shield benefit is therefore based upon 1 million of debt, 800,000 at
6% and the remaining 200,000 at the normal market rate of 9%.
Tax relief on annual interest
800,000 x 6% = 48,000 x 0.3 = 14,400
200,000 x 9% = 18,000 x 0.3 = 5,400
19,800
The discount rate used will be a rate reflecting the risk of the debt, in this
case the pre-tax cost of debt, 9%
PV annuity 9% for five years 3.890 x 19,800 x
09 . 1
1
= 70,662
The PV of tax relief, commencing year 2, is 70,662
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(ii) Subsidised loan
Tovell is receiving 800,000 at 3% less than normal market rates because of
its financing choice.
This produces an after-tax saving (with a one year lag in tax) of:
Years 1 to 5 800,000 x (0.09 0.06) per year = 24,000
Years 2 to 6 tax of 24,000 x 0.3 = (7,200)
The PV of this saving, discounted at 9% representing the market risk of debt
is:

3.890 x 24,000 = 93,360
3.890 x (7,200) = (25,695)
1.09 _____
67,665
(iii) Issue costs
The cost of the investment after issue costs (it is assumed that none exist on
the loan) is 2.3 million. Net proceeds of the rights issue are 2.3m 0.8m
= 1.5m.
With issue costs of 5%, the gross proceeds of the rights issue are
95 . 0
m 5 . 1

= 1,578,947.
Issue costs are (1,578,947 1,500,000) = 78,947
The expected APV of the investment is:

Base case NPV (173,000)
Tax relief on interest 70,662
Benefit from subsidised loan 67,665
Issue costs (78,947)
APV (113,620)
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Alastair Brown plc
Alastair Brown plc is considering diversifying into a new industry. The company is
investigating an investment project which would cost 18.8 million. Internally
generated funds would provide 5.8 million of the necessary finance, a further 5.5
million (net of costs) would be raised by means of a rights issue, 2 million would
be provided by a subsidised development loan and the remainder from a clearing
bank term loan at a fixed interest rate of 10%. The subsidised loan offers a 3%
subsidy on normal market rates. Issue costs associated with the loans are 1%.
The rights issue will incur 3% administration costs. This financing package is
thought to fully utilise the projects debt capacity. Both loans would be for a five
year term.
The project is expected to generate after tax (but, before WDA tax relief) net cash
flows of approximately 4 million per year during the companys five year planning
period. A residual value of 9 million is expected at the end of the five years.
Corporation tax is at a rate of 40% and is paid 12 months in arrears. Capital
expenditure attracts a 25% Writing Down Allowance (WDA) on the reducing
balance.
Alastair Brown plc has identified a correlation coefficient of +0.7 between the equity
returns from a random sample of companies in the new industry and returns from
the market. The standard deviation of market returns is 5%, and the standard
deviation of equity returns of companies in the new industry is 8%. The
companies sampled in the new industry have an average gearing of 50% equity,
50% debt by book values, and 70% equity, 30% debt by market values.
The yield on Treasury Bills is 10%, and the return on the market is 15.6%.
Corporate debt may be assumed to be approximately risk free.
Required:
(a) Estimate the adjusted present value (APV) of the proposed investment, and
recommend whether it should be undertaken.
(b) Discuss the advantages and disadvantages of the APV relative to alternative
techniques of capital investment appraisal.
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Alastair Brown solution
(a) (i) equity =
m
m , industry industry

x

=
5%
70 . 0 % 8
=1.12
(ii) asset =
( ) t 1 D E
E

e
+

= 1.12 x
( ) 40 . 0 1 3 7
7
+
= 0.89
(iii) Base-case discount rate = r
F
+ [Er
M
r
F
] asset
= 10% + [15.6% 10%] x 0.89
= 15% (approx)
Writing-down allowances tax relief (assumes project is bought at start of
companys accounting year)
m WDA Tax relief Timing
18.8 x 0.25 = 4.7 x 0.40 = 1.88 Year 2
4.7
14.1
x 0.25 = 3.52 x 0.40 = 1.41 Year 3
3.52
10.58
x 0.25 = 2.65 x 0.40 = 1.06 Year 4
2.65
7.93
x 0.25 = 1.98 x 0.40 = 0.79 Year 5
1.98
5.95 9.0 = (3.05) x 0.40 = (1.22) Year 6
(18.8 9.0) x 0.40 = 3.92
Base-case net present value (m)
0 1 2 3 4 5 6
Outlay (18.8)
WDA tax
relief 1.88 1.41 1.06 0.79 (1.22)
After-tax cash
flow 4.0 4.0 4.0 4.0 4.0
Scrap value 9.0
____ ___ ___ ___ ___ ____ ____
Net cash flow (18.8) 4.0 5.88 5.41 5.06 13.79 (1.22)
15% discount
factor _1__ 0.870 0.756 0.658 0.572 0.497 0.432
PV cash flow (18.8) 3.48 4.44 3.56 2.89 6.85 (0.53)
Base-case net present value = +1.89m
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PV of financing side-effects
Financing of project
m m
Internal funds 5.8
Rights issue (net receipts) 5.5
Loans (net receipts):
Development 2.0
Bank (balancing figure) 5.5
_7.5
18.8

Funds raised from loans
m
Total (as above) 7.5m is a net receipt, therefore
The gross amount is (7.5m 0.99) = 7.576
Development loan (2.00)
Bank term loan 5.576
PV of the tax shield
(i) Bank term loan
5.576m x 0.10 = 0.5576m per annum interest
0.5576m x 0.40 = 0.223m per annum tax relief
0.223m x a
5(

0.10
x (1.10)
-1
= 0.223m x 3.791 x 0.909 =
0.77m
(ii) Development loan
2m x 0.07 = 0.14m per annum interest
0.14m x 0.40 = 0.056m per annum tax relief
0.056m x a
5(

0.10
x (1.10)
-1
= 0.056m x 3.791 x 0.909 =
0.19m
PV of cheap loan
(i) PV of interest saved on cheap loan
Interest saved 2m x (0.10 0.07) = 60,000 per annum
PV : 60,000 x 3.791 = 0.227m
(ii) Tax relief lost
2m x 0.03 = 60,000 per annum interest saving
60,000 x 0.40 = 24,000 per annum tax relief lost
PV : 24,000 x 3.791 x (1.10)
-1
= (0.083m)
PV of the rights issue costs
The rights issue must raise
97 . 0
m 5 . 5
= 5.67m
Therefore the rights issue costs are 5.67m 5.5m = (0.17m)
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PV of the after-tax loan issue cost
Pre-tax loan issue cost
( )
99 . 0
m 2 m 5 . 5 +
x 0.01 = (0.076m)
Tax relief thereon 0.076m x 0.4 x (1.10)
-1
= 0.028m
Adjusted present value
m
Base-case net present value 1.89
PV of term loan tax shield 0.77
PV of development loan tax shield 0.19
PV of subsidised development loan: Interest saved 0.227
Tax relief lost (0.083)
PV of rights issue costs (0.17)
PV of loan issue costs: Gross cost (0.076)
Tax relief thereon 0.028
APV +2.776
(b) Include the following points:
(1) APV is similar to NPV in that both are DCF models. However NPV is only
a project appraisal technique and needs to assume that a company is
maintaining its capital structure. In contrast, APV is a more general
model which can evaluate both a project and its proposed financing
package.
(2) APV is a lengthier analysis than NPV and would only be used for major
projects especially where there was a complex financing package
involved. The much simpler approach of NPV would be an advantage for
smaller, more routine projects.
(3) APV has similar advantages and disadvantages with respect to the other
main capital investment appraisal techniques (i.e. IRR, payback and
return on investment) it is more complex and so more difficult to use.
On the other hand its divide and conquer approach makes it able to
handle much more complex decisions correctly.

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Chapter 9
Valuations,
acquisitions and
mergers section 1


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CHAPTER CONTENTS
REASONS FOR VALUATIONS ------------------------------------------- 207
METHODS OF SHARE VALUATION ------------------------------------- 208
THE DIVIDEND VALUATION MODEL ---------------------------------- 209
DISCOUNTED CASH FLOW BASIS ------------------------------------- 214
PRICE EARNINGS RATIO BASIS --------------------------------------- 216
NET ASSETS BASIS ----------------------------------------------------- 218
DIVIDEND YIELD BASIS ----------------------------------------------- 220
VALUATION OF DEBT AND PREFERENCE SHARES ------------------- 221
IRREDEEMABLE DEBT 221
REDEEMABLE LOAN STOCK 221
PREFERENCE SHARES 222
CONVERTIBLE DEBT 222
THE THREE ACQUISITION TYPES ------------------------------------- 224
TYPE I ACQUISITIONS 224
TYPE II ACQUISITIONS 224
TYPE III ACQUISITIONS 226
HIGH GROWTH START-UPS -------------------------------------------- 229

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REASONS FOR VALUATIONS
Valuations of businesses and financial assets may be needed for several reasons
e.g.
To establish the terms of takeover bids or mergers;
To fix a share price for an initial public offering;
For investors to make buy, hold or sell decisions;
For capital gains tax or inheritance tax purposes;
Where a major shareholder or director wishes to dispose of a large block of
shares;
When the company needs to raise additional finance.
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METHODS OF SHARE VALUATION
The main approaches are:
The dividend valuation model or dividend growth model;
The discounted cash flow basis;
The PE ratio (or earnings yield) basis;
The net assets basis;
The dividend yield method.
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THE DIVIDEND VALUATION MODEL
This method is based upon the fundamental theory of share valuation, whereby a
current share price is taken to reflect the PV of expected future cash flows,
discounted at the required rate of return of the shareholder. In the case of
minority shareholders, this would represent the PV to infinity of the future dividend
stream. In the case of majority shareholders, these amounts will be increased by
the PV of synergies achieved as a result of the acquisition.
Illustration 1
The market expects a rate of return of 20% per annum on ordinary shares in
Winterburn plc, a company which is expected to pay constant annual dividends of
20p per share.
At what price will the market value the shares?
Solution 1
P
0
=
Ke
D
=
2 . 0
20 . 0
= 1.00
Illustration 2
Seaman plc is expected to pay a dividend of 30p per share next year. The market
expects dividends to grow at the rate of 5% per annum and has a required return
of 20%.
Estimate the share price.
Solution 2
P
0
=
g Ke
D
1

=
05 . 0 2 . 0
30 . 0

= 2.00
Illustration 3
Merson plc is just about to pay a dividend of 40p per share. Future dividends are
expected to grow at the rate of 6% per annum. The markets required return on
shares of this risk level is 25%.
What is the cum-div share valuation?
Solution 3
This years dividend, D
0
= 40p. Next years dividend will be a factor of g higher:
D
1
= D
0
(1 + g) = 40p (1 + 0.06)
= 42.4p
P
0
=
0
1
D
g Ke
D
+

= p 40
06 . 0 25 . 0
p 4 . 42
+


= 2.63
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Illustration 4
Wright plc has just paid a dividend of 15p per share. The market is in general
agreement with directors forecasts of 30% growth in earnings and dividends for
the next 2 years. Thereafter, a reasonable estimate is 15% growth in year 3
followed by 6% growth to perpetuity.
The markets required return on investments of this risk level is 25% per annum.
Estimate the share value.
Solution 4
For years1 to 3, compute the expected dividends and discount them.
Dividend computation, Years 1 3
Year Dividend 25% factor Present value, p
1 15p x 1.3 = 19.5 0.800 15.60
2 19.5p x 1.3 = 25.35 0.640 16.22
3 25.35p x 1.15 = 29.15 0.512 14.93
46.75p
Then compute the dividend for year 4 and plug this into the growth formula with g
= 0.06
Year 4 dividend = 29.15p x 1.06 = 30.90p
Using the growth formula P
3
=
06 . 0 25 . 0
p 90 . 30

= 162.63p
The growth formula for P is based on dividends from year 1 to perpetuity. Since
the dividends in the above calculation go from year 4 to perpetuity, the value for P
above must be at year 3. But we want its present value at year 0. Therefore we
must discount back three further years, using the 3 year factor at 25%, which is
0.512.
Present value at year 0 of dividends from year 4 to perpetuity = 162.63p x 0.512
= 83.27p
Adding the present value of dividends from years 1 to 3 gives:
Share value = 46.75p + 83.27p = 1.30
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Illustration 5
Zed plc is considering the immediate purchase of some, or all, of the share capital
of one of two companies Red Ltd and Yellow Ltd. Both Red and Yellow have 1
million ordinary shares issued and neither company has any debt capital
outstanding.
Both firms are expected to pay a dividend in one years time Reds expected
dividend amounting to 30p per share and Yellows being 27p per share. Dividends
will be paid annually and are expected to increase over time. Reds dividends are
expected to display perpetual growth at a compound rate of 6% per annum.
Yellows dividend will grow at the high annual compound rate of one third until a
dividend of 64p per share is reached in year 4. Thereafter Yellows dividend will
remain constant.
If Zed is able to purchase all the equity capital of either company then the reduced
competition would enable Zed to save some advertising and administrative costs
which would amount to 225,000 per annum indefinitely and, in year 2, to sell
some office space for 800,000. These benefits and savings will only occur if a
complete take-over were to be carried out. Zed would change some operations of
any company completely taken over the details are:
(i) Red No dividend would be paid until year 3. Year 3 dividend would be 25p
per share and dividends would then grow at 10% per annum indefinitely.
(ii) Yellow No change in total dividends in years 1 to 4, but after year 4,
dividend growth would be 25% per annum compound until year 7. Thereafter
annual dividends would remain constant at the year 7 amount per share.
An appropriate discount rate for the risk inherent in all the cash flows mentioned is
15%.
Required
(a) Ignoring taxation, calculate:
(i) the valuation per share for a minority investment in each of the firms
Red and Yellow which would provide the investor with a 15% rate of
return.
(ii) the maximum amount per share which Zed should consider paying for
each company in the event of a complete take-over.
(b) Comment on any limitations of the approach used in part (a) and specify the
other major factors which should be important to consider if the proposed
valuations were being undertaken as a practical exercise.
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Solution 5
(a) (i) Valuation per share for minority interest
Red Ltd
Employing the dividend growth model:
Ex-div value per share =
g Ke
D
1

=
% 6 % 15
p 30

= 3.33
Yellow Ltd
PV of future dividend stream:
Year Dividend DF(15%) PV

1 0.27 0.870 = 0.235
2 0.36 0.756 = 0.272
3 0.48 0.658 = 0.316
4 0.64 0.572 = 0.366
1.189
5 to infinity
% 15
64 . 0

x 0.572 = 2.441
3.630
Ex-div value per share = 3.63
(ii) Maximum amount per share for take-over
Red Ltd
PV
Total dividends for year 3
= 1m @ 25p = 250,000

PV of future dividend stream at Year 2
=
% 10 % 15
000 , 250


= 5,000,000

PV at Year 0 = 5,000,000 x 0.756 = 3,780,000

Annual savings:
% 15
000 , 225

= 1,500,000

Sale of office space 800,000 x 0.756 = 604,800

PV of savings and benefits 2,104,800
Total value 5,884,800
Maximum amount per share 5.8848
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Yellow Ltd
PV
PV of total dividends in Years 1 to 4
(see i) above 1m x 1.189 = 1,189,000

Year Dividends DF(15%)
000
5 (1m x 0.64 x 1.25) 800 0.497 = 397,600
6 1,000 0.432 = 432,000
7 1,250 0.376 = 470,000
2,488,600
8 to infinity
% 15
250 , 1

x
0.376
= 3,133,333
PV at Year 0 5,621,933
PV of savings and benefits (see Red Ltd above) 2,104,800
Total value 7,726,733
Maximum value per share 7.726733
(b) Limitations and practical factors
The approach used in part (a) was to base the equity valuation only on future
dividends alone and no consideration was given to underlying asset values which
may be of importance in a take-over situation. The dividend valuation model is a
valid approach capable of producing accurate results provided the data used are
themselves accurate. The major limitations of the use of the model stem not from
the formula itself, but from the assumptions concerning the input data. The major
limitations include the assumptions of:
(i) Smooth dividend growth. In reality dividends may display some volatility
from year to year.
(ii) Perpetual growth and infinite life. It may be unrealistic to expect an infinite
life for the firm, but due to discounting this assumption may produce a good
working approximation for purposes of the valuation.
(iii) A constant discount rate or expected rate of return.
Other factors which should be considered include:
(i) Are all alternatives equally risky and is risk constant over the whole life?
There may be greater risk during periods of expected high growth (years 1-4
of Yellow) than during periods of low or zero growth. An adjustment to the
required return may be necessary during periods of abnormal risk.
(ii) Asset values may be an important aspect in a take-over and should be
considered. Generally the higher the asset values of the firm taken over, the
greater their marketability, then the lower is the potential risk inherent in that
take-over.
(iii) Management and competition. Will the existing management team continue
and/or will competition increase? The cash flow estimates should consider the
actions of existing management, competition etc.
(iv) Financing of the take-over. The method of financing the take-over (i.e. loans,
own equity etc.) must be considered carefully.
(v) Full consideration of all tax consequences should be taken into account.
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DISCOUNTED CASH FLOW BASIS
This method is based upon the present value of the free cash flow to equity of an
enterprise, either for a limited time horizon (fifteen years may be regarded as
typical) or to infinity.
There are a number of variations in the definition of free cash flow to equity, but it
is often described as follows:
Free cash flow to equity is the cash flow available to a company from
operations after interest expenses, tax, repayment of debt and lease
obligations, any changes in working capital and capital spending on assets
needed to continue existing operations (i.e. replacement capital expenditure
equivalent to economic depreciation)
In theory, this is probably the best method by which to value a company. However
it relies on estimates of cash flows, discount rates, tax rates, inflation rates and the
choice of a suitable time horizon. The notion of using a valuation to infinity is
probably unrealistic.
Illustration 6
The predicted free cash flows of Miller Ltd, an all equity company, for its planning
horizon, (which for simplicity is taken to be the next five years) are:
Year Free cash flows
000
1 150
2 200
3 250
4 375
5 500
A cost of capital of 12% is assumed to represent the systematic risk of the cash
flows of Miller Ltd.
What is the estimated market capitalisation of this company?
Solution 6
Year Free cash flows Discount factor Present values
000 12%
1 150 0.893 133,950
2 200 0.797 159,400
3 250 0.712 178,000
4 375 0.636 238,500
5 500 0.567 283,500
Estimated market capitalisation for 5 year planning horizon 993,350
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Illustration 7
The following data relating to Morrison Ltd is expected to continue annually for the
foreseeable future:
m
Turnover 525
Cost of goods sold, excluding depreciation 315
Distribution costs and administrative expenses, excluding depreciation 36
Capital allowances claimed 46.5
Non-current assets purchased in the year 72
Irredeemable bonds (market value 130) 21

Working capital changes are assumed to be insignificant because of the
absence of growth.

Corporation tax rate 30%
Weighted average cost of capital in nominal (i.e. money) terms 13.3%
Predicted inflation rate 3%
Calculate the estimated equity market capitalisation of this company.
Solution 7
Net cash flows
000
Turnover 525,000
Cost of goods sold (315,000)
Distribution costs and administrative expenses (36,000)
174,000
Tax on operating profits (30% x 174,000) (52,200)
Tax saved on writing down allowances (30% x 46,500) 13,950
Non-current assets purchased (72,000)
Annual net cash flows 63,750
Real discount rate (using Fisher effect)
r =
( )
( )
1
i 1
m 1

+
+
= 1
03 . 1
133 . 1
= 10%
Since the annual net cash flows are perpetuities expressed in terms of real cash
flows, it has been necessary to establish a real discount rate.
000
Corporate value
% 10
750 , 63

637,500
Less market value of irredeemable bonds (21,000 x 1.3) (27,300)
Equity market capitalisation 610,200
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PRICE EARNINGS RATIO BASIS
This income based method is popular for the valuation of majority holdings in a
going concern. It requires the prediction of a maintainable EPS for the company
being valued and the use of the PE ratio of a listed company, whose activities are
very similar to those of the business being valued i.e.
Share value = EPS of company being valued x PE of similar listed company
If a similar listed company (pureplay company) is not readily available, it may be
appropriate to use the average PE for the market sector in which the company
operates.
It may be necessary to adjust the PE used or the final calculated price, if the
company being valued is an unlisted company, or where the company in question
has different risk or different growth potential from the similar company or
constituents of the industry average.
Since an earnings yield is simply a reciprocal of the PE ratio, a valuation on an
earnings yield basis would be as follows:
Share value = EPS of company being valued earnings yield of similar listed
company
Illustration 8
Flycatcher Ltd wishes to make a takeover bid for the shares of an unlisted
company, Mayfly Ltd. The earnings of Mayfly Ltd over the past five years have
been as follows.
2002 50,000 2005 71,000
2003 72,000 2006 75,000
2004 68,000
The average P/E ratio of listed companies in the industry in which Mayfly Ltd
operates is 10. Listed companies which are similar in many respects to Mayfly Ltd
are:
Bumblebee plc, which has a P/E ratio of 15, but is a company with very good
growth prospects;
Wasp plc, which has had a poor profit record for several years, and has a
P/E ratio of 7.
What would be a suitable range of valuations for the shares of Mayfly Ltd?
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Solution 8
Earnings. Average earnings over the last five years have been 67,200, and over
the last four years 71,500. There might appear to be some growth prospects, but
estimates of future earnings are uncertain.
A low estimate of earnings in 2007 would be, perhaps, 71,500.
A high estimate of earnings might be 75,000 or more. This solution will use the
most recent earnings figure of 75,000 as the high estimate.
P/E ratio. A P/E ratio of 15 (Bumblebees) would be much too high for Mayfly Ltd,
because the growth of Mayfly Ltd earnings is not as certain, and Mayfly Ltd is an
unlisted company.
On the other hand, Mayfly Ltds expectations of earnings are probably better than
those of Wasp plc.
A suitable P/E ratio might be based on the industrys average, 10; but since Mayfly
is an unlisted company and therefore more risky, a lower P/E ratio might be more
appropriate: perhaps (60% to 70% of 10) = 6 or 7, or conceivably even as low as
(50% of 10) = 5.
Valuation. The valuation of Mayflys shares might therefore range between:
High P/E ratio and high earnings: 7 x 75,000 = 525,000; and
Low P/E ratio and low earnings: 5 x 71,500 = 357,500
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NET ASSETS BASIS
Asset-based valuation models include:
net book value (balance sheet basis) largely a meaningless figure, since it is
affected by accounting conventions;
net realisable value basis again, not particularly relevant. However, where
the break-up value exceeds income-based valuations, it would be advisable
for the proprietor to cease trading and sell the assets as quickly as possible;
net replacement cost basis this represents the current cost of setting up the
existing business. Sadly it totally ignores goodwill, which can only be
established by using income-based valuations.
Illustration 9
The current balance sheet of Cactus Ltd is as follows:

Fixed assets
Land and buildings 160,000
Plant and machinery 80,000
Motor vehicles 20,000
Goodwill 20,000
280,000
Current assets
Stocks 80,000
Debtors 60,000
Short-term investments 15,000
Cash 5,000
160,000
440,000



Capital and reserves
Ordinary shares of 50p 80,000
Reserves 140,000
220,000
4.9% preference shares of 1 50,000
270,000
12% debentures 60,000
Deferred taxation 10,000
70,000
Creditors: amounts falling due within one year
Creditors 60,000

Taxation 20,000
Proposed ordinary dividend 20,000
100,000
440,000
What is the value of an ordinary share using the net assets basis?
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Solution 9
THERE IS INSUFFICIENT INFORMATION TO ANSWER THIS QUESTION, BUT AN
ATTEMPT MUST BE MADE, OTHERWISE NO MARKS WILL BE GAINED, i.e.

Total value of net assets 270,000
Less Goodwill (20,000)
Preference shares (50,000)
Net asset value of equity 200,000

Number of ordinary shares (of 50p each) 160,000
Share price 1.25
NOW STATE THAT FAIR VALUE (UNDER IFRS 3 OR FRS 7) DETAILS ARE NEEDED
FOR A DECENT ANSWER! FURTHERMORE, HOW DOES ONE ESTABLISH
GOODWILL?
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DIVIDEND YIELD BASIS
This income based method is popular for the valuation of minority holdings in a
going concern. It requires the prediction of a maintainable dividend for the
company being valued and the use of the dividend yield of a listed company, whose
activities are very similar to those of the business being valued i.e.
Share value =
company listed similar of yield Dividend
valued being company the of Dividend

If a similar listed company (pureplay company) is not readily available, it may be
appropriate to use the average dividend yield for the market sector in which the
company operates.
It may be necessary to adjust the calculated price if the company being valued is
an unlisted company, or where the company in question has different risk or
different growth potential from the similar company or constituents of the industry
average.
Care must be taken to ensure consistency in the treatment of tax credits i.e. look at
the information given in a question very carefully to establish whether the yields
given are net or gross dividend yields and whether the dividends provided include
or exclude related tax credits.
Illustration 10
Taylor Ltd, which has on issue 500,000 ordinary shares of 25p each, intends to
pay a constant dividend of 360,000 (net) for the foreseeable future. Listed
companies within the same industry sector as Taylor Ltd currently provide a gross
dividend yield of 5% p.a. The current rate of tax credit on gross dividends is 10%
(i.e. 1/9
th
of net dividend).
Estimate a current share price for Taylor Ltd.
Solution 10
Number of ordinary shares on issue = 2,000,000
Expected net dividend per share =
000 , 000 , 2
000 , 360
= 18p
Expected gross dividend per share = 18p + (1/9 x 18p) = 20p
Net dividend yield for market sector = 5% x 0.9 = 4.5%
Share price =
yield Gross
dividend Gross
=
% 5
p 20
= 4.00
or
yield Net
dividend Net
=
% 5 . 4
p 18
= 4.00
Since Taylor Ltd is a private company the calculated share price of 4.00 could be
reduced by between 30% to 50%, i.e. around 2.80 to 2.00, due to lack of
marketability.
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VALUATION OF DEBT AND PREFERENCE SHARES

Irredeemable debt
Illustration 11
Koren plc has on issue 7% irredeemable loan stock. The gross return required by
investors is 5% p.a. The corporation tax rate is 30%.
Establish the current market value for this stock.
Solution 11
Market value =
yield Gross
payment interest Gross
=
5%
100 % 7
= 140
Redeemable loan stock
Illustration 12
Beattie plc has issued 1,000,000 of 6% redeemable bonds. Interest payments will
be made at the end of March, June, September and December of each year until
redemption occurs on 30 June 2010 at 120 per cent. Bondholders require a gross
redemption yield of 1% per quarter.
Calculate the current market value of these bonds at 1 January 2007.
Solution 12
Interest payment for 14 quarters =
4
000 , 000 , 1 % 6
= 15,000
Redemption value = 120% x 1,000,000 = 1,200,000
Market value
Period Cash flow Discount factor 1% per
quarter
Present value

1-14 15,000 13.00 195,000
14 1,200,000 0.870 1,044,000
Market value of redeemable bonds 1,239,000
Since there are 10,000 bonds on issue each with a 100 par value, an individual
bond has a market value of:
000 , 10
000 , 239 , 1
= 123.90
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Preference shares
Illustration 13
Steele Ltd has on issue some 9% preference shares of 1 nominal value. Investors
require a return of 12.5% p.a. on these shares.
Estimate the current market price per share.
Solution 13
P
0
=
Kps
D
=
0.125
1 % 9
= 72p
Convertible debt
The value of a convertible cannot fall below its value as debt, but upside potential
exists due to the possibility of an increase in the share price prior to expiry of the
conversion period.
Therefore the theoretical value of a convertible (known as its formula value) is
the greater of its value as debt and its value as shares i.e. its conversion value. In
practice the actual price of convertibles will tend to trade at a value in excess of
formula value, reflecting so called time value i.e. the possibility that the share
price could rise prior to expiry of the conversion period.
Illustration 14
Kiely plc has 11% convertible loan notes on issue. Each 100 unit may be
converted at any time up to the date of expiry (in seven years time) into 15 fully-
paid ordinary shares in Kiely plc. Any loan notes which remain outstanding at the
end of the seven year period are to be redeemed at 120 per cent.
Loan note holders normally require a yield of 9% p.a. on seven year debt.
Recommend whether investors should convert, if the current share price
is:
(a) 7.00, or
(b) 8.00, or
(c) 9.00.
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Solution 14
Value as debt (i.e. if conversion does not take place):
End of year
Discount
factor
Present
value
9%
1 - 7 Gross annual interest 11 5.033 55.36
7 Redemption value 120 0.547 65.64

Value as debt 121.00

Value as equity Value as debt Formula value Convert ?

(a) (15 shares @ 7) = 105 121 121 NO

(b) (15 shares @ 8) = 120 121 121 NO

(c) (15 shares @ 9) = 135 121 135 YES
Notice that there is no need to calculate the present value of the share price, since
under the fundamental theory of share valuation a current share price reflects the
PV of the future cash flow streams associated with holding the share.
The conversion price where the investor would be indifferent between redemption
and conversion is (121 15 shares) i.e. 8.07. The value of the convertible will
never fall below its value as debt (121). However if the share price rises above
8.07, the convertible loan notes will then reflect the value of the equity receivable
on conversion.
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THE THREE ACQUISITION TYPES

Type I acquisitions
These are acquisitions that do not disturb the acquirers exposure to either business
risk or financial risk. In theory, the value of the acquired company, and hence the
maximum amount that should be paid for it, is the Present Value of the future cash
flows of the target business discounted at the WACC of the acquirer. The valuation
techniques already considered would deal adequately with this type of business
combination.
Type II acquisitions
These are acquisitions which do not disturb the exposure to business risk, but do
impact upon the acquirers exposure to financial risk e.g. through changing the
gearing levels of the acquirer. Such acquisitions may be valued using the Adjusted
Present Value (APV) technique by discounting the Free Cash Flows of the acquiree
using an ungeared cost of equity and then adjusting for the tax shield.
Illustration 15
The directors of Heincarl plc are considering the acquisition of Newscot Ltd, an
unlisted company. The shareholders of Newscot Ltd are willing to sell the business
on 1
st
January 2009 for 500 million. From the perspective of the directors of
Heincarl plc, the projections of the performance of Newscot Ltd are as follows:

Current
year
Projections during planning horizon (years)
2008 2009 2010 2011 2012 2013 2014
m m m m m m m
EBITDA 117.00 138.70 162.57 188.83 217.71 249.48 251.48
Depreciation
&
amortisation (40.00) (42.00) (44.00) (46.00) (48.00) (50.00) (52.00)
EBIT 77.00 96.70 118.57 142.83 169.71 199.48 199.48
Interest
charges _ -_ (32.00) (26.88) (20.19) (11.73) (1.28) _ -__
Profit before
tax 77.00 64.70 91.69 122.64 157.98 198.20 199.48
The assumed rate of corporation tax is 35% p.a. The terminal value of the
investment is treated as a constant perpetuity equal to the free cash flows for the
year 2014. The risk free rate of interest is assumed to be 6% p.a., the return on a
market portfolio is taken to be 13.5%, whilst an asset beta of 1.1 is used for
purposes of the appraisal.
Annual capital expenditure from 2008 onwards is estimated at 20 million each
year indefinitely. Newscot Ltd currently has on issue 400 million of 8% debt and it
is intended that all available cash flows should be applied to repaying this debt at
the earliest opportunity.
Advise the directors of Heincarl plc whether to proceed with the
acquisition.
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Solution 15
Calculation of Keu
Keu = Rf + (Rm Rf) a = 6% + (13.5% 6%) 1.1 = 14.25%
Calculation of Free Cash Flow of Newscot Ltd
2008 2009 2010 2011 2012 2013 2014
m m m m m m m
EBIT 77.00 96.70 118.57 142.83 169.71 199.48 199.48
Less CT @
35% (26.95) (33.84) (41.50) (49.99) (59.40) (69.82) (69.82)
50.05 62.86 77.07 92.84 110.31 129.66 129.66
Add back
Depreciation 40.00 42.00 44.00 46.00 48.00 50.00 52.00
Less Capital
expenditure (20.00) (20.00) (20.00) (20.00) (20.00) (20.00) (20.00)
Company
Free Cash
Flow 70.05 84.86 101.07 118.84 138.31 159.66 161.66

Total
m
Discount
factor
(14.25%) - 0.875 0.766 0.671 0.587 0.514
PV (m) - 74.25 77.42 79.74 81.19 82.07 394.67
From 2014 to infinity:
514 . 0
1425 . 0
66 . 161

= 583.11
PV to infinity of Company Free Cash Flow 977.78
Tax Shield (discounted at Kd of 8%)
(32.00 x 35% x 0.926) + (26.88 x 35% x 0.857) + (20.19 x 35% x 0.794)
+ (11.73 x 35% x 0.735) + (1.28 x 35% x 0.681) = 10.37 + 8.06 + 5.61 + 3.02 +
0.31 = 27.37
APV m
Corporate value (977.78 + 27.37) 1005.15
Less Value of debt (400.00)
Value of equity 605.15
Less Purchase consideration (500.00)
APV 105.15
Therefore, the directors of Heincarl plc should proceed with the acquisition of
Newscot Ltd.
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Type III acquisitions
These are acquisitions that impact upon the acquirers exposure to both business
risk and financial risk. In order to estimate WACC there is a need to establish the
cost of capital of the combined businesses. However, the Ke of the combination is
dependent upon the price paid for the equity capital of the target, but it is
impossible to establish the price to be paid until the value of the target is
determined.
Illustration 16
Edwards plc is considering the acquisition of a 100% stake in Colman Ltd in order
to achieve backward vertical integration. Considerable savings are anticipated due
to the combination of both the marketing operations and distribution networks of
the two companies. Therefore synergies will arise to create cash flows which are in
excess of the current estimated cash flows of the two separate companies. Upon
the acquisition of Colman Ltd, Edwards plc will immediately sell one of the
warehouses of the target company, providing instant cash inflows of 5 million.
The forecast cash inflows of the merged businesses are as follows:
Year millions Year millions
2008 (proceeds from warehouse sale) 5.00 2014 92.32
2009 60.00 2015 100.63
2010 65.40 2016 109.68
2011 71.29 2017 119.55
2012 77.70 2018 130.29
2013 84.69 Terminal value 2,396.84
The forecast rate of corporation tax is expected to remain at 30%. The risk free
rate of interest is to be taken at 5% and the expected return on a market portfolio
is 9%.
Information currently relating to the two companies is as follows:
Edwards plc Colman Ltd
m m
Market values:
Debt 100 20
Equity 900 280
Total 1,000 300

asset 0.9 2.4

Cost of debt 7% 7%
Edwards plc plans to make a cash offer of 380 million for the purchase of the
entire share capital of Colman Ltd. This cash offer will be funded by additional
borrowings undertaken by Edwards plc.
Advise the directors of Edwards plc whether to proceed with the
acquisition.
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Solution 16
asset of combined company

a = 4 . 2
300 000 , 1
300
9 . 0
300 000 , 1
000 , 1

+
+
+
= 1.25
equity of combined company
Revised gearing levels are: m
E = 900 + 280 = 1,180
D = 100 + 20 + 380 = 500
1,680
e =
( ) ( )
180 , 1
3 . 0 1 500 180 , 1
25 . 1
E
t 1 D E
a
+
=
+
= 1.62
Cost of equity
Ke = 5% + (9% 5%) 1.62 = 11.48%
Weighted average cost of capital

WACC = ( ) 3 . 0 1 % 7
680 , 1
500
% 48 . 11
680 , 1
180 , 1
+ = 9.52%
Present value of combined cash flows
Cash flows of
combined entity
Discount factor
(9.52%)
Present value @
9.52%

m m
2008 5.00 1 5.00
2009 60.00 11.0952 54.78
2010 65.40 11.0952
2
54.52
2011 71.29 11.0952
3
54.27
2012 77.70 11.0952
4
54.01
2013 84.69 11.0952
5
53.75
2014 92.32 11.0952
6
53.50
2015 100.63 11.0952
7
53.24
2016 109.68 11.0952
8
52.99
2017 119.55 11.0952
9
52.74
2018 130.29 11.0952
10
52.48
Terminal value 2,396.84 11.0952
11
881.48
1,422.76
Value of equity
m
PV of combined entity 1,422.76
Less combined value of debt (500.00)
Value of equity 922.76
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Therefore the combination is beneficial to the shareholders of Edwards plc, since
the value of their equity shareholding will increase from 900 million to 922.76
million.
However, one further major problem remains! There is an inconsistency! In the
weightings used for the WACC calculation, (1,180 1,680) about 70% has been
applied to equity, whilst (500 1,680) about 30% has been used for debt. On the
other hand, ultimately the value of equity has been shown to represent (922.76
1,422.76) about 65% of corporate value and the value of debt (500 1,422.76)
about 35% of corporate value.
Where these two sets of weights differ significantly an inconsistent valuation will
occur. There is then a need to adopt an iterative revaluation procedure to achieve
consistency between the WACC and the corporate value. This would involve a
recalculation of e, using weightings that are closer to those derived from the
valuation. This procedure would be continuously repeated until the assumed
weights and the weightings ultimately derived from the corporate valuation are
reasonably consistent.
Thankfully this iterative process is not performed manually, since it can be
calculated in Excel (shown in Tools > Options > Calculation). The consistent results
of the iterative revaluation procedure apparently work out as follows:
m
PV of combined entity 1,395.45
Less combined value of debt (500.00)
Value of equity 895.45
e will now become:
( )
895.45
3 . 0 1 500 45 . 895
25 . 1
+
= 1.74
Ke is now revised to become: 5% + (9% 5%) 1.74 = 11.96%
The weighted average cost of capital is revised to:
WACC = ( ) 3 . 0 1 % 7
45 . 395 , 1
500
% 96 . 11
45 . 395 , 1
45 . 895
+ = 9.43%
The increased proportion of debt (500 1,395.45) i.e. about 36% of corporate
value has caused both e and Ke to increase, whilst there has been a slight
reduction in WACC due to the larger weighting applied to debt.
Since the value of equity has now fallen to 895.45 million, which is below the
current value of the equity shares in Edwards plc (i.e. 900 million), the acquisition
would cause a reduction in shareholder wealth of 4.55 million. The business
combination should thus be abandoned.
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HIGH GROWTH START-UPS
The valuation of Start-ups create additional problems to that of well established
businesses. This may be due to:
their lack of a proven track record,
initial on-going losses,
untested products with little market acceptance,
little market presence,
unknown competition,
high development costs, and
inexperienced managers with over-ambitious expectations of the future.
The valuation procedures depend upon the reasonableness of financial projections,
the length of the period chosen for long-term projections and the selection of future
growth rates. The growth in earnings may be forecast using Gordons growth
approximation i.e. g = br, where normally b = 1, since all profits made are likely to
be reinvested into the business. Therefore the sole determinant of growth is the
measure of r.
The decision as to growth expectations is rather critical as shown in the following
illustration:
Illustration 17
Bednar plc anticipates costs of 1,200 million in the coming year, thereafter
growing at a rate of 4% per annum. The anticipated revenues for that year are
expected to be 320 million. The company expects to achieve a return on
reinvested funds of between 16% and 18% per annum. Furthermore the directors
of Bednar plc do not anticipate the payment of any dividends for the foreseeable
future.
Using a cost of equity of 20% p.a., produce a valuation for Bednar plc
based upon both the maximum and the minimum growth rate predictions,
using the Growth Model combined with Gordons growth approximation.
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Solution 17
Since no dividends are expected to be paid, b = 1
Maximum valuation
Growth prediction: (g = br) g = 1 x 0.18 = 18%
Valuation using the Growth Model:
% 4 % 20
200 , 1
% 18 % 20
320

= 16,000 7,500 = 8,500 million


Minimum valuation
Growth prediction: (g = br) g = 1 x 0.16 = 16%
Valuation using the Growth Model:
% 4 % 20
200 , 1
% 16 % 20
320

= 8,000 7,500 = 500 million


Growth rates are affected by changes in technology, management competence,
demand and inflation levels, and are therefore extremely difficult to predict. Notice
the dramatic change in the business valuation that has been caused by a slight
change in the predicted rate of growth.
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Chapter 10
Valuations,
acquisitions and
mergers section 2


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CHAPTER CONTENTS
MERGERS AND ACQUISITIONS ---------------------------------------- 233
1. SYNERGY 233
2. HIGH FAILURE RATE OF ACQUISITIONS IN ENHANCING SHAREHOLDER VALUE 234
3. MODE OF OFFER 235
4. DEFENCES 235
5. SIGNIFICANT PERCENTAGE HOLDINGS 236
6. CONDUCT OF TAKEOVER BIDS 236
DARK POOL TRADING -------------------------------------------------- 238
OXCLOSE PLC AND SATAC LTD ---------------------------------------- 239
DEMAST LTD ------------------------------------------------------------- 245
KELLY PLC --------------------------------------------------------------- 250
EICHNER PLC ------------------------------------------------------------ 253

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MERGERS AND ACQUISITIONS

1. Synergy
An expansion policy based on merger or takeover can be justified on the basis
of synergy. (Sometimes stated as 2 + 2 = 5) i.e.
Value of A plc Value of A plc Value of B plc
and B plc combined
> >> >
operating
+
operating
independently independently
Acquisitions and mergers are ultimately justified as leading to an increase in
shareholder wealth.
The potential for synergy is often classified as follows:
Revenue synergy: Sources of which include:
o Economies of vertical integration;
o Market power and the elimination of competition i.e. the desire to earn
monopoly profits (which is good for shareholders but not in the public
interest);
o Complementary resources e.g. a company with marketing strengths
could usefully combine with the company owning excellent research and
development facilities.
Cost synergy: Sources of which include:
o Economies of scale (arising from e.g. larger production volumes and
bulk buying);
o Economies of scope (which may arise from reduced advertising and
distribution costs where combining companies have duplicated
activities);
o Elimination of inefficiency;
o More effective use of existing managerial talent.
Financial synergy: Sources of which include:
o Elimination of inefficient management practices;
o Use of the accumulated tax losses of one company that may be made
available to the other party in the business combination;
o Use of surplus cash to achieve rapid expansion;
o Diversification reduces the variance of operating cash flows giving less
bankruptcy risk and therefore cheaper borrowing;
o Diversification reduces risk (however this is a suspect argument, since it
only reduces total risk not systematic risk for well diversified
shareholders);
o High PE ratio companies can impose their multiples on low PE ratio
companies (however this argument, known as bootstrapping, is rather
suspect).
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Conclusions on Synergy
o Synergy is not automatic
o When bid premiums are considered, the consistent winners in mergers
and takeovers are victim company shareholders.
2. High failure rate of acquisitions in enhancing
shareholder value
In practice, the shareholders of predator companies seldom enjoy synergistic gains,
whereas the shareholders of victim companies benefit from a takeover. The
acquiring company often pays a significant premium over and above the market
value of the target company prior to acquisition; this problem is particularly acute
for the successful predator following a contested takeover bid.
The reasons advanced for the high failure rate of business combinations from the
perspective of the predator shareholders are as follows:
Agency theory suggests that takeover bids are primarily motivated by the
self- interest of the managers of bidding companies. Often free cash flow
may be used to increase the size of their company in order to enhance the
status of directors who wish to be seen as heading a large listed plc.
Diversification of the activities of the predator may provide job security for the
directors of such companies;
Over-optimistic assessment of the economies of scale or economies of scope
that may be achieved as a result of the business combination;
Inadequate investigation of the victim company prior to the bid being made,
or insufficient appreciation of the problems that may arise after the acquisition
takes place (e.g. the difficulties experienced by Wm. Morrison Supermarkets
following the takeover of Safeway);
Following a successful bid, the directors and managers of the predator
become too keen to identify their next victim, instead of devoting time to
ensuring that the company that they have already taken over provides the
expected synergies;
Directors of the predator company become so obsessed with the success of
their bid that they fail to seek alternative target companies. Furthermore,
their valuations of the victim and their justifications for the acquisition
become exaggerated.
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3. Mode of offer
Advantages Disadvantages
Cash - Simple - Liquidity problems
- Price certain - Capital gains tax

Shares - Saves cash - Value uncertain
- Maintains ownership state - Dilution of EPS
- Avoids capital gains tax

- Vendor placings for sellers
who need cash


Loan stock - Saves cash - Gearing problems
- Avoids capital gains tax - Changes character of
investment
Sometimes hybrid instruments (e.g convertible loan stock) may be issued.
4. Defences
Pre-bid
o Strategic shareholdings
o Poison pills
o Fat man strategy
o Golden parachutes
o Crown jewels (or scorched earth) policy
o Pacman strategy (likely target making a reverse takeover bid for a
potential bidder).
o Revaluation of fixed assets
Post-bid (Note: all defences must be in line with the City Code)
o Appeal to your own shareholders. Argue that victim shares are
undervalued, bidders shares are overvalued (contrary to EMH but
directors have inside information).
o White knight defence encourage a more friendly bid.
o Appeal to the Competition Commission.
o Greenmail questionable in the UK.
o Crown jewels (or scorched earth) policy, with the approval of
shareholders in general meeting (City Code Rule 21.1 (b)(iv)).
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5. Significant percentage holdings
Under CA 2006, the City Code or Listing Rules, the following percentage
acquisitions have a significant impact.
3% or more. Disclose your identity to the directors of the company
concerned.
15%, but less than 30%. The Substantial Acquisitions Rules once applied to
purchases of shares within this range of shareholding. However, these
Rules were abolished with effect from 20
th
May 2006.
30% or more. A general offer must be made to all remaining shareholders of
the target company
More than 50%. In normal circumstances control is gained and a
parent/subsidiary undertaking relationship is established.
75% or more. A special resolution can be passed once this level of control
has been achieved.
90% or more. An offer to minority shareholders can generally be enforced.
6. Conduct of takeover bids
The following information was circulated by the Board of Forte plc as part of its first
Defence document following the takeover offer by Granada plc in November 1995:
Guidance note on the conduct of takeover bids
The purpose of this appendix is to provide some guidance to Forte shareholders
who may be unfamiliar with the detailed provisions contained in the Takeover Code
which govern takeover bids. It is not intended to be a definitive guide and you
should consult your own professional adviser.
Timing
The offer document was posted to you by the bidder; Granada, on 24
th

November, 1995.
The first closing date for the offer is 15
th
December, 1995. Typically, in a
contested bid, this date will pass without any action by the vast majority of
shareholders and acceptances at the first closing date will usually be very low.
The bidder has reserved the right to lapse or close its full cash alternative on
the first, or any subsequent closing date.
The bidder normally extends the offer in 14 day steps. Alternatively, the
bidder may allow the bid to lapse on the first, or any subsequent closing date,
but only if it is not unconditional as to acceptances.
Forte cannot normally disclose trading results, profit or dividend forecasts,
asset valuations or proposals for dividend payments after the 39
th
day after
the offer document is posted, currently 2
nd
January, 1996.
The bidder cannot normally revise the terms of its bid after the 46
th
day after
the posting of the offer document, currently 9
th
January, 1996.
The bidder must normally declare its bid unconditional as to acceptances (see
below) by 23
rd
January, 1996, the 60
th
day after posting, or it will lapse
automatically.
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Acceptance condition
The bidder may declare the bid unconditional as to acceptances at any level
above 50 per cent of the ordinary shares outstanding (assuming that the
bidder is permitted to exclude the Forte trust shares for this purpose).
Shareholders who have not yet accepted when a bid is declared unconditional
as to acceptances are still able to accept the offer (although not necessarily
any cash alternative) as the bid must be kept open for acceptance for at least
another 14 days after it has been declared unconditional as to acceptances.
Communication with shareholders
The offer document you have received contains the bidders arguments.
Forte has set out in this defence circular a response to the bidders arguments
and why the bid should be rejected.
Further circulars to shareholders are likely to follow from both Forte and the
bidder.
If another bidder announces an offer, the timetable normally restarts from the date
that its offer document is posted.
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DARK POOL TRADING
The recent financial crisis has seen the alleged (see newspaper article below)
growth of a practice, which is sometimes referred to as Dark pool trading. It is
also known as Dark pool liquidity, the Upstairs market, Dark liquidity or simply
Dark pool.
The term Dark pool relates to trades which are concealed from the public as if
they had been undertaken in pools of murky water. Many traders believe that
such activities should be publicised in order to make trading more fair for all parties
involved, so that all such transactions are performed on a level playing field.
Dark pool trading refers to the volume of trade created by institutional investors in
financial trading venues or crossing networks that are unavailable to the general
public. The bulk of Dark pool liquidity is represented by block trades undertaken
away from the central exchanges. Such transactions are never displayed and are
useful for institutions who wish to deal in large numbers of shares, whilst not
revealing such trades to the open market.
Dark liquidity pools avoid the risk of revealing the actions of such institutions, since
neither the identity of the trader nor the price at which the transactions took place
are displayed. Dark pools are recorded as over-the-counter transactions, but
detailed information is only reported to clients if they so desire and are under a
contractual obligation to do so.
The Upstairs market allows Fund managers to move large blocks of equity shares
without revealing details as to what has actually occurred. The lack of human
intervention within the electronic platforms employed has reduced the time scale
for such trades. The increased responsiveness of equity price movements has
made it extremely difficult to trade large blocks of shares without affecting the
price.
A report in The Independent newspaper on 25th May 2010 stated:
Six big investment banks published trading volumes for their dark pools for the
first time yesterday, showing them as a tiny fraction of the market and not the
major hidden rivals to stock exchanges that some argue.
Citi, Credit Suisse, Deutsche Bank, J P Morgan Cazenove, Morgan Stanley and UBS
together executed 596 million (513 million) of equity trades from 15 countries on
their automated crossing systems on Friday, according to Markit data.
That accounted for about 0.4 per cent of all types of cash equity trades in Europe
and 1.6 per cent of all over-the-counter (OTC) trades reported on the Markit BOAT
service that day, according to Thomson Reuters data.
Dark pools are electronic platforms that allow would-be buyers and sellers of large
orders of shares to avoid revealing pre-trade information and signalling their
intentions to the rest of the market.
Bankers argue that for the bulk of OTC trades they act purely as dealers, using
their own money or share inventories to take one or another side, or they act in a
non-automated way to match buyers and sellers for big blocks of stock.
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Oxclose plc and Satac Ltd
The board of directors of Oxclose plc is considering making an offer to purchase
Satac Ltd, a private limited company in the same industry. If Satac is purchased it
is proposed to continue operating the company as a going concern in the same line
of business.
Summarised details from the most recent financial statements of Oxclose and Satac
are shown below:
Balance sheet at 31 March
Oxclose plc Satac Ltd
m m 000 000

Freehold property 33 460
Plant and equipment (net) 58 1,310
Stock 29 330
Debtors 24 290
Cash 3 20
Less: Current liabilities (31) (518)
25 122
116 1,892

Financed by:
Ordinary shares* 35 160
Reserves 43 964
Shareholders equity 78 1,124
Medium-term bank loans 38 768
116 1,892
*Oxclose plc 50p ordinary shares; Satac Ltd 25p ordinary shares.
Year # Oxclose plc Satac Ltd
Profit after tax Dividend Profit after tax Dividend
m m 000 000
t5 14.30 9.01 143 85.0
t4 15.56 9.80 162 93.5
t3 16.93 10.67 151 93.5
t2 18.42 11.60 175 102.8
t1 20.04 12.62 183 113.1
# t5 is five years ago, t1 the most recent year, etc.
Satacs shares are owned by a small number of private individuals. The company is
dominated by its managing director who receives an annual salary of 80,000,
double the average salary received by managing directors of similar companies.
The managing director would be replaced if the company were purchased by
Oxclose.
The freehold property of Satac has not been revalued for several years and is
believed to have a market value of 800,000.
The balance sheet value of plant and equipment is thought to fairly reflect its
replacement cost, but its value if sold is not likely to exceed 800,000.
Approximately 55,000 of stock is obsolete and could only be sold as scrap for
5,000.
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The ordinary shares of Oxclose are currently trading at 430p ex div. It is estimated
that, because of difference in size, risk and other factors, the required return on
equity by shareholders of Satac is approximately 15% higher than the required
return on equity of Oxcloses shareholders (i.e., 115% of Oxcloses required
return). Both companies are subject to corporate taxation at a rate of 40%.
You are required:
(a) to prepare estimates of the value of Satac using three different methods of
valuation, and advise the board of Oxclose plc as to the price, or possible
range of prices, that it should be prepared to offer to purchase Satacs shares;
(b) to briefly discuss the theoretical and practical problems of the valuation
methods that you have chosen;
(c) to discuss the advantages and disadvantages of the various terms that might
be offered to the shareholders of a potential victim company in a takeover
situation.
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Oxclose plc and Satac Ltd solution
(a) There are various methods by which the value of an unlisted company may be
estimated. These include:
(i) Dividend valuation model
(ii) Price/earnings ratio
(iii) Net assets basis in this case a going concern
These three are illustrated below. Other methods exist (including the present
value of expected future cash flows for a fixed number of years) but some of
these are of little practical or theoretical relevance.
(i) Dividend valuation model
g Ke
D
P
1
0

=
Ke for Oxclose may be estimated from Ke = g
P
D
0
1
+
Growth of dividends is approximately 8.8% i.e.
g = 1 ) 01 . 9 62 . 12 (
4

= 8.8%
Current dividend per share is 18.03 pence i.e.
D
0
=
70
62 . 12
= 18.03
(N.B. Oxclose has 70m shares on issue of 50p each)
The cost of equity of Oxclose plc is
Ke =
( )
088 . 0
430
088 . 1 03 . 18
+
= 13.36%
The cost of equity of Satac Ltd is approximately 15% higher than
Oxcloses Ke
13.36% x 1.15 = 15.36%
The dividend growth model can now be used to establish the value of
the shares of Satac. Growth in dividends in all years except t3
(which is assumed to be an extraordinary year) is approximately
10%. The dividend of Satac in the most recent year is 113,100,
thus
P
0
=
10 . 0 1536 . 0
1 . 1 100 , 113

= approximately 2,321,000
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(ii) Price/earnings ratio
The valuation method here is to multiply the current earnings of Satac by
the P/E ratio of a similar company. The only data given relates to
Oxclose plc, a much larger company in the same industry.
EPS of Oxclose =
70
04 . 20
= 28.63p
P/E ratio of Oxclose =
63 . 28
430
= 15.02
Satacs earnings, adjusted for the extra earnings generated if the
managing director is replaced, are: 183,000 + 40,000 (1 0.4) =
207,000
207,000 x 15.02 = 3,109,140
Some adjustment to the P/E, and therefore to this valuation, is desirable
as:
(1) Satac is not a listed company;
(2) it is much smaller than Oxclose;
(3) the systematic risk of the companies is likely to be different;
(4) earnings growth of Satac has been lower than that of Oxclose and
may be so in the future.
These factors would suggest that a substantially lower P/E ratio and
valuation are appropriate.
(iii) Net assets basis
Replacement cost rather than net realisable value is used, as the
company will continue as a going concern.
000 000
Freehold property 800
Plant and equipment (net) 1,310
Stock 280
Debtors 290
Cash 20
Less: Current liabilities (518)
72
2,182
Less: Medium term bank loan (768)
1,414
The replacement cost value of net assets is 1,414,000. However, this
does not include any allowance for the goodwill of the business.
On the basis of these estimates a valuation of Satac of well in excess of
1,414,000, but well below 3,109,140 (say between 2,300,000 and
2,700,000) would appear to be reasonable. The valuation of unquoted
companies is far from an exact science, and other price ranges are
acceptable. The actual price paid will be a matter for negotiation and
will depend in part upon the current ownership pattern of Satacs
shares. The highest price suggested might not prove high enough to
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purchase Satac if Satacs managing director or others have majority
control of the shares and do not wish to sell the company.
Other factors of relevance to the buyer might be the impact on future
profits if the managing director is replaced. If he is a key man and is
important to the success of the business, profits might fall when he is
replaced. There is also the possibility of a golden handshake for the
managing director, which would add to the cost of buying the company.
The question assumes that the taxation rates and regimes for both
Oxclose and Satac are similar. In practice this might not be the case,
and Oxclose might wish to assess the value of Satac based upon pre-tax
rather than post-tax earnings.
On economic grounds the maximum price that Oxclose should be
prepared to offer should depend upon the difference between the
present value of its own expected cash inflows before the acquisition,
and the present value of the combined expected cash flows after the
acquisition which, if synergy occurs, might justify a higher price than
any other valuation methods that have been illustrated.
(b) In theory the present value of the incremental cash flows associated with the
acquisition should form the basis of the valuation. None of the valuation
methods illustrated offers a valuation of this nature (indeed such a valuation,
while theoretically desirable, is in practice very difficult to undertake). The
three valuation methods should only be considered as rough estimates.
(i) Dividend valuation model
The model relies on restrictive assumptions, including a constant
expected growth rate (or a series of different expected growth rates).
How should the growth rates(s) be estimated? If historical data is used
as a guide, over what period of time? Should more recent growth be
more heavily weighted in the estimate?
Any growth rate estimate is likely to involve subjectivity. The valuation
in this question is dependent upon the estimate that Ke for Satac is 15%
higher than for Oxclose. There is no accurate way of estimating such a
relationship.
Dividends can be set at any level that a majority shareholder (or
perhaps dominating managing director) chooses, within the constraints
set by earnings (past and present) and liquidity. It might not, therefore,
be appropriate to value the company by the discounted value of the
future dividend stream.
(ii) P/E ratio
Some of the possible problems of the P/E ratio have been outlined
above. It is difficult to find a comparable company from which the P/E
may be taken in order to estimate another companys value
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(iii) Net assets basis
Asset based valuations, even after adjustments, may bear little
relationship to the market value of a company. The market value of
going concern is based upon an expected stream of future earnings,
which will depend upon the quality of management and many other
factors, in addition to the nature of the assets that a company
possesses.
(c) Terms that might be offered in a takeover situation include cash, shares, fixed
interest stock or a combination of these. Occasionally the shareholders of the
victim company will be offered a choice of terms e.g. all cash or less cash
plus shares or fixed interest stock. Fixed interest stocks might include a
convertible element, or have warrants associated with them.
Advantages and disadvantages may be considered from both the viewpoint of
the bidding company and the shareholders of the potential victim.
The bidding company will wish to offer the terms that result in success at the
minimum expected cost. The use of shares conserves corporate liquidity but
leads to possible dilution in ownership. However, a bid mainly in the form of
shares might be the only possibility when the victim company is relatively
large. The use of debt will also conserve corporate liquidity; but it will
increase gearing. A cash bid allows the bidder to know exactly the cost of the
bid.
The victims shareholders will similarly only know the exact value of the bid if
it is in the form of cash, as fluctuations in the prices of shares and fixed
interest stocks make their values uncertain. Cash gives shareholders the
freedom to spend the cash or to invest elsewhere (in the bidding company if
they wish!) without incurring the transaction costs of selling the shares.
However, a cash payment might be subject to an immediate tax liability e.g.,
in countries where capital gains tax exists. The use of shares allows the
shareholders to maintain a continued interest in the company, as part of a
larger group. Fixed interest stock also allows a continued interest, but not an
ownership interest, unless the offer is convertible into shares at some future
date (and if market prices are favourable). Fixed interest stock is likely to
alter the nature and risk of the shareholders investment portfolios which
might not be well received by the shareholders. Although the stock could be
sold, this would incur additional transaction costs.
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Demast Ltd
Demast Ltd has grown during the last five years into one of the UKs most
successful specialist games manufacturers. The companys success has been
largely based on its Megaoid series of games and models, for which it holds patents
in many developed countries. The company has attracted the interest of two plcs,
Nadion, a traditional manufacturer of games and toys, and BZO International, a
conglomerate group that has grown rapidly in recent years through the strategy of
acquiring what it perceives to be undervalued companies.
Summarised financial details of the three companies are shown below:
Demast Ltd
Summarised balance sheet as at 31 December 2003
000 000

Fixed assets (net) 8,400
Current assets
Stock 5,500
Debtors 3,500
Cash 100
9,100
Less: Current liabilities
Trade creditors 4,700
Tax payable 1,300
Overdraft 1,200
7,200
10,300
Medium and long-term loans 3,800
Net assets 6,500

Financed by:
Ordinary shares (25 pence nominal) 1,000
Reserves 5,500
6,500
Summarised profit and loss account for the year ended 31 December 2003
000
Turnover 27,000
Profit before tax 4,600
Taxation _1,380
3,220
Dividend 1,500
Retained earnings 1,720
Additional information
(1) The realisable value of stock is believed to be 90% of its book value
(2) Land and buildings, with a book value of 4 million were last revalued in 1989
(3) The directors of the company and their families own 25% of the companys
shares
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Demast Nadion BZO Int
Turnover (m) 27 112 256
Profit before tax (m) 4.6 11 24
Fixed assets (m net) 8.4 26 123
Current assets (m) 9.1 41 72
Current liabilities(m) 7.2 33 91
Overdraft (m) 1.2 6 30
Medium and long-term liabilities (m) 3.8 18 35
Interest payable (m) 0.5 3 10
Share price (pence) - 320 780
EPS (pence) 80.5 58 51
Estimated required return on equity 16% 14% 12%
Growth trends per year
Earnings 12% 6% 13%
Dividends 9% 5% 8%
Turnover 15% 10% 23%
Assume that the following events occurred shortly after the above financial
information was produced.
7 September BZO makes a bid for Demast of two ordinary shares for every
three shares of Demast. The price of BZOs ordinary shares after the announcement
of the bid is 710 pence. The directors of Demast reject the offer.
2 October Nadion makes a counter bid of 170 pence cash per share plus one
100 10% convertible debenture 2018, issued at par, for every 6.25 nominal
value of Demasts shares. Each convertible debenture may be exchanged for 26
ordinary shares at any time between 1 January 2007 and 31 December 2009.
Nadions share price moves to 335 pence. This offer is rejected by the directors of
Demast.
19 October BZ0 offers cash of 600 pence per share. The cash will be raised by a
term loan from the companys bank. The board of Demast are all offered seats on
subsidiary boards within the BZO group. BZOs shares move to 680 pence.
20 October The directors of Demast recommend acceptance of the revised offer
from BZO.
24 October BZO announces that 53% of shareholders have accepted its offer
and makes the offer unconditional.
Required
(a) Discuss the advantages and disadvantages of growth by acquisition.
(b) Discuss whether or not the bids by BZO and Nadion are financially prudent
from the point of view of the companies shareholders. Relevant supporting
calculations must be shown.
(c) Discuss problems of corporate governance that might arise for the
shareholders of Demast Ltd and BZO plc.
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Demast Ltd solution
(a) Growth by acquisition is said to allow companies to expand much more rapidly
than by organic growth. Rapid increases in size may offer:
(i) Economies of scale in production, marketing, R & D and finance
(ii) A reduction in the companys risk, and cost of capital
(iii) Greater market share and market power. In some markets to operate
effectively requires the achievement of a critical mass size.
Additionally acquisitions may allow:
(i) Improvements in gearing
(ii) Purchase of patents, brands or skilled management
(iii) Synergistic effects
(iv) Entry into a new market quickly
(v) Acquisition of undervalued assets or companies, as is the stated strategy
of BZO International. This may encompass the removal of relatively
inefficient management.
However, there is evidence that many acquisitions are financially
unsuccessful. There is often some abnormal return for the shareholders of the
target company (in the form of high prices received for their shares), but very
little for the bidding companys shareholders. Acquisitions often experience
difficulties in integrating the operations of the companies concerned (unless
asset-stripping is the motive for the acquisition).
(b) Demast is an unlisted company, with no market price. Ideally the valuation of
the company should be based upon the expected net present value of future
cash flows, but accurate estimates of this value will rarely be available in an
acquisition situation. Valuation could in practice be based upon either assets
or earnings. For Nadion, which is likely to be purchasing Demast as a going
concern, an earnings valuation is appropriate. BZO International has a
strategy of acquiring what are perceived to be undervalued companies. If the
intention is to quickly dispose of all or part of the company, the realisable
value of Demasts assets would provide a useful guide, but if asset stripping is
not to occur an earnings valuation would once again be recommended.
Asset valuations
No precise estimate of the realisable value of assets is possible. Net asset
value, adjusted for a 10% decrease in the value of stock, is 5,950,000 or
149 pence per share. This, however, ignores important factors including:
(i) Land and buildings have not been revalued since 1989. In the light of
the subsequent recession and fall in commercial property prices, the
realisable value could be less than the book value of 4 million.
(ii) No information is provided regarding the difference between book and
realisable values of other fixed assets.
(iii) The patents are not valued in the balance sheet. These could have
substantial value if they have a number of years to run.
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Earnings valuations
Two common methods of earnings based valuations are the P/E ratio and the
dividend valuation model.
P/E ratio model
As Demast is not listed a P/E valuation must be based upon the P/E of a
similar (pure play) company. The only available information for a company in
the same industry is for Nadion, a much larger company.
The EPS of Demast is 80.5 pence (given in question).
EPS of Nadion is 58 pence.
P/E of Nadion is 320p 58p = 5.52
If this is used for Demast the estimated value per share is:
5.52 x 80.5p = 444 pence
Although Nadion is listed and much larger than Demast, the much higher
growth rates of Demast might justify the use of the P/E of Nadion, without any
adjustment for lack of marketability.
Dividend valuation model
P
0
=
g Ke
D
1


Current dividend of Demast is
000 , 000 , 4
000 , 500 , 1
= 37.5p per share
At 9% growth the expected net dividend is 37.5 x 1.09 = 40.875p
P
0
=
09 . 0 16 . 0
875 . 40

= 584 pence per share


All of these estimates are subject to considerable margins of error.
Value of the bids
7 September BZO bids 710 x 2/3 = 473 pence per share
2 October Nadion bids 170 pence plus effectively 4 per share (100
debentures at par for 6.25 nominal value or 25 ordinary shares), amounting
to 570p per share plus the conversion opportunity. The conversion is
currently at an implied price of 100 26 = 385 pence per share.
This is only 14.9% above the current share price of Nadion (335p), and the
opportunity for substantial capital gains on conversions exists as there are up
to five years before the final conversion date. A rise in market price could
mean that Nadion issues new shares on conversion at well under market price
to Demasts old shareholders.
19 October BZO cash offer of 600 pence per share.
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Commentary
Although all offers are significantly above the estimated asset valuation, the
final successful bid is only 16 pence above the dividend valuation model
figure. If this is accurate, the bid would seem to be financially prudent.
However, BZOs strategy is to acquire undervalued companies. Unless BZO
has knowledge of how to significantly increase the value of Demast e.g. by
disposing of part of the operations, or the land, the acquisition of Demast does
not appear to be in line with this strategy. Additionally financing the 600
pence cash offer with a 24 million term loan increases the book value of
BZOs gearing (measured by loans and overdraft to shareholders funds) from
its already high level of
35 91 72 123
35 30
+
+
=
69
65
= 94%
If the stock market is efficient the significant falls in BZOs share price on the
occasions of both the companys bids illustrate that the acquisition is not
regarded as financially beneficial by the companys shareholders.
(c) Corporate governance is the system by which companies are directed and
controlled. The board of directors should act on behalf of the shareholders,
taking note of other interest groups such as the government, creditors,
customers and employees.
In an acquisition situation the actions of directors are constrained by the City
Code on Takeovers and Mergers, a set of self-regulatory rules administered
and enforced by the Panel on Takeovers and Mergers. The directors of both
the bidding and target companies should disregard their own personal
interests when advising shareholders.
It is questionable whether BZOs directors actions are in the best interests of
the companys shareholders, given the market reaction to the bid and the
likely adverse effects on the companys gearing and interest cover. The
company appears short of liquidity (current ratio 0.79:1), and may be trying
to maintain its high growth in turnover through acquisitions.
The directors of Demast advised shareholders to reject the bid of Nadion
worth 570 pence plus a likely capital gain on conversion, and accept the bid
from BZO of 600 pence, which also offered them seats on subsidiary boards
within BZO. It could be argued that the directors were acting in their own
interests to retain well-paid employment, and not in the interests of the
owners of the 75% of the shares not controlled by the directors and their
families, although the value of the conversion option is difficult to quantify.
Acceptance of the bid by BZO might also affect the operations and
employment levels of Demast, if part of the operation or the patents were
sold. Continuity of current operations would be more likely under the
ownership of Nadion, a company in the same industry, though some cost-
saving might occur, with loss of employment.
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Kelly plc
On 1
st
July 2005, Kelly plc had the following three classes of debenture all of which
had been in issue for some years:
Coupon
Rate
Year(s) of
redemption
Date of
redemption
Dates of
interest payments
Market price
at 1 July 2005

14% 2009 31 December 1 July, 31 December 110.43 ex int.
14% 2008-2010 1 July 1 July, 31 December 110.15 ex int.
6% 2010 1 April 1 April, 1 October unlisted
All the companys debentures will be redeemed at par. Market evidence suggests
that the 6% 2010 debentures should have a six-monthly gross redemption yield (i.e
internal rate of return to maturity) of 6%. The prevailing level of market interest
rates can be assumed to remain unchanged over the next six years.
Requirements
(a) Calculate the six-monthly gross redemption yield of the 14% 2009 debenture
(b) Determine when investors are likely to assume that Kelly plc will redeem the
14% 2008-2010 debentures, and hence calculate their effective annual gross
redemption yield.
(c) Estimate the price on 1
st
July 2005 that an investor should be prepared to pay
for the 6% 2010 debentures.
NOTE: Ignore taxation
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Kelly plc solution
(a) Six-Monthly Gross Redemption Yield
This is found as the IRR of the following cash flows:
Initial capital cost: market value 110.43
Interest: nine payments of 7 due yearly
Redemption: one payment of 100 in nine years time.
Time Cash flows 10% factor PV at 10% 5% factor PV at 5%

0 (110.43) 1 (110.43) 1 (110.43)
1-9 7.00 5.759 40.31 7.108 49.76
9 100.00 0.424 42.40 0.645 64.50
Net present values (27.72) 3.83
IRR, i.e. 6 monthly yield = |

\
|
+ 5
55 . 31
83 . 3
5 = 5.6%
(b) Redemption Date and Effective Annual Gross Redemption Yield
Kelly plc will presumably choose the option which minimises the effective cost
(based on similar IRR calculations) of the loan stock to themselves.
(i) Redeem 2008
PV at 10% PV at 5%

Market value (110.15) (110.15)
Six interest payments of 7 30.49 35.53
One payment of 100 56.40 74.60
Net present values (23.26) (0.02)
IRR = 5%

(ii) Redeem 2010

Market value (110.15) (110.15)
Ten interest payments of 7 43.02 54.05
One payment of 100 38.60 61.40
(28.53) 5.30
IRR = |

\
|
+ 5
83 . 33
30 . 5
5 = 5.8%
Therefore Kelly will redeem the loan stock in July 2008. The effective annual
gross redemption yield is (1.05)
2
1 = 10.25%.
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(c) Price of Debentures on 1 July 2005
The value at 1 October 2005 is the present value, at 6%, of two cash flows:
(1) Interest: 9 interest payments of 3 plus 3 due on 1 October
(2) Redemption payment: 100 in nine years time
PV of interest = [3.00 x a
9(

0.06
]

+

3.00

= [ ] 00 . 3 802 . 6 00 . 3 +
= 20.41 + 3.00 = 23.41
PV of capital = 592 . 0 100 = 59.20
DF @ six monthly yield of 6% for 3 month period
= 06 . 1 = 1.0296

Value at 1 July = (23.41 + 59.20) 1.0296 = 80.24
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Eichner plc
At 31 July 2003, Eichner plc and Beck plc both have in issue 5 million ordinary
shares each with a nominal value of 50p. In addition, the companies have in issue
the following actively traded securities.
Eichner plc: 50,000 units of convertible debentures, carrying an annual coupon rate
of 11%. Each unit has a nominal value of 100 and may be converted into 40
ordinary shares at any time up to and including 31 July 2008. At that date any
unconverted debenture will be redeemed at 105 per 100 nominal value.
Beck plc: 800,000 warrants, each of which provides the holder with the option to
subscribe for one ordinary share at a price of 2.50 per share. The warrants can be
exercised at any time up to and including 31 July 2008.
Required:
(a) Calculate the value of each 100 unit of convertible debenture and of each
warrant on 30 July 2008, if the share price for each company on 30 July 2008
is either 2 or 3, and advise holders of the securities whether or not to
exercise their conversion or option rights.
(b) Estimate the market price at 31 July 2003 of each 100 unit of convertible
debenture, if the current share price on the same date is either 2 or 3. The
current pre-tax rate of interest on 11% debentures of companies with similar
risk to Eichner plc is 8% per annum.
(c) Discuss, briefly the factors which would influence the current price of a
warrant.
NOTE: Ignore personal taxation.
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Eichner plc solution
(a) Value of convertibles and warrants
(i) Value of convertibles
Share
price
Value as
debentures
Value as shares Market value Convert?
2 105 40 x 2 = 80 105 NO
3 105 40 x 3 = 120 120 YES
(ii) Value of warrants
Share price Exercise price Value of warrant Exercise option?
2 2.50 NIL NO
3 2.50 0.50 YES
(b) Market price of convertible debentures
(i) Value as debt

t
15
11 x 3.993 = 43.92

t
5
105 x 0.681 = 71.51
115.43
5 year annuity factor at 8% = 3.993
5 year single discount factor at 8% = 0.681
(ii) Value as equity will be 40 x market price per share
Share price
Value as debt
(ex int)
Value as equity
(ex div)
Formula value
2 115.43 80 115.43
3 115.43 120 120.00
The actual price of the convertibles is likely to display a premium on the
formula value prices, reflecting the time to go before expiry (i.e. time
value). There is no downside risk on the lower share price and only a
limited amount on the higher.
The value of a convertible cannot fall below its value as debt, but upside
potential is available due to the possibility of an increase in share price.
Thus a convertible will trade at a value in excess of formula value, and that
premium will be at its greatest where the value as debt and the value as
equity are fairly close to each other.
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(c) Factors influencing the current price of a warrant
Warrants are effectively call options on equity and their value may be
estimated within an option pricing framework.
The major factors determining the market price of a warrant are as follows:
1. The price of the underlying security. Clearly the higher the security
price the more valuable the warrant.
2. The exercise price, i.e. the price at which the underlying security may
be purchased. The lower the exercise price the more valuable the
warrant.
3. The time to expiry. The longer the period to expiry the greater the
probability that the value of the underlying security will rise in value.
4. The volatility of the underlying security. Warrants like options can
give protection from downside risk, but give participation in upside
potential. Accordingly the greater the variability of the underlying
security the greater the probability of the warrant showing high returns.
5. Interest rates. As the exercise of the warrant is at some future date
we must consider the present value of the exercise price in determining
the value of a warrant. As interest rates rise, the present value of the
exercise price will be lower and hence the value of the warrant will
increase.
6. Exercise conditions. Warrants sometimes may only be exercised on
expiry (equivalent to European Call Options) whilst others may be
exercised at any time up to expiry (American Call Options). In most
circumstances it is not sensible to exercise warrants until expiry as
whilst there is still time left to run, the underlying security could
increase in value. In this case both variants should have the same
value. Large dividend payouts effectively transferring equity value to
cash can be detrimental to European type warrants. American type
warrants could exercise early and avoid this problem and therefore may
be more valuable.

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Chapter 11
Valuations,
acquisitions and
mergers section 3


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CHAPTER CONTENTS
A QUESTION OF VALUES ----------------------------------------------- 259
MARKET VALUE ADDED 259
ECONOMIC VALUE ADDED (EVA) 261
SHAREHOLDER VALUE ADDED (SVA) 268
INTELLECTUAL CAPITAL ----------------------------------------------- 271
VALUING INTELLECTUAL CAPITAL 271
MARKET-TO-BOOK VALUES 271
TOBINS Q 272
CALCULATED INTANGIBLE VALUE 272
ILLUSTRATION DESTROYING VALUE ------------------------------- 274

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A QUESTION OF VALUES
By Steve Jay, BA, M Phil
This is an article, which appeared in the October 2001 edition of Student
Accountant.
Introduction
It is generally accepted that the objective of corporate financial management is to
maximise shareholder wealth in the form of rising share prices and dividends.
Whilst this is obviously in the interest of shareholders it should also benefit society
as a whole. This is because it should lead to the most efficient companies finding it
easiest to raise new share capital and thus ensure that societys scarce resources
are allocated and managed most efficiently. Unfortunately history shows us that
accounting profit measures often appear to have little correlation with share price
performance. This is particularly true in new-economy companies, many of whom
have poor profit records but who have demonstrated large increases in wealth for
their investors during the 1990s.
Market value added
Before proceeding with a look at economic value added it is important that we
clarify our measure of shareholder wealth. Imagine two quoted companies A plc
and B plc. Both firms are entirely equity financed. Both have a start of year stock
market equity capitalisation of 400 million. A plc raises 20 million via a rights
issue and invests it in a project that adds 100m to the present value of its future
earnings. B plc raises 150 million via a rights issue and invests in a project that
adds 120m to the present value of its future earnings. Table 1 demonstrates the
changes to equity market capitalisation and shareholder wealth.
---------------------------------------------------------------------------------------------
Table 1
Changes in stock market value
Company A Company B
Opening total value (equity market capitalisation) 400m 400m
Addition to present value of earnings stream 100m 120m
Closing total value (equity market capitalisation) 500m 520m
Changes in shareholder wealth
Increase in total value (equity market capitalisation) 100m 120m
Funds subscribed by shareholders (20m) (150m)
Market value added for the period 80m (30m)
---------------------------------------------------------------------------------------------
It is clear that although Company B has the greatest increase in market
capitalisation it has decreased the wealth of its shareholders as the present value
of the future income generated by its new project is less than the funds invested.
Company A on the other hand adds 80m to the wealth of its investors.
This is a simple but important point. Shareholder wealth is not simply the increases
in stock market value over the period; rather it is the increase in stock market
value less funds subscribed by shareholders.
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This concept can be enlarged to cover the whole life of the business. Over a longer
time period the market value added is the difference between the cash that
investors have put into the business (either by purchase of shares or the
reinvestment of potentially distributable profits) and the present value of the cash
they could now get out of it by selling their shares.
The link with NPV
None of the above is particularly new. NPV is a well-established rule that measures
the impact that new projects will have on shareholder wealth. Table 2 adds some
more detail to the two projects being considered by Companies A and B.
---------------------------------------------------------------------------------------------
Table 2
Cash flows
Company A
Project
Company B
Project
m m
t0 Initial investment (20) (150)
tl-t4 Net cash flow pa 35.03 46.35

CAPM based required rate of return 15% 20%
Net present value of Project A = (20) + Annuity factor for 4 years @ 15% x 35.03
= (20) + 2.855 x 35.03
= 80m
Net present value of Project B = (150) + Annuity factor for 4 years @ 20% x 46.35
= (150) + 2.589 x 46.35
= (30m)
Both of these figures correspond with the market value added in the period, thus
the NPV rule should guide managers to select projects that maximise shareholder
wealth.
---------------------------------------------------------------------------------------------
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Economic value added (EVA)
So far we have established that the prime objective of financial management is to
maximise investor wealth and that this can be achieved by using NPV in decision
making. What is lacking is an operating performance measure for management
that will guide managers to maximise NPV and thus shareholder wealth.
Traditionally operating managers are judged on accounting profit based measures
(controllable profit, return on investment, etc) which we have noted, often lack
correlation with shareholder wealth and largely ignore NPV. It seems very strange
that we expect managers to evaluate new projects on the basis of NPV, but that we
subsequently ignore NPV in appraising managerial performance.
Economic value added attempts to cure this problem.
Economic value can be defined as
Cash earnings before interest but after tax* MINUS An imputed charge for
the capital consumed.
*often referred to as NOPAT (net operating profit after tax)
In this way a managers operating performance is judged after charging a amount
for capital funds used.
It will be noted that this is very similar to residual income, a performance measure
you will have considered in earlier studies.
Crucially the present value of the economic value added figure equals the NPV of
the project.
Economic value added is sometimes referred to as EVA. EVA is the registered
trademark of Stern Stewart and Co who have done much to popularise and
implement this measure of residual income.
Table 3 shows the calculation of economic value added for our two projects and
demonstrates its equivalence with NPV.
---------------------------------------------------------------------------------------------
Table 3
million
t1 t2 t3 t4
Company A Project
Year beginning capital employed (net) 20 15 10 5

Net of tax operating cash flow 35.03 35.03 35.03 35.03
Economic depreciation* (5) (5) (5) (5)
Imputed capital charge (15% of capital employed) (3)__ (2.25) (1.5) (0.75)
Economic value added 27.03 27.78 28.53 29.28

Company B Project
Year beginning capital employed (net) 150 112.5 75 37.5

Net of tax operating cash flow 46.35 46.35 46.35 46.35
Economic depreciation* (37.5) (37.5) (37.5) (37.5)
Imputed capital charge (20% of capital employed) (30) (22.5) (15)_ (7.5)_
Economic value added (21.15) (13.65) (6.15) 1.35


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Equivalence with NPV

Company A economic value added 27.03 27.78 28.53 29.28
PV factors @ 15% 0.870 0.756 0.658 0.572
Present value 23.50 21.00 18.76 16.74

Total present value = 80 million = Project NPV

Company B economic value added (21.15) (13.65) (6.15) 1.35
PV factors @ 20% 0.833 0.694 0.579 0.482
Present value (17.62) (9.47) (3.56) 0.65

Total present value = (30 million) = Project NPV
*Economic depreciation measures the true fall in the value of assets each year through wear and tear
and obsolescence. Although depreciation would not normally be charged in calculating discounted cash
flow, in this case it must be recovered from a companys cash flow to provide investors with a return of
their capital before they can enjoy a return on their capital G Bennett Stewart. Alternatively it could be
viewed as the capital expenditure the firm would have to make each year to maintain its capital base.
In this example, for simplicity, economic depreciation is assumed to occur on a straight-line basis though
clearly other patterns are possible.
---------------------------------------------------------------------------------------------
The Linkages
To recap, the increase in shareholder wealth = Market value added
= Project NPV
= Present value of economic value
added
Therefore if we tell managers that their performance will be judged upon economic
value added, this should result in the maximisation of NPV and thus shareholder
wealth. We now have a performance measure that corresponds exactly with the
NPV based decision-making technique.
Proponents therefore recommend that managers and divisions operating
performance should be measured on an economic value added basis
Some complications
1. Geared companies
Not all companies are financed entirely by equity; many fund substantial parts
of their plant and equipment by using debt finance. The principles of
economic value added still apply.
Cash earnings before interest but after tax are charged for capital at a rate
that blends the after-tax cost of debt and the cost of equity in the target
proportions the firm would plan to employ (rather than the actual mix used in
a particular year).
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Imagine that Company A financed its project by 50% equity finance and 50%
risk free debt finance and that this was considered to reflect the target capital
structure. To reflect this higher gearing As cost of equity finance increases to
18.5%. Its post-tax cost of debt is 7%. This gives a weighted average cost
of capital for the project of:
18.5% x 50% + 7% x 50% = 12.75%
The capital charge to the project will now be at 12.75% of capital employed at
the start of the year. Note that interest on the loan should not be deducted
from the net of tax operating cash flow as it is allowed for in the imputed
capital charge. The tax relief on interest should not be allowed for in the tax
bill, as once again this is included in the capital charge. Students will note
that this is similar to the approach taken in estimating net cash flow in NPV
calculations.
This approach is illustrated in table 4 together with other adjustments.
2. Economic value added and reported accounting results
Published accounting profit figures are more complicated than operating cash
flow less economic depreciation as featured in Table 3. For reasons of
prudence, losses are often recognised at an early date and accruals
accounting makes many timing adjustments to cash flow in converting it to
accounting profit.
As we are really interested in economic profit rather than accounting profit
these adjustments have to be eliminated or added back in. The consulting
firm Stern-Stewart, have identified 164 performance measurement issues in
its calculation of EVA from published accounts. The adjustments mainly
involve:
(i) Converting accounting profit to cash flow
(ii) Distinguishing between operating cash flows and investment cash flows
They include such issues as treatment of stock valuation, revenue recognition,
bad debts, the treatment of R & D, advertising and promotion, pension
expenses, contingent liabilities etc. Whilst it is unlikely that you would have
to make 164 adjustments in the exam some simple changes may be required!
Some of these are demonstrated in Table 4, which includes a calculation of
EVA from a set of published results.
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Table 4
XYZ plc Profit and Loss Account year ended 31/12/2000 (unadjusted)
m
Sales revenue 50
Cost of sales (28.3)
Depreciation (0.8)
Net operating profit 20.9
Interest paid (1.6)
R & D (2.1)
Advertising (2.3)
Amortisation of goodwill (1.3)
Profit before tax 13.6
Tax paid (30%) (4.08)
Available to equity 9.52
XYZ plc Balance Sheet as at 31/12/1999 (unadjusted)
m
Fixed assets (net) 40
Current assets 125
Less Current liabilities (98)
Borrowings (27)
Net assets 40

Ordinary shareholders funds 40
XYZ plc Profit and Loss Account year ended 31/12/2000 after
adjustments
m
Profit before tax 13.6
Add
Interest paid 1.6 note 1
R & D 2.1 note 2
Advertising 2.3 note 3
Goodwill 1.3 note 4
Net operating profit 20.9
Less adjusted tax bill (4.56) note 5
Adjusted profit 16.34 note 7
XYZ plc Balance Sheet as at 31/12/1999 after adjustments
m
Ordinary shareholders funds 40
Add
Borrowings 27 note 1
R & D 13.4 note 2
Advertising 15 note 3
Goodwill 8.9 note 4
Adjusted capital employed 104.3

Adjusted return 16.34
Required return (15% x 104.3m) = (15.645) note 6
EVA 0.695m
Conclusion: this company has added value for its shareholders
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Notes
1 Interest paid is added back as this will be charged in the imputed capital
charge. Borrowings are added to the capital base as profits must cover
the cost of borrowings (see geared companies above).
2 R & D is considered an investment in the future in the same way as
expenditure on capital equipment. 2.1m is therefore removed from the
P & L account. At the same time the last (say) 5 years R & D expense
(assumed 13.4m) is added back to the balance sheet. This will
increase the capital base and thus the imputed capital charge. A small
charge for R & D may remain in the P & L a/c to reflect the economic
depreciation of the capitalised value.
3 Advertising is a market building investment and is removed from the P &
L a/c. The last (say) 5 years advertising expense is added to the capital
base (assumed 15m).
A small charge for advertising may remain in the P & L a/c to reflect the
economic depreciation of the capitalised value.
4 Goodwill represents the premium paid for a business on acquisition.
Again this is an investment in the future and similar adjustments as for
R & D and advertising apply. The cumulative goodwill write off of
(assumed 8.9m) is added to the capital base.
5 The tax figure will include tax relief on debt interest. As this will be
allowed for in the weighted average cost of capital it should be adjusted
out. The tax bill will rise to 4.08 + (30% x 1.6m) = 4.56m.
6 This is an assumed 15% WACC applied to the adjusted capital
employed. Note that WACC would be calculated following the approach
outlined in geared companies above.
7 No adjustment is made for depreciation as this is assumed to
approximate economic depreciation on physical assets as discussed
above.
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Arguments for and against Economic Value Added
FOR
1. It makes the cost of capital visible to managers. Under conventional
management accounting performance measures the only profit and loss
charge for capital is depreciation on the asset. Under the economic value
added approach managers will also be charged the financing cost of capital
employed. This should cause managers to be more careful in investing new
funds and to control working capital investment. It can also lead to under-
utilised assets being disposed of. To improve their performance managers will
have to:
Invest in positive NPV projects, OR
Eliminate negative NPV operations, OR
Reduce the firms weighted average cost of capital, OR
Hopefully all three
2. It supports the NPV approach to decision making. If managers pursue
negative NPV projects they will eventually find that the imputed capital charge
outweighs earnings and will lead to a deterioration in their reported
performance.
AGAINST
1. Economic value added does not measure NPV in the short term. Some
projects have poor cash flows at the beginning, but much better ones at the
end (and vice versa). Projects with good NPVs may show poor economic
value added in earlier years and thus be rejected by managers with an eye on
their performance measure. Managers who have a short term time horizon
(possibly due to impending promotion or retirement) could still make
decisions that conflict with NPV and thus the maximisation of shareholder
wealth.
If we return to projects being considered by Companies A and B, but this time
alter the pattern of cash flows (but not the NPVs) the point will be clearer.
Table 5 illustrates this point.
-----------------------------------------------------------------------------------------------------
Table 5
Cash flows m
Company A Project Company B Project

m
DF
15%
PV
m

m
DF
20%
PV
m
t0 Investment (20) 1 (20) (150) 1 (150)
t1 Net cash flow 5 0.870 4.35 133.52 0.833 111.22
t2 Net cash flow 5 0.756 3.78 5 0.694 3.47
t3 Net cash flow 5 0.658 3.29 5 0.579 2.90
t4 Net cash flow 154.87 0.572 88.58 5 0.482 2.41
NPV 80m (30m)
NPVs are unchanged and should therefore have the same effect on market
value added as before.
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Economic value added computations
Company A Project
Year beginning capital employed
(net)
20 15 10 5

Net of tax operating cash flow 5 5 5 154.87
Economic depreciation (5) (5) (5) (5)
Imputed capital charge (15% of
capital employed) (3) (2.25) (1.5) (0.75)
Economic value added (3) (2.25) (1.5) 149.12
DF(15%) 0.870 0.756 0.658 0.572
PV NPV = 80m (2.61) (1.70) (0.99) 85.30
Company B Project
Year beginning capital employed
(net)
150 112.5 75 37.5

Net of tax operating cash flow 133.52 5 5 5
Economic depreciation (37.5) (37.5) (37.5) (37.5)
Imputed capital charge (20% of
capital employed) (30) (22.5) (15) (7.5)
Economic value added 66.02 (55.0) (47.5) (40.0)
DF(20%) 0.833 0.694 0.579 0.482
PV NPV = 30m 54.99 (38.20) (27.50) (19.29)
Conclusion
The present value of the economic value added figures is still equal to the
projects NPV, but the year-by-year distribution of economic value added has
changed. Managers with a short term time horizon may well accept Company
Bs project but reject Company As project.
----------------------------------------------------------------------------------------
2. Validity of EVA adjustments
Part of the problem with economic value added in the short term lies in the
accounting measurement of profit. In table 5, Company As project might
show poor cash flows earlier on due to large investments in R & D. To a
certain extent this problem can be removed by using the adjustments
proposed by Stern Stewart covered above. However Brealey and Myers
question if these adjustments to accounting profit are sufficient. They cite the
case of Microsoft and question whether its capital base has been understated
in published Stern Stewart figures. The value of its intellectual property - the
fruits of its investment in software and operating systems is not shown in the
balance sheet. This would undervalue its capital base and result in its
imputed capital charge being too small and thus overstate its EVA.
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Shareholder value added (SVA)
Shareholder value is a much-discussed concept and many companies now express
a commitment to it. It should be noted however that economic value added is
simply one way of measuring the increase in shareholder wealth achieved by the
company. Kevin Mayes gave a useful overview of the various shareholder value
metrics in a Student Newsletter article in the November/December 2000 edition.
Of these competitors to EVA, shareholder value added is also included in the Paper
P4 syllabus.
Shareholder value added involves calculating the present value of the projected
future free cash flow to equity of the business. Any increase in this present value
should result in an equivalent increase in market value added and thus increase
shareholder wealth.
Free cash flow to equity is the cash flow available to a company from operations
after interest expenses, tax, repayment of debt and lease obligations, any changes
in working capital and capital spending on assets needed to continue existing
operations (i.e. replacement capital expenditure equivalent to economic
depreciation).
Although different definitions of free cash flow exist they all relate to cash flow after
replacement capital expenditure. Free cash flow in our definition represents the
cash available to shareholders, which in principle could be used to invest in new
positive NPV projects, paid out as dividend or used for share repurchase. The
present value of this free cash flow should equal the current equity market
capitalisation of the business, and any changes in this present value (less
shareholder funds subscribed) represent the market value added.
Table 6 gives an example of the types of calculation involved.
---------------------------------------------------------------------------------------------
Table 6
A company prepares a forecast of future free cash flow at the end of each year. A
period of 15 years is used as this is thought to represent the typical time horizon of
investors in this industry. The companys CAPM derived cost of equity is 10%.
During 2000, a rights issue of 5m is made which is invested in a project that will
increase future earnings.
Note that present values are calculated at a cost of equity, as free cash flow is
measured after debt servicing costs (i.e. it represents a return to equity holders).
If debt interest and principal payments had been excluded from the free cash flow
calculation then the present value would have been calculated at the WACC as this
version of free cash flow represents a return to both equity and debt holders. The
resultant present values would then represent the value of debt plus equity in the
company. The value of equity could be calculated by subtracting the stock market
value of debt.
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Free cash flow forecast as at 31/12/1999
m
t1 t2 t3-t15
Sales 10,000 12,000 14,000
Operating costs (4,000) (5,000) (6,000)
Interest (1,000) (1,000) (500)
Debt repayments - (4,000) -
Working capital (500) (500) (500)
Replacement capital expenditure - (3,000) -
Tax (1,000) (1,000) (1,000)
Free cash flow to equity 3,500 (2,500) 6,000
PV factors @ 10% (the companys cost of equity) 0.909 0.826 5.870*
Present value of free cash flow to equity 3,182 (2,065) 35,220

Total present value 36,337
Free cash flow forecast as at 31/12/2000
m
t1 t2 t3-t15
Sales 12,000 14,000 15,000
Operating costs (5,000) (6,000) (6,000)
Interest (1,000) (500) (500)
Debt repayments (4,000) - -
Working capital (500) (500) (500)
Replacement capital expenditure (3,000) - -
Tax (1,000) (1,000) (1,000)
Free cash flow to equity (2,500) 6,000 7,000
PV factors @ 10% (the companys cost of equity) 0.909 0.826 5.870*
Present value of free cash flow to equity (2,273) 4,956 41,090

Total present value 43,773

m
PV of free cash flow to equity as at 31/12/2000 43,773
PV of free cash flow to equity as at 31/12/1999 36,337
Increase in present value 7,436
Funds subscribed by shareholders in the year (5,000)
Market value added 2,436
Conclusion This company has increased the wealth of its shareholders
* The annuity factor for t3-t15 is calculated as follows:
t Annuity factor
1 to 15 7.606
1 & 2 (1.736)
5.870
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Arguments for and against the shareholder value added approach
For
It takes a multi-period view and should therefore overcome some of the short
termism of EVA
Against
1. The estimates of future free cash flow are very subjective and are very
difficult to verify. This technique would be almost impossible for outsiders to
the business to use.
2. The time horizon over which free cash flow is forecast is difficult to determine.
If you use a short period you lose the present value earned in later years, but
if a long period is used the forecasting of cash flows becomes very subjective.
Conclusions
Shareholder value is high on the agenda of many companies as shareholders
increasingly look for competitive rates of return on their investments. The two
metrics discussed here draw heavily on traditional financial management and
management accounting theory. EVA, SVA and free cash flow are all included in
the Paper P4 syllabus and are fair game for future exam questions.
References and Acknowledgements
G Bennett Stewart: The EVA Fact or Fantasy-Journal of Applied Corporate Finance
1994.
R Brealey & S Myers: Principles of Corporate Finance-McGraw Hill 6
th
Edition 2000
K Mayes: Shareholder Value-ACCA Student Newsletter November/December 2000
Thanks to Scott Goddard for his valuable comment on the drafts of this article.
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INTELLECTUAL CAPITAL
Patents, trademarks and copyrights are the only form of intellectual capital that are
regularly recognised in financial reporting. However, accounting conventions based
upon historical cost often understate their value, since market values and value in
use would be more appropriate.
The the Value Platform is an intellectual capital management model which
recognises its three main components:
Human capital this refers to the know-how, capabilities, skills and expertise
of the human members of the organisation;
Organisational (structural) capital this refers to the organisational
capabilities developed to meet market requirements e.g. patents, design
rights, trade secrets, corporate culture, information systems and financial
relations;
Customer (relational) capital this refers to the connections outside the
organisation e.g. customer loyalty, brands, distribution channels, supplier
relations and franchising agreements.
Valuing intellectual capital
Intellectual capital is influenced by the unique culture of the organisation and the
distinct processes and relationships evolving therein. In view of its complexity the
measurement of intellectual capital would require a number of evaluation
measures.
Three broad indicators have been developed to facilitate comparisons of intellectual
capital stocks between organisations:
market-to-book values;
Tobins q;
Calculated intangible value
Market-to-book values
This is the most widely known indicator of intellectual capital. The contention is
that the value of an entitys intellectual capital will be represented by the difference
between the book value of the enterprise and its market value. If a companys
market value is 10m and its book value 5m, then the residual 5m represents
the value of the firms intangible (or intellectual) assets. The principal benefit of
this method is its simplicity. However, as with most other measures, the more
simple the calculation, the less likely it is to capture the complexities of the real
world. In this case, simply subtracting book value from market value tends to
ignore external factors that can influence market value, such as deregulation,
supply conditions and general market nervousness, as well as the various other
types of information that determine investors perception of the income-generating
potential of the business, such as industrial policies in foreign markets, media,
political influences, rumour, etc.
In addition, the current accounting model does not attempt to value a company in
its entirety. Instead it records each of its separate net assets at an amount
appropriate to the relevant financial reporting standard, under which the accounts
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have been prepared (e.g. historical cost, modified historical cost, replacement cost,
etc.). The market, however, values a business in its entirety as a going concern
with strategic intent. It may be argued that the differences between these two
forms of valuation can be defined as the value of intellectual capital. This value will
then be subject to variations arising from the book value of the separable net
assets, their current market price, and various imperfections that may exist in the
market valuations.
Calculations of intellectual capital that use the difference between market and book
values can also suffer from inaccuracy because book values can be affected if
businesses choose, or are required, to adopt tax depreciation rates for accounting
purposes, and the tax rates reflect factors other than an approximation of the
diminution in value of an asset.
Tobins q
Another way of getting around the depreciation rate problem when comparing the
intellectual capital between entities is to use Tobins q. This was developed initially
by James Tobin as a method of predicting investment behaviour. It uses the value
of the replacement costs of a companys assets to predict the investment decisions
of a business, independent of interest rates. The q is the ratio of the market value
of the enterprise (i.e. number of shares on issue multiplied by mid-market price) to
the replacement cost of its assets. If the replacement cost of a companys assets is
lower than its market value, then a company is obtaining monopolistic benefits, or
higher-than-normal returns on its investments. A high value of q indicates that the
company will likely purchase more of those assets. Technology and human capital
assets are typically associated with high q-values. As a measure of intellectual
capital, Tobins q identifies a companys ability to get unusually high profits because
it has something that no other business has.
However, Tobins q is subject to the same external variables that influence market
price as the market-to-book value approach. Both methods are best suited to
making comparisons of the value of intangible assets of businesses within the same
industry, serving the same markets, and having similar types of tangible assets. In
addition, these ratios are useful for comparing the changes in the value of
intellectual capital over a number of years. When both the Tobins q and the
market-to-book value ratio of a company are falling over time, it is a good indicator
that the intangible assets of the firm are depreciating. This may provide a signal to
investors that a particular company is not managing its intangible assets effectively
and may cause them to adjust their investment portfolios towards companies with
increasing or stable values of q.
By making intra-industry comparisons between a companys primary competitors,
these indicators can act as performance benchmarks and can be used to improve
the internal management or corporate strategy of the entity.
Calculated intangible value
A third measure, calculated intangible value (CIV) has been developed by NCI
Research to calculate the fair market value of the intangible assets of the entity.
The CIV involves taking the excess return on tangible assets, using this figure as a
basis for determining the proportion of return attributable to intangible assets.
Merck & Co, a pharmaceutical company, can be used as an example in illustrating
how the CIV works:
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1. Calculate average pre-tax earnings for three years. For Merck: $3.694bn.
2. Go to the balance sheet and calculate the average year-end tangible assets
over three years: US$12.952bn.
3. Divide earnings by assets to get the return on assets (ROA): 29 per cent.
4. For the same 3 years, find the industrys return on assets. For
pharmaceuticals, the number in this example was 10 per cent. If a companys
ROA is below average, then stop. NCIs method will not work.
5. Calculate the excess return. Multiply the industry-average ROA by the
companys average tangible assets; this shows what the average drug
company would earn from that amount of tangible assets. Now subtract that
from the companys pre-tax earnings. For Merck, excess earnings are:
3.694bn (0.10 x 12.952bn) = $2.39bn
This figure shows how much more Merck earns from its assets than the
average drug-maker would!
6. Calculate the 3-year average income tax rate and multiply this by the excess
return. Subtract the result from the excess return to show the after-tax
premium attributable to intangible assets. For Merck (average tax rate 31 per
cent) the figure was $1.65bn.
7. Calculate the net present value (NPV) of the premium. This is done by
dividing the premium by an appropriate discount factor such as the companys
cost of capital. Using an arbitrarily chosen 15 per cent yields, for Merck,
$11bn. This is the CIV of Mercks intangible assets the one that does not
appear on the balance sheet.
While the CIV offers the potential to make inter- and intra-industry comparisons on
the basis of audited financial results, two problems remain. First, the CIV uses
average industry ROA as a basis for determining excess returns. By nature,
average values suffer from certain problems and could result in excessively high or
low ROA. Second, the companys cost of capital will dictate the NPV of intangible
assets. However, in order for the CIV to be comparable within and between
industries, the industry average cost of capital should be used as a proxy for the
discount rate in the NPV calculation. Again, the problem of averages emerges, and
one must be careful in choosing an average that has been adjusted for excessively
high or low values.
Conclusion
It is recognised that the intellectual capital of a business plays a significant role in
creating competitive advantage, and thus managers and other stakeholders in
organisations are asking, with increasing frequency, that its value be measured and
reported for planning, control, reporting and evaluation purposes. However, at this
point, there is still a great deal of room for experimentation in quantifying and
reporting on the intellectual capital of the entity. Given the potential for both
complexity and diversity, developing intellectual capital measures and reporting
practices that are comparable between enterprises remains one of the key
challenges to the accountancy profession.
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Illustration Destroying value
The most recent published results for V plc are shown below.
m
20XX profit before tax 13.6


Summary consolidated balance sheet at 31 December 20XX
m
Fixed assets 35.9

Current assets 137.2
Less: current liabilities (95.7)
Net current assets 41.5

Total assets less current liabilities 77.4
Borrowings (15.0)
Deferred tax provisions (7.6)
Net assets 54.8

Capital and reserves 54.8
An analyst working for a stockbroker has taken these published results, made the
adjustments shown below, and has reported his conclusion that the management
of V plc is destroying value.
Analysts adjustments to profit before tax
m
Profit before tax 13.6
Adjustments
Add: Interest paid (net) 1.6
R & D (research and development) 2.1
Advertising 2.3
Amortisation of goodwill 1.3
Less: Taxation paid (4.8)
Adjusted profit 16.1

Analysts adjustments to summary consolidated balance sheet at 31 December
20XX
m
Capital and reserves 54.8
Adjustments
Add: Borrowings 15.0
Deferred tax provisions 7.6
R & D 17.4 Last 7 years expenditure
Advertising 10.5 Last 5 years expenditure
Goodwill 40.7 Written off against
reserves on acquisitions in
previous years
_____
Adjusted capital employed 146.0

m
Required return (12% x 146.0m) 17.5 (weighted average cost of capital = 12%)
Adjusted profit 16.1
Value destroyed 1.4
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The chairman of V plc has obtained a copy of the analysts report.
Required
(a) Explain, as management accountant of V plc, in a report to your chairman,
the principles of the approach taken by the analyst. Comment on the
treatment of the specific adjustments to R & D, advertising, interest and
borrowings and goodwill.
(b) Having read your report, the chairman wishes to know which division or
divisions are destroying value, when the current internal statements show
satisfactory returns on investment (ROIs). The following summary statement
is available.
Divisional performance, 20XX

Division A
(Retail)
Division B
(Manufacturing)
Division C
(Services)
Head
Office
Total
m m m m m
Turnover 81.7 63.2 231.8 - 376.7
Profit before
interest and tax
5.7 5.6 5.8 (1.9) 15.2
Total assets less
current liabilities
27.1 23.9 23.2 3.2 77.4
ROI 21.0% 23.4% 25.0%
Some of the adjustments made by the analyst can be related to specific
divisions:
Advertising relates entirely to Division A (retail)
R & D relates entirely to Division B (manufacturing)
Goodwill write-offs relate to
Division B (Manufacturing) 10.3m
Division C (Services) 30.4m
The deferred tax relates to
Division B (Manufacturing) 1.4m
Division C (Services) 6.2m
Borrowings and interest, per divisional accounts, are as follows:

Division A
(Retail)
Division B
(Manufacturing)
Division C
(Services)
Head
Office
Total
m m m m m
Borrowings - 6.6 6.9 1.5 15.0
Interest
paid/(received)
(0.4) 0.7 0.9 0.4 1.6
Required
Explain, with appropriate comment, in a report to the chairman, where value
is being destroyed. Your report should include:
A statement of divisional performance
An explanation of any adjustments you make
A statement and explanation of the assumptions made
comment on the limitations of the answers reached
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Solution to Destroying value
(a)
REPORT
To: Chairman
From: Management accountant Date: XX.XX.XX
Subject: Destroying value in V plc
This report considers the recent observations by the analyst of X Stockbrokers
on our 20XX results. It will explain the principles of the approach taken by
the analyst and will provide a commentary on the treatment of the specific
adjustments made to our reported profit figure and balance sheet.
I Principles of the approach taken: economic value added
1. A management team is required by an organisations shareholders
to maximise the value of their investment in the organisation and
several performance indicators are used to assess whether or not
the management team is fulfilling this function.
2. The majority of these performance measures are based on the
information contained in the organisations published accounts.
These indicators can be easily manipulated and often provide
misleading information. Earnings per share, for example, are
increased by deferring expenditure in research and development
and in marketing.
3. The financial statements themselves do not provide a clear picture
of whether or not shareholder value is being created or destroyed:
(a) The profit and loss account, for example, indicates the
quantity but not quality of earnings
(b) It ignores the cost of equity financing and only takes into
account the costs of debt financing, thereby penalising
organisations such as ourselves which choose a mix of debt
and equity finance.
(c) Neither does the Cash flow statement provide particularly
appropriate information. Cash-flows can be large and
positive if an organisation reduces expenditure on
maintenance and undertakes little capital investment in an
attempt to increase short-term profits at the expense of long-
term success.
4. The analyst has therefore adopted an approach known as economic
value added to evaluate our performance.
This approach hinges on the calculation of economic profit,
which requires several adjustments to be made to
traditionally reported accounting profits.
These adjustments are made to avoid the immediate write-
off of value-enhancing expenditure such as research and
development or the purchase of goodwill. They are intended
to produce a figure for capital employed, which is a more
accurate reflection of the base upon which shareholders
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expect their returns to accrue. They also provide a profit-
after-tax figure, which is a more realistic measure of the
actual cash yield generated for shareholders from recurring
business activities.
It is not very surprising that if management are assessed using
performance measures calculated using traditional accounting
policies, they are unwilling to invest in activities which immediately
reduce current years profit.
II The Treatment of specific items
1. Research and development
The analyst has added back expenditure of 2.1 million to the
20XX profit figure on the grounds that the expenditure is providing
a base for future activities. Similarly the research and
development expenditure over the last seven years of 17.4million
has been added back to the capital employed figure on the basis
that we are continuing to benefit from the expenditure. A
depreciation charge should probably be made against this
capitalised value, however, to reflect any fall in its value.
2. Advertising
The analyst has added back advertising expenditure of 2.3 million
to the 20XX profit figure on the assumption that the expenditure
has supported sales, raised customer awareness and/or increased
brand image/loyalty, all of which could produce significant
cashflows in the future and hence are for the long-term benefit of
the organisation. The advertising expenditure over the last five
years of 10.5 million has been added back to the capital
employed figure (in much the same way as the research and
development expenditure) to reflect the fact that the costs will
provide for future growth. Again, an amortisation charge should
be made if brand values are being eroded, possibly by competition.
3. Interest and borrowings
Because our profits are being earned using both debt and equity
finance, the published profit figure is overstated since it takes no
account of the cost of the equity finance. The analyst has
therefore added back the cost of the debt finance to the 20XX
profit figure and the borrowings figure to the capital employed.
This produces a profit figure before the cost of borrowing, which
can be compared with a figure representing the total long-term
finance in our organisation.
4. Goodwill
The analyst has added back goodwill amortisation of 1.3 million to
the 20XX profit figure. Goodwill is the difference between the price
paid for a business acquisition and the current cost valuation of
that acquisitions net assets. On the assumption that a realistic
price was paid, the goodwill purchased should provide benefits in
the future, not just in the year of purchase. And the goodwill of
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40.7 million, which has been written off against reserves on
acquisitions in previous years has been added back to the capital
employed figure so as to provide a more realistic base upon which
we must earn a return. Again, the goodwill capitalised should be
regularly reviewed and amortised to reflect any reductions in its
value.
I hope this information has been of use. If I can be of any further assistance
please do not hesitate to contact me.
Signed: Management Accountant
(b)
REPORT
To: Chairman
From: Management accountant Date: XX.XX.XX
Subject: Where is value being destroyed?
An analyst working for X Stockbrokers has recently commented that the
management of V plc is destroying value. In an attempt to establish where
value is being destroyed in our organisation, a revised statement of divisional
performance has been prepared, adopting an approach similar to that used by
the analyst. The statement, plus supporting explanations, is set out in
Appendix 1.
The analysis shows that value of 0.1 million was destroyed in Division B,
while value of 2.3 million was destroyed in Division C. Division A, on the
other hand, created value of 1 million.
This is in marked contrast to the performance indicated in the conventional
divisional performance report prepared for 20XX. This shows all three
divisions earning a return on investment in excess of 20%, with Divisions B
and C, the destroyers of value, making higher returns on investment than
Division A, the creator of value.
The analysts approach is similar to performance evaluation using residual
income in that a charge is made for the capital employed within the division.
Further adjustments are also made to both profit and capital employed to
provide more realistic measures for performance analysis (as explained in my
earlier report and in Appendix 1). The results of the analysis are dependent
upon the following factors:
1. Head office expenses are assumed to have been incurred in relation to
divisional turnover. Any one of a number of other bases might be
equally valid.
2. Tax paid is assumed to be related to divisional profit after interest and
head office expenses. Deferred tax liabilities have not been incorporated
into the analysis.
3. Each divisions share of head office assets has been assumed to be in
proportion to the divisions share of total turnover. Other bases could be
equally valid.
4. It has been assumed that each division has the same cost of capital.
This takes no account of the individual characteristics of each division,
its risk profile and its mix of financing.
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Despite the limitations set out above, the analysts approach provides an
alternative insight into how our divisions are performing and could well prove
useful in enabling us to create value for our shareholders in the future.
Signed: Management Accountant
APPENDIX 1
Statement of profitability
Divisions
A B C Head office Total
m m m m m
20XX PBIT 5.7 5.6 5.8 (1.9) 15.2
Add back
Advertising 2.3 - - - 2.3
R & D - 2.1 - - 2.1
Goodwill (1) - 0.3 1.0 - 1.3
Head office expenses (2) (0.4) (0.3) (1.2) 1.9 -
Less: tax paid (2.0) (1.6) (1.2) - (4.8)
Revised profit 5.6 6.1 4.4 - 16.1
Statement of capital employed
Divisions
A B C Head office Total
m m m m m
Total assets less current
liabilities
27.1 23.9 23.2 3.2 77.4
Adjustments
Advertising 10.5 - - - 10.5
R & D - 17.4 - - 17.4
Goodwill - 10.3 30.4 - 40.7
Head office assets (4) 0.7 0.5 2.0 (3.2) -
Revised capital 38.3 52.1 55.6 - 146.0
Economic value added
Divisions
A B C Head office Total
m m m m m
Revised profit 5.6 6.1 4.4 - 16.1
Required return (5) 4.6 6.2 6.7 - 17.5
Value added/(destroyed) 1.0 (0.1) (2.3) - (1.4)
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Explanation of adjustments made
1. Goodwill
Goodwill amortised has been apportioned to Divisions B and C in
proportion to the value of goodwill written off to capital and reserves.
Division
Goodwill
write-off
Goodwill amortised
m % m
B 10.3 25.3 x 1.3m 0.3289
C 30.4 74.7 x 1.3m 0.9711
40.7 100.0 1.3000
2. Head office expenses
No direction is provided as to the way in which head office expenses
should be apportioned to the three divisions. An activity-based
approach could be the most suitable but, in the absence of appropriate
data, allocation based on turnover has been adopted.
3. Tax paid
The tax liability of 4.8 million for V plc has to be apportioned over the
three trading divisions. Given that the divisions taxable profits will be
affected by the allocation of head office expenses and the interest paid,
the overall tax liability has been apportioned on the basis of divisional
profit after interest paid and allocated head office costs.
Division PBIT
Interest
paid

Head office
expenses

Apportionme
nt figures
Charge
m m m % m
A 5.7 (0.4) 0.4 = 5.7 41 2.0
B 5.6 0.7 0.3 = 4.6 33 1.6
C 5.8 0.9 1.2 = 3.7 26 1.2
14.0 100 4.8
4. Head office assets
Head office assets have been apportioned to the three trading divisions
on the basis of divisional turnover so as to be consistent with the basis
used to apportion head office expenses
5. Required return
The required return is based on a weighted average cost of capital of
12%.

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Chapter 12
Corporate
reconstruction and
reorganisation


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CHAPTER CONTENTS
FINANCIAL RECONSTRUCTION ---------------------------------------- 283
ILLUSTRATION JENKINS PLC --------------------------------------- 285
MANAGEMENT BUYOUTS (MBO)--------------------------------------- 290

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FINANCIAL RECONSTRUCTION
The Companies Act (CA) 2006 provides for the reduction of the share capital
of a company, subject to:
o The passing of a special resolution;
o Confirmation by the High Court*; and
o The articles of the company not specifically restricting or prohibiting a
reduction of capital (N.B. Under CA 1985, the articles of the company
had to actually give authority for the reduction).
*Under CA 2006, where a private company limited by shares undertakes a
capital reduction scheme, confirmation of the court is not necessary if the
directors make a Solvency statement. This is a statement, made before the
date of the proposed resolution, that each of the directors has the view that
there are no grounds on which the company could then be found unable to
pay its debts and are of the opinion that any winding up made within the next
year would be a solvent liquidation.
The Court will usually sanction such a scheme, provided that the rights of all
creditors are protected and that losses are fairly divided among all interested
parties.
Under a scheme of capital reduction, a company may:
1. Extinguish or reduce the liability on any of its shares, which are not paid
up; or
2. Cancel any paid-up share capital that is lost or unrepresented by
available assets; or
3. Repay any paid-up share capital in excess of the companys wants.
The Court must settle a list of creditors entitled to object and hear objections.
However the Court may choose to dispense with the consent of any creditor
provided the company secures payment of that claim.
The Court may order the company to publish the reasons for the reduction in
capital. It may also order the company to add the words and reduced to the
end of its name.
Under Situation 2. above, the objective of a capital reduction scheme is
normally to:
o Write-off any debit balances on the profit and loss reserve;
o Write-off or write-down any asset values, which are considered to be
excessive;
o Revalue all assets on a going concern basis; and
o Reorganise the capital structure of the company in line with the assets
employed.
Guidelines for implementation of the scheme are as follows:
o Ordinary shareholders (i.e. the risk-takers) must bear the majority of
the losses;
o Preference shareholders may be asked to bear a small part of such
losses. However, they may be issued with new equity shares in the
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company as compensation for their waiver of any arrears of unpaid
preference dividends;
o In exceptional circumstances, bondholders and other creditors may be
persuaded to participate in part of the losses;
o Amounts made available under the terms of the scheme would then be
used to write-off any overstated values and to adjust the values of all
assets on a going concern basis;
o It would also be necessary to ensure the provision of adequate working
capital to meet foreseeable future needs. A rights issue is likely to be
necessary, with the directors expected to take up any such shares which
are rejected by other shareholders.
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Illustration Jenkins plc
Jenkins plc has been suffering from adverse trading conditions largely due to the
effect of obsolescence on its products. This has resulted in losses in each of the
last five years. The companys bankers have refused to extend the present
overdraft facility and creditors are pressing for payment.
The directors feel that a new product recently developed by the company will make
the company profitable in the future, but they are worried that a winding-up order
may be made before this can be achieved.
They have therefore asked you to suggest a scheme of capital reduction that would
be acceptable to both the court and creditors and to advise them as to what action
should be taken to enable the company to continue trading.
The following is the present balance sheet of the company:

Book
values

Present
going
concern
values

Non-current assets
Intangible
Goodwill 30,000 -
Patents, trade marks etc 11,000 2,000
41,000
Tangible
Freehold land and buildings 120,000 150,000
Plant and vehicles _50,000 36,000
170,000
Current assets
Stocks and debtors 64,000 58,000
Listed shares at cost 15,000 14,000
79,000
Creditors falling due within
one year
Trade 118,000
Overdraft _31,000
(149,000)
Net current liabilities (70,000)
Total assets less current liabilities 141,000
Creditors falling due after one year
12% mortgage loan secured on freehold (60,000)
81,000

Capital and reserves
Called up share capital
7% cumulative preference shares (1)
fully paid (dividends are three years in
arrears)
50,000
Ordinary shares of 50p each fully paid 200,000
250,000
Share premium account 60,000
Profit and loss account reserve (229,000)
81,000
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You ascertain the following:
1. Scheme costs are estimated at 4,800.
2. Preference shares rank in priority to ordinary shares in the event of winding-
up.
3. The bank has indicated that it would advance a loan of up to 50,000
provided that the overdraft is cleared and a second mortgage on the freehold
is given.
4. To ensure speedy manufacture of the new product it would be necessary to
expend 20,000 on new plant and 15,000 on increasing stocks.
5. The creditors figure of 118,000 includes 19,000 that would be preferential
in a liquidation.
Requirements:
(a) Suggest a scheme of capital reduction and write up the capital reduction
account.
(b) Outline your suggestions as to the action that should be taken by the
directors.
(c) Show the balance sheet after implementing your suggestions.
Ignore taxation.
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Solution to Jenkins plc
Explanation
The first step is to estimate the losses to be suffered by preference shareholders on
a liquidation.
For example, on liquidation the following position may arise
Proceeds

Freehold 150,000
Plant (say 2/3 of 36,000) 24,000
Stocks and debtors (say of 58,000) 29,000
Listed shares _14,000
217,000
These proceeds will be used to repay the liabilities:

Secured mortgage 60,000
Overdraft 31,000
Trade creditors 118,000
209,000
This leaves 8,000 for the shareholders. This will go to the preference
shareholders in priority to the ordinary shareholders. Therefore, the loss suffered
by the preference shareholders is (50,000 8,000), i.e. 42,000. The loss
allocated to them under the scheme must be less than this.
Memorandum to the board
(a) Scheme of capital reduction
The objective of such a scheme is to write down the capital of the company so that
it realistically reflects the present values of the assets (on a going concern basis).
The major part of the loss should be borne by the ordinary shareholders although
the preference shareholders should bear a part of the loss where it is unlikely that
they would receive all their capital in a winding-up. A corresponding increase in the
rate of preference dividend is sometimes given as compensation. The reduced
capital of the company will ensure that it is possible to pay dividends when the
company achieves profitability.
Where arrears of cumulative preference dividends have accrued, it is usual to
compensate preference shareholders by issuing reduced ordinary shares in part
satisfaction of such arrears.
Explanation
Draw up a pro forma balance sheet after the scheme, and capital reduction
account; post through the opening position (writing off all goodwill and
accumulated losses); then adjust the assets to going concern values posting the
double entry as you work through.
Remember to post through the scheme costs and compensation in new shares to
the preference shareholders; then write down the ordinary and preference shares
to a round sum amount to cover the overall loss. The loss written off to the
preference shareholders may not exceed 42,000 and ideally should be less than
that.
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Capital reduction account

Write offs Surplus on freehold 30,000
Profit & loss reserve 229,000
Plant & vehicles 14,000
Goodwill, patents etc 39,000
Investments 1,000
Current assets 6,000 Losses c/d 259,000
289,000 289,000

Losses b/d 259,000 Share premium account 60,000
Costs of scheme 4,800 Amounts written off
Ordinary share capital Ordinary shares (49p) 196,000
Issue re arrears of preference Preference shares (30p) 15,000
dividend (50%) 5,250
Balance c/d __1,950 ______
271,000 271,000
Explanation
Use notes c) to e) in the question; list total costs, compare to money coming in
(always sell any non-trade investments). Issue enough new shares to leave a
positive cash balance. Complete double entries as you work. Finally complete the
balance sheet.
(b) Suggested action (outline)
(i) The preferential creditors to be paid off in full immediately to prevent them
blocking the scheme.
(ii) The investments to be sold to produce part of the funds necessary to continue
trading.
(iii) Accept the banks offer of a maximum loan of 50,000 (subject to a second
mortgage charge being created)
(iv) The balance of the funds necessary to be provided by an issue of shares (on a
10 for 1 basis) at par for cash to the directors and shareholders. The
following cash is required:

Preferential creditors 19,000
Purchase of new plant 20,000
Additional stock 15,000
Pay costs of scheme 4,800
Clear existing overdraft 31,000
89,800



Produced by
Sale of investments (ignoring costs) 14,000
Bank loan 50,000
Issue of shares to directors and existing shareholders
(10 x 400,000 x 1p) _40,000
104,000
Leaving a balance at bank of 14,200
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(c) Balance sheet if scheme adopted

Non-current assets
Intangible
Patents (11,000 9,000) 2,000
Tangible
Freehold (120,000 + 30,000) 150,000
Plant and vehicles (50,000 14,000 + 20,000) 56,000
206,000
208,000
Current assets
Stock/debtors (64,000 6,000 + 15,000) 73,000
Bank balance (per b) iv) above) 14,200
87,200
Creditors Amounts falling due within one year
Trade (118,000 19,000) (99,000)
Net current liabilities (11,800)
Total assets less current liabilities 196,200
Creditors falling due after one year
Loan (secured on the freehold) (60,000)
Bank loan (50,000)
(110,000)
86,200
Capital and reserves
Called up share capital
1p ordinary shares fully paid
(200,000 196,000 + 5,250 + 40,000) 49,250
70p 10% preference shares fully paid
(50,000 15,000) 35,000
84,250
Reserve arising on scheme (capital reduction account) 1,950
86,200
Explanation
It could be argued that Jenkins plc is still not in a sufficiently strong liquidity
position.
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MANAGEMENT BUYOUTS (MBO)

Distinguishing features
Group of managers acquire effective control and substantial ownership of an
operation and form an independent business.
Also employee buyouts, buy-ins, spinouts.
Motivations
For sale - Parent company disposals due to losses, lack of fit, or
size
- Private business owners wishing to sell out
For purchase - Potential high returns
- Relatively low risk as compared to green field starts
- Elimination of managerial slack
Financing
Commonly highly geared to leave managers with controlling interest in equity.
Support from institutions normally required
o Examples include clearing banks, 3i group
o Institutions normally require business plans, details of exit routes,
sometimes board representation
o Commonly instruments include debt, preference shares, equity (limited),
mezzanine finance (e.g. convertible loan stock, junk bonds)
Potential problems
Loss of head office support services
Quality and resources of management team
Third party bids at buyout stage
Problems of high gearing


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Chapter 13
Corporate dividend
policy


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CHAPTER CONTENTS
DIVIDEND IRRELEVANCE HYPOTHESIS ------------------------------ 293
DIVIDENDS IN AN IMPERFECT MARKET ----------------------------- 294
POSSIBLE APPROACHES TO DIVIDEND POLICY --------------------- 295
ALTERNATIVES TO A CASH DIVIDEND ------------------------------- 296
PARABAT PLC ----------------------------------------------------------- 297

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DIVIDEND IRRELEVANCE HYPOTHESIS

Theory
The proponents of the dividend irrelevance hypothesis (Miller & Modigliani) claim
that the value of a firm is determined by its future earnings stream. The way this
stream is split between dividends and retentions has no impact upon shareholder
wealth.
Given a set investment policy, a dividend cut now to finance new projects will be
compensated by higher dividends at a later stage.
The shareholder will be indifferent to the dividend policy provided the PRESENT
VALUE of dividend payments remains unchanged.
Assumptions
A set investment policy so that shareholders know the reason for withholding
dividends
No transactions costs
No distorting taxes
Share prices move in the manner predicted by the model
In the case of a withheld dividend, the shareholder can maintain his level of income
by selling shares to generate home made dividends, with no consequent decrease
in wealth.
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DIVIDENDS IN AN IMPERFECT MARKET

Information content (dividend signalling)
Dividends are an important current source of information
Share price will increase if the dividend is greater than expected and vice
versa. Tendency to over-react
Transactions costs
Shareholder can no longer replace a withheld dividend by selling shares
without incurring dealing commissions
Company will benefit by financing investments from retained earnings to
avoid the high costs associated with raising new finance
Preference for current income
It is sometimes argued that shareholders prefer high dividend payouts as they see
these as more secure than capital gains (the bird in the hand theory)
This argument is sometimes thought to be weak. Current dividends are safe, but
so are current capital gains. Future dividends are just as uncertain as future capital
gains.
Distorting taxes
Individuals will generally prefer dividends to capital gains whether a basic-rate
or higher-rate tax payer, subject to certain complications:
exemption limit for capital gains tax
non-tax-paying individuals
tax-exempt institutions.
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POSSIBLE APPROACHES TO DIVIDEND POLICY

Stable policy with moderate payout
Stable level of dividends with occasional increases (where justified). This
would avoid sharp movements in share price.
Moderate payout policy in order to sustain the level of dividends in the face of
fluctuating earnings.
Very common approach for listed companies.
Constant payout ratio
Constant proportion of earnings paid out as a dividend.
Not particularly suitable as dividends will fluctuate, causing erratic share price
movements.
Residual dividend policy
Remaining earnings, after funding all profitable projects, are paid out as
dividend.
Tends to lead to fluctuating dividends and therefore not particularly suitable.
Clientele theory
Consistent dividend policy is maintained which will attract a group of
shareholders to whom the policy is suited in terms of tax, need for current
income, etc.
Other considerations
Legality, re distributable profits.
Existence of inflation and consideration of real profitability.
Growth and requirements for retained earnings.
Liquidity position.
Limited sources of funds (particularly for small companies).
Stability of earnings.
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ALTERNATIVES TO A CASH DIVIDEND
During the last twenty years or so, a number of companies have established ways
of rewarding shareholders other than by traditional dividend payments. These
methods include:
Shareholder perks
Several UK companies (notably hotel operators) offer discounts to shareholders on
room bookings and restaurant meals. A number of transport companies offer
reductions in fares. Some retailers provide discount vouchers, which are sent to
shareholders at the same time as the annual report and accounts.
Scrip dividends
When the directors of a company consider that they must pay a certain level of
dividend, but would really prefer to retain funds within the business, they can
introduce a scrip dividend scheme.
This involves giving ordinary shareholders the choice of a cash dividend or newly
created shares in the company of a similar monetary value. Scrip dividend plans
were very popular in the 1990s since they enabled companies to use share
premium accounts to create the new shares (instead of reducing retained profits)
and there were certain tax advantages for the company.
However a change in the accounting regulations subsequently forced companies to
charge the profit and loss account with the scrip dividend, and a later change in UK
legislation removed the tax advantages, which companies had enjoyed. Therefore
UK companies abandoned scrip dividend schemes at the turn of the century,
although there is now evidence of a few companies re-introducing this method (e.g.
Millennium and Copthorne Hotels plc and Whitbread plc).
Dividend reinvestment plans (DRIPs)
Since many companies had spent the 1990s persuading shareholders to take more
shares in the company (rather than receive a cash dividend) shareholders were
keen for an alternative to be offered when scrip dividend schemes were abandoned.
In the early years of the 21
st
century DRIPs were created. Shareholders opting for
these schemes choose to have their dividends used to purchase existing shares in
the company on the open market, through a special arrangement involving very
low dealing charges and the payment of stamp duty.
Share repurchases
Companies with cash surpluses, but having no positive NPV projects, may choose to
introduce a share buy-back scheme, whereby the companys shares are purchased
at the companys instructions on the open market.
This will have the effect of using up the surplus cash, increasing future EPS
(because of the reduction in the number of shares in issue), changing the gearing
level of the company and (hopefully) reducing the likelihood of a takeover.
However share repurchases are often seen as an admission that the company
cannot make better use of shareholders funds.
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Parabat plc
Parabat plc has an issued capital of 2 million ordinary shares of 50p each and no
fixed interest securities. It has paid a dividend of 70p per share for several years,
and the stock market generally expects that level to continue. The market price is
4.20 per share, cum div.
The firm is now considering the acceptance of a major new investment which would
require an outlay of 500,000 and generate net cash receipts of 120,000 per
annum for an indefinite period. The additional receipts would be used to increase
dividends.
Parabat is appraising three alternative sources of finance for the new project:
(i) Retained earnings. The usual annual dividend could be reduced. Parabat
currently holds 1.4 million for payment of the dividend which is due in the
near future.
(ii) A rights issue of ordinary shares. One new share would be offered for every
ten shares held at present at a price of 2.50 per share; the new shares
would rank for dividend one year after issue, when cash receipts from the new
project would first be available.
(iii) An issue of ordinary shares to the general public. The new shares would rank
for dividend one year after issue.
Assume that, if the project were accepted, the firms expectations of future results
would be discovered and believed by the stock market, and that the market would
perceive the risk of the firm to be unaltered.
You are required to:
(a) Estimate the price ex div of Parabats ordinary shares, following acceptance of
the new project, if finance is obtained from (i) retained earnings or (ii) a
rights issue.
(b) Calculate the price at which the new shares should be issued under option (iii)
assuming the objective of maximising the gain of existing shareholders.
(c) Calculate the gain made by present shareholders under each of the three
finance options.
Ignore taxation and issue costs of new shares
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Parabat plc solution
(a) This is a company financed entirely by equity, hence the dividend valuation
model can be used to find the cost of capital i.e.
Ke =
) div ex ( P
D
0


Ke =
( ) p 70 p 420
p 70

=
p 350
p 70
= 20%
(i) Financed by retained earnings
Here the valuation model incorporating a new project can be used i.e.
New Price =
capital equity of t cos
increase future dividend existing +

Future increase per share =
000 , 000 , 2
000 , 120
= 6p
Hence new price =
20 . 0
p 6 p 70 +
= 3.80
(ii) Financed by rights issue
First the new dividend per share must be calculated, and then the new
ex div price
Future expected earnings 1,400,000 + 120,000 = 1,520,000
Future number of shares 2,000,000 + 200,000 = 2,200,000
Future dividend per share =
000 , 200 , 2
000 , 520 , 1

= 69p approx
New price =
20 . 0
p 69
= 3.45
(b) Issue of ordinary shares to the public
The issue price can be calculated by reference to the change in wealth of the
shareholders i.e.
New market value = old market value + NPV of new project
Old market value = 2m shares x 3.50 = 7m
NPV of new project = 000 , 500
20 . 0
000 , 120
= 100,000
Therefore new market value = 7,100,000
Issue price per new share should be
000 , 00 , 0 , 2
000 , 100 , 7
= 3.55p
As 500,000 is required, this would result in the issue of (500,000 3.55)
= 140,845 new 50p shares.
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This can be checked as follows:
Total number of shares x Market Price = Market Value of company
2,140,845 shares x 3.55 per share = 7,600,000
Expected dividend now equals 1,520,000.
Hence the return of
00 , 600 , 7
000 , 520 , 1
= 20% to the shareholders has been
maintained.
(c) Gain made by present shareholders under each option:

Retained
Earnings
Rights
Issue
New
Issue

Expected future value 3.80 3.80* 3.55
Current value per share 3.50 3.50 3.50
Gain 0.30 0.30 0.05
Less: Dividend foregone
000 , 000 , 2
000 , 500

0.25

Paid for rights issue
10
50 . 2


0.25

___ ___ ___
Net gain per share 0.05 0.05 0.05
* This represents 1.1 shares @ 3.45 each (i.e. allowing for the 1 for 10
rights issue).
Hence the gain to the original shareholders is 5p per share in each case,
whatever the method of financing. The NPV of the project (i.e. 100,000) has
been allocated over the 2,000,000 shares already on issue, irrespective of
whether the project has been financed by retentions, a rights issue or a
correctly priced issue of shares to the general public.
Hence the dividend decision was irrelevant.

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Chapter 14
Management of
international trade
and finance


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CHAPTER CONTENTS
INTERNATIONAL TRADE ----------------------------------------------- 303
FREE TRADE AND PROTECTIONISM 303
TRADE BLOCKS 303
GATT AND THE WORLD TRADE ORGANISATION (WTO) 304
MULTINATIONAL COMPANIES (MNCS) 304
THE BALANCE OF PAYMENTS 304
THE INTERNATIONAL FINANCIAL INSTITUTIONS 305
THE EUROMARKETS 305
THE GLOBAL DEBT PROBLEM 306
RISKS OF FOREIGN TRADE 306
SOURCES OF FINANCE FOR FOREIGN TRADE 307
COUNTERTRADE 308
ARTICLE FROM STUDENTS NEWSLETTER ---------------------------- 309

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INTERNATIONAL TRADE
International trade occurs to allow companies to enjoy economies of scale, increase
their turnover and profits, use up spare capacity and to promote division of labour.
In economics, theoretical justifications of the benefits of international trade were
put forward by:
Adam Smith the theory of absolute advantage
David Ricardo the theory of comparative advantage
Sources of advantage may include close proximity to raw materials or markets,
access to capital or an available labour force with the necessary skills.
Free trade and protectionism
Free trade is the unhindered movement of goods and services throughout world
markets.
Protectionism aims to boost the economic wealth of the country concerned through
government measures which prevent free trade. However retaliatory measures
may defeat such government action. Protectionist measures may include:
Tariffs
Import quotas
Bureaucratic regulations (red tape)
Exchange controls
Government subsidies to domestic industries
Imposition of import licenses
Devaluation of the currency making imports more expensive
Subsidies to exporters
Trade blocks
Trade blocs arise where a group of countries conspire to promote trade between
themselves. Trade blocs include:
Free trade area free movement of goods and services (no internal tariffs)
between member countries, with external tariffs set individually e.g. North
American Free Trade Area (NAFTA)
Customs union no internal tariffs between member countries and with
common external tariffs against non-member countries e.g. the former
European Economic Community
Common market no internal tariffs, common external tariffs, as well as the
free movement of labour and capital between member countries e.g.
European Union
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GATT and the World Trade Organisation (WTO)
The General Agreement on Tariffs and Trade was set up in 1947 with the aim of
achieving agreements between trading nations to reduce protectionism and to free
international trade by the progressive removal of artificial barriers. Several rounds
of agreement were achieved - notably the Kennedy Round in the mid 1960s, the
Tokyo Round in the late 1970s and the Uruguay Round which ended in 1994.
The treaty at the conclusion of the Uruguay Round created the WTO as a
replacement body to continue the work of GATT into the future. GATT ceased to
exist in 1994.
The WTO will press for future reductions on trade barriers in areas such as
agriculture, textiles, intellectual property rights and services. The WTO, based in
Geneva, currently has a membership of about 150 countries. Membership obliges
countries to sign up to an extensive range of agreements, rather than be selective,
as was the case with GATT.
Multinational companies (MNCs)
A MNC owns or controls production or service facilities based in a number of
overseas countries. MNCs may engage in foreign direct investment (FDI) in order
to seek markets, raw materials, knowledge, production efficiency, or safety from
political interference. Horizontal or vertical integration and product specialisation
have fuelled the growth of companies such as General Motors, Royal Dutch Shell,
BP Amoco, Nissan and Hitachi and many MNCs now have annual turnovers
exceeding the GNPs of several large countries.
The balance of payments
The balance of payments is a statistical record of a countrys international trade
transactions (current account) and capital transactions with the rest of the world
over a period of time e.g.
UK balance of payments 2010
bn
Current account
Exports 200
Imports (215)
Visible balance (15)
Invisibles balance 5
(10)

UK external assets and liabilities: net transactions 2
Balancing item 8
10
N.B. The statistics that are gathered are not wholly perfect and some transactions
will be omitted. Thus the balancing item is unavoidable.
Temporary deficits can be financed by short term borrowing, but persistent balance
of payments deficits usually require government intervention, such as:
Devaluation of the currency or government intervention on the foreign
exchange markets
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Raising interest rates
Restricting the money supply
Imposing tariffs or import quotas
The international financial institutions
International Monetary Fund (IMF)
Founded in Bretton Woods, New Hampshire in 1944 with the aim of promoting
world trade and maintaining global monetary stability. Assists countries with
balance of payments problems by making loans in the form of Special Drawing
Rights.
Such loans are normally dependent upon the country concerned making strict
internal financial adjustments to solve their economic problems.
The International Bank for Reconstruction and Development
(IBRD)
Popularly known as the World Bank, it was also created at Bretton Woods in 1944,
with the aim of financing the reconstruction of Europe after the Second World War.
The World Bank is now an important source of long-term low interest funds for
developing countries.
The Bank for International Settlements (BIS)
Established in Basle, Switzerland in 1930, it acts as a supervisory body for central
banks assisting them in the investment of monetary assets. It acts as a trustee for
the IMF in loans to developing countries and provides bridging finance for members
pending their securing longer term finance for balance of payments deficits.
The Euromarkets
The Euromarkets refer to transactions between banks and depositors/borrowers of
Eurocurrency.
Eurocurrency refers to a currency held on deposit outside the country of its
origin e.g. Eurodollars are $US held in a bank account outside the USA
Eurocurrency loans are bank loans made to a company, denominated in a
currency of a country other than that in which they are based. The term of
these loans can vary from overnight to the medium term.
Eurobonds are bonds issued (for 3 to 20 years) simultaneously in more than
one country. They usually involve a syndicate of international banks and are
denominated in a currency other than the national currency of the issuer.
Interest is paid gross.
Euronotes are issued by companies on the Eurobond market. Companies
issue short-term unsecured notes promising to pay the holder of the Euronote
a fixed sum of money on a specified date or range of dates in the future.
Euroequity market refers to the international equity market where shares in
US or Japanese companies are placed on as overseas stock exchange (e.g
London or Paris). These have had only limited success, probably due to the
absence of a effective secondary market reducing their liquidity.
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The global debt problem
This problem arose following the oil price increases in the 1970s, when the OPEC
countries invested their large surpluses with banks in the western world. The
banks then lent substantial sums to the less developed countries (LDCs) believing
the default risk to be low. The oil price rises fuelled inflation and interest rates
increased, forcing the developed countries into recession.
High interest rates and reduced exports placed LDCs in a situation where they could
no longer pay interest or repay loans. These problems made economic conditions
in many LDCs extremely difficult, affecting the position of multinationals and
making international banks less willing to lend.
Methods of dealing with such excessive debt burdens have been:
A programme of debt write-offs by banks and other lenders
Rescheduling existing debt repayments
Re-selling debt at a discount to recoup capital
Provision of additional loans where the debt problem is regarded as temporary
Drastic changes in the economic policies of the LDC imposed and monitored
by the IMF
Risks of foreign trade
Importing from and exporting to foreign countries includes the following categories
of risk:
Currency risk sometimes referred to as exchange rate risk. It involves the
possibility of financial gains or losses arising out of unpredictable changes in
exchange rates. It can be classified into
o Translation risk the gains or losses to be reported when overseas
operations are consolidated into group accounts in accordance with
SSAP 20/UITF 9, or IAS 21 and 29,or FRS 23 and 24 .
o Economic risk the possibility that the value of the overseas entity
(based upon the PV of all future cash flows) will change due to
unexpected exchange rate movements arising at sometime in the future.
o Transaction risk the gains or losses that are made when ultimate
settlement occurs at a date when the exchange rate differs from the rate
prevailing at the date of the original transaction. This is seen as the
short-term manifestation of economic risk. It is this category of foreign
currency risk, which is particularly relevant to this syllabus.
Political risk the possibility of the financial success of a venture being
affected by the actions of an overseas government or population.
Government agencies can advise on potential risks.
Physical risk the likelihood of damage or theft arising from the physical
distances involved and the length of time between despatch and receipt of the
goods by the customer. Normal commercial insurance is, of course, available.
Credit risk this is the risk of non-payment for the goods/services involved in
an export transaction. Insurance cover for up to 180 days can be provided by
NCM UK; for longer periods the ECGD may provide this service. Private sector
companies such as Trade Indemnity plc provide similar services.
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Trade risk the overseas customer may refuse to accept the goods and be
uncooperative in returning them, thus taking advantage of the long physical
distances involved.
Liquidity risk this is caused by the duration of the delivery period and the
lengthy periods of credit expected by some overseas customers.
Cultural risk there may be misunderstandings caused by differences in trade
practice, religious and moral attitudes, legal systems and language barriers.
Sources of finance for foreign trade
Bank overdrafts either in sterling or in the overseas currency
Bills of exchange a negotiable instrument drafted by the exporter (the
drawer), accepted by the importer (the drawee) who thereby agrees to pay
for the goods/services either immediately or more commonly after a specified
period of credit. If the importer accepts the bill it is known as a trade bill,
whereas if the importer arranges for its bank to accept the bill, it becomes a
less risky bank bill.
Where payment will be made after the specified period of credit, the exporter
can sell the bill at a discount to its face value and receive the cash
immediately. If the bill is dishonoured the exporter can seek legal remedies
in the country of the importer.
Promissory notes similar, but less common than bills of exchange, since
they cannot usually be discounted prior to maturity.
Documentary letters of credit the importer obtains a Letter of Credit from its
bank, which guarantees payment to the exporter via a trade bill. Though slow
to arrange, this method is virtually risk free provided the exporter presents
specified error free documents (e.g shipping documents, certificates of origin
and a fully detailed invoice) within a specified time period. The high bank fees
for this procedure are normally borne by the importer, and the DLC is
normally reserved for expensive goods only.
Factoring the factoring company (often the subsidiary of a bank) assumes
the responsibility for collecting the trade debts of another in this case an
exporter. The factor may provide a range of services e.g. providing advances,
administering the sales ledger, credit insurance etc for an additional fee.
Widely regarded as a useful means of obtaining trade finance and collecting of
debts for small or medium sized exporters. However the exporter must
always bear in mind the eventual consequences of dispensing with the
services of the factor and undertaking the running of the sales ledger and
cash collection activities itself.
Forfaiting a medium term source of finance whereby a domestic bank will
discount a series of medium term bills of exchange, which have normally been
guaranteed by the importers bank. The forfaiting bank normally forgoes the
right of recourse to the exporter if the bill is dishonoured. The exporter
obtains the benefit of immediate funds, but the bank charges are expensive.
Forfaiting is normally used for the export of capital goods, where the importer
pays in a series of instalments over a period of years.
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Leasing and hire purchase the exporter sells capital goods to a lessor, which
in turn enters into a leasing agreement with the exporters overseas
customer. Alternatively the equipment can be sold to a hire purchase
company which resells to the importer under a HP agreement.
Acceptance credits a large reputable exporter can arrange for its bank to
accept bills of exchange (which are related to its export activities) on a
continuing basis. These bills can then be discounted at an effective cost,
which is lower than the bank overdraft interest rate.
Produce loans where an importer acquires commodities for the purpose of
immediate resale, it can raise a loan from its bank, which takes custody of the
goods until the importer is able to sell them. Thereafter the principal sum,
interest and storage costs are repaid to the bank out of the proceeds of the
sale.
Requesting payment in advance from the importer if this were possible it
would avoid all of the above complications.
Countertrade
This is an agreement in which the export of goods to a country is matched by a
commitment to import goods from that country. This usually occurs because the
foreign importing country either lacks foreign currency, has exchange controls in
place or where there are barriers to imports which can be circumvented by means
of countertrade.
The volume of countertrade is now reported at about 30% of total international
trade. In the case of some Eastern European and Third World countries it is the
only way of organising international trade because of their shortage of foreign
currency. Many countertrade deals can be highly complex involving many parties.
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ARTICLE FROM STUDENTS NEWSLETTER
This is a slightly updated version of an article, which appeared in the November
1999 edition of Students Newsletter. The article was not originally intended for
Paper 3.7 or Paper P4 students, but it provides a useful insight into the introduction
of the Euro. You are therefore asked not to learn the contents of this article in
detail, but to gain an overall insight into the features of the single European
currency and the arguments in favour and against the entry of the UK into the
European Monetary Union. The author, John OToole, is a lecturer at Griffith
College, Dublin.
EUROPEAN MONETARY UNION AND THE SINGLE EUROPEAN CURRENCY
In 1998, the Heads of State or Government of the European Union (EU) Member
States confirmed that 12 Member States qualified to form Economic and Monetary
Union (EMU) and adopt the single currency, the euro, from 1 January 1999. The
twelve original member states of the Eurozone were Austria, Belgium, Finland,
France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and
Spain. On 31 December 1998 the Council of Economic and Finance Ministers
irrevocably fixed the conversion rates to apply between the currencies of these
Member States and the euro, and on 1 January 1999 the euro came into being.
The United Kingdom and Denmark exercised their Treaty opt-outs from EMU and
Sweden deliberately failed to fulfil all the criteria for entry and was therefore
rejected by the Commission.
Slovenia also joined the Eurozone on 1 January 2007, followed by Malta and Cyprus
on 1 January 2008. In addition, three European microstates (Vatican City, Monaco,
and San Marino), although not EU members, have adopted the euro via currency
unions with member states. Andorra, Montenegro, Kosovo, and Akrotiri and
Dhekelia have adopted the euro unilaterally despite not being EU members.
Nine relatively new EU member states are required by their Accession Treaties to
join the Eurozone, on 1 January of the following years:
Slovakia in 2009, Lithuania in 2010, Estonia in 2011, Bulgaria, Czech
Republic, Hungary, Latvia and Poland in 2012 and finally Romania in 2014.
The formation of EMU and the creation of the euro were the culmination of a
process of preparation which had been going on since the signing in 1992 of the
Treaty on European Union (the Maastricht Treaty). EMU is one of the most far-
reaching steps in the history of the European enterprise.
Internally, the single currency was intended contribute to a greater sense of
common purpose and common endeavour among the peoples of the European
Union; externally it is intended to strengthen the Unions ability to play a role in the
world commensurate with its economic and political importance.
The European Monetary System (EMS)
To understand why this single currency was set up it is necessary to look at the
previous arrangements.
The idea of a single currency in Europe is not new. It goes back at least to 1970.
While its fortunes have varied since, the then European Community never lost sight
of it as a goal. The European Monetary System (EMS) and its Exchange Rate
Mechanism (ERM), which were set up in 1979, were intended to move towards
monetary union. The Single Market programme of the late 1980s gave fresh
impetus to it.
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In April 1978 at a meeting of the European Heads of State the German Chancellor
Schmidt and the French President, Giscard dEstaing, proposed the creation of a
European Monetary System (EMS) with the purpose of creating a zone of monetary
stability in Europe. In March 1979 the EMS commenced operations in the hope that
closer monetary co-operation between member states would lead to monetary
stability and economic growth. The EMS utilised a system of quasi-fixed exchange
rates, known as the Exchange Rate Mechanism (ERM), and had as its unit of
account the European Currency Unit (ECU). The value of the ECU was the weighted
average of a basket of national currencies with the weight allocated to each
currency being determined by that countrys GNP and intra-EC trade.
Those countries which were members of the ERM declared a central exchange value
for their currency and the majority of currencies agreed to fluctuate within a band
2.25% of this central value. This meant that the Central Bank of each participating
currency was committed to intervening, when necessary, in order to maintain their
exchange rate within the specified band. This was done by buying their own
currency when it was weak and selling their currency when it was strong. The UK,
although a member of the EMS since its inception, did not join the ERM until
October 1990.
The rules of the EMS allowed governments to realign the central value of their
exchange rate if changing circumstances showed it to be no longer appropriate. In
the early part of the EMS from 1979 to 1983 there were a number of realignments.
However, from 1987 the system became very rigid and there was only one
realignment from 1987 the lira was realigned in January 1990 until the currency
crisis in 1992.
The currency crisis
Speculators interpreted a number of developments in the world economy during
1992 as being attributable to fundamental weaknesses within currency markets.
This perception stimulated a period of intense speculative pressure which caused a
currency crisis.
German unification was a principal cause of the currency crisis. It is difficult to
imagine a bigger shock to the fixed parities of the ERM than the absorption of the
then East Germany into the European economy. Demand for consumer goods
soared, pushing up inflation. The governments budget expanded adding to the
Bundesbanks (German Central Bank) alarm. Very low, short-term American
interest rates caused huge surges of money from the US into Germany, further
fuelling German inflation rates. The Bundesbank reacted by pushing up German
interest rates. These high German interest rates occurred just when the rest of
Europe needed the rates to be low. The German mark was the anchor currency of
the ERM, so no European country could hold its interest rates below those in
Germany. When interest rates in Germany were increased all other EMS countries
followed suit.
Other causes of the currency crisis were the lack of realignments with the EMS, so
that its exchange rates had become increasingly rigid and out of touch with
international developments. Furthermore, the necessary behind the scenes macro-
economic co-ordination was not taking place as EU Member States publicly bickered
over interest rate policy. The existence of widespread unemployment as economic
recession threw millions out of work intensified these tensions.
The straw that broke the camels back was 2 June 1992 when the Danish people
rejected the Maastricht Treaty in a referendum. The Danish rejection by 50.7% to
49.3% cast immediate doubt over the whole process of economic and monetary
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union. Under EU law, the Danish failure to ratify the Maastricht Treaty made the
treaty null and void. As there had been no realignments within the ERM since
January 1987, the money markets had assumed that the European Unions political
commitment to EMU meant that the parties were virtually fixed. Doubts over
Maastricht destroyed this assumption. Almost immediately the weaker currencies
came under selling pressure.
The pressure resulted in the devaluation of the Finnish mark, the Spanish peseta,
the Irish punt, the Portuguese escudo and the Swedish krona, in addition to forcing
the UK and Italy to leave the ERM in September 1992. In August 1993, further
speculative pressure against the French franc and the Danish krone led to a
decision to widen fluctuation bands within the ERM to 15%. This action
effectively ended the currency crisis.
These events strengthened the political resolve in Europe to introduce Economic
and Monetary Union and the single currency.
The Maastricht Treaty
The Treaty on European Union was signed at the Dutch town of Maastricht in
February 1992. This Treaty became known as the Maastricht Treaty. The
centrepiece of the Maastricht Treaty was the decision to set up a single European
currency.
A single European currency meant that all the participating countries would use the
same currency. The new currency was called the euro. It is divided into one
hundred cents.
An essential aspect of a single European currency is the close co-ordination of
economic policies between Member States of the European Union. Economic and
Monetary Union means that the currencies of the member states are locked
irrevocably to one another at the same exchange rate. (Irrevocably means that
these exchange rates cannot be changed afterwards). The EMU depends on a
similar level of development of the economies of the countries which are members.
In order to ensure that the economies of the countries concerned are at similar
levels of development five convergence criteria were developed. These
convergence criteria are economic indicators of the strength of each economy.
Economic and Monetary Union involves:
an internal market with free movement of persons, goods, services and
capital;
the irreversible locking of exchange rates;
a single currency among participating Member States;
EU management of macro-economic policy with intensified co-ordination of
the economic and budgetary policies of participating countries;
EU management of market-regulating policies, for example, competition
policy, to ensure every country plays by the same rules;
a European Central Bank in Frankfurt deciding European monetary policy.
The Stability and Growth Pact is part of the arrangements agreed by those
countries which are part of the EMU. The pact requires Member States in the EMU
to commit themselves to aim for a medium-term budgetary position of close to
balance or in surplus. As part of the process of ensuring that the euro is as stable
as possible, the Stability and Growth Pact is aimed at minimising internal fiscal
imbalances in the short term. The rationale underlying the pact is that in
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favourable economic times, Member States should so manage their budgets as to
ensure that they can, over the course of a normal economic cycle, reliably keep
under the 3% ceiling on budget deficits set out in the Treaty. The pact allows for
exceptional circumstances when deficits can exceed 3% of GDP. It provides for
penalties and fines of up to 0.5% of GDP if deficits persist.
The five Maastricht criteria
These criteria are measures of the economy of each country across a number of
headings:
Inflation
The level of inflation must be within 1.5% of the average of the three lowest
inflation countries in the system.
Government borrowing
The amount of Government borrowing is an important measure of the strength of
the economy. The amount of this borrowing as a percentage of the Gross Domestic
Product must be below 60% or making progress towards 60%.
Interest rates
States are permitted a maximum of 2% points above the average of the three
lowest inflation countries.
Budget deficit
This is the toughest and politically most sensitive criterion involving tax policy and
overall debt. Member states must keep their government budget deficit within 3%
of Gross Domestic Product.
Exchange rates
The fifth and final criterion for joining the EMU covers exchange rates. Countries
must carefully manage their exchange rate and must not have unilaterally devalued
their currency within two years.
The timetable to EMU
The timetable to Economic and Monetary Union was decided by European leaders.
On 1 January 1999 the new European currency, the euro, came into being. From
this date there was be no change in the exchange rates of the member countries.
Euro notes and coins were introduced into circulation on 1 January 2002. Dual
circulation of the euro and the legacy currencies of each country continued for a
short period of time. Thereafter participating countries have only used euro notes
and coins.
The arguments in favour of EMU
Transparency
The strongest argument in favour of a single European currency is transparency
prices of goods in the shops will be in the same currency and this will allow people
to compare prices between euro countries.
Foreign exchange costs
Another advantage is that bank commission charges will no longer be levied on
transactions between the currencies of member states. Economists call these
transaction costs. The EU Commission has estimated that there will be savings of
0.25% of GDP on transaction costs which will improve conditions for trade within
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the EU and make EU industry more competitive on world markets. The elimination
of these transaction costs will help also tourism and investment among participating
Member States.
Stability in global trade
The introduction of a single currency will help eliminate exchange rate uncertainty
and currency fluctuations within Europe and with other countries. This will increase
trade among members of the Union and globally. This is because currency
movements can inhibit business people from expanding their sales in other
countries.
Political union
Economic and monetary union is an important step towards closer European
integration.
Interest rates
Interest rates will be lower and fairly uniform in participating countries within the
EMU, and this will reduce costs for government and business.
Price stability
With prices, margins and profits coming under competitive pressure as a result of
the introduction of the single currency, inflation rates will tend to move towards
lower levels under the EMU.
Economic growth and stability
Economic growth will be increased by entering the EMU and there will be increased
attractiveness of participating Member States to foreign investment.
The EMU makes it necessary that Governments act very responsibly as regards tax
and spending.
Fragmentation of Europe
If a country refuses to join, it may be isolated and risk becoming excluded from
important decisions that will apply to it in any event.
Global currency
The euro is emerging as a significant international reserve currency.
The level playing field
The discipline of a single currency prevents individual countries depreciating their
currency to steal competitive advantages over each other. Without a single
currency, there would always be a temptation for some countries to devalue, which
undermines a single market.
The arguments against EMU
Loss of control over economic policy
The most important argument against the EMU is the loss of economic sovereignty.
Countries are no longer able to pursue their own independent economic policies.
This is particularly important in the area of exchange rates. With independent
monetary policies the countries with weaker economies were able to devalue their
currencies. With the EMU, devaluation will not be possible for any reason.
European monetary policy will now be decided by the European Central Bank in
Frankfurt, Germany.
Less flexibility
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A disadvantage of joining the EMU would be that countries would have less
flexibility in their economic policies. Under the Stability and Growth Pact countries
will have less economic flexibility.
Loss of national pride
Many countries, like Britain are proud of their currencies as a symbol of economic
success and national cohesion.
Price increases
Some firms might use the transition to the euro to disguise price increases.
The weak currencies
Those in favour of the EMU make much of the benefits of being tied to Europes
stronger currencies. There would be powerful pressures on members to bail out
economies that borrow too much. This could be very costly.
Regional disparities
Another disadvantage of the EMU is that it may contribute to greater regional
disparities, especially for more peripheral regions. There may be a tendency for
economic activity to move towards the core of Europe, the golden triangle between
Paris, Hamburg and Rome.
Loss of foreign exchange earnings
A disadvantage of the EMU is the loss of money to the banks for the purchase and
sale of foreign exchange.
One way Street
The EMU sets EU member states on an inevitable track to a federal Europe.
Effectively, once a country signs up it loses control of economic policy. As a result,
national parliaments would be no more than regional town halls within Europe, with
effectively little more power than local government.
Changeover costs
The changeover to the euro involves transition costs for business, public
administrations and financial institutions.
The position of the UK
In a speech in July 1997, the UK Chancellor of the Exchequer specified five
economic tests of the UKs suitability for EMU membership. The five economic tests
are:
1 Are business cycles and economic structures compatible, so that the UK and
others could live comfortably with euro interest rates on a permanent basis?
2 If problems emerge, is there sufficient flexibility to deal with them?
3 Would joining the EMU create better conditions for firms making long-term
decisions to invest in Britain?
4 What impact would entry into the EMU have on the competitive position of the
UKs financial services industry, particularly the Citys wholesale markets?
5 Will joining the EMU promote higher growth, stability and a lasting increase in
jobs?
In his statement on the EMU to the House of Commons on 27 October 1997, the
Chancellor assessed these five economic tests. His analysis was based on a UK
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Treasury paper published on that date. This concluded that a successful EMU would
bring benefits for the UK economy by securing macro-economic stability and
underpinning a well-functioning single market. This in turn would be good for
investment, growth and employment in the UK economy.
However, reflecting the cyclical divergences between the UK and continental
European economies at this time, the Chancellor concluded it would not be right for
the UK to join the EMU from the outset.
On 23 February 1999 the UK Prime Minister, in a statement to the House of
Commons, launched an Outline National Changeover Plan. In his statement he
indicated that Britains intention is that it should join a successful single currency
provided that the five conditions are met. The plan indicated that making a
decision to join the single currency at that time was not realistic but that, should
the economic tests be met, this could be decided at some future time.
Conclusion
The global economic environment is changing fast. This process will continue, and
would continue if the EMU had never been thought of. It involves greater
globalisation of activity, increasing intensification of competition among all the
countries of the world and increasing technological change.
The formation of the EMU marked a substantial change in the economic
environment of the European Union as a whole. This is true for all Member States,
and it is true whether or not they have joined the EMU. Continuation of the status
quo is not an option for any Member State, whether it has joined the EMU or not.
Appendix One: International Financial Institutions
The European Central Bank
A European Central Bank (ECB) to operate the single monetary policy of the euro
was set up on 1 June, 1998. The European System of Central Banks (ESCB) is
comprised of the ECB and the central banks of the Member States. The primary
objective of the ESCB is to maintain price stability. Without prejudice to this
objective, the ESCB supports the general economic policies of the EU with a view to
contributing to the achievement of EU objectives. Briefly, these are to promote
sustainable and non-inflationary growth, a high level of employment and social
protection, economic and social cohesion and solidarity among the Member States.
The basic tasks of the ESCB are to:
decide and implement the monetary policy of the EU;
conduct foreign exchange operations;
hold and manage the official external reserves of the Member States; and
promote the smooth operation of payment systems
The Maastricht Treaty provides for the strict independence and accountability of the
ECB.
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The International Monetary Fund the IMF
The IMF is a specialised agency within the UN system. It had its origins in the
desire of members of the international community to avoid unemployment and
economic recession. It is the central institution in the international monetary
system and its aims are:
to promote international monetary co-operation and to allow the expansion of
international trade
to provide financial support to countries with temporary balance of payments
deficits
to provide for the orderly growth of international liquidity.
The World Bank
The World Bank (the International Bank for Reconstruction and Development i.e.
the IBRD) assists the economic development of countries by making loans
available. These loans are used to build up the educational system, through new
schools, and the health system, through new hospitals. This helps to reduce
poverty in the developing countries. In recent years the World Bank has
increasingly emphasised environmental protection in its work.
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Chapter 15
Hedging foreign
exchange risk


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CHAPTER CONTENTS
HEDGING TECHNIQUES FOR FOREIGN CURRENCY RISK ----------- 319
TRADE IN THE DOMESTIC CURRENCY ONLY 319
MATCHING 319
NETTING 319
LEADING AND LAGGING 320
FORWARD EXCHANGE CONTRACTS 320
SYNTHETIC FOREIGN EXCHANGE AGREEMENTS (SAFES) 320
MONEY MARKET HEDGING 321
FOREIGN CURRENCY OPTIONS 321
FINANCIAL FUTURES MARKET 321
CURRENCY SWAPS 321
FINANCIAL TIMES CURRENCY TABLES ------------------------------- 322
THE FOREX MODIFIED BLACK-SCHOLES OPTION PRICING MODEL334
MULTILATERAL NETTING ---------------------------------------------- 343

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HEDGING TECHNIQUES FOR FOREIGN CURRENCY RISK
When an enterprise decides to trade internationally, it will become exposed to
exchange rate risk. Indeed, where a company has a long-term overseas
investment (e.g. in a foreign subsidiary), it may wish to hedge its foreign currency
assets by raising a long-term loan in the same foreign currency whereby
exchange losses or gains on the assets are offset by matching currency gains or
losses on the liability. Sometimes management may consider it appropriate not to
hedge exchange rate risk in order to avoid transaction costs this must be
carefully considered and not be an outright gamble, which could of course, be
dangerous!!
The main methods of currency risk management are:
Trade in the domestic currency only
If an exporter always invoices in his domestic currency or an importer insists on
paying in his own domestic currency, there is no foreign exchange risk for that
company. However, the risk shifts to the other party in the transaction, which may
not be welcomed by an exporters overseas customers.
Matching
When an enterprise has both receipts and payments expected on the same date for
the same amount in the same foreign currency, no formal hedge is really
necessary, since they can be matched against each other.
Netting
When an enterprise has both receipts and payments expected on the same date in
the same foreign currency, but the amounts are different, netting may be
employed. For instance, if a UK company expects to receive 5,000,000 from an
Italian customer and expects to pay 3,700,000 to a Spanish supplier on the same
future date, it would only be necessary to use a formal hedging technique (with the
associated transaction costs) for the net receipt of 1,300,000.
In instances where two group members wish to settle their inter-company
indebtedness using the same currency, the transaction costs associated with
foreign exchange receipts and payments that are payable to banks can be reduced
considerably by employing bilateral netting. In cases where several group
members wish to settle their inter-company indebtedness, large savings in
transaction costs can also be achieved by the use of multilateral netting. These
procedures are illustrated starting on page 343.
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Leading and lagging
If an importer believes that the currency that it is shortly expecting to pay will
appreciate against its home currency, it may decide to settle the liability as soon as
possible. This is referred to as leading (and, of course, it may also be possible to
take advantage of an early settlement discount). However, if an importer believes
that the currency it is shortly expecting to pay will depreciate against its home
currency, it may choose to delay payment beyond the due date. This course of
action is known as lagging.
These approaches are not really hedging techniques, they are simply based upon
belief and this will only succeed if the direction of rate movement is correctly
estimated.
Forward exchange contracts
A forward market hedge offers protection against foreign exchange risk through a
company entering into a binding contract with a bank to purchase or sell a specified
quantity of foreign currency at a rate of exchange that is fixed when the contract is
made. The purchase or sale is fixed for a specified date when a company expects
foreign currency payments or receipts, or between two specified dates (an option
forward contract). Most forward contracts are for periods of up to one year, but
longer contracts may be arranged in major currencies.
Synthetic foreign exchange agreements (SAFEs)
In order to reduce the volatility of their exchange rates, some countries (e.g. China,
Russia, India, Brazil, Philippines and Korea) have attempted to ban forward foreign
exchange trading. In these markets, non-deliverable forwards (NDFs) have been
developed. Although they resemble forward contracts, no physical currency
delivery actually takes place. Instead, the difference between the actual spot rate
and the NDF rate is calculated. This will result in a profit or loss on the transaction
between the two counterparties, who merely settle with each other for this net
amount.
When this profit or loss is combined with the actual currency exchanged at the
prevailing spot rate, this will effectively fix the ultimate exchange rate in a manner
which resembles a forward exchange contract.
The underlying principles of a SAFE are similar to the procedures employed for a
forward rate agreement (FRA), which is offered by banks for clients who wish to
hedge their interest rate risk. These procedures are dealt with in detail in Chapter
17 Hedging Interest Rate Risk starting on page 375
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Money market hedging
This involves the company borrowing funds in one currency and exchanging the
proceeds for another currency, often with reinvestment in the second currency. For
example a UK company due to pay a dollar debt in three months time might borrow
pounds now, convert these pounds to dollars at the present spot rate (this fixes the
exchange rate) and invest the dollars in the USA for three months at the end of
which the total proceeds of the investment may be used to pay the dollar debt.
The cost of the money market hedge is directly determined by the interest rate
differential between the two countries concerned. This is in contrast to the cost of
a forward market hedge, which depends upon the forward rates quoted by the bank
(NB these are, of course, indirectly influenced by that interest rate differential, as
explained below under the interest rate parity theory).
Foreign currency options
These offer the right to buy or sell a given amount of foreign exchange at a fixed
price (the exercise price) usually at any time during a specified period. There is
normally a choice of exercise price and maturity date, the price of the option
varying according to the combination of exercise price and maturity date selected.
The price of the option is determined by the difference between the exercise price
and spot rate, maturity, relative interest rates in the countries concerned, currency
volatility and the supply and demand for specific options. The option need only be
exercised if exchange rates move in favour of the option holder; this limits the
downside risk of the holder.
Options may be purchased in standard sizes and maturities on certain Futures
Exchanges or over-the-counter in major banks to the clients particular size and
maturity requirements.
Financial futures market
Several financial futures markets offer foreign currency futures. These offer
purchase or sale of a standard amount of a limited number of foreign currencies at
a specified time and price.
They may be considered as an alternative to the forward foreign exchange market,
but are less flexible and require initial margin and thereafter variation margin may
have to be paid dependent upon subsequent movements in exchange rates.
Currency swaps
These are dealt with in Chapter 18 Swaps starting on page 407.
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FINANCIAL TIMES CURRENCY TABLES



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Illustration 1
(a) Structure of Exchange Rates
The following information on exchange rates was extracted from the Financial
Times several years ago
Pound spot - forward against the pound:
Days spread Close Three months
United States 1.7545 1.7710 1.7680 1.7690 1.56 1.51 cpm
Switzerland 2.2669 2.2770 2.2693 2.2714 3.39 3.73 cdis
Required:
(i) Identify the banks buying and selling rates.
(ii) Calculate the three months rates for the US dollar and the Swiss franc.
(b) Determinants of Forward Rates
The spot rate for the $/ exchange is $1.77. Interest rates in London are
14% p.a. and in New York 12% p.a.
Required:
Ignoring transaction costs calculate the best rate (for the customer) at which
a bank will sell the US $ twelve months forward.
(c) Hedging Forex Risk
The following information is available with respect to the $/ exchange rate
and interest rates in London and New York.
$/
Spot 1.7680 1.7690
Three months 1.56 1.51 cpm
Interest rates:
Borrow Lend
London 15% p.a 13% p.a.
New York 10.5% p.a. 8.5% p.a.
Required:
(i) An American customer will pay $3m in three months time. Show how
foreign exchange risk can be eliminated using:
(1) forward market cover, and
(2) money market cover.
(ii) You must pay an American supplier $3m in three months time. Show
how foreign exchange risk can be eliminated using:
(1) forward market cover, and
(2) money market cover.
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Solution 1
(a) The spot and the three month forward rates are:
US Dollars Swiss Francs
(i) Spot 1.7680 1.7690 2.2693 2.2714
(Prem)/dis (0.0156) (0.0151) cpm 0.0339 0.0373 cdis
(ii) 3 month rates 1.7524 1.7539 2.3032 2.3087

BANK Sell $ Buy $ Sell SF Buy SF
WE Buy $ Sell $ Buy SF Sell SF
(b) This exchange rate can be calculated from first principles as follows:
Bank borrows at 14% (say) 1,000
Buys $ spot at $1.77 = $1,770
Invests $ at 12% for twelve
months

In one year, the bank has:
$ asset $1,770 x 1.12 = $1,982.4
liability 1,000 x 1.14 = 1,140.0
Therefore the bank cannot sell $ forward for more than $1.7389 (i.e. $1,982.4
1,140).
However the interest rate parity theory can alternatively be used i.e.
Interest rate parity theory (IRPT)
Proponents of this theory claim that the difference between current spot rates and
forward rates is based upon interest rate differentials between the two countries
concerned. Therefore the principle of interest rate parity links the international
money markets with the foreign exchange markets.
Forward rate (F
o
) = Current Spot rate
rate erest int ome
rate erest int oreign
x
h 1
f 1
+
+

=
|
|

\
|
+
+

b
c
0
i 1
i 1
S
Forward rate = $1.77
14 . 1
12 . 1
= $1.7389
In this instance the current spot rate is $1.77 = 1, whereas the one year forward
rate is $1.7389 = 1. Thus there is a premium of $0.0311!!
Accordingly, provided this theory holds, where:
Foreign interest rates < UK interest rates, the forward rate is quoted at a
premium,
and where:
Foreign interest rates > UK interest rates, the forward rate is quoted at a
discount.

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(c) (i) (1) Forward market hedge
The selling rate in the 3 month forward market (i.e. the banks buying
rate) is $1.7539 (see part a))
By selling forward you will receive $3,000,000 1.7539 =
1,710,474 in three months time.
(2) Money market hedge : exporter case
Has a $ asset therefore must create $ liability
(1) Borrow in USA $3,000,000 1.02625* = $2,923,264

(2) Sell $ spot $2,923,264 1.7690 = 1,652,495

(3) Invest in UK 1,652,495 x 1.0325# = 1,706,201 proceeds

(4) Repay $ loan with receipts from customer = $3,000,000
*
4
% 5 . 10
= 2.625%
#
4
% 13
= 3.25%
It is more effective to hedge in the forward market.
(ii) (1) Forward market hedge
Buy $ forward : $3,000,000 1.7524 = 1,711,938
(2) Money market hedge : importer case
Has $ liability therefore must create $ asset
(3) Borrow in UK = 1,661,525
(2) Convert to $ 1,661,525 x 1.7680 = $2,937,577
(1) Invest in USA $2,937,577 x 1.02125* = $3,000,000
(4) Repay loan 1,661,525 x 1.0375# = 1,723,832 cost
*
4
% 5 . 8
= 2.125%
#
4
% 15
= 3.75%
The forward market cover is cheaper.
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Illustration 2 (Oxlake plc)
Oxlake plc has export orders from a company in Singapore for 250,000 china cups,
and from a company in Indonesia for 100,000 china cups. The unit variable cost to
Oxlake of producing china cups is 55 pence, and unit sales price to Singapore
$2.862 and to Indonesia, 2,246 Rupiahs. Both orders are subject to credit terms of
60 days, and are payable in the currency of the importers. Past experience
suggests that there is 50% chance of the customer in Singapore paying 30 days
late. The Indonesian customer has offered to Oxlake the alternative of being paid
US $125,000 in 3 months time instead of payment in the Indonesian currency. The
Rupiah is forecast by Oxlakes bank to depreciate in value during the next year by
30% (from an Indonesian viewpoint) relative to the $US.
Whenever appropriate, Oxlake uses option forward foreign exchange contracts.
Foreign Exchange Rates (mid rates)
$Singapore/$US $US/ Rupiahs/

Spot 2.1378 1.4875 2,481
1 month forward 2.1132 1.4963 No forward
2 months forward 2.0964 1.5047 market exists
3 months forward 2.0915 1.5105
Assume that in the United Kingdom any foreign currency holding must be
immediately converted into pounds sterling.
Money Market Rates (% per year)
Deposit Borrowing
UK clearing bank 6 11
Singapore bank 4 7
Euro-dollars 7 12
Indonesian bank 15 Not available
Euro-sterling 6 10
US domestic bank 8 12
These interest rates are fixed rates for either immediate deposits or borrowing over
a period of two or three months, but the rates are subject to future movement
according to economic pressures.
Required
(a) Using what you consider to be the most suitable way of protecting against
foreign exchange risk, evaluate the sterling receipts that Oxlake can expect
from its sales to Singapore and to Indonesia, without taking any risks.
All contracts, including foreign exchange and money market contracts, may
be assumed to be free from the risk of default. Transactions costs may be
ignored
(b) If the Indonesian customer offered another form of payment to Oxlake,
immediate payment in $US of the full amount owed in return for a 5%
discount on the Rupiah unit sales price, calculate whether Oxlake is likely to
benefit from this form of payment.
(c) Discuss the advantages and disadvantages to a company of invoicing an
export sale in a foreign currency.
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Solution 2 (Oxlake plc)
(a) Sales to Singapore
Cross rates S$ to
Spot 2.1378 x 1.4875 = 3.1800
1 month forward 2.1132 x 1.4963 = 3.1620
2 months forward 2.0964 x 1.5047 = 3.1545
3 months forward 2.0915 x 1.5105 = 3.1592
The management of Oxlake plc may cover the foreign exchange risk in one of
two ways:
1. In the forward currency market
Since the payment date is uncertain the appropriate device is an option
forward contract (sometimes called an option date contract).
(Note: an ordinary forward contract specifies the date of the exchange
and the exchange rates). Option forward contracts specify a period over
which the contract may be completed, at Oxlakes option. The forward
rate for an option forward contract is the worst rate prevailing during the
period of the option. Oxlake could take out an option forward contract
to sell S$ to be fulfilled between two and three months hence. The rate
will be the worse of the 2 month and 3 month rates (for the seller) i.e.
3.1592.
Sterling received
(3 months hence)
=
1592 . 3
862 . 2 000 , 250

=
1592 . 3 $ S
500 , 715 $ S

= 226,481

This is worse than the two month rate:

1545 . 3 $ S
500 , 715 $ S

= 226,819

2. In the money market
Oxlake expects to receive 250,000 x 2.862 = S$715,500 in 3 months
time. Therefore:
1) Borrow in Singapore S$715,500 1.0175* = S$703,194
2) Sell S$ spot S$703,194 3.18 = 221,130
3) Invest in Eurosterling 221,130 x 1.01625# = 224,723
(better than UK rate of 6% p.a.) proceeds
4) Repay S$ loan in 3 months time with receipts = S$715,500
*
4
% 7
= 1.75%
#
4
% 6
2
1
= 1.625%
Oxlake is best advised to deal in the forward exchange market
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Sales to Indonesia
Oxlake will receive 100,000 x 2,246 = 224,600,000 Rupiahs in two months
time. No forward rate exists so Oxlake cannot cover its position in the
forward market. Furthermore a money market hedge cannot be achieved
since a Rupiah liability cannot be created. However, the management still has
two options using the US$ alternative.
1. Forward currency market
Oxlake may accept the alternative payment of $125,000. It can sell the
$ forward, thus guaranteeing a sterling receipt in 3 months time of
125,000 1.5105 = 82,754.
2. Money market
1) Borrow in Eurodollar market $125,000 1.03* = $121,359
(better than US rate of 12% p.a.)
2) Sell $ spot $121,359 1.4875 = 81,586
3) Invest in Eurosterling 81,586 x 1.01625#= 82,912
(better than UK rate of 6% p.a.) proceeds
4) Repay Eurodollar loan in 3 months with receipts = $125,000
*
4
% 12
= 3%
#
4
% 6
2
1
= 1.625%
Oxlake should cover its position in the money market.
(b) Alternative form of payment
Sales value in Rupiahs = 100,000 cups x 2,246 = 224,600,000
Less 5% discount (11,230,000)
Discounted sales value 213,370,000

Using cross rates: 2,481 1.4875 = 1,667.90

Proceeds of sale =
90 . 667 , 1
000 , 370 , 213

= $127,927
The best US$ deposit rate of interest is 8% p.a. in a US domestic bank. The
yield after three months is $127,927 x 1.02* = $130,486. Converted into
sterling, using the three month forward market, this is
5105 . 1
486 , 130 $

= 86,386.
*
4
% 8
= 2%
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Alternatively, the US dollar proceeds could be converted immediately into
sterling and then invested for three months in the Eurosterling market. The
calculation is as follows:
(i) Conversion of US$127,927 into sterling yields
4875 . 1
927 , 127
= 86,001 i.e.
481 , 2
000 , 370 , 213
= 86,001
(ii) Yield of Eurosterling 3 month deposit
= 86,001 x 1.01625 # = 87,399
#

4
% 6
2
1
= 1.625%
Conclusion: The best yield without the offer of immediate payment was
82,912. With the alternative form of payment, both the forward market and
the money market yield better returns, with the money markets 87,399 as
the better form of hedging.
(c) When a company invoices sales in a currency other than its own, the amount
of home currency it will eventually receive is uncertain. This may be an
advantage or a disadvantage, depending on changes in the exchange rate
over the period between invoicing and receiving payment. With this in mind,
invoicing in a foreign currency has the following advantages.
The foreign customer will find the deal more attractive than a similar
one in the exporters currency, since the customer will bear no foreign
exchange risk. Making a sale will therefore be that much easier.
The exporter can take advantage of favourable foreign exchange rate
movements by selling the exchange receipts forward (for more of the
home currency than would be obtained by conversion at the spot rate).
In some countries, the importer may find it difficult or even impossible
to obtain the foreign exchange necessary to pay in the exporters
currency. The willingness of the exporter to sell in the importers
currency may therefore prevent the sale falling through.
The disadvantages of making export sales in foreign currency are the reverse
of the advantages.
The exporter (rather than the foreign customer) bears the foreign
exchange risk
If the exchange rate movement is unfavourable, the exporters profit will
be reduced.
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Illustration 3 (Fidden Ltd)
Fidden Ltd is a medium-sized UK company with export and import trade with the
USA. The following transactions are due within the next six months. Transactions
are in the currency specified.
Purchases of components, cash payment due in three months: 116,000
Sale of finished goods, cash receipt due in three months: $197,000
Purchase of finished goods for resale, cash payment due in six months: $447,000
Sale of finished goods, cash receipt due in six months: $154,000

Exchange rates (London market)
$/
Spot 1.7106 1.7140
Three months forward 0.82 0.77 cents premium
Six months forward 1.39 1.34 cents premium

Interest rates
Three months or six months Borrowing Lending
Sterling 12.5% 9.5%
Dollars 9% 6%

Foreign currency option prices (New York market)
Prices are cents per , contract size 12,500
Calls Puts
Exercise price ($) March June Sept March June Sept
1.60 15.20 2.75
1.70 5.65 7.75 3.45 6.40
1.80 1.70 3.60 9.90 9.32 15.35
Assume that it is now December with three months to expiry of the March contract
and that the option price is not payable until the end of the option period, or when
the option is exercised.
Requirements:
(a) Calculate the net sterling receipts/payments that Fidden Ltd might expect for
both its three and six month transactions if the company hedges foreign
exchange risk on:
(i) the forward foreign exchange market;
(ii) the money market.
(b) If the actual spot rate in six months time was with hindsight exactly the
present six months forward rate, calculate whether Fidden Ltd would have
been better to hedge through foreign currency options rather than the forward
market or money market.
(c) Explain briefly what you consider to be the main advantage of foreign
currency options.
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Solution 3 (Fidden Ltd)
(a)
Fidden Ltd Buys Sells
$ $
Spot 1.7106 1.7140
3 months 1.7024 1.7063
6 months 1.6967 1.7006
THREE MONTH TRANSACTIONS
1. Forward Cover
Sell $ $197,000 1.7063 = 115,454
2. Money Market Cover (Exporter)
1. Borrow in USA at 9% p.a. for 3 months
0225 . 1
000 , 197 $
= $192,665
2. Convert to (sell $ spot)
7140 . 1
665 , 192 $
= 112,407
3. Invest in UK at 9% for 3 months
112,407 x 1.02375 = 115,076
4. Repay loan with $197,000 proceeds
FORWARD MARKET IS MORE LUCRATIVE!
THEREFORE, NET STERLING PAYMENT IS:
(116,000 115,454) = 546
SIX MONTH TRANSACTIONS
1. Forward Cover
Buy $
( )
6967 . 1
000 , 154 $ 000 , 447 $
=
6967 . 1
000 , 293 $
= 172,688
2. Money Market Cover (Importer)
3. Borrow in UK at 12% for 6 months = 166,296
2. Convert to $ (buy $ spot)
166,296 x 1.7106 = $284,466
1. Invest in USA at6% for 6 months
$284,466 x 1.03 = $293,000
4. Repay loan 166,296 x 1.0625 = 176,690
FORWARD MARKET IS CHEAPER!
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(b)
We want a right to sell in New York, therefore buy put options!
A) $1.70 put costs 3.45 c per
$1.70 puts require
70 . 1 $
000 , 293 $
= 172,353
500 , 12
353 , 172
= 14 contracts (approx)
Premium is: 14 x 12,500 x 3.45 c per = $6,037.50
In six months:
$ $
14 contracts x 12,500 x $1.70 297,500

Payment to supplier 293,000
Payment of premium 6,037.50
299,037.50
Short by $1,537.50
Total cost

14 contracts @ 12,500 175,000

Extra $
6967 . 1 $
50 . 537 , 1 $

906
_______
Total cost of exercising option 175,906
N.B. If the currency option were not exercised, the sterling cost would
be:
6967 . 1 $
50 . 037 , 6 $ 000 , 293 $ +
= 176,247
B) $1.80 put costs 9.32 c per
$1.80 puts require
80 . 1 $
000 , 293 $
= 162,778
500 , 12
778 , 162
= 14 contracts (approx)
Premium is: 14 x 12,500 x 9.32 c per = $16,310
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In six months:
$ $
14 contracts x 12,500 x $1.80 315,000

Payment to supplier 293,000
Payment of premium 16,310
309,310
Over by $5,690
Total cost

14 contracts @ 12,500 175,000

less $ sold
7006 . 1 $
690 , 5 $

(3,346)
_______
Total cost of exercising option 171,654
N.B. If the currency option were abandoned, the sterling cost would be:
6967 . 1 $
310 , 16 $ 000 , 293 $ +
= 182,301
Therefore the purchase of $1.80 put options is the cheapest strategy of
all.
(c) Advantages of foreign currency options
The main advantage of foreign currency options is that they offer a right,
which need not be exercised, to buy or sell foreign currency. If exchange
rates move such that exercising the option is favourable, then the option will
be sold or exercised. If exchange rates move in an unfavourable manner for
the option holder, the option will be allowed to lapse unexercised and the only
cost will be the option premium. Options therefore offer a way of limiting
downside risk while offering potentially unlimited returns.
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The FOREX modified Black-Scholes option pricing model
Currency options can be priced using an adapted version of the Black-Scholes
model, known as the Grabbe variant. The risk free rate of interest is one of the
five components used in the Black-Scholes formula, however the problem that
arises with currency options is that there are two risk free rates to consider one
for each of the countries whose currencies are involved.
These two interest rates are incorporated into the formula by predicting the forward
rate using the interest rate parity theory. For the more familiar indirect currency
quotes, this is expressed as follows:
Forward rate (F
o
) = Current Spot rate
rate erest int ome
rate erest int oreign
h 1
f 1
+
+

=
|
|

\
|
+
+

b
c
0
i 1
i 1
S
However, since the Grabbe variant employs direct quotes, the basic formula must
be rearranged as follows:
Forward rate (F
o
) = Current Spot rate
rate erest int oreign
rate erest int ome
f 1
h 1
+
+

=
|
|

\
|
+
+

c
b
0
i 1
i 1
S
Formulae, which were provided in the 2007 version of the ACCA Formulae sheet for
the FOREX modified Black-Scholes option pricing model are shown below in bold
print:
Value of a currency call option (c) c = e

-rt
[ F
0
N(d
1
) XN(d
2
)]
Value of a currency put option (p) p = e

-rt
[ XN(d
2
) F
0
N(d
1
)]
The values for d
1
and d
2
in the specification are:
d
1
=
( )
T s
T/2 s /X F ln
2
0
+

d
2
= T s d
1

Where:
F
0
= the forward rate, calculated using the interest rate parity formula (as
above)
X = the current spot rate employing direct quotes
r = the continuous compound domestic (home) risk-free interest rate
The remaining symbols have already been introduced in the basic Black-Scholes
option pricing model. Notice that the ACCA have used both T and t to represent the
remaining life of the option, expressed in years and percentages thereof.
The 2011 version of the ACCA Formulae sheet has omitted this FOREX modified
formulae. However this topic has not yet been officially removed from the revised
P4 syllabus. Accordingly, this subject is retained within these Class Notes pending
formal clarification.
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Illustration 4
Sophie plc (a British company) is planning to undertake a construction project in
Belgium and in three months time expects to learn whether its tender has
succeeded. In that event, an immediate euro () payment will have to be made.
The corporate treasurer intends to hedge this payment using currency options.
Relevant information is as follows:
/ direct spot rate 0.80 = 1
/ indirect spot rate 1.25 = 1
Three month LIBOR 4.5% p.a.
Three month EURIBOR 3% p.a.
Volatility () of the against 20% p.a.
Required
Calculate the premium on a three month at the money call option with an
exercise price of 0.80 = 1.
Solution 4
Forward rate (F
0
) = Current Spot rate
f 1
h 1
+
+

= 0.8
( )
( ) % 3 12 / 3 1
% 5 . 4 12 / 3 1
+
+
= 0.8
0075 . 1
01125 . 1
= 0.803
X = 0.8
F
0
= 0.803
r = 0.045
T/t = 0.25
s = 0.2
d
1
=
( ) ( )
25 . 0 2 . 0
2 25 . 0 2 . 0 8 . 0 803 . 0 ln
2
+
=
1 . 0
005 . 0 00374 . 0 +
= 0.0874
d
2
= 0.0874 0.2 25 . 0 =0.0126
Using the standard normal distribution tables:
d
1
= 0.0874 (i.e. 0.09) gives 0.0359
d
2
= 0.0126 (i.e. 0.01) gives 0.004
N(d
1
) = 0.5 + 0.0359 = 0.5359
N(d
2
) = 0.5 0.004 = 0.496
c = e
-(0.045 x 0.25)
[0.803 x 0.5359 0.8 x 0.496]
= 0.9888 x [0.43033 0.3968]
= 0.03315 i.e. 3.315p per
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Illustration 5 Marion Inc
Marion Inc., a company based in the USA, is taking legal action for breach of
copyright against an Italian competitor. The matter will be resolved in nine months
time and, if successful, Marion Inc. will benefit from an immediate euro () receipt.
The corporate treasurer intends to hedge this receipt using currency options.
Relevant information is as follows:
$/ direct spot rate $1.3249 = 1
/$ indirect spot rate 0.7548 = $1
Three month $ Federal Reserve rate 5% p.a.
Three month EURIBOR 3% p.a.
Volatility () of the against $ 25% p.a.
Required:
Calculate the premium on a nine month at the money put option with an
exercise price of $1.3249 = 1.
Solution 5
Forward rate (F
0
) = Current Spot rate x
f 1
h 1
+
+

= $1.3249 x
( )
( ) % 3 12 9 1
% 5 12 9 1
+
+

= $1.3249 x
0225 . 1
0375 . 1
= $1.3443
X = 1.3249
F
0
= 1.3443
r = 0.05
T/t = 0.75
s = 0.25

d
1
=
( ) ( )
75 . 0 25 . 0
2 75 . 0 25 . 0 3249 . 1 3443 . 1 ln
2
+

=
2165 . 0
02344 . 0 01454 . 0 +
= 0.1754
d
2
= 75 . 0 25 . 0 1754 . 0 = -0.0411
Using the standard normal distribution tables:
d
1
= 0.1754 (i.e. 0.18) gives +0.0714
d
2
= 0.0411 (i.e. 0.04) gives 0.0160
N(d
1
) = 0.5 0.0714 = 0.4286
N(d
2
) = 0.5 + 0.0160 = 0.5160
p = e
-(0.05 x 0.75)
[1.3249 x 0.5160 1.3443 x 0.4286]
= 0.9632 x [0.68365 0.57617]
= $0.10353 i.e. 10.353 cents per
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Illustration 6 (currency futures)
A UK company imports from the USA and is invoiced for $297,500 payable in
October.
$/ spot rate 1.7500 1.7520
October forward 1.7000 1.7015
Required
(a) Show how a forward market hedge would be carried out.
(b) Show how a futures market hedge would be carried out (one futures
contract represents 12,500 and December futures are priced at $1.70).
What would be the result in October of the futures market hedge in each of
the following independent circumstances?
(i) The $/ spot turned out to be $1.5000 $1.5020 and December
futures were then priced at $1.50?, and
(ii) The $/ spot turned out to be $1.7800 $1.7820 and December
futures were then priced at $1.78?
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Solution 6
IMPORTER SITUATION
(a) Forward market hedge
7000 . 1 $
500 , 297 $
= 175,000
(b) Futures market hedge
70 . 1 $
500 , 297 $
= 175,000
500 , 12
000 , 175
= 14 contracts
Situation (i)
The UK importer requires protection against a weakening . As the $
strengthened to $1.5000 = 1 by October, he would have to pay ($297,500
1.5000) 198,333 to clear his obligation.
Obviously he could protect his exposure to foreign exchange risk by SELLING
14 December futures contracts NOW at $1.70, and then closing his position
by BUYING a similar number of December futures when the price has moved
to $1.50. Clearly the ($0.20 x 12,500) $2,500 gain on each of the 14
futures contracts i.e. $35,000 would be converted at the then spot rate
$1.5000 to provide 23,333 which would compensate for the adverse
movement on the foreign exchange market i.e.
CASH MARKET
Payment to supplier ($297,500 1.5000) = 198,333

FUTURES MARKET $
Now: SELL 14 contracts 1.70
In October: BUY 14 contracts 1.50
Gain per $0.20
Total Gain 000 , 35 $
1
20 . 0 $
500 , 12 contracts 14 = |

\
|



In : ($35,000 1.5000) = (23,333)
TOTAL COST 175,000
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Situation (ii)
CASH MARKET
Payment to supplier ($297,500 1.7800) = 167,135

FUTURES MARKET $
Now: SELL 14 contracts 1.70
In October: BUY 14 contracts 1.78
Loss per $(0.08)
Total loss 000 , 14 $
1
08 . 0 $
500 , 12 contracts 14 = |

\
|



In : ($14,000 1.7800) = 7,865
TOTAL COST 175,000
As can be seen from the above calculations, hedging with a futures contract
means that any profit or loss on the underlying will be offset by any loss or
profit made on the futures contract. In practice, a perfect hedge is unlikely
because of:
The round sum nature of futures contracts, which can only be bought
or sold in whole numbers, and
Basis risk i.e. the possibility of variability in the prices of the two related
securities in the hedging arrangement. For example, if changes in the
price of the currency future do no perfectly match the change in the
price of the underlying security then a profit or loss may occur on the
hedge position. This potential variability in the outcome of a hedge is
referred to as basis risk.
Since this example had a precise round number of contracts and there was no
basis risk, the total cost is the same whatever the actual exchange rate.
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Illustration 7 currency options
(a) Explain briefly what is meant by foreign currency options and give examples
of the advantages and disadvantages of exchange traded foreign currency
options to the financial manager.
(b) Exchange traded foreign currency option prices in Philadelphia for
dollar/sterling contracts are shown below:
Sterling (12,500) contracts
Calls Puts
Exercise price
($)
September December September December
1.90 5.55 7.95 0.42 1.95
1.95 2.75 3.85 4.15 3.80
2.00 0.25 1.00 9.40 -
2.05 - 0.20 - -
Option prices are in cents per . The current spot exchange rate is $1.9405 -
$1.9425/.
Required:
Assume that you work for a US company that has exported goods to the UK
and is due to receive a payment of 1,625,000 in three months time. It is
now the end of June.
Calculate and explain whether your company should hedge its sterling
exposure on the foreign currency option market if the companys treasurer
believes the spot rate in three months time will be:
1. $1.8950 $1.8970/.
2. $2.0240 $2.0260/.
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Solution 7
(a) A foreign currency option is a financial instrument, which gives the buyer of
the option the right, but not the obligation, to buy or sell a currency at a
specified rate of exchange (normally) at any time up to a specified date.
Advantages include:
They limit downside risk whilst allowing companies to take advantage of
favourable foreign exchange rate movements.
They are a useful hedge against exchange risk when a company is
unsure whether a future foreign exchange risk will occur, for example,
when tendering for a contract which it might not obtain, or issuing a
price list in foreign currencies.
They provide an effective currency hedge, especially when foreign
exchange markets are volatile.
Disadvantages include:
Cost. A premium is payable when the option is arranged, whether or
not the option is exercised.
Exchange traded options are only available in a small number of
currencies with specific expiry dates (OTC options are much more
flexible).
(b) Any belief about future spot exchange rates by the companys treasurer is a
personal viewpoint and, if acted upon, could leave the company exposed to
foreign exchange risk. If the company is worried about foreign exposure it
should hedge the risk using options, forward contracts or other techniques no
matter what the treasurer personally believes the future spot rate will be.
If the company acts upon the treasurers forecasts it will need to sell sterling
for dollars, i.e. buy put options on sterling. 1,625,000 will require
(1,625,000 12,500) 130 contracts.
1. $1.8950 - $1.8970/.
The relevant future spot rate for selling for $ is $1.8950/, since a
bank would obviously hand over the lower number of $ for each sold.
If the future spot rate is $1.8950, the company would receive (1.625m
x $1.8950) i.e. $3,079,375 using the spot market. The is expected to
weaken relative to the dollar. September options are available at
exercise prices of $1.90, $1.95 and $2.00. At all of these prices the
option will be exercised.
At $1.90 $
Receipts are 1.625m x $1.90 3,087,500
Option cost of 1.625m x $0.0042 (6,825)
Net $3,080,675

At $1.95 $
Receipts are 1.625m x $1.95 3,168,750
Option cost of 1.625m x $0.0415 (67,438)
Net $3,101,312

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At $2.00 $
Receipts are 1.625m x $2.00 3,250,000
Option cost of 1.625m x $0.0940 (152,750)
Net $3,097,250
All three options result in higher expected dollar receipts than using the
spot market in three months (excluding any further transactions costs).
Selection of the $1.95 exercise price would give the highest expected
receipts.
2. $2.0240 - $2.0260/.
If the spot rate for buying dollars in three months time is $2.0240/
then, if purchased, the options would not be exercised as using the spot
rate in three months would give higher dollar receipts (i.e. 1.625m x
$2.0240 = $3,289,000) than any of the available option exercise prices.
Therefore, the company would not purchase currency options.
It must be stressed that this would leave the company exposed to
foreign exchange risk, as the spot rate in three months time could be
very different to the rate forecast by the treasurer.
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Multilateral netting
This is a procedure whereby the debts of the different group companies
denominated in a given currency are netted off against each other. The principal
benefit is that foreign exchange purchase costs, including commission, the buy/sell
spread and money transmission costs are reduced. Additionally, it will reduce the
loss of interest earned. This is because funds spend less time in transit.
Illustration 8
Forun plc, a UK registered company, operates with four subsidiaries in different
foreign countries. It has a number of intra-group transactions with its four foreign
subsidiaries in six months time. These are summarised below denominated in US
dollars:
Paying company
Receiving company UK Sub 1 Sub 2 Sub 3 Sub 4
$US000
UK - 300 450 210 270
Subsidiary 1 700 - 420 - 180
Subsidiary 2 140 340 - 410 700
Subsidiary 3 300 140 230 - 350
Subsidiary 4 560 300 110 510 -
Required
Explain and demonstrate how multilateral netting might be of benefit to Forun plc.
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Solution 8
Multilateral netting is an effective means of reducing the transaction costs
associated with foreign exchange receipts and payments that are payable to banks.
The netting of Foruns intra-company US dollar exposures gives the following net
payments and receipts:
Paying company
Receiving
company
UK Sub 1 Sub 2 Sub 3 Sub 4
Total
receipts
Net
receipts
(payments)
$US000
UK - 300 450 210 270 1,230 (470)
Subsidiary 1 700 - 420 - 180 1,300 220
Subsidiary 2 140 340 - 410 700 1,590 380
Subsidiary 3 300 140 230 - 350 1,020 (110)
Subsidiary 4 560 300 110 510 - 1,480 (20)
Total payments 1,700 1,080 1,210 1,130 1,500 6,620 NIL
US dollar payments will still need to be made by the UK parent, Subsidiary 3 and
Subsidiary 4 to Subsidiary 1 and Subsidiary 2. However these payments/receipts
only amount to a total of $600,000. These amounts are insignificant when
compared to the total value of transactions amounting to $6,620,000, which would
have been involved if multilateral netting had not taken place.
Therefore, this technique will reduce transaction and other costs that would
otherwise have been payable on the net difference of $6,020,000.
Where only two group members are involved in attempting to settle their intra-
company indebtedness, the much simpler technique called bilateral netting may be
employed.

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Chapter 16
Futures and options



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CHAPTER CONTENTS
FUTURES ----------------------------------------------------------------- 347
OPTIONS ----------------------------------------------------------------- 348
THE BLACK-SCHOLES OPTION PRICING MODEL --------------------- 350
PUT-CALL PARITY ------------------------------------------------------ 360
THE GREEKS ------------------------------------------------------------- 361
1. DELTA 361
2. GAMMA 361
3. VEGA 362
4. THETA 362
5. RHO 362
SUMMARY OF THE GREEKS 362
REAL OPTIONS ---------------------------------------------------------- 363
APPLYING THE BLACK SCHOLES MODEL TO ESTIMATE THE VALUE OF
EQUITY ------------------------------------------------------------------ 368
LIFFE EQUITY OPTIONS TABLE --------------------------------------- 374

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FUTURES

Financial futures contracts
A financial futures contract is a legally binding agreement between two parties to
buy or to sell a standardised quantity of a specific financial instrument at a future
date, but at a price agreed today, through the medium of an organised exchange.
The Clearing House
Each futures exchange has a Clearing House. When a futures deal has been made
the Clearing House assumes the role of counterparty to both the buyer and the
seller. Thus the buyer has effectively bought from the Clearing House whilst the
seller is treated as having sold to the Clearing House, thus removing the risk of
default on the futures contract. The Clearing House imposes upon its members the
requirement to pay margin, which effectively acts as a security deposit.
Margin
When a deal has been made both buyer and seller are required to pay margin to
the Clearing House. This sum of money must be deposited (and maintained) in
order to provide protection to both parties.
Initial margin is the sum deposited when the contract is first made. Variation
margin is payable or receivable to reflect the day-to-day profits or losses made on
the futures contract. If the futures price moves adversely a payment must be
made to the Clearing House, whilst if the futures price moves favourably variation
margin will be received from the Clearing House. This process of realising profits or
losses on a daily basis is known as marking to market.
Ticks
A tick is the minimum price movement permitted by the exchange on which the
futures contract is traded. Price movements are then stated in numbers of ticks.
Thus if a three month interest rate futures contract has a contract size of 500,000
and a tick size of 0.01%, the tick value is (0.0001 x 3/12 x 500,000) 12.50.
If you bought 15 Contracts at 93.20 and the contract price rose to 94.50, each
contract will have risen in price by (1.30 x 100) 130 ticks. Thus your total profit is
(15 contracts x 130 ticks x 12.50 per tick) 24,375, which will wholly or partly
cancel any losses made on the cash market due to adverse movements in market
interest rates.
Hedging
Hedging with a futures contract means that any profit or loss on the underlying
instrument will be offset by any loss or profit made on the futures contract. A
perfect hedge is unlikely because of:
(a) Basis risk i.e. the possibility that the futures price will move slightly differently
to the cash (or spot) market price, and
(b) The round sum nature of futures contracts, which can only be bought or sold
in whole numbers.
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OPTIONS
A number of types of option may be created, for example:
Companies can create call options on their own shares for purposes of share
option schemes for directors and employees, and
Over-the-counter (OTC) or negotiated options are often created by e.g. banks
to suit the needs of the buyer.
However a large volume of trading occurs in options created by dealers on
specialised exchanges. In the UK, the London International Financial Futures and
Options Exchange (LIFFE) oversees the creation of options on various financial
assets. In 2002, LIFFE was taken over by Euronext and is now known as
Euronext.liffe. The paragraphs which follow are mainly concerned with these
exchange traded options.
Option
An option confers on the buyer the right, but not the obligation to buy from or sell
to the writer, a fixed amount of a financial asset (or instrument) on or before a
future maturity date, at a specific exercise price which is fixed today.
Call option
The buyer of a call option has the right to buy the asset, whilst the writer (or seller)
of a call option will be obliged to sell the asset should the buyer so elect.
Put option
The buyer of a put option has the right to sell the asset, whilst the writer (or seller)
of a put option will be obliged to buy the asset should the buyer so elect.
Exercise price
This is the price, which is fixed in the contract at which the underlying instrument
can be bought or sold. Sometimes referred to as the strike price. These strike
prices are fixed by the Exchange in accordance with a predetermined scale.
Expiry date
Also known as maturity date. Options are traded for delivery either on (or at any
time up to) the maturity date.
American style options
The majority of options are American style, in that they can be exercised, should
the buyer so decide, at any time between entering into the contract and expiry
date.
European style options
The comparatively rare European style options can only be exercised on the
maturity date.
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Bermudan style options
These are options where early exercise is restricted to certain specified dates over
the life of the option.
Premium
The premium is the price that the buyer of the option pays for his right to trade the
instrument and is the maximum he can lose on the deal. The writer receives the
premium for having taken on the obligation to go through with the deal should the
buyer so elect. The writer of an option risks potentially unlimited losses.
In-the-money options
A call option is in-the-money if the current market price exceeds the exercise price.
A put option is in-the-money if the current market price is below the exercise price.
Out-of-the money options
A call option is out-of-the money if the current market price is below the strike
price. A put option is out-of-the money if the current market price exceeds the
strike price.
At-the-money options
Put and call options are at-the-money if the current market price happens to be
equal to the exercise price.
Intrinsic value of an option
The profit that the buyer of an in-the-money option could make if the option were
to be exercised immediately.
Time value of an option
If there is still a period of time to go before an option expires the option premium
will exceed the intrinsic value. Thus the value of the option premium will be equal
to intrinsic value plus time value. The greater the time to expiry, the greater the
time value.
The determinants of the value of a call option premium
1. The higher the price of the underlying instrument, the higher the value of
the call option premium.
2. The longer the time to expiry of the option, the higher the value of the call
option premium.
3. The greater the price volatility of the underlying instrument, the higher the
value of the call option premium.
4. The higher the risk free rate of interest, the higher the value of the call
option premium.
5. The higher the exercise price of the option, the lower the value of the call
option premium.
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THE BLACK-SCHOLES OPTION PRICING MODEL
In 1973, Fischer Black and Myron Scholes developed a model to value particular
types of options. This model, commonly called the Black-Scholes option pricing
model, and its many derivations have been used extensively in establishing the
value of a call option. Such sophisticated models are used to determine the
appropriate relationship between the price of an option trading on an organised
exchange and the cash market price of the underlying financial claim.
The Black-Scholes model includes the following five factors in its specification:
1. The price of the underlying security
2. The length of time to expiry of the option period
3. A measure of price volatility
4. The risk-free rate of interest
5. The exercise price
In its basic form, the model cannot be used to incorporate income (i.e. dividends or
interest) received on the financial claim.
The model originally developed by Black-Scholes was designed for European call
options. The model assumes no return on the underlying financial claim and that
the options are marketable, that is, they can be bought and sold. This is a very
important assumption, since many forms of option that are created cannot be
transferred (i.e. are not traded options). This means that the value of options,
without transferability, will be less than would be calculated using the Black-Scholes
formula. The original model also ignored transaction costs and taxes, but a later
improved version introduced the assumption that transaction costs are minimal and
that all parties to the transaction have the same marginal tax rate.
Given these limitations the model has been successfully used to value many types
of options. The objective of the model is to estimate the market value of a call
option, c. The model specification is:
c = P
a
N(d
1
) P
e
N(d
2
) e
-rt

where:
c = Call price for a European option
P
a
= Current market price of the related security
P
e
= The exercise price at the options maturity
e = The exponential constant i.e. 2.7183
r = Continuous compound risk-free interest rate
t = Remaining life of the option, expressed in years and percentages
thereof
N(d
1
) = The cumulative probability distribution from a normal distribution
for the value of d
1
. N(d
1
) provides an estimate of delta (refer to
page 361).
N(d
2
) = The cumulative probability distribution from a normal distribution
for the value d
2
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The values for d
1
and d
2
in the specification are
d
1
=
t s
)t 0.5s + (r + ) /P ln(P
2
e a
or t s 5 . 0
t s
rt + ) /P ln(P
e a
+ ++ +
N.B. The left hand version is given on the ACCA Formulae sheet, whilst
the right hand version was used (with different symbols) in the old
syllabus Paper 3.7
d
2
= d
1
t s
where:
ln(P
a
/P
e
) = the natural logarithm of (P
a
P
e
)
s = the standard deviation () of the continuously compounded rate of
return on the underlying financial claim
The assumptions for the Black-Scholes model appear to be numerous i.e.
Returns on the underlying stock are normally distributed;
The standard deviation of returns must be estimated and be constant over the
life of the option;
Transaction costs and taxes are zero;
The share pays no dividends;
The option has European exercise terms;
The market is efficient and operates continuously;
The short-term (risk-free) interest rate is known and constant.
Although these assumptions are necessary for the Black-Scholes model to be
correct - if they do not hold, a variation is often available. Many financial scholars
have expanded upon the original work. For example, in 1973, Robert Merton
relaxed the assumption of no dividends by simply reducing the current share price
by the present value of all dividends expected to be paid before expiry of the
option. These dividends must be discounted at the risk free rate. Therefore, if a
current share price is 520p and a dividend of 21p is expected to be paid shortly
before expiry of a call option in one years time and the risk-free rate of interest is
5%, P
a
will become: 520p (21p 1.05) = 500p.
In 1976, Jonathan Ingerson relaxed the assumption of no taxes or transaction
costs, whilst Merton responded by removing the restriction of constant interest
rates.
The values of the options given by the Black-Scholes model vary considerably. The
impact of changes in s (i.e. the ) and time to expiry have a particularly large
impact on value. A number of computer programs have been developed to permit
analysts to calculate quickly the option values using this model and variations of it.
This clearly simplifies the complex and laborious calculations.
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Illustrations of the Black-Scholes model
1. The following details relate to an option to buy one share in Hoult plc:
Strike price = 45p
Time remaining to expiration = 183 days
Current share price = 47p
Expected price volatility = standard deviation = 25%
Short-term risk-free rate = 10%
Calculate the price of a European call option premium using the Black Scholes
option pricing model.
2. The following details concern the shares and related call options of Lyttle plc:
Current share price = 165p
Exercise price = 150p
Risk-free interest rate = 6%
Time to the options expiry = 2 years
Volatility (standard deviation) of share price = 15%
Calculate the price of a European call option premium using the Black Scholes
option pricing model.
3. Consider an option to purchase an ordinary share in Clement plc at 65p when
the price of the share is 62.5p. The option will expire in four months or 120
days. The risk-free interest rate is 5 per cent. The volatility of Clement plc
shares as measured by the standard deviation of the return on the shares for
the 120-day period to expiry is estimated to be 40%.
Calculate the price of a European call option premium using the Black Scholes
option pricing model.
4. A call option on an ordinary share in Gilchrist plc has a strike price of 1.20.
The current share price is 1.50 and the risk free rate of interest is 7.5%.
The standard deviation of the share is measured at 25% for the 6 month
period to maturity.
Calculate the price of a European call option using the Black Scholes option
pricing model.
5. The current share price of McInnes plc is 2.90. Estimate the value of a
European call option on the shares of the company (with an exercise price of
2.60) which has 6 months to run before it expires. The risk free rate of
interest is 6% and the variance of the rate of return on the share has been
15%.
6. The price per ordinary share of Balis plc is 36p, whilst the exercise price is
40p. The risk-free interest rate is 10%, whilst the standard deviation of the
rate of return is 40% and the time to expiry is 90 days.
Calculate the price of a European call option premium using the Black Scholes
option pricing model.
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7. From the following data, calculate the call premium on an ordinary share of
Butler plc.
The share price is 1, whilst the related strike price is 90p. The risk free
interest rate is 10%. The volatility (measured by standard deviation) is 30%,
whilst the remaining time to expiry is 90 days.
Suggested solutions to illustrations
1. P
e
= 45
t = 0.5 (183/365, rounded)
P
a
= 47
s = 0.25
r = 0.1
d
1
=
( ) ( )
5 . 0 25 . 0
5 . 0 25 . 0 5 . 0 1 . 0 45 47 ln
2
+ +

=
1768 . 0
015625 . 0 05 . 0 0435 . 0 + +

=
1768 . 0
109125 . 0

= 0.6172
d
2
= 0.6172 0.25 x 5 . 0 = 0.4404
Using the standard normal distribution tables:
d
1
= 0.6172 gives 0.2324
d
2
= 0.4404 gives 0.1700
N(d
1
) = 0.5 + 0.2324 = 0.7324
N(d
2
) = 0.5 + 0.17 = 0.67
c = (47 x 0.7324) (45 x 0.67 x e
-0.1 x 0.5
)
= 34.423 (45 x 0.67 x 2.7183
-0.05
)
= 34.423 (45 x 0.67 x 0.9512)
= 34.423 28.68
= 5.74p
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2. P
a
= 165
P
e
= 150
r = 0.06
t = 2
s = 0.15
d
1
=
( ) ( )
2 15 . 0
2 15 . 0 5 . 0 06 . 0 150 165 ln
2
+ +

=
2121 . 0
0225 . 0 12 . 0 0953 . 0 + +

=
2121 . 0
2378 . 0

= 1.121
d
2
= 1.121 0.15 2 = 0.91
Using the standard normal distribution tables:
d
1
= 1.121 gives 0.3686
d
2
= 0.91 gives 0.3186
N(d
1
) = 0.5 + 0.3686 = 0.8686
N(d
2
) = 0.5 + 0.3186 = 0.8186
c = (165 x 0.8686) (150 x 0.8186 x e
-0.06 x 2
)
= 143.319 (150 x 0.8186 x 2.7183
-0.12
)
= 143.319 (150 x 0.8186 x 0.8869)
= 143.319 108.905
= 34.41p
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3. P
e
= 65
P
a
= 62.5
t = 0.33 (about four months)
r = 0.05
s = 0.4
d
1
=
( ) ( )
33 . 0 4 . 0
33 . 0 04 5 . 0 05 . 0 65 5 . 62 ln
2
+ +

=
2298 . 0
0264 . 0 0165 . 0 0392 . 0 + +

=
2298 . 0
0037 . 0

= 0.016
d
2
= 0.016 0.4 33 . 0 = 0.2138
Using the standard normal distribution tables:
d
1
= 0.016 gives 0.0080
d
2
= 0.2138 gives 0.0832
N(d
1
) = 0.5 + 0.008 = 0.508
N(d
2
) = 0.5 0.0832 = 0.4168
c = (62.5 x 0.508) (65 x 0.4168 x 2.7183
-0.05 x 0.33
)
= 31.75 (65 x 0.4168 x 2.7183
-0.0165
)
= 31.75 (65 x 0.4168 x 0.9836)
= 31.75 26.65
= 5.1p
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4. P
e
= 120
P
a
= 150
t = 0.5
r = 0.075
s = 0.25
d
1
=
( ) ( )
5 . 0 25 . 0
5 . 0 25 . 0 5 . 0 075 . 0 120 150 ln
2
+ +

=
1768 . 0
015625 . 0 0375 . 0 2231 . 0 + +

=
1768 . 0
27622 . 0

= 1.5624
d
2
= 1.5624 0.25 5 . 0 = 1.386
Using the standard normal distribution tables:
d
1
= 1.5624 gives 0.4406
d
2
= 1.386 gives 0.4177
N(d
1
) = 0.5 + 0.4406 = 0.9406
N(d
2
) = 0.5 + 0.4177 = 0.9177
c = (150 x 0.9406) (120 x 0.9177 x e
-0.075 x 0.5
)
= 141.09 (120 x 0.9177 x 2.7183
-0.0375
)
= 141.09 (120 x 0.9177 x 0.9632)
= 141.09 106.07
= 35.02p
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5. P
a
= 290
P
e
= 260
t = 0.5
r = 0.06
s
2
= 0.15
d
1
=
( ) ( )
5 . 0 15 . 0
5 . 0 15 . 0 5 . 0 06 . 0 260 290 ln

+ +

=
075 . 0
0375 . 0 03 . 0 1092 . 0 + +

=
2739 . 0
1767 . 0

= 0.6451
d
2
= 0.6451 5 . 0 15 . 0 = 0.3712
Using the standard normal distribution tables:
d
1
= 0.6451 gives 0.2422
d
2
= 0.3712 gives 0.1443
N(d
1
) = 0.5 + 0.2422 = 0.7422
N(d
2
) = 0.5 + 0.1443 = 0.6443
c = (290 x 0.7422) (260 x 0.6443 x e
-0.06 x 0.5
)
= 215.24 (260 x 0.6443 x 2.7183
-0.03
)
= 215.24 (260 x 0.6443 x 0.9704)
= 215.24 162.57
= 52.67p
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6. P
a
= 36
P
e
= 40
r = 0.1
s = 0.4
t = 0.25 (90/365, rounded)
d
1
=
( ) ( )
25 . 0 4 . 0
25 . 0 4 . 0 5 . 0 1 . 0 40 36 ln
2
+ +

=
5 . 0 4 . 0
02 . 0 025 . 0 1054 . 0

+ +

=
2 . 0
604 . 0

= 0.302
d
2
= 0.302 25 . 0 4 . 0 = 0.502
Using the standard normal distribution tables:
d
1
= 0.302 gives 0.1179
d
2
= 0.502 gives 0.1915
N(d
1
) = 0.5 0.1179 = 0.3821
N(d
2
) = 0.5 0.1915 = 0.3085
c = (36 x 0.3821) (40 x 0.3085 x e
-0.1 x 0.25
)
= 13.76 (40 x 0.3085 x 2.7183
-0.025
)
= 13.76 (40 x 0.3085 x 0.9753)
= 13.76 12.04
= 1.72p
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7. P
a
= 100
P
e
= 90
r = 0.1
s = 0.3
t = 0.25 (90/365, rounded)
d
1
=
( ) ( )
25 . 0 3 . 0
25 . 0 3 . 0 5 . 0 1 . 0 90 100 ln
2
+ +

=
15 . 0
01125 . 0 025 . 0 1054 . 0 + +

=
15 . 0
14165 . 0

= 0.9443
d
2
= 0.9443 25 . 0 3 . 0 = 0.7943
Using the standard normal distribution tables:
d
1
= 0.9443 gives 0.3264
d
2
= 0.7943 gives 0.2852
N(d
1
) = 0.5 + 0.3264 = 0.8264
N(d
2
) = 0.5 + 0.2852 = 0.7852
c = (100 x 0.8264) (90 x 0.7852 x e
-0.1 x 0.25
)
= 82.64 (90 x 0.7852 x 2.7183
-0.025
)
= 82.64 (90 x 0.7852 x 0.9753)
= 82.64 68.92
= 13.72p
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PUT-CALL PARITY
Once a value has been established for call options, the following equation can be
used to establish the value of a put option with the same exercise price and expiry
date as the related call:
Price of a
put
= Price of a call
Current value of
underlying
security
+
Present value of
the exercise price
p =
c P
a
+ P
e
e

-rt

Referring to the earlier illustrations, the related put premium in each case is:
Example
1. 5.74 47 + (45 x e
-0.1 x 0.5
)
= 5.74 47 + (45 x 2.7183
-0.05
)
= 5.74 47 + 42.81 = 1.55p
2. 34.41 165 + (150 x e
-0.06 x 2
)
= 34.41 165 + (150 x 2.7183
-0.12
)
= 34.41 165 + 133.04 = 2.45p
3. 5.1 62.5 + (65 x e
-0.05 x 0.33
)
= 5.1 62.5 + (65 x 2.7183
-0.0165
)
= 5.1 62.5 + 63.94 = 6.54p
4. 35.02 150 + (120 x e
-0.075 x 0.5
)
= 35.02 150 + (120 x 2.7183
-0.0375
)
= 35.02 150 + 115.58 = 0.6p
5. 52.67 290 + (260 x e
-0.06 x 0.5
)
= 52.67 290 + (260 x 2.7183
-0.03
)
= 52.67 290 + 252.32p = 14.99p
6. 1.72 36 + (40 x e
-0.1 x 0.25
)
= 1.72 36 + (40 x 2.7183
-0.025
)
= 1.72 36 + 39.01 = 4.73p
7. 13.72 100 + (90 x e
-0.1 x 0.25
)
= 13.72 100 + (90 x 2.7183
-0.025
)
= 13.72 100 + 87.78 = 1.5p
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THE GREEKS
In principle, an option writer could sell options without hedging his position. If the
premiums received accurately reflect the expected payouts at expiry, there is
theoretically no profit or loss on average. This is analogous to an insurance
company not reinsuring its business. In practice, however, the risk that any one
option may move sharply in-the-money makes this too dangerous. In order to
manage a portfolio of options, the dealer must know how the value of the options
he has sold and bought will vary with changes in the various factors affecting their
price. Such assessments of sensitivity are measured by the Greeks, which can be
used by options traders in evaluating their hedge positions.
1. Delta
For each option held, the delta value can be established i.e.
Delta =
security underlying of price in Change
price option in Change

Delta is a measure of how much an option premium changes in response to a
change in the security price. For instance, if a change in share price of 5p results
in a change in the option premium of 1p, then the delta has a value of (1p/5p) 0.2.
Therefore, the writer of options needs to hold five times the number of options than
shares to achieve a delta hedge. The delta value is likely to change during the
period of the option, and so the option writer may need to change his holdings to
maintain his delta hedge position.
Accordingly a writer can hedge a holding of 300,000 shares using options with a
delta value estimated by N(d
1
) of 0.6, by holding the following number of LIFFE
contracts (each on 1,000 shares).
size Contract value Delta
shares of Number

=
000 , 1 6 . 0
000 , 300

= 500 contracts.
A delta value ranges between 0 and +1 for call options, and between 0 and -1 for
put options. The actual delta value depends on how far it is in-the-money or out-
of-the-money.
The absolute value of the delta moves towards 1 (or -1) as the option goes further
in-the-money and shifts towards 0 as the option goes out-of-the-money. At-the-
money calls have a delta value of 0.5, and at-the-money puts have a delta value of
-0.5.
2. Gamma
Gamma measures the amount by which the delta value changes as underlying
security prices change. This is calculated as the:
security underlying the of price the in Change
value delta the in Change

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3. Vega
Vega measures the sensitivity of the option premium to a change in volatility. As
indicated above higher volatility increases the price of an option. Therefore any
change in volatility can affect the option premium. Thus:
Vega =
volatility in Change
price option the in Change

N.B. Vega is the name of a star, not a letter of the Greek alphabet!!
4. Theta
Theta measures how much the option premium changes with the passage of time.
The passage of time affects the price of any derivative instrument because
derivatives eventually expire. An option will have a lower value as it approaches
maturity. Thus:
Theta =
expiry to time in Change
value) in changes to (due price option the in Change

5. Rho
Rho measures how much the option premium responds to changes in interest rates.
Interest rates affect the price of an option because todays price will be a
discounted value of future cash flows with interest rates determining the rate at
which this discounting takes place. Thus:
Rho =
interest of rate the in Change
price option the in Change

Summary of the Greeks
Changes in In response to changes in

DELTA Option premium Value of underlying security
GAMMA Delta value Value of underlying security
VEGA Option premium Volatility
THETA Time value in option premium Time to expiry
RHO Option premium Risk free rate of interest
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REAL OPTIONS
Flexibility increases the value of an investment and financial options theory
provides a guide as to how this flexibility can be incorporated into project appraisal.
Conventional project appraisal techniques do not adequately recognise the value of
flexibility. However, real options theory attempts to apply the principles used in the
evaluation of financial options and develop them for use in capital investment
appraisal.
In some project evaluation situations, a company may have one or more options to
make strategic changes to the project during its life e.g. the:
Option to delay (i.e. defer investment without loss of the opportunity for
further investment, effectively creating a call option);
Option to expand (i.e. to increase the scale of investment if market conditions
change). Thus the right to expand is effectively a call option;
Option to abandon (i.e. where a project consists of clearly identifiable stages,
an abandonment option can be considered at the end of each stage, if this is
preferable to continuation). The right to generate some salvage value if
abandonment occurs is effectively a put option;
Option to redeploy (i.e. switch to another use). This could result in the
creation of a put option if there is salvage value from the work already
performed, together with a call option arising on the right to commence the
new investment at a later stage.
There may even be options to downsize, options to change inputs or outputs,
options to shut down and then subsequently restart or, perhaps, options to invest
in stages (as opposed to one single major investment).
The building of the East Stand at West Bromwich Albion FC is cited as an example
of real options in investment appraisal.
This stand, which contains extensive corporate facilities, was built between 1999
and 2001 as a single tier stand. However, due to the stronger foundations which
were laid and the design of exits and walkways etc., it would be relatively
straightforward to add a second tier at some future stage without having to
demolish the existing first tier. Obviously, this single tier stand was more
expensive to build than a conventional one tier stand, but the additional
expenditure was the premium that was paid as a call option to expand, if or when
attendances grow to justify the additional ground capacity.
The Black-Scholes option pricing model can be applied to real options (sometimes
referred to as embedded options), where there is a single source of uncertainty
and a single expiry date (i.e. a European style option). Obviously this model
employs the usual five features i.e.
P
a
: The value of the underlying asset is no longer a share price, but
the PV of the future cash flows arising from the project;
P
e
: The exercise price is the capital expenditure (or receipts) arising
from the option;
s : This will represent the volatility (in the form of the ) of the
operating cash flows related to projects of the type under
consideration;
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r : This is the risk free rate of interest, however some writers believe
that additional project risk should be reflected with the use of a
higher interest rate;
t : This is, as usual, the time to expiry for exercising a European style
option.
Illustration of an option to expand
Winter plc has investigated the opening of a new restaurant in the Isle of Man. The
initial capital expenditure is estimated at 12 million, whilst the present value of the
net cash inflows is expected to be 12.005 million. Since the resulting NPV of
0.005 million is a very small positive amount, this appraisal suggests that the
project is extremely marginal.
However, if this first restaurant is opened, Winter plc would gain the right, but not
the obligation to open a second restaurant in five years time at a capital cost of 20
million. The present value of the associated future net cash inflows is estimated at
15 million, with a standard deviation of 28.3%.
If the risk free rate of interest is 6%, determine whether to proceed with the
restaurant projects.
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Solution to illustration
t = 5; P
e
= 20; P
a
= 15; s = 0.283; r = 0.06
d
1
=
( ) ( )
5 283 . 0
5 283 . 0 5 . 0 06 . 0 20 15 ln
2
+ +

=
6328 . 0
2002 . 0 3 . 0 2877 . 0 + +
=
6328 . 0
2125 . 0
= 0.3358
d
2
=
5 283 . 0 3358 . 0 = 0.297
Using the standard normal distribution tables:
d
1
= 0.3358 gives 0.1331; thus N(d
1
) = 0.5 + 0.1331 = 0.6331
d
2
= 0.297 gives 0.1179; thus N(d
2
) = 0.5 0.1179 = 0.3821
c = (15 x 0.6331) (20 x 0.3821 x e
-0.06 x 5
)

= 9.4965 (20 x 0.3821 x 0.7408)
= 9.4965 5.6613
= 3.8352m
Conclusion:
m
NPV of first restaurant 0.005
Value of call option (to expand) on second restaurant 3.8352
Value of combined projects +3.8402
Therefore the project should be accepted, since the additional value (which
incorporates the option to expand), allows Winter plc to avoid the downside
element of risk.
Illustration of an option to abandon
Summer plc is undertaking a brewing joint venture with Autumn Inc. This project
requires an initial outlay by Summer plc of 250 million. The present value of the
net cash inflows is expected to be 254 million, with a variance of 9%. The
arrangement thus provides an extremely small positive NPV of 4 million. Summer
plc, however, has the right but not the obligation to sell its share of the joint
venture to Autumn Inc for 150 million at the end of the first five years of the
venture.
If the risk free rate of interest is 7%, calculate the value of this abandonment
option.
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Solution to illustration
P
a
= 254; P
e
= 150; s
2

= 0.09; t = 5; r = 0.07
Firstly, calculate the value of the call option:
d
1
=
( ) ( )
5 09 . 0
5 09 . 0 5 . 0 07 . 0 150 254 ln

+ +

=
6708 . 0
225 . 0 35 . 0 5267 . 0 + +
= 1.6423
d
2
= 1.6423 0.6708 = 0.9715
Using the standard normal distribution tables:
d
1
= 1.6423 gives 0.4495; thus N(d
1
) = 0.5 + 0.4495 = 0.9495
d
2
= 0.9715 gives 0.3340; thus N(d
2
) = 0.5 + 0.3340 = 0.8340
c = (254 x 0.9495) (150 x 0.8340 x e
-0.07 x 5
)
= 241.173 (150 x 0.8340 x 0.7047)
= 241.173 88.156 = 153.017
Secondly, using the put call parity relationship, calculate the value of the put option
p = c - P
a
+ P
e
e
-rt

= 153.017 254 + (150 x 2.7183
-0.07 x 5
)
= 153.017 254 + 105.703
= 4.72m
Alternatively, it is possible to directly calculate the value of the put option using the
following modified Black-Scholes formula, but this is not provided on the ACCA
formula sheet:
p = P
e
N( d
2
)e
-rt
P
a
N( d
1
)
where:
N( d
1
) = 0.5 0.4495 = 0.0505
N( d
2
) = 0.5 0.3340 = 0.166
p = (150 x 0.166 x 2.7183
-0.35
) (254 x 0.0505)
= (150 x 0.166 x 0.7047) 12.827
= 17.547 12.827
= 4.72m
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Conclusion:
m
NPV of joint venture project 4
Value of put option (to abandon joint
venture)
4.72
Total NPV with the abandonment option +8.72
Therefore Summer plc should go ahead with the joint venture, since the additional
value, which incorporates the option to abandon allows Summer plc to avoid the
downside element of risk.

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APPLYING THE BLACK SCHOLES MODEL TO ESTIMATE
THE VALUE OF EQUITY
A major aspect of the P4 syllabus is the emphasis on corporate valuation. There
may, of course, be some companies that cannot realistically be valued by
conventional techniques.
The Black Scholes Option Pricing (BSOP) model provides a basis for corporate
valuation in cases where traditional methods are either inappropriate, or where
they fail to fully reflect the risks involved. Some authors refer to the Black Scholes
Merton model to reflect the work performed by Robert Merton (a key member of
the research team which developed the model).
The usual determinants in the valuation of options need to be redefined, when the
valuation of equity is treated as a call option:
Determinants Possible appropriate measures
Valuation of the underlying The fair value of the assets of the company
Exercise price Settlement values of outstanding liabilities
Volatility of the underlying Standard deviation of underlying assets
Risk-free rate of interest Current yield on company debt
Time to expiry Average period to settlement of company liabilities
Where the assets of the company are actively traded and easily liquidated, their
current market value would be appropriate. In the case of most companies, fair
value will normally be based upon the present value of the future cash flows that
the companys assets are expected to generate over their useful lives.
The volatility of the underlying assets is likely to be the most difficult measure to
estimate accurately. One approach is to estimate the probabilities of the likely
future cash flows of the company and generate a distribution of their present values
from which a standard deviation could be established.
A possible approach to the determination of an exercise price is to assume that the
companys liabilities consist entirely of debt in the form of a zero coupon bond. If
the companys debt includes other types of bond, adjustments are necessary as
shown in the following illustration.
Illustration 1
A company has on issue a 5% bond with five years to redemption with a gross yield
to maturity of 8%.
Required:
Estimate the market value of that bond and that of an equivalent zero coupon
bond.
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CHAPTER 16 FUTURES AND OPTIONS
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Solution 1
The market value of the debt is estimated as follows:
Year 1 2 3 4 5
Annual interest and redemption payments () 5 5 5 5 105
Discount factors @ 8% 0.926 0.857 0.794 0.735 0.681
Present values () 4.63 4.29 3.97 3.67 71.50
Present value of debt = 88.06
The redemption value of a zero coupon bond of the same market value is calculated
by establishing the unknown future value which (when discounted at 8% p.a. for a
five year period) provides a present value of 88.06 i.e.
Future value = 88.06 x 1.08
5
= 129.39
Therefore 129.39 is treated as the exercise price (i.e. the redemption value of a
zero coupon bond with the same features as the debt currently in issue, which has
a yield to maturity of 8%).
Assuming that acceptable estimates of the input variables have been established,
the next step is to incorporate them into the BSOP model. The model does have a
number of restricting assumptions, but it can be used to produce an acceptable
valuation of a company.
Illustration 2
In March 2007, Northern Rock (a UK bank) reported assets and liabilities at fair
values of 113.2 billion and 110.7 billion respectively. The average term to
maturity on the liabilities of the bank (which consisted of short-term money market
borrowing and deposits) was 100 trading days, whilst the annual number of trading
days was 250 approximately. At that time the risk-free rate of interest was 3.5%
and the company had 495.6 million equity shares in issue.
Required:
(a) Using the BSOP (sometimes referred to as the Black Scholes Merton) model,
estimate the share price of Northern Rock in each of the following situations:
(i) Assuming that the standard deviation of the banks assets was 5%; and
(ii) Assuming that the volatility of the banks assets was 10%.
(b) Using the Black Scholes Merton model, recalculate an estimate of the share
price of Northern Rock if the fair value of the companys assets fell to 110.7
billion and their volatility was 5%.
(c) Comment upon the results and consequences of the calculations performed in
parts (a) and (b) above.
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Solution 2
This entire procedure is based on the notion that if equity shareholders pay off the
liabilities at expiry date, they are effectively paying the exercise price of a call
option and thus exercising their right to buy the underlying assets of the company
at their fair value.
Taking the data provided and converting to the ACCA symbols:
(a)
P
a
= 113.20; P
e
= 110.70; r = 0.035; t = (100 250) = 0.4 (since
the annual number of trading days is 250); s is initially taken as 0.05 and,
subsequently as 0.1
(i) If volatility (s or ) = 0.05:
d
1
=
( ) ( )
4 . 0 05 . 0
4 . 0 05 . 0 5 . 0 035 . 0 70 . 110 20 . 113 ln
2
+ +

=
0316227 . 0
0005 . 0 014 . 0 0223323 . 0 + +

=
0316227 . 0
0368323 . 0
= 1.16474
d
2
= 1.16474 - 0.0316227 = 1.13312

From Normal Distribution tables:
d
1
= 1.16474, by interpolation:
1.16 gives 0.3770
1.17 gives 0.3790
1.16 gives 0.3770
(474 1000) x 0.0020 = 0.00095
0.37795
d
2
= 1.13312, by interpolation:
1.13 gives 0.3708
1.14 gives 0.3729
1.13 gives 0.3708
(312 1000) x 0.0021 = 0.00065
0.37145
Of course, in an exam it is quicker to round up or down to the two decimal
places provided by the ACCA tables. In this case, 1.16 (giving 0.3770) and
1.13 (giving 0.3708) would be used!
N(d
1
) = 0.5 + 0.37795 = 0.87795
N(d
2
) = 0.5 + 0.37145 = 0.87145
c = (113.20 x 0.87795) (110.70 x 0.87145 x e
-0.035 x 0.4
)
= 99.384 (110.70 x 0.87145 x 0.98610)
= 99.384 95.128 = 4.258 bn
Price = (4.258 bn 495.6 m shares) = 8.59 per share
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(ii) If volatility (s or ) = 0.1:
d
1
=
( ) ( )
4 . 0 1 . 0
4 . 0 1 . 0 5 . 0 035 . 0 70 . 110 20 . 113 ln
2
+ +

=
0632455 . 0
002 . 0 014 . 0 0223323 . 0 + +

=
0632455 . 0
0383323 . 0
= 0.60609
d
2
= 0.60609 0.0632455 = 0.54284

From Normal Distribution tables:
d
1
= 0.60609, by interpolation:
0.60 gives 0.2257
0.61 gives 0.2291
0.60 gives 0.2257
(609 1000) x 0.0034 = 0.00207
0.22777
d
2
= 0.54284, by interpolation:
0.54 gives 0.2054
0.55 gives 0.2088
0.54 gives 0.2054
(284 1000) x 0.0034 = 0.00097
0.20637
Again, in an exam it is quicker to round up or down to the two decimal places
provided by the ACCA tables. In this case, 0.61 (giving 0.2291) and 0.54
(giving 0.2054) would be used!
N(d
1
) = 0.5 + 0.22777 = 0.72777
N(d
2
) = 0.5 + 0.20637 = 0.70637
c = (113.20 x 0.72777) (110.70 x 0.70637 x e
-0.035 x 0.4
)
= 82.3836 (110.70 x 0.70637 x 0.98610)
= 82.3836 77.1082 = 5.2754 bn
Price = (5.2754 bn 495.6 m shares) = 10.64 per share

(b)
In this instance, the asset value (P
a
) falls and is now equal to the liability value (at
a volatility of 0.05), so that both P
a
and P
e
become 110.70. All other facts are
unchanged.
The calculations are:
d
1
=
( ) ( )
4 . 0 05 . 0
4 . 0 05 . 0 5 . 0 035 . 0 70 . 110 70 . 110 ln
2
+ +

=
0316227 . 0
0005 . 0 014 . 0 0 + +

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=
0316227 . 0
0145 . 0
= 0.45853
d
2
= 0.45853 0.0316227 = 0.42691

From Normal Distribution tables:
d
1
= 0.45853, by interpolation:
0.45 gives 0.1736
0.46 gives 0.1772
0.45 gives 0.1736
(853 1000) x 0.0036 = 0.0031
0.1767
d
2
= 0.42691, by interpolation:
0.42 gives 0.1628
0.43 gives 0.1664
0.42 gives 0.1628
(691 1000) x 0.0036 = 0.0025
0.1653
Once more, in an exam it is quicker to round up or down to the two decimal places
provided by the ACCA tables. In this case, 0.46 (giving 0.1772) and 0.43 (giving
0.1664) would be used!
N(d
1
) = 0.5 + 0.1767 = 0.6767
N(d
2
) = 0.5 + 0.1653 = 0.6653
c = (110.70 x 0.6767) (110.70 x 0.6653 x e
-0.035 x 0.4
)
= 74.9107 (110.70 x 0.6653 x 0.98610)
= 74.9107 72.6250 = 2.29 bn
Price = (2.29 bn 495.6 m shares) = 4.62 per share
(c) Comments
As can be seen from the calculations in part (a), the value of an option increases as
the level of risk rises. At a standard deviation of 5%, the share price is 8.59,
whilst at a volatility of 10%, the share price rises to 10.64. The actual share price
of Northern Rock in March 2007 fluctuated around 9.50 per share.
In part (b) of this illustration, the fair value of the banks assets fell to 110.7
billion to be equal to the fair value of its liabilities. Accordingly, the Statement of
financial position would show an equity value of zero. However, the BSOP model
shows a quite different result, at a volatility of 5% the total value of the equity is
still worth 2.29 billion, that is 4.62 per share almost precisely its value in
September 2007!
At this date, the information being released from the company suggested that its
assets had fallen in value as the banks mortgage receivables were written down in
line with falling house prices and potential defaults.
It was only when the threat of nationalisation became a real possibility (during the
final months of 2007) that the equity value began to collapse - and this can be
explained within the framework of the BSOP model. Nationalisation eliminates the
possibility of asset recovery for the shareholders. This deprives them of the time
value on their call option on the underlying assets of the business.
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The rationale for this rather strange result is that the equity of a business can still
have a substantial positive value (despite the Statement of financial position
showing a zero equity value) because of the presence of limited liability!
Limited liability protects shareholders from a loss - and in fact they have everything
to gain if the fair value of the assets should recover! When the equity of a
company is at or near the money, ie when its gearing levels approach 100%, the
equity investors will become increasingly risk aggressive (i.e. risk-seeking). Agency
theory suggests they will provide management with incentives to increase risk,
rather than reduce it. Hence, the very high levels of reward offered to bank
employees, particularly those employed in the risk-taking departments of the
business.
The work of Black, Scholes and Merton provides a framework to value those
companies that are financed, in part, by borrowing. Where shareholders are
protected by limited liability, they have a call option on the underlying business
assets. Employing the BSOP model, an estimate can be made of the value of a
companys equity on the basis of the value of its assets and their volatility.
For companies that are deep in-the-money, time value is small and the intrinsic
value of the business (i.e. the present value of the net assets) will dominate the
value of the equity. In this case, normal risk aversion can be expected to apply as
that intrinsic value will be exposed to equal positive and negative movements in the
value of the companys assets.
This situation dramatically changes when companies are near-the-money. This
occurs with high growth start-ups financed by debt, leveraged buyouts and
companies that are in risk of default.
One class of company (banks) always operate near-the-money, and in valuing
such businesses, time value would be more significant than intrinsic value in equity
valuation.
When time value dominates, shareholders become risk-seekers and they will grant
management incentives to take greater risk, which will cause the company to be
pushed closer and closer to-the-money, by expanding assets and liabilities
without increasing the equity capital.
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LIFFE EQUITY OPTIONS TABLE




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Chapter 17
Hedging interest
rate risk



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CHAPTER CONTENTS
METHODS OF HEDGING INTEREST RATE RISK ---------------------- 377
FORWARD RATE AGREEMENTS (FRA) 377
INTEREST RATE GUARANTEES (IRG) 377
INTEREST RATE FUTURES 378
OPTIONS ON INTEREST RATE FUTURES 379
THE MACAULAY DURATION METHOD --------------------------------- 401
TERM STRUCTURE OF INTEREST RATES ------------------------------ 404
THE NORMAL YIELD CURVE 404
THE INVERSE YIELD CURVE 405


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METHODS OF HEDGING INTEREST RATE RISK
There are a number of methods that may be used by a company to reduce its
exposure to possible adverse fluctuations in interest rates, in either a borrowing or
lending arrangement.
The main methods are as follows:
Forward rate agreements (FRA)
A forward rate agreement allows a company to effectively agree with a banker a
fixed interest rate for a specified level of borrowing or lending for a given future
period.
An FRA is commonly quoted so as to specify the number of months hence when the
borrowing or lending starts and the number of months hence when it finishes. For
instance, where a company wishes to borrow for a five month period starting in two
months time, this would require a 2 v.7 FRA, i.e. the borrowing will start in two
months time and end in seven months time.
Accordingly, a company which has borrowed at a floating rate of interest may enter
into an FRA, which effectively locks the company into a fixed rate of interest.
Whatever happens, the company will continue to pay its original lender the
appropriate amount of interest based upon the agreed floating rate.
However, if actual interest rates rise higher than the percentage agreed under the
FRA, the bank will pay the amount of the difference as compensation to the
company. If rates fall lower than agreed, the company must pay the difference as
compensation to the bank.
Conversely a lender (i.e. investor) may enter into a similar agreement. If actual
floating interest rates fall below the agreed fixed percentage, the bank will pay the
difference to the company. If rates rise above that specified in the FRA, the
company must pay the difference to the bank.
FRAs involve no borrowing or lending of the principal sum. They are usually for at
least 500,000 (or the equivalent in major currencies) and for periods of less than
one year.
Interest rate guarantees (IRG)
An interest rate guarantee is an interest rate option specifically arranged with a
bank, i.e. it is an over-the-counter (OTC) product. An IRG provides the right, but
not the obligation, to pay or receive a fixed specified rate of interest for a defined
period of time. Accordingly, it would provide a borrower with the assurance of
never paying more than a maximum interest rate (a cap) or give an investor the
peace of mind of never earning less than a minimum interest rate (a floor).
However, an IRG, like all options will allow the buying company to take advantage
of favourable movements in interest rates.
An interest rate guarantee therefore gives the best of both worlds, in that if a
borrower purchases such an option, it will be exercised if rates rise above the
guaranteed percentage, but will be abandoned if rates fall below that percentage,
so that the borrower will be able to take advantage of the lower market interest
rates.
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Equally, if an investor buys an interest rate guarantee, it will be exercised if rates
fall below the guaranteed percentage, but will be allowed to lapse if rates rise
above that percentage, so that the investor can take advantage of the higher
market interest rates.
The opportunity to abandon the arrangement is not available with FRAs or the
futures market. However this advantage must be weighted against the price of the
option (the premium) which must be paid up-front to the bank. Many companies
consider that they are too expensive since a significant premium is payable.
Interest rate futures
An interest rate future is a binding contract between a buyer and a seller for
delivery of an agreed interest rate commitment on an agreed date and at an agreed
price. It can be used to protect against unwanted interest rate movements.
For example, if a borrower is worried about interest rates rising, it may sell interest
rate futures, knowing that if interest rates do rise, the price of the futures will fall,
allowing the borrower to buy them back at a lower price. The gain on the futures
market can be offset against the additional interest suffered. The reverse happens
if interest rates fall. This will have the effect of more or less fixing the effective
interest rate paid by the borrower.
Equally, if an investor is concerned about interest rates falling, it may buy interest
rate futures, knowing that if interest rates do fall, the price of the futures will rise,
allowing the investor to sell them at a higher price. The gain on the futures market
can be added to the smaller amount of interest actually earned. The reverse
happens if interest rates rise. This again has the effect of more or less fixing the
effective interest rate received by the investor.
Each futures exchange has a Clearing House. When a futures deal has been made
the Clearing House assumes the role of counterparty to both the buyer and the
seller. Thus the buyer has effectively bought from the Clearing House, whilst the
seller is treated as having sold to the Clearing House, thus removing the risk of
default on the futures contract.
When a deal has been made, both buyer and seller are required to pay margin to
the Clearing House. This sum of money must be deposited (and maintained) in
order to provide protection to both parties.
Initial margin (of between 5% and 10% of contract value) is the sum deposited
when the contract is first made. Variation margin is payable or receivable to
reflect the day-to-day profits or losses made on the futures contract. If the futures
price moves adversely a cash payment must be made to the Clearing House, whilst
if the futures price moves favourably the party concerned can elect to receive a
cash refund from the Clearing House. This process of realising profits or losses on
a daily basis is known as marking to market.
Contract sizes are for fixed sums, e.g. 500,000 for short sterling contracts, which
means that a perfect hedge is difficult to achieve.
A further reason why a perfect hedge is unlikely is basis risk i.e. the possibility of
variability in the prices of the two related securities in the hedging arrangement.
For example, if changes in the price of the interest rate future do not perfectly
match the changes in the rate of interest, a profit or loss may occur on the hedge
position.
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Futures contracts are available from LIFFE (London International Financial Futures
and Options Exchange). In 2002, LIFFE was taken over by Euronext and is now
known as Euronext.liffe.
Options on interest rate futures
These exchange traded instruments provide the buyer with the right, but not the
obligation to buy or sell the related interest rate futures contract. Once more, the
objective is to protect the buyer of the instrument against unwanted interest rate
movements.
LIFFE deals in option contracts in standard amounts (e.g. 500,000 for short
sterling contracts), at standard exercise prices and expiry dates. These traded
options are of two kinds:
o put options carry the right to sell the related interest rate futures
contract, and
o call options carry the right to buy the related interest rate futures
contact.
LIFFE offers these option contracts at a limited number of different exercise (strike)
prices. The buyer of the option is required to pay a non-refundable option
premium for the flexibility of being allowed to exercise or abandon the option.
This premium is the maximum that the buyer can lose on the deal. A writer
receives the premium for having taken on the obligation to go through with the deal
should the buyer so elect. The writer of an option risks potentially unlimited losses.
Borrowers
If a borrower is worried about interest rates rising, but is not totally convinced that
they will in fact do so, he may decide to buy put options.
If interest rates do subsequently increase, the borrower can exercise the put option
and thus sell the related interest rate futures contract, then immediately buy it
back at a profit. This gain will obviously offset the additional interest payment
suffered on the amount of the borrowing.
Should interest rates subsequently remain steady or indeed fall, the borrower would
then allow the put option contracts to lapse.
Investors
If an investor is fearful that interest rates will fall, but is not totally convinced that
they will in fact do so, he may decide to buy call options.
If interest rates do subsequently decline, the investor will exercise the call option
and thus buy the interest rate futures contract, then immediately sell it at a profit.
This gain will of course compensate for the smaller amount of interest received on
the investment.
Should interest rates subsequently remain steady or actually increase, the investor
would then abandon the call option contracts.
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Illustration 1
It is now 31 December 2006. The corporate treasurer of Tripod plc is concerned
about the level of cash flows of the company during the next six months, and how
the company might be protected from the adverse effects of changing interest
rates. Interest rates are widely expected to change in late April when a General
Election is due, but the size and direction of the change is dependent upon the
result of the election which is forecast by opinion polls to be very close. Current
interest rates for Tripod are 11% per year for short-term borrowing, and 8% per
year for short-term investment.
Apart from an overdraft facility to finance short-term cash shortages, the company
has no other form of floating rate debt.
Cash forecasts reveal that the company expects to have a fairly consistent
overdraft level of approximately 2,420,000 between the end of April and the end
of June 2007.
June sterling three months deposit futures are currently priced at 90.25. The
standard contract size is 500,000 and the minimum price movement is one tick
(the value of one tick is 0.01% per year of the contract size).
Interest rate guarantees at 11.5% per year for a two month period from May are
available to Tripod for a premium of 0.2% of the size of the loan to be guaranteed.
Forward rate agreements are available for period of up to four months from May at
11.88-11.83%.
Required:
If at the end of April, interest rates have moved as follows:
Scenario (1)
Borrowing rate for Tripod 13% per year
Investment rate for Tripod 10% per year
June sterling three month time deposit futures 88.05
Scenario (2)
Borrowing rate for Tripod 9.5% per year
Investment rate for Tripod 6.8% per year
June sterling three month time deposit futures 91.75,
evaluate with hindsight, separately for each of scenarios (1) and (2) above, the
results of four alternative strategies that the company might have adopted towards
its interest rate risk.
Taxation, margin requirements and the time value of money may be ignored.
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Solution 1
Four strategies that the company could adopt are as follows:
1. Adopt no protective strategy on the basis that the companys exposure to
adverse rate movements may be negligible;
2. Enter into forward rate agreements (FRAs) with bank;
3. Use interest rate guarantees; or
4. Use sterling three month interest rate futures.
Each of these strategies is considered in turn.
Tutorial note: since the question only gives data for the prices of FRAs, interest rate
guarantees and futures we have no choice but to select these strategies. There is
no further information on the fourth strategy, so it must be to do nothing. The risk
exposure from interest rates is sometimes very small. Given that rates can move
favourably as well as unfavourably, it may be appropriate for no complex hedging
strategy to be adopted. The cost of a hedging strategy might be avoided if the risk
of adverse movements were minimal.
1. No hedge
Scenario I
May and June interest = 2.42m x 13% x 2/12 = 52,433
Scenario II
May and June interest = 2.42m x 9.5% x 2/12 = 38,317
2. Use an FRA
(A 4 v. 6 FRA is needed i.e. one starting 4 months hence and ending in 6 months
time)
Scenario I

Cost in cash market = 2.42m x 13% x 2/12 = 52,433
Less compensation
paid by the bank to
Tripod
2.42m x (11.88% 13%) x 2/12 = (4,517)
May and June interest = 2.42m x 11.88% x 2/12 = 47,916
Scenario II

Cost in cash market = 2.42m x 9.5% x 2/12 = 38,317
Plus compensation
paid by Tripod to the
bank
2.42m x (11.88% 9.5%) x 2/12 = 9,599
May and June interest = 2.42m x 11.88% x 2/12 = 47,916
(Tutorial note: once the FRA has been entered into, the interest paid by the
company for the two months will be 47,916, whatever the prevailing level of
interest rates).
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3. Interest rate guarantee
Scenario I
Premium payable = 0.2% x 2.42m = 4,840
Interest payable = 2.42m x 11.5% x 2/12 = 46,383
Total cost of strategy = 4,840 + 46,383 = 51,223
Scenario II
Premium payable = 4,840 (as above)
This time the option will be abandoned, so the company can enjoy the lower
prevailing interest rate.
Interest payable = 2.42m x 9.5% x 2/12 = 38,317
Total cost of strategy = 4,840 + 38,317 = 43,157
4. Use futures
Scenario I
Cash market: May and June interest, as i) above = 52,433
In December, the company wants to hedge for two months an amount of 2.42m
using three month futures contracts each of 500,000.
Therefore need to sell
m 5 . 0
m 42 . 2
3
2
= 3.22 contracts
We may choose to round down to 3 contracts see result in the Summary shown
below. However, rounding up, the company must sell 4 contracts to be fully
hedged.
Profit on the futures contracts = 4 x (90.25 88.05)
= 4 x 220 ticks
= 4 x 220 x 12.50*
= 11,000
The net interest payable is 52,433 11,000 = 41,433
*Note: one tick is valued at 0.0001 x 500,000 x 3/12 = 12.50
Scenario II
Cash market: May and June interest, as i) above = 38,317
Loss on the futures contracts = 4 x (91.75 90.25)
= 4 x 150 ticks
= 4 x 150 x 12.50
= 7,500
The net interest payable is 38,317 + 7,500 = 45,817
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SUMMARY
Scenario I Scenario II

No hedge 52,433 38,317
FRA 47,916 47,916
Interest rate guarantee 51,223 43,157
Futures
Using 3 contracts 44,183 43,942
Using 4 contracts 41,433 45,817
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Illustration 2
The corporate treasury team of Murwald plc are debating what strategy to adopt
towards interest rate risk management. The companys financial projections show
an expected cash deficit in three months time of 12 million, which will last for a
period of approximately six months. Base rate is currently 6% per year, and
Murwald can borrow at 1.5% over base, or invest at 1% below base. The treasury
team believe that economic pressures will soon force the European Central Bank to
raise interest rates by 2% per year, which could lead to a similar rise in UK interest
rates. The European Central Bank move is not certain, as there has recently been
significant pressure from certain European Union countries not to raise interest
rates.
In the UK, the economy is still recovering from a recession and representatives of
industry are calling for interest rates to be cut by 1%. Opposing representations
are being made by pensioners, who do not wish their investment income to fall
further due to an interest rate cut.
The corporate treasury team believes that interest rates are more likely to rise than
to fall, and does not want interest payments during the six month period to
increase by more than 10,000 from the amounts that would be paid at current
interest rates. It is now 1 December.
Liffe prices (1 December)
Futures: LIFFE 500,000 three month sterling interest rate (points of 100%)
December 93.75
March 93.45
June 93.10
Options: LIFFE 500,000 short sterling options (points of 100%)
Calls Puts
Exercise price June June
9200 3.33 -
9250 2.93 -
9300 2.55 0.92
9350 2.20 1.25
9400 1.74 1.84
9450 1.32 2.90
9500 0.87 3.46
Required:
(a) Illustrate the results of futures and options hedges if, by 1 March:
(i) Interest rates rise by 2%. Futures prices move by 1.8%
(ii) Interest rates fall by 1%. Futures prices move by 0.9%
Recommend with reasons, how Murwald plc should hedge its interest rate
exposure. All relevant calculations must be shown. Taxation, transactions
costs and margin requirements may be ignored. State clearly any
assumptions that you make.
(b) Discuss the advantages and disadvantages of other derivative products that
Murwald might have used to hedge the risk.
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Solution 2
(a) The treasury team believe that interest rates are more likely to increase than
to decrease, and any hedging strategy will be based upon this assumption.
There is also a requirement that interest payments do no increase by more
than 10,000 from current interest payments.
Current expectations
12m deficit: interest payments 12m x (6% + 1.5%) x 6/12 = 450,000
Using futures hedges (Either March or June contracts may be used or
both).
The suggested solution uses June contracts.
(i) If interest rates rise
With an expected 12m deficit using June contracts
As a six month hedge is required the number of contracts sold will be:
months 3
months 6
000 , 500
m 12
= 48 contracts
The tick value is
12
3
000 , 500 0001 . 0 = 12.50
Cash market Futures market
Current cost = 450,000 Dec 1: Sell 48 three month
sterling futures at 93.10
With 2% increase
12m x 9.5% x 6/12 = 570,000 After interest rate increase:
Buy 48 three month sterling
futures at (93.10 1.80) =
91.30
Extra cash market cost = 120,000
Futures gain: 48 x 180
#
x
12.50 = 108,000
#
(100 x 1.80) = 180 ticks
Net additional cost after hedging = 12,000
If Murwald expects basis risk to exist (i.e., the futures price moves by a
different amount to the cash market interest rates), the number of
contracts could be modified to reflect such risk:
i.e.
% 8 . 1
% 2
48 = 53.3 contracts
then 53.3 x 180 x 12.50 = 120,000.
However, basis risk is difficult to predict.
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(ii) If interest rates fall
With an expected 12m deficit
Cash market Futures market
Current cost = 450,000 Dec 1: Sell 48 contracts at
93.10
With 1% decrease After interest rate decrease:
12m x 6.5% x 6/12 = 390,000 Buy 48 three month sterling
futures at (93.10 + 0.90) =
94.00

Cash market saving = 60,000 Futures loss 48 x 90* x
12. 50= 54,000
*
(100 x 0.90) = 90 ticks
Overall net extra saving = 6,000
Based upon these futures prices, hedging in the futures market does not
allow the company to guarantee that interest costs (in the case of a
deficit) do not increase by more than 10,000.
Using option hedges
The expectation is for interest rates to rise, therefore put options on futures
will be purchased.
N.B. Since Murwald may want the right to sell futures, put options must be
bought. (If interest rates rise the value of the put options will also increase)
For example, using the 9400 exercise price:
(i) If interest rates rise
With an expected 12m deficit
Cash market Options market
Current cost = 450,000 Dec 1: Buy 48 9400 puts at 1.84
With 2% increase After interest rate increase:
Cost (see above) = 570,000 The option may be exercised to sell
June futures at 94.00

Extra cash market
cost
= 120,000 June futures may be purchased on
LIFFE at (93.10 1.80) = 91.30
Profit from options is:
94.00 (91.30 + 1.84) = 0.86
(0.86 x 100) = 86 ticks
48 x 86 x 12.50 = 51,600
Overall net extra cost = 68,400
In reality the options are likely to be sold rather than exercised, as being
June contracts they will still have time value which will be reflected in the
option price. The gain from the options sale is therefore likely to be
higher than the gain from exercising the options. However, no data is
provided on option prices on 1 March.
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(ii) If interest rates fall
With an expected 12m deficit
Cash market Options market
Current cost = 450,000 Dec 1: Sell 48 contracts at
93.10
With 1% decrease After interest rate decrease:
Cost (see above) = 390,000 The futures price moves to
(93.10+ 0.90) = 94.00 and
the option would not be
exercised

Cash market saving = 60,000 The loss on options is the
premium paid 48 x 184
#
x
12.50 = 110,400
#
(100 x 1.84) = 184 ticks
Overall net extra cost = 50,400
Summary
Futures Options

2% interest rate increase
on 12m deficit
(12,000) (68,400)
1% interest rate decrease
on 12m deficit 6,000 (50,400)
Different option outcomes will exist if different put option exercise prices are
selected. The best exercise price to select if the put options are used
will be the 9350 option:
This will give a gain if exercised of:
93.50 (91.30 + 1.25) = 0.95 or 95 ticks
i.e. 48 contracts x 95 ticks x 12.50 = 57,000
If the futures price moves to 94.00, the option will not be exercised, and the
loss will be the premium paid of:
(1.25 x 100) i.e. 125 ticks x 48 contracts x 12.50 = 75,000
Outcomes using 9350 options:
Cash market Options market

2% increase (120,000) + 57,000 = (63,000)
1% decrease 60,000 + (75,000) = (15,000)
Neither futures nor options hedges can satisfy, with certainty, the requirement
that the interest payment should not increase by more than 10,000.
However, one way to achieve this would be to use a collar option, whereby
downside risk is protected, but potential gains are also restricted. A collar
effectively fixes both a maximum and a minimum interest rate.
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If a company expects to be borrowing and is worried about interest rate
increases, a suitable collar can be achieved by buying put options and selling
(or writing) call options, to reduce the cost of protection.
For example, a collar could be achieved by buying 48 9400 put options at
1.84 and selling 48 9400 call options at 1.74, a net premium cost of 0.10
(N.B. other alternatives are possible).
Murwald does not want interest to move adversely by more than 10,000 for
a six month period on a 12 million loan.
In annual terms this is
months 6
months 12
m 12
000 , 10
= 0.167% p.a.
A put option at the current interest rate (6%) and a total premium cost of less
than 0.167% will satisfy the companys requirement. In the above example,
the total premium cost is 0.10%, and no matter what happens to interest
rates Murwald can fix its borrowing cost at 7.6% p.a. that is:
Interest rate implied by 9400 exercise price %
(100 94.00) 6.0
Risk premium 1.5
Net option premium paid (1.84 1.74) 0.1
Borrowing cost p.a. 7.6%
This satisfies the requirement. Interest payments would be 12m x 7.6% x
6/12 = 456,000, which is only 6,000 higher than the current interest
payment.
The use of a collar is thus the recommended hedging strategy.
(b) Alternative interest rate hedges include:
Forward rate agreements (FRAs)
Over-the-counter (OTC) interest rate options including interest rate
guarantees
Interest rate swaps.
1. A forward rate agreement is a contract to agree to pay a fixed
interest rate that is effective at a future date. As such Murwald could
fix now a rate of interest of 6.1% (for example) to be effective in three
months time for a period of six months.
If interest rates were to rise above 6.1%, the counter-party (usually a
bank) would compensate Murwald for the difference between the actual
rates and 6.1%. If interest rates were to fall below 6.1%, Murwald
would compensate the counter-party for the difference between 6.1%
and the actual rate.
2. OTC options. Instead of market traded interest rate options such as
those that are available on LIFFE, Murwald might use OTC options
through a major bank. This would allow options to be tailored to the
companys exact size and maturity requirements. An OTC collar would
be possible, and the cost of this should be compared with the cost of
using LIFFE options. Interest rate options for periods of less than one
year are sometimes known as interest rate guarantees.
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3. Interest rate swaps. Murwald expects to borrow at a floating rate of
interest. It might be possible for Murwald to swap its floating rate
interest stream for a fixed rate stream, pegging interest rates to
approximately current levels (the terms of the swap would have to be
negotiated). Interest rate swaps are normally for longer periods than
six months.
Solutions could also have made reference to Swaptions. A Swaption is a option to
enter into an interest rate swap. Murwald could purchase such an instrument,
which gives the right but not the obligation to enter into a swap within a
predetermined period. The premium would be relatively high in cases where there
was a general expectation of interest rate rises and furthermore the arrangement
may not satisfy the financial objectives set by Murwald.
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Illustration 3
It is now 31 October. Barney plc wishes to borrow 20 million on 1 March next
year for a period of six months, but wishes to protect itself against market interest
rates rising above the current LIBOR (London Inter Bank Offered Rate) of 6%.
Barney plc can borrow at LIBOR +2%.
LIFFE three month Sterling futures: 500,000 contract size, 12.50 tick size
December 93.95
March 93.90
June 93.85
LIFFE option price on the appropriate three months Sterling futures: 500,000
contract size, 12.50 tick size
Calls Puts
Strike price Dec Mar June Dec Mar June
9375 0.18 0.35 0.46 0.14 0.25 0.42
9400 0.07 0.22 0.33 0.28 0.37 0.54
9425 0.02 0.13 0.23 0.48 0.53 0.69
Required:
Using interest rate options, calculate the outcome of the hedge if interest rates and
futures prices were to move on 1 March next under each of the following scenarios:
SCENARIO ONE: LIBOR falls by 2% and the relevant futures price rises to 95.90
SCENARIO TWO: LIBOR rises to 9% and the relevant futures price falls to 91.20
SCENARIO THREE: LIBOR rises by 100 basis points and the change in the futures
price reflects no basis risk.
Note:
Assume that interest rates charged by the bank remain constant following the
interest rate change.
Ignore margin requirements
Do NOT employ collars or similar option combinations.
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Solution 3
To protect against interest rates rising above current LIBOR, Barney plc (a
borrower) will need to buy put option contracts at a (100 6) 9400 exercise price.
December contracts will expire before the borrowing starts, therefore March or June
contracts are suitable. March contracts are preferred due to their cheaper
premium.
No. of contracts needed
months 3
months 6
000 , 500
m 20
= 80 contracts
The premium payable on exercise or expiry for March 9400 puts is (0.37 x 100) =
37 ticks. Thus, the total premium is 80 contracts x 37 ticks x 12.50 = 37,000.
Scenario one

Cash market saving (2% x 6/12 x 20m) 200,000
Options market
NOW: Buy 80 March put option contracts at 9400
exercise price

AFTER THE INTEREST RATE CHANGE:
Abandon the option (since Barney would not
wish to sell at 94.00, then buy at 95.90)

Loss is the premium paid - as above (37,000)
NET GAIN 163,000
Scenario two

Cash market loss (3% x 6/12 x 20m) (300,000)
Options market
NOW: Buy 80 March put option contracts at 9400
exercise price

AFTER THE INTEREST RATE CHANGE:
1. Exercise and sell at 94.00
2. Then buy at (91.20)
2.80
less premium (0.37)
2.43 x 100
= 243 ticks
Profit (80 contracts x 243 ticks x 12.50) 243,000
NET LOSS (57,000)
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Scenario three (100 BASIS POINTS = 1%)

Cash market loss (1% x 6/12 x 20m) (100,000)
Options market
NOW: Buy 80 March put option contracts at 9400
exercise price

AFTER THE INTEREST RATE CHANGE:
1. Exercise and sell at 94.00
2. Then buy at (93.90 1.00) (92.20)
1.10
less premium (0.37)
0.73 x 100
= 73 ticks
Profit (80 contracts x 73 ticks x 12.50) 73,000
NET LOSS (27,000)
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Illustration 4
It is now 31 December 2006 and the corporate treasurer of Omniown plc is
concerned about the volatility of interest rates. His company needs to immediately
borrow 5,000,000 for a six month period. Current interest rates are 14% per year
for the type of loan Omniown would use, and the treasurer does no wish to pay
more than this. He is considering using either:
(i) A forward rate agreement (FRA), or
(ii) Interest rate futures, or
(iii) An interest rate guarantee
(a) Explain briefly how each of these three alternatives might be useful to
Omniown plc.
(b) The corporate treasurer of Omniown plc expects interest rates to increase
by 2% almost immediately and has decided to hedge the interest rate risk
using interest rate futures.
June sterling three months time deposit futures are currently priced at 86.25.
The standard contract size is 500,000 and the minimum price movement is
one tick (the value of one tick is 0.01% per year of the contract size).
Required:
Illustrate the results of using a futures hedge under each of the following
three scenarios, if for the entire six month period:
(i) Interest rates increase by 2% and the futures market price also moves
by 2%.
(ii) Interest rates increase by 2% and the futures market price moves by
1.5%.
(iii) Interest rates fall by 1% and the futures market price moves by 0.75%
Ignore taxation, margin requirements, and the time value of money.
(c) As an alternative to interest rate futures, the corporate treasurer has been
able to purchase interest rate guarantees at a rate of 14% per annum for a
premium of 0.2% of the size of the loan to be guaranteed.
Required:
Calculate whether the total cost of the loan after hedging in each of the three
scenarios in (b) above would have been cheaper or more expensive with the
futures hedge than with the interest rate guarantee. The guarantee would be
effective for the entire six month period of the loan.
Ignore taxation, margin requirements, and the time value of money.
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Solution 4
(a) Explanation of the three alternative hedging strategies
(i) Forward rate agreements
A forward rate agreement is a contract between a company and a bank
which sets the interest rate on future borrowings (or deposits). A
company can make a FRA with a bank that fixes the rate of interest to
be paid at a certain time in the future. If the actual interest rate at the
time is higher than that agreed, the bank pays the difference; if it is
lower than the rate agreed then the company pays the difference. A
FRA does not affect the principal sum. The actual borrowing itself must
be arranged separately either with the same bank as the FRA is
organised or with a different bank.
A FRA could be useful to Omniown since the treasurer will know in
advance what the loan is going to cost. The minimum amount is usually
500,000 so would not be a problem in this case. However, if it is
expected that interest rates are going to rise, the treasurer might have
difficulty in negotiating a FRA at the current rate of 14%.
(ii) Interest rate futures
Interest rate futures are contracts of standard amounts and for standard
periods of time running from a limited number of dates. They are
therefore less flexible than a FRA. They take the form of a contract
between buyer and seller on an interest rate at an agreed price on an
agreed date. The contract will require a small initial margin payment
and thereafter variation margin will apply. Interest rate futures are
similar in effect to forward rate agreements, except that the terms,
amounts and periods are standardised. They are traded on the
Euronext.liffe.
For Omniown protection against interest rate increases could be
achieved by selling futures contracts now. As interest rates rise the
value of futures contracts will fall. Hence Omniown can buy back the
contracts at a lower price and make a profit. This profit should
compensate the company for the increase in market interest rates,
though (due to basis risk) this profit is unlikely to match perfectly the
additional interest costs incurred.
(iii) Interest rate guarantees
An interest rate guarantee is an option which enables the treasurer to fix
a maximum interest rate for a period in the future. If the market rate
falls the treasurer would choose not to exercise the option and take
advantage of the lower rate. Because of the additional benefit of taking
advantage of lower interest rates, options tend to be rather expensive.
They involve payment of a non-refundable premium in advance at the
time the contract is entered into.
In this case, since the option would be to guarantee rates at their
existing level and because it is a short-term option, the premium is
likely to be fairly high unless the market expects rates to fall.
N.B. The premium would be lower if the guaranteed rate were higher
than existing rates e.g. 16%.
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(b) Interest rate futures
Number of contracts sold =
months 3
months 6
000 , 500
000 , 000 , 5
= 20 contracts
The value of one tick is 0.0001 x 500,000 x 3/12 = 12.50
(i) Interest rates increase by 2% and the futures market price falls by
2%
CASH MARKET

Extra interest paid (2% x6/12 x 5,000,000) (50,000)
FUTURES MARKET
On 31 December 2006:
Sell 20 500,000 June sterling time deposit
contracts at (effectively 13.75% per year
interest)
86.25
After interest rate increase:
Buy 20 500,00 June sterling time deposit
contracts at (effectively 15.75% per year
interest)
84.25
2.00 x 100
= 200 ticks
Gain on futures contracts
= 20 contracts x 200 ticks x 12.50 = 50,000
OVERALL NET PROFIT/(LOSS) ON STRATEGY NIL
This is a perfect hedge with 100% hedge efficiency.
(ii) Interest rates increase by 2% and the futures market price falls by
1.5%
CASH MARKET

Extra interest paid (as above) (50,000)
FUTURES MARKET
On 31 December 2006:
Sell 20 500,000 June sterling time deposit
contracts at (effectively 13.75% per year
interest)
86.25
After interest rate increase:
Buy 20 500,00 June sterling time deposit
contracts at effectively 15.75% per year
interest)
84.25
1.50 x 100
= 150 ticks
Gain on futures contracts
= 20 contracts x 150 ticks x 12.50 = 37,500
OVERALL NET (LOSS) ON STRATEGY (12,500)
This is a hedge efficiency of
000 , 50
500 , 37
= 75%
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(iii) Interest rates fall by 1% and the futures market price increases by
0.75%
CASH MARKET

Saving of interest (1% x 6/12 x 5,000,000) 25,000
FUTURES MARKET
On 31 December 2006:
Sell 20 500,000 June sterling time deposit
contracts at (effectively 13.75% per year
interest)
86.25
After interest rate reduction:
Buy 20 500,00 June sterling time deposit
contracts at effectively 13% per year interest)
87.00
(0.75) x 100
= 75 ticks
Loss on futures contracts
= 20 contracts x 75 ticks x 12.50 = (18,750)
OVERALL NET GAIN ON STRATEGY 6,250
This is a hedge efficiency of
750 , 18
000 , 25
= 133 %
SUMMARY:
Scenario (i) (ii) (iii)

Cash market interest paid:
(16% x 6/12 x 5,000,000) 400,000 400,000
(13% x 6/12 x 5,000,000) 325,000

(Gain)/Loss on futures contracts (50,000) (37,500) 18,750
OVERALL COST 350,000 362,500 343,750
(c) Interest rate guarantees
The cost (premium) of the guarantee is 5,000,000 x 0.2% = 10,000, payable
whether or not the guarantee is exercised.
(i) & (ii) Interest rates increase by 2%
As interest rates have risen to 16%, the guarantee at 14% will be used
i.e.

Cash market cost (14% x 6/12 x 5,000,000) 350,000
Premium 10,000
360,000
This is more expensive than the futures hedge for (i) and cheaper than
for (ii)
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(iii) Interest rates fall by 1%
As interest rates have fallen to 13%, the guarantee at 14% will not be used
i.e.

Cash market cost (13% x 6/12 x 5,000,000) 325,000
Premium 10,000
335,000
This is cheaper than the futures hedge as the guarantee has allowed the
company to take advantage of lower cash market interest rates.
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Illustration 5
The directors of Tayquer plc are considering the use of options to protect the
current interest yield from their companys 9.75 million short-term money market
investments. Having made initial enquiries they have been discouraged by the cost
of the option premium. A member of the treasury staff has suggested the use of a
collar as this would be cheaper.
Protection is required for the next eight months. Assume that it is now 1st June.
LIFFE interest rate options on three month money market futures
Contract size is 500,000; premium cost is in annual %
Calls Puts
Dec March Dec March
9100 0.90 1.90 - 0.02
9150 0.56 1.45 0.05 0.06
9200 0.27 1.04 0.17 0.13
9250 0.09 0.68 0.45 0.24
9300 0.01 0.20 0.83 0.32
9350 - 0.05 1.13 0.54
Tick size is 0.01%, and tick value 12.50.
The current interest rate received on Tayquers short-term money market
investments is 7.5% per annum.
Assume that Tayquer can buy or sell options at the above prices. Commission,
taxation and margins may be ignored.
Required:
Discuss how, and estimate at what cost, collars may be used to protect against the
interest yield risk. Recommend at which exercise price(s) the collar should be
arranged.
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Solution 5
A collar will involve Tayquer arranging both a floor and a ceiling (lower and upper
limits) on its interest yield. This may be achieved by buying a call option on futures
and selling (or writing) a put option on the same futures contract, but with a
different exercise price.
As protection is required for the next eight months, to cover the full period, March
contracts will be used.
If Tayquer wishes to protect its current interest yield, the company is likely to fix
the floor at the current yield, i.e. it will buy call options at 9250, which implies an
interest rate of 7.5%.
The option would be exercised if interest rates fall below 7.5% and the futures price
rises above 9250. In order to reduce the net premium cost, the potential gain on
the interest from short-term investments (if interest rates were to rise) may be
reduced by selling March put contracts at a lower exercise price than 9250.
For example, if the interest rate rose to 9% and the put option had been sold at the
9150 exercise price, the buyer of the put option would exercise the option at any
futures price lower than 9150. A 9% interest rate implies a futures price of 9100.
The 1.5% gain in interest rate rises would be split 1% to Tayquer and 0.5% to the
buyer of the put option. Any further interest rate rises will result in the extra
interest earned by Tayquer being equal to the increased loss on the puts.
Hence Tayquer will only benefit from the first 1% of interest rate increases, but will
be protected from any reduction in interest rates. Tayquer, in this example, has
fixed the minimum interest received at 7.5%, and the maximum at 8.5%.
To protect 9.75 million for eight months, the following number of contracts are
required:
500,000
million 75 . 9
x
months 3
months 8
= 52 contracts
The net percentage premium payable at various combinations of collar are:
Buy call Premium
paid
Write put Premium
received
Net premium
cost (%)
Net premium
cost ()
1) 9250 0.68 9200 0.13 0.55 35,750
2) 9250 0.68 9150 0.06 0.62 40,300
3) 9250 0.68 9100 0.02 0.66 42,900
The net premium cost is calculated as follows:
1) 0.55 x 100 = 55 ticks
52 contracts x 55 ticks x 12.50 = 35,750

2) 0.62 x 100 = 62 ticks
52 contracts x 62 ticks x 12.50 = 40,300

3) 0.66 x 100 = 66 ticks
52 contracts x 66 ticks x 12.50 = 42,900
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The choice of exercise price at which to sell the put option will depend upon
Tayquers views on how far interest rates could rise, and the potential gains if rates
do rise.
Interest
rate
Put
exercise
price
Net
premium
cost %
Interest
gain %
Net gain or
loss %
Net gain or
loss
8% 9200 (0.55) 0.50 (0.05) (3,250)
8% 9150 (0.62) 1.00 0.38 24,700
9% 9100 (0.66) 1.50 0.84 54,600
The net sterling gains and losses are calculated as follows:
52 contracts x (0.05) x 100 x 12.50 = (3,250)
52 contracts x 0.38 x 100 x 12.50 = 24,700
52 contracts x 0.84 x 100 x 12.50 = 54,600
The best potential gains are from a put option exercise price of 9100, but Tayquer
may not be willing to lose the 7,150 premium income relative to 9200 put option
exercise price.
The 7,150 premium income that would be lost is calculated as follows:
9200 premium income = 52 x 0.13 x 100 x 12.50 = 8,450
9100 premium income = 52 x 0.02 x 100 x 12.50 = 1,300
7,150
Alternatively, compare the net premium cost in 3) above of 42,900 with the net
premium cost in 1) above of 35,750. The difference between these two amounts
is 7,150.
In reality trading costs may make any option strategies more expensive than they
appear to be from the figures presented.
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THE MACAULAY DURATION METHOD
In 1938, Frederick R. Macaulay defined Duration as the total weighted average
time for recovery of the payments and principal in relation to the current market
price of a bond.
The maturity of a bond is not a particularly good indication of the timing of the cash
flows associated with that bond, since a significant proportion of those cash flows
will occur prior to maturity normally in the form of interest payments.
One could calculate an average of the timings of each cash flow, weighted by the
size of those cash flows. Duration is very similar to such an average, but instead of
taking each cash flow as a weighting, duration uses the present value of each cash
flow.
Steps required to calculate bond duration
1. Establish the cash flows arising at each future time period;
2. Calculate the present value of these future cash flows, discounted at the IRR
(i.e. the gross yield to maturity) of the security. Incidentally, the sum of
these figures must be the current price of the bond;
3. Calculate each years discounted cash flow as a proportion of the current
value of the bond;
4. Take the time from investment to each discounted cash flow and multiply by
the respective proportion. Finally, sum the weighted year values.
Illustration 6
Seven years prior to the maturity of a bond with a 10% coupon, it is trading at a
price of 95.01 per cent and has a gross yield to maturity of 11.063%. Using the
Macaulay duration method, you are required to calculate the bond duration.
Solution 6
Yr 1 2 3 4 5 6 7
1 Annual cash
flows ()
10.00 10.00 10.00 10.00 10.00 10.00 110.00
2 Discounted
@11.063%
()
9.00 8.11 7.30 6.57 5.92 5.33 52.78
3 Proportion of
price (95.01)
0.095 0.085 0.077 0.069 0.062 0.056 0.556
4 Proportion
multiplied by
year number.
0.095 0.170 0.231 0.276 0.310 0.336 3.892
Finally, find the totals of row 4, since these provide the bond duration of 5.31
years, ie the weighted average time to full recovery of an investment in this bond.
Remember that if the monetary amounts in row 2 (above) are cross-cast, the result
must obviously be the current price of the bond, since the gross yield to maturity is
the internal rate of return of all cash flows associated with the bond.
Furthermore, the above calculation is almost identical to the approach used for
calculating the duration taken to recover an original investment in project appraisal
(as described earlier on page 78 and page 79).
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Significance of the calculation of Duration
Duration is an important measure for fixed-income investors and their advisers,
since bonds with higher durations may have greater price volatility than similar
bonds with lower durations. In general:
Changes in the value of a bond are inversely related to changes in the rate of
return i.e. the lower the yield to maturity, the higher the value of the bond;
Long-term bonds have higher interest rate risk than shorter term bonds, due
to the greater probability (over the longer time period) of market interest rate
increases; and
High coupon bonds have less interest rate sensitivity than low coupon bonds,
since the greater the amounts of the cash flows received in the short-term,
the earlier the purchase price of the bond will be recouped.
The Macaulay duration method measures the number of years required to recover
the cost of the bond (taking account of the present value of all interest and capital
cash flows within the future time period). The result is expressed in years.
A measure referred to as Modified Duration (or Volatility) expands on the basic
method, but the ACCA P4 Syllabus only requires a knowledge of the simple
Macaulay duration method, as a means of assessing exposure to interest rate
changes.
The basic lessons of duration are:
As maturity increases, the measure of duration will also increase and the
market value of the bond will become more sensitive to changes in the level
of interest rates;
As the coupon rate of a bond increases, duration will decrease and the value
of the bond will be less sensitive to changes in the level of interest rates; and
As interest rates rise, duration will decrease and the value of the bond will be
less sensitive to subsequent rate changes.
Illustration 7
In each of the following cases, you are required to use the Macaulay duration
method to calculate the duration for each of the following securities:
(a) A bond with a five year maturity has a current value of 92.41 per cent, a
coupon rate of 8% and a market yield of 10%.
(b) On the 1 February 2011, a 5.5% Treasury Bond (which is redeemable on 1
February 2015), has a market value of 110.28 per cent and a yield to
maturity of 2.75%.
(c) A 6% bond has three years to redemption. It has a current market price of
89.85 per cent. Interest is paid half-yearly and its market yield is 10% per
annum (i.e. 5% every six months).
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Solution 7
(a)
Year 1 2 3 4 5
1 Annual cash flows () 8.00 8.00 8.00 8.00 108.00
2 Discounted @ 10% () 7.27 6.61 6.01 5.46 67.06
3 Proportion of bond value
(92.41)
0.079 0.072 0.065 0.059 0.726
4 Proportion multiplied by year
number
0.079 0.144 0.195 0.236 3.630
Finally, establish the totals of row 4, since these provide the bond duration of 4.284
years i.e. the weighted average time to full recovery of an investment in this bond.
(b)
Year 1 2 3 4
1 Annual cash flows () 5.50 5.50 5.50 105.50
2 Discounted @ 2.75% () 5.35 5.21 5.07 94.65
3
Proportion of bond value
(110.28)
0.049 0.047 0.046 0.858
4
Proportion multiplied by year
number
0.049 0.094 0.138 3.432
Finally, establish the totals of row 4., since these provide the bond duration of
3.713 years i.e. the weighted average time to full recovery of an investment in this
bond.
(c)
Period 1 1 2 2 3
1 Half-yearly cash flows () 3 3 3 3 3 103
2 Discounted @ 5% per
half year ()
2.86 2.72 2.59 2.47 2.35 76.86
3 Proportion of bond value
(89.85)
0.032 0.030 0.029 0.028 0.026 0.855
4 Proportion multiplied by
period number
0.016 0.030 0.044 0.056 0.065 2.565
Finally, establish the totals of row 4., since these provide the bond duration of
2.776 years i.e. the weighted average time to full recovery of an investment in this
bond.
General observations
Note that Macaulay duration will always be lower than the term to maturity
(assuming that the coupon rate exceeds zero - you may think that this is a stupid
comment, but the world of finance is going through some amazing times!!).
Nowadays, the value of Macaulay duration is less evident, due to wide availability of
computer programs with Monte Carlo simulation. Obviously, bonds are subject to
risk, but duration is not intended to reflect risk; it measures interest rate
sensitivity.
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TERM STRUCTURE OF INTEREST RATES
The term structure of interest rates reflects the manner in which the gross
redemption yield on government bonds varies with the term to maturity i.e. the
period of time before the stock is to be redeemed. For example, government bonds
may be short-dated (e.g. repayment within 5 years), medium-dated (repayment
between 5 and 20 years) or long-dated (redemption in excess of 20 years). Of
course, some government bonds e.g. 2% Consols are undated (i.e.
irredeemable).
This data is often presented in the form of a graph to illustrate the bond yield
curve, which is created by plotting the gross redemption yield of the bond against
the term to maturity. In normal circumstances the yield curve is upward sloping.
The gross redemption yield reflects the internal rate of return on the cash flows
associated with the bond i.e. it incorporates the effect of the current market value
of the bond, the gross interest payments and the redemption value of the bond in
other words it measures not only the gross interest yield but also the capital gain or
loss to maturity. The calculation of the gross redemption yield is very similar to the
calculation of the cost of redeemable debt for the company the notable difference
is that interest payments are included gross (as opposed to net of corporation tax
as is used in arriving at Kd).
The normal yield curve
The general shape of the normal upward sloping yield curve appears as follows:



0 5 10 15 20 25 30
Term to maturity (years)
A normal yield curve slopes upwards because the yield on longer dated bonds is
normally higher than the yield on shorter dated bonds. If you are confused by this
point, remember that your mortgage is only cheaper than your overdraft because
the mortgage is secured on the property, whereas the overdraft is unsecured. The

Gross
Redemption
Yield
%
Bond
Yield Curve
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reason for the upward sloping shape of the yield curve is thought to be based on
the following theories:
liquidity preference theory
expectations theory
market segmentation theory
Liquidity preference theory
Lenders have a natural preference for holding cash rather than securities even
low risk government securities. They therefore need to be compensated for being
deprived of their cash for a longer period of time hence the higher yield on long-
dated securities and the lower yield on short-dated securities. There is a greater
risk in lending long-term than in lending short-term. To compensate lenders for
this risk they would require a higher return on longer dated investments.
Expectations theory
This theory states that the shape of the yield curve will vary dependent upon a
lenders expectations of future interest rates (and therefore inflation levels). A
curve that rises from left to right indicates that rates of interest are expected to
increase in the future to reflect the investors fear of rising inflation rates.
Market segmentation theory
The slope of the yield curve is thought to reflect conditions in different segments of
the market. In other words lenders and borrowers tend to confine themselves to a
particular segment of the market and thus it is probably futile to compare short-
term with long-term lending and borrowing. Thus, companies typically finance
working capital with short-term funds and non-current assets with long-term funds.
This leads to different factors affecting short-term and long-term interest rates
leading to irregularities which cause humps, dips or wiggles in the shape of the
yield curve.
The inverse yield curve
A yield curve may occasionally slope downwards, since short-term yields may be
higher than long-term yields for the following reasons:
Expectations i.e. if interest rates are currently high, but the market
anticipates a steep fall in the near future, the resultant yield curve will be
downward sloping.
Government intervention i.e. a policy of keeping interest rates relatively high
might have the effect of forcing short-term yields higher than long-term
yields.
An inverse yield curve is downwards sloping and its general shape is as follows:
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0 5 10 15 20 25 30
Term to maturity (years)



Gross
Redemption
Yield
%
Bond
Yield Curve
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Chapter 18
Swaps



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CHAPTER CONTENTS
INTEREST RATE SWAPS, CURRENCY SWAPS AND SWAPTIONS --- 409
INTEREST RATE SWAPS 409
CURRENCY SWAPS 409
SWAPTIONS 410
ILLUSTRATION 1 INTEREST RATE SWAPS ------------------------- 410
ILLUSTRATION 2 CURRENCY SWAPS ------------------------------- 414
ILLUSTRATION 3 SWAPTIONS -------------------------------------- 420

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INTEREST RATE SWAPS, CURRENCY SWAPS AND
SWAPTIONS

Interest rate swaps
These are transactions which allow a company to exploit different interest rates in
different markets for borrowing, and thereby reduce or alter the timing of interest
payments. The parties to a swap may either be two companies, or a company and
a bank. In the former case the companies may arrange the agreement themselves
or a bank may act as intermediary.
The parties to a swap exchange their interest rate commitments with each other.
That is, the company with a fixed rate commitment (which believes that interest
rates are about to fall) effectively swaps with a counterparty with a floating rate
commitment (which believes that interest rates are about to increase). In doing
this they simulate each others borrowings, but retain their obligations to the
original lenders. Thus they must accept a degree of counterparty risk since if the
other party defaults on the interest payments, the original borrower remains liable
to the lender.
The benefits are that the company can obtain interest rates which are lower than it
could get directly from a bank or from other investors, and may be able to structure
the timing of payments so as to improve the matching of cash outflows with
revenues. Swaps are easy to organise and are flexible since they can be arranged
in any size. They may also be reversible by negotiation, but this may involve the
payment of a substantial termination premium by the party seeking release from
the swap commitment.
Currency swaps
Two parties agree to swap equivalent amounts of currency for a given period. This
effectively involves the exchange of debt from one currency to another. Again,
liability on the principal is retained and the parties are liable to counterparty risk.
One benefit to a company is that it can gain access to debt finance in another
country and currency where it is little known (and consequently has a poorer credit
rating) than in its home country. It can therefore take advantage of lower interest
rates than it could obtain if it arranged the loan itself.
A further purpose of currency swaps is to restructure the currency base of the
companys liabilities. This may be important where the company is trading
overseas and receiving revenues in foreign currencies, but its borrowings are
denominated in its home currency. Currency swaps therefore provide a means of
reducing exchange rate risk exposure.
A third benefit of currency swaps is that at the same time as exchanging currency,
the company may also be able to convert fixed rate debt to floating rate or vice
versa. Thus it may obtain some of the benefits of an interest rate swap in addition
to achieving the other advantages of a currency swap.
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Swaptions
These are an option to enter into an interest rate swap or currency swap. A
company could purchase such an instrument, which gives the right, but not the
obligation to enter into a swap arrangement within a predetermined period. The
premium paid to the bank would be relatively high in cases where there was a
general expectation of volatile interest rate or exchange rate movements.
Illustration 1 Interest rate swaps
Manling plc has 14 million of fixed rate loans at an interest rate of 12% per year
which are due to mature in one year. The companys treasurer believes that
interest rates are going to fall, but does not wish to redeem the loans because large
penalties exist for early redemption. Manlings bank has offered to arrange an
interest rate swap for one year with a company that has obtained floating rate
finance at London Interbank Offered Rate (LIBOR) plus 1.125%. The bank will
charge each of the companies an arrangement fee of 20,000 and the proposed
terms of the swap are that Manling will pay LIBOR plus 1.5% to the other company
and receive from the company 11.625%.
Corporation tax is at 35% per year and the arrangement fee is a tax allowable
expense. Manling could issue floating rate debt at LIBOR plus 2% and the other
company could issue fixed rate debt at 11.75%. Assume that any tax relief is
immediately available.
Required:
(a) Evaluate whether Manling plc would benefit from the interest rate swap
1. If LIBOR remains at 10% for the whole year
2. If LIBOR falls to 9% after 6 months
(b) If LIBOR remains at 10% evaluate whether both companies could benefit from
the interest rate swap if the terms of the swap were altered. Any benefit
would be equally shared.
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Solution 1
(a) Evaluation of interest rate swap
1. If LIBOR remains at 10% for whole year
Manling Other company
% %
Existing commitment (12) (10% + 1.125%) (11.125)
Manling pays (10% + 1.5%) (11.5) 11.5
Manling receives 11.625 (11.625)
Revised commitment (11.875) (11.25)

The current cost of fixed rate debt is:
14m x 12% less tax relief at 35% = 1,092,000

The cost under the swap is:
14m x 11.875% less tax relief at 35% = 1,080,625
Plus the arrangement fee 20,000
less tax relief at 35% 13,000
Total cost 1,093,625
The swap would not be beneficial, as the final cost, after tax, is
increased by (1,093,625 less 1,092,000) = 1,625
2. If LIBOR falls to 9% after six months
Manling Other company
% %
Existing commitment (12) (9% + 1.125%) (10.125)
Manling pays (9% + 1.5%) (10.5) 10.5
Manling receives 11.625 (11.625)
Revised commitment (10.875) (11.25)

If LIBOR falls to 9% after six months the cost is
14m x 11.875% x 6/12 x 0.65 = 540,312
14m x 10.875% x 6/12 x 0.65 = 494,813
1,035,125
Plus arrangement fee (net of tax) = 13,000
Total cost 1,048,125
The swap would then be beneficial since Manling benefits by
(1,092,000 less 1,048,125) = 43,875
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(b) Whether both parties would benefit from the swap if LIBOR remains
at 10%
Ignoring the arrangement fee, both companies are benefiting from the swap
i.e.
For a floating rate arrangement:
%
Manling would normally pay LIBOR plus 2%
but is actually paying LIBOR plus 1.875%
Thus saving 0.125
For a fixed interest rate arrangement:
The other company would normally pay 11.75%
but is actually paying fixed interest of 11.25%
Thus saving 0.5
Total saving 0.625%
If this saving were divided equally, each company would save 0.3125% i.e.
Manling Other company
% %
Normal floating rate
LIBOR of 10% + 2% = (12) Normal fixed rate (11.75)
Saving 0.625% 2 = 0.3125 0.3125
Revised commitment (11.6875) (11.4375)
Accordingly if the terms of the swap were varied so that Manling paid the
other company LIBOR plus 1.3125%, which is calculated as follows:
%
Present arrangement of LIBOR plus 1.5
add back original saving 0.125
less revised saving (0.3125)
Revised arrangement of LIBOR plus 1.3125
and the remaining terms of the swap were unchanged, the effect would be:
Manling Other company
% %
Existing commitment (12) (10% + 1.125%) (11.125)
Manling pays LIBOR
+ 1.3125%
(11.3125) 11.3125
Manling receives 11.625_ (11.625)_
Revised commitment (11.6875) (11.4375)
Thus Manling is paying interest at 0.3125% below its normal floating rate of
LIBOR + 2% and the other company is paying at 0.3125% below its normal
fixed rate of 11.75%.
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The total cost to Manling of using these new terms is:

14m x 11.6875% x 0.65 1,063,562
Plus arrangement fee (net of tax) 13,000
Total cost 1,076,562
This is a saving of (1,092,000 1,076,562) = 15,438 relative to not
undertaking the swap.
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Illustration 2 Currency swaps
(a) Discuss how interest rate swaps and currency swaps might be of value to the
corporate financial manager.
(b) Calvold plc has a one year contract to construct factories in a South American
country. At the end of the year the factories will be paid for by the local
government. The price has been fixed at 2,000 million pesos, payable in the
South American currency.
In order to fulfil the contract Calvold will need to invest 1,000 million pesos in
the project immediately, and a fixed additional sum of 500 million pesos in six
months time.
The government of the South American country has offered Calvold a fixed
rate-fixed rate currency swap for one year for the full 1,500 million pesos at a
swap rate of 20 pesos/. Net interest of 10% per year would be payable in
pesos by Calvold to the government.
There is no forward foreign exchange market for the peso against the pound.
Forecasts of inflation rates for the next year are:
Probability UK South American country
0.25 4% and 40%
0.50 5% and 60%
0.25 7% and 100%
The peso is a freely floating currency which has not recently been subject to
major government intervention.
The current spot rate is 25 pesos/. Calvolds opportunity cost of funds is
12% per year in the UK. The company has no access to funds in the South
American country.
Taxation, the risk of default, and discounting to allow for the timing of
payments may be ignored.
Required:
Evaluate whether it is likely to be beneficial for Calvold plc to agree to the
currency swap.
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Solution 2
(a) Interest rate swaps
An interest rate swap is a transaction which allows a company to exploit
different interest rates in different markets for borrowing, and thereby reduce
or alter the timing of interest payments. The parties to a swap may be either
two companies, or a company and a bank. In the former case the companies
may arrange the agreement themselves or a bank may act as intermediary.
The parties to a swap, exchange their interest rate commitments with each
other. In doing this they simulate each others borrowings but retain their
obligations to the original lenders. Thus they must accept a degree of
counterparty risk since if the other party defaults on the interest payments,
the original borrower remains liable to the lender.
The benefits are that the company can obtain interest rates which are lower
than it could get directly from a bank or from other investors, and may be
able to structure the timing of payments so as to improve the matching of
cash outflows with revenues. Swaps are easy to arrange and are flexible since
they can be arranged in any size. They may also be reversible by
negotiation, but this may involve the payment of a substantial termination
premium by the party seeking release from the swap commitment.
Interest rate swaps also provide a means of financial speculation, but your
course is more concerned with the hedging of risk as opposed to the seeking
of risk.
Currency swaps
In a currency swap, two parties agree to swap equivalent amounts of currency
for a given period. This effectively involves the exchange of debt from one
currency to another. As with interest rate swaps, liability on the principal is
not transferred and the parties are liable to counterparty risk.
One benefit to the company is that it can gain access to debt finance in
another country and currency where it is little known, and consequently has a
poorer credit rating, than in its home country. It can therefore take
advantage of lower interest rates than it could obtain if it arranged the loan
itself.
A further purpose of currency swaps is to restructure the currency base of the
companys liabilities. This may be important where the company is trading
overseas and receiving revenues in foreign currencies, but its borrowings are
denominated in the currency of its home country. Currency swaps therefore
provide a means of reducing exchange rate exposure.
A third benefit of currency swaps is that at the same time as exchanging
currency, the company may also be able to convert fixed rate debt to floating
rate or vice versa. Thus it may obtain some of the benefits of an interest rate
swap in addition to achieving the other purposes of a currency swap.
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b) Currency swap by Calvold plc
The expected level of inflation in the UK is 5.25%, and in the South American
country 65%. The purchasing power parity theory may be used to estimate
an expected exchange rate at the end of the year, but it is likely to be more
useful to Calvold to see the range of exchange rates that might occur under
each of the different inflation scenarios, and evaluate their effects on sterling
cash flows.
Rate after one year = current spot rate x
h 1
f 1
+
+

Rate after six months = current spot rate x
h 1
f 1
+
+

where f = the foreign inflation rate; and h = the home inflation rate
Illustration
With 40% SA inflation and 4% UK inflation:
Rate after one year = 25 x
04 . 1
4 . 1
= 33.65
Rate after six months = 25 x
04 . 1
4 . 1
= 29.00
However a six month exchange rate of 29.325 pesos/ would be acceptable,
being the simple average of the current spot rate (25 pesos) and the predicted
one year spot rate (33.65 pesos).
Forecast exchange rates are:
Inflation Forecast exchange rate
Month SA UK
% %
0 25.00
6 40 4 29.00
12 40 4 33.65

0 25.00
6 60 5 30.86
12 60 5 38.10

0 25.00
6 100 7 34.18
12 100 7 46.73
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The effect of the swap will be compared with the use of currency markets for
each of the three scenarios. It is assumed that Calvold will have to borrow
funds in the UK to finance the deal and interest is therefore calculated at the
opportunity cost of funds i.e.
For one year 12%
For six months: use 12% x 6/12 = 6%

or 1 12 . 1
= 5.8%
this will depend upon the method of calculating interest charges. In the
following solution a six-monthly rate of 6% is used.
(i) Using the currency markets
1. Inflation rates 4% and 40%

Exchange
rate

Interest
@12%
p.a.
Pesos (m) m m
Investment
month 0
(1,000.00) 25.00 (40.00) (4.80)
Investment
month 6
(500.00) 29.00 (17.24) (1.03)
(57.24) (5.83)
Interest (5.83)
Total cost (63.07)
Received
month 12
2,000.00 33.65 59.44

Net (loss) (3.63)
2. Inflation rates 5% and 60%
Investment
month 0
(1,000.00) 25.00 (40.00) (4.80)
Investment
month 6
(500.00) 30.86 (16.20) (0.97)
(56.20) (5.77)
Interest (5.77)
Total cost (61.97)
Received
month 12
2,000.00 38.10 52.49
Net (loss) (9.48)
3. Inflation rates 7% and 100%
Investment
month 0
(1,000.00) 25.00 (40.00) (4.80)
Investment
month 6
(500.00) 34.18 (14.63) (0.88)
(54.63) (5.68)
Interest (5.68)
Total cost (60.31)
Received
month 12
2,000.00 46.73 42.80
Net (loss) (17.51)
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(ii) Using the currency swap
The currency swap will provide some protection against the likely
depreciation in the value of the peso. 1,500 million pesos will be
swapped, with the swap reversed at the year end at the same swap
rate of 20 pesos/. Calvold will have to borrow sterling in the UK to
finance the swap, which will cost (1,500 million pesos 20) i.e. 75
million.
Since the cost of funds in the UK is 12% p.a., the interest charge for the
year will be (12% x 75 million) = 9million.
However swaps involve the transfer of interest rate liabilities as well as
of principal, therefore the interest cost to Calvold will be the rate given
in the swap agreement of 10% p.a. i.e. (10% x 1,500 million pesos) 150
million pesos.
It is assumed that no interest will be earned on the 500 million pesos
which will be lying idle until month 6.
Accordingly, Calvold will only remain exposed to exchange risk on the
balance of the purchase price (500 million pesos) which will be
converted at whatever the prevailing end of year rate happens to be. If
it is assumed that no interest will be paid to the South American
government until the end of the year, the sterling value of interest
payments (based on 150 million pesos) will also be dependent on the
then prevailing exchange rate.
1. Inflation rates 4% and 40%
m
Receipts (500 million pesos 33.65) 14.86
Interest paid (150 million pesos 33.65) (4.46)
Net receipt 350 ____
Net profit with swap 10.40

Net loss without swap (m) (3.63)
2. Inflation rates 5% and 60%
m
Receipts (500 million pesos 38.10) 13.12
Interest paid (150 million pesos 38.10) (3.94)
Net receipt 350 ____
Net profit with swap 9.18

Net loss without swap (m) (9.48)
3. Inflation rates 7% and 100%
m
Receipts (500 million pesos 46.73) 10.70
Interest paid (150 million pesos 46.73) (3.21)
Net receipt 350 ____
Net profit with swap 7.49

Net loss without swap (m) (17.51)
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The above calculations show that since Calvolds receipts, denominated
in pesos, will not be received until year end, the profitability of the deal
is eroded by inflation if the currency is traded on the markets. However
a swap arrangement should be entered into, whereby Calvold borrows
75 million in the UK and immediately exchanges this for 1,500 million
pesos from the South American government (whilst similarly swapping
interest payment obligations). The effect will be that only the balance of
the receipts (500 million pesos) will be subject to exchange fluctuations
and therefore the effects of inflation diminished. Thus it appears that it
would be beneficial for Calvold to use the currency swap.
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Illustration 3 Swaptions
Noswis plc borrowed two million Euros () in four year floating rate notes funds
nine months ago at an interest rate EURIBOR plus 1%, in an attempt to reduce the
level of interest paid on its loans. At that time EURIBOR was 6%. Unfortunately
EURIBOR interest rates have increased since that time to 7.2%. The company
wishes to protect itself from further interest rate volatility, but does not wish to lose
the benefit of possible interest rate reductions that might occur in a few months
time. An adviser has suggested the use of a six month American style Euro
swaption at 8.5% with a premium of 50,000, commencing in three months time
and with a maturity date the same as the floating rate Euro loan.
Required:
Briefly explain what is meant by a swaption, and illustrate under what
circumstances this proposed swaption would benefit Noswis. The time value of
money may be ignored.
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Solution 3
Swaptions are hybrid derivative products that integrate the benefits of swaps and
options. The buyer of a swaption has the right, but not the obligation, to enter into
an interest rate or currency swap during a limited period of time and at a specified
rate.
Swaptions are available on the over-the-counter market and involve the payment of
a premium, normally in advance. They may be European style, exercisable only
on the maturity date, or American style, exercisable on any business day during
the exercise period.
Noswis is interested in protection against interest rate volatility, but wishes to
maintain the flexibility to benefit from falls in interest rates. A swaption would offer
the opportunity to do this.
Noswis is currently paying 8.2% on its Euro loan. The swaption offers a swap from
floating rate to fixed rate finance for the remaining three year period of the Euro
loan. (N.B. the four year loan was raised nine months ago and the swaption will
not commence until another three months have elapsed).
The fixed rate is 0.3% per annum above the current floating rate payable by
Noswis.
The premium payable of 50,000 is 2.5% of the total value of the loan, or, ignoring
the time value of money, 0.833% per year over the remaining three year period of
the loan.
If Euro interest rates rise during the next nine months by more than 0.3% the
swaption is likely to be exercised. For the swaption to be beneficial to Noswis, the
average floating rate payable by Noswis without the swap over the three year
period would have to exceed:
8.2% + 0.3% + 0.833% = 9.333%
This is a 13.8% increase on the current EURIBOR payable rate (i.e. over 8.2%)
If interest rates fall then the swaption would not be exercised and Noswis would
benefit from borrowing at the lower floating rates. If the swaption is not exercised
the premium is still payable, and Noswis would be worse off by the amount of the
premium than if no swaption had been agreed.
However, this premium is the price that must be paid for the flexibility of being able
to take advantage of any lower interest rates in the future.
Furthermore it should be noted that once the swaption is exercised this action
cannot be reversed. Therefore if interest rates subsequently fall, Noswis will
continue to pay the fixed rate of interest set out in the agreement.

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Chapter 19
International
investment
appraisal


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CHAPTER CONTENTS
INTERNATIONAL INVESTMENT AND FINANCING DECISIONS ----- 425
INTRODUCTION 425
PARENT OR PROJECT VIEWPOINT? 425
PURCHASING POWER PARITY THEORY (PPPT) 426
FOUR-WAY EQUIVALENCE 427
REMISSION OF FUNDS 428
EXCHANGE RATE RISK 428
POLITICAL RISK 428
PROJECT DISCOUNT RATES 429
FINANCING OVERSEAS PROJECTS 429
REPATRIATION OF CASH FROM OVERSEAS INVESTMENTS 430
TRANSFER PRICING ---------------------------------------------------- 435
ARTICLE FROM A USA PUBLICATION 435
BROOKDAY PLC --------------------------------------------------------- 439
ZEDLAND POSTAL SERVICE -------------------------------------------- 443
AXMINE PLC ------------------------------------------------------------- 448

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INTERNATIONAL INVESTMENT AND FINANCING
DECISIONS

Introduction
In essence capital budgeting for overseas investments is similar to domestic
investment appraisal. The normal procedure of determining the relevant cash flows
and discounting at the rate of return commensurate with the projects risk should
be followed to determine project NPVs. In practice, however, several complexities
may be encountered. These are examined below.
Parent or project viewpoint?
Any overseas capital project can be assessed from the point of view of the parent
company or the local subsidiary. Relevant cash flows may vary between the two
viewpoints due to the following factors:
Timing of the receipt of funds;
Impact of exchange rate changes on the value of the funds;
Impact of local and home country tax on the value of funds received;
Effect on other parts of the organisation (e.g. sales by the subsidiary reducing
the parents export market sales).
As the objective of financial management is to maximise shareholder wealth, and
the vast majority of the shareholders are likely to be located in the parent country,
it is essential that projects are evaluated from a parent currency viewpoint. After
all, in the UK only sterling receipts can be used to pay sterling dividends.
Accordingly, the following three-step procedure is recommended for calculating
project cash flows:
1. Compute local currency cash flows from a subsidiary viewpoint as if it were an
independent entity;
2. Calculate the amount and timing of transfers to the parent company in
sterling terms;
3. Allow for the indirect costs and benefits of the project in sterling terms (e.g.
the contribution lost due to the turnover of other members of the group being
affected by this overseas project).
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Purchasing power parity theory (PPPT)
This theory is based upon the law of one price i.e. in equilibrium identical
products must have the same relative cost irrespective of the currency used. PPPT
claims that the rate of exchange between two currencies depends upon the inflation
levels in the countries concerned. The formula is designed to estimate a predicted
spot rate between two currencies at some future time.
Formula (assuming use of indirect currency quotes)
Predicted Spot rate (S
1
) =
rate lation inf ome
rate lation inf oreign
h 1
f 1
rate Spot Current
+
+

=
|
|

\
|
+
+

b
c
0
h 1
h 1
S
Illustration 1
Startall plc wishes to estimate future exchange rates based upon the following
projections of inflation.
UK USA Bargonia
Year 1 5% 5% 20%
2 5% 5% 30%
3 5% 7% 30%
4 5% 7% 30%
5 5% 7% 30%
If current spot rates are US$1.60 = 1 and Bargonian Dowl 250 = 1, using the
PPPT, what are the predicted spot rates for the currencies concerned at the end of
each of the next five years?
Solution 1
Exchange rates
Year 0 1 2 3 4 5

Dowl/ 250.0 285.7 353.7 438.0 542.2 671.3


05 . 1
2 . 1

05 . 1
3 . 1

05 . 1
3 . 1

05 . 1
3 . 1

05 . 1
3 . 1


US$/ 1.60 1.60 1.60 1.630 1.662 1.693


05 . 1
05 . 1

05 . 1
05 . 1

05 . 1
07 . 1

05 . 1
07 . 1

05 . 1
07 . 1

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Four-way equivalence

Where F
o
= forward rate
S
o
= current spot rate
S
1
= predicted spot rate
i
c
= interest rate in country c (the foreign country)
i
b
= interest rate in country b (the home country)
h
c
= expected inflation rate in country c (the foreign
country)
h
b
= expected inflation rate in country b (the home country)
i (or m) = money (or nominal) interest rate (i.e. including the
effect of inflation)
r = real interest rate (i.e. excluding the effect of inflation)
h (or i) = expected inflation rate
INTEREST RATE PARITY THEORY

Forward rate (F
0
) =
|
|

\
|
+
+
= |

\
|
+
+

b
c
0
i 1
i 1
S
rate nterest i ome
rate nterest i oreign
h 1
f 1
rate Spot Current
PURCHASING POWER PARITY THEORY

Predicted Spot rate (S
1
) =
|
|

\
|
+
+
= |

\
|
+
+

b
c
0
h 1
h 1
S
rate nflation i ome
rate nflation i oreign
h 1
f 1
rate Spot Current
INTERNATIONAL FISHER EFFECT
( ) ( )( ) h 1 r 1 i 1 + + = +
or
( ) ( )( ) i 1 r 1 m 1 + + = +
EXPECTATIONS THEORY
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Remission of funds
Certain costs to the subsidiary may in reality be revenues to the parent company.
For example, royalties, supervisory fees and purchases of components from the
parent company are costs to the project, but result in revenues to the parent. Care
should be exercised in identifying exactly how and when funds are repatriated. The
normal methods of returning funds to the parent company are:
Dividends
Royalties
Transfer prices; and
Loan interest and principal
It is important to note that some of these items may be locally tax-deductible for
the subsidiary but taxable in the hands of the parent.
Exchange rate risk
Changes in exchange rates can cause considerable variation in the amount of funds
received by the parent company. In theory this risk could be taken into account in
calculating the projects NPV, either by altering the discount rate or by altering the
cash flows in line with forecast exchange rates. Virtually all authorities recommend
the latter course, as no reliable method is available for adjusting discount rates to
allow for exchange risk.
Political risk
This relates to the possibility that the NPV of the project may be affected by host
country government actions. These actions can include:
Expropriation of assets (with or without compensation!);
Blockage of the repatriation of profits;
Suspension of local currency convertibility;
Requirements to employ minimum levels of local workers or gradually to
pass ownership to local investors.
The effect of these actions is almost impossible to quantify in NPV terms, but their
possible occurrence must be considered when evaluating new investments. High
levels of political risk will usually discourage investment altogether, but in the past
certain multinational enterprises have used various techniques to limit their risk
exposure and proceed to invest. These techniques include the following
(a) Structuring the investment in such a way that it becomes an
unattractive target for government action. For example, overseas
investors might ensure that manufacturing plants in risk-prone countries
are reliant on imports of components from other parts of the group, or
that the majority of the technical know-how is retained by the parent
company. These actions would make expropriation of the plant far less
attractive.
(b) Borrowing locally so that in the event of expropriation without
compensation, the enterprise can offset its losses by defaulting on local
loans.
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(c) Prior negotiations with host governments over details of profit
repatriation, taxation, etc, to ensure no problems will arise. Changes in
government, however, can invalidate these agreements.
(d) Attempting to be good citizens of the host country so as to reduce the
benefits of expropriation for the host government. These actions might
include employing large numbers of local workers, using local suppliers,
and reinvesting profits earned in the host country.
Project discount rates
In the same way as for domestic capital budgeting, project cash flows should be
discounted at a rate that reflects their systematic risk. Many firms assume that
overseas investment must carry more risk than comparable domestic investment
and therefore increase discount rates accordingly.
This assumption, however, is not necessarily valid. Although the total risk of an
overseas investment may be high, in the context of a well-diversified parent
company portfolio much of the risk may be diversified away. Because of the lack of
correlation between the performance of some national economies, the systematic
risk of overseas investment projects may in fact be lower than that of comparable
domestic projects.
It must therefore be realised that the automatic addition of a risk premium simply
because a project is located overseas does not always make sense, and any
increase in the discount rates used for foreign projects should be viewed with
caution.
Financing overseas projects
The chief sources of long-term finance are the following:
(a) Equity
The subsidiary is likely to be 100% owned by the parent company. However,
in some countries it is necessary for nationals to hold a stake, sometimes
even a majority of the ordinary shares on issue.
(b) Loans
These could be in sterling, or in the currency of the country of operation, or in
another currency (e.g. US dollars) particularly if funds are raised through the
Euromarkets.
The usual approach taken is to match the assets of the subsidiary as far as
possible with a loan in the local currency. This has the advantage of reducing
exposure to currency risk. However, this reduced risk must be weighed
against the interest rate paid on the loan. A loan in the local currency may
carry a higher interest rate, and it may be preferable, for example, to arrange
a Eurocurrency loan in a major currency which is highly correlated with the
currency of the overseas operations.
(c) Government grants
Finance may be available from the UK, the overseas government, or an
international body, such as the World Bank.
(d) Intercompany accounts
Financing by intercompany account is useful in a situation where it is difficult
to get funds out of the foreign country by way of dividends. This is further
discussed below.
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Repatriation of cash from overseas investments
If it is difficult to repatriate the cash as dividends, various other alternatives are
possible, for example
Reasonably high management charges
Moderately excessive royalties
Slightly inflated transfer prices; and
Fairly high interest rates on inter-company loans.
Comprehensive example
The directors of Eibl plc are considering whether to set up a subsidiary in Heina, a
country whose currency is the Croll. The Heina subsidiary would assemble and
market a sophisticated tractor. Survey data indicates that the Heina subsidiary
could expect to sell 500 tractors in the first year of operations, increasing by 10
tractors in each of the next four years.
In the first year, the unit selling price of a tractor would be three million Crolls,
increasing at an annual rate of 10% (rounded to the nearest 100,000 Crolls) and
each tractor would require components costing 5,000. The cost of the
components would increase by 6% per annum in subsequent years. Eibl plc would
provide the components to be assembled and would invoice its Heina subsidiary for
these with no profit mark-up. The unit cost would be calculated to the nearest
100.
Annual production, administration and selling costs in Heina are expected to be
45% of the sales value of tractors sold in that year.
At the start of its operations, the Heina subsidiary would require working capital of
160 million Crolls. At the end of each year of production, the required level of
working capital would be approximately equal to 10% of that years sales.
Assembly equipment costing 1,200 million Crolls would be installed and paid for
immediately. Annual profits of companies in Heina are subject to a business tax of
40%. Working capital movements are excluded from the computation of taxable
profit, but companies are entitled to include a deduction, representing 20% of the
cost of equipment for each of the first five years of the equipments life. Business
tax is paid at the end of the year to which the assessment relates.
Eibl plc would usually evaluate this type of investment over a five-year period. At
the end of the fifth year, a notional market value of the subsidiary would be
calculated by applying a price-earnings ratio of six to the profit after tax arising in
the fifth year (as pre-tax accounting profit equals taxable profit, no deferred tax
liabilities can arise). If Eibl plc were to sell its subsidiary after five years, the sale
proceeds would be taxed in Heina at a rate of 30%
The initial finance of 1,360 million Crolls would be provided in the form of equity
capital from the existing cash resources of Eibl plc. The cost of capital used by Eibl
plc for this type of venture is 25%, but investors based in Heina would require a
return of only 20%, when investing in an equivalent venture. At present, the
Croll/ exchange rate is 150 Croll/ although predictions of the relative interest and
inflation rates of the UK and Heina suggest that the Croll will depreciate against the
by 4% per annum. In the project appraisals of Eibl plc, the exchange rate is
rounded to the nearest whole number.
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Apart from the initial investment, revenues costs and working capital changes can
be assumed to arise at the end of the year in which they occur.
Required
(a) Prepare a statement showing to the nearest 100,000 Crolls the net cash flow
that would arise in each year of the venture and hence determine whether the
investment would be acceptable to investors based in Heina (assuming details
of the venture remain as outlined).
(b) Calculate whether Eibl plc should set up the Heina subsidiary, assuming cash
surpluses are remitted to the UK at the end of each year.
(c) Discuss what improvement could be made by Eibl plc to the proposed financial
arrangements with the Heina subsidiary.
Note: Ignore UK taxation
Use the following discount factors:
End of year 1 2 3 4 5
20% 0.83 0.69 0.58 0.48 0.40
25% 0.80 0.64 0.51 0.41 0.33
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Solution
(a) Net cashflow for each year of the venture and appraisal from
viewpoint of investors in Heina
Crolls (millions)
Year 0 1 2 3 4 5
Sales revenue (W1) 1,500.0 1,683.0 1,872.0 2,120.0 2,376.0
Components (W2) (390.0) (437.9) (492.1) (556.5) (619.1)
Overhead cost
(45% x sales) (675.0) (757.3) (842.4) (954.0) (1,069.2)
435.0 487.8 537.5 609.5 687.7

Business tax @
40%

(excluding capital
allowances)
(174.0) (195.1) (215.0) (243.8) (275.1)

Assembly
equipment
(1,200)
Tax relief @ 40%
(over 5 years) 96.0 96.0 96.0 96.0 96.0
Profit after tax 508.6
Working capital
(W3)
(160) 10.0 (18.3) (18.9) (24.8) (25.6)
Net cash flow in
first 5 years* (1,360) 367.0 370.4 399.6 436.9 483.0

20% factor 1 0.83 0.69 0.58 0.48 0.40
PV (1,360) 305 256 232 210 193
NPV = 164 million Crolls
(*ignoring any final value of investment or return of working capital)
This NPV figure ignores the value of the investment at the end of the five-year
period because the question asks for the net cashflow in each year. However, the
computations are not complete without including this factor. There are various
possibilities:
1. The business winds up after five years, returning only working capital. This
has a value of 238m Crolls, if recovered in its entirety, which has a present
value of 238m x 0.40 = 95m Crolls.
The NPV of the project is then 69m Crolls (not worthwhile).
2. The business continues as a going concern with a value of 6 x profit after tax
in fifth year: i.e. 6 x 509 (approx) = 3,054m Crolls.
PV of this = 3,054 x 0.40 = 1,222m Crolls
NPV of project = 1,058m Crolls which is obviously worthwhile.
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Workings
1. Sales revenue
Year 0 1 2 3 4 5
Sales price per
tractor (Cr
millions)

3 3.3 3.6 4.0 4.4
Sales volume
(units)

500 510 520 530 540
Sales revenue
(Cr millions)

1,500 1,683 1,872 2,120 2,376
2. Component cost
per tractor 5,000 5,300 5,600 6,000 6,300
Total
component
Cost (m)

2.500 2.703 2.912 3.180 3.402
Exchange rate 150 156 162 169 175 182
Component
cost (Cr
millions)

390 437.9 492.1 556.5 619.1
3. Working capital
WC at end of
each year
(10% x sales) 160 150 168.3 187.2 212.0 237.6
Increase/
(decrease) in
year (10) 18.3 18.9 24.8 25.6
(b) Appraisal from viewpoint of Eibl plc
Year 0 1 2 3 4 5
Net
cashflow
remitted (Cr
millions) (1,360) 367 370.4 399.6 436.9 483
Exchange
rate 150 156 162 169 175 182
Net
cashflow
(m) (9.07) 2.35 2.29 2.36 2.50 2.65

25% factor 1 0.80 0.64 0.51 0.41 0.33
PV (9.07) 1.88 1.47 1.20 1.03 0.87
NPV = 2.62m.
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However this excludes the cashflow from sale of the subsidiary at its notional
market value of 3,054m Crolls. Net of tax this produces:
3,054 x (1 0.3) = 2,138m Crolls
182
m 138 , 2
= 11.75m
which has a present value of 11.75m x 0.33 = 3.88m
The project is therefore worthwhile, with an NPV of 3.88 2.62 = 1.26m.
(c) Improvement to the proposed financial arrangements with the Heina
subsidiary
Investments in foreign countries involve significant additional risks. Chief amongst
these are the problems caused by currency movements. There are several ways in
which currency fluctuations can be handled, but the most important point to
concern Eibl is that the currency risk attached to a foreign subsidiary can be
reduced by matching the subsidiarys assets with liabilities in the same currency.
This implies that the subsidiary should be financed to a large extent by borrowing in
Crolls. This particularly applies if it is estimated that the Croll will be depreciating
against the , because the annual interest suffered becomes lower each year when
converted to . However, it is said that there are no free gifts in foreign exchange
and it is likely that the interest rate suffered on a Heina loan is higher than on a
sterling loan.
A further risk of investments in some countries is the problem of remitting the
subsidiarys cash surpluses back to the UK. Usually, dividends are the most difficult
to get past exchange control regulations. It may be that Eibl would do better to
invoice for the components which it supplies at a mark-up on cost rather than at
straight cost. Tax considerations are also of prime importance in transfer pricing
policy.
The following amendments to the financial arrangements could also be considered:
Eibl could charge the subsidiary with a royalty per tractor produced or sold;
Eibl could invoice the subsidiary for management charges for advice given;
Eibl could lend money to the subsidiary and charge interest on those loans.
However these revenues would cause a UK corporation tax liability to be incurred.
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TRANSFER PRICING

Article from a USA publication
A particularly sensitive problem for multinational firms is establishing a rational
method for pricing of goods, services, and technology between related affiliates in
different countries. Even purely domestic firms find it difficult to reach agreement
on the best method for setting prices on transactions between affiliates. In the
multinational case, managers must balance conflicting considerations. These
include fund positioning, income taxes, managerial incentives and evaluation, tariffs
and quotas, and joint-venture partners.
Fund positioning effect
Transfer price setting is a technique by which funds may be positioned within a
multinational enterprise. A parent wishing to remove funds from a particular
foreign country can charge higher prices on goods sold to its affiliate in that
country. A foreign affiliate can be financed by the reverse technique, a lowering of
transfer prices. Payment by the affiliate for imports from its parent transfers funds
out of the affiliate. A higher transfer (sales) price permits funds to be accumulated
within the selling country.
Transfer pricing may also be used to transfer funds between sister affiliates.
Multiple sourcing of component parts on a worldwide basis allows changes in
suppliers from within the corporate family to function as a device to transfer funds.
Income tax effect
A major consideration in setting transfer price is the income tax effect. Worldwide
corporate profits may be influenced by setting transfer prices to minimise taxable
income in a country with a high income tax rate and maximise income in a country
with a low income tax rate.
Needless to say, government tax authorities are aware of the potential income
distortion from transfer price manipulation. A variety of regulations and court cases
exist on the reasonableness of transfer prices, including fees and royalties as well
as prices set for merchandise. If a government taxing authority does not accept a
transfer price, taxable income will be deemed larger than was calculated by the firm
and taxes will be increased. An even greater danger, from the corporate point of
view, is that two or more governments will try to protect their respective tax bases
by contradictory policies that subject the business to double taxation on the same
income.
Typical of laws circumscribing freedom to set transfer prices is Section 482 of the
US Internal Revenue Code. Under this authority the Internal Revenue Service
(IRS) can reallocate gross income, deductions, credits, or allowances between
related corporations in order to prevent tax evasion or to reflect more clearly a
proper allocation of income. Under the IRS guidelines and subsequent judicial
interpretation, the burden of proof is on the taxpayer to show that the IRS has
been arbitrary or unreasonable in reallocating income. The correct price
according to the guidelines is the one that reflects an arms length price, that is,
a sale of the same goods or service to an unrelated customer.
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IRS regulations provide three methods to establish arms length prices: comparable
uncontrolled prices, resale prices, and cost-plus. A comparable uncontrolled price is
regarded as the best evidence of arms length pricing. Such prices arise when
transactions in the same goods or services occur between the multinational firm
and unrelated customers, or between two unrelated firms. The second-best
approach to arms length pricing starts with the final selling price to customers and
subtracts an appropriate profit for the distribution affiliate to determine the
allowable selling price for the manufacturing affiliate. The third method is to add an
appropriate markup for profit to total costs of the manufacturing affiliate. The
same three methods are recommended for use in member countries by the
Organisation for Economic Cooperation and Development (OECD) Committee on
Fiscal Affairs.
Although all governments have an interest in monitoring transfer pricing by
multinational firms, not all governments use these powers to regulate transfer
prices to the detriment of multinational firms. In particular, transfer pricing has
some political advantages over other techniques of transferring funds. Although
the recorded transfer price is known to the governments of both the exporting and
importing countries, the underlying cost data are not available to the importing
country. Thus the importing country finds it difficult to judge how reasonable the
transfer price is, especially for non-standard items such as manufactured
components. Additionally, even if cost data could be obtained, some of the more
sophisticated governments might continue to ignore the transfer pricing leak. They
recognise that foreign investors must be able to repatriate a reasonable profit by
their own standards, even if this profit seems unreasonable locally. An unknown or
unproven transfer price leak makes it more difficult for local critics to blame their
government for allowing the country to be exploited by foreign investors. On the
other hand, if the host government has soured on foreign investment, transfer price
leaks are less likely to be overlooked. Thus within the potential and actual
constraints established by governments, opportunities may exist for multinational
firms to alter transfer prices away from an arms length market price.
Managerial incentives and evaluation
When a firm is organised with decentralised profit centres, transfer pricing between
centres can disrupt evaluations of managerial performance. This problem is not
unique to multinational firms, but has been a controversial issue in the
centralisation versus decentralisation debate in domestic circles. In the domestic
case, however, a modicum of coordination at the corporate level can alleviate some
of the distortion that occurs when any profit centre sub-optimises its profit for the
corporate good. This statement might also be true in the multinational case, but
coordination is often hindered by longer and less efficient channels of
communication and the need to consider the unique variables that influence
international pricing. Even with the best intent, a manager in one country finds it
difficult to know what is best for the firm as a whole when buying at a negotiated
price from an affiliate in another country. If corporate headquarters establishes
transfer prices and sourcing alternatives, managerial disincentives arise if the prices
seem arbitrary or unreasonable. Furthermore, if corporate headquarters makes
more decisions, one of the main advantages of a decentralised profit centre system
disappears. Local management loses the incentive to act for its own benefit.
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Tariff and quota effect
Transfer pricing may have an influence on the amount of import duties paid. If the
importing affiliate pays ad valorem import duties, and if those duties are levied on
the invoice (transfer) price, duties will arise under the high-markup policy.
The incidence of import duties is usually opposite to the incidence of income taxes
in transfer pricing, but income taxes are usually a heavier burden than import
duties. Therefore transfer prices are more often viewed from an income tax
perspective. In some instances, however, import duties are actually levied against
internationally posted prices, if such exist, rather than against the stated invoice
price. If so, duties will not be influenced by the transfer price policy. Income taxes
will still be affected by both the residual location of operating profit and the
deductibility of the assessed import duties.
Related to the tariff effect is the ability to lower transfer prices to offset the volume
effect of foreign exchange quotas. Should a host government allocate a limited
amount of foreign exchange for importing a particular type of good, a lower transfer
price on the import allows the firm to bring in a greater quantity? If, for example,
the imported item is a component for a locally manufactured product, a lower
transfer price may allow production volume to be sustained or expanded, albeit at
the expense of profits in the supply affiliate.
Effect on joint-venture partners
Joint ventures pose a special problem in transfer pricing, because serving the
interest of local stockholders by maximising local profit may be suboptimal from the
overall viewpoint of the multinational firm. Often the conflicting interests are
irreconcilable. When Ford Motor Company decided to rationalise production on a
worldwide basis so that each division could specialise in certain products or
components, it was forced to abandon its policy of working with joint ventures
partly because of the transfer pricing problem. It had to purchase the large British
minority interest in Ford some years ago, despite the well publicised and ill-timed
drain on the US balance of payments. For identical reasons, General Motors has
seldom worked with joint ventures despite its arrangement with Toyota.
Transfer pricing in practice
Given the potential for conflicting objectives, what transfer pricing policies do
multinational firms utilise in practice? An empirical study of 164 US multinational
firms sheds considerable light on this question.
Although Section 482 of the US Internal Revenue Code requires use of arms
length pricing, only 35% of the responding firms indicated that they used market
based methods to set the arms length transfer price. Almost all of the other
firms used either some version of a cost plus price or a negotiated price. This
split presumably reflects the relative proportion of products which had a recognised
external market price compared to products or components that had no external
market price.
The authors of the study used the response data to test various hypotheses about
the determinants motivating a firms choice of a particular transfer pricing policy.
They found that legal and size variables were statistically significant
determinants of market-based transfer pricing. Legal considerations include
compliance with tax rules (Section 482), customs regulations, antidumping laws,
antitrust laws, and the accounting norms of host countries. Large-size firms with
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multiple products and locations were also likely to use market-based transfer
pricing whenever possible. This was probably because they are highly visible and it
would be difficult to customise transfer pricing given the complexities of their sales
networks.
Another interesting finding of the study was that economic restrictions (such as
exchange controls, price controls, and restrictions on imports), political-social
conditions, and the extent of economic development in host countries are either
unimportant or are secondary determinants of market-based transfer pricing
strategy. Furthermore, they found no statistical support for assuming that these
variables influenced non market-based transfer pricing policies. These findings
suggest that transfer pricing policies are not very sensitive to the positioning of
funds considerations which were described earlier in this article.
The study also found that internal considerations, such as performance evaluation
of subsidiaries and their management, were not statistically significant
determinants of transfer pricing policies. Presumably multinational firms prefer to
maintain separate sets of books for that purpose.
A much earlier study of 60 non-US multinational firms and their US affiliates found
distinct national differences with respect to the weight accorded host country
environmental variable and internal company parameters. Canadian, French,
Italian, and US parent firms judged that the tax effect of transfer pricing was the
most important consideration. British parent firms emphasised the strong financial
appearance of their US affiliates. Inflation was an important consideration by all
parent firms, except those in Scandinavia; these firms considered acceptability to
the host government to be the most important determinant of their transfer pricing
policies. German firms appeared to be least concerned about transfer pricing
policies. Non-US firms, in contrast to US firms, did not consider the evaluation of
managerial performance to be important because, contrary to the practice of many
US firms, they did not usually operate their foreign affiliates on a profit centre
basis.
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Brookday plc
Brookday plc is considering whether to establish a subsidiary in the USA. The
subsidiary would cost a total of $20 million, including $4 million for working capital.
A suitable existing factory and machinery have been located and production could
commence quickly. A payment of $19 million would be required immediately, with
the remainder required at the end of year one.
Production and sales are forecast at 50,000 units in the first year and 100,000 units
per year thereafter.
The unit price, unit variable cost and total fixed costs in year one are expected to
be $100, $40 and $1 million respectively. After year one prices and costs are
expected to rise at the same rate as the previous years level of inflation in the
USA; this is forecast to be 5% per year for the next 5 years. In addition a fixed
royalty of 5 per unit will be payable to the parent company, payment to be made
at the end of each year.
Brookday has a 4 year planning horizon and estimates that the realisable value of
the fixed assets in 4 years time will be $20 million.
It is the companys policy to remit the maximum funds possible to the parent
company at the end of each year. Assume that there are no legal complications to
prevent this.
Brookday currently exports to the USA yielding an after tax net cash flow of
100,000. No production will be exported to the USA if the subsidiary is
established. It is expected that new export markets of a similar worth in Southern
Europe could replace exports to the USA. United Kingdom production is at full
capacity and there are no plans for further expansion in capacity.
Tax on the companys profits is at a rate of 50% in both countries, payable one
year in arrears. A double taxation treaty exists between the UK and the USA and
no double tax is expected to arise. No withholding tax is levied on royalties payable
from the USA to the UK.
Tax allowable depreciation is at a rate of 25% on a straight line basis on all fixed
assets.
Brookday believes that the appropriate beta for this investment is 1.2 The after-
tax market rate of return is 12%, and the risk free rate of interest 7% after tax.
The current spot exchange rate is US $1.300/1, and the pound is expected to fall
in value by approximately 5% per year relative to the US dollar.
Required:
(a) Evaluate the proposed investment from the viewpoint of Brookday plc. State
clearly any assumptions that you make.
(b) What further information and analysis might be useful in the evaluation of this
project?
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Brookday plc solution
(a) Brookdays stated policy is to remit the maximum funds possible to the parent
company. The net present value of relevant cash flows to the parent
company will be the appropriate decision criterion, and should lead to
maximisation of parent shareholder wealth.
The dollar profit and relevant cash flow from the subsidiary must be
determined first:
Projected earnings data of the US subsidiary
Year 1 Year 2 Year 3 Year 4 Year 5
$000 $000 $000 $000 $000
Sales (note 1) 5,000 10,500 11,025 11,580

Variable cost 2,000 4,200 4,410 4,630
Fixed costs 1,000 1,050 1,102 1,158
Royalty (note
2)
309 586 557 529
Depreciation 4,000 4,000 4,000 4,000
7,309 9,836 10,069 10,317

Taxable profit (2,309) 664 956 1,263
US tax payable
(note 3)

0 0 0 0 (287)
Profit after tax (2,309) 664 956 1,263 (287)

Projected cash flow data of the US subsidiary
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
$000 $000 $000 $000 $000 $000
Profit after tax (2,309) 664 956 1,263 (287)
Depreciation 4,000 4,000 4,000 4,000
Initial
investment (19,000)
Additional
capital (1,000)
Realisable
value of fixed
assets (note 4) 20,000
Tax on
realisable value (10,000)
Working capital
available ______ _____ _____ _____ 4,000 ______
Cash flow
available to
parent (19,000) 691 4,664 4,956 29,263 (10,287)
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Projected cash flow data for the parent company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
000 000 000 000 000 000
Available from
US subsidiary (14,615) 559 3,976 4,445 27,633 (10,226)
Royalty
payment
250 500 500 500
UK tax on
royalty (note
5) _____ ___ (125) (250) (250) (250)
Net cash flow (14,615) 809 4,351 4,695 27,883 (10,476)

Discount
factors @ 13%
(note 6) 1 0.885 0.783 0.693 0.613 0.543
Present values (14,615) 716 3,407 3,254 17,092 (5,688)
Net present value = +4,166,000
The loss of exports to the USA if the project is undertaken is not a relevant
cash flow.
Notes:
1. Sales price increases by 5% per year
Year 1 Year 2 Year 3 Year 4
Price ($) 100.00 105.00 110.25 115.80
Units (000) 50 100 100 100
Sales revenue ($000) 5,000 10,500 11,025 11,580
Similar calculations are necessary for variable costs and price
adjustments for fixed costs.
2. The royalty is payable in s and will depend upon the $/ exchange
rate. The is expected to fall in value by 5% per year relative to the $.
Year 1 Year 2 Year 3 Year 4 Year 5
Expected exchange rates $/ 1.235 1.173 1.115 1.059 1.006
Royalty (000) 250 500 500 500
Royalty ($000) 309 586 557 529
3. Losses are assumed to be carried forward and allowed against future
profits for taxation purposes.
4. Although the subsidiary will exist for more than four years, the
companys planning horizon is only four years. A value must be placed
upon the subsidiary at this time. The only information available is an
estimate of realisable value of fixed assets. Tax on this realisable value
will be payable as the assets are fully depreciated. Potential working
capital available must also be considered.
5. There will be no double taxation on cash flows from the USA. However,
the royalty has not been subject to US tax, and will be liable to UK
taxation.
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6. Using the capital asset pricing model to determine the discount rate:
ke = rf + (Erm rf) project
ke = 7% + (12% 7%) 1.2 = 13%
(b) Further information and analysis might include:
(i) How accurate are the cash flow forecasts? How have they been
established?
(ii) Why has a four year planning horizon been chosen? The valuation of the
fixed assets at year 4 is highly significant to the NPV solution. How has
this valuation been established? Is this valuation based upon future
earnings as a going concern? It would be more desirable to evaluate the
project over the whole of its projected life.
(iii) Risk is taken into account by using a CAPM derived discount rate. How
has this rate been derived for a situation involving two countries? Does
this fully reflect the risk of the project? Is the use of CAPM appropriate
as it is a single period model? Other, theoretically weaker, measures of
risk might be useful as an aid to decision-making e.g., sensitivity
analysis of the key variables or simulation.
(iv) Cash flow is usually assumed to occur at the end of each year. Greater
accuracy would result if consideration were given to when during the
year cash flow arises and these cash flows discounted at the appropriate
rate.
(v) Political and economic factors should be considered. How stable is the
US government policy? Will a change in government lead to changes in
taxation policy, exchange controls, restrictions on the remittance of
funds or attitudes towards foreign investment?
(vi) Are there any intangible benefits of establishing a manufacturing plant in
the USA e.g. making the American public more aware of Brookdays
product?
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Zedland Postal Service
The general manager of the nationalised postal service of a small country, Zedland,
wishes to introduce a new service. This service would offer the same-day delivery
of letters and parcels posted before 10am, within a distance of 150 km. The
service would require 100 new vans costing $8,000 each and 20 trucks costing
$18,000 each. 180 new workers would be employed at an average annual wage of
$13,000 and five managers at average annual salaries of $20,000 would be moved
from their existing duties, where they would not be replaced.
Two postal rates are proposed. In the first year of operation, letters will cost
$0.525 and parcels $5.25. Market research undertaken at a cost of $50,000
forecasts that demand will average 15,000 letters each working day and 500
parcels each working day during the first year, and 20,000 letters a day and 750
parcels a day thereafter. There is a five-day working week. Annual running and
maintenance costs on similar new vans and trucks are estimated in the first year of
operation to be $2,000 a van and $1,000 a truck. These costs will increase by 20%
a year compound (excluding the effects of inflation). Vehicles are depreciated over
a five-year period on a straight line basis. Depreciation is tax-allowable and the
vehicles will have negligible scrap value at the end of the five years. Advertising in
year one will cost $1,300,000 and in year two $250,000. There will be no
advertising after year two. Existing premises will be used for the new service, but
additional costs of $150,000 a year will be incurred.
All the above data are based on price levels in the first year and exclude any
inflation effects. Wage and salary costs and all other costs are expected to rise
(because of inflation) by approximately 5% a year during the five-year planning
horizon of the postal service. The government of Zedland will not permit annual
price increases within nationalised industries to exceed the level of inflation.
Nationalised industries are normally required by the government to earn at least an
annual after-tax return of 5% on average investment and to achieve, on average,
at least zero net present value on their investments.
The new service would be financed half with internally generated funds and half by
borrowing on the capital market at an interest rate of 12% a year. The opportunity
cost of capital for the postal service is estimated to be 14% a year. Corporate
taxes in Zedland, to which the postal service is subject, are at the rate of 30% for
annual profits of up to $500,000 and 40% for the balance in excess of $500,000.
Tax is payable one year in arrears. The postal services taxable profits from
existing activities exceed $10,000,000 a year. All transactions may be assumed to
be on a cash basis and to occur at the end of the year, with the exception of the
initial investment which would be required almost immediately.
Required:
Acting as an independent consultant, prepare a report advising whether the new
postal service should be introduced. Include in your report a discussion of other
factors that might need to be taken into account before a final decision is made on
the introduction of the new postal service.
State any assumptions that you make.
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Zedland Postal Service solution
Report on proposed same-day delivery service
To: The Governing Board, National Postal Service, Zedland.
From: International Management Consultants Ltd
1. Terms of reference
This report considers whether the proposed new same-day delivery service
will earn sufficient to meet the twin targets of a 5% after-tax return on
average investment and a net present value of at least zero. Other factors
affecting the decision are also considered.
2. Conclusion and recommendation
Our calculations on target returns are shown in the appendix. The return on
investment, as calculated by us, is 12%, which is acceptable, but the net
present value is negative. We therefore recommend that the service is not
run under the existing proposals, but this recommendation is subject to the
factors considered in the next section.
3. Other factors affecting the decision
(a) The project could possibly be made more profitable by increasing prices
or reducing costs. These possibilities should be investigated. It is good
practice to carry out a sensitivity analysis on the estimates made to
discover which are the key factors in determining the success or failure
of the project. Furthermore analysis can be undertaken on these factors
with the objective of making more accurate estimates. For example, our
initial reaction is that the price/demand relationship and the staffing
levels required should both be subject to further analysis.
(b) The proposed service might be of great benefit to the public and to the
economy as a whole. The government may consider that it is worth
subsidising this service from the profits of the Postal Services other
operations.
(c) The effect of the new service on existing services does not appear to
have been specifically investigated. There will possibly be a reduction in
revenue from existing services which should be included in the
calculations.
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Appendix
1. Incremental profit figures for the five-year planning horizon
Year 1 2 3 4 5
$000 $000 $000 $000 $000
Revenue:
Letters (W1) 2,048 2,867 3,010 3,160 3,318
Parcels (W2) _682 1,075 1,129 1,185 1,244
2,730 3,942 4,139 4,345 4,562

$000 $000 $000 $000 $000
Expenses:
Additional staff (W3) 2,340 2,457 2,580 2,709 2,844
Vehicle depreciation (W4) 232 232 232 232 232
Vehicle running costs (W5) 220 277 349 440 554
Advertising 1,300 263
Premises costs 150 158 165 174 182
4,242 3,387 3,326 3,555 3,812

Profit before tax (1,512) 555 813 790 750
Taxation @ 40% 605 (222) (325) (316) (300)
Profit after tax (907) 333 488 474 450
2. Average annual after-tax return on average investment
$
Total investment 800,000
Vans 360,000
Advertising 1,563,000
2,723,000
Average investment = $2,723,000 2 = $1,361,500
Average profit = (-907 + 333 + 488 + 474 + 450) 5
= $167,600
Average annual after-tax return on average investment
=
5 . 361 , 1
6 . 167
= 12.3%
3. Net present value (in $000)
Year 0 1 2 3 4 5 6
Profit before tax (1,512) 555 813 790 750
Add depreciation 232 232 232 232 232
Taxation (one
year delay)
605 (222) (325) (316) (300)
Cost of vehicles (1,160) ____ ____ ___ ___ ___ ___
(1,160) (1,280) 1,392 823 697 666 (300)

14% factor 1 0.877 0.769 0.675 0.592 0.519 0.456

Present value (1,160) (1,123) 1,070 556 413 346 (137)
Net present value = $35,000 negative
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4. Assumptions
(i) The rate of inflation for revenue and costs (excluding depreciation) is
assumed to be 5% p.a. over the five-year planning horizon.
(ii) The cost of market research already undertaken is ignored (sunk cost).
(iii) The cost of the five managers used for the project is already contracted
for and therefore ignored in these calculations, which assume that they
would not be made redundant if the project did not go ahead.
(iv) Return on investment has been computed including advertising costs as
part of the investment but, ignoring financing costs.
(v) The cost of borrowings is assumed to be already included in the
opportunity cost of capital of 14%.
Workings
1. Revenue from letters:
Year 1: 15,000 letters x 5 x 52 x $0.525 = $2,047,500
Year 2: 20,000 letters x 5 x 52 x $0.525 x 1.05 = $2,866,500,
increasing at 5%
p.a. thereafter.
2. Revenue from parcels:
Year 2: 500 parcels x 5 x 52 x $5.25 = $682,500
Year 2: 750 parcels x 5 x 52 x $5.25 x 1.05 = $1,074,937,
increasing at 5%
p.a. thereafter.
3. Additional staff cost:
180 x $13,000 in year 1 = $2,340,000, rising at 5% p.a. thereafter.
The cost of managers is not relevant, as they would have been paid anyway,
and it is assumed that they will not be made redundant if the new project is
not undertaken.
4. Depreciation:
$
Cost of vans: 100 x $8,000 = 800,000
Cost of trucks: 20 x $18,000 = 360,000
$1,160,000
Annual depreciation = $1,160,000 5 = $232,000
(Note: No inflation increase!)
5. Vehicle running costs:
$
Year 1: Vans 100 x $2,000 = 200,000
Year 1: Trucks 20 x $1,000 = 20,000
$220,000
These running costs in subsequent years are found by multiplying by 1.26
each year.
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6. Taxation
Because the other operations of the postal service make high profits, not only
will all marginal tax calculations be at 40%, but it is assumed that the losses
made in year 1 will result in a reduction in the total tax charge of 40% of the
loss made. This is therefore shown as a notional receipt.
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Axmine plc
(a) The managers of Axmine plc, a major international copper processor are
considering a joint venture with Traces, a company owning significant copper
reserves in a South American country. If the joint venture were not to
proceed Axmine would still need to import copper from the South American
country. Axmines managing director is concerned that the government of the
South American country might impose some form of barriers to free trade
which puts Axmine at a competitive disadvantage in importing copper. A
further director considers that this is unlikely due to the existence of the
World Trade Organisation (WTO).
You are required to briefly discuss possible forms of non-tariff barrier that
might affect Axmines ability to import copper, and how the existence of the
WTO might influence such barriers. (8 marks)
(b) The proposed joint venture with Traces would be for an initial period of four
years. Copper would be mined using a new technique developed by Axmine.
Axmine would supply machinery at an immediate cost of 800 million pesos
and 10 supervisors at an annual salary of 40,000 each at current prices.
Additionally Axmine would pay half of the 1,000 million pesos per year (at
current prices) local labour costs and other expenses in the South American
country. The supervisors salaries and local labour and other expenses will be
increased in line with inflation in the United Kingdom and the South American
country respectively.
Inflation in the South American country is currently 100% per year, and in the
UK it is expected to remain stable at around 8% per year. The government of
the South American country is attempting to control inflation, and hopes to
reduce it each year by 20% of the previous years rate.
The joint venture would give Axmine a 50% share of Traces copper
production, with current market prices at 1,500 per 1,000 kilogrammes.
Traces production is expected to be 10 million kilogrammes per year, and
copper prices are expected to rise by 10% per year (in pounds sterling) for
the foreseeable future. At the end of four years Axmine would be given the
choice to pull out of the venture or to negotiate another four year joint
venture, on different terms.
The current exchange rate is 140 pesos/. Future exchange rates may be
estimated using the purchasing power parity theory.
Axmine has no foreign operations. The cost of capital of the companys UK
mining operations is 16% per year. As this joint venture involves diversifying
into foreign operations the company considers that a 2% reduction in the cost
of capital would be appropriate for this projct.
Corporate tax is at the rate of 20% per year in the South American country
and 35% per year in the UK. A tax treaty exists between the two countries
and all foreign tax paid is allowable against any UK tax liability. Taxation is
payable one year in arrears and a 25% straight-line writing-down allowance is
available on the machinery in both countries.
Cash flows may be assumed to occur at the year end, except for the
immediate cost of machinery. The machinery is expected to have negligible
terminal value at the end of four years.
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You are required to prepare a report discussing whether Axmine plc should
agree to the proposed joint venture. Relevant calculations must form part of
your report or an appendix to it.
State clearly any assumptions that you make. (18 marks)
(c) If the South American government were to fail to control inflation, and
inflation were to increase rapidly during the period of the joint venture,
discuss the likely effect of very high inflation on the joint venture. (4 marks)
Total: 30 marks
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Axmine plc solution
(a) Forms of non-tariff barrier and the WTO
Axmines ability to import copper from the South American country might be
affected by the following forms of non-tariff barrier:
(i) Deliberately obstructive customs procedures. The authorities might
require time-consuming documentation to be completed before exports
of copper are permitted, or might carry out detailed quality assurance
inspections. Such inspections would be justified in the name of safety or
quality control, but in reality the purpose is to reduce the volume of
exports.
(ii) Export quotas. The country might set maximum limits of copper that it
is prepared to export. The purpose would be to reduce supply and
therefore hope to increase the price of copper provided.
(iii) Artificial exchange rates. The country might insist that an artificially
high exchange rate is used to pay for goods exported. Perhaps a range
of different rates could be set by the country for different forms of
exports (copper, electrical goods, timber etc) so that control can be
exercised over each category.
(iv) Selective embargo. The country might totally refuse to permit exports
to a certain country, either on human rights grounds or to retaliate
against alleged unfair trading practices from that other country.
Essentially this is a special case of export quotas, with the quota to
particular countries set at zero.
(v) Withdrawal of government assistance. Governments commonly offer
their exporters a range of export credit guarantees to encourage foreign
trade, perhaps taking on the risk of other countries not honouring their
debts. Where these guarantees are reduced or withdrawn altogether,
exports will be discouraged. Similar points apply to other forms of
government assistance e.g., grants or subsidised loans.
The General Agreement on Tariffs and Trade (GATT) was signed in 1947 by 23
countries in an attempt to encourage world-wide trade after the Second World
War. The aims of GATT were to reduce existing barriers to free trade, to
reduce discrimination in world-wide trade and to prevent protectionism by
encouraging member countries to consult with others before taking
protectionist measures.
GATT eventually had more than one hundred signatory member countries,
including many less developed countries, and the last round of negotiations
undertaken (the Uruguay Round) was concluded in 1994.
A new body, the World Trade Organisation (WTO) was set up in 1995 as a
successor body to GATT, which itself officially ceased to exist at the end of
1995.
The WTO, with a membership of about 150 countries, has to try to map out
the road ahead for global trade policy. The Uruguay Round bequeathed the
WTO a substantial agenda. It included further negotiations or reviews in
areas including agriculture, textiles, intellectual property rights and services.
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The implications of the WTO on Axmine plc depend on a number of factors:
(i) If the South American country is not a member of the WTO, then the
WTO is irrelevant.
(ii) GATT was generally successful in driving tariff barriers out of the world
trade scene, but has been much less successful in non-tariff barriers.
Many countries continue to impose non-tariff barriers, especially against
imports rather than exports, since they see doing this as in their best
domestic interests.
(iii) GATT allowed a number of facilities to favour less developed countries at
the expense of developed countries, so the South American country
might not contravene GATT/WTO terms by its actions of imposing
barriers. GATT also allowed preferential rates to exist within trade blocs
(e.g.