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Advanced Financial Management
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Professional Paper P4
Advanced Financial Management
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Preface Contents
Welcome to BPP Learning Medias ACCA Passcards for Professional Paper P4 Advanced Financial
Management.
They focus on your exam and save you time.
They incorporate diagrams to kickstart your memory.
They follow the overall structure of BPP Learning Medias Study Texts, but BPP Learning Medias ACCA
Passcards are not just a condensed book. Each card has been separately designed for clear presentation.
Topics are self contained and can be g rasped visually.
ACCA Passcards are still just the right size for pockets, briefcases and bags.
Run through the Passcards as often as you can during your final revision period. The day before the exam, try
to go through the Passcards again! You will then be well on your way to passing your exams.
Good luck!
Page iii
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Preface Contents
Page Page
1 The role and responsibility of senior 9 Acquisitions and mergers vs growth 81
financial executive 1 10 Valuation for acquisitions and mergers 87
2 Financial strategy formulation 7 11 Regulatory framework and processes 99
3a Conflicting stakeholder interests 17 12 Financing mergers and acquisitions 105
3b Ethical issues in financial management 23
1314 Reconstruction and reorganisation 111
3c Environmental issues 25
15 The treasury function in multinationals 119
4 Trading and planning in a multinational
environment 31 16 Hedging forex risk 123
5 DCF 41 17 Hedging interest rate risk 135
6 Application of option pricing theory in 18 Dividend policy in multinationals and
investment decisions 47 transfer pricing 143
7a Impact of financing and APV method 51 19 Recent developments 149
7b Valuation and free cash flows 65
8 International investment decisions 73
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1: The role and responsibility

of senior financial executive
Topic List Senior financial executives are required to make crucial

decisions, including those related to investment,
distribution and retention.
Financial management
Financial planning
Financial Financial
management planning
Financial objectives Non-financial objectives

The prime financial objective is to maximise the Non-financial objectives do not negate financial
market value of the companys shares. Primary objectives, but they do mean that the pr imary
targets are profits and dividend growth. Other targets financial objectives may be modified. They take
may be the level of gearing, profit retentions, operating account of ethical considerations.
profitability and shareholder value indicators.
Why profit maximisation is not a Examples

sufficient objecture
Employee welfare
Risk and incertainty Management welfare
Profit manipulation Societys welfare
Sacrifice of future profits? Service provision
Dividend policy Responsibilities towards customers/suppliers
Investment Financing Dividend

decisions decisions decisions
Investment decisions include: Financial decisions include: Dividend decisions may affect
New projects Long-term capital structure views of the companys long-term
Takeovers Need to determine source, cost prospects, and thus the shares
Mergers and risk of long-term finance. market values.
Sell-off/Divestment Payment of dividends limits the
Short-term working capital
The financial manager must: management amount of retained earnings
Identify decisions available for re-investment.
Balance between profitability and
Evaluate them liquidity is crucial.
Decide optimal fund allocation
Page 3 1: The role and responsibility of senior financial e xecutive

Financial Financial
management planning
Strategic planning Key elements of financial planning

The formulation, evaluation and selection of Long-term investment and short-term cash flow
strategies to prepare a long-term plan of action to Surplus cash
attain objectives. Strategic decisions should be How finance raised
suitable, feasible and acceptable. Profitable
Long-term direction Strategic cash flow management

Matching activities to environment/resources
Planning involves a long horizon, uncertainties and
contingency plans.
Strategic analysis means analysing the
organisation in its environment, its resources,
competences, mission and objectives. Strategic fund management
Strategic choice involves generating and evaluating Consideration of which assets are essential and
strategic options and selecting strategy. how easily assets can be sold.
Investment Financing Dividend

Strategic Selection of products/markets
Target profits
Debt/equity mix Growth v dividend payout
Purchase of major non-current

assets
Tactical Other non-current asset
purchases
Lease v buy Scrip v cash dividends
Efficient/effective resource
usage
Pricing
Tactical planning and control

Conflict may arise between strategic planning (need
to invest in more expensive machinery, research and
development) and tactical planning (cost control).
Page 5 1: The role and responsibility of senior financial e xecutive

Financial Financial
management planning
Johnson and Scholes separate power groups into 'internal coalitions' and 'external stakeholder groups'.
Stakeholder goals
Shareholders Providers of risk capital, aim to maximise
wealth
Suppliers To be paid full amount by date agreed,
and continue relationship (so may accept
later payment)
Long-term To receive payments of interest and
lenders capital by due date
Employees To maximise salaries and benefits; also
prefer continuity in employment
Government Political objectives such as sustained

economic growth and high employment
Management Maximising their own rewards
2: Financial strategy formulation
Topic List Formulating the correct financial strategy is crucial for

business success. The four main areas of financial
strategy are capital structure policy, dividend policy, risk
Assessing corporate performance management and capital investment monitoring.
Financial strategy
Arbitrage
Risk and risk management
Assessing corporate Financial Arbitrage Risk and risk

performance strategy management
Profitability and return Liquidity ratios

Current ratio Acid test ratio
Return on capital employed Inventory turnover Payables days
Profit margin
Receivables days
Asset turnover
Debt and gearing Stock market ratios

Debt ratio (Total debts: Assets)
Gearing (Proportion of debt in long-term capital) Dividend yield Interest yield
Interest cover Earnings per share Dividend cover
Cash flow ratio (Cash inflow: Total debts) Price/earnings ratio
Comparisons with Comparisons with other Comparisons with companies

previous years companies in same industry in different industries
% growth in profit These can put improvements on Investors aiming for diversified
previous years into perspective if portfolios need to know
% growth in revenue differences between industrial
other companies are doing better,
Changes in gearing ratio and provide further evidence of sectors.
Changes in current/quick ratios effect of general trends. Sales growth
Changes in inventory/ Profit growth
Growth rates
receivables turnover ROCE
Retained profits
Changes in EPS, market price, Non-current asset levels P/E ratios
dividend Dividend yields
Remember however
Inflation can make figures
misleading
Results in rest of
industry/environment, or
economic changes
Page 9 2: Financial strategy formulation


Economic Value Added (EVATM)
EVATM = NOPAT (cost of capital capital employed)
Adjustments to NOPAT Adjustments to capital employed
Add: Add:
Interest on debt Cumulative goodwill written off
Goodwill written off Cumulative depreciation written off
Accounting depreciation NBV of intangibles
Increases in provisions Provisions
Net capitalised intangibles
Shares Comparison of finance sources

Ownership stake
Equity (full voting rights) When comparing different sources of finance, for
example different categories of debt, the following
Preference (prior right to dividends)
factors will generally be important:
All companies can use rights issues
Listed companies can use offer for sale/placing Cost
Flexibility
Commitments
Debt/Bonds Uses
Fixed or floating rate Speed/availability
Zero coupon (no interest) Certainty of raising amounts
Convertible Time period available
Bank loans
Security over property may be required


Estimating cost of equity Practicalities in issuing new shares

Theoretical valuation models, eg Capital Asset
Pricing Model (CAPM) or Arbitrage Pricing Costs
Theory (APT) Income to investors
Bond-yield-plus-premium approach: adds a Tax
judgmental risk premium to the interest rate on Effect on control
the firms own long-term debt
Market-implied estimates using discounted cash
flow (DCF) approach (based on an assumption
on the growth rate of earnings of the company)

Pecking order Suitability of capital structure
Retained earnings
Debt Company financial position/ stability of ear nings
Equity Need for a number of sources
Time period of assets matched with funds
Change in risk-return
Cost and flexibility
Tax relief
Minimisation of cost of capital
Feasibility of capital structure
Acceptability of capital structure
Whether lenders are prepared to lend (secur ity)
Availability of stock market funds Risk attitudes
Future trends Loss of control by directors
Restrictions in loan agreements Excessive costs
Maturity of current debt Too heavy commitments


Dividend policy
Dividend decisions determine the amount of, and
the way in which, a companys profits are distributed Theories of why dividends are paid
to its shareholders.
Residual theory
Target payout ratio
Dividends as signals
Ways of paying dividends Taxes
Agency theory
Cash
Shares (stock)
Share repurchases

CAPM exam formula Arbitrage pricing theory

E(r i) = Rf + i (E(rm) Rf) The theory assumes that the return on each security
is based on a number of independent factors.
Factor analysis r = E(r j ) + B1F1 + B2F2 ... + e
Analysis used to determine factors to which security

E (rj ) is expected return on security
returns are sensitive. Research indicates:
Unanticipated inflation B1 is sensitivity to changes in Factor 1
Changes in industrial production levels F1 is difference between Factor 1 actual and
Changes in risk premiums on bonds expected values
Unanticipated changes in interest rate term e is a random term
structure


Types of risk Risk management

Systematic and unsystematic Overriding reason for managing risk is to maximise
Business shareholder value.
Financial
Political
Economic Risk mitigation
Fiscal
Regulatory The process of minimising the likelihood of a risk
Operational occurring or the impact of that r isk if it does occur.
Reputational
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3a: Conflicting stakeholder interests
Topic List Governance of a modern corporation can give rise to

conflicts between the various stakeholders of the firm.
Be prepared to answer questions on key concepts such
Stakeholders as agency theory or goal congruence, or developments
Corporate governance in corporate governance.
Stakeholders Corporate
governance
Separation of ownership and management: ordinary Transaction costs economics

(equity) shareholders are owners of the company, but
The transaction costs economics theory
the company is managed by its board of directors.
postulates that the governance structure of a
Central source of stakeholder conflict: difference corporation is determined by transaction costs.
between the interests of managers and those of o wners.
Sources of stakeholder conflict

The transactions costs include search and
information costs, bargaining costs and policing
Short-termism
and enforcement costs.
Sales objective (instead of shareholder value)
Overpriced acquisitions
Resistance to takeovers
Relationships with stakeholders may be difficult
governance
Agency theory Goal congruence

proposes that, whilst individual team members act is accordance between the objectives of agents
in their own self-interest, individual well-being acting within an organisation and the objectives of
depends on the well-being of other individuals and the organisation as a whole.
on the performance of the team.
Corporations are set of contracts between principals Management incentives may enhance congruence:
(suppliers of finance) and agents (management).
Profit-related pay
Rights to subscribe at reduced price
The agency problem Executive share-option plans
If managers dont have significant shareholdings, BUT management may adopt creative accounting.
what stops them under-performing and over-
Sound corporate governance is another approach.
rewarding themselves?
Page 19 3a: Conflicting stakeholder interests

governance
UK Corporate Governance Code

AUDITORS provide external assurance
DIRECTORS responsible for FINANCIAL REPORTING

SHAREHOLDERS
corporate governance SYSTEM links
OTHER USERS
(employees, creditors)
Board of directors Non executive directors
Executive
Meet regularly directors Majority independent
Matters refer to board Limits on service contracts, No business/financial links
Division of responsibilities emoluments decided by Dont participate in options
Committees audit, nomination, remuneration committee Appointed for specified term
remuneration and fully disclosed
Annual general meeting Accountability and audit
20 working days notice Audit committee of non-executive directors

Separate resolutions on separate issues Consider need for internal audit function
All committees answer questions Accounts contain corporate governance statement
Directors review and report on internal controls
The Higgs Report stresses the importance of the board including a balance of e xecutive and non-executive
directors such that no individual or small g roup can dominate decision-making. The report also lays down
criteria for establishing the independence of non-executive directors, and stresses the need to separ ate the
roles of Chairman and Chief Executive.
Page 21 3a: Conflicting stakeholder interests

governance
International comparisons
USA Europe Japan
By means of Stock Exchange By means of tax law. Also two-tier Flexible approach to governance,
regulation, stringent reporting board system to protect shareholder low level of regulation. All
requirements, tightened by interests. stakeholders collaborate.
Sarbanes-Oxley.
The US system is based on In Germany, banks have longer- Stock market is less open, more
control by legislation, regulation, term role, may have equity stake. links with banks than in UK.
more rules on directors duties Separate supervisory board has Policy boards (long-term)
than in UK. Major creditors are workers and shareholders Functional boards (executive)
often on boards. representatives.
Monocratic boards (symbolic)
Management culture
Management culture comprises views on management and methods of doing b usiness. Multinationals may have
particular problems imposing the parent companys culture overseas eg American practices in Europe.
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3b: Ethical issues in financial management
Topic List Ethics have become increasingly important in formulating

financial strategies. Financial managers must remember
to build ethical considerations into the decision-making
Ethical aspects process.
Ethical
aspects
Human resource Minimum wage, discrimination

management
Marketing Social and cultural impact

Business
ethics
Market behaviour Dominant position, treatment of
suppliers and customers
Product development Animal testing, sensitivity to

culture of different countries
and markets
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3c: Environmental issues
Topic List You could be asked to discuss how the financial manager
needs to take into account environmental issues when
formulating corporate policy.
Business practice
Regulation
Business Regulation
practice
Green issues and business practice Environmental reporting

Direct environmental impacts on business eg: Many companies produce an external report for external
Changes affecting costs or resource stakeholders, covering:
availability How business activity impacts on environment
Impact on demand An environmental objective (eg use of 100%
recyclable materials within x years)
Effect on power balances between competitors
in a market The company's approach to achieving and
monitoring these objectives
Indirect environmental impacts: eg, legislative
An assessment of its success towards achieving
change; pressure from customers or staff as a
the objectives
consequence of concern over environmental
problems. An independent verification of claims made
Sustainability Companys environmental policy

may include reduction/management of risk to the
refers to the concept of balancing g rowth with business, motivating staff and enhancement of
environmental, social and economic concerns. corporate reputation.
Triple bottom line decision making Triple bottom line proxy indicators
Economic
Economic impact
Gross operating surplus
Dependence on imports
Stimulus to domestic economy by purchasing
locally produced goods and services
Social impact
Environmental Social Organisations tax contribution
Employment
Environmental impact
Triple bottom line reporting: a quantitative Ecological footprint
summary of a companys economic, Emissions to soil, water and air
environmental and social performance over the Water and energy use
previous year.
Page 27 3c: Environmental issues

Business Regulation
practice
Financial Manufactured Intellectual

capital capital capital
Integrated reporting
Human Social and Natural

capital relationship capital
capital
Principles of integrated reporting Contents of integrated report

Integrated reports should be based on a n umber of
principles: Organisational overview and external environment
Governance structure and value creation
Strategic focus and future orientation
Connectivity of information Business model
Stakeholder responsiveness Opportunities and risks
Materiality Strategy and resource allocation
Conciseness
Reliability and completeness Performance achievement of strategic objectives
and impact on capitals
Consistency and comparability
Basis of preparation and presentation
Integrated thinking involves consideration of the
interrelationships between operating and financial
units and the capitals the business uses.
Page 29 3: Environmental issues

Business Regulation
practice
Carbon trading Environment Agency

allows companies which emit less than their allowance to Mission: to protect or enhance environment,
sell the right to emit CO2 to another company. so as to promote the objective of achieving
sustainable development.
UNFCCC
United Nations Framework Convention on Climate Change
agreements: Environmental audit
To develop programs to slow climate change
is an audit that seeks to assess the
To share technology and cooperate to reduce greenhouse environmental impact of a company's policies.
gas emissions
To develop a greenhouse gas inventory listing national The auditor will check whether the companys
sources and sinks environmental policy:
1997 Kyoto Protocol to the UNFCCC

Satisfies key stakeholder criteria
Meets legal requirements
obliged signatories to reduce total greenhouse gas emissions Complies with British Standards or other
by 2012, compared to 1990 levels. EU15 reduction target: 8%. local regulations
4: Trading and planning in a multinational

environment
Topic List The growth of international trade brings benefits and

risks for the corporation. The globalisation of international
markets facilitates the flow of funds to emerging mar kets
Trade but may create instability.
Institutions
International financial markets
Global financial stability
Multinationals strategy
Risk
Trade Institutions International Global financial Multinationals Risk

financial markets stability strategy
International trade Barriers to market entry
World output of goods and ser vices is increased if Product differentiation barriers
countries specialise in the production of Absolute cost barriers
goods/services in which they have a comparative Economy of scale barriers
advantage and trade to obtain other goods and The level of fixed costs
services. Legal/patent barriers
Protectionist measures
Comparative advantage Tariffs or customs duties

Import quotas
Countries specialising in what they produce, even Embargoes
if they are less efficient (in absolute ter ms) in Hidden subsidies
production of all types of good, is the compar ative Import restrictions
advantage justification of free trade, without Restrictive bureaucratic procedures
protectionism or trade barriers. Currency devaluations
Whats wrong with trade protection Why protect trade?
Mutually beneficial trade may be reduced To combat imports of cheap goods

There may be retaliation To counter dumping
Economic growth prospects may be damaged Infant industries might need special treatment
Political ill-will may be created
Declining industries might need special
treatment
Protection might reduce a trade deficit
European Union
The EU combines a free trade area with a
customs union (mobility of factors of production).
Page 33 4: Trading and planning in a multinational environment


World Trade Organisation and IMF aims
International Monetary Fund Promote international monetary co-operation, and

establish code of conduct for international payments
WTO aims Provide financial support to countries with temporary
balance of payments deficits
Reduce existing barriers to free trade
Provide for orderly growth of international liquidity
Eliminate discrimination in
international trade (in eg tariffs and
subsidies)
World Bank (IBRD)
Prevent growth of protection by supplements private finance and lends money on a commercial
getting member countries to consult basis for capital projects, usually direct to governments or
with others first government agencies.
Act as a forum for assisting free trade,
and offering a disputes settlement BIS
process Bank for International Settlements: the banker for central banks.
Establish rules and guidelines to Promotes co-operation between central banks
make world trade more predictable Provides facilities for international co-operation

Globalisation of financial markets has contributed to Arguments for EMU

financial instability, despite facilitating the transfer of
funds to emerging markets. Economic policy stability
Facilitation of trade
Lower interest rates
Preservation of the Citys position
European Monetary System (EMS) Arguments against EMU

Purposes
To stabilise exchange rates between member Loss of national control over economic policy
countries The need to compensate for weaker economies
To promote economic convergence in Europe Confusion in transition to EMU
To develop European Economic and Monetary Lower confidence arising from loss of national
Union (EMU) pride


The global debt crisis arose as governments in less Negative impacts on multinational
developed countries (LDCs) took on levels of debt firms
that were above their ability to finance.
Resolving the global debt crisis Deflationary policies damage profitability

Devaluation of currency
Restructure or rescheduled debt Reduction in imports by developing countries
Economic reforms to improve balance of trade Increased reliance on host countries for
Lending governments write off some of the debts funding
Convert some debt into equity

Strategic reasons for FDI Ways to establish an interest abroad
Market seeking Economies of scale Joint ventures industrial co-operation

Raw material seeking Managerial and (contractual) or joint-equity
Production efficiency marketing expertise Licensing agreements
seeking Technology Management contracts
Knowledge seeking Financial economies Subsidiary
Political safety seeking Differentiated products Branches
Management contracts: a firm agrees to sell

management skills sometimes used in combination
with licensing. Can serve as a means of obtaining Many multinationals use a combination of methods
funds from subsidiaries, where other remittance for servicing international markets.
restrictions apply.


Multinationals financial planning

Multinational companies need to develop a financial planning A company raising funds from local
framework to ensure that the strategic objectives and equity markets must comply with the
competitive advantages are realised. Such a financial planning listing requirements of the local exchange.
framework will include ways of raising capital and risks related
to overseas operations and the repatriation of profits.
Blocked funds
Finance for overseas investment depends Multinationals can counter exchange
on: controls by management charges or
Local finance costs, and any available subsidies royalties.
Tax systems of the countries (best group structure may
be affected by tax systems) Control systems
Any restrictions on dividend remittances Large and complex companies may be
Possible flexibility in repayments arising from the organised as a heterarchy, an organic
parent/subsidiary relationship structure with significant local control.

Factors in assessing political risk Litigation risks

Government stability Level of import restrictions can generally be reduced by keeping abreast
Political and business ethics Remittance restrictions of changes, acting as a good cor porate citizen
Economic stability/inflation Assets seized and lobbying.
Degree of international Special taxes and regulations
indebtedness on overseas investors, or Cultural risks
Financial infrastructure investment incentives
should be taken into account when deciding
where to sell abroad, and how much to
Dealing with political risk centralise activities.
Negotiations with host government

Insurance (eg ECGD) Environmentally Environmentally
Production strategies sensitive insensitive
Contacts with customers Adaptation necessary Standardisation possible
Financial management eg borrowing funds locally Fashion clothes Industrial and agricultural products
Management structure eg joint ventures Convenience foods World market products, eg jeans


Agency issues Solutions to agency problems in

Agency relationships exist between the CEOs of multinationals
conglomerates (the principals) and the strategic
business unit (SBU) managers that report to these Multiple mechanisms may be needed, working in
CEOs (agents). unison. Eg:
Board of directors: separate ratification and
The interests of the individual SBU managers may monitoring of managerial decisions from
be incongruent not only with the interests of the initiation to implementation
CEOs, but also with those of the other SB U
Executive incentive systems can reduce
managers.
agency costs and align the interests of
Each SBU manager may try to make sure his or managers and shareholders by making top
her unit gets access to critical resources and executives pay contingent on the value they
achieves the best performance at the expense of create for the shareholders
the performance of other SBUs and the whole
organisation.
5: DCF
Topic List In this chapter, we discuss the evaluation of projects using

the Net Present Value (NPV) method and the Inter nal Rate
of Return.
NPVs The NPV method is extended to include inflation and
specific price variation, taxation and the assessment of
Internal rate of return fiscal risk and multi-period capital rationing.
We also look at the potential inter nal rate of return to
assess a project's return margin and its vulnerability to
competitive action.
NPVs Internal
rate of return
Net present value (NPV) Real and nominal discount factors

The sum of the discounted cash flows less the What nominal rate (i) should be used for discounting
initial investment. cash flows, if the real rate is r and the rate of inflation h?
The net effect of inflation
(l + i) = (1 + r)(1 + h) on the NPV of a project
Decision criterion (the Fisher equation,
will depend on three
inflation rates: the rates
given in exam)
Invest in a project if its net present v alue is positive for revenues, costs, and
ie when NPV > 0 the discount factor.
Do not invest in a project if its net present v alue is
zero or negative, ie when NPV 0 Tax effects on NPV
Corporate taxes Other local taxes

Value added taxes Capex tax
allowances
Capital rationing
Capital rationing problem exists when there are The multi-period capital rationing problem can be
insufficient funds to finance all available profitable formulated as an integer programming problem.
projects.
Case I The Monte Carlo method

Fractional investment allowed: rank the
amounts to adopting a par ticular probability
alternatives according to the ratio of NPV to initial
distribution for the uncertain (random) variables that
investment or the benefit cost ratio.
affect the NPV and then using sim ulations to
generate values of the random variables.
Case II
Fractional investment not allowed: a more Project Value at Risk
systematic approach may be needed to find the NPV-
maximising combination of entire projects subject to is the minimum amount by which the value of an
the investment constraint. This is provided by the investment or portfolio will fall over a given period of
mathematical technique of integer programming. time at a given level of probability.
Page 43 5: DCF
NPVs Internal
rate of return
IRR
The discount rate at which NPV equals zero.
The IRR calculation also produces the breakeven cost
of capital and allows calculation of the margin of safety
If the cash flows change signs then the IRR may not
be unique: this is the multiple IRR problem
With mutually exclusive projects, the decision
depends not on the IRR but on the cost of capital
being used
Decision criteria using IRR
A project will be selected as long as the IRR
is not less than the cost of capital.
Modified IRR (MIRR) Re-investment rate

The NPV method assumes that cash flows can be
MIRR is the IRR which would result without the
reinvested at the cost of capital over the life of the
assumption that project proceeds are reinvested at
project.
the IRR rate.
Selection of investments based on the higher IRR
1 Calculate the present value of the return phase assumes that cash flows can be reinvested at the
(the phase of the project with cash inflo ws) IRR over the life of the project.
2 Calculate the present value of the investment The IRR assumption is unlikely to be valid and so
phase (the phase with cash outflows) the NPV method is likely to be superior. The better
reinvestment rate assumption will be the cost of
3 Calculate MIRR using the following formula: capital used for the NPV method.
1
PVR n Decision criterion
MIRR = (1+ r e) 1
PV1 If MIRR is greater than the required rate of return:
ACCEPT
This formula is given in the exam. If MIRR is lower than the required rate of return:
REJECT
Page 45 5: DCF
Notes
6: Application of option pricing theory in

investment decisions
Topic List Option valuation techniques can be applied to capital

budgeting exercises in which a project is coupled with a
put or call option. For example, the firm may have the
Options concepts option to abandon a project dur ing its life. This amounts
to a put option on the remaining cash flo ws associated
Real options with the project. Ignoring the value of these real options
(as in standard discounted cash flow techniques) can
lead to incorrect investment evaluation decisions.
Options Real
concepts options
Options Determinants of option values
An option is a contract that gives one party the option to The higher the exercise price, the lower
enter into a transaction either at a specific time in the future the probability that the call will be in the
or within a specific future per iod at a price that is agreed money
when the contract is issued. As the current price of the underlying
asset goes up, the higher the
The buyer of a call option acquires the r ight, but not the probability that the call will be in the
obligation, to buy the underlying at a fixed price money
The buyer of a put option acquires the r ight, but not the Both a call and put will increase in
obligation, to sell the underlying shares at a fixed price price as the underlying asset becomes
more volatile
Both calls and puts will benefit from
In the money option: intrinsic value is +ve
increased time to expiration
At the money option: intrinsic value is zero The higher the interest rate, the lower
Out of the money option: intrinsic value is ve the present value of the exercise price
Options Real
concepts options
Real options Option to abandon

Strategic options known as real options is if the firm has the option to cease a project
arising from a project can increase the project during its life. Abandonment is effectively the
value. They are ignored in standard DCF analysis, exercising of a put option. The option to abandon is
which computes a single present value. a special case of an option to redeplo y.
Option to redeploy
Option to delay is when company can use its productive assets for
When a firm has exclusive rights to a project or product for activities other than the original one. The switch will
a specific period, it can delay taking this project or product happen if the PV of cash flows from the new
until a later date. For a project not selected today on NPV activity will exceed costs of switching.
or IRR grounds, the rights to the project can still have value.
Option to expand Black-Scholes valuation

is when firms invest in projects allowing further investments In applying Black-Scholes valuation techniques to
later, or entry into new markets, possibly making the NPV real options, simulation methods are typically used
+ve. The initial investment may be seen as the premium to to overcome the problem of estimating volatility.
acquire the option to expand.
Page 49 6: Application of option pricing theory in investment decisions
Options Real
concepts options
Determinants of option values Black-Scholes formulae

C = Pa N(d1 ) PeN(d 2 )e rt
Exercise price (Pe)
Price of underlying asset (Pa) P
In a + (r + 0.5s 2 )t
P
Volatility of underlying asset (s) d1 = e
Time to expiration (t) s t
Interest rate (r)
d 2 = d1 s t
Intrinsic and time value
These formulae are given in the exam.
Put option
Real options are highly examinable. P = C Pa + Pe e rt

7a: Impact of financing and APV method
Topic List The cost of capital is the r ate of return required by investors
in order to supply their funds to the compan y. It is also the
rate of return a company must earn in a project in order to
Sources of finance
maintain its market value. There are two forms of capital to a
Duration firm, equity and debt, and each supplier of capital requires a
return which is determined by the risks each type of investor
Credit risk faces.
Modigliani & Miller The overall cost of capital to the fir m is the weighted
Other theories average of the cost of equity and the cost of debt.
APV approach
Sources of Duration Credit Modigliani Other APV

finance risk & Miller theories approach
Equity Venture Business Asset

capital angels securitisation
Sources of finance
Short-term/ Lease Hybrids Islamic

long-term finance finance
debt
Islamic finance Similar to Features

transaction
Murabaha Trade credit/loan Pre-arranged mark up for convenience of later payment, no interest
Musharaka Venture capital Profit share per contract, no dividends, losses per capital contribution,
both parties participate
Mudaraba Equity Profit share per contract, no dividends, losses borne by capital
provider, organisation runs business
Ijara Leasing Whatever the other features, lessor remains asset owner and incurs
risks of ownership
Sukuk Bonds Underlying tangible asset in which holder shares may be asset-based
(sale/leaseback) or asset-backed (securitisation)
Salam Forward contract Commodity sold for future delivery, cash received at discount from
financial institution, payments received in advance
Istisna Phased payments Project funding, initial payment and then instalments from business
undertaking the project
Page 53 7a: Impact of financing and APV method


Cost of equity Cost of irredeemable debt

d0 (1 + g) i(1 T)
ke = +g kd =
P0 P0
Cost of redeemable debt

IRR calculation, including amount payable on
g = br redemption
g is growth rate of dividends WACC

b is proportion of profits retained
r is rate of return on investments Ve Vd
WACC = ke + kd (1 - T )
CAPM Ve + Vd Vd + Ve
E(r i) = Rf + i (E(rm) Rf)
Beta factors of portfolios Limitations of CAPM

Portfolio of all stock Beta factor 1
market securities Difficulties in determining excess return
Difficulties in determining risk-free rate
Portfolio of risk-free Beta factor 0 Errors in statistical analysis used to calculate
securities betas
Investors portfolio Beta factor weighted Difficulties in forecasting companies with low
average of individual P/E ratios
beta factors Assumption that costs are zero
Assumption that investment market is efficient
Assumption that portfolios are well-diversified


Geared betas Exam formula

may be used to obtain an appropr iate required Ve Vd(1 T)
a =
return when an investment has differing business (Ve + Vd(1 T)) e + (Ve + Vd(1 T)) d
and finance risks from the existing business.
Weaknesses in the formula where

a = asset (or ungeared) beta
Difficult to identify firms with identical operating
characteristics e = equity (or geared) beta
Estimate of beta factors not wholly accurate d = beta factor of debt in the geared company
Assumes that cost of debt is r isk-free Vd = market value of debt in the geared company
Does not include growth opportunities
Ve = market value of equity capital in the geared compan y
Differences in cost structures and size will
affect beta values between firms T = rate of corporate tax

Duration (Macaulay duration) Properties of duration
The weighted average length of time to the receipt

Longer-dated bonds have longer durations
of a bonds benefits (coupon and redemption value).
The weights are the present values of the benefits Lower-coupon bonds will have longer
involved. durations
Lower yields will give longer durations
Calculating duration
1 Multiply PV of cash flows for each time period Modified duration
by the time period and add together
Macaulay duration
Add the PV of cash flows in each period Modified duration =
2 1 + gross redemption yield
together Modified duration shares the same proper ties as
Divide the result of step 1 by the result of Macaulay duration.
3 step 2


Credit risk (or default risk) Standard & Poors Moodys

is the risk for a lender that the AAA Aaa Highest quality, lowest default risk
borrower may default on interest AA Aa High quality
payments and/or repayment of
A A Upper medium grade quality
principal.
BBB Baa Medium grade quality
Credit risk for an individual loan or
BB Ba Lower medium grade quality
bond is measured by estimating:
Probability of default B B Speculative
typically, using information on CCC Caa Poor quality (high default risk)
borrower and assigning a credit CC Ca Highly speculative
rating (eg Standard & Poors,
Moodys, Fitch) C C Lowest grade quality
Recovery rate the fraction of
face value of an obligation
Credit migration
recoverable once the borrower is the change in the credit r ating after a bond is issued.
has defaulted
Determinants of cost of debt capital Option pricing models to assess default risk
The equity of a company can be seen as a call
Credit rating of company option on the assets of the company with an exercise
Maturity of debt price equal to the outstanding debt.
Risk-free rate at appropriate maturity
Corporate tax rate
Expected losses are a put option on the assets of
Credit spread the firm with an exercise price equal to the value of
the outstanding debt.
is the premium required by an investor in a
corporate bond to compensate for the credit risk of
the bond. From the Black-Scholes formula, the probability of
Yield on corporate bond = risk free rate + credit default depends on three factors:
spread The debt/asset ratio
The volatility of the company assets
Cost of debt capital = (1 tax r ate)(risk free rate
The maturity of debt
credit spread)


Excess spread
Internal credit enhancement Over-collateralisation
Surety bonds
External credit enhancement Letters of credit
Cash collateral accounts

MM theory (no tax) MM and cost of equity

The use of debt would only transfer more Vd
k e = k ie + (1 T)(k ie k d )
risk to the shareholders, therefore will not Ve
reduce the WACC. where ke = cost of equity in a geared compan y
ke i = cost of equity in an ungeared compan y
Vd, Ve = market values of debt and equity
kd = pre-tax cost of debt
This formula is given in the exam.
MM theory (with tax)
Debt actually saves tax (due to tax relief Limitations of MM theory
on interest payments) therefore firms
should only use debt finance. Too risky in reality to have high levels of gearing
Assumes perfect capital markets
Does not consider bankruptcy risks, tax exhaustion,
agency costs and increased borrowing costs as risk rises


Static trade-off theory Agency theory

A firm in a static position will adjust their gear ing levels The optimal capital structure will occur where the
to achieve a target level of gearing. benefits of the debt received by the shareholders
matches the costs of debt imposed on the
shareholders.
Problems with financial distress costs
Direct financial Indirect financial

distress distress
Legal and admin Higher cost of capital

costs associated with Loss of sales
bankruptcy Downsizing
High staff turnover
Pecking order theory Predictions

is, unlike the MM models, based on the idea To finance new investment, firms prefer internal
of information asymmetry: investors have a finance to external finance
lower level of information about the company If retained earnings differ from investment outlays,
than its directors do. As a result, shareholders the firm adjusts its cash balances or mar ketable
use directors' actions as a signal to indicate securities first, before either taking on more debt or
what directors believe about the company increasing its target payout rate
with their superior information.
Internal finance is at the top, and equity is at the
bottom, of the pecking order. A single optimal debt-
equity ratio does not exist: a result similar to the
MM model with no taxes


Adjusted present value (APV) approach Steps in applying APV

The adjusted present value (APV) method of 1 Calculate the NPV as if the project w as
valuation is based on the Modigliani Miller model financed entirely by equity (use k ei )
with taxation. Add the PV of the tax saved as a result of the
2
debt used to finance the project (use k d)
We assume that the primary benefit of borrowing is 3 Subtract the cost of issuing new finance
the tax benefit and that the most significant cost of
borrowing is the added risk of bankruptcy.
7b:Valuation and free cash flows
Topic List This chapter mainly focuses on the use of free cash
flows and their use for valuation puposes.
Yield curve and bond values It also briefly considers using the yield cur ve for bond
Free cash flows values and recaps equity valuation methods from Paper
F9 financial management.
Equity valuation
Yield curve and Free cash Equity

bond values flows valuation
Using the yield curve

The yield curve can be used to estimate bond v alue by splitting, say a four year bond into four separate
bonds. Each bond can then be discounted by using the rates from the yield curve.
The total of the discounted cash flows represents the issue price.
An IRR style calculation can be used to calculate the yield to matur ity.
In general:
1 1 1 1
Price = Coupon + Coupon + + Coupon
n
+ Redemption value
n
2
(i + r1) (i + r2 ) (i + rn ) (i + rn )

Free cash flow (FCF) Forecasting FCF

Free Cash Flow = Earnings before Interest Constant growth
(FCF) and Taxes (EBIT)
FCF = FCF0 (1 + g)n
less Tax on EBIT
plus Non cash charges where FCF0 is the free cash flow at beginning
(eg depreciation) n is the number of years
less Capital expenditures Differing growth rates
less Net working Forecast each element of FCF separately using
capital increases appropriate rate.
plus Net working
capital decreases
plus Salvage value received
Page 67 7b: Valuation and free cash flows


Forecasting dividend capacity

The dividend capacity of a fir m is measured by its
free cash flow to equity (FCFE).
Direct method of calculating FCFE Indirect method

Net income (EBIT net interest tax paid) Free cash flow
Add depreciation Less (Net interest + net debt paid)
Less total net investment Add Tax benefit from debt
(net interest tax rate)
Add net debt issued
Add net equity issued
Firm valuation using FCF Terminal values and company valuation

Value of the firm is the sum of the discounted free Value of the firm is the present value over the
cash flows over the appropriate time horizon. forecast period + terminal value of cash flows
beyond the forecast period.
Assuming constant growth, use the Gordon model:

Firm valuation using FCFE
FCF0 (1 + g) Calculate value of equity (present value of
PV0 = 1 FCFE discounted at the cost of equity)
kg
where g = growth rate 2 Calculate value of debt
k = cost of capital
3 Value = value of equity + value of debt


Range of values Uses of net asset valuation method

As measure of security in a share valuation
Max Value the cashflows or earnings under
new ownership. As measure of comparison in scheme of
Value the dividends under the existing merger
management. As floor value in business that is up for sale
Min Value the assets.
Problems in valuation
Possible bases of valuation
Need for professional valuation
Realisation of assets
Contingent liabilities
Historic Replacement Realisable Market for assets
basis basis basis
(unlikely to (asset used (asset sold/
be realistic) on ongoing business
basis) broken up)
Price-earnings ratio Have to decide suitable P/E ratio.

Factors to consider:
Market value Industry
P/E ratio =
EPS Status
Marketability
Market value = EPS P/E r atio Shareholders
Asset backing and liquidity
Nature of assets
Gearing
Shows the Shows the markets view of
current profitability the growth prospects/risk of
of the company a company Earnings yield valuation model
Which P/E ratio to use? Earnings
May be affected by Market value =
one-off transactions Adjust downwards if Earnings yield
valuing an unquoted
company

Dividend valuation model Features
Based on expected future income

D
P0 = Can be used to value minority stake
ke
Growth rate difficult to estimate
Where P0 is price at time 0 Dividend policy may change
D is dividend (constant) Companies that dont pay dividends dont have
ke is cost of equity zero values
D 0 (1 + g)
P0 = Discounted cash flow method
ke g
Value investment using expected after-tax cash flows
Where D0 is dividend in current year of investment and appropriate cost of capital.
g is dividend growth rate
8: International investment decisions
Topic List Companies that undertake overseas projects are subject

to exchange rate risks as well as other risks such as
exchange controls, taxation and political action.
NPV and international projects Capital budgeting methods for multinational companies
Exchange controls can incorporate these additional complexities in the
decision-making process.
Exchange rate risks
Capital structure
NPV and Exchange Exchange Capital

international projects controls rate risks structure
Purchasing power parity NPVs for international projects

Absolute purchasing parity theory: prices of products in different Alternative methods for calculating
countries will be the same when expressed in the same currency. the NPV from a overseas project:
Alternative purchasing power parity relationship: changes in Convert project cash flows into
exchange rates are due to differences in the expected inflation rates sterling and discount at sterling
between countries. discount rate to calculate NPV
in sterling terms
International Fisher effect Discount cash flows in host
1 + ic 1 + hc country's currency from project
= at adjusted discount rate for
1 + ib 1 + hb that currency and then convert
resulting NPV at spot exchange
This equation is given in the exam.
rate
In the absence of trade or capital flows restrictions, real interest rates
in different countries will be expected to be the same. Differences in
interest rates reflect differences in inflation rates.
Effect of exchange rates on NPV Effect on exports

When there is a devaluation of sterling relative to a When a multinational company sets up a subsidiary
foreign currency, the sterling value of cash flows in another country in which it already exports, the
increases and NPV increases. The opposite relevant cash flows (and NPV) for evaluation of the
happens when the domestic currency appreciates. project should account for loss of export earnings in
the particular country.
Impact of transaction costs

Transaction costs are incurred when companies
invest abroad due to currency conversion or other
administrative expenses. These should also be
taken into account.
Page 75 8: International investment decisions


Taxes in international context Tax haven characteristics
Host country Low tax on foreign investment or sales income

Corporate taxes earned by resident companies
Investment allowances Low withholding tax on dividends paid to the
Withholding taxes parent
Home country Stable government and currency
Double taxation relief Adequate financial services support facilities
Foreign tax credits
Subsidies
The benefit from concessionary loans should be included in the NPV calculation as the diff erence between the
repayment when borrowing under market conditions and the repayment under the concessionary loan.

Exchange controls Strategies

Types Multinational company strategies to overcome
exchange controls:
Rationing supply of foreign exchange.
Payments abroad in foreign currency are Transfer pricing, where the parent company
restricted, preventing firms from buying as much sells goods or services to the subsidiary and
as they want from abroad obtains payment
Restricting types of transaction for which Royalty payments adjustments, when a parent
payments abroad are allowed, eg suspending or company grants a subsidiary the right to make
banning payment of dividends to foreign goods protected by patents
shareholders, such as parent companies in
multinationals: blocked funds problem Loans by the parent company to the subsidiary:
setting interest rate at appropriate level
For an overseas project, we include only the Management charges levied by the parent
proportion of cash flows that are expected to be company for costs incurred in the management
repatriated in the NPV calculation. of international operations


Transaction exposure Economic exposure

is the risk of adverse exchange rate movements is the risk that the present value of a companys
between the date the price is agreed and the date future cash flows might be reduced by adverse
cash is received/paid, arising during normal exchange rate movements.
international trade.
Translation exposure Economic exposure:

is the risk that the organisation will make exchange Can be longer-term (continuous currency
losses when the accounting results of its f oreign depreciation)
branches or subsidiaries are translated.
Can arise even without trade overseas (effects of
Translation losses can arise from restating the book pound strengthening)
value of a foreign subsidiarys assets at the
exchange rate on the statement of financial position
date only important if changes arise from loss of
economic value.

Overseas subsidiaries Choice of finance

Parent company needs to consider a number of
issues when setting up an overseas subsidiary: Finance costs
Taxation systems
Amount of equity capital Restrictions on dividend remittances
Whether parent owns 100% of equity Flexibility in repayments
Profit retention by subsidiary Reduction in systematic risk
Amount of subsidiarys debt Access to foreign capital
Amount of subsidiarys working capital Agency costs
Whether subsidiary should obtain local listing


International borrowing options Advantages of international borrowing

(1) Borrow in the same currency as the inflo ws from
the project
Availability. Domestic financial markets, except
(2) Borrow in a currency other than the currency of larger countries and the Euro zone, generally
the inflows, with a hedge in place lack the depth and liquidity to accommodate
large or long-maturity debt issues
(3) Borrow in a currency other than the currency of
the inflows, without hedging the currency r isk Lower cost of borrowing. In Eurobond
markets interest rates are normally lower than
borrowing rates in national markets
Option (3) exposes the company to exchange
rate risk which can substantially change the Lower issue costs. Cost of debt issuance is
profitability of a project. normally lower than the cost of debt issue in
domestic markets
9: Acquisitions and mergers vs growth
Topic List Firms may decide to increase the scale of their

operations through a strategy of internal organic growth
by investing money to purchase or create assets and
Acquisitions and mergers product lines internally.
Shareholder value issues Alternatively, companies may decide to grow by buying

other companies in the market, thus acquiring ready-
made tangible and intangible assets and product lines.
Acquisitions Shareholder
and mergers value issues
Operating Management Diversification Asset backing Earnings

economies of acquisition quality
Mergers and acquisitions
Finance/ Internal expansion Tax Defensive Economic

liquidity costs merger efficiency
Factors in a takeover
Cost of acquisition Form of purchase consideration

Reaction of predators shareholders Accounting implications
Reaction of targets shareholders Future policy (eg dividends, staff)
VERTICAL MERGER
Supplier
Aim: control of
supply chain
BACKWARD MERGER
HORIZONTAL MERGER CONGLOMERATE MERGER
Two merging firms Two firms operate in
produce similar products Firm
different industries
in the same industry Aim: diversification
Aim: increase market
power FORWARD MERGER
Customer/distributor
Aim: control of
distribution
Page 83 9: Acquisitions and mergers vs growth

Takeover strategy Acquire

Growth prospects limited Younger company with higher growth rate
Potential to sell other products to existing Company with complementary product range
customers
Operating at maximum capacity Company making similar products operating below capacity
Under-utilising management Company needing better management
Greater control over supplies or customers Company giving access to customer/supplier
Lacking key clients in targeted sector Company with right customer profile
Improve statement of financial position Company enhancing EPS
Increase market share Important competitor
Widen capability Key talents and/or technology
Synergy
Revenue synergy exists when the acquisition will Sources of financial synergy
result in higher revenues, higher return on equity or
a longer period of growth for the acquiring company.
Diversification Tax benefits
Revenue synergies arise from: Use of cash slack Debt capacity
(a) Increased market power
(b) Marketing synergies
(c) Strategic synergies
Cost synergy results from economies of scale. As

scale increases, marginal cost falls and this will be
manifested in greater operating margins for the
combined entity.
Page 85 9: Acquisitions and mergers vs growth

Failures to enhance shareholder value Market irrationality argument: when

a companys shares seem overvalued,
Why do many acquisitions fail to enhance shareholder value? management may exchange them for
an acquiree firm: merger. The lack of
synergies or better management may
lead to a failing merger.
Agency theory: takeovers may be motivated by self-interested
acquirer management wanting: Preemptive theory: several firms may
compete for opportunity to merge with
Diversification of management's own portfolio target to achieve cost savings. Winning
Use of free cash flow to increase size of the firm firm could improve market position and
Acquisitions that increase firm's dependence on management gain market share. It can be rational for
Value is transferred from shareholders to managers of acquir ing firm. the first firm to pre-empt a merger with
its own takeover attempt.
Hubris hypothesis: bidding company bids too much because
managers of acquiring firms suffer from hubris, excessive pride and Window dressing: where companies
arrogance. are acquired to present a better shor t-
term financial picture.
10: Valuation for acquisitions and mergers
Topic List There are different methods for predicting earnings

growth for a company, using external and internal
measures. An acquisition potentially affects the risk of
Valuation issues the acquiring company and its cost of capital.
Type I First, we consider the overvaluation problem: the
problem that when a company acquires another
Type II
company, it often pays more than the companys current
Type III market value.
High-growth start-ups
Intangible assets
Valuation Type I Type II Type III High-growth Intangible

issues start-ups assets
The overvaluation problem Estimating earnings growth

Gordon constant growth model:
is paying more than the current mar ket value, to
acquire a company. FCF0 (1 + g)
PV =
(k g)
During an acquisition, there is typically a fall in
the price of the bidder and an increase in the Three ways to estimate g:
price of the target Historical estimates: extrapolate past values
The overvaluation problem may arise as Rely on analysts forecasts
miscalculation of potential synergies or Use the companys return on equity and
overestimation of ability of acquiring firm's retention rate of earnings (g = ROE retention
management to improve performance rate)
Both errors will lead to a higher pr ice than
current market value
Business risk of combined entity Asset beta

The risk associated with the unique circumstances The weighted average of the betas of the target,
of the combined company. Affected by the betas of predator and synergy of the combined entity.
the individual entities (target and predator) and the
beta of the resulting synergy.
Acquisitions and acquirers risk Geared equity beta

Acquisition Affects Affects 1 Calculate value of debt (net of tax). Divide by
financial risk? business risk? value of equity
Type 1 N N 2 Multiply the above by difference between beta
of combined entity and beta of debt
Type 2 Y N
Type 3 Y Y
3 Add the above to the beta of the combined
entity
Page 89 10: Valuation for acquisitions and mergers


Type I valuations Market-relative models (P/E ratio)

Methods to value company: Market value
P/E ratio =
(1) Book value-plus models EPS
(2) Market-relative models so market value per share = EPS P/E ratio
(3) Cash flow models, including EVATM, MVA
Decide suitable P/E ratio and multiply by EPS: an
Book value-plus models earnings-based valuation.
Use the statement of financial position as star ting EPS could be historical EPS or prospective future
point. EPS. For a given EPS, a higher P/E ratio will result
in a higher price.
Total Asset Value
Less Long-term and short-term payables High P/E ratio may indicate:
Equals Company's Net Asset Value
Optimistic expectations
Book value of net assets is also 'equity shareholders' Security of earnings
funds': the owners' stake in the company. Status
Q Ratio
Points to note
is the market value of company assets (MV)
divided by replacement cost of the assets (RC). RC of capital is difficult to estimate, so is proxied
by the book value of capital. The equity Q ie Q e
is approximated as:
MV
Q= Market value of equity
RC Qe =
Equity capital
Equity version of Q:
If Q <1, management has destroyed the value of
MV Market value of debt contributed capital: firm is vulnerable to takeover
Qe =
RC Total debt If Q >1, management has increased the v alue of
contributed capital


Free cash flow model 3 Calculate WACC from cost of equity (K e) and cost
of debt (K d).
1 Calculate Free Cash Flow. Ve Vd
WACC = K e + (1 T) K d
(Vd + Ve ) Vd + Ve
FCF = EARNINGS BEFORE INTEREST where
AND TAXES (EBIT)
T is the tax rate
Less: TAX ON EBIT
Vd is the value of the debt
Plus: NON-CASH CHARGES
Ve is the value of equity
Less: CAPITAL EXPENDITURES
4 Discount free cash flow at WACC to obtain value of
Less: NET WORKING CAPITAL INCREASES firm.
Plus: SALVAGE VALUES RECEIVED
5 Calculate equity value.
Plus: NET WORKING CAPITAL DECREASES Equity Value = Value of the firm Value of debt
2 Forecast FCF and Terminal Value.
EVA approach Market value added approach

EVA = NOPAT WACC Capital Employed shows how much management has added to the
value of capital contributed by the capital providers.
Or, EVA = (ROIC WACC) Capital Employed
where NOPAT = Net Operating Profits After Taxes
ROIC= Return on Invested Capital MVA = Market Value of Debt + Market Value of
WACC = Weighted average cost of capital Equity Book Value of Equity
Value of firm = MVA related to EVA: MVA is simply PV of future
Value of invested capital + sum of discounted EVA EVAs of the company.
(Subtract value of debt from value of company to get

value of equity.) If the market value and book value of debt are the
same, MVA measures the difference between the
market value of common stock and equity capital of
the firm.


Type II valuations: APV 4 Discount free cash flow at ungeared cost of

Acquisition is valued by discounting Free Cash equity to obtain NPV of ungeared fir m or project
Flows by ungeared cost of equity, then adding PV 5 Calculate interest tax shields
of tax shield.
6 Discount interest tax shields at pre-tax cost of
APV = Initial Investment + Value of acquired company
debt to obtain PV of interest tax shields
if all-equity financed + PV of Debt Tax Shields
If APV is +ve, acquisition should be under taken. 7 APV = NPV OF UNGEARED FIRM OR
PROJECT
APV calculation steps Plus: PV OF INTEREST TAX SHIELDS
1 Calculate FCF (as previously) Plus: EXCESS CASH AND MARKETABLE
SECURITIES
2 Forecast FCFs and Terminal Value
Less: MARKET VALUE OF CONTINGENT
3 Ungeared beta of firm is calculated from geared beta: LIABILITIES
= MARKET VALUE OF FIRM
= G
U D Less: MARKET VALUE OF DEBT
1 + (1 T)
E = MARKET VALUE OF EQUITY

Type III iterative valuations A problem with WACC

1 Estimate value of acquiring company before acquisition If WACC weights are not consistent with
2 Estimate value of acquired company before acquisition the values derived, the valuation is
internally inconsistent.
3 Estimate value of synergies Then, we use an iterative procedure:
Estimate beta coefficients for equity of acquiring and Go back and re-compute the beta
4
acquired company, using CAPM using a revised set of weights closer to
the weights derived from the valuation.
5 Estimate asset beta for each company
The process is repeated until assumed
6 Calculate asset beta for combined entity weights and weights calculated are
approximately equal.
7 Calculate geared beta of the combined fir m
8 Calculate WACC for combined entity
Use WACC derived in step 8 to discount cash Value of equity: difference between the
9 value of the firm and the value of debt.
flows of combined entity post-acquisition


Valuation of high-growth start-ups Valuation methods

Typical characteristics of start-ups: few revenues, Asset-based method not appropriate: most investment of a
untested products, unknown product demand, start-up is in people, marketing and /or intellectual rights that
high development/ infrastructure costs. are treated as expenses rather than capital.
Market-based methods also present problems: difficult to
Steps in valuation find comparable companies; usually no earnings to calculate
Identify drivers (eg market potential, resources P/E ratios (but price-to-revenue ratios may help).
of the business, management team)
Discounted Cash Flows
Period of projection needs to be long-term With constant growth model:
Forecasting growth FCF
V=
Growth in earnings (g) = b ROIC rg
For most high growth start-ups, b = 1 and sole Since FCF = Revenue Costs = R C, value of company:
determinant of growth is the return on invested RC
capital (ROIC), estimated from industry V=
projections or evaluation of management, rg
marketing strengths, and investment. Probabilistic valuation methods can be used.

Intangible assets Measuring intangible assets

Market-to-book value measures intangible assets
Differ from tangible assets as they do not have as the difference between book value of tangible
physical substance. assets and market value of the firm.
Market capitalisation of firm
Tobins q =
Replacement cost of assets
Used to compare intangible assets of firms in same
Examples of intangible assets industry serving the same markets and with similar
tangible non-current assets.
Goodwill Customer loyalty Calculated intangible values (CIV) calculates an
Brands Research and excess return on tangible assets, which is used to
development determine the proportion of return attributable to
Patents
intangible assets.


Levs knowledge earnings method separates Valuing product patents as options.

earnings deemed to come from intangible assets,
1 Identify value of underlying asset (based
which are then capitalised.
on expected cash flows)
2 Identify standard deviation of cash flows
Methods of valuing intangible assets
3 Identify exercise price of the option
Relief from royalties

Premium profits
4 Identify expiry date of the option
Capitalisation of earnings Identify cost of delay (the greater the
Comparison with market transactions 5 delay, the lower the value of cash flows)
11: Regulatory framework and processes
Topic List The agency problem can have a significant impact on

mergers and acquisitions. Takeover regulation is a key
device in protecting the interests of all stak eholders.
Global issues Different models of regulation have been used in the UK
UK and EU regulation and in continental Europe. EU level regulation seeks to
create convergence in takeover regulation.
Defensive tactics
Global UK and EU Defensive

issues regulation tactics
Agency problem Takeover regulation

The agency problem and the issues arising from Takeover regulation can:
the separation of ownership and control have
Protect the interests of minority shareholders
potential impact on mergers and acquisitions.
and other stakeholders
Ensure a well-functioning market for corporate
control
Potential conflicts of interest Two models of regulation

Protection of minority shareholders. Transfers UK/US/Commonwealth countries: market-based
of control may turn existing majority shareholders model case law-based, promotes protection of
of the target into minority shareholders shareholder rights especially
Target company management measures to Continental Europe: 'block-holder' or stakeholder
prevent the takeover, which could run against system codified or civil law-based, seeking to
stakeholder interests protect a broader group of stakeholders: creditors,
employees, national interest

UK takeover regulation City Code Principles

Mergers and acquisitions in the UK subject to:
Similar treatment for all shareholders
City Code
Companies Act Sufficient time and information for
Financial Services and Markets Act 2000 informed decision
Criminal Justice Act 1993 (insider dealing provisions) Directors must act in interests of whole
company
City Code Avoid false markets in shares
The City Code on Takeovers and Mergers: Offer only made if it can be fully
implemented
Originally voluntary code for takeovers/mergers of
UK companies now has statutory basis Offeree company not distracted for
excessive time by offer for it
Administered by the Takeover Panel
Page 101 11: Regulatory framework and processes


Competition and Markets Authority EU Takeovers Directive

The Competition and Markets Authority (CMA) can accept or Effective from May 2006 to converge market-
reject proposed merger, or lay down certain conditions, if based and stakeholder systems.
there would be a substantial lessening of competition.
Takeovers Directive principles
Substantial lessening of competition tests:
Mandatory-bid rule: required at 30%
Turnover test (70m min. for investigation by CMA) holding, in UK
Share of supply test (25%) Equal treatment of shareholders
European Union Squeeze-out rule and sell-out rights: in

UK, 90% shareholder buys all shares
Mergers fall within jurisdiction of the EU (which will evaluate
Principle of board neutrality
it, like the CMA in UK) where, following the merger:
Break-through rule: bidder able to set
(a) Worldwide turnover of more than 5bn per annum aside multiple voting rights (but countries
(b) EU turnover of more than 250m per annum can opt out of this)
% Consequence of share stake levels

Any Company may enquire on ultimate ownership under s793 CA 2006
3% Beneficial interests must be disclosed to company Disclosure and Transparency Rules
10% Shareholders controlling 10%+ of voting rights may requisition company to serve s793 notices
Notifiable interests rules become operative for institutional investors and non-beneficial stakes
30% City Code definition of effective control. Takeover offer becomes compulsory
50%+ CA 2006 definition of control (At this le vel, holder can pass ordinary resolutions.)
Point at which full offer can be declared unconditional with regard to acceptances
75% Major control boundary: holder able to pass special resolutions
90% Minorities may be able to force majority to buy out their stake. Equally, majority may be able to
require minority to sell out
Page 103 11: Regulatory framework and processes


Defensive tactic Explanation

Golden parachutes Compensation payments made to eliminated top-management of target
firm
Poison pill Attempt to make firm unattractive to takeover, eg by giving existing
shareholders right to buy shares cheaply
White knights and white squires Inviting a firm that would rescue the target from the unwanted bidder. A
white squire does not take control of the target
Crown jewels Selling firms valuable assets or arranging sale and leaseback, to make
firm less attractive as target
Pacman defence Mounting a counter-bid for the attacker
Litigation or regulatory defence Inviting investigation by regulatory authorities or Courts
12: Financing mergers and acquisitions
Topic List Questions on the subjects discussed in this chapter ma y

be regularly set in the compulsory section of this paper.
Questions could involve calculations.
Financing methods A bidding firm might finance an acquisition either by cash
Effects of offer or by a share offer or a combination of the tw o. We
consider how a financial offer can be evaluated in terms
of the impact on the acquir ing company and criteria for
acceptance or rejection.
Financing Effects
methods of offer
Methods of financing mergers Funding cash offers

Payment can be in the form of: Methods of financing a cash offer:
Cash Retained earnings common when a firm acquires a
Share exchange smaller firm
Convertible debt Sale of assets
Issue of shares, using cash to buy target firm's shares
Debt issue but, issuing bonds will aler t the market to the
intentions of the company to bid for another company and
may lead investors to buy shares of potential targets, raising
The choice will depend on: their prices
Available cash Bank loan facility from a bank a possible short-term
Desired levels of gearing strategy, until bid is accepted: then the company can make a
Shareholders' tax position bond issue
Changes in control
Mezzanine finance may be the only route for companies
without access to bond markets
Use of convertible debt Mezzanine finance

Problems with using debentures, loan stock, preference
shares: With cash purchase option for target
company's shareholders, bidding company
Establishing a rate of return attractive to target may arrange mezzanine finance loans that
shareholders are:
Effects on the gearing of acquiring company Short-to-medium term
Change in structure of target shareholders' portfolios Unsecured ('junior' debt)
Securities potentially less marketable, possibly lacking At higher rate of interest than secured
voting rights debt (eg LIBOR + 4% to 5%)
Often, giving lender option to exchange
Convertible debt can overcome some such problems,
loan for shares after the takeover
offering target shareholders the oppor tunity to gain from
future profits of company.
Page 107 12: Financing mergers and acquisitions

Financing Effects
methods of offer
Cash or paper?
Company and existing shareholders
Dilution of EPS May be a fall in EPS attributable to existing shareholders if purchase consideration is in
equity shares
Cost to the company Loan stock to back cash offer: tax relief on interest, lower cost than equity. May be lower
coupon if convertible
Gearing Highly geared company may not be able to issue further loan stock for cash offer
Control Major share issue could change control
Authorised share capital increase May be required if consideration is shares: requires General Meeting resolution
Borrowing limits increase General Meeting resolution required if borrowing limits need to change
Shareholders in target company

Taxation If consideration is cash, many investors may suffer CGT
Income If consideration is not cash, arrangement must mean existing income is maintained, or be
compensated by suitable capital gain or reasonable growth expectations
Future investments Shareholders who want to retain stake in target business may prefer shares
Share price If consideration is shares, recipients will want to be sure that shares retain their v alues
Financing Effects
methods of offer
EPS before and after a takeover Dilution of earnings may be acceptable if there is:
If a company acquires another by issuing shares, its Earnings growth

EPS will go up or down according to the P/E ratio at Superior quality of earnings acquired
which target company was bought. Increase in net asset backing
If target company's shares bought at higher P/E Post-acquisition integration

ratio than predator company's shares, predator
company's shareholders suffer fall in EPS A clear programme should be in place, re-defining
objectives and strategy.
If target company's shares valued at a lower P/E
ratio, the predator company's shareholders The approach adopted will depend on:
benefit from rise in EPS
The culture of the organisation
The nature of the company acquired, and
Buying companies with a higher P/E r atio will result
in a fall in EPS unless there is profit g rowth to offset How it fits into the amalgamated organisation
this fall. (eg horizontally, vertically, or in diversified
conglomerate?)
Page 109 12: Financing mergers and acquisitions
Notes
(016)ACP4PC14_CH13-14.qxp 3/30/2015 5:38 PM Page 111
1314: Reconstruction and reorganisation
Topic List Reorganisations of business operations and business

structures are a constant feature of business life.
Business reorganisations include various methods of
Financial reconstruction unbundling companies, including include sell-offs, spin-
Divestment and other changes offs, carve-outs, and management buyouts.
MBOs and buy-ins Corporate restructuring may typically take place when
companies are in difficulties or are seeking a change in
Firm value focus.
Financial Divestment and MBOs and Firm

reconstruction other changes buy-ins value
Capital reconstruction scheme

is a scheme where a company re-organises its Providers of finance will need to be con vinced that
capital structure, often to avoid liquidation. the return is attractive.
Company must therefore prepare cash/profit
Steps in a capital reconstruction forecasts.
Estimate position of each par ty if Creation of new share capital at different
1 liquidation is to go ahead nominal value
2 Assess additional sources of finance Cancellation of existing share capital
Conversion of debt or equity
3 Design reconstruction
Calculate and assess new position, and Most importantly, a scheme of reconstruction
4 compare for each party with Step 1 needs to treat all par ties fairly and offer
creditors a better deal than liquidation.
5 Check company is financially viable
Leveraged recapitalisation Debt-equity swaps

A firm replaces most of its equity with a pac kage of debt securities In an equity/debt swap, shareholders are
consisting of both senior and subordinated debt. given the right to exchange stock for a
predetermined amount of debt (ie bonds)
Leveraged capitalisations are used to discourage corporate raiders in the same company
who will not be able to borrow against assets of the target fir m to
In a debt/equity swap, debt is exchanged
finance the acquisition.
for a predetermined amount of stock
To avoid financial distress from a high debt le vel, the company
After the swap takes place, the preceding
should have stable cash flows and not require substantial ongoing
asset class is cancelled for the newly
capital expenditure to retain their competitive position.
acquired asset class
Leveraged buy-outs Debt-equity swaps may occur because
the company must meet certain
A group of private investors uses debt financing to purchase a contractual obligations, such as
company or part of it. The company increases its level of leverage maintaining a debt/equity ratio below a
but (unlike leveraged recapitalisations) no longer has access to certain number
equity markets. A company may issue equity to avoid
making coupon and face value payments
A higher level of debt will increase the companys geared beta; a in the future
lower level of debt will reduce it.
Page 113 1314: Reconstruction and reorganisation

Demerger Disadvantages of demergers

is the splitting up of a cor porate body into two or Loss of economies of scale
more separate bodies, to ensure share prices Ability to raise extra finance reduced
reflect the true value of underlying operations. Vulnerability to takeover increased
Sell-off Reasons for sell-offs

is the sale of par t of a company to a third par ty, Strategic restructuring
generally for cash. Sell off loss-making part
Protect rest of business from takeover
Organisational restructuring typically involves Cash shortage
changes in divisional structures or hierarchy, and Reduction of business risk
often accompanies restructuring of ownership Sale at profit
(portfolio restructuring).
A divestment is a partial or complete reduction in ownership stake in an organisation.
Spin-offs and carve-outs Advantages of spin-offs to investors

Merger or takeover of only part of business
Spin-off: a new company is created whose
made easier
shares are owned by the shareholders of
original company. There is no change in asset Improved efficiency/management
ownership, but management may change. In a Easier to see value of separate parts
carve-out, part of the firm is detached and a Investors can adjust shareholdings
new companys shares are offered to the
public.
Going private Advantages of going private to company

Costs of meeting listing requirements saved
occurs when a group of investors buys all the Company protected from volatility in share prices
companys shares. The company ceases to be
listed on a stock exchange. Company less vulnerable to hostile takeover bids
Management can concentrate on long-term
business


Management buy-outs (MBOs) Evaluation of MBOs by investors

is the purchase of all or par t of a business by its Management skills of team
managers. The managers generally need financial Reasons why company is being sold
backers (venture capital) who will want an equity Projected profits, cash flows and risks
stake. Shares/selected assets being bought
Price right?
Financial contribution by management team
Reasons for company agreeing to MBO are similar to
Exit routes (flotation, share repurchase)
those for sell-off, also:
When best offer price available is from MBO
Venture capital
When group has decided to sell subsidiar y, best
way of maximising management co-operation Venture capitalists are often prepared to fund
Sale can be arranged quickly MBOs. They typically require shareholding, right to
appoint some directors and right of veto on certain
Selling organisation more likely to retain
beneficial links with sold segment business decisions.
Performance of MBOs Problems with MBOs

Management-owned companies typically achieve
better performance. Lack of financial experience
Tax and legal complications
Possible reasons: Changing work practices
Inadequate cash flow
Favourable price
Board representation by finance suppliers
Personal motivation
Loss of employees/suppliers/customers
Quicker decision-making/flexibility
Savings on overheads
Buy-ins Buy-ins often occur when a business is in trouble or

shareholder/managers wish to retire. Finance
are when a team of outside managers mount a sources are similar to buy-outs. They work best if
takeover bid and then run the business themselves. management quality improves, but external
managers may face opposition from employees.


Unbundling and firm value

When firms divest themselves of existing
Unbundling affects the value of the firm through investments, they affect the expected return on
changes in return on equity and the asset beta. assets (ROA), as good projects increase ROA and
bad projects reduce it.
Growth rate following a restructuring:
g = b re
where
Investment decisions taken by firms affect their
re is the return on equity (ie Ke)
riskiness and therefore the asset beta a.
b is the retention rate
15: The treasury function in multinationals
Topic List The treasury function of a multinational company should

deal with short-term decisions in a way that is consistent
with the long-term management objective of maximising
Markets shareholder value.
Instruments The treasury function deals with the management of

short-term assets of a company and its risk exposure.
You should understand the principal money market
instruments that are available.
Markets Instruments
Financial markets
INDIRECT FINANCE
Financial
Funds intermediaries Funds
Funds
Lenders - Savers Borrowers - Spenders
1 Households Financial 1 Firms
2 Firms Funds markets Funds 2 Government
3 Government 3 Households
4 Overseas 4 Overseas
DIRECT FINANCE
Primary and secondary markets Capital markets

Primary market: a financial market in which new are markets in which the securities that are traded
issues are sold by issuers to initial buyers have long maturities, ie represent long-term
obligations for the issuer. Securities that trade in
Secondary market: a market in which securities
capital markets include shares and bonds.
that have already been issued can be bought and
sold
Secondary markets can be organised as

exchanges or over the counter (OTC) where
Money markets
buyers and sellers transact with each other are markets in which the securities traded have
through individual negotiation short maturities, less than a year, and repayment of
Securities that are issued in an over the funds borrowed is required within a shor t period of
counter market and can be resold are time.
negotiable securities
Page 121 15: The treasury function in multinationals

Markets Instruments
Coupon bearing instruments Discount instruments Derivatives

Money Market Deposits Treasury Bill (T-bill) Forwards and futures
Very short-term loans between institutions, Debt instruments issued by central Forward rate agreement (FRA): cash-settled
including governments. Either fixed with governments with maturities ranging OTC forward contract on a short-term loan.
agreed interest and maturity dates, or call from one month up to one year. Futures contract: standardised agreement to
deposits with variable interest and buy/sell asset at set date and pr ice.
deposit can be terminated on notice. Interest rate future: underlying is debt
security, or based on interbank deposit.
Certificate of Deposit (CD) Banker's Acceptances Swaps
Either negotiable or non-negotiable Negotiable bills issued by firms to Interest rate swap: two parties exchange
certificate of receipt for funds deposited at finance transactions such as imports payments stream at one interest rate for
a financial institution for a specified term, or purchase of good and guaranteed stream at a different rate.
paying interest at a specified rate. (accepted) by a bank, for a fee.
Repurchase Agreement (repo) Commercial Paper (CP) Options
Loan secured by a marketable instrument, Short-term unsecured corporate debt Interest rate option: an instrument sold by
usually a Treasury Bill or a bond. Typical with maturity up to 270 days but option writer to option holder, for a price known
term: 1180 days. typically about 30 days. Used by as a premium.
Counterparty sells on agreed date and corporations with good credit ratings
simultaneously agrees to buy back to finance short-term expenditure.
instrument later for agreed price.
16: Hedging forex risk
Topic List Any future payments or distributions payable in a foreign

currency carry a risk that the foreign currency will
depreciate in value before the foreign currency payment
FX markets is received and is exchanged into the home currency.
Money market hedging While there is a chance of profit if the pr ice of the foreign
currency increases, most investors and lenders would
Futures give up the possibility of currency exchange profit if they
Swaps could avoid or hedge the risk of currency exchange loss.
Options
FX Money market Futures Swaps Options

markets hedging
Exchange rates Term/reference currency

An exchange rate is the price of one currency Bank sells LOW
expressed in another currency. buys HIGH
For example, if UK bank is buying and selling
The spot rate at time t0 is the price for delivery dollars, selling (offer) price may be $/1.50,
at t0 buying (bid) price may be $/1.53.
A forward rate at t0 is a rate for delivery at time
t1. This is different from whatever the new spot
rate turns out to be at t 1
Term and base currencies Direct quote is amount of domestic

currency equal to one foreign currency unit
If a currency is quoted as say $/1.50, the $ is the
term (or reference) currency, the is the base Indirect quote is amount of foreign
currency. currency equal to one domestic unit
Forward exchange contract Forward rates as adjustments to spot rates

A firm and binding contract between a bank and Forward rate cheaper Quoted at discount
its customer Forward rate more expensive Quoted at premium
For the purchase/sale of a specified quantity of a Add discounts, or subtract premiums from spot
stated foreign currency
rate.
At a rate fixed at the time the contract is made
For performance at a future time agreed when Interest rate parity
contract is made Interest rate parity must hold between spot rates
Closing out is the process of the bank requir ing the and forward rates (for the interest rate period),
customer to fulfil the contract by selling or buying at otherwise arbitrage profits can be made:
spot rate.
(1 + i c )
f0 = s 0
Netting (1 + i b )
is the process of setting off credit against debit Where f0 = forward rate
balances within a group of companies so that only s0 = spot rate
the reduced net amounts are paid by currency ic = interest rate in overseas country
flows. Multilateral netting involves offsetting
ib = interest rate in base country
several companies balances.
Page 125 16: Hedging forex risk


markets hedging
Money market hedging

Future foreign currency payment Future foreign currency receipt
1 Borrow now in home currency 1 Borrow now in foreign currency
2 Convert home currency loan to foreign currency 2 Convert foreign currency loan to home currency
3 Put foreign currency on deposit 3 Put home currency on deposit
4 When have to make payment 4 When cash received
(a) Make payment from deposit (a) Take cash from deposit
(b) Repay home currency borrowing (b) Repay foreign currency borrowing
Remember
International Fisher effect 1 + ia 1 + h a
=
1 + ib 1 + hb

markets hedging
Futures terminology
Closing out a futures contract means entering a Basis risk is the risk that futures price movement
second futures contract that reverses the effect of the may differ from underlying currency movement.
first.
Tick size is the smallest measured movement in
Contract size is the fixed minimum quantity that can contracts price (movement to fourth decimal place).
be bought/sold.
Contract price is in US dollars. eg $/ 0.6700.

Transactions not involving US dollars
Settlement date is the date when trading on a
futures contract ceases and accounts are settled. If trading one non-US dollar currency with another,
sell one type of future (to get dollars) and b uy other
Basis is spot price futures price. type (with dollars), and reverse both contracts when
receipt/payment made.


markets hedging
What type of contract?

Transaction on future date Now On future date
Receive currency Sell currency futures Buy currency futures
Receive currency Buy currency futures Sell currency futures
Receive $ Buy currency futures Sell currency futures
Pay $ Sell currency futures Buy currency futures
Disadvantages of futures
Advantages of futures
Cant tailor to users exact needs
Only available in limited number of currencies
Transaction costs lower than forward contracts
Hedge inefficiencies
Futures contract not closed out until cash Conversion procedures complex if dollar is not one
receipt/payment made of the two currencies
Step 1 Setup process

(a) Choose which contract (settlement date after date currency needed) and type
(b) Choose number of contracts Amount being hedged
Size of contract
Convert using todays futures contract price if amount being hedged is in US dollars
(c) Calculate tick size: Minimum price movement Standard contract size
Step 2 Estimate closing futures price (May have to adjust closing spot pr ice using basis,
assuming basis declines evenly over life of contract)
Step 3 Hedge outcome
(a) Outcome in futures market Short-cut for calculating the
Futures profit = Tick movement Tick value Number of contracts effective futures rate = opening
futures price closing basis
(b) Net outcome
Spot market payment (closing spot rate) (x)
Futures profit / (loss) (closing spot r ate unless US company) x
Net outcome (x)


markets hedging
Currency swaps Risks of swaps
In a currency (or cross-currency) swap,

Credit risk
equivalent amounts of currency and interest cash
(Counterparty defaults)
flows are swapped for a period. However the original
borrower remains liable to the lender (counter par ty Position or market risk
risk). A cross-currency swap is an interest rate swap (Unfavourable market movements)
with cash flows in different currencies.
Sovereign risk
(Political disturbances in other countries)
Advantages of currency swaps
Flexibility any size and reversible Spread risk
Can gain access to debt in other currencies (For banks which combine swap and hedge)
Restructuring currency base of liabilities Transparency risk
Conversion of fixed to/from floating rate debt (Accounts are misleading)
Absorbing excess liquidity
Cheaper borrowing
Obtaining funds blocked by exchange controls
Example
Edward Ltd wishes to borrow US dollars to Gordon borrows US $ and Edward borrows .
finance an investment in the USA. Edwards
1
The two companies then swap funds at the
treasurer is concerned about the high current spot rate
interest rates the company faces because it
is not well-known in the USA. Edward Ltd 2 Edward pays Gordon the annual interest cost on
the $ loan. Gordon pays Edward the annual
should make an arrangement with an
interest cost on the loan
American company, Gordon Inc, attempting
to borrow sterling in the UK money 3 At the end of the per iod, the two companies
markets. swap back the principal amounts at the spot
rates/predetermined rates
An FX swap is simply a spot currency transaction that will be reversed, in a single transaction, by an offsetting
forward transaction at a pre-specified date.


markets hedging
Currency option Why option is needed

Uncertainty about foreign currency receipts
is a right to buy or sell currency at a stated or payments (timing and amount)
rate of exchange at some time in the future.
Support tender for overseas contract
Call right to buy at fixed rate
Allow publication of price lists in foreign
Put right to sell at fixed rate currency
Protect import/export of price-sensitive
Over the counter options are tailor-made goods
options suited to a companys specific needs.
Traded options are contracts for standardised
Choosing the right option
amounts, only available in certain currencies. Complicated by lack of US dollar options. UK
company wishing to sell US dollars can
purchase call options (options to buy sterling
with dollars).
Strike price May need to use exercise price to convert US dollars

Surplus cash If option contracts dont cover amount to be hedged, convert remainder at spot price on
day of exercise or with formal contract
What type of contract
Transaction on Buy now On future
future date date
Receive currency Currency put Sell currency
Pay currency Currency call Buy currency
Receive $ Currency call Buy currency
Pay $ Currency put Sell currency

Notes
17: Hedging interest rate risk
Topic List The value of a firms assets, liabilities and cashflows is

affected by changes in interest rates. Various derivatives
are available to reduce interest rate risk, including
FRAs forward rate agreements, interest rate futures contracts,
interest rate swaps and options.
IR futures
Here we deal with the application of these der ivative
IR swaps contracts for hedging.
IR options
The Greeks
FRAs IR IR IR The
futures swaps options Greeks
Interest rate risk

Fixed v floating rate debt Change in interest rates may make borrowing chosen the less attractive option
Currency of debt Effect of adverse movements if borrow in another currency
Term of loan Having to re-pay loan at time when funds not a vailable => need f or new loan at
higher interest rate
Forward rate agreement 5.75-5.70 means a borrowing rate can be fixed at

An FRA means that the interest r ate will be 5.75%
fixed at a certain time in the future. Loans > 3-6 FRA starts in three months time and lasts
500,000, period < 1 year. for three months
Basis point is 0.01%
FRAs IR IR IR The
Interest rate futures Example

hedge against interest rate movements. The LIFFE three months sterling futures 500,000 points
terms, amounts and periods are standardised. of 100% price 92.50.
Tick size will be:
The futures prices will vary with changes in 500,000 0.01% 3/12 = 12.50
interest rates
A 2% movement in the futures price would represent
Outlay to buy futures is less than buying the 200 ticks. Gain on a single contr act would be 200
financial instrument 12.50 = 2,500.
Price of short-term futures quoted at discount
to 100 per value (93.40 indicates deposit
trading at 6.6%)
Long-term bond futures prices quoted at % of
par value
Page 137 17: Hedging interest rate risk

FRAs IR IR IR The
Step 1 Setup process

(a) Choose which contract: Date should be after borrowing/lending begins.
(b) Choose type: sell if protecting against an increase in r ates, buy if protecting against a fall.
Exposure Loan period
(c) Choose number of contracts:
Contract size Length of contract
Length of contract
(d) Calculate tick size: Min price movement as % Contract size
12 months
Step 2 Estimate closing futures price

May have to adjust using basis.
Step 3 Hedge outcome

(a) Futures outcome
Opening futures price:
Closing futures price:
Movement in ticks:
Futures outcome: Tick movement Tick value Number of contracts
(b) Net outcome
Payment in spot market (X)
Futures market profit/(loss) X
Net payment (X)

FRAs IR IR IR The
Interest rate swaps Uses of interest rate swaps
are agreements where parties exchange interest Switching from paying one type of interest to another
commitments. In simplest form, two parties swap Raising less expensive loans
interest with different characteristics. Each party Securing better deposit rates
borrows in market in which it has comparative Managing interest rate risk
advantage. Avoiding charges for loan termination
Example Complications
Company A Company B
Interest paid on loan (9%) (LIBOR + 1%) Bank commission costs
A pays to B (LIBOR + 1%) LIBOR + 1% One company having better
B pays to A 9%
__________ 9%
_________ credit rating in both relevant
LIBOR + 1%
__________ (9%)
_________ markets should borrow in
Companies may decide to use a swap rather than terminating their comparative advantage
original loans, because costs of termination and taking out a new loan market but must want
may be too high. If LIBOR is at 8%, neither par ty will gain nor lose. Any interest in other market
rate other than 8% will result in gain/loss .
FRAs IR IR IR The
Interest rate option Interest rate caps, collars

grants the buyer the right, to deal at an agreed
interest rate at a future maturity date.
and floor
Caps set an interest rate
If a company needs to hedge borrowing, purchase put options ceiling
If a company needs to hedge lending, purchase call options Floors set a lower limit to rates
To calculate effect of options, use same proforma as currency options. Collars mean buying a cap
UK long gilt futures options (LIFFE) 100,000 100ths of 100%. and selling a floor
Strike Calls Puts

price Nov Dec Jan Nov Dec Jan
11,350 0.87 1.27 1.34 0.29 0.69 1.06
Strike price is price paid for futures contract
Numbers under each month represent premium paid f or options
Put options more expensive than call as interest rates predicted to rise

FRAs IR IR IR The
Greeks
Delta change in call option pr ice/change in value of share

Delta hedging
Gamma change in delta value/change in value of share determines number of shares required to create
Theta change in option price over time the equivalent portfolio to an option, and hence
hedge it.
Rho change in option price as interest rates change
Vega change in option price as volatility changes
Vega
Gamma is the change in value of an option (call or put)
resulting from a 1% point change in its v olatility.
Higher for share which is close to expiry and 'at
the money'

+ve gamma means that a position benefits from movement
-ve theta means the position loses money if the underlying asset price does not move
18: Dividend policy in multinationals and

transfer pricing
Topic List Multinational businesses operate through subsidiaries,

affiliates or joint ventures in more than one countr y, and
produce and sell products globally. Revenues are
Dividend policy repatriated to the parent company in the form of
dividends, royalties or licence payments. Overseas
Transfer pricing operations ability to repatriate funds can have a major
impact on the parent companys ability to pay dividends
to external shareholders and finance its investment
plans.
Dividend Transfer
policy pricing
Dividend capacity Dividend policy

Revenue after operating costs, interest and tax
The dividend capacity of a company depends on: after tax
profits, investment plans, foreign dividends. +
Dividends from foreign affiliates and subsidiaries

Net investment in non-current assets
Free Cash Flow to Equity (FCFE)
FCFE = Dividends that could be paid to shareholders Net investment in working capital
= Net profit after tax + Depreciation + F oreign Dividends +
Total Net Investment + Net debt Issuance + Net Share
Net debt issued
Issuance
+
Net equity issued
Dividend repatriation UK companies subsidiaries foreign profits are

liable to UK corporate tax, whether repatriated or
Factors affecting dividend repatriation not, with a credit for tax already paid to the host
policies country.

Financing how much needed for dividends / Similarly, the US government does not distinguish
investment at home? between income earned abroad and income
earned at home and gives credit to MNCs
Tax often the primary reason for the firms headquartered in the US for tax paid to foreign

repatriation policies governments.
Managerial control regularised dividends restrict
discretion of foreign managers (so reducing agency
problems)
Collecting early (lead) payments from currencies
Timing to take advantage of possible currency vulnerable to depreciation and late (lag) from
movements (although these are difficult to forecast currencies expected to appreciate will benefit
in practice) from expected movements in exchange rates.
Page 145 18: Dividend policy in multinationals and transfer pricing

Dividend Transfer
policy pricing
Transfer prices Using market value transfer prices

are prices at which goods or ser vices are Giving profit centre managers freedom to negotiate
transferred from one process or depar tment to prices with other profit centres results in market-
another or from one member of a g roup to another. based transfer prices.
Transfer price bases Transfer pricing motivations

Standard cost
Marginal cost: at marginal cost or with gross Evaluation of performance of divisions
profit margin added Management incentives
Opportunity cost Cost allocation between divisions
Full cost: at full cost, or at a full cost plus pr ice Financing considerations to boost or to
Market price disguise the profitability of a subsidiar y
Market price less a discount External factors, including taxes, tariffs, rule of
origin tests and exchange controls
Negotiated price, which could be based on any
of the other bases
Transfer price regulation

Tax authorities often use an arm's length standard: price intra-firm trade of multinationals as if it took place
between unrelated parties acting in competitive markets.
Method 1: use price negotiated between unrelated Method 2: use price at which A sells to unrelated
parties C and D as proxy for intra-firm transfer A to B party C as proxy
Arms length transfer Intrafirm transfer
C D A B
Arms length
A B transfer
Intrafirm transfer
C
Page 147 18: Dividend policy in multinationals and transfer pricing

Dividend Transfer
policy pricing
CUP: Based on a product comparable transaction,

Arms length pricing methods (tangible
possibly between different parties but in similar
goods)
circumstances a method preferred by tax
authorities.
Transaction-based
Comparable uncontrolled price (CUP) RP: Tax auditor looks for firms at similar trade levels
Resale price (RP) that perform a similar distribution function (a
Cost plus (C+) functional comparable) method best used when
Profit based distributor adds relatively little value, making it
Comparable profit method (CPM) easier to estimate. Profit margin derived from that
Profit split (PS) earned by comparable distributors, subtracted from
known retail price to determine transfer price.
PS: Common when there are no suitable product C+: Appropriate mark-up (estimated from similar
comparables (CUP) or functional comparables manufacturers) added to costs of production,
(RP and C+). Profits on a transaction earned by measured using recognised accounting principles.
two related parties are split between the parties, CPM: Method is based on premise of similar
usually on basis of return on operating assets: financial ratios and performance of companies in
operating profits to operating assets. similar industries.
19: Recent developments
Topic List It is important to keep up to date with recent

developments in the business environment. This chapter
focuses on such developments in world financial markets
Developments in world financial and international trade.
markets
Developments in international trade
Developments in Islamic finance
Developments in world Developments in Developments in

financial markets international trade Islamic finance
The credit crunch Financial reporting

The credit crunch first became a global issue in Common accounting standards are increasing
early 2007. transparency and comparability for investors
improving capital market efficiency and facilitating
How the global crisis happened. cross-border investment.
Billions of dollars of sub-prime mortages in the US
Monetary policy
Rise in interest rates caused defaults on such In advanced economies, monetary policy has
mortgages encompassed the task of controlling inflation.
Collateralised debt obligations (CDOs) containing Interest rates are commonly set by central banks
sub-prime mortgages sold onto hedge funds independent of Government enhancing credibility
and so lowering inflation expectations.
Value of CDOs fell due to defaults A low inflation environment is conducive to long-
term business planning and investment.
Huge losses by the banks
The credit crunch and IFRS

Entities must value financial assets and liabilities at fair value.
Page 151 19: Recent developments


Tranching
Where claims on cash flows are split into several classes (such as Class A, Class B)
Risks of tranching Benefits of tranching
Very complex A good way of dividing risk

May not be divided properly Potential to make a lot of money from junior
Rebuilding tranches
Credit default swaps (CDS)

allow the transfer of third party credit risk from one party to
another. Uses of CDS
Speculation
Similar to insurance Hedging
policies
Spread is similar to
Credit default swaps
an insurance premium
CDS market is
unregulated


Trends in global financial markets Effects of financial sector convergence

Integration and globalisation fostered by
liberalisation of markets and technological
change; creating more efficient allocation of Economies of scale
capital and economic growth Economies of scope: a factor of production can
Growth of derivatives markets advances in be employed to produce multiple products
technology, financial engineering and risk Reduced earnings volatility
management have enhanced demand for more Reduced search costs for consumers
complex derivatives products
Securitisation eg sale of loan books by banks.
Now a common form of financing, leading to
increased bond issuance
Money laundering
Convergence of financial institutions A side effect of globalisation and the free movement
abolition of barriers to entry in various segments of capital has been a growth in money laundering,
of financial services industries has led to and there has been increased legislation and
conglomerates with operations in banking, regulation to combat it.
securities and insurance
Developments in world Developments in Delevopments in

Trade financing Regulation

has become easier for companies to obtain.
Globalisation creates incentives for governments
Financing for international trade transactions includes to intervene in favour of domestic MNCs in
commercial bank loans within the host country and respect of macroeconomic and macrostructural
loans from international lending agencies. policies.
Trade bills may be discounted through foreign banks,
for short-term financing. Eurodollar financing is another
method for providing foreign financing.
Eurodollar loans are short-term working-capital loans, Pressure groups
unsecured and usually in large amounts.
The Eurobond market is widely used for long-term Transnationally networked pressure groups can
funds for multinational US companies. influence the public and put pressure on
governments to take measures against
In many countries, development banks provide
multinational companies.
intermediate- and long-term loans to private
enterprises.

Developments in world Developments in Delevopments in

Islamic finance operates under the principle that there should be a link betw een the economic activity that
creates value and the financing of that activity.
Advantages of Islamic Drawbacks of Islamic
finance finance
Islamic funds are available worldwide No international consensus on Shariaa

interpretations
Gharar (uncertainty, risk, speculation) is not
allowed No standard Shariaa model, which leads to
higher transaction costs
Excessive profiteering is not allowed
Additional compliance work increases
Banks cannot use excessive leverage
transaction costs
All parties take a long-term view
Islamic banks cannot minimise risk through
Emphasis on mutual interest and co-operation hedging
Some Islamic products may not be compatible
with financial regulations
Limited trading in Sukuk products

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1: The role and responsibility

Topic List Senior financial executives are required to make crucial

Financial objectives Non-financial objectives

Why profit maximisation is not a Examples

Investment Financing Dividend

Page 3 1: The role and responsibility of senior financial e xecutive

Strategic planning Key elements of financial planning

Long-term direction Strategic cash flow management

Investment Financing Dividend

Purchase of major non-current

Tactical planning and control

Page 5 1: The role and responsibility of senior financial e xecutive

Government Political objectives such as sustained

2: Financial strategy formulation

Topic List Formulating the correct financial strategy is crucial for

Assessing corporate Financial Arbitrage Risk and risk

Profitability and return Liquidity ratios

Debt and gearing Stock market ratios

Comparisons with Comparisons with other Comparisons with companies

Page 9 2: Financial strategy formulation

Assessing corporate Financial Arbitrage Risk and risk

Economic Value Added (EVATM)

EVATM = NOPAT (cost of capital capital employed)

Adjustments to NOPAT Adjustments to capital employed

Shares Comparison of finance sources

Page 11 2: Financial strategy formulation

Assessing corporate Financial Arbitrage Risk and risk

Estimating cost of equity Practicalities in issuing new shares

Assessing corporate Financial Arbitrage Risk and risk

Pecking order Suitability of capital structure

Page 13 2: Financial strategy formulation

Assessing corporate Financial Arbitrage Risk and risk

Assessing corporate Financial Arbitrage Risk and risk

CAPM exam formula Arbitrage pricing theory

Factor analysis r = E(r j ) + B1F1 + B2F2 ... + e

Analysis used to determine factors to which security

Page 15 2: Financial strategy formulation

Assessing corporate Financial Arbitrage Risk and risk

Types of risk Risk management

3a: Conflicting stakeholder interests

Topic List Governance of a modern corporation can give rise to

Separation of ownership and management: ordinary Transaction costs economics

Sources of stakeholder conflict

Agency theory Goal congruence

Page 19 3a: Conflicting stakeholder interests

UK Corporate Governance Code

DIRECTORS responsible for FINANCIAL REPORTING

Annual general meeting Accountability and audit

20 working days notice Audit committee of non-executive directors

Page 21 3a: Conflicting stakeholder interests

3b: Ethical issues in financial management

Topic List Ethics have become increasingly important in formulating

Human resource Minimum wage, discrimination

Marketing Social and cultural impact

Product development Animal testing, sensitivity to

3c: Environmental issues

Green issues and business practice Environmental reporting

Sustainability Companys environmental policy

Page 27 3c: Environmental issues