p4 LSBF by ACCA Reloaded

ACCA Paper P4
Advanced Financial
Management

Class Notes

June 2013

2 www.st udyi nteracti ve. org

Original version prepared by Ken Preece.
Interactive World Wide Ltd. January 2013.
All rights reserved. No part of this publication may be reproduced, stored in a
retrieval system, or transmitted, in any form or by any means, electronic,
mechanical, photocopying, recording or otherwise, without the prior written
permission of Interactive World Wide Ltd.
www.st udyi nteracti ve. org 3
Contents
PAGE
INTRODUCTION TO THE PAPER 5
FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER 7
CHAPTER 1: ISSUES IN CORPORATE GOVERNANCE 13
CHAPTER 2: ADVANCED INVESTMENT APPRAISAL SECTION 1 25
CHAPTER 3: ADVANCED INVESTMENT APPRAISAL SECTION 2 51
CHAPTER 4: COST OF CAPITAL 69
CHAPTER 5: THEORIES OF GEARING 85
CHAPTER 6: CAPITAL ASSET PRICING MODEL 103
CHAPTER 7: ADJUSTED PRESENT VALUE 117
CHAPTER 8: INTERNATIONAL INVESTMENT APPRAISAL 129
CHAPTER 9: VALUATIONS, ACQUISITIONS AND MERGERS SECTION 1 145
CHAPTER 12: CORPORATE RECONSTRUCTION AND REORGANISATION 197
CHAPTER 13: CORPORATE DIVIDEND POLICY 211
CHAPTER 14: MANAGEMENT OF INTERNATIONAL TRADE AND FINANCE 221
CHAPTER 15: HEDGING FOREIGN EXCHANGE RISK 237
CHAPTER 16: HEDGING INTEREST RATE RISK 255
CHAPTER 17: FUTURES 269
CHAPTER 18: OPTIONS 283
CHAPTER 19: SWAPS 317
CHAPTER 20: PRINCIPLES OF ISLAMIC FINANCE 329
ACCA STUDY GUIDE 341



Introduction to the
paper

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


Formulae & tables
provided in the
examination paper

FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER
Formulae

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

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

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

The asset beta formula
a
=
(
+
e
d e
e
)) T - 1 ( V V (
V

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

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

Gordons growth approximation
g = br
e

The weighted average cost of capital
WACC =
|
|
\
|
+
d e
e
V V
V
k
e
+
|
|
\
|
+
d e
d
V V
V
k
d
(1T)

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

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

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

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

Modified Internal Rate of Return
MIRR =
n
1
I
R
PV
PV
|
|
\
|
(1 + r
e
) 1

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

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

and
d
2
= d
1
t s

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

-rt

Present value table
Present value of 1 ie (1 + r)
-n

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

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

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

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

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

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

Annuity table
Present value of an annuity of 1 ie
r
r) + (1 - 1
-n

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

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

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

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

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

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

Standard normal distribution table
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0
0.1
0.2
0.3
0.4

0.5
0.6
0.7
0.8
0.9

1.0
1.1
1.2
1.3
1.4

1.5
1.6
1.7
1.8
1.9

2.0
2.1
2.2
2.3
2.4

2.5
2.6
2.7
2.8
2.9

3.0
0.0000
0.0398
0.0793
0.1179
0.1554

0.1915
0.2257
0.2580
0.2881
0.3159

0.3413
0.3643
0.3849
0.4032
0.4192

0.4332
0.4452
0.4554
0.4641
0.4713

0.4772
0.4821
0.4861
0.4893
0.4918

0.4938
0.4953
0.4965
0.4974
0.4981

0.4987
0.0040
0.0438
0.0832
0.1217
0.1591

0.1950
0.2291
0.2611
0.2910
0.3186

0.3438
0.3665
0.3869
0.4049
0.4207

0.4345
0.4463
0.4564
0.4649
0.4719

0.4778
0.4826
0.4864
0.4896
0.4920

0.4940
0.4955
0.4966
0.4975
0.4982

0.4987
0.0080
0.0478
0.0871
0.1255
0.1628

0.1985
0.2324
0.2642
0.2939
0.3212

0.3461
0.3686
0.3888
0.4066
0.4222

0.4357
0.4474
0.4573
0.4656
0.4726

0.4783
0.4830
0.4868
0.4898
0.4922

0.4941
0.4956
0.4967
0.4976
0.4982

0.4987
0.0120
0.0517
0.0910
0.1293
0.1664

0.2019
0.2357
0.2673
0.2967
0.3238

0.3485
0.3708
0.3907
0.4082
0.4236

0.4370
0.4484
0.4582
0.4664
0.4732

0.4788
0.4834
0.4871
0.4901
0.4925

0.4943
0.4957
0.4968
0.4977
0.4983

0.4988
0.0160
0.0557
0.0948
0.1331
0.1700

0.2054
0.2389
0.2703
0.2995
0.3264

0.3508
0.3729
0.3925
0.4099
0.4251

0.4382
0.4495
0.4591
0.4671
0.4738

0.4793
0.4838
0.4875
0.4904
0.4927

0.4945
0.4959
0.4969
0.4977
0.4984

0.4988
0.0199
0.0596
0.0987
0.1368
0.1736

0.2088
0.2422
0.2734
0.3023
0.3289

0.3531
0.3749
0.3944
0.4115
0.4265

0.4394
0.4505
0.4599
0.4678
0.4744

0.4798
0.4842
0.4878
0.4906
0.4929

0.4946
0.4960
0.4970
0.4978
0.4984

0.4989
0.0239
0.0636
0.1026
0.1406
0.1772

0.2123
0.2454
0.2764
0.3051
0.3315

0.3554
0.3770
0.3962
0.4131
0.4279

0.4406
0.4515
0.4608
0.4686
0.4750

0.4803
0.4846
0.4881
0.4909
0.4931

0.4948
0.4961
0.4971
0.4979
0.4985

0.4989
0.0279
0.0675
0.1064
0.1443
0.1808

0.2157
0.2486
0.2794
0.3078
0.3340

0.3577
0.3790
0.3980
0.4147
0.4292

0.4418
0.4525
0.4616
0.4693
0.4756

0.4808
0.4850
0.4884
0.4911
0.4932

0.4949
0.4962
0.4972
0.4979
0.4985

0.4989
0.0319
0.0714
0.1103
0.1480
0.1844

0.2190
0.2517
0.2823
0.3106
0.3365

0.3599
0.3810
0.3997
0.4162
0.4306

0.4429
0.4535
0.4625
0.4699
0.4761

0.4812
0.4854
0.4887
0.4913
0.4934

0.4951
0.4963
0.4973
0.4980
0.4986

0.4990
0.0359
0.0753
0.1141
0.1517
0.1879

0.2224
0.2549
0.2852
0.3133
0.3389

0.3621
0.3830
0.4015
0.4177
0.4319

0.4441
0.4545
0.4633
0.4706
0.4767

0.4817
0.4857
0.4890
0.4916
0.4936

0.4952
0.4964
0.4974
0.4981
0.4986

0.4990

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

Chapter 1
Issues in corporate
governance

CHAPTER 1 ISSUES IN CORPORATE GOVERNANCE
CHAPTER CONTENTS
FINANCIAL OBJECTIVES ------------------------------------------------ 15
THE UK CORPORATE GOVERNANCE CODE ----------------------------- 16
CODE OF BEST PRACTICE 16
INTERNATIONAL COMPARISONS OF CORPORATE GOVERNANCE -- 22
UNITED STATES OF AMERICA 22
GERMANY 22
JAPAN 23
FINANCIAL OBJECTIVES
Advanced Financial Management is concerned with the following key decisions:
- What to invest in (INVESTMENT DECISIONS)
- How to finance the investment (FINANCING DECISIONS)
- The level of dividend distributions (DIVIDEND DECISIONS).
Objectives
Primary objective: to maximise the wealth of shareholders. A positive NPV equates
(in theory) to an increase in shareholder wealth.
Secondary objectives may be e.g. meeting financial targets (say satisfactory
ROCE), meeting productivity targets, establishing brands and quality standards and
effective communication with customers, suppliers, employees.
As an alternative to maximising the wealth of shareholders a company must in
reality consider satisficing objectives for each of the major stakeholders.
Stakeholders (user groups) and their goals
These include:
Shareholders
Directors
Management and employees
Loan creditors
Customers
Suppliers
The government
Environmental pressure groups
The general public
Many of these groups may have conflicting objectives, which need to be reconciled.
Corporate governance
Clearly the executive directors of a listed company are both decision-makers and
major stakeholders. They are therefore open to the accusation of making key
decisions for their own benefit. Following a number of notable financial scandals in
the UK during the late 20
th
century (e.g the Maxwell affair and the collapse of the
BCCI) the Cadbury Committee was set up to investigate procedures for appropriate
corporate governance.
The Cadbury Code (1992) defined corporate governance as the system by which
companies are directed and controlled. This initial document has been subject to
subsequent amendments by the Greenbury, Hampel and Higgs Reports. The
Financial Services Authority requires listed companies to confirm that they have
complied with the Code provisions or in the event of non-compliance to provide
an explanation of their reasons for departure.
THE UK CORPORATE GOVERNANCE CODE

Code of best practice
Section A: Leadership
A.1 The Role of the Board
Main Principle: Every company should be headed by an effective board
which is collectively responsible for the long-term success of the company.
The annual report should identify the chairman, the deputy chairman (where there
is one), the chief executive, the senior independent director and the chairmen and
members of the board committees. It should also set out the number of meetings
of the board and its committees and individual attendance by directors.
A.2 Division of Responsibilities
Main Principle: There should be a clear division of responsibilities at the
head of the company between the running of the board and the executive
responsibility for the running of the companys business. No one individual
should have unfettered powers of decision.
The roles of chairman and chief executive should not be exercised by the same
individual. The division of responsibilities between the chairman and chief
executive should be clearly established, set out in writing and agreed by the board.
A.3 The Chairman
Main Principle: The chairman is responsible for leadership of the board and
ensuring its effectiveness on all aspects of its role.
The chairman should on appointment meet the independence criteria set out in B.1
below. A chief executive should not go on to be chairman of the same company.
If, exceptionally, a board decides that a chief executive should become chairman,
the board should consult major shareholders in advance and should set out its
reasons to shareholders at the time of the appointment and in the next annual
report. (Compliance or otherwise with this provision need only be reported for the
year in which the appointment is made).
A.4 Non-executive Directors
Main Principle: As part of their role as members of a unitary board, non-
executive directors should constructively challenge and help develop
proposals on strategy.
The board should appoint one of the independent non-executive directors to be the
senior independent director to provide a sounding board for the chairman and to
serve as an intermediary for the other directors when necessary. The senior
independent director should be available to shareholders if they have concerns
which contact through the normal channels of chairman, chief executive or other
executive directors has failed to resolve or for which such contact is inappropriate.
The chairman should hold meetings with the non-executive directors without the
executives present. Led by the senior independent director, the non-executive
directors should meet without the chairman present at least annually to appraise
the chairmans performance and on such other occasions as are deemed
appropriate.
Section B: Effectiveness
B.1 The Composition of the Board
Main Principle: The board and its committees should have the appropriate
balance of skills, experience, independence and knowledge of the company
to enable them to discharge their respective duties and responsibilities
effectively.
The board should identify in the annual report each non-executive director it
considers to be independent. The board should determine whether the director is
independent in character and judgement and whether there are relationships or
circumstances which are likely to affect, or could appear to affect, the directors
judgement. The board should state its reasons if it determines that a director is
independent notwithstanding the existence of relationships or circumstances which
may appear relevant to its determination, including if the director:
has been an employee of the company or group within the last five
years;
has, or has had within the last three years, a material business
relationship with the company either directly, or as a partner,
shareholder, director or senior employee of a body that has such a
relationship with the company;
has received or receives additional remuneration from the company
apart from a directors fee, participates in the companys share option or
a performance-related pay scheme, or is a member of the companys
pension scheme;
has close family ties with any of the companys advisers, directors or
senior employees;
holds cross-directorships or has significant links with other directors
through involvement in other companies or bodies;
represents a significant shareholder; or
has served on the board for more than nine years from the date of their
first election.
Except for smaller companies (i.e. those below the FTSE 350 throughout the year
immediately prior to the reporting year), at least half the board, excluding the
chairman, should comprise non-executive directors determined by the board to be
independent. A smaller company should have at least two independent non-
executive directors.
B.2 Appointments to the Board
Main Principle: There should be a formal, rigorous and transparent
procedure for the appointment of new directors to the board.
There should be a nomination committee which should lead the process for board
appointments and make recommendations to the board. A majority of members of
the nomination committee should be independent non-executive directors. The
chairman or an independent non-executive director should chair the committee, but
the chairman should not chair the nomination committee when it is dealing with the
appointment of a successor to the chairmanship. The nomination committee should
make available its terms of reference, explaining its role and the authority
delegated to it by the board. (This requirement would be met by including the
information on the company website).
B.3 Commitment
Main Principle: All directors should be able to allocate sufficient time to the
company to discharge their responsibilities effectively.
For the appointment of a chairman, the nomination committee should prepare a job
specification, including an assessment of the time commitment expected,
recognising the need for availability in the event of crises. A chairmans other
significant commitments should be disclosed to the board before appointment and
included in the annual report. Changes to such commitments should be reported to
the board as they arise, and their impact explained in the next annual report.
The board should not agree to a full time executive director taking on more than
one non-executive directorship in a FTSE 100 company nor the chairmanship of
such a company.
B.4 Development
Main Principle: All directors should receive induction on joining the board
and should regularly update and refresh their skills and knowledge.
The chairman should ensure that the directors continually update their skills and
the knowledge and familiarity with the company required to fulfil their role both on
the board and on board committees. The company should provide the necessary
resources for developing and updating its directors knowledge and capabilities.
To function effectively, all directors need appropriate knowledge of the company
and access to its operations and staff.
The chairman should ensure that new directors receive a full, formal and tailored
induction on joining the board. As part of this, directors should avail themselves of
opportunities to meet major shareholders.
The chairman should regularly review and agree with each director their training
and development needs.
B.5 Information and Support
Main Principle: The board should be supplied in a timely manner with
information in a form and of a quality appropriate to enable it to discharge
its duties.
B.6 Evaluation
Main Principle: The board should undertake a formal and rigorous annual
evaluation of its own performance and that of its committees and
individual directors.
The board should state in the annual report how performance evaluation of the
board, its committees and its individual directors has been conducted.
Evaluation of the board of FTSE 350 companies should be externally facilitated at
least every three years. A statement should be made available of whether an
external facilitator has any other connection with the company. (This requirement
would be met by including the information on the company website).
The non-executive directors, led by the senior independent director, should be
responsible for performance evaluation of the chairman, taking into account the
views of executive directors.
B.7 Re-election
Main Principle: All directors should be submitted for re-election at regular
intervals, subject to continued satisfactory performance.
All directors of FTSE 350 companies should be subject to annual election by
shareholders. All other directors should be subject to election by shareholders at
the first annual general meeting (AGM) after their appointment, and to re-election
thereafter at intervals of no more than three years. Non-executive directors who
have served longer than nine years should be subject to annual re-election. The
names of directors submitted for election or re-election should be accompanied by
sufficient biographical details and any other relevant information to enable
shareholders to take an informed decision on their election.
Section C: Accountability
C.1 Financial and Business Reporting
Main Principle: The board should present a balanced and understandable
assessment of the companys position and prospects.
C.2 Risk Management and Internal Control
(The Turnbull Guidance, last updated in October 2005, suggests means of
applying this part of the Code)
Main Principle: The board is responsible for determining the nature and
extent of the significant risks it is willing to take in achieving its strategic
objectives. The board should maintain sound risk management and
internal control systems.
The board should, at least annually, conduct a review of the effectiveness of the
companys risk management and internal control systems and should report to
shareholders that they have done so. The review should cover all material controls,
including financial, operational and compliance controls.
C.3 Audit Committee and Auditors
(The FRC Guidance on Audit Committees - formerly referred to as the Smith
Guidance - suggests means of applying this part of the Code)
Main Principle: The board should establish formal and transparent
arrangements for considering how they should apply the corporate
reporting and risk management and internal control principles and for
maintaining an appropriate relationship with the companys auditor.
The board should establish an audit committee of at least three, or in the case of
smaller companies (i.e. those below the FTSE 350 throughout the year immediately
prior to the reporting year) two, independent non-executive directors. In smaller
companies the company chairman may be a member of, but not chair, the
committee in addition to the independent non-executive directors, provided he or
she was considered independent on appointment as chairman. The board should
satisfy itself that at least one member of the audit committee has recent and
relevant financial experience.
Section D: Remuneration
D.1 The Level and Components of Remuneration
Main Principle: Levels of remuneration should be sufficient to attract,
retain and motivate directors of the quality required to run the company
successfully, but a company should avoid paying more than is necessary
for this purpose. A significant proportion of executive directors
remuneration should be structured so as to link rewards to corporate and
individual performance.
The performance-related elements of executive directors remuneration should be
stretching and designed to promote the long-term success of the company.
The remuneration committee should judge where to position their company relative
to other companies. But they should use such comparisons with caution, in view of
the risk of an upward ratchet of remuneration levels with no corresponding
improvement in performance.
They should also be sensitive to pay and employment conditions elsewhere in the
group, especially when determining annual salary increases.
In designing schemes of performance-related remuneration for executive directors,
the remuneration committee should follow the provisions of this Code.
Where a company releases an executive director to serve as a non-executive
director elsewhere, the remuneration report (required by UK legislation) should
include a statement as to whether or not the director will retain such earnings and,
if so, what the remuneration is.
D.2 Procedure
Main Principle: There should be a formal and transparent procedure for
developing policy on executive remuneration and for fixing the
remuneration packages of individual directors. No director should be
involved in deciding his or her own remuneration.
The board should establish a remuneration committee of at least three, or in the
case of smaller companies two, independent non-executive directors. In addition
the company chairman may also be a member of, but not chair, the committee if he
or she was considered independent on appointment as chairman. The
remuneration committee should make available its terms of reference, explaining
its role and the authority delegated to it by the board. Where remuneration
consultants are appointed, a statement should be made available of whether they
have any other connection with the company (This requirement would be met by
including the information on the company website).
Section E: Relations with shareholders
E.1 Dialogue with Shareholders
Main Principle: There should be a dialogue with shareholders based on the
mutual understanding of objectives. The board as a whole has
responsibility for ensuring that a satisfactory dialogue with shareholders
takes place.
The chairman should ensure that the views of shareholders are communicated to
the board as a whole. The chairman should discuss governance and strategy with
major shareholders. Non-executive directors should be offered the opportunity to
attend scheduled meetings with major shareholders and should expect to attend
meetings if requested by major shareholders. The senior independent director
should attend sufficient meetings with a range of major shareholders to listen to
their views in order to help develop a balanced understanding of the issues and
concerns of major shareholders.
E.2 Constructive Use of the AGM
Main Principle: The board should use the AGM to communicate with
investors and to encourage their participation.
At any general meeting, the company should propose a separate resolution on each
substantially separate issue, and should, in particular, propose a resolution at the
AGM relating to the report and accounts. For each resolution, proxy appointment
forms should provide shareholders with the option to direct their proxy to vote
either for or against the resolution or to withhold their vote. The proxy form and
any announcement of the results of a vote should make it clear that a vote
withheld is not a vote in law and will not be counted in the calculation of the
proportion of the votes for and against the resolution.

The company should ensure that all valid proxy appointments received for general
meetings are properly recorded and counted. For each resolution, where a vote has
been taken on a show of hands, the company should ensure that the following
information is given at the meeting and made available as soon as reasonably
practicable on a website which is maintained by or on behalf of the company:
the number of shares in respect of which proxy appointments have been
validly made;
the number of votes for the resolution;
the number of votes against the resolution; and
the number of shares in respect of which the vote was directed to be
withheld.
The chairman should arrange for the chairmen of the audit, remuneration and
nomination committees to be available to answer questions at the AGM and for all
directors to attend.
The company should arrange for the Notice of the AGM and related papers to be
sent to shareholders at least 20 working days before the meeting.
INTERNATIONAL COMPARISONS OF CORPORATE
GOVERNANCE
The broad principles of corporate governance are similar in the UK, the USA and
Germany, but there are significant differences in how they are applied. Whereas
the UK and Germany have voluntary corporate governance codes, the US system is
based upon legislation within the Sarbanes-Oxley Act.
United States of America
Whereas the UK has historically relied upon a system of self-regulation and
voluntary codes of best practice, the USA corporate governance structure is more
formalised, with legally enforceable controls.
In the US, statutory requirements for publicly-traded companies are set out in the
Sarbanes-Oxley Act. These requirements include the certification of published
financial statements by the CEO and the chief financial officer (CFO), faster public
disclosures by companies, legal protection for whistleblowers, a requirement for an
annual report on internal controls, and requirements relating to the audit
committee, auditor conduct and avoiding improper influence of auditors.
The Act also requires the Securities and Exchange Commission (SEC) and the main
stock exchanges to introduce further rules, relating to matters such as the
disclosure of critical accounting policies, the composition of the Board and the
number of independent directors. The Act has also established an independent
body to oversee the accounting profession, which is known as the Public Company
Accounting Oversight Board. Managers must be careful to comply with regulations
to avoid possible legal action against the company or themselves individually.
Germany
As both the UK and Germany are members of the EU, they must both follow EU
directives on company law. A major difference that exists in the board structure for
companies is that the UK has a unitary board (consisting of both executive and
non-executive directors), whereas German companies have a two-tier board of
directors. The Supervisory Board of non-executives (Aufsichtsrat) has
responsibility for corporate policy and strategy and the Management Board of
executive directors (Vorstand) has responsibility primarily for the day-to-day
operations of the company.
The Supervisory Board typically includes representatives from major banks that
have historically been large providers of long-term finance to German companies
(and are often major shareholders). The Supervisory Board does not have full
access to financial information, is meant to take an unbiased overview of the
company, and is the main body responsible for safeguarding the external
stakeholders interests. The presence on the Supervisory Board of representatives
from banks and employees (trade unions) may introduce perspectives that are not
present in some UK boards. In particular, many members of the Supervisory Board
would not meet the criteria under UK Corporate Governance Code for their
independence.
Japan
Although there are signs of change in Japanese corporate governance, much of the
system is based upon negotiation or consensual management rather than upon a
legal or even a self-regulatory framework. Banks as well as representatives of
other companies (in their capacity as shareholders) also sit on the Boards of
Directors of Japanese companies.
It is not uncommon for Japanese companies to have cross holdings of shares with
their suppliers, customers and banks etc., all being represented on each others
Board of Directors. There are often three boards of directors: Policy Boards,
responsible for strategy and comprised of directors with no functional responsibility;
Functional Boards, responsible for day to day operations; and largely symbolic
Monocratic Boards. The interests of the company as a whole should dictate the
actions of these boards. This is in contrast to the UK or USA systems where, at
least in theory, the board should act primarily in the best interests of the
shareholders, being the owners of the company.


Chapter 2
Advanced
investment
appraisal section
1

CHAPTER 2 ADVANCED INVESTMENT APPRAISAL: SECTION 1
CHAPTER CONTENTS
INVESTMENT APPRAISAL TECHNIQUES ------------------------------- 27
1. ACCOUNTING RATE OF RETURN 27
2. PAYBACK PERIOD 28
3. DISCOUNTED CASH FLOW 28
INFLATION AND DISCOUNTED CASH FLOW -------------------------- 34
MONEY CASH FLOWS 34
REAL CASH FLOWS 34
RELATIONSHIP BETWEEN MONEY INTEREST RATES AND REAL INTEREST RATES 34
TAXATION AND INVESTMENT APPRAISAL ---------------------------- 36
CAPITAL RATIONING ---------------------------------------------------- 38
WHAT ARE THE 2 TYPES OF CAPITAL RATIONING? 38
CAPITAL RATIONING AND TIME 38
SINGLE PERIOD CAPITAL RATIONING 40
MULTI-PERIOD CAPITAL RATIONING 43

INVESTMENT APPRAISAL TECHNIQUES

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

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

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

Total depreciation 500 1,315

Annual depreciation 100 263

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

Average accounting profit 100 237

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

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

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

IRR 25% 20%

(d) Payback period

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

Payback period in years

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

or, according to the ACCA Formula Sheet, (1 + i) = (1 + r)(1 + h)
Where r is the real interest rate, m is the money interest rate and i is the rate of
inflation.
Thus 1 + r = 1.07/1.04 in the above example, giving r = 0.029 or 2.9%.


Suggested solution to AP
Method 1: Compute the real discount rate and discount the real cash flows
1 + r = 1+ m = 1.155 = 1.1
1 + i 1.05
Thus r = 0.1 or 10%
Real cash flow 10% factor Present value
Year
0 (1,500) 1 (1,500)
1 670 1/1.1 609.1
2 500 1/1.1
2
413.2
3 1,200 1/1.1
3
901.6
NPV 423.9

Method 2: Compute the money cash flows, using the rate of inflation and discount
at the money discount rate.
Money cash flow 15.5% factor Present value
Year
0 (1,500) 1 (1,500)
1 670 x 1.05 = 703.5 1/1.155 609.1
2 500 x 1.05
2
= 551.25 1/1.155
2
413.2
3 1,200 x 1.05
3
=1,389.15 1/1.155
3
901.6
NPV 423.9
Please note that discount rates have been computed as opposed to looked up in
tables, to ensure that accuracy is obtained for the reconciliation.
Example AP
A project requires an outlay of 1.5m in year 0 and will repay cash flows in real
terms (todays prices) as follows:
Year 000
1 670
2 500
3 1,200
The companys money cost of capital is 15%. Appraise the project if inflation is
estimated to remain at 5% per annum.
TAXATION AND INVESTMENT APPRAISAL
Example AA plc
AA plc buys a fixed asset for 10,000 at the beginning of an accounting period (1
January 2001) to undertake a two year project.
Net trading revenues at t
1
and t
2
are 5,000 per annum.
The company sells the fixed asset on the last day of the second year for 6,000.
Corporation tax = 33%. Writing down allowance = 25% reducing balance.
Required:
Calculate the net cashflows for the project.
Suggested solution to AA plc

t
0
t
1
t
2
t
3

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

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

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

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

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

t
0
Investment in fixed asset 10,000

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

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

5,625
t
2
Proceeds ____

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

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

Example of single period capital rationing Banden Ltd
Banden Ltd is a highly geared company that wishes to expand its operations. Six
possible capital investments have been identified, but the company only has access
to a total of 620,000. The projects are not divisible and may not be postponed
until a future period. After the projects end, it is unlikely that similar investment
opportunities will occur.
Expected net cash inflows (including salvage value)
Initial
Project Year 1 2 3 4 5 outlay

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

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

A, B, D (6,350 + 1,882 + 8,294) 16,526 (246 + 180 + 180) 606
A, B, F (6,350 + 1,882 + 4,993) 13,225 (246 + 180 + 150) 576
A, D, F (6,350 + 8,294 + 4,993) 19,637 (246 + 180 + 150) 576
B, D, E (1,882 + 8,294 + 5,490) 15,666 (180 + 180 + 180) 540
B, D, F (1,882 + 8,294 + 4,993) 15,169 (180 + 180 + 150) 510
B, E, F (1,882 + 5,490 + 4,993) 12,365 (180 + 180 + 150) 510
D, E, F (8,294 + 5,490 + 4,993) 18,777 (180 + 180 + 150) 510
The recommended selection is projects A, D and F
Tutorial note: Neither the NPV nor PI rankings will necessarily be appropriate
because of the sheer size of these indivisible investments. In this particular
instance, because of the similarity in size of the projects, only three can be
undertaken, and the NPV ranking clearly leads to A, D and E. Profitability
index will not work if projects are indivisible or where multiple limiting factors
exist. The PI might lead to the incorrect solution of D, E and F.
Multi-period capital rationing
Please remember that you are only likely to be asked to set up the
equations for both the linear programming and integer programming
formulations and then to interpret the output. The actual solving of these
equations are computer-based calculations.

Example of multi-period capital rationing using linear
programming Barney Ltd
The management team of Barney Ltd has identified the following independent
investment projects, all of which are divisible.
No project can be delayed or performed on more than one occasion. The projected
cash flows during the life of each project are as follows:
Year 0 Year 1 Year 2 Year 3 Year 4
000 000 000 000 000
Project A (25) (50) 25 50 50
Project B (25) (25) 75 - -
Project C (12.5) 5 5 5 5
Project D - (37.5) (37.5) 50 50
Project E (50) 25 (50) 50 50
Project F (20) (10) 37.5 25 -
The capital available at Year 0 is only 50,000

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

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

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

Example of the use of dual values in linear programming
Bruno Ltd
Bruno Ltd is experiencing capital rationing during both Year 0 and Year 1 in
relation to a number of divisible projects. It has used linear programming to
develop an investment strategy over its three year planning horizon for dividend
payments, using a cost of capital of 10%.
Shadow prices have been calculated under the NPV formulation for the two years
of capital constraints and under the PV of dividends formulation for the three year
planning horizon. The dual prices per 1 of capital available are as follows:
NPV method PV of dividends method

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


Solution to Toby Ltd
The problem is to identify that combination of investment projects which will
produce the highest possible total NPV (within the annual funding limitations).
For instance, if Projects C and D were undertaken, they would satisfy the annual
capital constraints, because the combined investment for Year 0 is 12,500, for
Year 1 is 30,000 and for Year 2 is 37,500, whilst achieving a total positive NPV of
25,000.
On the other hand, if Projects A and B were selected, they would also remain within
the annual capital limitations. The combined investment for Year 0 is 40,000, for
Year 1 is 25,000 and for Year 2 is 40,000, whilst achieving a total positive NPV of
47,500. This amount exceeds the NPV earned by the combination of Projects C
and D.
This problem can be solved by an integer programming formulation. The
procedures would be to establish the value of variables Y
A
, Y
B
, Y
C
and Y
D
for each of
the four projects, which maximise the total net present value ie
Maximise: 20,000 Y
A
+ 27,500 Y
B
+ 15,000 Y
C
+ 10,000 Y
D
Example of multi-period capital rationing using integer
programming Toby Ltd
The management team of Toby Ltd has identified four indivisible projects, which
require funds to be invested over the next few years, as set out below:
Project A Project B Project C Project D

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

Year 0 40,000
Year 1 35,000
Year 2 42,500
The four projects are expected to produce the following positive net present
values:
Project A Project B Project C Project D
Project NPV +20,000 +27,500 +15,000 +10,000
Required:
Discuss the approach for calculating the optimum mix of projects.
Subject to three annual capital investment constraints:
Year 0 : 17,500 Y
A
+ 22,500 Y
B
+ 0 Y
C
+ 12,500 Y
D
40,000
Year 1 : 25,000 Y
A
+ 0 Y
B
+ 15,000 Y
C
+ 15,000 Y
D
35,000
Year 2 : 10,000 Y
A
+ 30,000 Y
B
+ 20,000 Y
C
+ 17,500 Y
D
42,500
The solution to the above problem would result in Y
A
= 1, Y
B
= 1, Y
C
= 0, Y
D
= 0.
In other words, both Project A and Project B would be selected, whilst the other two
projects would be rejected and the positive NPV of the entire investment strategy
would be 47,500.
Notice that the above solution is superior to the combination of Y
A
= 0, Y
B
= 0, Y
C

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

Chapter 3
Advanced
investment
appraisal section
2

CHAPTER CONTENTS
MODIFIED INTERNAL RATE OF RETURN ------------------------------ 53
CALCULATING THE MIRR 53
FREE CASH FLOW -------------------------------------------------------- 56
DEFINITION OF FREE CASH FLOW 56
FREE CASH FLOW TO EQUITY 57
RISK AND UNCERTAINTY ----------------------------------------------- 61
SENSITIVITY ANALYSIS 61
PROBABILITY AND EXPECTED VALUES 62
MONTE CARLO SIMULATION 62
PROJECT VALUE AT RISK 63
DURATION ---------------------------------------------------------------- 64
THE MACAULAY DURATION METHOD ---------------------------------- 66

MODIFIED INTERNAL RATE OF RETURN
To assist in remedying some of the deficiencies of IRR, a technique called Modified
Internal Rate of Return (MIRR) has been developed. MIRR has certain advantages
in that it:
Eliminates the possibility of multiple internal rates of return.
Addresses the reinvestment rate issue ie it does not make the assumption
that the companys reinvestment rate is equal to whatever the project IRR
happens to be.
Provides rankings which are consistent with the NPV rule (which is not always
the case with IRR).
Provides a % rate of return for project evaluation. It is claimed that non-
financial managers prefer a % result to a monetary NPV amount, since a %
helps measure the headroom when negotiating with suppliers of funds.
Calculating the MIRR
The MIRR assumes a single outflow at time 0 and a single inflow at the end of the
final year of the project. The procedures are as follows:
Convert all investment phase outlays as a single equivalent payment at time
0. Where necessary, any investment phase outlays arising after time 0 must
be discounted back to time 0 using the companys cost of capital.
All net cash flows generated by the project after the initial investment (ie the
return phase cash flows) are converted to a single net equivalent terminal
receipt at the end of the projects life, assuming a reinvestment rate equal to
the companys cost of capital.
The MIRR can then be calculated employing one of a number of methods, as
illustrated in the following example.

Example Carter plc
Carter plc is considering an investment in a project, which requires an immediate
payment of 15,000, followed by a further investment of 5,400 at the end of the
first year. The subsequent return phase net cash inflows are expected to arise at
the end of the following years:
Net cash inflows
Year
1 6,500
2 7,750
3 5,750
4 4,750
5 3,750
Required:
Calculate the modified internal rate of return of this project assuming a
reinvestment rate equal to the companys cost of capital of 8%.
Solution to Carter plc
Single equivalent payment discounted to year 0 at an 8% discount rate:
Year
0 15,000
1 (5,400 x 0.926) _5,000
Present Value (PV) of investment phase cash flows 20,000
Single net equivalent receipt at the end of year 5, using an 8% compound rate:
Year 8% compound factors
1 6,500 1.3605 8,843
2 7,750 1.2597 9,763
3 5,750 1.1664 6,707
4 4,750 1.08 5,130
5 3,750 1 3,750
Terminal Value (TV) of return phase cash flows 34,193
The above compound factors are produced with a calculator.
A five year PV factor can now be established ie (20,000 34,193) = 0.585
Using present value tables, this 5 year factor falls between the factors for 11% and
12% ie 0.593 and 0.567. Using linear interpolation:
MIRR = 11% +
0.567) - (0.593
0.585) - 0.593 (
x (12% - 11%) = 11.3%
Alternatively, the MIRR may be calculated as follows;
MIRR =
000 , 20
193 , 34
5
1 = 11.3%
Furthermore, in examples where the PV of return phase net cash flows has already
been calculated, there is yet another formula for computing MIRR (which is given
on the ACCA formulae sheet). This formula avoids having to establish the Terminal
Value of those return phase net cash flows ie
PV of return phase net cash flows
(6,500 x 0.926) + (7,750 x 0.857) + (5,750 x 0.794) + (4,750 x 0.735) + (3,750 x
0.681) = 23,271
MIRR = 1 - 1.08
000 , 20
271 , 23
5
|
|
\
|
= 11.3%
The reservations which are often cited concerning the MIRR technique include:
In what are claimed to be the very exceptional circumstances where the
reinvestment rate exceeds the companys cost of capital, the MIRR will
underestimate the projects true rate of return.
The determination of the life of a project can have a significant effect on the
actual MIRR, if the difference between the projects IRR and the companys
cost of capital is large.
Like IRR, the MIRR is biased towards projects with short payback periods and
large initial cash inflows.
The extent to which this method is being used in industry is unclear and only
time will tell whether it eventually becomes popular.
FREE CASH FLOW

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

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

Suggested solution to Molineux Ltd
(a) Free cash flow
m
EBIT 313.50
Less: Corporation tax (@ 35% thereon) (109.72)
203.78
Add back: Depreciation (non-cash amount) 30.00
Deduct: Capital expenditure (60.00)
Free cash flow 173.78
Dividend cover (in terms of free cash flow)
Dividends paid
=
Example Molineux Ltd
The following data relates to Molineux Ltd:
Forecast Income statement for 2010
m
Revenue 1,950.00
Cost of sales (1,314.00)
Gross profit 636.00
Operating expenses (322.50)
Earnings before interest and tax 313.50
Interest charges (24.00)
Profit before tax 289.50
Corporation tax(@ 35%) (101.32)
Profit after tax 188.18
During the year loan repayments are expected to amount to 69 million,
depreciation charges to 30 million and capital expenditure to 60 million.
Required:
Calculate:
(a) Free cash flow;
(b) Free cash flow to equity.
(b) Free cash flow to equity
Method One
m
Free cash flow (as above) 173.78
Deduct: Loan repayments (69.00)
Interest charges, net of tax [24m x (1 0.35)] (15.60)
Free cash flow to equity 89.18
Method Two
m
Profit after tax 188.18
Add back: Depreciation (non-cash amount) 30.00
Deduct: Capital expenditure (60.00)
Loan repayments (69.00)
Free cash flow to equity 89.18

Example Bescot plc
The following information relates to the forecasts of Bescot plc for the forthcoming
year:
000
Capital expenditure for expansion 100
Capital expenditure to replace existing non-current assets 240
Depreciation charges 300
Amounts raised from fresh bond issue 120
Increase in working capital 220
Interest paid 40
Repayment of loans 60
Profit from operations 1,880
Corporation tax paid (@ 30%) 552
Ordinary share capital (@ 25p par value) 1,840
Dividend paid for the year is expected to be 5p per share
Required:
Calculate:
(a) Free cash flow;
(b) Free cash flow to equity;
(c) Dividend cover based upon free cash flow to equity.
Suggested solution to Bescot plc
(a) Free cash flow
000
Profit from operations (EBIT) 1,880
Deduct: Corporation tax (@ 30% thereon) (564)
1,316
Add back: Depreciation (non-cash amount) 300
Deduct: Capital expenditure to replace existing non-current assets (240)
Capital expenditure for expansion (ARGUABLY, THIS SHOULD NOT
BE DEDUCTED IN ARRIVING AT FREE CASH FLOW)
(100)
Increase in working capital (220)
Free cash flow 1,056
(b) Free cash flow to equity
Method One
000
Free cash flow (as above) 1,056
Deduct: Loan repayments (60)
Interest charges, net of tax [40,000 x (1 0.3)] (28)
Add: Proceeds of bond issue 120
Free cash flow to equity 1,088
Method Two
000
EBIT 1,880
Interest charges (40)
Corporation tax (552)
Profit after tax (ie Earnings after interest and tax) 1,288
Add back: Depreciation (non-cash amount) 300
Deduct: Increase in working capital (220)
Capital expenditure [240,000 + 100,000] (340)
Loan repayments (60)
Add: Amounts raised from bond issue 120
Free cash flow to equity 1,088
(c) Dividend cover

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

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

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

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

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

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

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

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

+
= 13.79%
Cost of capital will have to increase by 37.9% (ie from 10% to 13.79%) for an NPV
of 0 to arise.
Project life: Clearly if the project life were for a shorter period than 3 years an NPV
of 0 would at some point arise. Accurate calculations are in this case not possible,
since at a life of less than 3 years, the scrap value would be greater, but the precise
amount is unknown.
Probability and expected values
A probability distribution of expected cash flows could be estimated and used to
calculate the expected value of the NPV and measure risk (normally the standard
deviation of that NPV). This aspect will be demonstrated during the lectures
dealing with Project Value at Risk (VAR) and the Capital Asset Pricing Model
(CAPM).
This expected value is unlikely to be the same amount as one of the specific
outcomes, since it is based upon a weighted average calculation. Whilst the
expected value is simple to calculate and easy to understand, it does suffer from
the following limitations:
Probabilities usually have to be estimated and therefore may be inaccurate or
unreliable;
Expected values are long-term averages, which assume repetition of the task
and may clearly be inappropriate for one-off projects;
Does not take into account the decision makers attitude to risk think of a
banker!;
May not take into account the time value of money.
Monte Carlo simulation
Sensitivity analysis assesses the effect on an overall decision if a single constituent
variable were to change. Monte Carlo simulation is a mathematical model which
will include all combinations of the potential variables associated with the project. It
results in the creation of a distribution curve of all possible cash flows which could
arise from the investment and allows for the probability of the different outcomes
to be calculated. The steps involved are as follows:
1. Specify all major variables
2. Specify the relationship between those variables
3. Using a probability distribution, simulate each environment.
The advantage of this technique is it includes all foreseeable outcomes. The
disadvantages are the difficulty in formulating the probability distribution and the
model becoming very complex.
Project value at risk
Value at risk (VaR) is the value which can be attached to the downside of a value or
price distribution of known standard deviation and within a given confidence level.
VaR and related measures give an indication of the potential loss in monetary value
which is likely to occur with a given level of confidence. The setting of the
confidence level is necessary because in principle, if a price distribution is normally
distributed for example, the downside loss is potentially infinite.
Confidence levels are often set at either 95% (in which case the VaR will provide
the amount that has only a 5% chance of decline) or at 99% (when the VaR
considers a 1% chance of loss of value).
Example Andrews plc
Andrews plc estimates the expected NPV of a project to be 100 million, with a
standard deviation of 9.7 million.
Required:
Establish the value at risk using both a 95% and also a 99% confidence
level.
Solution to Andrews plc
Using Z =
- X
and establishing Z from the normal distribution tables ie at a
95% confidence level, 1.65 is the value for a one tailed 5% probability of decline (ie
0.4505) and at a 99% confidence level, 2.33 is the value for a one tailed 1%
probability of loss of NPV (ie 0.4901).
At 95% confidence level, Z =
9.7
100 - X
= 1.65;
therefore X = (9.7 x 1.65) + 100 = 84
At 99% confidence level, Z =
9.7
100 - X
= 2.33;
therefore X = (9.7 x 2.33) + 100 = 77.4
There is a 5% chance of the expected NPV falling to 84 million or less and a 1%
probability of it falling to 77.4 million or below.
DURATION
Duration is the average time taken to recover the cash flows on an investment.
The average is taken as the value weighted average of the number of the year (1 to
n) in which the cash flows arise. In capital investment, the duration can be
calculated using either the firms original outlay, or the present value of its future
cash flows as the basis for the annual weighting.
If duration is based upon the average time to recover the initial capital investment:
1. Calculate the value of each future net cash flow, discounted at the IRR of the
project;
2. Calculate each years discounted cash flow as a proportion of the original
capital outlay;
3. Take the time from investment to each discounted cash flow and multiply by
the respective proportion. Finally, sum the weighted year values.
If duration is based upon the average time taken to recover the present value of
the project:
1. Calculate the value of each future net cash flow, discounted at the chosen
hurdle rate;
2. Calculate each years discounted cash flow as a proportion of the PV of total
cash inflows;

Solution to FCF plc
Duration taken to recover the original investment
Year 1 2 3 4
1. Discount cash inflows @ 11.13% 6,839 13,361 9,473 4,327
2. Proportion of initial outlay (34,000) 0.201 0.393 0.279 0.127
3. Proportion multiplied by year number 0.201 0.786 0.837 0.508
Finally, sum these to provide the duration ie on average the company will take
2.332 years to recover the initial investment ie an indication of project uncertainty
(see below).
Example FCF plc
The forecast cash flows relating to a proposed project are:
Year 0 1 2 3 4
Incremental cash
flows
(34,000) 7,600 16,500 13,000 6,600
Required:
Establish both the duration to recover the original investment (using the
IRR of this project of 11.13%) and the duration to recover the present
value of the project (at an 8% hurdle rate).
Duration taken to recover the present value of the project
Year 1 2 3 4
1. Discount cash inflows @ 8% 7,037 14,146 10,320 4,851
2. Proportion of project PV (36,354) 0.194 0.389 0.284 0.133
3. Proportion multiplied by year number 0.194 0.778 0.852 0.532
Finally, sum these to provide the duration ie on average the company will take
2.356 years to recover half the present value of the project ie a different
indication of project uncertainty. The longer the duration, the greater the
uncertainty attaching to future returns!!

THE MACAULAY DURATION METHOD
In 1938, Frederick R. Macaulay defined Duration as the total weighted average
time for recovery of the payments and principal in relation to the current market
price of a bond.
The maturity of a bond is not a particularly good indication of the timing of the cash
flows associated with that bond, since a significant proportion of those cash flows
will occur prior to maturity normally in the form of interest payments.
One could calculate an average of the timings of each cash flow, weighted by the
size of those cash flows. Duration is very similar to such an average, but instead of
taking each cash flow as a weighting, duration uses the present value of each cash
flow.
Steps required to calculate bond duration
1. Establish the cash flows arising at each future time period;
2. Calculate the present value of these future cash flows, discounted at the IRR
(ie the gross yield to maturity) of the security. Incidentally, the sum of these
figures must be the current price of the bond;
3. Calculate each years discounted cash flow as a proportion of the current
value of the bond;
Example Seven Years
Seven years prior to the maturity of a bond with a 10% coupon, it is trading at a
price of 95.01 per cent and has a gross yield to maturity of 11.063%. Using the
Macaulay duration method, you are required to calculate the bond duration.
Solution to Seven Years
Yr 1 2 3 4 5 6 7
1 Annual cash
flows ()
10.00 10.00 10.00 10.00 10.00 10.00 110.00
2 Discounted
@11.063%
()
9.00 8.11 7.30 6.57 5.92 5.33 52.78
3 Proportion of
price (95.01)
0.095 0.085 0.077 0.069 0.062 0.056 0.556
4 Proportion
multiplied by
year number.
0.095 0.170 0.231 0.276 0.310 0.336 3.892
Finally, find the totals of row 4, since these provide the bond duration of 5.31
years, ie the weighted average time to full recovery of an investment in this bond.
Remember that if the monetary amounts in row 2 (above) are cross-cast, the result
must obviously be the current price of the bond, since the gross yield to maturity is
the internal rate of return of all cash flows associated with the bond.
Furthermore, the above calculation is almost identical to the approach used for
calculating the duration taken to recover an original investment in project appraisal
(as described earlier on page 64).
Significance of the calculation of duration
Duration is an important measure for fixed-income investors and their advisers,
since bonds with higher durations may have greater price volatility than similar
bonds with lower durations. In general:
Changes in the value of a bond are inversely related to changes in the rate of
return ie the lower the yield to maturity, the higher the value of the bond;
Long-term bonds have higher interest rate risk than shorter term bonds, due
to the greater probability (over the longer time period) of market interest rate
increases; and
High coupon bonds have less interest rate sensitivity than low coupon bonds,
since the greater the amounts of the cash flows received in the short-term,
the earlier the purchase price of the bond will be recouped.
The Macaulay duration method measures the number of years required to recover
the cost of the bond (taking account of the present value of all interest and capital
cash flows within the future time period). The result is expressed in years.
A measure referred to as Modified Duration (or Volatility) expands on the basic
method, but the ACCA P4 Syllabus only requires a knowledge of the simple
Macaulay duration method, as a means of assessing exposure to interest rate
changes.
The basic lessons of duration are:
As maturity increases, the measure of duration will also increase and the
market value of the bond will become more sensitive to changes in the level
of interest rates;
As the coupon rate of a bond increases, duration will decrease and the value
of the bond will be less sensitive to changes in the level of interest rates; and
As interest rates rise, duration will decrease and the value of the bond will be
less sensitive to subsequent rate changes.
Example Macaulay Duration Method
In each of the following cases, you are required to use the Macaulay duration
method to calculate the duration for each of the following securities:
(a) A bond with a five year maturity has a current value of 92.41 per cent, a
coupon rate of 8% and a market yield of 10%.
(b) On the 1 February 2011, a 5.5% Treasury Bond (which is redeemable on 1
February 2015), has a market value of 110.28 per cent and a yield to
maturity of 2.75%.
(c) A 6% bond has three years to redemption. It has a current market price of
89.85 per cent. Interest is paid half-yearly and its market yield is 10% per
annum (ie 5% every six months).
Solution to Macaulay Duration Method
(a)
Year 1 2 3 4 5
1 Annual cash flows () 8.00 8.00 8.00 8.00 108.00
2 Discounted @ 10% () 7.27 6.61 6.01 5.46 67.06
3 Proportion of bond value
(92.41)
0.079 0.072 0.065 0.059 0.726
4 Proportion multiplied by year
number
0.079 0.144 0.195 0.236 3.630
Finally, establish the totals of row 4, since these provide the bond duration of 4.284
(b)
Year 1 2 3 4
1 Annual cash flows () 5.50 5.50 5.50 105.50
2 Discounted @ 2.75% () 5.35 5.21 5.07 94.65
3
Proportion of bond value
(110.28)
0.049 0.047 0.046 0.858
4
Proportion multiplied by year
number
0.049 0.094 0.138 3.432
(c)
Period 1 1 2 2 3
1 Half-yearly cash flows () 3 3 3 3 3 103
2 Discounted @ 5% per
half year ()
2.86 2.72 2.59 2.47 2.35 76.86
3 Proportion of bond value
(89.85)
0.032 0.030 0.029 0.028 0.026 0.855
4 Proportion multiplied by
period number
0.016 0.030 0.044 0.056 0.065 2.565
General observations
Note that Macaulay duration will always be lower than the term to maturity
(assuming that the coupon rate exceeds zero - you may think that this is a stupid
comment, but the world of finance is going through some amazing times!!).
Nowadays, the value of Macaulay duration is less evident, due to wide availability of
computer programs with Monte Carlo simulation. Obviously, bonds are subject to
risk, but duration is not intended to reflect risk; it measures interest rate
sensitivity.

Chapter 4
Cost of capital

CHAPTER 4 COST OF CAPITAL
CHAPTER CONTENTS
PURPOSE OF COST OF CAPITAL ---------------------------------------- 71
CALCULATING THE COMPONENT COSTS OF CAPITAL ---------------- 72
1. COST OF EQUITY SHARE CAPITAL 72
2. COST OF PREFERENCE SHARE CAPITAL 74
3. COST OF DEBT 74
CALCULATING THE WEIGHTED AVERAGE COST OF CAPITAL -------- 77
MAIN ASSUMPTIONS UNDERLYING USE OF WACC AS THE DISCOUNT
RATE ---------------------------------------------------------------------- 80
SOURCES OF FINANCE -------------------------------------------------- 81
SOURCES OF SHORT-TERM FINANCE 81
SOURCES OF LONG-TERM FINANCE 82
SMALL AND MEDIUM-SIZED ENTITIES (SMES) ----------------------- 83
PROBLEMS FACED BY SMALL BUSINESSES IN RAISING EXTERNAL FINANCE 83
WAYS OF RESOLVING PROBLEMS FACED BY SMALL BUSINESSES IN RAISING FINANCE 84

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

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

Example Naylor plc
Naylor plc is expected to pay a constant annual net dividend of 30p per ordinary
share. The current market price per share is 2.30 (cum-div). The dividend is
about to be paid.
What is Ke?
Solution to Naylor plc
Ke =
p 30 p 230
p 30
= 15%
(b) Fresh issue of equity
Two views:
(i) Ke =
f P
D
0

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

= g
P
D
0
1
+

Solution to CCDP plc
Ke = % 10
2
p 22
+ = 21%
Two methods of estimating future growth
(i) Historical growth in dividends

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

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

=
000 , 150
350 , 262

= 1.749

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

g = 15%
(ii) Use of Gordon growth approximation
g = br
where: b = proportion of earnings retained p.a.
r = average return on reinvested funds.
Strictly only applicable to all-equity companies, but is often used for geared
companies as an approximation of growth rates.

Solution to V plc
g = 40% x 10% = 4%
Ke =
p 96
p 48 . 12
+ 4% = 17%
2. Cost of preference share capital
Kps =
div) - (ex P
) net ( D
0

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

Example V plc
Establish an estimate of future growth and of Ke if:
Proportion of earnings distributed p.a. 60%
Average return on reinvested funds 10%
Current cum-div price 1.08
Impending dividend 12p

(b) Redeemable
IRR exercise
Example VI plc
A 5% debenture is currently quoted at 95.84 (ex-int). It is redeemable at the end
of 3 years at 100.
Taking corporation tax at 50%, and ignoring the timing lag for tax savings,
calculate Kd.
Solution to VI plc
Year Try DF @ 4%
0 Cost (95.84) 1.00 (95.84)
1 Interest 5(0.5) 0.962 2.41
2 Interest 2.50 0.925 2.31
3 Interest & Redemption 102.50 0.889 91.12
NPV NIL
Therefore, Kb = IRR = 4%
NB Try 3% (NPV + 2.74) and 5% (NPV - 2.63), then by linear interpolation
Kb = 3% +
37 . 5
74 . 2
x 2% = 4.02%
ie linear interpolation tends to overstate the IRR of normal cash flows
(c) Convertible
The cost of convertible debt is calculated in a similar manner to the calculation of
the cost of redeemable debt, EXCEPT that in the final year, one must include the:
- redemption value of the debt, or
- conversion value of the debt
whichever is the GREATER.
Example
Some 8% convertible debentures have a current market value of 106 per cent.
The debenture will be converted into equity shares in 3 years time at the rate of 40
shares per 100 of debentures. The market price is expected to be 3.5 on the
date of conversion.
What is the cost of capital to the company for the convertible debentures? Assume
a corporation tax of 33%.
Solution
Net interest = 8% x 100 (1 - 0.33) = 5.36
Conversion value = 40 x 3.5 = 140 higher
Redemption value = 100
Year Item cashflow DF(12%) PV DF(15%) PV
0 current MV (106) 1 (106) 1 (106)
1 - 3 interest 5.36 2.402 12.87 2.283 12.24
3 conversion value 140 0.712 99.68 0.658 92.12
6.55 (1.64)
Cost of capial = ( ) % 12 % 15
64 . 1 55 . 6
55 . 6
% 12 |
\
|
+
+ = 14.4%
(d) Floating rate debt
The cost of floating rate debt (eg most bank loans and overdrafts) is the current
interest rate being charged on such funds.
Accordingly, if a company is paying interest at LIBOR + 8%, when LIBOR is set at
5% p.a. and corporation tax rates are at 30%, Kd will be calculated as follows:
Kd = (5% + 8%) x (1 0.3) = 9.1%
CALCULATING THE WEIGHTED AVERAGE COST OF
CAPITAL (WACC)
Difficult to associate a project with a specific source of finance, as a pool of
resources are available in order to invest in projects. Thus a WACC is an
appropriate discount rate/cut off rate.
Example Whyte plc
Whyte plc has on issue:
(a) 500,000 ordinary shares of 1 each, whose ex-div share price is 2. A
constant dividend of 36p per share will be paid on these for several years
hence.
(b) 500,000 6% preference shares of 1 each, whose ex-div share price is 50p.
(c) 1,000,000 10% irredeemable debentures, quoted at 75 (ex-interest).
Calculate K
0
(ie the WACC) assuming Corporation Tax at 40%.
Solution to Whyte plc
Market Value Component Cost

Equity (m @ 2) 1,000,000 18% 180,000
Prefs (m @ 50p) 250,000 12% 30,000
Debt (1m @ 75) 750,000 8%* 60,000
2,000,000 270,000
K
0
=
000 , 000 , 2
000 , 270
= 13.5%
*K
b
=
75
) 4 . 0 1 ( 10
= 8%

Solution to Hunt plc
Ke = % 5
p 12 17 . 1
) 05 . 1 ( p 12
+
= 17%
Kps =
p 40
p 6
= 15%
Kb
Year Capital Interest Tax Net Try DF @ 8% Net

0 (95.30) (95.30) 1.00 (95.30)
1 10 10 0.926 9.26
2 100 10 (5) 105 0.857 89.99
3 (5) (5) 0.794 (3.97)
-0.02
Therefore, Kb = IRR = 8%
Comprehensive example Hunt plc
The management of Hunt plc is trying to decide upon a cost of capital discount rate
to apply to the evaluation of investment projects.
The company has an issued share capital of 500,000 ordinary 1 shares, with a
current market value cum div of 1.17 per share. It has also issued 200,000 of
10% debentures, which are redeemable at par in 2 years and have a current
market value of 105.30 per cent and 100,000 of 6% preference shares,
currently priced at 40p per share. The preference dividend has just been paid, and
the ordinary dividend and debenture interest are due to be paid in the near future.
(The preference dividend is shown net).
The ordinary share dividend will be 60,000 this year, and the directors have
publicised their view that earnings and dividends will increase by 5% per annum
into the indefinite future.
The fixed assets and working capital of the company are financed by:

Ordinary shares of 1 500,000
6% 1 Preference shares 100,000
Debentures 200,000
Reserves 380,000
1,180,000
Required:
Calculate the WACC. Assume corporation tax at 50% per annum, payable
one year in arrears.
WACC
Market Value Component Cost

Equity (m @ 1.05) 525,000 17% 89,250
Prefs (100K @ 40p) 40,000 15% 6,000
Debt (200K @ 95.30) 190,600 8% 15,248
755,600 110,498
Ko =
600 , 755
498 , 110
= 14.6%
MAIN ASSUMPTIONS UNDERLYING USE OF WACC AS THE
DISCOUNT RATE
1. Only under conditions of perfect capital markets will the costs of capital
calculated represent the true opportunity cost of funds used.
2. The project must be small relative to the size of the company (ie it represents
a marginal investment). This is because the costs of capital calculated refer
to the minimum required return of marginal investors and therefore are only
appropriate for the evaluation of marginal changes in the companys total
investment.
3. Using the existing market value mix of funds as weights in the calculation
assumes that in the long run funds will be raised in this proportion (ie in the
long run the capital structure of the company will remain unchanged). This
implies that the current gearing ratio is thought to be optimal.
4. No attempt is made to match a project with a particular source of funds. All
funds are regarded as forming a pool out of which all projects are financed
(the pool concept).
5. The project is of average risk for the firm and will cause no change in the risk
of the company as perceived by investors. This is because the cost of capital
estimates are only valid for the existing level of risk in the enterprise.
SOURCES OF FINANCE

Sources of short-term finance
Bank overdrafts
If cash outflows from a bank current account exceed inflows for a temporary period,
a clearing bank may provide an overdraft. Overdrafts may be arranged speedily,
but are subject to review by the bank, may be renewable and offer a level of
flexibility, whilst interest is only paid on the overdrawn amount.
Overdrafts are technically repayable on demand and may require some form of
security or guarantee. Interest is often payable at a variable rate (ie benchmark
rate plus a premium) and an arrangement fee is normally payable upon the initial
grant of the facility.
Short-term loans
Bank loans are an agreement for the provision of a specific fixed sum for a
predetermined period at an agreed interest rate. A term loan is provided in full at
the start of the loan period and is repaid at a specified time or in instalments over a
period of agreed dates.
Bank loans are only repayable on the agreed dates, but are more expensive and
less flexible than overdrafts. The terms of the loan must be adhered to and the
bank may impose loan covenants with which the borrower must comply.
Trade credit
Raw materials are normally purchased on credit and this effectively represents an
interest free short-term loan. It is important to remember that payment delays
would worsen the credit rating of the company and that additional credit may then
be difficult to obtain. The loss of settlement discounts that suppliers may offer for
early payment must be considered.
Lease finance
Instead of the outright purchase of a non-current asset, a company may choose to
obtain the temporary use of that asset by means of an operating lease, whereby
the risks and rewards of ownership are retained by the lessor (ie the legal owner).
An operating lease contract between a lessor and lessee is for the hire of a specific
asset, whereby the lessee has possession and use of equipment for a period which
is shorter than the economic useful life of the asset, but the lessee is committed to
pay specified rentals during the period of the lease. The lessor is normally
responsible for repairs and maintenance and the lease can sometimes be cancelled
at short notice.
Sources of long-term finance
The main sources are:
Fixed interest capital (ie debt finance) and preference share capital;
Equity finance, which is commonly raised by rights issues, placings, offers for
sale or public issues following a stock exchange introduction. Details may be
found in your Study Manual.
Two other long-term sources of finance available to businesses are:
1. Lease finance
A long-term leasing arrangement is likely to be finance lease, ie a lease that
transfers substantially all the risks and rewards incidental to the ownership of an
asset to the lessee. Legal title may or may not eventually be transferred.
The lessor is likely to be a bank or other financial institution, which does not
normally trade in the type of asset concerned. The lessee normally becomes
responsible for the cost of repairs and maintenance.
The substance of a finance lease arrangement is that the lessee is effectively
borrowing in order to have use of a non-current asset for substantially the whole of
its useful economic life and thereby becomes liable for all lease payments. In
contrast, an operating lease is equivalent to the short-term rental of an asset from
an organisation which normally trades in that type of asset.
2. Venture capital
Venture capital is the provision of risk bearing capital, normally provided in return
for an equity stake in companies with high growth potential.
The 3i Group is one of the worlds oldest venture capital organisations and is
involved in schemes in Europe, the USA and the Far East. The 3i Group is prepared
to invest in companies with a highly motivated management team, having a well
defined strategy and target market, which are committed to innovation and a
proven ability to outperform competitors.
Venture capitalists may provide finance for business start-ups, the development of
existing businesses, management buyouts and the realisation of the investments of
existing owners who wish to exit their companies.
Where company directors seek assistance from a venture capitalist they must
expect that the institution will require an equity stake in the company, need
convincing that the business will be successful, seek representation on the
companys board of directors, demand exceptional returns on their investment and
expect an obvious ultimate exit route.

SMALL AND MEDIUM-SIZED ENTITIES (SMES)

Problems faced by small businesses in raising external
finance
Small businesses face a number of well-documented problems when seeking to
raise additional finance. These problems have been extensively discussed and
governments regularly make initiatives seeking to address these problems.
Risk
Investors are less willing to offer finance to small companies as they are seen as
inherently more risky than large companies.
Security
Since small companies are likely to possess little by way of assets to offer as
security, banks usually require a personal guarantee instead, and this limits the
amount of finance available.
Marketability of ordinary shares
Small companies are likely to be very limited in their ability to offer new equity to
anyone other than family and friends.
The equity issued by small companies is difficult to buy and sell, and sales are
usually on a matched bargain basis, which means that a shareholder wishing to sell
has to wait until an investor wishes to buy. There is no financial intermediary
willing to buy the shares and hold them until a buyer comes along, so selling shares
in a small company can potentially take a long time. This lack of marketability
reduces the price that a buyer is willing to pay for the shares.
Tax considerations
Individuals with cash to invest may be encouraged by the tax system to invest in
large institutional investors rather than small companies, for example by tax
incentives offered on contributions to pension funds. These institutional investors
themselves usually invest in larger companies, such as stock-exchange listed
companies, in order to maintain what they see as an acceptable risk profile, and in
order to ensure a steady stream of income to meet ongoing liabilities. This tax
effect reduces the potential flow of funds to small companies.
Cost
Since small companies are seen as riskier than large companies, the cost of the
finance they are offered is proportionately higher. Overdrafts and bank loans will
be offered to them on less favourable terms and at more demanding interest rates
than debt offered to larger companies. Equity investors will expect higher returns,
if not in the form of dividends then in the form of capital appreciation over the life
of their investment.
Lack of information
Potential lenders may refuse to provide finance to a small business because of lack
of financial information about the small business to asses it creditworthiness.
Funding gap
Funding gap is the difference between the amount available for lending and the
amount required to finance investment. Small businesses often need more funds
than are available for them to finance growth.
The maturity gap
This presents a further problem for SMEs, who may ideally wish to obtain medium-
term loans. This arises due to the mismatching of the maturity of assets and
liabilities. Since the SME can secure long-term loans with mortgages against their
property assets, they find that longer term borrowing is much easier to obtain than
the medium term loans that they require.
Ways of resolving problems faced by small businesses in
raising finance
Business angel
Business Angels refer to wealthy individuals who are prepared to help smaller
companies by purchasing shares in that company. A Business Angel may have
expertise and experience to offer that could be useful in a small company situation.
Enterprise investment scheme in the UK
This is where the government offers tax advantages in terms of income tax and
capital gains tax in order to encourage investment by individuals in the ordinary
shares of small companies.
Small firms loan guarantee schemes
This is where the government guarantees loans from financial institutions on behalf
of small business that have good business prospects and have failed to secure a
loan because of lack of security.
Venture capital trusts
Government schemes offer tax advantages to Venture Capital Trusts, which are
required to invest a large part of their funds in the ordinary shares of small
companies.

Chapter 5
Theories of gearing

CHAPTER 5 THEORIES OF GEARING
CHAPTER CONTENTS
THE TRADITIONAL VIEW ----------------------------------------------- 87
MODIGLIANI & MILLER TAX IGNORED (1958) -------------------- 89
GRAPH 89
FORMULAE 89
ASSUMPTIONS 90
MODIGLIANI & MILLER INCLUDING CORPORATION TAX (1963) 91
GRAPH 91
FORMULAE 91
WHY DO COMPANIES NOT ATTEMPT A 99.9% DEBT STRUCTURE? 93
PECKING ORDER THEORY ----------------------------------------------- 94
STATIC TRADE-OFF THEORY -------------------------------------------- 95
SOLVENCY RATIOS ------------------------------------------------------ 96
1. GEARING RATIO 96
2. INTEREST COVER 97

THE TRADITIONAL VIEW
The traditional view claims that there is an optimal capital structure where WACC is
at a minimum and at this point the combined market value of the firms debt and
equity will be at maximum. Managers therefore should identify this optimum level
of gearing and ensure that their company maintain its capital structure.
The bases of the traditional theory are:
The cost of equity increases as the level of gearing increases. The
introduction of debt brings financial risk. This financial risk will make the
earning available to equity shareholders to become more volatile. The equity
shareholders will therefore require additional return to compensate for the
increase in financial risk, and will push the cost of equity up.
Debts finance is cheaper than equity as it is ranked before equity in terms of
distribution of earnings and on liquidation, and also interest on debt is a tax
allowable expense. The issue cost on debt is also cheaper than issuing cost of
equity.
Cost of debt remain constant, as the level of gearing increase, up to some
point of gearing level and beyond which it will increase. The reason being
that risk to providers of debt finance increases because interest cover will be
falling and there may be few assets available to offer as security against non-
payment. This will push the cost of debt up.
WACC will then form a type of U-shape. At first falling as level of debt
increases as reflecting the low cost of debt, and then tending to increase as
rising equity cost and rising cost of debt become more significant. The
optimum capital structure is where the WACC is at its minimum.


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

Formulae
Preposition 1: value of company
Vg = Vu
Preposition 2: cost of equity
Keg =
E
D
) Kb Keu ( Keu +

Preposition 3: WACC

WACCg = WACCu (Keu)
N.B. These formulae may be derived from the expressions which include the effect
of corporation tax treating t = 0
Assumptions
Investors are rational
Investors have the same view of the future
Personal and corporate gearing are perfect substitutes
Information is freely available
No transaction costs
No tax
Firms can be grouped into similar risk classes.
The arbitrage proof, which incorporates these assumptions, can be used to
support this M & M proposition.
MODIGLIANI AND MILLER INCLUDING CORPORATION
TAX (1963)
The values of companies with the same earnings in the same risk class are no
longer independent. Companies with a higher gearing ratio have a greater net
future income stream (purely due to corporation tax relief on interest payments)
and therefore a higher value.
Graph

D
Formulae
Proposition 1: value of company
Vg = Vu + Dt
Proposition 2: cost of equity
Keg =
E
) t 1 ( D
*) Kb Keu ( Keu

+ or
e
d
d
e
i
e
i
V
V
) k - T)(k - (1 + k
*Kb or k
d
is the PRE-TAX COST OF DEBT for this formula.
NB The formula on the right-hand side is provided on the ACCA P4 Formulae sheet.
Proposition 3: WACC
WACCg = |
\
|
+
D E
Dt
1 Keu

Solution to Grant plc
Vg = Vu + Dt
N.B. D =
100
125
x 000 , 000 , 8 = 10m
m
Vu = 6,000,000 @ 2.50 = 15
Dt = 10,000,000 x 35% = 3.5
Vg = 18.5m

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

Price per share =
m 17
m 5 . 8

= 50p
Capital structure example Grant plc
Grant plc (an all equity company) has on issue 6,000,000 1 ordinary shares at
market value of 2.50 each.
Bell plc (a geared company) has on issue:
17,000,000 25p ordinary shares; and
8,000,000 15% debentures (quoted at 125)
Taking corporation tax at 35%, and assuming that:
1. The companies are in all other respects identical; and
2. The market value of Grants equity and the market value of Bells debt
are in equilibrium.
Calculate the equilibrium price per share of Bells equity.
Why do companies not attempt a 99.9% debt structure?
1. Bankruptcy costs
The higher the level of gearing the greater the risk of bankruptcy with the
associated COSTS OF FINANCIAL DISTRESS.
Vg = Vu + Dt Present value of costs of financial distress
2. Agency costs
Costs of restrictive covenants to protect the interests of debt holders at high levels
of gearing.
3. Tax exhaustion
The value of the company will be reduced if advantage cannot be taken of the tax
relief associated with debt interest.
4. Debt capacity
Generally loans must be secured against a companys assets and clearly some
assets (eg property) provide better security for loans than other assets (eg high-
tech equipment which may become obsolescent overnight). The depth of the
assets second hand market and its rate of depreciation are important
characteristics.
5. Personal taxes (MILLERS CRITIQUE 1977)
Investors will be concerned with returns net of all taxes.
If a firms income is paid out as debt interest, corporation tax savings are
made (see M & M 1963) but investors will have to pay income tax on debt
interest.
If a firms income is paid out as an equity return, corporation tax has to be
paid but personal tax can be saved (eg by avoidance of capital gains tax using
exemptions).
In deciding its gearing level, a firm should consider its corporation tax position
and the personal tax position of its investors if it wishes to maximise their
wealth.
In his 1977 article, Miller argues that firms will gear up until marginal
investors face a personal tax cost of holding debt equal to the corporation tax
saving. At this point there is no further advantage of gearing.
PECKING ORDER THEORY
The Pecking Order Theory is that a companys capital structure decision is not
determined by the costs and benefits of using a combination of debt and equity
finance to minimise the cost of capital.
The theory suggests that a company has a well defined order of preference in
relation to available sources of finance ie
(a) The first preference is the use of retained earnings, since internal finance is
readily accessible, has no issue costs and does not involve negotiating with
third parties, such as banks.
(b) If external finance has to be used (because the company has identified more
positive NPV projects than can be financed by retentions alone), bank
borrowings, loan stock and debentures are the initial preferred source of
external finance. The cost of issuing new debt is normally much smaller than
the cost of equity issues. Furthermore it is possible to raise smaller amounts
of debt than of equity.
When raising debt, initially it is advisable to issue low risk secured debt, and
when there are no more assets available as security, then to issue unsecured
debt with a consequent higher risk and higher cost.
(c) If, after the companys level of debt capacity is reached, there remain further
positive NPV projects that remain to be financed, the final and least preferred
source of finance is the issue of new equity capital.
Accordingly there appears to exist a financing pecking order ie first use retained
profits, then secured debt, then unsecured debt and finally equity.
A more sophisticated explanation of the Pecking Order Theory was developed in
1984, when it was suggested that the order of preference stemmed from the
existence of asymmetry of information between the company and the capital
markets. This term refers to the fact that company management are likely to have
a much better idea of the true worth of the companys shares than do outside
investors.
Accordingly if a company wishes to raise new project finance and the capital market
has underestimated the benefits of the project, company management (with their
inside information) will be aware that the market has undervalued the company.
They would therefore choose to finance the project through retentions, so that
when the market discovers the true value of the project, existing shareholders will
benefit. If retained earnings are inadequate, the company would choose to raise
debt finance in preference to a new equity issue (since they would not wish to issue
new equity shares which are undervalued by the market).
However if the companys management believe that investors are overvaluing the
benefits of the new project and therefore placing too high value on the companys
shares, they would prefer to issue new equity at that overvalued price.
STATIC TRADE-OFF THEORY
This variation on the 1963 with corporate tax theory of Modigliani and Miller arrives
at a conclusion, which is similar to that of the traditional theory of gearing ie there
exists an optimum level of leverage that companies should attempt to attain.
Provided a company is in a static position ie not in a period of extreme growth, it is
likely to have a gearing policy that is stable over time. This is achieved by striking
a balance between the benefits and the costs of raising debt.
The benefits of debt relate to the tax relief that is enjoyed when interest payments
are made the cheaper debt finance will reduce the weighted average cost of
capital and increase corporate value.
The costs of debt relate to the increases in the costs of financial distress (eg
bankruptcy costs) and increases in agency costs that arise when the company
exceeds its optimum gearing levels. The resultant increase in required returns
demanded by investors cause the weighted average cost of capital of the company
to increase and hence corporate value to fall.
There is accordingly, in theory, a trade-off between these two effects and hence the
cost of capital and the value of the company will be optimised. However,
subsequent research suggests that there is little evidence of the static trade-off
theory operating in the real world.
SOLVENCY RATIOS

1. Gearing ratio
This indicates the relationship between:
Equity : Fixed return securities (or Debt) on issue
It may be based upon balance sheet values (in which case Equity will comprise
ordinary share capital and reserves) or upon stock exchange values (in which event
the shares and debentures on issue are valued at mid market price).

Solution to CGR plc
(a) Book values = (250,000 + 100,000) : (500,000 + 200,000) = 0.5 : 1
(b) Market values = 540,000 : (360,000 + 240,000) = 0.9 : 1
N.B. Gearing ratios are expressed in a number of ways eg
Equity
Debt

Debt Equity
Debt
+

Debt may include long-term borrowings only or both short and long-term debt.
A further problem is the classification of hybrid securities e.g preference shares. In
the above illustration they have been classified as debt, but this is open to debate
when the ratio is calculated for the benefit of lenders.
Example CGR plc
Called-up share capital:
250,000 of ordinary shares of 25p, quoted price 53p 55p
500,000 of 7% preference shares of 1, quoted price 71p 73p
Reserves 100,000
Loans: 200,000 of 12% irredeemable debentures market yield currently 10%.
Required:
Calculate the Capital Gearing Ratio, based upon
(a) Book values
(b) Market values.
2. Interest cover
ie
Interest Gross
Tax and Interest before Earnings

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

Number of shares = 12.5 million x 4 = 50 million

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

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

Cost of equity capital, using the dividend valuation model and assuming constant
dividends
=
000 , 40
7285
= 18.21%
Cost of debt
A market value higher than redemption value implies that the cost (pre-tax) is less
than the nominal rate of 16%.
Using 8% and 9% as discount rates.
Year
8%
factors
PV
9%
factors
PV
0 Market value (105.50) 1 (105.50) 1 (105.50)
1-3 Interest (net of tax) 10.40 2.577 26.80 2.531 26.32
3 Redemption 100.00 0.794 79.40 0.772 77.20
+0.70 1.98
Cost of debt = % 1 X
98 . 1 7 . 0
7 . 0
% 8 |
\
|
+
+ = 8.26%
Market value of debt =
100
50 . 105
x million 697 . 23 = 25 million
Value of debt plus equity = (25 + 40) million = 65 million
Weighted average cost of capital
WACC =
65
25
x % 26 . 8
65
40
x % 21 . 18 + = 14.38%
Changes to capital structure: Canalot plc
(a) (i) Market value
Using a Modigliani-Miller formula for the value of a geared company
(with irredeemable debt):
Vg = Vu + Dt
When Canalot replaces equity with loan stock, the company will increase
in value by the tax shield, Dt.
= 5 million debt issued x 35% tax rate
= 1.75 million
The market value of the company increases to
32.5 million + 1.75 million = 34.25 million
The market value of equity becomes
34.25 million 5 million = 29.25 million
(ii) The cost of equity
This can be computed
- from first principles, or
- by using the MM formula for Ke
From first principles
Consider the distribution of profits before and after the change in capital
structure.
Before the change, equity earnings = 18% x market value of
32.5 million = 5.85 million.
Pre-tax profits =
65
100
x million 85 . 5 = 9 million.
After the debt issue:
000
Earnings before interest and tax 9,000
Less interest: 5m x 13% _650
8,350
Tax (35% x 8,350) 2,922
Equity earnings (= dividend) 5,428
Cost of equity =
250 , 29
428 , 5
= 18.56%
The cost of equity has increased by 0.56% because of the increased
financial risk experienced by shareholders.
Using the MM formula for Ke:
Keg =
E
) t 1 ( D
) Kb Keu ( Keu

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

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

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


Chapter 6
Capital asset
pricing model

CHAPTER 6 CAPITAL ASSET PRICING MODEL
CHAPTER CONTENTS
THE CAPITAL ASSET PRICING MODEL (CAPM) ---------------------- 105
THE UNDERLYING THEORY OF CAPM 105
SYSTEMATIC AND UNSYSTEMATIC RISK 106
CAPM FORMULAE 106
SYSTEMATIC BUSINESS RISK AND SYSTEMATIC FINANCIAL RISK 108
ASSUMPTIONS, ADVANTAGES AND LIMITATIONS OF CAPM 114

THE CAPITAL ASSET PRICING MODEL (CAPM)

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

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

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

CAPM can be used to determine the best composition of an investors portfolio by
comparing the expected return and the CAPM minimum required return of each
security in the portfolio to ascertain their alpha values.
A shares alpha value is a measure of it abnormal return, which is the amount by
which the shares returns are above or below what would be expected, given the
systematic risk.
A positive alpha value indicate that, the share is expected to yield a higher return
relative to its systematic risk, so that an investor should buy more of that share,
and that the share is underpriced.
A negative alpha value, indicate that the share is not expected to give satisfactory
return relatively to its systematic risk and so should be sold, and that the shares
are overpriced.

Example
Details of a portfolio, which consistent of shares in 3 UK companies, are as follows:
Company Beta(equity) Average Return
A 1.16 19.5%
B 1.28 24.0%
C 0.90 17.5%
The current market return is 19% and the treasury bill yield is 11%
Required:
Asses the best composition of the portfolio.

Solution
The alpha values of each share is:
Company expected return CAPM return Alpha
A 19.5% 11% + 1.16(19 - 11) = 20.8% -0.78%
B 24% 11% + 1.28(19 - 11) = 21.24% 2.76%
C 17.5% 11% + 0.90(19 11) = 18.20% -0.70%
These figures suggest that shares in A and B are to be sold because they are
overpriced and buy more shares in B because they are underpriced.
Note the following
Alpha values -
are only temporary abnormal return;
can be positive or negative;
over time will tend towards zero for any individual share, and for a well
diversified portfolio taken as a whole will be zero;
If positive might attract investors into buying the shares to benefit from the
abnormal return, so that the share price will temporarily go up.
Systematic business risk and systematic financial risk
At a gearing level of zero, the equity shareholders of a company would have to bear
systematic business risk only. However as a company increases its debt levels and
becomes more and more highly leveraged, its equity shareholders will not only
have to face the same level of systematic business risk as before, but will also have
to accept increasing amounts of systematic financial risk.
Accordingly:
Equity shareholders in an ungeared company bear systematic
business risk only, whereas
Equity shareholders in an otherwise identical geared company bear the
same level of systematic business risk as before, but will also have to
face an ever increasing level of systematic financial risk as borrowing
levels become greater and greater,
with a consequence increase in the Ke of the company concerned. This is
illustrated below.
Following the M & M with corporation tax theory of 1963, as gearing levels increase,
Ke behaves as follows:

Now that the issue of leverage has been introduced, there becomes a need to
distinguish:
asset (a), which reflects systematic business risk only, and
equity (e), which reflects both systematic business risk TOGETHER
WITH ANY systematic financial risk which MAY exist.
Therefore:
In the case of an all equity company, e = a, since no systematic financial
risk can possibly exist.
In the case of a geared company, e > a, since e contains both
systematic business risk and systematic financial risk, whereas a reflects
systematic business risk only.
The theoretical relationship between a and e is commonly expressed by the
following formulae:
a
=
( ) ( )
( )
( ) ( )
|
|
\
|
+
+
|
|
\
|
+
d
d e
d
e
d e
e
T 1 V V
T 1 V
T 1 V V
V

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

The latter version will now be used throughout this course.
Gearing % D
E
Ke
%
SYSTEMATIC BUSINESS RISK
Ke
SYSTEMATIC
FINANCIAL RISK

Solution to Giles plc
Since the debt of Stiles plc may be assumed to be risk free:
a
=
( ) t 1 D E
E
e
+

Therefore since Giles plc is an all equity company within the same industry as Stiles
plc, the
e
of Stiles plc can be calculated as follows:
e
=
( )
E
t 1 D E
a
+

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

= 1.178
Example Giles plc
Giles plc is an all-equity company whose coefficient is 0.95. Stiles plc is a
levered company and in all other respects has the same risk and operating
characteristics as Giles.
The capital structure of Stiles plc is as follows:
Nominal value Market value
m m
Equity 6 15
Debt 4 6
10 21
The debentures of Stiles plc are virtually risk-free and the corporation tax rate is
40%.
What would be the predicted of the equity of Stiles plc?

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

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

Turnover 35,200 42,700 46,300 28,400 45,000
Earnings per share
(in pence)
25 53.3 38.1 32.3 106
Dividend per share
(in pence)
11 20 15 14 40
Price/earnings ratio 12 10 9 14 8
Beta equity 1.1 1.25 1.30 1.05 0.95
*The par value per ordinary share is 25p for Freezeup and Shiverall, 50p for Topice
and 1 for Glowcold and Hotalot.
Corporate debt may be assumed to be almost risk-free, and is available to Hotalot
at 0.5% above the Treasury Bill rate, which is currently 9% per year. Corporate
taxes are payable at a rate of 35%. The market return is estimated to be 16% per
year. Hotalot does not expect its financial gearing to change significantly if the
company diversifies into the production of freezers.
Required:
(a) Estimate what discount rate Hotalot should use in the appraisal of its
proposed diversification into freezer production.
(b) Corporate debt is often assumed to be risk-free. Explain whether this is a
realistic assumption and calculate how important this assumption is likely to
be to Hotalots estimate of a discount rate in (b) above. For this purpose
assume that Hotalot and the four freezer companies all have a debt beta of
0.3.
(c) Discuss whether systematic risk is the only risk that Hotalots shareholders
should be concerned with.
Solution to Hotalot plc
(a) Discount rate for the appraisal of the proposed diversification into
freezers
First, estimate the average equity beta in the freezer industry, then degear this
figure. Regear it up to Hotalots debt/equity ratio and apply the CAPM to find
Hotalots cost of equity. A WACC can then be calculated for Hotalot.
Average equity beta in the freezer industry
Company Value of shares* Equity Beta factor
F 16 million x 0.25 x 12 = 48 million 1.1
G 9 million x 0.533 x 10 = 48 million 1.25
S 14 million x 0.381 x 9 = 48 million 1.30
T 10.6 million x 0.323 x 14 = 48 million 1.05
192 million
*Value of shares = Number of shares x eps x PE ratio
Since all the companies have the same market value of shares, the average equity
beta is simply:
4
05 . 1 30 . 1 25 . 1 1 . 1 + + +
= 1.175
Total value of debt in the companies is:
million
F: 5.3
G: 12.6
S: 18.2
T: 4.0
40.1 million
The average debt/equity ratio in the freezer industry is therefore
192
1 . 40

Degearing the equity beta:
a
=
( ) t 1 D E
E
e
+

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

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

1.07 = 075 . 0 750 . 0 x e +
e = 1.327
Applying the CAPM gives Hotalots cost of equity as
9% + (16% 9%) 1.327 = 18.29%
Hotalots WACC then becomes
32 . 51
4 . 17
x 65 . 0 x % 5 . 9
32 . 51
92 . 33
x % 29 . 18 + = 14.18%
compared with the original estimate of 14.42%. The margin of error on these
estimates is, however, quite high which means that the assumption that
corporate debt is risk-free is unlikely to have a significant effect on the accuracy of
Hotalots estimates.
(c) Does systematic risk give the complete picture?
The capital asset pricing model assumes that Hotalots shareholders are well
diversified and are only concerned with systematic risk. Undiversified or partly
diversified shareholders should also be concerned with unsystematic risk and
should seek a total return appropriate to the total risk that they face.
Even well diversified shareholders might be concerned with unsystematic risk. The
total risk of a company comprises systematic and unsystematic risk. It is total risk
(the total variability of cash flows) which determines the probability of a company
failing, and the investor experiencing additional bankruptcy costs. The greater the
expected bankruptcy costs and the greater the probability of corporate failure, the
more concerned investors are likely to be with the total risk and not just systematic
risk.
Assumptions, advantages and limitations of CAPM
Assumptions
All shareholders hold the market portfolio. Although this is questionable in
practice, even a limited spread of shareholdings produces some
diversification, therefore this assumption is appropriate;
A perfect capital market (eg no transaction costs, information about risk and
return is freely available);
The ability of investors to both borrow and lend at the risk free rate of
interest;
All forecasts are made for a single time period only;
All investors share the same uniform expectations concerning future earnings
streams and are only concerned with risk and return.
Advantages
It demonstrates that unsystematic risk can be diversified away, therefore the
only risk premium required is for systematic risk only;
Probably the best practical method for establishing the Ke of a publicly traded
company;
It highlights the relationship between risk and return, based upon stock
market performance and provides a measure of the risk of shares held within
a well-diversified portfolio and measures the required rate of return in view of
that level of risk;
Helps to provide a risk adjusted discount rate for use in investment appraisal.
Limitations
It concentrates purely upon systematic risk and is therefore of limited use for
investors who do not hold a well-diversified portfolio;
Since CAPM only considers the level of return to investors, it ignores the
manner in which that return is received. Therefore, it treats dividends and
capital gains as equally desirable to investors, thus totally ignoring the tax
position of individual investors;
It is purely a single period model, therefore not ideal for use in projects which
extend for multiple periods;
The model requires the use of data which can be difficult to obtain ie
(i) The risk free rate of interest: It is necessary to take the best proxy
measure of a short-term default free rate eg UK 90 day Treasury bills;
(ii) The return on the market portfolio: Should the FT all-share index be
used, or the FTSE 100, or the FTSE 350, or a world composite share
price index?;
(iii) Beta: Clearly this should strictly be based on subjective probabilities of
future events, but since this is impracticable in practice, regression
analysis is often used to compare the historical behaviour of individual
securities with the behaviour of a suitable market index within the same
time period.
CAPM tends to overstate the required return of high beta securities and to
understate the required return of low beta securities. The returns of small
companies, returns on certain days of the week or months of the year have in
practice been observed to differ from those expected from CAPM.


Chapter 7
Adjusted present
value

CHAPTER 7 ADJUSTED PRESENT VALUE
CHAPTER CONTENTS
ADJUSTED PRESENT VALUE ------------------------------------------- 119
SITUATIONS WHERE APV IS BETTER THAN NPV -------------------- 120
CALCULATION OF APV ------------------------------------------------- 121
ISSUE COST 122
TAX SAVINGS ON INTEREST 123
SUBSIDY 124
PRACTICAL PROBLEMS OF THE APV APPROACH -------------------- 125

ADJUSTED PRESENT VALUE (APV)
Traditionally financial management has appraised new investments by discounting
their after-tax operating cash flows to present value at the firms weighted average
cost of capital and subtracting the initial investment cost to arrive at an NPV. We
have already noted problems with the use of the WACC and seen that adjustments
are commonly needed to tailor the discount rate to the systematic business risk and
the financial risk of the project under consideration.
M & M based adjustments to the cost of capital form one approach to this problem.
Here we examine another, adjusted present value (APV), which offers significant
advantages.
APV is often described as a divide and conquer approach. To do this the project
will first be evaluated as if it were being undertaken by an all-equity company.
Side effects like the tax shield on debt and the issue costs being ignored. This
first stage will give us the so-called base NPV or base case NPV. The second stage
is to calculate the present value of the side effects and to add these to the base
NPV. The result is the APV which shows the net effect on shareholder wealth of
adopting the project.
SITUATIONS WHERE APV IS BETTER THAN NPV
The APV method may be better than NPV because:
1. There is a significant change in capital structure of the company as a result of
the investment.
2. There are subsidised loans or other benefits (grant) associated explicitly with
an individual project and which requires discounting at different rate than that
applied to the mainstream cash flows.
3. The investment involves complex tax payments and tax allowances, and or
has periods when taxation is not paid.
4. The operating risk of the company changes as a result of the investment.
CALCULATION OF APV
The APV method therefore sees the value of the project to shareholders as being:
Project value if all equity financed + present value of tax + Present value of
(the base case NPV) shield on the loan other side effects
The APV method involves two stages:
1. Evaluate the project first of all as if it were all equity financed, and so as if the
company were an all equity company to find the based case NPV.
2. Make adjustment to the based case NPV to allow for the side effects of the
method of financing that has been used. The financing effects may consist of:
(i) Present value of tax savings on interest paid on debt raised to finance
the investment.
(ii) Present value of issue costs incurred in raising both debts and equity
capital.
(iii) Present value of subsidies/cheap loans. This is technically an
opportunity benefit.
Example
A project with an initial cost of 80,000 is expected to yield an annual return of
10,000 in perpetuity. The 80,000 will be financed by 30,000 debts and 50,000
equity.
Required:
Calculate APV, assuming 10% ungeared cost of equity and corporation tax
of 30%.
Solution
Based case NPV (NPV if all equity financed) = (10,000/ 0.10) 80,000 =20,000
PV of tax shield 30,000 x 30% = 9,000
APV = 29,000
Issue cost
The issue cost is the cost associated with raising funds needed to finance the
project. The issue cost is a cash outflow and that its present value should be
deducted from the base case NPV in the calculation of APV. Risk free rate is usually
used as the discount factor in calculating the present value of issue cost.
Example
A project requires immediate capital expenditure of 20m. The amount is expected
to be raised from a 1 for 3 rights issue at a price of 2 per share.
Right issue costs are 5% of the amount raised. Assume a risk free rate of 10%.
Required:
Calculate the issue cost that should be included in the APV calculations
assuming:
(a) the issue cost is not a tax allowable expense;
(b) the issue cost is a tax allowable expense and tax is paid one year in
arrears. Corporation tax rate is 30%.
Solution
(a) Issue cost is not tax allowable expense.
The issue cost is 5% of the amount raised. Therefore the 20m represents
the amount raised less the issue cost, hence the need to gross up as follows:
If issue cost is 5%, then the 20m represents 95%.
Issue cost = 20m x (5 / 95) = 1.05m
PV of issue cost = 1.05 as it occurs in year zero (immediately). This must be
deducted from base case NPV in APV calculation as it represents cash outflow.
(b) Issue cost is a tax allowable expense and tax is paid one year in
arrears.
Issue cost = 20m x (5 / 95) = 1.05m
Tax saving on issue cost = 1.05m x 30% = 0.315m
PV of issue cost:
Year Item cash flow () Discount factor
(10%)
Present value
0 issue cost (1.05) 1.000 (1.05)
1 tax saved 0.315 0.909 0.286
Present value
of issue cost

0.764
Tax savings on interest
Interest payments on debt are tax allowable expense and the APV will increase by
the present value of the tax savings on the interest otherwise called the tax shields.
The calculation of the tax shield depends on whether the interest is payable on a
fixed amount every year or there is equal repayment.
Example
A project requires immediate capital expenditure of 20m. The amount will be
raised through a 10% bank loan over a period of 5 years.
Tax is paid one year in arrears at a rate of 30%.
Required:
Calculate the present value of tax shields assuming:
(a) 10% interest on the 20m per annum;
(b) the amount will be paid in equal instalments over 5 years.
Solution
(a) 10% interest on the 20m per annum
Annual interest = 10% x 20m = 2m
Tax savings = 2m x 30% = 0.6m
PV of tax savings = Year 2 to Year 6 as tax is one year in
arrears:
0.6 x (4.355 0.909) = 2.067m
(b) The amount will be paid in equal instalments over 5 years
Annual instalment = debt value divided by the annuity factor
= 20m/3.791
= 5.3 per annum
Interest payment will therefore be as follows:
Year opening balance interest@10% instalments closing balance
m m m m
1 20 2 5.3 16.7
2 16.7 1.7 5.3 13.1
3 13.1 1.3 5.3 9.1
4 9.1 0.9 5.3 4.7
5 4.7 0.5 5.3 0
PV of tax savings on interest:
Year interest tax saved (30%) DF
10%
PV
m
1 2.0 0.00 0.909 0.00
2 1.7 0.60 0.826 0.496
3 1.3 0.51 0.751 0.383
4 0.9 0.39 0.683 0.266
5 0.5 0.27 0.621 0.167
6 0.0 0.15 0.564 0.085
Tax shield 1.397
Subsidy
It may be possible for a company to raise a subsidised loan to finance a project. In
this case the company will save interest cost which is the difference between the
normal interest and the subsidised interest. However, by paying less interest the
company forfeits the tax benefit on the amount of interest not paid.
The present value of the net interest saved represents an addition to the base case
NPV in APV calculation.
Example
A project requires immediate capital expenditure of 20m. The company normally
borrow at 8% but a government loan will be available to finance the project at 6%.
Assume a risk free rate of 5% and that the project is expected to last for 5 years.
Tax rate is 30%.
Required:
Calculate the present value of tax shields and present value of subsidy.
Solution
Present value of tax shield
Annual interest = 6% x 20m = 1.2m
Tax savings = 1.2m x 0.3 = 0.36m
Present value (at risk free rate) of tax shield 0.36 x 4.329 = 1.56
Present value of subsidy
Subsidy = 8% - 6% = 2%
Total subsidy per annum = 2% x 20m = 0.4
PV of net subsidy = 0.4 x (1-0.3) x 4.329 = 1.21
PRACTICAL PROBLEMS OF THE APV APPROACH
1. Determining a suitable cost of equity for the initial DCF computation as if the
project was all equity financed, and also establishing the all equity beta are
still based on M&M assumptions.
2. Difficulties in identifying all the cost associated with the method of financing.
3. Difficulties in choosing the correct discount rate used to discount the side
effects such as issue cost and the corporation tax savings on debt capital
interest. Although the risk-free rate of return is assumed.
4. In complex investment decisions the calculations can be extremely long and
hence more difficult.
Example Strayer
The managers of Strayer Inc are investigating a potential $25 million investment.
The investment would be a diversification away from existing mainstream activities
and into the printing industry. $6 million of the investment would be financed by
internal funds, $10 million by a rights issue and $9 million by long term loans. The
investment is expected to generate pre-tax net cash flows of approximately $5
million per year, for a period of ten years. The residual value at the end of year ten
is forecast to be $5 million after tax. As the investment is in an area that the
government wishes to develop, a subsidised loan of $4 million out of the total $9
million is available. This will cost 2% below the company's normal cost of long-
term debt finance, which is 8%.
Strayer's equity beta is 0.85, and its financial gearing is 60% equity, 40% debt by
market value. The average equity beta in the printing industry is 1.2, and average
gearing 50% equity, 50% debt by market value.
The risk free rate is 5.5% per annum and the market return 12% per annum.
Issue costs are estimated to be 1% for debt financing (excluding the subsidised
loan), and 4% for equity financing. These costs are not tax allowable. The
corporate tax rate is 30%.
Required:
(a) Estimate the Adjusted Present Value (APV) of the proposed
investment. (15 marks)
(b) Comment upon the circumstances under which APV might be a better
method of evaluating a capital investment than Net Present Value
(NPV). (5 marks)
(20 marks)
Solution to Strayer
(a)
APV = Base case NPV Present value of financing effects
Base case NPV
This may be estimated by discounting net cash flows by the discount rate applicable
to the risk associated with an ungeared investment.
As Strayer is moving to the printing industry the geared beta of the printing
industry can be used as a proxy beta.
Ungear the proxy beta to an ungeared beta using the formula on the
assumption that companies in the industry have the same business risk and
debt is risk free.
a =
( ) t 1 D E
E
e
+

a =
( ) 3 . 0 1 50 50
50
2 . 1
+
=0.71
Using CAPM, calculate the ungeared cost of equity as
Keu = 5.5% + 0.71(12% 5.5%) = 10.115%
Say 10%
Calculate the base case NPV by discounting the relevant cash flows by 10% as
follows:
Cash flow Df10% PV
$ $
Year 0 (25) 1 (25)
Y 1 10 (5 x 0.7) 3.5 6.145 21.508
Y10 5 0.386 1.93
Base case NPV (1.562)
Present value of financing effects
Issue cost
$
Rights issue = 10m x 4% = 0.40
Debts = 5m x 1% = 0.05
PV of issue cost 0.45m
Tax savings on debt interest
8% loan of $5m
Annual interest = $5m x 8% = 0.4m
Tax saved per annum = $0.4 x 30% = 0.12m
$4m subsidized loan
Annual interest = $4m x 6% = 024m
Tax saved per annum = $0.24 x 30% = 0.072m
PV of tax savings on interest using risk-free rate of 5.5% as discount factor
Annuity factor of 5.5% over 10 years is simply calculated as the sum of annuity
factor of 5% and 6% over 10 years divided by 2:
= (7.722 + 7.360)/2 = 7.541
Total tax saving on interest = 0.12m + 0.072m = $0.192m
PV of tax savings = $0.192 x 7.541 = $1.448
Present value of Subsidy
After tax interest saved as a result of subsidy = 2% x $4m = $0.08 x (1 0.3)
= $0.056
Present value of subsidy at risk-free rate = $0.056 x 7.541 = $0.422
APV calculation $
Present value of tax savings on interest 1.448
Present value of subsidies 0.422
Present value of issue cost (0.45)
Adjusted present value (0.142)
Since the APV is negative, the project is financially not viable.
(b)
The APV method may be better than NPV in situations where:
The operating risk of the company changes as a result of the new investment.
There is a significant change in the capital structure and hence financial risk of
the company as a result of the investment.
The investment has complex tax payments and tax allowances, and/or periods
when tax is not paid.
There are subsidised loans or other benefits associated explicitly with an
individual project.


Chapter 8
International
investment
appraisal

CHAPTER 8 INTERNATIONAL INVESTMENT APPRAISAL
CHAPTER CONTENTS
INTERNATIONAL INVESTMENT AND FINANCING DECISIONS ----- 131
INTRODUCTION 131
PARENT OR PROJECT VIEWPOINT? 131
TAXATION AND INTERNATIONAL INVESTMENT APPRAISAL 132
FORECASTING EXCHANGE RATES 132
PROJECT DISCOUNT RATES 133
REMISSION OF FUNDS 133
OVERCOMING EXCHANGE CONTROLS BLOCK REMITTANCES 134
EXCHANGE RATE RISK 134
POLITICAL RISK 134
ECONOMIC RISK 135
FISCAL RISK 135
REGULATORY RISK 135
FINANCING OVERSEAS PROJECTS 136

INTERNATIONAL INVESTMENT AND FINANCING
DECISIONS

Introduction
In essence capital budgeting for overseas investments is similar to domestic
investment appraisal. It includes the following steps:
Identification of relevant cash flows.
Dealing with inflation to assess real or nominal cash flows.
Dealing with tax, including the tax savings on capital allowances.
Dealing with inter-company transactions, such as management charges and
royalties and cash flow remittance restrictions.
Estimating future exchange rates (spot rates).
Dealing with double taxation arrangements.
Estimating the appropriate cost of capital (discount factor).
Parent or project viewpoint?
Any overseas capital project can be assessed from the point of view of the parent
company or the local subsidiary. Relevant cash flows may vary between the two
viewpoints due to the following factors:
Timing of the receipt of funds;
Impact of exchange rate changes on the value of the funds;
Impact of local and home country tax on the value of funds received;
Effect on other parts of the organisation (eg sales by the subsidiary reducing
the parents export market sales).
As the objective of financial management is to maximise shareholder wealth, and
the vast majority of the shareholders are likely to be located in the parent country,
it is essential that projects are evaluated from a parent currency viewpoint. After
all, in the UK only sterling receipts can be used to pay sterling dividends.
Accordingly, the following three-step procedure is recommended for calculating
project cash flows:
1. Compute local currency cash flows from a subsidiary viewpoint as if it were an
independent entity;
2. Calculate the amount and timing of transfers to the parent company in
sterling terms;
3. Allow for the indirect costs and benefits of the project in sterling terms (eg the
contribution lost due to the turnover of other members of the group being
affected by this overseas project).
Taxation and international investment appraisal
The following procedure can be applied:
1. Allow for host country investment incentives (capital allowance) before
applying the local tax rate to local taxable cash flows.
2. Apply the relevant parent company rate of tax to the taxable/remitted cash
flows.
3. Adjust point 2 above for any double taxation agreement.
Consider the following:
Italy tax UK tax
(1) 20% 20%
(2) 20% 30%
(3) 20% 18%
In (1) no further tax will be paid in the UK as profit is taxed in Italy at 20%.
In (2) profit would be taxed at 30%, 20% in Italy and a further 10% in the UK.
In (3) no further tax will be paid in the UK. The 20% is charged in Italy.
Forecasting exchange rates
Exchange rates can be estimated using purchased power parity (PPP) or
international Fisher effect (IFF).
The PPP is used when inflation rates are given and the IFE is used when interest
rates are given.
The formula is simply stated as:
Purchasing power parity and interest rate parity
S
1
= S
0

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

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

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

Dowl/ 250.0 285.7 353.7 438.0 542.2 671.3

05 . 1
2 . 1

05 . 1
3 . 1

05 . 1
3 . 1

05 . 1
3 . 1

05 . 1
3 . 1

US$/ 1.60 1.60 1.60 1.630 1.662 1.693

05 . 1
05 . 1

05 . 1
05 . 1

05 . 1
07 . 1

05 . 1
07 . 1

05 . 1
07 . 1

Project discount rates
In the same way as for domestic capital budgeting, project cash flows should be
discounted at a rate that reflects their systematic risk. Many firms assume that
overseas investment must carry more risk than comparable domestic investment
and therefore increase discount rates accordingly.
This assumption, however, is not necessarily valid. Although the total risk of an
overseas investment may be high, in the context of a well-diversified parent
company portfolio much of the risk may be diversified away. Because of the lack of
correlation between the performance of some national economies, the systematic
risk of overseas investment projects may in fact be lower than that of comparable
domestic projects.
It must therefore be realised that the automatic addition of a risk premium simply
because a project is located overseas does not always make sense, and any
increase in the discount rates used for foreign projects should be viewed with
caution.
Remission of funds
Certain costs to the subsidiary may in reality be revenues to the parent company.
For example, royalties, supervisory fees and purchases of components from the
parent company are costs to the project, but result in revenues to the parent. Care
should be exercised in identifying exactly how and when funds are repatriated. The
normal methods of returning funds to the parent company are:
Dividends
Royalties
Transfer prices; and
Loan interest and principal
It is important to note that some of these items may be locally tax-deductible for
the subsidiary but taxable in the hands of the parent.
Overcoming exchange controls block remittances
Block funds are funds in overseas bank accounts subject to exchange controls, such
that restrictions are placed on remitting the funds out of the country.
A number of ways have been devised to try and avoid such restrictions. They
mainly aim to circumvent restrictions on dividends payments out of the account by
reclassifying the payment as something else:
1. Management Charges
The parent company can impose a charge on subsidiary for the general
management services provided each year. The fees would normally be based on
the number of management hours committed by the parent on the subsidiarys
activities.
2. Royalties
The parent company can charge the subsidiary royalties for patent, trade names or
know-how. Royalties may be paid as a fixed amount per year or varying with the
volume of output.
3. Transfer Pricing
The parent can charge artificially higher prices for goods or services supplied to the
subsidiary as a means of drawing cash out. This method is often prohibited by the
foreign tax authorities.
Exchange rate risk
Changes in exchange rates can cause considerable variation in the amount of funds
received by the parent company. In theory this risk could be taken into account in
calculating the projects NPV, either by altering the discount rate or by altering the
cash flows in line with forecast exchange rates. Virtually all authorities recommend
the latter course, as no reliable method is available for adjusting discount rates to
allow for exchange risk.
Political risk
This relates to the possibility that the NPV of the project may be affected by host
country government actions. These actions can include:
Expropriation of assets (with or without compensation!);
Blockage of the repatriation of profits;
Suspension of local currency convertibility;
Requirements to employ minimum levels of local workers or gradually to
pass ownership to local investors.
The effect of these actions is almost impossible to quantify in NPV terms, but their
possible occurrence must be considered when evaluating new investments. High
levels of political risk will usually discourage investment altogether, but in the past
certain multinational enterprises have used various techniques to limit their risk
exposure and proceed to invest. These techniques include the following:
(a) Structuring the investment in such a way that it becomes an unattractive
target for government action. For example, overseas investors might ensure
that manufacturing plants in risk-prone countries are reliant on imports of
components from other parts of the group, or that the majority of the
technical know-how is retained by the parent company. These actions
would make expropriation of the plant far less attractive.
(b) Borrowing locally so that in the event of expropriation without compensation,
the enterprise can offset its losses by defaulting on local loans.
(c) Prior negotiations with host governments over details of profit repatriation,
taxation, etc, to ensure no problems will arise. Changes in government,
however, can invalidate these agreements.
(d) Attempting to be good citizens of the host country so as to reduce the
benefits of expropriation for the host government. These actions might
include employing large numbers of local workers, using local suppliers, and
reinvesting profits earned in the host country.
Economic risk
Economic risk is the risk that arises from changes in economic policies or conditions
in the host country that affect the macroeconomic environment in which a
multinational company operates. Examples of economic risk include:
Government spending policy.
Economic growth or recession.
International trading conditions.
Unemployment levels.
Currency inconvertibility for a limited time.
Fiscal risk
Fiscal risk is the risk that the host country may increase taxes or changes the tax
policies after the investment in the host country is undertaken. Examples of fiscal
risk include:
An increase in corporate tax rate.
Cancellation of capital allowances for new investment.
Changes in tax law relating to allowable and disallowable tax expenses.
Imposition of excise duties on imported goods or services.
Imposition of indirect taxes.
Regulatory risk
Regulatory risk is a risk that arises from changes in the legal and regulatory
environment which determines the operation of a company. Examples are:
Anti-monopoly laws.
Health and safety laws.
Copyright laws.
Employment legislation.
Financing overseas projects
The chief sources of long-term finance are the following:
1. Equity
The subsidiary is likely to be 100% owned by the parent company. However,
in some countries it is necessary for nationals to hold a stake, sometimes
even a majority of the ordinary shares on issue.
2. Eurocurrency Loan
Eurocurrency loan is a loan by a bank to a company denominated in a
currency of a country other than that in which they are based. For example, a
UK company may require a loan in dollars which it can acquire from a UK
bank operating in the Eurocurrency market. This is called Eurodollar loan.
The usual approach taken is to match the assets of the subsidiary as far as
possible with a loan in the local currency. This has the advantage of reducing
exposure to currency risk. However, this reduced risk must be weighed
against the interest rate paid on the loan. A loan in the local currency may
carry a higher interest rate, and it may be preferable, for example, to arrange
a Eurocurrency loan in a major currency which is highly correlated with the
currency of the overseas operations.
3. Government grants
Finance may be available from the UK, the overseas government, or an
international body, such as the World Bank.
4. Intercompany accounts
Financing by intercompany account is useful in a situation where it is difficult
to get funds out of the foreign country by way of dividends. This is further
discussed below.
5. Syndicated Loan Market
Syndicated loan market developed from the short-term eurocurrency market.
A syndicate of banks is brought together by a lead bank to provide medium-to
long-term currency loans to large multinational companies. These loans may
run to the equivalent of hundreds of millions of pounds. By arranging a
syndicate of banks to provide the loan, the lead bank reduces its risk
exposure.
6. Eurobond
Eurobond are bonds sold outside the jurisdiction of the country in whose
currency the bond is denominated.
Eurobond is a bond issued in more than one country simultaneously, usually
through a syndicate of international banks, denominated in a currency other
than the national currency of the issuer. They are long-term loans, usually
between 3 to 20 years and may be fixed or floating interest rate bonds
An investor subscribing to such a bond issue will be concerned about the
following factors:
security;
marketability;
return on the investment.
7. Euroequity
These are equity sold simultaneously in a number of stock markets. They are
designed to appeal to institutional investors in a number of countries. The
shares will be listed and so can be traded in each of these countries.
The reasons why a company might make such an issue rather than an issue in
just its own domestic markets include:
larger issues will be possible than if the issue is limited to just one
market;
wider distribution of shareholders;
to become better known internationally;
queuing procedures which exist in some national markets may be
avoided.
Example Brookday plc
Brookday plc is considering whether to establish a subsidiary in the USA. The
subsidiary would cost a total of $20 million, including $4 million for working capital.
A suitable existing factory and machinery have been located and production could
commence quickly. A payment of $19 million would be required immediately, with
the remainder required at the end of year one.
Production and sales are forecast at 50,000 units in the first year and 100,000 units
per year thereafter.
The unit price, unit variable cost and total fixed costs in year one are expected to
be $100, $40 and $1 million respectively. After year one prices and costs are
expected to rise at the same rate as the previous years level of inflation in the
USA; this is forecast to be 5% per year for the next 5 years. In addition a fixed
royalty of 5 per unit will be payable to the parent company, payment to be made
at the end of each year.
Brookday has a 4 year planning horizon and estimates that the realisable value of
the fixed assets in 4 years time will be $20 million.
It is the companys policy to remit the maximum funds possible to the parent
company at the end of each year. Assume that there are no legal complications to
prevent this.
Brookday currently exports to the USA yielding an after tax net cash flow of
100,000. No production will be exported to the USA if the subsidiary is
established. It is expected that new export markets of a similar worth in Southern
Europe could replace exports to the USA. United Kingdom production is at full
capacity and there are no plans for further expansion in capacity.
Tax on the companys profits is at a rate of 50% in both countries, payable one
year in arrears. A double taxation treaty exists between the UK and the USA and
no double tax is expected to arise. No withholding tax is levied on royalties payable
from the USA to the UK.
Tax allowable depreciation is at a rate of 25% on a straight line basis on all fixed
assets.
Brookday believes that the appropriate beta for this investment is 1.2 The after-
tax market rate of return is 12%, and the risk free rate of interest 7% after tax.
The current spot exchange rate is US $1.300/1, and the pound is expected to fall
in value by approximately 5% per year relative to the US dollar.
Required:
(a) Evaluate the proposed investment from the viewpoint of Brookday plc. State
clearly any assumptions that you make.
(b) What further information and analysis might be useful in the evaluation of this
project?
Solution to Brookday plc
(a) Brookdays stated policy is to remit the maximum funds possible to the parent
company. The net present value of relevant cash flows to the parent
company will be the appropriate decision criterion, and should lead to
maximisation of parent shareholder wealth.
The dollar profit and relevant cash flow from the subsidiary must be
determined first:
Projected earnings data of the US subsidiary
$000 $000 $000 $000 $000
Sales (note 1) 5,000 10,500 11,025 11,580

Variable cost 2,000 4,200 4,410 4,630
Fixed costs 1,000 1,050 1,102 1,158
Royalty
(note2)
309 586 557 529
Depreciation 4,000 4,000 4,000 4,000
7,309 9,836 10,069 10,317

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

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

Projected cash flow data of the US subsidiary
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
$000 $000 $000 $000 $000 $000
Profit after tax (2,309) 664 956 1,263 (287)
Depreciation 4,000 4,000 4,000 4,000
Initial
investment (19,000)
Additional
capital (1,000)
Realisable
value of fixed
assets (note 4) 20,000
Tax on
realisable value (10,000)
Working capital
available ______ _____ _____ _____ 4,000 ______
Cash flow
available to
parent (19,000) 691 4,664 4,956 29,263 (10,287)

Projected cash flow data for the parent company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
000 000 000 000 000 000
Available from
US subsidiary (14,615) 559 3,976 4,445 27,633 (10,226)
Royalty
payment
250 500 500 500
UK tax on
royalty (note5) _____ ___ (125) (250) (250) (250)
Net cash flow (14,615) 809 4,351 4,695 27,883 (10,476)

Discount
factors @ 13%
(note 6) 1 0.885 0.783 0.693 0.613 0.543
Present values (14,615) 716 3,407 3,254 17,092 (5,688)
Net present value = +4,166,000
The loss of exports to the USA if the project is undertaken is not a relevant
cash flow.
Notes:
1. Sales price increases by 5% per year
Year 1 Year 2 Year 3 Year 4
Price ($) 100.00 105.00 110.25 115.80
Units (000) 50 100 100 100
Sales revenue ($000) 5,000 10,500 11,025 11,580
Similar calculations are necessary for variable costs and price
adjustments for fixed costs.
2. The royalty is payable in s and will depend upon the $/ exchange
rate. The is expected to fall in value by 5% per year relative to the $.
Expected exchange rates $/ 1.235 1.173 1.115 1.059 1.006
Royalty (000) 250 500 500 500
Royalty ($000) 309 586 557 529
3. Losses are assumed to be carried forward and allowed against future
profits for taxation purposes.
4. Although the subsidiary will exist for more than four years, the
companys planning horizon is only four years. A value must be placed
upon the subsidiary at this time. The only information available is an
estimate of realisable value of fixed assets. Tax on this realisable value
will be payable as the assets are fully depreciated. Potential working
capital available must also be considered.
5. There will be no double taxation on cash flows from the USA. However,
the royalty has not been subject to US tax, and will be liable to UK
taxation.
6. Using the capital asset pricing model to determine the discount rate:
ke = rf + (Erm rf) project
ke = 7% + (12% 7%) 1.2 = 13%
(b) Further information and analysis might include:
(i) How accurate are the cash flow forecasts? How have they been
established?
(ii) Why has a four year planning horizon been chosen? The valuation of the
fixed assets at year 4 is highly significant to the NPV solution. How has
this valuation been established? Is this valuation based upon future
earnings as a going concern? It would be more desirable to evaluate the
project over the whole of its projected life.
(iii) Risk is taken into account by using a CAPM derived discount rate. How
has this rate been derived for a situation involving two countries? Does
this fully reflect the risk of the project? Is the use of CAPM appropriate
as it is a single period model? Other, theoretically weaker, measures of
risk might be useful as an aid to decision-making eg, sensitivity analysis
of the key variables or simulation.
(iv) Cash flow is usually assumed to occur at the end of each year. Greater
accuracy would result if consideration were given to when during the
year cash flow arises and these cash flows discounted at the appropriate
rate.
(v) Political and economic factors should be considered. How stable is the
US government policy? Will a change in government lead to changes in
taxation policy, exchange controls, restrictions on the remittance of
funds or attitudes towards foreign investment?
(vi) Are there any intangible benefits of establishing a manufacturing plant in
the USA eg making the American public more aware of Brookdays
product?

Example Polycalc plc
Polycalc plc is an internationally diversified company. It is presently considering
undertaking a capital investment in Australia to manufacture agricultural fertilizers.
The project would require immediate capital expenditure of A$15m, plus A$5m of
working capital which would be recovered at the end of the projects four year life.
It is estimated that an annual revenue of A$18m would be generated by the
project, with annual operating costs of A$5m. Straight-line depreciation over the
life of the project is an allowable expense against company tax in Australia, which
is charged at a rate of 50%, payable at each year-end without delay. The project
can be assumed to have a zero scrap value.
Polycalc plans to finance the project with a 5m 4-year loan at 10% from the Euro-
sterling market, plus 5m of retained earnings. The proposed financing scheme
reflects the belief that the project would have a debt capacity of two-thirds of
capital cost. Issue costs on the Euro debt will be 2 % and are tax deductible.
In the UK the fertilizer industry has an equity beta of 1.40 and an average
debt:equity gearing ratio of 1:4. Debt capital can be assumed to be virtually risk-
free. The current return on UK government stock is 9% and the excess market
return is 9.17%.
Corporate tax in the UK is at 35% and can be assumed to be payable at each year-
end without delay. Because of a double-taxation agreement, Polycalc will not have
to pay any UK tax on the project. The company is expected to have a substantial
UK tax liability from other operations for the foreseeable future.
The current A$/ spot rate is 2.0000 and the A$ is expected to depreciate against
the at an annual rate of 10%.
Required:
Using the Adjusted Present Value technique, advise the management of Polycalc on
the projects desirability.
Solution to Polycalc
Base-case discount rate
asset = 1.40 x
( ) 35 . 0 1 1 4
4
+
= 1.20
Base-case discount rate = 9% + (9.17% x 1.20) = 20%
Project tax charge and cash flows in A$m (Years 1 to 4)
Tax Cash flow
Revenue 18 18
Operating costs (5) (5)
Depreciation (15 4) (3.75)
Taxable profit 9.25
Tax charge @ 50% 4.625 (4.625)
8.375
Base-case net present value calculation in m
Year A$m
Exch.
Rate
increasing
at 10% pa m
20%
Discount
rate
m PV of
cash flows
0 (15 + 5) = (20) 2 = (10) x 1 = (10)
1 8.375 2.2 = 3.807 x 0.833 = 3.171
2 8.375 2.42 = 3.461 x 0.694 = 2.402
3 8.375 2.662 = 3.146 x 0.579 = 1.821
4 (8.375 + 5) = 13.375 2.9282 = 4.568 x 0.482 = 2.202
Base-case NPV = (0.404m)
PV of tax shield
Based upon debt capacity created ie
3
2
x
2
m 15 $ A
= 5m (which happens to be equal to the loan raised)
Annual tax relief on interest = 5m x 0.10 x 0.35 = 175,000
PV of tax relief for 4 years: 175,000 x 3.170 = 554,750
PV of issue costs
5m x 0.025 x (1 0.35) = 81,250
Adjusted present value
m
PV of tax shield 0.555
PV of issue costs (0.081)
Adjusted present value 0.07m or +70,000 approx
Therefore accept project and finance it in the manner indicated.


Chapter 9
Valuations,
acquisitions and
mergers section 1

CHAPTER 9 VALUATIONS, ACQUISITIONS AND MERGERS: SECTION 1
CHAPTER CONTENTS
REASONS FOR VALUATIONS ------------------------------------------- 147
METHODS OF SHARE VALUATION ------------------------------------- 148
THE DIVIDEND VALUATION MODEL ---------------------------------- 149
DISCOUNTED CASH FLOW BASIS ------------------------------------- 151
PRICE EARNINGS RATIO BASIS --------------------------------------- 153
NET ASSETS BASIS ----------------------------------------------------- 155
DIVIDEND YIELD BASIS ----------------------------------------------- 157
VALUATION OF DEBT AND PREFERENCE SHARES ------------------- 158
IRREDEEMABLE DEBT 158
REDEEMABLE LOAN STOCK 158
PREFERENCE SHARES 159
CONVERTIBLE DEBT 159
THE THREE ACQUISITION TYPES ------------------------------------- 161
TYPE I ACQUISITIONS 161
TYPE II ACQUISITIONS 161
TYPE III ACQUISITIONS 163
HIGH GROWTH START-UPS -------------------------------------------- 166

REASONS FOR VALUATIONS
Valuations of businesses and financial assets may be needed for several reasons,
eg
To establish the terms of takeover bids or mergers;
To fix a share price for an initial public offering;
For investors to make buy, hold or sell decisions;
For capital gains tax or inheritance tax purposes;
Where a major shareholder or director wishes to dispose of a large block of
shares;
When the company needs to raise additional finance.
METHODS OF SHARE VALUATION
The main approaches are:
The dividend valuation model or dividend growth model;
The discounted cash flow basis;
The PE ratio (or earnings yield) basis;
The net assets basis;
The dividend yield method.
THE DIVIDEND VALUATION MODEL
This method is based upon the fundamental theory of share valuation, whereby a
current share price is taken to reflect the PV of expected future cash flows,
discounted at the required rate of return of the shareholder. In the case of
minority shareholders, this would represent the PV to infinity of the future dividend
stream. In the case of majority shareholders, these amounts will be increased by
the PV of synergies achieved as a result of the acquisition.
Example Winterburn plc
The market expects a rate of return of 20% per annum on ordinary shares in
Winterburn plc, a company which is expected to pay constant annual dividends of
20p per share.
At what price will the market value the shares?
Solution to Winterburn plc
P
0
=
Ke
D
=
2 . 0
20 . 0
= 1.00
Example Seaman plc
Seaman plc is expected to pay a dividend of 30p per share next year. The market
expects dividends to grow at the rate of 5% per annum and has a required return
of 20%.
Estimate the share price.
Solution to Seaman plc
P
0
=
g Ke
D
1
=
05 . 0 2 . 0
30 . 0
= 2.00
Example Merson plc
Merson plc is just about to pay a dividend of 40p per share. Future dividends are
expected to grow at the rate of 6% per annum. The markets required return on
shares of this risk level is 25%.
What is the cum-div share valuation?
Solution to Merson plc
This years dividend, D
0
= 40p. Next years dividend will be a factor of g higher:
D
1
= D
0
(1 + g) = 40p (1 + 0.06)
= 42.4p
P
0
=
0
1
D
g Ke
D
+
= p 40
06 . 0 25 . 0
p 4 . 42
+

= 2.63
Example Wright plc
Wright plc has just paid a dividend of 15p per share. The market is in general
agreement with directors forecasts of 30% growth in earnings and dividends for
the next 2 years. Thereafter, a reasonable estimate is 15% growth in year 3
followed by 6% growth to perpetuity.
The markets required return on investments of this risk level is 25% per annum.
Estimate the share value.
Solution to Wright plc
For years1 to 3, compute the expected dividends and discount them.
Dividend computation, Years 1 3
Year Dividend 25% factor Present value, p
1 15p x 1.3 = 19.5 0.800 15.60
2 19.5p x 1.3 = 25.35 0.640 16.22
3 25.35p x 1.15 = 29.15 0.512 14.93
46.75p
Then compute the dividend for year 4 and plug this into the growth formula with g
= 0.06
Year 4 dividend = 29.15p x 1.06 = 30.90p
Using the growth formula P
3
=
06 . 0 25 . 0
p 90 . 30
= 162.63p
The growth formula for P is based on dividends from year 1 to perpetuity. Since
the dividends in the above calculation go from year 4 to perpetuity, the value for P
above must be at year 3. But we want its present value at year 0. Therefore we
must discount back three further years, using the 3 year factor at 25%, which is
0.512.
Present value at year 0 of dividends from year 4 to perpetuity = 162.63p x 0.512
= 83.27p
Adding the present value of dividends from years 1 to 3 gives:
Share value = 46.75p + 83.27p = 1.30
DISCOUNTED CASH FLOW BASIS
This method is based upon the present value of the free cash flow to equity of an
enterprise, either for a limited time horizon (fifteen years may be regarded as
typical) or to infinity.
There are a number of variations in the definition of free cash flow to equity, but it
is often described as follows:
Free cash flow to equity is the cash flow available to a company from
operations after interest expenses, tax, repayment of debt and lease
obligations, any changes in working capital and capital spending on assets
needed to continue existing operations (ie replacement capital expenditure
equivalent to economic depreciation)
In theory, this is probably the best method by which to value a company. However
it relies on estimates of cash flows, discount rates, tax rates, inflation rates and the
choice of a suitable time horizon. The notion of using a valuation to infinity is
probably unrealistic.

Solution to Miller Ltd
Year Free cash flows Discount factor Present values
000 12%
1 150 0.893 133,950
2 200 0.797 159,400
3 250 0.712 178,000
4 375 0.636 238,500
5 500 0.567 283,500
Estimated market capitalisation for 5 year planning horizon 993,350
Example Miller Ltd
The predicted free cash flows of Miller Ltd, an all equity company, for its planning
horizon, (which for simplicity is taken to be the next five years) are:
Year Free cash flows
000
1 150
2 200
3 250
4 375
5 500
A cost of capital of 12% is assumed to represent the systematic risk of the cash
flows of Miller Ltd.
What is the estimated market capitalisation of this company?

Solution to Morrison Ltd
Net cash flows
000
Turnover 525,000
Cost of goods sold (315,000)
Distribution costs and administrative expenses (36,000)
174,000
Tax on operating profits (30% x 174,000) (52,200)
Tax saved on writing down allowances (30% x 46,500) 13,950
Non-current assets purchased (72,000)
Annual net cash flows 63,750
Real discount rate (using Fisher effect)
r =
( )
( )
1
i 1
m 1

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

637,500
Less market value of irredeemable bonds (21,000 x 1.3) (27,300)
Equity market capitalisation 610,200
Example Morrison Ltd
The following data relating to Morrison Ltd is expected to continue annually for the
foreseeable future:
m
Turnover 525
Cost of goods sold, excluding depreciation 315
Distribution costs and administrative expenses, excluding depreciation 36
Capital allowances claimed 46.5
Non-current assets purchased in the year 72
Irredeemable bonds (market value 130) 21

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

Corporation tax rate 30%
Weighted average cost of capital in nominal (ie money) terms 13.3%
Predicted inflation rate 3%
Calculate the estimated equity market capitalisation of this company.
PRICE EARNINGS RATIO BASIS
This income based method is popular for the valuation of majority holdings in a
going concern. It requires the prediction of a maintainable EPS for the company
being valued and the use of the PE ratio of a listed company, whose activities are
very similar to those of the business being valued ie
Share value = EPS of company being valued x PE of similar listed company
If a similar listed company (pureplay company) is not readily available, it may be
appropriate to use the average PE for the market sector in which the company
operates.
It may be necessary to adjust the PE used or the final calculated price, if the
company being valued is an unlisted company, or where the company in question
has different risk or different growth potential from the similar company or
constituents of the industry average.
Since an earnings yield is simply a reciprocal of the PE ratio, a valuation on an
earnings yield basis would be as follows:
Share value = EPS of company being valued earnings yield of similar listed
company.

Example Flycatcher Ltd
Flycatcher Ltd wishes to make a takeover bid for the shares of an unlisted
company, Mayfly Ltd. The earnings of Mayfly Ltd over the past five years have
been as follows.
2002 50,000 2005 71,000
2003 72,000 2006 75,000
2004 68,000
The average P/E ratio of listed companies in the industry in which Mayfly Ltd
operates is 10. Listed companies which are similar in many respects to Mayfly Ltd
are:
Bumblebee plc, which has a P/E ratio of 15, but is a company with very
good growth prospects;
Wasp plc, which has had a poor profit record for several years, and has a
P/E ratio of 7.
What would be a suitable range of valuations for the shares of Mayfly Ltd?
Solution to Flycatcher Ltd
Earnings. Average earnings over the last five years have been 67,200, and over
the last four years 71,500. There might appear to be some growth prospects, but
estimates of future earnings are uncertain.
A low estimate of earnings in 2007 would be, perhaps, 71,500.
A high estimate of earnings might be 75,000 or more. This solution will use the
most recent earnings figure of 75,000 as the high estimate.
P/E ratio. A P/E ratio of 15 (Bumblebees) would be much too high for Mayfly Ltd,
because the growth of Mayfly Ltd earnings is not as certain, and Mayfly Ltd is an
unlisted company.
On the other hand, Mayfly Ltds expectations of earnings are probably better than
those of Wasp plc.
A suitable P/E ratio might be based on the industrys average, 10; but since Mayfly
is an unlisted company and therefore more risky, a lower P/E ratio might be more
appropriate: perhaps (60% to 70% of 10) = 6 or 7, or conceivably even as low as
(50% of 10) = 5.
Valuation. The valuation of Mayflys shares might therefore range between:
High P/E ratio and high earnings: 7 x 75,000 = 525,000; and
Low P/E ratio and low earnings: 5 x 71,500 = 357,500
NET ASSETS BASIS
Asset-based valuation models include:
net book value (balance sheet basis) largely a meaningless figure, since it is
affected by accounting conventions;
net realisable value basis again, not particularly relevant. However, where
the break-up value exceeds income-based valuations, it would be advisable
for the proprietor to cease trading and sell the assets as quickly as possible;
net replacement cost basis this represents the current cost of setting up the
existing business. Sadly it totally ignores goodwill, which can only be
established by using income-based valuations.

Example Cactus Ltd
The current balance sheet of Cactus Ltd is as follows:

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

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

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

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

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

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

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

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

Value as debt 121.00

Value as equity Value as debt Formula value Convert ?

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

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

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

Type I acquisitions
These are acquisitions that do not disturb the acquirers exposure to either business
risk or financial risk. In theory, the value of the acquired company, and hence the
maximum amount that should be paid for it, is the Present Value of the future cash
flows of the target business discounted at the WACC of the acquirer. The valuation
techniques already considered would deal adequately with this type of business
combination.
Type II acquisitions
These are acquisitions which do not disturb the exposure to business risk, but do
impact upon the acquirers exposure to financial risk, eg through changing the
gearing levels of the acquirer. Such acquisitions may be valued using the Adjusted
Present Value (APV) technique by discounting the Free Cash Flows of the acquiree
using an ungeared cost of equity and then adjusting for the tax shield.

Example Heincarl plc
The directors of Heincarl plc are considering the acquisition of Newscot Ltd, an
unlisted company. The shareholders of Newscot Ltd are willing to sell the business
on 1
st
January 2009 for 500 million. From the perspective of the directors of
Heincarl plc, the projections of the performance of Newscot Ltd are as follows:

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

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

= 583.11
PV to infinity of Company Free Cash Flow 977.78
Tax Shield (discounted at Kd of 8%)
(32.00 x 35% x 0.926) + (26.88 x 35% x 0.857) + (20.19 x 35% x 0.794)
+ (11.73 x 35% x 0.735) + (1.28 x 35% x 0.681) = 10.37 + 8.06 + 5.61 + 3.02 +
0.31 = 27.37
APV m
Corporate value (977.78 + 27.37) 1005.15
Less Value of debt (400.00)
Value of equity 605.15
Less Purchase consideration (500.00)
APV 105.15
Therefore, the directors of Heincarl plc should proceed with the acquisition of
Newscot Ltd.
Type III acquisitions
These are acquisitions that impact upon the acquirers exposure to both business
risk and financial risk. In order to estimate WACC there is a need to establish the
cost of capital of the combined businesses. However, the Ke of the combination is
dependent upon the price paid for the equity capital of the target, but it is
impossible to establish the price to be paid until the value of the target is
determined.

Example Edwards plc
Edwards plc is considering the acquisition of a 100% stake in Colman Ltd in order
to achieve backward vertical integration. Considerable savings are anticipated due
to the combination of both the marketing operations and distribution networks of
the two companies. Therefore synergies will arise to create cash flows which are in
excess of the current estimated cash flows of the two separate companies. Upon
the acquisition of Colman Ltd, Edwards plc will immediately sell one of the
warehouses of the target company, providing instant cash inflows of 5 million.
The forecast cash inflows of the merged businesses are as follows:
Year millions Year millions
2008 (proceeds from warehouse
sale)
5.00 2014 92.32
2009 60.00 2015 100.63
2010 65.40 2016 109.68
2011 71.29 2017 119.55
2012 77.70 2018 130.29
2013 84.69 Terminal value 2,396.84
The forecast rate of corporation tax is expected to remain at 30%. The risk free
rate of interest is to be taken at 5% and the expected return on a market portfolio
is 9%.
Information currently relating to the two companies is as follows:
Edwards plc Colman Ltd
m m
Market values:
Debt 100 20
Equity 900 280
Total 1,000 300

asset 0.9 2.4

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

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

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

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

m m
2008 5.00 1 5.00
2009 60.00 11.0952 54.78
2010 65.40 11.0952
2
54.52
2011 71.29 11.0952
3
54.27
2012 77.70 11.0952
4
54.01
2013 84.69 11.0952
5
53.75
2014 92.32 11.0952
6
53.50
2015 100.63 11.0952
7
53.24
2016 109.68 11.0952
8
52.99
2017 119.55 11.0952
9
52.74
2018 130.29 11.0952
10
52.48
Terminal value 2,396.84 11.0952
11
881.48
1,422.76
Value of equity
m
PV of combined entity 1,422.76
Less combined value of debt (500.00)
Therefore the combination is beneficial to the shareholders of Edwards plc, since
the value of their equity shareholding will increase from 900 million to 922.76
million.
However, one further major problem remains! There is an inconsistency! In the
weightings used for the WACC calculation, (1,180 1,680) about 70% has been
applied to equity, whilst (500 1,680) about 30% has been used for debt. On the
other hand, ultimately the value of equity has been shown to represent (922.76
1,422.76) about 65% of corporate value and the value of debt (500 1,422.76)
about 35% of corporate value.
Where these two sets of weights differ significantly an inconsistent valuation will
occur. There is then a need to adopt an iterative revaluation procedure to achieve
consistency between the WACC and the corporate value. This would involve a
recalculation of e, using weightings that are closer to those derived from the
valuation. This procedure would be continuously repeated until the assumed
weights and the weightings ultimately derived from the corporate valuation are
reasonably consistent.
Thankfully this iterative process is not performed manually, since it can be
calculated in Excel (shown in Tools > Options > Calculation). The consistent results
of the iterative revaluation procedure apparently work out as follows:
m
PV of combined entity 1,395.45
Less combined value of debt (500.00)
e will now become:
( )
895.45
3 . 0 1 500 45 . 895
25 . 1
+
= 1.74
Ke is now revised to become: 5% + (9% 5%) 1.74 = 11.96%
The weighted average cost of capital is revised to:
WACC = ( ) 3 . 0 1 % 7
45 . 395 , 1
500
% 96 . 11
45 . 395 , 1
45 . 895
+ = 9.43%
The increased proportion of debt (500 1,395.45) ie about 36% of corporate value
has caused both e and Ke to increase, whilst there has been a slight reduction in
WACC due to the larger weighting applied to debt.
Since the value of equity has now fallen to 895.45 million, which is below the
current value of the equity shares in Edwards plc (ie 900 million), the acquisition
would cause a reduction in shareholder wealth of 4.55 million. The business
combination should thus be abandoned.
HIGH GROWTH START-UPS
The valuation of Start-ups create additional problems to that of well established
businesses. This may be due to:
their lack of a proven track record,
initial on-going losses,
untested products with little market acceptance,
little market presence,
unknown competition,
high development costs, and
inexperienced managers with over-ambitious expectations of the future.
The valuation procedures depend upon the reasonableness of financial projections,
the length of the period chosen for long-term projections and the selection of future
growth rates. The growth in earnings may be forecast using Gordons growth
approximation ie g = br, where normally b = 1, since all profits made are likely to
be reinvested into the business. Therefore the sole determinant of growth is the
measure of r.
The decision as to growth expectations is rather critical as shown in the following
illustration:
Example Bednar plc
Bednar plc anticipates costs of 1,200 million in the coming year, thereafter
growing at a rate of 4% per annum. The anticipated revenues for that year are
expected to be 320 million. The company expects to achieve a return on
reinvested funds of between 16% and 18% per annum. Furthermore the directors
of Bednar plc do not anticipate the payment of any dividends for the foreseeable
future.
Using a cost of equity of 20% p.a., produce a valuation for Bednar plc
based upon both the maximum and the minimum growth rate predictions,
using the Growth Model combined with Gordons growth approximation.
Solution to Bednar plc
Since no dividends are expected to be paid, b = 1
Maximum valuation
Growth prediction: (g = br) g = 1 x 0.18 = 18%
Valuation using the Growth Model:
% 4 % 20
200 , 1
% 18 % 20
320
= 16,000 7,500 = 8,500 million

Minimum valuation
Growth prediction: (g = br) g = 1 x 0.16 = 16%
Valuation using the Growth Model:
% 4 % 20
200 , 1
% 16 % 20
320
= 8,000 7,500 = 500 million

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


Chapter 10
Valuations,
acquisitions and
mergers section 2

CHAPTER CONTENTS
MERGERS AND ACQUISITIONS ---------------------------------------- 171
1. SYNERGY 171
2. HIGH FAILURE RATE OF ACQUISITIONS IN ENHANCING SHAREHOLDER VALUE 172
3. MODE OF OFFER 173
4. STRATEGIC DEFENCES 176
5. REGULATION OF TAKEOVERS 177
6. COMPETITION COMMISSION IN UNITED KINGDOM 177
DARK POOL TRADING -------------------------------------------------- 178

MERGERS AND ACQUISITIONS

1. Synergy
An expansion policy based on merger or takeover can be justified on the basis
of synergy. (Sometimes stated as 2 + 2 = 5) ie
Value of A plc Value of A plc Value of B plc
and B plc combined
> >> >
operating
+
operating
independently independently
Acquisitions and mergers are ultimately justified as leading to an increase in
shareholder wealth.
The potential for synergy is often classified as follows:
Revenue synergy: Sources of which include:
o Economies of vertical integration;
o Market power and the elimination of competition ie the desire to earn
monopoly profits (which is good for shareholders but not in the public
interest);
o Complementary resources eg a company with marketing strengths could
usefully combine with the company owning excellent research and
development facilities.
Cost synergy: Sources of which include:
o Economies of scale (arising from eg larger production volumes and bulk
buying);
o Economies of scope (which may arise from reduced advertising and
distribution costs where combining companies have duplicated
activities);
o Elimination of inefficiency;
o More effective use of existing managerial talent.
Financial synergy: Sources of which include:
o Elimination of inefficient management practices;
o Use of the accumulated tax losses of one company that may be made
available to the other party in the business combination;
o Use of surplus cash to achieve rapid expansion;
o Diversification reduces the variance of operating cash flows giving less
bankruptcy risk and therefore cheaper borrowing;
o Diversification reduces risk (however this is a suspect argument, since it
only reduces total risk not systematic risk for well diversified
shareholders);
o High PE ratio companies can impose their multiples on low PE ratio
companies (however this argument, known as bootstrapping, is rather
suspect).
Conclusions on Synergy
o Synergy is not automatic
o When bid premiums are considered, the consistent winners in mergers
and takeovers are victim company shareholders.
2. High failure rate of acquisitions in enhancing
shareholder value
In practice, the shareholders of predator companies seldom enjoy synergistic gains,
whereas the shareholders of victim companies benefit from a takeover. The
acquiring company often pays a significant premium over and above the market
value of the target company prior to acquisition; this problem is particularly acute
for the successful predator following a contested takeover bid.
The reasons advanced for the high failure rate of business combinations from the
perspective of the predator shareholders are as follows:
Agency theory suggests that takeover bids are primarily motivated by the
self- interest of the managers of bidding companies. Often free cash flow
may be used to increase the size of their company in order to enhance the
status of directors who wish to be seen as heading a large listed plc.
Diversification of the activities of the predator may provide job security for the
directors of such companies;
Over-optimistic assessment of the economies of scale or economies of scope
that may be achieved as a result of the business combination;
Inadequate investigation of the victim company prior to the bid being made,
or insufficient appreciation of the problems that may arise after the acquisition
takes place (eg the difficulties experienced by Wm. Morrison Supermarkets
following the takeover of Safeway);
Following a successful bid, the directors and managers of the predator
become too keen to identify their next victim, instead of devoting time to
ensuring that the company that they have already taken over provides the
expected synergies;
Directors of the predator company become so obsessed with the success of
their bid that they fail to seek alternative target companies. Furthermore,
their valuations of the victim and their justifications for the acquisition
become exaggerated.
3. Mode of offer
Cash consideration
The offer is made to purchase the shares of the target company for cash. This
method is very appropriate for relatively small acquisitions, unless the acquirer has
accumulation of cash from operations or divestments.
The advantages of cash offer to the target entitys shareholders are that:
The price that they will receive is obvious. It is not like share exchange where
the movements in the market price may change their wealth.
The cash purchase increases the liquidity of the target shareholders who are
in position to alter their investment portfolio to meet any changing
opportunities.
A disadvantage to target shareholders for receiving cash is that if the price that
they receive is on sale is more than the price paid when purchasing the shares,
they may be liable to capital gains tax.
The advantages to the predator company are that:
The value of the bid is known and target company shareholders are
encouraged to sell their shares.
It represents a quick and easily understood approach when resistance is
expected.
The shareholders of the target company are bought out and have no further
participation in the control and profits of the combined entity.
The main disadvantages to the predator company are that it may deplete the
companys liquidity position and may increase gearing.
Methods of raising cash
The predator company can raise cash from many sources to finance the acquisition,
some of the sources are:
Borrowing to obtain cash
The predator company may not have enough cash immediately available to finance
the acquisition and may have to raise the necessary cash through bank loans and
issuing of debt instruments.
Mezzanine finance
Mezzanine finance is a form of finance that combines features of both debt and
equity. It is usually used when the company has used all bank borrowing capacity
and cannot also raise equity capital.
It is a form of borrowing which enables a company to move above what is
considered as acceptable levels of gearing. It is therefore of higher risk than
normal forms of borrowing.
Mezzanine finance is often unsecured.
It offers equity participation in the company either through warrants or share
options. If the venture being financed is successful the lender can obtain an equity
stake in the company.
Retained earnings
This method is used when the predator company has accumulated profits over time
and is appropriate when the acquisition involves a small company and the
consideration is reasonably low. This method may be the cheapest option of
finance.
Vendor placing
In a vendor placing the predator company issues its shares by placing the shares
with institutional investors to raise the cash required to pay the target
shareholders.
Share exchange
The predator company issues its own shares in exchange for the shares of the
target company and the shareholders of the target company become shareholders
of the predator company.
The advantages of a share exchange to target shareholders include:
Capital gains tax is delayed.
The shareholders of the target company will participate in the control and
profits of the combined entity.
The main disadvantage is that there is uncertainty with a share exchange where the
movements in the market price may change their wealth.
The advantages to the predator company are that:
It preserves the liquidity position of the company as there are no outflows of
cash.
Share exchange reduces gearing and financial risk. However, this may
depend on the gearing of the target company.
The predator company can bootstrap earnings per share if its price earnings
ratio is higher than that of the target company.
The main disadvantages of a share exchange are that:
It causes dilution in control.
It may cause dilution in earnings per share.
As equity shares are issued this comparatively more expensive than debt
capital.
The company may not have enough authorized share capital to issue the
additional shares required.
Debentures, loan stock and preference shares
Very few companies use debentures, loan stock and preference shares as a means
of paying a purchase consideration on acquisitions.
The main problems of using debentures and loan stock to the predator company are
that:
It affects gearing and financial risk.
Difficulty in determining appropriate interest rate to attract the shareholders
of the target company.
Availability of collateral security against repayment.
The main advantages of using debentures and loan stock are that:
Interest payments are a tax allowable expense.
Cost of debt is cheaper than equity.
Does not dilute control.
The main problems of using preference shares are that:
Dividends on preference shares are fixed and not tax allowable.
May not be attractive to target shareholders as preference shares carry no
voting power.
Preference shares are less marketable.
Earn-out arrangements
An earn-out arrangement is where the purchase consideration is structured such
that an initial payment is made at the date of acquisition and the balance is paid
depending upon the financial performance of the target company over a specified
period of time.
The main advantages of earn-out arrangements are that:
Initial payment is reduced.
The risk to the predator company is reduced as it is less likely to pay more
than the target is worth. The price is limited to future performance.
It encourages the management of the target company to work hard as the
overall consideration depends on future performance.
4. Strategic defences
Post-bid
A target company can use the following to defend itself against a possible takeover:
Try to convince the shareholders that the terms of the offer are
unacceptable. This can be done using the following:
o Attempt to show that the current share price of the company is
unrealistically low relative to the future potential. Assets revaluation,
new profit forecasts, dividends and promises of rationalisation are
commonly employed here.
o If it is for share for share exchange, the target company can attempt to
convince the shareholders that the offers equity is currently overvalued.
The suitability of the bidding company to run the merged business can
also be questioned.
Lobbying the office of fair trading and or the department of trade and
industry to have the offer referred to the competition commission. This will at
least delay the takeover and may prevent it completely.
Launching an advertising campaign against the takeover bid. One
technique is to attack the account of the predator company.
A reverse takeover (Pac Mac), that is make a counter offer for the predator
company. This can be done if the companies are of reasonably similar size.
Finding a white knight, a company which will make a welcome takeover
bid. This involves finding a more suitable acquirer and promoting it to
compete with the predator company.
Crown jewels (or scorched earth) policy, with the approval of shareholders
in general meeting.
Pre-bid
Selling crown jewels the tactic of selling off certain highly valued assets
of the company subject to a bid is called selling the crown jewels. The
intention is that, without the crown jewels, the company will be less
attractive.
Golden parachutes this is a policy of introducing attractive termination
packages for the senior executives of the victim company. This makes it
more expensive for the predator company.
Shark repellent super-majority. The articles of association are changed to
require a very high percentage of shares to approve an acquisition or merger,
say 80%.
Poison pill
The most commonly used and seeming most effective takeover defence is the
so called poison pill.
An example is the Flip-in pill. This involves the granting of rights to
shareholders, other than the potential acquirer, to purchase the shares of the
target company at a deep discount. This dilutes the ownership interest of the
potential acquirer.
5. Regulation of takeovers
The regulation of takeovers varies from country to country and mainly concentrates
on controlling directors in order to ensure that all shareholders are treated fairly.
Typically, the rules will require the target company to:
notify its shareholders of the identity of the bidder and the terms and
conditions of the bid;
seek independent advice;
not issue new shares or purchase or dispose of major assets of the company,
unless agreed prior to the bid, without the agreement of a general meeting;
not influence or support the market price of its shares by providing finance or
financial guarantees for the purchase of its own shares;
the company may not provide information to some shareholders which is not
made available to all shareholders;
shareholders must be given sufficient information and time to reach a
decision. No relevant information should be withheld;
the directors of the company should not prevent a bid succeeding without
giving shareholders the opportunity to decide on the merits of the bid
themselves.
Directors and managers should disregard their own personal interest when advising
shareholders.
6. Competition commission in United Kingdom
Under the terms of this commission, the office of fair trading (OFT) is entitled to
scrutinise all major mergers and takeovers. If the OFT thinks that a merger or
takeover might be against the public interest, it can refer it to competition
commission. If no referral is made to the commission within normally 20 days, the
merger can proceed without fear of a referral.
The function of the competition commission is to advise the government. The
commission can make recommendations to the relevant government department or
to any other body including the companies involved in the bid.
The result of the investigation by the commission might be:
Withdrawal of the proposal for the merger or takeover, in anticipation of it
rejection by the commission.
Acceptance or rejection of the proposal by the commission.
Acceptance of the proposal by the commission subject to the new company
agreeing to certain conditions laid down by the commission, for example on
prices, employment or arrangement for the sale of the groups products.
DARK POOL TRADING
The recent financial crisis has seen the alleged (see newspaper article below)
growth of a practice, which is sometimes referred to as Dark pool trading. It is
also known as Dark pool liquidity, the Upstairs market, Dark liquidity or simply
Dark pool.
The term Dark pool relates to trades which are concealed from the public as if
they had been undertaken in pools of murky water. Many traders believe that
such activities should be publicised in order to make trading more fair for all parties
involved, so that all such transactions are performed on a level playing field.
Dark pool trading refers to the volume of trade created by institutional investors in
financial trading venues or crossing networks that are unavailable to the general
public. The bulk of Dark pool liquidity is represented by block trades undertaken
away from the central exchanges. Such transactions are never displayed and are
useful for institutions who wish to deal in large numbers of shares, whilst not
revealing such trades to the open market.
Dark liquidity pools avoid the risk of revealing the actions of such institutions, since
neither the identity of the trader nor the price at which the transactions took place
are displayed. Dark pools are recorded as over-the-counter transactions, but
detailed information is only reported to clients if they so desire and are under a
contractual obligation to do so.
The Upstairs market allows Fund managers to move large blocks of equity shares
without revealing details as to what has actually occurred. The lack of human
intervention within the electronic platforms employed has reduced the time scale
for such trades. The increased responsiveness of equity price movements has
made it extremely difficult to trade large blocks of shares without affecting the
price.
A report in The Independent newspaper on 25th May 2010 stated:
Six big investment banks published trading volumes for their dark pools for the
first time yesterday, showing them as a tiny fraction of the market and not the
major hidden rivals to stock exchanges that some argue.
Citi, Credit Suisse, Deutsche Bank, J P Morgan Cazenove, Morgan Stanley and UBS
together executed 596 million (513 million) of equity trades from 15 countries on
their automated crossing systems on Friday, according to Markit data.
That accounted for about 0.4 per cent of all types of cash equity trades in Europe
and 1.6 per cent of all over-the-counter (OTC) trades reported on the Markit BOAT
service that day, according to Thomson Reuters data.
Dark pools are electronic platforms that allow would-be buyers and sellers of large
orders of shares to avoid revealing pre-trade information and signalling their
intentions to the rest of the market.
Bankers argue that for the bulk of OTC trades they act purely as dealers, using
their own money or share inventories to take one or another side, or they act in a
non-automated way to match buyers and sellers for big blocks of stock.

Chapter 11
Valuations,
acquisitions and
mergers section 3

CHAPTER CONTENTS
SHAREHOLDER VALUE ADDED (SVA) --------------------------------- 181
VALUE DRIVERS 181
STRENGTHS OF SVA 182
PROBLEMS 183
ECONOMIC VALUE ADDED (EVA) -------------------------------------- 184
STRENGTHS OF EVA 186
PROBLEMS OF EVA 186
INTELLECTUAL CAPITAL ----------------------------------------------- 187
VALUING INTANGIBLE ASSETS/INTELLECTUAL CAPITAL 187

SHAREHOLDER VALUE ADDED (SVA)
Shareholder value added was developed in the 1980s from the work of Rappaport
and focuses on the value creation using the NPV approach. Thus SVA assumes that
the value of a business is the present value of its future cash flows discounted at
the appropriate cost of capital.
Shareholder value added involves calculating the present value of the projected
future free cash flows to equity of the business. Any increase in the present value
should result in an equivalent increase in market value added and thus increase
shareholder wealth.
Value drivers
Seven key factors, called value drivers, are identified as being fundamental to the
determination of value:
sales growth rate;
operating profit margin;
tax rate;
incremental fixed capital investment;
incremental working capital investment;
the planning horizon;
the required rate of return.
The model assumes a constant percentage rate of sale growth and a constant
operating profit margin. Tax is assumed to be a constant percentage of operating
profit. Finally, fixed and working capital investments are assumed to be a constant
percentage of change in sale.
Free cash flows
Given sales for the current year and the input values for the various percentage
relationships, the operating free cash flows can be calculated as:
Free cash flows = operating profit tax incremental investment in fixed and
working capital.
Corporate value
Using the free cash flows, corporate value is then computed using the companys
WACC as a discounting factor:
Corporate value = PV of free cash flows + current value of marketable securities
and other non operating investment.
Share value
The share value may then be calculated as:
SV = Corporate value Debt
Example 1 Zoozo Ltd
The following information is available for Zoozo Ltd.
Sales growth rate 15% pa
Current sales 10m
Operating profit margin 6%
Tax rate 35% of Operating profit
Incremental fixed capital investment 15%of changes in sales
Incremental working capital investment 10% of changes in sales
WACC 20%
Perpetuity planning horizon
Debt capital 600,000
Investment in shares and other securities 530,000
Required:
Compute Zoozos corporate value and share value.
Solution to Zoozo Ltd
In year one free cash flows is calculated as:
Sales 10m x 1.15 11.5m
Operating profit 11.5 x 6% 690,000
Tax 690,000 x 35% (241,500)
Fixed capital investment (11.5 10) x 15% (225,000)
Working capital investment (11.5 - 10) x 10% (150,000)
Free cash flows 73,500
This means that 73500 is available to be distributed to the suppliers of finance
after investment in non-current assets and working capital.
Since the planning horizon is in perpetuity, we can calculate the PV of free cash
flows using the dividend valuation approach as:
PV =
g - R
FCF

Where: FCF = free cash flows
R = WACC
g = growth rate of sales
PV of FCF =
15 . 0 2 . 0
500 , 73
=1.47m
Corporate value = 1.47 + 0.53 = 2m
Share value = 2 - 0.6 = 1.4m
Strengths of SVA
Simple approach.
It is consistent with the concept of share valuation by DCF.
It creates management awareness of the key value variables (drivers).
Sensitivity analysis can be applied to each of the value drivers.
Problems
The constant percentage assumptions may be unrealistic.
The input data may not be easily available from current system.
There are subjective judgments necessary to determine the value drivers.
ECONOMIC VALUE ADDED (EVA)
EVA developed by Stern Stewart focuses on the concept of economic income.
Economic income is the income generated by the company less investors required
return on capital.
EVA is based on simple concept that a business must make economic profit in
excess of the cost of capital that has been invested to earn that profit in order to
add to its economic value.
EVA is simply calculated as:
EVA = NOPAT CAPITAL CHARGE
NOPAT = net operating profit after tax
Capital charge = investor required return on capital, calculated as:
(WACC x Adjusted capital employed)
Calculating EVA
To calculate EVA the following steps can be followed:
Calculate the net operating profit after tax (NOPAT).
Calculate the adjusted/economic capital employed.
Find the weighted average cost of capital (WACC) of the company.
Calculate capital charge as the WACC multiplied by the adjusted/economic
capital employed.
Calculate the EVA as difference between NOPAT and capital charge.
Net operating profit after tax (NOPAT)
The NOPAT can be calculated as:
Reported accounting profit before interest and tax xxxx

Add
- accounting depreciation xx
- any goodwill written off for the year xx
- any increase ( less any decrease) in provision for doubtful debts xxx
- any increase in net capitalised development cost xxx
- any increase in net capitalised lease expenditure xxx

Less
- replacement cost depreciation (economic depreciation) (xx)
- amortisation of development cost and leases (xx)
- cash payment for tax on operating profit (xx)
NOPAT xxxx
Adjusted/economic capital employed
Reported accounting total asset (current and non-current) xxxx

Add
- cumulative amortised goodwill xxx
- provision for doubtful debts xxx
- economic value = (net book value) of capitalised development cost xxx
- economic value = (net book value) of leased expenditure xxx

Less
- non-interest bearing liabilities such as trade payables and tax payable (xxx)
- economic capital employed xxxxx
Example
A company has reported annual operating profits for the year of 892m after
charging 96m for the full development costs of a new product that is expected to
last for the current year and two further years. The cost of capital is 13% per
annum. The balance sheet for the company shows fixed assets with a historical
cost of 120m. A note to statement of financial position estimates that the
replacement cost of these fixed assets at the beginning of the year is 168m. The
assets have been depreciated at 20% per year.
The company has a working capital of 272m.
Ignore the effects of taxation.
Required:
Calculate EVA.
Solution
m
Profit 8920
Add
Current depreciation (120 x 20%) 2400
Development costs (960 x 2/3) 640
Less
Replacement depreciation (168 x 20%) 3360
Adjusted profit 8600
Less cost of capital charge (Working 1) 2184
EVA 6416

Working 1
Cost of capital charge
Fixed assets (168 336) 1344
Working capital 272
Development costs 64
Adjusted capital employed 168.0
x 13% = 2184
The value of a company using EVA technique can be seen as the adjusted
capital employed plus the present value of future EVA discounted at the
WACC.
Strengths of EVA
It measures the value added to the organisation after deducting a charge for
the use of capital made by that organisation.
It is based on economic profit and economic value of capital employed, not
accounting profit and assets values which can be manipulated.
EVA may be consistent with the objective of maximising shareholder wealth.
It can easy be communicated to, and understood by, managers and
employees.
EVA can be used to assess performance by managers, and linked to
remuneration schemes that reward the creation of value to the organization
Problems of EVA
EVA is complicated and requires many adjustments to accounting information.
It does not capture all the value drivers, especially non-purchase goodwill.
EVA is normally historic. It does not help to decide future investments and
strategy. It is based on historical accounts which may be of limited use as a
guide to the future.
It usually relies on CAPM for the estimation of the weighted average cost of
capital. CAPM is based on restrictive assumptions and may not accurately
determine cost of capital.
INTELLECTUAL CAPITAL

Valuing intangible assets/intellectual capital
Valuing intangible assets, such as intellectual capital, is not an exact science but
several methods exist to estimate their value.
Market-to-book values
Compare the market value of the company to the book value of the assets. The
difference between the two should be equivalent to the value of the intangibles.
However, this method values the assets based on accounting policies and therefore
may no longer represent their true worth. A better alternative would be to value
the assets based on realisable value.
Calculated intangible value (CIV)
The CIV involves taking the excess return on intangible assets and uses this figure
as a basis to determine the proportion of return attributable to intangible assets.
The CIV can be calculated using the following steps:
1. Calculate average pre-tax earnings for a given period.
2. Calculate the average year-end tangible assets over the same given period
3. Divide average earnings by the average assets to get the return on assets
(ROA).
4. For the same given period find the industrys return on assets as average
earnings divided by average tangible asset.
5. Calculate the excess return. Multiply the industry-average ROA by the
companys average tangible assets; this shows what the average the company
would earn from that amount of tangible assets. Now subtract that from the
companys pre-tax earnings.
This figure shows how much more the company earns from its assets than the
industry average.
6. Calculate the given period average income tax rate and multiply this by the
excess return. Subtract the result from the excess return to show the after-
tax premium attributable to intangible assets.
7. Calculate the net present value (NPV) of the premium. This is done by
dividing the premium by an appropriate discount factor such as the companys
cost of capital. This is the CIV of the companys intangible assets the one
that does not appear on the balance sheet.


Example Emboss plc
The summarised financial information about Emboss plc for the last three years is
provided below:
Income statement for the years ended 31 March:
2009 2010 2011
millions millions millions
Revenue 125 137.5 149.9
Less cash operating cost 37.5 41.3 45
Depreciation 20 22 48
Pre-tax earnings 67.5 74.2 56.9
Taxation 20.25 22.26 17.07
Statement of financial position as at 31March:
2009 2010 2011
millions millions millions
Non-current asset 150 175 201
current assets 48 54 62
198 229 263

Share capital (1) 30 30 30
retained earnings 148 179 203
178 209 233
Current liabilities 20 20 30
198 229 263

Additional information:
(1) The average pre-tax return on total assets for the industry over three years
has been 15%.
(2) The estimated cost of equity capital for the industry is 10% after tax.
(3) The market price of Emboss plc share is 12 per share at 31 March 2011.
(4) The current replacement cost of a plant with a book value of 60 million is
estimated at 80 million.
Required:
Calculate the value of the company using the asset valuation method including
estimate of intellectual capital.
Solution to Emboss plc
Valuing intellectual capital/intangible assets
Based on the information in the question the following methods can be used to
value intellectual capital:
Market-to-book value method
millions
Market value at 31 March 2011 30 x 12 360
book value 31 March 2011 233
Value of intangible asset 127
Market-to-replacement cost method
millions
Market value at 31 March 2011 30 x 12 360
Replacement value 31 March 2011 233 -60 + 80 253
Value of intangible asset 107
Calculated intangible value (CIV) method
Average pre-tax earnings =
3
9 . 56 2 . 74 5 . 67 + +

= 66.2 million
Average tangible assets =
3
263 229 198 + +

= 230 million
Return on assets = % 100
230
2 . 66

= 28.8%
Return that an average company can earn from 230 tangible asset in the industry
would be = 15% x 230 = 34.5 million.
Premium attributable to intangible assets = 66.2 34.5 = 31.7 million
After tax premium = 31.7 x (1 -0.3) = 22.19
Net present value of premium (value of intellectual capital) = 22.19 x 1/0.1
= 221.9 million.

Example Destroying Value
The most recent published results for V plc are shown below.
m
20XX profit before tax 13.6

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

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

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

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

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

m
Required return (12% x 146.0m) 17.5 (weighted average cost of capital = 12%)
Adjusted profit 16.1
Value destroyed 1.4

The chairman of V plc has obtained a copy of the analysts report.
Required:
(a) Explain, as management accountant of V plc, in a report to your chairman, the
principles of the approach taken by the analyst. Comment on the treatment of
the specific adjustments to R & D, advertising, interest and borrowings and
goodwill.
(b) Having read your report, the chairman wishes to know which division or divisions
are destroying value, when the current internal statements show satisfactory
returns on investment (ROIs). The following summary statement is available.
Divisional performance, 20XX

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

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

Head office
expenses

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

Chapter 12
Corporate
reconstruction and
reorganisation

CHAPTER 12 CORPORATE RECONSTRUCTION AND REORGANISATION
CHAPTER CONTENTS
BUSINESS REORGANISATION ----------------------------------------- 199
UNBUNDLING 199
DIVESTMENT 199
SELL-OFFS 199
SPIN-OFFS/DEMERGERS 200
MANAGEMENT BUY-OUT (MBO) 200
MANAGEMENT BUY-IN 202
SHARE REPURCHASE 202
GOING PRIVATE 203
CAPITAL RECONSTRUCTION SCHEMES ------------------------------- 204

BUSINESS REORGANISATION

Unbundling
Unbundling is the process of selling off incidental non-core businesses to release
funds, reduce gearing, and allow management to concentrate on their chosen core
business.
The main forms of Unbundling are:
Divestment.
Demergers.
Sell-offs.
Spin-offs.
Management buy-outs.
Divestment
Divestment is a proportional or complete reduction in ownership stake in an
organisation. It is the withdrawal of investment in a business. This can be
achieved either by selling the whole business to a third party or by selling the
assets piecemeal.
Reasons for divestment
The principal motive for divestment will be if they either do not conform to
group or business unit strategy.
A company may decide to abandon a particular product/activity because it
fails to yield an adequate return.
Allowing management to concentrate on core business.
To raise more cash possibly to fund new acquisitions or to pay debts in order
to reduce gearing and financial risk.
The management lack the necessary skills for this business sector
Protection from takeover possibly by disposing of the reasons for the takeover
or producing sufficient cash to fight it effectively.
Sell-offs
A sell-off is a form of divestment involving the sale of part of an entity to a third
party, usually in return for cash. The most common reasons for a sell-off are:
To divest of less profitable and/or non-core business units.
To offset cash shortages.
The extreme form of sell-off is liquidation, where the owners of the company
voluntarily dissolve the business, sell-off the assets piecemeal, and distribute the
proceeds amongst themselves.
Spin-offs/demergers
This is where a new company is created and the shares in the new company are
owned by the shareholders of the original company which is making the distribution
of assets. There is no change in ownership of assets but the assets are transferred
to the new company. The result is to create two or more companies whereas
previously there was only one company. Each company now owns some of the
assets of the original company and the shareholders own the same proportion of
shares in the new company as in the original company.
An extreme form of spin-off is where the original company is split up into a number
of separate companies and the original company broken up and it ceases to exist.
This is commonly called demerger.
Demerger involves splitting a company into two or more separate parts of roughly
comparable size which are large enough to carry on independently after the split.
The main disadvantages of de-merger are:
Economies of scale may be lost, where the de-merged parts of the business
had operations in common to which economies of scale applied.
The ability to raise extra finance, especially debt finance, to support new
investments and expansion may be reduced.
Vulnerability to takeovers may be increased.
There will be lower revenue, profits and status than the group before the de-
merger.
Management buy-out (MBO)
A management buy-out is the purchase of a business from its owners by its
managers. For example, the directors of a company in a subsidiary company in a
group might buy the company from the holding company, with the intention of
running it as proprietors of a separate business entity.
Reasons for MBOs
MBOs may exist for several reasons including:
A parent company wishes to divest itself of a business that no longer fits in
with its corporate objectives and strategy.
A company/group may need to improve its liquidity. In such circumstances a
buy-out might be particularly attractive as it would normally be for cash.
A company may decide to abandon a particular product/activity because it
fails to yield an adequate return.
In administration a buy-out may be the managements only best alternative
to redundancy.
Advantages of MBOs to disposing company
To raise cash to improve liquidity.
If the subsidiary is loss-making, sale to the management will often be better
financially than liquidation and closure costs.
There is a known buyer.
Better publicity can be earned by preserving employers jobs rather than
closing the business down.
It is better for the existing management to acquire the company rather than it
possibly falling into enemy hands.
Advantages of buy-out to acquiring management
It preserves their jobs.
It offers them the prospects of significant equity participation in their
company.
It is quicker than starting a similar business from scratch.
They can carry out their own strategies, no longer having to seek approval
from the head office.
Problems of MBOs
Management may have little or no experience financial management and
financial accounting.
Difficulty in determining a fair price to be paid.
Maintaining continuity of relationships with suppliers and customers.
Accepting the board representation requirement that many sources of funding
may insist on.
Inadequate cash flow to finance the maintenance and replacement of assets.
Sources of finance for MBOs
Several institutions specialise in providing funds for MBOs. These include:
The clearing banks.
Pension funds and insurance companies.
Venture capital.
Government agencies and local authorities, for example Scottish Development
Agency.
Factors a supplier of finance will consider before lending
The purchase consideration. Is the purchase price right or high?
The level of financial commitment of the buy-out team.
The management experience and expertise of the buy-out team.
The stability of the businesss cash flows and the prospects for future growth.
The rate of technological change in the industry and the costs associated with
the changing technologies.
The level of actual and potential competition.
The likely time required for the business to achieve a stock market flotation,
(so as to provide an exit route for the venture capitalist).
Availability of security.
Conditions attached to provision of finance
Board representation for the venture capitalist.
Equity options.
A right to take a controlling equity stake and so replace the existing
management if the company fails to achieve specified performance targets.
Management buy-in
A management buy-ins occurs when a group of outside managers buys a controlling
stake in a business.
Share repurchase
Any limited company may, if authorised by it articles, purchase its own shares. The
Companies Act permits any company to purchase its own shares. Therefore if a
company has surplus cash and cannot think of any profitable use of that cash, it
can use that cash to purchase its own shares.
Share repurchase is an alternative to dividend policy where the company returns
cash to its shareholders by buying shares from the shareholders in order to reduce
the number of shares in issue.
Shares may be purchased either by:
Open market purchase the company buys the shares from the open market
at the current market price.
Individual arrangement with institutional investors.
Tender offer to all shareholders.
Reasons for share repurchase
Shares may be purchased in order to buy out dissident shareholders.
To adjust the gearing ratio towards an optimal capital structure.
Reduction in the size of the company. Where circumstances indicate a
permanent reduction in company size is desirable this can be achieved easily
with share repurchase and subsequent cancellation of the shares.
Purchase of own shares may be used to take a company out of the public
market and back into private ownership.
Purchase of own shares provide an efficient means of returning surplus cash
to the shareholders.
It enables companies to reduce total dividend payments whiles maintaining or
increasing the level of dividend to individual shareholders. This may mean
more earnings available for capital investment which leads to growth.
Purchase of own shares increases earning per share and return on capital
employed.
To increase the share price by creating artificial demand.
Problems of share repurchase
Lack of new ideas. Shares repurchase may be interpreted as a sign that the
company has no new ideas for future investment strategy. This may cause
the share price to fall.
Costs. Compared with a one-off dividend payment, share repurchase will
require more time and transaction costs to arrange.
Resolution. Shareholders have to pass a resolution and it may be difficult to
obtain their consent.
Gearing. If the equity base is reduced because of share repurchase, gearing
may increase and financial risk may increase.
Going private
A public company may occasionally give up its stock market quotation and return
itself to the status of a private company.
The reasons for such move are varied, but are generally linked to the
disadvantages of being in the stock market and the inability of the company to
obtain the supposed benefits of a stock market quotation.
Other reasons are:
To avoid the possibility of takeover by another company.
Savings of annual listing costs.
To avoid detailed regulations associated with being a listed company.
Where the stock market undervalues the companys shares.
Protection from volatility in share price with its financial problems.
CAPITAL RECONSTRUCTION SCHEMES
A capital reconstruction scheme is a scheme whereby a company reorganises its
capital structure by changing the rights of its shareholders and possibly the
creditors. This can occur in a number of circumstances, the most common being
when a company is in financial difficulties, but also when a company is seeking
floatation or being acquired.
Financial difficulties
If a company is in financial difficulties it may have no recourse but to accept
liquidation as the final outcome.
Typical financial difficulties
Large accumulated losses.
Large arrears of dividends on cumulative preference shares.
Large arrears of debenture interest.
No payment of ordinary dividend.
Market share price below nominal value.
However, it may be in position to survive, and indeed flourish, by taking up some
future contract or opening in the market. The only major problem is the cash
needed to finance such operations because the present structure of the company
will not be attractive to outside investors. To get cash the company will need to
reorganise or reconstruct.
Possible reconstruction
The changing or reconstruction of the companys capital could solve these
problems. The company can take any or all of the following steps:
write off the accumulated losses.
write of the debenture interest and preference share dividend arrears.
write down the nominal value of the shares.
To do this the company must ask all or some of its existing stakeholders to
surrender existing rights and amount owing in exchange for new rights under a new
or reformed company.
The question is why would the stakeholder be willing to do this? The answer to
this is that it may be preferable to the alternatives which are:
to accept whatever return they could be given in a liquidation;
to remain as they are with the prospect of no return from their investment
and no growth in their investment.
Generally, stakeholders may be willing to give up their existing rights and amounts
owing (which are unlikely to be met) for the opportunity to share in the growth in
profits which may arise from the extra cash which can be generated as a
consequence of their actions.
General guidelines in reconstruction
For a reconstruction to be successful the following principles are to be followed:
1. Creditors must be better off under reconstruction than under liquidation. If
this is not the case they will not accept the reconstruction as their agreement
is a requirement for the scheme to take place.
2. The company must have a good chance of being financially viable and
profitable after the reconstruction.
3. The reconstruction scheme must be fair to all the parties involved, for
example preference shareholders should have preferential treatment over
ordinary shareholders.
4. Adequate finance is provided for the companys needs.
In solving reconstruction questions the following steps can be followed:
1. State the above principles of reconstruction.
2. Check what each party will get if the company were to go on liquidation. This
can be done by adding up the break-up values of the assets.
Note the sequence of creditor priorities as followings:
taxes and unpaid wages
secured debts, including unpaid interest fixed charge
secured debt floating charge
unsecured creditors
preference shareholders including unpaid dividend
ordinary shareholders.
3. Check the sufficiency of the amount of finance that will be raised from the
scheme. This includes proceeds from the sale of investment, existing assets
when new assets are to be bought to replace them, and reduction in working
capital.
4. Check if the parties will be better off under the proposed scheme than under
liquidation. Assess the fairness of the scheme.
5. Assess the post-reconstruction financial viability and profitability of the
company by calculating post-reconstruction EPS and P/E ratio.
6. Come to a conclusion.

Example Jenkins plc
Jenkins plc has been suffering from adverse trading conditions largely due to the
effect of obsolescence on its products. This has resulted in losses in each of the
last five years. The companys bankers have refused to extend the present
overdraft facility and creditors are pressing for payment.
The directors feel that a new product recently developed by the company will make
the company profitable in the future, but they are worried that a winding-up order
may be made before this can be achieved.
They have therefore asked you to suggest a scheme of capital reduction that would
be acceptable to both the court and creditors and to advise them as to what action
should be taken to enable the company to continue trading.
The following is the present balance sheet of the company:

Book
values

Present
going
concern
values

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

Called up share capital
7% cumulative preference shares (1)
fully paid (dividends are three years in
arrears)
50,000
Ordinary shares of 50p each fully paid 200,000
250,000
Share premium account 60,000
Profit and loss account reserve (229,000)
81,000

Solution to Jenkins plc
Explanation
The first step is to estimate the losses to be suffered by preference shareholders on
a liquidation.
For example, on liquidation the following position may arise
Proceeds

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

Secured mortgage 60,000
Overdraft 31,000
Trade creditors 118,000
209,000
This leaves 8,000 for the shareholders. This will go to the preference
shareholders in priority to the ordinary shareholders. Therefore, the loss suffered
by the preference shareholders is (50,000 8,000), ie 42,000. The loss
allocated to them under the scheme must be less than this.
You ascertain the following:
1. Scheme costs are estimated at 4,800.
2. Preference shares rank in priority to ordinary shares in the event of winding-
up.
3. The bank has indicated that it would advance a loan of up to 50,000
provided that the overdraft is cleared and a second mortgage on the freehold
is given.
4. To ensure speedy manufacture of the new product it would be necessary to
expend 20,000 on new plant and 15,000 on increasing stocks.
5. The creditors figure of 118,000 includes 19,000 that would be preferential
in a liquidation.
Required:
(a) Suggest a scheme of capital reduction and write up the capital reduction
account.
(b) Outline your suggestions as to the action that should be taken by the
directors.
(c) Show the balance sheet after implementing your suggestions.
Ignore taxation.
Memorandum to the board
(a) Scheme of capital reduction
The objective of such a scheme is to write down the capital of the company so that
it realistically reflects the present values of the assets (on a going concern basis).
The major part of the loss should be borne by the ordinary shareholders although
the preference shareholders should bear a part of the loss where it is unlikely that
they would receive all their capital in a winding-up. A corresponding increase in the
rate of preference dividend is sometimes given as compensation. The reduced
capital of the company will ensure that it is possible to pay dividends when the
company achieves profitability.
Where arrears of cumulative preference dividends have accrued, it is usual to
compensate preference shareholders by issuing reduced ordinary shares in part
satisfaction of such arrears.
Explanation
Draw up a pro forma balance sheet after the scheme, and capital reduction
account; post through the opening position (writing off all goodwill and
accumulated losses); then adjust the assets to going concern values posting the
double entry as you work through.
Remember to post through the scheme costs and compensation in new shares to
the preference shareholders; then write down the ordinary and preference shares
to a round sum amount to cover the overall loss. The loss written off to the
preference shareholders may not exceed 42,000 and ideally should be less than
that.
Capital reduction account

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

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

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

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

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

Chapter 13
Corporate dividend
policy

CHAPTER 13 CORPORATE DIVIDEND POLICY
CHAPTER CONTENTS
DIVIDEND IRRELEVANCE HYPOTHESIS ------------------------------ 213
DIVIDENDS IN AN IMPERFECT MARKET ----------------------------- 214
POSSIBLE APPROACHES TO DIVIDEND POLICY --------------------- 215
ALTERNATIVES TO A CASH DIVIDEND ------------------------------- 216

DIVIDEND IRRELEVANCE HYPOTHESIS

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

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

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

Ke =
( ) p 70 p 420
p 70
=
p 350
p 70
= 20%
(i) Financed by retained earnings
Here the valuation model incorporating a new project can be used ie
New Price =
capital equity of t cos
increase future dividend existing +

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

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

Retained
Earnings
Rights
Issue
New
Issue

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

0.25

Paid for rights issue
10
50 . 2

0.25

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


Chapter 14
Management of
international trade
and finance

CHAPTER 14 MANAGEMENT OF INTERNATIONAL TRADE AND FINANCE
CHAPTER CONTENTS
INTERNATIONAL TRADE ----------------------------------------------- 223
FREE TRADE AND PROTECTIONISM 223
TRADE BLOCKS 223
GATT AND THE WORLD TRADE ORGANISATION (WTO) 224
MULTINATIONAL COMPANIES (MNCS) 224
THE BALANCE OF PAYMENTS 224
THE INTERNATIONAL FINANCIAL INSTITUTIONS 225
THE EUROMARKETS 225
THE GLOBAL DEBT PROBLEM 226
RISKS OF FOREIGN TRADE 226
SOURCES OF FINANCE FOR FOREIGN TRADE 227
COUNTERTRADE 228
ARTICLE FROM STUDENTS NEWSLETTER ---------------------------- 229

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

UK external assets and liabilities: net transactions 2
Balancing item 8
10
N.B. The statistics that are gathered are not wholly perfect and some transactions
will be omitted. Thus the balancing item is unavoidable.
Temporary deficits can be financed by short term borrowing, but persistent balance
of payments deficits usually require government intervention, such as:
Devaluation of the currency or government intervention on the foreign
exchange markets.
Raising interest rates.
Restricting the money supply.
Imposing tariffs or import quotas.
The international financial institutions
International Monetary Fund (IMF)
Founded in Bretton Woods, New Hampshire in 1944 with the aim of promoting
world trade and maintaining global monetary stability. Assists countries with
balance of payments problems by making loans in the form of Special Drawing
Rights.
Such loans are normally dependent upon the country concerned making strict
internal financial adjustments to solve their economic problems.
The International Bank for Reconstruction and Development
(IBRD)
Popularly known as the World Bank, it was also created at Bretton Woods in 1944,
with the aim of financing the reconstruction of Europe after the Second World War.
The World Bank is now an important source of long-term low interest funds for
developing countries.
The Bank for International Settlements (BIS)
Established in Basle, Switzerland in 1930, it acts as a supervisory body for central
banks assisting them in the investment of monetary assets. It acts as a trustee for
the IMF in loans to developing countries and provides bridging finance for members
pending their securing longer term finance for balance of payments deficits.
The Euromarkets
The Euromarkets refer to transactions between banks and depositors/borrowers of
Eurocurrency.
Eurocurrency refers to a currency held on deposit outside the country of its
origin eg Eurodollars are $US held in a bank account outside the USA.
Eurocurrency loans are bank loans made to a company, denominated in a
currency of a country other than that in which they are based. The term of
these loans can vary from overnight to the medium term.
Eurobonds are bonds issued (for 3 to 20 years) simultaneously in more than
one country. They usually involve a syndicate of international banks and are
denominated in a currency other than the national currency of the issuer.
Interest is paid gross.
Euronotes are issued by companies on the Eurobond market. Companies
issue short-term unsecured notes promising to pay the holder of the Euronote
a fixed sum of money on a specified date or range of dates in the future.
Euroequity market refers to the international equity market where shares in
US or Japanese companies are placed on as overseas stock exchange (eg
London or Paris). These have had only limited success, probably due to the
absence of a effective secondary market reducing their liquidity.
The global debt problem
This problem arose following the oil price increases in the 1970s, when the OPEC
countries invested their large surpluses with banks in the western world. The
banks then lent substantial sums to the less developed countries (LDCs) believing
the default risk to be low. The oil price rises fuelled inflation and interest rates
increased, forcing most of the worlds economies into recession.
High interest rates and reduced exports placed LDCs in a situation where they could
no longer pay interest or repay loans. These problems made economic conditions
in many LDCs extremely difficult, affecting the position of multinationals and
making international banks less willing to lend.
Methods of dealing with such excessive debt burdens have been:
A programme of debt write-offs by banks and other lenders.
Rescheduling existing debt repayments.
Re-selling debt at a discount to recoup capital.
Provision of additional loans where the debt problem is regarded as
temporary.
Drastic changes in the economic policies of the LDC imposed and monitored
by the IMF.
Risks of foreign trade
Importing from and exporting to foreign countries includes the following categories
of risk:
Currency risk sometimes referred to as exchange rate risk. It involves the
possibility of financial gains or losses arising out of unpredictable changes in
exchange rates. It can be classified into:
o Translation risk the gains or losses to be reported when overseas
operations are consolidated into group accounts in accordance with
SSAP 20/UITF 9, or IAS 21 and 29, or FRS 23 and 24.
o Economic risk the possibility that the value of the overseas entity
(based upon the PV of all future cash flows) will change due to
unexpected exchange rate movements arising at sometime in the future.
o Transaction risk the gains or losses that are made when ultimate
settlement occurs at a date when the exchange rate differs from the rate
prevailing at the date of the original transaction. This is seen as the
short-term manifestation of economic risk. It is this category of foreign
currency risk, which is particularly relevant to this syllabus.
Political risk the possibility of the financial success of a venture being
affected by the actions of an overseas government or population.
Government agencies can advise on potential risks.
Physical risk the likelihood of damage or theft arising from the physical
distances involved and the length of time between despatch and receipt of the
goods by the customer. Normal commercial insurance is, of course, available.
Credit risk this is the risk of non-payment for the goods/services involved in
an export transaction. Insurance cover for up to 180 days can be provided by
NCM UK; for longer periods the ECGD may provide this service. Private sector
companies such as Trade Indemnity plc provide similar services.
Trade risk the overseas customer may refuse to accept the goods and be
uncooperative in returning them, thus taking advantage of the long physical
distances involved.
Liquidity risk this is caused by the duration of the delivery period and the
lengthy periods of credit expected by some overseas customers.
Cultural risk there may be misunderstandings caused by differences in trade
practice, religious and moral attitudes, legal systems and language barriers.
Sources of finance for foreign trade
Bank overdrafts either in sterling or in the overseas currency.
Bills of exchange a negotiable instrument drafted by the exporter (the
drawer), accepted by the importer (the drawee) who thereby agrees to pay
for the goods/services either immediately or more commonly after a specified
period of credit. If the importer accepts the bill it is known as a trade bill,
whereas if the importer arranges for its bank to accept the bill, it becomes a
less risky bank bill.
Where payment will be made after the specified period of credit, the exporter
can sell the bill at a discount to its face value and receive the cash
immediately. If the bill is dishonoured the exporter can seek legal remedies
in the country of the importer.
Promissory notes similar, but less common than bills of exchange, since
they cannot usually be discounted prior to maturity.
Documentary letters of credit the importer obtains a Letter of Credit from its
bank, which guarantees payment to the exporter via a trade bill. Though slow
to arrange, this method is virtually risk free provided the exporter presents
specified error free documents (eg shipping documents, certificates of origin
and a fully detailed invoice) within a specified time period. The high bank fees
for this procedure are normally borne by the importer, and the DLC is
normally reserved for expensive goods only.
Factoring the factoring company (often the subsidiary of a bank) assumes
the responsibility for collecting the trade debts of another in this case an
exporter. The factor may provide a range of services (eg providing advances,
administering the sales ledger, credit insurance etc) for an additional fee.
Widely regarded as a useful means of obtaining trade finance and collecting of
debts for small or medium sized exporters. However the exporter must
always bear in mind the eventual consequences of dispensing with the
services of the factor and undertaking the running of the sales ledger and
cash collection activities itself.
Forfaiting a medium term source of finance whereby a domestic bank will
discount a series of medium term bills of exchange, which have normally been
guaranteed by the importers bank. The forfaiting bank normally forgoes the
right of recourse to the exporter if the bill is dishonoured. The exporter
obtains the benefit of immediate funds, but the bank charges are expensive.
Forfaiting is normally used for the export of capital goods, where the importer
pays in a series of instalments over a period of years.
Leasing and hire purchase the exporter sells capital goods to a lessor, which
in turn enters into a leasing agreement with the exporters overseas
customer. Alternatively the equipment can be sold to a hire purchase
company which resells to the importer under a HP agreement.
Acceptance credits a large reputable exporter can arrange for its bank to
accept bills of exchange (which are related to its export activities) on a
continuing basis. These bills can then be discounted at an effective cost,
which is lower than the bank overdraft interest rate.
Produce loans where an importer acquires commodities for the purpose of
immediate resale, it can raise a loan from its bank, which takes custody of the
goods until the importer is able to sell them. Thereafter the principal sum,
interest and storage costs are repaid to the bank out of the proceeds of the
sale.
Requesting payment in advance from the importer if this were possible it
would avoid all of the above complications.
Countertrade
This is an agreement in which the export of goods to a country is matched by a
commitment to import goods from that country. This usually occurs because the
foreign importing country either lacks foreign currency, has exchange controls in
place or where there are barriers to imports which can be circumvented by means
of countertrade.
The volume of countertrade is now reported at about 30% of total international
trade. In the case of some Eastern European and Third World countries it is the
only way of organising international trade because of their shortage of foreign
currency. Many countertrade deals can be highly complex involving many parties.
ARTICLE FROM STUDENTS NEWSLETTER
This is a slightly updated version of an article, which appeared in the November
1999 edition of Students Newsletter. The article was not originally intended for
Paper 3.7 or Paper P4 students, but it provides a useful insight into the introduction
of the Euro. You are therefore asked not to learn the contents of this article in
detail, but to gain an overall insight into the features of the single European
currency and the arguments in favour and against the entry of the UK into the
European Monetary Union. The author, John OToole, is a lecturer at Griffith
College, Dublin.
EUROPEAN MONETARY UNION AND THE SINGLE EUROPEAN CURRENCY
In 1998, the Heads of State or Government of the European Union (EU) Member
States confirmed that 12 Member States qualified to form Economic and Monetary
Union (EMU) and adopt the single currency, the euro, from 1 January 1999. The
twelve original member states of the Eurozone were Austria, Belgium, Finland,
France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and
Spain. On 31 December 1998 the Council of Economic and Finance Ministers
irrevocably fixed the conversion rates to apply between the currencies of these
Member States and the euro, and on 1 January 1999 the euro came into being.
The United Kingdom and Denmark exercised their Treaty opt-outs from EMU and
Sweden deliberately failed to fulfil all the criteria for entry and was therefore
rejected by the Commission.
Slovenia also joined the Eurozone on 1 January 2007, followed by Malta and Cyprus
on 1 January 2008. In addition, three European microstates (Vatican City, Monaco,
and San Marino), although not EU members, have adopted the euro via currency
unions with member states. Andorra, Montenegro, Kosovo, and Akrotiri and
Dhekelia have adopted the euro unilaterally despite not being EU members.
Ten relatively new EU member states are required by their Accession Treaties to
join the Eurozone, on 1 January of the following years:
Slovakia in 2009; Lithuania in 2010; Estonia in 2011; Bulgaria, Czech
Republic, Hungary, Latvia and Poland in 2012; Croatia in 2013; and finally
Romania in 2014.
The formation of EMU and the creation of the euro were the culmination of a
process of preparation which had been going on since the signing in 1992 of the
Treaty on European Union (the Maastricht Treaty). EMU is one of the most far-
reaching steps in the history of the European enterprise.
Internally, the single currency was intended contribute to a greater sense of
common purpose and common endeavour among the peoples of the European
Union; externally it is intended to strengthen the Unions ability to play a role in the
world commensurate with its economic and political importance.
The European Monetary System (EMS)
To understand why this single currency was set up it is necessary to look at the
previous arrangements.
The idea of a single currency in Europe is not new. It goes back at least to 1970.
While its fortunes have varied since, the then European Community never lost sight
of it as a goal. The European Monetary System (EMS) and its Exchange Rate
Mechanism (ERM), which were set up in 1979, were intended to move towards
monetary union. The Single Market programme of the late 1980s gave fresh
impetus to it.
In April 1978 at a meeting of the European Heads of State the German Chancellor
Schmidt and the French President, Giscard dEstaing, proposed the creation of a
European Monetary System (EMS) with the purpose of creating a zone of monetary
stability in Europe. In March 1979 the EMS commenced operations in the hope that
closer monetary co-operation between member states would lead to monetary
stability and economic growth. The EMS utilised a system of quasi-fixed exchange
rates, known as the Exchange Rate Mechanism (ERM), and had as its unit of
account the European Currency Unit (ECU). The value of the ECU was the weighted
average of a basket of national currencies with the weight allocated to each
currency being determined by that countrys GNP and intra-EC trade.
Those countries which were members of the ERM declared a central exchange value
for their currency and the majority of currencies agreed to fluctuate within a band
2.25% of this central value. This meant that the Central Bank of each participating
currency was committed to intervening, when necessary, in order to maintain their
exchange rate within the specified band. This was done by buying their own
currency when it was weak and selling their currency when it was strong. The UK,
although a member of the EMS since its inception, did not join the ERM until
October 1990.
The rules of the EMS allowed governments to realign the central value of their
exchange rate if changing circumstances showed it to be no longer appropriate. In
the early part of the EMS from 1979 to 1983 there were a number of realignments.
However, from 1987 the system became very rigid and there was only one
realignment from 1987 the lira was realigned in January 1990 until the currency
crisis in 1992.
The currency crisis
Speculators interpreted a number of developments in the world economy during
1992 as being attributable to fundamental weaknesses within currency markets.
This perception stimulated a period of intense speculative pressure which caused a
currency crisis.
German unification was a principal cause of the currency crisis. It is difficult to
imagine a bigger shock to the fixed parities of the ERM than the absorption of the
then East Germany into the European economy. Demand for consumer goods
soared, pushing up inflation. The governments budget expanded adding to the
Bundesbanks (German Central Bank) alarm. Very low, short-term American
interest rates caused huge surges of money from the US into Germany, further
fuelling German inflation rates. The Bundesbank reacted by pushing up German
interest rates. These high German interest rates occurred just when the rest of
Europe needed the rates to be low. The German mark was the anchor currency of
the ERM, so no European country could hold its interest rates below those in
Germany. When interest rates in Germany were increased all other EMS countries
followed suit.
Other causes of the currency crisis were the lack of realignments with the EMS, so
that its exchange rates had become increasingly rigid and out of touch with
international developments. Furthermore, the necessary behind the scenes macro-
economic co-ordination was not taking place as EU Member States publicly bickered
over interest rate policy. The existence of widespread unemployment as economic
recession threw millions out of work intensified these tensions.
The straw that broke the camels back was 2 June 1992 when the Danish people
rejected the Maastricht Treaty in a referendum. The Danish rejection by 50.7% to
49.3% cast immediate doubt over the whole process of economic and monetary
union. Under EU law, the Danish failure to ratify the Maastricht Treaty made the
treaty null and void. As there had been no realignments within the ERM since
January 1987, the money markets had assumed that the European Unions political
commitment to EMU meant that the parties were virtually fixed. Doubts over
Maastricht destroyed this assumption. Almost immediately the weaker currencies
came under selling pressure.
The pressure resulted in the devaluation of the Finnish mark, the Spanish peseta,
the Irish punt, the Portuguese escudo and the Swedish krona, in addition to forcing
the UK and Italy to leave the ERM in September 1992. In August 1993, further
speculative pressure against the French franc and the Danish krone led to a
decision to widen fluctuation bands within the ERM to 15%. This action
effectively ended the currency crisis.
These events strengthened the political resolve in Europe to introduce Economic
and Monetary Union and the single currency.
The Maastricht Treaty
The Treaty on European Union was signed at the Dutch town of Maastricht in
February 1992. This Treaty became known as the Maastricht Treaty. The
centrepiece of the Maastricht Treaty was the decision to set up a single European
currency.
A single European currency meant that all the participating countries would use the
same currency. The new currency was called the euro. It is divided into one
hundred cents.
An essential aspect of a single European currency is the close co-ordination of
economic policies between Member States of the European Union. Economic and
Monetary Union means that the currencies of the member states are locked
irrevocably to one another at the same exchange rate. (Irrevocably means that
these exchange rates cannot be changed afterwards). The EMU depends on a
similar level of development of the economies of the countries which are members.
In order to ensure that the economies of the countries concerned are at similar
levels of development five convergence criteria were developed. These
convergence criteria are economic indicators of the strength of each economy.
Economic and Monetary Union involves:
an internal market with free movement of persons, goods, services and
capital;
the irreversible locking of exchange rates;
a single currency among participating Member States;
EU management of macro-economic policy with intensified co-ordination of
the economic and budgetary policies of participating countries;
EU management of market-regulating policies, for example, competition
policy, to ensure every country plays by the same rules;
a European Central Bank in Frankfurt deciding European monetary policy.
The Stability and Growth Pact is part of the arrangements agreed by those
countries which are part of the EMU. The pact requires Member States in the EMU
to commit themselves to aim for a medium-term budgetary position of close to
balance or in surplus. As part of the process of ensuring that the euro is as stable
as possible, the Stability and Growth Pact is aimed at minimising internal fiscal
imbalances in the short term. The rationale underlying the pact is that in
favourable economic times, Member States should so manage their budgets as to
ensure that they can, over the course of a normal economic cycle, reliably keep
under the 3% ceiling on budget deficits set out in the Treaty. The pact allows for
exceptional circumstances when deficits can exceed 3% of GDP. It provides for
penalties and fines of up to 0.5% of GDP if deficits persist.
The five Maastricht criteria
These criteria are measures of the economy of each country across a number of
headings:
Inflation
The level of inflation must be within 1.5% of the average of the three lowest
inflation countries in the system.
Government borrowing
The amount of Government borrowing is an important measure of the strength of
the economy. The amount of this borrowing as a percentage of the Gross Domestic
Product must be below 60% or making progress towards 60%.
Interest rates
States are permitted a maximum of 2% points above the average of the three
lowest inflation countries.
Budget deficit
This is the toughest and politically most sensitive criterion involving tax policy and
overall debt. Member states must keep their government budget deficit within 3%
of Gross Domestic Product.
Exchange rates
The fifth and final criterion for joining the EMU covers exchange rates. Countries
must carefully manage their exchange rate and must not have unilaterally devalued
their currency within two years.
The timetable to EMU
The timetable to Economic and Monetary Union was decided by European leaders.
On 1 January 1999 the new European currency, the euro, came into being. From
this date there was be no change in the exchange rates of the member countries.
Euro notes and coins were introduced into circulation on 1 January 2002. Dual
circulation of the euro and the legacy currencies of each country continued for a
short period of time. Thereafter participating countries have only used euro notes
and coins.
The arguments in favour of EMU
Transparency
The strongest argument in favour of a single European currency is transparency
prices of goods in the shops will be in the same currency and this will allow people
to compare prices between euro countries.
Foreign exchange costs
Another advantage is that bank commission charges will no longer be levied on
transactions between the currencies of member states. Economists call these
transaction costs. The EU Commission has estimated that there will be savings of
0.25% of GDP on transaction costs which will improve conditions for trade within
the EU and make EU industry more competitive on world markets. The elimination
of these transaction costs will help also tourism and investment among participating
Member States.
Stability in global trade
The introduction of a single currency will help eliminate exchange rate uncertainty
and currency fluctuations within Europe and with other countries. This will increase
trade among members of the Union and globally. This is because currency
movements can inhibit business people from expanding their sales in other
countries.
Political union
Economic and monetary union is an important step towards closer European
integration.
Interest rates
Interest rates will be lower and fairly uniform in participating countries within the
EMU, and this will reduce costs for government and business.
Price stability
With prices, margins and profits coming under competitive pressure as a result of
the introduction of the single currency, inflation rates will tend to move towards
lower levels under the EMU.
Economic growth and stability
Economic growth will be increased by entering the EMU and there will be increased
attractiveness of participating Member States to foreign investment.
The EMU makes it necessary that Governments act very responsibly as regards tax
and spending.
Fragmentation of Europe
If a country refuses to join, it may be isolated and risk becoming excluded from
important decisions that will apply to it in any event.
Global currency
The euro is emerging as a significant international reserve currency.
The level playing field
The discipline of a single currency prevents individual countries depreciating their
currency to steal competitive advantages over each other. Without a single
currency, there would always be a temptation for some countries to devalue, which
undermines a single market.
The arguments against EMU
Loss of control over economic policy
The most important argument against the EMU is the loss of economic sovereignty.
Countries are no longer able to pursue their own independent economic policies.
This is particularly important in the area of exchange rates. With independent
monetary policies the countries with weaker economies were able to devalue their
currencies. With the EMU, devaluation will not be possible for any reason.
European monetary policy will now be decided by the European Central Bank in
Frankfurt, Germany.
Less flexibility
A disadvantage of joining the EMU would be that countries would have less
flexibility in their economic policies. Under the Stability and Growth Pact countries
will have less economic flexibility.
Loss of national pride
Many countries, like Britain, are proud of their currencies as a symbol of economic
success and national cohesion.
Price increases
Some firms might use the transition to the euro to disguise price increases.
The weak currencies
Those in favour of the EMU make much of the benefits of being tied to Europes
stronger currencies. There would be powerful pressures on members to bail out
economies that borrow too much. This could be very costly.
Regional disparities
Another disadvantage of the EMU is that it may contribute to greater regional
disparities, especially for more peripheral regions. There may be a tendency for
economic activity to move towards the core of Europe, the golden triangle between
Paris, Hamburg and Rome.
Loss of foreign exchange earnings
A disadvantage of the EMU is the loss of money to the banks for the purchase and
sale of foreign exchange.
One way Street
The EMU sets EU member states on an inevitable track to a federal Europe.
Effectively, once a country signs up it loses control of economic policy. As a result,
national parliaments would be no more than regional town halls within Europe, with
effectively little more power than local government.
Changeover costs
The changeover to the euro involves transition costs for business, public
administrations and financial institutions.
The position of the UK
In a speech in July 1997, the UK Chancellor of the Exchequer specified five
economic tests of the UKs suitability for EMU membership. The five economic tests
are:
1 Are business cycles and economic structures compatible, so that the UK and
others could live comfortably with euro interest rates on a permanent basis?
2 If problems emerge, is there sufficient flexibility to deal with them?
3 Would joining the EMU create better conditions for firms making long-term
decisions to invest in Britain?
4 What impact would entry into the EMU have on the competitive position of the
UKs financial services industry, particularly the Citys wholesale markets?
5 Will joining the EMU promote higher growth, stability and a lasting increase in
jobs?
In his statement on the EMU to the House of Commons on 27 October 1997, the
Chancellor assessed these five economic tests. His analysis was based on a UK
Treasury paper published on that date. This concluded that a successful EMU would
bring benefits for the UK economy by securing macro-economic stability and
underpinning a well-functioning single market. This in turn would be good for
investment, growth and employment in the UK economy.
However, reflecting the cyclical divergences between the UK and continental
European economies at this time, the Chancellor concluded it would not be right for
the UK to join the EMU from the outset.
On 23 February 1999 the UK Prime Minister, in a statement to the House of
Commons, launched an Outline National Changeover Plan. In his statement he
indicated that Britains intention is that it should join a successful single currency
provided that the five conditions are met. The plan indicated that making a
decision to join the single currency at that time was not realistic but that, should
the economic tests be met, this could be decided at some future time.
Conclusion
The global economic environment is changing fast. This process will continue, and
would continue if the EMU had never been thought of. It involves greater
globalisation of activity, increasing intensification of competition among all the
countries of the world and increasing technological change.
The formation of the EMU marked a substantial change in the economic
environment of the European Union as a whole. This is true for all Member States,
and it is true whether or not they have joined the EMU. Continuation of the status
quo is not an option for any Member State, whether it has joined the EMU or not.
Appendix One: International Financial Institutions
The European Central Bank
A European Central Bank (ECB) to operate the single monetary policy of the euro
was set up on 1 June, 1998. The European System of Central Banks (ESCB) is
comprised of the ECB and the central banks of the Member States. The primary
objective of the ESCB is to maintain price stability. Without prejudice to this
objective, the ESCB supports the general economic policies of the EU with a view to
contributing to the achievement of EU objectives. Briefly, these are to promote
sustainable and non-inflationary growth, a high level of employment and social
protection, economic and social cohesion and solidarity among the Member States.
The basic tasks of the ESCB are to:
decide and implement the monetary policy of the EU;
conduct foreign exchange operations;
hold and manage the official external reserves of the Member States; and
promote the smooth operation of payment systems
The Maastricht Treaty provides for the strict independence and accountability of the
ECB.
The International Monetary Fund the IMF
The IMF is a specialised agency within the UN system. It had its origins in the
desire of members of the international community to avoid unemployment and
economic recession. It is the central institution in the international monetary
system and its aims are:
to promote international monetary co-operation and to allow the expansion of
international trade
to provide financial support to countries with temporary balance of payments
deficits
to provide for the orderly growth of international liquidity.
The World Bank
The World Bank (the International Bank for Reconstruction and Development ie the
IBRD) assists the economic development of countries by making loans available.
These loans are used to build up the educational system, through new schools, and
the health system, through new hospitals. This helps to reduce poverty in the
developing countries. In recent years the World Bank has increasingly emphasised
environmental protection in its work.

Chapter 15
Hedging foreign
exchange risk

CHAPTER 15 HEDGING FOREIGN EXCHANGE RISK
CHAPTER CONTENTS
EXCHANGE RATES ------------------------------------------------------ 239
VARIABLE AND BASE CURRENCY 239
BID AND OFFER PRICES 239
SPOT AND FORWARD RATES 239
OUTRIGHT QUOTATION 240
POINT QUOTATION 240
CROSS RATES 240
RISK AND FOREIGN EXCHANGE --------------------------------------- 242
TRANSACTION EXPOSURE 242
TRANSLATION EXPOSURE 242
ECONOMIC EXPOSURE 242
RELATIVE IMPORTANCE OF THE DIFFERENT TYPES OF EXPOSURES 243
PROTECTION AGAINST ECONOMIC EXPOSURE ---------------------- 244
FACTORS TO CONSIDER BEFORE DECIDING TO PROTECT TRANSACTION EXPOSURE 244
PROTECTION AGAINST TRANSACTION EXPOSURE ----------------- 245
INTERNAL HEDGING TECHNIQUES 245
EXTERNAL HEDGING TECHNIQUES 247
INTEREST RATE PARITY THEORY (IRPT) 252

EXCHANGE RATES
An exchange rate is the rate at which one countrys currency can be traded in
exchange for another countrys currency.
Variable and base currency
Exchange rate is quoted as the number of one currency for one of another
currency. The base currency is the currency expressed as one and the variable
currency is the currency expressed as the number of a currency for the base
currency.
Example 1
Consider the following exchange rate quotation:
$/
1.500
This means $1.500 dollars is equal to 1. The dollar is the variable currency and
the pound is the base currency.
Bid and offer prices
Bid
A bid is the rate at which the dealer is willing to buy the foreign currency (base
currency) from a customer by paying in home currency (variable currency).
Offer or ask price
It is the rate the dealer will sell the foreign currency (base currency) and buying the
home currency (variable currency).
Spread
The spread is the difference between the bid price and the offer price. The offer
price is slightly higher than the bid price and the difference (spread) exist to
compensate the dealer for holding the risky foreign currency and for providing the
services of converting currencies.
Spot and forward rates
Spot rate is the price at which foreign exchange can be bought or sold today with
payment made within two business days. It is simply the rate of buying or selling
for immediate settlement.
Forward rate is the rate quoted today for delivery at a fixed future date of specified
amount of one currency against another currency. It is simply the buying or selling
now, but settlement at an agreed future date. Note that the agreed future date
could be one month, two, three, six months up to one year, although two years
contract can exist in some currencies like sterling and dollar.
Outright quotation
Outright quotation means that the full price to all of its decimal point is given.
Example 2
Bid Offer
Spot rate 1.6878 1.7694
One month forward rate 1.6078 1.7574
Here both the spot and forward bid/offer are given in the full decimal places.
Point quotation
A point quotation is the number of points away from the outright spot rate with the
first number referring to points away from the spot bid and second number to
points away from the spot offer price.
Whether the point quotation is subtracted or added to the spot rate is explained by
premium or discount on the exchange rate movements.
Subtract premium from the spot rate and add discount to the spot rate.
Example 3
Bid Offer
Spot rate 1.4432 1.4442
One month forward rate (premium) 58 56
Solution 3
58 56 is the point quotation, hence the forward rate is
Spot rate 1.4432 1.4442
Point -0.0058 -0.0056

One month forward rate 1.4374 1.4386
Cross rates
A cross rate is the computation of an exchange rate for a currency from the
exchange rates of two other currencies. In other words it is the exchange rate
between two currencies determined by their common relationships to a third
currency.
Example 4
If
Y1 = $0.55
1 = $1.60
Required:
What is the price of the pound in Yen?
Solution
If $0.55 = Y1
$1.60 = x
X = (1.6 x 1) / 0.55 = Y2.91
Hence Y2.91 = 1.
Example 5
Consider the following exchange rates:
Bid Offer
Dollar/sterling ($/) 1.4580 1.4980
Sterling/Euro (/) 0.4570 0.4890
Required:
(a) What would be received in pounds sterling by a UK company expecting to
receive $400,000?
(b) What would be paid in pound sterling by a UK company expecting to pay
$500,000?
(c) What would be received in pounds sterling by a UK company expecting to
receive 400,000?
(d) What would be paid in pound sterling by a UK company expecting to pay
500,000?
Solution 5
(a) 400,000/1.4980 = 267,023
(b) 500,000/1.4580 = 342,936
(c) 400,000 x 0.4570 = 182,800
(d) 500,000 x 0.4890 = 244,500
RISK AND FOREIGN EXCHANGE
Foreign exchange risk, basically Currency risk, is the possibility of making profit or
loss as a result of changes in exchange rate. Examples of situations a company
may be exposed to currency risk are:
Imports of raw materials.
Exports of finished goods.
Importation of foreign-manufactured non-current assets.
Investments in foreign securities.
Raising an overseas loan.
Having a foreign subsidiary or being a foreign subsidiary.
The foreign exchange risk exposures are divided broadly into three categories as
follows:
transaction exposure;
economic exposure;
translation exposure.
Transaction exposure
Transaction exposure relates to the gains and losses to be made when settlement
takes place at some future date of a foreign currency denominated contract that
has already been entered into. These contracts may include import or export of
goods on credit terms, borrowing or investing funds denominated in a foreign
currency, receipt of dividends from over-seas, or unfulfilled foreign exchange
contract. Transaction exposure can be protected against by adopting a hedged
position: that is, entering into a counter balancing contract to offset the exposure.
Translation exposure
This arises from the need to consolidate worldwide operations according to
predetermined accounting rules. This is the risk that the organisation will make
exchange losses or gains when the accounting results of its foreign subsidiaries are
translated into the presentation currency of the parent company. Assets, liabilities,
revenue and expenses must be restated into presentation currency of the parent
company in order to be consolidated into the group accounts.
Translation exposure can result from restating the book value of a foreign
subsidiarys assets at the exchange rate on the balance sheet date. Such exposure
will not affect the firms cash flows unless the asset is sold.
Economic exposure
Economic exposure also called operating or competitive exposure or strategic
exposure measures the changes in the present value of the firm resulting from any
changes in the future operating cash flows of the firm caused by an unexpected
changes in exchange rates. The change in value depends on future sale volume,
price and costs.
For example, a UK company might use raw materials which are priced in US dollars,
but export its product mainly within the EU. A depreciation of the pound against
the dollar or appreciation of pound against the Euro will both erode the
competitiveness of this UK company.
The magnitude of economic exposure is difficult to measure as it considers
unexpected changes in exchange rates and also because such changes can affect
firms in many ways.
Relative importance of the different types of exposures
to the financial manager
Transaction and economic exposures both have cash flow consequences for the firm
and they are therefore considered to be extremely important. Economic exposure
is really the long-run equivalent of transaction exposure, and ignoring either of
them could lead to reduction in the firm future cash flows, resulting in a fall in
shareholders wealth.
Both of these exposures should therefore be protected against.
The importance of translation exposure to financial managers is however often
questioned. In financial management terms we ask the question does translation
loss reduces shareholders wealth? The answer is that it is unlikely to be of
consequence to shareholders who should in an efficient market, value shares on the
basis of the firms future cash flows, not on assets value in the published accounts.
Unless management believes that translation losses will greatly affect shareholders
there would seem little point in protecting against them.
PROTECTION AGAINST ECONOMIC EXPOSURE
The usual methods of protecting economic exposure include the following;
Diversification of financing
If a firm borrows in a foreign currency it must pay back in that same currency. If
that currency should appreciate against the home currency, this can make interest
and principal repayments far more expensive. However, if borrowing is spread
across many currencies it is unlikely they will all appreciate at the same time and
therefore risk can be reduced. Borrowing in foreign currency is only truly justified if
returns will then be earned in that currency to finance repayment and interest.
Diversification of product and supply
If a firm manufactures all its products in one country and that countrys exchange
rate strengthens, then the firm will find it increasingly difficult to export to the rest
of the world. Its future cash flows and therefore its present value would diminish.
However, if it had established production plants worldwide and bought its
components worldwide it is unlikely that the currencies of all its operations revalue
at the same time. It would therefore find that, although it was losing exports from
some of its manufacturing locations, this would not be the case in all of them.
Also if it had arranged to buy its raw materials worldwide it would find that a
strengthening home currency would result in a fall in its input cost and this would
compensate for lost sales.
Factors to consider before deciding to protect
transaction exposure
The factors may include the following:
Future exchange rate movement, where the currency is very volatile. The
future movements in exchange rate may depend on a number of factors
including interest rate, inflation, central bank actions and economic growth.
The availability of a market for the currency in question.
The cost involved in the hedging, eg commission.
The ability of the company to absorb foreign exchange losses.
Expertise within the company.
the companys attitude towards foreign currency transactions and the
importance of overseas trading.
PROTECTION AGAINST TRANSACTION EXPOSURE
Once, a company has decided to hedge a particular foreign currency risk, there are
a number of methods to consider. They can be grouped as internal and external
hedging techniques.
Internal hedging techniques
Invoicing in the home currency
One way of avoiding exchange risk is for an exporter to invoice his foreign customer
in his home currency, or for an importer to arrange with his supplier to be invoiced
in his home currency. However, although either the exporter or importer can avoid
any exchange risk in this way, only one of them can deal in his home currency.
The other must accept the exchange risk.
Although invoicing in the home currency has the advantage of eliminating exchange
rate risk, the company is unlikely to compete well with a competitor who invoice in
the buyers home currency, hence the customer may purchase from the competitor.
Leading and lagging
Leading and lagging is a mechanism whereby a company accelerates (leads) or
delay (lags) payment or receipt in anticipation of exchange rate movements. This
technique can be used only when exchange rate forecasts can be made with some
degree of confidence. Interest rates would also have to be considered in granting
long term credit.
Netting
Netting is setting the debtors and creditors of all the companies in the group
resulting from transactions between them so that only net amount is either paid or
received.
There are two types of netting:
1. Bilateral Netting
In the case of bilateral netting, only two companies are involved. The lower
balance is netted against the higher balance and the difference is the amount
remaining to be paid.
2. Multilateral Netting
Multilateral netting is a more complex procedure in which the debts of more than
two group companies are netted off against each other. There are different ways of
arranging for multilateral netting. The arrangement might be co-ordinated by the
companys own central treasury or alternatively by the companys bankers. The
common currency in which netting is to be affected needs to be decided on.

Solution 7
Step 1: convert the balance into a common currency, the US dollar.
Debtors creditors amount
UK SA 1,200,000/6.126 = 195,886
UK FR 480,000/5.880 = 81,633
FR SA 800,000/6.126 = 130,591
SA UK 74,000/0.6800 = 108,824
SA FR 375,000/5.880 = 63,776

Paying subsidiaries

UK SA FR
TOTAL
Receipts
$ $ $ $
Receiving subsidiary
UK - 108,824 - 108,824
SA 195,886 - 130,591 326,477
FR 81,633 63,776 - 145,409
Total payments (277,519) (172,600) (130,591) (580,710)

Total receipts 108,824 326,477 145,409 580,710
Net receipts/(payments) (168,695) 153,877 14,818 0
The possible advantages of this method are that, transaction cost may be lower as
a result of fewer transactions, and regular settlements may reduce intra-company
exposure risk.
It disadvantages may include:
The central treasury may have difficulties in exercising control that the
procedure demands.
Subsidiary companys result may be distorted if the base currency is weaken
in the sustained period.
Example 7
A group of companies controlled from the USA has subsidiaries in the UK, South
Africa and France. At 31/12/X3, inter-company indebtedness were as follows
Debtors Creditors Amount
UK SA 1,200,000 SA Rand
UK FR 480,000 Euro
FR SA 800,000 SA rand
SA UK 74,000 Sterling
SA FR 375,000 Euro
It is the companys policy to net off inter-company balances to the greatest extent
possible. The central treasury department is to use the following exchange rates
for these purposes:
US $ = R 6.126 / 0.6800 / Euro 5.880
Required:
Calculate the net payment to be made between the subsidiaries after netting of
inter-company balances.
Matching
This is the use of receipts in a particular currency to match payment in that same
currency. Wherever possible, a company that expects to make payments and have
receipts in the same foreign currency should plan to of set it payments against its
receipts in that currency.
Since the company is offsetting foreign payment and receipt in the same currency,
it does not matter whether that currency strengthens or weakens against the
companys domestic currency because there will be no purchase or sale of the
currency.
The process of matching is made simply by having a foreign currency account,
whereby receipts and payments in the currency are credited and debited to the
account respectively. Probably, the only exchange risk will be limited to conversion
of the net account balance into the domestic currency. This account can be opened
in the domestic country or as a deposit account in oversees country.
External hedging techniques
External hedging techniques means using the financial markets to hedge foreign
currency movements.
The techniques include the following:
forward contract,
money market hedge,
currency futures contract,
currency options, and
currency swaps.
Forward contract
The foreign-exchange forward market is an inter-bank market, where one party
agrees to deliver a specified amount of one currency for another at a specified
exchange rate at a designated date in the future. The designated exchange rate
and date are called the forward rate and settlement (delivery) date respectively.
Where an investor takes a position in the market by buying a forward contract, the
investor is said to be in a long- position, and where he takes a position to sell a
forward contract we say the investor is in a short-position.
A forward contract is a binding contract on both parties. This means that having
made the contract, a company must carry out the agreement, and buy or sell the
foreign currency on the agreed date and at the rate of exchange fixed by the
agreement. If the spot rate moves in the companys favour, that will be bad for the
company and vice versa.
Example 8
Consider the following exchange rate:
$/
Bid Offer
Spot rate 1.5090 1.5600
2months forward 1.5060 1.5590
3 month forward 1.5000 1.5500
A UK company is expecting to receive $100,000 in three months time from the
goods supplied to a USA company.
Required:
What is the sterling receipt if the company decides to hedge using a forward
exchange contract?
Solution 8
Guaranteed sterling receipts is = $100,000/1.5500 = 64,516.13
This is the guaranteed right from the outset when the contract was made, and it is
irrelevant what the exchange rate will be in three months.
Example 9
A company expects to receive $10m in two month time. Exchange rates are as
follows:
Spot $1.6100 1.6400
1 month dis 200 - 300
2 months dis 400 - 600
3 months dis 800 - 120
Required:
Show how forward contract can be used to hedge the exposure.
Solution 9
Three month forward rate will be: $/
Spot 1.6100 - 1.6400
2 month points (add) 0.0400 - 0.0600
2 months forward rate 1.6500 1.7000
The guaranteed sterling receipt is $10m / 1.7000 = 5,882,353
Example 10
The exchange rate for dollar and sterling: $/
Spot 1.5100 1.5150
3 months forward (premium) 45 42
A UK company is expected to pay $1,000,000 in three months time and wish to fix
a rate for the transaction.
Required:
Use forward market contract to hedge this exposure.
Solution 10
Spot rate 1.5100 -- 1.5150
Points (less) 0.0045 -- 0.0042
3 months forward rate 1.5055 1.5108
Guaranteed payment = 1,0 00,000/ 1.5055 = 664231.2
Implications of using forward contracts
Forward contracts are obligatory and both parties have legal obligation to fulfil their
part of the contract. This means that if one party, say the customer, is not able to
satisfy the contract the other party (bank) can legally force him to meet it.
However, the bank can also extend the contract at an extra cost to the customer.
Money market hedge
The money market is a market where companies and individuals lend and borrow
money for a short period of time. The period of time could be overnight or up to a
year.
Steps in money market hedge are:
Borrow an appropriate amount in foreign currency today.
Convert it immediately to the home currency.
Place it on deposit account in the home currency.
Settlement.
Example 11
A UK company export goods to a number of companies in the USA and Europe. It
is due to receive $100,000 in three month time from the goods supplied to a USA
company. The three months forward rate is 1.4550 1.4600. The spot rate is
1.4960-1.4990
The interest rates available in the money market are:
UK US
Annual interest 6% - 9% 11% - 14%
Solution 11
Normally two interest rates will be given. Note that the lower rate is the rate for
depositing or investing your money in the bank and the higher rate is the
borrowing/taking money from the bank.
Following the steps!
1. Borrow from a bank an appropriate amount
this means that we will borrow in the US bank at an interest rate of 14%
the appropriate amount to be borrowed now at 14% to get $100,000 in
three month time is:
$100,000/ 1.035 = $96618.4
14/4 = 3.5% = three months interest rate
The amount borrowed of $96618.4 will compound up to $100,000 in three
month at the rate of 14% per annum or 3.5% for three months.
2. Convert the amount borrowed into sterling at the spot rate
$96618.4/ 1.4990 = 64455.2
3. Invest the 64455.2 in UK at an interest rate of 6% for three months
64455.2 x (1.015) = 65422.028
This amount is less than the amount given by the forward contract hence the
company can hedge the exposure by using the forward contract.
Example 12
Assume the same facts as example one above except that the UK company is
making payment of $1,000,000.
Solution 12
Step 1
The UK company should buy dollars now and put them into a deposit account for
three months in order to get $1,000,000.
= $1,000,000 / (1+ (0.11/4) = $973,236.01
Step 2
Convert this amount to sterling at the spot rate, = 973,236.01/ 1.4960
= 650,558.83
Step 3
This means the company has to borrow 650558.83 in the UK for three months at
an interest rate of 9%. The total amount payable in sterling is:
650,558.83 x (1 + (0.09/4) = 665,196.40


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

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

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

=
|
|
\
|
+
+
b
c
0
i 1
i 1
S
Forward rate = $1.77
14 . 1
12 . 1
= $1.7389
In this instance the current spot rate is $1.77 = 1, whereas the one year forward
rate is $1.7389 = 1. Thus there is a premium of $0.0311!!
Accordingly, provided this theory holds, where:
Foreign interest rates < UK interest rates, the forward rate is quoted at a
premium,
and where:
Foreign interest rates > UK interest rates, the forward rate is quoted at a
discount.
(c) (i) (1) Forward market hedge
The selling rate in the 3 month forward market (ie the banks buying
rate) is $1.7539 (see part a))
By selling forward you will receive $3,000,000 1.7539 =
1,710,474 in three months time.
(2) Money market hedge : exporter case
Has a $ asset therefore must create $ liability
(1) Borrow in USA $3,000,000 1.02625* = $2,923,264

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

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

(4) Repay $ loan with receipts from customer = $3,000,000
*
4
% 5 . 10
= 2.625%
#
4
% 13
= 3.25%
It is more effective to hedge in the forward market.
(ii) (1) Forward market hedge
Buy $ forward : $3,000,000 1.7524 = 1,711,938
(2) Money market hedge : importer case
Has $ liability therefore must create $ asset
(3) Borrow in UK = 1,661,525
(2) Convert to $ 1,661,525 x 1.7680 = $2,937,577
(1) Invest in USA $2,937,577 x 1.02125* = $3,000,000
(4) Repay loan 1,661,525 x 1.0375# = 1,723,832 cost
*
4
% 5 . 8
= 2.125%
#
4
% 15
= 3.75%


Chapter 16
Hedging interest
rate risk

CHAPTER 16 HEDGING INTEREST RATE RISK
CHAPTER CONTENTS
INTEREST RATE RISK -------------------------------------------------- 257
TERM STRUCTURE OF INTEREST RATES ------------------------------ 258
THE NORMAL YIELD CURVE 258
THE INVERSE YIELD CURVE 259
BOND VALUATION AND BOND YIELDS ------------------------------- 261
VALUATION OF BONDS 261
GROSS REDEMPTION YIELD OR YIELD TO MATURITY OR REQUIRED RATE OF RETURN 261
VALUING BONDS BASED ON THE YIELD CURVE 262
ESTIMATING THE YIELD CURVE 263
HEDGING/PROTECTING INTEREST RATE RISK ---------------------- 264
FORWARD RATE AGREEMENTS (FRA) 264

INTEREST RATE RISK
Interest rate risk is the risk of incurring losses or higher costs due to an adverse
movement in interest rates or gains as a result of favourable movement in interest
rates. The interest rate exposure can arise due to many reasons including the
following:
The company has an asset whose market value changes whenever market
interest rates changes.
The company is expected to make some payment in the future, and the
amount of the payment will depend on the interest rate at that time.
The company is expecting some income in the future, and the amount of
income received will depend on the interest rate at that time.
LIBOR and LIBID
LIBOR means the London inter-bank offered rate. It is the rate of interest at which
a top-level bank in London can borrow wholesale short-term funds from another
bank in London money markets.
LIBID means the London inter-bank bid rate. It is the rate of interest that a top-
level bank in London could obtain short-term deposits with another bank in London
money markets. The LIBID is always lower than the LIBOR
TERM STRUCTURE OF INTEREST RATES
The term structure of interest rates reflects the manner in which the gross
redemption yield on government bonds varies with the term to maturity, ie the
period of time before the stock is to be redeemed. For example, government bonds
may be short-dated (eg repayment within 5 years), medium-dated (repayment
between 5 and 20 years) or long-dated (redemption in excess of 20 years). Of
course, some government bonds e.g. 2% Consols are undated (ie irredeemable).
This data is often presented in the form of a graph to illustrate the bond yield
curve, which is created by plotting the gross redemption yield of the bond against
the term to maturity. In normal circumstances the yield curve is upward sloping.
The gross redemption yield reflects the internal rate of return on the cash flows
associated with the bond, ie it incorporates the effect of the current market value of
the bond, the gross interest payments and the redemption value of the bond in
other words it measures not only the gross interest yield but also the capital gain or
loss to maturity. The calculation of the gross redemption yield is very similar to the
calculation of the cost of redeemable debt for the company the notable difference
is that interest payments are included gross (as opposed to net of corporation tax
as is used in arriving at Kd).
The normal yield curve
The general shape of the normal upward sloping yield curve appears as follows:

0 5 10 15 20 25
Term to maturity (years)
A normal yield curve slopes upwards because the yield on longer dated bonds is
normally higher than the yield on shorter dated bonds. If you are confused by this
point, remember that your mortgage is only cheaper than your overdraft because
the mortgage is secured on the property, whereas the overdraft is unsecured. The
reason for the upward sloping shape of the yield curve is thought to be based on
the following theories:
liquidity preference theory

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

0 5 10 15 20 25
Term to maturity (years)
Significance of the yield curve to financial managers
Financial managers should inspect the current shape of the yield curve when
deciding on the term of borrowings or deposits, since the curve shows the market
expectations of future movement in interest rates.
If the yield curve slopes steeply upwards, it suggests increase in interest rate in the
future. In this case the financial manager should avoid borrowing long-term on
variable rates, since the interest rate charge may increase over the term of the
loan. It would be better to either borrow on long-term fixed rate or short-term
variable rate.

Gross
Redemption
Yield
%
Bond
Yield Curve
BOND VALUATION AND BOND YIELDS

Valuation of bonds
A plain vanilla bond will make regular interest payments to the investors and pay
the capital to buy back the bond on the redemption date when it reaches maturity.
Therefore the value of a redeemable bond is the present value of the future income
stream discounted at the required rate of return (or yield or the internal rate of
return) as seen in chapter 9.
Example
A company has issued some 9% bonds, which are redeemable at par in three years
time. Investors require an interest yield of 10%.
What will be the current market value of 100 of bond?

Solution
10%
Year Cash flow discount factor PV
1-3 net interest 9.0 2.487 22.38
3 redemption value 100 0.751 75.10
Market value 97.48
This means that 100 of bonds will have a market value of 97.48
Remember that there is an inverse relationship between the yield of a bond and its
price or value. The higher rate of return (or yield) required, the lower the price of
the bond, and vice versa.
Gross redemption yield or yield to maturity or required
rate of return
The cost of redeemable bond is the internal rate of return or required rate of return
or redemption yield or yield to maturity of the cash flows of the bond.
Example
A 5.6% bond is currently quoted at 95 ex-int. It is redeemable at the end of 5
years at par. Corporation tax is 30%.
Calculate gross cost of the bond.

Solution
Year CF DF10% PV DF5% PV
0 MP (95) 1 (95) 1 (95)
1-5 gross interest 5.6 3.791 21.23 4.329 24.24
5 Redemption value 100 0.621 62.1 0.784 78.4
NPV (11.67) 7.64
IRR = 5% + (7.64 / 7.64 + 11.67) X(10% - 5%) = 7%
Valuing bonds based on the yield curve
The spot yield curve can be used to estimate the price or value of a bond. Normally
these rates are published by the central banks or in financial press.
Example
A company wants to issue a bond that is redeemable in four years for its par value
or face value of $100, and wants to pay an annual coupon of 5% on the par value.
Estimate the price at which the bond should be issued and the gross
redemption yield.
The annual spot yield curve for a bond of this risk class is as follows:
Year Rate
1 3.5%
2 4.0%
3 4.7%
4 5.5%

Solution
The market price of the bond should be the present value of the cash flows from
the bond (interest and redemption value) using the relevant years yield curve spot
rate as the discount factor.
Year 1 2 3 4
Cash flows 5 5 5 105
Df 1.035
-1
1.04
-2
1.047
-3
1.055
-4

Present value 4.83 4.62 4.36 84.76
The market price = $98.57.
Given a market price of $98.57, the gross yield to maturity is calculated as follows:
Year CF DF10% PV DF5% PV
0 MP (98.57) 1 (98.57) 1 (98.57)
1-4 gross interest 5 3.170 15.85 3.546 17.73
4 Redemption value 100 0.683 68.3 0.823 82.3
NPV (14.42) 1.46
IRR or to maturity = 5% + (1.46 / 1.46 + 14.42) X(10% - 5%) = 5.46%
Note that the yield to maturity of 5.46% is not the same as the four year spot yield
curve rate of 5.5%. The reasons for the difference are as follows:
The yield to maturity is a weighted average of the term structure of interest
rates.
The returns from the bond come in earlier years, when the interest rates on
the yield curve are lower, but the largest proportion comes in Year 4.
Estimating the yield curve
There are different methods used to estimate a spot yield curve, and the iterative
process based on bootstrapping coupon paying bonds is perhaps the simplest to
understand. The following example demonstrates how the process works.
Example
A government has three bonds in issue that all have a face or par value of $100
and are redeemable in one year, two years and three years respectively. Since the
bonds are all government bonds, lets assume that they are of the same risk class.
Lets also assume that coupons are payable on an annual basis.
Bond A, which is redeemable in a years time, has a coupon rate of 7% and is
trading at $103.
Bond B, which is redeemable in two years, has a coupon rate of 6% and is trading
at $102.
Bond C, which is redeemable in three years, has a coupon rate of 5% and is
trading at $98.
Determine the yield curve. (ACCA 2011 student article)

Solution
To determine the yield curve, each bonds cash flows are discounted in turn to
determine the annual spot rates for the three years, as follows:
Bond A: $103 = $107 x (1+r1)-1
r1 = 107/103 1 = 0.0388 or 3.88%
Bond B: $102 = $6 x 1.0388-1 + 106 x (1+r2)-2
r2 = [106 / (102 5.78)]1/2 - 1= 0.0496 or 4.96%
Bond C: $98 = $5 x 1.0388-1 + $5 x 1.0496-2 + 105 x (1+r3)-3
r3 = [105 / (98 4.81 4.54)]1/3 1 = 0.0580 or 5.80%
The annual spot yield curve is therefore:
Year
1 3.88%
2 4.96%
3 5.80%
HEDGING/PROTECTING INTEREST RATE RISK
There are several methods of hedging interest rate risk including the following:
forward rate agreements
interest rate options
interest rate swaps
interest rate futures.
Forward rate agreements (FRA)
A forward rate agreement for interest rate is similar to forward foreign exchange
contract.
A forward rate agreement offer companies the facility (with a bank) to fix future
interest rates today on either borrowing or lending for a specified future period.
If the actual interest rate proves to be higher than the rate agreed, the bank pays
the company the difference. If the actual rate is less than the rate agreed, the
company pays the difference. This is called compensation payment.
If a company knows for instance that it will take a loan in few months at a floating
rate of interest it may worry what the interest rate will be and try to manage it by
using FRA. The company arranges FRA with a third party (the bank) at a mutually
agreed interest rate for a specified period in advance.
The company then takes the loan on the due date and pays interest at the
prevailing (actual) rate. At the end of the specified period the interest actually paid
is compared with the rate agreed under the FRA and adjustments are made
accordingly between the two parties.
No premium or commission is paid on FRAs.
FRA quotations or prices
FRAs are over-the counter transaction between a bank and a company. The bank
quotes two-way prices for each FRA period for each notional borrowing (loan) or
lending (deposit).
Examples of bank quotations for FRA are:
2 v 5 5.75 - 6.00
Means forward rate agreement that start in 2 months and last for 3 months at
a borrowing rate of 6% and lending rate of 5.75%.
3 v 5 5.78 - 6.13
a borrowing rate of 6.13% and lending rate of 5.78%.
3 v 6 5.95 - 6.45
a borrowing rate of 6.45% and lending rate of 5.95%
Example
A bank has quoted the following FRA rates:
2 v 6 5.75 - 6.00
3 v 5 5.78 - 6.13
4 v 7 5.95 - 6.45
Assume that now is 1
st
November 2008.
Required:
Determine the FRA interest applicable to the following situations:
1. A company wants to borrow on 1
st
February 2009 and repay the loan on 1
st
of
April 2009.
2. A company wants to deposit money on 1
st
January 2009 and expect to with
draw the amount for an investment on 1
st
of May 2009.
3. A company wants to borrow on 1
st
March 2009 and repay the loan on 1
st
of
June 2009.
Solution
1. 3 v 5 at a borrowing rate of 6.13%
2. 2 v 6 at lending rate of 5.75%
3. 4 v 7 at a borrowing rate of 6.45%
Compensation payment
Compensation period is calculated as the difference between the FRA rate fixed and
the LIBOR rate at the fixing date (actual LIBOR) multiplied by the amount of the
notional loan/deposit and the period of the loan/deposit.
The FRA therefore protects against the LIBOR but not the risk premium attached to
the customer.
The settlement of FRA is made at the start of the loan period and not at the end
and therefore compensation payment occurs at start of the loan period. As a result
the compensation payment should be discount to it present value using the LIBOR
rate at the fixing date over the period of the loan.
Example
A company will have to borrow an amount of 100 million in three month time for a
period of six months. The company borrow at LIBOR plus 50 basis points. LIBOR is
currently 3.5%. The treasurer wishes to protect the short-term investment from
adverse movements in interest rates, by using forward rate agreement (FRAs).
FRA prices (%)
3 v 9 3.85 3.80
4 v 9 3.58 3.53
5 v 9 3.55 3.45
Required:
Show the expected outcome of FRA:
(a) If LIBOR increases by 0.5%.
(b) If LIBOR decreases by 0.5%.
Solution
The FRA will be 3 v 9 as the money will be needed in three months time and will
last for six months. The applicable interest rate will be 3.85%.
(a) If LIBOR increases by 0.5%
LIBOR (Actual) at fixing date = 3.5 + 0.5 = 4.0%
Actual interest paid on the loan
(4 + 50/100)
= 4.5% x 100m x 6/12 = 2.25m
Compensation received from the bank
(4 3.85)
= 0.15% x100m x 6/12 = (0.075m)
Net interest payment 2.175m
Effective rate = (2.175/100) x (12/6) x 100% = 4.35%
Same as FRA rate + spread = 3.85 + 50/100 = 4.35%
(b) If LIBOR decreases by 0.5%
LIBOR (Actual) at fixing date = 3.5 - 0.5 = 3.0%
Actual interest paid on the loan
(3 + 50/100)
= 3.5% x 100m x 6/12 = 1.75m
Compensation received from the bank
(3 3.85)
= -0.85% x100m x 6/12 = (0.425m)
Net interest payment 2.175m
Effective rate = (2.175/100) x (12/6) x 100% = 4.35%
Same as FRA rate + spread = 3.85 + 50/100 = 4.35%
Example
Assume that it is now 1 June. Your company expects to receive 7.1 million from a
large order in five months time. This will then be invested in high-quality
commercial paper for a period of four months, after that it will be used to pay part
of the companys dividend. The treasurer wishes to protect the short-term
investment from adverse movements in interest rates, by using forward rate
agreement (FRAs).
FRA prices (%)
4 v 5 3.85 3.80
4 v 9 3.58 3.53
5 v 9 3.50 3.45
The current yield on the high-quality commercial paper is LIBOR + 0.60%. LIBOR
is currently 4%.
Required:
If LIBOR falls or increase by 0.5% during the next five months, show the expected
outcome of FRA.
Solution
The FRA will be 5 v 9 as the money will be invested in five month time and will last
for four months. The applicable interest rate will be 3.45%.
If LIBOR falls by 0.5%
LIBOR (Actual) at fixing date = 4 - 0.5 = 3.5%
Actual interest received on
investment (3.5 + 0.6)
= 4.1% x 7.1m x 4/12 = 97,033.33
Compensation paid to the bank
(3.5 3.45)
= 0.05%x 7.1m x 4/12 = (1,183.33)
Net interest payment 95,850
If LIBOR increases by 0.5%
LIBOR (Actual) at fixing date = 4 + 0.5 = 4.5%
Actual interest received on
investment (4.5 + 0.6)
= 5.1% x 7.1m x 4/12 = 120,700
Compensation paid to the bank
(4.5 3.45)
= 1.05%x 7.1m x 4/12 = (24,850)
Net interest payment 95,850


Chapter 17
Futures

CHAPTER 17 FUTURES
CHAPTER CONTENTS
DERIVATIVES ----------------------------------------------------------- 271
FUTURES ----------------------------------------------------------------- 272
CURRENCY FUTURES --------------------------------------------------- 276
INTEREST RATE FUTURES---------------------------------------------- 278
PRICING FUTURES CONTRACTS 278
TICKS AND TICK VALUES 278
DIFFERENCES BETWEEN FORWARD AND FUTURES CONTRACTS -- 281
ADVANTAGES OF USING FUTURES CONTRACTS 281
DISADVANTAGES OF FUTURES CONTRACTS 282

CHAPTER 17 FUTURES
DERIVATIVES
A derivative is a financial instrument that derives its value from the price or rate of
an underlying item. A company can enter into Derivative position for one of two
reasons:
To hedge against exposure to a particular risk, or
To speculate, and hope to make a profit from favourable movements in rate
or price.
Examples of derivatives are forward contracts, futures contracts, options and
swaps.
CHAPTER 17 FUTURES
FUTURES
A futures is a legal binding contract between two parties to buy or to sell a
standardised quantity of an underlying item at a future date, but at a price agreed
today, through the medium of an organised exchange.
Future contracts are forward contracts traded on a future and options exchange.
Underlying item
Underlying item is the quantity of the item which is to be bought or sold under the
futures contract. Each futures contract has a standardised quantity of this
underlying items and the futures contract cannot be undertaken in fractions.
The underlying item may include agricultural products, like meat, cocoa, maize,
energy products, like crude oil gas, financial products, like currency and interest
rate, and stock index futures on shares.
Delivery dates
Financial futures are normally traded on a cycle of three months, March, June,
September and December of each year.
The clearing house
Each futures exchange has a clearing house. When a futures deal has been made
the clearing house assumes the role of counterparty to both the buyer and the
seller. Thus the buyer has effectively bought from the clearing house whilst the
seller is treated as having sold to the clearing house, thus removing the risk of
default on the futures contract. The clearing house imposes upon its members the
requirement to pay margins, which effectively acts as a security deposit.
Closing a future position
If you entered the futures contract by buying, then that contract will be closed by
selling and if you entered by selling futures contract, you close by buying. That is,
a position is closed by reversing what you did to enter the futures contract.
A person who bought a futures contract will close by selling and is said to hold a
long position.
A person who sold a futures contract will close by buying and is said to hold a short
position.
Ticks
A tick is the minimum price movement permitted by the exchange on which the
future contract is traded. Ticks are used to determine the profit or loss on the
futures contract. The significance of the tick is that every one tick movement in
price has the same money value.
CHAPTER 17 FUTURES
Example 1
If the price of a sterling futures contract changes from $1.4523 to $1.4555, then
price has risen by $0.0032 or 32 ticks.
If you entered/bought into 50 contracts the profit on the futures contract will be
calculated as:
Number of contracts x ticks x tick value
50 x 32 x $6.25 = $10,000
Ticks are used to calculate the value of a change in price to someone with a long or
a short position in futures.
If someone has a long position, a rise in the price of the future represents a profit,
and a fall in price represents a loss.
If someone has a short position, a rise in the price of the future represents a loss,
and a fall represents a profit.
Margins
When a deal has been made both buyer and seller are required to pay margin to
the clearing house. This sum of money must be deposited and maintained in order
to provide protection to both parties.
Initial margin
Initial margin is the sum deposited when the contract is first made. This is to
protect against any possible losses on the first day of trading. The value of the
initial margin depends on the future market, risk of default and volatility of interest
rates and exchange rates.
Variation margin
Variation margin is payable or receivable to reflect the day-to-day profits or losses
made on the futures contract. If the future price moves adversely a payment must
be made to the clearing house, whilst if the future price moves favourably variation
margin will be received from the clearing house. This process of realising profits or
loss on a daily basis is known as marking to market.
This implies that margin account is maintained at the initial margin as any daily
profit or loss will be received or paid the following morning. Default in variation
margins will result in the closure of the futures contract in order to protect the
clearing house from the possibility of the party providing cash to cover
accumulating losses.
CHAPTER 17 FUTURES
Example 2
Contract size 62,500
3 months future price $1. 3545
Number of contract entered 50 contracts
Tick value $6.25
Tick size 0.0001
Required:
Calculate the cash flow if the future price moves to in day one $1.3700 and 1.3450
day two (variation margin). Assume a short position.
Solution 2
Day One
Selling price 1.3545
Buying price 1.3700
Loss 0.0155 = 155 ticks
Variation margin = payment of the loss
= 155 x 50 x $6.25 = $48,437
Day 2
Selling price 1.3700
Buying price 1.3450
Profit 0.025 = 250 ticks
Variation margin = receipt of the profit
= 250 x 50 x $6.25 = $78,125
Basis and basis risk
Basis is the difference between the futures price and the current cash market price
of the underlying security. In the case of exchange rates, basis is the difference
between the current market price of a future and the current spot rate of the
currency. At final settlement date itself, the futures price and the market price of
the underlying item ought to be the same otherwise speculators would be able to
make an instant profit by trading between the futures market and spot cash
market.
Most futures positions are closed out before the contract reaches final settlement,
hence a difference between the close out future price and the current market price
of the underlying item.
Basis risk may arise from the fact that the price of the futures contract may not
move as expected in relation to the value of the underlying item which is being
hedged.
CHAPTER 17 FUTURES
Futures hedge
Hedging with a future contract means that any profit or loss on the underlying item
will be offset by any loss or profit made on the future contract. A perfect hedge is
unlikely because of:
Basis risk.
The round sum nature of futures contracts, which can only be bought or sold
in whole number.
CHAPTER 17 FUTURES
CURRENCY FUTURES
A currency futures is an exchange traded agreement between two parties to
buy/sell a particular quantity of one currency in exchange of another currency at a
particular rate on a particular future date.
Typical available futures contracts are as follows:
Futures
quantity of currency
per contract
price quotation tick size
value of one
tick
/ $ 62,500 $ per 1 $0.0001 $6.25
/ $ 125,000 $ per 1 $0.0001 $12.50
/ 100,000 per 1 0.0001 10
Example Franco plc
Assume that it is now 30 June. Franco plc is a company located in the USA that has
a contract to purchase goods from Japan in two months time on 1
st
September.
The payment is to be made in yen and will total 140 million yen.
The managing director of Franco plc wishes to protect the contract against adverse
movements in foreign exchange rates, and is considering the use of currency
futures. The following data are available.
Spot foreign exchange rate:
Yen/$ 128.15
Yen currency futures contracts on SIMEX (Singapore Monetary Exchange).
Contract size 12,500,000 yen. Contract prices are in US$ per yen.
Contract prices:
September 0.007985
December 0.008250
Assume future contract matures at the end of the month.
Assuming the spot exchange rate is 120 yen/$1 on 1
st
September and that basis
risk decreases steadily in a linear manner.
Required:
Calculate what the result of the hedge is expected to be. Briefly discuss why this
result may not occur.
Solution to Franco plc
What contract. The most suitable contract will be the contract that matures
at the nearest date after the transaction date 1
st
September. This is the
September contract, which matures at the end of September.
Buy or sell. To protect against the risk of the yen strengthening against the
US$, Franco plc should buy yen future contracts, hoping to sell at a higher
price if the yen strengthens.
Number of contracts. Each contract size is 12.5m yen and the amount
involved is 140m yen. Therefore the number of contracts to be bought are =
140/12.5 = 11.2 contracts. However, contracts cannot be bought or sold in
fractions (it should be whole number), therefore it can enter into 11 whole
CHAPTER 17 FUTURES
contracts. This means 0.2 x 12.5 = 2.5 million yen is left unhedged under the
futures contract. The company can either hedge this 2.5m yen by using
forward contract or leave it unhedged.
Calculation of closing price. This can be done, by using the basis and basis
risk. Basis is the difference between current spot rate and the future price.
Yen
Spot rate 128.15
Future price (September) = $ 0.007985 to yen = 1/ 0.007985 125.23
Basis 2.92 yen
Basis will be zero at maturity date of the future contract, 30
th
September. If
it reduces in a linear manner over the three months period (30/6 to 30/9), the
expected basis on 1
st
September, when there is still one month to maturity =
(2.92 x1)/3 = 0.973 yen.
The expected futures price on 1
st
September is therefore 0.973 yen below the
spot price of 120 yen/$1
Closing price
Yen
Spot rate = 120
Basis 0.973
Future price 1 Sept = 119.027 or $0.008401 (1/119.027)
Calculation of profit or loss:
$
Entered by buying 11 future contract each at 0.007985
Will close by selling the 11 contracts each at 0.008401
Profit on futures position for each contract 0.000416
Total profit on future position = 0.000416 x 11 x 12.5m
= $57,200
Expected result of the hedge or outcome
$
1
st
September- spot market (140/120) 1,166,667
Profit from the future position 57,200
Net payment 1,109,467
Hedge efficiency. This is to check whether the hedge is a perfect hedge.
Spot market
30
th
June spot market (140/128.15) 1,092,470
1
st
September spot market (140/120) 1,166,667
Loss in the spot market 74,197
Hedge efficiency = 57,200/74,197 = 77%
This result may not occur as basis is not likely to decrease in a linear manner.
CHAPTER 17 FUTURES
INTEREST RATE FUTURES
Interest rate futures are futures contracts and similar to currency futures. They are
standardised exchange-traded contract agreement now between buyers and sellers,
for settlement at a future date, normally in March, June, September and December.
Pricing futures contracts
The pricing of an interest rate futures contract is determined by the three months
interest rate (r %) contracted for and is calculated as (100 r). For example if
three months Eurodollar time deposit interest rate is 8%, a three months Eurodollar
futures contract will be priced at (100-8) = 92; and if interest rate is 11%, the
future price = 89= (100-11).
The decrease in price or value of the contract reflects the reduced attractiveness of
a fixed rate deposit in times of rising interest rates.
Ticks and tick values
Examples of ticks and tick values are:
1. For 3 months Eurodollar futures, the amount of the underlying instrument is a
deposit of $1,000,000. With a tick of 0.01%, the value of the tick is:
0.01% x $1m x 3/12 = $25
2. For 3 months sterling, the underlying instrument is a 3 months deposit of
500,000. With a tick of 0.01%, the value of tick is:
500,000 x 0.01% x 3/12 = 12.5
Basis and basis risk
Example
If three months LIBOR is 7% and the September price of three months sterling
future is 92.70 now, at the end of March (lets say), the basis is:
LIBOR (100 - 7) 93.00
Futures 92.70
0.30%
30 basis points
Maturity mismatch
Maturity mismatch occurs if the actual period of lending or borrowing does not
match the notional period of the futures contract (three months). The number of
futures contract used has to be adjusted accordingly. Since fixed interest is
involved, the number of contracts is adjusted in proportion to the time period of the
actual loan or deposit compared with three months.
Number of contracts =
|
\
|
|
\
|
months 3
it loan/depos for required period time
size contrat futures
it loan/depos actual of amount

CHAPTER 17 FUTURES
Example AA plc
The monthly cash budget of AA plc shows that the company is likely to need 18m
in two months time for a period of four months. Financial markets have recently
been volatile, and the finance director fears that short term interest rates could rise
by as much as 150 ticks (ie 1.5%). LIBOR is currently 6.5% and AA plc can borrow
at LIBOR plus 0.75%.
LIFFE 500,000 3 months futures prices are as follows:
December 93.40
March 93.10
June 92.75
Required:
Assume that it is now 1
st
December and that exchange traded futures contract
expires at the end of the month, estimate the result of undertaking an interest rate
futures hedge on LIFFE if LIBOR increases by 150 ticks (1.5%).
Solution to AA plc
What contract = 3 months contract = March futures contract.
What type = sell as interest rates are expected to rise.
Number of contracts
=
3 m 5 . 0
4 m 18
= 48 contracts.
Tick size = 0.01% x 500,000 x 3/12 = 12.5
Calculate the closing future price using basis and basis risk.
Calculate opening basis as
Current LIBOR 6.5% = (100 6.5) 93.50
Future price 93.10
Basis 0.40
This will fall to zero when the contract expires, and it is assumed that it will
fall at an even or linear manner.
There are four months until expiry and the funds are needed in two month
time, therefore the expected basis at the time of borrowing is:
0.4 x 2/4 = 0.2
Closing future price:
LIBOR = 6.5% + 1.5% = 8% = (100 8) 92.0
Basis 0.2
Future price 91.8
CHAPTER 17 FUTURES
Calculate profit or loss
Selling price 93.10
Buying price 91.80
Gain per contract 1.3 = 130 ticks
Total profit 130 x 0.01% x 500,000 x 3/12 x 48 = 78,000
OR
130 x 12.5 x 48 = 78,000
Overall outcome (total cost)

Interest cost (8 +0.75) = 8.75% x 4/12 x 18m 525,000
Profit on future position (78,000)
Net cost 447,000
Effective rate of interest = (447,000/18m) x 12/4 x 100%
= 7.45%
CHAPTER 17 FUTURES
DIFFERENCES BETWEEN FORWARD AND FUTURES
CONTRACTS
Futures contracts differ from forward contracts in a number of ways including the
following:
Size of the contract
Futures contracts are for multiples of standard-size contracts whereas forward
contracts with a bank can be negotiated for any size desired.
Maturity
Futures contracts are available only for a set of fixed maturities, the longest of
which is typically for less than a year. A bank will write a forward contract for
maturity up to a year and occasionally for longer than a year.
Location
Futures trading is conducted by brokers on the flow of an organised exchange,
where orders from all buyers and sellers compete in one central place.
Forward contracts are negotiated with banks at any location in person or by
telephone.
Price
Futures prices are determined through an open outcry process at the pit in
which the particular contract is traded. Forward contracts prices are quoted
by the bank in the form of bid and offer.
Counter parties
Purchasers and sellers of futures contracts are unknown to each other, since
the opposite party to every trade is the exchange clearing house. Purchasers
and sellers of forward contracts deal with the bank where they are known,
either personally or by reputation.
Margin
Futures contracts require payment of margin while no payments are made
under forward contract apart from settlement payment.
Advantages of using futures contracts
1. Futures could be used to hedge both interest rates and foreign currency risk
2. Default risk is minimal as contracts are marked to market daily by the clearing
house, with the protection of the margin payment.
3. There is single specified price, which is transparent. No bid and offer.
CHAPTER 17 FUTURES
Disadvantages of futures contracts
1. Futures prices might not move by exactly the same amount as the cash
market due to basis risk, and perfect hedges are rare.
2. An initial margin (deposit) is required, and further variation margins may be
necessary.
3. Futures contracts are not very flexible. Contracts are only on standardised
size.
4. It is more complex than forward contract.
5. Futures contract is not available in every currency.

Chapter 18
Options

CHAPTER 18 OPTIONS
CHAPTER CONTENTS
OPTIONS ----------------------------------------------------------------- 285
TERMINOLOGIES OF OPTIONS ---------------------------------------- 286
OVER-THE-COUNTER AND TRADED OPTIONS------------------------ 288
PRICING OF OPTIONS -------------------------------------------------- 289
FACTORS DETERMINING THE VALUE(PRICE) OF OPTION 289
THE BLACK-SCHOLES OPTION PRICING MODEL 291
PUT-CALL PARITY: PRICING A PUT OPTION 292
LIMITATIONS OF THE BLACK-SCHOLES MODEL 293
DIVIDEND PAID BEFORE DATE OF EXPIRY 293
REAL OPTIONS ---------------------------------------------------------- 294
OPTION TO DELAY OR DEFER 294
OPTION TO EXPAND 294
OPTION TO ABANDON 295
OPTION TO REDEPLOY OR SWITCH 295
VALUATION OF REAL OPTIONS 295
APPLYING THE BLACK SCHOLES MODEL TO ESTIMATE THE VALUE OF
EQUITY ------------------------------------------------------------------ 299
THE GREEKS ------------------------------------------------------------- 305
1. DELTA 305
2. GAMMA 305
3. VEGA 306
4. THETA 306
5. RHO 306
SUMMARY OF THE GREEKS 306
HEDGING WITH OPTIONS --------------------------------------------- 307
CURRENCY OPTIONS --------------------------------------------------- 308
INTEREST RATE OPTIONS --------------------------------------------- 312
INTEREST RATE GUARANTEES OR OPTIONS ON FORWARD RATE AGREEMENTS 312
OPTIONS ON INTEREST RATE FUTURES 313
CAPS, COLLARS AND FLOORS 316

CHAPTER 18 OPTIONS
OPTIONS
An option is a contract giving it holder the right, but not an obligation to buy or sell
a specific quantity of a specific asset at a fixed price on or before a specific future
date.
Options can be bought and sold over a wide range of assets from coffee beans to
pork bellies and financial assets such as amount of currency, an interest bearing
security or bank deposit, and companys shares.
CHAPTER 18 OPTIONS
TERMINOLOGIES OF OPTIONS
The holder or buyer
The holder or buyer of the option is an investor or speculator who pays the option
money as consideration for the right to buy or sell at a fixed price over a limited
period.
The writer or seller
The writer or seller of the option is an organisation or individual who will grant the
option and take the option money in payment for the services. Unlike the holder,
the writer has an obligation to the deal, if the holder is to exercise the right under
the option.
Call option
A call option is the option that gives its holder the right, but not an obligation to
buy the underlying item at the specific price on or before the specific expiry date of
the option. For example, a call option on shares of central college, gives its holder
the right to buy that number of shares in central college at the fixed price on or
before the expiry date of the option.
Put option
A put option is the option that gives its holder the right to sell the underlying item
at the specific price on or before the specific expiry date of the option. For
example, a put option in central college shares, gives its holder the right to sell that
number of shares at the specific price on or before the specific expiry date of the
option.
Note that options are contractual agreements, so when the holder of the option
exercises the option, the seller or writer of the option must fulfil his side of the
contract by selling (call option) or buying (put option) the underlying item at the
specified price.
American and European options
European options only allow the option holder to exercise the right on the expiry
date itself and not before.
American options allow the holder to exercise the right at any time up to and
including the expiry date of the option.
Striking or exercise price
This is the predetermined price at which the underlying item would be bought or
sold if the holder of the option decides to exercise the right under the option
contract.
At, in, and out of the money
If the exercise price is more than the market price of the underlying item, a call
option will be out of money and a put option will be in the money.
CHAPTER 18 OPTIONS
If the exercise price is less than the market price of the underlying item, a call
option will be in the money and a put option will be out of the money.
If the exercise price is equal to the market price of the underlying item both call
and put options will be at the money.
Option money or premium
Option premium or money is the fee payable by the holder to the writer. It is the
writers return for the risks they are accepting. The premium will vary in value
according to the market expectations of future values of the underlying assets.
Intrinsic value
Intrinsic value is the difference between the strike price for the option and the
current market price of the underlying item. However, an in-the-money option has
an intrinsic value; but because intrinsic value cannot be negative, an out of the
money option has an intrinsic value of zero.
CHAPTER 18 OPTIONS
OVER-THE-COUNTER AND TRADED OPTIONS
Over-the-counter options are options bought and sold in off-exchange transactions,
negotiated directly between the buyer (company) and seller (bank), tailored to the
customers specific requirements.
Traded options are options bought and sold in a recognised exchange such as the
LIFFE, and like futures, have standardised contract terms.
Advantages of traded options over-the-counter options
1. There is greater price transparency, with current price on the market
immediately available and would be disseminated, which facilitates the
management of option position.
2. It offers greater liquidity, with easy sale or purchase of options of a known
standard quality.
3. Lower counter party risk. Contracts are marked to the market on a daily
basis, and a central clearing house monitors the ability of all counter parties
to meet their obligations.
4. Better regulations. Most options exchanges are subject to stringent regulation
by government authorities.
5. Market traded options are normally American style options and may be
exercised at any time. OTC options are often European style, and can only be
exercised at their maturity date.
Advantages of OTC options
1. OTC options offer a much larger choice of contract size and maturity which
allows the purchaser of the option to tailor the option much more specifically
to individual needs.
2. Option sizes are typically much larger on the OTC market.
3. Options may be arranged for longer periods than is possible with traded
options.
CHAPTER 18 OPTIONS
PRICING OF OPTIONS
Writers of options need to establish a way of pricing them. This is important
because there has to be a method of deciding what premium to charge to the
buyers.
The pricing model for call options are based on the Black-Scholes model.
Factors determining the value(price) of option
The major factors determining the price of options are as follows:
The price of the underlying item
For a call option, the greater the price for the underlying item the greater the value
of the option to the holder. For a put option the lower the share price the greater
the value of the option to the holder.
The price of the underlying item is the market prices for buying and selling the
underlying item. However, mid-price is usually used for option pricing, for
example, if price is quoted as 200202, then a mid-price of 201 should be used.
The exercise price
For a call option the lower the exercise price the greater the value of the option.
For a put option the greater the exercise price, the greater the value of the option.
The exercise price will be stated in terms of the option contract.
Time to expiry of the option
The longer the remaining period to expiry, the greater the probability that the
underlying item will rise in value. Call options are worth more the longer the time
to expiry(time value) because there is more time for the price of the underlying
item to rise. Put options are worth more if the price of the underlying item falls
over time.
The term to expiry will also be stated in the terms of the option contract.
Prevailing interest rate
The seller of a call option will receive initially a premium and if the option is
exercised the exercise price at the exercised date. If interest rate rises the present
value of the exercise price will diminish and he will therefore ask for a higher
premium to compensate for his risk.
The risk free rate such as treasury bills is usually used as the interest rate.
CHAPTER 18 OPTIONS
Volatility of underlying item
The greater the volatility of the price of the underlying item the greater the
probability of the option yielding profits.
The volatility represents the standard deviation of day-to-day price changes in the
underlying item, expressed as an annualized percentage.
The following steps can be used to calculate volatility of underlying item, using
historical information:
Calculate daily return = Pi/Po, where Pi = current price and Po = previous
days price
Take the In of the daily return using the calculator
Square the result above to get, say, X
Calculate the standard deviation as
= ( ) ( )
2 2
n / X n / X
Then annualise the result using the number of trading days in a year.
The formula = daily volatility x trading days

Solution
Standard deviation = Daily volatility = ( )
2
019275 . 0 0006275 . 0
= 0.016
= 2%
Since there are five trading days in a week and 52 weeks in a year, we assume the
trading days in a year is 52 x 5 = 260 days.
Annualised volatility = 2% x 260 = 32.2%.
Example
Day Price Pi/Po In(Pi/Po) X
2

X
Monday 100 - - -
Tuesday 103 1.03 0.0296 0.000874
Wednesday 106 1.0291 0.0287 0.000823
Thursday 105 0.9906 -0.0094 0.000089
Friday 108 1.0282 0.0282 0.000795
Total 0.0771 0.00251
n 4 4
Average 0.019275 0.0006275

CHAPTER 18 OPTIONS
The Black-Scholes option pricing model
Black-Scholes model is a model for determining the price of a call option. The
model considers the factors discussed above and states that the market value of a
call option at a particular time can be calculated as:
Option price = PaN(d1) Pe(Nd2) e
-rt

d
1
=
( ) ( )
t s
t s 5 . 0 r Pe / Pa ln
2
+ +

d
2
= d
1
st
ln = natural log
Nd
1
and Nd
2
are the normal distribution function of d
1
and d
2
respectively.
Where:
Pa = current market price of the underlying item
Pe = the exercise price
R = the annual risk free rate in decimals
T = time to expiry of option in years, so six months will be 0.5
years.
S = the standard deviation of the underlying instrument returns.
This measures the volatility of underlying item.
Example
The current share price of AA plc is 2.90.
Estimate the value of a call option on the share of the company, with an exercise
price of 2.60, and 6 months to run before it expires.
The risk free rate of interest is 6% and the variance of the rate of return on the
shares has been 15%.
Solution
d
1
=
( ) ( )
5 . 0 15 . 0
15 . 0 5 . 0 06 . 0 6 . 2 / 9 . 2 ln
+

d
1
= 0.6452, approximate to two decimal places = 0.65
d
2
= 0.65 (0.15 x0.5)
= 0.3713 rounded to 0.37
Using the normal distribution table:
Nd
1
= N( 0.65) = 0.5 + 0.24 = 0.74
Nd
2
= N(0.37) = 0.5 + 0.14 = 0.64
Using calculator e
-rt
= e
-0.03
= 0.97
Call option price = (2.90 x 0.74) (2.60 x 0.97 x 0.64)
= 0.53
CHAPTER 18 OPTIONS
Put-call parity: pricing a put option
The Black-Scholes model is used to price call options. The price of a put option can
be derived from the price of a call option using the put-call parity.
The relationship between the value of call option, C, and that of its associated put
option, P, is given by the following put-call parity equation as:
P = c Pa + Pe e
-rt

P = 0.53 2.9 + 2.60 (0.97)
P = 0.15
CHAPTER 18 OPTIONS
Limitations of the Black-Scholes model
The model has a number of limitations including the following:
It assumes that no dividends are paid in the period of the option.
It applies to European call options only, and not to American options.
It assumes that the risk free rate is known and constant throughout the
option life.
It assumes that there is no transaction costs and tax effects involved in
buying or selling the option or its underlying item.
The difficulty of estimating the standard deviation of the returns of the
underlying item to which the model is sensitive, and the use of this historical
measure to estimate future movements.
Dividend paid before date of expiry
One of the main limitations of the Black-Scholes model is the assumption that no
dividends are paid in the period of the option. However, the formula can be
adjusted to reflect a situation where dividend is paid before the expiry date.
The only and simple adjustment is to calculate the dividend-adjusted share price,
which is the difference between the current share price and the present value of
dividend to be paid.
PV of dividend = De
-rt
Where D = dividend.
Example
The following information relates to a call option:
Current share price 60
Exercise price 70
Dividend to be paid in 3 month time 1.5
Risk free rate 5%
Expiry date is 5 months.
The dividend-adjusted share price for Black-Scholes option pricing model can be
calculated as:
PV of dividend = De
-rt

r = 0.05
t = 3/12 = 0.25 of a year.
PV of dividend = 1.5 e
-(0.05 x 0.25)

= 1.48
Dividend-adjusted price = 60 1.48 = 58.52 and this will replace the price of the
underlying item in the formula.
CHAPTER 18 OPTIONS
REAL OPTIONS
Real options are concerned with options related to operational and strategic
decisions, in particular those concerned with investment in projects.
Conventional DCF analysis looks at whether a project is going to add value for
shareholders. In practice, managers of a business are unlikely to consider net
present values of projects alone. Investing in a particular project might lead to
other opportunities that may have been ignored in a DCF analysis. Managers could
take action to help boost a projects NPV if it falls behind forecast. They can create
and take advantage of options in managing projects.
The flexibility provided by real options in investments appears in many guises.
Busby and Pitts identify the following types:
Timing options options to embark on an investment, to defer it or abandon
it.
Scale options options to expand or contract an investment.
Staging options option to undertake an investment in stages.
Growth options options to make investments now that may lead to greater
opportunities later, sometimes called toe-in-the-door option.
Switching option options to switch input or output in a production process.
Based on the P4 syllabus, we have to consider option to delay, expand, redeploy
and withdraw.
Option to delay or defer
An option to delay gives the company the right to undertake the project in a later
period without losing the opportunity creating a call option on the future
investment. This is more applicable if a company has exclusive rights to a project
or product for a specific period.
Option to expand
The option to expand exists when firms invest in projects which allow them to make
further investments in the future or to enter new market. The initial project may
be found in terms of its NPV as not worth undertaking. However, when the option
to expand is taken account, the NPV may become positive and the project
worthwhile.
Expansion will normally require additional investment creating a call option.
The option will be exercised only when the present value from the expansion is
higher than the extra investment.
CHAPTER 18 OPTIONS
Option to abandon
An abandonment options is the ability to abandon the project at a certain stage in
the life of the project. Whereas traditional investment appraisal assumes that a
project will operate in each year of its lifetime, the firm may have the option to
cease a project during its life.
Abandon options gives the company the right to sell the cash flows over the
remaining life of the project for a salvage/scrape value therefore like American put
options. Where the salvage value is more than the present value of future cash
flows over the remaining life, the option will be exercised.
Option to redeploy or switch
The option to redeploy or switch exist when the company can use it productive
assets for activities other than the original one. The switching from one activity to
another will be exercised only when the present value of cash flows from the new
activity will exceed the cost of switching. This could result to a put option if there is
a salvage value for the work already performed, together with a call option arising
on the right to commence the new investment at a later stage.
Valuation of real options
The Black-Scholes model can be used to value real options just as financial options
seen earlier, but the following should be noted:
The exercise price will be replaced by the capital investment (initial
investment).
The price of the underlying item will be replaced by the present value of
future cash flows from the project.
Time to expiry is replaced by the life of the project.
Interest rate is still the risk free rate.
Volatility of cash flows can be measured using typical industry sector risk.
Illustration of an option to expand
Winter plc has investigated the opening of a new restaurant in the Isle of Man. The
initial capital expenditure is estimated at 12 million, whilst the present value of the
net cash inflows is expected to be 12.005 million. Since the resulting NPV of
0.005 million is a very small positive amount, this appraisal suggests that the
project is extremely marginal.
However, if this first restaurant is opened, Winter plc would gain the right, but not
the obligation to open a second restaurant in five years time at a capital cost of 20
million. The present value of the associated future net cash inflows is estimated at
15 million, with a standard deviation of 28.3%.
If the risk free rate of interest is 6%, determine whether to proceed with the
restaurant projects.
CHAPTER 18 OPTIONS
Solution to illustration
t = 5; P
e
= 20; P
a
= 15; s = 0.283; r = 0.06
d
1
=
( ) ( )
5 283 . 0
5 283 . 0 5 . 0 06 . 0 20 15 ln
2
+ +

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

= 9.4965 (20 x 0.3821 x 0.7408)
= 9.4965 5.6613
= 3.8352m
Conclusion:
m
NPV of first restaurant 0.005
Value of call option (to expand) on second restaurant 3.8352
Value of combined projects +3.8402
Therefore the project should be accepted, since the additional value (which
incorporates the option to expand), allows Winter plc to avoid the downside
element of risk.
Illustration of an option to abandon
Summer plc is undertaking a brewing joint venture with Autumn Inc. This project
requires an initial outlay by Summer plc of 250 million. The present value of the
net cash inflows is expected to be 254 million, with a variance of 9%. The
arrangement thus provides an extremely small positive NPV of 4 million. Summer
plc, however, has the right but not the obligation to sell its share of the joint
venture to Autumn Inc for 150 million at the end of the first five years of the
venture.
If the risk free rate of interest is 7%, calculate the value of this abandonment
option.
CHAPTER 18 OPTIONS
Solution to illustration
P
a
= 254; P
e
= 150; s
2

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

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

= 153.017 254 + (150 x 2.7183
-0.07 x 5
)
= 153.017 254 + 105.703
= 4.72m
Alternatively, it is possible to directly calculate the value of the put option using the
following modified Black-Scholes formula, but this is not provided on the ACCA
formula sheet:
p = P
e
N( d
2
)e
-rt
P
a
N( d
1
)
where:
N( d
1
) = 0.5 0.4495 = 0.0505
N( d
2
) = 0.5 0.3340 = 0.166
p = (150 x 0.166 x 2.7183
-0.35
) (254 x 0.0505)
= (150 x 0.166 x 0.7047) 12.827
= 17.547 12.827
= 4.72m
CHAPTER 18 OPTIONS
Conclusion:
m
NPV of joint venture project 4
Value of put option (to abandon joint
venture)
4.72
Total NPV with the abandonment option +8.72
Therefore Summer plc should go ahead with the joint venture, since the additional
value, which incorporates the option to abandon allows Summer plc to avoid the
downside element of risk.
CHAPTER 18 OPTIONS
APPLYING THE BLACK SCHOLES MODEL TO ESTIMATE
THE VALUE OF EQUITY
A major aspect of the P4 syllabus is the emphasis on corporate valuation. There
may, of course, be some companies that cannot realistically be valued by
conventional techniques.
The Black Scholes Option Pricing (BSOP) model provides a basis for corporate
valuation in cases where traditional methods are either inappropriate, or where
they fail to fully reflect the risks involved. Some authors refer to the Black Scholes
Merton model to reflect the work performed by Robert Merton (a key member of
the research team which developed the model).
The usual determinants in the valuation of options need to be redefined, when the
valuation of equity is treated as a call option:
Determinants Possible appropriate measures
Valuation of the underlying The fair value of the assets of the company
Exercise price Settlement values of outstanding liabilities
Volatility of the underlying Standard deviation of underlying assets
Risk-free rate of interest Current yield on company debt
Time to expiry Average period to settlement of company liabilities
Where the assets of the company are actively traded and easily liquidated, their
current market value would be appropriate. In the case of most companies, fair
value will normally be based upon the present value of the future cash flows that
the companys assets are expected to generate over their useful lives.
The volatility of the underlying assets is likely to be the most difficult measure to
estimate accurately. One approach is to estimate the probabilities of the likely
future cash flows of the company and generate a distribution of their present values
from which a standard deviation could be established.
A possible approach to the determination of an exercise price is to assume that the
companys liabilities consist entirely of debt in the form of a zero coupon bond. If
the companys debt includes other types of bond, adjustments are necessary as
shown in the following illustration.
Illustration 1
A company has on issue a 5% bond with five years to redemption with a gross yield
to maturity of 8%.
Required:
Estimate the market value of that bond and that of an equivalent zero coupon
bond.
CHAPTER 18 OPTIONS
Solution 1
The market value of the debt is estimated as follows:
Year 1 2 3 4 5
Annual interest and redemption payments () 5 5 5 5 105
Discount factors @ 8% 0.926 0.857 0.794 0.735 0.681
Present values () 4.63 4.29 3.97 3.67 71.50
Present value of debt = 88.06
The redemption value of a zero coupon bond of the same market value is calculated
by establishing the unknown future value which (when discounted at 8% p.a. for a
five year period) provides a present value of 88.06, ie:
Future value = 88.06 x 1.08
5
= 129.39
Therefore 129.39 is treated as the exercise price (ie the redemption value of a
zero coupon bond with the same features as the debt currently in issue, which has
a yield to maturity of 8%).
Assuming that acceptable estimates of the input variables have been established,
the next step is to incorporate them into the BSOP model. The model does have a
number of restricting assumptions, but it can be used to produce an acceptable
valuation of a company.
Illustration 2
In March 2007, Northern Rock (a UK bank) reported assets and liabilities at fair
values of 113.2 billion and 110.7 billion respectively. The average term to
maturity on the liabilities of the bank (which consisted of short-term money market
borrowing and deposits) was 100 trading days, whilst the annual number of trading
days was 250 approximately. At that time the risk-free rate of interest was 3.5%
and the company had 495.6 million equity shares in issue.
Required:
(a) Using the BSOP (sometimes referred to as the Black Scholes Merton) model,
estimate the share price of Northern Rock in each of the following situations:
(i) Assuming that the standard deviation of the banks assets was 5%; and
(ii) Assuming that the volatility of the banks assets was 10%.
(b) Using the Black Scholes Merton model, recalculate an estimate of the share
price of Northern Rock if the fair value of the companys assets fell to 110.7
billion and their volatility was 5%.
(c) Comment upon the results and consequences of the calculations performed in
parts (a) and (b) above.
CHAPTER 18 OPTIONS
Solution 2
This entire procedure is based on the notion that if equity shareholders pay off the
liabilities at expiry date, they are effectively paying the exercise price of a call
option and thus exercising their right to buy the underlying assets of the company
at their fair value.
Taking the data provided and converting to the ACCA symbols:
(a)
P
a
= 113.20; P
e
= 110.70; r = 0.035; t = (100 250) = 0.4 (since
the annual number of trading days is 250); s is initially taken as 0.05 and,
subsequently as 0.1
(i) If volatility (s or ) = 0.05:
d
1
=
( ) ( )
4 . 0 05 . 0
4 . 0 05 . 0 5 . 0 035 . 0 70 . 110 20 . 113 ln
2
+ +

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

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

From Normal Distribution tables:
d
1
= 1.16474, by interpolation:
1.16 gives 0.3770
1.17 gives 0.3790
1.16 gives 0.3770
(474 1000) x 0.0020 = 0.00095
0.37795
d
2
1.13 gives 0.3708
1.14 gives 0.3729
1.13 gives 0.3708
(312 1000) x 0.0021 = 0.00065
0.37145
Of course, in an exam it is quicker to round up or down to the two decimal
places provided by the ACCA tables. In this case, 1.16 (giving 0.3770) and
1.13 (giving 0.3708) would be used!
N(d
1
) = 0.5 + 0.37795 = 0.87795
N(d
2
) = 0.5 + 0.37145 = 0.87145

c = (113.20 x 0.87795) (110.70 x 0.87145 x e
-0.035 x 0.4
)
= 99.384 (110.70 x 0.87145 x 0.98610)
= 99.384 95.128 = 4.258bn
Price = (4.258 bn 495.6 m shares) = 8.59 per share
CHAPTER 18 OPTIONS
(ii) If volatility (s or ) = 0.1:
d
1
=
( ) ( )
4 . 0 1 . 0
4 . 0 1 . 0 5 . 0 035 . 0 70 . 110 20 . 113 ln
2
+ +

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

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

d
1
0.60 gives 0.2257
0.61 gives 0.2291
0.60 gives 0.2257
(609 1000) x 0.0034 = 0.00207
0.22777
d
2
0.54 gives 0.2054
0.55 gives 0.2088
0.54 gives 0.2054
(284 1000) x 0.0034 = 0.00097
0.20637
Again, in an exam it is quicker to round up or down to the two decimal places
provided by the ACCA tables. In this case, 0.61 (giving 0.2291) and 0.54
(giving 0.2054) would be used!
N(d
1
) = 0.5 + 0.22777 = 0.72777
N(d
2
) = 0.5 + 0.20637 = 0.70637
c = (113.20 x 0.72777) (110.70 x 0.70637 x e
-0.035 x 0.4
)
= 82.3836 (110.70 x 0.70637 x 0.98610)
= 82.3836 77.1082 = 5.2754 bn
CHAPTER 18 OPTIONS
(b)
In this instance, the asset value (P
a
) falls and is now equal to the liability value (at
a volatility of 0.05), so that both P
a
and P
e
become 110.70. All other facts are
unchanged.
The calculations are:
d
1
=
( ) ( )
4 . 0 05 . 0
4 . 0 05 . 0 5 . 0 035 . 0 70 . 110 70 . 110 ln
2
+ +

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

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

d
1
0.45 gives 0.1736
0.46 gives 0.1772
0.45 gives 0.1736
(853 1000) x 0.0036 = 0.0031
0.1767
d
2
0.42 gives 0.1628
0.43 gives 0.1664
0.42 gives 0.1628
(691 1000) x 0.0036 = 0.0025
0.1653
Once more, in an exam it is quicker to round up or down to the two decimal places
provided by the ACCA tables. In this case, 0.46 (giving 0.1772) and 0.43 (giving
0.1664) would be used!
N(d
1
) = 0.5 + 0.1767 = 0.6767
N(d
2
) = 0.5 + 0.1653 = 0.6653
c = (110.70 x 0.6767) (110.70 x 0.6653 x e
-0.035 x 0.4
)
= 74.9107 (110.70 x 0.6653 x 0.98610)
= 74.9107 72.6250 = 2.29 bn
(c) Comments
As can be seen from the calculations in part (a), the value of an option increases as
the level of risk rises. At a standard deviation of 5%, the share price is 8.59,
whilst at a volatility of 10%, the share price rises to 10.64. The actual share price
of Northern Rock in March 2007 fluctuated around 9.50 per share.
In part (b) of this illustration, the fair value of the banks assets fell to 110.7
billion to be equal to the fair value of its liabilities. Accordingly, the Statement of
CHAPTER 18 OPTIONS
financial position would show an equity value of zero. However, the BSOP model
shows a quite different result, at a volatility of 5% the total value of the equity is
still worth 2.29 billion, that is 4.62 per share almost precisely its value in
September 2007!
At this date, the information being released from the company suggested that its
assets had fallen in value as the banks mortgage receivables were written down in
line with falling house prices and potential defaults.
It was only when the threat of nationalisation became a real possibility (during the
final months of 2007) that the equity value began to collapse - and this can be
explained within the framework of the BSOP model. Nationalisation eliminates the
possibility of asset recovery for the shareholders. This deprives them of the time
value on their call option on the underlying assets of the business.
The rationale for this rather strange result is that the equity of a business can still
have a substantial positive value (despite the Statement of financial position
showing a zero equity value) because of the presence of limited liability!
Limited liability protects shareholders from a loss - and in fact they have everything
to gain if the fair value of the assets should recover! When the equity of a
company is at or near the money, ie when its gearing levels approach 100%, the
equity investors will become increasingly risk aggressive (i.e. risk-seeking). Agency
theory suggests they will provide management with incentives to increase risk,
rather than reduce it. Hence, the very high levels of reward offered to bank
employees, particularly those employed in the risk-taking departments of the
business.
The work of Black, Scholes and Merton provides a framework to value those
companies that are financed, in part, by borrowing. Where shareholders are
protected by limited liability, they have a call option on the underlying business
assets. Employing the BSOP model, an estimate can be made of the value of a
companys equity on the basis of the value of its assets and their volatility.
For companies that are deep in-the-money, time value is small and the intrinsic
value of the business (i.e. the present value of the net assets) will dominate the
value of the equity. In this case, normal risk aversion can be expected to apply as
that intrinsic value will be exposed to equal positive and negative movements in the
value of the companys assets.
This situation dramatically changes when companies are near-the-money. This
occurs with high growth start-ups financed by debt, leveraged buyouts and
companies that are in risk of default.
One class of company (banks) always operate near-the-money, and in valuing
such businesses, time value would be more significant than intrinsic value in equity
valuation.
When time value dominates, shareholders become risk-seekers and they will grant
management incentives to take greater risk, which will cause the company to be
pushed closer and closer to-the-money, by expanding assets and liabilities
without increasing the equity capital.
CHAPTER 18 OPTIONS
THE GREEKS
In principle, an option writer could sell options without hedging his position. If the
premiums received accurately reflect the expected pay-outs at expiry, there is
theoretically no profit or loss on average. This is analogous to an insurance
company not reinsuring its business. In practice, however, the risk that any one
option may move sharply in-the-money makes this too dangerous. In order to
manage a portfolio of options, the dealer must know how the value of the options
he has sold and bought will vary with changes in the various factors affecting their
price. Such assessments of sensitivity are measured by the Greeks, which can be
used by options traders in evaluating their hedge positions.
1. Delta
For each option held, the delta value can be established i.e.
Delta =
security underlying of price in Change
price option in Change

Delta is a measure of how much an option premium changes in response to a
change in the security price. For instance, if a change in share price of 5p results
in a change in the option premium of 1p, then the delta has a value of (1p/5p) 0.2.
Therefore, the writer of options needs to hold five times the number of options than
shares to achieve a delta hedge. The delta value is likely to change during the
period of the option, and so the option writer may need to change his holdings to
maintain his delta hedge position.
Accordingly a writer can hedge a holding of 300,000 shares using options with a
delta value estimated by N(d
1
) of 0.6, by holding the following number of LIFFE
contracts (each on 1,000 shares).
size Contract value Delta
shares of Number
=
000 , 1 6 . 0
000 , 300
= 500 contracts.
A delta value ranges between 0 and +1 for call options, and between 0 and -1 for
put options. The actual delta value depends on how far it is in-the-money or out-
of-the-money.
The absolute value of the delta moves towards 1 (or -1) as the option goes further
in-the-money and shifts towards 0 as the option goes out-of-the-money. At-the-
money calls have a delta value of 0.5, and at-the-money puts have a delta value of
-0.5.
2. Gamma
Gamma measures the amount by which the delta value changes as underlying
security prices change. This is calculated as the:
security underlying the of price the in Change
value delta the in Change

CHAPTER 18 OPTIONS
3. Vega
Vega measures the sensitivity of the option premium to a change in volatility. As
indicated above higher volatility increases the price of an option. Therefore any
change in volatility can affect the option premium. Thus:
Vega =
volatility in Change
price option the in Change

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

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

Summary of the Greeks
Changes in In response to changes in

DELTA Option premium Value of underlying security
GAMMA Delta value Value of underlying security
VEGA Option premium Volatility
THETA Time value in option premium Time to expiry
RHO Option premium Risk free rate of interest

CHAPTER 18 OPTIONS
HEDGING WITH OPTIONS
An option contract is bought by paying premium in order to have the right to buy
(call option) or sell (put option) the underlying item (currency) such that, if the
underlying cash market rate moves in an adverse direction, the holder of the option
will exercise the right to take advantage of the option. However if the underlying
cash market rate moves in favour of the holder of the option, the holder will let the
option lapse and take advantage of the more favourable cash market rate as
options are not obligatory.
Options involve the payment of premium, often upfront, which is payable whether
or not the option is exercised.
CHAPTER 18 OPTIONS
CURRENCY OPTIONS
A currency option is the right, but not an obligation, to buy (a call option) or sell
(put option) a particular currency at a specified exchange rate on a particular date
or at any time up to a particular date.

Solution to Diano plc
Receipts Payments Net exposure
3 month time 4.8 million 7.6 million 2.8 million
Forward contract
Guaranteed payment = 2.8 x 5.6190 = GHC 15,733,200
Currency options
What date contract - The most suitable contract will be the contract that matures
at the nearest date after the transaction date 1
st
September. This is the September
contract, which matures at the on 15th September.
Example Diano plc
Diano plc is a company based in Ghana that trades frequently with companies in
the UK. The national currency of Ghana is the Cedi (GHC).
Transactions to be completed within the next three months are as follows:
Receipts Payments
3 months time 4.8 million 7.6 million
3 months time GHC 5.8 million
Exchange rates GHC/1
Spot 5.5640 5.5910
3 month forward 5.5880 5.6190
Ghana Cedi market traded option prices (125,000 Cedis contract size against
sterling) in the UK.
Exercise price
(pence per GHC)
June contracts September contracts
Calls Puts Calls Puts
0.175 0.331 0.082 0.476 0.143
0.180 0.112 0.241 0.203 0.314
0.185 0.034 0.530 0.096 0.691
Option premia are in UK pence per Ghana Cedi and are payable up front. The
options are American style.
Assume that it is now 1 June and that option contracts mature on the 15
th
of the
month.
Diano plc can borrow at an interest rate of 7% per year.
Required:
Show the outcome of using both forward contract and currency options to hedge
foreign currency risk and recommend the best action.
CHAPTER 18 OPTIONS
Call or put option. Select call option to give right to buy or put option to give the
right to sell the contract size currency. In this case, since the contract size is
denominated in Ghana Cedi, the company will need to sell GHC for Sterling,
therefore it needs to buy a put option to get the right to sell GHC, hence
September put option should be selected.
Calculate the number of contracts
a b c = b/a d e = c/d
Exercise
price
GHC
Contract
size
Number of
contracts

0.175 2.8 16,000,000 125,000 128 exact hedge
0.18 2.8 15,555,556 125,000 124.4 125 over hedge
0.185 2.8 15,135,135 125,000 121.08 121 under hedge
Calculate premium
a b c d e f g d
Exercise
price
Contract
size
Number
of
contracts
Premium
per
contract
Premium in

= b x c x d
Spot
rate
Premium
in GHC
Premium
plus
interest
0.175 125,000 128 0.143 22,880 5.591 127,922 130,161
0.18 125,000 125 0.314 49,063 5.591 274,311 279,111
0.185 125,000 121 0.691 104,514 5.591 584,338 594,564
We assume that Diano plc will borrow to finance the premium at 7% per annum,
therefore three month = 7 x 3/12 = 1.75%.
Forward contract for under/over hedge
Exercise
price
Number
of
contracts
Contract
size
Amount
hedged
GHC
= b x c
Amount
hedged
Exposure

(Over)/
under
Forward
rate
Outcome
GHC
0.18 125 125,000 15,625,000 2,812,500 2,800,000 (12,500) 5.5880 (69,850)
0.185 121 125,000 15,125,000 2,798,125 2,800,000 1,875 5.5880 10,535

a b c d e f g h i
Overall outcome if the option is exercised
(a) (b) (c) (d) e = b+c+d
Exercise
Price
Basic cost
(GHC)
Premium
cost (GHC)
(Over)/under hedge
outcome (GHC)
Total cost
(GHC)
0.175 16,000,000 130,161 0 16,130,161
0.180 15,625,000 279,111 (69,850) 15,834,261
0.185 15,125,000 594,564 10,536 15,730,100
It is recommended that Diano plc should use 0.185 currency option to hedge
against the sterling exposure as it is the cheapest.
CHAPTER 18 OPTIONS
Example Canta plc
Canta plc a UK based company is to build a large factory block in the USA. This will
involve an initial payment of $300m in 5 months time and the management of
Canta plc are worried about adverse movement in exchange rate, and has decided
to protect this risk by currency options. Upon investigation the following
information was made available:
The exercise price of call option 0.54 = $1
5 months interest rate in UK 5.79%
5 months interest rate in USA 4.83%
Spot rate $1.8234/1
Annual $/ volatility during recent past was 10%
Required:
Calculate the value of the call option.
Solution to Canta plc
Using Spot rate S basis
Spot rate in direct quote = 1/1.8234 = 0.5484/$1
T = 5/12 = 0.4167
d
1
=
( ) [ ]
4167 . 0 1 . 0
4167 . 0 1 . 0 5 . 0 0483 . 0 0579 . 0 54 . 0 / 5484 . 0 ln
2
+ +

= 0.02152/0.06455
d
1
= 0.3334 = 0.33
d
2
= 0.3334 - 0.1 x0.4167 = 0.2688 = 0.27
Reading from normal distribution table:
N(d
1
) = 0.5 + 0.1293 = 0.6293
N(d
2
) = 0.5 + 0.1064 = 0.6064
Value of call option = e
-rf x T
S N(d
1
) e
-rT
XN(d
2
)
= e
-(0.0483 x 0.4167)
x 0.5484 x 0.6293 e
-(0.0579 x 0.4167)
x 0.54 X0.6064
= 0.0185799 = 1.858 pence
Using forward rate F basis
Forward rate can be calculated using interest rate parity.
F
5 months
= |
\
|
0241 . 1
0201 . 1
8234 . 1 5/12 x 4.83% = 2.01%
F
5 months
= |
\
|
0241 . 1
0201 . 1
8234 . 1 5/12 x 5.79% = 2.41%
= $1.8163
Direct quote = 1/1.8163 = 0.5506/$1
CHAPTER 18 OPTIONS
d
1
=
( )
T s
T s 5 . 0 X / F ln
2
+

d
1
=
( )
4167 . 0 1 . 0
4167 . 0 1 . 0 5 . 0 54 / 5506 . 0 ln
2
+

= 0.3334
d
2
= 0.3334 - 0.1 x 0.4167 = 0.2688 = 0.27
Reading from normal distribution table:
N(d
1
) = 0.5 + 0.1293 = 0.6293
N(d
2
) = 0.5 + 0.1064 = 0.6064
Value of a currency call option = e
-rT
[F N(d
1
) XN(d
2
)]
Value of a currency call option
= e
-(0.0579 x 0.4167)
[0.5506 x 0.6293 0.54 x 0.6064]
= 0.01858 = 1.858 pence
CHAPTER 18 OPTIONS
INTEREST RATE OPTIONS

Interest rate guarantees (IRGs) or options on forward
rate agreements (FRAs)
Interest rate guarantees (IRA) are short-term interest-rate options, usually with a
maximum maturity of one year. If a company wants longer term guarantees it can
use caps, collars or floors.
IRGs allow a borrowing company to hedge against adverse movements in interest
rates and to take advantage of favourable movement. The company can do this
without losing (other than the cost of the guarantee) if there is a favourable
movement interest rate.
IRG involves the payment of a premium to the seller of the guarantee, which has to
be paid whether or not the guarantee is exercised.
IRGs are similar to FRA with the following differences:
IRG involves the payment of a premium to the seller of the guarantee, which
has to be paid whether or not the guarantee is exercised. No premium is
payable with FRA
Unlike an FRA the interest rate included in the IRG only comes into play if it is
in the customers favour.
Example A plc
A plc needs to borrow 100m in four months time, 1/4/2003, but is worried about
interest rate changes in the intervening period. Its bankers are prepared to enter
into a IRG with it. The terms of the IRG are that it will last for six months and
include an interest rate of 8% per annum. Initial premium payment is 1,000,000
Required:
Show how IRG could be used, if on 1/4/2003 interest rate is 11%.
Solution
The interest rate in the IRG is 8% and this is lower than the open market rate of
11%, hence the bank will operate the IRG on the companys behalf at 8% per
annum.
Interest payment 100m x 8% x 6/12 4,000,000
Premium payment 1,000,000
Total payment 5,000,000
If the IRG has not been bought the total interest would have been
11% x 100m x 6/12 = 5,500,000
Therefore the premium of 1m has saved interest of 5,500,000- 4,000,000 =
1,500,000, with a net savings of 500,000.
The IRG allows the company to participate in favourable interest rate movements,
but this flexibility is paid for through the premium.
CHAPTER 18 OPTIONS
IRG like FRA cannot normally be arranged for periods of longer than one year but
successive IRG can be arranged so the maximum interest cost is always known one
period in advance.
IRG and FRA are all over the counter hedging techniques.
Options on interest rate futures
Interest rate option is a right, but not obligation, to either borrow or lend a notional
amount of principal for a given interest period, starting on or before a date in the
future (expiry date for the option), at a specified rate of interest (exercise price of
the option).
It is simply options to buy or sell futures. This is one of the challenging aspects of
hedging interest rate and the following example will be used to illustrate how it
works.

Example Shawter
Assume that it is now mid-December.
The finance director of Shawter plc has recently reviewed the companys monthly
cash budgets for the next year. As a result of buying new machinery in three
months time, the company is expected to require short-term finance of 30 million
for a period of two months until the proceeds from a factory disposal become
available. The finance director is concerned that, as a result of increasing wage
settlements, the Central Bank will increase interest rates in the near future.
LIBOR is currently 6% per annum and Shawter can borrow at LIBOR + 0.9%.
Derivative contracts may be assumed to mature at the end of the month.
Three types of hedge are available:
Three months sterling Future (500,000 contract size, 12.50 tick size)
December 93.870
March 93.790
June 93.680
Options on three months sterling futures (500,000 contract size,
premium cost in annual %)
Calls Puts
December March June December March June
93750 0.120 0.195 0.270 0.020 0.085 0.180
94000 0.015 0.075 0.115 0.165 0.255 0.335
94250 0.000 0.030 0.085 0.400 0.480 0.555
FRA prices
3 v 6 7.01 6.91
3 v 5 7.08 7.00
3 v 8 7.28 7.20
Required:
Illustrate how the short-term interest risk might be hedged, and the possible
results of the alternative hedges if interest rates increase by 0.5%.

CHAPTER 18 OPTIONS
Solution Shawter
Futures
What contract = 3 months contract = March futures contract
What type = sell interest rate futures as interest rates are expected
to rise. If interest rate rises, future price will fall, and we can close the
position by buying futures.
Number of contracts
=
3 m 5 . 0
2 m 30
= 40 contracts
Tick size = 0.01% x 500,000 x 3/12 = 12.5
Calculate the closing future price using basis and basis risk.
Calculate opening basis as:
Current LIBOR = 6% = (100 6) = 94.00
Future price 93.790
Basis 0.21
This will fall to zero when the contract expires, and it is assumed that it will
fall at an even or linear manner
There are three and half months until expiry and the funds are needed in
three months time, therefore the expected basis at the time of borrowing is:
0.21 x 1/7 = 0.03
Closing future price
LIBOR = 6.5% (100 6.5) 93.5
Basis 0.03
Future price 93.47
Selling price 93.79
Buying price 93.47
Gain per contract 0.32 = 32 ticks
Total profit 32 x 0.01% x 500,000 x 3/12 x 40 = 16,000
OR
32 x 12.5 x 40 = 16,000
Overall outcome (total cost)

Interest cost (6.5 +0.9) = 7.4% x 2/12 x 30m = 370,000
Profit on future position (16,000)
Net cost 354,000
CHAPTER 18 OPTIONS
Option
What date contract = March contract
Call or put = buy put option to have the right to sell sterling futures
Calculate premium
Exercise price Premium cost
93750 30,000,000 x 0.085% x 2/12 = 4,250
94000 30,000,000 x 0.225% x 2/12 = 12,750
94250 30,000,000 x 0.480% x 2/12 = 24,000
The premium cost is annual % so it should be expressed to 2/12, to reflect
period of borrowing.
If interest rate increases, the option will be exercised and the futures contract
sold at the exercise price.
Exercise price Profit
93750 (93.75 93.47) x 100 x 40 x12.5 = 14,000
94000 (94.00 93.47) x 100 x 40 x 12.5 = 26,500
94250 (94.25 93.47) x 100 x 40 x 12.5 = 39,000

Calculate total cost
Exercise
price
Cost of
borrowing at
7.4%, 2 months
Premium
cost
Profit on
future

Net cost
93750 370,000 4,250 (14,000) = 360,250
94000 370,000 12,750 (26,500) = 356,250
94250 370,000 24,000 (39,000) = 355,000
FRA
As the company wants to borrow funds in three months time for a period of
two months, the appropriate FRA would be the 3 v 5 contract.
The effective lock in rate would be 7.05% as borrowing carries more rate than
investing.
The overall cost is 30,000,000 x 7.08% x 2/12 = 354,000
Conclusion
The future and FRA have the same expected total cost. However, future contract
require margin payments and the associated basis risk makes the future cost
uncertain, therefore the FRA would be preferable. However, if there is any belief of
a chance of interest rate falling, then the best alternative would be the option with
exercise price of 94,250.
CHAPTER 18 OPTIONS
Caps, collars and floors
These are hedging techniques that can be used to cover risk on long term
borrowing. As the name implies, a cap is the upper-level interest rate, and a
floor a lower-level interest rate. With collar a company enters into an
arrangement such that it will borrow for a period of time with a floating interest
rate, but it knows it will not have to pay more than the cap rate, but on the other
hand it will not be able to pay less than the floor rate.
Interest rate

10% CAP

open market rate

5% floor

0 time

The open market rate will be applied to the loan as long as it remains between 5%
and 10%. If the open market interest rate goes outside these parameters (say
12% or 4%) the bank will activate the cap or floor as appropriate to keep the
loan interest cost between the agreed limits.
The advantage of the collar compared to a normal cap is that the collar has a lower
overall premium cost, due to the potential benefit of floor to the bank.
Interest rate option is a right, but not obligation, to either borrow or lend a notional
amount of principal for a given interest period, starting on or before a date in the
future (expiry date for the option), at a specified rate of interest (exercise price of
the option).


Chapter 19
Swaps

CHAPTER 19 SWAPS
CHAPTER CONTENTS
SWAPS ------------------------------------------------------------------- 319
INTEREST RATE SWAPS ------------------------------------------------ 320
REASONS FOR INTEREST RATE SWAPS 322
CURRENCY SWAPS ------------------------------------------------------ 323
BENEFITS OF CURRENCY SWAPS 324
FOREX SWAP (FX SWAP) ---------------------------------------------- 325
TYPES OF RISK ASSOCIATED WITH SWAPS ------------------------- 326
SWAPTIONS ------------------------------------------------------------- 327

CHAPTER 19 SWAPS
SWAPS
A swap is an agreement between two parties to exchange cash flows related to
specific underlying obligations for an agreed period of time. It is the exchange of
one stream of future cash flows for another stream of future cash flows with
different characteristics.
CHAPTER 19 SWAPS
INTEREST RATE SWAPS
Interest rate swap allows a company to exchange either:
Fixed rate interest payments into floating rate payment, or
Floating rate interest payment into fixed rate payments.
Here a company worried about interest rate volatility on a floating rate loan finds a
swap partner with a fixed interest loan who is unworried by interest rate volatility.
The parties swap their interest rate commitments to obtain the interest style they
want. This is operative over the duration of the loans and so provides long-run
hedging. Normally a financial intermediary is employed to find a suitable swap
partner for the arrangement and is paid a fee.
Example 1 Fred plc
Fred plc has a loan of 20m repayable in one year. Fred plc pays interest at LIBOR
plus 1.5% and could borrow fixed at 13% per annum. Martin plc also has a 20m
loan and pays fixed interest at 12% per annum. It could borrow at a variable rate
of LIBOR plus 2.5%.
The companies agree to swap their interest commitments with Fred plc paying
Martin plc fixed rate plus 0.5% and Martin plc paying Fred plc LIBOR plus 2%. An
arrangement fee of 10,000 is charged on each company.
Required:
Calculate the total interest payments of the two companies over the year if LIBOR
is 10% per annum
Solution
LIBOR at 10%
Fred plc

Interest on own loan (10% + 1.5%) x 20m (2,300,000) (11.5%)
Interest received from Martin (10%+2%) x 20m 2,400,000 12%
Interest paid to Martin (12%+0.5%) x 20m (2,500,000) (12.5%)

Total interest payment (2,400,000) (12%)
Martin plc

Interest on own loan (12% x 20m) (2,400,000 12%)
Interest received from Fred (12% + 0.5%) x 20 2,500,000 12.5%
Interest paid to Fred (10% +2%) x 20m (2,400,000) (12%)

Total interest payment (2,300,000) 11.5%
CHAPTER 19 SWAPS
Calculation of arbitrage gains from the swap
Fixed rate Floating rate
Fred 13% LIBOR + 1.5
Martins 12% LIBOR + 2.5
--------- --------------
Difference 1% -1%
---------- -----------
Arbitrage gains = 1% - (-1%) = 2%
Example 2
A company wants to borrow 6 million at a fixed rate of interest for four years, but
can only obtain a bank loan at LIBOR plus 80 basis points. A bank quotes bid and
ask prices for a four year swap of 6.45% - 6.50%.
Required:
(a) Show what the overall interest cost will become for the company, if it
arranges a swap to switch from floating to fixed rate commitments.
(b) What will be the cash flows as a percentage of the loan principal for an
interest period if the rate of LIBOR is set at 7%?
Solution 2
(a)
%
Actual interest floating rate (LIBOR + 0.8)
Swap
Receive floating rate interest from bank LIBOR
Pay fixed rate (higher-ask price) (6.50)
Overall cost (7.3)
(b)
%
Actual interest floating rate (7 + 0.8) (7.8)
Swap
Receive floating rate interest from bank 7
Pay fixed rate (higher-ask price) (6.50) 0.5
Overall cost (7.3)
CHAPTER 19 SWAPS
Reasons for interest rate swaps
Interest rate swaps have several uses including:
1. Long-term hedging against interest rate movements as swaps may be
arranged for periods of several years.
2. The ability to obtain finance at a cheaper cost than would be possible by
borrowing directly in the relevant market.
3. The opportunity to effectively restructure a companys capital profile without
physically redeeming debt.
4. Access to capital markets in which it is impossible to borrow directly, for
example because the borrower is relatively unknown in the market or has a
relatively low credit rating.
CHAPTER 19 SWAPS
CURRENCY SWAPS
Currency swaps are similar to interest rate swaps, but the underlying obligations
are in different currencies.
Currency swaps are characterised by the following mechanism:
Initial exchange of principal currencies at the commencement of the swap.
Exchange of regular interest payment during the life of the swap.
Final exchange of principal currencies at maturity of the swap.
When currencies are exchanged at the commencement and maturity of the swap,
the same exchange rate is used. In other words, the amounts exchanged at the
start of the swap and at the end are exactly the same.
Example 3 DD plc
DD plc needs to borrow $50m to finance it US subsidiary. DD plc is not well known
in US and can only borrow in US at US basic rate + 3%. DD plc contacts a US
company it has known for many years, FFK plc. FFK plc is in a similar position to
DD plc in that it requires a sterling loan to finance its UK operations. FFK plc can
borrow sterling at 11% per annum fixed and floating rate in US at US base rate +
1%.
The two companies come into a swap arrangement where:
DD plc will borrow sterling at 9% per annum fixed and FFK plc will borrow
dollars at US base rate + 1%
DD plc will pay FFK plc US base rate + 1.5% per annum and FFK plc will pay
DD plc sterling 9.5% per annum
There will be an exchange of principal now and in five years time at the
current spot rate of $8 = 1
UK base rate is currently 7% and US base rate is 5% per annum.
Required:
Show whether the suggested swap would benefit the two companies.
CHAPTER 19 SWAPS
Solution 3
DD plc borrows = $50/ 8 = 6.25m at 9%
FFK plc borrows = $50 at base rate + 1% = 6%
The currencies borrowed will then be swapped so that each company obtains the
currency they require.
The swap arrangement results in the following interest rates:
DD plc FFK plc
% %
Actual cost of loan (9) (6)
Swap arrangement:
FFK to DD 9.5 (9.5)
DD to FFK (6.5) 6.5
Overall cost of foreign currency finance 6% 9%
Cost without swap 8% 11%

Savings 2% 2%
At the end of the swap arrangement both companies have benefited considerably,
not only they have managed to get the currencies they wanted, but also have
obtained them at a lower interest rate than they could have achieved by borrowing
overseas directly.
Benefits of currency swaps
1. Hedging against foreign exchange risk. Swaps can be arranged for up to ten
years which provide protection against exchange rate movements for much
longer periods than forward contracts. It is very useful when dealing with
countries with exchange controls and/or volatile exchange rates.
2. The ability to obtain finance at a cheaper cost than would be possible by
borrowing directly in the relevant market.
3. The opportunity to effectively restructure a companys capital profile without
physically redeeming debt.
4. Access to capital markets in which it is impossible to borrow directly, for
example because the borrower is relatively unknown in the market or has a
relatively low credit rating.
5. Swaps can be arranged for any sum typically $5m to $50m over varying time
periods, and may be reversed by re-swapping with other counter parties.
Hence it is flexible.
6. There may be low transaction cost, as cost may be limited to the legal fees in
agreeing the documentations and arrangement fees.
CHAPTER 19 SWAPS
FOREX SWAP (FX SWAP)
A forex swap is an agreement between two parties to exchange equivalent amount
of currency for a period and then re-exchange them at the end of the period at a
predetermined agreed rate.
Forex swaps are characterised by the following mechanism:
Initial exchange of principal currencies at the commencement of the swap.
Final exchange of principal currencies at maturity of the swap normally at a
different rate.
The purpose of forex swap are to hedge against foreign exchange risk for longer
period, say more than one year, and where it is difficult to raise money directly.
CHAPTER 19 SWAPS
TYPES OF RISK ASSOCIATED WITH SWAPS
1. Credit Risk
This is the risk that the counter party to the swap will default before the end of the
swap and fail to carry out their agreed obligation. Such risk is reduced if a
reputable bank is used as an intermediary to the deal
2. Market Risk
This is the risk that interest rates or exchange rates will move unfavourably against
the company after it has committed itself into the swap.
3. Sovereign Risk
This is the risk associated with the country in whose currency a swap is being
considered. It covers political instability or the possibility of exchange controls
being introduced.
4. Liquidity Risk
Liquidity risk is the risk that the entity will not have access to sufficient cash to
meet its payment obligations when these are due.
CHAPTER 19 SWAPS
SWAPTIONS
Swaption may also be referred as swap option, options on swap or option swap.
Swaptions are combination of swap and option.
In return for the payment of premium by the holder, a swaption gives the right, but
not an obligation, to enter into swap on or before a particular date.
Swaptions are available on an over-the-counter market and are therefore tailored
to the exact specifications of the holder. They may be American or European style.
Swaptions are example of financial engineering. Financial engineering is the
construction of a financial product from a combination of existing derivative
products.
Illustration 3 Swaptions
Noswis plc borrowed two million Euros () in four year floating rate notes funds
nine months ago at an interest rate EURIBOR plus 1%, in an attempt to reduce the
level of interest paid on its loans. At that time EURIBOR was 6%. Unfortunately
EURIBOR interest rates have increased since that time to 7.2%. The company
wishes to protect itself from further interest rate volatility, but does not wish to lose
the benefit of possible interest rate reductions that might occur in a few months
time. An adviser has suggested the use of a six month American style Euro
swaption at 8.5% with a premium of 50,000, commencing in three months time
and with a maturity date the same as the floating rate Euro loan.
Required:
Briefly explain what is meant by a swaption, and illustrate under what
circumstances this proposed swaption would benefit Noswis. The time value of
money may be ignored.
Solution 3
Swaptions are hybrid derivative products that integrate the benefits of swaps and
options. The buyer of a swaption has the right, but not the obligation, to enter into
an interest rate or currency swap during a limited period of time and at a specified
rate.
Swaptions are available on the over-the-counter market and involve the payment of
a premium, normally in advance. They may be European style, exercisable only
on the maturity date, or American style, exercisable on any business day during
the exercise period.
Noswis is interested in protection against interest rate volatility, but wishes to
maintain the flexibility to benefit from falls in interest rates. A swaption would offer
the opportunity to do this.
Noswis is currently paying 8.2% on its Euro loan. The swaption offers a swap from
floating rate to fixed rate finance for the remaining three year period of the Euro
loan. (N.B. the four year loan was raised nine months ago and the swaption will
not commence until another three months have elapsed).
The fixed rate is 0.3% per annum above the current floating rate payable by
Noswis.
CHAPTER 19 SWAPS
The premium payable of 50,000 is 2.5% of the total value of the loan, or, ignoring
the time value of money, 0.833% per year over the remaining three year period of
the loan.
If Euro interest rates rise during the next nine months by more than 0.3% the
swaption is likely to be exercised. For the swaption to be beneficial to Noswis, the
average floating rate payable by Noswis without the swap over the three year
period would have to exceed:
8.2% + 0.3% + 0.833% = 9.333%
This is a 13.8% increase on the current EURIBOR payable rate (ie over 8.2%)
If interest rates fall then the swaption would not be exercised and Noswis would
benefit from borrowing at the lower floating rates. If the swaption is not exercised
the premium is still payable, and Noswis would be worse off by the amount of the
premium than if no swaption had been agreed.
However, this premium is the price that must be paid for the flexibility of being able
to take advantage of any lower interest rates in the future.
Furthermore it should be noted that once the swaption is exercised this action
cannot be reversed. Therefore if interest rates subsequently fall, Noswis will
continue to pay the fixed rate of interest set out in the agreement.

Chapter 20
Principles of islamic
finance

PRINCIPLES OF ISLAMIC FINANCE
CHAPTER CONTENTS
INTRODUCTION TO ISLAMIC FINANCE ------------------------------- 331
ISLAMIC BANKING HAS THREE MAIN PRINCIPLES: 332
SHARIAA IMPOSES THE FOLLOWING THREE PROHIBITIONS: 333
IN ADDITION TO THE ABOVE PROHIBITIONS: 334
TYPES OF TRANSACTIONS IN ISLAMIC FINANCE ------------------- 335
PROFIT AND LOSS SHARING PARTNERSHIP METHODS 335
LEASING AND DEFERRED PAYMENT SALES 336
HIRE PURCHASE (IJARA WA-IQTINA) 337
DIRECT INVESTMENT 338
QARD HASAN OR BENEVOLENT LOANS 338
INTERNATIONAL ACCOUNTING STANDARDS FOR ISLAMIC FINANCE339

INTRODUCTION TO ISLAMIC FINANCE
The rapid growth of Islamic Banking has received considerable attention in
international financial circles and its growth potential for the future is being widely
acknowledged.
Social and economic forces operating in modern day commerce have ensured that
economic and financial activities are given prominence in the Islamic world. It has
therefore become necessary to question whether the growing Islamic Banking
sector will be able to compete with the traditional commercial banks in the area of
international trade and finance.
The growing importance levied on Islamic banking is also attributed to the fact that
unlike conventional banking, it is concerned about the viability of the project and
the profitability of the operation and does not focus on the size of the
collateral. Shareholder value maximizing projects that might be rejected by
conventional banks due to lack of collateral would be financed by Islamic banks on
a profit-sharing basis. This ensures that Islamic banks can play a significant role in
stimulating economic development.
The Islamic Development Bank (IDB) is an international financial institution with 46
member countries established in 1973. The IDB is primarily a development
assistance agency rather than a commercial bank, but one of its major roles has
been to promote Islamic banking worldwide through its co-sponsorship with the
Accounting Organization for Islamic Financial Institutions (AAOIFI) of conferences,
seminars and research.
Since the creation of the IDB, a number of Islamic banking institutions have been
formed and countries have taken measures to organise their banking systems along
Islamic principles. The first private Islamic commercial bank, the Dubai Islamic
Bank, was founded in 1975.
Among private Islamic commercial banks, a number of banks belong to certain
holding companies. Today, the Al-Baraka' group, operates banks, investment
companies, financial advisory and management companies in more than a dozen
countries. It launched its activities in 1982 and is today considered to be one of
the fastest growing Islamic enterprises. The group has operations in Tunisia,
Sudan, Bahrain, Turkey, and Malaysia. It is the first group to obtain a license to
launch Islamic banking in London.
The primary intention behind establishing Islamic banks was the desire to
reorganize financial activities in a way that do not contradict the principles of
Shariaa which is the code of law derived from the Koran and from the teachings
and example of Prophet Mohammed.
The authority of Sharia is drawn from four sources. The first source is specific
guidance laid down in the Quran, and the second source is the Sunnah, literally the
'Way', ie the way that Muhammad (the Prophet of Islam) lived his life. The third
source is Qiyas, which is the extension by analogy of existing Sharia law to new
situations. Finally Sharia law is based on ijma, or consensus. Justification for this
final approach is drawn from the Hadith where Muhammad states: "My nation
cannot agree on an error." The umma, or community of Muslims, comes together
with each applying his ijtihad, or independent thought and judgment, to achieve
this consensus. The comprehensive nature of Sharia law is due to the belief that
the law must provide all that is necessary for a person's spiritual and physical well-
being. All possible actions of a Muslim are divided (in principle) into five
categories: obligatory, meritorious, permissible, reprehensible, and forbidden.
In theory, there is no conflict between the process as outlined by Prophet
Mohammed and very progressive and consultative political movements. The
consensus-driven process ensures that the whole community arrives at a well-
reasoned conclusion compatible with science and scholarship. In practice, however,
there is often incredible tension between conservative, liberal or secular forces.
Islamic banking or interest-free banking came into existence because borrowing
from the banks and depositing their savings with the bank are strictly avoided in
order to keep away from dealing in interest which is prohibited by religion. Islamic
banking is also referred to as Profit-Loss-Sharing Banking (PLS). It is based on the
principle that factors of production, goods and services are provided for deferred
payment. Transactions are based on the sharing of risk and reward between the
provider of the funds (the investor) and the user of the funds. Money is treated as
a medium of exchange and therefore Islamic scholars do not allow payment of
interest on it. In addition, payment of interest stifles entrepreneurship and passes
on the risk of any venture solely on the entrepreneur and creates a moral hazard
where the owner of capital is guaranteed return as against the other party, which
has to take all the risk.
Islamic banking has three main principles:
1. It is interest-free
The Western concept of the transaction between individuals and institutions rests
on the basis of time value of money, whereby someone borrowing money has to
repay the lender a higher amount in return for the satisfaction of using that money
today. Western societies reward capitalism and private enterprise through interest.
Islamic societies are founded on the concept of welfare and equitable distribution of
income, whereby growth will be collective, and societal welfare will be prioritized
over individual enterprise. Interest is, hence, considered illegal, and all the tools
and mechanisms for growth will have a profit sharing component instead of an
interest component where one segment in society gains at the expense of the
other.
Thus, in an Islamic society, everyone will share in the profits of an enterprise, and
everyone will bear a loss equally.
2. It is multi-purpose dealing with both Central Bank
functions as well as commercial banking functions
This multi-purpose character of Islamic banking creates difficulties in relation to the
skills required to handle diverse and complex transactions. Islamic banking does
not provide capital guarantee in all its deposit accounts. In many countries, this is
one of the two main objections to permitting the establishment of Islamic banks.
3. It is equity-oriented
Lending and investing are separate functions as loans are interest-free but carry a
service charge, while investing is on a profit-and-loss-sharing (mudaraba) basis.
Commercial banks only grant loans and do not engage in investment-financing.
Investment-financing is conducted through investment banks and investment
companies. Value erosion of capital due to inflation is compensated.
Overall
Therefore, the difference between Islamic banking and finance and conventional
banking lies in the social concept of sharing responsibility, risk, and property.
Consequently, fixed interest transactions where risk is entirely assigned to the
borrower are avoided.
Shariaa imposes the following three prohibitions:
1 Prohibition on riba and interest
There are two forms of riba:
riba al naseeyah which is the interest or monetary compensation paid to the
lender.
riba al fadl or excess compensation without consideration.
The rate of interest in the conventional banking mechanism is considered to be
synonymous to Riba. The Islamic prohibition on interest does not mean that capital
is costless in an Islamic banking system. Islam recognizes capital as a factor of
production but it does not allow the factor to make a prior or pre-determined claim
on the productive surplus in the form of interest. Profit-sharing is the alternative.
In Islam, the owner of capital can legitimately share the profits made by the
entrepreneur. Profit sharing is permissible while interest is not, because in profit
sharing, it is only the profit-sharing ratio, not the rate of return itself that is
predetermined. Even the rate of return on financial assets held in financial
institutions is not known and not fixed prior to undertaking of the transaction. The
rate of return is determined after actual profits are derived from the use of assets
within the economy.
It has been argued that profit-sharing can help allocate resources efficiently, as the
profit sharing ratio can be influenced by market forces so that capital will flow into
those sectors which offer the highest profit- sharing ratio to the investor, other
things being equal.
2 Prohibition on gharar or risk and uncertainty
This includes transactions involving speculation.
Gharar occurs when consequences of a contract are unknown. In this case, what
happens to asset managers who have to take a number of decisions based upon
incomplete information? Decisions often need to be based on what the market is
doing instead of basing actions on rational factors. Examples of irrational decision-
making include investing in familiar assets, excessive trading based on
overconfidence with respect to market knowledge.
Islamic finance spreads risk over society as a whole as profit and loss need to be
shared equally by all as would be the profits.
3 Prohibition on dealing with businesses which involve
forbidden activities such as gambling
In addition to the above prohibitions:
The transaction must be associated with an asset or an
enterprise
This means that the asset should have the following characteristics:
It should be permissible under shariaa and therefore excludes alcohol,
arms, tobacco.
The asset should exist at the time the contract was entered into.
The asset must be owned by the seller. Constructive ownership is acceptable
where the goods are under the direct control of the owner even if the owner
does not have physical possession.
The subject should be specific and determined without uncertainty.
Due to the above prohibitions, majority of the conventional financial instruments
are not suitable to Islamic finance. The prohibition on riba means that Islamic
banks can not lend at interest but can provide financing on a profit and loss sharing
basis and take ownership of the underlying asset.
The prohibition on gharar means that forward contracts and derivatives are not
allowed. Short selling is prohibited because the seller needs to own the asset.
TYPES OF TRANSACTIONS IN ISLAMIC FINANCE

Profit and loss sharing partnership methods
Musharaka or joint venture
Where all parties provide capital as well as skills and expertise and share the profits
and losses on agreed basis. Partners have unlimited liability.
A musharaka transaction arises when one or more entrepreneurs approach an
Islamic bank for the finance required for a project. The bank, along with other
partners, provides complete finance. All partners, including the bank, have the
right to participate in the project. They can also waive this right. The profits are to
be distributed according to an agreed ratio, which need not be the same as the
capital proportions. However, losses are shared in exactly the same proportion in
which the different partners have provided the finance for the project.
Most Islamic banks participate in the equity of companies. There are different
types of musharaka. In permanent musharaka the bank participates in the equity
of a company and receives an annual share of the profits on a pro rata basis. The
period of termination of the contract is not specified. This financing technique is
also referred to as continued musharaka.
Diminishing musharaka is a special form of musharakah, which ultimately results in
the ownership of the asset or the project by the client. The bank participates as a
financial partner, in full or in part, in a project with a given income forecast. An
agreement is signed by the partner and the bank through which the bank receives a
share of the profits as a partner. However, the agreement also provides payment
of a portion of the net income of the project as repayment of the principal financed
by the bank. The partner is entitled to keep the rest. In this way, the bank's share
of the equity is progressively reduced or diminished and the partner eventually
becomes the full owner. The Islamic banks finance real estate projects and the
construction of commercial buildings and housing projects through diminishing
partnership. The bank finances the projects, fully or partially, and the bank obtains a
proportion of the net profits as a partner and receives another payment toward the
final payment of the principal advanced. When the original amount is fully repaid, the
ownership is fully transferred to the partner and the bank has no claim whatsoever.
Mudaraba or passive partnership
Only one of the partners contributes capital and the other contributes skill and
expertise.
One of the partners is providing the capital and the other is running the business,
the relationship is based on trust. The partner contributing capital is liable to the
extent of the capital provided. The contract can be terminated at any time with
reasonable notice.
Mudaraba transactions are appropriate for private equity investments. In the case
of financial institutions and banks, the mudaraba method become applicable as the
bank is a lender to a business it can share in the profits that the business makes
instead of charging an interest on the loan. The result is that risk is shared equally
between lender and borrower. Similarly, if the bank is a borrower, the lenders
deposit is treated as an equity investment, and he or she shares in the profit that
the bank makes through its investments. Conventional banks make a profit on the
spread between the interest rate charged to borrowers and paid to depositors
Islamic banks make a profit on the investments that they make or their borrowers
make.
There are various limitations on the use of mudaraba as a viable basis of financial
intermediation in an interest-free framework. The legal system operating in the
country should provide legal safeguards to the provider of capital so that he can
finance projects on the basis of mudaraba. As a result, the number of banks
providing finance on the basis of mudaraba is not very large. Even among those
banks that use mudaraba as a financing technique, the frequency of its use is not
very high. An Islamic financial institution (IFI) will perform the functions of
financial intermediation through appraising profitable projects and monitoring the
performance of projects on behalf of the investors who deposit their funds with the
IFI. Therefore, the mudaraba contract becomes the cornerstone of financial
intermediation and thus banking.
Leasing and deferred payment sales
Leasing or ijara transaction
A lease contract has to fulfill all of the essentials of a valid contract stipulated by
the shariah. The contract should be clear, should be by mutual agreement, the
responsibilities and benefits of both parties should be clearly spelled out, the
agreement should be for a known period and against a known price. These
conditions become more important in a lease contract because there is more room
for uncertainty or gharar. Hence, it is necessary that the benefits and costs of each
party are clearly stated in the contract.
Leasing is emerging as a popular technique of financing among Islamic banks.
Under this scheme of financing, the bank purchases a real asset and leases it to the
client. The period of lease may be from three months to five years or more, and is
determined by mutual agreement according to the nature of the asset. During the
period of lease, the asset remains in the ownership of the bank but the physical
possession of the asset and the right of use is transferred to the lessee. After the
expiry of the leasing period these revert to the lessor. A lease payment schedule is
agreed by the bank and the lessee based on the amount and terms of financing is
agreed upon by the bank and the lessee. The agreement may or may not include a
grace period.
According to the Islamic principles, the maintenance of the asset during the leasing
period is the responsibility of the owner of the asset, as the benefit or rental is
linked to the responsibility of maintenance. Some Islamic banks may invite other
investors to participate in the leasing operation. For example, some investors and
an Islamic bank may participate in an income yielding real asset leasing project. All
participants in this venture take their share of profit out of the rental income. The
bank also has the right to repurchase participation according to the agreed terms.
The main recipient of leasing based finance is the agricultural sector where all kinds
of equipment, such as tractors, trailers, fishing boats, solar energy plants, other
farm machinery and transport equipment are leased. The Al Baraka Investment
Company uses the technique of ijarah wa iqtina to finance the purchase of large
capital items such as property, industrial plants and heavy machinery. It involves
direct leasing where investors in the scheme receive regular monthly payments that
represent an agreed rental. At the expiry of the lease, the lessee purchases the
equipment.
Murabaha or deferred payment sale or instalment credit sale
If a consumer wishes to purchase an asset, the bank can buys the asset for the
individual on an agreed upon price between the individual and the seller. The
individual then purchases the asset from the bank at the purchase price plus a
mark-up. However, critics have pointed out that the mark-up has the same
connotation as interest, and this similarity with traditional banking is perhaps one
of the reasons why murabaha contracts are widely accepted.
Murabaha contracts are applied to financing of raw materials, machinery,
equipment and consumer durables as well as short-term trade financing.
One application of murabaha sale is in the issuing of a letter of credit:
The customer requests the bank to open a letter of credit to import goods
from abroad through an application which includes a pro-forma invoice and
other necessary details and information.
After securing the necessary guarantee and scrutinizing the application, the
bank opens a letter of credit in favour of the client and sends copies to the
correspondent bank abroad and to the exporter.
The customer endorses a "Promise to Buy" the merchandise.
The cost of the goods and the conditions of delivery are negotiated.
The exporter makes arrangements to export the goods and delivers the
documents to the correspondent bank abroad.
The shipment of the goods takes place and the correspondent bank advises
the bank and sends the documents.
After the confirmation of the bank's ownership of the goods in question
through the acquisition of related documents an Agreement of Sale is signed
with the client.
Hire purchase (ijara wa-iqtina)
Advance purchase financing, (istisna)
Long term production finance or a purchase contract for future delivery of an asset
and is exempt from the conditions of ownership and existence.
The payment to the producer or contractor of the asset does not have to be in full
in advance. Payment is made in instalments depending on the progress made.
Salam contract
Salam contract is a short term production contract or a purchase contract in which
payment is made today against future delivery of an asset. (Sale with deferred
delivery).
Salam contracts are exempted from criteria of existence and ownership.
In istisna and salam contracts, the buyer takes a business risk and is therefore not
subject to the prohibitions of gambling and uncertainty.
Direct investment
In direct investment, the Islamic bank performs the role of an investment company.
The option of direct investment gives Islamic banks an opportunity to invest in
priority projects in chosen sectors. In this way, banks can channel their funds in
the direction they think most desirable.
There are several ways in which Islamic banks undertake direct investment. A
number of Islamic banks have taken the initiative in establishing and managing
subsidiary companies.
The general method of undertaking direct investment includes establishing a company
dealing with investment, insurance and reinsurance, trade, construction and real
estate. Another method of undertaking direct investment is participation in the equity
capital of other companies. The companies are established by the Islamic banks
themselves and the public subscription of shares are invited or banks participate in
the equity capital of companies established by others.
Qard Hasan or benevolent loans
A loan given in accordance with the Islamic principles has to be a benevolent loan
(qard hasan), without interest. It has to be granted on the grounds of compassion,
to remove the financial distress caused by the absence of sufficient money in the
face of dire need.
Since banks are profit-oriented organizations, it would seem that there is not much
scope for the application of this technique. However, Islamic banks also play a
socially useful role. Hence, they make provisions to provide qard hasan besides
engaging in income generating activities.
Islamic banking is sophisticated in respect of financing techniques and hence
permits Islamic banks to compete in international trade and finance. Islamic
banking has been able to offer various kinds of financial products. It is in the area
of assets rather than liabilities that the practices of Islamic banks are more diverse
and complex than those of conventional banks. There is a near-consensus that
Islamic banks can function well without interest.
INTERNATIONAL ACCOUNTING STANDARDS FOR
ISLAMIC FINANCE
An area that is gaining global importance is that of International Accounting
Standards. There has been an emphasis to develop international accounting
standards in response to the increasing globalisation of markets and economies. It
is argued that international standards will increase comparability and
understandability of financial statements, save time and money, ease interpretation
and improve the credibility of the financial reporting process.
The process of international standard setting is dominated by western accounting
practices that are not always applicable to Islamic purposes, as Islamic economics
is based on completely different considerations than is Western economics.
International Accounting Standards and Practices would be particularly inapplicable
to zakat and interest-free banking. Islamic countries should have a greater input
into the international standard-setting process if they are to compete in the area of
international trade and finance.
Those with a certain level of accumulated wealth are obliged to pay zakat in an
effort to eradicate poverty and redistribute wealth from the rich to the poor and
needy. Thus zakat keeps wealth constantly circulating in society. It creates a
society based on mutual assistance and ensures that a minimum standard of living
is available to all people in the Islamic society.
The rules for zakat are inconsistent with the generally accepted accounting practice
(GAAP) of international accounting. The two primary assets in the context of
international trade would be inventories and accounts receivables. Discrepancies
arise in the valuation of inventories, accounts receivable and the concept of
conservatism.
According to GAAP, inventories are to be valued at the lower of cost or market
value. Market value can be either replacement cost or net realisable value.
However, for zakat purposes, only the selling price is relevant. This means that
Islamic organizations cannot apply GAAP valuation for inventories as by doing so
they would not be complying with the rules for zakat.
Zakat is payable on net receivables or accounts receivable net of expected bad
debts minus accounts payable. However, Islamic economics does not provide for
an estimated provision for bad debts. Accounts are assessed one-by-one to
determine whether and to what extent they are expected to be collected.
The accounting concept of conservatism is also is inconsistent with the concept of
zakat. Conservatism requires that assets and revenues are not overstated and
liabilities and expenses are not understated. Understating assets would mean less
zakat liability. However, paying zakat is one of the most important religious duties
of Muslims, and Islam encourages Muslims to be generous with their wealth.
Therefore, they must be careful not to understate their assets or overstate their
liabilities, and thus the concept of conservatism is not applicable for assessing
zakat.
The AAOIFI standards attempt to take into account many transactions that occur in
international trade and finance such as documentary credit. For example, it is not
permissible for an Islamic bank to secure obligations arising out of documentary
credit or to provide documentary credit as security for payment in favour of
institutions and banks dealing with it.



ACCA STUDY
GUIDE

ACCA STUDY GUIDE
ACCA STUDY GUIDE

Can I rely on these Class Notes to cover the syllabus?
The answer is YES!
To quote ACCA:
This is the main document that students, tuition providers and
publishers should use as the basis of their studies, instruction and
materials. Examinations will be based on the detail of the study guide
which comprehensively identifies what could be examined in any
examination sitting. The study guide is a precise reflection and
breakdown of the syllabus.
Below I have set out ACCAs Study Guide in detail for you.
A Role and responsibility towards stakeholders
1. The role and responsibility of senior financial executive/
advisor
a) Develop strategies for the achievement of the companys goals in line with its
agreed policy framework.
b) Recommend strategies for the management of the financial resources of the
company such that they are utilised in an efficient, effective and transparent
way.
c) Advise the board of directors of the company in setting the financial goals of
the business and in its financial policy development with particular reference
to:
i) Investment selection and capital resource allocation.
ii) Minimising the companys cost of capital.
iii) Distribution and retention policy.
iv) Communicating financial policy and corporate goals to internal and
external stakeholders.
v) Financial planning and control.
vi) The management of risk.
2. Financial strategy information
a) Assess corporate performance using methods such as ratios, trends, EVA
TM

and MVA.
b) Recommend the optimum capital mix and structure within a specified business
context and capital asset structure.
c) Recommend appropriate distribution and retention policy.
d) Explain the theoretical and practical rationale for the management of risk.
ACCA STUDY GUIDE
e) Assess the companys exposure to business and financial risk including
operational, reputational, political, economic, regulatory and fiscal risk.
f) Develop a framework for risk management comparing and contrasting risk
mitigation, hedging and diversification strategies, and demonstrate risk
diversification through the application of portfolio theory.
g) Establish capital investment monitoring and risk management systems.
3. Conflicting stakeholder interests
a) Assess the potential sources of the conflict within a given corporate
governance/stakeholder framework informed by an understanding of the
alternative theories of managerial behaviour.
Relevant underpinning theory for this assessment would be:
i) The Separation of Ownership and Control.
ii) Transaction cost economics and comparative governance structures.
iii) Agency Theory.
b) Recommend, within specified problem domains, appropriate strategies for the
resolution of stakeholder conflict and advise on alternative approaches that
may be adopted.
c) Compare the emerging governance structures and policies with respect to
corporate governance (with particular emphasis upon the European
stakeholder and the US/UK shareholder model) and with respect to the role of
the financial manager.
4. Ethical issues in financial management
a) Assess the ethical dimension within business issues and decisions and advise
on best practice in the financial management of the company.
b) Demonstrate an understanding of the interconnectedness of the ethics of good
business practice between all of the functional areas of the company.
c) Establish an ethical financial policy for the financial management of the
company which is grounded in good governance, the highest standards of
probity and is fully aligned with the ethical principles of the Association.
d) Recommend an ethical framework for the development of a companys
financial policies and a system for the assessment of their ethical impact upon
the financial management of the company.
e) Explore the areas within the ethical framework of the company which may be
undermined by agency effects and/or stakeholder conflicts and establish
strategies for dealing with them.
5. Impact of environmental issues on corporate objectives
and on governance
a) Assess the issues which may impact upon corporate objectives and
governance from:
i) Sustainability and environmental risk.
ii) The carbon-trading economy and emissions.
ACCA STUDY GUIDE
iii) The role of the environment agency.
iv) Environmental audits and the triple bottom line approach.
B Economic environment for multinationals
1. Management of international trade and finance
a) Advise on the theory and practice of free trade and the management of
barriers to trade.
b) Demonstrate an up to date understanding of the major trade agreements and
common markets and, on the basis of contemporary circumstances, advise on
their policy and strategic implications for a given business.
c) Discuss the objectives of the World Trade Organisation.
d) Discuss the role of international financial institutions within the context of a
globalised economy, with particular attention to the International Monetary
Fund, the Bank of International Settlements, The World Bank and the principal
Central Banks (the Fed, Bank of England, European Central Bank and the
Bank of Japan).
e) Assess the role of the international financial markets with respect to the
management of global debt, the financial development of the emerging
economies and the maintenance of global financial stability.
2. Strategic business and financial planning for
multinationals
a) Advise on the development of a financial planning framework for a
multinational taking into account:
i) Compliance with national governance requirements (for example the
London Stock Exchange admission requirements).
ii) The mobility of capital across borders and national limitations on
remittances and transfer pricing.
iii) The pattern of economic and other risk exposures in the different
national markets.
iv) Agency issues in the central coordination of overseas operations and the
balancing of local financial autonomy with effective central control.
C Advanced investment appraisal
1. Discounted cash flow techniques and the use of free cash
flows
a) Evaluate the potential value added to a company arising from a specified
capital investment project or portfolio using the net present value model.
Project modelling should include explicit treatment and discussion of:
i) Inflation and specific price variation.
ii) Taxation including capital allowances and tax exhaustion.
ACCA STUDY GUIDE
iii) Multi-period capital rationing to include the formulation of programming
methods and the interpretation of their output.
iv) Probability analysis and sensitivity analysis when adjusting the risk and
uncertainty in investment appraisal.
b) Outline the application of Monte Carlo simulation to investment appraisal.
Candidates will not be expected to undertake simulations in an examination
context but will be expected to demonstrate an understanding of:
i) Simple model design.
ii) The different types of distribution controlling the key variables within the
simulation.
iii) The significance of the simulation output and the assessment of the
likelihood of project success.
iv) The measurement and interpretation of project value at risk.
c) Establish the potential economic return (using internal rate of return and
modified internal rate of return) and advise on a projects return margin.
d) Forecast a companys free cash flow and its free cash flow to equity (pre and
post capital reinvestment).
e) Advise, in the context of a specified capital investment programme, on a
companys current and projected dividend capacity.
f) Advise on the value of a company using its free cash flow and free cash flow
to equity under alternative horizon and growth assumptions.
2. Application of option pricing theory in investment
decisions and valuation
a) Apply the Black-Scholes Option Pricing (BSOP) model to financial product/
asset valuation:
i) Determine, using published data, the five principal drivers of option
value (value of the underlying, exercise price, time to expiry, volatility
and the risk-free rate).
ii) Discuss the underlying assumptions, structure, application and
limitations of the BSOP model.
b) Evaluate embedded real options within a project, classifying them into one of
the real option archetypes.
c) Assess and advise on the value of options to delay, expand, redeploy and
withdraw using the BSOP model.
d) Apply the BSOP model to estimate the value of equity of a company and
discuss the implications of the change in value.
3. Impact of financing on investment decisions and adjusted
present values
a) Assess the appropriateness and price of the range of sources of finance
available to a company including equity, debt, hybrids, lease finance, venture
capital, business angel finance, private equity, asset securitisation and sale.
ACCA STUDY GUIDE
b) Assess a companys debt exposure to interest rate changes using the simple
Macaulay duration method.
c) Discuss the benefits and limitations of duration including the impact of
convexity.
d) Assess the companys exposure to credit risk, including:
i) Explain the role of, and the risk assessment models used by the
principal rating agencies.
ii) Estimate the likely credit spread over risk free.
iii) Estimate the companys current cost of debt capital using the
appropriate term structure of interest rates and the credit spread.
e) Explain the role of BSOP model in the assessment of default risk, the value of
debt and its potential recoverability.
f) Assess the impact of financing and capital structure upon the company with
respect to:
i) Pecking order theory.
ii) Static trade-off theory.
iii) Agency effects.
g) Apply the adjusted present value technique to the appraisal of investment
decisions that entail significant alterations in the financial structure of the
company, including their fiscal and transactions cost implications.
h) Assess the impact of a significant capital investment project upon the reported
financial position and performance of the company taking into account
alternative financing strategies.
4. International investment and financing decisions
a) Assess the impact upon the value of a project of alternative exchange rate
assumptions.
b) Forecast project or company free cash flows in any specified currency and
determine the projects net present value or company value under differing
exchange rate, fiscal and transaction cost assumptions.
c) Evaluate the significance of exchange controls for a given investment decision
and strategies for dealing with restricted remittance.
d) Assess the impact of a project upon a companys exposure to translation,
transaction and economic risk.
e) Assess and advise upon the costs and benefits of alternative sources of
finance available within the international equity and bond markets.
D Acquisitions and mergers
1. Acquisitions and mergers versus other growth strategies
a) Discuss the arguments for and against the use of acquisitions and mergers as
a method of corporate expansion.
b) Evaluate the corporate and competitive nature of a given acquisition proposal.
ACCA STUDY GUIDE
c) Advise upon the criteria for choosing an appropriate target for acquisition.
d) Compare the various explanations for the high failure rate of acquisitions in
enhancing shareholder value.
e) Evaluate, from a given context, the potential for synergy separately classified
as:
i) Revenue synergy.
ii) Cost synergy.
iii) Financial synergy.
2. Valuation for acquisitions and mergers
a) Outline the argument and the problem of overvaluation.
b) Estimate the potential near-term and continuing growth levels of a companys
earnings using both internal and external measures.
c) Assess the impact of an acquisition or merger upon the risk profile of the
acquirer distinguishing:
i) Type 1 acquisitions that do not disturb the acquirers exposure to
financial or business risk.
ii) Type 2 acquisitions that impact upon the acquirers exposure to financial
risk.
iii) Type 3 acquisitions that impact upon the acquirers exposure to both
financial and business risk.
d) Advise on the valuation of a type 1 acquisition of both quoted and unquoted
entities using:
i) Book value-plus models.
ii) Market relative models.
iii) Cash flow models, including EVA
TM
, MVA.
e) Advise on the valuation of type 2 acquisitions using the adjusted net present
value model.
f) Advise on the valuation of type 3 acquisitions using iterative revaluation
procedures.
g) Demonstrate an understanding of the procedure for valuing high growth start-
ups.
3. Regulatory framework and processes
a) Demonstrate an understanding of the principal factors influencing the
development of the regulatory framework for mergers and acquisitions
globally and, in particular, be able to compare and contrast the shareholder
versus the stakeholder models of regulation.
b) Identify the main regulatory issues which are likely to arise in the context of a
given offer and:
i) Assess whether the offer is likely to be in the shareholders best
interests.
ACCA STUDY GUIDE
ii) Advise the directors of a target company on the most appropriate
defence if a specific offer is to be treated as hostile.
4. Financing acquisitions and mergers
a) Compare the various sources of financing available for a proposed cash-based
acquisition.
b) Evaluate the advantages and disadvantages of a financial offer for a given
acquisition proposal using pure or mixed mode financing and recommend the
most appropriate offer to be made.
c) Assess the impact of a given financial offer on the reported financial position
and performance of the acquirer.
E Corporate reconstruction and reorganisation
1. Financial reconstruction
a) Assess a company situation and determine whether a financial reconstruction
is the most appropriate strategy for dealing with the problem as presented.
b) Assess the likely response of the capital market and/or individual suppliers of
capital to any reconstruction scheme and the impact their response is likely to
have upon the value of the company.
c) Recommend a reconstruction scheme from a given business situation,
justifying the proposal in terms of its impact upon the reported performance
and financial position of the company.
2. Business reorganisation
a) Recommend, with reasons, strategies for unbundling parts of a quoted
company.
b) Evaluate the likely financial and other benefits of unbundling.
c) Advise on the financial issues relating to a management buy-out and buy-in.
F Treasury and advanced risk management techniques
1. The role of the treasury function in multinationals
a) Describe the role of the money markets in:
i) Providing short-term liquidity to industry and the public sector.
ii) Providing short-term trade finance.
iii) Allowing a multinational company to manage its exposure to FOREX and
interest rate risk.
b) Explain the role of the banks and other financial institutions in the operation
of the money markets.
c) Explain the characteristics and role of the principal money market
instruments:
i) Coupon bearing.
ACCA STUDY GUIDE
ii) Discount instruments.
iii) Derivative products.
d) Discuss the operations of the derivatives market, including:
i) The relative advantages and disadvantages of exchange traded versus
OTC agreements.
ii) Key features, such as standard contracts, tick sizes, margin
requirements and margin trading.
iii) The source of basis risk and how it can be minimised.
iv) Risks such as delta, gamma, vega, rho and theta, and how these can be
managed.
e) Explain the role of the treasury management function within:
i) The short term management of the companys financial resources.
ii) The longer term maximisation of shareholder value.
iii) The management of risk exposure.
2. The use of financial derivatives to hedge against FOREX
risk
a) Assess the impact on a company to exposure in translation, transaction and
economic risks and how these can be managed.
b) Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk
exposure:
i) The use of the forward exchange market and the creation of a money
market hedge.
ii) Synthetic foreign exchange agreements (SAFEs).
iii) Exchange-traded currency futures.
iv) Currency swaps.
v) FOREX swaps.
vi) Currency options.
c) Advise on the use of bilateral and multilateral netting and matching as tools
for minimising FOREX transactions costs and the management of market
barriers to the free movement of capital and other remittances.
3. The use of financial derivatives to hedge against interest
rate risk
a) Evaluate, for a given hedging requirement, which of the following is the most
appropriate given the nature of the underlying position and the risk exposure:
i) Forward Rate Agreements.
ii) Interest Rate Futures.
iii) Interest rate swaps.
iv) Options on FRAs (caps and collars), interest rate futures and interest
rate swaps.
ACCA STUDY GUIDE
4. Dividend policy in multinationals and transfer pricing
a) Determine a companys dividend capacity and its policy given:
i) The companys short- and long-term reinvestment strategy.
ii) The impact of any other capital reconstruction programmes on free cash
flow to equity such as share repurchase agreements and new capital
issues.
iii) The availability and timing of central remittances.
iv) The corporate tax regime within the host jurisdiction.
b) Develop company policy on the transfer pricing of goods and services across
international borders and be able to determine the most appropriate transfer
pricing strategy in a given situation reflecting local regulations and tax
regimes.
G Emerging issues
1. Developments in world financial markets
Discuss the significance to the company, of latest developments in the world
financial markets such as the causes and impact of the recent financial crisis,
growth and impact of dark pool trading systems, the removal of barriers to the free
movement of capital, and the international regulations on money laundering.
2. Developments in international trade and finance
Demonstrate an awareness of new developments in the macroeconomic
environment, establishing their impact upon the company, and advising on the
appropriate response to those developments both internally and externally.

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

= 8,000 7,500 = 500 million

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