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ACCA Passcards Paper P4 Advanced Financial Management Passcards for exams from 1 September 2015 – 31 August 2016



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Professional Paper P4 Advanced Financial Management



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First edition 2007, Eighth edition Apr il 2015 ISBN 9781 4727 2708 4 e ISBN 9781 4727 2773 2 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Published by BPP Learning Media Ltd BPP House, Aldine Place 142-144 Uxbridge Road London W12 8AA www.bpp.com/learningmedia



Printed in the UK by RICOH UK Limited Unit 2 Wells Place Merstham RH1 3LG



Your learning materials, published by BPP Learning Media Ltd, are printed on paper obtained from traceable sustainable sources.



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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 BPP Learning Media. © BPP Learning Media Ltd 2015



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Preface



Contents



Welcome to BPP Learning Media’s ACCA Passcards for Professional Paper P4 Advanced Financial Management.  They focus on your exam and save you time.  They incorporate diagrams to kickstart your memory.  They follow the overall structure of BPP Learning Media’s Study Texts, but BPP Learning Media’s ACCA Passcards are not just a condensed book. Each card has been separately designed for clear presentation. Topics are self contained and can be g rasped visually.  ACCA Passcards are still just the right size for pockets, briefcases and bags. Run through the Passcards as often as you can during your final revision period. The day before the exam, try to go through the Passcards again! You will then be well on your way to passing your exams. Good luck!



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Preface



Page 1 2 3a 3b 3c 4 5 6 7a 7b 8



The role and responsibility of senior financial executive Financial strategy formulation Conflicting stakeholder interests Ethical issues in financial management Environmental issues Trading and planning in a multinational environment DCF Application of option pricing theory in investment decisions Impact of financing and APV method Valuation and free cash flows International investment decisions



1 7 17 23 25 31 41 47 51 65 73



Contents



Page 9 Acquisitions and mergers vs growth 81 10 Valuation for acquisitions and mergers 87 11 Regulatory framework and processes 99 12 Financing mergers and acquisitions 105 13–14 Reconstruction and reorganisation 111 15 The treasury function in multinationals 119 16 Hedging forex risk 123 17 Hedging interest rate risk 135 18 Dividend policy in multinationals and transfer pricing 143 19 Recent developments 149



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1: The role and responsibility of senior financial executive Topic List Financial management Financial planning



Senior financial executives are required to make crucial decisions, including those related to investment, distribution and retention.



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Financial management



Financial planning



Financial objectives



Non-financial objectives



The prime financial objective is to maximise the market value of the company’s shares. Primary targets are profits and dividend growth. Other targets may be the level of gearing, profit retentions, operating profitability and shareholder value indicators.



Non-financial objectives do not negate financial objectives, but they do mean that the pr imary financial objectives may be modified. They take account of ethical considerations. Examples



Why profit maximisation is not a sufficient objecture    



Risk and incertainty Profit manipulation Sacrifice of future profits? Dividend policy



    



Employee welfare Management welfare Society’s welfare Service provision Responsibilities towards customers/suppliers



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Investment decisions Investment decisions include:  New projects  Takeovers  Mergers  Sell-off/Divestment The financial manager must:  Identify decisions  Evaluate them  Decide optimal fund allocation



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Financing decisions



Dividend decisions



Financial decisions include:  Long-term capital structure Need to determine source, cost and risk of long-term finance.  Short-term working capital management Balance between profitability and liquidity is crucial.



Dividend decisions may affect views of the company’s long-term prospects, and thus the shares’ market values. Payment of dividends limits the amount of retained earnings available for re-investment.



1: The role and responsibility of senior financial e xecutive



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Financial management



Financial planning



Strategic planning



Key elements of financial planning



The formulation, evaluation and selection of strategies to prepare a long-term plan of action to attain objectives. Strategic decisions should be suitable, feasible and acceptable.



   



 Long-term direction  Matching activities to environment/resources Strategic analysis means analysing the organisation in its environment, its resources, competences, mission and objectives. Strategic choice involves generating and evaluating strategic options and selecting strategy.



Long-term investment and short-term cash flow Surplus cash How finance raised Profitable



Strategic cash flow management Planning involves a long horizon, uncertainties and contingency plans.



Strategic fund management Consideration of which assets are essential and how easily assets can be sold.



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Strategic Tactical



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Investment



Financing



Dividend



Selection of products/markets Target profits Purchase of major non-current assets Other non-current asset purchases Efficient/effective resource usage Pricing



Debt/equity mix



Growth v dividend payout



Lease v buy



Scrip v cash dividends



Tactical planning and control Conflict may arise between strategic planning (need to invest in more expensive machinery, research and development) and tactical planning (cost control). Page 5



1: The role and responsibility of senior financial e xecutive



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Financial management



Financial planning



Johnson and Scholes separate power groups into 'internal coalitions' and 'external stakeholder groups'. Stakeholder goals Shareholders



Providers of risk capital, aim to maximise wealth



Suppliers



To be paid full amount by date agreed, and continue relationship (so may accept later payment)



Long-term lenders



To receive payments of interest and capital by due date



Employees



To maximise salaries and benefits; also prefer continuity in employment



Government



Political objectives such as sustained economic growth and high employment



Management



Maximising their own rewards



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2: Financial strategy formulation



Topic List Assessing corporate performance Financial strategy Arbitrage Risk and risk management



Formulating the correct financial strategy is crucial for business success. The four main areas of financial strategy are capital structure policy, dividend policy, risk management and capital investment monitoring.



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Assessing corporate performance



Profitability and return  Return on capital employed  Profit margin  Asset turnover



Debt and gearing    



Debt ratio (Total debts: Assets) Gearing (Proportion of debt in long-term capital) Interest cover Cash flow ratio (Cash inflow: Total debts)



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Financial strategy



Arbitrage



Risk and risk management



Liquidity ratios  Current ratio  Inventory turnover  Receivables’ days



 Acid test ratio  Payables’ days



Stock market ratios  Dividend yield  Earnings per share  Price/earnings ratio



 Interest yield  Dividend cover



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Comparisons with previous years     



% growth in profit % growth in revenue Changes in gearing ratio Changes in current/quick ratios Changes in inventory/ receivables turnover



 Changes in EPS, market price, dividend Remember however



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Comparisons with other companies in same industry These can put improvements on previous years into perspective if other companies are doing better, and provide further evidence of effect of general trends.  Growth rates  Retained profits  Non-current asset levels



Comparisons with companies in different industries Investors aiming for diversified portfolios need to know differences between industrial sectors.     



Sales growth Profit growth ROCE P/E ratios Dividend yields



 Inflation – can make figures misleading  Results in rest of industry/environment, or economic changes Page 9



2: Financial strategy formulation



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Assessing corporate performance



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Financial strategy



Arbitrage



Risk and risk management



Economic Value Added (EVATM) EVATM = NOPAT – (cost of capital × capital employed)



Adjustments to NOPAT Add:  Interest on debt  Goodwill written off  Accounting depreciation  Increases in provisions  Net capitalised intangibles



Adjustments to capital employed Add:  Cumulative goodwill written off  Cumulative depreciation written off  NBV of intangibles  Provisions



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Shares     



Ownership stake Equity (full voting rights) Preference (prior right to dividends) All companies can use rights issues Listed companies can use offer for sale/placing



Debt/Bonds     



Fixed or floating rate Zero coupon (no interest) Convertible Bank loans Security over property may be required



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Comparison of finance sources When comparing different sources of finance, for example different categories of debt, the following factors will generally be important:       



Cost Flexibility Commitments Uses Speed/availability Certainty of raising amounts Time period available



2: Financial strategy formulation



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Assessing corporate performance



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Financial strategy



Estimating cost of equity  Theoretical valuation models, eg Capital Asset Pricing Model (CAPM) or Arbitrage Pricing Theory (APT)  Bond-yield-plus-premium approach: adds a judgmental risk premium to the interest rate on the firm’s own long-term debt  Market-implied estimates using discounted cash flow (DCF) approach (based on an assumption on the growth rate of earnings of the company)



Arbitrage



Risk and risk management



Practicalities in issuing new shares    



Costs Income to investors Tax Effect on control



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Assessing corporate performance



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Financial strategy



Pecking order  Retained earnings  Debt  Equity



Whether lenders are prepared to lend (secur ity) Availability of stock market funds Future trends Restrictions in loan agreements Maturity of current debt



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Risk and risk management



Suitability of capital structure       



Feasibility of capital structure     



Arbitrage



Company financial position/ stability of ear nings Need for a number of sources Time period of assets matched with funds Change in risk-return Cost and flexibility Tax relief Minimisation of cost of capital Acceptability of capital structure



   



Risk attitudes Loss of control by directors Excessive costs Too heavy commitments 2: Financial strategy formulation



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Assessing corporate performance



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Financial strategy



Arbitrage



Risk and risk management



Dividend policy Dividend decisions determine the amount of, and the way in which, a company’s profits are distributed to its shareholders.



Ways of paying dividends  Cash  Shares (stock)  Share repurchases



Theories of why dividends are paid     



Residual theory Target payout ratio Dividends as signals Taxes Agency theory



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Assessing corporate performance



CAPM exam formula E(r i) = Rf + βi (E(rm) – Rf)



Factor analysis



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Financial strategy



Arbitrage



Risk and risk management



Arbitrage pricing theory The theory assumes that the return on each security is based on a number of independent factors. r = E(r j ) + B1F1 + B2F2 ... + e



Analysis used to determine factors to which security returns are sensitive. Research indicates:



E (rj ) is expected return on security



   



F1 is difference between Factor 1 actual and expected values e is a random term



Unanticipated inflation Changes in industrial production levels Changes in risk premiums on bonds Unanticipated changes in interest rate term structure



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B1 is sensitivity to changes in Factor 1



2: Financial strategy formulation



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Assessing corporate performance



Types of risk         



Systematic and unsystematic Business Financial Political Economic Fiscal Regulatory Operational Reputational



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Financial strategy



Arbitrage



Risk and risk management



Risk management Overriding reason for managing risk is to maximise shareholder value.



Risk mitigation The process of minimising the likelihood of a risk occurring or the impact of that r isk if it does occur.



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3a: Conflicting stakeholder interests



Topic List



Governance of a modern corporation can give rise to conflicts between the various stakeholders of the firm.



Stakeholders



Be prepared to answer questions on key concepts such as agency theory or goal congruence, or developments in corporate governance.



Corporate governance



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Stakeholders



Separation of ownership and management: ordinary (equity) shareholders are owners of the company, but the company is managed by its board of directors. Central source of stakeholder conflict: difference between the interests of managers and those of o wners. Sources of stakeholder conflict     



Short-termism Sales objective (instead of shareholder value) Overpriced acquisitions Resistance to takeovers Relationships with stakeholders may be difficult



Corporate governance



Transaction costs economics The transaction costs economics theory postulates that the governance structure of a corporation is determined by transaction costs.



The transactions costs include search and information costs, bargaining costs and policing and enforcement costs.



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Stakeholders



Agency theory



Corporate governance



Goal congruence



proposes that, whilst individual team members act in their own self-interest, individual well-being depends on the well-being of other individuals and on the performance of the team.



is accordance between the objectives of agents acting within an organisation and the objectives of the organisation as a whole.



Corporations are set of contracts between principals (suppliers of finance) and agents (management).



Management incentives may enhance congruence:



The agency problem If managers don’t have significant shareholdings, what stops them under-performing and overrewarding themselves?



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 Profit-related pay  Rights to subscribe at reduced price  Executive share-option plans BUT management may adopt creative accounting. Sound corporate governance is another approach.



3a: Conflicting stakeholder interests



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Stakeholders



Corporate governance



UK Corporate Governance Code AUDITORS provide external assurance DIRECTORS responsible for corporate governance



FINANCIAL REPORTING SYSTEM links



SHAREHOLDERS



OTHER USERS Board of directors    



Meet regularly Matters refer to board Division of responsibilities Committees – audit, nomination, remuneration



(employees, creditors)



Executive directors Limits on service contracts, emoluments decided by remuneration committee and fully disclosed



Non executive directors    



Majority independent No business/financial links Don’t participate in options Appointed for specified term



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Annual general meeting  20 working days’ notice  Separate resolutions on separate issues  All committees answer questions



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Accountability and audit    



Audit committee of non-executive directors Consider need for internal audit function Accounts contain corporate governance statement Directors review and report on internal controls



The Higgs Report stresses the importance of the board including a balance of e xecutive and non-executive directors such that no individual or small g roup can dominate decision-making. The report also lays down criteria for establishing the independence of non-executive directors, and stresses the need to separ ate the roles of Chairman and Chief Executive.



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3a: Conflicting stakeholder interests



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Stakeholders



International comparisons USA



Europe



Corporate governance



Japan



By means of Stock Exchange regulation, stringent reporting requirements, tightened by Sarbanes-Oxley.



By means of tax law. Also two-tier board system to protect shareholder interests.



Flexible approach to governance, low level of regulation. All stakeholders collaborate.



The US system is based on control by legislation, regulation, more rules on directors’ duties than in UK. Major creditors are often on boards.



In Germany, banks have longerterm role, may have equity stake. Separate supervisory board has workers’ and shareholders’ representatives.



Stock market is less open, more links with banks than in UK. Policy boards (long-term) Functional boards (executive) Monocratic boards (symbolic)



Management culture Management culture comprises views on management and methods of doing b usiness. Multinationals may have particular problems imposing the parent company’s culture overseas eg American practices in Europe.



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3b: Ethical issues in financial management



Topic List Ethical aspects



Ethics have become increasingly important in formulating financial strategies. Financial managers must remember to build ethical considerations into the decision-making process.



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Ethical aspects



Human resource management



Business ethics



Marketing Market behaviour



Product development



Minimum wage, discrimination



Social and cultural impact Dominant position, treatment of suppliers and customers Animal testing, sensitivity to culture of different countries and markets



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3c: Environmental issues



Topic List Business practice Regulation



You could be asked to discuss how the financial manager needs to take into account environmental issues when formulating corporate policy.



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Business practice



Regulation



Green issues and business practice



Environmental reporting



Direct environmental impacts on business – eg:



Many companies produce an external report for external stakeholders, covering:  How business activity impacts on environment  An environmental objective (eg use of 100% recyclable materials within x years)  The company's approach to achieving and monitoring these objectives  An assessment of its success towards achieving the objectives  An independent verification of claims made



 Changes affecting costs or resource availability  Impact on demand  Effect on power balances between competitors in a market Indirect environmental impacts: eg, legislative change; pressure from customers or staff as a consequence of concern over environmental problems.



Sustainability refers to the concept of balancing g rowth with environmental, social and economic concerns.



Company’s environmental policy



may include reduction/management of risk to the business, motivating staff and enhancement of corporate reputation.



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Triple bottom line decision making



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Triple bottom line proxy indicators



Economic



Economic impact  Gross operating surplus  Dependence on imports  Stimulus to domestic economy by purchasing locally produced goods and services



Environmental



Social



Triple bottom line reporting: a quantitative summary of a company’s economic, environmental and social performance over the previous year. Page 27



Social impact  Organisation’s tax contribution  Employment Environmental impact  Ecological footprint  Emissions to soil, water and air  Water and energy use 3c: Environmental issues



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Business practice



Financial capital



Manufactured capital



Intellectual capital



Integrated reporting



Human capital



Social and relationship capital



Natural capital



Regulation



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Principles of integrated reporting Integrated reports should be based on a n umber of principles:       



Strategic focus and future orientation Connectivity of information Stakeholder responsiveness Materiality Conciseness Reliability and completeness Consistency and comparability



Integrated thinking involves consideration of the interrelationships between operating and financial units and the capitals the business uses.



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Contents of integrated report      



Organisational overview and external environment Governance structure and value creation Business model Opportunities and risks Strategy and resource allocation Performance – achievement of strategic objectives and impact on capitals



 Basis of preparation and presentation



3: Environmental issues



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Business practice



Carbon trading allows companies which emit less than their allowance to sell the right to emit CO2 to another company.



UNFCCC



United Nations Framework Convention on Climate Change agreements:



 



To develop programs to slow climate change To share technology and cooperate to reduce greenhouse gas emissions







To develop a greenhouse gas inventory listing national sources and sinks



1997 Kyoto Protocol to the UNFCCC obliged signatories to reduce total greenhouse gas emissions by 2012, compared to 1990 levels. EU15 reduction target: 8%.



Regulation



Environment Agency Mission: to protect or enhance environment, so as to promote the objective of achieving sustainable development.



Environmental audit is an audit that seeks to assess the environmental impact of a company's policies. The auditor will check whether the company’s environmental policy:   



Satisfies key stakeholder criteria Meets legal requirements Complies with British Standards or other local regulations



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4: Trading and planning in a multinational environment Topic List Trade Institutions International financial markets Global financial stability Multinationals’ strategy Risk



The growth of international trade brings benefits and risks for the corporation. The globalisation of international markets facilitates the flow of funds to emerging mar kets but may create instability.



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Trade



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International financial markets



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Global financial stability



International trade World output of goods and ser vices is increased if countries specialise in the production of goods/services in which they have a comparative advantage and trade to obtain other goods and services.



Multinationals’ strategy



Barriers to market entry     



Product differentiation barriers Absolute cost barriers Economy of scale barriers The level of fixed costs Legal/patent barriers Protectionist measures



Comparative advantage Countries specialising in what they produce, even if they are less efficient (in absolute ter ms) in production of all types of good, is the compar ative advantage justification of free trade, without protectionism or trade barriers.



      



Tariffs or customs duties Import quotas Embargoes Hidden subsidies Import restrictions Restrictive bureaucratic procedures Currency devaluations



Risk



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What’s wrong with trade protection    



Mutually beneficial trade may be reduced There may be retaliation Economic growth prospects may be damaged Political ill-will may be created



Why protect trade?    



To combat imports of cheap goods To counter ‘dumping’ Infant industries might need special treatment Declining industries might need special treatment  Protection might reduce a trade deficit



European Union The EU combines a free trade area with a customs union (mobility of factors of production).



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4: Trading and planning in a multinational environment



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Trade



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International financial markets



World Trade Organisation and International Monetary Fund WTO aims



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Global financial stability



Multinationals’ strategy



Risk



IMF aims  



Promote international monetary co-operation, and establish code of conduct for international payments Provide financial support to countries with temporary balance of payments deficits Provide for orderly growth of international liquidity



 



Reduce existing barriers to free trade Eliminate discrimination in international trade (in eg tariffs and subsidies)







Prevent growth of protection by getting member countries to consult with others first



supplements private finance and lends money on a commercial basis for capital projects, usually direct to governments or government agencies.







Act as a forum for assisting free trade, and offering a disputes settlement process



BIS







Establish rules and guidelines to make world trade more predictable







World Bank (IBRD)



Bank for International Settlements: the banker for central banks. Promotes co-operation between central banks Provides facilities for international co-operation



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International financial markets



Globalisation of financial markets has contributed to financial instability, despite facilitating the transfer of funds to emerging markets.



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Global financial stability



 To promote economic convergence in Europe  To develop European Economic and Monetary Union (EMU) Page 35



Risk



Arguments for EMU    



European Monetary System (EMS) Purposes  To stabilise exchange rates between member countries



Multinationals’ strategy



Economic policy stability Facilitation of trade Lower interest rates Preservation of the City’s position Arguments against EMU



   



Loss of national control over economic policy The need to compensate for weaker economies Confusion in transition to EMU Lower confidence arising from loss of national pride 4: Trading and planning in a multinational environment



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International financial markets



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Global financial stability



The global debt crisis arose as governments in less developed countries (LDCs) took on levels of debt that were above their ability to finance. Resolving the global debt crisis    



Restructure or rescheduled debt Economic reforms to improve balance of trade Lending governments write off some of the debts Convert some debt into equity



Multinationals’ strategy



Risk



Negative impacts on multinational firms    



Deflationary policies damage profitability Devaluation of currency Reduction in imports by developing countries Increased reliance on host countries for funding



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Trade



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International financial markets



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Global financial stability



Strategic reasons for FDI Market seeking



Economies of scale



Raw material seeking



Managerial and marketing expertise



Production efficiency seeking



Technology



Knowledge seeking



Financial economies



Political safety seeking



Differentiated products



Management contracts: a firm agrees to sell management skills – sometimes used in combination with licensing. Can serve as a means of obtaining funds from subsidiaries, where other remittance restrictions apply. Page 37



Multinationals’ strategy



Risk



Ways to establish an interest abroad  Joint ventures – industrial co-operation (contractual) or joint-equity    



Licensing agreements Management contracts Subsidiary Branches



Many multinationals use a combination of methods for servicing international markets.



4: Trading and planning in a multinational environment



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Trade



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International financial markets



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Global financial stability



Multinationals’ strategy



Risk



Multinationals’ financial planning Multinational companies need to develop a financial planning framework to ensure that the strategic objectives and competitive advantages are realised. Such a financial planning framework will include ways of raising capital and risks related to overseas operations and the repatriation of profits. Finance for overseas investment depends on:  Local finance costs, and any available subsidies  Tax systems of the countries (best group structure may be affected by tax systems)  Any restrictions on dividend remittances  Possible flexibility in repayments arising from the parent/subsidiary relationship



A company raising funds from local equity markets must comply with the listing requirements of the local exchange.



Blocked funds Multinationals can counter exchange controls by management charges or royalties.



Control systems Large and complex companies may be organised as a heterarchy, an organic structure with significant local control.



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Trade



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International financial markets



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Global financial stability







Government stability Political and business ethics Economic stability/inflation Degree of international indebtedness Financial infrastructure



   



Level of import restrictions Remittance restrictions Assets seized Special taxes and regulations on overseas investors, or investment incentives



Dealing with political risk      



Negotiations with host government Insurance (eg ECGD) Production strategies Contacts with customers Financial management eg borrowing funds locally Management structure eg joint ventures



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Risk



Litigation risks



Factors in assessing political risk    



Multinationals’ strategy



can generally be reduced by keeping abreast of changes, acting as a good cor porate citizen and lobbying.



Cultural risks should be taken into account when deciding where to sell abroad, and how much to centralise activities.



Environmentally sensitive



Environmentally insensitive



Adaptation necessary



Standardisation possible



 Fashion clothes  Convenience foods



 Industrial and agricultural products  World market products, eg jeans



4: Trading and planning in a multinational environment



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Trade



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Institutions



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International financial markets



Agency issues Agency relationships exist between the CEOs of conglomerates (the principals) and the strategic business unit (SBU) managers that report to these CEOs (agents). The interests of the individual SBU managers may be incongruent not only with the interests of the CEOs, but also with those of the other SB U managers. Each SBU manager may try to make sure his or her unit gets access to critical resources and achieves the best performance at the expense of the performance of other SBUs and the whole organisation.



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Global financial stability



Multinationals’ strategy



Risk



Solutions to agency problems in multinationals Multiple mechanisms may be needed, working in unison. Eg:  Board of directors: separate ratification and monitoring of managerial decisions from initiation to implementation  Executive incentive systems can reduce agency costs and align the interests of managers and shareholders by making top executives’ pay contingent on the value they create for the shareholders



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5: DCF



Topic List



In this chapter, we discuss the evaluation of projects using the Net Present Value (NPV) method and the Inter nal Rate of Return.



NPVs



The NPV method is extended to include inflation and specific price variation, taxation and the assessment of fiscal risk and multi-period capital rationing.



Internal rate of return



We also look at the potential inter nal rate of return to assess a project's return margin and its vulnerability to competitive action.



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NPVs



Net present value (NPV) The sum of the discounted cash flows less the initial investment.



Decision criterion Invest in a project if its net present v alue is positive ie when NPV > 0 Do not invest in a project if its net present v alue is zero or negative, ie when NPV ≤ 0



Internal rate of return



Real and nominal discount factors What nominal rate (i) should be used for discounting cash flows, if the real rate is r and the rate of inflation h? (l + i) = (1 + r)(1 + h) (the Fisher equation, given in exam)



The net effect of inflation on the NPV of a project will depend on three inflation rates: the rates for revenues, costs, and the discount factor.



Tax effects on NPV  



Corporate taxes Value added taxes



 



Other local taxes Capex tax allowances



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Capital rationing Capital rationing problem exists when there are insufficient funds to finance all available profitable projects.



Case I Fractional investment allowed: rank the alternatives according to the ratio of NPV to initial investment or the benefit cost ratio.



Case II Fractional investment not allowed: a more systematic approach may be needed to find the NPVmaximising combination of entire projects subject to the investment constraint. This is provided by the mathematical technique of integer programming. Page 43



The multi-period capital rationing problem can be formulated as an integer programming problem.



The Monte Carlo method amounts to adopting a par ticular probability distribution for the uncertain (random) variables that affect the NPV and then using sim ulations to generate values of the random variables.



Project Value at Risk is the minimum amount by which the value of an investment or portfolio will fall over a given period of time at a given level of probability. 5: DCF



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NPVs



Internal rate of return



IRR The discount rate at which NPV equals zero.  The IRR calculation also produces the breakeven cost of capital and allows calculation of the margin of safety  If the cash flows change signs then the IRR may not be unique: this is the multiple IRR problem  With mutually exclusive projects, the decision depends not on the IRR but on the cost of capital being used



Decision criteria using IRR A project will be selected as long as the IRR is not less than the cost of capital.



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Modified IRR (MIRR)



Re-investment rate



MIRR is the IRR which would result without the assumption that project proceeds are reinvested at the IRR rate. 1



Calculate the present value of the return phase (the phase of the project with cash inflo ws)



2



Calculate the present value of the investment phase (the phase with cash outflows)



3



Calculate MIRR using the following formula: PVR MIRR = PV1



1 n



(1+ r e) –1



This formula is given in the exam.



Page 45



Page 45



The NPV method assumes that cash flows can be reinvested at the cost of capital over the life of the project. Selection of investments based on the higher IRR assumes that cash flows can be reinvested at the IRR over the life of the project. The IRR assumption is unlikely to be valid and so the NPV method is likely to be superior. The better reinvestment rate assumption will be the cost of capital used for the NPV method.



Decision criterion If MIRR is greater than the required rate of return: ACCEPT If MIRR is lower than the required rate of return: REJECT 5: DCF



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Notes



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6: Application of option pricing theory in investment decisions Topic List Options concepts Real options



Option valuation techniques can be applied to capital budgeting exercises in which a project is coupled with a put or call option. For example, the firm may have the option to abandon a project dur ing its life. This amounts to a put option on the remaining cash flo ws associated with the project. Ignoring the value of these real options (as in standard discounted cash flow techniques) can lead to incorrect investment evaluation decisions.



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Options concepts



Options



Real options



Determinants of option values



An option is a contract that gives one party the option to enter into a transaction either at a specific time in the future or within a specific future per iod at a price that is agreed when the contract is issued.  The buyer of a call option acquires the r ight, but not the obligation, to buy the underlying at a fixed price  The buyer of a put option acquires the r ight, but not the obligation, to sell the underlying shares at a fixed price In the money option: intrinsic value is +ve At the money option: intrinsic value is zero Out of the money option: intrinsic value is –ve



 The higher the exercise price, the lower the probability that the call will be in the money  As the current price of the underlying asset goes up, the higher the probability that the call will be in the money  Both a call and put will increase in price as the underlying asset becomes more volatile  Both calls and puts will benefit from increased time to expiration  The higher the interest rate, the lower the present value of the exercise price



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Options concepts



Real options Strategic options – known as real options – arising from a project can increase the project value. They are ignored in standard DCF analysis, which computes a single present value.



Option to delay When a firm has exclusive rights to a project or product for a specific period, it can delay taking this project or product until a later date. For a project not selected today on NPV or IRR grounds, the rights to the project can still have value.



Option to expand is when firms invest in projects allowing further investments later, or entry into new markets, possibly making the NPV +ve. The initial investment may be seen as the premium to acquire the option to expand. Page 49



Real options



Option to abandon



is if the firm has the option to cease a project during its life. Abandonment is effectively the exercising of a put option. The option to abandon is a special case of an option to redeplo y.



Option to redeploy



is when company can use its productive assets for activities other than the original one. The switch will happen if the PV of cash flows from the new activity will exceed costs of switching.



Black-Scholes valuation In applying Black-Scholes valuation techniques to real options, simulation methods are typically used to overcome the problem of estimating volatility. 6: Application of option pricing theory in investment decisions



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Options concepts



Determinants of option values      



Exercise price (Pe) Price of underlying asset (Pa) Volatility of underlying asset (s) Time to expiration (t) Interest rate (r) Intrinsic and time value



Black-Scholes formulae C = Pa N(d1 ) – PeN(d 2 )e – rt ⎛P In⎜⎜ a P d1 = ⎝ e



⎞ ⎟ + (r + 0.5s 2 )t ⎟ ⎠ s t



d 2 = d1 – s t



These formulae are given in the exam. Put option



Real options are highly examinable.



P = C – Pa + Pe e – rt



Real options



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7a: Impact of financing and APV method



Topic List Sources of finance Duration Credit risk Modigliani & Miller Other theories APV approach



The cost of capital is the r ate of return required by investors in order to supply their funds to the compan y. It is also the rate of return a company must earn in a project in order to maintain its market value. There are two forms of capital to a firm, equity and debt, and each supplier of capital requires a return which is determined by the risks each type of investor faces. The overall cost of capital to the fir m is the weighted average of the cost of equity and the cost of debt.



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Sources of finance



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Duration



Equity



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Credit risk



Venture capital



Page 52



Modigliani & Miller



Business angels



Other theories



Asset securitisation



Sources of finance



Short-term/ long-term debt



Lease finance



Hybrids



Islamic finance



APV approach



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Islamic finance transaction



Similar to



Features



Murabaha



Trade credit/loan



Pre-arranged mark up for convenience of later payment, no interest



Musharaka



Venture capital



Profit share per contract, no dividends, losses per capital contribution, both parties participate



Mudaraba



Equity



Profit share per contract, no dividends, losses borne by capital provider, organisation runs business



Ijara



Leasing



Whatever the other features, lessor remains asset owner and incurs risks of ownership



Sukuk



Bonds



Underlying tangible asset in which holder shares may be asset-based (sale/leaseback) or asset-backed (securitisation)



Salam



Forward contract



Commodity sold for future delivery, cash received at discount from financial institution, payments received in advance



Istisna



Phased payments



Project funding, initial payment and then instalments from business undertaking the project



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7a: Impact of financing and APV method



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Sources of finance



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Duration



Cost of equity ke =



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Credit risk



Page 54



Modigliani & Miller



Other theories



APV approach



Cost of irredeemable debt d0 (1 + g) P0



+g



kd =



i(1 – T) P0



Cost of redeemable debt g = br g is growth rate of dividends b is proportion of profits retained r is rate of return on investments



CAPM E(r i) = Rf + βi (E(rm) – Rf)



IRR calculation, including amount payable on redemption



WACC é



ù é Vd ù ú ke + ê ú kd (1 - T ) ë Ve + Vd û ë Vd + Ve û



WACC = ê



Ve



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Beta factors of portfolios Portfolio of all stock – market securities



Beta factor 1



Portfolio of risk-free – securities



Beta factor 0



Investors’ portfolio



Beta factor weighted average of individual beta factors



Page 55



–



Page 55



Limitations of CAPM  Difficulties in determining excess return  Difficulties in determining risk-free rate  Errors in statistical analysis used to calculate betas  Difficulties in forecasting companies with low P/E ratios  Assumption that costs are zero  Assumption that investment market is efficient  Assumption that portfolios are well-diversified



7a: Impact of financing and APV method



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Sources of finance



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Duration



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Credit risk



Geared betas may be used to obtain an appropr iate required return when an investment has differing business and finance risks from the existing business. Weaknesses in the formula  Difficult to identify firms with identical operating characteristics    



Page 56



Estimate of beta factors not wholly accurate Assumes that cost of debt is r isk-free Does not include growth opportunities Differences in cost structures and size will affect beta values between firms



Modigliani & Miller



Other theories



APV approach



Exam formula βa =



Vd(1 – T) Ve β β (Ve + Vd(1 – T)) e + (Ve + Vd(1 – T)) d



where βa = asset (or ungeared) beta βe = equity (or geared) beta βd = beta factor of debt in the geared company Vd = market value of debt in the geared company Ve = market value of equity capital in the geared compan y T = rate of corporate tax



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Sources of finance



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Duration



Credit risk



Duration (Macaulay duration) The weighted average length of time to the receipt of a bond’s benefits (coupon and redemption value). The weights are the present values of the benefits involved.



Calculating duration 1



Multiply PV of cash flows for each time period by the time period and add together



2



Add the PV of cash flows in each period together



3



Divide the result of step 1 by the result of step 2



Page 57



Page 57



Modigliani & Miller



Other theories



APV approach



Properties of duration  Longer-dated bonds have longer durations  Lower-coupon bonds will have longer durations  Lower yields will give longer durations



Modified duration Modified duration =



Macaulay duration



1 + gross redemption yield Modified duration shares the same proper ties as Macaulay duration.



7a: Impact of financing and APV method



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Sources of finance



3/31/2015



Duration



Credit risk (or ‘default risk’) is the risk for a lender that the borrower may default on interest payments and/or repayment of principal. Credit risk for an individual loan or bond is measured by estimating:  Probability of default – typically, using information on borrower and assigning a credit rating (eg Standard & Poor’s, Moody’s, Fitch)  Recovery rate – the fraction of face value of an obligation recoverable once the borrower has defaulted



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Page 58



Credit risk



Modigliani & Miller



Other theories



APV approach



Standard & Poor’s



Moody’s



AAA



Aaa



Highest quality, lowest default risk



AA



Aa



High quality



A



A



Upper medium grade quality



BBB



Baa



Medium grade quality



BB



Ba



Lower medium grade quality



B



B



Speculative



CCC



Caa



Poor quality (high default risk)



CC



Ca



Highly speculative



C



C



Lowest grade quality



Credit migration is the change in the credit r ating after a bond is issued.



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Determinants of cost of debt capital    



Credit rating of company Maturity of debt Risk-free rate at appropriate maturity Corporate tax rate



Credit spread is the premium required by an investor in a corporate bond to compensate for the credit risk of the bond. Yield on corporate bond = risk free rate + credit spread Cost of debt capital = (1 – tax r ate)(risk free rate – credit spread) Page 59



Page 59



Option pricing models to assess default risk The equity of a company can be seen as a call option on the assets of the company with an exercise price equal to the outstanding debt.



Expected losses are a put option on the assets of the firm with an exercise price equal to the value of the outstanding debt. From the Black-Scholes formula, the probability of default depends on three factors:  The debt/asset ratio  The volatility of the company assets  The maturity of debt 7a: Impact of financing and APV method



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Sources of finance



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Duration



Credit risk



Internal credit enhancement External credit enhancement



Page 60



Modigliani & Miller



Other theories



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



APV approach



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Sources of finance



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Duration



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Credit risk



Page 61



Modigliani & Miller



Other theories



APV approach



MM theory (no tax)



MM and cost of equity



The use of debt would only transfer more risk to the shareholders, therefore will not reduce the WACC.



Vd Ve where ke = cost of equity in a geared compan y ke i = cost of equity in an ungeared compan y Vd, Ve = market values of debt and equity kd = pre-tax cost of debt This formula is given in the exam.



MM theory (with tax) Debt actually saves tax (due to tax relief on interest payments) therefore firms should only use debt finance.



Page 61



k e = k ie + (1 − T)(k ie − k d )



Limitations of MM theory  Too risky in reality to have high levels of gearing  Assumes perfect capital markets  Does not consider bankruptcy risks, tax exhaustion, agency costs and increased borrowing costs as risk rises 7a: Impact of financing and APV method



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Sources of finance



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Duration



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Credit risk



Static trade-off theory



Modigliani & Miller



Other theories



APV approach



Agency theory



A firm in a static position will adjust their gear ing levels to achieve a target level of gearing.



Problems with financial distress costs Direct financial distress  Legal and admin costs associated with bankruptcy



Page 62



Indirect financial distress    



Higher cost of capital Loss of sales Downsizing High staff turnover



The optimal capital structure will occur where the benefits of the debt received by the shareholders matches the costs of debt imposed on the shareholders.



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Pecking order theory



Predictions



is, unlike the MM models, based on the idea of information asymmetry: investors have a lower level of information about the company than its directors do. As a result, shareholders use directors' actions as a signal to indicate what directors believe about the company with their superior information.



 To finance new investment, firms prefer internal finance to external finance



Page 63



 If retained earnings differ from investment outlays, the firm adjusts its cash balances or mar ketable securities first, before either taking on more debt or increasing its target payout rate  Internal finance is at the top, and equity is at the bottom, of the pecking order. A single optimal debtequity ratio does not exist: a result similar to the MM model with no taxes



7a: Impact of financing and APV method



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Sources of finance



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Duration



Page 64



Credit risk



Adjusted present value (APV) approach



Modigliani & Miller



Other theories



APV approach



Steps in applying APV



The adjusted present value (APV) method of valuation is based on the Modigliani Miller model with taxation.



1



Calculate the NPV as if the project w as financed entirely by equity (use k ei )



2



Add the PV of the tax saved as a result of the debt used to finance the project (use k d)



We assume that the primary benefit of borrowing is the tax benefit and that the most significant cost of borrowing is the added risk of bankruptcy.



3



Subtract the cost of issuing new finance



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7b:Valuation and free cash flows



Topic List Yield curve and bond values Free cash flows Equity valuation



This chapter mainly focuses on the use of free cash flows and their use for valuation puposes. It also briefly considers using the yield cur ve for bond values and recaps equity valuation methods from Paper F9 financial management.



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Yield curve and bond values



Free cash flows



Equity valuation



Using the yield curve The yield curve can be used to estimate bond v alue by splitting, say a four year bond into four separate bonds. Each bond can then be discounted by using the rates from the yield curve. The total of the discounted cash flows represents the issue price. An IRR style calculation can be used to calculate the yield to matur ity. In general: Price = Coupon ×



1



(i + r1)



+ Coupon ×



1



(i + r2 )



2



+ … + Coupon ×



1 n



(i + rn )



+ Redemption value ×



1 n



(i + rn )



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Yield curve and bond values



Free cash flow (FCF) Free Cash Flow (FCF)



=



Free cash flows



Equity valuation



Forecasting FCF Earnings before Interest and Taxes (EBIT)



less Tax on EBIT



Constant growth



FCF = FCF0 (1 + g)n



plus Non cash charges (eg depreciation)



where FCF0 is the free cash flow at beginning n is the number of years



less Capital expenditures



Differing growth rates



less Net working capital increases



Forecast each element of FCF separately using appropriate rate.



plus Net working capital decreases plus Salvage value received Page 67



7b: Valuation and free cash flows



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Free cash flows



Yield curve and bond values



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



Direct method of calculating FCFE



Indirect method



Net income (EBIT – net interest – tax paid)



Free cash flow



Add



depreciation



Less



(Net interest + net debt paid)



Less



total net investment



Add



Add



net debt issued



Tax benefit from debt (net interest × tax rate)



Add



net equity issued



Equity valuation



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Firm valuation using FCF



Terminal values and company valuation



Value of the firm is the sum of the discounted free cash flows over the appropriate time horizon.



Value of the firm is the present value over the forecast period + terminal value of cash flows beyond the forecast period.



Assuming constant growth, use the Gordon model:



Firm valuation using FCFE



PV0 = where



Page 69



FCF0 (1 + g) k−g g = growth rate k = cost of capital



1



Calculate value of equity (present value of FCFE discounted at the cost of equity)



2



Calculate value of debt



3



Value = value of equity + value of debt



7b: Valuation and free cash flows



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Yield curve and bond values



Range of values Max



Min



Equity valuation



Uses of net asset valuation method



Value the cashflows or earnings under new ownership. Value the dividends under the existing management. Value the assets.



Possible bases of valuation Historic basis (unlikely to be realistic)



Free cash flows



Replacement basis (asset used on ongoing basis)



Realisable basis (asset sold/ business broken up)



 As measure of security in a share valuation  As measure of comparison in scheme of merger  As floor value in business that is up for sale Problems in valuation    



Need for professional valuation Realisation of assets Contingent liabilities Market for assets



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Price-earnings ratio Market value EPS Market value = EPS × P/E r atio



P/E ratio =



Shows the current profitability of the company



Shows the market’s view of the growth prospects/risk of a company



May be affected by one-off transactions



Which P/E ratio to use? Adjust downwards if valuing an unquoted company



Page 71



Page 71



Have to decide suitable P/E ratio. Factors to consider:  Industry  Status  Marketability  Shareholders  Asset backing and liquidity  Nature of assets  Gearing



Earnings yield valuation model Market value =



Earnings Earnings yield



7b: Valuation and free cash flows



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Yield curve and bond values



Dividend valuation model P0 =



D ke



Where P0 is price at time 0 D is dividend (constant) ke is cost of equity



P0 =



D 0 (1 + g) ke – g



Where D0 is dividend in current year g is dividend growth rate



Free cash flows



Equity valuation



Features     



Based on expected future income Can be used to value minority stake Growth rate difficult to estimate Dividend policy may change Companies that don’t pay dividends don’t have zero values



Discounted cash flow method Value investment using expected after-tax cash flows of investment and appropriate cost of capital.



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8: International investment decisions



Topic List



Companies that undertake overseas projects are subject to exchange rate risks as well as other risks such as exchange controls, taxation and political action.



NPV and international projects



Capital budgeting methods for multinational companies can incorporate these additional complexities in the decision-making process.



Exchange controls Exchange rate risks Capital structure



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NPV and international projects



Page 74



Exchange controls



Exchange rate risks



Capital structure



Purchasing power parity



NPVs for international projects



Absolute purchasing parity theory: prices of products in different countries will be the same when expressed in the same currency. Alternative purchasing power parity relationship: changes in exchange rates are due to differences in the expected inflation rates between countries.



Alternative methods for calculating the NPV from a overseas project:



International Fisher effect 1 + ic 1 + ib



=



1 + hc 1 + hb



This equation is given in the exam. In the absence of trade or capital flows restrictions, real interest rates in different countries will be expected to be the same. Differences in interest rates reflect differences in inflation rates.



 Convert project cash flows into sterling and discount at sterling discount rate to calculate NPV in sterling terms  Discount cash flows in host country's currency from project at adjusted discount rate for that currency and then convert resulting NPV at spot exchange rate



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Effect of exchange rates on NPV



Effect on exports



When there is a devaluation of sterling relative to a foreign currency, the sterling value of cash flows increases and NPV increases. The opposite happens when the domestic currency appreciates.



When a multinational company sets up a subsidiary in another country in which it already exports, the relevant cash flows (and NPV) for evaluation of the project should account for loss of export earnings in the particular country.



Impact of transaction costs Transaction costs are incurred when companies invest abroad due to currency conversion or other administrative expenses. These should also be taken into account.



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8: International investment decisions



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NPV and international projects



Taxes in international context Host country  Corporate taxes  Investment allowances  Withholding taxes



Page 76



Exchange controls



Exchange rate risks



Capital structure



Tax haven characteristics  Low tax on foreign investment or sales income earned by resident companies  Low withholding tax on dividends paid to the parent



Home country



 Stable government and currency



 Double taxation relief  Foreign tax credits



 Adequate financial services support facilities



Subsidies The benefit from concessionary loans should be included in the NPV calculation as the diff erence between the repayment when borrowing under market conditions and the repayment under the concessionary loan.



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NPV and international projects



Page 77



Exchange controls



Exchange rate risks



Capital structure



Exchange controls



Strategies



Types



Multinational company strategies to overcome exchange controls:



 Rationing supply of foreign exchange. Payments abroad in foreign currency are restricted, preventing firms from buying as much as they want from abroad



 Transfer pricing, where the parent company sells goods or services to the subsidiary and obtains payment



 Restricting types of transaction for which payments abroad are allowed, eg suspending or banning payment of dividends to foreign shareholders, such as parent companies in multinationals: blocked funds problem



 Royalty payments adjustments, when a parent company grants a subsidiary the right to make goods protected by patents



For an overseas project, we include only the proportion of cash flows that are expected to be repatriated in the NPV calculation.



 Management charges levied by the parent company for costs incurred in the management of international operations



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 Loans by the parent company to the subsidiary: setting interest rate at appropriate level



8: International investment decisions



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NPV and international projects



Page 78



Exchange controls



Exchange rate risks



Capital structure



Transaction exposure



Economic exposure



is the risk of adverse exchange rate movements between the date the price is agreed and the date cash is received/paid, arising during normal international trade.



is the risk that the present value of a company’s future cash flows might be reduced by adverse exchange rate movements.



Translation exposure is the risk that the organisation will make exchange losses when the accounting results of its f oreign branches or subsidiaries are translated. Translation losses can arise from restating the book value of a foreign subsidiary’s assets at the exchange rate on the statement of financial position date – only important if changes arise from loss of economic value.



Economic exposure:  Can be longer-term (continuous currency depreciation)  Can arise even without trade overseas (effects of pound strengthening)



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NPV and international projects



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Exchange controls



Overseas subsidiaries Parent company needs to consider a number of issues when setting up an overseas subsidiary:      



Amount of equity capital Whether parent owns 100% of equity Profit retention by subsidiary Amount of subsidiary’s debt Amount of subsidiary’s working capital Whether subsidiary should obtain local listing



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Exchange rate risks



Capital structure



Choice of finance       



Finance costs Taxation systems Restrictions on dividend remittances Flexibility in repayments Reduction in systematic risk Access to foreign capital Agency costs



8: International investment decisions



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NPV and international projects



International borrowing options (1) Borrow in the same currency as the inflo ws from the project (2) Borrow in a currency other than the currency of the inflows, with a hedge in place (3) Borrow in a currency other than the currency of  the inflows, without hedging the currency r isk  Option (3) exposes the company to exchange rate risk which can substantially change the profitability of a project.



Page 80



Exchange controls



Exchange rate risks



Capital structure



Advantages of international borrowing  Availability. Domestic financial markets, except larger countries and the Euro zone, generally lack the depth and liquidity to accommodate large or long-maturity debt issues  Lower cost of borrowing. In Eurobond markets interest rates are normally lower than borrowing rates in national markets  Lower issue costs. Cost of debt issuance is normally lower than the cost of debt issue in domestic markets



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9: Acquisitions and mergers vs growth



Topic List Acquisitions and mergers Shareholder value issues



Firms may decide to increase the scale of their operations through a strategy of internal organic growth by investing money to purchase or create assets and product lines internally. Alternatively, companies may decide to grow by buying other companies in the market, thus acquiring ‘readymade’ tangible and intangible assets and product lines.



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Acquisitions and mergers



Operating economies



Management of acquisition



Diversification



Asset backing



Shareholder value issues



Earnings quality



Mergers and acquisitions Finance/ liquidity



Internal expansion costs



Tax



Defensive merger



Factors in a takeover  Cost of acquisition  Reaction of predator’s shareholders  Reaction of target’s shareholders



  



Form of purchase consideration Accounting implications Future policy (eg dividends, staff)



Economic efficiency



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VERTICAL MERGER Supplier Aim: control of supply chain BACKWARD MERGER HORIZONTAL MERGER Two merging firms produce similar products in the same industry Aim: increase market power



CONGLOMERATE MERGER Firm



Two firms operate in different industries Aim: diversification



FORWARD MERGER Customer/distributor Aim: control of distribution



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9: Acquisitions and mergers vs growth



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Acquisitions and mergers



Shareholder value issues



Takeover strategy



Acquire



Growth prospects limited



Younger company with higher growth rate



Potential to sell other products to existing customers



Company with complementary product range



Operating at maximum capacity



Company making similar products operating below capacity



Under-utilising management



Company needing better management



Greater control over supplies or customers



Company giving access to customer/supplier



Lacking key clients in targeted sector



Company with right customer profile



Improve statement of financial position



Company enhancing EPS



Increase market share



Important competitor



Widen capability



Key talents and/or technology



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Acquisitions and mergers



Shareholder value issues



Synergy Revenue synergy exists when the acquisition will result in higher revenues, higher return on equity or a longer period of growth for the acquiring company. Revenue synergies arise from:



Sources of financial synergy  Diversification  Use of cash slack



 Tax benefits  Debt capacity



(a) Increased market power (b) Marketing synergies (c) Strategic synergies



Cost synergy results from economies of scale. As scale increases, marginal cost falls and this will be manifested in greater operating margins for the combined entity. Page 85



9: Acquisitions and mergers vs growth



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Acquisitions and mergers



Failures to enhance shareholder value Why do many acquisitions fail to enhance shareholder value?



Agency theory: takeovers may be motivated by self-interested acquirer management wanting:  Diversification of management's own portfolio  Use of free cash flow to increase size of the firm  Acquisitions that increase firm's dependence on management Value is transferred from shareholders to managers of acquir ing firm. Hubris hypothesis: bidding company bids too much because managers of acquiring firms suffer from hubris, excessive pride and arrogance.



Shareholder value issues



Market irrationality argument: when a company’s shares seem overvalued, management may exchange them for an acquiree firm: merger. The lack of synergies or better management may lead to a failing merger. Preemptive theory: several firms may compete for opportunity to merge with target to achieve cost savings. Winning firm could improve market position and gain market share. It can be rational for the first firm to pre-empt a merger with its own takeover attempt. Window dressing: where companies are acquired to present a better shor tterm financial picture.



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10: Valuation for acquisitions and mergers



Topic List Valuation issues Type I Type II Type III High-growth start-ups Intangible assets



There are different methods for predicting earnings growth for a company, using external and internal measures. An acquisition potentially affects the risk of the acquiring company and its cost of capital. First, we consider the ‘overvaluation problem’: the problem that when a company acquires another company, it often pays more than the company’s current market value.



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Type II



The overvaluation problem is paying more than the current mar ket value, to acquire a company.



Page 88



Type III



 The overvaluation problem may arise as miscalculation of potential synergies or overestimation of ability of acquiring firm's management to improve performance  Both errors will lead to a higher pr ice than current market value



Intangible assets



Estimating earnings growth Gordon constant growth model: PV =



 During an acquisition, there is typically a fall in the price of the bidder and an increase in the price of the target



High-growth start-ups



FCF0 (1 + g) (k – g)



Three ways to estimate g:  Historical estimates: extrapolate past values  Rely on analysts’ forecasts  Use the company’s return on equity and retention rate of earnings (g = ROE × retention rate)



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Asset beta



Business risk of combined entity The risk associated with the unique circumstances of the combined company. Affected by the betas of the individual entities (target and predator) and the beta of the resulting synergy.



Acquisitions and acquirer’s risk



The weighted average of the betas of the target, predator and synergy of the combined entity.



Geared equity beta



Affects financial risk?



Affects business risk?



1



Calculate value of debt (net of tax). Divide by value of equity



Type 1



N



N



2



Type 2



Y



N



Multiply the above by difference between beta of combined entity and beta of debt



Type 3



Y



Y



3



Add the above to the beta of the combined entity



Acquisition



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10: Valuation for acquisitions and mergers



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Type II



Type I valuations Methods to value company: (1) Book value-plus models (2) Market-relative models (3) Cash flow models, including EVATM, MVA



Book value-plus models Use the statement of financial position as star ting point. Total Asset Value Less Long-term and short-term payables Equals Company's Net Asset Value Book value of net assets is also 'equity shareholders' funds': the owners' stake in the company.



Page 90



Type III



High-growth start-ups



Intangible assets



Market-relative models (P/E ratio) P/E ratio =



Market value



EPS so market value per share = EPS × P/E ratio



Decide suitable P/E ratio and multiply by EPS: an earnings-based valuation. EPS could be historical EPS or prospective future EPS. For a given EPS, a higher P/E ratio will result in a higher price. High P/E ratio may indicate:  Optimistic expectations  Security of earnings  Status



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Q Ratio is the market value of company assets (MV) divided by replacement cost of the assets (RC).



Q=



MV RC



Equity version of Q: MV – Market value of debt Qe = RC – Total debt



Page 91



Points to note  RC of capital is difficult to estimate, so is proxied by the book value of capital. The equity Q ie Q e is approximated as: Qe =



Market value of equity Equity capital



 If Q 1, management has increased the v alue of contributed capital



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Type II



Free cash flow model



Type III



3



1 Calculate Free Cash Flow. FCF = EARNINGS BEFORE INTEREST AND TAXES (EBIT)



High-growth start-ups



Intangible assets



Calculate WACC from cost of equity (K e) and cost of debt (K d). Vd Ve + (1 − T) × K d × WACC = K e × Vd + Ve (Vd + Ve ) where T is the tax rate



Less: TAX ON EBIT



Vd is the value of the debt



Plus: NON-CASH CHARGES



Ve is the value of equity



Less: CAPITAL EXPENDITURES Less: NET WORKING CAPITAL INCREASES



4



Discount free cash flow at WACC to obtain value of firm.



Plus: SALVAGE VALUES RECEIVED



5



Calculate equity value.



Plus: NET WORKING CAPITAL DECREASES



2 Forecast FCF and Terminal Value.



Equity Value = Value of the firm – Value of debt



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EVA approach EVA = NOPAT – WACC × Capital Employed



Page 93



Market value added approach shows how much management has added to the value of capital contributed by the capital providers.



Or, EVA = (ROIC – WACC) × Capital Employed where NOPAT = Net Operating Profits After Taxes ROIC= Return on Invested Capital WACC = Weighted average cost of capital



MVA = Market Value of Debt + Market Value of Equity – Book Value of Equity



Value of firm = Value of invested capital + sum of discounted EVA



MVA related to EVA: MVA is simply PV of future EVAs of the company.



(Subtract value of debt from value of company to get value of equity.)



Page 93



If the market value and book value of debt are the same, MVA measures the difference between the market value of common stock and equity capital of the firm. 10: Valuation for acquisitions and mergers



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Type II



Type II valuations: APV Acquisition is valued by discounting Free Cash Flows by ungeared cost of equity, then adding PV of tax shield. APV = – Initial Investment + Value of acquired company if all-equity financed + PV of Debt Tax Shields If APV is +ve, acquisition should be under taken.



Type III



Discount free cash flow at ungeared cost of equity to obtain NPV of ungeared fir m or project



5



Calculate interest tax shields



6



Discount interest tax shields at pre-tax cost of debt to obtain PV of interest tax shields



7



APV = NPV OF UNGEARED FIRM OR PROJECT Plus: PV OF INTEREST TAX SHIELDS Plus: EXCESS CASH AND MARKETABLE SECURITIES Less: MARKET VALUE OF CONTINGENT LIABILITIES = MARKET VALUE OF FIRM Less: MARKET VALUE OF DEBT = MARKET VALUE OF EQUITY



1



Calculate FCF (as previously)



2



Forecast FCFs and Terminal Value



3



Ungeared beta of firm is calculated from geared beta: β β = G 1 + (1 − T)



D E



Intangible assets



4



APV calculation steps



U



High-growth start-ups



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Type II



Type III iterative valuations 1



Estimate value of acquiring company before acquisition



2



Estimate value of acquired company before acquisition



3



Estimate value of synergies



4



Estimate beta coefficients for equity of acquiring and acquired company, using CAPM



5



Estimate asset beta for each company



6



Calculate asset beta for combined entity



7



Calculate geared beta of the combined fir m



8



Calculate WACC for combined entity



9



Use WACC derived in step 8 to discount cash flows of combined entity post-acquisition



Page 95



Type III



High-growth start-ups



Intangible assets



A problem with WACC If WACC weights are not consistent with the values derived, the valuation is internally inconsistent. Then, we use an iterative procedure:  Go back and re-compute the beta using a revised set of weights closer to the weights derived from the valuation.  The process is repeated until assumed weights and weights calculated are approximately equal.



Value of equity: difference between the value of the firm and the value of debt. 10: Valuation for acquisitions and mergers



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Valuation of high-growth start-ups



Typical characteristics of start-ups: few revenues, untested products, unknown product demand, high development/ infrastructure costs.



Steps in valuation



Page 96



Identify drivers (eg market potential, resources of the business, management team) Period of projection – needs to be long-term Forecasting growth Growth in earnings (g) = b × ROIC For most high growth start-ups, b = 1 and sole determinant of growth is the return on invested capital (ROIC), estimated from industry projections or evaluation of management, marketing strengths, and investment.



Type III



High-growth start-ups



Intangible assets



Valuation methods Asset-based method not appropriate: most investment of a start-up is in people, marketing and /or intellectual rights that are treated as expenses rather than capital. Market-based methods also present problems: difficult to find comparable companies; usually no earnings to calculate P/E ratios (but price-to-revenue ratios may help). Discounted Cash Flows With constant growth model: V=



FCF r–g



Since FCF = Revenue – Costs = R – C, value of company: V=



R–C r–g



Probabilistic valuation methods can be used.



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Intangible assets



Page 97



Type III



Market-to-book value measures intangible assets as the difference between book value of tangible assets and market value of the firm. Tobin’s ‘q’ =



Examples of intangible assets



Page 97



Intangible assets



Measuring intangible assets



Differ from tangible assets as they do not have ‘physical substance’.



 Goodwill  Brands  Patents



High-growth start-ups



 Customer loyalty  Research and development



Market capitalisation of firm



Replacement cost of assets Used to compare intangible assets of firms in same industry serving the same markets and with similar tangible non-current assets.



Calculated intangible values (CIV) – calculates an ‘excess return’ on tangible assets, which is used to determine the proportion of return attributable to intangible assets.



10: Valuation for acquisitions and mergers



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Lev’s knowledge earnings method separates earnings deemed to come from intangible assets, which are then capitalised.



Methods of valuing intangible assets    



Relief from royalties Premium profits Capitalisation of earnings Comparison with market transactions



Page 98



Type III



High-growth start-ups



Intangible assets



Valuing product patents as options.



1



Identify value of underlying asset (based on expected cash flows)



2



Identify standard deviation of cash flows



3



Identify exercise price of the option



4



Identify expiry date of the option



5



Identify cost of delay (the greater the delay, the lower the value of cash flows)



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11: Regulatory framework and processes



Topic List



The agency problem can have a significant impact on mergers and acquisitions. Takeover regulation is a key device in protecting the interests of all stak eholders.



Global issues



Different models of regulation have been used in the UK and in continental Europe. EU level regulation seeks to create convergence in takeover regulation.



UK and EU regulation Defensive tactics



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Global issues



UK and EU regulation



Agency problem



Takeover regulation



The agency problem and the issues arising from the separation of ownership and control have potential impact on mergers and acquisitions.



Takeover regulation can:



Defensive tactics



 Protect the interests of minority shareholders and other stakeholders  Ensure a well-functioning market for corporate control



Potential conflicts of interest



Two models of regulation



 Protection of minority shareholders. Transfers of control may turn existing majority shareholders of the target into minority shareholders



 UK/US/Commonwealth countries: market-based model – case law-based, promotes protection of shareholder rights especially



 Target company management measures to prevent the takeover, which could run against stakeholder interests



 Continental Europe: 'block-holder' or stakeholder system – codified or civil law-based, seeking to protect a broader group of stakeholders: creditors, employees, national interest



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Global issues



UK takeover regulation Mergers and acquisitions in the UK subject to:    



City Code Companies Act Financial Services and Markets Act 2000 Criminal Justice Act 1993 (insider dealing provisions)



City Code The City Code on Takeovers and Mergers:  Originally voluntary code for takeovers/mergers of UK companies – now has statutory basis  Administered by the Takeover Panel



Page 101



UK and EU regulation



Defensive tactics



City Code Principles  Similar treatment for all shareholders  Sufficient time and information for informed decision  Directors must act in interests of whole company  Avoid false markets in shares  Offer only made if it can be fully implemented  Offeree company not distracted for excessive time by offer for it



11: Regulatory framework and processes



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Global issues



UK and EU regulation



Defensive tactics



Competition and Markets Authority



EU Takeovers Directive



The Competition and Markets Authority (CMA) can accept or reject proposed merger, or lay down certain conditions, if there would be a substantial lessening of competition.



Effective from May 2006 – to converge marketbased and stakeholder systems.



Substantial lessening of competition tests:  Turnover test (£70m min. for investigation by CMA)  Share of supply test (25%)



European Union Mergers fall within jurisdiction of the EU (which will evaluate it, like the CMA in UK) where, following the merger: (a) Worldwide turnover of more than €5bn per annum (b) EU turnover of more than €250m per annum



Takeovers Directive principles  Mandatory-bid rule: required at 30% holding, in UK  Equal treatment of shareholders  Squeeze-out rule and sell-out rights: in UK, 90% shareholder buys all shares  Principle of board neutrality  Break-through rule: bidder able to set aside multiple voting rights (but countries can opt out of this)



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%



Consequence of share stake levels



Any



Company may enquire on ultimate ownership under s793 CA 2006



3%



Beneficial interests must be disclosed to company – Disclosure and Transparency Rules



10%



Shareholders controlling 10%+ of voting rights may requisition company to serve s793 notices Notifiable interests rules become operative for institutional investors and non-beneficial stakes



30%



City Code definition of effective control. Takeover offer becomes compulsory



50%+



CA 2006 definition of control (At this le vel, holder can pass ordinary resolutions.) Point at which full offer can be declared unconditional with regard to acceptances



75%



Major control boundary: holder able to pass special resolutions



90%



Minorities may be able to force majority to buy out their stake. Equally, majority may be able to require minority to sell out



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11: Regulatory framework and processes



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Global issues



UK and EU regulation



Defensive tactics



Defensive tactic



Explanation



Golden parachutes



Compensation payments made to eliminated top-management of target firm



Poison pill



Attempt to make firm unattractive to takeover, eg by giving existing shareholders right to buy shares cheaply



White knights and white squires



Inviting a firm that would rescue the target from the unwanted bidder. A ‘white squire’ does not take control of the target



Crown jewels



Selling firm’s valuable assets or arranging sale and leaseback, to make firm less attractive as target



Pacman defence



Mounting a counter-bid for the attacker



Litigation or regulatory defence



Inviting investigation by regulatory authorities or Courts



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12: Financing mergers and acquisitions



Topic List



Questions on the subjects discussed in this chapter ma y be regularly set in the compulsory section of this paper. Questions could involve calculations.



Financing methods



A bidding firm might finance an acquisition either by cash or by a share offer or a combination of the tw o. We consider how a financial offer can be evaluated in terms of the impact on the acquir ing company and criteria for acceptance or rejection.



Effects of offer



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Financing methods



Effects of offer



Methods of financing mergers



Funding cash offers



Payment can be in the form of:  Cash  Share exchange  Convertible debt



Methods of financing a cash offer:  Retained earnings – common when a firm acquires a smaller firm  Sale of assets  Issue of shares, using cash to buy target firm's shares  Debt issue – but, issuing bonds will aler t the market to the intentions of the company to bid for another company and may lead investors to buy shares of potential targets, raising their prices  Bank loan facility from a bank – a possible short-term strategy, until bid is accepted: then the company can make a bond issue  Mezzanine finance – may be the only route for companies without access to bond markets



The choice will depend on:  Available cash  Desired levels of gearing  Shareholders' tax position  Changes in control



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Use of convertible debt Problems with using debentures, loan stock, preference shares:



Mezzanine finance



 Establishing a rate of return attractive to target shareholders



With cash purchase option for target company's shareholders, bidding company may arrange mezzanine finance – loans that are:



 Effects on the gearing of acquiring company



 Short-to-medium term



 Change in structure of target shareholders' portfolios



 Unsecured ('junior' debt)



 Securities potentially less marketable, possibly lacking voting rights



 At higher rate of interest than secured debt (eg LIBOR + 4% to 5%)



Convertible debt can overcome some such problems, offering target shareholders the oppor tunity to gain from future profits of company.



Page 107



 Often, giving lender option to exchange loan for shares after the takeover



12: Financing mergers and acquisitions



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Financing methods



Effects of offer



Cash or paper? Company and existing shareholders Dilution of EPS



May be a fall in EPS attributable to existing shareholders if purchase consideration is in equity shares



Cost to the company



Loan stock to back cash offer: tax relief on interest, lower cost than equity. May be lower coupon if convertible



Gearing



Highly geared company may not be able to issue further loan stock for cash offer



Control



Major share issue could change control



Authorised share capital increase



May be required if consideration is shares: requires General Meeting resolution



Borrowing limits increase



General Meeting resolution required if borrowing limits need to change Shareholders in target company



Taxation



If consideration is cash, many investors may suffer CGT



Income



If consideration is not cash, arrangement must mean existing income is maintained, or be compensated by suitable capital gain or reasonable growth expectations



Future investments



Shareholders who want to retain stake in target business may prefer shares



Share price



If consideration is shares, recipients will want to be sure that shares retain their v alues



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Financing methods



EPS before and after a takeover If a company acquires another by issuing shares, its EPS will go up or down according to the P/E ratio at which target company was bought.  If target company's shares bought at higher P/E ratio than predator company's shares, predator company's shareholders suffer fall in EPS  If target company's shares valued at a lower P/E ratio, the predator company's shareholders benefit from rise in EPS Buying companies with a higher P/E r atio will result in a fall in EPS unless there is profit g rowth to offset this fall. Page 109



Effects of offer



Dilution of earnings may be acceptable if there is:  Earnings growth  Superior quality of earnings acquired  Increase in net asset backing



Post-acquisition integration A clear programme should be in place, re-defining objectives and strategy. The approach adopted will depend on:  The culture of the organisation  The nature of the company acquired, and  How it fits into the amalgamated organisation (eg horizontally, vertically, or in diversified conglomerate?) 12: Financing mergers and acquisitions



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Notes



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13–14: Reconstruction and reorganisation



Topic List



Reorganisations of business operations and business structures are a constant feature of business life.



Financial reconstruction



Business reorganisations include various methods of unbundling companies, including include sell-offs, spinoffs, carve-outs, and management buyouts.



Divestment and other changes MBOs and buy-ins Firm value



Corporate restructuring may typically take place when companies are in difficulties or are seeking a change in focus.



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Financial reconstruction



Page 112



Divestment and other changes



MBOs and buy-ins



Firm value



Capital reconstruction scheme is a scheme where a company re-organises its capital structure, often to avoid liquidation.



Steps in a capital reconstruction



Providers of finance will need to be con vinced that the return is attractive. Company must therefore prepare cash/profit forecasts.



1



Estimate position of each par ty if liquidation is to go ahead



 Creation of new share capital at different nominal value



2



Assess additional sources of finance



 Cancellation of existing share capital



3



Design reconstruction



4



Calculate and assess new position, and compare for each party with Step 1



5



Check company is financially viable



 Conversion of debt or equity Most importantly, a scheme of reconstruction needs to treat all par ties fairly and offer creditors a better deal than liquidation.



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Leveraged recapitalisation A firm replaces most of its equity with a pac kage of debt securities consisting of both senior and subordinated debt. Leveraged capitalisations are used to discourage corporate raiders who will not be able to borrow against assets of the target fir m to finance the acquisition. To avoid financial distress from a high debt le vel, the company should have stable cash flows and not require substantial ongoing capital expenditure to retain their competitive position.



Leveraged buy-outs A group of private investors uses debt financing to purchase a company or part of it. The company increases its level of leverage but (unlike leveraged recapitalisations) no longer has access to equity markets. A higher level of debt will increase the company’s geared beta; a lower level of debt will reduce it. Page 113



Debt-equity swaps 



In an equity/debt swap, shareholders are given the right to exchange stock for a predetermined amount of debt (ie bonds) in the same company







In a debt/equity swap, debt is exchanged for a predetermined amount of stock







After the swap takes place, the preceding asset class is cancelled for the newly acquired asset class







Debt-equity swaps may occur because the company must meet certain contractual obligations, such as maintaining a debt/equity ratio below a certain number







A company may issue equity to avoid making coupon and face value payments in the future 13–14: Reconstruction and reorganisation



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Financial reconstruction



Demerger is the splitting up of a cor porate body into two or more separate bodies, to ensure share prices reflect the true value of underlying operations.



Sell-off is the sale of par t of a company to a third par ty, generally for cash. Organisational restructuring typically involves changes in divisional structures or hierarchy, and often accompanies restructuring of ownership (portfolio restructuring).



Page 114



Divestment and other changes



MBOs and buy-ins



Firm value



Disadvantages of demergers  Loss of economies of scale  Ability to raise extra finance reduced  Vulnerability to takeover increased



Reasons for sell-offs      



Strategic restructuring Sell off loss-making part Protect rest of business from takeover Cash shortage Reduction of business risk Sale at profit



A divestment is a partial or complete reduction in ownership stake in an organisation.



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Spin-offs and carve-outs Spin-off: a new company is created whose shares are owned by the shareholders of original company. There is no change in asset ownership, but management may change. In a carve-out, part of the firm is detached and a new company’s shares are offered to the public.



Going private occurs when a group of investors buys all the company’s shares. The company ceases to be listed on a stock exchange.



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Advantages of spin-offs to investors  Merger or takeover of only part of business made easier  Improved efficiency/management  Easier to see value of separate parts  Investors can adjust shareholdings



Advantages of going private to company    



Costs of meeting listing requirements saved Company protected from volatility in share prices Company less vulnerable to hostile takeover bids Management can concentrate on long-term business 13–14: Reconstruction and reorganisation



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Financial reconstruction



Management buy-outs (MBOs) is the purchase of all or par t of a business by its managers. The managers generally need financial backers (venture capital) who will want an equity stake. Reasons for company agreeing to MBO are similar to those for sell-off, also:  When best offer price available is from MBO  When group has decided to sell subsidiar y, best way of maximising management co-operation  Sale can be arranged quickly  Selling organisation more likely to retain beneficial links with sold segment



Page 116



Divestment and other changes



MBOs and buy-ins



Firm value



Evaluation of MBOs by investors       



Management skills of team Reasons why company is being sold Projected profits, cash flows and risks Shares/selected assets being bought Price right? Financial contribution by management team Exit routes (flotation, share repurchase)



Venture capital Venture capitalists are often prepared to fund MBOs. They typically require shareholding, right to appoint some directors and right of veto on certain business decisions.



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Performance of MBOs Management-owned companies typically achieve better performance. Possible reasons:    



Favourable price Personal motivation Quicker decision-making/flexibility Savings on overheads



Buy-ins are when a team of outside managers mount a takeover bid and then run the business themselves.



Page 117



Problems with MBOs      



Lack of financial experience Tax and legal complications Changing work practices Inadequate cash flow Board representation by finance suppliers Loss of employees/suppliers/customers



Buy-ins often occur when a business is in trouble or shareholder/managers wish to retire. Finance sources are similar to buy-outs. They work best if management quality improves, but external managers may face opposition from employees. 13–14: Reconstruction and reorganisation



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Financial reconstruction



Page 118



Divestment and other changes



MBOs and buy-ins



Firm value



Unbundling and firm value Unbundling affects the value of the firm through changes in return on equity and the asset beta. Growth rate following a restructuring:



When firms divest themselves of existing investments, they affect the expected return on assets (ROA), as good projects increase ROA and bad projects reduce it.



g = b × re



where re is the return on equity (ie Ke) b is the retention rate



Investment decisions taken by firms affect their riskiness and therefore the asset beta βa.



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15: The treasury function in multinationals



Topic List Markets Instruments



The treasury function of a multinational company should deal with short-term decisions in a way that is consistent with the long-term management objective of maximising shareholder value. The treasury function deals with the management of short-term assets of a company and its risk exposure. You should understand the principal money market instruments that are available.



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Markets



Financial markets



Instruments



INDIRECT FINANCE



Financial intermediaries



Funds



Funds



Funds



Lenders - Savers 1 Households 2 Firms 3 Government 4 Overseas



Funds



Financial markets



DIRECT FINANCE



Funds



Borrowers - Spenders 1 Firms 2 Government 3 Households 4 Overseas



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Primary and secondary markets



Capital markets



Primary market: a financial market in which new issues are sold by issuers to initial buyers



are markets in which the securities that are traded have long maturities, ie represent long-term obligations for the issuer. Securities that trade in capital markets include shares and bonds.



Secondary market: a market in which securities that have already been issued can be bought and sold  Secondary markets can be organised as exchanges or over the counter (OTC) – where buyers and sellers transact with each other through individual negotiation  Securities that are issued in an over the counter market and can be resold are negotiable securities Page 121



Money markets are markets in which the securities traded have short maturities, less than a year, and repayment of funds borrowed is required within a shor t period of time.



15: The treasury function in multinationals



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Markets



Instruments



Coupon bearing instruments



Discount instruments



Derivatives



Money Market Deposits Very short-term loans between institutions, including governments. Either fixed – with agreed interest and maturity dates, or call deposits – with variable interest and deposit can be terminated on notice.



Treasury Bill (T-bill) Debt instruments issued by central governments with maturities ranging from one month up to one year.



Forwards and futures Forward rate agreement (FRA): cash-settled OTC forward contract on a short-term loan. Futures contract: standardised agreement to buy/sell asset at set date and pr ice. Interest rate future: underlying is debt security, or based on interbank deposit.



Certificate of Deposit (CD) Either negotiable or non-negotiable certificate of receipt for funds deposited at a financial institution for a specified term, paying interest at a specified rate.



Banker's Acceptances Negotiable bills issued by firms to finance transactions such as imports or purchase of good and guaranteed (accepted) by a bank, for a fee.



Swaps Interest rate swap: two parties exchange payments stream at one interest rate for stream at a different rate.



Repurchase Agreement (repo) Loan secured by a marketable instrument, usually a Treasury Bill or a bond. Typical term: 1–180 days. Counterparty sells on agreed date and simultaneously agrees to buy back instrument later for agreed price.



Commercial Paper (CP) Short-term unsecured corporate debt with maturity up to 270 days but typically about 30 days. Used by corporations with good credit ratings to finance short-term expenditure.



Options Interest rate option: an instrument sold by option writer to option holder, for a price known as a premium.



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16: Hedging forex risk



Topic List FX markets Money market hedging Futures Swaps Options



Any future payments or distributions payable in a foreign currency carry a risk that the foreign currency will depreciate in value before the foreign currency payment is received and is exchanged into the home currency. While there is a chance of profit if the pr ice of the foreign currency increases, most investors and lenders would give up the possibility of currency exchange profit if they could avoid or ‘hedge’ the risk of currency exchange loss.



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Exchange rates An exchange rate is the price of one currency expressed in another currency.  The spot rate at time t0 is the price for delivery at t0



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Swaps



Futures



Options



Term/reference currency Bank



sells buys



LOW HIGH



For example, if UK bank is buying and selling dollars, selling (offer) price may be $/£1.50, buying (bid) price may be $/£1.53.



 A forward rate at t0 is a rate for delivery at time t1. This is different from whatever the new spot rate turns out to be at t 1



Term and base currencies If a currency is quoted as say $/£1.50, the $ is the term (or reference) currency, the £ is the base currency.



 Direct quote is amount of domestic currency equal to one foreign currency unit  Indirect quote is amount of foreign currency equal to one domestic unit



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Forward exchange contract



Forward rates as adjustments to spot rates



 A firm and binding contract between a bank and its customer  For the purchase/sale of a specified quantity of a stated foreign currency  At a rate fixed at the time the contract is made  For performance at a future time agreed when contract is made Closing out is the process of the bank requir ing the customer to fulfil the contract by selling or buying at spot rate.



Forward rate cheaper – Quoted at discount Forward rate more expensive – Quoted at premium Add discounts, or subtract premiums from spot rate.



Netting is the process of setting off credit against debit balances within a group of companies so that only the reduced net amounts are paid by currency flows. Multilateral netting involves offsetting several companies’ balances. Page 125



Interest rate parity Interest rate parity must hold between spot rates and forward rates (for the interest rate period), otherwise arbitrage profits can be made:



f0 = s 0



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



Where f0 s0 ic ib



= forward rate = spot rate = interest rate in overseas country = interest rate in base country 16: Hedging forex risk



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Money market hedging



FX markets



Page 126



Swaps



Futures



Options



Money market hedging Future foreign currency payment



Future foreign currency receipt



1 Borrow now in home currency



1 Borrow now in foreign currency



2 Convert home currency loan to foreign currency



2 Convert foreign currency loan to home currency



3 Put foreign currency on deposit



3 Put home currency on deposit



4 When have to make payment



4 When cash received



(a) Make payment from deposit



(a) Take cash from deposit



(b) Repay home currency borrowing



(b) Repay foreign currency borrowing



Remember International Fisher effect



1 + ia 1 + h a = 1 + ib 1 + hb



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Futures



Swaps



Options



Futures terminology Closing out a futures contract means entering a second futures contract that reverses the effect of the first. Contract size is the fixed minimum quantity that can be bought/sold. Contract price is in US dollars. eg $/£ 0.6700. Settlement date is the date when trading on a futures contract ceases and accounts are settled. Basis is spot price – futures price.



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Basis risk is the risk that futures price movement may differ from underlying currency movement. Tick size is the smallest measured movement in contracts price (movement to fourth decimal place).



Transactions not involving US dollars If trading one non-US dollar currency with another, sell one type of future (to get dollars) and b uy other type (with dollars), and reverse both contracts when receipt/payment made.



16: Hedging forex risk



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Futures



Money market hedging



Swaps



Options



What type of contract? Transaction on future date



Now



On future date



Receive



currency



Sell



currency futures



Buy



currency futures



Receive



currency



Buy



currency futures



Sell



currency futures



Receive



$



Buy



currency futures



Sell



currency futures



Pay



$



Sell



currency futures



Buy



currency futures



Disadvantages of futures Advantages of futures



 



Transaction costs lower than forward contracts Futures contract not closed out until cash receipt/payment made



   



Can’t tailor to user’s exact needs Only available in limited number of currencies Hedge inefficiencies Conversion procedures complex if dollar is not one of the two currencies



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Step 1 Setup process (a) Choose which contract (settlement date after date currency needed) and type (b) Choose number of contracts Amount being hedged Size of contract Convert using today’s futures contract price if amount being hedged is in US dollars (c) Calculate tick size: Minimum price movement × Standard contract size



Step 2 Estimate closing futures price Step 3 Hedge outcome



(May have to adjust closing spot pr ice using basis, assuming basis declines evenly over life of contract)



(a) Outcome in futures market



Short-cut for calculating the effective futures rate = opening futures price – closing basis



Futures profit = Tick movement × Tick value × Number of contracts (b) Net outcome Spot market payment (closing spot rate) Futures profit / (loss) (closing spot r ate unless US company) Net outcome Page 129



(x) x (x) 16: Hedging forex risk



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Currency swaps In a currency (or ‘cross-currency’) swap, equivalent amounts of currency and interest cash flows are swapped for a period. However the original borrower remains liable to the lender (counter par ty risk). A cross-currency swap is an interest rate swap with cash flows in different currencies.



Advantages of currency swaps       



Flexibility – any size and reversible Can gain access to debt in other currencies Restructuring currency base of liabilities Conversion of fixed to/from floating rate debt Absorbing excess liquidity Cheaper borrowing Obtaining funds blocked by exchange controls



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Futures



Swaps



Options



Risks of swaps  Credit risk (Counterparty defaults)  Position or market risk (Unfavourable market movements)  Sovereign risk (Political disturbances in other countries)  Spread risk (For banks which combine swap and hedge)  Transparency risk (Accounts are misleading)



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Example Edward Ltd wishes to borrow US dollars to finance an investment in the USA. Edward’s treasurer is concerned about the high interest rates the company faces because it is not well-known in the USA. Edward Ltd should make an arrangement with an American company, Gordon Inc, attempting to borrow sterling in the UK money markets.



1



Gordon borrows US $ and Edward borrows £. The two companies then swap funds at the current spot rate



2



Edward pays Gordon the annual interest cost on the $ loan. Gordon pays Edward the annual interest cost on the £ loan



3



At the end of the per iod, the two companies swap back the principal amounts at the spot rates/predetermined rates



An FX swap is simply a spot currency transaction that will be reversed, in a single transaction, by an offsetting forward transaction at a pre-specified date. Page 131



16: Hedging forex risk



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Currency option is a right to buy or sell currency at a stated rate of exchange at some time in the future. Call – right to buy at fixed rate Put – right to sell at fixed rate Over the counter options are tailor-made options suited to a company’s specific needs. Traded options are contracts for standardised amounts, only available in certain currencies.



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Futures



Swaps



Options



Why option is needed  Uncertainty about foreign currency receipts or payments (timing and amount)  Support tender for overseas contract  Allow publication of price lists in foreign currency  Protect import/export of price-sensitive goods



Choosing the right option Complicated by lack of US dollar options. UK company wishing to sell US dollars can purchase £ call options (options to buy sterling with dollars).



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Strike price



–



May need to use exercise price to convert US dollars



Surplus cash



–



If option contracts don’t cover amount to be hedged, convert remainder at spot price on day of exercise or with formal contract



What type of contract Transaction on future date



Page 133



Buy now



On future date



Receive currency



Currency put



Sell currency



Pay currency



Currency call



Buy currency



Receive $



Currency call



Buy currency



Pay $



Currency put



Sell currency



16: Hedging forex risk



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Notes



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17: Hedging interest rate risk



Topic List FRAs IR futures IR swaps IR options The Greeks



The value of a firm’s assets, liabilities and cashflows is affected by changes in interest rates. Various derivatives are available to reduce interest rate risk, including forward rate agreements, interest rate futures contracts, interest rate swaps and options. Here we deal with the application of these der ivative contracts for hedging.



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IR swaps



IR options



The Greeks



Interest rate risk Fixed v floating rate debt



Change in interest rates may make borrowing chosen the less attractive option



Currency of debt



Effect of adverse movements if borrow in another currency



Term of loan



Having to re-pay loan at time when funds not a vailable => need f or new loan at higher interest rate



Forward rate agreement An FRA means that the interest r ate will be fixed at a certain time in the future. Loans > £500,000, period < 1 year.



 5.75-5.70 means a borrowing rate can be fixed at 5.75%  ‘3-6’ FRA starts in three months time and lasts for three months  Basis point is 0.01%



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IR swaps



Interest rate futures hedge against interest rate movements. The terms, amounts and periods are standardised.



IR options



The Greeks



Example LIFFE three months sterling futures £500,000 points of 100% price 92.50. Tick size will be:



 The futures prices will vary with changes in interest rates  Outlay to buy futures is less than buying the financial instrument



£500,000 × 0.01% × 3/12 = £12.50 A 2% movement in the futures price would represent 200 ticks. Gain on a single contr act would be 200 × £12.50 = £2,500.



 Price of short-term futures quoted at discount to 100 per value (93.40 indicates deposit trading at 6.6%)  Long-term bond futures prices quoted at % of par value



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17: Hedging interest rate risk



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IR swaps



IR options



Step 1 Setup process (a) Choose which contract: Date should be after borrowing/lending begins. (b) Choose type: sell if protecting against an increase in r ates, buy if protecting against a fall. (c) Choose number of contracts:



Exposure Contract size



(d) Calculate tick size: Min price movement as % ×



Step 2 Estimate closing futures price May have to adjust using basis.



×



Loan period Length of contract



Length of contract 12 months



× Contract size



The Greeks



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Step 3 Hedge outcome (a)



Futures outcome Opening futures price: Closing futures price: Movement in ticks: Futures outcome: Tick movement × Tick value × Number of contracts



(b)



Net outcome Payment in spot market Futures market profit/(loss) Net payment



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(X) X (X)



17: Hedging interest rate risk



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IR swaps



IR futures



Interest rate swaps



IR options



The Greeks



Uses of interest rate swaps



are agreements where parties exchange interest commitments. In simplest form, two parties swap interest with different characteristics. Each party borrows in market in which it has comparative advantage.



    



Switching from paying one type of interest to another Raising less expensive loans Securing better deposit rates Managing interest rate risk Avoiding charges for loan termination



Example Company A Company B Interest paid on loan (9%) (LIBOR + 1%) A pays to B (LIBOR + 1%) LIBOR + 1% B pays to A 9% 9% __________ _________ LIBOR + 1% (9%) __________ _________ Companies may decide to use a swap rather than terminating their original loans, because costs of termination and taking out a new loan may be too high. If LIBOR is at 8%, neither par ty will gain nor lose. Any rate other than 8% will result in gain/loss .



Complications  Bank commission costs  One company having better credit rating in both relevant markets – should borrow in comparative advantage market but must want interest in other market



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IR swaps



Interest rate option grants the buyer the right, to deal at an agreed interest rate at a future maturity date.  If a company needs to hedge borrowing, purchase put options  If a company needs to hedge lending, purchase call options To calculate effect of options, use same proforma as currency options. UK long gilt futures options (LIFFE) £100,000 100ths of 100%.



IR options



The Greeks



Interest rate caps, collars and floor  Caps set an interest rate ceiling  Floors set a lower limit to rates  Collars mean buying a cap and selling a floor



Strike Calls Puts price Nov Dec Jan Nov Dec Jan 1.27 1.34 0.29 0.69 1.06 11,350 0.87  Strike price is price paid for futures contract  Numbers under each month represent premium paid f or options  Put options more expensive than call as interest rates predicted to rise Page 141



17: Hedging interest rate risk



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Greeks Delta – change in call option pr ice/change in value of share Gamma – change in delta value/change in value of share Theta – change in option price over time Rho – change in option price as interest rates change Vega – change in option price as volatility changes



Gamma Higher for share which is close to expiry and 'at the money' 



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IR swaps



IR options



The Greeks



Delta hedging determines number of shares required to create the equivalent portfolio to an option, and hence hedge it.



Vega is the change in value of an option (call or put) resulting from a 1% point change in its v olatility.



 +ve gamma means that a position benefits from movement -ve theta means the position loses money if the underlying asset price does not move



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18: Dividend policy in multinationals and transfer pricing Topic List Dividend policy Transfer pricing



Multinational businesses operate through subsidiaries, affiliates or joint ventures in more than one countr y, and produce and sell products globally. Revenues are repatriated to the parent company in the form of dividends, royalties or licence payments. Overseas operations’ ability to repatriate funds can have a major impact on the parent company’s ability to pay dividends to external shareholders and finance its investment plans.



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Dividend policy



Dividend capacity The dividend capacity of a company depends on: after tax profits, investment plans, foreign dividends.



Transfer pricing



Dividend policy Revenue after operating costs, interest and tax + Dividends from foreign affiliates and subsidiaries –



Free Cash Flow to Equity (FCFE) FCFE = Dividends that could be paid to shareholders = Net profit after tax + Depreciation + F oreign Dividends – Total Net Investment + Net debt Issuance + Net Share Issuance



Net investment in non-current assets – Net investment in working capital + Net debt issued + Net equity issued



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Dividend repatriation Factors affecting dividend repatriation policies Financing – how much needed for dividends / investment at home? Tax – often the primary reason for the firm’s  repatriation policies Managerial control – regularised dividends restrict discretion of foreign managers (so reducing agency problems) Timing – to take advantage of possible currency movements (although these are difficult to forecast in practice)  Page 145







UK companies’ subsidiaries’ foreign profits are liable to UK corporate tax, whether repatriated or not, with a credit for tax already paid to the host country. Similarly, the US government does not distinguish between income earned abroad and income earned at home and gives credit to MNCs headquartered in the US for tax paid to foreign governments.



Collecting early (lead) payments from currencies  vulnerable to depreciation and late (lag) from currencies expected to appreciate will benefit from expected movements in exchange rates. 18: Dividend policy in multinationals and transfer pricing



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Dividend policy



Transfer prices are prices at which goods or ser vices are transferred from one process or depar tment to another or from one member of a g roup to another.



Using market value transfer prices Giving profit centre managers freedom to negotiate prices with other profit centres results in marketbased transfer prices.



Transfer price bases  Standard cost  Marginal cost: at marginal cost or with gross profit margin added  Opportunity cost  Full cost: at full cost, or at a full cost plus pr ice  Market price  Market price less a discount  Negotiated price, which could be based on any of the other bases



Transfer pricing



Transfer pricing motivations Evaluation of performance of divisions Management incentives Cost allocation between divisions Financing considerations – to boost or to disguise the profitability of a subsidiar y  External factors, including taxes, tariffs, rule of origin tests and exchange controls    



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Transfer price regulation Tax authorities often use an arm's length standard: price intra-firm trade of multinationals as if it took place between unrelated parties acting in competitive markets. Method 1: use price negotiated between unrelated parties C and D as proxy for intra-firm transfer A to B



C



Arm’s length transfer



A



A



Intrafirm transfer



B



Arm’s length transfer



B Intrafirm transfer



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D



Method 2: use price at which A sells to unrelated party C as proxy



C



18: Dividend policy in multinationals and transfer pricing



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Dividend policy



Arm’s length pricing methods (tangible goods) Transaction-based  Comparable uncontrolled price (CUP)   Resale price (RP)   Cost plus (C+)  Profit based  Comparable profit method (CPM)   Profit split (PS) 



PS: Common when there are no suitable product comparables (CUP) or functional comparables (RP and C+). Profits on a transaction earned by two related parties are split between the parties, usually on basis of return on operating assets: operating profits to operating assets.



Transfer pricing







CUP: Based on a product comparable transaction, possibly between different parties but in similar circumstances – a method preferred by tax authorities.







RP: Tax auditor looks for firms at similar trade levels that perform a similar distribution function (a functional comparable) – method best used when distributor adds relatively little value, making it easier to estimate. Profit margin derived from that earned by comparable distributors, subtracted from known retail price to determine transfer price.







C+: Appropriate mark-up (estimated from similar manufacturers) added to costs of production, measured using recognised accounting principles.







CPM: Method is based on premise of similar financial ratios and performance of companies in similar industries.



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19: Recent developments



Topic List Developments in world financial markets Developments in international trade Developments in Islamic finance



It is important to keep up to date with recent developments in the business environment. This chapter focuses on such developments in world financial markets and international trade.



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Developments in world financial markets



The credit crunch The credit crunch first became a global issue in early 2007. How the global crisis happened. Billions of dollars of ‘sub-prime’ mortages in the US Rise in interest rates caused defaults on such mortgages Collateralised debt obligations (CDOs) containing sub-prime mortgages sold onto hedge funds Value of CDOs fell due to defaults Huge losses by the banks



Developments in international trade



Developments in Islamic finance



Financial reporting Common accounting standards are increasing transparency and comparability for investors – improving capital market efficiency and facilitating cross-border investment.



Monetary policy In advanced economies, monetary policy has encompassed the task of controlling inflation. Interest rates are commonly set by central banks independent of Government – enhancing credibility and so lowering inflation expectations. A low inflation environment is conducive to longterm business planning and investment.



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The credit crunch and IFRS Entities must value financial assets and liabilities at ‘fair value’.



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19: Recent developments



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Developments in world financial markets



Developments in international trade



Developments in Islamic finance



Tranching Where claims on cash flows are split into several classes (such as Class A, Class B) Risks of tranching  Very complex  May not be divided properly  Rebuilding



Benefits of tranching  A good way of dividing risk  Potential to make a lot of money from ‘junior’ tranches



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Credit default swaps (CDS) allow the transfer of third party credit risk from one party to another.



Similar to insurance policies Credit default swaps



Uses of CDS  Speculation  Hedging



‘Spread’ is similar to an insurance premium CDS market is unregulated



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19: Recent developments



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Developments in world financial markets



Trends in global financial markets Integration and globalisation – fostered by liberalisation of markets and technological change; creating more efficient allocation of capital and economic growth  Growth of derivatives markets – advances in technology, financial engineering and risk management have enhanced demand for more complex derivatives products  Securitisation – eg sale of loan books by banks. Now a common form of financing, leading to increased bond issuance  Convergence of financial institutions – abolition of barriers to entry in various segments of financial services industries has led to conglomerates with operations in banking, securities and insurance



Developments in international trade



Developments in Islamic finance



Effects of financial sector convergence







Economies of scale  Economies of scope: a factor of production can be employed to produce multiple products  Reduced earnings volatility  Reduced search costs for consumers 



Money laundering A side effect of globalisation and the free movement of capital has been a growth in money laundering, and there has been increased legislation and regulation to combat it.



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Developments in world financial markets



Trade financing



has become easier for companies to obtain. Financing for international trade transactions includes commercial bank loans within the host country and loans from international lending agencies. Trade bills may be discounted through foreign banks, for short-term financing. Eurodollar financing is another method for providing foreign financing. Eurodollar loans are short-term working-capital loans, unsecured and usually in large amounts. The Eurobond market is widely used for long-term funds for multinational US companies. In many countries, development banks provide intermediate- and long-term loans to private enterprises. Page 155



Developments in international trade



Delevopments in Islamic finance



Regulation Globalisation creates incentives for governments to intervene in favour of domestic MNCs in respect of ‘macroeconomic’ and ‘macrostructural’ policies.



Pressure groups Transnationally networked pressure groups can influence the public and put pressure on governments to take measures against multinational companies.



19: Recent developments



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Developments in world financial markets



Developments in international trade



Delevopments in Islamic finance



Islamic finance operates under the principle that there should be a link betw een the economic activity that creates value and the financing of that activity. Advantages of Islamic finance



Drawbacks of Islamic finance



 Islamic funds are available worldwide  Gharar (uncertainty, risk, speculation) is not allowed  Excessive profiteering is not allowed  Banks cannot use excessive leverage  All parties take a long-term view  Emphasis on mutual interest and co-operation



 No international consensus on Sharia’a interpretations  No standard Sharia’a model, which leads to higher transaction costs  Additional compliance work increases transaction costs  Islamic banks cannot minimise risk through hedging  Some Islamic products may not be compatible with financial regulations  Limited trading in Sukuk products