acca p4 advanced financial management december 2011 exams

ACCA P4Advanced Financial

Management December 2011

Exams

Capital asset pricing model

CAPM basics Arbitrage

CAPM basics 1

The CAPM formula

• E (ri) = Rf + βi (E (rm) – Rf)

Where E (ri) is expected return from security / project

• Rf is risk-free rate of return

• E(rm) is expected return from market

• βi is beta factor of security / project

• (E (rm) – Rf) is market premium for risk

This formula is given in the exam.

Slide 3

CAPM basics 2

Capital asset pricing model

• Based on a comparison of the systematic risk of individual investments with the risks of all shares in the market

CAPM assumes:

• Investors / companies require return in excess of risk-free rate

• Unsystematic risk can be diversified away and no premium is required for it

• Investors / companies require a higher return from investments where systematic risk is greater

CAPM Basics 3

Beta factor of portfolios

• Portfolio consisting of all (non risk-free) securities on stock market will have beta factor of 1

• Portfolio consisting entirely of risk-free securities will have beta factor of 0

• Beta factor of investor’s portfolio is weighted average of beta factors of securities in portfolio

• Investors should decide on desired β levels, invest in low β shares when returns falling, high β shares when returns rising

CAPM Basics 4

• Investors should consider international diversification through investment in different countries or multinationals

• Market segmentation may complicate situation

Slide 6

CAPM Basics 5

Problems with CAPM

Assumptions unrealistic?

• Zero insolvency costs

• Investment market efficient

• Investors hold well-diversified portfolios

• Perfect capital market

Slide 7

CAPM Basics 6

Problems with CAPM continued

Required estimates difficult to make:

• Excess return

• Risk-free rate (govt. securities’ rates vary with lending terms)

• β factors difficult to calculate

• Hard to determine risk-free rate, systematic risk and expected return on market portfolio

Slide 8

CAPM Basics 7

CAPM and returns

• CAPM can be used to calculate the required return on projects

• Particularly projects with significantly different business risk characteristics to a company’s current operations

• CAPM produces a discount rate based on systematic risk and can be used to compare projects of different risk classes

• CAPM assumes company’s investors wish investments to be evaluated as if they are capital market securities

Slide 9

CAPM Basics 8

Limitations of CAPM in investment decisions

• Hard to estimate returns under different economic environments

• CAPM is single period, but investments are evaluated over time

• Difficult to model complications in decision-making

Slide 10

CAPM Basics 9

Geared betas

• May be used to obtain an appropriate required return when an investment has differing business and finance risks from the existing business

Slide 11

CAPM Basics 10

Where:

• βa = asset (or ungeared) beta

• βe = equity (or geared) beta

• βd = beta factor of debt in the geared company

• Vd = market value of debt in the geared company

• Ve = market value of equity capital in the geared company

• T = rate of corporate tax

Slide 12

CAPM Basics 11

Weaknesses in the formula

• Difficult to identify firms with identical operating characteristics

• Estimate of beta factors not wholly accurate

• Assumes that cost of debt is risk-free

• Does not include growth opportunities

• Differences in cost structures and size will affect beta values between firms

Slide 13

Arbitrage 1

Arbitrage pricing theory

• The theory assumes that the return on each security is based on a number of independent factors

Arbitrage 2

• Where E (rj) is expected return on security

• B1 is sensitivity to changes in Factor 1

• F1 is difference between Factor 1 actual and expected values

• B2 is sensitivity to changes in Factor 2

• F2 is difference between Factor 2 actual…e is a random term

• Main problem – identifying macroeconomic factors and risk

Slide 15

Arbitrage 3

Factor analysis

• Analysis used to determine factors to which security returns are sensitive

Four key factors indicated by research are:

• Unanticipated inflation

• Changes in industrial production levels

• Changes in risk premiums on bonds

• Unanticipated changes in interest rate term structure

Slide 16

Arbitrage 4

Arbitrage trading

• Trading will occur if certain combinations of securities are expected to produce higher returns than indicated by risk sensitivities

Slide 17

Chapter 1

The role and responsibility of senior financial

executive

Financial management Financial planning

Financial management 1

Financial objectives

• The prime financial objective is to maximise the market value of the company’s shares

• Primary targets are profits and dividend growth

• Other targets may be the level of gearing, profit retentions, operating profitability and shareholder value indicators

Slide 19


Why profit maximisation is not a sufficient objective

• Risk and uncertainty

• Profit manipulation

• Sacrifice of future profits?

• Dividend policy

Slide 20


Non-financial objectives

• Non-financial objectives do not negate financial objectives

• However they do mean that the primary financial objectives may be modified

• They take account of ethical considerations

Slide 21


Examples - non-financial objectives

• Employee welfare

• Management welfare

• Society’s welfare

• Service provision

• Responsibilities towards customers / suppliers

Slide 22


Investment decisions

Investment decisions include:

• New projects

• Takeovers

• Mergers

• Sell-off / Divestment

Slide 23


The financial manager must:

• Identify decisions

• Evaluate them

• Decide optimal fund allocation

Slide 24


Financing decisions

Financing decisions include:

• Long-term capital structure

• Need to determine source, cost and risk of long-term finance

• Short-term working capital management

• Balance between profitability and liquidity is crucial

Slide 25


Dividend decisions

• 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

Slide 26

Financial planning 1

Strategic planning

• The formulation, evaluation and selection of strategies to prepare a long-term plan of action to attain objectives

• Strategic decisions should be suitable, feasible and acceptable

• Long-term direction

• Matching activities to environment / resources

Slide 27


Key elements of financial planning

• Planning involves a long horizon, uncertainties and contingency plans

• Consideration of which assets are essential and how easily assets can be sold

• Long-term investment and short-term cash flow

• Surplus cash

• How finance raised

• Profitable

Slide 28


• Strategic analysis means analysing the organisation - its resources, competences, mission and objectives

• Strategic choice involves generating and evaluating strategic options and selecting strategy

Slide 29


Strategic cash flow management

• Planning involves a long horizon, uncertainties and contingency plans

Strategic fund management

• Consideration of which assets are essential and how easily assets can be sold

Slide 30


Strategic planning

• Selection of products / markets

• Target profits

• Purchase of major non-current assets

• Debt / equity mix

• Growth v dividend payout

Slide 31


Tactical planning

• Other non-current asset purchases

• Efficient / effective resource usage

• Pricing

• Lease v buy

• Scrip v cash dividends

Slide 32


Tactical planning and control

• Conflict may arise between strategic planning (need to invest in more expensive machinery, R&D) and tactical planning (cost control)

Slide 33


• Johnson and Scholes separate power groups into 'internal coalitions' and 'external stakeholder groups'

Slide 34


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

Slide 35


Stakeholder goals continued

• Employees

– To maximise salaries and benefits; also prefer continuity in employment

• Government

– Political objectives such as sustained economic growth and high employment

• Management

– Maximising their own rewards

Slide 36

Chapter 2

Financial strategy formulation

Assessing corporate performance Financial strategyRisk and risk management

Assessing corporate performance 1

Probability and return

• Return on capital employed

• Profit margin

• Asset turnover

Debt and gearing

• Debt ratio (Total debts: Assets)

• Gearing (Proportion of debt in long-term capital)

• Interest cover

• Cash flow ratio (Cash inflow: Total debts)

Slide 38


Liquidity ratios

• Current ratio

• Acid test ratio

• Inventory turnover

• Receivables’ days

• Payables’ days

Slide 39


Stock market ratios

• Dividend yield

• Interest yield

• Earnings per share

• Dividend cover

• Price / earnings ratio

Slide 40


Comparisons with previous years

• % growth in profit

• % growth in turnover

• Changes in gearing ratio

• Changes in current / quick ratios

• Changes in inventory / receivables’ turnover

• Changes in EPS, market price, dividend

Slide 41


Remember however

• Inflation – can make figures misleading

• Results in rest of industry / environment, or economic changes

Comparisons with companies in same industry

• These can put improvements on previous years into perspective if other companies are doing better

• Also can provide further evidence of effect of general trends

• Eg growth rates, retained profits, non-current asset levels

Slide 42


Comparisons with companies in different industries

• Investors aiming for diversified portfolios need to know differences between industrial sectors

• Sales growth

• Profit growth

• ROCE

• P/E ratios

• Dividend yields

Slide 43


Economic Value Added (EVATM)

• EVATM = NOPAT - (cost of capital x capital employed)

Adjustments to NOPAT

• Add:

– Interest on debt

– Goodwill written off

– Accounting depreciation

– Increases in provisions

– Net capitalised intangibles

Slide 44


Adjustments to capital employed

• Add:

– Cumulative goodwill written off

– Cumulative depreciation written off

– NBV of intangibles

– Provisions

Slide 45


Types of sources of funds

Shares

• Ownership stake

• Equity (full voting rights)

• Preference (prior right to dividends)

• All companies can use rights issues

• Listed companies can use offer for sale / placing

Slide 46


Debt / Bonds

• Fixed or floating rate

• Zero coupon (no interest)

• Convertible loan stock

• Bank loans

• Security over property may be required

Slide 47


Comparison of finance sources

When comparing different sources of finance, the following factors will generally be important:

• Cost

• Flexibility / time period available

• Commitments

• Uses

• Speed / availability

• Certainty of raising amounts

Slide 48


Estimating cost of equity

• Theoretical valuation models, eg Capital Asset Pricing Model (CAPM) or Arbitrage Pricing Theory (APT)

• Bond-yield-plus-premium approach: adds a judgmental risk premium to the interest rate on the firm’s own long-term debt

• Market-implied estimates using discounted cash flow (DCF) approach (based on an assumption on earnings growth rate of earning of the company)

Slide 49


Practicalities in issuing new shares

• Costs

• Income to investors

• Tax effect

• Effect on control

Slide 50


Ethical framework for business

• In order of priority:

(1) Economic responsibility

(2) Legal responsibility

(3) Ethical responsibility

(4) Philanthropic responsibility

Slide 51

Financial strategy 1

Suitability of capital structure

• Company financial position / stability of earnings

• Need for a number of sources

• Time period of assets matched with funds

• Change in risk-return

• Cost and flexibility

• Tax relief

• Minimisation of cost of capital

Slide 52


Feasibility of capital structure

• Whether lenders are prepared to lend (security)

• Availability of stock market funds

• Future trends

• Restrictions in loan agreements

• Maturity of current debt

Slide 53


Acceptability of capital structure

• Risk attitudes

• Loss of control by directors

• Excessive costs

• Too heavy commitments

Slide 54


Pecking order

• Retained earnings

• Debt

• Equity

Slide 55


Dividend policy

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

Ways of paying dividends

• Cash

• Shares (stock)

• Share repurchases

Slide 56


Theories of why dividends are paid

• Residual theory

• Target payout ratio

• Dividends as signals

• Tax implications

• Agency theory

Slide 57

Risk and risk management 1

Types of risk

• Systematic and unsystematic

• Business

• Financial

• Political

• Economic

• Fiscal / regulatory

• Operational

• Reputational

Slide 58


Risk management

• Over-riding reason for managing risk is to maximise shareholder value

Risk mitigation

• The process of minimising the likelihood of a risk occurring or the impact of that risk if it does occur

Slide 59


Portfolio theory

• Used to reduce unsystematic risk by diversification

Hedging

• Financial – use financial instruments

• Operational – real options

Slide 60

Chapter 3a

Conflicting stakeholder

interests

Stakeholders Corporate governance

Stakeholders 1

Separation of ownership and management:

• Ordinary (equity) shareholders are owners of the company, but the company is managed by its board of directors

Central source of stakeholder conflict:

• Difference between the interests of managers and those of owners

Slide 62

Stakeholders 2

Sources of stakeholder conflict

• Short-termism

• Sales objective (instead of shareholder value)

• Overpriced acquisitions

• Resistance to takeovers

• Relationships with stakeholders may be difficult

Slide 63

Stakeholders 3

The transaction costs economics theory

• This postulates that the governance structure of a corporation is determined by transaction costs

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

Slide 64

Corporate governance 1

Agency theory

• Proposes that individual team members act in their own self-interest

• Individual well-being however depends on the well-being of other individuals and on the performance of the team

• Corporations are sets of contracts between principals (suppliers of finance) and agents (management)

Slide65


The agency problem

• Managers don’t have significant shareholdings, what stops them under-performing and over-rewarding themselves?

Goal congruence

• Accordance between the objectives of agents acting within an organisation and the objectives of the organisation as a whole

Slide 66


Management incentives may enhance congruence:

• Profit-related pay

• Rights to subscribe at reduced price

• Executive share-option plans

• However management may adopt creative accounting

• Sound corporate governance is another approach

Slide 67


UK Corporate Governance Code (formerly The Combined Code)

•Directors responsible for corporate governance

Board of Directors

•Meet regularly

•Matters refer to board

•Division of responsibilities

•Committees – audit, nomination, remuneration

Slide 68


Executive directors

• Limits on service contracts

• Emoluments decided by remuneration committee and fully disclosed

Non-executive directors

• Majority independent

• No business / financial links

• Don’t participate in options

• Appointed for specified term

Slide 69


• Auditors provide external assurance

• Financial reports link directors to shareholders and other users

Accountability and audit

• Audit committee of non-executive directors

• Consider need for internal audit function

• Accounts contain corporate governance statement

• Directors review and report on internal controls

Slide 70


Annual general meeting

• 20 days’ notice

• Separate resolutions on separate issues

• All committees answer questions

Slide 71


• The Higgs report stresses the importance of the board including a balance of executive and non-executive directors

• No individual or small group can dominate decision-making

• The report also lays down criteria for establishing the independence of non-executive directors

• Also stresses the need to separate the roles of Chairman and Chief Executive

Slide 72


International comparisons

USA

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

• The US system is based on control by legislation/regulation, more rules on directors’ duties than in UK

• Major creditors are often on boards

Slide 73


Europe

• By means of tax law

• Also two tier board system to protect shareholder interests

• In Germany, banks have longer term role, may have equity stake

• Separate supervisory board has workers’ and shareholders’ representatives

Slide 74


Japan

• Flexible approach to governance, low level of regulation

• All stakeholders collaborate

• Stock market is less open, more links with banks than in UK

• Policy boards (long-term)

• Functional boards (executive)

• Monocratic boards (symbolic)

Slide 75


Management culture

• Management culture comprises views on management and methods of doing business

• Multinationals may have particular problems imposing the parent company’s culture overseas eg American practices in Europe

Slide 76

Chapter 3b

Ethical issues in financial

management

Ethical dimension Ethical aspects

Ethical dimension

Ethical considerations are part of the non-financial objectives of an organisation

They will tend to include:

•Employee and management welfare

•Welfare of society

•Responsibilities to customers and supplies

•Leadership in R & D

•Minimum standard of service provision

Slide 78

Ethical aspects 1

Business ethics

Human resource management

• Minimum wage, discrimination

Marketing

• Social and cultural impact

Market behaviour

• Dominant position, treatment of suppliers and customers

Slide 79

Ethical aspects 2

Business ethics continued

Product development

• Animal testing, sensitivity to culture of different countries and markets

Slide 80

Chapter 3c

Environmental issues

Business practice Regulation

Business practice 1

Green issues and business practice

• Direct environmental impacts on business – eg:

– Changes affecting costs or resource availability

– Impact on demand

– Effect on power balances between competitors in a market

• Indirect environmental impacts - eg:

– Legislative change; pressure from customers or staff as a consequence of concern over environmental problems

Slide 82

Business practice 2

Environmental reporting

• Many companies produce an external report for external stakeholders, covering:

– How business activity impacts on environment

– An environmental objective (eg use of 100% recyclable materials within x years)

– The company's approach to achieving and monitoring these objectives

– An assessment of its success towards achieving the objectives

– An independent verification of claims madeSlide 83

Business practice 3

Company’s environmental policy

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

Sustainability

• Refers to the concept of balancing growth with environmental, social and economic concerns

Slide 84

Business practice 4

Triple bottom line decision making

Triple bottom line reporting

• A quantitative summary of a company’s economic, environmental and social performance over the previous year

Slide 85

Business practice 5

Triple bottom line proxy indicators

Economic impact

• Gross operating surplus

• Dependence on imports

• Stimulus to domestic economy by purchasing locally produced goods and services

Slide 86

Business practice 6

Triple bottom line proxy indicators continued

Social impact

• Organisation’s tax contribution

• Employment

Environmental impact

• Ecological footprint

• Emissions to soil, water and air

• Water and energy use

Slide 87

Regulation 1

Carbon trading

• Allows companies which emit less than their allowance to sell the right to emit CO2 to another company

1997 Kyoto Protocol to the UNFCCC

• Advised signatories to reduce total greenhouse gas emissions by 2012, compared to 1990 levels

• EU15 reduction target: 8%

Slide 88

Regulation 2

UNFCCC

• United Nations Framework Convention on Climate Change agreements:

• To develop programmes to slow climate change

• To share technology and co-operate to reduce greenhouse gas emissions

• To develop a greenhouse gas inventory listing national sources and sinks

Slide 89

Regulation 3

Environment agency

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

Slide 90

Regulation 4

Environmental audit

• An audit that seeks to assess the environmental impact of a company's policies

The auditor will check whether the company’s environmental policy:

• Satisfies key stakeholder criteria

• Meets legal requirements

• Complies with British Standards or other local regulations

Slide 91

Chapter 4

Trading and planning in a multi-

national environment

Trade Institutions International financial markets Global financial stability Multinationals’ strategy Risk

Trade 1

International trade

• World output of goods / services increased if countries specialise in production of goods / services in which they have a comparative advantage

• And trade to obtain other goods and services

Slide93

Trade 2

Comparative advantage

• Countries specialising in what they produce, even if they are less efficient (in absolute terms) in production of all types of good

• This is the comparative advantage justification of free trade, without protectionism or trade barriers

Slide 94

Trade 3

Barriers to market entry

• Product differentiation barriers

• Absolute cost barriers

• Economy of scale barriers

• The level of fixed costs

• Legal / patent barriers

Slide 95

Trade 4

Protectionist measures

• Tariffs or customs duties

• Import quotas

• Embargoes

• Hidden subsidies

• Import restrictions

• Restrictive bureaucratic procedures

• Currency devaluations

Slide 96

Trade 5

Why protect trade?

• To combat imports of cheap goods

• To counter ‘dumping’

• Infant industries might need special treatment

• Declining industries might need special treatment

• Protection might reduce a trade deficit

Slide 97

Trade 6

What’s wrong with trade protection?

• Mutually beneficial trade may be reduced

• There may be retaliation

• Economic growth prospects may be damaged

• Political ill-will may be created

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

Slide 98

Institutions 1

World Trade Organisation – aims

• Reduce existing barriers to free trade

• Eliminate discrimination in international trade (in eg tariffs and subsidies)

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

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

• Establish rules and guidelines to make world trade more predictable

Slide 99

Institutions 2

International Monetary Fund – aims

• Promote international monetary co-operation, and establish code of conduct for international payments

• Provide financial support to countries with temporary balance of payments deficits

• Provide for orderly growth of international liquidity

Slide 100

Institutions 3

World Bank (IBRD)

• Supplements private finance and lends money on a commercial basis for capital projects

• Usually direct to governments or government agencies

Bank for International Settlements (BIS)

• The banker for central banks

• Promotes co-operation between central banks

• Provides facilities for international co-operation

Slide 101

International financial markets 1

• Globalisation of financial markets has contributed to financial instability

• Despite facilitating the transfer of funds to emerging markets

Slide 102


European Monetary System (EMS) – purposes

• To stabilise exchange rates between member countries

• To promote economic convergence in Europe

• To develop European Economic and Monetary Union (EMU)

Slide 103


Arguments for EMU

• Economic policy stability

• Facilitation of trade

• Lower interest rates

• Preservation of the City’s position

Slide 104


Arguments against EMU

• Loss of national control over economic policy

• The need to compensate for weaker economies

• Confusion in transition to EMU

• Lower confidence arising from loss of national pride

Slide 105

Global financial stability 1

• The global debt crisis arose as governments in less developed countries took on levels of debt above their ability to finance

Resolving the global debt crisis

• Restructure or rescheduled debt

• Economic reforms to improve balance of trade

• Lending governments write off some of the debts

• Convert some debt into equity

Slide 106

Global financial stability 2

Negative impacts on multinational firms

• Deflationary policies damage profitability

• Devaluation of currency

• Reduction in imports by developing countries

• Increased reliance on host countries for funding

Slide 107

Multinationals’ strategy 1

Strategic reasons for Foreign Direct Investment (FDI)

• Market seeking / raw material seeking

• Production efficiency / technology seeking

• Knowledge seeking

• Political safety seeking

• Economies of scale / financial economies

• Managerial and marketing expertise

• Differentiated products

Slide 108


Ways to establish an interest abroad

• Joint ventures – industrial co-operation (contractual) or joint-equity

• Licensing agreements

• Management contracts

• Subsidiary

• Branches

Slide 109


Management contracts:

• A firm agrees to sell management skills – sometimes used in combination with licensing

• Can serve as a means of obtaining funds from subsidiaries, where other remittance restrictions apply

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

Slide 110


Multinationals’ financial planning

• Multinational companies need to develop a financial planning framework

• This is to ensure that the strategic objectives and competitive advantages are realised

• It will include ways of raising capital and risks related to overseas operations and the repatriation of profits

Slide 111


Finance for overseas investment depends on:

• Local finance costs, and any available subsidies

• Tax systems of the countries (best group structure may be affected by tax systems)

• Any restrictions on dividend remittances

• Possible flexibility in repayments arising from the parent / subsidiary relationship

Slide 112


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

Blocked funds

• Multinationals can counter exchange controls by management charges or royalties

Control systems

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

Slide 113

Risk 1

Factors in assessing political risk

• Government stability

• Political and business ethics

• Economic stability / inflation

• Degree of international indebtedness

• Financial infrastructure

• Level of import restrictions

Slide 114

Risk 2

Factors in assessing political risk continued

• Remittance restrictions

• Assets seized

• Special taxes and regulations on overseas investors, or investment incentives

Slide 115

Risk 3

Dealing with political risk

• Negotiations with host government

• Insurance (eg ECGD)

• Production strategies

• Contacts with customers

• Financial management – eg, borrowing funds locally

• Management structure, eg joint ventures

Slide 116

Risk 4

Litigation risks

• Can generally be reduced by keeping abreast of changes, acting as a good corporate citizen and lobbying

Cultural risks

• Should be taken into account when deciding where to sell abroad, and how much to centralise activities

Slide 117

Risk 5

Agency issues

• Agency relationships exist between the CEOs of multinationals conglomerates (the principals)

and

• The strategic business unit (SBU) managers that report to these CEOs

• The interests of the individual SBU managers may be incongruent not only with the interests of the CEOs

• But also with those of the other SBU managers

Slide 118

Risk 6

Agency issues continued

• Each SBU manager may try to make sure his or her unit gets access to critical resources

And

• Achieves the best performance at the expense of the performance of other SBUs and the whole organisation

Slide 119

Risk 7

Solutions to agency problems in multinationals

• Multiple mechanisms may be needed, working in unison

• Examples: Board of directors: separate ratification and monitoring of managerial decisions from initiation to implementation

• Executive incentive systems can reduce agency costs and align the interests of managers and shareholders

• This can be done by making top executives’ pay contingent on the value they create for the shareholders

Slide 120

Chapter 5

DCF and free cash flow

NPVsInternal rate of return Free cash flow

NPVs 1

Net present value

• The sum of the discounted cash flows less the initial investment

Decision criteria

• Invest in a project if its net present value is positive ie when NPV > 0

• Do not invest in a project if its net present value is zero or negative, ie when NPV ≤ 0

Slide 122

NPVs 2

Real and nominal discount factors

• What nominal rate (i) should be used for discounting cash flows if the real rate is r and the rate of inflation h?

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

• Use the Fisher equation (given in exam)

• (l + i) = (1 + r)(1 + h)

Slide 123

NPVs 3

The tax effect on NPV

• Corporate taxes

• Value added taxes

• Other local taxes

• Capital expenditure tax allowances

Slide 124

NPVs 4

Capital rationing

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

Case 1

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

Slide 125

NPVs 5

Capital rationing continued

Case 2

Fractional investment not allowed

• A more systematic approach may be needed to find the NPV maximising combination of entire projects subject to the investment constraint

• This is provided by the mathematical technique of integer programming

Slide 126

NPVs 6

Capital rationing continued

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

The Monte Carlo method

• Amounts to adopting a particular probability distribution for the uncertain (random) variables that affect the NPV

• Then using simulations to generate values of the random variables

Slide 127

NPVs 7

Project Value at Risk

• The minimum amount by which the value of an investment or portfolio will fall over a given period of time at a given level of probability

Slide 128

Internal rate of return 1

IRR

• The discount rate at which NPV equals zero

• The IRR calculation also produces the breakeven cost of capital and allows calculation of the margin of safety

• If the cash flows change signs then the IRR may not be unique: this is the multiple IRR problem

• With mutually exclusive projects, the decision depends not on the IRR but on the cost of capital being used

Slide 129


• A project will be selected as long as the IRR is not less than the cost of capital

Slide 130


Modified internal rate of return (MIRR)

• The IRR which would result without the assumption that project proceeds are reinvested at the IRR rate

• Calculate present value of the return phase (the phase of the project with cash inflows)

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

Slide 131


MIRR continued

• Calculate MIRR using the following formula:

• This formula is given in the exam

Slide 132


Re-investment rate

• The NPV method assumes that cash flows can be reinvested at the cost of capital over the life of the project

• The IRR assumes that cash flows can be reinvested at the IRR over the life of the project

• The IRR assumption is unlikely to be valid and so the NPV method is likely to be superior

• The better reinvestment rate assumption will be the cost of capital used for the NPV method

Slide 133


Decision criterion

• If MIRR is greater than the required rate of return: ACCEPT

• If MIRR is lower than the required rate of return: REJECT

Slide 134

Free cash flow 1

Free cash flow (FCF)

• Free Cash Flow = Earnings before Interest and Taxes (EBIT)

• less Tax on EBIT

• plus Non cash charges (eg depreciation)

• less Capital expenditures

• less Net working capital increases

• plus Net working capital decreases

• plus Salvage value received

Slide 135

Free cash flow 2

Forecasting FCF

Constant growth

• FCF0 is the free cash flow at beginning

• n is the number of years

Slide 136

Free cash flow 3

Forecasting FCF continued

Differing growth rates

• Forecast each element of FCF separately using appropriate rate

Forecasting dividend capacity

• Dividend capacity of a firm is measured by its free cash flow to equity (FCFE)

Slide 137

Free cash flow 4

Direct method of calculating FCFE

• Net income (EBIT - net interest - tax paid)

• Add depreciation

• Less total net investment

• Add net debt issued

• Add net equity issued

Slide 138

Free cash flow 5

Indirect method

• Free cash flow

• Less (net interest + net debt paid)

• Add Tax benefit from debt (net interest x tax rate)

Slide 139

Free cash flow 6

Firm valuation using FCF

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

• Assuming constant growth, use the Gordon model:

Slide 140

Free cash flow 7

Terminal values and company valuation

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

Firm valuation using FCFE

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

• Calculate value of debt

• Value = value of equity + value of debt

Slide 141

Chapter 6

Application of option pricing decisions in

investment decisions

Option concepts Real options

Options concepts 1

Options

• An option is a contract that gives one party the option to enter into a transaction

• Either at a specific time or within a specific future period at a price that is agreed when the contract is made

Slide 143

Options concepts 2

• The buyer of a call option acquires the right, but not the obligation, to buy the underlying at a fixed price

• The buyer of a put option acquires the right, but not the obligation, to sell the underlying shares at a fixed price

• In the money option: intrinsic value is +ve

• At the money option: intrinsic value is zero

• Out of the money option: intrinsic value is –ve

Slide 144

Options concepts 3

Determinants of options values

• The higher the exercise price, the lower the probability that the call will be in the money

• As the current price of the underlying asset goes up, the higher the probability that the call will be in the money

• Both a call and put will increase in price as the underlying asset becomes more volatile

Slide 145

Options concepts 4

Determinants of options values continued

• Both calls and puts will benefit from increased time to expiration

• The higher the interest rate, the lower the present value of the exercise price

Slide 146

Real options 1

• Strategic options – known as real options – arising from a project can increase the project value

• They are ignored in standard DCF analysis, which computes a single present value

Option to delay

• When a firm has exclusive rights to a project or product for a specific period, it can delay taking this up until a later date

• For a project not selected today on NPV or IRR grounds, the rights to the project can still have value

Slide 147

Real options 2

Option to expand

• When firms invest in projects allowing further investments later

• Or entry into new markets, possibly making the NPV +ve

• The initial investment may be seen as the premium to acquire the option to expand

Slide 148

Real options 3

Option to abandon

• If the firm has the option to cease a project during its life

• Abandonment is effectively the exercising of a put option

• The option to abandon is a special case of an option to redeploy

Slide 149

Real options 4

Option to redeploy

• When company can use its productive assets for activities other than the original one

• The switch will happen if the PV of cash flows from the new activity will exceed costs of switching

Black-Scholes valuation

• When applying Black-Scholes valuation techniques to real options

• Simulation methods are typically used to overcome the problem of estimating volatility

Slide 150

Real options 5

Slide 151

Real options 6

Determinants of options values

• Exercise price (Pe)

• Price of underlying asset (Pa)

• Volatility of underlying asset (s)

• Time to expiration (t)

• Interest rate (r)

• Intrinsic and time value

Slide 152

Chapter 7

Impact of financing and APV method

Duration Credit risk Credit enhancement Modigliani and Miller Other theories APV approach

Duration 1

Duration (Macaulay duration)

• The weighted average length of time to the receipt of a bond’s benefits (coupon and redemption value)

• The weights are the present values of the benefits involved

Properties of duration

• Longer-dated bonds have longer durations

• Lower-coupon bonds will have longer durations

• Lower yields will give longer durations

Slide 154

Duration 2

Calculating duration

• 1) PV of cash flows for each time period by the time period and add together

• 2) Add the PV of cash flows in each period together

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

Modified duration

• = Macaulay duration/1 + gross redemption yield

• Modified duration shares the same properties as Macaulay duration

Slide 155

Credit risk 1

Credit risk (or default risk)

• The risk for a lender that the borrower may default on interest payments and / or repayment of principal

• Credit risk for an individual loan or bond is measured by estimating:

• Probability of default – typically, using information on borrower and assigning a credit rating (eg Standard & Poor’s, Moody’s, Fitch)

• Recovery rate – the fraction of face value of an obligation recoverable once the borrower has defaulted

Slide 156

Credit risk 2

• Credit migration is change in the credit rating after a bond is issued

Slide 157

Credit risk 3

Determinants of cost of debt capital

• Credit rating of company

• Maturity of debt

• Risk-free rate at appropriate maturity

• Corporate tax rate

Slide 158

Credit risk 4

Credit spread

• The premium required by an investor in a corporate bond to compensate for the credit risk of the bond

• Yield on corporate bond = risk free rate + credit spread

• Cost of debt capital = (1 – tax rate)(risk free rate – credit spread)

Slide 159

Credit risk 5

Option pricing models to assess default risk

• The equity of a company can be seen as a call option on the assets of the company

• with an exercise price equal to the outstanding debt

• Expected losses are a put option on the assets of the firm

• with an exercise price equal to the value of the outstanding debt

Slide 160

Credit risk 6

From the Black-Scholes formula, the probability of default depends on three factors:

•The debt / asset ratio

•The volatility of the company assets

•The maturity of debt

Slide 161

Credit enhancement

Internal credit enhancement

• Excess spread

• Over-collateralisation

External credit enhancement

• Surety bonds

• Letters of credit

• Cash collateral accounts

Slide 162

Modigliani and Miller 1

MM theory (no tax)

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

MM theory (with tax)

• Debt actually saves tax (due to tax relief on interest payments) therefore firms should only use debt finance

Slide 163


MM and cost of equity

Slide 164


Limitations of MM theory

• Too risky in reality to have high levels of gearing

• Assumes perfect capital markets

• Does not consider bankruptcy risks, tax exhaustion, agency costs and increased borrowing costs as risk rises

Slide 165

Other theories 1

Static trade-off theory

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

• Problems with financial distress costs

• Direct financial distress costs

• Legal and admin costs associated with bankruptcy

Slide 166

Other theories 2

Indirect financial distress costs

• Higher cost of capital

• Loss of sales

• Downsizing

• High staff turnover

Agency theory

• Optimal capital structure is where benefits of debt received by shareholders matches costs of debt imposed on the shareholders

Slide 167

Other theories 3

Pecking order theory

• Unlike the MM models, it based on the idea of information asymmetry:

• Investors have a lower level of information about the company than its directors do

• Shareholders use directors' actions as a signal to what directors believe about the company with their superior information

Slide 168

Other theories 4

Predictions

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

• If retained earnings differ from investment outlays, the firm adjusts its cash balances or marketable securities first

• Before either taking on more debt or increasing its target payout rate

Slide 169

Other theories 5

Predictions continued

• Internal finance is at the top, and equity is at the bottom, of the pecking order

• A single optimal debt equity ratio does not exist: a result similar to the MM model with no taxes

Slide 170

APV approach 1

Adjusted present value (APV) approach

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

• It assumes that the primary benefit of borrowing is the tax benefit

• And that the most significant cost of borrowing is the added risk of bankruptcy

Slide 171

APV approach 2

Steps in applying APV

• Calculate the NPV as if the project was financed entirely by equity (use ke)

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

• Subtract the cost of issuing new finance

Slide 172

Chapter 8

International investment decisions

NPV and international projects Exchange controls Exchange rate risks Capital structure

NPV and international projects 1

Purchasing power parity

Absolute purchasing parity theory:

• Prices of products in different countries will be the same when expressed in the same currency

Alternative purchasing power parity relationship:

• Changes in exchange rates are due to differences in the expected inflation rates between countries

Slide 174

NPV and international investment 2

International Fisher effect

• This equation is given in the exam

• With no trade or capital flows restrictions, real interest rates in different countries will be expected to be the same

• Differences in interest rates reflect differences in inflation rates

Slide 175


NPVs for international projects

Alternative methods for calculating the NPV from an overseas project:

• Convert project cash flows into sterling and discount at sterling discount rate to calculate NPV in sterling terms

OR

• Discount cash flows in host country's currency from project at adjusted discount rate for that currency

• Then convert resulting NPV at spot exchange rate

Slide 176


Effect of exchange rates on NPV

• When there is a devaluation of sterling relative to a foreign currency, the sterling value of cash flows and NPV increase

• The opposite happens when the domestic currency appreciates

Slide 177


Effect on exports

• A multinational company sets up a subsidiary in another country in which it already exports

• The relevant cash flows for evaluation of the project should account for loss of export earnings in the particular country

Impact of transaction costs

• Transaction costs are incurred when companies invest abroad due to currency conversion or other administrative expenses

• These should also be taken into account

Slide 178


Taxes in international context

Host country

• Corporate taxes

• Investment allowances

• Withholding taxes

Home country

• Double taxation relief

• Foreign tax credits

Slide 179


Tax haven characteristics

• Low tax on foreign investment or sales income earned by resident companies

• Low withholding tax on dividends paid to the parent

• Stable government and currency

• Adequate financial services support facilities

Slide 180


Subsidies

• The benefit from concessionary loans should be included in the NPV calculation as:

• The difference between repayment of borrowing under market conditions and repayment under the concessionary loan

Slide 181

Exchange controls 1

Exchange controls – types

Rationing supply of foreign exchange

• Payments abroad in foreign currency are restricted, preventing firms from buying as much as they want from abroad

Restricting types of transaction for which

• Payments abroad are allowed, eg suspending or banning payment of dividends to foreign shareholders

• Eg parent companies in multinationals: blocked funds problem

Slide 182

Exchange controls 2

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

Slide 183

Exchange controls 3

Strategies

• Multinational company strategies to overcome exchange controls:

Transfer pricing

• Where the parent company sells goods or services to the subsidiary and obtains payment

Royalty payments adjustments

• When a parent company grants a subsidiary the right to make goods protected by patents

Slide 184

Exchange controls 4

Loans by the parent company to the subsidiary:

• Setting interest rate at appropriate level

Management charges

• Levied by the parent company for costs incurred in the management of international operations

Slide 185

Exchange rate risks 1

Transaction exposure

• The risk of adverse exchange rate movements between the date the price is agreed and the date cash is received/paid

• Arising during normal international trade

Slide 186


Translation exposure

• Risk that organisation will make exchange losses when accounting results of foreign branches/subsidiaries are translated

• Translation losses can arise from restating the book value of a foreign subsidiary’s assets at:

– The exchange rate on the statement of financial position date – only important if changes arise from loss of economic value

Slide 187


Economic exposure

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

• Can be longer-term (continuous currency depreciation)

• Can arise even without trade overseas (effects of pound strengthening)

Slide 188

Capital structure 1

Capital structure of a MNC

Special factors

• Global taxation

• Exchange risk

• Political risk

• Business risk

Slide 189

Capital structure 2

International borrowing options

• Borrow in the same currency as the inflows from the project

• Borrow in a currency other than the currency of the inflows, with a hedge in place

• Borrow in a currency other than the currency of the inflows, without hedging the currency risk

• This option exposes the company to exchange rate risk which can substantially change the profitability of a project

Slide 190

Capital structure 3

Advantages of international borrowing

Availability

• Many smaller domestic financial markets might lack the depth and liquidity to accommodate large or long-maturity debt issues

Lower cost of borrowing in Eurobond markets

• Interest rates are normally lower than borrowing rates in national markets

Slide 191

Capital structure 4

Advantages of international borrowing continued

Lower issue costs

• Cost of debt issuance is normally lower than the cost of debt issue in domestic markets

Slide 192

Chapter 9

Acquisitions and mergers vs growth

Acquisitions and mergers Shareholder value issues

Acquisitions and mergers 1

Mergers and acquisitions - reasons

• Operating economies

• Management of acquisition

• Diversification

• Asset backing

• Earnings quality

Slide 194


Mergers and acquisitions - reasons continued

• Finance / liquidity

• Internal expansion costs

• Tax

• Defensive merger

• Economic efficiency

Slide 195


Factors in a takeover

• Cost of acquisition

• Form of purchase consideration

• Reaction of predator’s shareholders

• Accounting implications

• Reaction of target’s shareholders

• Future policy (eg dividends, staff)

Slide 196


Vertical merger – backward merger

• With supplier – aim to control supply chain

Vertical merger – forward merger

• With customer / distributor – aim to control distribution

Horizontal merger

• The two merging firms produce similar products in the same industry – aim to increase market power

Conglomerate merger

• Two firms in different industries – aim of diversification

Slide 197


Takeover strategy – what to acquire

• Growth prospects limited – younger company with higher growth rate

• Potential to sell other products to existing customers – company with complementary product

• Operating at maximum capacity – company making similar products operating below capacity

• Under-utilising management – company needing better management

Slide 198


Takeover strategy – what to acquire continued

• Greater control over supplies or customers – company giving access to customer / supplier

• Lacking key clients in targeted sector – company with right customer profile

• Improve balance sheet – company enhancing EPS

• Increase market share – important competitor

• Widen capability – key talents and / or technology

Slide 199

Shareholder value issues 1

Failures to enhance shareholder value

• Why do many acquisitions fail to enhance shareholder value?

• Agency theory: Takeovers may be motivated by 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 acquiring firm

Slide 200


Hubris hypothesis

• Bidding company bids too much because managers of acquiring firms suffer from hubris, excessive pride and arrogance

Market irrationality argument

• When a company’s shares seem overvalued, management may exchange them for an acquiree firm ie merger

• The lack of synergies or better management may lead to a failing merger

Slide 201


Pre-emptive theory

• Several firms may compete for opportunity to merge with target to achieve cost savings

• Winning firm could improve market position and gain market share

• It can be rational for the first firm to pre-empt a merger with its own takeover attempt

Window dressing

• Where companies are acquired to present a better short term financial picture

Slide 202


Synergy – Revenue synergy

• Acquisition will result in higher revenues, higher return on equity or longer period of growth for the acquiring company

• Revenue synergies arise from:

(a) Increased market power

(b) Marketing synergies

(c) Strategic synergies

Slide 203


Synergy – cost synergy

• Results from economies of scale

• As scale increases, marginal cost falls leading to greater operating margins for the combined entity

Sources of financial synergy

• Diversification

• Use of cash slack

• Tax benefits

• Debt capacity

Slide 204


Possible reasons for high failure rate of acquisitions

• Agency theory

• Valuation errors

• Market irrationality

• Pre-emptive theory

• Window dressing

Slide 205

Chapter 10

Valuations for acquisitions and

mergers

Valuation issues Type IType IIType IIIHigh-growth start-upsIntangible assets

Valuation issues 1

The over-valuation problem

• Paying more than the current market value, to acquire a company

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

• Overvaluation may arise as miscalculation of potential synergies or

• Overestimation of ability of acquiring firm's management to improve performance

• Both lead to a higher price than current market value

Valuation issues 2

Estimating earnings growth

• Gordon constant growth model:

Slide 208

Valuation issues 3

Three ways to estimate g:

• Historical estimates: extrapolate past values

• Rely on analysts’ forecasts

• Use the company’s return on equity and retention rate of earnings (g = ROE x retention rate)

Slide 209

Valuation issues 4

Business risk of combined entity

• The risk associated with the unique circumstances of the combined company

• Affected by the betas of the individual entities (target and predator) and the beta of the resulting synergy

Asset beta

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

Slide 210

Valuation issues 4

Geared equity beta

• Calculate value of debt (net of tax)

• Divide by value of equity

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

• Add the above to the beta of the combined entity

Slide 211

Valuation issues 5

Acquisitions and acquirer’s risk

• Acquisition type I – does not affect financial risk or business risk

• Acquisition type II – does affect financial risk but does not affect business risk

• Acquisition type III – affects both financial risk and business risk

Slide 212

Type I 1

Type 1 valuations

• Methods of value company:

(1) Book value-plus models

(2) Market-relative models

(3) Cash flow models, including EVATM, MVA

Slide 213

Type I 2

Book value-plus models

• Use statement of financial position as starting point

• Total Asset Value less Long-term and short-term payables = Company's Net Asset Value

• Book value of net assets is also 'equity shareholders' funds': the owners' stake in the company

Slide 214

Type I 3

Market-relative models (P/E ratio)

• P/E ratio = Market value/EPS

• Market value = P/E ratio x EPS

• Decide suitable P/E ratio and multiply by EPS: an 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

Slide 215

Type I 4

High P/E ratio may indicate:

• Optimistic expectations

• Security of earnings

• Status

Slide 216

Type 1 5

Q ratio

• The market value of company assets (MV) divided by replacement cost of the assets (RC)

• Q = MV/RC

• Equity version of Q:

– Qe = MV – Market value of debt/RC – Total debt

Slide 217

Type 1 6

Q ratio continued

Points to note

• RC of capital is difficult to estimate so is proxied by the book value of capital

• The equity Q ie Qe is approximated as:

• Qe = Market value of equity/Equity capital

• If Q <1, management has destroyed the value of contributed capital: firm is vulnerable to takeover

• If Q >1, management has increased the value of contributed capital

Slide 218

Type 1 7

Free cash flow model

Step 1

• Calculate Free Cash Flow (FCF)

• FCF = Earnings before interest and tax (EBIT)

• Less: Tax on EBIT

• Plus: Non-cash charges

• Less: Capital expenditures

Slide 219

Type I 8

Free cash flow model continued

• Less: Net working capital increases

• Plus: Salvage values received

• Plus: Net working capital decreases

Step 2

• Forecast FCF and Terminal Value

Slide 220

Type 1 9

Step 3

• Calculate from cost of equity (Ke ) and cost of debt (Kd)

where

• T is the tax rate

• Vd is the value of the debt

• Ve is the value of equity

Slide 221

Type I 10

• Step 4

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

• Step 5

• Calculate equity value

• Equity Value = Value of the firm – Value of debt

Slide 222

Type I 11

EVA approach

• EVA = NOPAT – (WACC x Capital Employed)

• Or, EVA = (ROIC – WACC) x Capital Employed

where

• NOPAT = Net Operating Profits After Taxes

• ROIC= Return on Invested Capital

• WACC = Weighted average cost of capital

Slide 223

Type I 12

EVA approach continued

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

• Subtract value of debt from value of company to get value of equity

Slide 224

Type I 13

Market value added (MVA) approach

• Shows how much management has added to the value of capital contributed by the capital providers

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

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

• If market value and book value of debt are the same, MVA is the difference between market value of common stock and equity capital of the firm

Slide 225

Type II 1

Type II valuations – adjusted present value (APV)

• Acquisition is valued by discounting Free Cash Flows by ungeared cost of equity, then adding PV of tax shield

• APV = – Initial Investment + Value of acquired company if all-equity financed + PV of Debt Tax Shields

• If APV is +ve, acquisition should be undertaken

Slide 226

Type II 2

APV calculation

• Step 1

– Forecast FCF (as previously)

• Step 2

– Forecast FCFs and Terminal Value

• Step 3

– Ungeared beta of firm is calculated from geared beta:

Slide 227

Type II 3

• Step 4

– Discount cash flow at ungeared cost of equity to obtain NPV of ungeared firm or project

• Step 5

– Calculate interest tax shields

• Step 6

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

Slide 228

Type II 4

Step 7

• APV = NPV of ungeared firm or project

• Plus PV interest tax shields

• Plus excess cash and marketable securities

• Less market value of contingent liabilities

= Market value of the firm

• Less: Market value of debt

= MARKET VALUE OF EQUITY

Slide 229

Type III 1

Type III iterative valuations

• Estimate value of acquiring company before acquisition

• Estimate value of acquired company before acquisition

• Estimate value of synergies

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

• Estimate asset beta for each company

Slide 230

Type III 2

Type III iterative valuations continued

• Calculate asset beta for combined entity

• Calculate geared beta of the combined firm

• Calculate WACC for combined entity

• Use WACC derived above to discount cash flows of combined entity post-acquisition

• Value of equity: difference between the value of the firm and the value of debt

Slide 231

Type III 3

A problem with WACC

• If WACC weights are not consistent with the values derived, the valuation is internally inconsistent

• Then, we use an iterative procedure:

– Go back and re-compute the beta using a revised set of weights closer to the weights derived from the valuation

– The process is repeated until assumed weights and weights calculated are approximately equal

Slide 232

High-growth start-ups 1

Valuation of high-growth start-ups

• Typical characteristics of start-ups:

• Few revenues, untested products, unknown product demand, high development / infrastructure costs

Slide 233


Steps in valuation

• Identify drivers eg market potential, resources of the business, management team

• Period of projection – needs to be long-term

Slide 234


Steps in valuation continued

Forecasting growth

Growth in earnings (g) = b x ROIC

• For most high growth start-ups, b = 1 and sole determinant of growth is the return on invested capital (ROIC)

• This is estimated from industry projections or evaluation of management, marketing strengths, and investment

Slide 235


Valuation methods

• Asset-based method not appropriate:

• Most investment of a start-up is in people, marketing and / or intellectual rights

• These are treated as expenses rather than capital

• Market-based methods also present problems:

• Difficult to find comparable companies; usually no earnings to calculate PE ratios (but price-to-revenue ratios may help)

Slide 236


Slide 237

Intangible assets 1

Intangible assets

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

Examples of intangible assets

• Goodwill

• Brands

• Patents

• Customer loyalty

• Research and development

Slide 238

Intangible assets 2

Market-to-book value

• Measures intangible assets as the difference between book value of tangible assets and market value of the firm

• Tobin’s ‘q’ = Market value of firm/Replacement cost of assets

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

Slide 239

Intangible assets 3

• Calculated intangible values (CIV) - calculates an ‘excess return’ on tangible assets

• This is used to determine the proportion of return attributable to intangible assets

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

Slide 240

Intangible assets 4

Methods of valuing intangible assets

• Relief from royalties

• Premium profits

• Capitalisation of earnings

• Comparison with market transactions

Slide 241

Intangible assets 5

Valuing product patents as options

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

• Identify standard deviation of cash flows

• Identify exercise price of the option

• Identify expiry date of the option

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

Slide 242

Chapter 11

Regulatory framework and

processes

Global issues UK and EU regulation Defensive tactics

Global issues 1

Agency problem

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

• Potential conflicts of interest

• Protection of minority shareholders

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

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

Slide 244

Global issues 2

Takeover regulation

• Protect the interests of minority shareholders and other stakeholders, and

• Ensure a well-functioning market for corporate control

Slide 245

Global issues 3

Two models of regulation

UK / US / Commonwealth countries

• Market-based model – case law-based, promotes protection of shareholder rights especially

Continental Europe

• ‘Block-holder' or stakeholder system – codified or civil law based

• Seeking to protect a broader group of stakeholders: creditors, employees, national interest

Slide 246

UK and EU regulation 1

UK takeover regulation

• Mergers and acquisitions in the UK subject to:

• City Code

• Companies Acts 1985 and 2006

• Financial Services and Markets Act 2000

• Criminal Justice Act 1993 (insider dealing provisions)

Slide 247


City Code

• The City Code on Takeovers and Mergers:

– Originally voluntary code for takeovers / mergers of UK companies

– Now has statutory basis, in line with EU Takeover Directive

– Administered by the Takeover Panel

Slide 248


City Code principles

• All offeree’s shareholders treated similarly

• Information available to all shareholders

• Shareholders given sufficient information / advice

• Shareholders given time to make decision

• Directors not to frustrate takeover

• No oppression of minorities

• Offer to all shareholders when control (30%) acquired

Slide 249


Competition Commission

• Office of Fair Trading thinks a merger may be against the public interest, it can refer to the Competition Commission

• The CC can accept or reject proposal, or lay down certain conditions, if competition substantially reduced

• Substantial lessening of competition tests:

• Turnover test (£70m min. for investigation by CC)

• Share of supply test (25%)

Slide 250


European Union

• Mergers will fall within jurisdiction of the EU (which will evaluate it, like the CC in UK) where, following the merger:

(a) Worldwide turnover of more than €5bn per annum

(b) EU turnover of more than €250m per annum

Slide 251


EU Takeovers Directive

• Effective from May 2006 – to converge market based and stakeholder systems

Takeovers Directive principles

• Mandatory-bid rule: required at 30% holding, in UK

• Equal treatment of shareholders

• Squeeze-out rule and sell-out rights: in UK, 90% shareholder buys all shares

Slide 252


EU Takeovers Directive continued

• Principle of board neutrality

• Break-through rule: bidder able to set aside multiple voting rights (but countries can opt out of this)

Slide 253


Bid timetable summary

• Talks (optional)

• Announcement of offer then 28 days until

• Last date for posting of offer document = D day

• Last date for posting of offeree board circular – D day + 14

• First closing date – D day + 21

• Last date for announcements by offeree – D day + 39

Slide 254


Bid timetable summary continued

• Earliest date for withdrawal of acceptances by shareholders – D day + 42

• Last date for revision of offer – D day + 46

• Last day an offer can be declared unconditional as to acceptances – D day + 60

Slide 255


Consequence of share stake levels

• Any - company may enquire on ultimate ownership under s793 CA 2006

• 3% - beneficial interests must be disclosed to company – Disclosure and Transparency Rules

• 10% - Shareholders controlling 10%+ of voting rights may requisition company to serve s793 notices

• Notifiable interests rules become operative for institutional investors and non-beneficial stakes

Slide 256


Consequence of share stake levels continued

• 30% - City Code definition of effective control. Takeover offer becomes compulsory

• 50% - CA 1985 definition of control (At this level, holder can pass ordinary resolutions)

• Point at which full offer can be declared unconditional with regard to acceptances

Slide 257


Consequence of share stake levels continued

• 75% - Major control boundary: holder able to pass special resolutions

• 90% - Minorities may be able to force majority to buy out their stake

• Equally, majority may be able to require minority to sell out

Slide 258

Defensive tactics 1

Golden parachutes

• Compensation payments made to eliminated top-management of target firm

Poison pill

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

White knights and white squires

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

Slide 259

Defensive tactics 2

Crown jewels

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

Pacman defence

• Mounting a counter-bid for the attacker

Litigation or regulatory defence

• Inviting investigation by regulatory authorities or Courts

Slide 260

Chapter 12

Financing mergers and acquisitions

Financing methods Effect of offer

Financing methods 1

Methods of financing mergers

• Payment can be in the form of:

– Cash

– Share exchange

– Convertible loan stock

Slide 262

Financing methods 2

Methods of financing mergers continued

• The choice will depend on:

– Available cash

– Desired levels of gearing

– Shareholders' tax position

– Changes in control

Slide 263

Financing methods 3

Funding cash offers

• Methods of financing a cash offer:

– Retained earnings – common when a firm acquires a smaller firm

– Sale of assets

– Issue of shares, using cash to buy target firm’s shares

Slide 264

Funding methods 4

Funding cash offers continued

– Debt issue – but, issuing bonds will alert the market to the intentions of the company to bid for another company

– This may lead investors to buy shares of potential targets, raising their prices

– Bank loan facility – a possible short-term strategy, until bid is accepted: then the company can make a bond issue

– Mezzanine finance – may be the only route for companies without access to bond markets

Slide 265

Funding methods 5

Use of convertible loan stock

• Problems with using debentures, loan stock, preference shares:

– Establishing a rate of return attractive to target shareholders

– Effects on the gearing of acquiring company

– Change in structure of target shareholders' portfolios

– Securities potentially less marketable, possibly lacking voting rights

Slide 266

Funding methods 6

• Convertible loan stock can overcome some such problems

• Offers target shareholders the opportunity to gain from future profits of company

Slide 267

Funding methods 7

Mezzanine finance

• With cash purchase option for target company's shareholders, bidding company may arrange mezzanine finance

• Short-to-medium term

• Unsecured ('junior' debt)

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

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

Slide 268

Funding methods 8

Cash or paper? – Company and existing shareholders

Dilution of EPS

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

Cost to the company

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

Gearing

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

Slide 269

Funding methods 9

Cash or paper? – Company and existing shareholders

Control

• Major share issue could change control

Authorised share capital increase

• May be required if consideration is shares; requires General Meeting resolution

Borrowing limits increase

• General Meeting resolution required if borrowing limits need to change

Slide 270

Funding methods 10

Cash or paper? – Shareholders in target company

Taxation

• If consideration is cash, many investors may suffer CGT

Income

• If consideration is not cash, arrangement must mean existing income is maintained

• Or be compensated by suitable capital gain or reasonable growth expectations

Slide 271

Funding method 11

Cash or paper? – Shareholders in target company

Future investments

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

Share price

• If consideration is shares, recipients will want to be sure that shares retain their values

Slide 272

Effects of offer 1

EPS before and after a takeover

• If a company acquires another by issuing shares

• Then its EPS will go up or down according to the P/E ratio at which target company was bought

• If target company's shares bought at higher P/E ratio than predator company's shares, predator company's shareholders suffer fall in EPS

• If target company's shares valued at a lower P/E ratio, the predator company's shareholders benefit from rise in EPS

Slide 273

Effects of offer 2

• Buying companies with a higher P/E ratio will result in a fall in EPS unless there is profit growth to offset this fall

• Dilution of earnings may be acceptable if there is:

– Earnings growth– Superior quality of earnings acquired– Increase in net asset backing

Slide 274

Effects of offer 3

Post-acquisition integration

• A clear programme should be in place, re-defining objectives and strategy

The approach adopted will depend on:

• The culture of the organisation

• The nature of the company acquired, and

• How it fits into the amalgamated organisation eg horizontally, vertically, or in diversified conglomerate?

Slide 275

Chapters 13 - 14

Reconstruction and reorganisation

Financial reconstruction Divestment and other changes MBOs and buy-ins Firm value

Financial reconstruction 1

Capital reconstruction scheme

• A scheme where a company re-organises its capital structure, often to avoid liquidation

Slide 277


Steps in a capital reconstruction

• Estimate position of each party if liquidation is to go ahead

• Assess additional sources of finance

• Design reconstruction

• Calculate and assess new position, and compare for each party with first step

• Check company is financially viable

A scheme of reconstruction needs to treat all parties fairly and offer creditors a better deal than liquidation

Slide 278


• Providers of finance will need to be convinced that the return is attractive

• Company must therefore prepare cash / profit forecasts

• Creation of new share capital at different nominal value

• Cancellation of existing share capital

• Conversion of debt or equity

Slide 279


Leveraged recapitalisation

• A firm replaces most of its equity with a package of debt securities consisting of both senior and subordinated debt

• Used to discourage corporate raiders not able to borrow against assets of the target firm to finance the acquisition

• To avoid financial distress from a high debt level, the company should have stable cash flows

• Company should not require substantial ongoing capital expenditure to retain their competitive position

Slide 280


Leveraged buyouts

• A group of private investors uses debt financing to purchase a company or part of it

• The company increases its level of leverage but no longer has access to equity markets

• A higher level of debt will increase the company’s geared beta; a lower level of debt will reduce it

Slide 281


Debt equity swaps

• In an equity / debt swap, shareholders are given the right to exchange stock for a predetermined amount of debt

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

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

Slide 282


Debt equity swaps continued

• Debt-equity swaps may occur because the company must meet certain contractual obligations

• A typical example is maintaining a debt / equity ratio below a certain number

• A company may issue equity to avoid making coupon and face value payments in the future

Slide 283

Divestment and other changes 1

Demerger

• The splitting up of a corporate body into two or more separate bodies

• To ensure share prices reflect the true value of underlying operations

Disadvantages of demergers

• Loss of economies of scale

• Ability to raise extra finance reduced

• Vulnerability to takeover increased

Slide 284


Sell-off

• The sale of part of a company to a third party, generally for cash

Slide 285


Reasons for sell-offs

• Strategic restructuring

• Sell off loss-making part

• Protect rest of business from takeover

• Cash shortage

• Reduction of business risk

• Sale at profit

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

Slide 286


Spin-offs and carve-outs

Spin-off

• A new company is created whose shares are owned by the shareholders of original company

• There is no change in asset ownership, but management may change

• In a carve-out, part of the firm is detached and a new company’s shares are offered to the public

Slide 287


Advantages of spin-offs to investors

• Merger / takeover of only part of a business made easier

• Improved efficiency / management

• Easier to see value of separate parts

• Investors can adjust shareholdings

Slide 288


Going private

• When a group of investors buys all the company’s shares

• The company ceases to be listed on a stock exchange

Advantages of going private to company

• Costs of meeting listing requirements saved

• Company protected from volatility in share prices

• Company less vulnerable to hostile takeover bids

• Management can concentrate on long-term business

Slide 289

MBOs and buy-ins 1

Management buy-outs

• The purchase of all or part of a business by its managers

• The managers generally need financial backers (venture capital) who will want an equity stake

Venture capital

• Venture capitalists are often prepared to fund MBOs

• They typically require shareholding, right to appoint some directors and right of veto on certain business decisions

Slide 290

MBOs and buy-ins 2

Reasons for company agreeing to MBO are similar to those for sell-off, also:

•When best offer price available is from MBO

•When group has decided to sell subsidiary, best way of maximising management co-operation

•Sale can be arranged quickly

•Selling organisation more likely to retain beneficial links with sold segment

Slide 291

MBOs and buy-ins 3

Evaluation of MBOs by investors

• Management skills of team

• Reasons why company is being sold

• Projected profits, cash flows and risks

• Shares / selected assets being bought

• Price right?

• Financial contribution by management team

• Exit routes (flotation, share repurchase)

Slide 292

MBOs and buy-ins 4

Performance of MBOs

• Management-owned companies typically achieve better performance

Possible reasons:

• Favourable price

• Personal motivation

• Quicker decision-making / flexibility

• Savings on overheads

Slide 293

MBOs and buy-ins 5

Problems with MBOs

• Lack of financial experience

• Tax and legal complications

• Changing work practices

• Inadequate cash flow

• Board representation by finance suppliers

• Loss of employees / suppliers / customers

Slide 294

MBOs and buy-ins 6

Buy-ins

• When a team of outside managers mount a takeover bid and then run the business themselves

• Buy-ins often occur when a business is in trouble or shareholder / managers wish to retire

• Finance sources are similar to buy-outs

• They work best if management quality improves, but external managers may face opposition from employees

Slide 295

Firm value 1

Unbundling and firm value

• Unbundling affects the value of the firm through changes in return on assets and the asset beta

• When firms divest themselves of existing investments, they affect the expected return on assets (ROA)

• This is due to the fact that good projects increase ROA and bad projects reduce it

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

Slide 296

Firm value 2

• Growth rate following a restructuring:

• ROA is the return on the net assets of the company

• b is the retention rate

• D is the book value of debt

• E is the book value of equity

• i is the cost of debt

• T is the corporate tax rate

Slide 297

Chapters 15

The treasury function in

multinationals

Markets Instruments The Greeks

Markets 1

Financial markets

• Direct / Indirect finance from lenders / savers:

– Households

– Firms

– Government

– Overseas

– Invested in financial markets and financial intermediaries eg banks

Slide 299

Markets 2

• Funds from financial markets and financial intermediaries eventually reach borrowers / spenders:

– Firms

– Governments

– Households

– Overseas

Slide 300

Markets 3

Capital markets

• In which the securities that are traded have long maturities, ie represent long-term obligations for the issuer

• Securities that trade in capital markets include shares and bonds

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

• Secondary market: a market in which securities that have already been issued can be bought and sold

Slide 301

Markets 4

• Secondary markets can be organised as exchanges or over the counter (OTC)

• Where buyers and sellers transact with each other through individual negotiation

• Securities that are issued in an over the counter market and can be resold are negotiable securities

Money markets

• Securities traded have short maturities, less than a year, and repayment of funds borrowed is required within a short period of time

Slide 302

Instruments 1

Coupon bearing instruments

Money Market Deposits

• Very short-term loans between institutions, including governments

• Either fixed – with agreed interest and maturity dates, or call deposits – with variable interest and deposit

• Can be terminated on notice

Slide 303

Instruments 2

Coupon bearing instruments continued

Certificate of Deposit (CD)

• Either negotiable or non-negotiable certificate of receipt for funds deposited at an financial institution

• For a specified term and paying interest at a specified rate

Slide 304

Instruments 3

Coupon bearing instruments continued

Repurchase Agreement (repo)

• Loan secured by a marketable instrument, usually a Treasury Bill or a bond

• Typical term: 1-180 days

• Counterparty sells on agreed date and simultaneously agrees to buy back instrument later for agreed price

Slide 305

Instruments 4

Discount instruments

Treasury Bill (T-bill)

• Debt instruments issued by central governments with maturities ranging from one month up to one year

Banker’s Acceptances

• Negotiable bills issued by firms to finance transactions such as imports or purchase of goods

• Guaranteed (accepted) by a bank, for a fee

Slide 306

Instruments 5

Discount instruments continued

Commercial Paper (CP)

• Short-term unsecured corporate debt with maturity up to 270 days but typically about 30 days

• Used by corporations with good credit ratings to finance short term expenditure

Slide 307

Instruments 6

Derivatives

Forward rate agreement (FRA)

• Cash settled OTC forward contract on a short term loan

Futures contract

• Standardised agreement to buy / sell asset at set date and price

• Interest rate future: underlying is debt security, or based on interbank deposit

Slide 308

Instruments 7

Derivatives continued

Interest rate swap

• Two parties exchange payments stream at one interest rate for stream at a different rate

Interest rate option

• An instrument sold by option writer to option holder, for a price known as a premium

Slide 309

The Greeks 1

• Delta – change in call option price / change in value of share

• Gamma – change in delta value / change in value of share

• Theta – change in option price over time

• Rho – change in option price as interest rates change

• Vega – change in option price as volatility changes

Delta hedging

• Determines number of shares required to create the equivalent portfolio to an option, and hence hedge it

Slide 310

The Greeks 2

Gamma

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

• +ve gamma means that a position benefits from movement

• -ve theta means the position loses money if the underlying asset price does not move

Vega

• Change in value of an option (call or put) resulting from a 1% point change in its volatility

Slide 311

Chapters 16

Hedging forex risk

FX markets Money market hedging Futures Swaps Options

FX markets 1

Exchange rates

• An exchange rate is the price of one currency expressed in another currency

• The spot rate at time t0 is the price for delivery at t0

• A forward rate at t0 is a rate for delivery at time t1

• This is different from whatever the new spot rate turns out to be at t1

Slide 313

FX markets 2

Term and base currencies

• If a currency is quoted as say £/$1.50, the $ is the term (or reference) currency, the £ is the base currency

Bank sells LOW

buys HIGH

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

Slide 314

FX markets 3

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

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

Slide 315

FX markets 4

Forward exchange contracts

• A firm and binding contract between a bank and its customer

• For the purchase / sale of a specified quantity of a stated foreign currency

• At a rate fixed at the time the contract is made

• For performance at a future time agreed when contract is made

• Closing out is the process of the bank requiring the customer to fulfil the contract by selling or buying at spot rate

Slide 316

FX markets 5

Netting

• The process of setting off credit against debit balances within a group of companies so that only the reduced net amounts are paid by currency flows

• Multilateral netting involves offsetting several companies’ balances

Slide 317

FX markets 6

Forward rates as adjustments to spot rates

• Forward rate cheaper – Quoted at discount

• Forward rate more expensive – Quoted at premium

• Add discounts, or subtract premiums from spot rate

Slide 318

FX markets 7

Interest rate parity

• Interest rate parity must hold between spot rates and forward rates (for the interest rate period)

• Otherwise arbitrage profits can be made:

Slide 319

FX markets 8

Where

• f0 = forward rate

• s0 = spot rate

• ic = interest rate in overseas country

• ib = interest rate in base country

Slide 320

Money market hedging 1

Future foreign currency payment

• Borrow now in home currency

• Convert home currency loan to foreign currency

• Put foreign currency on deposit

• When have to make payment

(a) Make payment from deposit

(b) Repay home currency borrowing

Slide 321


Future foreign currency receipt

• Borrow now in foreign currency

• Convert foreign currency loan to home currency

• Put home currency on deposit

• When cash received

(a) Take cash from deposit

(b) Repay foreign currency borrowing

Slide 322


Remember

Slide 323

Futures 1

Futures terminology

• Closing out a futures contract means entering a second futures contract that reverses the effect of the first

• Contract size is the fixed minimum quantity that can be bought / sold

• Contract price is in US dollars eg $/£ 0.6700

• Settlement date is the date when trading on a futures contract ceases and accounts are settled

• Basis is spot price – futures price

Slide 324

Futures 2

Futures terminology continued

• Basis risk is the risk that futures price movement may differ from underlying currency movement

• Tick size is the smallest measured movement in contracts price (movement to fourth decimal place)

Slide 325

Futures 3

Transactions not involving US dollars

• If trading one non-US dollar currency with another

• Sell one type of future (to get dollars) and buy other type (with dollars)

• Then reverse both contracts when receipt / payment made

Slide 326

Futures 4

What type of contract?

• Receive currency on future date – NOW sell currency futures – ON FUTURE DATE buy currency futures

• Pay currency on future date – NOW buy currency futures – ON FUTURE DATE sell currency futures

• Receive $ on future date – NOW buy currency futures – ON FUTURE DATE sell currency futures

• Pay $ on future date – NOW sell currency futures – ON FUTURE DATE buy currency futures

Slide 327

Futures 5

Advantages of futures

• Transaction costs lower than forward contracts

• Futures contract not closed out until cash receipt / payment made

Slide 328

Futures 6

Disadvantages of futures

• Can’t tailor to user’s exact needs

• Only available in limited number of currencies

• Hedge inefficiencies

• Conversion procedures complex if dollar is not one of the two currencies

Slide 329

Futures 7

Set up process

(a) Choose which contract (settlement date after date currency needed) and type

(b) Choose number of contracts = Amount being hedged/Size of contract

Convert using today’s futures contract price if amount being hedged is in US dollars

(c) Calculate tick size: Minimum price movement × Standard contract size

Slide 330

Futures 8

Estimate closing futures price

• May have to adjust closing spot price using basis, assuming basis declines evenly over life of contract

Hedge outcome

• Outcome in futures market

• Futures profit = Tick movement × Tick value × Number of contracts

Slide 331

Futures 9

Net outcome

• Spot market payment (closing spot rate) (x)

• Futures profit / (loss) (closing spot rate unless US company) x

• Net outcome (x)

Slide 332

Swaps 1

Currency swaps

• In a currency swap equivalent amounts of currency and interest cash flows are swapped for a period

• However the original borrower remains liable to the lender (counter party risk)

• A cross-currency swap is an interest rate swap with cash flows in different currencies

Slide 333

Swaps 2

Advantages of currency swaps

• Flexibility – any size and reversible

• Can gain access to debt in other currencies

• Restructuring currency base of liabilities

• Conversion of fixed to / from floating rate debt

• Absorbing excess liquidity

• Cheaper borrowing

• Obtaining funds blocked by exchange controls

Slide 334

Swaps 3

Risks of swaps

• Credit risk (Counterparty defaults)

• Position or market risk (Unfavourable market movements)

• Sovereign risk (Political disturbances in other countries)

• Spread risk (For banks which combine swap and hedge)

• Transparency risk (Accounts are misleading)

Slide 335

Swaps 4

Example

• Edward Ltd wishes to borrow US dollars to finance an investment in the USA

• Edward’s treasurer is concerned about the high interest rates the company faces as it is not well-known in the USA

• Edward Ltd should make an arrangement with an American company, Gordon Inc

• Gordon Inc is attempting to borrow sterling in the UK money markets

Slide 336

Swaps 5

Example continued

• Gordon borrows US $ and Edward borrows £

• The two companies then swap funds at the current spot rate

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

• Edward pays Gordon the annual interest cost on the $ loan

• Gordon pays Edward the annual interest cost on the £ loan

Slide 337

Swaps 6

FX swap

• A spot currency transaction that will be reversed by an offsetting forward transaction at a pre-specified date

Slide 338

Options 1

Currency option

• A right to buy or sell currency at a stated rate of exchange at some time in the future

• Call – right to buy at fixed rate

• Put – right to sell at fixed rate

• Over the counter options are tailor-made options suited to a company’s specific needs

• Traded options are contracts for standardised amounts, only available in certain currencies

Slide 339

Options 2

Why option is needed

• Uncertainty of foreign currency receipts or payments (timing and amount)

• Support tender for overseas contract

• Allow publication of price lists in foreign currency

• Protect import / export of price-sensitive goods

Slide 340

Options 3

Choosing the right option

• Complicated by lack of US dollar options

• UK company wishing to sell US dollars can purchase £ call options (options to buy sterling with dollars)

• Strike price – may need to use exercise price to convert US dollars

Surplus cash

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

Slide 341

Options 4

What type of contract?

• Receive currency at future date – buy currency put option NOW – sell currency on FUTURE DATE

• Buy currency at future date – buy currency call option NOW – buy currency at FUTURE DATE

• Receive $ at future date – buy currency call option NOW – buy currency on FUTURE

• Pay $ at future date – buy currency put option NOW – sell currency on FUTURE DATE

Slide 342

Chapter 17

Hedging interest rate risk

FRAsIR futures IR swaps IR options

FRAs 1

Interest rate risk

• Fixed v floating rate debt - change in interest rates may make borrowing chosen the less attractive option

• Currency of debt - effect of adverse movements if borrow in another currency

• Term of loan - having to re-pay loan at time when funds not available means need for new loan at higher interest rate

Slide 344

FRAs 2

• An FRA means that the interest rate will be fixed at a certain time in the future

• Loans > £500,000, period < 1 year

• 5.75-5.70 means a borrowing rate can be fixed at 5.75%

• ‘3-6’ FRA starts in three months and lasts for three months

• Basis point is 0.01%

Slide 345

IR futures 1

Interest rate futures

• To hedge against interest rate movements

• The terms, amounts and periods are standardised

• The futures prices will vary with changes in interest rates

• Outlay to buy futures is less than buying the financial instrument

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

• Long-term bond futures prices quoted at % of par value

Slide 346

IR futures 2

Example

• LIFFE three month sterling futures £500,000 points of 100% price 92.50

• Tick size will be:

– £500,000 × 0.01% × 3/12 = £12.50

– A 2% movement in the futures price would represent 200 ticks

– Gain on a single contract would be 200 × £12.50 = £2,500

Slide 347

IR futures 3

Step 1 set up process

(a) Choose which contract: Date should be after borrowing / lending begins

(b) Choose type: Assuming you are borrower sell if rates expected to rise, buy if rates expected to fall

(c) Choose number of contracts: Exposure / contract size x Loan period / length of contract

Calculate tick size: Min price movement as % length of contract / 12 months x contract size

Slide 348

IR futures 4

Step 2 estimate closing futures price

• May have to adjust using basis

Step 3 hedge outcome

(a) Futures outcome

– Opening futures price:

– Closing futures price:

– Movement in ticks:

– Futures outcome: Tick movement × Tick value × Number of contracts

Slide 349

IR futures 5

(b) Net outcome

– Payment in spot market (X)

– Futures market profit / (loss) X

– Net payment (X)

Slide 350

IR swaps 1

Interest rate swaps

• Agreements where parties exchange interest commitments

• In simplest form, two parties swap interest with different characteristics

• Each party borrows in market in which it has comparative advantage

Slide 351

IR swaps 2

Uses of interest rate swaps

• Switching from paying one type of interest to another

• Raising less expensive loans

• Securing better deposit rates

• Managing interest rate risk

• Avoiding charges for loan termination

Slide 352

IR swaps 3

Complications with interest rate swaps

• Bank commission costs

• One company having better credit rating in both relevant markets

• Should borrow in comparative advantage market but must want interest in other market

Slide 353

IR swaps 4

Example

Slide 354

IR swaps 5

• Companies may decide to use a swap rather than terminating their original loans

• Costs of termination and taking out a new loan may be too high

• If LIBOR is at 8%, neither party will gain or lose

• Any rate other than 8% will result in gain / loss

Slide 355

IR options 1

Interest rate options

• Grants the buyer the right to deal at an agreed interest rate at a future maturity date

• If a company needs to hedge borrowing, purchase put options

• If a company needs to hedge lending, purchase call options

• To calculate effect of options, use same proforma as currency options

• UK long gilt futures options (LIFFE) £100,000 100ths of 100%

Slide 356

IR options 2

• Strike price is price paid for futures contract.

• Numbers under each month represent premium paid for options

• Put options more expensive than call as interest rates predicted to rise

Slide 357

IR options 3

Interest rate caps, collars and floor

• Caps set an interest rate ceiling

• Floors set a lower limit to rates

• Collars mean buying a cap and selling a floor

Slide 358

Chapter 18

Dividend policy in multinationals and

transfer pricing

Dividend policy Transfer pricing

Dividend policy 1

Dividend capacity

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

Free cash flow to equity (FCFE)

• FCFE = dividends that could be paid to shareholders

• = Net profit after tax + Depreciation + Foreign Dividends –Total Net Investment + Net Debt Issuance + Net Share Issuance

Slide 360

Dividend policy 2

Factors affecting dividend repatriation

• Financing – how much needed for dividends / investment at home?

• Tax – often the primary reason for the firm’s repatriation policies

• Managerial control – regularised dividends restrict discretion of foreign managers (so reducing agency problems)

• Timing – to take advantage of possible currency movements (although these are difficult to forecast in practice)

Slide 361

Dividend policy 3

Tax issues

• A companies’ subsidiaries’ foreign profits are liable to UK corporate tax, whether repatriated or not

• With a credit for tax already paid to the host country

• Similarly, the US government does not distinguish between income earned abroad and income earned at home

• It gives credit to MNCs headquartered in the US for tax paid to foreign governments

Slide 362

Dividend policy 4

Timing of dividend payments

• Collecting early (lead) payments from currencies vulnerable to depreciation and late (lag) from currencies expected to appreciate

• This will mean benefit from expected movements in exchange rates

Slide 363

Transfer pricing 1

Transfer price

• Prices at which goods or services are transferred from one process or department to another or from one member of a group to another

Slide 364

Transfer pricing 2

Transfer price bases

• Standard cost

• Marginal cost: at marginal cost or with gross profit margin added

• Opportunity cost

• Full cost: at full cost, or at a full cost plus price

• Market price

• Market price less a discount

• Negotiated price, based on any of the other bases

Slide 365

Transfer pricing 3

Using market value transfer prices

• Giving profit centre managers freedom to negotiate prices with other profit centres results in market based transfer prices

Slide 366

Transfer pricing 4

Transfer price regulation

• Tax authorities often use an arm's length standard:

• Price intra-firm trade of multinationals as if it took place between unrelated parties acting in competitive markets

• Method 1 - use price negotiated between unrelated parties C and D as proxy for intra-firm transfer A to B

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

Slide 367

Transfer pricing 5

Arm’s length pricing methods (tangible goods)

Transaction-based

• Comparable uncontrolled price (CUP)

• Resale price (RP)

• Cost plus (C+)

Profit based

• Comparable profit method (CPM)

• Profit split (S)

Slide 368

Transfer pricing 6

Comparable uncontrolled price (CUP)

• Based on a product comparable transaction, possibly between different parties but in similar circumstances

• A method preferred by tax authorities

Cost plus (C+)

• Appropriate mark-up (estimated from similar manufacturers) added to costs of production

• Measured using recognised accounting principles

Slide 369

Transfer pricing 7

Resale price (RP)

• Tax auditor looks for firms at similar trade levels that perform a similar distribution function

• Method best used when distributor adds relatively little value, making it easier to estimate

• Profit margin derived from that earned by comparable distributors, subtracted from known retail price to determine transfer price

Slide 370

Transfer pricing 8

Comparable profit method (CPM)

• Method is based on premise of similar financial ratios and performance of companies in similar industries

Profit split (PS)

• Common when there are no suitable product comparables (CUP) or functional comparables (RP and C+)

• Profits on a transaction earned by two related parties are split between the parties

• Usually on basis of return on operating assets: operating profits to operating assets

Slide 371

Chapter 19

Recent developments

Developments in world financial markets Developments in world trade

Developments in world financial markets 1

The credit crunch

• The credit crunch first became a global issue in early 2007

• Billions of dollars of ‘sub-prime’ mortgages in the US

• Rise in interest rates caused defaults on such mortgages

• Collateralised debt obligations (CDOs) containing sub-prime mortgages sold onto hedge funds

• Value of CDOs fell due to defaults

• Huge losses by the banksSlide 373


Financial reporting

• Common accounting standards are increasing transparency and comparability for investors

• Improving capital market efficiency and facilitating cross-border investment

Slide 374


Monetary policy

• In advanced economies, monetary policy has encompassed the task of controlling inflation

• Interest rates are commonly set by central banks independent of Government

• This enhances credibility and so lowers inflation expectations

• A low inflation environment is conducive to long-term business planning and investment

Slide 375


The credit crunch and IFRS

• IAS 39: Entities must value financial assets and liabilities at ‘fair value’

• Markets collapse

• Banks forced to write down assets to fair value

• Reduction in lending capacity

• Further uncertainty

• Further write downs of assets to fair value and so on

Slide 376


Tranching

• Where claims on cash flows are split into several classes (such as Class A, Class B)

Benefits of tranching

• A good way of dividing risk

• Potential to make a lot of money from ‘junior’ tranches

Risks of tranching

• Very complex / may not be divided properly

• Rebuilding

Slide 377


Credit default swaps

• Allows the transfer of third party credit risk from one party to another

• Similar to insurance policies

• ‘Spread’ is similar to an insurance premium

• CDS market is unregulated

Uses of CDS

• Speculation

• Hedging

Slide 378


Trends in global financial markets

• Integration and globalisation – fostered by liberalisation of markets and technological change

• Creating more efficient allocation of capital and economic growth

• Growth of derivatives markets – advances in technology, financial engineering and risk management

• Led to enhanced demand for more complex derivatives products

Slide 379


Securitisation – eg sale of loan books by banks

• Now a common form of financing, leading to increased bond issuance

Convergence of financial institutions

• Abolition of barriers to entry in various segments of financial services industries

• Has led to conglomerates with operations in banking, securities and insurance

Slide 380


Effects of financial sector convergence

• Economies of scale

• Economies of scope: a factor of production can be employed to produce multiple products

• Reduced earnings volatility

• Reduced search costs for consumers

Slide 381


Money laundering

• A side effect of globalisation and the free movement of capital has been a growth in money laundering

• There has been increased legislation and regulation to combat it

Slide 382

Developments in international trade 1

• Trade financing has become easier for companies to obtain

• Financing for international trade transactions includes commercial bank loans within the host country

• Also loans from international lending agencies

• Trade bills may be discounted through foreign banks, for short-term financing

• Eurodollar financing is another method for providing foreign financing

Slide 383


• Eurodollar loans are short-term working-capital loans, unsecured and usually in large amounts

• The Eurobond market is widely used for long-term funds for multinational US companies

• In many countries, development banks provide intermediate- and long-term loans to private enterprises

Slide 384


Regulation

• Globalisation creates incentives for governments to intervene in favour of domestic MNCs

• In respect of ‘macroeconomic’ and ‘macrostructural’ policies

Pressure groups

• Trans-nationally networked pressure groups can influence the public and put pressure on governments to take measures against MNCs

Slide 385

acca p4 advanced financial management december 2011 exams

Documents

limitations of capm

capm continuedrequired

greatercapm basics

risingcapm basics

beta factor of debt

capm formulae ri

market premium

expected return