p4 course note bpp

Advanced Financial Management Paper P4 Course Notes (ANP413)

For BPP Students Only

2 ANP413

The online classroom – supporting your ACCA studies and helping you to pass!

Q - What’s included in the taught phase? Q - I’ve seen a chapter once – how should I use the online lecture?

Online lectures of all the chapters – audio and visual walkthroughs of all the key concepts, techniques and lecture examples. Select debriefs of exam standard questions from the Q&A Bank.

If you’re comfortable with a chapter, then there’s no need to revisit it online. However, if there are some elements where another guided walk through would help, then use the online lecture to specifically address the aspects you need to see again. All the lectures have easy-to-use indexes that allow you to jump straight to the section or lecture example you’d like to see again.

Q - What about assumed knowledge from previous papers?

Q - I haven’t received my log-on details, or have encountered problems accessing the online classroom – what should I do?

If your paper has highly examinable topics that were covered in detail in a previous paper, there will be online lectures to help you cover these. Specific details will be provided at the appropriate place in the checkpoint/stage guidance as you progress through the course.

Contact our support team who will be happy to help. [email protected] 0845 0751 100

Improving study material and removing errors

There is a constant need to update and enhance our study materials in line with both regulatory changes and new insights into the exams. BPP appoints, from one of our experienced tutor team, a subject expert to update and improve these course notes regularly. These updates are technically checked by another tutor and frequently proof read.

We always aim to leave no numerical errors and narrative typos. However, given the volume of detailed information being changed in a short space of time, it is regrettable that an error may slip through our net despite our best intentions. We apologise sincerely for any inconvenience that this might cause.

If you find a specific error or typo please let us know at [email protected] so we can correct it immediately. In addition we would welcome any suggestions you may have to further improve these study materials.

I really like the fact that you can pause the tuition and play it as many times as you like - great feature!

Thanks for the course - this Online Classroom really seems to work


INTRODUCTION

3 ANP413

P4 Advanced Financial Management Study Programme Step 1 – Taught Phase Study Programme Page

Introduction to the paper and the course 4

1 The role and responsibility of the senior financial executive ........................................................................ 13 2 Financial strategy formulation....................................................................................................................... 19 3 Conflicting stakeholder interests .................................................................................................................. 37 4 Management of international trade and finance ........................................................................................... 47 5 DCF techniques and the use of free cash flows ........................................................................................... 55

Checkpoint 1 Additional Study Guidance and Progress Test 63

5 DCF techniques and the use of free cash flows (cont) ..................................................................................... 79 6 Application of option pricing theory in investment decisions & valuations .................................................... 89 7 Impact of financing on investment decisions and adjusted present values .................................................. 97


8 International investment decisions and financing decisions ....................................................................... 127 9 Acquisitions and mergers versus other growth strategies .......................................................................... 139 10 Valuation for acquisitions and mergers ...................................................................................................... 145 11 Regulatory framework and processes ........................................................................................................ 159 12 Financing acquisitions and mergers ........................................................................................................... 165 Checkpoint 3 Additional Study Guidance and Progress Test 169

12 Financing acquisitions and mergers (cont)..................................................................................................... 187 13 Financial reconstruction.............................................................................................................................. 189 14 Business re-organisation ............................................................................................................................ 195 15 The role of the treasury function in multinationals ...................................................................................... 199 16 The use of financial derivatives to hedge against forex risk ....................................................................... 207


16 The use of financial derivatives to hedge against forex risk (cont) ................................................................. 233 17 The use of financial derivatives to hedge against interest rate risk ............................................................ 239 18 Dividend policy and transfer pricing in multinationals................................................................................. 253 19 Recent developments in world financial markets, international trade & finance......................................... 259


20 Answers to Lecture Examples .................................................................................................................... 281 21 Question and answer bank......................................................................................................................... 319 22 Appendix A: Mathematical tables and formulae ......................................................................................... 363


INTRODUCTION

4 ANP413

Introduction to Paper P4 Advanced Financial Management

Overall aim of the syllabus To apply relevant knowledge, skills and exercise professional judgement as expected of a senior financial executive or advisor, in taking or recommending decisions relating to the financial management of the organisation.

The syllabus The broad syllabus headings are:

A Role and responsibility towards stakeholders B Economic environment for multinationals C Advanced investment appraisal D Acquisition and mergers E Corporate re-organisation and reconstruction F Treasury and advanced risk management techniques G Emerging issues in finance and financial management

Main capabilities On successful completion of this paper, candidates should be able to:

Explain the role and responsibility of the senior financial executive or advisor in meeting conflicting needs of stakeholders

Evaluate the impact of macroeconomics and recognise the role of international financial institutions in the financial management of multinationals

Evaluate potential investment decisions and assessing their strategic and financial consequences, both domestically and internationally

Assess and plan acquisitions and mergers as an alternative growth strategy Evaluate and advise on alternative corporate re-organisation strategies Apply and evaluate alternative advanced treasury and risk management techniques Identify and assess the potential impact of emerging issues in finance and financial management

Links with other papers

This diagram shows where direct links exist between this paper and other papers that may precede or follow it.

Advanced Financial Management (P4)

Financial Management (F9)

Management Accounting (F2)


INTRODUCTION

5 ANP413

Taught Phase Aims

A Role and responsibility towards stakeholders

A1 The role and responsibility of the senior financial executive Chapter 1 A2 Financial strategy formulation Chapter 2 A3 Conflicting stakeholder interests Chapter 3 A4 Ethical issues in financial management Chapter 3 A5 Impact of environmental issues on corporate objectives and governance Chapter 3

B Economic environment for multinationals

B1 Management of international trade and finance Chapter 4 B2 Strategic business and financial planning for multinationals Chapter 4

C Advanced investment appraisal

C1 Discounted cash flow techniques and the use of free cash flows Chapter 5 C2 Application of option pricing theory to investment decisions Chapter 6 C3 Impact of financing on investment decisions and adjusted present values Chapter 7 C4 Valuation & the use of free cash flows Chapter 10 C5 International investment and financing decisions Chapter 8

D Acquisitions and mergers

D1 Acquisitions and mergers versus other growth strategies Chapter 9 D2 Valuation for acquisitions and mergers Chapter 10 D3 Regulatory framework and processes Chapter 11 D4 Financing acquisitions and mergers Chapter 12

E Corporate reconstruction and reorganisation

E1 Financial reconstruction Chapter 13 E2 Business re-organisation Chapter 14

F Treasury and advanced risk management techniques

F1 The role of the treasury function in multinationals Chapter 15 F2 The use of financial derivatives to hedge against forex risk Chapter 16 F3 The use of financial derivatives to hedge against interest rate risk Chapter 17 F4 Dividend policy and transfer pricing in multinationals Chapter 18


INTRODUCTION

6 ANP413

G Emerging issues in finance and financial management

G1 Developments in world financial markets Chapter 19 G2 Developments in international trade and finance Chapter 19 G3 Developments in Islamic finance Chapter 19


INTRODUCTION

7 ANP413

The Examination Paper

Examiner: Shishir Malde The examination is a three-hour paper with 15 minutes of reading and planning time consisting of one compulsory 50 mark question and two optional questions from a choice of three.

The exam paper will have a balance of 50:50 between computational and discursive elements.

Candidates are provided with a formulae sheet and tables of discount factors and annuity factors (given in Appendix A).

Format of the Exam Marks

Section A

Question 1 Compulsory question 50

Section B

Questions 2,3,4 Optional questions, choice of 2 from 3 50

100

Time pressure warning

Section A

Section B

50% Numerical 50% Discussion

40% Knowledge 60% Application


INTRODUCTION

8 ANP413

Key to icons

Question practice from the Study Text This is a question we recommend you attempt to reinforce your learning on a key topic.

Real-life examples For further details see your checkpoint guidance.

Section reference in the Study Text Further reading is needed on this area to consolidate your knowledge.

Formula to learn

Formula given in exam

ACCA P4 is a high level finance paper, and it is important that you look to extend your understanding of the issues in this paper by actively studying using a variety of sources. The course notes are a great starting point but you will also need to consult your study text and, ideally, read a good quality paper such as the Financial Times or the weekend business supplement of any good quality paper.

These checkpoints give guidance on the relevant sections of the study text to read and also provide a selection of articles to read, but you should treat this as the minimum work that you should be doing and you should actively seek out more study material form the text book and further reading from a good quality newspaper or website to build your understanding of the key topics in this paper.


SKILLS BANK

9 ANP413

Key skills required to pass Our analysis of the examiner’s comments on past exams, together with our experience of preparing students for this type of exam, suggests that to pass Paper P4 you will need to develop a number of key skills.

1 Effective use of reading time

2 Analysis of a question’s scenario & requirements

3 Time management

5 Effective presentation of written answers

4 Effective presentation of numerical calculations

A B C


SKILLS BANK

10 ANP413

Skill 1 – Effective use of reading time

You are allowed 15 minutes reading / planning time before the examination begins during which you should read the question paper and highlight or make notes on the question paper itself; you can also use your calculator for preliminary calculations. You will not be allowed to start writing in you answer booklet until advised by the exam supervisor.

One approach that can work well is start the exam by spending 5 minutes focussing on the requirements of the three shorter optional questions in Section B, and to choose which of these questions you will attempt. You need to choose two questions from three, and it is important that you choose the questions that play to your strengths.

At the end of this exercise you will have made some important positive decisions about question choice and, should be feeling more confident. You will now be in a better frame of mind to attack the Section A compulsory question.

Skill 2 – Analysis of a question's scenario & requirements

1 Be aware of the verbs used in exam questions Paper P4 is a professional level paper ‘skills module’ in the ACCA syllabus; approximately 75% of the syllabus will be tested at intellectual level 3 (synthesis), 20% at level 2 (application) and 5% at level 1 (knowledge). You will have come across intellectual level 1 and 2 earlier in your studies and so these are mentioned briefly below. It is critical that you understand that the focus of this paper is on intellectual level 3.

Intellectual level 1 discussion verbs (identify /describe) will be rare at this level; where you come across them, you can assume that they require brief discussion and are likely to be worth 1 mark per point made. Intellectual level 2 discussion verbs (discuss, analyse) are more common and require a greater depth of analysis; you can assume that a brief paragraph is likely to be worth 2 marks per point made.

Intellectual level 3 verbs (advise, report) test your ability to take a complex situation and to use your judgement and technical knowledge (from a number of different syllabus areas) to construct appropriate decisions and recommendations; the points that you make are likely to be worth about 2 marks per discussion point.

Intellectual level 3 numerical requirements (estimate) will mean that you need to use your judgement rather than apply a set numerical technique and can also require you to apply appropriate assumptions and judgement to construct a reasonably accurate numerical analysis (as you would in real life).

The solutions to these types of questions in the revision kit will sometimes give the impression that this is ‘the correct answer’ – in fact the challenge in this paper is to construct a reasonable approach to highly challenging numerical problems that do not have a single correct answer. This is why it is always important to include a brief explanation of your approach alongside your numerical calculations.

2 Relating your answer to the scenario During your planning time you will need to consider the scenario in the question. In this exam the scenario will often be thought-provoking and may require you integrate your understanding of a number of different syllabus areas as you develop your answer. It is essential that you make every attempt to relate your answer to the given scenario.

You will be more confident in handling different scenarios if you have kept up to date with developments in the business & economic environment. An excellent source for you to maintain your awareness of current events is:

http://www.telegraph.co.uk/finance/ or http://www.guardian.co.uk/business/uk-edition


SKILLS BANK

11 ANP413

3 Identify ALL the question’s requirements in your answer plan The requirements of a question often contain a number of sub-requirements.

In your answer plan, or on the question paper, you need to ensure that these sub-requirements are clearly highlighted.

Failure to answer the whole question is often due to candidates forgetting to address these sub-requirements and is a key reason why people fail this paper.

Skill 3 – Time management

1 Planning your time At the planning stage you should write on to your exam paper the amount of time that you will spend. This will be determined by the mark allocation; 180 minutes (excluding reading time) equates to 1.8 minutes per mark.

Allocating 1.8 minutes per mark will be appropriate for the compulsory question because you will have used (most of) your reading time to analyse and plan this question. So, if part (a) of Q1 is for 10 marks then you will aim to complete this in approximately 10 x 1.8 = 18 minutes.

However, because you will not have planned your optional questions during the reading time, your time management may need to be adapted by allowing 20% of the time allowed for planning. This means that the 1.8 minutes per mark becomes 1.8 x 0.8 = 1.44 minutes per mark. So, if part (a) of an optional question is for 10 marks then you will aim to complete this in approximately 10 x 1.44 = approximately 15 minutes.

2 Handling time pressure in numerical questions To avoid time overruns in the numerical parts of a question you need to practice

(a) Concentrating on all the easy marks, and

(b) Making a reasonable approach at the harder calculations, and accept that your answer won’t be perfect.

Concentrate on what you can do in the time available Don’t be too concerned if you can’t do everything – you won’t be alone!

3 Using your time effectively in discussion questions

In discussion questions you need to avoid making points that the marker does not see the relevance of i.e. waffle. A technique you could use is to explain what you mean in one sentence and then to explain why it matters in another; this should make it clear to the marker that your point is relevant.

A briefly made point should score 1 mark; if that same point is explained in a whole page it may only score 2 marks, and will take a lot of your time. So we recommend you use short punchy paragraphs as you develop your answer.


SKILLS BANK

12 ANP413

Skill 4 – Effective presentation of numerical calculations

You will not be awarded marks if the marker cannot follow your logic, or cannot see what your final conclusions are. To maximise your marks, you need to ensure that your numbers are presented neatly. For example, NPV calculation answers could be presented in a tabular (ie spreadsheet) format.

Don’t forget to underline key numbers and to show your workings (numbered), references to these workings, and brief explanations in your workings explaining what you are trying to do.

Finally, accompany your calculations with appropriate narrative to explain what you are doing, and what your numbers mean e.g. having calculated a negative NPV briefly comment that this indicates that the return from the project is less than the providers of finance would require and therefore the project should be rejected.

Skill 5 – Effective presentation of written answers

4 ‘professional marks’ will be available in section A of the exam for you to demonstrate your clarity, persuasiveness, presentation, and the integration of analytical data with the written text. This is likely to involve writing in a report format, so you should make sure that you include a title, an introduction, a conclusion and appendices.These should be easy marks to attain.

In fact, in all questions it is important that your answers are clear and well structured. So, always label your workings and use headings to structure your answer.

A B C


13 ANP413

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes How has this been examined ?

Example past paper questions

Having studied this chapter you will be able to:

Develop strategies for the achievement of the firm’s goals in line with its agreed policy framework

Recommend strategies for the management of the financial resources of the firm such that they are utilised in an efficient, effective and transparent way.

Advise the board of directors of the firm in setting the financial goals of the business and in its financial policy development with particular reference to: (i) Investment selection & capital resource

allocation (ii) Minimising the firm’s cost of capital (iii) Distribution and retention policy (iv) Communicating financial policy and

corporate goals to external and internal stakeholders

(v) Financial planning and control (vi) The management of risk

This chapter sets up a crucial framework for this paper; this will help you to give practical advice to the board across a range of financial management issues. Some of these issues may have an ethical dimension (chapter 3).

The concepts introduced here will be tested numerically in later chapters.

Agenda for Change Q4a of the December 2007 exam. Solar Supermarkets Q4 of the December 2008 exam. Lamri Co Q4b of the December 2010 exam. Mezza Co Q4 of the June 2011 exam.

The role and responsibility of the senior financial executive


1: THE ROLE AND RESPONSIBILITY OF THE SENIOR FINANCIAL EXECUTIVE

14 ANP413

Overview

Dividend decision Investment decision Financing decision

Maximisation of shareholder wealth

Pay out or reinvest? Find attractive new projects or acquisitions

Minimise cost of capital

Risk management

Role of the senior financial executive

– in setting financial goals



15 ANP413

1 Financial objectives 1.1 Profit maximisation is often assumed, incorrectly, to be the main objective of a business.

Reasons why profit is not a sufficient objective Investors care about the future Investors care about the dividend Investors care about financing plans Investors care about risk management

1.2 For a profit-making company, a better objective is the maximisation of shareholder wealth; this can be measured as total shareholder return (dividend yield + capital gain).

2 Financial strategy formulation

Investment decisions 2.1 Investment decisions (in projects or takeovers or working capital) need to be analysed to

ensure that they are beneficial to the investor. This analysis is covered fully in Chapters 5-12.

2.2 Investments can help a firm maintain strong future cash flows by the achievement of key corporate objectives e.g. market share, quality.



Risk management

Case 1



16 ANP413

Financing decision 2.3 Financing decisions mainly focus on how much debt a firm is planning to use. The level of

gearing that is appropriate for a business depends on a number of practical issues:

Practical issues Explanation

Life cycle

A new, growing business will find it difficult to forecast cash flows with any certainty so high levels of gearing are unwise.

Operating gearing

If fixed costs are a high proportion of total costs then cash flows will be volatile; so high gearing is not sensible.

Stability of revenue

If operating in a highly dynamic business environment then high gearing is not sensible.

Security

If unable to offer security then debt will be difficult and expensive to obtain.

Risk management 2.4 Risk management decisions mainly involve management of exchange rate and interest

rate risk and project management issues: these are covered in later chapters.

Dividend decision 2.5 The dividend decision is related to how much a firm has decided to spend on investments

(the investment decision) and how much of the finance needed for this it has decided to raise externally (the finance decision), and is a good example of the interrelationship between these three decisions. The dividend decision is discussed in the next section.



17 ANP413

3 Dividend policy 3.1 Dividend policy is mainly a reflection of the investment decision and the financing

decision.

Investment decision 3.2 If a company is growing then any cash it has will be used for investments, so it will not have

the liquidity to pay dividends; shareholder expectations will be for a low or zero dividend.

Financing decision

3.3 However, if a company can borrow to finance its investments, it can still pay dividends. This is sometimes called borrowing to pay a dividend. There are legal constraints over a company’s ability to do this; it is only legal if a company has accumulated realised profits.

3.4 Dividend policy tends to change during the course of a business’s lifecycle.

Young company Mature company

Zero / Low dividend High stable dividend High growth / investment needs Lower growth Wants to minimise debt Able & willing to take on debt

Possibly share buybacks too



18 ANP413

4 Chapter summary

Section Topic Summary

1 Key financial objective

Despite its obligations to other stakeholders and to the environment, the prime objective of a profit making company is to maximise shareholder wealth.

2 Financial strategy formulation

To maximise shareholder wealth an organisation must put in place a sensible financial strategy consisting of appropriate investment, financing, risk management and dividend decisions.

3 Dividend policy As a business matures, it will generally use more debt finance and increase its dividend payout

END OF CHAPTER


19 ANP413




Having studied this chapter you will be able to: Recommend the optimum capital mix

and structure within a specific business context and capital asset structure (also covered in chapters 1 & 7)

This area can be tested with numbers by asking you to calculate a cost of capital. This is commonly tested in investment appraisal questions (chapter 5) and business valuation questions (ch 9- 12).

Jupiter Co - December 2008

Assess organisational performance using methods such as ratios, trends, EVA and MVA

This may require you to use a cost of capital (see above) to calculate EVA as a part of an overall assessment of a company’s performance that will also use other ratios.

International Enterprises - December 2007, part c Anchorage Retail - December 2009, part b

Recommend appropriate distribution and retention policy (covered in chapter 1)

Explain the theoretical and practical rationale for the management of risk

Assess the company’s exposure to business and financial risk including operational, reputational, political, economic, regulatory and fiscal risk

Develop a framework for risk management, comparing and contrasting risk mitigation, hedging and diversification strategies

Establish capital investment monitoring (covered in chapter 5) and risk management systems

Risk management is likely to be tested as a part of a question giving practical financial advice. Risk management features in many of the remaining chapters in these notes.

Financial strategy formulation


2: FINANCIAL STRATEGY FORMULATION

20 ANP413

Overview


Financing decision Investment decision Dividend decision

Risk management

Risk management systems Credit risk and its impact on the cost of debt

Cost of capital



21 ANP413

1 Financing decision 1.1 Despite its environmental/ stakeholder obligations, the prime objective of a profit making

company is to maximise shareholder wealth. Investments will increase shareholder wealth if they cover the cost of capital and leave a surplus for the shareholders.

Cost of capital 1.2 The cost of the different forms of capital reflect their risk; in the event of a company

being unable to pay its debts and going into liquidation, ordinary shareholders rank after preference shareholders, who in turn rank after the providers of debt finance.

1.3 This means that the cheapest type of finance is debt and the most expensive type of finance is equity (ordinary shares).

2 The cost of equity – the dividend growth model 2.1 By looking at how much shareholders are prepared to pay for a share, it is possible to

estimate the return that shareholders require.

g0P1D

Ke This equation is not given in the exam.

P0 = today’s share price D1 = dividend in 1 year g = annual dividend growth rate

2.2 If a firm fails to provide this return to shareholders, then its share price will fall.

Lecture example 1 Technique demonstration Easy plc has just paid a 50p dividend; its share price is £5.00 and its dividend growth rate is 10%. Required Estimate Easy’s cost of equity.

Solution

Sections 4.7-5.4



22 ANP413

Assumptions 2.3

g0

P1

DKe

Dividends are paid and Dividend growth can be estimated and is constant

the company has a share price Footnote: if there is a dividend about to be paid & the share is cum div, then the share price needs to be adjusted by stripping the dividend out of the share price.

Estimating g 2.4 There are two methods of estimating ‘g’ that you need to know.

2.5 With the current re-investment level approach, the formula g= br is given in the exam.

Lecture example 2 Based on a past exam question worth 6 marks (a) AB plc has just paid a dividend of 40p per share, this has grown from 30p four years ago.

Required What is the estimated cost of equity capital if the share price is £8.20?

(b) RS plc has just paid a dividend per share of 30p. This was 50% of earnings per share. In turn, earnings per share were 20% of net assets per share. The current share price is 150p. Required

What is the cost of equity capital?

Estimating future dividend growth

Use historic growth – see lecture example 2a

Use current re-investment levels g = br see lecture example 2b



23 ANP413

Solution (a) (b)

3 The cost of equity – using the CAPM 3.1 Rational, risk averse investors will spread their investment across a wide range of securities

in order to reduce their exposure to risk.

Lecture example 3 Idea generation Annual returns on possible investments Oil price Likelihood Oil company Airline company 50:50 portfolio High 25% 25% -5% Average 50% 10% 10% Low 25% -5% 25% Required What is the expected return and risk on each investment opportunity?

Solution

3.2 By continuing to diversify, shareholders can further reduce risk.



24 ANP413

3.3

Unsystematic (or specific) risk is gradually eliminated as the investor increases the diversity of the portfolio until a point where it need not be considered (the “well-diversified portfolio”). Systematic (or ‘market’) risk is caused by factors which affect all industries and businesses to some extent or other such as: interest rates, tax legislation, exchange rates and economic boom or recession.

3.4 Another method of calculating the cost of equity (Ke) is to use the Capital Asset Pricing Model (CAPM). This model assumes that investors have a broad range of investments, and are worried about how a fall in the stock market as a whole would affect their investments; some shares are very sensitive to stock market downturns and because of this risk shareholders would expect a high return on these shares.

3.5 Commercial databases monitor the sensitivity of firms to a stock market downturn by calculating the average fall in the return on a share each time there is a 1% fall in the stock market as a whole; this is called a beta factor. beta factors

beta < 1.0 beta = 1.0 beta > 1.0 share < average risk share = average risk share > average risk Ke < average Ke = average Ke > average

Increasing risk

SYSTEMATIC RISK

UNSYSTEMATIC RISK

Portfolio Risk

Diversity of Portfolio



25 ANP413

Cost of equity 3.6 Having worked out the risk of a company, by measuring its beta, the Capital Asset Pricing

Model gives a formula for calculating required return.

3.7 The CAPM is shown on your formula sheet as:

E(ri) = Rf + (E(Rm – Rf))

where E(ri) = the expected (target) return on security by the investor (ie Ke) Rm = expected return in the market = the beta of the investment Rf = the risk-free rate of interest Rm – Rf = market premium

Lecture example 4 Technique demonstration Required Assume there is a market premium for risk of 8%, and the risk-free rate is 4%. (a) What is the required rate of return on a share with an equity beta of 1.6? (b) What is the required rate of return on a share with an equity beta of 0.8?

Solution

Limitations of the CAPM Discussion Estimating market return

Achieved by estimating comparing movements in the stock market as a whole; this will be volatile and will overstate the returns achieved because it will not pick up the firms that have failed and have dropped out of the stock market.

Estimating the beta factor Beta values are historic and will not give an accurate measure of risk if the firm has recently changed its gearing or its strategy.

Other risk factors It has been argued the CAPM ignores the impact of: size of the company the ratio of book value of equity to market value of equity



26 ANP413

4 Cost of irredeemable debt

Irredeemable debentures 4.1 Similar to the dividend growth model; the formula is not given in the exam.

4.2 The cost of debt to the company is reduced because paying interest reduces taxable profits and this reduces the tax charge

Kd = 0Pt)1(i where P0 is the market value of debt

Lecture example 5 Technique demonstration Bush plc has 6% debentures quoted at 95%, tax is at 30%. Required What is the cost of debt?

Solution

4.3 If issue costs are given, these reduce the net proceeds from the sale of a debenture and so they need to be subtracted from the market value of the debt in the calculations above.

5 Cost of redeemable debt 5.1 If the debt is redeemable, the cost of raising the debenture is assessed by looking at the

cash flows.

Note 5.2 It is easiest to assess one unit of £100 debt (or $100,€100 etc)

Section 4.4



27 ANP413

Internal rate of return (IRR) approach 5.3 IRR is used in project appraisal to calculate the % return given by a project. You may find it

to lay out the cash flows so that they look like a project ie Time £ 0 (Market value) 1 – n Interest [1 – tax] n Redemption value

5.4 Step 1 – calculate the NPV of the project, at say 5% Step 2 – calculate the project, at say 10% Step 3 – calculate the internal rate of return using the formula

IRR formula

IRR = a + a)(bNPVbNPVa

NPVa

(not given in the exam)

Lecture example 6 Based on a past exam question worth 6 marks Mantra plc has $100,000 5% redeemable debentures in issue. Interest is paid annually on 31 December. The ex-interest market value of the stock on 1 January 2007 is $90 and the stock is redeemable at a 10% premium on 31 December 2011. Corporation tax is 30%. Required What is the cost of debt?

Solution



28 ANP413

5.5 If the examiner gives you a debt beta, then the cost of debt can be estimated using the CAPM.

Lecture example 7 Technique demonstration Required If the market return is expected to be 8% and the risk-free rate is 4% on debt which has a debt beta of 0.2; what is the cost of debt to the company if the tax rate is 30%?

Solution

6 Convertible debt 6.1 Convertible debentures give the holder the right to convert $100 into a no. of shares. If the

conversion ratio was £100 for 20 shares and the share price at the redemption date was $4, conversion would not happen and the calculations for the cost of debt would be unchanged. However, if the share price was $6 then the calculations would change to the IRR of:

Time 0 (Market value) 1 – n Interest [1 – tax] n Value of the shares (here $120)

7 Cost of preference shares 7.1 The preference shareholder will receive a fixed income, based upon the nominal value of

the shares held (not the market value). These dividends are paid out of post-tax profits and therefore do not receive tax relief. The cost of preference share capital is calculated as:

Kpref = (ex div)ueMarket Val

Dividend = 0Pd

8 Cost of bank debt 8.1 The cost of a bank loan will be given by the examiner – just multiply this by (1-t) to get the

post-tax cost.



29 ANP413

9 Weighted average cost of capital 9.1 To calculate a project NPV you may be required to calculate the weighted average cost of

capital for the business (WACC).

WACC formula (given in the exam)

9.2 WACC=

de

e

VVV Ke +

de

d

VVV Kd (1-t)

Ve = total market value (ex-div) of issued shares Vd = total market value (ex-interest) of debt Ke = cost of equity in a geared company Kd = cost of debt

9.3 A third source of finance may have to be added in to the formula.

Lecture example 8 Based on a past exam question worth 8 marks Berlap plc is financed by 7m £1 ordinary shares and £8m 8% redeemable debentures; market values are £1.20 ex div and £90% ex interest. A dividend of 10p has just been paid and future dividends are expected to grow by 5%. The debentures are redeemable at par in 5 years' time. Required If taxation is 30%, calculate the WACC.

Solution



30 ANP413

Assumptions 9.4 The WACC can only be used for project evaluation if:

(a) in the long-term the company will maintain its existing capital structure (ie financial risk is unchanged)

(b) the project has the same risk as the company (ie business risk is unchanged).

Changing risk 9.5 Where the risk of an extra project is different from normal, there is an argument for a cost of

capital to be calculated for that particular project; this is called a marginal cost of capital. This is covered in Chapter 7.

Q1 if time



31 ANP413

10 Assessing corporate performance 10.1 The concept of a weighted average cost of capital can also be useful in analysing company

performance because it is a measure of the required minimum rate of return that shareholders and debt holders could get by investing in other securities of comparable risk.

Economic value added 10.2 EVA™ is an estimate of the amount by which earnings exceed or fall short of the required

minimum rate of return that shareholders and debt holders could get by investing in other securities of comparable risk. It can be used as a performance evaluation tool, and can also be relevant to valuing acquisitions. The formula is as follows: EVA = net operating profit after tax – (WACC x book value of capital employed)

10.3 Typical adjustments required in EVA™ calculations include capitalising the following: Intangibles (e.g. R&D, training, advertising) – these are viewed as investments and

added to the balance sheet Goodwill written off and accounting depreciation - these are replaced by economic

deprecation, which is a measure of the actual decline in the market value of the assets

Operating leases (off-balance sheet financing)

10.4 Other adjustments involve removing the following from the income statement: Provisions (non cash expenses) such as those in respect of bad debts and deferred

tax – there is the tendency to be over-prudent in the making of provisions which could seriously undermine the use of reported profit as a measure of performance.

Net interest on debt capital (debt is included in capital employed, and the cost of debt is included in the weighted average cost of capital).

Lecture example 9 Technique demonstration

Summary income statement for the year: 20X0 $m

Revenue 608 Pre-tax accounting profit (Note 1) 134 Taxation (46) Profit after tax 88 Dividends (29) Retained earnings 59

Sections 2.1-2.2



32 ANP413

Summary balance sheet / statement of position for the year ending: 20X0 $m Non-current assets 250 Net current assets 256 506 Financed by: Shareholders’ funds 380 Medium and long-term bank loans 126 506 Note 1: After deduction of economic depreciation Other information is as follows: 1 Capital employed at the end of the previous year amounted to $400m. 2 There were non-capitalised leases valued at $16m. 3 The pre-tax cost of debt was estimated to be 10% in 20X0. 4 The cost of equity was estimated to be 17% in 20X0. 5 The target capital structure is 70% equity, 30% debt. 6 The rate of taxation is 30% in 20XO. 7 Economic depreciation amounted to $72m in 20X0. These amounts were equal to the

depreciation used for tax purposes and depreciation charged in the income statements. 8 Interest payable amounted to $8m in 20X0. 9 Other non-cash expenses amounted to $20m per year in 20X0. Required Calculate the EVA for 20X0.

Solution

10.5 Stern Stewart & Co., who developed EVA, have also developed the concept of market value added (MVA) which attempts to measure business performance as the difference between the market value of a company’s shares and the amount invested by shareholders using balance sheet values.



33 ANP413

11 Risk management 11.1 This chapter has illustrated that higher risk will mean that investors expect a higher return;

the approach of quantifying the return that investors will require to compensate for the risk that they face is an essential part of risk management.

11.2 There are other practical risk management issues that need to be considered during the process of selecting equity and debt finance.

Equity finance

11.3 One of the insights of the capital asset pricing model is that companies should think very carefully before diversifying – because their shareholders will already have done this.

Debt finance

11.4 The cost of debt will generally be lower than the cost of equity, however companies need to be careful about using excessive levels of debt finance because this will lead to financial distress costs.

Lecture example 10 Idea generation If by increasing its gearing a company experiences a significant fall in its credit rating, how might this cause damage to the company in respect of its impact on: (a) the cost of its existing debt finance? (b) its customers? (c) its suppliers? (d) the behaviour of its managers?

Solution



34 ANP413

Risk management system 11.5 The management of risk in any context is important to shareholders. There are a wide

variety of risks that a business faces:

Risk types Definition Political* The risk of damaging government action–can involve changes

in regulations (regulatory risk), or tax policy (fiscal risk) Economic* The risk of a change in the present value of future cash flows

due to unexpected movements in foreign exchange rates Reputational The risk of damaging bond of trust with its stakeholders –

often due to unethical action (see chapter 3)

* Chapter 8 will focus on the management of political and economic risk in the context of international investments.

11.6 These risks are important to manage, this requires an effective risk management system.

Risk management system 11.7 Effective risk management will involve the regular monitoring of the risk profile of the

business; this can be achieved by risk mapping.

Low Frequency/probability High C A High

Impact Low

D B

Lecture example 11 Technique demonstration Required

For each of the grids A-D above identify a practical approach to risk management.

Solution A B C D



35 ANP413

12 Chapter summary Section Topic Summary 1 The financing

decision Investments will increase shareholder wealth if they cover the cost of capital and leave a surplus for the shareholders. In this chapter we have looked at how to assess the cost of capital.

2 Cost of equity – the dividend growth model*

g0

P1

DKe

3 Cost of equity - CAPM

))(()( RfRmERfirE

This is based on the assumption that the investor has a well diversified portfolios.

4 Cost of irredeemable debt *

Kd =0Pt)1(i

5 & 6 Cost of redeemable or convertible debt *

Kd =IRR of the cash flows

7 Cost of preference shares * 0P

DKe

8 Cost of a loan* Kd = interest x (1-t) 9 WACC These costs are then put into the WACC formula

(given) to calculate the costs of capital for a project. 10 EVA The WACC can also be used to create a measure of

company performance EVA = net operating profit after tax – (WACC x book value of capital employed)

11 Risk management

An effective risk management system is essential e.g. in managing the risks associated with financial distress costs; but managing away risk by diversifying may not be required if shareholders already have fully diversified portfolios.

*formula not given If the risk of an extra project is different from normal, there is an argument for a cost of capital to be calculated for that particular project; this is covered in Chapter 7.



36 ANP413

END OF CHAPTER


37 ANP413




Having studied this chapter you will be able to: Assess the potential sources of conflict within a given corporate

governance / stakeholder framework, informed by an understanding of alternative theories of management behaviour. Relevant underpinning theory: the separation of ownership & control, transaction cost economics & corporate governance structures, agency theory

Recommend within specified problem domains appropriate strategies for the resolution of stakeholder conflict & advise on alternative approaches that may be adopted.

Compare emerging structures with respect to corporate governance (with emphasis on European stakeholder & US/UK shareholder model) & to the role of the financial manager.

Assess the ethical dimension within business issues & advise on best practice in the financial management of the firm. Show an understanding of the interconnectedness of the ethics of good business practice between all functional areas of a firm.

Establish an ethical framework for the financial management of the company grounded in good governance, highest standards of probity & aligns with the ethical principles of the Association

Recommend an ethical framework for the development of financial policies and a system for the assessment of their ethical impact upon the financial management of the company

Explore the areas within the ethical framework of the company which may be undermined by agency effects and/or stakeholder conflicts and establish strategies for dealing with them.

The examiner has said that ‘in any area assessed there may be an ethical dimension introduced or explored’. This is likely to be practical, not theoretical.

Q4b December 2007, Agenda for Change Q4a June 2008, Saturn Systems Q4 June 2009. Pharmaceutical Co Q5 June 2011 Mezza Co

Assess the issues which may impact upon corporate objectives and governance from: (i) sustainability and environmental risk (ii) the carbon trading economy and emissions (iii) the role of the environment agency (iv) environmental audits and the triple bottom line approach

Q5 Dec 2011 Kengai Co Q1b new pilot paper

Conflicting stakeholder interests


3: CONFLICTING STAKEHOLDER INTERESTS

38 ANP413

Overview

Environmental issues

Conflicting stakeholder interests


Resolved by – Corporate governance

Agency theory

Differing corporate governance structures

- Europe (stakeholder based) - UK/US (shareholder based)

Sustainability encouraged by Carbon trading Triple bottom line approach Environmental audits

Ethical issues

Are investments unethical?

Has risk been communicated to investors?



39 ANP413

1 Key financial objective 1.1 The key financial objective for a business is to benefit the owners ie the shareholders. This

can be measured as total shareholder return (dividend yield + capital gain).

Lecture example 1 Idea generation

Required What other objectives could managers have, and how could these conflict with maximisation of total shareholder return?

Solution

Agency theory 1.2 The danger that managers may not act in the best interest of shareholders is referred to as

the agency problem; its existence has stimulated the development of corporate governance schemes.

UK corporate governance 1.3 In the UK listed companies have to state in their accounts that they comply with the

following regulations:

Board of directors Key committees Separate MD & chairman Minimum 50% non executive directors

(NEDs) Independent chairperson Maximum one-year notice period Independent NEDs (three-year contract,

no share options)

Remuneration committee (Pay & incentives of executives) Audit committee (Risk management, NEDs only) Nomination committee (Choice of new directors)

Chapter 3a; sections 1- 2



40 ANP413

1.4 These developments have been felt to be necessary because of the separation between ownership and control in the UK. Most large UK companies are listed on the Stock Market and are owned by a wide range of private and institutional shareholders.

1.5 Another factor encouraging corporate governance in the UK is the existence of an active takeover market ie if a firm underperforms then they can be expected to be taken over.

1.6 In the UK corporate governance focuses on protecting the shareholder; it is a shareholder based model.

US corporate governance 1.7 The US approach is similar to the UK, but has legal backing (Sarbanes-Oxley Act). Again

most large US companies are listed and therefore corporate governance is stimulated by the existence of an active takeover market. In the US corporate governance focuses on protecting the shareholder; it is a shareholder based model.

European corporate governance 1.8 In Europe most large companies are not listed on a Stock Market, and are often dominated

by a single shareholder with more than 25% of the shares (often a corporate investor or the founding family). Banks are powerful shareholders and generally have a seat on the boards of large companies.


Required What impact could the existence of dominant shareholders have on the need for corporate governance regulations?

Solution

1.9 There are often restrictions on takeovers eg in Germany there are state laws preventing shareholders acquiring a majority stake in local companies.

1.10 It is also common in Europe to have a two-tier board structure consisting of a supervisory board (elected by shareholders normally) and an executive board. In Germany, the supervisory board has to consist of 50% trade union representatives.

Case 2



41 ANP413

1.11

1.12 In Europe, the features of corporate governance described above act to protect the interests of powerful stakeholders; it is a stakeholder based model.

2 Ethical issues in financial management 2.1 The ethical stance of a company is concerned with the extent that an organisation will

exceed its minimum obligations to its stakeholders.

2.2 The structure developed in this chapter will help to analyse some ethical issues in exam questions; but it will also be appropriate to apply your common sense to create practical solutions to ethical problems.

Lecture example 3 Idea generation BP plc is a multinational energy company, with a workforce of nearly 100,000 employees. It operates in over 100 countries and its activities include drilling oil, refining oil into different types of fuel and selling fuel through more than 25,000 petrol stations worldwide. Required

Discuss what ethical issues BP may come across in formulating its: (a) investment decisions (b) financing decisions (c) dividend decisions (d) risk management policies

Appoint members of the executive board

Authorise key investments

Agree rationalisation plans

Supervisory board

Control executive pay & incentives

Chapter 3a; Section 3



42 ANP413

Solution (a) (b) (c) (d)

3 An ethical framework for developing policies

3.1 The ACCA has developed a five-step framework to help you make ethical decisions. This can be applied at a corporate level too.

Step 1 - establishing the issues 3.2 A business needs to be aware of the ethical issues that it faces.

Lecture example 4 Idea generation Required

How could BP plc ensure that it is aware of the ethical issues present in its financial policies?

Solution



43 ANP413

Step 2 - are there threats to compliance with fundamental principles? 3.3 A company’s fundamental ethical principles need to be clearly understood.

Lecture example 5 Idea generation Extract from BP’s website (Feb 2009): We have a responsibility to set high standards: to be a business which is committed to integrity. Our code of conduct is designed to help us achieve this. The code covers five key areas: safety and the environment – protection of the environment, communities and staff employees – covering fair treatment and equal opportunity business partners – detailed guidance on gifts, conflicts of interest, competition etc governments and communities – covering such areas as bribery company assets and financial integrity – guidance about reporting, insider trading etc Required What is the importance of this type of code of conduct statement?

Solution

Step 3 - are the threats significant? 3.4 If an employee is unsure about this, they should use the mirror test (see step 5 below). If felt

to be significant, it needs to be reported to the ethics department to deal with it.

Step 4 - are there safeguards to reduce threats to an acceptable level? 3.5 Safeguards in place in the work environment such as policies and procedures to monitor the

quality of work, or to encourage communication of ethical concerns.



44 ANP413

Lecture example 6 Idea generation To try to improve the relevance of BP’s code of conduct there is a list of specific issues within each section of the code covering areas that employees may require guidance on, here are some examples. (a) I have a large grass-mower at home which I’m lending to a friend. Is it OK if I borrow a BP

truck at the weekend to take it to my friend’s house and then use it again in two weeks time to bring it back?

(b) I attended a fundraising dinner for a pro-business candidate for a local office position. Since this candidate takes positions favourable to our interests, can I get this expense reimbursed by BP?

(c) Our business has from time to time made contributions to local governments, such as material for science training programmes, solar education materials, and surplus BP equipment. Are these donations allowed by the code?

(d) In the country where I work, women are not allowed to apply for the jobs we offer. If we put their names forward as candidates for approval by the state JV partner, we know that they will be rejected. Should we therefore just exclude them from the list?

Required

Discuss the advice that BP would be likely to give in the situations described above

Solution

Step 5 – can you face yourself in the mirror? 3.6 Sometimes called the mirror test. Whether or not you choose to perform the action, it's

useful to look in the mirror and ask yourself: Is it legal? What will others think? – How would you feel explaining what you did to a friend, a

parent, a spouse, a child, a manager, or the media? Is it right? – What does your conscience or your instinct tell you?

Chapter 3b



45 ANP413

4 Chapter summary Section Topic Summary 1 Key

financial objective

The prime financial objective of a profit making company is to maximise shareholder wealth, this can be measured by total shareholder return. The agency problem (that the directors might neglect the shareholder) is policed by corporate governance regulations and the existence of an active takeover market in the UK and the US. In Europe there is less emphasis on corporate governancAlthough the prime financial objective of a profit-making company is to maximise shareholder wealth, it is important to understand the needs of the powerful stakeholder groups and to ensure that where these conflicts exist then the conflict is sensibly managed.

2 Ethical issues

The ethical stance of a company is concerned with the extent that an organisation will exceed its minimum obligations to its stakeholders.

3 Ethical framework

A company will come across ethical issues in its financing strategy; these can be managed by: 1 Ensuring that it understands the issues – ie

ensuring that information is collected and assessed and reported to the appropriate management

2 Assessing these issues against its principles – ie a clear statement of the company’s ethical principles can clearly communicate and reinforce the company’s ethical stance

3 Assessing whether these threats are significant – performed at a senior management level

4 Assessing whether safeguards can be put in place – putting in place policies, an ethical code and performance measures

5 Assessing whether it can meet the mirror test



46 ANP413

END OF CHAPTER


47 ANP413

47

47




Advise on the theory and practice of free trade and the management of barriers to trade.

Demonstrate an up-to-date understanding of the major trade agreements and common markets &, on the basis of contemporary circumstances, advise on their policy & strategic implications for a business.

Discuss the objectives of the World Trade Organisation.

Discuss the role of the international financial institutions within the context of a globalised economy, with particular reference to the International Monetary Fund, the Bank of International Settlements, the World Bank, and the principal Central Banks (the Fed, Bank of England, European Central Bank the Bank of Japan).

Assess the role of the international financial markets with respect to the management of global debt, the financial development of emerging economies and the emergence of global financial stability.

Advise on the development of a financial planning framework for a multinational taking into account:

(i) Compliance with national governance requirements (for example, the LSE requirements for admission for trading).

(ii) The mobility of capital across borders and national limitations on remittances and transfer pricing.

(iii) The pattern of economic and other risk exposures in the different national markets.

(iv) Agency issues in the central coordination of overseas operations and the balancing of local financial autonomy with effective central control.

This chapter is likely to be tested as a part of a discussion question.

Q5 pilot paper, Multimedia company Q4 June 2009, Pharmaceutical Co Q4 December 2009, Moose Co

Management of international trade and finance


4: MANAGEMENT OF INTERNATIONAL TRADE AND FINANCE

48 ANP413

Overview



Problems of central co-ordination

Financing decisions chosen to minimise tax paid and currency/political risk

Management of international finance

– role of the IMF, World Bank etc

Management of barriers to free trade

– role of the WTO



49 ANP413

1 The management of barriers to free trade 1.1 Free trade is encouraged within regions of the world by organisations such as the EU and

NAFTA. However, for multinationals, it is common to encounter barriers to trade outside these free trade zones.

Lecture example 1 Idea generation Diageo is a UK-based drinks group that owns the Johnnie Walker and Guinness brands, international markets now account for about a third of sales. Required (a) Identify trade barriers that Diageo might encounter as it tries to penetrate into Asia. (b) Suggest approaches to dealing with these issues

Solution

The World Trade Organisation (WTO) 1.2 To support the development of international trade, the WTO (with over 100 members)

provides a mechanism for: (a) identifying and reducing trade barriers (b) resolving trade disputes

1.3 The WTO will impose fines, if members are in breach of their rules. 1.4 Members of the WTO cannot offer selective free trade deals with another country without

offering it to all other members of the WTO (the most favoured nation principle).



50 ANP413

2 The management of international finance

Central banks 2.1 Central banks normally have control over interest rates and support the stability of the

financial system. Collaboration between central banks is supported by the Bank of International Settlements (BICS).

2.2 In the context of international trade, a key role of the central bank is to guarantee the convertibility of a currency (eg from £s to $s).

The International Monetary Fund (IMF) 2.3 The IMF's main purpose is to support the stability of the international monetary system by

providing support to countries with balance of payments problems; most countries are members.

2.4 Where a member is having difficulties overcoming balance of payments problems the IMF will: (a) offer advice on economic policy (b) lend money, at subsidised rates to finance short-term exchange rate intervention

2.5 IMF loans are conditional on action being taken to reduce domestic demand, and are normally repayable over a five-year period.

2.6 The IMF has been criticised as being controlled by those who don’t need funds, for failing to control its own costs and for holding on to its substantial gold reserves.

The World Bank 2.7 The World Bank, partially funded by the IMF, exists to fund reconstruction and

redevelopment. Loans are normally made directly to governments, for periods of 10-20 years and tied to specific projects.

Case 5, 6

Section 5



51 ANP413

3 Multinational financial planning issues 3.1 Multinationals need to consider three main issues in addition to the general issues affecting

funding identified in Chapter 1:

Minimisation of global taxes 3.2 Parent company financing of its overseas subsidiaries in the form of debt brings the benefits

of:

(a) reducing the corporation tax bill overseas (b) avoiding withholding taxes on dividend payments

Managing risk 3.3 Overseas debt finance is a useful means of managing risk:

Risk types Impact of overseas debt finance Political Reduces exposure to overseas tax increases

If assets are seized, allows the firm to default on the loan (if raised from the host government) or to use international development agencies (with influence over the local government)

Economic The risk of a local devaluation offset by the benefit of lower repayments on a loan

Manage risk Exploit financial

market distortions

Minimise taxes

Multinational issues



52 ANP413

Financial market distortions 3.4 Local governments may directly or indirectly offer subsidised finance:

Subsidised loan finance

Impact of overseas debt finance

Direct Low cost loans may be offered to encourage multinational investment

Other incentives may include exchange control guarantees, grants, tax holidays etc

Indirect Local governments may reduce the interest rates to stimulate the local economy

3.5 These distortions can sometimes mean that low cost local debt finance is attractive, this is covered in chapter 7.

4 Obtaining a listing on one or more exchanges 4.1 Where overseas equity is preferred a listing on an overseas exchange may be considered;

this can have a number of advantages.

Lecture example 2 Idea generation A US multinational, listed on the New York Stock Market, is planning to raise £200m of equity finance, it is considering a listing on the London Stock Exchange to facilitate this. Required (a) Identify the potential advantages of issuing the shares through the London market instead of

the New York market. (b) Identify the potential problems.



53 ANP413

Solution

4.2 It will be important to conform to local regulations. Taking when the London Stock Exchange is used as an overseas exchange, the relevant regulations are: (a) At least three years of audited published accounts (b) At least 25% of the company’s shares must be in public hands when trading begins (c) Minimum market capitalisation of £700,000 (d) A prospectus must be published containing a forecast of expected performance

4.3 In addition the company will have to be introduced by a sponsoring firm and to comply with the local corporate governance requirements.



54 ANP413

5 Chapter summary Section Topic Summary 1&2 International

financial institutions

The development of international trade is supported by a number of institutions: WTO Encouraging the reduction of trade barriers Central banks Guaranteeing the convertibility of a currency World Bank Providing funding for government capital projects IMF Providing finance for government’s experiencing balance of payments problems

3 Multinational financial planning issues

The use of local debt finance can help to manage tax and risk and can also exploit financial market imperfections.

4 Obtaining a listing on one or more exchanges

Where equity is preferred, an international issue of equity can raise the profile of the company, and expand its base of shareholdings which may make it more acceptable to the host government.

END OF CHAPTER


55 ANP413





Evaluate the potential value added to a firm arising from a specified capital investment project or portfolio using the net present value model. Project modelling should include explicit treatment of:

(a) Inflation & specific price variation (b) Taxation including capital allowances and tax exhaustion (c) Single & multi-period capital rationing to include the

formulation of programming methods and the interpretation of their output

(d) Probability analysis and sensitivity analysis when adjusting for risk and uncertainty in investment appraisal

(e) Risk adjusted discount rates (covered in chapter 7)

Outline the application of Monte Carlo simulation to investment appraisal. Candidates will not be expected to undertake simulations in the exam but will be expected to demonstrate understanding of

(a) simple model design (b) the different types of distribution controlling the key variables

in the simulation (c) the significance of the simulation output and the assessment

of the likelihood of project success (d) the measurement and interpretation of project value at risk Establish the potential economic return using IRR and modified

IRR & advise on a project’s return margin. Discuss merits of NPV & IRR.

Discounted cash flow techniques are also extensively examined in the context of business valuations (business valuations are covered in chapters 9-12).

Slow Fashions - 20 marks, June 09 Your business - 28 marks, June 09 Seal island - 24 marks, June 2010 Q1i,ii,iii Seal island - 4 marks, June 2010 Q1iv Tisa Co- 4 marks, June 2012 Q4c Tisa Co- 8 marks, June 2012 Q4b Neptune- 6 marks, June 2008 Q5b

DCF techniques and the use of free cash flows


5: DCF TECHNIQUES AND THE USE OF FREE CASH FLOWS

56 ANP413

Overview



DCF techniques & the use of free cash flows

Impact of capital rationing on project appraisal

Impact of a capital investment project on dividend capacity

Estimating the potential value added to a firm from a capital investment project



57 ANP413

1 Capital budgeting process 1.1 Capital expenditure is often expensive and requires careful analysis. This chapter and the

following chapters, deal with financial analysis of proposed investment projects. However, this is only a part, albeit the main part, of the capital budgeting process. The main stages in the capital budgeting process are:

Collecting ideas

(suggestion schemes, management style, innovation targets)

Preliminary screening – analysis of business logic (vs SWOT and strategic direction & feasibility eg approximate cash required & payback)

Financial analysis* (detailed investigation of the resource requirements, risk & returns ie NPV,IRR, competitor

modelling, risk modelling)

Authorisation, monitoring and review* (Ranking, board authorisation, post auditing)

* Board approval to proceed to these stages is normal, but divisional managers often have the authority to approve small projects

2 Net present value 2.1 You have already come across the need to discount future cash flows that are expressed in

terms of their present value; it is vital that you are familiar with the mechanics of discounting and the use of discount factor tables.



58 ANP413


Required Calculate the present value of the following cash flows assuming a discount rate of 10%. (a) A cash inflow of £5,000 in one year's time (b) A constant annual cash inflow (an annuity) of £5,000 received for the next five years (c) A constant cash inflow of £5,000 received in three years' time & for the next four years

(time 3 - 7). (d) A constant annual cash inflow (an annuity) of £5,000 received for the foreseeable future

Solution (a) Time 1 (b) Time 1 - 5 (c) Time 3 - 7 (d) Time 1 - infinity

Relevant costs 2.2 The figures put into the NPV working must be relevant to the decision being considered:

(a) Cash flows only – eg depreciation and allocated overheads should be ignored. (b) Future amounts – questions might refer to costs which have already been incurred.



59 ANP413

Finance-related cash flows 2.3 Finance-related cash flows are normally excluded from project appraisal because

discounting involves a deduction for the minimum annual return of debt and equity investors.

Opportunity costs 2.4 Remember to include opportunity costs; these are the costs incurred or revenues lost from

diverting existing resources from their existing use eg an overseas investment might cause lost contribution from existing exports; this is a relevant cost of the investment.

NPV layout 2.5 A neat layout will gain credibility in the exam and will help you make sense of the many

different cash flows that you will have to deal with. Time 0 1 2 3 4 5 Sales receipts X X X X Costs (X) (X) (X) (X) Sales less costs X X X X Taxation (X) (X) (X) (X) (X) Capital expenditure (X) Scrap value X Tax benefit of CAs X X X X X Working capital (X) (X) (X) X X Net cash flows (X) X X X X X Discount factors @ X X X X X X post-tax cost of capital* Present value (X) X X X X X * this has already been covered

Corporation tax on profits 2.6 Projects will cause tax to be paid on the profits, net of tax saved on capital allowances. Tax

cash flows can be calculated as one figure, but we recommend that two cash flows are shown:

Corporation tax on profits 2.7 Calculate the taxable profits (before capital allowances) and calculate tax at the rate given.

2.8 The effect of taxation will not necessarily occur in the same year as the relevant cash flow that causes it. Follow the instructions given in the exam question.



60 ANP413

Capital allowances 2.9 These are normally 25% writing down allowances on plant & machinery.

Approach 1 Calculate the amount of capital allowance claimed in each year. 2 Make sure that you remember the balancing adjustment in the year the asset is sold. 3 Calculate the tax saved, noting the timing of tax payments given in the question.

Working capital 2.10 Projects need funds to finance the level of working capital required (normally assumed to be

stock). The relevant cash flows are the incremental cash flows from one year’s requirement to the next. At the end of the project, the full amount invested will be released.

Inflation

Key terms Explanation Real terms or current prices Ignoring inflation Nominal or money Including inflation

2.11 Inflation has two impacts on NPV: Time 0 1 onwards

Cash flow

Discount factor Present value

Ignore inflation if 2.12 If there is one rate of inflation, inflation has no impact on the NPV of a domestic

investment. In this case it is normally quicker to ignore inflation in the cash flows (ie real cash flows) and to use an uninflated (real) cost of capital.

Include inflation if 2.13 If there is more than one rate of inflation, inflation will have an impact on profit margins and

therefore the cash flows must be inflated and inflation must also be incorporated into the cost of capital.

2.14 To incorporate inflation into the cost of capital the following equation must be used: [1 + real cost of capital] x [1 + general inflation rate] = [1 + inflated cost of capital] or (1 + r) (1 + h) = (1 + i)

The cost of capital will increase, making the project less attractive

Cash inflows will increase, making the project more attractive

The net impact on the NPV may be minimal



61 ANP413


Avanti plc is considering a major investment programme which will involve the creation of a chain of retail outlets throughout the United Kingdom. The following cash flows are expected. Time 0 1 2 3 4 £’000 £’000 £’000 £’000 £’000 Land and Buildings 3,250 Fittings and Equipment 700 Gross Turnover 1,800 2,500 2,800 3,000 Direct Costs 750 1,100 1,500 1,600 Marketing 170 250 200 200 Office Overheads 125 125 125 125 (a) 60% of office overhead is an allocation of head office operating costs. (b) The cost of land and buildings includes £80,000 which has been spent on surveyors’ fees. (c) Avanti plc expects to be able to sell the chain at the end of year 4 for £4,000,000. Avanti plc is paying corporate tax at 30% and is expected to do so for the foreseeable future. Tax is paid one year in arrears. The company will claim capital allowances on fittings and equipment at 25% on a reducing balance basis. Capital allowances are not available on land and buildings. Estimated resale proceeds of £100,000 for the fittings and equipment have been included in the total figure of £4,000,000 given above. Avanti plc expects the working capital requirements to be 15% of turnover during each of the four years of the investment programme. Avanti’s real cost of capital is 7.7% p.a. Inflation at 4% p.a. has been ignored in the above information. This inflation will not apply to the resale value of the business which is given in nominal terms. Required

Calculate the NPV for Avanti’s proposed investment and calculate its sensitivity to changes in the rate of corporation tax (fiscal risk)



62 ANP413

Solution Time 0 1 2 3 4 5


63 ANP413

Checkpoint 1 – Progress Review To reinforce your learning to date you should now follow the study guidance in the following pages. On completion, your progress towards full exam preparation will be:

You have now completed Stage 1 of the course. Before you attempt the Study Support work outlined on the subsequent pages, take some time to reflect on the knowledge and skills you covered on Stage 1.

Key messages from Stage 1 Take some time to reflect on the knowledge and skills you covered during Stage 1. If you feel you need further clarification on any of the key areas listed below you can use the on-line lecture for the relevant chapter. The Course Notes section for each chapter (starting overleaf) provides helpful guidance (and time commitments) on how to focus your review on the key learning points in your notes.

Key knowledge The formulation of financial strategy is the responsibility of the senior financial executive, you need to understand the framework for financial strategy and the interactions between the investment, financing and dividend decisions.

How to apply discounted cash flow techniques – in particular how to calculate a cost of capital and how to deal with tax and inflation.

ACCA P4 is a high level finance paper, and it is important that you look to extend your understanding of the issues in this paper by actively studying using a variety of sources. The course notes are a great starting point but you will also need to consult your study text and, ideally, read a good quality paper such as the Financial Times or the weekend business supplement of any good quality paper.

These checkpoints give guidance on the relevant sections of the study text to read and also provide a selection of articles to read, but you should treat this as the minimum work that you should be doing and you should actively seek out more study material form the text book and further reading from a good quality newspaper or website to build your understanding of the key topics in this paper.

Key skills You need to be able to identify, quickly and accurately, which formula you need to apply to calculate the cost of debt and equity.

You need to be able to appreciate the needs of other stakeholders and to incorporate their needs into the decision making process.


CHECKPOINT 1

64 ANP413

Checkpoint 1 – Study Support

Chapter 1 – The role of the senior financial executive 75 minutes

Key areas

Financial strategy formulation

Practical influences on gearing

Dividend policy

Course Notes The formulation of financial strategy is the responsibility of the senior financial

executive, note the framework in section 2 – the topics within this framework are gradually discussed over the rest of the course; review case 1 at the back of this checkpoint.

Review the practical influences on gearing in paragraph 2.3 and dividend policy in paragraph 3.4.

10 minutes

5 minutes

Study Text Question Bank Attempt Question 1 (Goals) as this tests your ability to discuss financial objectives.

Plan out your answer and read the solution.

15 minutes

Study Text Section 3.4 reminds you of the basic concept of capital rationing, which you will have

seen in paper F9. You will develop the concept of capital rationing later in the course (in chapter 5), but these basics have been tested in P4.

Section 4 reminds you of sources of finance which you will have seen in paper F9. Much of this is just good general knowledge, do not get bogged down in any detail here because these themes will be developed later in the course.

Section 5 examines some of the interactions between the investment, financing and dividend decisions. This short section is important and you should review it carefully.

15 minutes

15 minutes

15 minutes


CHECKPOINT 1

65 ANP413

Chapter 2 – Financial strategy formulation 125 minutes

Key areas

Calculation of the cost of equity and the cost of redeemable debt

Calculation of the WACC and the assumptions behind its use

Calculation and discussion of EVA and other ratios

Course Notes Review the chapter ensuring you can follow all the calculations. This is a crucial

chapter and is regularly tested, often in the context of investment appraisal.

30 minutes

Study Text Review sections 2.1-2.2 which look at the ratios that you might need to use to analyse

company performance: this is important, especially the shareholders’ investment ratios.

Section 4 is more important, read this section carefully, it is all useful background knowledge but you need to pay careful attention to the discussion of the cost of equity (section 4.7) and the mechanics of new share issues (section 4.8-4.9).

Section 5 continues the discussion of dividend policy from chapter 1, and this theme is discussed again later in chapter 18. Make sure that you understand the general issues concerning dividend policy and, most importantly, the terms ‘dividend capacity or free cash flow to equity’; these terms are frequently examined.

Section 7 categorises different types of risk. You will cover most of this later in the course but it is useful to read this section now, and to ensure that you understand the issues in sections 7.1 – 7.4, especially the relationship between business and financial risk.

10 minutes

50 minutes

20 minutes

15 minutes


CHECKPOINT 1

66 ANP413

Chapter 3a-3c – Conflicting stakeholder interests 75 minutes

Key areas Shareholder wealth maximisation UK v European corporate governance Management of stakeholder conflict Awareness of ethical issues in financial management An ethical framework for developing financial policies Environmental audits – the triple bottom line approach

Course Notes This chapter sets up the key objective of maximising shareholder wealth and the

corporate governance mechanisms that are in place to ensure that this is the focus of financial management.

You need to understand the differences between the UK/US shareholder approach to corporate governance and the European stakeholder approach. Review case 2 at the back of this course companion.

Ethics comes up frequently in this exam, but practical common sense points are likely to be more important than the framework laid out in this chapter; the framework is useful but not crucial. Also read case 3 at the back of this course companion.

15 minutes

Study Text Sections 1 and 2 of chapter 3a introduces some significant themes and terminology

(agency theory, transaction cost economics).

Read chapter 3c in full – concentrating on triple bottom line reporting (section 5). Also read case 4 at the back of this course companion.

15 minutes

45 minutes

Chapter 4 – Economic environment for multinationals 60 minutes

Key areas

Awareness of the role of the World Trade Organisation, the International Monetary Fund, and the World Bank

Understanding of the importance of overseas debt finance in the management of global taxes, risk and the exploitation of financial market distortions

The mechanics of issuing Eurobonds Understanding of the advantages of an overseas stock market listing and the

regulations that a company will need to conform to

Course Notes This is a short chapter, but is important so review all areas. Also read case 5 & 6.

20 minutes

Study Text Review section 1.3 which discusses issues related to overseas production decisions,

which is a likely exam scenario.

Sections 10-14 give useful strategies that can be employed to manage a range of risks faced by multinational companies.

20 minutes

20 minutes


CHECKPOINT 1

67 ANP413

Checkpoint 1 – Progress Test

Having completed the Study Support guidance, you are now ready to attempt Progress Test 1. You should aim to complete the test in 1 hour. If you find it takes you significantly longer to do so then please contact your course tutor for guidance.

The multiple choice questions contained within Progress Test 1 will thoroughly test your understanding of the material and your ability to perform the required calculations. Note that the P4 exam does not contain multiple choice questions. The four short written questions that follow will test your ability to apply your knowledge. These skills will prove important in preparing you for the more discursive elements of the exam.

It is important that you continually review your progress (solutions are after the test) and revise further any areas where you feel your understanding is weak.

A Multiple choice questions (8 questions – approximate time 40 minutes)

1 Which of the following is not a corporate governance requirement for a UK company that is listed on the London Stock Exchange’s main market?

A Minimum of 50% of the main board to consist of non-executive directors B The chairperson and the managing director should be separate C The audit committee to consist of a majority of non-executive directors D The chairperson should not be an ex-managing director (2 marks)

2 Which of the following is not a feature of the triple bottom line approach?

A Measurement of social objectives e.g. ethnic/gender diversity B Measurement of environmental issues e.g. CO2 emissions C Measurement of economic objectives e.g. number of jobs created in the local community D Measurement of economy, efficiency and effectiveness (2 marks)

3 Tryme plc issued its 7% irredeemable debentures at £98. Issue costs are 2% of the nominal value. The company is paying corporation tax at a rate of 28%.

The cost of capital to the company of these debentures is

A 5.1% B 5.0% C 7.3% D 5.3% (2 marks)

Data for questions 4-5 The dividends and earnings of Sparsholt plc over the last five years have been as follows:

Dividends Earnings Year £ £ 20X1 400,000 813,000 20X2 416,500 835,000 20X3 434,500 864,000 20X4 461,000 894,000 20X5 479,000 598,750 The company is financed entirely by equity and there are 2,000,000 shares in issue, each with a market value of £1.78 ex-div.


CHECKPOINT 1

68 ANP413

4 On the assumption that the data for 20X1 – 20X5 provides a basis for estimating future trends, what is the cost of equity?

A 18.7% B 17.7% C 18.1% D 17.2% (2 marks)

5 One of the directors has criticised the use of historic data, and has suggested that since the company is paying out a greater percentage of earnings each year, an estimate of dividend growth based on the current reinvestment level would be more appropriate. Using the current reinvestment level, and assuming a 20% return on equity, what is the cost of equity?

A 31.6% B 18.0% C 29.5% D 17.5% (2 marks)

Data for questions 6-7 It is now 20X7. Spinethorne plc’s equity has a beta factor of 0.9. The company is financed by a mixture of equity, preference shares and redeemable long-term debt capital, as follows.

£1 Ordinary shares: 40 million shares, market value £2 per share 7% Preference shares of

£1 each: 20 million shares, market value 100p per share

2012 5% Debt capital £20,000,000, market value £90, redeemable at par

The market rate of return is 8%, the risk-free rate of return is 5% and the rate of corporation tax 30%.

6 What is Spinethorne’s cost of equity (Ke), cost of debt (Kd, post-tax, to the nearest %) and cost of preference shares (Kp)?

A Ke = 7.7%, Kd = 6%, Kp = 7% B Ke = 12.2%, Kd = 8%, Kp = 7% C Ke = 7.7%, Kd=8%, Kp = 7% D Ke = 12.2%, Kd = 6%, Kp = 7% (4 marks)

7 What is Spinethorne’s WACC?

A 7.1% B 7.3% C 9.0% D 6.0% (2 marks)

8 Cranmoor Limited is about to embark on a project to eco friendly air-conditioning systems. It involves an initial outlay of £120,000 and cash inflows, at current prices, of £50,000, £60,000, and £40,000 at the end of years 1,2 and 3 respectively.

Inflation is expected to be running at 10% p.a. during the life of the project, and the real cost of capital is 10%.

What is the net present value of the project?

A £30,000 B £6,100 C £5,300 D -(£15,300) (2 marks)


CHECKPOINT 1

69 ANP413

B Short written questions (4 questions – approximate time 20 minutes) 1 Compare the main features of the systems that encourage corporate governance in the UK to European

(stakeholder-based) corporate governance. (7 marks)

2 Identify four reasons why earnings per share is not sufficient as a financial objective. (4 marks)

3 Identify the main aim of financial strategy and the four key decisions necessary to achieve it. (5 marks)

4 Describe the features of a company that should pay high dividends and/or use high levels of gearing. (4 marks)

END OF PROGRESS TEST


CHECKPOINT 1

70 ANP413

Checkpoint 1 – Progress Test solutions

Section A

1 C The audit committee should only consist of non-executive directors. Note that D is an aspect of the chairperson being independent.

2 D This is the value for money framework; the triple bottom line approach is an approach to environmental auditing, it involves points A, B and C.

3 D The net proceeds from the sale of the debenture is £96 so the cost is 7/96 x (1-t) = 5.3%.

4 A Dividend per share, 20X5 = £479,000 2 million = 23.95p

The dividend growth in the four years between 20X1 and 20X5 has been

198.1000,400000,479

The average annual growth rate is 4 198.1

= 0.046 approx, or 4.6% per annum.

Ke = 0.046+178(1.046)23.95

=g+Eg)+(1d0

= 0.187 or 18.7%.

5 B Dividend payout = £598,750£479,000

= 0.8 or 80%

So reinvestment level = 1 – 0.8 = 0.2 or 20.0%

g = br so g = 0.2 x 0.20 = 0.04 or 4.0%

Ke = 04.0+178)04.1(95.23

=g+Eg)+1(d0

= 0.18 or 18.0%.

6 A Ke = 5 + 0.9(8-5) = 7.7% Kd = internal rate of return to company

Time £ DF @ 10% PV DF @ 5% PV 0 (90) 1 (90) 1 (90)

1-5 5(1-0.3) 3.791 13.27 4.329 15.15 5 100 0.621 62.1 0.784 78.4 ( 14.6) 3.6

Kd post-tax = IRR = 5 + (3.6/18.2 x 5) = 5.99% 6% to the nearest %

Kp = 7/100 = 0.07 or 7%

7 B Total market value of capital = £80m + £20m + £18m = £118m

WACC = (7.7 x 80/118) + (6 x 18/118) + (7 x 20/118) = 7.3% (7.1% if book values are used).


CHECKPOINT 1

71 ANP413

8 C One rate of inflation so can use the real rate

DCF calculation

Time Flow DF PV 0 (£120,000) 1.0 (£120,000) 1 £50,000 0.91 £45,500 2 £60,000 0.83 £49,800 3 £40,000 0.75 £30,000 £5,300

Section B 1 In the UK the focus is on protecting the shareholder, because of the separation of ownership and control

– which means that the actions of managers need careful scrutiny. The main features are:

Reduction of the power of the chief executive – by having a separate, independent, chairperson and powerful non executive directors.

An active takeover market – it is very difficult to block takeovers, this is felt to be in the best interests of shareholders.

In Europe there is less of a separation between ownership and control; the main shareholders often have a large percentage of equity and are involved in the management of the business. Other stakeholders such as banks often have a large equity stake and a heavy involvement in the running of the business as well. Companies are often not listed so shareholders do not benefit from the existence of an active takeover market.

The main feature of European corporate governance is the existence of a two tier board structure which uses a supervisory board (elected by shareholders) to impose a control on the actions of the executive board. In some countries, trade unions have a powerful influence in the supervisory board.

2 Earning per share suffers from a number of problems, among these are:

It is historic, shareholders care about the future

It is not cash – shareholders often care more about the dividend they are getting than they do about the profit that the company is reporting

It does not communicate to shareholders how the company is planning for the future (i.e. its investment plans), and how these plans are going to be financed

It does not communicate to investors whether the company has a sound risk management strategy

3 The key financial objective is to maximise shareholder wealth, this requires four key decisions:

Investment planning – finding investments that will achieve a good return for shareholders

Financial planning – using a mix of debt and equity that is acceptable to the stakeholders of a business

Dividend planning – identifying whether it is better to pay out a dividend or re-invest it into the business

Risk management – use of hedging techniques to manage interest rate risk, currency risk, and other risks

4 Companies that are mature (i.e. lack growth opportunities), asset intensive (i.e. can offer security for loans) and have stable cash flows should pay high dividends and should use debt finance to fund their investment programs.


CHECKPOINT 1

72 ANP413

Checkpoint 1 – Real-life examples

Case 1 – Tesco announces £1bn makeover T H E G U A R D I A N – A P R I L 2 0 1 2 Tesco has signalled the end of the supermarket space race as it slammed the brakes on aggressive UK expansion to focus on a £1bn makeover of its existing outlets and website. The supermarket giant is trying to win back disgruntled shoppers after a shock profit warning in January exposed cracks in its UK business. Its chief executive Philip Clarke said on Wednesday that the investment would "put the heart and soul back into Tesco", which has been forced to reassess itself after suffering its first decline in UK profits in more than 20 years. "We fully recognise that we need to raise our game in the UK," said Clarke as the group reported a 1% fall in UK profits to £2.5bn [for the first time in 20 years]. With more than 2,700 stores, Tesco's domestic chain pumps out two-thirds of the group's profits. But Clarke said it had taken "a little bit too much away from the shopper" during years of penny-pinching to boost profits. To win their custom back, Clarke promised more staff on the shop floor as well as "better" products, prices and promotions. The grocer will invest £200m on 8,000 new staff for its large stores and fresh food departments, plus initiatives such as dedicated "fruit and veg teams" clad in green uniforms to help customers. It also plans to revamp 8,000 products in its standard ranges - 40% of its UK food sales. An initial 430 outlets will be overhauled this year, with the grocer promising new-look stores with a "warmer" atmosphere after shoppers complained that its stores felt cold and clinical. Tesco's problems come as retailers grapple with structural changes caused by growing numbers of consumers shopping from computers and smartphones. Clarke has slashed Tesco's "physical" opening plans for this year by nearly 40% as it prepares for the "digital era". But it will still open more than 100 stores as it focuses on expanding the Express and Metro chains alongside "dotcom-only" stores, which are used to fulfil internet orders. The sprawling Extra stores seem to be falling out of favour as shopping habits change, with clothing, DVDs and gadgets increasingly bought online. Instead Tesco is creating an Argos-style Click & Collect business where shoppers can collect goods ordered online. The service is to be rolled out to another 700 stores this year. Kantar Retail analyst Himanshu Pal said Tesco was "not on its knees, just off the boil". "There has been a clear lack of investment in stores and staff for the last couple of years. The retailer now trails several competitors in terms of fresh food offer, customer service and in-store standards." Shares closed down 2% at 321.05p. Profits at Tesco's international business, which takes in 12 countries including China and Thailand, rose nearly 18% at £1.1bn. Its contribution resulted in an overall increase in profits for the group of 1.3% to £3.8bn in the year to 25 February. Clarke moved the target that US chain Fresh & Easy breaks even from the current financial year to next year after it made "slower progress" than expected. Some investors have called for Tesco to pull out of the US, which has absorbed more than £1bn of investment, but Clarke said it was sticking with a chain that would provide "decades of growth". The four-year-old US chain, run by Tesco deputy chief executive Tim Mason, made a loss of £153m on sales of £638m. Clarke also signalled faith in the future of Tesco Bank, another business he inherited from long-serving predecessor Sir Terry Leahy. It has faced recent scrutiny from shareholders, with work on its IT systems complete and the financial services arm now "ready for further growth".

BPP Comment

This is a good example of rising profits not necessarily being enough to create a rising share price. Here, shareholders are concerned about Tesco’s future cash flows (especially given the risk of their US operations) as well as Tesco’s relatively high gearing (not mentioned in the article). There was also disappointment at Tesco’s decision to increase the dividend by only 2%, less than retail price inflation.


CHECKPOINT 1

73 ANP413

Case 2 – European corporate governance F I N A N C I A L T I M E S – J A N U A R Y 2 0 0 8 Sports carmaker Porsche signalled it would seek legal action against the German government if Berlin stuck with plans to give minority stakeholders unusual powers at Volkswagen, the carmaker Porsche wants to control.

Wendelin Wiedeking, chief executive, told shareholders at Porsche’s annual meeting that a proposed revision of the so-called VW-Law “clearly violates the European Court of Justice’s (ECJ) ruling” that last year forced Berlin to act. That puts Porsche, which owns 31 per cent of VW and wants to raise its stake to more than 50 per cent, on a collision course with the second largest shareholder, the state of Lower Saxony, which holds more than 20%.

The northern German state, home to VW, has seen its power at the carmaker cemented for half a century by an anti-takeover clause in the VW-Law that restricts voting rights to 20% even if someone owns more shares. The ECJ upheld the European Commission’s case that the rule hindered the free flow of capital. Berlin proposed to drop it, but also to give anyone with 20% a veto over big moves – a right that usually kicks in at 25 per cent. Mr Wiedeking said passage of the bill could see Porsche’s “fundamental proposals” – big cost cuts have been mooted – “blocked by Lower Saxony, which owns 20.1 per cent of VW – exactly the planned veto threshhold”.

F I N A N C I A L T I M E S – M A Y 2 0 0 9 (extract)

Shortly before Easter Porsche was struggling to refinance its debt and had started the negotiations with banks too late: the global financial crisis had changed the banking world. At that point, Wendelin Wiedeking, the blunt-speaking chief executive who had saved Porsche in the early 1990s – knew that the takeover plan had failed.

It became clear that Germany’s “Volkswagen law” – which gives the state of Lower Saxony special voting rights and had long been opposed by the European Commission – would not after all be overturned. Christian Wulff, the Lower Saxon premier, had enlisted the help of Angela Merkel, German chancellor, and headed off the Commission’s objections with an only modestly revised version of the law. That made it impossible for Porsche to win approval for a “domination agreement” that would give it total control. “Porsche did not think we were capable of doing that. They have simply underrated us,” Mr Wulff recently told party colleagues.

Matters came to a head when the families gathered this month (May) in Salzburg, Austria, where many of them live. In a loosely worded statement they promised to create an “integrated car manufacturer”, with Porsche as an independent tenth marque alongside parts of the VW group such as Audi, Skoda and Bentley. Some scoffed that the wording resembled a “G20 communiqué” that left ample room for different interpretations.

BPP Comment

Porsche had being trying to take over VW for many years. Porsche accumulated significant debts in the process of trying to acquire VW, and as a result was taken over by VW in 2009. The takeover was completed in July 2012. This saga illustrates the power that family groups and government regulations have in the running of major European companies.

Case 3 – 2012 Britain’s year of corporate shame T H I S I S M O N E Y . C O . U K – D E C 2 0 1 2

When the history books are written, 2012 will go down in the annals as Britain’s year of corporate shame. As FTSE 100 giants fell like ninepins under the wrath of UK and US regulators, one company, Rolls-Royce, stood out as a beacon of probity. It was our one undisputed champion of manufacturing and a standard bearer for British excellence around the world. Not any more. In a terse statement yesterday, the aero-engineer confessed it has passed information to the Serious Fraud Office (SFO) about bribery and corruption involving its middlemen in overseas markets, including China and Indonesia. No doubt to his intense anger and disgust, Rolls’ chief executive John Rishton has joined the sorry list of those whose companies stand accused of involvement in murky dealings. It will be little consolation that he is not alone. The country’s largest banks disgraced themselves with Libor rate-rigging and money-laundering. GlaxoSmithKline paid a £1.9bn fine for its involvement in the ‘biggest healthcare scandal in US history’ and BP continued to pay the multi-billion pound price for the Macondo oil disaster. BAE Systems, no stranger itself to


CHECKPOINT 1

74 ANP413

scandal, tried to clamber into a merger with European aerospace combine EADS at a time when the latter’s UK subsidiary GPT is under investigation for bribery by the SFO. It is not yet clear how damaging the issues at Rolls will prove, but the risk is that its so-far exemplary reputation will be badly tarnished. Rolls said it had passed to the SFO information over concerns relating to bribery and corruption involving middlemen in overseas markets, including China, Indonesia and other territories. Rolls launched a probe, conducted by an un-named external law firm, after the SFO approached it with a request for information on its dealings in Indonesia and China. The principal concerns are said to date back to the ‘distant past’, which is understood to mean the 1980s, when corporate ethics and behaviour were rather different. The implication, however, is that lesser – though still potentially serious – wrongdoing may have taken place much more recently. Other bribery & corruption cases have involved lurid allegations of slush funds, suitcases stuffed with cash & bribes funnelled through exotic tax havens. GPT is accused of showering Saudi generals with luxury cars, jewellery and cash gifts to win a contract to upgrade satellite systems for the National Guard. The bribes are said to have been handed out by shadowy middlemen, with dirty money routed via the Cayman Islands. Rolls is making much of the fact that it has recently strengthened its ethics and compliance. It set up an ethics committee in 2008 and a year later set out a new policy with stronger controls over its middlemen. Rishton is now appointing an independent senior figure to lead a review of procedures, a move already made by BAE, which hired Lord Woolf in a similar capacity following the Al Yamamah scandal. The firm also stresses that it makes much less use of middle men than in the past, though it still has around 100 of them, mainly companies rather than individuals. Local Mr Fix-its can provide a valuable and legitimate service, thanks to their knowledge & contacts. Indeed, one former senior BAE executive believes that company’s decision to stop using intermediaries has cost it valuable business – a claim denied by the current marketing supremos. The unfortunate thing is that they are hard to control from a boardroom suite thousands of miles away. Rolls could end up paying a heavy price financially. BAE ended up with a £279m in a joint settlement with the SFO and the DoJ over the Al Yamamah contract with Saudi Arabia; German engineer Siemens was fined £500m in the US in 2008 over bribery and corruption. Many would argue that there are still plenty of parts of the world where what we see as bribes are viewed as a natural part of doing business, and that if companies insist on being squeaky clean, they will lose out. Be that as it may, the authorities are showing little mercy.

Case 4 – Sustainability E C O N O M I A – M A R C H 2 0 1 2

(extract) There may still be hundreds of businesses in the UK led by people who, to be frank, couldn’t give a monkey’s about sustainability. But whether an entrepreneur or board member is a Green Party card-carrier or a climate change sceptic is becoming irrelevant. There are now just too many good business reasons to adopt a sustainable approach. Nor has the sustainability agenda been weakened by the recession, because one of the most immediately obvious effects of a sustainable approach is the generation of significant cost reductions. "This is a bottom line issue," says Jae Mather, director of sustainability at accountancy firm HW Fisher & Co. "It’s not going away. It can be cheaper to reduce your costs than to increase your income." Many organisations that have embraced sustainability now use the concept of the triple bottom line, a concept that involves combining the traditional financial bottom line with metrics for environmental and social impacts. In part, the advance of sustainability is a consequence of regulatory change. The UK government’s Carbon Reduction Commitment (CRC) Energy Efficiency Scheme now requires the private and public sector organisations that consume the most energy per year (only about 2% of organisations) to report energy efficiency in detail. In November, for the first time, league tables revealing their performances in this area were published. It is all but certain that energy efficiency reporting will gradually become mandatory for smaller organisations too. Retailers, manufacturers and other organisations are also increasingly anxious to avoid reputational damage as a result of working with business partners that behave unethically. It is possible that within the next few years new rules for ethical procurement in the public sector will be introduced, giving suppliers to the public sector another good reason to practise sustainability.


CHECKPOINT 1

75 ANP413

Large organisations that have implemented sustainability initiatives can point to some significant results. In 2010 Unilever introduced its Sustainable Living Plan. Its three goals are to halve the environmental footprint of its products by 2020, to source 100% of agricultural raw materials sustainably; and to help one billion people take action to improve their health and wellbeing. "Underlying these three big targets are 50 separate commitments," says Helen Fenwick, Unilever Sustainable Living Plan manager, Unilever UK and Ireland. "They cover everything from salt reduction in stock cubes to reducing the impact of washing our clothes and showering, to the use of renewable energy in our factories." Unilever plans to halve the waste associated with disposal of its products by 2020, through reducing, reusing and recycling packaging; and reducing manufacturing process waste. "Since 1995 we have reduced waste by nearly three quarters, [emissions of ] greenhouse gases by 40% and water [consumption] by two thirds in our 250 factories," says Fenwick. "Our 11 manufacturing sites in the UK, two R&D sites at Port Sunlight and Colworth and two major offices in London and Leatherhead no longer send waste to landfill. Following an agreement with [waste services supplier] Veolia 97% of waste is recycled. The remaining 3% is converted into usable energy." There have also been consumer recycling projects involving plastics and aluminium. Sticking to Plan A One of the UK’s biggest retail names, Marks & Spencer, launched its Plan A sustainability programme in 2007, making 100 commitments to be achieved within five years. This has now been extended to 180 commitments related to climate change mitigation, waste reduction, use of sustainable raw materials and ethical trading, to be achieved by 2015. "Because of the scale of our ambition and what we needed to deliver, we had to embed Plan A in the business, getting every bit of the business to own it and drive it forward," says Adam Elman, head of Plan A delivery at M&S. "We needed programme controls and governance for 75,000 employees. By year two we were saving as much money as we were spending. By year three we’d delivered a net benefit of £50m. Last year that had risen to £70m. So it isn’t just a green, fluffy corporate social responsibility programme. It’s the right thing to do for sustainability in its wider sense and in terms of the sustainability of the business. But the business case is much bigger than the cash figure. Around employees it’s about motivation and inspiration. From an employee point of view, working for a business that wants to do the right thing has become a positive. Employees talk about Plan A as a reason to join the company. There’s a big brand benefit too." Plan A has also generated cost savings in the supply chain through measures including use of more fuel-efficient vehicles transporting more products. M&S has also partnered with suppliers to create eco-factories, where new techniques can be trialled. Sustainability innovations tried out in new stores, such as LED lights, sustainable timber and recycled bricks, have since been incorporated into the company’s standard store build specifications. Elman says developing ways of measuring the cost benefits of Plan A has been complicated. "There is no historical precedent, but we’ve come up with something we think is robust. We have people working on this across the business. It’s now part of our financial analysts’ roles. It also identifies opportunities. It helps us look at costs and benefits from a total business level – for example, the total costs for printing and paper, ink, technical support and so on. You can look at the whole life cost of equipment and at future operating costs." Alongside these actions the retailer has nurtured partnerships with other organisations to help reduce negative environmental impacts, such as the Oxfam Clothes Exchange, which stops old clothes going into landfill. B B C W E B S I T E

Kyoto Protocol

After seven years of debate between leaders, politicians and scientists, on 16th February 2005 the 1997 Kyoto Protocol to control climate change finally became international law. Industrialised nations who sign up to the treaty are legally bound to reduce worldwide emissions of six greenhouse gasses (collectively) by an average of 5.2% below their 1990 levels by the period 2008-2012. The final ratified agreement means Kyoto will receive support from participating countries that emit 61.6% of carbon dioxide emissions. The protocol is officially the first global legally binding contract to reduce greenhouse gases.

Now the agreement is law, if any of the participating countries exceed their proposed 2012 target, they will then have to make the promised reductions from the 2012 target and an additional 30% more in the next period. The EU and Japan have already promised to reduce to pollution by 8% from their respective 1990 levels.

Individually, each country has developed its own method to meet its targets. The EU has setup a market by which 12,000 factories and power stations are given a carbon dioxide quota. If they exceed this amount they can purchase extra allowances or pay a financial penalty. If they fall below the amount they can sell on the extra quota.


CHECKPOINT 1

76 ANP413

There are still, parties who won't sign up to the agreement. The US, the world’s largest greenhouse gas polluter, says signing up would ruin the US economy and the pact wrongly disregards developing countries. Australia, which has a large coal industry, supports the US view and has also opted out. The Australian government has instead developed its own scheme called "The National Greenhouse Strategy". This will attempt to reduce emissions by only 10.1% by 2012, which is an 8% increase on 1990 levels. December 2011 update

UN climate talks have closed with an agreement that the chair said had "saved tomorrow, today". The European Union will place its current emission-cutting pledges inside the legally-binding Kyoto Protocol, a key demand of developing countries. Talks on a new legal deal covering all countries will begin next year and end by 2015, coming into effect by 2020. Management of a fund for climate aid to poor countries has also been agreed, though how to raise the money has not. The conclusion was delayed by a dispute between the EU and India over the precise wording of the "roadmap" for a new global deal. India did not want a specification that it must be legally binding. Eventually, a Brazilian diplomat came up with the formulation that the deal must have "legal force", which proved acceptable. The roadmap proposal originated with the EU, the Alliance of Small Island States (Aosis) and the Least Developed Countries bloc (LDCs). They argued that only a new legal agreement eventually covering emissions from all countries - particularly fast-growing major emitters such as China - could keep the rise in global average temperatures since pre-industrial times below 2C (3.6F), the internationally-agreed threshold. Impassioned arguments Delegates from the Basic group - Brazil, South Africa, India and China - criticised what they saw as a tight timetable and excessive legality. "I stand firm on my position of equity," said an impassioned Jayanthi Natarajan, India's environment minister. "This is not about India, it is about the entire world." India believes in maintaining the current stark division where only countries labelled "developed" have to cut their greenhouse gas emissions. Western nations, she said, have not cut their own emissions as they had pledged; so why should poorer countries have to do it for them? Green fund A management framework was adopted for the Green Climate Fund, which will eventually gather and disburse finance amounting to $100bn (£64bn) per year to help poor countries develop cleanly and adapt to climate impacts. There has also been significant progress on Reducing Emissions from Deforestation and forest Degradation (REDD). Environment groups were divided in their reaction, with some finding it a significant step forward and others saying it had done nothing to change the course of climate change. Many studies indicate that current pledges on reducing emissions are taking the Earth towards a temperature rise of double the 2C target. B B C W E B S I T E – D E C E M B E R 2 0 1 2

Doha The Kyoto protocol on climate change had been due to expire later this year. UN climate talks in Doha have closed with a historic shift in principle but few genuine cuts in greenhouse gases. The summit established for the first time that rich nations should move towards compensating poor nations for losses due to climate change. Developing nations hailed it as a breakthrough, but condemned the gulf between the science of climate change and political attempts to tackle it. The deal, agreed by nearly 200 nations, extends to 2020 the Kyoto Protocol. It is the only legally-binding plan for combating global warming. The deal covers Europe and Australia, whose share of world greenhouse gas emissions is less than 15%. But the conference also cleared the way for the Kyoto protocol to be replaced by a new treaty binding all rich and poor nations together by 2015 to tackle climate change. The final text "encourages" rich nations to mobilise at least $10bn (£6bn) a year up to 2020, when the new global climate agreement is due to kick in. The big players, the US, EU and China accepted the agreement with varying degrees of reservation. But the representative for the small island states at severe risk from climate change was vociferous. "We see the package before us as deeply deficient in mitigation (carbon cuts) and finance. It's likely to lock us on the


CHECKPOINT 1

77 ANP413

trajectory to a 3,4,5C rise in global temperatures, even though we agreed to keep the global average temperature rise of 1.5C to ensure survival of all islands," he said. "There is no new finance (for adapting to climate change and getting clean energy) - only promises that something might materialise in the future. Those who are obstructive need to talk not about how their people will live, but whether our people will live." The proposed new Loss and Damage mechanism is held up as an example of the success of the diplomatic process. Until now rich nations have agreed finance to help developing countries to get clean energy and adapt to climate change, but they have stopped short of accepting responsibility for damage caused by climate change elsewhere. But in Doha that broad principle was agreed.

Case 5 – IMF F I N A N C I A L T I M E S – D E C E M B E R 2 0 1 1

What have the Europeans agreed to give the IMF? One of the few almost-concrete decisions out of last week’s summit was for European Union countries to contribute about €200bn to the International Monetary Fund, with the money likely to come from bilateral loans from their central banks. On Sunday, the German Bundesbank was the first to get down to specifics, telling the German news agency DPA that it would be contributing €45bn. Where will the money come from and, if it is lent to Spain and Italy, isn’t that just circular? National central banks are allowed to create euros and lend them to the IMF if the European Central Bank permits it. The advantage of routing the money via the IMF rather than, say, the Bundesbank just printing money and giving it to Italy is that the fund takes on the credit risk. It seems likely that the money will go into the IMF’s general resources account, where in theory it can be lent to any of the fund’s 187 member countries but in practice it is western Europe that has the most overwhelming need for it. Will it allow the IMF to bail out Spain and Italy? Even with the extra money and a possible matching €200bn from non-European countries, the IMF could not finance a substantial bail-out for Spain and Italy on its own. The gross financing needs (new debt and rolling over existing debt) of the two countries over the next two years equal at least €600bn, so a rescue that would entirely take them out of the capital markets until the end of 2013 is out of the fund’s reach. Two other options present themselves. One, a giant bail-out largely financed by the eurozone itself through its own rescue funds, with the IMF playing a supporting role. Two, favoured by some involved in negotiations, is a smaller programme designed to ease short-term pressures on Spain and Italy but keep them borrowing in private capital markets, using a recently extended IMF liquidity facility. Under that facility, Italy and Spain together could only borrow about €140bn over the next year. What do the IMF’s other member countries think? The US and some other rich countries, including Canada and Australia, have been cool to the idea of a big IMF bail-out for western Europe. It is worth noting that the IMF has preferred creditor status in case of a default and has never taken a capital loss. Countries typically count the budgetary cost of contributing to the IMF as nil, since it means moving money in their foreign exchange reserves from one account to another rather than spending it. And the emerging markets? The Brics countries have said they will contribute to the eurozone’s rescue, but have insisted it be through the IMF. Some observers think that the Brics countries and Japan together could match the eurozone’s €200bn. When the IMF last did a round of emergency financing in 2009, China contributed about €40bn and Brazil €11bn. But they too will be wary of ploughing a huge amount of IMF lending into an uncertain situation in the eurozone. Does that give the emerging markets more power in the IMF? Not immediately, but possibly in the future. The voting weights on the fund’s executive board are determined by how much money each member government puts in under the regular so-called “quota” contributions, which are tortuously negotiated every few years, rather than ad hoc loans such as those being proposed.


CHECKPOINT 1

78 ANP413

Case 6 – Exchanges fight over new IPOs F I N A N C I A L T I M E S – F E B R U A R Y 2 0 0 8 The dreary prospects for new share offerings this year mean stock exchanges are competing for business in a shrinking market. Volatility and risk aversion have caused the cancellation of planned issues worth more than $28.7bn in the first two months alone – a record – according to data tracked by Thomson Financial. However, when the market stabilises, the main source of activity will be from companies in emerging markets seeking to raise capital, bankers believe. Almost 80 per cent of the 38 companies “in the pipeline” to raise more than $1bn each this year are from developing countries, according to Thomson. The trend started last year when emerging market share sales dominated trading volumes.

That should be good news for the London Stock Exchange, which has become a top destination in recent years for emerging market issuers, particularly those from Russia and other countries of the former Soviet Union. Over half the value of flotations completed in London’s main market last year were by overseas companies, says Richard Weaver, partner in the capital markets group at PwC.

Avtovaz, the Russian carmaker, plans to float up to a quarter of its shares in a secondary placement in both Moscow and London this autumn. Two Russian banks, KIT Finance and Bank Zenit, are considering initial public offerings – possibly in London – though the timing is uncertain. Sergey Grechishkin, deputy general director at KIT Finance, says: “I think the main driver for Russian companies choosing an exchange is the liquidity and to a certain extent the listing rules. “With the onerous rules in the US, London is the obvious choice compared to other European exchanges, in terms of deeper liquidity and access to a far greater pool of investors.”


79 ANP413


Syllabus learning outcomes

How has this been examined ?



Evaluate the potential value added to a firm arising from a specified capital investment project or portfolio using the net present value model. Project modelling should include explicit treatment of:

(a) Inflation & specific price variation (b) Taxation including capital allowances and tax exhaustion (c) Single & multi-period capital rationing to include the

formulation of programming methods and the interpretation of their output

(d) Probability analysis and sensitivity analysis when adjusting for risk and uncertainty in investment appraisal

(e) Risk adjusted discount rates (covered in chapter 7)

Outline the application of Monte Carlo simulation to investment appraisal. Candidates will not be expected to undertake simulations in the exam but will be expected to demonstrate understanding of

(a) simple model design (b) the different types of distribution controlling the key variables

in the simulation (c) the significance of the simulation output and the assessment

of the likelihood of project success (d) the measurement and interpretation of project value at risk Establish the potential economic return using IRR and modified

IRR & advise on a project’s return margin. Discuss merits of NPV & IRR.

Discounted cash flow techniques are also extensively examined in the context of business valuations (business valuations are covered in chapters 9-12).

Slow Fashions - 20 marks, June 09 Your business - 28 marks, June 09 Seal island - 24 marks, June 2010 Q1i,ii,iii Seal island - 4 marks, June 2010 Q1iv Tisa Co- 4 marks, June 2012 Q4c Tisa Co- 8 marks, June 2012 Q4b Neptune- 6 marks, June 2008 Q5b

DCF techniques and the use of free cash flows (continued)



80 ANP413

Overview



DCF techniques & the use of free cash flows

Impact of capital rationing on project appraisal

Impact of a capital investment project on dividend capacity

Estimating the potential value added to a firm from a capital investment project



81 ANP413

Lecture example 2 (from day 1) Avanti plc is considering a major investment programme which will involve the creation of a chain of retail outlets throughout the United Kingdom. The following cash flows are expected. Time 0 1 2 3 4 £’000 £’000 £’000 £’000 £’000 Land and Buildings 3,250 Fittings and Equipment 700 Gross Turnover 1,800 2,500 2,800 3,000 Direct Costs 750 1,100 1,500 1,600 Marketing 170 250 200 200 Office Overheads 125 125 125 125 (a) 60% of office overhead is an allocation of head office operating costs. (b) The cost of land and buildings includes £80,000 which has been spent on surveyors’ fees. (c) Avanti plc expects to be able to sell the chain at the end of year 4 for £4,000,000. Avanti plc is paying corporate tax at 30% and is expected to do so for the foreseeable future. Tax is paid one year in arrears. The company will claim capital allowances on fittings and equipment at 25% on a reducing balance basis. Capital allowances are not available on land and buildings. Estimated resale proceeds of £100,000 for the fittings and equipment have been included in the total figure of £4,000,000 given above. Avanti plc expects the working capital requirements to be 15% of turnover during each of the four years of the investment programme. Avanti’s real cost of capital is 7.7% p.a. Inflation at 4% p.a. has been ignored in the above information. This inflation will not apply to the resale value of the business which is given in nominal terms. Solution to NPV

Net Present Value working (All figures £'000s)

Year 1 2 3 4 5 Sales 1800 2500 2800 3000 Direct Costs (750) (1100) (1500 (1600) Marketing (170) (250) (200 (200) Office overheads (40%) (50) (50) (50 (50) Net Real Operating flows 830 1100 1050 1150 Inflated at 4% (rounded) 863 1190 1181 1345 Taxation at 30% in arrears 0 (259) (357 (354) (404) Tax relief from capital allowances 0 53 39 30 58 Resale value 0 0 0 4000 Working Capital Cash flows (120) (64) (52 506 Net Nominal cash flows 743 920 811 5527 (346) 12% Discount Rate 0.893 0.797 0 0.636 0.567 Present Values 663 733 577 3515 (196)Less Initial Investment (3250-80+700+270) (4140)NET PRESENT VALUE 1152



82 ANP413

3 Internal rate of return (IRR) 3.1 Internal rate of return is a discounted cash flow technique of a project that calculates the

% return given by a project; accept the project if the IRR is > the cost of capital.

Three step approach 3.2 Step 1 – calculate the NPV of the project at 5%

Step 2 – calculate the project at 10% Step 3 – calculate the internal rate of return using the formula

Formula

IRR = a + bNPVa - NPV

NPVa (b-a)

(you will need to learn the formula for the exam)


Required

Calculate the IRR of Avanti’s proposed investment.

Solution Net Present Value working at 12% = +1152 Redo the NPV at 15% Time 0 1 2 3 4 5 £000s -4140 743 920 811 5527 -346 d.f @15% 1.000 0.870 0.756 0.658 0.572 0.497 PV

IRR =



83 ANP413

Modified IRR 3.3 IRR assumes that the cash flows after the investment phase (here time 0) are

reinvested at the project’s IRR. In the previous Lecture example the 20% IRR was approximate, on an excel spreadsheet the IRR is 21%. Here is the proof. Time 1 2 3 4 5 £000s 743 920 811 5527Reinvest to time 5 at 21% x 421.1 x 321.1 x 221.1 x 21.1

Value at time 5 1593 1634 1187 6688

Terminal value 10756

The total return is 10756/4140 = 2.598 so the annual return= 598.25 = 1.21 ie 21%

3.4 A better assumption is that the funds are reinvested at the investors minimum required return (WACC) here 12%.

Time 1 2 3 4 5 £000s 743 920 811 5527Reinvest to time 5 at 12% x 412.1 x 312.1 x 212.1 x 12.1

Value at time 5 1169 1293 1017 6190

Terminal value 9323

The total return is 9323/4140 = 2.252 so the annual return is 252.25 = 1.176 ie 17.6%

this is the modified IRR

3.5 You are provided with a formula to calculate MIRR; in the formula below the return phase is the phase of the project from when cash inflows have commenced.

111

i

n/

phaseinvestmentPVphasereturnPV i = cost of capital


Using the formula, calculate the modified IRR of Avanti’s proposed investment.

Solution



84 ANP413

Advantages of MIRR

3.6 Using the formula, MIRR is quicker to calculate than IRR, it makes a more realistic assumption about the reinvestment rate, and does not give the multiple answers that can sometimes arise with the conventional IRR.

3.7 The extent to which the MIRR exceeds the cost of capital is called the return margin and indicates the extent to which a new project is generating competitive advantage.

4 Risk and uncertainty 4.1 Before deciding to spend money on a project, managers will want to be able to make a

judgement on its risk (predictable) and uncertainty (not predictable).

Risk

Techniques Description Expected values Using probabilities to calculate average expected NPV.

Risk adjusted discount factor

Using a higher cost of capital if the project is high risk, this is discussed in chapter 7.

Uncertainty

Techniques Description Payback period The quicker the payback the less reliant a project is on the later,

more uncertain, cash flows.

Discounted payback period

As above but uses the discounted cash flows and is a better method since it adjusts for time value.

Sensitivity analysis An analysis of what % change in one variable (eg sales) would be needed for the NPV of a project to fall to zero. Calculated as NPV of project / PV of sales (for example)

Simulation An analysis of how changes in more than 1 variable (eg earlier than expected competitor reaction and an adverse change in the exchange rate) may affect the NPV of a project

Project duration A measure of how long it takes to recover approximately half of the value of the investment; it is calculated by weighting each year of the project by the % of the present value of the cash inflows recovered in that year.



85 ANP413


Required Calculate the discounted payback period and the project duration for Avanti.

Solution Discounted payback Time 0 1 2 3 4 5 PV -4140 663 733 577 3517 -196

Project duration Time 1 2 3 4 5 PV as % of PV of inflows 4140+1152=5292



86 ANP413

5 Measuring risk – value at risk 5.1 A modern approach to quantifying risk involves estimating the likely change in the value of

an investment by using the concept of a normal distribution.

5.2 The standard properties of a normal distribution curve can be seen by analysing the normal distribution table (given in the exam).

Lecture example 6 Technique demonstration Required

Analyse a normal distribution table to demonstrate the maximum reduction in value that would be expected 95% of the time.

Solution

5.3 The value at risk in the above lecture example is the maximum likely loss over the next 24 hours (with only a 5% chance of being exceeded).

Change in value

Frequency

0 losses gains



87 ANP413

5.4 This can be illustrated as follows:

5.5 Value at risk can be quantified for a project using simulation to calculate the project’s standard deviation. In this context, the standard deviation needs to be adjusted by multiplying by the square root of the time period ie 95% value at risk = 1.645 x standard deviation of project x √time period of the project

Lecture example 7 Technique demonstration A four-year project has an NPV of $2m and a standard deviation of $1m per annum. Required Analyse the project’s value at risk at a 95% confidence level.

Solution

Value at risk and Monte-Carlo simulation 5.6 Where the assumption of a normal distribution is not appropriate, the risk of a project can be

measured by simulating the possible NPVs and weighting the outcomes by probabilities determined by management. This could be used to assess the probability, for example, of a project’s NPV exceeding zero.

50% 5%

Change in daily value

Frequency

01.645 std dev

45%

Q7 Jonas



88 ANP413

6 Chapter summary Section Topic Summary 1 Capital

budgeting process

The main stages are: Collecting ideas

Preliminary screening - analysis of business logic

Financial analysis

Authorisation, monitoring and review

2 NPV The value added to a firm from a capital

investment project can be assessed using NPV. Where inflation is present it is normally correct to inflate the cash flows and to ensure that a nominal cost of capital is used, the major exception is domestic projects where there is only one rate of inflation. A cost of capital will be nominal because investors expect inflation, it only needs to be adjusted if a question states that it is real.

3 IRR Where IRR is used, the problems with the reinvestment assumption mean that a modified IRR approach is normally a better measure of the economic return of a project. This involves compounding the cash flows after the investment phase at the firm’s cost of capital and then analysing the annual return given on the PV of the investment.

4&5 Risk & uncertainty

Where risk is being analysed discounted payback period or project duration is a better way of assessing the reliance of a project on later cash flows. Value at risk is also a useful and commonly used risk measurement device.

END OF CHAPTER


89 ANP413





Apply the Black-Scholes option pricing model (BSOP) to financial product / asset valuation:

(i) Determine & discuss, using published data, the five principal drivers of option value (value of the underlying, exercise price, time to expiry, volatility and the risk-free rate)

(ii) Discuss the underlying assumptions, structure, application and limitations of the BSOP model

Evaluate embedded real options within a project, classifying them into one of the real option archetypes.

Assess, calculateand advise on the value of options to delay, expand, redeploy and withdraw using the BSOP model.

This chapter is most likely to be tested in numerical questions that ask you to value call and put options in a variety of different contexts. Chapter 10 and 15 will revisit this area.

Digunder - Q3 Dec 2007 Alaska Salvage - Q3 Dec 2009 MMC - Q4 June 2011

Application of option pricing theory in investment decisions & valuations


6: APPLICATION OF OPTION PRICING THEORY IN INVESTMENT DECISIONS & VALUATIONS

90 ANP413

Overview



Application of option pricing theory Some investments offer flexibility or real options. Management need to be aware of these and can attempt to value them using the Black-Scholes option valuation model.



91 ANP413

1 Real options in decision making 1.1 Projects can be analysed to assess their value under different business scenarios.


Entraq plc is considering two proposals to invest in the manufacture of solar panels: Proposal A - to build a customised plant with specialist staff in Cornwall, which can only be used to construct solar panels. This proposal would build Entraq’s profile in the solar panel industry. Proposal B - to use more expensive machinery in Entraq’s existing premises in Basingstoke that could be adapted to produce components for the wind power industry. A general election is expected next year that will affect the likely growth of the solar panel industry. Required

Identify the real options present in these investments.

Solution Proposal A

Proposal B

Real options

Option to withdraw – easy to sell assets if the project fails, or low clear-up costs PUT OPTION

Option to expand – if successful, technology or brand name will be used in other projects CALL OPTION

Option to redeploy – assets can easily be switched from one project to another PUT OPTION

Option to delay – could mean that valuable new business information is available CALL OPTION



92 ANP413

2 Components of option value

Intrinsic value and time value – introduction to option valuation 2.1 There are five main components to the value of an option. Here these are applied to an

option to buy a share for £4 in 3 years time; the share price today is £5. (a) Intrinsic value, the difference between

(i) the current value of the asset = share price e.g. £5 (ii) the exercise price of the option = option price e.g. £4

(b) The time value of the premium, reflecting the uncertainty surrounding the intrinsic value between now and the exercise date. Relevant factors are: (i) variability in the value of the asset = standard deviation of the share (ii) time until expiry of the option = 3 years (iii) interest rates = risk free rate

2.2 If you had been told that the time value of an option was £2, then the value of this share option would be £2 time value + £1 intrinsic value = £3. The full mechanics of the calculation of the value of options are covered below.

Calculating real option prices using the Black Scholes model 2.3 Value of a call option at time 0

rt)eN(deP)N(daPC 210

N(dx) is the cumulative value from the normal distribution tables for the value dx

tstsr)e/Pa(Pd )25.0(ln

1

Ts1d2d

Pa = PV of the cash inflows Pe = Cost of the investment r = Risk free rate of return t = Time to expiry of option in years s = Standard deviation of the project


Project A has an NPV of – £10,000; it will also develop expertise so that Entraq would be ready to penetrate the European market with an improved product in four years' time. The expected cost at time 4 of the investment is £600,000. Currently the European project is valued at 0 NPV but management believe that economic conditions in four years' time may change and the NPV could be positive. The standard deviation is 30%, the risk free rate is 4%% and the cost of capital is 10%. Required

Evaluate the value of this option to expand.



93 ANP413

Solution



94 ANP413

2.4 Value of a put option at time 0 rteePaPCP

C = value of a call option P = value of a put option


Company X is a considering an investment in a joint venture to develop high quality office blocks to be let out to blue chip corporate clients. This project has a thirty year life, and is expected to cost Company X £90m and to generate an NPV of £10m for Company X. The project manager has argued that this understates the true value of the project because the NPV of £10m ignores the option sell Company X’s share in the project back to its partner for £40m at any time during the first 10 years of the project. The standard deviation is 45% p.a., and the risk free rate is 5% p.a. Required

Evaluate the value of this option to withdraw.



95 ANP413

Solution



96 ANP413

3 Drawbacks of the Black-Scholes model 3.1 The most significant drawback of the Black-Scholes model is the estimation of the

standard deviation of the asset. Historic deviation is often a poor guide to expected deviation in the future, so in reality the standard deviation is based on judgement.

3.2 The formulae also assume that the options are ‘European’ ie exercisable on a fixed date; an alternative model (the binomial model) can be used to value ‘American’ style options, this model is beyond the scope of this syllabus.

4 Chapter summary 4.1 Going beyond traditional NPV analysis, projects can be analysed to assess their value

under different business scenarios, there are four types of real options.

4.2 The most significant drawbacks of the Black-Scholes model is the estimation of the

standard deviation of the asset and the assumption that the options are ‘European’ ie exercisable on a fixed date.

END OF CHAPTER

Option to withdraw – easy to sell assets if the project fails, or low clear-up costs PUT OPTION

Option to expand – if successful, technology or brand name will be used in other projects CALL OPTION

Option to redeploy – assets can easily be switched from one project to another PUT OPTION

Option to delay – could mean that valuable new business information is available CALL OPTION


97 ANP413




Assess the appropriateness of sources of finance - equity, debt, hybrids, lease finance, venture capital, business angel finance, private equity, asset securitisation (see chapter 19) & islamic finance (see ch 19). Include assessment of the financial position, financial risk & value.

Calculate the cost of capital of a firm, including the cost of equity & debt. Discuss the appropriateness of using the cost of capital and discuss its relationship to value. (see chapter 2)

Calculate & evaluate project specific cost of equity & debt, including impact on the overall cost of capital. Show detailed knowledge of business & financial risk & relationship between equity & asset betas.

Assess the impact of financing & capital structure on a firm with respect to: pecking order theory, static trade off theory and agency effects & Modigliani & Miller before & after tax

Apply the APV technique to the appraisal of investment decisions that entail significant alterations in the financial structure of the firm, including their fiscal and transaction costs implications.

Assess the impact of a significant capital investment project on the reported financial position & performance of a firm taking into account alternative financial strategies (see ch 12).

Business valuations (see later) can involve using another company’s beta factor to calculate a Ke, where this happens Modigliani & Miller theory is used to adjust beta factors for differences in gearing; Adjusted present value calculations are a likely area. Discussion of the use of debt finance is also a common area.

Your company - approx 15 marks for adjusting betas BBS Stores - 10 marks adjusting a WACC for changes in business profile, Q2 June 09 Q5, June 2008 Q2 Dec 2010 exam Q1 Dec 2011 exam

Assess a company’s debt exposure to interest rate change using the Macaulay duration method. Discuss the benefits and limitations of duration including the impact of convexity.

Assess the company’s exposure to credit risk, including: (i) The role of, & the risk models used by, rating agencies. (ii) Estimate the likely credit spread over risk free (iii) Estimate the firm’s current cost of debt capital using the

appropriate term structure of interest rates & credit spread

Explain the role of the BSOP model in the assessment of default risk, the value of debt and its potential recoverability

This has mainly been examined by testing your ability to estimate the cost of debt using credit spreads.

Q3 June 2011 Q4 new pilot paper Q5, Dec 2007 Q3 Dec 2008

Impact of financing on investment decisions and adjusted present values


7: IMPACT OF FINANCING ON INVESTMENT DECISIONS & ADJUSTED PRESENT VALUES

98 ANP413

Overview

Financing decision


Investment decision Dividend decision

Investment decisions must reflect the business risk and the financial risk of a project

Impact of financing on investment decisions Tax saved from use of debt can reduce the cost of capital & increase the value added by a projects; this can be assessed by APV.



99 ANP413

1 The impact of financing on investment decisions

Theories of capital structure 1.1 As noted in chapter 2, debt is cheaper than equity so it is sensible for companies with stable

cash flows to use some debt finance. Traditional theory suggests that using some debt will lower the weighted average cost of capital (WACC), but if gearing rises above an acceptable level then the cost of equity will rise dramatically causing the WACC to rise.

Modigliani & Miller (M&M) theory 1.2 M&M demonstrated that, ignoring tax, the use of debt simply transfers more risk to

shareholders, and that this makes equity more expensive so that the use of debt does not reduce finance costs ie does not reduce the WACC.

1.3 M&M then introduced the effect of corporation tax to demonstrate that if debt also saves corporation tax then it does reduce finance costs, which benefits shareholders ie it reduces the WACC. This suggests that a company should use as much debt finance as it can.


Required (a) Discuss how this theory affects the use of the WACC to evaluate a project financed mainly

by debt (b) Discuss what will happen to the cost of equity (Ke) as the level of debt rises

Solution (a) (b)

Cost of capital

WACC

Gearing increasing



100 ANP413

Revised formula for Ke 1.4 M&M’s formula for the Ke of a geared company reflects the effects of using debt finance –

the benefit of the tax relief and the extra financial risk that it brings.

eVdV

dKieKTi

eKeK ))(1( (formula is given)

eK = cost of equity of a geared company, ieK = cost of equity in an ungeared company

dK = cost of debt (pre-tax) dV eV = market value of debt & equity


An ungeared company with a cost of equity of 12% is considering adjusting its gearing by taking out a loan at 6% and using it to buy back equity. After the buyback the ratio of the market value of debt to the market value of equity will be 1:1. Corporation tax is 30%. Required (a) Calculate the new Ke, after the buyback. (b) Calculate and comment on the WACC after the buyback (homework exercise)

WACC=

VdVeVe Ke +

VdVeVd Kd (1-t)

Solution (a) (b)

Drawbacks of M&M 1.5 A key assumption of M&M theory is that capital markets are perfect ie a company will

always be able to raise finance to fund good projects. In reality this is not true.

Capital market imperfections Discussion Direct financial distress costs Costs of higher debt payments Indirect financial distress costs Loss of sales / higher costs from suppliers. Agency costs Restrictive covenants prevent firms investing.



101 ANP413

Static trade off theory 1.6 Myers argues that these imperfections (static) mean that the level of gearing that is

appropriate for a business depends on its specific business context.

1.7 Mature asset intensive industries tend to have high gearing; which reflects the advantages that debt finance can bring and the reduced risk of default. Debt also acts as a discipline on these firms (agency theory) and allows them to return equity to shareholders as their growth opportunities diminish.

1.8 These theories of capital structure support the idea outlined in Chapter 1 that the level of gearing that is appropriate for a business depends on the type of industry that it is in.

Keep gearing low if: High gearing is fine if: SME Mature company, stable cash flows Volatile cash flows Tax benefits > financial distress costs (M&M) (high fixed costs, dynamic environment) Tax benefits < financial distress costs (M&M)

Footnote: pecking order theory 1.9 This suggest that firms will finance projects in the following order.

1 Use internal funds if available 2 Use debt 3 Issue new equity

1.10 This is also due to shares being undervalued (the stock market does not know the full benefits of the project being financed so the firm is reluctant to issue new equity).

1.11 Pecking order theory is an explanation of what some firms do, but this does not mean that it is right or that all firms should do it.

2 Investments that change financial risk

When not to use the WACC 2.1 The WACC cannot be used as a discount rate at which to appraise projects if:

(a) a project causes a company to change its existing capital structure (financial risk) (b) a project incurs higher than normal business risk (covered in the next section).

2.2 Where the risk of an extra project is different from normal, there is an argument for a cost of capital to be calculated for that particular project; this is called a marginal cost of capital.

Increasing issue costs



102 ANP413

Changing financial risk - adjusted present value (APV) 2.3 Modigliani and Miller’s theory on gearing tells us that the impact of debt finance is purely to

save tax; this can be quantified and added as an adjustment to the present value of a project.

2.4 If a question shows an investment has been funded entirely by debt or asks for project appraisal using ‘the adjusted present value method’, you must


Epsilon plc is considering a project that would involve investment of £11 million now and would yield £2.9m per annum (after tax) for each of the next five years. The project will raise Epsilon’s debt capacity by £8 million for the duration of the project at an interest rate of 5%. The costs of raising this loan are estimated at £200,000 (net of tax). The company’s existing Ke is 12% and corporation tax is 30%. Epsilon currently has a ratio of 1:2 for market value of debt to market value of equity. Required By calculating the APV, recommend whether Epsilon should accept this project with the proposed financing.

Solution

Step 1 Calculate the NPV as if ungeared ie 1

eK

Step 3 Subtract the cost of issuing new finance

Step 2 Add the PV of the tax saved as a result of the debt used in the project



103 ANP413

2.5 An alternative method of calculating an ungeared Ke in step 1 of APV is to adjust the company’s equity beta by stripping out the effect of gearing to create an ungeared or an asset beta. This approach is important later in the syllabus, in chapter 10, and is introduced here.

Formula (given in the exam)

βa = βet))1Vd ((VeVe

+ dt))(1 Vd(Vet)-(1 Vd



104 ANP413

Lecture example 4 Technique demonstration Epsilon (from Lecture example 3) has a equity beta of 1.75. The risk free rate of return is 5%, the market return is 9% and the rate of tax is 30%. The debt beta can be assumed to be zero. Required By calculating the APV, recommend whether Epsilon should accept this project with the proposed financing.

Solution

Key points 2.6 Be careful which discount factors you use in APV:

2.7 APV is an M&M theory and suffers from the drawbacks of M&M described above; also the

precise source of finance used on a project (eg a loan) is often part of a broader plan by a company to keep its gearing at a target level ie finance is often not specific to a project.

2.8 Also note that if a subsidised loan is offered then this clearly adds some extra value to the APV, this should be calculated as the present value of the savings due to the subsidy, discounted at the normal Kd (again it is low risk).

Step 1 Calculate the project NPV at ungeared Ke calculated either by using the M&M formula or an asset beta (see next section)

Step 2 Add the PV of the tax saved at Kd because this reflects the low risk of the tax savings



105 ANP413

Changing business risk 2.9 For projects with different business risk it is inappropriate to use the WACC to calculate a

project NPV; instead a marginal cost of capital (using the CAPM) should be used. This involves a similar approach.

Lecture example 5 Exam standard question worth 10 marks

Stetson plc is a passenger airline which has a debt:equity ratio of 1:1. It wishes to expand into air freight. It has identified that the Beta of a highly geared parcel delivery company (company X) is 1.8 and its Ke is 18.4% – these are influenced by its gearing of 2:1 debt to equity. Assume that debt has a beta of 0. Risk free rate = 4% Market rate = 12% Tax = 30% Required Calculate the cost of capital that Stetson should use to appraise this investment: (a) using the beta approach covered above (b) using the M&M Ke formula covered in the previous section

Formulae (given in the exam)

βa = et))(1 Vd(VeVe


eVdV

dKieKt

ieKeK ))(1(

Solution (a)

Step 1 – find a company’s equity beta in the area you are moving into Step 2 – ungear the beta then regear the beta

Step 3 – use the equity beta to calculate an appropriate cost of capital



106 ANP413

(b)

Step 1 – find a company’s Ke in the area you are moving into Step 2 – ungear the Ke then regear the Ke with your own gearing

Step 3 – use the revised Ke to calculate an appropriate cost of capital



107 ANP413

3 Sources of debt finance 3.1 Private equity firms often use very high gearing levels with the objective of maximising

returns to shareholders.

Domestic debt

3.2 There are many sources of debt finance including: Bank loans

– for large loans this may involve a syndicated loan. Bonds / debentures

– a tradeable IOU with a nominal value £100 or $1000, normally maturing in 7-30 years and paying fixed interest; protected by covenants

– slower and more expensive to organise than a loan and less flexible in the event of default

– cheaper interest costs compared to a loan Convertible bonds

– a hybrid of debt and equity – cheaper interest costs – fewer covenants – attractive if shares are underpriced

Preference shares

– more flexible than other debt because the dividend can be deferred.

IOU £100

pay interest of 4%

repay £100 in 10 years time

IOU £100

pay interest of 2% repay £100 in 10 years time or xx

shares

Q2



108 ANP413

Leasing – more likely to be available than a loan because ownership remains with the lessor – finance lease (long-term); lessee benefits from bulk purchase discounts – operating lease (short-term); removes risk of obsolescence

Overseas debt

3.3 Overseas debt can be obtained either by a local bank loan or by the issue of a Eurobond. Large companies with excellent credit ratings use the Euromarkets to borrow in any foreign currency using unregulated markets organised by merchant banks. The impact on gearing of needs to be considered (see Chapter 7). The Eurobond markets are organised by international commercial banks; this market is much bigger than the market for domestic bonds / debentures.

3.4 The advantages of using the Euromarkets compared to a local bank loan are:

Advantages Explanation

Cheaper debt finance

Can be sold by investors & a wide pool of investors share the risk

Unsecured, no covenants

Only issued by large companies with an excellent credit rating

Long-term debt in a foreign currency

Typically 5-15 years, normally in euros or dollars but possible in any currency

3.5 The mechanics of issuing Eurobonds are:

Step 1. Appoint a lead manager. Step 2. The lead manager may appoint a team of co-lead managers. Step 3. Credit rating assessed by a credit rating agency. Step 4. The lead manager and co-leads organise an underwriting syndicate. Step 5. The underwriting syndicate agree the interest rate etc and buy the bond. Step 6. The underwriting syndicate then organise the sale of the bond.

3.6 The benefits of using overseas debt is discussed in chapter 8.



109 ANP413

4 Credit risk measurement 4.1 One of the drawbacks of Modigliani & Miller theory is that is fails to recognise that a

significant increase in gearing will alter the credit rating of a company, which can cause extra costs e.g. a higher cost of debt.

Example of credit ratings

Standard & Poors Definition AAA,AA+, AAA-, AA, AA-,A+ Excellent quality, lowest default risk A, A-,BBB+ Good quality, low default risk BBB,BBB-,BB+ Medium rating BB or below Junk bonds (speculative, high default risk)

Calculating credit ratings

4.2 Statistical models are used to calculate the risk of a bond e.g. the Kaplan-Urwitz model.

Lecture example 6 Technique illustration A credit rating agency is assessing a bond due to be issued by NT Ltd. It has extracted the following data relating to NT Ltd: Firm size (F) = £100m Net income/total assets (π) = 10% Gearing (L = long term debt/total assets) = 10% Interest cover (C) = 5 Risk (σ, std deviation, / average earnings) = 5% Debt status (S if subordinated = 1 if not 0) = 0 The agency uses the following version of the Kaplan-Urwitz model to obtain a risk score: 4.41 + 0.0014F + 6.4π – 2.56S -2.72L + 0.006C – 0.53σ If the score is >6.76 a rating of AAA is given, if >3.28 a rating of A is given and if > 1.57 a rating of BBB is given. Required Calculate the likely credit rating for NT Ltd's bond issue.

Solution



110 ANP413

5 Estimating the credit spread 5.1 The cost of a bond will depend on two factors:

(a) The risk free rate derived from the yield curve for a bond of that specified duration (b) The credit risk premium – derived from the bond’s credit rating

Yield curve 5.2 The yield curve shows how the yield on government bonds vary according to the term of the

borrowing. Normally it is upward sloping.

5.3 There are a number of explanations of the yield curve; these are not competing explanations, and at any one time all may be influencing the shape of the yield curve. (a) Expectations theory – the curve reflects expectations that interest rates will rise in

the future, so the government has to offer higher returns on long-term debt. (b) Liquidity preference theory – the curve reflects the compensation that investors

require higher returns for sacrificing liquidity on long-dated bonds. (c) Market segmentation theory – short-dated bonds tend to be more popular with

banks and long-dated bonds are more popular with pension funds. If demand for bonds is higher in one of these markets the government can offer lower returns.

Credit risk premium 5.4 Adjustments to the risk free rate (as indicated by the yield curve), will be given in the exam

as a yield spread (in basis points ie 1 point = 0.01%) as follows:

Maturity 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr Rating AAA 4 8 12 18 20 30 50 A 55 65 75 85 95 107 120

% yield

Years to maturity 5 10

Normal yield curve

5.5

5.8



111 ANP413

Lecture example 7 Technique demonstration Mantra plc is considering the issue of £0.1bn of debt with a maturity of seven years. Currently Mantra has a total market capitalisation of £1bn, split 50% debt (with five years to maturity) and 50% equity; its existing Ke is 8%. Mantra is worried that the extra debt will worsen its credit rating from AAA to A and that this will increase its WACC. Tax is at 30%. Required Complete the following table (using the formulae below and the yield curve in paragraph 3.2) to assess the impact of the new bond issue on Mantra’s WACC.

Solution

Existing New Credit spread on existing debt

Yield curve benchmark

Cost of debt (pre-tax)

Value of debt

Credit spread on new debt

Yield curve benchmark

Cost of debt (pre-tax)

Value of debt

Cost of equity 8.00%

Value of equity £0.5bn

WACC

eVdV

)dK1eK)(T1(1

eKeK WACC=

VdVe

Ve Ke +

VdVeVd Kd (1-T)

Q8 if time



112 ANP413

Converting from maturity to (Macaulay) duration

5.5 The average amount of time taken to recover the cash flow from an investment is not only affected by its maturity date – it is also affected by the size of the interest (coupon) payments e.g. a 5% bond maturing in 3 years will not give cash back as quickly as a 10% 3 year bond. Duration measures the weighted average number of years to redemption where the weights are the proportion of the market value recovered by the investor in each year.

High

Lecture example 8 Technique illustration A company has 2 bonds in issue, both with a nominal value of £100 and redeemable at par value: Bond A 5% maturing in 3 years Bond B 10% maturing in 3 years The required yield is 4%. Required Calculate the duration of Bond A and Bond B.

Solution



113 ANP413

5.6 Duration will be higher if the bond is : (a) Long dated (b) Low coupon

Modified duration

5.7 Modified duration is calculated as: (Macaulay) duration 1 + yield

5.8 Modified duration predicts a linear relationship between the yield and the price. If the modified duration is 2.75 then, if required yields rise by 1%, the bond price will fall by 2.75%. This is a useful measure of the price sensitivity (risk) of a bond to changes in interest rates.

5.9 In fact, the actual relationship between price and yield is given by the line below. 5.10 The impact of convexity (i.e. non-linear relationship) will be that the modified duration will

tend to overstate the fall in a bond's price and understate the rise. The problem of convexity only becomes an issue with more substantial fluctuations in the yield.

6 Assessment of default risk 6.1 The concept of value at risk was covered in chapter 5; this can also be used to assess

credit risk, which will influence the cost of borrowing. 6.2 The probability of asset values falling to a level that would trigger default can be assessed

by looking at the past levels of volatility of a firms asset values and assessing the number of standard deviations that this fall would represent. This would then influence the interest rate that would be charged on the loan.

yield

price



114 ANP413

7 Chapter summary Section Topic Summary 1 The impact of

financing on investment decisions

The theories of capital structure support the idea that the level of gearing that is appropriate for a business depends on the type of industry that it is in. Keep gearing low if: High gearing is fine if: SME Mature company Volatile cash flows Stable cash flows Tax benefits < financial Tax benefits > financial distress costs (M&M) costs (M&M) (high fixed costs dynamic environment)

2 Investments that change financial risk

An insight of M&M is that if a project causes gearing to rise, the APV approach can be used.

The Ke ungeared can be calculated using an asset beta or using the M&M formula for Ke.

3 Sources of debt finance

There are many forms of domestic and overseas debt including bank loans, preference shares, debentures, leases and Eurobonds.

4 Credit risk measurement

Statistical models are used to calculate the risk of a bond; an example is the Kaplan-Urwitz model.

5 Estimating the credit spread

Credit ratings determine the credit spread on a bond and will also impact on the credit spread on existing bonds; so the impact of a new bond issue needs to be carefully assessed in terms of its overall impact on the company’s cost of capital.

6 Assessment of default risk

The concept of value at risk was covered in chapter 5; this can also be used to assess credit risk, which will influence the cost of borrowing.

END OF CHAPTER

Step 1 project NPV as if ungeared


Step 2 Add the PV of tax saved using Kd


115 ANP413




Key knowledge The techniques of analysing risk and uncertainty, especially value at risk and project duration.

The theories of capital structure, especially M&M (Modigliani & Miller) theory with tax, and static trade-off theory

The three stage approach to dealing with projects that change business risk.

Understanding the four types of real options.

Key skills Correctly classifying real options as calls or puts.

Valuing real options.

Calculating a project specific cost of debt, equity and overall project specific cost of capital.


CHECKPOINT 2

116 ANP413


Chapter 5 – DCF techniques and the use of free cash flows 75 minutes

Key areas

The capital budgeting process

Discounting with tax and inflation and dealing with risk and uncertainty

Internal rate of return and modified internal rate of return

Course Notes This is a crucial chapter and is regularly tested, often using the cost of capital theory

covered in chapter 2; ensure that you can follow all the calculations, especially project duration and value at risk.

30 minutes

Study Text Section 1.5 – you need to be able to formulate and interpret the linear programming

model. This was tested in the December 2012 exam. Section 2 gives some useful technical background on simulation and value at risk. Only

value at risk will be tested numerically. Section 4 is a useful recap of the differences between NPV and IRR, you will have seen

this in paper F9 but make sure that follow this section through carefully.

15 minutes

15 minutes

15 minutes

Chapter 6 – Application of option pricing theory in investment decisions

40 minutes

Key areas

Understanding the four main types of real options

Use of the Black-Scholes model to evaluate the value of a real option

Course Notes Review the types of real options. Check that you follow the calculations in the lecture examples, and that you can perform

them quickly and accurately

10 minutes

30 minutes


CHECKPOINT 2

117 ANP413

Chapter 7 – The impact of financing on investment decisions and adjusted present values

160 minutes

Key areas

M&M theory with tax, and adjusted present value

Static trade –off theory

Course Notes This is a very important chapter, carefully review all aspects making sure that you

completely understand the theory and the numbers. Review the chapter ensuring you can follow all the calculations, but also that you are confident with the drawbacks of M&M.

Pay close attention to the section on credit ratings, this has been regularly examined. Review Question 2b (Canadian plc). Read cases 7 & 8 later in this checkpoint.

40 minutes

40 minutes 20 minutes

Study Text Chapter 7a Section 1 is an important section on sources of finance. The most important

sections are 1.8 and 1.9, which are introduced here and developed in chapter 19. Section 3 will build your knowledge of the CAPM, which is a crucial model in this

syllabus. Section 7.3 – you need to be evaluate the impact of a change in credit rating on bond

values; carefully work through this section.

20 minutes

20 minutes

20 minutes


CHECKPOINT 2

118 ANP413



The multiple choice questions contained within Progress Test 2 will thoroughly test your understanding of the material and your ability to perform the required calculations. Note that the P4 exam does not contain multiple choice questions. The short written question that follows will test your ability to apply your knowledge. These skills will prove important in preparing you for the more discursive elements of the exam.

It is important that you continually review your progress (solutions are after the test) and revise further any areas where you feel your understanding is weak.


1 Extreme Wildlife plc is branching out into the pet accessory market. A company in this market, Gould Fisher Pond plc, has a beta factor of 1.20 and a debt:equity ratio of 1:4.

Extreme Wildlife plc has a beta factor of 1.50 and is ungeared. The rate of corporate tax is 28%, the risk-free return is 4% and the market return is 8%. Assume that the debt beta is zero.

The project will change Extreme Wildlife’s gearing, because it will be 100% debt financed.

What would be the cost of capital for Extreme Wildlife to use to appraise the project’s cash flows as part of an APV appraisal?

A 8.8% B 8.1% C 4.7% D 7.6% (4 marks)

2 Extreme Wildlife (from question 1) has identified the following project cash flows relating to the new investment in the pet accessory market: contribution is estimated at £2m per annum for the first year and then is estimated to rise at 20% per year for years 2,3 and 4 and 5% per year after that. Investment costs are estimated at £1.5m, of which £200,000 is the estimated cost of planned market research.

Tax is 28%, ignore capital allowances and inflation.

Extreme Wildlife estimates that its ungeared cost of equity is 8%.

What would be the NPV of this project if it was ungeared? (in £000s)

A 68.92 B 68.72 C 64.02 D 62.22 (4 marks)


CHECKPOINT 2

119 ANP413

3 Extreme Wildlife (from question 2) will fund the £1.5m investment using a ten year loan a pre-tax cost of 5%. Tax is at 28%, and the ungeared cost of equity is estimated at 8%.

Using ‘adjusted present value’ , what would be the present value of the tax saved from using debt finance, and the overall APV of the project (in £000s)? PV of tax saved APV of project A 262.50 331.22 B 140.91 209.63 C 420.00 488.72 D 162.16 230.88 (4 marks)

4 How much would the APV of the project increase by (in £000s) if Extreme Wildlife plc was offered subsidised debt finance at 1% by the government as an incentive to make this investment?

A 289.87 B 402.60 C 333.59 D 463.32 (4 marks)

5 Sturgeon plc is branching out into the fish food market. A company in this market, Piranha plc, has a cost of equity of 12% and a debt:equity ratio of 1:4, and a debt beta of 0.2. The risk free rate is 3% and the market return is 7% and tax is at 30%.

Sturgeon has a debt to equity ratio of 1:2 and a debt beta of 0.25.

The project will not change Sturgeons gearing.

What would be the cost of equity for Sturgeon to use to appraise the project’s cash flows (which are not given)?

A 13.15% B 13.22% C 10.78% D 12.15% (4 marks)

6 Using example 5 estimate the weighted average cost of capital that Sturgeon should use to appraise the project’s cash flows?

A 8.58% B 9.70% C 10.10% D 9.00% (2 marks)

7 Cranmoor Limited is about to embark on a project to eco friendly air-conditioning systems. It involves an initial outlay of £120,000 and cash inflows, at current prices, of £50,000, £60,000, and £40,000 at the end of years 1,2 and 3 respectively.

Cranmoor’s real cost of capital is 10%.

What is the project duration for this project ?

A 2.4 years B 1.9 years C 2.3 years D 2.1 years (2 marks)


CHECKPOINT 2

120 ANP413

B Short written question (approximate time 10 minutes) 1 Identify the main types of real options in investment appraisal. (4 marks)



CHECKPOINT 2

121 ANP413


Section A 1 B

Ea eE D(1 t)

41.204 1(1 0.28)

1.017Ke 4 (8 4)1.017 8.1%

This is an ungeared Ke and is suitable as step 1 in an APV calculation.

2 B

20%

growth 20%

growth 20%

growth 20%

growth 5% growth Time 0 1 2 3 4 5 onwards Contribution 2.00 2.40 2.88 3.46 3.63 tax paid -0.56 -0.67 -0.81 -0.97 -1.02 investment -1.50 total -1.50 1.44 1.73 2.07 2.49 2.61 annuity factor (1/(r-g)) 33.33 (1/(0.08-0.05)) value at time 4 86.99 df 1.000 0.926 0.857 0.794 0.735 0.735 PV -1.50 1.33 1.48 1.64 1.83 63.94 NPV 68.72 note - the market research is not a sunk cost since it has not yet been incurred

3 D £000s Interest paid on the loan p.a. (£1.5m x 0.05) 75.00 tax saved (interest x 0.28) 21.00 d.f 5% (annuity factor for 10 years) 7.722 PV of tax saved 162.16 PV from question 2 68.72 PV of tax saved 162.16 APV 230.88


CHECKPOINT 2

122 ANP413

4 C

Savings due to subsidy £000s 4% saved on £1.5m = 60 per year less tax relief lost -16.8 total 43.2 d.f 5% (annuity factor 10 years) 7.722 PV of subsidy 333.59

5 A

We need to ungear the cost of equity of Piranha

Kd of Piranha is obtained by using the debt beta in the capital asset pricing model This gives 3 + 0.2 (7-3) = 3.8% pre tax

12 = Kei + 0.175Kei - 0.665 12.665 = 1.175 Kei Kei = 10.78%

This needs to be regeared to reflect Sturgeon's higher gearing Kd of Sturgeon is obtained by using the debt beta in the capital asset pricing model This gives 3 + 0.25 (7-3) = 4.0% pre tax

Ke = 10.78 + 0.7 (10.78-4.0)1/2

Ke = 13.15 6 B

Ke 13.15 Kd 4 Vd 1 Ve 2 WACC = (13.15 x 2/3) + (4 x 0.7 x 1/3) WACC 9.7

7 B PV of inflows = Time 1 2 3 Total £000s 50 60 40 Df 0.909 0.826 0.751 PV 45.45 49.56 30.04 125.05 % inflow recovered 45.54/125.05 49.56/125.05 30.04/125.05

= 36.4% = 39.6% = 24.0% 100.0%

Duration (1 x 0.364) + (2 x 0.396) + (3 x 0.240) = 1.9 years

eVdV

)dKieT)(K(1i

eKeK

413.8)i

e(0.7)(KieK12

eVdV

)dKieT)(K(1i

eKeK


CHECKPOINT 2

123 ANP413

Section B 1 Option to withdraw - some projects are easy to abandon because the assets are easy to sell and / or

exit costs (clean-up costs, redundancy costs) are low.

Option to expand - some projects develop technology and /or brand identity that can be used in other projects

Option to redeploy – some projects use assets that can easily be switched to other projects

Option to delay – some projects will have a higher expected value if they are delayed to allow valuable new information to be analysed


CHECKPOINT 2

124 ANP413


Case 7 – Bank lending B B C W E B S I T E , U K B A N K L E N D I N G T O S H R I N K I N 2 0 1 2 – F E B 2 0 1 2 (extract) UK bank lending is set to shrink this year for the first time since 2009, according to the Ernst & Young Item Club economic forecasting group. Total lending is expected to fall by 2.2% with corporate loans down 5.7%, hitting small and medium-sized firms and affecting UK growth prospects. The Item Club said that overall bank lending rose by 4.3% last year. After contracting this year it expects lending will rise by just 0.9% in 2013. The contraction in corporate lending is expected to hit the construction and real estate sectors and smaller companies in particular. "Funding for small and medium-sized enterprises is likely to be particularly difficult to obtain as banks seek to reduce credit risk," said Neil Blake, senior economic adviser at the Item Club. "The average interest rate on smaller loans, of £1m or less, is already double that charged on loans of £20m or more, and we expect this trend to continue. As these young companies tend to be high-growth businesses, this will have adverse knock-on effects for economic growth." Banks were asked to increase their lending to small businesses in 2011 in an initiative from Business Secretary Vince Cable called Project Merlin. The four biggest British banks (RBS, HSBC, Lloyds and Barclays) plus Santander committed to make £190bn available to business in 2011, of which £76bn was for smaller businesses, an increase of £10bn or 15% compared to 2010. The Item Club's predicted fall in lending to smaller businesses for 2012 affects one of the most important commitments in Project Merlin, since it is smaller businesses that have been complaining of being starved of vital finance. The Item Club report noted that consumers were increasingly turning away from banks when seeking access to funds. It said that although bank and building society lending to individuals had shrunk by 23% (£34bn) since 2007, lending by alternative consumer credit providers had risen by 42% (£29bn) over the same period. F T – L E N D I N G A H A N D A S B A N K S P U L L B A C K – M A R C H 2 0 1 2

(extract) The news last month that Axa Investment Managers is to dip its toes into the previously bank-dominated waters of corporate lending would have come as little surprise to many. In Europe, around 70 per cent of funding for companies has traditionally come from banks, but regulation and worries over sovereign debt are putting lenders under intense pressure to shrink their balance sheets. As a result, alternative funding sources, such as that of asset managers, are emerging. Laurent Gueunier, head of structured finance at Axa IM, said in February that there was “a lot of appetite for its corporate lending project”, adding that with its new fund it wanted to “be the link” among banks, investors and mid-sized companies, which currently have little access to the financial markets. The French asset manager says it wants to raise “several billion euros” to finance mid-sized companies in Europe and expects a lot of interest in the vehicle from pension funds and other insurers. “Investing in mid-cap European corporate debt allows us to offer our [pension fund] clients a way to diversify their credit exposures with an efficient risk return profile. Furthermore, mid-cap European companies lack diversification in their financing sources and are much too dependent upon banks, which cannot meet the global financing demand in the current environment.” M&G Investments has been active in the corporate lending market for what it calls “a very long time” and its UK Companies Financing Fund has made 10 loans since it was launched in July 2009, including £100m to housebuilder Taylor Wimpey in November 2010 and £100m to vehicle hire company Northgate in April last year. William Nicoll, director of fixed income at M&G Investments, is convinced non-bank lending will again become a bigger portion of institutional investors’ fixed income portfolios. “Pension funds and insurance companies used to


CHECKPOINT 2

125 ANP413

provide long term capital to UK companies and other essential parts of the economy for years before banking deregulation in 1986. But between then and the 2008 collapse of Lehman Brothers, banks priced institutions out of many long-term lending markets. However, banks’ own cost of funding has risen above the interest rates at which they used to lend money and new regulations are making it more difficult for them to offer long-term loans. With competition reduced, institutional investors may want to take back their place as providers of long term debt capital.”

Case 8 – Credit rating agencies B B C W E B S I T E , W H A T I S A R A T I N G A G E N C Y ? – J U L Y 2 0 1 2 (extract) Rating agencies use different systems involving a long list of letters, a top mark is AAA or Aaa, down to BBB or Baa3 is also safe, BB or Ba1 down to C is speculative - or "junk". A high score from a credit rating agency means cheaper borrowing - a low mark carries a heavy price. The letter formations are given to large-scale borrowers, whether companies or governments, and tell the buyers of this debt how likely they are to be able to get it back. The score card also affects the amount that should be charged by way of return on that borrowing. A change to the score means a change to the amount a borrower must pay its debt-holders, something that can make it more expensive to borrow as investors demand a higher rate of return for taking on more risky debt. But while the borrowers in the news with the downgraded scorecards now include most European governments - even the mighty US - and are household names, the companies that have such an impact on their fortunes are nowhere near as familiar. They are credit-rating agencies, which exist to assess the creditworthiness of bond issuers - companies or, as in this case, countries who borrow money by issuing IOUs known as bonds. Their power is now so feared that the European Commission has a set of proposals designed to rein them in, including requiring them to be more transparent about their ratings and to be held accountable for their mistakes. It also views them as hostile because the leading agencies are US-based. It would like to see a European agency of equal status. But who are they? Do we need them and how do they work out whether to give the top-of-the-class AAA or a lower grade, such as CCC, which - sticking with the schools analogy - means the issuer is suspected of planning the financial equivalent of bunking off? Standard & Poor's (S&P), as the oldest, comes first. It was begun in 1860 by Henry Poor, who wrote a history of the finances of railroads and canals in the United States as a guide for investors. The "Standard" part came into being in 1906, when the Standard Statistics Bureau was set up to examine finances of non-railroad companies. The two businesses joined forces in the 1940s. Moody's was started in 1909 by John Moody, who published an analysis of the tangled and uncertain world of railway finances, grading the value of its stocks and bonds. These are now mighty concerns - Moody's operating income was $688m in 2010 and Standard & Poor's made $762m. They each have 40% apiece of the business of rating major companies and countries. Fitch, with another eponymous founder, John Fitch, was set up in 1913 and is a smaller version of the other two. There are hosts of other ratings agencies, whose names rarely appear even within the darker corners of the financial pages - so why are these three businesses the ones everyone watches? Part of the answer lies with the Securities and Exchange Commission (SEC), the US financial watchdog. In 1975, it acknowledged these three as Nationally Recognized Statistical Rating Organizations (NRSRO). Although the SEC has 10 NRSROs on its approved list, including a Canadian agency and two Japanese ones, the big three - Standard & Poor's, Moody's and Fitch - remain the industry standard-bearers. This is partly because they make their ratings available freely to investors - making their money from charging the organisations who want their bonds rated. So much for their size. What of their actual methods? Standard & Poor's says a committee of between five and eight people decides the actual rating. They base their judgments on a range of financial and business attributes that might influence the repayment, some of which may depend on the issuer of the bond (ie the borrower). In a statement, S&P gave a long list of indicators it might use,


CHECKPOINT 2

126 ANP413

including "economic, regulatory and geopolitical influences, management and corporate governance attributes, and competitive position". That seems to cover everything. But since the credit crisis that began in 2007, these agencies have come in for heavy criticism. The EU Internal Market Commissioner, Michel Barnier, said: "Ratings have a direct impact on the markets and the wider economy and thus on the prosperity of European citizens. They are not just simple opinions. And rating agencies have made serious mistakes in the past." After all, stacks of mortgage-backed securities - the investments that were backed by mortgages that were either never going to be paid back or were even fraudulent - were given the very best grade by the three supposed experts in rating the likelihood of the money being paid back. Changes in the ratings applied to government-backed, rather than private property-supported debt are generally less dramatic but still have a major effect. One day a country's bond is graded a safe top rating and the next given a mark that suggests investors' money is less safe. Many observers believe that if the rating on the UK's government bonds - or gilts - was downgraded by just one notch from AAA to AA it would put up the cost of official borrowing by around half of one per cent. That would mean a big rise in the annual interest bill which has to be met by taxpayers. When asked why it changes ratings, S&P responded: "The reasons for ratings adjustments vary, and may be broadly related to overall shifts in the economy or business environment - or more narrowly focused on circumstances affecting a specific industry, entity, or individual debt issue." It indeed appears a dark art - but one whose influence has a more measurable effect.

B B C W E B S I T E , D O C R E D I T R A T I N G A G E N C I E S T H R E A T E N O U R F I N A N C I A L S T A B I L I T Y ? - F E B 2 0 1 2

(extract) In the US, the credit rating agencies' reputation was severely dented by the sub-prime housing boom and bust. Banks had shovelled money towards people who could ill-afford to buy their own homes. Mortgages were parcelled up and sold on to investors as complex financial products. These products needed ratings and the agencies were happy to oblige - and were duly paid by the banks creating these securities. David Levy was a senior managing director at Moody's until he left in 2004 - he says agencies had to dance to the tune of the banks if they wanted business. Speaking to Radio 4's File on 4 programme, he said: "The investment bank putting together the bond could easily go to the various agencies and say 'how would you rate this pool?' They could just do it in preliminary way. If they didn't like the results they got, they [the banks] could just go with another agency that was willing to give them a higher rating." Another former Moody's insider is William J Harrington - he was a senior analyst from the 1990s until he resigned in 2010. He criticises the rating of complex instruments, based on mortgages, known as CDO's. "By 2006 I thought the rating process for CDO's had broken down so badly that I really didn't want anything else to do with them. I think after that the process was out of control because there was so much underwriting, and really the impetus was just to get deals out the door and bill for them." As defaults increased, the sub-prime bubble burst. Staff of the US regulator - the Securities and Exchange Commission - investigated Moody's, S&P and Fitch in 2008. They seized more than 2 million emails and instant messages - one said "they could be structured by cows and we would rate it." The agencies argue that the analysis of mortgage securities should have been better - but they point out that others failed to foresee the housing crash. More recently S&P removed the coveted Triple-A rating from the United States itself. The timing, in August last year, coincided with a round of market jitters over the eurozone. The US Treasury Secretary Timothy Geithner claimed S&P had made a $2 trillion mistake in its sums. Recently the UK was put on "negative outlook" by Moody's, meaning a possible loss of the Triple-A rating within 18 months - but it is not the first time the UK has faced such a warning. However, this week Andrew Tyrie MP, chairman of the Commons Treasury Select Committee, said the agencies had been "systemically wrong" with their analysis before the banking crisis and there was a need to assess what regulation should be in place.


127 ANP413




Assess the impact upon the value of a project of alternative exchange rate assumptions.

Forecast project or company free cash flows in any specified currency and determine the project’s net present value or firm value under differing exchange rate, fiscal and transaction cost assumptions.

Evaluate the significance of exchange controls for a given investment decision and strategies for dealing with restricted remittance.

Overseas investment appraisal was examined regularly under the old syllabus, and is expected to be a common theme in the new syllabus. All types of risk can be tested either as a discussion or as a numerical question.

Blipton International - Q1, December 2008 Tramont - Q1 December 2011 Kilenc Co - 15 marks, Q5, June 2012 Q5, June 2012 Kilenc Co - 15 marks, Q5, June 2012 Q1 new pilot paper

Assess the impact of a project on a firm’s exposure to translation, transaction (covered in chapter 16) & economic risk.

Assess and advise upon the costs of alternative sources of finance available within the international equity and bond markets.

Sources of finance for international investments was tested for 10 marks in Q4b of the pilot paper. Could also involve calculations as well as discussion.

Q2 December 2012, 14 marks McTee - 30 marks

International investment decisions and financing decisions


8: INTERNATIONAL INVESTMENT DECISIONS AND FINANCING DECISIONS

128 ANP413

Overview


Investment decision Dividend decision

International investment decisions and financing decisions Overseas NPVs are heavily dependent on exchange rate assumptions, so these need to be carefully analysed. Exchange controls are another risk that needs to be carefully analysed and managed.

International investment decisions and financing decisions The use of overseas debt finance, especially Eurobonds, are a useful way of managing the exchange rate risk of overseas investments.

Financing decision



129 ANP413

1 International investment 1.1 Why invest overseas?

The 5 Cs Explanation Company Expansion strategy may create economies of scale Country Locate near to high quality local suppliers or access cheap labour and

government grants. Local investment may be needed to overcome trade barriers.

Customer Locate close to the customer for shorter lead times. Competition Overseas markets may have weaker competition. Currency If a company already has revenue from these markets, international

investments creates costs and helps to manage exchange rate risk.

Exchange rate risk 1.2 If the value of the overseas ($) currency falls after an overseas investment has been made

then the £ NPV of that investment will fall. There are danger signals that indicate that a fall in the overseas currency is likely.


Required Discuss the implications of the following signals:

Danger signals Explanation High $ inflation

High $ interest rates

High $ balance of payments deficit

High $ government deficit

Case 9



130 ANP413

Purchasing power parity (PPP) 1.3 Often used in exams to forecast exchange rate movements, based on predicted future

inflation rates. The formula is given.

)bh1()ch1(

0s1s

1s = ex rate in 1 year, 0s ex rate today

ch inflation in foreign currency, bh inflation in base currency


The exchange rate in January 2007 was 1.95 $ to the £; inflation in US was 2.1% and 2.7% in the UK. The exchange rate in January 2007 was 0.67 £ to the euro; inflation in Europe was 2.1% and 2.7% in the UK. Required (a) What is the forecast spot rate in each of the next three years for the $ to the £? (b) What is the forecast spot rate in each of the next three years for the £ to the €?

Solution



131 ANP413

1.4 If interest rates are given instead of inflation rates, the same formula can be used.

Evaluating projects 1.5 1st approach (a) Forecast $ cash flows including inflation

(b) Forecast exchange rates and therefore the £ cash flows (c) Discount these £ cash flows at a UK cost of capital.


A professional accountancy institute in the United Kingdom is evaluating an investment project overseas – in Eastasia, a politically stable country. The project will cost an initial 2.5 million Eastasian dollars (EA$) and it is expected to earn nominal post-tax cash flows as follows. Year 1 2 3 4 Cash flow (EA$'000) 750 950 1,250 1,350 (a) The expected inflation rate in Eastasia is 3% a year, and 5% in the UK. (b) The current spot rate is EA$ 2 per £1 Sterling. (c) The company requires a sterling return from this project of 16%. Required Calculate the £ Sterling net present value of the project by discounting nominal annual cash flows in £ Sterling.

Solution



132 ANP413

1.6 2nd approach (a) Forecast $ cash flows including inflation. (b) Discount at $ cost of capital and calculate the $ NPV. (c) Convert into a £ NPV at the spot exchange rate.


Using the data from Lecture example 3 i.e. the project will cost an initial 2.5 million Eastasian dollars (EA$) and post-tax nominal cash flows are as follows.

Year 1 2 3 4 Cash flow (EA$'000) 750 950 1,250 1,350 (a) The expected inflation rate in Eastasia is 3% a year, and 5% in the UK. (b) The current spot rate is EA$ 2 per £1 Sterling. (c) The company requires a sterling return from this project of 16%. Required Calculate the £ Sterling net present value of the project by discounting nominal annual cash flows in Eastasian $.

Solution

1.7 Both approaches give the same answer – in the first approach £ may devalue due to high UK inflation (good news), and in the second approach the $ cost of capital is lower for the same reason (good news).

1.8 If there is one rate of inflation, inflation could be ignored under either approach but this is less likely to be the case in the exam.



133 ANP413

2 Managing risks

Political risk


Required Discuss how to manage the following examples of political risks:

Examples of political risk Manage by High $ inflation - government action could include higher interest rates / higher taxes

High $ balance of payments deficit - government action could also include a devaluation of the local exchange rates or bring in exchange controls

High unemployment - political instability increases the risk of assets being seized or damaged

2.1 Overseas debt is a useful method of managing political risk: large companies with excellent credit ratings use the Euromarkets to borrow in any foreign currency using unregulated markets organised by merchant banks (see chapter 7). The impact on gearing of needs to be considered, this is covered in Chapter 7.

Economic risks 2.2 This refers to the change in the present value of future cash flows due to unexpected

movements in foreign exchange rates. Overseas investment can diversify this risk by building an international portfolio.

Translation risk 2.3 Holding fixed assets in a foreign currency may result in exchange profits or losses, or in

exchange movements on reserves. These are book entries, not cash flows, so there is doubt as to whether translation risk should matter. However, if changes in book gearing or profitability (eg interest cover) affect a borrowing covenant there may be real economic

Case 10



134 ANP413

consequences that justify translation risk management. This risk can be managed by the use of overseas debt finance (eg a bank loan or a Eurobond).

Lecture example 6 Technique demonstration It is now November 20X7, QWE is a public listed company supermarket based in France. Its forecast balance sheet for 31 December 20X7 is given below. € million Assets 14,000 Equity 5,650 Floating rate debt 2,000 Current liabilities 6,350 14,000

This does not take into account an investment of $1,000m, that is about to be made. The current exchange rate is 1 euro = 1.1 $, but this could rise by to 1 euro = 1.40 $ by the end of the year. Required

(a) Prepare a revised balance sheet forecast assuming that the project is funded using long-term debt finance in euros under both exchange rate forecasts.

(b) Prepare the same calculations assuming that the project is funded using $ debt.

Solution (a) exchange rate 1 euro = 1.1 $ exchange rate 1 euro = 1.4 $ € million € million Assets Assets Equity (balance) Equity Floating rate debt Floating rate debt Current liabilities Current liabilities (b) exchange rate 1 euro = 1.1 $ exchange rate 1 euro = 1.4 $ € million € million Assets Assets Equity (balance) Equity Floating rate debt Floating rate debt Current liabilities

Current liabilities



135 ANP413

3 Overseas NPV – complications 3.1 In overseas investment appraisal questions you will also have to deal with:

(a) Overseas tax issues (b) Exchange controls

Overseas taxation 3.2 To prevent ‘double taxation’, most governments give a tax credit for foreign tax paid on

overseas profits (this is double tax relief, or DTR).

3.3 The home country will only charge the company tax as the differential between that suffered overseas and that due in the home country. A quick way of dealing with this in the exam is to apply the UK tax rate to tax paid on cash inflows and tax saved on capital allowances if UK tax is at a higher rate than overseas tax.

Exchange controls 3.4 Another potential problem is that some countries impose delays on the payment of a

dividend from an overseas investment. These exchange controls create liquidity problems and add to exchange rate risk because the exchange rate may have worsened by the time that dividends are permitted.

Case 11



136 ANP413

Lecture example 7 Technique demonstration Fulton plc is considering entering a 50% joint venture with a Central European company for the manufacture and supply of sportswear in Central Europe. Fulton plc will provide £2.2 million as 50% of the initial capital whilst the joint venture partner will provide the equivalent amount in Central European Crowns (CeK). The joint venture net cash flows attributable to Fulton plc, in nominal terms, are expected to be: CeK‘000 Forward rates of exchange to the

£ sterling Year 1 10,500 10 Year 2 16,000 14 Year 3 21,000 19 Required Calculate Fulton’s NPV under the two assumptions below, using a UK discount rate of 15% for each assumption; ignore tax. No interest is earned on any cash retained in the European country. Assumption 1 Exchange controls in the Central European country prohibit dividends above 50% of annual cash flows due to overseas investors being paid for the first two years of any project. The accumulated balance can be repatriated at the end of the third year. Assumption 2 The Central European country removes control restrictions on repatriation of profits.

Solution



137 ANP413

4 Chapter summary Section Topic Summary 1 International

investment Overseas projects expose a company to exchange rate risk, a clear signal of this danger is the existence of high(er) rates of inflation in the overseas economy. Investments can be assessed either by (a) discounting the nominal cash flows in £s at

a UK cost of capital (b) discounting the nominal cash flows in $ at a

US cost of capital and converting into £s at the spot rate.

2 Managing risk The major classes of risk are transaction risk,

economic risk, translation risk and political risk; the term fiscal risk is sometimes used to describe the risk that a government may change its taxation policy. All classes of risk need to be carefully analysed before an investment is made. The use of overseas debt finance is a common method of managing these risks, and Eurobonds (also discussed in Chapter 7) are an important source of finance in this context. Because overseas projects are often highly geared they could be examined in an APV context (see Chapter 7).

3 Overseas DCF - complications

If the UK rate tax rate is higher than the overseas tax rate – then use the UK rate to appraise the project. If there are exchange controls then analyse the impact of these in delaying remittances and exposing the company to further exchange rate risk. Questions may also ask you to calculate the cost of overseas debt and equity; these are % calculations so you can use the techniques in Chapter 2 to do this.



138 ANP413

END OF CHAPTER


139 ANP413


Syllabus detail How has this been examined ?

Past paper questions


Discuss the arguments for and against the use of acquisitions and mergers as a method of corporate expansion.

Evaluate the corporate and competitive nature of a given acquisition proposal.

Advise upon the criteria for choosing an appropriate target for acquisition

Compare the various explanations for the high failure rate for acquisitions in enhancing shareholder value

Evaluate, from a given context, the potential for synergy separately classified as: (i) Revenue synergy (ii) Cost synergy (iii) Financial synergy

This has been examined for a small number of marks as a discussion question.

Anchorage retail - December 2009 Q2, 6 marks Q3 December 2012

Acquisitions and mergers versus other growth strategies


9: ACQUISITIONS AND MERGERS VS OTHER GROWTH STRATEGIES

140 ANP413

Overview



Acquisitions and mergers vs other growth strategies

Why this type of growth strategy? Who should be the acquisition target? What are the risks?



141 ANP413

1 Growth strategies 1.1 To achieve its growth objectives, a company has three strategies that it can use:

(a) Internal development (b) Acquisitions / mergers (c) Joint ventures

Lecture example 1 Idea generation In the late 1990s, VW & BMW both targeted the luxury section of the car market as an area that they wanted to move into. Required Discuss the following. (a) Why this segment may have been seen as an attractive target. (b) The advantages of internal development. (c) The advantages of acquisition. (d) The advantages of a joint venture.

Solution

Case 12



142 ANP413

2 Acquisition targets 2.1 There are many issues to consider in selecting a target: two important areas to consider are:

(a) Are there potential synergies with the target? (b) Is there a likelihood of a good working relationship with the target?


In 1998 Daimler Benz acquired Chrysler for $36 billion to create DaimlerChrysler, in 2007 Daimler Benz disposed of Chrysler for approximately $5 billion. The loss to shareholders is the equivalent of the company giving away 4000 cars a month for a 10 year period. Required (a) Identify, using the frameworks below, why the acquisition of Chrysler was predicted to

generate synergies. (b) Why was the working relationship between the two companies always likely to be difficult?

Solution (a)

(b)

Synergies

2 + 2 = 5

Financial synergy

Cost synergy

Sales synergy

Case 13



143 ANP413

3 Risks of acquisition Risk Explanation Clash of cultures Especially if the two firms follow different business strategies

Uncertainty among staff

Lay-offs expected, the best staff often leave.

Uncertainty among customers

Customers fear post-acquisition problems and sales fall.

Unanticipated problems

Assets or staff prove to be lower quality then expected

Paying too high a price for the target

Managers desire to grow may stem less from a desire to benefit shareholders and more from a desire to empire build or to make the company less of a takeover target; so they may over pay to acquire the target.

3.1 To minimise these risks a firm should have a clear post-integration strategy. This should include:

(a) Control of key factors – new capex approval centralised (b) Reporting relationships – new MD appointed quickly, regular board meetings (c) Objectives and plans – to reassure staff and customers (d) Organisation structure – integrating business processes to maximise synergies (e) Position audit of the acquired company – build understanding of the issues faced by

the target via regular online employee surveys; also bi-annual strategy discussion forums with front line staff and managers at a business unit level.

Case 14



144 ANP413

4 Chapter summary Section Topic Summary 1 Growth

strategies Before justifying an acquisition a company should have a clear understanding why growth by acquisition is preferred to internal development or joint ventures.

2 Acquisition targets

Before justifying an acquisition a company should engage in a thorough review of the best targets for acquisition in terms of the likely working relationship and potential for synergies.

3 Risks of an acquisition

Before justifying an acquisition a company should also formulate a post-acquisition strategy so that if successful in the takeover there is less risk of post-acquisition integration problems.

END OF CHAPTER


145 ANP413



Example past question papers

Apply asset-based, income based & cash flow models to value equity. Apply appropriate models, including term structure of interest rates, the yield curve and credit spreads to value corporate debt.

Forecast a firm’s free cash flow and its free cash to equity (pre and post capital reinvestment).

Advise on the value of a firm using free cash flow (fcf) & fcf to equity under alternative horizon / growth assumptions

Explain the use of the BSOP to estimate the value of equity and discuss the implications of the model for a change in the value of equity

Outline the argument and the problem of overvaluation. Estimate the near-term and continuing growth levels of a firm’s

earnings using internal & external measures. Assess the impact of an acquisition or merger upon the risk

profile of the acquirer distinguishing: (i) Type 1 acquisitions that do not disturb the acquirer’s

exposure to financial or business risk (ii) Type 2 acquisitions that impact on the acquirer’s

exposure to financial risk (iii) Type 3 acquisitions that impact upon the acquirer’s

exposure to both financial and business risk Advise on the valuation of a type 1 acquisition of both quoted

and unquoted entities using: (i) Book value-plus models (ii) Market relative models (iii) Cash flow models including EVA™ and MVA Advise on the valuation of type 2 acquisitions using the

adjusted net present value model. Advise on the valuation of type 3 acquisitions using iterative

revaluation procedures. Demonstrate an understanding of the procedure for valuing

high growth start-ups.

This is an important chapter.

It is likely that there will be regular questions on type 1, type 2 and type 3 acquisitions. These questions may require you to use your knowledge from chapter 2 to calculate an appropriate cost of capital to value an acquisition.

Economic value added (EVA) is covered in this chapter – note that EVA can be examined as a method of performance evaluation (and has been covered in this context in chapter 2).

Type 1 Q1 Dec 2009 Q1 Q1 June 2011 Q1 June 2012

Q3 December 2012

Type 2 Intergrand - 30 marks

Type 3

Mercury training - 28 marks, June 2008 Burcolene - 30 marks, Dec 2007

Valuation for acquisitions and mergers


10: VALUATION FOR ACQUISITIONS AND MERGERS

146 ANP413

Overview



Valuation for acquisitions and mergers

If financial risk changes

Adjusted present value



147 ANP413

1 Acquisition types 1.1 To ensure that a company does not overpay for a target, it is important that careful analysis

is undertaken of the value of an acquisition.

1.2 The approach to evaluating acquisitions depends on the type of acquisition being considered.

Types Explanation 1 Acquisitions that do not change financial or business risk 2 Acquisitions that change financial risk only 3 Acquisitions that change business risk (and possibly financial risk too)

2 Type 1 – no change in business or financial risk 2.1 There are four simple techniques for valuing a target.

Value the cash flows or earnings under new ownership Value the dividends under the existing management Value the assets

2.2 Earnings methods are covered in Chapter 12, the other methods are covered below.

Assets basis 2.3 An approximate technique for establishing the minimum value of an unlisted company,

normally based on the realisable value of the assets. This value is often used as a base line to negotiate against with the level of profits determining the eventual price paid; this is sometimes called a book value + method.

Dividend basis 2.4 The value of a share is calculated as the present value of the future dividends being

generated by the existing management team. It is generally more relevant for minority shareholders.

2.5 Value per share = P0 = gKg)1 (d

e

0

this is given on the formula sheet

Where d0 = dividend paid now Ke = cost of equity of the target g = growth rate in dividends

2.6 There are two internal techniques for estimating g that you need to know. These have already been covered in Chapter 2.

Max Min



148 ANP413


Nykro Ltd has just declared a dividend of 39.25p per share. Previous dividends have been growing at 6.95% p.a. Required What is the estimated value of Nyko, if the Ke is 12% ?

Solution

2.7 Alternatively you may be given an external measure of growth from an analyst.

2.8 This approach to valuation has many drawbacks: (a) It is difficult to estimate future dividend growth. (b) It is inaccurate to assume that growth will be constant. (c) It creates 0 values for 0 dividend companies and negative values for high growth

companies.

Estimating future dividend growth

Use historic growth Use current re-investment levels g = rb



149 ANP413

Cash flow basis 2.9 This calculates the value of the firm as the discounted value of the future free cash flows to

equity.

Note: free cash flow to equity is sometimes called dividend capacity.

Approach 1 Approach 2

1 Identify the free cash flows of the target company (before interest)

1 Identify the free cash flow to equity of the target company (after interest)

2 Discount at WACC

2 Discount at the cost of equity, Ke.

3 NPV of company – debt

= value of the target

3 NPV

= value of the target

2.10 You need to be able to use these approaches under different time horizon and growth assumptions; remember that if growth is constant then the growth rate needs to be subtracted in step 2 above ( a similar approach to paragraph 2.5).

Free cash flows (FCF) = after tax operating (pre interest) cash flows – net investments in assets Free cash flows to equity (FCFE) = FCF – net interest paid



150 ANP413

Lecture example 2 Technique demonstration Wmart plc plans to make a bid for the entire share capital of Ada plc, a company in the same industry. It is expected that a bid of £75 million for the entire share capital of Ada plc will be successful. The acquisition will increase Wmart's after tax operating cashflows (ie pre interest) over the next few years by:

Year £m

1 5.6 2 7.4 3 8.3

4 onwards 12.1 Both companies have similar gearing levels of 16.7% (debt as a % of total finance) Ada plc has £15 million par value of 5.75% irredeemable debentures trading at par. Wmart plc has an equity beta of 2.178, the risk free rate is 5.75% and the market rate is 10%. Corporation tax is at 30%. Required

Assess whether the acquisition will enhance shareholder wealth in Wmart plc? (Use both approach 1 and approach 2 from Section 2.9).

Solution



151 ANP413

Earnings basis 2.11 Range of values (normally)

Max Value the earnings under new ownership Min

Market value = P/E Earnings (a)

Economic value added 2.12 EVA™ is an estimate of the amount by which earnings exceed or fall short of the required

minimum rate of return that shareholders and debt holders could get by investing in other securities of comparable risk. It can be used as a performance evaluation tool, and can also be relevant to valuing acquisitions. The formula is as follows: EVA = net operating profit after tax – (WACC x book value of capital employed)

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

Shows the current profitability of the company Q3



152 ANP413


In chapter 2, you calculated the Economic Value Added of the following company: Summary income statement for the year:

20X0 $m

Pre-tax accounting profit 134 Taxation (46) Profit after tax 88 Summary balance sheet / statement of position for the year ending: 20X0 $m Shareholders’ funds 380 Medium and long-term bank loans 126 Other information is as follows: 1 Capital employed at the end of the previous year amounted to $400m. 2 There were non-capitalised leases valued at $16m. 3 The pre-tax cost of debt was estimated to be 10% in 20XO. 4 The cost of equity was estimated to be 17% in 20X0. 5 The target capital structure is 70% equity, 30% debt. 6 The rate of taxation is 30% in 20X0. 7 Interest payable amounted to $8m in 20X0. 8 Other non-cash expenses amounted to $20m per year in 20X0. EVA was calculated as:

Adjusted profit $113.6m (88 + 20 + (0.7 x 8)) Capital employed $416m (400 + 16) The weighted average cost of capital based on the target capital structure is: (17% x 0.7) + (10% x 0.7 x 0.3) = 14.00% EVA = 113.6 - (416 x 0.14) = $55.36m

Required Use the EVA calculated above to value the business.



153 ANP413

Solution

3 Type 2 – change in financial risk only 3.1 Adjusted present value has been covered in Chapter 7, as a three-step approach.

3.2 APV is also used to value acquisitions that change the gearing of a company.

4 Type 3 – change in business risk 4.1 Where an acquisition alters a firm's business risk there is an impact on the existing value of

the acquirer as a result of the change in risk, so the following approach needs to be used.

Approach

1 Calculate the asset beta of both companies.

2 Calculate the average asset beta for the group post-acquisition.

3 Regear the beta to reflect the gearing of the group post-acquisition.

4 Calculate the group’s new WACC.

5 Discount the group’s post acquisition free cash flows at this WACC.

6 Calculate the revised NPV of the group and subtract debt to calculate the value of the equity.

Step 1 Calculate the project NPV as if ungeared





154 ANP413


Senso plc plans to make a bid for the entire share capital of Enco plc, a company in a different industry. It is expected that a bid of £80 million for the entire share capital of Enco plc will be successful. This will be entirely financed by new debt at 6.8%. After the acquisition the post-tax operating cash flows of Senso's existing business will be:

Time 1 2 3 4 5

£m 24.12 25.57 27.10 28.72 30.45

After the acquisition the post-tax operating cash flows of Enco's existing business will be:

Time 1 2 3 4 5

£m 6.06 6.30 6.56 6.84 7.13

After the acquisition, £6.5m of land will be sold and there will be synergies of £5m post-tax p.a. Before the acquisition, Senso had £45m of debt finance (costing 5.6% pre-tax) and 40m shares worth £11 each and an equity beta of 1.19. As a consequence of the acquisition, the credit rating of Senso will fall and the interest paid on existing debt will rise by 1.2% to 6.8%. Enco has an equity beta of 2.2, its existing share price is £1.00 and it has 62.4m shares in issue; it also has £5m of existing debt that would be taken over by Senso. The risk free rate is 4.5% and the market rate is 8% and corporation tax is 30%. Required

Evaluate the impact on shareholder wealth assuming that cash flows after year 5 will grow at 2% p.a (assume that the beta of debt is zero).

Solution



155 ANP413

4.2 In fact this approach is slightly inaccurate because the weightings used within the WACC do not reflect the value of the company post-acquisition; a computer model can solve this.



156 ANP413

5 Black-Scholes model and share valuation 5.1 This is mainly useful for a start-up firm that is high risk and difficult to value using normal

techniques. 5.2 The value of a firm can be thought of in these terms:

if the firm fails to generate enough value to repay its loans, then its value = 0; shareholders have the option to let the company die at this point.

if the firm does generate enough value then the extra value belongs to the shareholder

in this case shareholders can pay off the debt (this is the exercise price) and continue in their ownership of the company (i.e. just as the exercise of a call option results in the ownership of an asset).

the Black-Scholes model can be applied because shareholders have a call option on the business. The protection of limited liability creates the same effect as a call option because there is an upside if the firm is successful, but shareholders lose nothing other than their initial investment if it fails.

so the value of a company can be calculated as the amount that you would pay as a premium for this call option.



157 ANP413

6 Chapter summary 6.1 This chapter has reviewed the valuation techniques. The important issue is that there are

different techniques for different types of acquisitions.

Type 1 – no change in risk 6.2 NPV is the key technique, there are two approaches that can be taken.

Approach 1 Approach 2

1 Identify the free cash flows of the target company (before interest)

1 Identify the free cash flow to equity of the target company (after interest)

2 Discount at acquirer's WACC 2 Discount at the acquirer’s cost of equity, Ke. 3 NPV of company – debt = value of the target

3 NPV = value of the target

Type 2 – change in financial risk only 6.3 APV is the key technique here.

Type 3 – change in business risk 6.4. The following approach needs to be used:

Approach

1 Calculate the asset beta of both companies. 2 Calculate the average asset beta for the group post-acquisition. 3 Regear the beta to reflect the gearing of the group post-acquisition. 4 Calculate the group’s new WACC. 5 Discount the group’s post-acquisition free cash flows at this WACC. 6 Calculate the revised NPV of the group and subtract debt to calculate the value of the

equity.

Black-Scholes model 6.5 The protection of limited liability creates the same effect as a call option; i.e. an upside if

the company succeeds, and loss of the initial investment (= premium) if it fails.

Step 1 Calculate the project NPV as if ungeared



Sections 7&8



158 ANP413

END OF CHAPTER


159 ANP413





Demonstrate an understanding of the principal factors influencing the development of the regulatory framework for mergers and acquisitions globally and, in particular, be able to compare and contrast the shareholder versus the stakeholder models of regulation.

Identify the main regulatory issues which are likely to arise in the context of a given offer and (i) identify whether the offer is likely to be in

the shareholders’ best interests (ii) advise the directors of a target company

on the most appropriate defence if a specific offer is to be treated as hostile

This area is likely to be tested as a discussion part of a question on takeovers.

Q31 June 2011 – 5 marks on defence strategies Q3 December 2012 – 4 marks on regulation

Regulatory framework and processes


11: REGULATORY FRAMEWORK AND PROCESSES

160 ANP413

Overview



Regulatory framework and processes

City Code to protect shareholders Competition Commission to protect consumers



161 ANP413

1 Regulation of takeovers

City code 1.1 This is a voluntary code that aims to protect the interests of shareholders during the bid

process. Although it is voluntary, any listed company not complying may have the membership of the London Stock Exchange suspended. The details of this code do not have to be memorised, but awareness of its existence and purpose is examinable.

Lecture example 1 Homework exercise Here are a few of the key rules in the UK City Code (for full details see thetakeoverpanel.org.uk). Required What is the purpose of these types of regulations? (a) Rule 2.2, 2.4. A bid announcement is required if the offeree company is the subject of

speculation due to the bidding company’s actions. The bidding company will be forced to state whether an offer is being considered, and the offeree company can request the Takeover Panel to impose a time limit for the bidding company to clarify its intentions; if this is done and a firm bid is not made then the bidding company will have to wait 6 months before it can make another bid.

(b) Rule 2.5. Where a bid involves an element of cash, the bidding company must obtain confirmation by a 3rd party that it can obtain these resources.

(c) Rule 3. The Board of an offeree company must obtain competent independent advice on any offer and the substance of such advice must be made known to its shareholders. If the Board disagree with the advice this must be explained to shareholders.

(d) Rule 9. An offer must be made for all other shares if the % shareholding rises above 30%, at not less than the highest price paid by the bidding company in last year

(e) Rule 31. After a formal offer there is a 14 day deadline for the defence document to be published, a 46 day deadline for the offer to be improved and finalised, and an 81 day deadline for shareholder votes to be assessed and the result announced. Offers are normally conditional on more than 50% of the shares being secured.

(f) Rule 35. If a bid fails then the bidder cannot make another bid for another 12 months.

Solution

Case 15



162 ANP413

Competition Commission 1.2 In the UK the Competition Commission may intervene to prevent mergers that cause the

creation of a company with a combined market share of above 25%, if it feels that there has been a substantial lessening of competition.

2 Defence against a takeover 2.1 Where the Board feel that a takeover is not in their shareholders’ best interest they may

decide to launch a defence against the bid.

Illustration In 2004, M&S reacted to rumours of Philip Green’s takeover bid by appointing a new MD, Stuart Rose, who was able to announce a new strategy by the time that the bid materialised at £9.1bn, which valued M&S at £4.00 per share. The defence strategy proved successful. The new strategy included the following: (a) An announcement of the return of £2.3bn to shareholders, the biggest share buyback in UK

corporate history. (b) The sale of M&S money to HSBC (M&S will retain a 50% stake for 10 years). (c) A back to basics corporate strategy (closure of the Lifestyle home furnishings brand,

identification of cost savings worth £250m p.a.). (d) A revaluation of its property portfolio (to £1.4bn above its present book value).

Section 3



163 ANP413

3 Chapter summary Section Topic Summary 1 Regulation of

takeovers In the UK, as noted in Chapter 1, corporate governance focuses on protecting the shareholder; it is a shareholder based model. This is mainly achieved through the City Code.

2 Defence against a takeover

Where an offer is unlikely to be in the shareholders’ best interests, directors may embark on a defensive strategy; this is likely to involve a new corporate and financial strategy.



164 ANP413

END OF CHAPTER


165 ANP413





Compare the various sources of financing available for a proposed cash-based acquisition.

Evaluate the advantages and disadvantages of a financial offer for a given acquisition proposal using pure or mixed mode financing and recommend the most appropriate offer to be made.

Assess the impact of a given financial offer on the reported financial position and performance of the acquirer.

Financing is likely to be tested as a discussion part of a larger question on business valuations.

Q1 June 2011 7 marks on financing Q3 December 2012

Financing acquisitions and mergers


12: FINANCING ACQUISITIONS AND MERGERS

166 ANP413

Overview

Long-term finance Equity Debt Venture capital Leases



Financing acquisitions and mergers

Cash or paper bids



167 ANP413

1 Sources of finance for cash-based bids 1.1 Buying a target for cash gives the shareholders the advantage of a definite capital gain in

exchange for their shares. How to obtain the cash is a gearing decision, and this has been covered in earlier chapters. However, there are a few extra points to note when raising finance to fund a takeover.


Required Advise on the pros and cons of each of the following forms of financing a cash-based bid.

Sources of finance Discussion Cash on deposit

Bond issue

Line of credit

2 Paper bids 2.1 For larger bids, or to avoid capital gains tax for the target’s shareholders, paper bids (equity

swaps) are common.

2.2 In this situation, the bid is harder to design and to evaluate because of the need to estimate the value of the shares offered after the acquisition.

Section 1

Case 16



168 ANP413

To be continued ..


169 ANP413




Key knowledge Understanding the risks of international investment, and the role of Eurobonds in managing risk.

Understanding what is meant by a type I, type II or a type III acquisition.

Awareness of the key provisions of the City Code.

Key skills Applying a valid approach to evaluating international investments.

Applying a valid approach to business valuation depending on whether it is a type I, type II or a type III acquisition.

Using an appropriate cost of capital knowledge from stage 1 to assist in valuation techniques.


CHECKPOINT 3

170 ANP413


Chapter 8 – International investment decisions and financial decisions

120 minutes

Key areas Understanding the risks of overseas investment and how these risks can be managed

(especially through the use of overseas debt finance) Understanding the two main methods of appraising overseas investments

Course Notes Section 1 – make sure that you understand why the two methods of appraisal give the

same answer. Read case 9 at the back of this companion. Carefully review the three types of risk in section 2 and make sure that you understand

the role of overseas debt finance, often involving the use of the Euromarkets, in managing them. Read case 10.

Briefly review section 3 then read case 11.

10 minutes

10 minutes

10 minutes

Study Text Section 3.7 links overseas investment appraisal to APV, which you covered in chapter 7.

APV is likely to be examined in this context because overseas projects often involve the use of debt finance (this is tested in Q1 in the new pilot paper). Also review sections 5 and 6 to cement your understanding of risk and financing issues. Plan an answer to Question 14 (Canada) from the study text on methods of appraising overseas investments (note that this is not an APV question).

90 minutes

Chapter 9 – Acquisitions and mergers versus other growth strategies

45 minutes

Key areas

Understanding the pros and cons of different growth methods (of which acquisitions are one)

Awareness of the three different types of synergy

Course Notes Review the chapter concentrating on the types of synergy and the risks of acquisitions;

then read cases 12,13 (noting the key term ‘due diligence’) and 14 at the back of this course companion.

20 minutes

Study Text Section 5 – it will be important that you can comment on synergies in the exam, so make

sure that you are familiar with the three main categories. Section 6 is also an important discussion area.

25 minutes


CHECKPOINT 3

171 ANP413

Chapter 10 – Valuation for acquisitions and mergers 110 minutes

Key areas

Assessing type 1, type 2 and type 3 acquisitions

Course Notes Review the chapter ensuring you can follow all the calculations, concentrating on the

cash-based methods in sections 2 and 4.

20 minutes

Study Text Question Bank Question 18 (Univo plc), this tests your ability to use the dividend valuation model.

40 minutes

Study Text This is a very important area of the syllabus and you must not rush through it. Sections 1

and 2 are useful as an introduction to the area.

Review section 7 which discuss issues in valuing start-up companies. Section 8 is important; carefully review this section & make sure that you are aware of at

least 2 models for valuing intangibles (sections 8.2.1 & 8.2.3-8.2.5 are especially important).

20 minutes

10 minutes

20 minutes

Chapter 11 – Regulatory framework and processes 35 minutes

Key areas Awareness of the City Code and the Competition Commission Awareness of methods for defending against a takeover

Course Notes Review the whole of this short chapter, attempt example 1 and review the solution. Also

review case 15 at the back of this course companion.

10 minutes

Study Text Review section 3 & 4, especially the criteria used to trigger an investigation by the

Competition Commission or by the European Union (sections 3.4-3.5).

25 minutes

Chapter 12 – Financing acquisitions and mergers 30 minutes

Key areas Understanding the sources of finance available for a cash-based acquisition Understanding the advantages of a paper-based bid, and how to evaluate such a bid

Course Notes Review the chapter, and cases 16 & 17 which provide some contemporary discussion of

financing issues.

20 minutes

Study Text Review section 3, especially section 3.2 which covers the effect of a takeover bid on a

company’s financial statements

10 minutes

On completion of Stages 1,2 &3 Study Support and Progress Tests 1,2 &3 you are ready to attempt Course Exam 1


CHECKPOINT 3

172 ANP413



The multiple choice questions contained within Progress Test 3 will thoroughly test your understanding of the material and your ability to perform the required calculations. Note that the P4 exam does not contain multiple choice questions. The short written question that follows will test your ability to apply your knowledge. These skills will prove important in preparing you for the more discursive elements of the exam.

It is important that you continually review your progress and revise further any areas where you feel your understanding is weak.


1 Estimates for inflation for the next three years are given below:

UK Europe 20X7 3% 2% 20X8 2% 2.5% 20X9 2% 3.5%

The current spot rate is 1.5 € to the £. Using purchasing power parity theory, what is the forecast €/£ exchange rate for 20X9?

A 1.507 €/£ B 1.514 €/£ C 1.485 €/£ D 1.450 €/£ (2 marks)

2 Estimates for inflation for the next three years are given below:

UK USA 20X7 3% 4% 20X8 2% 5% 20X9 2% 3.5%

The current spot rate is 0.5 £ to the $. Using purchasing power parity theory, what is the forecast £/$ exchange rate for 20X9?

A 0.527 £/$ B 0.535 £/$ C 0.474 £/$ D 0.643 £/$ (2 marks)

Data for questions 3-4 A supermarket is evaluating an investment project overseas – in Switzerland. The project will cost an initial 5 million Swiss Francs (SFr) and it is expected to earn nominal post-tax cash flows as follows.

Year 1 2 3 4 Cash flow (SFr'000) 1,500 1,900 2,500 2,700 (a) The expected inflation rate in Switzerland is 3% a year, and 5% in the UK. (b) The current spot rate is 2 SFr per £1 sterling. (c) The company requires a sterling return from this project of 16%.


CHECKPOINT 3

173 ANP413

3 Using the data above, and using purchasing power parity theory to forecast the exchange rates, the NPV in £'000s is:

A 6319 B 2034 C 1039 D 546 (2 marks)

4 Using the data above, what would be the SFr cost of capital that could be used to assess the project in SFr (and then converting the SFr NPV into £ at the spot rate):

A 13.8% B 14.0% C 18.0% D 18.3% (2 marks)

Data for questions 5-7 The directors of Astra plc are considering the acquisition of Naught Ltd, a much smaller company making annual profits before tax of £400,000 (constant). The current rate of tax is 28%. Naught Ltd’s balance sheet is as follows:

£ £ Non-current assets (net book value) 1,600,000 Inventory 1,008,000 Receivables (less provision of 1% for doubtful debts) 792,000 Bank balances 40,000 1,840,000 Bank overdraft 100,000 Trade payables 980,000 (1,080,000) 2,360,000 Share capital and reserves 2,360,000 The estimated values of Naught Ltd’s assets are as follows.

Replacement Net realisable Cost value £ £ Fixed assets 1,700,000 1,200,000 Stocks and WIP 1,080,000 1,160,000 It is generally agreed that 2% of total debtors will be uncollectable.

Astra has a P/E ratio of 15. Naught’s cost of equity is 10%, and it pays out 90% of its earnings as a dividend.

5 What is minimum bid that Astra plc should make for Naught Ltd?

A £2,096,160 B £2,064,000 C £2,104,000 D £3,164,000 (2 marks)

6 If Astra plc and Naught Ltd are in the same industry, what is the maximum price that Astra should pay for Naught?

A £6,000,000 B £4,320,000 C £1,680,000 D £2,104,000 (2 marks)


CHECKPOINT 3

174 ANP413

7 Naught Ltd, using the dividend valuation model, is worth:

A £3,600,000 B £2,880,000 C £2,592,000 D £2,104,000 (2 marks)

8 Chancer plc is considering the acquisition of Risky plc. Risky plc is estimated to have free cash flows of £1,200,000 in the next year, growing at a rate of 4% p.a. for the foreseeable future. Risky has debt with a book value of £10m and a market value of £12m.

Chancer has a weighted average cost of capital of 10% and a cost of equity of 12%.

What is the value of Risky using the cash flow basis?

A £10m B £20m C £8m D £15m (2 marks)

9 Grace plc is considering the acquisition of Drama plc. Drama plc is estimated to have free cash flows to equity of £1,500,000 in the next year, growing at a rate of 2% p.a. for the foreseeable future. Drama plc has debt with a book value of £10m and a market value of £12m.

Grace has a weighted average cost of capital of 10% and a cost of equity of 12%.

What is the value of Drama plc using the cash flow basis?

A £15m B £18.75m C £5m D £3m (2 marks)

B Short written questions (2 questions – approximate time 15 minutes) 1 Identify three types of synergy that can result from an acquisition, and give an example of each. (6 marks)

2 Identify four of the requirements of the City Code, and the purpose of each requirement. (4 marks)



CHECKPOINT 3

175 ANP413


Section A

1 B

UK Europe Using PPP theory

Forecast

20X7 3% 2% x 1.02/1.03 1.485 20X8 2% 2.5% x 1.025/1.02 1.492 20X9 2% 3.5% x 1.035/1.02 1.514

2 C

UK US PPP theory Forecast 20X7 3% 4% x 1.03/1.04 0.495 20X8 2% 5% x 1.02/1.05 0.481 20X9 2% 3.5% x 1.02/1.035 0.474

As the exchange rate is to the $, the $ is treated as the domestic currency in the purchasing power parity theory formula.

3 D

The expected spot rate at the end of each year can now be found.

Year SFr/£ 0 2.0000

1 2.000 x 05.103.1 =

1.9619

2 1.9619 x 05.103.1 =

1.9245

3 1.9245 x 05.103.1 =

1.8878

4 1.8878 x 05.103.1 =

1.8518

The £ sterling NPV can now be found.

(i) Discounting annual cash flows in £ sterling at 16%

Year Cash flow SFr/£ Cash flow Discount PV SFr$'000 £'000 factor £'000 0 (5,000) 2.0000 (2,500) 1.000 (2,500) 1 1,500 1.9619 765 0.862 659 2 1,900 1.9245 987 0.743 733 3 2,500 1.8878 1,324 0.641 849 4 2,700 1.8518 1,458 0.552 805 Total NPV (£'000) 546

4 A (1 + UK rate) adjusted for overseas inflation in the same way as the exchange rate has been adjusted:

1.16 x 1.03/1.05 = 1.138, i.e. the cost of capital in Switzerland would be 13.8%


CHECKPOINT 3

176 ANP413

5 C £ Non-current assets 1,200,000 Inventory 1,160,000 Receivables, 98% of £396,000 (100 99) 784,000 Bank balances 40,000 Bank overdraft and trade payables (1,080,000) 2,104,000

6 B P/E x earnings = 15 x (£400,000 x (1-tax of 28%)) = 15 x £288,000 = £4,320,000

This is approximately what Astra will be worth under Naught’s ownership – so a higher price cannot be justified on the information provided.

7 C £288,000 x 0.9 = £259,200 dividend

Po = £259,200/ 0.1 = £2,592,000

8 C 1 Free cash flows = £1.2m (this is before interest)

2 Discount at WACC 10%

3 NPV = £1.2m / (0.1 – g) = £20m then subtract debt £12m = £8m.

9 A 1 Free cash flows to equity = £1.5m (this is after interest)

2 Discount at Ke 12%

3 NPV = £1.5m / (0.12 – g) = £15m.

Section B 1 Sales synergy – for example sharing sales facilities (dealer network, or sales force) to generate higher

levels of sales.

Cost synergy – for example shedding overlapping central costs (often Head Office functions but also R&D etc) or maximising discounts from suppliers.

Financial synergy – for example a lower cost of capital if the group is seen as being lower risk.

2 A bid announcement is required if the offeree company is the subject of speculation due to the bidding company’s actions. The bidding company will be forced to state whether an offer is being considered, and the offeree company can request the Takeover Panel to impose a time limit for the bidding company to clarify its intentions; if this is done and a firm bid is not made then the bidding company will have to wait 6 months before it can make another bid. This prevents the offeree company from being constantly distracted from their core business by rumours.

Where a bid involves an element of cash, the bidding company must obtain confirmation by a 3rd party that it can obtain these resources. This rule is intended to deter unrealistic bids.

The Board of an offeree company must obtain independent advice on any offer and the substance of such advice must be made known to its shareholders. This is intended to encourage the company to act in the best interests of its shareholders.

An offer must be made for all other shares if the % shareholding rises above 30%, at not less than the highest price paid by the bidding company in last year. This is intended to reflect that this level of shareholding gives a shareholder a high level of influence over the way that a company is being run.

After a formal offer there is a 14 day deadline for the defence document to be published, a 46 day deadline for the offer to be improved and finalised, and an 81 day deadline for shareholder votes to be assessed and the result announced.


CHECKPOINT 3

177 ANP413


Case 9 – Tesco international investment B B C W E B S I T E – D E C E M B E R 2 0 0 7 Las Vegas is home to some of the world's biggest hotels and casinos, but just three miles away from the razzle-dazzle of lights on The Strip lies a distinctly un-flashy supermarket - at least compared with the rest of Vegas' glamour. It is called Fresh & Easy and is owned by the world's third biggest retailer, Tesco.

Priding itself on offering gourmet-style produce, its branding tries to stress its range of all-natural food. And, as is the trend these stages, it is also promoting environmental awareness: the stores are painted green and there is parking for hybrid cars along with bike racks. Its new distribution centre in Riverside in California - where it makes its salads and ready meals - has one of the largest solar-panelled roofs in the US.

But is the company taking too much of a gamble by stepping foot on American soil? Certainly it is out to make a name for itself. Five branches have opened in Las Vegas within the past three weeks alone with 20 planned by this time next year. Another 10 are already up and running in Los Angeles and Orange County, with a further three stores opening in Phoenix this week.

In all Tesco hopes to have 250 Fresh & Easy stores dotted across California, Arizona and Nevada within the next 14 months - and as many as 800 of the outlets by 2012.

Tesco's entrance into the US market has been a long time coming, with the company, a £40bn international enterprise, studying US shopping habits for 20 years. The team even sent out researchers to live with 60 American families for two weeks to discover the products they bought and they food they ate. And the physical appearance of the store had been shrouded in secrecy - with a mock outlet set up in an LA warehouse to test designs and train staff. Members of the public who were invited were told they were there to take part in a film about supermarkets.

But setting up shop - and making it succeed - is not going to be as simple as the brand name suggests. Tesco has had to build a distribution network up from scratch and it aims to source 60% of its products locally. And while it has chosen to target the western US because of the size and density of its urban sprawl, where there are already many other chains looking to sell goods with an emphasis on "fresh" and "cheap". These include Vons, Trader Joe's, Ralphs, Albertsons and of course, the mighty Wal-Mart.

Tesco doesn't see Wal-Mart as the main competitor here though. There are comparatively few in this area of the US and the company is still very much focused on its superstore set-ups; nothing like the type of store that Tesco is going for here. But that competition, coupled with the sheer size of the area it aims to cover - a drive from Los Angeles to Las Vegas is almost 300 desert-covered miles - may make things much harder than in the UK. It is a factor that saw Marks & Spencer and Sainsbury's abandon their American dreams in the late 1980s and early 1990s.

But Tesco thinks it has got it right and the stores aim to cater for time-starved shoppers who want fresh, healthy food - including ready meals - at "affordable prices". The company is promising to locate some of its outlets in areas that desperately need them. Many low-income, high-poverty areas that have become so-called "food deserts": areas that lack access to fresh, healthy, affordable food.

European chains have long tried, mostly unsuccessfully, to make inroads into the US. Even US retailers, squeezed by rising costs and big players such as Wal-Mart often end up scaling back or selling out. Fresh & Easy has had its work cut out - with no established brand, no customers and no distribution network.

It's a far cry from its UK position where Tesco is the dominant grocery brand. From Tesco Extra to the smaller Express and Metro versions on the High Street, the company controls more than 30% of the UK grocery market.

Fresh & Easy have modelled their west coast outlets on the 800 Express stores in Britain. The aisles are wide and the shelves no higher than five feet. Each outlet employs between 20 and 30 people and are much smaller


CHECKPOINT 3

178 ANP413

than the typical US supermarket. The store has a kitchen table area where staff - or as they call them here "crew members" - offer customers the chance to try some of the food for themselves.

Fresh & Easy chief executive Tim Mason is convinced Tesco has developed a winning formula. "What we're trying to do is to be very useful and very beneficial to American neighbourhoods and I think we're achieving that," he said. "I mean, we haven't come here to be a small business. There's no point in coming to America and planning to be a small business."

The figures appear to back up that ambition. Tesco is putting £250m a year into the business after an initial investment of £89m, and it expects US operations to be profitable from the third year.

F T S E P T E M B E R 2 0 1 0 The US is the biggest retail market in the world, and Sir Terry knew that cracking it would secure Tesco’s growth for decades. Although British retailers have traditionally fared badly in the US, Tesco was confident that its Fresh & Easy venture would buck the trend. Six years on, that conviction looks misplaced. Fresh & Easy, armed with £1.25bn of capital and a clutch of top executives, has been a disappointment. It was meant to break even this year.

Instead, cumulative losses will be running at more than £450m by the time Sir Terry retires next March. It is little wonder that Philip Clarke, Sir Terry’s successor, refuses to rule out its closure regardless of the heavy investment already made.

Sir Terry first started to take a hard look at the US seven years ago. Although Tesco was clear number one in the UK, he needed new avenues of growth and overseas expansion was high on his list. The biggest market in the world, with more than $1,000bn of annual retail sales, was his top target. The executive team began taking trips over the Atlantic. They would “look at shops, all day everyday”, says Mr Smith, who went on one expedition with Sir Terry, and another with Mr Clarke. “[We looked at] every type of shop from the biggest, newest supercentres, to the neighbourhood stores that Walmart were developing, to all the other regional supermarket chains: HE Butt in Texas to Publix in Florida.”

Sir Terry saw a gap in the market for neighbourhood stores selling fresh, cheap food and came up with a provisional name, Fresh & Easy. He wanted Mr Smith to work out whether Tesco could profitably fill that gap. “The concept he had in his head [was] for something which was clearly missing in the American market, which was brilliant fresh food and a shop that offered ease of shopping, not just in terms of its position and locality, but also in terms of the range,” recalls Mr Smith.

Historically Tesco had only entered new markets through a small acquisition or joint venture. It would go slowly, test some stores and gradually build out a chain. It also opted for developing markets with plenty of scope for growth. The strategy had already worked in both Hungary and Thailand.

What Sir Terry was proposing in the US was entirely different. He was thinking of spending hundreds of millions of pounds upfront to get Fresh & Easy off the ground. He believed the chain would need its own food manufacturing plant to produce the sorts of fresh foods the US consumer might buy.

For any hope of success, the team believed that Fresh & Easy needed three things: to be as cheap as a Walmart supercenter; to have “mind-blowingly” good fresh foods; and to be easy to shop.

The proposal Mr Smith set out at Tesco’s strategy conference in November 2005 was not very different from what Sir Terry had previously jotted down on a sheet of A4. But less than a year before the planned launch, Mr Smith, who says he was in line for the chief executive job, was lured away from Tesco by a knockout offer from privately owned Somerfield. Mr Smith, who describes Fresh & Easy as “his baby” believes that it will be a success. “The work we did was of the highest quality, carried out by the highest calibre people that Tesco has. I’m as certain as I can be to this day that if that concept is delivered, obviously with some tweaks, it will work.

Despite that confidence, Fresh & Easy has not yet delivered. What to do about it will be one of Mr Clarke’s first tasks when he takes over next March, say analysts. Tesco had promised to open 200 stores by the end of 2009, but is still only trading from 168. And sales densities are well below the $14-$20 a square foot a week Tesco is targeting.


CHECKPOINT 3

179 ANP413

It has blamed this failure on the US economy, where the collapse of the housing bubble created a recession just as Tesco launched its new venture. New developments around Las Vegas and Phoenix turned into ghost towns. Gleaming new Fresh & Easy stores had no customers.

But observers say that there’s more to Fresh & Easy’s difficulties than just the economy. They argue that Tesco misread the US consumer by creating an environment that was too utilitarian. Vegetables and fruit were prepacked in bags when US consumers are used to seeing fresh produce stacked high. It stocked too few branded lines and too little frozen food.

“Fresh & Easy is very highly dependent on private label and the US consumer likes brands,” reflects one retail executive, who worked in the US for one of Tesco’s rivals. “Fresh & Easy was not a known brand, so by focusing on that there was nothing for the consumer to hang on to.”

Some in the industry say Tesco’s mistake was to promise too much too soon for Fresh & Easy. As Sir Terry says, it takes a decade to build a store network and another 10 years to build a brand, yet he had promised concrete results from Fresh & Easy within just two years of opening.

B B C W E B S I T E - D E C E M B E R 2 0 1 2 Tesco is launching a strategic review that may lead to the sale or closure of its US-based Fresh and Easy chain, the company has confirmed.

The UK's largest supermarket group has spent nearly £1bn ($1.6bn) on the loss-making US venture in an attempt to take on its main rival, Wal-Mart. Tesco said that all options for its US business were under consideration.

Mr Clarke said investment in the chain, which has about 200 stores in the US, would get better returns elsewhere: "While the business has many positives, its journey to scale and acceptable returns will take too long relative to other opportunities."

He has been under pressure after announcing Tesco's first fall in profits since 1994 at the half-year results stage in October.

In its statement, Tesco said that it had received a number of approaches from parties interested in all or part of the business, or in partnership with Tesco, and that it would give an update on the situation in April next year when it reports its full-year results.

The original concept for Fresh and Easy has been radically overhauled and the venture has faced opposition from trade unions. Its launch in the US came at a bad time, coinciding with the start of the sub-prime mortgage crisis and subsequent economic downturn.

Case 10 – Eurobonds F I N A N C I A L M A N A G E M E N T M A Y 2 0 0 8 Eurobonds are defined as bonds which are outside the control of the country in whose currency they are denominated; but don’t make the mistake of thinking that they are issued in Europe, or only denominated in euros- the eurobond market is global and involves a wide range of currencies (although dollars and euros are the most common). The reason for the name “eurobond” is that historically they were dollar denominated bonds raised in the European market as opposed to the USA. For example Walt Disney, despite being a US company, raised 100m US dollars on the euromarkets (i.e. outside the US) with its first eurobond issue in 1981. Eurobonds are normally repaid after 5-15 years, and are for major amounts of capital i.e. $10m or more.

Governments and large companies with excellent credit ratings regularly issue eurobonds, recent examples include: Cadbury-Schweppes (€1,200m 2004), VW (34 trillion Turkish lira 2004) and the Walt Disney Company ($100m in 1981, €80m in 1984, $400m in 1992 and $300m in 1995).


CHECKPOINT 3

180 ANP413

Eurobonds are ‘bearer instruments’, which means that the certificate is the sole title to ownership. Interest is paid gross of tax. Eurobonds are useful because they create a liability in a foreign currency to match against a foreign currency asset. The motive behind Walt Disney Corp issuing eurobonds in 1992 was to finance the launch of Euro Disney. Without this matching effect Walt Disney Corp would have faced the risk that a declining Euro would have reduced the dollar value of their overseas investment.

Eurobonds are often cheaper than a foreign currency bank loan because they can be sold on by the investor, who will therefore accept a lower yield in return for this greater liquidity. Eurobonds also are extremely flexible. Most eurobonds are fixed rate but they can be floating rate or linked to the financial success of the company. For example, in 1992 Walt Disney Corp issued a $300m Eurobond with a 3% coupon plus the right to benefit from the success of 13 named films which meant that the bonds could potentially provide a 13.5% p.a. yield.

Eurobonds are typically issued by companies with excellent credit ratings and are normally unsecured, which makes it easier for companies to raise debt finance in the future. Eurobond issues are not normally advertised because they are ‘placed’ with institutional investors (this is discussed below); this reduces issue costs.

The eurobond market can be used by companies to raise debt in dollars or euros (the majority of eurobond issues involve these currencies) and swap this into another currency using a currency swap; most eurobond issues are swapped in this way. For example, in 1984 Disney issued €80m of Euro-denominated Eurobonds and swapped them into yen to act as a hedge to the yen revenue from Disney’s Japanese operations. Eurobonds are an extremely important source of finance for major companies with strong credit ratings. As shown in table 1 below, Eurobonds accounted for about 70% of all funds raised by UK listed companies in 2007. Type of finance £m raised in 2007 Equity 16,453 UK bonds 155 Public sector 59,745 Eurobonds 165,925 Total 242,278 Table 1 : London Stock Exchange factsheet

And the problems? Like any form of debt finance there will be issue costs to consider (approximately 2% of funds raised in the case of eurobonds) and there may also be problems if gearing levels are too high. For example, Walt Disney Corp recently had to suspended royalty payments made by its European subsidiary because of financial difficulties at Euro Disney caused in part by the high levels of debt that it has taken on.

Eurobonds denominated in foreign currencies can also expose a company to foreign exchange risk unless they are being used to match against foreign currency assets as discussed above.

Doug Haste is an education specialist working at BPP Professional Education.


CHECKPOINT 3

181 ANP413

Case 11 – Exchange controls in Iceland F I N A N C I A L T I M E S – J U N E 2 0 0 9 (extract)

The kronor strengthened during the island’s boom years as the central bank kept interest rates high to damp inflation. This attracted speculative capital, which forced the exchange rate and interest rates still higher. The kronor then lost four fifths of its value last year before and during the island’s financial crisis in October, in which almost the entire banking sector was taken over by the state.

Last week the central bank felt confident enough to cut interest rates by 1 percentage point to 12 per cent – putting it 6 points down since the crisis – even though the International Monetary Fund recommended that it show caution.

Nevertheless, capital controls still impede the foreign operations of Icelandic corporates and have frozen some IKr630bn of foreign capital that was invested on the island before the crash. If controls were lifted the central bank fears some IKr250bn worth of “impatient investors” would convert their holdings, pushing the currency down.

“Capital controls are here to stay for some time,” Mr Oygard said, but added that by end of this year Iceland should have solved many issues that prevented them being lifted now.

Iceland is also undergoing a first review from the IMF, which wants to see more progress on these issues and on reducing the budget deficit before it releases the next $200m tranche of its $2.1bn stand-by loan.

In the longer term the future of the kronor will depend on Iceland’s moves towards the European Union. Parliament is currently debating a government bill giving it authority to open negotiations with the EU. If this is approved and the agreed terms later approved in a referendum, this could lead to the replacement of the kronor by the Euro within four years.

Case 12 – Mergers as kill or cure F I N A N C I A L T I M E S – J U N E 2 0 0 9 ( E X T R A C T ) There are two kinds of senior executive in the pharmaceuticals sector: those who are against mega-mergers, and those who have recently completed or are actively considering doing one. After a decade of big deals up to the mid-1990s in which many of the world’s biggest medicine manufacturers were created – such as GlaxoSmithKline (GSK), AstraZeneca and Sanofi-Aventis – there was a period of four quiet years, before the onset of a new wave of consolidation this year. At least in part, this has been set off by the downturn as valuations have fallen and any structural issues such as pricing have been accentuated. Pfizer, a serial acquirer, sealed the $68bn takeover of Wyeth in January, while Merck – which traditionally has preferred to concentrate on organic growth – said in March that it would buy Schering-Plough for $41bn.

Many pharmaceutical sector employees, investors, analysts – and even investment bankers until they became particularly hungry for fees in recent months – say mega-mergers have delivered little long-term benefit. Yet others – including some not involved in the latest round of restructuring – believe there is value to be gained if the target is chosen effectively and the combination is well handled. “I have not seen value creation through pharmaceutical mergers in the past 10 years,” says Steve Arlington, head of the pharma R&D practice at PwC, the professional services firm. “The industry has suffered from disruption through mergers, post-merger activity. Can big pharma become too big? You see a loss of leadership. The internal machine becomes very complex, and compliance overtakes leadership.”

But Daniel Vasella, chairman and chief executive of Novartis, who had an active role in the Swiss company’s creation through the merger of Ciba-Geigy and Sandoz in 1996, as well as several big takeovers since, is more positive. He argues that some companies might have been in a far worse shape if they had not combined. “An industry which has mounting pressure has a tendency to consolidate,” he says. “It’s a normal process. We have not yet reached the point of lethal size which is destructive.”

For deals to be successful, one lesson that veterans of such big initiatives cite is the need to move quickly in putting in place a new organisational structure in order to avoid protracted demoralisation. “You have to be aggressive, demanding and fast, or people start to retract and you lose a lot of energy and value-creating


CHECKPOINT 3

182 ANP413

activities,” says Mr Vasella. Roche unveiled a new organisational structure within weeks of its agreement with Genentech. It emphasised that Genentech would retain its brand in the US, while Art Levinson, a key architect of its success, would join the main corporate board in Switzerland. Even so, his replacement as Genentech’s longstanding chief executive by a Roche manager has raised concerns among investors and Genentech employees alike over their continued success.

Another lesson in making acquisitions work is the need to be radical. Tachi Yamada, who ran GSK’s research and development operations for six years after its merger in 2000, says: “The most important lesson when you do a merger is to be really bold in creating change. Otherwise you will create an organisation that is twice as big, and just as unsuccessful. People are very entrenched in their practices in R&D. They think they know the ans-wers and identify for a long time as being from company X or company Y and not part of company Z.” Mr Yamada, now head of global health at the Bill & Melinda Gates Foundation, created a series of smaller, more entrepreneurial, therapy-focused Centres of Excellence in Drug Discovery (CEDDs) across the company, that he says would have been impossible without the big disruption of a merger. “With hindsight, I might have been even bolder,” he says today, given that the CEDDs have again been restructured under his successor as analysts criticise insufficient productivity gains.

Case 13 – Due diligence F I N A N C I A L T I M E S – A U G U S T 2 0 0 7 (extract)

Intelligent M&A is the latest book to tackle the subject examines the factors that determine whether merger deals thrive or collapse. Its authors, Scott Moeller and Chris Brady, encourage executives to take a more active role in the "due diligence" process that unfolds before takeovers are announced. Moeller heads the executive education programme at Cass Business School in London. Brady,a former Royal Navy officer, is dean of the business school at Bournemouth University and a football coach.

Intelligent M&A is too basic to offer insights to practitioners, such as investment bankers, already versed in the techniques and pitfalls of dealmaking. The authors' main argument, that business intelligence techniques should be applied at every stage of a takeover, is too general to have a practical application. But for neophytes, such as managers who have little experience of corporate finance,or students, the book could be a useful guide, particularly at this point in the cycle.

For the past three years, deal volumes across the world have risen dramatically to $4,000bn (£1,976bn) last year, buoyed by factors such as globalisation and low interest rates, which have fuelled a boom in leveraged buy-outs. With equity markets and company valuations rising, few large strategic or private equity deals have soured. But as the credit markets turn, there is a palpable sense on Wall Street that the dealmaking glut could soon come to an end. That tends to be when M&A transactions unravel and leave investors nursing losses that can run into the hundreds of millions of dollars and managements trying to salvage their reputations.

Moeller and Brady do not suggest executives do away with the consultants and other advisers who typically take over due diligence. Rather, studying a target's business and its financial statements should be much more carefully supervised and vetted by top management.

The authors cite Alchemy, the UK private equity group, as an example of best practice. Jon Moulton, a top executive there, took special care in investigating carmaker MG Rover, which was being sold by BMW. "There were distribution issues, warranty issues, tax issues and pension issues," Moulton is quoted in the book as saying. "[The BMW executives] were shocked by things our investigation found out." By last year, Alchemy had decided against pursuing a deal.

A thorough examination of the target may not be enough of an insurance policy against a bad deal, however. Intelligent M&A reminds executives to stay attuned to how the potential transaction will be received among its investors and employees. Deutsche Börse, the main German stock exchange, fell foul of this principle in its bid for the London Stock Exchange in late 2004, the writers say. Deutsche Börse had failed to foresee that activist investment funds and arbitrageurs would pile into its shares and put pressure on the company to focus on its core business instead of the UK expansion.

The book's claim that it proposes a fresh paradigm for better M&A through the use of business and military intelligence techniques - a nod to Brady's experience - is overstated. Takeovers have involved warlike strategies


CHECKPOINT 3

183 ANP413

for years. But the authors have strong points to make on an activity in which thoroughness and common sense are sometimes lacking.

Case 14 – Successful integration F I N A N C I A L T I M E S – O C T O B E R 2 0 0 6 (extract)

In late 2000, TDC AS (TDC) took a majority stake in the Swiss company. At the time, this was the biggest-ever foreign takeover by a Danish company.

The new company faced a tough situation: the mobile division – normally the most profitable and promising part of the business – was losing 9 per cent of its customers per month. Financially, Sunrise was a disaster. Financial markets were concerned about future losses in Switzerland – where the local press had forecast a loss of up to 30 per cent of sales for 2001 – and even put TDC’s corporate management under pressure. Moreover, critics said that TDC had overpaid for this poorly performing company.

In December 2000, Mr Frimer was asked to jump in as president and CEO of Sunrise. With over 15 years of experience as a manager in various positions at TDC, he had the trust of TDC’s board to instil the necessary discipline into the new Swiss acquisition.

By 2003, Sunrise was a revived company. Mr Frimer and his team decided to drop the diAx brand, and the company had positioned itself as “the most human telecoms provider”: easy, friendly, and offering smart solutions at reasonable prices. This was quite different from the competition, which differentiated themselves on factors such as network power and tradition. Between 2000 and 2003, Sunrise nearly doubled its subscriber base for mobile phones, enabling it to regain the number two position in the market, and it launched various product innovations for fixed line and internet users. Finally, Sunrise had returned to profitability with a net income of 8.8 per cent of sales.

How did sunrise achieve such impressive results?

■ Weekly management board meeting This was the major decision-making body within Sunrise, at which all major challenges and choices were examined and decisions were made.

■ Project board When Mr Frimer and the new management team arrived in Switzerland, they soon discovered that there was a lot of cash outflow, leading to real “cash burn”. For example, equipment was being purchased without any prior internal discussion. This changed. Now, every purchase over SFr400,000 had to be discussed at the weekly forum. Managers had to present their planned purchases together with a net present value analysis.

■ One-on-one These biweekly meetings, lasting up to an hour, were forums for exchange between Mr Frimer and individual members of the board. There was no prearranged agenda; board members decided the issues to be discussed as necessary. One board member commented: “I have to tell him what I need, how it is running and where I expect help from him.” If neither the board member nor the CEO had anything to discuss, then the meeting could be cancelled.

■ Taskforces Once a problem was identified, board members were expected to fix it. If this did not happen, they would receive a warning. If the problem was not solved within the three to four months, Mr Frimer would send in a taskforce. This team would report directly to the CEO until the problem was resolved.

Meanwhile, as part of his managing up policy, Mr Frimer also implemented a monthly review meeting with HQ in Copenhagen. In so doing, his superiors understood what was going on in Switzerland and could provide input on how they would tackle the issues.

Enrolling the front-line employees

In Mr Frimer had a system to ensure that the 2,500 front-line employees knew exactly what to do to support the Sunrise strategy. For example, to overcome the barriers created by the divisional structure (mobiles, internet, fixed line) and to reach out to its customers, the company set up two marketing boards. One was for corporate customers, and one was for private customers. In these marketing boards, employees from various divisions had to work together to tailor their product offerings for various customer segments.


CHECKPOINT 3

184 ANP413

Also, Mr Frimer had frequent direct contact with front-line staff via “power breakfast” meetings held every six weeks. The meetings all followed the same format and anyone could apply to attend. The invited employees represented a wide pool of experience and were first asked to introduce themselves before Mr Frimer posed his question: “If you were CEO of Sunrise for a week, what would you do?” This served as a platform for making improvements and it was not uncommon for employees to later receive a personal letter from Mr Frimer highlighting important issues.

Since the number of places for the power breakfasts was limited, the top management team also visited the various offices. All employees were invited to the “EMT (executive management team) on tour” event, which took place twice a year at each location. There, the CEO would explain Sunrise’s overall strategy. Then, two other board members – different ones each time – described recent developments in their field. The meetings were set up so that employees had enough time to ask questions, which were treated seriously. In addition to these meetings, employees were strongly encouraged to voice their opinions in non-formal ways. They regularly received an online employee survey aimed at measuring feelings among employees.

Case 15 – Kay Review B B C W E B S I T E – N O V E M B E R 2 0 1 2 The government says it will take "a greater interest" in mergers and acquisitions involving UK companies as part of its response to the Kay Review. Its comments came in response to the Kay Review into how to discourage short-termism in markets. The government has decided it should "engage with companies and their investors... to promote investment which benefits the UK economy". There will be no change in legislation, Business Secretary Vince Cable said.

Prof John Kay's report, ordered by Mr Cable, suggests discouraging acquisitions that would threaten a firm's operations in the UK. The takeover of Cadbury by Kraft of the US in 2010 was criticised at the time for valuing a short-term share price gains above the long-term welfare of the company and its staff. It lead to the closure of one of Cadbury's long-standing production plants near Bristol with the loss of 400 jobs.

Regulation

The government said it supported Prof Kay's view that the duty of company directors to stakeholders requires decisions be made for the long-term, meaning that company directors can recommend rejecting a bid, even if the price appears to offer a good return, if they believe the transaction will destroy value in the longer term.

But the government's response says no changes to current regulation are needed because the Takeover Code,

which governs takeover activity, was changed last year to reflect that view.

It said it "does not believe there is a case for blanket regulation", but hopes that its reforms, designed to empower shareholders and create more transparency in remuneration, will help bring about such good practice.

The report also argues against a general hostility to foreign ownership, an approach the government said it endorsed because it acknowledges the continued importance of open markets for growth.


CHECKPOINT 3

185 ANP413

Case 16 – Financing and mergers G U A R D I A N – M A R C H 2 0 1 2 The turmoil sparked by the eurozone debt crisis has caused a 14% fall in the number of takeovers and mergers in the UK, a report has revealed.

The declining number of deals in the first quarter of 2012 compared with the previous three months was driven by fears over the future of the eurozone as Greece threatened default, Ernst & Young's M&A Tracker said.

The same trend was echoed on a global scale, with the number of deals down 24%. However, in the UK a 41% rise in the average size of the deals to $264m (£167m) meant their total value rose 20%, beating the global picture where average transaction values only increased slightly.

Jon Hughes, transaction advisory services leader at Ernst & Young, said: "The market uncertainty of late last year has clearly impacted transaction activity in the first quarter of 2012.

"That said, the small upswing in average deal values could indicate an increase in confidence amongst buyers, who, whilst still cautious about undertaking transactions, are more willing to push through larger deals."

The proportion of deals in the UK financed by cash rose to 91% from 88% previously, driven by an increase in the number of companies sitting on large surpluses. Globally, 55% of deals were financed by cash.

Hughes said: "Globally, the historically low cost of debt and improving equity markets have driven funding towards external sources of finance.

"This reflects an increasing confidence about access to capital markets for transactions.

"In contrast, deals in the UK have been, on the whole, financed by well-rated companies utilising their healthy cash piles to fund 100% cash payment transactions."

Case 17 – Private equity F I N A N C I A L T I M E S – M A Y 2 0 0 7 When Charles Lazarus opened his first children’s store in 1948, Henry Kravis, then four-years-old, was a potential customer. Nearly 60 years later, Toys “R” Us – the chain founded by Mr Lazarus to cater for baby-boomers – was reunited with one of the most successful children of that generation. In March 2005, Mr Kravis’s Kohlberg Kravis Roberts, together with fellow private equity group Bain Capital and Vornado Realty Trust, a property group, put an end to Toys “R” Us’s two tumultuous decades as a listed company by clinching a $6.6bn buy-out.

Since then, KKR and its allies have been busy applying their unique blend of financial engineering and managerial discipline to turn around a company that had lost touch with both its customers and its rivals.

Although a long way from Mr Lazarus’s credo – “retailing should be fun” – the tough love administered to Toys “R” Us by its new owners was a classic example of the modus operandi pioneered by KKR and adopted by many of its peers. It also offers a glimpse of what another retailer – Britain’s Alliance Boots, the country’s largest drugstore chain – could expect following its recent £11.1bn ($22bn) takeover by KKR.

Faithful to the buy-out industry adage that preparations for a sale, or “flip”, of a company begin on the stage it is acquired, KKR typically lays out an aggressive “100-stage” plan to address the most pressing issues. KKR declined to comment, but people familiar with its inner workings say the plan is a form of corporate shock therapy: a way to identify quickly and close the most glaring gaps in the company’s strategies and finances.

In the case of Toys “R” Us, KKR, Bain and Vornado immediately replaced the entire board with their appointees and poached a senior manager from one of its fiercest rivals, the mega-store chain Target, to be chief executive. Within months the new team took drastic action, sanctioning the closure of 75 stores, more than 10 per cent of the group’s US footprint, with the loss of some 3,000 jobs.


CHECKPOINT 3

186 ANP413

The moves underline the ability of private equity groups to enact rapid, and often painful, measures once the company is out of the public spotlight and no longer has to contend with stock market investors.

These radical restructurings are usually enforced by a taskforce of KKR operatives, overseen by senior partners at 9 West 57th St, its imposing Central Park-facing headquarters. Management consultants from Capstone, the in-house advisory firm KKR revamped in 1999 are also seconded to companies during the 100-stage plan to help the KKR executives with the early “heavy lifting”.

Such expertise does not come cheap. According to Toys “R” Us’s latest annual report, for example, the retailer will pay its private equity owners $15m a year for up to a decade for “management and advisory services”.

Leveraging the company up with debt can also be burdensome, though the hands-on approach of most private equity groups is a direct consequence of the high-stakes game they play with their companies’ balance sheets. Loading a heavy debt burden on their takeover targets enables buy-out groups to maximise their returns once they sell out. The latest figures show an annual $537m interest payment at Toys “R” Us. This financial high-wire act fuels KKR’s hunger to make its money work fast. KKR and other buy-out groups typically convene board meetings once a month, rather than four times a year like most listed companies. Board discussions are intense and to the point.

“It is not easy to be the chief executive of a private equity-owned company with five or six self-appointed ‘Masters of the Universe’ telling you what to do every stage,” says one buy-out executive.

And yet, KKR’s innovative approach to its stewardship of companies is anything but plain sailing.

Toys “R” Us, for example, lost $384m in the year to January 2006, mostly as a result of costs related to the buy-out. It swung back into an $85m profit in the year to February 2007 but in a recent regulatory filing said it had been forced to delay its annual report due to a “material weakness in its internal controls”. The company said it would file its annual report by May 21 and declined further comment. The delay prompted Diane Shand at Standard & Poor’s, one of the few analysts who still follow the company, to warn that its credit rating, already at junk bond level, could be downgraded. She also remains sceptical about the company’s operations. “We need to see the [core] toy business turn, but I am not sure we will,” she says.

Mr Kravis’s challenge is to prove that KKR can use its financial might and managerial savvy to ensure that another difficult case does not join the small number of KKR failures.


187 ANP413

Lecture example 2 Technique demonstration Minprice plc is considering making a bid for the entire share capital of Savealot plc. Both companies operate in the same industry. You are given the following information: Minprice Savealot Revenue £284m £154m Share price (£1 ordinary shares) 300p 500p EPS 19.1p 46.5p No shares in issue 155m 21m Gearing (D:E) 40:60 20:80

Required (a) Calculate the expected post-merger value for the group using the P:E basis. The acquisition will be financed by issuing ordinary shares in Minprice to replace those in Savealot. A premium of 20% will be paid to Savealot's shareholders; ie a 2 for 1 offer. (b) Calculate the effect on the EPS and the share price after the acquisition. (c) Calculate the impact on both group’s of shareholders; would they approve of the proposal? (d) Calculate the revised offer if Minprice needed a gain of £35m to cover the costs of the

acquisition and justify the takeover?

Solution

Financing acquisitions and mergers (cont)



188 ANP413

3 Chapter summary Section Topic Summary 1 Sources of

finance for cash based bids

Cash bids may require access to debt finance, if so a line of credit is often useful until a more permanent financing solution can be found.

2 Paper bids Paper bids require an evaluation of the post-acquisition value of the company, this can be achieved using P/E ratios.

Q4


189 ANP413





Assess a company situation and determine whether a financial reconstruction is the most appropriate strategy for dealing with the problem as presented.

Assess the likely response of the capital market and/or individual suppliers of capital to any reconstruction scheme and the impact their response it likely to have on the value of the company.

Recommend a reconstruction scheme from a given business situation, justifying the proposal in terms of its reported impact on the reported performance and financial position of the company.

This is most likely to be tested as an evaluation of a proposed rescue plan.

New pilot paper Q3 Q1 December 2010

Financial reconstruction


13: FINANCIAL RECONSTRUCTION

190 ANP413

Overview



Financial reconstruction A firm that is experiencing financial distress may be able to reorganise its finances by offering equity to its creditors.



191 ANP413

1 Financial reconstruction schemes 1.1 Restructuring a company is corporate surgery to enable a company to continue in business.

It will usually involve a radical change in the capital structure of a company.

Why restructure? 1.2 If a company is facing a high interest burden or severe cash flow problems in the short-term,

a compromise deal will be sought whereby the bondholders will be offered new debt and/or equity in exchange for their existing debt. The shareholders are likely to see a large dilution of their holding.

Legal framework 1.3 The deal must be agreed by all parties – classes of creditors should meet separately so that

substantial minorities are not voted down. Every class must vote in favour for the scheme to succeed.

Approach to reconstructions 1.4 (a) Estimate the position of each party if liquidation were to go ahead. This will represent

the minimum acceptable payment for each group. (i) Assets must be restated at realisable value. (ii) In liquidation the assets are shared out according to a predetermined order:

Fixed charges Floating charges Unsecured creditors Preference shares Ordinary shares

(iii) If the available assets do not cover a particular class of creditor in full, all creditors in that class will have their payout pro-rated.

(b) Design the reconstruction (often given by the question) (c) Calculate and assess new position for each group separately, and compare with (a). (d) Check the company is financially viable after the reconstruction.



192 ANP413

Lecture example 1 Technique demonstration Nomore Ltd, a private company that has for many years been making mechanical tools is faced with rapidly falling sales. Its bank overdraft (with M A Bank) is at its limit of £1,200,000 and the dividend on its cumulative preference shares had been unpaid for the fourth year in succession. The company has just lost another two major customers.

Statement of position / Balance sheet 31.3.X2

Projected Fixed assets £'000 Freehold property 4,400 Plant and machinery 3,100 Motor vehicles 320 Deferred development expenditure 1,260 Current assets Stock 1,600 Debtors 1,160 2,760 Current liabilities Trade creditors 3,100 Bank overdraft (MA bank, unsecured) 1,200 4,300 (1,540) 7,540 Long-term liabilities 10% loan 20X8 (secured on freehold property) (1,600) Other loans (VC bank, floating charges) (4,800) 1,140 Ordinary shares of £1 5,600 8% Cumulative preference shares 1,600 Accumulated reserves/(deficit) (6,060) 1,140 Other information

1 The freehold property has a market value of about £4,500,000. 2 It is estimated that the break up value of the plant at 31 March 20X2 will be £2,000,000. 3 The motor vehicles owned at 31 March 20X2 could be sold for £200,000. 4 It is believed that patents could be sold for about £1,250,000, which can be considered as

the break-up value of development expenditure incurred to 31 March 20X2. 5 On liquidation, the current assets at 31 March 20X2 would realise £1,600,000. 6 Liquidation costs would be approximately £500,000. The company believes that it has good prospects due to the launch next year of its new Pink Lady range of tools and has designed the following scheme of reconstruction:



193 ANP413

1 The existing ordinary shares to be cancelled and ordinary shareholders to be issued with £2,000,000 new £1 ordinary shares for £1.00 cash.

2 The existing preference shares to be cancelled and the holders to be issued with £500,000 new £1 ordinary shares.

3 The secured loan to be cancelled and replaced by a £1,250,000 10% secured debenture with a six-year term and £600,000 of new £1 ordinary shares.

4 V C Bank to receive £3,200,000 13% loan secured by a fixed charge 1,100,000 £1 new ordinary shares.

5 M A bank to be repaid the existing overdraft and to keep the overdraft limit at £1,200,000 secured by a floating charge.

If this plan is implemented, the company estimates that its earnings before interest and tax will rise to £1.441m. Average P/E ratios in this industry are 14.3. Corporation tax is 30%. Required Evaluate whether the suggested scheme of reconstruction is likely to succeed.

Solution



194 ANP413

2 Chapter summary 2.1 A company that is unable to pay its debts in the short-term, but has a sustainable trading

position in the medium – long term can use a financial reconstruction scheme to lower its debt burden and to allow it to survive. This scheme will often involve an offer of equity for debt; it has to be acceptable to all parties that are affected by it.

END OF CHAPTER


195 ANP413





Recommend, with reasons, strategies for unbundling parts of a quoted company.

Evaluate the likely financial and other benefits of unbundling.

Advise on the financial issues relating to a management buy-out and buy-in.

This chapter could be examined as a discussion area as part of an exam question or as a comprehensive financial evaluation for a significant number of marks involving business valuation techniques.

Q4 June 2010 Q5 December 2010 Q1 December 2010 Q4 December 2011 Q1 December 2012

Business re-organisation


14: BUSINESS RE-ORGANISATION

196 ANP413

Overview



Business re-organisation A key divestment decision, enabling a company to concentrate on its core business

Business re-organisation A method of raising finance



197 ANP413

1 Reasons for unbundling 1.1 Unbundling is splitting off a part of the business from the main group; the main reasons for

which are listed below.

Motives Explanation Raising cash Selling off allows cash to be raised to ease liquidity problems or to

reduce gearing. Disposal of non-core businesses

Acquired as a part of a group that has been taken over by the company or a consequence of a strategic review.

Take-over defence

Selling off underperforming divisions may deter a take-over bid that aims to add value by unbundling the company.

Synergy Other owners may be able to make better use of a division of the company, and will pay a high price for purchasing all or part of it.

2 Strategies for unbundling 2.1 Unbundling can be approached in many different ways:

Degree of ownership retained

Type of unbundling

Benefits

Sell-off (divest)

A method of raising cash*

MBO/MBI Raises cash* but has advantages vs sell-off in that it won’t be blocked by the Competition Commission, and may be viewed more positively by staff. This is considered further in Lecture example 1.

Joint venture Share costs, risks and expertise with a partner

Demerger (spin-off)

Splits up the business into two or more parts without raising any cash*.

* should be evaluated using techniques in Chapter 12 to see if a fair price is being offered.


In 1999 BA decided that its core business was premium airline travel. GO, its low cost subsidiary set up in 1997 for £25m, was seen as non-core because it blurred the BA brand and created internal competition for customers. In July 2001 GO was sold as an MBO for £100m. Required (a) How would BA have found a discount factor to calculate the NPV of its GO division? (b) What could have been the reasons for BA choosing this form of unbundling? (c) How could the management team have obtained the required finance?

Case 18



198 ANP413

Solution (a) (b) (c)

3 Chapter summary 3.1 To maximise value for shareholders, management may decide to unbundled the company

either by a complete sell-off (divestment or MBO) or by a spin-off (demerger).

END OF CHAPTER


199 ANP413




Having studied this chapter you will be able to: Discuss the role of the treasury management function

within: (i) The short-term management of financial resources (ii) The longer term maximisation of corporate value (iii) The management of risk exposure

Discuss the operations of the derivatives market, including: (i) The relative advantages and disadvantages of

exchange traded versus OTC agreements (ii) Key features, such as standard contracts, tick sizes,

margin requirements, and margin trading (iii) The sources of basis risk and how it can be

managed (iv) Risks such as delta, gamma, vega, rho and theta,

and how these can be managed

This is mainly a discussion chapter and each theme within it is most likely to be tested as a discussion requirement of a question.

This is covered in chapter 16

Q2 Dec 2011 (4 marks) Q3 Dec 2010

The role of the treasury function in multinationals


15: THE ROLE OF THE TREASURY FUNCTION IN MULTINATIONALS

200 ANP413

Overview



The role of the treasury function – management of short-term liquidity and of the cost of capital.

Risk management

The role of the treasury function – management of interest rate and currency risk.



201 ANP413

1 The role of the money markets 1.1 When a firm needs to borrow short-term funds (< 1 year), its corporate treasury function

may advise that it is appropriate to use the money markets; these are operated by major merchant banks.

1.2 Using the money markets brings the benefit of direct contact with investors, rather than borrowing through a middle-man. The money markets offer a secondary market to these investors; this liquidity benefit reduces the returns that they require. The trend to borrowing directly from investors is sometimes called disintermediation.

1.3 Here are some examples of the types of money market instruments that may be used to raise short-term finance or to manage short-term risk:

Short-term finance Explanation

Commercial paper IOUs issued by a company to investors, minimum £500,000.

interest is not normally payable on CPs

the debt is unsecured, with no restrictive covenants

CPs can be raised very quickly

Bills of exchange IOUs signed by a customer, minimum £75,000.

sold at a discount to their face value

often used to finance exports

Short-term risk Explanation

Eurocurrency deposits

Interest-bearing loans or deposits in a foreign currency

Useful in currency hedging (see Chapter 16).

Derivatives These are discussed in Chapters 16 and 17.



202 ANP413

2 The role of the treasury management function

Investment decisions 2.1 This will normally be analysed by the financial controller, the treasury will normally supply an

appropriate cost of capital to reflect the business risk and the financial risk of the investment; this should ensure longer-term maximisation of shareholder value.

Financing decisions 2.2 Short-term liquidity management will normally be analysed by the financial controller, the

treasury will organise the management of cash shortages or cash surpluses using the money market or direct bank borrowing.

2.3 Long-term financing needs will be managed by the treasury, who will advise on the target gearing level and organise appropriate sources of debt and equity; again this should ensure longer-term maximisation of shareholder value.

Dividend decisions 2.4 Treasury will advise on the level of dividend.

Risk management 2.5 This will normally be analysed by the financial controller eg the extent of $ inflows or

outflows expected over the next year. The treasury will advise on the management of risk exposure ie whether to do it and how to do it (this is covered in Chapters 16-18).

3 Managing risk – delta hedging 3.1 The writer of a call option can use delta hedging to manage its exposure to the risk the

asset increasing in value. A call option will increase in value in a rising market as it fixes a lower strike price allowing the holder to buy at a cheaper price. A delta hedge ensures that the option writer also owns the underlying asset which will show a gain as the price rises.



Risk management



203 ANP413

3.2 N(d1) is the number of shares that a trader will buy each time a call option is sold, the purchase of the underlying to hedge their position is called a delta hedge.

3.3 The formula for a delta hedge is : Assets held by option writer = Delta x options written

Where delta = N(d1).

Lecture example 1 Shares in For4Fore plc are currently trading at 444p. The standard deviation of the share price is 25% and the continuously compounded risk free rate of return is 4.17%. There are European style options to buy shares in For4Fore at 385p per share in exactly 4 months’ time.

rt)eN(deP)N(daPC 210 ts

tsr)e/Pa(Pd )25.0(ln1

Ts1d2d

Required

(a) Using the Black Scholes Option pricing model, calculate the value of these call options (b) How many shares should an options writer hold to create a delta hedge on his position on a

call option for 1,000 shares? (c) Would it be more appropriate to offer managers call options or put options as part of an

incentive package?

Solution



204 ANP413

3.4 If a dividend is to be paid prior to exercise, the share price in the formula (Pa) must be reduced by the present value of the dividends.

Gamma 3.5 Gamma measures how much Delta changes with the underlying asset value ie how much

the delta hedge needs to be adjusted as the underlying asset value changes, for example if the gamma is 0.01 this means that for a 1% rise in the underlying asset value the delta should change by a factor of 0.01.



205 ANP413

Summary of the ‘Greeks’ 3.6

Delta The amount to buy of the underlying each time a call option is sold Gamma Adjustment needed to the delta as the ‘underlying’ value changes Theta Time – the longer to expiry, the more valuable the option Vega Volatility – the more volatile the underlying, the more valuable the option

Rho Interest rates – the higher the interest rate the higher the value of the call option



206 ANP413

4 Chapter summary

Section Topic Summary

1&2 Treasury department

The treasury department is normally responsible for liquidity and risk management; in performing these operations it will make use of the money markets.

3 Delta hedging The writer of a call option can use delta hedging to manage its exposure to the risk the asset increasing in value. A call option will increase in value in a rising market as it fixes a lower strike price allowing the holder to buy at a cheaper price. A delta hedge ensures that the option writer also owns the underlying asset which will show a gain as the price rises.

END OF CHAPTER


207 ANP413

How has the syllabus been examined?



Assess the impact on a company to exposure in translation (covered in chapter 8), transaction and economic risks (covered in chapter 8) and how these can be managed.

Evaluate, for a given hedging requirement, which of the following is the most appropriate strategy, given the nature of the underlying position and the risk exposure:

(i) The use of the forward exchange market and the creation of a money market hedge

(ii) Synthetic foreign exchange agreements (SAFE's)

(iii) Exchange-traded currency futures contracts (iv) Currency swaps (covered in the next chapter) (v) FOREX swaps (covered in the next chapter) (vi) Currency options

Advise on the use of bilateral and multilateral netting and matching as tools for minimising FOREX transactions costs and the management of market barriers to the free movement of capital and other remittances.

Make sure that you are as strong on the discussion areas of the chapter as you are on the numerical areas.

Q3 June 2008 - 20 marks, money market hedging Q5 June 2010 - 20 marks, netting Q1 June 2011 - 30 marks, futures, options & swaps Q2 December 2012 - 9 marks, forwards &

options

The use of financial derivatives to hedge against forex risk


16: THE USE OF FINANCIAL DERIVATIVES TO HEDGE AGAINST FOREX RISK

208 ANP413

Overview



Currency risk can be offset by matching income in $ to finance costs in $s & other risk management techniques

Returns from overseas investments fall if the £ strengthens

The use of financial derivatives to hedge against foreign exchange

risk

Risk management



209 ANP413

1 Introduction 1.1 The main focus of this chapter is transaction risk; this is the risk of variations in the

exchange rate affecting the value of foreign exchange transactions (eg imports and exports). The management of other currency-related risks (political, translation, economic) has already been covered in Chapter 8.

Lecture example 1 Preparation question During 2008, the value of the £ decreased by 28% against the $; from 2.07 US$ per £ to 1.50 US$ per £. Required (a) Calculate the impact of this on a UK exporter due to receive $360,000 from a US customer. (b) Calculate the impact of this on a UK importer due to pay $360,000 to a US supplier.

Solution (a) (b)

£ strong £ weak

Quotation of spot exchange rates

Terminology 1.2 A spot rate is the rate available if buying or selling the currency immediately. In the UK

exchange rates are shown per £ eg 1.9615 US$ per £, but overseas it is more common for exchange rates to be quoted per unit of the foreign currency.

UK exporters suffer because the $ is weak and their revenue is in $s

UK importers suffer because the $ is strong and their costs are in $s



210 ANP413

UK exporter UK importer Receives $ Pays in $s Buys £s Sells £s

1.3 A bank would not offer a rate of 1.9615 US$ per £ to both exporters and importers; it will charge them different rates and make a profit on the spread e.g. 1.9612 – 1.9618 US$ per £

1.4 Remember that a company will always be offered the worst rate.

UK exporter UK importer Buys £ Sells £ Pays a high price Receives the low price

1.5 You can remember this as ‘always use the worst rate’ or ‘high expectations’ etc.

Lecture example 2 Preparation question Exchange rates on January 30th 2007 were 1.9612 – 1.9618 US$ per £ Required

(a) Calculate the receipts from a $2m sale to a US customer. (b) Calculate the cost of paying an invoice of $2m.

Solution (a) (b)



211 ANP413

2 Managing transaction risk – internal methods 2.1 Simple techniques can be used to eliminate some of the risk faced by a company.


ZA group consists of a French company, a US company and a UK company. ZA has the following inter-company transactions for the 1st quarter of the year. Paying subsidiary UK US French

UK – £2m £1m US $3m – $1m French €4.5m €6.6m –

ZA has decided to implement a system of multilateral netting using £s as the settlement currency. Exchange rates on March 31st are: 1.5 € per £ and 2.0 US$ per £ Required

Illustrate the impact of multilateral netting.

Solution Paying subsidiary Total

receipts Total

payments Net

UK US French UK – £2m £1m US – French –

Invoice in £s

Matching - creating $ costs

Lagging – delay conversion into £s to allow matching against $ costs

Leading – acceleration of receipts

$ revenue

Multilateral netting - netting against $ costs from other divisions, to reduce transaction costs and prevent hedging of intercompany transactions

Receiving subsidiary

Receiving subsidiary

Case 19



212 ANP413

3 Managing transaction risk – forward contracts

3.1 A contract with a bank covering a specific amount of foreign currency (FX) for delivery on a specific date at an exchange rate agreed now.

Quotation of forward rates 3.2 Again a bank will quote a (larger) spread e.g.

Forward rate 1.9600 – 1.9612 US$ per £

3.3 Again, a company will always be offered the worst rate; and you can remember this as ‘always use the worst rate’ or ‘high expectations’ etc.


Exchange rates on January 30th 20X7 are 1.9612 – 1.9618 US$ per £ and 3 month forward rates are 1.9600 – 1.9612 US$ per £. Required

(a) Calculate the receipts from a $2m sale to a US customer, due to be received in 3 months' time if forward rates are used.

(b) Calculate the cost of paying an invoice of $2m in 3 months' time, if forward rates are used.

Solution (a) (b)

Advantages of forward rates Disadvantages of forward rates Simple, no up-front fees Fixed date agreements Available for many currencies, normally for

more than one year ahead Rate quoted may be unattractive



213 ANP413

4 Managing transaction risk – money market hedging

Exports Expect revenue in $s in three months Borrow in $s today

4.1 This is most likely to be attractive if the company has a liquidity problem today.

4.2 In the exam a tabular approach ca n be helpful (nb the order suggested below is flexible).

EXPORTER UK £s USA $s

Now 4 pay $ loan into your UK account (1 + deposit rate )*

3 take out $ loan (1 + borrowing rate )*

Three months

5 to compare to a forward 1 receive $ from export 2 pay off $ loan with export revenue

* remember to take the interest rate quoted and multiply by 3/12 if a three-month loan


Three-month interest rates on January 30th 20X7 are as follows: UK US Borrowing rates 5.59% 5.38% Deposit rates 5.50% 5.31% The spot rate is 1.9612 – 1.9618 US$ per £. Required Calculate the receipts from a $2m sale to a US customer, due to be received in 3 months' time if money market hedging is used and compare to a forward contract (Lecture example 4(a)).

Solution

EXPORTER UK £s USA $s Now

3 months



214 ANP413

Imports Expect costs in $s in 3 months Make a $ deposit today

4.3 This is most likely to be attractive if the company has a cash surplus today.

4.4 In the exam a tabular approach can be helpful.

IMPORTER UK £s USA $s

Now 4 withdraw funds from UK account (1 + borrowing rate )*

3 put money into US account (1 + deposit )*

Three months

5 to compare to a forward 1 pay $ invoice from supplier 2 pay off with $ deposit

* remember to take the interest rate quoted and multiply by 3/12


Three-month interest rates on January 30th 20X7 are as follows: UK US Borrowing rates 5.59% 5.38% Deposit rates 5.50% 5.31%

The spot rate is 1.9612 – 1.9618 US$ per £. Required

Calculate the £ cost of an invoice for $2m payable in three months' time if money market hedging is used & compare to the result from a forward contract (Lecture example 4(b)).

Solution

IMPORTER UK £s USA $s Now

3 months

4.5 Banks use interest rates to calculate forward exchange rates; this is interest rate parity theory. This is covered numerically at the end of the chapter.

Fo = So x ib)1(ic)1(

b = base country and c = country overseas formula given



215 ANP413

5 Currency futures 5.1 Currency futures are contracts that fix the exchange rate for a set amount of currency over a

specified period of time.

5.2 Currency futures are mainly available from the US markets such as the New York Board of Trade (NYBOT) futures and options exchange.

5.3 Futures are a separate agreement from the actual transaction – they are a derivative (their value derives from movements in the spot rate). Here is an overview of how they work.

Now Three months' time 1. $ revenue or costs expected (this will be

converted at the spot rate in three months' time) 2. Set up a futures contract 3. Pay a margin 4. If the exchange rate has moved against you in

three months' time receive compensation OR 4. If the exchange rate has moved in your favour

in three months' time pay out losses 5. Net effect = fixed outcome

Margins

5.4 After paying an initial margin, additional funds are credited or debited to the firm’s account each day as profits or losses accumulate. If the initial margin drops below a certain safety level a variation margin will be called for.

Ticks 5.5 A tick is the smallest movement in the exchange rate, normally four decimal places. If

a futures contract is for £125,000 every 0.0001 movement will give a company £125,000 x 0.0001 = $12.5 profit or loss, this is called the tick size (note - it is in dollars).

5.6 If the futures exchange rate has moved in your favour by 0.0030 then this will be 30 ticks x $12.5 = $375 per contract.

Advantage of futures Disadvantages of futures Flexible dates ie a September futures

can be used on any day up to the end of September

Only available in large contract sizes

Margin payments



216 ANP413


Today is 31st December. Spandau plc anticipates that in two months' time it will need to make purchases of $11m and in four months' time it will have receipts of $5m; it has a policy of hedging 100% of its transaction risk in the month it arises. The exchange rates on the 31st December are: Spot rate: 1.9615 US$ per £. Futures rates: March June US$ per £ - contract size £125,000 1.9556 1.9502

Required

(a) Calculate the outcome of the futures hedge in two months' time if the spot rate is 1.9900 US$ per £ and the futures rate is 1.9880 US$ per £.

(b) Calculate the outcome of the futures hedge in four months' time if the spot rate is 2.0000 US$ per £ and the futures rate is 1.9962 US$ per £.

Solution

(a) Set-up today – 31st December Outcome – 28th February



217 ANP413

(b) Set-up today – 31st December Outcome – 30th April

Basis risk 5.7 In the examples above the movements in the futures exchange rates were given but in the

exam you will have to calculate them on the assumption that the difference between the spot price and futures price (known as the ‘basis’) falls over time. Typical movement of futures price versus spot price through time:

5.8 There is risk (basis risk) that basis will not decrease in this predictable way. To manage basis risk it is important that the futures contract chosen is the one with the closest maturity date to the actual transaction.

Delivery date

Spot future

Time

Price



218 ANP413

Lecture example 8 Technique demonstration (lecture example 7 continued). Today is 31st December. The exchange rates on the 31st December are: Spot rate: US$ per £ 1.9615 Futures rates: March June US$ per £ - contract size £125,000 1.9556 1.9502

Required

(a) Calculate the futures exchange rate in two months' time if the spot rate is 1.9900 US$ per £. (b) Calculate the futures exchange rate in four months' time if the spot rate 2.0000 US$ per £.

Solution

TO BE CONTINUED


219 ANP413




Key knowledge Understanding of non-derivative currency hedging techniques (internal, forwards, money market hedging).

Understanding of the pros and cons of currency derivatives.

Understanding how to manage basis risk.

Key skills Understanding how to analyse a financial reconstruction.

Ability to calculate the financial outcome of the various forms of currency hedging.


CHECKPOINT 4

220 ANP413


Chapter 13 – Financial reconstruction 60 minutes

Key areas Understanding how to analyse a financial reconstruction

Course Notes

Review the chapter concentrating on Lecture Example 1.

10 minutes

Study Text Question Bank Attempt Question 27 (Brive plc) – on financial reconstructions.

50 minutes

Chapter 14 – Business re-organisation 30 minutes

Key areas Understanding the motives for the different types of unbundling

Course Notes This is an important chapter. Read the chapter slowly and review the solution to

Lecture Example 1; then read case 18 at the back of this course companion. Make sure that you are comfortable with this area; this paper is called Advanced Financial Management , your ability to make sure that you can make sound management recommendations is important in P4.

30 minutes

Chapter 15 – The role of the treasury function in multinationals

15 minutes

Key areas Understanding the role of the money markets Understanding the role of the treasury function

Course Notes You must read the chapter carefully, it introduces the role of the treasury dept, before

looking its detail operations in the next four chapters.

15 minutes


CHECKPOINT 4

221 ANP413

Chapter 16 – The use of financial derivatives to hedge against forex risk

125 minutes

Key areas Understanding of non-derivative hedging techniques (internal, forwards, money market

hedging) Understanding of the pros and cons of currency derivatives, and an ability to calculate

their likely outcome Managing basis risk

Course Notes Review the chapter ensuring you can follow all the calculations. Read case 19 to build

your appreciation of practical business issues involved in currency hedging.

40 minutes

Study Text Question Bank Attempt Question 31 (Fidden plc) – this tests your ability to calculate the outcome of a

forward, a money market hedge and a currency options hedge. Currency options are not covered until the next day of the course so complete this aspect of the question after you have covered currency options.

55 minutes

Study Text This chapter is very important. Any time spend reviewing this chapter will be useful to

help to build your knowledge of this syllabus area; but it would be best to use it selectively to build your understanding of areas of the course notes that you find difficult.

Review section 4.8 which deals with ‘SAFEs’, a specific type of forward exchange rate agreement.

20 minutes

10 minutes


CHECKPOINT 4

222 ANP413



The multiple choice questions contained within Progress Test 4 will thoroughly test your understanding of the material and your ability to perform the required calculations. Note that the P4 exam does not contain multiple choice questions. The three short written questions that follow will test your ability to apply your knowledge. These skills will prove important in preparing you for the more discursive elements of the exam.

It is important that you continually review your progress and revise further any areas where you feel your understanding is weak.


1 A non-interest bearing, unsecured, IOU issued by a company for a minimum of £500,000 is a description of:

A Commercial paper B Bills of exchange C Certificate of deposit D Treasury bill (2 marks)

2 Which of the following statements is correct:

A A devaluation of the £ benefits UK exporters because it decreases the value of the £s that they are selling

B A devaluation of the £ harms UK exporters because it decreases the value of the £s that they are selling

C A devaluation of the £ benefits UK exporters because it decreases the value of the £s that they are buying

D A devaluation of the £ harms UK exporters because it decreases the value of the £s that they are buying (2 marks)

3 Which of the following is not an advantage of forward contracts?

A Simple, up front are either zero or very low B Widely available, often offering cover for more than one year ahead C Easy to understand and monitor, delivering savings in terms of management time D Flexible, so that if the transaction is delayed the forward contract can be delayed (2 marks)

4 A company has just received $100,000; if the exchange rate is 0.5100-0.4900 £ to the $ what sterling revenue will this generate?

A £204,082 B £196,078 C £49,000 D £51,000 (2 marks)


CHECKPOINT 4

223 ANP413

5 Calculate the cost to a UK company importing from the US and due to pay a $500,000 invoice in three months time, if money market hedging is used. The spot rate is 1.9605- 1.9595 $ to the £ +/- 0.0005 and annual three month interest rates are 5.5%-5.6% in the UK and 5.3-5.4% in the US.

The result of a money market hedge will be a cost to stage of:

A £251,831 B £255,357 C £252,607 D £251,702 (2 marks)

6 Using interest rate parity theory, and the data in the previous question, the three month forward rate for the importer will be which of the following:

A 1.9590 B 1.9581 C 1.9563 D 1.9600 (2 marks)

Data for questions 7-9 Today is 1 December. Washmore plc is expecting that in two months time it will have receipts of $4.9m; it

has a policy of hedging 100% of its transaction risk in the month it arises. The exchange rates on 1 December are:

Spot rate: $/£ 1.9615

Futures rates:

March June $/£ - contract size £12,500 1.9556 1.9502

7 Identify whether the number, type and date of the contracts needed is:

A 200 March contracts to buy B 201 June contracts to buy C 200 March contracts to sell D 201 June contracts to sell (2 marks)

8 Assuming that on 1 Feb the spot rate is 1.9600 $/£, calculate whether the likely closing futures price on 1 Feb is:

A 1.9630 $/£ B 1.9620 $/£ C 1.9580 $/£ D 1.9570 $/£ (2 marks)

9 Using your answer from the previous question, calculate whether the profit or loss on the futures contracts is:

A gain £1,786 B loss £1,790 C loss £1,786 D gain £1,790 (2 marks)


CHECKPOINT 4

224 ANP413

10 Six plc and Nine plc are planning a merger. Shareholders in Nine would accept two shares in Six for every share they hold. The current position is:

Six plc Nine plc Number of shares 20 million 6 million Annual earnings £5million £2.2 million P/E ratio 10 12

As a result of the merger, annual earnings of the enlarged company would be 10% higher than the sum of earnings of each company before the merger. The expected post-merger P/E ratio is 11.

By how much would the shareholders in Nine plc gain from the merger?

A £2.97 million B £3.30 million C £4.02 million D £6.27 million (2 marks)

B Short written questions (3 questions – approximate time 20 minutes) 1 Identify the four main ways of unbundling a division, with a specific motive for each method. (4 marks)

2 Identify the role of the treasury function in each of the key financial strategy policies; investment, financing, dividend and risk management. (6 marks)

3 List four methods of internal currency hedging. (4 marks)



CHECKPOINT 4

225 ANP413


Section A

1 A Bills of exchange are normally secured, certificates of deposit are interest bearing and treasury bills are issued by the government.

2 C UK exporters have revenue in $s which is used to buy £s, if the £ is cheaper they get more £s from their $ revenue.

3 D Dates are fixed, and delay means that the forward contract will still have to be honoured.

4 C $100,000 x 0.4900 (the worse part of the spread) = £49,000

5 A IMPORTER UK £s USA $s Now 4. $493,462/1.9595 =

£251,831

3. $500,000 / 1.01325 = $493,462

5.6% x 3/12 = 1.4%(loan rate) ie 1.014

5.3% x 3/12 = 1.325% (deposit rate) ie 1.01325

3 months 5. £1,006,419 x 1.01398 = £255,357

1.- $500,000 2.+$500,000 0

6 B 1.9595 x (1.01325/ 1.014) = 1.9581

7 A 200 March contracts to buy, because £s are being bought and March is closest to the transaction date.

$4,900,000 / 1.9556 / 12,500 = 200.4, so 200.

8 D Basis now = 0.0059 with four months of timing

Basis on 1 Feb = with two months of timing = 0.0030

So likely future rate = spot rate of 1.9600 – 0.0030 = 1.9570 $/£

9 A Opening position 200 contracts to buy £s at 1.9556, closed out by a closing position of 200 contracts to sell £s at 1.9570

Gain = 0.0014 or 14 ticks Tick value = 0.0001 x £12,500 = $1.25

Gain per contract = $1.25 x 14 = $17.5

so on 200 contracts this is $3,500 or (using spot of 1.96) £1,786


CHECKPOINT 4

226 ANP413

10 D

Post-merger combined earnings = £7.92 million Value of combination = £87.12 million Value per share (87.12/32) = £2.7225 Value of shares held by Nine plc shareholders = £32.67 million Value of Nine plc pre-merger (2.2m x 12) = £26.40 million Gain = £6.27 million

Section B

1 There are four main ways of unbundling a division.

Methods of unbundling Motive

1 Sell to another company Raise cash for re-investment in the remaining business 2 MBO A quick method of divesting that may be more positively

viewed by staff. 3 Joint venture Share costs, risks, expertise with partner 4 Demerger Creates more streamlined business, gives shareholders

choice over whether to sell shares in a particular division.

2 Investment – calculation of the appropriate cost of capital with which to appraise an investment.

Financing – management of short-term liquidity and of long term gearing levels.

Dividend – advice on the appropriate level of dividend to pay.

Risk management – how to manage currency risk and interest rate risk.

3 Methods include: leading, lagging, matching, netting and invoicing in the local currency (e.g. £s).


CHECKPOINT 4

227 ANP413


Case 18 – Unbundling F I N A N C I A L T I M E S - O C T 2 0 0 6

In 2001, Cisco divested a business unit that specialised in switchers, storage networking and SAN products. Andiamo, the new company, was funded with Cisco investment and assets, and staffed by Cisco employees. Cisco even retained 44 per cent ownership in the new entity. All of this was a clear sign of Cisco's continued interest. So why divest?

Unbundling operations are often seen as a sign of failure, a tool companies employ when they attempt to correct a mistake, readjust business focus or make up for an unsuccessful acquisition. But companies divest units for strategic reasons as well. By retaining a connection with the divested unit, the parent aims to benefit from the dynamism of the new company. Unbundling operations are much more than mere financial and tactical moves; they are a vital element of a company's corporate strategy toolkit.

What does unbundling mean?

A recent report by the European Commission on 144 companies in European manufacturing and service industries (including Hoechst, Finmeccanica, Deutsche Steinkohle, Ericsson, and Nestle) found that 13 per cent of all new companies created in Europe result from unbundling operations. Yet we still know relatively little about why companies unbundle and what happens when they do.

Unbundling is often understood as what happens when a company disposes of or sells assets, facilities, product lines, subsidiaries, divisions or business units. An unbundling operation is an alteration to a company's productive portfolio through the disposal or sale of a division, a business unit, a product line or a subsidiary.

Unbundling is discussed in terms of divestments and divestitures. These terms are often used as synonyms, but they are, in fact, distinct strategic options. A divestment is the partial or complete sale or disposal of physical and organisational assets, the closing of facilities and the reduction of the workforce. A divestiture, on the other hand, is the partial or complete sale or disposal of a business unit, product line, subsidiary or division. It is only with a divestiture, and not with a divestment, that the parent organisation creates a new company, able to operate more or less autonomously in the market.

It is important to understand that unbundling operations are more than just financing operations. Their design and implementation affect the success of the parent company and the divested unit, from both a financial and a strategic perspective. Why do companies unbundle?

Are divestitures merely a reflection of the economic cycle, a means to correct or reverse previous strategic decisions (for example, diversification), or are they a proactive strategic option?

We categorise unbundling operations according to the legal and strategic reasons for the operation. From a legal perspective, it is important to distinguish between voluntary and involuntary divestitures. An involuntary divestiture is a reaction to legal and/or regulatory limitations. For example, in recent years, many public European companies were de-nationalised and had to involuntarily divest part of their operations to comply with European Commission competition regulations.

This was the case, for example, for many national telecommunication companies, such as Spain's Telefonica, which split up its businesses into different tranches. Nevertheless, a company may voluntarily decide to divest part of its business for strategic, market-related reasons. While voluntary divestiture announcements are typically accompanied by positive movements in the parent company's stock price, the opposite applies to involuntary divestitures.

From a strategic perspective, companies divest for proactive or corrective reasons. The purpose of proactive divestitures is to restructure the company's asset portfolio by routinely redesigning, separating, transferring or exiting businesses and operations to adapt to changing market conditions and opportunities.

Corrective divestitures are intended to correct strategic mistakes. They aim to reduce over-diversification, refocus on core businesses, eliminate negative synergies or realign corporate strategy with the company's identity. For example, Toyoda Automatic Loom Works divested Toyota Motors in 1937 to separate


CHECKPOINT 4

228 ANP413

automotive manufacturing from the rest of the corporation in order to maintain a clear corporate identity for market analysts.

These two categories are neither mutually exclusive nor independent of each other. Companies make their strategic and organisational choices taking into account environmental changes, normative limitations and the strategic decisions of other companies. Divestitures may, at the same time, represent an adaptation to regulatory and legal boundaries, a reaction to environmental changes and variations in the sector, and/or a strategy to obtain and retain competitive advantage. Thus, in some cases it is difficult to determine whether an unbundling operation is a corrective or a proactive decision. For example, an involuntary divestiture could also be considered a corrective strategic action, to adjust the corporate strategy to the existing legal constraints.

More than one way to unbundle

The strategic toolkit for unbundling includes various options: sell-offs, spin-offs, carve-outs and buyouts. The divesting mode the parent company chooses, will depend on its objectives. The board of directors initiates an unbundling operation if the performance of the company is declining. Otherwise, the unbundling operation is more likely to be initiated by managers.

When the board of directors decides to divest a unit, it is generally because of pressure from stock market analysts. A company may unbundle a high-value unit, when it wishes to "cash in" some capital but still retain links with the unit. This typically happens when the parent's performance is declining, its leverage is high and a need for external financing arises. In such a case, the parent tends to sell the unit via a public offering, but remains in possession of a substantial part of the equity of the divested (carved-out) company.

When the parent does not need to raise cash, but wishes to redistribute value to its shareholders, it may prefer to divest a less valuable unit by redistributing its shares to the parent's shareholders (spin-offs). This is often the choice of companies operating in highly changeable and competitive environments, and companies whose units have great variations in R&D expenditure and intangible assets.

Companies undertake a carve-out or a spin-off if they believe that the market is incorrectly valuing the company in its current organisational form (the so-called hubris hypothesis). With a carve-out or a spin-off, parent companies may release information about the existence of positive net-present-value projects in the unit. They expect outside investors to price the new shares high and, therefore, maximise the total equity value of the company (parent plus divested unit). Cisco's carve-out of its Andiamo business unit is an example of this. Cisco's main strategic objective was to develop a new line of products to ensure competitiveness.

A parent company may also sell a unit to another company in exchange for cash (sell-off). This happens when the parent does not want to maintain a relationship with the divested unit. Usually, sell-off units have poor operating performance, high leverage or operate in underperforming sectors. Compared with their parent companies, they are low-value assets and operate in different or non-compatible sectors to the parent company's core interests. This was the case with General Electric and its Insurance Solutions division. The Insurance Solutions division had few connections with the core business of its parent and had been underperforming for years, so at the end of 2005, GE sold it to Swiss Re.

A divestiture can also be initiated by the unit managers. In such a case, managers, with the support of other investors, replace public stockholding of the parent company. These management buy-outs (MBOs) are normally also financed with large debt issues and the involvement of private equity houses. For the unit managers, an MBO is an interesting option when they believe that they can make the unit perform better as an independent company. A parent company, on the other hand, will only agree to sell the unit to its managers when the price managers are willing to pay is higher than its perceived value to the parent.

To summarise, the choice of an unbundling mode depends on three factors: the characteristics of the business unit (Is it worth selling? Does it perform well? Is it related to the parent's businesses? Is it related to the other parent industries?); the characteristics of the parent company (performance, leverage, need for cash, diversification); and the wider business environment (rate of growth and performance of the industry).

Given the parent company's need for external finance, the choice between a sell-off or a carve-out depends on whether the parent has something worthwhile to sell. Carve-out units show a better operating performance than their parents, and compared with spun-off units, they tend to be more profitable and grow faster. Spun-off units are more profitable and grow faster than sell-off divisions.


CHECKPOINT 4

229 ANP413

Spin-offs, carve-outs and MBOs may be used by parent companies to design new incentive systems in the divested unit, to boost entrepreneurial spirit and reduce staff turnover. However, this happens only when the decision makers are able to present the divestiture as an opportunity for the unit managers to lead their own company, grow its business and, at the same time, boost their careers – and their performance-related salaries and bonuses. This is why an MBO provides unit managers with the most powerful incentives, since these managers become the owners of the newly created company.

Internal resistance

Divestitures are often resisted within companies, because of the stigma that surrounds them. Both the parent company executives who sponsor and support the unit, and the managers of the unit itself tend to be reluctant to let the unit go. However, it is important that company executives consider unbundling as a strategic option for creating value for both the parent and the unit. Their analysis should include assessing whether to divest some "healthy" businesses. Every shrub needs some pruning occasionally, and divestitures should be considered throughout the lifespan of every company.

Unbundling is particularly beneficial when: there is a culture clash between the core and unit businesses; the unit is consuming too much of the parent company's resources, such as managerial time or capital; synergies between the parent and the unit are decreasing; or there is internal competition for resources, such as capital. The freed resources and the cash gained from the operation could be reinvested in other parent company businesses.

At the same time, the unit may benefit from its former, and sometimes ongoing, relationship with its parent. The parent may provide the divested unit with capital, resources, expertise, and an initial market and status. As a separate entity, the unit may be better off, attracting new investors or customers from the market that were reluctant to deal with the parent organisation. For example, some units unbundled by high-tech companies, such as telecommunications company Motorola, were able to access customers and providers who were competitors of the unit's parent, pre-divestiture. This way, parent companies are able to retain a stake in interesting businesses considered high risk, allowing them to test markets and promote innovation, while insulating themselves from the risks associated with full ownership.

The Dutch conglomerate Philips has a strong spin-off policy. It has a specific centre, called the Technology Incubator, which develops new business ideas, identifies the most promising opportunities and assists the unit managers in transforming these ideas into new businesses, allowing them to separate when they achieve profitability. The formation of business structures around promising ideas allows faster take-up by customers and attracts funding from venture capitalists.

The result is that sometimes divested units outperform their parents. This was the case with Toyoda Automatic Loom Works (parent) and Toyota Motors (spin-off). Toyoda Automatic Loom Works initially supported Toyota Motors. But the spun-off division grew larger than its parent and started serving and supporting it. Who is in charge?

The most frequent instigators of an unbundling operation are: changes in ownership; high levels of ownership concentration (caused by blockholders or institutional investors); and movements in top management. Board members, and specifically executive directors, tend to become involved in the operation only when managerial strategic controls are perceived to be weak and/or where the top management team is heterogeneous.

In all cases, the active participation of unit managers in the divesting process is essential for the success of the divestiture. The unit manager plays numerous vital roles in the divestiture, as information supplier, implementer of secondary decisions, protector of the morale and productivity of the unit's staff, host of potential purchasers on unit visits, and, finally, a potential buyer. As a result, they are responsible for all aspects of the procedure from due diligence to implementation of the unbundling operation.

In addition, the unit manager's co-operation and transparent communication has a positive influence on employees' perceptions of the procedural fairness of the divestiture. This is particularly important when undertaking divisional redesign or staff downsizing. In the case of the latter, employees only see the resulting changes and layoffs as fair where they consider them to be necessary for corporate survival. Once again, the unit manager's involvement is essential for the success of the divestiture – in influencing staff reaction to redundancy announcements and creating post-divestiture employee loyalty and trust in the organisation.


CHECKPOINT 4

230 ANP413

Nevertheless, external investors may perceive the role of management in unbundling operations in a negative way. This is particularly so in MBOs, where conflict of information and interests often arise. External investors may believe that unit managers are pursuing their own interests and that the divestiture may require specialised information unavailable to such managers. Even in these circumstances, however, unit managers often know more about a company's investment opportunities than external investors do.

Market reactions and beyond

Normally, when a company announces that it is going to unbundle, its share value jumps. Investors often believe that factors such as less diversification, wealth redistribution between stakeholders and efficiency will ultimately improve share value. However, in some cases, unbundling will have a negative impact on a company's market performance or no impact at all. This usually happens with involuntary unbundling announcements, which tend to incur negative price movements in the parent company's shares.

For voluntary divestitures, on the other hand, negative reactions at market level seem to depend on the information conveyed with the unbundling announcement and its credibility. The announcement may lack credibility, for example, if the company has not preceded it with preparatory organisational changes. Similarly, investors and analysts will be sceptical if they believe that the operation will have no impact on the company's future, or that public knowledge of the divestiture is already reflected in the company's stock price.

Research on European spin-offs undertaken by the European Commission reveals that companies originating from unbundling enjoy higher growth rates and reduced failure rates than traditional start-ups. This is unsurprising, since corporate spin-offs benefit from greater business experience and better access to development capital and markets than other newly incorporated companies. Unbundled units are also found to be an important source of job creation in Europe.

Conclusion

Unbundling should not only be on the agenda of managers and consultants but also policymakers. At corporate strategy level, we recommend regular evaluations of how different business units add value to the corporation. This will enable managers to decide early if, what, when and how to divest.

We stress that more attention needs to be given to the process of unbundling. Managers must go beyond considerations of immediate effect and evaluate the long-term benefits of such operations for both the divesting parent company and the divested unit. Unbundling may initially have a negative effect on the share price of both companies. However in the long term, this may be outweighed by an improvement to the companies' strategic positions and economic performance.

On a policymaker level, governments need to recognise the value-creating role of divestitures by providing companies with a supportive regulatory framework, and facilitating benchmarking and the exchange of best practices in unbundling.

Johanna Mair is an assistant professor at IESE Business School in Barcelona. Her research centres on the strategy of companies that operate in multiple lines of business and in the role of managers in formulating and implementing strategy.

Caterina Moschieri is a PhD candidate at IESE Business School. Her research centres on corporate strategy, including unbundling operations, organisational change and innovation.


CHECKPOINT 4

231 ANP413

Case 19 – Currency issues F I N A N C I A L T I M E S – M A R C H 2 0 0 8 Dieter Zetsche, chief executive of Daimler, likens European carmakers’ battles with the strong Euro to a session in the gym. “The currency situation is a permanent training course for us. We always have to keep going and improving and that is keeping us fit.” It is a situation that is mirrored across the industry. The Euro remains close to record highs against the dollar and sterling, representing two of the biggest export markets for the European car industry, while the long-lasting weakness of the yen gives Japanese competitors a potentially large cost advantage.

And yet almost all of the German carmakers (the two French manufacturers – Renault and Peugeot – do not sell cars in the US) are producing stronger results in cash terms now than they were when the Euro was much weaker.

“Every one of these companies except BMW is making more money now than they were in 2002 when the Euro was at parity with the dollar,” says Max Warburton, analyst at UBS. Increased efficiency and productivity are the main driving forces behind that, but a successful hedging policy has also helped.

That does not mean the currency issue is failing to hurt the Europeans. Combined, the likes of Daimler, BMW, Volkswagen and Porsche are losing at least €1bn ($1.5bn) a year because of the strength of the Euro. Every rise in the Euro by one cent costs BMW and Mercedes about €50m each, annually. “You have to weather this period,” says Erich Ebner von Eschenbach, head of treasury at BMW, which is expected to have lost several hundred millions of euros – but below 2006’s €666m – last year.

This has led all the German manufacturers, except Porsche, to examine the possibility of expanding production in North America. Daimler, BMW and VW all have one factory each in the Nafta region but they all sell more vehicles in the US than they produce there. The stubbornly high rate of the Euro – and the thought that it might persist for several more years – has caused them to do the sums. But the answer is not the straightforward one of simply building another factory. In fact, only VW is likely to construct a new plant in the US; Daimler and BMW are merely content with trying to expand their current facilities as much as they can. Part of the reason lies in the fact that production accounts for only a small proportion of a carmaker’s dollar exposure. BMW estimates it is worth about 10-15 per cent of its exposure whereas purchasing accounts for 60-80 per cent. And here matters are much trickier. The crisis in the US car industry has led to severe problems for suppliers and the German luxury carmakers have found difficulties in building up a reliable supply base that can provide them with the same quality of components as back home. “There is a big problem with suppliers over there – many of them are almost dead. That makes a new factory less likely,” says Mr Zetsche. Instead, existing factories are being expanded, with BMW looking to increase the numbers of cars made in its South Carolina plant from 140,000 currently to 240,000 a year by 2012. Even so, that will fall well short of its sales in the US, which were already 335,000 last year.

Mr Warburton says: “The luxury carmakers can’t make the economic case to build a new factory because they have such relatively small volumes. Only VW can because it could build a plant with a volume of, say, 300,000 cars.” Even then, VW faces some tough problems in the US headed by the fact that consumers seem turned off by its cars, and big quality problems. Despite all this VW is hoping to triple its sales by 2018 – with Audi, its luxury car arm, doubling its own. Many are sceptical it can pull it off in a sluggish and highly competitive market but VW, Europe’s largest carmaker, believes success in the US is essential to its worldwide health.

Another problem is the competitive advantage Japanese carmakers enjoy because of the weak yen. BMW estimates that Lexus, Toyota’s luxury brand, enjoys a 40 per cent cost advantage solely because of the currency. But Mr Warburton points out that evidence of the Japanese using that advantage to gain market share – at least in Europe – is hard to see. “Peugeot has been losing market share not to the Japanese but to VW,” he says. Some even see the strength of the Euro as some kind of sign for future success. Mr Zetsche says: “Of course it is a problem and it costs us money and we would like the exchange rate lower. But, historically, a weak currency has always meant a weak economy.”


CHECKPOINT 4

232 ANP413


233 ANP413

6 Currency options 6.1 Currency options are contracts giving the holder the right, but not the obligation, to buy (call)

or sell (put) a fixed amount of currency at a fixed rate in return for an up-front fee or premium. Options are another derivative product.

Over the counter options (OTC) 6.2 Currency options can be purchased directly (over the counter) from a merchant bank; these

options are normally fixed date options (European options).

Lecture example 9 Technique demonstration It is 1st October. Zero plc wishes to hedge the possible receipt of $2m from the sale of a US subsidiary that it expects to be completed in December. The current spot rate is 1.4615 US$ per £. $2m of December dollar OTC options with an exercise price of $1.47 can be bought for a premium of £50,000. Required What will the outcome of the hedge be in each of the following scenarios? (a) The spot exchange rate on 31st December is 1.50 US$ per £. (b) The spot exchange rate on 31st December is 1.30 US$ per £. (c) The sale of the subsidiary does not happen.


The use of financial derivatives to hedge against forex risk (cont)



234 ANP413

Exchange traded options 6.3 Currency options are also available from the US markets such as the Philadelphia Stock

Exchange (PHLX).

Advantages vs OTC options Disadvantages vs OTC options Exchange traded options cover a

period of time (American options)– OTC options are fixed date (European options)

Exchange traded options are normally offered up to two years ahead, OTC options can be agreed for longer periods.

Exchange traded options are tradable – so if they are not needed they can be sold on

Exchange traded options are in standard contract sizes.

Exchange traded options: quotations Call option – a right to buy (the contract currency)

Put option – a right to sell (the contract currency)

6.4 Philadelphia SE US$ per £ Options £31,250 (cents per £1)

Strike Calls Puts price Apr May June Apr May June

1.9500 2.20 2.75 3.10 0.65 1.20 1.60 1.9750 0.88 1.45 1.85 1.70 2.40 2.85 2.0000 0.25 0.70 1.05 3.65 4.10 4.50

Lecture example 10 Technique demonstration Required (a) What is the size of a contract? (b) What is a call US$ per £ option? (c) What do the numbers under each month mean? (d) Why is the cost of an April call at 1.9500 more expensive than an April call at 2.0000? (e) Why is an May call option more expensive than an April call option?

Solution (a) (b) (c) (d) (e)



235 ANP413

Lecture example 11 Technique demonstration Today is 31st December, the spot rate is 1.9653 US$ per £. XP plc anticipates that in four months' time it will need to make purchases of $5m and in six months' time it will have receipts of $2m. Options prices are quoted in paragraph 6.4 – assume that XP plc will take out an option at a rate closest to the spot rate ie 1.975 US$ per £. Required

(a) Calculate the outcome of the four-month hedge (import). (b) Calculate the outcome of the six-month hedge (export). Illustrate the outcome if the spot rate turns out to be (i) 2 US$ per £ or (ii)1.95 US$ per £.

Solution (a) 2 $/£ 1.95 $/£

Set-up today – 31st December Outcome – end April (i) (ii)



236 ANP413

(b) 2 $/£ 1.95 $/£ Set-up today – 31st December Outcome – end June (i) (ii)

Q5



237 ANP413

7 Chapter summary

Section Topic Summary 1 Introduction It can be argued that shareholders can manage

hedging themselves saving the company time and transaction costs. However, lower transaction risk should have the effect of lowering a company’s beta factor and boosting its share price. Exchange rates are normally given as a spread, the company will always be offered the worst rate.

2 Internal methods

Internal hedging techniques include leading lagging, netting and invoicing in the local currency.

3 Forward contracts

Fixes the exchange rate on a specific amount of money at a specific date in the future – very popular.

4 Money market hedging

A short term loan or investment in a foreign currency to hedge risk.

5 Futures Currency futures fix the rate in the future on a standard amount of money. Dates are more flexible than futures but only available in a narrow range of currencies, in standard contract sizes.

6 Options Currency options allow a company to use a worst case (option) rate, but the company can also use the spot rate if this is better.

Before any hedging is conducted it is important that a risk assessment has been completed and a clear policy on hedging has been established. Hedging costs (eg options) need to be approved by a senior manager, and hedging exposure needs to be continuously monitored.



238 ANP413

END OF CHAPTER


239 ANP413





Evaluate, for a given hedging requirement, which of the following is most appropriate given the nature of the underlying position and the risk exposure: (i) Forward Rate Agreements (ii) Interest Rate Futures (iii) Interest rate swaps (iv) Options on FRAs (caps and

collars), interest rate futures and interest rate swaps

Remember that exam questions are likely to be 50% discussion so do not neglect the discussion elements of this chapter. Past questions have often focussed on whether an option or futures hedge would allow a company to achieve its hedging objectives.

Q3 December 2008 - futures and options Q5 Dec 2009 - swaps and value at risk Q2 Dec 2011 – futures, options & collars Q3 June 2012 – interest rate swaps Q2 new pilot – futures, options & collars

The use of financial derivatives to hedge against interest rate risk


17: THE USE OF FINANCIAL DERIVATIVES TO HEDGE AGAINST INTEREST RATE RISK

240 ANP413

Overview



Higher interest rates on loans that are being planned can be managed using a variety of risk management techniques

Higher interest rates push up the cost of capital making investments less viable

Financial derivatives to hedge interest rate risk



241 ANP413

1 Interest rate risk Type of risk Explanation Higher costs on existing loans If loans are at a variable or floating rate Higher costs on planned loans Even if fixed interest finance is used Basis risk Interest bearing liabilities and interest bearing assets

may not move perfectly in line with each other. Mainly relevant to banks.

Gap exposure Interest rates on interest bearing liabilities and interest bearing assets may be revised at different time periods. Mainly relevant to banks.

1.1 Interest rate risk can be managed by ‘smoothing’ ie using a prudent mix of fixed and

floating rate finance, with an emphasis on using fixed rate finance if the company is risk averse or expects interest rates to rise.

1.2 If, however, a major loan is being planned in the future, then the risk is harder to manage since the interest rate on the loan cannot be fixed. This is shown below:

1.3 This risk can be managed by a variety of interest rate derivatives; these techniques either: (a) fix the rate of interest - Forward Rate Agreements and interest rate futures, or (b) cap the rate of interest – OTC options and exchange traded options

1.4 Finally, interest rate swaps can be used to adjust the mix of fixed and variable rate finance referred to in paragraph 1.1

2 Forward rate agreements (FRAs) – fixing the rate 2.1 A contract with a bank (ie over-the-counter) covering a notional amount of money to be

borrowed over a specific time period at an interest rate agreed now. Quotation of forward rates

£5m 3-9 FRA at 5%

Size of loan Start & end month Base rate guaranteed

Now 3 months' time

– plan to take out a £5m loan in three months' time

take out £5m loan, by this time rates may have risen



242 ANP413

2.2 An FRA is separate from the bank loan and allows a company to borrow in, say, three months' time at the best rate available.

Advantages of forward rates Disadvantages of forward rates Simple Fixed date agreements Normally free, always cheap Rate quoted may be unattractive Normally available for > 1 year ahead

Lecture example 1 Technique demonstration Altrak plc is planning to take out a six-month fixed rate loan of £5m in three months' time. It is concerned about the base rate (LIBOR) rising above its current level of 5.25%. Altrak has been offered a 3-9 FRA at 5.5%. Altrak can borrow at about 1% above the base rate. Required

(a) Advise Altrak of the likely outcome if in three months' time the base rate is 5.75%. (b) Advise Altrak of the likely outcome if in three months' time the base rate is 4.5%.

Solution (a) (b)



243 ANP413

3 Interest rate futures – fixing the interest rate 3.1 These are similar agreements to FRAs ie agreements on a fixed interest rate but are

available on an exchange for standard amounts (£0.5m) and standard periods (three months).

Advantage of futures Disadvantages of futures Flexible dates ie a September future can

be used on any day until the end of Sept Only available in large contract sizes

Margin needs to be topped up on a daily basis to cover expected losses

Lecture example 2 Technique demonstration Altrak (see example 1) is considering using the futures market. It is 1 December, and Euronext.liffe is quoting the following prices for a standard £500,000 three-month contract. Contracts expire at the end of the relevant month. LIBOR is 5.25%. Prices are quoted (at (100 – annual yield)) in basis points, as follows:

December 94.75 March 94.65 June 94.55 Required Illustrate the outcome of a futures hedge, assuming that a loan is taken out at LIBOR +1% fixed at the start of the loan and that LIBOR is: (a) 5.75% (b) 4.50% Note: it is quicker to leave your answer in %, and to convert into £s as a final step.

Solution Set-up today – 1st December Outcome – 1st March (a) (b)

Working Now – 1st December 1st March March future LIBOR Basis



244 ANP413

4 Exchange traded options – cap the interest rate 4.1 These are agreements on an interest rate for standardised amounts (£500,000) and for

standard periods (three months). The difference is that they do not have to be exercised (you can’t make a loss on an option) and they require a premium to be paid.

Lecture example 3 Technique demonstration Altrak is considering using the options market. It is 1 December, and the London International Financial and Futures Exchange (LIFFE) is quoting the following prices for a standard £500,000 three month contract. Contracts expire at the end of the relevant month. LIBOR is 5.25%. Call option – a right to buy (receive interest) Put option – a right to sell (Pay interest) Short sterling options (Euronext.LIFFE)

Strike Calls Puts price March June March June

94375 0.010 0.025 0.125 0.140 94550 0.005 0.012 0.245 0.248 94750 0.004 0.008 0.490 0.492

Required Illustrate an option hedge at 5.45%, again assume a loan is taken out at LIBOR +1% and LIBOR is: (a) 5.75% (b) 4.50%




245 ANP413

Advantages of options Disadvantages of options Flexible dates (like a future) Only available in large contract sizes Allow a company to take advantage of

favourable movements in interest rates. Expensive

Useful for uncertain transactions, can be sold if not needed

Collars (for a borrower) 4.2

4.3 A collar is cheaper but the company will lose if % falls below the floor rate.

Lecture example 4 Technique demonstration Lecture example 3 continued – Altrak's FD considers the options market to be too expensive. Required Illustrate the outcome of a collar with a put at 5.45% and the call at 5.25% if LIBOR in 3 months is (a) 5.75% (b) 4.50%


FLOOR – sell a call , receive a premium

Loan rate

%

% Market interest rate

COLLAR

CAP – buy a put, expensive

Q6



246 ANP413

5 Over-the-counter options – cap the interest rate 5.1 Options are also available directly from a bank. These are tailored to the precise loan size

and timing required by a company but will be more expensive and cannot be sold on if not needed. Like exchange traded options caps, floors and collars are available.

6 Swaps 6.1 A swap is where two counterparties agree to swap their liabilities for interest payments. This

may be in the same currency (an interest rate swap) or in different currencies (a currency swap).

6.2 Usually a bank will organise the swap (1) to remove the need for counterparties to find each other and to remove default risk.

Interest rate swaps 6.3 Swaps enable a company to:

(a) Manage interest rate risk – for example, by swapping some of its existing variable rate finance into fixed rate finance a company can protect itself against interest rate rises; this may be cheaper than refinancing the original debt.

(b) Reduce borrowing costs – by taking out a loan in a market where they have a comparative interest rate advantage.

(1) when a bank organises a swap, for simplicity the variable interest rate payment is assumed to be at the LIBOR, this is a useful approach to use in the exam.


Altrak is interested in the idea of using a swap arrangement to create a fixed rate for a long-term loan of £20m that is also being arranged. The swap will be organised and underwritten by a merchant bank who has found another company (company A) willing to participate in a swap arrangement; the merchant bank will charge a fee of 0.20% to both companies. Company A is a retailer with low levels of gearing; it has reviewed its balance of existing fixed and variable rate finance and wants to increase its exposure to variable rate finance. The borrowing rates available to Altrak and to company A are:

Altrak Company A Fixed 6.50% 5.55%

Variable LIBOR +1.00% LIBOR + 0.75%

Required

(a) Explain why Altrak wants a fixed rate loan at the same time as company A wants a variable rate. (b) Identify whether a swap could be organised to the benefit of both companies. (c) If so, identify the reason(s) for this.



247 ANP413

Solution



248 ANP413

Lecture example 6 Homework example Company A wants to borrow using a floating rate loan. Company B wants to borrow using fixed rate finance. A bank would charge 0.1% fees to both parties for organising the swap.

Company A Company B Fixed 8.00% 7.00%

Variable LIBOR +1.00% LIBOR -1.00%

Required

Show how a swap could benefit both companies.

Solution



249 ANP413

Currency swaps 6.4 Currency swaps enable a company to:

(a) Manage currency risk – by swapping some of its existing or new £ debt into euros a company can match revenue/assets in euros to costs/liabilities in euros.

(b) Reduce borrowing costs – by taking out a loan in a market where they have a comparative interest rate advantage.

6.5 Currency swaps are similar to interest rate swaps but normally involve the actual transfer of the funds that have been borrowed.


Altrak plc intends to purchase a European company for €90m with euro debt finance. Franco is a European company that is setting up operations in the UK and wants to use £ debt finance. A bank has indicated that it can organise a swap for a fee of 0.2% to each party. The exchange of principal will be at the rate of €1.50 to the £ and the principal amount will be exchanged and re-exchanged at the start and end of the swap.

Variable rates Altrak Franco £ % 6.25% 7.25%

€ % 4.50% 5.00%

Required Estimate the gain or loss in % to both Altrak and Franco from entering into this swap.

Solution

Chapter 16section 9&10



250 ANP413

6.6 A swap can be valued as the NPV of the net cash flows under the swap.


Steiner plc has a 10 year fixed rate loan of €8.8m, which pays 5% (p.a.) interest at the end of each 6 month period. The company is concerned about the risk of the euro strengthening against the £ over the next 2 years and is considering whether to use a currency swap or forward rates. The available forward rates are (in terms of euros to the pound):

6 months 12 months 18 months 24 months €1.201 to the £ €1.203 to the £ €1.205 to the £ €1.206 to the £

UK LIBOR is as follows: 6 months 12 months 18 months 24 months

3.25% 3.45% 3.50% 3.52% The swap currently being proposed is €1.2032 to the £. Required (a) Estimate the present value of the gain or loss in £m from entering into this swap. (b) Estimate the swap rate that would make it competitive with the use of forward rates.



251 ANP413

Solution



252 ANP413

Swaptions 6.7 A swaption is an option to enter into a swap, in return for an up-front premium. For example,

if there was any uncertainty over the proposed acquisition in the previous lecture example, then a swaption could be used.

7 Chapter summary Section Topic Summary 1 Types of risk Interest rate risk can be managed by ‘smoothing’ ie

using a prudent mix of fixed and floating rate finance, with an emphasis on using fixed rate finance if the company is risk averse.

2 Forward rate agreements

Fixes the rate of interest on a short term loan being planned in the near future.

3 Futures Interest rate futures fix the rate in the future on a standard amount of money.

4 & 5 Options Interest rate options allow a company to use a worst case (option) rate. Exchange traded options differ from currency options because they are notional contracts that are closed out against the futures price.

6 Swaps Swaps are appropriate for long-term hedging of interest rate or currency risk.

END OF CHAPTER


253 ANP413





Determine a firm’s dividend capacity and its policy given:

(i) The firms’ short- and long-term reinvestment strategy

(ii) The impact of any other capital reconstruction programmes on free cash flow to equity such as share repurchase agreements and new capital issues

(iii) The availability and timing of central remittances

(iv) The corporate tax regime within the host jurisdiction

Advise, in the context of an investment programme, on a firm’s current & projected dividend capacity.

See chapter 9 for a definition of dividend capacity and chapters 1 & 8 for further discussion of dividend policy.

Lamri - Q4 Dec 2010

Q1 Dec 2012, Q1 Dec 2007

Develop company policy on the transfer pricing of goods and services across international borders and be able to determine the most appropriate transfer pricing strategy in a given situation reflecting local regulations and tax regimes.

Short questions have been set in this area, these have required an understanding of how tax issues can affect transfer pricing strategies.

Lamri - Q4 Dec 2010

Dividend policy and transfer pricing in multinationals


18: DIVIDEND POLICY AND TRANSFER PRICING IN MULTINATIONALS

254 ANP413

Overview



Risk management

Dividend policy and transfer pricing in multinationals

Alternative mechanisms for obtaining remittances from

overseas investments



255 ANP413

1 Dividend policy 1.1 Dividend policy has been covered in Chapter 1 where it was discussed as a reflection of

the investment and financing decision. In Chapter 10, the dividend capacity of a firm was identified and used to value a business (cash flow basis).

1.2 Chapter 8 covered dividend policy in an international context, there were two main points:

(a) Double tax relief – extra tax will be payable on overseas dividends if the rate of tax paid in the UK is higher. It is possible to use an overseas holding company (a dividend cleaning company) to collect all overseas dividends together (some taxed at a high rate and some taxed at a low rate) and pay a dividend to the UK head office. This dividend income will be treated as having paid tax at an average of the overseas tax rates paid; this can reduce the need to pay extra tax in the UK.

(b) Exchange controls – reduce the ability of a company to pay dividends from its overseas subsidiaries

2 Transfer pricing

Lecture example 1 Idea generation As an alternative to paying a dividend from an overseas subsidiary, a company may set a high transfer price on goods supplied to an overseas subsidiary, or a low transfer price on goods supplied by an overseas subsidiary.

Required

(a) Identify reasons why a company might want to adopt this transfer pricing strategy.

(b) Identify potential problems with this strategy.

(c) Identify reasons why a company might want to reverse this strategy (ie set a low transfer price on good supplied to a subsidiary).


Case 20

Sections 4&5



256 ANP413

Lecture example 2 Technique demonstration Olando plc, a UK based multinational company, has subsidiaries in three countries – U, M and B.

The subsidiary in U manufactures specialist components, which are assembled and sold in either M or B. Production and sales will be 400,000 units per year no matter where the assembly and sales take place.

Manufacturing costs in U are $16 per unit and fixed costs (for the normal range of production) $1·8 million. Assembly costs in M are $9 per unit, and in B $7·5 per unit. Fixed costs are $700,000 and $900,000 respectively. The unit sales price in M is $40 and in B $37.

Corporate taxes on profits are at the rate of 40% in U, 25% in M, 32% in B, and 30% in the UK. No tax credits are available in these three countries for any losses made.

A withholding tax of 15% is deducted from all dividends remitted from U.

Olando expects about 60% of profits from each subsidiary to be remitted to the UK each year.

Required

(a) Identify whether the transfer price from U should be based on fixed cost + variable cost , or fixed + variable + a 30% mark-up.

(b) Identify whether assembly should take place in M or B.

Solution (a)



257 ANP413

(b)



258 ANP413

3 Chapter summary Section Topic Summary 1 Dividend policy In an international context, there are two main

points: (a) Double tax relief – extra tax will be payable on overseas dividends if the rate of tax paid in the UK is higher. It is possible to use an overseas holding company (a dividend cleaning company) to collect all overseas dividends together (some taxed at a high rate and some taxed at a low rate) and pay a dividend to the UK head office. This dividend income will be treated as having paid tax at an average of the overseas tax rates paid; this can reduce the need to pay extra tax in the UK. (b) Exchange controls – reduce the ability of a company to pay dividends from its overseas subsidiaries

2 Transfer pricing

Transfer pricing is a possible alternative to dividend policy in generating remittances from overseas investments. It is an attractive strategy if overseas taxation is high. There are heavy penalties for charging a distorted price to avoid overseas tax, so other approaches (such as using an overseas holding company as a dividend clearing company) need to be considered as well.

END OF CHAPTER


259 ANP413

h





Discuss the significance to the company, of the latest developments in the world financial markets such as the causes and impact of the recent financial crisis, growth and impact of dark pool trading systems, the removal of barriers of free movement of capital and international regulations on money laundering.

Demonstrate an awareness of new developments in the macroeconomic environment, establishing their impact upon the firm, and advising on the appropriate response to those developments both internally and externally.

Demonstrate an understanding of the role of, and developments in, Islamic financing as a growing source of finance for organisations; explaining the role for its use, and identifying its benefits and deficiencies.

Questions on this area are often signalled by an article on the ACCA website, make sure that you check for any new articles in the lead up to the exam.

Q4 Dec 2009 Q3 June 2010 Q2b & 5b June 2012 Q5b Dec 2012

Recent developments in world financial markets and international trade & finance


19: RECENT DEVELOPMENTS IN WORLD FINANCIAL MARKETS AND INTERNATIONAL TRADE & FINANCE

260 ANP413

Overview


Recent developments in financial markets and

international trade

Financial markets – Securitisation Dark pool trading systems

International trade – Globalisation Tensions in the Eurozone



261 ANP413

1 Recent developments in financial markets

Securitisation and the credit crunch

1.1 Securitisation is a financing technique where financial assets (mortgages) are grouped and the securitised assets can be sold transferring the risk of mortgage default to the new holder. However, the credit risk rating on these securitised assets often reflected the selling banks AA+ rating and not the real risk of mortgage default.

1.2 This has allowed banks to issue further bonds or use sale proceeds to fund further mortgage lending. This situation allowed banks to offer mortgage business without having depositor savings to support its lending i.e. without having to commit the funds themselves. Banks also earned arrangement fees and paid themselves bonuses as mortgages were essentially passed around the market.

1.3 In exchange for fees, some investment banks underwrote bond issues without fully understanding risk and were left holding the credit risk as the bonds defaulted. Huge losses resulted in bank merger and failure with equity investors bearing the drop in share price. This is further discussed in example 1.

Lecture example 1 Idea generation The credit crunch explained: Times Online August 2008

What is a credit crunch? In simple terms, it is a crisis caused by banks being too nervous to lend money to us or each other. Where they will lend, they charge higher rates of interest to cover their risk. In the real world, that means more expensive mortgages, dearer credit cards, pain for pension savers and other investors as stock markets fluctuate wildly, and in the worst cases repossession and bankruptcy.

What sparked the current crisis? Years of lax lending inflated a huge debt bubble as people borrowed cheap money and ploughed it into property. Lenders were free with their funds, especially in the US, where billions of dollars of so-called Ninja mortgages - no income, no job or assets - were sold to people with weak credit ratings (called sub-prime borrowers). The barmy notion was that if they ran into trouble with their repayments rising house prices would allow them to remortgage their property.

Section 1

Case 21&22

Mortgages Banks Investors (including banks)



262 ANP413

It seemed a good idea when Central Bank interest rates were low; the trouble was it could not last. Interest rates hit rock bottom in America in 2004 at just 1 per cent, but in June that year they began to rise. As interest rates jumped, US house prices started to fall and borrowers began to default on their mortgage payments.

How did it turn into a global crunch? The way the debt was sold on to investors gave the crisis global significance. The US banking sector package sub-prime home loans into mortgage-backed securities known as CDOs (collateralised debt obligations). These were sold on to hedge funds and investment banks who decided they were a great way to generate high returns. When borrowers started to default on their loans, the value of these investments plummeted as the risk of bond default increased. The holders of these bonds, principally investment banks, incurred huge losses as bond values fell and demise (some big names are Bear Sterns, Lehman brothers, Morgan Stanley and Merrill Lynch).

How did this affect the UK? Many UK banks had invested large sums in sub-prime backed bonds and have had write off billions of pounds in impairment losses as their traded values fell. But it got worse. Investors became nervous about buying any investment linked to mortgages, no matter how high their quality. The increased awareness of credit risk impacted on all money lending. Many of the UK’s banks, such as Northern Rock, had been borrowing on the short term money markets to fund large chunks of their mortgage business following government deregulation. They essentially borrowed money on a very short term basis from investment banks which they lent to homeowners for repayment on a long term basis. Such banks found they couldn’t secure ongoing credit as their massive short term loans matured and required renewal whilst mortgage repayment lay many years in the future. A financing black hole was created which has required public sector finance to bridge the gap. Required (a) Discuss the impacts of the failure of securitisation (b) Discuss any unethical practices that have helped cause the credit crunch

Solution



263 ANP413

2 Dark pool trading systems 2.1 Since 2007, when legislation removed monopoly status of European stock exchanges, there

has been a rapid growth in trading systems for shares, especially off-exchange venues known as “dark pools” where large orders are matched in private.

2.2 Dark pools allow large shareholdings to be disposed of without prices and order quantities being revealed until after trades are completed.

2.3 The impact of dark pools has been to reduce transaction fees and to improve the prices that large institutional shareholders can obtain when they buy / sell shares.



264 ANP413

3 Recent developments in international trade

Globalisation 3.1 The emergence of global markets has been stimulated by a number of factors eg the

creation of free trade zones (eg NAFTA 1994) and the activities of the WTO (covered in Chapter 23). This has created major growth opportunities for multinational companies, able to benefit from the free movement of capital to exploit these opportunities.

3.2 A key development in recent years has been the emergence of China and India as major players in the global market place. One effect of this has been a low cost production base for manufactured goods leading to low inflation globally.

3.3 Massive trade surpluses in some countries (e.g. China) have led to a flood of investment into countries with deficits (notably the US) which in turn has contributed to the asset price bubble that contributed to the credit crunch.



265 ANP413

4 New developments in the macroeconomic environment

Tensions in the Eurozone

Lower interest rates 1. Lower interest rates helped to stimulate high levels of private sector borrowing, especially

in economies where inflation was high. This lead to a rapid increase in consumer spending.

German economic policies 2. Continued emphasis by Germany on export led growth – driven by low inflation (and

therefore low wage rises) boosted German export growth at the expense of their neighbours. The accumulation of surplus funds in Germany helped to finance excessive borrowing in Southern European economies. This led to a sharp increase in the price of assets such as houses and shares and thus reinforced a boom into a bubble.

Government debt 3. Government debt has become a major problem, but is probably not a key cause of the

crisis. For example, before 2008 Spain was the only European government to have always kept to the rule that government borrowing is less than 3% of GDP.

2002 - euro comes into circulation

Bursting the asset price bubble 2008 4. Following the global financial crisis of 2007, asset prices in Southern Europe have tumbled.

Since 2008 house prices in Spain have fallen by over 30% which has led to a savage recession with over 50% of young people being unemployed in 2011. It was the bursting of the house price bubble, not any lax spending policies by the government, that crashed Spain's economy and caused its budget troubles. Therefore, government borrowing - which has ballooned since the 2008 global financial crisis - had very little to do with creating the current eurozone crisis in the first place, especially in Spain (Greece's government is the big exception here). So even if governments don't break the borrowing rules this time, that won't necessarily stop a similar crisis from happening again.



266 ANP413

Notes

1. Interest rates in the Eurozone were mainly driven by the strength of the leading European economies such as Germany. This made it possible for some Eurozone countries to borrow at much cheaper rates than previously. For example, Spain joined the Eurozone in 1999. Interest rates then fell dramatically to reflect the much lower interest rates in the larger European economies such as Germany. In economies where inflation was higher (e.g. Ireland, Greece and Spain) the “real” interest rate was even lower, and this further encouraged high levels of borrowing. Consumer spending rose less in Germany because German Unions agreed to hold their wages steady and ‘real’ interest rates were higher. Unit labour costs in Spain - a measure of the cost of employing an average Spaniard - rose 36% from the euro's creation in 1999 until the end of 2008. Contrast that with Germany, where unit labour costs rose just 3% over the same period.

2. In fact, the Spanish government resisted the lure of cheap loans, but most ordinary Spaniards did not. The country experienced a long boom, underpinned by a housing bubble, as Spanish households took on bigger and bigger mortgages. For example, house prices rose by 44% from 2004 to 2008. Returning to Spain's decade of experience with the euro, the adoption of the euro opened up a period of bubble growth. Spain's economy grew by a third between 1999 and 2007, and its net debt fell to just 26.5% of GDP in 2007. But this was bubble-driven growth: the stock market peaked at 125% of GDP in November 2007 and dropped to 54% of GDP a year later.

3. However, Italy broke the 3% rule 6 times between 1999 and 2007 and Greece manipulated its borrowing statistics and probably never complied. Germany - along with Italy - was the first big country to break the 3% rule and broke it in four of the nine years. After that, France followed and broke the rule in 3 of the 9 years.

4. Spain’s economy is now in a mess - its workers are overpriced compared with German workers, its construction sector has collapsed, and the economy is in recession.So, although the Spanish government still has relatively little existing debts, it is now having to borrow to fill the gap left by the jump in unemployment benefits and collapse in tax revenues during the downturn. And the government may also have to throw a lot more money at its banks, which are looking very exposed to the housing collapse thanks to all the mortgages they have lent.

5. As the crisis has developed, the loss of confidence in the countries affected has led to rises in the bond yields required on their government debt. Given the amount of debt their governments have, bond yields can quickly achieve a level at which the government can no longer afford to service their debt.

5. Spain and Italy are now facing nasty recessions, because no-one wants to spend. Companies and mortgage borrowers are too busy repaying their debts to spend more. Exports are uncompetitive. And now governments - whose borrowing has exploded since the 2008 financial crisis savaged their economies - have agreed to drastically cut their spending back as well.

Further research – to keep up to date see http://www.bbc.co.uk/news/business-18094883

Today



267 ANP413

5 Chapter summary Section Explanation 1 Securitisation and

the credit crunch Securitisation has allowed banks to support more

lending (earning fees by underwriting and placing) without having to commit the funds themselves. Recently banks have securitised sub-prime home loans; the failure of these securities has caused great damage to the economy.

2 Dark pool trading systems

The impact of dark pools has been to reduce transaction fees and to improve the prices that large institutional shareholders can obtain when they buy / sell shares.

3 Globalisation The emergence of global markets has been stimulated

by a number of factors e.g. the creation of free trade zones and the activities of the WTO. This has created major growth opportunities for multinational companies, able to benefit from the free movement of capital to exploit these opportunities.

The trade surpluses of China and India, among others,

have created a trade imbalance that has helped to lead to the credit crunch.

4 New developments in the macroeconomic environment

The tensions in the Eurozone are causing severe problems.



268 ANP413

END OF CHAPTER


269 ANP413




Key knowledge Understanding of the types of interest rate derivatives and their pros and cons. You need to be able to demonstrate an understanding of the issues that led to the credit crunch, and its impact on business.

Key skills Ability to evaluate interest rate risk management techniques.

Ability to construct an interest rate collar.


Chapter 17 – The use of financial derivatives to hedge against interest rate risk

90 minutes

Key areas Methods and limitations of interest rate hedging techniques

Course Notes Review the detailed calculations in your notes, make sure that for every technique you

can discuss the limitations. Make sure that you are able to discuss and construct an interest rate collar.

15 minutes

5 minutes

Study Text Question Bank Question 36 (Burger Queen) tests your knowledge of interest rate futures.

30 minutes

Study Text Review sections 9 & 10 from chapter 16 which discuss different types of currency

swap. Review any elements of chapter 17 that caused you difficulty in the course notes, make sure that you read section 7 of chapter 17 as a good way of rounding off this section on risk management.

40 minutes


CHECKPOINT 5

270 ANP413

Chapter 18 – Dividend policy and transfer pricing in multinationals

50 minutes

Key areas Understanding dividend policy and transfer pricing policy in international context

Course Notes Carefully review the chapter concentrating on the discussion areas and read case 20.

20 minutes

Study Text Review sections 4 and 5, concentrating on section 5.2 which looks at how to establish

an arms length transfer price.

30 minutes

Chapter 19 – Recent developments in world financial markets and international trade

60 minutes

Key areas Awareness of the importance of securitisation, derivatives and globalisation

Course Notes This is a topical chapter, read the overview in the course notes and then follow the

study text links given below. Read cases 21 & 22.

20 minutes

Study Text Quickly review section 1.2 thoroughly which looks at the topical area of debt crisis in

European countries. Also read section 1.7 on money laundering and section 3 which looks at developments in Islamic finance carefully. Remember that the basics of Islamic finance were covered in chapter 7a section 1.9. Finally, make sure that you monitor the ACCA website for any new articles on ‘new divelopoments’ that are published in the lead up to your exams.

40 minutes

On completion of all Study Support and Progress Tests you are ready to attempt Course Exam 2


CHECKPOINT 5

271 ANP413



The multiple choice questions contained within Progress Test 5 will thoroughly test your understanding of the material and your ability to perform the required calculations. Note that the P4 exam does not contain multiple choice questions. The four short written questions that follow will test your ability to apply your knowledge. These skills will prove important in preparing you for the more discursive elements of the exam.

It is important that you continually review your progress and revise further any areas where you feel your understanding is weak. Note that some of these questions recap on areas covered earlier in your course.

A Multiple choice questions (11 questions – 45 minutes) 1 What will be the cost in £s of a £2m loan if a company uses a 6-9 FRA at 5.6% (assume the company can

borrow at the base rate)?

A £448,000 B £28,000 C £56,000 D £112,000 (2 marks)

Data for questions 2-4 Today is 31 December. Washmore plc is expecting that in two months time it will need to borrow £5m for

a period of four months. Washmore can borrow at LIBOR + 1%.

LIBOR on 31 Dec : 5.10%

Futures rates on 31 Dec:

March June Contract size £500,000 94.80 94.70

2 Identify whether the number, type and date of the contracts needed is:

A 10 March contracts to sell B 7 March contracts to sell C 10 June contracts to buy D 13 March contracts to sell (2 marks)

3 Assuming that on 1 March the LIBOR is 5.4%, calculate whether the likely closing futures price on 1 March is:

A 94.50 B 94.53 C 94.57 D 94.60 (2 marks)


CHECKPOINT 5

272 ANP413

4 Using your answer from the previous question, calculate whether the interest costs as a result of the futures hedge is:

A 6.17% B 5.17% C 6.63% D 5.63% (2 marks)

5 Which of the following is not a feature of an exchange traded interest rate option?

A Contract sizes need to be adjusted for the length of the loan versus the standard contract length of three months

B Can be sold on if not needed

C Do not have to be used if the interest rate has moved in your favour

D It is closed out against the LIBOR (2 marks)

6 A credit rating is quoting the following yield spread (in basis points ie 1 point = 0.01%):

Rating 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr AAA 4 8 12 18 20 30 50 A 55 65 75 85 95 107 120

Mantovani plc is considering the issue of £0.1bn of debt with a maturity of three years. Currently the yield on one year government securities is 5% and the yield on five year government securities is 5.7%. Mantovani will have a credit rating of A after the debt issue.

The cost of debt (pre-tax) will be:

A 6.45% B 6.10% C 5.57% D 5.42% (2 marks)

7 Disintermediation is a term used to describe which of the following?

A A move away from negotiating directly with Trades Unions B A shift towards increasing the level of debt used by a company C A shift away from large syndicated loans to issuing bonds directly to investors D A move towards maximising the global sales of a product during its life cycle (2 marks)

8 Analyse whether the maximum reduction in value that would be expected 95% of the time for a company that estimates the standard deviation on its futures contracts over a one stage period to be £100,000 is:

A £164,000 B £165,000 C £196,000 D £164,500 (2 marks)

9 A nine year project has an NPV of $4m and a standard deviation of $2m.

Calculate the probability of the project’s NPV being above 0.

A 97.72% B 47.72% C 95% D 97.5% (2 marks)


CHECKPOINT 5

273 ANP413

10 Using the data in Question 9 analyse whether the project’s value at risk is:

A £9.87m B (£5.87m) C £0.71m D £3.29m (2 marks)

11 Which of the following is not an advantage of an exchange traded currency option?

A Dates are flexible B Can be sold on if not needed C Do not have to be used, if the exchange rate has moved in your favour D Free, although a deposit does have to be paid (2 marks)

B Short written questions (4 questions – approximate time 20 minutes) 1 Describe the two main approaches to capping and the two main approaches to fixing interest rate risk on

loans that are due in the near future. (4 marks)

2 Identify two motives for a fixed – variable interest rate swap, and two motives for a currency swap. (4 marks)

3 Describe how risk mapping can be used to profile the different types of risk that a business is exposed to, and how to describe appropriate risk management strategies. (7 marks)

4 Briefly outline the role of the World Bank, the IMF, a central bank, and the WTO in supporting the development of international trade. (5 marks)



CHECKPOINT 5

274 ANP413


Section A

1 B £2,000,000 x 0.056 = £112,000 this needs to be adjusted because the loan is for three months

£112,000 x 3/12 = £28,000

2 D 13 March contracts to sell £5m / £0.5m contract size = 10 then x 4/3 = 13.33, so 13 contracts.

3 C Basis on 31 Dec = 0.10% with three months of time difference

Basis on 1 March with one month of time difference = 0.03%

So futures price = 5.4% + 0.03% = 5.43% or 94.57

4 A Loan = %5.4% + 1% = 6.4%

Future : opening position is to pay 5.20% (94.80), the closing position is to receive 5.43% giving a profit of 0.23%.

6.4% - 0.23% = 6.17%

5 D Interest rate options are closed out against the futures price.

6 B The difference between the one year and the five year rate is 0.70%. There are 4 years between year 1 and year 5, year 3 is half way between year 1 and year 5 – so the three year return on government debt is estimated as 5% + (0.70% x 2/4) = 5.35%.

The extra return on an A rated debt issue is 0.75% so the cost of debt is 5.35% + 0.75% = 6.10%

7 C

8 D 45% below the mean = 1.645 standard deviations.

1.645 x £100,000 = £164,500

9 A Z = 2/1 = 2 standard deviations between the project NPV and zero. This suggests that there is a 0.4772 chance of being above zero + 0.5 chance of being above $2m – so there is a 97.72% change of the NPV being above zero.

10 B The VAR at 95% is 1.645 x 2,000,000 x √9 = £9,870,000 ie worst case NPV (only 5% chance of being worse) = £4m – £9.87m = -£5.87m

11 D This is an advantage of currency futures.

Section B 1 Fixing the rate - interest rate futures (contracts to sell) and FRAs (the OTC equivalent) are techniques

for fixing the rate.

Capping the rate – this can be achieved by the use of put options (or a collar) or by the use of OTC options (which offer cover that it is tailored to a firm’s needs, but are more expensive).

2. Interest rate swaps – allow a company to change its mix of fixed/variable debt without incurring redemption fees or issue costs.

Currency swaps – allow a company to exploit its comparative advantage in borrowing in their domestic capital market, also allow easy, quick access to foreign currency debt.


CHECKPOINT 5

275 ANP413

3 Risk mapping involves an analysis of the frequency that a risk issue may damage a business and the severity of the potential impact of this issue. This is illustrated below.

Low Frequency/probability High

C

A High

Impact

Low

D

B

Each grid, can potentially be managed with similar techniques.

A Hedging to remove the frequency and the impact

B Partial hedging (e.g. hedging <100% of currency risk)

C Diversification to remove the impact (eg move some production overseas in case a minimum wage is introduced locally), or risk mitigation to manage the impact (eg insurance against asset seizure, move base overseas to mitigate the impact of higher corporation tax)

D This can be ignored

4 The development of international trade is supported by a number of institutions:

WTO encouraging the reduction of trade barriers

Central banks guaranteeing the convertibility of a currency

World Bank providing funding for government capital projects

IMF providing finance for government’s experiencing balance of payments problems


CHECKPOINT 5

276 ANP413


Case 20 – Transfer pricing B B C W E B S I T E – D E C 2 0 1 2 (extract)

The decision by Starbucks to voluntarily pay £10m in taxes in each of the next two years has come under fire from critics who say the move makes a mockery of the tax system, while the tax authorities reaffirmed that corporation tax was not voluntary. Prem Sikka, professor of accountancy at Essex University, criticised "private sweetheart deals" with HMRC, saying this would send a bad signal to other businesses.

Tory MP John Redwood said the best way of getting more revenue was by cutting taxes, as well as pursuing "very strongly" those who break the law. He added: "The transfer pricing – where you buy things and how much royalty you pay within the business – is always a difficult set of questions. They don't avoid profit tax overall because the profit comes out somewhere. They are discussing where they should put the profit. They would obviously rather do that in a lower tax jurisdiction if that fits the facts sufficiently to satisfy the tax authorities."

Sikka said corporation tax in the UK had fallen over the years from 52% and is heading to 21%: "So this idea that lower corporation tax rates somehow makes us more attractive doesn't hold water."

Corporation tax is levied on profits but Starbucks has avoided paying the tax for three years in the UK through complex international payments within the company known as transfer pricing.

Starbucks currently makes a loss due to a 4.7% premium paid to the Netherlands division – where its coffee beans are roasted – and another 20% premium to Switzerland to buy the coffee beans. The company said it would not claim deductions on these payments, or against intercompany loans.

The unprecedented announcement by Starbucks was made at the London Chamber of Commerce, where Kris Engskov, the managing director of Starbucks UK, said: "I am announcing changes which will result in Starbucks paying higher corporation tax in the UK – above what is currently required by law. Specifically, in 2013 and 2014 Starbucks will not claim tax deductions for royalties or payments related to our intercompany charges. In addition, we are making a commitment that we will propose to pay a significant amount of corporation tax during 2013 and 2014 regardless of whether our company is profitable during these years. These decisions are the right things for us to do. We've heard that loud and clear from our customers."


CHECKPOINT 5

277 ANP413

Case 21 – Securitisation F I N A N C I A L T I M E S – M A Y 2 0 0 8 Last week’s £500m issue of mortgage-backed securities by the UK bank HBOS caused a tremor in banking circles. It is effectively the first such deal in Europe since the credit crisis struck. Is securitisation back? Alas, probably not. But it is a vital question. Domestic mortgages lie at the heart of the market, accounting for about half of Europe’s €1,300bn (£1,035bn) stock of securitised assets.

Without mortgages, securitisation can scarcely revive. The converse is true, for if banks cannot sell their mortgages on, they are hampered in issuing new ones. So much the worse for house prices and for prospects of recession.

Why is the HBOS deal not decisive? Mainly because – according to specialists I spoke to – it is unlikely to make HBOS any money. Rather, it is a symbolic gesture from the UK’s biggest mortgage lender, an exhortation to others.

The question is what the credit debacle has done to securitisation itself. For its fans, it taps a new pool of savings by creating an asset class, extending the supply of credit to house-buyers and others. But the past year has thrown up awkward questions. Why did some of those assets behave as they did under stress? Why were some classes of investor lured into buying them? Are there perverse incentives for bankers to securitise? Is critical information lost in the securitisation process? Does securitising illiquid assets such as mortgages make them liquid, or just dress them up in shiny gift-wrap?

As for asset classes, recall that a big proportion of residential mortgage-backed securities in recent years were repackaged into collateralised debt obligations. It proved a disaster.

The reasons have to do with the amplifying nature of the process. As default rates on the underlying subprime mortgages rose, the triple A and super-senior tranches were wholly protected up to a point. Beyond that point they fell off a cliff, in some cases losing all their value.

A central point of securitisation is to convert non-investment-grade loans into investment grade, so that institutions such as pension funds can buy them. That is why 70 to 80 per cent of the typical asset-backed security is triple A. No triple A buyers, no securitisation. And it was triple A buyers that got burnt.

Who were those buyers? According to Citi, about half of triple A asset-backed securities were bought by three classes: off-balance sheet bank vehicles, money market funds and hedge funds. All three are now effectively out of the market. In the case of the banks, the reason is self-evident. Off-balance-sheet tricks such as structured investment vehicles were in effect an abuse, and have died accordingly. As for the money market funds, arguably they should never have been involved. Apart from anything else, they are mostly not allowed to buy assets above a year or so in duration. Securitisation was a dodge to allow them to buy what were in effect 25-year mortgages. As for the hedge funds, they are still apparently active in trading low-grade securitisations, in which they specialise. The snag about triple A is that, even if the yields are manipulated upwards through the securitisation process, the hedge funds can only get their expected return through steep leverage, which the banks are no longer willing to provide.

For investors in general, the attraction of this form of triple A security was that it ostensibly offered something for nothing, a magical extra yield. If that goes, much of the raison d’être of securitisation goes with it.

What about incentives for the banks to securitise? There were plenty, one of the biggest being “gain on sale” accounting in the US. The effect was that in the old stages, the banks could book handsome profits through the mere act of securitisation, mainly by making heroic assumptions on future default rates. Then there is the question of loss of information through the securitisation process. A traditional lending bank works from both hard and soft information – the bare numbers, but also knowledge of individuals and markets. Securitisation, like the ratings agencies on which it depends, works on hard information alone. This may be why, according to recent academic research, securitised loans have a higher default rate than comparable loans that have not been securitised.

So to our final question, whether securitisation amounts to mere gift-wrapping. That is probably too sweeping a view, but it reflects the temper of the times. For practical purposes, the effect is the same. For a long while,


CHECKPOINT 5

278 ANP413

securitisation will be a shadow of its former self. This, as much as anything else, is the route by which the follies of the credit bubble will hit the real economy.

Case 22 – Spain Eurozone Crisis – where jobs are a lottery

B B C W E B S I T E – N O V E M B E R 2 0 1 2

In a Spanish town where one in three people are without a job, getting one can depend quite literally on the luck of the draw.

Alameda is surrounded by neat rows of olive trees that stretch for miles towards the distant sierra. Two hours east of Seville, the town is a maze of narrow streets lined by orange trees and whitewashed houses. The mayor, Juan Lorenzo Pinera, seems to know most of the people he passes in the town square. Many of them shout greetings or stop to ask him a question. Since Spain's housing bubble burst, the thing most people want to know is whether he has any work going.

"The situation is very difficult," he says. "All the men who were working in construction lost their jobs, and now many of them are no longer eligible for government help. We have families who have been thrown out of their homes and everyday people come to the town hall asking for food."

He has come up with an idea to share out the work that is available at the town hall: a jobs lottery. Those who are unemployed - 34% of the population of 5,600 people - can sign up to be in the running for jobs as cleaners, street sweepers or builders. Each month eight women are selected at random to clean the town's public buildings. They work four hours per day, and are paid 650 euros (£526; $843) for the month.

More than 600 women have signed up to the cleaning lottery and many of them squeeze into a room at the town hall every month to watch the mayor pick folded slips of paper out of a cardboard box.

Maria Jose Bastida's husband used to have a well-paid building job so she has never needed to work before. She was delighted when her name came up in the lottery. "My husband has been unemployed for five years," she says. "At the moment we get 426 euros each month in family allowances, and the money I earn cleaning will go towards our mortgage."

Signs hanging from palm trees high above the square read: "We should save people, not the banks!" and "Shame on you, politicians, we don't applaud your cuts".

The central government has enacted severe austerity measures and the subsidies that once flooded into the region from Madrid and the EU are drying up.

Which is why, the mayor says, the town's jobs lottery is so important. "People here know that they won't have work for some time," he says. "The economy is dead. They don't see a future. The lottery at least gives them something to hope for each month."


CHECKPOINT 5

279 ANP413

Let BPP Professional Education help you with your revision You have now completed the very important Taught Phase of your studies. You have built core skills and have tested these using course exams and practice questions. You now need to focus on developing new skills to address the ultimate test – the exam itself.

Phase 2 – Revision

Revision courses Our Revision Courses, available in the period running up to the exam, will focus on one objective – passing the exam. Success in the exam requires more than just understanding the syllabus; you also need to apply this knowledge to the context of the exam questions. Using real exam questions written by the examiner you’ll learn the unique exam skills for each paper. We will teach you how to: Pick up easy marks for that paper Write in the correct style for that particular exam Choose the best questions for you Apply simple and understandable methods to pass the most difficult technical questions Build exceptional time management skills During a BPP Revision Course you will cover all of the issues above, maximising your chances of picking up marks. After all, those extra marks could mean the difference between a pass and a fail! We also suggest that if possible, the final step in your preparation should be a Question Day as an effective exam rehearsal that will test your technique under timed conditions. Finally, don’t forget that if you wish to make use of our FREE Pass Assurance, then attending a revision course is one of the criteria you must fulfil. Phase 3 – Exam practice This phase allows you to perfect your exam technique, giving you the confidence you need to apply key skills in the exam and therefore critical to passing the exam. BPP offers the following:

Question Days A Question Day provides one final day of practice (normally 1-2 weeks before the actual exam) giving you a chance to attempt a targeted mock exam under timed conditions. Your answers will be marked and you will receive feedback during the day allowing you to practise improvements to your question technique as the day progresses. During the day your tutor will provide debriefs of the questions and helpful tuition tips. Please note that places are very limited so book early to avoid disappointment.

Final Mock with Online Debrief You will receive an exam standard mock to attempt in your own time, suggested solutions, marking guide, and access to an online debrief. Ideal if you can’t secure a place on a Question Day or would prefer to practice in your own time. These are a convenient and flexible alternative to the Question Day.

Note. Question Days or the Final Mock with Online debrief are not a substitute for a revision course and do not count as a ‘revision course’ under the Pass Assurance rules.


CHECKPOINT 5

280 ANP413


281 ANP413

Answers to Lecture Examples


20: ANSWERS TO LECTURE EXAMPLES

282 ANP413

Chapter 1 No Lecture examples

Chapter 2

Answer to Lecture Example 1

The cost of equity is

Answer to Lecture Example 2 (a) 30 x (1+g)4 = 40 g =7.46%

ke = 20.8

)0746.1 (40 + 0.0746 = 12.7%

(b) growth = 50% x 20% = 10% pa

ke = ((30 x 1.1)/150)+0.1 = 32%

Answer to Lecture Example 3 Each investment has an expected return of 10% but investing 100% in either company leaves risk i.e. return might be as high as 25% or as low as –5%.

Investing in a 50:50 portfolio gives the same expected return of 10% p.a. but with no risk and therefore the portfolio is preferable.

Answer to Lecture Example 4 Use the beta of the company; 1.6

Ke = 4 + (8 x 1.6) = 16.8%

Use the beta of 0.8

Ke = 4 + (8 x 0.8) = 10.4%


Cost of debt to the company, = £95

0.30) - (1 £6 = 4.4%

%211.0p500

)10.01p(50



283 ANP413

Answer to Lecture Example 6 Internal Rate of Return to Company

Time $

DF @ 10% PV $

DF @ 5% PV $

0 (90) 1 (90) 1 (90) 1-5 5(1-0.3) 3.791 13.27 4.329 15.15 5 110 0.621 68.31 0.784 86.24 ( 8.42) 11.39

IRR = 5 + (11.39/19.81 x5) = 7.87%

Answer to Lecture Example 7 rD = 4 +( 0.2 (8 – 4)) = 4.8%

Cost to company = (1 – 0.3) 4.8% = 3.4%


Ke =

0.05120

10(1.05)g

oPg1oD

= 13.75%

Kd : Internal Rate of Return to company per year

Time 0 1-5 5 total per £100 -90 8(1-0.3) 100 df 5% 1 4.329 0.784 PV -90.00 24.24 78.40 12.64 df 10% 1 3.791 0.621 PV -90.00 21.23 62.10 -6.67

Using linear interpolation

IRR = 8.27%5%6.6712.64

12.64%5

Vd = 8,000,000 90% = £7,200,000

Ve = 7m x £1.20 = £8,400,000

WACC = %7.28.4

7.28.27%7.28.4

8.43.75%1 2.11



284 ANP413

Answer to Lecture Example 9 $m Adjusted profit 113.6 (88 + 20 + (0.7 x 8))

Capital employed 416 (400 + 16)

The weighted average cost of capital should be based on the target capital structure.

The calculation is as follows:

(17% x 0.7) + (10% x 0.7 x 0.3) = 14.00%

EVA = 113.6 - (416 x 0.14) = $55.36m


(a) This will often trigger an increase in the interest paid on existing debt

(b) Customers may stop using the company as a supplier (because it looks unstable), or may demand lower prices

(c) Suppliers may demand better payment terms (because the company looks unstable)

(d) Managers may introduce capital expenditure freezes, causing damage to the business

Answer to Lecture Example 11 A Extremely rigorous ethical standards to reduce/eliminate the frequency of damaging ethical

issues resulting from the company’s activities. 100% hedging of currency risk to reduce/eliminate the frequency of damaging currency risk issues resulting from the company’s activities.

B Capital expenditure procedures to reduce the frequency of investments failing, partial (<100% hedging) to control currency risk.

C Diversification to remove the impact (eg move some production overseas in case a minimum wage is introduced locally)

Risk mitigation to manage the impact (eg insurance against asset seizure, move base overseas to mitigate the impact of higher corporation tax)

D Ignore

Chapter 3

Answer to Lecture Example 1 Unless they are also owners of the business, managers may prefer to:

(a) Maximise short-term profits – to trigger bonuses and pay rises (b) Minimise dividends – to free up funds to use within the business (c) Reduce risk by diversifying profits – but shareholders can do this themselves (d) Boost their own pay and perks (e) Avoid debt finance – but sometimes debt finance can be beneficial to shareholders (f) Prevent takeovers that would benefit the shareholders, because they are might lose their jobs



285 ANP413

Answer to Lecture Example 2 Arguably, there is less need for control because there is no separation between ownership

and control.

This has been the excuse for the very slow movement towards UK style corporate governance.

Answer to Lecture Example 3 (a) Investment decisions

Some environmental investments may not generate a good commercial return (eg solar power has take 30 years to become profit making). Some investments may risk damage the environment (eg oil spills, fires at refineries). Some investments generate products that are damaging to the environment (jet fuel etc).

Bribery to obtain licenses.

(b) Financing decisions

Some banks lending the company money may have an unethical profile. Tempting to suppress bad news at a time that investment is being raised. Too much equity is used because managers prefer not to have the discipline of debt finance.

(c) Dividend decisions

May be too high at the expense of other stakeholders.

(d) Risk management policies

Preventative maintenance involves shutting down production, this may be neglected if there is pressure to hit profit targets.

Answer to Lecture Example 4 There is a need to ensure that all investments are assessed in terms their impact on stakeholders, and that solutions are researched to try to meet stakeholder needs where possible eg building pipelines below ground to reduce disruption to communities, development of solar power and so on.

Key decision makers need to be trained to ensure that they are aware of the main ethical areas that could damage the company's reputation.

A confidential whistleblowers' hotline could be used to ensure confidential responses to employee concerns (BP’s is called ‘open-talk’ which is an independent helpline).

Ethical concerns should then reported to a senior manager or an ethics committee to ensure that the Board is aware of them and can take appropriate action (any concerns at BP are reported to their ‘compliance and ethics team’).


It shows commitment from senior management and outlines key values, BP sacked 1,472 people in 2007 for failure to comply with its code of conduct (ethical code).



286 ANP413


(a) No. BP provides vehicles solely for use on company business, not for personal activities.

(b) No. Reimbursement of this expense would amount to a contribution by BP and would not comply with BP’s prohibition against political contributions. As an individual, you can support the candidate.

(c) Yes. In-kind contributions of materials to schools or local governments are a critical feature of BP’s community relations in some areas and are allowed by the code.

(d) No. Doing so would make it appear that we, as a company, agree with discrimination.. you should continue to put the best candidates forward based on merit- this ..might .. be an influence for change.

Chapter 4

Answer to Lecture Example 1 (a) The issues (b) Possible solutions

Tariffs on imports Lobby the WTO (via the EU) eg in 2006 the EU filed a formal complaint at the World Trade Organisation against India's trade barriers to European spirits and wine, in a bid to open up one of the world's largest potential markets for alcoholic drinks. India imposes tariffs of up to 540 per cent on imported spirits.

Embargoes The Indian state of Tamil Nadu prohibits sale of non-Indian spirits and wines. If consultations fail, the dispute will go to a WTO panel for adjudication. The WTO has already ruled in the EU's favour in three similar complaints against Japan, Chile and South Korea.

Subsidies to local companies Joint venture with a local company to receive similar treatment.


(a) Local investors might be more likely to invest if they can see that the issue is subject to the controls imposed by their local capital market (unlikely to be a problem for a US company already complying with Sarbannes-Oxley)

A higher price might be obtained if issue costs are lower, or corporate governance is tighter (unlikely to be a problem for a US company already complying with Sarbannes-Oxley)

Timing problems that may exist over the issue of equity in the US market can be avoided by being able to issue on the London market

Funds are obtained in the required currency

Higher visibility of the company in the UK may benefit sales in the UK

Ability to use UK share options to incentivise local managers

Broader shareholder base may make overseas acquisitions easier



287 ANP413

(b) Costs of membership of the London Stock market

Compliance with local regulations (unlikely to be a problem for a US company already complying with Sarbannes-Oxley)

Chapter 5

Answer to Lecture Example 1 (a) Time 1

£ 5000

d.f. 0.909

PV 4545

(b) Time 1 – 5

£ 5000

d.f. 3.791

PV 18955

(c) Time 3 – 7

£ 5000

d.f. 3.791

PV at time 2 18955

d.f. 0.826

PV at time 0 15657

(d) Time 1 – infinity

£ 5000

d.f. (1/r) 10.0

PV 50000



288 ANP413

Answer to Lecture Example 2 Net Present Value working (All figures £'000s)

Year 1 2 3 4 5 Sales 1800 2500 2800 3000 Direct Costs (750) (1100) (1500 (1600) Marketing (170) (250) (200 (200) Office overheads (40%) (50) (50) (50 (50) Net Real Operating flows 830 1100 1050 1150 x 1.04 x 1.042 x 1 x 1.044 Inflated at 4% (rounded) 863 1190 1181 1345 Taxation at 30% in arrears 0 (259) (357 (354) (404)Tax relief from capital allowances (W1) 0 53 39 30 58 Resale value 0 0 0 4000 Working Capital Cash flows (W2) (120) (64) (52 506 Net Nominal cash flows 743 920 811 5527 (346)12% Discount Rate (W3) 0.893 0.797 0 0.636 0.567Present Values 663 733 577 3515

(196)Cumulative PV 5292 Less Initial Investment (3250-80+700+270) (4140)NET PRESENT VALUE 1152

The present value of the tax cash flows = 792 (see workings below) Time 0 1 2 3 4 5 £'000s -206 -318 -324 -346 d.f @12% 1.000 0.893 0.797 0.712 0.636 0.567 PV -164 -226 -206 -196 total PV -792

Sensitivity = 1152 / 792 = 1.45 ie the tax rate would need to increase by 145% ie to 30 x 2.45 = 74% before the project NPV would fall to 0. Fiscal risk is therefore low for this project.

Workings Reducing Balance Tax Relief Year 1 700 Claim in year 1 25% (175) 30% 53 2 525 Claim in year 2 25% (131) 30% 39 3 394 Claim in year 3 25% (99) 30% 30 4 295

Resale value (100) Balance allowance claimed year 4 (195) 30% 58 5

2 Working capital Required at start of year ie 0 1 2 3 4 15% of Turnover 270 375 420 450 0 inflate current values 270 390 454 506 0 (increments) -270 -120 -64 -52 506 3 Nominal discount rate (1.077)*(1.04)= 1.12



289 ANP413

Answer to Lecture Example 3 Time 0 1 2 3 4 5 £'000s -4140 743 920 811 5527 -346 d.f @15% 1.000 0.870 0.756 0.658 0.572 0.497 PV -4140 646 696 534 3161 -172 total PV +725

IRR = 12+ (1152/427 x (15-12)) = 20.1%


1120151

14042925

.

/

,,

= 17.6%

17.6% is the modified IRR

Note – the 5292 comes from the PV of the cash flows after time 0 from example 2

Answer to Lecture Example 5 Time 0 1 2 3 4 5

PV -4140 663 733 577 3515 -196 Cumulative £ -3477 -2744 -2167 1348 1152

Discounted payback = 3 years + 2167/3515 = 3.6 years (ignoring the fact that most of the year 4 cash flow is a one off cash flow from asset sales that occurs at the end of year 4)

Time 1 2 3 4 5 PV as % of inflows 4140+1152=5292

663/5292 = 0.13

733/5292 =0.14

577/5292 =0.11

3515/5292 =0.66

-196/5292 =-0.04

Project duration =(1x0.13)+(2x0.14)+(3x 0.11)+(4x0.66)+(5x-0.04) =0.13+ 0.28 + 0.33 + 2.64 -0.2 = 3.18

This means that it takes approximately 3.18 years to recover half of the present value of the project; which shows the reliance on year 4 but unlike payback looks at all the years of the project.

Proof: the total present value of the cash received after 3.18 years is £2.6m (663k + 733k + 577k + 0.18 x 3515k) , which is about half of the total PV of the cash inflows of £5.3m (1152k + 4140k).

Answer to Lecture Example 6 45% below the mean = 1.645 standard deviations.

Answer to Lecture Example 7 The VAR at 95% is √1.645 x 1,000,000 x 4 = $3,290,000 ie worst case NPV (only 5% chance of being worse) = $2m – $3.29m = – $1.29m



290 ANP413

Chapter 6

Answer to Lecture Example 1 The main options present are:

Proposal A Option to expand – yes, greater capacity to expand possibly higher profile in the industry Option to delay – yes, must be worth evaluating

Proposal B Option to withdraw – yes – assets can be redeployed and land should be easy to sell

Option to expand – no, assuming limited capacity in existing factory and lower profile in the industry

Option to redeploy – yes

Option to delay – yes, must be worth evaluating

Answer to Lecture Example 2 Pa = £600,000 discounted back to time 0 at 10% = £409,800.

If this has been given in present value terms then you would not have discounted this value.

Pe = £600,000 T = 4 r = 0.04 s = 0.30 e-rT = 0.852

d1 = 40.3

)420.5x0.3(0.04/600,000)ln(409,800 =

0.60.340.381

= -0.07

d2 = -.07 – 0.3 2 = - 0.67

N(d1) = 0.5 – 0.0279 = 0.4721 N(d2) = 0.5 – 0.2486 = 0.2514

Option to expand = (409,800 x 0.4721) – (600,000 x 0.2514 x 0.852) = £193,467- £128,516 = £64,951

Project A now becomes a +NPV project (£64,951-10,000 = £54,951)

Answer to Lecture Example 3 Pa = £100m

Pe = £40m

T = 10 r = 0.05 s = 0.45

e-rT = 0.6065

d1 = 100.45

)1020.5x0.45(0.05ln(100/40) =

1.4231.5130.916

= 1.71

d2 = 1.71 – 0.45 3.162 = 0.29

N(d1) = 0.5 +0.4564 = 0.9564 N(d2) = 0.5 +0.1141 = 0.6141



291 ANP413

Call option = (100 x 0.9564) – (40 x 0.6141 x 0.6065) = £95.64- £14.9 = £80.7m

Put option = 80.7 – 100 + 40x0.6065 = £5m - the project’s NPV is understated by this value.

If this option can be exercised at any point up to the end of the 10 year period then the option would be worth more than this since it could be exercised if the project is failing; the Black Scholes model assumes that the option is exercised on a specific date i.e at the end of 10 years.

Chapter 7

Answer to Lecture Example 1 (a) The existing WACC could not be used because this would ignore the benefit of using debt

finance.

(b) Ke would rise because the use of debt makes equity more risky (higher financial risk, dividends become more volatile).

Answer to Lecture Example 2 (a) Ke = 12 + (1-0.3)(12-6) x 1 = 12 + 4.2 = 16.2%

(b) WACC = ( 0.5 x 16.2) + (0.5 x 6 x 0.7) = 6 + 2.1 = 10.2%

The use of debt will bring benefit to the company because the lower WACC will enable future investments to bring greater wealth to the company's shareholders.

Answer to Lecture Example 3 12 = x + (0.7)(x-5)1/2 so 12 = x + 0.35 (x-5)

12 = x + 0.35x – 1.75 so 13.75 = 1.35x

X = 13.75 / 1.35 = 10.19% this is the cost of equity ungeared. Round this down to 10% to use the discount tables.

Step 1 -Base case NPV (£m)

Time 0 1-5 -11 2.9 3.791 PV -11 10.994 = – 0.006 million

Step 2

Interest payable = £400,000 and tax saved = £400,000 x 30% = 120,000 or 0.12m Discount at cost of debt 5% over 5 years = 4.329 PV of tax shield (4.329 x 0.12) = £0.519

Step 3 Issue costs = £0.2m

APV (£m) –0.006+ 0.519 – 0.2 = +£0.313m Accept



292 ANP413

Answer to Lecture Example 4 Step 1

Equity beta = 1.75

Ungear Ba = 1.75 * (2/2.7) = 1.2963

Ke = 5 + (4)1.2963 = 10.19% (as previous example)

Answer to Lecture Example 5 (a) Step 1

beta of parcel delivery company = 1.8

Step 2

Ungear regear Ba = 1.8 * (1/2.4) = 0.75 Be= 0.75/ (1/1.7) = 1.275

Step 3

Ke = 4 + (8)1.275 = 14.2%

WACC = (14.2% x 1/2) + (4% x 0.7 x 1/2) = 7.1 + 1.4 = 8.5%

This WACC reflects the business and financial risk of the new investment.

(b) Step 1

Ke = 18.4%

Step 2

ungear 18.4 = X+ 0.7(X – 4) 2/1 18.4 = X + 1.4X - 5.6 24 = 2.4X X = 10%

regear

Ke= 10 + (0.7 x (10-4) 1/1 = 14.2%

Step 3

WACC = (14.2% x 1/2) + (4% x 0.7 x 1/2) = 7.1 + 1.4 = 8.5%

This is a WACC that reflects the business and financial risk of the new investment.

Answer to Lecture Example 6 Score = 4.41 + (0.0014 x 100) + (6.4 x 0.1) – (2.56 x 0) – (2.72 x 0.1) + (0.006 x 5) – (0.53 x 0.05) = 4.92

Credit rating = A

In reality this model would support an analysis of NT’s risk which would also involve judgements over the quality of NT’s management and systems.



293 ANP413

Answer to Lecture Example 7 Existing New Credit spread on existing debt

0.18% 0.85%

Yield curve benchmark 5.50% 5.50% Cost of debt (pre-tax) 5.68% 6.35% Value of debt £0.50bn £0.50bn Credit spread on new debt 0.95% Yield curve benchmark 5.5 + (2/5 x 0.3) = 5.62% Cost of debt (pre-tax) 6.57% Value of debt £0.10bn Cost of equity 8% 8.19% Value of equity £0.50bn £0.50 (assumed) WACC (8 x 0.5) + (5.68x0.7x 0.5) =

5.99%

(8.19 x 0.5/1.1) + (6.57 x 0.1/1.1x 0.7) + (6.35 x 0.5/1.1x 0.7) = 3.72+0.418 + 2.020 = 6.16%

0.50.55.68)1

e0.3)(K(11eK8

8 = Ke + (0.7 x Ke) -3.976 8 = 1.7Ke – 3.976 11.976 / 1.7 = Ke = 7.045%

New gearing = Debt = £0.60bn Equity = £0.50bn (assumed)

Ke geared = 7.045 + (1-0.30)(7.045-5.68)0.6/0.5 = 8.19%

Conclusion – the tax advantages of issuing new debt are outweighed by the impact of the debt issue on the credit rating and the Ke of Mantra.


Bond A Time 1 2 3 total cash 5 5 105 df 4% 0.962 0.925 0.889 PV 4.8 4.6 93.3 102.8 % in year 5% 4% 91% x year 0.05 0.09 2.72 2.86 years



294 ANP413

Bond B Time 1 2 3 total cash 10 10 110 df 4% 0.962 0.925 0.889 PV 9.6 9.3 97.8 116.7 % in year 8% 8% 84% x year 0.08 0.16 2.51 2.76 years

Chapter 8

Answer to Lecture Example 1 Danger signals Explanation

High $ inflation If inflation is higher in the US then this should decrease the purchasing power of the $. This is purchasing power parity theory (see below).

High $ interest rates If long term $ interest rates are higher, it is an indication that $ inflation will be higher then this should again decrease the purchasing power of the $, this is the international fisher effect (see below)..


Increases the supply of $ on the foreign exchange markets and can decrease the value of the $.

High $ government deficit

Debt repayments increase the supply of $ on the foreign exchange markets.

Answer to Lecture Example 2 (a) year 1 = 1.95 x 1.021/1.027 = 1.939

year 2 = 1.939 x 1.021/1.027 = 1.928

year 3 = 1.928 x 1.021/1.027 = 1.917

this is good news for a UK firm investing in the US

(b) the euro is the base currency

year 1 = 0.67 x 1.027/1.021 = 0.674

year 2 = 0.674 x 1.027/1.021 = 0.678

year 3 = 0.678 x 1.027/1.021 = 0.682

this is good news for a UK firm investing in Europe

Answer to Lecture Example 3 The first step is to calculate the expected exchange rate between the EA$ and the pound at the end of each year. This can be estimated using purchasing power parity theory.

It is assumed that expected UK inflation remains constant.

Formula: Forward rate = Spot rate x 1 + EA Inflation EA $/£ EA $/£ 1 + UK Inflation



295 ANP413

The expected spot rate at the end of each year can now be found.

Year EA$/£ 0 2.0000

1 2.000 x 05.103.1

= 1.9619

2 1.9619 x 05.103.1

= 1.9245

3 1.9245 x 05.103.1

= 1.8878

4 1.8878 x 05.103.1

= 1.8518

The £ sterling NPV can now be found.

Discounting annual cash flows in £ sterling at 16%

Year Cash flow $/£ Cash flow Discount PV EA$'000 £'000 factor £'000 0 (2,500) 2.0000 (1,250) 1.000 (1,250) 1 750 1.9619 382 0.862 329 2 950 1.9245 494 0.743 367 3 1,250 1.8878 662 0.641 424 4 1,350 1.8518 729 0.552 402 Total NPV (£'000) 272

Answer to Lecture Example 4 Discounting annual cash flows in Eastasian $

In this case the discount rate must be adjusted to take into account the lower rate of interest in Eastasia.

The adjusted rate will be given by x in the following equation.

05.0103.01

16.01x1

x = 13.7905%, this exact rate is used below, but 14% would be fine in the exam.

Year Cash flow Discount PV EA$'000 factor EA$000 0 (2,500) 1.000 (2,500) 1 750 0.879 659 2 950 0.772 733 3 1,250 0.679 848 4 1,350 0.596 804 Total NPV (EA$'000) 544

This converts to sterling at the spot rate of 2.0000 to give £272,000



296 ANP413

Answer to Lecture Example 5 Danger signals Manage by

High $ inflation

- government action could include higher interest rates / higher taxes

Higher taxes – use of overseas debt finance and transfer prices

Higher interest rates – fixed rate debt or equity


- government action could also include a devaluation of the local exchange rates or bring in exchange controls

Lower exchange rate – match overseas assets to overseas liabilities by using overseas debt finance

Exchange controls – use overseas debt finance, transfer prices and royalties

High unemployment

- political instability increase the risk of assets being seized or damaged

Joint ventures to build local profile

Build an incomplete value chain in the risky country

Use local debt finance and default if assets are seized.

Answer to Lecture Example 6 (a)

exchange rate 1.1 $/€ exchange rate 1.4 $/€ € million € million Assets 14,909 Assets 14,714 Equity (balance) 5,650 Equity 5,455 Floating rate debt 2,909 Floating rate debt 2,909 Current liabilities 6,350 Current liabilities 6,350 14,909 14,714

(b) exchange rate 1.1 $/€ exchange rate 1.4 $/€ € million € million Assets 14,909 Assets 14,714

Equity (balance) 5,650 Equity 5,650

Floating rate debt 2,909 Floating rate debt 2,714

Current liabilities 6,350 Current liabilities 6,350 14,909 14,714

Using overseas debt means that if the local exchange rate falls the decline in the value of the overseas assets is matched by a decline in the value of the liabilities – if local debt finance is used this does not happen and the book value of equity is damaged.



297 ANP413

Answer to Lecture Example 7 Assumption 1

Year Profits 50% retained Remittance £ Sterling PV @ 15% 1 10,500 5,250 5,250 525 457 2 16,000 8,000 8,000 571 432 3 21,000 – 34,250 1,803 1,185 2,074

Cost (2,200) NPV (126)

Assumption 2

Year Profits remitted

£ Sterling PV @ 15%

1 10,500 1,050 913 2 16,000 1,143 864 3 21,000 1,105 727 2,504 (2,200) NPV 304

Chapter 9

Answer to Lecture Example 1 (a) Builds on their strengths (competences in manufacturing)

Avoids their weaknesses (low cost base not essential) An opportunity to move into an expanding market Threats from other rivals limited because of brand loyalty

(b) Control of quality Create development opportunities for staff Avoid paying a bid premium Avoid post acquisition integration problems

BMW bought the Rolls Royce brand name only and built their own factory, their first model was launched in 2003

(c) Speed into the market Elimination of a rival Economies of scale (if horizontal) Create entry barriers (if vertical) Overcome entry barriers (brand loyalty, government restrictions on imports) VW bought Bentley and used Bentley’s operations; they launched their first new model in 2001

(d) Share costs, risks and knowledge



298 ANP413


(b) Possible issues include language, culture and strategic values – this has made for a very difficult working relationship. More likely to work well if the target it is not a hostile takeover. These issues should be examined as part of a due diligence investigation prior to a takeover being finalised.

Synergies

2 + 2 = 5

Financial synergyCould a broader product portfolio reduce risk? Utilise tax losses of Chrysler

Cost synergy Better prices from suppliers? Share technology? Share R&D?

Sales synergy Opportunities for sharing sales facilities and brand names?



299 ANP413

Chapter 10


Po = 0695.12.0

)0695.1 (3925.0

= £8.31 ex div

Answer to Lecture Example 2 Approach 1 Time 1 2 3 4 onwards £m 5.6 7.4 8.3 12.1 Annuity (1/r) 7.692 Value at time 3 93.1 @ 13% 0.885 0.783 0.693 0.693 PV 5.0 5.8 5.8 64.5 Total 81.1 Less debt 15 Value of equity 66.1 This suggests that the target is not worth £75m Ke (using CAPM) 5.75 + 2.178(10-5.75)= 15.0% Kd (I/Po x (1-t) 5.75/100 x 0.7 = 4.03% WACC = (15x0.833) + (4.03x0.167) = 13.2% Approach 2 Interest p.a. = £0.6m after tax Time 1 2 3 4 onwards £m after interest 5.0 6.8 7.7 11.5 Annuity (1/r) 6.667 Value at time 3 76.7 @ 15% 0.870 0.756 0.658 0.658 PV 4.4 5.1 5.1 50.5 Value of equity 65.1 small rounding error



300 ANP413


The EVA can be used to suggest that the value of this business is

Book value of adjusted assets + present value of EVA discounted to infinity

$416m + ($55.36m x 1/ 0.14) = $811.4m

This is the value of the pre-interest cash flows and to work out the valuation of the equity you would need to subtract the value of the debt (126 + 16 = 142 including leases) to obtain the value of the shares.

i.e. $811.4m - $142m = $669.4m


βa = βet))1Vd ((VeVe


Asset beta calculations assuming a debt beta of zero

Senso 1.19x (440/ (440 + 45x(1-0.3)) = 1.11 Enco 2.2x (62.4/ (62.4+ 5x(1-0.3)) = 2.08 post acquisition asset beta (1.11x440/502.4) + (2.08x62.4/502.4) = 1.23

Regear the beta using pre-acquisition equity and debt weightings, including the £80m of extra debt (ie total debt = 80 + 45 + 5 = 130).

1.23 / (502.4/ 502.4 + (130 x (1–0.3) = 1.45 so Ke = 4.5 + (3.5 x 1.45) = 9.58%

Calculate the new post-acquisition WACC

(9.58 x 502.4/ 632.4) + (6.8 x 130/632.4 x (1-0.3)) = 8.6%



301 ANP413

Post-acquisition NPV

Time 1 2 3 4 5 After year 5

35.18 36.87 38.66 40.56 42.58 43.43 Annuity (1/r-g)) 15.15

Value as at time 5 657.96

d.f. at 8.6% 0.921 0.848 0.781 0.719 0.662 0.662 NPV 32.40 31.27 30.19 29.16 28.19 435.57 total 586.71 land 6.5 senso debt 45

enco debt 5

new debt 80 value 463.21

This is higher than the pre merger value of Senso (40m x £11) of £440m.

Chapter 11

Answer to Lecture Example 1 (a) Prevents the offeree company from being constantly distracted from their core business by

rumours.

(b) To prevent unrealistic bids.

(c) Encourages the offeree company not to reject bids that are in the best interests of their own shareholders.

(d) Prevents the bidder from exercising control without giving other shareholders the chance to sell out.

(e) Bid timetable aims to get bids out of the way quickly. Conditional offers mean that extra shares only have to be bought by the bidding company if they have achieved more than 50% control.

(f) See (a).



302 ANP413

Chapter 12

Answer to Lecture Example 1 Sources of finance Discussion

Cash on deposit For small acquisitions, has the advantage of avoiding issue costs but involves equity finance which is expensive

Bond issue Bonds are often a cheap way of raising debt, but a large bond issue (or rights issue) will signal the takeover and may lead to a rise in the price of the target's shares as speculators buy shares in likely takeover targets

Line of credit A line of credit is a discreet way of allowing a firm to fund a takeover bid – this will involve a fee.


Minprice Savealot Total earnings £29.61m £9.77m P/E 300/19.1= 15.71 500/46.5 = 10.75 Valuation at higher P/E (same industry) £465.2m + £153.5 = £618.7m

(b) No shares in issue 155m 42m new shares= 197m EPS 29.6 +9.77 = £39.38,divide by no shares = 20p Share price = 20 x 15.71 = 314p

Note that the use of the P/E ratio of 15.71 assumes that the performance of the target will be improved by the new owner (a reasonable assumption since they are both in the same industry).

(c) Wealth before bid £3 X 155 = £465m £5 x 21m = £105m Wealth after bid £3.14x155= £486.7m £3.14 x 42m =

£131.9m Gain £21.7m £26.9m

(d) Wealth after bid £465m + £35m = £500m Post bid share price £500m / 155 = £3.226 Valuation of group £618.7m (from part a) No shares to give price of £3.226 618.7 / 3.226 = 191.8m No new shares 191.8 – 155 = 36.8m

36.8m new shares for 21m existing shares =1.75 new shares per existing share (or 7 for 4)



303 ANP413

Chapter 13


Break-up values of assets at 31 March 20X2 £'000

Freehold 4,500 Liquidation costs (500) 10% loan (fixed charge) (1,600) 2,400 Plant and machinery 2,000 Motor vehicles 200 Patents 1,250 Current assets 1,600 7,450 Secured creditors (floating charges) (4,800) 2,650 Trade creditors and overdraft 4,300

If the company was forced into liquidation, the secured loan and other loans would be met in full but after allowing for the expenses of liquidation the bank and trade creditors would receive a dividend of 61p per pound. The ordinary and preference shareholders would receive nothing.

Post rescue share price

Interest = £541,000

Earnings after interest = £900,000

Earnings after tax = £630,000

P/E discounted by 30% (a ltd company) = 10

£6.3m / 4.2m shares = £1.50

Comments

1 Secured loan

This has more than adequate asset backing, and their current nominal yield is 10%. If the reconstruction is to be acceptable to them, they must have either the same asset backing or some compensation in terms of increased nominal value and higher nominal yield. Under the scheme they will receive securities with a total nominal value of £2,150,000 (£1.25m debenture + £0.9m shares); this is an increase. The new debentures issued can be secured on the freehold property.

2 V C

V C’s existing loan of £4.8m will, under the proposed scheme, be changed into a £3.2m secured loan and £1.65m of ordinary shares (1.1m shares worth £1.50 – see part a). In total this gives total loans of £4,850,000 (including the debenture) secured on property with a net disposal value of £4,500,000. This is low asset cover which might increase if property values were to rise. The scheme will give an improvement in security on the first £3,200,000 to compensate for the risk involved in holding ordinary shares. This is a marginal gain for a position that exposes the bank to high levels of risk.

4 M A bank

This should be acceptable because of the security of a floating charge.



304 ANP413

5 Preference shares

In a liquidation at the present time, the preference shareholders would receive nothing. The issue of 500,000 £1 ordinary shares should be acceptable as it is equivalent to their current arrears of dividend. If the preference shares were left unaffected by the scheme, the full arrears of dividend would become payable on the company's return to profitability, giving preference shareholders an undue advantage.

6 Ordinary shareholders

In a liquidation, the ordinary shareholders would also receive nothing. Under the scheme, they will lose control of the company but, in exchange for their additional investment, equity in a company which will have sufficient funds to finance the expected future capital requirements.

7 Cash flow forecast, on reconstruction

£'000 Cash for new shares from equity shareholders 2,000 Repayment of overdraft 1,200 Cash available 800

This scheme of reconstruction might not be acceptable to all parties, if the future profits of the company seem unattractive. In particular, V C might be reluctant to agree to the scheme. In such an event, an alternative scheme of reconstruction must be designed, perhaps involving another provider of funds (such as another venture capitalist). Otherwise, the company will be forced into liquidation.

Chapter 14


Approach

1. Calculate the asset beta of the division (using a proxy company, eg Ryan air)

2. Regear the beta to reflect the gearing of the division

3 . Calculate the division’s new WACC

4. Discount the division’s post acquisition cash flows at this WACC

5. Calculate the revised NPV of the division and subtract debt to calculate the value of the equity

Note. in a demerger this calculation would have to be done for both parts of the demerged group – then the value of both demerged parts is added together to see if this exceeds the value of the group before the demerger.

(b) Didn’t have to find a buyer so an easy way of disposing of a business.

Seen as protecting the jobs of staff who have been loyal to you.

If it is a way of retaining divisional managers then a MBO could be the best way of maximising shareholder value – since the division without the management team may dramatically drop in value (GO’s MD, Barbara Casani would have left).

Acquisition by a competitor may be delayed by investigation by the competition authorities (this was one reason that BA rejected a bid from KLM).



305 ANP413

(c) 75% provided by venture capitalists

MBO’s are financed by venture capital. 75% of venture capital goes into MBOs.

Venture capitalists like 3i expect a return of about 28% typically. Since many of these ventures fail, venture capitalists make annual returns of about 15%.

Venture capitalists look for an exit after about five years, appoint director(s) and impose performance ratchets (raising their equity stake by being given free shares if the company underperforms).

GO was backed by 3i who took close to a 50% stake – the airline expected to float in a couple of years (but was subsequently sold to Easyjet).

Chapter 15

Answer to Lecture Example 1a Pa = 444 Pe = 385 T = 0.3333 r = 0.0417 = 0.25

e-rT = 0.9862

d1 = 1.16 d2 = 1.16 – 0.25 .333 = 1.01

N(d1) = 0.8770 N(d2) = 0.8438

Call value = (444 x 0.8770) – (385 x 0.9862 x 0.8438) = 69p

Answer to Lecture Example 1b Delta is N(d1) = 0.8770

The number of shares required is 1000 × 0.8770 = 877

Answer to Lecture Example 1c Call options are preferred – the value of a put option will rise as the share price falls!

Chapter 16

Answer to Lecture Example 1 (a) $360,000 / 2.07 = £174,913 expected

$360,000 / 1.50 = £240,000 received Profits = £65,087: UK exporters gain when the £ gets weaker

(b) $360,000 / 2.07 = £174,913 expected $360,000 / 1.5 = £240,000 paid Losses = £65,087 :UK importers lose when the £ gets weaker

Answer to Lecture Example 2 (a) $2m / 1.9618 = £1,019,472 (b) $2m / 1.9612 = £1,019,784



306 ANP413


Paying subsidiary Total receipts

Total payments

Net

UK US French

Receiving UK - £2m £1m £3m £4.5m (£1.5m)

subsidiary US £1.5m - £0.5m £2m £6.4m (£4.4m)

French £3m £4.4m - £7.4m £1.5m £5.9m

This minimises transaction costs for inter-company payments and should prevent hedging

Answer to Lecture Example 4 (a) $2m / 1.9612 = £1,019,784 (b) $2m / 1.9600 = £1,020,408

Answer to Lecture Example 5 EXPORTER UK £s USA $s Now 4. $1,973,360/1.9618 =

£1,005,893 3. loan 2,000,000/1.0135= $1,973,360

5. 5% x 3/12 = 1.38% ie 1.0138

5.38% x 3/12 = 1.35% ie 1.0135

3 months £1,005,893 x 1.0138 = £1,019,774

1. +$2,000,000 2. -$2,000,000 $0

The same outcome (minimal difference) as a forward contract (but could be better if the company was saving money from repaying a bank overdraft in the UK)

Answer to Lecture Example 6 IMPORTER UK £s USA $s Now 4. $1,973,788 / 1.9612 =

£1,006,419 3. $2,000,000 / 1.01328 = $1,973,788

5.59% x 3/12 = 1.398%

ie 1.01398

5.31% x 3/12 = 1.328%

ie 1.01328

3 months 5. £1,006,419 x 1.01398 = £1,020,489

1.- $2,000,000 2.+$2,000,000 0

Same outcome as a forward (but could be better if the company was using money on deposit in the UK)

Note. forward contract can be calculated as 1.9612 x (1.01328/1.01398) = 1.96



307 ANP413

Answer to Lecture Example 7(a) Set-up today – 31st December Outcome – 28th February 1. Calculate the £ required @ 1.9556 = £5,624,872 this is the approximate

cover needed 2. Divide by the contract size to determine

the no. of contracts needed

= £5,624,872 / £125,000 = 45 contracts

3. Decide whether to buy/sell the currency Need to sell £s (to buy $s) Enter into 45 March contracts to sell @ 1.9556

4. Actual transaction @ Feb spot rate 1.9900 = £5,527,638

5. Calculate $ profit / loss on the future Opening position – to sell £s @ 1.9556 Closing position - to buy £s @ 1.9880 0.0324 Loss has been made (buy price is > sell) Tick value = £125,000 x 0.0001 = $12.50 Total losses = $12.50 x 324 x 45 contracts = $182,250 (or 0.0324 x 125,000 x 45 contracts = $182,250)

6. Convert step 5 into £s at Feb spot & net off $182,250 / 1.9900 = £91,583 Net position = £5,527,638 + £91,583 = £5,619,221

This assumes that purchases in 2 months time result in payments in 2 months time.

Answer to Lecture Example 7(b) Set-up today – 31st December Outcome – 30th April

1. Calculate the £ required @1.9502 = £2,563,840 this is the

approximate cover needed 2. Divide by the contract size to

determine the no. of contracts = £2,563,840 / £125,000 = 20.5 =

21 contracts 3. Decide whether to buy/sell the

currency Need to buy £s (sell $s) Enter into 21 June contracts to buy @ 1.9502

4. Actual transaction @ April spot 2.0000 = £2,500,000 5. Calculate $ profit / loss on the future Opening position – to buy £s @ 1.9502 Closing position - to sell £s @ 1.9962 0.0460 Gain has been made (sell price is > buy) Tick value = £125,000 x 0.0001 = $12.50 Total profits = $12.50 x 460 x 21 contracts = $120,750 (or 0.0460 x 125,000 x 21 contracts = $120,750) 6. Convert step 5 into £s at April spot & net off $120,750 / 2.0000 = £60,375 Net position = £2,500,000 + £60,375 = £2,560,375



308 ANP413


Today 31st Dec 28th Feb March future 1.9556 1.9880 0.0020 below the spot (basis) Spot 1.9615 1.9900 given Basis 0.0059 x 1/3 = 0.0020 Due to three months

of time difference. One month of time difference.

(b) Today 31st Dec 30th April March future 1.9502 1.9962 0.0038 below the spot (basis) Spot 1.9615 2.0000 given Basis 0.0113 x 2/6 = 0.0038 Due to six months

of time difference Two months of time difference remain.

Answer to Lecture Example 9 (a) The option rate is better than the spot so the option is used giving a value of $2m / 1.47 =

£1.36m which becomes £1.31m after the premium (which is paid up front).

(b) The option rate is worse then the spot, so the spot is used giving a value of £1.54m or £1.51m after the premium

(c) If the option is worthless it will be abandoned (eg in (b)) or the company can exercise the option and make a profit (buy $2m at spot for £1.33m and then sell the $2m for £1.36m). In either case the premium still has to be paid.

Answer to Lecture Example 10 (a) £31,250

(b) Contract to buy £s (eg UK exporter)

(c) Cost in cents / £ (the market is in the US) eg May call at $2.0000 will cost $0.0070 x £31,250 = $218.75

(d) It is a better rate

(e) A May call gives cover in April and May, so it will be more expensive



309 ANP413

Answer to Lecture Example 11 (a) 2 $/£ 1.95 $/£

Set-up today – 31st December Outcome – end April (i) (ii)

1. Calculate the £ required 4. Actual transaction £ £

$5m / 1.975 = £2,531,646 @ spot rate in April 2,500,000

2. Divide by the contract size @ option rate (1.975)

£2,531,646 / £31,250 = 81 contracts 81 x £31250 2,531,250

Note that 81 x 31250 x 1.975 = $4,999,219 shortfall @April spot 401

There is a shortfall of $781.25 5. Net

(this could be hedged with a forward) Step 4 + premium 2,521,895 2,553,546

3. Date & type worst case

81 April put options at $1.975

4. Calculate premium

$0.0170 x 81 x 31250 = $43,031

Paid at today’s spot of 1.9653 = £21,895

(b) 2 $/£ 1.95 $/£

Set-up today – 31st December Outcome – end June (i) (ii)

1. Calculate the £ required 4. Actual transaction £ £

$2m / 1.975 = £1,012,658 @ spot rate in June 1,025,641

2. Divide by the contract size @ option rate (1.975)

£1,012,658 / £31,250 = 32.4 = 32 contracts 32 x £31,250 1,000,000

Note that 32 x 31250 x 1.975 = $1,975,000 shortfall ($25k) @spot 12,500

There is a shortfall of $25,000 5. Net

(this could be hedged with a forward) Step 4 less premium 1,003,087 1,016,228

3. 32 June call options at $1.975 worst case

4. Calculate premium

$0.0185 x 32 x 31250 = $18,500

Paid at today’s spot of 1.9653 = £9,413



310 ANP413

Chapter 17

Answer to Lecture Example 1 (a) Bank pays compensation of 0.25% to Altrak

Altrak borrows at the best rate available eg 5.75 + 1 = 6.75%

Net costs = 6.5%

(b) Altrak pays bank compensation of 1%

Altrak borrows at the best rate available eg 4.5 + 1 = 5.5%

Net costs = 5.5 + 1 = 6.5%

In £s this is 0.065 x £5m x 6/12 = £162,500

Answer to Lecture Example 2 Set-up today – 1st December Outcome – 1st March

1. Number of contracts required 4 Actual transaction (a) (b)

– adjusting for the term of the loan @ LIBOR + 1% 6.75% 5.50%

£5m / £0.5m = 10

10 x 6/3 = 20 contracts

2. Date ? – start of the loan 5. Profit / loss on the future

March Opening position – pay 5.35% 5.35%

Closing position – receive 5.78% 4.53%

0.43% 0.82%

profit loss

3. Contracts to sell 6. Net step 4 & 5 6.32% 6.32% FIXED OUTCOME

Enter into 20 March contracts to pay Note. in £s this is 0.0632 x £5m x 6/12 = £158,000 interest at 5.35%

A better outcome than the FRA in Lecture example 1

Workings (a) (b) Now – 1st Dec 1st March 1st March March future 5.35 5.78 4.53 LIBOR 5.25 5.75 4.50 Basis 0.10 x 1/4 = 0.03 0.03 4 months of timing 1 month remaining



311 ANP413

Answer to Lecture Example 3 Set-up today – 1st December Outcome – 1st June

1. Number of contracts required 5. Actual transaction (a) (b)

– adjust for the term of the loan @ LIBOR + 1% 6.75% 5.50%

20 contracts (as futures)

2. Date ? – start of the loan 6. Profit / loss on the option

March (as futures) Opening position- put 5.45% 5.45%

Closing position – future 5.78% 4.53%

0.33% don’t use

profit

3. Type of contract (sell = pay) 7. Net steps 3 & 4 & 5 6.665% 5.745%

Put worst case

20 March put options at 94550 May be better than forward and future, worse if exercised.

4. Premium 0.245%


Set-up today – 1st December Outcome – 1st March

1. Number of contracts required 5. Actual transaction (a) (b)

20 (as before) @ LIBOR + 1% 6.75% 5.50%

2. Date ? - March 6. Profit/loss on the option?

3. Type of contract – put @5.5% 0.33% profit (as before)

Buy puts, sell calls – call @5.25% 0.72% loss

(holder of call option receives 5.25%-4.53% future = 0.72%)

4. Premium 7. Net steps 4 & 5 & 6

0.245% - 0.004% = 0.241% 6.661% 6.461%

This is a slightly better outcome if rates rise but worse if rates fall.



312 ANP413

Answer to Lecture Example 5 (a) Altrak could have

(i) Different expectations about the future direction of interest rates.

(ii) A different attitude to risk – Altrak’s business risk or financial risk could be higher.

(b)

Step 1 – position if no swap

Altrak Company A Total

6.5% LIBOR + 0.75% = LIBOR + 7.25%

Step 2 – potential gain from swap

Altrak Company A Total

LIBOR + 1% 5.55% + 0.40% fees = LIBOR + 6.95%

Potential gain = 0.30%

Step 3 – borrowing action

Altrak Company A

LIBOR + 1 % new loan 5.55% existing loan Step 4 – swap – giving 0.15% gain to Altrak ie net finance costs of 6.35% vs step 1

0.20% fee 0.20% fee

LIBOR received LIBOR paid

5.15% paid 5.15% received

Step 5 – check net position

6.35%

LIBOR + 0.60%

0.15% gain vs step 1 0.15% gain vs step 1

(c) The swap has worked by using Company A's access to cheap fixed rate finance to drive down finance costs. In addition it will have saved Company A the costs of redeeming fixed rate finance and organising new variable rate finance.



313 ANP413

Answer to Lecture Example 6 Step 1 – position if no swap

A B Total

LIBOR + 1% 7% = LIBOR + 8%


A B Total

8% LIB0R – 1% + 0.20% fees = LIBOR + 7.2%



A B

8% LIBOR – 1% Step 4 – swap – giving 0.4% gain to Company A ie net finance costs of LIBOR + 0.60% vs step 1

0.10% fee 0.0% fee

LIBOR paid LIBOR received

7.50% received 7.50% paid

Step 5 – check net position LIBOR + 0.6%

6.6%

0.40% gain vs step 1 0.40% gain vs step 1



314 ANP413

Answer to Lecture Example 7 A bank has indicated that it can organise a swap for a fee of 0.2% to each party.

Variable rates Altrak Franco

£ % 6.25% 7.25%

€ % 4.50% 5.00%

Step 1 – position if no swap

Altrak Franco Total

4.50% 7.25% = 11.75%


Altrak Franco Total

6.25% 5.00% + 0.40% fees = 11.65%



Altrak Franco

6.25% (in £s) 5% (in euros)

Step 4 – swap – giving 0.05% gain to Altrak ie net finance costs of 4.45% vs step 1

0.20% fee 0.20% fee

6.45% paid (assume)

4.45%

Step 5 – check net position 4.45% 7.20%

0.05 gain vs step 1 0.05% gain vs step 1

Note. there is no currency risk on repayment of the principal, because the exchange rate has been fixed.



315 ANP413

Answer to Lecture Example 8 Part (a) Workings Time (in 6 month periods) 1 2 3 4 annual interest rate 3.25% 3.45% 3.50% 3.52% in terms of 6 month periods 1.625% 1.725% 1.750% 1.760% Time (in 6 month periods) 1 2 3 4 cash flow in euro thousands 220 220 220 220 (2.5% every 6 months)

proposed swap rate 1.2032 1.2032 1.2032 1.2032 £ cash paid (cash outflow) 182.846 182.846 182.846 182.846 forward rate 1.201 1.203 1.205 1.206 £ equivalent of euro receipts 183.181 182.876 182.573 182.421 (cash inflow) net gain / loss 0.335 0.030 -0.273 -0.425 discount rate 0.984 0.966 0.949 0.933 (see workings above) present value 0.330 0.029 -0.259 -0.396 total -0.296 in £s the swap is not acceptable on these terms Part (b) Workings Time (in 6 month periods) 1 2 3 4 cash flow in euro thousands 220 220 220 220 (2.5% every 6 months) forward rate 1.201 1.203 1.205 1.206 £ equivalent 183.181 182.876 182.573 182.421 discount rate 0.984 0.966 0.949 0.933 present value 180.252 176.726 173.313 170.125 total 700.416 in £s cumulative discount factor 3.832 (addition of the discount factors given) (addition of the discount factor given) annuity 182.768 in £s swap proposed Time (in 6 month periods) 1 2 3 4 cash flow in euro thousands 220 220 220 220 cash flow in £ thousands 182.768 182.768 182.768 182.768 ie swap rate = 1.2037 (220 / 182.768)



316 ANP413

Chapter 18

Answer to Lecture Example 1 (a) To reduce exposure to higher levels of corporation tax in the overseas country

To avoid exchange controls that restrict dividend payments

To avoid the political damage from the charge that the company is exploiting its overseas stakeholders (staff, suppliers, customers)

(b) Tax authorities may impose fines if transactions are proved not to be at an arm's lengths prices

Penalties may also include being barred from local government contracts

(c) To avoid duties on imported goods

To allow an overseas subsidiary to undercut / drive out local competitors


Tax paid in U 40.0% corporation tax

5.4%

withholding tax (PBT x0.6= PAT; PATx0.6 =remittance; remittance x0.15= tax rate of 5.4%)

45.4% Tax paid in B 32.0% corporation tax Tax paid in M 25.0% corporation tax 5.0% extra in UK Clearly prefer not to make profits in U, so transfer at cost

(b) M $'000s B $'000s fixed 700 fixed 900 variable 3600 variable 3000 transfer 8200 transfer 8200 total 12500 total 12100 sales 16000 sales 14800 profit 3500 profit 2700 tax 1050 at 30% tax 864 at 32% p.a.t 2450 p.a.t 1836

choose M



317 ANP413

Chapter 19


(a) Good value mortgages have become more difficult to find as borrowing rates have soared. Lenders have become more choosy about who they lend money to by, for example, demanding bigger deposits.

Stock markets have dropped dramatically as strife in the mortgage market has caused confidence to plunge. That's been bad news for millions saving into pensions and Isas.

The impact on the wider economy is difficult to fathom. Even before the crunch, economists were expecting a global slowdown. However, there is no doubt that the credit crunch has exacerbated downturns in the housing market and wider economy.

(b) – estate agents earning commission by selling mortgages to customers with a poor credit rating (often self certifying their own income)

– commercial banks have been buying securitised debt without fully understanding the risk of these investments; they have also been criticised for failing to pass on recent interest rate cuts

– investment banks have earned huge commissions by selling securitised debt as a low risk investment

– some commentators have suggested that the government have behaved unethically by failing to adequately supervise the banking sector

– even the media have been blamed by some for helping to create financial panic.



318 ANP413

END OF ANSWERS TO LECTURE EXAMPLES


319 ANP413

Question and Answer bank


320 ANP413

Index to Question and Answer bank

Page

Questions Answers

1 Nile plc.......................................................................................................................................... 321.......................335 2 Canadian plc ................................................................................................................................ 322.......................336 3 Black Raven Ltd ........................................................................................................................... 323.......................339 4 Atlas International......................................................................................................................... 324.......................341 5 Curropt plc.................................................................................................................................... 325.......................342 6 Shawter ........................................................................................................................................ 326.......................345 7 Jonas Chemical Systems ............................................................................................................. 327.......................346 8 Fly 4000........................................................................................................................................ 328.......................350 9 Sigra ............................................................................................................................................. 330.......................355 10 Lignum.......................................................................................................................................... 331.......................357 11 Coeden......................................................................................................................................... 333.......................359


21: QUESTION AND ANSWER BANK

ANP413

321

1 Nile plc 30 mins Nile plc is considering an investment of capital to be raised from the issue of new ordinary shares and debentures in a mix which will hold its gearing ratio approximately constant.

It wishes to estimate its weighted average cost of capital.

The company has an issued share capital of 1 million ordinary shares of £1 each; it has also issued £800,000 of 8% debentures.

The market price of ordinary shares is £4.76 per share (ex div) and debentures are priced at £69 per cent (ex interest). Debentures are redeemable at par in twenty years' time.

A summary of the most recent balance sheet is as follows:

£'000 £'000 £'000 Ordinary share capital 1,000 Non-current assets 1,276 Reserves 1,553 Current assets 4,166 Deferred taxation 164 Less: current Debentures 800 Liabilities 1,925 2,241 3,517 3,517

Dividends have been as follows.

Dividends £'000 20X4 200 20X5 230 20X6 230 20X7 260 20X8 300

Assume that there have been no changes in the system or rates of taxation during the last five years, and that the rate of corporation tax is 35%.

Assume that 'now' is 20X8.

Required

(a) Calculate Nile plc's weighted average cost of capital; and (10 marks)

(b) Discuss briefly any difficulties and uncertainties in your estimation. (5 marks)

(Total = 15 marks)



322 ANP413

2 Canadian plc 72 mins Canadian plc is a regional electricity generating company with several coal, oil and gas powered generating stations. The opportunity to bid for the coal mine supplying one of its local stations has arisen, and you have been asked to assess the project. If Canadian does not bid for the pit, then it is likely to close, in which case coal for the station would have to be obtained from overseas.

Canadian's bid is likely to be successful if priced at £6 million. Regional development fund finance is available at a subsidised interest rate of 4% for the full cost of the purchase, as against Canadian's marginal cost of debt if financed commercially. If Canadian invests a further £6 million in updated machinery, the pit is likely to generate £10 million of coal per annum for the next five years at current UK coal prices. Operating costs will total £3 million per annum, plus depreciation. Thereafter it will have to close, at a net cost after asset sales of £17 million, which includes redundancy, cleanup and associated costs, at present prices.

You have ascertained the following information about the coal industry.

Coal industry Gearing (debt/equity): (average) Book values 1 to 0.5 Market values 1:1 Equity beta 0.7 Debt beta 0.2

Capital allowances would be available at 25% on a reducing balance basis for all new machinery. The purchase price of the mine can be depreciated for tax at 25% per annum straight line. All other costs are tax allowable in full.

Other than the regional development fund loan (repayable after five years), the project would be financed by retained earnings. The project is likely to add another £3 million of borrowing capacity to Canadian, in addition to the £6 million regional development fund loan. Corporation tax is expected to remain to 30% during the life of the project. The company as a whole expects to be in a tax payable position for all years except the third year of the project.

Assume that all prices rise with the RPI, currently by 3% pa, except coal prices, which in view of reduced demand are set to remain static. You may assume that original investment cash flows arise at the start of the first year, and that all other cash flows arise at the end of the year in which the costs are incurred, except for tax, which lags one year. Treasury bills currently yield 8%, and the return required of the market portfolio is currently 16%.

You have discovered the following information concerning Canadian. Canadian plc Gearing (debt/equity): 1 to 1 1:2 Equity beta 1.0 Debt beta 0.25 P/E ratio 14 Dividend yield 6% Share price 220 pence Number of ordinary shares 8 million

Required

Write a memorandum for the finance director advising on whether the mine should be acquired. you should divide your memorandum into the following sections:

(a) Overall summary and conclusion (6 marks) (b) Detailed numerical workings (23 marks) (c) Assumptions behind the report (8 marks) (d) Areas for further research (3 marks)

(Total = 40 marks)



323 ANP413

3 Black Raven Ltd 45 mins Black Raven Ltd is a prosperous private company, whose owners are also the directors. The directors have decided to sell their business, and have begun a search for organisations interested in its purchase. They have asked for your assessment of the price per ordinary share a purchaser might be expected to offer. Relevant information is as follows.

MOST RECENT STATEMENT OF POSITION / BALANCE SHEET £'000 £'000 £'000 Fixed assets (net book value)

Land and buildings 800 Plant and equipment 450 Motor vehicles 55 Patents 2

1,307 Current assets

Stock 250 Debtors 125 Cash 8

383 Current liabilities

Creditors 180 Taxation 50

230 153 1,460 Long-term liability

Loan secured on property 400 1,060 Share capital (300,000 ordinary shares of £1) 300

Reserves 760 1,060

The profits after tax and interest but before dividends over the last five years have been as follows.

Year £ 1 90,000 2 80,000 3 105,000 4 90,000 5 (most recent) 100,000

The company's five year plan forecasts an after-tax profit of £100,000 for the next 12 months, with an increase of 4% a year over each of the next four years. The annual dividend has been £45,000 (gross) for the last six years.

As part of their preparations to sell the company, the directors of Black Raven Ltd have had the fixed assets revalued by an independent expert, with the following results. £ Land and buildings 1,075,000 Plant and equipment 480,000 Motor vehicles 45,000

The gross dividend yields and P/E ratios of three quoted companies in the same industry as Black Raven Ltd over the last three years have been as follows.



324 ANP413

Albatross plc Bullfinch plc Crow plc Div. yield P/E ratio Div. yield P/E ratio Div. yield P/E ratio % % % Recent year 12 8.5 11.0 9.0 13.0 10.0 Previous year 12 8.0 10.6 8.5 12.6 9.5 Three years ago 12 8.5 9.3 8.0 12.4 9.0 Average 12 8.33 10.3 8.5 12.7 9.5

Large companies in the industry apply an after-tax cost of capital of about 18% to acquisition proposals when the investment is not backed by tangible assets, as opposed to a rate of only 14% on the net tangible assets.

Your assessment of the net cash flows which would accrue to a purchasing company, allowing for taxation and the capital expenditure required after the acquisition to achieve the company's target five year plan, is as follows. £ Year 1 120,000 Year 2 120,000 Year 3 140,000 Year 4 70,000 Year 5 120,000

Required

Use the information provided to suggest alternative valuations which prospective purchasers might make.

(Total = 25 marks)

4 Atlas International 27 mins Atlas International plc is considering a bid for Olympic Global plc. The following information is given for both companies: Atlas Olympics £ £ Earnings per share 4 0.90 Share price 70 22 Number of shares 1,000,000 500,000

The consensus view is that Olympic will grow at a rate of 5%. The management of Atlas believe that without additional investment they can raise the growth rate to 7%.

(a) What is the gain from the acquisition? (5 marks)

(b) What is the cost of acquisition if Atlas pays £30 per share in cash for each share of Global? Should the acquisition go ahead? (5 marks)

(c) What is the cost of acquisition if Atlas offers one of its own shares for every two shares of Global? Should the acquisition go ahead? (5 marks)

(Total = 15 marks)



325 ANP413

5 Curropt plc 54 mins It is now 1 March and the treasury department of Curropt plc, a quoted UK company, faces a problem. At the end of June the treasury department may need to advance to Curropt's US subsidiary the amount of $15,000,000. This depends on whether the subsidiary is successful in winning a franchise. The department's view is that the US dollar will strengthen over the next few months, and it believes that a currency hedge would be sensible. The following data is relevant.

Exchange rates US$ per £ 1 March spot 1.4461 – 1.4492; 4 months forward 1.4310 – 1.4351.

Futures market contract prices Sterling £62,500 contracts:

March contract 1.4440; June contract 1.4302.

Currency options: Sterling £31,250 contracts (cents per £)* Calls Puts Exercise price June June $1.400/£ 3.40 0.38 $1.425/£ 1.20 0.68 $1.450/£ 0.40 2.38

Required

(a) Explain whether the treasury department is justified in its belief that the US dollar is likely to strengthen against the pound. (3 marks)

(b) Explain the relative merits of forward currency contracts, currency futures contracts and currency options as instruments for hedging in the given situation. (7 marks)

(c) Assuming the franchise is won, illustrate the results of using forward, future and option currency hedges if the US$/£ spot exchange rate at the end of June is:

(i) 1.3500 (ii) 1.4500 (iii) 1.5500 (20 marks)

(Total = 30 marks)



326 ANP413

6 Shawter 27 mins Assume that it is now mid December.

The finance director of Shawter plc, the parent company of the Shawter group, has recently reviewed the company's monthly cash budgets for the next year. As a result of buying new machinery in three months' time, his company is expected to require short-term financing of £30 million for a period of two months' until the proceeds from a factory disposal became available. The finance director is concerned that, as a result of increasing wage settlements, the Central Bank will increase interest rates in the near future.

LIBOR is currently 6% per annum and Shawter can borrow at LIBOR + 0.9%. Derivative contracts may be assumed to mature at the end of the relevant month.

Three types of hedge are available:

– Three month sterling futures (£500,000 contract size, £12.50 tick size)

December 93.870 March 93.790 June 93.680

– Options on three month sterling futures (£500,000 contract size, premium cost in annual %)

Calls Puts December March June December March June 93750

0.120 0.195 0.270 0.020 0.085 0.180

94000

0.015 0.075 0.155 0.165 0.255 0.335

94250

0 0.085 0.085 0.400 0.480 0.555

– FRA prices (based on LIBOR):

3 v 6 6.11-6.01 3 v 5 6.18-6.10 3 v 8 6.38- 6.30

Required

Illustrate how the short-term interest rate risk might be hedged, and the possible results of the alternative hedges, if interest rates increase by 0.5%. (Total = 15 marks)



327 ANP413

7 Jonas Chemical Systems 36 mins The board of directors of Jonas Chemical Systems Limited has used payback for many years as an initial selection tool to identify projects for subsequent and more detailed analysis by its financial investment team. The firm’s capital projects are characterised by relatively long investment periods and even longer recovery phases. Unfortunately, for a variety of reasons, the cash flows towards the end of each project tend to be very low or indeed sometimes negative. As the company’s new chief financial officer (CFO), you are concerned about the use of payback in this context and would favour a more thorough pre-evaluation of each capital investment proposal before it is submitted for detailed planning and approval. You recognise that many board members like the provision of a payback figure as this, they argue, gives them a clear idea as to when the project can be expected to recover its initial capital investment.

All capital projects must be submitted to the board for initial approval before the financial investment team begins its detailed review. At the initial stage the board sees the project’s summarised cash flows, a supporting business case and an assessment of the project payback and accounting rate of return.

A recent capital investment proposal, which has passed to the implementation stage after much discussion at board level, had summarised cash flows and other information as follows:

Distillation Plant at the Gulf Refining Centre Investment phase Recovery phase Cash flow Cash flow (tax adjusted, Cumulative (tax adjusted, Cumulative nominal) cash flow nominal) cash flow $m $m $m $m 1 January 20X6 (9.50) (9.50) 31 December 20X6 (5.75) (15.25) 31 December 20X7 (3.00) (18.25) 31 December 20X8 4.5 (13.75) 31 December 20X9 6.40 (7.35) 31 December 20Y0 7.25 (0.10) 31 December 20Y1 6.50 6.40 31 December 20Y2 5.50 11.90 31 December 20Y3 4.00 15.90 31 December 20Y4 (2.00) 13.90 31 December 20Y5 (5.00) 8.90

Cost of capital 8% Expected net present value ($m) 1.964 Net present value volatility ($m) 1.02 Internal rate of return 11.1% Payback (years) 5.015

The normal financial rules are that a project should only be considered if it has a payback period of less than five years. In this case the project was passed to detail review by the financial investment team who, on your instruction, have undertaken a financial simulation of the project’s net present value to generate the expected value and volatility as shown above. The board minute of the discussion relating to the project’s preliminary approval was as follows:

31 May 20X5 Agenda Item 6

New capital projects – preliminary approvals

Outline consideration was given to the construction of a new distillation facility at the Gulf Refining Centre which is regarded as a key strategic component of the company’s manufacturing capability. The cash flow projections had been prepared in accordance with existing guidelines and there was some uncertainty with respect to capital build and future profitability. Mrs Chua (chief financial officer) had given approval for the project to come to the board given its strategic importance and the closeness of the payback estimate to the company’s barrier for long term capital investment of five years. Mr Lazar (non-executive director) suggested that they would need more information about the impact of risk upon the project’s



328 ANP413

outcome before giving final approval. Mr Bright (operations director) agreed but asked why the board needed to consider capital proposals twice. The board was of the view that what was needed was clearer information about each proposal and the risks to which they were exposed. The chair requested the CFO to provide a review of the company’s capital approval procedures to include better assessment of the firm’s financial exposure. The revised guidelines should include procedures for both the preliminary and final approval stages. Approved (Action CFO to report)

Required

(a) Prepare a paper for the next board meeting, recommending procedures for the assessment of capital investment projects. Your paper should make proposals about the involvement of the board at a preliminary stage and the information that should be provided to inform their decision. You should also provide an assessment of the alternative appraisal methods. (8 marks)

(b) Using the appraisal methods you have recommended in (a), prepare a paper outlining the case for the acceptance of the project to build a distillation facility at the Gulf plant with an assessment of the company’s likely value at risk. You are not required to undertake an assessment of the impact of the project upon the firm’s financial accounts. (12 marks)

(Including 2 professional marks)

(Total = 20 marks)

8 Fly 4000 54 mins You are the chief financial officer of Fly4000 a large company in the airline and travel business whose principal market base is in Europe and the Middle East. Its principal hub is a major Northern European airport and Fly4000 has a small holiday business through its partnership with a number of independent tour operators. It has a good reputation as a business carrier within its European market, earned through very high standards of punctuality and service. Following the recent disinvestment of associated interests and a joint venture, it has cash reserves of $860 million.

FliHi is a smaller airline which also has its centre of operations at the same airport as Fly4000. It has, since it was founded in 1988, developed a strong transatlantic business as well as a substantial position in the long and medium haul holiday market. In the year to 31 December 20X5 its reported turnover was in $1.7 billion and its profit after tax for the financial year was $50 million. The company’s net assets are $120 million and it has $150 million of long term loans on its statement of financial position. It has recently expanded its fleet of wide bodied jets suitable for its expanding holiday business and has orders placed for the new Airbus 380 super-Jumbo to supplement its long haul fleet. FliHi has route licenses to New York and six other major US cities.

FliHi’s cash flow statement for the current and preceding year is as follows:

FliHi Consolidated Cash Flow Statement (extract)



329 ANP413

For the year ended 31 December 20X5 31 December 20X5 31 December 20X4 $m $m $m $m Net cash inflow from operating activities 210.0 95.0 Return on investment and servicing of finance Interest received 12.0 6.0 Interest paid (4.0) (3.0) Interest element on finance leases (6.5) (4.0) 1.5 (1.0) Taxation (4.1) (0.2) Capital expenditure (120.2) (75.0) Acquisitions and disposals Proceeds from the sale of interest in joint ventures 10.0 15.0 Cash inflow before management of liquid resources and financing 97.2 33.8 Management of liquid resources Decrease/(increase) in short-term deposits 35.5 (32.2) Financing Repayment of secured loans (31.0) (25.0) Increase/(decrease) in cash for the year 101.7 (23.4)

There is no other airline of comparable size and business mix to Fly4000 although analysts regard Rover Airways as a useful comparator. The statement below contains market data relating to Rover Airways:

Key fundamentals

Forward P/E* 11.00 Dividend Yield 0.00 Price to Book value of equity 1.25 1Yr Total Return (%)** 25.07 Price To Cash Flow 3.00 Beta** 2.00 1Yr Sales Growth -1.67 1Yr EPS Growth 80.50

** Equity Market Cap $3bn

You also note the following:

The current risk-free rate is 4.5 per cent and the equity risk premium is estimated at 3.5 percent. The prevailing share price for Rover Airways is 290¢ per share and its P/E ratio is 10. The corporation tax rate for both companies is 30 per cent.

The gearing ratio for Rover Airways, expressed as total debt to total capital (debt plus equity), is 60 per cent and as total debt to equity is 150 per cent.

You may assume that:

1 FliHi has undertaken a consistent programme of reinvestment 2 The debt in both companies is not expected to be sensitive to market risk.

There has been considerable consolidation in the airline industry and you are advising your board of directors of Fly4000 on the value of FliHi as a potential target for acquisition. It is anticipated that over the longer term the domestic airline industry will settle down to a rate of growth in line with GDP growth in the European economy which stands at 4 per cent per annum (nominal). However, the current rates of growth for this company are likely to be sustained for the next five years before reverting to the GDP growth rate from the sixth year forward.

Required

(a) Estimate the current cost of equity capital for FliHi using the Capital Asset Pricing Model, making notes on any assumptions that you have made. (9 marks)

(b) Estimate the expected growth rate of Flihi using the current rate of retention of free cash flow and your estimate of the required rate of return on equity for each of the next six years. Make notes on any assumptions you have made. (6 marks)



330 ANP413

(c) Estimate the value of Flihi on the basis of its expected free cash flow to equity, explaining the limitations of the methods you have used. (7 marks)

(d) Write a brief report outlining the considerations your colleagues on the board of Fly4000 might bear in mind when contemplating this acquisition. (8 marks)

(Total = 30 marks)

9 Sigra 36 mins Sigra Co is a listed company producing confectionary products which it sells around the world. It wants to acquire Dentro Co, an unlisted company producing high quality, luxury chocolates. Sigra Co proposes to pay for the acquisition using one of the following three methods:

Method 1

A cash offer of $5·00 per Dentro Co share; or

Method 2

An offer of three of its shares for two of Dentro Co’s shares; or

Method 3

An offer of a 2% coupon bond in exchange for 16 Dentro Co’s shares. The bond will be redeemed in three years at its par value of $100.

Extracts from the latest financial statements of both companies are as follows:

Sigra Co Dentro Co $’000 $’000 Sales revenue 44,210 4,680 Profit before tax 6,190 780 Taxation (1,240) (155) Profit after tax 4,950 625 Dividends (2,700) (275) Retained earnings for the year 2,250 350 Non-current assets 22,450 3,350 Current assets 3,450 247 Non-current liabilities 9,700 873 Current liabilities 3,600 436 Share capital (40c per share) 4,400 500 Reserves 8,200 1,788

Sigra Co’s current share price is $3·60 per share and it has estimated that Dentro Co’s price to earnings ratio is 12·5% higher than Sigra Co’s current price to earnings ratio. Sigra Co’s non-current liabilities include a 6% bond redeemable in three years at par which is currently trading at $104 per $100 par value.

Sigra Co estimates that it could achieve synergy savings of 30% of Dentro Co’s estimated equity value by eliminating duplicated administrative functions, selling excess non-current assets and through reducing the workforce numbers, if the acquisition were successful.

Required

(a) Estimate the percentage gain on a Dentro Co share under each of the above three payment methods. Comment on the answers obtained. (16 marks)



331 ANP413

(b) In relation to the acquisition, the board of directors of Sigra Co are considering the following two proposals:

Proposal 1

Once Sigra Co has obtained agreement from a significant majority of the shareholders, it will enforce the remaining minority shareholders to sell their shares; and

Proposal 2

Sigra Co will offer an extra 3 cents per share, in addition to the bid price, to 30% of the shareholders of Dentro Co on a first-come, first-serve basis, as an added incentive to make the acquisition proceed more quickly.

Required

With reference to the key aspects of the global regulatory framework for mergers and acquisitions, briefly discuss the above proposals. (4 marks)

(Total = 20 marks)

10 Lignum Lignum Co, a large listed company, manufactures agricultural machines and equipment for different markets around the world. Although its main manufacturing base is in France and it uses the Euro (€) as its base currency, it also has a few subsidiary companies around the world. Lignum Co’s treasury division is considering how to approach the following three cases of foreign exchange exposure that it faces.

Case One

Lignum Co regularly trades with companies based in Zuhait, a small country in South America whose currency is the Zupesos (ZP). It recently sold machinery for ZP140 million, which it is about to deliver to a company based there. It is expecting full payment for the machinery in four months. Although there are no exchange traded derivative products available for the Zupesos, Medes Bank has offered Lignum Co a choice of two over-the-counter derivative products.

The first derivative product is an over-the-counter forward rate determined on the basis of the Zuhait base rate of 8·5% plus 25 basis points and the French base rate of 2·2% less 30 basis points.

Alternatively, with the second derivative product Lignum Co can purchase either Euro call or put options from Medes Bank at an exercise price equivalent to the current spot exchange rate of ZP142 per €1. The option premiums offered are: ZP7 per €1 for the call option or ZP5 per €1 for the put option.

The premium cost is payable in full at the commencement of the option contract. Lignum Co can borrow money at the base rate plus 150 basis points and invest money at the base rate minus 100 basis points in France.

Case Two

Namel Co is Lignum Co’s subsidiary company based in Maram, a small country in Asia, whose currency is the Maram Ringit (MR). The current pegged exchange rate between the Maram Ringit and the Euro is MR35 per €1. Due to economic difficulties in Maram over the last couple of years, it is very likely that the Maram Ringit will devalue by 20% imminently. Namel Co is concerned about the impact of the devaluation on its Statement of Financial Position.



332 ANP413

Given below is an extract from the current Statement of Financial Position of Namel Co.

MR ’000 Non-current assets 179,574 Current assets 146,622 Total assets 326,196 Share capital and reserves 102,788 Non-current liabilities 132,237 Current liabilities 91,171 Total capital and liabilities 326,196

The current assets consist of inventories, receivables and cash. Receivables account for 40% of the current assets. All the receivables relate to sales made to Lignum Co in Euro. About 70% of the current liabilities consist of payables relating to raw material inventory purchased from Lignum Co and payable in Euro. 80% of the non-current liabilities consist of a Euro loan and the balance are borrowings sourced from financial institutions in Maram.

Case Three

Lignum Co manufactures a range of farming vehicles in France which it sells within the European Union to countries which use the Euro. Over the previous few years, it has found that its sales revenue from these products has been declining and the sales director is of the opinion that this is entirely due to the strength of the Euro. Lignum Co’s biggest competitor in these products is based in the USA and US$ rate has changed from almost parity with the Euro three years ago, to the current value of US$1·47 for €1. The agreed opinion is that the US$ will probably continue to depreciate against the Euro, but possibly at a slower rate, for the foreseeable future.

Required

Prepare a report for Lignum Co’s treasury division that:

(i) Briefly explains the type of currency exposure Lignum Co faces for each of the above cases; (3 marks)

(ii) Recommends which of the two derivative products Lignum Co should use to manage its exposure in case one and advises on alternative hedging strategies that could be used. Show all relevant calculations; (9 marks)

(iii) Computes the gain or loss on Namel Co’s Statement of Financial Position, due to the devaluation of the Maram Ringit in case two, and discusses whether and how this exposure should be managed; (8 marks)

(iv) Discusses how the exposure in case three can be managed. (3 marks)

Professional marks will be awarded in question 2 for the structure and presentation of the report. (4 marks)

(Total = 27 marks)



333 ANP413

11 Coeden 59 mins Coeden Co is a listed company operating in the hospitality and leisure industry. Coeden Co’s board of directors met recently to discuss a new strategy for the business. The proposal put forward was to sell all the hotel properties that Coeden Co owns and rent them back on a long-term rental agreement. Coeden Co would then focus solely on the provision of hotel services at these properties under its popular brand name. The proposal stated that the funds raised from the sale of the hotel properties would be used to pay off 70% of the outstanding non-current liabilities and the remaining funds would be retained for future investments.

The board of directors are of the opinion that reducing the level of debt in Coeden Co will reduce the company’s risk and therefore its cost of capital. If the proposal is undertaken and Coeden Co focuses exclusively on the provision of hotel services, it can be assumed that the current market value of equity will remain unchanged after implementing the proposal.

Coeden Co Financial Information

Extract from the most recent Statement of Financial Position

$’000 Non-current assets (re-valued recently) 42,560 Current assets 26,840 Total assets 69,400 Share capital (25c per share par value) 3,250 Reserves 21,780 Non-current liabilities (5·2% redeemable bonds) 42,000 Current liabilities 2,370 Total capital and liabilities 69,400

Coeden Co’s latest free cash flow to equity of $2,600,000 was estimated after taking into account taxation, interest and reinvestment in assets to continue with the current level of business. It can be assumed that the annual reinvestment in assets required to continue with the current level of business is equivalent to the annual amount of depreciation. Over the past few years, Coeden Co has consistently used 40% of its free cash flow to equity on new investments while distributing the remaining 60%. The market value of equity calculated on the basis of the free cash flow to equity model provides a reasonable estimate of the current market value of Coeden Co.

The bonds are redeemable at par in three years and pay the coupon on an annual basis. Although the bonds are not traded, it is estimated that Coeden Co’s current debt credit rating is BBB but would improve to A+ if the non-current liabilities are reduced by 70%.

Other Information Coeden Co’s current equity beta is 1·1 and it can be assumed that debt beta is 0. The risk free rate is estimated to be 4% and the market risk premium is estimated to be 6%.

There is no beta available for companies offering just hotel services, since most companies own their own buildings. The average asset beta for property companies has been estimated at 0·4. It has been estimated that the hotel services business accounts for approximately 60% of the current value of Coeden Co and the property company business accounts for the remaining 40%.

Coeden Co’s corporation tax rate is 20%. The three-year borrowing credit spread on A+ rated bonds is 60 basis points and 90 basis points on BBB rated bonds, over the risk free rate of interest.

Required

(a) Calculate, and comment on, Coeden Co’s cost of equity and weighted average cost of capital before and after implementing the proposal. Briefly explain any assumptions made. (20 marks)

(b) Discuss the validity of the assumption that the market value of equity will remain unchanged after the implementation of the proposal. (5 marks)



334 ANP413

(c) As an alternative to selling the hotel properties, the board of directors is considering a demerger of the hotel services and a separate property company which would own the hotel properties. The property company would take over 70% of Coeden Co’s long-term debt and pay Coeden Co cash for the balance of the property value.

Required

Explain what a demerger is, and the possible benefits and drawbacks of pursuing the demerger option as opposed to selling the hotel properties. (8 marks)

(33 marks)

END OF QUESTION BANK



335 ANP413

Answers

1 Nile plc (a) The net dividend has increased 1.5 times from the end of 20X4 to the end of 20X8, a period of 4

years. This represents an approximate annualised growth rate of 10.67% (being 4 5.1 ).

Cost of ordinary share capital in after tax terms = 17.6% or 0.1760.1067476

30(1.1067)

Cost of debentures: = £69 is the current market price per cent. The cost of debentures (%) is the internal rate of return of the following cash flows:

Year MV £

Interest £

Tax Saving £

Cash Flow £

0 (69) (69.0) 1-20 8 (2.8) 5.2 20 100 100.0

At a discount rate of 7% the NPV is + £11.9, and at a discount rate of 9% the NPV is – £3.7. The IRR is (by interpolation)

%5.8%27.39.11

9.11%7

It is assumed that the new issue of shares and debentures will be weighted in accordance with the existing gearing ratio as measured by market values.

The weighted average cost of capital is:

Cost (%) Market Value (£000s) Ordinary share capital 17.6% 4,760 Debentures 8.5% 552 5,312

Weighted average cost of capital (Ko) = (17.6 x 4760/5312) + (8.5 x 552/5312) = 16.7%

(b) The following difficulties and uncertainties should be mentioned.

(i) Will the growth rate in dividend remain the same as in previous years?

(ii) Should a premium for risk be added to the weighted average cost of capital; e.g. should the test discount rate for projects be, say, 20% or more rather than 16.7% (or 17%)?



336 ANP413

2 Canadian plc MEMORANDUM

To: The Finance Director From: Accountant Date: 12 December 20X5 Subject: Proposed investment in local coal mine

(a) Overall summary and conclusion

I have performed an analysis of the available figures using the adjusted present value technique (APV). This method is appropriate because the project:

(i) Represents an activity fundamentally different from that of the company (ii) Has a different risk profile, as evidenced by the differing betas, from Canadian (iii) Is to be financed using a gearing ratio different from the company (iv) Is a significant investment for the company (ie is not a marginal investment)

An alternative to this method might be the adjusted discount rate method, in which an estimate is made of the appropriate discount rate to use and the project cash flows discounted at this rate. However, insufficient data is available to perform this sort of analysis.

APV demonstrates that while the project appears to be marginally attractive under the stated assumptions (a positive NPV of £86,000), the total project allowing for the financing effects has a positive net present value of £2,010,000. These positive financing effects result from the interest savings on the Regional Development Board loan, plus the tax effects of the additional debt capacity of the firm.

However, I should stress that these figures assume a great deal about the future, both as regards the values of the factors that have been taken into account, and the factors that have been ignored. I would refer you to the later sections of this memo, but broadly:

(i) There would be substantial implications for power station X if this pit were to close. These costs should also be considered in coming to our conclusion.

(ii) Even if the power station is judged viable in the absence of the pit, buying coal from overseas will expose us to currency fluctuations which would need to be managed.

(iii) No sensitivity analysis has been carried out. It would appear likely that the project is highly sensitive to the price of coal, and to the level of redundancy and environmental clean-up costs. This implies a high degree of political risk, which will be outstanding for five years.

(b) Workings

The adjusted present value represents the NPV of the project based on an all equity financed situation, adjusted for any finance costs/benefits.

The appropriate discount rate is found from the formula:

asset = et)D(1E

E

+ dt)D(1E

t)D(1

This should be based on the betas for the coal mining industry, which obviously has a different risk profile from that of the power generation industry.

asset = 0.7 )3.01(11

)3.01(2.0

)3.0 _ 1(111

= 0.494

Justify APV

Summarise main effects of using APV

Opportunity cost

Risk management

Uncertainty

Can't use Canadian's Beta



337 ANP413

Therefore the appropriate discount rate is:

Ke = 8% + (16% – 8%) 0.494 = 12%

The cash flows generated by the project are therefore discounted at 12% to find the base NPV.

Cash flow forecast, £'000s

Year 0 1 2 3 4 5 6 Inflows

Value of coal production 10,000 10,000 10,000 10,000 10,000 Outflows OOperating costs (3,000 3% inflation factor) (3,090) (3,183) (3,278) (3,377) (3,478) Initial investment

(12,000)

Final payment (17,000 1.035) (19,708) Tax (1,173) (1,313) (1,347) 4,525 Tax from year 3 (1,258) Net cashflow (12,000) 6,910 5,644 6,722 4,052 (14,533) 4,525 NPV factor (12%) 1.000 0.893 0.797 0.712 0.636 0.567 0.507 NPV (12,000) 6,171 4,498 4,786 2,577 (8,240) 2,294 Total NPV 86

Workings

Year 1 2 3 4 5 Tax calculations Operating cash flows Inflows 10,000 10,000 10,000 10,000 10,000 Outflows (3,090) (3,183) (3,278) (3,377) (3,478) Capital allowances On equipment (1,500) (1,125) (844) (633) (1,898) On mine (1,500) (1,500) (1,500) (1,500) Termination costs 19,708) Net taxable flow 3,910 4,192 4,378 4,490 15,084) Tax on taxable flow 1,173 1,258 1,313 1,347 (4,525)

Financing effects are as follows.

Borrowing effect

The company can borrow a total of £6 million (the regional development loan) plus the £3 million increase in the borrowing capacity as a result of this project. This means that debt benefits flow on a total of £9 million of additional debt. This is worth:

Debt benefit = Total debt Canadian's borrowing rate tax rate

Canadian's borrowing rate can be found using CAPM as:

Kd = 8% + (16% – 8%) 0.25 = 10%

Don't Inflate

Take inflation into account

Use Canadian beta



338 ANP413

Therefore the increase in debt capacity is worth:

£9 million 10% 30% = £270,000 pa

This tax benefit will be received between the years 2 and 6, and should be discounted at the cost of debt (10%).

£270,000 3.791 10.11

= £931,000

Regional development loan

The value of the subsidy can be related directly to the cost of debt that Canadian plc would otherwise have paid (10%).

Therefore the saving in interest charges is:

£6 million (10% – 4%) = £360,000 pa

Again, this is discounted at the cost of debt. However, there are two things to notice:

(i) The benefit of the interest rate reduction is received in years 1–5.

(ii) There is an associated reduction in the tax benefit, detrimental in years 2–6, of the interest cost tax charge.

Present value of interest saved in years 1–5:

£360,000 3.791 = £1,365,000

Present value of tax benefit foregone in years 2–6:

£6m 6% 30% 3.791 10.11

= £372,000

The expected APV of the project, including financing effects, will therefore be:

£'000 NPV of project 86 NPV of tax shelter on interest 931 NPV of interest saved 1,365 NPV of tax benefit forgone on interest saved (372) 2,010

(c) Assumptions behind this report

As regards the data used in the report, it assumes the following.

(i) The various output and costing figures are reasonably accurate.

(ii) The clean-up and redundancy costs are correctly estimated – this assumes a stable political environment over the next five years.

(iii) The price of coal will stay at the current level for the foreseeable future.

(iv) The RPI can be accurately used as a measure of the cost inflation factors that will affect the pit.

(v) The Regional Development Board loan is obtained.

(vi) Retained earnings are available to finance the equity component of the project. If additional equity finance were required then issue costs could make this project unviable.

(vii) That the debt capacity added to the firm is accurate. It is not known how this figure is arrived at, but the project might well affect the total perceived risk of the firm for both equity and debt, and therefore change borrowing capacities for the rest of the firm.

Discounting adjustments

Don't forget to discount

Available funds very important

Change in risk



339 ANP413

(viii) The tax regime is at least as favourable as regards capital allowances as at present over the next five years

As regards the APV model, it assumes the following.

(i) The value of the tax shield is the full corporate tax rate. This is questionable when shareholders obtain the benefit of a dividend imputation system and annual capital gains tax allowances.

(ii) The project will contribute a full £9 million to the borrowing capacity of the group for the whole of its useful life. In reality it is likely that the asset base, and hence the borrowing capacity, will diminish over time.

(iii) The CAPM can be used to arrive at an ungeared cost of capital, which can then be used to discount the cash flows over five years. The CAPM is an annual model, so the assumption must be questioned.

(d) Areas for further research

(i) This memo is incomplete without a detailed sensitivity analysis being carried out. Such an analysis would seek to determine which of the above assumptions was likely to change, and by how much.

(ii) It is also not possible to assess whether this project is advisable in isolation from other capital opportunities and needs of the firm. It is unclear whether capital is in short supply.

(iii) The scenario presumes that there is no alternative bidder for the mine. However, it is possible that supplies to Station X might be secured by offering a fixed price contract to an alternative bidder for the supply of coal. In this case we ourselves can avoid the risks inherent in this industry, about which we know so little, and concentrate on our strengths.

3 Black Raven Ltd (a) Earnings basis valuations

If the purchaser believes that earnings over the last five years are an appropriate measure for valuation, we could take average earnings in these years, which were:

000,93£5

000,465£

An appropriate P/E ratio for an earnings basis valuation might be the average of the three publicly quoted companies for the recent year. (A trend towards an increase in the P/E ratio over three years is assumed, and even though average earnings have been taken, the most recent year's P/E ratios are considered to be the only figures which are appropriate.)

P/E ratio Albatross plc 8.5 Bullfinch plc 9.0 Crow plc 10.0 Average 9.167 (i) Reduce by about 40% to allow for unquoted status 5.5 (ii)

Must include APV assumptions

Due to uncertainty



340 ANP413

Share valuations on a past earnings basis are as follows.

P/E ratio Earnings Valuation Number of shares Value per share £'000 £'000 (i) 9.167 93 852.5 300,000 £2.84 (ii) 5.5 93 511.5 300,000 £1.71

Because of the unquoted status of Black Raven Ltd, purchasers would probably apply a lower P/E ratio, and an offer of about £1.71 per share would be more likely than one of £2.84.z

(b) Future earnings might be used. Forecast earnings based on the company's five year plan will be used. £ Expected earnings: Year 1 100,000 Year 2 104,000 Year 3 108,160 Year 4 112,486 Year 5 116,986 Average 108,326.4 (say £108,000)

A share valuation on an expected earnings basis would be as follows.

P/E ratio Average future earnings Valuation Value per share 5.5 £108,000 £594,000 £1.98

It is not clear whether the purchasing company would accept Black Raven's own estimates of earnings.

(c) A dividend yield basis of valuation with no growth

There seems to have been a general pattern of increase in dividend yields to shareholders in quoted companies, and it is reasonable to suppose that investors in Black Raven would require at least the same yield.

An average yield for the recent year for the three quoted companies will be used. This is 12%. The only reliable dividend figure for Black Raven Ltd is £45,000 a year gross, in spite of the expected increase in future earnings. A yield basis valuation would therefore be:

%12000,45£

= £375,000 or £1.25 per share.

A purchasing company would, however, be more concerned with earnings than with dividends if it intended to buy the entire company, and an offer price of £1.25 should be considered too low. On the other hand, since Black Raven Ltd is an unquoted company, a higher yield than 12% might be expected.

(d) A dividend yield basis of valuation, with growth

Since earnings are expected to increase by 4% a year, it could be argued that a similar growth rate in dividends would be expected. We shall assume that the required yield is 17%, rather more than the 12% for quoted companies because Black Raven Ltd is unquoted. However, in the absence of information about the expected growth of dividends in the quoted companies, the choice of 12%, 17% or whatever, is not much better than a guess.

P0 = )g_(rg)1(D0

= )04.0_17.0()04.1(000,45 = £360,000 or £1.20 per share



341 ANP413

(e) The discounted value of future cash flows

The present value of cash inflows from an investment by a purchaser of Black Raven Ltd's shares would be discounted at either 18% or 14%, depending on the view taken of Black Raven Ltd's assets. Although the loan of £400,000 is secured on some of the company's property, there are enough assets against which there is no charge to assume that a purchaser would consider the investment to be backed by tangible assets.

The present value of the benefits from the investment would be as follows.

Year Cash flow Discount factor PV of cash flow £'000 14% £'000 1 120 0.877 105.24 2 120 0.769 92.28 3 140 0.675 94.50 4 70 0.592 41.44 5 120 0.519 62.28 395.74

A valuation per share of £1.32 might therefore be made. This basis of valuation is one which a purchasing company ought to consider. It might be argued that cash flows beyond year 5 should be considered and a higher valuation could be appropriate, but a figure of less than £2 per share would be offered on a DCF valuation basis.

(f) Summary

Any of the preceding valuations might be made, but since share valuation is largely a subjective matter, many other prices might be offered. In view of the high asset values of the company an asset stripping purchaser might come forward.

4 Atlas International (a) We need to find the value of Global under the assumption that it will grow at 7%. We do not know

the cost of equity for Global so we find it implicitly for the share price.

P = g–k

EPS

Or £22 = 05.0–k

90.0£ or k =

22£90.0£

+ 0.05 = 0.09

The value of the target company is

0.07–0.09£0.90

= £43.04 per share

The value of Global's equity will therefore be

43.04 500,000 = £21,521,739

The value will increase by

21,521,739 – 11,000,000 = 10,521,739



342 ANP413

(b) The acquisition premium is

£30 – £22 = £8 per share

or £4000,000

The NPV of acquisition is

NPV = Additional Revenues – Costs of Acquisition

= 10,521,739 – 4,000,000

= 6,521,739

The acquisition should proceed

(c) Atlas needs to issue another 250,000 shares. The value of the combined company will be 70,000,000 + 21,521,739 = 91,521,739

The value of each share will be

000,250,1739,521,91

= £73.22

Cost of acquisition = 250,000 × 73.22 – 11,000,000 = 7,304,348

NPV of acquisition = 10,521,739 – 7,304,348 = 3,217,391

The acquisition should proceed

but allow the company to benefit from a fall in interest rates.

5 Curropt plc (a) The department's view that the US dollar will strengthen is in agreement with the indications of

the forward market and the futures market. Forward and futures rates show a stronger dollar than the spot rate. The forward rate is often taken as an unbiased predictor of what the spot rate will be in future. However, future events could cause large currency movements in either direction.

(b) The company needs to buy dollars in June.

Forward contract

A forward currency contract will fix the exchange rate for the date required near the end of June. If the exact date is not known, a range of dates can be specified, using an option forward contract. This will remove currency risk provided that the franchise is won. If the franchise is not won and the group has no use for US dollars, it will still have to buy the dollars at the forward rate. It will than have to sell them back for pounds at the spot rate which might result in an exchange loss.

Futures contract

A currency hedge using futures contracts will attempt to create a compensating gain on the futures market which will offset the increase in the sterling cost if the dollar strengthens. The hedge works by selling sterling futures contracts now and closing out by buying sterling futures in June at a lower dollar price if the dollar has strengthened. Like a forward contract, the exchange rate in June is effectively fixed because, if the dollar weakens, the futures hedge will produce a loss which counter-balances the cheaper sterling cost. However, because of inefficiencies in future market hedges, the exchange rate is not fixed to the same level of accuracy as a forward hedge.

A futures market hedge has the same weakness as a forward currency contract in the franchise situation. If the franchise is not won, an exchange loss may result. Lack of

flexibility

Lack of flexibility

Use sterling futures



343 ANP413

Currency option

A currency option is an ideal hedge in the franchise situation. It gives the company the right but not the obligation to sell pounds for dollars in June. It is only exercised if it is to the company's advantage, that is if the dollar has strengthened. If the dollar strengthens and the franchise is won, the exchange rate has been protected. If the dollar strengthens and the franchise is not won, a windfall gain will result by selling pounds at the exercise price and buying them more cheaply at spot with a stronger dollar.

(c) Results of using currency hedges if the franchise is won

Forward market

Using the forward market, the rate for buying dollars at the end of June is 1.4310 US$/£. The cost in sterling is 15 million/1.4310 = £10,482,180.

Futures

Set-up

1. cover needed = $15,000,000 / 1.4302 (June futures rate) = £10,488,044

2. contracts needed = £10,488,044 / £62,500 = 167.8 168 contracts

3. contracts to sell £s

Outcome

4. Actual transaction at the spot rate 1.3500 1.4500 1.5500 £15,000,000 / spot rate = £11,111,111 £10,344,828 £9,677,419 Loss on actual Gain on actual Gain on actual

5. Profit/loss on future

Workings

Tick size

0.001 62,500 = $6.25

Closing futures price Now 3 months' time Mid point of spot 1.4477 June future 1.4302 Basis 0.0175 0

So whatever the spot rate is in three months' time, this will also be the futures rate.

1.3500 1.4500 1.5500 $ $ $ Opening futures price – to sell £s 1.4302 1.4302 1.4302 Closing futures price – to buy £s 1.3500 1.4500 1.5500 Movement in ticks 802 198 1198 Futures profits /(losses) per contract 5012.5 (1237.5) (7487.5) 168 contracts 842,100 (207,900) (1,257,900)

Tick size

0.001 62,500 = $6.25

Gain without loss

Bank selling low



344 ANP413

6. Net outcome

$ $ $ Spot market payment (15,000,000) (15,000,000) (15,000,000) Futures market (profits)/losses 842,100 (207,900) (1,257,900) (14,157,900) (15,207,900) (16,257,900)

Translated at closing rate £10,487,333 £10,488,207 £10,488,968 Options – assume 1.45 because closest to the spot 1. Cover needed in £s – at option rate of 1.4500 15,000,000 / option rate = £10,344,828

2. No contracts (step 1 / 31,250) 331 3. Date/type June put

4. Premium 0.0238

x no contracts x £31,250 $246,181

at today’s spot of 1.4461 £170,238

5. Outcome

1.3500 1.4500 1.5500 $ $ $ Option market Strike price 1.4500 1.4500 1.4500 Closing price 1.3500 1.4500 1.5500 Exercise? Yes No No – – Outcome of Sell 331

contracts

Options position Pay £10,343,750

(331 31250)

Receive $14,998,437.5

Shortfall $1562.5

Net outcome

1.3500 1.4500 1.5500 $ $ $ Spot market payment (1,562.5) (15,000,000) (15,000,000) £s at spot rate (1,157) (10,344,828) (9,677,419) Option in £s (10,343,750)

£ £ £ Net in £s (10,343,750)+(1,157)=

(10,344,907) (10,344,828) (9,677,419)

Premium in £s (170,238) (170,238) (170,238) 10,515,145 10,515,066 9,847,657

Summary

The company will either choose to purchase a future or an option. Although futures are more advantageous at lower exchange rates, the net benefits of using an option if the rate is $1.5500 are much greater than the difference between futures and options at 1.3500 and 1.4500. An option would seem more suitable given the uncertain nature of the transaction.



345 ANP413

6 Shawter needs a £30m loan for two months starting in mid March FRAs 3v5 at 6.18% loan LIBOR + 0.9% 6.50%+0.9% = 7.40% FRA compensation 6.50-6.18 = 0.32% net = 7.08% or £354,000 futures set-up in Dec March at 6.21% 40 contracts evaluate spot +0.9 7.40% future Dec* 6.21% future Mar* 6.53% gain 0.32% NET 7.08% or £354,000 * basis risk mid Dec mid March spot 6.00% 6.50% Mar future 6.21% 6.53% basis -0.21% -0.03% 0.5 month left options set-up March put at 6.00% 40 contracts to sell cost = 0.255% evaluate spot + 0.9% 7.40% option 6.00% future Mar* 6.53% max 4 gain 0.53% NET 7.13% or £356,250



346 ANP413

7 Jonas Chemicals Systems

Marking scheme

Marks

(a) Prepare a paper for the next Board meeting recommending

procedures for the assessment of capital investment projects. Your paper should make proposals about the involvement of the Board at a preliminary stage and the information that should be provided to inform their decision. You should also provide an assessment of the alternative appraisal methods.

Clear definition of a two stage process for Board involvement in capital expenditure decisions Recommendation for the stage 1 appraisal procedure and metrics focusing on the role of payback and viable alternatives Stage 2 appraisal focusing on the business plan, value and accounting impact and cash recovery.

2

3

3

8

(b) Using the appraisal methods you have recommended in (a) prepare a paper outlining the case for acceptance of the project to build a distillation facility at the Gulf plant with an assessment of the company's likely value at risk. You are not required to undertake an assessment of the impact of the project upon the firm's financial accounts.

Calculation of the project VAR and assessment of its significance Estimation of the potential value impact using MIRR and the assumptions that underpin it. Estimation of the potential cash recovery using procedures recommended in (a) Quality and persuasiveness of the written report

4

3

3

2

12 20



347 ANP413

(a) Board Paper Presenting Proposal Procedures for Large Capital Expenditure Projects.

This paper proposes revised guidelines for the board approval of large capital investment projects. The current two stage process of preliminary and final approval is retained because it serves an important role in ensuring that any initial concerns of the board in terms of strategic fit and risk are brought to the attention of the Financial Appraisal Team. In addition, it helps to ensure that this team does not waste time in detailed analysis of projects that do not survive the first (preliminary) stage.

Stage 1 – preliminary approval

An outline business proposal including assessment of strategic importance, business fit and identified risks.

Outline financial appraisal to include capital requirement and modified internal rate of return to give an assessment of the project's economic return that takes into account the time value of money. This is likely to be important for investments with a long life span that are not assessed by accounting rate of return (which is currently being used).

It is recommended that conventional payback is dropped because it ignores the cost of finance and the magnitude of post payback cash flows. Duration is recommended as this measures the time required to recover approximately half of the project's weighted average present value.

Stage 2 – final approval stage

For projects that have passed the initial screening in stage 1, a detailed business plan must be presented, giving the business case with a rigorous assessment of strategic benefits and risks (including environmental analysis and possible competitor response, finalised capital spend and capital sources).

A project specific cost of capital should be estimated that reflects both the business risk and financial risk of the project under consideration. This assessment should be used to analyse the project's net present value and should be supported by a calculation of the project's value at risk (VaR). The NPV of the project represents our best estimate of the likely impact of the investment on the value of the firm and the VaR should show the downside of the project (for example, a 95% VaR would show the maximum downside with only a 5% risk of being exceeded).

NPV is the key statistic from the capital market perspective in that, unless we are assured that the project NPV is positive, the investment will reduce and not enhance the value of the firm. This net present value calculation should be supported by a modified internal rate of return which measures the additional economic return of the project over the firm's cost of capital where intermediate cash flows are reinvested at that cost of capital. In a highly competitive business the reinvestment assumption implicit in the MIRR is more realistic than that assumed with IRR where intermediate cash flows are assumed to be reinvested at the IRR. This may be satisfactory for near-the-money projects but is far less satisfactory for projects which offer high levels of value addition to the firm.

An accounting impact assessment including the differential rate of return on capital employed and a short term liquidity assessment. Although positive NPV projects are value enhancing, they may not do so in ways that are readily apparent in the financial reports. To manage investor expectations effectively the firm needs to be aware of the impact of the project on the firm's reported profitability and this is most accurately reflected by the differential rate of return measure. Accounting rate of return as normally calculated does not examine the impact of the project on the financial position of the firm but is restricted to the rate of return the investment offers on the average capital employed.

(b) The proposed business case concludes that this is a key strategic investment for the firm to maintain operating capacity at the Gulf Plant. The financial assessment is detailed in the Appendix



348 ANP413

to this report (excluding an assessment of impact of the project on the financial reports of the firm).

(i) The net present value of this project calculated using a discount rate of 8% gives a value of $1.965 million (Appendix 3). The volatility attaching to the net present value of $1.02 million (given) indicates that there is (Z) standard deviations between the expected net present value and zero as follows:

Z = 1.02

01.965 = 1.9265

This suggests that this project has a 97.3 per cent probability that it will have a positive net present value or conversely a 2.7 per cent probability of a negative net present value.

The project value at risk relies upon an assessment of the number of years that the project cash flow is at risk (10 years), the annual volatility ($1.02m) and the confidence level required by the firm. The formula for the project VaR is:

Project VaR = σ t

At the 98% level σ = 1.645 giving

Project VaR = 1.645 $1.02m 3.162 = $5.3 million

This assumes a 95% confidence level, at 99% the project VaR is $7.51 million. This value reflects the fact that the capital invested is at risk for ten years and assumes that the volatility of the project is fairly represented by the volatility of its net present value.

(ii) Project return

The internal rate of return is given as 11.0%. The modified internal Rate of Return is calculated by

Projecting forward the cash flows in the recovery stage of the project at 8% to future value of $41.7983 million. (Appendix 4)

Discounting back the investment phase cash flows to give a present value of the investment of $17.3955 million. (Appendix 1)

The Modified Internal Rate of Return is therefore:

MIRR = 10

3955.177983.41

– 1 = 0.09162 or 9.162%

This rate suggests that the margin on the cost of capital is rather small with only a 1.162% premium for the strategic and competitive advantage implied by this project

(iii) Project liquidity

With a present value of the recovery phase of $19.3607 million and of the investment phase of $17.3955 million this suggests that the project will have recovery period of:

Recovery = 2 + 19.360717.3955

8 = 9.1879 years

In practice the actual recovery is shorter than this because the expected cash in flows occur earlier rather than later during the recovery phase of the project. The above calculation effectively assumes that the recovery cash flows arise evenly through the recovery period. The actual discounted payback period is just over 6 years. (Appendix 5)

The project duration of 4.461 years (Appendix 2) reveals that the project is more highly cash generative in the early years notwithstanding the two year investment phase.

In summary, the analysis confirms that this project is financially viable as it will be value adding to the firm. There is, however, substantial value at risk given the volatility of the net



349 ANP413

present value quoted. In terms of return, the premium over the firm's hurdle is small at 1.162% and any significant deterioration in the firms cost of capital would be damaging to the value of this project. The liquidity statistics reveal that the bulk of the project's cash returns are promised in the earlier part of the recovery phase and that value invested in the project should be recovered by year six. Taking this into account acceptance is recommended to the board.

Appendix Note: All calculations have used the discount factor tables. If formulae are used unrounded on a calculator slightly different figures would arise.

1 PV of investment/base Time Cash flow DF PV $m $m 0 (9.50) 1.000 (9.5000) 1 (5.75) 0.926 (5.3245) 2 (3.00) 0.857 (2.5710) (17.3955)

2 PV and duration of recovery phase

The recovery phase duration is calculated by multiplying the present value of the cash recovered in each year by the relevant time from project commencement. The sum of the weighted years gives the recovery phase duration.

Time Cash flow DF PV @ tPV t $m 8% 3 4.50 0.794 3.5730 10.7190 4 6.40 0.735 4.7040 18.8160 5 7.25 0.681 4.9372 24.6860 6 6.50 0.630 4.0950 24.5700 7 5.50 0.583 3.2065 22.4455 8 4.00 0.540 2.1600 17.2800 9 (2.00) 0.500 (1.0000) (9.0000) 10 (5.00) 0.463 (2.3150) (23.1500) 27.15 19.3607 86.3725

Project duration = phase recovery of valuePresent

phase recovery of valuepresent weighted time of Sum =

19.360786.3725

= 4.461 years

3 PV of project

$m PV investment phase (17.3955) PV recovery phase 19.3607 1.9652

4 TV if recovery phase cash flow

PV (1+r)n = TV 19.3607 1.0810 = 41.7983



350 ANP413

5 Discounted payback period

Time PV ($m) Cumulative PV ($m) 0 (9.5000) (9.5000) 1 (5.3245) (14.8245) 2 (2.5710) (17.3955) 3 3.5730 (13.8225) 4 4.7040 (9.1185) 5 4.9372 (4.1813) 6 4.0950 (0.0863) 7 3.2065 3.1202 8 2.1600 5.2802 9 (1.0000) 4.2802

10 (2.3150) 1.9652

8 Fly 4000

Marking scheme

Marks

(a) Calculation of the asset beta for Rover Airways 2 Regear asset beta for FliHi 1 Calculate FliHi's cost of equity 2 Notes on the assumptions relating to the CAPM 2 Notes on the assumptions of more practical significance 2 (b) Calculation of the retention ratio 2 Estimation of the growth for the next six years (justifying the return on equity

chosen

2 Assumptions embedded within the growth calculation and Gordon's

approximation

2 (c) Calculation and projection of the free cash flow to equity with explanations

2 Discount these values at the rate of return to equity 2 Calculation of the present value of the perpetuity with explanations 2 Calculation of the present value of the firm's equity 1 (d) Discussion of synergies and their capture 2 Examination of the risk exposure and the potential real options 3 Review of the financing options 2 Summary of valuation and recommendations for the next steps 1



351 ANP413

(a) FliHi cost of equity

Since all three companies (Fly 4000, FliHi, Rover Airways) operate in the same sector it is reasonable to presume that they will all have the same asset beta.

Based on the information for Rover Airways we have

e = 2.0

D:E = 1.5:1.0 So using

a = e

e

e d

V

V + V (1- T) + d

d

e d

V (1 T)

V V (1 T)

and assuming zero systematic risk to the debt (d = 0), we have

a = 2.0

).(. 301511

1= 2

0521.

= 0.9756

To obtain the equity beta (e) for FliHi we now need to re-gear based on the market values of FliHi's equity and debt. Since this information is not available we will use the book values as a proxy.

So using a rearrangement of the above formula to solve for e

e = ae d

e

V V (1- T)V

– d

d

e

V (1- T)

V

and assuming again that d = 0, we have for FliHi

e = 0.9756

120301150120 ).(

= 0.9756 120225

= 1.82925

Now, applying CAPM gives

re = rf + (rm – rf) = 4.5 + 1.82925 (3.5) = 10.90%

Assumptions made in this calculation are:

That we can use book values of equity and debt as proxies for market values, this may be a reasonable assumption in a capital intensive business such as an airline, but certainly not in a service business where much of the value is in intangibles.

All of the assumptions inherent in the theories of Modigliani and Miller whose gearing formulae we have applied, ie

– Investors are rational and risk averse

– Capital markets are perfect

– Investors and companies can freely borrow at the same risk-free rate, hence individuals are indifferent between personal and corporate borrowings.

All of the assumptions inherent in CAPM

– Investors are rational and risk-averse

– Investors are diversified

– Capital markets are perfect, efficient and in equilibrium

– All investors have the same expectations regarding the probability distribution of returns from each security

– All investors can freely invest or borrow at the same risk-free rate

Specific assumption noted in the question that debt is not sensitive to market risk, ie d = 0.



352 ANP413

– That since all three companies operate in the same sector they will have the same asset beta, unless their operations are exactly the same this is unlikely to be true. Since it is a smaller company and will, therefore, be less internally diversified and at greater risk of default, perhaps a premium should be applied to its cost of capital through such variants of CAPM as the Fama and French 3 factor model.

(b) FliHi growth rate

We can estimate the growth rate (g) using

g = rb

Where

r = real return (after tax) on reinvested income/cash flows

b = proportion of profits/free cash retained and reinvested

Free cash flow to equity before reinvestment 20X5 20X4 $m $m Operating cash flow 210.0 95.0 Net interest 1.5 (1.0) Tax (4.1) (0.2) FCFE (pre reinvestment) 207.4 93.8

Reinvestment 120.2 75.0 FCFE (part reinvestment) 87.2 18.8

b 0.58 0.80

These figures are clearly inconsistent and so we will use the most recent figures as indicative of the future, ie b = 0.58.

The rate of return on reinvested FCFE is harder to establish but, for a business in a competitive market where its shares are fairly valued, this should correspond to the return on equity (re) of 10.90%, giving

g = rb = 0.58 10.9% = 6.322%

Clearly this is substantially lower than the growth rate from 20X4 to 20X5 based on the FCFE calculated earlier, though this exceptional growth could be a function of higher reinvestments in earlier years that we are not assuming will continue into the future. Such growth appears unlikely to be sustainable in a highly competitive environment.

In conclusion, we expect future growth rates of: Years Growth Comment

1-5 6.322% Calculated above 6 onwards 4.000% Assumption stated in question

The assumptions made here are as follows.

Gordon's growth model can be validly applied based on the FCFE.

That it is valid to use re as a proxy for r in a competitive business whose shares are fairly valued.

That the shares of FliHi are fairly valued.

That it is correct to use the reinvestment figure of 0.58 from 20X5 as representative of the future.

That the FCFE for 20X5 are, indeed, typical, and likely to be repeated (subject to growth) in future years.

That growth will be 4% from year 6.



353 ANP413

(c) Value of FliHi

Applying DVM ideas based on the 20X5 FCFE post reinvestment of $87.2m, which represents a surrogate for the dividend that could be paid, we have the following:

Time Cash flow DF PV $

1 d1 = 87.2 1.06322 = 92.71 10911

. 83.60

2 d2 = 87.2 1.063222 = 98.57 21.1091

80.16

3 d3 = 87.2 1.063223 = 104.81 31.1091

76.84

4 d4 = 87.2 1.063224 = 111.43 41.1091

73.67

5 d5 = 87.2 1.063225 = 118.48 51.1091

70.63

5 E5 = = 1,785.73 51.1091

1,064.53

1,449.43

Where E5 is the share price at time 5 which can be calculated from the constant growth formulation of DCF as

E5 = 5

6

e

d 87.2 1.06322 1.04 123.22r g 0.1090 0.04 0.0690

= 1,785.73

The assumptions made here are:

The FCFE post reinvestment is a valued surrogate for the dividend payable.

The growth pattern of dividends is correct and the FCFE is sustainable.

The company is a going concern and will trade indefinitely into the future (the constant dividend growth model is a perpetuity).

The required return of 10.9% will remain constant into perpetuity.

The limitations of our method hinge on the reality of the assumptions made. For example the 10.9% required was based (via CAPM) on a 4.5% risk-free rate and a 3.5% premium. It is most likely that these figures will vary as, say, the central bank charges interest rates in response to inflationary pressures. An interest rate of 4.5% is very low and may be expected to rise. Is a growth rate of 40% sustainable indefinitely into the future?



354 ANP413

(d) To: Whom it may concern From: Chief financial officer Date: December 20X5

Subject: Proposed acquisition of FliHi

Having completed the divestment of various associated interests and joint ventures, we now have cash reserves of $860m. One of the alternative proposals for these funds is to partially finance the acquisition of FliHi, though the total cost of that acquisition may be of the order of $1,450m and hence require a further $590m finance. The factors I believe we should consider here, each of which I discuss below are:

Strategic objectives Risk exposure Other factors Operating synergies Valuation Financial synergies Financing

Strategic objectives

A takeover should only be considered if it helps satisfy some strategic objectives of the business. Fly 4000's principal markets are in Europe and the Middle East from a Northern European hub. FliHi uses the same hub but has developed a strong transatlantic business as well as a substantial business in long-haul and medium-haul markets. As such, the business of FliHi is a good strategic fit with that of Fly 4000, allowing us to diversity into new markets.

In addition, FliHi is currently generating superior growth which helps to satisfy our strategic objective of achieving long-term growth in shareholder wealth.

Finally, from a strategic objective, the acquisition would provide defensive qualities since, as a larger more diversified operation, we would be able to compete more efficiently and effectively through offering a broader service range.

Operating synergies

Operating synergies that are likely to arise from a takeover would include:

Revenue gains from being able to offer a broader range of flights, which is likely to enhance market share beyond that of the simple sum of the two entities.

Cost savings and efficiency gains through the removal of any duplication (currently competition) between Fly 4000 and FliHi, resulting in planes operating with higher capacity loads.

Revenue gains from the re-deployment of any planes released through this process.

Cost savings from merging maintenance operations in our Northern European hub.

Economies of scale with respect to fuel purchasing, in-flight catering, maintenance and ticketing operations.

Financial synergies

As a larger entity operating in a greater number of markets we are liable to be able to increase our borrowing capacity offering the opportunity for further expansion. In addition to this there may be tax benefits arising from how and when FliHi operates and the group structure it has.

Risk exposure

There is no reason why the market risk of our operations should be altered by this merger since both businesses operate in broadly the same sector.

We would need to recognise, however, that by increasing our geographical coverage we increase our exposure to overseas markets and exchange rates. There are obviously some diversification benefits to be gained from this, though we must also consider the associated risks, most particularly political risk, economic risk, exchange rate exposure (transaction risk, translation risk) as well as the increased risks of terrorism and the costs of anti-terrorist requirements especially on transatlantic markets.



355 ANP413

Valuations

Our initial valuation of $1,450m for FliHi is a pessimistic figure based on our far from in-depth knowledge of the business based on FliHi's published accounts. This value has been established using discounted cash flow techniques.

Using a simple earnings based valuation gives a figure of $550m ($50m × 11.00) when applying the PE ratio of Power Airways to the earnings of FliHi. This is, however, very simplistic since the PE of 11.0 reflects the growth, management, prospects etc of Power, not FliHi which has achieved very strong recent growth.

As a result, a value in this range ($550m – $1,450m) would probably be achievable, but this is a very broad range and would be difficult to narrow without further information.

Financing

Clearly if we are at the lower end of this price range then we will need no additional finance to achieve this acquisition. If, however, we are at the higher end of this range then additional finance would be needed.

Consideration should be given to the practicability of raising new debt finance in the current economic circumstances for airlines, especially since many of our assets and many of those being acquired are subject to operating losses and cannot be offered as security for any debt.

On balance a combined cash plus shares offer would probably be advisable for this acquisition.

Other factors

What is FliHi's reputation in its markets of operation?

FliHi has recently expanded its fleet with the modern Airbus 380 super-Jumbo, which is ideal for its long-haul and transatlantic markets, with the result that little new investment is likely to be needed in aircraft.

Are there any unique features to FliHi's offering such as limo's to and from the airport? We would need to assess the business case for any such items.

Is FliHi dependent on a few key entrepreneurial individuals, and if so do we need to take any action to maintain their services?

What is the age and experience of their flight crews and their industrial relations record?

9 Sigra (a) Number of Sigra Co shares = 4,400,000/0·4 = 11,000,000 shares

Sigra Co earnings per share (EPS) = $4,950,000/11,000,000 shares = 45c/share Sigra Co price to earnings (PE) ratio = $3·6/$0·45 = 8 Dentro PE ratio = 8 1·125 = 9 Dentro Co shares = $500,000/0·4 = 1,250,000 shares Dentro Co EPS = $625,000/1,250,000 = 50c/share Estimate of Dentro Co value per share = $0·5 9 = $4·50/share

Cash offer

Dentro share percentage gain under cash offer $0·50/$4·50 100% = 11·1%



356 ANP413

Share-for-share exchange

Equity value of Sigra Co = 11,000,000 $3·60 = $39,600,000 Equity value of Dentro Co = 1,250,000 $4·50 = $5,625,000 Synergy savings = 30% $5,625,000 = $1,688,000

Total equity value of combined company $46,913,000

Number of shares for share-for-share exchange 11,000,000 + [1,250,000 3/2] = 12,875,000

Expected share price of combined company $3·644/share

Dentro share percentage gain under share-for-share offer [($3·644 3 – $4·50 2)/2]/$4·50 100% = 21·5%

Bond offer

Rate of return

$104 = $6 (1 + r)–1 + $6 (1 + r)–2 + $106 (1 + r)–3

If r is 5%, price is $102·72 If r is 4%, price is $105·55

r is approximately = 4% + (105·55 – 104)/(105·55 – 102·72) 1% = 4·55%

Price of new bond = $2 1·0455 – 1 + $2 1·0455 – 2 + $102 1·0455–3 = $93·00

Value per share = $93·00/16 = $5·81/share

Dentro share percentage gain under bond offer Bond offer: ($5·81 – $4·50)/$4·50 100% = 29·1%

Comments

An initial comparison is made between the cash and the share-for-share offers. Although the share-for-share exchange gives a higher return compared to the cash offer, Dentro Co’s shareholders may prefer the cash offer as the gains in the share price are dependent on the synergy gains being achieved. However, purchase for cash may mean that the shareholders face an immediate tax burden. Sigra Co’s shareholders would probably prefer the cash option because the premium would only take $625,000 of the synergy benefits ($0·50 1,250,000 shares), whereas a share-for-share exchange would result in approximately $1,209,000 of the synergy benefits being given to the Dentro Co shareholders (21·5% $4·50 1,250,000 shares).

The bond offer provides an alternative which may be acceptable to both sets of shareholders. Dentro Co’s shareholders receive the highest return for this and Sigra Co’s shareholders may be pleased that a large proportion of the payment is deferred for three years. In present value terms, however, a very high proportion of the projected synergy benefits are given to Dentro Co’s shareholders (29·1% $4·50 $1,250,000 = $1,637,000).

(b) The regulatory framework within the European Union, the EU takeovers directive, will be used to discuss the proposals. However it is acceptable for candidates to refer to other directives and discuss the proposals on that basis.

Proposal 1

With regards to the first proposal, the directive gives the bidder squeeze-out rights, where the bidder can force minority shareholders to sell their shares. However, the limits set for squeeze-out rights are generally high (UK: 90%; Belgium, France, Germany and the Netherlands: 95%; Ireland 80%). It is likely therefore that Sigra Co will need a very large proportion of Dentro Co’s shareholders to agree to the acquisition before they can force the rest of Dentro Co’s shareholders to sell their shares. Dentro Co’s minority shareholders may also require Sigra Co to purchase their shares, known as sell-out rights.



357 ANP413

Proposal 2

With regards to the second proposal, the principle of equal treatment in the directive requires that all shareholders should be treated equally. In general terms, the bidder must offer to minority shareholders the same terms as those offered to other shareholders. It could be argued here that the principle of equal treatment is contravened because later shareholders are not offered the extra 3 cents per share, even though the 30% is less than a majority shareholding. It is highly unlikely that Sigra Co will be allowed to offer these terms.

10 Lignum Report to the Treasury Division, Lignum Co

Discussion and recommendations for managing the foreign exchange exposure

The report discusses and makes recommendations on how the treasury division may manage the foreign exchange exposure it faces under three unrelated circumstances or cases.

The appendices to the report show the detailed calculations to support the discussion around case one (see appendix I) and around case two (see appendix II).

Foreign exchange exposures

With case one, Lignum Co faces a possible exposure due to the receipt it is expecting in four months in a foreign currency, and the possibility that the exchange rates may move against it between now and in four months time. This is known as transactions exposure. With case two, the exposure is in the form of translation exposure, where a subsidiary’s assets are being translated from the subsidiary’s local currency into Euro. The local currency is facing an imminent depreciation of 20%. Finally in the third case, the present value of future sales of a locally produced and sold good is being eroded because of overseas products being sold for a relatively cheaper price. The case seems to indicate that because the US$ has depreciated against the Euro, it is possible to sell the goods at the same dollar price but at a lower Euro price. This is known as economic exposure.

Hedging strategies

Case one

Transactions exposure, as faced by Lignum Co in situation one, lasts for a short while and is easier to manage by means of derivative products or more conventional means. Here Lignum Co has access to two derivative products: an OTC forward rate and OTC option. Using the forward rate gives a higher return of €963,988, compared to options where the return is €936,715 (see appendix I). However, with the forward rate, Lignum Co is locked into a fixed rate (ZP145·23 per €1) whether the foreign exchange rates move in its favour or against it. With the options, the company has a choice and if the rate moves in its favour, that is if the Zupeso appreciates against the Euro, then the option can be allowed to lapse. Lignum Co needs to decide whether it is happy receiving €963,988, no matter what happens to the exchange rate over the four months or whether it is happy to receive at least €936,715 if the ZP weakens against the €, but with a possibility of higher gains if the Zupeso strengthens.

Lignum Co should also explore alternative strategies to derivative hedging. For example, money markets, leading and lagging, and maintaining a Zupeso account may be possibilities. If information on the investment rate in Zupesos could be obtained, then a money market hedge could be considered. Maintaining a Zupeso account may enable Lignum Co to offset any natural hedges and only convert currency periodically to minimise transaction costs.

Case two

Hedging translation risk may not be necessary if the stock market in which Lignum Co’s shares are traded is efficient. Translation of currency is an accounting entry where subsidiary accounts are incorporated into the group accounts. No physical cash flows in or out of the company. In such cases, spending money to hedge such risk means that the group loses money overall, reducing the cash flows attributable to shareholders. However, translation losses may be viewed negatively by the equity holders and may



358 ANP413

impact some analytical trends and ratios negatively. In these circumstances, Lignum Co may decide to hedge the risk.

The most efficient way to hedge translation exposure is to match the assets and liabilities. In Namel Co’s case the assets are more exposed to the Maram Ringit compared to the liabilities, hence the weakening of the Maram Ringit from MR35 per €1 to MR42 per €1 would make the assets lose more (accounting) value than the liabilities by €1,018,000 (see appendix II). If the exposure for the assets and liabilities were matched more closely, for example by converting non-current liabilities from loans in Euro to loans in MR, translation exposure would be reduced.

Case three

Economic exposure, which is not part of transactions exposure, is long-term in nature and therefore more difficult to manage. There are for example, few derivatives which are offered over a long period, with the possible exception of swaps. A further issue is that economic exposure may cause a substantial negative impact to a company’s cash flows and value over the long period of time. In this situation, if the US$ continues to remain weak against the Euro, then Lignum Co will find it difficult to maintain a sustained advantage against its American competitor. A strategic, long-term viewpoint needs to be undertaken to manage risk of this nature, such as locating production in countries with favourable exchange rates and cheaper raw material and labour inputs or setting up a subsidiary company in the USA to create a natural hedge for the majority of the US$ cash flows.

In conclusion, the report examined, discussed and made recommendations on managing foreign exchange exposure in each of the three cases.

Report compiled by:

Date:

APPENDICES

Appendix I: Financial impact of derivative products offered by Medes Bank (case one)

Using forward rate Forward rate = 142 (1 + (0·085 + 0·0025)/3)/(1 + (0·022 – 0·0030)/3) = 145·23 Income in Euro fixed at ZP145·23 = ZP140,000,000/145·23 = €963,988

Using OTC options Purchase call options to cover for the ZP rate depreciating Gross income from option = ZP140,000,000/142 = €985,915

Cost

€985,915 ZP7 = ZP6,901,405 In € = ZP6,901,405/142 = €48,601 €48,601 (1 + 0·037/3) = €49,200 (Use borrowing rate on the assumption that extra funds to pay costs need to borrowed initially; investing rate can be used if that is the stated preference)

Net income = €985,915 – €49,200 = €936,715



359 ANP413

Appendix II: Financial impact of the devaluation of the Maram Ringit (case two)

MR devalued rate = MR35 1·20 = MR42 per €1

€ ’000 at € ’000 at current rate devalued rate MR ’000 Exposed? MR35 per €1 MR42 per €1

Non-current assets 179,574 Yes 5,131 4,276 Current assets 146,622 60% 2,514 2,095 Non-current liabilities (132,237) 20% (756) (630) Current liabilities (91,171) 30% (781) (651) Share capital and reserves 102,788 6,108 5,090

Translation loss = €6,108,000 – €5,090,000 = €1,018,000

11 Coeden (a) Before implementing the proposal

Cost of equity = 4% + 1·1 6% = 10·6% Cost of debt = 4% + 0·9% = 4·9%

Market value of debt (MVd):

Per $100: $5·2 1·049–1 + $5·2 1·049–2 + $105·2 1·049–3 = $100·82 Total value = $42,000,000 $100·82/$100 = $42,344,400

Market value of equity (MVe):

As share price is not given, use the free cash flow growth model to estimate this. The question states that the free cash flow to equity model provides a reasonable estimate of the current market value of the company.

Assumption 1: Estimate growth rate using the rb model. The assumption here is that free cash flows to equity which are retained will be invested to yield at least at the rate of return required by the company’s shareholders. This is the estimate of how much the free cash flows to equity will grow by each year.

r = 10·6% and b = 0·4, therefore g is estimated at 10·6% 0·4 = 4·24%

MVe = 2,600 1·0424/(0·106 – 0·0424) approximately = $42,614,000

The proportion of MVe to MVd is approximately 50:50

Therefore, cost of capital: 10·6% 0·5 + 4·9% 0·5 0·8 = 7·3%

After implementing the proposal

Coeden Co, asset beta estimate 1·1 0·5/(0·5 + 0·5 0·8) = 0·61

Asset beta, hotel services only

Assumption 2: The question does not provide an asset beta for hotel services only, which is the approximate measure of Coeden Co’s business risk once the properties are sold. Assume that Coeden Co’s asset beta is a weighted average of the property companies’ average beta and hotel services beta.

Asset beta of hotel services only: 0·61 = Asset beta (hotel services) 60% + 0·4 40% Asset beta (hotel services only) approximately = 0·75



360 ANP413

Coeden Co, hotel services only, estimate of equity beta:

MVe = $42,614,000 (Based on the assumption stated in the question)

MVd = Per $100: $5·2 1·046 – 1 + $5·2 1·046–2 + $105·2 1·046–3 = $101·65 Total value = $12,600,000 $101·65/$100 = $12,807,900 say $12,808,000

0·75 = equity beta 42,614/(42,614 + 12,808 0·8)

0·75 = equity beta 0·806

Equity beta = 0·93

Coeden Co, hotel services only, weighted average cost of capital

Cost of equity = 4% + 0·93 6% = 9·6%

Cost of capital = 9·6% 0·769 + 4·6% 0·231 0·8 = 8·2%

Comment: Before proposal After proposal implementation implementation Cost of equity 10.6% 9.6% WACC 7.3% 8.2%

Implementing the proposal would increase the asset beta of Coeden Co because the hotel services industry on its own has a higher business risk than a business which owns its own hotels as well. However, the equity beta and cost of equity both decrease because of the fall in the level of debt and the consequent reduction in the company’s financial risk. The company’s cost of capital increases because the lower debt level reduces the extent to which the weighted average cost of capital can be reduced due to the lower cost of debt. Hence the board of directors is not correct in assuming that the lower level of debt will reduce the company’s cost of capital.

(b) It is unlikely that the market value of equity would remain unchanged because of the change in the growth rate of free cash flows and sales revenue, and the change in the risk situation due to the changes in the business and financial risks of the new business.

In estimating the asset beta of Coeden Co as offering hotel services only, no account is taken of the changes in business risk due to renting rather than owning the hotels. A revised asset beta may need to be estimated due to changes in the business risk.

The market value of equity is used to estimate the equity beta and the cost of equity of the business after the implementation of the proposal. But the market value of equity is dependent on the cost of equity, which is, in turn, dependent on the equity beta. Therefore, neither the cost of equity nor the market value of equity is independent of each other and they both will change as a result of the change in business strategy.

(c) Demerger

A demerger would involve the company splitting into two (or more) parts, with each part becoming a separate, independent company. The shareholders would then hold shares in each separate, independent company. Each company would most probably have its own separate management team. On the other hand, selling the hotel properties outright would be termed as a divestment, where a company would sell part of its assets.

Benefits

There are a number of possible benefits in pursuing a demerger option for Coeden Co and its shareholders. The management teams would be able to focus on creating value for each company separately, and create a unique financial structure that is suitable for each company. The full value of each company would become apparent as a result. Coeden Co’s shareholders may have invested in the company specifically for its risk profile and selling the properties may imbalance their portfolios. With a demerger, the portfolio diversification remains unchanged. Communication may be stronger between the



361 ANP413

two management teams with a demerger. Since Coeden Co trades heavily on its brand name, the quality and maintenance of the hotel properties is critical, and good communication links will help ensure that these are safeguarded. However, responsibility for maintenance of the properties will need to be negotiated. Selling a lot of properties all at once may flood the market and lower the value that can be obtained for each hotel property.

Drawbacks

A number of possible drawbacks for Coeden Co and its shareholders may occur if it pursues the option to demerge. The demerger may be an expensive process to undertake and may result in a decline in the value of the companies overall. The bond holders may not agree to 70% of the long-term loans to be transferred to a property company and may ask for the terms of the loans to be re-negotiated. The new property company would need to raise the extra finance to pay the cash for the remaining property values. Coeden Co may not have the expertise amongst its management staff to manage a property company or to recruit an appropriate management team. Overall, the main drawbacks revolve around the additional costs that would probably need to be incurred if the demerger option is pursued.

[Note: Credit will be given for alternative, valid points]



362 ANP413

END OF ANSWER BANK


363 ANP413

Appendix A: Mathematical tables

and formulae


22: APPENDIX A: MATHEMATICAL TABLES AND FORMULAE

364 ANP413



365 ANP413



366 ANP413

Formulae sheet

Present value table Present value of 1 ie (1+r)–n where r = discount rate, n = number of periods

Discount rates (r)

Periods

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065



367 ANP413

Annuity Table

Present value of an annuity ie r

nr)1(1 where r = discount rate, n = no. of periods

Interest rates (r)

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675



368 ANP413

Standard normal distribution table

)(xZ 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09

0.0 .0000 .0040 .0080 .0120 .0160 .0199 .0239 .0279 .0319 .0359 0.1 .0398 .0438 .0478 .0517 .0557 .0596 .0636 .0675 .0714 .0753 0.2 .0793 .0832 .0871 .0910 .0948 .0987 .1026 .1064 .1103 .1141 0.3 .1179 .1217 .1255 .1293 .1331 .1368 .1406 .1443 .1480 .1517 0.4 .1554 .1591 .1628 .1664 .1700 .1736 .1772 .1808 .1844 .1879 0.5 .1915 .1950 .1985 .2019 .2054 .2088 .2123 .2157 .2190 .2224 0.6 .2257 .2291 .2324 .2357 .2389 .2422 .2454 .2486 .2517 .2549 0.7 .2580 .2611 .2642 .2673 .2704 .2734 .2764 .2794 .2823 .2852 0.8 .2881 .2910 .2939 .2967 .2995 .3023 .3051 .3078 .3106 .3133 0.9 .3159 .3186 .3212 .3238 .3264 .3289 .3315 .3340 .3365 .3389 1.0 .3413 .3438 .3461 .3485 .3508 .3531 .3554 .3577 .3599 .3621 1.1 .3643 .3665 .3686 .3708 .3729 .3749 .3770 .3790 .3810 .3830 1.2 .3849 .3869 .3888 .3907 .3925 .3944 .3962 .3980 .3997 .4015 1.3 .4032 .4049 .4066 .4082 .4099 .4115 .4131 .4147 .4162 .4177 1.4 .4192 .4207 .4222 .4236 .4251 .4265 .4279 .4292 .4306 .4319 1.5 .4332 .4345 .4357 .4370 .4382 .4394 .4406 .4418 .4429 .4441 1.6 .4452 .4463 .4474 .4484 .4495 .4505 .4515 .4525 .4535 .4545 1.7 .4554 .4564 .4573 .4582 .4591 .4599 .4608 .4616 .4625 .4633 1.8 .4641 .4649 .4656 .4664 .4671 .4678 .4686 .4693 .4699 .4706 1.9 .4713 .4719 .4726 .4732 .4738 .4744 .4750 .4756 .4761 .4767 2.0 .4772 .4778 .4783 .4788 .4793 .4798 .4803 .4808 .4812 .4817 2.1 .4821 .4826 .4830 .4834 .4838 .4842 .4846 .4850 .4854 .4857 2.2 .4861 .4864 .4868 .4871 .4875 .4878 .4881 .4884 .4887 .4890 2.3 .4893 .4896 .4898 .4901 .4904 .4906 .4909 .4911 .4913 .4916 2.4 .4918 .4920 .4922 .4925 .4927 .4929 .4931 .4932 .4934 .4936 2.5 .4938 .4940 .4941 .4943 .4945 .4946 .4948 .4949 .4951 .4952 2.6 .4953 .4955 .4956 .4957 .4959 .4960 .4961 .4962 .4963 .4964 2.7 .4965 .4966 .4967 .4968 .4969 .4970 .4971 .4972 .4973 .4974 2.8 .4974 .4975 .4976 .4977 .4977 .4978 .4979 .4979 .4980 .4981 2.9 .4981 .4982 .4982 .4983 .4984 .4984 .4985 .4985 .4986 .4986 3.0 .4987 .4987 .4987 .4988 .4988 .4989 .4989 .4989 .4990 .4990

This table can be used to calculate N(d1), the cumulative normal distribution functions needed for the Black-Scholes model of option pricing. If d1>0, add 0.5 to the relevant number above. If d1<0, subtract the relevant number above from 0.5.

END OF APPENDIX B

BPP House, Aldine Place, London W12 8AA

Tel: 0845 0751 100 (for orders within the UK) Tel: +44 (0)20 8740 2211 Fax: +44 (0)20 8740 1184

www.bpp.com/learningmedia


p4 course note bpp

Documents