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www.globalapc.com ACCA P4 AFM

ACCA P4 Advanced Financial Management

Tuition Study Note

For exams in June 2015

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© Lesco Group Limited, April 2016

All rights reserved. No part of this publication may be reproduced,

stored in a retrieval system, or transmitted, in any form or by any

means, electronic, mechanical, photocopying, recording or otherwise,

without the prior written permission of Lesco Group Limited.

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Content

Chapter1 Financial Crisis & Corporate Governance .................................. 4

Sessoin1: Why financial crisis .............................................................. 4

Session2 Corporate governance ............................................................ 6

Chapter 2 Accounting Equation: Assets=liability +Equity ..................... 9

Session1 Assets ................................................................................... 10

Session1.1 Domestic investment appraisal ................................ 10

Session1.2 International investment appraisal .......................... 63

Session1.3 Business Valuation ................................................... 70

Session1.4 Risk Management .................................................. 109

Session2 Liability + Equity .............................................................. 180

Session2.1 Financing decision .................................................... 181

Session 2.2 Dividend Policy Decision ........................................ 203

Chapter 3 How to grow and save your business? ................................... 205

Session3.1 International Trade.................................................... 206

Session3.3 Business Reorganization and Reconstruction .......... 213

Chapter4 Other current issues ................................................................. 223

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Chapter1 Financial Crisis & Corporate Governance

Sessoin1: Why financial crisis

In order to boost the economy, in 2007 government in USA slashed interest rate

to make borrowing cheaper and of course another effect of this is that when

deposit money into the bank investors would get lower return because of the

low interest rate.

As a result of this investors looked for other investment opportunities and

focused on Prime mortgage market. What this means is that people want to

borrow money from bank to buy a house and then bank lends them money to

purchase it. Then bank sells the right to receive future cash inflow, ie, interest to

some investors by creating collateralized debt obligation(CDO) and dividing

CDOs into different categories and requires credit rating agency like Standard

&Poor’s to rate the mortgage like AAA, BB etc.

Then this can be sold to different investors with different needs, eg, pension

funds like safe investment so would like to buy higher credit rating mortgage.

Hedge funds like investment with higher return so would like to buy a slightly

low credit rating mortgage.

To make the top tranches safer banks would buy insurance on these mortgages

called “credit default SWAP” and hence insurance companies like AIG which gets

future money from investors gets very wealthy.

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This went well and investors loved to do so because they thought they were risk

free, ie, if home owners default on payment investors would not suffer a loss

because they believed that house prices would increase all the time and

investors would get their homes even though home owners default on

payments.

As more and more people in the Prime market (wealthy people) have borrowed

money to buy a house, Bank still got lots of money into the system(because of

the low interest rate so they can borrow from US federal reserve at a very low

cost) and there were not too many mortgages available any more whilst the

demand by investors regarding mortgages are very high so they decide to turn

to Subprime market(low income people).

Same process continues as the above one and eventually there were more and

more home owners defaulted on payment and bank gets the house then supply

is greater than demand hence prices for houses dropped down significantly.

Insurance company needed to pay large amount of credit default SWAP and

they don't have enough money to do so and so many of them collapsed like AIG.

As CDOs are worth less and more risky so many investors like pension funds

wouldn't buy them any more so many of investment banks like Lehman Brothers

and American banks have gone bankruptcy.

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Session2 Corporate governance

In the p4 exam it’s highly unlikely your examiner will test you about the detail

rules regarding corporate governance.

You should know:

Best practices(UK CG code)

International corporate governance issues

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Session2.1 Best practices

There should be separation of executive directors and non-executive

directors to the board and they should be balanced.

There should be separation between chairman and CEO.

Executive directors include like CEO, CFO and other managers who are

involved in day to day operation of business, ie, they should go to work on

time daily.

Non-executive directors are not involved in the day to day running of the

business. They are here to oversee the performance of executive directors.

They are allocated to different sensible areas within company to form into

committees like, remuneration committee; nomination committee; audit

and risk committee.

The reason why they are called sensible areas is because EDs in these areas

are not independent to do the job, ie, they would like to pay them more even

though company is in trouble. They would like to employ someone who will

not challenge them during the work.

Of course their roles would be:

People role: Employ right EDs to the board

Risk role: Ensure risks are properly identified and addressed

Strategy role: Challenge strategy made by EDs to make sure it doesn't do

harm to co.

Scrutiny role: Oversee performance of EDs

The idea behind NEDs is they should be independent, ie, they are outsiders

of company and you can think about them to be consultant to company. So

when employing NEDs to company of course they shouldn't be close family

relationship members with EDs and they shouldn't have major business

transactions with company etc.

Talking about sensible areas such as remuneration committee they need to

ensure the remuneration package is performance related and fair.

Audit committee should ensure internal and external auditors are doing their

work properly, ie, they should be independent and competent.

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Nomination committee should ensure directors in the board are competent

and have different skills, ie, being diversified.

International corporate governance issues

In this exam you need to know briefly about different countries corporate

governance structure and its implication to managers within company as well.

Germany companies often have 2 tier board system including supervisory

board and management board. In the supervisory board there would be lots of

representatives from the company like employees, major shareholders, banks

etc. So when manager’s work in Germany companies they need to makes sure

any decisions must be communicated to supervisory board and agreed by them

before implementation.

Japanese companies mainly have 3 boards:

Policy boards deal with long term strategy.

Functional boards deal with day to day running of business.

Symbolic boards only have symbolic function.

And companies in Japanese would focus on collaboration so mangers in Japan

should seek to establish long-term consensual business relationships with

banks, suppliers and customers. In many companies they will focused primarily

on long-term objectives such as market share rather than short-term profit

maximization.

USA companies are following Sarbanes Oxley Act so mangers working in USA

companies should ensure they follow the rules otherwise it will have to pay a

large amount of penalties.

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Chapter 2 Accounting Equation:

Assets=liability +Equity

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Session1 Assets

Session1.1 Domestic investment appraisal

The idea behind this is to use techniques to evaluate whether the investment

proposal is worthwhile.

Techniques would be classified between:

Non-discounting techniques Discounting techniques

Payback period Net present value(NPV)

Other decisions

Asset replacement

Capital rationing

Lease or buy decision

Free cash flow

Risks &Uncertainty

Sensitivity analysis

Monte Carlo simulation

Value at risk

Option pricing model

Real option

Black-Scholes

option pricing

model

Accounting rate of return(ARR/ROCE/ROI) Adjusted present value

Internal rate of return(IRR)

Discounted payback period

Duration/ Macaulay Duration method

Modified internal rate of return(MIRR)

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Payback period

It means how long that company can recover its initial investment.

Decision criteria: if it’s less than target payback period then project would be

accepted.

GOGO Ltd

1, GOGO Ltd spent $1,000 to purchase a machine A and expects to generate

into future cash flow of $200 per annum.

Target payback period for machine A is 3 years.

2, GOGO Ltd spent $100,000 to purchase a machine B and expects to generate

into future cash flow as follows:

Years Cash flow($000)

1 50,000

2 40,000

3 30,000

4 25,000

5 20,000

Target payback period for machine A is 3.5 years.

Required:

Calculate the payback period for machine A and B.

Answer:

Machine A:

$1,000

$200 = 5years (reject project)

Machine B:

Years Cash flow($000) Cumulative cash flow

0 (100,000)

1 50,000 (50,000)

2 40,000 (10,000)

3 30,000 20,000

4 25,000

5 20,000

Payback period= 2years+ 10,000 =2.33years (accept project)

30,000

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Comment on payback period

Advantages:

1, it’s easy to calculate and understand.

2, when company has limited cash resources and want to speed up the return.

3, it uses cash flow not profit and hence reduce manipulation.

Disadvantages:

1, it doesn’t give a return but just to indicate when the initial investment would

be recovered.

2, it ignores time value of money.

3, it doesn’t consider cash flows beyond payback point.

4, any target payback period set it subjective.

Tutor tips: Because payback period:

It ignores time value of money- So discounted payback has been developed.

It doesn’t consider cash flows beyond payback point. - So duration has been

developed.

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Accounting rate of return (ARR)

This means we invested money into project and how much profit we can get as

a percentage of investment.

Decision criteria: If this is greater than target accounting rate of return then

we should accept this project.

Calculation:

ARR (ROCE/ROI) = AAP (Annual Average profit) X100

AI (Average Investment)

AAP:

Total cash profit(Sales-Expenses) X

-Total depreciation(Cost-RV) (X)

Total profit X

No of years X

AAP X

AI= initial investment + residual value

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Initial investment=fixed capital +working capital

Residual value = fixed capital residual value + working capital recovered

LALA ltd

LALA ltd is considering investing in a project which generates Sales of $500 and

incurs expense of $250.

The initial investment in the project is to be $100 and at the end of 5th year it can

be scrapped for $10.

LALA ltd would need to spend $20 buying inventory and plans to incur $10

receivable from customers as well as $5 payable to suppliers.

At the end of 5th year 80% of working capital would be recovered by LALA ltd.

Required:

Calculate ARR of this project for LALA ltd.

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Answer:

ARR (ROCE/ROI) = AAP (Annual Average profit) X100

AI (Average Investment)

AAP:

Total cash profit(Sales-Expenses) 500-250 250

-Total depreciation(Cost-RV) 100-10 (90)

Total profit 160

No of years 5

AAP 32

AI= initial investment + residual value

2

fixed capital +working capital + fixed capital residual value + working capital

recovered

=100+ (20+10-5) +10 + 80% (20+10-5)

=155/2=77.5

So ARR= 32 = 41.3%

77.5

Comment on ARR

Advantages:

1, it’s easy to calculate and understand.

2, it’s widely used by company to evaluate projects.

3, it can be calculated from available accounting data.

Disadvantages:

1, it doesn’t consider time value of money.

2, it’s based on subjective accounting profit and easy to subject to manipulation.

3, it’s easy to be manipulated because it can be expressed in different ways.

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Net present value (NPV)

Basic NPV theory

This method considers time value of money.

Time value of money means as time goes by the value of money goes down.

Decision rule:

If NPV>0 then accept the project

If NPV<0 then reject the project

Pro forma:

Yeas 0 1 2

1. Net trading revenue

2. Tax payable

3. Tax allowances

4. Capital expenditure

5. Residual value

Working capital

Net cash flow

Discount factor

Present value

Comment on NPV

Advantages:

1. Project with a positive NPV will increase company value and hence maximize

shareholders wealth.

2. It considers time value of money and hence opportunity cost of capital.

3. It is based on cash flow not profit and hence less subject to manipulation.

4. It is an absolute measure of return and it can reflect the size of a project.

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Disadvantages:

1. Determination of future cash flow would be difficult and subjective.

2. Determination of discount rate would be difficult.

Tax allowances:

Year Capital allowance Tax relief (30%) Timing

0 (1,000)

1 1,000X25%= 250 75 2

2 250X75%= 188 56 3

3 188X75%= 141 42 4

3 Balancing =allowance 371 111 4

1,000-50= 950

Tax Exhaustion

Year 1 2

PBT 3 8

Tax paid (25%)

PAT

Capital allowance is 4 in year 1 and 2.

Required: calculate PAT.

Answer:

Year 1 2

PBT 3 8

Tax paid (25%) 0 (0.75) (W)

PAT 3 7.25

W:

Tax paid in year2:

Way1:

Tax paid based on PBT: 8X25% = (2)

Tax allowance: (1+4) X 25% =1.25

(0.75)

Way2:

Tax paid: (8-5) X25%=0.75

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Other NPV Decisions

1, Asset Replacement

Think about you owned a car which helps you walk less. You bought it in 2000

and now decides to replace this car and after you replace this car which still

helps you walk less which has the same effect as before and so one of the

assumptions that asset replacement would consider is that this happens

throughout the lifecycle of the business and assumes revenue generated from

the replacement of assets is the same.

Another assumption is that the operating efficiency of machines will be similar

with differing machines or with machines of differing ages.

So how can we calculate the costs associated with the asset replacement?

1, calculate NPV of each asset

2, calculate EAC for each asset (=NPV/annuity)

3, compare and rank the asset with a lower EAC.

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Example: EAC Company:

EAC Company is considering the replacement of an asset with the following two

machines:

Machine

A B

$000s $000s

INVESTMENT COST 60 30

Life 3 years 2 years

Running costs 10 p.a. Yr 1: 20

Yr 2: 15

Residual value 5 nil

Required:

Determine which machine should be bought using a NPV analysis at a cost of

Capital of 10%.

Answer:

Year CF DF@10% Discounted CF

A B A B

0 (60) (30) 1 (60) (30)

1 (10) (20) 0.909 (9) (18)

2 (10) (15) 0.826 (8) (12)

3 (10)+5 - 0.751 (4) -

1,NPV (81) (60)

2,Annuity factor 2.487 1.736

3,EAC 32.57 34.56

4,Ranking 1 2

Comment of EAC:

Main criticism would be:

It assumes revenue of each asset are the same.

It ignores technological change.

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2. Capital rationing

General issues:

It means a limit on the level of funding available to a business, there are two

Types:

1, hard capital rationing

2, soft capital rationing

*hard capital rationing means the limit is externally imposed by banks.

Due to:

Wider economic factors (e.g. a credit crunch)

Company specific factors

(a) Lack of asset security

(b) No track record

(c) Poor management team.

2, Soft capital rationing means the limit is internally imposed by senior

management.

Issue: Contrary to the rational aim of a business which is to maximize

shareholders’ wealth (i.e. to take all projects with a positive NPV)

Reasons:

1. Lack of management skill

2. Wish to concentrate on relatively few projects

3. Unwillingness to take on external funds

4. Only a willingness to concentrate on strongly profitable projects.

Mutually exclusive project means you can’t do both of them.

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Single period or multi period capital rationing:

1, Single period capital rationing

Divisible projects

It means funds are limited at a time.

If the project is divisible then we can use profitability index. Example would be

looking at APC we have a study project including basic, super and gold study

packages and if we have limited funds right now and we can only make good use

of our funds given those packages which would generate into a higher NPV.

Example:

Funds are just $200.

Project 1 would include the following items:

Items Initial investment NPV

A 100 25

B 200 35

C 80 21

D 75 10

Required:

Which items should we invest in order to maximize the return to company?

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Answer:

PI & ranking

Items Initial investment NPV Profitability index(PI)(NPV/II) ranking

A 100 25 0.25 2

B 200 35 0.175 3

C 80 21 0.265 1

D 75 10 0.133 4

Production schedule:

Items Funds NPV

200

C (80) 21

120

A (100) 25

20

B (20) 20

200 X 35 =3.5

0 Total NPV 49.5

Indivisible projects

Example:

Funds are just $200.

Project 1 would include the following items:

Items Initial investment NPV

A 100 25

B 200 35

C 80 21

D 75 10

Item A and C are mutually exclusive.

Required:

Which items should we invest in order to maximize the return to company?

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Answer:

PI & ranking

Items Initial investment NPV Ranking based on NPV only

A 100 25 2

B 200 35 1

C 80 21 3

D 75 10 4

Items Funds NPV

200

B (200) Total:35

0

Items Funds NPV

200

A (100) 25

100

D (75) 10

25

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2, Multi period capital rationing

It means funds are limited not just at a time.

Steps: Mnemonics: DD computer

1: define objective

2: define constraints

Indivisible projects: either 0 or 1

Divisible projects: 0<X<1

3: slot into computer and let it do this.

Example:

Projects A B C

Funds required:

Year 0

30

-

40

Year 1 - 20 50

Year 2 40 50 60

NPV 50 70 80

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Funds available:

Year 0: 65

Year 1: 60

Year 2: 100

Required:

Layout steps involved in determining optimal mix of projects in order to

maximize NPV of the business.

-if projects are indivisible

-if projects are divisible.

Answer: DDD computer

1: define objective

Z=50A+70B+80C

2: define constraints

If projects are indivisible: if projects are divisible:

A, B and C would be 0 or 1. 0<A, B, C<1

30A+40C <=65

20B+50C<=60

40A+50B+60C<=100

3: slot into computer and let it do this.

3. Lease or buy decision

A specific decision that compares two specific financing options, the use of a

finance ease or buying outright financing via a bank loan.

Key concerns:

1. Discount rate = post tax cost of borrowing

The rate is given by the rate on the bank loan in the question, if it is pre-tax then

the rate must be adjusted for tax. If the loan rate was 10% pre-tax and

corporation tax is 30% then the post -tax rate would be 7%. (10% x (1 – 0.3)

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Free Cash flows

Bank loan Finance lease

1, Cost of investment 1. Lease rental

2, WDA tax relief on investment 2. Tax relief on rental

3, Residual value

Banana Ltd

Banana plc is considering how to finance a new project that has been accepted

by its investment appraisal process.

For the four year life of the project the company can either arrange a bank loan

at an interest rate of 15% before corporation tax relief. The loan is for $100,000

and would be taken out immediately prior to the year end. The residual value of

the equipment is $10,000 at the end of the fourth year.

An alternative would be to lease the asset over four years at a rental of $30,000

per annum payable in advance.

Tax is payable at 33% one year in arrears. Capital allowances are available at

25% on the written down value of the asset.

Required:

Should the company lease or buy the equipment?

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Answer:

Buy:

Year 0 1 2 3 4 5

CAPEX (100)

Tax relief(W) 8.3 6.3 4.7 10.6

RV 10

Net CF (100) - 8.3 6.3 14.7 10.6

DF (15%X(1-33%) 1 0.909 0.826 0.751 0.683 0.621

PV (100) - 6.856 4.731 10.040 6.583

NPV= (71,800)

Lease:

Year CF AF @(15%X(1-33%)=10%

0-3 Rental

expense

(30,000) 3.487 (104,610)

2-5 Tax relief 9,900 2.881 28,530

(76,100)

Decision: lease the asset

Free cash flow

Free cash flow to firm is cash flow from operations+ interest expense -cash flow

from investing activities.

Free cash flow to equity is free cash flow-interest expense (net of tax)-net debt

borrowing.

Once we have calculated the free cash flow to equity we can then establish the

dividend cover based on free cash flow to equity. We have learnt how to

calculate dividend cover where we take PAT/Dividend paid. But before PAT is

profit and it’s subject to manipulation by management so we can use a cash flow

approach to do this.

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There are 2 ways to calculate free cash flow to equity:

Direct method:

PAT x

Adjustment for non cash item x

Adjustment for changes in working capital x

-cash flow from investing activities x

Adjustment for net debt borrowing x

Free cash flow to equity x

Indirect method:

Free cash flow x

-Interest paid (net of tax)-because in free cash flow we have subtracted the whole taxes x

Adjustment for net debt borrowing x

Free cash flow to equity x

Free cash flow needs to be assessed not in a single period because sometimes

company would spend money into expanding the business in the current year so

the current year’s free cash flow would be low but it does benefit the company

for the long term.

Example Human Ltd

The following statement of profit or loss relates to Human Ltd.

$m

Sales 90

Cost of sales (30)

Gross profit 60

Operating expense (20)

PBIT 40

Interest (10)

PBT 30

Tax@20% (6)

PAT 24

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During the year loan repayments are expected to amount to $20 million.

Issue of new debt is $69m.

Deprecation charge is $30 million and capital expenditure is $10 million.

Human ltd bought $3 inventory during the year.

Human Ltd ha 100m shares in issue and DPS is $0.03.

Required:

1, calculate free cash flow to firm

2, calculate free cash flow to equity

3, calculate dividend cover using free cash flow to equity method.

Answer:

1, FCF to firm:

PBIT 40

Tax at 20% on PBIT (8)

32

Depreciation 30

Working capital (3)

Capital expenditure (10)

FCF to firm 49

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2, FCF to equity:

Indirect method:

FCF to firm 49

-interest net of tax (10 x (1-20%)) (8)

Adjustment to net debt borrowing

(69-20)

49

FCFTE 90

Direct method:

PAT 24

Adjustment to non cash item

Depreciation

30

Adjustment to working capital (3)

CAPEX (10)

Adjustment to net debt borrowing

(69-20)

49

FCFTE 90

3, dividend cover: = FCFTE

Dividend value

= 90

100mX0.03

=30times

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1, Risks & Uncertainty

2, Sensitivity analysis

This means by what extent something changes then NPV becomes 0.

There are 3 types of sensitivity analysis which can be asked in the exam:

For:

Selling price,

Variable cost,

Fixed cost,

Units to sell,

Initial investment,

Scrap value.

We use: Sensitivity margin= NPV X100

PV of variable

For:

Number of years we use discounted payback period methods.

For:

Cost of capital we use internal rate of return (IRR).

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Example Sisi

The following NPV analysis of SISI ltd would be as follows:

Years 0 1 2

Sales revenue 100 100

Variable Costs (5) (5)

Fixed costs (5) (5)

CAPEX (100)

Scrap value 10

Net cash flow (100) 90 100

Discount factor (10%) 1 0.909 0.826

Discounted cash flow (100) 82 83

NPV=65

Required:

Provide a sensitivity analysis of the above variables including:

1, sales revenue;

2, variable costs;

3, fixed costs;

4, units to sell;

5, capital expenditure;

6, scrap value;

7, cost of capital;

8, number of years.

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Answer:

Sensitivity margin for:

1, sales revenue= NPV = 65 X100= 37%

PV of sales revenue 100X0.909+100X0.826

It means if sale revenue drops by 37% (or 37%X100=37) then NPV=0.

2, variable costs= NPV = 65 X100= 749%

PV of variable costs 5X0.909+5X0.826

It means if variable costs increase by 749 % (or 749%X5=37.5) then NPV=0.

3, fixed costs= NPV = 65 X100= 749%

PV of fixed costs 5X0.909+5X0.826

It means if fixed costs increase by 749% (or 749%X5=37.5) then NPV=0.

4, units to sell= NPV = 65 X100= 39%

PV of contribution (100-5) X0.909 + (100-5) X0.826

It means if units to sell decreases by 39% (or 39%X (100-5) =37) then NPV=0.

5, capital expenditure= NPV = 65 X100= 65%

PV of CAPEX 100X1

It means if capital expenditure increase by 65% (or 65%X100=65) then

NPV=0.

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6, scrap value= NPV = 65 X100= 79%

PV of scrap value 10X0.826

It means if scrap value decreases by 79% (or 79%X10=7.9) then NPV=0.

7, cost of capital: (IRR approach)

1,




NPV=65

2,




NPV=44

IRR=L+ NPV L X (H-L)

NPV L – NPV H

=10%+65 X (20%-10%)

65-44

=41%

So when cost of capital increases to 41% or increases by 31 % (changes from

10% to 41%) then the NPV=0.

8, number of years (discounted cash flow method)

Years 0 1 2


Cumulative cash flow (18) 65

So

Number of years=1+18 = 1.22 years

83

So when project life becomes 1.22years then the NPV=0(breakeven).

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3, Monte Carlo simulation

Sensitivity analysis we have looked at just analyze the single variable change

would have an impact on the NPV which haven’t included all of other variables.

E.g., in the real life variable costs increase by 5% then company might want to

increase its selling price of 5% in order to compensate for the losses then it

would have a further impact on the NPV.

So using Monte Carlo Simulation which would help us identify all of the variables

and set up the relationship among them and usually this would be done by a

computer ERP system.

In the exam you are required to know the steps involved in the Monte Carlo

Simulation and comment about it.

Steps:

1. Specify all major variables

2. Specify the relationship between those variables

3. using a probability distribution, simulate each environment.

Comment:

Advantage:

It includes all foreseeable outcomes.

Disadvantages

It’s difficult in formulating the probability distribution and the model becoming

very complex.

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4, Value at risk

It means that although we have established the NPV of this project is to be 100

but maybe we haven’t got 100% confidence that we can get these full 100 but

instead we are confident to get 180 of it. So there would be a value of 20 at risk

that we can’t get.

So that value at risk is a value we are going to lose.

Z can be found in normal distribution table:

If it’s 99% confidence then Z=2.33

If it’s 95% confidence then Z=1.65

Standard deviation graph:

Probability

Value

mean

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Something we are going to lose [Value at risk(VAR)]:

In one period:

VAR (1 period) = XZ

More than one period:

VAR (multi period) =VAR (1 period) X T

T would stand for how many times that 1 period would become multi period.

Eg, if one period=1year and multi period=5years then T=5.

If one period is 3months and multi period =1year then T=4.

Something we can get at least:

Mean-VAR

If we are given , the mean and actual result then we can calculate Z

and from distribution table we can find the % that we can get the actual

result.

What is ?

This is a measure of how data would be different from the average figure

(mean).

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Example: Apple Ltd

Apple ltd has estimated an annual standard deviation of $800,000 on one of its

other projects, based on a normal distribution of returns. The average annual

return on this project is $2,200,000.

Required:

Estimate the project’s Value at Risk (VAR) at a 99% confidence level for one

year and over the project’s life of five years.

Answer:

In one period:

VAR (1 period) = XZ =$800,000 X2.33=$1,864,000.

This means we would have a 1% of chance to lose $1,864,000 in 1 year.

In turn we have a 99% chance to get $2,200,000-$1,864,000=$336,000.and

this is the X value.

5 years

VAR (multi period) =VAR (1 period) X T =$1,864,000X 5 =$4,168,000.

This means we would have a 1% of chance to lose $4,168,000 over a 5 year

period.

In turn we have a 99% chance to get $2,200,000X5 -$4,168,000

=$6,832,000.and this is the X value.

37


Apple ltd (continued):

Apple ltd has estimated an annual standard deviation of $800,000 on one of its

other projects, based on a normal distribution of returns. The average annual

return on this project is $2,200,000.

Required:

Calculate the percentage that Apple Ltd can guarantee to get at least $336,000.

Answer:

= 336,000 -2,200,000

800,000

=2.33

From the normal distribution table this gives us 0.4901 and due to its “mirror

effect” then we take 0.4901+0.5=99% so this means there would be 99% of

chance we can get 336,000 and 1% of chance we will lose 336,000

-2,200,000=$1,864,000.

38


Option pricing model

Real options &Black-Scholes Option Pricing Model in investment decision making

When appraising the project the traditional NPV method doesn’t consider future

uncertainty relating to the project, i.e., a rise in material price leading to rise in

production costs to company would make company delay its projects to a

certain date later and if this is the case then we need to calculate that value

management would make as well, i.e., by delaying projects would save

company money and hence increase the overall value in the project as well.

1, Real Options

Types of options: (Real Options)

Option to delay To start a project later when it’s in at appropriate time

Option to expand To expand its business buying more NCAs or investment in overseas

Option to abandon To sell off something at the end of its life

Option to redeploy To abandon something in order to improve it

The first two options would be call options: a right to buy in the future, i.e.,

spending money.

The last two options would be put options: a right to sell in the future, i.e., to

withdraw something.

Project value= traditional value (NPV) + option value*

39


*option value

This means an uncertainty taken into account by management into appraising a

project such as the options outline above.

Factors affecting option value

Call option value Put option value

Market price

Exercise price

Time to expiry

Volatility

Interest rate

Of course using Black Scholes Option pricing model can give you that option

value.

Black Scholes Option pricing is a European style option meaning it can be

exercised only ON the expiry date.

American option can be exercised before the expiry date.

40


The calculation is to use Black-Scholes Option Pricing Model and your P4

examiner tends to focus on “option to delay” which has been tested in DEC2007

and June2011.

Formulae: (this has been given in your formulae sheet):

c= call option value

Pa= future cash flow resulting from the investment

Pe =cost incurred relating to the investment

e= 2.7183 (exponential constant which is developed by scientist)

r= risk free rate (not cost of capital)

t= time remaining before costs incurred (ie, the investment begins in 2years

time so t=2 not 24months because it’s expressed in years.)

2, Black Scholes Option Pricing model

Characteristics of Black Scholes Option Pricing model:

Transaction costs and taxes are zero;

The share pays no dividends;

The option has European exercise terms;

The short-term (risk-free) interest rate is known and constant.

The standard deviation of returns must be estimated and be constant over

the life of the option;

41


Q MMC (June2011 Q4) (call option)

Mesmer Magic Co (MMC) is considering whether to undertake the development

of a new computer game based on an adventure film due to be released in 22

months. It is expected that the game will be available to buy two months after

the film’s release, by which time it will be possible to judge the popularity of the

film with a high degree of certainty. However, at present, there is considerable

uncertainty about whether the film, and therefore the game, is likely to be

successful. Although MMC would pay for the exclusive rights to develop and sell

the game now, the directors are of the opinion that they should delay the

decision to produce and market the game until the film has been released and

the game is available for sale.

MMC has forecast the following end of year cash flows for the four-year sales

period of the game.

Year 1 2 3 4

Cash flow 25 18 10 5

MMC will spend $7 million at the start of each of the next two years to develop

the game, the gaming platform, and to pay for the exclusive rights to develop

and sell the game. Following this, the company will require $35 million for

production, distribution and marketing costs at the start of the four-year sales

period of the game.

It can be assumed that all the costs and revenues include inflation. The relevant

cost of capital for this project is 11% and the risk free rate is 3·5%. MMC has

estimated the likely volatility of the cash flows at a standard deviation of 30%.

Required:

(a) Estimate the financial impact of the directors’ decision to delay the

production and marketing of the game.

The Black-Scholes Option Pricing model may be used, where appropriate. All

relevant calculations should be shown.

(12 marks)

(b) Briefly discuss the implications of the answer obtained in part (a) above.

(5 marks)

(17 marks)

42


Answer:

(b)

It allows uncertainty to be considered when appraising a project.

I.e., if the film is so successful then company would continue its investment.

Based on the traditional NPV calculation it is a negative figure which is

unacceptable from shareholders perspective but when the option value is

calculated and integrated then it would be attractive because it’s positive.

This calculation has lots of assumption and hence limitations come when

doing the calculation, e.g.:

1. Transaction costs and taxes are zero;

2. The share pays no dividends;

3. The option has European exercise terms;

4. The short-term (risk-free) interest rate is known and constant.

5. The standard deviation of returns must be estimated and be constant over

the life of the option;

Company would have other options not just to delay, ie, when investing

money into the game platform maybe lots of programmers can be used

potentially for other future game centers as well and hence option to

redeploy can be considered.

Or if the project is successful and so lots of advertisement expenses would

go into the company and hence company can further expand its businesses,

ie, option to expand by taking follow-on projects involving games based on

film sequels

43


Q Dilute Ltd

Assume that Dilute ltd is considering taking a 20-year project which requires an

initial investment of $ 250 million in a real estate partnership to develop time

share properties with a UK real estate developer, and where the present value of

expected cash flows is $ 254 million. While the net present value of $ 4 million

is small, assume that dilute ltd has the option to abandon this project anytime

by selling its share back to the developer in the next 5 years for $ 150 million.

A simulation of the cash flows on this time share investment yields a variance in

the present value of the cash flows from being in the partnership of 0.09. The 5

year risk-free rate is 7%.

Required:

Calculate the total NPV of the project, including the option to abandon.

Answer:

44


Adjusted Present Value (APV)

We have looked at NPV calculation and we use WACC (weighted average cost of

capital) to discount cash flow.

WACC has incorporated debt and equity element and one of the arguments for

this is future sales, costs incurred have nothing to do with financing but instead

they are something to do with operations.

So that’s why we developed APV to separate business option from financing.

APV is used when you are appraising a project where its financial risk is

changed.

This means we use cost of equity (ungeared) to discount the basic cash flow

including revenue & expenses because they are something to do with business

not finance.

We can then establish present value of finance effect including issue cost, tax

saving on interest and subsidy as well and for these items we use risk free

rate/cost of debt to discount because APV doesn’t specify which discount rate

we should choose and you can argue that e.g., for tax saving on interest we

have no idea when tax rate may change and as a result we can use Rf or Kd to

discount the cash flow. Here notice you can either use Rf or Kd to discount cash

flow and whichever you use your examiner would give you a mark in the

exam(although your answer may be different from examiner’s and that’s totally

acceptable).

45


Calculation:

APV= Base case NPV + PV of Finance Effect

Issue costs

Tax savings on interest

Subsidy

Only include relevant cash flow from operations

Discount factor would only include BR (Keu)

But when Co is geared(2approach to separate (Keu))

M&M preposition Beta

2 cost of equity Keg=Keu+(Keu-Kd)D(1-T)

E

Geared Ungeared

3 WACC WACC(g)=WACC(ungeared)(1-Dt )

(Keu) D+E

1, ungeared βa= βe [ E ]

E+D(1-T)

2,CAPM Keu=rf+βa(Rm-Rf) Keu=rf+βa(Rm-Rf)

PV of finance effect calculation:

Issue costs:

1, % X amounts raised (not amounts required)

2, net off with tax saving

3, discount them

Tax saved on interest:

1, interest expense

2, multiply by tax rate

3, discount it

Subsidy:

1, PV of tax shield on interest

2, PV of subsidy (amounts saved net of tax because save interest=save

expense so increase in tax)

46


Base Case NPV Example1:

Company A is an equity finance company with Ke=10%.

Company B is considering a project that would cost $100,000 to be financed

50% by equity (ke= 21.6%) and 50% by debt (kd (pre-tax) =12%).

Required:

Calculate Keu for company A and company B.

Answer:

Company A: Keu=10%

Company B:

Keg=Keu + (Keu-Kd)D(1-T)

E

21.6% =Keu + (Keu-12%) X 50 X (1-30%)

50

Keu=17.6%


Company has the following market value of finance:

Value of debt is $6m.

Value of equity is $11.8m.

Company’s current WACC is 19.7%.

Tax rate is 30%.

Required:

Calculate Keu for company.

Answer:

WACC (g) =WACC (ungeared) (1- Dt )

(Keu) D+E

19.7% =WACC (ungeared) X 1- 6X30%

6+11.8

WACC (ungeared) (Keu) =21.9%

47



Company diversifies its business by entering into the mining industry.

The company’s equity beta is 0.85, and its financial gearing is 60% equity, 40%

debt by market value.

The average equity beta in the mining industry is 1.2, and average gearing 50%

equity, 50% debt by market value.

Tax rate is 30%.

The risk free rate is 5.5% per annum and the market return 12% per annum.

Required:

Calculate Keu.

Answer:

1,

ungeared

βa= βe [ E ]

E+D(1-T)

βa=1.2 x 50

50+50 X (1-30%)

=0.71

2,CAPM Keu=rf+βa(Rm-Rf) Keu=5.5%+0.71X12%

=10%


Company has an equity beta of 0.85 and asset beta of 0.5.

Rf =5%

Rm=10%

Required:

Calculate Keu.

Answer:

Keu= Rf+βa(Rm-Rf)

=5%+0.5x(10%-5%)

=0.075

48


Example: (JOJO Ltd) (issue cost)

CAPEX required: $20m

How to raise $20m: from a 1 for 3 rights issue at a price of £2 per share.

Right issue cost: 5%.

Rf: 10%.

Required:

Calculate issue cost to be incorporated into APV calculation where:

1, issue cost is not a tax allowable expense

2, issue cost is a tax allowable expense and tax is paid 1 year in arrears while tax

rate is 30%.

Answer:

1,

Amounts raised – issue costs = amounts required

100% 5% 95%

20m

20/0.95

=21.05 21.05-20=1.05

21.05X5%

DF @ yr 0= 1.05X1=1.05

APV= base case NPV - 1.05

2, DF@10% PV

Issue cost = 1.05 (1) yr0 1 (1.05)

Tax saved: 30%X1.05 =0.315 yr1 0.909 0.32

(0.73)

APV= base case NPV - 0.73

49


Example: TT Ltd (tax saving on interest)

CAPEX required: $10m.

How to raise $10m: use a 5 year bank loan (year1-5) and interest expense is

10%.

Tax is paid 1 year in arrears at 30%.

Rf =10%.

Required:

Calculate tax saving on interest to be incorporated into APV calculation.

Answer:

1, interest 10%X$10m=$1m.

2, tax saved: 30% X$1m= $0.3m

3, discount it:

1 year in arrears based on year 1-5

$0.3X AF (YR2-6) @10%

$0.3XAF1-6 XDF (yr 1-5)@10%

=0.3X 1/0.1 X (1-1/1.1^5)X0.909

=0.3X3.791X0.909

=1.03

So APV=base case NPV + 1.03

50


Example: SS ltd

CAPEX required=$20m

Company would normally borrow at 8%

Government has offered a loan at 6% (which is lower than market rate)

Risk free rate=5%

Project is for 5years

Tax rate is at 30% paid in the current year.

Required:

Calculate subsidy to be incorporated into APV calculation.

Answer:

1, PV of tax shield on interest

$20m X6%X30% XAF@5%(1-5yr) = 1.56

4.33

2, PV of subsidy

Subsidy %= 8%-6% =2%

Total subsidy p.a.= 2% X$20m=0.4

PV of subsidy (net off tax) 0.4X(1-30%)XAF@5% 5yrs =1.21

APV=base case NPV +1.56+1.21

51


Comment of APV:

1, Difficult to choose an appropriate discount rate for side effect, ie, tax shield.

2, when establish the discount rate for base case NPV, ie, Keu, the beta factor is

based on M&M assumptions.

52


Internal rate of return (IRR)

This is a point at which NPV=0.

It means that any cost of capital which is more than this then company will lose

money.

It also means if any cost of capital=IRR then company would make no profit or

loss out of it so IRR is the maximum cost of capital company would suffer.

But IRR doesn’t consider the size of the project because it uses relative

measure.

IRR has got an assumption that cash flow would be reinvested at IRR but this is

too optimistic because maybe the project is very profitable once and you get

money from this project trying to invest in another profitable project? Well may

be yes and maybe no. Also most business when they got surplus funds they

would invest they in short term security and normally this would yield a lower

return than IRR.

Decision criteria:

IRR>cost of capital -accept the project

Calculation:

IRR= L + NPVL X (H-L)

NPVL-NPVH

Example Insider Ltd:

Insider Ltd has got net cash flows of project over 3 years to be $10m, $20m and

$30m. The cost of capital of Insider Ltd is 10%.

Required:

Calculate the internal rate of return (IRR) for the project.

53


Answer:

Years Net cash flow DF@10% PV

1 10 0.909 9

2 20 0.826 17

3 30 0.751 23

49

Years Net cash flow DF@20% PV

1 10 0.833 8

2 20 0.694 14

3 30 0.579 17

39

IRR= L + NPVL X (H-L)

NPVL-NPVH

=10% + 49 X (20%-10%)

49-39

=59%

54


Modified internal rate of return (MIRR)

Because IRR is too optimistic so that’s why MIRR is developed and MIRR has got

an assumption to reinvest its cash flow based on cost of capital rather than IRR.

Calculation (given in the exam):

Way1: use growth method:

g=(Do )^1/n -1

Dn

Where Do=terminal value

Dn=initial investment

Way2: formulae (particularly useful when you are asked to calculate NPV and

then use NPV to slot into this formulae)

Example: MM ltd

MM Ltd is going to invest in a project with initial investment of $10m and a

further investment at the end of 1st year of $5m (present value is

$5m/1.08=4.6).

Cash flow expected from this project is as follows:

Year Cash

flow

DF@8% PV Compound

factor@8%

Terminal

value

1 6 0.925 6 1.08^4 8

2 5 0.856 4 1.08^3 6

3 4 0.793 3 1.08^2 5

4 3 0.734 2 1.08^1 3

5 5 0.679 3 1.08^0 5

18 27

Required:

Calculate MIRR.

55


Answer:

WAY1：

Year CF DF

0+1 10X1+5X0.925 14.6

1-5 27 So 0.54 (14.6)

0

So from PV table DF should be @ 13%.

Way2: growth method

g=(Do )^1/n -1 = ( 27 )^1/5 -1 =13%

Dn 14.6

Way3:

Use formulae in the exam:

=( 18 )^1/5 (1+8%) -1

14.6

=13%

Comment about MIRR

It gives the same result when using NPV and MIRR

Does not assume that the CFs are reinvested at the IRR

Eliminates the possibility of multiple IRRs

Relative measure, easier for non-financial managers

56


Duration

This is the time taken to recover the approximately 50% of initial investment (if

discounted using IRR) or approximately 50% of present value of the project (if

discounted using cost of capital).

We’ve looked at payback period but it doesn’t consider the time value of money.

Then we developed discounted payback period but still this doesn’t consider the

cash flow beyond the pay back point.

In order to fix this problem we develop DURATION which stands for the average

time it takes to recover the initial investment considering the whole life of

projects.

Calculation:

Duration= PV x YRS

PV

We can develop present value by choosing either IRR or Cost of capital as

discount factor.

Example: Duration ltd

Duration ltd has the following project:

Years Cash flow

0 Initial investment (35)

1 Cash inflow 10

2 Cash inflow 20

3 Cash inflow 30

4 Cash inflow 40

5 Cash inflow 50

Required:

1 calculate the duration of project using IRR of 56% as a discount rate.

2 calculate the duration of project using cost of capital of 30% as a discount rate.

57


Answer:

1, using IRR as a discount rate

Years Cash flow DF @

56%(IRR)

PV PVxYRs

1 Cash inflow 10 0.641 6 6

2 Cash inflow 20 0.411 8 16

3 Cash inflow 30 0.263 8 24

4 Cash inflow 40 0.169 7 28

5 Cash inflow 50 0.108 6 30

35 104

So duration=104/35=2.97years.

2, using cost of capital of 30% as a discount rate

Years Cash flow DF @

30%(COC)

PV PVxYRs

1 Cash inflow 10 0.769 8 8

2 Cash inflow 20 0.592 12 24

3 Cash inflow 30 0.455 14 42

4 Cash inflow 40 0.350 14 56

5 Cash inflow 50 0.269 13 65

61 195

So duration = 195/61=3.19years.

58


Macaulay Duration

This measures the time taken to recover approximately 50% of the initial

investment in the bond.

The method would be the same as the above while for the bond we are going to

discount cash flow using IRR.

Calculation:

Duration= PV x YRS

PV

1, we establish cash flow using coupon rate.

2, we discount cash flow using yield to maturity (IRR).

Example: Ma Ltd

Ma Ltd has a 5 year bond with a coupon rate of 10% at par value and market

value of $80.

At the end of 5th year Ma ltd would get 10% over the par value of bond.

The gross yield to maturity (IRR) is 16%.

Required:

Calculate Macaulay duration for this bond.

Answer:

Years Cash flow PV@16% PV x YRs

1 10 8.6 8.6

2 10 7.4 14.8

3 10 6.4 19.2

4 10 5.5 22

5 110 52.3 261.5

80 326.1

Macaulay duration=326.1 =4.07years.

80

It takes an average of 4.07 years to recover the initial investment in

bond.

59


Bond price:

E.g., 5% coupon rate on 1000 par value.

If MV is 1200 so current yield is 50 =4%

1200

If MV is 800 so current yield is 50 =6%

800

Since par value is only1000 and for the option 1 you would need to pay the extra

of 200 to the company so actually you spent money out and so the gross return

you can get would reduce of course you can buy the bond with a higher coupon

rate in the market.

Since par value is only1000 and for the option 2 you have paid less 200 to the

company so actually you spent money out and so the gross return you can get

would increase of course you can buy the bond with a lower coupon rate in the

market.

Macaulay duration in detail:

This is also a measure of interest rate risk, i.e., as interest rate increases by 1%

then bond price would fall by 4.07% from the above calculation.

But is this correct? Well maybe no because the figure we just calculated is the

straight line figure but the actual figure would be in the slope line.

So we need to account for the error between actual and prediction value.

So that’s why we introduce “Convexity”.

The prediction value is always lower than the actual one so we need to plus that

convexity amount to arrive at the actual value.

60


Modified Duration

An alternative way to calculate the interest impacting on the bond price would

be using “Modified Duration”.

Formulae:

Modified duration= Macaulay duration

1+yield to maturity(gross redemption yield)

Example:

Macaulay duration is 4.07, the gross redemption yield is 3%.

Calculate the modified duration.

Answer:

Modified duration= Macaulay duration =4.07 =3.95

1+yield to maturity 1+3%

This means when interest rate increases by 1% the bond price would fall by

3.95% or if interest rate decreases by 1% the bond price would increase by

3.95%.

Comment

If there’s higher duration this means bond would be more risky than the one

with lower duration.

Maturity period increases then duration increases.

Coupon payment increases then duration decreases.

As interest rate increases the market value of bond decreases and so

duration would decrease as well.

61


Past exam question about Macaulay Duration: (June2011 Q3)

GNT Co is considering an investment in one of two corporate bonds. Both bonds

have a par value of $1,000 and pay coupon interest on an annual basis. The

market price of the first bond is $1,079·68. Its coupon rate is 6% and it is due

to be redeemed at par in five years. The second bond is about to be issued with

a coupon rate of 4% and will also be redeemable at par in five years. Both bonds

are expected to have the same gross redemption yields (yields to maturity).

GNT Co considers duration of the bond to be a key factor when making decisions

on which bond to invest.

Required:

(a) Estimate the Macaulay duration of the two bonds GNT Co is considering for

investment.

(9 marks)

(b) Discuss how useful duration is as a measure of the sensitivity of a bond price

to changes in interest rates.

(8 marks)

(17 marks)

62


(b)

Bonds which pay higher coupons effectively mature ‘sooner’ compared to

bonds which pay lower coupons.

Therefore these bonds are less sensitive to interest rate changes and will

have a lower duration.

Duration assumes there’s a linear relationship between bond price and the

yield to maturity.

As yield to maturity (YTM) increases the bond price decreases.

It also assumes an e.g., 5% increase in YTM would result in 5% decreases in

bond price.

But this is different from the actual price.

So therefore we need to calculate “convexity” between the two and modify

the prediction value.

Duration is only useful in assessing small changes in interest rates.

63


Session1.2 International investment appraisal

When appraising an overseas project using NPV this is very similar to what we

have done in the domestic NPV calculation.

We have 5 steps which would be applied in the international investment

appraisal as well.

64


Pro forma:

Years 0($) 1($) 2($) 3($) 4($)

Sales revenue x x x x

Variable costs (x) (x) (x) (x)

Fixed costs (x) (x) (x) (x)

Taxable profit x x x x

Tax (x) (x) (x)

Tax saving on CA x x x

CAPEX (x)

Residual value x

Working capital (x) (x) (x) (x) x

Net cash flow($) (x) x x x x

Exchange rate(W)

Net cash flow(£) (x) x x x x

Additional tax

Net cash flow(£) (x) x x x x

Discount factor() 1

Present value (x) x x x x

NPV x

The difference between international and domestic NPV calculation is in the

international investment appraisal we include:

1. Retranslating overseas cash flow into home currency.

2. Additional tax we need to pay for.

Retranslation

When retranslating overseas cash flow into home currency we need to use

exchange rate.

So for the year0 (current year) we use the spot rate given by examiner.

But for year1, 2, 3 etc. which exchange rate we should use?

Well, we need to predict those using:

Inflation rate (purchasing power parity theory)*

Interest rate (interest rate parity theory)*

65


*theories

1, PPPT (purchasing power parity theory)

What is it?

It means two currencies should have the same purchasing power, ie, buying

things at the same price in different countries.

If we buy an iPhone in US at $90 then in the UK suppose the current spot rate is

$2/ £ so in the UK we should purchase the iPhone for £45.

In one year’s time the price of the IPhone becomes $94.5 because of the 5%

inflation in US and £47.7 in UK because of the 6% inflation in UK.

In order to make the purchasing power equal(parity) then the exchange rate

would become $1.981/£. (94.5)

47.7

How to apply?

Example:

Spot rate is £1:$2 ($2/£)

Inflation:

UK USA

1 10% 15%

2 8% 10%

3 12% 8%

4 11% 11%

Required:

Estimate the foreign exchange rate for year 1-4.

66


Answer:

St=So X (1+I1)

(1+I2)

Year

1 2X (1+15%) =2.09

(1+10%)

2 2.09 X(1+10%)=2.13

(1+8%)

3 2.13X (1+8%) =2.05

(1+12%)

4 2.05X(1+11%)=2.05

(1+11%)

2, interest rate parity theory (IRPT)

What is it?

It means two currencies should have the same amount. Wherever you’re going

to deposit money that would make no difference.

But in the real life different banks in different world offers different interest rate.

So if the current spot rate between $ and £ is $2/ £ which means if I put $50 in

US bank then it should be equal to £25 in the UK bank.

But if USA bank interest rate is 5% whilst in the UK bank it’s 6% then the money

would become:

US: $50 x (1+5%) =$52.5

UK: £25 X (1+6%) =£26.5

So in order to make two amounts interest rate equal to each other then the

exchange rate would become $1.981/£. ($52.5)

£26.5

67


How to apply?

Example:

Spot rate is £1:$2 ($2/£)

Interest rate:

UK USA

1 10% 15%

2 8% 10%

3 12% 8%

4 11% 11%

Required:

Estimate the foreign exchange rate for year 1-4.

Answer:

St=So X (1+Int1)

(1+Int2)

Year

1 2X (1+15%) =2.09

(1+10%)

2 2.09 X(1+10%)=2.13

(1+8%)

3 2.13X (1+8%) =2.05

(1+12%)

4 2.05X(1+11%)=2.05

(1+11%)

68


Summary international fisher effect (1+m)=(1+r)(1+i)

It means after taking into account the inflation as well as interest rate (included

in m) the real rate of return of two currencies would be the same.

Illustration:

Interest rate Inflation rate

USA UK USA UK

6.08% 4.04% 4% 2%

Required:

What is the real rate of return for $ and £.

Answer:

R($) = 1+m =1+6.08% -1 =2%

1+I 1+4%

R(£) = 1+m =1+4.04% -1 =2%

1+I 1+2%

69


Additional tax

The objective of the company is to maximize shareholders wealth so after

investing money into overseas starting a project those NPV should be remitted

back to the parent company because most of the shareholders would be based

in there.

The question is should be pay additional tax?

Well, this is relating to double tax treaties.

The simple idea being if overseas tax rate is 20% but the home tax rate is 30%

then when remitting dividend to the home country we need to pay additional

10% of tax.

The reason why double tax treaties exist is because if country A has a lower tax

rate than country B then most companies in country B would invest in country A

in order to enjoy a lower tax rate and hence create benefits when competing

with local competitors in country A. so usually country A&B would sign a double

tax agreement to project the local market.

The next question is where do we apply the additional tax rate?

Example:

Years 0($) 1($) 2($) 3($) 4($)

Taxable profit 10 20 30 40

UK US

Tax rate 30% 20%

Tax rate 20% 30%

Tax rate 30% 30%

Required:

What is the additional tax we need to pay?

1.

Years 0($) 1($) 2($) 3($) 4($) 5($)

Taxable profit 10 20 30 40

Additional

tax@10%

(1) (2) (3) (4)

2, no additional tax

3, no additional tax

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